7 November 2015

Base Erosion and Profit Shifting (BEPS)

Vishal Gada

Introduction and Overview of BEPS

Background of BEPS

Meaning of BEPS

“Base Erosion Profit Shifting (‘BEPS’) refers to tax planning strategies that exploit gaps

and mismatches in tax rules to make profits “disappear” for tax purposes or to shift

profits to locations where there is little or no real activity but the taxes are low, resulting

in little or no overall corporate tax being paid” – OECD FAQs

Base Erosion refers to the reduction of companies that can be taxed and the amount of

profits that a country can tax

- Achieved by means of shifting residence to different country or causing profits to arise

in different country (by transfer of intellectual property, etc.)

Profit Shifting refers to aggressive tax planning strategies focussed on shifting profits out

of high tax country to lower tax country

BEPS strategies may not necessarily be illegal Increased globalisation enables companies to exploit gaps arising on interaction of domestic tax systems

and treaty rules within the boundary of acceptable tax planning

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Causes and Consequences of BEPS

Causes of BEPS Failure of tax rules to keep

pace with global corporations,

fluid capital and digital

economy thereby leading to

gaps

Mismatch in domestic tax

systems and international tax

rules

Conscious aggressive tax

planning and tax dodging by

MNEs

Consequences arising Unfair competition – MNEs

gain competitive advantage

compared to domestic

enterprises due to BEPS

Inefficient allocation of

resources towards activities

that have lower pre-tax rates

of return but higher after tax

rates of return

Undermining of voluntary tax

compliance by other taxpayers

BEPS Project initiated by OECD at behest of G20 countries to counter opportunities for BEPS

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BEPS Project Timeline

June 2012G20 summit launches

BEPS Project Feb 2013 OECD publishes background report on Addressing BEPS

July 2013Release of 15 Action

Plans to Address BEPS

2016 OnwardsImplementation, Monitoring and

further work

July – August 2014Release of Report on

Impact of BEPS in Low Income Countries

Sept 2014Release of interim reports on Action

Points 1, 2, 5, 6, 8, 13 and 15

Oct 2015Release of Final

Reports on all Action Points

Nov 2015Final Reports to be endorsed at G20

Summit in Turkey

6

Transactions leading to BEPS

Transactions leading to BEPS…

Country AHead Office

Country BBranch

Low tax branch of foreign company

Country A follows exemption system for foreign branches under domestic laws

Low tax in country B achieved as –• Country B levies zero /

low tax; or• Activities of branch not

sufficient to create taxable presence; or

• Deduction for deemed interest on branch’s capital by country B

Undertakes business in

Country B by way of branch

Hybrid Entities

Country AHold Co

Country BSub Co (LLP)

Loan

Interest

Country A treats Sub Co as transparent entity – No tax on interest income since country A doesn’t recognise income in hands of Hold Co received from Sub Co

Country B treats Sub Co as non-transparent entity –Deduction of interest paid to Hold Co allowed in Country B

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…Transactions leading to BEPS…

Country AHold Co

Country BSub Co

Hybrid Financial Instruments

Country A treats CCDs as Equity –Exempts receipts of interest from Sub Co treating them as dividend

Country B treats CCDs as debt – Allows deduction for interest payments to Hold CoPayment of

Interest

Conduit CompaniesCountry A (Tax Haven)

IP Owner – Hold Co

Country CSub Co (Conduit)

Subscription to CCDs

Source Country BSales / Services

Rendered

Licensing of IP

Royalty Payment

Sales / Service Receipt

Country B doesn’t have a treaty with Country A (being a tax haven)Thus, conduit company interposed in country C, which has treaty with country B to reduce tax liability in country B

Income from sales / services accrues in C but minimal tax liability due to deduction of royalty payments

Income ultimately up streamed to Country A - No tax liability in C owing to no withholding tax under domestic laws of C or under treaty

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…Transactions leading to BEPS

Derivatives

- Fees for derivative contracts economically replace interest payments- However, withholding taxes avoided as such fees not subject to tax at source under

domestic laws or treaty

Transfer Pricing

- Shifting of risks and hard to value intangibles to low tax jurisdictions by MNEs- Low risk manufacturing and distribution arrangements and contract R&D

arrangements with principal located in low tax jurisdiction and service provider located in high tax jurisdiction

Circumvention of anti-avoidance Rules

- Channelling financing through an independent third party when thin capitalisation rules apply only in respect of borrowings from related parties

- Replacing the existing parent company with a non-resident company located in a low / no-tax jurisdiction with no CFC regime

- Use of hybrid entities to make income disappear in country of ultimate parent

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BEPS Project by OECD and Action Points

Target Areas of BEPS Project

International mismatches in entity and instrument characterisation – hybrid mismatch arrangements and arbitrage

Application of treaty concepts to profits from digital goods and services

Tax treatment of related party debt-financing, captive insurance and other inter-group financial transactions

Transfer Pricing – Shifting of risks and intangibles, artificial splitting of ownership of assets

Effectiveness of anti-avoidance measures – GAAR, CFC regime, thin capitalisation rules, prevention of treaty abuse

