Isak Roffe Senior Manager International Tax Department
[email protected] BEPS recommendations on Hybrids, CFC, & finance transactions (Actions 2, 3, 4)
BEPS WAKE UP!
1
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Agenda Action 1: Address the tax challenges of the digital economy “Gaps”
“Frictions”
“Transparency”
i. Establishing international coherence of corporate income taxation
ii. Restoring the full effects and benefits of international standards
iii. Ensuring transparency while promoting increased certainty and predictability
Action 2:
Action 6:
Action 11:
Neutralise the effects of hybrid mismatch arrangements
Prevent treaty abuse
Establish methodologies to collect and analyze data on BEPS and the actions to address it
Action 3:
Action 7:
Action 12:
Strengthen controlled foreign company (CFC) rules
Prevent the artificial avoidance of PE status
Require taxpayers to disclose their aggressive tax planning arrangements
Action 4:
Assure that transfer pricing outcomes are in line with value creation
Action 8:
Action 13:
Intangibles
Re-examine transfer pricing documentation
Limit base erosion via interest deductions and other financial payments Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance
Action 9:
Risk and capital
Action 14:
Action 10:
Make dispute resolution mechanisms more effective
Other high-risk transactions
Action 15: Develop a multilateral instrument 2 © 2015 Brightman Almagor Zohar & Co.
Interest Deductions
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Action 4: Limitation of deductions for interest expenses and other financial payments What is the Problem? • Member states are concerned with “No or low taxation associated with practices that artificially segregate taxation income from the activities that generate it” • Money is mobile and fungible – invitation for tax planning • Countries have introduced a wide range of rules to address issues of BEPS involving third party and intragroup interest. E.g. thin cap rules, general anti avoidance rules, general arm’s length principals.
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Action 4: Limitation of deductions for interest expenses Best practice Approach De Minimis Threshold
Group Ratio Rule
Fixed Ratio Rule
or Deductible interest expense up to 10%30% of the entity’s EDITDA
optional Additional deduction up to group’s net interest / EBITDA ratio.
Carry forward of disallowed interests
Targeted rules for specific BEPS Risks Specific rules for Banking and Insurance to be structured
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Action 4: Limitation of deductions for interest expenses and other financial payments • “Interest” is defined in 3 ways: o Interest on all forms of debt
o Payments that are economically equivalent to interest o Expenses incurred with the raising of finance
• Rules are intended to cover all interest expenses – related party and third party; cross-border and domestic.
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Action 4: Limitation of deductions for interest expenses and other financial payments Fixed ratio rule • Calculate tax-EBITDA for an entity o Tax-EBITDA - entity’s taxable income + tax values for its net interest expense + tax values for depreciation and amortisation
o The report emphasises that tax exempt income should not form part of tax-EBITDA o Also says that “appropriate adjustments should also be made for taxable branch profits and dividend income to the extent that they are shielded from tax by foreign tax credits….” • Apply the fixed statutory percentage to the tax-EBITDA o The best practice approach is that the fixed statutory percentage be fixed by the relevant country at some point in the “corridor” of 10% to 30% • Compare the maximum deductible net interest expense with the actual net interest expense
o If the actual net interest expense exceeds the maximum, then the excess is nondeductible © 2015 Brightman Almagor Zohar & Co.
Action 4: Limitation of deductions for interest expenses and other financial payments Group Ratio Rule • Cautionary comments regarding the group ratio rule: o The report treats the group ratio rule as optional i.e., countries are free to apply a different type of group ratio (e.g., based on the ratio of assets to equity) or indeed no group ratio rule at all o Even regarding the group ratio rule, there are several unresolved issues, such as: • How should the group’s net third party interest expense be calculated?
• How should the group’s EBITDA be calculated? • Should the group’s ratio be applied to the entity’s tax or accounting EBITDA? • the report states that a country can choose to allow an uplift of net third party interest expense of up to 10%.
