New architecture for international taxation

OECD's recommendation to implement a country by country reporting under Action 13 is a welcome move and will establish an important mechanism for exchange of information between different jurisdictions.

In 2013, Group of 20 (G20) countries requested the Organisation for Economic Cooperation and Development (OECD) to formulate measures to address concerns on international tax avoidance by multinational companies and reform the interantional tax system.

Since then, OECD has outlined 15 focus areas to tackle so-called Base Erosion and Profit Shifting (BEPS), released 23 discussion drafts, and had several intense rounds of public consultations.

Earlier this week, it released a comprehensive plan to tackle BEPS through 15 action steps. These are to be considered by finance ministers of the G20 nations in a meeting in Lima, Peru, on 8 October.

The BEPS initiative was the result of the perception that some multinational corporations resort to opaque structures to achieve a low taxable income and park their profits in low-tax jurisdictions.

India, a member of the G20, has always maintained it has been at the receiving end of BEPS, and was an active participant to this initiative.

From an Indian perspective, while some of the measures suggested by OECD may not be relevant in the near future, others are significant. These include the taxation of the digital economy (Action 1); treaty shopping and abuse (Action 6); avoidance of permanent establishments (Action 7); transfer pricing rules in the key area of intangibles (Action 8); transfer pricing documentation and country-by-country reporting (Action 13); and the agreement to implement BEPS action steps through a multilateral instrument (Action 15).

The issue of treaty shopping and abuse was a key driver for the BEPS initiative. Action 6 is aimed at suggesting measures to curb multi-layered structures involving low or no tax regimes. OECD has suggested three approaches to eliminate treaty shopping:

(i) To incorporate a clear statement in the title and preamble of the tax treaties that tax treaties do not intend to create opportunities for treaty shopping;

(ii) Limitation-on-Benefits (LOB) rule—largely similar to the rule existing in tax treaties entered by the US;

(iii) A more general anti-abuse rule based on principle purposes of transactions or arrangements (PPT test).

The LOB test in the tax treaties will be a significant deterrent to treaty shopping. However, an all-encompassing LOB provision, coupled with the PPT test, may make tax treaty entitlement difficult for even genuine taxpayers and inhibit genuine cross-border trade and investments.

India has a LOB test in its tax treaty with the US and Singapore. It has been attempting to incorporate an LOB clause in its treaty with Mauritius, which exempts capital gains earned by its residents. Given the current draft of LOB test, large number of multinational companies investing through group holding structures incorporated in a low tax jurisdiction may fail this test.

Actions 8 to 10 are an outcome of OECD’s realization that the current framework of international transfer pricing rules can be misapplied, specifically with regard to the allocation of profits with the economic activity undertaken. Accordingly, they provide special measures with regard to intangibles, risk and over-capitalization.

For intangibles, the guidance clarifies that legal ownership alone does not necessarily generate a right to all the return that is generated by the exploitation of the intangible. Group companies performing important functions, contributing assets and controlling economically significant risks should be entitled to appropriate returns, reflecting the value of their contributions.

For India, the precedence of economic ownership over legal ownership as asserted under Action Step 8 will assist the tax department to lay a legitimate claim on the research and development (R&D) operations carried on in India and funded by a foreign principal.

On the aspect of marketing intangibles, the action step suggests the independent compensation to distributor (incurring marketing expenditure) is not necessary if he is compensated by way of increase profits through other modes. This view is contrary to the view taken by select Indian courts.

OECD’s recommendation to implement a country by country reporting under Action 13 is a welcome move and will establish an important mechanism for exchange of information between different jurisdictions. Given the comprehensive details required to be maintained under such reporting, a revenue threshold of €750 million is quite useful and will reduce the compliance burden on medium and small-sized multinational enterprises.

From an Indian perspective, the threshold of €750 million is sufficiently high to avoid the compliance burden of such reporting being imposed on several Indian companies that operate in multiple locations around the world. However, it will certain allow the Indian taxman to bring on the radar several foreign groups and get hold of critical information with respect to the business operations of such groups in different jurisdictions where the significant part of profits are alleged to be parked.

OECD has not specifically suggested any measures to address the direct tax challenges of the digital economy under Action 1 with a view that other measures with respect to permanent establishments, transfer pricing, and so-called controlled foreign company rules will address such challenges. However, the rules have been devised to ensure that value-added taxes are collected in a country where the consumer is located, a reasoned and rationale tax regime for business-to-consumer e-commerce transactions.

Last but not the least, Action 15 attempts to address how the measures proposed under Action 1 to 14 are proposed to be endorsed and made effective. OECD’s recommendation is that the interested countries will develop a multilateral instrument to provide an innovative approach in implementing tax treaty measures agreed upon.

The development of such an instrument is aimed to be completed by December 2016. India’s approach on each of the action steps will need to be closely observed as it could have an overarching and long-lasting impact on basic principles and interpretation of international taxation and transfer pricing laws in the country.

The author is leader, direct tax, BMR & Associates LLP. The column has inputs from Puneet Gupta, associate director, BMR & Associates LLP.

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