Foreword The tax world is in a state of flux – certainly the BEPS project has seen to that. The former certainties are no longer sure, and questions abound everywhere. It is against this backdrop that this book was conceived. Its aim is a simple one – to clarify the finer and wider points of the BEPS story, casting this narrative against a thorough analysis of
relevant anti-avoidance rules. This book does two things. First, in picking up the key themes of the BEPS project, it provides a solid critique of the main proposals set out by the OECD. Each chapter draws its authority from in-depth research carried out by its author, not only into the OECD proposals, but also into existing domestic and international tax measures. This approach provides the reader with a clear view on how the BEPS proposals would, or could, work in practice. Second, this book is invaluable for the excellent analysis that it provides on the main anti-avoidance rules currently in force, whether set out in domestic law, or under tax treaties. How these would interact with the BEPS proposals, and where the challenges remain – those are the key themes of this timely publication. This book is written entirely by a team of researchers at IBFD. Drawing upon their own specialist expertise, each author has brought to this book a contribution of ideas, research, and rich experience. Such research activities enrich us in our daily work. It is our expectation that our readers are similarly enriched. Belema R. Obuoforibo CTA ATT (Fellow) Director, IBFD Knowledge Centre
General Acknowledgements The editorial team would like to thank the authors for their tremendous efforts in drafting the chapters of this book. Special thanks go to the research staff of the IBFD Knowledge Centre for the provision of valuable input in the initial research phase, to the IBFD Library and Information Centre for their constant support of the research, to the IBFD Production Coordination Department for their work and efforts to ensure the timely release of this book.
Introduction Tax planning structures used by some MNEs (where it is considered that low or no tax is paid in comparison with small-sized enterprises and individuals), have become the bane of policymakers nowadays, at OECD level as well as at EU level. This is due to the fact that recent statistics revealed that the public budgets were deprived of billions of euros. The OECD and G20 members initiated the BEPS Action Plan based on the idea that “BEPS is a global problem which requires global solutions”. 1 The objectives of the BEPS Action Plan are to release reports which “will give countries the tools they need to ensure that profits are taxed where economic activities generating the profits are performed and where value is created, while at the same time give business greater certainty by reducing disputes over the application of international tax rules, and standardising requirements”. 2 At EU level, the European Commission is working on a Tax Transparency Package where the key element is “to introduce the automatic exchange of information between EU Member States on their tax rulings”. 3 The next step is to launch an Action Plan on Corporate Taxation to “focus on measures to make corporate taxation fairer and more efficient within the Single Market, including a re-launch of the Common Consolidated Corporate Tax Base (CCCTB) and ideas for integrating the work of OECD and G20 members to combat BEPS at EU level”. 4 Within the context of these developments, this book examines the anti-abuse measures that already exist in different countries and scrutinizes how effective these measures are in countering abusive tax structures. This book can be considered complementary to the reports issued, or to be issued, by the OECD as it provides practical information on what happens in various countries that encounter abusive tax structures and evaluates the effectiveness of anti-abuse measures. It also discusses the measures proposed by the OECD until 1 May 2015, with some exceptions. Part One provides the reader with a global overview of the most common strategies against tax avoidance by trying to find clear answers to what tax avoidance is and what the conditions are that facilitate and encourage tax avoidance (see chapter 1). The authors agree that, although taxpayers are free to organize their affairs as they consider fit within the law, they should nevertheless pay their “fair share of tax”. Unfortunately, the principle of “fair share of tax” is not defined and policymakers and taxpayers frequently meet challenges, not least due to uncertainty. Part Two focuses on key concepts in international tax structuring, such as the use of PEs (see chapter 2) and the exploitation of transfer pricing rules (see chapter 3) in the current tax arena. Much attention is paid to the problems arising from the narrow scope of the definition of the permanent establishment. However, the authors emphasize that no concrete proposals have yet been put forward as regards the profit allocation to such a PE and recommend that it would be better to consider some form of quantitative profit threshold for deeming the presence of a PE. Furthermore, the arm’s length principle is vital in the quest for more transparency, as intra-group transactions will be increasingly scrutinized by the tax authorities. However, at this stage, there is no clear guidance on how taxpayers and tax authorities will benefit from the new reporting rules. The third part of the book focuses on tax structuring used for financing activities. The authors
analyse the state of practice and recent developments in various countries related to intra-group debt financing (see chapter 4), as well as transactions involving hybrid instruments (see chapter 5) and hybrid entity mismatches (see chapter 6). The final four chapters analyse the most common tax structures related to selected business models, specifically related to supply chain management (see chapter 7), IP migration and exploitation (see chapter 8), the digital economy (see chapter 9), and holding companies (see chapter 10). This book highlights the intricacies of the anti-abuse measures that the countries apply in countering abusive tax structures, which are expected to be relevant for EU and OECD work. Similarly, the book highlights the challenges implicit in the recommended measures in the draft reports issued by the OECD until 1 May 2015, with some exceptions. We hope this book will stimulate further discussion and be of use to practitioners, students and policymakers. Madalina Cotrut Managing Editor 1 May 2015
1. About BEPS, available at: http://www.oecd.org/tax/beps-about.htm. 2. Id. 3. European Commission – Press Release, Brussels 18 March 2015, available at: http://europa.eu/rapid/press-release_IP-15-4610_en.htm. 4. Id.
