What is BEPS?
Much has been said in both professional and commercial circles on the imminent introduction in Hong Kong of the Common Reporting Standard (CRS) regime for the automatic exchange of tax information between participating jurisdictions. There is, however, a much lesser awareness of the commitments undertaken by the Government to the new Organisation for Economic Co-operation and Development (OECD) standard to combat base erosion and profits shifting (BEPS). Navigating the currents of the OECD alphabet soup of acronyms can be frustrating; conceptually, BEPS has two limbs: base erosion refers to the artificial reduction of one jurisdiction’s tax base by shifting profits (hence, the second ‘profits shifting’ limb) from the jurisdiction where the profits were economically generated to a jurisdiction with a lower rate of tax.
BEPS- Impact on Double Taxation Treaties
It is not practicable to summarise in a brief article the full implications of what is an immensely wide-ranging and technically sophisticated project, but BEPS is best understood at a high level as a set of international tax norms that will have a profound and lasting effect on cross-border tax planning. BEPS will in particular impact the application of double taxation treaties (DTT), of which Hong Kong is currently party to just under 40. Once the implementation process for BEPS begins, a critical re-examination and, where necessary, re-organisation of international tax structures operating with a Hong Kong nexus will need to be effected to ensure that those structures continue to generate the fiscal outcomes for which they were first established.
The BEPS project is subdivided into 15 action points, organised around three main pillars: coherence, substance, and transparency. Those 15 action points can be boiled down to four minimum standards, which are the core and essence of BEPS:
- The prevention of treaty abuse, including so-called ‘treaty shopping’ – in other words establishing a notional presence in a jurisdiction in order to take advantage of a particularly favourable DTT;
- Country-by-country reporting to give tax administrations a global picture of where multinational enterprises conduct economic activities and so in substance derive profits;
- The prevention of ‘harmful tax practices’, with such practices including many historic tax incentive schemes such as patent boxes; and
- Progress on dispute resolution mechanisms for the timely resolution of disputes through DTT mutual agreement procedures.
The four minimum standards were conceived with a view to achieving the following general policy and fiscal objectives:
- Combat tax strategies exploiting gaps in tax rules to shift profits from the jurisdiction where they were in substance economically generated to a low / no tax jurisdiction;
- Realign taxation with economic activities: profits should be taxed in the place where they are in substance generated;
- Ensure multinational corporations pay their ‘fair share’ of tax;
- Prevent double non-taxation – in other words, avoid a scenario where income or capital gains are not taxed in both jurisdictions party to a given DTT;
- Reflect changes brought about by the digital economy;
- Ensure that the system is and is perceived to be ‘fair’; and
- Maintain a longstanding consensus based framework through a binding, multilateral instrument.
A ‘Fair’ Framework?
The risks the BEPS framework poses to tax structuring as we know it are apparent. There is, in particular, an alarming focus on the term ‘fair’, which is evidently a relative concept and one which is perhaps more suited to a political soundbite rather than to clear fiscal legislation. BEPS has its origins in the experience of OECD member states, which generally have the dubious distinction of being high-tax jurisdictions, but nonetheless burdened with considerable public sector debt. In other words, it is in the interests of OECD jurisdictions to make tax efficiency outcomes through cross-border planning more difficult to attain. Further, the introduction of country-by-country reporting of business profits is likely to be the coup-de-grâce to tax secrecy, a process which began with CRS.
As with CRS, the Hong Kong government considers adherence to the BEPS project to be a mark of responsible global citizenship. Whatever the political merits of that position, it is plain that both tax advisers and their clients should begin considering how BEPS will affect tax arrangements currently in place and begin to outline viable solutions. For instance, structures that have historically relied on Hong Kong resident companies as conduits for dividends, but have failed to endow those companies with substance in Hong Kong, will need to be substantially revised.
Hong Kong’s Simple Tax Code is a Thing of the Past
BEPS will furthermore necessitate the implementation of a comprehensive statutory transfer pricing regime in Hong Kong, which should prompt a re-examination of received wisdom on tax-efficient structuring in Hong Kong. To date, transfer pricing in Hong Kong has been governed by a relatively basic and rarely applied statutory provision; however, the Hong Kong Inland Revenue Department has identified the introduction of a BEPS-compliant transfer pricing regime as an area of particularly high priority for legislative reform.
The days of Hong Kong having a simple tax code are over, this practitioner fears, never to return. But, as is often the case with radical legislative reform, there is a first mover advantage to be obtained in being among the first to adapt and respond to the challenges posed by changes in the international tax landscape. That will require greater sophistication in tax planning and the acceptance of the fact that practices that have long gone unchallenged will need to be examined under the lens of BEPS.