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Demystifying BEPS – Base Erosion and Profit Shifting

What is BEPS?

In recent months, HMRC has been actively involved in the implementation of the Base Erosion and Profit Shifting (BEPS) ideas into the British tax system.

It is a perception that international tax is a reserve for multinationals, however, the reality is that Owner Managed Businesses (OMBs) and Small and Medium Enterprises (SMEs) should also have awareness of cross-border trade.

The BEPS project might have some impact on SMEs with international dealings or SMEs who are members of groups that include large companies. Mid-size companies are going to be swept up in the tide of the changes and face extra work in compliance, even though they are often not the ones using the avoidance schemes the BEPS project is seeking to eliminate.

The news has been abuzz with the top multinational firms being scrutinised by various revenue authorities on their tax base given the huge amount of profits that these firms report.

In the UK, Facebook and Amazon recently reported high profits and relatively low taxes, which has raised eyebrows as to whether these firms are eroding the tax base in the UK by shifting their revenues to other jurisdictions considered as low tax jurisdictions.

‘The hunter becomes the hunted!’ might be an apt description for the Irish tax authority, as the European Commission recently announced that it will take Ireland to court for failure of collecting the sum that Apple was ordered to pay last year. This will force different countries to be in line with the BEPS agenda despite trying to remain an attractive investment jurisdiction to multinational organisations.

To shed more light on this topic, BEPS is the term used by the Organisation for Economic Corporation and Development (OECD) to describe tax planning strategies that take advantage of gaps and mismatches in tax rules. These strategies make profits ‘disappear’ for tax purposes or divert income to locations where the prevailing rate of corporate tax is low, but where the company carries out little or no real activity. The BEPS project has a 15-point action plan.

The 15-point action plan presented by the OECD calls for the development of tools that countries can use to shape fair, effective and efficient tax that are coherent, have substance and transparent.

The 15 actions for the BEPS project

The 15 actions for the BEPS project are as outlined below:

Action point 1: Address the tax challenges of digital economy – Review of the application of existing international tax rules to e-commerce/online businesses. It broadly looks at application of Value Added Tax on online sales.

Action point 2: Neutralise the effects of hybrid mismatch arrangements – Hybrid mismatch arrangements are arrangements intended to secure tax advantages (mismatches) within multinational groups resulting from differences in tax treatment of the same instrument or entity between different jurisdictions.

Action point 3: Strengthen Controlled Foreign Company rules (CFC) – A foreign company is a CFC if it is a non-resident UK company that is controlled by a UK resident person or persons. The CFC rules are anti-avoidance provisions designed to prevent diversion of UK profits to low tax territories.

Action point 4: Limit base erosion via interest deductions and other financial payments – Interest deductions reduce the taxable profits (tax base) of a company. A parent company may provide financial assistance to its subsidiary in return of interest which is deductible by the subsidiary subsequently reducing the subsidiary profits.

Action point 5: Counter harmful tax practices more effectively, taking into account transparency and substance – Transparency is achieved through spontaneous exchange of information between countries.

Action point 6: Preventing tax treaty abuse –Proposes introducing a preamble in tax treaties to prevent creation of non-taxation opportunities as opposed to preventing double taxation.

Action point 7: Prevent the artificial avoidance of Permanent Establishment status – Broaden the definition of Permanent Establishment (PE) to prevent the avoidance of the PE status through commissionaire arrangements i.e. an independent agent. Commissionaire arrangements can potentially occur when a foreign principal replaces a local distributor (that could give rise to a PE) with a commissionaire without a substantive change in the functions performed in that country.

Action point 8, 9 and 10: Assure the transfer pricing outcomes are in line with value creation for intangibles, risk and capital, and other high-risk transactions – This seeks to address the arm’s-length pricing of intangibles when valuation is highly uncertain at the time of the transaction or the intangibles are hard to value. These action points look at amending of Transfer pricing rules by broadening the definition of intangibles and that the rules are in line with value creation.

Action point 11: Establish methodologies to collect and analyse data on BEPS and the actions to address it – This aims at developing recommendations regarding indicators of the scale and economic impact of BEPS and ensure that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis.

Action point 12: Require taxpayers to disclose their aggressive tax planning arrangements – This is to counter tax avoidance by companies. The Disclosure of Tax Avoidance Schemes (DOTAS) in the UK is a good example of this.