Abbreviations and Acronyms BEPS BEPS Action Plan CFC ECJ EC EEA EU GAAR G20
IP MNE PE OECD OECD Model SAAR TFEU UN Model VAT
Base erosion and profit shifting OECD and G20 Action Plan on Base Erosion and Profit Shifting Controlled foreign company Court of Justice of the European Union European Community European Economic Area European Union General anti-avoidance rule /general anti-abuse rule Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States and the EU Intellectual property Multinational enterprise Permanent establishment Organisation for Economic Co-operation and Development OECD Model Tax Convention on Income and on Capital Specific anti-avoidance rule/specific anti-abuse rule Treaty on the Functioning of the European Union (formerly EC Treaty) United Nations Model Convention on Income and Capital Value added tax
Table of Contents
Foreword General Acknowledgements Introduction Abbreviations and Acronyms Part One Recent Developments in International Tax Structuring Chapter 1: 1.1. 1.2. 1.2.1. 184.108.40.206. 220.127.116.11. 18.104.22.168. 1.2.2. 1.3. 1.3.1. 22.214.171.124. 126.96.36.199.1. 188.8.131.52.2. 184.108.40.206.3. 220.127.116.11.4. 18.104.22.168. 22.214.171.124.1. 126.96.36.199.2. 188.8.131.52. 184.108.40.206.1. 220.127.116.11.2. 1.3.2. 18.104.22.168. 22.214.171.124. 126.96.36.199.
Common Strategies against Tax Avoidance: A Global Overview Lydia G. Ogazón Juárez and Ridha Hamzaoui Introduction Tax avoidance: General Scope of the term Tax avoidance versus tax evasion Tax avoidance versus tax planning The role of policymakers in defining clear boundaries Conditions facilitating tax avoidance Tax planning schemes: Domestic law and treaty provisions Domestic law rules Regimes allowing for exemption of foreign-source income Patent box regimes Participation exemption regimes Holding company regimes Territorial tax systems Regimes allowing the use of mismatches between tax rules in different countries US check-the-box regime Use of hybrid financial instruments and entities Provisions relating to residence Dual resident companies and stateless companies Tie-breaker rule for companies Tax treaty rules Tax sparing clauses Modification of treaty classification of income Circumvention of thresholds found in treaty provisions
Countering aggressive tax planning Domestic legislation: General anti-avoidance rules General anti-avoidance rules generally The concept of “arrangement” or “scheme” The concept of “tax benefit” or “tax advantage” Compatibility of domestic GAARs with tax treaties Domestic legislation: Specific anti-abuse rules Specific anti-abuse rules in particular Controlled foreign company rules CFC rules: Main features Strengthening CFC rules: BEPS Action 3 Tax treaties: Anti-abuse provisions Another approach: Exchange of information and cooperation between tax authorities Convention on Mutual Administrative Assistance in Tax Matters Standard for Automatic Exchange of Financial Account Information OECD Aggressive Tax Planning Directory United States: Foreign Account Tax Compliance Act Conclusion Part Two New Roles of the Concepts in International Tax Structuring
Permanent Establishments in International Tax Structuring Rijkele Betten and Monia Naoum Introduction Use of permanent establishments for tax structuring purposes Avoidance of permanent establishment status Commissionaire arrangements Splitting up of contracts Undertaking activities of a preparatory or auxiliary nature Limited attribution of profits to permanent establishments Intentional creation of a permanent establishment Exemption regimes Financing structures Approach of countries to tackling abuse structures BEPS Action Plan Artificial avoidance of permanent establishment status through commissionaire agreements and similar strategies
Artificial avoidance of permanent establishment status through the specific activity exemptions
Splitting up of contracts Profit attribution to permanent establishments and interaction with Actions on transfer pricing Limitation and restrictions regarding solutions Conclusions and expectations
Transfer Pricing from the Perspective of Substance and Transparency: Is the OECD on the Right Track? Anuschka J. Bakker Introduction Selected transactions with transfer pricing relevance Business restructurings Services Intra-group financing Background Intercompany loans Guarantees Transfer Pricing and the BEPS Action Plan Country-by country reporting Low-value-adding services Changes to Chapter I of the OECD Guidelines Financial transactions Conclusion Part Three Financing Activities
Anti-Base-Erosion Measures for Intra-Group Debt Financing René Offermanns and Boyke Baldewsing Introduction: Funding with debt or equity? Tax structures for group financing and the applicable anti-base erosion measures Tax structures using a low-taxed group financing company Thin capitalization rules as an anti-base erosion measure General anti-abuse rules Restrictions in the case of notional interest deduction regimes CFC rules Restrictions applicable to payments to tax haven entities
Tax structures using a finance company with a financing branch Anti-triangular rule in tax treaties to counter the use of low taxed finance branches
188.8.131.52. 4.2.3. 184.108.40.206.
