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July 22, 2013
News Analysis: OECD BEPS Action Plan: Trying to Save the System
by Lee A. Sheppard

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By Lee A. Sheppard -- lees@tax.org

The OECD Centre for Tax Policy and Administration released its action plan to deal with base erosion and profit shifting (BEPS) last week. As predicted, it is a multifaceted attempt to shore up the current international consensus of separate company accounting and transfer pricing.

Around here, your correspondent has never had much good to say about the current system, which is moribund and doesn't deliver a fair share of business income tax revenue to affected countries. But the action plan is a good-faith effort to save the current system, and with it, the OECD's reputation.

"It's a way to save the international standard. If not, chaos," said Centre head Pascal Saint-Amans at a July 17 press briefing on the action plan. Après moi, le déluge? Seems overstated, but to multinationals, the word chaos merely means aggressive auditing based on heretofore unacceptable theories. That is already happening.

In lawyers' terms, the action plan represents exhaustion of remedies. If the current international consensus is to be salvaged, then some deep thinking about issues like permanent establishment is required. The action plan recognizes that reality. The OECD cannot be accused of being myopic. Much as they cling to the current system, the drafters understand that serious problems have to be addressed, and quickly.

Topics addressed in the action plan are bolded in this article, which are not presented in the same order as the plan. The action plan itself is written for nonspecialists, so it may strike many readers as superficial.

The OECD works by consensus, and the action plan widens the consensus group to include India and China, which wanted the plan to go further than base erosion and toward restoration of source taxation. The action plan treats all members of the G-20 equally, even though many of them, like India and China, are not OECD members. Thus the mostly European organization recognized that the United States and Europe can't boss the world's tax system anymore.

At the briefing, reporters professed bafflement that European tax havens had signed on to the plan. Surely someone's ox will be gored? Saint-Amans explained that Switzerland, Ireland, and the Netherlands are OECD members, and that they support the action plan.

The larger European havens were not fingered in the OECD's 1998 harmful tax practices project, which was unceremoniously killed by the United States. The action plan would resurrect this project. It is not the only dubious OECD project that is implicated by the action plan, which shows the organization's lack of progress on several long-standing problems.

Saint-Amans noted that the OECD plans to look at patent boxes, which have recently been adopted by some European countries. The income tax rate for royalty income on offer in some of these schemes indicates that they are intended to prevent residents from fleeing more than attracting newcomers.

The plan observes that the problem of preferential regimes has not been ameliorated in the 15 years since the project was started. The islands of Great Britain have joined the list of sad, desperate tax haven countries with lousy beaches. The action plan identifies across-the-board corporate rate reductions as harmful. No prizes for guessing which countries insisted on that.

The plan mentions requiring substantial activity for access to a preferential regime. Presumably that would be enforced by the taxpayer's country of residence, not the haven itself (some European havens are asking for boots on the ground). Paragraph 19(b) of the OECD model commentary on article 1 suggests a treaty clause requiring substantial business activity as a condition of treaty benefits. The European Commission might have a better idea -- don't sign treaties with havens.

Procedural Proposals

Indeed, the most creative proposals in the plan are procedural, or in the words of Saint-Amans, "horizontal." The OECD proposes to make existing bilateral OECD model treaties ambulatory by creating a multilateral treaty amendment document akin to the International Swaps and Derivatives Association master swaps agreement.

Rosbif tax haven? The beach at Blackpool, England. The OECD action plan identifies across-the-board corporate rate reductions as harmful. (iStockphoto.com)Signatories will automatically accept amendments and treaty interpretations contained in the document for their in- force treaties. That way, they will not have to renegotiate them to get the latest interpretation -- a painful process.

Yes, OECD commentary was supposed to have an ambulatory effect, but it doesn't. Some countries, including the United States, treat their treaties as static -- frozen in time on the date of signing. New additions to the commentary are not used to interpret them. Other countries don't give legal effect to the commentary regardless of timing. The use of commentary in court is controversial in some places. So having countries using the treaty sign an ambulatory document will give force to newly accepted interpretations.

