By John Hintze
By widening the financial transaction tax net, governments set up a choice between the lesser of two evils.
Although most developed countries levy limited transaction taxes, 11 European countries formally announced February 14 that they would pursue a broader, far reaching tax on not only securities but derivatives, directly impacting companies’ bottom lines and hedging strategies.
As the market digests the European Commission’s (EC) proposed tax, slated to be implemented at the start of 2014, it looks like it will have the biggest impact on small and mid-size companies based in the tax zone. It could also present an unusual choice for multinational corporations, which may have the resources to choose between jurisdictions with the new derivatives rules that hurt them the least. And one outcome that seems fairly certain for all, according to a study conducted by Marsh & McClennan’s Oliver Wyman research unit, is that nonfinancial corporates and other end users will face significantly higher costs to hedge risk.
Seems minuscule but. . .
Nonfinancial corporations are technically exempt from the tax, and the 0.1 percent tax on securities transactions and 0.01 percent tax on the notional amounts of derivative trades initially appear minuscule. The Oliver Wyman study, however, quickly puts the cost of the tax into perspective by illustrating that the EUR 279 cost to end users today for a one-week, Euro/US dollar FX swap with a notional amount of EUR 25 million would, under the proposed tax, increase to as much as EUR 2779–a 1000 percent jump.
“The bank is not going to be able to eat EUR 2500 when it only made EUR 279 on the trade in the first place. So it’s going to have to pass it on to the end user,” said James Kemp, managing director of the FX division of the Global Financial Markets Association (GFMA).
The tax and subsequent cost increases apply to other types of derivatives as well, and while end users and especially nonfinancial corporates are not major users of credit derivatives, they regularly hedge using interest-rate swaps. Companies and financial institutions in the eleven countries supporting the transaction tax, including the major economies of Germany, France and Italy, although not the UK, would be impacted the most. However, the EC proposal seeks to extend the reach of the tax by requiring it to be levied on counterparties to a transaction no matter where they are located, as long as one counterparty is based in the tax zone.
In fact, the tax is to be applied to the trade of any financial instrument issued by an entity located in the tax zone, although that requirement impacts securities more than derivatives, and so has less direct impact on corporates. As a result, US corporates and banks that deem the tax or its resulting costs too high will essentially lose the ability to enter into transactions with some of the biggest derivative counterparties in the world, such as banks in France and Germany. Likewise, global corporations headquartered in the tax zone will face some major decisions, such as whether to relocate treasury departments and other derivative trading units to jurisdictions outside the tax zones.
Craig Pirrong, a professor of finance at the University of Houston’s Bauer College of Business, noted that the largest companies will be best positioned to reorganize their operations to reduce the impact
of the transaction tax, leaving other companies in the tax zone at a disadvantage in terms of hedging costs.
The transaction tax also may create a quandary for big MNCs in Europe as well as the US, where the Dodd-Frank Act will add restrictions and costs to trading OTC derivatives, including FX transactions. US regulators are currently proposing to stretch the jurisdiction of Dodd-Frank to counterparties outside US borders, if a US-based counterparty is involved, instead of the more traditional approach of letting counterparties adhere to the rules of their local jurisdictions. If the traditional approach prevails, however, multinationals may have a difficult choice to make.
“Then it’s pick my poison,” Pirrong said. “If you trade from one of the 11 EU countries, you’re subject to the tax; but if you say you’ll do your FX trading away from the tax, in the US, then you may end up in Dodd-Frank’s sights.”
More market segmentation
The mishmash of new rules and taxes impacting derivatives seems likely to lead to more segmentation of markets and market participants, and increased market volatility. The Oliver Wyman study points to research indicating higher transaction costs can lead to more price volatility, reduced activity of speculative traders—one of the tax’s stated goals—and so less liquidity and price discovery, and perhaps a delay in prices reaching their fundamental values. The study also notes that a reduction in liquidity will likely widen bid/ask spreads and increase trading costs.
Richard Raeburn, chairman of the European Association of Corporate Treasurers (EACT) pointed to the big-picture impact of the tax. He said politicians were taking advantage of the public’s current wrath toward banks to promote the tax, but in fact the tax “will be paid by all except the banks themselves.
“It’s difficult to see the [transaction tax] as anything other than a tax on the real economy rather than on financial institutions,” Raeburn said, adding that as the tax “accumulates within the financial markets, the total tax burden will be
recovered from the real economy and pension fund customers of banks.”
The Oliver Wyman study, which discusses only the FX market impact, estimates that the transaction tax would result in between 70 percent and 75 percent of trading volume relocating outside the tax zone. Most of that volume will be among highly mobile counterparties such as banks and hedge funds, while corporates, insurance companies and other less mobile financial institutions may be able to relocate only 30 percent to 40 percent of their FX volumes. The study also notes that previous research indicates 90 percent of new taxes on financial institutions is passed on to end users. This does not bode well for an already struggling EU. “We believe the tax will be a brake on economic growth,” Kemp said.
Low impact?
The EU’s revised impact assessment, however, isn’t especially severe. It estimates the tax will hold back GDP by 0.28 percent, so that GDP growth by 2050 would be 81.1 percent above today’s level rather than 81.4 percent. The assessment also notes that costs for industries that actively hedge risk could “become somewhat more expensive as a consequence of direct effects of a [FTT] of 0.01 percent.”
However, the assessment adds that “the positive indirect effects from squeezing out excessive intermediation or of ‘spread internalization’ should largely offset this direct effect.” The commission also notes that administration costs to apply the tax should be “very subdued,” and it points to the UK stamp tax on securities trades that “is reported to be about 0.1 percent of revenue collected.”
However those costs actually play out for banks and their customers, the commission is clearly betting on the economic size of the 11 proposal-supporting EU members, which represent about two thirds of the EU economy, as being too big a market to ignore. In addition, the proposal would assess the tax on any transactions involving a counterparty that’s based in the tax zone and includes “economic substance” involving one of the eleven countries, although precise details about how that would be instituted are unclear at present.
Thus an FX swap between the treasury office of a major European corporation that’s based in Singapore and a major US bank could see the tax levied on the bank, which would most likely pass on most or all of that cost to the corporate. How such a tax would be collected is a detail that still must be worked out, said Kemp, adding, “one way to do it would be to make the entity based in the tax zone liable for the tax the other party should pay.”
The commission also appears to be counting on other countries to adopt a similarly broad transaction tax, to reduce the temptation to relocate trading activity. Several European policy-makers have called on the US, which is the only major financial center that does not impose some sort of transaction tax, to reconsider its opposition. One lure may be the tax revenue it could generate. The commission estimates the tax raising as much as EUR 35 billion annually, although critics say transaction taxes, such as the UK’s stamp tax, typically produce far less revenue than projected as market participants adopt avoidance schemes. So far, US opposition to such a tax appears to be unchanged, although some Democratic lawmakers have backed one.
hurdles remain
Although there appears to be plenty of momentum among European states to pursue a common transaction tax, there are a number of hurdles. For one, existing transaction-tax initiatives from tax-zone members such as France and Italy are much more limited, and they’re likely to push for a final version that resembles the one they’ve devoted resources to implement. The approval process also faces several stages that could each upset progress or result in the proposal being altered significantly.
The decision on February 14 was to proceed with the proposal, and now the eleven countries must work on a common version that each can institute as national law, hopefully by September if it is to go live next year.
“It’s very political,” said Kemp, noting several elections occurring later this year that could have an impact, including federal elections in Germany, which tends to support the broader transaction tax. “We’re anticipating there will be an awful lot of debate about the scope of the tax, in terms of the instruments and end users it covers, and possibly even the tax rate.”