This topic of “Base Erosion and Profit Shifting (BEPS): Concepts, Examples, India, BEPS 2.0” is important from the perspective of the UPSC IAS Examination, which falls under General Studies Portion.
Base Erosion and Profit Shifting (BEPS) refers to tax planning strategies employed by multinational enterprises to exploit gaps and mismatches in tax rules, artificially shifting profits to low or no-tax locations with little or no economic activity, thereby eroding the tax base of higher-tax jurisdictions. While some tactics are illegal, most are not. The Organization for Economic Co-operation and Development (OECD) initiated the BEPS project to combat tax avoidance and establish an international framework for fair taxation.
Definition and concept
- Base Erosion and Profit Shifting (BEPS) refers to corporate tax planning strategies used by multinational companies to “shift” profits from higher-tax jurisdictions to lower-tax jurisdictions or no-tax locations where there is little or no economic activity, thus “eroding” the “tax-base” of the higher-tax jurisdictions using deductible payments such as interest or royalties.
- BEPS exploits gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low, resulting in little or no overall corporate tax being paid.
Tax planning strategies
- Some common tax planning strategies used by multinational companies to engage in BEPS include:
- Transfer pricing manipulation: A multinational company may sell goods from its subsidiary in a high-tax jurisdiction to its subsidiary in a low-tax jurisdiction at an artificially low price, thereby shifting profits to the low-tax jurisdiction.
- Debt shifting: A multinational company may allocate a large amount of debt to its subsidiary in a high-tax jurisdiction, allowing the subsidiary to claim interest deductions and reduce its taxable income in the high-tax jurisdiction.
- Treaty shopping: A multinational company may establish a holding company in a jurisdiction that has a favorable tax treaty with another country, allowing the company to reduce withholding taxes on dividends, interest, or royalties paid between the two countries.
- Use of hybrid mismatch arrangements: Companies may exploit differences in the tax treatment of financial instruments or entities between countries to create double deductions or deductions without corresponding income inclusions.
Impact on global economy
- BEPS has significant negative consequences for the global economy, including:
- Loss of tax revenue: Governments lose tax revenue due to the erosion of their tax base, which can lead to budget deficits and reduced public spending on essential services and infrastructure.
- Distortion of competition: BEPS can create an uneven playing field, as multinational companies that engage in aggressive tax planning strategies may have a competitive advantage over smaller businesses and domestic companies that cannot access the same tax planning opportunities.
- Erosion of public trust: The perception that multinational companies are not paying their fair share of taxes can undermine public trust in the fairness and integrity of the tax system, leading to reduced voluntary compliance and increased tax evasion.
- Harm to developing countries: Developing countries may be disproportionately affected by BEPS, as they often rely more heavily on corporate income tax revenue and may have limited capacity to implement and enforce complex anti-BEPS measures.
III. OECD’s BEPS Action Plan
In response to the growing concerns about BEPS, the Organisation for Economic Co-operation and Development (OECD) and G20 countries launched the BEPS project in 2013, which aims to develop a comprehensive set of 15 Actions to tackle base erosion and profit shifting.
15 Actions and their objectives
The OECD’s BEPS Action Plan consists of 15 Actions designed to address various aspects of base erosion and profit shifting. The objectives of each Action are as follows:
- Address the tax challenges of the digital economy: Analyze and identify the main tax challenges posed by the digital economy and develop recommendations to address them.
- Neutralize the effects of hybrid mismatch arrangements: Develop model tax treaty provisions and recommendations for domestic rules to neutralize the tax effects of hybrid mismatch arrangements, which exploit differences in the tax treatment of financial instruments or entities between countries.
- Strengthen controlled foreign company (CFC) rules: Develop recommendations to strengthen CFC rules, which are designed to prevent taxpayers from shifting income to low-tax jurisdictions through the use of foreign subsidiaries.
- Limit base erosion via interest deductions and other financial payments: Develop recommendations to limit base erosion through the use of interest deductions and other financial payments, including through the use of group-wide tests.
- Counter harmful tax practices more effectively: Revamp the work on harmful tax practices, focusing on improving transparency and requiring substantial activity for preferential tax regimes.
