Is your Financial Services organisation ready for changes to the international tax framework?

Aamer Rafiq Transfer Pricing and Tax Policy, Partner, PwC United Kingdom 12 November, 2019

For the last few years, the Organisation for Economic Co-operation and Development (OECD) has been looking at the impact on the international tax system of the digitalisation of the economy. You may well then be forgiven for thinking that the solutions they are considering will affect just digital or tech companies. But what is now being discussed will impact the entire economy, including the financial services (FS) industry. 

Work is also underway by the OECD to determine the extent of what any change to the tax system will mean for the FS industry. In particular, one of the key areas being discussed is whether (and to what extent) financial services will get a potential carve-out and not be subject to any changes.

The OECD work has focused on how, over the past 30 years, companies have been allowed to generate significant profits in relation to a jurisdiction without paying a commensurate amount of tax there. It consists of two aspects (or pillars, as the OECD refers to them).

Pillar I looks at reallocation of taxing rights. To use a line that people believe is from Star Trek (but is actually not): “It’s life, Jim, but not as we know it.” The reallocation is quite unlike any other approach that has gone before. First, it shifts taxing rights away from locations where physical activity is carried out towards market jurisdictions (where customers or users are). The conventional wisdom of the last 90 years was to give tax rights to where the activity (of the business) was taking place. 

Second, the starting point for the reallocation is group consolidated financial profits. It takes a portion of the group consolidated financial profits and, on that basis, allocates profit to market jurisdictions. This has ramifications for the existing framework (transfer pricing), which allocates profits within a multinational company. The new framework would effectively require a company to transfer price as usual and then overlay the reallocation, creating, in effect, a two-step analysis framework. For the financial services industry, which already has significant regulatory and reporting requirements, this potentially adds another major compliance burden. 

Pillar II looks at creating a system whereby a multinational group would be subject to a minimum effective tax rate. Whereas the Pillar I work could be seen as devising a new system to deal with issues that can’t be addressed within the existing international tax framework, think of the Pillar II work as tinkering with the system to deal with the unfinished business of the Base Erosion and Profit Shifting (BEPS) work. It’s effectively version 2 of BEPS. 

We’ve seen a variation of the minimum tax implemented in the United States through the GILTI legislation. This has been quite onerous for financial services companies with significant legislation to work through and myriad collateral issues because the legislation has not been specifically designed for the FS industry. 

The OECD work looks at four rules: an income inclusion rule, a denial of deduction rule, a switchover rule and a subject to tax rule. All are aimed at ensuring that there is no double non-taxation and no minimal level of taxation.

The OECD has had to move forward with its work at unprecedented speed, in part because countries have initiated their own unilateral actions. Countries have introduced or are proposing unilateral digital services taxes (DST) where highly digitalised companies are taxed on their turnover (and not profits) at a rate ranging from 2% (UK) and 7% (Czech Republic) or 7.5% (Turkey). At last count, almost 20 countries had introduced, proposed or were in the process of introducing these unilateral DSTs. These could be hugely distortive for multinationals, and the OECD is trying to ensure that changes to the international framework are done in a coordinated and consistent manner to eliminate double taxation. 

So where are we in the process? The OECD Secretariat has recently released a unified approach proposal for how to move forward with the Pillar I proposal. This proposal may result in narrowing the scope for those businesses that have a consumer-facing (essentially retail) element and this would exclude most business-to-business transactions. What this essentially means is that financial services companies will need to segment their business lines to determine what’s in-scope and what’s out and then decide which part of the business pays the tax and where. 

The proposal also introduces a formulaic basis for determining how the reallocated profit would be calculated for the in-scope business lines. Although it is not obvious how this would be computed, we could see somewhere between 5% and 20% of operating profits being subject to tax in market jurisdictions. How this evolves will be very political and we can expect more developments in the coming months. The OECD is looking to agree a framework by mid-2020 with implementation in 2021. 

On the Pillar II proposals, the OECD issued a progress report on 8 November. It covers, at a high level, the areas identified previously but does not give a great deal more detail. Unlike the Pillar I work, which requires coordinated, concerted action to bring about, the Pillar II proposals are more focussed on domestic action and implementation, so they do not need the same level of participation or coordinated action.

Both Pillar proposals, if implemented, will have three key impacts for financial-services companies:

An increase in the effective tax rate (ETR): There will be a redistribution of taxing rights towards market jurisdictions under Pillar I and a minimum level of tax under Pillar II. Depending on the overall tax profile of the market jurisdictions, we can expect that, on average, the ETR for financial services companies will increase.

More compliance work: Pillar I will mean that financial services companies will need to do detailed analysis to determine which parts of the business will be in scope and then to compute what the tax liability will be in market jurisdictions. This could create new financial processes. Once those computations are done, local tax returns will likely need to be completed and filed in these jurisdictions to meet compliance requirements. Similarly, the Pillar II work, if the experience on the US GILTI is a representative example, will require significant work by companies to ensure they are in compliance. 

Force commercial decisions: Given the consequences above, financial services companies will need to assess the benefits of interacting with economies along with the collateral impact, such as regulatory and reputational concerns. 

So, what should FS companies be doing at this moment? Now that the OECD has provided more detail, it’s clear that the impact of these changes on ETR and compliance will be significant. Some companies have already begun the process of assessing what commercial decisions they may need to make before the new policies come into effect. 

There is already a plethora of information available within an organisation to model this, including country-by-country reporting information, financial accounting information, and transfer pricing models. Whilst multinationals do not need to fully implement the thinking yet, understanding what this means for them will allow them to prepare for the journey ahead. 

Contact us

Aamer Rafiq

Transfer Pricing and Tax Policy, Partner, PwC United Kingdom

Colin Graham

Global Financial Services Tax Leader, PwC United Kingdom