BEPS Action 5: Countering harmful tax practice more effectively

Action 5 of the Base Erosion and Profit Shifting (BEPS) Project of the Organisation for Economic Co-operation and Development (OECD) addresses issues relating to and/or arising from the enhanced mobility of income to gain tax advantages. Action 5 recommends a “nexus approach” to prove substantial activity for preferential intangible property (IP) regimes. The nexus approach ties up income with the qualifying expenditures in the development of the IP asset. This approach allows a taxpayer to benefit from the IP regime only to the extent that the taxpayer itself incurred qualifying research and development (R&D) expenditures that gave rise to the IP income. The goal in limiting qualifying expenditures is to prevent mere capital contribution or expenditures from qualifying the income for benefits under the IP regimes. For example, if the IP asset was merely acquired through purchase, only the expenditures incurred for improving the IP asset after it was acquired would be treated as qualifying expenditures, and the acquisition cost is excluded.
The application of the nexus approach is not, however, limited to IP regimes. The principle underlying the substantial activity requirement in IP regimes can also be applied to other preferential regimes in that it looks to the entity undertaking the core income generating activities required to produce the type of business income covered by the preferential regime. This may be applied in the context of preferential tax rates on the income received by headquarters engaged in the management and coordination of business activities for group members within a specific region given its ring-fencing concerns. The nexus approach is also suggested in the distribution and service center, financing or leasing, fund management, banking and insurance, shipping, and holding company regimes.
In addition to the nexus approach and the substance requirement as pillars to counter tax harmful practices, Action 5 also stressed the need for the compulsory and spontaneous exchange of information between jurisdictions to improve transparency. The risk of preferential regimes being used for artificial profit shifting was partly attributed to lack of transparency. The information to be exchanged, however, is not limited to rulings on preferential regimes but also covers unilateral advance pricing agreements (APAs) or other cross-border unilateral rulings with respect to transfer pricing, cross-border rulings providing for a downward adjustment of taxable profits, permanent establishment rulings, related party conduit rulings, and any other type of ruling that, in the absence of a spontaneous information exchange, gives rise to BEPS concerns. This covers both past and future rulings. In fact, it was agreed that information on rulings issued as early as Jan. 1, 2010 and were still in effect must be exchanged.
The OECD reports that the exchange of information must take place with the countries of residence of all related parties with which the taxpayer enters into a transaction for which a ruling is granted, or which gives rise to income from related parties benefiting from a preferential treatment, and the residence country of the ultimate parent company and the immediate parent company. The country with the obligation to spontaneously exchange information must exchange it with the affected country no later than three months after the date on which the ruling becomes available to the competent authority that granted the ruling, unless delayed by a legal impediment such as an appeal filed by the taxpayer against the exchange of information.
Nevertheless, the OECD emphasized that the benefits of a compulsory spontaneous exchange of information will be achieved only if both jurisdictions have a legal system in place allowing the exchange. Clearly, the benefits of reciprocity do not appear to have any relevance where the legal system or administrative practice of only one country provides for a specific procedure. Accordingly, a country that has granted a ruling that is subject to the obligation to spontaneously exchange information cannot invoke the lack of reciprocity as an argument for not spontaneously exchanging information with an affected country, where the affected country does not grant, and therefore cannot exchange rulings which are subject to the obligation to spontaneously exchange information.
Although consensus has been reached on the substance requirement approach and the framework for compulsory spontaneous exchange of information has been made, the OECD recognizes that there is still much to be done to counter harmful tax practices. The OECD acknowledges the need to develop strategies to expand participation in third countries. Otherwise, harmful tax practices would be simply shifted or displaced to non-OECD member countries.