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By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
I just read the Action Plan on Base Erosion and Profit Shifting (BEPS) issued by the Organisation for Economic Co-Operation and Development (OECD). There is much to think about in the report and I commend the OECD on its speedy initial effort. I also wholeheartedly agree with the need for concerted governmental action in this area. From my standpoint, the key term there is "concerted," because I view the current environment as a patchwork of disparate but aggressive enforcement activities by tax authorities - egged on by politicians and media - which put businesses at risk for both the cost of unrelieved double taxation and the very significant cost and distraction of tax controversy. So let's get consensus on a clear set of rules that we can all understand and comply with. While we're at it, how about going back to an environment where compliance with the law involves following an accepted standard, not vague notions of discerning the spirit of the law (or what the spirit might have been if there were a spirit) or predicting ever-changing tax authority interpretations of "appropriate" tax planning. Indeed, it was good to see the OECD acknowledgment of the risks inherent in the current environment - that inaction could lead to emergence of competing sets of international rules which in turn could lead to "global chaos" marked by massive reemergence of unrelieved double taxation. I would not have put it quite that strongly myself, but only for fear of being accused of hyperbole. But I agree and I am afraid that we are already seeing country actions consistent with the beginnings of some OECD-predicted chaos.
The report clearly recognizes the complexity of the issues in the areas that are of concern to policymakers with respect to the broad BEPS topic. As expected, no specific conclusions are reached or recommendations made in the report. Instead, the report discusses the issues and sets forth 15 Actions which will lead to specific recommendations by the OECD. Underlying themes in the report include reiteration of support for the existing global international tax framework of the arm's-length standard for transfer pricing and the specific rejection of formulary methods, respect for existing bilateral tax treaty obligations but with the view that more guidance needs to be provided to avoid treaty abuse, and emphasis on the need for more information, including potentially global tax and business information, to be provided to tax authorities to better enable them to identify and address BEPS abuse.
The report reflects laudable goals involving very complex issues and very challenging topics on which to achieve consensus. The report notes the importance of business input so I'll jump right in with my initial thoughts on the specific Actions included in the report. As we look at the report, let's keep in mind that the overall framework approach is "not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income." Which seems to me a very good thing. I'm too old to learn a new set of international standards and I kind of like the current ones. But, as I have mentioned in the past, I have some paranoid tendencies, which means I do have a tad bit of concern about the inclusion of the adjective "directly" in the above quote. So close watching and active engagement are needed.
Action 1 - Address the Tax Challenges of the Digital Economy
An ambitious place to start, with an issue that is quite multifaceted. A number of countries have expressed concern over the virtualness of e-commerce with respect to nexus, the location of intangible property (IP), the character of digital income, and the application of indirect taxation. The report includes all of these issues in scope and anticipates a "thorough analysis of the various business models in this sector." The goal of this action item is to identify the digital economy issues under the existing international tax rules and develop detailed options for addressing them. The due date for the report and options is September 2014. Having agonized over some of the above issues in the U.S. context with respect to specific segments of the broader digital economy, I would submit that this is perhaps the most ambitious of the 15 Actions. I hope some of the focus here will be on what actions should not be taken by governments in order to help avoid the global chaos that the OECD and I are united in fearing. I'm not sure I agree that there is any need for new rules or approaches for this business category. While the new technologies are fascinating on many levels, I don't really think the core international tax policy issues are all that unique. So I'm glad they're talking about a study and options. And clearly this is an area where significant business consultation will be essential.
The next four Actions deal with the perceived need to better align domestic tax rules to "establish international coherence in corporate taxation." This seems to be based on the assumption that there already is coherence on a national level, which I consider a bit optimistic.
Action 2 - Neutralize the Effects of Hybrid Mismatch Arrangements
The OECD's output here will be changes to the OECD model treaty and recommendations regarding domestic law provisions. As I've previously written, examples of potential "solutions" to the "problem" of hybridity include not allowing a deduction for payments that are not taxed to the recipient, not allowing an exemption for a "dividend" that is deductible by the payor, etc. Clear and consistent rules in this area could be an improvement over the current situation, where global businesses have to deal with the apparent ire of tax authorities over hybrid arrangements (which are possible, of course, only because of inconsistencies in governments' characterization of entities and instruments) as played out in aggressive attacks using various tax abuse theories and with the vagaries of what at times seem to be entirely results-oriented court decisions which are hard to understand or predict. (See my commentary "Tasman Hybrids," 42 Tax Mgmt. Int'l J. 295 (5/10/13).)