- Prevent treaty abuse: Develop model tax treaty provisions and recommendations for domestic rules to prevent the granting of treaty benefits in inappropriate circumstances, such as treaty shopping.
- Prevent the artificial avoidance of permanent establishment (PE) status: Develop changes to the definition of PE to prevent the artificial avoidance of PE status through the use of commissionaire arrangements and other strategies.
- Align transfer pricing outcomes with value creation (Intangibles): Develop rules to ensure that transfer pricing outcomes are in line with value creation, particularly with respect to the allocation of income from intangibles.
- Align transfer pricing outcomes with value creation (Risks and capital): Develop rules to ensure that transfer pricing outcomes are in line with value creation, particularly with respect to the allocation of income from risks and capital.
- Align transfer pricing outcomes with value creation (Other high-risk transactions): Develop rules to ensure that transfer pricing outcomes are in line with value creation, particularly with respect to other high-risk transactions.
- Establish methodologies to collect and analyze data on BEPS: Develop recommendations for the collection and analysis of data on BEPS and the actions to address it, including indicators of the scale and economic impact of BEPS.
- Require taxpayers to disclose their aggressive tax planning arrangements: Develop recommendations for the design of mandatory disclosure rules for aggressive tax planning arrangements, including a requirement to disclose schemes that have the potential to undermine the BEPS Action Plan.
- Re-examine transfer pricing documentation: Develop guidance on the design of transfer pricing documentation, including a country-by-country reporting template that requires multinational companies to report income, taxes paid, and certain indicators of economic activity for each country in which they operate.
- Make dispute resolution mechanisms more effective: Develop solutions to address obstacles that prevent countries from resolving treaty-related disputes, including the development of a mandatory binding arbitration mechanism.
- Develop a multilateral instrument to modify bilateral tax treaties: Develop a multilateral instrument to enable countries to swiftly implement measures developed in the course of the BEPS project and amend their existing network of bilateral tax treaties.
Implementation and monitoring
- The OECD’s BEPS Action Plan is implemented through a combination of domestic legislation, bilateral tax treaties, and multilateral instruments.
- The Inclusive Framework on BEPS, which includes over 130 countries and jurisdictions, was established to ensure the consistent and effective implementation of the BEPS measures and to monitor their impact on an ongoing basis.
- The Inclusive Framework conducts peer reviews to assess the implementation of the BEPS minimum standards, which include Action 5 (harmful tax practices), Action 6 (treaty abuse), Action 13 (transfer pricing documentation and country-by-country reporting), and Action 14 (dispute resolution).
- The OECD also provides guidance and support to countries in implementing the BEPS measures, including through the development of model legislation, guidance on the application of the measures, and capacity-building initiatives for developing countries.
IV. Key BEPS Issues
- Transfer pricing refers to the pricing of goods, services, and intangibles exchanged between related parties within a multinational company.
- Transfer pricing is a key BEPS issue because it can be manipulated to shift profits from high-tax jurisdictions to low-tax jurisdictions, thereby eroding the tax base of the high-tax jurisdictions.
- The OECD’s BEPS Action Plan includes several Actions aimed at addressing transfer pricing issues, such as Actions 8, 9, and 10, which focus on aligning transfer pricing outcomes with value creation.
- The OECD has also developed the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which provide guidance on the application of the arm’s length principle for transfer pricing purposes.
- A permanent establishment (PE) is a fixed place of business through which the business of an enterprise is wholly or partly carried on, and it is a key concept in international taxation because it determines the taxing rights of a country over the profits of a foreign enterprise.
- BEPS concerns arise when multinational companies artificially avoid having a PE in a country to minimize their tax liabilities.
- Action 7 of the OECD’s BEPS Action Plan aims to prevent the artificial avoidance of PE status through the use of commissionaire arrangements and other strategies.
- The OECD has developed changes to the definition of PE in the Model Tax Convention on Income and on Capital to address these concerns.
- Treaty abuse occurs when taxpayers take advantage of tax treaties between countries to reduce their tax liabilities in ways that were not intended by the treaty negotiators.
