The impact of BEPS on tax compliance
Ronald van den Brekel and Tim Meijer analyse the compliance-related challenges which companies face, and how they can best allocate their resources to deal with them.
When the BEPS Action Plan was launched in July 2013, the OECD hinted at the purpose of these new measures and their potential impact on global tax compliance. While large multinational enterprises (MNEs) may have asserted that they are tax compliant today, this assertion may have to be reassessed due to the rapidly changing regulatory environment. An increased focus on tax and appropriate management of tax risks by tax authorities means MNEs will have to re-evaluate to what degree they comply with the tax rules of the countries in which they operate.
Based on the OECD recommendations in the final BEPS reports, many countries have started to make BEPS-driven changes to their domestic tax laws. Some Action Points will have an immediate impact on MNEs (for example, transfer pricing (TP) related topics, including Action 13 and Actions 8 to 10), while others require legislative changes to domestic tax laws or amendments of treaties in place (for example, Action 7).
Broadly speaking, the OECD's recommendations will have an impact on the tax compliance process in the following ways. Firstly, through Action 13, a re-examination of existing global TP documentation is needed. Action 13 is primarily aimed at enhancing transparency for tax administrations by providing them adequate information to conduct TP risk assessments and evaluate other BEPS related issues. The new three-tiered approach (master file; local file; country-by-country report) will not only provide tax administrations with more detailed information regarding the global value chain of a company, but will bring inconsistencies in both TP policies and the implementation thereof to the surface. The increased documentation requirements, as well as other new mandatory disclosure requirements (such as those described in Action 12), will empower tax administrations across the globe to scrutinise the allocation of profit that results from existing TP policies within MNEs.
Actions 8 to 10 will place more emphasis on significant people functions and their relative functional contributions to key processes within MNEs. There is a clear shift in focus from the legal form to the economic reality of a transaction. In cases where the economically relevant characteristics of a transaction are inconsistent with the contractual terms, the actual transaction should be identified based on the actual conduct of parties. Contractual allocation of risk without sufficient control will not be regarded as arm's-length behaviour, which has led to detailed guidance on analysing risks as an integral part of a functional analysis, including a new six-step analytical framework. In combination with the expansion of the definition of intangibles, this requires a thorough, two-sided analysis to determine which party to the transaction is entitled to the profits related to these intangible assets.
Lastly, the impact of Action 7 is that the threshold for creating a taxable presence for corporate income tax (CIT) purposes in a country is lowered, with inventory holding, warehousing functions and sales activities being particular targets. As some of these proposed changes are already being implemented in newly negotiated tax treaties, the lower permanent establishment (PE) threshold will, among other things, impact how organisations will have to manage, monitor and report on their globally mobile workforce.
BEPS impact assessment
The BEPS Action Plan represents a fundamental change in international tax law and in the way tax administrations operate and cooperate. This means that MNEs need to change the way they organise themselves internally to reflect these changes in the external environment. The first step for MNEs to prepare for the increased compliance requirements is to perform a BEPS impact assessment.
Based on the specific facts and circumstances of a company, the key attention points are identified, based on the materiality and complexity of the transactions. In addition, the assessment should identify the specific jurisdictions in which they are doing business and that may be affected by BEPS. Subsequently, a detailed analysis of potential country specific impact areas should be performed. One of the main elements of a BEPS impact assessment is to determine whether additional resources are required (internal or external) in order to gather and provide the required information (for example, to meet Action 13 requirements). Ultimately, the impact assessment should result in a transition plan covering all relevant impact areas.
Multinationals should determine which departments (and persons) will be responsible for preparation of the new global master file. Subsequently, through a gap analysis, the main differences as compared to the existing documentation need to be identified. One of the starting questions is the strategic consideration what information to include in the master file, and what information to include in the local file. Companies should ensure the documents provided to tax authorities around the globe are consistent. Therefore, coordination between different regions when preparing the documentation will become crucial. The new guidance provides MNEs with several options, but at the same time creates quite some ambiguity. Specifically, the first year of preparation of a master file is crucial, as companies will have to make deliberate choices. One of these choices is whether to prepare the master file for the organisation as a whole (that is, in one single report), or whether to structure the documentation per business unit (where necessary with cross-references to other documents).
