This article was first published in the February 2014 Malaysia edition of Accounting and Business magazine.
There is a perception that international business, particularly large multinational corporations (MNCs), are not paying their fair share of corporate income tax where they do business,’ says John Wonfor, global head of tax at BDO International. ‘They are perceived to be engaged in legal or aggressive tax planning and taking advantage of existing tax laws to lower their effective global tax rates.
Wonfor estimates that, in the US, 37 out of the 50 largest high-tech companies by market cap are practising aggressive tax planning and paying effective tax rates averaging 6% to 7% compared with the US corporate tax rate of 35%. This strategy is known as base erosion and profit shifting (BEPS) – the use of planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’, or to move profits to locations where there is little activity but the taxes are low. The end result is that little or no overall corporate tax is paid.
In order to address BEPS, the international tax architecture must evolve to better reflect the dynamics of the global economy and regulate international business more effectively. ‘International tax concepts developed a hundred years ago in the 1920s worked very well for a number of years, but the way business operates has changed,’ Wonfor says. ‘So much value in international business is now driven by intellectual property and companies in the digital economy are able to do business in countries without being physically present. Tax laws need to address these changes.’
At the request of G20 finance ministers, in July 2013 the Organisation for Economic Co-operation and Development (OECD) launched an action plan on BEPS, identifying 15 specific actions to equip governments with the domestic and international instruments to address this challenge.
‘The OECD is not looking at fundamental changes to international tax principles, but will focus on abuses and specific changes to curb companies from maybe taking advantage of tax rules in ways that they were not meant to be applied,’ says Wonfor.
Permanent establishment is, says Wonfor, the biggest issue in the action plan. According to international taxation concepts, the taxpayer should be taxed where he is resident. One of the criteria defining a permanent establishment is when a company concludes contracts in that jurisdiction. Therefore, businesses that don’t want to be taxable in a particular jurisdiction avoid concluding contracts there. ‘Any company that has done planning to avoid having a fixed place of business in another country by ensuring that sales contracts are not approved in that other jurisdiction could be impacted by the action plan,’ says Wonfor. ‘A company might be marketing its products and services and doing sales and negotiations in one jurisdiction, but by avoiding concluding contracts there, it could avoid a permanent establishment there and being taxed there.’
Google, for example, carries many sales and marketing functions in its London office but contracts are legally approved in Ireland. Amazon’s UK site concludes contracts in Luxembourg but fulfils orders from its UK warehouse. Using current definitions, a warehouse doesn’t count as a permanent establishment.
Historically, the OECD favoured a residence-based taxation approach with certain exceptions, while other jurisdictions, especially non-OECD countries such as China and India, are leaning more towards source-based approach. ‘They are pushing the boundaries of what a permanent establishment is and including more things in a permanent establishment than perhaps originally envisioned by the OECD,’ Wonfor explains.
Apart from permanent establishment, the OECD will also be looking at legal but aggressive tax planning related to intangibles like intellectual property – a huge driver for companies in the digital economy. Say a company owns intellectual property in a low-tax jurisdiction. Its subsidiaries located in other higher tax jurisdictions will then pay royalties on that intellectual property, thereby allowing the company to shift profits and lower its effective tax rate. ‘Any industry operating internationally where a large amount of its value is driven by intangible property, such as technology companies, could be impacted [by the action plan],’ says Wonfor.
Companies should also be wary of anti-treaty shopping measures which seek to curb deficiencies in tax treaties. ‘Treaty shopping’ – or investing through another jurisdiction rather than investing into a country directly to achieve tax benefits due to a more favourable tax treaty – is an area that is being looked at,’ remarks Wonfor.
What’s the outlook for tax competition? ‘The OECD doesn’t support tax preferential regimes but the reality is that most countries have some sort of competition going on,’ Wonfor notes. ‘The bottom line is it’s going to be very tough to get an agreement on tax preferential regimes. » Jurisdictions will continue to use taxation to compete for business, although the OECD might be able to set goalposts as to what’s appropriate and what’s harmful.’
While tax havens might not seem to fit into a post-BEPS scenario, Wonfor suggests that they are not problematic provided there is ‘economic substance’. ‘For example, if you have a huge company with a lot of people and activities going on in, say, Bermuda, and minimal corporate tax, that would be fine, but in actuality there is not a lot of substance.’
BDO is advising companies to prepare by ensuring that tax planning respects commercial realities. ‘If I have a message to any organisation, it’s to not let tax drive your business decisions. Look at what makes business sense because it’s critical that you can support any tax plan you’re doing with the economic substance of the business,’ urges Wonfor.
‘Also, we are advising companies to pay close attention to their tax risk and take steps to reduce that risk to a level acceptable to the company. This would include paying close attention to the transfer pricing policies of the business and having the transfer pricing documentation prepared that is required by law.’
While BEPS and other international tax developments might escalate business risks, the good news is that prospects look bright for tax practitioners. Going forward, BDO International expects to grow its tax advisory practice, says Wonfor, who is responsible for developing the tax service line in the BDO international network and ensuring high quality and consistent service in BDO tax advisory across the globe.
The OECD action plan also demands more transparency through Actions 11 (establish methodologies to collect and analyse data), 12 (require taxpayers to disclose aggressive tax planning), 13 (re-examine transfer pricing documentation) and 14 (make dispute resolution mechanisms more effective), and companies may need to provide more disclosure on their tax planning strategies in order to comply with revised rules. ‘The reality is that more jurisdictions now require compliance with disclosure rules on tax planning and these will spread,’ Wonfor says. ‘The more information the OECD and governments have, the more they’ll know about the extent of aggressive tax planning and be able to devise legislation to counter this. This will probably be an easy win for OECD compared to, perhaps, permanent establishments.’
Impact of BEPS in Malaysia
According to the OECD, for the first time, the implementation of the BEPS action plan will place non-OECD/G20 countries on an equal footing. As such, Malaysia will not be exempt from the OECD’s 15 actions to tackle base erosion and profit shifting (BEPS).
Malaysian businesses with crossborder operations, as well as multinational corporations with operations in Malaysia, are likely to be affected by tighter BEPS rules.
Since transfer pricing is a key instrument in profit shifting, John Wonfor, head of tax at BDO International, and David Lai, head of tax advisory, BDO Malaysia, are calling on businesses to watch out for transfer pricing risks.
‘Transfer pricing is a major issue for Malaysian companies and foreign companies operating in Malaysia, and a big area of concern for both the OECD and the Malaysian tax authorities,’ says Lai, who has led numerous transfer pricing engagements and has extensive experience in crossborder transactions, international mergers and acquisitions and offshore investment structures. ‘BEPS will likely mean that companies will have to pay more attention to their transfer pricing documentation to ensure compliance with tax laws in each jurisdiction in which the business is operating.
‘Companies need to be able to defend their transfer pricing policies with sufficient documentation to ensure that the transfer prices used for transactions between non-arm’s length entities are at arm’s length prices,’ says Lai. ‘Tax authorities will pay more attention to prices charged for the use of intangible assets between related entities and charges for services between these entities.’
Regulators will also be keeping a close eye on treaty shopping. Companies using a third-country holding company to invest in Malaysia (or Malaysian companies using a third-country holding company to invest into another country) to achieve tax benefits should be concerned, says Lai.
Nazatul Izma Abdullah, journalist