International Tax: Base Erosion and Profit Shifting Action Plan

BEPS (OECD?) - Massive Changes to Taxation of International Business

I. Introduction

BEPS stands for ‘Base Erosion and Profit Shifting.’ The BEPS plan was launched during the 2008 global reccession. The notion behind this launch was threefold:

• Firstly, to revise the international tax structure;
• Secondly, to align the framework with the enlargements of the global economy; and
• Lastly, to make sure that profits are duly taxed where the economic activities are carried out.

This expression is commonly used along with the tax-evading strategies in which the taxpayers shift their profit from a high tax-paying jurisdiction to a truncated tax-paying jurisdiction. In fact, the Organisation for Economic Co-operation and Development (OECD) once pointed out that autonomous measures by countries could lead to global tax disorder marked by the re-emergence of double taxation. The world, therefore, recognized that some of the policies, especially relating to the taxation of overseas share transfers and e-commerce transactions, are inconsistent with international approaches and may be far beyond what the OECD has proposed. In the face of hostile international tax avoidance schemes, it can be said that BEPS is an attempt stemming from countries’ efforts to protect their legitimate tax base.

The framework basically abuses the gaps and disparities in the tax rules, which results in shifting of tax. To this end, the framework seeks to eradicate double non-taxation, end treaty abuse, etc. This requires countries to implement comprehensive changes to the existing tax treaty network. The BEPS edge mirrors the budding commercial, economical and vibrant changing aspects between advanced and developing markets, and hints a major move in the worldwide tax and regulatory environment.

The BEPS Action Plan (“B Action Plan”) has identified 15 action items, as carrying out changes to every treaty may have led to inconsistencies and would also have been time-consuming. To allow for a more coordinated approach and to avoid the time-consuming process, Action 15 of the BEPS Action Plan recognized Multilateral Instrument (“MLI”).

II. An overview of the B Action Plan

a. Digital economy and tax challenges

Action 1 recommends widening the scope of permanent establishment. This can be done by restraining exemption for preparatory/auxiliary activities;

It essentially addresses the tax challenges that are raised by the digitalisation, solutions to which include the re-allocation of revised nexus rules and profit. It means that this pillar will explore the potential solutions in determining the basis for tax be paid and where such tax is to be paid. Another solution includes the anti-base erosion mechanism which explores the design of the system that will ensure the payment of minimum level of tax by multinational enterprises in the digital economy.

The imposition of taxes on the country where the customer is located. Additionally, the OECD provides support to the developing countries on this work which are carried out through a set of events on digitalisation in partnership with development banks and regional organisations.

b. Hybrid mismatch arrangements and their effects

As the second action, BEPS called for developing a model treaty recommendations and provisions with regards to the design of domestic rules in order to neutralise the effect of hybrid entities and instruments. It essentially highlights that hybrid mismatch arrangements are generally used in aggressive tax planning to take undue advantage of and exploit the difference in the treatment of tax entities under the laws of two or more tax jurisdictions. 

c. Controlled Foreign Company (“CFC”) Rules

Action 3 recommends approaches to attribute some categories of income of foreign companies to their shareholder (s) to counter offshore structures that generally shift income from the shareholder jurisdiction, thereby limiting opportunities for tax rearrangement through blocker entities in low tax countries.

d. Interest deductions

Action 4 recommends limiting the entity’s deductions for interest pay-outs by proposing some fixed ratio rules that are based on earnings before interest income and expense, depreciation and amortisation (EBITDA)/net interest.

The OECD believed that due to excessive interest costs countries are losing out on tax receipts, which could have been used by multinational groups to reduce taxable profits in companies in high tax jurisdictions.

