On 1 August 2017 the Platform for Collaboration on Tax (PCT) issued a draft toolkit on the tax treatment of offshore indirect transfers. The PCT was set up by the IMF, OECD, UN and World Bank at the request of the G20 group of countries to recommend mechanisms to ensure effective implementation of technical assistance programs. The deadline for comments on the draft toolkit is 25 September 2017.
An offshore indirect transfer of an asset is essentially the sale of an entity owning an asset located in one country by a resident of another country. This issue was not specifically covered by the reports issued by the OECD on base erosion and profit shifting (BEPS) but it has emerged during discussions with developing countries as an important issue. The issue has been noted during IMF work on technical assistance and offshore indirect transfers are also being examined as part of the UN work on taxation of extractive industries.
Different countries have approached the issue in widely different ways, in terms of the assets covered by their legislation and the legal approach followed. A more coherent policy among jurisdictions could increase tax certainty and increase collection of tax.
The discussion draft considers that not only immovable assets should be covered by legislation on offshore indirect transfers but the definition of assets covered should also include more generally assets that are generating location specific rents. Location specific rents are returns that exceed the minimum required by investors and that are not available in other jurisdictions. The report therefore suggests appropriate wording for inclusion of a broad range of assets in the definition of assets for the purpose of offshore indirect transfers.
The provisions of the OECD and UN Model treaties both indicate that capital gains tax on offshore indirect assets should be allocated primarily to the jurisdiction where the asset is located. The relevant provision is in Article 13 (4) of the UN Model. Article 13 (4) states that “gains derived by a resident of a contracting state from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other contracting state may be taxed in that other state”
The provision is however only currently present in around 35% of bilateral double tax treaties and is less likely to be included in a treaty where one of the contracting states is a low income resource rich country. Even where this provision is included in a bilateral tax treaty the jurisdiction still requires an appropriate definition of these assets in domestic law to assert the right to tax the assets.
Approaches to taxing offshore indirect transfers
Two main approaches are outlined in the report for taxation of offshore indirect transfers by the jurisdiction where it is located. Sample simplified language for insertion into domestic law is provided for both approaches.
One of the approaches involves treatment of the offshore indirect transfer as a deemed disposal of the underlying asset. The tax liability would be triggered by a change of control whether onshore or offshore. Change of control would be determined by considering either direct or indirect ownership. In the case of a change of control the local entity would be treated as disposing of its assets at their market value, triggering the tax charge, and then reacquiring them. As this is a deemed disposal the local entity would still be the legal owner of the assets following the deemed disposal.
The other approach considers that the gain on the transfer of the asset is made by the non-resident seller but treats the gain on the transfer as sourced within the location jurisdiction, thereby enabling that jurisdiction to tax it. This approach is more commonly used by countries taxing offshore indirect transfers. The source rules are critical for this approach because a non-resident is normally only taxed on income from sources in the location country (the “source country”). The draft suggests a source rule including a gain arising from the disposal of immovable property in the location country; or the disposal of shares or comparable interests, if at any time during the 365 days preceding the disposal more than 50% of the value of the shares or other interest is derived, directly or indirectly through one or more interposed entities, from immovable property in the location country.
On 29 July 2017 the OECD published a report entitled SME and Entrepreneurship Policy in Canada. The report looks at entrepreneurship activity, business structures, federal programmes, productivity and innovation among small and medium enterprises (SMEs). It also considers the business environment, ease of doing business, access to finance and the labor market.
The OECD report notes that Canada’s tax system is generally favorable to business and the ratio of total tax revenues to GDP is 30.5%, below the OECD average. Compared to the OECD average Canada raises more tax revenue from income taxes and a smaller proportion from social security contributions and tax on goods and services. Canada has achieved a high level of harmonization between the federal and provincial taxes and this has made the tax system rather easier for business to deal with. In addition to the generally business-friendly tax system small businesses also enjoy special tax provisions.
Small business deduction
A small business deduction applies to the first CAD 500,000 of active business income of Canadian Controlled Private Corporations (CCPCs). The small business concession is phased out from capital of CAD 10 million and eliminated altogether for businesses with capital of CAD 15 million and above. The provinces also have their own small business tax rates and thresholds.
