7 November 2015
Base Erosion and Profit Shifting (BEPS)
Vishal Gada
Introduction and Overview of BEPS
Background of BEPS
Meaning of BEPS
“Base Erosion Profit Shifting (‘BEPS’) refers to tax planning strategies that exploit gaps
and mismatches in tax rules to make profits “disappear” for tax purposes or to shift
profits to locations where there is little or no real activity but the taxes are low, resulting
in little or no overall corporate tax being paid” – OECD FAQs
Base Erosion refers to the reduction of companies that can be taxed and the amount of
profits that a country can tax
- Achieved by means of shifting residence to different country or causing profits to arise
in different country (by transfer of intellectual property, etc.)
Profit Shifting refers to aggressive tax planning strategies focussed on shifting profits out
of high tax country to lower tax country
BEPS strategies may not necessarily be illegal Increased globalisation enables companies to exploit gaps arising on interaction of domestic tax systems
and treaty rules within the boundary of acceptable tax planning
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Causes and Consequences of BEPS
Causes of BEPS Failure of tax rules to keep
pace with global corporations,
fluid capital and digital
economy thereby leading to
gaps
Mismatch in domestic tax
systems and international tax
rules
Conscious aggressive tax
planning and tax dodging by
MNEs
Consequences arising Unfair competition – MNEs
gain competitive advantage
compared to domestic
enterprises due to BEPS
Inefficient allocation of
resources towards activities
that have lower pre-tax rates
of return but higher after tax
rates of return
Undermining of voluntary tax
compliance by other taxpayers
BEPS Project initiated by OECD at behest of G20 countries to counter opportunities for BEPS
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BEPS Project Timeline
June 2012G20 summit launches
BEPS Project Feb 2013 OECD publishes background report on Addressing BEPS
July 2013Release of 15 Action
Plans to Address BEPS
2016 OnwardsImplementation, Monitoring and
further work
July – August 2014Release of Report on
Impact of BEPS in Low Income Countries
Sept 2014Release of interim reports on Action
Points 1, 2, 5, 6, 8, 13 and 15
Oct 2015Release of Final
Reports on all Action Points
Nov 2015Final Reports to be endorsed at G20
Summit in Turkey
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Transactions leading to BEPS
Transactions leading to BEPS…
Country AHead Office
Country BBranch
Low tax branch of foreign company
Country A follows exemption system for foreign branches under domestic laws
Low tax in country B achieved as –• Country B levies zero /
low tax; or• Activities of branch not
sufficient to create taxable presence; or
• Deduction for deemed interest on branch’s capital by country B
Undertakes business in
Country B by way of branch
Hybrid Entities
Country AHold Co
Country BSub Co (LLP)
Loan
Interest
Country A treats Sub Co as transparent entity – No tax on interest income since country A doesn’t recognise income in hands of Hold Co received from Sub Co
Country B treats Sub Co as non-transparent entity –Deduction of interest paid to Hold Co allowed in Country B
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…Transactions leading to BEPS…
Country AHold Co
Country BSub Co
Hybrid Financial Instruments
Country A treats CCDs as Equity –Exempts receipts of interest from Sub Co treating them as dividend
Country B treats CCDs as debt – Allows deduction for interest payments to Hold CoPayment of
Interest
Conduit CompaniesCountry A (Tax Haven)
IP Owner – Hold Co
Country CSub Co (Conduit)
Subscription to CCDs
Source Country BSales / Services
Rendered
Licensing of IP
Royalty Payment
Sales / Service Receipt
Country B doesn’t have a treaty with Country A (being a tax haven)Thus, conduit company interposed in country C, which has treaty with country B to reduce tax liability in country B
Income from sales / services accrues in C but minimal tax liability due to deduction of royalty payments
Income ultimately up streamed to Country A - No tax liability in C owing to no withholding tax under domestic laws of C or under treaty
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…Transactions leading to BEPS
Derivatives
- Fees for derivative contracts economically replace interest payments- However, withholding taxes avoided as such fees not subject to tax at source under
domestic laws or treaty
Transfer Pricing
- Shifting of risks and hard to value intangibles to low tax jurisdictions by MNEs- Low risk manufacturing and distribution arrangements and contract R&D
arrangements with principal located in low tax jurisdiction and service provider located in high tax jurisdiction
Circumvention of anti-avoidance Rules
- Channelling financing through an independent third party when thin capitalisation rules apply only in respect of borrowings from related parties
- Replacing the existing parent company with a non-resident company located in a low / no-tax jurisdiction with no CFC regime
- Use of hybrid entities to make income disappear in country of ultimate parent
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BEPS Project by OECD and Action Points
Target Areas of BEPS Project
International mismatches in entity and instrument characterisation – hybrid mismatch arrangements and arbitrage
Application of treaty concepts to profits from digital goods and services
Tax treatment of related party debt-financing, captive insurance and other inter-group financial transactions
Transfer Pricing – Shifting of risks and intangibles, artificial splitting of ownership of assets
Effectiveness of anti-avoidance measures – GAAR, CFC regime, thin capitalisation rules, prevention of treaty abuse
Availability of harmful preferential regime
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Core Principles and Action Points
