FTT is a tax on transactions in financial instruments, including derivatives, and is payable by financial institutions. All financial institutions in the FTT zone will be liable, but those outside the FTT zone (eg. London) will also be liable if dealing with an FTT zone counterparty or in a security issued in the FTT zone. The current proposals are very broad and there are few exemptions.
The FTT failed to win the backing of the G20 so this recent move at the European level, with its significant extraterritorial reach, will be of concern to many countries.
We expect FTT to have a significant impact and expose both financial institutions, and their end customers, to multiple layers of taxation. Some lines or businesses (eg. high frequency trading) may become uneconomic and others will need to be restructured. Trading volumes (and therefore liquidity and the bid/offer spread) in FTT zone-issued securities are likely to be adversely affected. There will be significant costs for end-users seeking exposure to FTT zone securities. This is damaging for both issuers and investors, both in terms of the direct cost but also a reduction in overall yield for FTT zone asset allocations. Pension funds are likely to be particularly adversely affected.
The Commission has proposed a commencement date of 1 January 2014. This gives financial institutions a very short window to assess the impact on business models and pricing and develop systems to account for and pay the tax. The challenge is significant and while the current proposals may be refined by member states, businesses should start preparing now.
Implications for market participants:
- Existing counterparty relationships should be reassessed in light of potential tax implications. For example, a FTT zone bank trading through its Hong Kong branch will expose its counterparty to the FTT, whereas a local institution would not.
- Affected instruments should be identified and reviewed by each business to assess implications for strategy and pricing – for example, will institutions avoid (or seek to synthesise) FTT zone issued securities?
- Systems should be reviewed to assess the changes needed to flag counterparties or instruments subject to FTT.
- Models must be updated to reflect FTT implications in pricing and valuation.
- Processes and IT should be reviewed to assess the necessary change to identify, record, collect and pay FTT incurred.
In the detail…
The concept of an FTT was initially introduced in 2011 for all 27 European Union countries – after failing to win the backing of the G20. Significant push back from many members has led to this revised proposal based on a smaller number of countries. Many of the original attributes of the proposed FTT remain the same, but the scope of the tax has broadened to try and limit avoidance by moving trading activity outside the FTT zone.
Many of these latest EU FTT proposals were in line with expectations on key issues:
- Minimum rate of tax remains unchanged (0.01% of nominal or face value for derivatives, 0.1% for other securities).
- Tax is payable by financial institutions, regardless of whether their counterparty is itself exempt from paying the FTT (see below for exemptions). Financial institutions are very broadly defined to include banks, investment firms, pension funds, insurance entities, UCITS and AIFs.
- Taxability is governed by two principles, 'residence' and 'issuance'.
- The residence principle will catch transactions involving:
- Entities which are incorporated, regulated, tax resident, or have a branch in the FTT zone.
- Non FTT zone entities dealing with a FTT zone entity (eg. this will catch all trades between UK entities and entities treated as established in the FTT zone under any of the tests, including trading with branches of an FTT zone entity).
- This includes transactions between two separate financial institutions within the same group (i.e. intra group transactions) where at least one is resident in the FTT zone.
- A subsidiary of a FTT headquartered entity located outside the FTT zone is treated like any other entity in the same country.
- The issuance principle will catch:
- Securities or listed derivatives issued or deemed to be issued in the FTT zone – theoretically wherever traded.
- The principle of joint and several liability of all parties to a transaction has been preserved – which in practice means that if one counterparty refuses to pay the FTT, the other counterparty could find itself held liable for both sides of the tax (eg. where both counterparties are not in the FTT zone, but are trading in a FTT issued security).
- Certain institutions (central counterparties and clearing houses as well as central banks and similar EU institutions) are exempt, though if a financial institution clears or settles through a CCP located in the FTT zone the financial institution will then itself be subject to the FTT.
- The only full exemption from the FTT is for primary market transactions (ie. share issuances, lending transactions and entering into insurance contracts, UCITs and AIF unit issues).
