Introduction
The recent tax investigations by the British Parliamentary Committees, U. S. Senate and the Australian Senate Economics References Committee on the tax-avoidancedriven structures of multi-national corporations, such as Starbucks, Apple, Google and Microsoft among others, have shifted the focus from prevention of tax evasion to prevention of tax avoidance and aggressive tax planning. Today, countries, whilst trying to maintain a certain form of tax competitiveness, have realised the effect that the tax loss on account of the aggressive tax planning structures is having on the recovering economies, and are trying hard to crack down on aggressive tax planning structures, which result in the erosion of their sovereign tax base. Closer home, this shift is also reflected in the big-bang amendments to the Finance Bill, 2012 in the aftermath of the Vodafone judgement.
However, there was a growing consensus among the member countries of the G20 that there would need to be a common set of guidelines to be enacted by all the countries so as to effectively tackle such aggressive structures. Hence, the OECD on request by the leaders of the member countries of the G20, in 2013, formulated a 15 – point Action Plan under the Base Erosion and Profit Shifting (‘BEPS’) Project. On 5th October 2015, the OECD issued the final reports on the BEPS Project. During the 2 years, the OECD released discussion drafts for public comments under each of the Action Plans. The final reports were issued after taking into consideration the public comments received on the discussion drafts as well as on the basis of discussion with various other organisations such as the United Nations, African Tax Administration, Centre de recontre des administrations fiscales and the Centro Interamericano de Administraciones Tributarias, the International Monetary Fund and the World Bank.
This article attempts to briefly summarise all the Action Plans of the BEPS Project and the possible impact in India, due to likely amendments in the Income-tax Act, 1961 (‘Act’) in light of the BEPS Project. In this regard, it may be pointed out that it would be worthwhile for a practitioner in the field of international tax to understand all the Action Plans, irrespective of their effect in an Indian context, as international tax involves the interaction of the domestic tax laws of various countries. It may be possible that while not implemented in India, some of the Action Plans may have been implemented in various other countries, involved in future transactions with India, and would therefore impact such transactions.
Action 1: Addressing the Tax Challenges of the Digital Economy
While recognising that in today’s world of the digital economy, the international tax laws, many of which are nearly a century old, would need to be amended, the report on Action 1 states that it is difficult to ring fence the digital economy from the non–digital economy and therefore, in respect of direct taxes, the recommendations have been incorporated in the other Action Plans of the BEPS Project.
Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements
A hybrid financial instrument is generally treated as a debt instrument in the country of the payer, thus leading to a deduction of the interest, but as equity in the country of the recipient, thus leading to be considered eligible for a participation exemption. A hybrid entity on the other hand is one which varies in respect of it’s opacity from a tax perspective in different jurisdictions. One country treats such entity as transparent under its tax laws, whereas another country treats the same entity as opaque under its tax law.
The OECD recognises that hybrid mismatch arrangements can be used to achieve double non – taxation or long – term deferral by exploiting the differences in the tax treatment of instruments or entities under the laws of two or more tax jurisdictions. The Action Plan clearly defines the scope as covering only those mismatch arrangements which involve a hybrid element. Therefore, payments made to exempt entities have not been considered in this Action Plan. Hybrid mismatch arrangements generally involve the use of hybrid financial instruments or hybrid entities. The Action Plan states that the use of hybrid mismatch arrangements leads to lower tax by way of three outcomes, namely
(a) Deduction and Non – Inclusion of Income (D/NI Income): This generally refers to a deduction being claimed in one country for a particular payment with no corresponding income being considered in the country of the recipient.
(b) D ouble Deduction (DD): This generally refers to a single payment being claimed twice as a deduction in two different countries.
(c) Generation of multiple foreign tax credits for one amount of foreign tax paid.