- Treaty abuse is a key BEPS issue because it can result in reduced withholding taxes or double non-taxation, thereby eroding the tax base of the countries involved.
- Action 6 of the OECD’s BEPS Action Plan focuses on preventing treaty abuse by developing model tax treaty provisions and recommendations for domestic rules.
- The OECD has also developed the Principal Purpose Test (PPT) and the Limitation on Benefits (LOB) provisions as anti-abuse measures to be included in tax treaties.
Intangibles and intellectual property
- Intangibles and intellectual property (IP) are important BEPS issues because they can be easily transferred or licensed across borders, and their value is often difficult to determine.
- Multinational companies may shift profits from high-tax jurisdictions to low-tax jurisdictions by manipulating the pricing of intangibles and IP.
- Action 8 of the OECD’s BEPS Action Plan focuses on aligning transfer pricing outcomes with value creation, particularly with respect to the allocation of income from intangibles.
- The OECD has developed guidance on the transfer pricing aspects of intangibles, including the use of the arm’s length principle and the application of various transfer pricing methods.
- The digital economy poses unique challenges for international taxation because it allows businesses to generate significant profits in jurisdictions where they have little or no physical presence.
- The OECD’s BEPS Action Plan includes Action 1, which addresses the tax challenges of the digital economy and develops recommendations to adapt international tax rules to the impact of digitalization.
- The OECD has also developed a two-pillar approach to address the tax challenges arising from digitalization, with Pillar One focusing on new taxing rights for market jurisdictions and Pillar Two focusing on a global minimum tax.
Table: Key BEPS issues and related Actions in the OECD’s BEPS Action Plan
|Key BEPS Issue
|Actions 8, 9, and 10
|Intangibles and intellectual property
V. BEPS and Developing Countries
Challenges and opportunities
- Developing countries face unique challenges in addressing BEPS issues due to their reliance on corporate income tax revenue, limited resources, and capacity constraints.
- Challenges faced by developing countries in implementing BEPS measures include:
- Limited administrative capacity: Developing countries may lack the resources and expertise needed to implement and enforce complex BEPS measures.
- Inadequate access to information: Developing countries may face difficulties in obtaining the necessary information to assess and address BEPS risks, particularly with respect to transfer pricing and cross-border transactions.
- Vulnerability to tax competition: Developing countries may be more susceptible to harmful tax practices and tax competition, as they often use tax incentives to attract foreign investment.
- Opportunities for developing countries in addressing BEPS include:
- Increased tax revenue: Implementing BEPS measures can help developing countries protect their tax base and increase tax revenue, which can be used to fund essential public services and infrastructure.
- Enhanced international cooperation: Participation in the BEPS project and the Inclusive Framework can facilitate knowledge sharing, capacity building, and cooperation on tax matters between developing and developed countries.
- Improved investment climate: Addressing BEPS can contribute to a more transparent and predictable tax environment, which can promote sustainable investment and economic growth.
Capacity building and technical assistance
- Recognizing the unique challenges faced by developing countries, the OECD and other international organizations have launched various initiatives to provide capacity building and technical assistance to support the implementation of BEPS measures in these countries.
- The Tax Inspectors Without Borders (TIWB) program, a joint initiative of the OECD and the United Nations Development Programme (UNDP), aims to strengthen tax administrations in developing countries by providing practical, hands-on assistance in the areas of auditing and tax administration.
- The Platform for Collaboration on Tax (PCT), a joint initiative of the International Monetary Fund (IMF), the OECD, the United Nations (UN), and the World Bank Group, aims to enhance global cooperation on tax matters and provide support to developing countries in implementing BEPS measures and other tax reforms.
- The BEPS Inclusive Framework, which includes over 130 countries and jurisdictions, provides a platform for developing countries to participate in the development and implementation of BEPS measures on an equal footing with developed countries.
- These capacity-building initiatives and technical assistance programs can help developing countries overcome their capacity constraints, enhance their tax administration capabilities, and effectively address BEPS issues.
VI. BEPS and India
India’s involvement in the BEPS project
- India has been actively involved in the BEPS project in alliance with the OECD and G20 member countries, and is keen to implement and make changes to domestic law to ensure parity with BEPS recommendations.