The small business rate gives incorporated privately owned small businesses additional after-tax income to use for reinvestment and expansion if they choose to do so. However as businesses are not obliged to use the additional income for investment the OECD report suggests that the impact may be smaller than more targeted measures to support specific growth and development activities.
Sometimes this type of measure may cause clustering of businesses just below the income or turnover threshold, thereby effectively discouraging expansion above the threshold for relief. Studies suggest however that this has not occurred in Canada. The small business tax rate could also be used for tax planning by wealthy individuals and families. Measures to counter tax planning strategies were introduced in the 2016 federal budget.
Lifetime capital gains exemption
An individual is given a lifetime tax exemption for capital gains realized on the sale of qualified small business qualification shares. This exemption is intended to boost investment in small business and facilitate transfer of a business between generations. This supports investment and risk-taking by owners and investors of small companies but evidence suggests that it has been used for artificial tax avoidance, for example by large companies providing benefits to specific shareholders through the creation of CCPCs.
Small business capital gains rollover
This measure enables a taxpayer to defer the taxation of capital gains realised on the sale of common shares of an eligible small business corporation where the proceeds are reinvested in common shares of another eligible small business corporation. The CCPC must have under CAD 50 million in assets, of which less than half represent real estate. The OECD report suggests that more flexibility in the time limit for reinvestment would be helpful, perhaps through introducing a capital gains deferral account where capital gains could be deferred without being taxed until the assets are eventually sold for purposes other than general investment.
Income tax deduction for allowable business investment losses
A capital loss on a small business investment can be used to offset income tax. The allowable portion of 50% of a capital loss on shares or debt of a small business corporation may be deducted against any other source of income in the year. This is primarily intended to support start-up businesses.
Small business job credit
This credit introduced in September 2014 applied to a business paying Employment Insurance premiums equal to or less than CAD 15,000 in 2015 or 2016, reducing the amount of payroll taxes. The measure was intended to encourage job creation but the OECD report points out that social security contributions are already low in Canada, so the impact would be limited.
The OECD recommends that the trend of reduction in the small business tax rate could be discontinued and replaced by targeted measures to address market failures for specific groups of SMEs and start-ups. Federal and provincial loan guarantee programmes could be expanded to increase bank lending to SMEs and direct government lending could be increased, especially to groups unlikely to be served by commercial banks. The government could also strengthen the apprenticeship training system for SMEs; consider introducing a system of combining academic studies with on-the-job training; and create new work-integrated learning programmes.
On 28 July 2017 the OECD’s Committee on Fiscal Affairs (CFA) issued a document entitled Neutralising the Effects of Branch Mismatch Arrangements, Action 2. This document was issued as part of the implementation of the action plan on base erosion and profit shifting (BEPS) through the Inclusive Framework. It sets out rules to combat branch mismatch arrangements.
Previously a discussion draft on branch mismatch rules was issued on 22 August 2016 with recommendations to bring the treatment of branch mismatches into line with the hybrid mismatch rules. Following consideration of comments received on the document and legal changes made by various countries the OECD has now finalized the document.
Branch mismatches are the result of inconsistency between domestic tax rules to determine income and expenditure subject to taxation. Branch mismatch structures may help the taxpayer avoid tax by exploiting differences between jurisdictions in rules determining if the taxpayer is subject to tax in a particular jurisdiction and differences in rules for including income and expenditure in the computation of taxable profit. These differences in rules may allow a taxpayer to leave an item outside the charge to tax in both jurisdictions or claim a deduction for the same item in both jurisdictions (double deduction).
Branch mismatch rules are similar to hybrid mismatch rules in their structure and outcomes. Therefore countries adopting hybrid mismatch rules have generally also adopted an equivalent set of rules relating to branch mismatches. The branch mismatch rules proposed by the OECD therefore apply similar analysis and solutions to the branch mismatch rules set out in the recommendations on BEPS action 2. By aligning the branch and hybrid mismatch rules jurisdictions can prevent taxpayers shifting from hybrid to branch mismatches to achieve similar tax advantages.
