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OECD BEPS – Action 5: Countering Harmful Tax Practices

In my last two posts, I presented the actions of BEPS which were published by OECD in September and which are considered final. In the coming weeks, I will move on to the reports that were intended as transitional.

From these, I will summarize Action 5 below, which analyses the challenges relating to harmful tax practices with special regard to aspects of transparency and the substantial activity requirement. It must be noted that Action 5 is currently published in a transitional form and will only be finalized in 2015.

Under Action Item 5, the Forum on Harmful Tax Practices (FHTP) is to deliver three outputs:

  1. Finalization of the review of OECD member countries’ preferential regimes;
  2. Development of a strategy to expand participation to non-OECD countries;
  3. Consideration of revisions or additions to the existing framework.

Especially regarding point 1 above, the emphasis has been put in Action 5 on:

  • elaborating a methodology to define a “substantial activity” requirement regarding intellectual property (IP);
  • improving transparency through compulsory spontaneous exchange on rulings relating to preferential regimes (the interpretation of rulings for the purpose of this Action is detailed below);
  • progress report on the review of the regimes of the analysed countries.

OECD’s past efforts to curb harmful tax practices

This survey serves the further development of a process launched earlier and going back to 1998, when OECD published its first document on harmful tax competition. A number of chapters in Action 5 summarize this publication from 15 years ago and similar publications of OECD issued since then. The 1998 report concentrated, above all, on geographically “mobile” harmful tax practices, i.e. practices relating to financial and other services (including IP). The report classified tax regimes into three different categories:

  1. preferential regimes in OECD countries,
  2. tax havens,
  3. non-OECD economies.

The report set out four key factors and eight other factors to determine whether a preferential regime is potentially harmful and four key factors used to define “tax havens”. Finally, the report offers 19 grand recommendations to counter harmful effects.

Action Item 5 summarizes the many reviews which have taken place since 1998: in 2000, 2001, two in 2004 – a guideline and a review - and in 2006. Three of these should be pointed out, not to the least because of their Hungarian implications.

The report of 2000 identified 47 potentially harmful tax regimes in OECD member countries and classified 35 tax regimes as tax havens. In Hungary, the report qualified as potentially harmful the 6-year tax exemption of venture capital companies and the 3% corporate tax rate applicable to companies performing activities abroad (offshore companies). Hungary was taken out of this group of countries in the 2004 report as the former practice was no longer classified as harmful and as Hungary eliminated the regulation providing for the latter practice. The 2006 review came to the conclusion that the 46 of the 47 regimes classified in 2000 as such were, in fact, not potentially harmful any more.,

Substantial activity requirement regarding IP

As OECD laid great emphasis in recent year on the substantial activity requirement (elevating the last of the 8 other criteria defined in the 1998 report),Action 5 analyses this matter in the context of the other matter in the centre of international attention, IP.

The report mentions 3 potential approaches to requiring substantial activities in an IP regime; the value creation approach, the transfer pricing approach and the nexus approach (nexus referring to the connection, relation of various things). The value creation approach was rejected after all and support of the transfer pricing approach was also lower than that of the nexus approach, so the report addresses this third approach (however, the analysts of the nexus approach raised concerns about the nexus approach not necessarily being compatible with the legal system of the EU).

The nexus approach recommends a formula for the calculation of IP-deriving income that qualifies for tax benefits, which is based on the connection (i.e. the nexus) between qualifying expenditures incurred by the taxpayer in relation to the development of IP (in proportion to all expenditures) and the revenues deriving from the IP.

The survey makes the following further (summarized) recommendations in relation to the use of the nexus approach:

  • IP shall mean patents and other IP assets that are functionally equivalent to patents only.
  • Qualifying expenditures must be directly connected to the development of IP (i.e. costs relating to the acquisition of IP are excluded),including the costs of work outsourced to independent parties.
  • Overall expenditures shall mean, in addition to qualifying expenditures, the costs, which would be regarded as qualifying expenditures if they were incurred by the taxpayer, including all costs relating to the acquisition of IP.
  • Under overall income the report basically understands royalties, income from the sale of an IP asset, and embedded IP income from the sale of products directly related to the IP asset.

Transparency by spontaneous exchange of information

The other matter addressed by Action 5 is the obligation of spontaneous exchange of information between tax authorities in certain cases regarding the rulings issued to taxpayers in relation to rules of preferential regimes. According to the Action, the term ruling includes general (non-binding) and taxpayer-specific (binding) rulings such as Advance Tax Ruling (ATRs) requests and Advance Pricing Arrengements (APAs) applied in transfer pricing.

The goal is to make the exchange of information increasingly automatic based on a pre-defined procedure, which is described in the report.

The report deals with four key questions in this regard:

  • When does the obligation to spontaneously exchange information on rulings arises?
  • Which countries must information be exchanged with?
  • What information must be exchanged?
  • What is the legal basis for the spontaneous information exchange?

The text also makes suggestions for aspects such as the deadlines to be applied, feedback and reciprocity between tax authorities, the protection of confidential information relating to taxpayers etc.

Status report on the review of preferential tax regimes in progress

Finally, Action 5 includes a status report on the latest review of preferential regimes initiated in 2010. The review is undertaken in 2 parts. OECD examines separately the preferential tax regimes relating to IP and anything else. The table includes a total of 30 preferential tax regimes divided exactly fifty-fifty to IP and non-IP related regimes.

As I already mentioned in my first post on BEPS, there is a Hungarian reference in this regard: OECD examines the 50 percent tax base benefit of income from royalty and the tax exemption of the sale of registered intangible assets. We must note in this regard that the current Hungarian regulation expressly allows the application of the tax benefit in relation to acquired intangible assets, i.e. intangible assets not developed in Hungary. This means that the Hungarian regulation expressly includes the element that the report recommends to be excluded from preferential regimes.

A result, however, is only expected in 2015 as OECD would also like to extend the review to aspects that were just formulated in the current version of Action 5.

Next steps

FHTP will complete the tasks in progress regarding the substantial activity requirement and transparency and results in this regard are promised in the report for 2015.

In addition, FHTP will start to work on aspects concerning non-OECD countries for which September 2015 was set as the deadline.

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