Do you have responsibility, whether direct or dotted line, for the tax function in your company?
Does your company have, or plan to have, operations outside the United States? If so, you need to know about a significant global tax initiative.
The initiative is known as the “base erosion and profit shifting” project. BEPS “refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid,” according the Centre for Tax Policy and Administration of the Organisation for Economic Co-operation and Development (OECD). In simplest terms, the project seeks to stop the erosion of the tax bases of member countries.
The project began when the global tax planning of companies like Starbucks and Apple came to light in Europe. European governments were up in arms that U.S. multinationals could arrange their businesses to have “stateless income” – income not taxed in any jurisdiction. U.S.-style tax planning was seen as highly objectionable and too complex to audit.
The global initiative isn’t limited to companies as big as Starbucks or Apple. It will change the record-keeping and tax reporting of all companies with non-U.S. operations, and it may have a direct bottom-line impact on the taxes of your company.
The BEPS project is being run by the OECD. In September 2014 final reports on four topics are due out. Those are:
• Standard transfer-pricing documentation. The OECD action plan calls for countries to re-examine their requirements for multinationals’ transfer-pricing documentation. That includes providing information on the allocation of income, economic activity and taxes paid based on a common template for all counties (or country-by-country reporting). The documentation is intended to allow each country to determine where the multinational’s operations are located and where its profits are earned and taxed. If the United States adopts this, which appears likely, that may significantly increase the resources companies need dedicate to the collection and reporting of the information.
• Managing hybrid mismatches. International companies often use hybrid instruments and hybrid entities in international tax planning to achieve tax savings. They do it by taking advantage of the disparate treatment of the instrument or entity among two or more countries. For example, a U.S. corporation might get an interest deduction on an instrument that’s treated as debt for U.S. tax purposes, while the payee company might be in a jurisdiction that considers the instrument equity. For the payee, the payment would be considered a dividend payment that can be excluded from income or taxed at a lower rate. Similarly, companies can now use the disparate tax treatment of entities to obtain double deductions or to take advantage of treaty benefits. The report is likely to propose common legislative changes to avoid taxpayers taking a deduction in one country and not having income in another, or using hybrid entities to achieve double deductions.
• Addressing challenges of the digital income age. The concern is that while companies realize value from customers in outside countries via digital sales, they’re not subject to tax in that country if the company doesn’t have a physical presence there. While the issue is under review, it doesn’t appear the OECD report will recommend significant changes to the current standard for jurisdiction to tax. Some countries, however, appear to be getting ready to implement self-help solutions.
• Treaty abuse Unlike the treaties the U.S. negotiates, many countries have treaties that don’t contain restraints on treaty shopping. The report is likely to recommend that a specific anti-abuse rule be included in new treaties.
Over the course of the next year, OECD will consider a bevvy of issues related to the project. They’re likely to include strengthening rules regarding controlled foreign corporations and limiting base erosion via the use of certain financial products. Transparency and transfer pricing are also likely to be on the docket.
The U.S. Response
Much of what is in the OECD action plan is already addressed in U.S. tax law, although not in a way that precludes stateless income. There are a number of legislative proposals aimed at addressing BEPS issues. For example, the federal government has become concerned about the trend for some U.S. multinationals to enter into “inversion” transactions to create new foreign corporate parents for their world-wide groups, including some recent widely publicized inversion transactions.
The Obama Administration has proposed provisions to prevent inversions, and Congress has proposed legislation in keeping with the administration’s proposal for creating substantial impediments for U.S. multinationals to invert. Although the proposed changes to U.S. tax law are aimed at preventing inversions, the effect of the legislation would be in keeping with many of the proposals in the BEPS action plan: to prevent profit- shifting-payments from a U.S. group to foreign affiliates.
Further, the Obama Administration’s 2015 Revenue Proposals contain a number of international tax reforms. One, for example, would broaden the definition of “intangibles” and tax excess profits from the transfer of intangibles outside the United States to a related foreign party. Another would limit interest deductions for U.S. groups with foreign parents.
Given the wide ideological divide between Republicans and Democratics in Congress, the prospect for broad-based international tax reform in the United States seems murky at best. That’s especially true in the short-term, with elections looming in the fall of 2014.
For its part, Ireland, heretofore a particularly attractive domicile for U.S.-based corporations seeking to reduce taxes on foreign-based income, has passed a law eliminating duel-resident structures. In such structures, a corporation could be incorporated in Ireland but managed and controlled in another country (such as the United States).
Under the new provision, a company incorporated in Ireland but managed and controlled in a treaty-partner country will be treated as an Irish resident corporation unless the corporation is resident in the other country for that country’s tax purposes.
Elsewhere, Switzerland is implementing significant international tax reforms in response to the BEPS action plan, Australia has made changes to its transfer-pricing rules, and France is looking at a plan to subject companies like Google and Facebook to a country’s taxing authority if its residents are using the websites within the country.
CFOs and BEPS
CFOs of U.S.-based multinationals need to understand their employers’ current international tax structures. Most important is the extent to which their current tax structures and strategies rely upon base-eroding payments of interest, rents, royalties, management fees and other inter-company payments to shift income to lower-tax jurisdictions.
They should also take note of how much their companies use hybrid instruments or hybrid entities to shift income to lower tax jurisdictions or reduce the effective tax rates on payments. That includes how the company’s intellectual property migrates to other countries. As part of their inventory, finance chiefs should learn how frequently their companies use transactions with controlled foreign corporations to shift income from high-tax to low-tax jurisdictions
Once they’ve made their assessments, finance chiefs should project the impact of pending international tax legislation and changes on the group’s worldwide tax structure and consider changing the structure in reaction to changes in international tax law.
In any event, they need to prepare for increased, and more significant, tax disputes with governments around the world with respect to transfer pricing, related-party interest payments and other issues identified in the BEPS action plan.
Joan C. Arnold is a partner and chair and Kevin M. Johnson is a partner of the tax practice group at Pepper Hamilton LLP.