Availability of harmful preferential regime

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Core Principles and Action Points

1. Digital Economy (Industry Specification)

2. Hybrid Mismatch Arrangement3. Controlled Foreign Company Rules4. Interest Deductions5. Harmful Tax Practices

15. Multilateral Instrument (Execution)

6. Preventing Treaty Abuse7. Artificial Avoidance of PE Status8. Transfer Pricing of Intangibles9. Transfer Pricing – Risk and Capital10. Transfer Pricing – High Risk Transactions

11. Methodologies and Data Analysis12. Disclosure Rules13. Transfer Pricing Documentation14. Dispute Resolution

Coherence

Substance

Transparency

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Action Points…

Action 1 – Addressing the Tax Challenges of Digital Economy

Ring fencing of digital economy from the rest of economy difficult Measures in other Actions that address BEPS in digital economy –

- Action 7: Modification of exceptions to definition of PE and anti-fragmentation rule- Action 3: New definition of CFC income to ensure inclusion of income typically earned

in digital economy and its taxation in the jurisdiction of ultimate parent- Actions 8 – 10: Emphasis on substance rather than legal ownership of intangibles

Other potential options considered –- Modification to exceptions to PE so that only activities that are actually preparatory or

auxiliary are excluded- Collection of VAT / GST on cross-border transactions- New nexus in the form of significant digital presence test, withholding tax on certain

digital transactions, equalisation levy, etc. (not recommended presently)Tax authorities in India have sought to treat website as a PE in some cases. Besides,

India has also expanded the definition of royalty to bring transactions in digital economy in its purview

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…Action Points…

Action 2 – Neutralising Effects of Hybrid Mismatch Arrangements

Arrangements seeking to exploit differences in tax treatment of entities and instruments in multiple jurisdictions addressed

Part I: Changes to domestic laws- Measures to address outcomes like multiple deductions for single expense,

deductions without corresponding taxation, generation of multiple foreign tax credits Part II: Changes to treaty

- Measures to ensure that hybrid mismatches not used to unduly obtain treaty benefits- Dual residency to be resolved on case to case basis by competent authorities and not

on the basis POEM- Benefit of treaty not to be granted to hybrid entities when where income of such

entity not taxed under domestic laws of either of the contracting states- Tax treaties not to prevent application of changes to domestic law recommended in

Part INo specific rules under Indian laws to counter hybrid arrangements

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…Action Points...

Action 3 – Designing Effective Controlled Foreign Company (CFC) Rules

CFC Rules aimed at preventing taxpayers from shifting income to foreign subsidiaries Six building blocks for design of effective CFC rules

- Determination of level of influence so as to constitute CFC and recommendations for bringing non-corporate entities in CFC net

- CFC rules to apply only if effective tax rate lower than in parent jurisdiction- CFC income to be defined- CFC income to be computed as per rules of parent jurisdiction- CFC income to be calculated by reference to proportionate ownership- Credit of foreign taxes paid to be allowed

NO CFC provisions under Indian domestic laws presently

Action 4 – Limiting Base Erosion involving Interest Deductions and Other Financial Payments

Fixed Ratio Rule – Net deduction for interest to an entity to be limited to fixed percentage of EBITDA (ranging from 10% to 30%)

Optional Group Ratio Rule for groups with high third party debt - Net deduction for interest above fixed ratio to be permitted up to level of net interest / EBITDA ratio of worldwide group

Separate specific rules to be developed for banking and insurance sectors

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…Action Points…

Action 4 – Limiting Base Erosion involving Interest Deductions and Other Financial Payments

Additional Optional Elements -- Entities with low level of net interest below minimum threshold to be carved out- Interest paid to third party lenders on loans for funding public benefit projects to be excluded

subject to conditions- Disallowed interest expense / unused interest capacity of earlier years to be carried forwardNo formal thin capitalisation rules under Indian tax law presently – Thin Cap norms may be made

applicable under GAAR

Action 5 – Countering Harmful Tax Practices

‘Nexus Approach’ to be adopted to assess preferential regimes with respect to substantial activityrequirement

Expenditure incurred to be used as proxy for activity for Nexus Approach Eligible IP Income = Qualifying R&D Expense * Income from IP Asset / Total R&D Expense for IP Asset Framework for exchanging information covering rulings relevant from BEPS perspective agreed

Action Point less relevant vis-à-vis preferential regimes offered by India as India plans to remove incentive regimes with a corresponding reduction in corporate tax rate

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…Action Points…

Action 6 – Preventing the granting of Treaty Benefits in Inappropriate Circumstances

Minimum Standard - A clear statement that contracting states intend to avoid creating opportunitiesfor non-taxation / tax avoidance / treaty shopping to be included in treaties

A specific Limitation of Benefit (LOB) Rule that limits the availability of treaty benefits on fulfilment ofcertain conditions that establish link between entity and state of residence

