The impact of BEPS on financing and treasury
Shaun Lucey and Ariana Kosyan provide a comprehensive review of the way financing and treasury functions will be affected by Actions 2, 4, 5, 6, 8, 9, 10, 13 and 15 of the BEPS Project.
Financing and treasury (F&T) is a significant part of the OECD's BEPS work, and is represented in eight of the 15 Action reports: • The level of return that a lender is entitled to under transfer pricing (TP) principles as governed by Actions 8 to 10;
The introduction of double taxation treaty anti-avoidance through the Action 6 and Action 15 reports;
The cataloguing of international tax arbitrages in the Action 2 report, and a pathway for a domestic legislator to tackle these;
Internationally coherent approaches to interest caps in the Action 4 report;
Tackling harmful tax regimes through Action 5; and
The documentation of significant F&T transactions in the master and local files recommended in the Action 13 report.
There is an underlying theme in tacking F&T BEPS, which is the lack of coherence of tax legislation in different countries. The thorny question is that, if tax law is made by domestic legislators, and approved by domestic governments, is it reasonable to expect territories to apply legislation consistently and coherently?
Transfer pricing guidelines-based implementation
The impact of Actions 8 – 10
From both a coherence and immediate impact perspective, this is the most significant part of F&T BEPS, as many territories automatically bring the transfer pricing guidelines (TPGs) into their domestic legislation. Our experience is that some tax authorities are approaching open enquiries as if the Action 8-10 report is a 'clarification' of the previous TPGs. It is definitely not this; it is a shift, and a fundamental one for F&T.
Actions 8-10 are aimed at developing TP rules to create TP outcomes in line with value creation. Specifically, Actions 9 and 10 target arrangements between associated companies which, in the mind of the OECD, enable BEPS by allowing inappropriate returns as a result of risk transfer, or an allocation of excessive capital to a group member, or by engaging in transactions that would only very rarely or never occur between third parties. If rules in line with the recommendations of BEPS Action 8-10 are adopted in local law (which in many countries will happen automatically), they will have a significant impact on the TP of both intra-group financial transactions and of financial entities.
The standard practice in most countries is to follow the contractual arrangements regarding the allocation of risk. What the OECD is suggesting is that tax authorities undertake a shift towards a world in which an overlay to contractual arrangements is postulated based on the ability of and conduct of companies in relation to the control of risk. It can be expected that this will lead, in the short to medium term, to a great deal of confusion as different tax authorities interpret this overlay differently.
The updated TPGs focus on economically significant risk (ESR). According to the OECD, the significance of an ESR depends on the likelihood and size of the potential profits or losses arising from the risk and can be determined as a result of a broader functional analysis of how F&T value is created in a group.
The Action 8-10 reports suggest that once ESRs have been identified, it should be established which entity controls them. Controlling the risk requires having the capability of making decisions on taking or declining of an ESR bearing opportunity and on responding to the ESR together with the actual performance of that decision-making. If the entity contractually assuming the ESR does not control it or does not have the financial capacity to assume it, the ESR should instead be allocated to the group entity which factually does so. Where multiple entities exercise control over ESR and have the financial capacity to assume it, the ESR should be allocated to the entity (group of related entities) exercising the most control.
The TP treatment of capital-rich companies which fund risk-taking opportunities but have little other relevant economic activity (referred to as 'cash boxes') may be strongly affected. It is suggested that if such an entity does not demonstrate the control wished for by the OECD over its ESRs that the company exercising such a control has the right to collect the risk premium, and the cash box would be entitled to a risk-free capital return. This is one of the most difficult areas in respect of Actions 8-10, namely the suggestion that by operating a relatively low-activity company in a different manner could have a dramatic impact on return entitlement. This transfer pricing approach pierces the corporate veil, and is likely to create a great deal of confusion as different practitioners and tax authorities interpret it differently It could also lead to double taxation and almost certainly increased controversy.
Many multinational enterprises have companies which undertake only financial activities. The transactions they are involved in may range from the provision of simple loans to more complex funding or the provision of guarantees, hedging and cash pooling activities. In the increasingly globalised business models of multinational companies leading to matrix management it, may be challenging to locate the person(s) actually exercising control over ESR as well as their location, which may sometimes deviate from the entity engaged in financing activities. These cases may become a target of Actions 8-10 along with cash boxes.
