Attribution of Profits to Permanent Establishments

The BMG has made a Submission to the OECD on its consultation on revisions to the guidance on Attribution of Profits to Permanent Establishments.

Summary

This discussion draft (DD) deals with attribution of profits to a host country resulting from changes to the taxable presence requirement in the definition of a permanent establishment (PE) in BEPS project’s Action 7. Although generally clear and well reasoned, it is of limited usefulness in our view, for two main reasons. These comments explain these shortcomings and suggest how they could be corrected.

First, it applies only to the 2010 version of the OECD model convention, which introduced the ‘authorised OECD approach’ (the AOA) for attribution of profits to a PE. The AOA attempts to extend to PEs as far as possible the independent entity principle as applied to associated enterprises within a multinational enterprise (MNE). A number of OECD countries have not accepted the AOA, and it has also been generally rejected by developing countries. One reason for this is that the independent entity principle is especially inappropriate for a PE, which by definition is part of the same legal entity. Hence, few actual treaties are based on the AOA, and this is also true for most national tax law rules which would apply to entities resident in non-treaty countries. States, especially developing countries (whether or not they decide to join the Inclusive Framework for BEPS), should not be pressurised into adopting the AOA. Instead, the UN Committee of Tax Experts, in liaison with the OECD, should develop its own revisions to the commentary to the UN treaty model consequent on the changes to the PE definition introduced by Action 7. Further work is clearly necessary, by a wider range of countries, and adopting a broader approach, to produce guidance that would be of use to tax payers and tax authorities, especially in the bulk of cases where the AOA is not applicable.

Secondly, the examples provided in the DD adopt a very restricted approach, which assumes that all or most significant people functions take place in the non-resident entity, and hence attribute only limited profits to the PE. They include some illustrations of when aspects of inventory and credit risk management may take place in a PE, but significantly the examples include no discussion of other sales-related functions such as marketing and advertising, which are instead assumed to be controlled by the non-resident entity, with no relevant local input. Similarly, the examples are silent regarding core business functions conducted in host countries that are often found in modern MNE business models. These simple examples may be relevant to relatively small firms based almost entirely in their home countries, which employ a foreign sales agent.  But they are entirely unrealistic in relation to most large MNEs and their modern business models, which aim to be both global and local. No MNE can operate effectively by centralising virtually all its significant people functions and all its core business functions at a distance from its customers and suppliers, as is assumed in the examples provided here. Indeed, there are many well known examples of MNEs which employ significant staff in host countries engaged in both customer-facing and many core business functions. The failure of this DD to discuss such situations suggests a lack of consensus on how to deal with them, which may regrettably exacerbate the likelihood of conflicts even between OECD countries.

As the DD is now drafted with its focus on the AOA and its unrealistically simple examples, its effect is to strengthen the BEPS mechanisms used by many MNEs. This contradicts the mandate for the BEPS project, which is to align taxation and value creation.

Revised Guidance on Profit Splits

The BMG has made a Submission to the OECD Consultation on its draft revisions to the Transfer Pricing Guidelines concern the Profit Split Method.

General Remarks and Summary

We applaud the continued interest of the OECD and Working Party 6 in its work to make the profit-split approach a more viable and important tool in intercompany pricing.

In this submission we propose the development and use of defined allocation keys and weights to apply the profit-split method to actual profits of common business models (see Appendix). In our comments to the specific questions we point out that the examples in the discussion draft assume, without explicitly saying it, that the various business units of a multinational enterprise (MNE) are normally independently managed, albeit with common ownership and some top-level management over policy and direction. In contrast to this assumption, we believe that most MNEs operate as centrally-managed unitary businesses performing core functions and using intangible property in multiple countries. We therefore suggest that it is appropriate to apply the profit-split method to actual profits in these cases. Nevertheless, if Working Party 6 takes a different view, due to their belief that some level of integrated risk sharing is required for application to actual profits, the profit-split method with defined allocation keys and weights could be applied to anticipated gross profits or other measure appropriate for the specific business model. Whether our recommended approach or this alternative is chosen and inserted into the Guidelines, it would greatly simplify things for taxpayers and tax authorities alike.

