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A Roadmap for a Tax on Base-Eroding Payments

Posted on Nov. 18, 2019

John N. Bush is a consultant on tax, finance, accounting, and legal matters affecting developing countries. He is based in New Castle, New Hampshire, and New York City.

The author would like to thank Jessie Coleman, Joseph Guttentag, and Suresh Yadav for their helpful comments during the preparation of this article. The statements made in the article are purely the author’s and do not reflect the policies of any organization he is associated with or of anyone who read and commented on earlier drafts of the article.

In this article, the author offers a roadmap for implementing the OECD’s proposed undertaxed payment rule, part of pillar 2 in the OECD’s broader plan to address the tax challenges of digitalization, with a focus on how the proposal can help developing countries.

Copyright 2019 John N. Bush. All rights reserved.

This article addresses the undertaxed payment rule (the OECD proposal) that the OECD proposed in the section of its March consultation document, “Addressing the Tax Challenges of the Digitalisation of the Economy,” focused on global anti-base-erosion (GLOBE) measures.1 The OECD proposal would deny a deduction for base-reducing payments made to a related party unless the payments were subject to a minimum effective tax rate (ETR). It is aimed at the aggressive tax avoidance practices that many multinational enterprises have employed in recent years. This article recommends that the countries involved in the inclusive framework on base erosion and profit shifting adopt a relatively simple set of rules constituting a roadmap that countries may employ in implementing the OECD proposal. This roadmap is intended to be particularly helpful to developing countries. Many developing countries are part of the inclusive framework, which includes over 130 countries to date, and these countries are likely to encourage the adoption of many of the positions taken in this article.2

To facilitate the application of the OECD proposal, it should be given priority over the income inclusion rule that the OECD also proposes in the consultation document. Further, this article develops and recommends three rules for implementing the OECD proposal. Rule A covers payments made directly to an ultimate parent company. Rule B applies to payments to an intermediate related payee company in a jurisdiction that has no business income tax (BIT)3 or a BIT with a nominal ETR. Rule C applies to all other related-party payments.

Under Rule A, payments are tested for deductibility by comparing the statutory tax rate of the parent’s resident jurisdiction with a minimum acceptable ETR. Tax deductions for Rule B payments are disallowed. Rule C payments are analyzed to see if they should be presumed to be conduit or imported arrangements. If either presumption applies, the payee must offer clear and convincing evidence of an acceptable ETR to be permitted to deduct the payments; if neither presumption applies, the payments are tested using a simple set of audit procedures to see if they incurred an acceptable ETR.

On November 8, subsequent to the writing of this article, the OECD secretariat released a public consultation document on the GLOBE proposal under pillar 2. Given when it was released, the article does not comment on the document, which, in any event, is focused on the income inclusions rule. It has little to say about the subject matter of this article, the provisions in pillar 2 relating to base-eroding payments.

I. The OECD’s GLOBE Proposal

A. The Proposal

In March the OECD released the consultation document presenting two pillars for the countries in the inclusive framework to consider. The first pillar consisted of revised profit allocation and nexus rules. These suggestions are interesting, but they are not addressed in this article. The second pillar contained the GLOBE proposal, which consisted of two parts: an income inclusion rule and the OECD proposal. Although the proposals in pillar 1 are ostensibly designed to address issues raised by the digitalization of the world’s economies, several would substantially rework many of the international tax rules — most notably, the arm’s-length transfer pricing principle — that have been in existence since the 1920s.

In late May the OECD supplemented the consultation document with a work program4 focused on addressing the problems identified in the consultation document. In October the OECD released a public consultation document proposing a unified approach to pillar 1.5

The work program lays out several questions regarding pillar 2 for consideration by commentators to the consultation document. The questions most pertinent to this article can be summarized as:

  • What are the most important design considerations for implementing the OECD proposal with a particular emphasis on reducing complexity and avoiding multijurisdictional disputes?

  • What scope of limitations should be incorporated in the recommended design?

  • How can the income inclusion rule and the OECD proposal best be coordinated?

Each of these questions is addressed in this article with a focus on design considerations.

B. Key Comments on the Proposal

The OECD solicited comments on both pillars 1 and 2. Because of the broad reach of the consultation document, the OECD received many comments on the two pillars. The individual comments are too numerous to analyze individually in this article, but this subsection summarizes the comments most pertinent to the OECD proposal.6

To begin with, almost all the commentators recommend that the definition of related parties be set at greater than 50 percent control rather than at 25 percent as suggested in the proposal. Otherwise, the rules would be hard to administer. It would also be difficult for affected parties to comply with the rules if an interest of only 25 percent might not be sufficient to allow the person making a payment to obtain information on how a base-reducing payment is taxed.

The OECD also received many comments on the priority of the income inclusion and OECD proposals. A good number suggested that they move forward together. Some recommended that the income inclusion rule take priority, with the OECD proposal being viewed as a backstop. And others favored giving priority to the OECD proposal.

Many also noted the complexity of measuring the ETR on a base-reducing payment. It was viewed as being particularly difficult if the tax imposed on a parent company under the income inclusion rule or a controlled foreign corporation regime was to be taken into account. Also, some commentators said that making ETR calculations on a separate transaction basis would cause needless difficulty. Several commentators focused on the sources for measuring the ETR with suggestions including the statutory tax rate of the recipient jurisdiction, the ETR of the payee company on its tax return, and the ETR on the payee company’s financial statement. A number of commentators noted that the ETR measurement had to consider the treatment of losses and special tax regimes, such as patent boxes. Oxfam made the helpful suggestion that two lists be prepared: one list identifying countries with acceptable minimum tax regimes and one listing countries that fail that test. To limit the reach of the OECD proposal, some commentators proposed netting similar payments (inbound and outbound) between related parties, and others suggested setting a size limit for payments that need to be analyzed and excluding payments made in the ordinary course of business, such as payments reflected in the cost of goods sold.

