EU Financial Transaction Tax

The tiny tax with global ramifications

1 EU Financial Transaction Tax The tiny tax with global ramifications

The backstory through to April 2013

The taxation of the financial sector in Europe has been seen as a piece of unfinished business coming out of the financial crisis. Many across Europe want the sector to make a ‘fair and substantial’ contribution to government finances in effect to repair the damage done to European economies since the crisis.

The EU’s Financial Transaction Tax (EU FTT)

The key milestones have been:

► 28 September 2011 — EU Commission (the commission) publishes a draft Directive proposing a broad-based tax.

► November 2011 (G20 Cannes meeting) — President Sarkozy and Bill Gates fail to achieve a global consensus on FTT — EU must pursue alone, if at all.

► March 2012 — with certain countries in Europe clearly opposing FTT, notably Sweden and the UK, President Sarkozy proposes an equities only FTT for France.

► Summer 2012 — in light of German political agreement on an EU FTT, the Commission announce that 11 Member States have asked for an “enhanced co-operation” process on the EU FTT.

► Autumn 2012 — Spain and Portugal also propose varieties of FTT (both subsequently deferred).

► October 2012 — Italy proposes FTT on equities and equity derivatives.

► January 2013 — at ECOFIN the 27 member states permit a group of 11 to begin formal negotiation in respect of the EU FTT. The proposed start date is 1 January 2014. The EU 11 are: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.

► 14 February 2013 — a revised draft Directive is published by the Commission.

► 19 April 2013 — UK announces it has launched a legal challenge to the decision authorizing the “enhanced co-operation procedure”.

Will it really be 2014?There is a lot of politics left to play out. The German election of September 2013 is likely to be an important factor. Significant lobbying is already underway.

As of March 2013, the formal EU FTT start date is 1 January 2014. Many politicians and administrators across Europe have expressed public doubts about whether this date will be achieved, and it seems likely it will be deferred. Broadly, the official timetable is:

► End of Summer 2013 — unanimous agreement on wording of the draft Directive.

► By the end of September 2013, all participating Member States will have incorporated the Directive into national law, leaving three months for industry to get ready for compliance.

It is not practical to deal with the major operational and IT challenges that arise in relation to compliance in just three months.

Key details of the EU FTTThe design of the EU FTT makes it far from just another tax that is borne by the end purchaser of an equity, as similar taxes do in the UK, Switzerland or Ireland.

The taxable person and taxable transactions

Any financial institution (FI) is theoretically liable to the EU FTT. This includes banks, insurers, brokers, pension schemes, asset managers, and any non-FI with revenue from financial activities greater than 50% of turnover. Broadly, sovereigns, exchanges and securities depositaries are exempt.

Jan. 2013

ECOFIN authorized an ‘enhanced co-operation’ procedure

Sept. 2013

National laws published

Feb. 2013

Revised draft Directive published

Jan. 2014

Start date (likely to be deferred)

EU 11 negotiation and incorporation in domestic law

Official timeline

2EU Financial Transaction Tax The tiny tax with global ramifications

Essentially any secondary market transaction is taxed, i.e., purchases and sales of bonds and equities, securities of any kind, derivatives over any asset class or index. Redemptions of fund units are also taxed.

What is exempt?

Payments. Credit cards. Loan origination and issuance of shares and fund units. Insurance contracts. Cash transactions.

What kind of reliefs are there?

There are very few and this is one of the very unusual features of the EU FTT. For instance:

► There is no credit mechanism within the financial supply chain, so everyone in the chain is taxed.

► There is no market-maker exemption (although where an FI acts as agent for another FI, then there is an exemption).

► Intragroup transactions are taxed.

► Both the seller and buyer are taxed on the same transaction.

What about the international dimension?

Although the tax directly applies to all FIs located within the EU 11 technically, the EU FTT could apply to any FI, wherever it operates. There are two key aspects here:

► Whenever a non-EU 11 FI undertakes a taxable transaction with a customer within the EU 11, then the non-EU FI is deemed to be an EU FI for the purposes of the tax. (This means for instance, that a French bank selling securities to a personal customer in France would be on a level playing field with a UK, Swiss or US bank selling securities to a French resident.)

► The tax has an “issuance principle” for equity, securities and exchange traded derivatives. This means that wherever in the world a trade in EU 11 issued paper is undertaken, the EU FTT is due for both the buyer and the seller.

The minimum rates

► One basis point on the notional principal of derivatives.

► Ten basis points on the consideration for secondary market transactions.

