On December 18, 2014, the OECD released a discussion draft for BEPS Action 14, titled “BEPS Action 14: Make Dispute Resolution Mechanisms More Effective.” The objective of Action 14 is to develop solutions to address obstacles that prevent countries from solving treaty-related disputes under the mutual agreement procedure (“MAP”). On the same day, the OECD released the first discussion draft for BEPS Action 4 titled “BEPS Action 4: Interest Deductions and Other Financial Payments.” The objective of Action 4 is to prevent base erosion and profit shifting by using deductions for interest and other financial payments. This article provides a summary of the Action 14 and Action 4 discussion drafts.
These discussion drafts are among the latest deliverables produced pursuant to the OECD’s 15-point Action Plan on Base Erosion and Profit Shifting (“BEPS”). Earlier deliverables have been discussed in prior editions of this newsletter. See prior Tax News and Developments article OECD Delivers First Seven Components of its Action Plan on Base Erosion and Profit Shifting (BEPS), (Vol. 14, Issue 5, October 2014) and OECD Delivers Two New Discussion Drafts As Part of its Action Plan on Base Erosion and Profit Shifting (Vol. 14, Issue 6, December 2014) located under publications at www.bakermckenzie.com.
BEPS Action 14: Make Dispute Resolution Mechanisms More Effective
The discussion draft for BEPS Action 14 illustrates the OECD’s commitment to improving the effectiveness of dispute resolution proceedings under the MAP of bilateral tax treaties. In doing so, the discussion draft identifies a number of current obstacles that hinder dispute resolution through the MAP and calls on contracting states to address those obstacles through the framework of four general principles, as summarized below.
The first principle adopted to improve the MAP process is ensuring good faith implementation of treaty obligations relating to MAP. Most notably, the authors suggest that the absence of an obligation to resolve MAP cases under the current interpretation of Article 25 of the OECD Model Treaty is itself an obstacle to the resolution of disputes. In addition, the absence of Paragraph 2 of Article 9 (providing for secondary corresponding adjustments following an Article 9
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adjustment in another jurisdiction) in some treaties frustrates the primary objective of tax treaties - the elimination of double taxation. The discussion draft recommends addressing these impediments through revisions and commentaries to the relevant treaties.
The second principle focuses on administrative processes that promote the prevention and resolution of treaty-related disputes. The discussion draft proposes measures to increase efficiency and objectivity in MAP proceedings. For example, timely and efficient case resolution is achievable if countries allocate adequate resources (personnel, funding, training, etc.) to their competent authority (“CA”) offices. Further, disputes can be prevented if more countries participate in bilateral APA programs and apply the agreed results to transactions across multiple years, including roll-back to audit years. On the other hand, countries can encourage an objective environment for MAP proceedings by safeguarding the autonomy of the CA office from the local audit functions and urging CA staff to focus on factors such as consistency, timely resolution of cases, and principled and objective MAP outcomes, rather than maintaining tax revenues already collected. Lastly, the discussion draft discourages certain practices by field auditors that pressure taxpayers to forego their right to initiate a MAP in exchange for perhaps a lighter settlement offer.
The third principle emphasizes the importance of taxpayers' ease of access to the MAP when eligible. The discussion draft calls for greater transparency and simplicity in the procedures required for taxpayers to access and use MAP, reducing excessive or unduly onerous documentation requirements for MAP requests, providing guidance on the relationship between the MAP and domestic law remedies, clarifying issues connected with time limits to access the MAP, and addressing ambiguities related to MAP and self-initiated foreign adjustments.
Finally, the last principle is ensuring that cases are resolved once they are in the MAP. The authors encourage tax administrators to commit to conducting fair and objective MAP negotiations based on good-faith application of the treaty and to foster cooperative and transparent working relationships with their counterparts. This will allow CAs to keep an open dialogue and continue to hold frequent meetings to resolve cases. In addition, while acknowledging the existence of controversies surrounding mandatory arbitration, the discussion draft suggests revisiting this topic and addressing some of the policy concerns that discourage countries from utilizing this mechanism.
This discussion draft was the OECD’s first step in recognizing several common factors across treaty countries that hamper CA dispute resolution processes. While the obstacles identified and the suggested measures resonate with taxpayers and practitioners, the authors fail to highlight the relative significance of a number of the issues in comparison to others. For example, two fundamental difficulties in the MAP process are the lack of resources of tax agencies and the aggressive and unprincipled positions taken by certain countries that jeopardize effective CA working relationships. Although the OECD has proposed reasonable measures to address such difficulties, the solutions will only be effective when most, if not all, countries commit to implementing the changes in a uniform manner.