1. Digital Economy (Industry Specification)
2. Hybrid Mismatch Arrangement3. Controlled Foreign Company Rules4. Interest Deductions5. Harmful Tax Practices
15. Multilateral Instrument (Execution)
6. Preventing Treaty Abuse7. Artificial Avoidance of PE Status8. Transfer Pricing of Intangibles9. Transfer Pricing – Risk and Capital10. Transfer Pricing – High Risk Transactions
11. Methodologies and Data Analysis12. Disclosure Rules13. Transfer Pricing Documentation14. Dispute Resolution
Coherence
Substance
Transparency
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Action Points…
Action 1 – Addressing the Tax Challenges of Digital Economy
Ring fencing of digital economy from the rest of economy difficult Measures in other Actions that address BEPS in digital economy –
- Action 7: Modification of exceptions to definition of PE and anti-fragmentation rule- Action 3: New definition of CFC income to ensure inclusion of income typically earned
in digital economy and its taxation in the jurisdiction of ultimate parent- Actions 8 – 10: Emphasis on substance rather than legal ownership of intangibles
Other potential options considered –- Modification to exceptions to PE so that only activities that are actually preparatory or
auxiliary are excluded- Collection of VAT / GST on cross-border transactions- New nexus in the form of significant digital presence test, withholding tax on certain
digital transactions, equalisation levy, etc. (not recommended presently)Tax authorities in India have sought to treat website as a PE in some cases. Besides,
India has also expanded the definition of royalty to bring transactions in digital economy in its purview
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…Action Points…
Action 2 – Neutralising Effects of Hybrid Mismatch Arrangements
Arrangements seeking to exploit differences in tax treatment of entities and instruments in multiple jurisdictions addressed
Part I: Changes to domestic laws- Measures to address outcomes like multiple deductions for single expense,
deductions without corresponding taxation, generation of multiple foreign tax credits Part II: Changes to treaty
- Measures to ensure that hybrid mismatches not used to unduly obtain treaty benefits- Dual residency to be resolved on case to case basis by competent authorities and not
on the basis POEM- Benefit of treaty not to be granted to hybrid entities when where income of such
entity not taxed under domestic laws of either of the contracting states- Tax treaties not to prevent application of changes to domestic law recommended in
Part INo specific rules under Indian laws to counter hybrid arrangements
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…Action Points...
Action 3 – Designing Effective Controlled Foreign Company (CFC) Rules
CFC Rules aimed at preventing taxpayers from shifting income to foreign subsidiaries Six building blocks for design of effective CFC rules
- Determination of level of influence so as to constitute CFC and recommendations for bringing non-corporate entities in CFC net
- CFC rules to apply only if effective tax rate lower than in parent jurisdiction- CFC income to be defined- CFC income to be computed as per rules of parent jurisdiction- CFC income to be calculated by reference to proportionate ownership- Credit of foreign taxes paid to be allowed
NO CFC provisions under Indian domestic laws presently
Action 4 – Limiting Base Erosion involving Interest Deductions and Other Financial Payments
Fixed Ratio Rule – Net deduction for interest to an entity to be limited to fixed percentage of EBITDA (ranging from 10% to 30%)
Optional Group Ratio Rule for groups with high third party debt - Net deduction for interest above fixed ratio to be permitted up to level of net interest / EBITDA ratio of worldwide group
Separate specific rules to be developed for banking and insurance sectors
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…Action Points…
Action 4 – Limiting Base Erosion involving Interest Deductions and Other Financial Payments
Additional Optional Elements -- Entities with low level of net interest below minimum threshold to be carved out- Interest paid to third party lenders on loans for funding public benefit projects to be excluded
subject to conditions- Disallowed interest expense / unused interest capacity of earlier years to be carried forwardNo formal thin capitalisation rules under Indian tax law presently – Thin Cap norms may be made
applicable under GAAR
Action 5 – Countering Harmful Tax Practices
‘Nexus Approach’ to be adopted to assess preferential regimes with respect to substantial activityrequirement
Expenditure incurred to be used as proxy for activity for Nexus Approach Eligible IP Income = Qualifying R&D Expense * Income from IP Asset / Total R&D Expense for IP Asset Framework for exchanging information covering rulings relevant from BEPS perspective agreed
Action Point less relevant vis-à-vis preferential regimes offered by India as India plans to remove incentive regimes with a corresponding reduction in corporate tax rate
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…Action Points…
Action 6 – Preventing the granting of Treaty Benefits in Inappropriate Circumstances
Minimum Standard - A clear statement that contracting states intend to avoid creating opportunitiesfor non-taxation / tax avoidance / treaty shopping to be included in treaties
A specific Limitation of Benefit (LOB) Rule that limits the availability of treaty benefits on fulfilment ofcertain conditions that establish link between entity and state of residence
A general anti-abuse rule based on principal purpose of transactions (PPT Rule)Many Indian treaties already include ‘prevention of fiscal evasion’ as one of the objectives and also
include LOB clause - Further, GAAR provisions to override treaties
Action 7 – Preventing the artificial avoidance of PE status
