As a part of the OECD/G20 project to combat base erosion and profit shifting ("BEPS"), the OECD released the first set of reports and recommendations on September 16, 2014. These reports address seven of the actions described in the 15-point action plan to address BEPS published in July 2013 (the "Action Plan") and consist of the following items:
- Recommendations for domestic rules to neutralize hybrid mismatch arrangements and recommended changes to the OECD Model Tax Convention to deal with transparent entities (Action 2, the "Hybrids Report");
- Proposed changes to the OECD Model Tax Convention for preventing tax treaty abuse (Action 6, the "Treaty Abuse Report");
- Revisions to the OECD Transfer Pricing Guidelines to align transfer pricing outcomes with value creation in the area of intangibles (Action 8, the "Intangibles Report");
- Revised standards for transfer pricing documentation and a template for country-by-country reporting of income, earnings, taxes paid, and certain measures of economic activity (Action 13, the "Documentation Report");
- A report on the issues raised by the digital economy (Action 1, the "Digital Economy Report");
- A report on harmful tax practices, outlining the progress of the review of preferential regimes, etc. (Action 5, the "Harmful Tax Practices Report"); and
- A report on the feasibility of developing a multilateral instrument to amend bilateral tax treaties (Action 15, the "Multilateral Instrument Report").
These deliverables include specific proposed changes to domestic laws, tax treaties, and transfer pricing guidelines that, if adopted, could significantly affect both the taxation and compliance burdens of multinational enterprises ("MNEs"). After the discussions by G20 finance ministers in September 2014, these reports will be presented to G20 leaders in November 2014, and the OECD continues work on the remaining actions by 2015 in accordance with the Action Plan. As the 2014 deliverables are closely connected to the 2015 deliverables and there is still disagreement on some of the issues, the recommendations made in the 2014 reports will remain in draft form until then. However, it is expected that some countries may begin implementing some of the proposals before finalized versions have been released, and the United Kingdom has already announced its intention to implement country-by-country reporting along the lines of the suggestions in the Documentation Report. Some key points of the new reports are summarized below.
Hybrid Mismatch Arrangements (Action 2). The Hybrids Report, which differs little from the prior draft released in March 2014, provides a set of recommended changes to domestic law designed to prevent hybrid mismatch arrangements (as described below) even in situations where it is unclear which country has lost revenue. The report also provides proposed changes to the OECD Model Tax Convention regarding dual resident entities (a case-by-case approach) and fiscally transparent entities (rules in line with the OECD Partnership Report in 1999). Finally, the report raises additional issues, including intragroup hybrid regulatory capital and on-market stock lending transactions, which need to be further explored.
The report includes specific recommendations on improvements to domestic law, including denying participation exemptions for deductible payments and a set of hybrid mismatch rules. Although the report encourages all countries to adopt the recommended changes to domestic law, the hybrid mismatch rules are designed with both a primary rule and a secondary defensive rule to be applied in case the primary rule is not adopted by the relevant jurisdiction. The hybrid mismatch rules require linking of domestic law, whereby the tax treatment of a payment is determined, in part, by the treatment of that payment under the laws of another country. The report discusses some of the difficulties with implementing such a rule, and the OECD is still considering appropriate mechanisms for ensuring the necessary cooperation between taxing authorities for such a rule to be administrable. The scope of the primary and defensive rules has been narrowed from the prior draft, and the rules now generally are applicable only in related-party contexts (as defined below) and to payments made pursuant to an arrangement designed to produce the hybrid mismatch.
A brief overview of the hybrid mismatch rules is provided below. With regard to situations where a single payment gives rise to duplicate deductions in different countries, the report recommends as a primary rule that the payee's jurisdiction deny the duplicate deduction in all cases. As a secondary defensive rule, the report recommends that the payer's country of residence deny the deduction, but only in the case of payments between members of a control group (a 50 percent or greater ownership threshold). In the case of a payment that is deductible to the payer but not included into income by the payee, the primary rule is to deny the payer's deduction, and the defensive rule is to include the payment into the payee's ordinary income; both the primary and defensive rule apply only to payments between related parties (a 25 percent or greater ownership threshold, increased from the 10 percent proposed in the earlier draft). Finally, in the case of disregarded payments (i.e., payments deductible by payers while being disregarded in the payees' jurisdiction) involving a hybrid entity where the parties are members of the same controlled group, the primary rule is to deny the deduction, and the defensive rule is to require inclusion.
