The G20/OECD Inclusive Framework on base erosion and profit shifting (BEPS Inclusive Framework), which consists of 134 jurisdictions, has agreed to work on detailed technical aspects of proposals outlined in the OECD's Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy. The technical work being undertaken will help to inform the political discussions, with a view to countries reaching political agreement by the end of 2019 on key elements of new international tax rules.
The programme of work highlights the technical work that needs to be completed. Key areas will include determining when a country has the right to tax trading profits and the rules for allocation of trading profits to each country. The programme will focus on ensuring that sufficient profit is awarded to the market jurisdiction, whether the home country of the users or of sales.
For businesses, the key concerns will be to ensure that profits are taxed only once and that there is effective and timely resolution of disputes between countries. Clear rules and boundaries will help with this, but binding arbitration or other measures to give certainty will also be necessary. The programme makes clear that, given the potentially extensive and disruptive changes being considered, both governments and businesses want simplification where possible. This is particularly important given that the BEPS Inclusive Framework includes many developing countries and that all stakeholders seem to want a system that can be administered and adopted on a global basis.
The programme will require significant resources from the governments participating in the OECD Inclusive Framework. The overarching objective, for businesses and for international growth, is that there remain a consistent global framework that does not hinder cross-border financial services or the efficient functioning of the global financial markets.
Potential implications for financial services
While the broader implications are relevant for both the retail (B2C) and institutional/corporate client (B2B) segments of the financial sector (especially the discussions regarding nexus and market jurisdictions), certain aspects of the work relate more closely to the B2C dimension, particularly with respect to the proposal on user contributions.
In February 2019, the OECD stated that it did not foresee the adoption of any industry or sector-specific exemptions, given that every business is impacted by the digitalisation of the economy, albeit to varying degrees: "[…] it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes because of the increasingly pervasive nature of digitalisation".
In the UK, the digital services tax (DST) that is expected to apply from April 1 2020 will not apply to regulated activities of financial services providers, assuming that more than half of the relevant revenues arise in connection with the facilitation of the trading or creation of financial assets. It is unclear whether the G20 or the Inclusive Framework will recommend a similar exemption. It will therefore be important to closely monitor upcoming developments at the level of the Inclusive Framework on the question of sector exemptions.
Should no sector-specific exemptions be included, the OECD proposals and resulting wide-reaching reforms under consideration could have a significant impact on the financial services sector. This impact is especially relevant for organisations that have access to customers in different jurisdictions under freedom of establishment or passporting rules, as is the case in the European Union.
Four key points
There are four key points that financial institutions across the banking, asset management, and insurance spaces should monitor closely as developments relating to the digitalised economy unfold.
The first, in the context of the financial services sector, is the regulatory dimension. Such regulations essentially require financial institutions to have a regulated entity in local jurisdictions that the respective financial regulators and supervisors have direct access to and control over. The situation is slightly different for financial institutions operating in Europe under the freedom of establishment and passporting rules, whereby there is one regulated entity in one jurisdiction (for instance, Luxembourg) that engages across borders with customers in other jurisdictions (for instance, Germany).
This point links directly to the possibly revised nexus rules in section 2.2.3 of the OECD's consultation documentation, which states that the underlying issue to be addressed is "that the digitalisation of the economy and other technological advances have enabled business enterprises to be heavily involved in the economic life of a jurisdiction without a significant physical presence".
Considering that financial institutions are often subject to the requirement to have regulated entities in many local jurisdictions, some financial services sector participants hold the view that the regulatory nexus already creates the necessary physical, and therefore taxable, nexus. In other words, most financial institutions outside the EU are generally present in their customers' jurisdictions, and profits are attributed according to existing transfer pricing rules and regulations.
This links directly to the second key point, that there is a generalised view in the financial services sector that the existing guidance – the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, and more importantly, the OECD Report on the Attribution of Profits to Permanent Establishments (which includes specific guidance for the banking and insurance sectors) – already provides the necessary basis for the arm's-length allocation or attribution of profits to the local market jurisdictions based on the existing nexus.
The third key point is that the financial services sector tends to rely less on user participation as a value driver. Therefore, the application of the user participation concept, if adopted, would be challenging for the sector. This view is also reflected in the UK's DST. Section 3.30 of the consultation paper issued by HM Treasury/HMRC specifically states that activities in connection to the provision of financial services are not "considered to derive significant value from user participation and are often subject to unique tax and regulatory regimes already. Financial and payment services will not therefore be in-scope of the DST".
The fourth key point relates to the role of marketing intangibles in the financial services sector that might be a key driver for assigning a return to market jurisdictions. In practice, it is becoming difficult to distinguish between marketing and non-marketing intangibles, given the new role of technology in the financial services and its reach into distribution, marketing and communication with customers.
In the past, the prevalent view in the financial services industry on the value of marketing-related intangibles has been noticeably different than in other sectors. The key question relates to the concept of customer inertia, which implies that historically, customers have been slow to change financial providers due to switching costs. Particularly in mature markets, consumers have gravitated toward established and enduring brands in the banking or insurance spaces that were regarded as bulwarks of stability in times of economic or financial turbulence. Thus, marketing and branding efforts often focus on maintaining or rebuilding trust, or serve as a means of attracting 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 the proximity of retail branches, fees, or the track record of investment funds (for example, in the asset management sector). Consequently, it is necessary to carefully consider the question of marketing intangibles in the financial services sector, especially with respect to attracting customers, lowering acquisition costs, increasing volume, or sustaining price premiums.
