The BMG has made a new submission on Tax Challenges of the Digital Economy in response to the Request for Comments by the OECD in connection with the work of the Task Force on the Digital Economy, preparing a report for the G20.
Digitalisation has further exacerbated the fundamental flaws in international tax rules. The ability to do substantial business in a country without a significant physical presence has long been a problem especially in relation to services. The importance of intangibles and the ability to transfer ownership of such assets to affiliates in low-tax jurisdictions was pioneered long ago by pharmaceutical companies.
Although digitalisation has resulted in important changes in business models, their effects are less significant for those rules than the transformations resulting from the emergence and growth of multinational enterprises (MNEs) since those rules were devised almost a century ago. MNEs have exploited the ‘independent entity’ principle, by creating complex corporate groups and fragmenting their functions to allocate a high proportion of their global income to low-taxed affiliates. The BEPS project has so far aimed only to patch up these rules, and has not resolved the central challenge of how profits should be allocated according to where ‘economic activities occur and value is created’. This requires a paradigm shift, to move away from the independent entity principle, and treat MNEs in accordance with the economic reality that they are unitary firms.
The BEPS issues raised by digitalised products or services are not caused by small companies, such as software firms, selling digital products to customers around the world, but by the giant web-based MNEs. These firms usually do have a significant physical presence in countries where they have a significant level of consumers, but they fragment their activities, and attribute functions such as sales, order fulfillment, production, marketing and customer support to different affiliates.
The main changes due to digitalisation are (i) the closer relationship it both requires and enables between producers and consumers; (ii) the digital services that are often supplied with no direct charge to users, while their inputs are monetised through revenue generated through services provided to other customers, especially advertising; and (iii) the ability that digitalisation gives for some firms to recharacterise themselves as pure intermediaries between producers and consumers. The various unilateral and defensive measures introduced or proposed by countries (diverted profits tax, equalisation levy, etc) may be necessary in the short term but are only interim solutions.
We propose a new definition for taxable presence based on significant presence; a holistic approach in attributing profits to take account of the combined contributions of all the affiliates of a MNE within a country; and a shift towards allocating aggregate profits of all relevant associated enterprises based on factors reflecting the drivers of profit for typical business models.
The BMG has submitted comments on a further discussion draft from the OECD relating to transfer pricing of hard-to-value intangibles.
The transfer of intangible property rights to related entities is one of the main techniques used by multinational enterprises (MNEs) to avoid taxes through base erosion and profit shifting (BEPS). Such assets are especially hard to value if they are transferred at an early stage, since their income-generating potential will be speculative, although best known to the firm itself. The three examples in the discussion draft all involve a transfer of such rights that have been only partially developed. Specifically, the examples involve a patented pharmaceutical compound that is partially through its clinical trials.
Although the draft still claims to apply the fiction of the arm’s length principle, it allows for transfer pricing adjustments based on actual outcomes, due to “information asymmetry” and its negative effects. Our comments support this approach, and propose some specific ways to strengthen it further.
The BMG has now published its Explanation and Analysis of MC-BEPS to implement the tax treaty related provisions of the BEPS project. (A slightly revised version was substituted on 24 April 2017, to add a couple of sentences at the bottom of p.8 explaining the procedure for entry into effect under article 35.7).
This multilateral convention aims to implement the tax treaty related changes recommended by the G20/OECD project on base erosion and profit shifting (BEPS), by modifying existing tax treaties as rapidly as possible. It is open for all countries to join, even if they are not otherwise participants in the BEPS project. It is formulated so that it can apply to all tax treaties, whether based on the OECD or the UN model, or indeed another.
It is understandable that some countries may feel resistance to accepting provisions which they had little or no involvement in formulating. We also have been critical of the BEPS project outcomes, which fell short of providing a comprehensive and cohesive approach to reform of international tax rules. Nevertheless, it is important to evaluate the provisions in this convention in relation to existing tax treaty provisions. This report aims to provide an explanation and analysis of the convention, including most importantly also our recommendations for individual country implementation of the convention. We hope this will help to inform those in government as well as the wider public about its effects.
Overall, we consider that most of the provisions would be improvements on existing tax treaty rules. Tax treaties generally restrict rights to tax income at source, in favour of the residence countries of taxpayers. By restricting abusive techniques which erode the tax base, these provisions help to restore some source country taxation powers. The provisions against tax treaty abuse, including treaty shopping, will also strengthen the general powers of tax authorities to control tax avoidance.