Many of the comments that were made have been incorporated in one fashion or another in this article.

II. The BEAT and Similar Proposals

The minimum tax imposed as part of the Tax Cuts and Jobs Act, the base erosion and antiabuse tax, is somewhat analogous to the OECD proposal and likely has given some impetus to the OECD proposal suggestion.

Briefly, the BEAT is an alternative minimum tax that is applied by adding specified tax-deductible payments made to related foreign persons — such as payments for services, interest, and royalties, as well as charges properly embedded in the cost of goods sold — back to taxable income. The BEAT only applies to large groups, specifically those with average annual gross receipts that exceed $500 million for the previous three years. To trigger its application, base erosion payments must comprise 3 percent or more of the taxpayer’s deductions. The tax is calculated on 10 percent of “modified taxable income” less the regular tax liability. The tax rate started at 5 percent in 2018 and will ratchet up to 12.5 percent in 2025.

Mexico recently proposed similar legislation that would deny a tax deduction to a foreign entity paying tax at a rate less than 75 percent of the ETR applicable under Mexican law.7 In September 2019 the Dutch also proposed a conditional withholding tax on interest and royalty payments made to affiliated companies in jurisdictions with a BIT of less than 9 percent.8

The BEAT acts to disallow excess deductions attributable to deductible payments made to related parties. The OECD proposal would act to disallow deductions for base-eroding payments that incur a low rate of tax when made to related parties. The two are somewhat analogous, acting in a different fashion to accomplish a common goal — protecting the tax base of the payer company’s jurisdiction. Unlike the BEAT, the Mexican and Dutch proposals are very similar to the OECD proposal in that they disallow a deduction or impose a withholding tax on base-eroding payments.

III. Roadmap for Implementation

This section provides a detailed analysis of the OECD proposal, creating a set of rules that countries can use to implement it, with a focus on workable rules for developing countries. While the suggested rules for the OECD proposal may initially appear to be complicated, they should not be difficult to administer in practice.

A. Giving Countries Flexibility

MNEs have used a variety of techniques to diminish the tax bases of many countries over the past few decades, including many developing countries. No single device can be relied upon to solve this problem. Accordingly, countries should be allowed to choose from several options to address it:

  • disallowing deductions under the OECD proposal;

  • employing withholding taxes;

  • using the “subject to tax” rule to limit the untoward effects of double tax agreements;9

  • setting limits on deductions (as was done for interest under BEPS action 4); or

  • some combination of these.

The choice between these different methods will depend on the facts and circumstance relevant to each country and to the problem being addressed. Some developing countries will weigh the benefit of these measures against the possible loss of inbound investments if they are adopted. The discussion that follows focuses on the OECD proposal choice.

B. Priority Versus the Income Inclusion Rule

As a preliminary matter, the inclusive framework must decide whether the proposal or the income inclusion rule should take priority. The decision here is complicated by the fact that the details of both rules have yet to be decided.

Some commentators (including KPMG) suggest that the income inclusion rule be given priority, and the OECD proposal should simply be a backstop to the inclusion rule. However, this article recommends that the OECD proposal take precedence over the income inclusion rule for three reasons.

First, according to the consultation document, the goal of the proposal is to allow a “source jurisdiction to protect itself from the risk of base eroding payments.” The income inclusion rule might discourage tax avoidance techniques and thus indirectly bring about the end of abusive base eroding payments, but the proposal will accomplish this result directly. Further, it appears that the income inclusion rule is likely to offer the most benefit to large, developed countries and not the bulk of the other countries in the world. Arguably, the rule might facilitate an increase in the tax rates of developing countries up to the minimum tax rate in the rule, but many of these countries already have relatively high tax rates. The difficulty they face is in collecting the taxes owed. Second, giving precedence to the OECD proposal will greatly ease the administration of the rules under the proposal by eliminating the need to perform the difficult task of tracing taxes that an intermediate or ultimate parent company pays when determining the ETR for a particular base-reducing payment. Third, it should be relatively easy to take the additional taxes that payer jurisdictions may collect under the OECD proposal into account when administering the income inclusion rule, thus satisfying, in part, the goal of reaching the established minimum tax rate.

It is true that the OECD proposal could serve a backstop function if the income inclusion rule is adopted and given priority because the proposal could apply to any jurisdiction that has not adopted the income inclusion rule and to industries exempt from its application. But this backstop function would be less helpful to developing countries — the countries most likely to benefit from the OECD proposal — since they would lose out on the additional revenue it generates. If the income inclusion rule is not adopted, the additional taxes paid under the OECD proposal can be taken into account if a parent company is in a jurisdiction that has CFC taxation rules or if a jurisdiction taxes dividends and allows a credit for any underlying foreign taxes.

While the OECD proposal should be given priority over the income inclusion rule, the OECD proposal can also stand by itself without the supporting rule. Indeed, given its likely favorable effect, its adoption should move forward regardless of whether the income inclusion rule is adopted. The OECD proposal can be easily established under a convention that the inclusive framework adopts, and any country wishing to implement it could do so without the need for universal implementation.