Substance at the level of the financing branch Tax structures using back-to-back loans Substance and residence requirement for holding companies to obtain tax treaty protection Beneficial ownership requirement Limitation on benefits provision Anti-abuse rules in tax treaties Recent developments of the BEPS Action Plan Context of Action 4 Summary of the three main recommendations under Action 4 Conclusion
Hybrid Instruments in the Post-BEPS Era Shee Boon Law and Marjolein Kinds Introduction OECD recommendations on hybrid instrument mismatches Direct hybrid mismatches Hybrid transfers Indirect hybrid mismatches Hybrid mismatches and other actions in the BEPS Action Plan Managing coordination rules under domestic law Relationship between the OECD recommendations and other domestic law Netherlands New Zealand United States Other technical considerations Timing mismatches Structured arrangements Policy exceptions Deduction/non-inclusion outcomes caused by character and ownership mismatches Bona fide hybrids Tax treaty considerations Conclusion Past, Present and Future of Tax Structuring Using Hybrid Entity
Introduction: Hybrid entity mismatches in the spotlight Tax structures using hybrids and reverse hybrids: Manipulating mismatches (Ab)using the domestic rules for entity classification Basic models of tax structuring using hybrid entity mismatches Practical aspects Rules addressing hybrid entity mismatches before BEPS Experiences of various countries before BEPS Countries’ options before BEPS GAARs: An answer to artificial features of hybrid entity mismatches SAARs: Same purpose from two perspectives – Source and residence state defence against hybrid entity mismatches CFC rules Rules limiting interest deduction Other rules Withholding taxes Anti-tax haven rules Reconsideration of group consolidation regimes Lessons for the future Rules addressing hybrid entity mismatches in the BEPS era OECD recommendations Arrangements that produce DD outcomes Arrangements that produce D/NI outcomes Arrangements using reverse hybrids Responses of countries to BEPS: Current state of affairs Hybrid entity mismatches in the BEPS era: Closely scrutinized worldwide Concluding remarks Part Four Selected Business Models
Business Restructurings: The Toolkit for Tackling Abusive International Tax Structures Madalina Cotrut and Laura Ambagtsheer-Pakarinen Overview of potential reasons for business restructuring Typical business restructuring models
Restructuring manufacturing activities Restructuring distribution activities Centralization of services IP and centralization Business restructuring structures and anti-abuse measures: The fight for substance Testing business restructurings by applying GAARs Testing substance by analysing available documentation Transfer pricing analysis Analysis of the substance of the principal Testing the PE exposure Testing whether compensation upon conversion should be paid Restricting the tax deductibility of expenses arising from a conversion Conclusions Intellectual Property Structuring in the Context of the OECD BEPS Action Plan Ruxandra Vlasceanu Setting the scene Structuring IP Impact of the BEPS Action Plan General comments Actions tackling the prevention of double non-taxation Action 5 on harmful tax practices Existing regimes Specific comments on Action 5 Recent developments and a blueprint for the future Domestic provisions targeting aggressive tax planning The redesign of IP regimes Concluding remarks Taxation of the Digital Economy Aleksandra Bal and Carlos Gutiérrez Introduction: The digital economy as a new way of doing business Concept of the digital economy Tax challenges of the digital economy Residence taxation Source taxation: Physical versus digital presence Source taxation: Taxation of business profits of a PE
9.3.4. 9.3.5. 220.127.116.11. 18.104.22.168.
