Changes to the international tax system as a result of the 'BEPS' project

This guide was updated in January 2018.

Following press revelations that US owned multinationals such as Amazon, Starbucks, Google and Facebook were exploiting weaknesses in the international tax system to pay very little tax in the countries where they were operating, the G20 asked the OECD to come up with proposals for reforming the tax system. In July 2013, the OECD published a 15 point Action Plan setting out the areas where it considered reform was necessary.  In October 2015, the OECD published its final reports setting out its recommendations. Along with other jurisdictions, the UK is beginning to implement the proposals.

The OECD explored ways to prevent 'base erosion and profit shifting' (BEPS) – basically the shifting of profits of multinational groups to low tax jurisdictions and the exploitation of mismatches between different tax systems so that little or no tax is paid. As a result, the tax base of a particular country may be reduced - or 'eroded'.

The OECD recommendations are complex and cover a range of issues so businesses should take detailed specific tax advice on the implications for them, but, in outline, the most significant potential consequences are likely to be:

• restrictions on interest deductions
• new rules for 'hybrid mismatches'
• a more restrictive 'patent box' regime for intellectual property
• a tighter definition of 'permanent establishment'
• increased transparency about profits earned and tax paid in each country
• an increase in cross-border tax disputes
• a tightening of the transfer pricing rules and, in a separate EU development, the potential re-opening of rulings given by EU member states.

Although some of the changes will only impact on multinational groups – others, such as the restrictions on interest deductibility, could affect purely UK-based businesses.

Although the OECD did not recommend specific measures aimed at the digital economy, there is increased international pressure for more to be done to tax revenues of digital businesses like the major US tech groups.

Restrictions on interest deductions

The OECD believes that countries are losing out on tax receipts due to excessive interest costs, which can be used by multinational groups to reduce taxable profits in companies in high tax jurisdictions. In comparison with some other countries, the UK has historically had a generous regime for providing tax deductions for interest expenses.

The UK changed its favourable rules on the deductibility of interest payments to give effect to the OECD recommendations with effect from April 2017. 

The new fixed ratio rule means that tax relief for interest and certain other financing costs is limited to 30% of 'tax-EBITDA'. Groups will need to add the tax-EBITDA of each UK resident member company and UK permanent establishment. If the group’s net tax-interest expense exceeds this 30% limit there will be an interest restriction equal to the excess (subject to the application of the group ratio rule mentioned below).

If the fixed ratio rule results in an interest deduction restriction, international groups can instead use a group ratio rule based on the net interest to EBITDA ratio for the worldwide group. This is intended to help groups with high external gearing for genuine commercial purposes.

The amounts calculated under both the fixed ratio rule and the group ratio rule are subject to the 'modified debt cap'.  This replaces the 'worldwide debt cap' and means that groups cannot deduct more net tax interest in the UK than their global adjusted net group interest expense.

The restricted interest will be carried forward indefinitely and may be treated as a deductible interest expense in a subsequent period if there is sufficient interest capacity in that period. In addition, if a group has spare capacity for an accounting period it can carry this forward and use it as additional interest capacity in subsequent periods until it expires after five years.

There is a de minimis allowance of £2 million per annum which means that groups with net interest expense below this are unaffected by the rules.

The rules apply even if there is no tax avoidance motive, any lending is purely on arm's length terms and even if the transactions and parties are entirely UK based. 

Groups with significant intra group or external borrowings need to consider the impact of the proposals – which could increase tax charges and therefore reduce profits and impact on cashflows.

Interest relief restrictions are likely to have a particular effect on businesses in the infrastructure, energy and real estate sectors, where there are often high levels of debt funding.

The rules include a 'public infrastructure exemption' designed to take infrastructure projects and certain real estate projects, out of the interest deduction restriction. To qualify, a company’s income and assets must be referable to activities related to 'public infrastructure assets', be fully taxable in the UK and the company must make an election.

Any physical asset may be a 'public infrastructure asset' if it meets a 'public benefit test'. That is, the asset is procured by a relevant public body or its use is or could be regulated by an infrastructure authority.  This includes bodies regulating airports, harbours, utility companies, the environment, roads and rail.

Any building may be a 'qualifying infrastructure asset' if it is part of a UK property business and intended to be let on  a 'short-term basis' to persons who are not related parties.

The public infrastructure exemption will only apply to interest paid to third parties where the recourse of the creditor is limited to the income, assets, shares or debt issued by a qualifying infrastructure company. Guarantees from parent companies or non-infrastructure companies within the group could prevent the exemption from applying, although there are transitional provisions for guarantees provided before 1 April 2017.

For more details see Out-Law guide to the UK restriction on corporate interest tax relief.

Hybrid mismatches

'Hybrid mismatch' arrangements allow companies to exploit differences between countries' tax rules to avoid paying tax in either country or to obtain more tax relief against profits than they are entitled to. The OECD proposes that companies entering into these arrangements would have to report a corresponding taxable profit and would be prevented from using double tax reliefs if their principal reason for doing so was to avoid tax.

