The OECD’s BEPS Action Plan poses immediate challenges for oil and gas companies
Already on the radar of governments and regulatory bodies around the world, recent developments with respect to the Organization for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action Plan are raising further the profile of oil and gas companies globally with both tax authorities and the general public. Although historically relegated to esoteric tax policy discussions among practitioners, the tax structures used by multinational enterprises-including many in the energy space-are now under scrutiny in the popular press and by governments in public hearings.
Given the existing spotlight on transparency in the extractives industry-which predated the OECD’s BEPS initiative-it is critical that oil and gas companies proactively educate themselves with respect to the new BEPS milieu not just from a tax standpoint but also in light of the wide ranging implications for their businesses in areas ranging from asset deployment and human capital management to the development of intellectual property and public relations. Stated bluntly, the outcomes of the BEPS initiative have the potential to significantly impact effective tax rates, restructuring costs, and-ultimately-enterprise value and market capitalization.
It is imperative that oil and gas industry executives and corporate tax and finance professionals conduct cross-functional readiness assessments to determine their level of preparedness to meet the anticipated new challenges posed by the BEPS Action Plan and develop tactical-and practical-strategies to address any observed gaps. Moreover, given the reputation risk posed by the extensive coverage these issues are receiving far beyond technical tax publications, oil and gas companies should take immediate steps to implement a targeted corporate communications strategy to get ahead of inquiries from their people and the public.
AN OVERVIEW OF BEPS
Published in July 2013, the stated objective of the BEPS Action Plan was to develop a global framework to address perceived flaws in international tax rules that tax authorities contend result in the misallocation of income and expense among countries. One of the key issues relates to how multinational enterprises structure and price transactions among their related parties, known as “transfer pricing.”
Essentially, the OECD’s focus is on coordinating and harmonizing international tax rules to eliminate mismatches and incongruities between the laws of different jurisdictions that result in double non-taxation (i.e., income that is not taxed in any country) as well as instances where profits are perceived as geographically divorced from the activities that gave rise to that income.
Negotiated and drafted with the active participation of its member states as well as the G20 members, Latvia and Colombia-44 countries in total-the OECD has moved briskly since the 40-page Action Plan was published in 2013, with the stated aim of completing its final deliverables for all 15 workstreams by December 2015. To date, the OECD has largely kept to the initial time frame for its deliverables.
It is important to note that, generally, OECD pronouncements are regarded as “soft law,” as the OECD is neither an organization of any government nor does it have any authority to make or enforce international law. At the same time, there are many countries that have enacted legislation conforming to final guidance issued by the OECD or directly referencing it.
In the context of transfer pricing documentation and country-by-country (CbC) reporting, on September 22, the United Kingdom became the first of the OECD’s 34 member countries to formally commit to implementing the CbC reporting guidance. Although not an OECD member country, on September 1, Singapore released its proposed updated transfer pricing documentation rules which cleave to the tenets of the OECD’s BEPS proposals.
KEY BEPS WORKSTREAMS FOR OIL AND GAS COMPANIES
Although each of the BEPS workstreams offers points of consideration for multinational enterprises-including interest deductions (Action 4) and rethinking the allocation of profit to risk and capital (Action 9)-oil and gas companies may want to focus their attention on certain aspects of the BEPS Action Plan-in particular, Action 2 (Hybrid Mismatch Arrangements), Action 7 (Prevent the Artificial Avoidance of Permanent Establishment Status), Action 8 (Transfer Pricing Aspects of Intangibles), and Action 13 (Transfer Pricing Documentation and CbC Reporting).
Action 2: Hybrid Mismatch Arrangements. The OECD’s paper on hybrid mismatch arrangements was one of several BEPS deliverables issued on September 16, 2014; it was subsequently approved by the G20 Finance Ministers at their meeting the following week in Cairns. Taking the form of a comprehensive set of proposed rules, the Action 2 deliverable recommends changes to domestic laws to eliminate instances in which income would escape taxation in any jurisdiction.
For example, in the context of intercompany financing-under existing rules-interest paid in one country may be deducted from taxable income, but the payment may not be considered interest income in the other jurisdiction and, instead, treated as equity (and therefore not subject to tax). The Action 2 deliverable aims to eliminate these situations. Although the deliverable purports to take a comprehensive approach, in practice every jurisdiction will adopt its own rules which may-or may not-hew to the OECD’s guidance. As a result, given that oil and gas companies are very capital intensive businesses that habitually work through joint ventures and other types of contracting arrangements to secure significant cross-border financing and operate properties globally, careful attention should be paid by company executives to the developments around this action point.
