Introduction

The EU’s financial transaction tax (the “FTT”) is due to apply from the beginning of 2014. The FTT has attracted considerable criticism, especially in relation to its extraterritorial effects.

Although the UK is not participating in the FTT, many in the UK are particularly concerned about the potential adverse effect that the introduction of such a tax could have on London’s position as a major financial centre. The strength of the opposition in the UK is such that the UK government announced in April 2013 that it had launched a legal challenge in the European Court of Justice against the EU decision authorising the introduction of the FTT.

Background

The 2011 proposal

The European Commission first tabled a proposal for a directive introducing an EU-wide FTT in September 2011. The EU’s justification for the FTT was both to ensure that the financial sector made a contribution to the costs of the taxpayer-funded bailouts which have supported the financial sector, and to help to strengthen the EU single market. Although a number of member states, including France and Germany, were very much in favour of the FTT, others, notably the UK, with its significant international financial services industry, were opposed to the introduction of such a tax in the EU, unless similar taxes were also adopted on an international basis.

“Enhanced cooperation” procedure by 11 member states

As result of these objections, it became clear that an EU-wide FTT would not receive the necessary unanimous support from the 27 EU member states. Nevertheless, a number of member states expressed a strong willingness to go ahead with the FTT in any event, and so, in early 2013, the Council of the European Union decided to allow 11 member states to proceed with the introduction of an FTT through a process called "enhanced cooperation". This procedure can be used in certain circumstances where at least 9 member states participate, and where the proposed objectives cannot be attained within a reasonable period by the EU as a whole.

The 11 participating member states are Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia (the “participating states” or the “FTT jurisdictions”).

The February 2013 proposal

The February 2013 proposed directive

Accordingly, in February 2013 the European Commission adopted a proposal for a Council Directive implementing enhanced cooperation in connection with the introduction of an FTT. The objectives and principles underlying this proposal are essentially the same as those of the original 2011 proposal.

Rationale for the proposal

In summary, the views of those behind the FTT are that the financial sector played a major role in causing the economic crisis, whilst governments and European citizens at large have borne the costs. This viewpoint has led some member states to begin to implement their own financial transaction tax regimes. The FTT’s proponents consider that the current position has led to a fragmentation in the EU internal market as regards the tax treatment of financial services, and to financial institutions not contributing their fair share towards covering the costs of the recent financial crisis.

The revenue expected from FTT and how it is to be used

The European Commission has estimated that the FTT could generate €30-35 billion a year. It has proposed that a portion of the revenue could be used as a contribution towards the EU budget, with the remainder being allocated to the participating states national budgets.

Scope of the FTT

Application of the FTT

This FTT applies to all “financial transactions” where at least one party to the transaction is established in a participating state, and where a financial institution established in a participating state is a party to the transaction, acting either for its own account or for the account of another person, or acting in the name of a party to the transaction.

"Financial transactions"

In summary, the term “financial transaction” means any of the following: the purchase and sale, or exchange, of financial instruments; intragroup transfers of financial instruments that transfer risk between the parties; derivatives contracts; repurchase agreements; and securities lending agreements. The tax applies to over-the-counter transactions, as well as those conducted on-exchange.

Financial instruments, derivatives contracts, repurchase agreements and securities lending agreements

The terms “financial instrument” and "derivatives contract" are defined by reference to those listed in the EU Markets in Financial Instruments Directive (with the addition of “structured products”). Financial instruments include transferable securities, such as shares and debt securities, together with moneymarket instruments and units in collective investment funds, such as EU UCITS funds. Derivatives contracts include options, futures, swaps, contracts for differences and forwards.

Repurchase agreements and securities lending agreements are also caught by the tax.

Contractual loans (for example, syndicated lending to corporate borrowers) and spot foreign exchange transactions (though not foreign exchange derivatives) are outside its scope.

"Financial institutions"

The definition of “financial institution” is also wide, and includes pension funds, special purpose vehicles, investment firms, investment funds and their managers, banks and insurance companies.

Transactions excluded from the scope of the FTT

The FTT does not apply to primary market transactions (such as issuing securities), or to transactions with the European Central Bank, or to those with the central banks of EU member states.

Territorial application

This is probably the most contentious (and complex) area of the FTT. The tax's territorial application is dependent on its definition of where an entity is “established”.

Financial institutions “established” in a participating state by virtue of their residence

In summary, a financial institution is “established” in the state in which either it: is licensed to operate (in relation to transactions covered by its licence); is registered; has a permanent address; or has a branch (in respect of transactions carried out by that branch).

Financial institutions deemed to be “established” in a participating state by virtue of being party to a transaction with a person established in a participating state

Significantly, a financial institution is also deemed to be “established” in a participating state where it is a party to a financial transaction with a party established in that state. This deeming provision clearly extends the definition of “established” beyond what would normally be expected by this term. Therefore, a financial institution outside the 11 FTT jurisdictions will still be caught by the tax if it contracts with a party established in one of those states.

Parties deemed to be “established” in a participating state by virtue of the “issuance principle”

Furthermore, these provisions are supplemented by the "issuance principle", in order to prevent the relocation of transactions and financial institutions outside the FTT jurisdictions. For transactions in financial instruments, structured products and exchange traded derivatives, the persons involved will be considered to be established in the participating state in which the instrument has been issued.

Therefore, a financial institution can be caught by the tax, even if neither it, nor any of the other parties to the transaction are within the FTT jurisdictions, if it transacts in securities issued by a person established in a participating state.

Non-financial institutions “established” in a participating state

In summary, a non-financial institution is “established” in the state in which either it: is registered; has a permanent address (if a natural person); or has a branch (in respect of transactions carried out by that branch). This is supplemented by the issuance principle outlined above – if it is party to such a transaction, it will be deemed to be established in a participating state.

Exemption where there is no link between the economic substance of the transaction and a participating member state

Notwithstanding these provisions, a person (whether or not it is a financial institution) is not deemed to be “established” in a participating state, where the person liable for payment of the FTT proves that there is no link between the economic substance of the transaction and any participating state. However, the precise scope of this exemption is not yet entirely clear.

Chargeability and payment of the FTT

Tax rates

The minimum rates to be charged by the participating states will be 0.1% of the purchase price (or market price, if higher) of the transaction, save for derivatives, where the minimum rate will be 0.01% of the notional amount of the derivative contract. It is thought unlikely that participating states will impose higher rates.

Cascade effect of the FTT

The FTT will be levied on each financial transaction; there is no exemption for financial intermediaries (e.g., brokers) (save where they are acting on a disclosed agency basis). This means that the FTT may be incurred at each stage in a series of linked transactions. As result of this “cascade” effect, the effective rate in a complex arrangement which involves interconnected, but separate, transactions may end up being much higher than the 0.1% rate (or 0.01% for derivatives), contained in the proposed directive. The effect of this can be particularly pronounced with short-term trades that are frequently rolled over (e.g., repos), since the tax will be imposed each time the trade is refreshed.

Chargeability of the FTT

The FTT becomes chargeable for each financial transaction at the moment it occurs, even if the transaction is subsequently cancelled (except in cases of errors). There is also no exemption for intragroup transactions.

Persons liable for the payment of the FTT

In each financial transaction, the FTT is payable by each financial institution who is either party to the transaction (acting either for its own account or for the account of another person), who is acting in the name of a party to the transaction, or on whose account the transaction has been carried out.

There is one specified exception to this: where a financial institution acts in the name, or for the account of, another financial institution, only that other financial institution is liable to pay the FTT.

So, subject to this exception, each financial institution that is party to a transaction is separately liable to pay the FTT. In other words, a single transaction may be taxed more than once.

Joint and severable liability for the payment of the FTT

Where the tax due has not been paid within the requisite time limit by the relevant financial institution, each party to the transaction (including any party that is not a financial institution) will be jointly and severally liable for the payment of the tax due.

The tax authorities who receive the FTT

The FTT is payable to the tax authorities of the participating state in which the financial institution is deemed to be established.

Anti-abuse and implementation timetable

General anti-abuse rule

Not surprisingly, the FTT contains a general anti-abuse rule to prevent artificial arrangements designed for the purpose of avoiding taxation.

Implementation timetable

The participating states are required to adopt by 30 September 2013 their local laws that implement the provisions of the directive. These laws are due to apply from 1 January 2014. It remains to be seen whether this tight timetable is achievable.

Criticisms of the FTT

Potential impact on US money market funds and repurchase agreements.

Many industry bodies have voiced concerns about potential unintended consequences of the FTT. For example, the US-based Investment Company Institute (“ICI Global”) has stated that the FTT would adversely affect repurchase agreements (“repos”) between US money market funds and financial institutions in the FTT jurisdictions.

ICI Global has pointed out that the FTT would create a substantial drag on yields for money market funds in repo transactions with financial institutions in the FTT jurisdictions. Indeed, ICI Global predicts that the FTT would produce negative net yields on repo transactions in the current low interest rate environment.

ICI Global notes that the shorter the maturity of the repo, the higher the cumulative tax rate would be, because the tax would be paid each time the investor renewed (i.e. rolled over) the repo. Since repos have short maturities, normally of seven days or less, they may be rolled over 52 or more times per year, with the FTT being incurred on each occasion. Therefore, ICI Global believes that there is a significant risk that the tax would make the repo trade unprofitable with financial institutions in the FTT jurisdictions. In other words, in their view, the FTT could eliminate repos as a potential source of funding to financial institutions in the FTT jurisdictions, such as French and German banks.

The UK’s legal challenge

The UK is to challenge, in the European Court of Justice, the EU’s use of the enhanced cooperation procedure. Under EU law, “enhanced cooperation” is required to “respect the competences, rights and obligations” of non-participating member states. It is arguable that the FTT"s extraterritorial impact will infringe this provision.

The UK is concerned that the FTT will have an adverse impact on its financial services sector, even though it is not participating in the tax. On 19 April 2013, the Chancellor of the Exchequer, George Osborne, said that the UK is not against financial transaction taxes in principle (recognising that the UK has such a tax in the form of stamp duty on shares), but is concerned about some of the extraterritorial aspects of the proposal, and so has launched a legal challenge against the authorising decision. Luxembourg has indicated that it will support the UK’s legal challenge.

Conclusion

The FTT is controversial. Whilst it has support from many of the core Eurozone countries, a number of other EU member states such as the UK, Sweden and Luxembourg, will not participate in the tax, but are nevertheless concerned about the effects the tax will have on their domestic financial services industries. Its effect will extend far beyond the EU, with US and Asian institutions that operate in EU financial markets seeing diminishing returns as a consequence of the fiscal drag that will result from the FTT. There may well be further changes to the FTT before it is implemented that will address some of these concerns. The likelihood of changes to the FTT appears to have increased now that the UK has launched a challenge regarding the legality of the procedures used by the EU in adopting the proposed tax.