Transfer pricing in financial services: The outlook for 2020 and beyond

In this article, Deloitte's financial services transfer pricing (FSTP) network provides an outlook on four key transfer pricing trends (TP) that may impact the financial services sector in 2020 and beyond. These trends cover (i) the ongoing work of the G20/OECD in regard to the tax challenges arising from the digitalisation of the economy, (ii) the regulatory environment, (iii) the focus of regulators/supervisors, and (iv) the impact of technology.

On January 31 2020, the G20/OECD Inclusive Framework (IF) on base erosion and profit shifting (BEPS) released a statement about its ongoing work to address the tax challenges arising from the digitalisation of the economy. The work is comprised of a unified approach to addressing nexus and profit allocation challenges arising from digitalisation (pillar one) and the development of a global anti-base erosion (GloBE) proposal (pillar two). One of the key concerns 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".

In a recent statement, the IF suggested that regulated financial services organisations may be broadly excluded from the scope of pillar one. The statement acknowledges in section 31 that "most of the activities of the financial services sector take place with commercial customers and will therefore be out of scope per se". The statement continues that "there is also a compelling case for the consumer-facing business lines such as retail banks and insurance within financial services businesses to be excluded from scope given the impact of prudential regulation and, for example, bank/insurance licensing requirements that are designed to protect local deposit/policy holders in the market jurisdiction". The proposed sector outline follows the argument that financial institutions are typically required to have regulated entities in local jurisdictions and that such regulatory nexus already creates the necessary taxable nexus as basis for local taxation.

Tax departments of banks, asset managers and insurers will still need to monitor the ongoing developments at the G20/OECD level closely if the proposed sector outline remains in its proposed form. Further consideration is also required as to whether there are any unregulated elements of the financial services sector – or related to the sector – that may require special consideration. The IF intends to reach agreement on the key policy features of pillar one by early July 2020, with the aim to publish a final report by the end of 2020.

Regulation continues to be one of the key drivers of change, directly impacting the tax dimension. The key regulatory developments for 2020 are the upcoming interbank lending rate (IBOR) transition, changing banking regulations and the Markets in Financial Institutions Directive II (MiFID II).

Globally, regulators are spearheading one of the most complex transformation programmes in recent history under which existing interbank rates (IBR) will gradually transition to alternative risk-free rates (RFRs). The transition will be complex because of significant differences between RFRs and IBRs by region, tenor and currency. RFRs are overnight indices with no term structure, nearly risk-free and based on actual transactions, whereas IBRs are term rates, reflect perceived credit risk and are survey-based.

Tax departments of financial institutions will need to focus on the following areas to manage the transition to RFRs effectively:

• Capture existing financial products (products sold to clients and/or hedging instruments) and financing arrangements based on floating rates that are affected by the transition (depending on transition date of the underlying IBOR and potential transitional arrangements granted by regulators);

• Examine legal agreements with respect to fallback clauses;

• Perform impact assessments and determine transition from IBR to new RFRs and determine new spreads;

• Consider the broader impact on treasury/asset and liability management (ALM) functions of banks with respect to funds transfer pricing (FTP);

• Consider the impact on financial accounts (fair value calculation, hedge accounting, etc.)

• Use appropriate RFRs for new financial products; and

• Assess how to treat costs related to the IBOR transition for tax purposes and potential cost allocations.

Considering that IBRs are embedded so closely in the day-to-day activities of both providers and users of financial services (regulated and unregulated), stakeholders should keep all aspects of the transition, including the potential tax impact, on their radar and proactively include tax departments in the transition programme.

Banking regulations have a growing impact on the tax position of banking institutions. Triggers include increased capital, liquidity and counterparty risk requirements, as well as proposed requirements on centrally regulated entities. Banks will need to prepare for compliance with the Capital Requirements Directive V (CRD V) in advance of its June 2021 application date. Divergent implementation of the Basel III revisions will continue to add cost and complexity. Nonetheless, the EU's approach to implementation will become clearer in 2020.

