Action Item 5 of the BEPS Action Plan commits the Forum on Harmful Tax Practices ("FHTP") 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."
Work in the area of harmful tax practices is not new; the FHTP was created in 1998 as a result of the OECD report of the same year: Harmful Tax Competition: An Emerging Global Issue. The key focus of the work of the FHTP has been to reduce the way in which taxation can distort the location of mobile financial and services activities. Since 1998, several reports have been issued detailing the work and its progress. In September 2014, in the context of the BEPS project, the OECD issued an interim report outlining the progress made on the outputs to be delivered under Action Item 5, namely: (i) finalization of the review of member country preferential regimes; (ii) a strategy to expand participation to non-OECD member countries; and (iii) consideration of revisions or additions to the existing framework. The interim report is entitled "Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance" (the "Report").
The substance of the Report is an update on the first output: the finalization of the review of member country preferential regimes. The key points to note are set out below.
The substantial activity requirement:
The Report emphasizes that this is a specific requirement of Action Item 5, and one that has been elevated in importance. It will be considered alongside the four key factors when determining whether a preferential regime within the scope of the FHTP's work is potentially harmful (i.e., (i) the regime imposes no or low effective tax rates on income from geographically mobile financial and other service activities; (ii) the regime is ring-fenced from the domestic economy; (iii) the regime lacks transparency; and (iv) there is no effective exchange of information with respect to the regime). While the requirement is in particular being reviewed in the context of intangible regimes, it will ultimately also be considered in relation to other preferential regimes.
The approach to requiring substantial activities in an intellectual property ("IP") regime on which the FHTP has focused is the nexus approach. The nexus approach looks at whether an IP regime makes its benefits conditional on the extent of research and development activities of taxpayers receiving the benefits. It not only permits jurisdictions to provide benefits in relation to the expenditures incurred to create the IP, but also in relation to income arising out of that IP, provided there is a direct nexus between the income receiving tax benefits and the expenditures contributing to the income. In effect, the nexus approach allows a regime to provide for a preferential rate on IP-related income to the extent it was generated by qualifying expenditures and applies the following calculation:
Qualifying expenditures incurred to develop IP
asset x overall income from IP asset = income receiving
Overall expenditures incurred to develop IP asset
Points to note in particular in the context of the nexus approach are that:
- the only IP assets that could qualify for tax benefits under an IP regime are patents1 (and any functionally equivalent assets);
- overall expenditures would exclude anything that would not be a qualifying expenditure (i.e., incurred by the qualifying taxpayer and directly connected to the IP asset) in the hands of the qualifying taxpayer (e.g., interest payments, building costs, etc.) with exceptions for costs of IP acquisition and certain costs of outsourcing that would not count as qualifying expenditures;
- outsourcing costs would only be included as qualifying expenditures to the extent they were made to unrelated parties (in some cases, up to a certain percentage or proportion);
- as referred to above, the acquisition cost of IP would not be a qualifying expenditure, but payments to enhance it would be; and
- it will be important for taxpayers to track expenditures, IP assets and income to ensure that the income receiving tax benefits does in fact arise from the expenditures that qualified for those benefits and for jurisdictions to establish a reasonable tracking method. The report appreciates this may be complex, but sees it as a function of the preferential regime as opposed to the nexus approach.
Improving transparency through compulsory spontaneous
exchange of rulings related to preferential regimes:
The work on this requirement is intended to lead to the FHTP applying the agreed transparency framework following the FHTP's autumn 2014 meeting and to report on the status of the implementation and time frame to achieve it in a FHTP 2015 Progress Report. OECD member and associated countries have until the end of 2014 to initiate steps to put in place the legal framework for spontaneous information exchange between countries to be able to take place (with an adjustment period being allowed for those countries that do not yet have the necessary legal framework to do this).
The framework developed by the FHTP seeks to ensure that there is a relevant exchange of information but not by imposing an unnecessary administrative burden on any party involved. To this end, a number of filters will apply to determine whether an obligation to spontaneously exchange information arises. The obligation to exchange does not just apply to preferential regimes that are harmful, but to any preferential regime. The current intention is for the obligation to apply just to taxpayer specific rulings (such as advance tax rulings and advance pricing agreements) and not general rulings.
The information is to be exchanged with any affected country (e.g., the country of residence of the immediate parent company) as quickly as possible, and no later than three months after the ruling becomes available to the competent authority of the country that has granted the ruling. In terms of content, a short summary of the ruling should be sufficient, although if the ruling refers to transfer-pricing then the information should be sufficient to enable the receiving country to decide whether it should request further information. The exchange does not give rise to any reciprocal obligation.
The FHTP is in the process of completing the second stage of its work on transparency, including considering in more depth the content of the information that should be exchanged, whether general rulings are transparent, and what further information might assist in assessing whether a country has complied with its obligation under the framework.
Review of member and associated country
As an ongoing task, the FHTP is reviewing all the intangible regimes of member countries and associate countries, and will consider the review of other preferential regimes going forward in light of the substantial activity test. The Report sets out its conclusion on some preferential tax regimes (not intangibles regimes) reviewed to date.
The FHTP will complete the work on the first output, including carrying out further work on substantial activity and transparency and reviewing the preferential regimes of associate countries. It will also commence work on the second output, the deadline for which is September 2015.
It is clear that there is still further work to be undertaken in these areas and that agreement is not yet fully reached. The emphasis on the substantial activity requirement is clear and it remains to be seen whether the nexus approach will be agreed upon. For instance, a transfer-pricing approach is preferred by the UK, the Netherlands, Spain and Luxembourg (although other countries oppose this). The Report also flags that arguments that the approach may not be compatible with European Union law have been advanced. Presumably, until such agreement is reached, no conclusive review of any of the intangibles regimes can be carried out; the Report also notes that some preferential regimes already reviewed may need reconsidering in due course.
If the nexus approach is adopted then it seems that those countries that have IP regimes, including intangibles other than patents, or those that include IP acquisition costs as qualifying expenditure, may find that their regimes are seen as harmful, although OECD guidance will be issued on grandfathering when amendments are required to be made to such regimes.
It will also be interesting to see the extent of any exchanges made to comply with the transparency framework and the administrative burden it puts on members despite the presence of filters. Countries will, in any event, be required to provide data to the FHTP as part of its monitoring and review mechanism to ensure countries' compliance.
Generally, the Report wants to make clear that the work on harmful tax practices is not intended to promote the harmonization of taxes and tax structures within or without the OECD, but designed to create a level playing field, with free and fair competition, without tax being a distortive influence.
1Some IP regimes such as the Luxembourg 80% exemption regime also apply to other types of assets such as trademarks.
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