Podcast transcript: How the Pillar Two rules may impact Oceania financial services groups

Tony Merlo: 

Hello everyone, and thank you for joining this edition of the EY Oceania BEPS 2.0 podcast series, where we discuss the latest developments and our subject-matter professionals from around the EY organization provide their practical insights. 

My name is Tony Merlo, and I'm the Tax Policy Leader for Oceania at Ernst & Young in Australia. 

Joining me today is Jacqueline Bennett, who is an International Tax Partner in EY Australia’s Asia Pacific Financial Services team based in Sydney. 

I'm very keen to hear from Jacqueline today about how the BEPS 2.0 rules will impact the financial services industry, which of course spans a very broad spectrum of sub-sectors. 

So Jacqueline, how does BEPS 2.0 affect the financial services industry and what are the specific issues that impact particular parts of the industry? 

Jacqueline Bennett

Hi Tony. I mean, while the big picture issues are obviously the same across all industries, there are some areas that require specific focus for financial services organisations. 

And if we start with insurers, they really need to work through the model rules and how they may be impacted. 

The first point that I want to make is the difference between captive insurers versus traditional insurers. 

Because as we know, Tony, Pillar One is not expected to apply to regulated financial services entities. And so, for this reason, commercial insurers should be carved out of Pillar One, which means they really need to closely focus on Pillar Two. But captive insurers are expected to be in scope for both Pillar One and Pillar Two. 

So just making a couple of points around Pillar Two and commercial insurers. The first point is that in calculating the ETR, which obviously is compared back to the minimum 15% rate, certain deferred taxes are taken into account where the deferral is under five years. Now, many deferred taxes across the insurance industry, crystallise only well into the future. 

Now, the model rules do recognise this to a certain extent, but there are still expected to be some specific insurance deferred taxes that are not able to be taken into account when calculating the ETR, and this may be quite problematic. 

The second point is that taxes paid in respect to returns to policyholders are carved out of covered taxes. The model rules currently provide that policyholder tax is carved out of the numerator, but not clearly carved out of the GloBE income (being the denominator), and this is likely to worsen the ETR for certain insurance groups, and that's going to really require close attention as well. 

And the third point to make is that, as we've heard on previous podcasts, there are some substance-based carve-outs which are going to be really helpful for organisations with tangible assets and teams of people. But for many financial services organisations, of course, these carve outs won't be of significant help as they leverage capital and risk, which doesn't necessarily rely on a tangible asset-intensive activity. 

And I think as a final point to make, which is critical for the financial services sector: organisations requiring regulatory capital to operate - the application of these rules could see tax being paid in a location and by an entity that's got nothing to do with the entity to which the tax relates, and this could have very real regulatory capital implications. 

So you see, Tony, it's not just about tax, but it's got a much broader implication for the way financial services organisations are structured and operate. 

Merlo:

Absolutely Jacqueline. I think your point around the regulatory capital issue is going to be a very key issue for both insurance and banking groups to manage. What other issues should banks be focused on? 

Bennett:

I mean at a very big picture level, as we all know, it's expected that the data gathering and analysing process will be very intensive and this is particularly so for banks, given they generally operate in a large number of jurisdictions, and frankly I think this is probably the number one challenge. 

In relation to the complexity of the various Pillar Two calculations, there are probably not as many issues for banking and capital markets clients as you may find in applying the Pillar Two rules for the insurance industry. And this is because banks are taxed on a fair value basis, so a lot of the complexity around deferred taxes, particularly for financial arrangements, should on the face of it go away. 

But given banks generally operate globally through branch structures for core banking activities, the precise application of the GloBE rules to permanent establishment structures will need to be worked through. And then, similarly to the insurance industry, the substance-based income exclusions may not be that helpful to the banking industry. 

Then lastly, other issues to be worked through and then you know this is just a couple of the key ones that that are being sort of considered at the moment, is the impact of pre-implementation tax losses and the impact of recognition of deferred tax assets. It is worth noting that some banks have losses tracing back to the GFC. 

And the second issue to think about is what accounts can be relied upon here in Australia or elsewhere for determining GloBE income calculations for branches. 

Thirdly, consolidated groups and loss sharing for branches is certainly an issue that's going to need to be considered.y

And then finally, the application of the rules to group financing structures will be important as well. 

I think, as a parallel consideration for banking clients, is that a lot of thought is going to need to be given to how these rules are going to impact the clients of banks and their products. 

