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This article was originally published on Lexpert.
The Organisation for Economic Co-operation and Development has its sights set on corporations structuring their businesses to eliminate their tax burden. Canadian companies and their tax lawyers are watching closely
Microware Inc. is a fictitious software company that has its headquarters and software developers in Waterloo, Ont. It has sales and marketing offices on five continents.
Microware also has a subsidiary in a Caribbean tax haven. The Canadian parent invests $10 million in the subsidiary and assigns it a new software development project. The subsidiary, in turn, sub-contracts the work to the parent's programmers in Waterloo. The subsidiary pays $10 million to have the work done, and acquires ownership of the intellectual property.
The new product's sales are in many jurisdictions, the value of the product was created in Waterloo, but the profits accrue to the Caribbean subsidiary. They are taxed at a much lower rate than if they accrued to the parent company in Canada. Enter the OECD – the 34-member Organisation for Economic Co-operation and Development – which has been campaigning for several years for reform of the global tax regime. The OECD is challenging the current allocation among member states of corporate profits and their taxability. Its mantra is BEPS, for Base Erosion Profit Shifting.
BEPS, according to the OECD, refers to “tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear' for tax purposes — or to shift profits to countries where there is little or no real economic activity but the taxes are low, resulting in little or no overall corporate tax being paid.”
> The OECD has its sights set on the real Microwares of the world. Multinationals such as Google, Apple and Starbucks have been heavily criticized for structuring their business affairs in a way that has largely eliminated their tax burden.
But as Angeline Zioulas, CA, partner and National Transfer Pricing Leader with MNP LLP in Vancouver, notes: “It's good tax planning, as long as you're playing within the rules.” If those rules change, she says, “there will probably be some restructuring for clients. If they were enjoying a tax savings of 15 per cent by operating in another jurisdiction and that's gone, there's no point in keeping that structure.”
Historically, national tax systems targeted bricks and mortar enterprises; they haven't adapted to the digital revolution — the increase in intellectual property and e-commerce businesses globally. The OECD has been trying to address this new reality; it has promoted discussion of having taxation apply where the value is created or where the sales take place.
THE BEPS ACTION PLAN
The OECD's BEPS Action Plan was endorsed by G20 Finance Ministers last July in Moscow. The G20 Summit in St. Petersburg, Russia in September then approved it.
Canada is part of this emerging consensus; indeed, the federal government has actually overtaken the OECD's agenda with some of its recent tax legislation. “The Department of Finance has been ahead of the curve on a lot of the aspects of the OECD Action Plan,” says Claire Kennedy, tax partner at Bennett Jones LLP in Toronto.
“You can see Canadian fingerprints on many of these OECD recommendations,” says Christopher Steeves, tax partner at Fasken Martineau DuMoulin LLP in Toronto. The current federal government, he says, wants “to be perceived as closing loopholes.”
But with the American tax systems –one of the biggest – prone to legislative gridlock, it's unclear that the OECD blueprint really has as much momentum as the G20 endorsements suggest.
“Is this going to be the template going forward?” asks Blair Nixon, tax partner at Felesky Flynn LLP in Calgary. “I think it will be, but there'll be differences among jurisdictions as to how it's applied.
“I'm telling clients, ‘let's be cognizant of what the OECD is saying, pay attention to the thrust of legislation, not just in the next budget but over the next few years, and be properly structured to take into account the changes.' It's the Gretzky Principle: let's go where the puck will be, not necessarily where it is right now.”
The Action Plan envisions 15 areas of reform across a range of tax issues, “but not all 15 items are likely to be acted upon,” says Patrick Marley, tax partner at Osler, Hoskin & Harcourt LLP in Toronto. Perhaps the least likely is the Plan's call for a multilateral instrument to amend the world's 3,000 bilateral tax treaties. “It's extremely complicated to impose comprehensive multilateral agreement on issues,” he says.
The OECD's approach is aimed at “modifying the existing system rather than deconstructing it and rebuilding it,” says Timothy Wach, a tax partner at Gowling Lafleur Henderson LLP in Toronto. “That may be motivated by a desire to get changes in place relatively quickly.” The timetable for BEPS is tremendously ambitious, aiming for implementation of the Action Plan by December 2015.
At the heart of BEPS is suspicion of transfer pricing — the way in which intra-corporate purchases are priced. The international standard has been the arm's length principle. Says Wach: “Non-arm's length parties, when contracting across borders, have to treat each other as if they were arm's length parties. They have to pay what they would pay another service provider or seller of goods for the same goods or services.”
