RSM New Zealand

International tax alert : BEPS action plan

With the OECD’s base erosion and profit shifting (“BEPS”) action plan final reports having been released late in 2015, it’s now time to take note of the potential risks that the plan poses. This article provides an overview of the main risk areas and for this reason we have not provided commentary on all 15 action points. This article is intended to help businesses assess the impact that the BEPS action plan may have on them.

The current international tax system lacks coherence and consistency. It is also seen by many as being out of date and not dealing with modern business structures, globalisation and the use of the digital economy. The aim of the BEPS action plan is therefore to bring greater coherence to the international tax environment, increased transparency for tax authorities and to try to ensure that profits accrue where economic substance resides.

It is worthy to note that a number of the OECD’s recommendations will take force when the OECD transfer pricing guidelines are updated in 2016. Most member nations use these guidelines to form the basis of their international tax legislation and therefore, by default, a large number of the OECD’s proposals will be introduced without major re-writes of local tax legislation.

The OECD’s BEPS report actions

ACTION 1 – the digital economy

ACTION 7 – avoidance of permanent establishment status

ACTION 2 – hybrid mismatch arrangements

ACTION 8-10 – transfer pricing outcomes

ACTION 3 – controlled foreign companies

ACTION 13 – documentation and country-by-country reporting

ACTION 4 – interest deductions and financial payments

ACTION 14 – dispute resolution

ACTION 5 – harmful tax practices

ACTION 15 – multilateral instrument

ACTION 6 – treaty benefits

 

ACTION 1 – The digital economy

The digital economy is becoming an ever increasing area of contention. Unlike a manufacturing plant or an office building with employees, it is very difficult for tax authorities to legally conclude on the geographical location of a website. This means tax planning and compliance issues arise in terms of reporting the sales and profits from selling online. The issue arises where a company in Country Y sells goods or services via its website to customers in country X. It is a question of whether the income generated by these sales is reported in country X or in country Y.

The OECD’s main response to the above is by broadening the definition of having a ‘taxable presence’ i.e. a permanent establishment (“PE”) in a tax jurisdiction. Essentially, this means a business is potentially more likely to have a taxable presence in a country than before. We will cover this in more detail later in the article. Another suggestion is for tax authorities to consider introducing GST onto cross-border transactions. The IRD and the New Zealand Customs Service have already taken small steps to put this into action. The OECD feel a number of the other BEPS action points taken together will tighten the tax net on the digital economy.

ACTION 2 – Hybrid mismatch arrangements

The hybrid entity and transaction issues are one of the more complex areas of the BEPS action plan and therefore require a lot of detail to explain in-depth. For the purpose of this article we will consider this from a high level. A mismatch transaction or entity is one where differing tax treatments are observed in the alternate tax jurisdictions. For example a hybrid transaction could be where a loan is treated as a liability and therefore interest payments are deductible in country Y however the ‘loan’ is treated as equity in country X and therefore, no interest income is reported. A hybrid entity for example is where an entity is not treated as a taxpayer in one or both countries. Partnerships are often an example of this particularly in the US with their ‘check the box’ approach to including overseas partnership income in the US tax return.

The OECD has suggested a primary and secondary rule which allows a tax authority to either include a receipt as income or disallow a deduction to align the taxable treatment between jurisdictions. There is also a safeguard to stop both jurisdictions employing these rules, to eliminate double taxation. This stops the taxation of MNE’s in both jurisdictions.

ACTION 4 – Interest deductions and financial payments

Of particular interest to many member nations is the ability for MNE’s to deduct interest payments on debt. Common approaches from MNE’s include placing high levels of third party debt into high tax jurisdictions and/or the use of intercompany loans to generate interest expense in excess of third party interest expense.

To tackle this, the OECD has recommended that interest deductions be restricted to a fixed level of debt based on a percentage of earnings before interest, taxes, depreciation and amortisation (“EBITDA”). The OECD has identified possible ratios of 10% to 30% of EBITDA. As always there will be some exceptions to the rule. The OECD has also suggested a de minimis threshold for entities with a low level of net interest i.e. interest income less interest expense. The IRD’s thin capitalisation rules currently use an interest bearing debt to assets ratio and therefore do not comply with the OECD recommendation. This could be an area of significant change for New Zealand (“NZ”) taxpayers.

ACTION 7 – Avoidance of permanent establishment status

Broadly a PE means “a fixed place of business through which a business of an enterprise is wholly or partly carried on”. More specifically a PE includes a place of management, a branch, an office, a factory, a workshop or a place of extraction of natural resources.