Action 3 -Strengthen CFC Rules
There are now around 30 countries in the controlled foreign corporation (CFC) club, following our U.S. lead in 1962. The report endorses the use of CFC rules not only as effective in the BEPS area for the home country of a multinational corporation (MNC) group, but also as having a "positive spillover" effect for the source country in reducing incentives for profit shifting out of such country. As I've pointed out in the past in the context of complaining about the policy overreach of the U.S. CFC rules, the trend in CFC regimes really has not been focused on this "policeman of the world" positive spillover effect which requires attempting to discern and capture what could be "inappropriate" foreign-to-foreign profit shifting. Rather, the focus has been on shifts of profits away from, or "inappropriate" deferral of repatriation to, the home country of the MNC group. The implication of the report appears to be that the focus on foreign-to-foreign activity should be increased, which in many countries would require a major overhaul of the CFC rules for which there very well may not be much appetite. And it further seems that the OECD may be intending to encourage more countries to join the CFC club, which would increase compliance burdens for many MNCs. So I'll try to keep an open mind, but right now I'm not a fan of this action item.
Action 4 - Limit Base Erosion via Interest Deductions and Other Financial Payments
This item focuses both on "excessive" related-party interest or other financial payments by subsidiaries and also on "excessive" parent company leverage to the extent related to the production of exempt or deferred income. The latter focus would be similar to the Camp Discussion Draft's thin capitalization proposal and the Obama Administration's proposal to defer U.S. interest deductions attributable to unrepatriated earnings of CFCs. However, targeting parent interest expense would be a dramatic policy shift for many countries (the United Kingdom and Canada are two good examples) so this may be a hard topic on which to reach consensus. While the former focus on subsidiary over-leverage is an area that has been the source of legislative action in multiple countries in recent years, the actions taken have differed substantially from country to country, often resulting in a paradigm where unrelieved double taxation (or double non-deduction of legitimate financial expenditures) would be a likely result. Thus, a more concerted overall policy approach would be attractive here. However, this too is a topic where consensus is hard to imagine.
Action 5 - Counter Harmful Tax PracticesMore Effectively, Taking into Account Transparency and Substance
This item focuses on harmful tax practices and preferential tax regimes of individual countries. Not a new area for the OECD and the report harkens back to the 1998 OECD report which raised concerns about a "race to the bottom" for countries in trying to attract certain types of businesses. Today the downward trend in corporate tax rates continues and there are new regimes for IP (patent boxes, etc.) and R&D activity. The need for governments to deal with the competing goals of attracting business and protecting their tax base will no doubt ensure that some level of apparent tax policy schizophrenia will always remain. The line between competitive tax practices and harmful tax practices is necessarily subjective so the OECD's stated intention to "take a holistic approach to evaluate preferential tax regimes in the BEPS context" will be a challenge. And this item will be made all the more challenging by the OECD intention to corral non-member countries and their regimes as well.
Action 6 - Prevent Treaty Abuse
Implicit in this Action is the perspective that bilateral treaty provisions should generally be respected, which is a good thing and something I've been worried about recently in light of tax authority attacks on treaties around the world. The OECD plan is to develop model treaty provisions and recommendations for the design of domestic rules to prevent use of treaties in "inappropriate circumstances." It should be noted that there is a vast network of bilateral tax treaties in the world which are extremely helpful in facilitating cross-border investment flows. These treaties are not intended to be limited to situations where the recipient of a payment is resident in the same country as the ultimate parent company of the multinational group, although that seems to be the view of some tax authorities these days. A sensible and consistent approach to defining the threshold for entitlement to treaty benefits - be it level of group business activity, derivative benefits standards, or some other business focus - would be a welcome outcome for this Action. The paranoid part of me does worry about the risk of an approach that is overly subjective and thus prone to inconsistent application. And speaking of paranoid, I am troubled by the second prong of the expected outcomes here as domestic rules limiting use of treaties would seem to mean treaty overrides, which is not something I would have thought the OECD would ever be pushing.
