Introduction
Source-based taxation lies at the heart of the current international tax architecture (see Chapter 3), and its importance has further risen with the abolition of worldwide taxation of active business income by essentially all of the major capital exporting economies, including now the United States, the United Kingdom, and Japan.1 Notwithstanding its importance, defining the source of income is increasingly problematic, as discussed in Chapter 5. It has been made more difficult by the increasing importance of intrafirm cross-border trade and complex production chains, the increasing contribution of hard-to-value and easily mobile intangible assets to value added, and the increasing digitalization of the economy—and this increasing digitalization means that the old idea of physical presence as the main criterion for source is outmoded (see Chapter 10).
To sustain a tax system that taxes profits where they originate thus requires addressing three fundamental challenges of source-based taxation. First, the legal definitions of what constitutes domestically sourced income are out of line with today’s economic realities. Traditionally, source refers to the place where investments are made and where production takes place, which has been determined by the physical presence of labor and capital. Today, many of the most valuable companies provide electronic services, and the most valuable assets are intangible in nature and by their nature easily “moved.” Still, countries typically tax nonresidents only if certain thresholds of physical presence—known as permanent establishments—are met.
Second, source-based taxation requires allocating a multinational enterprise’s consolidated profit among its affiliates and between jurisdictions. Typically, countries’ laws aim at achieving an allocation of income within a group by requiring the subsidiaries of a multinational group to engage in arm’s length transactions, that is, to charge prices on internally provided goods and services at the same prices that unrelated parties would. However, multinational enterprises are integrated entities that benefit from economies of scope and scale. The productive activity of any one affiliate has positive spillovers on other group entities, making unrelated-party transactions and prices a poor proxy for the true profitability of the component parts of the multinational enterprise. The allocation of risk is a particularly strong example of this difficulty (see Chapter 5). Moreover, verification of whether internal prices are at arm’s length requires data from unrelated-party transactions. This information may be available for routine functions that bear limited risk and where profit margins do not vary widely. However, multinational enterprises are increasingly generating supernormal returns linked to unique intangible assets, such as patents or trademarks (see IMF, 2019). For transactions involving these assets, comparable data are often nonexistent and compliance with the arm’s length standard thus hard to verify. Multinational enterprises frequently exploit these ambiguities and shift taxable income to locations where the tax will be lowest (see Beer, De Mooij, and Liu 2019).2
Third, countries face pressures from tax competition (see Chapter 6). Governments have long provided preferential tax terms to attract internationally mobile investments that would be taxed at source, that is, in their jurisdiction. Tax competition between source countries is apparent in the massive declines in statutory corporate income tax rates over the past 40 years, in the spread of preferential regimes targeting specific income types, and in the continued reliance on special economic zones or tax holidays in many developing countries. Moreover, tax competition is likely to intensify in the future for three reasons: First, technological progress means that the production of goods and services is increasingly separated from the location of consumers; as a result, the tax base that is internationally mobile will increase and, with it, governments’ returns to offering preferential terms. Second, multilateral initiatives aimed at curbing harmful tax regimes3 will reduce governments’ options for providing tailored tax incentives and may put downward pressure on general tax rates, with negative effects on revenue generation (see Keen 2001). Third, the increasing spread of anti-avoidance measures reduces multinational enterprises’ ability to shift taxable profits between countries without commensurate adjustments in real production decisions. Actual investment decisions will thus become more sensitive to taxation, which in turn increases countries’ marginal returns to engage in tax competition.
This chapter discusses strategies to strengthen source-based taxation by addressing these three challenges. The next section recaps current approaches to taxing nonresidents in source countries and lays out options for expanding definitions of source income. This is followed by a section providing an overview of strategies that can strengthen the allocation of profits between tax jurisdictions, reducing ambiguities and the scope for profit shifting of multinational enterprises. The discussion then turns to strategies to address tax competition.
Expanding the Definition of Source-Based Taxation
Current Situation
Source-based taxation allows countries to tax the income of both resident and nonresident taxpayers, with the profits of nonresident taxpayers4 only taxed if there is sufficient “nexus” with the jurisdiction. Broadly, three types of income have historically met this requirement:
Profits (including capital gains on the sale of business assets) of permanent establishments: Since taxing one-off business transactions is administratively burdensome, countries have generally self-imposed a threshold only above which business activities will trigger the source country’s tax jurisdiction. Finding a permanent establishment typically requires that the activity is conducted through a fixed place of business.
Passive income payments (dividend, interest, and royalties) representing domestically sourced profits paid from resident to nonresident entities: These types of cross-border payments represent income generated in the source country, and the rights to tax them, in whole or in part, are typically exercised through withholding taxation.5
Capital gains from the sale of domestic immovable property located in the source country, and related rights. While capital gains on immovable property are typically taxed in the country where the property is located (the source country), capital gains on movable property, such as on shares, are typically taxed in the country where the owner is located (residence country). However, the distinction between movable and immovable property is not always clear-cut, effectively allowing taxpayers to choose where certain capital gains are taxed.
The increasing digitalization of the economy has challenged traditional definitions of what constitutes a source. Multinational enterprises benefit from customers or users in countries where they do not have a physical presence. Under current rules, these countries are not allocated a share of profits. By enacting or threatening to enact new taxes on these profits6—often referred to as digital service taxes—several countries have put pressure on the international community to find a solution (see Chapter 10).
