The Financial Transactions Tax – One Big Mess

So the Financial Transactions Tax (“FTT”) seems to be stuck in a rut at the moment. Last month, Chris Leslie MP voiced Labour’s support for the FTT provided that it was an international tax. In a rare show of cross party political agreement, the Tories agree. However the FTT is a complicated beast that does not seem to have been fully thought out. Whilst I too support the FTT in principle, there are just too many unanswered questions for the UK to agree to the current proposal.

It should be noted that the FTT is not a Tobin tax. James Tobin argued for an international tax to be imposed on spot currency transactions, designed to enhance international currency stability. The FTT is not international and does not apply to spot foreign exchange transactions.

I’ve also heard opponents of the FTT claim that ordinary consumers like you and I will have to pay the FTT as we daily enter into financial transactions using online banking, credit and debit cards. This again isn’t true, at least in the context of the financial transactions consumers commonly think of. The FTT specifically excludes from its scope loans, deposits, spot foreign exchange transactions, emissions credits and commodities and most consumer product such as insurance contracts, mortgage lending and consumer credit. You won’t pay the FTT every time you use your debit card at ASDA. However, it’s not impossible that consumers might be indirectly charged the cost of the FTT by financial institutions; however this is an argument against all taxation and does not take into account the splitting of retail and investment banking as proposed by the Independent Commission on Banking.

Although the cost may not be passed to us, it could be passed to our employers who transact with banks. If your employer has entered into financial transactions such as interest rate or currency rate swaps (a common practice by all companies who borrow at a floating rate or in a different currency to the one they trade in) they are likely to have to pay the FTT. This will indirectly impact on its employees.

Also, if you have a private pension (through your employer or a financial advisor) that works by investing in the stock market, you will have to pay this tax every time you fiddle with your investment portfolio or every time your pension provider buys more stock on your behalf (as you increase your pot). So how much will you pay? Or to put the more pertinent question out there, how much more tax will you pay than is currently paid?

At the moment, the relevant tax is stamp duty, currently 0.5% of the consideration for equities (the money paid for shares) and it doesn’t apply to debt i.e. bonds. In the UK this currently accounts for about £4 billion of tax receipts a year. FTT will replace stamp duty but the Commission’s report on the FTT gives no figure for how much stamp duty across the EU will be lost. The Commission does estimate a reduction in economic output of 1.8% as a result of the FTT but does not have a figure for the reduction in corporate or personal tax receipts. It does estimate that the FTT will generate anywhere between £16 billion and £43 billion across the EU (talk about a wide margin of error) and this depends on the degree that the securities and derivatives markets leave the EU (see further below). It also seems that the Commission’s original estimate of receipts was only £10 billion. The sums are not yet fully thought through, but it seems quite likely that the FTT could result in a net reduction of tax revenue, not an increase.

The FTT is clearly designed to reduce high frequency trading by positively encouraging financial institutions to take these practices outside the EU. It achieves this in two ways, the first by being jurisdiction specific albeit with a very wide scope of capture. The FTT will apply not just to financial institutions based in the EU but also to a financial institution located anywhere in the world that enters into a financial transaction (as principal or agent) with a financial institution in the EU. Contrast the FTT to stamp duty which applies regardless of where the relevant entity is located. The Commission has estimated that the derivatives market will shrink or relocate by 70-90%.

All this is good news for tax havens and tax avoidance. An SPV set up for tax avoidance purposes in the Cayman Islands that enters into a share trade with Barclays Bank now has to pay the 0.1% FTT. Sounds great until you realise that previously they were paying 0.5% stamp duty. If the derivatives market leaves the EU, well that’s even better news for our Cayman tax avoidance SPV if it now has to pay less or no tax at all as the derivatives market is located in Asia or America.

Surely this is madness? Not only does the FTT probably result in a reduction of tax receipts but it actually facilitates tax avoidance schemes using tax havens by a replacing a non-jurisdictional relevant stamp duty with a jurisdictional relevant FTT.

