Clarity on base erosion and profit shifting recommendations – but what next?

Tuesday 6 October 2015

Author: Graham Murray

​​​​​On 5 October 2015 the Organisation for Economic Co-operation and Development (OECD) released its final reports on the 15 “actions” for addressing base erosion and profit shifting (BEPS).

The New Zealand government will soon be deciding whether the recommendations in the reports should be incorporated into New Zealand’s tax laws.

What is BEPS?

BEPS generally refers to the practice of multi-national groups using tax rules in different jurisdictions to minimise their global taxation liability (e.g. through the “over” allocation of profits to low or no tax jurisdictions).

BEPS issues have received significant media attention in the last few years, and partly in response to this attention, the OECD published its report on Addressing Base Erosion and Profit Shifting in February 2013, followed by a 15-point action plan in June 2013.

The final reports released this week are intended to form the basis of a comprehensive, coherent and coordinated response to BEPS issues. It is anticipated that the suggestions detailed in the final reports will provide governments (including New Zealand) with solutions for closing down BEPS practices. The solutions proposed would need to be implemented by governments through a combination of domestic law changes and changes to their network of double tax agreements with other countries.

Key aspects of the final reports

A total of 15 individual final BEPS reports have been published by the OECD. We outline here aspects of the reports which may be of relevance or particular interest in a New Zealand context:

  • Hybrid mismatches: Hybrid mismatch arrangements are said to utilise differences in the tax treatment of an instrument or entity under the laws of different jurisdictions in order to achieve a beneficial asymmetrical tax treatment (e.g. an expense that is deductible in the payer’s jurisdiction, but non-assessable in the recipient’s jurisdiction). The report recommends that countries adopt a domestic law rule which would, for example, deny deductions for expenditure by a New Zealand company where there is no corresponding income from the transaction in the recipient’s jurisdiction.  

  • Interest deductions: A number of rules are recommended to prevent entities from reducing profits in a jurisdiction through “excessive” interest deductions. The recommended approach will limit an entity’s deductions for interest by reference to a fixed percentage (between 10% and 30%) of its EBITDA, with the possibility of exceeding that level if that is in line with the entity’s worldwide group’s net interest/EBITDA ratio. This approach would represent a significant change from the approach presently adopted in New Zealand’s thin capitalisation rules. It could involve the removal of the safe harbour rule which has been a feature of New Zealand’s thin capitalisation regime for many years and which provides certainty to taxpayers.

  • Treaty abuse: In order to counteract alleged treaty shopping practices, it is recommended that double tax agreements contain specific anti-abuse rules, as well as a more stringent limitation on benefits article (along the lines of that contained in the double tax agreement between New Zealand and the United States). In a New Zealand context, the Inland Revenue Department (IRD) has previously relied on the general anti-avoidance provision to address treaty abuse. The recommendations, if implemented, would give the IRD further options in relation to alleged treaty abuse, perhaps at the cost of certainty from a taxpayer perspective.

  • Permanent establishments: It is proposed that the “permanent establishment” definition in double tax agreements will be amended in order to address concerns relating to commissionaire arrangements and tax-driven fragmentation of activities which may currently prevent a permanent establishment from arising. These recommendations are likely to be particularly relevant to multinational entities which may have previously sold goods or services in a country through a local sale agent and have relied on the absence of a permanent establishment to prevent tax liabilities in that country on products or services sold. These recommendations form part of the wider OECD review relating to the increasing scope of the “digital economy”.

  • Transfer pricing: There are a number of significant recommendations relating to transfer pricing, and it is apparent that transfer pricing was a key focus of the BEPS review. The recommendations include an ability to disregard contractual arrangements between associated parties which are inconsistent with the conduct of those parties, or which lack commercial rationality. This is a substantial shift from the traditional approach to transfer pricing, which assesses the arms’ length nature of prices in legal arrangements entered into between associated parties. A further recommendation concerns the practice of contractually allocating risks between associated entities to support an advantageous profit allocation. Under the recommended approach, risks will only be taken into account in assessing whether profit allocation is appropriate if the party is able to exercise control over the risk, and has the financial capacity to assume that risk. In addition, a further recommendation proposes that capital-rich entities without any other significant economic activity will not be entitled to an allocation of super profits, and wi​ll instead be limited to deriving no more than a risk free return.

  • CFC rules: This report identifies six “building blocks” which are recommended in order to ensure an effective set of rules for controlled foreign companies (CFCs). While New Zealand already has a relatively robust CFC regime, it is possible that a number domestic law changes at the margin could be made to the CFC rules in light of the recommendations.

  • Mandatory disclosure: This report proposes a regime requiring mandatory disclosure of potentially aggressive or abusive tax planning schemes. The requirement for disclosure would be triggered by reference to recognised hallmarks of such schemes, and would be backed by a penalty for failure to disclose. No such regime exists in New Zealand at present.

  • Implementing BEPS changes: This report recommends that the changes to tax treaties in order to reflect the BEPS proposals be implemented by way of a multi-lateral instrument, rather than through the renegotiation of individual double tax agreements. It appears that work on preparing that instrument has already been commenced by what is described as an “ad hoc group” of officials. The report indicates that the instrument should be ready for signature by willing parties on 31 December 2016. This approach is the same as that adopted for information exchange under the Convention on Mutual Administrative Assistance in Tax Matters (to which New Zealand is a party).

What next?

Our expectation is that the IRD will consider the detail of the reports and what changes are appropriate in a New Zealand context. We expect that any changes that result will follow the usual consultation process. Indications are that the next step will be the release of an issues paper by the IRD after March 2016. The public will have an opportunity to comment on that document.

Although we will have to wait and see what aspects of the proposals are implemented in a New Zealand context, it seems that the recommendations around hybrid mismatches and interest deductions have the greatest potential to give rise to changes to the New Zealand Income Tax Act 2007.​


Disclaimer

This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

For more information
  • Mathew McKay

    Partner Auckland
  • Graham Murray

    Partner Auckland
  • Hayden Roberts

    Senior Solicitor Auckland
Related areas of expertise
  • Tax