What CFOs Need to Know About BEPS

The Base Erosion and Profit Shifting (BEPS) project is an initiative being pursued by the Organization of Economic Cooperation and Development (OECD) to curtail perceived exploitation of international tax rules and loopholes by multinational enterprises (MNEs).

The OECD’s BEPS project was initiated in 2013 at the request of the Group of 20 major economies (G20). The OECD has significant influence on international tax regulations around the world, whether by creating the framework within which local regulations are written, or in some cases, through direct reference to OECD guidelines embedded in regulations. The BEPS project resulted in a series of proposals for revising international tax standards, and several of its key final recommendations delivered on October 5, 2015.

The BEPS project covers a number of important areas in international tax, including:
• Guidance related to permanent establishments;
• Elimination of hybrid mismatch arrangements;
• Revisions to eliminate the potential for abusing tax treaty networks to achieve BEPS; and
• Revisions to guidance associated with Controlled Foreign Corporations.

In addition to these areas, much of the BEPS project has focused on guidance associated with cross-border transfer pricing (the practice of setting intercompany prices among related affiliates within a corporate group). All multinationals engage in some form of transfer pricing for various reasons. While many companies simply seek compliance, others structure their intercompany arrangements to achieve lower taxes.

It is not the intention of the BEPS project to eliminate the ability of corporations to lower their overall tax rate. It is, however, the intention of the BEPS project to limit or eliminate the ability of corporations to achieve this result by engaging in transfer pricing practices that allocate profits to jurisdictions that have little to no substance (or little to no actual contributions to the corporation’s value-creating activities).

Final deliverables associated with many of the action items were released on October 5, 2015. It is important for MNEs to understand the issues at hand. With respect to the transfer pricing guidance (the primary focus of this brief discussion), the United States has already stated that the revisions to OECD guidance will not require any significant changes to the transfer pricing regulations under Section 482. Other countries, however, such as China, have announced intentions to significantly overhaul their regulations based on the BEPS deliverables.

There is one change that is expected to be almost universal for countries participating in the BEPS project. This change is to the disclosures that companies provide to tax authorities and the documentation they prepare to demonstrate that their transfer pricing practices comply with the appropriate regulations around the world.

New Disclosure Requirements
In September 2014, the OECD issued its final report on Action Item 13, which sought to reexamine transfer pricing documentation “to enhance transparency for tax administrations.” As a result of this work, two key reforms have emerged from the BEPS project: the so-called “Master File” report and “Country-by-Country Reporting” (or CBCR) template. Both aim to provide local taxing authorities with a more global view of the MNEs operating in their jurisdiction. Many countries (such as Australia, Canada, Germany, South Korea, Spain, and the United Kingdom) have begun adopting requirements related to these documents.

The Master File is a comprehensive documentation requirement under which MNEs must detail their external and internal operations. Specifically, the Master File report must include the MNE’s organization structure, and describe the MNE’s business (or businesses), intangible property, financial activities, and financial and tax positions. These items must all be addressed from a global perspective. This Master File report is to be supplemented by a “Local File” report providing the detailed information needed to substantiate transfer prices for a specific tax jurisdiction. The Local File should be provided in conjunction with the Master File report. Collectively, the two documents will provide local tax authorities with much more information to examine the taxpayer’s affairs from a global perspective than is typically the case today.

The Master File and Local File are supplemented by a completed CBCR template. This template is one of the most important changes coming out of the BEPS project, and it has created a good deal of concern within the business community. With this report, the MNE provides certain information on a country-by-country basis including key financial and operational data such as revenue, income earned, taxes paid, number of employees, tangible assets, and the split of third-party and intercompany revenue. In addition, the CBCR must provide a global list of entities with their “main business activities” indicated. The “main business activities” follow a predefined grid of possibilities (such as research and development, manufacturing or production, purchasing or procurement, etc.)

There are several concerns held by MNEs with respect to the CBCR.

First, there is concern about the potential disclosure of information outside of tax authorities. The business community has expressed
worries that important confidential information may not be tightly controlled, and could fall into the wrong hands (such as those of competitors) unless tax authorities have proper safeguards in place to prevent its release.