The OECD finds the arm's length principle is problematic in transfers of intangibles (such as patents and copyrights), contractual risks and capital. It also warns against “common types of base eroding payments, such as management fees and head office expenses” that would not normally occur between unrelated parties.
Clients also shift profits between countries through certain types of financing transactions, says Zioulas. “Loan guarantees are an item specifically mentioned by the OECD.”
The Action Plan advocates aligning corporate income with value creation. But, asks Wach, exactly where is the value created? In the Microware example, it can be argued that the equity was in the subsidiary and it bore the risk of failure of the project. “Thus, it's only fair that all of the profits accrue to the subsidiary, and that's where the value creation was.”
Microware's transfer-pricing tax strategy could easily have backfired, says Wach. Assume its Caribbean subsidiary spent the $10 million but the programmers in Waterloo failed to develop a marketable product. “If the $10 million goes for naught,” he says, “that loss is the subsidiary's, and it can't be used to offset income that the Canadian parent has from other sources. Part of what underlies our current transfer pricing system is who is bearing the risk of the activity.”
Unless the BEPS advocates “put more meat on the bone to tell us what they mean by value creation,” says Wach, “we're still going to have the same issues.”
While Ottawa hasn't addressed these issues of value creation and risk directly, it has made Canada's corporate tax system more efficient. “When I started in this business,” says Wach, “you advised clients operating in Canada and the US, ‘Maximize your revenues in the US, where they'll be taxed at lower rates, and maximize your expenses in Canada, where you get to deduct them against the higher corporate tax rate.'”
In the past decade, the reverse has applied. “Now, you want to have revenues in Canada and expenses in the US. It has made Canada far more competitive from a corporate tax perspective.”
Adds Zioulas, “I wouldn't think there are a lot of Canadian companies trying to shift profits offshore. US companies tend to be more aggressive because they have higher tax rates.”
Still, tax directors of multinationals should expect more resources being devoted to transfer pricing enforcement by all national tax authorities, says Kennedy. “A client can end up getting whipsawed, because each government wants its share of the revenues. They don't always agree on whose share is what, so the potential for double taxation is very high.”
Canadian multinationals, having adjusted to Canada's lower corporate tax regime, might well prefer the status quo in transfer pricing rules. But Wach doubts that the status quo is tenable. “If the BEPS project is to have any impact, there will have to be a revisiting of the underlying basis of transfer pricing,” he says. “One of the big issues is intangibles and the allocation of value creation for intangibles.
“A second issue is transparency, in terms of taxpayers divulging the way they approach these issues.” This may include rules requiring companies to disclose to governments their global allocation of income as well as their apportionment of economic activity and taxes paid among countries. “I think we're going to see some significant proposals on the intangibles and transparency issues.” But, Wach says, the good news is “that can be done largely within the existing framework.”
The Action Plan takes a strong stance against treaty shopping. In this practice, a non-resident taxpayer seeks preferential tax treatment by using an entity resident in a country that has a tax treaty with Canada to earn income in Canada.
Canada's Finance Department published a consultation paper in August that examines the issue of treaty shopping, which the government says is an abuse of Canada's income tax treaties. “While Canada is prepared to reduce the level of Canadian tax imposed on residents of trading partners by concluding bilateral tax treaties,” says the consultation paper, “it is not prepared to extend these tax treaty benefits to third-country residents who indirectly access these benefits by treaty shopping.”
The federal government will go forward with an anti-treaty shopping measure, says Brian Bloom, tax partner at Davies Ward Phillips & Vineberg LLP in Montreal. “The question is what form will it take.”
Kennedy says the likely measure may not be limited to discouraging the use of “name-plate type structures” in third countries. “There is already substance to those arrangements that would be necessary to entitle you to the benefit of the third-country treaty in the first place. We're speculating the anti-treaty shopping rule may go beyond that.”
However, the federal government has already significantly narrowed the categories in which nonresidents would be taxable on the disposition of Canadian assets— limiting them essentially to real estate and resources. It also eliminated the withholding tax on interest paid to arm's length non-resident lenders.
With these moves, says Bloom, treaty-shopping is far less relevant an issue than it used to be. “The Canadian tax system is no longer seeking to tax non-residents except on their disposition of very limited types of property [resource and real estate assets or companies]. In those areas, it may still be beneficial to a foreigner to invest through a jurisdiction that has a favourable tax treaty with Canada.”
