The international tax system has faced significant and growing challenges over the past several years, with many countries implementing unilateral measures resulting in potential circumvention or overriding of their tax treaty obligations. In response, the Organisation for Economic Co-operation and Development (OECD) has undertaken an effort to develop a new international tax consensus. Those efforts reached a new milestone in the fall of 2020, giving players in the asset management space a clearer view of how sweeping tax proposals in the works might affect them. While it’s uncertain whether or when any final rules might be adopted, asset management companies should monitor developments closely so they can manage the potential impacts on their portfolios and their own organizations.
On October 12, 2020, the OECD/G20 Inclusive Framework on BEPS (the “Inclusive Framework”) released detailed “Blueprints” for its ongoing work in this area. The Inclusive Framework also laid out a revised timeline to gain consensus on final proposals by mid-2021.
The current work — often called BEPS 2.0 — aims to tackle tax issues arising from increasing digitalization of businesses and from other elements that allow multinationals (MNEs) to base erode or profit shift. The OECD’s blueprint sets out two “pillars” of proposed approaches:
The different pillars may have very different impacts on different segments of the asset management industry, and we consider each pillar in turn.
Pillar One is intended to allocate additional taxing rights to market countries – that is, jurisdictions in which users or consumers are located. For businesses that are in scope of the new taxing right, additional profits would be allocated to those jurisdictions on a formulaic basis. Pillar One also would create new taxable nexus standards that do not require a physical presence in most cases. The Pillar One proposals apply to companies with revenues over a certain threshold (probably in line with the threshold for country-by-country reporting) and that either provide automated digital services (ADS) (e.g. online ads and search engines, social media, online gaming) or are consumer-facing businesses (CFB) with revenue from the sale of types of goods or services commonly sold to individual consumers or exploit intangible property connected to such goods or services.
Many asset managers will not be subject to the new taxing right under Pillar One, both because of a proposed exemption for regulated financial services and because asset management services generally would not meet the definition of ADS or CFB activities.
Depending on the final proposals, other players in the asset management space may face different results:
Because of the financial services exemption, determining Pillar One’s potential impacts is fairly straightforward in most of these cases.
Determining the potential impacts of Pillar Two is more complex. This pillar aims to ensure international companies are subject to a minimum level of tax and prevent them from shifting profits to low-tax jurisdictions. Like Pillar One, the Pillar Two minimum tax will likely apply based on a revenue threshold, which will probably mirror the threshold for country-by-country reporting, which is based on consolidated group revenue of 750 million euros (EUR) in the preceding year.
So how is Pillar Two likely to affect players in the asset management industry?
Comments received by the OECD during a public consultation have highlighted a number of potentially unintended consequences if Pillar Two applies to investment funds that consolidate with investors or with lower-tier entities. In those cases, double taxation could arise if the income of the fund is subject to the minimum tax and the investors are subject to tax on their share of fund income under existing income tax rules. Comments have requested a number of changes to the proposed rules to avoid those seemingly unintended consequences.
Concerns also raised the possible impact on investments in infrastructure. For example, there are questions about whether a project company that holds or operates the investment is engaged in a trade or business so the exclusions for investment funds would not apply. Additional concerns relate to the treatment of intangible assets in infrastructure projects.
There are some strong policy arguments for exempting infrastructure investments from the rules. Many governments provide tax incentives to stimulate these investments, and it’s expected that activity in the sector could help fuel economic recovery. Applying Pillar Two could negate tax incentives intended to encourage new projects. Further, income from infrastructure is usually recognized in the jurisdiction of its location, whether by law or for practical reasons, leaving little opportunity for the type of profit shifting that Pillar Two aims to address.
While the Inclusive Framework has set a deadline of mid-2021 to reach an agreement on Pillars One and Two, there’s no guarantee that the 125+ member countries of the Inclusive Framework will succeed in reaching consensus on the proposals. If they do not, asset managers may need to contend with even more uncertainty and tax risk in the coming years, especially given recent statements that the European Union may move ahead with its own digital levy and a provision similar to Pillar Two. More broadly, lack of a consensus deal would increase the likelihood that other jurisdictions move forward with digital services taxes, their own versions of Pillar Two, and other unilateral measures.
For now, asset managers would do well to examine how their organizations, investments and returns may be affected under the range of possible scenarios. They should also think about contingency plans for revising international structures, payment arrangements and holdings to minimize BEPS 2.0’s potential impacts on their global tax situation.
The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of U.S. Treasury Department Circular 230.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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The original author of this article is Michael Plowgian, KPMG US