BEPS updates: key issues for financial services

BEPS updates: key issues for financial services

Our latest edition of frontiers in tax examines the new trends and developments that are transforming the financial services sector. In this issue, we take a closer look at the developments around BEPS.

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We have previously reviewed the major efforts now being devoted to tackling the issue of Base Erosion and Profit Shifting (BEPS).1 Following the lead of the G20, the OECD has been pursuing urgent measures to address the perceived use of mismatches and arbitrage opportunities between national tax systems designed to transfer profits to low(er)-tax jurisdictions. Such action is argued to erode domestic tax bases (‘base erosion’) and moves reported profits (‘profit shifting’) to locations where there may be little or no related economic activity. Although such planning may be allowable under tax law, there is an increasing perception that they are unfair, and undermine the integrity of tax systems.

The OECD argues that:

“In an increasingly interconnected world, national tax laws have not always kept pace with global corporations, fluid movement of capital, and the rise of the digital economy, leaving gaps that can be exploited to generate double non-taxation.”

The BEPS Action Plan is intended to enable tax authorities to determine that profits are taxed where economic activities generating those profits are performed and where value is created.2

However, while this principle certainly presents challenges when applied to manufacturing or trading activities, it may be even less straightforward in the case of financial services. For some, the financial sector is the epitome of globalized business. The buying and selling of risk is core to these businesses, and capital is the bricks and mortar. The financial services industry is highly regulated with specific capital and other requirements and one must determine any transfer pricing guidance appropriately recognizes and addresses these features. There are a number of key implications which companies need to consider. In this article, we briefly review three of them.

Reporting and transparency

A key tool in preventing the perceived inappropriate use of opportunities to shift profits is information. The BEPS project aims to enhance the transparency of revenues, costs and profits by reforming transfer pricing documentation and reporting. The OECD Action Plan emphasizes that:

"the rules to be developed will include a requirement that [multi-national enterprises] provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template."3

Hence, regardless of formal corporate structures, tax authorities in all jurisdictions where an institution has a presence can expect extensive transfer pricing documentation, including access to master files and country by country reports detailing economic activities, resources, employees, costs and profits across the globe.

This country-by-country (CBC) reporting could represent a particularly significant requirement for multinational financial services companies. Apart from the systems and process implications, a further major challenge will be to determine that the necessary information is presented, explained and interpreted in an appropriate manner. An effective communication plan will be essential. Some tax authorities may tend to focus on tangible aspects such as numbers of employees in specific locations. They may find it more difficult to assess the comparative value and profit generated by small numbers of highly senior or expert staff as opposed to the contribution of large numbers of more junior or back office employees. They also may not fully consider the contribution of capital and the need in cases for it to be rewarded in the jurisdiction where it is provided.

Reporting information will need to be coherent and effective. It will be important to determine that all public information, whether in formal reports, sales promotion, social media or even via channels such as recruitment advertising is consistent with CBC transfer pricing reporting, in order to mitigate misleading – and costly – conclusions being drawn and to minimize conflicts of interpretation.

Regardless of formal corporate structures, tax authorities in all jurisdictions where an institution has a presence can expect extensive transfer pricing documentation.

Risk transfer, special measures and recharacterization of transactions

The OECD is particularly aware of the practice – adopted by a number of multinational organizations – of transferring risk between members of the group and of developing associated capital and funding structures in order to shift profits and reduce tax. The OECD proposes new restrictions on transfer pricing rules to ensure that “inappropriate” returns and tax benefits are not captured by a group company simply as a consequence of its intra-group risk bearing or its capital position. Clearly this approach is driven by the objective of aligning the location of taxable returns with perceived economic value creation.

The arms-length principle plays a significant role here in determining whether an intra-group transaction is reasonable, or is being undertaken solely to transfer risk and capital to minimize tax liabilities. New transfer pricing rules could help weed out or prevent transactions which would normally not occur between unrelated parties and which do not exhibit an underlying economic rationale. The intent of the proposed rules is to provide the basis whereby such transactions should be non-recognized or re-characterized, and benefits accruing from them should be set aside.4

Hence the current discussion draft contains proposed revisions to Section D of Chapter I of the Transfer Pricing Guidelines which “emphasize the importance of accurately delineating the actual transactions”, and includes guidance on the “relevance and allocation of risk, determining the economically relevant characteristics of the controlled transaction, and on recharacterisation or non-recognition of transactions.”5 Special measures are also suggested to cope with transfers of hard-to-value intangibles.