C. Defining Covered Relationships

The consultation document and work program suggest that a 25 percent relationship between payer company and payee company should be sufficient to trigger the analysis called for by the proposal. That standard might make it difficult for many payer companies to comply with the proposal since they may not have ready access to the records needed to do so. Moreover, base-reducing payments are typically not made to noncontrolled third parties. For this reason, a degree of relationship of more than 50 percent in vote or value — that is, a controlling interest — is suggested.

D. Determining Which Payments to Cover

The following rules should be used to limit the payments subject to analysis:

  • All the base-reducing payments made by a payer company to a payee company should be grouped together when analyzing whether they run afoul of the OECD proposal.

  • A de minimis exemption for base-reducing payments that constitute (in total) less than 5 percent of the gross income of the payer company should apply. This test should be applied to each related group of payee companies. The 5 percent measure is often used to determine materiality for financial accounting purposes and should serve a similar purpose here, eliminating small payments from analysis. Further, a de minimis exemption for small payer companies — perhaps those with gross revenue of less than $50 million annually on a consolidated basis — should be adopted.

  • Two types of payments should be excluded from the OECD proposal’s scope. First, dividend payments should be excluded because they are made using after-tax income and are not true base-reducing payments. Second, charges for the cost of goods sold in the ordinary course of business to a related party should be excluded. While these two categories warrant mention now, others may be added in the future.

  • The netting of closely related inbound and outbound payments to the same related payee company should be allowed so that the tested payment is the resulting net amount. For example, “due to” and “due from” intercompany accounts should be netted.

E. Determining ETR and Cash Equivalence

In June 2019 the U.S. Treasury released proposed regulations (REG-101828-19) on the high-tax exclusion from the TCJA’s global intangible low-taxed income provision.10 Under the exclusion, shareholders of CFCs potentially subject to the GILTI tax will escape the tax if the CFC in question suffers a tax equal to 90 percent of the 21 percent GILTI tax rate. While the proposed regulations are probably more complex than most countries would wish to promulgate, they provide a useful point of departure for the determination of the ETR under the OECD proposal.

1. Source Rule for Determining the ETR

There are four methods for determining ETRs that could be employed for use with the OECD proposal. They are:

  • determining the ETR using the BIT rules of the payer company’s jurisdiction;

  • determining the ETR using the BIT rules of the payee company’s jurisdiction;

  • relying on the financial statement ETR of the payee company; and

  • relying on the management accounts of the payee company that reflect the ETR of the business line receiving the base-reducing payment.

While a good case can be made for each option, the first choice is adopted here because it determines the ETR calculations under the laws of the country being disadvantaged by the payment. This puts the burden on the payer company to produce evidence of the payee company’s ETR for the base-reducing payments, but this should not be an unfair burden because the companies are commonly controlled. The payer jurisdiction law will also be familiar to the payer jurisdiction tax authorities who will be responsible for auditing the base-reducing payments.

Accounting statements contain useful information, but they are not recommended as the primary source here because they are produced using accounting standards, not tax rules,11 and they may not be available in reliable form. The management reports are not recommended because they are not produced under standardized rules and may not reflect the information needed about the payee company in isolation. Also, management reports are designed for internal decision-making and typically are not intended to reflect the income of a particular payee company.12 Even though the financial information of the payee company should not be the primary source for determining if a base-reducing payment has suffered tax at an appropriate level, evidence from the financial statements and management reports can be used to support the analysis being made.

2. Business Unit to Be Evaluated

Under the proposed GILTI regulations, the U.S. Treasury considered three possibilities regarding the taxable unit to use for the ETR calculation:

  • each specific item;

  • a CFC-by-CFC basis; or

  • each relevant qualified business unit.

Treasury settled on the last choice. It dismissed the first as too complicated and the second as likely to lead to a misleading blending of low-taxed income with high-taxed income. Therefore, by process of elimination, it settled on the last alternative.

In the case of the OECD proposal, however, the second alternative is a better choice. While Treasury’s concern about the second choice is a real one, in most instances, the tax planning behind low-taxed base-reducing payments aims to create a pool of low-taxed earnings in a CFC to enhance publicly reported income.13 MNEs are unlikely to spoil this objective by mixing high-taxed and low-taxed earnings together in one CFC. Hence, the second choice makes the most sense here.

3. Setting the Minimum Acceptable Tax Rate

The minimum acceptable ETR (the low ETR) should be a specified percentage of the BIT rate of the payer country. An acceptable percentage would be between 60 percent of BIT — the figure the OECD uses in the commentary on article 1 of its model treaty to define a material reduction of tax — and 80 percent to allow for possible timing and minor permanent differences in the recognition of income between the payer and payee jurisdictions. The payer jurisdiction should have discretion to select the appropriate percentage.

If, however, an income inclusion rule is universally adopted and given priority over the OECD proposal, then the minimum tax top-up rate under that rule should also be used to set the low ETR for companies subject to the OECD proposal. Alternatively, if the inclusive framework establishes a universal low ETR measurement for the OECD proposal, then all jurisdictions that adopt the proposal should use that rate.

4. The Actual ETR and Its Cash Equivalent

An analogy with U.S. tax law is also useful here. Under subpart F (now largely undercut by the TCJA), the parent company determines the tax to be imposed on CFC earnings subject to subpart F taxation using U.S. tax principles to determine the amount of the earnings and any foreign taxes that may give rise to foreign tax credits.14 With the OECD proposal, the payer company can be seen as being in roughly the same tax position as the U.S. parent shareholder under subpart F.

