MinterEllison Alert | The OECD finalises its BEPS project

7 October 2015

What has happened?

On 5 October 2015, the OECD issued its final papers for each action item in the Base Erosion and Profit Shifting (BEPS) project. 

The BEPS project has been underway since 2013 and involves 15 action items designed to counteract BEPS by multinationals (such as the avoidance of a taxable presence in a jurisdiction, or profit shifting by way of the payment of fees to a related party out of a high tax jurisdiction to a low tax jurisdiction). 

The BEPS project is the most significant international tax reform project in decades.

The OECD's recommendations will lead to more work – including international action (such as changes to the model double tax treaties, and entry into other international agreements) as well as domestic law changes (including in Australia proposed country-by-country reporting rules for example: see Minter Ellison: Multinational anti-avoidance law and country-by-country reporting introduced).  For effective tax risk governance, it is important for multinational Boards to be aware of and to proactively respond to the OECD's recommendations and the jurisdictional and domestic responses to those recommendations.

In this Tax Alert we provide a high level overview which outlines the main recommendations made by the OECD in each of its final papers on each action item.  A further Alert will follow shortly outlining announcements or actions taken to date by Australia in respect of these measures.

For further detail, including:

  • access to all of the OECD Papers issued on each action item;
  • access to Minter Ellison's more detailed commentary as to how these proposals might affect you, and
  • access to the Australian Government's reaction to date

see: Minter Ellison: Tracking the changes to Base Erosion and Profit Shifting.

Summary of the OECD's BEPS Papers

BEPS Action Plan item Summary of OECD recommendations in its final Paper
  1. Addressing the Tax Challenges of the Digital Economy
  • The OECD Paper proposes modifications to the permanent establishment definition in tax treaties to:
    • ensure that exclusions from that definition only apply where the activities are of a preparatory or auxiliary character
    • prevent the fragmentation of a business via several related entities across jurisdictions to avoid having a permanent establishment
    • ensure that a permanent establishment arises for a multinational where a local entity has a routine or principal role in the effective conclusion of contracts in that jurisdiction on behalf of the multinational;
  • The OECD proposes to deal with the exploitation of intangible rights by multinationals by ensuring that transfer pricing rules apply so that group entities performing important functions, contributing assets or taking economic risks derive an appropriate return from the intangible
  • The OECD proposes that the definition of attributable income from the purposes of controlled foreign company rules should subject income typically earned in the digital economy to tax in the parent company's jurisdiction.
  • The OECD suggests that domestic law changes could be considered in the following areas:
    • GST/VAT on cross border transactions, particularly between business and consumers (already in Australia for example, there are rules proposed in this area – see Federal Budget 2015/16: Key tax announcements for business).
    • withholding taxes on digital transactions, or modifications to the definition of royalty.
  1. Neutralising the effects of Hybrid Mismatch Arrangements

This OECD Paper is an important paper for Australia, as the Government has tasked the Board of Taxation with making recommendations for the domestic implementation of anti-hybrid rules in Australia. The Board of Taxation's report is due in March 2016: see here.

This is a very long Paper. At a high level, the OECD Paper proposes rules to address cross-border mismatches in tax outcomes resulting from hybrid instruments or hybrid entities.  The proposals include:

  • establishing domestic rules aligning the tax treatment of an instrument or entity with the tax treatment in the counterparty jurisdiction. For example, this could include denying a deduction for a payment to the extent it is not included in the income of the counterparty jurisdiction, or including an amount in income where it might otherwise not be taxable if a deduction arises in a counterparty jurisdiction, or denying a duplicate deduction.
  • changes to double tax treaties:
    • to ensure that if the rules suggested above are implemented, double tax treaties apply appropriately – for example to ensure no double taxation arises;
    • to ensure that treaties deal with hybrid entities appropriately. For example,  changes are proposed to ensure that hybrid entities are granted treaty benefits unless neither State involved treat the income of that entity as the income of one of its residents; 
    • to ensure that dual resident entities are dealt with on a case by case basis under treaties, as opposed to under a place of effective management rule;
  • domestic law changes to address base minimisation due to dual residence.
  1. Designing Effective Controlled Foreign Company (CFC) rules

The OECD Paper sets out principles to apply when designing effective CFC rules. The Paper includes proposals focused on EU States in particular, but also general design principles.

