BEPS Action 5 – Harmful Tax Practices

In 1998 the report Harmful Tax Competition: An Emerging Global Issue was published by the OECD. BEPS Action 5 has continued the work on harmful tax practices as the underlying policy concerns are as relevant today as they were in 1998. The concern is with the risk that preferential tax regimes and tax havens present in being used for artificial profit shifting and about a lack of (perceived) transparency in connection with certain rulings. In relation to the work on BEPS Action 5 the Forum on Harmful Tax Practices has been committed to:

“Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime. It will take a holistic approach to evaluate preferential tax regimes in the BEPS context. It will engage with non-OECD members on the basis of the existing framework and consider revisions or additions to the existing framework.”

The work done in BEPS Action 5 is aimed at country and/or tax jurisdiction level. Those regimes that provide means for BEPS are targeted with this Action. Two main recommendations have been made. The first is to require substantial activity for preferential regimes and the second is to improve transparency.

As started off with, back in 1998 the OECD published the report Harmful Tax Competition: An Emerging Global Issue. In this report the work on harmful tax practices was divided in three areas:

1. Preferential regimes in OECD countries
2. Tax havens
3. Non-OECD economies

In light of BEPS Action 5 we will take a look at what constitutes a preferential regime in the definition of the 1998 report. Four key factors and eight other factors were determined to identify if a preferential regime is considered potentially harmful. The four key factors are:

1. The regime imposes no or low effective tax rates on income from geographically mobile financial and other service activities.
2. The regime is ring-fenced from the domestic economy.
3. The regime lacks transparency (for example, the details of the regime or its application are not apparent, or there is inadequate regulatory supervision or financial disclosure).
4. There is no effective exchange of information with respect to the regime.

The other eight factors to determine if a preferential regime is potentially harmful are:

1. An artificial definition of the tax base.
2. Failure to adhere to international transfer pricing principles.
3. Foreign source income exempt from residence country taxation.
4. Negotiable tax rate or tax base.
5. Existence of secrecy provisions.
6. Access to a wide network of tax treaties.
7. The regime is promoted as a tax minimization vehicle.
8. The regime encourages operations or arrangements that are purely tax-driven and involve no substantial activities.

The first key factor must apply in order for further determination of a preferential regime. If this criterion is not met then by definition the regime is not considered harmful.

An important note here is that no or low effective tax rates for the preferential regime is compared with the general principles of taxation in the same jurisdiction. If a jurisdiction has a corporate income tax rate of 5% and the preferential regime also has 5%, then this criterion does not meet and the regime is not considered harmful.

In case that a regime is considered potentially harmful based on the 4 key factors and 8 other factors there is an assessment of the economic effects of the regime. This is to determine if the regime is actually harmful or not. The OECD has listed three question that may help in the assessment:

1. Does the tax regime shift activity from one country to the country providing the preferential tax regime, rather than generate significant new activity?
2. Is the presence and level of activities in the host country commensurate with the amount of investment or income?
3. Is the preferential regime the primary motivation for the location of an activity?

If the assessment turns out to have economic effects, the regime is categorized as harmful. These regimes are then pressed to remove the features that create the harmful effect or to remove the regime as a whole.

Preferential regimes have not gone away in the years past. To increase the effectiveness of countering harmful tax practices BEPS Action 5 builds further on the framework that started in 1998.

It has  been agreed to strengthen the substantial activity requirement to asses preferential regimes. Realigning profits with the substantial activities that generate them is the goal. This is to match the taxation of profits with underlying economic activity. Foremost it is developed in the context of intellectual property (IP) regimes.

Using IP as an example, there are certain rules that allow for a holding company to charge for example for the use of the group’s brand name and/or central marketing costs and/or use of recipes to its sales, distribution and manufacturing companies. This shifts profits from the latter into the holding company’s resident country. If the holding is in a so-called preferential regime for IP then this means that income from IP is low taxed. The charge in the countries where sales, distribution and/or manufacturing takes place – the underlying economic activity – is likely to be higher taxed. In such a situation profits are shifted from high tax countries to low tax regimes.

This practice becomes an issue if the holding company – the taxpayer – does not perform (enough) activity to justify the charge to its subsidiaries. To charge for marketing costs centrally, also marketing activities must be undertaken by the holding company. The level of these activities should be in line with the charges applied.

