By Dwight Cass
Plan would require a level of international cooperation hitherto unheard of.
The Organization for Economic Cooperation and Development (OECD) issued its Action Plan on Base Erosion and Profit Shifting (BEPS) on July 19, listing some 15 actions for governments to take in order to stop international corporate tax dodging. The multilateral institution has targeted December 2015 as the implementation deadline; non-OECD members can participate as of September 2015 (see chart below).
The BEPS plan was unanimously approved at the G-20 meeting in Moscow the next day. However, this isn’t a sign that member governments, of the OECD or the G-20, are about to pass implementing legislation. Meeting the September and December 2015 deadlines may be difficult, given anticipated corporate pushback as companies attempt to derail national legislation. Nonetheless, the idea has current momentum, not least because of the fallout from tech giant Apple’s multi-billion-dollar tax strategy involving Ireland. The tax structure allowed Apple, which held much of its $137bn in cash overseas as of Q1, avoid billions in taxes.
“Countries wanted to eliminate double taxation, but they went too far and left room for companies to achieve double non-taxation,” said OECD Secretary General Angel Gurria. The OECD ticked off a number of reasons that the international tax system needs rehabilitation: the growth of digital technology and its consequences for the concept of corporate domicile, the crazy-quilt of hundreds of bilateral tax treaties among major economies, most of which are bespoke, and, “the increasing sophistication of tax planners in identifying and exploiting the legal arbitrage opportunities and the boundaries of acceptable tax planning.”
The 15 Steps
The proposal makes detailed recommendations in 15 somewhat overlapping areas. But in the Cliff Notes version it boils down to the following five:
1) Eliminate double non-taxation by harmonizing international tax systems;
2) Use profits to locate intangibles rather than allowing them to be booked in (for example) Ireland;
3) Require a domicile so everyone knows what accounting and financial rules the company must abide by;
4) Disclose accounting practices to allow investors to ferret out tax avoidance schemes; and
5) Create dispute resolution mechanisms for the inevitable cross-border clashes.
The OECD emphasizes the “digital nature” of the global business environment at several points in the proposal. By this, it means that many companies can have their headquarters in most any country they like—usually the one with the lowest taxes. Like Apple, companies claim that profits were made in the lowest tax jurisdictions they can find—in Apple’s case, Ireland. France had proposed a specific tax for digital firms, but this option didn’t make the final cut.
The key elements of the OECD’s 15 “Actions” are as follows:
Address the tax challenges of the digital economy. Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation.
Neutralize the effects of hybrid mismatch arrangements. Develop model treaty provisions and recommendations regarding the design of domestic rules to neutralize the effect (e.g., double non-taxation, double deduction, long-term deferral) of hybrid instruments and entities.
Strengthen CFC rules. Develop recommendations regarding the design of controlled foreign company rules. This work will be coordinated with other work as necessary.
Limit base erosion via interest deductions and other financial payments. Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example, through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments. The work will evaluate the effectiveness of different limitations.
Counter harmful tax practices more effectively, taking into account transparency and substance. Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime.
Prevent treaty abuse. Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances. Work will also be done to clarify that tax treaties are not intended to be used to generate double non-taxation and to identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country.
Prevent the artificial avoidance of Permanent Establishment (PE) status. Develop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions. Work on these issues will also address related profit attribution issues.
Assure that transfer pricing outcomes are in line with value creation for:
– Intangibles. Develop rules to prevent BEPS by moving intangibles among group members. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.
– Risks and capital. Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. The rules to be developed will also require alignment of returns with value creation.
– Other high-risk transactions. Develop rules to prevent BEPS by engaging in transactions that would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to: (i) clarify the circumstances in which transactions can be characterized; (ii) clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains; and (iii) provide protection against common types of base eroding payments, such as management fees and head office expenses.
Establish methodologies to collect and analyze data on BEPS and the actions to address it. Develop recommendations regarding indicators of the scale and economic impact of BEPS and ensure that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis.
Require taxpayers to disclose their aggressive tax planning arrangements. Develop recommendations regarding the design of mandatory disclosure rules for aggressive or abusive transactions, arrangements, or structures, taking into consideration the administrative costs for tax administrations and businesses and drawing on experiences of the increasing number of countries that have such rules.
Re-examine transfer pricing documentation. Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business.
Make dispute resolution mechanisms more effective. Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under Mutual Agreement Procedure (MAP), including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.
Battles ahead
How does the OECD expect to herd its cats? Secretary General Angel Gurría laid out the challenges in the speech he gave to announce the plan on July 19:
1) First, international tax rules will be developed to address the gaps between different countries’ tax systems, while still respecting the sovereignty of each country to design its own rules. Actions will be taken to neutralize hybrid mismatches and arbitrage, reinforce domestic legislation to protect the tax base of countries against shifting of profits to tax havens (through strengthening the so-called “CFC” rules—Controlled Foreign Companies) and limit interest deductibility).
2) Second, the existing rules on tax treaties and transfer pricing will be revisited to fix their deficiencies and to align them with substance and value creation. The Action Plan aims to prevent “treaty-shopping” and to revise the definition of the permanent establishment, to prevent BEPS. Three actions are identified in the area of transfer pricing to put an end to the divorce between the location of profits and the location of real activities. Importantly, there is recognition that if the “arm’s length” principle is not fit to address these issues properly, measures that go beyond it will be introduced.
3) Third, more transparency will be established, including through a “country-by-country” reporting by companies to tax administrations on their worldwide allocation of profits. It also requires more transparency between governments, with the need for countries to disclose tax rulings and other tax benefits to their partners. Going forward we will carry out a comprehensive analysis of the economic impact on BEPS, including the effects on taxpayers’ behavior and on public finances, and we will look at their macroeconomic implications including international spill-overs.
Many companies benefit from the current international tax mess, with its host of arbitrage opportunities. Saving on taxes gives a multinational an unfair advantage over a domestic company. So corporate lobbies will be hard at work to kill this effort.
The OECD goes to some pains to show that BEPS is a real problem, to counter lobbyists’ assertions that the tax system works fine. The chart below, from an earlier OECD report on the subject, shows the percent of corporate taxes as a percentage of GDP. Corporates have a host of counter-arguments, most obviously, that the tax system works as it is. A partial list is available on The Tax Analysts Blog, (How Will Business Lobbyists Spin the OECD Action Plan?) by Martin Sullivan.