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Roboadvisors: what are they and what advantages do they have over traditional advising?

Luis de la Peña and Francesc Cholvi, partner and senior associate respectively, of the Garrigues Corporate Department; and José Carlos Ruiz, principal associate at Garrigues Tax Department.

In this article, we analyze the main differences between roboadvisors and traditional investment advisors, as well as the pros and cons of automated portfolio management. We will also address how roboadvising is regulated in Spain and what requirements has established the CNMV for these fintech operators.

The so-called roboadvisors, also known as fintech advisory companies or automated portfolio management companies, are among the main operators harnessing today’s sophisticated financial technology for its use in the financial system. Roboadvisors are software-based technology platforms through which automated portfolio management and/or advisory activities are provided, which could even include the execution of orders on behalf of clients, i.e., the provision of automated investment services.

Roboadvisors first became popular in 2008 in the United States, as an after-effect of the international financial crisis that, along with the market’s loss of confidence in traditional financial sector agents, spurred the proliferation of artificial intelligence-based technology platforms geared towards the provision of investment activities and services with lower costs and greater efficiency and profitability than traditional players.

Nevertheless, during the management of the assets or the provision of advice there may or may not be some human involvement, with a distinction being made between pure roboadvisors, if these are fully automated, and hybrid roboadvisors, if they have an investment committee entrusted only with taking decisions based on the conclusions put out by the software.

How are roboadvisors different from traditional advisors? What are the pros? And the cons?

The main difference between roboadvisors and traditional investment services providers lies in the fact that the process is fully computerized through the use of algorithms determining the roboadvisor’s investment decisions or recommendations.

From the client’s perspective, roboadvisors offer several advantages over traditional financial advisors, both in terms of costs and operating procedures.

The main advantage for investors is that costs are lower thanks to a structure based on automation and economies of scale, by means of which roboadvisors can charge clients lower fees or even regular flat fees charged monthly, quarterly or annually. In addition, the marginal cost for each new client is also very low, since roboadvisors do not require human resources to analyze clients’ financial situation or to make recommendations, manage portfolios and execute orders.

Secondly, roboadvisors allow for greater diversification of products, lowering the barriers for entry to financial services, since initial investments are minimal and, in many cases, substantially lower than those required by traditional advisory services. This allows investors to diversify their risk by investing in a broader range of products, with a lower cost than in traditional services.

Moreover, roboadvisors offer a greater accessibility for clients, since clients can manage their investments online, any time, from anywhere in the world.

Furthermore, in terms of transparency, automation and computerization of processes brings greater traceability to the recommendation process and to the execution of orders on behalf of clients, which helps clarify any incidents that may arise during the provision of these investment services.

Lastly, roboadvisors could be considered to contribute to a more efficient financial advice, since the use of software programs minimizes the risk of human error and avoids all types of emotional bias, eliminating or notably reducing any conflicts of interest. Plus, by harnessing the power of artificial intelligence, these platforms can process and analyze large amounts of data, making it possible to observe real-time market trends quickly and objectively.

Notwithstanding the above, the automated provision of this type of investment service is not without its drawbacks or shortfalls, the most significant ones being (1) potential lack of transparency on the automated decisions taken by the roboadvisor in making its recommendations (the so called “black box risk”), which may entail some difficulties in the supervision by regulators, and (2) .that roboadvisors are fully dependent on technology systems, which could expose investors to potential risk situations derived from cyberattacks or IT glitches or outages.

In addition, the fact that the processes are automated deprives investors of any direct contact with their financial advisors, as is enjoyed in traditional advisory services, means that investors cannot ask questions and that advisors cannot pick up on certain nuances that could prove useful when issuing investment recommendations. This lack of human interaction can lead to an incomplete analysis of investor profiles, if the investor does not have sufficient financial knowledge to interpret the suitability questionnaires offered by the roboadvisor.

Regulation on roboadvisors in Spain

Investment advice, portfolio management and/or execution of orders on behalf of clients, all of which fall under the category of investment activities and services, can only be carried out by investment services firms, which are regulated, registered and supervised by the CNMV subject to the particular features of their computerized organization and activity.

In that regard, the provision of advisory or portfolio management services, whether traditionally or through automated platforms, is subject to the same financial regulations.