However, the application of these principles to the financial services sector can be particularly problematic. Generally, the core business of financial services often involves a risk transfer; and despite being intangible, capital is a key economic factor. An underlying premise of the OECD’s discussion draft is that capital is fungible and fluid and thus easily shifted. The assumption may not be entirely correct for financial institutions because they are regulated and by law must hold capital in fixed and specific locations according to regulation. Therefore it is difficult to reconcile this with the conventional and a simple analysis of key entrepreneurial risk-taking functions for separate legal entities in a financial services group without also acknowledging the special role of capital in this industry and the need for capital to be remunerated appropriately. The determination of where risk resides in financial institutions needs to reflect a sophisticated understanding of the regulatory framework that financial institutions operate under as well as risk allocation, management and control. Otherwise, there is a danger that the new OECD guidelines could be misapplied and lead to distorted outcomes in the financial services sector.

The financial services industry needs to determine that its case is made effectively.

Avoidance of permanent establishment status

Traditionally, profits recorded by a non-resident company are only taxable in a particular jurisdiction if the economic activities giving rise to those profits are undertaken through a local permanent establishment (PE). A number of factors can contribute to the judgement that a PE exists, such as the existence of an office with staff, retail premises, manufacturing base etc; a company which operates locally through an agent authorized to conclude contracts on its behalf may also be found to have established PE status.

In recent years, there has been increasing concern that globalization and the digital economy have significantly increased the scope to avoid PE status by supplying goods and services from remote geographical locations. Particular concern attaches to the major global e-commerce businesses. However, financial services companies may also in principle offer services without establishing a permanent physical presence in a particular country.

The threshold of activity or presence for determining the existence of a PE has historically been quite high. However, Action 7 of the BEPS Action Plan is directed at preventing the artificial avoidance of PE status; scheduled for introduction in September 2015, new rules could limit substantially the scope for arguing that a PE has not been established. In particular, these new rules are expected to tackle the practice of fragmenting group activity between separate legal entities in separate jurisdictions; and to restrict the scope for use of “independent” agents or commissionaires. The OECD is currently consulting on a number of possible changes to Article 5 of the Model Tax Convention that would achieve these objectives.

There is also a specific focus on insurers, who can write significant amounts of business in a country without having a PE in that location, in particular through arrangements with exclusive agents. One option under consideration is to establish a bespoke framework for insurers to address this concern. A less potentially burdensome regime would apply the general PE rules to insurers, but in a manner which recognized the particular nature of risk transfer in the industry, and the economic reality of cross-border insurance and reinsurance and the regulatory framework in which the industry operates.

More generally, in light of these impending new rules, financial institutions need to carefully review their current business models, PE status as some reorganization of structures and operations may be necessary.


The BEPS project, though still developing, reflects widespread changes in perceptions around corporate tax practices, and is likely to have far-reaching ramifications. The financial services sector has particular characteristics which make a number of the BEPS initiatives challenging; hence the industry should carefully consider its involvement with the OECD’s BEPS initiative. At the same time, as these examples make clear, there is a need to prepare for potentially significant changes.


1cf for example BEPS: Time for Action, Frontiers in Tax, KPMG, September 2014

2cf OECD, Bringing the International Tax Rules into the 21st Century: Update on Base Erosion and Profit Shifting (BEPS), Exchange of Information, and the Tax and Development Programme, Report from the Meeting of the OECD Council at Ministerial Level Paris, 6-7 May 2014

3Action Plan on Base Erosion and Profit Shifting, OECD, 2013

4OECD explains that “the term non-recognition is intended to convey the same meaning to that understood to be conveyed by the term recharacterisation.”

5cf BEPS Actions 8, 9 and 10: Discussion draft on revisions to Chapter 1 of the Transfer Pricing Guidelines (including risk, recharacterization and special measures), OECD, December 2014-February 2015

cf for example BEPS: Time for Action, Frontiers in Tax, KPMG, September 2014

cf for example BEPS: Time for Action, Frontiers in Tax, KPMG, September 2014

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