Income characterization Indirect taxation: EU VAT Digital supplies Distance sales
22.214.171.124. 9.4. 9.4.1. 9.4.2. 9.4.3. 9.5.
Intermediaries National initiatives concerning the digital economy New PE concepts New taxes on specific transactions New taxes on profits Conclusion
International Tax Structuring for Holding Activities Andreas Perdelwitz
Introduction General characteristics of holding companies Legal forms Types Planning strategies and key criteria for holding locations Repatriation strategies Allocation strategies Key criteria for holding company locations Limits on tax structuring with holding companies General anti-abuse rules Transfer pricing Residence Beneficial ownership requirement Interim conclusion Potential impact of the BEPS Action Plan Action 6: Prevent treaty abuse Limitation on benefits rules in tax treaties Publicly-traded companies test Ownership/base erosion test Active business test Derivative benefits test Principal-purpose test under tax treaties Conclusion
Recent Developments in International Tax Structuring
Chapter 1 Common Strategies against Tax Avoidance: A Global Overview Lydia G. Ogazón Juárez and Ridha Hamzaoui * 1.1. Introduction As a starting point for a chapter on tax avoidance strategies, it is pertinent to address several questions. First, precisely what is meant by the term “tax avoidance”? Second, what are the conditions that facilitate and encourage tax avoidance? A clear answer to the first question would define the scope of this chapter. A clear answer to the second would make apparent the necessity for properly drafted rules, as well as provide useful analysis of the likely success (or otherwise) of particular anti-avoidance rules. This chapter is structured as follows: Section 2 addresses the precise scope of the term “tax avoidance”, recognizing the clear distinction between “avoidance” and “evasion”, as well as the unclear distinction between the former and “tax planning”. The authors make the argument for certainty, and highlight the role of policymakers in clarifying the scope of these terms. The main conditions that facilitate and encourage tax avoidance are also examined. Section 3 offers a brief overview of the main tax planning considerations taken into account by taxpayers. This is necessary as a precursor to the discussion that follows in section 4. Section 4 is the heart of the chapter: now that there is some clarity on the scope of tax planning and tax avoidance (section 2), and the schemes that taxpayers frequently employ in pursuit of those objectives, have become clear (section 3), the question arises as to what governments around the world have been doing to address this, and how successful (or otherwise) have their efforts been. Section 5 presents the authors’ conclusions. The chapter is set against the backdrop of the OECD’s efforts against BEPS. 1 The BEPS project sprang into life in February 2013, with a report outlining the key issues and setting out proposals for an Action Plan. In July 2014, the OECD issued the Action Plan, which contained 15 specific actions to address BEPS (see Table 1) in a comprehensive and coordinated manner. The objective of those actions was: to complement existing standards that are designed to prevent double taxation with instruments that prevent double non-taxation in areas previously not covered by international standards and that address cases of no or low taxation associated with practices that artificially segregate taxable income from the activities that generate it. 2 Each action describes the issues to be addressed, the expected outcome and the deadline. The
Action Plan is expected to be completed within a two-year period, taking into account that some actions have already been advanced while others might require longer-term work. The Action Plans will be analysed in detail elsewhere in this publication. 3 The European Union has also made concerted efforts in the fight against tax fraud and tax evasion. In December 2012, the European Union presented an Action Plan 4 in this regard. The Action Plan sets out a comprehensive set of 34 measures “to help member states to protect their tax bases and recover billions of euros legitimately due”. 5 Most of those actions are also included in the BEPS Action Plan. 6 The 34 actions of the EU Action Plan are summarized in Table 2. 1.2. Tax avoidance: General 1.2.1. Scope of the term 126.96.36.199. Tax avoidance versus tax evasion Tax avoidance is a term: generally used to describe the arrangement of a taxpayer’s affairs that is intended to reduce his tax liability. Although the arrangement could be legal (i.e. in line with “the letter of the law”), it is usually in contradiction with the intent of the law it purports to follow (i.e. against “the spirit of the law”). 7 Therefore, tax avoidance is, in principle, lawful because the tax advantage is being sought within the boundaries of the rules. This behaviour has pushed the legislatures in several countries to enact measures dedicated to counter tax avoidance schemes, whether they are meant to catch all types of tax schemes or are designed to restrict only a specific type of avoidance. Tax avoidance is contrasted with tax evasion where a taxpayer takes steps to avoid paying a tax liability that has already arisen. 8 Tax evasion carries an element of dishonesty. In this sense, the term “tax evasion” is “generally used to mean illegal arrangements where the liability to tax is hidden or ignored”. 9 In addition, tax evasion may be characterized as intentional illegal behaviour consisting of not declaring, or under-declaring, income or assets which are subject to tax, which is often sanctioned by financial or criminal penalties. 10 188.8.131.52. Tax avoidance versus tax planning The distinction between tax avoidance and tax planning seems more difficult to determine. Both, tax avoidance and tax planning involve tax reduction arrangements that may comply with the specific wording of the law. 11 Tax planning is seen as compliant behaviour, while tax avoidance is more of a grey area. 12 Nevertheless, “tax planning may reach a point beyond which it cannot be tolerated within a legal
