The BEPS project: towards an international tax consensus in three stages
In July 2013, the OECD published an action plan with a view to addressing the perceived flaws in the international tax rules that were discussed in the 2013 Base Erosion and Profit Shifting (“BEPS”) report. Taking into account the ambitious scope and deadline of the project, it could be questioned whether the contemplated international reform would be successful. However, with a view on the 2015 deliverables it has become clear that the OECD is heading to a large international consensus on the key measures that should shape future international tax reforms.
Phase 1: July 2013 - September 2014
In September 2014, the OECD released the first three final reports with respect to: the tax challenges of the digital economy (Action 1), harmful tax competition, taking into account transparency and substance (Action 5) and the development of a multilateral instrument (Action 15). Four final instruments were proposed in to the context of: hybrid mismatch arrangements (Action 2), the prevention of treaty abuse (Action 6), transfer pricing aspects of intangibles (Action 8) and the re-examination of transfer pricing documentation requirements (Action 13).
Phase 2: September 2014 - September 2015
On October 8, 2015, the OECD will publish its final eight deliverables related to: the strengthening of CFC rules (Action 3), the limitation of base erosion via interest deductions and other financial payments (Action 4), harmful tax competition, taking into account transparency and substance (Action 5), the prevention of the artificial avoidance of the permanent establishment status (Action 7), the development of rules that assure that transfer pricing outcomes are in line with value creation (Actions 8-10), the establishment of methodologies to collect and analyse data on BEPS and the actions to address it (Action 11), requiring taxpayers to disclose their aggressive tax planning arrangements (Action 12), making dispute resolution mechanisms more effective (Action 14) and the development of a multilateral instrument (Action 15).
Phase 3: December 2015
The OECD has recognised that no final consensus has been reached yet on its work with respect to: the limitation of base erosion via interest deductions and other financial payments (Action 4), harmful tax competition, taking into account transparency and substance (Action 5) and the development of a multilateral instrument (Action 15).
Focus on BEPS phase 2 and 3: Work on Interest Deductions, Permanent Establishments and Transfer Pricing Most Significant
Action 3: CFC rules
On April 3, 2015, the OECD released recommendations for the design of enhanced controlled foreign corporation (“CFC”) regimes. CFC rules are generally intended to prevent shifting income from the parent jurisdiction and potentially other tax jurisdictions to a different, typically low-tax jurisdiction. The mechanism for doing so is having certain controlling shareholders include in their income the income of a foreign subsidiary as a constructive dividend or otherwise. The discussion draft considers all the constituent elements of CFC rules and breaks them down into the building blocks that are necessary for effective CFC rules. The building blocks include: the definition of a CFC, threshold requirements, the definition of control, the definition of CFC income, rules for computing income, rules for attributing income, and rules to prevent or eliminate double taxation. No consensus has been reached yet with regard to the definition of CFC income and the implementation modalities.
Action 4: The Limitation of Base Erosion via Interest Deductions and Other Financial Payments
The OECD focuses on best practices in the design of rules to prevent base erosion and profit shifting using interest and other financial payments economically equivalent to interest. The discussion draft considers a number of options, including general interest limitation rules which set an overall limit on the amount of interest expense in an entity, linking interest deductibility to the position of a group or fixed ratios and, finally, targeted interest limitation rules to counter specific base erosion and profit shifting risks. Either rule, if adopted, may have significant implications on multinational financing costs. Transfer pricing rules are deemed too complex and withholding taxes inefficient to adequately deal with excessive interest payments. The OECD seems to prefer combinations of the above two approaches, where one would be used as a default rule and the alternative only applied where the first test led to non-deductibility. This approach would allow entities with lower levels of interest expense to apply a simple fixed ratio rule, while more highly leveraged entities would apply a more complex group-wide test. Although the discussion draft appears to indicate the likely route the OECD will adopt, there is still a lot of further work to be done on this action. Transfer pricing guidance for related party financial transactions (financial guarantees, hedging transactions, captive insurance agreements, etc.) which also forms part of Action 4, will be addressed separately at a later stage.
Action 5: Harmful Tax Competition
The discussion draft reflects consensus on the importance of having appropriate “substantial activity” requirements in preferential regimes and on the need for increased transparency, including the mandatory spontaneous exchange of information on rulings on preferential regimes. The draft develops a substantial activity factor for intellectual property (“IP”) regimes based on three possible approaches that have been considered in this respect: a “value creation approach”, a “transfer pricing approach” and a “nexus approach”. The preferred nexus approach looks to calculate the IP income eligible for tax benefits by establishing a nexus between the qualifying expenditure incurred on developing IP assets (expressed as a proportion of overall expenditure on creating the IP assets) and the income received from those IP assets. Moreover, it is agreed that no new taxpayers can join any existing harmful regime, and neither can new IP assets owned by existing taxpayers benefit from such harmful tax system going forward (relevant end-date will be no later than 30 June 2016). The final abolition of the old regime would be 30 June2021. Second, the OECD has focused on developing a framework for compulsory spontaneous exchange of taxpayer specific rulings in respect of preferential regimes. Such exchanges will be “mechanical”, rather than discretionary for tax authorities.