Similarly to the master file, companies need to decide which people in the organisation will be responsible for preparing the local files, and assess what the main differences are compared to the existing documentation, both from a process and a content perspective. Attention should be paid to the increased level of transactional details required, and how the financial data used in applying the TP method may be reconciled to the annual financial statements. Furthermore, searches for comparables will need to be updated every three years, and financial data on the comparables will have to be updated annually. In addition, the local file needs to be consistent with both the master file and the country-by-country reporting.
Country-by-country reporting (CbCR) has received a significant amount of attention during the BEPS project. This is not just because it is a new filing requirement which mandates an unprecedented level of global tax transparency, but also because it is a matter of urgency for multinationals. Following the BEPS guidance, many countries have amended their domestic law requirements, some of which have already come into force on January 1 2016.
According to the recently published proposed EU Directive, CbCR will be mandatory for all countries in the EU as of this date, even when the country of the ultimate parent entity does not require CbCR. This means MNEs will have to assess, at short notice, whether there are any risks or anomalies in their operating models that will show up in the CbCR (and the master file and local file), as it takes time for the necessary changes to be implemented. The focus on compliance with the new requirements will not only come from tax authorities in the countries that have already implemented new documentation requirements; the party auditing the financial statements of an MNE will ask for BEPS proof documentation during the course of their 2016 audit in order to perform necessary risk assessments. To be best prepared for CbCR, MNEs need to realise that the impact of BEPS is broader than the tax function. As a first step, it is recommended that the (internal) CbCR team consists not only of representatives from the tax department, but also includes finance and IT specialists.
The process to produce a sustainable CbCR process can broadly be divided into three main phases:
Firstly, a high level risk and readiness assessment should take place to identify the availability of data and potential weaknesses in the tax structures or in control over certain (business) processes. An important element is to define early on in the process whether the tax and finance representatives agree on the data definitions required to eventually file the CbCR. Such a CbCR dry-run will, in our experience, likely produce 'spikes' in the data – some will be expected, and some will be more surprising. A true spike in the data simply reflects the reality of the operating model and tax structure. The dry run also enables you to identify so-called false spikes (for example, a year-end TP adjustment was erroneously booked in the wrong fiscal year). Based on all identified anomalies, a thorough mitigation plan and controversy strategy should be devised, including remediation of data issues.
Data collection process and impact on reporting systems
As aforementioned, global consistency between the various elements of TP documentation is important. The most logical way to achieve this is through a more centralised (global) coordination process. This starts with the data collection process, and the question of whether a company is capable of delivering globally consistent data. Multinationals should determine who is ultimately responsible for the data collection process. Ideally, the core CbCR team within MNEs will have tax, finance and IT capabilities.
Once the CbCR team is formed, one of the first steps is to jointly agree on the data definitions required for the CbCR process. There are often differences between the accounting entity hierarchy and the breakdowns necessary for CbCR. For example, consolidation systems frequently do not contain the results of sub-consolidations and, therefore, do not provide the detail by constituent entity necessary to compile the country-by-country aggregation. Similarly, at the entity level in the reporting system there may be embedded branches or PEs which will need to be broken down to provide data by jurisdiction.
As part of the assessment of the data collection process, a feasibility study of the existing IT and reporting infrastructure should be included in order to identify potential gaps in the existing systems. This study should link what kind of data (and from which sources) is required, and whether the existing reporting systems are ready to provide the required data. One of the key considerations is what sources of data to use (for example, group reporting GAAP, local GAAP or management reporting). In our experience, financial ledger data only will not be sufficient to produce a CbCR. Analyses early on in the process of the data definitions and of data availability are therefore important steps in planning for sustainable reporting.
In this phase, MNEs should assess how to design checks and balances to perform annual (global) reviews as well as monitor the CbCR process throughout the year, including how to 'certify' the input data for the CbCR filing. BEPS will increase the focus on financial data, where the bridge between consolidated figures and figures recorded in final tax returns will be increasingly important. Such reconciliation is not required for CbCR, but tax authorities most likely will ask for it during audits.
Furthermore, in the local file, the reconciliation between statutory accounts and TP policy will have to be included. Many MNEs first prepare their consolidation, then finalise their tax returns in a second stage, with any discrepancies being corrected in the following period. This might not be a best practice in the new 'BEPS environment'. The optimal position for the CbCR is to have system generated data without the need for manual offline workarounds. More (manual) workarounds will increase the risks of incorrect data. As tax authorities are becoming even more sophisticated in their ability to interpret data, tax functions within MNEs should probably be developing their own systems and processes. As an example, in order to timely identify potential anomalies, MNEs can monitor and test their CbCR output throughout the year, thus enabling corrective actions.
