Improving Dispute Resolution: The World of B.E.P.S.

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The Discussion Draft on Action plan 14 (the “Draft”) received an overwhelming response. On January 19, 2015, the O.E.C.D. published over 400 pages of comments on how to make dispute resolution mechanisms more effective.

Many believe that as a result of the B.E.P.S. program, the number of treaty-related tax disputes will increase. To accommodate this surge in tax cases, it is crucial to develop an effective dispute resolution mechanism that will enhance cross-border trade.

The Draft reflects a lack of consensus regarding the Mutual Agreement Procedure (“M.A.P.”). Most of the comments support creating a M.A.P. that facilitates final and binding decisions within a set timeframe. It is seen as a step towards improving the efficiency and effectiveness of the B.E.P.S. project as a whole. Creating an efficient M.A.P. will demonstrate the O.E.C.D.’s commitment to creating a mechanism that will provide progress.

Making the M.A.P. mandatory may not be enough, as other issues come into play. Here is a sampling of comments that appear in the 400 pages that were released:

• The fact that the initiative in solving the dispute remains with the Contracting States leaves the taxpayer with a limited role. As a result, the opportunity of having a smoothly functioning M.A.P. with taxpayer input bows to need protecting a States’ right to tax.
• The Draft pointed out that a taxpayer should not have an active role in the M.A.P. This is rooted in the belief that the involvement of the taxpayer will result in a lengthier process, which is more costly to the Contracting States. This observation may not be correct in all cases; the involvement of a taxpayer may motivate the Competent Authorities to promptly reach a good-faith agreement at an accelerated pace.
• Competent Authorities initiate M.A.P. with a belief in the validity of their position. Believing in the justification of their position will make it hard for a Competent Authority to concede. As a result, the Competent Authorities may have difficulty in preserving an atmosphere necessary to reach a solution through reconciliation.

Follow-Up Draft of Report on Action 6 (Treaty Abuse) and Public Comments Released

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Comments on the O.E.C.D.’s public discussion draft to the follow-up work on B.E.P.S. Action 6 (the “Follow-Up Draft”) were released on January 12, 2015. Action 6 of the B.E.P.S. Action Plan focuses on preventing treaty abuse and treaty shopping, which the O.E.C.D. has identified as being one of the most important sources of B.E.P.S. concerns.

The Follow-Up Draft modifies the “Report on Action 6 (Prevent the granting of treaty benefits in appropriate circumstances)” and identifies 20 issues on which interested parties may provide comments. It focuses on matters related to the application of the limitation on benefits (“L.O.B.”) rule and principal purpose test (“P.P.T.”) as well as the treaty entitlement of collective investment vehicles (“C.I.V.’s”) and non-C.I.V. funds. The 20 issues identified by the Follow-Up Draft and addressed in the comments are as follows:

Issues Related to the L.O.B. Provision

• C.I.V.’s: application of the L.O.B. and treaty entitlement,
• Non-C.I.V. funds: application of the L.O.B. and treaty entitlement,
• Commentary on the discretionary relief provision of the L.O.B. rule,
• Alternative L.O.B. provisions for E.U. countries,
• Requirement that each intermediate owner be a resident of either Contracting State,
• Issues related to the derivative benefit provision,
• Provisions dealing with “dual-listed company arrangements,”
• Timing issues related to the various provisions of the L.O.B. rule,
• Conditions for the application of the provision on publicly-listed entities, and
• Clarification of the “active business” provision.

B.E.P.S. Action 14: Make Dispute Resolution Mechanisms More Effective

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INTRODUCTION

The O.E.C.D. has continued to publish discussion drafts under its 15-part action plan (the “B.E.P.S. Action Plan”) for combatting base erosion and profit shifting (“B.E.P.S.”), with Action 14 being the most unique.

Action 14, entitled “Make Dispute Resolution Mechanisms More Effective,” provides as follows:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

While most components of the B.E.P.S. Action Plan address the problems caused by base erosion and profit shifting, the recently proposed discussion draft for Action 14 (“Discussion Draft” or “Draft”) addresses the mutual agreement procedures (“M.A.P.”) used to resolve treaty-related disputes. Action 14 addresses the current obstacles faced by taxpayers seeking M.A.P. relief to avoid economic double taxation and provides suggestions as to how to revise provisions in order to improve the integration of M.A.P. dispute resolution mechanisms. The O.E.C.D. describes it as a unique opportunity to overcome traditional obstacles and to provide effective relief through M.A.P. The Discussion Draft proposes complementary solutions that are intended to have a practical and measurable impact, rather than merely providing additional guidance which may not be followed.