One example of such a possible hybrid mismatch arrangement is provided in order to understand the term better. A partnership firm in India, ABC is treated as an entity, liable to tax in India (as it is a person defined in section 2(31) of the Act), whereas such a firm is treated as transparent in the UK, i.e. the partners are liable to tax on the income of the partnership in the UK. In case, ABC, which has its partners in the UK, makes a payment to a third party, the payment would be considered as a deduction in India while computing the income of ABC. Similarly, at the same time, the UK would disregard the existence of ABC and therefore, would grant the deduction of such payment to its partners, leading to a case of double deduction for the same payment in two different jurisdictions through the use of a hybrid entity, in this case, an Indian partnership.
The OECD has provided the following recommendations in respect of hybrid mismatch arrangements:
(a) I n the case of use of hybrid instruments or hybrid entities giving rise to a D/NI outcome, it is recommended that the payer jurisdiction deny the deduction in the hands of the payer. However, in case the payer jurisdiction does not deny the deduction in the hands of the payer, a secondary rule is recommended whereby the recipient jurisdiction is required to consider the payment as income in the hands of the recipient.
(b) I n the case of payment made to a reverse hybrid (an entity which is transparent under the tax laws of the country in which it is incorporated but opaque under the tax laws of other countries) giving rise to a D/NI outcome, it is recommended that the payer country deny the deduction.
(c) I n the case of payment made by a hybrid entity giving rise to a DD outcome, it is recommended that the jurisdiction of the parent deny the deduction. In case the jurisdiction of the parent is unable to deny the deduction, it is recommended that the jurisdiction of the payer deny the deduction.
(d) In the case of a payment made by a dual resident giving rise to a DD outcome, it is recommended that the jurisdiction of the residence deny the deduction.
In this regard, it may be pointed out that the recommendations provided require amendments in the domestic tax laws of various countries.
Therefore, there is a possibility of the Act being amended to incorporate these recommendations, especially the primary rule of denying the deduction which gives rise to a D/NI outcome. Moreover, the use of primary and defensive or secondary rule may result in an additional compliance burden on the taxpayer as well as the tax administration, as information would be required as regards the taxation of the payments in the corresponding countries, in order to determine if there is a hybrid mismatch arrangement on a case-by-case basis. It is also believed that even in case there is no specific amendment in order to incorporate the recommendations in respect of the hybrid mismatch arrangements, the GAAR in the Act, which is currently proposed to be effective from AY 2018-19, can be used to tackle such structures.
Action 3: Designing Effective Controlled Foreign Company Rules
Action 3 of the BEPS Project provides recommendations regarding the design of CFC rules. It does so by breaking down the CFC rules into building blocks:
a. Definition of CFC
b. Threshold requirements
c. Definition of CFC income
d. Rules for computing income
e. Threshold for attribution of income
f. Rules to prevent or eliminate double taxation
The report states that the main objective of CFC rules is to prevent the income from being shifted either from the parent jurisdiction or the parent as well as other jurisdictions. This would need to be kept in mind while formulating a policy. In respect of the definition of a CFC, it is recommended to broadly define the entities covered under the CFC regime, in order to include even the permanent establishments and transparent entities. With regards to the definition of control for the purpose of determining as to whether an entity is a CFC or not, the report recommends that the CFC rules should provide a combination of both legal and economic control, and supplement that with a de facto test (decision making) or a test based on consolidation for accounting purposes. Further, the report also provides that control should be defined to include both direct as well as indirect control. The report also recommends inclusion of a modified hybrid mismatch rule, which requires an intragroup payment to a CFC to be taken into account for calculation of the income under the CFC rules. Under this modified hybrid mismatch rule, an intragroup payment may be taken into account if the payment is not included in the CFC income and if the payment would have been included in the CFC income if there was no hybrid mismatch. With regards to threshold limits, the report recommends that the CFC rules only apply in case of those foreign companies who are effectively taxed at a rate meaningfully lower than that applied in the parent jurisdiction.
With regards to the CFC income, the report recommends that the rules cover at least the following types of income:
a. Dividends;
b. Interest and other financing income;
c. Insurance income;
d. Sales and services income;
e. Royalties and other IP income.