Processes and systems should be enhanced to develop a sustainable approach to reporting. Once the CbCR is finalised, it should be checked to ensure it is aligned with the facts and circumstances as described in the master file and local file. In this final phase, MNEs should also consider how to create an internal documentation audit trail, as some questions from tax authorities may only come in a couple of years from now.
Permanent establishments (PEs)
The impact of Action 7 will be that the threshold for creating a taxable presence for CIT purposes in a country is lowered. As a result, organisations will have to manage and report on their globally mobile workforce. The remit of the new guidance is not limited to traditional secondees, but includes short-term business travelers, employees within MNEs who hold global and/or regional roles and project workers, as well as individuals employed under central business models.
With changes to the definition of a dependent agent PE being proposed, the number of cases where individuals may create a dependent agent PE is likely to increase. This may impact activities performed by senior executives, contractors and sales representatives, among others. It will be increasingly important to be able to monitor and track the activities of the globally mobile workforce, not only to determine where they are physically performing their activities, but also to understand thoroughly the exact nature of their activities. The next step is to increase awareness of the so-called 'dos' and 'don'ts' in order to educate MNEs and their employees on what activities they can perform, and which activities they should steer clear of in order to avoid unwanted PEs.
Under the new PE guidance, globally mobile employees within MNEs will likely lead to (potentially significant) PE risks. Failure to manage appropriately these PE risks associated with mobile employees may result in additional reporting requirements, penalties for non-compliance, corporate tax exposure, reputational risk and increased scrutiny from tax authorities.
Transfer pricing (TP) compliance issues
Many countries are expected to follow the guidance of Action 13 when updating their domestic TP legislation. This could, in theory, lead to a convergence in TP rules across countries. However, the reports use fairly general and broad language, which on the positive side has allowed more countries to agree with the recommendations, but on the other side can lead to differences in interpretations by individual countries. A possible outcome could be that rather than greater cohesion and consistency between national tax regimes, instead, we may see inconsistencies leading to more controversy and dispute. In addition, some differences in implementation are already popping up (for example, some CbCR thresholds are in local currency as in Australia and UK), implementation dates differ, and additional exceptions may apply in specific instances, such as local file exemption for smaller companies in the Netherlands. To ensure that MNEs meet all the new local requirements, they should prepare a so-called dashboard to monitor compliance with local filing requirements across the globe. What may prove to be challenging in practice is that some countries will have informal requirements as well. Examples include jurisdictions that prefer local benchmark studies over regional ones, tax authorities that prefer to receive the documentation in local language, and more. All of these additional requirements and deviations from the main guidance may add to the complexity of meeting compliance standards in a timely manner.
The rapidly changing regulatory environment has, among other factors, led to implementation of new domestic TP legislation, which will likely lead to differences in interpretation by individual countries. Enhanced transparency measures in combination with new mandatory disclosure requirements enable tax authorities to scrutinise the allocation of global profits within MNEs. While tax authorities have become even more sophisticated in their understanding of TP issues, these new measures will be complemented by increased tax authority resources and new tools intended to increase taxpayer transparency. TP examinations have become more difficult and prolonged – a trend that is likely to continue.
More controversy expected
Fundamental changes and new rules subject to different local interpretation will create uncertainty for MNEs and, in all likelihood, lead to more controversy with tax authorities. This holds especially true in a transition period where countries may implement new rules at a different pace, and where part of the documentation that upon request may have to be provided to different tax authorities will be a translation of the document in original language.
In addition, the drive for increased transparency through automatic exchange of information (AEOI) will undoubtedly lead to more questions from tax authorities as they gain access to new sources of information, including CbCR. This, in turn, is likely to lead to more controversy. Lastly, when following the three-tiered documentation approach, additional details will need to be provided, especially in the local files, which may reveal some inconsistencies in the implementation of global TP policies.
Opposing views of tax authorities
Taxpayers are experiencing an external environment where tax administrations are facing demands to raise additional tax revenues as a result of the recent global economic downturn. In addition, through increased transparency, tax authorities have access to more information than ever before. In case this additional information leads to grounds for a different allocation of profits, such as in cases where a legal entity owning IP does not manage and control the key functions and risks, tax authorities may have opposing stakes in this discussion, which might increase disputes between tax authorities.
Structured controversy process
In order to be prepared in case of a tax audit, MNEs are advised to work on structured controversy strategies. Three main areas of attention should be addressed.