Expanding the Definition of Nexus
As noted, countries typically tax the income earned by nonresidents on a net basis, with expenses reducing the taxable base, if the activity is carried out through a fixed place of business.7 For instance, a building site or a construction and installation project usually constitutes a permanent establishment only if it lasts for more than a specified length of time—often 183 days in a calendar year. In addition, the activities of a dependent agent, which includes employees or other persons under the control of the principal, may give rise to a permanent establishment for the principal. However, many activities are explicitly excluded from the permanent establishment concept under typical treaties.8
Strengthening the jurisdiction over business income of nonresidents requires broader domestic permanent establishment definitions, which could be achieved incrementally or through more substantial deviations from current definitions. For instance, at the simplest level, source countries could refrain from granting typical exclusions for activities—such as those having an auxiliary and/or a preparatory character even where conducted through a fixed place of business. Similarly, countries could shorten the length of time required to recognize a construction-or project-based permanent establishment or to define a permanent establishment based upon the physical presence of service providers—so-called “ service-permanent establishments.” A still more pragmatic and simpler—though also far more radical—solution could be the introduction of a quantitative threshold as a backstop: a nonresident would become subject to profit taxation in the source country if, for instance, total annual turnover that source country exceeded a certain threshold. The “force of attraction” principle provides that when an enterprise sets up a permanent establishment in the source country that country can tax all profits that the foreign enterprise derives there, irrespective of whether the business transactions are related to the permanent establishment—thus expanding the source tax base. For instance, if the head office provides goods or services directly to customers in the source country in which it operates a permanent establishment and the permanent establishment is also involved in the same line of activity, the profits earned by the head office directly could be taxed as profits attributable to the permanent establishment. Some countries, and some treaties, permit such a force of attraction doctrine, but others do not.9
However, to secure source-based profits of nonresidents that do not have any physical presence will require more fundamental changes to current definitions, as referenced above. For instance, Action 7 of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project focuses on redefinitions of the permanent establishment concept to capture so-called “commissionaire arrangements,” which are loosely defined as arrangements through which a person sells products in a host country in their own name but on behalf of a foreign enterprise that is the owner of these products. The commissionaire does not take title to the products and hence traditionally does not establish a permanent establishment for the principal in the host country. BEPS has expanded the agency permanent establishment on this point. A dependent agent would now apply to anyone who “habitually concludes the contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification.”10
Various countries have introduced the concept of a “digital permanent establishment,” defined, for example, by the presence of a certain number of digital sales or by a website directed at their markets (see Chapter 10). Related variants were also discussed at the Taskforce on the Digital Economy under the OECD’s Inclusive Framework (OECD 2019a). While now superseded by the unified approach (OECD 2019b), their underlying principles remain part of the debate, and while primarily designed to address challenges of the digital economy, these principles are potentially applicable to a much broader group. First, the “marketing intangibles” proposal is based on the idea that marketing efforts establish country-specific intangible assets based on which that country would have some taxing rights. Second, the “user value” proposal suggests that in modern business models, users create value—just as do capital and labor—as they share digital information that the multinational enterprise may then monetize.
Expanding Withholding Taxes
Most source countries tax cross-border passive income payments, which include dividends, interest, and royalty payments, on a gross basis using withholding taxes. Withholding taxation is an important backstop to base erosion as it allows taxing payments that are often deductible from the domestic corporate tax base and otherwise hard to capture.
Strengthening source-based taxation of cross-border payments can take the form either of a rate increase or of broadening the definition of which payments are domestically sourced (and thus taxable via withholding). For example, unless a rental activity forms a business—in which case the permanent establishment rules apply—rental income is difficult to reach where it flows out of the country.
Withholding can be a solution to administer a tax on rental income of nonresidents. A few countries have introduced a withholding tax on intragroup cross-border (re-)insurance premiums for coverage of risks in their country (partly as an anti-avoidance device), as well as some other types of withholding, such as on management fees paid to a parent company abroad.
Finally, source countries may introduce a branch profit tax to afford equal tax treatment to income generated by a domestic company controlled by a foreign shareholder and to income generated by a permanent establishment of a nonresident. The idea is that the total tax burden on permanent establishment profit should equal that of profit realized by a subsidiary of a foreign parent company. Although this is normally the case for corporate income tax imposed on domestic profits, remittances by a permanent establishment to its foreign headquarters will not be subject to withholding tax, as are dividends distributed by the subsidiary to its foreign sharehold-er(s), unless this is specifically made the case by a branch profits tax provision.
Capital Gains
Most countries tax capital gains on the domestic sale of business assets, securities, and real property. However, capital gains on business assets sold by a nonresident will typically be subject to tax only if they can be attributed to a permanent establishment in the jurisdiction. Shares and other securities in most cases are not taxable (sourced) in the country in which the issuing company is located, but rather are subject to tax in the jurisdiction of the seller (only). A few countries have, however, extended their jurisdiction to tax capital gains on the alienation of shares representing a substantial shareholding in a resident company, typically defined by a minimum number or value of shares and holding period.11
Nonresidents owning real (immovable) property in the host country are typically subject to tax on the sale of those immovable assets. Source countries may use a withholding tax to ensure that capital gains on the sale of real property owned by nonresidents are effectively collected.12 However, there has been quite widespread concern among developing countries—especially those with substantial mineral resource deposits—that indirect transfers farther up the chain of ownership can be used to avoid capital gains on natural resources themselves, or on mining or exploitation licenses.13 The reason is that capital gains on the alienation of shares held in resident companies are typically exempt in a cross-border situation. Capital gains on immovable property can thus be avoided by selling the immovable asset indirectly, by incorporating a company that holds the assets and then selling shares in the company abroad (“indirect transfer”). To close this loophole, most source countries attempt to tax the capital gain on shares of a nonresident company if the value of its shares is derived principally from an asset located in the source country.14 This rule is, for example, embodied in Article 13.4 of the UN Model Treaty, regardless of whether the assets are held through a domestic company or a company resident in a third country.15
It is important to note that the above measures to extend the sourced-based taxation of nonresidents have most effect if double taxation treaties are not limiting the right to tax of the host country or the host country has not concluded any double taxation treaties, which typically restrict taxing rights of those countries. If a country extends its geographic source rules, it may have to amend its double taxation treaties to ensure that those extended rules are not restricted by the international agreements (see further discussion in Chapter 8).
Strengthening the Allocation of Profits
Market forces are not fully at play in transactions between related parties, providing multinational enterprises with much room to relocate profits to wherever they are taxed the least. Profit shifting is not limited to cross-border transactions. Developing countries often provide a preferential tax treatment to selected companies in special economic zones, and many countries apply higher statutory tax rates on the profits in the natural resource sector. These statutory tax rate differentials, irrespective of whether they arise between countries or within one jurisdiction, are factored into the internal pricing strategies and structures of multinational enterprises and used to reduce their overall tax burden.
Many countries have adopted transfer pricing rules to limit multinational enterprises’ tax avoidance. These rules require that the price used in internal transactions aligns with the prices that unrelated parties would charge in similar circumstances (the “arm’s length standard”). However, verification of the arm’s length standard builds on a comprehensive analysis of the transaction and requires reference to data from uncontrolled transactions. This information is frequently not available, and many tax administrations lack the expertise necessary to verify whether prices were at arm’s length.16
While profit shifting often involves the mispricing of internal transactions, multinational enterprises can avoid taxes at arm’s length prices too.17 For instance, multinational enterprises can exploit the tax deductibility of interest payments by providing loans from affiliates in low-tax jurisdictions to related parties in high-tax jurisdictions—where these loans trigger tax-deductible interest payments. With these internal loans, multinational enterprises can increase the group’s consolidated aftertax profit while leaving pretax profits and their overall debt exposure unaffected.