The UK's hybrid mismatch rules apply from 1 January 2017. Broadly, if there is a payment which is deductible in the UK and not taxable for the recipient, the UK will deny a deduction. Where the recipient is in the UK and the payer is overseas, the overseas jurisdiction should deny the deduction, but if it does not – perhaps because it has not yet implemented its BEPS anti-hybrid rules - the UK's rules will tax the recipient. And if there is an 'imported mismatch' (a UK payment which is part of a series of arrangements, with a hybrid somewhere up the chain) the UK is again likely to be the jurisdiction which imposes a tax charge (or refuses a deduction). 

US 'check the box' planning will be affected and is so widespread that any payment by a UK entity into a US related subgroup needs to be examined carefully.

Patent box

The UK's favourable regime for intellectual property is more restrictive from July 2016.

The patent box regime allows companies liable to UK tax to elect to have profits earned from their patented innovations taxed at a lower level of corporation tax – the relief is being phased in and the rate of tax will be 10% by 2017. Under the pre-July 2016 regime a company which is a member of a group can benefit from the regime if it has developed the IP rights itself or is actively managing them.

The OECD recommended that favourable regimes should only be available to the extent that the substantial activities that generated the income benefiting from that regime took place in the jurisdiction where the regime is available. The UK has closed its pre-July 2016 regime to new entrants, and patents within the regime by that time continue to benefit from the old regime only until 30 June 2021.

Under rules which apply to patents coming within the patent box after 30 June 2016, companies can only benefit from the patent box to the extent that they have carried out R&D activity themselves or sub-contracted it to unrelated parties. In order to calculate the relief companies have to keep very detailed records tracking their expenditure by IP asset or in some cases by product or product family.

Permanent establishment / digital economy

Changes are being made to double tax treaties as a result of the OECD BEPS recommendations. These include changes to the definition of 'permanent establishment'.

Changes to the definition of permanent establishment could affect UK companies operating outside the UK. Such companies are usually only taxed in that other country if their activities there amount to a permanent establishment.

The OECD recommends changes to the current double tax treaty test for determining whether a permanent establishment (PE) exists. These changes would see a PE being created in countries where contracts are routinely concluded by someone locally without material modification and where stock is held on a long term basis.

UK companies operating outside the UK other than through a local subsidiary and non-UK companies operating in the UK should reassess whether their operations could constitute a PE.

One significant challenge for the international tax system has been how to apply the existing rules, formulated many years ago, to the digital economy. An OECD report in 2015 proposed no measures aimed specially at the digital economy. However, since then international pressure has been mounting for measures enabling countries to be able to tax some of the profits made by US owned technology companies selling products or advertising in those countries. The OECD is expected to report further in 2018.

Some EU finance ministers support an 'equalization tax', which would be imposed by reference to where a company’s turnover is derived, rather than where it books its profits. The EU has also suggested that the current system needs to change. In late 2017 the UK published a paper suggesting that in relation to digital businesses, the concept of 'user generated value' could be used to determine where tax is levied.

In the meantime countries have been taking unilateral action. In April 2015 the UK introduced a new 25% tax, called diverted profits tax designed to apply where a foreign company exploits the permanent establishment rule or where a UK company or a foreign company with a UK-taxable presence creates a tax advantage by using transactions or entities that "lack economic substance".

The UK has also proposed a withholding from royalties from April 2019 where a non-UK resident entity making sales in the UK pays a royalty to a connected party in a low tax jurisdiction.

Other countries such as Australia, Japan and India have also taken unilateral action.

Treaty abuse

The OECD recommends that countries should include anti-abuse provisions in their tax treaties. There is a range of permitted options for achieving this. The most popular option is a principal purpose test. This is the option preferred by EU countries, Australia, China, Singapore, Turkey and South Africa. Other alternatives are a US-style detailed limitation of benefit provision or a combination of a principal purpose test and a simplified limitation of benefits test.

The principal purpose test is designed to disapply treaty benefits where obtaining that benefit is one of the principal purposes of the arrangements. The UK intends to apply a principal purpose test to all its treaties, other than where a limitation of benefits clause is negotiated on a bilateral basis.

A multilateral instrument (MLI) will be used to make the OECD recommended double tax treaty changes in the huge number of existing double tax treaties. Over 70 countries have signed up to the instrument. The signatories include almost all EU countries, as well as Russia, China, Hong Kong, India, South Africa, Australia, Turkey, Switzerland and Singapore, but not the US.

Signatories set out the treaties they want to be covered by the MLI and which provisions they want to apply to their treaties. The MLI will only apply to treaties where both states have chosen to apply the MLI to the relevant treaty and where any options they have chosen are compatible. As well as provisions to prevent treaty abuse and the artificial avoidance of permanent establishments, the MLI also includes improvements to the mutual agreement procedure for resolving disputes.

The MLI will come into force once five countries have ratified it. It will apply for a specific tax treaty after both parties to that treaty have ratified the multilateral instrument and a period has passed.