To eliminate that practice altogether, Bloom expects Ottawa will do a treaty override. Otherwise, he says, it would take a long time for Canada to renegotiate the individual treaties that contain the “business property exception” — and many of our treaty partners may refuse to eliminate it.
Steeves says “it's not acknowledged in the tax community that Canada has a problem with treaty shopping.” If Ottawa feels the need to address the practice, however, he urges that it do so on a treaty by treaty basis, rather than through an override. “If you look at the number of treaties where we have a concern, it's probably only half a dozen.”
Shareholders of resource or property companies (and their executives whose compensation is mainly stock-based) would probably be against anti-treaty shopping, says Bloom. “It will likely increase the cost of capital for such companies and make them less attractive to foreign buyers. But managers who want to protect their jobs may see an anti-treaty-shopping measure as a form of tax poison pill.”
HYBRID MISMATCH ARRANGEMENTS
Hybrid entities and instruments are another OECD target. An entity may be viewed as a corporation in one jurisdiction and as a partnership in another. Similarly, a preferred share issue may be viewed as equity in one place and debt in another.
These discrepancies can result in arbitrage opportunities such as double non-taxation, double deduction or long-term deferral of taxation of hybrid instruments and entities. The OECD wants to thwart these potential effects through changes both to multilateral tax treaties and domestic law.
“There could be broad implications [for Canada] but the degree is not yet clear,” says Marley. Canada has previously addressed hybrid mismatch arrangements through changes to its bilateral tax treaty with the US (especially article IV(7), which denies treaty benefits to certain hybrid entities).
“If the outcome of the Action Plan is to introduce rules like we have in article IV(7) of the bilateral treaty,” says Marley, “there would not likely be much impact on Canada in that the US is our major trading partner and we already have a rule in that treaty.
“On the other hand, if the recommendation is that all countries should come to a common view on the character of entities or instruments, then that could have a huge impact around the world,” he says.
But this seems unlikely, says Marley, as the OECD respects the differences in how countries craft their domestic laws. This means Canada would address hybrid arrangements in ways that it has already done.
For example, the 2010 federal budget introduced measures to counter “foreign tax credit generators,” schemes designed to avoid tax that would otherwise be payable on interest income from loans made, indirectly, to foreign corporations. Ottawa opposed these “generators” for artificially increasing foreign tax credits.
“Those are rules targeted at perceived mischief arising out of hybrid instruments,” says Marley. “If you've already passed such rules, it's not clear why you would need to go further.” Thus, Canadian taxpayers positioning themselves on this issue might do well to affirm the Canadian status quo.
STRENGTHENING CFC RULES
The Action Plan wants to strengthen controlled foreign corporation (CFC) rules. These are anti-deferral rules aimed at preventing the inappropriate deferral of tax on certain income that is shifted to an entity in a tax haven, particularly where the income is passive or mobile and the taxpayer has no real economic ties with the tax haven.
The intention is to tax the passive income earned in the tax haven in the home country on a current basis (i.e., in the year it is earned, regardless of whether or not the income is repatriated).
Canada already has CFC rules, notably the foreign accrual property income (FAPI) rules, which balance preventing inappropriate tax deferral on passive income while excluding active business income from FAPI (so as not to hinder the international competitiveness of Canada's companies).
Taxpayers have used some very sophisticated structures to try to ensure that a subsidiary corporation created in a tax haven is not considered a controlled foreign affiliate, so that it avoids FAPI treatment, says Brian Carr, tax partner at KPMG Law LLP. “Suppose a Canadian corporation incorporates a wholly owned subsidiary in the Cayman Islands and the subsidiary earns interest income. But if the Canadian corporation has only 40 per cent control and a taxpayer in another country has 60 per cent, then it's not FAPI to the Canadian corporation.”
It will be individuals and smaller businesses rather than large public companies that are likely to oppose strengthening the rules on CFCs, says Carr.
The Action Plan calls for the design of rules to prevent tax-base erosion through the use of interest expense and other financial payments. Using related-party debt and third-party debt to obtain “excessive” interest deductions or to finance the earning of exempt or deferred income are identified as practices to be targeted.
The BEPS proposal to strengthen the rules on interest deductibility could put pressure on Canada to retreat from its generous treatment of “double dip” financings.