A number of MNE’s use an ‘agent’ operating on their behalf in a foreign jurisdiction. In determining if the ‘agent’ constitutes a PE it is important to understand whether the ‘agent’ negotiates and/or concludes contracts. If the agent is independent, the business is deemed not to have a PE in that jurisdiction.

The OECD has defined the services performed in that country must only be of a preparatory or auxiliary nature to the business to avoid PE status. If the premises or warehouse do not fulfil this criteria then it is likely that a PE will now be deemed to exist.

The new PE definition broadens the meaning of concluding contracts and also what is meant by independent agent. The new definition of concluding contracts extends beyond the authority to conclude contracts and now specifies “playing the principle role leading to the conclusion of contracts that are routinely concluded without material modification”. Therefore where a business has an ‘agent’ in an overseas country, who negotiates terms and conditions of contracts that are merely approved by head office, this agent would now likely constitute the business having a PE in that country.

An independent agent can only be a person who is carrying on the business of being an independent agent. Therefore where a business uses an ‘agent’ overseas and that ‘agent’ exclusively or almost exclusively acts on behalf of one or more enterprises which are closely related, the agent will not be deemed to be independent.

ACTION 8-10 – transfer pricing outcomes

The main risk areas for action points 8-10 relate to the transfer pricing methodology for intangible assets and low value-adding services.

Intangible assets such as patents, brand names, knowhow, designs, processes etc. have been a useful tool for many tax planners over the years. The historical theory of parking legal ownership of intangible assets in low tax jurisdictions and charging related parties for the use of these intangibles could now be a thing of the past. The OECD recommends looking past legal ownership to the location of the development, control and maintenance of the intangible. In essence, the value of the intangible is located in the jurisdiction(s) where the value of that intangible is either controlled or created and this is where the bulk of the resulting profits should be allocated.

Low-value-adding services are the routine back office type services that are commonly recharged as part of a management fee. The OECD has suggested a fixed mark-up be allocated to the cost of these low value-adding services of 5%. The IRD currently have an administrative practice for service fees below NZ$1m where a mark-up to a maximum of 7.5% is deemed arm’s length. It is possible the IRD will look to update this to remain consistent with the OECD’s recommendations.

ACTION 13 – documentation and country-by-country reporting

One of the first outcomes to be introduced from the OECD’s BEPS report will be country-by-country (“CbC”) reporting. CbC reporting is split into three levels of transfer pricing documentation being a master file, a local file and a country-by-country report. Please note that CbC reporting comes into force for accounting periods beginning on or after 1 January 2016.

The master file is a new addition to the compliance burden of transfer pricing documentation. Although it will include information predominately held in current transfer pricing documents, the master file takes a holistic view of the group with regards to transfer pricing principles and functional analysis. Critically it will be shared amongst tax authorities in countries where the group has operations. This will increase the risk of transfer pricing audits and challenges.

The local file will be much the same to current transfer pricing documentation. Simplistically the local file will only include the local related party transactions, functional analysis of the local entity and the resulting transfer pricing analysis as to the application of the arm’s length principle. The local file will then provide reference back to the master file for information regarding how the local entities functions relate to the group as a whole.

The CbC report is only for large MNE’s. This is where group turnover exceeds €750m. The NZD equivalent is NZ$1.2b. The CbC report needs to be completed and filed in the tax jurisdiction of the ultimate parent entity. The report will then be automatically transferred to every tax jurisdiction within the group through information sharing agreements. This will only effect a very small number of businesses in NZ however many NZ subsidiaries may be required to pass information onto their parent company for the completion of this report.

Where to from here?

This article can only provide a high level review of the OECD’s BEPS report outcomes, it is down to each MNE as to how they assess these risks and implement changes where required. To assist with this risk assessment we have a high level BEPS risk assessment. This consists of a simple 10 questions with yes or no answers. This should help businesses identify if they need to take action to mitigate BEPS risks. This may involve business and transaction restructuring which will take time to complete. Other risks could be resolved with a simple update to current transfer pricing policies or perhaps incorporating an overseas operation. Whatever the level of risk BEPS poses to your business, the time for action is now.

download risk assessment

If you would like further information, please contact the your local RSM advisor to discuss the level of risk BEPS poses for your business.

 

Would you like to discuss this topic further?

Please email us to submit a question or click on the author below to directly discuss this article

CONTACT us

Authors

Craig Cooper
Partner - Auckland
Grant Hally
Partner - Auckland
Galina Bell
Tax Principal - Auckland