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Transfer pricing for financial services

Transfer pricing and evolving operating models

Innovations, such as changing platforms and fast-moving technologies, are having a significant impact on value creation in many areas of financial services, altering many value chains and defining new ones.

This is one of the most interesting and important elements of transfer pricing for financial services and – in a post-BEPS (Base Erosion and Profit Shifting), digital world – it deserves a careful look.

The BEPS project aligns profits with value creation. If the business’s value chain shifts, whether from the creation of technology intangibles, brand intangibles, the value of data, the role of synergies and network effects, or other factors, the group needs to be prepared to explain and to defend their models when the tax authorities start asking questions.

One thing is for certain: with the pace of commercial change, if a financial institution’s transfer pricing does not properly reflect value creation now, this misalignment is only likely to increase in the years ahead.

Some context

In many financial institutions (FIs), capital and key functions such as trading take centre stage when setting transfer prices and allocating profits. A FI’s, often significant, technology and other intangible costs are commonly shared and recharged across the group on a cost-plus basis. Sometimes this is with a single entity owning the intangible and in others through joint intangible ownership across the group, for example via a cost share. In many cases, this all still makes sense particularly where technology, data and other intangibles are not market differentiators creating significant value. 

So why look now?

We are having many discussions with our clients in this area for a number of reasons:

  1. The pace of commercial change: Financial institutions are responding to digital developments and the changing role of technology in their businesses. In addition, new business models are leading to increasing competition between established financial firms and disruptor fintechs.
  2. BEPS and a renewed focus on value creation: The BEPS project re-emphasises the need to reward value creation, causing taxpayers to ask whether intangibles and the functions supporting them are properly rewarded for the value they create in our varied business lines. Development, enhancement, maintenance, protection and exploitation (DEMPE) of intangible assets need to be assessed alongside key risk management activities and may require a significant share of entrepreneurial reward.
  3. Tax authority interest: Tax authorities around the world are raising questions about intangibles and their role within the financial services industry, with brand and technology IP charges being scrutinised by tax officials more than ever before. The UK’s profit diversion compliance facility and other similar initiatives identify ‘hallmarks’ of BEPS behaviour and insufficient rewards for centrally provided value, including intangibles, are likely to be challenged.
  4. Non-tax reasons to identify and value intangibles: Evolving regulation and industry developments mean intangibles are recognised and sometimes valued for non-tax purposes. This is happening particularly as banks have worked to ring fence their retail operations and also as FIs establish new entities in Europe as a result of Brexit. It is difficult to argue for tax purposes that there are no intangibles in the value chain if these are declared and recognised elsewhere for other reasons.
  5. Availability of incentives: The development of intellectual property can qualify for tax incentives in different countries. R&D credits, patent and innovation boxes and the US’s foreign derived intangible rules can provide significant benefits.
  6. OECD developments, including digital economy proposals and digital services taxes: Current OECD work is likely to change the environment around corporate tax again, with much of the focus being on how to tax digital business models. Potential solutions, for example around marketing intangibles, would have a significant impact on the financial services industry. 

Recommendations for taxpayers

Now is the right time to take a fresh look at value creation and the value chain. This will help position a financial services group to manage transfer pricing risks in the coming months and years. It may also help move toward an optimal tax model that properly identifies value-creating assets, recognising profit where it is due while taking advantage of tax incentives available to R&D activity and technology assets.

We recommend taxpayers analyse value chains through a BEPS lens, prioritising business lines where the role of technology, brand or data has evolved in recent years. This may include: customer facing business lines in a retail insurer, bank or wealth manager; FX or equities trading, where increasingly business is done exclusively through a trading platform with limited role for traditional voice based sales; algorithmic trading; or businesses such as custody or research, where the role of and value of data (and associated AI solutions employed to interpret this) is increasingly being recognised.

This analysis will create an up to date view of value creation across business lines, enabling the group to update its pricing model to reward the value-add of intangibles and demonstrate full compliance with BEPS and local tax rules to tax authorities. 

This article was co-authored by Richard Murray and Maggie Fritz, contact them below:

Richard Murray

Partner, Transfer Pricing

Richard.Murray@kpmg.co.uk

+44 20 76948132

Maggie Fritz

Principal, Tax, Transfer Pricing 

mjfritz@kpmg.com

+1 212 872 7882