Secondly, there is a concern that this information will be used by tax authorities inappropriately. While the OECD has made it clear that the CBCR should only be used as a “risk assessment” tool, much of the information being provided on the template might be used by certain tax authorities to inappropriately tax an apportionment of global profit based upon some factor using CBCR data (for instance, the total number of employees). There has already been anecdotal evidence of tax authorities in certain developing countries assessing additional taxes based on these types of profit splits.

Lastly, the proper way to fill out the template is not perfectly clear given ambiguities around the appropriate level of aggregation, the classification of “main business activities,” and other similar matters.

Generally speaking, the CBCR template will first be submitted to tax authorities for tax years starting on or after January 1, 2016. Many companies are already creating these materials for their current fiscal year to better understand the information-gathering challenges they may face (and to solve those challenges), and to understand the best way to address any actual or implied misalignments between taxable profit recognition and performance of value-creating functions.

Changes to the Transfer Pricing Guidance — Risk
The BEPS deliverables issued in final form, October 5, 2015, introduce certain intercompany transfer pricing guidance associated with risk. Nonetheless, some changes are certain to happen. Key areas of change include the treatment of development funding and the attribution of risk with associated investments, along with changes in pricing approaches that may follow.

The new guidance places more emphasis on the importance of managerial control over risk as a determinant of the ability for a given entity to attract and retain residual profits. It puts changes in place that will limit the tax benefits that accrue to entities that have minimal functions in low-tax jurisdictions based upon their funding of intangible development activities and their contractual assumption of risk. The final guidance holds that such risk allocations (and investments in risk activities) should only be respected if the managerial control of the associated risks occur in that entity. If entities are contributing funding without having the substance to make the decisions associated with managing the risky investments, they likely will not be able to retain the vast majority of profits arising from those investments.

On major concern coming out of the BEPS project is that both the guidance around controlling risk, and other areas of revised transfer pricing guidance could be interpreted and applied differently by different tax authorities, leading to a substantial increase in double taxation.
This is one of the most important outcomes that CFOs should expect from the BEPS project. Revisions reflected in the final guidance are somewhat unclear with respect to what needs to happen if multiple entities play important roles in controlling risks associated with an intercompany transaction. This (along with other areas not discussed here) may mean that companies may face a large increase in the incidence of double tax.

At the outset of BEPS, a proposal of using formulary apportionment was being considered. Formulary apportionment would use quantifiable metrics (such as headcount, assets, etc.) as a method for allocating each MNE’s global taxable income — a system similar on a broad level to unitary taxation approaches adopted for state tax purposes in certain states in the U.S. As a general matter, to the great relief of most taxpayers, the arm’s length standard as the basis of analysis has been repeatedly upheld throughout the BEPS project over the objections of certain countries (such as China) and organizations (such as the BEPS Monitoring Group). However, it should be recognized that certain aspects of the BEPS project (including the CBCR template and some of the discussions around risk management) have observers concerned that some outcomes from the BEPS project may lead certain countries to assess taxes using quasi-formulary apportionment approaches.

Intercompany Debt and Interest
There is one area where the OECD seems to have moved away from the arm’s length standard: intercompany financing. Intercompany debt and the associated interest expense deductions taken by taxpayers has long been a difficult area for tax authorities because of the basic premise that equity and debt are taxed differently. The decision to finance with debt capital versus other forms of financing (e.g., equity) can be driven by tax considerations, but that is not the only consideration. Nonetheless, tax authorities have for a long time viewed intercompany interest payments with skepticism. The result has typically been thin-capitalization rules used to limit the interest expense deductions that can be taken, such as the “earnings stripping” regulations of the IRS.

The OECD is trying to establish a uniform set of rules for intercompany debt under the BEPS project. However, unlike the pricing of goods, services, and intangible property, the framework included in the final report are not based strictly on the arm’s length standard, and are instead rules-based. Proposal included in the prior discussion draft for Action Item 4 included proposals for MNEs to allocate group-wide interest expense by some measure of economic activity, or outright capping of deductions at a fixed ratio. This latter proposal went so far as to potentially prevent an MNE from fully deducting its total third-party interest expense.

