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The Impact Of BEPS On Double Tax Treaties

By TreatyPro Editorial
09 August, 2013



This feature looks at the elements of the Organisation for Economic Cooperation and Development’s (OECD) Base Erosion and Project Shifting (BEPS) project which could have a major impact on the way double taxation avoidance treaties are drafted and enforced in the future.


Setting the Scene

Although the term BEPS has only recently entered the lexicon of international tax enforcement, the project’s origins can be traced back many years, to when the OECD first launched its crackdown on “opaque” offshore tax regimes and “harmful” tax practices over a decade ago.

A key moment in the OECD’s war against tax avoidance came at the G20 Summit in London in April 2009 when it published a list of jurisdictions it said had not implemented internationally agreed standards of tax cooperation, following through on the G-20 nations' pledge to take action against 'non cooperative' territories in the interests of maintaining stability in the global financial system. This resulted in a proliferation of new tax information exchange agreements between offshore and onshore territories, and the addition of the OECD information exchange wording in many existing and new double taxation avoidance agreements. Laws have also been changed in many jurisdictions as a result of this renewed push by the G20 and the OECD to increase tax transparency, to allow such information exchange provisions to be included in their bilateral tax agreements. Recent action by Hong Kong’s Legislative Council to allow the Government to enter into tax information exchange agreements with other countries is one example of this. The launching of a public consultation on a similar initiative in Singapore is another.

Much of the emphasis of this campaign has been concentrated on tax evasion by individuals in high-tax countries with bank accounts and other assets located in offshore territories, and legislation such as the European Union Savings Tax Directive, and the United States’s Foreign Account Tax Compliance Act have been brought into force to combat this. However, on the corporate tax front, politicians around the world have been prodded into action over the past year or two in response to reports of the tax minimisation strategies employed by large multinational companies, which have provoked rising levels of public anger. The BEPS project is therefore the OECD’s response to combatting corporate tax avoidance.


The BEPS Reports

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.

The report observed that due to imperfect interaction between nations' tax regimes, and their extensive networks of double tax agreements, the global tax system has failed to keep pace with the changing needs of the 21st century in terms of mitigating corporate tax avoidance. The study points that these inadequacies have allowed multinationals to legitimately structure their tax affairs using profit-shifting arrangements to pay tax on their profits at rates as low as 5%, against the corporate tax rates of around 30% in place on fiscally immobile businesses in OECD member states.

The report concedes however - amid widespread criticism of multinationals' tax affairs - that the blame may not lie with businesses. It acknowledges a prevailing sentiment among business leaders that they have a responsibility towards their shareholders to legally reduce the taxes their companies pay. “Some of them might consider most of the accusations unjustified, in some cases deeming governments responsible for incoherent tax policies and for designing tax systems that provide incentives for Base Erosion and Profit Shifting," the report concludes.

Furthermore, it was pointed out that multinationals often suffer at the hands of inadequate global tax rules, paying a greater share of taxes than should be required of them.

On July 19, 2013, the OECD finally 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, 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.

According to OECD Secretary-General Angel Gurría, the Action Plan “marks a turning point in the history of international tax co-operation.”

“It will allow countries to draw up the co-ordinated, comprehensive and transparent standards they need to prevent BEPS,” said Gurría. “International tax rules, many of them dating from the 1920s, ensure that businesses don’t pay taxes in two countries – double taxation. This is laudable, but unfortunately these rules are now being abused to permit double non-taxation. The Action Plan aims to remedy this, so multinationals also pay their fair share of taxes.”

The OECD says that its Action Plan will develop a new set of standards to prevent double non-taxation, based on closer international co-operation to close gaps that, on paper, allow income to ‘disappear’ for tax purposes by using multiple deductions for the same expense and “treaty-shopping”. It also proposes stronger rules on controlled foreign companies.

Much of the BEPS report is devoted to the prevention of tax treaty abuse, and the relevant sections are detailed below.