- India has been at the forefront in amending its domestic tax law to introduce an equalization levy, limit deductibility of interest, and introduce country-by-country reporting and master file rules.
- India has also ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the MLI) and deposited its instrument of ratification along with the list of Covered Tax Agreements, reservations, and notifications.
Amendments to domestic laws and treaties
- India has made several amendments to its domestic laws and treaties to bring them in line with the BEPS recommendations, including:
- Introducing an equalization levy to address the tax challenges of the digital economy (BEPS Action 1).
- Limiting the deductibility of interest (BEPS Action 4).
- Implementing country-by-country reporting and master file rules (BEPS Action 13).
- Amending the definition of permanent establishment (PE) to prevent the artificial avoidance of PE status (BEPS Action 7).
- India has also amended some of its key tax treaties, such as those with Canada, Cyprus, France, Japan, Luxembourg, the Netherlands, Singapore, and the UK, through the operation of the MLI.
Balancing BEPS implementation and investment attractiveness
- In a developing country like India, it is vital to balance the implementation of BEPS recommendations while continuing to be an attractive investment destination for foreign investors.
- India needs to carefully consider the impact of BEPS measures on its investment climate and ensure that the measures do not create undue compliance burdens or discourage foreign investment.
- As part of its efforts to maintain investment attractiveness, India has agreed on a transitional approach for its 2% equalization levy with the US, subject to a partial future credit to multinational enterprises, prior to the implementation of Pillar One rules under the ongoing work on BEPS 2.0.
VII. Criticisms and Limitations of BEPS
Effectiveness in addressing tax avoidance
- BEPS has been criticized for not fully addressing tax avoidance issues, as problems like those exposed in the LuxLeaks scandal and other corporate tax scandals can still exist even if BEPS outcomes are implemented.
- While BEPS provides 15 Actions to equip governments with the necessary tools to tackle tax avoidance, critics argue that the measures may not be sufficient to ensure that profits are taxed where economic activities generating the profits are performed and where value is created.
Complexity and reliance on the arm’s length principle
- The outcome of BEPS has led to increased complexity and a continued reliance on the much-criticized ‘arm’s length principle’.
- The arm’s length principle is a fact-based system for allocating income, and its accurate application and enforcement require tax administrations to have significant resources and expertise.
- Critics argue that the reliance on the arm’s length principle in BEPS may not be effective in addressing tax avoidance, as it can be challenging to apply and enforce, especially for developing countries with limited resources.
Ongoing debates and unresolved issues
- Several issues, including harmful tax practices, profit split, and the digital economy, remain debated within the OECD even after the implementation of BEPS.
- The BEPS project has been only partially successful in finding effective responses to the recognized pressures on the transfer pricing system, such as the treatment of intangibles and the treatment of risk.
- The future of the arm’s length principle is uncertain, as ongoing work on BEPS 2.0 and the OECD’s efforts to address tax challenges of digitalization may affect its application in the future.
Examples of ongoing debates and unresolved issues
- The discussion on profit split methods remains unresolved, as there is no consensus on how to allocate profits among related parties in a manner that accurately reflects the value created by each party.
- The digital economy poses unique challenges for international taxation, as it allows businesses to generate significant profits in jurisdictions where they have little or no physical presence. The OECD’s BEPS Action 1 report outlined a timeline for adapting international tax rules to the impact of digitalization, but the issue remains a subject of ongoing debate.
VIII. BEPS 2.0: Future of International Tax
Pillar One: New taxing rights for market jurisdictions
- Pillar One of BEPS 2.0 focuses on addressing the tax challenges arising from the digitalization of the economy and aims to allocate new taxing rights to market jurisdictions.
- The main objective of Pillar One is to ensure that multinational enterprises (MNEs) pay taxes where they have significant consumer-facing activities and generate profits, even if they do not have a physical presence in the jurisdiction.
- Pillar One introduces a new taxing right called Amount A, which allocates a portion of an MNE’s residual profit to market jurisdictions based on a formulaic approach.
