Implementing enhanced cooperation in the area of financial transaction tax

Analysis of policy options and impacts

This document is a response to the request by both participating and non-participating Member States for an analysis of the impacts and economic consequences associated with the introduction of a financial transaction tax by way of enhanced cooperation. It also tries to identify and analyse options that help to minimize evasive actions, distortions and transfer of financial services to other jurisdictions, and it analyses the impacts of some of the options discussed in the Council's Working Party on "Tax Questions" under the Danish Presidency in the first half of 2012. This document does not constitute in itself an Impact Assessment and it should be read in conjunction with the Impact Assessment having accompanied the initial proposal and additional analysis undertaken and made public by the European Commission since, as it builds on the findings of these analyses and makes use of them. This document commits only the Commission's services involved in its preparation.

Contents

1. INTRODUCTION.. 4

2. PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES. 6

3. PROBLEM DEFINITION AND SUBSIDIARITY.. 8

3.1 Problem definition. 8

3.2 EU right to act and subsidiarity. 9

4. OBJECTIVES. 11

5. POLICY OPTIONS. 13

6. ANALYSING THE IMPACTS OF DIFFERENT POLICY OPTIONS FOR A COMMON SYSTEM OF FTT UNDER ENHANCED COOPERATION.. 16

6.1 The Commission proposal under enhanced cooperation (Option C) 16

6.2 Sub-Option 1: Exempting certain products. 25

6.3 Sub-Option 2: Exempting certain actors. 33

6.4 Sub-Option 3: Changing the provisions on the residence principle. 39

6.5 Sub-Option 4: Phasing in of the common system.. 43

6.6 The macro-economic effects of an FTT under enhanced cooperation. 44

6.7 Other (micro-)economic effects. 47

7. COMPARING THE DIFFERENT POLICY OPTIONS. 50

8. IMPLEMENTATION, MONITORING AND EVALUATION.. 53

8.1 Implementation. 53

8.2 Monitoring. 55

8.3 Review.. 58

Annex 1: Taxes on transactions in financial instruments in the EU.. 60

Annex 2: Taxes on transactions in financial instruments in third countries. 69

1. INTRODUCTION

On 28 September 2011, the Commission adopted a proposal[1] for a Council Directive on a common system of financial transaction tax (FTT) and amending Directive 2008/7/EC[2].

The legal basis for the proposed Council Directive was Article 113 TFEU, as the Commission proposed provisions for the harmonisation of legislation concerning the taxation of financial transactions to the extent necessary to ensure the proper functioning of the internal market for transactions in financial instruments and to avoid distortion of competition. This legal basis prescribes Council unanimity in accordance with a special legislative procedure, after having consulted the European Parliament and the Economic and Social Committee.

While already before the onset of the financial and economic crisis some Member States had narrowly-based taxes on some financial transactions in place[3], several others have decided or committed themselves to either introduce such a tax, broaden its scope and/or increase the tax rates so as to ensure that financial institutions make a fair and substantial contribution to covering the costs of the recent crisis, and for consolidating public budgets.

In this context the efficient functioning of the internal market (for financial services and beyond) required action intended to avoid distortion of competition across borders, and among products and actors. Also, considerations as regards tax neutrality required harmonisation with a broad scope, notably to also cover very mobile products such as derivatives, mobile actors, and market places.

The Commission's proposal for a Directive on a common system of FTT set out the essential features of such a common system for a broad based FTT in the EU that aims at achieving these objectives. It was conceived so as to minimise the risk of relocation, notably by foreseeing very low tax rates, taxing both ends of the transaction, and foreseeing a taxation of all financial transactions in financial instruments (all markets, all actors, all products) in which at least one party to the transaction is established in a Member State and where a financial institution established in the territory of a Member State is party to the transaction, acting either for its own account or for the account of another person, or is acting in the name of a party to the transaction. Thus, the tax could only be avoided by those financial institutions that no longer wanted to serve the EU market.

However, despite these powerful anti-relocation measures foreseen, already during the first relevant meeting of the Council on Economic and Financial Affairs of 8 November 2011, some Member States declared that they were against any common system of financial transaction tax at the level of the European Union unless an FTT of similar kind was introduced at the global level.[4]

During the seven meetings of the Council's "Working Party on Tax Questions – Indirect Tax (FTT)" (hereafter "Council Working Party"), first under the Polish and then under the Danish Presidency, in which also numerous alternative design features of an FTT based on the Commission proposal were tabled, examined and discussed, it was confirmed that unanimous support for a common system of FTT, be it along the lines of the Commission proposal or any variant thereof, could not be reached at the level of all Member States.

At the Council meeting on 22 June 2012, the Member States that had expressed their opposition to a common system of FTT already at earlier stages reiterated their position. In those circumstances, several other Member States voiced their intention to request an authorisation for engaging in enhanced cooperation in accordance with Article 20 TEU and Article 329 TFEU. Some of the opponents to a common system of FTT (of any kind) stated that they would not oppose a procedure of enhanced cooperation on this issue in case all the necessary requirements were met.

Having regard to the views expressed, the (Danish) Presidency concluded at the same meeting that support for an FTT as proposed by the Commission was not unanimous. The Presidency also noted that there was support by a significant number of delegations for considering enhanced cooperation.

At the Council meeting of 10 July 2012, the (then Cypriot) Presidency referred to the discussions held at the Council meeting of 22 June 2012. It noted the lack of unanimous support for the FTT proposal discussed under the Danish Presidency. It concluded that essential differences in opinion persist as regards the need to establish a common system of FTT at EU level and that the principle of harmonised tax on financial transactions will not receive unanimous support within the Council in the foreseeable future. It finally noted that there is support by a substantial number of Member States for considering enhanced cooperation, which would allow a limited number of Member States to first proceed among themselves.

In these circumstances, eleven Member States (Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia, Spain) have addressed formal requests to the Commission indicating that they wish to establish enhanced cooperation between themselves in the area of the establishment of a common system of FTT and that the Commission should submit a proposal to the Council to that end.

On 23 October 2012, the Commission presented its findings on these requests. It could not find a single incidence of non-compliance of these requests with Treaty provisions and, after assessing the political opportunity of progress on this file, proposed a Council Decision authorising enhanced cooperation in the area of financial transaction tax.[5]

The present document summarises the findings of the analysis undertaken by the Commission notably in the context of facilitating the discussions in the Council Working Party under the Danish Presidency in 2012 and in the context of preparing the ground for the concrete design features of a Council Directive implementing enhanced cooperation in the area of financial transaction tax.

2. PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES

This analysis of policy options and impacts of implementing enhanced cooperation in the area of financial transaction tax benefited and builds on the Impact Assessment having accompanied the initial Commission proposal[6], the annexes to that Impact assessment as well as additional analysis undertaken and published by the European Commission[7].

The present document also benefited from the consultation of various interested parties over the last year, such as Member States, the European and national parliaments, representatives of the financial industry from within and from outside the European Union, the academic world, workers' and employers' associations, non-governmental organisations, and the results of ad hoc external studies and position papers that had been published in the aftermath of the tabling of the Commission's initial proposal on a common system of FTT for the entire European Union.[8]

Commission representatives participated in numerous public events across and outside Europe on the establishment of a common system of financial transaction tax. Also, the Commission actively participated in a dialogue with various national parliaments and their relevant committees that indicated interest in discussing the impacts and different policy options for taxing the financial sector.

This consultation complemented the consultation already carried out in the run-up to its initial proposal of September 2011, the conduct and results of which had been documented in the impact assessment document accompanying this initial proposal.[9]

Not surprisingly, the positions of stakeholders differed according to their affectedness by the tax proposed: representatives of the envisaged tax payers such as banks, alternative investment funds and other financial institutions were largely opposed to such a common system (and an FTT in general), while representatives of NGOs and trade unions expressed their preference in favour of such a common system (and the FTT in general).

The seven meetings of the Council Working Party organised under the Polish and under the Danish Presidency in December 2011 and between January and June 2012 have also helped the analysis and the debate on financial sector taxation to a great extent.

The analysis of policy options and impacts was presented to IAB on 27 November 2012. The IAB accepted the document subject to the revision suggested by the board. The IAB suggested firstly that the report should better indicate what changes have taken place since the completion of the original Impact Assessment in financial markets and relevant national tax regimes in order to strengthen the baseline scenario. In response, two Annexes describing the current national tax regimes in the EU and abroad, together with the interpretation of the results as well as additional explanation in section 5 were added. Secondly, the IAB noted that the report should give a clearer overview of the expected aggregate impacts of the discussed options, especially with regard to fiscal stability and private pension funds, and it should provide more clarity about the sensitivity of the results for the assumptions made regarding the recycling of revenues. To implement this suggestion, additional explanation was added in sections 6 and 7. Thirdly, the report should better motivate the qualitative assessments made in the comparison of options and include Annexes that adequately summarise the main quantitative outcomes of the original Impact Assessment. To implement the suggestions, additional explanations and additions covering these aspects have been made throughout the document and especially in Section 6.7. References to the original impact assessment quantitative results are directly made in the report in sections 6.1 and 6.5.

3. PROBLEM DEFINITION AND SUBSIDIARITY 3.1 Problem definition

Initiatives for taxing the financial sector were brought back into the public debate as of 2008, when the threatening collapse of the global financial system had triggered massive financial interventions by governments around the globe in favour of the financial sector. The costs of the crisis in Europe alone are estimated to be in excess of 15 to 20% of the GDP of EU27.[10]

The economic development since and the relative successful stabilisation of financial markets do not imply a change of the characteristics of the problems to be tackled, namely huge cost to rescue the financial sector pre-financed by the tax payer, the ever more pressing need for bringing public finances back on a sustainable path and the absence of a fair and substantial contribution from the financial sector.

