Lots of BEPS Output – What Outcome?

*Ernst & Young LLP, New York, NY

The BEPS beat plays on. Congratulations to the OECD for meeting (mostly) the ambitious goals for release of their reports on seven action items in September 2014 – right on schedule on September 16. The documents released on September 16 relate to Action 1 – Digital Economy, Action 2 – Hybrid Mismatch Arrangements, Action 5 – Harmful Tax Practices, Action 6 – Treaty Abuse, Action 8 – Transfer Pricing for Intangibles, Action 13 – Transfer Pricing Documentation and Country-by-Country Reporting, and Action 15 – Multilateral Instrument. We have seen discussion drafts with respect to most of these action items before – only the reports on Actions 5 and 15 are “new” releases. However, all of the documents contain changes and new features. None are yet final final and all include indication of various areas of future work and refinement to be done in the coming months before the final set of reports on these action items and the remaining open action items are due to be delivered by the end of 2015.

This commentary will not go into detail on each report. But rather, as usual, I will pick and choose some items I find particularly interesting and then make some observations/express concerns/maybe whine a bit about the application of these recommendations in the real world or at least the real world as I see it.

  I’ve written previously about the proposed country-by-country reporting (CBCR) template. I was pleased to see the scope of the template narrowed a bit from the draft proposal. The template now requires aggregate country-based information rather than per legal entity information, which in my mind is much more relevant and less cumbersome to produce.  The required country level information has been reduced to eight items of economic data – revenues (broken down by related and unrelated party revenues), profit before tax, income tax paid, current year income tax accrued, stated capital, accumulated earnings, number of employees, and tangible assets. This is still in my mind way too much data for the stated purpose of a high level risk assessment and will be a very substantial burden on all multinational corporations (MNCs) globally. However, I guess it could have been worse. And at least the report clearly states that MNCs may choose which data source to use – e.g., statutory accounting, local books and records, etc., based on which is less burdensome as long as the chosen source is disclosed and used consistently. Given the political level interest in country-by-country reporting, it’s probably time for companies to begin to think about implementation preparedness and assess the mechanisms needed – and cost involved – to produce the data. It’s also time for companies to anticipate increased local tax controversy because of the many countries that may use the data to conclude that their share of the worldwide profit pie should be higher based on whichever of the disclosed metrics could produce a higher level of local profit. I’d like to think I am too cynical on this point, but experiences in the current environment do not allow me to be my usual optimistic self.

  The final recommended effective date and the exact delivery mechanism for the CBCR template are still open issues. It’s not clear to me when the OECD will finalize its recommendations on these important issues. But guidance is needed. Concerns over confidentiality of information were acknowledged by the OECD, but barely. I expect some countries will start to adopt the template on their own schedule, and the longer the OECD takes to recommend a delivery mechanism and to address other implementation issues, the more likely that will be. The United Kingdom has already issued a press release formally committing to implement the template, but with no stated target date yet. I’m hoping for 2017 filing using 2016 information at the earliest so there is some time for companies to prepare. We’ll see.

  Action 13 also includes final requirements for the transfer pricing master file and local file — lots more information than is provided currently in most MNCs’ transfer pricing documentation. The new framework is likely to require a complete re-look at a company’s approach to its transfer pricing documentation and perhaps also at many of its transfer pricing policies.

  The Action 5 release on Harmful Tax Practices is new to the BEPS project in that there was no discussion draft for this action area. It represents a continuation of work started in the late 1990s in this area involving the OECD Forum on Harmful Tax Practices. This report is an interim report with two main recommendations. The first is that any preferential tax regime be premised on the existence of substantial business activity.  With a particular focus on intangible property regimes such as the popular patent box or innovation box regimes, this is intended to require the presence of significant development actions and not merely ownership of IP – which could be a problematic standard for the regimes of some countries to satisfy. The second recommendation, which is in the area of transparency, is that countries spontaneously exchange information on all tax rulings that involve geographically mobile income — interesting when considered together with the requirement that the master file include a summary of all tax rulings applicable to the particular taxpayer.

The report is an interim report with a deadline of September 2015 for the so-called second output which is to assess specific country incentive regimes which no doubt will be more challenging to reach consensus on. Combined with the current EU state aid review of tax ruling practices in the Netherlands, Ireland, and Luxembourg, one would expect the playing field in this area to be changing over the coming years.

