Base Erosion and Profit Shifting (BEPS)
Written by gkkedia Dt. June 9th, 2021
What is BEPS?
Base Erosion and Profit Shifting is the strategy which is implemented under the OECD/G20 Inclusive Framework on BEPS, over 135 countries are collaborating to put an end to tax avoidance strategies that exploit gaps and mismatches in tax rules to avoid paying tax. 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.
For this, OECD identifies specific actions that are needed for government to address all the hurdles. There are 15 Action Plans which have been implemented in three phases:
Why this concept introduced?
For the government, the tax base is the income or profit earned by companies. In recent times, MNCs are developing such tax planning’s which help in eroding tax base. Such practices are done by shifting their incomes/profits to other countries (say tax havens). To cope with such practices, Government launched a concept BEPS projected by the Organization for Economic Co-operation and Development (OECD). OECD has designed a 15-point action plan for tackling this problem of shifting profits.
Introduction to BEPS Action Plans
Action Plan 1: Address the tax challenges of the digital economy
- a (simplified) limitation-on-benefits (LOB) provision in combination with a principal purposes test (PPT),
- a PPT alone or,
- a LOB provision supplemented by provisions that would deny treaty benefits to conduit financing arrangements.
- Concentration of high levels of foreign direct investment (FDI) relative to GDP
- Differential profit rates compared to effective tax rates
- Differential profit rates between low-tax locations and worldwide MNE operations
- Effective tax rates of large MNE affiliates relative to non-MNE entities with similar characteristics
- Concentration of high levels of royalty receipts relative to research and development (R&D) spending
- Interest expense to income ratios of MNE affiliates in high-tax locations
The goal of Action 1 is to identify the challenges the digital economy poses to international taxation. It also aims to develop options to address these. An example of such a challenge is a company that has significant digital presence in the economy of another country than from which the company is run. Like selling digital products, or advertising to the local market.
Current tax rules are not very clear on how to tax the profits of such a company.
Not surprisingly, the final report on Action 1 concluded that the digital economy cannot be seen as separate from the rest of the economy. However, it also concluded that the digital economy has no unique BEPS issues. For that reason, some of the challenges identified for the digital economy have been addressed in other Action points.
Action Plan 2: Neutralize the effects of hybrid mismatch arrangements
Hybrid mismatch arrangements focus on the differences in the tax treatment of an entity or a financial instrument under the laws of two or more countries.
An example of a hybrid mismatch arrangement is a hybrid entity. A hybrid entity is a company which is taxed as a different type of entity in one country than another. For example, a company that is taxed as a corporation in a foreign country could be treated as a partnership for US tax purposes. It pays its own tax in a foreign country, but in the US its incomes and deductions flow to its owner, who pays the tax.
The Organization for Economic Co-operation and Development (OECD) has targeted hybrid entities and hybrid transactions as an international tax planning tool. Under their Base Erosion and Profit Shifting (BEPS) framework, the OECD has recently released recommendations designed to make it harder for companies to take advantage of certain tax planning common practices.
The goal of Action 2 is to neutralize the effects of hybrid mismatches. The final report on Action 2 proposes to include a new provision in the OECD Model Tax Convention. This will ensure that the benefits of tax treaties are granted in appropriate cases with regard to the income concerned. It will also ensure that these benefits are not granted when neither country taxes this income.
Action Plan 3: Strengthen CFC rules
Controlled Foreign Company rules (CFC rules) lead to the taxation of income of controlled foreign subsidiaries in the hands of resident shareholders, if certain conditions are met. For example, CFC rules can test whether a subsidiary is based in a low-tax jurisdiction and if it earns passive income.
Application of CFC rules can have the effect that low-taxed income of controlled foreign subsidiaries is taxed in the residence country of the parent company. An addition effect is that controlled foreign subsidiaries do not have an incentive to shift profits into a third, low-tax jurisdiction.
The final report on Action 3 provides recommendations on CFC rules, but also gives member status flexibility to implement these. Therefore, the impact of these recommendations is still uncertain. The recommendations could result in the implementation of CFC rules in countries that don’t have them now. In other cases, it could result in the amendment of existing CFC rules.