Interest relief restrictions may have a particular effect on businesses in the energy, infrastructure, and real estate sectors, where there are very high levels of debt funding for all countries. The B Action Plan mainly affects transfer pricing documentation and country-by-country reporting, permanent establishment status, and hybrid instruments. For the business environment in Latvia, the B Action Plan aims at improving tax administration for multinational enterprises as well as reduce the distortion of competition. But, it is not clear how the same will be implemented globally.

e. Provision for addressing special tax regimes

BEPS Action 5 recommends perceiving favoured tax regimes and preserving a framework of transparency including sharing of tax rulings, advance pricing agreements and providing substantial activities in a country to avail preferential tax regimes.

f. Avoiding treaty abuse

Action 6 of BEPS recommends countering treaty shopping through the following:

1. Clearly mention in the treaties that it does not seek to provide an opportunity for tax avoidance or evasion;
2. Inclusion of a test (for principal purposes) that denies any relief in case one of the purpose of arrangement or transaction is to obtain such relief which is not consistent with the objectives of the treaty; and
3. A limitation on the rule of benefits that limits the availability of reliefs under the treaty to entities which meet certain conditions or criteria based on their ownership, legal nature, and general activities.

g. Avoiding the artificial avoidance of permanent establishments Status

BEPS Action 7 had proposed several changes to the definition of permanent establishment as mentioned in the OECD Model Tax Convention. In short, the changes recommended that the restriction in the application of a number of exceptions to the definition of permanent establishment which includes preparatory and auxiliary natured activities should be not abused and that these exceptions should not be taken advantage of by fragmentation of a cohesive operating business into a number of small operations. The purpose of the review of the definition was primarily to prevent using tax avoidance strategies to circumvent the strategies which were used by the former model’s definition of permanent establishment. For example, there were arrangements through which the taxpayers were able to replace subsidiaries that acted as distributors by commissionaire arrangements, which consequently resulted in the shift of profits out of the jurisdiction where such sales took place. Further, these took place without a substantive change in the functions that were performed in such jurisdiction.

h. Bring into line transfer pricing outcomes with value creation

Actions 8-10 of the Action Plan addresses the transfer pricing guidance to make sure that the outcomes are better aligned, strengthened with the existing standards. Transfer pricing rules are used for tax purposes which are mainly concerned with determining the various conditions (which includes pricing) for transactions with an MNE group which results in the allocation of profits to such companies within that group in different jurisdictions. The arm’s length principle related to transfer pricing states the amount which is charged by one related party to the other party for a particular product must be the same, as if such parties were not related, therefore being the price as it would be in an open market. Further, arm’s length principle has often proved useful as a balanced and practical standard for taxpayers and tax administrations to evaluate the transfer prices between the associated enterprises, and also to prevent double taxation.

i. Data gathering

Action 11 with regards to monitoring and measuring BEPS suggested instigating better data collection and sharing tools for monitoring the scale of BEPS and determining counter-measures for the same. This action reflects the methodologies to collect data and analyse it on the fiscal and economic effects of tax avoidance behaviour as well as the impact of measures that are proposed under this project.

j. Disclosure rules

Action 12 provides references for the compulsory discovery of specific ‘reportable schemes’ in order for countries to be able to recognize possibly hostile and unmannered tax planning measures, along with enhanced information sharing between countries.

k. Transfer pricing certification and country-by-country reporting

Action 12 would include a master file which will provide an outline of large multinational enterprises’ global transfer and global trade pricing rule, as well as a local file which would contain comprehensive and detailed information with regards to the intercompany transactions. Additionally, a country-by-country report which will be consolidated annually would include details of taxes paid, distribution, and activities in each jurisdiction.

The transfer pricing regime ensures that transactions made between connected parties are taxed on an arms lengths basis and in the same way that they would have been taxed had the connection not existed. BEPS project, therefore, majorly focuses on transfer pricing. The transfer pricing rules authorize adjustment of the amount of income earned for tax purposes or expense incurred on transactions between companies. However, where it appears that the transaction did not take place at ‘arm’s length,’ the same terms would apply if the transaction involved an unrelated company. The mainstream proposals merely specify a 'general strategy direction' that countries could hypothetically choose whether, how, and when to the device. The BEPS Project therefore acclaimed minimum principles in three zones which are required to be effected as and when required.

