On 13 March 2013 the OECD released a report entitled “Aggressive Tax Planning Based on After-Tax Hedging”. This report uses information on aggressive tax avoidance schemes submitted to the OECD Directory on Aggressive Tax Planning and looks at the compliance and policy challenges to tax administrations. The report is a result of international tax cooperation through sharing information on such schemes.

Hedging is a normal risk management tool based on neutralizing the risk associated with a particular transaction by taking equal and opposite positions. For example, a company holding shares denominated in a foreign currency may hedge its exchange rate risk by taking an equivalent position such as borrowing foreign currency of the same amount as the value of the shares. Companies use derivative instruments such as futures, options and swaps to hedge risks arising from interest rates, currency exchange rates, commodity prices or financial instruments.

In many tax systems the two equal and opposite transactions may be subject to different tax treatment. This opens up the possibility of aggressive tax planning schemes that exploit this difference in tax treatment. A scheme may exploit the different treatment within a domestic tax system or may exploit differences between tax systems by means of cross-border transactions. The increasing number of available financial instruments and the increasing sophistication of financial transactions have given rise to a growing problem from such aggressive avoidance schemes, with the amount of tax potentially lost amounting to hundreds of millions of dollars.

The OECD report describes the nature of typical avoidance schemes based on after-tax hedging and sets out strategies that tax administrations may use to detect such schemes. Detection strategies suggested in the report involve gaining information about such schemes through advance ruling applications, tax audits, the normal process of dialogue with large taxpayers or mandatory rules for the disclosure of tax avoidance schemes.

From a tax policy point of view there is a problem for the tax authorities in deciding where to draw the line between a normal hedging transaction and an aggressive tax avoidance scheme. In addition to this the schemes may be difficult to detect as there may be no explicit link between the two transactions and they may not be evident from an examination of the taxpayer’s financial statements. Where the tax authorities have detected an artificial tax avoidance scheme they must decide what action to take.

The report suggests that a decision on whether transactions amount to an aggressive tax avoidance scheme should depend on factors such as the facts and circumstances of the case, the commercial reasons behind the transactions and the intended effects of the tax legislation.

To detect aggressive schemes of this nature a tax administration must have the appropriate expertise in place. Such schemes may be very complex and thorough knowledge of the types of transaction involved in the scheme is required. Dialogue with the taxpayer may help to gain further insight into the transactions and the reasons why they were undertaken. Tax administrations have responded to such schemes by passing measures to deter taxpayers from using them in the first place. They may also take steps to prevent the promoters of these schemes, or tax advisory firms, from promoting these schemes.

The report recommends that tax administrations need to ensure that they have sufficient expertise in financial instruments and derivatives to detect these schemes. They may also consider the possibility of changing their tax rules to eliminate the differences in tax treatment that give rise to opportunities to devise such schemes. Anti-avoidance rules should be examined to ensure that they are capable of dealing with these schemes and if necessary the rules should be adapted.

Hedging is a normal tool used by companies to manage risk. The report acknowledges that the dividing line between a normal hedging transaction and an aggressive tax avoidance scheme may be thin, and this means that the response of the tax administration to such schemes must be measured and flexible. A range of responses may be possible depending on the facts of each case.

The report also recommends that tax administrations should use measures such as the exchange of information, spontaneously or on request, to detect aggressive schemes based on after-tax hedging. Tax administrations can also share their knowledge and experience on the deterrence of such schemes and methods for detecting them. They may also collaborate on considering effective responses to these schemes.