Preventing Tax Treaty Abuse (Action 6). The Treaty Abuse Report recommends three changes to the OECD Model Tax Convention. First, the report recommends inclusion in the preamble of treaties an express statement that the common intention of the treaty partners is to eliminate double taxation without creating opportunities for nontaxation or reduced taxation through tax evasion or avoidance. Such a statement would be relevant in the interpretation and application of the provisions of a given treaty.
Additionally, the report recommends including an objective anti-abuse limitation of benefits rule (a "LOB Rule") based on the provisions in existing tax treaties concluded by the U.S. and some other countries, as well as a more general subjective anti-abuse rule denying a treaty benefit where obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted in that benefit (a "PPT Rule"). While these rules are already recognized in the existing Commentary on Article 1 of the OECD Model Tax Convention, the report proposes to establish an independent article with a new Commentary for these rules.
The report recommends that tax treaties include both the LOB Rule and PPT Rule. However, in response to strong U.S. criticism of the subjective PPT Rule, the report's proposal allows some flexibility as long as countries effectively address treaty abuses. The report requires countries to have only a minimum level of protection against treaty abuse, which can be satisfied with the LOB Rule (supplemented by a mechanism to address conduit arrangements as necessary) without the PPT Rule. Under this flexible approach, U.S. tax treaties that include a LOB Rule (incorporating objective standards such as the publicly traded entity test, the ownership and base erosion test, the derivative benefits test, and the active trade or business test) could comply with the report's recommendations. However, countries lacking laws akin to the economic substance doctrine in the United States may need to apply a PPT Rule in order to meet this minimum standard.
In addition, the report recommends other anti-abuse rules to address some specific transactions such as certain dividend transfer transactions and transactions circumventing source taxation of shares in real property holding entities. The report indicates that further work will be needed with respect to the precise contents of the proposed model provisions and related Commentary, and that the drafts are subject to improvement before the final version is to be released in September 2015. In particular, some of the terms of the proposed LOB provision, such as the scope of the derivative benefits rule, are still under discussion. Additionally, there is still some uncertainty regarding the level of tax-motivated decision-making that is permissible under the proposed preamble language and the PPT Rule.
Transfer Pricing Aspects of Intangibles (Action 8). The Intangibles Report contains final and interim revisions to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations . The report explains that due to the overlap of the transfer pricing aspects of intangibles with the other transfer pricing parts of the BEPS project (Action 9, transfer pricing aspects of risks and capital and Action 10, transfer pricing aspects of other high-risk transactions) large portions of the revisions are still in draft form pending the issuance of the deliverables under Actions 9 and 10 in 2015. In particular, the OECD is continuing to examine: (i) permitting taxing authorities to use actual results retrospectively to determine the value of transferred intangibles, (ii) treating entities whose activities are limited to funding intangibles development as lenders or otherwise limiting their returns, (iii) requiring contingent payment terms and/or the application of the profit split method to certain transfers of intangibles, and (iv) the treatment of situations involving excessive capitalization of low-function entities. These items are scheduled to be included in the 2015 deliverables.
Consistent with the Action Plan, the report does not propose a change from the arm's-length standard, but instead explains that the parties to a transaction should be compensated based on an analysis of the functions performed and risks assumed, and not just the legal ownership of the intangibles or the contractual arrangements in place. Significantly, the report provides in interim guidance that where the legal owner of an intangible outsources most or all of the important functions related to that intangible, it is "highly doubtful" that the owner is entitled to a material portion of the return derived from the exploitation of the intangible. Similarly, where an entity only bears funding risks associated with an intangible, the entity is generally only entitled to a risk-weighted return on such funding.
The report also contains final and interim guidance and examples regarding multinational group synergies, identifying intangibles, transfers of intangibles in development or that otherwise have uncertain value, the use of both the profit split method and "other methods," and valuation techniques (such as the discounted cash flow method) regarding transfers of intangibles.
