Base erosion and profit shifting (BEPS) is the term used for a set of tax planning strategies deployed by multinational corporations (MNCs) that either take advantage of loopholes between differing jurisdiction’s tax regulations to ‘hide’ profits, or shift profits to low-tax locations where they are largely inactive in order to pay less corporate tax.
MNCs build their corporate structures through cross-border expansion into international markets. Foreign direct investment (FDI) flows are often dictated by MNCs carrying out these international expansions in the most tax-efficient manner. In some cases, the interaction of domestic tax regimes can leave gaps in which companies find they can avoid paying tax. BEPS strategies exploit these gaps between national tax regimes to achieve non-taxation.
The BEPS project – what is it?
The use of BEPS strategies affects all countries and is something the OECD committed to address as tax avoidance became a priority for many jurisdictions after the 2008 financial crisis, and gained further momentum with the release of the so-called Panama Papers in 2016.
The OECD/G20 Inclusive Framework on BEPS is a coordinated effort that published guidance in 2015 to make significant changes to international tax laws, which had not been changed since 1928. The project includes more than 135 countries working together to implement 15 actions to tackle tax avoidance, streamline international tax rules and create more transparency. So far, the EU has led the world in implementing the BEPS project guidelines.
The OECD estimates that BEPS practices cost countries $100–240bn in annual lost revenue, which represents 4–10% of overall global corporate income tax revenue. BEPS also distorts competition and can put domestic companies at a competitive disadvantage. Tackling the problem has held particular importance for developing countries, as they tend to have a higher reliance on corporate income tax.
As well as the financial repercussions of tax avoidance, on a more existential level, the OECD has stated that governments must act together to restore public trust in domestic and international tax systems.
OECD action plan
The OECD action plan on BEPS has 15 action points that aim to standardise international tax rules and prevent MNCs from paying little or no tax. The areas covered by the plan include:
• The guidelines focus very much on the tax challenges that the digital economy poses for existing international tax rules. A significant market presence in a country without a corresponding physical presence in terms of tangible investment has become ever more prevalent with the advent of the digital age. The OECD conceived of BEPS 2.0 to directly address the tax challenges of this digitalisation of the economy. Following a public consultation in March 2019, a programme of work to develop a consensus solution to the tax challenges arising from the digitalisation of the economy was published on 31 May 2019.
The challenge in the digital economy is taxing profit where economic activities occur and identifying where value is created. Tax authorities are facing increasing challenges because the global economy now works though intangible property, which is easier to shift to low-tax jurisdictions. Some MNCs are assigning their intangible property to tax havens or investment hubs. The new BEPS guidelines suggest global tech companies may now be taxed where their consumers and users are as it is always possible to shift labour, investment, and research and development but not as easy to shift consumers.
Under the framework to address BEPS strategies, income from intangible property should be allocated to operations that cover a firm’s development, enhancement, maintenance, protection and exploitation of intangibles. The BEPS requirement to report a country-to-country breakdown of global profits and taxes paid will give governments greater transparency of the exact location where different functions take place and where profit is generated.
• Governments now have a mandate to crack down on companies seeking to exploit gaps in the international tax framework to achieve double non-taxation or base erosion by using hybrid mismatches. The BEPS project cannot legislate for a country’s corporate income tax rate, but it will have an impact on tax regimes that seek to attract foreign investors without requiring any economic activity in the location. Switzerland, the UK, Germany and other countries have already been prompted by the BEPS project to prevent companies from using hybrid structures for the sole purpose of gaining tax advantages. MNCs setting up corporate structures by channelling FDI through offshore investment hubs and offshore financial centres such as tax havens and jurisdictions offering special tax concessions will no longer be able to do so under the new BEPS recommendations.
These FDI flows are not always non-productive. For example, an investment by a UK firm in India to build a new factory may be channelled through Europe for tax reasons – this means that though the destination country (India) and the source country (the UK) lose out on tax revenue, the end result is still greenfield FDI, which creates jobs and value in the host country. The question is whether MNCs will alter investment patterns if the tax regime of locations hosting MNCs’ tangible operations renders the investment unattractive.
• The BEPS guidelines will attempt to strengthen controlled foreign company rules to address routing income of a resident enterprise through a non-resident affiliate to reduce or avoid taxation.
• The new BEPS guidelines will recommend a review of domestic tax rules to prevent the granting of treaty benefits in inappropriate circumstances as well as the rules for permanent establishment status.
• The guidelines will also focus on transfer pricing outcomes, making recommendations that they are in line with value creation by requiring that the attribution of value for tax purposes is consistent with economic activity generating that value. Greater transparency around documentation to do with transfer pricing will also be required.
