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By David Ernick, Esq.
PricewaterhouseCoopers LLP, Washington, DC
As at least the first phase of the OECD's BEPS project1 wound down with the October release of the "final" BEPS deliverables, questions remained regarding how much of the recommended changes would be implemented in the United States in the near term. Because many of the recommendations require legislative changes or incorporation into income tax treaties, it may be thought that the impact of the OECD's recommendations may be somewhat muted in the United States, at least initially, as the changes would take some time to implement. However, a number of actions from Treasury and the IRS in recent months indicate that the impact of the changes resulting from the BEPS project may be coming sooner than expected.
Proposed Revisions to the U.S. Model Income Tax Convention
The first such action came on May 20, when Treasury released for public comment draft updates to the U.S. Model Tax Convention on Income (the "U.S. Model"), which is the baseline text used by Treasury when it negotiates tax treaties. In releasing the draft provisions, Treasury sought to address, among other issues, issues arising from so-called "special tax regimes," which provide for low rates of taxation in certain countries with respect to mobile income, such as royalties and interest. Treasury stressed its concern that taxpayers can easily shift such income across the globe through deductible payments that can erode the U.S. tax base. Consequently, consistent with the BEPS project, the draft proposals are intended to avoid instances of "double non-taxation," where a taxpayer utilizes provisions in the tax treaty, combined with special tax regimes, to pay no or very low tax in treaty partner countries.
In order to do so, Treasury proposes to deny treaty benefits for interest, royalties, or other income that benefit from a "special" tax regime in the recipient's country of residence. This restriction is aimed at related-party income that is deductible in one country and taxed at preferential effective tax rates in the other country.
Under the proposal, a special tax regime would be defined as any legislation, regulation, or administrative practice (such as a tax ruling provided to a taxpayer by a government) that provides a preferential effective rate of tax to the tested income, including reductions in the tax rate or the tax base, unless an exception applies. Exceptions would include regimes that do not disproportionately benefit interest, royalties, or other income; regimes regarding royalties that satisfy a substantial activity requirement; regimes that implement the principles of the treaty's business profits or associated enterprises article (e.g., Advance Pricing Agreements); certain nonprofit exemptions; certain pension and retirement benefit exemptions; regimes aimed at certain collective investment vehicles; and any regime designated by an agreement of the Contracting States.
A number of comments pointed out that the proposal could potentially inhibit Congress from enacting any rules that a foreign tax official might consider to be a special tax regime, since the result would be for U.S. taxpayers to be assessed with additional foreign taxes. It also could have the effect of discouraging outbound trade and investment by denying treaty benefits where the United States chooses to reduce its effective tax rate on foreign-source income, and could discourage inbound trade and investment by denying treaty benefits where a treaty partner chooses to reduce its effective tax rate on U.S.-source income.2
In proposing changes to the U.S. Model, Treasury stated that treaties exist to eliminate double taxation, not to facilitate "double non-taxation," and that the tax regimes of U.S. treaty partners are more likely to change over time than has occurred previously, and that these changes may encourage base erosion and profit shifting by multinationals. In order to address these concerns, the proposed changes would also provide treaty partners the right to partially terminate a treaty for benefits under the dividends, interest, royalty, and other income articles if there has been a substantial reduction in the normal rate of taxation in either country after the treaty has entered into effect. Treaty partners could partially terminate a treaty if one treaty partner reduced its corporate income tax rate below 15% for substantially all income of a corporate resident, or exempted substantially all offshore income from tax.
Comment letters received on this proposal noted that its effect would be to limit tax competition and to compel a certain minimum level of foreign taxation, which is not an appropriate goal of tax treaties. Additionally, the proposed changes allow a reduction in the tax base to trigger a partial termination, which would create additional uncertainty in determining whether and how to make cross-border investments.3
Changes to the Procedures for Filing a Competent Authority Request
These tax treaty proposals are obviously driven by the same sort of concerns animating the BEPS project. However, because these are just proposals to change the U.S. Model, and have not yet appeared in any treaties that have been negotiated and ratified, it may appear that it would take some time for them to be actually implemented. However, Rev. Proc. 2015-40 (the New CA Procedure), issued by the IRS on August 12, giving guidance on obtaining assistance under U.S. tax treaties from the U.S. Competent Authority, has already incorporated new restrictions on discretionary grants of treaty benefits, based on similar BEPS concerns.
The Limitation on Benefits (LOB) article of U.S. tax treaties typically recognizes that the objective tests in the article may inappropriately deny treaty benefits in certain limited circumstances. Therefore, a discretionary grant of treaty benefits provision provides a "safety-valve" for a person that has not established that it meets one of the other more objective tests, but for which the allowance of treaty benefits would not give rise to abuse or otherwise be contrary to the purposes of the treaty. Under this provision, such a person may be granted treaty benefits if the Competent Authority of the source country determines that the establishment, acquisition, or maintenance of such resident and the conduct of its operations did not have the obtaining of benefits under the treaty as one of its principal purposes.
The New CA Procedure, however, does not include the standard expressly stated in virtually all LOB articles (not having a principal purpose of obtaining benefits under the treaty), and instead adds (or substitutes?) a requirement that the applicant have a substantial non-tax nexus to the treaty country, and that, if benefits are granted, neither the applicant nor its direct or indirect owners will use the treaty in a manner inconsistent with its purposes. The New CA Procedure also provides that the U.S. Competent Authority typically will not exercise his discretion to grant benefits where the applicant is subject to a "special tax regime" in its country of residence with respect to the class of income for which benefits are sought, or where no or minimal tax would be imposed on the item of income in both the country of residence of the applicant and the country of source, taking into account both domestic law and the treaty provision ("double non-taxation").
