Base Erosion and Profit Shifting - BEPS
What Is Base Erosion and Profit Shifting (BEPS)?
Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and inconsistencies in tax rules to:
- Artificially shift profits to low or no-tax locations where there is little or no economic activity; or
- Erode tax bases through deductible payments such as interest or royalties.
Although some BEPS strategies are illegal, many operate within legal boundaries. Nevertheless, BEPS undermines the fairness and integrity of tax systems by giving multinational businesses an unfair advantage over domestic companies. Moreover, the perception that multinational corporations legally avoid income tax undermines and diminishes public confidence and discourages voluntary tax compliance.
According to the Organisation for Economic Co-operation and Development (OECD), while BEPS impacts all countries, it disproportionately harms developing countries. This is because developing countries depend more heavily on corporate income tax, particularly from multinational corporations, compared to developed nations. It is crucial to involve developing nations in the international tax dialogue, providing them with the support needed to address their specific challenges and actively participate in the establishment of global tax standards. This inclusive approach ensures that the interests of developing countries are represented, fostering a more balanced and effective global tax framework.
BEPS 15 Actions
In October 2015, the OECD/G20 BEPS Project introduced a 15-point Action Plan to combat tax avoidance, improve consistency in international tax rules, and increase transparency in global taxation. This initiative reflects a unified effort by the international community to address the challenges posed by base erosion and profit shifting, laying the groundwork for a fairer and more accountable tax system worldwide.
Action 1 (Addressing the Tax Challenges of the Digital Economy):
Action 1 of the BEPS Project addresses the tax challenges posed by the digital economy, which can exacerbate base erosion and profit shifting and make current tax rules obsolete. Action 1 targets three main areas: (i) corporate profits taxes, (ii) withholding taxes on income, in particular royalties, and (iii) the value-added tax (VAT).
Action 2 (Neutralizing the Effects of Hybrid Mismatch Arrangements):
Action 2 of the BEPS Project focuses on developing model treaty provisions and recommendations for domestic rules to counteract the impacts of hybrid mismatch arrangements. These arrangements, used in aggressive tax planning, exploit differences in the tax treatment of an entity or instrument across jurisdictions to achieve double non-taxation or long-term deferral of taxes.
Action 3 (Designing Effective Controlled Foreign Company Rules):
Action 3 of the BEPS Project outlines methods for attributing specific income categories of controlled foreign corporations (CFCs) to their shareholders. This aims to tackle offshore structures that shift income away from the shareholder’s home jurisdictions.
Action 4 (Limiting Base Erosion Involving Interest Deductions and Other Financial Payments):
BEPS Action 4 of the BEPS Project targets base erosion by regulating the use of interest expenses to obtain excessive interest deductions or to fund activities that generate income exempt or deferred from taxation.
Action 5 (Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance):
Action 5 of the BEPS Project focuses on enhancing the effectiveness of countermeasures against harmful tax practices, considering both transparency and substance. Since the BEPS Project began, the OECD Forum on Harmful Tax Practices (FHTP) has assessed preferential tax regimes to determine their potential to erode the tax bases of other jurisdictions.
Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances):
Action 6 of the BEPS Project tackles treaty shopping by promoting treaty provisions the adoption of which constitutes a minimum standard agreed upon by members of the OECD/G20 Inclusive Framework on BEPS.
The Inclusive Framework on BEPS, established in 2016, allows interested countries and jurisdictions, including developing economies, to participate equally in the development of BEPS-related standards while also overseeing the implementation of the OECD/G20 BEPS Project. The Inclusive Framework on BEPS has 147 members as of 28 May 2024.
Action 6 also includes regulations and recommendations to combat various forms of treaty abuse, highlighting key tax policy considerations that jurisdictions should evaluate before deciding to enter into tax agreements.
Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status):
Action 7 of the BEPS Project introduces amendments to the definition of permanent establishment in the OECD Model Tax Convention to counteract strategies designed to avoid having a taxable presence in a jurisdiction under tax treaties. These amendments aim to:
- Ensure that, if an intermediary regularly conducts activities in a jurisdiction to conclude contracts on behalf of a foreign enterprise, that foreign enterprise will be deemed to have a taxable presence in that jurisdiction, unless the intermediary operates independently;
- Restrict a number of exceptions to the permanent establishment definition solely to activities of a preparatory or auxiliary nature, thereby preventing businesses from exploiting these exceptions by fragmenting a cohesive operating structure into separate, smaller operations; and
- Tackle the misuse of the construction site exception by addressing cases where contracts are split between closely related enterprises to avoid triggering permanent establishment status.
To facilitate the implementation of these changes across the global treaty network, over 100 countries and jurisdictions collaborated in 2016 to negotiate and develop a Multilateral Instrument (the MLI) designed to update existing bilateral tax treaties.
Action 8 (Aligning Transfer Pricing Outcomes with Value Creation (Intangibles)):
Action 8 of the BEPS Project addresses the transfer pricing challenges related to transactions involving intangible assets. Given that intangibles are inherently mobile and often difficult to assess in terms of value, the misallocation of profits stemming from valuable intangibles has significantly contributed to base erosion and profit shifting.
Action 8 includes updating the OECD Transfer Pricing Guidelines to better align transfer pricing outcomes with the actual creation of value.
Action 9 (Aligning Transfer Pricing Outcomes with Value Creation (Risks and Capital)):
Action 9 of the BEPS Project examines the contractual distribution of risks and the resulting allocation of profits to these risks, which may not accurately reflect the actual activities conducted. Furthermore, Action 9 addresses the allocation of returns to funding provided by a capital-rich member of a multinational enterprise (MNE) group, where such returns fail to align with the activities undertaken by the funding company.
Action 9 involves revisions to the OECD Transfer Pricing Guidelines to ensure that transfer pricing outcomes are in line with value creation.
Action 10 (Aligning Transfer Pricing Outcomes with Value Creation (Global Value Chains and other High - Risk Transactions)):
Action 10 of the BEPS Project addresses other high-risk areas, including:
- The allocation of profits from controlled transactions that lack a valid commercial basis;
- The manipulation of transfer pricing methods to shift profits away from the most economically important activities of the MNE group; and
- The use of certain intra-group payments (such as management fees and head office expenses) to erode the tax base without proper alignment with value creation.
Action 10 involves updating the OECD Transfer Pricing Guidelines to ensure that transfer pricing outcomes align with value creation.
Action 11 (Measuring and Monitoring BEPS):
Action 11 of the BEPS Project establishes methodologies to collect and analyze data on the economic and fiscal impacts of tax avoidance behaviours. It also examines the effects of measures proposed under the BEPS Project.
Action 12 (Mandatory Disclosure Rules):
Action 12 of the BEPS Project offers a framework to help countries create a disclosure regime that meets their need for early detection of: (i) potentially aggressive or abusive tax planning schemes, and (ii) the promoters and users of these schemes. For countries choosing to implement mandatory disclosure rules, Actions 12 provides recommendations that offer flexibility to balance the country’s need for improved and timely information with the compliance burdens on taxpayers.
The Action 12 also provides specific recommendations for addressing international tax schemes and enhancing the effectiveness of information exchange and cooperation between tax administrations.
Action 13 (Transfer Pricing Documentation and Country-by-Country Reporting):
Action 13 of the BEPS Project provides a framework for MNEs to annually disclose pertinent information for each tax jurisdiction where they operate through the Country-by-Country (CbC) Report. To streamline the adoption of this CbC Reporting standard, the BEPS Action 13 offers a CbC Reporting Implementation Package.
This package consists of:
- Model legislation to require the ultimate parent entity of an MNE group to file the CbC report in its country of residence, with provisions for backup filing; and
- Three model Competent Authority Agreements that aim to expedite the exchange of CbC Reports and are based on the Multilateral Convention on Administrative Assistance in Tax Matters, bilateral tax treaties, and Tax Information Exchange Agreements (TIEAs), respectively.
