Introduction to BEPS in India.
Driven by the political and public focus around the world on the taxation of multi-national enterprises (MNE) businesses, the Organisation of Economic Cooperation and Development (OECD) on 19 July 2013 released its Action Plan on Base Erosion and Profit Shifting (BEPS), listing 15 focus areas for potential change in international tax rules and treaties. The Action Plan aims to ensure that profits are taxed where economic activities generating the profits are performed and where value is created. The first set of reports and recommendations were delivered on 16 September 2014.
The BEPS reports are derived from dialogue and consultation with developing countries, including India, and the experiences of international organisations working with developing countries. BEPS relates chiefly to instances where the interaction of different tax rules leads to some part of the profits of MNEs not being taxed at all. 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. The international nature of tax planning means that unilateral and uncoordinated actions by countries will not suffice and may actually make things worse. The Action Plan to address the issues that lead to BEPS is a collective international effort which stands to assist both developed and developing countries. BEPS has the potential to considerably impact on domestic resource mobilisation in developing countries. The risks faced by many developing countries, however, may differ from those faced by more advanced economies. For these reasons, some of the action items in the Action Plan are of more relevance than to developing countries others. Developing countries may lack the necessary legislative measures to address BEPS and measures to challenge BEPS may often be hindered by lack of information. The lack of effective legislation and gaps in information may leave the door open to simpler, but potentially more aggressive tax avoidance than is typically encountered in developed economies.
From an Indian perspective, measures to deal with treaty shopping and other forms of treaty abuse, transfer pricing rules in the key area of intangibles and country-by-country reporting (CbCR) are of great importance. Equally important is the agreement to implement BEPS measures through a multilateral instrument as well as thinking on taxation of the digital economy.
This article discusses the implications of the above OECD reports from an Indian perspective.
- Action 1
The digital economy has revolutionized traditional ways of conducting business around the world, while international tax rules have been slow to adapt to this new business environment. The dominant players in the digital economy are large “ecosystems” who base their business model on radically new paradigms – for example, privileged relationship with customers/ users, exploit existing relationships by entering into new sectors, extensive use of digital technologies and constant innovation, optimize exploitation of data collected from their users, capability to generate "traction”, i.e. fast development of the user base. They are often structured from inception in a way that allows them to optimize the tax treatment of their income. From this starting point, the structure may remain optimized because most of their activity is “intangible” and therefore normally does not require significant business restructuring actions to adapt their models as they evolve.
The traditional tax optimization models that are used in other sectors produce exponential effects in the case of the digital economy. This could lead to tax base erosion in the country where the customers/ users of the digital products and services are based. While this could impact developed as well as developing countries equally, the effect on emerging economies, such as India, which constitute a large customer/ user base could be quite significant. Additionally, it could result in asymmetry in favor of countries where the digital companies have located their “headquarters” and/or ownership of intangible property.
The deliverable under Action 1 seeks to address the tax challenges of the digital economy. The guidance recognizes that digital economy also raises broader direct tax challenges (nexus, characterisation, and data) as well as indirect tax challenges (VAT collection in destination country for cross-border B2C transactions) and it is not possible to ring fence digital economy for tax purposes.
The guidance identifies the key features and business models of the digital economy that exacerbate BEPS risks and discusses options and agreement on framework for evaluation re direct tax challenges including modifications to nexus rules and withholding tax on digital goods/services.
India has no specific provisions in its tax laws concerning digital economy. The domestic tax law definition of the term royalty (after its amendment by the Finance Act, 2012) is perceived to be wide enough to capture most technology/ digital economy transactions. However, the characterization of payments (i.e. business income v. royalty) has been the subject of current litigation as business income in the hands of a non-resident is generally not taxable in India in the absence of a permanent establishment (PE).
India is not a member of the OECD, but has observer status and is serving on the OECD governing body for the BEPS project. The tax authorities generally tend to apply broad concepts for PE and royalty income and as a result their interpretation may not be fully in line with the OECD rules. Courts, however, do rely on the OECD commentary in interpreting tax treaties, unless the text of a particular tax treaty deviates from the OECD Model. It would be useful for taxpayers to analyze the impact the guidance could have on their existing cross-border arrangements and business models involving India, in light of current Indian case laws that address some of these issues.