Action point 13: Re-examine transfer pricing documentation – Companies with cross border transactions with their related entities are expected to have contemporaneous documentation that support the arm’s-length pricing of the transactions.

Action point 14: Make dispute resolution mechanisms more effective – As a quid pro quo, the BEPS project also looks at improving dispute resolution between tax payers and the revenue authorities. 

Action point 15: Develop a multilateral instrument – A new multilateral instrument has been created to curb treaty abuse by amending tax treaties. UK is among other 71 signatories to this instrument as at 31 August 2017. Countries have addendums attached to their treaties to include this multilateral instrument.

Where are we now?

The UK has implemented the following Action Items:

BEPS Action 2: Neutralise the effects of hybrid mismatch arrangements.

The action plan was to develop model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (e.g. double non-taxation, double deduction, long-term deferral) of hybrid instruments and entities.

Legislation was introduced in Finance Bill 2016. The measure applies to payments made on or after January 1, 2017, involving hybrid entities or instruments that give rise to a hybrid mismatch outcome.

BEPS Action 4: Limit base erosion via interest deductions and other financial payments

This action point aims at developing recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments.

The discussion draft published by the OECD in December 2014 outlined two possible approaches for consultation: a group ratio rule (more stringent than the UK’s worldwide debt cap (WWDC)); and a fixed ratio rule.

The final report recommends the fixed ratio rule as ‘best practice’, which can be supplemented by a group ratio rule permitting additional deductions where the group ratio is higher.

The UK has had public consultation only, however, the action was plan was to be legislated on April 1, 2017 and is yet to be finalised. The proposals will be of particular concern to sectors that are often highly leveraged, such as infrastructure, real estate and private equity. Conglomerates comprising several different businesses, some of which are highly geared and others of which are not, will need to consider the impact of the different levels of leverage across the businesses.

BEPS Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance

The aim of this action plan was to revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime.

To be in line with BEPS action plan 5 which aims at businesses creating substance over form and justifying their economic reasons for structuring of group companies, The Diverted Profits Tax was introduced in the UK, with the intention of making it tougher for multinational enterprises to divert profits out of the UK.

This ensures that multinationals pay tax in the UK when economic activity has taken place in the country.  The Diverted Profits Tax was enacted on April 1, 2015 and applies at a rate of 25%, which is higher than the UK’s current 19% corporation tax rate. Groups with structures covered by the DPT must notify HMRC within six months of their yearend, or may face a tax-geared penalty.

The UK’s patent box regime was identified by the BEPS as ‘harmful and open to abuse’. The UK therefore introduced a reformed patent box regime, effective 1 July 2016, compliant with OECD recommendations. The Patent Box regime is a Corporation Tax relief which gives a reduced rate of tax (10%) on income deriving from the commercial exploitation of patents.

BEPS Action 13: Re-examine transfer pricing documentation

This action plan was aimed at developing rules regarding transfer pricing documentation to enhance transparency for an administration, taking into consideration the compliance costs for business. The rules developed include a requirement that Multinational Enterprises provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

The UK adopted the revised OECD transfer pricing guidelines as of 1 April 2016.

A number of countries have implemented this action plan through the Country-by-Country reporting (CbC) to achieve transparency.

What is CbC reporting intended to achieve?

The CbC reports are not meant to be detailed tax returns. Rather they are designed to be a risk assessment tool for tax authorities, giving them, a brief overview of money made and tax paid from which they can judge which companies to follow up for further review and audit. While tax authorities can share the information, it would remain confidential.

The UK is party to the automatic exchange of CbC reports, and as of June 2017, has activated 39 exchange relationships. The UK rules for CbC reporting took effect 1 January 2016.

Do not get caught!

Now that the OECD has concluded most of the BEPS Actions, as at 30 June 2017, the UK has implemented or committed to implement most BEPS measures. For the remaining BEPS Actions, UK tax policy is considered as largely consistent with the OECD’s recommendations. Therefore, no material changes are expected.

Enterprise Tax Consultants can assist with the impact of BEPS

Taxpayers will now need to review their contractual arrangements and, where necessary, to undertake proactive steps to make sure that all the BEPS sensitive areas are properly addressed within the organisation.

We advise business on all aspects of international tax compliance and liability, to help them realise their commercial objectives in what is a fast-changing and highly competitive environment. Our services include:

For more information, get in touch with one of our specialist tax advisers.

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