Traversing the new landscape of international tax compliance

June 2015 | PROFESSIONAL INSIGHT | CORPORATE TAX

Financier Worldwide Magazine

In the wake of the recent global economic crisis and the media spotlight on multinationals which have been perceived to have eroded their local tax base, the global focus on base erosion and profit shifting (BEPS) has drastically intensified – and will continue to do so for the foreseeable future.

This focus on BEPS has resulted in the most fundamental change applied to the international tax rules since the 1920s. The changes are to be deployed through a 15 point Actions Plan issued by the Organisation for Economic Co-operation and Development (OECD) and supported by the G20 Group of 20 major industrialised nations.

The two-year Actions Plan, which is currently being rolled out, allows countries to draw up coordinated, comprehensive and transparent standards that ensure multinationals pay their fair share of taxes in the countries where they do business. The Plan involves, among others, a number of key initiatives; firstly, international tax rules will be developed to address the gaps between different countries’ tax systems, while still respecting the sovereignty of each country to design its own rules. Equally, the existing rules on tax treaties and transfer pricing will be revisited to fix their deficiencies. This will ensure that profits are taxed in the countries where the economic activities that generate them are carried out. There will be more transparency established between governments allowing tax authorities to evaluate whether or not the local taxes paid correspond with the economic activities performed locally versus the activities performed (and taxes paid) in other countries. Finally, the Plan will also lead to increased information requirements being imposed on tax payers, thus forcing tax payers to substantiate, on a per country basis, the financial and economic rationale behind international tax structures and instruments applied.

In order to ensure that the prescribed actions can be implemented as soon as possible, a multilateral instrument will be developed for countries that may want to amend the totality of their existing network of bilateral treaties at once, rather than proceed treaty by treaty.

This article discusses aspects of the practical consequences resulting from the increased transparency between tax authorities and the extended information requirements.

Increased transparency between tax authorities – what does that mean?

The BEPS initiative has already resulted in the fact that tax authorities have started to exchange information. On 18 March 2015, the European Commission published a proposal to amend the Directive on administrative cooperation between member states, introducing a mandatory automatic exchange of information on advance cross-border rulings, as well as advance pricing arrangements. The proposal was previously announced by the European Commission President Juncker in reaction to ‘LuxLeaks’.

LuxLeaks refers to the perceived financial misbehaviour revealed by a journalistic investigation. It is based on confidential information about Luxembourg’s tax rulings. This investigation resulted in making available to the public in November 2014 tax rulings for over 300 multinational companies in Luxembourg.

The European Commission proposal includes not only rulings and pricing arrangements which will be issued after the proposed amendment becomes effective, but also rulings and pricing arrangements issued less than 10 years ago that are still in force. If approved, the proposed amendment will be effective from 1 January 2016. The proposal is part of a package meant to increase transparency between member states in order to avoid perceived aggressive tax planning and abusive tax practices.

On 19 March 2015, Switzerland and the EU initialled an agreement regarding the introduction of the global standard for the automatic exchange of information in tax matters. Under this new agreement, Switzerland and the 28 EU member states will automatically exchange information on the full range of financial account information. Residents of EU member states and Switzerland will no longer be able to hide undeclared income in foreign accounts to evade paying taxes. It is expected that account data will be collected from 1 January 2017 and exchanged as of 1 January 2018.

In the years to come, a wider range of information is expected to be shared between tax authorities. The exchange of information will provide tax authorities with the tools to better monitor and control the corporate and individual taxes paid by taxpayers operating in multiple countries. Furthermore, understanding the ‘bigger picture’ will allow the authorities to minimise situations whereby taxable income falls between the cracks and is not taxed at all.

Extended tax information requirements

On top of the automatic exchange of information, multinationals are obliged to provide tax authorities with extended tax and transfer pricing documentation packages in order to determine the tax, legal, economic and accounting perspective of a local or regional tax position. These documentation packages are targeted at establishing the ‘economic rationale’ behind the legal/tax structuring of inter-company transactions.

This economic rationale does not only have to be defended for transfer pricing purposes, it also needs to be demonstrated for the substantiation of other fiscal instruments (e.g., loans, treaty applications, hybrid instruments, etc.). This means that the taxpayer will have to go to a greater effort to explain the economic substance behind any type of tax structuring.

