Question

1. Global taxing jurisdictions continually face the problem of transfer pricing for multinational corporations. Mangers endeavor to lower their corporate tax burden by shifting income to favorable tax havens. What do you believe is a good proposal that will address the needs of both the taxing jurisdictions and managers as they work to minimize the problem of transfer pricing?

Answer 1

(Giving you insight into my own research in the area of international taxation and base erosion profit shifting to tax havens, which I had as a subject in my CA Finals)

OECD Model Conventions has already striked off most of the ways to find refuge under tax havens in order to esape tax burden, through introduction of Base Erosion Profit Shifting.

BEPS Actions

Developed in the context of the OECD/G20 BEPS Project, the 15 actions set out below equip governments with domestic and international rules and instruments to address tax avoidance, ensuring that profits are taxed where economic activities generating the profits are performed and where value is created.

What is the BEPS-OECD project?

When MNCs misuse the gaps and mismatches present in the tax systems of various countries, tax revenue to governments reduce. Today, businesses operate globally, so all respective governments must act together to restore the trust in domestic as well as international tax systems for ensuring fair competition.

All concerned nations could join G-20 and the OECD member countries on an equal footing to implement the BEPS package. It could assist:

1. Nations facing fiscal deficits

Every country may tax the supply chain differently. However, despite the increasing digital business environment globally, the recommendations by OECD highlight the significance of allocating the profits to the location where you have real substance, including both the tangible assets as well as people actively performing the business operations. This change in the approach can cause a shift in how and where the income is taxed. It will reduce the overall fiscal deficit a country faces due to the loopholes in its tax structure.

2. A strict environment and improved focus on involvement from the businesses

Business information would be disclosed and accessible through automatic information exchanges. This information will be made available to tax authorities wherever a company has a presence. Companies would have to explain to the authorities clearly the need their operational purpose of the business arrangements which might include tax advantages.

3. Reporting requirements

The new reporting requirements for large companies would make a detailed Country-by-Country (CBC) financial and tax information visible, to various eyes and possibly not just to the tax authorities. Additionally, the amount of data disclosed would be much higher than what companies are reporting presently. So, the compliance burden would grow substantially.

What are the challenges for businesses?

For businesses, the BEPS project helps measure the need for behavioural change, at every level.

1. Tax administrations now won’t just introduce stricter measures and look for restricting tax treaty benefits, but would also test arrangements which in their view, lack substance or has a real commercial principal purpose. Business groups would have to reshape the business models and might have to adopt the practices for evaluating their position in the new environment.

2. Enhanced transparency is one of the key objectives of the BEPS framework. This brings new reporting obligations such as Country-by-Country Reporting (CbCR). Transparency would also mean to anticipate outcomes of extra disclosures that are required to be made. Such requirements could lead to additional transfer pricing challenges or might even cause adverse publicity.

3. As the implementation of BEPS quickens, businesses increasingly would require track how changes to transfer pricing practices and domestic laws, and the revised double tax treaties would affect them.

All of these changes would need allocation of more resources for tax function. Well-executed and timely reaction to the new measures wouldn’t just avoid difficulties – it would ensure that the businesses are better placed to manage the tax burdens, and can have more cost-beneficial and streamlined operational models.

BEPS and India

The involvement of India in the BEPS initiative has been intensive. India has been part of the forum in devising action plans, and also part of various working groups, committees and task forces that were set up for examining different aspects of these action plans. After the publication of the final BEPS deliverables, several Indian Government officials have taken active participation in addressing various public forums and gave statements to press on views of the Indian Government. These offer valuable insights about the possible transformation of a tax regime which might be in the offing due to the BEPS project, and how Government intends to deal with it.

India is following BEPS initiative actively and has been active in bringing the amendments into its domestic law and trying to make the tax framework in line with BEPS regulations. There are a number of proposals in the Finance Act, 2016 which are influenced by BEPS recommendations. Some of these include the implementation of:

1. Master File and CbC (Country-by-Country) Reporting

2. Patent Box tax regime with respect to royalty income

3. Equalization levy requiring withholding on the gross basis for payments for certain specified digital services

As mentioned previously, India is a key contributor to BEPS action plans and it has already implemented some BEPS recommendation through amendments in domestic tax law such as CbCR, thin capitalization, secondary adjustments, etc.

Conclusion

Response to BEPS needs to be managed in an orderly and phased manner and would need timely and proactive planning. Companies would need building consideration of possible BEPS impact into their current tax planning and arrange for different scenarios for its application.