- Action 6 and Action 15
Action 6 report includes proposed changes to the OECD Model Tax Convention to prevent treaty abuse. Countries participating in the BEPS Project have agreed on a minimum standard to prevent treaty shopping and other strategies aimed at obtaining inappropriately the benefit of certain provisions of tax treaties. The report also ensures that tax treaties do not inadvertently prevent the application of legitimate domestic anti-abuse rules. The report clarifies that tax treaties are not intended to be used to generate double non-taxation and identifies the tax policy considerations that countries should consider before deciding to enter into a tax treaty with another country. The model provisions included in the report provide intermediary guidance as additional work is needed, in particular in relation to the limitation on benefits rule.
Action 15 report identifies the issues arising from the development of a multilateral instrument that modifies bilateral tax treaties. Without a mechanism for swift implementation, changes to model tax conventions only widen the gap between the content of these models and the content of actual tax treaties. Developing such a mechanism is necessary not only to tackle base erosion and profit shifting, but also to ensure the sustainability of the consensual framework to eliminate double taxation. This is an innovative approach with no exact precedent in the tax world, but precedents for modifying bilateral treaties with a multilateral instrument exist in various other areas of public international law. Drawing on the knowledge of experts in public international law and taxation, the report concludes that a multilateral instrument is desirable and feasible, and that negotiations for such an instrument should be convened quickly.
There has been a heightened focus on part of the tax authorities on claims of treaty benefits. The Indian tax law contains provisions requiring tax residency certificates and other self declarations for claiming tax treaty benefits. Indian tax law also contains general anti avoidance rules (GAAR) provisions in the tax law, proposed to be effective from 1 April 2015. The GAAR provisions also contain a clause for treaty override under specific circumstances. India is also renegotiating certain tax treaties to specifically include anti abuse provisions like limitation of benefits rules and beneficial ownership clauses. Given this, the contents of the report under Action 6 should largely be welcomed by India. The introduction of the multilateral instrument to renegotiate treaties faster should also be welcomed by India.
- Action 8
The deliverable under Action 8 seeks to revise the OECD Transfer Pricing Guidelines to align transfer pricing outcomes with value creation in the area of intangibles.
With regard to allocation of returns derived from intangibles, the guidance states that if the legal owner of the intangible in substance: (i) performs and controls all of the functions related to the development, enhancement, maintenance, protection and exploitation of the intangible; (ii) provides all assets, including funding, necessary to the development, enhancement, maintenance, protection, and exploitation of the intangibles; and (iii) bears and controls all of the risks related to the development, enhancement, maintenance, protection, and exploitation of the intangible, then it will be entitled to all of the anticipated, ex ante, returns derived from the MNE group’s exploitation of the intangible. To the extent that one or more members of the MNE group other than the legal owner performs functions, uses assets, or assumes risks related to the development, enhancement, maintenance, protection, and exploitation of the intangible, such associated enterprises must share in the anticipated returns derived from exploitation of the intangible by receiving arm’s length compensation for their functions, assets and risks. This compensation may, depending on the facts and circumstances, constitute all or a substantial part of the return anticipated to be derived from the exploitation of the intangible.
As regards provision of research and development (R&D) services by a member of a MNE group under a contractual arrangement with an associated enterprise (AE) that is the legal owner of any resulting intangibles, the guidance states that appropriate compensation for research services will depend on all the facts and circumstances. The key considerations include whether the research team possesses unique skills and experience relevant to the research, bears risks (e.g. where “blue sky” research is undertaken), uses its own intangibles, or is controlled and managed by another party. Compensation based on a reimbursement of costs plus a modest mark-up will not reflect the anticipated value of or the arm’s length price for the contributions of the research team in all cases.
Globalization has led many MNEs to establish R&D centers in India. Most of these centers are typically set up as contract R&D service providers, not eligible for intangible related returns. There has been a fair bit of controversy on the transfer pricing issues relating to the R&D centres. Given the controversy, the Indian tax administration has issued Circular 6/2013 addressing transfer pricing aspects relating to development centres. The Circular lays down guidelines for identifying a development center as a contract R&D service provider with insignificant risk. The guidelines generally follow the principle outlined in OECD’s guidance.