Firstly, in case of (local) tax audits, the division of responsibilities between central and local teams within MNEs needs to be clearly defined. To ensure consistency, it is advisable to have a communication protocol in place that requires local teams to inform the central team in a timely manner in a case of an audit.
Secondly, it is important to have a policy in place which determines who is responsible for gathering the relevant information in case of a tax audit, and who is in charge of monitoring timely submission.
Lastly, because of increased transparency between tax authorities, taking a position in one tax audit may have repercussions on other jurisdictions. Before taking such a decision, it needs to be clearly defined which persons with a holistic overview of the entire group are able to provide guidance, in order to safeguard an optimal outcome across jurisdictions.
As a result of increased regulatory uncertainty, advisers are experiencing a growing demand from MNEs for bilateral advance pricing agreements (APAs) in order to mitigate double taxation. In addition, Action 14 presents measures that aim to strengthen the effectiveness and efficiency of the mutual agreement procedure process in order to minimise the risks of uncertainty and unintended double taxation. They do so by ensuring the consistent implementation of tax treaties, including the effective and timely resolution of disputes regarding their interpretation or application through the mutual agreement procedure.
To manage controversy risk effectively, it becomes increasingly important for MNEs to design a robust controversy strategy, in which they develop a strategic approach to TP design, implementation, documentation, and defence. Being proactive can prove successful for limiting uncertainty, minimising the potential for significant controversy, and avoiding double taxation.
What lies ahead
As already witnessed in many OECD countries, the new BEPS requirements are being implemented in different ways and at a different pace. Whereas the initial aim was to achieve more uniformity, this may prove to be challenging, especially in the intermediate transition period. It is therefore important to thoroughly monitor which non-OECD countries will implement the BEPS guidance into their domestic laws. Furthermore, the proposed EU anti-BEPS Directive, published on January 28 2016, will greatly influence the implementation of BEPS guidance into domestic laws of EU countries. Measures proposed in the Directive represent a minimum standard, which means that some local jurisdictions may introduce even stricter rules. Further work on the Directive is currently still underway, which means the final version may differ from the one published in January. Notwithstanding this fact, it is clear that there is a lot of momentum to further combat potential base erosion and profit shifting, which will in turn lead to a growing compliance cost for MNEs.
The implications for MNEs on their global compliance process are vast. Through an initial BEPS impact assessment, MNEs at a minimum need to assess whether:
Additional resources (internal or external) are required to cope with the increased compliance cost;
Internal processes need to be changed, including governance (clearly defining central versus local responsibilities), data gathering and monitoring of local regulatory developments;
Re-examination of global TP policies and documentation may lead to a different allocation of profits;
The tax, finance and IT departments are ready for country-by-country reporting; and
The new guidance of BEPS Action 7 has created increased PE exposure.
The immediate impact of the BEPS Action Plan and increased transparency is that there will be more scrutiny from tax authorities and auditors regarding policies, implementation, and consistency. It is clear that a proactive BEPS impact assessment is a prerequisite for MNEs managing global tax risks, as time is quickly running out to remediate some of the inherent risks in their operating models.
Ronald van den Brekel
Tel: +31(0)88-407 9016
Ronald van den Brekel is leader of EY's transfer pricing practices in Belgium and the Netherlands. He advises multinational clients in various industries on transfer pricing planning and implementation and operating model effectiveness. He has ample experience in transfer pricing controversy, including negotiating unilateral and multilateral APAs.
Before joining EY, Ronald served at the Dutch Tax Administration (DTA). He has more than 20 years of experience as a tax inspector and tax auditor. From 2004 until 2009 he was responsible for transfer pricing within the DTA. He was part of the bureau of OECD's Working Party 6, the international rule-setting body with regard to transfer pricing, representing the Netherlands.
Ronald holds a graduate degree in accountancy from the Erasmus University of Rotterdam; a graduate degree in IT auditing from the Free University of Amsterdam and a graduate degree in tax economics from the University of Tilburg.
Tel: +31(0)88-407 2117
Tim Meijer is a senior manager in EY's transfer pricing & operating model effectiveness group in Amsterdam. He has more than 10 years of experience at EY in managing transfer pricing and OME projects, and their implementation.
Tim has significant experience in designing, implementing and documenting global transfer pricing policies and models for large and medium-sized multinational companies. He also has broad experience in designing multi-country centralised business models and business restructuring projects as well as, in controversy cases, APA procedures and MAPs.