One significant new proposal is the inclusion of a broadly drafted anti-abuse rule, and a provision aimed specifically at the use of depositary receipts to avoid FTT on FTT zone issued securities. The depositary receipt provision proposes that authorities look through to the essential purpose of the depository receipts and whether they are primarily for the purpose of FTT avoidance. Trades in these instruments regardless of the residence of the counterparties, would then be subject to the FTT.
In practice, these anti avoidance provisions will create significant uncertainty. The status of many individual transactions could be unclear, for example:
- In what circumstances might the use of a synthetic exposure over FTT zone issued securities attract FTT?
- Would a significant shift of trading by FTT institutions to non FTT subsidiaries be caught by anti-avoidance provisions and therefore subject to the FTT? This anti-avoidance assessment will be complicated in the coming years by multiple regulatory pressures which are in any case slowly pushing cross border banks towards greater use of subsidiaries.
Practical economics of the FTT
The principle remains that all financial institutions party to a transaction are liable – so, for a normal buy-sell transaction involving two banks or brokers, the actual tax burden will be 0.1% for each of them, or 0.2% in total on the same transaction (0.02% for a derivative).
However, where a chain of individual transactions make up an overall trade the actual cost could be significantly higher because each transaction passing through the market attracts FTT. Hence, a buy-sell transaction involving a broker and two CCP members attracts six layers of charge (0.6%) even if the two ultimate counterparties are not financial institutions.
The only exceptions are:
- Transfers where the market participant acts as agent for another financial institution.
- Financial positions subject to FTT which are technically short term but in practice continually rolled over as part of a longer term position will attract FTT every time the trade is renewed – which will significantly increase the overall cost and could shake-up what is currently common market practice.
- Regulation is pushing the majority of derivatives trades towards central clearing, incentivised through the prospect of lower overall costs. But the prospect of attracting FTT if clearing through an FTT zone CCP may counteract this initiative and will in any case add cost.
- The number of layers of charge and hence total FTT cost will depend on exact contractual arrangements – these may be reduced depending on contracting arrangements for intermediaries and on hedging arrangements.
- Where transactions in non FTT zone countries already attract a tax or duty (eg. UK stamp duty), there is likely to be double taxation.
- Where banks engage in financing transactions which are not themselves subject to FTT (eg. loans to corporates), they will still incur FTT on their hedging costs, which will impact credit pricing.
- The impact on high frequency trading strategies will be substantial, and some businesses may become uneconomic.
- Securities lending and repo transactions will be caught albeit only treated as one overall transaction for the purposes of the FTT, rather than each party paying tax on both the sale and repurchase of an asset.
Participating member states must agree the draft directive and implement the directive under local law. The deadline for this is 30 September 2013.
It is possible that the directive could be subject to significant revision or a delay in implementation. However, financial institutions should start planning now for a 1 January 2014 commencement date for the FTT in its current form.
Actions to consider:
- Identify business lines that might be adversely affected and whether these could be restructured to mitigate the FTT burden (eg. by reducing the number of parties/steps to a trade or acting as agent rather as principal).
- Assess the regulatory implications of any proposed restructuring. The FTT will encourage more OTC trading but the collateral requirements and capital cost of doing this may significantly outweigh any FTT benefits.
- Consider choice of counterparty and location of trades.
- Consider pricing implications where cost is to be passed on to customers (particularly where different counterparties will have different liabilities).
- Assess changes to existing terms and conditions to limit the possibility that FTT costs are passed on and issues such as joint and several liability are addressed.
- Plan required systems modifications – these will be very significant and will require systems to identify:
- customer location
- location of issuance of securities
- location of clearing or settlement houses
- occasions of FTT charge
- different pricing models for different counterparties
- information required for FTT payment and reporting
- System modification will need to reflect that immediate payment is required for electronic transactions and is expected to be managed by central counterparties (eg. Euroclear). In all other cases payment is required in three days. In addition, reporting (possibly to all 11 FTT zone tax authorities) is required on a monthly basis.