system intended to conform to principles of justice”. 13 This gives rise to what has been labelled as “aggressive” tax planning which goes beyond an acceptable level and may fall in the area of tax avoidance, as it consists in taking advantage of the technicalities of a tax system, or of mismatches between two or more tax systems with the aim of reducing the overall tax liability. Aggressive tax planning can take various forms and its effects could include several tax advantages, such as double deductions and very often double non-taxation. 14 Aggressive tax planning refers, therefore, to arrangements that “push the limits” of acceptable tax planning 15 and would fall into the realm of tax avoidance. Similarly, tax avoidance exists where a taxpayer seeks to obtain a tax advantage by means of sham or artificial transactions, considering that the law could not have intended to grant a tax advantage in such way. In many instances, the distinction between tax avoidance and tax planning is also determined by the judicial system. 16 This would occur when a taxpayer takes advantage of a tax provision exploiting a legislative loophole; in that case the behaviour of the taxpayer could be challenged by the tax authority based on the fact that a loophole is an unintentional imperfection in the law. In several jurisdictions, the courts have considered the use of a loophole as permissible, such that the taxpayer’s transaction would then qualify as tax planning. This could, in turn, trigger the legislature to amend the existing legislation, thereby closing the loophole. 184.108.40.206. The role of policymakers in defining clear boundaries Multinationals are being strongly encouraged to justify their tax positions, especially regarding the level of taxes they pay, as an aspect of their corporate social responsibility. 17 Multinationals often justify and defend their actions by referring to the fact that they have acted according to the law. However, this explanation is not always considered acceptable. Consequently, the question concerns whether it is appropriate to exploit loopholes in the tax law or whether there is some sort of moral duty to refrain from doing so. Paying a “fair” amount of tax in the countries in which multinationals carry out transactions is increasingly seen as responsible behaviour, considering that such tax revenues are meant to finance public services and social benefits. Avoiding paying a fair share has been deemed to be morally indefensible, as it represents the avoidance of a social obligation. 18 It also deters governments from playing their role as redistributors of wealth. On the other hand, one might ask whether it is justified to focus so much on the behaviour of multinationals. Should they be blamed for using, to their own benefit, loopholes and existing mismatches between non-aligned domestic tax systems? It is clear that multinationals and, in general, taxpayers must bear social responsibility. However, should not this also apply to policymakers? 19 While governments complain that their tax bases have been eroded in recent years through the use of tax planning structures, should not policymakers bear the responsibility for enacting regimes and provisions that open the door to such erosion? There is also the very valid point that morality considerations undermine legal certainty. Taxpayers should have certainty under the law as to the precise extent of their tax liability. The moral dimension adds a layer of uncertainty. Policymakers have an unassailable duty to ensure that the law is clear and allows for no ambiguity. From a technical perspective, legislatures should not have trouble in designing and implementing legislative measures against base erosion. Some of these measures have been implemented in the past by several countries – in many cases, with much success. A good example is limitation on
benefits provisions to limit treaty shopping which are used by the United States in most of its treaties. That said, policymakers also face another dilemma, namely the need to improve the attractiveness of their countries from a tax perspective. The interaction of these competing considerations (the need to raise tax revenues versus the need to have an attractive tax system) often leads to incoherent tax policy and uncertainty for taxpayers. 1.2.2. Conditions facilitating tax avoidance Tax avoidance thrives where several conditions are present. Chief amongst these is the existence of a “favourable” domestic tax system. “Favourable”, in the sense, means that the system contains laws that lend themselves to be manipulated by taxpayers. This advantageous position could even be intensified by the interaction of those systems with the tax systems of other jurisdictions. Judicial precedent has sometimes affirmed the right of taxpayers to engage in tax planning. 20 However, this should be viewed against the development of comprehensive judicial antiavoidance doctrines. 21 Tax rules have failed to follow the astonishing evolution of cross-border trade. Globalization has transformed the way in which business has been carried out in recent decades which, undoubtedly, reflected on how tax planning has been implemented. In addition, free trade barriers have been gradually removed, and the digital economy, technology and telecommunications have all developed rapidly. In this regard, it is a fact that current international tax rules have not been able to keep pace with all these changes, due to an obvious absence of international tax harmonization efforts. For example the physical presence requirement – which is still a prerequisite under tax treaties for a non-resident person to be taxable in another country – is no longer necessary in order to conduct business in a foreign jurisdiction. 