All countries, including underdeveloped countries, are well aware of the strain that has been placed on tax administrators throughout the world in grappling with the billions if not trillions of revenue loss associated with base erosion techniques and strategies utilized by many multinational business enterprises (MNEs) that are principally driven by tax avoidance and not primarily based on sound business practices. This base erosion is visibly greater when comparing the aggregate tax loss impact suffered by high tax jurisdictions from more modest tax jurisdictions. But as long as there is a moderate if not high level of taxation in a particular country, there are indeed many ongoing efforts to strip out earnings through interest, business transactions among related parties and nimble supply chain participants.
The differences in the domestic tax laws of various countries including tax rates, transfer pricing rules and norms, and formalistic avoidance of permanent establishment status, have caused the G20 leaders and their tax administrators, as well as governmental officials of other countries, to support and participate in the comprehensive Action Plan on Base Erosion and Profit Shifting spearheaded by the Office of Economic Development (OECD). More than 90 countries have been directly involved in the process and many more have participated in regional forums. The idea is that by countries signing onto the base erosion and profit shift project or “BEPS” package as part of their domestic tax law and bilateral treaty provisions there will be a resulting fairer and more equitable alignment of taxable profits to the jurisdiction(s) where the economic activity is generated. There is a second related principle that enters into the mix and that pertains to the tax residence of the particular company engaged in the business operations. In certain instances under existing tax treaties (and domestic tax laws) and under the OECD BEPS study, the country of residence will be ceded the right to tax the taxpayer.
The History of the BEPS Study
The OECD’s BEPS overall purpose was to restore confidence in international tax administration by identifying techniques and other practices that exploit if not evade taxation. By setting forth rules and principles that could be adopted by member countries to ensure that profits are taxed where economic activities take place and value is created the importance of the BEPS Actions is that many countries will buy-in and sign up both for domestic tax law purposes and for bilateral tax treaties.
This process began in September 2013, when G20 leaders endorsed the action plan on BEPS. Two years later, in September 2015, a package of 13 reports or “actions” were promulgated which is now up to 15. It is noted in the Report that “the stakes are high”. Indeed estimates indicate that global corporate income tax revenue losses could be between 4% to 10% of global corporate income tax revenues. The losses arise from various sources including the taxes eliminated from aggressive tax planning by some MNEs, the lack of continuity between domestic tax rules, the lack of transparency and coordination between tax administrations, limited country enforcement resources and what some view as “exploitative” tax practices endorsed by countries such as “patent boxes”.
Model provisions contained in the Report are also directed to prevent treaty abuse, including anti-treaty shopping rules, and such rules and guidance will be included in a so-called “multilateral instrument” that countries may use to incorporate the MLI provisions into existing bilateral tax treaties. For example, the BEPS Project has revisited existing international tax standards to eliminate double taxation, including interpretation of provisions on Article 9 of both the OECD and UN model tax conventions. In addition, the BEPS changes to the transfer pricing guidelines will ensure greater allocation of economic profits among affiliates in different jurisdictions with an emphasis in certain instances that the transfer pricing rules applied to intercompany transactions of MNEs are consistent with BEPS goals. Another concern is the elimination of “cash boxes”, i.e., shell companies with few if any employees and little or no economic activity, which seek to take advantage of low or no tax jurisdictions. This could occur for example where a capital rich member, i.e., a cash box type company or branch, simply provides assets such as funding for use by an operating company but performs only limited activities. Another key factor is standardized country-by-country reporting and other documentation in order to provide tax administrators from various countries a much greater look into MNEs. This past June the Treasury issued final regulations on country-by-country reporting for large MNEs. Changes to the permanent establishment definition have also been agreed upon (Action 7) with additional work to follow. Another area addressed is earnings stripping such as interest expense abuses and abuses associated with controlled foreign corporations.
While countries are free to adopt Actions adopted in the BEPS report the OECD and G20 countries announced in 2015 to extend their cooperation until 2010 in completing the project.
Various Parts or Actions Included in the BEPS Package
Action 1—Tax Challenges of the Digital Economy
Action 2---Neutralize the Effects of Hybrid Mismatch Arrangements
Action 3---Strengthen Controlled Foreign Company Rules
Action 4---Limit Base Erosion Via Interest Deductions and Other Financial Payments
Action 5---Counter Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance
Action 6---Prevent Treaty Abuse
Action 7---Prevent the Artificial Avoidance of PE Status
Action 8-10 Assure That Transfer Pricing Outcomes Line Up with Value Creation
Action 11---Measuring and Monitoring BEPS
Action 12---Require Taxpayers to Disclose Aggressive Tax Planning Arrangements
Action 13---Re-examine Transfer Pricing Documentation
Article 14---Make Dispute Resolution Mechanisms More Effective
Action 15---Develop a Multilateral Instrument to Implement BEPS Treaty Measures and Amend Treaties
Where are We Now With Respect to BEPS?
