02.26.2013 Looking into the Crystal Ball: The OECD report Addressing Base Erosion and Profit Shifting
BY: GREGORY T. BRYANT
On February 12, 2013, the Organization for Economic Cooperation and Development (the “OECD”) published its 93-page report, “Addressing Base Erosion and Profit Shifting” (the “Report”). Drafted at the request of the G20 in their November 2012 meeting in Mexico, the Report is currently being discussed at the February 2013 meeting of the G20 in Moscow. The Report finds that multinational entities (“MNEs”) are manipulating tax rules to reduce or eliminate taxation of profits. The Report concludes that, although technically legal, these tax practices often cause inappropriate and unfair outcomes.
The OECD proposes to develop an initial comprehensive action plan dealing with the issues raised in the Report. The plan will be presented to the OECD’s Committee on Fiscal Affairs at its next meeting in June 2013.
The Report generally acknowledges that “current international tax standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of the digital economy.” The Report also reflects a growing suspicion that transfer pricing rules are being used to achieve base erosion.
The Report concludes that, in addition to a need for increased transparency on effective tax rates of MNEs, “key pressure areas” include those related to:
- International mismatches in entity and instrument characterization, including hybrid mismatch arrangements and arbitrage;
- Application of treaty concepts to profits derived from the delivery of digital goods and services;
- The tax treatment of related party debt-financing, captive insurance and other intra-group financial transactions;
- Transfer pricing, in particular in relation to the shifting of risks and intangibles, the artificial splitting of ownership of assets between legal entities within a group, and transactions between such entities that would rarely take place between independents;
- The effectiveness of anti-avoidance measures, in particular GAARs, CFC regimes, thin capitalization rules and rules to prevent tax treaty abuse; and
- The availability of harmful preferential regimes.
Glimpsing into the future is not too difficult in this case. As stated on pages 52-53 of the Report, the OECD tells us that the different components of the action plan will include proposals to develop:
- Instruments to end or neutralize the effects of hybrid mismatch arrangements and arbitrage;
- Improvements or clarifications to transfer pricing rules to address specific areas where the current rules produce undesirable results from a policy perspective (the current work on intangibles, which is a particular area of concern, would be included in a broader reflection on transfer pricing rules);
- Updated solutions to the issues related to jurisdiction to tax, in particular in the areas of digital goods and services (these solutions may include a revision of treaty provisions);
- More effective anti-avoidance measures, as a complement to the previous items. Anti-avoidance measures can be included in domestic laws or included in international instruments (examples include general anti-avoidance rules, controlled foreign companies rules, limitation of benefits rules and other anti-treaty abuse provisions);
- Rules on the treatment of intra-group financial transactions, such as those related to the deductibility of payments and the application of withholding taxes; and
- Solutions to counter harmful regimes more effectively, which also would take into account such factors as transparency and substance.
Get ready for more transparency and pressure on transfer pricing. Migrations of intangible property will become more controversial. MNE’s need to be aware that substance is necessary, meaning people in places doing meaningful things. In addition, obtaining up-to-date documentation for transfer pricing is good risk management.
The digital economy will continue to innovate much faster than tax policy, but in the end all successful business models generate cash. MNE’s need to have a strategy for explaining why the cash flowed to the ultimate recipient. Building the foundation to support your outcome requires a lot of forethought, and will need to be supported by business transactions.