Open Europe Flash Analysis
New Open Europe Flash Analysis: UK Government launches legal challenge against controversial EU Financial Transaction Tax - what does it mean and what happens next?
Summary: The UK has today announced a legal challenge at the European Court of Justice against the EU’s controversial financial transaction tax (FTT). Despite the British Government having chosen not to participate in the measure, UK financial firms that trade with an institution in a country that does participate will still be taxed. This, the UK claims, violates EU law and is inconsistent with international tax norms.
The economic, legal and political implications of this move for future EU-UK relations are huge. As currently drafted, the tax could cost fund managers (UCITS) based outside the FTT-zone around €5.6bn while one third of all derivatives trades in the UK could be caught by the tax. Legally, it could set out the parameters for how a “flexible Europe” involving different levels of participation in the EU – which Prime Minister David Cameron has said he champions – will be governed. Politically, it’s a test of the extent to which the UK – as a non-eurozone member - can halt or change EU measures with a profound impact on its national interest. Therefore, it will be a key issue in the on-going debate about the UK’s continued EU membership, though other EU countries have also expressed concerns about the impact of the tax.
The UK, Sweden, the Netherlands and others made clear they would veto any attempt to introduce the FTT for all EU member states. Instead, eleven EU countries – all Eurozone members – have decided to press ahead with the proposal under so-called ‘enhanced cooperation’, allowing a minimum of nine countries to go ahead with a proposal if an EU-wide agreement proves impossible. Decisions to authorise enhanced cooperation are taken by all member states but, crucially, using qualified majority voting, even if the proposal would have otherwise been covered by a UK veto. Therefore the UK simply abstained in the majority vote to authorise FTT enhanced cooperation. The final legislation must still be adopted by unanimity among those taking part.
Enhanced cooperation has only been used three times: for divorce law, an EU patent and now for the FTT.
The UK today lodged a challenge at the European Court of Justice on the basis that the FTT will have a substantial impact on non-participating member states, which the UK says breaks EU law and international tax norms. The Government hasn’t challenged the proposal itself but rather the decision to authorise the use of enhanced cooperation. It says that it fears that otherwise the ECJ could throw out a challenge against the actual proposal, once it has been agreed, for being too late.
What happens next?
The ECJ could rule in three different ways: in favour of the UK, against the UK or it could consider the challenge premature, instead deferring the challenge to the actual proposal, once it is agreed. If the first case, the Commission would have to revise its proposal to make sure it respects the rights of non-participating states. If this legal challenge is thrown out by the ECJ, the UK could still challenge the final legislation. Obviously, as the UK government has said, it could drop its challenge if the current proposal is adjusted to incorporate its concerns.
Is the UK right to challenge the FTT?
Yes. Under EU law, the conditions for “enhanced cooperation” are that:
“Such cooperation shall not undermine the internal market or economic, social and territorial cohesion.” (Article 326) and;
“Any enhanced cooperation shall respect the competences, rights and obligations of those Member States which do not participate in it.” (Article 327)
On 22 January 2013 the EU ministers authorised the use of enhanced cooperation. In the authorising decision it was stated that:
“Enhanced cooperation in the area concerned respects the competences, rights and obligations of non-participating Member States, in accordance with Article 327 TFEU.”
When the decision was taken to allow ‘enhanced cooperation’ the details of the proposed FTT and therefore the legality of the proposal wasn’t known. The House of Lord’s EU Committee and others raised concerns over this.
It now seems fairly clear from the proposal that a number of aspects of the FTT could conflict with the “competences” and “rights” of non-participating states (Art 327).
First, the FTT could be used to tax business in the UK. The so-called “deemed establishment rule” in the proposal would see financial institutions in the UK “deemed” to be in an FTT state if the counterparty to the transaction was – and so be liable to the tax.
