On 28 September 2011, the European Commission published a draft directive proposing the introduction of a financial transaction tax (FTT) across all of the member states of the European Union. In essence, the FTT would operate to tax all transactions in ‘financial instruments’ to which a ‘financial institution’ is party, provided at least one party to the transaction is established in the EU.
This article gives a brief background to the proposed FTT, outlines how it is intended to operate and who will be subject to the tax, and identifies certain concerns with the tax, both in terms of its specific provisions as well as with the tax in principle.
WHY HAS AN FTT BEEN PROPOSED?
The Commission has made no attempt to mask the fact that the FTT is effectively a form of punishment for the role of the financial sector in the ongoing global economic and financial crisis. The Commission reasons that governments and European citizens have borne the cost of this crisis and the associated bail-outs and that the financial sector should make a fair contribution to such costs.
A further, more high-minded (if seemingly somewhat secondary) objective of the FTT is to discourage risky trading activities such as high-volume, low-margin automated trading. These activities are considered undesirable due to their perceived potential to damage financial markets and the fact that they serve no wider business purpose other than generating profit. It is estimated that an FTT would remove much of the profit derived from such activities, causing such activities to decrease by 70-90%.
WHY IS THE FTT BEING PROPOSED AT AN EU LEVEL?
Taxation in the EU is still largely a domestic issue for member states (other than VAT), so why is the FTT being proposed at an EU level? The Commission wishes to avoid member states taking different approaches to taxing financial institutions or transactions that might lead to tax arbitrage opportunities, potential double taxation and tax competition.
Tax competition (between the tax regimes of different jurisdictions) is a particular concern in the context of the highly mobile and global financial services sector, which has the flexibility to relocate activities to mitigate onerous tax obligations. The experience of Sweden is an often cited example – when, in the 1980s, Sweden introduced an FTT, the bond, futures and options trading markets all but disappeared overnight, moving to untaxed markets such as London. Imposing the FTT on an EU-wide basis is intended to address such relocation issues, although the Commission does not explain why the same would not just happen again on an EU level.
COST AND BENEFIT
The Commission recognises that there will be a cost to member states introducing the tax, deriving from the impact of the tax on certain types of financial activity, the relocation of financial institutions and, most importantly, institutions passing the tax on to their customers. However, the Commission states that these costs should be ‘limited’ to a reduction in GDP of around 0.5%. The Commission does not, however, discuss the likely uneven spread of such costs between member states (the impact of the FTT inevitably being much greater for those member states with significant financial services sectors).
Predictably, the Commission shouts rather louder about the financial benefit of the FTT to the EU, estimating that it will raise approximately €57bn per annum. As an EU-wide tax like VAT, the revenues generated would contribute to the EU budget. However, as a carrot offered by the Commission to those states that might otherwise be reluctant to support the FTT, it is proposed that the FTT could replace, in whole or in part, the current system of member state contributions to the EU budget, meaning that member states would ultimately benefit financially from the FTT.
OUTLINE OF THE PROPOSED FTT
When will an FTT charge arise?
The FTT will be payable where:
- there is a ‘financial transaction’;
- involving a ‘financial institution’ (acting as principal or agent); and
- at least one of the parties to such transaction is ‘established’ in an EU member state.
The key aspects of the FTT are explained further below.
What is a ‘financial transaction’?
A financial transaction is defined as:
- the purchase and sale of a ‘financial instrument’ before netting and settlement;
- an intra-group transfer of a financial instrument to the extent not already caught within the point above; and
- the conclusion or modification of a derivatives agreement.
‘Financial instrument’ has a wide definition, including shares, securities, bonds, units and shares in collective investments undertakings, derivatives and structured financial products (such as securitised products).
What is not a financial transaction?
The FTT is not intended to apply to day-to-day financial activities relevant to businesses and individuals, such as:
- mortgage lending;
- consumer credit;
- insurance contracts; and
- payment services.
