The latest news on the Pillar 1 negotiations indicates an emerging uncertainty on the question of whether the financial services sector should or should not be included within the scope of the new arrangements. This is a significant development because agreement on an exemption for the financial services sector was largely agreed under the previous version of the Pillar 1 scoping, as for example reflected in the Pillar 1 Blueprint document of October 2020.
The question of whether to include financial services within the scope of Pillar 1 might seem a pretty straightforward issue that is capable of ready resolution. Given the significance of the potential financial services contribution if it were included, there is clearly a lot at stake. However, the issue provides yet another example – if one were needed – of the very difficult issues raised at every step of the negotiation process and the fact that, in Pillar 1, nothing is ever straightforward.
The financial services question raises a number of acute technical, practical and political difficulties.
From a technical perspective, one immediate problem is that the way banks account for their revenues and profits is different to other taxpayers. For financial reporting purposes, banks report trading revenue net of trading costs and interest revenue net of interest expense. Reporting revenues net of trading and interest costs in this way presents a different (reduced) measure of revenue but grossing up these revenues by trading costs would most likely mean that no financial services group would ever have an operating margin above 1%. This obviously means that the consolidated financial statements of banks are not directly comparable to other taxpayers, raising a host of questions such as whether a different metric should be used to assess profitability (such as a return on assets or capital) and how any such metric could meaningfully – and fairly - be applied alongside the accounting profitability metric that is applied to other multinational groups. This is not the only technical difficulty. For example, there may also be possible conflicts with regulatory requirements under Basel and Solvency II requirements for the booking of profits or the maintenance of capital. And in the insurance sector returns are often determined over a much longer period than other industries given that risk may be assumed with an uncertain timing of an insured event over a multiple year business cycle.
In connection with practical issues, the problems experienced by multinational groups generally are likely to be multiplied for many financial services institutions by the vast number of different - and sometimes interlinked - transactions entered into, the very large number of separate legal entities that typically comprise financial sector groups and the large number of business lines that may be operated, with variations in the pattern of all these transactions, entities and business lines from market to market and region to region. Leaving all those issues to one side, the inclusion of the financial services sector would also raise a potentially mammoth set of “revenue sourcing” issues (i.e. making sure that the appropriate source market for revenues can always be identified, notwithstanding the role of financial intermediaries, linked transactions, packaged transactions, etc), raising the question of the degree to which any wished-for inclusion could actually be delivered in practice.
Then there are the political issues. The financial services inclusion question re-opens a debate that had been broadly done and dusted in the negotiation process to date (in favour of a conclusion to exempt the financial services sector from the terms of Pillar 1). That conclusion was reached under the previous scoping parameters and on the basis of a fairly detailed analysis of the relevant policy, technical and practical arguments. The US-driven changes to the scoping of Pillar 1 (specifically, the shift from the former scoping by reference to consumer facing business and automated digital services to the currently proposed approach based only on size and profitability) is now seemingly having the effect of opening up the financial services inclusion issue once again. That may be more than some delegates to the OECD discussions are willing to accept, for example on the basis of the objection that the scoping changes were made to accommodate US preferences and should not be having a knock-on impact on the settled preferences of other states.
There are therefore some considerable difficulties behind the simple issue of whether financial services should or should not be included in the scope of Pillar 1. But, on the other hand, and as noted above, there is clearly a lot at stake in terms of the potential revenues that the financial services sector could contribute to the Pillar 1 re-allocation of taxing rights.
The nature of these difficulties discussed above, combined with the size of the potential revenues at stake, should ideally mean that the issues are carefully explored and assessed before a conclusion is reached that appropriately balances – or perhaps in part accommodates - the competing arguments. But that would require the one commodity that is in ever-shorter supply in this process, namely time.
As noted, nothing in Pillar 1 is straightforward.