On Sept. 16, 2014, the Organisation for Economic Co-operation and Development (OECD) announced the first seven recommended measures in its 15-part Base Erosion and Profit Shifting (BEPS) Action Plan. With the plan, the OECD is working to create a single set of international tax rules to eliminate aggressive tax planning which erodes the taxable income base of multinationals and shifts profits to low-tax jurisdictions.
In the OECD’s announcement, Secretary-General Angel Gurría said, “The G20 has identified base erosion and profit shifting as a serious risk to tax revenues, sovereignty and fair tax systems worldwide. Their recommendations constitute the building blocks for an internationally agreed and co-ordinated response to corporate tax planning strategies that exploit the gaps and loopholes of the current system to artificially shift profits to locations where they are subject to more favorable tax treatment.”
The OECD recommendations will remain in draft form until the remaining elements of the BEPS Action Plan are presented to the G20 governments for final approval in 2015. The project aims to not only help governments protect their tax bases, but also offer increased certainty and predictability to taxpayers.
The following are the first seven elements of the BEPS Action Plan:
- Tax challenges of the digital economy
- Hybrid mismatch arrangements
- Harmful tax practice
- Tax treaty abuse
- Transfer pricing issues in the key area of intangibles
- Feasibility of developing a multilateral instrument to amend bilateral tax treaties
- Transfer pricing documentation and a template for country-by-country reporting
Action 1 – Tax challenges of the digital economy
Tax challenges of the digital economy have been at the forefront of ongoing discussions amongst politicians and tax authorities from jurisdictions across the globe. The OECD Task Force of the Digital Economy (Task Force) was established to create a report on the tax challenges present in the digital economy. The Task Force concluded in its report that it would be difficult, if not impossible, to address the digital economy as a separate economy because it is effectively becoming the economy itself. Thus, due to the difficulty in parceling out the digital economy for tax purposes, specific structures utilized by multinational corporations were analyzed, focusing on key features of the digital economy and evaluating which of those features present overall tax challenges or concerns.
The Task Force highlighted the following key features that present challenges in the digital economy:
- Core business activities or artificial arrangements that avoid permanent establishment status;
- The importance of intangibles, the use of data, and the spread of global value chains, and their impact on transfer pricing methodologies;
- The need to fine-tune controlled foreign corporation (CFC) rules relating to intangibles and the income generated in the digital economy through sales of digital goods and services; and
- Focus on administrative procedures designed to collect VAT in business-to-consumer transactions.
The Task Force also identified developments in the digital economy which require monitoring in order to analyze and evaluate the potential impact on future tax systems. Emerging trends include:
- The Internet of things;
- Virtual currencies;
- Advanced robotics and 3-D printing;
- The sharing economy;
- Access to government data; and
- Reinforced protection of personal data.
The Task Force will continue to evaluate and assess potential tax challenges in the digital economy related to nexus, data, and characterization. Further, the Task Force is to make certain the key features of the digital economy are properly addressed in other areas of the BEPS Project that present tax challenges or concerns. The Task Force will present a supplementary report by December 2015.
Action 2 – Hybrid mismatch arrangements
Action 2 of the BEPS Action Plan provided two sets of recommendations. Part I of the report provided a number of recommended domestic rules to neutralizing the effect of the mismatches resulting from payments made under a hybrid financial instrument or payment made to or by a hybrid entity. The hybrid mismatch rules seek to align the tax treatment of an instrument or entity with the tax outcomes in the counterparty jurisdiction without disrupting commerce. The report specifically focuses on arrangements involving dividend exemptions, duplicate deductions, bringing the income of the hybrid under the local tax net, and reverse hybrid entities which are part of a consolidated group. The hybrid mismatch rules recommended by the OECD are broken down into two categories: primary response and defensive rule. According to the report, a defensive rule should apply where there is no hybrid mismatch rule in the other jurisdiction or the rule is not applied to the entity or arrangement.
Part II of Action 2 recommends changes to the OECD Model Tax Convention to address hybrid entities as well as other transparent entities. The OECD sought to prevent the use of dual-resident entities to obtain treaty benefits, while deferring to domestic laws on issues related to tax avoidance strategies involving dual-resident entities. In addition, Part II recommends the inclusion of a provision within the OECD Model Tax Convention which will capture the income of transparent entities in accordance with the OECD’s Model Tax Convention applicable to partnerships. Finally, the report reaffirms the OECD’s previous stated commitment to ensure bilateral tax treaties address double taxation without creating tax avoidance loopholes.
The report did not provide any guidance on the application of rules to the hybrid regulatory capital that is issued intragroup. Additional guidance is also needed to clarify whether income taxed under a CFC regime should be included in ordinary income. While further discussions are required on the open items, the OECD had committed to publishing its commentary on issues by September 2015.