22 Accordingly, a large quantum of profits is being extracted from several jurisdictions without first paying any taxes, due to the lack of physical presence there. This is increasingly pushing governments, academics and civil society to question the fairness of existing rules, including those pertaining to the allocation of taxation rights under tax treaties. Although it is true that tax planning has generally been considered as a legitimate practice around the world, the manner in which tax bases have been eroded based on complex and sophisticated structures in recent years has forced governments and international organizations to revisit their position. This move was accelerated by economic recessions, budgetary cuts and the substantial growth of the tax collection gap which forced governments to change their policy and demand that (large) taxpayers settle their fair share of taxes. Aggressive tax planning has also raised issues as to the fairness of the overall tax system. Civil society organizations and non-governmental organizations have also added their voices to the general debate. Various initiatives have been undertaken by tax administrations and international organizations to curtail what has been labelled as rampant corporate tax aggressiveness. In addition to several initiatives by individual countries, three major actors have recently played this role, namely the OECD, the European Union and the United States. Each of these actors has developed a special plan to address the issue. 1.3. Tax planning schemes: Domestic law and treaty provisions
The discussion below provides an overview of the main tax planning considerations taken into account by taxpayers, and the types of domestic law and treaty rules used in furtherance of such planning. The aim of this overview is to identify the main targets of attack for any effective antiavoidance strategy. The overview is necessarily brief, as these schemes are addressed in greater detail elsewhere in this publication. 1.3.1. Domestic law rules Several countries use their tax systems to compete with each other in order to attract foreign direct investment. In fact, in a competitive world, tax sovereignty is illusory. Governments consider they have the freedom to determine their effective tax rates for companies incorporated or effectively managed in their jurisdictions. However, in reality they are forced to establish their effective tax rates by taking into consideration what their competitors are implementing in terms of preferential tax regimes. 23 Many countries provide “attractive” tax regimes which allow taxpayers to minimize their tax liability, provided that certain conditions are met. These regimes – often in conjunction with tax treaties entered into by a specific jurisdiction – could contribute to base erosion and profit shifting. 220.127.116.11. Regimes allowing for exemption of foreign-source income 18.104.22.168.1. Patent box regimes A patent box regime (also known as an innovation box or intellectual property regime) is a preferential tax regime granted by several countries in order to attract research and development activities to their jurisdiction, as well as to encourage their local companies to invest in innovative technologies. Generally, a patent box regime provides for the application of an effective tax rate (exempting a substantial part of the tax base) which is lower than a country’s standard corporate tax rate, to income derived from licensing intellectual property (e.g. patents, models, copyrights, designs). Moreover, royalties and profits derived from selling products or providing services using the intellectual property can also be eligible for such a regime. In most jurisdictions where this regime is available, research activities are not required to be conducted in the country which grants the tax incentive. Table 3 summarizes some patent box regimes which are currently in force. On 18 October 2013, the European Commission announced 24 that it considered the UK patent box regime (which took effect as from 1 April 2013) as violating the EU Code of Conduct of business taxation, on the grounds that it constitutes harmful tax competition. 25 Accordingly, this regime and other patent box regimes in force in other EU Member States are subject to closer examination. 26 22.214.171.124.2. Participation exemption regimes
A participation exemption regime is a mandatory measure to avoid economic double taxation at the level of a parent company, based on the fact that dividends were already subject to corporate tax at the level of the distributing subsidiary. 27 The conditions required for application of a participation exemption regime (such as a minimum percentage holding requirement and/or a minimum holding period requirement) vary from country to country, but, in general, income derived from domestic and/or foreign participations would be wholly or partially tax exempt. Countries like Austria, Belgium, Cyprus, Denmark, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Spain, Switzerland, the United Kingdom and the United States include a participation exemption regime in their domestic legislation, making these countries an attractive jurisdiction to locate holding companies. Usually, under participation exemption regimes, the tax burden on foreign-source dividends is considerably reduced. In fact, participation exemption regimes, in combination with tax treaties, have allowed tax planners to achieve almost a double non-taxation of dividends by reducing the withholding tax on dividends at the subsidiary level and exempting those distributions when received by the parent company. 