The OECD v. Tax Havens: Pt IV The Digital Economy

     The current tax rules underpinning practically every tax code around the globe are derived from a "bricks and mortar" or manufacturing based economy.  What this means is the underlying concepts were developed when all world economies were based on building physical products that were bought and sold (think industrial revolution).  For example, the tax treaty phrase "permanent establishment" was actually developed by League of Nation's negotiators during their preliminary discussions to develop a working tax treaty framework.  Compare this to today's digital economy where "products" are actually multiple lines of computer code that exist in cyber-space (or a trademark or patented item) or where a "store front" (the old "permanent establishment") is in fact a web site located halfway around the globe on a server in a tax haven.  This mismatch between the underlying concepts of the old tax code and the new economy have allowed tax planners to devise tax plans that exploit the inherent conceptual incongruity between the underlying tax code and actual business being taxed.

     The original OECD model tax treaty attempted to deal with some of the problems created by this situation in their electronic commerce section of the OECD model tax treaty commentary (paragraphs 42.1-42.10).  Paragraph 42.8 of that section concluded:

Where, however, such functions form in themselves an essential and significant part of the business activity of the enterprise as a whole, or where other core functions of the enterprise are carried on through the computer equipment, these would go beyond the activities covered by paragraph 4 and if the equipment constituted a fixed place of business of the enterprise (as discussed in paragraphs 42.2 to 42.6 above), there would be a permanent establishment.

(for further explanation, you may also wish to see this presentation available on slideshare)

     However, this solution is rather narrow; serious exploitation of the old rules when applied to a more modern business is still part and parcel of modern international tax planning.  As such, this is an area which the OECD recommendations target for change, including a targeting of the following areas:

1. the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, 
2. the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services,
3. the characterisation of income derived from new business models, 
4. the application of related source rules, and 
5. how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.

Each of these areas is a topic onto itself, but suffice it to say that breadth of the potential changes is incredibly broad.

The OECD v. Tax Havens: Pt III New Concerns

On July 13, the OECD issued a new paper titled, Action Plan on Base Erosion and Profit Shifting.  The purpose of this paper was to outline the OECD's new round of concerns regarding tax havens and their use in international tax planning.  It's first important to understand what is behind the issuing of this new report:

Over time, the current rules have also revealed weaknesses that create opportunities for BEPS. BEPS relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation. 

One of the central purposes of the OECD's original tax treaty was to divide taxing rights and privileges between the two sovereigns that sign a particular treaty.  Essentially, each country can tax transactions which occur within their borders (hence the residence requirements of section 1, the residency stipulations of section 4 and the permanent establishment/business profits interaction in sections 5 and 7 of the OECD model treaty).  However, through the interaction of two different tax systems, planners have come to exploit situations so no taxation occurs.  Hence the issue of "double non-taxation."  

In addition, less than single taxation is also possible.  While this term may seem a misnomer, in fact it's not.  One of the central ideas both of accounting and taxation is to effectively align income and expenses.  For example, when a company produces a product, it is allowed under most tax and accounting systems to deduct expenses incurred in production of that product.  This is sometimes referred to as the matching principal.  Less than single taxation occurs when a company manipulates transfer pricing rules to drain money away from the location where the expense should occur to a lower tax jurisdiction.  One of the most common examples is placing intellectual property in a low-tax jurisdiction and paying royalties to that jurisdiction for use of the property, even though the production of that IP occurred in the higher tax jurisdiction. 

This point leads nicely into the third primary concern of the OECD:

The spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.

Over the last 6-9 months, the tax planning of Apple, Google, Amazon and Adobe have been publicized in a negative light.  Because these companies all utilize IP, they are able to send their valuable assets to offshore low-tax jurisdictions and use these venues as "hubs" which collect vast sums of money in a low tax manner.  The OECD is concerned that these structures remove money from higher tax jurisdictions in a manner that does not reasonably employ matching concepts.  The OECD expresses their concern thusly:

It also relates to arrangements that achieve no or low taxation by shifting profits away from the jurisdictions where the activities creating those profits take place. No or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it. In other words, what creates tax policy concerns is that, due to gaps in the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be only unduly lowly taxed.

 

The OECD v. Tax Havens, Part II: Initial Recomendations

As discussed in the previous post, the OECD originally went after tax havens in a 1998 document titled, Harmful Tax Competition, An Emerging Global Issue.  They defined a tax haven as a low or no tax jurisdiction that employs secrecy and does not exchange information with other taxing officials.  To counter-act the effect of havens, the OECD proposed a number of options.  There are several that stand out.

Recommendation concerning Controlled Foreign Corporations (CFC) or equivalent rules: that countries that do not have such rules consider adopting them and that countries that have such rules ensure that they apply in a fashion consistent with the desirability of curbing harmful tax practices.

Most advanced economies have some form of CFC rules, the purpose of which is to attribute offshore income to onshore shareholders.  The US adopted its rules in the early 1960s, as did most of the larger European countries.  