BEPS Action 4: Interest Deductions and Other Financial Payments
The Action 4 discussion draft outlines approaches for limiting interest deductions and identifies challenges to developing recommendations under Action 4. Action 4
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arises from a concern that multinational groups are able to erode the tax base and shift profits via excessive interest deductions. In many jurisdictions, debt financing generates tax-deductible interest expense for the borrower and taxable interest income for the lender. Taxpayers might structure intragroup debt to generate deductible interest payments in a high-tax jurisdiction and taxable interest income in a low-tax jurisdiction. According to the discussion draft, the use of hybrid financial instruments, hybrid entities, and preferential tax regimes increases base erosion and profit shifting concerns.
The discussion draft addresses three main types of rules to limit interest deductions. The three main types of rules are:
1. Fixed-ratio rules that limit deductions by reference to a fixed ratio (e.g., debt to equity, or interest to “EBITDA” (earnings before tax, depreciation and interest));
2. Group-wide rules that limit deductions by reference to the group of which the entity is a part; and
3. Targeted anti-avoidance rules that limit deductions in specific transactions (e.g., related-party transactions, conduit arrangements, and excessive-debt pushdowns).
As a general matter, the OECD prefers a group-wide rule but acknowledges that a combined approach using more than one type of rule could be most effective to curtail base erosion and profit shifting while minimizing burdens.
The OECD views group-wide rules as having the greatest potential to curtail base erosion and profit shifting. The theoretical underpinnings of this view are that: (i) the best measure for interest deductions within a group is the group’s net third-party interest expense; and (ii) at the entity level, interest expense should match economic activity. Based on these premises, the discussion draft focuses on developing a rule that aligns interest deductions at the entity level with both the overall group’s net third-party interest expense and the entity’s level of activity.
Group-wide rules have advantages compared to other alternatives. For example, application of group-wide rules depends on group-specific analyses. Therefore, group-wide rules are better suited to entities in different sectors characterized by different leverage profiles. By contrast, fixed-ratio rules are generally inflexible in this regard because they apply the same ratio across all sectors.
Group-wide rules also have disadvantages. For example, having a group-wide rule apply to a multinational group requires a high degree of international consistency across jurisdictions to avoid distortions. There are also challenges in measuring economic activity to determine the appropriate share of group interest deductions for each entity within the group. Moreover, measuring economic activity of an entity based on its earnings or asset values means that volatility from year to year for a group member can limit that group member’s ability to deduct its interest expense. The discussion draft contemplates the use of carry- forward mechanisms to mitigate these distortions; however, carry-forward rules will necessarily increase complexity.
The discussion draft suggested that countries might combine the rules discussed under Action 4. Such a combined approach might involve a general group-wide rule with a carve-out for entities that have a low fixed ratio (the low fixed ratio indicating a lower risk of base erosion and profit shifting). The combined approach could also use targeted anti-avoidance rules for specific transactions.
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The concept behind the combined approach is that it will use the group-wide rule as a default but allow lower-risk entities (and perhaps tax administrations) to control compliance costs by using a fixed-ratio rule that is easier to apply. The availability and quality of group-wide data will be a key driver of compliance costs for groups under any group-wide rule. Therefore, it is unclear whether the low fixed-ratio carve-out will have a material impact on compliance costs if the group must incur additional costs under a group-wide rule.
The OECD’s combined approach to Action 4 is similar to President Obama’s Greenbook proposal in that it utilizes a group-wide rule with a carve-out for low fixed-ratio situations. The General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals (the “Greenbook”) outlines the White House’s proposal for restricting interest deductions for members of financial reporting groups. Under the Greenbook proposal, a group member’s US interest expense deductions would be limited to the member’s interest income plus the member’s proportionate share of the group’s net interest expense. The member’s proportionate share of the group’s net interest expense would then be determined based on the member’s proportionate share of group earnings. The Greenbook proposal’s carve-out allows a member to elect to limit interest deductions to 10 percent of the member’s adjusted taxable income.
The OECD’s work on Action 4 cuts across several other BEPS Action items. In particular, Action 4 is intertwined closely with the OECD’s work on hybrid mismatch arrangements, CFC rules, and pricing of related-party financial transactions, among others. Therefore, it is important to follow progress on these other action items in order to track progress on Action 4.
By Steven Hadjilogiou, Miami, Paul F. DePasquale, New York