Canada and other members of the Organisation for Economic Co-operation and Development (OECD) and the G-20 are engaged in a project to address “base erosion and profit shifting” (BEPS) strategies used by multinational enterprises (MNEs) and are working to achieve the goals set out in the OECD’s Action Plan on Base Erosion and Profit Shifting(Action Plan), which was first announced in July 2013. The Action Plan includes 15 items to address BEPS in a coordinated and comprehensive manner. In the 2014 Canadian federal budget, the federal government reiterated its commitment to continue to improve the integrity of Canada’s international tax rules and that it is actively involved in the work of the OECD and the G-20 in this regard. For additional and more detailed comments on Budget 2014, see Economic Action Plan 2014 – International Tax Planning Under Continued Assault.
On September 16, 2014, the OECD released its first set of recommendations, focusing on 7 of the 15 items set out in the Action Plan. Since the release, the OECD issued, on October 1, 2014, a revised calendar for stakeholders’ consultation, setting out a timeline for the completion of discussion drafts and public consultations as part of the Action Plan, with a number of relevant deadlines occurring in the balance of 2014 and throughout 2015.
This article briefly summarizes the first set of OECD recommendations, which were arrived at through consensus of 44 countries (including all OECD members, OECD accession countries, and G-20 countries) and consultation with developing countries, business, NGOs, and other stakeholders. The next outputs of the BEPS project are due to be delivered by the OECD by the end of 2015. Given the interconnectedness of all 15 of the Action Plan items, 4 of the 2014 deliverables discussed below (Actions 2, 6, 8, and 13) remain in draft form and Action 5 is only an interim report. Each of these items will be further refined throughout the balance of 2014 and 2015, including to address technical issues and interaction with the 2015 deliverables. Actions 1 and 15, however, are considered final.
Action 1: Addressing the Tax Challenges of the Digital Economy
The goal of Action 1 is to understand the key features of the digital economy, together with its attendant BEPS issues and how to address them. The report acknowledges that it is likely impossible to ring-fence the digital economy as a component of the broader economy and that, rather, the digital economy is increasingly becoming the economy itself. Further, the report stresses a need to continually evaluate and monitor advances in the digital economy and their impact on tax systems. The report points to several specific areas of technological developments that may generate additional challenges for tax policy makers in the near future:
- the so-called “Internet of Things” (i.e., networked devices);
- virtual currencies (such as bitcoin);
- developments in advanced robotics and 3D printing (which may shift manufacturing closer to end consumers, altering value creation centres in supply chains and the characterisation of business income);
- peer-to-peer sharing of goods and services;
- increased access to government data; and
- reinforced protection of personal data, which is more widely available in the digital economy.
The development of the recommendations on Action 1 involved the creation, in September 2013, of the Task Force on the Digital Economy (TFDE), a subsidiary body of the Committee on Fiscal Affairs (CFA) involving both OECD and non-OECD G-20 members, which undertook extensive consultation with stakeholders prior to reaching its conclusions. The TFDE considers the BEPS issues relating to the digital economy to be primarily exacerbations of existing BEPS risks as opposed to unique ones and, accordingly, the ongoing work on each of the other Action Plan items will include consideration of the impact of the digital economy on those issues.
However, the TFDE did comment on the following specific issues and future action items linked to the digital economy:
- The solutions to BEPS will need to ensure that core activities cannot inappropriately benefit from the exceptions to permanent establishment (PE) status in tax treaties, and that artificial arrangements relating to sales of goods and services cannot be used to avoid PE status. This is because functions considered auxiliary to traditional business models are becoming increasingly significant components of businesses in the digital economy. For example, there may be circumstances in which the maintenance of a local warehouse may constitute a core activity such that it should be outside the scope of the exceptions in Article 5 of the OECD Model Tax Convention. In this regard, work in the context of Action 7 will be expanded to consider whether the scope of the PE exemption should be narrowed to exclude certain “preparatory or auxiliary” activities that are core components of the business.
