Are Forward Contracts Physical or Financial Transactions?

Are Forward Contracts Physical or Financial Transactions?

May 1, 2014

This question will be very relevant when the European Financial Transaction Tax (FTT), vigorously supported by France and Germany, is introduced in the 11 European Member States (MSs) that have agreed to it. The UK’s challenge to the tax has just been rejected by the European Court of Justice.

The FTT been proposed by the EC to harmonise the efforts of countries to claw money back from the banks that were bailed out in the 2008 meltdown of the financial system. Hence it is being pejoratively dubbed the “Robin Hood” tax.

Europe’s original proposal to make the FTT apply to all MSs has not been adopted, but Germany, France, Spain, Italy, Belgium, Austria, Portugal, Greece, Estonia, Slovakia and Slovenia are going ahead anyway, using a mechanism entitled “enhanced cooperation”,

According to Euractiv[1] “A declaration by the bloc on the future form of the tax is expected at the ECOFIN meeting of finance ministers on 6 May”.

Without harmonisation and without details of the exact nature and scope of the tax in each of the 11 countries it is difficult to say exactly what the impact will be. But under enhanced cooperation even those MSs who are not adopting the FTT will be required to collect the tax on behalf of those MSs that are.

Some Clues from the Proposed Directive

According to the proposed Council Directive implementing enhanced cooperation in the area of financial transaction tax[2] “Derivative contracts relating to commodities are covered, while physical commodity transactions are not.”  Hence my question: are forward contracts physical or financial?

The proposed Council Directive says that “Each exchange …. shall be considered to give rise to two financial transactions.” So the FTT applies when opening and closing a position and is not levied on the net amount of the gain or loss. Hence a hedger who places its hedges in a near forward month because it is more liquid would be taxed each time it rolled its positions forward to more closely mirror its underlying risk.

Are we to understand that spot gas transactions at, say, Zeebrugge are outside the scope of the FTT, while contracts for delivery next month may be in or out depending on whether or not they are cash-settled before delivery or whether they actually proceed to delivery? Are NBP forward transactions in the scope of FTT if they are transacted by a French or German company but not if they are transacted by, say, a Swedish and UK company? What about companies based in Switzerland or the USA that deal in the European gas market?

Ditto for forward oil contracts; if they are booked out, i.e. cash settled, are they within the scope of the FTT? Whereas if forward cargo deals are ultimately nominated  into chains and go to physical delivery are they outside the tax net? Precautionary avoidance of book outs to circumvent the FTT has huge implications for using up the credit lines of companies that trade oil.

Taxation Basis Risk

For hedgers the introduction of the FTT will add a further layer of complexity to the decision of how many hedge contracts to enter into the protect the price risk of a given quantity of physical risk. Already hedgers have to scale their hedges to reflect a different rate of  physical and derivative transactions. The hedge ratio[3] will have to be further adjusted to reflect whether the FTT applies to a particular deal and at what rate. That will vary depending on the location of the counterparty and the individual FTT rate of the participating MS.

The Winners

The proposed directive suggests that “In order for a financial transaction to be taxable in the participating Member States, one of the parties to the transaction needs to be established in the territory of a participating Member State.”  The big winners than are going to be estate agents handling commercial properties, as companies move location to take themselves outside the catchment area of the FTT. But don’t move too quickly. There is still a lot of detail to be worked out before a rational response can be worked out.

A Postscript for Colleagues in the Environmental Space

It is often said that emissions trading is too complex and that greenhouse gas emissions should instead be subject to a “pure and simple tax”. Get a load of this lot before saying taxation is pure and simple!





[3] See “Trading Crude Oil: the Consilience Guide”, pages 149-153