EU FTT: A taxing issue for market participants
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.
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