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Joy Svasti-Salee CTA, FCA Professorial Fellow Centre for Commercial Law Studies, Queen Mary University of London
Joy Svasti-Salee teaches international tax law at postgraduate level at Queen Mary University of London
We are entering into a period of unprecedented change and increasing complexity in international tax law. Multinationals will need to monitor the tax position in each country and each bilateral tax treaty with extreme care.
In November 2015 the G-20 ratified, approved and adopted recommendations made in 13 Reports, in relation to 15 Action Points, produced by the Organisation for Economic Co-operation and Development (“OECD”) to counter base erosion and profit shifting (“BEPS”), and further follow-up discussion drafts have been issued during 2016 (see table below). The output takes the form of new minimum standards, common approaches, and guidance, to be introduced through both domestic law and changes to tax treaties. These are soft law instruments, which are not legally binding, but there is an expectation that countries that are part of the consensus will implement them.
To date 85 countries have agreed to a new inclusive framework and to introduce the minimum BEPS standards, so there is clearly buy-in to this project; that buy-in is far broader than the 34 members of the OECD, and includes countries such a Brazil, China, India and South Africa. However, the real impact will depend upon whether, when, and to what extent countries actually implement the minimum standards and indeed what happens if some do not, and whether, when, and how countries implement the other recommendations.
Quite apart from BEPS, domestic tax laws in countries throughout the world continue to change at a pace. Many countries are introducing unilateral rules that go further than any of the BEPS proposals, with the U.K. and then Australia bringing in a Diverted Profits Tax, and India a six percent equalization levy on online advertising revenues of nonresident e-commerce companies earned in India.
So we are entering into a period of unprecedented change and increasing complexity.
The original tax policy concerns expressed were that “due to gaps in the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be only unduly lowly taxed.” Arguably the focus was on income diverted from “industrial countries” to tax havens, or to countries which would not normally be regarded as tax havens but which offer a beneficial tax regime to a class of taxpayers, in this case multinational corporations.
The discussions have been fueled by NGOs, and the public, who consider that multinationals should pay more tax on their profits—“their fair share of tax”. The expectation seems to be both that large corporates should pay more tax (taking the pressure off deficits and perhaps individual taxpayers) and that “developing countries” (especially those with natural resources or a strong customer base) should gain additional corporate tax revenues.
The OECD conservatively estimated the global revenue loss at $100–240 billion or 4–10% of global corporate income tax revenues, although there was no real attempt to articulate which countries had lost revenues (nor to establish whether any loss is actually a deferral rather than an absolute loss). The OECD will be monitoring the success of the project going forward, and although it will be difficult to determine what additional tax revenues arise as a result, it will be interesting to see the trends that emerge.
The big issues are which measures are likely to increase corporate taxes payable, which countries are likely to benefit, how countries generally will react, and perhaps most importantly, how multinationals will factor all the changes into their investment decisions.
It is undoubtedly true that over the years multinationals have done a fair amount of tax planning, especially in the area of financing their global operations, trading off the position that different countries have different definitions of interest and dividends, and that some countries offered beneficial treatment backed up by rulings to host treasury activity. Action 2 aims to neutralize such hybrid mismatch arrangement. Where countries introduce the recommendations made, multinationals will probably restructure their financing arrangements, and it is likely that the key beneficiaries will be the parent, or holding company, jurisdictions.
The other Action in this area, Action 4, is quite different. Countries have essentially agreed a common approach and best practice that the deduction of interest, a genuine trading expense, should essentially be restricted to 30% of profits. This is in addition to transfer pricing rules, existing domestic law restrictions, and general and targeted anti-abuse rules that investee countries already have. Even in a period of low interest rates such a disallowance of an expense could result in significant increases in corporate tax revenues, but may also impact foreign direct investment.
Neither of the above Actions are agreed minimum standards, but in making recommendations on hybrid mismatch arrangements and agreeing best practices on interest deductibility, countries have agreed a general tax policy direction. As they weigh the balance of their commitments to the BEPS project with their need to remain competitive, taxpayers will have to wait to see whether, when, and how such measures are introduced.
Putting to one side Actions requiring treaty change and Actions relating to transfer pricing, the other Actions are more about transparency and countries sharing best practice. Key measures here are the agreed minimum standard on country-by-country reporting and the exchange of tax authority rulings which, whilst not directly increasing tax revenues, will help tax authorities generally to identify areas on which to focus attention in their tax audits. It is likely that we will see many more tax disputes in the future, so it is helpful that another minimum standard is aimed at resolving tax disputes.
A number of the new minimum standards and common approaches require changes to tax treaties. Amending 3000+ existing bilateral tax treaties in a synchronized way quickly is quite a challenge and it has been agreed that a Multilateral Instrument (“MI”) is a desirable and feasible means of achieving this. It is expected that this will coexist with bilateral treaties and will be open for signature by December 31, 2016.