A general anti-abuse rule based on principal purpose of transactions (PPT Rule)Many Indian treaties already include ‘prevention of fiscal evasion’ as one of the objectives and also

include LOB clause - Further, GAAR provisions to override treaties

Action 7 – Preventing the artificial avoidance of PE status

Activities by an intermediary leading to regular conclusion of contracts to be performed by foreign enterprise to constitute PE (except in case of activities in course of independent business)

Exceptions to the definition of PE to be modified to ensure that core activities (hitherto considered auxiliary) are taxed in source state

Anti-fragmentation rule to ensure that PE status not avoided by fragmentation of cohesive operating business into smaller operations

Splitting up of contract between related parties not to avoid PE statusAction 7 reinforces the concept of Agency PE in Indian Treaties

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…Action Points…

Actions 8 – 10 – Aligning Transfer Pricing Outcomes with Value Creation

Action 8 - Transfer Pricing of Intangibles

Action 9 - Transfer Pricing – Risk and Capital

Action 10 - Transfer Pricing – High Risk Transactions

Actual conduct of parties to prevail over contractual arrangements

Risks to be reallocated to party that actually exercises control over risk and has the financial capacity toassume risks

CUP (Quoted prices) to be the MAM for benchmarking transfer of commodities

Right to returns by the exploitation of intangibles not to be determined merely by legal ownership

Cash boxes not to be entitled to more than risk free rate of return

Cost plus 5% mark up to be ALP for low value adding intra group services under simplified approach

ALP for contribution to CCAs to be determined based on expected benefits and not costs

In absence of specific guidance under Indian TP Regulations regarding CCAs or intra-group services –reference may be drawn to BEPS

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…Action Points…

Action 12 – Mandatory Disclosure Rules

Provides for mandatory disclosure rules for aggressive tax arrangements to increasetransparency

Recommends design features of such mandatory disclosure regime including personsrequired to report, matters to be reported, timing of reporting and penalties for non-reporting

Specific recommendations for rules targeting international tax schemes also provided

The Expert Committee on GAAR suggested reporting of tax avoidance schemes in excess of certain limits in tax audit report – However, recommendations not included in rules so far

Action 11 – Measuring and Monitoring BEPS

Recommendations at Government level to enable improved access to and enhanced analysis ofcorporate tax data and improvement of tools and data available to measure and monitor BEPS

In absence of availability of comprehensive data with Income Tax Department – Analysis as recommended in Action 11 to be difficult

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…Action Points…

Action 13 – TP Documentation and Country by Country Reporting

Existing guidelines on Documentation in OECD Transfer Pricing Guidelines substituted by the Report Master File – Group level information like overview of MNE group business operations, legal and

ownership structures, overall transfer pricing policies, description of intangibles and intercompanyfinancial activities, etc.

Local File – Country specific file containing details with respect to local entity like business description,management structure, related party transactions, arm’s length determination etc.

Country by Country Reporting –- Jurisdiction wide information on revenue earned, profit before tax, taxes paid, assets, etc.- Reporting to commence from 1st Jan 2016 for MNEs with consolidated group revenue of at least

EUR 750 million Search for comparables to be updated every three years rather than annually

- Financial data for comparables to be updated every yearNeed to amend existing domestic transfer pricing regulations to enable filing of master file and

country by country reporting – compliance burden for taxpayers to increase

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…Action Points

Action 14 – Making Dispute Resolution Mechanisms More Effective

Recommendations aimed at strengthening mutual agreement procedures under treaties Minimum standard developed aimed at –

- Resolution of MAP cases in a timely manner- Smoothening the administrative processes under MAP- Granting of access to MAP to eligible taxpayers

Some countries also keen on mandatory binding MAP arbitration for effective resolution of treaty-related disputes

No time limit for settlement under MAP in most Indian treaties

Action 15 – Developing a Multilateral Instrument to Modify Bilateral Tax Treaties

A multilateral instrument to serve as alternative mechanism for modification of tax treaties in line withBEPS Actions - expected to be open for signature by December 2016

India is a member of the group constituted for development of multilateral instrumentHowever amendments in domestic law (section 90) required to enable entering into multilateral

agreements for avoidance of double taxation

BEPS Action Points to equip countries with the tools to ensure that profits are taxed where economic activities generating profits are performed

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Implementation and Global Developments

Implementation Mechanics…

BEPS Outputs are soft law legal instruments – not legally binding but expected to be implemented accordingly by countries that are part of consensus

Minimum standards agreed by all OECD and G20 countries to tackle issues where no action by some countries would lead to negative spill overs on others

All OECD and G20 have committed to consistent implementation in the areas of –

- Preventing treaty shopping

- Country by country reporting

- Fighting harmful tax practices

- Improving dispute resolution

In other areas, countries have agreed over general tax policy direction (hybrid mismatch arrangements, interest deductibility, etc. )

Guidance based on best practices to countries intending to act in the areas of mandatory disclosure regime or CFC legislation

India has endorsed the Action Plans (being a G20 member) but is not bound by what OECD decides (in view of observer status within OECD) - likely to follow a selective

approach to adoption

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…Implementation Mechanics

Amendments to Domestic Law

• CFC Rules • Interest Deductions• Countering Harmful Tax Practices• Aligning Transfer Pricing Outcomes with Value Creation• Mandatory Disclosure Rules• TP Documentation and Country by Country Reporting