Action 5 – Harmful tax practice
A portion of the OECD’s Action Plan addresses the methods and actions meant to “counter harmful tax practices more effectively, taking into account transparency and substance.” More specifically, Action Item 5 of the plan requires generally that “substantial activity” exist before granting the benefits of a “preferential tax regime.” Furthermore, the plan places a renewed focus on improving the transparency of rulings related to such preferential regimes.
The harmful tax practices contemplated by the report often result from tax regimes which commonly offer reduced or zero-percent effective tax rates, limited or no substantial activity criteria, and little or no transparency or information exchange with respect to a given regime. Here, a “preferential tax regime” means that such a regime applies to income from geographically mobile activities, such as financial and other service activities (including the provision of intangibles), and which relates to the taxation of the relevant income from such activities. As an example, a preference may be as simple as a reduced rate of income tax on a specific type of income. However, a preference may also take the form of a reduced tax base or certain advantageous terms for the payment (or repayment) of taxes.
The OECD’s report takes care to highlight that it is the very nature of these types of activities (especially with respect to intangibles) that enable taxpayers to easily shift the activities from one country to another for tax purposes. Where taxpayers actively engage in efforts to deliberately shift the activities under preferential tax regimes, the tax bases of deserving countries are eroded, and the location of capital and services can become quite distorted. By further developing the substantial activity and transparency models within this project, the OECD is hoping to support the effective fiscal sovereignty of countries over their respective tax systems as well as enhance the ability of countries to react (in a defensive manner) against the potentially harmful practices of others.
The “substantial activity” requirement was designed to deter companies from artificially shifting otherwise taxable income away from the country wherein the value was actually created. In recent years, tax authorities the world over have seen growing efforts to shift certain income streams from one country to another, in many cases driven purely by tax motivations. For example, income arising from certain intellectual property (IP) rights has been given considerable attention in efforts to achieve lower effective income tax rates through migrations. As countries have implemented tax incentives for research and development, investment, and related activities, the potential for harmful tax practices has increased. Therefore, the OECD considered three different approaches to requiring substantial activities in an IP regime. After review, the transfer pricing approach and a nexus approach were given merit for purposes of determining whether “substantial activity” exists. Ultimately, these approaches are meant to help regimes limit preferences to only those taxpayers with appropriate levels of activities taking place within a respective country.
In its work on transparency and exchange, the OECD is aiming to eliminate issues which could make it harder for a home country to take certain defensive measures. The report notes that a lack of transparency can arise (1) in the way in which a regime is designed and administered, including favorable application of laws and regulations, negotiable tax provisions, and a failure to make administrative widely available, and (2) the existence of secrecy laws or other information requirements that may prevent the effective exchange of information. To remedy this issue and help install and/or improve transparency, the focus has been on developing a framework under which a requirement would exist for countries to provide unsolicited information on relevant rulings. The framework was designed to ensure important information related to preferential regimes is shared between countries, enabling each to modify or enact policy to appropriately respond to rulings as needed. The framework sets forth a hierarchy for determining when obligations to exchange information arise, the types of information subject to the process, who the information must be shared with, and confidentiality requirements, among others.
Action 6 – Tax treaty abuse
Action 6 of the BEPS Action Plan focuses on the perceived abuse of tax treaties and provides recommendations to address treaty shopping practices. If implemented by the member countries, the proposals may affect treaty benefits currently available to multinational enterprises under the existing treaty network.
The report recommends the inclusion of two anti-abuse rules in the OECD Model Tax Convention: a limitation of benefit (LOB) provision and a general anti-abuse rule, the so-called principal purpose test (PPT).
The proposed LOB rules closely resemble the provisions currently found in treaties concluded by the US and few other member countries. The provisions effectively prevent access to treaty benefits for those resident entities that do not have sufficient connections to the country of residence, whether in terms of legal ownership or business operations.
The LOB rules, for the most part relying on objective criteria, are coupled with the more general and subjective PPT, a “catchall” anti-abuse provision targeting treaty shopping practices—for example, certain conduit arrangements—that could escape the LOB net. Under the PPT, a tax benefit otherwise available under a tax treaty could be denied when it is reasonable to believe, based on the analysis of all the facts and circumstances, that obtaining the benefit was “one of the principal purposes of the arrangement” giving rise to the item of income.
From a tax policy perspective, the report calls for a clear acknowledgment by the member countries that the prevention of tax evasion and tax avoidance is one of the main purposes of a tax treaty, along with the prevention of double taxation. The limitation of abusive practices intended to attain “double nontaxation” should therefore become part of the tax policy considerations of the member countries before entering, modifying, or terminating a tax treaty with another country. Furthermore, the report endorses and recommends the use of domestic anti-abuse laws by the member countries to effectively prevent treaty benefits from being granted in inappropriate circumstances.