This means that in a trade between a firm in an FTT state and a UK-based financial firm, the latter will be taxed, but the revenue will be kept by the FTT state. ICAP estimate that 30% of OTC derivatives traded through London (worth trillions of pounds) involve an FTT-zone counterparty in at least one leg of the transaction, meaning they would be subject to the FTT in its current form.
Quite apart from whether the FTT is a good or a bad idea, it is hard to see how this respects the UK’s jurisdiction over its own tax system, and therefore it seems to violate Article 327.
What are the political implications of the challenge?
Domestically, the implications of this challenge could be far-reaching. Should the UK lose its legal challenge, the charge will be that the UK Government is powerless to defend British interests in the face of the large eurozone countries, which would severely undermine the case for continued EU membership.
In wider terms, the outcome will indicate the ability of the EU to accommodate the different interests of individual countries and groups of countries. The principle of ‘enhanced cooperation’, which is being used by the 11 countries pursuing the FTT, could serve as a useful method of facilitating different levels of EU integration but, if it is allowed to undermine the interests of others or the Single Market as a whole, concerns that the EU could become dominated by a eurozone caucus could be realised.
This draft of the FTT is not the final proposal and there could yet be amendments that would satisfy the UK Government, which can take part in negotiations but without a vote. The key country, as always, is Germany. With a Federal election campaign in full swing, Chancellor Angela Merkel is likely to retain her public support for the FTT in principle, but the outcome of the election could determine how close the finished FTT resembles the current draft. Merkel’s FDP coalition partners are opposed to the FTT in its current form but is struggling in the polls, while the opposition SPD have made the FTT a central part of their election programme and was the price for its parliamentary support for the Fiscal Treaty last year. Should the election produce a CDU-SPD grand coalition, the political scope for watering down the current proposal could be reduced.
Is the UK alone in opposing the FTT?
Far from it. 15 other countries have refused to join the FTT for numerous reasons. Sweden has been vocal in its opposition to the FTT, having previously attempted to implement its own financial transaction tax which had a detrimental effect on its financial markets and economy. In a January meeting of EU finance ministers Luxembourg submitted a report highlighting their own concerns about the legality of the current enhanced cooperation FTT proposal. Meanwhile, just a couple of days ago the London-based Global Financial Markets Association along with markets associations from Australia, Canada, Japan and Korea sent a letter to the G20 leaders warning about the FTT would have “unprecedented extraterritorial impacts” and will “increase market volatility, harm savings and impede growth.” In a letter to French Economy Minister Pierre Moscovici, six associations of French employers, bankers and insurers warned that the tax would be “wealth-destructing”.
What are the economic and financial implications?
There’s no doubt that as currently drafted, the FTT would have a major impact on the European economy as well as the City of London, while the uncertainty surrounding the proposal is in itself a major economic cost. If the proposal does go through in its current form we expect the following consequences:
Significant impact on GDP in Europe: In the long-term, the Commission itself expects a 0.28% contraction in the EU economy – about the same level that the Eurozone economy is expected to shrink by this year. This itself amounts to €12bn (35% of predicted FTT revenue) in lost tax revenue according to Citi research.
There will be a significant hit to liquidity in financial markets: In turn, this increases costs, reduces choice and hampers the responsiveness of markets. Any additional costs are likely to be passed on to consumers through higher borrowing costs and fees on financial instruments.
Similar taxes in France and Italy have already hurt stock markets: France and Italy introduced their own FTT’s in August 2012 and March 2013 respectively. The TABB Group noted that French equity turnover as a percentage of market share fell from 15.3% at the end of 2012 to 12.88% in March 2013 (down from 17.3% at the end of 2011 – a 26% fall). Italian stocks trading volumes also fell 40% in March from levels seen in January and February after the tax was introduced, according to some reports.
