India: Intellectual Property Regime: Post BEPS Impact - Analysis Of Action Plan 5: Countering Harmful Tax Practices

In a business environment that is continuously evolving, existing tax rules are facing challenges. More often than not they are criticized for setting out provisions that seems to be detached from economic reality. Tax Policy, at the moment is a subject that concerns business as well as general public at large.

Otherwise, once considered to be mundane topics such as tax behavior of Multinational Enterprises ('MNEs'), have become top headlines ever since the end of 2012.1 Debates on tax as a social responsibility and MNCs paying their 'fair share' of tax in the countries where they carry out business activities is in vogue these days.

1.1. BUSINESS MODEL

Vide this article we are aiming to provide an analysis into one of the technicalities of the root of the matter, being commonly employed by MNEs to reduce their overall tax burden, namely Intellectual Property ('IP') structuring and how OECDs BEPS Action Plan 5 intends to fight the same.

To understand the intent of Action Plan 5 it is significant that we first understand the commonly employed business models for exploiting IP and tax planning structures created for structuring IP.

In today's technology driven world, where business is being carried on mobile-apps the development and exploitation of an IP is the key to the modern businesses. Given that IP is a main driver of value creation and at the same time, a mobile asset, it plays a major part in tax structuring.

Corporations having global presence are forced to choose the best location for their manufacturing plants, distribution activities and R&D activities among others. A consequence of which is that, entities having fewer functions and assuming limited risks and owning little or no intellectual property appear in the structures of MNEs.

It has been observed that implementation of such business models has effectuated a reduction in the overall operating expenses as well as in the effective income tax rate at the group level achieved primarily by moving functions, risks and assets from high-tax jurisdictions to low tax jurisdictions.

In simpler words, such business structures exploit tax benefits arising from royalty payments made from a company resident in a high tax jurisdiction to the IP holding company that is located in a low tax jurisdiction thereby enjoying deductibility of royalty payments in the high tax jurisdiction and lowering the tax base of the group company residing there. On the other hand, the related income is subject to a much lower income tax, if any, since the company holding the IP s a resident of a low tax jurisdiction.

1.1.1. Royalty Model

Following are some of the business models that have been widely practiced.

In royalty model, the company licensing the IP to its final users is a resident of low tax jurisdiction. The Company licensing it is either the owner of the IP or alternatively licenses the non-transferrable IP rights from another group entity. IPs are developed under an R&D contract by an external party remunerated on a cost- plus basis for the services provide.

Usually implementation of such structures is easy as only few functions pertaining to the licensing of IP are performed at the level of intangible principal. The shortcoming of the model is the lack of business reasons for undertaking it because of minimal operational changes. Moreover, since the licensing company mostly receives licensing income in the form of royalty payments, such income may be subject to taxation in the country of its parent company in case Controlled Foreign Corporation Regulations (CFC Rules) are in place in that jurisdiction. Also, transfer pricing regulations shall have to be considered while determining the amount of royalty.

1.1.2. Cost Sharing Model (CSM)

The term cost sharing implies that the IP is jointly developed by several parties by getting into a cost sharing arrangement. The parties establish from the onset, the way research is performed and the resulting costs assigned. Ideally costs should be allocated to each party to the contract in proportion of the anticipated benefits from their own exploitation of the newly developed intangible.2

In comparison to the royalty model only deduction of actual cost contributions can be made from taxable profits. Moreover, no sale or transfer of the IP between the parties to the agreement is plausible.

The recent European Commission ruling in case of Apple in Ireland alleging a tax demand of Euro 13 bn plus interest involved a cost sharing model wherein the Irish counterparts of Apple Inc., headquartered in US entered into a CSM to hold rights to use Apple's intellectual property and to sell and manufacture Apple products outside North and South America and thereby made annual payments3 to US to fund research and development efforts conducted on behalf of the Irish companies in the US.

Such payments for expenses viz. contribution to fund amounted to more than half of all research efforts by the Apple group in the US to develop its intellectual property worldwide.

