It has become generally accepted that the international tax system is based on the principle that the profits of a business should be taxed in the countries in which it created value. The alignment between the taxation of profits and the notion of value creation or substance was the main driver of the Organisation for Economic Co-operation and Development's (OECD) Base Erosion Profit Shifting (BEPS) Project and its final reports.

The implementation of the BEPS Project has triggered considerable influence within all EU Member States, including Malta and this led to the transposition of the Anti-Tax Avoidance Directive (ATAD). The concept of value creation or substance in order to ensure that profits are taxed where a genuine economic activity is creating value has become extremely important worldwide.

In this respect, Malta companies are expected to go through a substance and value creation remediation process whereby companies should perform a functional analysis to strengthen the activities of the companies by adding and creating value to the Malta companies. In this respect, in order for a company to create and/or add value/substance, one must assess the four (4) main pillars:

  1. Functions
  2. Risks
  3. Assets
  4. Business Strategies

1. Functions

The idea is to assess any functions that local employees and directors perform in connection with the development, enhancement, maintenance, protection, and exploitation of the operations of the company. It is therefore necessary to determine, by means of a functional analysis, which governing body (primarily a locally composed Board of Directors) within a company perform and exercise control over development, enhancement, maintenance, protection, and exploitation functions, which member(s) provide funding and other assets, and which member(s) assume the various risks associated with the operations of the company.

This functional analysis seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the company and making sure that adequate local employees and directors are put in place according to the volume and needs of the company. The analysis focuses on what the company is actually doing and the capabilities it provides. Such activities and capabilities will include decision-making, including decisions about business strategy and risks.

2. Assets

Legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the assets of the company. The group of companies performing important functions, controlling economically significant risks and contributing assets, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return reflecting the value of their contributions.

In this respect, Malta companies should be assessing the type of assets used, such as plant and equipment, the use of valuable intangibles, financial assets, etc., and the nature of the assets used, such as the age, market value, location, property right protections available.

3. Risks

Risks are defined as the effect of uncertainty on the objectives of the business. Risk is inherent in business activities. Enterprises undertake commercial activities because they seek opportunities to make profits, but those opportunities carry uncertainty that the required resources to pursue the opportunities either will be greater than expected or will not generate the expected returns.

Identifying risks goes hand in hand with identifying functions and assets and is integral to the process of identifying the commercial or financial relations between the associated enterprises and of accurately delineating the transaction or transactions.

4. Business Strategies

Business strategies must also be examined. Business strategies would take into account many aspects of an enterprise, such as innovation and new product development, degree of diversification, risk aversion, assessment of political changes, input of existing and planned labour laws, duration of arrangements, and other factors bearing upon the daily conduct of business.

Business strategies also could include market penetration schemes. A taxpayer seeking to penetrate a market or to increase its market share might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market. Furthermore, a taxpayer seeking to enter a new market or expand (or defend) its market share might temporarily incur higher costs (e.g. due to start-up costs or increased marketing efforts) and hence achieve lower profit levels than other taxpayers operating in the same market.

Timing issues can pose particular problems for tax administrations when evaluating whether a taxpayer is following a business strategy that distinguishes it from potential comparables. Some business strategies, such as those involving market penetration or expansion of market share, involve reductions in the taxpayer's current profits in anticipation of increased future profits. If in the future those increased profits fail to materialise because the purported business strategy was not actually followed by the taxpayer, the appropriate transfer pricing outcome would likely require a transfer pricing adjustment. However, legal constraints may prevent re-examination of earlier tax years by the tax administrations. At least in part for this reason, tax administrations may wish to subject the issue of business strategies to particular scrutiny.

When evaluating whether a taxpayer was following a business strategy that temporarily decreased profits in return for higher long-run profits, several factors should be considered. Tax administrations should examine the conduct of the parties to determine if it is consistent with the purported business strategy.

Where a company has undertaken market development activities at its own risk and enhances the value of a product through a trademark or trade name or increases goodwill associated with the product, this situation should be reflected in the analysis of functions for the purposes of establishing comparability. An additional consideration is whether there is a plausible expectation that following the business strategy will produce a return sufficient to justify its costs.

Shell or letter-box companies should no longer be a viable option for investors wanting to set-up business in Malta and all of the above should be thoroughly assessed in order to ensure substance and value is being created in Malta.

As published on the Times of Malta Sunday Newspaper on the 15th December 2019.

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.