Praxity North America’s tax team discusses the impact and implications of the OECD’s action plan on Base Erosion and Profit Shifting (BEPS).
According to the OECD’s briefing notes, Base Erosion and Profit Shifting (BEPS) is a "tax planning strategy that exploits gaps and mismatches in tax rules to make profits disappear for tax purposes". It also says it "shifts profits to locations where there is little or no real activity but the taxes are low, resulting in little or no overall corporate tax being paid". These definitions can be taken two ways; the rules associated with BEPS focus solely on these very harmful tax practices or that virtually all perfectly legal, legitimate tax strategies utilizing these planning strategies are bad. We’d like to believe the OECD views its action plan as attacking the former; we fear, however, they are more likely to attack the latter – legitimate tax planning.
BEPS and its definition provide important clues on what is considered to be "bad" tax planning. Tax planning that makes "profits disappear" and "shifts profits to locations where there is little or no real activity but taxes are low" sounds admittedly like tax evasion, but this is very legal under today’s international tax rules.
When non-international tax practitioner and CEO of Apple Inc., Tim Cook, testified in front of US Congress he defended Apple Inc.’s use of offshore tax shelters in front of a hostile group of Senators. Mr Cook indicated that "we pay all the taxes we owe – every single dollar. We not only comply with the laws, we comply with the spirit of the laws." While Mr Cook felt confident defending his company’s practices, Bloomberg reported Senator Carl Levin felt Apple Inc. had used "loopholes" to avoid paying $9bn in US taxes in 2012 and stated that "offshore tax strategies’ main purpose is tax avoidance, pure and simple." It would appear minds differ on what is tax planning and what is tax avoidance or, God-forbid, tax evasion.
We consider tax planning, like beauty, to be in the eye of the beholder. International tax laws are very complex and differ by jurisdiction. The US uses a worldwide system of taxation that will, eventually, tax all of the income of a US company and the income of all of its subsidiaries. As a result, much US tax planning is devoted to either moving income to parents or brother-sister companies (through inversions) or moving income to low-tax jurisdictions and deferring the income. These tax planning techniques have invariably led to anti-inversion rules and anti-deferral rules (as well as anti-splitting and anti-abuse rules too; lots of negativity in these rules). Where Mr Cook and the Honorable Carl Levin disagree is where tax planning and tax avoidance begin.
So where does BEPs fit in? The current OECD BEPS Program has 15 Actions proposing changes in how companies report income and tax characteristics (through County-by-Country Reporting or CbC Reporting), changes in transfer pricing, treatment of hybrid entities and permanent establishment. Further concerns focus on when tax authorities can simply ignore contracts, when preferential tax regimes should be used, and when permanent establishments are deemed to exist. Each of the Actions received a significant number of public responses from CPA and Chartered Accounting firms, multinational companies and from various groups, evidencing the level of interest in BEPS.
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While BEPS refers to Small and Mid-size Entities (SMEs) and Multi-National Entities (MNEs) it very seldom differentiates the rules between them. In fact, the definitions themselves are not clear because many SMEs operate internationally and are, therefore, MNEs. However, we would assert that cross-border structures typically employed by SMEs do not have the same characteristics of large multi-nationals, but would still be subject to the same rules being employed to view certain entities with suspicion.
The BEPS Actions are lengthy and complex; changes being suggested could negatively impact SMEs by lowering the threshold for permanent establishments (thereby increasing costs of entering new markets) and viewing contracts between related parties with suspicion (thereby adding additional legal costs to document relationships). While the initial impact of CbC Reporting will be limited to MNEs with annual sales of €750m or more, the impact of the many other changes will be felt in increased governance, compliance costs and adversarial taxing authority audits.
Operating internationally provides benefits and costs to companies willing to take the risk. Adequate tax planning should always be a priority and the adoption of BEPS will make this an even higher priority. Documentation for permanent establishment positioning and transfer pricing will be even more important as will a paper-trail of contracts, transfers of intangibles and business reasons for operations in low-tax jurisdictions or the formation of low-risk entities.
While these changes are important from a SME’s perspective, we would urge the OECD to look at rules that differentiate SMEs from large MNEs, particularly in the area of cross-border dispute resolutions (competent authority or mutual agreement procedures). Without the adoption of more efficient cross-border dispute procedures – in a more complex international tax structure – SMEs will more often find themselves at the mercy of aggressive, local taxing authorities. Attention on large MNEs appears to focus on the tax structures that lower or avoid tax; we feel the attention should focus on the fair and equitable application of the law on all companies, particularly SMEs that will get caught up in the changes BEPS is bringing.
In its Risks, Recharacterizations and Special Measures Discussion Draft, the OECD appears to imply tax authorities have a lot of leeway to ignore legal contracts between related parties and to recharacterize the transactions. It also places significant emphasis on risks versus the performance of functions when analyzing an intercompany arrangement and essentially mandates that the ability to manage and control the risks is the key to identifying which party bears a particular risk. We voice concerns over the apparent support of formulary apportionment at the expense of the arm’s-length standard as evidenced by the ‘Special Measures’ section of the Discussion Draft.
By Steve Amigone, Dixon Hughes Goodman, Jerry Jonckheere, Plante Moran, Will James, BKD and Michael Schwart,WeiserMazars. Members of the Praxity North American Tax Group.