The OECD Report on Base Erosion and Profit Shifting
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.