The buzz word around the international tax community is ‘BEPS’, the acronym for the ‘Base Erosion and Profit Shifting’ project. BEPS is an initiative of the OECD launched at the request of G20 Finance Ministers. At first glance it appears to be a new initiative to create a level playing field and prevent taxpayers benefiting from aggressive tax planning structures. So confident does the OECD consider the acceptability of its proposed ideas on BEPS that it has given the participating States only two years to agree on all of the issues. To put this into perspective, the European Union issued its Proposed Directive on the Harmonisation of Taxes within the European Union in 1975 with very detailed Articles, and we are still waiting for harmonisation!
Before looking at the detailed provisions recommended by the OECD, it is interesting to understand the politics behind this initiative. Could it be that countries are concerned that the US is turning a blind eye to the tax planning adopted by US multinationals such as Apple? Its effective tax rate on non-US sales is 1.8%, enabling huge amounts of cash to be available in its offshore subsidiaries for acquisition of assets such as the rights to Nokia’s patents recently acquired for $600mn? Clearly the use of virtually pre-tax profits for asset acquisitions is a major advantage over competitors outside the US who have to use post-tax profits for such acquisitions. The benefits to companies such as Apple, Starbucks, Google and Amazon appear to have the tacit approval of the US government which allows its ‘check the box rules’ to be applied at the taxpayers’ discretion to blunt the US’ Sub-Part F rules on accumulation of untaxed profits outside of the US — an equivalent of UK’s CFC rules. Is this why the US have not been so keen on implementing the Action Plan envisaged by the BEPS project, whilst Germany and the UK are gold sponsors of the initiative? Yes, the OECD has had to obtain sponsorship to cover the costs of its initiative! And through that sponsorship, the UK is able to address the issues raised by Margaret Hodge and the Daily Mail and gives the UK a much larger role in shaping international tax policy.
There are certainly some valid issues within the BEPS initiative, probably the principal one being the impact that the digital economy has had on established concepts such as the permanent establishment concept and its constituent parts: the need for a fixed place of business and what constitutes auxiliary activities in today’s world. However, if the OECD really wants to address inequalities in the way multi-nationals are taxed, why are they limiting their initiative to corporate tax which forms only a small part of the total tax revenue of any developed State? In the UK, corporate tax has never exceeded 10% of total tax revenue and is currently approximately 6%, whilst by far the greater revenue raiser is VAT, a tax which must very clearly be relevant in today’s digital age. Ideally, VAT should be levied at the point of delivery, basically where the customer is based. Although this may be possible when delivering products to customers who have acquired them over the Internet, the downloading of items and the acquisition of digital services has proved to be a much more ‘knotty’ problem Indeed, would the UK’s City of London benefit from making its digitally received financial services more expensive to the consumer?
So in my view, the BEPS initiative, whilst of interest, does not address the inequality of revenue raising amongst the OECD’s Member States and other participating countries, and of course the provisions are not intended to apply to less developed nations, who may be seriously disadvantaged by some of the provisions. It appears that political issues may be driving the BEPS initiative, which of course is not overly surprising.
The digital economy has indeed raised issues relating to many forms of taxation, and in respect of corporate tax the concept of the permanent establishment is perhaps the most pressing issue. For example, keeping a warehouse in order to store goods in a country without conducting actual trade has traditionally been outside the scope of the permanent establishment. Yet if a warehouse is highly integrated within a business such as Amazon in order to process and deliver products within a certain time frame, this is no longer simply a storage facility but a functioning part of the enterprise. Amazon’s business is indeed to deliver parcels yet it is contended that most of the global profits of Amazon in relation to its UK business are outside of the UK tax net. But the UK does have legislation to counter such practices - it is called transfer pricing and the question is whether Amazon UK is paid commensurably for the function it undertakes, which is not merely to store goods but is a complex goods sorting and delivery activity. The transfer pricing adjustments should be able to establish an arm’s length price for the costs charged by Amazon UK to its related companies outside of the UK. This concept applies to Starbucks and other companies where products are delivered to the end user.