Using the subpart F rules as a point of departure, the ETR on the base-reducing payments in question should be determined in two steps.

First, the taxable income of the payee company should be calculated under the law of the payer country using a simple pro forma tax return — or a schedule designed to produce the same outcome — from the payer country. A hypothetical tax should be determined on this income, again using the payer country’s law. The hypothetical tax should be multiplied by the percentage set in the preceding section to produce the minimum cash tax that the payee company must have paid to its country of residence to satisfy the low ETR as required under the OECD proposal (the test tax).

Next, the test tax should be compared with the actual tax the payee company paid to see if it matches or exceeds the minimum acceptable tax. If it does not, then the deduction for the base-reducing payment should be denied. If desired for analytical purposes, the test tax can be converted into a percentage rate simply by dividing it by the pretax income on the pro forma tax return.

F. Three Simplifying Rules

Three simplifying rules — previewed in the introduction to this article — can help facilitate the analysis under the OECD proposal. The rules are:

  • Rule A — Rule A covers payments that the payee company makes directly to its ultimate parent corporation. If the parent company’s residence jurisdiction either does not have a BIT or has a statutory tax rate below the low ETR, the tax deduction for these payments should be disallowed. On the other hand, if the statutory tax rate of the parent company equals or exceeds the low ETR, a deduction for it should be allowed.

  • Rule B — Rule B covers all payments made to an intermediate payee company in a jurisdiction that has no BIT or has a BIT with a statutory tax rate below the low ETR. The deduction for payments made to these companies should be disallowed.

  • Rule C — Rule C covers all payments to an intermediate related payee company with a statutory tax rate equal to or greater than the low ETR. First, these payments should be tested to determine if they were made as part of a suspected conduit or imported arrangement. If so suspected, the rules in Section III.G.3 should be applied. If not, the rules in Section III.G.2 should be followed.

Rule A is useful because very few holding companies enter directly into schemes to reduce the group’s ETR. Moreover, while some tax-reducing schemes involve independent third parties, their role in a tax planning scheme is usually ephemeral and typically takes place below the level of the parent company. In the few cases when the parent company is directly involved in a tax-reducing scheme, a special antiavoidance rule (SAAR) should suffice to limit the benefits associated with the scheme.

In contrast, subsidiaries of a holding company are the mainstays in tax planning. Therefore, this article focuses on how to evaluate base-reducing payments between related-party subsidiaries.

G. Auditing the ETR for Rule C Payments

This analysis of Rule C and the process of auditing the ETR of potentially suspect base-reducing payments is broken into three parts. The first part examines, in greater detail, the burden of proof in the determination of the ETR on a base-reducing payment. The second part sets out the evidence needed and the process used to audit the ETR of base-reducing payments. The third part articulates a special rule for suspected conduit and imported arrangements.

1. Burden of Proof

Assuming the greater than 50 percent control test is adopted, the payer company and the payee company will be under common control and should collectively be able to provide the information necessary to prove the ETR on their related-party payments, as set forth in the next subsection. Moreover, almost without exception, MNEs as part of their management accounting know the ETRs of their various lines of business and the determinative factors — such as base-reducing payments — that give rise to these rates. In most tax systems, the burden of fulfilling tax-filing requirements falls directly on the subject taxpayers. Therefore, both the burden of producing relevant evidence and the burden of ultimately proving an ETR for purposes of applying the OECD proposal should fall on the MNE.

In some cases, the government can reinforce the burden of proof by including it in concession agreements granted to companies engaged in the extractive industry business.

If the burden of proof for establishing the ETR on a base-reducing payment is not satisfied, the tax deduction for the payment should be disallowed.

2. The Required Evidence

By definition, the base-reducing payments covered by Rule C are made to an entity in a jurisdiction with a BIT that has a statutory rate equal to or above the low ETR. With this starting point, the payer company should be required to produce the following records for any tax year during which a base-reducing payment has been made:

i) A schedule showing (a) the amount of base-reducing payments made to each related person and (b) the calculation of the test tax and the ETR of the payee company for the year in which the base-reducing payments were received plus, if requested, the underlying records used to prepare this schedule.

ii) A corporate organization chart showing the payer and payee companies plus each person in the legal chain of ownership up to and including the persons that hold the ultimate controlling interest in the payer and payee companies. Any hybrid entity included on the chart should be described as such.

iii) A corporate organization chart showing all material transactions between the payer and payee companies and any related persons (as defined by having a common controlling interest), including a description of any hybrid instrument. A transaction is material if it equals or exceeds 5 percent of the base-reducing payments between the payer and payee companies.

iv) Copies of the actual tax returns of the payee companies as filed in their respective jurisdictions, and, if requested, the underlying records used to produce these returns.

v) The audited financial statements of the payer and payee companies and any persons involved in suspected conduit or imported arrangements and, if requested, the underlying records used to produce the statements.

vi) The management report reflecting the ETR of the business line of the payee company that covers the related-party payment (if such a report exists) and, if requested, the underlying records showing the computation of this rate.

vii) The computation (described in the next section) that indicates whether the base-reducing payment is part of a suspect conduit or imported regime plus, if requested, the underlying records used to calculate it.

viii) The country-by-country reports reflecting information pertinent to the ETR analysis. These reports will be particularly important if the regulations regarding how they are prepared are amended to account for the rules on base-reducing payments.