 The Action 2 report on hybrid mismatches follows the earlier discussion draft with some minor modifications and is still very comprehensive and exceedingly complex.  As in the draft, the September 16 report has as its primary recommendation that all countries adopt a legislative regime focused on eliminating in a comprehensive coordinated fashion the potential for outcomes involving double deduction (DD) or deduction with no corresponding income inclusion (D/NI). The drafters have included a virtual universe of the hybrid instrument and hybrid entity-type arrangements in the market. Many involve check-the-box type structures common in U.S. MNC worldwide structures. U.S. entity classification rules have always had the result that U.S. and foreign country classifications of business entities may differ, although admittedly this has escalated significantly in the post check-the-box area.

The report’s proposals are extremely comprehensive.  They clearly recognize that uncoordinated country actions against hybrid arrangements carry a high risk of double taxation, with both countries to a hybrid arrangement potentially attempting to tax the same income. Therefore, the report includes priority rules for which country — investor / investee, etc. — should act first to eliminate the benefit. In a perfect world the rules might actually work quite well. However, clearly countries will act, and have already been acting, unilaterally in this area – the latest example being Spain which I will discuss below. For U.S. MNCs, this will likely result in a one-way street of increased foreign country disallowance of interest expense on hybrid instruments and on most financing involving hybrid entities. This result can occur under the report as drafted currently even where all or a part of the so-called hybrid income may be taxed under U.S. Subpart F rules or upon repatriation to the United States. Further, as I have whined before, no effort was made in the report to address the reverse case and eliminate double taxation where there is a denial of a local country interest deduction based on earnings-stripping or thin-cap-type provisions and full taxation of the interest to the lender. As discussed below, this type of deduction limitation is proliferating worldwide as countries look for increased tax revenue – Spain and Sweden examples are discussed below.  Maybe the OECD needs to follow the BEPS project with a companion project called Preventing Base Expansion and Deduction Denial (which would be BEDD). But I’m not optimistic about this either. For MNCs, a full review of their global treasury policies is urgently mandated.

  Turning to Action 6 on treaty abuse, consistent with the discussion draft, this report still includes a recommendation for a U.S.-style Limitation on Benefits (LOB) provision to be coupled with a principal-purpose-type GAAR provision. The good news is that the report is somewhat softened on this point in that it acknowledges that countries may just choose one or the other – although the OECD prefers the adoption of both. As I’ve previously written, as between the two approaches, I am a reluctant fan of LOB, not so much because I love the LOB rules but because I shudder to think about how a principal purpose test would be applied to holding and financing companies where inevitably a country’s tax treaty network will be an important criterion for selecting the location of the entity.

  Action 8 on transfer pricing for intangibles – again consistent with the discussion draft (which in this case was a revised discussion draft) — would directionally allocate IP returns based on value creation, not merely on ownership or funding of IP. A new addition is that an additional criterion for value creation could be the actual exploitation of the intangible. It’s not obvious to me that exploiting an intangible creates value. I worry that adding this criterion leads to even more potential profit-grab controversies. The report represents interim guidance – so more to come on how to allocate IP returns and also on tough issues such as dealing with risk and hard to value intangibles (but aren’t they all hard to value?). And seems to me to be tough issues to achieve country consensus on.

  Action 1 on the digital economy correctly in my mind concludes that the tax issues relating to the digital economy cannot be fenced off from the regular economy, i.e., recognizing that digital issues really have broad application to all industries as all companies have some digital element and therefore the issues of concern – including permanent establishment, transfer pricing, and indirect tax — are best dealt with in those other action areas.

  The report on Action 15 and the multilateral instrument report is very preliminary. At a high level it discusses why such an instrument would be valuable, considers how it could be applied to cover only BEPS-related issues so in essence it could act as a supplement to existing bilateral treaty arrangements, acknowledges some of the legal and practical difficulties in achieving this, and generally concludes that such an instrument could be feasible. Not really a big step forward. I think a vital element of any such instrument would be a commitment to enhanced dispute resolution by the participating governments, particularly in light of the spike in tax controversy that is likely to be created by all the recommendations with respect to the other action items.

