What is BEPS?
- BEPS refers to the erosion of a country’s tax base because of the shifting of profits by multinational companies to other regimes with low or zero tax rates.
- So, even though a company may do the bulk of its business in a high-tax country such as the US, it camouflages its profits as emanating from some low- or no-tax country, in order to bring down its tax liability.
- It transfers the profits through sophisticated tax planning strategies to a ‘letter-box company’ (with just a mailing address and no real business activity) set up in low tax regimes such as Luxembourg, Cayman Islands, Macao or Monaco for this purpose.
- As a result, the country which is the actual centre of economic activity is wrongfully deprived of tax revenues.
So how do companies shift profits?
Here’s one illustration. Take a US-based tech company that despite carrying out all product development and making the most of its sales in the US, pays hardly any tax in the country. How does it achieve that?
- The company transfers the intellectual property rights that it holds over its products to its letter-box subsidiary.
- It then pays royalty to the subsidiary at an arbitrarily high rate to bump up its expenses and reduce its profits in the US, thereby shrinking its tax outgo.
- At the same time, the subsidiary escapes taxation on income (royalty) earned by it as it is based out of a tax haven.
- But do note, though unfair, BEPS is not illegal. When companies engage in BEPS, they legally avoid taxes simply by taking advantage of the exemptions in a country’s tax regulations.
- What also works in their favour are the wide variations in tax regimes across countries, leaving ample scope for arbitraging taxes.
Why is it important?
- With governments deprived of tax revenues, BEPS has attracted the ire of tax authorities and taxpayers the world over.
- BEPS is estimated to cause an annual revenue loss of $100-240 billion, which amounts to 4-10 per cent of global corporate income tax revenues.
- This in turn means a higher burden on other taxpayers and less funds in the government coffers for funding welfare and essential infrastructure.
- BEPS is also discriminatory. Tax savings from BEPS give multinational companies an edge over domestic companies, who may lack the wherewithal to employ such strategies.
Ok, then what is TREATY SHOPPING ?
- “Treaty shopping” generally refers to a situation where a person, who is resident in one country (say the “home” country) and who earns income or capital gains from another country (say the “source” country), is able to benefit from a tax treaty between the source country and yet another country (say the “third” country).
- This situation often arises where a person is resident in the home country but the home country does not have a tax treaty with the source country.
For example, a corporation (“CayCo”) resident in the Cayman Islands (the home country) may own a corporation (“USCo”) in the U.S. (the source country). Dividends paid from USCo to CayCo would be subject to a 30% U.S. withholding tax. If CayCo were to form a corporation (“UKCo”) in the U.K. (the third country) and transfer the stock of USCo to UKCo, dividends would be paid from USCo to UKCo and, without anti-treaty shopping rules, these dividends would qualify for benefits under the U.S.-U.K. Income Tax Treaty.
If this approach were successful, the dividend withholding tax of 30% on dividends paid by USCo could be reduced to zero. In addition, because the U.K. does not impose any withholding taxes on dividends paid to non-U.K. residents, the overall tax rate of the group may decrease.
So why is it in news ..and why should it concern for we UPSC guys ?
- In 2013, Group of 20 (G20) countries requested the Organisation for Economic Cooperation and Development (OECD) to formulate measures to address concerns on international tax avoidance by multinational companies and reform the interantional tax system.
- Since then, OECD has outlined 15 focus areas to tackle so-called Base Erosion and Profit Shifting (BEPS), released 23 discussion drafts, and had several intense rounds of public consultations.
- The BEPS initiative was the result of the perception that some multinational corporations resort to opaque structures to achieve a low taxable income and park their profits in low-tax jurisdictions.
What is India's stand ?
- India, a member of the G20, has always maintained it has been at the receiving end of BEPS, and was an active participant to this initiative.
- From an Indian perspective, while some of the measures suggested by OECD may not be relevant in the near future, others are significant.
- These include the
1. taxation of the digital economy (Action 1);
2. treaty shopping and abuse (Action 6);
3. avoidance of permanent establishments (Action 7);
4. transfer pricing rules in the key area of intangibles (Action 8);
5. transfer pricing documentation and country-by-country reporting (Action 13);
6. agreement to implement BEPS action steps through a multilateral instrument (Action 15).
What OECD has suggested as far as dealing with Treaty shopping is concerned ?
OECD has suggested three approaches to eliminate treaty shopping:
(i) To incorporate a clear statement in the title and preamble of the tax treaties that tax treaties do not intend to create opportunities for treaty shopping;
(ii) Limitation-on-Benefits (LOB) rule—largely similar to the rule existing in tax treaties entered by the US;
(iii) A more general anti-abuse rule based on principle purposes of transactions or arrangements (PPT test).
(we dont need to go into details as to what this LOB test and PPT test are unless Ecnomics is our optional ! However a rough idea.)
- The LOB rule is based on treaty eligibility rules found in US treaties. This is also present as Article 24 of the India-US treaty. As the US Model Convention is presently undergoing a change, follow-up work is expected in 2016.
- The PPT rule is similar to the “main purpose” test found in UK treaties, which is a treaty general anti-abuse rule (GAAR). This rule is included in the India-UK treaty in 2012.
An LOB article containing anti-abuse provisions appears to be the norm in India’s treaties rather than exception.
- Even existing treaties are amended to include an LOB article; for example, India’s treaty with Israel.
- Presently, close to 40 of India’s treaties contain an LOB article.
- India has a LOB test in its tax treaty with the US and Singapore.
- It has been attempting to incorporate an LOB clause in its treaty with Mauritius, which exempts capital gains earned by its residents. Given the current draft of LOB test, large number of multinational companies investing through group holding structures incorporated in a low tax jurisdiction may fail this test.
- India’s treaties with Mexico, Iceland, Tajikistan, Tanzania, Sri Lanka, Albania, Uruguay and Romania contain a combination of the main purpose test (comparable to the PPT rule) along with US-styled LOB rule.
- India’s treaties with countries such as the UK, Finland, Syria, the UAE, Norway and Kuwait contain only the PPT rule.
- The India-Switzerland treaty has a specific provision to deny treaty benefits on conduit arrangements.
How must India react this is BEPS initiative ?
The development of such an instrument is aimed to be completed by December 2016. India’s approach on each of the action steps will need to be closely observed as it could have an overarching and long-lasting impact on basic principles and interpretation of international taxation and transfer pricing laws in the country.
So now what is the issue for BEPS to move forward ?
- BEPS cannot be brought into effect until multilateral agreements between nations get executed.
Moral of the Story?
- · The BEPS project is extremely relevant for India, especially the action plans dealing with treaty abuse, permanent establishment, intangibles, digital economy and transfer pricing country-by-country reporting.
- · Several Indian companies feel that BEPS initiatives should be rolled out in a way that it is applicable prospectively and not retrospectively.
- · Moreover, it should not adversely impact Indian headquartered multinationals adversely and allows them a level playing field while competing with foreign multinationals.
- · While incorporating various BEPS changes in the Budget, finance minister Arun Jaitley will also do well to ensure the taxman has as much exposure as possible to international best practices in taxation procedures/policy.