B.E.P.S. Action 10 - Part II: The Transfer Pricing Aspects of Cross-Border Commodity Transactions

Read Publication The discussion draft on Action 10 (the “Discussion Draft”) deals with transfer pricing issues in relation to commodities transactions and the potential for Base Erosion and Profit Shifting (“B.E.P.S.”). The commodity sector constitutes major economic activity for developing countries and provides both employment and government revenue.

In seeking to create clear guidance on the application of transfer pricing rules to commodity transactions, the Discussion Draft identifies several problems and policy challenges and seeks to establish a transfer pricing outcome that is in line with value creation.

B.E.P.S Action 10 - Part I: Profit Split Method in the Context of Global Value Chains

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INTRODUCTION

There has been another release on Base Erosion and Profit Shifting (“B.E.P.S.”) deliverables. B.E.P.S. refers to the tax planning that moves profits to a low-tax jurisdiction or a jurisdiction that allows a taxpayer to exploit gaps in tax rules. These deliverables have been developed to ensure the coherence of taxation at the international level. The aim of these deliverables is to eliminate double non-taxation. The measures have been developed throughout 2014, and they will be combined with the work that will be released in 2015.

In the December 16th release on Action 10 (the “Discussion Draft” or “Draft”), Working Party No. 6 on the Taxation of Multinational Enterprises (“M.N.E.’s.”) released various factual scenarios, posed questions and invited affected persons to suggest answers. The goals of the Draft are to assure that transfer pricing outcomes are in line with value creation and to determine whether it is more appropriate to apply the profit split method in some circumstance instead of a one-sided transfer pricing method.

RELEVANT ISSUES

The Draft identifies relevant issues in the posed scenarios, asks questions, and invites commentary as follows.

Value Chains

The term “global value chain” describes a wide range of activity, from the consumption of the product to the end use and beyond. Therefore, one particular method of transfer pricing may not be appropriate.

B.E.P.S. Action 4: Limit Base Erosion Via Interest Payments and Other Financial Payments

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Action 4 of the B.E.P.S. Action Plan focuses on best practices in the design of rules to prevent base erosion and profit shifting using interest and other financial payments economically equivalent to interest. Its stated goal is described in the following Action:

Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments. The work will evaluate the effectiveness of different types of limitations. In connection with and in support of the foregoing work, transfer pricing guidance will also be developed regarding the pricing of related party financial transactions, including financial and performance guarantees, derivatives (including internal derivatives used in intra-bank dealings), and captive and other insurance arrangements. The work will be coordinated with the work on hybrids and CFC rules.

On December 18, 2014, the O.E.C.D. issued a discussion draft regarding Action 4 (the “Discussion Draft”). The Discussion Draft stresses the need to address base erosion and profit shifting using deductible payments such as interest that can give rise to double non-taxation in both inbound and outbound investment scenarios. It examines existing approaches to tackling these issues and sets out different options for approaches that may be included in a best practice recommendation. The identified options do not represent the consensus view of the Committee on Fiscal Affairs, but are intended to provide stakeholders with substantive options for analysis and comment. This article discusses the Discussion Draft for Action 4 of the B.E.P.S. Action Plan.

T.I.G.T.A. Advises the I.R.S. on Improving International Tax Compliance

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In 2006, the I.R.S. created the International Collection program (“International Collection”), whereby collections officers are primarily responsible for collection of all delinquent taxes and tax returns of taxpayers located outside the U.S., but subject to the United States tax and reporting requirements. Since its inception, International Collection has undergone certain changes with the intention of developing a well-structured, long-term strategy to curb international tax noncompliance.

INTERNATIONAL TAXPAYERS

Significant emphasis now is placed on international tax compliance. The I.R.S. is concentrating on collecting delinquent payments, and through the three voluntary programs alone, it collected $6.5 billion from 45,000 participating taxpayers.

There are four types of international taxpayers that are of interest to the I.R.S.

