First automatic CbC report exchanges to trigger tax authority risk assessments
Alison Lobb and Christa Silverthorne of Deloitte take a look at the practical steps for large multinational groups to manage global tax authority enquiries following the automatic exchange of country-by-country (CbC) reports.
The first government-to-government exchanges of CbC reports were due by June 30 2018 (six months after the first filing deadline and reducing to three months after filing thereafter).
As acknowledged by Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, one of the main benefits of the CbC report regime is the “deterrent” effect it has because profits in low tax jurisdictions that are not supported by people functions will be more easily identifiable and subject to tax authority scrutiny.
However, with 57 jurisdictions having implemented the G20/OECD minimum standard for CbC data for the December 2016 reporting period, the expectation is that exchanges of CbC data will lead to an increase in tax authority audit and enquiry activity.
Whilst many groups have spent considerable time understanding the requirements to prepare their CbC reports, some tax authorities will be considering the data for the first time when they receive reports via exchange. With such high volumes of data, some tax authorities will seek to balance risk with compliance activity to allocate their limited resources and meet the objective to reduce the burden on lower-risk groups.
The OECD identified indicators of possible tax risk across two scenarios:
Entities engaging in recurring transactions that have the potential to erode a country’s tax base over time; and
Large or complex one-off transactions.
An important first step that multinational groups can take in preparing for potential questions from tax authorities is to consider the protocols in place to ensure the appropriate use of CbC data.
To obtain a copy of the CbC report, a country will have entered into a multilateral or bilateral competent authority agreement. These agreements outline that use of CbC reports should be limited to “assessing high-level transfer pricing, base erosion and profit shifting related risks, and where appropriate, for economic and statistical analysis”. Transfer pricing adjustments are not to be calculated based on the CbC data and any tax authority undertaking such activity will have adjustments overturned in competent authority processes and may face exclusion from receipt of future CbC reports. The CbC data is designed to be used in conjunction with other information available to the tax authorities, including transfer pricing documentation, tax returns, and statutory accounts.
It is permissible for tax authorities to ask further questions based on the CbC data. Therefore, a potential next step for MNEs is to consider the types of questions that might arise from the CbC data.
Tax authorities have been provided with some assistance by the OECD in the form of a handbook (Handbook on Effective Tax Risk Assessment – September 2017) that also provides useful insight to multinationals on the suggested methods for a tax authority to incorporate CbC reports into their tax risk assessment processes.
The handbook suggests that some tax authorities will look to use the CbC data to filter out some groups to reduce the population for which they may then wish to undertake a more comprehensive manual or automated risk assessment process. Also provided are a set of 19 potential tax risk indicators (see box) to help in risk assessment.
19 potential tax risk indicators:
The footprint of the group.
Only low-risk activities in a jurisdiction.
High related-party revenues in a jurisdiction.
Key financial ratios deviate from comparables.
Results not reflecting market trends.
Significant profits vs. activity in a jurisdiction.
Significant profits vs. low levels of tax in a jurisdiction.
Significant activities vs. low level of profit in a jurisdiction.
Activities that pose a BEPS risk.
Mobile activities in a low tax rate jurisdiction.
Changes to the group’s structure.
IP separated from related activities.
Marketing activities located outside key market for the group.
Procurement activities outside manufacturing locations.
Income tax paid lower than income tax accrued.
Dual resident entities.
Entities with no tax residence.
Inconsistent information with that previously provided for an entity.
Comparing the potential risk indicators to identify ‘patterns’ is encouraged to help identify a higher or lower level of tax risk. The handbook suggests three possibilities: using the group’s current year report and comparing it across countries, using the group’s reports from the current and prior years, or by comparing the current year report with a ‘typical’ group in the same sector. For the latter comparison, the tax authority would be required to compile a set of appropriate benchmarks, which would have certain comparability limitations such as functionality, group strategy and business models. It seems more likely (and logical given the policy objectives of CbC reporting) that to begin with a tax authority would compare a group’s profile with other information available about the group.
As an additional step in predicting possible future questions, groups could also consider the CbC relevant challenges faced by tax authorities. The handbook provides some thoughts on the challenges, including:
Dealing with the volume of data, the need for systems and training for tax authority staff;
Consistency of data across groups and year-on-year;
Differences in interpretation of CbC guidance by jurisdictions and MNE groups (including the options available to groups in preparing their CbC report); and
The presentation of financial data by country rather than activity.
Overcoming these challenges will take time and resources. Questions raised in the first instance are likely to be quantitative and based on financial ratios performed on the group’s data, rather than derived from multiple indicators or from comparison with external data.
Perhaps the best course of action for preparing for potential tax authority enquiries on the first CbC report would be to analyse the group’s CbC data for the key financial ratios identified in the handbook and understand any patterns presented. Then for groups looking to be further prepared, comparisons between the financial analysis and the remaining tax risk indictors could be made.
Preparation of a group’s second CbC report presents an opportunity for better understanding the data collection process and the links with data from other sources.
It is a time to take stock of the process and identify and remediate any challenges faced with obtaining the data or compiling the first report. More thoroughly understanding data sources would also be a useful step for groups to prepare for future queries. In addition, analysing the second year report against the first using the 19 tax risk indicators will provide the opportunity to get ahead of the queries and document responses whilst the information is fresh to the preparers.
Preparing a CbC report presented a perhaps much larger challenge to groups than the G20/OECD participating jurisdictions anticipated. Tax authorities now face a similar challenge with the receipt of CbC data from large and complex businesses across the world. Although countries will progress at different speeds and will adopt unique processes for analysing the data, it is a reasonable expectation that the number of tax authority queries will increase due to CbC reporting. Taking a practical approach will help groups prepare for and efficiently manage this possibility.