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May 21, 2014
News Analysis: BEPS and Tax Haven Islands
by Lee A. Sheppard

Full Text Published by Tax Analysts®

Here's what we've always wondered about tax havens: What do they get out of being tax havens?
Turns out they get quite a bit -- even though money merely moves through them to somewhere else -- provided they satisfy the immutable laws of tax havens.

First, a tax haven must be small. If businesses are not being taxed, someone has to pay for the ordinary expenses of government. There are two choices: tax the resident individuals a lot, or have a small enough population that incorporation fees and small corporate levies cover the budget. So Switzerland and Ireland have high taxes on their people, while Bermuda has a nice social welfare system serving slightly more people than a U.S. congressional district.

Second, a tax haven must be near the customers. Bermuda is a few hours from New York. The Channel Islands are a puddle-jump from London. Ireland is five hours from New York and a short distance from London. Switzerland is easily accessible from anywhere in Europe. Note to Luxembourg: Put in place a direct flight from New York or suffer the consequences.

Third, a tax haven must have rule of law, which usually means British corporate law and final appeals to the Privy Council. Tax haven lawyers always argue that customers don't come for the nontaxation, but for British corporate law. There's something to that argument. Businesses like the certainty of established corporate law and access to English courts. The shadier sort of customer likes the revenue rule and the restrictive court procedure (about which more in another article).

The title of this article refers to the OECD base erosion and profit-shifting project, a principal goal of which is to prevent multinationals from shifting profits to tax havens.

Let's reiterate the basic point that BEPS is a European project. European success in achieving the stated goals would not help the euro, the balance sheets of European zombie banks, or European national budgets (of which the corporate income tax is a tiny part). But it would make a lot of EU citizens feel better about the awful austerity policies they are being asked to endure by bankers and technocrats.

But what about the havens themselves? The European ones -- Ireland, Luxembourg, Switzerland, the Netherlands -- are making symbolic changes and nice noises about cooperation, while scrambling to retain their role in multinational planning. The little island havens are absent from the discussion. Multinationals hope to enlist them to defend their privileges, as a panel at the recent OffshoreAlert conference in Miami Beach showed.

Chris Faiferlick, a Tax Bureau member of the Business and Investment Advisory Committee to the OECD, prodded Ben Arrindell, a director of Cidel Bank & Trust of Barbados and a member of the U.N. Committee of Experts on International Tax Matters, to defend the islands' role in multinational planning. The short answer to why the Caribbean islands are not being more aggressive is that they compete with each other for business, according to Arrindell.

"Offshore financial centers won't be affected by BEPS in and of itself," said Arrindell. "It's all the other things."

Responding to a participant who asked whether the OECD was ignoring the interests of the islands, Faiferlick was blunt. "You're not on the radar screen. You have legitimate economic activities. You're collateral damage," he said.

But "you're going to have to give up on secret bank accounts," Faiferlick continued. Corporate tax is different, he stressed.

Translated, his comments mean that multinationals not only don't need bank secrecy, they don't want to be around customers who do. Some of the early inverters left Barbados for Switzerland to avoid the banking haven taint and to take advantage of a better U.S. treaty.

"Caribbean countries have not made their voices heard," Arrindell acknowledged. The OECD had a powwow with developing countries in Seoul. But island havens are a subset of developing countries -- and may well be on the other side of the table from larger developing countries from which income is being stripped.

Treaty Abuse

The elegant Sandy Lane Hotel in Barbados, a tax haven that also has a large tourist business. (Maisant Ludovic/ZUMAPRESS/Newscom)One would think that the proposed addition to the preamble of the OECD model treaty of a statement that treaties are intended to prevent tax evasion and avoidance, and not to create opportunities for double nontaxation, would not be controversial. This item is contained in action 6 of the BEPS action plan and explained in the OECD's March 14 treaty abuse discussion draft. (Prior coverage: Tax Notes, Mar. 24, 2014, p. 1313.)

One would be wrong. Faiferlick opposed this addition, echoing the OECD's Business and Industry Advisory Committee's (BIAC's) recent comments to the OECD, in which it called for a temporary suspension of treaty abuse discussions. (Prior coverage: Tax Notes, Apr. 21, 2014, p. 316. See http://www.oecd.org/tax/treaties/comments-action-6-prevent-treaty-abuse.pdf.)

BIAC argued that the statement should be restricted to unintended double nontaxation, which carries the implication that there is such a thing as intended double nontaxation. The group argued for narrowly targeted denial of treaty benefits only for the specific transaction established solely to obtain treaty benefits.

Faiferlick and Arrindell shared mutual opposition to the general antiavoidance rule that the OECD BEPS drafters are angling to have included in the OECD model treaty. The United States also opposes the GAAR, specifically its main purpose test (Tax Notes, Apr. 14, 2014, p. 157). The proposed GAAR would state that treaty benefits may be denied when one of the main purposes of the arrangement is obtaining treaty benefits.

In the BIAC Weltanschauung, a transaction undertaken to avoid high withholding rates imposed by a developing country should not be considered treaty abuse, because those governments really ought to lower their rates. So offshore group finance and holding companies should be respected. BIAC resisted putting the burden of proof on the taxpayer to show that the transaction was not treaty benefits motivated.

