In addition to these industry developments, the OECD BEPS Action Plan is fundamentally reshaping the international tax landscape. Under the work performed by the OECD and G20 countries on BEPS Action 8, the spotlight is on transfer pricing (TP) issues related to intangibles, with the aim of aligning taxation with the economic activity that produces profits. BEPS Action 8 introduced new concepts regarding the ownership and valuation of intangibles, as well as a substantially broader definition of intangibles that is expected to lead to the emergence of a greater range of intangibles for tax purposes. Although the BEPS Action Plan is applicable to all industries, there are some aspects that are unique to the financial services sector that warrant a renewed look at the topic in light of these recent changes. The complexity inherent to the financial services sector is also reflected by the continuing discussions at the level of the OECD where it has not yet been possible to reach a consensus regarding the TP treatment of related party financial transactions.
In this article, the authors revisit the TP dimension of intangibles in the financial services sector and provide insight into key issues, recent tax audit developments, and important takeaways for financial institutions.
The four key drivers that require financial institutions across the banking, asset management, and insurance space to revisit their TP approaches to intangibles are discussed below.
Industry-specific operating model
In many respects, the financial services industry is unique regarding its operating model. In other sectors such as the consumer goods, industrial, or technology sectors, there has been a growing trend since the 1990s to transition to so-called principal structures that centralise a range of functions, risks, and assets in a principal company. The particularly important result of this trend has been a gradual decline in the number of intercompany licensing transactions. Instead, the TP focus in many non-financial sectors is on the question of economic ownership of intangibles or setting the remuneration for support functions (for instance, for their contract research and development (R&D) functionality).
The financial services sector is different. Because it faces unique regulatory requirements that range from organisational, management, capital, and liquidity to reporting requirements based on the supervision by local regulators, it typically requires a more stand-alone business model in local jurisdictions, especially for retail banking and insurance. This results in a broader range of transactions within larger financial institutions regarding the use of potential intangibles and the provision of services. Consequently, the greater number of potential intangibles-related transactions also requires more attention from a TP perspective.
Nonetheless, many financial institutions may have not yet paid sufficient attention to the topic of intangibles to be prepared for the new TP challenges resulting from the OECD BEPS initiative, as well as the rising importance of intangibles in the financial services sector.
It is also essential to remember that the operating model of the financial services sector is different with respect to the stronger reliance on branches instead of legal entities as a means of efficiently using capital, putting additional pressure on the application of profit attribution between branches and head offices, the recognition of dealings and the relationship between Articles 7 and 9 of the OECD model tax convention.
Historic role of intangibles
Historically, the discussion of intangibles in the financial services sector pivoted primarily on customer relationships and regulatory licences. Regulatory licences typically include banking licences or licences for management companies under the UCITS or AIFMD regimes.
From a practical standpoint, there has been a noticeably different view in the financial services industry on the recognition and value of other marketing-related intangibles covering trade marks and trade names. While some financial institutions recognised trade marks as intangibles for TP purposes and established remuneration policies (for example, in the form of licensing fees), other financial institutions decided to treat marketing and other branding-related activities as services, and include related costs in group internal service recharges. The main argument for considering trade marks to have limited value is based on factors such as customer inertia, implying that customers have historically been slow to change financial providers due to switching costs. Particularly in mature markets, consumers have historically gravitated toward established and enduring brands in the banking or insurance space that were regarded as bulwarks of stability in times of economic or financial turbulence. Thus, marketing and branding-related efforts often focus on maintaining or rebuilding trust or serve as a means to attract employees. To put it differently, the argument is that the financial services sector is not an industry in which emotions are key drivers for customers` purchase decisions.
Instead, customers often tend to make their decisions based on criteria such as proximity of retail branches, fees, or the track record of investment funds (in the asset management sector). Consequently, the argument for not considering trade marks a key intangible is that they serve only as a form of entry ticket to being recognised as one of the financial institutions of choice, but that they provide limited additional financial benefits with respect to attracting customers, lowering acquisition costs, increasing volume, or sustaining price premiums.
It is clear that the question of the value of marketing-related intangibles needs to be examined on a case-by-case basis depending on the facts and circumstances. Nonetheless, the increasing level of consolidation in the financial services sector is expected to further drive branding/re-branding activities in the aftermath of mergers and acquisitions. In addition, the rise of FinTechs, new distribution channels, lower switching costs, and the need to establish a customer experience and social media presence will bring more attention to the role of trade marks and branding in the financial services space.
The new OECD guidance under BEPS Action 8 provides that a TP analysis should carefully consider whether an intangible exists and whether an intangible is being used. The notion is important that not all development or marketing-related expenditures will necessarily result in the creation or enhancement of an intangible. Reference can be made to Section 6.10 of the OECD guidelines, which states that 'the identification of an item as an intangible is separate and distinct from the process for determining the price for the use or transfer of the item under the facts and circumstances of a given case.'
It is also important to differentiate between trade marks (that are registered and legally protected) and the use of a group or company name. The OECD expands on this point in Section 6.81 of the OECD TP guidelines, stating that no payment per se should be recognised merely for the use of the group or company name when the use is only intended to reflect membership in the group (passive association). In addition, the extent to which the activities of the local affiliates contribute to the further development of the trade mark will also need to be considered.
The above discussion shows that financial institutions will need to consider carefully whether the use of a registered trade mark/brand provides a financial benefit for which a payment would be made between unrelated parties, and how to remunerate the use of the trade mark/brand.
Tax audit developments and the issue of 'missing transactions'
Increased tax audit activity in the financial services sector has been observed across various jurisdictions. While the tax authorities' level of experience and sector-specific knowledge greatly varies from one jurisdiction to another, a recent common focus in some tax audits has been what the authorities call 'missing transactions'.
