The OECD-led ‘BEPS 2.0’ initiatives evolved from the original BEPS Action 1 (tax challenges arising from digitisation) and resulted in the publication of the pillar one and two blueprints on 14 October 2020. Only six months ago, these initiatives might have been viewed as an ambitious academic exercise that was a long way from being ready for implementation by the major global economies.
Much however has changed in 2021, fuelled by an immediate and clear intent from the new US administration to engage with multilateral tax policy efforts, including the OECD inclusive framework (IF), culminating in the recent G7 communique announcement in June. A high-level consensus appears to have been reached by that group at least, although as we explain below, agreement by the IF, the G20 finance ministers, and implementation in the US, EU, UK and other major economies is likely to be some way off. Nevertheless, many multinational groups are taking the G7 communique as a trigger to accelerate their readiness for the potential implementation of the pillar one and two package, including taking control of the narrative with their respective government and other stakeholders, and stepping up their own advocacy efforts to frame how the detailed implementation should work.
The financial services (FS) industry now needs to understand and communicate the interaction of the pillar one and two package with their highly regulated and complex international operating models. In particular, the prospect of a carve-out for FS groups from pillar one, hopes for which were justified by the consultation process leading up to the October 2020 blueprint publication, appears now to have receded somewhat with the G7 consensus. The arguments that such a carve-out is entirely appropriate need to be advanced anew, both amongst technicians designing the rules and at an international public policy level.
The G7 consensus is for strong support of the G20/OECD IF. Whilst the October 2020 blueprint documents were not referenced explicitly, the brief communique can only be interpreted fully by reference to those documents. The G7 took the opportunity to make a specific choice from the options set out in the pillar one blueprint in relation to the new profit allocation principles, designed to operate outside the constraints of the established arm’s length pricing principle.
The G7 opted for the new profit allocation principles to apply to:
Contrary to the 2020 pillar one blueprint, there is no explicit reference to specific industries or types of business. It appears from the announcement that the scope of pillar one will now be determined only by reference to the size of a multinational group. How size is to be measured is not defined, but by any measure, the club of the ‘largest and most profitable’ multinationals will include many FS groups. It could also include large funds, fund-owned or privately-owned groups, unless expressly carved out.
The US government’s presentation to the IF Steering Group on 8 April 2021 advocated quantitative criteria to scope in the largest and most profitable multinationals, regardless of industry classification or business model, and that sector-based scope limitations, if any, should be principled and based only on fundamental policy mismatches or irresolvable administrative constraints. It seems clear that the US is not in favour of restricting the application of the rules to any particular types of business, nor of a carve-out for FS groups. In contrast, the press coverage of the G7 debates suggests that the UK government (with the support of the French government) remains in favour of, and will continue to advocate for, an FS sector carve-out.
In our view, an FS carve-out would be entirely appropriate. It would not be fair, as some commentators have, to depict the UK’s position as special pleading by a country highly dependent on the success of its FS industry. Rather, it is one informed by an understanding that measuring FS profits has to be determined differently from other industries, that reallocating FS profits would face administrative difficulties, and that current FS regulatory frameworks and transfer pricing principles, taken together, already operate in a way to allocate profits appropriately in the context of highly regulated businesses.
FS groups are legally required to be subject to extensive regulation in the jurisdiction of their customers. The requirements of regulatory supervision invariably create local substance requirements which lead to a taxable presence in that jurisdiction. There are mature and well-understood regulatory and transfer pricing norms for the allocation of profits to the jurisdiction of sales and regulated customer relationship management. Regulation defines where substance (i.e. people), risks and capital need to be, which drives the allocation of taxing rights. The perceived problem – which BEPS action 1 and the pillar one proposals seek to address of value being derived from digital business models that do not require presence in a customer or user’s jurisdiction, particularly where the profits made from those business models have been allocated to low (or no) tax jurisdictions – is not one which is usually observed in regulated FS industries, even those increasing their use of digital platforms.
The key metric at the heart of pillar one is a 10% margin, which cannot readily be identified for many regulated FS businesses. For FS groups, profitability is often not determined by standard concepts of sales/turnover and the cost of sales, but by the cumulative effect of high volumes of financial transactions, and the key relative profitability metrics are returns on capital and capital ratios. Moreover, FS businesses are not usually driven by intangible value or significant marketing intangibles.