126.96.36.199.3. Holding company regimes Holding company regimes provide significant tax benefits to multinationals (e.g. reduction or elimination of withholding taxes on dividends, interest and royalties; reduction or elimination of income tax and tax on capital gains; access to a wide treaty network). Currently, countries such as Austria, Belgium, Cyprus, Hungary and Ireland offer attractive benefits to holding companies set up in their jurisdictions. For tax planning purposes, holding companies are established in countries acting as a conduit of the group in order to have access to tax advantages which otherwise would not be available to the group. Table 4 summarizes some of the holding companies regimes currently in force. For more details on the use of holding companies for tax structuring purposes, see chapter 10. 188.8.131.52.4. Territorial tax systems Under a territorial tax system, foreign-source income is exempt from residence country taxation. Only that income which arises from sources within the country is subject to tax. A territorial tax system can be particularly attractive, as the exemption of foreign-source income reduces the effective income tax rate and encourages the location of activities for tax purposes rather than for business purposes. In addition, countries with a territorial tax system can be used to establish conduit companies or holding vehicles in order to engage in treaty shopping – a situation which may have harmful effects on other countries. 28 Currently, countries such as Hong Kong, Panama and Singapore have a territorial tax system in force. 184.108.40.206. Regimes allowing the use of mismatches between tax rules in different countries 220.127.116.11.1. US check-the-box regime
The US check-the-box regime allows certain business entities to make an election as to whether the entity will be fiscally transparent or opaque for US tax purposes. A business entity may be classified as a corporation or a partnership, or may be disregarded as an entity. If the entity is classified as a corporation, it will be fiscally opaque and subject to tax. However, if the entity is treated as a partnership or a disregarded entity, it will be fiscally transparent for US tax purposes. 29 Many types of tax planning opportunities are afforded by the US check-the-box regime. For example the US anti-tax haven legislation which deals with CFCs may be applicable even in situations where a CFC is, in fact, subject to a high tax rate in the residence country. The amount of foreign tax liability may be reduced without modifying the US CFC position. This is possible if the CFC sets up a new entity in a low-tax jurisdiction in circumstances where that new entity is not regarded as a corporation for US tax purposes. Subsequently, this new entity makes a loan to the CFC, thereby creating an interest deduction and reducing the profits of the CFC which are subject to a high tax rate. Consequently, as the United States does not recognize the new entity as a corporation, the interest payment and the receipt are treated as merely internal cash flows, leaving the US CFC tax liability unchanged. 30 18.104.22.168.2. Use of hybrid financial instruments and entities Hybrid financial instruments and entities used in international transactions allow tax planners to take advantage of characterization mismatches (e.g. different definitions or tax treatment) in different jurisdictions, in circumstances that give rise to international tax avoidance. 31 A hybrid financial instrument is defined as an: instrument with economic characteristics that are inconsistent, in whole or in part, with the classification implied by their legal form. Hybrid financial instruments normally contain elements from equity, debt and/or derivatives, the advantages of which they seek to combine in the same instrument. 32 A hybrid entity could be defined as “an entity that is characterized as transparent for tax purposes (e.g. a partnership) in one jurisdiction and non-transparent (e.g. a corporation) in another jurisdiction”. 33 Depending on the circumstances, a payment by a hybrid entity can give rise either to a double deduction (deduction in two countries) or to a deduction in one country with no taxable income in another country. One of the most prominent tax regimes which allows for the use of hybrid entities for tax planning purposes is the check-the-box regime in the United States. This regime allows US companies to create foreign entities that were treated one way in the United States and another way in the foreign country. In fact, it was possible to elect that the foreign entity is considered either as fiscally transparent or opaque for US tax purposes. A business entity may be classified as a corporation, a partnership or a disregarded entity. If the entity is classified as a corporation, it will be fiscally opaque. However, if the entity is treated as a partnership or a disregarded entity, it will be fiscally transparent for US tax purposes. For further details on tax structuring using entity mismatches, see chapter 6. 22.214.171.124. Provisions relating to residence
