Friday, June 10, 2011

Hedge Fund Industry Sees Problems with Proposed EU Financial Transactions Tax

The adverse consequences of a proposed EU financial transactions tax and financial activities tax would outweigh the benefits and could even increase systemic risks, in the view of the hedge fund industry. In a letter to the European Commission, the Managed Funds Association said that a financial transactions tax at the EU level would put EU investors and businesses at a competitive disadvantage in relation to non-EU investors and businesses and deter foreign persons and companies from transacting in EU instruments or with EU persons.

The imposition of a global financial transactions tax would increase the costs for investors seeking to invest in or provide financing to companies. These costs would be passed onto businesses raising the cost of capital and reducing the availability of credit to businesses in the EU and globally. Moreover, by increasing the cost of capital a financial transactions tax acts as a tax on all businesses seeking access to capital markets to create and grow their businesses. In the MFA’s view, increasing the cost of capital for companies will divert valuable resources away from being invested in their businesses, ultimately resulting in fewer jobs.

The financial transaction tax is problematic whether it is broad-based or narrow-based. One of the options being discussed is a tax only on stocks and bonds. Such a narrow-based financial transaction tax is unlikely to produce significant revenue, reasoned the MFA, because market participants would restructure their transactions to trade financial instruments not subject to the financial transactions tax in order to avoid incurring the tax. Providing an incentive for market participants to enter into such structured transactions can also lead to significant amounts of assets being put onto the balance sheets of large financial institutions, which are most likely to be counterparties for these transactions. Moving more assets onto the balance sheets of the largest financial institutions could increase systemic risks

A broad-based financial transactions tax that includes derivatives has its own set of difficulties, noted the MFA, since taxing derivatives transactions would be difficult to implement because many derivatives products will have a value of zero at the time of the transaction and there is no uniform method to determine future value, which means there is no clear value on which to base a tax. The proposal states that the tax base for a derivative transaction is in principle the value of the underlying asset. At the time of the derivative transaction, however, the value of the underlying asset and the value of the derivative contract are unlikely to be the same, observed the MFA, which means that this approach is unlikely to provide a fair method of assigning tax liability.

The MFA also pointed out that the imposition of a tax on financial instruments would lead to a reduction in the value of those instruments in order to reflect the additional cost imposed by the tax. Consequently, investments held by all investors, including pension plans and individual investors, would lose significant value. This means that all investors, not just financial institutions, are the effective tax payers of a financial transactions tax.

Indeed, noted the MFA, because individual investors are less likely than financial institutions to engage in structured transactions that are not subject to a financial transactions tax, these investors may ultimately bear the highest burden, a result that is inconsistent with the stated policy goal in implementing such a tax. Further, the imposition of new taxes and reduced asset values on investors, such as including pension plans and individual investors, could require increased government support to the extent these investors have insufficient resources to fund their retirements. Such increased government burden would reduce, or even outweigh, the benefit of any revenue generated by the tax.

The proposed financial activities tax is based on the policy rationale of government contributions during the crisis. But applying such a tax to all financial institutions is overly broad, said the MFA, since hedge funds did not cause the financial crisis and did not receive direct government support. While some argue that it would be fair to subject hedge funds to such a tax because they were indirect beneficiaries of government support, noted the MFA, this line of reasoning equally applies to all market participants, including individual investors and non-financial companies, which receive financing through capital markets.

In addition, imposing a financial activities tax on hedge funds or other investment funds or their advisers presents unique issues compared to a tax on other types of financial institutions. Hedge fund advisers typically do not have significant amounts of assets. Like all advisers, they manage assets on behalf of clients and investors. Any tax on an adviser would need to be based on the actual assets of the adviser, noted the MFA, not the adviser’s assets under management. Because hedge fund advisers have limited assets, a tax on these advisers is unlikely to raise significant revenues.

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