Harmful Tax Incentives Critically Curtailed: BEPS Action 5 In Action

BEPS Action 5 – Countering harmful tax practices more effectively by taking into account transparency and substance is one of the four BEPS minimum standards. To date, 102 jurisdictions have committed to its implementation, and 2017 is a decisive year in translating that commitment into action. Achim Pross, Kevin Shoom and Melissa Dejong of the OECD, discuss the first results of the work under BEPS Action 5, and its significance in achieving the goals of the BEPS project.

26 October 2017

In just over one year since its launch, the Inclusive Framework on BEPS has already delivered significant changes in the international tax landscape. The 103 members of the Inclusive Framework have committed to implementing the four minimum standards of the OECD/G20 BEPS package:

  • Countering harmful tax practices (Action 5);
  • Preventing treaty abuse (Action 6);
  • Country-by-country reporting (Action 13); and
  • Dispute resolution (Action 14).

Enormous change has happened in connection with those four standards, as domestic and international laws and administrative practices are being changed around the world.

The work under BEPS Action 5 has been carried out at a particularly swift pace. In fact, the BEPS Action 5 standard comprises two aspects:

 Diagram 1

The results of the work on preferential tax regimes have just been released in the 2017 Progress Report. This report marks the progress made by Inclusive Framework members in eliminating harmful preferential tax regimes, and it records the results of peer reviews of 164 preferential tax regimes, undertaken by the Forum on Harmful Tax Practices (FHTP).

The speed and impact of the changes being adopted on preferential regimes are impressive. Governments have dismantled, or are in the process of amending, nearly 100 preferential tax regimes that have harmful features. This is an early and tangible result from the BEPS project. Harmful tax regimes are being rapidly closed down, ensuring that targeted tax preferences cannot be used to encourage MNEs to shift income away from where the value is created.

The standard for reviewing preferential tax regimes

The Action 5 review of harmful tax practices focuses on tax incentives (i.e. preferential tax regimes) for mobile business income, such as income from financial and other services, or from intellectual property (IP). This is the type of income which, in a globalised economy, is able to be shifted easily from one jurisdiction to another in response to tax planning considerations, as opposed to income from activities such as manufacturing, agriculture, or tourism, which are more tied to a specific location.

In determining which regimes are within the scope of the Action 5 standard, the relevant analysis is shown in Diagram 2.

Many jurisdictions offer preferential tax regimes which are within the scope of Action 5, as a way to stimulate certain sectors of the economy and attract foreign investment, and these are not necessarily problematic. The Action 5 standard looks at how a regime is designed to assess whether it contains "harmful features" that allow the regime to be used for base erosion and profit shifting, for example:

  • The regime can be ring-fenced to protect the domestic tax base from its effects, such as by providing benefits only for transactions with non-residents;
  • The regime can lack transparency in the operation or granting of the regime, making it difficult for other jurisdictions to identify the impact of the regime on their own tax base; and/or
  • The regime may lack sufficient requirements for the taxpayer benefitting from the regime to engage in substantial activities. In the context of mobile income, this feature can encourage MNEs to shift income away from where the economic activity creating the income is located, into the jurisdiction with the preferential regime.

Diagram 3 shows how the assessment of a regime is undertaken, in order to determine if it has harmful features.

Critically, in the Action 5 report, the substantial activities factor was elevated to being a "key factor" in the criteria for reviewing regimes. This means that jurisdictions offering a regime must ensure that the taxpayer's benefits are conditional on the taxpayer undertaking the core income generating activities, with adequate employees and expenditure. This is crucial in delivering the policy outcomes of the Action 5 standard, by preventing a taxpayer from being able to split the genuine commercial substance from the location and taxation of the income.

Results of reviews

The FHTP has been reviewing preferential regimes offered by OECD countries since 1998. The Action 5 report contained an update of the review of preferential regimes of OECD countries, as well as for the first time the results of reviews of preferential regimes offered by G20 countries.

With the launch of the Inclusive Framework in June 2016, the reach of the standard on preferential regimes expanded significantly, which was extremely important in achieving a level playing field. The 2017 Progress Report contains the review of 164 regimes offered by Inclusive Framework members, undertaken in just over 12 months from the creation of the Inclusive Framework. The overall results of the review of the regimes are as shown in Diagram 4.

 Diagram 4

Results of review: IP regimes

The Action 5 report placed special emphasis on IP regimes, such as patent boxes, given that the (re)location of IP assets (and IP income) for tax planning purposes has been a common way for multinationals to reduce their overall tax burden.

