BEPS and the Elimination of 'Harmful' Taxes
By Lowtax Editorial
23 September, 2014
The Organisation for Economic Cooperation and Development's (OECD) work to eradicate base erosion and profit shifting (BEPS) by multinational corporations includes the pledge to "counter harmful tax practices more effectively". But what are "harmful" taxes, and why are the OECD and other groups of nations like the European Union so keen to remove them from the international tax landscape? This feature looks at the background to the OECD's harmful tax campaign and examines how it intends to progress its work in this area through BEPS, with an emphasis on how it might affect offshore financial centers.
Work to eliminate "harmful tax regimes" is not new. In May 1996, a ministerial communique called on the OECD to "develop measures to counter the distorting effects of harmful tax competition" and report back in 1998."
In 1998, the OECD published the report 'Harmful Tax Competition: An Emerging Global Issue'. This report laid the foundations for the OECD's work in the area of harmful tax practices and created the Forum on Harmful Tax Practices (FHTP) to take forward this work. It was published in response to a request by ministers to develop measures to counter harmful tax practices with respect to geographically mobile activities, such as financial and other service activities, including the provision of intangibles.
But what exactly is a "harmful" tax regime, and how can low taxation ever be harmful?
With regard to the first part of this question, the 1998 report identifies three situations in which one country utilises a tax regime that may be deemed harmful by the second country:
- The country is a tax haven and, as such, generally imposes no or only nominal tax on that income;
- The country collects significant revenues from tax imposed on income at the individual or corporate level but its tax system has preferential features that allow the relevant income to be subject to low or no taxation;
- The country collects significant revenues from tax imposed on income at the individual or corporate level but the effective tax rate that is generally applicable at that level in that country is lower than that levied in the second country.
The first two examples have been the focus of the OECD's work on harmful tax practices, and as a result severe pressure has been exerted on territories considered as tax havens to eliminate ring-fenced "offshore" tax and legal regimes which benefit only foreign investors.
The OECD's answer to the second part of the question is that tax havens have "no interest in trying to curb the 'race to the bottom' with respect to income tax and [are] actively contributing to the erosion of income tax revenues in other countries."
The 1998 report identified a further six "harmful" effects of low- or no-tax regimes:
- distorting financial and, indirectly, real investment flows;
- undermining the integrity and fairness of tax structures;
- discouraging compliance by all taxpayers;
- re-shaping the desired level and mix of taxes and public spending;
- causing undesired shifts of part of the tax burden to less mobile tax bases, such as labour, property and consumption; and
- increasing the administrative costs and compliance burdens on tax authorities and taxpayers
Most offshore financial centres have fallen into line with the demands of the OECD; for example, jurisdictions such as Britain's Crown Dependencies of Guernsey, Jersey and the Isle of Man, and the Caribbean offshore territory the British Virgin Islands have made far reaching changes to tax and company legislation. Thus, since May 2009 no jurisdiction is currently listed as an uncooperative tax haven by the OECD's Committee on Fiscal Affairs.
However, one unintended consequence of the OECD's crusade against harmful tax regimes is that in many cases, the tax havens put under the Organisation's microscope have actually thrived in recent years. This is partly due to the fact that their reputations are now seen as "cleaner". Meanwhile other tax havens have focussed less on offshore banking, trusts and wealth management - the traditional bread and butter of the offshore world - and more on corporate investment flows and activities.
Indeed, offshore financial centres have become invaluable as conduits for investment into larger, high-tax countries. For instance, a 2013 report by Capital Economics concluded that GBP500bn in foreign investment was channelled into the UK through Jersey. Notably, it calculated that more tax is generated in the UK by business coming into UK via Jersey than was lost because of Jersey's low taxes.
Not that you will ever hear the OECD acknowledging the benefits of tax havens in public, preferring to present a black-and-white "high tax good, low tax bad" view of things.
The EU Code Of Conduct For Business Taxation
The OECD's work against harmful taxes has been supplemented by a separate initiative launched in the late 1990s by the European Union, known as the Code of Conduct on Business Taxation, which was set out in the conclusions of the Council of Economics and Finance Ministers of December 1, 1997. By adopting this Code, the Member States undertook to roll back existing tax measures that constituted harmful tax competition and refrain from introducing any such measures in the future ("standstill").
Although the Council acknowledged the positive effects of tax competition at this meeting, the Code was adopted to detect measures which "unduly affect the location of business activity" in the EU by being targeted merely at non-residents and by providing them with a more favourable tax treatment than that which is generally available in the Member State concerned.
