05 Apr 2017 The Base Erosion and Profit Shifting Project (the “BEPS”)
The Base Erosion and Profit Shifting Project (the “BEPS”)
Over 80 developing countries and other non-OECD/non-G20 economies united together to develop the BEPS package in order to develop a modern and international tax framework under which profits are taxed where economic activity and value creation occur.
Background on BEPS
What is BEPS?
BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to shift profits to low or no-tax locations where there is little or no economic activity. The BEPS project will ensure the fairness and integrity of the tax system because businesses that operate across borders can make use of BEPS to gain a competitive advantage over other businesses that operate at a domestic level.
BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax.
The BEPS package provides for fifteen (15) actions that equip governments with domestic and international instruments needed to tackle BEPS. Countries now have the tools to ensure that profits are taxed where economic activities generating the profits are performed and where value is created.
What Causes BEPS?
When activities cross border, the interaction of domestic tax systems might lead to having an item of income taxed by more than one jurisdiction and thus might result in double taxation. The interaction might also leave gaps which will result in income not being taxed. BEPS strategies takes advantage of these gaps between tax systems in order to achieve double non-taxation.
OECD’s role in the BEPS project
The OECD plays an important role in the BEPS project given that unilateral action by individual governments could lead to double taxation. This would have a negative impact on investment, growth and employment globally. With the aid of the OECD, an international approach could be adopted which will facilitate and reinforce domestic actions, to protect tax bases and provide comprehensive international solutions to issued which come up.
G20’s role in the BEPS project
The G20 strongly support the BEPS project since its inception. All G20 countries participated as equal partners in the development of this project.
The delivery of BEPS is an example of how the G20 can work with the OECD to achieve consensus on important reforms with a worldwide impact.
The BEPS actions amount to fifteen (15). Below please find a summary of all of them:
Action 1: Addressing the tax challenges of digital economy
Digital economy is the result of a widespread in information and communication technology. It is nowadays becoming the economy itself. The BEPS report provides a detailed analysis of the digital economy, its business model and its key features. It also deals with the fact that VAT in the digital age should be paid at the country of consumption, that is, in the country where the customer is located.
Action 2: Neutralise the effects of hybrid mismatch arrangements
Hybrid mismatches are cross-border arrangements that take advantage of differences in the tax treatment of financial instruments, asset transfers and entities to achieve ‘double non-taxation’ which may not have been intended by either country. An example of this is an instrument which is considered as a debt in one country and an equity in another country so that a payment under the instrument is deductible when it is paid but is treated as a tax-exempt dividend in the country of receipt.
This action aims at tackling hybrids by eliminating the tax benefits derived therefrom. It sets out general and specific recommendations for domestic hybrid mismatch rules and model treaty provisions which will put an end to multiple deductions for a single expense, deductions in one country without corresponding taxation in another or the generation of multiple foreign tax credits for one amount of foreign tax paid.
Action 3: Strengthen controlled foreign companies rules
These relate to rules which respond to the risk that taxpayers with a controlling interest in a foreign low-taxed subsidiary can shift income into it and avoid taxation. Countries are not obliged to introduce these rules however the report identifies the building blocks necessary for effective rules on the matter.
These rules may pose the risk of double taxation in some cases for example where the attributed income is also subject to foreign corporate taxes. For this reason, the report recommend that the rules include provisions such as foreign tax credits or dividend exemptions, to ensure that there is no double taxation.
Action 4: Limit base erosion via interest deductions and other financial payments
This relates to the use of third-party and related party interests. This is considered as the most simple of the profit-shifting techniques available in international tax planning.
The recommended approach for interest deductions includes a fixed ratio which allows an entity to deduct net interest expense up to a benchmark net interest ratio within a corridor of 10%-30% and an optional group ratio rule which allows an entity to deduct net interest expense up to its group net interest ratio, where this is higher than the benchmark fixed ratio.