- The solutions to BEPS will need to be guided by an understanding of the importance of intangibles, the use of data, and the spread of global value chains, and their impact on transfer pricing, in light of the fact that companies in the digital economy rely heavily on intangibles in creating value and producing income.
- There is a concern that an MNE in a digital business can earn income in a controlled foreign company (CFC) in a low-tax jurisdiction by locating key intangibles there and using those intangibles to sell digital goods and services without that income being subject to current tax, even if the CFC itself does not perform significant activities in its jurisdiction. In making CFC recommendations under the Action Plan, consideration will be given to CFC rules that target income typically earned in the digital economy, such as income earned from the remote sale of digital goods and services.
- The collection of VAT in business-to-consumer (B2C) transactions is a pressing issue that needs to be addressed urgently to protect tax revenue and to level the playing field between foreign suppliers relative to domestic suppliers. Further work on this issue is expected to be completed by the end of 2015.
- The CFA is to consider and clarify the characterization under current tax treaty rules of certain payments under new business models (e.g., cloud computing).
Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements
The draft recommendations for Action 2 are split into two parts: Part I, which provides recommendations for domestic rules to neutralize the effect of hybrid mismatch arrangements, and Part II, which sets out recommended changes to the OECD Model Tax Convention to deal with transparent entities, including hybrid entities.
The recommendations are aimed at hybrid mismatches, which, generally speaking, are arrangements that, as a result of the different tax treatment or characterization in two jurisdictions of a particular financial instrument, asset transfer, or entity, achieve double non-taxation or long term deferral outcomes that may not have been intended by either country. For example, a common type of hybrid financial instrument is an instrument that is considered a debt in one country and a share in another so that a payment under the instrument is deductible when it is paid, but treated as a tax-exempt dividend in the country of receipt.
With respect to recommendations for domestic rules, generally, the report recommends measures to address hybrid mismatches by:
- denying a dividend exemption for the relief of economic double taxation in respect of deductible payments made under financial instruments;
- introducing measures to prevent hybrid transfers being used to duplicate credits for taxes withheld at source;
- improving CFC and other offshore investment regimes to bring the income of hybrid entities within the charge to taxation under the investor jurisdiction and the imposition of information reporting requirements on such intermediaries to facilitate the ability of offshore investors and tax administrations to apply such rules; and
- implementing rules restricting the tax transparency of reverse hybrids that are members of a controlled group.
- More specifically, the recommendations advocate for domestic rules targeting payments under hybrid mismatch arrangements that (i) are deductible under the rules of the payer jurisdiction and not included in the ordinary income of the payee or a related investor (referred to as “deduction / no inclusion” or “D/NI” outcomes), or (ii) give rise to duplicate deductions for the same payment (referred to as “double deduction” or “DD” outcomes). The report recommends a two-tiered response with a “primary” rule as well as a “defensive” measure that would apply if the other jurisdiction has not adopted the primary rule.
- As an example, the primary response to a D/NI outcome involving a hybrid financial instrument would be to deny the payer a deduction in respect of the payment and, as a defensive measure, if the payer jurisdiction does not neutralize the mismatch, then the payee jurisdiction would require the amount to be included in ordinary income.
- As an example, where a payment by a hybrid entity to its parent gives rise to a DD outcome, the primary response would be to deny the duplicate deduction in the parent jurisdiction and, as a defensive measure, if the parent jurisdiction does not neutralize the mismatch, then the payer jurisdiction would deny the deduction for such payment.
The report also provides comments as to the intended scope of the recommended domestic rules, which indicate that the primary targets are arrangements involving “related” parties, “controlled groups”, and certain “structured arrangements”. Proposed definitions for these terms are set out in the report.
In terms of recommended changes to the OECD Model Tax Convention, the report recommends:
- replacing Article 4(3) to provide that cases of dual treaty residence would be solved on a case-by-case basis (i.e., by mutual agreement between the competent authorities of the two states in issue) rather than the current rule, which is based on the place of effective management and has the potential for tax avoidance in some countries; and
- add a new provision that will ensure that income of transparent entities is treated in accordance with the principles of the 1999 OECD report on The Application of the OECD Model Tax Convention to Partnerships. The report notes that the proposed rule will not only ensure that the benefits of tax treaties are granted in appropriate cases but also that these benefits are not granted where neither contracting state treats, under its domestic law, the income of an entity as the income of one of its residents.
Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance
The OECD’s work on harmful tax competition began more than 15 years ago with a 1998 report entitled Harmful Tax Competition: An Emerging Global Issue. The interim report on Action 5 confirms that the OECD’s Forum on Harmful Tax Practices (FHTP) is committed to revamping this work, with a priority on improving transparency. Under Action 5, the FHTP has three deliverables: (i) finalization of the review of member country “preferential regimes”; (ii) a strategy to expand participation to non-OECD member countries; and (iii) consideration of revisions or additions to the existing framework established by the FHTP for assessing whether a particular preferential regime is harmful.
In connection with the first deliverable, the interim report provides an update on two priority areas, the first being a renewed focus on requiring “substantial activity” for any preferential regime. The second priority area is the development of a framework for compulsory spontaneous exchange of rulings related to preferential regimes (i.e., the exchange of taxpayer-specific rulings related to preferential regimes and which that taxpayer is entitled to rely upon). To the extent countries have the legal framework to start exchanging information covered by the framework, it is the intention that this apply from the end of 2014.
The FHTP’s work is primarily concerned with tax regimes that apply to income from geographically mobile activities, such as financial and other service activities, including the provision of intangibles, and more specifically to regimes that offer some form of tax preference in comparison with the general principles of taxation in the relevant country (e.g., a reduction in the tax rate or tax base or preferential terms for the payment or repayment of taxes).
A review of preferential regimes of OECD member countries commenced in late 2010 and the review of preferential regimes of associate countries commenced in late 2013; several aspects of this review are ongoing. However, the review process has so far identified 30 preferential regimes, some of which have been determined to be not harmful, and many of which are still under review. The next steps in respect of Action 5 will be to complete this review and then to engage with non-OECD member countries on the same basis.
Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances
On March 14, 2014, the OECD issued a public discussion draft on Action 6 and thereafter received a number of comments, which are available on the OECD’s website. The September 16, 2014 version of the recommendations on Action 6 advocate a treaty-based approach to addressing the issue of treaty abuse and includes a number of alternatives which may be adopted as part of the OECD Model Tax Convention. The report indicates that there is agreement that, whichever alternative is adopted, there is a common goal to ensure that states incorporate in their treaties sufficient safeguards to prevent treaty abuse, in particular in respect of treaty shopping.
The report recommends a “minimum level of protection” whereby countries would agree to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. In addition, the report advocates that such common intention be implemented either through the use of a specific anti-abuse rule based on the limitation-on-benefits provisions similar to those used in U.S. tax treaties (the “LOB” rule), supplemented by a mechanism to address certain conduit financing arrangements, and/or a more general anti-abuse rule based on the principal purposes of transactions or arrangements (the “PPT” rule). The PPT rule would deny treaty benefits if “one of the principal purposes” of an arrangement or transaction is to obtain the treaty benefit, unless granting that benefit would be in accordance with the object and purpose of the relevant treaty provisions. The report includes draft versions of the LOB and PPT rules and outlines the strengths and weaknesses of each, noting that they may not be appropriate for all countries (e.g., due to constitutional or EU law restrictions).
It is anticipated that a final version of Action 6 will be released in September 2015.
It is worth noting that Canada has been actively addressing this issue through domestic legislation and tax treaties. The general anti-avoidance rule (GAAR) contained in Canada’s domestic tax legislation already provides that it may be applied to deny a benefit arising from a misuse or abuse of any of Canada’s tax treaties. The 2014 Canadian federal budget proposed an additional domestic rule addressing treaty shopping, but on August 29, 2014, the federal government announced that it is deferring action on this initiative and will instead await further work by the OECD and G-20 in relation to BEPS. Also, the recently in-force Canada-Hong Kong tax treaty includes PPT rules with respect to the payment of dividends, interest, and royalties.
