On Oct. 5, 2015, the Organisation for Economic Co-operation and Development (OECD) issued the final report on all 15 BEPS Action Plans. This caps two years of work started in September 2013, when G20 Leaders endorsed the ambitious and comprehensive Action Plan on BEPS, to restore confidence in the international tax framework which was designed more than a century ago.
According to the OECD (2014), Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, OECD, the current rules have revealed weaknesses that create opportunities for Base Erosion and Profit Shifting, thus requiring a bold move from policy makers to restore confidence in the system and ensure that profits are taxed where economic activities take place and value is created. This package of 13 reports, delivered just two years later, includes new or reinforced international standards as well as concrete measures to help countries tackle BEPS. It represents the results of a major and unparalleled effort by the OECD and G20 countries working together on an equal footing, with the participation of developing countries.
Among the highlights of the OECD Final Reports are the new transfer pricing approach and reinforced international standards on tax treaties, the setting of minimum standards on harmful tax practices, treaty abuse, country-by-country reporting and dispute resolution, action items requiring national legislation particularly in hybrid mismatches and interest restriction, and analytical reports with recommendations concerning digital economy and multilateral instruments.
In this column, we provide an overview of the 15 BEPS Action Plans to give our readers an idea of what to expect in terms of Philippine tax developments in the context of the international tax framework.
Action 1: Addressing the tax challenges of the digital economy
The final report recommends that the list of exceptions to the definition of permanent establishment (PE) be modified to ensure that the listed exceptions are restricted to activities that are “preparatory” or “auxiliary” in character. The report also recommends the issuance of a new fragmentation rule to ensure that the fragmentation of business activities among closely related companies shall not be possible. Modification of the definition of a PE to address artificial arrangements through “conclusion of contracts” agreements between companies belonging to a multinational group is also recommended, along with revisions to the OECD Transfer Pricing Guidelines and the Controlled Foreign Company (CFC) rules.
Action 2: Neutralizing the effects of hybrid mismatch arrangements
The final report recommended that changes be made both to domestic law and the OECD Model Tax Convention in order to neutralize the effects of hybrid mismatch arrangements, which necessarily exploit differences in tax treatment of a single entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation including long-term deferral.
Part 1 of the report for Action 2 basically recommends the linking of rules that align the tax treatment of an instrument or entity with the tax treatment in the counterparty jurisdiction but otherwise do not disturb commercial outcomes. Also, Part 2 aims to ensure that hybrid instruments and entities do not abuse the treaty benefits and will not prevent the application of the changes in domestic law as recommended in Part 1.
Action 3: Designing effective controlled foreign company rules
The final report for Action 3 sets out recommendations that will effectively prevent taxpayers from shifting income into foreign subsidiaries. The recommendations were not meant to be minimum standards, but were designed as building blocks to help achieve the said goal.
The action point named six building blocks for the design of effective CFC rules. Briefly, these six building blocks are:
• Definition of CFCs -- How to determine when stockholders have sufficient influence over a foreign company as well as non-corporate entities and their income should be covered by the CFC rules;
• CFC Exemptions and threshold requirements -- CFC rules should only apply to CFCs that are subject to effective tax rates that are meaningfully lower than those applied in the parent jurisdiction;
• Definition of Income -- CFC rules should include a definition of what constitutes CFC income and provides for a non-exhaustive list of approaches or combination of approaches that the CFC rules could use to define CFC income;
• Computation of income -- CFC rules should use the rules of the parent jurisdiction to compute the CFC income to be attributed to shareholders. Moreover, CFC losses should only be offset against the profits of the same CFC or other CFCs in the same jurisdiction;
• Attribution of income -- When possible, the attribution threshold should be tied to the control threshold and the amount of the income to be attributed should be calculated by reference to the proportionate ownership or influence; and
• Prevention and elimination of double taxation -- To ensure that the CFC rules will not eventually lead to double taxation such as the allowance of foreign tax credits.