More generally, multinational enterprises use multiple techniques to avoid corporate income taxation and withholding taxes, which are the primary taxes employed to capture source-based income, including the following:
Exploiting the deductibility of operating expenses, such as of interest and royalty payments, to reduce the group’s corporate income tax liability
Exploiting a country’s double taxation treaty network to reduce withholding taxes
Using artificial structures to avoid the status of a permanent establishment (see previous section)
Countries have responded to these strategies by implementing diverse anti-avoidance measures. While the specificities of these measures differ, a common feature is that many disregard expenses that are normally deductible for corporate tax. In a way, antiabuse measures increase the importance of a firm’s turnover in assessing the tax liability, thus discouraging production at a theoretically efficient level. However, reducing production efficiency might be justified in situations where tax avoidance is pervasive. For instance, Beer and Loeprick (2018) show that a revenue-maximizing withholding tax policy effectively disallows the deductibility of interest payments as treaty shopping becomes excessive.18 This finding resembles an earlier result by Best and others (2015), showing that tax avoidance justifies the taxation on a gross rather than on a net basis to support revenue efficiency.
The following subsection lays out options to strengthen the arm’s length standard and presents the most important anti-avoidance measures.
Strengthening the Arm’s Length Principle19
Over 120 countries have implemented transfer pricing legislation, but with widely varying approaches: while some countries require multinational enterprises to submit granular information, including on the group structure, financial positions in each country, and transfer pricing strategies adopted, other countries have implemented the arm’s length principle but do not require companies to submit any information at all (see Figure 11.1).
Worldwide Transfer Pricing Rules
Sources: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Graph illustrates transfer pricing practices globally, with a lower score indicating less strict rules. Transfer pricing score is 0 when a country does not adopt transfer pricing regulation; a score of 4 indicates that the country adopts transfer pricing regulation, including all three of the following features: (1) documentation requirements for cross-border transactions, (2) documentation requirements for domestic transactions, and (3) penalties for inappropriate documentation.Worldwide Transfer Pricing Rules
Sources: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Graph illustrates transfer pricing practices globally, with a lower score indicating less strict rules. Transfer pricing score is 0 when a country does not adopt transfer pricing regulation; a score of 4 indicates that the country adopts transfer pricing regulation, including all three of the following features: (1) documentation requirements for cross-border transactions, (2) documentation requirements for domestic transactions, and (3) penalties for inappropriate documentation.Worldwide Transfer Pricing Rules
Sources: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Graph illustrates transfer pricing practices globally, with a lower score indicating less strict rules. Transfer pricing score is 0 when a country does not adopt transfer pricing regulation; a score of 4 indicates that the country adopts transfer pricing regulation, including all three of the following features: (1) documentation requirements for cross-border transactions, (2) documentation requirements for domestic transactions, and (3) penalties for inappropriate documentation.At its core, the arm’s length principle requires that the transaction taking place between related parties is comparable, in both its structure and its terms, to a transaction between unrelated parties. Verifying comparability requires an understanding of the key features of the transaction, including the market structure, the risk borne by each party, the functions performed, the assets provided, and the business strategies pursued. These characteristics determine which of the available methods is most suited to determine the price that unrelated parties would charge.
However, limited access to financial data and limited capacity is a distinctive characteristic of many developing countries, making implementation of the arm’s length standard difficult.20 The ORBIS database, commercially offered by the Bureau van Dijk, is one of most comprehensive data sets available for conducting comparability analyses outside North America. The information recorded in this database includes detailed accounting and ownership information, as well as independence indicators. ORBIS has also recently made it possible for tax administrations to access more detailed price information, including on interest and royalty rates used in independent transactions. The database records information on turnover and profit and loss before taxation for around 300,000 independent and active firms, allowing users to compute simple profitability margins. Figure 11.2 illustrates the distribution of these firms globally. Most firms are located in Europe, Russia, and some Asian countries. However, there is less data available for South America and hardly any data for African countries.
Profit and Loss Data from Independent Firms
Source: Authors’ calculation, based on ORBIS.Note: Figure illustrates ORBIS coverage of independent firms in July 2019. The selection criteria were that selected companies need to (1) be active, (2) have a known value for turnover and profit before taxation, and (3) have no shareholder owning more than 25 percent.Profit and Loss Data from Independent Firms
Source: Authors’ calculation, based on ORBIS.Note: Figure illustrates ORBIS coverage of independent firms in July 2019. The selection criteria were that selected companies need to (1) be active, (2) have a known value for turnover and profit before taxation, and (3) have no shareholder owning more than 25 percent.Profit and Loss Data from Independent Firms
Source: Authors’ calculation, based on ORBIS.Note: Figure illustrates ORBIS coverage of independent firms in July 2019. The selection criteria were that selected companies need to (1) be active, (2) have a known value for turnover and profit before taxation, and (3) have no shareholder owning more than 25 percent.Several options could increase data availability. For instance, the information collected by tax administrations through tax filings or at customs provides a valuable data source for verifying multinational enterprises’ pricing strategies. However, this information is often covered by tax secrecy rules and not available to taxpayers. Countries have taken different approaches to the use of such so-called secret comparables, ranging from provisions allowing the explicit use of such information in China to a strong opposition to their use in Austria and the United States. In cases where the use of secret comparables is not allowed, profitability margins observed elsewhere need to be adjusted to reflect potential differences in the accounting standards, market risks, or other factors that might drive a wedge in the profitability margins achieved. However, there exists no universally accepted adjustment method nor agreement on the reliability of different comparability adjustment methods.
Country-by-Country Reporting
The G20/BEPS Action 13 Report (OECD, 2015) provides for multinational enterprises to report annually and for each tax jurisdiction in which they do business specific information set out in a country-by-country report. The report contains the following key elements:
Model legislation that requires the ultimate parent company of a multinational enterprise to file the country-by-country report in its country of residence
Three model competent authority agreements that could facilitate the exchange of country-by-country reports (these three models are based on existing international agreements such as the Multilateral Convention on Administrative Assistance in Tax Matters, bilateral double tax treaties, and tax information exchange agreements)
Although the information received through the exchange of country-by-country reports cannot directly be used to make a transfer pricing adjustment, the receiving authority may use it to initiate further transfer pricing audits. A common criticism of country-by-country reports is the high threshold of €750 million to require multinational enterprises to file the reports. Many multinational enterprises located in developing countries may not exceed this threshold and are thus not required to file a report. The other criticism is that developing countries cannot use the information provided in the country-by-country report for transfer pricing adjustments, even though it might be their best comparable. Finally, concluding a competent authority agreement is not always easy for developing countries due to the high standards-of-secrecy rules that OECD member states require before being willing to exchange country-by-country reports.
