International businesses Vs OECD-BEPS

INTERNATIONAL TAXATION VS ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD)

The Organization for Economic Cooperation and Development (OECD) is a unique forum where the governments of 34 democracies with market economies work with each other, as well as with more than 70 non-member economies to promote economic growth, prosperity, and sustainable development. We measure productivity and global flows of trade and investment. We analyze and compare data to predict future trends. We set international standards on a wide range of things, from agriculture and tax to the safety of chemicals.

The mission of the Organization for Economic Co-operation and Development (OECD) is to promote policies that will improve the economic and social well-being of people around the world. We also look at issues that directly affect everyone’s daily life, like how much people pay in taxes and social security, and how much leisure time they can take. We compare how different countries’ school systems are readying their young people for modern life, and how different countries’ pension systems will look after their citizens in old age.

Drawing on facts and real-life experience, they recommend policies designed to improve the quality of people’s lives. They work with business, through the Business and Industry Advisory Committee to the OECD (BIAC), and with labour, through the Trade Union Advisory Committee (TUAC). They have active contacts as well with other civil society organizations. The common thread of their work is a shared commitment to market economies backed by democratic institutions and focused on the well being of all citizens.

Base Erosion and Profit Shifting in international businesses

BEPS also referred to as the Base Erosion and Profit Shifting is a term that is used for closing the gaps within international tax for organizations that tend to avoid tax or minimize taxation burden within their own country through engagement in taxation inversions or via migration of intangibles for lowering the taxation jurisdictions.

The Organization for Economic Cooperation and Development has basically issued fifteen actionable measures for addressing the primary areas, which they feel that organizations have extensively used to accomplish this shift of profit. This has allowed the OECD to address the country’s digital economic condition, abuse of treaty and transfer pricing related documents among other areas. For instance, BEPS Action Item number 13 aims at transforming documentation of transfer pricing, forcing the MNCs to rethink the manner in which the details pertaining to transfer pricing will be reported to the local taxation authorities and globally through CbC reporting.

In the past couple of years, a growing number of MNCs have been resorting to advanced taxation planning methods to avoid paying taxes by simply shifting their profits to other nations, particularly those countries that are regarded as tax havens. These practices have further eroded the taxation base in these countries and their governments faced losses due to such sophisticated planning & practices. Governments of different countries were of the impression that BEPS resulted in massive losses as far as the national taxation revenues were concerned. This prompted the Organization for Economic Cooperation and Development to launch the BEPS concept/project. The OECD has created 15 action points to better manage the issue of shifting profits.

The Action Plans were structured around three fundamental pillars viz.:

(i) Reinforcing of ‘substance’ requirements in existing international standards;

(ii) Alignment of taxation with location of value creation and economic activity; and

(iii) Improving transparency and tax certainty.

Below discover more about the 15 action points:

Action-1: It addresses the taxation problems of digital economies world-wide, while identifying the primary issues being posed by the digitally advanced economies when it comes to applying the international taxation rules. Action-1 highlights the options that governments can use for addressing these issue, while adopting an integrated approach as well as taking both indirect and direct taxes into consideration.

APPLICABILITY IN INDIA

Insertion of Chapter VIII in the Finance Act, 2016 on Equalization Levy to address this

Challenge

In order to address the challenges of the digital economy, Chapter VIII of the Finance Act, 2016, titled “Equalization Levy”, provides for an equalization levy of 6% of the amount of consideration for Specified services received or receivable by a non-resident not having permanent establishment In India, from a resident in India who carries out business or profession, or from a non-resident having Permanent establishment in India.

Meaning of “Specified Service”

(1) Online advertisement;

(2) Any provision for digital advertising space or any other facility or service for the purpose of online advertisement;

Specified Service also includes any other service as may be notified by the Central Government.

Further, in order to reduce burden of small players in the digital domain, it is also provided that no such levy shall be made if the aggregate amount of consideration for specified services received or receivable by a non-resident from a person resident in India or from a non-resident having a permanent establishment in India does not exceed ` 1 lakh in any previous year.

Action-2: This point aims at developing model provisions for treaty and recommends how domestic regulations should be designed for neutralizing the hybrid entities and instruments effect such as double tax deduction, double non-taxation etc.