The aim of these initiatives had been and still is to receive a fair and substantial contribution from the financial sector to the financing of the rescue operations from which it benefited either directly or indirectly. In the aftermath of the almost meltdown of the global financial system public debt in Europe soared by more than 20 percentage points and has reached unsustainably high levels which have to be reduced as a priority. In the absence of receiving a substantial and fair contribution from the financial sector itself, Member States are forced to raise taxes somewhere else in the economy and/or to cut public spending and the provision of public goods.

Further aims voiced in that context were also to discourage transactions that do not enhance the efficiency and stability of financial markets as well as high-risk transactions with the help of such a tax, through this complementing and reinforcing the effects of recent and forthcoming regulatory changes aiming at the same objectives.[11] Also, redistributive "internalisation" in favour of the financial sector itself and occurring at the expense of its non-financial clients would have been rolled back to a certain extent.[12]

Finally, other ideas on how the revenues collected could be used for were voiced (such as financing development or climate policy), including to replenish or strengthen bank resolution funds so that in a future crisis it would not have to once again be the tax payer who had to step in for rescuing the financial sector. Taxes to be used for such purposes were taxes on some financial transactions only, notably securities (STT), taxes on financial activity (FAT) and different forms of bank levies and levies on bonuses.

It was clear from the beginning of the discussions, that taxing financial transactions could only be meaningful if internationally coordinated in case one wanted to minimize tax induced relocation of activity and at the same time generate sufficient revenues. Given the high global mobility of financial services, taxing also very mobile financial transactions, thus going for a broad-based financial transaction tax (FTT) had always been seen as an option that should preferably be implemented and enforced in the context of a globally co-ordinated taxation policy so as to avoid the risk of tax-induced relocation of financial activities and services.

As this first-best solution was not considered likely to materialise in the foreseeable future, despite some verbal commitments at the level of the G-20 group of countries, second-best solutions for taxing financial transactions at the regional level were sought. In Europe, this culminated with the tabling by the European Commission of a proposal for a common system of FTT in September 2011. This proposal contained powerful anti-relocation mechanisms.

However, during the Council discussions, it became apparent that some Member States considered these anti-relocation features of the proposal as not being powerful enough and they feared of a massive relocation of financial activity to the benefit of non- or low-taxing third country jurisdictions and at the expense of their own financial centres and their own real economy.

Also, some Member States feared of negative knock-on effects of such a tax both on the efficiency of financial markets itself, on the non-financial part of the economy and on the overall growth and employment performance of their economies. The expected reduction in (virtual) liquidity triggered by the crowding out of certain business models (such as high frequency trading) or the discouragement of "internalisation" by market makers and broker dealers and the subsequent decline in market turnovers was seen as very problematic by these opponents of an FTT.

Some also considered action at the European level not being necessary at all and had a strong preference for co-ordinated or un-coordinated action at the national level by those that considered action necessary in first place, while other sceptical Member States might have accepted a common system of an FTT that would have been much narrower in scope and less ambitious in objectives.

As in the light of this very strict resistance by some Member States to the concept of tax harmonisation in this field at all the required unanimity in the Council was not reached in favour of the Commission's proposal for a Council Directive on a common system of FTT or for a variant thereof, the file was blocked at the level of the European Union for all 27 Member States.

In these circumstances, eleven Member States indicated that they wish to establish enhanced cooperation between themselves in the area of the establishment of a common system of FTT. This system should be based on the objectives and scope of the Commission's initial proposal. Moreover, special emphasis should be given to avoiding evasive actions, distortions and transfers to other jurisdictions.

3.2 EU right to act and subsidiarity

The right for the EU to act in relation to taxes on financial transactions is based on Article 113 of the Treaty on the Functioning of the European Union TFEU). The main rationale for EU action is that the functioning of the Internal Market would be hampered if Member States decided to act unilaterally in this field. Ten Member States have introduced taxes on transactions in financial instruments; others are preparing the introduction of such taxes.[13] This uncoordinated approach fragments the EU financial market, distorts competition and increases the risk of relocation of financial activities both within and outside the EU. It also increases the risk that the financial sector becomes subject to double taxation or (unintentional) non taxation.

While neither the first-best solution to this problem (the introduction of a common system of financial transaction tax at the global level) nor the second-best solution (introducing this system at the level of EU27) had a chance of being achieved in a reasonable period of time the Commission received by 23 October 2012 the formal request by eleven Member States to launch the necessary steps for establishing the third-best solution (introducing this system at the level of enhanced cooperation zone referred to hereinafter as EU11+)[14]. According to the Commission's findings[15] these requests fulfil the legal preconditions as laid down in the EU treaties:

· Harmonisation of indirect taxation is an area covered by the Treaty which does not belong to the exclusive competences of the Union. And following an intensive discussion in the Council, it is clear that enhanced cooperation is a last resort solution to progress on this file;

· Harmonising a patchwork of different national taxes will not undermine the internal market. On the contrary, it will strengthen it by creating more coherence in the FTT jurisdiction and less administrative burden for business in EU11+ and beyond. Nor will this procedure undermine the single market or economic, social and territorial cohesion. Neither will it constitute a barrier to trade between Member States or distort competition between them;

· And finally, the procedure respects the rights, competences and obligations of non-participating Member States. They remain free to define and modify their own approach to financial sector taxation any time they want to without being hampered by the enhanced cooperation of those Member States that have chosen to go ahead on the basis of the objectives and scope of the Commission proposal of 28 September 2011.

Introducing a financial transaction tax at the level of individual Member States alone will not be successful in fully achieving the key objectives of such a tax. Neither will it ensure the proper functioning of the internal market and avoid distortion of competition, nor will it raise a fair and substantive contribution from the financial sector for covering the costs of the crisis.

It must be concluded that EU action through the procedure of enhanced cooperation would respect the subsidiarity principle since the policy objectives cannot be sufficiently achieved by actions of the Member States, and can be better achieved through coordinated action in the context of the Treaties of the European Union.

4. OBJECTIVES

The initial proposal tabled by the Commission in September 2011 aimed at:

· Harmonising legislation concerning indirect taxation on financial transactions, which is needed to ensure the proper functioning of the internal market for transactions in financial instruments and to avoid distortion of competition between financial instruments, actors and markets across the European Union, and at the same time

· Ensuring that financial institutions make a fair and substantial contribution to covering the costs of the recent crisis and creating a level playing field with other sectors from a taxation point of view[16], and

· Creating appropriate disincentives for transactions that do not enhance the efficiency or stability of financial markets thereby complementing regulatory measures to avoid future crises[17].

Another aim had been to show to the rest of the world that such a tax could - against all odds - also work at the regional level and, thus, constitute a first tangible step towards a global solution.

Member States having requested receiving the authorisation for engaging in enhanced cooperation among themselves specified that this cooperation should be based on the objectives of this initial proposal.

From these general objectives of the initial proposal and from the context they were developed in, i.e. FTT at the regional level instead of the global level one can derive five principles with which the envisaged enhanced cooperation should stay in line:

· The common system should be designed in a way that there are no (significant) incidents of double taxation or unwarranted double non-taxation within the FTT jurisdiction. This would require that there should be no other (un-coordinated) national taxes levied on financial transaction covered by the FTT directive within the enhanced cooperation zone.

· The tax revenues collected should constitute a fair and substantial contribution from the financial sector for covering the cost of the financial crisis. Given that these costs (costs for public finances plus costs of economic losses triggered by the subsequent recession) are estimated to be in the order of magnitude of at least about 15% to 20% of the GDP of the EU (FTT jurisdiction)[18], the annual revenues raised should be in the order of magnitude of at least 0.3% to 0.5% of the GDP of the EU (FTT jurisdiction).

· The common system should not trigger a (significant) tax-induced geographical relocation of financial activity, neither within the FTT jurisdiction itself nor at the expense of the financial centres of the FTT jurisdiction. Actually, participating Member States in their request specified that evasive actions, distortions and transfers to other jurisdictions should be minimized. This would require that all financial transactions that aim at serving the economy of the FTT jurisdiction should be taxed in case they

o involve or serve the needs of financial institutions or other undertakings established in the FTT jurisdiction;

o involve instruments issued in the FTT jurisdictions, or

o are taking place in the FTT jurisdiction.

For further dealing with the imminent risk of tax evasion and avoidance, especially in this very creative and mobile markets and actors, the principle of "substance over form" should apply in this context so as to minimize incentives for entering into legal constructs that aim at avoiding the tax without also changing the substance of the transactions in financial instruments undertaken.

· All financial instruments, actors and markets within the FTT jurisdiction should be treated similarly so as to avoid (significant) tax-induced distortion of competition or (significant) tax-induced substitution activities, such as shifting from taxed products or markets to non-taxed ones. This would require a non-preferential treatment of products, actors or markets, i.e. no exemptions for some products, actors or markets from being taxed[19].

· Pure rent-seeking financial intermediation, excessive risk taking and leveraging and that do not improve the efficiency or stability of financial markets should be discouraged[20].

The Commission had proposed that these principles and this scope of the FTT directive (notably the coverage of all actors, all markets and all products) should be implemented at the same time ("big bang") so as to achieve the commonly agreed objectives as soon as possible and so as to avoid substantive evasive action and distortion amongst actors, markets and products.

