On 12 February 2015 the OECD held a webcast to update interested parties on the progress made in the action plan on base erosion and profit shifting (BEPS). The OECD and G20 countries have agreed on three elements that will enable implementation of the BEPS project, these being a multilateral instrument to coordinate tax treaty related measures; an implementation package for country by country reporting; and criteria to assess whether patent box regimes giving preferential treatment to income from intellectual property are harmful or not. A presentation was made to the G20 finance ministers at their meeting of 9 and 10 February 2015 in Istanbul updating them on progress made on the BEPS project.

Multilateral instrument

The webcast was also concerned with the BEPS action in relation to making dispute resolution mechanisms more effective. A multilateral instrument would enable existing double tax treaties to be modified on a multilateral basis with one instrument. The actions for which the multilateral instrument is likely to be used are the provisions on hybrid entities; provisions on treaty abuse; artificial avoidance of a permanent establishment; dispute resolution and other possible changes arising from the actions concerned with transfer pricing or other matters.

The work on the multilateral instrument would be carried on by an ad hoc group working under the aegis of the OECD and G20 and open to all interested states. Observer status is also possible for states, regional groupings and international organizations. The work would be finalized by 31 December 2016 and the multilateral instrument would then be open for signature.

A question raised with the OECD has been whether countries joining the multilateral instrument will have to consent to all the amendments made by the instrument or if they can opt into some treaty amendments and opt out of others. It currently looks as though it would be best to allow flexibility with an opt out for some of the measures if a country does not wish to make a particular amendment in its tax treaties. For example, it would be beneficial to include a provision for arbitration in the mutual agreement procedure as part of the multilateral instrument, but some countries may not wish to amend their treaties to provide for this. It would be best to allow those countries an opt-out so they can still participate in the other amendments covered by the multilateral instrument.

Country by country reporting

On country by country reporting, the OECD has determined that MNEs will not need to begin collecting the information for this until 1 January 2016. With respect to which MNEs are covered, they have decided not to include too many MNEs in the requirements and have therefore limited the rules to groups with turnover about EUR 750 million. This will exclude 85% of MNE groups but will include 90% of global MNE income in the provisions. The information will only be used by tax administrations for high level risk assessment purposes and not for other purposes. Information will be exchanged using existing agreements although in some cases where no agreement exists other measures will be needed. Only the country of the ultimate parent of the group will exchange the information on that group. There will be a monitoring mechanism for the reporting and information exchange and this will provide input for a review of the process in 2020.

Patent box rules

On patent box rules and harmful tax practices the OECD countries have agreed on the revised nexus approach. There will need to be a connection between qualifying expenditure and the income received that will qualify for the tax benefits. This will ensure that companies that are contributing to the economy and creating employment in the country concerned will received tax benefits and that the benefits received will be in proportion to their expenditure in the country. From 30 June 2016 existing patent box regimes will be closed to new entrants and there will be a grandfathering process to phase out benefits from the existing regimes.

The OECD is inviting comments on the methods to be used to track and trace the link between the expenditure and income within these regimes. There will be guidance on defining qualifying intellectual property. This will include patents but will not include marketing intangibles. The OECD also wants to guard against the possibility of companies engaging in IP regime shopping and moving their IP around to obtain tax benefits.

Developing country participation in BEPS

The structured dialogue with developing countries on BEPS includes direct participation by developing countries in the OECD’s Committee on Fiscal Affairs (CFA), the formation of regional networks of tax policy and administration officials and capacity building support (including developing toolkits for use with BEPS issues). Regional network meetings are taking place in February to April 2015 in the Asia Pacific region; Latin America and the Caribbean; French speaking countries; Eurasia and Africa.

Risk and recharacterisation

The discussion draft on revisions to Chapter 1 of the transfer pricing guidelines (including risk, recharacterisation and special measures) aims to make sure that the transfer pricing outcomes are in line with value creation. This involves ensuring that inappropriate returns will not be attributed to an entity solely because it has contractually assumed risks or has provided capital. There will also be clarification of the circumstances in which recharacterisation of transactions can take place.