The key G7 decision in relation to pillar two was to set a global minimum tax rate of ‘at least 15%’. Of course, all the G7 countries have corporate tax rates exceeding this level and do not themselves have jurisdiction to determine any other country’s rates. The natural inference is that the G7 has agreed to coordinated implementation of an ‘income inclusion rule’ (IIR) and an ‘undertaxed payments rule’ (UTPR). The aim is to create a liability to top-up tax in relation to the profits of any jurisdiction falling below the threshold rate, which would create a disincentive or deterrent for multinationals to locate profits in any jurisdiction with a lower rate.
How then is the effective tax rate by jurisdiction to be calculated? Under the pillar two blueprint, this is, essentially, a comparison of GAAP profits per jurisdiction (subject to a set of adjustments including for intragroup dividends) with the cash tax payable on those profits.
FS groups are concerned about the impact of tax losses and timing differences on this calculation (which in the insurance industry in particular could take decades to unwind). If losses or timing differences are not properly recognised, a jurisdiction with a seemingly high corporate tax rate could appear to have a low effective tax rate for pillar two purposes in a particular period, which might result in top-up tax being due outside low tax jurisdictions. Modelling indicates that, for example, a holding company jurisdiction could be required to apply a top-up IIR to domestic profits in their own jurisdiction.
Banks in the UK and EU are required under the Capital Requirements Directive IV to publish country by country reports detailing profits and tax by jurisdiction. These reports are not prepared on a basis entirely consistent with the pillar two proposals; nevertheless, they have enabled some commentators to speculate as to the potential scale of the impact of pillar two on some of Europe’s largest banks (see Collecting the tax deficit of multinational companies: simulations for the European Union (EU Tax Observatory), June 2021, at bit.ly/3wQuWqL). Closer observation of these calculations indicates that the significant potential additional tax cost is not being driven by location of profits in traditional low-tax jurisdictions, but by the calculations producing some surprisingly low rates (on a cash/current tax basis) for operations in high headline tax rate jurisdictions. In many cases, this will be due to the impact of tax losses (in some cases still remaining unutilised from the financial crisis) or because of conscious domestic policy choices in those jurisdictions to phase the taxation of income or relief for expenses differently from those recognised under GAAP.
For FS businesses, this creates a regulatory capital concern, since ratios can be sensitive to current and deferred tax calculations. If existing accounting tax liabilities are to be increased (or tax assets reduced) through the anticipation of incremental future IIR or UTPR taxes, this could significantly impact the capital strength of FS groups if pillar two were to be implemented as proposed. In addition, FS regulators have an active interest in profit allocations and so, to some degree, in the tax liabilities of regulated entities which could add a further layer of unintended complexity.
The G7 announcement was only the start and more detail is needed. The next key date is the upcoming G20 meeting on 9–10 July 2021 where the proposals would be discussed and potentially endorsed. There are press reports indicating that a G20 draft statement is in circulation saying that the G20 countries ‘endorse the core elements’ of pillars one and two, and calling on the IF to complete remaining technical work with a view to approving the framework for implementing both pillars by the next G20 meeting in October 2021.
Nonetheless, there will be political uncertainty surrounding the approval and eventual implementation of the proposals in many of these countries, especially the United States. The challenges for any US administration of passing major international tax reform through the US Congress are well known. Furthermore, implementing changes to taxing rights, which pillar one demands, will require treaty changes best achieved through a new multilateral instrument, and this presents even greater challenges to implementation under the US system.
Unlike the first wave of the BEPS initiative, individual governments may be far more wary of front-running any implementation of pillars one or two ahead of broad international consensus being secured. It will be important to monitor political developments in the EU, where the European Commission has already signalled its intention (with support from a number of EU member states) to bring forward legislation implementing both pillars – potentially ahead of a global agreement (see the Commission’s Communication on business taxation for the 21st century) and the Anti-Tax Avoidance Directive mechanism, which brought about broad changes under BEPS, so will likely be the approach used to ensure uniform adoption in the EU.
It is to be hoped that, as the dust settles following the G7 and (expected) G20 announcements, and further detailed design work continues, progress is made towards ensuring that the pillar one and two mechanisms address the policy concerns which were articulated in the original BEPS action 1 paper on the digital economy and minimise unforeseen consequences and collateral damage, especially for FS groups.
The changes to be introduced by BEPS 2.0 remain ambitious with many obstacles yet to be overcome. However, the latest developments could signal a change in direction that has the potential of broadening the scope of these measures, with FS businesses now having to prepare to potentially be in scope. Active stakeholder engagement is needed to ensure that their highly regulated business models are not inappropriately caught within the ambit of pillar one; and further that pillar two will not adversely impact their regulatory capital position.
