International Tax Reforms Target Tax Planning Strategies

On 5 October 2015, the OECD Secretariat published the 2015 Final Reports (the “BEPS Final Reports”) to the OECD/G20 Base Erosion and Profit Shifting Project (“BEPS”). The term BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax jurisdictions where there is little or no economic activity, resulting in little or no corporate tax being paid. It has been estimated by the OECD that these tax planning strategies have resulted in a global corporate income revenue loss of between US$100 to $240 billion annually. This is mostly due to tax planning schemes that involve transfer pricing and attributing profits to low-tax jurisdictions, inconsistencies between different countries’ domestic tax rules, lack of transparency and coordination between tax administrations, limited country enforcement resources and harmful tax practices.

In response, in September 2013, the G20 endorsed the OECD’s Action Plan on BEPS. Now, two years later, the newly released BEPS Final Reports contain comprehensive measures that countries have agreed upon to combat BEPS, ranging from new minimum standards, common approaches to facilitate a convergence of national practices and guidance drawing on best practices. More than 60 countries and important international organisations have participated in the project. The project was described by the OECD as the “first substantial – and overdue – renovation of the international tax standards in almost a century.” As such, the project could have a profound impact on the tax exposure of multinational entities (“MNEs”). The main purpose of the BEPS project is to align taxation with economic activities and value creation. Although the BEPS project focuses on MNEs, its recommendations have the potential to affect smaller entities that use structures that involve more than one country.

Below are some of the project’s key recommendations.

Key Recommendations

Country-by-Country Reporting

MNEs will be required to provide master files on their global business operations and transfer pricing policies, local files on detailed transactional transfer pricing information specific to each country and file a Country-by-Country Report annually for each tax jurisdiction in which they do business.

The master file is intended to be a high-level overview of the MNE’s transfer pricing practices, global operations and practices. It should provide a list of important agreements, intangibles and transactions. It should also contain information relating to the MNE’s organisational structure, business, intangibles, intercompany financial activities and financial and tax positions.

The local file focuses on information relevant to the transfer pricing analysis of transactions taking place between local entities and associate foreign entities, which are material in the context of the local country’s tax system. Thus, pertinent information includes financial information relating to such transactions, a comparability analysis and the selection and application of the most appropriate transfer pricing method.

The Country-by-Country Report is expected to expose instances in which profits are booked in low-tax jurisdictions where little or no economic activity takes place. The report will contain the following information for each jurisdiction in which an MNE does business: amount of revenue, profit before income tax and income tax paid and accrued, as well as the number of employees, stated capital, retained earnings and tangible assets. In addition, MNEs will need to identify each entity doing business in any particular jurisdiction and indicate the business activities in which such entity engages. While countries generally agree on the core elements of Country-by-Country reporting, some, such as China, have indicated that they will require additional transactional data regarding related party interest payments, royalty payments and services fees. Certain countries will start implementing the Country-by-Country reporting requirements for fiscal years beginning on or after 1 January 2016 and apply these requirements to MNEs with annual consolidated group revenue equal to or exceeding €750 million or approximately US$848,475,000.

Changes to the “Permanent Establishment” Definition

The definition of permanent establishment (“PE”) in the OECD Model Tax Convention will be changed to address ways used to avoid tax via replacement of distributors with commissionaire arrangements or via the artificial fragmentation of business activities.

A commissionaire (or dependent agent) arrangement is where a person sells products in a country in its own name but on behalf of a foreign enterprise that is the owner of these products, such that the foreign enterprise can sell its products without technically having a PE to which sales may be attributed for tax purposes. This arrangement fell into the exception to the existing PE definition as the contracts are not concluded in the name of the foreign enterprise. As such, the definition of PE is being modified to ensure that only entities undertaking activities that are truly preparatory or auxiliary are not classified as PEs. Fragmentation refers to the practice whereby MNEs avoid attracting PE status by fragmenting a cohesive business into several small operations in order to argue that each operation is merely preparatory or auxiliary. This will also be addressed by the new definition.

Treaty Abuse

In order to prevent the granting of treaty benefits in inappropriate circumstances, countries have agreed to include anti-abuse provisions in their tax treaties, including a minimum standard to counter treaty shopping. At minimum, countries should include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. In addition, the treaties should include a general anti-abuse rule based on the principal purposes of the arrangements and/or a limitation-on-benefits provision.

Changes to Transfer Pricing Guidelines

The OECD Transfer Pricing Guidelines (the “TP Guidelines”) will be changed so as to limit the use of cost-sharing arrangements and other tax planning strategies involving intangibles and other payments between related members of an MNE. This should be achieved through a careful delineation of the actual transaction between related enterprises, by analysing their contractual relationship as well as actual conduct. The TP Guidelines target tax planning strategies that are based on contractual re-allocation of risk and clarify that legal ownership alone does not necessarily guarantee a right to all the return generated by the exploitation of that intangible. Capital-rich entities without any other relevant economic activities will not be entitled to any excess profits.