• The guidelines recommend supranational implementation of the BEPS measures to more easily amend bilateral tax treaties, resolve treaty-related disputes, and cut down on aggressive tax transactions, arrangements and structures, all with a greater emphasis on more BEPS data collection and analysis.
What does this mean for MNCs?
Many within MNCs are sceptical about the new tax avoidance measures and see them as an opportunistic way for governments to essentially increase taxation by exploiting the public appetite for greater corporate accountability. However, the OECD insists that its measures are not designed to penalise MNCs or low-tax locations, but rather to weed out practices that artificially separate taxable income from the activities that generate it.
According to the OECD, the BEPS project aims to reduce disputes using a more coherent tax framework to give businesses greater certainty while reinforcing the fairness and consistency of the international tax system.
Shift towards real-world assets becoming profit centres
The most likely outcome from new BEPS recommendations is that MNCs will need to make a structural shift towards aligning jurisdictions in which they report profit with jurisdictions in which their tangible operations are based. This may result in reduced flexibility in operating models and holding structures. Transactions both within companies and externally will likely reflect a greater requirement to show they are directed from and towards tangible operations, including transferring intangible assets onshore.
The worry here for MNCs is that while the OECD, along with the European Commission’s own proposals for a common corporate tax base, may well succeed in eliminating tax avoidance, there is a real danger of transparency measures resulting in double taxation for some companies. An increased risk of double taxation will not happen by design but is a real possibility for some companies because of the increased complexity between differing country approaches.
In addition, differing interpretations of the BEPS guidelines and patchy adoption may create further complexity for MNCs rather than the intended supranational tax framework. For example, the US has tended to opt out of key initiatives within the recommendations, and Australia and the UK have gone further than the recommendations require. Many believe the ideal of a common consolidated tax base with minimum global tax rates is unlikely to be achieved through these recommendations.
Instead, the BEPS project will simply constitute a review of where profits are made and placed under tax law. Winners of this shifting tax framework will likely be governments of territories with large consumer markets as the shift will be towards taxing consumers. The digital economy is bound to be disproportionally affected as a significant portion of its business is reliant on intangible property. Primary industries such as mining, which are anchored to a physical location, will be the least affected. Companies that make large profits outside their home market will be affected by the rules.
Uncertainty and added complexity
As Europe leads the way on implementation of many of the BEPS project’s recommendations, many believe international companies operating in Europe will experience greater uncertainty, complexity – and tax disputes – than ever before. Tax authorities in Europe have been more aggressive in their audit practices as a result of the OECD’s BEPS recommendations. It seems likely that firms can expect more rigorous audits as countries implement new cross-border tax regimes and as a result many corporate structures may need to be revised or replaced entirely. Companies planning cross-border expansions need to ensure all international expansions are BEPS compliant. This may require intragroup finance arrangements, the development of new transfer pricing policies and documentation processes, as well as the migration of holding company structures for intellectual property holdings.
Companies need to evaluate whether they have the skills and resources to comply with the requirement to report country-by-country profit and taxes, which will lead to a proliferation of documentation. Country-by-country reporting requires a breakdown of MNCs’ financial statements by jurisdiction, which will need to be filed in each country that the company operates within. This aggregated information sharing will mean significant extra cost in order to stay compliant with the new requirements.
The BEPS project is likely to increase uncertainty within an ever-shifting global tax framework as countries interpret the rules slightly differently. Some rules are formulaic, but others are less defined, and some say it will be increasingly difficult for MNCs to ever become fully BEPS compliant. And with more financial data in their possession, tax authorities have the potential to enter into litigation for a greater share of a company’s profits. Companies must also be aware of the reputational risk that greater transparency can lead to, added to the public appetite for accountability and fairness regarding MNCs.
With increased complexity and uncertainty, forecasting revenue streams will become more problematic, particularly when broken down by jurisdiction, as MNC structures change to comply with the regulations. This may in turn change perceptions of deal value and pricing of assets. Aggregated tax information across different jurisdictions will increase complexity for companies looking to make acquisitions during the due diligence period.
To conclude, it is worth bearing in mind that all the OECD guidelines are just that, guidelines, and it is up to the individual countries/tax jurisdictions to implement them into law. MNCs will have to evaluate their global operations and foreign locations to reassess structures and determine whether they are BEPS compliant. However, until each county adopts the guidelines, companies can only evaluate and prepare for different scenarios. According to international tax firm KPMG, good tax leaders can still take action by rethinking legacy structures within firms and acting early. The most effective leaders will not wait for country-to-country legislation to be implemented but will act in advance to ensure smooth transitions.