The OECD Paper states that effective CFC rules will:

  • Define a CFC appropriately – including setting out tests from control or influence by shareholders, and covering non-corporate entities;
  • Not have de minimis thresholds -  but will rather apply to all CFCs that are subject to effective tax rates that are meaningfully lower than those applied in the parent jurisdiction;
  • Define CFC attributed income appropriately – for example including income typically earned in the digital economy;
  • Compute CFC income appropriately – for example not allowing the offset of CFC losses except from that CFC itself, or from CFC in that same jurisdiction;
  • Attribute CFC income in proportion to the control threshold;
  • Ensure there are rules preventing double taxation – for example ensuring that dividends from CFCs or the gains from disposing of the interest in a CFC are not further taxed, where income has been attributed and subject to tax under a CFC regime.
  1. Limiting Base Erosion involving Interest Deductions and other Financial Payments

At a high level, the OECD Paper proposes new domestic rules could be considered which would limit an entity’s net interest/interest equivalent deductions to its level of economic activity. The deductions would be calculated as a percentage of the entity's taxable earnings before deducting net interest expense, depreciation and amortisation (EBITDA).

Such a rule would be subject to a number of exclusions, including a de minimis exclusion, exclusions/modifications for the banking and insurance sectors, and rules to reduce the impact of the provisions on situations which have less BEPS risk.

This approach includes three parts:

  • a fixed ratio rule based on a benchmark net interest/EBITDA ratio (between 10% -30% is proposed);
  • a group ratio rule which allows an entity to deduct more interest expense in certain circumstances based on the position of its worldwide group; and
  • targeted rules to address specific risks.
  1. Countering Harmful Tax Practices more Effectively

The OECD considered a number of domestic regimes that were considered preferential in nature.  No Australian regimes are touched on as being harmful. The OECD Paper proposes that domestic rules need to be amended to ensure that preferential tax regimes can only apply where there are substantial activities in the state in question and a nexus arises to the activity which generates the preferential tax outcome. The OECD Paper particularly focuses on expenditure as a means of testing substantial activity.

This Paper focuses particularly on regimes outside of Australia, such as the patent box regime in the UK.  The Paper would mean that taxpayers can only benefit from a regime such as the patent box regime where they engage in research and development and incur actual expenditure on such activities.

The Paper also proposes greater transparency and sharing of tax rulings across jurisdictions so as to enhance the ability for identification of preferential tax treatment.

  1. Preventing the Granting of Treaty Benefits in Inappropriate Circumstances

The OECD Paper proposes a number of changes to double tax treaties. In particular:

  • the introduction of a statement in treaties making it clear that the States intend to avoid creating opportunities for tax evasion, avoidance or treaty shopping;
  • the introduction of a limitation on benefits (LOB) rule which acts as a specific anti-abuse rule and applies to limit the availability of treaty benefits to entities that meet specific conditions (the conditions would be designed to ensure there is a sufficient link between the entity and its State of residence);
  • the introduction of a more general anti-abuse rule which applies a principal purposes test. If one of the principal purposes of transactions or arrangements is to obtain treaty benefits, those benefits would be denied, unless it can be shown that the object or purpose of the treaty supports the benefits being granted;
  • the introduction of new targeted rules to address other forms of treaty abuse. For example, these are stated to include certain dividend transfer transactions and particular situations where an entity is resident in two Contracting States; and
  • the introduction of provisions to clarify that treaties do not generally restrict a Contracting State’s right to tax its own residents nor prevent the application of departure/exit taxes.
  1. Preventing the Artificial Avoidance of Permanent Establishment status

The OECD Paper proposes a number of changes to Article 5 in double tax treaties. In particular changes are proposed:

  • to ensure that both (i) commissionnaire arrangements and (ii) arrangements with agents which are intended to result in the regular conclusion of contracts of a foreign enterprise can give rise to a permanent establishment for the foreign enterprise;
  • to ensure that exclusions from the permanent establishment definition (for example the use of facilities for the purpose of storage of goods) only apply where the activities are of a preparatory or auxiliary character
  • to prevent the fragmentation of a business via several related entities across jurisdictions to avoid having a permanent establishment
  • to prevent construction projects from avoiding having a permanent establishment by fragmenting contracts.

It is also noted that further work will be done by the OECD and guidance provided in 2016 on the attribution of profits from permanent establishments.

  1. 9, and 10 Aligning Transfer Pricing Outcomes with Value Creation

The OECD Papers set out revisions to the OECD Transfer Pricing Guidelines, with a goal of aligning transfer pricing outcomes with value creation.

The papers focus on the following areas:

  • transfer pricing issues relating to transactions involving intangibles – Action 8 dealt with this work;
  • contractual arrangements, including the contractual allocation of risks and corresponding profits, which are not supported by the activities actually carried out – Action 9 dealt with this work;
  • the level of return to funding provided by a capital-rich member of a multinational group, where that return does not correspond to the level of activity undertaken by the funding company – also covered in Action 9; and
  • other high-risk areas – covered in Action 10.

The revised Guidelines include important clarification of the rules relating to risk.  In the context of intangibles for example, the Guidelines clarify that legal ownership alone does not necessarily generate a right to the return generated from the exploitation of an intangible. 