• U.S. individual taxpayers and resident aliens working, living, or doing business abroad;
• U.S. corporations doing business abroad;
• Nonresident aliens working or doing business in the United States; and
• Foreign corporations doing business in the United States

Action Item 6: Attacking Treaty Shopping

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BACKGROUND

Action Item 6 addresses abuse of treaties, particularly focusing on treaty shopping as one of the most important sources of B.E.P.S. The approach adopted amends the O.E.C.D. Model Convention that borrows from the U.S.'s approach to treaties but expands upon it in a way that can be very helpful to the U.S. and other developed countries if adopted by the C.F.E. next year in their final report. Among other measures, the report recommends inclusion of a Limitation on Benefits (“L.O.B.”) provision and a general anti-avoidance rule called the Principal Purpose Test (“P.P.T.”) to be included in the O.E.C.D. Model Convention. While it is expected the report will be finalized next year, whether countries will adopt the recommendations is the crucial factor that is still unclear.

RECOMMENDATIONS

The key recommendations can be found in Paragraph 14. It contains two basic recommendations:

• Countries should agree to include in the tax treaties an express statement of the common intention to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance through use of treaties.
• Countries should demonstrate their commitment to this goal by adopting an L.O.B. provision and a P.P.T. provision in income tax treaties.

The report also notes that special rules may be needed to address application of these rules to collective investment funds (“C.I.F.’s”). The provision should be supplemented by a mechanism that would deal with conduit arrangements not currently dealt with in tax treaties.

Action Item 5: Countering Harmful Tax Practices More Effectively

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The Organization for Economic Co-operation and Development (“O.E.C.D.”) worked together with G20 countries to develop a 15-point action plan to deal with Base Erosion and Profit Shifting (“B.E.P.S.”). The goal of the B.E.P.S. Action Plan is to develop a single global standard for automatic exchange of information and stop corporations from shifting profits to jurisdictions with little or no tax in order to ensure taxation in the jurisdiction where profit-generating economic activities are performed and where value is created.

B.E.P.S. occurs in situations where different tax laws interact in a way that creates extremely low global tax rates or results in double non-taxation. This kind of planning gives a competitive advantage to multinational entities that have substantial budgets to engage high-powered tax advisers and to implement their plans.

The O.E.C.D. published deliverables that intend to eliminate double non-taxation resulting from B.E.P.S. The final measures will be completed in 2015 and will be implemented either through domestic law or the existing network of bilateral tax treaties.

ACTION ITEM 5: HARMFUL TAX PRACTICE

Harmful Tax Competition: An Emerging Global Issue

In 1998, the O.E.C.D. published the report Harmful Tax Competition: An Emerging Global Issue (“the 1998 Report”) with the intention of developing methods to prevent harmful tax practices with respect to geographically mobile activities. These methods have been adopted in the Forum on Harmful Tax Practice (“F.H.T.P.”) with some modifications. Significant attention is given to:

• Elaborating on a methodology to define a substantial activity requirement in the context of intangible regimes; and
• Improving transparency through compulsory spontaneous exchange on rulings related to preferential regimes.

Action Item 2: Neutralizing the Effects of Hybrid Mismatch Arrangements

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On the heels of the discussion drafts issued in March, the Organization for Economic Cooperation and Development (“O.E.C.D.”) released the initial components of its plan to fight base erosion and profit shifting (the “B.E.P.S. Action Plan”). Action Item 2 addresses the effects of hybrid mismatch arrangements and proposes plans to neutralize the tax deficits caused.

These responses aim to tackle the following issues created by the hybrid mismatch arrangements:

• Reduction in overall tax revenue,
• Unfair advantage given to multinational taxpayers with access to sophisticated tax-planning expertise, and
• Increased expense often incurred in setting up hybrid arrangements compared to domestic structures.

This article introduces the different hybrid arrangements, looks at the proposed changes in both domestic law and international tax treaties, and discusses the ripple effect this could have if implemented.

INTRODUCTION

A hybrid mismatch arrangement is one that exploits a difference in the way an entity or instrument is taxed under different jurisdictions to yield a mismatch in total tax liability incurred by the parties. The two possible mismatches that could result are either a “double deduction” (“DD”) or a deduction that is not offset in any jurisdiction by ordinary income (“D/NI”). These mismatches are brought about by the different interpretations afforded to the entities and transactions in relevantjurisdictions. The root cause of the hybrid mismatch is that an entity may be a “hybrid entity” and an instrument may be a “hybrid instrument.” Understanding the different hybrid arrangements is instrumental to understanding the plan proposed by the O.E.C.D.

