Organisation for Economic Co-Operation and Development (OECD) Issues Final Report On Action Item 5: Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance
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The Organisation for Economic Cooperation and Development (OECD), a non-governmental forum established to promote economic growth, has developed a 15-point action plan to shape “fair, effective and efficient tax systems.” The OECD’s project regarding Base Erosion and Profit Shifting (BEPS) has addressed issues arising from tax planning strategies that exploit gaps or mismatches in member countries’ tax rules.
This alert is one installment in a series of alerts on the release of the OECD/G20 Base Erosion and Profit Shifting Project (the BEPS Project).
On October 5, 2015, the OECD released the final report (the “Report”) of the BEPS Project. This alert discusses Action Item 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance.
Background and Details
In an effort to address BEPS issues in a coordinated and comprehensive manner, the G20 finance ministers called upon the OECD to develop an action plan to equip countries with instruments that will better align tax with economic activity. Action Item 5 aims to “revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings relating to preferential regimes, and on requiring substantial activity for any preferential regime.” In 1998, the OECD published its report “Harmful Tax Competition: An Emerging Global Issue,” which set out to discuss the area of harmful tax practices that unfairly erode the tax bases of other countries. The report targeted geographically mobile activities, such as financial, intangibles and other services, which can easily move from one country to another and benefit from favorable tax regimes. These “preferential regimes” continue to be a cause for concern and, therefore, have been identified as an area for further work in the Report.
The OECD’s Report is outlined under three subheadings or pillars: coherence, substance and transparency. Under the second pillar, which is to align taxation with the real substance of transactions, Action Item 5 focuses on the need for there to be a stronger definition of substantial activity in order for companies to benefit from a preferential tax regime. The substantial activity requirement as defined within the Report, is in the context of Intellectual Property (IP) regimes, and is later applied to other non-IP regimes. Specifically, the need for an appropriate approach to address the situation of artificially moving IP away from where value is created and as such, the “nexus approach” was developed. This approach uses expenditures to determine where substantial activity takes place and provides that a taxpayer can benefit from a favorable tax regime only to the extent to which a taxpayer has itself incurred the qualifying research and development expenditures which gives rise to IP income.
As a result of the new requirements, countries with existing favorable tax regimes will now undertake a review of their current rules and determine whether any amendments are necessary in order for their regime to comply with the nexus approach and therefore strengthen the importance of substantial activity. This process will see OECD countries follow the same framework for operating preferential regimes, thereby encouraging an environment in which free and fair tax competition can take place.
In addition to the substantial activity and nexus approach, Action Item 5 identifies the need for increased transparency in tax rulings relating to preferential regimes. Therefore, a framework covering rulings that could give rise to BEPS concerns has been agreed to and a mandatory exchange of information under this framework will take place beginning April 1, 2016.
Action Item 5 will have a significant impact on existing IP regimes in OECD countries. Tax authorities will need to review their existing IP regimes in the context of Action Item 5 and may make changes to allow companies to benefit based on the new definition of substantial activity using the nexus approach. Companies with large amounts of IP which currently participate in preferential tax regimes will need to monitor developments in these regimes to ensure that they are still able to claim the benefits. Transparency in tax rulings may require multinationals to change their legal and tax structures as well as the form and format of transactions.
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