Part 1:
French transaction tax loophole could prompt tougher European regimes
Author: Tom Newton
Source: Risk magazine | 10 Jan 2013
Categories: Equity Derivatives
France went first with its new transaction tax regime â and found that leaving derivatives outside its scope created a loophole. Italy is up next and is set to fix that problem with a broader tax. Could other European nations follow suit? Tom Newton reports
In 1984, Sweden launched its first financial transaction tax (FTT), a 0.5% levy on equity trades. Over the next six years, it was refined and extended to other asset classes, including bonds and derivatives. The results were stark. Roughly half of Swedish equity trading migrated to London. Bond trading volumes dropped 85%, even though the tax rate was just 3 basis points. The volume of futures trading fell 98%, and the options market effectively disappeared.
Itâs an old story that has become newly relevant, as 11 European countries prepare to introduce a common transaction tax. The big question for dealers is whether over-the-counter derivatives will be caught â traders argue a tax would decimate the market â and the debate has taken a worrying turn for the industry in the past couple of months.
In France, a member of the 11-country bloc that introduced its own tax on cash equities last August, authorities have said they could act to prevent the levy being evaded by using untaxed derivatives to take equity market exposure instead â implying an expansion in the scope of the tax. In Italy â another member of the FTT bloc to move early â the countryâs Senate voted through a budget on December 20 that includes a tax on both cash equities and equity derivatives. That is thought by some observers to be a reaction to the problems France is experiencing with its tax loophole.
The commission closely monitors the experience of member states that have introduced an FTT
And the fear among dealers is that the common FTT slips back towards an original proposal published by the European Commission (EC) in September 2011, which included a blanket 0.01% levy on the notional value of all OTC derivatives. In a statement to Risk, the EC confirms it is keeping an eye on early adopters of the tax.
âThe commission closely monitors the experience of member states that have introduced an FTT, even where such national taxes differ significantly from the one the commission proposed last year,â says a spokesman for the ECâs taxation commissioner, Algirdas Semeta. The spokesman adds that the EC still considers it feasible to tax all derivatives, as per the original proposal.
To put it mildly, the industry disagrees. The ECâs levy of 0.01% might initially seem generous when compared with the 0.1% tax on other products, but it would have been applied to the notional value of OTC trades. The EC accepts that notional values can grossly overstate the economic value of a transaction, but claims it would be easier to apply.
It would not, though, be easier for the market to bear. The ECâs impact assessment predicted derivatives volumes could fall by up to 90%, and itâs not hard to see why even an apparently small levy would have a massive impact.
âThe fees are actually astronomical. If you compare the proposed charge of 0.01% to existing exchange and clearing fees, then itâs a multiple of those costs. For exposure to â¬1 million worth of three-month Euribor, exchange and clearing fees might typically amount to 25p. The proposed tax would add an extra â¬100 in cost,â says Guy Simpkin, head of business development at Bats Chi-X Europe in London.
The EC proposals resulted in stiff resistance from a number of countries, among them Sweden and the UK, but gained a new lease of life when a subset of European states decided to develop an FTT of their own, using an EC procedure known as enhanced co-operation, whereby a coalition of like-minded member states can implement legislation without the support of all 27 European Union countries (Risk February 2012, pages 26â29). And although France decided to go early rather than waiting for the process to run its course, it baulked at introducing a blanket derivatives tax â despite strong public support for measures designed to rein in trading.
âIf you looked at the way the French tax was designed, then you knew there was a disconnect between the political rhetoric and the reality. In all honesty, I donât believe the tax was intended to be very punitive, as French policy-makers knew they risked shooting themselves in the foot,â says Jiřà Król, director of government and regulatory affairs at the Alternative Investment Management Association in London.
On August 1 last year, France went live with its version of the transaction tax. The taxe sur les transactions financières applies to the equity instruments of companies headquartered in France with a market capitalisation greater than â¬1 billion â currently catching 109 stocks. Originally set at 0.1% of each transactionâs value, it had doubled to 0.2% by the time the law was adopted by the French parliament on February 29.
Almost as soon as the tax was introduced, reports emerged that market participants were looking for ways to dodge it â and derivatives markets, listed or OTC, were the obvious dodge. âMarket participants can just switch to derivatives, either through their brokers or directly on the listed markets,â Dominique Ceolin, chief executive of hedge fund ABC Arbitrage in Paris told Risk last November.
That translated into increased demand for equity swaps and contracts for difference (CFDs), say traders, as clients sought leveraged, synthetic exposure to movements in the underlying French equities without having to pay the tax. Industry sources estimate monthly cash equity volumes are down around 10% since the tax was introduced â which chimes with figures compiled by NYSE Euronext in November. At the same time, anecdotal evidence suggests CFD volumes have increased by as much as 25%.
Ironically, dealers are said to have been using the market-maker exemption the French tax grants to dealers in cash equities to hedge their tax-dodging OTC trades, according to one London-based market expert. âWhat is clearly happening is that banks are writing more equity swaps and CFD business with customers, and then using their market-maker exemption to trade stocks on the exchange as a hedge,â he says.
The upshot of the loopholeâs exploitation is that the tax may not bring in as much money as the French authorities had forecast, says Jorge Morley-Smith, head of tax at the Investment Management Association in London. âThere are a lot of rumours about the rate of the tax increasingâ as a result, he adds.
Increasing the rate of the tax might â temporarily â help fill a revenue shortfall, or it might simply encourage more market participants to turn to the derivatives market. Another possibility is that the scope of the tax could be widened, to close the loophole.
In an emailed comment to Risk in November, the French tax authorities signalled they were alert to the issue. âWe will be very careful on the risk of bypassing and tax evasion through synthetic instruments and take appropriate measures where needed,â wrote Laurent Martel, tax adviser to Pierre Moscovici, the French finance minister.
While no concrete proposals have emerged as yet in France, the baton has been seized by Italy. On December 20, the countryâs Senate voted through its own tax applying a 0.1% charge to equity transactions in Italian stocks with a market capitalisation over â¬500 million, as well as a levy on equity derivatives where the underlying is a taxable Italian stock.
The original draft of Italyâs tax went further than the EC proposal, suggesting a higher rate of 0.05% on the notional value of derivatives. However, the countryâs own impact assessment projected an 80% fall in volumes, and Italian lawmakers significantly pared back the tax in the face of intense industry lobbying. The law now prescribes levies for each counterparty, which vary according to the type of trade â ranging from â¬15 for a listed equity derivative to â¬200 for an OTC equity swap â according to Ernst & Young. The decision to leave equity derivatives within its scope may well be a direct response to the French experience.
âBy including a tax on equity derivatives, the goal is to avoid any possibility that people can avoid paying tax on cash share transactions,â says Marco Ragusa, a tax partner in Ernst & Youngâs financial services division in Milan.