An internal legal opinion prepared by the EU Council Legal Service (CLS) has raised concerns that the proposed financial transaction tax (FTT), currently under consideration, would have an extraterritorial reach that infringes on the tax rights of nonparticipating member states.
The opinion, dated September 6, says that the imposition of "deemed residency" on financial institutions resident in nonparticipating member states "would constitute the exercise of jurisdiction over entities located outside the geographical area concerned by the legislation adopted under enhanced cooperation." It finds that the exercise of jurisdiction goes beyond customary international law principles that the EU must follow and that it violates article 327 of the Treaty on the Functioning of the European Union, which requires legislation adopted under enhanced cooperation to respect the competencies of nonparticipating member states.
The European Commission issued the proposed FTT directive on February 14 to create a harmonized system of taxing securities and derivatives transactions in the 11 participating member states. The proposed directive is being advanced through the EU's enhanced cooperation procedure, which allows for a group of nine or more member states to adopt legislation applicable only in the territory of the participants.
The proposed directive calls for a minimum 0.1 percent tax on the total value of transactions in securities that is to be paid by both the seller and purchaser in all covered transactions. Derivatives are to be taxed at a minimum 0.01 percent rate on the notional value of the contract. For cross-border transactions between a participating and nonparticipating jurisdiction, the financial institution in the participating member state is responsible for paying the tax incurred by both parties.
Critics have long argued that the proposal's residency rules go beyond established international taxation principles and create a broad extraterritorial tax. The CLS opinion appears to support the critics' view.
At issue, according to the CLS opinion, is article 4(1)(f) of the proposed directive. The article deems a financial institution to be established in a participating member state if the counterparty to the transaction is established in a participating member state. The CLS found that in cases in which a financial institution is not established in a participating member state, the institution's jurisdiction has a stronger claim to taxation rights on the transaction that is not overcome by the stated goals of the FTT, including revenue raising, increasing the contribution of the financial sector toward the costs of the financial crisis, and reducing the risks in the financial markets.
"The concern that the introduction of a FTT will cause migration of financial transactions to non-participating States does not justify in itself extraterritorial tax legislation," the CLS said. "To regard any transaction of a financial institution resident in the FTT-jurisdiction as an act justifying, by definition, anti-fraud or anti-evasion measures would not be in compliance with the proportionality principle."
The CLS said that this provision also creates a discriminatory effect for cross-border transactions by treating transactions between participating member states differently from transactions between a participating and nonparticipating state.
The CLS also found that the "escape clause" provision of article 4(3), which allows for parties to avoid being deemed resident by proving that there is not an economic link between the transaction and the participating member state, was "totally unsatisfactory" as a potential cure for the problems with the expansive definition of residence. It suggested that this provision risks "creating disparity of application" and raises the risk of litigation.
A spokeswoman for EU Tax Commissioner Algirdas Šemeta rejected the CLS opinion, saying that it failed to consider the tax in its entirety because it focused on only one element of the residence principle. The CLS opinion also did not question the use of the enhanced cooperation procedure, she added.
The spokeswoman also defended the commission's stance in favor of the FTT, saying that it had performed a "very thorough" legal analysis before advancing the proposal.
"We stand firm that the proposed FTT is legally sound and fully in line with the EU treaties and international tax law," she said. "It does not pose the risk of discrimination against any member state -- whether inside the FTT zone or not."
In addition, the spokeswoman said that the commission's own legal service will further analyze the CLS opinion and revisit the issues in the EU Council.
"We expect the Member States not just to take on the CLS views, but to assess them critically against the Commission's robust legal analysis of this proposal," she added. "In any case, this opinion is one of many which have been fed into the discussions around this proposal -- it certainly doesn't imply any necessary slowdown in the work being done to progress the FTT."
Rita de la Feria, a professor of tax law at Durham University Law School and program director at the Oxford University Centre for Business Taxation, told Tax Analysts that she found the opinion interesting, if not entirely surprising. She said that the issues raised in the opinion echo similar concerns expressed by the U.K. House of Lords in a March letter. De la Feria said, however, that she finds the "comprehensive" reasoning of the opinion to be more convincing than the "brief reasoning -- at least the public version -- given by the commission to justify the proposal."
According to de la Feria, the FTT is becoming a "test case" for the use of enhanced cooperation on tax matters. She suggested that the FTT's success is important to the commission, because it could allow for the use of enhanced cooperation in other areas of taxation where unanimity is elusive.
"However, whilst I am sympathetic to the commission's difficult position, the conundrum is that extraterritoriality is -- probably -- being perceived as fundamental to the success of the proposal, namely to avoid the clear possibility of relocation of headquarters of financial institutions to nonparticipating member states to avoid the new tax; on the other hand, extraterritoriality is difficult to justify and may ultimately lead to the demise of this proposal," de la Feria said.
A spokesman for the German Finance Ministry reiterated its commitment to the FTT, saying that its position has not changed despite the CLS opinion and that it was necessary to clarify and resolve any legal concerns surrounding the controversial tax. The spokesman also said that no matter how the legal analysis unfolds, the ministry intends to proceed under the enhanced cooperation procedure with its FTT partners.
However, for FTT opponents in the U.K., the CLS opinion reinforces their argument that the tax would adversely affect the EU economy and would infringe on the rights of nonparticipating member states.
"This opinion recognises that the FTT would have damaging implications for growth, jobs and investment beyond the member states involved, so now is the time to draw a line under this flawed proposal," Leo Ringer, head of financial services and corporate governance for the CBI, a major U.K. business lobbying organization, said in a statement.
"It also makes clear that moves towards further integration between a number of EU countries can't be taken forward if they impact on the rights of all member states, unless all states affected have signed up," he added.
Jorge Morley-Smith, director of tax at the Investment Management Association, said that the opinion supports the U.K. government's legal challenge against the FTT proposal, which was filed on April 18 at the European Court of Justice on the grounds that it would have adverse extraterritorial effects on the British economy.
"It appears to vindicate the U.K. government's legal challenge and will cause a significant rethink of the proposals," Morley-Smith said. "It also highlights a number of the deeply complex consequences such as the risk of migration of financial services away from the participating countries, the extraterritoriality of the proposals, and the risk of differences in implementing the tax."
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