Report on BEPS and EU Progress from Recent Coverage in Tax Notes
In the June 27, 2016 issue of Tax Notes, well-known commentator and national authority on taxation, Lee A. Sheppard, provided us with an excellent summary or status report on the various Action reports issued by the OECD. Her comments are quite insightful on how close the participating members are to realizing the goals of the OECD’s base erosion and profit-shifting project. While there was and continues to be some optimism associated with the overall effort, her prognosis for wide-scale reform endorsed by the G20 and other countries with large economies is not good. Here are a few of Ms. Sheppard’s observations.
First, the BEPS project is essentially addressing European problems and is only a “patch job” in arriving at an international consensus let alone an international solution. As such, she cautions that we should not expect the rest of the world to buy into the solutions set forth in the various Actions. Sheppard also comments that the BRICS (Brazil, Russia, India, China and South Africa) shouldn’t be expected to fall in line with the BEPS Actions. Such countries may want to have their own set of advantages over the EU as well as the US in attracting business and capital and tax neutrality doesn’t really ring the bell for the BRICS. BRICS have signed OECD model treaties but it is reported that are not entirely happy with the results.
Second, there is also a critical issue of national sovereignty involved which we just witnessed under the BREXIT vote. While the OECD Actions look to the jurisdiction of economic activity or where value is created as the source country for taxation, in some instances this principle may have to defer to residency. But will all countries agree to this balance between sourcing and residency? Not all countries will think alike. Indeed the Director for OECD’s Centre for Tax Policy, Pascal Saint-Amans, has recently remarked that residence versus source problems have to be addressed if developing countries are going to join in. Then there is BREXIT and what effect will that have? In a news release last evening, it was reported that the UK wants another few years to effectuate the BREXIT withdrawal. It should also be noted that the EU has passed a draft of the BEPS anti-avoidance directive but it was a watered-down version with some add-ons. It goes into effect into domestic law by EU members by January 2019.
Well, what’s the good news? Ms. Sheppard tells us that it seems that the rest of the EU will stay in line with the OECD recommendations. There are other reports and commentary to the same effect. The EU members appear to be primarily concerned with three things: (i) earnings stripping through excess interest deductions; (ii) use supply chains which employ shell entities in low tax jurisdictions to arbitrarily siphon off income, reporting of zero taxable income in countries with moderate tax rates; and (iii) the need for CbC reporting to require greater transparency of a MNE’s revenues and asset base. A fourth concern might be to broaden the PE rules under the OECD Model Treaty for adoption by participating countries.
Summary of Where We Are Now on BEPS Actions as Per Ms. Sheppard’s Recent Report
Action 1 – Tax Challenges of the Digital Economy. An OECD task force is continuing its work on digital economy issues. There is tension in the air caused by “American data trawlers scooping up information” from citizens of various countries and selling such information to advertisers and treating such income as not sourced in the countries in which the information is trawled. In effect, little or no local income tax is paid where the value is sourced. Still, it is reported that Israel is asserting jurisdiction over digital activities of non-treaty-country residents. There also have been countries which are calling for the promulgation of a rule pertaining to permanent establishment status arising from digital activities in a jurisdiction from a non-resident company. Indeed, India has entered into this area of base erosion by enacting a digital equalization levy, which is a 6% tax on gross payments associated with business-to-business e-commerce transactions, including online advertising. See ITO v. Right Florists Pvt. Ltd., ITA 1336/Kol/2011). There is also action to impose a so-called “snippet tax” on information collectors such as Google. Spain has a “snippet tax” which resulted in Google’s shutting down its Spanish platform.
Action 2 -- Neutralize the Effects of Hybrid Mismatch Arrangements. Some countries don’t like “hybrid” entities in their territory. They don’t like our check-the-box rules and elections. So, Ms. Sheppard informs us to expect participant countries will enact laws to undo the local benefits for check-the-box elections. When this occurs, existing business structures for overseas and cross-border operations will have to be reviewed. Greater transparency will be required for so-called “defective entities” and related party transactions. For example, despite the CbC regulations being issued by the Treasury, disregarded entities will not be separately broken out on a U.S. CbC report filed by the U.S. parent of a multinational group. The EU anti-avoidance directive however, includes a requirement for a European taxpayer identification number.
