BEPS: The Six Pressure Areas

With the Organization for Economic Cooperation and Development to present its plan on base erosion and profit shifting one week from today, a review of what's at stake seems in order. Below is a shortened version of an article by Transfer Pricing Report's Kevin Bell that summarizes the "key pressure areas."

OECD Committed to Holistic, Fundamental Review of Broken Tax System, Transfer Pricing Chief Says

The head of the Organization for Economic Cooperation and Development's transfer pricing unit said Feb. 13 that the OECD is going to take a "serious shot" at fixing the international corporate tax system, which is effectively broken given the evolution of the world economy in recent decades.

The day after the release of the OECD's report, "Base Erosion and Profit Shifting," Joseph Andrus told a conference in Washington, D.C., that the report identified transfer pricing as a "key pressure area" involving the treatment of risks and intangibles, the artificial separation of assets and activities within members of a corporate group, and the recognition of transactions that would not normally occur between unrelated parties.

The day the report was released, Pascal Saint-Amans, head of the OECD's Center for Tax Policy and Administration, said the Group of 20 countries' nascent effort to fight base erosion and profit shifting (BEPS) could end up "accelerating" existing international work on transfer pricing issues related to intangibles. (See the related article in this issue.)

Andrus, speaking at the Tax Council Policy Institute conference, clarified that transfer pricing is only one of the problems with the international tax system. Base erosion and profit shifting are caused not just by transfer pricing rules that do not make sense, he said, but also by interactions between countries' many different tax rules that companies are able to legally manipulate to achieve results inconsistent with the underlying policies.

In addition to transfer pricing reform, Andrus said, the BEPS report points to the need for:

  •  instruments to end or neutralize the effects of hybrid arrangements, meaning hybrid mismatches of entity characterization and hybrid mismatches of instrument characterization;
  •  updated rules on jurisdiction to tax, particularly regarding the digital economy;
  •  more effective anti-abuse measures in the form of general anti-avoidance rules, controlled foreign corporation rules, tax treaty limitation-on-benefits provisions, and the like;
  •  better rules on intercompany financial transactions; and
  •  an end to preferential tax regimes.

Broken System

Garry Stone of PricewaterhouseCoopers in Chicago said that some statements in the BEPS report appear skewed toward the proposition that tangibles are good because they are real and substantive, whereas "intangibles and risk were, by implication, not real, not substantial, [and] maybe used to create some sort of `scheme.' "

Although "scheme" has a different usage in U.K. English, Stone said the report "comes off as a bit focused on factors of production and not so much on IP and risk" and expresses the "notion that there is something broken with arm's-length pricing and the methodologies."

Andrus said the notion that the governments responsible for the BEPS initiative think something is broken in the transfer pricing system "is an absolutely spot-on, accurate, reflection. I don't think we ought to mince any words about that."

He continued, "Whatever it is we are doing, for whatever reason, isn't producing accurate results if it turns out that 75 percent of the world's income under a transfer pricing system is reflected as being earned in Singapore, Switzerland, and the Cayman Islands, and Bermuda."

The BEPS project "is saying we need to take a hard look at those issues and look at them broadly and to see if there is a better way of running the railroad."

Profits `Untaxed Anywhere'

Michael McDonald, a U.S. Treasury financial economist, noted the statement in the report that historical rules and their underlying policies "were built on the assumption that one country would forgo taxation because another country would be imposing tax. In the modern global economy, this assumption is not always correct, as planning opportunities may result in profits ending up untaxed anywhere."

Compounding the problem, according to McDonald, is the risk of artificially shifting profits through transfer pricing and risk stripping, which has led the report to propose a comprehensive approach to addressing the problem of base erosion.

But while the report is provocative, the Treasury official said, it is raising questions rather than producing answers. The OECD project is a serious initiative but "it may not be worthwhile at this point to be extrapolating on where this is going to go, and what the ultimate result is going to be."

Andrus agreed. "I cannot possibility tell you what the countries will come up with as they take this fundamental look," he said. However, he emphasized that real change is coming. The report was unanimously approved by all 34 OECD member countries, including the United States, Canada, Luxembourg, Switzerland, and Japan.

Permanent Establishment

Andrus said the answer to many of the hard questions facing the BEPS project "may very well depend on jurisdiction to tax issues," noting that the project is reevaluating the permanent establishment rules.

If it is decided that the PE rules are at the heart of the problem in the world of electronic commerce, Andrus said, then it may be necessary to tax a provider of electronic digital goods in the customer's country even if it does not have a fixed place of business there. Under this scenario, "a transfer pricing system that is premised upon functions, risks, and assets makes very little sense."

He noted that the BEPS report "says that the digital economy is one of the problems—and maybe the tax system hasn't figured out the right way to go about dealing with the digital economy."