BEPS 2.0: Taxing times for treasurers as OECD tax avoidance scheme rolls out new rules
Experts explain the various challenges phase two of BEPS represents for corporate treasurers, not least for their hedging strategies
Experts explain the various challenges phase two of BEPS represents for corporate treasurers, not least for their hedging strategies
Six years on from launching its landmark Base-Erosion and Profit Shifting (BEPS) initiative to prevent international tax avoidance, the OECD is presenting corporates and its treasurers with fresh challenges as it rolls out phase two of the scheme.
Graham Robinson, tax partner at PwC, explains that in the first phase of BEPS the OECD launched fifteen “actions”, each of which was intended to provide a co-ordinated change of law to prevent international tax avoidance.
More specifically, BEPS aims to penalise multinationals that exploit gaps and mismatches between different tax systems to artificially shift profits to low or no-tax locations. Therefore, BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises.
Nearly 140 countries are now members of the scheme.
The first phase of BEPS, which has now been implemented by many territories, focussed on some key aspects of international tax planning by multinational companies, many of which were linked to funding strategies and as such impacted treasurers.
Robinson says key BEPS phase one measures included a limitation on tax deduction for interest expense and a curtailing of access to withholding tax exemptions based on international tax treaties to prevent inappropriate use of lending vehicles by organisations.
Phase one also included an “anti-hybrid” rule by which an expense could not be tax deducted if a “hybrid” arrangement was used to obtain tax benefits. Robinson explains that “hybrid” arrangements in this context are deemed to be group entities or instruments resulting in either no taxable income arising, or a double deduction for the expense.
“These features were common in many multinational companies before. Over the last few years, though, company funding strategies have moved to what are generally simpler arrangements,” says Robinson
“Under pressure from BEPS, complex ‘hybrid’ arrangements and finance vehicles without substance – that is without people, functions, and assets in the territory where they are tax resident – have been largely replaced with simpler arrangements managed from more substantial treasury centres.”
In the second phase of BEPS, also known as BEPS 2.0, the project members are proposing two further key measures, known as “Pillar One” and “Pillar Two”. These two proposals, which are currently being rolled out, aim to harmonise further the international tax system and deal with some of the challenges arising from the digital economy.
This new second phase of BEPS raises fresh challenges for corporates, says Robinson. The Pillar One proposal in BEPS 2.0 aims to ensure taxable profits are partly allocated to the location of the customer, rather than the location of the vendor as is currently the case.
“This would be regardless of whether the selling company has a taxable presence in the customer’s location under conventional definitions of residence,” says Robinson, adding that the proposal is only intended to apply to the very largest multinationals, with exemptions for certain types of financial services and natural resources companies.
“The issue treasurers of affected companies need to consider here is where this change might impose new tax liabilities that need to be funded,” he says. “Where might a tax authority need paying, where the existing group does not have the payment infrastructure? How is the new tax liability calculated and what market exposures does it cause?”
The Pillar Two proposal, meanwhile, is a global minimum tax rate of 15% in each territory where a group operates, calculated by a globally agreed method based on disaggregating the group’s consolidated accounting profit.
“Where a group’s operations in a territory are deemed to be under-taxed, a ‘top up’ tax charge arises to take that territory’s effective rate up to 15%. This rule will apply to all multinationals with a turnover above €750m,” says Robinson.
While Pillar Two implies a potentially significant change to a group’s tax profile, Robinson says the prescribed implementation method for the proposal is complex and, in some respects, counter intuitive.
“For example, there are many situations where a group’s business operations in a territory with a high nominal tax rate such as UK, USA or Germany could give rise to a ’top up’ charge,” he says.
“Treasurers will need to be alert to the possibility of additional tax charges, and to evaluate whether a company’s funding or hedging strategies are impacted by these rules.”
One of the intriguing issues with BEPS is that having been devised at a time when globalisation was in full swing, many onlookers are wondering how the initiative will impact corporates and their treasurers against a backdrop of deglobalisation.
Robinson firstly points out that one of the original drivers of BEPS was, in fact, to mitigate the possibilities for tax avoidance arising from the globalised and digital economy.
“For example, the possibility for providing goods and services online meant that a company could sell to customers in a territory where they had no taxable presence,” he says.
“Similarly, in treasury operations, the globalisation of the financial system facilitated the operation of finance companies which received income such as interest or royalties, with little or no substance in the territory of tax residence.”
The BEPS programme, says Robinson, mitigates the risks of tax base loss through such arrangements, by making them ineffective, by disallowing tax deductions for expenses paid to low tax or zero tax recipients; and by increasing a multinational company’s taxable presence in the customers’ location.
Multinational companies’ response to these measures has largely been to align better their taxable presence and operational presence, with Robinson noting that financing vehicles now tend to have appropriate operational functions in the location where they seek to be a tax resident.
Also, companies have responded to the BEPS measures regarding customer location by ensuring that they have an adequate tax presence in their end markets in order not to trigger anti-avoidance rules.
“BEPS, therefore, is to some extent complementary to the trend for deglobalisation. It tends to ensure that a multinational company has a meaningful footprint in places other than head office where it wishes to operate. It, therefore, aligns with the business need to operate in multiple nodes, closer to end markets,” says Robinson.