Types of mismatch arrangement
The OECD report sets out five types of branch mismatch arrangement:
- Disregarded branch structures – arising where the branch is not within the definition of a permanent establishment and does not have any other taxable presence in a jurisdiction;
- Diverted branch payments – arising where a jurisdiction recognizes the existence of the branch but the payment made to the branch is attributed to the head office in that jurisdiction, while the jurisdiction of the head office exempts the payment from tax because it was made to the branch;
- Deemed branch payments – arising where the branch is deemed to make a notional payment resulting in a mismatch in tax outcomes under the rules of the residence and branch jurisdictions;
- Double deduction branch payments – where the same item of expenditure creates a tax deduction under the laws of both jurisdictions; and
- Imported branch mismatches – arising where the payee offsets income from a deductible payment against a deduction arising under a branch mismatch arrangement.
Mismatches can also arise indirectly where a taxpayer invests through a tax transparent arrangement such as a partnership.
The document sets out recommendations relating to each type of branch mismatch, as follows:
- The scope and operation of the branch exemption can be adjusted so as to achieve a closer alignment with the policy of exempting income of a foreign branch under double tax relief rules;
- A branch payee mismatch rule would deny the payer a deduction for a diverted or disregarded branch payment to a related person or a payment under a structured arrangement to the extent that the payment is not included in income by the payee;
- A deduction would be denied for a deemed payment between a branch and head office (or two branches of the same person) to the extent that the payment results in a double non-income outcome and the resulting deduction is offset against non-dual inclusion income (dual inclusion income would be income taxable in both branch and head office jurisdictions);
- The double deduction rules are based on the rule set out in Chapter 6 of the report on BEPS action 2 but an adjustment would need to be made only when the payer jurisdiction allows the deduction to be set off against non-dual inclusion income; and
- An imported mismatch rule would deny a deduction for a payment made within the same control group or under a structured arrangement to the extent that the income from the payment is offset against expenditure giving rise to a branch mismatch.
The sixth aid-for-trade monitoring report has been published by the WTO and OECD under the title “Aid for Trade at a Glance: Promoting Trade Inclusiveness and Connectivity for Sustainable Development. The Aid for Trade initiative, launched in 2005, aims to help developing countries participate in global trade by assisting with the supply side and addressing trade-related infrastructure constraints. The report notes that more than USD 300 billion has been devoted to programs and projects since the initiative was launched.
The focus of the latest edition is on physical and digital connectivity. Trade connectivity is essential for inclusiveness, sustainable growth and reduction of poverty. Digital networks are essential to trade and are interlinked with the physical trade infrastructure. Without an affordable internet connection the market place of the world-wide web cannot be accessed. The report points out that around 3.9 billion people remain offline.
As a result of digitalization a larger number of low-value transactions and small shipments cross national borders, and goods are increasingly combined with services. Services therefore represent a growing share of exports of manufactured products. New technology lowers the cost of supplying cross-border services and facilitates connections between parts of the supply chain. This does not eliminate comparative advantage or other constrains from information symmetries and trade barriers; but many of the constraints of international trade are being overcome and new business models are being created.
The 2030 Agenda for Sustainable Development has set targets for universal, affordable access to the internet. Although mobile broadband networks are available to more than 50% of people in the less developed countries (LDCs) the devices and network connections are still expensive and coverage is limited. The high costs of digital connections can be seen as trade costs that exclude firms and consumers from the online market for goods and services.
Measures are required to improve the supply side of digital connectivity including ICT infrastructure and availability of network coverage; and the demand side such as affordability and internet usage. This involves mobilizing additional finance to develop infrastructure, ICT services markets and regulatory environments. Aid for Trade supports governments in their efforts to bridge the digital divide.
There is also a digital trade policy divide. Developing countries must consider the trade policy aspects of digitalization. Digital connectivity alone is not sufficient without additional policies to develop the potential of e-commerce, including technical and financial assistance to develop human, institutional and infrastructure capabilities.