Action 8 – Transfer pricing issues in the key area of intangibles
A significant point made by the OECD in Action 8, with respect to special measures, stated it will not be constrained by the arm’s-length principle and is considering going beyond this principle for hard-to-value intangibles. One potential special measure involves the elimination of “cash boxes” (i.e., preventing excess returns to be earned by legal entities set up in tax havens by multinationals where their only activities are the ownership of intangibles and funding of its development). In the case of cash boxes, the OECD is considering treating these entities as lenders rather than equity investors. Other special measures being contemplated include granting authority to tax administrators to apply rules based on actual results of hard-to-value intangibles; requiring contingent payment terms or application of profit split methods; and application of rules similar to Article 7 of the OECD Model Tax Convention, involving thinly capitalized or minimal function entities.
With regard to Action 8 – Intangibles, a segment of the final content will be affected by the subsequent deliverables that will be completed by the OECD over the course of the next year (areas to be addressed include risk, re-characterization, hard-to-value intangibles, and special measures). As such, parts of the intangibles report now serve as temporary guidance. Some of the primary points of guidance from Action 8 include the use of profit split and unspecified methods; hard-to-value intangibles, and ownership of intangible assets. Other key aspects of this guidance are renewed emphasis on detailed functional analysis, use of databases, and the assumption of risks.
Action 13 – Transfer pricing documentation and a template for country-by-country reporting
Action 13 provides updated guidance in the area of transfer pricing documentation, which is critical to ensure that transactions occurring among related parties across tax jurisdictions are priced using the arm’s-length standard. The report outlines three key objectives of transfer pricing documentation: (1) to ensure taxpayers appropriately consider transfer pricing requirements when establishing prices for related party transactions; (2) to provide tax administrations with information needed in order to perform transfer pricing risk assessments; and (3) to provide tax administrations with high-level information sufficient enough to conduct initial inquiries related to transfer pricing audits. On one hand, tax authorities need relevant, reliable, and sufficient data in order to appropriately select taxpayers and important transactions for audit. At the same time, taxpayers are interested in minimizing compliance costs and mitigating inappropriate use of transfer pricing information.
Keeping these objectives and considerations in mind, the OECD’s Committee on Fiscal Affairs (CFA) has provided guidance around three main tiers of required documentation: the master file, the local file, and the country-by-country report.
The master file gives an overview of the transfer pricing considerations of the multinational enterprise. It includes an organizational structure chart, a detailed description of the enterprise’s worldwide business, lists and descriptions of the enterprise’s R&D activities and intangible assets, description of enterprise and intragroup financing activities, and an overview of the enterprise’s overall financial and tax position. This high-level snapshot is primarily qualitative in nature and is intended to provide context to the multinational enterprise’s transfer pricing practices as a whole.
The local file is both qualitative and quantitative in nature, supplementing the master file by providing more detail. The local file is prepared specifically for a given tax jurisdiction and includes local entity overview information, information regarding controlled transactions, and financial information. The focus of the local file is material intragroup transactions in the context of the local country’s tax position and return.
The country-by-country report provides in tabular format an overview of how the multinational enterprise has allocated its income, taxes, and business activities across the various jurisdictions in which it does business. This report is highly quantitative and summarizes for each tax jurisdiction revenue (related party and unrelated party), pre-tax income or loss, income taxes paid and accrued, stated capital, retained earnings, number of employees, and tangible non-cash assets. In addition, a summary is provided for each jurisdiction regarding entities resident in the tax jurisdiction as well as the entities’ main business activities.
While the local file would be submitted to the local tax administration, the CFA will continue to analyze options for filing the master file and country-by-country report and oversee review and implementation of these guidelines.
Action 15 – Feasibility of developing a multilateral instrument to amend bilateral tax treaties
Action 15 discusses the benefits of a multilateral agreement as opposed to renegotiating many bilateral tax treaties. Under the current treaty system, there are common principles to eliminate double taxation. However, due to the number of existing bilateral treaties there are unfavorable tax results for certain jurisdictions. With the evolution of globalization, the growing number of treaties have created gaps between different countries’ tax systems and made it more favorable to do business in one country than another, impacting trade. Furthermore, current bilateral treaties facilitate base erosion and profit sharing.
According to the report, updating the current tax treaty network would be highly burdensome as it takes a substantial amount of time and resources to introduce new bilateral treaties. Nevertheless, governments have agreed to explore the feasibility of a multinational agreement that would be a modification of certain existing treaties. The first action step is focused exclusively on base erosion and profit sharing with future focus on other unidentified areas within current bilateral treaties. As a result, all nonbase erosion and profit-sharing issues would still be enforced through current bilateral treaties and not a new multilateral treaty.
While it appears a multilateral treaty is desirable, the question is whether this objective can be met based on the complexity of current bilateral treaties. These Action 15 outputs will be delivered by OECD in 2015.
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