Global Tax Alert | 15 February 2013
OECD releases report on base erosion and profit shifting
On 12 February 2013, the Organization for Economic Cooperation and Development (OECD) released its widely anticipated initial report on the issue of base erosion and profit shifting (BEPS) by multinational enterprises (MNEs). The report was released in connection with the week’s G20 Finance Ministers meeting in Moscow.
The stated aim of the BEPS report is to present the issues related to BEPS in an objective and comprehensive manner. The report, Addressing Base Erosion and Profit Shifting (the Report), describes the studies and data available regarding the perceived magnitude of BEPS and provides an overview of global developments that have an impact on corporate tax matters. The Report focuses on the key principles that underlie the taxation of cross-border activities, as well as the BEPS opportunities these principles may create.
The Report reflects the view that current international tax standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of e-commerce. The Report identifies relevant work that has already been done by the OECD, but states that a holistic approach is necessary to properly address the issue of BEPS.
The Report concludes that there is a need for increased transparency on effective tax rates of MNEs. It identifies the following key pressure areas:
- Mismatches in entity and instrument characterization
- Application of treaty concepts to profits derived from the delivery of digital goods and services
- Tax treatment of related-party debt-financing, captive insurance, and other intra-group financing
- Transfer pricing, in particular in relation to the shifting of risk and intangibles, the artificial splitting of ownership of assets between group legal entities, and group transactions that would rarely take place between independent entities
- The effectiveness of anti-avoidance measures such as GAARs, CFC regimes, thin capitalization rules, and rules to prevent treaty abuse
- The availability of harmful preferential regimes
The report indicates that the OECD intends to develop an initial comprehensive action plan to be finalized in June 2013.
Executive summary section
The Report begins with a statement that base erosion constitutes a serious risk to tax revenues, tax sovereignty, and tax fairness for OECD member countries and non-members alike. In this regard, it also notes further work on the evidentiary data relating to BEPS is important and necessary.
The Report first highlights the concern that current standards of international taxation may be out of date and have failed to keep pace with the rapidly changing climate for international business. Next, the Report states that its aim is to present the issues related to BEPS in an objective and comprehensive manner by (1) describing studies and data available in the public domain regarding the existence and magnitude of BEPS, (2) providing an overview of global developments that have an impact on corporate tax matters, and (3) setting out an overview of the key principles that underlie the taxation of cross-border activities and the BEPS opportunities these principles may create, including a discussion of three specific corporate structures and the issues that these structures raise.
The Report states that a holistic approach is necessary to address the BEPS issues. Government actions should be comprehensive and address the different aspects of the issue, including the balance between source-country and residence-country taxation, the tax treatment of intra-group financial transactions, the implementation of anti-abuse rules, and the transfer pricing rules. The Report stresses the need for coordinated action in order to fully address the issues and to avoid the risk of double taxation that would be caused by unilateral action by governments acting in isolation.
The Report notes that development of a comprehensive solution will require the contribution of all stakeholders, including member and non-member countries, the business community, and others. In this regard, the Report further notes the objective of providing businesses with the certainty they need to make long-term investment decisions.
Chapter 1 – Introduction
The introduction section discusses the growing perception that governments lose substantial corporate tax revenue because of planning aimed at shifting profits, citing some of the recent news headlines. It notes that the claims of some interest groups sometimes have addressed very complex tax issues in a simplistic manner. The Report also states the perspective of business leaders that they have a responsibility toward their shareholders to legally reduce the taxes their companies pay and the concerns expressed that countries’ tax policies can be incoherent and that the tax systems may even be designed to provide incentives for BEPS. In addition, the Report notes that MNEs can face double taxation on their profits from cross-border activities and that the current inter-governmental procedures are sometimes ineffective in resolving these disputes.
The Report references the involvement of governments in the BEPS issues, citing the concerns regarding income-shifting behavior of MNEs discussed in US President Obama’s President’s Framework for Business Tax Reform, and the UK, German and French governments’ call for coordinated action to strengthen international tax standards and for support of the OECD’s efforts in this area.
Chapter 2 – How Big a Problem is BEPS? An Overview of the Available Data
The Report describes initial efforts by the OECD to quantify the extent to which BEPS activity occurs. In particular, the Report reviews a number of statistical studies in order to assess their contributions to quantifying the extent of BEPS activity.
