SKP Tax Alert
15 October 2015 | Volume 8 Issue 18
BEPS 2015 final reports - analysis of the Action Plan
Multinational organisations are known to take advantage of unintended gaps and mismatches between varying tax systems and favourable tax treaties to lower their effective tax rate through double non-taxation of income or taxation at a lower rate. This has resulted in significant revenue losses through tax leakages in many countries. With the intention of putting an end to this practice, the OECD along with the G20 conceptualised the Base Erosion Profit Shifting (BEPS) Project in 2013. The initial report[1] released by the OECD in September 2013 identified 15 problem areas with significant BEPS risks. After numerous rounds of discussions and negotiations with various stakeholders, the OECD released the final reports[2] on 5 October 2015.
 
The final package represents the outcome of a significant joint effort by OECD and G20 member countries and is the first substantial collective initiative towards overhauling the long-standing and often outdated international tax standards.
 
The specific areas identified by the OECD have been addressed by way of a 15-point Action Plan, with each action explaining the specific issue at hand and the OECD’s recommendations on how to identify and tackle the identified problem. We have analysed each action point and provided a brief summary of the same below.
 
Action 1: Address the tax challenges of the digital economy
The current action plan does not lay down specific tax rules for the digital economy such as withholding tax or equalisation levy or new nexus approach. However, it states that all other BEPS measures and, in particular, measures relating to Permanent Establishment (PE), transfer pricing and Controlled Foreign Corporation rules will address BEPS issues relating to the digital economy.
 
This action provides an introduction and overview of the OECD’s efforts to identify and counter BEPS. The report acknowledges that it would be difficult to ring-fence the digital economy from the rest of the economy for tax purposes as digitalisation becomes increasingly pervasive in all businesses. 
 
With an intention to curb artificial avoidance of PE status by corporations, the OECD has proposed to amend the definition of what constitutes a PE so as to ensure that corporations are no longer able to claim exemption from PE status in situations where their activities in substance have a high degree of nexus with the host country. The OECD intends to target the following types of structures commonly being used by multinationals:
  • Agency arrangements where Dependent Agent Permanent Establishment status is avoided through the mere execution of contracts by the principal in the home country.
  • Bifurcation of activities between multiple entities in the same country to substantiate the ‘preparatory and auxiliary’ nature of each individual service. 
  • Appointing a single local agent for multiple foreign group companies where the agent is dependent on the group but not any individual entity.
Also, the OECD has proposed to revise transfer pricing guidelines to ensure that income is appropriately attributed based on functions performed, risks assumed and assets contributed towards and is not only dependent on legal ownership. Rules and implementation mechanisms have also been developed to help collect value added tax (VAT) based on the country where the consumer is located in the case of cross-border business-to-consumer transactions.
 
Action 2: Neutralise the effects of hybrid mismatch arrangements
The OECD has recommended changes to domestic and treaty laws so as to neutralise hybrid mismatches i.e. situations of differential tax treatment of a financial instrument/entity in two or more tax jurisdictions, which results in double non-taxation, including long-term deferral.

A common example of a hybrid mismatch would be an instrument (e.g. convertible debentures) that is considered to be a debt in one country and equity in another. In such a case, interest payment is deductible in one country (generally, a high tax jurisdiction) but is treated as tax-exempt dividend in the country of receipt due to a participation exemption.

The OECD has recommended bringing about changes in domestic tax laws in the form of linking rules and treaty law to eliminate such instances and harmonise the treatment of such instruments. The recommended linking rules will consist of a primary rule under which countries will deny the deduction for a payment to the extent that it is not included in the taxable income of the recipient in the counterparty jurisdiction and if the primary rule is not applied, then the counterparty jurisdiction should apply a defensive rule by including the receipt in the recipient’s income.
 
Action 3: Strengthen Controlled Foreign Company (CFC) rules
CFC rules are anti-avoidance rules brought in to address arrangements where taxpayers shift their income from their country of residence to a controlled corporation incorporated in a low tax jurisdiction so as to avoid paying higher taxes or delay their tax outlay in the country of residence.
 
Under CFC regulations, even the undistributed income of a CFC is taxed in the hands of the parent company. This dissuades the group from parking profits in a foreign country to avoid taxation.
 