Accordingly, those roboadvisors wanting to operate in Spain must request the pertinent prior CNMV authorization to provide investment services. To secure this authorization, they must meet certain requirements based on the activity they intend to carry out and the type of clients they target, as well as the other conduct of business rules set out in the Revised Securities Market Law and other applicable legislation derived from Directive 2014/65/EU of the European Parliament and of the Council, of 15 May 2014, on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, known as the MiFID II Directive, and its implementing and transposition legislation in Spain.

Depending on the activity they carry out, roboadvisors may take a number of legal forms under the investment services firm umbrella, the most common being financial advisory firms (EAF, in Spain).

As investment services firms, roboadvisors are subject to strict supervision by the CNMV, entailing, among other aspects, periodic filing of reports and financial statements with various regulatory bodies, so the latter can verify that the roboadvisors are correctly fulfilling their obligations, thereby protecting the consumers of these services.

In terms of obligations with clients, roboadvisors are required to gather client information by carrying out suitability tests and, in particular, to obtain information on clients’ investment objectives, knowledge, experience and financial situation, including, of note, clients’ capacity for loss.

As regulated entities in the investment activities and services sector, roboadvisors are also required to enter into a written base contract with each client, detailing the rights and obligations of both parties, and to keep a record of such contracts.

Lastly, it is important to note that roboadvisors have been operating in Spain, and quite successfully, for some time now.

Some tax considerations regarding roboadvisors and their services

One of the relevant issues in the field of direct taxation of non-resident entities that provide these services is the possible existence of a permanent establishment (PE) in Spain. In this regard, binding ruling V0066-18, of January 17, 2018, from the General Directorate of Taxes (DGT) is particularly interesting. This is a case of an Irish entity whose main activity is the electronic and algorithmic trading of financial products. To reduce the latency of the network in the system, it is intended to use a server in Spanish territory that would be located very close to the markets where it would carry out its trading operations. The DGT reviews the comments on the OECD model Convention regarding the concept of PE in the specific context of electronic commerce to come up with a list of the requirements that it considers should be met for the use of servers in Spain to constitute a PE for the purposes of Double taxation agreement with Ireland. In this regard, in addition to having a fixed place from where part of the activity is carried out (which can be fulfilled by a server), it is relevant that it can be considered that said server is at the disposal of the non-resident (which would be fulfilled if is owned or leased, unlike the case in which you simply use the software and data hosting services, as a cyber-site) and that the activities carried out is not merely preparatory or auxiliary, but main or core functions. All this requires a functional and factual analysis of the activity in Spain through the server. In any case, the taxation of businesses with a strong digital presence is currently one of the most debated issues at the international level, so it is a matter that will foreseeably evolve in the medium term.

With regard indirect taxation, commissions for the discretionary portfolio management service are subject to and not exempt from Value Added Tax (VAT) since the change in criteria of the DGT in 2013. Therefore, in the case of entities resident in Spain providing these services, the 21% VAT will be passed on to the investor. In the case of non-resident entities, the residence of the supplier and the place of supply rules must be taken into account.

Regarding the tax implications for the investor, in the case of an individual subject to personal income tax, the commissions paid will not generally be deductible. The DGT has confirmed that the management commissions that are paid periodically, the amounts of which are linked to the valuation of the portfolio or to the increase in its value during a given period, cannot be considered expenses inherent to the acquisition or transfer for the purposes to compute the capital gain or loss (for example, the binding query V0096-21, of January 28, 2021).

The rest of the tax implications for the investor will depend on the type of investments made through these services. It is common for investments to consist of mutual funds, in some cases listed or ETFs. It should be taken into consideration that in order for the rollover regime (“régimen de traspasos”) to be applied to European investment funds or UCITS, all acquisition, subscription, transmission or redemption operations are required to be carried out through a distributor located in Spain. This could be fulfilled, for example, if the entity that provides the roboadvisory service is also a Spanish distributor. In the case of ETFs, in general they would be excluded from the possibility of applying the rollover regime (which implies that each capital gain or loss due to portfolio adjustments must be included in the tax base, but without withholding taxes), without prejudice to the criteria of the DGT in the ruling V4596-16 of October 27, 2016 on ETFs listed outside of Spain (if the corresponding requirements are met). Note that the draft Law on prevention and fight against fraud includes a limitation with regard the application of the rollover regime to any ETF (if finally approved).

Finally, if the entity that provides the services were non-resident and the investments were deposited outside of Spanish territory, it is possible that the investor residing in Spain would be forced to submit the information model on investments abroad 720 if they are exceeded the established thresholds (in general, 50,000 euros).