The next four Actions relate broadly to transfer pricing - not surprisingly a key focus area of the report. While expressing support for the existing arm's-length standard, the OECD includes in the report some approaches that could erode the standard in various ways.
Action 7 - Prevent the Artificial Avoidance of PE Status
I consider the permanent establishment (PE) area to be in some senses a subset of the transfer pricing area because the effect of a PE determination could be to add another country to the equation for the appropriate allocation of a group's business profits. Lowering the bar for establishing PE status to me would just be adding unnecessary complexity and further risk of unrelieved double taxation to the international sphere. The report specifically focuses on the use of commissionaire arrangements - which has been the source of significant litigation in a number of European countries. Given the heightened audit activity in this area despite the taxpayer victories in several countries' courts, I agree more OECD guidance would be useful. However, OECD guidance confirming the result in the bulk of the commissionaire cases would be more useful than guidance reversing that result, which unfortunately seems to be the intended direction of this action item. If that is indeed the intent, then it would be better if any expansion of the PE concept is measured and is accompanied by an admonishment to countries to moderate their aggression in this area. Like I said earlier, I am trying to keep an open mind.
Actions 8, 9, and 10 - Assure that Transfer Pricing Outcomes Are in Line with Value Creation
The three specific transfer pricing areas relate to intangibles, risks and capital, and other high-risk transactions. I've previously written about my concerns with the OECD discussion draft on intangibles, highlighting what I see as the significant definitional issues with respect to intangibles and the uncertain mechanisms that might be employed to reallocate intangible returns. Only a very high-level description of scope is provided in the report for these three action areas, but there is nothing that allays my concerns about whether the OECD's ultimate recommendations for defining what are "appropriate" returns for IP, capital, and risk will recognize the practical realities of the complex legal entity and business model structures of most large MNCs. And I see further reason for concern that "risks" are not really considered risky anymore as this report, like others, focuses only on "inappropriate" profit allocated to risk as if losses are never realized. Why is it we never see any discussion of reallocating losses or even any acknowledgment that losses are a reality which must be accounted for in the analysis?
All three of these Actions make reference to "special measures" that may be needed to deal with the pesky transfer pricing issues in these areas, which would be above and apparently apart from regular arm's-length conventions. "Special measures" is a very scary term, and one only hopes the use of any such measures would be confined to situations that are indeed very special - and well-defined - and that such use would be very measured - and well-defined.
Interestingly, included under the high-risk transactions item is a reference to the potential need for special measures to deal with base-eroding payments such as management fees and head office expenses. I'm not a full-time transfer pricing guy, but I have always thought you are required to charge out head office expenses and management fees that are not in the nature of stewardship. With the proliferation of shared service models and the centralization of functions in most MNCs, intercompany charges in this area are merely a reflection of current business reality. One wonders which constituents in the OECD were concerned about these charges as high-risk transactions.
Action 11 - Establish Methodologies to Collect and Analyze Data on BEPS and the Actions to Address It
This Action seems to relate to the statement in the OECD's first report on BEPS back in February acknowledging that "[m]ost of the writing on the topic is inconclusive" but going on to say that "there is abundant circumstantial evidence that BEPS behaviours are widespread." Clearly, with MNCs subject to trial by media and judgment on the political stage, a little thought to something more than circumstantial evidence would be welcome. But it does seem a bit backward that it takes until Action 11 - after 10 other actions - to come to collecting data to analyze the problem and the actions to address it.