A key information source for verifying whether transactions have been priced at arm’s length is documentation submitted by multinational enterprises.21 Transfer pricing documentation can take different forms: simple transfer pricing returns or country-by-country reports, which are part of the BEPS minimum standards but not necessarily available to all tax administrations and contain high-level information on related-party transactions, such as on the turnover achieved with related parties and with independent entities (see Box 11.1). This type of information can support effective risk assessments and audit selection, thus increasing the efficiency of scarce administrative capacity. Local or master files contain more detailed information, such as the business purpose of a specific transaction, the transfer pricing method applied, and a comparability analysis of the price chosen. This type of information can support verifying implementation of the arm’s length standard during an audit. Moreover, many countries have made the filing of documentation a mandatory requirement, which is commonly assumed to have strong signaling effect that enhances taxpayer compliance (see Beer and Loeprick 2015).
While comprehensive documentation should provide tax administrations with better information to target its efforts, thus also reducing taxpayer compliance costs arising from unfocused or misdirected audits, the preparation of such reports can be costly, and finding the right balance between the tax authorities’ needs and avoiding excessive compliance costs is not always an easy task. Moreover, the increasing implementation of transfer pricing rules with widely varying approaches to documentation has also raised multinational enterprises’ compliance costs and limited governments’ ability to effectively exchange information. While there are several multilateral initiatives aimed at unifying documentation approaches, no internationally agreed format of documentation has been developed to date.22 In designing documentation requirements,23 countries should ensure they meet the following criteria:
Requirements must be sufficiently clear, so that taxpayers know how to document their transfer pricing calculations.
Requirements should be comprehensive enough to provide the tax administration with all relevant information needed before and during an audit.
Requirements should be sufficiently balanced to avoid an excessive documentation burden on multinational enterprises.24
Critically, requirements should be linked with a penalty if multinational enterprises fail to comply—which can take the form of late, incomplete, or incorrect filing.
Increased data availability is a prerequisite for an accurate implementation of the arm’s length principle. However, governments can also aim to implement approximate arm’s length results. With prescriptive approaches, such as safe harbors or fixed margins, transactions are considered to be at arm’s length if the applied price (or margin) falls within a prespecified range. For instance, Australia provides a safe harbor for intragroup financing arrangements: in-bound loans are considered to be at arm’s length if the interest rate applied to the loan does not exceed a specific indicator lending rate of the Reserve Bank of Australia.25
Prescriptive approaches are most appropriate in situations where one-sided transfer pricing methods, such as the comparable uncontrolled price method or cost-plus method, would also work. By eliminating the need to conduct a full comparability analysis, these approaches reduce the costs of both taxpayers and tax administrations. However, to effectively approximate arm’s length results, prescriptive approaches require a careful design that would also need to be based on some type of comparability analysis. If the specified profit margin is too low, countries may forgo tax revenue, while too high a margin would imply an excessive tax burden to firms and potentially deter investments. Moreover, differences in rules across countries can lead to double taxation or undertaxation of some part of profits.
Anti-avoidance Rules
Thin Capitalization Rules
Tax avoidance using related-party loans is one of the most pervasive forms of tax avoidance, ranking second after the mispricing of internal transactions (see, for instance, Beer, De Mooij, and Liu 2019; Heckemeyer and Overesch 2017). By exploiting differences in statutory tax rates across countries, multinational enterprises reduce their overall tax bill without increasing the group’s debt exposure or bankruptcy risk. Empirical studies show that tax differentials explain the internal debt decisions of multinational enterprises in Germany (for instance, Buettner and Wamser 2013; Schindler and others 2013); in Europe more generally (for instance, Huizinga, Laeven, and Nicodème 2008); or in the United States (for instance, Desai and others 2004). On average, a one percentage point higher corporate income tax rate increases the debt-to-asset ratio by between 0.17 and 0.28 (see De Mooij 2011).
To counter tax avoidance via related-party loans, many countries have introduced thin capitalization rules that limit the deductibility of interest payments in specific situations. These rules generally operate in one of two ways:
Ratio approaches: These operate by specifying the maximum amount of debt on which deductible interest payments are available. Often the maximum is expressed in terms of the firm’s equity.
Earning stripping approaches: Earning stripping rules, on the other hand, specify the maximum amount of deductible interest payments, rather than debt, by reference to some other variable, such as the firm’s profit.
Figure 11.3 illustrates the global spread of thin capitalization rules in 2017. In many African economies, thin capitalization rules are not yet implemented, and if they do exist, ratio approaches are more common. For instance, Kenya disallows the deductibility of interest payments on any debt that exceeds three times a firm’s equity; Ghana disallows the deductibility of interest payments once the debt-to-equity ratio exceeds 2:1. In contrast, advanced economies typically rely on earning stripping approaches. For instance, the United States introduced an earning stripping rule that caps deductibility of interest payments at 30 percent of earnings before interest, tax, depreciation, and amortization (EBITDA). Beginning in 2022 this limit will become more binding as it will apply to earnings before interest and tax (EBIT). Similarly, as of 2019, the European Union’s Anti-Tax Avoidance Directive limits the deductibility of interest payments at 30 percent of an affiliate’s EBITDA in all EU member states.
Global Thin Cap Rules
Source: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Map illustrates spread of thin cap rules globally in 2017. A thin cap score of 0 indicates that no thin cap rule is implemented; a score of 1 indicates reliance on a ratio approach; a thin cap score of 2 indicates reliance on an earning stripping approach.Global Thin Cap Rules
Source: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Map illustrates spread of thin cap rules globally in 2017. A thin cap score of 0 indicates that no thin cap rule is implemented; a score of 1 indicates reliance on a ratio approach; a thin cap score of 2 indicates reliance on an earning stripping approach.Global Thin Cap Rules
Source: Deloitte; Ernst and Young; PricewaterhouseCoopers; and authors’ calculations.Note: Map illustrates spread of thin cap rules globally in 2017. A thin cap score of 0 indicates that no thin cap rule is implemented; a score of 1 indicates reliance on a ratio approach; a thin cap score of 2 indicates reliance on an earning stripping approach.A common concern with ratio approaches is that the line between debt and equity is difficult to draw. To avoid loopholes exploiting this ambiguity, equity should be defined in a broad sense and include share capital, retained earnings, capital contributions, interest-free loans, or revaluation reserves. Debt, in turn, should encompass anything that is substantively a loan, such as finance leases, financial derivatives, or debt factoring arrangements. A simple indirect definition is that the thin cap rule regards as debt anything that triggers tax-deductible payments. Moreover, ratio approaches differ in whether they limit total or related-party debt. While the latter approach appears more targeted at tax avoidance, multinational enterprises can circumvent such rules by using back-to-back arrangements, where internal loans would appear as originating from a third-party lender (such as a bank) through shareholder or related-party guarantees. To avoid situations where multinational enterprises strategically reduce the amount of debt just before compliance with the ratio is verified, such as at the year’s end, many countries have opted to specify the debt limit as an average or a maximum over a reporting period. However, even modest loans can erode a country’s tax base if they are linked with excessive interest rates. Ratio approaches thus need to be complemented with effective transfer pricing legislation to curb profit shifting.