Activities by an intermediary leading to regular conclusion of contracts to be performed by foreign enterprise to constitute PE (except in case of activities in course of independent business)
Exceptions to the definition of PE to be modified to ensure that core activities (hitherto considered auxiliary) are taxed in source state
Anti-fragmentation rule to ensure that PE status not avoided by fragmentation of cohesive operating business into smaller operations
Splitting up of contract between related parties not to avoid PE statusAction 7 reinforces the concept of Agency PE in Indian Treaties
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…Action Points…
Actions 8 – 10 – Aligning Transfer Pricing Outcomes with Value Creation
Action 8 - Transfer Pricing of Intangibles
Action 9 - Transfer Pricing – Risk and Capital
Action 10 - Transfer Pricing – High Risk Transactions
Actual conduct of parties to prevail over contractual arrangements
Risks to be reallocated to party that actually exercises control over risk and has the financial capacity toassume risks
CUP (Quoted prices) to be the MAM for benchmarking transfer of commodities
Right to returns by the exploitation of intangibles not to be determined merely by legal ownership
Cash boxes not to be entitled to more than risk free rate of return
Cost plus 5% mark up to be ALP for low value adding intra group services under simplified approach
ALP for contribution to CCAs to be determined based on expected benefits and not costs
In absence of specific guidance under Indian TP Regulations regarding CCAs or intra-group services –reference may be drawn to BEPS
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…Action Points…
Action 12 – Mandatory Disclosure Rules
Provides for mandatory disclosure rules for aggressive tax arrangements to increasetransparency
Recommends design features of such mandatory disclosure regime including personsrequired to report, matters to be reported, timing of reporting and penalties for non-reporting
Specific recommendations for rules targeting international tax schemes also provided
The Expert Committee on GAAR suggested reporting of tax avoidance schemes in excess of certain limits in tax audit report – However, recommendations not included in rules so far
Action 11 – Measuring and Monitoring BEPS
Recommendations at Government level to enable improved access to and enhanced analysis ofcorporate tax data and improvement of tools and data available to measure and monitor BEPS
In absence of availability of comprehensive data with Income Tax Department – Analysis as recommended in Action 11 to be difficult
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…Action Points…
Action 13 – TP Documentation and Country by Country Reporting
Existing guidelines on Documentation in OECD Transfer Pricing Guidelines substituted by the Report Master File – Group level information like overview of MNE group business operations, legal and
ownership structures, overall transfer pricing policies, description of intangibles and intercompanyfinancial activities, etc.
Local File – Country specific file containing details with respect to local entity like business description,management structure, related party transactions, arm’s length determination etc.
Country by Country Reporting –- Jurisdiction wide information on revenue earned, profit before tax, taxes paid, assets, etc.- Reporting to commence from 1st Jan 2016 for MNEs with consolidated group revenue of at least
EUR 750 million Search for comparables to be updated every three years rather than annually
- Financial data for comparables to be updated every yearNeed to amend existing domestic transfer pricing regulations to enable filing of master file and
country by country reporting – compliance burden for taxpayers to increase
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…Action Points
Action 14 – Making Dispute Resolution Mechanisms More Effective
Recommendations aimed at strengthening mutual agreement procedures under treaties Minimum standard developed aimed at –
- Resolution of MAP cases in a timely manner- Smoothening the administrative processes under MAP- Granting of access to MAP to eligible taxpayers
Some countries also keen on mandatory binding MAP arbitration for effective resolution of treaty-related disputes
No time limit for settlement under MAP in most Indian treaties
Action 15 – Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
A multilateral instrument to serve as alternative mechanism for modification of tax treaties in line withBEPS Actions - expected to be open for signature by December 2016
India is a member of the group constituted for development of multilateral instrumentHowever amendments in domestic law (section 90) required to enable entering into multilateral
agreements for avoidance of double taxation
BEPS Action Points to equip countries with the tools to ensure that profits are taxed where economic activities generating profits are performed
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Implementation and Global Developments
Implementation Mechanics…
BEPS Outputs are soft law legal instruments – not legally binding but expected to be implemented accordingly by countries that are part of consensus
Minimum standards agreed by all OECD and G20 countries to tackle issues where no action by some countries would lead to negative spill overs on others
All OECD and G20 have committed to consistent implementation in the areas of –
- Preventing treaty shopping
- Country by country reporting
- Fighting harmful tax practices
- Improving dispute resolution
In other areas, countries have agreed over general tax policy direction (hybrid mismatch arrangements, interest deductibility, etc. )
Guidance based on best practices to countries intending to act in the areas of mandatory disclosure regime or CFC legislation
