The OECD action plan on Base Erosion and Profit Shifting

December 14, 2014

The OECD action plan on Base Erosion and Profit Shifting

IN TAX, the latest global buzzword is “BEPS” or base erosion and profit shifting. BEPS refers to the practice of multinational corporations (MNCs) of shifting profits from high tax jurisdictions to low tax jurisdictions as a tax mitigation strategy.

In February 2013, the Organization for Economic Co-operation and Development (OECD) claimed that available data on the extent of BEPS is inconclusive; nevertheless, there is circumstantial evidence suggesting that BEPS practices are pervasive. In fact, studies cited in the 2013 OECD BEPS Report suggest that in certain jurisdictions, there are significant discrepancies between the physical operations of companies and the countries where they report profits for tax purposes.

Conceptually, tax planning strategies are intended to improve the overall tax efficiency of companies through the use of legitimate approaches. However, problems arise when the very laws themselves create opportunities for BEPS, such as when the application of different tax laws results in double non-taxation. This is where the issue of fairness comes in, since many MNCs have been accused of not paying their share of taxes resulting from these practices.

The OECD Action Plan explains the harmful effects of these business practices to stakeholders such as governments, individual taxpayers, and businesses.

Many governments have to cope with less revenue and higher cost to ensure compliance. In developing countries, the lack of tax revenue leads to critical under-funding of the public investments that help promote economic growth. Overall resource allocation, affected by tax-motivated behavior, is not optimal. For individual taxpayers, they bear a greater share of the burden of paying more taxes when businesses shift income to lower tax jurisdictions. For businesses that operate only in domestic markets, they will have difficulty competing with MNCs that have the ability to shift their profits across borders to avoid or reduce tax. These disadvantaged businesses include family-owned corporations and new companies.

Because of the perceived harmful effects of these BEPS practices, the BEPS issue has become not only an economic issue but a political one as well. It has caught the attention of governments and tax administrators, the OECD and the G20 Leaders and Finance Ministers. In the G20 meeting in November 2012, G20 Finance Ministers finally called on the OECD for a coordinated action to address the BEPS issues. This call jump-started the OECD BEPS Action Plan which was released in July 2013.

The BEPS Action Plan identified 15 action areas that the OECD will focus on in the next two and a half years; these are:

1. The tax challenges of the digital economy;

2. The effects of hybrid mismatch arrangements;

3. Strengthening controlled foreign corporation (CFC) rules;

4. Limiting of base erosion via interest deductions and other financial payments;

5. Countering harmful tax practices more effectively, considering account transparency and substance;

6. Prevention of treaty abuse;

7. Prevention of artificial avoidance of permanent establishment (PE) status;

8. Assurance that transfer pricing (TP) outcomes are in line with value creation of intangibles;

9. Assurance that TP outcomes are in line with risks and capital;

10. Other high-risk transactions;

11. Establishment of methodologies to collect and analyze data on BEPS, and the actions to address it;

12. Requirement on taxpayers to disclose aggressive tax planning arrangements;

13. Reexamination of TP documentation;

14. Improvement of dispute resolution mechanisms; and

15. Development of more effective multilateral instruments.

The OECD envisioned the Plan to be implemented in three phases from September 2014 through December 2015. According to the OECD, the deliverables of the BEPS Action Plan will identify best practices, model domestic legislation, changes to the OECD Model Tax Convention and other tools needed to ensure that profits and taxes are aligned with economic activities, and close the loopholes in the tax policies and domestic legislation.

In September of this year, the OECD presented its first set of deliverables to the G20 Finance Ministers, but these reports will remain in draft form until the completion of the 2015 deliverables. Until then, the OECD will continue to work on recommendations and models for the seven action areas in order to achieve reasonable and sustainable solutions to counter these BEPS practices.

This first set of deliverables consists of three reports on Digital Economy (Action 1), Harmful Tax Practices (Action 5) and Feasibility of a Multilateral Instrument (Action 15) as well as four draft rules on Hybrid mismatch arrangements (Action 2), Treaty abuse (Action 6), Transfer Pricing of intangibles (Action 8) and Transfer Pricing documentation and a country-by-country reporting template (Action 13).

Briefly, these reports are summarized as follows:

Action 1: Addressing the challenges of the digital economy

The main challenge of the digital economy is how digital players such as online sellers or retailers, internet advertisers, and app stores make their profits, how these profits are characterized for tax purposes, and where taxes on these profits should be paid. The report presented potential options to address these challenges such as modifications of the PE threshold, the concept of significant digital presence, the creation of withholding tax on some types of digital transactions, and the imposition of a bandwidth or “bit” tax and VAT or consumption tax.