The definition of financial transaction also does not include spot currency transactions and physical commodity transactions. However, derivative or structured products in relation to all of the above activities will be caught.
There are also a number of transactions that have been specifically excluded, the most important of these being primary market transactions, such as share and bond issues (although the issue and redemption of shares and units in Undertakings for Collective Investment in Transferable Securities (UCITS) and alternative investment funds is not excluded).
What is a ‘financial institution’?
Financial institution has a wide definition, including:
- investment firms;
- stock brokers;
- insurance and reinsurance companies;
- alternative investment funds (eg hedge funds);
- credit institutions;
- pension funds and their investment managers; and
- certain special purpose vehicles.
These are obvious financial institutions in the ordinary meaning of that phrase, but the FTT definition also extends to any other entity that carries out the following financial activities to a significant extent:
- deposit taking, lending, financial leasing and providing guarantees and commitments;
- trading as agent for customers or principal in any financial instruments;
- acquiring holdings in undertakings; and
- participating in, or issuing, financial instruments and providing services related to such activities.
‘Established’ in the EU
A financial institution will be liable to the FTT in respect of a financial transaction if it is established in the EU. Establishment derives from the location of any of the following:
- regulatory authorisation for the relevant transaction;
- the registered seat;
- permanent address or usual residence; or
- branch location.
There is however an important additional limb to the definition – a financial institution that is not established in the EU under any of the above criteria will be deemed to be established in the EU should any other party to the financial transaction (whether a financial institution or not) be established in the EU.
KEY MECHANICS OF THE PROPOSED FTT
When will the tax be introduced?
The Commission intends for the FTT to apply from 1 January 2014, subject to the legislative process progressing as anticipated and with full member state support.
Who will be liable?
The relevant EU-established financial institution is primarily liable for the FTT.
However, significantly, every other counterparty to a financial transaction (whether a financial institution or not) is joint and severally liable with the relevant financial institution where any FTT has not been paid by the due date.
What will be the applicable tax rate?
Each EU member state is able to set its own FTT rate, subject to the following minimums:
- derivative-related financial transactions – 0.01%
- other (non-derivative) financial transactions – 0.1%
To what amount will the tax rate apply?
For derivative-related financial transactions, the amount subject to tax is the underlying nominal or face amount used to calculate payments.
For all other (non-derivative) financial transactions, the amount subject to tax is the consideration paid or owed. However this amount will be replaced with a market price figure if the total consideration is less than the market price or the financial transaction is intra-group.
When would the tax be payable?
The FTT becomes chargeable at the moment the financial transaction occurs. This FTT must then be paid to the relevant member state’s tax authority:
- immediately, if the transaction occurs electronically;
- otherwise, within three working days of the transaction.
The FTT appears to apply to every qualifying financial institution that is party to a particular financial transaction (including agents and intermediaries). As a result, for any one transaction, multiple FTT charges can arise. Although the proposed rates are low, on a complex transaction, there is potential for the cumulative FTT charge to become significant.
One particular concern identified in the consultation process was hedging arrangements. These often involve a series of transactions, each of which is likely to attract a FTT charge. For example, say a UK company takes out a floating rate, fixed-term loan that it wishes to hedge to a fixed rate via periodic fixed/floating rate swaps with a bank. On the inception and close of each swap, the bank will be required to pay the FTT. The bank would then be likely to pass this tax cost on to the UK company, increasing the overall cost of a standard hedging arrangement.
The wide territorial scope of the FTT has the potential to cause significant problems. As identified above, a financial institution will be deemed to be established in the EU (and so be liable to FTT on a financial transaction) where any counterparty to the relevant financial transaction is established in the EU. This essentially brings any global financial institution transacting with an EU counterparty into the scope of the FTT. There is a carve-out if it can be proved that there is ‘no link between the economic substance of the transaction and the territory of a member state’, but it is questionable how useful this carve-out will be.
