Further to the previous work by the OECD in respect of base erosion and profit shifting and the consideration of this work by the G8 group of countries, the OECD has now produced an action plan of measures to combat the shifting of profits across borders by means of artificial transactions. Many of the measures discussed in the action plan are to be implemented by way of changes to the OECD Model Tax Convention and commentary or by changes to the OECD Transfer Pricing Guidelines. There will also be recommendations from the OECD for changes to national law, coordinated with changes to tax treaties, to prevent abuse of tax rules to gain a tax benefit.

International tax rules were established long before the digital economy developed and the concepts on which the international rules are based are not well adapted to a digital world where services may be rendered to a client in another country at the touch of a button and cash transferred instantaneously. A company may be doing work for clients in another country and delivering that work electronically but without having any substantial presence in that other country. There are also problems arising from how to characterize income from the newer business models associated with the digital economy and consequently the taxation of such income is not consistent. Problems of identifying taxable income and collection of tax from firms operating in the digital economy arise in respect of both direct and indirect taxes. A report is therefore to be prepared by the OECD before September 2014 highlighting the tax problems arising from electronic commerce and suggesting action that could be taken to deal with the issues.

Another practice leading to base erosion and profit shifting is the use of hybrid financial instruments and hybrid entities in cross-border arrangements. These are aimed at achieving double non-taxation of income within a group of companies, or arriving at a situation where a double tax deduction is achieved or taxation of income is deferred for a long period. To counter this problem the action plan includes a provision for changes to the OECD Model Tax Convention by September 2014 to ensure that benefits under tax treaties are not available in the case of hybrid instruments and entities.

Recommendations will also be developed in respect of domestic tax laws to ensure that where the payer of income receives a tax deduction the recipient of the income cannot receive an exemption from tax on the income. Similarly, recommendations would be developed to ensure that if a payment is not included in taxable income by the recipient the payer cannot receive a tax deduction. Recommended tax rules would deny a deduction for a payment that is also eligible for a deduction in another jurisdiction. There may also need to be guidance in respect of coordinating the tiebreaker rules that decide where a person or entity is resident.

In addition to the above points there is also a need for recommendations in respect of the interaction of the domestic recommendations with the revised tax treaty provisions and guidance.

By September 2015 the OECD also aims to develop recommendations on domestic controlled foreign corporation (CFC) rules. This guidance will be coordinated with other aspects of the action plan.

Another problem to be tackled by the action plan is base erosion caused by excessive interest payments between related or unrelated parties that effectively transfer taxable profits from one jurisdiction to another.  Related party debt involving excessive interest payments could for example be used within a group of companies to transfer group profits from a high tax to a low tax jurisdiction.  Such debt could also be used to finance the production of deferred or exempt sources of income by such means as creating income that is not taxable but is economically equivalent to interest received.

There are various techniques that governments may use to combat this type of tax avoidance and the OECD will look at the different types of restriction that may be placed on these arrangements. The work will include an evaluation of transfer pricing measures that can be applied to financial arrangements such as financial and performance guarantees, derivative financial instruments, captive insurance companies, and other insurance arrangements that can be used for base erosion. This is clearly closely related to the other work being done on hybrid instruments and controlled foreign companies so some degree of coordination will be necessary. Recommendations on domestic arrangements would be produced by September 2015 and changes to the transfer pricing guidelines would be finalized by December 2015.

For some years the OECD and other bodies such as the European Union have been taking measures to combat harmful tax practices such as the creation of ring-fenced exemption regimes that divert economic activity to a particular country at the expense of the tax base of its neighboring countries or trading partners.  The OECD intends to look again at harmful tax practices as part of the action plan. The current reviews of OECD member country regimes will be finalized by September 2014, taking into account improved transparency, exchange of tax information in respect of tax rulings related to preferential tax measures, and emphasizing that there must be substantial activity by an enterprise in a country before it is eligible for a preferential tax regime. The expansion of the review to non-OECD member countries will be implemented by September 2015.

The action plan includes consideration of changes to the OECD Model Tax Convention and recommendations for domestic laws with regard to the prevention of treaty abuse.  Guidance will be given to countries in respect of points to consider before entering into a treaty with another country. This will be coordinated with the consideration of hybrid entities that is also part of the action plan.

It is currently possible for enterprises to artificially avoid creating a permanent establishment in a country, either by way of commissionaire arrangements or through exploiting the exemptions in the Model Tax Convention for certain types of activity in the other contracting state. This will be addressed in the action plan together with further work on the attribution of profits to permanent establishments.

The tax treatment of intangible assets has received increasing attention in recent years and the action plan is to include changes to the OECD Transfer Pricing Guidelines and if necessary to the Model Tax Convention to prevent attempts to shift profits by means of transfers of intangibles between the companies in a group. The OECD has already done some work on intangibles and the action plan will include arriving at a clear definition of intangibles. The plan will include measures to ensure that profits from the transfer and use of intangibles are allocated in line with value creation, and develop transfer pricing rules relating to transfers of intangible assets that are difficult to value. The guidance on cost contribution arrangements is also to be updated.

Similarly, transfer pricing rules would be developed to ensure that the transfer of risks among the entities in a group or the allocation of excessive capital does not lead to base erosion. Profits would be allocated according to value creation. Rules will also be developed to ensure that profit shifting cannot occur by means of transactions that would almost never take place between independent parties. Further work would be done on defining circumstances in which transactions could be re-characterized and the application of methods such as profit split to situations involving global value chains would be clarified.  Rules would protect countries against base erosion through management fees or allocation of excessive head office expenses.

For monitoring purposes the OECD will produce recommendations by September 2015 in respect of tools to evaluate the economic impact of base erosion and the impact of the prevention measures taken. Guidance would be developed on how to frame rules in respect of disclosure of tax avoidance schemes, including information sharing arrangements with respect to international tax avoidance schemes. Recommendations would be made on transfer pricing documentation rules taking into account the need to keep compliance costs under control.

More work will be done in relation to dispute resolution mechanisms. This will include measures to deal with problems of access to the mutual agreement procedure and the lack of arbitration provisions in most tax treaties. The action plan also involves consideration of tax and legal issues in relation to developing a multilateral instrument to implement measures resulting from the work on base erosion and profit shifting. Following this analysis a multilateral instrument will be developed to enable any interested countries to participate in developing a multilateral instrument to meet the challenges of the modern global economy and adapt the tax approach accordingly.