The banking sector - taking the TP pulse on regulation and transformation
Ralf Heussner of Deloitte Germany, Priscilla Ratilal of Deloitte Australia and Anna Lam of Deloitte UK examine the latest market and regulatory developments in the banking sector and their TP impact.
Finally, the banking sector is bouncing back. The Financial Times reported in May 2023 that profits in the US banking sector alone reached an all-time high in the first quarter, up more than 30% compared to 2022. This, even as the industry contended with the aftermath of two bank failures in the US and the most significant stress since the 2008 financial crisis.
While this is good news for the banking sector and the broader economy, these and other political events have sharpened the regulators’ focus on the operating models and risk management frameworks of banks.
Banks now increasingly have clarity on the future of their post-Brexit operating models in Europe after moving out of a lengthy transition period. Several EU and non-EU banks have already embarked on transformation journeys involving the design of new target operating models, focusing on cost optimisation, and increasing the return of their post-Brexit operations.
From a regulatory perspective, the European Central Bank (ECB) has published the results of its ‘desk-mapping’ review, which sought to assess the booking models as well as governance and risk management capabilities of new EU banking entities.
In its findings, the ECB raised concerns about the adequacy of the infrastructure, controls, and substance of the new EU banking hubs to manage risks locally in the EU, the use of split desks and the transfer of EU-originated risks outside the bloc (especially through back-to-back booking arrangements).
Now, the ECB is moving on to the outcome of the first phase of its review. At the same time, regulators, including tax authorities, are focused on tax governance as a fundamental tool in assessing the tax risk of companies in the banking sector.
All these developments give rise to important TP considerations and a range of questions which are examined further in this article.
Optimisation of operating models
Several banks already reviewed their legal entity structure and target operating model for their European businesses back in 2020, primarily by reducing the number of legal entities and converting, where possible, legal entities into branches to reduce costs. This has been followed more recently by a move towards centralising booking models and the related key functions across business lines into one jurisdiction.
The critical point is that typically any conversion of a legal entity into a branch requires, as a pre-requisite for tax neutrality, that there is no cross-border transfer of any key assets or functions. This needs to be carefully considered in the context of any subsequent centralisation which – even if not triggering a consideration from a TP perspective – could result in corporate tax implications at the point of the conversion.
The trend towards centralisation also raises other interesting observations. In the past, the market risk from smaller jurisdictions with local booking models was typically transferred into larger jurisdictions such as the UK (via back-to-back booking arrangements) where there were sufficient risk management capabilities.
These arrangements are a focus of the ECB as part of their desk-mapping review. Specifically, the ECB is considering whether there is appropriate infrastructure and number/seniority of traders to manage the risks locally for the business that is originated in the EU.
From an OECD perspective based on Chapter IX of the Transfer Pricing Guidelines, compensation may be appropriate if there is, in simplified terms, the transfer of something of value. In the context of banking operations, common indicators include a transfer of an existing customer base and the underlying business linked to these customers. This should be carefully evaluated in the context of the booking model centralisation and future remuneration of the sales location, especially from the perspective of countries such as Germany that have exit tax rules extending beyond the guidance of the OECD in Chapter IX of the Transfer Pricing Guidelines.
Another question to be evaluated is whether the centralisation of books leads to synergistic effects (e.g., typically there are natural hedges/offsets) that are not linked to an active function performed.
While there is a trend towards the centralisation of functions to optimise costs and to improve the quality of the support functions through standardisation, regulators are becoming more focused on the outsourcing of key management functions and support activities, especially where the functions or activities are outsourced to other jurisdictions.
The European Banking Authority’s guidelines on outsourcing arrangements state that outsourcing “should not create undue operational risk” or “lead to a situation where an institution becomes an ‘empty shell’ that lacks the substance to remain authorised”, particularly in the context of gaining or maintaining access to the EU financial market (see Final Report on EBA Guidelines on Outsourcing Arrangements, updated February 25 2019, and accompanying Compliance Table updated June 8 2022).
This is echoed in the draft updated Australian Prudential Standard CPS 230 that will be effective January 1 2024, which states that an entity regulated by the Australian Prudential Regulatory Authority must “identify, assess and manage its operational risks, with effective internal controls, monitoring and remediation and…effectively manage the risks associated with service providers, with a comprehensive service provider management policy, formal agreements and robust monitoring.”
While these regulatory standards may improve the level of documentation and governance on intercompany service arrangements, they may also result in TP considerations where there is a perceived duplication of activities by the service provider and service recipient. This could potentially lead to the local tax authority challenging the chargeability of centralised services.
Another more technical dimension of post-Brexit banking structures in Europe are intra-bank guarantees and FGS arrangements, where the local banks hit counterparty risk limits under the tougher Basel III regulations. Many post-Brexit banking hubs in the EU are still relatively small in terms of their capital base.
Whenever there are larger lending transactions as part of their core banking business, these can trigger counterparty risk limits as part of the new, increased Basel III standards. Various banks have already established guarantee arrangements (linked to specific lending transactions) that would reduce the counterparty risk for the origination location.
These guarantees may be priced using a credit default swap approach, considering the specifics of the lending arrangements. More recently, FGS arrangements have become a more common tool to establish an arrangement where the capital base is replenished through a funded guarantee. The TP impact is more complex than individual guarantees, starting with the initial question whether post-Brexit banks are sufficiently capitalised to support any guarantee payments in principle.
