Base Erosion and Profit Shifting
International tax planning is the art of using all means that are legally available to structure your affairs in such a way that you pay less tax. As a result of effective tax planning, increasingly there is segregation between the country/region where actual business activities take place and the country/region where profits are reported for tax payment purposes. The practice of using available legal tools to realize effective tax planning is also referred to as base erosion and profit shifting.
Since the release of the first set of recommendations by the OECD on September 16, 2014, the concept of base erosion and profit shifting became one of the most debated topics, especially among advisors, clients, academics, and (in certain countries) politicians. The “Base Erosion and Profit Shifting Project” (BEPS) has been initiated to create a single set of international tax rules to end the erosion of countries’ tax bases through the artificial shifting of profits between countries.
We are now living in an increasingly connected world but in general national tax laws have not kept pace with the way that multi-national corporations operate. In particular, this has given the rise to a large gap in the area of digital economy, as there are inconsistencies in the way that electronic transactions are monitored and taxed in the different countries and territories around the world. In fact, there is a growing perception that the current rules of international and domestic taxation no longer fit their intended purpose and that the fairness and integrity of the international tax system is in jeopardy.
Base erosion constitutes a serious risk to the tax revenues of all countries. The artificial profit-shifting strategies adopted by multi-national companies to lower their tax bill are the fundamental cause of base erosion. In certain circumstances it can even be claimed that the current international tax system encourages multi-national companies to eliminate or significantly reduce taxation by using elaborate corporate structures and subterfuge in their transactions. The tax avoidance strategies utilized by multi-national companies gives them an unintended competitive advantage over corporations operating within one country only.
Some of the areas where we believe the BEPS project will most likely have its greatest impact are:
-The Financing Structure: It is a common practice in international tax planning to organize the financial structuring of a corporation in such a way that it pays less tax. The use of interest expenses to increase costs is one of the ways this could be achieved. Probable revision and adaptation: The “thin capitalization rules,” which are the rules to determine how much of the interest paid on corporate debt is deductible for tax purposes.
-The Holding Structure: It is a common practice to use a holding and/or intercompany structure of a corporation in such a way to allow for the most effective use of international tax treaties, in order to lower the taxation on dividends, what are known as “holding companies.” Probable revision and adaptation: Current participation exemption rules, which in most cases makes the dividends received from a subsidiary non-taxable on the level of the parent company.
-Intellectual Property Structure: It is a common practice to structure the stream of royalties and patents in such a way to make effective use of available tax treaties to lower the taxation on these types of income. Probable revision and adaptation: Limitation of benefits clauses, that is, the rules that govern to whom the treaty benefits of royalties and patents should apply and under what circumstances.
-Permanent Establishment: In international taxation, there are two principles based on which a country can claim the right to tax an income:
1) source, the region where an income is generated, and
2) residence, the locality where the taxpayer who generated the income lives. Probable revision and adaptation: The permanent establishment rules of international tax treaties that describe the conditions of when a country can claim the right to tax an income on the basis of source.
-Transfer Pricing: This the name for the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods is the transfer price. Probable revision and adaptation: Most likely, BEPS will lead to an increase of transparency and disclosure, whereby multi-national companies will be required to provide tax authorities with increased level of documentation on transfers pricing and advanced tax-ruling arrangements.
The tax-planning arrangements implemented by multi-national companies are based on the proper application of available legal tools. However, the perception persists that they are breaking the rules of the law. Unilateral or bilateral actions between countries will not solve this problem, as the rules could vary from one country to another. In addition, the international holistic and comprehensive approach, which is necessary to address the issue, is proving to be quite difficult to achieve.
Most of the parameters that make it possible are imbedded into bilateral tax treaties between countries. A concerted, coordinated effort by governments everywhere to revise the tax treaties they have with other nations to bring them into line with the goals of the BEPS and proper oversight from international organizations such as OECD are required to reduce and perhaps eliminate the practice of base erosion and profit shifting by multi-national corporations.