In this edition: 68 jurisdictions participated in the signing ceremony of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting; the IRS signs three new competent authority agreements with Iceland, New Zealand and South Africa; the IRS increases its use of data analytics in case selection; the Indian Revenue Board's Central Board of Direct Taxes issued revised safe harbor rules; and the Australian Taxation Office issued Practical Compliance Guideline 2017/8.
68 Countries Sign OECD's Multilateral Convention to Implement Tax Treaty
On June 7, 2017, 68 jurisdictions participated in the signing ceremony for the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ("MLI"). This MLI represents the realization of the Action 15 objective, which sought to develop a multilateral instrument that would facilitate the rapid implementation by governments of measures developed during the course of the G20/OECD BEPS project to close gaps in existing international tax rules by amending numerous bilateral tax treaties simultaneously. Specifically, the MLI includes articles designed to counter hybrid mismatch arrangements, treaty abuse, and artificial avoidance of permanent establishment status, as well as to improve dispute resolution and arbitration.
The treaty covers the countries' adherence to minimum BEPS standards (i.e., those pertaining to BEPS Action 6-Treaty Abuse and BEPS Action 14-Improvement of Dispute Resolution). The signatories to the agreement have indicated which existing tax treaties are to be modified and which provisions are to be applied. Where two signatories both list a common tax treaty, it is subject to the modifications agreed under the MLI, which does not directly amend the text of the existing agreement but instead modifies its application. It is claimed that over 1,100 matched agreements are already affected.
The MLI is still open for additional signatories, and nine additional countries have already expressed their intention to sign, while others are said to be working towards signature. Notable among those countries not signing the MLI was the U.S. According to U.S. Treasury Department official Henry Louie, the U.S. withheld from signing the MLI primarily because the U.S.'s current bilateral treaties already include many of the same provisions, resulting in a low degree of exposure to base erosion and profit shifting issues. For example, current U.S. bilateral tax treaties include a savings clause to prohibit external investors from routing their investments through participating treaty partners to exploit treaty benefits. Other factors driving the U.S.' decision not to sign the MLI included: (i) that it did not provide for a sufficiently "robust" limitation-on-benefits ("LOB") clause, which considers the multinational enterprise's ("MNE's") legal structure and the MNE's activities in the tax jurisdiction to determine its eligibility for tax benefits; (ii) that the arbitration provisions have "free-form reservations" (i.e., allows the participating countries to decide on which issues they are willing to submit to arbitration); and, (iii) the fact that the U.S. Senate and State Department must ratify any new tax treaties. Since the majority of the protections offered by the MLI are consistent with the policy that the U.S. Treasury Department has followed for decades, the U.S. chose not to sign at this time. Instead, the U.S. will continue to pursue bilateral conventions using the revised U.S. Model Income Tax Convention. However, Mr. Louie did posit that the U.S. may sign or participate in the MLI in the future after further consideration by the U.S. Treasury.
Further information on the Multilateral Convention is available here.
IRS Signs Agreements with New Zealand, South Africa and Iceland to Exchange Global Tax Reports
As of June 5, 2017, the U.S. Internal Revenue Service ("IRS") had signed three new competent authority agreements ("CAAs") with Iceland, New Zealand and South Africa, respectively. The new CAAs signed with Iceland, New Zealand and South Africa are very similar to those previously signed by the IRS with the Netherlands and Norway, and brings the total number of jurisdictions covered to five. These CAAs increase international tax transparency by facilitating the sharing of the Country-by-Country ("CbC") Reports, as stipulated in Action 13 of the OECD's BEPS Project. The CbC Reports of Action 13 call for MNEs with group revenues of at least $750 million Euros (or the local equivalent) to report various financial statistics for each jurisdiction in which they operate. For U.S.-parented multinationals, the IRS intends to confidentially share this information with each CAA partner, given the company has operations in the partners’ jurisdiction, in order to combat tax base erosion and profit shifting.
