Modernising the global tax environment

Tax implications of base erosion and profit shifting

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In conversation with Henry Syrett, he discusses the Organisation for Economic Co-operation and Development’s proposal to re-evaluate the way in which corporate taxation is applied in a more globally integrated business environment.

Q


Why is there such a huge interest in the Organisation for Economic Co-operation and Development’s report on base erosion and profit shifting?

The Paris-based Organisation for Economic Co-operation and Development (OECD) released a report titled “Addressing Base Erosion and Profit Shifting” (BEPS) in February. This was a first step to initiate a series of discussions and documents that will seek to realign global tax rules to meet the demands of a more globally integrated business environment.

First, let’s dissect the key words. “Base erosion” refers to governments losing tax revenue as companies recognise lower profit bases on which taxes are applied in a given country. “Profit shifting” is when MNCs are able to recognise profits in one jurisdiction rather than another, potentially taking advantage of lower tax rates or other beneficial tax attributes.

The BEPS paper identifies the root of the problem to be in outdated international tax laws which no longer reflect how businesses operate in today’s globalised world.

The OECD is therefore proposing a review of international tax concepts. Any significant changes could require substantial re-writing of national legislation and renegotiation of many of the double taxation agreements that are currently in force.

Q


Why is the current system of taxing outdated?

The BEPS report notes that the existing principles of taxation are now outdated as they were set when there was a lower degree of economic integration. This has led to double taxation which in turn has led to bilateral agreements in the form of treaties to avoid such double taxation.

The BEPS report notes that there has been somewhat less focus on countering double non-taxation.

The digital economy is one instance where long-established tax principles are made to appear outdated, according to the OECD. For example, the concept of permanent establishment, or a fixed place of business, is being challenged by new technology and new business models.

Q


Can transfer pricing contribute to base erosion?

The OECD lists six key pressure areas that need to be considered. Transfer pricing is one such pressure area.

From a transfer pricing perspective, the OECD arm’s length principle starts from the premise that the different entities that make up a multinational group act independently from another. However, this is not an accurate portrayal of how MNCs operate. In reality, these “independent” entities act as a whole under an overall business strategy.

It is recognised that the arm’s length principle is focused on the identification of the location of functions, assets and risks. The OECD notes that it is difficult to shift underlying functions. Regardless, the OECD recognises that it is easier to shift the allocation of assets (in particular intangibles) and risks to low-tax jurisdictions.

This could pose genuine concerns in the relatively higher tax countries, especially when there is no real substance in the lower-tax jurisdiction to support the allocation of assets and risks.

Clearly companies relocate their businesses for many reasons, and corporate tax is likely to feature in a location decision. Governments across the world work hard to incentivise businesses to set-up (or remain) in their countries, and taxation can be a key feature of such incentives.

When implemented properly, MNCs should not be penalised for making legitimate business location decisions. However, the OECD has recognised that not all such structures are commercially driven.

Governments should have the necessary tools to tackle an artificial allocation of functions, assets or risks which deprive them of their fair share of tax revenue.

Q


Looking at where the OECD is heading, does this mean that tax planning may become a more risky venture?

The OECD wants to re-draw the boundaries for what is considered acceptable and legitimate cross-border tax planning. This does not mean that MNCs should cease all tax planning activity.

However, in line with much of the guidance released in recent years, any structures being considered should be supportable with clear commercial substance as substance is likely to play a large part of the BEPS discussions.

Even with commercial substance, changes emanating from the BEPS initiative may change the way certain models are taxed - we can only wait and see what recommendations the OECD puts through.

Ongoing OECD projects that overlap with BEPS will be brought into the frame.

The main question on my mind is how radical the changes will be and how long it will take for changes to be implemented. The more radical the changes, the longer the likely timeframe, as such an exercise cannot be undertaken unilaterally and will require significant co-operation within and between governments.


EY - Henry SyrettHenry Syrett
ASEAN Operating Model Effectiveness Leader