H i g h e r E d u c a t i o n

The Continuing Evolution of Tax Law, at Home and Abroad

Douglas W. Nakajima, J.D., LL.M.Managing Director

SMART DEVINE | 1600 Market Street, 32nd floor | Philadelphia, PA 19103 | 267.670.7300 | www.smartdevine.com

www.smartdevine.com 1

Professionals in the tax community are tasked with developing planning strategies under existing statutory schemes that minimize or eliminate their clients’ global tax burden. It is these planning structures that draw the attention of tax authorities as causing the “erosion” of taxable income bases and consequently, the tax revenues for their respective countries.

In my daily review of tax updates and headlines, I am deluged by news of the Organization for Economic Cooperation and Development’s (“OECD’s”) efforts under the battle banner of “BEPS”, the acronym for Base Erosion and Profit Shifting. At their September 2013 meeting, the G20 leadership endorsed a comprehensive Action Plan to examine how domestic laws in each country contribute to base erosion and profits shifting. The Action Plan was designed to ensure that international and domestic tax rules are not permitted to foster the artificial shifting of profits from high to low tax jurisdictions. BEPS seeks to establish a global tax policy where the taxation of profits is matched to where the economic activity generating the profits is performed and where economic value is created. Although some may question whether they are achievable the ultimate goals and ambitions set forth in the BEPS Action Plan are both necessary and laudable.

National governments must generate tax revenues to fund their security and essential operations. Multinational businesses are tasked with achieving their own revenues and profits, and do not share the “greater good” objective of sacrificing their own success to fund what are perceived as excessive government budgets. The BEPS Action Plan will not receive universal acceptance as it is designed to address funding objectives of the multiple governments in the multiple countries where they may be conducting business.

Background and Perspective

The challenge raised by BEPS in achieving a level of uniform tax treatment is similar to the problem facing U.S tax reformists who seek a tax code that is both fair and simple. The sheer number of politically-motivated groups who are attempting to impact the BEPS reform effort, such as the public interest groups in the U.S., are the same member nations who have rallied around the BEPS cause. In each country’s respective “be careful what you ask for” moments, their leaders and legislatures must weigh their sovereign national interests against the greater good of a uniform, fair and administrable global tax system. This will prove difficult as we are already seeing examples of unilateral, separate country legislation that has been enacted or under consideration that may follow the substance and spirit of the BEPS recommendations yet ignore the uniformity objectives BEPS seeks.

Since the legislatively progressive Reagan tax reform period of the 1980’s, U.S. tax legislation, major and minor, remains a fertile area for aspiring politicians and long-tenured public servants to brandish and obfuscate during their re-election campaigns and public forums. As a tax professional whose spouse interprets each “simplification” proposal as founded law which will essentially end the need for tax professionals, I have attempted to convince her, without success, to turn a deaf ear to the tax reform “noise” emanating from the hallways of the White House, the Capitol and many state houses. She should be assured that there will be plenty of tax work remaining in the aftermath of any “reform”. During the early 1980’s, President Reagan had major legislative success in enacting a series of significant tax rate reductions and incentives in the name of advancing the cause of “Fairness, Growth and Simplicity”. Even 30 years ahead of my current jaded views, I labeled them as a “failure to reform,” and despite enjoying some of the rate

www.smartdevine.com 2

reduction benefits, the reform efforts failed to achieve the fairness or simplicity they were supposed to provide.

Today, U.S. and global tax reform both appear as distant and impossible as ever. BEPS may be another valiant effort that will fall short of the mark on improving tax fairness among countries and advancing administrable tax simplification. However, in the spirit of “fairness,” the tax community is obliged to afford the overall BEPS effort the benefit of the doubt that it can succeed.

What is BEPS?

Understanding why BEPS might be different from other reform efforts and determining if it has a chance to succeed cannot be determined without a general understanding of BEPS. BEPS is a project championed by the OECD and the G20 leadership that seeks to close gaps in international taxation. This includes the review of the fundamental criteria for allowing countries to tax activities both within and outside their borders as well as the methodologies for pricing cross-border transactions. As is evident from its name, Base Erosion and Profit Shifting, BEPS targets the reduction of a country’s taxable income base by the shifting of revenues through a variety of means such as the manner that operations are conducted, the use of intangibles, related party services, and through the methodologies for pricing such intercompany transactions.

