In OECD’s opinion, base erosion is one of the most prejudicial phenomena for “tax revenues, tax sovereignty and tax fairness” and it is mainly caused by profit shifting – when that profit shifting is made to more favourable tax jurisdictions, by means of aggressive tax planning.
Multinational corporations also often “exploit differences or disparities in domestic tax rules and international standards that provide opportunities to eliminate or significantly reduce taxation”.
The Organisation for Economic Co-operation and Development (OECD) provides for a directory of aggressive tax planning schemes that it is used by many governments in order to improve their audit performance. Increasing tax compliance secures governments’ revenue and materializes the ideal of a level playing field.
In order to fight against Base Erosion and Profit Shifting (BEPS), the OECD report draws the following conclusions:
- There is a need for increased transparency on effective tax rates of multinationals;
- Hybrid mismatch arrangements must be tackled;
- Double Taxation Agreements (DTAs) must redefine concepts so as to adapt to digital realities;
- Transfer pricing rules must also be adapted to digital realities;
- It is necessary to improve the effectiveness of anti-avoidance mechanisms.
- Effective tax rates
The effective tax rate (in opposition to the statutory tax rate) is the real tax burden on the income generated, after application of tax base rules foreseen in legislation to assess the corporate taxable income.
The goal is for the effective tax rate (if much lower than the statutory tax rate) not to result from aggressive tax planning but only from legitimate means of tax planning.
- Hybrid mismatch arrangements
In the OECD’s definition, “these are arrangements exploiting differences in the tax treatment of instruments, entities or transfers between two or more countries. (…) They often lead to “double non-taxation” that may not be intended by either country, or may alternatively lead to a tax deferral which if maintained over several years is economically similar to double non-taxation.” Therefore, “they raise a number of tax policy issues, affecting for example tax revenue, competition, economic efficiency, transparency and fairness.”
OECD describes the main elements of hybrid mismatch arrangements as follows:
- “Hybrid entities: Entities that are treated as transparent for tax purposes in one country and as non-transparent in another country.
- Dual residence entities: Entities that are resident in two different countries for tax purposes.
- Hybrid instruments: Instruments which are treated differently for tax purposes in the countries involved, most prominently as debt in one country and as equity in another country.
- Hybrid transfers: Arrangements that are treated as transfer of ownership of an asset for one country’s tax purposes but not for tax purposes of another country, which generally sees a collateralized loan.”
And its main effects as follows:
- “Double deduction schemes: Arrangements where a deduction related to the same contractual obligation is claimed for income tax purposes in two different countries.
- Deduction / no inclusion schemes: Arrangements that create a deduction in one country, typically a deduction for interest expenses, but avoid a corresponding inclusion in the taxable income in another country.
- Foreign tax credit generators: Arrangements that generate foreign tax credits that arguably would otherwise not be available, at least not to the same extent, or not without more corresponding taxable foreign income.”
And some of the policy options for tackling hybrid mismatch arrangements have lately been the following:
- “Harmonisation of domestic tax laws”: this means the elimination of exploited differences in the tax treatment of entities, instruments and transfers;
- “General anti-avoidance rules”: using concepts such as “abuse of law”, “economic substance” and “business purpose”;
- “Specific anti-avoidance rules”: specifically design to tackle specific arrangements and schemes.
- Double Taxation Agreements (DTAs) in digital realities
DTAs do not provide for concepts that can be adapted to digital realities. They are only thought out to tackle physical and stable notions, such as residence in a given territory or a permanent establishment in a given territory. A nexus crisis occurs when trying to tax e-commerce transactions. That nexus crisis occurs also because of a prior issue, which is the characterization crisis: the real substance of the transactions taking place and what type of income to they generate.
- Transfer pricing in digital realities
The arm’s length principle demands for the price and conditions of transactions between associated enterprises to be consistent with those between unrelated enterprises for comparable transactions.
In transactions between two independent parties, compensation usually will reflect the functions that each enterprise performs, taking into account assets used and risks assumed.
In the area of intangibles and digital services there are no comparable transactions. Companies are complexly integrated and the operations involve non-replaceable services and intangibles. Tracing the source and value of the operations is also hard: it is not easy to follow the trace within the chain of distribution between intellectual property rights, cloud infra-structure and high-qualified personnel.
There are a variety of anti-avoidance strategies that countries use to ensure the fairness and effectiveness of their corporate tax system. These strategies focus on responding to aggressive tax planning.
The most relevant anti-avoidance rules in tax systems include:
- General anti-avoidance rules: their scope is to deny or limit the availability of undue tax benefits and they target transactions that are solely tax motivated and have no economic substance;
- CFC (Controlled foreign companies) rules: “under which base eroding or “tainted” income derived by a non-resident controlled entity is attributed to and taxed currently to the domestic shareholders regardless of whether the income has been repatriated to them”;
- Thin capitalization rules: their scope is to disallow the deduction of certain interest expenses when considered excessive or unjustified;
- Anti-avoidance provisions in tax treaties: their aim is to reduce the risk of abuse of treaties by persons who were not intended to benefit from them. Taxation can be reduced or eliminated through the interposition of intermediate entities in treaty jurisdictions so as to claim the benefits of the relevant tax treaty. The most common mechanism of abuse of treaties is the utilization of conduit companies. The interposition of a conduit company located in a State that has a treaty with the State competent to tax may allow for the taxpayer to claim the benefits of the treaty, thus reducing or eliminating tax at source.