As a result of the Base Erosion and Profit Shifting (BEPS) Agenda published by the Organisation for Economic Cooperation and Development (OECD), countries have been introducing domestic legislation to implement the recommendations aimed at coherence, substance and transparency between revenue authorities across the globe.
We have identified five key questions, which Private Equity managers should be considering in regards to the Base Erosion and Profit Shifting (BEPS) Agenda.
Can you demonstrate adequate substance?
A key element of the BEPS Agenda is substance. The aim is to ensure that business profits are taxed where the economic activities generating the profits are performed and where value is created.
It is becoming crucial for companies to demonstrate that they have real substance and clear control of important functions in the jurisdictions in which they operate. For Private Equity structures, the key will be to ensure that there is adequate substance in all relevant entities in the GPs and the AIFMs.
The Channel Islands is well placed to meet the substance requirement as it has a sophisticated network of experienced professional advisors and administrators which companies can rely on, a growing abundance of skilled investment and finance professionals and tax system to encourage entrepreneurial innovation and investment.
Do you have CPECs or check the box elections?
Intercompany transactions play a significant role in multinationals’ global operations. One of the aims of the BEPS agenda was to align the tax treatment of intercompany transactions to avoid the situation whereby companies used ‘hybrid’ transactions, involving companies or instruments that are treated differently in different tax jurisdictions, often resulting in tax efficiencies.
Action 2 of the BEPS Agenda recommends that countries introduce domestic rules to neutralize the results arising from hybrid mismatch arrangements. As a result, the approach taken by many countries is to deny the deduction in the payer's/investor's jurisdiction, as a primary step.
Funds with Convertible Preferred Equity Certificates (CPECs) or check the box elections may fall within the local definition of a "hybrid" in the countries where they have a taxable presence and, as a result, interest deductions may be denied. Structures with CPECs or check the box entities should consider how these rules will apply to the tax treatment of their intercompany transactions.
Does your structure use intercompany loans to manage its tax position?
The OECD was concerned that multinational groups were able to erode their tax base (i.e. reduce their taxableprofits) with interest expense by locating third party debt in high tax countries, using intra-group loans to achieve interest deductions in excess of the group’s actual thirdparty interest expense orusing related party or third party debt to financethe production of exempt or deferred income.
Action 4 of the BEPS Agenda has addressed this and recommends a fixed ratio (primary rule), whereby deductions will only be allowed for interest up to 10%-30% of EBITDA. It also recommends a group ratio (secondary rule) whereby deductions will be allowed for interest up to a group ratio based on the group’s actual net third party interest expense.
Private equity structures using intercompany loans may be impacted by this change. Structures should model the impact of the interest deductibility rules on funding and cash management arrangements in order to mitigate the risk. This should be factored into key business decisions, e.g. corporate acquisitions and long term contracts. Groups should consider a wider strategic review of their financing and treasury policies, in order to get the external leverage ratio right.
Have any arrangements/transactions been undertaken with the principal purpose of obtaining a treaty benefit?
In an effort to limit treaty abuse, Action 6 of the BEPS Agenda proposed including a principal purpose test (PPT) test in treaties, whereby treaty benefits could be denied if the arrangement/transaction was undertaken with the principal purpose of obtaining the treaty benefit.
The suggestion raised specific questions related to concerns as to how the new provisions could affect the treaty entitlement of non-collective investment vehicle funds (non-CIVs). The OECD has acknowledged the concerns and has prepared three draft examples which were subject to consultation, to be included in the Commentary for the PPT rule. The examples consider private equity structures, securitization companies and real estate funds.
Example 1 sets out a private equity example, where a regional investment platform (RCo) is set up as a subsidiary of a fund, in an offshore jurisdiction. The decision by the fund to establish RCo in an offshore jurisdiction was driven by commercial as well as tax reasons. When RCo considers an investment in another jurisdiction, with which it has a favorable treaty, the question arises as to whether or not the treaty benefits should be denied. Various factors are considered and the conclusion is reached that it would not be reasonable to deny the benefit of the treaty, based on the fact that RCo has sufficient substance in its jurisdiction (resident directors with the necessary skills and expertise), the investment would only constitute a part of RCo’s overall investment portfolio (which included investments in a number of jurisdictions) and the overall effect of the treaty benefit was only a 5% reduction in withholding tax.
Although the examples may be amended slightly to address some of the feedback which the OECD is likely to receive as a result of the consultation, the examples are indicative of the OECD’s intention.
The Channel Islands support the BEPS Agenda and, in 2016, the Islands committed to signing up to the BEPS Multilateral instrument when it is released later this year. Guernsey accepted an invitation from the OECD to join the Ad Hoc Group on the Multilateral Instrument - part of a select group in this regard and joined the BEPS inclusive framework, through which it is actively committed to the development and implementation of global standards in line with the BEPS Action Plans.
Have you considered the new Transfer Pricing requirements?
Action 13 of the BEPS Agenda introduced transfer pricing rules which impose new tax reporting requirements on multinational groups in order to elicit a reasonably complete picture of the global business.
Multinationals having global revenues of EUR 750 million or more are required to file annual reports to tax authorities at three levels. The first element (which taxpayers are generally required to provide for fiscal 2016) is a ‘country-by-country report’ that gives a detailed picture of business results for each country where the business operates (including things like number of employees, revenues, pre-tax profit, and taxes paid). Companies will also need to give an overall picture of their global business, aggregating data from all of the countries where you operate. In addition, companies will be required to report separately to each country where they operate with business and tax information about the local entities and operations in that country.
The disclosure of this business information will be accessible – through automatic information exchanges – to tax authorities wherever they have a presence (subject to certain conditions). Groups will need to consider how to explain the operational purpose of business arrangements which may include tax advantages.
In 2016, the Islands formally committed to the OECD model of country by country reporting (CbCR) and have already put in place the relevant implementing regulations. In addition, the Islands signed up to the Multilateral Competent Authority Agreement (MCCA) to assist with the sharing of relevant information in relation to CbCR, as well as broadly adopting the OECD’s CbCR implementation package, to facilitate its implementation of this BEPS minimum standard.
The Islands continue to stay at the forefront of tax policy change, committed to being BEPS compliant and helping their clients adjust to shifts in the tax landscape.
An original version of this article was first published in Ipes' Private Equity Update (edition 23), February 2017.