Given the far-reaching consequences of the Actions 8-10, groups should review their financing arrangements to ensure they are compliant from the TP perspective of the payer of financial payments, the recipient, and the recipient's parent jurisdiction. Groups will need to monitor the approach of tax authorities in this area very carefully to understand the diversity of likely interpretations. It is surprising that, whereas most of the interest related actions promote and are designed to achieve coherence, an impact of Actions 8-10 could be less coherence – in the short to mid-term, at least.
The impact of Actions 6 and 15
Many jurisdictions levy withholding taxes on financial payments to protect their tax bases. In international financing arrangements, treaties generally promote the cross border flow of money through reducing these withholding taxes. Action 6 poses the question of whether bilateral tax treaties are being used by companies in the way that they were intended, and suggests that either a principal purpose test (PPT) or limitation of benefit (LOB) clause should be introduced into existing treaties to counter avoidance.
Action 6 also suggests draft amendments to the model treaty whereby the interest article (and other income articles) are restricted so as to only apply where the interest income is fully brought into account.
To ensure consistency and coherence it is suggested that a multilateral instrument would directly implement the treaty-related measures. The aim is to finalise this instrument and to open it for signature by December 31 2016, sign up to the multilateral treaty will be optional.
In general, these developments will create more incentives for source countries to start scrutinising financial payments made from their jurisdiction. The combined impact of Actions 6 and 8-10 will create a far more uncertain environment for cross-border financial payments, whereby the application of treaties and determining the beneficiary of financing profits may be open to alternative interpretations by different taxing jurisdictions.
This new lack of coherence may well lead in some cases to double taxation, and groups may need to redesign their F&T arrangements so as to minimise these risks. In particular as the positions of different tax authorities become clear, it may be that F&T arrangements become tailored to particular countries, rather than generic, as they largely are now.
The impact of Action 2
One of the fundamental principles of tax law in most jurisdictions is the deductibility of interest expenses for tax purposes where there are sound business reasons for this expense. The types of instruments or constructs that give rise to borrowing arrangements vary hugely depending on the circumstance of a particular group. As tax laws are different in each territory, there is no consistent approach to the taxation of borrowing arrangements. In the Action 2 report, the OECD postulates that this has created opportunities for groups to transfer profits from one jurisdiction to another through the use of interest deductions and other financial payments.
The OECD has demonstrated in the Action 2 report a detailed knowledge of the lack of coherence between different country tax systems in this area (283 pages of examples). Its approach provides a way for each territory to legislate on a consistent basis so as to create coherence in this area.
At its heart, Action 2 requires a country to take into account the position of the taxpayer in the other country, and its tax treatment. To many countries' tax legislators this is an alien consideration. They are concerned about the protection of their own tax base, so determining the tax treatment in their own country based on the treatment in another is traditionally something which has been shied away from.
It will be very interesting to see the extent to which different countries take this work on board. At the time of writing only the UK has published draft legislation to take forward the work in Action 2 into its domestic rules, to be effective for tax years beginning from January 1 2017. Territories such as France and Mexico introduced 'half-way house' rules during the OECD work, and it will be interesting to see whether they upgrade their legislation to be more detailed and in line with the OECD's Action 2 final report.
An interesting development within the EU Commission is the proposal for an Anti-tax Avoidance Directive, issued on January 28 2016. The key thrust behind this draft directive is that the Commission believes that international tax avoidance can only be tackled by coherent action on behalf of its member states. The directive in many ways goes further than the OECD work on BEPS. However, in the area of F&T, its recommendations largely accord with the OECD's Action 2 and Action 4 work. It will be interesting to see whether the EU member states will be able to agree on such a directive, as unanimous consent is required for a directive to become effective.
The impact of Action 4
In its report on Action 4, the OECD provides for a collective international approach to limit base erosion involving interest deductions and other financial payments. The recommended approach ensures that an entity's net interest deductions are directly linked to its level of economic activity through the introduction of a fixed ratio rule based on taxable earnings before deducting net interest expense, depreciation and amortisation (EBITDA). In addition, a group ratio escape is introduced to align the deductible interest expense with the group's consolidated external net interest expense. A country may choose not to introduce the group ratio rule, but in this case it should apply the fixed ratio rule to multinational and domestic groups without improper discrimination.
