Global

It is widely assumed that the expense of Financial Transaction Taxes is simply that of the tax itself, but in reality the processes financial firms need to comply with them can be even more costly. By Daniel Carpenter, head of regulation at Meritsoft, a Cognizant company

There has been a steady stream of transaction tax announcements in the last 10 years. High profile Financial Transaction Taxes (FTTs) have been introduced in France and Italy and more specific dividend taxes in the US with 871(m) and 305(c), and Capital Gains Taxes (CGT) introduced globally – a trend that creates numerous practical issues.

As a result, the market has had to wake up to a growing operational challenge on top of those caused by the tide of regulations including the Markets in Financial Instruments Directive (MiFID) 2 and the European market infrastructure regulation (EMIR), not to mention planning for the arrival of the Central Securities Depositories Regulation (CSDR). 

As countries and regions look at new ways of raising revenues in the Covid-19 world, the transaction tax has been seen as an increasingly attractive option. Notably in Europe, the German presidency of the EU has outlined intentions to introduce FTTs on equity, fixed income and derivatives trades as a way to finance part of the new EU-wide Covid-19 recovery fund, along with other taxes on plastics and emissions. Spain has already passed a bill for a domestic FTT through part of its national parliament. Although progress is slow, these taxes are not going away. Add to this an emerging interest in FTTs in the US, and the number of potential taxes starts to rise.

Compliance costs

It is easy to assume that the only cost comes from the tax itself, but that would be wrong. As with other regulations, the implementation of a new tax regime comes with significant ‘soft costs’ due to the operational requirement for new processes and the implementation of new software to manage them. These extra costs can potentially dwarf the cost of the tax itself. An example of this is 871(m) that derived negligible revenues from dividends paid to foreign investors in equity derivatives but required enormous internal bank expenditure for operational and compliance purposes. Banks need to process and manage all the relevant data on the taxable security, and then process this data against a range of rules to determine appropriate tax or exoneration reasons, irrespective of a zero-tax calculation. While this is already a complex issue, an increase in taxable securities falling into scope and a growing list of regimes coming into play should cause real concern for operations teams and those responsible for the bank’s bottom line.

If the above taxes are introduced in quick succession, there will be a huge surge in the volume of securities that will fall under transaction tax regimes. Most banks do not have the centralised technology to process and manage such large streams of relevant data across this range of taxes. For example, when the French FTT was originally introduced, many houses set up a tactical solution for processing the tax on the specific French securities and then subsequently stretched this to also handle the Italian FTT introduced shortly after. The number of securities in scope was not significant and due to uncertainty about the longevity of the rule the majority of houses opted for tactical approaches. However, all of this was before renewed efforts to introduce the FTT across Europe, the addition of other taxes such as DAC6 and CGT, and increased scrutiny of activities under the cum-ex tax regime. 

Cum-ex challenges

While CGT functions in a similar way to FTT, DAC6 and cum-ex throw up an array of different operational challenges. In the case of cum-ex, there is a renewed pressure on the part of regulators and authorities in Europe to clamp down on the fraudulent activity that has captured headlines. The authorities require market participants to prove that the correct counterparty or intermediary is claiming the withholding tax, even if they were only acting as a market maker. Not only this, it must be shown that the market participant is the only party claiming the tax. To achieve this, houses need a system that provides full oversight of the trading lifecycle in any security, and its underlying derivatives, from the safe harbour point – which is 12 months prior to the dividend payment date – up to the 45-day post-dividend window. 

Although this seems like a tall order, there is no reason that these cum-ex tax requirements cannot be added to a central, automated tax solution that addresses FTTs and CGTs at the same time. This opens the door to new data analytics solutions that can automatically ease the burden as these new rules are introduced. By creating a centre of excellence around tax, financial houses will get to grips with the requirements in both a cost and operationally efficient way, one that is scalable for the introduction of new tax rules that could be implemented in the future.

Looking ahead, it seems clear that there are going to be more taxes. These will come in different shapes and sizes, and with global implications due to their extra-territorial reach. We can see this already with cum-ex which applies to American Depository Receipts of German securities. The tactical solutions currently in place  may have been tolerated to date, due to budget allocation to other regulatory projects, but they simply will not scale to meet the processing requirements of an ever-greater number of taxes, nor will they provide the levels of transparency required to evidence compliance with the rules. A strategic overhaul is required to industrialise this process, and it cannot come soon enough. While other software projects may be at the top of the agenda, it is time for tax to sit alongside them.

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