Financial Transaction Taxes for Fun and Profit

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.

Originally published on Tabb Forum

The attempts to impose financial transaction taxes (FTTs) have a long, if inglorious, history, so it shouldn’t surprise us that the European Union began looking at them recently. Whether they will work out for the EU is very much up in the air, but it would behoove us to understand at this point what the EU is doing, if we can.

To begin with, taxes are generally imposed for one or both of two reasons: to generate revenue and to discourage certain practices. When the purpose is to generate revenue, the big question is always whether the tax is fair. When the purpose is to discourage certain practices, the question is whether the tax is effective. When both purposes apply -- as appears to be the case in the EU FTT -- the question is whether the tax accomplishes either objective. In order to accomplish both, the EU tax planners attempted to jump through some complicated hoops, and they may have done something of a face plant in the process.

There have been other attempts at, or discussions of, FTTs in the past, including several times in the US. In each case, the effort was abandoned when legislators concluded that the taxes would be difficult to collect, easy to avoid, and counterproductive. The well-publicized threats by investors and market-makers to move their transactions to other venues were often enough to close the discussion and send the lawmakers in search of other revenue sources.

The European Commission (EC) was all too aware of this history, of course, when it set out to design an FTT, one that wouldn’t be difficult to collect, easy to avoid, or counterproductive. In late February the EC published a proposed directive, 2013/0045, laying out how its FTT would work. Or perhaps how the Commission hopes it will work.

The Transactions

The first difficulty the EC faced was in defining the transactions subject to taxation. The definition needed to exclude those transactions deemed to be beneficial, while including all the permutations that financial engineers might devise to avoid paying. Here is the definition the Commission came up with:

(a) the purchase and sale of a financial instrument before netting or settlement;

(b) the transfer between entities of a group of the right to dispose of a financial instrument as owner and any equivalent operation implying the transfer of the  risk associated with the financial instrument, in cases not subject to point (a);

(c) the conclusion of derivatives contracts before netting or settlement;

(d) an exchange of financial instruments;

(e) a repurchase agreement, a reverse repurchase agreement, a securities lending and borrowing agreement;

Now (a), (c), and (d) make some sense to me; but (b) and (e) are head-scratchers. Do you read (b) to mean that transfers of securities or derivatives within a consolidated entity is a taxable event – including the stock of a subsidiary? Me, too. And imposing a tax on repos breaks some new and rocky ground, since the tax on an overnight repo would probably be several times the interest earned on that repo. These definitions, if implemented, may force some significant changes in corporate structuring and in the financing market, both in Europe and worldwide.

The Entities

In addition, the Directive addresses which entities are taxable, and here, again, there are a few head-scratchers. For, example, in the scope section (on page 23) it says:

2. This Directive, with the exception of paragraphs 3 and 4 of Article 10 and paragraphs 1 to 4 of Article 11, shall not apply to the following entities:

(a) Central Counter Parties (CCPs) where exercising the function of a CCP;

And then it says:

3. Where an entity is not taxable pursuant to paragraph 2, this shall not preclude the taxability of its counterparty.

In other words, transactions done with CCPs are taxable for the CCP’s counterparty (as long as that counterparty is taxable). So if two dealers do a clearable trade, is that taxable? Then, when they clear it, are both the trades with the clearinghouse taxable for the dealers? What do you think?

What about non-financials? The taxability of a non-financial depends on whether the entity is “established” in the taxing country. The establishment rules for non-financials read like this:

2. A person which is not a financial institution shall be deemed to be established within a participating Member State where any of the following conditions is fulfilled:

(a) its registered seat or, in case of a natural person, its permanent address or, if no permanent address can be ascertained, its usual residence is located in that State;

(b) it has a branch in that State, in respect of financial transactions carried out by that branch;

(c) it is party to a financial transaction in a structured product or one of the financial instruments referred to Section C of Annex I to Directive 2004/39/EC issued within the territory of that Member State, with the exception of instruments referred to in points (4) to (10) of that Section which are not traded on an organised platform.

But wait. There’s more:                                              

3. Notwithstanding paragraphs 1 and 2, a financial institution or a person which is not a financial institution shall not be deemed to be established within the meaning of those paragraphs, where the person liable for payment of FTT proves that there is no link between the economic substance of the transaction and the territory of any participating Member State.

That certainly clears things up. Anyone doing business in a taxing country (if I may make so liberal a translation of paragraph 2), owes the FTT, unless the transaction has no link to the taxing country. And how do we determine what transaction is linked to the taxing country? Full employment for lawyers!

The Tax Itself

There is one more surprise in the rules. At the bottom of page 26, the EC says:

(a) it is party to the transaction, acting either for its own account or for the account of another person;

(b) it is acting in the name of a party to the transaction;

(c) the transaction has been carried out on its account.

So does that mean that each side of a trade pays the full tax? In other words, instead of 0.1% for securities and 0.01% for derivatives, it’s really 0.2% and 0.02%? And what about non-financials? They were listed as taxable earlier in the rule. No longer?

Can we start to see why FTTs have such an inglorious history? And it looks like that string will be unbroken.