For example, some tax authorities examined under audit marketing and investor-related materials (such as annual reports and investor presentations). In some cases, the tax authorities found marketing-oriented language on the key success factors and value drivers (especially in the banking and asset management areas) where the trade mark/brand was described as one of the key assets in the business and a driver of growth and profitability.
The tax auditors then compared these descriptions with the information contained in the TP documentation, and often identified inconsistencies with the position taken for tax purposes. Although foreign affiliates used the registered trade mark, the TP analysis/documentation did not identify it as an intangible and the trade mark holder was not remunerated for its use. Some tax authorities refer to this situation as 'missing transactions', and use the argument of non-timely documentation as the basis for their tax adjustments and applying presumptive taxation.
Rise of trade-related intangibles
Banking has historically been one of the business sectors more resilient to disruption by technology, partially due to the important role that scale, trust, and regulatory expertise have traditionally played.
Nonetheless, technology is becoming a key driver of change in the financial services sector. Examples include the rise of robotics and automation-related technologies to reduce operating costs, investment platforms and algorithmic models that evolved from internal risk management tools to key tools for investment decisions and portfolio management, and new payment systems and robo-advisors.
The future will entail employing digital technologies to automate processes, improve regulatory compliance, transform customers' experiences, and disrupt key components along the value chain. According to recent news, banks could be expected to reduce up to half of their operations staff in the next five years, as machines replace human workforce and automation takes over 'lower-value tasks' (see the Financial Times article entitled 'Citi issues stark warning on automation of bank jobs' dated June 12 2018).
The technological upheaval will require heavy investment and raise the question of how to structure such investments from a TP perspective with respect to ownership and use of the resulting intangibles within the group. The scale of the investments required is also expected to further drive consolidation in the financial industry. Interestingly, new financial institutions or those from emerging economies might achieve this transition more easily, given the relative absence of legacy investment and integration with older systems.
As in the area of marketing intangibles, only a few financial institutions have already probed the appropriateness of their existing TP policies/models to reflect the increased importance of technology, how the development activities should be structured (for example, under a contract development agreement to centralise economic ownership or under cost sharing arrangements) and if/how their use should be remunerated. While some financial institutions have already introduced TP approaches for the licensing of platforms using comparable uncontrolled price (CUP) approaches, others are considering including related costs in recharges for infrastructure services
Challenges may arise if certain platforms or systems are developed in pioneer jurisdictions (based on new regulatory requirements) that are then rolled out globally or regionally. It is also important to keep in mind that some banks and assets managers already started to license out certain of their trade intangibles (such as end-to-end investment platforms) to third parties. Theoretically, this should contribute to a greater spectrum of potential internal CUP data that would also need to be examined for TP purposes.
With the above in mind, the key takeaways for financial institutions are as follows:
- Re-examine the existence of potential intangibles in light of the broader definition under the OECD BEPS Action 8 and the use of such intangibles (also in the context of branches and attributing licence fees under the new OECD separate entity approach);
- Revisit existing TP positions regarding remuneration for the use of intangibles, depending on the financial benefit or whether related costs should be included in internal cost recharges;
- Identify all relevant intangibles and their use in TP analysis/documentation, even if use of those intangibles is not being remunerated (with supportive argumentation for the non-remuneration);
- Track development and branding-related activities, especially if performed out of pioneer locations;
- Ensure consistency between marketing and tax-related messaging, and coordinate with other stakeholders (for example, the public relations and marketing function); and
- Review the appropriateness of existing TP documentation and inter-company agreements.
The changes resulting from OECD BEPS Action 8, together with industry developments, will have a profound impact on the financial services sector. The key message for financial institutions is that additional effort should be devoted to analysing the appropriateness of existing TP approaches with respect to intangibles. If not, many financial institutions may find themselves exposed to more intangible-related tax disputes and controversies in the future across various jurisdictions.
Partner, transfer pricingFinancial services transfer pricing and value chain alignment
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Ralf Heussner is a partner with Deloitte based in Luxembourg specialising in the financial services sector. Ralf worked for many of the key players in the asset management industry (ranging from traditional to private equity, real estate, and hedge funds), and the banking and insurance sectors during his previous tenure in Tokyo, Hong Kong and Frankfurt. Over the last 15 years, Ralf gained extensive experience advising clients on a range of transfer pricing (TP), valuations, international tax, and value chain alignment engagements.
Ralf's experience covers TP planning and policy setting, risk reviews, operationalisation, documentation, restructurings, and dispute resolution engagements. He has worked on more than 25 advance pricing agreements and numerous high profile controversies on both the local and competent authority levels with the authorities in China, the EU, Japan, the US, and other key jurisdictions.
Ralf is a frequent speaker at tax seminars, has participated in government consultation projects about tax reform, and has contributed to thought leadership on TP issues.
Director, transfer pricingFinancial services transfer pricing
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Enrique Marchesi-Herce is a transfer pricing (TP) director specialised in advising multinational enterprises in terms of designing and implementing their TP policies and assisting with documentation. With more than 11 years of experience, Enrique has led a wide array of complex TP projects including intellectual property (IP) valuation, value chain alignment, global documentation and other tax planning projects. He has worked on multiple advance pricing agreements for multinationals in the automotive and financial services industries and participated in complex tax audit disputes (negotiation, mediation and litigation), notably assisting a leading telecom group in the defence of its TP position in Spain.
Over the last five years, Enrique has focused on the financial services sector advising a wide range of clients such as private equity houses, management companies, funds, banks and asset management firms. He has advised clients in complex tax matters including TP planning, negotiations with local tax authorities, the assessment of BEPS' impact on existing structures and alignment of TP policies from a tax and regulatory perspective.
As a TP specialist, Enrique regularly presents at tax seminars and contributes to Deloitte's publications.