As a further example, in the context of capital-rich member of a multinational group, if it does not control the financial risks associated with funding (eg by not assessing the creditworthiness of the group debtor), then it may not be entitled to all or any of the profits from its funding – perhaps only a risk-free return.

The papers note that access to information is a critical part of an effective transfer pricing regime, and cross refers to the Paper on BEPS Action 13 in particular.

The papers also set out follow up work to be carried out on the transactional profit split method. That work will lead to detailed guidance on how to use this method to align transfer pricing outcomes with value creation.

  1. Measuring and Monitoring BEPS

The OECD Paper sets out six indicators of BEPS activity, with the main indicators outlined below:

  • profit rates of multinationals in lower tax countries being high;
  • effective tax rates of multinationals being lower than domestic only operators (estimated currently to be between 4% - 8.5% lower);
  • foreign direct investment being concentrated in particular jurisdictions;
  • the separation of taxable profits from the location of value creating activity;
  • debt of multinational enterprises being concentrated in high tax jurisdictions.

The OECD Paper suggests that to monitor BEPS more effectively, the OECD needs to ensure that governments report and analyse corporate tax statistics in a consistent way internationally, and further work will be done in this area.  The Paper notes that country-by-country reporting data will be of assistance.

  1. Mandatory Disclosure Rules

The OECD Paper sets out a framework for countries which wish to consider mandatory disclosure rules, taking into account compliance costs. 

Mandatory disclosure rules are regimes such as the disclosure of tax avoidance schemes (DOTAS) regime in the United Kingdom.  The Paper canvases those regimes, and concludes they are beneficial to increase transparency, particularly information on tax risks to tax authorities.  The Paper also concludes that such regimes have a deterrence benefit.

The OECD Paper states that effective mandatory disclosure rules will:

  • impose disclosure obligations – this can be on both (preferable) or either of the promoter and taxpayer (with one having the primary obligation);
  • include generic and specific hallmarks which trigger a requirement for disclosure – specific hallmarks can focus on areas of specific concern in cross-border BEPS for example;
  • have mechanisms to track disclosures so as to identify scheme users – for example requiring a promoter to identify clients;
  • ensure that the timeframe for disclosure by promoters is linked to the scheme being made available to clients;
  • if disclosure is required from taxpayers, link the timeframe for disclosure to the implementation of the scheme;
  • introduce penalties to ensure compliance with the disclosure regime.

The OECD Paper also sets out specific recommendations for rules targeting international tax schemes, as well as for the development and implementation of more effective information exchange and co-operation between tax administrations.

  1. Transfer Pricing and Country-by-Country reporting

The OECD proposals are mirrored in provisions recently introduced into the Australian parliament which are proposed to be effective from 1 January 2016 (see Minter Ellison: Multinational anti-avoidance law and country-by-country reporting introduced).

The OECD Paper sets out a three-tiered standardised approach to transfer pricing documentation, and includes proposals for this information to be shared by tax authorities. The three-tiered approach is:

  • a master file providing an overview of global operations and transfer pricing policies;
  • a local file identifying material related party transactions involving the local entity – including the local entity's transfer pricing analysis;
  • a country-by-country report for each tax jurisdiction in which they do business including specified detail such as the amount of revenue, profit before tax, income tax paid and accrued, number of employees, stated capital, retained earnings and tangible assets in each jurisdiction.
  1. Making Dispute Resolution Mechanisms More Effective

The OECD Paper proposes measures to change double tax treaties to strengthen the effectiveness and efficiency of the mutual agreement procedure under double tax treaties.

The mutual agreement procedure applies so that competent authorities in double tax treaty Contracting States can work together to resolve differences or difficulties in the interpretation of treaties. 

  • The OECD Paper proposes a minimum standard when applying the mutual agreement procedure, in particular:
  • to ensure that treaty obligations relating to the procedure are applied in a timely and good faith manner;
  • to ensure that administrative processes are in place to promote the prevention and timely resolution of treaty-related disputes;
  • to ensure that eligible taxpayers can access the procedure to resolve treaty-related disputes, including by presenting their case to the competent authority of either Contracting State (not just of their resident State).

There are also proposals for mandatory binding arbitration as part of the mutual agreement procedure to be adopted in tax treaties, as a mechanism to ensure that disputes are resolved within a specified timeframe.  Countries which have stated they will commit to that in their tax treaties include Australia and New Zealand.

  1. Developing a Multilateral Instrument to Modify Bilateral Tax Treaties

The goal of Action 15 is to streamline the implementation of BEPS treaty-related proposals, such as those noted above.  The OECD Paper concluded that a multilateral agreement could be implemented to make changes to bilateral treaties.  The OECD Paper notes that there is a group working on this instrument with a goal of having an instrument for signature on 31 December 2016.

 

If you need further information about any of the key issues we have identified, please do not hesitate to contact our team listed on the right.

Author(s) Joanne Dunne