India has endorsed the Action Plans (being a G20 member) but is not bound by what OECD decides (in view of observer status within OECD) - likely to follow a selective
approach to adoption
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…Implementation Mechanics
Amendments to Domestic Law
• CFC Rules • Interest Deductions• Countering Harmful Tax Practices• Aligning Transfer Pricing Outcomes with Value Creation• Mandatory Disclosure Rules• TP Documentation and Country by Country Reporting
Amendments to Treaty –
OECD Model Convention / Multilateral Instrument
• Preventing Treaty Benefits in Inappropriate Circumstances• Artificial Avoidance of PE Status• Dispute Resolution Mechanisms
Amendments to Domestic Law as
well as Treaty
• Addressing Tax Challenges of Digital Economy• Hybrid Mismatch Arrangements
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Global Developments on BEPS…
Action Plan on Corporate Taxation released by EU Commission in June 2015 to overhaul EU’s corporate tax framework and plug existing loopholes in existing EU rules
- The plan to complement BEPS Project and facilitate creation of a framework for EU level integration of BEPS Project
Proposed revisions (Discussion Draft) to US Model Convention largely shaped by BEPS Project released by US Department of Treasury in May 2015, targeting below issues -
- Exempt PEs- Special tax regimes- Expatriated entities- Anti-treaty shopping measures of LOB article- Subsequent changes to treaty partners’ domestic tax laws
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…Global Developments on BEPS
Release of Model Competent Authority Agreement (CAA) and Common Reporting Standard (CRS) by OECD to create global standard for automatic exchange of information
- Modelled on US FATCA- No direct legal force but likely to be followed by countries when implementing
bilateral agreements- India also became a signatory to Multilateral Competent Authority Agreement
In Oct 2015, Geneva meeting of the UN’s Committee of Experts on International Cooperation in Tax Matters, following Action Agenda were discussed:
- Update of UN Model Convention for –- Hybrid entities - Meaning of ‘connected projects’ (Art 5)- Meaning of Auxiliary Activities (Art 8 &Art 12)- New Article on FTS
- New Article on FTS- Code of Conduct for Automatic Exchange of Information- Cross-cutting issues under the UN Model Convention, such as BEPS
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Unilateral Response by Countries…
Australia• GST to apply on supply of intangible products by non-residents to
Australian consumers • Multinational measures to tackle artificial avoidance of PE to apply to
businesses with global revenue of at least AUD 1 billion• Recommendations for TP Documentation and country by country
reporting to apply• Exchange of information with respect to MNEs contributing to tax
avoidance commenced• Steps towards anti-hybrid rules and preventing treaty abuse likely soon
Japan• Provisions for VAT in digital economy strengthened• Participation exemption on dividends on hybrid instruments now denied• Trigger rate for CFC provisions reduced from more than 20% to at least
20%
Ireland• Irish incorporated hitherto non-resident companies to be treated as tax
residents to counter double Irish structures for tax avoidance
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…Unilateral Response by Countries…
China• BEPS concepts have found increased applications in TP cases• Increased focus of tax authorities on ’disguised dividends’• Discussion draft of ‘Special Tax Adjustment Implementation Measures’
that revises adjustments under GAAR, TP, CFC and thin capitalisation and incorporates other OECD BEPS recommendations like country by country reporting released
• No firm changes in domestic tax law per se yet
USA• No unilateral action till date• Government considering BEPS related provisions like disallowance of
interest and royalty payments to related parties under hybrid arrangements, strengthening of CFC rules etc.
• Likelihood of action in near future is low
UK• Diverted profits tax @ 25% introduced for below situations -• Artificial avoidance of PE by non-UK company• UK company / PE has tax advantage owing to entity / transaction lacking
substance
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…Unilateral Response by Countries…
Canada• Proposed draft legislation on anti-treaty shopping delayed in 2014
pending further inputs from BEPS Project
Chile• The 2014 tax reform included a number of BEPS related measures like
GAAR, additional requirements to deduct expenses paid to related parties and CFC Rules
• Government starting to consider Action 6 and Action 7 in negotiation of tax treaties
Denmark• Government signed commitment to implement OECD CRS• Government adopted GAAR on abuse of tax treaties and EU directives
France• Anti-hybrid rules introduced and there are proposals in the digital area
Hungary• Anti-hybrid provisions (limited to treaty interpretation mismatches)
introduced
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…Unilateral Response by Countries…
Germany• Upper House of Parliament requested additional changes related to BEPS
1. Anti-arbitrage rule for hybrids 2. Rules on disclosure of tax planning schemes 3. Disallowing deduction of expenses in non-inclusion and double deduction cases
• Federal Ministry started deliberations on Action 13
Israel• Draft circular published in April 2015 relating to digital economy -
1. Circumstances in which foreign entity deemed to have PE 2. Principles for attributing profits to PE 3. Cases in which foreign entities to register for VAT purposes
• Circular on examination by tax authorities of each business model restructuring and resulting disposal of IP also published earlier
Italy• Law enacted to deal with cross border transactions related to advertising
industry and digital economy – rules consistent with recommendations of international organisations and EU may be made