The multilateral agreement is also a welcome signal that the OECD does not regard the model treaty as graven in stone and is willing to change it. The action plan states that the OECD is open to changing the definition of permanent establishment -- an important and much-abused limitation on source country tax jurisdiction.

European governments that asked for the BEPS project wanted a multilateral approach. They're already free to scour their laws for attractive nuisances on their own, although the action plan recognizes they need help in that area.

The other horizontal feature was predicted. The United States succeeded in shunting questions about tax jurisdiction over digital economy providers to a study on the view that these issues are not germane to income shifting (although some digital economy providers are no slouches at that, either). The OECD will form a task force on PE issues for the digital economy, which is expected to produce a report within a year.

If PE is to be opened up, then why not a services PE clause, which could have the same effect as an economic presence test? The OECD model commentary grudgingly blessed an optional services PE clause a few years ago (paragraph 42 of the commentary on article 5). Some countries have services PE clauses based on the U.N. model that do not require that the service provider's personnel be present in the source country to provide services. Services provided from outside can be taxable. (Prior analysis: Tax Notes, Nov. 5, 2012, p. 583.)

Companies whose business models involve no physical presence but heavy interaction with local customers -- whose freely uploaded information they sell to advertisers -- have been in the sights of tax administrators in France and other countries. None of them pay much tax to customer countries. The action plan promises to take a holistic approach that will consider both direct and indirect taxation.

The reference to indirect taxation refers to VATs, and also the French proposal for a byte tax on customer uploads or alternatively a PE defined by user creation of content. The action plan notes that a customer upload is a form of value creation, echoing the French report on the subject. (Prior analysis: Tax Notes, Apr. 22, 2013, p. 364.)

Businesses demanded that the mutual agreement procedure be beefed up, and the OECD is anxious to mend relations with them. The OECD will look at obstacles to the use of MAP to resolve bilateral cases.

Hybrids

The action plan proposes to put the hybrid problem in a treaty amendment, perhaps something akin to a subject to tax clause, and model domestic laws. On the one hand, hybrids are a huge problem, but on the other, countries are asking the OECD to rescue them from their own folly.

The hybrid problem encompasses both instruments and entities. Instruments are treated as debt in the country of the issuer, which claims an interest deduction, and equity in the country of the holder, where a dividend exemption is claimed for the interest payment.

Hybrid entities are usually a product of the U.S. check-the-box rule, which is not mentioned in the action plan (reg. section 1.7701-3). They are usually treated as corporations in their country of residence, where expenses are deducted, and as a passthrough or disregarded entity in the United States. Yes, the United States leads the world in tax planning.

But the rest of the world doesn't have to put up with U.S. entity characterization. If a Danish resident hybrid entity is disregarded in another country, Danish law prohibits deduction of the entity's payments in that jurisdiction (section 2A of the Danish Corporate Tax Act). If a group member -- Denmark has comprehensive combination rules -- receives exempt income, it may be disregarded and payments made to it nondeductible. (Prior analysis: Tax Notes Int'l, Apr. 9, 2012, p. 169.)

Domestic law changes would be superior to a treaty clause for two reasons. First, most hybrid problems can be solved by ridding domestic law of attractive nuisances. Sadly, the use of a certain business form or instrument by multinationals provides a ready guide to which provisions constitute attractive nuisances. Countries that leave easily abused provisions in their laws are contributorily negligent.

Doubtless European countries would not regard their universal dividend exemption as an attractive nuisance. But treatment of debtlike equity instruments as debt is a domestic choice, and not a rational one. Treatment of perpetual debt and convertible debt as debt is a bad choice. Treatment of repos as equity purchases instead of loans is a bad choice. European countries might usefully look to the rosbifs and accounting standards for less manipulated characterizations.

