Dr. Stephanie Pantelidaki is
Ryann Thomas is Partner
In July, the OECD released its Base Erosion and Profit Shifting (“BEPS”) Action Plan. Action 8 of the Action Plan outlines the OECD and BEPS views on intangibles. Not surprisingly, the principles outlined in Action 8 are remarkably consistent with the OECD's Revised Discussion Draft on Transfer Pricing Aspects of Intangibles (“OECD Revised Draft”) issued a few days after the Action Plan in July as well. It is understood that the BEPS process has had a significant influence on the development of the OECD Revised Draft.
Although the entire Action Plan, including Action 8, is applicable across all industries, the implications will differ across industries depending on:
i. the operating and transaction structures adopted in the industry;
ii. the substance of those structures; and
iii. the pricing pressure points arising.
For intangibles used in financial services, the impact of the Action Plan and the OECD Revised Draft will be primarily centred on two topics:
• identification of intangibles; and
• ownership of intangibles and allocation of intangibles profits in accordance with value creation.
Historically, the vast majority of intangibles identified in financial services have been market-facing (e.g., trade names, customer relationships). Nevertheless, as the industry continues to expand electronically, trade intangibles (e.g., quantitative or algorithmic models) and hybrid intangibles1 (e.g., trading platforms) are increasingly being acknowledged as creating value for the enterprise. As the scope of what has been considered an intangible in the financial services industry has been narrower in the past, proper analysis and identification of intangibles will be a critical task for financial institutions in the future.
Once an intangible has been identified, proving where the economic ownership resides, and that the provision of the intangible for exploitation in local jurisdictions is worth paying for, are the next most important issues. This is particularly exacerbated for financial services due to the globally integrated nature of many business lines and due to the growing use of electronic tools and solutions. There will be similarities in this regard with the difficulties faced by many e-commerce businesses in identifying ownership of intangibles.
Given the lack of focus on intangibles in financial services in the past, this new focus enters uncharted territory for many in the industry. To assist in directing some of this attention, the remainder of this article outlines the basic principles of Action 8, and describe in more detail its likely implications on financial institutions.
''Develop rules to prevent BEPS by moving intangibles among group members. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements’’.
Action 8 (i) points to the expanded nature of what will constitute an “intangible” in the future. As per the OECD Revised Draft, an intangible is “something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”.2 The breadth of this definition may be contrasted with that contained in Chapter 6 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”), which describes a much narrower scope.3
The OECD Revised Draft does restrict the definition of identified intangibles to exclude purely market conditions or circumstances such as locations savings, local market features, assembled workforce or synergies which, unlike an intangible, are incapable of being owned or controlled by a single enterprise. Nevertheless, the clear intention of Action 8 (i) and the expanded definition of “intangible” in the OECD Revised Draft must translate to increased scrutiny and vigilance from tax authorities on what constitutes an intangible for any enterprise, including financial institutions.
Action 8 (ii) refers to the classic principle of profit allocation being commensurate with value creation as captured through the functions, risk and assets at play in both the “use” and “transfer” of intangibles. The challenge for taxpayers here arises in how to practically apply this principle in cases of, e.g., split economic ownership or the delegation/sub-contracting of non-routine activities or important people functions, both of which are applicable in financial services.
Action 8 (iii) covers “hard-to-value” intangibles, which usually tend to be “hard-to-define” intangibles, for which clearly identifiable cash flow cannot always be identified. This may be applicable to financial services when dealing with hybrid intangibles, such as insurance claims history or access to liquidity, etc.
Updating the guidance on cost contribution arrangements as per Action 8 (iv) will have an impact on financial institutions that use such arrangements for development of systems/platforms across entities. The expected changes under this principle are likely to be around technical issues, such as allocation keys or ensuring an arm's length sharing of costs, rather than on the structure of such arrangements themselves.
As mentioned above, financial services intangibles have traditionally been found in market intangibles, such as trademarks/trade names or customer/distribution lists. However, under the more expansive definition of intangibles contained in Action 8 and the OECD Revised Draft, given the higher profile of intangibles generally as a result of the OECD's work in this area, and within the context of the current knowledge economy, it is expected that there may be an emergence and promotion of a far greater range of intangibles, particularly in the area of trade and hybrid intangibles.
The most commonly identified intangible in financial services tends to be trade name (group name) and its transfer price is usually expressed as a royalty fee, i.e., a percentage of revenue. Paragraphs 99-103 of the OECD Revised Draft make it clear that there needs to be a “financial benefit” received by the local affiliate through this trade name provision, in order for such a royalty charge to be justified. In practice this translates to demonstrating how the trade name contributes to increasing sales locally (i.e., premium pricing and/or volume increase), and/or reducing costs locally (i.e., cost savings through centrally-carried activities). In any event, it will be necessary to demonstrate that specific benefits received from the use of the trade name lead to increased profit at the local level. However, unlike many consumer facing industries, foreign financial services trade names often compete with strong local trade names, making it difficult to substantiate the value/benefit (i.e., market recognition) of the global name. In addition, any development of local marketing intangibles through efforts in the local jurisdiction to promote the global name needs to be recognised and appropriately taken into account in the royalty charge.
