The OECD's agreed recommendations for changing the international tax rules are wide-ranging under its first stage ofwork inconnection with base erosion and profit shifting (BEPS). Seven of the fifteen areas of the BEPS Action Plan are covered by this first stage. While agreed, the proposed measures arenot yet finalised as they may be impacted bythe 2015 deliverables, the OECD states.
To the extent that the changes relate to the OECD's Model Tax Convention and Transfer Pricing Guidelines, their implementation is assured and should follow fairly quickly. The speed with which they are then implemented in existing bilateral tax treaties will be heavily linked with the success of the OECD's proposed "multilateral instrument", which the OECD now reports can be applied without any obvious technical barriers (though practical issues may be of more concern). The proposed OECD rule changes that involve amendments being made by individual territories to domestic tax rules are likely to be widely but not universally adopted, though consistency and timing isuncertain. These recommendations have beenthe subject of four previous discussion drafts but we focus inthis bulletin on the principal differences from what we have seen before (orwhat is new) and on any response to comments made earlier.
Businesses will need to take action (in some cases, urgent action) both to comply with new requirements and to consider the ways inwhich they dobusiness indifferent countries. Meanwhile the OECD mu.st carry out the process of redrafting and agreeing materials and governments must decide what policy changes they will make, with tax authorities having to work out how to implement them effectively.
The OECD has published today, 16 September, reports on the BEPS Action Plan items dealing with the following:
•country-by-rountry reportingandtransfer pricingdocumentation
These reports are scheduled for formal official approval by the Finance Ministers of G2o countries at their meeting in Cairns, Australia, 20-21 September.
They were adopted by the OECD's Committee on Fiscal Affairs 25-26 June after months of work by OECD staff and representatives of the Revenue Authorities of
OECD and some non-member countries in working parties. Consultations also took place with input from other, particularly developing, countries and various supranational bodies like the European Commission, United Nations and International Monetary Fund as well as business and civil society organisations.
We're seeing for the first time the working parties' thoughts on two areas. These are, firstly, how to address the ability to apply changes to treaties using a multilateral instrument and, secondly, countering the use by governments of tax practices which are harmful to international trade. Reports on the other areas have previously been circulated in draft form.
Digitu.ation of tire economy
The OECD discussion draft on the digital economy of 24 March 2014 was exceptionally long (81pages). It sought to provide a large amount of contextual material which made it fairly complex. Inseven Chapters and one annex, it considered the impact
on the economy oflcr, new business models being used, common features of BEPS in relation to both direct and indirect tax and broader challenges to be addressed.
That discussion draft did not make recommendations but set out some options which had been considered for addressing the perceived problem with some taxpayers.
While the final version of the report issued today does not introduce any conclusions that were not trailed in the initial draft, it does bring greater clarity over the issues which have given rise to the need for the digital economy workstream. The report also explains the role of the Digital Economy Task Force (DETF) for the remainder of the BEPS project. A
primary conclusion is that the digital economy is so widespread that it represents not a special part of the economy but the economy itself. In consequence, it is not possible to isolate it for the purposes of creating separate tax rules.
Nonetheless ,it is clear that, if the other BEPS workstreams do not address the specific concerns and challenges identified,the DETF has
the remit to propose its own solutions.
Indeed, in referring to the continual developments of how technological innovation affects business, the DETF implies that its work may need to survive the end of the BEPS process to deal with a recurrence of the issues which it identifies. Italso notes as yet unidentified issues which may come from: the Internet of Things; virtual currencies; advanced robotics and 3D printing; the sharing economy; access to government data; and reinforced protection of personal data.
The report focuses on the fragmentation of international business models, aided by developments in technology, as being the key tax area to address, identifying the specific remedies to be considered by the other BEPS workstreams - specifically, controlled foreign company (CFC) rules; artificial avoidance of permanent
establishment (PE); and transfer pricing measures. On these specific points:
in one territory to avoid taxation in another should be reviewed. This is a new development and one which
potentially impacts the fragmented business models about which the DETF has concerns.
A new suggestion in the report (which picks up on a request in the public consultation) is that Working party No. 1of the CFA should consider the characterisation of various payments arising in the new information and communication technology enabled world (a couple of examples are given in the report,namely Cloud computing and 3D printing).