The impacts are game changingThe EU’s own impact assessment has focussed on the overall GDP impact of introducing an FTT. In the long run that impact is expected by the Commission to be broadly neutral. However, the Commission does expect certain dramatic impacts on the financial industry. For instance, it expects a reduction in derivatives volumes of over 70% and a reduction in securities trading of 10%. The EU 11 are fearful of the tax base migrating to a jurisdiction outside the FTT zone, and one key area on which they will focus will be how to prevent this happening.

However, the impacts for the financial industry are much deeper than the simple reduction of trading volumes. The strength of the financial system relies on key processes like collateral management, the ability to use securities positions to fund businesses overnight with repos and, more generally, using highly liquid markets to assist in price formation. Many of these core market activities will be directly affected by the EU FTT. Within each market, participants will gravitate towards longer term contracts, substitute products to lower EU FTT cost and consider activities that can take place outside the FTT zone.

Policy makers may be tempted to attempt to collect tax at source and therefore exchanges and clearing systems will need to understand their potential obligations. Custodians and fund administrators are likely to be similarly tasked with the compliance burden.

Each FI will need to consider the impact on its own business from both a commercial and operational perspective. Businesses within the FTT zone will be heavily affected, and the impact will be felt most by high volume, low margin businesses. There will be certain points in the draft Directive that will be highly important in determining the overall commercial impact and these should be identified and monitored.

The task of operational compliance with the EU FTT will be a step-change compared to any previous operational tax, including FATCA. Clearly any opportunity to reduce the burden through alignment with trade reporting, transaction reporting, know your customer (KYC) and anti-money laundering (AML) should be explored. The data and IT work will need to be planned taking into account other relevant in flight programs within each institution.

3 EU Financial Transaction Tax The tiny tax with global ramifications

FS sector

Market infrastructure and functioning

Non FS sector

Regulatory context and intersections

Non FS sector ► Large corporates to exit FTT zone

banking relationships?

► ►FTT zone corporates seek ways to issue paper outside FTT zone.

► ►Large corporates restructure hedging of currency commodities and interest rates.

► ►High net-worth and retail investor behavior changes, particularly in fund investments.

FS sectorAsset management►

► Investment and hedging strategies adapt, to minimize incidence of the EU FTT.

► Bifurcation between FTT zone funds and non-FTT zone funds.

► Increased EU FTT charges for complex distribution models.

► Seek alternative new trading strategies.

► Plan for alternatives to maintain high frequency trading (HFT) model.

Banking

► FTT zone fixed income, currency and commodities (FICC) businesses need new model to remain competitive.

► Significant relocations if issuance principle does not stick.

► ►Major changes in volumes, product substitution, liquidity and instrument maturity.

Insurance

► Lower impact. But still concern that hidden EU FTT costs will come through in outsourced asset management.

Market infrastructure and structure ► Will EU FTT clearing and settlement systems do

the heavy lifting? Will this spur growth of non-EU trading venues?

► Financial stability issues as financial system recalibrates for EU FTT on repos, stock loans, collateral, hypothecation, etc.

► Adaptation of market norms to enable trading models to utilize “disclosed agency” exemption.

► Will EU FTT zone central counter parties (CCPs) and central securities depositaries (CSDs) be viable for international business?

Regulatory context and intersections ► How does a structural response to the EU FTT align with

Dodd Frank, Liikanen, AIFMD, etc.?

► Can transactional and trade reporting initiatives be leveraged or do they conflict with the EU FTT? EMIR, MiFID II, etc.

► Given the increased public scrutiny of customer and institutional tax behaviors, will there be a behavioral response to the EU FTT, will compliance by some, despite potential unenforceability, mean that the playing field is not level?

► Are the operational risks of the EU FTT implementation understood by regulators?

What might the macro impacts be?As tax measures go, the EU FTT will be as big as it gets in terms of commercial impact:

4EU Financial Transaction Tax The tiny tax with global ramifications

Commercial ► ►How are individual lines of business affected?

► Are structural changes required to legal entity, booking model, etc.?

► What is the impact of the EU FTT on competitors (e.g., are they within the FTT zone or not)?

► ►Likely affect upon margins and volumes.

► Likely changes in customer behavior (e.g., product substitution).

► The effect of the joint and several liability clause on contracts.

► Can the financial supply chain be shortened and can “disclosed agency” be applied?

► What trading venues and clearing and settlement systems etc., are used, and are they the most efficient for the EU FTT?

► ►How are lines of business funded/optimized: e.g., collateral, stock loans, repos — and what are the EU FTT implications?

Implementation ► Governance — who?

► Dependencies — which?

► Change resources — fatigue.

► Cost and who pays.

