The OECD action plan on Base Erosion and Profit Shifting
IN TAX, the latest global buzzword is “BEPS” or base erosion and profit shifting. BEPS refers to the practice of multinational corporations (MNCs) of shifting profits from high tax jurisdictions to low tax jurisdictions as a tax mitigation strategy.
In February 2013, the Organization for Economic Co-operation and Development (OECD) claimed that available data on the extent of BEPS is inconclusive; nevertheless, there is circumstantial evidence suggesting that BEPS practices are pervasive. In fact, studies cited in the 2013 OECD BEPS Report suggest that in certain jurisdictions, there are significant discrepancies between the physical operations of companies and the countries where they report profits for tax purposes.
Conceptually, tax planning strategies are intended to improve the overall tax efficiency of companies through the use of legitimate approaches. However, problems arise when the very laws themselves create opportunities for BEPS, such as when the application of different tax laws results in double non-taxation. This is where the issue of fairness comes in, since many MNCs have been accused of not paying their share of taxes resulting from these practices.
The OECD Action Plan explains the harmful effects of these business practices to stakeholders such as governments, individual taxpayers, and businesses.
Many governments have to cope with less revenue and higher cost to ensure compliance. In developing countries, the lack of tax revenue leads to critical under-funding of the public investments that help promote economic growth. Overall resource allocation, affected by tax-motivated behavior, is not optimal. For individual taxpayers, they bear a greater share of the burden of paying more taxes when businesses shift income to lower tax jurisdictions. For businesses that operate only in domestic markets, they will have difficulty competing with MNCs that have the ability to shift their profits across borders to avoid or reduce tax. These disadvantaged businesses include family-owned corporations and new companies.
Because of the perceived harmful effects of these BEPS practices, the BEPS issue has become not only an economic issue but a political one as well. It has caught the attention of governments and tax administrators, the OECD and the G20 Leaders and Finance Ministers. In the G20 meeting in November 2012, G20 Finance Ministers finally called on the OECD for a coordinated action to address the BEPS issues. This call jump-started the OECD BEPS Action Plan which was released in July 2013.
The BEPS Action Plan identified 15 action areas that the OECD will focus on in the next two and a half years; these are:
1. The tax challenges of the digital economy;
2. The effects of hybrid mismatch arrangements;
3. Strengthening controlled foreign corporation (CFC) rules;
4. Limiting of base erosion via interest deductions and other financial payments;
5. Countering harmful tax practices more effectively, considering account transparency and substance;
6. Prevention of treaty abuse;
7. Prevention of artificial avoidance of permanent establishment (PE) status;
8. Assurance that transfer pricing (TP) outcomes are in line with value creation of intangibles;
9. Assurance that TP outcomes are in line with risks and capital;
10. Other high-risk transactions;
11. Establishment of methodologies to collect and analyze data on BEPS, and the actions to address it;
12. Requirement on taxpayers to disclose aggressive tax planning arrangements;
13. Reexamination of TP documentation;
14. Improvement of dispute resolution mechanisms; and
15. Development of more effective multilateral instruments.
The OECD envisioned the Plan to be implemented in three phases from September 2014 through December 2015. According to the OECD, the deliverables of the BEPS Action Plan will identify best practices, model domestic legislation, changes to the OECD Model Tax Convention and other tools needed to ensure that profits and taxes are aligned with economic activities, and close the loopholes in the tax policies and domestic legislation.
In September of this year, the OECD presented its first set of deliverables to the G20 Finance Ministers, but these reports will remain in draft form until the completion of the 2015 deliverables. Until then, the OECD will continue to work on recommendations and models for the seven action areas in order to achieve reasonable and sustainable solutions to counter these BEPS practices.
This first set of deliverables consists of three reports on Digital Economy (Action 1), Harmful Tax Practices (Action 5) and Feasibility of a Multilateral Instrument (Action 15) as well as four draft rules on Hybrid mismatch arrangements (Action 2), Treaty abuse (Action 6), Transfer Pricing of intangibles (Action 8) and Transfer Pricing documentation and a country-by-country reporting template (Action 13).
Briefly, these reports are summarized as follows:
Action 1: Addressing the challenges of the digital economy
The main challenge of the digital economy is how digital players such as online sellers or retailers, internet advertisers, and app stores make their profits, how these profits are characterized for tax purposes, and where taxes on these profits should be paid. The report presented potential options to address these challenges such as modifications of the PE threshold, the concept of significant digital presence, the creation of withholding tax on some types of digital transactions, and the imposition of a bandwidth or “bit” tax and VAT or consumption tax.
Action 2: Hybrid mismatch arrangements
This report provides recommended rules and model treaty provisions intended to neutralize the effect of hybrid mismatches like the denial of dividend exemption for deductible payments, introduction of measures to prevent the use of hybrid transfers to duplicate credits for taxes withheld at source, and denial of deduction for payment that is also deductible in another jurisdiction.
Action 5: Harmful tax practices
The OECD’s efforts to counter harmful tax practices of companies are nothing new. As early as 1988, the OECD had already begun looking at these practices. Now, however, the report focuses on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime especially in the context of intangible regimes.
Action 6: Treaty abuse
The OECD identified treaty abuse as one of the major sources of BEPS and as such, has focused on specific action items to counter treaty abuse and treaty shopping.
Article 8: Transfer Pricing of intangibles
One of the biggest challenges in Transfer Pricing is how to prevent BEPS when it involves intangibles. As such, the report on TP attempts to clarify the definition of intangibles, provide guidance on identifying transactions involving intangibles, and provide supplemental guidance for determining arm’s length conditions for transactions involving intangibles.
Action 13: Transfer Pricing documentation and a country-by-country reporting template
Part of the difficulty in countering BEPS is the lack of adequate information on how they operate within businesses. Action 13 aims to increase transparency for tax administrations by providing standards for TP documentation and as well as a template for country-by-country reporting. The guidance on TP documentation requires companies to disclose high-level information regarding their global business operations which will be available to all relevant country tax administrations, and provide documentation on relevant related party transactions. The country-by-country reporting will require companies to disclose substantial information on their businesses such as where they do business, amount of revenue, profit before income tax, income tax payments, total employment, capital, retained earnings, and tangible assets in each tax jurisdiction.
Action 15: Feasibility of a Multilateral Instrument
One of the mechanisms identified by the OECD in implementing the BEPS initiative on treaty-related matters is the use of multilateral instruments, which are seen to be more effective and sustainable since they can bind all parties, thereby ensuring a consistent and coherent approach to addressing treaty-related BEPS issues.
Looking back to more than a year ago, the BEPS initiative was met with both anticipation and criticism. While the initiative to level the playing field was prompted by good intentions, companies raised legitimate concerns on how this will impact their businesses. Key concerns include the risk of improper use of the country-by-country reports, the administrative costs of increased compliance and disclosure requirements, interpretation issues on treaty benefits which could lead to double taxation, and breach of confidentiality provisions which may expose sensitive corporate information to competitors, among others. The same issues stand today even after the OECD’s release of the first set of reports. Clearly, the OECD still has a lot of ground to cover in the next year. However, given all the potential issues surrounding BEPS and the BEPS measures, it is imperative for companies to actively participate in discussions on BEPS. Not only will this allow them to understand the impact on their own businesses, it will help them come up with new tax-planning strategies and business models that are compliant with the OECD BEPS guidelines.
Fidela I. Reyes is a Partner and International Tax Services Leader and Ma. Margarita Mallari-Acaban is a Tax Senior Director of SGV & Co.