Transfer Pricing Documentation and Country-by-Country Reporting (Action 13). The Documentation Report contains a new three-tiered documentation requirement to be included in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations that is designed to provide tax authorities with additional information necessary for transfer pricing inquiries and risk assessment. In light of the global trend for increased transparency, the report proposes a set of standard documentation requirements so as to avoid countries from promulgating different increased documentation requirements. The proposal requires MNEs to prepare three separate types of documentation as described below:
- A "Master File" available to all relevant jurisdictions providing an overview of the MNE's global operations and policies so as to provide an appropriate context for the other information. The Master File would include information regarding organizational structure, the MNE's intangibles, intercompany financial activities, financial and tax positions, and a description of the MNE's business(es);
- A "Local File" for each country providing more detailed information relating to specific intercompany transactions, including relevant financial information and transfer pricing analysis (including a comparability and functional analysis and an indication of the most appropriate method) regarding those transactions; and
- A "Country-by-Country Report" for annual submission to each tax jurisdiction in which a business unit of the MNE that is included in the consolidated group for financial reporting purposes (a "Constituent Entity") is a resident for tax purposes. This Country-by-Country Report will provide aggregate information relating to the global allocation of income, taxes, and business activities among the relevant tax jurisdictions (specifically, jurisdiction-by-jurisdiction information relating to revenues, pre- and post-tax profits, income tax accrued and paid, stated capital, accumulated earnings, number of employees, and tangible assets), as well as a list of all of the MNE's Constituent Entities including jurisdiction of incorporation (if different from tax residence) and the nature of the entity's main business.
Some emerging market countries pushed to require reporting of additional transaction data regarding related party interest payments, royalty payments, and service fees in the Country-by-Country Report, concerned that if taxpayers are permitted the discretion to determine what information is relevant for transfer pricing purposes, the taxpayers may underreport. The compromise reached was to require a review of the country-by-country reporting before 2020 to determine if the information in the Country-by-Country Report is sufficient for the taxing authorities and not being abused by the taxing authorities.
In addition, the report gives some guidelines as to documentation-related issues including timing of the preparation of the documentation, materiality of transactions, frequency of documentation updates, and penalties. Additional work will be undertaken with respect to the means of filing the required information and disseminating such information to tax administrations over the next several months. As concerns have been raised regarding the disclosure by tax authorities of trade secrets or other commercially sensitive information, the report requires tax authorities take all reasonable steps to ensure the confidentiality of such information.
Issues Raised by the Digital Economy (Action 1).The Digital Economy Report discusses at length the various challenges raised regarding BEPS due to the advent of information and communication technology, particularly with regard to nexus issues, attributing value to transactions in which data is collected, used, or supplied, and the characterization of new products and services. Because such a significant part of the worldwide economy is now "digital," the report recommends against ring-fencing the digital economy from the rest of the economy for tax purposes. Additionally, the report identifies several BEPS strategies permitted by the digital economy, particularly regarding value added taxes, that currently attract concern. The report discusses potential options, such as modifying the "preparatory or auxiliary" exemptions from permanent establishment status in the context of a direct tax, and requiring nonresident suppliers to register and account for the VAT on cross-border business-to-consumer supplies. The report concludes that further consideration is needed regarding some of these structures, and it provides insight into how some of these concerns can be addressed in other parts of the BEPS project.
Harmful Tax Practices (Action 5). The Harmful Tax Practices Report is an interim report on the progress made by the Forum on Harmful Tax Practices (the "Forum") on the outputs to be delivered under Action 5, including the review of the preferential tax regimes of OECD member countries. Although the report does not conclude that any specific regimes are harmful, it lists some regimes that the Forum has concluded are not harmful. Additionally, the report discusses requiring substantial activity to access the benefits of a preferential regime, improving transparency and compulsory exchange of information on rulings for tax holidays, and establishing a strategy to expand participation to non-OECD member countries.
Developing a Multilateral Instrument to Modify Tax Treaties (Action 15). The Multilateral Instrument Report concludes that addressing certain of the treaty-based BEPS actions through a multilateral agreement, rather than through amendments to every bilateral treaty, would be both efficient and effective, particularly for issues that are multilateral in nature, including mutual agreement procedures, dual-residence structures, fiscally transparent entities, and triangular arrangements. Although there was some initial concern that such a multilateral agreement would attempt to address some of the more complex international tax issues such as controlled foreign corporation regimes and transfer pricing, the Multilateral Instrument Report confines its scope to traditional treaty provisions (The precise content of a multilateral instrument would not be fixed until 2015, however).