Due to the generic nature of the proposals, almost all groups would be impacted in one way or another as Action 4 would provide an overlay on what is an acceptable borrowing cost from both an internal and external perspective. If the external borrowing strategies of groups lead to non-deductible financing costs under Action 4 it will be interesting to see whether groups will adopt different strategies, such as borrowing externally into different entities.
Further technical review will be conducted by the OECD, which should be completed by the end of this year. So far, there are limited signs of jurisdictions replacing or supplementing their existing anti-abuse rules in relation to interest deduction with the Action 4 recommendations. Germany already has an Action 4-type measure in place. The Netherlands, meanwhile, has indicated that it will only support Action 4 on a coordinated basis, such as in an EU context.
As suggested above, the EU's Anti-tax Avoidance Directive may also become important here. However, as with Action 2, it can be questioned whether countries will achieve consensus on the application of these rules due to different starting points, which is resembled in the wide variety of interest deduction limitation rules currently in place. It may be possible that (part of) the rules become optional. A country which has signalled the possible implementation as a result of initiating a consultation process on an Action 4-type rule is the UK.
The impact of Action 5
In Action 5 the OECD touches upon preferential tax regimes. In essence, the outcome of Action 5 is that preferential tax regimes require substantial activities. The OECD follows a so-called 'nexus approach', which requires that the economic activities are located in the same jurisdiction that provides the tax facility for these activities. Although the nexus approach is developed in the context of IP regimes, the same principle should apply to other preferential tax regimes, like financing regimes.
It can be expected that the nexus approach will become increasingly important over time, which is strengthened by an increase in transparency. Transparency is also a part of Action 5. In the report, a framework for the spontaneous exchange of rulings, which following the OECD could give rise to BEPS concerns, is provided. The spontaneous exchange will include rulings on financing structures that may be considered preferential and might not be considered in line with the nexus approach. This increase in transparency may result in more scrutiny towards existing financing arrangements and it can be expected that, over time, jurisdictions will act on this by closing down perceived loopholes.
Many jurisdictions have expressed their support towards the nexus approach and jurisdictions such as the UK, Luxembourg, Switzerland and the Netherlands have announced amendments to their IP regimes. In the field of transparency, the EU has taken a leading role with the 'transparency package', which was proposed by the European Commission in March 2015. As part of the package, a directive regarding the mandatory automatic exchange of information on tax rulings was agreed upon in October 2015. As of January 1 2017, EU member states will be required to communicate summaries of cross-border tax rulings and advance pricing agreements to all other EU member states and, within certain limitations, to the Commission itself.
The impact of Action 13
Action 13 contains provisions within the master file and local file for the documentation of significant inter-company F&T transactions, and the provision of rulings or agreements covering F&T. This Action is dealt with in a separate article but it is clear that due to its likely wide adoption by OECD states that F&T transactions will be available for inspection by multiple territories. It is therefore paramount that groups carefully and clearly document their F&T policies in anticipation of this, so as to reduce any follow-on controversy.
Tel: +44 (0) 207 951 2567
Shaun is a partner in EY's international tax services practice, based in London. He is a chartered accountant and holds a doctorate in theoretical physics.
His role is split between client work and leading our tax desk programme in EMEIA. During his 18 years of tax work he has spent much of that time advising clients on their international financing transactions, and as a consequence is the leader of our EMEIA finance and treasury tax services offering in the international tax space.
Tel: +44 (0) 207 951 0578
Ariana Kosyan is a senior manager with more than 10 years of experience in transfer pricing. She is based with EY's financial services transfer pricing practice in London, on a secondment from EY's transfer pricing practice in Dusseldorf, Germany.
Ariana is a co-founder of EY's global treasury transfer pricing initiative, which has created a network of EY tax and transfer pricing professionals around the world focusing on financial transaction analyses. The initiative aims to improve knowledge and experience sharing and develop best practices as well as aligned and consistent approaches for analysing intra-group financial transactions across numerous jurisdictions.
Ariana closely cooperates with providers of data and analytical tools in order to develop optimal transfer pricing solutions using all available capacities of external databases.
Ariana is a regular speaker at tax and transfer pricing events and conferences. She is an economist and holds the chartered financial analyst designation.