► Roadmap.

Operational ► ►Impact on front-to-back

processes.

► Reduction in straight through processing (STP) rate.

► Data sourcing requirement from front office and reference data platforms.

► Changes to tax rules engine.

► New reporting and settlement requirements.

► Dependency on external IT vendors.

Business-level micro impacts

Operational

Implementation

Commercial

5 EU FTT summary The tiny tax with global ramifications

A worked example: German pension fund sells Italian corporate bond to Hong Kong investor in a French fund

Italian corporate paper

Asset manager

creates fundFrench fund

Hong Kong investor

Transfer agent

Order fulfilment:

►Dark pool, MTF

► Exchange

► Interdealer broker

►Own book

Step 1 French fund issues new unit to Hong Kong investor — potentially exempt, but need to check whether this is actually a primary issue, transfer agent may have netted against redemptions.

Step 2 Fund manager gives order to buy to UK investment bank. Fund manager may be exempt if on behalf of the fund. (What about orders which are not allocated to specific funds?)

Step 3 UK investment bank fulfils order. EU FTT due from bank unless takes order on a (disclosed) agency basis.

Step 4 Order fulfilment. Will the place of the trade be exempt as CCP (e.g., an exchange system) or taxable (e.g., an interdealer broker)?

Step 5 German broker taxed on sell side unless (disclosed) agent.

Step 6 German pension fund taxed on sale. German broker taxed on purchase, unless acting as disclosed agent for pension fund.

Payment, reporting and recording obligations of custodian, fund administrator and clearing system are unclear. (How much tax? Who is reporting/collecting? Who will economically bear the tax?)

1

2

Fund administrator

Custodian bank

French fund manager

3

4

5

6

German pension fund

Custodian

German broker

UK investment

bank

Every market and asset class will have its own EU FTT analysis and there will be unique adaptations for each.

6EU FTT summary The tiny tax with global ramifications

How Ernst & Young can help

The EU FTT is not simply a tax problem. Our approach integrates a European team of Tax and Operational, IT and Regulatory specialists in order to address the wide range of challenges, from the macro to the micro, from the front office to finance.

Market leading EU FTT position

► We are a market thought-leader in relation to the EU FTT and are recognized by leading FIs in Europe, the US and Asia as a comprehensive outlook on its practical implications.

► Our close links with government treasuries and tax authorities enable us to have clear insights and timely updates on developments.

► We regularly share our knowledge and experience with our clients — presenting highlights and informative analysis via our FTT Alerts newsletter and EU FTT update calls.

► As the impact of the EU FTT becomes recognized globally, our subject matter experts can impart their knowledge and experience to clients who will have to face impacts across multiple jurisdictions.

Significant experience (Italian FTT and French FTT)

► Our market leading team has already engaged with top-tier banks and asset managers to provide advice on the impact and implications of the Italian FTT and the French FTT.

► We can draw on expertise developed through work on the local FTTs currently established within the EU 11. We have not only provided primary advice; a number of clients have also sought second opinions on the French FTT from us.

► Our Italian and French tax teams are closely aligned and continue to stay abreast of all developments, including interactions between the Italian Ministry of Finance and the French authorities on the subject of FTTs.

Integrated, multidisciplinary approach

► We have mobilized teams, bringing together the right people with the right skills, including specialist advisers, who have experience and understanding of the EU FTT.

► Our operations, finance and technology consultants work closely with our tax practice to turn technical tax legislation into a practical implementation plan through:

► Project management, test management and assistance with delivery of solutions.

► Commercial/business model advice.

► Evolution of target operating models, across functions and within lines of business.

► Advising on design of internal, or assessment of third-party, solutions.

► Assessments of data sourcing required to fulfil the obligations of the EU FTT.

► Clear and rapid definition of requirements and business rules.

► Commercial and operational impact assessments.

Why do an impact analysis now?Things may change

Reason 1: the impact of the EU FTT is potentially very significant indeed, which means that the leaders of affected business units need to understand it when they consider long-term strategic planning.

Reason 2: with so many multi-year, multi-phase regulatory change programs going on, FIs will not want to hard-wire new systems and processes which are not able to adapt to the EU FTT.

Reason 3: without an impact assessment FIs will not know what are the key technical aspects which put them at a competitive advantage or disadvantage and therefore they will not know what specific issues they need to monitor as the policy debate unfolds.

Reason 4: if an FI has not already done an impact study, then, once the EU 11 conclude on a Directive, there may be insufficient time to implement required changes. Having an impact assessment done now will allow the business to save time when the starting pistol fires.

Ernst & Young

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