1.1.3. Principal Model

Under the principal model, the company (principal), resident of a low tax risk jurisdiction is a full risk entrepreneur and is the party owning the IP; carrying out the general management activities including deciding on the marketing and sales strategies.

The Company enters into service agreements with other vendors for manufacturing activities, marketing and sales support etc. on a commission or a cost plus based model. Similar to royalty model, principal model too recognizes the outsourcing of development of IP to a low-risk contractor basis a R&D contract.

The implementation of such a structure involves major operational changes to the business model of the multinational group. From transfer pricing perspective, Arm's Length Pricing has to be maintained for service providers forming part of the group. Further, since the Principal establishes direct contact with the customers and assumes full commercial risks, the likelihood of taxation of higher profits at this level vis-à-vis the other two models is higher and thus one needs to consider that any subsequent distribution of profits from low tax jurisdiction to the ultimate parent company in a high tax jurisdiction might trigger additional tax liabilities.

1.2. TAX PLANNING

Exploitation/development of IP vide the above business models has resulted in complex tax planning structures giving rise to no or negligible taxes.

The recent decisions of the European Commissions that seems to be taking the world by the storm are evident of existence of such structures on a large scale whether it's the giant coffee house Starbucks or the tech gamut, apple. In terms of the ECs decision all of them have been found to be guilty employing techniques such as that of attribution of ownership of IP to a group company residing in a low tax jurisdiction.

Studies analyzing inter-company transactions of US based companies4 reveal that income resulting from IP represents half of the income which is moved from high tax jurisdictions to low tax jurisdictions.

One of the most commonly employed structures implemented in practice is the 'Double Irish with a Dutch Sandwich' structure.

Apparently, the structure was first implemented in the late 1980s by companies such as Apple and was later used by a large number of MNEs including Adobe Systems, Facebook, Google, IBM, Microsoft, Starbucks and Yahoo.5

The structure entails the use of a subsidiary of a US based MNE established in Ireland (Irish Co 1), but effectively managed from a low or nil tax jurisdiction, for instance Bermuda. Under the Irish laws, central management and control test is exercised to define corporate residency for tax purposes while the US applies the place of incorporation test. Resultantly, the Irish Co. 1 is not treated as a tax resident of Ireland under Irish law, but a resident of Bermuda. However, for US tax purpose, Irish Co. 1 is regarded as an Irish Corporation.

The IP owned by the US parent company that licenses the rights to develop and exploit the property to Irish Co. 1 further licenses the IP rights to Dutch Co., resident of Netherlands, which subsequently sub-licenses the rights to the group IP company, an Irish Company, managed and controlled in Ireland. Thereafter the IP Company enters into licensing agreements within the group.

Irelands treats the payments made by the IP Company to Dutch Co. as royalty payments for the use of IP. The taxable profits of IP Company are thus reduced by the amount of deductible royalties that it pays further to Dutch Co. the remaining profits derived by the IP Company are subject to a 12.5% corporation tax in Ireland, the tax rate applicable to active business income. Moreover, the royalty payments made by the IP Company to Dutch Co. are not subject to withholding taxes under the Interest and Royalties Directive which disallows the levy of withholding taxes on interest and royalty payments between affiliated companies resident in the European Union, subject to fulfilment of certain conditions.

Netherlands imposes a corporate tax rate of 20/25%. However, due to the fact that tax base in Dutch Co. is reduced by the amount of deductible royalties further paid to Irish Co. 1, only the ALP remains taxable in Netherlands. Further, the domestic tax laws of Netherlands do not levy withholding taxes on outbound payments made by Ditch Co to Irish Co. 1.

The profits earned by Irish Co. 1 are not subject to tax in Ireland, as the company is not a tax resident of Ireland but that of Bermuda and Bermuda does not levy taxes on royalty income.

Moreover, to complete a full circle and to avoid being taxed in the US, the US parent company uses the check-the-box election6 in the US for IP Company and Dutch company to ensure they are regarded as separate entities for US tax purposes. Accordingly, the transactions carried out between IP Company, Dutch Co. and Irish Co. 1 are not visible for US tax purposes.7

1.3. Impact of BEPS Action Plan 5

In the past, Switzerland and Luxembourg have also been preferred as jurisdictions instead of the Dutch land in similar structures.