5. POLICY OPTIONS

The baseline scenario against which alternative policy options are to be benchmarked should be a situation where no agreement on a common system of FTT can be found, neither at the level of EU27 nor at the level of EU11+.

This baseline scenario is characterised by a variety of un-coordinated national regimes under constant change (as some Member States decided to change their systems or introduce new forms of FTT)[21], characterised in general by:

· The scope of the tax in most countries is rather narrow and generally covers the trading in securities (especially shares) on regulated markets only, with little or no taxation of derivatives[22] or over-the-counter transactions;

· Significant substitution of financial instruments, in order to avoid taxation;

· Specific exemptions of instruments and actors (e.g. for derivatives, shares/units of UCITS, market makers[23], broker-dealers etc.);

· The collection of the tax is usually done through intermediaries/brokers and the tax is typically not levied on both ends of the financial transaction.

In consequence, these taxes would generate rather little revenue. For example, the tax introduced by France in August 2012 is expected to generate about EUR 1.1 bn. or 0.06% of GDP annually. Assuming that the other participating Member States had introduced a similar tax on their territory, the annual aggregate revenue would amount to around EUR 4 to 5 bn. (0.06% of EU11+ GDP). This is far below what one would characterise as a "fair and substantial contribution" from the financial sector.

Moreover, the tax systems in place and under consideration in several Member States violate a basic principle of taxation that primarily aims at neutral revenue-raising, i.e. to treat similar events (actors, instruments, market places) in a similar way. This, in turn, triggers a distortion in competition both within individual Member States and within the Single Market.

So as to overcome these shortcomings of the baseline, different alternatives for action could have been envisaged:

· Option A: an FTT at the global level,

· Option B: an FTT at the level of EU27

· Option C: an FTT at the level of EU11+ through enhanced cooperation,

· Option D: an FTT co-ordinated outside the framework of the EU treaties.

However, option A had already been discarded at the time of tabling the initial proposal as – besides some lip-services and analyses undertaken in the run-up and as a follow-up to G20 meetings, there was no momentum at all visible that could have been interpreted as giving impetus to such an initiative. Also, by now and at latest in the aftermath of the Ecofin Council meetings of 22 June and 10 July 2012 in Luxemburg, option B has also to be discarded. It has become clear, and it was officially concluded at the meeting of 10 July 2012 by the (Cypriot) Presidency that no progress would be possible at the level of EU27 in the area of a common system of FTT.

Option D, in order to be meaningfully pursued, would require a critical mass of Member States (representing both economic weight and size of financial markets) to engage in developing a common system of taxing the financial sector. However, none of the Member States wanting to go ahead with a broad-based FTT was showing interest in such an approach outside the framework of the Treaties. Instead, they opted for officially requesting to be allowed to make use of the Treaty provisions for enhanced cooperation in the area of a common system of FTT, and based on the scope and objectives of the proposal tabled in September 2011.

Thus, only option C, i.e. establishing a common system of FTT under the procedure of enhanced cooperation can presently be assumed to have the potential of achieving the objectives outlined in chapter 4. In consequence, this paper analyses policy options and the impacts of a common system of taxation to be implemented in the enhanced cooperation zone that is based on the scope of the proposal already tabled in September 2011, composed of the following features:

· All financial instruments (shares, government bonds, derivatives, structured products etc.) as defined in Annex I, Section C of the Markets in Financial Instruments Directive (MiFID)[24], all financial institutions (including also other undertakings with significant trading in financial instruments) and all markets (organised and non-organised markets) are taxed;

· Taxation is based on strong anti-relocation mechanisms, such as a broadly-defined residence principle. Under this principle, it matters who is interacting with whom, independent of whether the place of transaction is within or outside the territory of the FTT jurisdiction, and independent of whether the instrument has been issued within or outside the FTT jurisdiction, for as long as one of the financial institutions involved in the transaction is deemed to be established in the FTT jurisdiction. Moreover, as this residence principle is defined in a rather broad manner, it also means that all transactions taking place in the FTT jurisdiction are to be taxed as well;

· The tax rates are rather low (0.1% of the consideration paid for trading in securities and 0.01% of the notional value of the underlying for derivatives), and the tax has to be paid immediately (so as to minimize cash-flow advantages for the taxable persons - and cash-flow disadvantages for the tax authorities). The revenues accrue to the Member States where the taxable financial institution is deemed to be established;

· The tax is to be paid at both ends of the transaction for as long as a financial institution is involved at the respective end. Joint and several liability is foreseen so as to improve tax compliance.[25] The actual enforcement of taxation is largely left to the discretion of Member States.

Alternative policy options could be based on variations of the above parameters, e.g. they could aim at a narrower base by exempting certain products, actors or markets, or by going for an alternative principle of taxation, e.g. based on the issuance or on the place of transaction principle instead of the residence principle, they could aim at taxing only one leg of the transaction or envisage more differentiated tax rates.

In the political discussion and in the discussions in the Council Working Party, all these variants have been raised and discussed, with a special emphasis on the following policy options:

· Exempting certain products, notably government bonds, the issue (and redemption) of shares and units of undertakings for collective investments in transferable securities (UCITS) and alternative investment funds (AIF), repurchase and reverse repurchase agreements, and derivatives agreements;

· Exempting certain actors, notably regional and multilateral development banks, public bodies of Member States charged with or intervening in the management of the public debt, market makers and broker-dealers, and fully funded pension funds or institutions for occupational retirement provisions (pillar II and pillar III pension funds);

· Complementing or replacing the proposed residence principle by the issuance principle or elements thereof;

· Changing the order of criteria determining the Member State in which a financial institution is deemed to be established and, thus, to which Member State the tax revenues would eventually accrue;

· Phasing in the FTT by initially starting with a narrower scope.

6. ANALYSING THE IMPACTS OF DIFFERENT POLICY OPTIONS FOR A COMMON SYSTEM OF FTT UNDER ENHANCED COOPERATION

The first starting point for analysing different options for taxing financial transactions and their effects should be the impact assessment accompanying the initial proposal and complemented by the additional analysis undertaken and published since by the Commission[26], as the scope and objectives of the FTT initiative foreseen under the procedure of enhanced cooperation should be based on the scope and objectives of this initial proposal.

In a nutshell, this analysis found – as compared to the baseline scenario of no action at the EU level - very positive impacts on the functioning of the single market for financial instruments, namely the non-occurrence of any kind of double taxation or unintended double non-taxation, as well as very positive effects on public finances (additional annual revenue in the order of 0.5% of GDP). It was also found that the FTT system would trigger some rolling back of business models in financial markets that were mainly aiming at redistributing wealth and rents, even at the price of higher risk exposure, instead of creating wealth and values. Also, thanks to its powerful ring-fencing provisions (non-taxation of ordinary bank transactions such as providing capital to enterprises and private households), negative knock-on effects of the tax on the real economy could be largely avoided, the risk of geographical relocation could be minimized, while at the same time the proposed tax system was characterised by a high degree of tax neutrality across instruments, market places and actors within the financial sector.

6.1 The Commission proposal under enhanced cooperation (Option C)

The analysis referred to so far was based on a proposal for a common system of FTT for the entire EU (EU27) and not for a subset of Member States. Thus, in a first step, this initial analysis undertaken for a common system of FTT at the level of EU27 (option B) would need to be adjusted to take account of this narrower FTT jurisdiction (Option C), and changing outcomes would need to be highlighted. Three elements deserve special attention in this context: would EU11 instead of EU27 trigger different single-market effects (such as double taxation)? Would it result in different market reactions (such as turnover volumes, geographical relocation or additional substitution effects)? And finally: What is the revenue potential for a much smaller FTT jurisdiction?

6.1.1 The single market dimension (double taxation and double non-taxation)

It belongs to the nature of a process of enhanced cooperation in the field of taxation that it cannot succeed in avoiding all occurrences of double taxation within the European Union for as long as not all Member States of the European Union participate in this cooperation. This holds the more as all non-participating Member States have the freedom to change at any time and in any direction the way how they tax financial institutions and financial transactions (including not taxing them at all) for as long as the tax regime chosen complies with the body of EU legislation and with international law.

Thus, while the initial proposal of the European Commission, if applied in all 27 Member States of the European Union would have succeeded in eliminating and avoiding any kind of double taxation of financial transactions and of a fragmentation of the Single Market with respect to taxation, the enhanced cooperation of the EU11+ group of Member States can achieve this in the FTT jurisdiction only. Thus, instead of 9+ systems of taxing financial transactions within the FTT jurisdiction there will be only a single system in place. This should avoid any kind of distortion of competition within the FTT jurisdiction.

Also, risks of delocalisation of taxed activities within the FTT jurisdiction could be assumed to remain rather limited[27] for as long as the directive will be transposed, implemented and enforced in a similar way in all participating Member States and for as long as differences in actual tax rates (the directive proposes minimum rates only) do not invite for tax planning triggering a relocation of activities. Actually, such residual risks could only be avoided in the context of a proposal for a regulation instead of a directive, and prescribing standard rates instead of minimum rates.

As regards remaining potential occurrences of double taxation between the FTT jurisdiction on the one side and non-participating Member States on the other side, this might be most evident with respect to those Member States that host very important financial centres and a relatively large financial industry. Non-participating Member States, such as Cyprus, Finland, Ireland, Luxemburg, Malta, Poland and the UK, have in place their own national taxes on financial transactions. However, these countries only apply rather narrowly defined taxes on securities transactions, with generously defined exemptions or exclusions from the scope of the tax for financial intermediaries.