The Action Plan

Chapter 2 - Background

In the introductory passages of the report, the OECD acknowledges that the existing domestic law and treaty rules governing the taxation of cross-border profits produce the correct results and do not give rise to BEPS, and that international co-operation has resulted in shared principles and a network of thousands of bilateral tax treaties that are based on common standards and that therefore generally result in the prevention of double taxation on profits from cross-border activities. The OECD also observes that clarity and predictability “are fundamental building blocks of economic growth” which must be retained. However, in instances where the current rules “give rise to results that generate concerns from a policy perspective,” it argues that governments should not shy away from tackling them.

Chapter 3 – Action Plan

This section calls for the creation of new international standards designed to ensure the coherence of corporate income taxation at the international level. It notes that existing OECD standards and bilateral treaty provisions have failed to deal with “gaps, frictions or mismatches in the interaction of countries’ domestic tax laws.” It says that there is a need to complement existing standards that are designed to prevent double taxation with instruments that prevent double non-taxation in areas previously not covered by international standards and that address cases of no or low taxation associated with practices that artificially segregate taxable income from the activities that generate it.

“Whilst bilateral tax treaties have been effective in preventing double taxation, there is a concern that they often fail to prevent double non-taxation that results from interactions among more than two countries,” the report states. “In particular, the involvement of third countries in the bilateral framework established by treaty partners puts a strain on the existing rules, in particular when done via shell companies that have little or no substance in terms of office space, tangible assets and employees.”

Action 2 – Neutralise the Effect of Hybrid Mismatch Arrangements

This Action proposes the development of model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect of hybrid instruments and entities on a jurisdiction’s tax base. This may include: (i) changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities (as well as dual resident entities) are not used to obtain the benefits of treaties unduly; (ii) domestic law provisions that prevent exemption or non-recognition for payments that are deductible by the payor; (iii) domestic law provisions that deny a deduction for a payment that is not includible in income by the recipient (and is not subject to taxation under controlled foreign company (CFC) or similar rules); (iv) domestic law provisions that deny a deduction for a payment that is also deductible in another jurisdiction; and (v) where necessary, guidance on co-ordination or tie-breaker rules if more than one country seeks to apply such rules to a transaction or structure.

“Special attention should be given to the interaction between possible changes to domestic law and the provisions of the OECD Model Tax Convention,” says the report “This work will be co-ordinated with the work on interest expense deduction limitations, the work on CFC rules, and the work on treaty shopping.”

Action 5

Under the sub-heading “Restoring the full effects and benefits of international standards,” the OECD argues that there is need for tax treaties 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,” the report notes. “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.”

Indeed, it is stated in this section that treaty abuse “is one of the most important sources of BEPS concerns.” While Commentary on Article 1 of the OECD Model Tax Convention already includes a number of examples of provisions that could be used to address treaty-shopping situations as well as other cases of treaty abuse, which may give rise to double non-taxation, it adds that “tight treaty anti-abuse clauses coupled with the exercise of taxing rights under domestic laws will contribute to restore source taxation in a number of cases.”

Action 6 – Prevent Treaty Abuse

Action 6 proposes the development of model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in “inappropriate circumstances.” Work will also be done, it says, to clarify that tax treaties are not intended to be used to generate double non-taxation. Additionally, tax policy considerations will be identified that countries will be urged to examine before deciding to enter into a tax treaty with another country. It is intended that this segment of the Action Plan will be co-ordinated with the work on hybrids.

A key element of this Action will be modifications to the definition of permanent establishment (PE) which the report says “must be updated to prevent abuses.” It is observed that in many countries, the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor.

“In many cases, this has led enterprises to replace arrangements under which the local subsidiary traditionally acted as a distributor by ‘commissionnaire arrangements’ with a resulting shift of profits out of the country where the sales take place without a substantive change in the functions performed in that country,” says the report. “Similarly, MNEs may artificially fragment their operations among multiple group entities to qualify for the exceptions to PE status for preparatory and ancillary activities.”