The BEPS drafters are tiptoeing around the U.S. unwillingness to pull back on the check-the-box regulations, while European countries gear up to nullify the effects with domestic legislation. BIAC opposed the potential use of the GAAR to combat hybrids, howling that one country should not be allowed to use a treaty GAAR to nullify another country's laws.

BIAC also complained that a source country should not deny a treaty benefit when the residence country does not tax the item of income. This is precisely what German treaties and German domestic law accomplish (section 8 of the German Law on External Tax Relations (Aussensteuergesetz)). Moreover, the OECD model already contains an optional denial of benefits clause, in the form of a fourth paragraph to article 23A for exemption-method countries (para. 56 of the OECD model commentary to article 23A).

Faiferlick and Arrindell also questioned the proposed changes to the model treaty tiebreaker clause for corporate residence, which currently deems a corporation resident in its place of effective management. The proposed change would let competent authorities hash out where the corporation should be deemed resident -- the point being to prevent dual resident companies from having it both ways. Faiferlick complained that this change would create uncertainty. BIAC wants to retain the effective management test.

One of the ways multinationals got to zero was that publicly traded companies historically were not subject to U.S. limitation on benefits clauses. No one honestly thought that publicly traded companies would zero out. It was always assumed that when their business grew in a jurisdiction, they would have enough of a physical presence to start paying taxes.

The March discussion draft proposes to restrict the LOB exception to companies whose shares are regularly traded on exchanges in the country of claimed residence. Faiferlick disapproved of this proposed change. BIAC asked for a derivative benefits clause and a headquarters exception. Derivative benefits are being debated.

BIAC agreed with the BEPS drafters that governments ought to read treaties before they sign them, and revise or abrogate them if they don't like the effects. One would think this advice is obvious, and again one would be wrong.

For years, governments were encouraged to sign the standard model that everyone else signed, and not to worry too much about vague terms that could be interpreted against the signatory. By signing a tax treaty, a government was ostensibly opening the country up for business -- rather than sacrificing tax jurisdiction and facilitating abuse.

An important piece of the OECD treaty abuse draft could trouble tax havens. Reiterating advice from the European Commission, the OECD told countries not to sign treaties with tax havens. The draft advises that if double taxation is not an actual threat -- which it would not be with a tax haven on the other side -- a treaty may not be necessary.

The consequences of that advice could create a long-term problem for tax havens, if they are not able to grow their treaty networks. European havens already have extensive treaty networks, but the islands do not. Barbados has 33 treaties, and the LOB clause in its U.S. treaty contains a tough base erosion provision.

Intangibles

Intangibles parked in havens are a root cause of multinationals getting to zero. Yet the U.S. Treasury and the British government are trying to undermine the central BEPS goal of preventing income shifting to havens. Treasury wants U.S. companies to be able to allocate some sort of return to funding affiliates organized in havens, rather than zero. The British have become a tax haven and created a patent box that is certain to face an EU challenge.

The most serious threat to the incorporation fees flowing to the islands is the proposed action 10 requirement for substance to justify an income allocation. Obviously, multinationals would use the islands less if they cannot allocate income to people-free companies organized there.

The Europeans are dead serious about the substance requirement -- apparently oblivious to the fact that a principal company can be run with a relative handful of people that seems disproportionately small relative to the multinational's other establishments (Tax Notes, Apr. 7, 2014, p. 26). The substance requirement is important for principal companies in supply chains and for intangibles holding companies, both of which tend to be located in havens. It is also relevant for group finance companies in havens.

In its July 2013 revised intangibles draft, the OECD said performance of functions is necessary to justify an income allocation. The OECD said that mere legal ownership does not confer any right to any allocation of income from exploitation of the intangible. If the legal owner wanted to retain all of the return from an intangible, it should perform the important functions using its own employees. If there is insufficient substance, a company could only be allocated a routine risk-adjusted return to capital.

Faiferlick urged the islands to demonstrate that companies there do have sufficient substance to justify an income allocation. In its intangibles comments, BIAC argued that there should be a minimal functions threshold that would permit a tax haven affiliate to be treated as the tax owner of the intangible. BIAC disagreed that the significance of legal ownership should be reduced, and insisted on recognition of "observed arm's length behavior."

A related issue is action 7, prevention of artificial abuse of permanent establishment status. Faiferlick noted that the PE test was devised when telephones were expensive. For our younger readers, the reference was to what are now called landline phones, which were still a luxury after World War I when the PE definition was devised. (Telephone taxes -- which have never been repealed despite phones having become a necessity -- were originally intended as luxury taxes.)

Faiferlick presciently linked the action plan PE item to OECD Working Party 9's project to establish digital VAT jurisdiction at the destination of the sale. Once that change is accomplished, it would be relatively easy for European countries to use a destination sales test for income taxes.

Tax havens depend on multinational custom to protect them from serious international pressure. Tax treaties as currently interpreted enable income shifting, as the OECD admitted a year ago. The treaty system "is going to keep offshore financial centers in business after all unless the United States comes to its senses and the OECD takes steps," said Jack Blum, a former Senate investigative staffer who heads Tax Justice Network USA.

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