The end of the road for tax loopholes – The OECD’s new measures

3 December 2015

The OECD’s new measures to eliminate corporate tax avoidance are the most far-reaching changes to its taxation rules in decades. The organisation’s Pascal Saint-Amans, director at the Centre for Tax Policy and Administration, tells Chief Executive Officer how the package will enable governments to close the legal loopholes that corporations have exploited.

In October 2015, the OECD unveiled a 15-point plan to counter base erosion and profit shifting (BEPS). The proposals took more than two years to develop and are said to contain some of the most fundamental changes to tax rules in almost a century. They are intended to revolutionise the way that multinational companies pay corporation tax, and stamp out international tax avoidance.

The work to address BEPS, which was undertaken at the request of G20 leaders, began in earnest in July 2013 with the release of the BEPS Action Plan. The topic, however, had been on the OECD's radar for a while. With corporate tax avoidance scandals barely out of the headlines, it was becoming clear that the existing rules were no longer fit for purpose.

First drafted in 1928 in Article 9 of the OECD Model Tax Convention, the guidelines surrounding transfer pricing were developed for a very different business climate. In essence, they state that when goods and services are sold from one part of a corporation to another, the buyer and seller should keep another at "arm's length". This means treating each other as though they were separate entities, rather than belonging to the same enterprise.

The 'arm's length' principle theoretically ensures fair taxation. Because different countries levy different income taxes, a company might wish to lower its profits in highly taxed countries, and raise its profits in tax havens. This isn't likely to occur if transfer prices are set at a fair level - i.e., what the company would charge an independent buyer. However, if they are set unrealistically (with a view to the interconnectedness of the two entities), they can be used as a tool for BEPS.

Company benefits

Unfortunately, the 'arm's length' principle is somewhat vague and difficult to enforce. While the OECD has been working to ensure its correct interpretation, multinational companies have found loopholes to exploit. This leads to suspiciously low taxes paid by large corporates, with an influx of profits to tax havens.

As Pascal Saint-Amans, director for the Centre of Tax Policy and Administration at the OECD, explains, there has been a clear disconnect between companies' business activities and the location of their revenues.

"Since 1995, we've had a set of transfer pricing guidelines to precisely guide companies on the way they should be upholding the 'arm's length' principle," he says. "These rules were very primitive, to the extent that they did not really follow or reflect the reality of businesses - they facilitated purely contractual arrangements. For the past 20 or 30 years, there's been a growing gap between the globalisation of businesses and the rules, which had not kept pace with that globalisation."

Writing what we want on a piece of paper is easy, but if you really want to come up with rules that are binding that countries will implement, then you need to reach compromises.

The monetary implications are stark. The OECD estimates that every year, governments lose between $100 billion and $240 billion (or nearly a quarter of a trillion) in corporate income tax revenues, amounting to between 4% and 10% of the total.

This poses a particular problem in developing countries, in which corporation tax supplies a high proportion of total revenue.
According to the OECD, the profit rates reported by multinational enterprises (MNEs) in lower-tax countries are typically around twice as high as their overall profit rate. And when you compare MNEs with enterprises with domestic operations only, their effective tax rate is between 4% and 8.5% lower.

This suggests the problem is nothing short of endemic - MNEs are shifting profits around the world to take advantage of lower tax regimes through questionable, if legal, means.

The new BEPS package is designed to help governments close these loopholes. According to OECD secretary-general Angel Gurria, the measures included will "facilitate a better alignment of taxation with economic activity and value creation", and "render BEPS-inspired tax-planning structures ineffective".

"We have revised the existing rules, and we've also created a new set of standards and best practices to provide tax administrations and taxpayers with rules that will eliminate double non-taxation," explains Saint-Amans. "We needed to bridge the gaps between the sovereignties, so taxpayers would face a better-equipped tax administration and wouldn't be incentivised to plan in such a manner where you have this divorce between the location of the profits and the location of the activities. That is nonsense, but it was the outcome of the existing rules."

Clear guidance

The measures in question - which run to nearly 2,000 pages - provide far more detailed guidance than was previously available. They are structured around three pillars:

  • introducing coherence into the domestic rules that affect cross-border activities
  • reinforcing substance requirements in the existing international standards, to ensure alignment of taxation with the location of economic activity and value creation
  • improving transparency for businesses and governments.

