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May 16, 2022
OECD releases public consultation document on Regulated Financial Services Exclusion under Amount A for Pillar One
On 6 May 2022, the Secretariat of the Organisation for Economic Co-operation and Development (OECD) released a public consultation document regarding the Regulated Financial Services Exclusion under Amount A for Pillar One of the OECD/G20 project on Addressing the Tax Challenges Arising from the Digitalisation of the Economy (the BEPS 2.0 project).
The new taxing right established through Amount A applies only to those Multinational Enterprise (MNE) Groups that fall within the defined scope of Amount A. The Regulated Financial Services Exclusion will exclude from the scope of Amount A the revenues and profits of a Regulated Financial Institution.
The consultation document provides a definition of Regulated Financial Services that includes seven types of Regulated Financial Institutions. The definition for each type of Regulated Financial Institution, except one (i.e., Regulated Financial Institution Service Entity) contains three elements, all of which must be met: (i) a licensing requirement; (ii) a regulatory capital requirement; and iii) an activities requirement.
This consultation document covers Schedule [G] of the Model Rules which will govern the Regulated Financial Services Exclusion. Other parts of the Model Rules on Amount A, on which the corresponding provisions for the Regulated Financial Services Exclusion would be based, are pending finalization and therefore the Schedule for the Regulated Financial Services Exclusion provides a preliminary description and explanation of the envisaged draft rules.
The consultation document is a working document released by the OECD Secretariat to obtain input from stakeholders. It has been released on the basis that it is without prejudice as to the final agreement and it does not reflect consensus of the Inclusive Framework member jurisdictions on the substance of the document. The OECD invites comments on the draft rules to be submitted in writing by 20 May 2022.
The OECD has been considering tax issues related to the digitalization of the economy since the outset of the original Base Erosion and Profit Shifting (BEPS) project in 2013. In 2019, the OECD launched the BEPS 2.0 project, which consists of Pillar One on new nexus and profit allocation rules and Pillar Two on global minimum tax rules.1 Currently, there are 141 jurisdictions participating in the BEPS 2.0 project through the Inclusive Framework.
In October 2021, a final political agreement was reached on key parameters of both pillars and an implementation plan.2 Of the 141 participating jurisdictions, 137 members of the Inclusive Framework have joined this agreement. With respect to Pillar One, one of the agreed parameters is that MNEs with global turnover above €20 billion and profitability above 10%, calculated using an averaging mechanism, would be in scope of Amount A.
In December 2021, the OECD announced plans to release a series of Secretariat working documents in the first half of 2022 on the separate building blocks of Amount A in order to obtain stakeholder input, as well as a public consultation document on Amount B in mid-2022. The first of these working documents on Amount A, covering nexus and revenue sourcing rules, was released for public consultation on 4 February 2022.3 The second Amount A working document, on tax base, was released on 18 February 2022.4 Following, the third Amount A working document, on scope, was released on 4 April 2022.5 Most recently, the fourth Amount A working document, on the Extractives Exclusion, was released on 14 April 2022.6
On 6 May 2022, the OECD released the public consultation document related to the Regulated Financial Services Exclusion for Amount A of Pillar One. The proposed rules exclude from the scope of Amount A the revenues and profits from Regulated Financial Institutions.
An MNE Group that qualifies for the Regulated Financial Services Exclusion would follow seven steps to assess the application of Amount A. Steps 2 and 3 are specific to this exclusion, and public comments are invited on these two steps.
Step 2: Identify Regulated Financial Services Activities and apply the revenue threshold to in-scope revenue
The purpose of this step is to re-apply the revenue threshold (i.e., €20 billion) but only looking at the in-scope revenue (i.e., MNE group revenue (or the revenue of a disclosed segment) after subtracting third party revenue derived from Regulated Financial Services).
With the view to reducing the compliance burden, the consultation document provides for two simplified methods that may be used in applying Step 2. Under the first simplified test, an MNE Group could identify its largest Regulated Financial Institutions and subtract the total third party revenues of such entities from the consolidated revenue amount. The benefit of this test is that the MNE Group does not need to identify every Regulated Financial Institution in the group provided that the identified Regulated Financial Institutions are sufficient to bring the remaining revenue below €20 billion.
