Gearing up for BEPS

The OECD’s most significant area of focus in relation to business modelling is the area of intangibles. As business models evolved over time and value drivers within companies changed, it was clear that the fundamental rules of tax and the guidance relating to the arm’s length principle were no longer fit for purpose. One of the core pillars of the BEPS project was to align taxing rights with real economic substance and as such, through Action 8 on intangibles, the OECD targeted structures that were housing valuable intangibles or intellectual property (IP) offshore in locations with very little economic substance.

In its summary documents, the OECD referred to these companies as “cash box Caribbean companies” and new guidance in relation to the returns that are attributable to IP will put an end to structures using such companies. The new gold standard in the area of IP is Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE). If a company earns “super normal” returns from IP, they must be able to demonstrate that they are performing all DEMPE functions. The OECD also states that, in future, the mere holding and funding of IP may only be eligible for a risk-free rate of return. While these measures generally focused on “cash box” companies, the new transfer pricing guidelines – which will be updated for the recommendations in the report on actions 8-10 – will have a broader impact on companies’ business models. It is therefore more important than ever that every entity considers what and who drives value in their business, where this/they are located and whether the answers to these questions align with the current profit profile within the group.

The area of permanent establishment (PE) is one that is likely to gain significant additional attention into the future. It was the view of many countries, developed and developing alike, that multinational corporations were able to do business in their countries through people on the ground but, due to the weaknesses of the current rules, were able to circumvent the need to recognise a taxable presence. As such, the report on Action 7 has reduced the PE threshold through changes to the wording of the article and an updated commentary.

The dependent agent test now states that if a person or persons “habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise”, that company will be deemed to have a PE.

The commentary explains this new rule by stating that it is all about who convinced the buyer. Furthermore, the independent agent test has been amended so that if an agent acts exclusively or almost exclusively for connected parties, they will not be deemed independent. The broadening of the dependent agent rule along with the changes to the independent agent test could impact many groups with sales functions in foreign jurisdictions. Current operating guidelines may need to be reconsidered as a result.

Transparency could easily be the biggest success of the BEPS project, as the measures are likely to continue to drive change in the international tax environment. Country-by-Country Reporting (CbCR) is the single biggest item in the realm of transparency and is the output from the BEPS project that will have the most immediate impact.

This proposal will require multinational corporations with revenues over €750 million to populate and submit an annual CbCR template to the revenue authority of their headquartered jurisdiction disclosing the following data points for each tax jurisdiction in which they operate:

 

CbCR, and the wider changes to transfer pricing documentation, will fundamentally change the way multinational corporations document intercompany transactions and create a significant administrative burden. Consideration should be given to how this information and data will be reported; whether finance systems have the necessary capabilities to gather the required data; and what ongoing additional resources are needed to implement and manage CbCR. Preparation in the form of dry runs and initial analyses of the output is key. Tax transparency is of increasing importance for multinational organisations and is no longer just an issue for the Head of Tax. Engagement at board level early on will be crucial in ensuring that CbCR – and wider transfer pricing documentation requirements – are implemented effectively and in line with the organisation’s tax strategy and approach to transparency.

The report on Action 4, which deals with interest deductions, proposes that countries should implement an interest to the earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio between 10-30 per cent. However, there is a significant amount of freedom in relation to how the rule can be implemented and what options are included. The OECD does, however, suggest that the more options a country adds to their rule, the lower the ratio should be. There will therefore be some tough choices to be made both in Ireland and internationally if these rules are to be implemented in the medium-term.

From an Irish perspective, it is likely that an interest capping rule would have a greater impact on indigenous Irish companies than their FDI counterparts. In very general terms, Irish companies use interest whereas FDI entities use intellectual property planning as a tool to manage tax charges. Any rule, however, would need to be introduced in the context of the already complex interest rules in place in Ireland.

In terms of the transfer pricing of financing transactions, it is now essential to be able to demonstrate that the finance vehicle not only has the financial capacity to control risk but also has the functional capacity to manage risk. This will be increasingly important, as the guidance states that jurisdictions will be able to look through contracts in certain instances.

To understand the impact of BEPS on financing arrangements, groups must review their current interest to EBITDA ratios, financing structures, pricing and finance management. Once potential issues are known, solutions can then

be contemplated.

The success or failure of Action 6 on treaty abuse will likely lie in the hands of the multilateral instrument (MLI). The aim of the instrument is to simultaneously introduce BEPS treaty-based changes from actions 2, 6 and 7 in all bilateral treaties of the participating parties. This instrument will be worked on in 2016 and is due to be open for signing at the end of the year. The mechanics of how it will operate are still unclear and the possibilities are somewhat confusing but for the MLI, it really is a case of ‘watch this space’.

If the proposed treaty access changes do come into force through the MLI, it will no longer be possible to take treaty benefits for granted. At the core of this action is the proposed inclusion of an anti-abuse rule and the minimum standard agreed by all was that treaties should include a limitation on benefits clause (along with anti-conduit rules), a principal purpose test or a combination of both. The commentary in relation to the limitation on benefits is still in draft form as the OECD wants to ensure that it is aligned with the US approach, which is currently being decided upon in light of the recent consultation on its model treaty. However, the proposed limitation on benefits will be mechanical and there is a risk that the nature of the tests involved could lead to a denial of treaty benefits in certain unintended circumstances.

The principal purpose test is a general anti-abuse rule and states that “if one of the main benefits” of establishing in a jurisdiction was the access to treaty benefits, those benefits should be denied. This wording and the associated commentary is likely to result in a significant level of subjectivity when it comes to applying the rule. This could in turn lead to uncertainty. It is likely, however, that the majority of countries – including Ireland – are likely to choose this approach to satisfy the minimum standard in their treaties.

The output from the BEPS project is extensive and the above, while merely scratching the surface, attempts to capture some of the main issues multinational corporations need to consider.

Those who have yet to look at the potential impact of BEPS are not alone, but it is important that planning starts now to determine what actions need to be taken in the short, medium and longer term.

Peter Reilly is Base Erosion and Profit Shifting (BEPS) Policy Leader at PwC.