Despite the historic focus on marketing intangibles such as trade name in financial services, the future is far more likely to include a significant weighting on trade and hybrid intangibles. This reflects the growing importance of quantitative and algorithmic models (trade intangibles) in the banking and asset management industries, as well as the increasing focus on information technology, whether that be in trading platforms (hybrid intangibles) or claims processing, capital measurement and regulatory monitoring systems (trade intangibles), etc. As many of these tools have never previously been considered “intangibles”, a significant amount of work will be involved for each financial institution to firstly identify all such items, and secondly to confirm if they truly provide added value to local affiliates (as opposed to simply ensuring the enterprise retains its market position). Given the impending finalisation of the OECD Revised Draft, the release of Action 8 and the increasing focus on intangibles globally by tax administrations, it is recommended that - at a minimum -taxpayers in the financial services industry start focusing on the identification of intangibles in their enterprise as soon as possible.
The trend in terms of ownership and allocation of returns to intangibles is that, although contractual relationships between related parties will continue to serve as a starting point for any transfer pricing analysis, the location where material functions related to the intangible assets are performed is considered to be critical. This focus on functional value creation is formalised in the OECD Revised Draft through the concept of “important functions”, which are defined as crucial activities and decisions that have a material effect on the development of the intangible.4
In practice, this translates to the legal owner being able to outsource certain intangible-related functions, but in order to receive the premium return generated by the intangible, being required to control the functions outsourced and compensate those on an arm's length basis. In situations where all or a substantial part of the important functions are being outsourced to, or are being performed by, one or more members of the group other than the legal owner, it is likely that all or a substantial part of the return attributable to the arising intangible would need to be allocated to the parties actually performing the important functions.
In addition, a mere funding of the intangible-related costs, without the assumptions of any further risks (apart from funding risks), will only entitle the funder to a risk-adjusted funding return and no more.5
With the above background in mind, taxpayers in the financial services industry are likely to be impacted in some of the following areas:
• Important functions, as carried out by relevant employees, need to be rewarded with part or all (as appropriate) of an intangible's return. In many cases the location where the important functions are carried out is divorced from the location/entity where the intangible's return (of the majority thereof) is received. This is likely to be extremely relevant in the creation of quantitative models, which are often prepared in simple excel format by traders in local jurisdictions yet contain significant know-how and may - in certain circumstances - be identified as intangibles. There will also be flow-on consequences of identifying intangibles associated with particular employees in the financial services industry, where employee mobility tends to be relatively higher than in other industries. That is, if an employee moves from one local jurisdiction to another, is there a transfer of intangible where models used by that employee move with them?
• Many information technologies developed by financial institutions operate globally as a result of the integrated nature of financial services businesses, the focus on global capital maintenance and liquidity management for banks and insurance companies, and the increasing regulatory oversight that requires global transparency (particularly from the US). On the other hand, global systems of this kind almost always require some form of localisation, due to differences in regulatory requirements in each local jurisdiction. Difficult questions will arise in determining whether the localisation of such systems by local affiliates entitles those affiliates to an “ownership” share of any intangible return.
• In contrast, difficulties may also arise in the opposite case where material costs have been incurred to develop such global systems in a single jurisdiction (or a few central jurisdictions), but the value added by those systems in the generation of profit in local jurisdictions - which is required to support a royalty charge to local affiliates as described above - is not clear or easy to substantiate. Given the level of regulatory change in the financial services industry, which since the global financial crisis has significantly overshadowed any other industry worldwide, and the increasing pressure on tax authorities in headquarters jurisdictions (such as the US or UK) to push out these costs, this issue is responsible for more than its fair share of concerns raised by tax directors in financial institutions.
The combined impact of BEPS Action 8 and the OECD Revised Draft has been to clarify and strengthen the setting of principles and guidance by which the identification, ownership and valuation of intangibles should be practised by enterprises, including those in financial services. In particular this article has highlighted certain specific areas and topics that are likely to be of most interest to financial institutions.
Based on the summary contained in this article, it should be clear that the key message for tax directors in financial services is that it is never too early to begin work on the identification of, and determination of ownership for, intangibles. Past experience suggests that this is an area that has not been the subject of much focus in the industry, making it likely that more work may need to be done to identify the scope of potential intangibles than is perhaps the case in more traditional “widget” industries.
With the release of the BEPS Action Plan and the OECD Revised Draft, it is no longer possible to remain complacent on this topic. Intangibles in the financial services industry is unlikely to remain uncharted territory for much longer.
Pantelidaki is Director, Financial Services Transfer Pricing at
PricewaterhouseCoopers AG Switzerland, based in the Zurich office. She may be
contacted by email at
Ryann Thomas is Partner, Transfer Pricing Consulting at Zeirishi-Hojin PricewaterhouseCoopers, based in the Tokyo office. She may be contacted by email
© 2013 PwC. All rights reserved.
1 Exhibiting both market-facing and trade-related features.
2 OECD Revised Draft, ¶ 40.
3 OECD Guidelines, ¶ 6.2.
4 OECD Revised Draft, ¶ 79.
5 OECD Revised Draft, ¶¶ 82-84.
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