The Report looks at trends with respect to corporate income taxes as a percentage of gross domestic product. It also includes a brief discussion of tax reform efforts that have occurred in recent years, with many countries lowering their tax rates and increasing the taxable income base, with the effect of increasing total tax burden notwithstanding the reduced rates. In addition, the Report reviews foreign direct investment statistics and reviews recent studies on MNEs’ effective tax rates. Annex B of the Report contains summaries of economic studies related to BEPS.
The Report concludes that the data available does not allow for a clear conclusion about how much BEPS actually occurs, but that there is abundant circumstantial evidence suggesting that BEPS behaviors are widespread. The Report notes that several studies indicate there is increasing segregation over time between the locations where actual business activities and investment take place and the location where profits are reported for tax purposes.
Chapter 3 – Global Business Models, Competitiveness, Corporate Governance and Taxation
This chapter of the Report describes trends in the global economy that have influenced the manner in which MNEs are organized and manage their tax affairs. It also considers competitiveness and tax policy, and corporate governance and taxation.
First, in terms of business models, the Report notes that enhanced mobility of capital and labor, technological and telecommunication developments, and the management of intellectual property, all have caused a shift away from country-specific operating models and toward global models based on regional or worldwide integrated supply chains. The Report then notes that globalization has made it possible for businesses to locate many productive activities in geographic locations that are distant from the physical locations of their customers.
The Report describes global value chains in some detail, discussing how it is increasingly common for production of both manufactured goods and services to take place in stages across jurisdictions. It states that although global strategies to maximize profits while minimizing costs and expenses (including tax expenses) have evolved accordingly, the rules of taxation on profits from cross-border activities have remained fairly unchanged.
The Report then discusses recent work by the OECD on the subject of competitiveness and taxation, including a discussion of so-called harmful tax regimes and the criteria suggested by the OECD to determine whether a preferential regime is harmful. One of the criteria for a harmful regime is a lack of transparency, and the Report discusses the significant progress that has been made in this area in recent years, highlighting the number of agreements on tax information exchange that have been signed and the number of countries moving toward automatic information exchange as a result of the US Foreign Account Tax Compliance Act intergovernmental agreements.
Chapter 3 also discusses corporate governance and taxation, providing an overview of recent changes in how the assessment of risk is treated for financial reporting purposes. The Report notes that tax administrators and large businesses have been trending toward more collaborative, and away from purely adversarial, relationships, reflecting an exchange of transparency for certainty.
Chapter 4 – Key Tax Principles and Opportunities for Base Erosion and Profit Shifting
This chapter of the Report describes foundational principles of international taxation, and the reasons why such principles may allow for BEPS activities to occur. The Report observes that current rules, based on key historic principles regarding of jurisdiction to tax, transfer pricing, treatment of leverage, and anti-avoidance appearances, “provide opportunities to associate more profits with legal constructs and intangible rights and obligations, and to legally shift risk intra-group, with the result of reducing the share of profits associated with substantive operations.”
The Report discusses the matter of jurisdiction to tax, and states that while an extensive network of treaties has been developed to address the issue of double taxation that can result from two jurisdictions subjecting the same item of income to tax, there are also instances of “double non-taxation” that the treaty network currently does not address. In addition, the Report expresses the view that the current rules on the taxation of business profits are no longer keeping pace with developments brought about by the digital economy; for example, under current concepts of permanent establishment, companies may do business with customers in another country, and derive substantial profits therefrom, without having a taxable presence in that country. The Report also states that countries’ allowance of deductions for interest expense may lead to a tax-induced bias for debt finance.
The Report goes on to describe general categories of existing anti-avoidance rules that have been enacted by many countries, such as controlled foreign company rules, thin-cap rules, anti-hybrid rules, anti-base erosion rules, and general anti-avoidance rules (GAAR).
The Report then describes a number of BEPS strategies that are designed to apply the current rules to achieve low or no taxation with respect to financing activity or through the use of intermediate entities:
- Low-taxed branch of a foreign company
- Hybrid entities (which allow a deduction in one country for an item of income paid to an entity in another country that does not subject that item of income to tax)
- Hybrid financial instruments and other financial transactions
- Conduit companies
- Derivatives (which may replace interest payments with payments that are not subject to withholding taxes)
Transfer pricing strategies that involve the shifting of functions, assets and risks (and therefore income) from high-tax to low-tax jurisdictions are also discussed, as are strategies to escape the application of general anti-avoidance rules.
