Pascal Saint-Amans, Director of the Centre for Tax Policy and Administration at the OECD, released the 2015 BEPS reports during a global webcast on Monday 5 October 2015. Consisting of 13 Final Reports and an explanatory statement, the package of measures has been adopted by the OECD Ministerial Council, and must now be adopted by the G20 finance ministers (8 October 2015, at Lima) and then the G20 Leaders (15-16 November 2015, at Antalya).
Notwithstanding the remaining formal authorisations, the OECD ‘body language’ is positive – confident the political consensus will carry the technical solutions into effect. There remain a small number of technical issues to resolve in 2016, but the focus of the BEPS Project Team has moved on to implementation issues, and monitoring.
In summarising the anticipated effect of the BEPS project, M. Saint-Amans expects a ‘paradigm shift’ in the corporate world’s approach to international tax planning. The existing international tax framework has proved to be no longer ‘fit for purpose’ in the digital age, and the gaps created have allowed actions, arrangements and structures to proliferate which, whilst not illegal, have nevertheless resulted in profit shifting and national tax base erosion.
The BEPS project has resulted in a ‘comprehensive, coherent and coordinated reform of the international tax rules’, which when implemented through international and domestic tax law changes, will close the tax gaps and make illegal what is currently (arguably) legal.
At that point, he expects corporates will respond positively and adhere to the new laws, with tax administrations far better equipped to deal with any continuing (illegal) non-compliance.
Speaking later, Raffaele Russo, Head of the BEPS Project, nominated a change in corporate tax payer behaviour as the best measure of the success of the BEPS Project. The corporate international tax function is expected to be redefined; no longer will it be a profit centre, but it will revert to its more traditional role as a support function.
And the size of the BEPS pot of gold?
Research released as part of the Project suggests the loss of global corporate tax is in the range of 4-10%, translating to somewhere between $US100bn and $US240bn annually. If sovereign nations were otherwise ambivalent about their commitment to the BEPS project, the opportunity to share in the spoils of this magnitude would act as a strong incentive to participate; and actively so.
Winners – and losers?
It is likely that to some extent, there will be winners and losers between nations, as the new tax rules begin to take effect. But the overwhelming recovery of tax will come from the corporate sector, with a likely unavoidable increase in the reported effective global tax rates for many large groups. It will be interesting to see how the stock market reacts to the prospect of increasing tax burdens.
Reports on the BEPS Action items
The BEPS project comprises of 15 action items. Of these, reports were issued in 2014 for 7 of the action items. The 2014 reports were considered ‘final’ at the time, but with the further work done during 2015, and to achieve better integration across all the action items, final reports have been issued in 2015 for each action item.
Action 1: Tax challenges of the Digital Economy
The digital economy is increasingly becoming the economy itself; it would be difficult, if not impossible, to ring-fence the digital economy. Ring fencing is not proposed.
The digital economy and business models do not generate unique BEPS issues, however they exacerbate BEPS risks.
Measures are proposed to strengthen the definition of ‘permanent establishment’ (PE) to reflect digital business models; to strengthen transfer pricing rules to align taxing rights with value creation; to strengthen controlled foreign countries (CFC) regimes; in all cases reacting to the changes brought about by digital business models.
There are broader tax challenges posed by the digital economy in addition to BEPS. In the tax area, these relate to issues of nexus of income with jurisdictions; how income from the use of data should be taxed; and the characterisation of income from certain digital transactions
In the indirect tax area, the International VAT/GST Guidelines have recommended adoption of the ‘destination principle’ for B2C transactions, with taxing rights given to the country of effective consumption. But the practical difficulties of implementing appropriate tax collection measures remain.
At this stage, recommendations have not been made to create a new deemed taxable presence to tax instances of ‘significant economic presence’ in a source country, in the absence of a minimum physical presence. Similarly, no recommendations are made to create a new withholding tax on certain types of digital transactions, or to apply a form of equalisation levy.
Whilst there are no recommendations to proceed down this path, the Report notes countries could pursue measures unilaterally, subject to compliance with international law and bilateral treaty obligations.
Given the OECD’s decision to not create a taxing right over a digitally significant economic presence, does this ‘strand’ Australia’s multinational anti-avoidance law, and the UK’s diverted profits tax?
