Lecture 8: Issues in International Taxation Flashcards
Why are there issues with the tax system according to Mills et al, 1998?
National tax systems have evolved over many years but cross border trade and globalisation have grown significantly since the latter half of the 20th century.
Tax systems are difficult to change and taxes which operate well nationally are not necessarily appropriate in a global environment.
This creates opportunities for taxpayers, particularly MNEs, who can take advantage of the differences between national tax systems. This in turn creates a threat to governments in terms of capital flight and loss of tax revenue.
Mills et al (1998) estimate that large corporations save on average $4 for every $1 spent on tax planning. These include the use of tax havens, specially targeted tax regimes and transfer pricing to transfer profits from high tax jurisdictions into low tax ones.
A country must weigh up the costs of losing tax revenue through such planning against the risk of losing the MNE with strict anti-avoidance legislation.
Developed countries have taken steps in terms of anti-avoidance legislation to protect their tax base, but developing countries may not have the resources and infrastructure to do so.
What is the OECD?
The OECD is made up of a group of developed nations.
Working for developed nations.
What is the Base Erosion and Profit Shifting Action Plan?
On 19 July 2013 the OECD presented to the G20 finance ministers an action plan on base erosion and profit shifting (BEPS Action Plan).
It updated the OECD’s work in this area and identifies key areas to be progressed, including ways for countries to work together to address ‘double non-taxation’.
It identified 15 specific actions. Key areas include transfer pricing, intra-group interest payments, permanent establishment rules, intangibles, digital economy, harmful tax practices and country by country reporting.
The 15 Actions were split over 3 timelines, with the final deadline being Autumn 2015. The deadline was met with the release of its final proposals on 5 October 2015.
What is Action 1 of the OECD BEPS?
Address the tax challenges of the digital economy.
There is a recognition that the Permanent Establishment (PE) concept is out-of-date.
It was originally developed for manufacturing trades.
Businesses such as financial and internet-based services which involve little physical or human capital are better placed to take advantage of attractive tax regimes than manufacturing businesses, because operations can more easily be moved from country to country.
Action 1 is to identify the main difficulties and develop options to address them. The intention is not to develop new rules for e-commerce, but to ensure that general transfer pricing and PE rules are better suited.
What is action 2 of the OECD BEPS?
Neutralise the effects of hybrid mismatch arrangements:
Many countries have different definitions as to what constitutes debt capital and equity capital, or, indeed as to what constitutes a company.
The action covers hybrid financial instruments and hybrid entities. A hybrid financial instrument could, for example, be used to finance an overseas subsidiary.
It could be constructed such that the payment from the subsidiary to the holding company is treated as deductible interest in the subsidiary, but as a dividend (often not taxable) or even as return of capital (not taxable) in the holding company.
A hybrid entity is usually a subsidiary or Special Purpose Vehicle (SPV) set up purely or mainly for tax avoidance purposes.
The US ‘check the box’ regime allows companies to choose how such a vehicle is to be treated for tax purposes. The action suggests changes to domestic laws, but countries may fear loss of sovereignty by changing their own laws.
What is action 3 of the OECD BEPS?
Strengthen the CFC rules (controlled foreign company).
This action encourages individual jurisdictions to enact strict CFC legislation. (Easier for developed countries?)
UK has been a bit soft on CFC legislation
What is action 4 of the OECD BEPS?
Limit base erosion via interest deductions and other financial payments.
Again, this action involves tightening-up of domestic rules.
Many jurisdictions have rules against ‘thin capitalisation’. This concerns the amount of funds lent by one group member to another relative to the amount of equity share capital of the borrower.
A company is said to be thinly capitalised if its ratio of equity capital to debt capital is lower than would be expected if the company were an independent enterprise borrowing from, say, a bank.
The temptation is for a MNE to finance a subsidiary in high-tax jurisdictions using a high ratio of debt capital to equity.
Why is debt capital risky in the open market? (action 4)
In the open market debt capital is risky – the interest and capital have to be repaid, where equity capital and dividends don’t.
Similarly, many jurisdictions, including the UK with its corporate interest restriction (replacing the world-wide debt cap), limit in some way (often by a fixed ratio of earnings) the total net interest deductions in a group.
What does thin capitalisation legislation do (action 4)?
Thin capitalisation legislation reclassifies part of the interest deduction as a dividend on the grounds that there is so much debt capital that the borrower could never hope to repay it and remain in business.
What is Action 5 of the OECD BEPS?
Counter harmful tax practices more effectively, taking into account transparency and substance.
This covers the use of tax havens and preferential regimes such as ring-fencing. The ongoing review of member country regimes will be completed.
What is Action 6 of the OECD BEPS?
Prevent treaty abuse.
Most bilateral double tax treaties are based on the OECD Model Tax Convention (MTC), published in 1963. Some give treaty benefits, such as exemption from withholding taxes, and MNEs have set up Special Purpose Vehicles to take advantage of this. The OECD MTC will be updated by the Action Plan to prevent inappropriate reliefs. A recommendation is that a general anti-abuse rule should be included in all double tax treaties.
What is action 7 of the OECD BEPS?
Prevent the artificial avoidance of PE status.
A construction site is generally considered a PE after 12 months. Action 7 prevents artificial splitting up of a contract to avoid this. It also covers the use of agents and removes the distinction between a dependent agent (PE) and an independent agent (not a PE). An agent who concludes contracts, or arranges contracts between the customer and the principal, will now lead to a PE.
Google tax, diverted profit tax
What is action 8 of the OECD BEPS?
Assure that transfer pricing outcomes are in line with value creation: intangibles
Intangible assets are particularly mobile and attract favourable tax rules, particularly in Luxembourg and the Netherlands, but also with the UK patent box rules, whereby income from patents is taxed at 10%.
What is action 9 of the OECD BEPS?
Assure that transfer pricing outcomes are in line with value creation: risks and capital
Transfer pricing can often inflate prices due to the risks a company has assumed or the capital it has provided.
What is action 10 of the OECD BEPS?
Assure that transfer pricing outcomes are in line with value creation: other.
Actions 8, 9 and 10 (and 13 – below) cover transfer pricing, widely believed to be the key way of shifting profits. Where there are no similar transactions outwith the group to determine an ‘arm’s-length price’ MNEs have a significant advantage over tax authorities (information asymmetry) when arguing how the transfer price is determined.
Governments may not want to be too draconian for fear of losing the MNE, and this is a particular problem for developing countries.
Furthermore, enforcing arm’s length prices requires interpreting substantial commercial data and/or negotiation with the MNE, areas where developing countries may not have the necessary wherewithal.
Changes will be made to the OECD’s Transfer Pricing Guidelines and to the Model Tax Convention.
