US: What multinationals can expect when BEPS dust settles
Joel Williamson, Charles Triplett and Jason Osborn of Mayer Brown
On February 12 2013, the OECD published its report on Addressing Base Erosion and Profit Shifting (the BEPS report). The BEPS project is remarkable due to its backing by the political leaders of the world's largest economies. It was commissioned by the G20 in 2012 as these governments scramble to preserve and recover corporate tax revenue, which declined sharply during the down economy years, from 3.8% of OECD members' combined GDP in 2007, to 2.9% of GDP in 2010. Beginning with the bold statement that "[b]ase erosion constitutes a serious risk to tax revenues, tax sovereignty and tax fairness for OECD member countries and non-member countries alike," the BEPS report identifies a number of key pressure areas where multilateral action may be needed. These include:
Hybrid entities and instruments;
Application of treaty concepts to the digital economy;
Tax treatment of related party debt financing, captive insurance and other intra-group financial transactions;
Transfer pricing, particularly with respect to the shifting of risks and intangibles;
Effectiveness of anti-avoidance measures, including general anti-avoidance rules (GAARs), controlled foreign company (CFC) regimes, thin capitalisation rules and rules to prevent treaty abuse; and
Harmful preferential regimes.
A common denominator underlying each of these pressure areas is double non-taxation, which, according to the BEPS report, occurs when gaps in the interaction of different domestic tax systems result in an item of income not being taxed anywhere.
The essence of this perceived problem is not flaws in any single country's tax system, but, rather, how multinational enterprises are able to exploit differences between individual countries' tax systems. Given the fundamentally multilateral nature of the perceived problem, it is no surprise that the OECD is now calling for a new era of international collaboration and coordination.
To this end, the BEPS report called for the development of a comprehensive, coordinated action plan addressing each of these key pressure areas. This action plan was presented to the G20 Finance Ministers and Central Bank governors at their July meeting in Moscow, and will be presented to the political leaders of the G20 at their September summit in St. Petersburg.
The specific actions that governments might take in response to the BEPS action plan are likely years away from implementation. And while we are reticent to speculate on the specific changes that the future may hold, there are nevertheless a number of general trends in tax policy and tax administration that might take shape as the BEPS dust begins to settle.
First, there will likely be an increased focus by policymakers and tax administrators on the worldwide taxes paid by multinationals. The perceived problem of double non-taxation may make for strange bedfellows among the world's tax authorities, which are otherwise accustomed to acting as adversaries in vigorous pursuit of the interests of their own fiscal authorities.
While we will continue to see the classic situation of two or more governments haggling over which gets the larger slice of the corporate income tax pie, we will also increasingly see governments working together to recapture any unclaimed slices. The G8 leaders' recent communiqué released on June 18 is particularly noteworthy in this regard, as it signals that fundamental change in how the world's tax authorities view their responsibilities to each other is now at hand:
"We agree to work together to address base erosion and profit shifting, and to ensure that international and our own tax rules do not allow or encourage any multinational enterprises to reduce overall taxes paid by artificially shifting profits to low-tax jurisdictions."
The words "overall taxes" are particularly significant because they imply an unprecedented commitment by the G8 governments to police both domestic and foreign tax avoidance by the multinationals under their taxing jurisdiction. While this may lead governments to address perceived holes in domestic tax systems that have been viewed as enabling foreign tax avoidance through policy changes, it also portends a rapid acceleration of the current trend towards more cooperation among tax authorities through means such as exchange of information and joint audits.
Second, as governments increase their efforts to crackdown on double non-taxation, we can expect to see the mutual agreement procedure (MAP) of income tax treaties take on a new importance.
Efforts to eliminate double non-taxation, whether focused on jurisdiction to tax (permanent establishments), transfer pricing, or the characterisation of entities and instruments, invariably increase the risk of double taxation. It is simply not possible to close the gap between domestic tax systems that allow some income to go untaxed without creating overlaps where income may be taxed twice. As the incidence of actual and threatened double taxation increases, the world's competent authorities will rise to a new level of prominence as they become the final decision-makers in an increasing number of cases that cannot be satisfactorily resolved under domestic procedures.
Third, in the transfer pricing area, we can expect to see a continued and growing focus on the substance of intercompany risk allocations and transfers of intangible property, but no fundamental change in the arm's-length principle.
According to the BEPS report, transfer pricing arrangements often raise thorny questions, among which are "the level of economic substance required to respect contractual allocations of risk, including questions regarding the managerial capacity to control risks and the financial capacity to bear risks."
While governments may never reach a full consensus on such thorny questions, the debate is still largely focused on how the arm's-length principle can be strengthened and/or supplemented through backstop approaches such as enhancements to CFC regimes. Non-arm's length alternatives such as formulary apportionment are not under serious consideration by the OECD.
Consequently, typical arrangements such as cost sharing, contract R&D and licensing, that multinationals have relied upon for decades to align legitimate tax and non-tax business objectives should remain viable, provided that they are structured in a way that meets the heightened post-BEPS standards for economic substance. The biggest beneficiaries of these possible changes may be the fiscal authorities and economies of countries that are able to offer multinationals both relatively low tax rates and strong non-tax incentives to locate significant functions and economic activities within their borders, such as Ireland, Switzerland and Singapore.
Fourth, we expect that the pain of post-BEPS policy changes will not be felt uniformly across industries. Industries that derive most of their income from more mobile sources, such as the exploitation of intangible assets and/or sales activities that are difficult to pinpoint to a particular geographic location, have long had both the incentive and ability to reduce their effective tax rates (ETRs) through the types of legitimate international tax planning that are now under the microscope of BEPS.
In contrast, industries characterised by extensive fixed assets, correspondingly fewer intangible assets, and sales activities that occur in locations that are easy to identify have always had fewer international tax planning opportunities. While exceptions abound for many reasons, these old economy industries generally tend to have higher ETRs that may approach the statutory tax rates in their respective jurisdictions. As such, they potentially stand to benefit from potential post-BEPS policy changes – such as the various corporate tax reform proposals concurrently under consideration in the US – that would combine base-broadening measures to address the BEPS key pressure areas with lower statutory tax rates.
While we can predict with some confidence a number of general trends that multinationals can expect to see in the post-BEPS world, the details of the specific policy changes that will likely be implemented on a national and international level remain largely a guessing game. With so much uncertainty surrounding the changes looming on the horizon, multinationals should engage in watchful waiting. Flexibility and openness to future change will serve multinationals well, but rash immediate action should be avoided in recognition of the reality that specific changes in the law may be years away from being implemented.