It is appropriate to highlight that the existence of such structures/arrangements rely heavily upon the availability of a preferential tax regime for income generated from the use and exploitation of IP in the country where such property is located and thus the domestic tax rules assume significant importance as they may act as a key factor in electing a specific jurisdiction.

A preferential tax regime is a practice widely followed by member States of European Union whereby the public authorities grant certain undertakings a favourable tax treatment which places them in a more favourable financial position than other taxpayers. For instance, the following may be made available, tax deferrals; tax allowances and tax credits.

Such rulings affording preferential treatment are also described in the western world as sweetheart deals.

Nevertheless, where the level of favourable activities carried out in such jurisdictions does not commensurate with the level of the investment or income derived therein, the existence of such preferential regimes may create harmful economic effects as the same results in shifting of profits of multinational corporations to jurisdiction via mobile instruments having preferential tax regime as easy as pie.

This issue has been addressed by Action 5, Countering Harmful Tax Practices More effectively, Taking into Account Transparency and Substance of BEPS Action Plans and recognizes a harmful tax regime as firstly, applicable to income derived from geographical mobile activities for instance, licensing, finance etc.; secondly, the tax treatment of such income must be preferential compared to the other incomes not benefiting from the regime in the same country.

BEPS aim at aligning taxation with substance, by ensuring that taxable profits can't be shifted away and Action Plan 5 focuses on revamping the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings to preferential regimes and on requiring substantial activity for any preferential regime.8

One of the focal points of Action Plan 5 is the substantial activity requirements, which aims to ensure a better alignment of economic activity and taxation. In this regard three different approaches were considered namely, a value creation approach based on the development activities undertaken to avail benefits; a transfer pricing approach, determining the benefits to be granted under a certain regime based upon the level of functions performed in respective jurisdiction and a nexus approach wherein benefits are given subject to the extent of R&D activities that the taxpayer performs in the jurisdiction granting the preferential tax rules. The nexus approach uses the level of expenditure to determine the tax benefit granted, has been chosen as the preferred approach to decide the substantial activity requirement for IP regimes.

Nexus approach ensures that benefits are bestowed only to income derived from IP in cases where there the R&D activities are undertaken by the taxpayer.

Moreover, Action Plan 5 also mandates exchange of information on rulings related to preferential tax regimes. However, general rulings, applicable to everyone do not fall within the scope of information exchange. Additionally, cross border advance pricing agreements, the advance tax rulings, the permanent establishment rulings and related party conduit rulings shall be shared between the member states with respect to the rulings issued after January 1, 2010.9

However, despite the enthusiasm with the implementation of BEPS, similar structures may still be operative.

Footnotes

1. http://www.economist.com/news/business/21568432-starbuckss-tax-troubles-are-sign-things-come-multinationals-wake-up-and-smell

2. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Chapter VIII (OECD 2010)

3. USD 2bn in 2011 which significantly increased in 2014. Source European Commission Press Release, August 30, 2016

4. H. Grubert, intangible income, Intercompany Transactions, Income shifting and the choice of location (Part 2), 56 Ntl. Tax J. 1 (2003) at 221

5. Structuring IP- International Tax Structures in BEPS Era: An analysis of Anti-abuse measures

6. check-the-box election is an entity classification election that is made on I.R.S. Form 8832, Entity Classification Election.

7. http://www.ip-tax.com/2010/11/us-double-irishdutch-sandwich/  

8. OECD, Harmful Tax Competition: An emerging global issue (OECD 2013)

9. And Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 - 2015 Final Report https://www.linkedin.com/pulse/oecd-beps-preferential-tax-regimes-g%C3%A1sp%C3%A1r-bagam%C3%A9ry  

This article was first published in the Conference Journal of IFA- Asia Pacific Tax Conference, New Delhi.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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