In respect of computation of income, the report recommends that the rules of the jurisdiction of the parent company apply. It also recommends that the losses of a CFC should be offset against the profits of the same CFC or against the profit of another CFC from the same jurisdiction. Finally, in respect of the attribution of the CFC income to the appropriate shareholders of the CFC, the report recommends that the attribution should be tied to the minimum control threshold and the amount of income to be attributed to each shareholder should be determined in reference to their proportionate shareholding or influence. It may be worthwhile to point out that the proposed Direct Taxes Code Bill, 2010 included CFC rules. The Finance Minister, while presenting the Finance Bill, 2015, stated that the work on DTC would be abandoned as most of the proposed amendments have already been enacted in the Income-tax Act, 1961. However, the legislation in relation to CFC has not yet been enacted in the domestic tax law, and therefore, it is only a matter of time before the same is introduced in the Act.
Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments
Action 4 relating to limitation of interest deductions attempts to address three main risks:
(a) High level of debts being shifted to high tax countries thus leading to an overall lower tax burden for the group;
(b) Intragroup loans being used to generate interest deductions in excess of the group’s actual third party interest expense;
(c) Third party debt or intragroup financing being used to fund the generation of tax exempt income.
In order to address these risks, the report recommends a fixed ratio rule whereby the interest deduction available is linked as a percentage (recommended range of 10% to 30%) of the profits of the entity before taking into account the interest deduction, tax expenditure, depreciation and amortisation (EBITDA). Additionally, the report also recommends that in case the interest expense of an entity exceeds the fixed ratio rule, a country may still allow the deduction up to a limit of the ratio of the overall group’s net interest/EBITDA. In this regard, it may be pointed out that this limit on deduction of interest will apply to all interest expenditure and not just that involving related entities. The Act currently allows deduction of the interest only to the extent it qualifies for a business purpose. There are no rules in the Act specifically limiting the deduction of interest to a specified percentage of profits or earnings. Such a limitation, if introduced, would have a significant tax impact on many Indian companies, which are highly leveraged. Such an amendment may also make it difficult to monitor the overall group’s interest deductions and ratio, and therefore, may lead to an increase in the administrative as well as compliance burden of the taxpayer, as well as that of the tax authorities.
Action 5: Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance
The report on Action 5 deals with preferential tax regimes, such as the IP Box regime, and the amendments required in such regimes, in order to ensure that there is a fair tax competition between the countries. One of the approaches recommended is the nexus approach, which provides that a taxpayer can avail the benefit of the preferential regimes (mainly IP regimes) only to the extent it incurred qualifying R&D expenditure, which gave rise to IP income. The report also recommends the exchange of information in relation to rulings where BEPS may be an issue between countries. Finally the report reviews the preferential regimes of a few countries to determine if they are amounting to harmful tax competition. In this regard, the report provides that the special tax regimes available to certain taxpayers in India such as those in the SEZ, for shipping companies, offshore banking units and life insurance business are not harmful. Therefore, no amendment is expected in respect of this recommendation.
Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances
The Action Plan released in July 2013 by OECD on Action 6 read, “Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances. Work will also be done to clarify that tax treaties are not intended to be used to generate double non – taxation and to identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country. The work will be co – ordinated with the work on hybrids.” In order to combat treaty shopping, the report follows a three-pronged approach:
a. A mendment in Preamble to treaties;
b. LOB clause; and
c. PPT rule
The report recommends the introduction of the LOB clause in the tax treaties. There are two versions of the clause provided in the report – a simplified version and a detailed version, with the choice given to the Contracting States.
