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Grant Wardell-Johnson is Partner at KPMG, Australia
The OECD's Action Plan on BEPS was published in July 2013 to reform the international tax system. The Action Plan identified 15 Actions to address BEPS. Seven of the 15 Action Plan items are now moving out of the station.
On September 16, 2014 the OECD, together with the G20, released seven documents totalling 720 pages as part of the first set of deliverables for the OECD-G20 Action Plan of July 2013.
There are approximately 20 more deliverables due by 2015. The September 2014 releases would best be seen as a significant interim step in a substantial project, rather than discrete sub-projects. All of the seven deliverables require further work and moreover, what has become clear since the release of the original Action Plan is that there are strong interdependencies between the various Action Items. This extends well beyond consideration of the digital economy. The treatment of hybrids, for instance, is linked to the controlled foreign company (CFC) rules and both have linkages to tax treaties and the notion of permanent establishment. Transfer pricing asserts an omnipresence, not only in its multiplicity of concepts but as a fundamental statement of what this whole project is mostly about.
There are 44 countries involved in this project directly: 34 OECD countries, two OECD Accession countries, Colombia and Latvia, and eight G20 countries which are not part of the OECD. They are China, India, Brazil, Russia, South Africa, Indonesia, Argentina and Saudi Arabia. Others are indirectly involved. Singapore, for instance, has observer status at some of the meetings and the OECD has sought input from developing countries.
An important observation, which may be considered remarkable and uplifting, is that no country has yet chosen to throw its toys out of the cot — all parties are still on the Action Plan train. Moreover, it would now be surprising if any country chose to leave the group.
This is an important observation because it goes to the heart of what agreement in this domain is all about. It seems clear there will be agreement at the end of the project, but there may be higher or lower degrees of optionality or specificity within that agreement. The political-economic dimension of this is very different from what was sought to be achieved in Kyoto, Copenhagen and Cancun on climate change or Bretton Woods on foreign exchange. It seems that China, India, Russia, Brazil and the United States are in the fold and will stay there.
That is not to deny that the implementation phase at the country level will be difficult. It will be so. Yet one must ask at what level approval is required for implementation on a country-by-country basis: will it be treasury or finance, is it the administration or the minister, or is it the legislature? Moreover, one must ask whether a number of countries “holding out” damages for all, or whether a sufficient quorum of change sets the pace for all, as may well be the case with the recommendations on hybrids.
Action Item 1 calls for a review of the taxation of the digital economy and the Task Force on the Digital Economy has responded with a 200 page report, which, at its heart, is a progress report. Two significant conclusions are drawn.
Firstly, you cannot ring-fence the digital economy. What we are experiencing is the digitalization of the international economy.
Secondly, the so-called digital economy is in a state of revolution with a multiplicity of business models. They include:
• Free content for paid advertising;
• User pays per download;
• Online retail of tangible products;
• Premium delivery subscription service;
• Traditional services provided online;
• Provision of technical content, software and algorithms;
• Sale of data and customized research;
• Alternative currencies such as Bitcoin;
• Huge social medial build, then monetise; and
• Cross subsidy of physical operations.
These business models are said to exacerbate the risks for base erosion and profit shifting, rather than generate unique risks. There are six features of the business models outlined which are considered specifically relevant for taxation. They are:
• Mobility of intangibles, users and business functions;
• Reliance on data;
• Network effects;
• The spread of multi-sided business models;
• Tendency towards monopoly or oligopoly; and
Three main direct options have been put forward to deal specifically with the digital economy. They are:
(i) The creation of a taxable presence or permanent establishment where there is a “significant digital presence” based on contracts, payments and functions;
(ii) A virtual permanent establishment is created through a website or technologically-based agency (as against a human being) giving rise to a taxable presence; and
(iii) A withholding tax to be created on digital transactions.
All three are problematic and although they have not been rejected outright in the September 2014 report, they are likely to be rejected in future reports. Rather, the approach of the Task Force has been to focus on how other OECD-G20 Action items will impact the digital economy which may significantly reduce the problems which have become evident. These include:
• Changing the definition of permanent establishment so that local sales forces for goods and services or advertising create a taxable presence;
• Changing the definition of permanent establishment so that truly core activities do not fall within the preparatory or auxiliary exemption in the current rules;
• Changing treaty rules to prevent treaty shopping;
• Denying hybrid mismatches as existing structures within the digital economy often use hybrids;
• Countering harmful tax practices that seek to provide intellectual property deductions where there is little substance;
• Ensuring transfer pricing outcomes align with value creation; and
• Modifying CFC on rules to address the high levels of mobile income in the digital economy.
Some in civil society may be disappointed with the lack of direct attack on companies operating in the digital economy. However, the nuanced and practical approach of dealing with other areas, will stand up in the long term and avoid many unintended consequences.
Action Item 2 addresses hybrid transactions in a relatively clever manner and one would expect wide country support. That said, there are still a number of contentious areas to be worked out, particularly in relation to certain hybrids used by financial institutions for regulatory capital purposes and market traded instruments.