Action 8: Guidance on Transfer Pricing Aspects of Intangibles
Action 8 proposes to develop rules to prevent BEPS by moving intangibles among group members, which will involve adopting a clear definition of “intangibles”, ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with value creation, developing transfer pricing rules or special measures for transfers of “hard to value” intangibles, and updating the guidance on cost contribution arrangements.
The Action Plan contemplates continuing work on the transfer pricing rules, including under Actions 9 (risks and capital) and 10 (other high-risk transactions), in 2015. Accordingly, the report on Action 8 remains in draft form, with some of its elements being merely interim drafts of guidance which have not yet been fully agreed by delegates.
The most interesting aspect of the report is the apparent willingness to go beyond the arm’s length principle and consider special measures in order to identify effective responses to certain concerns. Key among these are the following special measures, which will be considered during the course of 2015:
- providing tax administrations with authority in appropriate instances to apply rules based on actual results to price transfers of hard to value intangibles and potentially other assets;
- limiting the return to entities whose activities are limited to providing funding for the development of intangibles, and potentially other activities, for example by treating such entities as lenders rather than equity investors under some circumstances;
- requiring contingent payment terms and/or the application of profit split methods for certain transfers of hard to value intangibles; and
- requiring application of rules analogous to those applied under Article 7 of the OECD Model Tax Convention to certain situations involving excessive capitalisation of low function entities.
No decision has been made with respect to the adoption of any “special measures”. The report notes that the work on Action 8, together with ongoing BEPS work, will be part of a coordinated and coherent response to transfer pricing generally.
Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting
Action 13 advocates enhancements to transparency for tax administrations by providing them with more information to conduct transfer pricing risk assessments and examinations. This is noted in the draft report to be an “essential part of tackling the [BEPS] problem”. The recommendations, if adopted, would require MNEs to report for each tax jurisdiction in which they do business: (i) the amount of revenue, profit before income tax, and income tax paid and accrued; (ii) their total employment, capital, retained earnings, and tangible assets in each tax jurisdiction; and (iii) an identification of each entity within the group doing business in a particular tax jurisdiction and an indication of the business activities each entity engages in.
A standardized approach to transfer pricing documentation comprising a three-tiered structure is recommended. Specifically, the recommended documentation would consist of:
- a master file containing standardized information relevant for all MNE group members;
- a local file referring specifically to material transactions of the local taxpayer; and
- a country-by-country report containing certain information relating to the global allocation of the MNE’s income and taxes paid together with certain indicators of the location of economic activity within the MNE group.
The report includes as Annexes, templates for the above files with descriptions of the types of information that are proposed to be included in each. The structure of the proposed documentation and types of information to be reported are indicative of an intention to equip tax administrations with the information necessary to determine whether a significant amount of income is being allocated within an MNE group to low-tax jurisdictions in which there is little business substance (e.g., due to lack of employees, assets, etc.).
In the report, the OECD acknowledges that the recommended mechanisms are new and untested. Accordingly, the transfer pricing documentation standards and country-by-country reporting standards are to be revisited no later than the end of 2020.
Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
Action 15 is principally concerned with how the recommendations generated by the Action Plan, once finalized, may be swiftly implemented. The OECD is cognizant of the fact that it takes a significant amount of time and resources in order to introduce any changes to its Model Tax Convention into the vast network of bilateral tax treaties. The result is that bilateral treaties generally lag behind the Model Tax Convention. In light of the scope of the BEPS project, governments have agreed to explore whether it may be feasible to implement a multilateral instrument that would have the same effect as the simultaneous renegotiation of the many bilateral tax treaties. This approach in the tax context would be unprecedented, but such an approach has been used in other areas of public international law.
While the report identifies, based on input from experts in public international law and tax law, certain issues arising from the development of such an instrument, it concludes that a multilateral instrument is a desirable and feasible method for implementing some of the measures developed in the BEPS project that are “multilateral in nature”. The report indicates that negotiations for such an instrument should be convened as soon as possible and, in this regard, the OECD is developing a mandate to call an international conference for this purpose in 2015.