Building an effective dispute resolution mechanisms

l. Developing a multilateral instrument

Action 14 suggested developing minimum standards and best practices for resolution of disputes through in a timely (within an average timeframe of 24 months) and transparent manner.

m. Developing a multilateral instrument

Action 15 recommended the development of a multilateral instrument for amendment of all bilateral tax treaties between signatories for expediting implementation of BEPS action points.

III. Impact and Changes in the International Tax System

The international tax system has changed rapidly as a result of synchronized actions by directions and independent measures designed by individual countries. These measures are intended to tackle concerns over the BEPS and supposed international tax avoidance techniques of high-profile corporations. The sanctions of the BEPS Project led by the OECD are at the root of much of the harmonized activity, although the timing and methods of portrayal differ.

International businesses are a significant part of BEPS and are represented in several ways in the B Action Plans. When the BEPS package was finally accepted, it served as a stepping-stone for modern international tax limits, which is based on the base principle that multinational corporation income has to be taxed there, where they are collected, or business activities carried on. 

The B Action Plan aims to resolve irregularities by fetching tax from a place closer to where it was created. The assessment will be demonstrated within the country, which has human resource and infrastructure.

As regard permanent establishments, it is said that global market places may be compressed if immunities are reduced. The B Action Plan suggests that the preparatory/auxiliary activity exemption may not apply if the foreign enterprise running the web platform has a warehouse in India, and proximity to customers is integral to the business model. In some cases, countries have argued that even a website or intangible property could itself create a permanent establishment, the OECD does not endorse such a broad concept of nexus based on significant economic presence.     

What the ultimate value of B Action Plan is, will only be determined by its implementation With regard to implementation, many parts of the package were already being introduced by member jurisdictions and the imminent agreement within the European Union of compulsory information-sharing regarding tax rulings. Other measures will require domestic law changes. Although some actions do not require a lot of attention from businesses, some actions cause the most concern for accountants and experts, for example, country-by-country reporting of business activities. As mentioned above, many of the BEPS reports recommends changes to international tax rules vis-à-vis domestic rules. For valuation purposes, companies apply tax rules to allocate values within the entities and assets. Therefore, there may be a possibility that companies may not have the necessary expertise to deal with the situation.

There are also concerns about security transmission, storage, handling, while it is too early to analyse the impact, it can be said that for advanced and developing countries revenue losses from profit shifting remain.

IV. Conclusion

With an initial membership of 82 jurisdictions and countries in the year 2016, the inclusive framework has expanded, and has brought together 116 countries and prerogatives, and includes numerous universal and regional parties. It is planned to be implemented by 2020. From a commercial point of view, this will lead to certain minutest criteria to be applied for achieving the desired results. However, the most pressing challenge is how to bridge the divide among the various points of view so that coherence of the international tax system is maintained. Importantly, businesses based on the manner of subjective application will gain the most. Developing countries, to protect its tax bases, have much to gain from the implementation of the BEPS measures.  Sequences of new data-gathering processes and analytical tools have been established and are now being put in place, including data in respect of Country-by-Country reports, to address this issue. However, a major challenge of assessing the scale and impact of BEPS is the limitation of existing data sources.

Most entities face the issue of high cost, ambiguity and complexity, which could hamper the growth of business on an international platform. Some of the B Action Plan may hold up investment within which may make it harder for the businesses to expand. Further, many ‘brick and mortar’ companies may expect minor changes.

It is believed that the BEPS Project is the most aspiring bilateral global tax policy initiative ever undertaken. Nonetheless, the impact will be significant, and the framework will irretrievably change the manner in which businesses are taxed. The effort to device BEPS is indeed laudable, but there is also an equally compelling need to focus on providing certainty. However, with its implementation, world-wide companies, funds and international stakeholders will have to revisit prevailing structures for securing treaty relief and most notably additional tax acquaintance that may arise on account of permanent establishments and intra-group transfer pricing.

Further, it is also believed that the developments taken together will show great progress. However, the implementation of the BEPS measures is still at an early stage, and more tangible results are yet to come. The digitalization of the economy and the actions to cope with the challenges that digitalization may create will be one of the main topics for the years to come, with many coordinated actions to be expected.