The first key challenge is that banking institutions may need to revisit their existing transfer pricing for the attribution of free capital and to determine an appropriate response on how to consider capital increases in the context of free capital attribution to branches. Capital requirements have been emphasised as a key issue for European banks by the European Central Bank (ECB) and that the supervisory work will continue to focus on capital adequacy, business models and governance.

The second key change of Basel III is the introduction of higher liquidity requirements for banking institutions. One of the new requirements is the net stable funding ratio (NSFR), which aims to introduce more stable sources of funding. As a result, certain banking institutions already needed to inject longer-term funding into their banking affiliates to meet NSFR targets. This also triggers a range of complex transfer pricing questions on how to appropriately structure and price the provision of long-term funding in the intra-bank context and how to align such funding transactions with existing FTP and treasury policies.

The third key change triggered by Basel III is increased counterparty credit risk (CRR) measures. This affects banks where certain affiliates (and their loan portfolios) are overly concentrated on one counterparty or a group of counterparties. In practice, this forces affiliates to enter into guarantees (which are often internal) to transfer part of the counterparty credit risk to other banking affiliates. This again prompts complex transfer pricing questions on how to appropriately structure and price the provision credit guarantees in the intra-bank environment for tax purposes.

The European Commission (EC) published a range of proposals for the transposition of Basel III (and already part of the future Basel IV framework) into EU law as part of the new CRD V. As part of the proposals, the EC considers introducing a requirement for banks to establish a centrally regulated and supervised entity (known as intermediate parent undertaking or IPU) for non-EU banking groups with substantial EU activities. CRD V is commonly regarded as an opportunity for European regulators to counter fragmented supervision by local regulators and the potential risk of regulatory and supervisory arbitrage in cases in which banking groups are subject to oversight by several local regulators.

MiFID II, which was rolled out in 2018, placed additional restrictions on inducements paid to investment firms or financial advisors by any third party in relation to services provided to clients. Clean share classes emerged as a MiFID II-compliant response to the ban on inducements. Clean shares have no loads, commissions or other distribution fees, which typically pay for an investment fund's distribution costs, and no platform fees. Nonetheless, the rise of new share classes has led to increased operational complexity.

From a transfer pricing perspective, this implies that asset managers may need to take into consideration the impact of new fee arrangements, share classes and the unbundling of fees. Most notably, there is a potential impact on existing fee flows, transactions and transfer pricing policies (especially fee splits and the fee basis for the split). This trend could also affect the availability and applicability of both internal and external market data for benchmarking/testing purposes.

Asset managers increasingly rely on fund distribution platforms. These platforms work as intermediaries between distributors and asset managers, performing administrative functions such as order routing and settlement, data processing, rebate calculations, compliance and managing distribution agreements. Thus, tax departments will need to assess the potential impact on existing fee flows, transactions and transfer pricing policies.

Tax departments will also need to monitor political developments with the proposed overhaul of MiFID II and revisiting concessions that had been made to the UK in the six years it took to complete the regulations following the UK's departure from the European Union on January 31 2020.

Strong governance is required to deliver financial services in a safe and sound manner. Regulators continue to focus on governance frameworks during their onsite visits where all levels of the organisation are scrutinised – from the board to senior management to the business lines. In boardrooms around the world, financial services executives are taking appropriate action against risk. Risks include both traditional financial risk (e.g., credit, market and liquidity risk) but also non-financial risks (NFR). One of the new NFRs is tax, given the potential impact of tax risks on the financial stability, reputation, capital and liquidity positions of regulated entities.

Today, financial regulators are already probing tax as one of the indicators of proper management of regulated entities across a range of jurisdictions by requesting information on the tax strategy, policies, agreements, documentation and the involvement of executives in the identification and mitigation of tax risks.

In view of these challenges, management and boards need to start embracing tax on their governance agenda to meet the expectations of both tax authorities and regulators.

Since 2016, the ECB and local regulators have focused on creating a more stable banking sector through harmonised rules at the EU level and stricter risk and capital requirements. To achieve this goal, in 2016, the ECB and local regulators launched the business model analysis (BMA), whereby as part of the supervisory reviews the ECB and local regulators assess a range of criteria including strategy, risk management, financial performance and regulatory compliance to determine the viability of a bank`s business model and operations.

