The EU Financial Transaction Tax has a very high global profile, as trading entities and legislators begin to understand the potential impact that lies ahead. Capital markets and buy-side firms have now implemented their solutions to handle the French tax and elements of the Italian tax while the task of getting prepared is underway, or at least on the agenda, for most Heads of Tax or Operations for other FTT’s. The major consultancy firms are busy advising asset managers, banks, brokers and custodians globally on the best approach as the FTT sands continue to shift.
Pre-existing regimes are hampering EU negotiations, with France understandably pushing for a more limited tax in line with its own. Further European announcements on individual jurisdictions are certain to only make the situation even more complex and capital markets firms are beginning to understand just how much is beneath the surface of the FTT iceberg. Of particular note is the impact of FTT on fixed income trading; no doubt the FTT rules for this asset class will be changing.
It is likely that a consensus will be reached sometime in Europe in 2013, but the implementation of rules and detailed legislation in each country will perhaps take a further 6-12 months after that. In all likelihood each country will apply various rates and have different reporting requirements. There will still be many complexities and a multitude of rules involved in rebating and netting, amendments to backdated trades and the retrieval of missing data. Add to the mix the varying systems interfaces and trading formats, global mandates and the differing roles of the asset manager, broker and custodian, and one begins to appreciate the challenge that capital market players face.
The Financial Transaction Tax has become a global phenomenon, in that any firm buying a French or Italian equity for one of its clients – even if it is an overseas asset manager – will need to consider the collation of tax on that trade. If the firm has passed this responsibility to a third party such as a custodian, it will ultimately still have to oversee the tax calculation and posting to the custodian. Even an inter-company transfer within an asset manager that crosses jurisdictions where the FTT applies must calculate the tax and advise the custodian for reporting and payment.
The Italian experience
Meanwhile the collation of Italian data with its increased level of complexity is making life much harder for firms trading in Italian securities. What at first appeared to be a straightforward tax in France has become more complicated in Italy. Even since 1 March when financial firms began capturing the data in Italy, the problems being experienced are far greater than those of France. For example, gathering the underlying security information prior to applying one of more than 50 different fees for the tax on derivative trades, adds great complexity. In the absence of clear methodology guidelines for calculating tax on a derivative trade, financial firms face an uphill struggle as they prepare to begin the reporting phase on 1 June.
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There is also the question of the underlying structure of a derivative. Firms need to understand all of the elements involved in a derivative, as theoretically, some of these may be non-taxable. For example, if a derivative has partially invested in Germany, which rate of tax will apply? The rate of tax is applied at the derivative level, but for an Italian derivative where 51% of the value is based on German equities, does no tax apply?
Indeed, trading in Italian stocks through major banks has dropped sharply amid a wider fall in volumes since Italy introduced the tax. Trading volumes have dropped by some 40 percent between January and March 2013. This is partially due to the fact that Italy moved forward with the tax in isolation! Initial signs are that people may also be confused and avoiding Italy altogether because they are not sure whether FTT will effect their trade.
For those firms involved in calculating the FTT, there will be far more data flows within the organisation in order to understand how a derivative is structured. There will also be a need for scalability in back-office systems, as the amount of processing to undertake this analysis will spike. This processing is also happening in real-time, both pre- and post-trade, with the resultant changes being made to the deal ticket.
For any firm with a dealing system, that system is not designed to handle the post trade payments and declarations involved in FTT. Is the solution to run two systems, one for pre-trade and one for post-trade? Or do you have one system that can do both?
The market challenge
Most institutions have tactical solutions in place but are now looking for a strategic solution. Tactical solutions are resource intensive and typically have little workflow or flexible rules, making them expensive to run. As each country implements its own unique version of the FTT, brokers, custodians and fund managers will potentially need to develop a unique set of rules for each jurisdiction.
What aspects of implementing FTT schemes has been the most challenging to date? According to industry feedback, time to market and the uncertainty around the legislation are causing the most consternation. Institutions know from experience that as soon as an FTT scheme is registered, there are only a few months’ lead-time from the requirements being provided by the tax authority to the financial firm having to pay and report. And there are many different interpretations within the industry concerning the individual FTT country scheme registrations. From a systems perspective, it is therefore very difficult to come up with a standardised approach that will future-proof any investment designed to meet all the needs of this tax.
For capital markets firms, one thing that is certain is that there will be numerous other countries introducing a tax in the coming years. The alternative is to either select a vendor provider or build something internally that will be able to manage the processes and messaging. Key questions for Chief Operating Officers or Heads of Tax to ask include: how much of the functionality do you really need to build, bearing in mind the post-trade systems that you already have internally; how will the rules vary in the different jurisdictions (there is a real benefit here in having an out-of-the box solution which has been designed to be able to adapt to the differing regimes); and how quickly could your IT team design and implement a new FTT system?
Finding the right solution
With these questions in mind, it will probably make sense for the major houses that may have several entities in different jurisdictions involved in the tax calculations, to have a separate engine to handle the FTT. The ability to interface with other post-trade systems will be very important and for the larger firms, that typically have the most systems operating across geographies, asset classes and investment strategies, this will tend to necessitate a standalone FTT system. For the smaller brokers and asset managers, it will be a simpler process that can possibly be handled using existing in-house tax applications or an ASP service.
In terms of reporting requirements, from France we know that there are two separate activities that need to be recorded: one for the actual trade and one for the tax being applied by the relevant authorities. The system needs to be able to make a report to the client and it needs to be able to rebate the net tax liability. The ideal situation is to have one engine that can handle all markets, so when a new market comes on stream the firm does not have to build anything new – it can simply upload data for that market and produce a report.
We still have a long way to go on this journey and the landscape will be forever changing as we travel. One thing that we do know is that FTT is a rules-based problem that will require a rules-based solution, that is able to configure and adapt to the current rules and those that will inevitably change. Outside of the eleven EU voting states, other countries, such as the USA, Ukraine, Hungary, Switzerland and South Africa are considering or have introduced an equivalent tax. At present it is a global issue for European markets, but soon it will be a global issue for global markets.
If all goes to plan, the FTT will become law and all eleven adopting countries will go ‘live’ on 1 January 2014. This will exert an immense strain on tax processing within brokers, custodians and asset managers. Inevitably there will be some compromise and dilutions along the way, as has been the case with almost every major item of European financial regulation in the last five years. But with the search for new government revenues influencing almost every economy in Europe, FTT is a headache that will not be dispelled easily.
Denis Orrock CEO, GBST Capital Markets