Action 2: Hybrid mismatch arrangements

This report provides recommended rules and model treaty provisions intended to neutralize the effect of hybrid mismatches like the denial of dividend exemption for deductible payments, introduction of measures to prevent the use of hybrid transfers to duplicate credits for taxes withheld at source, and denial of deduction for payment that is also deductible in another jurisdiction.

Action 5: Harmful tax practices

The OECD’s efforts to counter harmful tax practices of companies are nothing new. As early as 1988, the OECD had already begun looking at these practices. Now, however, the report focuses on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime especially in the context of intangible regimes.

Action 6: Treaty abuse

The OECD identified treaty abuse as one of the major sources of BEPS and as such, has focused on specific action items to counter treaty abuse and treaty shopping.

Article 8: Transfer Pricing of intangibles

One of the biggest challenges in Transfer Pricing is how to prevent BEPS when it involves intangibles. As such, the report on TP attempts to clarify the definition of intangibles, provide guidance on identifying transactions involving intangibles, and provide supplemental guidance for determining arm’s length conditions for transactions involving intangibles.

Action 13: Transfer Pricing documentation and a country-by-country reporting template

Part of the difficulty in countering BEPS is the lack of adequate information on how they operate within businesses. Action 13 aims to increase transparency for tax administrations by providing standards for TP documentation and as well as a template for country-by-country reporting. The guidance on TP documentation requires companies to disclose high-level information regarding their global business operations which will be available to all relevant country tax administrations, and provide documentation on relevant related party transactions. The country-by-country reporting will require companies to disclose substantial information on their businesses such as where they do business, amount of revenue, profit before income tax, income tax payments, total employment, capital, retained earnings, and tangible assets in each tax jurisdiction.

Action 15: Feasibility of a Multilateral Instrument

One of the mechanisms identified by the OECD in implementing the BEPS initiative on treaty-related matters is the use of multilateral instruments, which are seen to be more effective and sustainable since they can bind all parties, thereby ensuring a consistent and coherent approach to addressing treaty-related BEPS issues.

Looking back to more than a year ago, the BEPS initiative was met with both anticipation and criticism. While the initiative to level the playing field was prompted by good intentions, companies raised legitimate concerns on how this will impact their businesses. Key concerns include the risk of improper use of the country-by-country reports, the administrative costs of increased compliance and disclosure requirements, interpretation issues on treaty benefits which could lead to double taxation, and breach of confidentiality provisions which may expose sensitive corporate information to competitors, among others. The same issues stand today even after the OECD’s release of the first set of reports. Clearly, the OECD still has a lot of ground to cover in the next year. However, given all the potential issues surrounding BEPS and the BEPS measures, it is imperative for companies to actively participate in discussions on BEPS. Not only will this allow them to understand the impact on their own businesses, it will help them come up with new tax-planning strategies and business models that are compliant with the OECD BEPS guidelines.

Fidela I. Reyes is a Partner and International Tax Services Leader and Ma. Margarita Mallari-Acaban is a Tax Senior Director of SGV & Co.

January 04, 2015

BEPS action plan 1: The digital economy

IN A PREVIOUS column (http://www.bworldonline.com/content.php?section=Economy&title=the-oecd-action-plan-on-base-erosion-and-profit-shifting&id=99561), we wrote about the general framework of the Base Erosion and Profit Shifting (BEPS) initiative, why addressing BEPS is a key priority for many governments across the globe, and the 15-point BEPS Action Plan drafted by the Organization for Economic Co-operation and Development (OECD). The Action Plan aims to ensure that profits are taxed where economic activities generating the profits are performed and where value is created. In this column, we tackle the OECD Report on Action 1, which addresses the tax challenges of the digital economy.

Over the years, many stakeholders have raised concerns on how businesses operating in the digital economy have made use of their mobility as well as the gaps in the different tax systems to create “stateless income.” Questions have likewise been raised on how to attribute value from the generation of data through digital products and services, or how to characterize payments for digital goods or services. More significantly, the question is whether current tax residence or Permanent Establishment (PE) rules are still applicable considering the rise of “digital presence.”

THE DIGITAL ECONOMY: KEY FEATURES, NEW BUSINESS MODELS AND BEPS OPPORTUNITIES
Some key features of the digital economy identified by the OECD include mobility with respect to intangibles, users/consumers and business functions; reliance on data and use of multi-sided business models where two sides of the market are located in separate jurisdictions. These features have allowed enterprises to conduct substantial business in different market jurisdictions from a remote location, or transfer intangible assets to associated enterprises with relative ease and, often, to those which do not have any economic activity, in order to reduce or avoid taxes in countries in the entire supply chain. To date, digital enterprises have been successful in doing so due to gaps in the countries’ tax systems and tax treaties. If not addressed soon, more and more digital enterprises will have “stateless” income which will remain untaxed to the detriment of governments and smaller businesses.

