Competitive pressure, digital progress, and the ever-growing regulatory demands on organizations have driven an evolution of traditional financial services models in ways that are changing the landscape of the industry. We now see an industry where the lines are constantly blurred: the physical and digital overlaps, organizations are connected in new ways, and activity constantly transcends borders.
The international tax system does not cope with these new models particularly well. In most established jurisdictions, the tax system is characterized by a number of common issues.
As business models evolve, pressure on the international tax system grows. Legislative action to deal with the inadequacies of the tax system takes time, yet the complexity of the business models grows with increasing speed.
Let's look at some of the emerging new models.
Banking: Markets as a Service platforms
Markets as a Service (or MaaS) is a new operating model for the banking industry whereby one bank, with sufficient access to infrastructure expenditure, back-office capability and existing large volume of transactions, provides a platform-based service across the trade lifecycle to other banks and financial institutions. The service would provide other banks, that do not possess the necessary expenditure, back-office capability or scale, the opportunity to operate efficiently with their client base, paying the MaaS service provider a fee to use the platform. The platform provider has a responsibility to ensure the MaaS platform is operational on an ongoing basis, including from a technical and regulatory standpoint.
Insurance: Open-source language coding of actuarial models
Evolving regulatory demands are putting pressure on actuarial activities — whether reduced reporting timelines, more efficient coding of models or the quantity of actuarial processes required. This pressure is driving new activities, such as cloud-based actuarial models, and the emergence of actuarial model coding using open-source languages such as ‘Python’ and ‘R’, enabling better data analysis and visualization. ‘Open-source’ means the code is freely available, can be modified, enhanced and reviewed, inevitably driving more collaboration, but also standardization, across organizations.
Asset Management: Distributed Ledger technology
Distributed Ledger Technology (DLT) enables the fund management industry to meet the growing demands of investor needs, digital operational processes and new regulations. The service provides scalable solutions for back and middle offices, enabling automation of manual and repetitive tasks through the use of smart contracts. This includes the processing of fund orders, corporate actions, account management (fund registers), and a drastic decrease in the need for reconciliations, as trades are shared among interested parties instantly. DLT also gives asset managers greater visibility on their value chain, enabling them to develop new products that respond more accurately to the needs of their final customers.
Tax departments in financial services organizations will need to spend time understanding the detail of new business models; the tax issues requiring consideration are complex and the related regulation and practice is emerging. Some key areas for consideration are set out below.
What drives value?
Tax professionals will need to think differently about what drives value compared to the traditional business models; transfer pricing and profit allocation principles will need to evolve to deal with the new business models. For example, in a MaaS model, is the value in the operation (e.g. speed, security) of the platform being offered, the technical/ regulatory sanctity of the platform, or the infrastructure backbone (and its associated capital expenditure) that supports the platform?
The development (and protection) of intellectual property in these new models is critical to preserving the relevance of organizations. Tax professionals will need to assess whether new intellectual property is being developed, or whether the new activity is simply a digitalization or re-packaging of an existing activity.
Due to open-source coding in actuarial models, tax professionals will need to re-evaluate whether, and to what extent, value exists in the model, particularly where there is a convergence to standardization. Given that there is potentially a shift in the way actuaries operate, is there value in the actuarial model itself, or does value shift to the analysis and insights actuaries now focus their time on?
Where is the income generated?
DLT provides a new set of challenges in relation to the taxation of income. Where a ledger is distributed, ownership of the ledger necessarily sits with multiple parties in potentially multiple locations; identifying where value in relation to the ledger is generated can be a considerable task, in particular, given how rapidly the DLT platform expands as new parties and transactions join the ledger.
Similar challenges exist in the cloud-based model where multiple actuaries access the model from potentially different locations. Identifying who has created value in relation to a sequential exercise is clear; identifying value in a shared model where activities interact and overlap is likely to be more challenging.
Whose income is it?
Allocation of income across legal entities will become far more complicated. For example, in the MaaS model, the trade lifecycle is adapted to introduce a service provision from one bank to another. The recipient of the platform service utilizes the platform in order to continue serving its own clients, creating a certain dependency on the platform, particularly where the integration of the platform creates a relationship with the service provider that is difficult to switch without operational disruption. The platform is backed by infrastructure and operations that may potentially sit across multiple legal entities in multiple locations.
Taxation of `flow'
The discussions regarding a financial transactions tax in the EU, and the evolving OECD/EU proposals in relation to digital taxation, have not yet impacted financial services, but there is growing concern that new rules could hit financial services organizations, many of whom operate on very thin margins; similarly, there is concern that digital taxation could have collateral impact on financial services business models, in particular where those rules are not tightly defined — to date, the financial services industry has relied upon exemptions relating to regulated activity (e.g. under MiFID II), but these come under pressure with new business models, whether this be service provision between banks, or the use of DLT to facilitate transaction flows.
This article provides the briefest of snapshots into an industry that is evolving at an unprecedented pace. The challenge of tax professionals is to ensure they can balance the requirement to fully understand the models that are emerging, while dealing practically with the challenges of an international tax system that must adapt to the evolution that is taking place.