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• Foreign investors also invest in India through hybrid instruments viz convertible debentures/Bonds which are treated as debt and interest payments are allowed as tax deductible, while such instrument may be treated as equity and not debt in the home country of investor and consequently such interest income may be treated as dividend in home country. If home country does not tax such dividend, it may result in deduction-non inclusion scenario.
• Although India has stated that hybrid mismatch is not such a major issue in the Indian context. However, India may consider reviewing the funding structures of many multinationals operating in India where potential risk of hybrid mismatches may be there.

Action-3: This point makes recommendations about the different ways in which the CFC (Controlled Foreign Corporations) taxation rules can be strengthened.

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• At present, there are no CFC rules in the Income-tax Act, 1961;
• CFC rules formed part of the proposed Direct Tax Code.
• CFC regime has been debated over last many years in India and is one of the last remaining concepts from the DTC to be incorporated in the Income-tax Act, 1961.
• In order to encourage repatriation of profits, section 115BBD provides a concessional tax rate of 15% (gross basis) on dividends received from a specified foreign company i.e., a foreign company in which the Indian company holds 26% or more in the nominal value of the equity share capital of the company.

Action-4: This point lays down a common method by which the tax base can be prevented from erosion by using the interest expenditure. For instance, via the usage of 3rd party and related party debt for achieving additional deductions of interest or for financing the deferred or exempt income production.

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Section 94B of the Income-tax Act, 1961: Addressing Thin Capitalization

Debt financing of cross-border transactions is often favorable than equity financing for taxpayer. In view of the above, in line with the recommendations of OECD BEPS Action Plan 4, section 94B has been inserted in the Income-tax Act, 1961 by the Finance Act, 2017 to provide a cap on the interest expense that can be claimed by an entity to its associated enterprise. The total interest paid in excess of 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise for that previous year, whichever is less, shall not be deductible.

Applicability

The provision is applicable to an Indian company or a permanent establishment of a foreign company, being the borrower, who pays interest in respect of any form of debt issued by a non- resident who is an ‘associated enterprise’ of the borrower. Further, the debt is deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender, being a non-associated enterprise, or deposits a corresponding and matching amount of funds with such lender.

Carry forward of disallowed interest expenditure

The provision allows for carry forward of disallowed interest expense for 8 assessment years immediately succeeding the assessment year for which the disallowance is first made and deduction against the income computed under the head “Profits and gains of business or profession” to the extent of maximum allowable interest expenditure.

Threshold limit

In order to target only large interest payments, it provides for a threshold of interest expenditure of 1crore in respect of any debt issued by a non-resident exceeding which the provision would be applicable. Banks and Insurance business are excluded from the ambit of the said provisions keeping in view of special nature of these businesses.

Action-5: This point redesigns the adverse taxation practices, while emphasizing on enhancing transparency.

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Section 115BBF of the Income-tax Act, 1961: In line with nexus approach of BEPS Action 5

The nexus approach has been recommended by the OECD under BEPS Action Plan 5. This approach requires attribution and taxation of income arising from exploitation of Intellectual property (IP) in the jurisdiction where substantial research and development (R & D) activities are undertaken instead of the jurisdiction of legal ownership. Accordingly, section 115BBF of the Income-tax Act, 1961 provides that where the total income of the eligible assessee includes any income by way of royalty in respect of a patent developed and registered in India, then such royalty shall be taxable at the rate of 10% (plus applicable surcharge and cess). For this purpose, developed means at least 75% of the expenditure should be incurred in India by the eligible assessee for any invention in respect of which patent is granted under the Patents Act, 1970.

Action-6:  Action 6 designs model provisions for treaty and also offers recommendation with regard to the creation of domestic regulations for preventing the treaty from abuse.

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 Lob clause introduced in India-Mauritius Tax Treaty – On 10^th May, 2016, India and Mauritius has signed a protocol amending the India-Mauritius tax treaty at Mauritius. In the said treaty, for the first time, it has been provided that gains from the alienation of shares acquired on or after 1.4.2017 in a company which is a resident of India may be taxed in India. The tax rate on such capital gains arising during the period from 1.4.2017-31.3.2019 should, however, not exceed 50% of the tax rate applicable on such capital gains in India. A Limitation of Benefit (LOB) Clause has been introduced which provides that a resident of a Contracting State shall not be entitled to the benefits of 50% of  the tax rate applicable in transition period if its affairs are arranged with the primary purpose of taking advantage of concessional rate of tax. Further, a shell or a conduit company claiming to be a resident of a Contracting State shall not be entitled to this benefit. A shell or conduit company has been defined as any legal entity falling within the meaning of resident with negligible or nil business operations or with no real and continuous business activities carried out in that Contracting State. A resident of a Contracting State is deemed to be a shell/conduit company if its expenditure on operations in that Contracting State is less than Mauritian rupee 15,00,000 or Indian ` 7,00,000 in the respective Contracting State as the case may be, in the immediately preceding period of 12 months from the date the gains arise.