The report recognises that various participating countries have already implemented CFC rules; however, the same have not kept pace with the changing times. The report provides suggestive criteria for countries to design effective CFC rules. These include:
  • Definition of what constitutes a CFC – the report prescribes a threshold of 50% shareholding to qualify as sufficient controlling interest. However, individual countries may implement a lower threshold.
  • Control of the CFC – how to establish whether there is sufficient control to qualify as CFC.
  • CFC exemptions – CFC rules should apply only to overseas structures located in low tax jurisdictions and having majorly passive income.
  • Manner of computation of CFC’s income.
  • Attribution of income – the report suggests that attribution should be tied to control and the attribution should be calculated by reference to proportionate ownership.
The report emphasises that CFC rules should ensure that regulations do not result in double taxation. It recommends a series of measures to avoid double taxation under CFC rules by allowing credit for foreign taxes paid, prevent double taxation of dividends and sale of the CFC’s shares.
 
Action 4: Limit base erosion via interest deductions and other financial payments
Action 4 of the report targets instances where inter-company loans are used as a profit shifting tool. BEPS risk arises in situations where multinational groups utilise higher levels of third-party debt in high tax jurisdictions or use intra-group loans to generate interest deductions (in high tax jurisdictions).
 
To tackle this, the report recommends a fixed ratio rule wherein an entity will be denied interest deduction when the net interest expense being claimed as deduction exceeds a prescribed percentage of the EBITDA. The report recommends a corridor of possible ratios between 10% and 30%.
 
Recognising that some multinationals are highly leveraged with third party debt for non-tax reasons, the recommended approach proposes a group ratio rule along with the fixed ratio rule. This would allow an entity with net interest expense above the fixed ratio set by the country’s tax authority to claim interest deduction as per the average of the entity’s other worldwide group companies. Also, the report recommends an exclusion from this rule for entities engaged in public benefit projects subject to certain conditions as these entities and projects which they undertake are closely linked to the public sector and hence carry less BEPS risk.
 
Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance
Action 5 of the report primarily recommends a nexus approach wherein substantial activity is to be used as a criterion to tax profits arising from intellectual property (IP). The nexus approach prescribes that income arising from exploitation of IP should be attributed and taxed in the jurisdiction where substantial research & development (R&D) activities are undertaken rather than the jurisdiction of legal ownership only.

Also, in order to improve international transparency, the report recommends real-time sharing of important judicial rulings on various subjects (PE, conduit entities, unilateral APAs, etc.) that could give rise to BEPS concerns with other members.
 
The report also requests countries with preferential tax regimes to review their tax laws keeping in mind that the intention of creating such regimes was to encourage inbound investments and not to provide a platform for multinationals to artificially shift profits.
 
Action 6: Prevent treaty abuse
Action 6 acknowledges that multinational taxpayers often engage in treaty shopping and other treaty abuse strategies in order to claim treaty benefits in situations where these benefits were not intended to be granted, thereby depriving countries of tax revenues.
 
To curb treaty shopping strategies adopted by multinationals, the OECD recommends the following changes to tax treaties:
  • Explicitly mentioning in the preamble of the treaty that the states intend to curb opportunities of double non-taxation and tax evasion/avoidance.  
  • Introducing a Limitation-on-Benefits (LOB) rule which ensures that certain entities (termed as letterbox companies) not satisfying conditions (which ensure that there is sufficient link between the entity and its state of residence) are denied treaty benefits. As a matter of fact, India has already included the LOB rule in some of its existing treaties with an intention to curb treaty shopping.
  • Including a more general anti-abuse rule, termed as Principal Purpose Test, which ensures that treaty benefits are denied if a transaction had the principal purpose of obtaining a tax benefit under the treaty.
 
Action 7: Prevent the artificial avoidance of PE status
The report recommends modifying the existing definition of PE in tax treaties to prevent the use of certain common tax avoidance strategies that are currently used to circumvent the existing PE definition. The report recommends specific changes to Article 5 of the OECD Model Convention so as to ensure that PE status is not artificially avoided by structuring the transactions in a manner that evades the PE conditions without altering the economic reality of the enterprise’s operations in that state. These recommendations have already been discussed above in Action 1 – Address the tax challenges of the digital economy.
 