Specifically, oil and gas company leadership should review and develop an inventory of any existing arrangements to which this guidance may apply and monitor legislative developments in the relevant jurisdictions to stay ahead of potential issues as a result of anticipated rule changes.
Action 7: Prevent the Artificial Avoidance of Permanent Establishment (PE) Status. Strictly speaking, PE is a term defined in double taxation treaties-as opposed to a function of local law-and relates to the threshold level of activity that must be met in a particular jurisdiction in order for a business to be taxable locally either on an income or value-added tax basis or both. Occasionally, the term PE may be used as shorthand to encompass situations where there may not be a treaty defining PE and, instead, a company is subject to the local ‘trade or business’ rules which serve as the local law equivalent of PE, but which may be more stringent and potentially more likely to trigger the payment of tax on income derived from activity in a jurisdiction at a much lower threshold than a PE definition might otherwise provide.
Historically, PE has been a critical consideration for oil and gas companies as hydrocarbon reserves often are most plentifully located in emerging markets whose tax authorities may lack sophistication and struggle with the seemingly continuous and unpredictable movement of personnel and assets across borders that are a hallmark of the industry. For oil and gas companies, perhaps the most immediately relevant portions of the discussion draft issued by the OECD on Oct. 31, 2014, are the proposed rules to counter the splitting up of contracts and the specific activity exemptions.
Primarily discussed in the context of construction contracts, the rules with respect to the splitting up of contracts also are a concern for oil and gas companies. The OECD’s apprehension is that contracts may be artificially divided or split up with the intention of allocating the resulting split contracts to a different related party in order to avoid the existence of a PE. This issue is particularly germane for upstream oil and gas operators and service companies which frequently must split contracts for a variety of reasons-such as local content rules and customer requirements.
Drilling companies should also pay particular attention to this issue as mobile offshore drilling units-and the personnel and services that attend them-routinely move between jurisdictions at a moment’s notice potentially creating the appearance of artificial PE avoidance when, in reality, the business is reacting to customer demands or other market forces. Although the discussion draft states that this provision is focused on countering abuse of the PE provision in tax treaties and, as such, would apply only to tax-motivated cases and not where there are legitimate business purposes for the involvement of associated enterprises, in practice this distinction is likely to prove highly contentious.
The topic of specific activity exemptions is also pertinent for oil and gas companies. Among other things, the Action 7 discussion draft examines the list of exemptions contained in Article 5(4) of the OECD Model Tax Convention according to which a PE is deemed not to exist where a place of business is used solely for certain activities enumerated in that paragraph such as warehousing, purchasing, and collecting information.
Concerned that multinational enterprises may potentially-in the words of the Commentary to the OECD Model Tax Convention-“fragment a cohesive operating business into several small operations in order to argue that each is merely engaged in preparatory or auxiliary activity,” the discussion draft calls for the creation of anti-fragmentation rules to force companies to combine activities-not just of a given legal entity but also of related parties-resulting in the assertion of a PE.
In the oil and gas industry, generally, and the oilfield equipment and services sector, specifically-where separate purchasing and warehousing functions in the local country are not uncommon-this approach has the potential to lead to material increases in uncertainty and subjectivity as regards what constitutes a “cohesive operating business” and would also give source countries an ability to piece together or ignore the separate legal personality of substantive legal entities.
As a result of this draft guidance, oil and gas company leadership should ensure that corporate tax personnel are involved early in the process of developing tenders and negotiating customer contracts to ensure that potential PE issues are considered and addressed prospectively to avoid potentially costly missteps. Further, corporate tax personnel should monitor potential changes to PE definitions in the jurisdictions in which they operate and in which they intend to operate. Such ‘treaty awareness’ should be considered an essential element of the due diligence process when exploring entrance into any new market.
Action 8: Transfer Pricing Aspects of Intangibles. Of particular concern to oilfield equipment and services companies, the revisions to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) promulgated under the Action 8 deliverable issued Sept. 16, 2014, address a variety of subjects related to the definition of and compensation related to intangibles in the context of transfer pricing.
Although there are many aspects of the Action 8 guidance relevant to the oil and gas industry, the topic of contract research and development (R&D) activities is particularly salient. Under the revised sections of the OECD Guidelines, the traditional compensation structure for an R&D service provider is turned on its head. In many cases, an oilfield company will want to consolidate economic ownership of its intangibles centrally for administrative ease and more efficient management and deployment. (It is important to distinguish between the economic owner-the party that expects to reap the benefits from commercializing the intangibles it paid to develop-and the legal owner-the party under whose name the intangibles are legally owned and protected).