A common approach on interest deductibility has been agreed to facilitate convergence of national tax practices over time and enabling further considerations of whether such measures should become minimum standards in the future.
Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance
This addressed the harmful tax competition issue. This Action entailed a revamp of the work on harmful tax competition with focus on requiring substantial activity for any preferential regime and on improving transparency.
Transparency is very important in this aspect as the lack of transparency makes it harder for other countries to take defensive measures. In fact, the report tackles the exchange of rulings that could give rise to BEPS concerns in the absence of compulsory spontaneous exchange. Such rulings are to be exchanged as quickly as possible and generally not later than three (3) months after the date on which the ruling becomes available to the competent authority of the country that granted the ruling.
Action 6: Prevent treaty abuse
This deals with ‘treaty shopping’ which refers to arrangements through which a person who is not a resident of one of the two States that concluded a tax treaty, may attempt to obtain benefits that the treaty grants to residents of those two (2) States. This usually takes place through the establishment of companies in States with desirable tax treaties leading to ‘letterbox’ entities which exist on paper but do not have any substance in reality.
The minimum standard of ‘treaty shopping’ requires the adoption of rules in bilateral tax treaties that effectively address ‘treaty shopping’.
Action 7: Prevent the artificial avoidance of permanent establishment status
The definition of ‘permanent establishment’ has been changed to address techniques used to inappropriately avoid the existence of a permanent establishment.
For this change to become applicable, tax treaties will have to be amended.
Action 8-10: Assure that transfer pricing outcomes related to intangibles are in line with value creation
Collective Analysis of Actions 8 to 10 – These three (3) Actions are usually discussed together as their objective is to make sure that transfer pricing outcomes are in line with value creation by requiring that the attribution of value for tax purposes is consistent with economic activity generating that value.
BEPS used the arm’s length principle to deal with transfer pricing given that, in most cases where two (2) countries with broadly similar tax systems are involved, this principle effectively and efficiently allocated the income of multinationals among taxing jurisdictions.
The transfer pricing rules have been revised accordingly. Below are the main issues which had been revised:
- Transactions involving intangibles;
- Contractual allocation of risks;
- The level of returns to funding where those returns do not correspond to the level of activity undertaken by the funding company;
- Re-characterisation of transactions which are not commercially rational; and
- Service fees and commodity transaction.
Action 8 – This looks specifically at intangibles and it aims at developing rules to prevent base erosion and profit shifting where intangibles are owned by, used by, contributed to or moved among group members.
Action 9 – This specifically looks at the risks and develops rules to prevent base erosion and profit shifting by transferring risks among, or allocating excessive capital to, group members.
Action 10 – This Action looks specifically at other high-risk transactions and will develop rules to prevent base erosion and profit shifting by engaging in transactions which would not, or would only very rarely, occur between third parties.
Action 11: Establish methodologies to collect and analyse data on BEPS and the actions to address it
Country-by-country data may be used where appropriate for economic and statistical analysis. While this may be restricted to governments and in some countries to qualified researchers under strict confidentiality rules, statistical analyses based on the date included in the country-by-country report have potential to significantly improve the data available for the future analysis of BEPS.
This Action called for the development of recommendations to ensure that new data and rules are available to monitor and evaluate the effectiveness and economic impact of BEPS actions in the future. This proposes recommendations on how governments can make better use of the data that is already collected and the important new data that will be collected as a result of the BEPS project.
Action 12: Require taxpayers to disclose their aggressive tax planning arrangements
Mandatory disclosure regime requires promoters and/or taxpayers to disclose upfront to the tax administration the use of schemes presenting certain features or hallmarks. This provides early information to tax administrations on aggressive or abusive tax planning schemes and the identity of the users of those schemes.
This Action provides a number of options that enable countries to design a regime that fits their need to obtain early information on aggressive or abusive tax planning schemes and their users.
The recommendations include on (i) who should have the obligation to report; (ii) type of hallmarks; (iii) when the obligation to disclose should be triggered; and (iv) the introduction of penalties to ensure compliance with mandatory disclosure regimes.