Among other areas, the BMA now explicitly focuses on FTP as part of the review of the management of the banking operations, funding structure/management and profitability management. FTP is not a new concept – it is relevant for most banking institutions, but so far has often been addressed very differently, if at all, across the banking sector based on the maturity of banks, their business model, funding profile and other criteria.

It will be important for banks that are supervised under the single supervisory mechanism (SSM) to prepare for the BMA campaign and revisit their FTP framework to be aligned with current market practice and to confirm that it meets the expectations of both regulators and tax authorities with respect to pricing the provision and use of funding.

Technology continues to be a game changer in the financial services sector. Examples include the rise of robotics and automation-related technologies to reduce operating costs, algorithmic models that evolve from internal risk management tools to key portfolio management tools and robo-advisors and artificial intelligence facilitating investment decisions and product selection. The future will entail using digital technologies to automate processes, improve regulatory compliance, transform customer experience and disrupt key components along the value chain.

This technological upheaval continues to require heavy investment and raises the question of how to structure such investments from a transfer pricing perspective with respect to ownership and use of the resulting intangibles within the group. The essential question is whether technology needs to be characterised as a key intangible for tax purposes going forward, which would also require a change to approaches for the tax treatment of development expenses. The result could be that an allocation of development costs via service (re-)charges may no longer be appropriate, but instead a license fee/royalty model may need to be introduced to remunerate the owner of the intangible(s) for the development activities.

Consequently, financial institutions may need to do the following:

• Identify all relevant intangibles and their use, even if use is not subject to remuneration (noting that even the non-remuneration needs to be supported and documented);

• Revisit existing transfer pricing positions regarding remuneration for the use of intangibles (cost recharge vs. license fee);

• Track development activities, especially if performed out of certain (pioneer) locations and decide if strategic development activities should be centralised in specific location(s) to centralise the ownership of intangibles;

• Confirm consistency between tax-related communication and other channels (especially for investor relations and regulatory purposes); and

• Review the completeness and appropriateness of existing transfer pricing documentation and inter-company agreements.

The financial services sector faces a range of future challenges, and transfer pricing is becoming increasingly significant given the focus of regulators on tax governance but also the impact of regulatory developments on the tax dimension. It is important that tax departments be properly involved in addressing the upcoming challenges and working with the board and key stakeholders.

Ralf Heussner

Partner Deloitte Luxembourg Tel: +352 45 14 53 313 rheussner@deloitte.lu Ralf Heussner is a partner with Deloitte Luxembourg. He specialises in the financial services sector and is part of Deloitte's global financial services leadership team. He has 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 tenure in Frankfurt, Hong Kong and Tokyo. Over the past 18 years, he has gained extensive experience advising clients on a range of tax, transfer pricing, valuations and controversy-related engagements. His experience covers transfer pricing planning and policy setting, risk reviews, operationalisation, documentation, restructurings, and dispute resolution engagements. He has worked on more than 30 advance pricing agreements and numerous high-profile tax controversy cases on both the local and competent authority levels with the authorities in China, the European Union, Japan, the US, and other key jurisdictions.

Iva Gyurova

Senior manager Deloitte Luxembourg Tel: +352 45 14 53 778 ivgyurova@deloitte.lu Iva Gyurova is a senior manager in the transfer pricing practice of Deloitte Luxembourg. She has more than eight years of experience assisting multinational clients on transfer pricing matters, including transfer pricing policy design and implementation, restructurings, controversy, inter-company transactions assessments (intangible assets valuation, business and financial transactions, intra-group services), and preparation of defence transfer pricing documentation. Over the past few years, she has focused on the financial services sector and has assisted many clients in the asset management (traditional and alternative) and banking sector. Her most recent experience includes the redesign of global transfer pricing policy for leading asset managers including economic analyses, implementation and documentation; assisting a large investment house with bilateral advance pricing agreement negotiations; and providing support with the business reorganisation of a banking client. She regularly presents at tax seminars organised by Deloitte and covers different transfer pricing related matters. Additionally, she regularly contributes to Deloitte publications.