Consequently, it appears that, rather than waiting for treaties to be renegotiated to include the May 20 proposed changes to the U.S. Model, the IRS has already implemented some of the changes through the New CA Procedure. Written comments expressed concerns that this may amount to a unilateral treaty override by the United States.4
Transparency and Disclosure – Country-by-Country Reporting
In addition to treaty changes to implement BEPS recommendations, the United States also has recently taken action to move towards implementation of country-by-country reporting, which falls under Action 13 of the BEPS Action Plan and is part of the OECD's push for increased transparency and disclosure. On July 31, Treasury and the IRS released their 2015-2016 Priority Guidance Plan, listing projects they consider to be priorities and on which they will be actively working during the period July 2015-June 2016. One of the projects listed in the Plan is: Regulations under §§6011 and 6038 relating to the country-by-country reporting of income, earnings, taxes paid, and certain economic activity for transfer pricing risk assessment.
Substantive Changes to the Section 482 Transfer Pricing Regulations
Finally, the United States has moved recently to make substantive changes to its transfer pricing regulations under §482. First, on August 6 the IRS issued Notice 2015-54 (the Notice), announcing its intention to issue regulations limiting deferral of gain on contributions to partnerships with related foreign partners and also addressing valuation of controlled transactions involving partnerships. The new regulations under §482 will apply transfer pricing methods applicable to cost sharing arrangements (CSAs) under Reg. §1.482-7 to controlled transactions involving partnerships.
In particular, the Notice announced that the regulations will provide specified methods for these partnership transactions that are based on the methods specified for cost-sharing "platform contribution transactions." Currently, the valuation methods outlined in the cost-sharing regulations are only considered to be "specified methods" for transactions that are part of a CSA, and are only available as "unspecified methods" in evaluating non-cost-sharing transactions.
In addition to incorporating the specified methods from the cost-sharing regulations to evaluate transactions involving related-party partnerships, the Notice also announced that new regulations will include periodic adjustment rules based on those from the cost-sharing regulations. Consequently, periodic adjustments will be applicable to transactions involving related-party partnerships when there is a significant divergence of actual returns from projected returns. These adjustments will mirror those set forth in the cost-sharing regulations (rather than the general periodic adjustment rules in Reg. §1.482-4).
Secondly, on September 14, Treasury and the IRS issued temporary regulations under §482 (the Temporary Regulations) (along with proposed regulations under §367) that would, among other things, provide for aggregate valuation of interrelated transactions that are covered in part by §482 and in part by other Code sections (such as §367). The Temporary Regulations aim to "clarify" Reg. §1.482-1(f)(2)(i)(A), which provides that the combined effect of two or more separate transactions may be considered if they are so interrelated that an aggregate analysis provides the most reliable measure of an arm's-length result. The Temporary Regulations provide that arm's-length compensation must be consistent with, and must account for all of, the value provided between the parties in a controlled transaction, without regard to the form or character of the transaction. The Temporary Regulations also note that consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation is consistent with the value provided, including any synergies among items and services provided.
The requirement that arm's-length compensation be consistent with the "value" provided in a transaction between related parties may create confusion, however, because the definition of "value" may be different from the price charged in an arm's-length transaction. Similarly, the "clarification" of when an aggregate analysis is appropriate depends on subjective tests that may be susceptible to differing interpretations, like determining whether transactions are "interrelated" or "economically interrelated," and whether "synergies" are present. In practice, this may lead to increased assertions that one-sided transfer pricing methods are less reliable than a method (such as the income method) based on a discounted cash flow analysis. Note, however, that the use of subjective terminology and greater use of aggregation mirror the proposals set forth in the work of the OECD to revise the guidance on use of the profit split method as part of its BEPS project.5
Viewed as a whole, then, actions taken within the past several months indicate that Treasury and the IRS are actively seeking to implement some of the changes being recommended by the OECD as part of its BEPS Action Plan. The scope of the changes involving treaty policy and the transfer pricing rules indicate that taxpayers should be prepared for some fundamental changes to historical tax standards. And the fact that the §482 regulations were issued in temporary form and the provisions in the New CA Procedure for discretionary grant of treaty benefits deviate from the text of existing treaties indicates that the changes may come quickly, and with limited opportunity for public comment.
This commentary also appears in the November 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, Chip, Culbertson, and Maruca, 6936 T.M., Transfer Pricing: OECD Transfer Pricing Guidelines, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
1 It appears that the release in October of final reports under the BEPS Action Plan is not the end of the BEPS project, as the G20 has requested a second phase of the project from the OECD concerning implementation and monitoring. The focus will be on implementation of the final BEPS recommendations in domestic laws and in bilateral and multilateral tax treaties, as well as monitoring of the application of agreed minimum standards. SeeOfficials Look to Next Steps to Halt International Tax Avoidance, 24 Transfer Pricing Rep. 322 (July 23, 2015).
5 See BEPS Action 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains (available at http://www.oecd.org/ctp/transfer-pricing/discussion-draft-action-10-profit-splits-global-value-chains.pdf) (Dec. 16, 2014), ¶ 7:In particular, where there is significant integration involving parties to a specific transaction or transactions within that value chain, for example in the effective sharing of key functions and risks, the reliability of one-sided methods may be reduced. One-sided methods may not be able to account reliably for the interdependence of the key functions and risks, or for the synergies and benefits created by such integration. In such cases transactional profit split methods may be an appropriate means of determining an arm's-length outcome, which takes into account the specific contributions of the parties to value creation.
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