The proposals made by the EU Commission on 28 September 2011 regarding an EU directive on a common system of financial transaction taxation in the 27 Member States of the EU have been debated widely in the three weeks since they were presented. The presentation of the proposed Directive (the "Directive"), together with proposals to amend Directive 2008/7/EC concerning indirect taxes on the raising of capital, represent the latest stage in a series of announcements by EU authorities directed towards ensuring that the European financial sector should "contribute more fairly"1 towards the costs of addressing and rectifying the current European financial crisis. A series of conclusions from the European Council2, communications addressed to the European Parliament3 and EU Commission staff working papers4 and consultations throughout 2010 and 2011 have created a platform upon which the relative merits of various options for taxing the financial sector have been analysed. These developments have taken place in tandem with both Member State initiatives (such as the UK bank levy introduced in Finance Act 20115) and international discussions involving the International Monetary Fund6 and the G-20 group of countries7.
With the depth and nature of the European financial crisis continuing to evolve and the costs of stabilising and recapitalising the European financial sector showing no signs of abating, the Directive comes at a profoundly sensitive political and economic time. This memorandum considers both the mechanics of the proposed financial transaction tax (the "FTT") and looks at some of the challenges which the EU Commission, Member State governments and financial institutions will face in attempting to create a workable tax which achieves the aims of its proponents. The analysis in this memorandum is based on the Directive, and supporting documents, published on 28 September 2011.
The objectives of the FTT have been stated by the EU Commission as being:
to raise revenue and obtain an adequate contribution from the financial sector to compensate for the costs of the financial crisis, thereby ensuring a "level playing field with other sectors from a tax perspective"; to limit undesirable market behaviour and stabilise markets; and to ensure the functioning of the internal market of the EU and prevent internal market fragmentation through disparate unilateral Member State initiatives.8 These objectives are, in turn, devolved from the reasoning behind the FTT that, among other things, the financial sector "should bear its fair share of the costs of the financial crisis"9 and that the financial crisis was attributable to, or exacerbated by systemic risks in the financial sector, not least of which was the proliferation of financial products and counterparty risk.
Scope of FTT
The FTT is a tax applied to financial transactions where at least one of the parties is a financial institution and either that party or another party to the financial transaction is established in a Member State of the European Union (a "Member State"). The key terms "financial transaction" and "financial institution" are both defined in the Directive. It is not relevant whether the financial institution which is a party to the transaction is acting as a principal or an agent in that transaction10.
The definition of "financial institution" includes a wide range of entities, including banks, credit institutions, insurance and reinsurance undertakings, pension funds, UCITS collective investment funds and their investment managers, securitisation SPVs and other special purpose vehicles and certain leasing companies.11 The breadth of the definition of financial institution may also encompass Treasury companies within corporate groups, which points towards a possible inconsistency between the financial sector-focused policy objectives underpinning FTT and the precise drafting of the Directive.12 Central counterparties for clearing houses, securities depositories, the European Financial Stability Fund and (with an eye to the future, possibly) any "international financial institution established by two or more Member States which has the purpose to mobilise funding and provide financial assistance to the benefit of its members that are experiencing or threatened by severe financing problems" are not "financial institutions".13
Where a person carries on deposit taking, lending, providing guarantees, finance leasing or participates in financial instruments as a "significant activity in terms of volume or value of financial transactions", such a person would also be treated as a financial institution14.
The FTT taxes a "financial transaction". This is defined as being:
the sale and purchase of a financial instrument before netting or settlement including repos and securities lending agreements; the transfer between group entities of the right to dispose of a financial instrument and any other operation effecting a transfer of risk associated with that instrument; and the "conclusion or modification" of derivatives agreements (the terms "conclusion or modification" are not further defined in the Directive and no further guidance is given in any of the supporting documentation produced by the EU Commission). The entry into a derivative, any change in its terms, any extension or close out of a derivative, whether cash or physically settled would appear to fall within these concepts and therefore fall within the scope of FTT. Certain types of derivatives, such as variance swaps, reflect daily price changes based on the closing price of the underlying product, so such swaps can arguably be said to be "modified" on a daily basis. Any "subsequent cancellation or rectification" of a financial transaction has no effect on chargeability (except where an error can be proven), with no rebate of previously chargeable tax being available in these circumstances.15
"Financial instruments" are themselves defined as being the instruments falling within Section C of Annex I of Directive 2004/39/EC (the Markets in Financial Instruments Directive). This definition encompasses a wide range of instruments covering shares, securities (including listed bonds), units or shares in collective investment undertakings, options, futures and other derivatives. Derivatives are included irrespective of whether they are physically or cash-settled and regardless of whether the underlying is itself a financial instrument16. Both repos and securities lending agreements are expressly defined as "financial instruments", as are "structured products", the latter being securities or other financial instruments offered by way of securitisation17 or equivalent transactions involving the transfer of risk other than credit risk. The Explanatory Memorandum to the Directive makes it clear that the scope of FTT extends to regulated markets, multi-lateral trading facilities and also over-the-counter trading in financial instruments.
Importantly, a number of transactions are excluded from the scope of FTT. The EU Commission has announced that "all transactions in which private individuals or SMEs were involved would fall outside the scope of the tax"18. Elsewhere reference is made to "ring-fencing of the lending and borrowing activities of private households, enterprises or financial institutions and other day-to-day financial activities".19 The precise scope of this exclusion is currently unclear. It appears that mortgage lending...