BEPS Action 2 report on hybrids is quite long and complex, perhaps too complex. The primary BEPS rule on hybrids is the denial of a deduction for a payment to the extent it is not included in the taxable income of the recipient. A second rule results in the denial of a dividend exemption or a double deduction for a deductible payment. This is designed to block the ability to claim an interest deduction with a non-inclusion of income. Taxpayers would be expected to apply the rules automatically, declaring their hybrid deductions and non-inclusions on their returns. Some countries in the EU may deny a participation exemption for payments made to hybrids. See EU parent-subsidiary directive, 2014/86/EU.
It is reported that Europe is trying to deny deduction of payments by resident companies to tax havens lenders. In this regard, several EU countries already have blacklists of non-EU countries to which payments cannot be deducted. The EU anti-avoidance directive calls for an EU blacklist of tax havens with a list of sanctions for their governments and financial institutions. The EU ant-tax avoidance directive sets out six key anti-avoidance measures: (i) a CFC rule to deter profit shifting to a low/or tax country; (ii) a switchover rule to present double non-taxation of certain income; (iii) exit taxation, to prevent companies from avoiding tax when re-locating assets; (iv) interest limitation in order to discourage artificial debt arrangements designed to minimize tax; (v) assault on hybrids to prevent companies from exploiting national mismatches to avoid taxation; and (vi) a general anti-abuse rule (AAR) to defeat aggressive tax strategies when other rules do not directly apply.
Action 3 -- Strengthen Controlled Foreign Company Rules CFCs. There are nine EU countries which have CFC rules; Germany, United Kingdom, Italy, France, Spain, Denmark, Finland, Sweden and Portugal. Sheppard warns that Europe can't make strong controlled foreign corporation rules. Some of the CFC rules within the EU include exemptions for EU entities, with the exception of the UK, Danish and German CFC rules which also apply to EU entities. But not all countries have CFC rules such as European tax havens Luxembourg and Ireland. The Netherlands has a special rule for portfolio investment gains of CFCs. The UK version is reported to be weak.
With that in mind, the EU commission wants entity-based rules that claw back the undistributed income of a low-taxed, 50% controlled foreign entity that has more than 50 percent passive income (including related-party services). Low-taxed for this purpose means that the CFC's actual effective rate is less than 50% of the effective rate it would have faced had it been taxed in its parent's country of residence (a PE can be a CFC). Take the current CFC rule in Germany for example. Income received by a German shareholder from a CFC is taxed if the following conditions are met: (i) German-resident shareholders either alone or together own more than 50% of the foreign company, or in the case of passive investment income, any single German-resident shareholder holds at least 1% of the company; (ii) the foreign company realizes passive income; and (iii) the income is subject to “low tax”, i.e. a rate less than 25%. There is no exemption for EU companies.
Action 4 -- Limit Base Erosion Via Interest Deductions and Other Financial Payments. The EU and other countries, including developing countries, are very suspicious of allowing interest deductions to non-resident based affiliates. The BEPS limitation on net interest expense of 10% to 30% of earnings before interest, taxes, depreciation and amortization would also include a safe harbor based on a debt ratio not to exceed its worldwide group’s net third party interest expense-EBITDA ratio based on financial statements. This is currently being worked on by the OECD. The BEPS proposal applies to all debt not just related party debt such as under the proposed U.S. section 385 regulations.
Action 5 -- Counter Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance. The OECD wants transparency of tax information amongst counties including the production of domestic tax rulings. This will enhance prospects for the automatic exchange of tax rulings and advance pricing agreements beginning January 2017.
Action 6 -- Prevent Treaty Abuse. The BEPS treaty abuse recommendation wants countries to incorporate a principal purpose clause or limitations on benefits article in their treaties. The mechanism for adoption will be the multilateral instrument. A principal purpose clause is a general anti-abuse rule (GAAR) for treaties. The difficulty with GAARs of course is that you never know when it could be used successfully by the taxing authorities. It should also be noted that the EU anti-avoidance directive calls for members to adopt GAARs. As the directive explanation admits, the GAAR would be subject to Court of Justice of the European Union case law. See, e.g., Cadbury Schweppes, C-196/04 (CJEU 2006). The GAAR will incorporate a step transaction concept. When it applies, the GAAR permits the government to rewrite the deal according to the economic reality. Member governments could also apply penalties. See 26 U.S.C. §7701(o).
Action 7 -- Prevent the Artificial Avoidance of Permanent Establishment Status. Many companies, including MNEs, have engaged in tax planning with supply chains. Typically, this involves an intermediary entity located in a tax efficient jurisdiction earning profit through the supply chain transactions. In many instances, such entities lack sufficient economic substance. With respect to this issue, BEPS proposes treaty changes to eliminate popular supply chain structures.