The term “hybrid” used in international taxation is slightly different and broader from how it is used in finance, although it encompasses financial instrument hybrids from which the specific tax use is derived. A hybrid financial instrument is one which has both debt and equity characteristics, such as a redeemable preference share. If it is issued cross border and two jurisdictions treat it differently, there is likely to be a mismatch — usually deductions for dividends as one country looks at the substance of the instrument and exempt dividends as the other country looks at the legal form. Here there is a deduction and no income pick-up. With our great propensity for acronyms, this is being labelled as a “D-NI” case.
In the world of international taxation, the concept of hybrids has extended to an entity that has been treated differently in two jurisdictions — transparent in one jurisdiction and opaque in another. A common example is a US “check-the-box” or disregarded subsidiary which is the top company of a group of companies outside the US. If such an entity were to have debt (and thus interest expense), it is possible for a deduction to occur in two jurisdictions. This is a double deduction or “D-D” case.
Both D-NI and D-D cases are examples of double non-taxation. There are many different types, such as deferred price share sales and collateralized REPOs. There is even a reverse hybrid, which is different from an ordinary entity hybrid, in so far as the former involves an opaque investor and a transparent investee, where the latter involves a transparent investor and an opaque investee. Some involve two countries, others involve three countries or possibly more.
The OECD-G20 report recommends countries adopt certain domestic rules which neutralize the benefit of the double deduction or deduction with no income pick-up. These are primary rules and secondary or defensive rules. The primary rules generally deny a deduction if there is no income pick-up and would be effective if both countries had them to neutralize the impact of double non-taxation. The secondary or defensive rules are in place to ensure neutralization occurs even if only one jurisdiction has them and would generally say we will impose an income pick-up if the paying country continues to allow a deduction. There are varying relationship rules, either a 25% related party rule or a 50% control rule and certain structured arrangements rules that determine how the hybrid rules operate.
Since the mid-1990s, the OECD has been focused on “inappropriate” concessionary tax regimes that may create a “race to the bottom”. Through a Forum on Harmful Tax Practices, it has looked at 95 tax regimes through five reports, 20 of which are still under consideration and are substantially all intellectual property regimes like the UK Patent Box or the Netherlands Innovation Box. Of the remaining 75, 43 have been considered not harmful, 12 have been amended and 20 have been abolished.
The current difficulty with which the Forum is grappling lies in the level of “substantial activity” that is required to take place in a country to justify a tax concession. The patent box regimes, which grant a concession for income on intellectual property that has already been developed and is transferred to a particular country, is particularly challenging and will be subject to further review. This form of concession is quite different from a traditional research and development (R&D) regime, insofar as the R&D has already occurred. The Forum will continue to work on this vexing issue in addition to establishing “notification” rules on rulings and new tax concessions.
There are two reports that deal with tax treaties. The first is essentially about stopping treaty shopping and the second is about finding a multilateral instrument that will enable a rapid mechanism for changing treaties, which circumvents multiple bilateral negotiations. On the multilateral instrument, it is indicated that such a model is desirable and feasible and that developing countries need to be brought into the fold with a conference in 2015.
On treaty shopping, there are two models — a US-based Limitation of Benefits model which is a black line model that seeks to deny the benefits of a treaty unless there is sufficient level of beneficial interest located in the country seeking to obtain the benefits, and a European Principal Purpose Test model which denies benefits if the principal purpose of the arrangement is to obtain a treaty benefit. This has often been criticized for uncertainty. The report suggests having both tests is preferable, but either test will be acceptable. More work is being done on this element and on making sure that investments from pension funds and sovereign wealth funds are not inappropriately damaged by these rules.
There are two reports dealing with transfer pricing. The first deals with intangibles. It provides a definition which is “something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”. This includes intangibles that are not recognized for accounting purposes.
The existence of location savings, group synergies and assembled workforce are factors that may impact comparability and arm's length prices, but are not of themselves, treated as intangibles. There is considerable guidance on how to perform a functions, assets and risk analysis. Moreover the guidance appears to endorse any pricing method depending on the facts and circumstances.
Another report deals with transfer pricing documentation and country-by-country reporting. This report outlined what needs to be in a master file, a local file and a country-by-country template. The Master File deals with five broad items: organizational structure, description of businesses, intangibles, intercompany financial activities and a description of the financial and tax positions. There are about 23 sub-questions. The local file deals with the local entity, controlled transactions and financial information. There are about 25 sub-questions.
The country-by-country template contains three tiers. The first is an overview of ten indicia such as profit before tax and accumulated earnings, which is to be completed on a country-by-country basis.
The second element is a constituent entities table which looks at each entity and requests details of the main business activities of each entity divided into 13 components. The third element is simply the opportunity to explain the information in the other two tables. The processes for the transfer of information have yet to be fully determined.
Businesses will be concerned that this initiative will give rise to increased disputation, that the material may be used for purposes beyond transfer pricing, that the information may become public where it is commercially sensitive and that materiality rules generally do not apply. There will also be a cost of compliance.
The seven deliverables released on September 16, 2014 is a major, but interim step, in the whole Action Plan. Ultimately, there are three messages: all 44 countries involved are “on the train”; there are significant interdependencies between these deliverables and the 2015 deliverables such that this should be viewed as a whole project, rather than a set of sub-projects and finally, that now is a good time for CEOs, CFOs and non-executive directors to question the stability and longevity of their international structures. While the train has some way to go, it is gaining pace. It is dealing in a place that often requires deep thinking and time.
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