The detailed version, as the nomenclature suggests, provides specific conditions to be satisfied, instead of the more generic ones provided in the simplified version. The LOB clause is a refined residence concept, as it goes beyond the concept of residence for the purposes of claiming the benefit of the treaty. The LOB clause provides that only a qualified person would be entitled to the benefits of the treaty. A qualified person is a person who has satisfied certain ownership and business requirements to provide sufficient link between the person and the Contracting State, the benefit of whose treaty network is being utilised. In addition to the LOB clause, the draft also includes a PPT clause as provided below, “Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining the benefit was one of the principle purposes of any arrangement or transactions that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention”.
Thus, the PPT clause makes it clear that no benefit shall be provided for an income if one of the purposes (and not necessarily the sole purpose) was to obtain the benefits of the treaty. Further, the report also attempts to tackle the abuse of the lower rate of tax in the country of source, in the case of dividends paid to parent companies exceeding a certain threshold of ownership under Article 10(2)(a) of the OECD Model Convention. The report provides that the required percentage of holding for obtaining the benefit of the lower rate of tax should also include a minimum period, for which such shareholding should be maintained, before the dividend is paid. Currently, Article 13(4) of the OECD Model Convention provides that gains derived by a company from the sale of shares, of which an immovable property constituted more than 50% of the value, is taxable in the country of source. The report recommends that this clause should be extended to include comparable interests in other forms of entities such as partnership. Additionally, the report also recommends that there should be a provision for considering a period for which the percentage of value of the immovable property must be considered, in order to tackle situations wherein assets are transferred from other entities in order to dilute the percentage of value of the immovable property to that of the shares or comparable interest being alienated. In the case of dual resident companies, Article 4(3) of the OECD Model Convention provides that for the purposes of the Convention, a dual resident company shall be deemed to be a resident of the Contracting State in which the place of effective management is situated. However, in order to combat tax avoidance through this area, the report recommends that the residence of a dual resident company for the purposes of a tax treaty be determined by competent authorities, and not where the place of effective management is situated. In respect of abuse of the domestic tax laws, the report recommends the enactment of the GAARs along with specific anti – abuse rules, such as thin capitalisation rules, in the domestic tax laws. Finally, the report recommends the change in the Preamble to the treaty to include non – creation of opportunities for non – taxation or reduced taxation through tax evasion or tax avoidance. This would enable the reader to understand the object of the treaty in accordance with Article 31(1) of the Vienna Convention on the Law of Treaties. From an Indian context, the Act has already provided for GAARs which would come into effect from Assessment Year 2018-19. Currently, India’s treaty with the US (the LOB clause was first introduced in the US Model Convention) has an LOB clause which prevents tax avoidance to a certain extent.
Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status
Currently, business carried on by a resident of a Contracting State through a commissionaire structure in the other Contracting State is not taxable in the latter State on account of the absence of a permanent establishment. Under Article 5 of the OECD Model Convention, an agent can said to constitute a PE for the principal if he habitually concludes contracts which are binding on the principal. This lead to many abusive transactions wherein the agent (commissionaire) negotiated the major terms of the contract but would be officially concluded only by the principal. In order to counter such abusive transactions, the report has recommended an amendment in Article 5(5) of the Model Convention to extend the definition of permanent establishment to these commissionaire structures as well, by providing that in case a person plays an important role in the conclusion of the contract which is concluded by the principal without any material modifications, such person or agent shall be deemed to be considered as the permanent establishment of the principal. Further, it has been recommended that the meaning of the term “independent agent” under Article 5(6) of the OECD Model be amended to exclude an agent, which satisfies certain ownership criteria in respect of the holding of the principal in the agent. Currently, Article 5(4) of the OECD Model provides a list of activities which do not constitute a fixed – place permanent establishment in a Contracting State. These activities included use of facilities and maintenance of stock of goods for storage, delivery or display of goods, maintenance of a fixed place of business for processing by another enterprise or for collecting information. These activities were considered to be excluded from the definition of the permanent establishment, irrespective of whether the activities were considered to be of a preparatory or auxiliary nature in respect of the business of a taxpayer. The report now has recommended that the aforementioned activities be excluded from being considered as a permanent establishment only if they are of a preparatory or auxiliary nature to the business of the taxpayer. In order to ensure that there is no abuse of the exclusion of the activities from the definition of a permanent establishment by splitting up the activities of the group, the report recommends that a new paragraph of anti – fragmentation be added to Article 5(4), which provides that in case the activities of the enterprise along with its related enterprise together do not constitute activities of a preparatory or auxiliary nature, the enterprise would not be eligible to claim the benefit of Article 5(4). As these recommendations refer to the OECD Model and the tax treaties, no amendment is expected in this regard in the Act.