Other challenges for the financial services sector include the treatment of losses (as a result of risk assumption) and the potential recognition of capital as an allocation key for new apportionment methods – as typical allocation keys such as employees, tangible assets, and sales may be more suited to non-financial services companies.
In this context, the OECD, in the transfer pricing guidelines, has already pointed out the distinguishing characteristic of the financial services sector. The guidelines state that "the regulatory approach to risk allocation for regulated entities should be taken into account and reference made as appropriate to the transfer pricing guidance specific to financial services businesses in the Report on the Attribution of Profits to Permanent Establishments (OECD 2010)".
It is important to underscore that the OECD's ongoing work is considering changing the profit allocation and nexus rules for all businesses, potentially subject to some carve-outs for smaller businesses and possibly, but by no means certainly, some sectors of the financial services industry. New rules, if adopted, are likely to apply by reference to group profitability (or business line profitability) and not on a separate entity basis under traditional transfer pricing rules.
The discussion below focuses on the ways in which the digitalised aspects of certain financial services businesses may be especially impacted.
For organisations in the banking and capital markets space, direct market access offerings and digital banking platforms may extend the reach of the retail banks. This makes the OECD's work programme a topical issue for both challenger banks and established players with an active digital strategy.
In addition, the nature and the extent of the reforms may impact the taxation of activities undertaken to source funding from international investors, or to offer global risk management solutions (through derivatives to hedge various types of financial risks, which are usually booked in a single or select few entities to allow for centralised risk management and natural hedges for the financial institution).
While the OECD has specifically highlighted the applicability of new taxing rights to commodities and financial instruments as a potential area for which scope limitations may be designed, the availability, extent and nature of any limitations would require careful consideration by governments and businesses alike. The reforms may also affect the commercial operations of offshore banking regimes that have been specifically designed to improve the international competitiveness of the financial services sectors of particular countries.
In the insurance sector, the proposals in the OECD programme may impact multinational groups whose business activities include the provision of digital insurance services to customers without a brick and mortar presence, such as insurtech. For example, under this type of operating model, an insurtech company may distribute insurance products through digital channels from a company based in one tax jurisdiction to customers based in other tax jurisdictions. Under the proposed nexus rules, this could create a taxable presence in the market location. Consideration would then have to be given to how taxing rights should be allocated among the various jurisdictions under the proposed profit allocation rules.
Within the asset management industry, certain business models could be affected. The main impact could be on cross-border fund distribution models, where a nexus and (additional) return might need to be considered for certain jurisdictions where there are no locally regulated entities yet. Another example relates to distribution solutions for retail clients where customers are able to log on to a website or an online platform to manage investments, including from jurisdictions where the asset management business may not have a significant physical presence. Because the asset manager would be able to acquire customer data through these activities, there is a risk that these situations could be caught by the proposed nexus rules.
The devil is in the detail
The potentially ground-breaking developments at the OECD/G20 require careful monitoring of the potential impact on the financial services sector.
The first question is whether there will be any sector-specific exemptions that would apply to regulated financial service providers. If not, businesses will need to be prepared for the potential impact on their business and operating/tax models.
Another important question is to what extent intangibles – given their limited historic role in the financial services sector, the increasing focus on marketing intangibles and the integration of marketing and non-marketing intangibles – could be the catalyst for the introduction of new transfer pricing paradigms in the financial services sector.
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Stephen Weston is a partner in Deloitte UK's financial services tax group, and leads the financial services transfer pricing team. Over a career spanning 28 years, Stephen has advised a number of multinational corporate and financial institutions on the taxation of international finance and treasury and TP matters. He also has direct tax litigation experience in these areas.
Stephen's financial services sector clients include global banks and reinsurance and insurance groups. Recent projects have included an assessment of the impact of OECD Actions 8-10 on the financial services industry.
Stephen is a qualified chartered accountant and a full member of the Association of Corporate Treasurers.
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Ralf Heussner is a partner with Deloitte Luxembourg. He specialises in the financial services sector and is part of Deloitte's global financial services TP leadership. 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 prior tenures in Deloitte Frankfurt, Hong Kong and Tokyo.
Over the past 17 years, Ralf has gained extensive experience advising clients on a range of TP challenges, valuations, international tax, and value chain alignments. Ralf's experience covers: TP planning and policy setting; risk reviews; operationalisation; documentation; restructurings; and dispute resolution. He has worked on more than 35 advance pricing agreements (APAs) and numerous high-profile controversies on both the local and competent authority levels with the authorities in China, the EU, Japan, the United States 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.
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Priscilla Ratilal is a director in the Deloitte UK financial services TP team. Priscilla has more than 12 years of experience and worked in Sydney and New York before moving to London.
Priscilla has advised a number of clients in the financial services sector in the areas of TP policy development, documentation preparation and engagement with tax authorities, in the context of both advance pricing agreements (APAs) and audits.
While based in New York, Priscilla gained in-house experience in a diversified financial services group, where she managed transfer pricing for the Americas region across a range of business units including: asset management, investment banking and capital markets.
Priscilla's experience includes advising on shared support services for multinational banks, fee splits for corporate and investment banking activities, profit allocation for global trading, operational TP issues and country-by-country (CbC) reporting. She has also successfully negotiated APAs on the attribution of profits to permanent establishments and profit splits to reward intangibles owned by multiple related entities.
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