“It discourages the use of low or zero tax territories which would not be commercially viable absent the tax benefit, and therefore discourages operation in these territories unless there is genuine commercial rationale for a business locating there. It encourages businesses to sell to end markets where they have, or can have, a reasonable level of operational substance.”
Looking ahead and mulling advice for treasurers, Robinson says the key task for them now is getting to grips with the second phase of BEPS.
“BEPS phase two is likely to have a real impact on the tax profile of multinational companies. Treasurers should liaise with their tax departments to understand the likely impact,” he says
Areas he believes treasurers need to focus on include evaluating the potential for ‘top up’ tax charges under the 15% minimum tax regime, as there could be significant cash flow implications.
Treasurers also need to consider whether the allocation of profits to end markets brings new territories into the group tax profile, where funding arrangements may need to be made.
A re-evaluation of hedging arrangements by treasurers is also called.
“These arrangements are particularly sensitive to the 15% minimum rate because they typically result in amounts being taxed under domestic law on a different basis from the accounts,” he says. “This may distort the effective rate calculation, causing hedges to be economically ineffective.”
Looking back at how BEPS has fared in terms of its remit and how corporate treasurers have coped with it to date, Robinson says that when the first phase of the BEPS programme was brought into effect by legislation in major territories, there was a rush of activity as multinational groups unwound structures which became inefficient because of their tax consequences.
While Robinson is clear treasurers need to re-evaluate their hedging strategies in response to BEPS and the new phase two rules, Helen Kane, risk & exposure fellow at financial risk consultant Hedge Trackers, an arm of US-based GTreasury, sounds a more urgent note on this front.
“There is an opportunity that people are missing when it comes their hedging programmes. Companies had been centralising their revenues into some regional hubs, for example Ireland, Singapore. That resulted in those revenues not being recognised in Australia, and so benefit Australian GDP, but in Singapore, boosting Singapore GDP.
“As countries like Australia clamp down and try to reverse this through BEPS, corporations that are responding and changing their operations should also take this opportunity to review their functional currency.”
Such a review is warranted when companies have to change their legal and tax structure but Kane says one thing they haven’t been appropriately aware of, and maybe not taking appropriate actions to prepare for with BEPS, is what the functional currency decision does to a company’s ability to hedge or protect itself from currency risk.
“Altering the tax structure will create changes in the accounting for the currency exposures which in turn creates changes in the hedgeable risks,” says Kane.
To illustrate her argument, she cites as an example a company that recorded a sale in its Singapore entity that was US dollar functional for an Australian sale before the arrival of BEPS. At the time, the company would freeze the US dollar value and amortize it to revenue over 12 months. That meant each month that company recorded Australian sourced revenue made up of 12 different AUD rates, as sales booked over the prior 12 months were reclassified from deferred revenue to revenue.
“Under this scenario, when you have a big rate drop, just one-twelfth of your revenue drops in a month not 100%. And you can hedge 100% of that revenue, further ameliorating currency impacts,” says Kane.
“One hedge program I implemented has resulted in a software company having 24 months of rates smoothing each month. Revenue is predictable and smoothed. That is the best of all possible worlds.”
Kane explains that when BEPS requires a company to move the revenue from one entity to another the receiving entity is usually not USD functional.
“That means that all the revenue will now be consolidated into earnings at the current month’s rate only, not the lovely 12 months of rates you got even without hedging. Whereas I could hedge up to 100% of the revenue value before [BEPS] I am now limited to hedging a much smaller amount of the transaction, limited by tax driven intercompany transfer pricing,” she explains.
“The upshot is you go from great hedging environment that gives management a lot of control over the financials to a lousy hedging environment that gives management the ability to protect net income, maybe by currency, but not have much of an impact on revenue—a key metric for such multinational companies.”
The good news for treasurers though, says Kane, is that when they change the total activity structure of the subsidiary it creates “a generational opportunity” to change the functional currency decision for their subsidiary.
It is not a change, however, that can be taken lightly.
“Changing functional currency is painful. It is like having your wisdom teeth out. Not pleasant but makes your whole mouth healthier and better looking over the long run,” says Kane.
“If you make the change, however, you gain the right to manage currency in your financial statements—which is healthier and looks better for the Street over the long run.”
Companies may well be put off making the change to their functional currency arrangements because of the time and effort needed but Kane, who founded Silicon Valley-based Hedge Trackers in 2000, also believes the issue is generally poorly understood across organisations.
“From my experience over many years, nobody in accounting wants to do it so you can’t depend on them to drive that change. It’s really something that has got to be championed by CFOs and treasurers, they are ones who are impacted by the issue. It really needs CFOs, in particular, to step up, become the executive sponsor behind the move, or the board itself pushing for it.”
“Right now though, it seems it is too painful, too hard for many companies to perhaps even contemplate. After three years of firefighting, finance personnel across organisations are feeling overworked and stressed as it is. But this really is something where an ounce of prevention is worth a pound of cure. It is hard, yes, but it’s also the smart thing to do.”