The Code covers tax measures (legislative, regulatory and administrative) which have, or may have, a significant impact on the location of business in the Union. The criteria for identifying potentially harmful measures include:
- An effective level of taxation which is significantly lower than the general level of taxation in the country concerned;
- Tax benefits reserved for non-residents;
- Tax incentives for activities which are isolated from the domestic economy and therefore have no impact on the national tax base;
- Granting of tax advantages even in the absence of any real economic activity;
- A basis of profit determination for companies in a multinational group which departs from internationally accepted rules, in particular those approved by the OECD; and
- A lack of transparency.
In 1998, the EU's Finance Ministers established the Code of Conduct Group (Business Taxation) and in a report of November 1999 the Group identified 66 tax measures with harmful features, including 40 in EU Member States, three in Gibraltar and 23 in dependent or associated territories.
The Code is not legally binding, but, as the European Commission has stated, "it clearly does have some political force." It has been instrumental in ridding the EU of special tax regimes like Coordination Centres in Belgium, Germany and Luxembourg, the Headquarters and Logistics Centres Regime in France, and Exempt Offshore Companies in Gibraltar, among others.
The Code Group has also continued to play particularly close attention to the corporate tax regimes of the United Kingdom's three Crown Dependencies and all three jurisdictions were obliged to phase out their offshore company formats in accordance with the roll-back provisions of the Code.
In February 2013, the OECD released its preliminary BEPS report "Addressing Base Erosion and Profit Shifting" on the use of tax-efficient business structuring by multinationals to lower group corporate tax liability, as a first step to addressing the use of profit-shifting tax planning techniques by international businesses. This project has effectively brought the OECD's campaign against harmful taxation back onto its agenda.
On July 19, 2013, the OECD released its much anticipated BEPS Action Plan, which it claims provides "a global roadmap that will allow governments to collect the tax revenue they need to serve their citizens" while giving "businesses the certainty they need to invest and grow."
Introduced at the G20 Finance Ministers' meeting in Moscow last year, the Action Plan identifies 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes. They are as follows:
- Action 1: Address the challenges of the digital economy
- Action 2: Neutralize the effects of hybrid mismatch arrangements
- Action 3: Strengthen controlled foreign company rules
- Action 4: Limit base erosion via interest deductions and other financial payments
- Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance
- Action 6: Prevent treaty abuse
- Action 7: Prevent the artificial avoidance of PE status
- Action 8: Assure that transfer pricing outcomes are in line with value creation: intangibles
- Action 9: Assure that transfer pricing outcomes are in line with value creation: risks and capital
- Action 10: Assure that transfer pricing outcomes are in line with value creation: other high-risk transactions
- Action 11: Establish methodologies to collect and analyze data on BEPS and the actions to address it
- Action 12: Require taxpayers to disclose their aggressive tax planning arrangements
- Action 13: Re-examine transfer pricing documentation
- Action 14: Make dispute resolution mechanisms more effective
- Action 15: Develop a multilateral instrument
According to the text of the Action Plan, the Action 5 aims to: "Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime. It will take a holistic approach to evaluate preferential tax regimes in the BEPS context. It will engage with non-OECD members on the basis of the existing framework and consider revisions or additions to the existing framework."
The Action Plan goes on to observe that while current rules work well in many cases, they need to be adapted to prevent BEPS that results from the interactions among more than two countries and to fully account for global value chains.
"The interposition of third countries in the bilateral framework established by treaty partners has led to the development of schemes such as low-taxed branches of a foreign company, conduit companies, and the artificial shifting of income through transfer pricing arrangements," it states."FDI figures show the magnitude of the use of certain regimes to channel investments and intra-group financing from one country to another through conduit structures. In order to preserve the intended effects of bilateral relationships, the rules must be modified to address the use of multiple layers of legal entities inserted between the residence country and the source country."
The Plan calls for existing domestic and international tax rules to be modified "in order to more closely align the allocation of income with the economic activity that generates that income".
Action 5 "Deliverables"
On September 16, 2014, the OECD released its keenly-awaited first set of recommendations for "a co-ordinated international response to base erosion and profit shifting".
According to OECD Secretary-General Angel Gurría, these recommendations "constitute the building blocks for an internationally agreed and co-ordinated response to corporate tax planning strategies that exploit the gaps and loopholes of the current system to artificially shift profits to locations where they are subject to more favourable tax treatment".
Except that only four of the seven reports released on September 16 contained actual recommendations (Actions 2, 6, 8 and 13), and then only in draft form in recognition of the likelihood that changes will have to be made when related deliverables are released in 2015. The remainder of the package contained two final reports (Action 1 and Action 15), and, in relation to Action 5, a mere interim report.