If any of these documents are in a language foreign to the payer jurisdiction, they should be translated into the payer jurisdiction’s language.

3. The Auditing Process

With these materials, the authorities of the payer company’s jurisdiction should find the following audit steps relatively straightforward.

The audit should begin with an examination of the schedule (from point i) above) showing the test tax and the payee company’s ETR. If necessary, the test tax figure should be corrected to ensure that it complies with the payer company’s tax law. Next, the tax return that the payee company filed in its resident jurisdiction should be reviewed to identify the tax it paid for the year in which the base-reducing payments were received to confirm that the figures on the schedule are accurate. Finally, the tax figure and ETR reflected on the payee company’s financial statements and management reports, if any, for the relevant line of business should be noted.

The figures on the payee company’s tax return and financial reports should be checked against the test tax figure as corrected (if corrections were needed) and the figures on the schedule. If these figures come reasonably closer to matching, no further analysis should be necessary, and a deduction should be allowed for the payments in question. If, for any reason, the analysis does not produce a satisfactory result, the tax deduction for the base-reducing payment should be disallowed unless the payer company produces clear and convincing evidence showing that the payments suffered a tax rate equal to or exceeding the low ETR.

Once an audit confirms that a payee company’s ETR is above the low ETR, the analysis in future years should be confined to determining whether there has been any material change in the facts and circumstances surrounding the payee company and how it computes its taxes. If not, no further analysis would be needed for those years.

4. Suspected Arrangements

Countries should subject suspected conduit or imported arrangements to a rebuttable denial of a deduction for the payment.

A conduit arrangement should be presumed to exist when the payee company makes payments to (or has transactions with) a related party that give rise to tax deductions exceeding a set percentage of its earnings before interest, tax, depreciation, and amortization. Notably, the final report on action 4 of the BEPS project disallows interest deductions that exceed a set percentage of EBITDA; the OECD allows each jurisdiction to select a limit of between 10 and 30 percent. Similarly, the rule for presuming a conduit scheme exists should apply when the base-reducing payments exceed a threshold between 10 and 30 percent of EBITDA, and the paying company’s jurisdiction should be able to set the specific percentage.

An imported arrangement should be presumed to exist if any hybrid entities or hybrid instruments appear in the charts included in the payer company’s information package. The final report on action 2 of the BEPS project directs participating countries to eliminate multiple forms of hybrid arrangements — and, over time, this should occur. Nevertheless, some hybrid arrangements may still exist, so the OECD proposal should include a rule addressing them. The following example illustrates an imported arrangement and its relationship to a hybrid instrument:

Example. Parent Company in Country X advances money to Subsidiary A in Country Y using a hybrid instrument. Country Y treats the advance as a loan and allows Subsidiary A to deduct the interest. Meanwhile, Country X treats the advance as a form of equity and does not tax the payments made on the advance, instead treating them as exempt dividends under its tax law.

Subsidiary A advances the same funds to Project Company in Country Z. Under Country Z’s law, Project Company is allowed a tax deduction for its payments to Subsidiary A. Country Y treats the payments to Subsidiary A as taxable, but Subsidiary A has very little taxable income to report because it is paying interest to Parent Company.

Thus, the tax savings generated by the hybrid instrument are “imported” into the Project Company’s residence, Country Z.

In the case of conduit or hybrid arrangements, the payer company should be allowed to rebut the presumption of tax avoidance by presenting clear and convincing evidence that the arrangement either does not exist or, if it does exist, that it does not materially reduce the payer company’s tax base. If the payer company fulfills this requirement, then the normal rules that test for a low ETR apply. Absent such proof, the deduction for the base-reducing payments should be disallowed or a withholding tax imposed on them — another decision that, in line with the flexibility noted above, should be left to the discretion of the payer company’s jurisdiction.

H. Supporting Evidence

1. Evidence on Financial Statements

A review of the internationally recognized standards for producing audited financial statements may help demonstrate how they can provide useful information on ETRs.

In the United States, these standards are set out in generally accepted accounting principles and specific tax provisions contained in Accounting Standards Codified (ASC) paragraph 740.15 Other countries rely on the International Financial Reporting Standards, with specific tax provisions appearing in International Accounting Standard No. 12. For the most part, the provisions relevant to the instant analysis are the same in the United States and elsewhere.

Financial accounting for taxes has two main purposes, namely:

  • to recognize the amount of taxes payable for a given year; and

  • to recognize deferred tax assets and liabilities — that is, the future tax consequences of events reported in the statements.

The accounting standards also require a reconciliation between the reporting company’s actual ETRs and statutory tax rates. The tax rate reconciliation provision for U.S. GAAP, ASC paragraph 740-10-50-12, states:

A public entity shall disclose a reconciliation using percentages or dollar amounts of the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations. . . . The estimated amount and the nature of each significant reconciling item shall be disclosed.

The SEC rate reconciliation rules for public companies are found in SEC regulation rule
4-08(h)(2). That regulation provides that all reconciling items that constitute 5 percent or more of the computed tax amount — that is, income before tax multiplied by the domestic federal statutory rate — should be separately disclosed. Unlike public entities, nonpublic entities are not required to provide a full reconciliation for their ETRs — but they often do so anyway.