Action 7: The Prevention of the Artificial Avoidance of the Permanent Establishment Status
The OECD asserts the need to update the treaty definition of permanent establishment (“PE”) in order to prevent abuses of that threshold. It notes that the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor, which has led enterprises to replace arrangements under which the local subsidiary traditionally acted as a distributor with “commissionnaire arrangements” with a resulting shift of profits out of the country where the sales take place without a substantive change in the functions performed in that country. The OECD also notes that multinationals may artificially fragment their operations among multiple group entities to qualify for the exceptions to PE status for preparatory and auxiliary activities. The discussion draft covers several options for changes to the PE rules in six areas (four options for the tightening of the dependent agent rule, four options for narrowing the scope of the specific activity PE exemptions; as well as six options for the splitting up of contracts, insurance agreements and the fragmentation of activities between related parties). The preferred options, if implemented, would significantly modify the current PE thresholds, thereby potentially creating a taxable presence for companies where none exists today.
Actions 8-10: Assure that Transfer Pricing Outcomes are in Line with Value Creation
The discussion draft states that the legal ownership of an intangible by itself does not confer any right to retain the return from exploiting an intangible, even where this return may initially accrue to the legal owner as a result of its legal or contractual rights. Instead, the return ultimately retained by the legal owner depends on the contributions it makes to the development, enhancement, maintenance, protection and exploitation (“DEMPE”) that contribute to the real value of the anticipated intangibles (“functional value creation”). The draft also provides in a definition of an intangible for transfer pricing purposes: “something which is not a physical asset or a financial asset, and which is capable of being owned or controlled for use in commercial activities and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.” The thrust of the discussion draft is that “location savings”, “synergies” and “assembled workforce” are all comparability factors that should be taken into account in a transfer pricing analysis, but that are not themselves intangibles. The OECD has also provided a large number of practical examples in order to illustrate its intangibles guidance.
b) The Use of Profit Split Methods in the Context of Global Value Chains
The discussion draft addresses nine scenarios where in the OECD’s view it may be more difficult to apply one-sided transfer pricing methods to determine transfer pricing outcomes that are in line with value creation and the application of the profit split method may be more appropriate. The situations described in the draft include transactions where the parties to a transaction are highly integrated and share the key functions and risks, digital business models, trading transactions and hard to value intangibles. The OECD notes that the use of allocation keys within a profit split method analysis has been criticized as being subjective in the past, and states that one of the focus areas will be to develop objectivity in profit split factors so that the outcomes of the transfer pricing analysis are aligned with value creation.
c) Low Value Adding Intra-Group Services
The discussion draft contains additional guidance with respect to an elective, simplified transfer pricing approach for low value-adding intra-group services, including:
- A standard definition of low value-adding intra-group services;
- Clarifications of the meaning of shareholder activities and duplicative costs, specifically in the context of low value-adding intra-group services;
- A determination of appropriate mark-ups (in the limited range between 2% and 5%) for low value-adding intra-group services;
- A determination of appropriate cost allocation methodologies and satisfaction of a simplified benefit test relating to low value-adding services; and
- A description of documentation that should be prepared by a multinational enterprise group to qualify for the simplified approach.
d) Transfer Pricing Aspects of Cross-Border Commodity Transactions
The discussion draft states that the aim is to ensure that the pricing of commodity transactions reflects value creation, thereby protecting the tax base of commodity dependent countries. The OECD proposes clarifying that the CUP method would generally be the most appropriate transfer pricing method for determining the arm’s length price for controlled commodity transactions, and that, under the CUP method, the arm’s length price for the controlled commodity transaction can be determined, not only by reference to comparable uncontrolled transactions, but also by reference to a quoted price.
e) Cost Contribution Arrangements
The discussion draft defines a cost contribution arrangement (“CCA”) as a contractual arrangement in which business enterprises share the contributions and risks involved in the joint development, production, or obtaining of intangibles, tangible assets, or services with the expectation that those intangibles, tangible assets, or services will produce a direct benefit for the participant’s business. This makes clear that in the OECD’s new view contributions (rather than costs) are shared under a CCA. The proposed changes deviate significantly from existing guidance on CCAs by requiring each participant’s contribution to be measured at value rather than at cost.
f) Hard to Value Intangibles
The discussion draft states that the term hard to value intangible (“HTVI”) covers intangibles for which, at the time of the transaction, (i) no sufficiently reliable comparables exist, and (ii) there is a lack of reliable projections, or the assumptions used in valuing the intangible are highly uncertain. In evaluating the ex ante pricing arrangements, the discussion draft states that tax administrations are entitled to use the ex post evidence about financial outcomes to inform the determination of the arm’s length pricing arrangements, including any contingent pricing arrangements, that would have been made between independent enterprises at the time of the transaction.
g) Risk, Recharacterisation and Special Measures
There is still much disagreement about how to proceed more efficiently with a requalification of contracts or other transfer pricing corrections. Nor have the “special measures” yet been defined, and it has been announced that these will be developed further in 2016.