Action Item 1: The O.E.C.D.'s Approach to the Tax Challenges of the Digital Economy

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The O.E.C.D.’s Action Plan adopted in Saint Petersburg in 2013 aims at tracking where economic activities generating taxable profits are performed and where value is created. It aims at ensuring that taxation follows the economic activities and the creation of value and not the other way around. Action Item 1 of the Action Plan (the “Action 1 Deliverable”) focuses on the tax challenges of the digital economy. Along with the 2014 Deliverable on Action 15 (Developing a Multilateral Instrument to Modify Bilateral Tax Treaties), the Action 1 Deliverable is a final report.

The Action 1 Deliverable published on September 16, 2014 mainly reiterates the March 2014 Public Discussion Draft on Action 1 (click here to access our article on the 2014 Public Discussion Draft). It restates that, while B.E.P.S. is exacerbated in the digital economy space, the digital economy cannot be ring-fenced from other sectors of the economy for B.E.P.S. purposes because the digital economy is an ever growing portion of the entire economy. The Action 1 Deliverable thus refers to other Actions to address common B.E.P.S. issues that are not specific to the digital economy. Action Item 1 also refers to the O.E.C.D.’s International V.A.T./G.S.T. Guidelines with regard to V.A.T. issues raised by the digital economy. Although the Action 1 Deliverable adds relatively little to the previously published Public Discussion Draft on Action Item 1, the benefit of a set of uniformly accepted rules should not be understated. With European countries struggling to raise tax revenue in order to close budget gaps, the risk of adverse unilateral action by one or more countries is real. During a symposium held in Rome at the beginning of the month, certain European countries, and especially Italy, pushed for unilateral action with regard to the taxation of the digital economy. If that action proceeds to enactment, digital tax chaos could be encountered.

Tax 101: Tax Planning and Compliance for Foreign Businesses with U.S. Activity

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I. INTRODUCTION

The U.S. tax laws affecting foreign businesses with activity in the U.S. contain some of the more complex provisions of the Internal Revenue Code. Examples include:

• Effectively connected income,
• Allocation of expenses to that income,
• Income tax treaties,
• Arm’s length transfer pricing rules,
• Permanent establishments under income tax treaties,
• Limitation on benefits provisions in income tax treaties that are designed to prevent “treaty shopping,”
• State tax apportionment,
• F.I.R.P.T.A. withholding tax for transactions categorized as real property transfers,
• Fixed and determinable annual and periodical income, and
• Interest on items of portfolio debt.

One can imagine that it is no easy task to identify income that is subject to tax, to identify the tax regime applicable to the income, and to quantify gross income, net income, and income subject to withholding tax. Nonetheless, the I.R.S. has identified withholding tax obligations of U.S. payers as a Tier I audit issue.

Tax 101: Outbound Acquisitions - Holding Company Structures

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When a U.S. company acquires foreign targets, the use of a holding company structure abroad may provide certain global tax benefits. The emphasis is on “global” because standard U.S. benefits such as deferral of income while funds remain offshore may not be available without further planning once a holding company derives dividends and capital gains. This article will discuss issues that should be considered when setting up a company overseas, particularly a foreign holding company, in order to maximize foreign tax credits despite the limitations under the U.S. tax rules, and to reduce the overall U.S. taxes paid. These issues include challenges to the substance of a holding company, recent trends in inversion transactions, the net investment income tax on investment income of U.S. individuals, and the significance of the O.E.C.D. Base Erosion and Profit Shifting report on tax planning structures.

U.S. TAXATION OF INTERCOMPANY DIVIDENDS AMONG FOREIGN SUBS

If we assume the income of each foreign target consists of manufacturing and sales activities that take place in a single foreign country, no U.S. tax will be imposed until the profits of the target are distributed in the form of a dividend or the shares of the target are sold. This is known as “deferral” of tax. Once dividends are distributed, U.S. tax may be due whether the profits are distributed directly to the U.S. parent company or to a holding company located in another foreign jurisdiction. Without advance planning to take advantage of the entity characterization rules known as “check-the-box,” the dividends paid by the manufacturing company will be taxable in the U.S. whether paid directly to the parent or paid to a holding company located in a third country. In the latter case, and assuming the holding company is a controlled foreign corporation (“C.F.C.”) for U.S. income tax purposes, the dividend income in the hands of the holding company will be viewed to be an item of Foreign Personal Holding Company Income, which generally will be taxed to the U.S. parent company, or any other person that is treated as a “U.S. Shareholder” under Subpart F of the Internal Revenue Code.