Certainly, the warehouse exemption under Article 5(4)(a) of the Model Tax Convention needs to be revisited. The exemption may have been applicable when it related to the simple storage of goods, but this may not be the case nowadays. However, it should be recognised that opening up the definition of what constitutes a permanent establishment in different countries could result in significant additional reporting requirements and resultant tax liabilities which may discourage global trade. Indeed, it may even create tax assessments covering prior years where companies did not believe they had such liability. The effect on global economic recovery by requiring the BEPS initiative to be implemented within two years could be very serious indeed. In any event, it will be legally necessary to amend the provisions of the relevant double tax treaties between two countries, and this is clearly a procedure that will take much longer than two years.
In respect of the provision of services over the Internet, there are many different opinions as to what may create a permanent establishment in a particular country. For example, in India the provision of services for more than six months may create an Indian tax liability even if the services are delivered virtually; there is no personnel in India, no fixed place of business and therefore seemingly no permanent establishment. Knowing how aggressive India is on raising corporate tax assessments (possibly because of its inability to impose effective VAT) it may well be that services supplied electronically to Indian customers will create a services PE and be subject to Indian taxation.
And it is not only the provision of a particular service that adds to the value of a global service provider such as Google. Its advertising revenue, for example, is derived from analysing its customers’ browsing patterns – they are feeding important information such as their purchase habits, and this becomes very valuable to advertising companies and therefore the value of Google. The French tax authorities have recognised this and are now intending to impose tax on Google on the basis of having a services permanent establishment in France.
There are also some bizarre findings coming from the OECD in the shape of its Intangibles Report which primarily focuses on patents. It basically disregards the ownership condition stating that income derived from licensing intellectual property rights should be attributed to those entities who developed the rights rather than who currently has the legal ownership to such rights. For example, if rights are created and subsequently transferred within a group to say a Liechtenstein entity, it is not the Liechtenstein entity that should receive the relevant income and pay tax on it, but the group entities that have contributed to the development process. Whilst this is clearly understandable, one cannot dispute that income derived from licensing must legally be taxable on the entity which owns the intellectual property rights, be it patents, copyrights or any other intellectual property rights. What tax authorities need to investigate is whether other group entities who have contributed to the development process have been adequately remunerated for their services, or if a transfer of rights has been made within a group, whether that transfer has been made at the appropriate price and tax paid accordingly. Indeed, US tax policy has the ability to look back at who has created the intangibles and assess such entities on what they refer to as a ‘super royalties’ basis if the rights have been transferred to an entity outside of the US.
In other words, in connection with this aspect of taxation of intellectual property rights, or indeed the provision of services and the idea that one could create a services permanent establishment, countries do not need to follow the BEPS recommendations but can rely on their own existing transfer pricing legislation. All of these issues could be dealt with by requiring companies within a multi-national group to submit a transfer pricing memorandum signed off by its auditors demonstrating the activities conducted by each group company, explaining the functional analysis of these activities, why profits have been allocated to each country in the way that they have been, and thereby justify the taxable profits that are being reported to the relevant local tax administration.
In the US, the unitary tax system is a system which attempts to create a level playing field within the States of the US whereby US profits are allocated to the relevant Member States through a weighted method according to assets in that particular State, personnel in that State (payroll) and sales in that State. The weighted average of these three elements is then calculated against the global US profits, and a comparison made with the profit reported by the US company in a particular State under normal accounting principles. A transfer pricing adjustment is then made by each State according to the unitary system. At one stage, the US adopted this approach globally, but had to restrict it to a ‘water’s edge’ approach in the light of the inability to have other countries outside of the US adopt a similar approach.
The transfer pricing approach that I am suggesting would address in part some of the issues raised by BEPS, but again it is only in the corporate tax area. The VAT approach is a much more complex one and in my opinion should be considered at the same time as considering the corporate tax inequalities derived from aggressive tax planning.