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Action 4: Limitation of deductions for interest expenses and other financial payments Targeted Rules • Report recommends that countries introduce two types of so-called “targeted rules” • First type: targeted rules to prevent avoidance of the fixed ratio rule and group ratio rule • E.g.: An entity with net interest expense enters into an arrangement to reduce the net interest expense which is subject to the fixed ratio rule (by converting interest expense into a different form of deductible expense, or by converting other taxable income into a form which is economically equivalent to interest)
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Action 4: Limitation of deductions for interest expenses and other financial payments Targeted Rules (cont’d) Second type: designed to address other BEPS risks E.g.:
An entity makes an interest payment under a so-called “artificial loan”, where no new funding is raised by the entity or group An entity makes an interest payment to a related party, under a loan which is used to finance the production of exempt income An entity makes an interest payment to a related party, which is subject to no or low taxation on the corresponding interest income
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Action 4: Limitation of deductions for interest expenses and other financial payments Implementation Level: “Common Approach” - agreement on “general tax policy direction”; aspiration that they become “minimum standards” over time Regarding the start date, the report makes two statements: First: a country should “give entities reasonable time to restructure existing financing arrangements before the rules come into effect” Second: “interest on any loans entered into after the announcement of the new rules should not benefit from any transitional provisions” Further work on the detailed design and operation of the group ratio rule Specific rules to take into account features of the banking and insurance sectors
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Action 4: Limitation of deductions for interest expenses and other financial payments Implementation (cont’d) • Apart from the fixed ratio rule and the group ratio rule, a country would typically have a number of other interest deduction rules E.g.:
The hybrid mismatch rules under Action 2 General interest limitation rules (e.g. the arm’s length principle, rules which disallow a percentage of all interest expense, and thin cap rules) Targeted rules Regarding the interaction of the fixed ratio rule and the group ratio rule with all of these other interest deduction rules in a country, the report says that all of the other rules should be applied before the fixed ratio rule and the group ratio rule
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Action 4: Limitation of deductions for interest expenses and other financial payments Implementation (cont’d) • the report recommends that there be no change to a country’s existing laws in regard to withholding tax E.g.: if the existing law is that non-deductible interest payments are nevertheless subject to withholding tax, that treatment should remain the case with these new rules
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Hybrid mismatch arrangements
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Action 2: Hybrid mismatch arrangements Definition
A No Income in A Deduction in A
Treated as Equity for country A
Hybrid Instrument
Loan
C Deduction in C
Company in jurisdiction C treated as transparent for A and as non transparent for C
Equity
B Deduction in B Treated as Debt for country B
Deduction/no inclusion (D/NI) Double deduction (DD)
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Action 2: Hybrid mismatch arrangements
6 types of arrangements Deduction / no inclusion (D / NI)
Double deduction (DD)
Indirect Deduction / no inclusion (D / NI)
Hybrid financial instruments
Deductible hybrid payments
Imported mismatch arrangements
Disregarded hybrid payments
Deductible payments made by dual residents
Reverse hybrids There are structures and/or instruments that may be targeted by this action Need to analyse the structure and instrument to determine if a mismatch exists © 2015 Brightman Almagor Zohar & Co.
Action 2: Hybrid mismatch arrangements What is not a Hybrid financial instruments? non-inclusion due to another factor: Tax-exempt entity
If there is no payment under the instrument (an interest-free loan even if the payer is given a deduction for deemed interest). However, deemed payment accrual of a discount on a note, or if an interest component is recognised in the deferred purchase price for the transfer of an asset
Resident in a tax haven Its country of residence applies a territorial tax system No payment
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Action 2: Hybrid mismatch arrangements
Hybrid financial instruments (cont’d)
1 A very wide concept of “Deductible”
2 Timing Differences Irrelevant
3 Follows CFC Regime
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Action 2: Hybrid mismatch arrangements OECD recommendation Domestic Law - Withholding tax Regarding all of the 6 arrangements, the rules in the report might cause a deduction to be denied for an outbound payment If that occurs, the report emphasises that the relevant country should continue to impose withholding tax on the outbound payment, in accordance with its domestic law and consistent with its treaty obligations Treaty Action Part II focuses on treaty issues recommends the introduction of a new provision, Article 1(2), into the OECD model treaty: “For the purposes of this Convention, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State shall be considered to be income of a resident of a Contracting State but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State.” © 2015 Brightman Almagor Zohar & Co.