Earning stripping approaches, on the other hand, protect the domestic tax base more directly by specifying limits to the tax deductibility of interest payments. Many countries include de minimis thresholds where the rule is only applicable if net interest payments exceed a specific amount. For instance, the threshold is set to €3 million in the European Union’s Anti-Tax Avoidance Directive. One challenge of earning stripping approaches is that the limitation is affected by the economic cycle. With the denominator of earning stripping ratios decreasing during downturns, the restrictions become more binding and increase the costs of capital in times when additional spending would be most needed.26 Most countries that rely on earning stripping approaches thus define exceptions to the general deductibility limit in so-called escape clauses. For instance, the European Union’s Anti-Tax Avoidance Directive allows taxpayers to fully deduct its net interest payments if their ratio of equity to total assets is equal or above the group’s equity ratio. However, the application of escape clauses is not always straightforward: the reference to a group’s equity ratio typically requires adjustments to account for potential differences in accounting standards between the group’s affiliates. Moreover, local balance sheets need to be adjusted for any claims against, or shares in, foreign group entities to ensure a fair basis of comparison.
More General Deductibility Limits
Related-party loans are just one of many assets used within a multinational enterprise that can erode a country’s corporate income tax base. More generally, structures that facilitate tax avoidance are often created in two steps: First, multinational enterprises transfer valuable assets, such as financial or intangible assets, into jurisdictions that tax the return to these assets at low rates. Second, the assets are provided to other group affiliates where they erode the tax base by triggering tax deductible payments, such as interest, royalty, or service-fee payments. These payments increase profits in the low-tax jurisdiction where the asset is located. Tax avoidance that combines such structures with transfer mispricing is more effective but not necessary to reduce the multinational enterprise’s global tax bill. Two important examples of assets that are easy to relocate and whose value is difficult to determine are intangible assets and internal services. Hebous and Johanesson (2015) provide evidence for the importance of tax avoidance using internal service fees related to captive insurance companies or entities providing headquarter functions, such as advertising or management. Several empirical studies highlight the importance of intangible assets in international tax avoidance, either by mispricing royalty payments (see, for instance, Desai, Foley, and Hines 2006; Grubert 2003) or by the strategic location of intangible assets in low-tax jurisdictions (see, for instance, Dischinger and Riedel 2011; Griffith, Miller, and O’Donnell 2014). While governments have long relied on thin capitalization rules, restrictions to the deductibility of other payments have spread more recently. For instance, restrictions on the deductibility of royalty payments have been introduced in Austria in 2014, in Germany in 2017, and in Poland in 2018. The Polish rule caps deductibility at 5 percent of EBITDA, while the Austrian and German rules disallow any deduction if the royalty income is taxed lightly abroad.27
Alternative minimum taxes are blunter instruments, targeting all types of related-party payments. Corporations generally pay the greater of their regular tax liability and the minimum tax liability. For instance, the United States introduced an alternative minimum tax, the Base Erosion Anti-Abuse Tax (BEAT), as part of the Tax Cuts and Jobs Act. The measure targets corporations with gross receipts exceeding $500 million per year on average over the last three years that make more than 3 percent of their deductible payments to foreign base related parties. In calculating the tax base, the Base Erosion Anti-Abuse Tax disregards most related-party payments—except those for intermediate goods—and applies a lower rate on this base.28 African economies often rely on simpler and less targeted alternative minimum taxes that are calculated as a small share, often 1 to 2 percent, of a corporation’s turnover and that apply also domestically.
India chose a different approach and introduced a so-called equalization levy in 2016, applicable to payments for online advertising. The equalization levy is imposed at the rate of 6 percent of the gross amount paid to a nonresident for online advertising services. It is collected by withholding from the payer and applies only to payments made by businesses. While imposed as a separate levy, it is, in substance, an extension of the withholding tax on technical fees that many developing countries already impose and thus reduces the incentive to overcharge for service fees. Late in 2019 the OECD published a consultation document on the “undertaxed payments” and “subject to tax” rules in the Pillar Two approach of its response to digitalization of the economy (OECD, 2019c). The consultation document notes that these rules may operate by way of imposition of source-based taxation (including withholding tax) for a payment to a related party if that payment was not subject to tax at or above a minimum rate. Further work will develop the parameters of these rules, but an important feature is that the right will be to tax the “payment” and so apply to the gross amount. However, the country of the payer would have to investigate the tax treatment in other countries (to determine if the minimum tax is reached) before it can impose the tax. This is not the case with regular withholding taxes and may add substantial complexity to the administration of the rules.
Anti-avoidance Measures Targeting Other Forms of Tax Avoidance
While related-party payments reduce the domestic corporate income tax base, some of these income flows are still taxed domestically: withholding taxes apply in most countries on cross-border interest-, royalty-, and service-fee payments. For multinational enterprises, these taxes increase the effective costs of intragroup transactions with low-tax affiliates and limit incentives to engage in tax arbitrage.29 They can thus act as a second line of defense in safeguarding the domestic tax base, especially when administrative capacity is limited, the scope of antiabuse provisions is narrowly defined (see Balabushko and others 2017), or tax incentives have eroded the corporate tax base. For instance, Brazil levies withholding taxes at a rate of 15 percent on royalty and interest payments. However, this rate is increased to 25 percent if the recipient is domiciled in a low-tax jurisdiction.
Yet many countries have concluded double tax treaties that limit their right to tax passive income payments. Reduced withholding taxes vis-à-vis low-tax jurisdictions are especially problematic, eroding a country’s tax base both directly and indirectly: the direct effect is a reduction in withholding tax revenue collected on existing income flows, because these flows are now taxed at lower rates. In addition, behavioral responses imply that the bilateral volume of flows with both the treaty partner country and all other countries will change, with potentially more important revenue implications. Specifically, reduced withholding tax rates increase the tax differential between the source country and the low-tax jurisdiction the treaty was concluded with. Multinational enterprises will respond with the following actions:
Restructuring operations: By setting up intermediate holding companies in the treaty partner country, multinational enterprises can benefit from lower bilateral taxation. Intermediate holding companies are especially effective in reducing the group’s tax bill if the treaty-partner country (1) taxes business income minimally, (2) does not apply withholding taxes on outgoing income flows, and (3) has weak substance requirements associated with its treaty benefits. These conditions provide for an easy flow of money to the ultimate parent’s location.30 The restructuring will lead to increased flows through the low-tax jurisdiction and reduced flows through all other jurisdictions that apply higher effective taxes on income payments.