Increased transparency – country-by-country reporting

Large groups have to file reports showing the tax paid and other financial information for each country in which they make profits. 

Businesses with annual consolidated group revenue in the preceding fiscal year of €750 million or more are required to file country-by-country reports with a breakdown of financial information for all countries in which they make profits and pay taxes around the world.

The report will usually be submitted to the tax authority in the jurisdiction where the parent company is located – HM Revenue & Customs (HMRC) in the case of UK parented groups.  The OECD proposes that the reports will only be shared with other tax authorities and will not be made public. However, the European Commission is proposing that EU headquartered companies or those operating in the EU would have to make the information public.

The report must be filed with HMRC within 12 months of the end of the accounting period to which the report relates.

Cross-border disputes

The implementation of the BEPS proposals is likely to lead to many more instances of double taxation as, because domestic law changes will be needed in many cases, implementation will lag behind in some countries and not all countries will implement the proposals in exactly the same way. There is likely to be an increase in cross-border tax disputes, with companies suffering double taxation if these cannot be resolved effectively. Groups should be prepared for an increase in disputes and should consider whether they have structures or arrangements that could result in double taxation.

The current provision for the resolution of double tax treaty disputes is inadequate, resulting in significant delays and disputes which never get resolved. OECD and G20 countries have agreed to commit to minimum standards on the resolution of international tax disputes.

25 countries, including the UK, have agreed to mandatory binding arbitration where tax authorities are unable to reach agreement under the mutual agreement procedure. Binding arbitration will only apply to treaties where both states choose to apply it.

Unilateral measures, such as the UK's diverted profits tax (DPT), are likely to increase the instances of double taxation. The UK claims that DPT is not covered by existing double tax treaties.

Transfer pricing  

Transfer pricing is a major focus of the BEPS project.  Favourable transfer pricing rulings given by EU member states are also being attacked and effectively overturned by the European Commission

The transfer pricing regime exists to ensure that transactions made between connected parties are taxed in the same way that they would have been had the connection not existed. The rules permit HMRC to adjust the amount of income earned for tax purposes or expense incurred on transactions between companies in the same corporate group where it appears that the transaction did not take place at ‘arm’s length’, with the same terms as those that would apply if the transaction involved an unrelated company. The OECD has recommended the tightening up of the transfer pricing guidelines.

Separately from the BEPS project, the European Commission is investigating several companies with favourable tax rulings from EU countries, which the Commission believes constitute unlawful state aid. The Commission has been investigating rulings from the Netherlands to Starbucks and IKEA, Ireland to Apple and Luxembourg to Fiat Finance and Trade, Amazon and McDonald's. The Commission has already ruled that State aid exists in some of these cases and rulings are awaited in others. The Commission has also found that rulings to multinationals under a Belgian 'excess profit' scheme also constituted State aid. Companies found to have benefited from unlawful state aid are required to repay the benefit – with repayments potentially going back 10 years or more. The Commission is also investigating the finance company exemptions in the UK's controlled foreign company (CFC) regime.

Transfer pricing can be an issue for businesses which may be manufacturing or distributing products outside the UK, importing raw materials or holding intellectual property rights outside the UK. All these transactions can give rise to transfer pricing issues if goods or services are being supplied to the UK company from non-UK members of the group or by the UK company to non-UK group members. For example, the European Commission's investigation into Starbucks’ tax arrangements related to its arrangements for purchasing coffee beans in Switzerland and roasting them in the Netherlands before importing them to the UK, as well as paying a royalty to another group entity for the use of the Starbucks name.

Transfer pricing does not just affect large multinationals – HMRC recovers significant amounts of tax from transfer pricing investigations into mid-tier businesses. Tax authorities throughout the world are looking more closely at transfer pricing.  Many developing countries are becoming much more aggressive in pursuing businesses for additional tax.

Any business with a favourable transfer pricing ruling should consider how robust that ruling is. Mid-tier companies with overseas operations should conduct a ‘health check’ to make sure they have the formal evidence needed to back up their position.

Next steps

Although the OECD recommendations include minimum standards in four areas (including country-by-country reporting and improving dispute resolution) which OECD and G20 countries would be required to implement, the majority of the proposals merely indicate a 'general policy direction' that countries could theoretically choose whether, how and when to implement.

However, the European Union (EU) has adopted an anti-tax avoidance directive (ATAD) which will force EU countries to make changes to their laws in certain areas (including interest deductibility) by 31 December 2018. This is unlikely to have a significant impact on the UK, as any changes required should have been made well before then. A further directive (ATAD II) will require EU countries to introduce rules to prevent hybrid mismatches between an EU Member State and a non-EU country. The UK hybrid mismatch rules already contain such provisions.

Many OECD and G20 member countries are still considering their response to the OECD proposals.  As a keen supporter of the BEPS project, the UK is making early changes to its tax laws in number of areas to comply with the OECD recommendations.  These include the interest restriction and hybrid mismatch provisions mentioned above.  Businesses face a period of uncertainty and possible double taxation in the short term as different jurisdictions implement the recommendations at different times and in slightly different ways.