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OECD Forum to Scrutinize Tax Havens’ Substance Requirements

Posted on Nov. 19, 2018

In an effort to treat zero-tax jurisdictions and preferential tax regimes consistently, the OECD Forum on Harmful Tax Practices (FHTP) will begin reviewing both under the “substantial activities” factor previously applied only to preferential regimes.

According to a November 15 report released by the OECD, the FHTP will resume application of the substantial activities requirement adopted in the base erosion and profit-shifting project’s report on action 5 (countering harmful tax practices) to jurisdictions with no corporate tax or only a nominal corporate tax. The move is necessary to address the inconsistency in the FHTP’s approach to jurisdictions that offer preferential treatment for a particular type of income and jurisdictions that impose no significant tax on corporate income at all, according to the report. It notes that participants in the BEPS inclusive framework are committed to abolishing or amending any preferential tax regime that does not meet the substantial activities requirement, but no corresponding requirement applies for zero-tax jurisdictions.

“If the [preferential] regime is being amended, this includes the addition of substantial activities requirements. At the same time, similar international business company laws apply in [no-tax] or only nominal tax jurisdictions, but based on the current application of the criteria, the inclusive framework would not ask for the same amendments or abolition of the corresponding legislation,” the report says. “It has been argued that this may even increase the pressure on taxing jurisdictions with low rates of corporate income tax to consider abolishing them — possibly triggering a race to the bottom that the FHTP was created to address.”

Members of the inclusive framework are bound to comply with the BEPS project’s four minimum standards, one of which is set out in the action 5 report. Although the 2015 report focuses on the “nexus approach” for intellectual property regimes, the action 5 minimum standard requires that all preferential regimes impose a substantial activity condition that links qualifying income with the core activities that generate the income. The FHTP will now begin applying the same standard to jurisdictions that do not tax corporate income or tax it at a nominal rate, according to the report.

The standard would apply to jurisdictions that impose no significant corporate income tax and would require a substantial activities condition for geographically mobile income, including IP income and financial income. It would also require ongoing monitoring by the jurisdiction and “enhanced spontaneous information exchange” with other jurisdictions, according to the report. Passive activities are categorically excluded, the report says.

“At the outset, in all cases, the substantial activities requirements for IP income would always be insufficient if the entity only passively held IP assets, which had been created and exploited on the basis of decisions made and activities performed outside of the jurisdiction,” according to the report. “Similarly, the test would never be met if the only activities contributing to the income were the periodic decisions of nonresident board members in the jurisdiction.”

The report says jurisdictions will need to ensure that the relevant core activities take place locally and are supported by an adequate amount of operating expenditures and qualified employees. For high-risk scenarios involving related-party IP transfers or cost-sharing arrangements, income from patents and similar assets must be supported by research and development activities and income from trademarks and other marketing intangibles must be supported by branding, marketing, and distribution activities unless the entity can establish that other types of core activities take place within a jurisdiction. These conditions would apply regardless of how much profit would be allocated to the jurisdiction for transfer pricing purposes, the report says.

Expanding the scope of the FHTP’s review is an important step in countering profit shifting, according to Pascal Saint-Amans, director of the OECD Centre for Tax Policy and Administration.

“This new global standard means that mobile business income can no longer be parked in a zero-tax jurisdiction without the core business functions having been undertaken by the same business entity, or in the same location,” Saint-Amans said in the OECD announcement of the report’s release. “The inclusive framework’s actions will ensure that substantial activities must be performed in respect of the same types of mobile business activities, regardless of whether they take place in a preferential regime or in a [no-tax] or only nominal tax jurisdiction.”

The announcement also provides an update of the OECD’s review of individual countries’ preferential regimes. The update reflects significant progress and demonstrates “jurisdictions’ continuing resolve to ensure that tax breaks are only offered to substantive activities and only if they do not pose risks of harmful competition to others,” the announcement says.

According to the update, 18 jurisdictions have kept their commitments to abolish noncompliant regimes, including Hong Kong, Mauritius, and Spain. The only two regimes classified as harmful are France’s reduced rate for long-term capital gains and IP licensing profits and Italy’s extension of the registration deadline for its pre-BEPS regime for 6 months past the date set in the action 5 report. The update lists the U.S. foreign-derived intangible income regime as one of 17 new regimes under review.

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