As an alternative simplification, the MNE Group could test whether the revenues of the remaining in-scope Entities exceed €20 billion by adding the total revenues of all such Entities. If the total revenues are still below €20 billion, then the Group (or disclosed segment) is not in scope.
The consultation document states that the term Regulated Financial Services means services carried out by a Regulated Financial Institution. This means that the exclusion is operated on an Entity-by-Entity basis. The consultation document provides that Regulated Financial Institution means a: (i) Depositary Institution; (ii) Mortgage Institution; (iii) Investment Institution; (iv) Insurance Institution; (v) Asset Manager; (vi) Mixed Financial Institution; and (vii) service entity that exclusively performs functions for a Regulated Financial Institution. To qualify as a Regulated Financial Institution under categories (i) through (vi), an institution needs to satisfy three elements: a licensing requirement; a regulatory capital requirement, and an activities requirement.
While reinsurance and asset management businesses are included as Regulated Financial Institutions in the public consultation document, the document notes that some members of the Inclusive Framework are not supportive of excluding these businesses from Amount A.
Types of Regulated Financial Institutions
A Depositary Institution means an Entity licensed to accept Deposits in the ordinary course of a banking or similar business. A Deposit means funds which are required to be repaid on demand or at the time agreed under the applicable legal and contractual conditions, with or without interest or a premium. This type of Regulated Financial Institution is subject to capital adequacy requirements that reflect the Core Principles for Effective Banking Supervision as provided by the Basel Committee on Banking Supervision.7 Also, the definition requires that at least a certain percentage of the liabilities of the Entity consist of Deposits, as at the balance sheet date for the Period (i.e., a reporting period with respect to which the Ultimate Parent Entity (UPE) of a Group prepares Consolidated Financial Statements). The consultation document suggests that this percentage could be [20%],8 indicated in the draft model rules in brackets.
A Mortgage Institution means a Group Entity licensed to accept repayable funds from the public for the purpose of granting credits directly to individuals for the purchase of real estate. As in the case of the definition of Depositary Institution, this type of Regulated Financial Institution is subject to capital adequacy requirements that reflect the Core Principles for Effective Banking Supervision as provided by the Basel Committee on Banking Supervision. Also, the total gross income of a Mortgage Institution is required to equal or exceed a certain percentage of the Group Entity’s total gross income during the Period. The consultation document suggests that this percentage could be [75%].
An Investment Institution means a Group Entity licensed to carry on financial activities, including: i) dealing, broking or trading in Financial Assets (e.g., money market instrument, securities, commodities, foreign exchange) for its own account or for account of customers; ii) holding securities in inventory; and/or iii) hedging customer transactions. The institution must be subject to capital adequacy requirements that reflect the Core Principles for Effective Banking Supervision as provided by the Basel Committee on Banking Supervision or Objectives and Principles of Securities Regulation as adopted by the International Organisation of Securities Commissions (IOSCO) and the related implementing methodology.9 The total gross income attributable to these activities must equal or exceed [75%] of the Group Entity’s total gross income during the Period.
An Insurance Institution means a Group Entity licensed to carry on activities related to Insurance Contracts (i.e., contracts of insurance or reinsurance) and Annuity Contracts (i.e., contracts under which the issuer or operator agrees to make payments for a period determined in whole or in part by reference to the life expectancy of one or more individuals). The institution must be subject to solvency standards incorporating a risk-based capital measure. Additionally, the gross income associated with Insurance Contracts and Annuity Contracts (including investment income from assets associated with such contracts) must exceed [75%] of total gross income for such Period, or the aggregate value of the assets held to manage risk associated with Insurance Contracts and Annuity Contracts must exceed [75%] of total assets as at the balance sheet data for the Period.
An Asset Manager means a Group Entity licensed to invest in, administer, manage or distribute interests in an Investment Fund or Real Estate Investment Vehicle, Financial Assets or money for or on behalf of other persons. The institution must be subject to solvency standards incorporating a risk-based capital measure. For these activities, the total gross income must equal or exceed [75%] of the Group Entity’s total gross income during the Period.
The consultation document describes a Mixed Financial Institution as a Group Entity licensed to carry on business described in any of the definitions of Depositary Institution, Investment Institution, Insurance Institution, or Asset Manager. A Mixed Financial Institution is subject to the capital requirements for the relevant Regulated Financial Institution. Also, the total gross income attributable to these activities must equal or exceed [75%] of the Group Entity’s total gross income during the Period.
Finally, the consultation document describes a Regulated Financial Institution Service Entity as a Group Entity (i) that is wholly owned by a UPE that also owns (directly or indirectly) another Regulated Financial Institution and (ii) that performs services exclusively for the benefit of one or more other Regulated Financial Institutions in the same Group (other than a Regulated Financial Institution Service Entity) that are necessary to the carrying out of the activities of such Regulated Financial Institution.
Step 3: Identifying excluded and in-scope profits
Groups that meet the general scope provisions of Step 1 and that after application of Step 2 have above €20 billion of in-scope third-party revenues will need to identify the profits derived from Regulated Financial Services Activities and exclude these from Amount A. They will also need to identify the remaining profits from in-scope activities to test whether these profits exceed the profitability threshold of 10%. In the earlier consultation documents on nexus and revenue sourcing and on tax base, it is noted that special rules may be necessary to calculate the profits of financial institutions that are subject to Step 3.
Identification of in-scope profits
Similar to Step 2, the exclusion calculation is performed on an Entity-by-Entity basis. The taxpayer must identify every in-scope Entity in the Group. This will involve identifying any in-scope entities which were not already identified under Step 2 (i.e., because the simplified approach was used to apply the revenue threshold).
After the identification of in-scope entities, the taxpayer combines these entities into one consolidated bespoke segment for Amount A purposes. There are two ways to perform this segmentation: (i) top-down approach; or (ii) bottom-up approach.
Under the first step of the top-down approach, third-party revenues and third-party costs of Regulated Financial Institutions should be excluded from the consolidated group or disclosed segment financials. Under the second step, related-party revenues or related-party costs arising at the level of non-excluded entities (i.e., the bespoke segment) derived from transactions with the Regulated Financial Institutions (i.e., transactions excluded under Step 1) are included.
Under the bottom-up approach, the Group recombines the in-scope entities into a consolidated bespoke segment. This means recognizing third-party transactions of the in-scope entities and transactions with the Regulated Financial Institutions in the same Group, but not including revenue earned and costs incurred in relation to transactions between the in-scope entities that are eliminated when preparing the bespoke segment.
Regardless of the approach used, the bespoke segment that is made up of the non-excluded entities of the Group or disclosed segment are treated as a separate and independent business from the Regulated Financial Institutions. This means that the revenue earned and costs incurred from transactions with such Entities is recognized (based on arm’s-length principles) rather than eliminated.
Reapplication of the profitability test
Once the new combined bespoke segment has been determined, the Group would reapply the profitability test. It would not be subject to Amount A where the profit margin of that bespoke segment is below 10%.
Similarly, a Group would also calculate losses and carryforward losses in respect to its disclosed bespoke segment consisting of in-scope entities. This calculation should be in line with accounting principles and the consultation document indicates that further consideration is being given as to how to apply this rule.
If after the application of the averaging mechanism and losses of the segment the profit margin is above 10%, those remaining profits are within scope of Amount A.
If adopted, the application of the draft model rules would have significant implications for companies that are in scope of Pillar One Amount A, affecting the amount of profits to be re-allocated to market jurisdictions and leading to new compliance requirements, including requiring a new calculation of a tax base separate from the entity-based domestic tax base calculations. Importantly, the Inclusive Framework has not yet reached a consensus as to whether financial services companies in the reinsurance and asset management businesses should be out of scope of Amount A.
Companies that could be in scope of Pillar One Amount A and that carry on financial activities should monitor these developments closely and start evaluating the impact of the proposed rules. They should also consider the opportunity to submit comments on the consultation document.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Belastingadviseurs LLP, Rotterdam
Ernst & Young Belastingadviseurs LLP, Amsterdam
Ernst & Young Limited (New Zealand), Auckland
Ernst & Young LLP (United States), New York
Ernst & Young LLP (United States), Washington, DC