Since the U.S. has not signed the OECD's Multilateral Competent Authority Agreement on the Exchange of CbC Reports, it must facilitate the exchange of information through bilateral agreements with treaty partners. For the U.S. filing of CbC reports to fulfill the filing requirements of U.S.-parented MNEs in other jurisdictions for 2016, the IRS is determined to have 100 agreements signed by October 16, 2017, the extended due date for filing tax returns in the United States. At a conference in Washington, D.C. on June 7, Deborah Palacheck, Director of Treaty Administration at the IRS Large Business and International Division ("LB&I"), confirmed that the IRS is "in the active signatory process" with other jurisdictions and that other agreements are close to coming together.
The U.S. CbC Final Regulations apply to a U.S.-parented MNE's first fiscal year beginning on or after June 30, 2016. The first exchange of CbC Reports should occur within 18 months of the MNE's first fiscal year end on or after January 1, 2016.
Further information on the IRS's guidance on CbC Reporting and its model CAAs is available here.
The IRS Increases its Use of Data Analytics in Case Selection
During the 7th Annual Bloomberg BNA and Baker McKenzie Global Transfer Pricing Conference held on June 7-8, Tom Kane, division counsel for the LB&I division of the IRS Office of Chief Counsel, stated that the IRS is using analytics to develop a more efficient system of selecting cases the division will pursue. The IRS' move toward data-based case selection echoes a global tax administration shift toward collecting more detailed data (e.g., CbC reports) and using data analytics to improve their tax systems.
The IRS has not revealed the details behind their increasingly data-based approach or how this differs from their previous approach to case selection. The former case selection process was based on computer scoring and used computer programs to assign numeric scores to particular line items. The overall scores were calculated based on (i) the Discriminant Function System ("DIF") score which rates the potential for change based on past IRS experience with similar cases; and, (ii) the Unreported Income DIF ("UIDIF") score which rates the return for the potential of unreported income. Once all returns had been scored, IRS personnel then screened the highest-scoring returns for potential audit selection. While the IRS has shared its general case selection process, the algorithms themselves remain a closely guarded secret. Therefore, it is unknown what role, if any, such algorithms will play in the new case selection process.
The shift toward data-based case selection also echoes the IRS' general trend of using data analytics to improve its tax system. On January 31, 2017, the LB&I announced the selection of 13 campaigns that more narrowly focus the agency's enforcement efforts. These campaigns were identified through extensive data analysis, suggestions from IRS employees, and feedback from the tax community.
Recent India Transfer Pricing Developments: Release of Revised Safe Harbour Rules 2017
On June 7, 2017, the Indian Revenue Board's Central Board of Direct Taxes ("CBDT") issued revised safe harbor rules for transfer pricing purposes ("New Safe Harbor Rules"). These rules take effect from the fiscal year beginning April 1, 2017 (i.e., Fiscal Year 2017-18) and will continue to remain in force for two immediately succeeding years thereafter (i.e., up to Fiscal Year 2019-20). Prior to the effective date, the taxpayer is free to choose to apply either the earlier safe harbor rules (issued in September 2013) or the New Safe Harbor Rules to the Fiscal Year 2016-17.
The New Safe Harbor Rules implement the following changes:
- Moderation of safe harbor rates for the provision of all contracted services as follows:
- For Information Technology ("IT") and IT-enabled services ("ITeS"), the prior proscribed markup range of 20-22 percent was lowered to 17-18 percent.
- For Knowledge Process Outsourcing ("KPO") services, the prior proscribed markup rate of 25 percent was lowered to 17 percent, 21 percent, and 24 percent, respectively, depending on the proportion of employee cost.
- For contract Research and Development ("R&D") services for IT and generic pharmaceutical drugs, the prior proscribed markup of 29-30 percent was lowered to 24 percent.
- Introduction of an upper limit of INR 200 crore (approximately USD 30 million) for application of the safe harbor rates to all contract services.