Actually, no. Although the positions may appear inconsistent, the Australian and UK laws do no more than reinforce the integrity of the existing PE laws. Income will only be taxed in Australia and the UK to the extent that there is an artificially avoided PE within the country; and the income to be taxed is that amount which is properly attributable to that PE.
Beyond the present challenges, comes that of future change as digital business models continue to develop and create new and unexpected tax risks.
Action 2: Hybrid mismatch arrangements
Hybrid entities and hybrid arrangements have been at the heart of creating ‘stateless income’.
Different tax treatments in different jurisdictions are navigated so a mismatch arises, and income effectively disappears untaxed.
The 2015 report on action 2 supersedes the interim 2014 report. Much is the same – recommended changes to domestic tax law and international tax law will neutralise mismatches; will stop multiple deductions for single expenses; deductions without corresponding taxation; or the generation of multiple foreign tax credits for a single foreign tax payment.
The focus is not on cancelling the commercial validity of hybrid arrangements, but rather on cancelling the tax mismatch which can be generated.
The report calls for linked domestic tax rules which align the tax consequences of hybrid arrangements in the various counterparty jurisdictions.
The primary rule calls for a deduction to be denied to a taxpayer in its jurisdiction, unless the amount is taxable to the recipient in its jurisdiction.
If the primary rule does not apply, the counterparty jurisdiction can apply a defensive rule to tax the otherwise deductible amount, or to deny the double deduction.
International tax law changes are recommended to address dual resident entities, and hybrid entities which are not resident in any jurisdiction.
The 2015 report contains considerably more guidance and examples to explain the operation of the new rules. Additional work has been done, and is reflected in the 2015 report on asset transfer transactions (e.g. stock lending and repurchase transactions), imported hybrid mismatches and the interaction of some arrangements with the controlled foreign company rules.
Action 3: Controlled Foreign Company (CFC) rules
This report does not propose minimum standards for CFC rules, but rather lists design building blocks which will avoid profit shifting into foreign subsidiaries.
The report recognises that different countries assign different policy priorities to economic growth measures, and CFC rules must be sufficiently flexible to accommodate these variances, but subject to maintenance of the integrity of the international tax system.
CFCs appear to have presented some particular ‘consensus’ challenges, and the language of the report, and the flexibility permitted, suggests the position achieved was the ‘best available’ in the circumstances.
Action 4: Limiting interest deductions
Recommendations are made to adopt ‘best practice’ in the design of domestic tax laws to restrict base erosion through the use of interest expense.
A fixed ratio rule is proposed, limiting an entity’s net deductions for interest (and economic equivalents) to a fixed % of the entity’s earnings before interest, taxes, depreciation and amortisation (EBITDA). The fixed percentage is up to country choice but should be in a corridor of between 10% and 30% of EBITDA. The Report lists factors which countries could consider in settling the percentage limit to be adopted.
The fixed ratio rule could be supplemented with a worldwide group ratio rule, to allow for more highly leveraged groups. A company would be entitled to a tax deduction for net interest expense which exceeded the country specific fixed ratio limit, provided the deduction was within the group’s global net interest ratio. This additional rule is not mandated – it is up to country choice.
Various other potential exceptions are included in the Report, in particular a de minimis threshold and the proposed carry-forward of undeducted interest expense, to avoid potential double taxation.
Action 5: Countering Harmful Tax Practices
This report is concerned with preferential tax regimes which can artificially shift profits, and a lack of transparency in connection with certain tax rulings.
Preferential tax regimes will not be harmful where there is ‘substantial activity’ within the sponsoring country. The ‘nexus’ approach has been adopted which requires the taxpayer itself, and not outsourced associates, to incur the qualifying expenditure. Where the requirement is satisfied, the taxpayer can avail itself of the preferential tax regime.
The nexus approach was adopted in the context of IP regimes, but will apply equally to non-IP preference regimes.
Transparency is the other concern. Agreement has been reached requiring the exchange of rulings in the following categories:
- preferential regime rulings
- unilateral cross border advance pricing agreements
- downward profit adjustments
- PE rulings
- ‘other rulings’ which may raise BEPS risks
New rulings are to be exchanged with effect from 1 April 2016 and certain legacy rulings must be exchanged by 31 December 2016.
The report sets out the results of reviews of existing preferential tax regimes, in which all cases fell short of the nexus approach to the substantial activity requirement. Amendments will be required and monitoring will fall to the forum on harmful tax practices.