Thus, some financial institutions (deemed to be) established in the FTT jurisdiction might have to pay both the FTT and tax in some of these non-participating Member States for the same financial transactions.[28]

However, these potential occurrences of double taxation should constitute only a tiny fraction of transactions for which the common system of FTT is designed, and this only in case these taxing but non-participating Member States were not to join the FTT jurisdiction at a later stage. A "second-best" possible solution (next to enlarging the EU11+ to EU27) for dealing with such remaining occurrences of double taxation would be the use of the instrument of bilateral double-taxation agreements.

6.1.2 Market reactions (turnover, relocation, substitution)

The application of an FTT bears the intrinsic risk of agents "relocating" their activities to reduce the fiscal burden, independent of whether the jurisdiction applying this tax comprises the entire European Union or only parts of it. "Relocation" might take place by (i) moving the relevant activities to jurisdictions where they are taxed less, (ii) by shifting to products/suppliers outside the scope of taxation within the same jurisdiction e.g. by changing the business model or contract design, or (iii) abandoning the taxable activity altogether. In principle, this latter might even lead some products/markets to disappear in the medium and longer run, however, without necessarily undermining the efficiency of the market itself. Obviously, the risk of both physical relocation of markets/market players and migration to non-taxed products decreases the broader the geographic coverage of the taxes is and the broader their scope. Thus, the risk of geographical relocation might at first glance be somewhat higher for an FTT introduced at EU11+ instead of EU27, as the geographical coverage of its application is narrower.

However, it would eventually be the concrete design of a tax in combination with the presence or absence of transaction costs of relocation (i.e. the availability or not of cheap substitution possibilities) that will largely impact on the actual extent of relocation. The cases of Sweden and the UK, which both introduced a tax on financial transactions at national level but with different relocation effects, provide some evidence for this.

Also the responsiveness of traded volumes to taxes (and transaction costs in general) varies across products and markets, as it is heavily influenced by available substitution possibilities and the characteristics of the relevant trading platforms. Thus, the design of the tax will be as important as its rate or change in the rate.

The risks of geographical relocation, as well as those arising from potential migration towards untaxed substitute products, could be minimised by (i) not taxing certain activities at all (not really an option if one wanted to treat similar products similarly), by (ii) extending the geographical coverage of the tax and by (iii) including a wide range of financial products and markets (exchange and over-the-counter) in its scope. It can also be reduced by linking the FTT with some form of registration. Clearly, coordination in terms of products covered by the tax as well as of applicable tax rates is a prerequisite for lowering the incentives to relocation across jurisdictions.

Geographical relocation

So as to effectively avoid having to pay FTT it would not suffice that a financial institution simply moves its seat outside the FTT jurisdiction. This is, because for as long as a financial institution intends to either undertake transactions in the FTT jurisdiction or to serve a client base of the FTT jurisdiction it would be deemed to be established in the territory of a participating Member State (Article 3.1 of the initial FTT proposal – Article 4.1 of the new proposal). Thus, a financial institution would have to both abandon to trade on trading platforms in the FTT jurisdiction (this would also hold for the remote access to such trading platforms from outside the FTT jurisdiction) and to abandon all its clients in participating Member States if it wanted to avoid paying the tax.

Client base

Example1:

An American bank sells a derivative via an UK investment bank on a French trading platform to a German regional authority. The UK investment bank acts for the account of the German regional authority.

· FTT is due twice in Germany at the German rate as both banks are deemed to be established in Germany.

· If the notional value of this derivative was EUR 10 mn. and Germany applied the minimum rate of 0.01% each financial institution would have to pay EUR 1.000.

Example 2:

A French company asks a German bank which asks its American-based Investment Bank subsidiary (AS) to hedge a currency risk in the name of its parent company but for the account of the French company. For this, the American subsidiary (AS) enters into a derivative agreement in the name and for the account of the German bank with another American bank (AB) having no link to the territory of a Member State.

· FTT is due twice in Germany at the German rate as for this transaction the AS is deemed to be established in Germany and for this transaction the second American bank (AB) is equally deemed to be established in Germany. But as the AS was acting in the name of the German bank the tax would have to be paid by the German bank.

· If the notional value of this derivative agreement was EUR 10 mn. and Germany applied the minimum rate of 0.01% the German bank itself and the American bank (AB) would each have to pay EUR 1.000.

This very broadly defined residence principle distinguishes the actual design of the FTT as initially proposed by the Commission from the design typically analysed in studies preceding the Commission proposal, and highlighting the relocation risk in case an FTT was introduced at a sub-global level.

Thus, the risk of geographical relocation remains rather limited for both relocation to non-EU jurisdictions and relocation to non-participating Member States. So do the benefits of relocation. Also, there is no obvious mechanism that would invite for the conclusion that the risk of relocation to financial centres of non-participating Member States of the EU is higher than the risk of relocating to financial centres of non-EU countries, such as Switzerland, the USA or other well-established financial centres in the world.[29]

Substitution and changing business models

The Commission proposal is characterised by a very broad definition of transactions, instruments and institutions, as defined in Article 2 of the proposal of September 2011. This approach to cover all markets (organised and non-organised), all actors (from traditional financial institutions to big non-financial companies that undertake significant trading in financial instruments) and all products (shares, bonds, bills, derivatives, structured products etc.) was inspired by the invariable strive of market participants to minimize their tax burden and engage in economic activities that are either not taxed or less taxed. By the same token, it was also inspired by the need for preserving "tax neutrality" and not to discriminate against or to privilege certain actors, markets or products.

A significant share of the market reactions triggered by the introduction of this tax is assumed to be the result of actors replacing taxable events with (new) un-taxed business models, and deleveraging transactions. For example, the traditional way of brokering (where brokers buy and sell in the name or on account of other financial institutions) might replace the current practice of broker-dealers trade in their own name and on their own account as this would relieve them from paying the tax (see Art. 9.2 of the initial proposal[30]). However, as this change of business models would deprive the broker-dealers, market-makers and high-frequency traders of some rents (the so-called "internalised" ) they might only abandon this business model for those transactions where these "internalised" spreads allowed by the market would be smaller than the tax they would have to pay.

In the present business model of transaction chains being dominated by such "market-making" and "internalisation" proprietary trading by all actors, each transaction shows up (in the statistics of market turnover) as a buying and selling transaction, i.e. a single purchase/sale operation triggered from outside the financial sector might (statistically) show up as two, three or even four trades at each side of the transaction. Once such proprietary trading will turn into taxable events the trading might – depending on the size of the internalized spread - be replaced by "intermediation". So, while "trading" turnovers will decline, the initiating underlying economic substance (one actor wants to buy and get ownership of a product and one other wants to sell and dispose of this ownership) remains unchanged, and the potential cascading effect of the tax within a single transaction chain can be avoided.

Brokerage and market-making services – the "internalisation" of spreads

Example 1:

A Belgian and a French private household use respectively their Belgian and French retail banks and order them to buy/sell on the Paris stock exchange, in the name or for the account of the respective households, shares of a French joint-stock company in the value of EUR 10.000. The retail banks pass on these orders to their wholesale banks and those to their brokers on the Paris stock exchange. All three intermediate only, without buying or selling for their own account.

· Both retail banks are liable to pay the FTT due in their country of establishment (Belgium and France respectively). Neither the wholesale banks nor the brokers are liable to pay FTT.

· The retail banks would have to pay EUR 10 each for this transaction in France and Belgium respectively. The effective tax to be paid by all actors in the whole transaction chain corresponds to 0.2% of the economic value of the transaction.

Example 2:

Same case as example 1, but, this time, the shares are passed on through five successive sales and purchase ("internalisation" of spreads): Apart from the two retail banks, who act in the name or for the account of the respective households, all other participants act in their own name and for their own account as well.

· All six financial institutions are liable to pay FTT in France and in Belgium respectively. Both brokers and both wholesale banks have to pay FTT twice, while the retail banks have to pay only once.

· The brokers and wholesale banks would each have to pay EUR 20 and the retail banks each EUR 10. The effective tax to be paid by all actors in the whole transaction chain would correspond to 1.0% of the economic value of the transaction.

It is assumed that financial institutions will not ignore the tax when developing and implementing their business strategies. However, this should not be confused with less efficient markets or an unwarranted squeeze in liquidity in affected markets.

In this economic analysis it is also assumed that the reduction in market volumes is partly the result of the rolling back of certain high frequency but low-margin transactions which would no longer be attractive for the transaction partners once a tax of 0.1% or 0.01% is levied. Thus, it is assumed that in some market segments the tax will create a structural break in the sense that business models change (e.g. in the field of automated High Frequency Trading and high-frequency δ-hedging) which leads to fewer transactions and potentially other ways of trading assets and shifting risks.

6.1.3 Revenue estimations

When presenting and reading revenue estimations for taxes which would be newly introduced or where the tax base is substantially broadened or changed and that – on top of this – have to a certain extent the goal to change market behaviour and market structure bears a high degree of uncertainty. For the initial proposal of the draft directive, and at a tax rate of 0.1% for securities and of 0.01% of the notional value for derivatives agreements and payable by each side of a transaction, the revenue estimates for the tax about EUR 57 bn. annually for the entire European Union, with about EUR 19.4 bn. stemming from the taxation of transactions in securities and about EUR 37.7 bn. stemming from the taxation of derivatives[31].