• Provisions relating to digital economy inconsistent with EU principles repealed
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…Unilateral Response by Countries…
Mexico• 2014 tax reforms included measures like disallowance of deduction for
interest, royalty, FTS unless payment subject to tax in recipient country• Also, NR claiming treaty benefits to demonstrate double taxation in
absence of treaty benefits
Netherlands• Draft law including provisions for hybrid loans and GAAR published in Sept
2014• Renegotiation of tax treaties with 23 countries with respect to anti-abuse
provisions underway – 5 countries already agreed
New Zealand• Current Inland Revenue proposals include -
1. Broadening application of NR withholding tax 2. Extension of GST on cross border goods and services 3. Hybrid changes and limitation of interest deductions
Russia• No unilateral measures as such but BEPS Action Plan mentioned in Russia’s
tax policy plans for 2015-17
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…Unilateral Response by Countries…
Singapore• Government also considering ‘profit per employee’ while assessing
applications for tax incentives• TP guidelines revised to provide for maintenance of contemporaneous
documentation except in safe harbour situations
Switzerland• Corporate tax reforms announced to align rules with international tax
laws• Unlikely to adopt unilateral measures (like CFC rules, etc.) but will
develop new tax system with international tax standards
Spain• Anti-abuse rule for hybrid entities introduced• Application of CFC rules to cover more transactions and types of income• Recharacterisation of intragroup profit participating loans as equity
instruments• Limitation on deductibility of financing expenses in leveraged buyout• Introduction of CBC reporting
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…Unilateral Response by Countries
South Africa• No specific unilateral BEPS actions but implementation of country by
country likely
No significant unilateral actions by Argentina, Austria, Belgium, Estonia, Finland, Norway, Poland, Slovakia, Slovenia and Sweden but future steps likely to be in line with BEPS
Recommendations
Luxembourg and Saudi Arabia unlikely to take any actions in response to BEPSNo actions taken by Hong Kong and Iceland as well
Brazil and Turkey likely to wait for initial results of OECD’s efforts on BEPS before taking any further action
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BEPS Case Study
Case Study – Leveraged Acquisition
An MNE, Parent Co, headquartered in Country 1 has operations in Country 2 through Op
Co
Parent Co plans to acquire manufacturing company, Target Co, in Country 3 from seller in
Country 3
The acquisition price is EUR 1 billion, of which 60% is to be financed through external
debt
The Parent Co sets up a holding company in Country 2, A Hold Co, which further sets up B
Hold Co in Country 3 for acquisition of Target Co in Country 3
Parent Co grants a loan of EUR 400mn to A Hold Co and A Hold Co advances the amount
to B Hold Co by way of subscription to redeemable preference shares, with remaining EUR
600mn being raised by B Hold Co by way of external bank debt
Country 2 treats redeemable preference shares as equity and Country 3 as debt
Countries 2 and 3 allow grouping of related domestic companies for tax purposes
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Case Study - Structure
Parent Co
A Hold CoOp Co
B Hold Co
Target Co
Seller Bank
Country 1
Country 3
Country 2
Tax Grouping
Tax Grouping
Loan
Redeemable Preference Shares
EUR 1bn
Loan
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Case Study - Implications
Country 3
- Interest payment to bank by B Hold Co allowed as deduction against Target Co’s operating income- Dividend on Redeemable Preference Shares also allowed as deduction against income of Target
Co, preference shares being treated as debt- Withholding tax liability on dividend payment eliminated / reduced under treaty
Country 2
- Dividend received on Preference Shares exempt under domestic laws as participation exemption- Interest payment by A Hold Co to Parent Co allowed as deduction against operating income of Op
Co- Withholding tax liability on interest payment to Parent Co eliminated / reduced under treaty
Country 1- Interest received on loan from A Hold Co to be taxed in Country 1 and credit of withholding tax in
Country 2 to be available
On exit from investment by way of sale of B Hold Co, Country 3 may be prevented from taxing capitalgains under treaty and Country 2 to grant participation exemption on LTCG
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Next Steps for BEPS
Next Steps for BEPS
Multilateral instrument to streamline implementation of treaty related BEPS measures expected to be open for signature in 2016• 90 countries have joined the group as members for
development of the instrument till date
Country by country reporting by prescribed MNEs to start in 2016 and
tax administrations would begin exchange of first country by country
reports in 2017
Revised OECD Model Tax Convention and Transfer Pricing Guidelines in light
of BEPS measures to be released by 2017
OECD’s Forum on Harmful Tax Practices to continue assessment of
whether various preferential regimes are harmful based on nexus approach recommended under BEPS
Practical toolkits containing reports, guidance, model legislation, etc. based
on real life cases to be developed to facilitate implementation of solutions to
BEPS
Follow up work by OECD and G20 on issues like TP (hard to value
intangibles, financial transactions), attribution of profits to PE, details of
group carve-out and rules for insurance and banking sectors for
interest deductibility to remain
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Action 1 – Addressing the Tax Challenges of Digital Economy
Why Digital Economy a concern ?