What Must Foreign Trusts and Family Corporations Do About F.A.T.C.A.?

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After years of preparation and trepidation, the Foreign Account Tax Compliance Act (“F.A.T.C.A.”) will soon become effective. While F.A.T.C.A. was initially targeted to major commercial and investment banks aiding U.S. persons in avoiding paying tax on their income, F.A.T.C.A.’s effective scope is far broader, covering any foreign trust or family corporation. Starting on July 1, 2014, F.A.T.C.A. can impose a new 30% U.S. withholding tax on payments of interest, dividends and other amounts from the U.S. to any foreign person unless that person complies with F.A.T.C.A. regulations. If the foreign person is a foreign financial institution (“F.F.I.”), compliance is onerous. However, with the recent revisions to the regulations and careful planning, the foreign trust or family corporation may be considered a nonfinancial foreign entity (“N.F.F.E.”) and thus subject to far less burdensome requirements.

F.A.T.C.A. divides the world of non-U.S. investors into two categories: F.F.I.’s and N.F.F.E.’s. The crucial factor for any foreign person is to first determine its classification. As F.F.I. status results in a much greater burden for an entity and the deadlines for actions are fast approaching, obtaining N.F.F.E. status holds numerous advantages. For a typical foreign trust or family corporation that holds investments for its beneficiaries or shareholders, this determination had been clouded in uncertainty, until the I.R.S.’s recent issuance of temporary F.A.T.C.A. regulations.

The O.E.C.D.'s Approach to B.E.P.S. Concerns Raised by the Digital Economy

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On March 24, 2014, ten days after the O.E.C.D. released its public discussion draft on prevention of treaty abuse, a second public discussion draft was released, addressing the tax challenges of the digital economy (the “Discussion Draft”).

The Discussion Draft emphasizes the concept that the digital economy should not be ring-fenced and separated from the rest of the economy, given its relationship to the latter. It provides a detailed introduction to the digital economy, including its history, components, operations, and different actors. Surprisingly, it does not propose any groundbreaking approaches to addressing the base erosion and profit shifting (“B.E.P.S.”) challenges encountered in the digital economy. It simply reflects an approach that is consistent with the fight against B.E.P.S. – seeking to determine where economic activity takes place in the digital economy in order to best achieve taxation in a non-abusive fashion.

The Discussion Draft singles out six factors that characterize the digital economy in light of B.E.P.S. concerns:

1. Mobility of all facets of the digital economy, including the intangibles used, the users themselves, and the business functions carried on by various players in the business model;
2. Reliance on data;
3. Network effects;
4. Use of multi-sided business models;
5. Tendency towards monopoly or oligopoly; and
6. Volatility

O.E.C.D. Discussion Drafts Issued Regarding B.E.P.S. Action 2 - Neutralizing the Effects of Hybrid Mismatch Arrangements

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INTRODUCTION

On March 19, 2014, the O.E.C.D. issued two discussion drafts proposing steps to neutralize abusive tax planning through hybrid mismatch arrangements. One report proposed changes in domestic law; the second proposed changes to the O.E.C.D. Model Tax Convention.

The discussion drafts reflect the O.E.C.D.’s attempt to bring “zero-sum game” concepts to global tax planning. In a zero-sum game, transactions between two or more parties must always equal zero (i.e., if one party to a transaction recognizes positive income of “X” and pays tax on that amount, the other party or parties generally must recognize negative income of the same amount, thereby reducing tax to the extent permitted under law). Seen from the viewpoint of the government, tax revenue is neither increased nor decreased on a macro basis if timing differences are disregarded.

If all transactions are conducted within one jurisdiction, the government is the ultimate decision maker as to the exceptions to the zero-sum analysis. For policy reasons, a government may decide to make an exception to a zero-sum game result by allowing the party reporting positive income to be taxed at preferential rates or not at all, while allowing the party reporting negative income to fully deduct its payment. But, when transactions cross borders and involve related parties, taxpayers have a say in what is taxed and what is not taxed.