The broad attack on tax avoidance is set forth in the OECD’s Action Plan on BEPS. The Action Plan provides 15 separate action points. Each of which is assigned to work groups to provide an understanding of the inherent issues in their action area, to propose solutions that satisfy the overall BEPS multinational objectives, and finally, to deliver a written report to the G20 leaders for review and approval. BEPS’ multinational approach, which involves multiple OECD member

nations, suggests the possibility of uniform approaches to the solutions that are to be proposed to address the issues confronted within the several Action Plan groups.

By the fall of 2014, 7 of the 15 groups were tasked with reporting out their discussion drafts. Commentary on the issues addressed and suggested modifications to the solutions and actions proposed in the discussions drafts were received and considered for attention by the work groups in their final reports. By the way of illustration, we provide capsule views of two areas of primary taxpayer focus in this discussion: the Action 7 report addressing the prevention of the artificial avoidance of permanent establishment status; and the Action 13 discussion draft, which deals with improvement of transfer pricing documentation and includes the so-called “Country-by-Country” (“CbC”) reporting. The Action 7 and 13 reports are only individual pieces of the larger BEPS Plan. However, like the other Action Plan recommendations, if adopted, each has the ability to impact a number of taxpayers in multiple countries in the near-term.

BEPS Action 7

The BEPS Action 7 proposals have a far-reaching impact with the potential to disrupt many taxpayer business structures that were implemented under current dual tax treaties. More specifically, the treaty definitions and interpretations of what constitutes a Permanent Establishment (“PE”) under existing treaty definition may be altered. Most dual tax treaties employ PE definitions to establish when a country is entitled to tax activity within their borders. Typically, in countries not employing a territorial tax regime, when the business activity does not rise to the level of a local country PE, the business profits derived from such activity are taxable only in the home country of the taxpayer’s headquarters. Where a local country PE is present, Business Profits

www.smartdevine.com 3

attributable to the local country PE are taxable in the country where the PE is located, as well as the home country of the multinational business’s base of operations. By comparison in a territorial system, business profits earned outside the home country may not be taxable by the home country.

Under the Action 7 discussion drafts, changes in what constitutes a PE could extend the tax reach of the local country. For example, many PE definitions now call for a fixed place of business, or the authority and habitual exercise of the authority, to conclude contracts within the second country. Legacy planning employing the prior PE standards would typically have dictated that businesses avoid concluding and executing contracts in the local country. Operating procedures would establish that final approval of contract terms and conditions, including pricing, would require review, approval and execution by headquarters personnel in the U.S. or elsewhere outside the local country with no PE.

Proposed changes in the BEPS discussion draft would include profits from business arrangements whose material elements were negotiated in the second country. These changes raise many issues, including the definition of “material elements” and “negotiation” among many others. The actions inside the local country of operations may be viewed as creating a PE where the contract was almost complete, except for the final approval, specifically where final approval of the detailed contract terms were previously cleared with headquarters.

This standard becomes very important in the financial services sector, and could increase the risks of double taxation significantly as well as the need for increased compliance and administrative costs. Further, the tax implications raised by the PE rules could require some multinational businesses to consider changes in their sales and

distribution operations to avoid changes in the tax expenses generated under the new PE rules.

BEPS Action 13

BEPS Action 13 focuses attention on transfer pricing documentation, and developing the concept of CbC reporting. Transfer pricing continues to rate among the highest concerns of tax executives at multinational businesses. U.S transfer pricing documentation continues to be an ongoing burden for companies satisfying annual documentation requirements, and an ongoing exposure area for companies hoping they have sufficient documentation available to tax examiners information requests and avoid penalties.

Likewise, tax authorities outside the U.S have stepped up their own efforts to standardize the reporting of transfer pricing documentation. BEPS Action 13 could require multinational companies, at least within the OECD group, to alter the documentation of their related party transactions so the reporting will become standardized across the member nations, simplifying the audit process and the availability of taxpayer data for the examinations. This standardized master file approach would provide tax administrations with high-level global information regarding the multinational’s business operations and transfer pricing policies. In addition, this approach will provide for more detailed local country reporting known as local files, to set forth relevant related party transactions as well as the amounts involved in the transactions and additional documentation of the transfer pricing determinations more typical of transfer pricing reports.

The summary presentation of the transfer pricing methodologies will require coordination and consistency of such methodologies from country to country, allowing the respective authorities to gain a full view of transfer pricing risk and value

www.smartdevine.com 4

creation. Combined with the CbC reporting the master and local files will provide tax authorities, in the name of tax transparency, significantly greater information they deem necessary to support their examination efforts and to preserve their home country taxable income bases.