In the final report, the OECD recommends countries establish a fixed interest/EBITDA ratio as the maximum interest deduction. The OECD allows an alternative to this position by suggesting that countries adopt an “opt-out” option for highly leveraged companies to use their group-wide interest coverage ratio (or some derivative of it), so they are not impacted unduly by the fixed ratio rule. The OECD expects to release further guidance on this topic that would specifically apply to banks and insurance companies. MNEs with significant intercompany debt are advised to watch these developments closely.

Intercompany Services
Action Item 10 sought to develop approaches to “achieve the necessary balance between appropriate charges for low value added services and head office expenses and the need to protect the tax base of the payor countries.” A key area of tension for these charges is how allocations are made for certain functions performed for affiliates globally that provide a true benefit, versus activities primarily intended to help the parent company monitor its global enterprise.

For many taxpayers, the OECD’s focus on this topic was welcome because they find charges made of the parent company are inappropriately being denied deductibilityabroad on a regular basis. Making matters worse, it is often a series of small charges to different countries, but these are material when considered in aggregate worldwide. When deductions for these charges are denied in the payor’s country, such charges are rarely recouped through Competent Authority because of the cost/benefit of such proceedings, and double taxation tends to remain unresolved. This is an especially sore point for many U.S.-based multinationals due to U.S. transfer pricing regulations requiring most headquarters operations to allocate some portion of their cost.

The BEPS project attempted to reduce this tension. The final guidance on services acknowledges that there is a need for MNEs to limit headquarters’ allocated costs to those that provide some benefit abroad. At the same time, however, the proposal recognizes that some functions and costs are truly beneficial, but their benefit is more of a general nature, and so may not be easily demonstrated for specific entities.

Other areas explored are safe harbors for cost mark-ups on low value-added service charges, documentation, intercompany agreements and cost allocation calculations. Final recommendations in the OECD’s guidelines may provide clarification and practical solutions to issues faced by taxpayers associated with low-value services. It remains to be seen, however, how widespread the adoption new rules will be for countries that feel unfairly subject to general allocations of cost.

Take-aways for CFOs
Governments have been increasingly focused on the ways that MNEs may engage in behavior that might be viewed as abusive as it relates to international taxation practices. One need look no further than cases alleging inappropriate State Aid in the European Union and the highly publicized tax shaming of several U.S.-based MNEs by certain governmental figures in the UK to see this is the case. In this environment, the G20 sought to have the OECD undertake a project to change international tax guidance to combat corporate behaviors that create misalignment in income recognition and value creating activities to generate tax benefit. The final deliverables from the BEPS project lead to some important revision in guidance around several areas of international tax, including transfer pricing.

While the objectives of the BEPS project are legitimate, some of the changes may lead to increases in incidence of potential double tax, even for MNEs that are not engaging in behaviors that are meant to reduce taxation through BEPS. This is the case because increased disclosure requirements and vagueness in the final guidance may empower certain revenue authorities (and particularly those in developing countries) to take aggressive revenue positions that substantially increase taxable income in their country relative to anything that could legitimately be supported under the arm’s length principle.

Companies may try to resolve instances of double taxation through the mutual agreement process where such relief is available by tax treaty. However, this process can require a great commitment of resources, and can, based on historical evidence, take a long time to resolve.

Companies can best prepare themselves by acting now. Compiling the Master File report and CBCR template that will satisfy the new disclosure requirements is a great first step. The real value-add, however, is in taking this a step further by reviewing these documents from the perspective of a local tax auditor. This process will help identify where a company’s risks may be, how great those risks are, and what measures can be taken to mitigate them.

As for the broader consequences of the BEPS project, specifics will become clearer as countries adopt various provisions of the final BEPS deliverables into domestic legislation. It will take time for local transfer pricing regulations to change in response to the BEPS deliverables (if they are changing at all). At least one general conclusion that can be drawn now is that the people and substance will need to align more with the tax positions taken.

As stated by Robert Stack, the U.S. Treasury’s lead delegate to the OECD’s committee of Fiscal Affairs, “the idea that you have got to put substance in place and have real activities is going to catch on.”