Hammer of BEPS on Harmful Tax Practices in disregard of transparency and substance

By: Pinakin D Desai, Partner – Tax & Regulatory services, EY India

The term Base Erosion and Profit Shifting (BEPS) refers to tax avoidance strategies which, by exploiting gaps and mismatches in tax rules, shift profits of Multinational Enterprise (‘MNE’) Groups to low or no tax locations where there is little or no real activity. The Organisation for Economic Co-operation and Development (OECD) has published ‘Action Plans’ on BEPS as an initiative aimed at curbing such strategies. The Action Plans are built around three pillars viz. Coherence, Substance and Transparency.

Background on Action Plan: 5:

As part of its initiative, the Forum on Harmful Tax Practices (FHTP or Forum) set up in 1998 is activated with renewed focus on substance and transparency in evaluation of tax strategies of MNE. In this regard, OECD had released an interim report on Action Plan 5- ‘Countering Harmful Tax Practices More Effectively, Taking into
Account Transparency and Substance’ on 16 September 2014.

Objective of OECD Initiative:

The Action Plan built around pillar of “coherence” aims at bringing consistency between countries by discouraging unfair tax competition amongst tax jurisdictions and thereby creating a “level playing field”. It aims to eliminate scope and opportunity to artificially shift profits from a jurisdiction where the actual economic activity takes place to a low or no tax jurisdiction where there is no commensurate economic activity or substance.

Which regimes are to be reviewed by the Forum?

Currently, only regimes relating to business taxation of income from geographically mobile activities, like financial and other service activities, including the provision of intangibles are within the lens of FHTP. Each of these activities is considered sensitive since it is mobile in nature and can be housed in any jurisdiction with relative ease.

Regime and preferential tax regime:

A regime is a set of Rules and regulations or practices within a tax jurisdiction. When regimes offer some form of tax preference in comparison with general principles of taxation in that country, it is regarded as preferential. It can be equated with grant of a tax exemption. Few examples of regimes are Intellectual Property (IP) Regime, Financial transactions Regime, etc.

There can be a preferential tax regime within a jurisdiction which is otherwise not regarded to be a ‘tax haven’.

The object is not to question grant of a legitimate ‘tax incentive’. For example, SEZ regime in India is a preferential tax regime, but it is not harmful since it is meant to attract economic development and it limits right to enjoy exemption for income which has nexus with SEZ undertaking in India.

When is a preferential regime harmful?

A Preferential regime is classified as potentially harmful where it imposes no or low tax on income, accompanied by ring-fencing from domestic economy or lacking transparency or effective exchange of information.

In order to determine whether or not a regime is harmful, the “substantial activity requirement” test along with certain other key factors are examined to conclude whether, under the regime, profits are taxed where economic activities generating profits are performed and where value is created.

For example, to determine whether preferential IP regime in a country meets this “substantial activity requirement”, the “nexus approach” may be a litmus test. The nexus approach deploys ‘expenditure’ criterion to identify proportion of income which can legitimately avail preferential tax treatment. IP regime is not harmful if preferentially taxed income allocated to a country is proportional to expenditure incurred in that country on creation of IP.

Is the potentially harmful regime actually harmful?

A potentially harmful regime is actually harmful if it generates harmful economic effects, such as temptation of shift of activities from one country to the other for tax advantage rather than for generation of new activities. This can happen if tax concession is allowed in host country even if activities are not commensurate with the amount of investment or income, the ‘preferential regime’ is the primary motivation for the location of an activity, etc.

Consequences that follow on a harmful regime

As part of BEPS, the country which hosts a harmful tax regime is required to abolish the regime or remove the features that create harmful effect. Further, if the regime persists, other countries are allowed or encouraged to take defensive measures to counter the effects of harmful regime. For example, Switzerland proposes to replace its ‘Swiss patent box’ regime; United Kingdom issued directions to modify its patent box regime to align it with the requirements stated in this Action Plan; Ireland too has initiated the process of phasing out the Double Irish Structures which offer preferential treatment to Ireland resident companies.

India’s efforts to take defensive measures in this light can be seen from the special provisions under Indian Tax Law such as applicability of higher withholding to remittances to Cyprus residents where Cyprus was perceived to be harmful due to lack of transparency.

The framework mandates member countries to voluntarily share information to the foreign tax authorities on preferential tax regime practiced or introduced by it irrespective of it being found to be actually harmful. This will provide an opportunity to other countries to cross verify whether tax preference is based on pillar of substance and transparency.

Way forward for Indian MNE Groups

With directions provided in this Report, OECD expects completion of work in this regard in 2015. In the meanwhile, Indian MNE Groups establishing companies in other jurisdictions should be aware that attractive tax incentives which are not sanctioned by the pillars of substance and transparency may not survive for long.