Recommendation concerning foreign information reporting rules: that countries that do not have rules concerning reporting of international transactions and foreign operations of resident taxpayers consider adopting such rules and that countries exchange information obtained under these rules.

The US tax system -- as with most other tax systems -- is a self-reporting system.  Taxpayers annually report their income, and the threat of an audit prevents abuse.  However, in the age of electronic banking, it's very easy for people to open an account and then fund it in an un-reportable manner.  This led to the passage and implementation of FATCA rules.

Recommendation concerning greater and more efficient use of exchanges of information: that countries should undertake programs to intensify exchange of relevant information concerning transactions in tax havens and preferential tax regimes constituting harmful tax competition.

While the OECD Model Tax Treaty contains an exchange of information section, after the organization published the Harmful Tax Competition document, they began to encourage the signing of mutual assistance treaties between countries that focused exclusively on the exchange of relevant information.  A report issued in 2007 noted the progress that had been made:

The 2006 Report showed that both OECD and non-OECD countries had implemented or made considerable progress towards implementing the transparency and effective exchange of information standards that the Global Forum wishes to see achieved. It also showed that further progress is needed if a global level playing field is to be achieved. Thus, the Statement of Outcomes issued after the Global Forum meeting in Melbourne on 15-16 November 2005 outlined a series of steps involving individual, bilateral and collective actions which would be needed to both achieve and maintain the goal of a level playing field.

Countries continue to sign mutual assistance treaties. 

The report contained other recommendations; those listed above are simply the more important proposals.

The OECD v. Tax Havens, Part I: What Is A Tax Haven?

Recently, the OECD ramped up its conflict with tax havens by issuing a report titled, Action Plan on Base Erosion and Profit Sharing.  Obviously, the purpose of this report is to provide a set of options that OECD countries can enact to counter the negative impact of tax base erosion, or the shifting of tax revenue away from developed/higher tax countries to lower tax/tax havens.  But before I get to the report, a bit of background is necessary to provide some context to the conflict.

First, how did tax havens develop?  As I noted in a post I wrote on my economic blog about the Cyprus  situation:

First, let's classify countries geographically.  If you look at a map of the world and then look at the tax rates of most countries, the small countries -- typically islands -- have low to non-existent tax rates.  The reason is actually pretty simple: they have small populations and small geographic areas.  Hence, their need for tax revenue is greatly reduced (they don't have a social safety net to pay for and they don't have a great deal of infrastructure needs).  This is why the islands in the Caribbean have become tax havens -- a development made far easier because of electronic banking.  And when low tax rates are combined with bank-secrecy laws, an entire industry is now born -- offshore banking.

While these countries were bit players for the first half of the 20th century, their importance has increased as electronic commerce makes it far easier to form and manage companies from a distance and transfer certain types of assets through electronic or paper means.  As the world economy become more integrated, these jurisdictions increased in importance, slowly draining tax revenue out of higher tax countries.

In response to this cash drain,  the OECD issued a report called Harmful Tax Competition, An Emerging Global Issue in 1998.  The report noted that as the modern economy developed, certain types of economic activities could be moved from higher tax to lower tax countries.  Some of the more common structures include the following:

1.) Intellectual property centers: all IP is stored in an offshore company that is located in a low tax environment.  The company's branches pay royalties to the company, thereby draining cash from high tax countries to low tax countries.

2.) International finance centers: companies place all of their liquid financial assets in an offshore company which then provides financing to branches.  Interest payments allow money to move from high tax countries to low tax countries.

3.) Offshore transportation registry: Companies with transportation sections place all of their transportation assets into an offshore company which then owns the various boats, planes and the like.

4.) Offshore e-commerce: a website located on a server is considered a permanent establishment for tax treaty purposes.  Therefore, companies will house their websites on servers located in tax havens, creating a point of sale in the low tax jurisdiction and trapping profit there.

There are or course, many variations on the above along with others concepts.

The report also had to define a tax haven.  They settled on with the following criteria.  

1.) A low tax or no tax environment: this is an obvious main point that must exist.  If the territory has 0% tax rate or a very low tax rate (say less than 10%), then it's a good bet it's a tax haven.

2.) Are there laws that prevent the effective exchange of information? If the home country can't find out about a company's activities in a jurisdiction, it's highly likely that the company doesn't want to have its activities discovered.  This requirement also ties into another qualification: an overall lack of transparency.  Secrecy also encourages certain types of activities such as money laundering and terrorist financing.

3.) The absence of a requirement that the activity be substantial.  By now, we've all heard about the Cayman Island street address that is actually the home of over 1,000 companies.  Obviously, no actual business is transacted at these locations; no meetings are held, no votes are taken no decisions are actually made.  Instead, these companies only exist on paper, usually to house highly mobile company asset.  The fact that no substantive business has to occur at these locations is very important, as it allows MNEs to create numerous paper companies.

4.) Does the jurisdiction hold itself out as a tax haven?  Some places have an international reputation as an offshore tax haven.   If a country says it is, it's probably true.

5.) While the report notes that "failure to adhere to international transfer pricing principles" is an "other" factor, I would argue it's a primary qualification -- and one that exists in all tax havens.  

