The OECD has published a consultation on the exclusion of certain Financial Services entities from pillar one of its two-pillar solution to address the tax challenges arising from the digitalisation of the economy. The OECD/G20 proposals involve fundamental changes to traditional tax rules to meet the needs of a globalised and digitalised economy, and in October 2021 agreement was reached on the key terms of this two-pillar approach.
- Pillar 1: consists of a new taxing right that applies to the largest multinational enterprises based on where goods or services are used or consumed (the “market jurisdictions”). This applies to multinational enterprises with global revenue over €20bn and profitability above 10 per cent (before tax). 25 per cent of profit above the 10 per cent threshold (the so-called Amount A) will be reallocated to market jurisdictions.
- Pillar 2: introduces a global minimum corporate tax rate set at 15 per cent for companies with revenue above €750m.
Overview
The OECD has been consulting on various aspects of the two pillars and this latest consultation looks at the scope of the financial services exclusion from pillar one. It was agreed in last year’s framework agreement that there would be some form of exclusion from pillar one for regulated financial services, and this consultation aims to agree its exact scope. It has been published for public comment with the proviso that this does not yet reflect a position agreed by all Inclusive Framework members, and certain points are highlighted as points of disagreement, but it is unclear to what extent there is consensus in relation to the rest of the proposal.
The consultation proposes that the “Regulated Financial Services Exclusion” will exclude the revenues and profits from Regulated Financial Institutions (RFIs) when calculating the profits that could potentially be re-allocated under Amount A. In particular, the RFI’s revenues and profits will be excluded when applying the revenue and profit thresholds. This means that for many traditional financial institution groups, it should be straightforward to determine that they do not meet the thresholds for pillar one to apply.
The stated basis for the exclusion is that such entities are subject to capital adequacy requirements that reflect the risks taken on and borne by such firms and the consultation notes that this regulatory driver generally helps to align the location of profits with the market, giving such entities a nexus to the jurisdiction where the risks are incurred, such that the rationale for pillar one should not apply to these entities.
The exclusion would work on an entity-by-entity basis, so that the revenues and profits of an entity that is an RFI (including its branches) are wholly excluded from Amount A. (Conversely, the revenues and profits of an entity that does not meet the conditions to qualify as an RFI are wholly included, even though the entity might carry on some regulated financial services activity.)
What is an RFI? Which entities will fall within the exclusion?
A taxpayer must identify all RFIs within its group. There are six types of RFIs defined in the document: Depositary Institution; Mortgage Institution; Investment Institution; Insurance Institution; Asset Manager; and Mixed Financial Institution. A seventh category is added, RFI Service Entities, which is a limited type of service entity that exclusively performs administrative functions for other group RFI(s) e.g. an entity providing payroll functions or holding real estate that is invested in or used by the RFI as part of its business. The consultation notes that the RFI Service Entity concept would not include the conduct of customer-facing activities nor would it cover the provision of fintech or payment processing services.
The definition of RFI is still up for debate, with certain Inclusive Framework members apparently taking the position that reinsurance and asset management entities should not benefit from the exclusion. This may reflect the fact that in some jurisdictions the capital requirements for such entities may not be fully risk-based and thus adequately reflect the risks. This is more difficult to justify where the requirements for such firms are risk-based e.g. under the EU’s Investment Firms legislation or the UK’s Investment Firms Prudential Regime.
The definition for each type of RFI generally contains three elements, all of which must be satisfied:
- a licensing requirement;
- a regulatory capital requirement; and
- an activities requirement.
The activities requirement in each case sets out not only the nature of activity that an entity must carry out, but also the quantum of that activity (for instance, at least 20 per cent of an entity’s liabilities must consist of deposits for it to be a Depositary Institution). Note that group treasury centres and captive insurers would not qualify for the exclusion under the current proposals.
Architecture: how would the exclusion work?
Where the conditions are met, the revenues and profits of the RFI are wholly excluded from Amount A.
Once it is established which entities are excluded, the €20bn revenue threshold is re-tested on the third party revenues of the non-excluded entities (only), with simplifications permitted for the purposes of this calculation.
For those that still meet the €20bn revenue threshold test on that basis, the group then has to carry out the full computation to identify revenues from in-scope activities to test whether the 10 per cent profitability threshold test is satisfied. The non-excluded entities are treated as a separate and independent business or a bespoke segment, such that revenues of non-excluded entities derived from transactions with group entities that are excluded RFIs are treated as in-scope for these purposes.
For groups meeting the profitability threshold, the other steps in determining Amount A to be reallocated to market jurisdictions would be the same as for other multinational groups falling within the rules, but with the RFI revenues and profits being excluded from the various tests (e.g. in determining nexus to market jurisdictions, or in applying the safe harbour etc). For more on how pillar one will work, see our dedicated webpage.
Conclusion
The consultation sets out clear criteria for the exclusion of financial services entities from Amount A. However, given that all three elements of the definition (licencing, regulatory capital requirement and the activities requirement) need to be fulfilled, there will be many financial services entities (both standalone or within financial services groups) that fall outside the scope of the exclusion, the revenues of which potentially would be within the scope of these rules. It also remains to be seen whether the final proposals permit the exclusion of asset management or reinsurance entities.
The deadline for comments on the consultation is 20 May 2022.
