After BEPS – the OECD’s proposals for corporate tax reform, and how governments and corporates are responding
December 2017 | SPECIAL REPORT: GLOBAL TAX
Financier Worldwide Magazine
December 2017 Issue
One significant consequence of the financial crisis was greater scrutiny of the techniques and cross-border structures used by major multinational groups to reduce their effective tax rates. Increasingly, cash-strapped governments have seen an opportunity to respond to public concerns and to raise revenue; they have also recognised that this issue could only be tackled on an international level.
Thus, the Base Erosion and Profit Shifting (BEPS) initiative was born. It was led by the OECD, which has traditionally led the way in framing the international tax system, working with the G20 and involving many developing countries. Many of the proposals that were made in the final reports on the 15 action items, released in 2015, are therefore starting to be adopted around the world. At the root of the project was a recognition that the international tax system, largely designed in the 1920s, needed updating for the globalised and digital age, and that the worldwide tax treaty network was reasonably effective at ensuring income did not get taxed twice, but did nothing to ensure it did not go entirely untaxed.
The three founding principles of the BEPS project were coherence, substance and transparency. In simple terms, the ‘coherence’ strand was aimed at preventing income from falling into untaxed ‘black holes’ as a result of inconsistencies between tax systems, the ‘substance’ strand at preventing income from being directed to low-tax jurisdictions with little in the way of employees or activities and the ‘transparency’ strand was aimed at ensuring that interested tax authorities had access to consistent information about a group’s tax planning arrangements, so that they could see the bigger picture. As a quid pro quo for taxpayers, the project also sought to improve dispute resolution mechanisms where different tax authorities were claiming the right to tax the same income.
Some action items are being widely and consistently adopted. More than 60 countries have adopted country-by-country reporting, which obliges multinationals with a turnover in excess of €750m to file annual reports setting out their income, profits and tax liabilities in each jurisdiction in which they operate, together with the value of their assets and number of employees broken down by jurisdiction. The report must be filed in the group’s parent company jurisdiction, and is then automatically shared with other participating tax authorities. Significantly, this is effectively the only action item which has been adopted by the US.
Country-by-country reports have been decried by some advisers as a first step away from the traditional arm’s length standard of transfer pricing toward a formulary apportionment method, under which taxable profits would be allocated between jurisdictions based upon the value of assets, sales and the number (or total cost) of employees in each. The OECD denies it has any such agenda: the reports, it insists, are meant to be a risk assessment tool to facilitate enforcement of conventional transfer pricing. The reports will, however, lay bare structures which result in substantial profits being generated by companies in low tax jurisdictions with few employees and little capacity to oversee the risks they are supposedly managing. Such structures are typically founded on the holding of intellectual property (IP), either in a conventional tax haven or in a low tax jurisdiction with access to a wide-ranging treaty network.
Having identified structures they may wish to challenge, tax authorities will have a new weapon to do so in the form of the changes to OECD transfer pricing guidelines. These shift the emphasis away from ownership and toward activities when assessing where the profits from IP should reside. At the more extreme end, the new guidelines allow tax authorities greater latitude to re-characterise transactions that would not be entered into between unrelated parties, and provide that ‘cash box’ companies which merely own IP without having the capacity to manage it will be entitled to no more than a ‘risk-free’ return, broadly equivalent to interest on a cash deposit.
The new guidelines have not been consistently adopted, which reflects the increasingly inconsistent approach that different countries have taken to pricing transactions involving intangibles. Notably, the US has not adopted the new guidelines, which potentially cut across many cost-sharing structures adopted by US multinationals for developing IP, which frequently involve non-US rights being held in a low tax jurisdiction. The UK, by contrast, adopted the guidelines into law with effect from April 2016, while also asserting that they merely reflect established practice: the UK has supplemented this with the introduction of diverted profits tax, which is targeted at related party transactions which “lack economic substance”.
Unsurprisingly, many groups have concluded that IP holding structures based in tax havens have outlived their usefulness. The current trend is toward ‘onshoring’ IP to a more conventional jurisdiction where the group has, or can build, substance to underpin their transfer pricing model: the UK, Netherlands, Switzerland and Ireland are all candidates. As many countries now offer amortisation relief for the expense of acquiring IP, this may not result in significantly increased tax rates in the short term, as amortisation deductions can be used to offset the additional royalty income that will be subject to tax. Some jurisdictions also offer research and development credit or a ‘patent box’ giving reduced rates of taxation on certain IP profits, which can improve the analysis further.
Another technique commonly used by multinational groups is to erode the tax base of higher tax jurisdictions by making intercompany loans from low tax jurisdictions and claiming interest deductions. Such arrangements are less susceptible to challenges based on substance – the making of loans is, inherently, not an activity that requires much substance – and the OECD has instead taken the different approach of proposing that interest expense in excess of a fixed proportion of a group’s earnings in a particular jurisdiction should simply be disallowed (though highly-geared groups may be permitted to claim a higher ratio). This follows a model already adopted by Germany, Spain and Italy, among others, each of which disallows interest in excess of 30 percent of EBITDA. The UK is in the process of enacting similar rules, and an EU Directive will require all other EU members to follow suit over the next few years.
A separate action plan seeks to counteract a favoured technique of US multinationals: hybrid financing. Broadly, this counteracts arrangements which give rise to two deductions for the same expense or a deduction without taxation of the corresponding receipt: results which are typically achieved by use of instruments treated as debt in one jurisdiction and equity in another, or entities treated as partnerships in one and companies in another. The UK enthusiastically adopted these rules some time ahead of anyone else, but other countries are now doing so, and all EU states will be required to do so by 2020.
One technique for ‘cleansing’ these structures is to remove the hybrid element. Another is to move from a no-tax structure to a low-tax structure, within the constraints of any general interest limitation rules. We are thus seeing a move away from pure tax haven structures to low-tax finance centres, often coupled with treasury and cash management/pooling functions.
The final limb of BEPS is an attack on ‘treaty-shopping’: the routing of interest, royalty or dividend payments through third countries with the primary aim of obtaining the benefit of a tax treaty to reduce or eliminate withholding tax. The new ‘multilateral instrument’, signed by over 70 countries, contains extensive provisions designed to combat this, which once again place a premium on establishing substance behind the recipient. Linking long-term structural loans to treasury functions can help to achieve this.
Tax planning is not dead, although increasingly the name of the game is to avoid tax authority challenges or public opprobrium. Not only must corporates put in place structures which are technically robust (in a world where the international rules seem to be diverging, growing in complexity and are becoming increasingly vague), they also need to pass the ‘smell test’, particularly where the company is in the public eye.
James Ross is a partner at McDermott Will & Emery LLP. He can be contacted on +44 (0)20 7577 6953 or by email: firstname.lastname@example.org.
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