Commonly, the central economic owner will contract with a related party to develop intangibles in return for a fee typically consisting of the total cost of providing the service plus a markup. This remuneration mechanism reflects that the contract R&D service provider does not own the intangibles it was contracted to create and also does not bear any risk with respect to commercializing the developed intangibles. Under the new guidance-particularly as expressed in Example 7 under Chapter VI of the OECD Guidelines-this arrangement may no longer be accepted.
Essentially, the new argument is that in cases where the R&D service provider possesses unique skills and experience relevant to the research-a highly subjective determination-bears risk related to commercialization, uses its own intangibles, or is managed or controlled by a party other than the legal owner of the intangibles, a cost plus markup approach is unlikely to be viewed as reflecting the anticipated value of the arm’s length price for the contribution of the R&D service provider. Instead, Example 7 posits that the lion’s share of the future income from the intangible would be expected to attach to the R&D service provider while the entity paying for the development would earn an anticipated risk-adjusted rate of return, similar to what would be expected in a financing transaction. Although the specific example cited above is bracketed and shaded in the deliverable-meaning that it has not been agreed by the OECD member states or the G20-that is no guarantee that certain jurisdictions will not implement rules consistent with its premise.
As a result, oil and gas companies should take steps now to examine their intercompany contract R&D arrangements and agreements, paying particularly close attention to the allocation of functions, risks, and responsibilities between the contractor and the contractee and ensuring that the terms and conditions of the agreements reflect the economic substance of the transactions and the actual conduct of the parties. Comprehensive intercompany agreements executed prior to the transactions taking effect are a must.
Action 13: Transfer Pricing Documentation and CbC Reporting. On Sept. 16, 2014, the OECD issued guidance intended to replace the existing Chapter V (Documentation) of the OECD Guidelines. Although the stated objective of the exercise was to provide for a uniform standard and approach to transfer pricing documentation applicable across jurisdictions, in reality the guidance has the potential to drive the opposite result depending upon how it is implemented by individual tax authorities around the world.
Calling for a three-tiered approach to transfer pricing documentation, the guidance directs multinational enterprises to prepare a Master file-providing a holistic view of a company’s global business dealings and operations-as well as Local files containing specific information relevant to each jurisdiction in which the company operates.
The third element is the CbC report (CbCR) which has three tables. The first table is intended to capture the global allocation of the income, economic activity, and taxes paid on a CbC basis, while the second is aimed at identifying the activities performed by each legal entity by country. The third table calls for any additional information that would facilitate the understanding of the first two tables and is optional, unless-on Table 2-the functional characterization “Other” is selected, in which case an explanation is required.
As noted previously, several countries with large oil and gas industry presence have already announced their intention to adopt the new guidance. This development, combined with the speed with which personnel and assets can move across borders in the oil and gas industry, makes it imperative that corporate tax professionals take immediate, proactive steps to assess the readiness of their company’s management information systems-as well as their tax, finance, and accounting personnel-to comply with the new documentation requirements.
THE ROAD AHEAD
Although BEPS has brought about a new and uncertain world in terms of tax administration and policy, there are affirmative steps that oil and gas companies can take now to assess their readiness and, potentially, avail themselves of opportunities for greater efficiency going forward. By cooperating across corporate functions and appropriately engaging with external advisors, oil and gas companies can best position themselves to face the dynamic BEPS landscape, take steps to proactively mitigate enterprise risk, and drive greater value for their stakeholders.
About the authors
Kathryn Horton O’Brien, Nick Raby, and Elizabeth A. Sweigart are with PricewaterhouseCoopers LLP, the US firm of the PwC network of member firms. Pete Calleja is with PricewaterhouseCoopers Australia, the Australian firm of the PwC network of member firms. O’Brien, a principal, is a member of PwC’s Washington National Tax Transfer Pricing Practice and a global coordinator of BEPS issues for the firm. Raby, a principal at PwC, has been with the firm for over 30 years and is a member of the global leadership team with responsibility for operations for the firm’s Tax Controversy and Dispute Resolution practice and also principal in charge of transfer pricing services for PwC in the western US. Sweigart, a director, has nearly 15 years of transfer pricing, tax controversy, and project management experience primarily in the oil and gas industry. Calleja, a partner, is PwC Australia’s transfer pricing leader, the Value Chain Transformation leader for the PwC global network, and a member of PwC’s global transfer pricing leadership team.