The OECD transfer pricing guidelines will contain new wording in respect of the functional analysis, risks and the non-recognition of transactions. The expression non-recognition is being used instead of recharacterisation. There will also be the option for countries to adopt special measures to ensure that the correct outcomes are achieved.

The OECD emphasizes that profits may be out of line with value creation if there is a misalignment of form and substance. If the tax administration relies only on the purely contractual ownership, and purely contractual assumption of risk and provision of capital, the remuneration attributed to an entity may be out of line with the real value creation.

The OECD therefore aims to emphasize that the first step in any transfer pricing analysis is to accurately delineate the actual transaction. After this, the second step is to price the accurately delineated transaction by choosing a transfer pricing method and finding comparable transactions. The two steps in this analytical framework are often not dealt with separately by taxpayers.

The accurate delineation of the transaction involves first looking at the written contracts. However the conduct of the parties in the context of their commercial and financial relations must also be examined. Where the conduct of the parties contradicts or adds to the written contracts this information must be used to supplement (or replace) the written contractual arrangements when the actual transaction is delineated.

Delineation of the transaction is not the same as non-recognition or recharacterisation but involves identifying the transaction by aligning the form and substance. After the transaction has been delineated, the circumstances in which non-recognition would then apply are where the transaction does not make commercial sense. A transaction that does not make commercial sense is one which does not provide the parties with the possibility to protect or enhance their commercial and financial positions. In other words, there is no economic substance. Non-recognition would only occur in very exceptional circumstances.

Specific risks should be identified and their role in the specific business environment must be assessed. Valuable risk management activities should be compensated appropriately and the risk should only be allocated to a party that controls that risk.

The new guidance aims to price the business reality not the situation on paper. If there is broad agreement on the action to be taken there will be more alignment between the approaches of each country. As there will always be a risk of double taxation through unilateral adjustments it is important to have effective dispute resolution mechanisms.

Control over risk means the capability to make a decision to take on the risk and on whether and how to manage the risk. If the risk mitigation is outsourced, control of the risk would mean the ability to assess monitor and direct the outsourced measures that affect risk outcomes.

The new guidance will strengthen the arm’s length principle but may not prevent all possibilities for base erosion and profit shifting. There will be opportunities for profit shifting owing to information asymmetries and the allocation of capital to entities with minimum functions that are subject to low or no tax. This is why Part II of the discussion draft sets out some special measures that could be taken to deal with the remaining concerns. Also, the transfer pricing aspects of BEPS would interact closely with other actions such as those on controlled foreign corporations and on interest deductibility.

There is a public consultation meeting on the transfer pricing issues on 19 and 20 March 2015. A discussion draft on CCAs, intangibles, profit splits and financial transactions will be released in April to June 2015, with a public consultation in early July 2015. Actions 8 to 10 on transfer pricing will be finalized in September 2015 and action 4 on interest deductibility will be finalized in December 2015.

International VAT/GST guidelines and the digital economy

A short update was given on progress on the international VAT/GST guidelines in connection with BEPS issues. Global standards are being developed for the VAT treatment of international trade. Two new draft chapters have been produced for the VAT guidelines.

The developments on the VAT/GST guidelines are relevant to work on the tax challenges of the digital economy under action 1 of the BEPS action plan. Countries have complained about the difficulty of collecting VAT on digital products sold from an offshore location to private consumers. There have also been questions about whether VAT should be collected on these transactions.

The OECD considers that VAT needs to be paid on these transactions in the residence jurisdiction of the consumer and this means that the remote supplier must register for and remit VAT in the jurisdictions in which its customers are usually resident. As this imposes a considerable compliance burden on the suppliers the OECD is encouraging countries to introduce simplified registration and compliance procedures for suppliers of these products. International administrative cooperation in VAT must be strengthened to ensure that the VAT is collected in these situations.