Amendments to Treaty –

OECD Model Convention / Multilateral Instrument

• Preventing Treaty Benefits in Inappropriate Circumstances• Artificial Avoidance of PE Status• Dispute Resolution Mechanisms

Amendments to Domestic Law as

well as Treaty

• Addressing Tax Challenges of Digital Economy• Hybrid Mismatch Arrangements

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Global Developments on BEPS…

Action Plan on Corporate Taxation released by EU Commission in June 2015 to overhaul EU’s corporate tax framework and plug existing loopholes in existing EU rules

- The plan to complement BEPS Project and facilitate creation of a framework for EU level integration of BEPS Project

Proposed revisions (Discussion Draft) to US Model Convention largely shaped by BEPS Project released by US Department of Treasury in May 2015, targeting below issues -

- Exempt PEs- Special tax regimes- Expatriated entities- Anti-treaty shopping measures of LOB article- Subsequent changes to treaty partners’ domestic tax laws

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…Global Developments on BEPS

Release of Model Competent Authority Agreement (CAA) and Common Reporting Standard (CRS) by OECD to create global standard for automatic exchange of information

- Modelled on US FATCA- No direct legal force but likely to be followed by countries when implementing

bilateral agreements- India also became a signatory to Multilateral Competent Authority Agreement

In Oct 2015, Geneva meeting of the UN’s Committee of Experts on International Cooperation in Tax Matters, following Action Agenda were discussed:

- Update of UN Model Convention for –- Hybrid entities - Meaning of ‘connected projects’ (Art 5)- Meaning of Auxiliary Activities (Art 8 &Art 12)- New Article on FTS

- New Article on FTS- Code of Conduct for Automatic Exchange of Information- Cross-cutting issues under the UN Model Convention, such as BEPS

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Unilateral Response by Countries…

Australia• GST to apply on supply of intangible products by non-residents to

Australian consumers • Multinational measures to tackle artificial avoidance of PE to apply to

businesses with global revenue of at least AUD 1 billion• Recommendations for TP Documentation and country by country

reporting to apply• Exchange of information with respect to MNEs contributing to tax

avoidance commenced• Steps towards anti-hybrid rules and preventing treaty abuse likely soon

Japan• Provisions for VAT in digital economy strengthened• Participation exemption on dividends on hybrid instruments now denied• Trigger rate for CFC provisions reduced from more than 20% to at least

20%

Ireland• Irish incorporated hitherto non-resident companies to be treated as tax

residents to counter double Irish structures for tax avoidance

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…Unilateral Response by Countries…

China• BEPS concepts have found increased applications in TP cases• Increased focus of tax authorities on ’disguised dividends’• Discussion draft of ‘Special Tax Adjustment Implementation Measures’

that revises adjustments under GAAR, TP, CFC and thin capitalisation and incorporates other OECD BEPS recommendations like country by country reporting released

• No firm changes in domestic tax law per se yet

USA• No unilateral action till date• Government considering BEPS related provisions like disallowance of

interest and royalty payments to related parties under hybrid arrangements, strengthening of CFC rules etc.

• Likelihood of action in near future is low

UK• Diverted profits tax @ 25% introduced for below situations -• Artificial avoidance of PE by non-UK company• UK company / PE has tax advantage owing to entity / transaction lacking

substance

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…Unilateral Response by Countries…

Canada• Proposed draft legislation on anti-treaty shopping delayed in 2014

pending further inputs from BEPS Project

Chile• The 2014 tax reform included a number of BEPS related measures like

GAAR, additional requirements to deduct expenses paid to related parties and CFC Rules

• Government starting to consider Action 6 and Action 7 in negotiation of tax treaties

Denmark• Government signed commitment to implement OECD CRS• Government adopted GAAR on abuse of tax treaties and EU directives

France• Anti-hybrid rules introduced and there are proposals in the digital area

Hungary• Anti-hybrid provisions (limited to treaty interpretation mismatches)

introduced

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…Unilateral Response by Countries…

Germany• Upper House of Parliament requested additional changes related to BEPS

1. Anti-arbitrage rule for hybrids 2. Rules on disclosure of tax planning schemes 3. Disallowing deduction of expenses in non-inclusion and double deduction cases

• Federal Ministry started deliberations on Action 13

Israel• Draft circular published in April 2015 relating to digital economy -

1. Circumstances in which foreign entity deemed to have PE 2. Principles for attributing profits to PE 3. Cases in which foreign entities to register for VAT purposes

• Circular on examination by tax authorities of each business model restructuring and resulting disposal of IP also published earlier

Italy• Law enacted to deal with cross border transactions related to advertising

industry and digital economy – rules consistent with recommendations of international organisations and EU may be made

• Provisions relating to digital economy inconsistent with EU principles repealed

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…Unilateral Response by Countries…