LoB clause in India-Singapore Tax Treaty – On similar lines, India and Singapore has signed a protocol amending the India-Singapore tax treaty. Capital gains on alienation of shares would be taxable in a similar manner as laid out in India-Mauritius tax treaty, subject to LoB clause. The transition period benefit is also similar to that contained in India-Mauritius Tax Treaty. In respect of shares acquired after 1.4.2017 and sold before 1.4.2019, the expenditure test needs to be met for the 12 month period immediately preceding the date of transfer.

Action-7: This point consists of the alterations that can be made in the permanent establishment’s definition. For instance, using the commissionaire systems and similar other terms.

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The OECD, under BEPS Action Plan 7, reviewed the definition of ‘PE’ with a view to preventing avoidance of payment of tax by circumventing the existing PE definition by way of commissionaire arrangements or fragmentation of business activities. In order to tackle such tax avoidance scheme, the BEPS Action plan 7 recommended modifications to Article 5(5) to provide that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts. Similarly Action Plan 7 also recommends the introduction of an anti fragmentation rule as per paragraph 4.1 of Article 5 of OECD Model tax conventions, 2017 so as to prevent the tax payer from resorting to fragmentation of functions which are otherwise a whole activity in order to avail the benefit of exemption under paragraph 4 of Article 5 of DTAAs.

Further, with a view to preventing base erosion and profit shifting, the recommendations under BEPS Action Plan 7 have now been included in Article 12 of Multilateral Convention to implement Tax Treaty Related Measures (MLI), to which India is also a signatory. Consequently, these provisions will automatically modify India’s bilateral tax treaties covered by MLI, where treaty partner has also opted for Article 12. As a result, the DAPE provisions in Article 5(5) of India’s tax treaties, as modified by MLI, became wider in scope than the erstwhile provisions in Explanation 2 to section 9(1)(i).  Similarly, the antifragmentation rule introduced as per paragraph 4.1 of Article 5 of the OECD Model Tax Conventions, 2017 has narrowed the scope of the exception under Article 5(4), thereby expanding the scope of PE in DTAA vis-a-vis domestic provisions contained in Explanation 2 to section 9(1)(i). In effect, the relevant provisions in the DTAAs became wider in scope than the domestic law.

However, section 90(2) of the Income-tax Act, 1961 provides that the provisions of the domestic law would prevail over corresponding provisions in the DTAAs, to the extent they are beneficial. Since, in the instant situations, the provisions of the domestic law being narrower in scope are more beneficial than the provisions in the DTAAs, as modified by MLI; such wider provisions in the DTAAs would become ineffective, unless the provisions of domestic law are appropriately amended.

In view of the above, section 9(1)(i) has been amended to align the same with the provisions in the DTAA as modified by MLI so as to make the provisions in the treaty effective. Accordingly, section 9(1)(i) has been amended by the Finance Act, 2018 to provide that “ business connection” shall also include any business activities carried through a person who, acting on behalf of the non-resident, habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by the non-resident . Such contracts should be-

• in the name of the non-resident; or
• for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that the non-resident has the right to use; or

(iii)   For the provision of services by that non-resident.

Action 8 – Develop rules to prevent BEPS by moving intangibles among group members, including drafting effective provisions and updating the guidance on cost contribution arrangements.

Action 9 – Develop rules against transferring risks among, or allocating excessive capital to, group members. That would involve rules that align returns with value creation.

Action 10 – Develop rules to prevent BEPS by engaging in non-commercial transactions.

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Indian authorities believe that excessive intra-group service payments in form of management fee, technical fee, royalty, interest etc have been major source of base erosion and thus one of the high risk area. These intra-group payments are also the one of the most litigated issue in India. The Indian courts have delivered judgment both in favour of taxpayer and revenue authorities on case to case basis. Indian government though believes that many recommendations of reports are already being followed by the tax authorities and they are sort of endorsement or give support to the approach already being followed.