Canadian rules encourage corporations to borrow money here, deduct the interest here and invest the money in a foreign affiliate, which then lends it to a third-country subsidiary. When the subsidiary pays interest to the affiliate, the affiliate claims an interest deduction in the third country.
In 2007, Ottawa was ahead of the OECD curve when it proposed limiting domestic interest deductions related to foreign affiliate “double dip” transactions. These proposals were withdrawn, however, under intense opposition from Bay Street.
Under the impetus of the OECD, Ottawa might revisit the idea that corporations borrowing in Canada should not be able to double-dip. “From a public policy perspective, it's difficult to justify two deductions from the same amount of money,” says Carr.
But he notes that Canada isn't losing any revenue on the second deduction. Furthermore, if Canadian corporations were denied a second dip, “You'd be making Canada uncompetitive compared to other countries. If you could get all the other countries onside, that would be different.”
Ottawa has, however, recently enacted “foreign affiliate dumping” rules. These rules are intended to prohibit foreign-based multinationals with affiliates in Canada from reducing Canadian tax exposure by “dumping” into Canada shares of foreign corporations to create deductions from Canadian-source income or to create “paid-up capital” that could be returned without triggering withholding tax.
Kennedy says: “The concern [at Finance] was that foreign multinationals were loading up the Canadian affiliates with debt to finance investments in affiliates that would ultimately yield a type of income that was not going to be taxable in Canada.”
USE OF COMMISSIONAIRES
The Action Plan wants to discourage the practice of companies entering a foreign market (with civil rather than common law) and using independent agents, or commissionaires, to sell their products as an alternative to setting up distributorships, which would be a permanent establishment (PE) within the foreign market.
“Once you have a PE in that country, you're taxable in that country,” says Zioulas. “Under the commissionaire arrangement, the actual business that's selling the products is not considered to have a PE in, say, France. So they're not taxed there.”
Tax avoidance, however, may not be the main motivation in avoiding a PE abroad. Some companies, especially if privately held, wish to ensure that all their capital remains in Canada. “As a shareholder,” says Zioulas, “it's easier to pull capital out of the company if it's not trapped in another jurisdiction.
“All you're paying the agent is a commission,” she says. “All the rest of the income from a sale comes back to Canada.” Canadian businesses selling in civil-law jurisdictions abroad may therefore wish to advocate retention of the existing practice.
AGGRESSIVE TAX PLANNING
The Action Plan calls for mandatory rules that would require taxpayers to disclose so-called “aggressive tax planning” arrangements. Following the lead of the British, US and Quebec governments, the Canadian government announced in the 2010 federal budget new reporting requirements for tax avoidance transactions that comply with the letter of the law but abuse its spirit.
A major purpose of Ottawa's transaction reporting requirements is not only to identify which aggressive tax planners it might be appropriate for Canada Revenue Agency to audit but also to deter moves by tax advisors to develop standardized tax products for their clients.
“These rules are aimed at marketed tax schemes,” says Kennedy. “They've modulated those rules in the correct way to get at what those rules ought to be aimed at: tax shelters in another guise. They're aimed at avoidance transactions where the GAAR [General Anti-Avoidance Rule in Canada's Income Tax Act] would apply, and you have elements of confidentiality, typically, contingent fees or guaranteed tax results.”
Says Carr, “I suspect that people will try mightily to avoid having to report anything. They'll find some way to structure the transaction so that it's not reportable. I've certainly seen people going out of their way to make sure they don't have to report.”
AUTOMATIC TAX DATA EXCHANGE
One of the OECD's initiatives that is most likely to affect Canada and other countries is outside, but parallel to, BEPS: the proposed automatic exchange of taxpayer information among tax authorities.
Traditionally, the sharing of a taxpayer's data occurred upon request when noncompliance was suspected. But automatic sharing involves the systematic and periodic transmission of “bulk” taxpayer data by the source country to the residence country even where tax authorities have no indications of tax evasion.
“The implications for Canadian taxpayers include potential loss of privacy and the risk of misappropriation of tax data,” says Marley. “The taxpayer's information is protected only to the extent of the weakest link in the weakest country.”
While the weakest links might be suspected of being in less developed countries, a Snowden-esque penchant for disclosure could just as easily situate leakage in the most developed ones.
Unfazed by such concerns, the OECD is designing a standardized model of bilateral automatic exchange for multilateral adoption. While Canadian companies and their tax lawyers watch uneasily, the old tax order transitions to the new. Microware is on notice.
Related Topics:International Tax; BEPS; OECD
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