Facing up to the Financial Transaction Tax
A European financial transaction tax on equities and derivatives trades could be damaging for European liquidity levels and the City of London, but it also looks set to impose serious operational challenges for banks, brokers and their buy-side clients following the failure of a UK appeal to the European Court of Justice earlier this year.
“Based on what we know of the FTT so far, there is a strong risk that this will hurt the market,” said Christian Voigt, business solutions architect at Fidessa. “The tax will impact those who trade a lot, such as liquidity providers. Market makers are needed to provide liquidity to the market in times of stress – but the FTT will discourage them from doing so at the very moment when the market needs liquidity the most.”
The Financial Transaction Tax was originally proposed in 2011 as an EU-wide tax of 0.1% on shares and bonds and 0.01% on derivatives. However, the idea is highly controversial, and has been strongly opposed by some countries on the grounds that its extra-territorial effects would be harmful even outside the countries choosing to implement it. A new report by GBST and Deloitte, Financial Transaction Taxes – practical lessons from a strategic solution roll-out, warns that the tax is likely to increase the compliance burden on financial institutions and create major operational processing issues that will need to be addressed.
Objections to the tax point out that financial institutions located outside a participating EU country could be obliged to pay the FTT if they trade securities that were issued within the participating countries. This is called the issuance principle. Also, they may be obliged to pay if they entered a transaction with a financial institution established in the member countries – an approach known as the residence principle. These measures are seen as infringing on the sovereignty of states that have not agreed to the tax. Specifically, the UK objects that the Treaty on the Functioning of the European Union says that any enhanced cooperation must respect the rights and obligations of member states that do not participate in it.
On 30 April the EU Court of Justice rejected a legal challenge from the UK government, on the grounds that there were insufficient details known about the final shape of any financial transaction tax to be sure how it would affect the UK. According to GBST and Deloitte, it remains uncertain whether the tax will follow the issuance principle or the broader residence principle, or some combination of both. The report also notes that “it is widely anticipated that national interests and financial markets will result in divergences” in the tax rates and exemptions available, as well as different methods of collection, payment and reporting.
There are also signs that the tax is causing serious unease further afield. Sweden’s resistance to the tax is widely known, based on a failed experiment with a similar tax that resulted in companies simply leaving the country to avoid paying it. Meanwhile at the end of June, it was reported by Reuters that Germany’s Deutsche Borse was investigating ways of expanding outside the euro area so that its non-European clients could avoid the FTT. These moves include the firm’s new derivatives clearing house in Singapore, and the application its subsidiary Eurex Zurich has made for a licence from US regulator the CFTC.
“We don’t know how the tax would affect the UK, because we don’t know the scope,” said Voigt at Fidessa. “Will it be based on the location of the issuer, or the location of the parties to the trade? The extra-territoriality of the rules is a concern, because markets are global and countries need to acknowledge that their rulemaking will affect others. I understand that the authorities need to raise money. But rules should be made in such a way that they don’t hurt the market.”
Despite these concerns, France and Italy have already unilaterally introduced their own versions of the transaction tax. According to GBST and Deloitte, the French tax introduced in 2012 is the simpler of the two has it applies to equities issued by French companies, in a way that has some similarities with the existing UK stamp duty. However, the report observes that the introduction of daily netting added to the complexity of processing, and that despite high hopes that participants might be able to lower their tax liability by processing the rebates more accurately, in many instances this was not the case. The decision to expand the scope of the tax to include depositary receipts added to the workload of the buy and sell sides.
The Italian tax introduced in 2013 is more expansive because it applies to equities and equity derivatives issued by Italian firms. In addition, the Italian tax features 48 different tax rates and types on derivatives trades, and different rates to on and off-market trades, as well as an aggregated tax rate for trades on and off market, changing exoneration codes, and changes to the tax reporting formats and frequency. Also, the tax has an extra-territorial reach, since it also applies to Italian listings outside Italy, for example Hong Kong-listed Prada shares. GBST and Deloitte note that while brokers involved in the execution of a transaction are responsible for collecting, paying and reporting the tax, in the absence of a broker the asset manager is responsible.
“We see a need for flexibility as more changes are likely in France and Italy when the other EU members catch up,” said Denis Orrock, chief executive at GBST. “Some countries have already put this through their Parliaments and can implement it at any time between now and 2016. We expect to see further updates on this in September. But there are more than 40 transaction taxes out there in use today, so this is nothing new. These taxes are likely to become more widespread in future.”
The remaining EU member countries Germany, Austria, Belgium, Greece, Portugal, Slovakia, Slovenia and Spain have all committed to introduce the FTT by January 2016.