Second, the OECD model already offers a handy optional switchover clause, which some countries already have in their treaties (article 24(4)). Alternate wording for a subject to tax clause resides in paragraph 15 of the OECD model commentary on article 1. As the action plan acknowledges, a treaty clause could cover only the availability of treaty benefits like exemption from withholding. It could not cover allowance of an interest deduction or dividend exemption.

The plan states that the OECD will develop model domestic law provisions that deny a deduction, deny an exemption, deny a double deduction, or establish a tiebreaker rule for entity classification. The plan anticipates coordination with model rules for interest deductions and controlled foreign corporation rules.

Saint-Amans explained that the point of the hybrid proposals is to neutralize the tax benefit of forming hybrids. Taxpayers would still be permitted to form them (despite there rarely being a nontax purpose for doing so). Throughout its efforts, the OECD gives the benefit of the doubt to tax planning, as though there is some business purpose to everything that businesses choose to set up.

Other Treaty Proposals

The OECD will draft an antiabuse provision for treaties and clarify that treaties are not meant to facilitate double nontaxation. For all the blather, the OECD has never said in commentary that treaties are to be interpreted in a way that ensures that items of income or gain are taxed at least once.

Paragraph 7 of the OECD model commentary on article 1 states:


    The principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. It is also a purpose of tax conventions to prevent tax avoidance and evasion.

By treaty abuse, the OECD apparently means the use of third countries to gain unwarranted treaty benefits. Saint-Amans mentioned the use of shell companies in friendly jurisdictions for inbound investment, like Hong Kong to China and Mauritius to India.

The plan cites the commentary on article 1 of the OECD model treaty as a source of ideas to address three-party treaty abuse. Paragraphs 15 and 17 of that commentary respectively describe subject to tax and anti-conduit clauses that could be added to treaties. There's even a suggested low-tax kickout clause (paragraph 21.2). If the subscribing countries really meant it, and weren't just out for their national champions, they could incorporate a universal subject to tax clause in the ambulatory multilateral amendment.

Purely domestic approaches to treaty abuse have been unsatisfactory because for many countries, treaties trump domestic law. The expanded paragraphs 9 and 22 of the article 1 commentary give countries leeway to apply their domestic antiabuse rules to treaty situations. This has not been terribly successful in court. Expanded paragraph 10 offers the cold comfort of an examination of the facts and circumstances of a phony company in a haven. (Prior analysis: Tax Notes, Aug. 8, 2011, p. 571.)

In its treaties, the United States uses limitation on benefits clauses to combat treaty abuse, with a short version that works (the anti-conduit clause found in paragraph 17) and a complicated one that enables multinational planning (paragraph 20). A LOB clause is essentially a drawn-out beneficial ownership clause.

The OECD has a beneficial ownership project. But the beneficial clause has built-in limitations that preclude its use as an all-purpose LOB clause, as Saint-Amans explained.

"Beneficial ownership is only relevant with respect to income when the words 'paid' or 'payment' are used," he said. "When these words are not used, we want to avoid an a contrario reading that would give a free ride on items of income for which there is no beneficial owner clause. There is no argument that treaty benefits should be granted simply because the income has been paid to an intermediary like an agent or nominee."

Readers will recall that some years back, the OECD blessed business restructurings as the genuine product of globalization, which is still incanted in the action plan (Chapter IX to the 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations). The OECD even said that intragroup contracts should be respected.

European market countries found themselves on the losing end of stripped-risk planning, with civil law countries' commissionnaire laws turned against them. A domestic fix to adopt rosbif agency laws would suffice to knock out this tactic. The two principal court decisions blessing stripped-risk distribution arrangements relied on local commissionnaire statutes (Dell Products (NUF) v. Tax East, HR-2-11-2245-a (2011) and Société Zimmer Ltd., Conseil d'Etat, Nos. 304715, 308525 (Mar. 31, 2010)).

Nonetheless, the OECD plans to draft a treaty provision to disallow artificial tactics that avoid PE status. The action plan specifically mentions commissionnaire structures as a PE abuse. The OECD promises to work on profit attribution as well, given that a PE finding for a commissionnaire may not result in any more profit being attributed to it under current rules.