Actions 8–10 and 13 deal with transfer pricing measures and were covered in our Transfer Pricing Alert: OECD launches final reports on BEPS Action Plan dated 14 October 2015.
 
Action 11: Measuring and monitoring BEPS
The OECD has acknowledged that accurately identifying and quantifying instances of BEPS is severely constrained by lack of accurate data. To tackle this, the report recommends that the OECD should work with governments to report and analyse more corporate tax statistics and to present them in an internationally consistent way so that BEPS instances can be identified and countered in a timely manner.

Action 12: Mandatory disclosure rules
The report recognises that lack of timely, comprehensive and relevant information on aggressive tax planning strategies is one of the main challenges faced by tax authorities worldwide. To tackle this issue, the report provides a modular framework that enables countries to design a regime that fits their need to obtain early information on potentially aggressive or abusive tax planning schemes and their users by keeping in mind the administrative costs for tax administrations and businesses.
 
Action 14: Make dispute resolution mechanisms more effective
The OECD has recognised that timely disposal of cross-border tax disputes is critical in building a sound international tax system. The report aims to strengthen the effectiveness and efficiency of the Mutual Agreement Procedure (MAP) by ensuring that treaty-related disputes are resolved mutually by countries in a timely manner.

Action 15: Develop a multilateral instrument to modify bilateral tax treaties 
The report recognised that existing bilateral treaties are obsolete as they fail to tackle modern tax issues created due to evolving complex business arrangements. As a result, some features of the current bilateral tax treaty system fail to prevent BEPS and this is the primary area where this action intends to bring changes.

The OECD recognises that updating the current bilateral tax treaty network of over 2,000 treaties will be extremely burdensome and practically unfeasible. Accordingly, to overcome this problem, the OECD has already set in motion the process of creating a multilateral instrument that would, in effect, amend all the tax treaties simultaneously. The goal of Action 15 is to streamline the implementation of tax-treaty-related BEPS measures. The ad hoc group established for this aims to conclude its work and open the multilateral instrument for signing by 31 December 2016.
 

[1]OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris.
DOI: http://dx.doi.org/10.1787/9789264192744-en
[2] OECD (2015), BEPS 2015 Final Reports, OECD. http://www.oecd.org/tax/beps-2015-final-reports.htm
SKP's comments
We believe that the international tax changes stemming from the BEPS Project will transform the global tax environment. The recommendations and measures suggested in the report will go a long way in helping countries tackle the long-standing issue of planned tax evasion strategies adopted by corporate groups. However, as of now, it is not possible to gauge the magnitude of impact or success of the BEPS Project on various stakeholders as it is still in the recommendation stage, and it would depend on how each country implements the same in their respective tax jurisdictions.

While there is no doubt that the intention of the BEPS Project is to curb tax evasion and ensure that economic activities and tax collections are appropriately synchronised; some key concerns from a taxpayer’s perspective could include the following:
  • Partial/differential implementation by various countries
    Implementation of the BEPS Project requires simultaneous amendments in domestic tax laws along with treaty modifications. However, if countries undertake unilateral changes in their domestic tax laws that are not synchronised, it could lead to lack of clarity and instances of double taxation, which is obviously not the aim of this Project.
  • Excessive documentation and compliance
    Various measures introduced by the Project require taxpayers to undertake extensive documentation and compliance. Documentation requirements for transfer pricing matters introduced in the form of country-by-country reporting in addition to the existing local documentation requirements will be an added burden. These requirements may prove costly for taxpayers as undertaking these compliances and maintaining such detailed documentation will require dedicating costly resources without any direct commercial benefit accruing from it.
  • Harassment of taxpayers utilising legitimate commercial structures
    Certain measures introduced in the form of LOB rules, Principal Purpose Test, CFC regulations, etc. will serve as additional firepower for tax authorities to question the legitimacy of transactions and arrangements even where the taxpayer had no intention of avoiding taxes. Tax authorities may use these rules as a tool to harass taxpayers without any substantial proof of any wrongdoing on the part of the taxpayer.
Ultimately, we believe that if the measures intended to be introduced by the BEPS Project are implemented by various tax authorities around the globe in a synchronised and well-planned manner, this will go a long way in achieving the macro-level objectives of ensuring efficient allocation of resources and restoring equality in the global tax environment.  

SKP
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