Financial services industry value chains and TP
Samuel Gordon and Ralf Heussner of Deloitte provide an overview of a series of articles on the impact of three modern trends on value chains, and the implications for transfer pricing.
This series of articles focuses on transfer pricing in a value chain context. Financial services firms provide the funding, payment processing, insurance, investment management products, and hedging to members of supply chains but banks, insurers, and investment managers tend to be thought of as outside production supply chains. Within the financial services industry, firms frame their own business operations in terms of value chains, not supply chains.
A value chain is a set of activities that a firm operating in a specific industry performs to deliver a valuable product (a good and/or a service) to end customers. The key difference from a supply chain is that the value chain was created as a business strategy concept or decision tool, whereas a supply chain exists as a logistical representation of how a product makes its way from raw material to the finished product received by a customer.
In an international tax context, the value chain concept is present in sections of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and the OECD Guidance on Permanent Establishments. This lends credence to efforts to use the value chain concept to organise and address transfer pricing management issues.
Underlying a financial service firm’s value chain is capital and human talent/experience, and intangibles ranging from licences to brands to technology. Financial service firms’ value chains represent sequences of business decision making, financing, functional operations, risk management, and production of services, often across borders and among related parties. These value chains are changing at a rapid pace due to factors such as COVID-19, digitalisation, new work arrangements, new competitors, and competitive forces, and many of these changes will be permanent.
Deloitte’s three financial services industry articles look at changes and disruption to value chains or business set-ups and what this means for transfer pricing purposes across banking, capital markets, fintech, and insurance, and from an investment management subsector perspective.
Article 1: Remote working
The first article examines the remote working environment in the banking, capital markets, and fintech sectors. Remote working arrangements can disrupt where functions within a value chain are performed, resulting in source versus resident tax issues, potentially income attribution issues, and transfer pricing issues, which are addressed in the article. The focus is on three scenarios.
The first scenario involves senior management personnel based in locations other than the global or a regional headquarters location. There is a high degree of interaction between potential permanent establishment (PE) risk (fixed place or agency PE) and transfer pricing in this scenario. As a practical mitigating matter, some tax examiners may be less likely to raise PE issues if they are satisfied that the local entity employing the senior management personnel or hosting the senior management personnel as a secondee is sufficiently remunerated.
The second scenario involves front-office employees working remotely in a country with an existing bank or securities brokerage branch of a group company domiciled in a different jurisdiction. In the case of front-office employees involved in significant client interaction and business development, tax examiners may expect additional attribution of income to an existing branch for the functions of travelling front-office employees.
The third scenario involves remote working for software development at a fintech company. The total cost-plus profit level indicator has commonly been used to remunerate contract development functions and it may come under strain where the performance of development and enhancement decision making is spread widely. This potentially suggests that the economic ownership of valuable and unique intangible property (IP) is highly fragmented and the return on that valuable and unique IP should be shared in a fragmented way.
Flexible work models are a feature in most conversations about recruiting and retaining talent and therefore cross-border remote working must be managed in a way that means transfer pricing risk does not detract from its benefits. This could involve a combination of controls designed to limit the remote arrangements to situations deemed to be worth it from a cost benefit analysis perspective, and the transfer pricing analysis that can mitigate the financial impact of any potential revenue or profit split arguments that tax examiners may raise.
Article 2: Insurers and intangibles
The second article focuses on insurers as they are revisiting transfer pricing positions on marketing intangibles and formulating transfer pricing for the development and use of digitalisation and technology IP.
Marketing IP is an increasing area of focus of tax administrations and multinational insurers across tax examinations, competent authority cases, and advance pricing arrangements. At the heart of the debate is the question of how valuable a global brand is in local markets around the world and whether a cost-based or a fee-based transfer pricing method for the use of a brand is more appropriate.
The article also discusses a new class of technology IP: the software, systems, customer experience, algorithm, etc that make up digitalisation (for example, digital platforms and robo-advisors). This investment in technology is a proactive, top-of-the-firm-level choice and there is some degree of uncertainty as to whether the investment will result in unique and valuable IP that would drive measurable economic benefits such as greater market share, higher revenues, cost efficiencies, and/or greater operating margins.
The key message of this second article is twofold. There is an increasingly important class of on- or off-balance sheet IP that requires consistent attention from a transfer pricing life cycle perspective. Understanding what is changing when moving from a traditional value chain to a digitally enabled value chain, and the value of the IP underlying that change, is a big looming question for multinational insurers that are confident their digitalisation can drive measurable economic benefit.
Article 3: Alternative investment products
The third financial services industry article looks at the shift to alternative investment products from traditional investment products by investment management firms and what this means from a business model and transfer pricing perspective.
Alternative investments have become common investments for a much broader class of investors globally. Factors such as ESG, digitalisation, cryptocurrency/digital assets, and the economic and political volatility of the current business cycle have helped this trend. This, in turn, has driven the expansion of cross-border value chains for alternative investment products.
Different business set-ups (including new legal entity structures) for alternative investment products have arisen as alternative investment managers have moved from unregulated to (lightly) regulated environments in various jurisdictions. This change in business set-up may encompass functions ranging from regulatory compliance to separate investment committees for making investment decisions.
Through interaction with a new alternative investment product team, it is paramount for tax and finance staff charged with managing transfer pricing to gain a deep understanding of the investor acquisition, investment process, and value chain.
This understanding of the alternative investment products can be compared to analogous information for traditional investment management products. Based on this, there can be a reasonable assessment of whether an existing transfer pricing policy with no modifications meets the best method standard, or whether an existing transfer pricing policy with modifications or a new transfer pricing policy is warranted.
The importance of value chains
Across these three articles, value chains are emphasised as a way of framing transfer pricing, since they provide a variety of benefits in terms of understanding a firm’s views on value and key decision making, and – in a time of significant changes – they also provide a shared reference. Also, value chain information is central for answering the question of whether cost-, revenue-, or profits splitting-based transfer pricing is the best method for an intercompany transaction.
Senior decision makers within multinational corporations tend to be familiar with, and may think in terms of, value chains. This provides a common basis for a regular dialogue on who is, and what key decisions are intended, to drive value generation, and where. Transfer pricing analysis is often clearer and better aligned with business objectives and views of what is valuable when tax/transfer pricing experts discuss matters in business strategy and commercial terms and then take that away to delineate intercompany transactions.
The value chain dialogue between senior decision makers and tax/transfer pricing experts lends itself to transfer pricing design opportunities that can be value adding or value enhancing. At key business planning, merger and acquisition, and restructure points, tax/transfer pricing experts can provide useful insights into optimal locations where key revenues- and/or profits-driving decisions should be made.
However, this can only occur with a good understanding of the relevant value chains. This, in turn, can have a positive bottom-line effect on cashflow and taxes.
The value chain and relative importance of people, capital, and IP to the value chains can be framed for transfer pricing policy decision making, transfer pricing documentation, and transfer pricing risk mitigation/management purposes in a way that allows one to make decisions about remunerating functions/decision making.
Deloitte hopes the three articles provide some insight into the changes across various financial services subsectors and the transfer pricing considerations for those changing value chains and business set-ups. The importance of value chains as a strategic and tax framework that allows one to align stakeholders and commercial and technical considerations to address important issues cannot be understated.