More aggressively pricing related-party transactions: With a larger tax differential, the return to transfer mispricing increases, which is what multinational enterprises can exploit by charging higher royalty and service-fee payments than they otherwise would. As a consequence, not only the quantity but also the price of related-party payments going to the low-tax jurisdiction will likely increase.
A structured approach to concluding double taxation treaties is one of the most effective anti-avoidance measures against treaty abuse (see also Chapter 8). Ministries of finance should scrutinize the cost and benefits of treaty conclusion on a case-by-case basis and abstain from concluding double taxation treaties with countries that do not tax or minimally tax the income of their residents. To minimize variation in the tax treatment of bilateral income flows, countries should rely on a model treaty that provides the same terms to all countries with which this treaty is concluded. The model should limit source countries’ taxing rights as little as possible. For instance, the treaty should allow source countries to withhold substantive amounts on passive income payments and fully tax the capital gains derived from a sale of location-specific assets, such as mining rights or telecommunication licenses, even if the ownership of these assets has been transferred and sold abroad (see Platform for Collaboration on Tax 2018). Finally, the treaty should include robust anti-abuse measures that effectively limit treaty benefits to residents of the treaty partner country.
Under current rules, multinational enterprises can avoid being subject to tax altogether by avoiding physical presence (although, as discussed above, there are also discussions and in some countries recent actions about changing definitions of permanent establishments). For instance, selling goods usually requires local marketing and sales functions. Foreign multinational enterprises can either establish a subsidiary that performs these functions, or they can commission another entity, possibly part of the same group, to perform these functions on its behalf. While the profit from selling goods would be taxed at the branch or subsidiary level in the former case, it is not taxed in the latter. The United Kingdom and Australia have introduced diverted profits taxes to target, among other things, the avoidance of permanent establishments. While these taxes differ in some respects, there are important commonalities: both taxes target (primarily) the international tax avoidance of large multinational enterprises, apply punitive rates on profits that businesses are considering diverting, and are sufficiently broad in scope to act as an effective deterrent device for a range of abusive structures. For instance, the UK Diverted Profits Tax applies at a rate of 25 percent, which is higher than the standard corporate income tax rate of 19 per-cent.31 While the tax primarily targets the avoidance of corporate taxes by large multinational enterprises with turnover exceeding €50 million, it may also apply to purely domestic firms. Moreover, the diverted profits taxes target the avoidance of both nonresidents (that avoid a permanent establishment) and residents that abuse tax deductibility of related-party payments. For instance, if tax deductible payments in the United Kingdom are not subject to an effective tax rate of at least 80 percent of the UK tax rate abroad, these payments are also considered as diverted profits.
Alternatives to Arm’s Length Allocation Mechanisms
Instead of attempting to estimate arm’s length prices, profits can also be allocated by simple formulae to different locations. Chapter 14 discusses how such formula apportionment could be used to allocate consolidated profits across jurisdictions, as well as the pros and cons of such an approach.
The formulae used in such approaches can include different apportionment factors, such as capital, labor, or sales. It is possible to allocate aggregate profits using a unique formula, or to distinguish between routine and residual profits (residual profit allocation), with different allocation mechanisms for both. Specifically, under residual profit allocation, the ordinary profit is typically allocated only to capital, while residual profit may include more factors, including sales.
The choice of factors used in the formula is crucial for determining whether the approach aims at maintaining source-based taxation—at least as an approximation—or includes a move to destination-based taxation. Specifically, factors such as capital and labor still imply source-based taxation, because they suggest that profits are allocated to where production takes place. The use of sales, however, especially if defined by the destination rather than their origin, would imply a move away from source-to destination-based taxation. That is certainly a reform option—and as discussed in detail in Chapter 13, a very powerful one—but it would not be a way to strengthen source-based taxation.
A full move to formulary methods is not the only option. Already now, for certain transactions, transfer pricing methods allow a transaction-level profit split, which could include remuneration of routine functions with some split of residual profits.
Addressing Tax Competition
With the increasing implementation of antiabuse measures, multinational enterprises’ tax avoidance opportunities are likely to decrease in the future. However, even if all loopholes to artificially move tax bases to low-tax jurisdictions were effectively eliminated—which will be hard to achieve—multinational enterprises could still minimize their global tax burden by relocating actual production to these places. Empirical research provides ample evidence for the sensitivity of real investments to tax. For instance, in a metastudy, De Mooij and Ederveen (2008) show that foreign direct investment increases by an average of 2.4 percent in response to a 1 percentage point reduction in the domestic corporate income tax rate. When profit shifting opportunities as a tax minimization device cease to exist, the sensitivity of real investments to tax will likely increase.
Governments are keenly aware of the risk that neighboring countries could offer more attractive tax terms to invite investments that might otherwise be made domestically. And since foreign direct investment is a vital source of growth for many developing countries, generating employment, technology, and skill transfers and increasing demand for local production through backward linkages, the willingness of many governments to trade tax revenue against an increased likelihood of attracting investments is not surprising. Indeed, in a static environment, providing tax incentives can be rational or even revenue maximizing. But in a dynamic context where other countries react to a given country’s policy changes, tax competition leads to suboptimal outcomes globally. Take the corporate income tax rate competition as an example. By lowering the cost of capital, a reduction in a country’s corporate income tax rate should attract real investments, with positive effects on a country’s growth and tax revenue in the short run. However, historically, other countries have responded to foreign tax rate reductions by reducing their rates too (Leibrecht and Hochgatterer 2012). While the average corporate income tax rate was at around 40 percent in 1990, it was around 23 percent in 2019. If the decline in rates were to continue at the same pace, the average rate will have declined to below 20 percent well before 2030. Gains from tax competition thus tend to be short lived, with all countries collecting less revenue than before.
Tax competition is inherently tied to source-based taxation. Alleviating the mutually adverse effects from competing over an internationally mobile tax base requires strong commitment devices or tax instruments that will reduce the strategic interdependency between domestic tax rules. For instance, more reliance on residence-based taxation—where countries tax the income of their residents from both domestic and foreign sources (see Chapter 12)—that is, a return to more residence-based taxation—would reduce the dependency of overall tax burdens on the tax treatment in source countries.