“Digital business technologies are formulating / modifying the conduct of
businesses, result of which is that there has been a transformative process
brought by Information and Communication Technology (‘ICT’)”
ICT has made technologies easier, cheaper, more powerful and widely
standardized, improving business processes and bolstering innovation across all
sectors of the economy
The pace at which the tax laws needs to be evolved in the respective country
has not matched with the change in the business models, thereby resulting in
exploitation of loopholes by MNEs in ‘Digital Economy’
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Impact of Digital Economy (DE) in Various Sectors
The Information and Communication Technology (ICT) revolution has made
technologies cheaper, more powerful and widely standardised, improving business
processes and bolstering innovation across all sectors of the economy. For example
Online Retail – Retailers allow customers to place online orders and are able to
gather and analyse customer data to provide personalised service and advertising;
Logistics – The ability to track vehicles and cargo across continents;
Financial – Enable customers to manage their finances, conduct transactions and
access new products on line;
Manufacturing – Ability to remotely monitor production processes and to control
and use robots
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Digital Economy – Key Features
Ability to have virtual presence
Dispensing with traditional revenue models
Mobility with respect to (i) the intangibles, (ii) users, (iii) business functions
Flexibility to choose the location of servers and other resources
Reliance on data, including in particular the use of so called “big data”
Unique challenges of determining nexus
Volatility due to low barriers to entry and rapidly evolving technology
While DE does not generate unique BEPS issue, its key features exacerbate BEPS risks
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Background and Objective of BEPS for DE
Objectives of BEPS Action 1 – DE
Objective of DE Report:
- To identify difficulties posed by DE while applying existing international taxrules
- To develop options to address such difficulties by taking a holistic approach
Innovation in ICT and DE has accelerated spread of global value chains whereby
MNEs integrate their worldwide operations which traditionally required physical
presence
The DE and its business models do not generate unique BEPS issues, some of its
key features exacerbate BEPS risks. The said Action deals to address those
challenges emerging out of such business models
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OECD TAG and High Powered Committee Views
Technical Advisory Groups (TAG) constituted in 2002 to deal with attribution of profits topermanent establishment (PE), the place of effective management concept and treaty rules in thecontext of e-commerce
Options evaluated
- Characterisation of business profits and taxation along the lines of royalty- ‘New nexus’ i.e. taxability of income if corresponding payment is tax deductible (base eroding
payment rule)- Adding concept of ‘Electronic (virtual) Permanent Establishment (PE)- Global formulary approach based on ‘group’ profits
Views of High Powered Committee set up by CBDT in December 1999:
- With e-commerce, need for physical presence, which is the cornerstone for creation of “PE”(to tax business profits) virtually ceases.
- Hence, the concept of PE should be abandoned and other alternative shouldbe evaluated
- ‘Base erosion’ approach (i.e. source trigger for all tax deductible payments) may bea possible alternative.
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BEPS in the context of Direct Taxation for DE
The February 2013 Report Addressing Base Erosion and Profit Shifting (OECD. 2013b) identifies anumber of co-ordinated strategies associated with BEPS in the context of direct taxation, which can bebroken down into four elements -
Minimisation of taxation in the market country by avoiding a taxable presence, or in the
case of taxable presence, either by shifting gross profits via transfer of IP or trading
structures or by reducing net profit by maximising deduction at the level of the payer
Low or no withholding tax at source considering lack of provisions of taxing DE transactions
under source and residency Rule
Low or no taxation at the level of the recipient (which can be achieved via low-tax
jurisdiction, preferential regimes, or hybrid mismatch arrangements) with entitlement to
substantial non-routine profits often build-up via intra-group arrangements
No current taxation of the low-tax profits in the level of the ultimate parent
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Opportunity for BEPS in the context of VAT
As per the OECD’s “Guidelines on place of taxation for B2B supplies of servicesand intangibles”, opportunities for tax planning by businesses and correspondingBEPS concerns for government in relation to VAT may arise with respect to -
- Remote supply of digital goods and services to VAT exempt businesses
- Remote digital supplies acquired by enterprises that have establishments(branches) in more than one jurisdiction that are engaged in exempt activities
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BEPS Planning for business models operating in DE
Local activity or Sub
Intermediate Country 2 (Low Tax)Market Country Ultimate Residence Country
Avoid taxable presence or
Minimise Assets / Risks or
Maximise Deductions
Intermediate Sub 2
Maximise Assets Functions & Risk
Intermediate Country 1 (High Tax)
Intermediate Sub 1
Preferential Regime or
Hybrid Mismatches or
Base Eroding Payments