Action 11: The Establishment of Methodologies to Collect and Analyze Data on BEPS and the Actions to Address it
The OECD stated that existing studies did not conclusively determine how much BEPS actually occurs, but asserted that there was abundant circumstantial evidence suggesting that BEPS behaviors are widespread. The discussion draft identifies data, indicators, and economic methodologies for monitoring and evaluating actions taken to address BEPS.
Action 12: Requiring Taxpayers to Disclose their Aggressive Tax Planning Arrangements
The discussion draft sets out a standard framework for a mandatory disclosure regime that ensures consistency while providing sufficient flexibility to deal with country specific risks and to allow tax administrations to control the quantity and type of disclosure.
Action 13: country-by-country reporting
The OECD has provided guidance for the first Country by Country (“CbC”) reports to be filed covering 2016 fiscal years for MNE groups with a minimum turnover of EUR 750 million. The discussion draft focuses on implementation issues, such as: the timing of preparation and filing of CbC reports, the MNE groups required to file CbC reports, the conditions for obtaining and use of the CbC reports by jurisdictions, and the framework for government-to-government mechanism to exchange the CbC reports.
Action 14: Making Dispute Resolution Mechanisms more Effective
The discussion draft identifies four basic principles that will guide the political commitment to enhance dispute resolution procedures:
- Ensuring that treaty obligations related to the MAP are fully implemented in good faith
- Ensuring that administrative processes promote the prevention and resolution of treaty-related disputes
- Ensuring that taxpayers can access the MAP when eligible
- Ensuring that cases are resolved once they are in the MAP
The OECD states that the work is intended to result in measures that will constitute a minimum standard to which participating countries will commit, but additional optional and more comprehensive measures will also be included (such as, for example, MAP arbitration). Even though the report does not propose adoption of universal mandatory and binding arbitration, the proposed practical measures could help improve the access of taxpayers to the MAP and ensure better protection against double taxation if they are implemented in a consistent way.
Action 15: The Development of a Multilateral Instrument
An ad hoc group has been established within the OECD to conduct work on a multilateral instrument that would implement solely the BEPS measures that take the form of recommended tax treaty provisions. The aim is to have the multilateral instrument ready to open for signature by year-end 2016.
BEPS Outlook: What will be the Impact for 2016?
Increased Tax Exposure and Stringent Unilateral Measures
As a result of the BEPS changes, taxpayers will no longer be able to view documentation as a local, separable issue. Instead, multinationals must begin to address documentation globally with a consistent focus on the functional value creation within their organization. The impact will be profound, with significant implications for tax compliance and reporting functions, transfer pricing policies and oversight, tax audits and controversies, and reputational risk.
The OECD deliverables have already influenced a large range of new legislative measures in Australia, Chile, Poland, Russia, South Africa, South Korea, Spain, etc. related to hybrid mismatch arrangements, interest deduction limitations, CFC rules and the so-called “diverted profits” or “Google tax”. It will be crucial that these new measures are integrated effectively into multinationals’ overall business strategies and operational decisions.
EU Tax Transparency Package and State Aid Investigations
On March 18, 2015 the European Commission published a tax transparency package that contains proposals to introduce the automatic exchange of tax rulings between the tax authorities of EU member states. Other features of the tax transparency package, which are specifically aimed at information exchange include a revision of the code of conduct on business taxation, public disclosure of tax information and a discussion on the Common Consolidated Corporate Tax Base (“CCCTB”).
The Commission has confirmed that the application of EU State aid law to Member States’ tax ruling practices will be a priority. If the Commission’s current in-depth investigations confirm that the contested rulings of Ireland (Apple), Luxembourg (Amazon and Fiat), the Netherlands (Starbucks) and Belgium (excess profit rulings) amount to illegal State aid, the Member States concerned will be required to recover the amount of the aid. These developments have resulted in more stringent information and documentation requirements when negotiating tax rulings in the EU.
Increased Global Compliance Burden and Cross-Border Controversy
The BEPS deliverables will likely result in a difficult and time-consuming compliance process. Taxpayers are required to identify each entity within the group doing business in a particular tax jurisdiction and to provide an indication of the business activities each entity conducts. This information is to be made available to the tax authorities in all jurisdictions in which the group operates. The OECD has also emphasised a requirement to analyze the value creation within global organizations and the actual conduct of related parties. However, many interpretation issues remain and conflicting views between OECD Member States and developing countries are likely to result in tax controversy.
However, there is limited guidance on how it might be made.
Should you have any questions regarding this topic or require assistance, please feel free to contact the BDO Transfer Pricing Team: