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Expat Briefing Editorial Team, 20 February, 2014
With new research suggesting that the proposed European Union financial transactions tax (FTT) could wipe billions of euros off the value of pensions and other investments, in this week's briefing we give the low-down on the FTT and the possible ramifications of the tax.
What Is the FTT and Where’s it Being Introduced?
The FTT is the European Union’s way of ensuring that the financial services industry pays a contribution towards cleaning up the mess left behind by the recent financial and economic crisis. Except that not even half of the 28 member states have agreed to go ahead with it (although, as mentioned below, it has been designed to have maximum impact). The tax is also designed to discourage certain types of undesirable financial trading activities thought to have exacerbated the crisis, such as high-frequency and automated trading.
In its current form, the FTT is based on the proposal unveiled by the European Commission in September 2011 and approved by the European Council of Economic and Financial Affairs in January 2013. It will be levied on all transactions in financial instruments, with the exchange of shares and bonds taxed at a rate of 0.1 percent and derivative contracts at a rate of 0.01 percent.
Usually, new EU tax laws need to be agreed by all member states before they can be introduced. However, because the FTT is so contentious it is only being implemented in 11 countries on the basis of ‘enhanced cooperation’, a rarely-used legislative mechanism that allows at least nine member states to proceed with European legislation if unanimity in the EU Council cannot be found. The so-called ‘EU11’ are: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.
The tax is designed to focus on transactions that take place between financial institutions. Transactions of individuals, such as credit card payments or private loans, savings or insurance contracts are not included in the scope of the tax. The primary issuance of shares and bonds, loans to businesses and spot foreign exchange transactions also won’t be subject to the FTT. However, that leaves a lot of financial assets and instruments that still will be subject to the tax – about 85% of all financial transactions will be taxed , according to the Commission’s own estimate (which presumably means transactions within the EU11).
Initially, the FTT was supposed to be in place by 2014. But growing uncertainties over its application have cast considerable uncertainty over exactly when it will be introduced.
Will The FTT Affect Investors?
Despite not taxing individuals and transactions in the “productive economy,” the FTT as drafted is still expected to have a huge knock-on effect on individual investments.
A new report commissioned by the City of London Corporation and TheCityUK on behalf of the International Regulatory Strategy Group (IRSG) has highlighted the negative impact on UK and European households’ savings that would occur if the proposed FTT was implemented. The study – authored by London Economics – looked at the potential impact of the FTT on six European Union member countries. Four (Germany, Italy, Spain and Slovakia) are planning to participate in the FTT and two (the United Kingdom and Luxembourg) are not.
According to the report, in the UK, the FTT as currently designed would lead to a reduction in the value of equity and debt holdings of EUR4.4bn (GBP3.6bn - equivalent to 0.2% of GDP). Luxembourg – which like the UK is not participating in the FTT – would see a reduction in the value of equity and debt holdings of similar proportions – about EUR0.4bn (equivalent to 0.9% of GDP, 2.2% of total holdings).
In countries that plan to introduce the tax, the impact could be as large as EUR204.9bn (in Italy) representing a loss of 14.1% of the value of the assets being taxed. Germany would be the next most affected (EUR150.6bn, equivalent to 5.8% of GDP), followed by Spain (EUR79.6bn, equivalent to 7.6% of GDP, 16.0% of total holdings) and Slovakia (EUR0.1bn, equivalent to 0.1% of GDP, 2.3% of total holdings).
According to the report, the adjustment would be immediate due to the expected costs being capitalised into the price of assets, and would in some cases be a multiple of annual household savings. Spanish households would have to save for an entire year to restore the value of their savings to the level prior to the introduction of the tax; in Italy, they would have to save for eighteen months.
However, the study concludes that if intermediaries were exempt from the tax, the loss in the value of savings would be reduced to 3-4% of the value of the portfolio for Germany, Italy and Spain.
Mark Boleat, Deputy Chairman of the IRSG, observed: “This report highlights the negative impact that the FTT could have on economic prospects across Europe by hitting household savings. It is not a ‘tax on markets’ but rather a tax borne by end users such as pension funds. The tax could also increase the cost of capital for businesses and sovereign governments.”
These conclusions support numerous other studies conducted into the likely effects of the FTT. For example, the Global Financial Markets Association (GFMA) warned last year that although FX spot transactions are excluded from the proposal, imposing an FTT on other FX products risks discouraging companies and investors from carrying out international trades. Pension fund managers are expected to be particularly badly hit. Pension funds could see their expenses rise by around 700-1,500 percent, a figure that could even go up to 4,700 in some cases. The GFMA also argues that the impact of an FTT on pension funds using FX would be compounded by the "double sided nature" of the proposed FTT. It has calculated that a pension fund accustomed to annual transactions costs, via a single dealer, of EUR1.2m, could see them rocket to more than EUR57.6m.
A report produced by economic consultants Oxera on behalf of the Association for Financial Markets in Europe drew similar conclusions. Dismissing the EC’s assertion that the FTT as proposed would “have a rather limited impact on… pension funds and their beneficiaries”, the report argues that ultimately the FTT would “further undermine the confidence of savers in making long-term provisions for retirement, which would conflict with other Commission objectives to boost pension provision.”