Action 14 – Make Dispute Resolution Mechanisms More Effective

Action 14 calls for solutions to address obstacles that prevent countries from solving treaty-related disputes under mutual assistance procedures (MAP), including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

Under the sub-heading “From agreed policies to tax rules: the need for a swift implementation of the measures,” the OECD says that there is a need to consider “innovative ways” to implement the measures resulting from the work on the BEPS Action Plan with the likelihood that some actions will result in recommendations regarding domestic law provisions, as well as in changes to the Commentary to the OECD Model Tax Convention as well as the Convention itself, in addition to the Transfer Pricing Guidelines. “This is for example the case for the introduction of an anti-treaty abuse provision, changes to the definition of permanent establishment, changes to transfer pricing provisions and the introduction of treaty provisions in relation to hybrid mismatch arrangements,” the report states.

However, it goes on to caution that changes to the Model Tax Convention are not directly effective without amendments to bilateral tax treaties, which would represent a mammoth undertaking if done on a purely treaty-by-treaty basis, especially where countries embark on comprehensive renegotiations of their bilateral tax treaties. The OECD proposes to bypass this process with a multilateral instrument to amend bilateral treaties, and idea it says is “a promising way forward in this respect.”

Action 15 – Develop a Multilateral Instrument

This Action calls for an analysis of the tax and public international law issues related to the development of a multilateral instrument to enable jurisdictions that wish to do so to implement measures developed in the course of the work on BEPS and amend bilateral tax treaties. On the basis of this analysis, interested Parties will develop a multilateral instrument designed to provide an “innovative approach to international tax matters, reflecting the rapidly evolving nature of the global economy and the need to adapt quickly to this evolution.”


Timing

The report suggests that amongst the actions more likely to be delivered in the 12-18 month timeframe that the OECD has set itself to complete the BEPS project, are those in the areas of hybrid mismatch arrangements, treaty abuse, the transfer pricing aspects of intangibles, documentation requirements for transfer pricing purposes, a report identifying the issues raised by the digital economy and possible actions to address them, as well as part of the work on harmful tax practices.


Conclusion

The corporate world has generally accepted that taxation rules have fallen far behind the fast-evolving world of international business practice, and that the BEPS project provides a basis for a discussion between taxpayers and governments on how things can change for the better for both parties. However, it is difficult to see how such an ambitious project needing the cooperation so many countries can be completed with the time frame that the OECD has set itself. Indeed, most of the concern about BEPS from the business angle concerns this ambitious timetable. As Greg Wiebe, Global Head of Tax at KPMG International, commented upon the release the of Action Plan: “"Bringing today’s proposals to fruition within the 24-month timetable presents an enormous challenge.”

“There is undoubtedly an urgent need to work quickly as uncertainty helps no one, but modernizing over 75 years of international tax laws in just two years’ time without jeopardizing the aspects of the current system that operate as intended and are fit for purpose will not be straightforward," Wiebe observed.

Bill Dodwell, Head of Tax Policy at Deloitte warns that the changes proposed in the BEPS Action Plan will “undoubtedly” lead to high cost for businesses, and shares Wiebe’s concerns over the short lead time.

“The OECD’s base erosion and profit shifting action plan is the most significant potential change to international taxation for decades,” he said, adding: â€œUltimate delivery of the plan will depend on continued cooperation and agreement between countries, since the plan will lead to recommendations for changes to national law, the Model Tax Treaty and the OECD Transfer Pricing Guidelines.”

“Businesses should also expect to see more imminent changes in connection with hybrid instruments and entities and the tax deductibility of interest,” he continues. The outcomes are not pre-determined, though. A very tight deadline has been imposed: some groups must report by autumn 2014, whilst others are given an extra year.

As mentioned, the OECD itself acknowledges that clarity and predictability are vital to investment and economic growth, and this is especially so when the global economy remains vulnerable in the wake of the financial crisis. BEPS on the other hand, looks set to achieve exactly the opposite.







 

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