The OECD-led ‘BEPS 2.0’ initiatives evolved from the original BEPS Action 1 (tax challenges arising from digitisation) and resulted in the publication of the pillar one and two blueprints on 14 October 2020. Only six months ago, these initiatives might have been viewed as an ambitious academic exercise that was a long way from being ready for implementation by the major global economies.
Much however has changed in 2021, fuelled by an immediate and clear intent from the new US administration to engage with multilateral tax policy efforts, including the OECD inclusive framework (IF), culminating in the recent G7 communique announcement in June. A high-level consensus appears to have been reached by that group at least, although as we explain below, agreement by the IF, the G20 finance ministers, and implementation in the US, EU, UK and other major economies is likely to be some way off. Nevertheless, many multinational groups are taking the G7 communique as a trigger to accelerate their readiness for the potential implementation of the pillar one and two package, including taking control of the narrative with their respective government and other stakeholders, and stepping up their own advocacy efforts to frame how the detailed implementation should work.
The financial services (FS) industry now needs to understand and communicate the interaction of the pillar one and two package with their highly regulated and complex international operating models. In particular, the prospect of a carve-out for FS groups from pillar one, hopes for which were justified by the consultation process leading up to the October 2020 blueprint publication, appears now to have receded somewhat with the G7 consensus. The arguments that such a carve-out is entirely appropriate need to be advanced anew, both amongst technicians designing the rules and at an international public policy level.
The G7 consensus is for strong support of the G20/OECD IF. Whilst the October 2020 blueprint documents were not referenced explicitly, the brief communique can only be interpreted fully by reference to those documents. The G7 took the opportunity to make a specific choice from the options set out in the pillar one blueprint in relation to the new profit allocation principles, designed to operate outside the constraints of the established arm’s length pricing principle.
The G7 opted for the new profit allocation principles to apply to:
Contrary to the 2020 pillar one blueprint, there is no explicit reference to specific industries or types of business. It appears from the announcement that the scope of pillar one will now be determined only by reference to the size of a multinational group. How size is to be measured is not defined, but by any measure, the club of the ‘largest and most profitable’ multinationals will include many FS groups. It could also include large funds, fund-owned or privately-owned groups, unless expressly carved out.
The US government’s presentation to the IF Steering Group on 8 April 2021 advocated quantitative criteria to scope in the largest and most profitable multinationals, regardless of industry classification or business model, and that sector-based scope limitations, if any, should be principled and based only on fundamental policy mismatches or irresolvable administrative constraints. It seems clear that the US is not in favour of restricting the application of the rules to any particular types of business, nor of a carve-out for FS groups. In contrast, the press coverage of the G7 debates suggests that the UK government (with the support of the French government) remains in favour of, and will continue to advocate for, an FS sector carve-out.
In our view, an FS carve-out would be entirely appropriate. It would not be fair, as some commentators have, to depict the UK’s position as special pleading by a country highly dependent on the success of its FS industry. Rather, it is one informed by an understanding that measuring FS profits has to be determined differently from other industries, that reallocating FS profits would face administrative difficulties, and that current FS regulatory frameworks and transfer pricing principles, taken together, already operate in a way to allocate profits appropriately in the context of highly regulated businesses.
FS groups are legally required to be subject to extensive regulation in the jurisdiction of their customers. The requirements of regulatory supervision invariably create local substance requirements which lead to a taxable presence in that jurisdiction. There are mature and well-understood regulatory and transfer pricing norms for the allocation of profits to the jurisdiction of sales and regulated customer relationship management. Regulation defines where substance (i.e. people), risks and capital need to be, which drives the allocation of taxing rights. The perceived problem – which BEPS action 1 and the pillar one proposals seek to address of value being derived from digital business models that do not require presence in a customer or user’s jurisdiction, particularly where the profits made from those business models have been allocated to low (or no) tax jurisdictions – is not one which is usually observed in regulated FS industries, even those increasing their use of digital platforms.
The key metric at the heart of pillar one is a 10% margin, which cannot readily be identified for many regulated FS businesses. For FS groups, profitability is often not determined by standard concepts of sales/turnover and the cost of sales, but by the cumulative effect of high volumes of financial transactions, and the key relative profitability metrics are returns on capital and capital ratios. Moreover, FS businesses are not usually driven by intangible value or significant marketing intangibles.