In thwarting base erosion strategies involving “nimble” supply chain entities in low or no tax jurisdictions, tax administrators can be expected to assert the existence of an authorized dependent agent situated in the source country to be sufficient activity to establish permanent establishment status. Indeed, BEPS wants a more expansive definition of PE. There is some debate over whether tax administrators can apply the new BEPS interpretations of the expanding PE definition to older treaties. At a recent international business conference held in Washington, it was reported that due to conflicting priorities among countries as to the scope of the PE in general for tax treaty purposes, the whole PE standard has been thrown into a state of uncertainty.
The BEPS changes to the OECD model to defining a permanent establishment for treaty purposes would primarily attack commissionnaire structures. The standard will be reduced to the dependent agent’s playing a “principal role in the contract negotiations”, so that the contract is expected to be accepted by the principal. A related provision is that a 50% direct or indirect ownership agent that works wholly or almost exclusively for its principal cannot be independent.
There is an anti-fragmentation rule under the proposed BEPS treaty reforms. The exceptions to PE status are now not going to be analyzed separately but combined. See Roche Vitamins Europe Ltd., No. 1626/2008 (Jan. 11, 2012)). See, in general, OECD 2010 Report on the Attribution of profits to Permanent Establishments, hhhp://www.oecd.org/ctp/transfer-pricing/45689524.pdf.
On the issue of “switch-overs”, the draft EU anti-avoidance directive called for a switchover clause in member domestic law, which would have affected principal companies or other dividend-paying affiliates located in non-EU tax havens. A switchover clause would block access to a participation exemption for dividends paid out of countries that did not tax the associated income or taxed it at a rate lower than 15%. Some EU members wanted to get rid of the switchover clause, and they succeeded in getting it eliminated from the approved version. This was applauded by several European tax havens.
Actions 8, 9, 10 -- Assure That Transfer Pricing Outcomes Line Up with Value Creation. The BEP Actions on transfer pricing can be in effect now for countries that have adopted the guidelines into their domestic tax law. It will not be more difficult to deflect profits out of the source company as it was prior to the BEP recommendations. Of course, critical elements such as risk shifting or acceptance and residual profit allocation, etc. should be care evaluated. So, “stripped-risk supply chain” companies located in low or no tax jurisdictions that are parties to intercompany transactions will be most adversely effected. It is understood that the tougher rules will reallocate income and therefore result in greater taxes in the source country with or without a concomitant PE argument if the affiliate in the source country were not to report as having a PE. Expect “profit splitting” to be the base erosion antidote used by tax administrators in licensing and similar arrangements.
Action 13 -- Re-examine Transfer Pricing Documentation; Country-by-Country (CbC) Reporting. As discussed in a recent posting on this blog, CbC reporting, which has recently been adopted by the issuance of final regulations by the Treasury (T.D. 9733), is a key feature of the BEPS study. The EU Council formally adopted the CbC amendments to directive 2011/16/EU. While the principle is to be adopted by many countries, each country will have its own version of CbC reporting which may in certain instances make full transparency a little more difficult.
Action 14 -- Make Dispute Resolution Mechanisms More Effective. Under BEPS Action 14 mandatory arbitration is an option but some countries may never agree on this. However there must be a provision that requires that countries permit access to competent authority processes for transfer pricing questions, which some countries do not do. Changes to model treaty articles 9 and 25 reflect minimum standards for BEPS participants. Expect an uneven playing field on alternative dispute mechanisms and approaches to competent authority in comparing various tax treaties. It is reported that only 8 countries have agreed to mandatory arbitration in their U.S. treaties. Therefore, in deference to MNEs, dispute resolution will remain somewhat discretionary among the auditors and then, where necessary, by tax administrators acting under competent authority.
Action 15 -- Develop a Multilateral Instrument (MLI) to Implement BEPS Treaty Measures and Amend Treaties. At present, and despite some confusion, governments signing onto the BEPS Actions are expected to sign a package of BEPS minimum standards that includes the permanent establishment definition treaty changes, the hybrid denial of withholding exemption, the treaty abuse provision of their choice, and transfer pricing dispute resolution. The MLI would not create bilateral relationships between countries when no current treaty exists. It would apply only to countries that have bilateral treaties. What then happens to existing treaty protocols that are in effect? Are they overridden by the MLI?
The major benefit of the MLI is that changes could be adopted by the international tax community on a far more efficient basis, including ongoing amendments of bilateral tax treaties. But there is some push-back to the MLI at least to making it automatic. It should be anticipated that despite the BEPS Action 15, each country will want to negotiate particular provisions of a tax treaty with another specific country. There may however be widespread reluctance to adopting a universal tax treaty approach. Indeed the principles in the BEPS Actions, including the MLI, can at least be persuasive in fostering greater adherence to the core principles of the BEPS project and the adopting of specific recommendations to prevent base erosion.
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