The international tax system is inherently complex. As sovereign entities, countries have the right to set taxes as they see fit. However, the resulting discrepancies in tax rules create opportunities for arbitrage and hence tax avoidance. These so-called ‘hybrid mismatch arrangements’ allow companies to arrange their global operations in such a way that they can minimize their overall tax burden.
For many multinational companies, these ‘tax optimization strategies’ have become a central part of their business model. Following the economic and financial crisis and subsequent austerity measures, high-profile revelations about multinational companies benefitting from favorable tax regimes have sparked public outrage. However, the international tax system, based on thousands of bilateral tax treaties, is currently not equipped to change the perceived harmful practices of companies (who, in turn, are also locked-in to making use of these practices), which is why there has been mounting pressure on policymakers to develop a new international framework.
In 2013, the OECD, encouraged by G20 leaders, launched its Base Erosion and Profit Shifting (BEPS) project which set out 15 action points aimed at improving multilateral coordination and curbing corporate tax avoidance at the international level. Through several rounds of consultations with governments, companies and civil society actors, the OECD has worked out the technical details to these 15 action points, each of which have further sub-actions and sub-goals. The final package was approved in October 2015 by G20 finance ministers meeting in Lima, Peru.
Although spearheaded by the G20, more than 60 countries are participating in the BEPS project, which together represent some 90% of gross world product. The final package includes a revision of existing international guidelines and also presents new minimum standards that countries are expected to implement. Some measures only require an adjustment to national laws, while others will first require the development of a new multilateral instrument. The BEPS project is not a complete overhaul of the international tax system, but it is still expected to minimize tax competition and will have important implications for how multinational companies structure their global operations in the future.
The International Tax System
In the past, the primary concern for companies with cross-border economic activities was how to avoid double taxation. Over the years, international guidelines were established to tackle double taxation in order to facilitate international trade and investment. The OECD Model Tax Convention provides guidelines on how governments can extend instruments like credits, exemptions and deductions to multinational companies in order to rectify the problem of double taxation by balancing taxes levied at the ‘residence’ (i.e. the headquarters) of a multinational company with taxes levied at the ‘source’ (i.e. the subsidiary in another tax jurisdiction) where the economic activity actually takes place. However, incoherent rules create loopholes for multinational companies to pay lower overall taxes, or even arrange for double non-taxation or long-term deferral.
What is profit shifting?
A large proportion of international trade is actually the trade of goods and services among subsidiaries of the same multinational company. According to the arm’s length principle (which is a component of most bilateral tax treaties), the transfer price (TP) that is set between subsidiaries for a cross-border trade should equal the market price that would normally be set between two independent companies. This is where problems arise since the principle of arm’s length is difficult to implement in practice. For example, for intragroup trading in specialized goods or services, there might not be a comparable market value. Especially when it comes to intangibles like trademarks or patents, it can be difficult to determine the market value.
Transfer pricing can also be used to shift profits or costs to places with more favorable tax regimes. The OECD uses the term ‘profit shifting’ to refer to this deliberate practice of transfer mispricing, since this practice artificially separates where an economic activity is reported for fiscal purposes from where it actually takes place. This leads to the incongruous situation where multinational companies sometimes report significant profits in low tax jurisdictions where the company carries out few or no real economic activities.
15 Action Points of the BEPS Project
Action 1: Addressing the Tax Challenges of the Digital Economy
In the context of a digitalizing global economy, with its rapidly evolving business models and complex multi-country value chains, the problem of artificial profit shifting (referred to as just BEPS hereafter) will only intensify as the dilemma of determining where economic value is created and where it is considered to be most appropriately taxed becomes ever more difficult. Therefore, the BEPS project takes the digital economy as its starting point. This has implications for central features of the international tax system like permanent establishment (PE) status or transfer pricing (TP) guidelines. Additionally, VAT/GST Guidelines have been updated, stipulating for example that digital economy products will need to be paid in the consumer’s home country rather than the source country.
Action 2: Neutralizing the Effects of Hybrid Mismatch Arrangements
Action 3: Designing Effective Controlled Foreign Company Rules
Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments
The next several action points relate to mechanisms to offset hybrid mismatch arrangements in national tax rules which gives rise to BEPS. By using hybrid financial instruments (e.g. convertible bonds), multinational companies can shift costs and profits around the globe via intragroup trading (and lending). By harmonizing national laws, there will now be a joint approach to the regulation of interest deductions and exemptions whereby deductions in one jurisdiction will be denied if granted in another. The BEPS project also offers new guidelines for strengthening controlled foreign corporation (CFC) rules .
Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance
To complement the preceding recommendations on unintended mismatches, the BEPS project aims to improve transparency and counter harmful tax practices. Artificial profit shifting is often stimulated by preferential regimes, which is why the OECD’s Forum on Harmful Tax Practices (FHTP) was tasked with designing a methodology to assess whether preferential tax regimes adhere to the new ‘substantial activity’ requirement. The FHTP used the case of intellectual property (IP) regimes to develop the so-called ‘nexus approach’ which will be applied to other preferential regimes. Belgium will probably update its own ‘patent income deduction’ law, which subjects revenues generated by patents, copyrights, trademarks and other intangible proprietary information to favorable tax treatment. The nexus approach will continue to allow these sorts of regimes, but new minimum standards will ensure that the favorable treatment of the IP income is qualified. In particular, expenditure on R&D activities will be used as a proxy for substantial activity in a country.
Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances
Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status
The BEPS project will also tackle even more aggressive strategies like treaty shopping and the artificial avoidance of permanent establishment (PE) status. This is because through so-called ‘cash box’ or ‘IP box’ arrangements, multinational companies can easily create a presence in a certain jurisdiction when really it just holds financial or IP assets in a shell company. Through limitations-on-benefits (LOB) rules and principle purpose test (PPT) rules, countries can determine whether a company is a ‘true resident’ and not merely abusing treaty provisions. New tougher standards of what it means to have a presence in a country will mean that companies will have to pay the appropriate amount of taxes based on their actual PE status.
Actions 8-10: Aligning Transfer Pricing Outcomes with Value Creation
The BEPS project also deals with the underlying mechanism of transfer pricing (TP) and how it can best be (re-)aligned with value creation. The arm’s length principle is reaffirmed as the chosen method to determine transfer prices, but the rules pertaining to it will be strengthened. Specific actions relate to intangibles, the intra-group allocation of risk (i.e. moving excessive capital around), and so-called low value-adding intragroup services.
Action 11: Measuring and Monitoring BEPS
Action 12: Mandatory Disclosure Rules
Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting
Action 14: Making Dispute Resolution Mechanisms More Effective
Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
The last five action plans relate to the instruments that will be developed to improve transparency and the availability of tax-related information. These are critical since further research and monitoring of BEPS, compulsory disclosure rules and documentation of TP arrangements will be needed for tax authorities to overcome the information asymmetry that gives rise to BEPS. Country-by-country reporting (CbC) will give tax authorities easy access to data upfront. Multinational companies will have to periodically disclose financial data for every territory they operate in and report how much they pay in taxes on their earnings in each of these jurisdictions. When this information is easily available from all countries, transparency will be greatly improved and can help close the gap between where economic value is created and where in turn it is taxed. It is important to note that these reports will not be available to the general public, but only to national tax authorities.
“Restore legal certainty to improve the investment climate.”
-Jan Oversteyns, Group Tax Director, Allnex Belgium
Jan Oversteyns, Group Tax Director at Allnex, suggests that “despite the understandable fiscal policy reaction toward greater tax transparency, the new CbC rules risk imposing new administrative burdens upon economic agents without any real safeguards around the confidentiality of proprietary business data”. He further notes a lack of clarity so far that the proposed multilateral instrument, which should alleviate double taxation, would actually work.
This greater transparency feeds into improving the efficacy of dispute resolution mechanisms. For a swift implementation of the OECD’s BEPS recommendations, it has also been decided to develop a multilateral instrument in order to avoid amending all existing bilateral tax treaties.
Implementation and reception
Most BEPS project deliverables can be implemented right away since they only require an adjustment of international guidelines. Similarly, it is expected that many countries will start amending national laws to comply with BEPS recommendations. Work is also ongoing on developing the multilateral instrument (launch planned end of December 2016) and implementation of the country-by-country reporting (CbC) mechanism.
Concerns abound about the efficacy of the OECD’s new BEPS measures. Both consistency and uncertain timing become an issue as the implementation phase continues. Jan Oversteyns further suggests that “uncertainty has been created around intellectual property structures, advance tax rulings and other elements of tax certainty that have long distinguished especially the small open economies in Europe from larger, more closed economies that have their own domestic base”. The BEPS measures will not eliminate tax competition completely, but the risk is that smaller countries will lose out to bigger ones. This is why it is important that the Belgian Government needs to be smart about how it devises its tax policy while still complying with BEPS, according to Henk Vanhulle, National Manager Partner, Linklaters. He adds that it is important to keep an eye on what neighboring countries are doing so that Belgium stays fiscally competitive.