While complete residence-based taxation is unlikely to return any time soon, minimum taxes on outbound investment are one important example of a residence-based tax instrument. Minimum taxes are already in use. For instance, the United States introduced the Global Intangible Low Taxed Income (GILTI) provision in its latest tax reform. The tax targets intangible returns accruing abroad by specifying as the tax base all active business income exceeding 10 percent of the group’s tangible assets. It is levied at 10.5 percent and provides a nonrefundable tax credit for 80 percent of foreign taxes paid, implying that usually no tax is due if the group’s intangible returns are taxed at a rate of 13.125 percent or above (see Beer, Klemm, and Matheson 2018). One aspect that weakens the implications of these provisions is that the tax is assessed globally, rather than on a country-by-country basis. This means that it is often not binding for multinational enterprises that also have operations in high-tax countries. As long as their average tax rate is sufficiently high, they still gain by shifting profits into low-tax countries.
Recent developments in the Inclusive Framework show that outbound taxes may spread quickly. Specifically, the income inclusion proposal tabled in the OECD’s Inclusive Framework suggests taxing the income of foreign subsidiaries and permanent establishments if this income is subject to a low effective tax rate abroad. The proposal has much in common with existing controlled foreign company rules that are primarily used by capital-exporting countries. However, while controlled foreign company rules are typically targeted at passive income payments, the income inclusion rule is broader and would also include active income. Clavey and others (2019) propose translating the OECD’s income inclusion proposal into a rule designed to better meet developing economy interests (see Box 11.2). As more capital-exporting countries apply taxes on lightly taxed income abroad, source countries will see less need to reduce their own tax rates. Minimum taxes can thus provide a floor in the race to the bottom. While minimum taxes can be implemented unilaterally, multilateral adoption by all important capital exporters would be particularly powerful, as it would immediately provide such a floor, below which it would not be worth cutting taxes.
An Income-Inclusion Rule for Developing Economies
Based on the concept of diverted profits, the approach of Clavey and others (2019) would target profit shifted to low-taxed and low-substance entities and use a simple redistributive formula to reallocate any excess of these profits above what is justified by the observable indicators in these locations.
Specifically, the rule would be implemented as follows:
The rule would apply to taxpayers with related parties, possibly with a de minimis rule to exclude small and medium sized enterprises. It would target cases of tax mismatches.
Identification would be relatively mechanical, targeting low-taxed entities in a group with “super profits” (either absolute or relative to the multinational enterprise group). An amount of profit representative of the earning capacity would be determined for these low-taxed entities based on a mechanical approach using observable indicators of substance, such as the direct cost of labor.
Profit in excess of the representative earning capacity would be reallocated to all countries involved in the relevant multinational enterprise supply chain. A formulaic approach (potentially based on sales) could be used to determine a country’s share of the diverted profits.
Moreover, several multilateral initiatives aim at improving international cooperation to overcome the mutually damaging outcomes of uncoordinated tax policies. For instance, in 1997 the European Union adopted a non-binding legal instrument, the Code of Conduct on Business Taxation, to curb harmful tax competition within the European Union. While the Code of Conduct was initially designed as a commitment device so that member states would reexam-ine, amend, or abolish any tax measures that constitute harmful tax competition (and refrain from introducing new ones), it has since morphed into a standard the European Union uses to evaluate the national systems of third countries.
In 2017 the EU Commission published its first blacklist of jurisdictions that are subject to punitive measures because their national tax systems do not conform with the Code of Conduct. Similarly, the OECD’s Forum on Harmful Tax Practices has been conducting reviews of national tax systems since 1998. In 2000 the OECD published its first blacklist, which included the names of 35 countries where elements of the national tax systems were considered harmful. The specific inclusion criteria differ across lists, but a common feature is that a ring-fenced preferential treatment of nonresidents, or of activities that do not impinge on the domestic market, is considered especially problematic by both the OECD and European Union. Keen (2001) shows, however, that these regimes may, in fact, reduce negative spillovers by confining tax competition to the most mobile parts of the international tax base. In contrast, undifferentiated tax incentives might attract investment at higher government cost. Care thus needs to be taken in coordinating national policies, as discussed in detail in Chapter 6.
Another simple and effective—though politically hard to agree upon—measure targeting tax competition might be self-imposed constraints on applicable tax rates. For instance, the European Union allows all member states to levy VAT at a standard rate, which cannot be below 15 percent, and a maximum of two reduced rates, which normally cannot be less than 5 percent. The Western and Central African Economic and Monetary regions prescribe minimum excise tax rates as well as bands for the VAT and corporate income tax rates that countries can apply. While excise and VATs are levied on goods and services, leaving little ambiguity on the base, the situation is different for the corporate income tax, where definitions of the tax base are more complex and standardized tax bases across countries are less prevalent. Source-based taxes, like corporate income taxes, however, are precisely those under competitive pressure and will potentially benefit from coordination, while such pressure on destination-based taxes, like VATs, is much more limited.
Conclusion
Digitalization and, more broadly, the globalization of the economy are disrupting traditional business models and challenging definitions of value creation. The fundamentals of the international tax framework, in contrast, still reflect the logic of a brick-and-mortar economy. This dislocation has provided multinational enterprises with vast opportunities to avoid source-based taxation. In the aftermath of the global financial crisis, when public coffers were depleted, international taxation became a priority area for public policy coordination. The OECD/G20 BEPS Project has been one of the most ambitious efforts in this respect, raising awareness about international tax avoidance risks and guiding a multilateral dialogue. However, national business models differ, as do perceptions of what is an appropriate tax burden. These differences complicate a multilateral solution process, and larger countries have moved unilaterally, increasing the pressure on the international community.
However, the international tax system is tightly interlinked, and policy reactions of one country can have ramifications on public revenues globally. Source-based taxation induces tax competition. This means that even if legal definitions of source were aligned with today’s business realities and the allocation of profits properly strengthened with anti-avoidance rules, multinational enterprises might nevertheless end up paying minimal taxes due to a race to the bottom.
This chapter has described both incremental and more radical deviations from the current system that would allow maintaining source-based taxes in the future. The chapter proposed three main approaches:
Defining source: The concept of permanent establishment allows for a qualitative threshold, self-imposed by the source country, that limits its taxing possibility. A broader permanent establishment concept could strengthen source-based taxation. In addition, source countries should refrain from giving up withholding rights on investment income and ensure—both domestically and under their treaty policy—that capital gains on business assets, securities, and real property are taxable.
Strengthening the allocation of profits: Documentation requirements can support an effective implementation of the arm’s length principle. However, deviations from pure arm’s length pricing, such as mechanical or formulaic approaches, including safe harbors or residual profit allocation mechanisms, might be better suited to fit the needs of developing countries. Restrictions on the deductibility of expenses can strengthen the allocation of profits.