Action 6: Preventing Tax Treaty Abuse
All countries have agreed to adopt a ‘minimum standard’ of anti-abuse provisions to counter treaty shopping. The proposals are similar to the 2014 Report, although more flexibility is introduced. The changes should stop the use of ‘letterbox companies’ in jurisdictions of convenience.
The minimum standard calls for:
- inclusion in the preamble of a statement that the treaty is not intended to create opportunities for non-taxation or reduced taxation
- inclusion of a specific anti-abuse rule, the limitation on benefits (LOB) rule, which requires minimum ownership links between the entity and the state of residence
- a general anti-abuse rule, designed to counter instances of treaty abuse not covered by the LOB – the ‘principal purpose test’ where at least one of the principal purposes of the activity was to obtain treaty benefits to which the entity would not otherwise be entitled
Action 7: Preventing artifical PE avoidance
The language of Article 5 on PEs will be changed to make clear that commissionaire arrangements will no longer fall outside the definition of PE. This has been a major point of conflict between companies and tax administrations for an extended period, and significant business model restructuring is expected to follow this change.
Similar strategies – which separate in-country sales/negotiations functions from ex-country contract signing - will be brought within the amended definition of PE.
Changes will be made to the specified exceptions in Art.5(4). The language will now make clear that each of the specified exceptions must satisfy the ‘preparatory or auxiliary’ requirement; ie, in order for the source country activity fall within an exception and avoid constituting a PE in the country, the activity must be merely ‘preparatory or auxiliary’ in the context of the foreign entity’s business model. This change will result in a controlled warehouse in a source country, involved in the on-time delivery of goods within the country or region, and which is staffed by foreign entity employees, will now be deemed to be a source country PE of the foreign entity.
A new anti-fragmentation rule is also introduced, which will stop artificial segmentation of a cohesive business operation to sub-PE levels by taking advantage of Art.5(4) exceptions. Artificial manipulation of contracts to avoid PE time thresholds will be addressed via the principal purpose test, to be introduced under Action 6.
Now that the substantive work has been done in relation to the identification of a PE, follow-on work will continue in 2016 on the related issue of attribution of profits to these deemed PEs.
Actions 8-10: Aligning transfer pricing outcomes with value creation
The report strongly reinforces the use of the arm’s length standard, and in his comments, M. Saint-Amans specifically explained why that standard has been followed, rather than the alternative, global formulary apportionment (GFA) approach. The current arm’s length standard is not working, but the proposed changes will ‘fix’ it and that is preferable to changing approaches, particularly to an untried approach which has as many flaws as advantages. (M. Saint-Amans noted that the EU has been trying for 20 years to agree on a common consolidated corporate tax base for use by companies operating across Europe (ie a European limited form of global formulary apportionment) but without any success. He also noted that no country supported a change from the arm’s length standard to GFA.)
This one consolidated report covers the following the following work streams:
Action 8: intangibles
Action 9: contractual risk shifting
Action 10: other high risk areas, including re-characterisation of transactions that make no commercial sense
In common, they all exhibit a disconnect between the place where the value is created, and the (different) place in which the resulting profit is taxed.
The new guidance will have immediate effect in those countries which adopt the transfer pricing guidelines (TPG).
Initial focus will be on the careful delineation of the actual transaction to be analysed. The conduct of the parties and the commercial reality will override the contractual arrangements (real transactions, not paper transactions).
Profits will then be allocated between the contributing group members based on the actual transaction, and having regard to the value of each contribution.
If a transaction lacks commercial rationality, it can be disregarded or re-characterised.
Risks will only be accepted where the party has real control over the risks, and has the financial capacity to assume the risk.
Ownership of intangibles will not result in all residual profits flowing to the intellectual property (IP) holder. Value will be allocated between all associates which contribute to its creation. A cash box IP funder will only be entitled to a risk-free return on funds invested, not all the excess profits.
Synergetic benefits are to be shared amongst all group members who participated in their generation (further work to follow during 2016 on the profit split methodology).
Further guidance has been included on hard to value intangibles, low value services, cost contribution arrangements, and risk identification for global commodity traders.
The transparency requirements of action 13 will provide tax administrations with real insights into value creation and contributions by group companies.