Submission on Amendments to Chapter IX: Business Restructurings

The BMG has made a Submission to the OECD Consultation on its proposed revisions to Chapter IX of its Transfer Pricing Guidelines, on Business Restructurings.

Summary

Chapter IX was introduced into the OECD Transfer Pricing Guidelines (TPGs) in 2010 to help deal with the consequences of the spread since the 1990s of corporate restructurings by multinational enterprises (MNEs) essentially aimed at tax avoidance, typically involving transfers of rights to intangibles, redesignation of the responsibilities or functions of affiliates, and notional reassignments of risk-bearing. This draft rewrites the chapter to bring it into line with the other changes to the TPGs resulting from the BEPS project.

Our comments suggest ways in which the draft should be revised to make its purpose clearer, with additional coverage of restructurings that are only contractual in nature or that involve insubstantial movements of assets, people, and risks. It should state that the burden of proof is on the taxpayer to establish the validity and substantive nature of any stated business reasons behind any business restructuring, and should bring out more clearly the applicability of the profit split method.

Presentation to the Enlarged Framework on BEPS of the OECD Committee on Fiscal Affairs

A presentation was made on behalf of the BEPS Monitoring Group by Professor Kerrie Sadiq, to the first meeting of the Enlarged Framework of the OECD Committee on Fiscal Affairs, in Kyoto (Japan) on 29 June 2016. The outline of this presentation is here.

Submission to OECD on the Multilateral Instrument

The BMG submitted on 30 June 2016 these Comments on Action 15 on the proposed Multilateral Instrument which will amend existing tax treaties to implement changes agreed in the BEPS project.

Summary

The reports resulting from the project on Base Erosion and Profit Shifting (BEPS) include a number of proposals for changes in tax treaties, formulated as amendments to the OECD Model Convention and its Commentaries. The Multilateral Instrument (MLI) is intended to provide a method for quickly amending existing bilateral treaties. Hence, it must take the form of an actual self-standing treaty, and not a model. However, there are differences in the texts of the actual treaties to be amended, especially those involving developing countries, and based on the UN model. Hence, we suggest that the MLI should be accompanied by Country Schedules, bilaterally agreed, to ensure clarity as regards which treaties are amended and how. This would ensure that tax authorities, taxpayers and courts know which treaties have in fact been amended and their new language.

The core provisions of the MLI should be the basic provisions for preventing abuse of tax treaties and eliminating double non-taxation. Several variants have been proposed in BEPS Action 6, and it is essential that the MLI includes options which are suitable for developing countries. The revisions of the Permanent Establishment definition have been drafted in relation to the OECD Model, and a variant should be included which is compatible with the UN model, in consultation with the UN Committee.

The proposals for strengthening the Mutual Agreement Procedure (MAP) for resolving tax treaty disputes are unsuitable for developing countries, and should remain purely voluntary. This applies in particular to Mandatory Binding Arbitration, which we regard as illegitimate for all countries. Tax treaty provisions are binding in domestic law, and can be enforced through national tribunals. Accordingly, MNEs should not be given further privileges over other taxpayers. The MAP is an ‘amicable procedure’, and it is not appropriate to try to convert it into a supranational dispute settlement procedure. It is contrary to the due process of law, and indeed in many countries regarded as unconstitutional, for contentious interpretations of legal provisions to be made by secret and unaccountable administrative procedures, rather than by courts or tribunals in an open legal process. To make it mandatory for all conflicting interpretations to be resolved would provide a guarantee that aggressive tax planning would be riskless, and create an incentive to continue BEPS behavior. The main cause of the increase in tax disputes is the subjective basis of the transfer pricing rules, and it is inappropriate to expect the MAP to resolve issues which negotiators have failed to deal with in a principled manner.

 

Treaty Entitlement of Non-Collective Investment Vehicle Funds

The BMG has now made a submission to the consultation on Non-CIV Funds, under BEPS Action 6 on preventing the granting of treaty benefits in inappropriate circumstances. Although presented in technical terms the proposals raise wider policy issues, since they could result in granting tax treaty benefits to hedge funds and private equity funds even if formed in tax havens.