This is a real challenge for governments and taxpayers alike. Whilst we know what measures are expected to be in the MI, we do not know how it will operate in practice, we do not know which pairs of countries (it is essentially updating bilateral treaties) will agree to accept the changes proposed, and we do not know how the MI will interact with bilateral tax treaties in the longer term.
It is expected that the MI will include:
Within each of the above there are several provisions and different permutations of some provisions are expected to be available.
Changes which lower the permanent establishment (“PE”) threshold will mean that all companies in a group will need to carefully consider what the new threshold is in each country, whether they have stepped over the threshold, and to deal with the local reporting, filing requirements, and penalties regimes. Whilst the financial services sector is used to operating through branches (due to regulations and capital requirements) other sectors have little experience of trading through PEs, as once they establish profitable operations they tend to establish subsidies instead. So the lowering of the PE threshold may mean that more subsidiaries will be set up. It also becomes increasingly likely that companies will accidentally cross the threshold, and some form of agreed de minimis would probably be helpful to all.
Whilst the trend has been for global corporate tax rates to decrease, withholding taxes on payments of interest, royalties and dividends have largely remained unchanged (the U.S. rate is 30%) and as withholding taxes are applied to gross payments rather than the profit they can be substantial and lead to double taxation. Domestic withholding tax rates are reduced under double taxation treaties, often to a low or nil rate, so establishing whether a treaty continues to apply after the Action 6 changes will be particularly important.
The practicalities of keeping track of what treaty changes different pairs of countries will make, either through the MI or through renegotiation of a bilateral treaty, and when they start to apply, will be quite a challenge. Essentially each group company wanting to benefit from a tax treaty will need to continually ask:
Overall these treaty changes are likely to lead to more source-based taxation (for countries into which multinationals expand), and probably to increased levels of double taxation.
Transfer pricing is a difficult “science”, as it essentially requires connected parties to transact in a similar manner to third parties, in circumstances where third parties do not transact with each other in a consistent manner!
Work in this area heralds a significant change, especially in the complex areas of intangibles, the contractual allocation of risks, and other high-risk areas (Actions 8–10). The underlying concern is that the current transfer pricing emphasis on the contractual allocation of functions, assets and risks is vulnerable to manipulation and can lead to outcomes not aligned with value creation.
The revised guidance requires careful “delineation” of actual transactions between associated enterprises by considering both the contractual position and the conduct of the parties. Where contracts are incomplete or not supported by the conduct of the parties, the conduct will supplement or replace the contractual arrangements, and where an arrangement lacks commercial rationale it can be disregarded. Essentially this is about arriving at what is considered to be the “real deal” and not the “paper deal” and then pricing it, which in and of itself is fair enough.
In relation to the discussion on disregarded transactions, one example given is that the legal ownership of intangibles alone does not necessarily generate a right to all (or indeed any) of the return that is generated by their exploitation. Legal ownership brings with it the right to possession, the privilege to use, and the power to convey those rights and privileges. To move away from legal ownership, which is often the only constant factor in an arrangement that continues over several years, towards conduct which changes over time, is concerning.
Clearly the BEPS concern is over highly profitable intangibles held in tax havens or territories benefiting from special regimes, and in today's low interest rate environment providing the legal owner with a risk-free financing return may well lead to reduced taxable profits in such countries and increased profits elsewhere. However, countries that wish to benefit from super profits in good years may not be so willing to give relief for losses that generally arise at some point during the IP lifecycle. In addition, such a policy would also lead to increased profitability for the legal owner in periods of high interest rates (which may be hard to imagine at present but we could return to this in the future) which would probably not be liked either.
The issue here is that transfer pricing continues to produce disliked or unintended consequences, governments continue to think the arm's length approach is the best way to divide profits between companies in a multinational group and therefore to countries, and so continue to apply “sticky tape and plasters” to the transfer pricing guidelines.
The underlying difficulty is determining where value is really created! This goes to the heart of who should earn the profits (or losses) and therefore which country has the right to tax them.
These questions are particularly difficult in the context of a highly integrated multinational group.
Nations will continue to compete for capital and jobs and foreign direct investment—and will need to continue to balance this with their need to collect taxes. Having clear tax rules and a robust but fair tax authority will continue to be important.
Multinationals are faced with a period of unprecedented change and will need to monitor the position in each country, and each bilateral tax treaty, carefully to ensure they are aware of the rule of law within which they have to operate; it is likely that tax disputes between countries will increase.
Domestic tax law and tax treaties are becoming way too complex. Perhaps having made huge progress on changing the ground rules to encourage behavioral change, it is time to consider monitoring the position and considering if simplification is possible.
Joy Svasti-Salee is an international tax law specialist. After a career in practice in three of the big six accountancy firms, she leads the teaching of this subject at LLM level at Queen Mary University of London.She may be contacted at: firstname.lastname@example.org
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