Action Plan 4: Limiting Base Erosion involving Interest Deductions and Other Financial Payments
Action 4 aims to limit base erosion involving interest deductions and other financial payments. A final report on Action 4, which was published as part of the OECD’s 5 October 2015 package of final reports, includes recommendations for domestic rules to restrict interest deductions by reference to a proportion of the profits of an entity or group. The report recommends a fixed ratio rule that would allow an entity to deduct interest and other financial payments up to a fixed percentage of its earnings before interest, tax, depreciation, and amortization (EBITDA) and a group ratio rule that would allow groups with higher levels of external debt to deduct net interest equal to the group’s net interest-to-EBITDA ratio.
Action Plan 5: Counter harmful tax practices more effectively, taking into account transparency and substance
The goal of Action 5 is to revamp the work on harmful tax practices with a priority on improving transparency. It will evaluate preferential tax regimes in a BEPS context.
The final report on Action 5 focuses on two priority issues:
The development of a substantial activity requirement for preferential tax regimes. Preferential tax regimes are those offering special treatment to non-residents or enterprises not active in the domestic market.
[The implementation of compulsory spontaneous information exchange on certain rulings, like advance tax rulings. An advance tax ruling is a written interpretation of tax laws issued by tax authorities. These rulings provide clarity to tax payers as to how much tax they have to pay. In the past, the case has been made that countries “compete” for foreign businesses by offering them favorable advanced tax rulings.
In terms of substantial activity, the report refers to intellectual property regimes. The report endorses the “nexus approach.” Under this approach, taxpayers may only benefit from an IP regime to the extent that they incurred costs giving rise to the IP income. In addition, it mentions that this approach can also be applied to other preferential regimes.
With respect to the exchange of information on rulings, the report confirms that the spontaneous exchange applies both to future rulings (issued after 1 April 2016) and to past rulings (issued after 1 January 2010 and in effect as of 1 January 2014). The information must be exchanged with all countries involved in the transaction covered by the ruling, as well as the residence country of the immediate parent company and the group’s ultimate parent company.
Action Plan 6: Prevent treaty abuse
The goal of Action 6 is to prevent the granting of treaty benefits in inappropriate circumstances. It needs to be made clear that tax treaties are not intended to be used to generate double non-taxation. In addition, countries should consider this before entering into a tax treaty with another country.
The final report on Action 6 proposes that countries include in their tax treaties either:
The report contains detailed proposals for treaty provisions as well as elaborate explanatory guidance. At the same time, it is now explicitly recognized that countries will have to tailor these provisions to cater for their specific situation.
The multilateral instrument (see Action 15) provides tools for implementation of these concepts in tax treaties (see Action 15).
Action Plan 7: Prevent the artificial avoidance of Permanent Establishment status
The goal of Action 7 is to develop changes to the definition of Permanent Establishment (PE) to prevent the artificial avoidance of PE status. Work on these issues will also address related profit attribution.
To recap; a permanent establishment is a fixed place of business which generally gives rise to a tax liability. For example, a company in France hires an office in the UK where activities take place.
Another example could be a company registered and operating out of the UK of which all the decisions are made by the manager who permanently lives in France.
The final report on Action 7 proposes to lower the PE threshold in the OECD Model Tax Convention. This means that a Multinational Enterprise with activities in multiple countries will establish a PE in those countries. The result is that multinational companies will become liable to tax in more countries.
Lowering the PE threshold may fuel future discussions between tax payers and tax authorities. This goes not just for the PE status, but more importantly for the PE profit attribution (and tax liability). In addition, compliance costs and administrative burdens are likely going to increase.
Action 8, 9 and 10: Aligning transfer pricing outcomes with value creation
BEPS Actions 8,9 and 10 address transfer pricing guidance to ensure that transfer pricing outcomes are better aligned with value creation of the MNE group. In this regard, Actions 8,9 and 10 clarify and strenghten the existing standards, including the guidance on the application of the arm’s length principle and an approach for appropriate pricing of hard-to-value-intangibles within the arm’s length principle.
Action Plan 11: Measuring and monitoring BEPS
Based on a number of studies, the OECD concludes that Base Erosion and Profit Shifting is responsible for significant global corporate income tax (CIT) revenue losses. The goal of Action 11 is to ensure that the effectiveness and economic impact of the actions taken to address BEPS are effective.
The final report on Action 11 contains recommendations on improved access to and enhanced analysis of available data to measure BEPS, and on a consistent method of presentation. The report provides tools to assist countries in evaluating the effects of BEPS. Moreover, it enables them to measure the impact of efforts to prevent BEPS.