Mexico• 2014 tax reforms included measures like disallowance of deduction for

interest, royalty, FTS unless payment subject to tax in recipient country• Also, NR claiming treaty benefits to demonstrate double taxation in

absence of treaty benefits

Netherlands• Draft law including provisions for hybrid loans and GAAR published in Sept

2014• Renegotiation of tax treaties with 23 countries with respect to anti-abuse

provisions underway – 5 countries already agreed

New Zealand• Current Inland Revenue proposals include -

1. Broadening application of NR withholding tax 2. Extension of GST on cross border goods and services 3. Hybrid changes and limitation of interest deductions

Russia• No unilateral measures as such but BEPS Action Plan mentioned in Russia’s

tax policy plans for 2015-17

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…Unilateral Response by Countries…

Singapore• Government also considering ‘profit per employee’ while assessing

applications for tax incentives• TP guidelines revised to provide for maintenance of contemporaneous

documentation except in safe harbour situations

Switzerland• Corporate tax reforms announced to align rules with international tax

laws• Unlikely to adopt unilateral measures (like CFC rules, etc.) but will

develop new tax system with international tax standards

Spain• Anti-abuse rule for hybrid entities introduced• Application of CFC rules to cover more transactions and types of income• Recharacterisation of intragroup profit participating loans as equity

instruments• Limitation on deductibility of financing expenses in leveraged buyout• Introduction of CBC reporting

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…Unilateral Response by Countries

South Africa• No specific unilateral BEPS actions but implementation of country by

country likely

No significant unilateral actions by Argentina, Austria, Belgium, Estonia, Finland, Norway, Poland, Slovakia, Slovenia and Sweden but future steps likely to be in line with BEPS

Recommendations

Luxembourg and Saudi Arabia unlikely to take any actions in response to BEPSNo actions taken by Hong Kong and Iceland as well

Brazil and Turkey likely to wait for initial results of OECD’s efforts on BEPS before taking any further action

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BEPS Case Study

Case Study – Leveraged Acquisition

An MNE, Parent Co, headquartered in Country 1 has operations in Country 2 through Op

Co

Parent Co plans to acquire manufacturing company, Target Co, in Country 3 from seller in

Country 3

The acquisition price is EUR 1 billion, of which 60% is to be financed through external

debt

The Parent Co sets up a holding company in Country 2, A Hold Co, which further sets up B

Hold Co in Country 3 for acquisition of Target Co in Country 3

Parent Co grants a loan of EUR 400mn to A Hold Co and A Hold Co advances the amount

to B Hold Co by way of subscription to redeemable preference shares, with remaining EUR

600mn being raised by B Hold Co by way of external bank debt

Country 2 treats redeemable preference shares as equity and Country 3 as debt

Countries 2 and 3 allow grouping of related domestic companies for tax purposes

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Case Study - Structure

Parent Co

A Hold CoOp Co

B Hold Co

Target Co

Seller Bank

Country 1

Country 3

Country 2

Tax Grouping

Tax Grouping

Loan

Redeemable Preference Shares

EUR 1bn

Loan

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Case Study - Implications

Country 3

- Interest payment to bank by B Hold Co allowed as deduction against Target Co’s operating income- Dividend on Redeemable Preference Shares also allowed as deduction against income of Target

Co, preference shares being treated as debt- Withholding tax liability on dividend payment eliminated / reduced under treaty

Country 2

- Dividend received on Preference Shares exempt under domestic laws as participation exemption- Interest payment by A Hold Co to Parent Co allowed as deduction against operating income of Op

Co- Withholding tax liability on interest payment to Parent Co eliminated / reduced under treaty

Country 1- Interest received on loan from A Hold Co to be taxed in Country 1 and credit of withholding tax in

Country 2 to be available

On exit from investment by way of sale of B Hold Co, Country 3 may be prevented from taxing capitalgains under treaty and Country 2 to grant participation exemption on LTCG

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Next Steps for BEPS

Next Steps for BEPS

Multilateral instrument to streamline implementation of treaty related BEPS measures expected to be open for signature in 2016• 90 countries have joined the group as members for

development of the instrument till date

Country by country reporting by prescribed MNEs to start in 2016 and

tax administrations would begin exchange of first country by country

reports in 2017

Revised OECD Model Tax Convention and Transfer Pricing Guidelines in light

of BEPS measures to be released by 2017

OECD’s Forum on Harmful Tax Practices to continue assessment of

whether various preferential regimes are harmful based on nexus approach recommended under BEPS

Practical toolkits containing reports, guidance, model legislation, etc. based

on real life cases to be developed to facilitate implementation of solutions to

BEPS

Follow up work by OECD and G20 on issues like TP (hard to value

intangibles, financial transactions), attribution of profits to PE, details of

group carve-out and rules for insurance and banking sectors for

interest deductibility to remain

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Action 1 – Addressing the Tax Challenges of Digital Economy

Why Digital Economy a concern ?