In order to meet the requirements of the various Actions defined by BEPS, taxpayers are expected to explain the economic purpose and reasoning behind inter-company transactions. Even when applying tax treaties, taxpayers will need to explain whether or not their actions can be justified when considering the factual goal of the specific tax treaty. Furthermore, simply following the codified fiscal rules and relying on formalised legal agreements will often no longer suffice as the impact of many international tax events will ultimately be measured on their economic defensibility rather than their defensibility from a tax/legal perspective only.

The OECD report on Action 13, dated 16 September 2014 (the Action 13 Report), is in the form of a revised chapter of the OECD Transfer Pricing Guidelines. It sets forth a three-tier approach for transfer pricing documentation that includes a framework for the master file and local file and a template for Country-by-Country (CbC) reporting.

The CbC report requires multinationals with a turnover of at least €750m to report the following information as from 2016: revenues (from both related and unrelated party transactions), profit before income tax, income tax paid (cash basis), current year income tax accrual, stated capital, accumulated earnings, number of employees, and tangible assets (excluding cash and equivalents). It can be expected that the abovementioned financial indicators will be measured against the (significant) people functions triggering the financial and fiscal results. If such a result does not correspond with the people functions performed, the tax authorities will very likely argue that the economic reality does not correspond with the legal/tax reality.

Preparing for the future

In the first instance it is vitally important for multinationals to be in a position where they are able to substantiate any international tax structure, not only from a tax and legal perspective, but also from an economic and accounting perspective. Risks emerge once there is a mismatch between these perspectives. Consequently, multinationals must perform a ‘health-check’ on the robustness of their international tax structures. The lifespan of international tax structures lacking any link with economic and accounting reality is shortening at an increasing pace.

Action 11 aims to develop recommendations regarding “indicators of the scale and economic impact of BEPS. It also ensures that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis”. The work will involve assessing a range of existing data sources, identifying new types of data that should be collected, and developing methodologies based on both aggregate (e.g., FDI and balance of payments data) and micro-level data (e.g., from financial statements and tax returns). In this respect, taxpayer confidentiality and the administrative costs for tax administrations and businesses should also be considered.

Recommendations regarding data to be collected and the methodologies to analyse them are expected by September 2015. The focus of this action item is diagnostic in nature and reveals a new approach to cross-border tax issues.

With the above in mind, companies should focus on readying themselves by carrying out the necessary steps to ensure their ability to produce the required information, including preparing protocols for gathering the information and developing internal processes and responsibilities with regard to the new reporting.

The increased level of detail and amount of information requested by tax authorities will drastically increase the flow of information that will be exchanged among tax authorities, and between tax authorities and tax payers. This flow of information will result in a situation where tax authorities will have to process a ‘wall’ of information. As almost all tax authorities are, at present, not equipped to process such information flows, tax authorities are currently investigating and testing technology-based solutions that can help them prepare for their future tasks.

Multinationals are also often not equipped to deliver the level of information required. In order to bridge the gap, increasing the quality of tax reporting mechanisms should be a priority.

Inevitably, multinationals, like tax authorities, will have to look for technology-based compliance instruments that that are able to derive relevant tax related information from existing enterprise resource systems (e.g., SAP, Oracle) typically used for internal and external financial reporting purposes.

The challenges pertaining to the increased transparency between tax authorities and the extended international-tax-related-information requirements can only be addressed and managed properly when working with tax technology that allows multinational companies to operate with so-called ‘dashboards’ that are connected to the multinational’s ERP systems, preferably in real-time. Such dashboards should provide insight in the (segmented) tax accounts and be able to provide tax authorities with the data required within a foreseeable timeframe.

Michel Sijmonsbergen and Todd Behrend are principals at Ryan. Mr Sijmonsbergen can be contacted on +31 (0) 20 570 3520 or by email: michel.sijmonsbergen@ryan.com. Mr Behrend can be contacted on +1 (404) 365 0022 or by email: todd.behrend@ryan.com.

Michel Sijmonsbergen and Todd Behrend

Ryan