There is hardly anything controversial in the above statements.  

Next, we'll look at the new report issued by the OECD.

More Signs Of An International Tax Evasion Clampdown

In 1998, the OECD issued a document titled Harmful Tax Competition: An Emerging Global Issue.  This was the first shot in a war between developed countries and offshore tax havens.  Over the ensuing 15 years offshore havens have become far more cooperative with higher tax countries -- at least in the compliance area; many have signed mutual assistance treaties which allow the exchange of information.  And the US has aggressively clamped down on certain evasion structures, specifically targeting UBS and Switzerland.  

The US is not alone in its efforts.  Over the last 6-12 months, we've seen the OECD and EU adopt a more aggressive posture towards advanced tax planning strategies.  The latest news is reported by the Financial Times:

Brussels is probing Ireland, Luxembourg and the Netherlands over their tax deals with multinationals paving the way potentially for a formal investigation into illegal sweeteners.

Europe’s top competition authority has asked the governments to explain their system of tax rulings and give details of assurances given to several specific companies – including Apple and Starbucks – according to people who have seen the request.

How Not To Create Corporate Substance; the Flowers Case

As we approach the end of the year, the annual tax scam circus will start coming around.  Expect promoters to make pitches for numerous half-baked schemes.  A good example of same is the Flowers case from 1983 (80 T.C. 914).  The case's facts are still a great example of how to not create corporate substance, thereby making the whole transaction suspect.

The facts are very simple: the promoters sought to form a limited partnership which invested in the record business by buying the rights to four "albums" and then selling the right to use the copyrights (The judge went so far as to describe all music albums as poorly performed and recorded).  Unfortunately for the taxpayers, the transaction was an utter sham as shown by the following facts:

The promoters had no experience in the business -- absolutely none: While this alone is not fatal to their business venture, they also didn't seek the input of people who did have the experience.  All businesses require a special skill set in order to make money.  Some -- such as the music business -- are especially skill specific.  When no one involved in the transaction has any expertise, its a sure bet there's something wrote.

There was no arms length negotiation: The promoters purchased four master recordings from a recording studio who simply named their price.  There was no second hand evaluation of product to determine if the valuation was in any way realistic.

The promotional literature was heavy on the promoter CYA and tax benefits:  Essentially the promoters wrote the package to escape all liability.  There assumed no responsibility for the potential sales of the product and stated that the shelter could be audited by the IRS.  In addition, the sales brochures were heavy on promoting the tax benefits.

The promoters were completely unaware of their responsibilities as managing partners: When questioned at trial, it became apparent the promoters had no idea what a general partner in a limited partnership was supposed to do.  And after forming the limited partnership, the promoters simply walked away.  They did not hold meetings nor they did not keep any corporate records.

There was no physical business: the limited partnership had no fixed address, no phone and no equipment.  There was literally nothing save a state level filing to prove the business even existed.

Fantastical business projections: the individuals who sold the albums projected all four would be rise to platinum level status (over 1 million units sold).  The promoters did not challenge these projections nor did they seek a second opinion. 

Like all tax plans, if it sounds too good to be true, it probably is.  

The OECD Model Treaty, Business Profits and Transfer Pricing

One of the key benefits to international transactions is the ability to utilize a network of inter-related corporate entities to shift profits to lower tax regions.  In tax vernacular, this is  referred to as transfer pricing.  While a complete discussion of this discipline is far beyond the scope of this post, it's important to understand the OECD model treaty grants broad authority to taxing authorities to recast the economic terms of a transaction to better reflect arms-length principles.

The granting of authority starts in paragraph 2 of Section 7:

2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.

This section ties directly into Section 9, which is titled "Associated Enterprises," and states the following:

1. Where

a)  an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b)  the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

The granting of authority is developed and explained over several sections of the commentary.

1.) The starting place for the analysis is the company's books and records.  Paragraph 12 of the commentary to section 7 states:  In the great majority of cases, trading accounts of the permanent establishment -- which are commonly available if only because a well-run business organisation is normally concerned to know what is the profitability of its various branches -- will be used by the taxation authorities concerned to ascertain the profit properly attributable to that establishment.

2.) However, the taxing authority does not have to take these accounts at face value.  Paragraph 12.1 of the commentary to section 7 states: However, where trading accounts are based on internal agreements that reflect purely artificial arrangements instead of the real economic functions of the different parts of the enterprise, these agreements should simply be ignored and the accounts corrected accordingly.

3.) The related commentaries give the taxing authorities broad authority to re-write internal accounts if they do not reflect economic reality.  Paragraph 2 of the commentary to section nine states: "This paragraph provides that the taxation authorities of a Contracting State may, for the purpose of calculating tax liabilities of associated enterprises, re-write the accounts of the enterprises if, as a result of the special relations between the enterprises, the accounts do not show the true taxable profits arising in that State."

So, the taxing authority will start by looking at the company's records.  If these appear to be fine, then the analysis stops there.  But if there's a problem, they can dig deeper and if warranted completely rewrite the transactions if the original terms to not reflect "economic reality."