In examining financial reports, an auditor should expect to find several key pieces of information. The income statement will contain the total tax provision, including both current and deferred taxes. The cash flow statement will show the cash taxes paid. The balance sheet will include the deferred tax assets and liabilities, enabling the auditor to determine changes in these accounts between the current and preceding year. These changes can be helpful as a way of deducing current taxes paid. The tax footnote will break out the difference between current and deferred taxes. It will also show a reconciliation between the statutory tax rate of the parent’s resident country and the company’s actual ETR. Sometimes, the reconciliation will also reference the statutory tax rate in other jurisdictions where the MNE conducts major operations. Typically, the ETR in percentage terms is given in either the management discussion of operations or the tax footnote.

The difficulty in simply relying on the information in financial reports to determine whether an acceptable rate of tax has been paid is that the reports for the payee company standing alone may not exist, and the information in the parent company’s consolidated report may shed little information on a particular subsidiary. Even if separate subsidiary reports exist, they may be less than reliable and may not be independently audited. Unfortunately, this may also be the case with financial reports that companies submit with tax returns. Also, accounting rules and tax rules differ in ways that are not always obvious. Still, despite these concerns, information in financial reports can be quite useful to an auditor trying to judge the rate of tax suffered on base-reducing payments.

How do the U.S. GAAP and IFRS rules play out in the public disclosure of MNEs that have extensive overseas operations? To get a sense of the detail included in ETR disclosures made on a consolidated financial reporting basis, consider the 2018 tax disclosures of Rio Tinto, an MNE with large-scale international mining operations. It is also a member of the B Team16 — a group of MNEs that has embraced responsible corporate tax principles including a commitment to transparency in tax affairs. Thus, Rio Tinto’s tax disclosures are fairly extensive, probably more so than many similarly situated MNEs. In addition to the tax information on its annual financial statements, the company issues an annual public tax statement that sets forth, in some detail, pertinent tax information. This statement appears to be made, at least in part, to satisfy the U.K. law requiring major public companies — those with revenue in excess of £200 million and a balance sheet with assets in excess of £2 billion — to publicly disclose their tax strategy.17

In the financial review section of its 2018 report, Rio Tinto states that its worldwide ETR is 29 percent. Its income statement includes a “taxation” line item of $4.242 billion. On its cash flow statement, it lists “tax paid” as $3.602 billion. However, these figures probably include several other types of taxes in addition to income taxes. Consequently, they may not be helpful in figuring out Rio Tinto’s ETR. Between 2017 and 2018, Rio Tinto’s net deferred tax liability as shown on its balance sheet increased by $303 million, indicating that it deferred paying this amount of income tax on its income in 2018. The company does offer some detail to reconcile the U.K. statutory rate (where the parent company is resident) of 19 percent with its actual ETR, suggesting that the major factor was the 30.7 percent tax rate on its large Australian operations. In its separate 2018 annual tax statement, Rio Tinto states that its “group effective corporate income tax rate on underlying earnings” is 28.4 percent. The bottom line: This analysis suggests that there is considerable evidence that any base-reducing payment made between Rio Tinto subsidiaries would probably have suffered a tax somewhere in the range between 20 and 30 percent.

This example illustrates the value of financial statement information. If the same type of information is disclosed on the financial statements of Rio Tinto’s operating subsidiary, it would be even more valuable.

2. Evidence on CbC Reports

Under BEPS action 13, MNEs must create a master file, a local file, and, for MNEs with gross revenue equal to or greater than €750 million, a CbC report. The master file contains five sections:

  • the organizational structure of the MNE;

  • a description of the MNE’s businesses and business strategies;

  • a description of any intangible assets and how the MNE exploits those assets;

  • a list of the MNE’s financial activities between related parties; and

  • the MNE’s financial statements, along with an explanation of its tax positions.

The local file mimics the master file, but the information is confined to local activities. The CbC report asks for jurisdiction-by-jurisdiction information on pretax income, taxes paid and accrued, stated capital, the number of employees, tangible assets, and lines of business. The local and master reports must be filed in or otherwise made available to each jurisdiction in which the MNE engages in business. The MNE must file the CbC report in the parent company’s residence jurisdiction, which will share it with local governments under proper confidentiality procedures. The CbC reports are not made available to the public.

Much of the information in these reports is the same as the information that this article has suggested be made available for an evaluation of an MNE’s ETR. However, only large enterprises must create a CbC report — which may contain the most valuable information — and, thus, it may not be available for use in many cases. Moreover, the information that must be produced is not intended to be used for the specific purpose of determining the ETR realized on base-reducing payments. If the OECD proposal is put into effect, the OECD should modify action 13 to ask MNEs to produce specific information on the ETRs on base-reducing payments. Properly produced, this information would obviate the need for a more detailed analysis of the relevant ETR.

3. Evidence on Management Reports

Management reporting is one of the most important devices driving management behavior in a company. As discussed previously, there is no single accounting standard prescribed for the preparation of these reports, and the types of reports differ considerably from enterprise to enterprise. Regardless, most businesses will create management reports along their various lines of business. Management reports may break out these lines of business on a worldwide or a regional basis. Often they will not show the figures on a stand-alone basis for the payee company. The level of detail of these reports will determine their usefulness as evidence of the ETR on a base-reducing payment.

In many cases, as part of a tax planning exercise, an MNE will structure a base-reducing payment to achieve a specific ETR on the payment. When this occurs, the MNE will often check the projected ETR against the actual ETR that is realized once the structure is in operation. If this information exists, it will provide direct evidence of the ETR on the base-reducing payment, and this information should be checked against the other ETR information.

