AMIDST all the gloomy news of terrorist attacks, mass shootings, knife attacks, murders, refugee crisis, Brexit and what have you, the hullabaloo over the OECD BEPS project appears to have been relegated to the background. Yet this is the time when nations need maximum tax revenue to salvage their own economies and the world economy as a whole that is in the doldrums for almost a decade. A few pockets of growth is not going to make any difference. The BEPS project arose in that context with a lot of hope riding on it. With an impressive time frame of 2 years within which the OECD promised to deliver its solution, it did come up with a 15 point action plan in November 2015. Consensus eluded and there were yet lots of gaps in the practical implementation of the proposed plans. So, after a temporary lull, there is again a flurry of activities.
On the 16th June, 2016, the OECD conducted its first 'inclusive framework' conference in Kyoto where tax representatives of more than 80 countries participated apparently 'on an equal footing' to endorse whatever the OECD is doing. More on that a little later. On the 4 th of July, 2016, the OECD put out discussion drafts on BEPS Action 7 providing additional guidance on the attribution of profits to permanent establishments and its revised guidance on the use of profit split under Action 8-10. Discussion draft has also been issued in relation to design and operation of the group ratio under Acton point 4. Public review has also been sought on the BEPS conforming changes to chapter IX of OECD Transfer Pricing Guidelines. As the subsequent discussion will show, there are various linkages amongst the different action points and it is quite likely to miss the correlations. Civil society therefore needs to be vigilant about these proposed guidances as some of these are likely to have adverse consequences for the developing countries.
The BEPS project gives the OECD an unprecedented opportunity to stamp its authority as the informal arbiter of the world of international taxation. Its primacy came under serious challenge from the developing countries and the civil society during the United Nations Financing for Development conference in Addis Ababa in July, 2015. The developed world had at that time successfully stymied the effort by G-77 including India and Brazil to elevate the status of the current UN Committee of Experts to that of an intergovernmental tax committee that could act as the premier tax authority in the world.
The truth is that in the absence of any viable alternative with equal financial and brain power, the OECD work, whether one understands the full implication of the same or not becomes the soft law for the entire world. This is particularly worrisome when the taxing powers of the sovereign nations are sought to be regulated to the detriment of the nations that are not OECD members. The BEPS project initially received endorsement from all sections since it was aimed at reducing tax base erosion by multinationals that affected the revenues of all States that depend on tax revenue- whether developing or developed. The end product, even if better than the existing one however has disappointed many. It is acknowledged even by the OECD that base erosion is a more pressing problem for developing countries. However, the solution it has come up with suits more the interests of the developed countries. As is well known, the OECD has stubbornly refused to reconsider the distribution of taxing rights that is at the core of base erosion by multinationals operating in the developing countries.
OECD is aware of the fact that it is seen as a club of rich nations which it indeed is. Yet, it wants to speak for the entire world. Therefore, it had to first rope in the non-OECD G-20 countries and get their endorsement for its work. That still left about 150 countries out of its decision making process. Therefore, it first invited a few more developing countries in its work towards the end of the project, apparently on an 'equal footing' . Still facing criticism from the civil society groups, the OECD thereafter decided that it will work on an 'inclusive framework' where any nation willing to participate could do so. Of course, there are strings attached for such participation as we shall see later. The OECD handouts these days never tire of proclaiming that nations have participated in its deliberations 'on an equal footing'. We do not know how equal, the equal footing participation is. The meetings that are pod cast involving serious policy matters never shows any member from any developing country participating in the discussions. It is always the old CTPA hands that direct the whole affair.
Coming to the BEPS per se, the suggestions for some incremental changes has not enthused many in the developing world. However, whatever has been agreed to have to be coordinated. Implementation of the BEPS Package into different tax systems should not result in conflicts between domestic systems and interpretation of the new standards should not lead to increased disputes. “The need to ensure a level playing field among countries and jurisdictions is key in the fight against tax avoidance. Therefore, in order to support an effective and consistent implementation, OECD and G20 countries have agreed to continue to work together to implement the BEPS Package and to develop standards on remaining BEPS issues.” [Background brief- Inclusive framework for BEPS Implementation].In plain English, the OECD has developed some rules without consulting the poorer countries and now these countries should implement the rules.
It is stated that the framework will
- develop standards in respect of remaining BEPS issues;
- review the implementation of agreed minimum standards through an effective monitoring system;
- monitor BEPS issues, including tax challenges raised by the digital economy; and
- facilitate the implementation processes of the members by providing further guidance and by supporting development of toolkits and guidance to support low-capacity developing countries.
There are of course, further rules for participation. As mentioned in the background brief, countries and jurisdictions interested in joining the framework are required
- to commit to the comprehensive BEPS Package and its consistent implementation ; and
- to pay an annual member's fee to cover the costs of the framework.
So, the countries that wish to participate in the deliberations that decide the international tax rules must commit to the OECD philosophy, pay fees and then can participate in the OECD meetings to put their stamp of approval on what has already been agreed upon. In return, they will get a seat on the table to participate in the work (endorse?) on an equal footing to tackle tax avoidance, to improve the coherence of international tax rules, and to ensure a more transparent tax environment.