So, in the standard hedging example above, were the hedging bank to be based in the US, it would still be liable to FTT on the basis that the hedging counterparty is a UK company.
Liability of non-financial institutions
Significantly for EU businesses that are not in the financial sector, where such businesses are counterparties to financial transactions with non-EU financial institutions, they will be jointly and severally liable for any FTT payable on such transaction. Should the non-EU financial institution not account for its FTT liability, the tax authorities could demand payment from the EU counterparty.
In our example, if the US hedging bank were not to pay the FTT due on the hedge transaction, the UK tax authorities could pursue the UK company for the FTT.
Non-financial sector businesses may also be brought within the scope of the tax where they carry on certain financial activities to a significant extent. Of specific note is the activity of ‘acquiring holdings in undertakings’ ie acting as a holding company. This could mean that large corporate enterprises and private equity funds, among others, are considered to be financial institutions for the purposes of the FTT.
In our example, if the UK company was the holding company of a corporate group, it may therefore have a direct FTT liability in respect of the hedging arrangement.
Abolition of stamp duty/ stamp duty reserve tax
The proposed Directive requires that, on the introduction of an FTT, member states withdraw all other similar taxes on financial transactions. In the UK, this is would mean the abolition of stamp duty and stamp duty reserve tax. This is likely to be advantageous to business as the replacement FTT charge should be much lower (the FTT must be applied at the same rate across all financial transactions within the same category, meaning share transfers cannot be treated differently, and it seems unlikely that the UK would set any FTT at a 0.5% rate). Further, for transfers that do not involve a financial institution (such as between individuals), no FTT would be payable at all, removing transfer taxes completely from such transfers.
Will the UK implement the FTT?
For the FTT to be introduced, the unanimous approval of all 27 member states of the EU is required. However, the UK government has already indicated that at present it would resist the introduction of any FTT that is not applied on a global level. This stems from the likelihood that an EU-wide FTT would have a disproportionate and significant financial impact on London, given its status as Europe’s leading financial centre. Not only would UK financial institutions bear much of the burden of the FTT (some estimates put the UK’s contribution to overall FTT revenues at 80%), but it is likely that the more mobile institutions will move from London to other global financial centres not subject to an FTT.
There is consequently a significant possibility that the UK will veto the FTT proposals. This is not however certain, and a number of factors may persuade the UK to support the FTT, either in its current or an amended form. First among these is the ongoing need to raise finances – the negative impact on the UK’s financial sector may be acceptable if significant tax revenues can be raised for the UK. The FTT may also play well politically to the public at large, although there is a difficult tightrope to walk here given that the financial sector is the traditional heartland of Conservative support and finance.
The possible consequences of a veto may also not be attractive to the UK. The FTT could in fact still be introduced on a more limited basis among only the 17 Eurozone member states. If this were to occur, UK financial institutions may still find themselves subject to significant FTT charges on their transactions with the Eurozone, but the UK government would not benefit from any of the tax revenues raised.
Finally, there is the possibility that the FTT could be adopted on a more global scale, which the UK broadly supports. In November 2011, the Commission are presenting the draft FTT proposals to the G20. However, adoption by the G20 seems a remote possibility at present given the objections and reservations raised by certain G20 members, not least the US.
At a policy level, it must be questionable whether the proposed FTT would in fact satisfy its primary objective of forcing a ‘fair contribution’ to the costs of the economic crisis from the financial sector. It is inevitable, and recognised by the Commission, that wherever possible, financial institutions will pass the economic cost of the FTT to their customers or shareholders. It would probably therefore be more realistic to recognise the FTT as a further general tax on business, which in the current constrained economic environment must be unwelcome.
At a more detailed level, the scope and application of the tax is extremely wide, and inequitable between different member states. This makes the FTT a highly controversial tax and will lead to much heated discussion and debate as it develops. If it is finally introduced, it may well be the catalyst for significant change to the landscape of the global financial sector, and will certainly increase the cost and complexity of doing business in the EU.