Giving further insight into each action plan through my research papers :

1) Action 1: Tax challenges arising from digitalisation

Action 1 deals with challenges that new digital businesses and transactions bring to the traditional tax systems. Considering high reliance on intangibles, internet and technology, digital companies are assumed to be particularly apt at optimising their corporate structures by navigating between national tax regimes in order to lower tax bases in places of factual value creation. To some extent, this is even characterised as unfair competition between traditional industries and companies that have embraced new technology. Where business in ran online and globally, the aim of anti-BEPS action plan is to find effective measures to follow and detect the place of profit and to tax it in the place, where it creates value. The digital world makes this task even more difficult because it facilitates cross-border collaboration, production, and sales of intangible goods and services. Factors, such as the use of new payment systems, e.g. bitcoin and the enhanced trading of personal information for ‘‘free’’ services in the cross-border business-to-consumer context. Accordingly, hybrid entities, which take advantage of different national laws that promote dissimilar and often conflicting tax outcomes, may be deployed to a greater extent to take advantage of this new global reality. Similarly, enhanced global activity in the digital world leads to more treaty shopping to take advantage of treaties with countries that have low- or no-income taxes. Action 1 basically considers other anti-BEPS actions, whereby they shall be adequately adjusted to digital economy. When an enterprise maintains a significant digital presence in an economy, it may still lack a nexus to it, resulting in the fact that it is not taxable in it under the existing international tax rules. The focus of Action 1 is put on how taxing rights on income generated from cross-border activities should be allocated among countries, and the suggestion that the changes caused or facilitated by digitalisation – notably scale without mass, heavy reliance on intangible assets, and the importance of data – require to revisit some fundamental aspects of the international tax system (so-called ‘profit allocation’ and ‘nexus’ rules).

2) Action 2: Neutralising the effects of hybrid mismatch arrangements

Interaction of various jurisdictions in combination with application of international tax rules, means also different and incoherent interpretation of certain institutes, causing different tax treatment of the same institute among various jurisdictions. OECD BEPS Project tackles the misuse of hybrid instruments and hybrid financial instruments that create tax optimization opportunities for MNEs, since hybrid mismatches can result in the fact that less or no tax is paid in the end. E.g. an entity resident in State A provides a convertible loan to an entity resident in State B. State B treats payments arising out of such a loan to be deductible interest, whereas State A considers such payments to be dividends and allows a participation exemption. The taxpayer enjoys tax favourable treatment in both jurisdictions due to the difference in qualification of the payment. Slovenia adopted hybrid mismatches rules in October 2019.

3) Action 3: Controlled Foreign Company

One of the most typical means of profit shifting is allocation of the profit to subsidiaries in low or zero tax jurisdictions. MNEs were establishing subsidiaries in such jurisdictions, however, such establishment may also be well founded when it has economic sense and purpose. Where such subsidiaries are established for actually doing business in a certain jurisdiction, providing that a subsidiary in fact has a certain degree of substance (e.g. staff, assets, significant functions), the issue of subsidiaries, even in low tax jurisdictions, is not problematic. Where, to the contrary, a subsidiary is established only or mainly for tax purposes, without justifiable business or financial reasons, the Action 3 provides that countries shall implement such rules that the income, shifted to such controlled entities, will be able to be re-allocated back to the parent company and taxed according to tax rules, applicable in their tax jurisdiction. Slovenia implemented CFC Rules with January 1st, 2019.

4) Action 4: Limitation on interest deductions

Interest payments are generally tax deductible. MNEs found the way to lower their tax bases by financing their subsidiaries by debt instead of equity. Enterprises of high tax jurisdictions were paying interests to related persons of lower tax jurisdictions, causing tax base erosion in high tax jurisdictions and profit shift to low tax jurisdiction. A well-established rule in the field is thin capitalisation, providing that debt financing should not exceed a certain relation to equity financing. Moreover, the interest payments shall always be determined and paid according to the Arm’s Length Principle. It is now being recommended to adopt further interest deduction limitation rules based on fixed ratio rules, limiting tax recognised interest expenses and economically equivalent payments in comparison to EBITDA level (net interest/EBITA ratio; OECD, 2016). Slovenia currently regulates thin capitalisation rules, whereby interest on the loans, granted by the qualified 25% direct or indirect shareholder, when such loans exceed four times the amount of the share of the relevant shareholder in the taxpayer's equity (loan surplus), determined with respect to the amount and the period of the loan surplus within the tax period, are non-deductible, unless the taxpayer proves that such a surplus could be achieved also towards non-related creditors. With respect to loans that do not represent the loan surplus, the interest on such loans, received from related persons, may be considered deductible only up to the amount of the last published recognised interest rate, which was known at the time of granting the loan, unless the taxpayer proves that he would under the same or comparable circumstances receive the loan under an interest rate, which is higher to the recognised interest rate also from a non-related creditor.

5) Action 5: Harmful tax practices

Action 5 represents the minimum standard to be implemented by the countries. It addresses preferential tax regimes, mostly the issues with their detection and monitoring. Action 5 elaborates further on the nexus approach, stressing the evaluation of substantial activity in case of intangible assets. A simultaneous automatic exchange of tax decisions (e.g. advanced pricing agreements, other unilateral transfer pricing agreements, agreements of permanent establishments, actions of related entities, etc.) that represent a BEPS risk was also agreed. The latter is of particular importance, since the lack of transparency of specific tax regimes is one of the reasons why they are harmful and trigger BEPS opportunities in the first place.

