The OECD vs. tax havens, Pt. 3: New concerns
By F Hale Stewart, JD, LLM, CAM, CWM, CTEP
The Law Office of Hale Stewart
Note: This is the third article in a five-part series. Be sure to read parts one and two, and watch for the final two articles in the coming weeks.
On July 13, the OECD issued a new paper titled, Action Plan on Base Erosion and Profit Shifting. The purpose of this paper was to outline the OECD's new round of concerns regarding tax havens and their use in international tax planning. It's first important to understand what is behind the issuing of this new report:
Over time, the current rules have also revealed weaknesses that create opportunities for BEPS. BEPS relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation.
One of the central purposes of the OECD's original tax treaty was to divide taxing rights and privileges between the two sovereigns that sign a particular treaty. Essentially, each country can tax transactions which occur within their borders (hence the residence requirements of section one, the residency stipulations of section four and the permanent establishment/business profits interaction in sections five and seven of the OECD model treaty). However, through the interaction of two different tax systems, planners have come to exploit situations so no taxation occurs. Hence the issue of "double non-taxation."
In addition, less than single taxation is also possible. While this term may seem a misnomer, in fact it's not. One of the central ideas both of accounting and taxation is to effectively align income and expenses. For example, when a company produces a product, it is allowed under most tax and accounting systems to deduct expenses incurred in production of that product. This is sometimes referred to as the matching principal. Less than single taxation occurs when a company manipulates transfer pricing rules to drain money away from the location where the expense should occur to a lower tax jurisdiction. One of the most common examples is placing intellectual property in a low-tax jurisdiction and paying royalties to that jurisdiction for use of the property, even though the production of that IP occurred in the higher tax jurisdiction.
This point leads nicely into the third primary concern of the OECD:
The spread of the digital economy also poses challenges for international taxation. The digital economy is characterized by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterization of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not necessarily an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.
Over the last six to nine months, the tax planning of Apple, Google, Amazon and Adobe have been publicized in a negative light. Because these companies all utilize IP, they are able to send their valuable assets to offshore low-tax jurisdictions and use these venues as "hubs" which collect vast sums of money in a low tax manner. The OECD is concerned that these structures remove money from higher tax jurisdictions in a manner that does not reasonably employ matching concepts. The OECD expresses their concern:
It also relates to arrangements that achieve no or low taxation by shifting profits away from the jurisdictions where the activities creating those profits take place. No or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it. In other words, what creates tax policy concerns is that, due to gaps in the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be only unduly lowly taxed.