Current international tax rules are based on principles that have not kept up with globalisation and the rise of the digital economy. Over the years the rules have been patched up but, almost two years ago, the Organisation for Economic Co-operation and Development (OECD), acknowledging that a substantial overhaul was needed to combat base erosion and profit shifting (Beps), launched its ambitious 15-point action plan designed to re-write the rules for international taxation.
With the support of the G20 and many other countries, the OECD is working hard to meet the goals of its action plan, with the final self-imposed deadline being this December. This will give countries the domestic and international tools they need to eliminate double non-taxation of income and prevent tax minimisation strategies while continuing to prevent double taxation.
On the face of it the initiative is aimed at multinationals but its reach will be far wider and will affect hedge funds whether they are based onshore or offshore.
The key issues are:
In ascertaining whether a business has a taxable nexus in a particular country the current rules for businesses that are not resident in that country, generally look at whether the business has a physical presence or 'permanent establishment' there. Such a presence can include an office or agent but there are a number of exclusions to the concept so that, for example, a distribution warehouse, a server or a significant customer base in a particular country are not typically enough on their own for a business to have a taxable presence there.
This is set to change soon. Proposals coming out of the Beps project include extending the concept of permanent establishment to cover a number of other situations. In addition to capturing the physical presences that are not currently counted, the proposals also include the creation of a 'virtual permanent establishment' in a country where a server is located or contracts are habitually concluded through technological means with persons located in that country. A new taxable nexus based on having a 'significant digital presence' in a country is also proposed.
Hedge funds that use high frequency trading, particularly co-location, will need to keep an eye on these proposals as, for example, a taxable presence of the fund could be created in a country where the fund's server is located.
Such funds will need to consider their digital infrastructure in preparation for the implementation of these new rules.
Closely tied to taxable nexus is profit allocation which is the most complex area of the BEPS project and the one that is likely to take the longest to implement. It could also result in the most litigation because different countries may well have different views as to what or where the profit allocation should be.
The ability to demonstrate substance will be paramount but there are a number of other factors that will be relevant, including value creation, capital at risk, personnel and physical presence.
At the heart of profit allocation is transfer pricing and the OECD aims to change the rules around this to ensure that taxable profits are allocated to the jurisdiction where the value was created. The OECD is focusing on the following three criteria:
1. Intangibles including ensuring that such profits are appropriately allocated in line with value creation, developing transfer pricing rules for hard-to-value intangibles and updating guidance on cost-contribution arrangements
2. Risks and capital including allocating income on the basis of the location of business operations and disregarding related-party contractual and risk-shifting arrangements
3. High-risk activities including re-characterising transactions that would not, or would only very rarely, occur between third parties.
For high-frequency traders a number of factors will need to be taken into account such as the location of the programmers that create and maintain the algorithm, and the capital put at risk, which could make the allocation of profits a complex and costly task.
Model treaty provisions dealing with limitation of benefits,a general anti-abuse rule and targeted anti-abuse ruleshave all been proposed to prevent the inappropriate use ofdouble tax treaties to obtain relief such as the minimisationof local withholding or capital gains tax.
This could affect illiquid investments in structures that rely on tax treaties to minimise the impact of taxes in the jurisdiction where the investment has been established.
Both onshore and offshore structures could be affected because companies resident in tax treaty jurisdictions maybe directly affected and holding companies
It must be stressed that the OECD can only produce 'soft law' in the form of reports, recommendations, model legislation, model treaty provisions, guidance and a model multi- national treaty. These are not backed by the weight of law and so countries will still need to take action to adopt them.
While some actions are likely to happen in the near future others are likely to take much longer and it is also recognised that some proposals do not yet adequately address funds – meaning further work needs to be done.
There is broad political support for the Beps project but countries will need to harmonise their laws in certain areas for it to succeed. To prevent base erosion it must first be established which country's tax base is being eroded and, where businesses are located over various countries, this is not an easy thing to establish. Therefore it is likely that some businesses will end up with more than one country laying claim to taxing rights over its profits.
It was the prevention of such double taxation that gave rise to the international tax rules we currently abide by. While the OECD firmly maintains the goal of preventing double taxation the focus of individual countries on eliminating double non-taxation could cause them to jump the gun and bring in domestic anti-BEPS legislation designed to protect their own domestic tax base, which would not be in step with the laws of other countries. The UK, for example, has recently implemented a 'diverted profits tax' – an extra-territorial tax that is aimed at contrived or artificial arrangements used by large multinationals to erode its tax base. Crucially this new tax is designed not to be subject to the 100 plus double tax treaties that the UK has entered into.
If countries adopt an uncoordinated approach to protect their tax bases, especially in rules relating to taxable nexus and allocation of profits, then we could see more uncertainty in the application of international-focussed tax rules as well as an increase in associated litigation and overall costs.
Australia has suggested that it will implement a diverted profits tax and, if other countries follow the UK's lead, then existing double tax treaties could become less relevant and the risk of double taxation will increase significantly.
Businesses such as hedge funds may consider either increasing their presence in an offshore jurisdiction, such as Guernsey, or relocating offshore altogether. While such a move may not protect a business from anti-Beps laws entirely it can protect it from the uncertainty, and associated cost climbs, that could arise if rules are introduced in an uncoordinated manner.
An original version of this article was published in HFM Week, Guernsey supplement, April 2015.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
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