Impact of ECB desk mapping review
The desk mapping review conducted by the ECB in 2022 was significant. The ECB stated that it “[…] wants to ensure that incoming legal entities have onshore governance and risk management arrangements that are commensurate, from a prudential perspective, with the risk they originate.”
The review further supports the ECB’s long-running push for global banks based outside the EU to increase the staff and capital they commit to financial market operations in the EU.
From the 256 EU-based trading desks that the ECB assessed, it found none “retain full control of their balance sheets”. About 70% use back-to-back models, offsetting eurozone trades with entities outside the bloc to manage the risk remotely. A fifth used desk-splitting, managing the risk of eurozone trades jointly from desks both in the bloc and elsewhere.
The acute COVID-19 pandemic lasted officially from March 11 2020 until May 5 2023, when the World Health Organisation declared an end to the pandemic. Until this point, both regulators and tax authorities had been more lenient when enforcing substance requirements (including for Europe on post-Brexit structures) with employees working out of jurisdictions other than their home country, given that people could not travel and relocate cross-border.
Formally, the ECB had specifically granted foreign banks more time to move senior executives to the EU due to the disruption of the COVID-19 pandemic. But even since travel restrictions have been lifted and the central bank increased its pressure to enforce substance requirements, the observation of the ECB is that many top traders still seem reluctant to leave London.
While Germany has been the main new hub jurisdiction (with 11 out of 31 new post-Brexit EU hubs located in Frankfurt as of 2022, according to the ECB), there are increasing tensions in the target operating models both from a tax and regulatory perspective. This is due to senior executives either remaining in London or not moving to where they should be. For example, Paris has proved to be more attractive as an EU location to some bankers given personal tax incentives and the location.
In an inter-branch context, this may raise difficult questions in relation to split key entrepreneurial risk-taking (KERT) functions and the attribution of assets/profits, and how to price internal transfers between trading and booking locations. For example, the German tax authority does not recognise the idea of split KERTs and would, in cases of both centralisation when KERT functions are moving out of Germany or where the KERT location is unclear, look towards where the customer relationship is located (i.e., the relationship manager) as the overriding principle for the attribution of assets/profits.
As such, it is expected that there will be more local booking structures in Europe, and significant changes to functional profiles of EU operations where the TP impact on the attribution of assets and profits will need to be assessed carefully. Further, there will likely be more split KERT functions across banking business lines where the lending or trading functions and subsequent risk management are performed across different locations or situations where substance (e.g., trading functions) is in locations other than the (regulatory) booking location.
The focus of the OECD and most tax authorities during the COVID-19 pandemic was on whether remote work will create a potential fixed place of business. The focus is now expanding to the question of how remote work will impact the attribution of assets and profits from banking and global trading.
We expect that financial regulators will be among the first probing this topic based on their ongoing desk-mapping review and there will also likely be an exchange with tax authorities. Certain tax authorities have used the regulatory substance argument that certain functions should have been performed locally to deny incoming management charges from the US or UK or deem at least a partial duplication. It is also likely that there will be questions around the business and regulatory rationale for back-to-back booking arrangements to transfer risk outside the EU if the function to control the market risk should be performed locally. As a result, some banks have looked at utilising advance pricing agreements (APAs) with tax authorities to achieve certainty with regard to their TP positions.
Governance focus by regulators and tax authorities
Regulators are increasingly focused on tax governance as one of the many indicators of proper management for regulated financial institutions. In the EU, part of the driver is the aim to reduce tax competition, but also to ensure that tax risks (especially impacting reputation and liquidity) are not becoming another material risk in the financial sector.
Regulators are also concerned that the economics of Brexit entities are sensitive to how TP is managed. Due to the limited capital and substance of some Brexit entities, TP may significantly swing the profitability of the Brexit entity quarter over quarter. For example, banks with significant difference in transfer price booked for the last quarter as compared to the transfer price booked in the previous quarters, as well as those with significant true up after year-end, may be questioned by the regulator on their TP processes and controls.
Tax authorities are also increasingly focused on the tax governance frameworks of large taxpayers. For example, the Australian Taxation Office has leaned on the OECD concept of ‘justified trust’ to “build and maintain community confidence that taxpayers are paying the right amount of tax”. This is a marked departure from an approach of auditing arrangements where material tax risks are suspected to have arisen.
As such, both financial regulators and tax authorities seek information from banks on tax compliance management and governance systems, to ensure that there is appropriate organisation, process, control and responsibility across direct and indirect taxes.
It is expected that this trend will continue, and there will be growing interaction between regulators and tax authorities, especially on the approval of business plans as part of new licence requests or approval for new delegation arrangements, to front-end tax risks. Increasingly, the establishment, documentation and ongoing monitoring of intra-group arrangements is a “whole-of-house” function, requiring a bank’s tax, finance, risk and compliance functions to work closely to manage risks from both tax and regulatory perspectives.
While the banking sector's profitability is bouncing back in the new higher interest environment, it is facing the need to transform and optimise existing operating models. This, while also managing the scrutiny of regulators around their substance, control frameworks, capitalisation and booking arrangements.
The ongoing centralisation of booking and operating models will need to be carefully examined under Chapter IX of the Transfer Pricing Guidelines, and the rise of new regulatory-driven arrangements on intra-banks guarantees will require the attention of in-house TP professionals.
Finally, the new focus of both regulators and tax authorities on tax governance increases the importance for all stakeholders and the need for a consistent approach on regulatory inspections and tax audits where TP is moving into focus.