Upon the collection of this data, the tax administration will use it to introduce changing in behaviour and to counteract tax avoidance schemes.
Action 13: Re-examine transfer pricing documentation
Transfer pricing documents will be held in a ‘master file’ that would be available to all relevant country tax administrations. Moreover, a ‘local’ file also needs to be maintained. This should contain the relevant third party transactions, the amounts involved in these transactions and the company’s analysis of the transfer pricing determinations they have made with regard to those transactions.
Such information will not be available to the public to protect the confidentiality of potentially sensitive information. The information is to be transferred between different jurisdictions through the automatic exchange of information mechanism. This reporting will provide the tax administrations with useful information to assess transfer pricing risks, make determinations about where audit resources can most effectively be deployed and in the event audits are called for, commence and target audit enquiries.
This means that three (3) different reports are to be carried out for transfer pricing, namely (i) country-by-country report, which is intended to allow tax administrations to perform high level transfer pricing risk assessments or evaluate related risks, (ii) master file, which would be available to all relevant country tax administrations; and (iii) local file, which will identify the relevant related party transactions, the amounts involved in those transactions and the analysis of the transfer pricing determinations, in each country.
Mechanisms will emerge to make sure that proper monitoring is in place for jurisdictions to comply with these reporting commitments. The outcome of this monitoring will be examined in the 2020 review.
Action 14: Make dispute resolution mechanisms more effective
Countries have agreed on a minimum standard and a number of best practices to make dispute resolutions more effective. These will ensure that treaty obligations related to the mutual agreement procedure are fully implemented in good faith and that administrative processes promote the prevention and timely resolution of treaty-related disputes.
Countries commit to seek to resolve cases within an average timeframe of 24 months. This target will be periodically reviewed.
A large number of countries have committed to adopt and implement mandatory binding arbitration as a way to resolve disputes that otherwise prevent the resolution of cases through the mutual agreement procedure.
Action 15: Develop a multilateral instrument
The goal of developing a multilateral instrument is to expedite and streamline the implementation of the measures developed to address BEPS, mostly by modifying bilateral tax treaties.
The BEPS multilateral instrument will modify existing bilateral tax treaties in order to swiftly implement the tax treaty measures developed in the course of the BEPS project. About 90 countries are working together to develop this multilateral instrument.
Implementation of BEPS
Important changes have been triggered through the working methods and composition of the OECD committee on fiscal affairs. Going forward an inclusive mechanism will be designed for monitoring the work of the countries participating in BEPS on an equal footing.
Developing countries participated in the introduction of the fifteen (15) Actions and this will continue. The model tax convention and the transfer pricing guidelines will be completed and released by this year, 2017.
The domestic implementation of BEPS will be supported by the introduction of capacity building, including toolkits, to guarantee effectiveness. These are being developed by the OECD, the United Nations, the International Monetary Fund and the World Bank Group.
The implementation of BEPS will be duly monitored by means of targeted monitoring of the minimum standards on treaty shopping and on dispute resolution, the application of the criteria on harmful tax practices and the implementation of country-by country reporting requirements.
Are BEPS strategies illegal?
Although some strategies used might be illegal, the majority of them are not. These strategies take advantage of the current rules that are still grounded in economic environment rather than in today’s environment of global players which is characterised by the increasing importance of intangibles and risk management.
Why should we worry about BEPS if it is legal?
It distorts competition and may lead to inefficient allocation of resources by distorting investment decisions towards activities that have lower pre-tax rates of return but higher after-tax returns.
How will the success (or otherwise) of BEPS project be judged?
There are many ways to assess this with the first one being whether consensus has been reached on different measures. The second is whether the measures are actually implemented and applied according to the consensus reached and the third one being whether instances of BEPS still exist after implementation.
The BEPS project will always be a success if businesses do not have to comply with hundreds of different disclosure requirements or anti-avoidance measures and can therefore benefit from lower compliance costs.
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