Global Tax Reform OECD publishes draft rules on the financial services exclusion from Pillar One

The OECD has published draft rules setting out the parameters of a financial services exclusion from new rules reallocating taxing rights to market jurisdictions under Pillar One of the global tax reform project.

Pillar One aims to ensure that a proportion of "excess" profits of the largest and most profitable multinational groups may be taxed in the countries in which they supply goods or services or their consumers are located, but in which they are not taxable under existing rules. The revenues and profits from "Regulated Financial Institutions", however, will be excluded from Pillar One by these new rules, on the basis that this sector is subject to capital adequacy requirements that already help to align the location of profits with the market.

In addition, entities within financial services groups which do not meet the definition of "Regulated Financial Institution" will only fall within the scope of Pillar One to the extent that their combined third party revenues exceed €20 billion. This is likely to take most such groups out of Pillar One altogether.

There is an extremely tight timeframe for comment on these draft rules, with responses requested by 20 May. This reflects the OECD's ambitious timetable to have the rules come into effect next year. Further 'building blocks' of Pillar One will be released for feedback in due course.

Pillar One

Despite huge changes in recent years to domestic tax systems across the world as a result of the OECD's Base Erosion and Profit Shifting project, concerns remained that today's digitalised economy allows companies to create value in a market jurisdiction by way of a virtual presence, without necessarily becoming liable to tax there.

The OECD's two pillar solution is designed to ensure that multinational enterprises pay a "fair share" of tax wherever they operate and generate profits.

Alongside Pillar Two's 15% global minimum tax rate for large multinationals, Pillar One provides for a new taxing right for market jurisdictions over certain profits of the largest multinationals. Those that are within scope will see 25% of profits above a 10% profit margin (so called "Amount A") reallocated and then subjected to tax in the countries in which they operate and earn revenue of at least €1m per year (or €250,000 for smaller jurisdictions), rather than taxing rights sitting where the business has physical presence.

This consultation sets out the scope of an exclusion from these rules for the financial services sector.

Regulated Financial Services Exclusion

The regulated financial services exclusion works on an entity by entity basis. Where an entity meets the definition of a Regulated Financial Institution (RFI), its revenues and profits are wholly excluded from Amount A. Entities that do not meet the definition are wholly included.

Six types of Regulated Financial Institution are defined in this document (i) Depositary Institution; (ii) Mortgage Institution; (iii) Investment Institution; (iv) Insurance Institution; (v) Asset Manager; and (vi) a Mixed Financial Institution. There is also a seventh category for a limited type of service entity that exclusively performs functions for a Regulated Financial Institution (RFI Service Entity). This is not necessarily a final list. In particular, there is ongoing discussion about whether reinsurance and asset management should or should not be excluded from Amount A. Any in-scope groups within those sectors may particularly want to consider representations.

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.

Applying the exclusion

A group will potentially be in-scope of Amount A where either the group on a consolidated basis (including activities covered by the exclusion), or a disclosed segment (where the exceptional segmentation rules apply), has more than €20 billion of revenue and a profit margin above 10%.

It is only if these thresholds are met that a group would apply the regulated financial services exclusion. This involves first re-determining whether the €20 billion revenue threshold is met and then, if necessary, re-determining whether the 10% profitability threshold is also met. In each case, this must be by reference only to in-scope (i.e. non-Regulated Financial Services) revenue and profits, and calculated at the level that the taxpayer is found to be in-scope under the general rules (i.e. either at the level of the group or of a disclosed segment):

Revenue threshold: Groups will only be in scope if the combined third party revenues of each non-RFI entity exceeds €20 billion.

As most, if not all, financial services groups generally have limited amounts of third party revenue earned outside the RFIs, the draft rules allow for simplified methods of calculating the in-scope revenues which avoid the need for a full review of every entity in the group. The taxpayer will be able to subtract total third party revenues of the group's largest RFIs until it is able to establish that the remaining revenue does not exceed €20bn. In addition, the taxpayer could test whether the revenues of the remaining in-scope entities exceed €20 billion by adding the total revenues of these remaining entities until the threshold is passed, although this is less likely to be of use.

Profitability threshold: Groups will only be in scope if the profits of the non-RFIs exceed 10% (including the averaging rule and the ability to carry forward losses).

If the group has exceeded the revenue threshold, the taxpayer must then identify every in-scope entity in the group, including those which were not already identified under the re-application of the revenue threshold (i.e. where the simplified approach was used). Essentially, these are combined into a bespoke segment for calculating the non-excluded revenues and profits for Amount A purposes. The segment is treated as a separate and independent business from the RFIs and therefore revenues and costs from transactions with RFIs are recognised (on arms' length principles).

The group would then reapply the profitability test to the new consolidated bespoke segment in the normal way, although the difficulties inherent in calculating average profits and historic losses for a 'notional' segment created solely for the purposes of Amount A are acknowledged. There will be further consideration of these issues.

A work-in-progress

As with earlier consultations on elements of the Pillar One rules, this draft is still very much a work-in-progress which does not, as yet, reflect consensus on the substance of the rules. Pillar One is due to come into effect from next year and, to meet that tight timetable, the OECD feels the need to obtain public input early in order to help in further refining and finalising the rules.

The OECD is hoping in particular for input on:

• areas where the definitions of Regulated Financial Institutions are unclear or insufficient (including the reasonableness of the thresholds proposed);
• the practical challenges in applying the rules for identifying excluded and in-scope revenues and profits; and
• the additional guidance or compliance simplifications that would be needed to effectively apply the exclusion.

Businesses in this sector should consider responding to this consultation to ensure that the final rules are sufficiently certain and workable for their purposes. Comments should be sent electronically (in Word format) by email to tfde@oecd.org though respondents should be aware that any response will be made publicly available on the OECD website.

You can find a full list of our global tax partners here.

You can find a full list of our global regulatory partners here.