Addressing tax competition: Minimum taxes on outbound investments—especially if coordinated multilaterally—are potentially the most effective measure in strengthening residence-based taxation components in the international tax system and thus relaxing source countries’ need to reduce their tax rate to attract investment. But regional cooperation is another potential tool for reducing pressure on corporate tax rates.
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Residence-based taxation is also an important, but typically secondary or additional component, of tax systems. Strengthening residence-based taxation—which in turn strengthens source-based taxation, given the interaction between the principles—is covered in Chapter 12.
For example, Tørsløv, Wier, and Zucman (2018) estimate that roughly 40 percent of global profits end up in low-tax jurisdictions annually.
The OECD/G20 Base Erosion and Profit Shifting (BEPS) Project’s Action 5, which is one of the four minimum standards, targets harmful tax regimes to limit negative spillovers between countries’ tax bases. The preferential regimes of all members of the Inclusive Framework are subject to peer review.
Note that subsidiaries of foreign multinational enterprises are incorporated businesses and hence are normally residents in the jurisdiction where they are incorporated.
The residence country, if it imposes tax on its residents on a worldwide basis, also would have the right to tax this income. Tough in most cases either unilaterally or under tax treaties, the residence country would grant a credit for taxes paid in the source country. Importantly, though, under the standard international tax architecture using bilateral double taxation treaties, the source country would lower its withholding rates, in some cases to zero, in favor of leaving some or all taxing rights with the country of residence of the recipient person or entity.
India was the first to tax multinational enterprises without a physical presence by enacting its equalization levy.
Most countries use a permanent establishment definition that is similar to that of the OECD and UN Model treaties. See Article 5(1) of the OECD and UN Models.
Most importantly, activities of independent agents, ancillary and preparatory activities, the use of storage facilities, the maintenance of stock and goods solely for processing, and purchasing or information gathering activities typically do not trigger a permanent establishment. See Article 5(4) of the OECD and UN Models.
Article 7.1 of the UN Model explicitly allows source countries to apply a “force of attraction” rule.
Article 5, paragraph 5 OECD Model 2017; See also the discussion of the diverted profits tax in the following section, “Strengthening the Allocation of Profits.”
Capital gains on other movable assets is very hard to tax and therefore often not attempted by jurisdictions at all.
The United States, for instance, withholds a 15 percent tax on the sales proceeds from real property owned by nonresidents. If the nonresident subsequently fles a proper tax return and is assessed, this withholding tax is creditable against the capital gain tax due.
For more detailed approaches to address these indirect transfers, see The Taxation of Offshore Indirect Transfers—A Toolkit (Platform for Collaboration on Tax 2018).
“Principally” is often defined as a minimum value of assets (for example, $10 million) or as a minimum percentage (“more than 50 percent”), and some source countries decide that taxation on indirect transfers will only be triggered if there is a minimum change of control.
Recently, countries confronted with dilution of the proportion of the value of shares that is derived from immovable property have added that “at any time during the 365 days preceding the alienation” the value should be derived more than 50 percent directly or indirectly from such property.
Implementation of the arm’s length standard in the extractive industries, which constitute a critical revenue source for many developing countries, can be particularly challenging, given the high importance of hard-to-price intangible assets, highly specialized services, and vertically integrated production processes (see Chapter 15, this volume; Beer and Loeprick 2015).
Notably, the arm’s length principle is broader than arm’s length pricing. For example, while the price of a specific transaction could be in line with general market prices, it is possible that this transaction would not occur between unrelated parties due to the specifics of the situation. In this case, the transaction would not be at arm’s length even though the prices used may seem to be.
The intuition for this result is that lower withholding tax rates may facilitate base erosion through treaty shopping while reducing the cost of capital, with positive effects on investment. As the costs of abusing double tax treaty networks decreases, the (revenue) costs associated with reduced withholding tax rates increases and there is less justifcation to apply reduced rates.
For a comprehensive discussion of the arm’s length principle and its implementation in developing countries, see Cooper and others (2016), which this section heavily draws on. See also Chapter 5.
See Platform for Collaboration on Tax. 2017. A Toolkit for Adressing Addressing Difficulties in Accessing Comparables Data for Transfer Pricing Analyses, https://www.oecd.org/tax/toolkit-on-comparability-and-mineral-pricing.pdf
See Platform for Collaboration on Tax (2019) and OECD (2017), chapter 5, “Documentation.”
For instance, the OECD/G20 BEPS initiative outlined a standardized approach to documentation in its BEPS Action 13, consisting of three elements: (1) a master file, which contains information on the overall group level; (2) a local file, containing specific information on the local enterprise and relevant related-party transactions; and (3) a country-by-country report, which describes the financial and economic position of the overall multinational group. Another example is the Code of Conduct on Transfer Pricing Documentation for Associated Enterprises in the European Union, which suggests a common master fle as well as standardized country-specific documentation. However, application of the Code of Conduct was optional for taxpayers. To date, only country-by-country reporting has become part of the minimum standards that all members of the Inclusive Framework pledged to implement.
See also Practical Toolkit to Support the Successful Implementation by Developing Countries of Effective Transfer Pricing Documentation Requirements (Platform for Collaboration on Tax 2019).
For instance, many countries have restricted comprehensive documentation requirements to their largest taxpayers to avoid disproportionate compliance costs.
In addition, the following conditions need to be met: (1) the combined cross-border loan balance must be less than AUD 50 million at all times during the year, (2) the funds provided and the interest paid must be denominated in Australian dollars, (3) the taxpayer should have no sustained losses, (4) the taxpayer should have no related-party dealings with affiliates in specified countries, and (5) the entity must be in compliance with general transfer pricing rules.
This is somewhat mitigated by the any decline interest rates during downturns.
The introduction of these restrictions was triggered by the spread of intellectual property boxes throughout Europe, where royalty income was taxed at low rates.
The applicable rate was 5 percent in 2018 and 10 percent in 2019; it will rise to 12.5 percent in 2026.
Withholding taxes increase the effective tax cost of transactions with affiliates in low-tax jurisdictions only because high-tax countries typically provide some form of tax relief—a credit or a deduction—for the foreign taxation of passive income. Consequently, withholding taxes allocate the tax base between high-tax countries, with limited effects for multinational enterprises. However, they increase the tax burden for entities in low-tax jurisdictions.
Empirical evidence suggests that the misuse of countries’ double taxation treaties with investment hubs has historically reduced corporate income tax revenue in Sub-Saharan Africa by an average of between 15 and 20 percent. At the same time, these treaties did not attract additional investments (Beer and Loeprick 2018).
For firms in the oil and gas sector, it is levied at 55 percent.