Action 12 - Require Taxpayers to Disclose Their Aggressive Tax Planning Arrangements
Here in the United States we are used to the Reportable Transactions and UTP reporting requirements. Likewise, in the United Kingdom there has been reporting of this ilk for several years. This Action seemingly contemplates that all OECD countries should adopt something similar. The report states that the recommendation "will use a modular design allowing for maximum consistency but allowing for country specific needs and risks." Not quite sure what that means actually, though it sounds like some kind of flexible consistency? Overall I have no problem with a disclosure requirement, and the requirements in the United States and the United Kingdom have not seemed to be too overly burdensome. However, I'm not sure if the U.S. and U.K. tax authorities have found the information to be valuable enough to justify exporting these requirements to the rest of the OECD and beyond. And not surprisingly I do worry a lot about overly broad and/or creeping definitions of "aggressive tax positions." So whatever "modular design" means, I hope it will be prescriptive enough to limit the risk of countries getting carried away and burying MNCs in reporting requirements (which in turn would bury the tax authorities in paper).
Action 13 - Re-Examine Transfer Pricing Documentation
The report states that this Action "may include" a requirement that MNCs "provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries." (Emphasis supplied.) Good that the focus here is on provision of information to tax authorities and not on disclosure in the public domain. However, I fear that the drafters may not appreciate the potential administrative burdens of such a requirement. This kind of reporting might not be too tough for a single-dimension business model. But many clients I deal with are complex conglomerates with a multitude of businesses, disparate business models, varying transfer pricing methodologies, etc. Providing the above data in the aggregate would not seem particularly helpful to tax authorities. Providing it by segment (however one might define "segment") would likely be a huge undertaking and it still, in my mind, would be of uncertain value to tax authorities. That said, given the current political pressures, I think it would be prudent for companies to start to think hard about these issues and to consider getting involved in the dialogue around shaping the new reporting requirements which seem to be a certain outcome of this project.
Action 14 - Make Dispute Resolution Mechanisms More Effective
The report recommends improvement of existing approaches for the Mutual Agreement Procedure (MAP) and treaty dispute resolution. I couldn't agree more. Arbitration is still provided for in only a small percentage of treaties and is rarely used. MAP is slow at best and is ineffective in too many countries. Also needed here, and what I hope will be a focus for this action item, is more effective advance ruling procedures around the world. Advance Pricing Agreements (APAs) are the primary vehicle, but broader ruling procedures that will address the issues that inevitably will arise in connection with the other action items in the report also are needed. Nothing is more important than certainty. And with the increasingly aggressive tax audit environment these days, more effective APA programs and advance ruling procedures that can work openly and with reasonable speed would be enthusiastically welcomed by MNCs.
Action 15 - Develop a Multilateral Instrument
This last Action reflects another admirable goal. In order to speed up amendments to treaties which could be a part of various of the other Actions, rather than the agonizingly slow pace of bilateral negotiations, the OECD suggests some out-of-the-box thinking, in the form of a "multilateral instrument" to agree all at once to treaty amendments reflecting the OECD recommended changes. In my view, while in many respects desirable, this action item seems the most unrealistic as a practical matter. It is hard for me to see the Senate Foreign Relations Committee signing off on this, when we are having difficulty getting individual and seemingly uncontroversial treaties through the Senate process. A multilateral approach with universal changes to, say, our U.S. Limitation on Benefits approach or the definitions of "residence" or "beneficial owner" seems too complex as a technical matter and a bridge too far as a political matter.
So, all in all, 15 Actions, all universally challenging, seems quite a daunting task for the OECD to embark upon. And then to try to coordinate individual country actions following the conclusion of the OECD work. This could take awhile. Quite awhile. But to quote Lao-tze, "even a journey of a thousand miles begins with a single step" and, to be fair, it seems to me the report is worth at least several steps. And perhaps another journey quote from an unknown author has some application as well: "Even if the path is a little blurry, keep walking. You'll focus in when you know what you want." While it seems pretty blurry right now, I am hopeful that the Action Plan outcomes will be clear on what the OECD wants and what it does not want. We wouldn't want to walk all that way only to realize at the end of the journey that we would have been better off staying right where we had been. Care to join me in keeping an open mind about this, at least for the first few milestones?
This commentary also will appear in the September 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions, Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties - Income Not Attributable to a Permanent Establishment, and in Tax Practice Series, see ¶2330, Interest Expense, ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers, and ¶7160, U.S. Income Tax Treaties.
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