“Digital business technologies are formulating / modifying the conduct of

businesses, result of which is that there has been a transformative process

brought by Information and Communication Technology (‘ICT’)”

ICT has made technologies easier, cheaper, more powerful and widely

standardized, improving business processes and bolstering innovation across all

sectors of the economy

The pace at which the tax laws needs to be evolved in the respective country

has not matched with the change in the business models, thereby resulting in

exploitation of loopholes by MNEs in ‘Digital Economy’

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Impact of Digital Economy (DE) in Various Sectors

The Information and Communication Technology (ICT) revolution has made

technologies cheaper, more powerful and widely standardised, improving business

processes and bolstering innovation across all sectors of the economy. For example

Online Retail – Retailers allow customers to place online orders and are able to

gather and analyse customer data to provide personalised service and advertising;

Logistics – The ability to track vehicles and cargo across continents;

Financial – Enable customers to manage their finances, conduct transactions and

access new products on line;

Manufacturing – Ability to remotely monitor production processes and to control

and use robots

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Digital Economy – Key Features

Ability to have virtual presence

Dispensing with traditional revenue models

Mobility with respect to (i) the intangibles, (ii) users, (iii) business functions

Flexibility to choose the location of servers and other resources

Reliance on data, including in particular the use of so called “big data”

Unique challenges of determining nexus

Volatility due to low barriers to entry and rapidly evolving technology

While DE does not generate unique BEPS issue, its key features exacerbate BEPS risks

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Background and Objective of BEPS for DE

Objectives of BEPS Action 1 – DE

Objective of DE Report:

- To identify difficulties posed by DE while applying existing international taxrules

- To develop options to address such difficulties by taking a holistic approach

Innovation in ICT and DE has accelerated spread of global value chains whereby

MNEs integrate their worldwide operations which traditionally required physical

presence

The DE and its business models do not generate unique BEPS issues, some of its

key features exacerbate BEPS risks. The said Action deals to address those

challenges emerging out of such business models

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OECD TAG and High Powered Committee Views

Technical Advisory Groups (TAG) constituted in 2002 to deal with attribution of profits topermanent establishment (PE), the place of effective management concept and treaty rules in thecontext of e-commerce

Options evaluated

- Characterisation of business profits and taxation along the lines of royalty- ‘New nexus’ i.e. taxability of income if corresponding payment is tax deductible (base eroding

payment rule)- Adding concept of ‘Electronic (virtual) Permanent Establishment (PE)- Global formulary approach based on ‘group’ profits

Views of High Powered Committee set up by CBDT in December 1999:

- With e-commerce, need for physical presence, which is the cornerstone for creation of “PE”(to tax business profits) virtually ceases.

- Hence, the concept of PE should be abandoned and other alternative shouldbe evaluated

- ‘Base erosion’ approach (i.e. source trigger for all tax deductible payments) may bea possible alternative.

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BEPS in the context of Direct Taxation for DE

The February 2013 Report Addressing Base Erosion and Profit Shifting (OECD. 2013b) identifies anumber of co-ordinated strategies associated with BEPS in the context of direct taxation, which can bebroken down into four elements -

Minimisation of taxation in the market country by avoiding a taxable presence, or in the

case of taxable presence, either by shifting gross profits via transfer of IP or trading

structures or by reducing net profit by maximising deduction at the level of the payer

Low or no withholding tax at source considering lack of provisions of taxing DE transactions

under source and residency Rule

Low or no taxation at the level of the recipient (which can be achieved via low-tax

jurisdiction, preferential regimes, or hybrid mismatch arrangements) with entitlement to

substantial non-routine profits often build-up via intra-group arrangements

No current taxation of the low-tax profits in the level of the ultimate parent

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Opportunity for BEPS in the context of VAT

As per the OECD’s “Guidelines on place of taxation for B2B supplies of servicesand intangibles”, opportunities for tax planning by businesses and correspondingBEPS concerns for government in relation to VAT may arise with respect to -

- Remote supply of digital goods and services to VAT exempt businesses

- Remote digital supplies acquired by enterprises that have establishments(branches) in more than one jurisdiction that are engaged in exempt activities

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BEPS Planning for business models operating in DE

Local activity or Sub

Intermediate Country 2 (Low Tax)Market Country Ultimate Residence Country

Avoid taxable presence or

Minimise Assets / Risks or

Maximise Deductions

Intermediate Sub 2

Maximise Assets Functions & Risk

Intermediate Country 1 (High Tax)

Intermediate Sub 1

Preferential Regime or

Hybrid Mismatches or

Base Eroding Payments

Low or no withholding

Low or no withholding

Parent Co

Ineffective/ No CFC Rules

Minimise Assets / (Risks) Maximise Deductions

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Tax Policy Concerns and Potential Options

Tax Policy Concerns…

Nexus

• Distance forms less of a barrier totrade

• Growth of customer base doesnot necessarily demand changein organisational infrastructure

• Ability to have significant digitalpresence (and not physicalpresence) resulting into ‘no PE –no tax’ scenario

• Concern on establishing nexuswith jurisdiction with substantialactivity or value creation, e.g.,having a market place in acountry clearly valuable to seller

Data

• Data gathered from varioussources often primary input intothe process of value creation

