Globalisation has, no doubt, benefited businesses over the past two decades, leading to a mushrooming of multinational enterprises (MNEs). These enterprises have centralised functions; they have integrated supply chains operating in the digital world, and fiscal and tax treaties between countries boost trade, ensuring avoidance of double taxation.
Although tax is the sovereign right of a country, there are a host of conspicuous avenues to plan taxes, by the use of tax treaties and favourable tax laws of certain countries.
MNEs have capitalised on such arbitrage by aggressively planning their tax affairs, leading to shifting of profits to lower-tax jurisdictions or double non-taxation of income, using a mirage of tax treaties. Understandably, this has led to a colossal loss of tax revenues and impacted governments, individual and local players.
Tax transparency
The Organisation for Economic Cooperation and Development (OECD), a global body, realised this phenomenon and initiated the Base Erosion and Profit Shifting (BEPS) project to bring in transparency and improve co-ordination of tax affairs.
Key themes, action plans
The BEPS project has been designed around five key themes and has devised 15 focused Action Plans to implement them. The draft reports on these action plans were released recently and, especially for entrepreneurs who want to take their businesses global, it is imperative that they understand this project.
In today’s dynamic world, it is important to understand the nuances of the digital economy, and an effective tax framework needs to be built; the extant international tax laws are obsolete and cannot govern digital businesses.
Traditionally, taxation or a taxable nexus in a foreign country, is triggered if there is a business presence, typically referred to as a Permanent Establishment (PE). But in the digital world, business presence is difficult to determine.
For this, Action plan 1, which deals with addressing tax challenges in the digital economy, introduces new concepts such as fully dematerialised digital activities (in order to cover e-commerce businesses). The taxable nexus has been widened to cover significant digital presence, rather than other conventional parameters. Levying something called bandwidth tax or “Bit” tax is also envisaged.
International tax coherence
To establish international tax coherence, it is important that the effects of hybrid mismatch arrangements are neutralised (this is dealt with in Action Plan 2); it is also imperative to strengthen rules with respect to Controlled Foreign Corporation (Action Plan 3), and limit the base erosion via exorbitant interest deductions and financial payments (Action Plan 4). Harmful tax practices, such as use of low-tax jurisdictions, need to be countered by introducing transparency (Action Plan 5).
There are hybrid financial instruments, such as preference shares or convertible debentures, which are treated by one country as equity, and another as debt. These mismatches lead to tax deduction in one country and no corresponding taxability in the other. Action plan 2 suggests changes in domestic laws by denial of deduction for tax, or levying of tax for such instruments, and bringing in modification in tax treaties.
Action plan 4 suggests that interest deductions be allocated to each group entity based on an appropriate basis — say, level of economic activity. The interest is to be capped at a fixed percentage of profits, and specific rules must be prescribed for certain industries, such as banks and insurance.
Action plan 5 suggests avoidance of harmful tax practices to encourage investments. These practices include no or low effective tax rate (Mauritius), lack of transparency (Switzerland earlier) and negotiable tax rate or base (Singapore).
Benefits of international standards
Several international standards are prevalent by way of tax treaties and transfer pricing mechanisms, which ensure that related tax-payers deal in a fair manner and operate on an arm’s-length principle. The BEPS project focuses on prevention of abuse of tax treaties (Action plan 6) and prevention of avoidance of PE status (or taxable nexus, dealt with in Action Plan 7).
Action Plan 6 proposes to introduce in the preamble that treaty provisions are not for double non-taxation or reducing taxation, but for establishing the purpose and business substance tests.
Further, critical steps are being taken to streamline transfer pricing outcomes — allocating income commensurate with the activity; for instance, value creation undertaken by preventing unnecessary migration of intangibles (Action Plan 8), transferring of risk and allocating excessive capital to specific jurisdictions (Action Plan 9), and discouraging rare high-risk transactions (Action Plan 10).
Ensuring transparency
Transparency at different levels can be achieved by collecting and analysing data on the use of the BEPS methodology, and taking steps to address the same (Action plan 11).
Action plan 12 proposes to make mandatory the reporting of aggressive tax planning schemes, mechanics of the scheme, details of those enjoying the tax benefits and any other details as prescribed by the tax authorities. It could be reported by the tax-payer or a promoter.
The schemes that can be reported include hybrid instruments, use of low tax jurisdictions, and utilisation of losses, among others. The promoter can report when he develops and sells the scheme, while the tax-payer can report it when he implements the same.
Transparency can also be enhanced by re-examining transfer pricing documentation. This can be done by calling for information on global allocation of income, economic activity and taxes paid among countries, according to a common template, such as a country-by-country reporting mechanism (Action Plan 13).
Further, a certainty dispute resolution mechanism can be made more effective (Action plan 14). Adopting the BEPS approach would lead to several tax issues among countries, which is why it is suggested that an Effective Mutual Agreement Procedure be formulated. Resolutions under the MAP should be made compulsory, instead of recommendatory, as it stands today.
Swift implementation
As can be seen, the BEPS project is elaborate and envisages significant analysis and solutions. It is imperative that innovative ways are explored to implement these measures through multilateral instruments, which would serve as a guiding force for countries to amend their bilateral tax treaties. This would enable better global co-ordination in tax affairs.
Need for multilateral agreement
Implementation of this project would require significant amendments in the domestic laws of some countries, robust international law guidance through commentaries and guidelines from OECD. To expedite the process, a multilateral agreement needs to be introduced, which can be agreed upon by several countries.
India has been an avid follower of the BEPS project and it is likely that some suggestions related to BEPS will be made in the upcoming Budget. Although these weapons are in the government’s arsenal, businessmen should not deviate from their religion of entrepreneurship — they need to understand the impact of the BEPS action plans, and arrange their affairs accordingly.