Budget 2016: How base erosion and profit shifting (BEPS) brings HR function into focus

Tax function of an organisation was traditionally run from the tax director’s room. Transfer Pricing (TP) was governed by contracts between related parties and this at times resulted in profits moving to legal entities that had contractual rights but had no significant people functions. There were instances of IP Holding companies in tax havens, that had no employees, but since they funded the R&D they were considered to be entitled to royalties from group entities.

The rewards were disproportionate to the functions performed and intangible related returns were held to accrue to the legal owner of intangibles. Apart from the mismatch between functions and rewards, there are other structures that may lead to unfair tax minimisation.

Base Erosion and Profit Shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes. The gaps and mismatches in tax systems could emerge due to – lack of coordination between domestic tax systems across borders, lack of transparency and coordination between tax administrations, lack of information with tax administrations, limited resources for tax enforcement in different countries.

Media scrutiny of legitimate tax structures (compliant with the applicable laws and acceptable tax and TP principles) that may have led to unfair tax minimisation coupled with political activism against perceived abuse of tax system has brought the spotlight on BEPS in the last few years and the need for coordinated action between different countries.

The G20, through the Organization for Economic Cooperation and Development (OECD), has embarked on a journey to prevent BEPS. The OECD has rolled out reports on various action items dealing with various areas of BEPS, identified by G20. The OECD BEPS reports have a strong flavor of tax policy that attempts to marry profits with value creation. Value creation essentially depends on people functions and hence, the profits and tax would be impacted by the human capital of each legal entity in the group

It is evident from the above that there is an inextricable link between tax and location of key personnel of the group and hence, the HR function of hiring key personnel would have an impact on the effective tax of the group. TP and Tax teams have to coordinate with the business and HR to be able to devise business and HR strategies with due regard to the tax consequences.

Apart from the tax consequence of location of the key personnel, there is a higher degree of transparency envisaged by the OECD. The level of transparency required by regulators in the evolving era is significantly higher than in the past. The taxpayers have to identify their key personnel, their location, their functions and the organization structure.

This could mean that going forward, HR would have to be more vigilant about the tax impact of reporting employee headcount, understanding roles and responsibilities of their employees on a move and review their employment related documentation as these could be well under the scanner of tax authorities in different countries.

Specific areas in the OECD BEPS Action Plan that directly impact HR are:

The threshold for permanent establishment (PE) has been lowered and the scope of “preparatory or auxiliary” activities (which list instances where a PE would not be created) has been limited. Under the Action Plan, if a person negotiates the essence of a transaction, or solicits or receives (but does not formalize) contracts, this could now lead to a PE.

India’s tax treaties with other countries generally provide a lower threshold for PE and also include a provision on service PE. Even before the OECD BEPS Action Plan was announced, the Indian Revenue was seen to be more focused on enforcement around the issue of PE specifically for companies seeking to rely on the exemption of preparatory or auxiliary activities. In view of the change brought about by the OCED BEPS Action Plan, it would become more important to track employees, and understand their roles and responsibilities while they hop around different countries.

Even under the current transfer pricing legislation in India, the taxpayer is required to obtain an accountant’s certificate regarding the arm’s length nature of pricing of inter-company transactions and adequacy of documentation being maintained. More activity can be expected around transfer pricing documentation in the Budget 2016.

Another area of work for HR and tax functions of any organization would be – instituting appropriate cross-charging methodology and ensuring that entities are adequately compensated for the value created by them. In addition to cross-charge of employees’ compensation, appropriate allocation for deemed transfer of intellectual property (IP), that may be seen as being transferred on secondment of employees, will also be required. This will add complexity to the process of cross-charging employees’ compensation for secondment.

Given the level of impact people functions have on tax and transfer pricing, the HR needs to devise appropriate strategy to align the HR function to the overall tax strategy of the group and have systems in place to track functions and to report people related data that may be required for compliance purposes.