Although we endorse some of the improvements to the mutual agreement procedures for amicable resolution between tax authorities of conflicts over interpretation of legal provisions and factual situations, we do not support those which entail a shift towards legalized dispute resolution, especially arbitration. International tax rules, especially on allocation of MNE profits, are subjective and discretionary, so it is inappropriate for states to assume a binding obligation to accept the decisions of arbitrators. Public opinion will not accept the legitimacy of decisions involving substantial government revenue being taken in complete secrecy by a small community of specialists likely to remain dominated by corporate tax advisers and officials mostly from rich countries.
The BMG made a submission to the UK government in February 2017 on the UK’s implementation of the Multilateral Convention to Implement the Treaty-Related Provisions of the BEPS project.
This multilateral instrument (MLI) aims to enable rapid implementation of the tax-treaty related proposals resulting from the G20/OECD project on base erosion and profit shifting (BEPS), by amending the bilateral tax treaties of participating jurisdictions. Although we have advocated a more coherent and comprehensive approach to the problem, we support the overarching aim of the provisions in the MLI to reduce the exploitation of gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate taxation being paid. The MLI provides the easiest method of ensuring that this occurs quickly and coherently. If countries cherry-pick among the provisions of the MLI, its effectiveness would be greatly reduced, and instead of moving towards a simpler and more uniform structure of anti-abuse provisions in tax treaties, the MLI would add a new layer of complexity and potential confusion.
We would expect the UK, having been in the forefront in initiating the BEPS project and having played a major part in formulation of the proposals, to be in the lead in implementation of the outcomes. We are therefore surprised and concerned that it is proposed that the UK should adopt a selective approach to implementation. The intention apparently is to rely on general anti-abuse principles and unilateral measures, notably the Diverted Profits Tax, instead of implementing the more targeted provisions which have been agreed in the BEPS project and incorporated in the MLI.
We are especially concerned at the proposal not to adopt the provisions aiming at abuse of the taxable presence criteria provided by the permanent establishment (PE) concept. This seems based on a policy to reject attributing significant taxable profits if a MNE has an entity within the jurisdiction significantly involved in sales, even when it also has other affiliates engaged in related activities which constitute complementary functions that are part of a cohesive business operation. The approach proposed by Treasury and HMRC seems out of line with public opinion on how tax should be aligned with real economic activity, as expressed quite forcefully in several reports of the Public Accounts Committee. Treasury and HMRC policy seems to be that this should be dealt with by the diverted profits tax, which is both a unilateral and a blunt weapon. The UK rejection of the changes to the PE definition would deny them to its treaty partners, apparently aiming to offer an attractive country of residence for MNEs to carry on business outside the UK, by minimising taxation of their foreign income. However, other countries might also seek to defend their tax base with their own unilateral measures. Hence, the UK would effectively be engaging in tax competition, a beggar-thy-neighbour approach, which runs counter to the aims of the BEPS project and, we believe, to the long-term interests of the UK.
Such a partial adoption of MLI provisions, and reliance on unilateral measures and broad anti-abuse principles, would inevitably generate a higher number of conflicts. Indeed, this seems to be anticipated, by the inclusion in the MLI of a special chapter providing for mandatory binding arbitration. In our view this is putting the cart before the horse. Priority should be given to preventing disputes, by agreeing clear rules for allocation of profit which are easy to administer. We oppose the proposal that the UK should adopt mandatory binding arbitration, since this involves giving up UK sovereignty, which should be unacceptable in the key area of direct taxation.
For these reasons we have major concerns about the approach towards the MLI outlined so far by the UK Treasury and HMRC, which we explain further below, and hope that it can be reconsidered.
The BEPS Monitoring Group in September 2016 submitted its Comments on the OECD proposals on branch mismatch structures.
These responded to some specific questions in the OECD discussion paper. Howver, we also recalled that In our comments on the Action 2 proposals over two years ago, we commended the OECD for having produced a technically sophisticated analysis and solutions which were carefully and elegantly designed, but also pointed to their complexity and stressed the need to begin with an overview of the causes of the problems. Rules regarding hybrids are necessary purely because of the insistence on applying the ‘separate entity’ principle to entities which are under common control, instead of basing the taxation of multinational enterprises (MNEs) on the economic reality that they operate as unitary firms. The separate entity fiction is especially inappropriate when applied to branches, which even legally are not regarded as independent. This creates a strong incentive for MNE tax advisers to devise techniques such as the use of hybrids to exploit this basic flaw. While the sophisticated and complex counter-measures being proposed may patch up the system to some extent, the rules will be ineffective while the basic flaw remains.
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.
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.
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.
We have made a submission to the an All-Party Parliamentary Group in the UK, chaired by Margaret Hodge M.P., former chair of the Public Accounts Committee.
It deals with some of the immediate issues of implementation in the UK, and the longer-term issues which were not resolved in the BEPS project.