These estimations took as a starting point a bottom-up approach based on the "place of transaction" principle, by looking at the cumulated turnover in (taxable) financial transactions in all Member States of the European Union. Such an approach would only reflect to match the proposed tax design in case all transactions in Europe were actually transactions between European financial institutions, or where at least one party to the transaction was a financial institution deemed to be established in the EU. However, this assumption is not expected to hold, mainly for two reasons:

· Under the proposal for EU27 it was foreseen that also transactions carried out outside the EU should be taxed for as long as one of the parties or one of the financial institutions involved is deemed to be established in the EU. Thus, an estimation only taking into account transactions carried out within the EU would tend to underestimate potential revenues of the proposed FTT.

· On the other hand, there is also a part of the turnover in financial instruments in Europe where a European party is acting in the name or for the account of a non-European party. An estimation also taking into account these transactions would tend to overestimate the revenue potential of the proposed FTT having in mind the exemption in Art. 9.2 of the original Commission proposal.

As both effects tend to work in opposite directions, it could be reasonably assumed that revenue estimations at the aggregate level taking the cumulative turnover at the place of transaction in all Member States could serve as a proper proxy for the potential revenue at the aggregate level of the FT proposed.

What might still work at the aggregate level will, nevertheless, be less and less acceptable as a proxy the more one disaggregates, as cross-border transactions are becoming more and more important. Instead, one would first have to identify the financial institution that is the person liable to pay the tax, for instance, with the help of the Markets in Financial Instruments Directive (MiFID)[32] and the European Markets Infrastructure Regulation (EMIR)[33]. Then, due account would have to be taken of the provisions of "establishment" of the proposal as well as of the provision according to which in cases "where a financial institution acts in the name or for the account of another financial institution only that other financial institution shall be liable to pay the tax." Such comprehensive data mining and analysis was not possible as most of the data needed for this are not yet public.

Also, such an approach would not have resulted in an accurate reflection of the market structures and involvement of participants once the tax will have been introduced, as it would not have been possible to assign to individual actors the potential market reactions, behavioural changes and changing business models expected to be triggered by the levying of the tax. As these market reactions were assumed to be rather significant (minus 15% the trading in securities and minus 75% for the derivatives markets, such dynamic developments would to a certain extent substantially alter the results of the ex-ante data mining, and could not have been ignored when estimating the regional incidence of the tax.

When adjusting the revenue estimations to the new FTT jurisdiction comprising 11 countries one has, once again, to work with proxies. In the light of the methodological difficulties proxies could be used that correlate the volume of taxable transactions with different parameters, such as:

· the size of the economies of the FTT jurisdiction, measured by the GDP of the economy (either in current prices terms or expressed in purchasing power standard);

· the size of the financial sectors of participating economies, measured by the value added of the sector before taxes (the sum of profits and the wage bill or the net operating income).

The first proxy is based on the assumption that the need for (taxable) financial services increases and correlates with the size and wealth of an economy: the bigger and richer an economy, the more (taxable) financial services it requires. It also assumes that the share between taxable financial services (trading in securities and conclusion of derivatives agreements) and non-taxable financial services (such as bank or mortgage loans) is similar in all countries and does not change with the wealth of a nation. It also assumes that the share between the different taxable financial services (notably trading in securities on one side and the conclusion of derivative agreements on the other) is similar across Member States. In 2011 both the GDP at current prices and in PPS of the EU11 represented 66.4% of the EU27 GDP. On that basis, and taking as a basis the revenue estimations for EU27 as developed in the initial impact assessment, the total amount of revenues for the EU11 would be approximately EUR 38 bn.

However, such a proxy would largely ignore that some economies (such as the UK or Luxemburg) have to a certain degree specialised in the provision of financial services, or that have financial institutions with large portfolios and assets available for trading etc. In order to take such specialisation into account, the size of the national financial sector (as e.g. measured by the net operation income in the EU banking sector) in the overall European financial sector[34] could be considered as well. By using such a proxy it would on the one side be assumed that bigger financial institutions of the FTT jurisdiction are also more involved in (taxable) transactions in financial instruments than smaller institutions. On the other side, such a proxy would also – at least partially – cater for the assumption that in non-participating Member States with large financial centres there are more transactions that are exclusively undertaken between or on behalf of actors of these economies and third countries, and that are, thus, falling outside the scope of the proposed FTT regime. In 2011, the size of the banking sector (as measured by the net operating income) of the EU11 represented 59.8% of the total EU27 size. On that basis, and taking as a basis the revenue estimations for EU27 as developed in the initial impact assessment, the total amount of revenues for the EU11 would be approximately EUR 34 bn.

This second proxy, based on the shares of the banking sector, appears to be more accurate considering that important EU27 financial centres are not covered by EU11, and the revenue-raising potential according to this proxy will be used henceforth. However, when using this proxy as a basis, one should be conscientious of the fact that the underlying parameter (net operating income in the EU banking sector) is much more volatile that the parameter underlying the alternative proxy (GDP). On the basis of this proxy it is estimated that a EU11 FTT would produce EUR 34 bn. of tax revenues for the participating Member States.

Whatever of these two proxies used, the amount of revenues represents around 0.4% of the EU11 GDP. This result is somewhat smaller than the relative size of revenues expected for a EU27 implementation, but still looks plausible, especially when taking into account that certain important financial centres in the EU (such as Luxemburg and the UK or Ireland) are not (yet) part of the FTT jurisdiction for the moment.

Considering the arguments developed earlier in this section (difficulties in catching market structures and dynamics after the introduction of the tax and disaggregating cross-border transactions), it is hardly possible to estimate the individual participants' share of revenues within the limits of an acceptable margin of error. However, if one assumed that the share of each participating Member State in total revenues correlated with the size of their underlying economies, the following pie chart could illustrate what this would mean for each Member State. Taking as total revenue the sum as indicated by proxy 2 (EUR 34 bn. annually) the amounts could range from EUR 95 mn. for Estonia to EUR 11.75 bn. for Germany.

Chart 1: Breakdown of revenues in the EU11+ according to GDP in PPS (2011)

As prone with difficulties as estimating total revenue and their breakdown by country is the breakdown by product category. However, when taking the revenue estimations and the breakdown of revenues per product category of the findings of the impact assessment accompanying the initial proposal as a starting point, one could arrive (at least for illustrative purposes) at a breakdown as presented in table 1.

Table 1: Revenue estimations by product group (in EUR bn.)

|| EU27 || EU11

Securities || 19.4 || 13.0

- shares || 6.8 || 4.6

- bonds || 12.6 || 8.4

Derivatives || 37.7 || 21.0

- equity linked || 3.3 || 1.8

- interest rate linked || 29.6 || 16.5

- currency linked || 4.8 || 2.7

The breakdown in table 1 for securities is based on the assumption that the share of revenues generated by taxing the trading in securities (shares and bond) for EU11 corresponds more or less with the share of the EU11 economy in EU27 GDP, as securities trading might correspond more with the size of the underlying economy than with the size of the financial sector. This assumption then gives total revenues from taxing the trading in securities of EUR 13 bn. for EU11.

The remainder of the total revenues of EUR 34 bn. is then allocated to taxing derivatives products, and proportionate to what had already been estimated for EU27. This approach reflects that key financial centres of the EU and also specialised in derivatives trading such as the City of London are for the time being located outside the FTT jurisdiction.

6.2 Sub-Option 1: Exempting certain products[35]

The initial proposal stipulates that the proposed directive shall apply to all transactions in financial instruments, on condition that at least one party to the transaction is established in a (participating) Member State and that a financial institution established in the territory of a (participating) Member state is party to the transaction or is acting in the name of a party to the transaction.

A financial transaction is defined as any of the following:

· The purchase and sale of a financial instrument, including securities lending and borrowing;

· The transfer between (legal) entities of a group of the right to dispose of a financial instrument as owner and any equivalent operation, and

· The conclusion or modification of derivatives agreements.

However, primary market transactions, i.e. the issuance of shares and bonds are excluded from the scope of the directive so as not to tax the raising of capital.

Financial instruments covered by the directive are in principle all kinds of securities (such as shares, bonds and structured products, money market instruments, units/shares of UCITS and AIF and derivatives). This guarantees a very broad tax base, fiscal neutrality between the different products as well as a minimization of tax evasion through substituting transactions in one product category by transactions in another product category.

However, concerns were raised that taxing transactions in some instruments and products would either be in contradiction with the body of existing EU legislation or that it could have negative side effects that would outweigh the benefits of raising revenue or discouraging high-risk or socially useless transactions and should, thus, be avoided. This held namely for (i) the taxing of the issue and redemption of shares and units of UCITS and AIFs, (ii) the taxing of the transactions on secondary markets for government bonds and bills, (iii) the taxing of repurchase and reverse repurchase agreements, and (iv) the taxing of derivatives.

6.2.1 UCITS and AIF

Units of undertakings for collective investments in transferable securities (UCITS) and alternative investment funds (AIF) are important investment vehicles used both by the non-financial economy as well as by institutional investors, such as pension funds, banks, insurance companies or other UCITS and AIF. These investors have the possibility to buy shares or units of the UCITS and give them back at a later stage. In the EU, these UCITS and AIF manage assets worth more than EUR 11 tn., of which UCITS manage about EUR 5.8 tn.[36] The corresponding figures for EU11+ would be EUR 3.74 tn. and EUR 1.97 tn. respectively[37]. UCITS and AIF can raise capital by issuing shares or units giving the owner of these shares and units the right for fixed or variable benefits, and the right to redeem these shares or units at any given time. In 2011, UCITS experienced net outflows of EUR 88 bn. and EUR 29.9 were outstanding in EU27 and EU11+ respectively (redemptions were superior to sale/issuance of shares/units)[38]. In 2011, UCITS have issued and redeemed shares and units worth EUR 15,485 bn. in EU 27 and EUR 5,264.9 bn. in EU11+ respectively[39].