Summary

This consultation document concerns proposals put forward by interested parties and not the Committee on Fiscal Affairs, which is now asking for comments. We regret that the document did not explain the policy issues, to facilitate a wider public engagement. This is especially important since the proposals concern the BEPS Action 6 measures to prevent treaty abuse, which are a core commitment for the expanding group of countries participating in the BEPS process, and may become a global standard through tax treaties.

Non-CIVs typically include private equity funds, hedge funds, trusts or other investment vehicles that generally do not have the key characteristics of CIVs. In particular, they are usually both unregulated and narrowly held, since they are aimed at sophisticated investors. Governments are therefore right to be concerned that these non-CIVs could be used to allow access to treaty benefits, in particular reduced withholding taxes at source, for investors who would not otherwise be entitled to such benefits, and who may be able to evade being taxed on such income.

We believe that any rules created to deal with these non-CIVs should require a positive demonstration by any non-CIV desiring treaty benefits that it can verify the bona fides of all its investors. To ensure taxation of income flowing through a fund which itself is exempt from tax, measures should be in place to ensure that its investors comply with their obligations to pay tax on payments to them from the fund. Hence, we consider that, to be eligible for treaty benefits, investment funds must be subject to

  • Regulation which includes know-your-customer requirements, and
  • Obligations to participate in comprehensive, automatic exchange of information for tax purposes.

Where, a fund is not itself able to verify the identity of all its customers because it receives investments from other funds, it must verify that its investors are subject to the same obligations. This would provide an incentive to ensure that jurisdictions hosting financial centres comply with the appropriate global standards, not only for financial regulation, but more importantly in this context for preventing tax evasion.

In addition, it is critical that high threshold tests be set to ensure that eligible funds are in fact widely held and are genuinely channels for portfolio investment. In particular:

  • No one investor or group of related investors should own above 1% of the fund,
  • The fund should have a maximum of 10% of its assets in any one investment,
  • It should not own more than 5% of any such investment, and
  • A minimum of 95% of funds investing in such a fund should be entitled to the same or similar treaty benefits.

Submission on US Draft Regulations on Country by Country Reporting

The BMG has now made a submission to the US Treasury on its draft Regulations for Country by Country Reporting.

Overall, we applaud this implementation of Country-by-Country Reporting (CbCR) in accordance with the recommendations of the 5 October 2015 Final Report on Action 13 of the G20/OECD project on Base Erosion and Profit Shifting (BEPS). The proposed regulation as drafted will be an important contribution to the ability of the IRS to enforce U.S. tax laws. Recent estimates by Kimberly Clausing suggest that profit shifting likely cost the U.S. government between $77 and $111 billion in corporate tax revenue in 2012, and that these revenue losses have increased substantially in recent years.

A strong and effective CbCR program will provide the IRS with an important tool to identify situations not only involving potential transfer pricing issues, but also potential application of judicial concepts and other laws, such as determining whether income is effectively connected with a trade or business being conducted in the U.S. Often, the real business of some low- or zero-taxed foreign group members is being conducted by group members located within the U.S. Where this is found, the IRS can potentially choose to impose tax through re-characterization under judicial concepts, through transfer pricing adjustments, or through application of the effectively connected income rules. Often, where the facts support it, applying the effectively connected income rules will provide a more statutory basis to assess tax, which will be assessed at higher effective tax rates due to the §884 branch profits tax and the potential loss of deductions and credits under §882(c)(2) where a foreign group member has previously filed no U.S. tax return.

We wish to add as well that effective CbCR will better allow the IRS to target their examinations on both domestic MNEs and foreign-based MNEs. Importantly, foreign-based MNEs include inverted MNEs and foreign MNEs that have acquired U.S.-run multinational businesses. Especially for these purposes, it is of extreme importance that the IRS fully and actively participates in the automatic exchange of CbCRs among treaty partners as contemplated by BEPS Action 13.

The U.S. is the most important single country whose actions will help define the BEPS process and its degree of future success. The resolute actions of the Treasury and the IRS, both in timely publishing effective regulations and in implementing sharing through information exchange mechanisms, will provide a meaningful leadership position that sets an example for the rest of the world.