• Challenging to assign value toraw data vis-à-vis FAR analysis

• Remote collection of data vis-à-vis nexus for tax purposes (evenif no physical presence) – notlikely in the current scenario

• How to characterize or attributevalue to information collectedacross borders and to valuecreated digital products /services from data

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…Tax Policy Concerns

Characterization

• Whether income should be characterized as royalty, FTS or business income

• Whether infrastructure-as-a-service transaction should be treated as services

• Development and increasing use of 3D printing may also raise character questions

• Appropriate characterization of income in the context of new business models

VAT Collection

• Capability of private consumers to receive from goods and service from remote suppliers and use of low-value VAT-exemptions

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Potential Options to address tax challenges in DE…

Replacing PE with “significant economic presence”

• Country from which sustained significant revenue generated• Due regard to be given to factors such as nature of transactions to be covered,

viz., only digital transactions executed on digital platform of the company, level of threshold of transactions and administration of such a threshold

• For digital factors, factors could be whether an entity has • a local domain name;• a local digital platform;• local payment options

• User based factors, such as number of Monthly active users, Online contract conclusions, nature and quantum of Data collected

• Also, possible to have combinations of any of the above factors

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…Potential Options to address tax challenges in DE…

Withholding of taxes on digital transaction

• Impose final withholding tax by resident customers on purchase of digital goods/ service for collection of taxes, alternatively, nominal withholding taxes as a primary tool to collect data for determining ‘nexus’

• Factors to be considered for the same –• Scope of transactions covered should be clearly defined as well as should not

give rise to disputes over characterisation of such income• Collection of taxes could be a challenge in case of B2C transactions, however,

comparatively easier in case of B2B transactions – automation process of payments to be considered

• Gross basis withholding of taxes to be applied at a lower than normal rate of tax so as to consider the relevant costs in earning such income

• Taxes may also be withheld by financial institutions processing the payments, however, characterisation of income, net income taxable, etc. may need to be provided

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…Potential Options to address tax challenges in DE

Introducing an “equalisation levy”

• Approach is based on equal treatment to foreign and domestic suppliers• Taxation to non-resident enterprises having a significant economic presence in

a country• Imposition of equalisation levy subject to credit of levy against its domestic

corporate income tax. Such an approach to ensure that foreign entities with no nexus for corporate income tax would be subject only to the levy in source country

Consumption tax options

• Remote digital supplies to consumers to trigger tax • Exemptions for imports of low valued goods• EU countries experience this option to be most viable

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DE Case Studies

Case Study 1 - Online Retailer

RCo(Country R)

RCo Regional Holding

(Country T)

RCo Regional Op Co

(Country T)

SCo(Country S)

Rights to IP for Country T/S Region

License IP for business in T/S Region

Country S Customers

Performs R&D, Operates Country R Website, Co-ordinates services to sales and procurement, Owns IP Initial buy-in payment plus Contractual Payments

Holds stock of regional subsidiaries , Owns IP for Country T/S region, Sub-licenses IP to regional subsidiaries

Royalties

Operates Country T/S regional websites, Owns physical and digital inventory, Performs payment

Operates warehouse, Delivery through courier, After sales assistance

Fee (cost-plus-basis)

Management fees

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Case Study 1 - Tax Consequences…

Direct Tax Consequences in Country S

- Since serviced provided by SCo is routine in nature, minimal income is allocated to Sco

- Income derived in Country S to be treated as income of Bco, due to its role but since

BCo has no physical presence, no income is taxed by Country S either under domestic

tax laws or treaty

Direct Tax Consequences in Country T

- The income from intangibles earned by ACo is taxed at a less rate on the royalty

income. Further, income of BCo is entirely offset by the royalty payments and

management fees

- No withholding obligation on BCo since the royalty is paid to ACo, a resident company

and on management fees paid to RCo, a non-resident company due treaty protection.

No withholding obligation on payments by ACo to Rco due to treaty protection

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…Case Study 1 - Tax Consequences

Direct Tax Consequences in Country R

- Country R levies income tax on the profits derived by RCo, including the buy-in

payment from Aco on transfer of existing intangibles. However, in the absence of a

significant track record of RCo’s performance, the value of intangibles was very low,

resulting into minimal exposure

- Amount received by RCo from ACo under cost sharing is lower than royalty received

by ACo. Further, RCo may also be entitled to R&D tax credits, resulting in reduction in

tax liabiltiy

- Under its CFC rules, Country R may treat royalties received by ACo as passive income

of RCo. However, because BCo is treated as transparent entity in Country R, the

income of BCo is treated as having directly earned by ACo and is therefore taxable in

Country R only when paid to RCo

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Case Study 2 - Internet App Store

RCo(Country R)

TCo(Country T)

SCo(Country S)

Sale of IP R&D Contract

Marketing Promotion

R&D Services

Payment for IP transfer Services for R&D activities

Service fee(Cost-plus basis)

Third Party Developers

Net Amount less Agency fee

WW IP Owner, Manages Marketplace, Transaction processing, Marketing Strategy

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Case Study 2 - Tax Consequences…

Direct Tax Consequences in Country S

- Since serviced provided by SCo is routine in nature, minimal income is allocated to Sco

- Income derived in Country S from sale of applications in Country S and T are treated

as income of TCo, due to its role as the counterparty to the transactions with local

customers and administrator of local app stores and since TCo has no physical

presence, no income is taxed by Country S under domestic tax law or under treaty

Direct Tax Consequences in Country T

- Income of TCo is taxed at roughtly 50% of rates in Country S and R in Country T

- No withholding obligation on the various fees paid by TCo, RCo and SCo under treaty

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…Case Study 2 - Tax Consequences

Direct Tax Consequences in Country R

- Country R imposes tax on the profits of RCo, notably the capital gain derived from the

sale of the technology to TCo and the service fee received for its R&D activities.