Actions 8-10: Aligning Transfer Pricing Outcomes with Value Creation
The reports on Actions 8, 9 and 10 attempt to revise the OECD Transfer Pricing Guidelines (‘TPG’) in order to ensure that the transfer pricing outcomes are linked to value creation.
Some of the major amendments recommended in the TPG are as follows:
a. Contractual arrangements would need to be matched with actual conduct of the parties to the contract/ transaction. In case the contract and the conduct does not match, the contractual arrangements would need to be ignored for determining the arm’s length price;
b. An entity would not be entitled to higher returns if it undertakes risks which it does not control, or it does not have the financial capacity to control the risks.
In other words, it is not just the undertaking of the risk, but also the control over the risk and ability to control the risk, that would entitle an entity to higher returns in the case of determination of the arm’s length price;
c. In the case of the synergistic benefits available for being a member of a group, the benefit of the synergies should be allocated only to those parties, which have contributed to such benefit being available;
d. In the case of funding without any additional economic activities, the entity funding would be only entitled to a risk – free return and no additional return is to be provided while determining the arm’s length price, specifically under the profit split method.
The report recommends the following steps for analysing the transactions involving intangibles:
a. Identifying the legal owner of the intangibles;
b. Identifying the parties performing the functions, using the assets and assuming risks relating to the development, enhancement, maintenance, protection and exploitation of the intangibles (‘DEMPE functions’);
c. Confirming the actual conduct of the parties in accordance with legal arrangements;
d. Identifying the controlled transactions related to the above activities;
e. Determining the arm’s length price in accordance with each party’s contributions to the functions, assets and risks.
The report further provides that the legal owner of the intangibles is entitled to all the anticipated returns from the exploitation of the intangible if it performs functions, provides assets and controls as well as bears the risks in relation to the development, enhancement, maintenance, protection and exploitation of the intangible. As the recommendations discussed above involve an amendment to the TPG, which is merely guidance in respect of determining the arm’s length price, no major amendment in the Act is expected in this regard. However, one may see an impact of this change in the future assessments in transfer pricing cases.
Action 11: Measuring and Monitoring BEPS
Understanding the effect that base erosion and profit shifting has on the economic activity of a country, Action 11 provides guidance and recommendations on how to measure and monitor BEPS.
The report provides the following indicators of BEPS behaviours and activity in a country:
a. The profit rates of an MNE group is higher in a lowtax country as compared to the average worldwide profit rate;
b. T he effective tax rate of an MNE entity is substantially lower than similar enterprises having only domestic operations;
c. T he FDI is heavily concentrated;
d. The taxable profits of an entity are not higher where the intangible assets are situated in a commercial or economic sense;
e. T here is a high intragroup and third – party debt specifically in the high – tax countries
As this would require high co-ordination between the countries, the report recommends that the OECD work closely with the participating countries and provide corporate tax statistics. As this report merely refers to how BEPS can be monitored, major amendment is expected in this regard in the Act.
Action 12: Mandatory Disclosure Rules
The report on Action 12 provides a framework for formulation of mandatory disclosure rules of international tax schemes in order to enhance transparency, provide timely information and act as a deterrence. As the reports only provides the framework for such rules, they have not been analysed in this article.
Action 13: Transfer Pricing Documentation and Country-by-Country Reporting
In order to provide the necessary tools to the tax authorities in order to ensure that the profit attributed is linked to value creation, the report on Action 13 recommends certain changes in the transfer pricing documentation.