Commerce is hindered by border clearance delays and inadequate physical infrastructure. Digitalization of customs services can make the customs and border agencies more efficient. The report emphasizes the need to streamline customs services for micro, small and medium enterprises (MSMEs). Many of these concerns will be addressed by the WTO Trade Facilitation Agreement.
The Trade Facilitation Agreement aims to simplify and harmonize international trade procedures, speeding up the movement and clearance of goods. Complete implementation of the agreement could lower trade costs by 16.5% for low income countries and 17.4% for lower middle income countries. The TFA covers a range of trade facilitation measures including customs cooperation, customs procedures, freedom of transit, formalities, appeals procedures and fees and charges. Countries self-assess and declare their ability to implement each measure.
Services trade is important in growing connectivity as services support trade in goods, supply chains and manufacturing activities. They are also involved in the infrastructure enabling e-commerce and online services. Governments need to help promote the development of e-commerce strategies supporting trade logistics, development of e-commerce skills, adequate legal frameworks, online payments and access to finance. These combined with an increase in connectivity can increase e-commerce possibilities, generating economic growth and employment.
E-commerce can raise productivity in developing countries across all economic sectors, including MSMEs and enterprises owned by women, by connecting to customers and suppliers worldwide. Governments need to promote internet access and training to ensure that existing inequalities of access do not increase. The private sector is also important in supporting MSMEs and individuals to become connected to the global economy.
On 20 July 2017 the OECD published the latest edition of its publication Revenue Statistics in Asian Countries. This covers trends of revenue statistics in Indonesia, Japan, Kazakhstan, Korea (Rep), Malaysia, Philippines and Singapore between 1990 and 2015. The publication looks at tax ratios, tax structures and taxes by level of government, with a special feature on electronic services in tax administration. Of the countries covered Japan and Korea are members of the OECD but the other countries are not OECD members.
Developing countries need to mobilize government revenue to provide funds for public goods and services including health, education and infrastructure. Taxation is a reliable source of revenue compared to diminishing levels of development assistance and volatility of non-tax revenues relating to commodities. The tax-to-GDP ratio measures the total tax revenue of a country as a proportion of GDP. According to UNESCAP in 2014 a minimum tax-to-GDP ratio of 25% is essential for a country to become a developed economy.
The report points out that tax-to-GDP ratios tend to be lower in Southeast Asia compared to Japan and Korea. The main factors explaining this are low tax compliance in many of the countries (apart from Singapore) and narrow tax bases due to a high number of tax exemptions and incentives introduced to attract foreign investment. The survey shows that tax-to-GDP ratios in the surveyed countries range from 11.8% in Indonesia to more than 32% in Japan, all lower than the OECD average of 34.3% in 2015. All the countries other than Japan and Korea had tax-to-GDP ratios below 18%.
Tax-to-GDP ratios are affected by various domestic and international factors including the importance of agriculture in the economy; the presence of natural resources; openness to trade; the size of the informal economy; powers of the tax administration; levels of corruption; and tax morale. International factors such as tax policies of other countries can also affect the tax-to-GDP ratio.
The tax structure refers to the different taxes that contribute to total revenue. This is an important indicator because different taxes have different social effects. The structures in Japan and Korea are evenly divided between the main categories of tax revenue. In Korea 30.3% of tax revenue is from taxes on income and profits; 26.6% from social security contributions and 28% from taxes on goods and services. This structure is similar to the OECD average. In Japan almost 40% of total tax revenue is from social security contributions and a little below 20% of revenue was from tax on goods and services in 2014.
Indonesia, Malaysia, Philippines Singapore and Kazakhstan derive their tax revenue mainly from taxes on goods and services and taxes on incomes and profits. Together these make up more than 75% of their total tax revenue.
The share of value added tax (VAT) in total tax revenues increased significantly in most Asian countries between 2000 and 2015 including in five of the seven countries surveyed. However the percentage share of VAT revenue in Kazakhstan has decreased mainly owing to a decrease in the VAT standard rate from 20% in 2000 to 12% in 2015. The percentage contribution from VAT also decreased in Korea. The share of VAT to total revenues in the countries remains smaller than the OECD average of 20% (except in Indonesia) partly owing to lower VAT rates in many countries.