WHAT NEEDS TO BE DONE
To address these challenges in the digital economy, the approach should be comprehensive and coordinated. The OECD proposes to do this by combining the BEPS measures under Action 1 with the other Action Areas such as Action 2 (Neutralizing the effects of hybrid mismatch arrangements), Action 5 (Counter harmful tax practices), Action 6 (Prevent Treaty Abuse) and Action 7 (Prevent the artificial avoidance of PE status) in order to align taxation with economic activities and value creation.

In Action 1, the OECD proposes several corporate income tax and VAT options to address the digital issues, such as:

CHANGES IN PERMANENT ESTABLISHMENT (PE) RULES.
The OECD notes that some activities which have been previously defined as merely preparatory or auxiliary under the treaty have now become the main business activity of some enterprises. To the extent, therefore, that these exceptions do not or cannot apply to digital activities, it is proposed that they be removed from the treaty, or at least limit the PE exemption to those activities which are actually preparatory or auxiliary in nature.

Action 1 introduces the concept of “significant digital presence” whereby an enterprise engaged in “fully dematerialized digital activities” will be deemed to have a PE in a certain jurisdiction if it maintains “significant digital presence” therein.

According to the report, “significant digital presence” can be deemed to exist if a significant number of contracts for the provision of fully dematerialized digital goods or services are remotely signed between the enterprise and a customer who is a tax resident in the country, or if digital goods or services of the enterprise are widely used or consumed in said country. Meanwhile, an activity will qualify as a “fully dematerialized digital activity” if: (1) The core business of the enterprise relies completely or in a considerable part on digital goods or services; (2) No physical elements or activities are involved in the actual creation of the goods or services and their delivery other than the existence, use, or maintenance of servers, Web sites or other IT tools and the collection, processing, and commercialization of location-relevant data; (3) Contracts are generally concluded remotely either through Internet or telephone; (4) Payments are made solely through credit cards or other means of electronic payments; (5) Web sites are the only means used to enter into a relationship with the enterprise; no physical stores or agencies exist for the performance of the core activities other than offices located in the parent company or operating company countries; (6) All or a majority of profits are attributable to the provision of digital goods or services; (7) Legal or tax residence and the physical location of the vendor are disregarded by the customer and do not influence its choices; and (8) Actual use of the digital goods or the performance of the digital service do not require physical presence or the involvement of a physical product other than the use of a computer, mobile devices or other IT tools.

The proposal to replace the PE concept with “significant presence” is meant to account for the contribution of closer and interactive customer relationships in digital transactions. The criteria include (1) long-term [i.e., more than six months] relationships with customers combined with some physical presence in the country; (2) sale of goods or services through a Web site in the local language, offering delivery from suppliers in the jurisdiction, using banking and other facilities from suppliers in the country, or offering goods or services sourced from suppliers in the country; and (3) supplying goods or services to customers in the country resulting from or involving systematic data-gathering from persons in the country.

WITHHOLDING TAX ON DIGITAL TRANSACTIONS
Considering that digital enterprises have been able to conduct business activity in different jurisdictions without creating a PE therein, the OECD proposes to impose a final withholding tax on payments made by residents of a country for digital goods or services supplied by said enterprises. To operationalize this proposal, the OECD suggests that the withholding be done by the financial institutions involved with the payments, instead of requiring the customers themselves to do the actual withholding of the tax.

BANDWIDTH OR “BIT” TAX
A bandwidth tax refers to a tax paid based on a Web site’s bandwidth use. Said tax assumes that a larger bandwidth equates to more data flow and economic activity. It is envisioned that this tax would only apply once a certain threshold annual bandwidth is reached.

VAT
A digital enterprise’s ability to sell its goods without paying VAT on its supplies due to certain import exemptions has created undue advantage over domestic suppliers. To address this issue, the OECD suggests a review of the thresholds for exemptions on imports of low-valued goods. It likewise calls for the VAT registration of non-resident suppliers of digital business-to-consumer (B2C) supplies in the jurisdiction of their consumers, as this will ensure that the VAT is properly collected on said B2C transactions.

The OECD Report on Action 1 acknowledges that there is still work to be done to fully understand the tax challenges of the digital economy and, consequently, develop a comprehensive solution to counter these challenges. As such, the Task Force on Digital Economy has expressed its commitment to ensure that work will be carried out in the remaining action areas affecting the digital economy. While there is still much debate on these areas, it is clear that the initial report offered good starting points in addressing the BEPS issues affecting the digital economy. Businesses are well advised to follow these developments.

Ma. Margarita Mallari-Acaban is a Tax Senior Director of SGV & Co.

source:  Businessworld