While the redemption of such shares or units can be easily interpreted as a transaction on a secondary market, the issue of shares and units of UCITS and AIF can be interpreted as both a transaction on a primary market so as to raise capital to work with and as a transaction on a secondary market when shares or units, having been redeemed by previous investors, are resold to new investors.

In case such issuance was to be seen as a transaction that aimed at raising capital such issuance should not be taxed according to Directive 2008/7/EC. In case such issuance was, however, to be seen as a transaction on a secondary market for shares and units in UCITS and AIF this issuance should be treated the same way as the trading in shares and bonds of other undertakings so as to preserve fiscal neutrality across products. This part should then be taxed. However, and in contrast to the issuance of shares and bonds of other undertakings, it is not clear to what extent the issuance of a specific share or unit in UCITS and AIF is actually linked to the (non-taxable) raising of capital or to the (taxable) trading on secondary markets.

Ø In order to respect the provisions of Directive 2008/7/EC and for reasons of tax neutrality, the issue of shares and units of UCITS and AIF should not be taxed. As a consequence, annual revenues would be around EUR 4 bn lower as compared to a situation where this issuance was taxed.

6.2.2 Government bonds (and bills)

As already stated in the Impact Assessment accompanying the initial proposal[40], at a tax rate of 0.1% for securities the revenue estimates for the bonds taxation is about EUR 12.6 bn. At least three quarters of these revenues, which is around EUR 9.5 bn., was expected to be generated by taxing trading, borrowing and lending in government bonds. The corresponding figures for EU11 are estimated to be EUR 8.64 bn. and EUR 6.51 bn. respectively.

The increase in the transaction costs in the secondary market following the implementation of a transaction tax on government bonds trading may impact on the primary market by increasing the interest rates to be offered for newly emitted public bonds, therefore implying an increased cost for public budgets. According to modelling simulations undertaken by the Commission[41], the increase in the cost of capital following the introduction of the tax could be about 0.07%. If this rate of increase was applied to the issuance conditions of Government bonds and bills and considering the overall EU27 and EU11 outstanding government bonds of around EUR 8.1tn. and EUR 5.5 tn., respectively[42], the initially modelled increase in the cost of the debt would be about EUR 5.6 bn. and EUR 3.85 bn. respectively.

However, these estimations do not take into account some mitigating effects:

· First, the exclusion of primary markets from the scope of the tax will make this primary market more attractive, especially for institutional investors that pursue a "buy and hold strategy", i.e. once they have bought a bond or bill they will hold it until maturity. Also, other investors might start preferring primary over secondary markets as the first are after all tax free. The resulting higher supply of lending capital on the primary market should exert a downward pressure on borrowing rates, which could partially compensate for the upward pressure following the introduction of the tax in the secondary market. This should in principle have a moderating impact on the cost of borrowing for governments;

· Second, interest rates for primary markets for outstanding debt (debt already issued) and, thus, the cost of the outstanding debt will not be affected by the tax. At the same time the taxing of the trading in outstanding government bonds (and bills) will generate substantial revenue. This is especially interesting for highly indebted countries. Only when it comes to rolling over this debt, which will typically take some years, conditions on the primary market for this debt might be affected as well;

· Finally, as the net revenues accruing to the public budgets will help to sustain the process of budget consolidation, this will also contribute to the easing of the issuance conditions in the longer term and therefore induce a decrease of the cost of borrowing for public funds.

If one estimated these mitigating effects to half the modelled predicted increase in the cost of capital (to less than EUR 2 bn.), the net return of taxing the trading in government bonds based on the initial revenue estimates (2011) would amount to about EUR 4.5 bn. For EU11+, in other words: for each euro potentially to be spend on higher interest rates governments would receive more than three euro in return in form of higher FTT revenue (gross revenue: EUR 6.5 bn., higher borrowing cost: EUR 2 bn., net revenue: EUR 4.5 bn.). As a result, the net budgetary implication of taxing the trading of Government bonds will remain highly positive, even when considering a measurable indirect impact of the tax on the primary market. This notably tends to hold for highly-indebted countries.

Ø Exempting government bonds would not only negatively affect the tax neutrality of the proposed approach but it would also have considerable negative revenue implications for those countries doing so. It will also jeopardize achieving the objective of ensuring a fair and substantial financial contribution to covering the costs of the recent crisis, as it could be expected that the (gross) revenues from the financial sector would be reduced by about EUR 6.5 bn. by such an exemption.

6.2.3 Repurchase agreements

Repurchase agreements typically serve as cash management tools in the interbank market and also substitute for corresponding transactions with central banks, as the latter are typically offered at less attractive terms. A repurchase agreement is equivalent to a spot sale (of a security) and a forward contract, and it is economically similar to a (securities) secured loan. A reverse repurchase agreement is the same repurchase agreement from the buyer's viewpoint.

Such transactions are to be taxed as they comprise a sale and purchase of securities. However, they could easily be substituted by an economically rather similar secured loan, which would not be taxed (see box) or by an untaxed transaction with the central bank.

Repurchase agreements

Example 1:

A bank established in France lends “over-night” EUR 10 mn. to a bank in Italy (possibly backed up by securities as collateral).

· No FTT is due as outright lending and borrowing is out of scope of the FTT.

Example 2:

A bank established in France buys “over-night” EUR 10 mn. of French government bonds from a bank established in Italy and sells them back the next day (repo transaction):

· FTT is due both in France and in Italy for each transaction (Art. 2.1).

· As the market price of the transaction is EUR 10 mn., and as there are two transactions, each bank has to pay EUR 20.000 FTT in their country of establishment if both countries applied the minimum rate.

Example 3:

A bank established in France lends shares (with a market value of EUR 10 mn.) of an Italian listed-stock company to a bank in Italy. In accordance with the agreement, the shares are returned to the lender after three months. The lending fee is EUR 10.000.

· FTT is due both in France and Italy (Art. 2.1).

· As the market value of the shares is EUR 10 mn. both the French and the Italian bank would have to pay EUR 10.000 FTT in case both France and Italy applied the minimum tax rate.

In 2011, repurchase agreements had a market turnover of about EUR 6.18 tn. in Europe[43], and of about EUR 3.5 tn. in EU11+[44]. Theoretically, and as each repurchase agreement consists in principle of two purchase and sale transactions, taxing such a market volume could generate annual tax revenues in the order of EUR 17.6 bn. and EUR 10.5 bn. for EU27 and EU11+ respectively, assuming that 87.5% are transactions inside a year (and 100% transactions with at least one financial institution involved[45]), no market reaction, a tax rate of 0.1%, a transaction cost of 0.6% and tax elasticity of -1.5. If economic agents replaced repurchase agreements by a combination of spot sales and forward contracts or by another type of untaxed contract (for instance, a market reaction of 40%), and as forward contracts were derivatives to be taxed at a rate of 0.01%, potential tax revenues from repos would go down from EUR 17.6 bn. for EU 27 and EUR 10.5 bn. for EU11+ annually to EUR 10.3 bn. and EUR 6.1 bn. respectively when taxing two transactions. In the theoretical case such repurchase agreements were entirely replaced by secured loans, potential tax revenues would disappear altogether.

Not taxing repurchase agreements would harm fiscal neutrality in so far as a combination of spot sales (purchases) and forward contracts as well as securities lending and borrowing would be taxed while repurchase agreements would not. Also, it could entail foregoing significant revenues for public budgets, depending on the market reaction to the imposition of such a tax on repurchase agreements. Taxing them as two transactions, on the other hand, would in a way discriminate against repurchase agreements, e.g. as compared to securities lending and borrowing. Taxing only one transaction, for instance, with a market shift of 40% in volumes would yield only EUR 5.1 bn. for EU27 and EUR 3.0 bn. for EU11. Taxing 'over-night' repurchase agreements for example would make this business model unattractive, even when taxing them as one transaction only. Indeed, repurchase agreements would in all likelihood either be replaced by securitised lending operations or by transactions with a central bank, in case the securities offered were of sufficient quality for being accepted by a central bank and for as long as the terms offered by central banks were attractive enough. However, not taxing 'over-night' repurchase agreements could constitute a loophole also for repurchase agreements with a longer maturity as it might be rather easy to design them in a way so as to also qualify for the 'over-night' exemption. Thus, effective tax avoidance provisions would need to be put in place so as to close this loophole.

In the revenue estimations of the impact assessment accompanying the initial proposal (2011), it was assumed that all (taxable) repurchase agreements would be replaced by (non-taxable) securitised loans. This assumption could be considered to be realistic to a certain extent for 'over-night' repurchase agreements which cover the largest part of the market[46]. However, for agreements with a longer maturity the default risk of the counterparty might provide an incentive for maintaining the initial business model even in the presence of a tax.

6.2.4 Derivatives

Over the last three decades, it has namely been the market for derivatives where turnovers have grown exponentially, and most of the detachment of the turnovers on financial markets from the growth of the real economy has been taken place in derivatives markets. Indeed, while the size of the global economy about doubled over the last three decades, the turnover on financial markets grew exponentially.

