For market participants affected by the proposed European Union Financial Transaction Tax (EU FTT), the question is no longer “if” but “when”. On May 6, 2014, 10 out of 11 countries (except Slovenia) agreed to a ‘progressive’ implementation that will first focus on the taxation of shares and some derivatives.
The first step should be implemented on Jan 1, 2016, at the latest. Therefore the type of products will be taxed and how the rules will look in final form is yet to be determined – EU FTT aims to capture all securities, all derivatives, repos and stock lending, all types of fund units, money market instruments, structured products, swaps and possibly collateral.
Some transactions are excluded, mainly loans, spot FX transactions, spot commodities, new issues and transactions with the European Central Bank, Central Counterparties and Central Securities Depositories.
Even though the tax calculation on financial products is relatively straightforward, the end-to-end flow brings distinct implementation challenges.
Previous experiences with national FTT implementations and the current EU FTT definitions suggest that it will impact many functional and technical units, including: trading, sales, operations, process management, tax and legal departments, Know Your Customer (KYC), static data, IT, accounting and client communication.
However, determining whether a financial institution is subject to EU FTT taxation is based on two core principles, the Principle of Establishment and the Principle of Issuance, that are more intricate than the existing national FTTs.
There is also the additional extra-territorial application to consider, where financial institutions outside of the EU could be imposed with the tax by entering into a transaction with a financial institution that is established in the participating member state.
The following examples shed some light on the intricacies of their implementation.
The Principle of Establishment
A Danish bank (non EU-11) sells a stock issued in Denmark to a German bank (EU-11 establishment):
· Due to the residence principle and the fact that the German Bank is an EU-11 member state, the Danish bank is considered to be established in Germany. The tax amount is to be paid by both parties to the German authority. In this case, it doesn’t matter whether the stock is issued in Germany or Denmark.
Corporation X, based in Estonia (EU-11), manages the assets of its shareholders, who live in Estonia. Corporation X purchases Finnish government bonds at the price of €500,000 from Bank A in Finland (non EU-11):
· Both parties (X and A) are assumed to be financial institutions and are both liable to pay FTT in Estonia. This is due to the principle of establishment, and specifically the counterparty principle, where the tax is applied irrespective of the location of the issuer of the traded product
FTT impact on business operations
The EU FTT could potentially have a huge impact on trading volumes, market liquidity, trading strategy and subsequently the business model of many financial services firms. As a result, the analysis should cover two distinct areas with the goals to identify the scope and develop a road map for further activities.
Firstly, the business impact on trading activities should be evaluated. The EC estimates a 75% drop in derivatives and financial bets when modelling the expected market reaction. The extension proposed by Germany to include FX business would have a huge impact on margins and trade volume.
FTT assessment should include:
· Assuming current trading activities and trading volumes in the EU-11 countries, what is the expected tax liability on the basis of the currently proposed legislation?
· What is the anticipated revenue impact and shift in business activity of the organisation?
· How does this influence existing client relationships and the business model (e.g., will front-office desks have to revisit their trading strategies)?
Secondly, firms should scrutinise their current process landscape and systems architecture by doing the following:
· Derive a high-level heat map of potential needs to meet projected future activity.
· Define the potential risks and drivers of complexity in a future implementation project.
These examples illustrate that there are a number of operational considerations and challenges, including the following:
· A clear categorization is required for clients in financial/ non-financial institutions.
· Decision support is required during pre-trade activities to evaluate the tax impact.
· A review of the type of cross-border business is required.
· Brokers might have to consider a principle-agent approach to change their business model.
· Market-making activities are not tax exempt as they are in the French and Italian FTTs.
· Intraday trade netting is not allowed.
· There may be missing implementation rules (like uniform methods of tax collection and payment, possibly via Central Securities Depositories (CSD), accounting and reporting obligations).
While many financial institutions that will be impacted by the EU FTT have already implemented French and Italian taxes to some extent, additional analysis and implementation of new systems and process will be required.
The experience with those existing taxation regimes will certainly help in assessing the upcoming operational challenges and develop an implementation project plan that addresses the impacted processes. With some breathing space before the EU FTT is due to be enacted, now is the opportune time to undertake that analysis.