The OECD's March 2014 papers on hybrids (dealing separately with treaty issues and domestic law issues) were
amongst the most complex and lengthy of its proposals to date.
The initial proposals for changes to domestic laws dealt separately with hybrid instruments and transfers; hybrid entity payments; and imported mismatches and reverse hybrids.
The discussion left open a number of important points on which responses were requested .The chief open issue was the type of approach, i.e. whether a "top-down" or "bottom-up"
approach should be adopted. Other questions posed related to the clarity and scope of the rules and the particular treatment that should be applied in the case of regulatory capital.
The discussion paper has been turned into a comprehensive set of proposed rules with more work to occur in 2015 on imported mismatches, repos, interaction with controlled foreign companies (CFCs),regulatory capital and collective investment vehicles, and to take account of deliverables from other workstreams .
The domestic law recommendations now made by the OECD generally have relatively minor changes from
the March 2014 draft discussed above. The principle of automatic application with no motive or purpose test, and a structure of primary and defensive linked rules with a hierarchy, has been preserved. Some of the main changes and points to note are set out below.
or even payments for goods, but do not include deemed payments, for example notional interest deductions.
There is no substantive change to the treaty recommendations.
The OECD and G20 will consider the coordination of the timing of the implementation of these rules. It is possible that this may not be until after a Commentary and guidance have been produced, foreseen by September 2015.
The OECD published a discussion draft in March 2014 on the proposals for counteracting perceived abuse of tax treaties.It was unexpectedly robust in its proposed changes to the Model Treaty. Clarity was called for in relation to the overall intention that treaties are not designed to allow double non-taxation. Italso included recommendations regarding the design of domestic rules to prevent
the granting of treaty benefits and identified tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country.
There were two major proposals:
The OECD originally proposed that both specific measures be applied simultaneously to combat treaty shopping.
The OECD Action 6 report now recommends that in accordance with proposed changes to the Model Treaty,States adopt a "minimum level of protection" to prevent treaty abuse. However, the report recognizes the need for further refinements in the objective tests, particularly in view of constitutional or EU law restrictions that prevent some States from adopting the exact wording of the model provisions recommended in the Action 6 report. Rather than a one size fits all solution, the report concludes that any of the following would suffice:
The LoB now includes a "derivative benefits" provision allowing certain entities owned by residents of other States to obtain treaty benefits that these residents would have obtained if they had invested directly.
The PPT is identical to the previous March 2014 version except with the substitution of "principal" purpose for "main" purpose regarding obtaining a treaty benefit, unless granting that benefit would be in accordance with the object and purpose of the relevant provisions of the treaty in question.
The report continues to recommend that treaties include in their title and preamble a clear statement that the
Contracting States, when entering into a treaty, intend to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements.
The report also includes recommendations to deal with
- certain dividend transfer situations (usufruct and similar transactions)
- transactions designed to circumvent the application of the treaty rule that allows source taxation of real estate companies
- situations where an entity is a resident of two contracting States where a competent authority tie breaker is recommended but States retain the right to use the effective management tie-breaker, and
- situations where the State of residence exempts the income of permanent establishments (PEs) situated in third States and where shares, debt-claims, rights or property are transferred to PEs set up in countries that do not tax such income or offer preferential treatment to that income, where it is recommended that to fully
access treaty benefits the income must be taxed at a rate that is at least 6o% of the rate that would have applied absent the residence country tax exemption .
Apart from the type and form of the appropriate LoB (and the recommendation remains largely to adopt the US model) and compatibility with EU law, there are two main concerns:
- There is an argument that this is a disproportionate restriction to accessing treaty benefits in order to counter abuse that would be better prevented by other measures. This
has been mitigated slightly by the inclusion of a derivative benefits clause.
- There are still to be finalised issues regarding the application of income tax treaties to collective investment vehicles (CIVs) and pension funds, which is being addressed independently of the BEPS project, and for which a 'carve-out' from these rules is expected subject to certain thresholds.
The report states that further work is required on the precise contents of the model provisions and related Commentary and in particular the
LoB rule, and on the policy
considerations relevant to treaty entitlement of CIVs and non-CIV funds. Accordingly, the Model provisions and related Commentary should be considered as drafts subject to improvement before their final release in September 2015.