The key G7 decision in relation to pillar two was to set a global minimum tax rate of ‘at least 15%’. Of course, all the G7 countries have corporate tax rates exceeding this level and do not themselves have jurisdiction to determine any other country’s rates. The natural inference is that the G7 has agreed to coordinated implementation of an ‘income inclusion rule’ (IIR) and an ‘undertaxed payments rule’ (UTPR). The aim is to create a liability to top-up tax in relation to the profits of any jurisdiction falling below the threshold rate, which would create a disincentive or deterrent for multinationals to locate profits in any jurisdiction with a lower rate.
How then is the effective tax rate by jurisdiction to be calculated? Under the pillar two blueprint, this is, essentially, a comparison of GAAP profits per jurisdiction (subject to a set of adjustments including for intragroup dividends) with the cash tax payable on those profits.
FS groups are concerned about the impact of tax losses and timing differences on this calculation (which in the insurance industry in particular could take decades to unwind). If losses or timing differences are not properly recognised, a jurisdiction with a seemingly high corporate tax rate could appear to have a low effective tax rate for pillar two purposes in a particular period, which might result in top-up tax being due outside low tax jurisdictions. Modelling indicates that, for example, a holding company jurisdiction could be required to apply a top-up IIR to domestic profits in their own jurisdiction.
Banks in the UK and EU are required under the Capital Requirements Directive IV to publish country by country reports detailing profits and tax by jurisdiction. These reports are not prepared on a basis entirely consistent with the pillar two proposals; nevertheless, they have enabled some commentators to speculate as to the potential scale of the impact of pillar two on some of Europe’s largest banks (see Collecting the tax deficit of multinational companies: simulations for the European Union (EU Tax Observatory), June 2021, at bit.ly/3wQuWqL). Closer observation of these calculations indicates that the significant potential additional tax cost is not being driven by location of profits in traditional low-tax jurisdictions, but by the calculations producing some surprisingly low rates (on a cash/current tax basis) for operations in high headline tax rate jurisdictions. In many cases, this will be due to the impact of tax losses (in some cases still remaining unutilised from the financial crisis) or because of conscious domestic policy choices in those jurisdictions to phase the taxation of income or relief for expenses differently from those recognised under GAAP.
For FS businesses, this creates a regulatory capital concern, since ratios can be sensitive to current and deferred tax calculations. If existing accounting tax liabilities are to be increased (or tax assets reduced) through the anticipation of incremental future IIR or UTPR taxes, this could significantly impact the capital strength of FS groups if pillar two were to be implemented as proposed. In addition, FS regulators have an active interest in profit allocations and so, to some degree, in the tax liabilities of regulated entities which could add a further layer of unintended complexity.
The G7 announcement was only the start and more detail is needed. The next key date is the upcoming G20 meeting on 9–10 July 2021 where the proposals would be discussed and potentially endorsed. There are press reports indicating that a G20 draft statement is in circulation saying that the G20 countries ‘endorse the core elements’ of pillars one and two, and calling on the IF to complete remaining technical work with a view to approving the framework for implementing both pillars by the next G20 meeting in October 2021.
Nonetheless, there will be political uncertainty surrounding the approval and eventual implementation of the proposals in many of these countries, especially the United States. The challenges for any US administration of passing major international tax reform through the US Congress are well known. Furthermore, implementing changes to taxing rights, which pillar one demands, will require treaty changes best achieved through a new multilateral instrument, and this presents even greater challenges to implementation under the US system.
Unlike the first wave of the BEPS initiative, individual governments may be far more wary of front-running any implementation of pillars one or two ahead of broad international consensus being secured. It will be important to monitor political developments in the EU, where the European Commission has already signalled its intention (with support from a number of EU member states) to bring forward legislation implementing both pillars – potentially ahead of a global agreement (see the Commission’s Communication on business taxation for the 21st century) and the Anti-Tax Avoidance Directive mechanism, which brought about broad changes under BEPS, so will likely be the approach used to ensure uniform adoption in the EU.
It is to be hoped that, as the dust settles following the G7 and (expected) G20 announcements, and further detailed design work continues, progress is made towards ensuring that the pillar one and two mechanisms address the policy concerns which were articulated in the original BEPS action 1 paper on the digital economy and minimise unforeseen consequences and collateral damage, especially for FS groups.
The changes to be introduced by BEPS 2.0 remain ambitious with many obstacles yet to be overcome. However, the latest developments could signal a change in direction that has the potential of broadening the scope of these measures, with FS businesses now having to prepare to potentially be in scope. Active stakeholder engagement is needed to ensure that their highly regulated business models are not inappropriately caught within the ambit of pillar one; and further that pillar two will not adversely impact their regulatory capital position.
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