In July 2013, the Organisation for Economic Co­operation and Development (OECD) released the final reports under its Action Plan on Base Erosion and Profit Shifting (BEPS). The project broadly looks to ensure that profits are taxed where the economic activities generating the profits are performed and where value is created through amendments to double tax treaties, the Commentary on the OECD Model Tax Convention, transfer pricing guidelines and domestic law.

These reports represent two years’ worth of intense effort, both on the part of the OECD working groups and by industry, advisors and other interested parties who provided over 15,000 pages of comments on the discussion drafts and participated in numerous public consultations.

Although final reports on the original 15 action points were released yesterday, work on some topics such as the multilateral instrument and financial payments will carry on into 2016 and 2017. The work of industry, advisors and lobbying groups will also continue as governments decide whether and how to implement the OECD recommendations.

The banking sector faces a unique challenge in coming to terms with BEPS developments, coming at the same time as unprecedented requirements for regulatory-­driven structural reform. This alert briefly identifies some of the key issues arising from the reports that are most relevant for banks in this context; more detailed tax alerts focusing on the recommendations and their potential impact on the banking industry will follow.

Actions 2 and 4 – hybrid arrangements and interest deductions

In relation to Action 2 on hybrid arrangements, the OECD report follows the discussion draft in proposing recommendations for domestic law changes and changes to tax treaties. As indicated in the September 2014 report, countries remain free in their policy choices as to whether the hybrid mismatch rules should be applied to mismatches that arise under intra-­group hybrid regulatory capital. Where one country chooses not to apply the rules to neutralize a hybrid mismatch in respect of a particular hybrid regulatory capital instrument, this does not affect another country’s policy choice of whether to apply the rules in respect of the particular instrument. For example, the UK Government has committed to take into account the special position of banks’ regulatory capital entities and has included a number of proposals in its previous consultation.

Action 4 makes recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense. The report acknowledges that a number of particular features of groups in the banking and insurance sectors need to be taken into account but does not propose an industry exclusion. Further work will therefore be conducted in 2016, to identify best practice rules to deal with the potential BEPS risks posed by banks and insurance companies, taking into account the particular features of these sectors, although we note the report does not expand on describing these risks. However, the report does highlight that it is crucial that any recommended interest limitation rules do not conflict with, or reduce the effectiveness of, capital regulation intended to reduce the risk of a future financial crisis

Action 5 – harmful tax practices

Action 5 calls for the development of a framework for compulsory spontaneous exchange of information between tax authorities on rulings with respect to preferential regimes that meet specified criteria. For this purpose the OECD has been working on defining categories of rulings as well as a process that will assist in determining which countries should receive the ruling. The framework covers six categories of rulings: (i) rulings related to preferential regimes, (ii) cross border unilateral advance pricing arrangements (APAs) or other unilateral transfer pricing rulings, (iii) rulings giving a downward adjustment to profits, (iv) permanent establishment (PE) rulings, (v) conduit rulings and (vi) any other type of ruling where there is a view that the absence of exchange would give rise to BEPS.
These developments, together with the European Union taking steps to introduce the automatic exchange of information between Member States on their tax rulings, mean that banking groups should generally consider their approach to seeking rulings going forward.

Action 6 – treaty abuse

The OECD has confirmed that treaties should include a clear statement that the states that enter into a tax treaty intend to avoid creating opportunities for non­-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements and one of the following:

• A general treaty anti­-abuse rule in the form of the principle purpose test (PPT) and a limitations-­on-­benefits (LOB) rule.
• A PPT only.
Or
• An LOB rule supplemented by anti­conduit rules (as can be found in some current US treaties)

We are expecting most major territories to continue to favor a PPT but there are some notable exceptions such as the US and Japan that favor an LOB rule. Additional work will be required in order to consider proposals recently released by the US concerning the LOB rule and this will therefore not be finalized until the first part of 2016. A review of the issues related to the treaty entitlement of certain types of funds will also continue with a similar deadline for its conclusion.

Action 7 – permanent establishments

The final report includes changes to the definition of permanent establishment in the OECD Model Tax Convention. The new definition seeks to combat commissionaire and similar arrangements to avoid PE status by amending the circumstances in which a person acting on behalf of an enterprise can give rise to a PE of that enterprise. The PE definition has been widened beyond the traditional authority to ‘conclude contracts’ to include situations under the new drafting where a person “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification”. Banks with cross border business models will need to review the extent to which a person exercises the authority to conclude contracts or plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the relevant enterprise, for example standardized contracts. Furthermore, in deciding whether a person is an independent agent, this will not be the case where a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related (a new term). Whether a person is closely related to an enterprise will depend on whether, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises. This is a less precise test than the connected test previously proposed. The guidance also notes that an independent agent cannot be said to act in the ordinary course of its business as such when it performs activities that are unrelated to the business of an agent. Specific consideration should be given to banks with global booking models to determine whether such models give rise to incremental dependent agency PE risks.

The report notes that follow-­up work will be needed to provide guidance on attribution of profits to the PEs that will result from the changes proposed and this is likely to build on the 2010 Report on the Attribution of Profits to Permanent Establishments. This work is intended to conclude before the end of 2016.

Finally, these proposals only deal with the treaty definition of PEs and so consideration will need to be given to whether the domestic legislation is similarly wide and whether territories will expand their domestic definition
Actions 8 to 10 – risk and re­characterization

The outcome of the OECD work under Actions 8–10 will be changes to the OECD Transfer Pricing Guidelines. The OECD has increased its focus on economic substance, moving from a balanced assessment of functions, assets and risks towards an increased focus on (people) functions on the basis that assets and risks follow functionality. Furthermore, there is an increased emphasis on the importance of economic substance in order to justify transfer pricing returns.

The report indicates an intention that the role of capital-­rich, low-­functioning entities in “BEPS planning” will become less relevant. Despite representations from the industry, the report does not refer to the specific role and importance of capital in a banking context in determining the appropriate location of profits. However, some comfort may be taken from the acknowledgement that further work will be undertaken on profit splits and financial transactions

Summary

The banking industry has and continues to go through significant commercial and regulatory transformation and over the last two years the industry has made considerable effort to share information with the relevant OECD working parties about banking business models. The final reports released yesterday reflect that effort, but the work of the banking industry is far from finished. As we move into the next phase of the BEPS project, and as governments begin to implement the OECD’s recommendations, the banking industry will need to continue its work to ensure that decision makers are well-­informed before taking policy choices that may impact the industry.