Hard times
We are almost halfway through 2012 at the time of writing. Financial services seem to be on the ropes. Large banks are trading at a steep discount to their book value. The headlines are dismal on both sides of the Atlantic. The Bankia bailout rattled the sovereign debt market and JP Morgan's hedging strategy loss fueled calls for tighter regulations. BIS data show that global banks scaled back cross-border lending at the fastest rate since 2008, reducing cross-border assets by 2.5% ($799 million) in the last quarter, ending December 31.
Analysts are predicting that global investment banking revenues will fall as much as 17% in the second quarter of 2012 compared to the first. At the macroeconomic level, the Eurozone is rehearsing contingency plans for a Greek exit, the US recovery is showing signs of weakness and the Indian and Chinese economies are 2% off their recent trend growth rates.
Financial services transfer pricing (TP) practice has also become more challenging. In a time of budget deficits and austerity, transfer pricing becomes ever more attractive as both a means to protect the domestic tax base but also to extend taxing rights to income that is otherwise offshore in a much less obviously extraterritorial fashion compared to measures such as FATCA. In response, countries as diverse as Russia, India, Hong Kong, Australia and Nigeria are updating or enacting new TP rules.
Financial services TP managers facing these challenges have to contend with tighter headcount, travel and adviser budgets and pressures to offshore to cheaper locations. Furthermore, managers and advisers have to constantly refresh and keep abreast of evolving tax and regulatory changes that impact TP such as the interaction with permanent establishment (PE) principles, new GAAR and offshore stock transfer rules, reorganisation necessitated by the Volcker and other rules ring-fencing risks and risk-taking and new capital and liquidity buffer regulations. These rules vary greatly across different countries and the task of maintaining global consistency in TP across a banking group is not helped by the OECD TP principles being rather general, with what specific guidance there is on financial services barely keeping pace with these changes, for example, the Attribution of Profits to PE Report finalised in 2010 was largely based on work done prior to the 2008 crisis.
Tax and fiscal authorities (Fiscs) in the major financial centres have been dealing with issues around global trading such as loss transfers, appropriateness of allocation keys and advance pricing agreements (APA); both new and renewals. In line with heightened regulatory scrutiny and requirements around capital and liquidity, funding centres increasingly expect commensurate remuneration for (a) the provision of capital and liquidity that benefits the rest of the group and (b) more 'KERT' functions relating to assuming and managing risks being required by regulators to be performed onshore rather than offshore by relationship bankers.
Outside the major financial centres, some Fiscs have questioned guarantee fees paid to parent entities. Notwithstanding this, such Fiscs are generally less familiar with financial services and focus their attention on cost recharges and entity profitability. Here, deduction for head-office and shared services cost is challenged on familiar grounds such as demonstrable benefit, duplication of functions, inadequate documentation and unreasonable mark-ups. This area of cost recharges is complicated by an added layer of regulatory scrutiny especially in countries with capital or exchange controls. This takes the form of prohibitions against the outsourcing of core prudential functions such as risk management or requirements to maintain a certain level of profitability as a prerequisite to any license to expand onshore businesses.
Advisers and conference organisers sometimes group the broader related-party lending as part of financial services. In this area, there has been a string of audit and case law development, the most prominent of which is the GE Capital Canada case, that has generated much discussion around adjusting intra-group loan pricing to take into account implicit/explicit parental support, entity stand-alone default risks and other factors influencing commercial loan pricing that would not normally be considered by group treasurers. This has led to a proliferation of service providers offering rating agency type models to help establish arm's-length pricing for intra-group lending and supporting documentation. However, these developments have generally been outside the core financial services sector without major impact on the internal treasury and funds transfer pricing practices within banks.
What does the future hold?
Financial services TP growth drivers remain intact. The foregoing may seem a hazardous contrarian punt but one needs to distinguish short-run sentiment from long-term trends – the forces driving the growth of cross border financial activity and the increasing sophistication of TP authorities and regimes.
The massive deleveraging in the west notwithstanding, global imbalances actually portend a sustained increase in cross border financing. The IMF World Economic Outlook in April 2012 forecasted real GDP growth for emerging and developing economies to reach 5.75% in 2012 with acceleration to 6% in 2013. This growth will continue to drive both in inbound hunger for FDI and the outbound need to deploy massive foreign exchange reserves and excess savings in these economies. Facilitating this flow is the liberalisation of capital market and exchange controls. China has recently granted private capital the same entry standards to the banking industry as other capital, increased QFII quota from $50 billion to $80 billion and given birth to the Dim Sum bond market in HK and London with the internationalisation of the Renminbi. India has increased the FII limit in long-term corporate bonds from $5 billion to $25 billion and allowed QFIs to subscribe to Mutual Fund Debt Schemes. Such liberalisation is augmented by rapidly growing equity and debt markets with Hong Kong now topping New York in terms of IPO volumes and Brazil coming in third in the world in 2010.
From the perspective of financial institutions in the developed world, recession or anemic growth in the home markets are compelling them to look to emerging markets as the source of sustainable growth for the future. JP Morgan moved their Head of Global Investment Banking Coverage, Capital Markets and Mergers & Acquisitions, from New York to Hong Kong in April 2012 and Morgan Stanley and Goldman Sachs are applying for expanded commercial banking licences in India. The withdrawal of European banks is also offset somewhat in Asia by the expansion of Australian and Japanese banks. Japanese banks increased their lending to Asia by 24% in 2011 according to BIS data and ANZ aims to increase earnings from its Asia-Pacific, European and American businesses from 14% to 25% to 30% percent in 2017. The pressure on profit has also incentivised banks to charge out more cost to their network to claim deductions, thereby increasing the significance of transfer pricing.
The other major driver is the increasing sophistication of Fiscs in their knowledge of and ability to question cross-border constitution of functions, assets and risks. Some Fiscs have requested financial services firms to submit their TP documentation for review, others ask the Big 4 for specialist financial services TP briefings, exchange intelligence and know-how with their counterparts and form cross-functional audit teams with lawyers and economists, which are better equipped to appreciate the regulations and complex business models in financial services. On the dispute resolution front, the development of APA/MAP regimes in countries such as Indonesia, India and China offer new avenues for offshore financial services firms to gain tax certainty for their onshore activities. The new HK APA regime, together with Singapore's increased APA activities (the first bilateral with UK was recently concluded) raise the interesting prospect of these two key financial centres joining the traditional New York-London-Frankfurt-Tokyo axis in concluding bilateral and multilateral APAs. The great expectations of APA/MAPs are unfortunately often tempered by the heavy resource demand in pursuing an APA strategy and the risks of opening up to, effectively, a quasi-audit scrutiny; especially when facing a Competent Authority in a country that does not follow conventional OECD transfer pricing principles and practices.
In summary, there is sufficient impetus for financial services TP to grow in significance and keep its practitioners fully engaged because we live in interesting times.
The only constant is change, continuing change, inevitable change, that is the dominant factor in society today.
~ Isaac Asimov
Sam Sim chairs the Capital Markets Tax Committee TP Sub-Committee and heads a team covering wholesale banking transfer pricing globally at a leading bank. The views expressed herein are the author's own and do not represent in any way the view, position or facts related to the Committee or the bank.