Because, for example, certain banking products may eventually need to be priced higher to cover the top-up taxes imposed under the GloBE rules. 

Merlo:

Definitely a lot to consider, Jacqueline, thanks. How do you expect that the wealth and asset management sector to be most impacted? 

Bennett:

So, for WAM clients, it’s necessary to consider the application of the GloBE rules separately for the house, and for the funds under management. 

So, for most Australian asset managers, we wouldn't expect the revenue received, which is primarily management fees by the consolidated group to exceed the threshold of 750 million Euros. 

I mean, depending on the level of the management fees, this would likely require an in-scope manager to have AUN well in excess of 35 billion Euros. 

And then if you look at the funds themselves, they're generally expected to be out of scope, either because they don't consolidate or, for investment funds or real estate investment vehicles which are UPEs (the Ultimate Parent Entity) they’re specifically excluded from the GloBE rules, and similarly pension funds and government entities are also excluded entities. 

Also, in general, if you look at investors into funds, they don't typically consolidate with their funds, but it's worth considering that there may be exceptions to this, and an example of that would be where you have a sponsor who seeds the fund, and may be the majority or the sole investor in that fund for a period of time. 

Looking down at the fund structure, investment platforms and holding stacks should also be out of scope as they should be considered an extension of the fund where they're performing holding activities. 

And then, lastly, looking at the funds, and this is particularly relevant in a private equity context or potentially infrastructure funds, each underlying portfolio group then needs to be considered separately for the 750 million Euro revenue threshold. And so, to the extent that a portfolio is in scope, the rules quite possibly could have an impact on valuation and the GloBE rules certainly need to be addressed as part of due diligence going forward. And managers should be engaging with the tax department of their portfolios now making sure that BEPS Pillar Two is obviously on the radar if they're in scope, making sure that there are regular updates to assess, making sure that the impact assessment is starting and that the appropriate planning is underway. 

Merlo:

Thanks Jacqueline. So, what should all financial services organisations be prioritising and doing now to prepare for the rules? 

Bennett:

As we've heard on the previous podcasts impact of assessment for Pillar Two needs to start now. 

At a very high level, as we've heard before, there are three key components, the first one being ETR assessment. So for example, the EY Pillar Two modeling tool can be used to model the impact of the income inclusion rule under different scenarios. 

The second thing is reviewing the impact on existing structures and then considering what changes might need to be made to those structures. 

And then thirdly, the big one on compliance and data management. As we've heard, the data sources need to be identified. Available technology needs to be assessed, and planning for systems implementation needs to be undertaken, looking at how they're integrating into other tax and finance processes. 

Clearly, effective use of technology is going to be critical in effectively managing the additional data requirements and the compliance demands of Pillar Two, and this is going to be discussed in further detail in one of our next podcasts, with Caroline Wright from our Tax Transformation and Technology team, so do keep listening to hear more. 

Merlo:

Thanks, Jacqueline. Finally, how should the tax function be approaching the very important stakeholder engagement process? 

Bennett:

Tony, at its heart, BEPS Pillar Two is not just an issue for tax departments. Given the scope of the rules, key stakeholders at the C-suite level need to understand the impact on, realistically, multiple facets of their organisations. 

Firstly, stakeholder reporting needs to be considered, particularly the impact on shareholder returns and disclosure to investors if the ETR increases. 

The impact on the ESG strategies is also a critical aspect that will likely have profile within organisations. 

I think the next thing is obviously existing structures may need to be changed, as a result of, for example, recalibration of operating models. And this may include material legal entity rationalisation projects which, as we know, can soak up a lot of time and resources. 

And then, critically, the expected compliance demands created by the rules need to be flagged now. Whether it's reporting systems, and whether they can meet the demands, budgeting for additional tax department and other resources, as well as looking at automation of processes and overall spend on technology. 

And then lastly, I think this is important. Controversy management will continue to be important with these rules clearly bringing more scrutiny to cross-border arrangements.

And this, I think Tony, also plays into the ESG agenda as companies want to be seen to be doing the right thing and having their tax contribution recognised. 

Merlo:

Thanks Jacqueline, as I'm sure our listeners will agree a heightened focus on BEPS 2.0 has really been necessitated with the release of the model rules in December. 

Still much more to come, not just from the OECD but also from individual countries as they proceed to implement the model rules in practice. 

We'll continue to explore these and other developments with other subject matter professionals in future sessions. In the meantime, thank you to Jacqueline for your thoughtful insights. 

Thank you all for joining us and until next time, take care.