In all the countries surveyed the share of corporate income tax revenue in their total tax revenue is higher than the OECD average of 8.8% in 2014. The figures is around 13% for Japan and Korea and higher in the other countries, ranging from 23% in Indonesia to 42.5% in Malaysia. The share of personal income taxes to total revenue rises from 9.4% in Kazakhstan to 21.5% in Indonesia. The Southeast Asian countries and Kazakhstan receive a higher proportion of total tax revenue from corporate income taxes than from personal income taxes, whereas Japan and Korea have a higher proportion from corporate income tax.
VAT Revenue Ratios
The VAT Revenue Ratio (VRR) is the difference between VAT revenue collected and the VAT that could be raised if the VAT standard rate was applied to the whole potential VAT base and all revenue was collected. Of the countries surveyed Japan, Korea and Singapore have quite high VRRs above 65%, mainly owing to the relatively broad VAT base in those countries. The report notes that these countries do not have many reduced rates whereas many OECD countries have one or more reduced VAT rates. This leads to a lower average VRR among OECD countries generally, currently measured at 56%.
On 11 July 2017 the OECD issued the draft 2017 update of the OECD Model Tax Convention. The changes are to be submitted later in 2017 for approval by the Committee on Fiscal Affairs and the OECD Council.
Some parts of the update relate to the recommendations of the project on base erosion and profit shifting (BEPS) and consultation on these issues has already taken place. Comments are however invited from interested parties on some parts of the draft updates that have not previously been the subject of consultation. The closing date for comments is 10 August 2017.
Commentary on Article 4
The draft changes concern a situation where a house is rented to an unrelated person and whether this could be regarded as a permanent home available to the landlord for the purposes of the residence tiebreaker rule. The changes are made in paragraph 13 of the commentary on Article 4 and refer to Article 4 (2) (a) of the OECD Model.
Further changes to be made to the commentary on Article 4 with a view to clarifying the meaning of “habitual abode” in the tiebreaker rule. The draft changes are made in paragraphs 17 and 19 of, the commentary to Article 4 and by the addition of new paragraph 19.1 to the commentary.
Commentary on Article 5
The draft changes insert a new paragraph 1.1 to the Commentary on Article 5 of the OECD Model. This is intended to clarify that registration for value added tax (VAT) or goods and services tax (GST) is by itself not relevant to the application and interpretation of the permanent establishment definition.
The draft changes include the deletion of the words “(other than a partnership)” from subparagraph 2 (a) of Article 10. The subparagraph has been changed to ensure that the reduced rate of source taxation on dividends applies where relevant to a transparent entity.
This change has been made because under the new Article 1 (2) of the OECD Model income derived by an entity that is fiscally transparent under the laws of either Contracting State is considered to be income of a resident of a Contracting State to the extent that it is treated as income of a resident of that State for tax purposes.
The change to subparagraph 2 (a) of Article 10 therefore ensures that the reduction of withholding tax on dividends provided for in that Article can apply to dividends paid to a transparent entity where the relevant conditions apply. New paragraphs 11 and 11.1 have been added to the Commentary on Article 10 in relation to this change.
Other draft changes
Other draft changes to the OECD Model have been approved as part of the BEPS project, relate to BEPS follow-up work or have previously been subject to consultation. These include changes relating to the work on hybrid mismatch arrangements; changes resulting from the report on Action 6 to prevent the granting of treaty benefits in inappropriate circumstances; work on Article 5 to present artificial avoidance of permanent establishment status; and work on making tax dispute resolution procedures more effective.
Other changes made to the commentary to Article 5 relate to the work on integrating changes from work on BEPS action 7 (preventing the artificial avoidance of permanent establishment status) with work on the interpretation and application of Article 5. There are also draft changes to Article 8 on the taxation of crews of ships and aircraft operating in international traffic.
Changes have also been made to paragraph 5 of Article 25 in relation to arbitration. The amendments concern the MAP arbitration provision developed in the negotiation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting adopted on 24 November 2016.
The final version of the 2017 update will include also changes to the observations, reservations and positions of OECD member countries and non-member economies. These changes are still being formulated.