Action 4: Limiting base erosion involving interest deductions and other financial payments
The final report acknowledges BEPS risks involving interest deductions and other financial payments. To address these risks, the report recommended the “fixed ratio rule” which limits an entity’s net deductions for interest and payments. So as not to restrict a group’s ability to incur third-party debt for non-tax reasons, the report also recommended a “group ratio rule” which would enable an entity with net interest expense above a country’s fixed ratio to deduct interest up to a certain level.
Recognizing that banks and insurance sectors have specific features which must be considered before any rules to address BEPS for this sector are issued, the report recommends the development of suitable and specific rules which will address BEPS risks in these sectors.
Action 5: Countering harmful tax practices more effectively taking into account transparency and Substance
The final report on Action 5 focuses on the definition of substantial activity to assess preferential regimes as well as transparency. This aims to address the concern that preferential regimes are currently being used for artificial profit shifting and lack of transparency in connection with some rulings.
It was agreed by the countries that for purposes of substantial activity, the requirements used to assess preferential regimes should be aligned with the substantial activities that generate them and the agreed approach is called the “nexus approach.”
Action 6: Preventing the granting of treaty benefits in appropriate circumstances
In order to address treaty abuse, it was recommended that treaties between States categorically state that the treaty intends to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty shopping arrangements. Moreover, the introduction of anti-abuse rules, limitation-on-benefits rule and limits on the availability of treaty benefits were recommended to be included in the OECD Model Tax Convention. Where the LOB rule cannot apply, the introduction of a more general anti-abuse rule based on the principal purposes of transactions or arrangements in the OECD Model Tax Convention is proposed.
Action 7: Preventing the artificial avoidance of permanent establishment status
The report for Action 7 primarily recommends the amendment of Article 5 (the Business Profits provision) of the OECD Model Tax Convention. This is to address common tax avoidance strategies which are used to circumvent the PE definition. These strategies allow an entity to operate in a country without creating a PE through commissionaire agreements, activities which are preparatory and auxiliary in character but in reality are in itself core business activities, and the splitting of contracts among closely related parties.
In the second part of this article, we will discuss the remaining Action Plans, including issues on transfer pricing, measuring and monitoring BEPS, and mandatory disclosure, among others.
Ma. Fides A. Balili and Maria Margarita D. Mallari-Acaban are a Partner and a Senior Director, respectively, of SGV & Co.
According to the OECD (2014), Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, OECD, the current rules have revealed weaknesses that create opportunities for Base Erosion and Profit Shifting, thus requiring a bold move from policy makers to restore confidence in the system and ensure that profits are taxed where economic activities take place and value is created. This package of 13 reports, delivered just two years later, includes new or reinforced international standards as well as concrete measures to help countries tackle BEPS. It represents the results of a major and unparalleled effort by the OECD and G20 countries working together on an equal footing, with the participation of developing countries.
Among the highlights of the OECD Final Reports are the new transfer pricing approach and reinforced international standards on tax treaties, the setting of minimum standards on harmful tax practices, treaty abuse, country-by-country reporting and dispute resolution, action items requiring national legislation particularly in hybrid mismatches and interest restriction, and analytical reports with recommendations concerning digital economy and multilateral instruments.
In this column, we provide an overview of the 15 BEPS Action Plans to give our readers an idea of what to expect in terms of Philippine tax developments in the context of the international tax framework.
Action 1: Addressing the tax challenges of the digital economy
The final report recommends that the list of exceptions to the definition of permanent establishment (PE) be modified to ensure that the listed exceptions are restricted to activities that are “preparatory” or “auxiliary” in character. The report also recommends the issuance of a new fragmentation rule to ensure that the fragmentation of business activities among closely related companies shall not be possible. Modification of the definition of a PE to address artificial arrangements through “conclusion of contracts” agreements between companies belonging to a multinational group is also recommended, along with revisions to the OECD Transfer Pricing Guidelines and the Controlled Foreign Company (CFC) rules.
Action 2: Neutralizing the effects of hybrid mismatch arrangements
The final report recommended that changes be made both to domestic law and the OECD Model Tax Convention in order to neutralize the effects of hybrid mismatch arrangements, which necessarily exploit differences in tax treatment of a single entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation including long-term deferral.