Why not completely rewrite the agency PE clauses in article 5 to find a PE whenever a local person is acting for a foreign principal (essentially common law agency)? Saint-Amans confirmed that changes to article 5 are on the table. (Prior analysis: Tax Notes, July 1, 2013, p. 7.)

Domestic Law Proposals

The action plan's domestic law proposals are noteworthy for the failure of the OECD to address these huge issues in the past. Maybe the Europeans were too busy dealing with the wreckage in the European Court of Justice.

One would have thought that European countries would have wanted model thin capitalization rules when all of them are subject to rampant income stripping via interest deductions, and the ECJ has restricted the use of these rules (Bosal, C-168/01). Instead, German thin cap rules have provided the model, as Saint-Amans acknowledged. In the German rule, net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. (Prior analysis: Tax Notes, Nov. 28, 2011, p. 1061.)

Interest deductibility tops the list of domestic law proposals in the action plan. The plan hints that the OECD may propose a model domestic law that denies a deduction for related-party interest that is not taxed to the recipient. This should also address interest paid to a third-party lender with a related-party guarantee. The parent guarantee is a loophole in many thin cap rules (see section 163(j)).

Oh, but that means that the tax law would be prescribing equity finance of affiliates! In some European countries, a parent can recognize a tax loss on devalued subsidiary shares without a realization event like a sale or liquidation. Why should interest deductions also be available to the subsidiary in that scenario?

The OECD should specifically address tax haven group finance companies, a common practice among multinationals that is enabled by the U.S. check-the-box rules and the British CFC exemption. It's one thing if a group wants a group treasury operation for cash management and a single entity to face third-party banks and swap dealers.

But market countries should not have to tolerate the use of these entities for income stripping, which usually takes the form of real payments. Even if they do have to recognize related-party interest, they should not have to tolerate the recipient group treasury company being in a tax haven. They should be allowed to deny a deduction when interest is not taxed. A domestic law change would be the easiest approach.

The OECD should think about restoring withholding for related-party interest payments all around, or solely when the income is not taxed at the receiving end. OECD policy and European policy has been to do away with withholding rules wherever they exist. The OECD model treaty aims to reduce withholding on interest without analyzing the propriety of the alleged interest. The European Union interest and royalties directive (2003/49/EC) removes withholding on interest.

Here one must ask whether related-party loans should be respected in the first place. Accounting does not respect them, and bankruptcy does not have a lot of respect for shareholder advances either. The OECD is not going in that direction at all -- instead, it will be trying to devise a proper transfer price for related-party interest, guarantees, and derivatives.

Controlled foreign corporation legislation is hugely important because European countries face constraints on their laws. CFC legislation is a clawback rule. It entails a presumption, stated or unstated, that a domestic taxpayer has engaged in shifting of passive forms of income. The ECJ has banned the use of presumptions and restricted clawback to obviously artificial situations, effectively nullifying CFC rules all over Europe (Cadbury-Schweppes plc and CSO Ltd. v. Commissioners of Inland Revenue (C-196/04)).

The action plan merely says that the OECD will develop model CFC rules, without indicating any direction for them. "The sense of direction is that we want effective CFC rules. Issues of compatibility with European Union law will be taken into account. There are already some EU member states with pretty tight CFC rules," Saint-Amans told Tax Analysts.

Transfer Pricing

No OECD effort would be complete without another wheel-spinning effort to make the transfer pricing rules administrable. Oh, and we need better transfer pricing documentation!

The OECD intangibles project will be rebooted. The concept of intangible will be defined, and rules for valuing hard-to-value intangibles will be developed. Cost-sharing guidelines will be fixed. As Saint-Amans explained, the aim will be to make sure the residual profits from intangibles are allocated in accordance with value creation.