The aim of strengthening the substantial activity requirement is to reach agreement on the level of economic activity a holding must perform in order to charge for IP to its subsidiaries and how to determine the economic activity.

BEPS Action 5 has reached consensus on the nexus approach to be used for this matter. It allows a taxpayer to benefit from an IP regime only if the taxpayer itself incurred qualifying research and development costs that gave rise to the IP income. The nexus approach uses expenditure as a proxy for activity. IP regimes are originally designed with the purpose of stimulating research and development activities and to foster growth and development. With this in mind a substantial activity requirement should ensure that taxpayers benefiting from such a regime should actually be engaging in and expending on such activities.

Instead of using the expenditure amount, the nexus approach applies a proportionate analysis of expenditure. The proportion of qualifying expenditure directly related to development activities to overall expenditure is applied to overall income that may benefit from an IP regime. If 80% of total expenditure is related to development activities, then maximum 80% of total income may benefit from an IP regime.

This ratio calculation is referred to as the nexus calculation. At the start of the development of an IP asset by a qualifying tax payer the calculation starts. The calculation is a running total over the life time of the asset.

Qualifying expenditures are those expenditures directly linked to one or more IP assets. This includes unrelated party outsourcing. Related party outsourcing on the other hand is not included as qualifying expenditures, no matter if the related party resides within the jurisdiction or not. Also acquisition costs are not a form of qualifying expenditures as the actual R&D activities are not made by the taxpayer itself but by the party from whom the asset is bought/transferred from.

Qualifying expenditures are included in the nexus calculation at the time they are incurred. This is regardless of their accounting treatment. For example capitalized development cost are taken in full in the nexus calculation even when they are not deductible for taxation. For this reason unrelated party outsourcing is included in qualifying expenditures.

Jurisdictions may permit taxpayers to apply a 30% up-lift to expenditures that are included in qualifying expenditures. This up-lift may not result in qualifying expenditures to be higher than overall expenditures.

Overall expenditures are all expenditures that would count as qualifying expenditures if they were undertaken by the taxpayer itself.

IP Acquisition costs are included in overall expenditures even if they do not count towards qualifying expenditures. For acquisition costs the source of acquisitions – related or unrelated – does not matter. The value of the acquisition costs must be documented based on arm’s length pricing and do not require an actual payment to be made for this valuation to arise.

Related party outsourcing expenditures are included in overall expenditures. This is based on the reasoning that if those expenditures had been borne by the taxpayer itself they would have counted towards qualifying expenditure.

The nexus ratio then is defined as:

This nexus ratio is then applied on the overall income to arrive at the income that may benefit from the IP regime.

Overall income is defined as that income that is derived from the IP asset. It is not defined as gross income, but net income. This means that gross income from the IP asset earned in the year is reduced with the qualifying expenditures incurred in that same year to arrive at net income.

The nexus approach aims to link between income derived from an IP by a taxpayer and the incurred R&D expenditures that contributed to that IP by the same taxpayer. For this matter it is important to track both expenditures and income over the full life time of the IP asset.

IP has been used as an example but this extends to other forms of preferential regimes. The requirement ensures a link between the income generated under a preferential regime with actual activity performed to earn that income. Other preferential regimes include

• Headquarters,
• Distribution and service centre,
• Financing or leasing,
• Fund management,
• Banking and insurance,
• Shipping, and
• Holding company regimes.

The second priority under BEPS Action 5 is to improve transparency, including the spontaneous exchange of information on certain rulings. A framework for information exchange between tax administrations has been developed. It has been concluded that in this exchange all types of rulings are to be exchanged.

Furthermore in BEPS Action 13 on Transfer Pricing Documentation the advance pricing arrangements (APAs) and advance tax rulings (ATRs) must be included in the local and master files, which are provided by the tax-payer to the local tax administration. The information exchange by the tax administrations provides for a useful cross-check with the information supplied by the tax-payer.

As can be observed in other BEPS Actions as well the recommendations aim to create a more direct link between actual economic activity and taxable profits. By raising the bar on substance for preferential regimes there will be more emphasis on underlying economic activity in order to benefit from a preferential regime. This alignment, in combination with increased transparency around preferential regimes and rulings in general, will indeed prevent abuse of preferential regimes.