Co1Dttry-by-country reporting and tranlffer pricing documentation
With regard to transfer pricing documentation, notwithstanding considerable pushback from business, a three-tier approach comprising a master file, a local file and a separate country-by-country (CbC) template has been proposed in the earlier work of the OECD on this topic. The CbC information is to be reported to tax authorities at a very high level and for risk assessment only.
In today's OECD report, there are few substantive changes from the earlier, January, draft. The report now confirms that the data points that will be required to be reported for each country will be the following:
- Revenues (from both related and unrelated party transactions)
- Profit before income tax
- Income tax paid (cash basis)
- Current year income tax accrual
- Stated Capital
- Accumulated earnings
- Number of employees
- Tangible assets (excluding cash and equivalents)
The clear implication is that the template is designed to highlight those low-tax jurisdictions where a significant amount of income is allocated without some "proportionate" presence of employees.What this means in practice is that, there will be pressure to assure that profit allocations to a particular jurisdiction are supported by the location in that State of sufficient appropriately qualified employees who are able to make a "substantial contribution" to the creation and development of intangibles.
Concerns regarding confidentiality of this data and the potential for adjustments by tax administrations based on a formulary apportionment approach leading to many more transfer pricing controversies, have already been noted.
The OECD has also noted that some countries (for example Brazil, China, India, and other emerging economies) would like to add further data points to the template regarding interest, royalty and related party service fees. Those data points will not be included in the template in this report,but the compromise is that the OECD has agreed that they will review the implementation of this new reporting and, before 2020 at the latest, decide whether there should be reporting of additional or different data. A concern in this context is that there may well be a tendency to expand CbC reporting, particularly in developing countries. That is, the emerging
market economies that implement CbC reporting will likely require reporting of interest, royalty and related party service fees and they will likely require CbC reporting for any company doing business in their jurisdiction, regardless of where the MNE parent is located. The availability of the data to requesting countries will also be considered in the OECD's review of the implementation of CbC reporting.
The proposals on the transfer pricing documentation master file and local file are broadly in line with what has already been announced.
The OECD does not yet have absolute consensus on the arrangements for the sharing of master file and CbC information although they are seeking to finalise those arrangements by January 2015, including confidentiality issues with indications that information will only be exchanged pursuant to treaty or tax information exchange agreement provisions.
TranJifer pricing and intangibles The OECD has a long running project on intangibles which now forms part
of its BEPS agenda.
With regard to today's report, given that a portion of the content of the intangibles report will clearly be influenced by the work the OECD is doing over the course of the next year on risk, recharacterisation, hard to value intangibles, and special measures, parts of the intangibles document will not be finalised now but will represent only interim guidance.
The relevant portions are the guidance on:
- ownership of intangibles
- intangibles whose valuation is uncertain at the time of the transaction
- use of unspecified methods, and
- using profit split methods. Importantly, the OECD has stated that
with respect to special measures, they will not be constrained by the arm's length principle, and may be willing to go beyond that for "hard to value intangibles" (which would essentially be any important intangible). Some of the potential special measures which have been discussed publicly so far include:
- commensurate with income rules (pricing intangibles with hindsight, using actual results)
- treating pure "cash-box" entities as per se debt investors rather than equity investors sharing in residual profits
- mandatory use of contingent payment terms or application of profit split methods, and
- application of the Article 7 KERT or "significant people function" analysis to pure cash boxes or "thickly capitalized" entities.
The level of support for these various options among OECD/G2o countries is not known, but given that they reflect a willingness to consider moving beyond the arm's length principle may indicate that a complete consensus will be difficult.
Whilst the bulk of the work on BEPS is directed at the position and actions of taxpayers, the work on countering harmful tax practices focusses on the actions of States.
The OECD has recognised that there has been a shift by some States from creating ring-fenced tax regimes (which were largely the focus of the harmful tax practices work bythe OECD 15years ago) to introducing more broadly-based corporate tax reductions for particular types of
income such as financial activities or intangibles. This explains the reason for the revamping of the work in this area under the BEPS project and also indicates why much of the early work on this topic within the BEPS project has focussed on patent box regimes.
The plan for the harmful tax practices work in BEPS is based on a three stage approach of looking first at the tax regimes of OECD members, then at those of non-OECD members before then revising as required the existing harmful tax framework.