Following are the six specific indicators in measuring and monitoring BEPS:
Action Plan 12: Require taxpayers to disclose their aggressive tax planning arrangements
The goal of Action 12 is to develop recommendations regarding the design of mandatory disclosure rules for aggressive tax planning arrangements. In short, it should be clear what tax payers are doing. If they use aggressive tactics to lower the tax burden, tax authorities have a means to address this.
The final report on Action 12 sets out options and provides best practice recommendations. It provides a modular approach that gives countries wishing to introduce a mandatory disclosure regime the option to choose what best fits their needs.
The report also makes specific recommendations for disclosure rules in relation to international tax schemes.
Finally, it identifies opportunities to enhance the exchange of information obtained by countries through such rules.
Action Plan 13: Re-examine Transfer Pricing Documentation
Organisation for Economic Co-operation and Development’s (OECD), BEPS Action 13 has provided for a three-tier structure for TP documentation, namely Master File, Local File and Country by Country (“CbC”) reporting framework. Majority of the countries having TP regulations have adopted BEPS Action 13 as a part of their regulatory framework, increasing onus of compliance by the enterprises operating in multiple geographies.
First, the guidance on transfer pricing documentation requires multinational enterprises (MNEs) to provide tax administrations with high-level information regarding their global business operations and transfer pricing policies in a “Master file” that is to be available to all relevant tax administrations.
Secondly, it requires that detailed transactional transfer pricing documentation is provided in a ”Local file” specific to each country, identifying material related party transactions, the amounts involved in those transactions and the company’s analysis of the transfer pricing determinations they have made with regard to those transactions and a comparability analysis.
Thirdly, the newly introduced Country-by-Country Report is a tool intended to allow tax administrations to perform high-level transfer pricing risk assessments, or to evaluate other BEPS-related risks. The Country-by-Country Reporting template will require multinational enterprises to provide annually and for each jurisdiction in which they do business, aggregated information relating to the global allocation of the multinational enterprises income and taxes paid, together with certain indicators of the location of economic activity within the multinational enterprises groups, as well as information about which entities do business in a particular jurisdiction and the business activities each entity is engaged in. Insofar, Country-by-Country Reporting will provide a clear overview of where profits, sales, employees and assets are located and where taxes are paid and accrued.
Action Plan 14: Make dispute resolution mechanisms more effective
It might happen that two jurisdictions seek to tax the same transactions or activities. Generally, tax treaties directly resolve most such cases. However, two jurisdictions might disagree on the interpretation or application of a tax treaty. The mutual agreement procedure (MAP) article of a tax treaty provides a mechanism to resolve these cross-border tax disputes.
The goal of Action 14 is to address obstacles that prevent countries from solving treaty related disputes under MAP.
In the final report on Action 14, the OECD recognizes that dispute resolution mechanisms should be improved. The plan is to develop a minimum standard. The goal of this standard is to ensure that treaty-related disputes are resolved in a quick, effective and efficient manner. This is needed badly. We wouldn’t be surprised if we’ll soon see a rise of treaty- related disputes because of all the changes caused by all these BEPS Action points…
In practice, these new minimum standards require amendments to both the OECD Model Tax Convention and its Commentary, domestic law and regulations, and administrative procedures.
The Multilateral Instrument (Action 15) as published on 24 November 2016, establishes a separate mandatory binding arbitration route. For now, countries are free to adopt this procedure.
Action Plan 15: Develop a multilateral instrument
Most countries have Double Tax Treaties (DTT) in place with other countries. These DTT’s provide clarity as to where a company has to pay taxes, if activities are spread over two or more countries.
Although a lot of these treaties are based on the OECD Model Tax Treaty, almost all treaties are the result of bilateral negotiations. If BEPS is to be implemented correctly, these treaties have to be renegotiated one by one. This would take ages.
Instead, Action point 15 aims to develop a Multilateral Instrument (MLI). The MLI is expected to be adopted by 100 countries. This MLI allows countries to swiftly modify their bilateral treaties to implement BEPS measures.
On 24 November 2016, the OECD issued the agreed text of the MLI which, when adopted, includes BEPS measures into more than 2,000 existing tax treaties worldwide.
The MLI, gives countries the flexibility to specify which treaties are covered. They can decide how they meet the minimum standards. If desired, they can opt out of all or part of the provisions which extend beyond the minimum standard.
This flexible approach means that each bilateral treaty will be changed in a unique way, depending on how the parties to the bilateral treaty adopt the MLI provisions. Only when both parties agree to amend their treaties in the same way for that particular article (when there is a “match”), a treaty article will be amended.