In February of 2014, the Organization for Economic Cooperation and Development
(OECD) published a report titled
Addressing Base Erosion and Profit Shifting. What is base erosion and profit shifting (BEPS)? BEPS strategies are
legal strategies used by companies to lawfully reduce their tax burden.
No one is required to pay more than their fair share of taxes. Simply
put, just because a company decides to adopt a particular business model,
financing arrangement, or business restructuring that has tax benefits
does not make it wrong. If a U.S. taxpayer is motivated to buy a second
home to benefit from the deduction of real estate taxes and mortgage interest,
we do not accuse that person of being unethical. Rather, it’s simply
seen as an educated business decision. It’s a business decision
with tax benefits.
The OECD BEPS report identified the six main “causes” BEPS.
In reality, the OECD is saying that these are the six strategies used
by international tax planners to reduce the tax burden of their corporate clients.
First, it identified the use of hybrids and mismatches to generate arbitraging
opportunities. A hybrid is an entity that is viewed as a pass-through
for U.S. tax purposes yet viewed as a corporation for foreign tax purposes.
A reverse hybrid is the opposite; it’s viewed as a corporation for
U.S. tax purposes and a pass-through for foreign tax purposes. How does
this create opportunities? If a company has operations in Ireland via
a company organized under Irish law but managed in Bermuda, then it would
be an Irish corporation for U.S. tax purposes but a Bermuda corporation
for Irish tax purposes. If the entity is structured to avoid Subpart F,
then none of its income will be taxed by either the U.S. or Ireland; it
ends up in Bermuda. And this is just one of many examples.
Second, the OECD report identified residence-source taxation for digital
sales. Currently, digital sales can be structured to effectively bottle-up
income tax-free in Bermuda. The OECD would like to force all income from
digital sales to be traced and taxed based on the residence of the seller
regardless of the sale arrangement.
Third, the OECD report identified intragroup financing. How does this work?
Well, Japan has a higher effective tax rate than the United States. Let’s
say you want to do business in Japan. If you open operations and make
a $5M in the first year, you’re facing an effective tax rate of
36.7%. However, if you make a $50M loan to the Japanese company with a
5% annual interest rate, the Japanese company will be able to pay you
$2.5M, which is deductible to the Japanese company and cuts its tax bill
in half. Should we now expect taxing authorities to question whether a
loan was necessary even when the interest rate is reasonable?
Fourth, the OECD report identified transfer pricing issues like synergistic
value. What is synergy value? How much is a pile of wood and nails worth?
How much is the house made from wood and nails worth? That’s an
oversimplified example, but the basic point is that something has more
value when it’s well assembled and structured. When transferring
intangibles overseas, companies value each intangible separately rather
than as a group. While it is certainly logical to value a group of items
as a whole rather than individually, that’s not what the current
law requires. Companies are required to comply with current law; not try
to rewrite the law in a manner that increases their tax burden. This is
an issue for national legislatures.
Fifth, the OECD identified the ineffectiveness of anti-avoidance rules,
which are designed to prevent tax avoidance. Again, tax avoidance is legal.
It simply means that a taxpayer is structuring his affairs in a tax-beneficial
manner. More often than not, it’s the politicians that create exceptions
and loopholes. The blame goes to lobbying, but lobbying is an integral
part of any democratic system. Are we now anti-democracy? There will always
be special interests lobbying their national legislatures for special
exception in order to be more globally competitive. Until there is either
a global government or an end to democracy, this will always be a “problem”
in the eyes of the OECD.
Sixth, the OECD identified “preferential regimes.” This is
a reference to most Caribbean island nations. Again, it’s hard to
fathom how one could resolve this problem. There is very little pressure
that can be exerted upon these nations.
Long story made short; the OECD is wasting its time. The U.S. will never
conform its taxing rules to that of the OECD’s, and OECD-nations
will never adopt the U.S. tax rules; thus, we’re at a stalemate.
If OECD-nations were to simply adopt all of our rules, we would have global
conformity. They have chosen not to; therefore, our companies will continue
to enjoy the benefits of arbitraging the differences and structuring their
affairs as they deem proper.