I. Use of Lists

A set list of jurisdictions that have acceptable BIT systems with tax rates set in excess of the low ETR could greatly simplify the process of determining the ETR on base-reducing payments. The best source of information for producing such a list would be the inclusive framework. It could use a system like the one the Global Forum on Exchange of Information and Transparency for Tax Purposes uses to judge whether jurisdictions are in conformity with the exchange of information on request and automatic exchange of information requirements.

If the inclusive framework does not create such a list, regional groups, such as the African Tax Administration Forum, or individual countries could create them.

J. Special Cases

In the submissions that the OECD received on its digital tax initiative, several commentators raised concerns about the treatment of losses and the treatment of special tax regimes, such as patent boxes. These areas are analyzed in the following subsections.

1. Losses

The treatment of losses, both in the year incurred and in the carryforward year (if allowed), presents theoretical and practical problems. If a payer country denies a deduction to a resident company on a base-reducing payment because the recipient company is not paying any tax because it incurred a loss, the group will suffer double tax on its income when the loss has been fully utilized. A simple example will illustrate:

Example. Assume a group with Parent Company resident in Country A, Subsidiary Company X resident in Country B, and sister Subsidiary Company Y resident in Country C. All three countries have a BIT with a tax rate of 30 percent. Country A does not impose a BIT on the operation of foreign subsidiaries.

In year 1, Company X has gross income of 100 and it claims a deduction for a payment of 50 to Company Y, leaving Company X with taxable income of 50. Company Y has a loss of 100 without taking into account the 50 payment from Company X, and it has a loss of 50 after taking the payment into account.

In year 2, Company X has no net income, and Company Y has net income of 50, offset by the loss carryforward of 50.

In total, the group has net income of 50 over two years. Collectively, it should pay a tax of 15. However, if Country B denies Company X a deduction for its payment to Company Y, then the group will pay a tax of 30.

The treatment of losses presents three questions:

  • What law should be used when evaluating whether a deduction should be allowed?

  • Does the relevant law allow a loss deduction carryforward?

  • If so, when should the loss be deductible?

On the first issue, the law of the payer jurisdiction should be employed because it is being used for all other purposes. Its use ensures that the rule will not discriminate between payers making domestic and cross-border payments. Further, it is familiar to the payer jurisdiction tax authorities.

As for the second issue, the payer jurisdiction should allow the deduction if its law provides for the use of loss carryforwards and the recipient company’s jurisdiction otherwise satisfies the minimum tax standards.

Finally, for ease of administration, the deduction for the base-reducing payment should be allowed in the year the payment was made, even if it wasn’t subject to tax at that time in the payee’s jurisdiction because of the payee company’s loss.

The alternative rule — one that would only allow the deduction in the year the loss is used in the payee jurisdiction — might be employed, but only if the payer jurisdiction has a practical method of tracing the use of the loss in the payee jurisdiction.

If the facts and circumstances indicate that this rule is being abused, a SAAR should be used to deny a tax deduction for any affected payment.

2. Patent Boxes and Similar Regimes

The treatment of favorable tax regimes, such as patent boxes, calls for a different result than that for the treatment of losses. Jurisdictions create these regimes to encourage the development of specific types of businesses locally. A jurisdiction’s decision to reduce taxes to generate a local benefit is acceptable as long as it satisfies the parameters set forth in the BEPS program and follows any other governing rules, such as the EU’s anti-tax-avoidance directive (2016/1164).18

However, countries — particularly developing countries — should not be required to give up their taxing rights to encourage the development of businesses in foreign — often, developed — jurisdictions.

Accordingly, unless these programs use ETRs that are greater than the applicable low ETR, a payer company’s attempt to deduct a payment to a payee company that is seeking to take advantage of one of these favorable tax regimes should be denied.

K. Adopt a SAAR

No set of rules can foresee every tax avoidance scheme or other eventuality. For example, some ultimate parent companies might find a new way to create a tax-efficient conduit arrangement. Consequently, countries should incorporate a SAAR in their OECD proposal laws. This will empower them to disallow deductions for base-reducing payments when a taxpayer or transaction is avoiding the substance of the OECD proposal laws.

IV. Impact of Double Tax Agreements

One important question is whether the OECD proposal discriminates against contracting parties in contravention of article 24(4) of most DTAs. The OECD, United States, and U.N. model tax conventions all contain the same language in article 24(4). The provision indicates that payments that an enterprise resident in one state makes to a resident of the other contracting state shall “be deductible under the same conditions as if they had been paid to a resident of the first-mentioned Contracting State.”

If this provision applies, it might appear to override any law that enacts the OECD proposal and allow a deduction for the base-eroding payment if similar payments would be deductible if made to a domestic recipient. However, a country that implements the OECD proposal might argue that it is not discriminatory because local businesses suffer a rate of tax equal to or in excess of the minimum tax under the OECD proposal. It might also argue that a newly enacted law of this nature was not captured by article 24(4) or that the new law overrides existing treaty provisions. The outcome of these arguments will depend on the laws of the countries in question, and examining the issue in detail is beyond the scope of this article.19

V. Avoiding Multijurisdictional Disputes

Absent the DTA issue discussed above, the disallowance of a deduction under the OECD proposal should not generate a multijurisdictional dispute. A nation’s tax code is firmly within each country’s national purview, and the validity of its provisions is (typically) not subject to third-party review. The most obvious exception to this rule is when a regional authority has adopted rules that the participating countries must honor, such as the various tax rules adopted by the EU.