The Indian tax administration believes that core R&D functions which are located in India require important strategic decisions by management and employees of the Indian subsidiary and, accordingly, the Indian subsidiary exercises control over operational and other risks. In this context, allocation of routine cost plus return will not reflect an arm’s length price for the services rendered.
With regard to location savings, local market features and skilled workforce, the OECD report states that these factors may have an effect on the determination of arm’s length conditions for controlled transactions and should be addressed for transfer pricing purposes as comparability factors. The guidance further states that where reliable local market comparables are available and can be used to identify arm’s length prices, specific comparability adjustments for these factors should not be required.
With respect to location savings, the Indian tax administration believes that, apart from location savings, profit from location specific factors such as skilled manpower, access to market, a large customer base, superior information and a distribution network should also be allocated between AEs. India is of the view that price determined on the basis of local comparables does not adequately allocate location savings and it is possible to use the profit split method to determine arm's length allocation of location savings and location rents where comparable uncontrolled transactions are not available. Functional analysis of the parties to the transaction and the bargaining power of the parties should both be considered appropriate factors.
The Indian transfer pricing regulations do not contain any specific guidance on transfer pricing aspects of intangibles. In this backdrop, the guidance assumes significance from an Indian perspective. Courts in India have often acknowledged the role of OECD TP Guidelines while applying the applying Indian TP regulations.
- Action 13
Action 13 recognises the need to improve transparency for tax administrations and increase certainty and predictability for taxpayers through improved transfer pricing documentation and a template for CbCR. As a result, the OECD has issued an updated guidance on transfer pricing documentation and CbCR.
The recently issued guidance contains revised standards for transfer pricing documentation and a template for CbCR of revenues, profits, taxes paid and certain measures of economic activity. The revised guidance recommends a three tiered structure to documentation consisting of a master file, a local file and a CbC report.
The revised guidance has significantly toned down the reporting requirements than the previous discussion draft. The guidance categorises the information required in the master file into five broad categories: (i) the MNEs organisational structure; (ii) a description of the MNEs business or businesses; (iii) the MNEs intangibles; (iv) the MNEs intercompany financial activities; and (v) the MNEs financial and tax positions. The local file focuses on information relevant to the transfer pricing analysis related to the transactions taking place between a local country affiliate and associated enterprises in different countries and which is material in the context of the local country’s tax system. The CbCR, meant to be helpful got high level transfer pricing risk assessment purposes, requires aggregate tax jurisdiction wise information relating to the global allocation of income, the taxes paid and certain indicators of the location of economic activity among tax jurisdictions in which the MNE group operates. The guidance provides as annexures the information to be included in the master file, local file and the CbCR.
From an Indian perspective, it may be noted that Rule 10D of the Indian transfer pricing rules provides for an exhaustive list of such documents which a taxpayer is expected to maintain. From a compliance point of view Indian taxpayers would be governed by the Indian rules regarding documentation and the OECD guidance may not directly impact their compliance obligations. However, they do set a higher standard of expectation of the Indian tax authorities on the information they may want to see in the TP documentation. The executive summary of the report states that some emerging countries, including India, may require reporting in the CbCR of additional transactional data (beyond what is available in the master file and local file for transactions operating in their jurisdictions) regarding related party interest payments, royalty payments and especially related party service fees.
Taxpayers may therefore need to consider the need to enhance or improve the documentation they prepare under Indian rules. In the course of a TP audit the tax authorities may often require information and documentation that will be in possession of the MNE group other than the Indian entity. The OECD guidance may result in the Indian tax authorities seeking the "master file" and the CbCR maintained by the headquarter of the MNE. The Indian tax authorities may also show and interest in reviewing the global value chain of an MNE as gleamed from the master file and CbC report to assess whether the transfer pricing outcome to the Indian affiliate is consistent with value creation in India. The tax authorities will be scrutinizing business structures more closely and the onus will be on MNEs to provide evidence of commercial substance. Taxpayers will have to understand that transfer pricing documentation is no longer a routine exercise and they may need to adopt a coordinated approach to preparing the master file and local file and be prepared for a more detailed information/ document requests during an audit.
Taxpayers should monitor developments in the OECD BEPS project as well as local enforcements. Taxpayers should undertake a review of current operating models and structures to identify specific target areas and proactively manage controversy through MAPs, APAs and prepare for increased reportin