6) Action 6: Prevention of tax treaty abuse

One of the biggest success of the international taxation system is the network of bilateral international agreements, entered by the countries mainly to agree on the taxing rights with the purpose of avoiding double taxation (hereinafter “DTC”). Double taxation represented an obstacle to MNEs in expanding their business cross border, however it unintentionally provided options for misuse in form of e.g. treaty shopping. By using the latter, MNEs were achieving tax benefits that were not intended for their cases. Action 6 proposes amendments to the OECD Model Convention5 , expressly eliminating the purpose of tax avoidance and evasion from the general purpose of the DTCs. A minimal standard to fight treaty shopping shall be implemented, together with the limitation on benefits rule and a principle purpose test. Action 6 is a minimum standard.

7) Action 7: Permanent establishment status (IMPORTANT)

Permanent establishments (hereinafter “PE”) are often used to avoid taxes. Namely, its former definition in the most of DTCs enabled MNEs to avoid triggering PEs and consequently paying adequate taxes in countries where they had performed their activities. The main issue of the former definition were the exemptions, under which a certain economic presence was not deemed a PE, therefore not taxable in that economy. Such exemptions were e.g. ancillary activities (e.g. warehouse, marketing, exhibitions) and short-term projects in construction businesses. MNEs changed their usual distribution models to agencies, formally transferring all essential distribution functions to other related companies. In a country, where an enterprise previously paid taxes on sales profits, it now pays taxes only to agency commission profits. Agency commission incomes are often further reduced by payments for various management and maintenance services (e.g. management fees, IT fees, insurance fees). Action 7 stresses that where such function transfers are artificial, the PE status can no longer be avoided. Moreover, it establishes that where such functions are important and form a coherent activity with activities of other related entities, they cannot be deemed ancillary. One of the most famous cases on the field of PE misuse is Amazon’s. Amazon is an international on-line retailer, 5 OECD Model Tax Convention on Income and on Capital. basing its business model on warehousing and fast delivery to customers. In countries, where Amazon held a warehouse, it has been avoiding triggering a PE due to warehousing being deemed ancillary activity under the DTC and usually also local tax regulations. Now, therefore, under Action 7 an activity cannot be deemed ancillary, when it forms a coherent activity with the other functions. It was recognised that warehousing is one of the main activities of Amazon, thus, cannot be deemed ancillary. The short-term project exception was exploited enormously by the construction MNEs, which misused the exception by fragmenting the activities among related and unrelated parties and concluding several short-term contracts for the same project. Action 7 recommends implementing the anti-fragmentation rule to prevent such practices.

8) Action 8 – 10: Transfer pricing

The main goal of Actions 8-10 is connection of profits to the MNE’s created values. A special attention is given to hard-to-value intangible assets. An MNE member shall be entitled only to profit, attributable to its factual activity. Cash box companies are in the centre of attention.

9) Action 11: BEPS data analysis

The action envisages methodologies for data collecting and monitoring, measuring fiscal effects of harmful tax practices and impact of the BEPS actions. In 2015 the OECD determined that the cost of tax avoidance of MNEs amounted from 100 to 240 billion of dollars, which corresponds to 4-10% of the worldwide corporate income tax (OECD, 2019a).

10) Action 12: Mandatory Disclosure Rules

Action 12 recommends rules that will oblige taxpayers and their advisors to disclose aggressive tax planning arrangements. Tax authorities will be able to detect harmful tax practices in advance and they will be able to target such practices more effectively.

11) Action 13: Transfer pricing and Country-by-Country reporting

The centre of Action 13 is the transfer pricing documentation, which shall be formed in 3 pillars:

i) a master file, which can be prepared on a group level;

ii) a local file, which is prepared for a local entity; and

iii) Country-by-Country report. Moreover, under Action 13 all large MNE groups are liable to report by country aggregated data about their global income distribution, taxes paid and economic activity among the tax jurisdictions (hereinafter “CbC Reporting”). The purpose of CbC Reporting is to provide tax authorities first and at least minimum indications of economic activity of an MNE group on their territories, which can enable more targeted audits. Action 13 is a minimum standard. Slovenia adopted the CbC Reporting and exchange rules within the DAC 4 implementation. The three-pillar transfer pricing documentation as also envisaged by Action 13 is thus already implemented.

12) Action 14: Effective tax dispute resolution

Action 14 is the minimum standard as well and it aims to improve tax dispute resolution among the countries. The Mutual Agreement Procedure is well established tax dispute resolution tool, however, it proved to be time consuming and ineffective. Action 14 provides recommendations for improvements. Slovenia amended its rules on the Mutual Agreement Procedure in June 2019.

13) Action 15: Multilateral instrument (the “MLI”)

With Action 15, OECD aimed to simplify the implementation of necessary amendments into existing DTCs, by proposing a multilateral instrument. By concluding and ratifying the MLI, existing loopholes in DTCs are intended to be eliminated, while the countries are able to avoid new and often hard bilateral negotiations in amending all of the DTCs. Nevertheless, MLI provides a lot of options available for countries’ discretion, which makes the use of the MLI as well as the DTCs relatively complicated. Some countries, Slovenia as well, are preparing consolidated texts of the DTCs, simplifying the use of newly amended DTCs.