French transaction tax loophole could prompt tougher European regimes

France went first with its new transaction tax regime – 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 three basis points. The volume of futures trading fell 98%, and the options market effectively disappeared.

It is 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 - traders argue a tax would decimate the market - 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 - implying an expansion in the scope of the tax. In Italy - another member of the FTT bloc to move early - the country's 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.

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, the EC confirms it is keeping an eye on early adopters of the tax.

"The 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," says a spokesman for the EC's taxation commissioner, Algirdas Semeta. The spokesman adds that the EC still considers it feasible to tax all derivatives, as per the original proposal.

The commission closely monitors the experience of member states that have introduced an FTT

To put it mildly, the industry disagrees. The EC's 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 EC's impact assessment predicted derivatives volumes could fall by up to 90%, and it is not hard to see why even an apparently small levy would have a massive impact.

"The fees are actually astronomical. If you compare the proposed charge of 0.01% to existing exchange and clearing fees, then it's a multiple of those costs. For exposure to €1 million worth of three-month Euribor, exchange and clearing fees might typically amount to 25p. The proposed tax would add an extra €100 in cost," 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. 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 - despite strong public support for measures designed to rein in trading.

"If 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 don't believe the tax was intended to be very punitive, as French policy-makers knew they risked shooting themselves in the foot," says Jiří 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 €1 billion - currently catching 109 stocks. Originally set at 0.1% of each transaction's 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 - and derivatives markets, listed or OTC, were the obvious dodge. "Market participants can just switch to derivatives, either through their brokers or directly on the listed markets," said Dominique Ceolin, chief executive of hedge fund ABC Arbitrage in Paris 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 - which chimes with figures compiled by NYSE Euronext in November. At the same time, anecdotal evidence suggests CFD volumes have increased by up to 25%.

 

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