On 16 September 2014, the OECD issued its report titled Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance (Report). The Report is the first document released by the OECD dealing with Action 5 of the OECD's wider 15 point Base Erosion and Profit Shifting (BEPS) Action Plan.

The BEPS Action Plan as a whole is discussed in more detail in our earlier Alert OECD releases BEPS Action Plan.

In this Alert we consider the key issues raised in the Report.

Background

The purpose of Action 5 was revamp the earlier work done by the OECD on harmful tax practices, with a priority on improving transparency and substance. There has been considerable prior work by the OECD, including as to how to identify what a preferential tax regime is. The work on Action 5 includes a review of preferential tax regimes currently in existence in OECD countries followed by those of non-OECD countries with a view to revising the existing harmful tax framework.

The Report

One of the underlying objectives of the BEPS Action Plan is to work to build a framework for international tax that better aligns taxability of profits with substantial activity. Action 5 considers what is meant by the requirement for 'substantial activity' in the context of preferential tax regimes with an emphasis on intangibles regimes.

Another important part of a new framework for international tax the improvement of transparency between countries. Action 5 also considers improving transparency through compulsory spontaneous exchange of tax rulings on preferential regimes.

Importantly, the work on harmful tax regimes focuses solely on business taxation of income from geographically mobile activities, such as financial services and other service activities, including the provision of intangibles. Preferential tax regimes that attract investment in tangible assets are not considered (e.g. factories, plant and machinery).

Common approach to substantial activities

The Report considers what is meant by the requirement for 'substantial activity' in the context of access to preferential tax regimes.  The Report describes three approaches to be considered further: 

  • value creation approach, which requires taxpayers to undertake a set number of significant development activities;
  • transfer pricing approach which requires the taxpayer to undertake a set level of important functions in the jurisdiction; to have legal ownership of intellectual property and to bear economic risk; and
  • the nexus approach, which seeks to link any benefit afforded under a regime to the proportion of qualifying expenditure incurred by the taxpayer which contributes to that income.

Consensus has not yet been reached on the meaning of 'substantial activity' in relation to preferential regimes for intangible assets and work on this will continue in 2015.

Transparency

The Report also considers improving transparency through compulsory spontaneous exchange of tax rulings on preferential regimes.

The Report notes that this would impose an obligation on States to exchange the relevant information, without a need for the other State to request such information. The work in this area sought to develop a framework and then to apply the framework to preferential regimes.

The Report acknowledges that some form of enabling legal instrument is needed for such information exchanges to occur. This could be based on existing frameworks which have been established for the exchange of similar information such as the OECD's Convention on Mutual Administrative Assistance in Tax Matters.

In terms of scope, the Report notes that this proposal would apply to taxpayer specific rulings, on which only the taxpayer can rely, and not to general rulings that apply to groups or types of taxpayer. Examples of taxpayer specific rulings that are cited include advance tax rulings and advance pricing arrangements.

Next Steps

There is still a fair amount of work required on Action 5. The next steps for Action 5 consist of further work on: 

  • substantial activity;
  • developing the framework under which information will be exchanged with a view to starting to apply this in 2015; and
  • on the review of preferential regimes in non-OECD members.

The OECD's objective is to update the existing framework for evaluating harmful tax regimes to take into account the findings, with further deliverables due by December 2015.

Comment and practical implications

Action 5 is directed to the actions the States rather than directly affecting Australian taxpayers. In particular, the OECD does not consider that the Australian corporate tax rate or any of Australia's specific tax regimes are harmful. However, depending upon where Australian taxpayers have business interests located or where operations are undertaken and how those are structured, the work on Action 5 could have an impact on Australian multinationals in particular.

Once the outcome of the further review into Action 5 is known, Australia will be able to conclude whether to introduce any sort of tax incentive to encourage companies to make profits from their patents by reducing the tax paid on those profits (commonly referred to as a 'patent box' regime similar to that introduced in the United Kingdom and some other jurisdictions (see detail on the United Kingdom regime). The further work in Action 5 on defining the meaning of 'substantial activity' will also be important in this context.

Importantly, in the context of the desire for greater transparency, since the release of the Report, Mark Konza has stated that the Australian Taxation Office has established an Integrated Tax Design team to blueprint and implement the proposed compulsory exchange of tax rulings initiative, intended to be up and running by the end of 2014.