Low or no withholding
Low or no withholding
Parent Co
Ineffective/ No CFC Rules
Minimise Assets / (Risks) Maximise Deductions
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Tax Policy Concerns and Potential Options
Tax Policy Concerns…
Nexus
• Distance forms less of a barrier totrade
• Growth of customer base doesnot necessarily demand changein organisational infrastructure
• Ability to have significant digitalpresence (and not physicalpresence) resulting into ‘no PE –no tax’ scenario
• Concern on establishing nexuswith jurisdiction with substantialactivity or value creation, e.g.,having a market place in acountry clearly valuable to seller
Data
• Data gathered from varioussources often primary input intothe process of value creation
• Challenging to assign value toraw data vis-à-vis FAR analysis
• Remote collection of data vis-à-vis nexus for tax purposes (evenif no physical presence) – notlikely in the current scenario
• How to characterize or attributevalue to information collectedacross borders and to valuecreated digital products /services from data
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…Tax Policy Concerns
Characterization
• Whether income should be characterized as royalty, FTS or business income
• Whether infrastructure-as-a-service transaction should be treated as services
• Development and increasing use of 3D printing may also raise character questions
• Appropriate characterization of income in the context of new business models
VAT Collection
• Capability of private consumers to receive from goods and service from remote suppliers and use of low-value VAT-exemptions
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Potential Options to address tax challenges in DE…
Replacing PE with “significant economic presence”
• Country from which sustained significant revenue generated• Due regard to be given to factors such as nature of transactions to be covered,
viz., only digital transactions executed on digital platform of the company, level of threshold of transactions and administration of such a threshold
• For digital factors, factors could be whether an entity has • a local domain name;• a local digital platform;• local payment options
• User based factors, such as number of Monthly active users, Online contract conclusions, nature and quantum of Data collected
• Also, possible to have combinations of any of the above factors
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…Potential Options to address tax challenges in DE…
Withholding of taxes on digital transaction
• Impose final withholding tax by resident customers on purchase of digital goods/ service for collection of taxes, alternatively, nominal withholding taxes as a primary tool to collect data for determining ‘nexus’
• Factors to be considered for the same –• Scope of transactions covered should be clearly defined as well as should not
give rise to disputes over characterisation of such income• Collection of taxes could be a challenge in case of B2C transactions, however,
comparatively easier in case of B2B transactions – automation process of payments to be considered
• Gross basis withholding of taxes to be applied at a lower than normal rate of tax so as to consider the relevant costs in earning such income
• Taxes may also be withheld by financial institutions processing the payments, however, characterisation of income, net income taxable, etc. may need to be provided
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…Potential Options to address tax challenges in DE
Introducing an “equalisation levy”
• Approach is based on equal treatment to foreign and domestic suppliers• Taxation to non-resident enterprises having a significant economic presence in
a country• Imposition of equalisation levy subject to credit of levy against its domestic
corporate income tax. Such an approach to ensure that foreign entities with no nexus for corporate income tax would be subject only to the levy in source country
Consumption tax options
• Remote digital supplies to consumers to trigger tax • Exemptions for imports of low valued goods• EU countries experience this option to be most viable
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DE Case Studies
Case Study 1 - Online Retailer
RCo(Country R)
RCo Regional Holding
(Country T)
RCo Regional Op Co
(Country T)
SCo(Country S)
Rights to IP for Country T/S Region
License IP for business in T/S Region
Country S Customers
Performs R&D, Operates Country R Website, Co-ordinates services to sales and procurement, Owns IP Initial buy-in payment plus Contractual Payments
Holds stock of regional subsidiaries , Owns IP for Country T/S region, Sub-licenses IP to regional subsidiaries
Royalties
Operates Country T/S regional websites, Owns physical and digital inventory, Performs payment
Operates warehouse, Delivery through courier, After sales assistance
Fee (cost-plus-basis)
Management fees
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Case Study 1 - Tax Consequences…
Direct Tax Consequences in Country S
- Since serviced provided by SCo is routine in nature, minimal income is allocated to Sco
- Income derived in Country S to be treated as income of Bco, due to its role but since
BCo has no physical presence, no income is taxed by Country S either under domestic
tax laws or treaty
Direct Tax Consequences in Country T
- The income from intangibles earned by ACo is taxed at a less rate on the royalty
income. Further, income of BCo is entirely offset by the royalty payments and
management fees
- No withholding obligation on BCo since the royalty is paid to ACo, a resident company
and on management fees paid to RCo, a non-resident company due treaty protection.