A key lending mechanism is not exempt: The FTT would hit repurchase agreements (repo) – a key source of lending in financial markets – very hard. In the wake of the crisis, this market is already struggling with limited lending between domestic markets. International Capital Markets Association’s (ICMA) latest repo survey found that the level of repos declined by 11.9% in Europe in 2012. ICMA also estimates that short term repo market would contract by 66% if the FTT is introduced. This would have knock on effects for banks’ ability to provide loans to businesses – the very opposite of what’s needed.
Those not responsible for the crisis would be hit hard: The European Fund and Asset Managers Association (EFAMA) estimates that €13bn (€5.6bn from funds outside the FTT zone) would be raised from UCITS funds.  Despite the tax being presented as a way for banks to “pay for the crisis”, these investment funds (often used by small individual investors) had no direct role in triggering the crisis, and have not received a penny in taxpayer-backing.
The cost will be far greater than headline rates suggest: Since the tax is levied at all stages of the transaction, the actual cost for financial firms will be far greater than the headline rates (0.1% for shares and bonds and 0.01% for derivatives) imply. This is particularly problematic for financial services since a single transaction can often involve many different parties and intermediaries, especially if it happens across borders. For example, Citi estimates that a simple transaction with a buyer, seller, two brokers and a clearing house could cost as much as 1% of the total value of the sale.
Could make financial supervision more challenging: Since the FTT is focused on enforcement through exchanges, an increasing number of transactions will likely move from these platforms and become ‘over the counter’ (OTC). This is wholly counter-productive as it decreases transparency and efficiency in the markets. As the crisis demonstrated OTC transactions are much harder to track, meaning that the FTT could, in fact, make it more difficult for authorities to supervise financial markets.
Increasing banks’ reliance on cheap ECB cash: With central bank lending exempt from the FTT but the market channels to obtain liquidity hit hard, the FTT actually provides a perverse incentive for banks to borrow cheap money from the ECB and central banks. This runs completely contrary to efforts in the Eurozone to get banks off ECB liquidity and could instead further entrench market fragmentation.
Though many of these consequences would stand even if the UK’s challenge is successful, watering down the FTT’s reach would radically reduce the impact on countries outside the FTT-zone and therefore global financial markets.
For more information please contact the office on 0044 (0)207 197 2333, Mats Persson on (0)779 946 0691 or Raoul Ruparel on 0044 (0)757 696 5823.
 European Commission, http://europa.eu/legislation_summaries/glossary/enhanced_cooperation_en.htm
 FCO, Consolidated EU Treaties, www.official-documents.gov.uk/document/cm73/7310/7310.pdf (Article 326)
 EU Council, Council Decision of 22 January 2013 authorising enhanced cooperation in the area of financial transaction tax, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:022:0011:0012:EN:PDF
 House of Lords EU Committee, letter to Greg Clarke 26 March 2013, http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/FTTEnhancedScrutiny/260313FTT.pdf
 European Commission, ‘Taxation of the financial sector’, proposals; http://ec.europa.eu/taxation_customs/taxation/other_taxes/financial_sector/
 European Commission, The current proposed FTT, http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2012_631_en.pdf
 In addition it is also possible that the FTT is contrary to international tax treaties FTT states have made with both EU and non EU states, Open Europe Blog, 15 February 2013, “The Financial Transaction Tax: Who will pay, will it work?”; http://openeuropeblog.blogspot.co.uk/2013/02/the-financial-transaction-tax-who-will.html
 Cited by the FT, ‘Tax blow to Italian stock trading’, 13 March 2013: http://www.ft.com/cms/s/0/e593af72-8bf9-11e2-8fcf-00144feabdc0.html#axzz2QW3oiDnL
 The International Capital Markets Association (ICMA) produces biannual surveys of the European repo market, see here for more details: http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/short-term-markets/Repo-Markets/repo/
 UCITS Industry: EFAMA’s impact analysis of the Commission’s proposal for a Council Directive on a common financial transactions tax: http://www.efama.org/Publications/Public/FTT/EFAMA%20impact%20analysis%20on%20Commission%20proposals%20on%20FTT.pdf