A greater implication of the BEPS Action 13 changes is that taxpayers could be required to alter their methodologies for establishing the transfer pricing on their intercompany transactions. Based on the interplay between tax transfer pricing methodologies/requirements, multinational taxpayers’ supply-chain arrangements which includes intercompany transactions, business operations may be impacted.

Additional administrative burdens will most likely be created with the implementation of CbC reporting. The CbC report will require multinational companies to provide an annual report for each tax jurisdiction in which they do business including the amount of revenue, profit before income tax, income taxes paid, income taxes accrued, total employment, capital, retained earnings and tangible assets. Further, the multinational businesses must identify each entity within the group doing business in a particular jurisdiction and provide a summary of the business activities in which the respective entities engaged.

From a practical perspective, CbC will play a role similar to the U.S. tax return disclosures of uncertain tax positions, Schedule UTP, and the financial statement Fin 48 (ASC 740-10) reporting, which require the disclosure of uncertain tax positions. Based on the information required to be disclosed, tax authorities will have their choice of audit “triggers” to determine where audit scrutiny needs to be directed. The disclosures of local country assets, employment and revenues may also lend support to those commentators that suspect that CbC is a forerunner to the adoption

of a system of formulary apportionment to determine the respective shares of profits to which the affected member nations are entitled. While there are those who favor the certainty provided by a mathematically sound system of apportioning taxable revenues, similar to apportionment of taxable state income in the U.S., the use of such a system crossing sovereign borders may be more of a long-term objective for the present.

To meet the CbC reporting requirements, many multinational businesses will need to modify their internal accounting systems to accommodate the annual information disclosures. The disclosures may also point to the need for multinational businesses to re-evaluate where they maintain assets, as well as where workforce is justified or not justified, based on comparative local country margins and tax rates.

Prepare for change

The BEPS Action Plan discussion drafts will become final at some point in 2015. Presumably, the conclusions and recommended responses from the discussion drafts will be turned over to the OECD member nations for local consideration. Although there is a possibility for concerted remedial action and implementation of the BEPS proposals, the likelihood is that partial agreements will be reached to implement certain portions of BEPS across the OECD group. Certain countries may reject parts or all of the BEPS recommendations and enact their own rules designed to achieve the desired closure of tax gaps. In the U.S. we have already seen initial comments concerning the legality under U.S. tax confidentiality laws of distributing CbC reporting to other countries. Further, as seen with the recently enacted U.K. Diverted Profits Tax, multinational taxpayers can expect to contend with separate requirements added by unilateral action of member nations in order to implement their own views of the proposed BEPS remedial actions.

www.smartdevine.com 5

The legality of the unilateral provisions and their implications to previously negotiated tax treaty provisions may require testing before administrative or judicial tribunals.

Multinational businesses are best advised to prepare for change. They should prepare for implementation of certain BEPS requirements such as Master File, Local file and CbC reporting. While full implementation of the Action 13 recommendations may be premature until the reports are concluded and local country consideration is complete, a wait and see posture may place companies at a severe disadvantage if and when the provisions are implemented.

As to the Action 7 PE recommendations, preliminary planning to consider the comparative implications of alternative PE definitions should allow taxpayers to take initial steps in preparedness for subsequent changes. In addition, this will provide an opportunity and motivation for the review of current structures and transfer pricing documentation to test their sufficiency under current law.

BEPS may be the first step in the required change to administer a fair and simplified global system for allocating tax revenues between countries. Or, as we have seen before, BEPS could join a long list of well-intentioned attempts at achieving such goals, providing moderate victories but overall disappointment. Too soon to tell, but here’s hoping!

About the Author Doug Nakajima is a Managing Director in Smart Devine’s Tax Services Group. Doug has over 30 years of experience in federal and international tax and strategic business planning, serving a U.S. and foreign client base of multinational manufacturing,

service and technology businesses. Doug advises clients on the tax treatment of domestic and cross-border transactions, inbound and outbound business expansion strategies, domestic and cross-border acquisitions, dispositions and reorganizations, intercompany transfer pricing analysis, documentation and audit defense, treaty interpretation, and repatriation planning. He works extensively with tax advisers in foreign countries to develop global structures that minimize U.S. and foreign tax exposures.

Doug is an attorney admitted to practice in Pennsylvania and earned his B.A. from the University of Pennsylvania, and earned his J.D. and LL.M. (Taxation) from the Villanova University School of Law.

Please contact Doug for more information at dnakajima@smartdevine.com or 267.670.7307.

SMART DEVINE 1600 Market Street, 32nd floor

Philadelphia, PA 19103 267.670.7300

info@smartdevine.com www.smartdevine.com