No withholding obligation on payments by ACo to Rco due to treaty protection
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…Case Study 1 - Tax Consequences
Direct Tax Consequences in Country R
- Country R levies income tax on the profits derived by RCo, including the buy-in
payment from Aco on transfer of existing intangibles. However, in the absence of a
significant track record of RCo’s performance, the value of intangibles was very low,
resulting into minimal exposure
- Amount received by RCo from ACo under cost sharing is lower than royalty received
by ACo. Further, RCo may also be entitled to R&D tax credits, resulting in reduction in
tax liabiltiy
- Under its CFC rules, Country R may treat royalties received by ACo as passive income
of RCo. However, because BCo is treated as transparent entity in Country R, the
income of BCo is treated as having directly earned by ACo and is therefore taxable in
Country R only when paid to RCo
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Case Study 2 - Internet App Store
RCo(Country R)
TCo(Country T)
SCo(Country S)
Sale of IP R&D Contract
Marketing Promotion
R&D Services
Payment for IP transfer Services for R&D activities
Service fee(Cost-plus basis)
Third Party Developers
Net Amount less Agency fee
WW IP Owner, Manages Marketplace, Transaction processing, Marketing Strategy
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Case Study 2 - Tax Consequences…
Direct Tax Consequences in Country S
- Since serviced provided by SCo is routine in nature, minimal income is allocated to Sco
- Income derived in Country S from sale of applications in Country S and T are treated
as income of TCo, due to its role as the counterparty to the transactions with local
customers and administrator of local app stores and since TCo has no physical
presence, no income is taxed by Country S under domestic tax law or under treaty
Direct Tax Consequences in Country T
- Income of TCo is taxed at roughtly 50% of rates in Country S and R in Country T
- No withholding obligation on the various fees paid by TCo, RCo and SCo under treaty
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…Case Study 2 - Tax Consequences
Direct Tax Consequences in Country R
- Country R imposes tax on the profits of RCo, notably the capital gain derived from the
sale of the technology to TCo and the service fee received for its R&D activities.
However, because of the absence of a significant track record of RCo’s performance,
the value of intangibles was very low, resulting into minimal exposure. In addition
depending on the domestic laws of Country R, RCo may be entitled to R&D tax credits,
thereby reducing its tax liability for corporate tax purposes
- Country R imposes corporate tax on territorial basis and does not have any CFC rules.
As a result, RCo is exempt from both on income earned by TCo and on dividends
received by TCo
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Way Forward
Way Forward
Actions which may particularly address BEPS concern on DE:
- PE (Action 7) - Ensuring that core activities cannot inappropriately benefit from
the exception to PE status and that artificial arrangements relating to sales of
goods and services cannot be used to avoid PE status
- Data & Intangible (Action 8 to 10) – Address importance of data/ intangibles and
impact of transfer pricing
- CFC Rules (Action 3) - Possible need to adapt CFC rules for DE
- VAT – Address opportunities for tax-planning by businesses engaged in value-
added tax exempt activities
If other actions do not fully address DE challenges, may need to work on potential
actions
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An Indian Perspective
Indian Perspective on BEPS
In addition to OECD member- countries, India was actively involved in the BEPS project on an equal footing
However, no significant activities seen except becoming a signatory Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information in June 2015
Source based taxation and withholding taxes for digital transactions strongly moved by India
Mandatory and binding arbitration under MAP not favoured by India
LOB clause likely in ongoing renegotiation of India-Mauritius DTAA
India to strike a balance between strengthening integrity of tax system and attracting foreign investment
Indian Govt. planning to remove tax incentive regime in sync with the reduction in corporate tax rate
Structures involving hybrid arrangements may potentially be hit under the GAAR scenario
Likelihood of pressure to abide by BEPS outcomes while negotiating treaties with OECD countries
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Indian Perspective on DE…
India has taken several unilateral measures aimed at countering the challenges exacerbating
from DE . These include –
• Treating a website as a PE - There are several instances of the Indian tax authorities
seeking to treat websites as a PE of a foreign enterprise. While this position has not found
favour with the Courts so far (for instance ITO v. Right Florist (2013) (25 ITR 639) (Kolkata
Tribunal)
• Expanded scope of Royalty /fees for technical services (FTS) - India has also sought to
bring several transactions of the digital world within the ambit of royalties or FTS (such as
subscription to online database, payments for online advertisements).
The interplay between India’s unilateral measures as above and the BEPS recommendations is
not yet clear.
It would be interesting to see if India continue to assert the existence of PE through websites, notwithstanding the fact that BEPS have expressly
not accepted the nexus test based on significant digital presence
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...Indian Perspective on DE
Exposure for Foreign Company conducting business in India through electronic mode:
As per Section 2(42) of the Act a “foreign company” means any company or body corporate
incorporated outside India which has a place of business in India whether by itself or through an agent,
physically or through electronic mode; and conducts any business activity in India in any other manner.
As per Rule 2(c) of the Companies (Registration of Foreign Companies) Rules, 2014, ”electronic mode”,
for the purposes of meaning of “foreign company”, means carrying out certain activities electronically,
whether main server is installed in India or not, whether conducted by e-mail, mobile devices, social
media, cloud computing, document management, voice or data transmission or otherwise.
As per Rule 3 of the Companies (Registration Offices and Fees) Rules, 2014, every company including
foreign company which carries out its business through electronic mode, whether its main server is
installed in India or outside India, shall be deemed to have carried out business in India.
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Thank You
Disclaimer: This is a general presentation for information and educational purposes only and should not be construed as a professional advice
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Mumbai
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