Another little wrinkle, the actual rate that applies to a transaction entered into by your pension fund is not 0.1%. The second way that the FTT wants to reduce high frequency trading is by not allowing for exemptions for intermediaries such as brokers and clearing members in the same way that stamp duty does. So when your pension fund buys a share, it does so through a broker and a clearing member from a vendor (likely to also be a financial institution) which also uses a broker and a clearing member. The vendor pays 0.1% when it sells to its broker. The vendor’s broker pays 0.1% when it buys from the vendor and another 0.1% when it sells to the clearing member. The clearing member pays 0.1% when it buys from the broker and another 0.1% when it sells to the central counter party (which is exempt from the FTT). When the pension fund’s clearing member buys from the central counterparty it pays 0.1% and it pays again when it sells to the pension fund’s broker. The pension fund’s broker pays 0.1% when it buys from the pension fund’s clearing member and pays 0.1% again when it sells to the pension fund. Finally your pension fund pays 0.1% when it buys from its broker. Total paid is 1% on the transaction.

And there folks is the dilemma. That is 1% paid taken from the value of your pension fund and collective investment schemes that currently pay no tax on bond transfers and only 0.5% on the purchase of equities. However, if we allow for exemptions for intermediaries, then this will defeat the policy objective of the FTT. The FTT is specifically designed to make it expensive to conduct high frequency trading of securities and derivatives which is done through intermediaries. Will our tax avoidance Cayman SPV be picking up more than 0.1%? Maybe, but then again, maybe not. It could be that to make the deal happen, one party (your pension fund?) might have to pick up the whole 1%. And despite the headline increase in the amount paid, its effect is to reduce tax receipts.

The Commission’s estimate of a reduction in the EU derivatives market is probably accurate. Certainly when Sweden introduced a similar tax on bonds in the 1980’s (set at 0.003%), their market reduced by 85%. However, in the case of the FTT, it is not a reduction but more likely a relocation due to the geographical nature of the tax. The EU will certainly lose the taxation benefits of that market but will it also lose the risk of that market?

No. The old adage “When America sneezes, the rest of world catches cold” is a true today as it was in the 1930’s and is especially true when it comes to the financial services industry. If the derivatives market leaves the EU and suffers a collapse or encourages a collapse in the liquidity of the banks that trade in it (i.e. a credit crunch) then that will still spread to the EU due to how interdependent the banks are across the globe. One of the lessons learned from the credit crunch is that regulation prior to it was far too institution specific and did not focus on the inherent risks of the market as a whole. The FTT is ignoring this lesson by pretending that if the derivatives market is not in the EU, it’s not a problem. Both Chris Leslie and the government are right to oppose the FTT on the grounds it is not international and Chris Leslie is right to criticise the government for not taking a stronger leadership position in trying to develop one. Even the original Tobin tax only worked if it was international. The Commission recognised the problem of relocation and its failure to address risk in a 2010 discussion document. Nonetheless, they are still pushing for the FTT. Bizarre!

Leaving the jurisdictional nature of the FTT aside, the complexity of the FTT is also a big fat open doorway to tax avoidance structures. Don’t be surprised if clever lawyers start coming up with ways around it (I used to be one, they will). So if a borrower borrows £X at a floating rate of interest and wants to hedge that into a fixed rate of interest, instead of entering into a FTT subject interest rate swap, the borrower and bank might use another lending structure (loans being exempt from FTT) to avoid the FTT.

If Cameron has successfully killed the FTT, we are likely to see it being replaced with arguments for an FAT (Financial Activities Tax) i.e. a tax on a financial institution’s profits and their employee remunerations above a threshold or to put it another way a bank specific increase in corporation tax and a tax on bonuses. That too has problems, not least that it is probably unconstitutional in many member states particularly Germany. However, it is likely that the political determination to tax the banking sector more than other business will turn this way.

Those who advocate the Robin Hood tax cry “justice” as a reason to tax the banks. Whilst I have every sympathy for their motivations, I strongly believe that tax should be about raising revenue for public services and adjusted so as to encourage economic development where needed or restrict on balance harmful activities (which may include high frequency derivative trading). It should be progressive (i.e. the rich pay more than the poor), transparent and as simple as possible. Introducing taxes for political motivations or social adjustment, be it things I might like such as revenge on bankers or things I dislike such as encouraging marriage at the expense of single parents (anyone remember that?), should not be on the agenda. If the FTT or the FAT would increase the taxman’s revenue without being outweighed by any harm to the economy done by a reduction in economic output from the financial services sector, I’d be all for it. However, the current proposal is just a big mess that in the long run is more likely to benefit the bankers and harm the taxpayer.