For a developing country, the cost for such proforma participation is not minimal. First, the participating countries will have to find participants who are well conversant with the topic of international taxation and transfer pricing and also understand the implications of all the proposals that are quite complex. The financial cost of attending the meetings has to be borne by these states and apparently, the poorest countries will have to pay a fee of 20000 euros per year while the somewhat richer nations would have to pay more.
[http://www.eurodad.org/OECD_inclusive_framework]
In this connection, it is interesting to note that very recently the OECD has cancelled its annual tax treaty meeting on Global Forum for 2016 considering the fact that a large number of delegates from non-OECD countries will be present in the plenary meeting of the Ad Hoc group on the multilateral instruments which will be held the week before. In short, to participate on an equal footing the poorer nations need to be prepared financially and otherwise in all the numerous meetings of different working parties that take place almost ceaselessly.
Coming to the technical aspects, as we have seen, the OECD has released more discussion drafts. Let's examine the case of attribution of profits to a PE in some details as this is a very important issue and has a long history.
Action 7 of the BEPS Action Plan mandated the development of changes to the definition of “permanent establishment” to prevent the artificial avoidance of PE status, particularly through the use of commissionnaire arrangements and through the preparatory and auxiliary activity exemptions. It also proposed a principal purpose test in the context of construction PE so that there is no artificial division of work in order to keep each component below the time threshold.
It is true that as a result of these recommendations, there was a slight increase in the situations in which a PE could be constituted. For example, in the commissionnaire arrangements that earlier escaped PE taxation, it is possible depending on the facts of the case, that a dependent agent permanent establishment will be constituted because of the proposed changes in Article 5(5) and 5(6). Under the current rules, conclusion of contracts in the name of the enterprise is the essential ingredient of the dependent agent PE. Under the revised rules, contract conclusion is not necessary, satisfying the principal role test will do.
So far so good. But then comes the vital question of attribution of profits. It is here that the OECD decided to bowl a googly. Action 7 had also mandated that the work should address the related profit attribution issue. The preliminary work in this regard had earlier concluded that there was no need for any substantive changes to the rules of attribution but that additional guidance was needed on how the rules will apply to the PEs that might result from the changes proposed in article 5. It was also mentioned that the BEPS report on Action 8-10 relating to transfer pricing would have an impact and hence follow up work was necessary.
The present additional guideline relating to attribution profit arose in that context. The Discussion Draft on profit allocation now released states that while the Report on Action 7 has modified the threshold (which may now be met even if a person does not habitually concludes contracts in the name of the enterprise), it has not modified the nature of the deemed PE. It is stated that any guidance on how to attribute profits to a PE that is deemed to exist under the pre-BEPS version of Article 5(5) should be applicable to a PE that is deemed to exist under the post-BEPS version of Article 5(5). Same is the case, according to the OECD, relating to Article 5(4) exceptions or article 5(3) situations. They do not create any new kind of PE. Therefore, the OECD decided to merely issue additional guidance on the application of the OECD's method of attribution of profit.
The relationship between attribution of profit to a PE and the transfer pricing work arises out of the fiction that a PE is to be treated as if it were a separate entity dealing at arm's length with the other parts of the enterprise. The OECD decided that the entire gamut of the guidelines on transfer pricing between related parties (parent and subsidiaries etc.) should apply to the application of profits to PEs as well.
The OECD had already come out in 2008 (and adopted in 2010) with its report on attribution of profit to permanent establishments and propounded its authorized OECD approach (AOA) and changed the language of Article 7. Very briefly, in this approach, a two step process is to be followed. In the first step, in line with the OECD transfer pricing guidelines, a functional and factual analysis has to be carried out to determine the ' significant people function' and based on the same, the assets and capital will be allocated between the PE and the head office. A PE is not a separate legal entity under the law and there cannot be contractual arrangement with its head office. Therefore the 'dealings' of the PE have to be identified and transfer pricing rules will have to be applied by analogy in the second step.
It is also important to note that the OECD had been struggling with this issue for more than a decade and very few of even the OECD's own members follow this approach. As mentioned in the current discussion draft, “through reservations and positions included in the OECD Model, a number of OECD and non-OECD countries have expressly stated their intention not to include the new version of Article 7 in their treaties.”
Importantly, the issue of attribution of profits to permanent establishment was considered at the United Nations as well and attempt was made to push through the OECD view. However, the UN Committee of experts found that the proposed OECD article 7 would require permanent establishments to be treated as fictional or notional separate legal entities, with assets, capital and liabilities allocated between branches and head offices largely on the basis of “significant people functions” and this will have other ramifications. In particular, deductions would have to be provided for notional payments of royalties and interests and profit margins allowed for services provided by head offices for branches. The OECD Model would not, however, allow for the levying of withholding tax on such notional payments. The new OECD article 7 was therefore seen as having the potential to change the balance between source and resident taxation, contrary to the interests of many developing countries. It was also explicitly contrary to paragraph 3 of the article of the United Nations Model Convention, which did not allow deductions for such notional payments (although banks were treated as a special case in the case of notional interest). Accordingly, the UN rejected the so-called AOA. [2011 UN Commentary on Article 7]. There is however a few developed countries that have decided to implement the same. But broadly speaking, the consensus is that the AOA is against the interests of the developing countries.