Chapter 4 concludes with the observation that it is the interaction of various principles and practices in various countries that allows BEPS to occur. BEPS strategies, the Report observes, incorporate several elements: (1) minimization of tax in a foreign operating or source country, by shifting gross profits or reducing net profit through deductions; (2) low or no withholding tax at source; (3) low or no taxation of the income recipient; and (4) no current taxation of the low-taxed profits at the level of the ultimate parent.
Certain corporate tax structures employing these strategies (an e-commerce structure involving the transfer of intangibles; a structure that transfers manufacturing operations along with intangibles; and a leveraged acquisition with debt push-down) are described in Annex C of the report.
Chapter 5 – Addressing Concerns Related to Base Erosion and Profit Shifting
The Report concludes that, based on a number of indicators, BEPS activity is taking place, and that it “poses a threat in terms of tax sovereignty and of tax revenue.” The Report calls for a collaborative, multinational effort to address BEPS concerns, noting that unilateral actions could lead to further mismatches, additional disputes, increased uncertainty, or a “race to the bottom” with respect to corporate income taxes.
The Report proposes that action be taken to address these problems, first by developing a comprehensive, global action plan aimed at better aligning rights to tax with real economic activity. The Report states that such an action plan should be developed in consultation with all stakeholders, including the business community, practitioners, civil society and others. The Report concludes there is an urgent need to deal with the BEPS issue and proposes that a plan of action be developed and approved by the OECD’s Committee on Fiscal Affairs at its next meeting in June 2013.
The Report states that this Action Plan will include proposals to develop:
- Instruments to put an end to or neutralize the effects of hybrid mismatch arrangements and arbitrage.
- Improvements or clarifications to transfer pricing rules to address specific areas where the current rules produce “undesirable results from a policy perspective.”
- Updated solutions to the issues related to jurisdiction to tax, in particular in the areas of digital goods and services. Solutions may include a revision of treaty provisions.
- More effective anti-avoidance measures to be included in domestic laws or international instruments, in particular GAARs, CFC regimes, limitation on benefits rules and other anti-treaty abuse provisions.
- Rules on the treatment of intra-group financial transactions, such as those related to the deductibility of payments and the application of withholding taxes.
- Solutions to counter harmful regimes more effectively, taking into account factors such as transparency and substance.
The Report also calls for immediate action from tax administrators through the Forum of Tax Administration, which includes the tax commissioners of OECD and G20 countries. This work on actions to improve tax compliance may draw on work that has already been done by the OECD in developing a tax planning directory identifying more than 400 schemes.
The BEPS Report is essentially a background document that contains a description of BEPS issues generally and as such includes no specific recommendations. However, it is an important statement of where the OECD intends to focus its energies in terms of cross-border taxation issues over the coming months and years.
The Report suggests several fundamental elements of international tax that will be the subject of further analysis and ultimately recommendations. The Report proposes reviewing transfer pricing standards in order to see if
they can be updated for the increased level of cross-border trade that occurs today. The Report also proposes reconsidering the discussions of jurisdiction to tax, in particular focusing on the balance of source- versus residence- country taxation. In addition, the Report proposes reviewing other measures, such as general anti-avoidance rules, in order to determine the extent to which non-specific rules can play a role in addressing perceived BEPS concerns. The “pressure areas” identified in the report suggest other more targeted areas where the OECD will focus its attention. The Action Plan, targeted for finalization in June, will provide further specifics and timelines.
Although the Report does not provide specifics for how the OECD intends to consult with the business community, it clearly views such input as a key part of the overall project. Thus, in the near term, it is important for MNEs and other stakeholders to take stock of the BEPS project and determine whether, when and how to participate in BEPS-related discussions with the OECD and with their home governments.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, International Tax Services, Washington, DC
- Barbara Angus
+1 202 327 5824
- Julia Tonkovich
+1 202 327 8801
- Yuelin Lee
+1 202 327 6378
- David Macall
+1 202 327 7055
EYG no. CM3210