While these derivatives had initially been an instrument for hedging and risk management, they have more recently also become widely traded financial assets in their own. In consequence derivatives based on financial instruments are now dominating the market as compared to previous decades where the derivative contracts had been more based on agricultural products, precious metals, energy products or currencies. This has also brought concerns related to increased systemic risk because of the leverage inherent to the use of derivatives.

It can therefore no longer be taken as granted that all this financial intermediation in the domain of derivatives markets really serves the purpose of "oiling the wheels" of the economic fabric. Instead, it is safe to assume that significant parts of this intermediation serve the purpose of generating rents for the financial industry and at the expense of the non-financial economy as each individual intermediation comes at a cost, eventually to be shouldered by the non-financial part of economy.

Most countries having a kind of financial transaction tax typically apply it to the trading in securities only (thus they have a securities transaction tax – STT – instead of an FTT) and less frequently to derivatives as well[47]. This is for different reasons, the most important of which are: the mobility of the tax base, the difficulty in defining a proper taxable amount, the fact that most of the high-volume / high-value derivatives agreements are concluded over the counter and the reluctance of taxing risk-hedging activities having as a purpose to "oil the wheels" of the real economy.

However, this reluctance in taxing derivatives had some inconvenient side effects (besides foregoing substantial tax revenues) as it first led to a privileged treatment of such derivatives and second, as it nurtured the rapid growth of business models aiming at tax-avoidance, such as the emergence of tax-free "contracts for difference" instead of (taxable) trades in the underlying shares.

Also, competent authorities will have access to information on trading in different markets through the use of key financial market legislation in force, such as MiFID or EMIR. This is complemented by specific provisions in the proposal for a directive implementing enhanced cooperation in the area of FTT.

Finally, the fear that reduced market volumes in derivatives markets would harm the efficiency of financial markets, would increase the volatility on such markets and would make it more difficult for the non-financial and financial industry to hedge risks look largely unfounded. Instead, this rolling back of (inflated) market volumes might to a large extent boil down to a statistical effect, and a drying out of the rent-generation business models for the financial sector itself.[48]

Indeed, the main reason for the assumed decrease in derivatives turnover is that it is the notional value of derivative transactions that is taken for measuring trading volumes and the market size. It is not the economic value which is, by the way, often very difficult to determine, both ex ante and ex post. It is also the notional value that is the tax base for the taxation of the derivative, mainly for reasons of administrative ease and cash-flow considerations. Given the large difference between the notional value and the economic value it is reasonable to expect that – through changing business models or because the economic value of a transaction is that small that it is not considered worth to pay a tax on this - turnover measured in notional values is expected to shrink significantly.

Risk hedging volumes

Example:

A trader exposes himself to a high nominal risk (e.g. EUR 50 mn.) and then hedges the biggest part of this risk accordingly by also taking the opposite risk (e.g. in the order of EUR 40 mn), so that the net risk exposure would effectively be limited to the difference between these two positions (EUR 10 mn. in this case).

· The introduction of a tax on the notional value of the underlying would provide incentives to go for the net risk only, i.e. EUR 10 mn., as this institution would then not have to pay an FTT of EUR 9.000 (for a notional value of EUR 50 mn. + EUR 40 mn.) but only EUR 1.000 (for a notional value of EUR 10 mn.)

· Statistically, the turnover volumes would have declined by almost 90% as the new turnover would only be EUR 10 mn. instead of the previous EUR 90 mn.

When determining the tax rate for derivatives, one has to keep in mind that investing in derivatives and investing in the underlying asset are to a certain extent different activities, especially with respect to the leverage effect of the capital invested. It is thus proposed to set the tax rate for derivatives at a tenth of the rate for securities.[49] As a consequence, the tax rate for derivatives renders derivative agreements with a leverage factor of less than ten relatively attractive, i.e. where the capital to be invested will be more than 10% of the notional value of the underlying.

Delta hedging

Delta hedging is a (usually) dynamic process where an investor continuously hedges an open position from an option by buying the underlying assets (or other derivatives closing the position). In option pricing models, the Greek letter delta is used to describe the sensitivity of the price of an option to a change in the underlying asset. The value is derived from the application of option pricing models. For example, a delta of 0.6 indicates that the option price increases by 0.6 Euro if the asset price increases by 1 Euro.

Take the following example for a hedge from Hull (2006). Assume an initial share price of 100 Euro and an option price of 10 Euro (100 shares per option). An investor sells 20 option contracts each on buying 100 shares (2000 shares in total). Delta is assumed to be 0.6. If the share prices decreases by 1 Euro, the value of the options decreases by 2000*0.6=1200. In order not to be exposed to this risk, the investor could buy 1200 shares of the underlying. In that case the price increase in the shares (+1200 Euro) equals the loss of the value of the options. The investor is said to be in delta neutral position since the total delta from his short position (option, -1200) and the long position (shares, +1200) is zero. Note that such a hedge also works the other way round, e.g. an investor with opposite positions would hedge accordingly. Also, instead of buying the underlying the investor could buy other derivatives closing the position.

A financial transaction tax as proposed by the Commission will increase the cost of delta hedging. In the example above, the tax is levied at least two times: When the options are sold (underlying: 200,000 Euro * 0.01% = 20 Euro), when the underlying is bought to hedge (120,000 Euro * 0.1% = 120 Euro), or – alternatively – when the position is closed (120,000 Euro * 0.01% = 12 Euro). If at the end of the option contract shares are exchanged as well, the tax would be due again on the price of the actual exchange value of the shares. Thus, the investor might not have an incentive for hedging changes in his position (delta) that were below 0.1% (in case he hedged by buying the underlying) or 0.01% (in case he hedged by closing the position. In case the counterparty was able to pass on its increase in transaction costs, the thresholds for hedging would increase to 0.2% and 0.02% respectively.

Note that this simple textbook example is static in the sense that only one hedge is considered. In reality, (large) investors hedge dynamically by controlling the evolution of delta for the whole portfolio continuously and adapting hedges accordingly. The real tax burden will depend on the specific hedging strategies employed.

By contrast, those contracts where this ratio falls below 10% will be less attractive. Thus, derivatives implying a hedging of very small and tiny risks (that means, the premiums to be paid are very small as compared to the notional value) or small and tiny changes in the risk (e.g. in the case of the so-called "delta-hedging" – see box) will be discouraged. This should significantly reduce the volumes and frequency of risk-hedging activities without necessarily triggering a higher risk exposure in the long run. This should also be expected to happen to the volume and frequency of transactions which are "speculative", i.e. where the actor invested little money so as to gain a lot, but with a small likelihood. Also, "excessive" financial intermediation in risk-hedging activities will be discouraged, and, thus, letting these activities fall more in line with the risk-hedging needs of the non-financial economy.

Ø Given (i) the high revenue-raising potential from taxing these products (EUR 21 bn. out of a total of EUR 34 bn.), (ii) the massive tax avoidance loopholes generated by not taxing these products and (iii) the contribution taxing these products for achieving the objective of discouraging transactions that do not contribute to the efficiency and stability of financial markets and that primarily aim at redistributing values instead of creating them, it can hardly be recommended not to tax derivatives.

6.2.5 Conclusion

Exempting certain products from the scope of the common system of FTT would have significant negative repercussions for the achievement of the key objectives of the initiative. It would notably:

· jeopardize achieving the aimed-at tax neutrality of the initiative as it would trigger distortions between different products (and actors) in the Single Market,

· jeopardize the achievement of the goal of receiving a fair and substantial contribution from the financial sector to covering the cost of the recent crises. This would also jeopardize achieving the goal of consolidating public budgets or to generate revenues for growth-enhancing public investment,

· jeopardize the achievement of the goal to contribute to a better functioning of financial markets. This holds especially when one decided not to tax derivative contracts or high frequency trading.

On the other hand, taxing transactions that aim at raising capital for investment activities could have negative knock-on effects on growth and jobs and the overall competitiveness of the economy. That is, why already the initial proposal foresaw not to tax such activities. As it is not ruled out that the issue of shares and units of UCITS and AIF also constitutes raising capital for investment (besides resembling part of a secondary market transaction when these shares and units had first been redeemed by investors in UCITS and AIF) it is recommended not to tax such issue. The effect (shortfall) on expected tax revenues of this recommendation is estimated at around EUR 4 bn. annually.

6.3 Sub-Option 2: Exempting certain actors

The initial proposal stipulates that the proposed directive shall apply to all financial institutions deemed to be established in the FTT jurisdiction involved in transactions in financial instruments, except the following entities: the European Financial Stability Facility, the European Stability Mechanism, Central Counter Parties, Central Securities Depositories and International Central Securities Depositories. Also, transactions with the European Central Bank and central banks of Member States should not be taxed.

The definition of what constitutes a financial institution was rather broad so as to avoid a potential loophole when taxing the trading in financial instruments. Thus, the definition of what means "financial institution" is rather broad, covering everything from credit institutions to "any other undertaking" carrying out financial transactions in case these latter constituted a significant part of their overall activity.

While the general aim of such a broad definition was shared by Member States, certain concerns were raised as regards the inclusion of some institutions either being public (such as the managers of public debt), pursuing activities in the interest of the general public (such as regional development banks), institutions whose activities "should be encouraged and not be taxed", such as pillar II and pillar III pension funds, or actors that are essential for an efficient functioning of financial markets such as the so-called "market makers".