• On intangibles, India endorses the emphasis of substance, that mere capital does not attract income unless it does something to enhance the value. It also expressed that reports does not specifically comment on marketing intangible and for which it need to find solution locally.
• On recharacterisation or disregarding a transaction as articulated in Action 8-10, Government has stated that GAAR provisions will take into account the concepts.
• On low-value adding services, the India has recently introduced the revised safe harbor rules which also incorporate the low value adding services. The safe harbor rules specifies the mark-up of 5% on cost, thus broadly aligning the treatment recommended by the OECD BEPS Action 8-10 for receipt of low-value adding services.

Action-11: Action 11 provides different methods for collecting and analyzing data/information on Base Erosion and Profit Shifting as well as the right actions for addressing it.  It also offers recommendations with regard to the indicators of economic and scale of BEPS’s impact, while ensuring that all the tools for monitoring are available. It also measures whether the actions are economically impactful and effective when it comes to addressing BEPS on a consistent basis.

Action-12: This offers recommendations around the framework of compulsory rules of disclosure for tax planning plans that are aggressive in nature, while also taking the administration costs of business and taxation administration into consideration. It also takes into account the experiences of nations that have already implemented similar rules.

Action 13: It consists of revised guide around the documentation of transfer pricing, in addition to information for CBC reporting that helps in enhancing transparency and also takes compliance related costs into account.

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Transfer pricing provisions under the Income-tax Act, 1961

Chapter X of the Income-tax Act, 1961 comprising sections 92 to 92F contain provisions relating to transfer pricing regime.

Section 92D requires maintenance of prescribed information and document relating to the international transaction and specified domestic transaction.

Implementation of international consensus in India

India is one of the active members of BEPS initiative and part of international consensus. For the purpose of implementing the international consensus, a specific reporting regime in respect of CBC reporting and also the master file has been incorporated in the Income-tax Act, 1961. The essential elements have been incorporated in the Income-tax Act, 1961 while remaining aspects are being dealt with in detail in the Income-tax Rules, 1962.

Note – Refer to Chapter 3 Transfer pricing, wherein the following have been discussed at length –

• Elements relating to CbC reporting requirement and related matters which have been incorporated in section 286 of the Income-tax Act, 1961
• Maintenance and furnishing of Master file: Consequent provisions incorporated in section 92D of the Income-tax Act, 1961.

Threshold limit of consolidated group revenue for applicability of CBC reporting requirement

The CBC reporting requirement for a reporting year does not apply unless the consolidated revenues of the preceding accounting year of the group, based on consolidated financial statement, exceeds   a threshold to be prescribed. The current international consensus is for a threshold of € 750 million equivalent in local currency. This threshold for total consolidated group revenue of the international group prescribed under section 286 of the Income-tax Act, 1961 read with Rule 10DB of the Income- tax Rules, 1962 is ` 5,500 crores.

Action -14: Action 14 designs solutions for addressing the hindrances that restrict nations from finding adequate solutions to disputes related to treaty under Mutual Agreement Procedure, through a standard within this particular area and other acceptable practices. It also involves arbitration as one of the options for countries that are willing to address the issues.

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• India continues to be reluctant to accept mandatory arbitration. It tends to rely on appellate mechanism and court to deal with the disputes. It believes in strengthening the effectiveness and efficiency of MAP process under tax treaties and feels mandatory arbitration as addition complication rather than an additional solution. Being a minimum standard, India has opted for bilateral notification or consultation. Indian has also been unwilling to adopt the Chapter VI of MLI dealing with mandatory arbitration.
• APAs and MAP are tools of alternative tax dispute resolution mechanism in matters involving transfer pricing. Recently, India has relaxed the norms and decided to accept Transfer Pricing MAP and bilateral APA applications regardless of the presence or otherwise of Paragraph 2 of Article 9 (or its relevant equivalent Article) in the DTAAs viz ‘corresponding adjustment’ (Press release dt. 27.11.2017). India has concluded around 189 APAs which includes 173 unilateral APAs and 16 Bilateral APAs. Out of which maximum APAs (more than110) concluded from service sector (IT, Finance & Banking). India signed its first Bilateral APA with Japan in December 2014. Recently India signed first ever bilateral APA with USA covering IT/ITeS transactions; India has already signed 16 bilateral APAs with countries like Japan, UK, and Netherlands etc. Similarly, India has been actively resolving MAP cases for two years and more than 180 cases have been resolved.

Action- 15: This point analyzes legal problems concerning the creation of a multilateral treaty that further helps countries in developing a Multilateral Instrument to Modify Bilateral Tax Treaties.

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