Action 2: Hybrid mismatch arrangements Practical considerations Level: “Common Approach” - agreement on “general tax policy direction”; aspiration that they become “minimum standards” over time The recommended primary rule is that countries deny the taxpayer’s deduction for a payment to the extent that it is not included in the taxable income of the recipient in the counterparty jurisdiction or it is also deductible in the counterparty jurisdiction. If the primary rule is not applied, then the counterparty jurisdiction can generally apply a defensive rule, requiring the deductible payment to be included in income or denying the duplicate deduction depending on the nature of the mismatch. co-ordination in the implementation and application of the hybrid mismatch rules between countries, to ensure that the rules are effective and to minimise compliance and administration costs for taxpayers and tax administrations. To this end, it sets out a common set of design principles and defined terms intended to ensure consistency in the application of the rules.
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Action 3: Strengthen CFC rules
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Action 3: Strengthen CFC rules 30 of the countries participating in the BEPS Project already have CFC rules However, existing CFC rules have often not kept pace with changes in the international business environment, and many of them have design features that do not tackle BEPS effectively The report is structured as “Best Practice” as negotiators failed to reach consensus that countries must adopt legislation on the topic in question The report itself is not materially different from the discussion draft which was released in April 2015 Means that it still contains the two major hurdles:
CFC in compliance with EU “Freedom of Establishment” (see Cadbury Schweppes case) hybrid mismatch arrangements and, in particular, the U.S. “check the box” rules are not align with CFC Rules
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Action 3: Strengthen CFC rules Seven Building Blocks
Of Note
• Definition of a CFC
• Interaction with EU law
• Threshold requirements • Definition of control
• Definition of CFCs: non-corporate entities
• Definition of CFC income
• Hybrid mismatch arrangements
• Rules for computing income
• Low-tax threshold
• Rules for attributing income
• Tax rate to apply to CFC income
• Rules to prevent or eliminate double taxation
• “Primary rule / secondary rule” framework
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Action 3: Strengthen CFC rules • Recommendations that CFCs should include: ‒ corporate entities
‒ trusts ‒ non-transparent partnerships ‒ permanent establishments (PE) where the income of the PE is exempt in the head office jurisdiction • Further recommendation for an anti-hybrid rule to prevent entities from circumventing CFC rules by use of hybrids ‒ E.g. by treating an overseas subsidiary as transparent for tax purposes, it may be possible to take advantage of a same country exception from its CFC rules
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Action 3: Strengthen CFC rules Threshold requirements • low-tax threshold based on effective tax rate • Similar to 'lower level of tax' test adopted by many jurisdictions (including Israel) • Consideration to use ‘black’ or ‘white’ lists to simplify process • For example, UK regime has both a ‘lower level of tax’ test together with a ‘white list’ via its ‘excluded territories’ exemption
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Action 3: Strengthen CFC rules Definition of control • a minimum both a legal and economic control test
• Controlled where residents hold more than 50% ‒ with individual jurisdictions free to lower their control below 50% • Control to be aggregated through interests of related parties, unrelated resident parties or interests of any taxpayers that are found to be ‘acting in concert’
• Should apply where there is direct or indirect control
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Action 3: Strengthen CFC rules Attribution of income and preventing double taxation • Report includes different approaches on how CFC income should be defined and computed • Broadly CFC’s income should be attributed to each controlling person, by reference to proportion and period of ownership • Applying the tax rate of the parent jurisdiction • Alternatively applying a top-up tax • Preventing double taxation ‒ Credit for foreign taxes actually paid, including CFC tax paid by intermediate companies in cases where CFC rules in more than one jurisdiction apply to the same CFC income ‒ At discretion of individual jurisdictions, exemption for dividends from CFCs and gains on the disposal of CFC shares where CFC income has previously been subject to CFC tax charge.
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