Proposals regarding Hybrid Mismatches and Interest Deductions

The BEPS Final Reports propose a common approach which will facilitate the convergence of national practices by interested countries to limiting base erosion through interest expenses and hybrid mismatches. The BEPS Final Reports also recommends changes to the OECD Model Tax Convention, to ensure that hybrid instruments and entities, and dual resident entities, are not used to obtain unduly the benefits of tax treaties. In terms of interest expenses, a cap of a certain percentage (10–30 percent) of the earnings before interest, tax and depreciation is recommended.

Dispute Resolution between Countries

In order to resolve disputes between countries more efficiently, a large group of countries agreed to move quickly towards mandatory and binding arbitration. There are different views as to the scope of mandatory arbitration. While some countries would prefer to have no limitation, others believe it should be limited to a defined subset of cases. A monitoring mechanism will be established to focus on improving dispute resolution processes.

Implementation

Countries can implement the BEPS project’s recommendations through domestic legislation. For changes in agreements between countries, the OECD is promoting a multilateral treaty that will modify existing bilateral treaties between countries who join the multilateral treaty without having to negotiate and amend each treaty separately. Although they are not legally binding, various countries are committed to the consistent implementation of the project’s recommendations in the areas of preventing treaty shopping, Country-by-Country Reporting, curbing harmful tax practices and improving dispute resolution. However, some countries have not endorsed the underlying standards on tax treaties or transfer pricing. There is still work to be done and the OECD Model Tax Convention and TP Guidelines are anticipated to be completed and released by 2017.

What to Expect

The BEPS Final Reports are expected to have a tremendous influence on the way countries tax MNEs. Many countries are in the process of enacting domestic legislation or regulations to implement the Country-by-Country reporting obligations and other BEPS recommendations. Over time we will be able to observe how tax authorities implement the recommendations with respect to transfer pricing policies, and the impact of the BEPS project on existing and new tax treaties. The BEPS project’s recommendations are expected to become new international tax norms.

China’s Response

China has actively participated in the project and has already started to implement parts of the project’s recommendations into its domestic legislation. On 18 March 2015, the State Administration of Taxation of China (the “SAT”) introduced the Bulletin on Enterprise Income Tax Issues related to Outbound Payments by Enterprises to Overseas Related Parties (SAT Bulletin [2015] No. 16), which targets service fees and royalty payments made by Chinese companies to their overseas affiliates that do not undertake functions and risks and/or lack economic substance. Furthermore, on 17 September 2015, the SAT released the discussion draft of the revised Implementing Measures for Special Tax Adjustments (the “TP Rules”), which is another attempt to introduce the transfer pricing concepts and recommendations (including Country-by-Country reporting) under the BEPS project into domestic legislation. It is expected that the revised TP Rules will be finalised before the end of 2015.

Notably, the revised TP Rules also include some special Chinese characteristics that may create further difficulties for MNEs in China, such as:

  • the value contribution allocation method, which is very similar to the global formulary apportionment method, as an alternative to other transfer pricing methods for allocating MNE profits;
  • value chain analysis as part of the local file, which will encourage the PRC tax authorities to use profit splits more frequently when determining the Chinese affiliates’ proper returns; and
  • location specific advantages (“LSAs”), for which the tax authorities are required to carry routine analysis to identify the additional profits generated by the LSAs.

We expect more legislation changes, audits and tax disputes to follow. In a meeting held by the SAT on 10 October 2015 in Beijing, the SAT emphasised that it will take this opportunity to improve China’s domestic rules and international tax administration capabilities by:

  • revising the Tax Administrative and Collection Law to permit PRC tax authorities to collect more information from taxpayers (including the mandatory disclosure of aggressive tax planning schemes) so that they can effectively counter aggressive tax planning;
  • establishing automatic information exchanges with more than 45 countries by the end of 2018; and
  • revising Chinese treaty interpretative guidance to actively counter treaty abuses and artificial avoidance of permanent establishment status.

Hong Kong’s Response

Hong Kong is expected to follow the new international tax norms, as it has done with respect to other international tax developments. It is important to note that the BEPS Final Reports do not target low tax rates per se, as long as the low rates apply consistently both to domestic players and MNEs. Therefore, Hong Kong should be able to sustain the main features of its tax systems, including a low corporate tax rate and non-taxation of capital gains and offshore income. However, businesses with structures that include Hong Kong entities might be under pressure from other jurisdictions. In general, cross-border businesses will need to proactively reassess whether their current structures and tax planning strategies remain sustainable in view of the BEPS Final Reports.

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Partner, Baker & McKenzie

Associate, Baker & McKenzie