These are broken down further into 15 actions that were agreed in 2013. Beginning with Action 1 (addressing the tax challenges of the digital economy) and moving all the way through to Action 15 (developing a multilateral instrument to modify bilateral tax treaties), the reports set out a series of recommendations, or building blocks, that governments can implement in their own way.

"We want to make sure that contracts accurately reflect the reality of businesses," explains Saint-Amans. "This means when you shift profits you also shift risks, and to shift risks you need to shift the people and the function to manage the risks - you can't just do it through a piece of paper. Transfer pricing should reflect the reality of the organisation of the business."

The BEPS measures include new minimum standards on country-by-country reporting (which will give tax administrations a global picture on the operations of MNEs), treaty shopping, curbing harmful tax practices, and effective mutual agreement procedures. They also revise the existing transfer pricing guidance.

Action points

"We created a new set of rules or best practices - for instance, with novel legislation to neutralise hybrid mismatch arrangements - which is a way to facilitate cooperation between countries," says Saint-Amans. "Action 11 provides indicators to help understand the dynamic of corporate income tax. Action 12 provides for model tax legislation on the disclosure regime. Together, these actions will change the paradigm of international taxation."

In November, the OECD took part in the annual G20 summit in Antalya, Turkey, where it delivered the BEPS measures to G20 leaders. Following this, the focus has shifted to designing and implementing a framework for putting the measures in place.

The time frame for implementation varies from action to action, but it will need to be coordinated between countries. After all, if some countries apply the rules before others, it won't make much sense for a MNE that operates across all of them.

"The countries have established minimum standards, particularly regarding treaty shopping, helpful tax practices, country-by-country reporting and mutual agreement procedures," says Saint-Amans. "Here, all the countries said they will implement together on the same time frame, and some of these actions are timed. Some have already started."

For other actions that currently have no minimum standards and hence no expected time frame, the difficulty has been holding countries back from implementing the new rules too fast. The OECD wants governments to wait for a package to be agreed before rushing in to act to prevent this kind of asynchrony.

The one exception is transfer pricing, for which the rules may be put into action straight away. Due to being classed as an authorised interpretation of existing treaties, judges can apply the new BEPS actions directly to court cases happening today.

If governments that are desperately seeking their missing tax revenues have been swift to jump at these measures, large corporates may be somewhat more reluctant to embrace them. That said, the OECD has worked hard to ensure their voices have been heard along the way.

"Large corporates are deeply involved in this work, and they have a clear overview of what's going on," says Saint-Amans.

"They have been able to comment, and a significant chunk of those comments were taken into account when developing the final product. On the way forward, we will create an inclusive framework for the implementation of the best measures for the member states, and keep the consultative processes we have, which, of course, includes businesses."

Some within the business community have pointed to a risk of increased double taxation, which Saint-Amans concedes may be a teething problem while the measures are implemented. However, he says this is not related to BEPS itself but to the new business environment, in which emerging economies play a greater role. The plan contains provisions designed to counter this problem.

As for the tax campaigners who, conversely, have suggested that the measures don't go far enough, Saint-Amans has a clear response.

Creating rules

"Writing what we want on a piece of paper is easy to do, but when you really want to come up with rules that are binding that countries will implement, then you need to reach compromises," he says.

"What we've done is change the paradigm. I think the real test is whether the CEO will be able to understand the tax planning of the company, and I think the answer will be 'yes'."

If that is the case, it will indeed be a significant, positive change for MNEs. For some years now, tax has been regarded as a highly technical and specialist activity - the remit of tax experts who navigated its intricacies with care.

The rules were simply too opaque to make much sense to anyone else. Under the new BEPS measures, the CEO should be able to take a clear overview of how their corporation's tax is structured.

For the time being, the OECD is taking the first steps on the long and winding road towards implementation. This will mean monitoring how countries behave, and how its measures translate into domestic legislation, adapting it to the needs of developing countries as necessary. Ultimately, It hopes to eliminate double non-taxation and double taxation alike, through taking a fair and balanced approach.

"Some people don't like it because they loved double non-taxation, and I have to tell them, sorry guys but that's over," concludes Saint-Amans.

"What we expect is that the taxpayers, given the rules, will plan in a way that's not aggressive, so we expect things to go back to what I would call 'normal'."

Pascal Saint-Amans took on his duties as director of the Centre for Tax Policy and Administration (CTPA) at the OECD in February 2012 having joined the organisation in 2007 as head of the international cooperation and tax competition division of the CTPA.