126.96.36.199.1. Dual resident companies and stateless companies Unless domestic legislation or the applicable tax treaty includes a tie-breaker rule, there are circumstances in which a company might be considered to be resident in two different countries. This could be the case where a company is incorporated in a country which determines residence based on legal registration, while at the same time it is controlled and managed from a country which uses an economic test to determine such residence. A dual resident company could be used for tax planning purposes where, for example, a multinational group has profitable group members in both countries, the same losses could be offset twice through a consolidation regime. 34 In addition, a dual resident company can take advantage of the tax treaty network of both countries of residence, electing to apply that which offers the most advantageous tax treatment. The reverse situation of a dual resident company concerns an entity that is incorporated in a country relying on the place where the company is managed and controlled in order to determine tax residence, while the same company is managed and controlled in a country that determines tax residence based on the place of incorporation. This results in a “stateless company”. The entity is therefore not resident for tax purposes in any of those jurisdictions, and, accordingly, would not be subject to tax in either country. 188.8.131.52.2. Tie-breaker rule for companies In order to avail itself of relevant tax treaty benefits, a taxpayer must be a resident of one or both of the relevant treaty states. Where a company qualifies as a resident under the domestic legislation of both states, if there is a tie-breaker rule in the applicable tax treaty, it will determine which of the two states should be treated as the taxpayer’s state of residence. In general, the OECD 35 and UN 36 Models consider as the decisive criterion the place where the company has its place of effective management. This criterion has been used for tax planning purposes in many ways. Therefore, as part of the proposals made in the BEPS Action Plan, the tie breaker rule which gives preference to the country where the place of effective management is located should be replaced with a provision that, in the case of double resident companies, the matter should be resolved based on the mutual agreement procedure. 1.3.2. Tax treaty rules 184.108.40.206. Tax sparing clauses Tax sparing clauses are, in general, incorporated in tax treaties negotiated by developed countries with developing countries, but can also be found in tax treaties between developed countries. Currently, although tax sparing clauses are not negotiated as often as they were in the past, there are countries that still include them in their tax treaties mainly because they have been shown to be “very vulnerable to taxpayer abuse” 37, offering plenty of opportunities for tax planning and tax avoidance that erode the tax bases of the residence and source countries, several (developing) countries still include them in their tax treaties in order to secure the efficiency of their tax incentives legislation. In this respect, it has been argued that tax sparing clauses are considered an ineffective tool to promote economic development 38.
A tax-sparing provision may be inappropriately exploited by residents under a particular tax treaty. Additionally, the residence country may also be used as a conduit by third-country residents. The cost of such use to the residence country – which is required to grant a tax sparing credit for foreign taxes (which should have been paid but were not, due to specific legislation such as tax incentive rules) – may be significant. This is the case particularly where the country is used as a conduit to obtain access to such provision. Moreover, the source country may find that its revenue base is eroded in unintended ways as a natural result of the tax incentive rules. The OECD Report on Tax Sparing mentions the following as the most common tax avoidance schemes involving tax sparing provisions: transfer pricing abuse, conduit situations, routing and potential government abuse. 39 220.127.116.11. Modification of treaty classification of income In general, taxing rights are allocated between countries depending on the nature of the income under the rules established in articles 6 to 21 of tax treaties. Such classification is based on a combination of tax treaty and domestic law definitions. However, in some cases, taxpayers may try to manipulate such classification in order to obtain treaty benefits that would not otherwise be available. 40 18.104.22.168. Circumvention of thresholds found in treaty provisions Some tax treaty provisions include thresholds to determine the country which has the right to tax. In certain cases, taxpayers may manipulate these thresholds to obtain tax treaty benefits that would otherwise not be available to them (e.g. the time limit for certain PEs, the participation required on dividend payments in order to apply a lower withholding tax rate, the thresholds for the source taxation of capital gains on shares). 1.4. Countering aggressive tax planning In recent years, governments have witnessed the spread of aggressive tax planning structures and have had to react swiftly to address the risk that this poses to their tax bases. It is clear that taxpayers may be tempted to abuse the tax laws of a state by exploiting the mismatches between the laws of several countries. However, such attempts may be countered by provisions or legal doctrines that are part of the domestic law of the state concerned. 41 These provisions range from specific, general anti-avoidance rules to new penalty regimes for taxpayers and scheme promoters, as well as mandatory disclosure rules and additional reporting obligations. In this regard, it has been mentioned that the main weapon that a government has against tax avoidance is to introduce amending legislation to prevent avoidance schemes being used in the future, specifically taking into account that it can be dangerous for a government to rely on courts to interpret provisions so as to prevent tax schemes. 42 The discussion below considers the main strategies available to tax administrations in their efforts to defeat tax avoidance schemes of the sort covered in this publication.