So, overall, lots of guidance but more work to be done and lots of open questions in each of the action areas.  Not surprising. Let’s see how progress develops over the next 12 months.

My concerns from a practical standpoint relate to what anti-BEPS steps countries will take based on the incomplete guidance to date from the OECD. Of course, this has been ongoing even before the BEPS project, with many countries adopting more aggressive base erosion provisions, using local GAAR concepts to deny treaty benefits, and using various theories in tax audits to try to tax foreign IP profits. I fear that the September action item documents will further fuel such activity. I would have hoped that the OECD would do more to admonish against such unilateral action while the BEPS project is still a work in progress.

The latest two countries where I note some clearly tax-revenue-focused proposals are Spain and Sweden. Both have only proposed legislation at this date, but both would dramatically increase the local tax base for corporations operating in those countries.  Some highlights:

  The statutory corporate tax rate would be reduced in both countries – from 30% to 25% in Spain and from 22% to effectively 16.5% in Sweden.

  Additional interest deduction limits would be introduced in Spain.  Spain already has an earnings-stripping-type limitation for interest deductions equal to 30% of operating profit, similar to Germany and France. New anti-abuse debt-creation rules also are proposed, which would potentially disallow a portion of interest deductions for certain leveraged intergroup transactions. Again not a new concept – for example, France and the Netherlands have adopted similar rules.

  The Swedish proposals would go farther and would disallow deductions for net interest and other financial costs, instead allowing all companies a deductible financing allowance equal to 25% of taxable income (which is what in practice would reduce the effective tax rate to 16.5% — pre-interest!). The proposal also contains an alternative approach which would allow deductions for net financial costs including interest, up to a cap of 20% of taxable income, and would reduce the statutory tax rate to 18.5%.

The Swedish proposal is the most dramatic approach I’ve seen for limiting interest deductions, but the Spanish proposal and recent limitations enacted in France and Germany and some other countries all continue the trend of potential disallowance of group financing costs, which will inevitably lead to some level of double taxation. Addressing this eventuality is unfortunately not at all a focus of the BEPS action items so far. Maybe good news will be coming when the recommendations under Action 4 on interest deductions and financial arrangements are issued next year? Or maybe not? Hard to be too optimistic here either.

  Both the Spanish and Swedish proposals also would impact the deduction for tax loss carryforwards. The Swedish proposal is to permanently reduce existing tax loss carryforwards (as of January 1 of the year the law enters into force) by 50%. The Spanish rules are positive – in that they remove the 18-year limitation on loss carryovers and increase the limit for utilization of loss carryforwards in the current year from 25% of taxable income (these limits only apply above certain turnover thresholds) to 60% of taxable income. As with interest limitations, lots of tweaking taking place by countries to limit the use of NOLs in order generally to increase current cash collections. That’s troubling to me from an equitable point of view. I figure if I lose money I should not have to pay tax until I at least break even? But the arbitrary permanent disallowance proposed by Sweden seems really over the top and the type of tax policy that the OECD should weigh in against.

  Spain also proposes to implement anti-hybrid rules very similar to the OECD proposals – consistent with my concern about selective BEPS implementation in advance of final guidance.

So what’s it all mean? First, we have an ambitious, hard-working, more empowered OECD producing lots of detailed reports with lots of open questions and further work to be done before the final versions are released. The extent of the open questions in each of the areas seems to me to evidence some degree of non-consensus among the extended OECD group, so it would appear that final versions may well contain some optionality or other compromises. But the reports produced to date can and are serving already as a basis for legislative change on a country level and are potentially viewed as a global imprimatur for action by local governments for revenue-raising legislation.  To date such legislation and proposals all seem to go the same direction – increased local tax and reporting burdens. What to do – I’d encourage more proactive business involvement with the OECD, where we need more balance and support against unilateral local country actions with likely double tax outcomes. At the same time, I’d also encourage businesses to carefully monitor country actions and to try to be more nimble in reassessing their global tax strategy and options.  All of which easier said than done, of course.

This commentary also will appear in the December 2014 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation,  and in Tax Practice Series, see ¶7110, U.S. International Taxation: General Principles.

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