Action 11: Measuring BEPS
This area is under the control of David Bradbury, a past Australian Assistant Treasurer. Research has begun to flesh out the magnitude of BEPS, although much remains to be done. Some of the findings of the research to date are:
- multinational enterprise (MNE) members in low tax countries have a higher profit rate than the group’s global profit rate
- corporate income tax revenue losses are estimated at between 4% and 10% of global corporate tax revenues
- this translates to a range of between $US 100-240bn annually
- effective tax rates of MNEs are in the range of 4 to 8.5% lower than domestic only enterprises
Action 12: Mandatory disclosure rules
Countries should implement mandatory disclosure rules which require taxpayers or scheme promoters to disclose arrangements which fall within the nominated boundaries of reportable activities.
The new design features are these, although they do not amount to ‘minimum standards’:
- obligation on promoter and/or participant taxpayer to disclose the arrangement
- identify generic hallmarks for disclosure, e.g. confidentiality requirement, premium fee
- institute a tracking mechanism to follow the spread of schemes
- impose timeframes which link promotion to implementation of the scheme
- impose penalties to ensure compliance
- for cross-border schemes, they tend to be more bespoke, but identification of generic hallmarks, ie Indicia of BEPS risks, should be developed
Exchange of international scheme details will be promulgated through the ever - growing OECD Forum on tax administration.
Action 13: Country by Country Reporting (CbC), etc.
This report is a compilation of the existing material; nothing new is added.
The CbC reports will be required first for 2016, with lodgement with the parent’s resident tax administration by the end of 2017.
Only groups with global turnover in excess of EUR 750 ml are caught initially, but the arrangements will be reviewed in 2020. It is expected the threshold will drop on review.
The data to be provided is limited to the eight categories. It can be used only for risk assessment purposes, but must not be used for assessment purposes, i.e. it is not global formulary apportionment through the back door.
Information will be exchanged between tax administrations, but only those who agree to meet the data security safeguards.
Where an MNE does not lodge a CbC report for some reason, affected tax administrations can seek equivalent information from group subsidiaries within their jurisdictions.
In addition, there is the requirement for groups to prepare and lodge master files, and local country files, which provide additional levels of detail to assist tax administrators in transfer pricing risk assessment.
Australia has recently introduced legislation (not yet enacted) to give effect to CbC reporting, but only for companies which are part of a group with global revenues in excess of $A1 bn.
Action 14: More effective dispute resolution mechanisms
Double taxation remains the enemy of economic growth, and the objective of the BEPS project, the eradication of double non-taxation, raises the spectre of increased double taxation. There is general recognition the present state to state dispute mechanism is not working effectively, with the number of referred cases growing each year, and the number of resolved matters falling further behind.
Countries have agreed a minimum standard with respect to the resolution of treaty related disputes. They have committed to:
- ensure that treaty obligations related to the mutual agreement procedure (MAP) are fully implemented in good faith and that MAP cases are resolved in a timely manner
- ensure the implementation of administrative processes that promote the prevention and timely resolution of treaty-related disputes
- ensure that taxpayers can access the MAP when eligible
Countries committed to this minimum standard will be subject to a robust peer-based monitoring mechanism with a reporting line through the OECD’s Committee on Fiscal Affairs, directly to the G20.
In addition to this commitment, a number of countries (including Australia) have committed to a mandatory binding arbitration process. With these changes implemented, the MAP process may yet win back a little taxpayer respect, and confidence.
Action 15: Developing a Multilateral Instrument (MLI)
This is the means by which the international (and non-transfer pricing) tax changes will be updated by fast track.
The concept of the MLI is accepted, and the first serious negotiations are scheduled for November 2015. The USA has now joined the process, and negotiations are expected to continue throughout 2016, with the MLI anticipated to be signed towards the end of 2016.
Existing bilateral double tax agreements will then be upgraded to the extent signatory nations have agreed to adopt the new language of the model tax convention and the accompanying commentary. The application of double tax agreements is expected to become very much more complicated as a consequence, with different rule sets being adopted by different bilateral nations.
This is an interesting document. It is in part, a summary (very brief) of the BEPS measures; and also an historical context document. But the sense in reading it is of binding together the participating countries, and recording why it has been in their collective best interests to act cooperatively and deliver the BEPS measures.
No doubt this will become a key document in the years ahead as the euphoria of delivering the technical measures gives way to the hard grind and conflict of the implementation process.
With more than 1,000 pages of material released, it will take time to work through the detail of the new measures. But there is now sufficient certainty for international companies to really engage with the new measures, and determine just where their existing arrangements do sit on the ‘BEPS compliant’ scale.