This article was first published in the June 2013 International edition of Accounting and Business magazine.
To listen to opposing sides in a polarised debate, 14 February 2013 could go down as a St Valentine’s Day Massacre of Europe’s capital markets or the start of a love affair with regulation that could help prevent speculative trading turning boom to bust.
Presented on that date, the European Commission’s revamped draft directive for a financial transaction tax (FTT) in 11 participating EU member states is expected to generate as much as €57bn annually for the EU and the ‘FTT zone’ countries as they deal with the economic fallout for which many EU politicians blame the financial sector.
In the real economy, it has led to warnings of a credit crunch with consequences beyond the FTT zone nations – Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain – if it comes into effect as proposed in January 2014.
The proposed FTT would tax transactions in equities, bonds, fund units and derivatives at minimum rates of 0.1% for bonds and shares and 0.01% on the value of derivatives. Superficially, these rates look low, but the devil is in the detail of what Ernst & Young has dubbed ‘the tiny tax with big effects’.
In a recent alert to clients, EY describes how the tax would apply to buyers and purchasers where each was defined as a financial institution (FI). The definition is broad and, in EY’s view, will probably encompass treasury companies, pension funds, and other non-financial sector entities with a significant average value of financial transactions.
The risks extend to other nations because any entity falling into these definitions would be taxed on transactions with parties based in the FTT zone or for transactions in financial instruments issued there. It would also apply, with some exceptions, to each link in a chain of transactions – for example when parties use a blend of instruments (contracts-for-difference, swaps, futures, options, etc) to cover risks involved in price movements.
EY highlights the financial risks inherent in FTT provisions on liability to pay. Each party to a transaction, including non-FIs, would be jointly and severally liable for unpaid FTT. So a seller paying FTT could also be liable if the purchaser did not.
New compliance systems will be needed to pay the FTT on the same day the liability arises (three days in the case of paper transactions). In practice, EY says, compliance will mean separating financial transactions by location, counterparty status (FI/non-FI), and place of issuance of the financial instrument. It will also require systems to report to, and account to, tax authorities in the participating member states. Tax authorities in different states could set different FTT rates (though the proposed rates are the minimum permissible) and implementation procedures.
EY reckons that FIs will pass on some €35bn (US$45bn) annually in FTT costs. The likely results are higher borrowing and hedging costs, lower returns on pension and investment fund assets, and higher energy and commodity costs.
Alarming predictions have been made about the effect on the market for repurchase agreements (repo), where banks raise short-term funding and put up government bonds as collateral.
The FTT as currently framed could see repo in Europe contract by at least 66%, says a study for the International Capital Market Association (ICMA). Repo and securities lending should be exempt from the FTT, according to Richard Comotto of the ICMA Centre, who authored the study.
‘Some corporate treasuries invest cash in the repo market either directly with borrowers or through third parties and that would stop,’ Comotto says. ‘There are doubts about whether there would be any other money market instruments left but unsecured deposits.’
He foresees lending to companies drying up because FTT zone banks get their funding through the repo market and from large money market depositors such as corporate treasuries and mutual funds which, if they invest with banks at all, prefer to do so via repo because it is collateralised.
‘An FTT zone company seeking to invest cash would probably set up a subsidiary abroad to invest in markets outside the zone and to issue company bonds and shares which would otherwise be subject to the FTT. If the proposals go ahead as framed, I think there will be capital flight from the EU and serious problems in raising capital.’
The City of London Corporation, which provides local government for the heart of the UK’s financial epicentre, has warned that the FTT could increase the cost of issuing sovereign debt because purchasers would demand higher interest on government bonds to compensate for the FTT.
While companies and the accounting profession ponder change, the FTT has fuelled robust academic debate.
Some focus on likely economic benefits to the FTT zone nations. The EU FTT would be ‘minuscule relative to the impact of the austerity measures currently pursued by some EU governments’, according to UK professors Philip Arestis and Malcolm Sawyer in a soon-to-be-published paper. ‘GDP could even increase once the potential positive effects of the FTT materialise – like, for example, preventing crises by reducing speculative activities. To the extent that the proceeds of the FTT are properly reinvested by the relevant governments, a positive impact on GDP could very well materialise.’
Some academics believe the FTT is a blunt instrument that needs refining. ‘The EU is taking the wrong path in designing the FTT, given that it is not calibrated on any assessment on the relative toxicity of the different financial instruments (at which it is aimed),’ says professor Donato Masciandaro of Bocconi University, Italy.
While arguments continue, FDs and accountants cannot ignore what is happening. ‘Although there is a growing anti-FTT lobby, businesses shouldn’t assume the FTT will automatically go away,’ says Rod Roman, London-based partner in the global tax services team at EY. ‘Many large financial institutions are working through the detail to see how it will specifically affect them, their customers and the overall financial landscape. If the starting gun does ever get fired, it has put them ahead of the game when it comes to commercial and operational impact.’
EY’s checklist for non-FI companies is:
- review banking relationships, including with London, New York and Singapore branches of FTT zone banks;
- consider FTT’s impact on treasury, financing vehicles and pension funds;
- review contracts with banks to see where FTT liability sits, bearing in mind joint and several liability;
- consider your hedging strategy for interest rate, currency and commodity risks – all will be taxable if executed with FTT zone counterparties.
Robert Stokes, journalist