Base erosion and profit shifting (BEPS): explained in 2023
What is base erosion?
Base erosion is the use of financial measures and tax planning to reduce the size of a company’s taxable profits in a country. It is often achieved by structuring income to have more favourable tax treatment or by finding ways to write off certain expenditure against taxable income. This has the effect of reducing a company’s tax bill below what it would otherwise be expected to pay.
What is profit shifting?
Profit shifting involves making payments to other group companies in order to move profits from high-tax jurisdictions to low-tax regimes. This serves to increase the overall profits available to group shareholders. Often, these intra-group payments (known as “transfer pricing”) take the form of royalties and interest payments, as these expenses can be deducted from pre-tax profits. Another advantage of these payment types is that some jurisdictions have lower tax rates on these kinds of income; Luxembourg, for example, has a very favourable regime on royalty income.
Who uses these techniques?
Multinational groups of companies are best placed to take advantage of these tax avoidance tactics due to the following factors:
- Their international operations provide a ready-made network of companies through which group funds can flow;
- They have the capital to set up and maintain entities used for tax-reduction purposes; and
- Their income tends to be large enough to support the costs of i) taking advice on tax structuring ii) putting in place and maintaining the recommended tax structure and iii) updating the structure with countries’ annual changes in tax law.
What techniques are used in base erosion and profit shifting?
- Trademark and technology licensing/transfer pricing: Managing the group’s trademark, designs and patents through an entity that applies a lower tax rate to intellectual property, then charging group companies royalties on the use of the brand. As royalties are often affected by withholding taxes, it is important to prioritise the IP holding company’s tax treaty relationship with the countries where the other group companies are. Coupled with its 80% reduction on the normal tax rate for IP royalties, this is why Luxembourg is so popular as an IP holding company in Europe;
- Thin capitalization: By setting up subsidiaries with minimal share capital, groups can use a financing arm to fund the new company’s operations with debt. This large debt load attracts interest, which has different treatment in some jurisdictions and can therefore reduce the group’s overall tax bill if structured correctly. One aggressive scheme revealed in 2014 involved the use of a Swiss branch of a Luxembourg finance company to lower tax on such interest payments;
- Hybrid mismatch arrangements: Different tax rules between countries can sometimes give rise to unintended effects like “double non-taxation”, which can be exploited by businesses to reduce their tax burden. This primarily applies to national treatment of certain instruments in such a way that they are treated in the paying country as tax-deductible debt, but seen in the receiving country as a tax-exempt dividend;
- Putting assets into entities without substance: Some countries introduce preferential tax regimes as a way to compete for business. However, this is only useful if businesses with substance begin to locate themselves in the country; otherwise, this form of tax competition simply erodes the tax base of the country where the activity takes place. Current rules often allow for business owners to set up paper companies that take advantage of preferential regimes such as patent boxes or Luxembourg’s 80% IP holding tax deduction.
What factors are affecting countries’ ability to determine the right amount of taxable income for these companies?
- The digital economy means that services can be delivered from anywhere, while generating value and making sales everywhere. The EU has handled one part of this with new rules for VAT on digital services, and this the OECD lists similar action as a deliverable for the end of 2015;
- Since tax is levied domestically, it is difficult to determine what should be taxed where, and in what manner, without some form of international cooperation. The OECD’s BEPS policies are being designed to create a framework that allows this to happen.
What is being done to address base erosion and profit shifting?
As BEPS revolves around arbitrage between domestic taxation rules, the key is to tackling its negative effects is to improve international transparency and cooperation on tax matters. The OECD is coordinating this work and has proposed the following actions:
- Addressing the challenges of the digital economy – A plan to “neutralise the effects of hybrid mismatch arrangements and arbitrage”, introducing coherence into national tax systems while allowing nations to retain sovereignty over their domestic tax policies;
- Neutralising the effects of hybrid mismatch arrangements – Preventing tax exemption on payments that were tax deductible for the payer;
- Strengthening controlled foreign company (CFC) rules – These rules impose tax liability on parent companies for their subsidiaries’ profits. The OECD is going to develop its own recommendations on implementing these rules. According to the OECD, CFC rules “have positive spillover effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low-tax jurisdiction)”;
- Limiting base erosion via interest deductions and other financial payments – Preferential tax regimes are under review, as they drive a race to the bottom and BEPS tactics to reduce taxable income. A core aim of this is to reduce interest deducted for payments to related financing vehicles and this work will be coordinated with Action 3’s work on CFC rules;
- Countering harmful tax practices more effectively, taking into account transparency and substance – Exchange of information on rulings relating to preferential regimes will be made compulsory, adapting current rules to work better in situations involving more than two countries.
This is necessary to take into account the complexity of the global value chain, while currently tax arrangements are only bilateral. The core of this is to more closely align apportionment of income with the economic activity that generates it, part of which will be cutting down on treaty abuse (a key source of BEPS concerns);
- Preventing treaty abuse – Tax treaties will be updated to clarify that they are not intended to be use for double non-taxation. They are intended to prevent double taxation, which hurts businesses, but these same businesses exploit the other side of the coin, taking double exemptions where possible;
- Preventing the artificial avoidance of permanent establishment status – This item will redefine permanent establishments to prevent undue avoidance of local taxes. Transfer pricing and arms-length principles are related to this item to reduce shifting of income into low-tax systems;
- Transfer pricing of intangibles – Reducing the tax benefits of transferring intangibles within the same group. The OECD will define a broad but clear definition of intangibles, create well-defined valuation rules to apply to transfers of intangibles, find ways to price transfers of hard-to-value intangibles, and examine cost contribution arrangements;
- Transfer pricing of risks and capital – Preventing inappropriately large returns being enjoyed by a group entity simply for providing capital or assuming contractual risks. New rules will align value creation with returns under new rules;
- Transfer pricing of other high-risk transactions – Intra-group transactions that would not ordinarily take place between third parties suggest that they may not be arms-length transactions. Rules will be developed to clarify the application of transfer pricing methods like profit splits in the face of global value chains, as well as to protect against management fees, head office expenses and other common base eroding payments;
- Establishing methodologies to collect and analyse data on BEPS and the actions to address it – Data collection, data analysis and the selection of the appropriate metrics will be key to evaluate the scope of BEPS and the efficacy of countermeasures. Disclosure initiatives and co-operative compliance between taxpayers and tax authorities will increase transparency to drive this forward;
- Requiring taxpayers to disclose their aggressive tax planning arrangements – Introducing mandatory disclosure of international tax planning schemes that may fall under the scope of BEPS. This would increase consistency between regimes but be flexible enough to account for country-specific needs and risks. Enforcement bodies can take a “big picture” view and minimise the use of aggressive avoidance schemes by opening up visibility of a taxpayer’s global value chain;
- Re-examining transfer pricing documentation – Requiring multi-nationals to provide information of their transfer pricing arrangements to all relevant governments in a common template. The common template will help to ensure certainty and predictability for business, so that new rules do not introduce an undue additional reporting burden;
- Making dispute resolution systems more effective – Updating tax treaty dispute resolution mechanisms to use arbitration so that disputes can be resolved more efficiently and effectively;
- Developing a multilateral instrument – OECD proposes to introduce a multilateral treaty that would amend consenting countries’ bilateral tax arrangements in line with the OECD’s recommendations.
For more detail on the plans to address base erosion and profit shifting, read the OECD’s full BEPS action plan.