6.3.1 Managers of public debt

One of the main aims of managers of public debt is to smoothen market developments for the secondary market of tradable public debt products such as government bonds and bills, as well as to steady the returns (on the secondary market) for investors in public debt products. Through this they also aim at minimizing the cost of issuing public debt.

Taxing such actors and their activities could make their business model less efficient while at the same time contributing to none of the primary objectives of developing a common system of FTT (no contribution of the financial sector, "zero-sum game" for the public budget, no discouragement of socially useless or highly leveraged activities) for as long as the managers of public debt are not massively active on markets with highly leveraged derivatives (on public debt).

Ø Managers of public debt of Member States of the FTT jurisdiction should be excluded from the scope of the directive. However, this shall not preclude the taxability of their counterparties. Such an exemption is neither expected to have negative impacts on public revenues nor is it expected to create additional tax-circumvention options.

6.3.2 Regional development banks

The main task of regional development banks it to raise capital on financial markets and to lend it on to the private sector or to finance public investment, e.g. in infrastructure. Trading in financial instruments does not belong to the business models of such banks, while some risk hedging might nevertheless be required.

The initial proposal does not foresee exempting from the scope of the FTT the activities of regional development banks. This was seen by some as taxing activities that should instead be supported. It is expected that only few transactions to be taxed would be those risk-hedging operations that are linked to the potential exposure to currency, interest rate and default risks.

On the other hand, exempting certain regional development banks might raise the issue of also totally or partially exempting other actors that also provide financing for private or public investment projects, including banks, AIF, insurance companies or pension funds. Exempting the one but taxing the others would challenge the fiscal neutrality of the FTT. Partly or fully exempting both would significantly narrow the tax base, especially as it would be difficult to define the fine line between financial transactions that are needed to hedge risks linked to the financing of such projects and those transactions that are not linked to the financing of such projects.

Ø It should be avoided to exempt regional development banks from the scope of the directive.

6.3.3 Market makers, broker-dealers, proprietary traders ("internalisers")

Taxing professional dealers such as market makers, brokers and proprietary traders could – at least at first glance – have two unintended effects: it could hamper the effectiveness of the functioning of financial markets (as it might trigger a reduction in liquidity and, thus, increase spreads and volatility), and it could generate a cascading effect in the value chain of a single transaction on substance, in case more than one financial institution was involved on each side of a transaction. On the other hand, taxing such activities could roll back business models that "internalise" spreads and, thus, only redistribute rents to the financial sector at the expense of the non-financial economy. Also, exempting them would have significant negative impacts on the tax yield.

To cater for the risk of a cascading effect within a transaction chain the initial proposal foresees to only tax one financial institution on each leg of a transaction (the last in the chain) for as long as the other financial institutions were acting in the name or for the account of this last financial institution (the "disclosed client" provision).[50] An alternative to this disclosed client provision would have been to exempt market makers and broker-dealers from the scope of the tax in first place. However, this would then not only have put out of scope those trades between financial institutions that, after all, are a rent-seeking complement to intermediation (so-called "internalisation-of-spreads" transactions), but also those that are genuine trades between financial institutions. This, in turn, could have significant negative revenue implications as well and jeopardize the objective of ensuring a fair and substantial contribution from the financial sector for covering the cost of the crisis.

The potential impact of taxing market makers and broker-dealers on the efficiency of financial markets looks at first glance as being a real concern in case "high liquidity" and "minimal spreads" were ends in themselves and not means to an end. However, none of them is an end in itself but a means so as to minimize volatility and match marginal supply and demand at an equilibrium price.

Also, one would have to analyse to what extent additional liquidity (as e.g. provided by high frequency traders) really triggers liquid markets when there is a risk of illiquidity and whether minimizing spreads between ask and bid prices between different actors is not replaced by injecting spreads between the ask and bid price by the "market makers" and proprietary traders themselves.

Since the emergence of the global financial crisis in 2008, mainly hitting OECD economies having had the most sophisticated financial markets, the traditional paradigm of "the more the better" as regards liquidity and financial intermediation has been challenged. This also holds for the role of broker-dealers, market makers, propriety traders, high frequency traders and so-called "modern" investment banking activities (as opposed to "traditional" investment banking activities that tried to facilitate the raising of capital, restructuring of companies or mergers and acquisitions) in general.

This review eventually led to a paradigm shift triggering off a plethora of new financial market regulations trying to:

· better control what is going on in the shadow-banking sector;

· limit high-frequency and proprietary trading;

· deleverage derivatives markets and

· limit the turnover in products that are considered carrying a lot of risk or not contributing to the efficient functioning of financial markets but constituting mainly rent-seeking business models in favour of financial-market actors themselves.

Taxing the financial market transactions of such actors would, thus, complement and support financial market regulation, while not taxing them would forego this positive effect while at the same time violating the fiscal neutrality of the tax aimed at, as it would privilege these actors over all the other actors. Also, not taxing the transactions of market makers etc. would significantly reduce the tax base (with at least 50% in the case of transactions in securities).

Ø The transactions of brokers trading in their own name, and of market makers and proprietary traders should be taxed.

6.3.4 Pillar II and pillar III pension funds

The reference to pension funds in the context of the proposal for a directive for a common system of FTT is to Institutions for occupational retirement provision (IORPs) regulated by the Directive 2003/41/EC (see Article 2.1(7) (f) of the initial Commission proposal). The quoted article also covers their specialised managers, especially for the case in which these institutions – which are usually the funds themselves – are not legal persons. Such institutions are private and are completely separate from the public (government-managed) schemes (under public law). So, in this context this paper will actually discuss only the so-called "pillar II" and "pillar III" pension systems.[51]

The relative importance of (funded) pension funds is very different across the European Union. It is the highest in the Netherlands (135% of its GDP or around EUR 850 bn. in 2010) followed by Finland (82% of the Finnish GDP)[52]. In Denmark and Ireland it corresponds to around 50% of GDP, while in countries like Germany, Austria and Italy it reaches around 5% of GDP. In some of EU10 Member States, such as Poland or Hungary, these pension funds have accumulated assets corresponding to around 15% of GDP.

The impact of an FTT on pension funds will depend on both the asset allocation (portfolio) and on the investment strategy (more frequent trading vs. less frequent trading, for example). If one looks at the asset allocation in selected pension funds, not all these assets represent taxable financial instruments as defined in the proposal, neither do all the transactions. As an illustration, cash and deposits and other assets (including derivatives, but also investment in real estate and others) make up for 22% (or almost EUR 190 bn.) in the Netherlands (over 4% in cash and deposits) and 34% in Bulgaria (over 28% in cash and deposits).

One could now argue that the introduction of an FTT would affect (private) pension funds involved in more frequent trading much more than those that trade less frequently in financial instruments, i.e. those funds pursuing a "buy and hold" strategy would be much less affected than those following an "active" strategy with significant and frequent turning over of assets. This difference is illustrated in the below box.

"Buy and hold" versus "active management" strategies

Example 1:

A Dutch pension fund has invested its assets of EUR 10 bn. the following way: 10% in shares, 10% in real-estate funds, 70% in bills and bonds, and 10% in other (such as cash or deposits or real estate). The Fund follows a passive “buy and hold” strategy, i.e. it shadows the relevant indices for shares, it purchases bills and bonds when they are issued and holds them until maturity. Pay-outs (to pensioners) and pay-ins (from contributors) are balanced. Due to changes in the composition of the stock-market indices, it has to turn over (buy and sell) on average 10% of its shares and real-estate funds each year. None of the new purchases are purchases on primary markets.

· Transactions in 80% (primary markets for bills and bonds, cash and deposit and other such as real estate) are out of scope of the FTT directive. The turning over of the shares and real-estate funds carries Dutch FTT.

· The pension fund has to pay EUR 400.000 Dutch FTT annually for the turning over of its shares in case the Netherlands applied the minimum tax rates. This corresponds to 0.004% of its assets.

· If these assets represented 20 years of savings / asset accumulation the annual figure of 0.004% of total assets translated into 0.08% of annual savings, i.e. a pensioner who has invested EUR 100/month would receive returns (after FTT) as if he had invested only EUR 99.92/month in case the fund managers passed these costs on fully to the pensioners and not to the borrowers of capital.

Example 2:

Same asset structure etc. as in the previous case, but this time the pension fund follows an “active” strategy, and turns over all its assets except cash and deposits and other (such as real estate), i.e. 90% twice a year. It does not intervene on primary markets for bonds, bills and shares. Also, as it is more exposed to market volatility, it is assumed to hedge 90% of all its assets four times a year against diverse risks.

· The turning over of assets carries Dutch FTT, so do the hedging operations;

· The pension fund has to pay EUR 36 mn. Dutch FTT annually for the turning over of its assets. Annual Dutch FTT for hedging 3.6 mn. This corresponds to 0.396% of its assets.

· If these assets represented 20 years of savings / asset accumulation the annual figure of 0.396% of total assets translated into 7.92 % of annual savings, i.e. a pensioner who has invested EUR 100/month would receive returns (after FTT) as if he had invested only EUR 92.08/month in case the fund managers passed these costs on fully to the pensioners and not to the borrowers of capital.

As these active funds would also have to cover the market risk of falling bond prices on a permanent basis (mark to market), as they would like to maintain the option to sell these bonds before maturity their derivatives activities might also be more important by several orders of magnitude. This impact could possibly be partly offset due to the potentially positive effect a FTT would have on volatility of bond prices which would benefit the longer term investment strategy of pension funds (because of higher predictability). Evidence in the economic literature on this effect on volatility