Similarly, if a jurisdiction chooses to use withholding taxes to enforce its rule against base-eroding payments, this should not raise multijurisdictional disputes. Nonetheless, the provisions of many treaties — in particular those in article 11 dealing with interest and article 12 dealing with royalties — should be examined to see if they limit the application of a withholding tax.

Any treaty issues might be dissipated if the multilateral instrument, a tool used to foster the adoption of the BEPS action items, were amended to include the OECD proposal.

VI. Conclusion

This article offers a roadmap for implementing the OECD’s proposal for protecting countries’ tax bases against the effects of low-taxed, base-reducing payments to related parties. While the OECD has also suggested the possibility of a universal minimum tax (the income inclusion rule), the proposal for base-reducing payments is simpler and should take precedence over the income inclusion rule; its adoption is recommended regardless of whether the income inclusion rule moves forward. The OECD proposal will be a welcome addition to the BEPS rules and will help revenue authorities fight aggressive tax avoidance techniques and will prove particularly valuable to developing countries.

FOOTNOTES

1 OECD, “Addressing the Tax Challenges of the Digitalisation of the Economy — Public Consultation Document” (Mar. 2019) (hereinafter, “the consultation document”).

2 See, e.g., African Tax Administration Forum, “ATAF’s Opinion on the Inclusive Framework Pillar One (Including the Unified Approach) and Pillar Two Proposals to Address the Tax Challenges Arising From the Digitalisation of the Economy” (Oct. 2019). No solicitation was sought by the author from any developing country in preparing this article.

3 This article refers to the BIT, rather than a corporate income tax because some businesses in payer jurisdictions may not be operating in corporate form. The BIT includes corporate taxes and any other form of income tax on businesses. This article also uses the term “company” instead of corporation to encompass any form of business enterprise.

6 OECD, “Comments Received on Addressing the Tax Challenges of the Digitalisation of the Economy — Public Consultation Document” (Mar. 2019). Of particular relevance to this article are the comments made by KPMG; Oxfam; Skadden, Arps, Slate, Meagher, & Flom; and the United States Council for International Business.

7 See proposed amendment to article 28, Para. XXIII of the Mexican income tax law. See also Koen van ’t Hek and Terri Grosselin, “Mexican Economic Package Targets BEPS and Digital Economy,” Tax Notes Int’l, Oct. 14, 2019, p. 149; and PwC, “Mexico Tax Reform Would Deny Deductibility of Payments to Preferred Tax Regimes” (Oct. 7, 2019).

8 See proposed Withholding Tax Act to the Netherlands tax law. See also Teri Sprackland, “Dutch Budget Slows Corporate Cuts, Contains New Withholding Tax,” Tax Notes Int’l, Sept. 23, 2019, p. 1306; and Baker McKenzie, “Introduction of New Withholding Tax on Interest and Royalty Payments to Specific Low Tax Jurisdictions,” Client Alert (Sept. 2019).

9 The subject-to-tax rule would subject low-taxed payments to withholding or other taxes at source and deny treaty benefits under several articles of the OECD model tax convention.

10 Prop. reg. section 1.951A-2.

11 For example, under the accounting rules in GAAP set out in Accounting Standards Update No. 2016-13, currently expected credit losses (the CECL standard) on many financial assets must be deducted against income when the assets are acquired and thereafter while holding them, while most tax regimes only allow tax deductions for credit losses when realized. Although the consolidated financial statements of an MNE may ultimately be adopted to make the calculations under the income inclusion rule, this should not mandate their use for the proposal.

12 For a thorough examination of the principles and uses of cost accounting, see Srikant Datar and Madhav Rajan, Horngren’s Cost Accounting: A Managerial Emphasis (2018).

13 APB 23 (codified as ASC 740-10-25-3) provides that, absent tax law provisions that would subject foreign subsidiary earnings to immediate U.S. tax, such earnings indefinitely invested only need to be reported in financial statements as suffering the relevant foreign tax. Before the TCJA, many MNEs reported substantial sums of foreign earnings under APB 23, accounting for the low ETRs on these earnings.

14 See reg. sections 1.952-1 et seq. and 1.954-1 et seq.

15 A detailed description of the U.S. GAAP tax accounting rules can be found in KPMG, “Accounting for Income Taxes: Handbook” (Oct. 2019).

16 See The B Team, “A New Bar for Responsible Tax” (Feb. 2018).

17 See HMRC, “Publish Your Large Business Tax Strategy” (last updated June 22, 2018). Australia encourages businesses to voluntarily disclose their tax strategy. See Australian Taxation Office, “Voluntary Tax Transparency Code” (Aug. 10, 2016).

18 For information on the anti-tax-avoidance directive and related guidance see European Commission, Taxation and Customs Union, “The Anti Tax Avoidance Directive.”

19 For further discussion of the DTA issues, see H. David Rosenbloom and Fadi Shaheen, “The BEAT and the Treaties,” Tax Notes Int’l, Oct. 1, 2018, p. 53; Reuven S. Avi-Yonah, “Beat It: Tax Reform and Tax Treaties,” University of Michigan Law & Economics Working Papers (Jan. 8, 2018); and Troy Ware, “The BEAT and Bilateral Tax Treaties: Where Might the Tension Lead?” 37(3) ABA Tax Times (May 25, 2018).

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