Under Action 5, the FHTP is supposed to deliver three "outputs" as follows:
- finalisation of the review of member country preferential regimes;
- a strategy to expand participation to non-OECD member countries; and,
- consideration of revisions or additions to the existing framework.
All the new report really "delivers" however, is a progress report on the delivery of these outputs.
The report, entitled "Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance", describes progress made and identifies the next steps towards completion of this work, in particular on the first output.
As regards the review of the existing preferential regimes, the emphasis has been put on: elaborating a methodology to define a substantial activity requirement in the context of intangible regimes; and improving transparency through compulsory spontaneous exchange on rulings related to preferential regimes.
Finally, it provides a progress report on the review of the regimes of OECD member and associate countries in the OECD/G20 Project on BEPS.
There is much emphasis in the report on the concept of "substantial activity". Action 5 specifically requires substantial activity for any preferential regime, and, in the wider context of the work on BEPS, this requirement contributes to the "second pillar"of the project as a whole, which is to "align taxation with substance by ensuring that taxable profits can no longer be artificially shifted away from the countries where value is created".
The substantial activity factor has been elevated in importance under Action Item 5, which mandates that this factor be elaborated in the context of BEPS.
The report also describes how the FHTP is paying closer attention to intellectual property (IP) and other "intangibles" tax regimes and tax rulings, noting that the issue is not so much about traditional "ring-fencing" but on corporate tax rate reductions on particular types of income, such as income from the provision of patents.
According to the report, work has accelerated in this area, with "significant progress" made on improving transparency on rulings and of consideration of IP preferential regimes. Ironically however, this is an initiative that could backfire on the very countries pressing for the elimination of harmful tax regimes which themselves have introduced special tax regimes for IP and other types of income and trading activities. A prime example is the United Kingdom's new patent box regime, under which income derived from patents qualifies for a special 10% rate of corporation tax.
In October 2013, an opinion document by the European Commission (EC) raised doubts about the UK's patent box tax break, warning that aspects of the arrangement may amount to harmful tax competition, prompting the EC to suggest that it may undertake a general review of patent boxes. The opinion suggests that that the registration of patents in the UK is not sufficiently linked to real economic activity in the UK, and that the way profit is calculated in relation to actual patents is not in line with OECD principles.
The UK patent box regime has also been criticised by the German Government, with Finance Minister Wolfgang Schäuble having said that the tax break is not in "the European spirit".
Besides the UK, patent box regimes are also available in Belgium, France, Hungary, the Netherlands and Spain, and these are all under review by the FHTP.
Furthermore, intangibles regimes in Colombia, Israel, Portugal, Switzerland and Turkey are also under review.
Certain tax regimes other than intangibles are also under scrutiny including the following:
- Greece's offshore engineering and construction regime
- Latvia's special economic zone regime
- Switzerland's auxiliary, mixed and holding company regimes, and its commissionaire ruling regime
Canada's life insurance business regime is considered "potentially harmful but not actually harmful".
Next Steps and Conclusion
Going forward, the FHTP intends to complete the work under the first output of Action 5 and commence work on the second output, i.e. engaging with other non-OECD member countries on the basis of the existing framework. The deadline for the delivery of the second output is September 2015.
It is noticeable however, how few mentions the phrase "tax haven" gets in the Action 5 interim report released in September 2014, and the few times it is mentioned is in the context of background information describing what has happened in the past. Instead, there seems to be a lot more emphasis on tax regimes in onshore countries rather than offshore jurisdictions.
This might be because much of the OECD's work on tax havens has been done and it is now the turn of OECD members themselves to fall into line with standards they preach so readily to low-tax and offshore territories.
Yet one always gets the feeling that offshore will never completely be let off the hook as far as the OECD is concerned, and the rising political and public hysteria over tax avoidance has only intensified the spotlight on tax havens.
So far, the world of offshore, for the most part, has done everything required of it by the OECD. But each time these requirements have been met, the goal posts seem to shift. Don't bet against them being moved again at some point in the not-too-distant future.
As for the BEPS project itself, the OECD has pronounced that the goal in terms of Action 5 is to achieve a "level playing field and avoid the risk of the work on harmful tax practices displacing regimes from OECD member and associate countries to other countries, giving them an unwarranted competitive advantage and limiting the effectiveness of the whole exercise."
The so-called level playing field in the area of taxation seems to be the Holy Grail of the OECD, as well as for the EU. But it is very hard to envisage this being achieved by the BEPS initiative unless all countries are prepared to act in unison, which most level-headed observers think is going to be highly unlikely, if not impossible.
And surely, a level playing field is never going to be achieved unless tax competition is eliminated altogether? Perhaps that's what the OECD really wants. But it's never going to get it.
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