Part 1 of the report for Action 2 basically recommends the linking of rules that align the tax treatment of an instrument or entity with the tax treatment in the counterparty jurisdiction but otherwise do not disturb commercial outcomes. Also, Part 2 aims to ensure that hybrid instruments and entities do not abuse the treaty benefits and will not prevent the application of the changes in domestic law as recommended in Part 1.
Action 3: Designing effective controlled foreign company rules
The final report for Action 3 sets out recommendations that will effectively prevent taxpayers from shifting income into foreign subsidiaries. The recommendations were not meant to be minimum standards, but were designed as building blocks to help achieve the said goal.
The action point named six building blocks for the design of effective CFC rules. Briefly, these six building blocks are:
• Definition of CFCs -- How to determine when stockholders have sufficient influence over a foreign company as well as non-corporate entities and their income should be covered by the CFC rules;
• CFC Exemptions and threshold requirements -- CFC rules should only apply to CFCs that are subject to effective tax rates that are meaningfully lower than those applied in the parent jurisdiction;
• Definition of Income -- CFC rules should include a definition of what constitutes CFC income and provides for a non-exhaustive list of approaches or combination of approaches that the CFC rules could use to define CFC income;
• Computation of income -- CFC rules should use the rules of the parent jurisdiction to compute the CFC income to be attributed to shareholders. Moreover, CFC losses should only be offset against the profits of the same CFC or other CFCs in the same jurisdiction;
• Attribution of income -- When possible, the attribution threshold should be tied to the control threshold and the amount of the income to be attributed should be calculated by reference to the proportionate ownership or influence; and
• Prevention and elimination of double taxation -- To ensure that the CFC rules will not eventually lead to double taxation such as the allowance of foreign tax credits.
Action 4: Limiting base erosion involving interest deductions and other financial payments
The final report acknowledges BEPS risks involving interest deductions and other financial payments. To address these risks, the report recommended the “fixed ratio rule” which limits an entity’s net deductions for interest and payments. So as not to restrict a group’s ability to incur third-party debt for non-tax reasons, the report also recommended a “group ratio rule” which would enable an entity with net interest expense above a country’s fixed ratio to deduct interest up to a certain level.
Recognizing that banks and insurance sectors have specific features which must be considered before any rules to address BEPS for this sector are issued, the report recommends the development of suitable and specific rules which will address BEPS risks in these sectors.
Action 5: Countering harmful tax practices more effectively taking into account transparency and Substance
The final report on Action 5 focuses on the definition of substantial activity to assess preferential regimes as well as transparency. This aims to address the concern that preferential regimes are currently being used for artificial profit shifting and lack of transparency in connection with some rulings.
It was agreed by the countries that for purposes of substantial activity, the requirements used to assess preferential regimes should be aligned with the substantial activities that generate them and the agreed approach is called the “nexus approach.”
Action 6: Preventing the granting of treaty benefits in appropriate circumstances
In order to address treaty abuse, it was recommended that treaties between States categorically state that the treaty intends to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty shopping arrangements. Moreover, the introduction of anti-abuse rules, limitation-on-benefits rule and limits on the availability of treaty benefits were recommended to be included in the OECD Model Tax Convention. Where the LOB rule cannot apply, the introduction of a more general anti-abuse rule based on the principal purposes of transactions or arrangements in the OECD Model Tax Convention is proposed.
Action 7: Preventing the artificial avoidance of permanent establishment status
The report for Action 7 primarily recommends the amendment of Article 5 (the Business Profits provision) of the OECD Model Tax Convention. This is to address common tax avoidance strategies which are used to circumvent the PE definition. These strategies allow an entity to operate in a country without creating a PE through commissionaire agreements, activities which are preparatory and auxiliary in character but in reality are in itself core business activities, and the splitting of contracts among closely related parties.
In the second part of this article, we will discuss the remaining Action Plans, including issues on transfer pricing, measuring and monitoring BEPS, and mandatory disclosure, among others.
Ma. Fides A. Balili and Maria Margarita D. Mallari-Acaban are a Partner and a Senior Director, respectively, of SGV & Co.
source: Businessworld
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