City goes into battle over tax

News Analysis: A levy on Eurobonds would send the trade to New York, opponents say
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THE CITY'S flourishing Eurobond market seems an unlikely source of political controversy, but today its future will be top of the agenda when European finance ministers meet in Brussels.

Eurobonds were of limited interest to those outside the Square Mile until the European Commission stepped in with controversial plans to impose a new tax on bonds issued in the EU.

In the City it is now feared that the Commission's plans to impose a withholding tax on investment income could destroy this $2 trillion market, which the City of London dominates.

The Corporation of London, which is lobbying aggressively against the imposition of the new tax, warns that the Eurobond trade could be forced from London to New York, putting up to 10,000 City jobs at risk.

Under the Commission's proposals, all EU member states would have to choose between two options when looking at the interest that non-residents earn on investment income.

The first is to provide the non-residents' home tax authority with detailed information on revenue flows, thus enabling the home tax authority to levy the appropriate tax.

The second is to levy a 20 per cent minimum withholding tax on interest paid to non-residents - which is the route most institutions would be likely to take.

The Commission says these proposals would eliminate "unfair" tax competition between member states, thus ensuring that money did not flow to, say, Luxembourg from Germany simply because of the differing tax regimes.

Many European countries, the UK included, already have some type of withholding tax in place. Most banks pay interest on income net of tax, for example. Indeed, the idea of taxing income as close to its source as possible has long been advocated by academics - it helps crack down on tax avoidance. So if the Commission's proposals simply extend this regime to all European countries, what is all the fuss about?

The main difficulty is that the Commission's proposals, as they stand at present, will affect wholesale financial markets that are currently exempt from the withholding tax.

Individuals from outside the UK, for example, who currently receive income from Eurobonds issued in London, will suddenly see sharp falls in the interest. As a result, they will demand higher returns from Eurobonds if they are going to hold them in preference to other financial instruments. This in turn, makes it more expensive for companies to issue debt in Europe, forcing them to look elsewhere.

As Judith Mayhew of the Corporation of London puts it: "The main difficulty is that until the US adopts such a tax then it is easy for global financial institutions to move part of the Eurobond market to New York."

Bill Robinson, a former director of the Institute for Fiscal Studies and now a director of London Economics, the consultancy, says: "The world these days is a global village. Tax revenue equals tax rate times tax base. There's no point raising the tax rate if the tax base is simply going to shrink."

Professor Richard Dale of the University of Southampton, author of a recent study of the effect of regulation in the financial markets commissioned by the Corporation of London, agrees. He says: "It is well established that financial regulatory initiatives implemented in one national jurisdiction may cause financial activity to shift to other, more permissive, jurisdictions."

However, proponents of the Commission's proposals point out that they will only apply to individuals, not companies. Individuals only hold around 10 per cent of all Eurobonds - so the bulk of the market will be unaffected. And although there have been attempts by some MEPS to extend the scope of the tax to companies, this is seen as highly unlikely by senior sources.

Those who oppose the Commission's moves counter that financial markets only work if they are deep and they are liquid.

Ms Mayhew, for example, argues that the main attraction of London is the depth of its financial markets - the consequences of tampering with this competitive advantage could be disastrous.

Historical experience seems to support the view that in financial markets, size matters. The recent experience of Liffe - which lost the whole of the market for German government bond futures to Frankfurt within months because of its reluctance to introduce electronic trading - still smarts with many in the City.

Professor Dale's study also provides real-life evidence to back up those who oppose the imposition of the tax in the wholesale financial markets. Until 1984, for example, the US imposed a 30 per cent withholding tax on income paid by US issuers to non-resident investors. The result, according to the study, was to help kickstart the Eurodollar bond market, now key to the financial health of the City and other European financial centres.

In late 1987, the German government proposed a new 10 per cent withholding tax on domestic bonds, to come into effect in 1989. The results were nothing short of spectacular. In 1988, just before the tax was due to come in, DM9bn flowed out of German bonds, and the mark came under severe pressure. In April 1989, four months after the tax had come into force, the government was forced into an embarrassing U-turn.

There seems to be a broad consensus among academics and the City alike that the extension of a withholding tax to Europe's wholesale financial markets will cause institutions to channel business elsewhere, and that jobs - not just in London but across Europe - will go.

The high-profile lobbying conducted by the City seems to be having some impact. The Government has said it will not jeopardise the City's future prospects. The UK's opposition to the plans is gathering support in Europe. There are moves afoot by MEPs to propose that the Eurobond market be exempt from the tax. If they fail, the argument goes, then it is not only London's financial markets, but Europe as a whole that will suffer.

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