The BEPS report on action 7 on artificial avoidance of PE had mentioned that for allocation of profits, the effects of the transfer pricing work under action points 8-10 would have to be taken into account. This is more so under the AOA. The present Discussion Draft makes it clear that there is no question of reopening the related issue of TP work under 8-10 as also the ambit of the changes to the definition of permanent establishments. According to the draft, though the change in Article 5(5) and 5(6) might lower the threshold for creating a PE, they do not create any new type of PE. The Discussion draft considers four different scenarios and performs the analysis by applying the Authorised OECD Approach (AOA). Such analysis shows that the scope of the work of the PE may not increase and hence little profit will be allocated to the newly created PE.
In the very first example, a company 'Prima' in the resident state manufactures consumer parts and sales are effected through a subsidiary Sellco in a source country. The sales activities of Sellco are assumed to create a dependent agent permanent establishment (DAPE) in the source State under Article 5(5) and it has no physical presence in the country S.
For allocating profit to the PE, in terms of the AOA, following the transfer pricing methodology, a functional analysis of Sellco shows that it undertakes the following functions: Identifying customers, soliciting and processing customer's orders with Prima, implementing Prima's marketing strategy in the source country for which it is reimbursed by Prima. It is also assumed that no local marketing intangibles are created. Prima has no inventory of goods stored in the source country. The factual and functional analysis also finds that Prima is the legal owner of the inventory, marketing intangibles and receivables and the risks are borne by Prima. In short, all the key risks are assumed by Prima. It is stated that Prima has also the financial capacity to assume the risks. Sellco therefore performs no significant people function regarding Prima's assets or risks, and the fee paid by Prima to Sellco satisfies the arm's length standard. In such circumstances, even if there is a DAPE in the source country, according to the illustration given the profit attributable to it would be zero thereby nullifying the very reason of finding a PE.
In example 2, the fact pattern is slightly different. Here, Sellco is responsible for warehousing the inventory and determining and monitoring the appropriate inventory levels required to fulfil customer orders expeditiously while minimising obsolescence risk and costs. Amounts due from customers are for the account and at the risk of Prima, and Prima contractually bears credit risk with respect to customer receivables. However, Sellco sets the parameters within which credit can be extended to customers. It approves every sale to customers through the review of the customer's creditworthiness and also handles the collection of customer receivables.
The example states that under the transfer pricing analysis under Article 9, since inventory and credit risks are actually controlled by Sellco, these risks should be allocated to Sellco even though the parent contractually assumes these risks. Consequently, the arm's length fee to Sellco under article 9 will also be higher than in the first example. Consequently, the inventory and bad debt losses will also be to the account of Sellco. For the purpose of attribution of profits under Article 7, since Sellco undertakes significant peoples function in respect of inventory and receivables, these will be allocated to Sellco thereby leaving only a small amount to be allocated to the PE representing the interest for funding the inventory. Bulk of the profits will be allocated to the head office.
The other two examples are not considered for the purpose of this article. The short point is that application of significant people's functions as advocated by the OECD can work to the detriment of the developing countries.
Scholars have also questioned the excessive importance given in the AOA to the significant peoples function. Adolfo Martin Jimenez in his work for the United Nations [ Preventing the Artificial Avoidance of PE Status] has observed that this approach is flawed because it tends to ignore that a company is much more than 'significant people' and that all parts of the firm, and especially employees but also other associated companies and subcontractors, contribute to profits. He also points out that t he significant people's functions concept can be used for tax planning purposes by locating such functions in favourable low tax jurisdictions. This would mean that most important profits of a company would go with them since risks follows functions, and functions are identified with significant people within the company. The 'significant peoples' can be made to travel in and out of the source country so that no PE is created. According to Jimenez, this has the effect of removing more profit from that jurisdiction if 'services' are provided there. Besides, risks can be allocated anywhere just by drawing up appropriately worded contracts. Therefore, he concludes: “Probably Combined with the PE thresholds and the freedom of contract to allocate risks between associated companies, the final result is that it is relatively easy to remove profits from the country of sale or manufacture of a product (through contract-manufacture agreements combined with fragmentation and / or commissionaire agreements if the country is also a relevant market), provided significant people are in the right place.” [Source:http://www.un.org/esa/ffd/wp- content/uploads/2014/09/20140923_Paper_PE_Status.pdf]
Comprehending the interconnectedness of the different action plans on such a massive scale as is being done in the BEPS project requires a lot of resources to protect the interests of respective countries, particularly the developing ones. Mere occasional seating at the high table will not prepare them for many nasty surprises. There also needs to be more coordination amongst the non-OECD G-20 countries to properly understand the implications of each proposal and then put forward their points of view. |