- Introduction of safe harbor for receipt of (or payment for) low-value adding intragroup services at an aggregated value less than INR 10 crore (approximately USD 1.5 million) with a markup of less than 5 percent. In order to be eligible for such treatment, the following aspects of cost determination need to be certified by an accountant:
- method of cost pooling;
- exclusion of shareholder costs and duplicate costs; and,
- reasonableness of the allocation keys.
The definitions for what qualifies as a "low-value adding intragroup service" and "accountant" are set out in the New Safe Harbour Rules.
- Introduction of safe harbor rates on loans advanced in foreign currency to Indian taxpayers to be based on the London Interbank Offer Rate ("LIBOR") plus spreads, which varies according to the credit rating of the borrower.
The safe harbor regime is optional to taxpayers. However, taxpayers who want to benefit from this rule must make an application, providing the necessary details of the transaction, to the appropriate authority prior to the due date for filing the income tax return for the relevant fiscal year. For Fiscal Year 2016-17, the income tax filing is due on 30 November, 2017.
Further information on India's New Safe Harbor Rules is available here.
Australia Releases New PE Attribution Guidelines Pertinent to Intra-Entity Derivatives
On May 26, 2017, the Australian Taxation Office ("ATO") issued Practical Compliance Guideline ("PCG") 2017/8, setting out the ATO's practical approach to applying Australia’s permanent establishment ("PE") attribution rules to internal derivatives of multinational banks under Subdivision 815-C of the Income Tax Assessment Act 1997 ("ITAA 1997"). PCG 2017/18 applies to tax returns lodged on or after October 31, 2014 for both Australian multinational banks and foreign banks (excluding those foreign banks that apply Part IIIB of the ITAA 1936).
This will bring some welcome relief to Australian banks, who for years have sought the ATO's approval of Taxation Ruling TR 2005/11 (Income tax: branch funding for multinational banks) as the practical approach to applying Australia's PE attribution rules to both internal bank loans and internal derivatives. Released in 2005, TR 2005/11 permits a separate entity approach by recognizing "internal loans" as a proxy for attributing the actual income and expenses of a bank from third-party funding transactions where it is not possible to trace external source and end-use of the borrowed funds. The issue stems from the fact that Australia's PE attribution rules do not adopt a "separate entity approach" to recognize notional transactions between different branch operations. Rather, profit attribution is based on allocation of actual income and expenses arising from dealings with third-parties. As a matter of practice, banks have historically recorded notional internal derivatives between branches as a proxy to (i) reflect where the risk on third-party bank transactions is managed, and (ii) to allocate the gains and losses accordingly. PCG 2017/8 confirms that this approach is appropriate in certain circumstances.
PCG 2017/8 also outlines a framework based on "complexity" to guide compliance activity:
- Low complexity transactions are generally those in which (i) the internal derivatives relate directly to an unrelated third-party derivative transaction, (ii) the terms of the internal derivative closely mirror the terms of the third-party derivative (though the pricing may leave a spread in another part of the bank to compensate a function such as sales), and (iii) the risk exposure is managed in the jurisdiction of the trader who manages risk on a portfolio basis.
- Medium complexity transactions also relate directly to unrelated third-party derivative transactions, but the terms either do not directly match the terms of the third-party derivative or multiple internal derivatives relate to a single third-party transaction (e.g., where components of risk associated with the third-party transaction are transferred to different locations).
- High complexity transactions may reference a third-party transaction on materially different terms, that was entered into between locations that do not manage that risk, or that do not reference any actual third-party transaction but instead transfer a net position (i.e., bulk risk transfer).
PCG 2017/18 provides guidance on the level of analysis and documentation (including functional and comparability analysis) expected by the ATO to support the attribution outcomes, which varies depending on the complexity level of the transaction. Banks with higher complexity transactions can expect to be subject to a greater level of scrutiny by the ATO in any transfer pricing review.
Further information on PCG 2017/8 is available here.