The action plan shows that the OECD likes value creation as a criterion for income allocation. The OECD wants to ensure that inappropriate returns do not inure to an entity simply by virtue of intragroup contracts -- even though the 1995 transfer pricing guidelines require that these self-serving contracts be respected except in drastic circumstances. The plan will clarify the circumstances in which transactions can be recharacterized (paragraph 1.36 of the 1995 Transfer Pricing Guidelines).

Where you stand depends on where you sit. Countries may legitimately differ on the locus of value creation. If the parent's country of residence, where the intangibles were developed, wants to tax the excess returns from the intangibles, that tax claim may conflict with the market countries' claim to tax the excess returns for marketing intangibles or on some other basis attributable to exploitation of the local customer base.

What does value creation as a criterion mean for the authorized OECD approach (AOA) to profits attribution to PEs, which is only obliquely mentioned in the plan? The AOA attributes capital and employees and all sorts of factors to a PE. The plan also calls for developing rules for allocation of capital. (For the 2008 OECD report "Attribution of Profits to Permanent Establishments," see http://www.oecd.org/tax/transfer-pricing/41031455.pdf.)

To top it off, there is a paragraph in the plan that recommends rules against practices that would not pass the laugh test, although it does not phrase it that way. Some of those ornery South American countries that don't sign OECD model treaties prohibit deduction of nonsense like management fees and head office expenses. The plan suggests that the OECD will think about these provisions.

And what about formulary apportionment? The world is headed toward formulary apportionment of intangibles income, but the OECD and its members cling to separate company accounting. Saint-Amans reported that there was no consensus among countries on pursuing formulary apportionment, so the OECD should not waste its limited resources studying it.

Transparency

The OECD also reads headlines, and apparently read the one in which the executive told Parliament that his company's Dutch ruling could not be disclosed. The OECD will create a working party on aggressive tax planning, Saint-Amans noted. "The golden era where we don't pay taxes anywhere is over," he said.

Disclosure of rulings and aggressive tax planning disclosures are on the action plan shopping list. British and American tax administrators have benefited from national laws requiring disclosure of aggressive tax schemes (section 6111).

Country-by-country reporting. Saint-Amans explained that the OECD will develop a technical protocol for this reporting. There is reason to be cynical about what the OECD will allow to be reported. Reportable items will include where a company makes its profits, where it pays taxes or is liable to tax, and where it makes its sales.

There is no good reason to restrict country-by-country reporting to tax administrators, except that multinationals and the U.S. government want it that way. Most multinationals are publicly traded -- and exempt from LOB clauses in U.S. treaties on that basis. They file publicly available financial reports. They have no legitimate privacy interests.

Are their taxes a trade secret? Is how much income they earn in a particular country a trade secret? If tax planning is so important to these companies' business and earnings per share -- it really is for some of these companies -- then shareholders should wonder how the business is being run. And indeed, what the business is.

Why didn't the action plan call for joint audits of multinationals, which are being pursued through the OECD Forum on Tax Administration (FTA)? A few joint audits are already taking place between mostly common law countries. The FTA is ramping up its efforts, and its members are considering joint audits of digital economy companies.

"The action plan only includes tax policy aspects and not tax administration ones," Saint-Amans told Tax Analysts. "That said, we are very much in favor of joint audits as well as some other forms of tax administration cooperation, which is necessary to complement the action plan."

Many countries want to participate in joint audits but lack the domestic law enabling information sharing and cooperation. Surely a model law for information sharing and joint/multilateral audit cooperation would be useful for civil law countries facing constraints on participation in this worthwhile process. (Prior analysis: Tax Notes, Oct. 15, 2012, p. 230.)

The action plan calls for data collection on base erosion. At the press briefing, a reporter asked how the OECD would be able to tell if its recommendations had succeeded. Saint-Amans suggested that an increased effective tax rate and a reduced use of sham entities might be good measures of success. But there is no good baseline against which to measure success. Corporate income taxes account for a tiny proportion of total revenues in the United States and Europe.



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