Now is the time to prepare for significant potential changes in the international tax environment
The October 5, 2015, release of the Base Erosion and Profit Shifting (BEPS) package containing final reports on 15 identified focus areas represents a splendid culmination of the OECD’s work on the BEPS project. The final reports include recommendations for significant changes in key elements of the international tax architecture. To recall, the focus areas were built around the three main pillars of coherence, substance, and transparency and certainty.
The measures range from new minimum standards, through common approaches to guidance drawing on best practice for domestic tax laws. Though there is some follow-up work to be done, such as on profit to be allocated to permanent establishments and taxation of hybrids, consensus has been reached on many focus areas. Significantly, there are choices for governments to make, as some of the recommendations include alternative options. One such recommendation is on treaty abuse (Action 6).
Treaty shopping by letterboxes
Often, multinational enterprises (MNEs) try to interpose a sham or a conduit entity (a letterbox) in a tax favourable jurisdiction to avail favourable treaty benefits (treaty shopping). Treaty shopping is one of the major BEPS concerns as it violates bilateral character of treaties by enabling MNEs in a third country to avail treaty benefits.
The OECD and G20 countries including India have committed to address treaty shopping by agreeing to a minimum standard to provide a minimum level of protection against treaty shopping. Countries are expected to include in their treaties an express statement that the common intention is to eliminate double taxation without creating opportunities for treaty shopping, and either the combined approach of subjective principal purpose test (PPT) rule and objective limitation on benefits (LOB) rule; or PPT rule alone; or LOB rule supplemented by specific rules targeting conduit financing arrangements.
Where a country decides to use a combined approach, a variation of the LOB rule (simplified version) can be used.
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.
The rules on minimum standard would be part of the multilateral instrument (Action 15) that will implement the results of the BEPS project on treaty issues.
Anti-abuse provisions in India’s treaties
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’s treaties such as with the US and Armenia contain only the LOB rule, while certain others such as 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.
Some of India’s treaties that include the PPT rule also state that the treaty will not prevent application of domestic anti-abuse rules (for example, India’s treaties with Columbia, Fiji, Georgia, Luxembourg, Malaysia, Malta and Saudi Arabia). These treaties are likely to create concerns for taxpayers, since they may have to go through GAAR twice—first in the relevant treaty (under the PPT rule) and thereafter under the Indian domestic tax law. A clarification to the effect that, where the PPT rule in a treaty is met, domestic GAAR provisions will not be applied would be helpful to assuage fears of taxpayers against aggressive enforcement. Nonetheless, at present, India has deferred GAAR implementation until April 1, 2017.
The India-Mauritius treaty currently does not contain an LOB article, but there is news that an LOB article is in the pipeline. Well, this may now be achieved sooner than later, if both India and Mauritius were to sign the multilateral instrument with the minimum standard on treaty abuse included. Multilateral instrument would then prevail over the treaty. Both India and Mauritius are part of the 90 countries participating in the development of the multilateral instrument on an equal footing basis which is expected to be ready for signature by December 31, 2016.
Other BEPS issues dealt by OECD
Indian MNEs establishing companies in other jurisdictions should be aware that attractive tax incentives which are not compliant with ‘substance’ and transparency requirements (Action 5) may not survive for long.
The report on controlled foreign company (CFC) (Action 3) contains best global practices in designing CFC rules to prevent shifting of income by a parent to an overseas CFC or long-term deferral of taxation of income. If India were to introduce CFC rules in the near future, the report provides the necessary framework to draft the rules.
Interest deduction is another way for achieving BEPS, by shifting interest in high tax jurisdictions or by using interest expenses to fund tax exempt income. This is addressed (Action 4) by fixing interest deduction (including intra-group debt) to a fixed percent (between 10% and 30%) of profits.
While flexibility is a boon, dissimilarities in the options adoption may result in enhanced disputes. Though 20 countries have committed to adopt mandatory binding arbitration to resolve disputes, India is not one of them.
However, a minimum standard (Action 14) has been agreed to resolve disputes to be evaluated through a peer review monitoring mechanism.
In an accompanying explanatory statement, the OECD also discussed “post-BEPS environment”, emphasising on the implementation of BEPS recommendations in a consistent and coherent manner, monitoring the impact on both double non-taxation and double taxation. Further, BEPS work will continue until 2020 with an intent to develop “a more inclusive framework to support and monitor the implementation of the BEPS package.”
As focus now shifts to countries, they must determine whether, when and how to implement the various recommendations. Given that some countries have already taken unilateral action, taxpayers must evaluate the implications of the recommendations contained for their business models and operating structures, as also monitor legislative and tax administrative developments in the countries where they operate or are considering investing. Now is the time to be preparing for significant potential changes in the international tax environment.
Cynthia D’Almeida, senior tax professional, EY, contributed to the article
The author is national leader, International Tax Services, EY India. Views are personal