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:
- Pillar One focuses on allocating taxing rights (including new nexus rules) for certain digital businesses and certain consumer-facing businesses.
- Pillar Two seeks to ensure that MNEs are liable for at least a minimum level of tax.
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 — Which asset management players may be affected?
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:
- Investors are not necessarily covered by the financial services exception. While institutional investors such as pensions or sovereign wealth funds will likely remain outside of Pillar One, multinational companies that are investors may be affected if they also engage in ADS or CFB businesses. Similarly, insurance companies that consolidate funds and underlying investments may be subject to Pillar One with respect to the ADS or CFB activities of those underlying investments.
- Investment funds that are regulated are expected to qualify for the financial services exception. Unregulated funds would not, but they are unlikely to be subject to the new taxing right under Pillar One because the fund entity itself does not generally engage in a trade or business, let alone an ADS or CFB business.
- Management companies and general partners are expected to qualify for the financial services exception if the fund or fund manager is regulated. Again, even if they are not, it’s hard to see how the services of the management company or general partner would qualify as ADS or CFB. The October blueprint recognizes that the services of the asset manager generally are provided to the fund itself, rather than to the investors, so even in the case of a retail fund there generally is no CFB. Similarly, the services provided by asset managers generally would not meet the definition of ADS. However, some business activities carried on by the largest players, like collecting and selling data, could be viewed as ADS, and there is an open question as to whether those activities would be carved out under the financial services exception or would be separately subject to the new taxing right.
- Portfolio companies are not excluded from the new taxing right under Pillar One, so it may apply to them under the general rules, depending on the company’s business model.
Because of the financial services exemption, determining Pillar One’s potential impacts is fairly straightforward in most of these cases.
Who’s at risk under Pillar Two?
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?
- Investors rarely consolidate with funds, so they are usually part of different consolidated groups— with some major exceptions. For example, some large insurance groups consolidate with non-wholly owned fund entities, so the investor could be subject to Pillar Two regarding the fund’s earnings. As currently drafted, Pillar Two would exempt excluded entities, such as pension funds and government entities, when they are the ultimate parent, but this exclusion does not apply to insurance companies.
- Investment funds generally are not consolidated with investors or management companies, and therefore are usually the ultimate parent entity of their group. If a fund is the ultimate parent entity and qualifies as an excluded entity, Pillar Two would not apply to the fund entity. Holding companies that are exclusively or almost exclusively owned by an excluded fund also appear intended to be excluded (provided that the holding company conducts no trade or business), but a technical glitch makes that result not totally clear.
- Management companies and general partners generally do not consolidate with funds, so Pillar Two would not apply to them regarding the fund’s income. However, the management companies themselves might be subject to Pillar Two if the management group meets the revenue threshold and earns income that has a low effective tax rate as calculated under the Pillar Two rules.
- Portfolio companies in most cases also do not consolidate with the fund. Pillar Two would apply to the portfolio company group if that group exceeds the revenue threshold.
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.
Monitor developments and plan for contingencies
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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