The Action 5 standard requires that IP regimes must be consistent with the "nexus approach". The nexus approach stops profit shifting on IP income because jurisdictions that offer an IP regime ensure that the taxpayer can only benefit from the regime to the extent the income is earned from IP generated by research and development activity undertaken by the taxpayer itself, with limited scope for outsourcing.

Almost all of the IP regimes in OECD and G20 countries have now been amended to comply with the nexus approach, with only one of these regimes found to be actually harmful because it is inconsistent with the nexus approach, and this is why they are now shown as "not harmful" in the table. The IP regimes offered by other Inclusive Framework members have also been assessed. Virtually all of these – 30 of 31 regimes – are being abolished or amended to conform to the nexus approach, or meet the condition for treatment as a low risk "disadvantaged area regime". One IP regime remains under review (see Table 1).

Table 1
Jurisdiction Regime Status
Andorra Companies involved in the international exploitation of intangible assets In the process of being amended
Barbados International societies with restricted liability In the process of being amended
Barbados International business companies In the process of being amended
Belgium Patent income deduction Not harmful
Belize International business companies In the process of being amended
China Reduced rate for high and new tech enterprises Not harmful (While the regime did not technically comply with the nexus approach, it was considered functionally equivalent and therefore evaluated as not harmful, given its distinct features and safeguards and the willingness of China to provide additional information.)
Colombia Software regime Abolished
Curaçao Tax exempt entity In the process of being amended
Curaçao Export facility In the process of being amended
France Reduced rate for long term capital gains and profits from the licensing of IP rights Harmful because it does not comply with the nexus approach
Hungary IP regime for royalties and capital gains Not harmful
India Tax on income from patent (new IP regime) Not harmful
Ireland Knowledge development box (new IP regime) Not harmful
Israel Amended preferred enterprise regime Not harmful
Israel Preferred technological enterprise regime Not harmful
Italy Taxation of income from intangible assets Not harmful except for the extension to new entrants for trademark between July 1 2016 and December 31 2016, which is harmful.
Korea Special taxation for transfer, acquisition, etc. of technology Not harmful (subject to final adoption of new legislation)
Liechtenstein IP box Abolished
Lithuania Free economic zone taxation regime Disadvantaged area regime
Luxembourg Partial exemption for income/gains derived from certain IP rights Abolished
Macau (China) Macau offshore institution In the process of being eliminated/amended
Malaysia Principal hub In the process of being amended
Malaysia Biotechnology industry In the process of being amended
Malaysia MSC Malaysia In the process of being amended
Malaysia Pioneer status In the process of being amended
Malta Patent box Abolished
Mauritius Global business license 1 In the process of being amended
Mauritius Global business license 2 In the process of being amended
Netherlands Innovation box Not harmful
Panama City of knowledge technical zone In the process of being amended
Portugal Partial exemption for income from certain intangible property Not harmful
San Marino IP regime provided by law no. 102/2004 Abolished
San Marino New companies regime provided by art. 73, law no. 166/2013 In the process of being amended
San Marino Regime for high-tech start-up companies under Law No. 71/2013 and delegated Decree No. 116/2014 In the process of being amended
Seychelles International business companies In the process of being amended
Seychelles Companies special license In the process of being amended
Seychelles International trade zone In the process of being amended
Singapore Development and expansion incentive - services Abolished
Singapore Pioneer incentive (services) Abolished
Spain Partial exemption for income from certain intangible assets (Federal regime) In the process of being amended
Spain Partial exemption for income from certain intangible assets (Basque country) In the process of being amended
Spain Partial exemption for income from certain intangible assets (Navarra) In the process of being amended
Switzerland – Canton of Nidwalden Licence box Not harmful
Thailand International headquarters In the process of being amended
Thailand Regional operating headquarters In the process of being amended
Turkey 5/B regime (new IP regime) Not harmful
Turkey Technology development zones regime Potentially harmful because it is not consistent with the nexus approach as regards qualifying IP assets and grandfathering provisions. A reassessment will take place in 2018 as Turkey is considering amendments to the definition of qualifying IP assets.
United Kingdom Patent box Not harmful
Uruguay Benefits under law 16.906 for biotechnology In the process of being amended
Uruguay Benefits under lit S art. 52 for biotechnology and for software In the process of being amended
Uruguay Free zones In the process of being amended
Vietnam Export processing zone Under review

 

The timelines for making these amendments have been ambitious, and the fact that Inclusive Framework members are working to these timelines shows the level of commitment to addressing base erosion and profit shifting. The key timelines are shown in Table 2, with the different tranches of timelines reflecting the fact that jurisdictions joining the Inclusive Framework in 2016 and later needed additional time to make the necessary legislative changes. However, the final cessation date is the same for all pre-existing IP regimes, with a relatively limited grandfathering period available and requirements for exchange of information on those grandfathered taxpayers as a further safeguard.

