United States: BEPS Developments Usher in New Era of International Taxation

Last Updated: October 9 2017
Article by Larry R. Kemm

Four years after the OECD and G20 countries adopted a 15-point action plan to attack base erosion and profit shifting (BEPS), a new era of international taxation was launched on June 7 when 68 countries signed a multilateral instrument. Several additional countries are committed to sign in the near future. The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) is significant because it enables the rapid introduction of new terms into bilateral tax treaties worldwide.

The BEPS project's goal is stated simply: Prevent multinationals from exploiting gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity. However, achieving this objective is exceedingly difficult due to differences in how countries characterize entities for tax purposes and tax corresponding income streams. Moreover, standards for determining whether a business has a taxable presence within a country are not universally applied in a consistent manner. Many of these differences are ultimately reconciled by applying income tax treaties negotiated by countries with their trading partners. Thus, to implement measures arising out of the BEPS project, participating countries must incorporate changes arising from BEPS into existing tax treaties.

The MLI will effectively serve as an overlay to the expansive networks of treaties in effect throughout the world. Absent the MLI, a country that has entered into numerous bilateral income tax treaties would be required to independently renegotiate each treaty in order to adopt measures recommended through the BEPS project.

Key aspects of the MLI include measures to prevent treaty shopping or abuse as well as enhanced dispute resolution mechanisms. Signatories are required to adopt minimum standards for the application of treaties which will prevent treaty abuse, improve dispute resolution, prevent the artificial avoidance of a taxable presence (i.e., a "permanent establishment") and neutralize the effects of hybrid mismatch arrangements.

Certain elective MLI provisions permit countries to opt into or out of their application on a country-by-country basis. Most notably, the MLI provides an election to apply mandatory binding arbitration as a mechanism for dispute resolution. Historically, the mutual agreement procedure (MAP) contained in most tax treaties is the primary mechanism for resolving international tax disputes. Under MAP, a taxpayer seeks review by the competent authority of its resident country to avoid double taxation. However, due to constrained government resources and ever-increasing caseloads, the competent authorities for taxing jurisdictions often have difficulty resolving complex cases within reasonable timelines. Cases may languish for years under MAP. Thus, the introduction of a mandatory and binding arbitration process provides the ability to reach resolution with the certainty of stated timelines. If elected, the binding arbitration provision may apply where the competent authorities have been unable to reach agreement within two years after the MAP is initiated. Under the MLI a country may choose to apply the mandatory and binding arbitration provision on a treaty-by-treaty basis.

The MLI takes effect three months after it is ratified or approved by at least five countries. Thereafter it becomes effective for taxes levied six months after it enters into force. Because the effective date is linked to ratification procedures in the participating jurisdictions, it is likely that modifications the MLI made will not take effect until well into 2018 or later for most treaties. Based on the number of countries that have already signed the MLI, it is estimated that it will affect more than 1,100 existing bilateral tax treaties.

It may seem surprising that the United States chose not to sign the MLI. However, many of the underlying policies and recommendations coming out of the BEPS project are already reflected in U.S. law and bilateral treaties signed by the United States. For example, the comprehensive limitation on benefits article contained in substantially all U.S. treaties effectively precludes treaty shopping targeted by certain BEPS recommendations. The fact that the United States did not sign the MLI does not mean, however, that U.S. multinationals are unaffected. To the contrary, U.S. multinationals with operations or subsidiaries in multiple countries will nevertheless be subject to the MLI with respect to dealings between and among countries that are MLI signatories.

Applying the MLI after it takes effect will be a complex process. First, it will be necessary to determine if a treaty is a covered tax agreement. Because each country can selectively identify which treaties will be covered, the MLI will only apply if both countries that are party to an agreement have listed the agreement as a covered agreement under the MLI. Second, it will be necessary to determine whether either country has reserved on the application of certain provisions or selected to apply optional provisions of the MLI. For an optional provision (such as mandatory and binding arbitration), both contracting jurisdictions are required to choose the same position in order for the optional provision to apply. Finally, administrative notification requirements state that MLI parties must identify existing treaty provisions to be modified before the MLI provisions can have effect.

The development and implementation of policy recommendations arising from the BEPS project are ongoing. Indeed, as recently as July 27, the OECD released its report under Action 2 to address Neutralising the Effects of Branch Mismatch Arrangements. This report targets five situations where the use of a branch office or operation facilitates a deduction in one jurisdiction without a corresponding income inclusion in the payee jurisdiction, or a double deduction for the same payment in two jurisdictions. To combat these outcomes, the report recommends changes to deny the deduction of branch payments to the extent there is no corresponding income recognized in the payee jurisdiction. The report also recommends changes to align the branch exemption regimes of jurisdictions in order to reduce instances of double non-taxation. These changes are recommended as best practices, rather than minimum standards. As such, they may be discretionarily adopted through domestic legislation but require no modifications to treaty provisions through the MLI.

If all works as planned the MLI and implementation of BEPS recommendations will substantially diminish certain international planning structures used for many years by multinationals to minimize global taxes. Yet these measures may also enhance the management of tax risk by providing greater certainty to competing claims of primary taxing jurisdiction by separate countries.

Efforts to implement BEPS measures through the MLI are laudable. Although any clear measure of success may take some time to see, anecdotal evidence suggests many multinationals have already altered their tax planning behavior — or at least delayed tax planning — due to these developments. The practicalities of administering the MLI may dictate the extent of its ultimate success. Certainly layering MLI modifications on top of existing treaties will present administrative challenges. Nevertheless, the new MLI and BEPS measures have the potential to significantly alter the course of international taxation.

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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