The paper just released by the OECD is concerned with the first phase of this work, on the tax regimes of OECD members.
Three key pieces of work are identified as needing to be done:
- the elaboration of a methodology to define a substantial activity requirement in the context of intangible regimes
- the improvement of transparency through the introduction of compulsory spontaneous exchange of rulings related to preferential regimes, and
- the provision of a progress report on the review of member and associate country regimes.
It should also be noted that much of the work expressed throughout the BEPS Action Plan is a variation on the same theme, with a focus on aligning taxation with the "substance" of transactions - and that seems to be defined as determining where people are located, and where the performance of significant people functions takes place. "Substantial activity" is similarly the touchstone in this report on harmful tax practices. Nonetheless, determining the location of substantial activity is inevitably a subjective determination, making objective criteria difficult.
The report also voices concerns with regimes that apply to mobile activities and that unfairly erode the tax bases ofothercounnies,potentially distorting the location of capital and services. There is some overlap of this work with that in the transfer pricing space relating to intangibles and risk and capital, as well as similar issues being addressed in the report on the tax challenges of the digital economy, which is not particularly surprising given that much of the BEPS work is heavily focussed on re-examining basic transfer pricing principles, as well as the threshold for jurisdiction
to tax embodied in the permanent establishment rules.
With respect to the proposals for improving transparency through compulsory spontaneous exchange on rulings related to preferential regimes, this requirement contributes to the third pillar of the BEPS project, which is to ensure transparency while promoting increased certainty and predictability .This reinforces the OECD's point that transparency of an MNE's tax affairs is an important way to address BEPS. It should also be noted that the word "compulsory" is understood to introduce an obligation to spontaneously exchange information wherever the relevant conditions are met, meaning this is a further step in moving more generally from exchange of information upon request to automatic exchange of information.
The framework proposed by the OECD requires spontaneous information exchange only on taxpayer-specific rulings related to preferential regimes, i.e. rulings that are specific to an individual taxpayer and on which that taxpayer is entitled to rely. There is currently no such requirement for general rulings, meaning rulings that apply to groups or types of taxpayers or may be given
in relation to a defined set of circumstances or activities.
Use qf a multilateral instrument
Since the start of the work on BEPS, the OECD has recognised the need to address the speed of implementation of any measures that it develops to counter BEPS practices. In the absence of any special measures, changes to be effected through bilateral tax treaties would take many years to introduce across the network of double tax treaties, as individual treaties are re-negotiated.
To address this situation, the OECD proposes to develop a multilateral instrument so that countries may implement rapidly measures developed in the course of the work on BEPS.
The work in this area has raised uncertainties at a technical and practical level. Technically, it has not been clear if the objectives of the OECD can be readily achieved given the essentially bilateral nature of tax treaties. Practically, there have been uncertainties as to the likely level of participation by States in such a multilateral instrument.
The recently-released OECD paper now answers the first of these issues and confirms that a multilateral instrument is both desirable and, from a tax and public international law perspective, technically feasible. The report indicates that in January 2015,
OECD and G2o countries will consider a draft mandate for an international conference for the negotiation of a multilateral convention.
There is also an indication that such an instrument could, in addition to updating bilateral treaties, be used for other things, such as to "express commitments" to implement certain
domestic law measures or provide the basis for exchange of the country-by country template, discussed above.
There is no discussion of the practicalities of such an instrument but the reference to the fact that "interested countries" may wish to develop a multilateral instrument perhaps hints at the difficulties of achieving a full consensus in this area.
For those closely following the OECD's work on BEPS, the package of information released by the OECD today will contain relatively few surprises given what has been known or trailed about the ongoing work on the Action Plan. Nonetheless what stands out is an overall determination on the part of the OECD to push through the entirety of the BEPS package on the basis ofbuilding and retaining a very broad consensus of States. In that regard,the clear involvement of developing countries across the BEPS programme is significant.
Itwill be important that continued commitment to the process balances the task of rebuilding public trust in the international tax system with the task of supporting, rather than damaging cross border trade and investment that are key to economic growth.
There are clearly implementation details to work on, as the OECD itself acknowledges. What is very clear is the material change which is in progress. Taxpayers will need to take account of the speed of these developments , including in relation to the work which remains in progress, in framing their response.