- The scope of Amount A covers large MNEs with annual consolidated group revenue above a certain threshold, which is yet to be finalized.
- Pillar One also includes Amount B, which aims to standardize the remuneration of distribution and marketing functions in market jurisdictions, ensuring a fixed return for baseline marketing and distribution activities.
Pillar Two: Global minimum tax
- Pillar Two of BEPS 2.0 aims to establish a global minimum tax to address remaining BEPS issues and ensure that MNEs pay a minimum level of tax regardless of where they are headquartered or operate.
- The global minimum tax is designed to counter profit shifting to low-tax jurisdictions and ensure a more level playing field among countries.
- Pillar Two consists of four components: the Income Inclusion Rule (IIR), the Undertaxed Payments Rule (UTPR), the Switch-Over Rule (SOR), and the Subject to Tax Rule (STTR).
- The IIR requires parent companies to include in their tax base the income of their controlled foreign companies (CFCs) if that income is subject to an effective tax rate below the global minimum tax rate.
- The UTPR denies deductions or imposes withholding taxes on payments made to related parties if the payment is not subject to tax at or above the global minimum tax rate.
- The SOR requires countries to switch from an exemption to a credit method for the taxation of foreign income if the foreign income is subject to an effective tax rate below the global minimum tax rate.
- The STTR imposes a withholding tax on certain outbound payments if the payment is not subject to tax at or above the global minimum tax rate in the recipient’s jurisdiction.
Implications for businesses
- The implementation of BEPS 2.0, including Pillar One and Pillar Two, will have significant implications for businesses, particularly MNEs.
- Businesses will need to adapt to new tax rules and compliance requirements, such as the calculation and reporting of Amount A and Amount B under Pillar One, and the application of the IIR, UTPR, SOR, and STTR under Pillar Two.
- MNEs may need to reevaluate their existing tax planning strategies and structures to ensure compliance with the new rules and minimize potential tax risks.
- The global minimum tax under Pillar Two may reduce the incentives for MNEs to engage in profit shifting and tax competition, leading to a more stable and predictable international tax environment.
- Businesses should closely monitor the ongoing developments in BEPS 2.0 and engage with tax advisors to understand the potential impact of the new rules on their operations and tax planning strategies.
Achievements and challenges of the BEPS project
- The BEPS project has made significant progress in addressing tax avoidance issues by developing a comprehensive set of 15 Actions to tackle base erosion and profit shifting.
- Over 130 countries and jurisdictions have joined the Inclusive Framework on BEPS, which ensures the consistent and effective implementation of the BEPS measures and monitors their impact on an ongoing basis.
- The BEPS project has led to increased transparency, cooperation, and information exchange among tax authorities, which can help prevent tax evasion and improve tax compliance.
- However, the BEPS project has also faced criticisms and limitations, such as its effectiveness in addressing tax avoidance, increased complexity, reliance on the arm’s length principle, and ongoing debates and unresolved issues.
Future prospects for international tax reform
- The ongoing work on BEPS 2.0, which includes Pillar One and Pillar Two, aims to address the tax challenges arising from the digitalization of the economy and establish a global minimum tax.
- Pillar One focuses on allocating new taxing rights to market jurisdictions, ensuring that multinational enterprises pay taxes where they have significant consumer-facing activities and generate profits.
- Pillar Two aims to establish a global minimum tax to counter profit shifting to low-tax jurisdictions and ensure a more level playing field among countries.
- The implementation of BEPS 2.0 will have significant implications for businesses, particularly multinational enterprises, as they will need to adapt to new tax rules and compliance requirements.
- As the global economy continues to evolve, it is crucial for policymakers and stakeholders to address the criticisms and limitations of the BEPS project and work towards a fair and effective international tax system that can adapt to the challenges of digitalization and globalization.
- Analyze the challenges faced by developing countries in implementing the BEPS measures and discuss the role of capacity building and technical assistance initiatives in addressing these challenges. (250 words)
- Evaluate the effectiveness of the OECD’s BEPS Action Plan in addressing transfer pricing issues and the tax challenges of the digital economy. What are the potential implications of BEPS 2.0 for multinational enterprises? (250 words)