The three – tiered approach recommended in respect of the transfer pricing documentation is as follows:
a. A “master file” containing information of the global operations of the MNE group and the transfer pricing policies shall be made available to all the tax authorities in which the group does business;
b. A “local file” containing detailed information about the transactions and related parties in respect of each entity shall be made available to the tax authorities in which the entity is situated.
This local file is similar to the transfer pricing documentation that is available today; c. A “Country – by – Country Report (CBCR)” shall be made available to the tax authorities of the jurisdiction in which the parent company of the group is situated. The CBCR will contain information concerning business activity, profits before tax, income tax paid, number of employees, capital structure, retained earnings and tangible assets of each entity in the group irrespective of the jurisdiction in which it is situated. A number of countries have begun implementation of the CBCR. It is expected that India may also amend the transfer pricing regulations in order to ask for this information from the taxpayer. One of the major concerns in the introduction of the CBCR is that it enables the tax authorities to ascertain the transfer prices beyond the principle of the arm’s length price. However, the report clearly states that this information should not be used by tax authorities to conduct complementary audits.
Action 14: Making Dispute Resolution Mechanisms More Effective
The report on Action 14 recommends minimum standards for countries to adhere to in order to ensure that the Mutual Agreement Procedure provided in the tax treaties through Article 25 has been effectively implemented. The minimum standards recommended are:
a. Treaty obligations in respect of Mutual Agreement Procedures have been fully effected in a timely manner and with good faith;
b. Administrative issues in relation to treaty disputes should be resolved in a timely and effective manner;
c. Taxpayers should face minimum administrative and procedural burden to request for a MAP.
In order to ensure that corresponding adjustments in respect of transfer pricing adjustments do not face any hurdles, the report recommends that Article 9(2) of the OECD Model should be incorporated in all tax treaties. A group of countries (which notably does not include India) have agreed to incorporate a mandatory arbitration clause in the MAP Article in their tax treaties. No major amendment to the Act is expected in respect of this recommendation.
Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
The report on Action 15 recommends incorporating the recommendations discussed above in the existing tax treaties through a multilateral instrument. This will ensure that the lengthy procedure of negotiating each bilateral tax treaty is not required. India is one of the expected signatories to the multilateral instrument, which is expected to be open for signatures from December 2016. However, the major challenge in this multilateral instrument is that bilateral treaties in most countries, including India, come into effect after they have been approved by the Parliament. Therefore, the concern in signing a multilateral treaty to override the existing bilateral tax treaties without approval from the Parliament is genuine. In this regard, it is believed that the Income -tax Act, 1961 will be amended to allow the multilateral treaty to override the bilateral tax treaties signed by India without any approval of the Parliament. Moreover, in the case of a multilateral instrument, the wordings of the instrument would need to be carefully written in order to ensure that all the treaties, which may not necessarily have the same wordings, are appropriately modified. Similarly, it would be important to ensure that all the countries, which would be a signatory to the instrument, come to a consensus in respect of the wordings of the instrument as well as the recommendations itself. Additionally, all the countries in the world are not signatories to the multilateral instrument. Therefore, it would be interesting to see how the countries which are not signatories would react in respect of treaties with the countries which are signatory to the instrument.
Conclusion
To conclude, there is a question mark over the success of the BEPS Project, especially in respect of the implementation of the recommendations. However, that has not stopped countries from viewing tax avoidance very seriously. It is only a matter of time before countries start amending their tax laws to implement some, if not all, of the recommendations. India, being an active member in the BEPS Project, is almost certain to do so, and we may see quite a few amendments in the Finance Act, 2016 in respect of some of the recommendations. This will significantly alter the way multinational enterprises and we, as tax advisors will have to function. It will give rise to a new line of thought in the evolving world of tax planning wherein one would need to balance value creation and substance along with transparency with tax efficiency. _