Action 14 (Making Dispute Resolution Mechanisms More Effective):
Action 14 of the BEPS Project establishes a Minimum Standard with 21 elements and 12 best practices to assess a jurisdiction’s legal and administrative framework in four key areas:
- Preventing disputes;
- Availability and access to the mutual agreement procedure (MAP);
- Resolution of MAP cases; and
- Implementation of MAP agreements.
Action 15 (Developing a Multilateral Instrument to Modify Bilateral Tax Treaties):
Action 15 of the BEPS Project introduces the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (commonly known as the “Multilateral Instrument” or “BEPS MLI”). This convention allows governments to amend existing bilateral tax treaties in a coordinated and efficient manner. By using the BEPS MLI, countries can incorporate the tax treaty measures developed during the BEPS Project without the need for extensive, individual negotiations for each treaty.
BEPS Four Minimum Standards
Countries and jurisdictions that are members of the Inclusive Framework on BEPS have committed to implementing the four minimum standards outlined in the BEPS actions. The Inclusive Framework on BEPS regularly reviews the progress in implementing these standards.
The minimum standards are:
- Action 5 – Countering harmful tax practices more effectively, with focus on measures such as patent boxes, taking into account transparency and substance;
- Action 6 – Preventing treaty abuse, particularly by addressing arrangements that channel payments through pass-through countries with treaties to reduce withholding taxes on dividends and other passive payments;
- Action 13 – Implementing the CbC reporting that requires MNEs to disclose financial information for each tax jurisdiction; and
- Action 14 – Improving effectiveness of dispute resolution mechanisms to resolve tax disputes more efficiently.
Further Developments for Tax Burden in Digital Economy
The OECD’s Final Report, released in October 2015, did not propose specific standards or solutions for Action 1 of the BEPS Project (Tax Challenges Arising from Digitalisation). Since then, many jurisdictions have implemented unilateral measures to address international tax challenges in the digital economy, such as introducing digital services taxes (DSTs). In October 2021, the OECD and G20 announced that the Inclusive Framework on BEPS had reached an agreement in principle on a two-pillar solution proposed by the OECD to address these challenges.
Pillar 1 for Reallocation of Taxing Rights
Pillar 1 aims to achieve a fairer distribution of profits and taxing rights among jurisdictions with respect to the largest multinational corporations, including digital companies. Pillar 1, comprising Amount A and Amount B, proposes reallocating some taxing rights over multinationals from their residence jurisdictions to the market jurisdictions where the multinationals conduct business and generate profits. This reallocation applies even if the multinationals lack a physical presence (i.e. permanent establishment or PE) in those market jurisdictions.
Pillar 2 for Global Minimum Tax
Pillar 2 seeks to end the race to the bottom on corporate income tax rates by introducing a global minimum tax on profits of the largest multinational corporations. The global minimum tax would help jurisdictions protect their tax bases and ensure that multinational corporations pay a minimum level of tax on their profits.
Pillar 2 aims to achieve these goals by establishing a minimum corporate tax rate of 15% enforced through top-up taxes. These top-up taxes include a qualified domestic minimum top-up tax (QDMTT), an income inclusion rule (IIR), and an undertaxed profits rule (or undertaxed payments rule) (UTPR).
Comparison with Deferred Profit Sharing Plan
Despite the similarity in terminology, a profit sharing plan is unrelated to BEPS.
A profit sharing plan, also known as a deferred profit sharing plan, is a retirement plan that provides employees with a percentage of their employer’s profits based on company earnings. The employer’s contribution to a profit sharing plan is discretionary and may be made even in years without profits.
Profit sharing plans can take various forms:
- Cash plans, which allow employees to receive cash or stock on a regular basis;
- Deferred plans, which allow employees to receive compensation at a later date, usually at retirement; or
- A combination of both.