However, because of the absence of a significant track record of RCo’s performance,

the value of intangibles was very low, resulting into minimal exposure. In addition

depending on the domestic laws of Country R, RCo may be entitled to R&D tax credits,

thereby reducing its tax liability for corporate tax purposes

- Country R imposes corporate tax on territorial basis and does not have any CFC rules.

As a result, RCo is exempt from both on income earned by TCo and on dividends

received by TCo

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Way Forward

Way Forward

Actions which may particularly address BEPS concern on DE:

- PE (Action 7) - Ensuring that core activities cannot inappropriately benefit from

the exception to PE status and that artificial arrangements relating to sales of

goods and services cannot be used to avoid PE status

- Data & Intangible (Action 8 to 10) – Address importance of data/ intangibles and

impact of transfer pricing

- CFC Rules (Action 3) - Possible need to adapt CFC rules for DE

- VAT – Address opportunities for tax-planning by businesses engaged in value-

added tax exempt activities

If other actions do not fully address DE challenges, may need to work on potential

actions

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An Indian Perspective

Indian Perspective on BEPS

In addition to OECD member- countries, India was actively involved in the BEPS project on an equal footing

However, no significant activities seen except becoming a signatory Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information in June 2015

Source based taxation and withholding taxes for digital transactions strongly moved by India

Mandatory and binding arbitration under MAP not favoured by India

LOB clause likely in ongoing renegotiation of India-Mauritius DTAA

India to strike a balance between strengthening integrity of tax system and attracting foreign investment

Indian Govt. planning to remove tax incentive regime in sync with the reduction in corporate tax rate

Structures involving hybrid arrangements may potentially be hit under the GAAR scenario

Likelihood of pressure to abide by BEPS outcomes while negotiating treaties with OECD countries

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Indian Perspective on DE…

India has taken several unilateral measures aimed at countering the challenges exacerbating

from DE . These include –

• Treating a website as a PE - There are several instances of the Indian tax authorities

seeking to treat websites as a PE of a foreign enterprise. While this position has not found

favour with the Courts so far (for instance ITO v. Right Florist (2013) (25 ITR 639) (Kolkata

Tribunal)

• Expanded scope of Royalty /fees for technical services (FTS) - India has also sought to

bring several transactions of the digital world within the ambit of royalties or FTS (such as

subscription to online database, payments for online advertisements).

The interplay between India’s unilateral measures as above and the BEPS recommendations is

not yet clear.

It would be interesting to see if India continue to assert the existence of PE through websites, notwithstanding the fact that BEPS have expressly

not accepted the nexus test based on significant digital presence

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...Indian Perspective on DE

Exposure for Foreign Company conducting business in India through electronic mode:

As per Section 2(42) of the Act a “foreign company” means any company or body corporate

incorporated outside India which has a place of business in India whether by itself or through an agent,

physically or through electronic mode; and conducts any business activity in India in any other manner.

As per Rule 2(c) of the Companies (Registration of Foreign Companies) Rules, 2014, ”electronic mode”,

for the purposes of meaning of “foreign company”, means carrying out certain activities electronically,

whether main server is installed in India or not, whether conducted by e-mail, mobile devices, social

media, cloud computing, document management, voice or data transmission or otherwise.

As per Rule 3 of the Companies (Registration Offices and Fees) Rules, 2014, every company including

foreign company which carries out its business through electronic mode, whether its main server is

installed in India or outside India, shall be deemed to have carried out business in India.

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Thank You

Disclaimer: This is a general presentation for information and educational purposes only and should not be construed as a professional advice

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Mumbai

12th Floor, Discovery of India, Dr. Annie Besant Road, Worli,Mumbai 400 018.

Tel: +91-22-6108 1000Fax:+91-22-6108 1001

Ahmedabad

B3, 3rd Floor, Safal Profitaire, Prahladnagar, Corporate Road, Opp. Auda Garden,Ahmedabad 380 015.

Tel: +91-79-6134 3434Fax: +91-79-6134 3477

Bangalore

Prestige Terraces, 2nd Floor, Union Street, Infantry Road, Bengaluru 560 001.

Tel: +91-80-4660 2500Fax: +91-80-4660 2501

Gurgaon

Unit Nos. CPB101 & CPB102, First Floor of Tower/Block No. 4BDLF Corporate ParkM G Road, Gurgaon, Haryana – 122 002.

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