These developments are significant, and the nexus approach is now firmly entrenched in IP regimes around the world. The widespread implementation of the nexus approach is a significant step forward in achieving the goals of the BEPS project, by ensuring that taxation is aligned with economic substance and value creation.

 

Table 2
Event Agreed timeline for OECD/G20 jurisdictions Adjusted timeline for (non-OECD/G20) Inclusive Framework members
Start legislative process to amend existing IP regimes (otherwise not eligible for grandfathering) December 31 2015 December 31 2017
Cut-off date for new entrants to an existing IP regime June 30 2016 As soon as possible and no later than June 30 2018
The latest abolition date (i.e. end of grandfathering) for existing IP regimes June 30 2021 June 30 2021

 

Results of reviews: Non-IP regimes

The results of the reviews of the other regimes, such as headquarters, banking, and financing regimes, are reported in Table 3, with additional details on the specific regimes reflected in the Progress Report.

Table 3
Status Jurisdictions
Not harmful Hong Kong (China) (two regimes), Liberia, Lithuania, Malaysia (two regimes), Malta, Mauritius (four regimes), Panama, Peru, Singapore (seven regimes)
Abolished Malaysia, San Marino, Singapore (two regimes), Uruguay
Amended Singapore
In the process of being amended/eliminated Andorra (three regimes), Barbados (five regimes), Belize, Botswana, Costa Rica, Curaçao (three regimes), Hong Kong (China) (three regimes), Macau (China), Malaysia (eight regimes), Mauritius (five regimes), Panama (two regimes), Seychelles (seven regimes), Thailand (five regimes), Trinidad and Tobago, Uruguay (two regimes)
Potentially harmful but not actually harmful Chile, Georgia (two regimes), Seychelles
Potentially harmful Barbados (two regimes), Jordan
Harmful -
Out of scope Barbados, Georgia (two regimes), Korea (two regimes), Malaysia (two regimes), Panama, Peru, Philippines, Turkey, Uruguay (two regimes)
Under review Barbados, Kenya (two regimes), Montserrat, Nigeria, Philippines, Sint Maarten, Vietnam

 

Where regimes are in the process of being amended/eliminated in order to conform to the Action 5 standard, Inclusive Framework members have agreed to apply very ambitious timelines. Other than for IP regimes that are discussed above and have specific timelines, the expectation is that the jurisdiction will close down the regime as soon as possible, and generally by October 2018 – in just 12 months from now.

Limited grandfathering can be provided in appropriate circumstances, with safeguards that ensure that any new entrant to a regime after October 2017 will not be permitted to benefit from grandfathering. This means that the benefits available under these regimes, which have potentially harmful features, is significantly curtailed in terms of both the number of taxpayers and the amount of time that benefits can continue.

Next steps

While much has been achieved and reported in the 2017 Progress Report, the work will continue throughout 2018. In particular, the FHTP will monitor and review the regimes that are in the process of being amended or eliminated to ensure consistency with the Action 5 standard. Where possible and relevant, the OECD Secretariat will provide support to the Inclusive Framework members to amend their regimes.

Importantly, these results under Action 5 demonstrate the effectiveness of the Inclusive Framework. The Inclusive Framework is the vehicle for jurisdictions to participate, to obtain constructive and fair feedback and support, and to be held accountable to their peers. The collective interest in a fair international tax system and the need for a level playing field are driving swift and meaningful change.

This article was written by Achim Pross, head of the International Cooperation and Tax Administration division in the Centre for Tax Policy and Administration at the OECD, who has overall responsibility for the Action 5 peer reviews, and Kevin Shoom, senior adviser, and Melissa Dejong, adviser, who work on Action 5 in the Forum on Harmful Tax Practices. The views expressed in this article are the views of the authors and may not represent the views of the OECD or its members.

The above article was published on www.internationaltaxreview.com on October 26 2017 and has been republished with the approval of the Publisher.