The Commission’s own impact assessment suggests that the FTT would not affect passive pension funds. However, it found that the impact on actively-managed funds would be substantial, potentially reducing the final pension by nearly 8%. This, cautioned the report’s authors, could encourage funds to shift into untaxed investments, “which may or may not be in the interests of consumers”.
Such findings have led to calls from the investment industry for the EU to exclude pension funds from the draft legislation. However, while the EC and the EU11 are beginning to waver on some aspects of the tax, they do not appear to have taken these concerns fully on board. At least not yet.
Is FTT Legal?
Patently not, according to the Council of the European Union’s own lawyers.
One of the most critical components of the draft FTT law is the residence principle. This ensures that the tax will apply according to where a financial instrument was issued, rather than where it was traded. In the words of the EC, this clause is designed to “reduce to an acceptable level the risk of tax avoidance through geographical relocation of transactions outside the EU". However, in effect, it also means that certain trades taking place outside of the EU11 – and outside Europe altogether – would be subject to the FTT. Unsurprisingly, many countries are up in arms about this extra-territoriality, particularly the United Kingdom and the United States. But the FTT may also breach EU, as well as international, law.
In a highly embarrassing development for the European commission and the tax’s supporters, a legal opinion by the Council’s legal services, leaked to the media last September, confirmed what many observers had already realised, that the FTT "infringes upon the taxing competences of non-participating member states," and is therefore incompatible with the EU treaty.
The document goes on to warn that imposing "deemed residency" on financial institutions in non-participating states amounts to the exercise of jurisdiction over entities outside the zone, in contravention of customary international law, and that the proposals therefore go beyond what is allowable under enhanced cooperation. Further, in cases where a financial institution engaged in a transaction is not established within the zone, that institution's jurisdiction has a stronger claim to impose a tax on the transaction.
The lawyers explain that a concern that the FTT would prompt institutions to migrate transactions outside the zone would not justify extraterritorial tax legislation, and that anti-fraud or anti-evasion measures would not be justified under the principle of proportionality.
The opinion also suggests that the different treatment of cross-border transactions within and outside the zone would be discriminatory. Furthermore, a clause allowing a party to avoid being regarded as resident by showing that there was no economic link between a transaction and the state in which the party resides would risk disparity of application and litigation, as it would be "quite impossible" for member states to define when this would apply.
The opinion seems to have been swept under the carpet by the Commission and key EU11 member states. A spokesperson for EU Tax Commissioner Algirdas Šemeta rejected it out of hand, saying that the FTT had been subjected to a thorough legal analysis, and that EU member states should assess the document critically. However, it seems to be slowly dawning on the FTT participants that a change of approach may be needed.
So The FTT Is Doomed Then?
Not according to the European Commission. Addressing the European Parliament earlier this month, Šemeta claimed that the FTT is "a highly popular initiative, which Europeans believe in," and accused "strong vested-interest groups" of working "tirelessly to impede progress, over-estimating the threats and negative impact of this tax." However, cracks are undoubtedly appearing in the edifice of support for the tax.
Thus far, the German Government’s support for the FTT has been unflinching. However, Finance Minister Wolfgang Schäuble is now calling for the FTT to be introduced progressively, starting with a tax on share trading. French Finance Minister Pierre Moscovici recently underlined the need for a "solid and realistic" compromise proposal to be reached by the end of May. And Austrian Finance Minister Michael Spindelegger has said that there will be no FTT before 2016.
What’s more, the Commission isn’t in complete denial about the FTT’s obvious flaws. Talks are now focussing on possibly reducing both the scope and the rates of the tax. In his EP speech, Šemeta said that options are being explored to protect "those transactions which are closely linked to the real economy or whose objective is to ensure market liquidity."
The EU11 also have major doubts now about including derivative transactions within the scope of the tax.
However, the FTT as proposed is facing other legal obstacles. In April 2013, the UK brought a legal action at the European Court of Justice Challenging the EU Council’s decision to proceed with the FTT on the basis of enhanced cooperation. The UK’s attack is three pronged, arguing that: the decision fails “to respect the competences, rights and obligations of the Non-Participating States”; has no justification in customary international law; and will “inevitably cause costs to be incurred by the Non-Participating States.”
Meanwhile, across the pond, legislation has been introduced into Congress that would prohibit a United States-based company from paying a financial transaction tax imposed by any foreign government and prevent the US Treasury from assisting a foreign government in the collection of an FTT on securities transactions occurring on a US exchange.
Kansas Republican Pat Roberts, who introduced the bill in the Senate, pointed out that countries imposing an FTT have found that such a tax "impedes the efficiency of markets, impairs depth and liquidity, raises costs to issuers, investors and pensioners, and distorts capital flows by discriminating against asset classes." But particular concern has been expressed in the US with the extraterritoriality designed into the EU FTTs (including FTTs in France and Italy) that "would collect revenue from financial markets and investors around the world to which the EU countries that support the tax have little or no connection."
‘Banker bashing’ tax measures are popular at the moment and they might seem to some like the most appropriate response to the crisis. But it is becoming obvious that the EU11 risks bringing about a whole host of unintended consequences with its FTT, and the impact on savers and investors caught in the net is expected to be particularly acute. The EC and the member states do appear be listening to the concerns of the finance industry and investors at last, and Šemeta has said that talks between the EU11 are focusing on how to make the proposal "better." Just when that moment will come though is subject to much uncertainty.