Publication of final OECD BEPS reports: Implications for the wealth and asset management industry
On Monday, 5 October the Organisation for Economic Cooperation and Development (OECD) released the final reports under its Action Plan on Base Erosion and Profit Shifting (BEPS) launched in July 2013. 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, work on some topics such as the multilateral instrument and financial payments will carry on into 2016 and 2017. And the work of industry, advisors and lobbying groups will also continue as governments decide whether and how to implement the OECD recommendations.
This alert briefly identifies some of the key issues arising from the reports which are most relevant for the wealth and asset management industry; more detailed tax alerts focusing on specific the recommendations and their potential impact on the asset management industry will follow in due course.
Treaty Abuse (Action 6)
While the report is titled as “Final,” there will be further OECD work specific to investment funds in 2016 and amendments will be made.
With regard to collective investment vehicles (CIVs) i.e. widely held, regulated funds, the report restates the OECD view that the 2014 Action 6 drafting is suitable for addressing the potential treaty eligibility concerns of CIVs and that it reflects the conclusions of the OECD’s 2010 CIV report. The OECD’s previous Treaty Relief and Compliance Enhancement (TRACE) implementation package is again referred to as the solution for implementing certain limitations-on-benefits (LOB) tests in practice. As such, the report has not materially changed with regard to CIVs since the last discussion document, and we understand no further work will be performed in this area.
For nonCIVs such as private equity, hedge funds or trusts, the OECD indicates that further work is required in certain areas:
• NonCIVs funds in general — The OECD reiterates that they recognize the economic importance of these funds and that they should be granted treaty benefits where appropriate. This is supported by the final report on hybrid mismatches (Action 2), which suggests changes to the Model Tax Convention that would clarify the treaty position of transparent vehicles. The report also points towards potential derivative benefits provisions to be introduced in 2016, i.e., provisions that would allow certain entities owned by non-residents to obtain the treaty benefits that these residents would have obtained if they had invested directly.
• LOB rules — The US entered into public consultation on its LOB rules in 2015, and the OECD wants to consider whether any resultant changes, to be published in 2016, should be factored into Action 6.
• REITs — Updating the LOB commentary to include specific provisions for REITs that reflect previous OECD work on treaty issues for REITs.
• Pension funds — Updating the OECD Model Tax Convention to include a definition of “recognized pension fund” that qualifies as treaty resident. The life and pensions industry will be interested to note that the proposed definition includes entities and arrangements that operate exclusively to invest funds for the benefit of recognized pension funds.
Permanent Establishments (Action 7)
There were few changes to the wording on permanent establishments (PEs) contained in the earlier discussion drafts; However, this area could have a significant impact on the asset management industry. In the final report published, the OECD has recommended that Article 5(5) of the Model Tax Convention should be amended to say:
“where a person is acting in a Contracting State on behalf of an enterprise and, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise … that enterprise shall be deemed to have a permanent establishment in that state in respect of any activities which that person undertakes for the enterprise …”
For an asset manager, this revised definition of what constitutes a PE could clearly impact sales and due diligence teams undertaking business in multiple jurisdictions. Although an increase in the number of PEs recognized may not necessarily raise substantially more tax revenue, it will clearly result in an increased administrative burden for these taxpayers.
There are still exceptions to the definition of PE, but amendments are recommended to these as well:
• While activities can still be considered “preparatory and auxiliary,” they must not be part of the core business activities to avoid giving rise to a PE. Article 5(4) has been modified to provide further guidance around what is considered “preparatory and auxiliary.”
• Businesses that seek to claim the independent agent exception may no longer be able to do so if they are considered to be closely related to the foreign enterprise on behalf of which they are acting and the activities are performed exclusively or almost exclusively on behalf of one enterprise or closely related enterprises.
Further analysis will be required to understand fully how the proposed changes could impact the PE risk for a fund itself. Some countries, such as Ireland and the UK, offer an investment manager exemption to mitigate this risk but in other jurisdictions a widening of the definition could cause problems for an actively traded fund.
Finally, if it is determined that an asset manager has a PE, a further exercise will need to be undertaken to determine the profit attributable to that PE using transfer pricing principles. The OECD has stated that further work will be undertaken regarding attribution of profit issues related to Action 7, with a view to providing the necessary guidance before the end of 2016.
Risk and Recharacterization (Actions 8 to 10)
Situations where an actual transaction may be disregarded have been clarified as being those where the “exceptional circumstances of commercial irrationality apply” such that transactions make no “commercial sense.” This appears to be a greater hurdle than was set out in the previous draft in relation to the discussions on recharacterization.
The new report contains an example clarifying how the concept of control of risk could be applied in an asset management context. The example at paragraph 1.70 is welcome in making clear that where an investor hires a fund manager to invest on its behalf, this does not equate to transferring control of that risk. The distinction is critical in determining the return that each party should achieve, confirming that a fund manager should receive payment for its fund management activities, with the return on the capital invested being attributed to the investor.
An additional specific asset management example focuses on the situation where a regulatory license is a required precondition for conducting investment management business in a particular country. In some cases, there may be a restriction on the number of foreign owned firms to which such licenses are granted, and in such cases, the example suggests that value may be attributed to the license holder. Conversely, where such licenses are readily available and do not restrict access to the market, attributing such value may not be appropriate. Consideration should be given to pricing arrangements in places where this fact pattern does not align with existing policy.
Transfer Pricing Documentation & Country-by-Country Reporting (Action 13)
The report from the OECD on transfer pricing documentation and country-by-country reporting introduced no new content.
Separately, and of interest for those with operations in the UK, last week saw the release of new material on this important topic when HMRC published for technical consultation the draft regulations for the UK implementation of country-by-country reporting (CBCR), together with an explanatory memorandum. As widely expected, the draft statutory instrument would bring CBCR into effect for accounting periods beginning on or after 1 January 2016 but the draft regulations also introduce specific penalty provisions for noncompliance. The technical consultation on the draft regulations is open until 16 November 2015.
Many asset managers will be below the threshold for CBCR. However, as a result of the OECD’s recommendations, all asset management groups will need to ensure the consistency and appropriateness of information included in their transfer pricing documentation and central ownership will be key to achieving this. In particular, the first year of documentation produced in the master file/local file format (from 1 January 2016) will be vital as this will form the basis for, and comparison with, subsequent years. Groups may therefore wish to plan now for the time needed to help ensure the appropriateness of information included in the FY2016 master file and local country files.
Interest Deductibility (Action 4)
The key proposal is to establish interest deductibility rules based on a fixed ratio that look to the ratio of an entity’s net interest expense (interest expense less interest income) to its EBITDA or EBIT. The report recommends setting a benchmarked “fixed ratio corridor” of 10% to 30%.
The fixed ratio may be supplemented in some jurisdictions with a group ratio, considering entity level leverage (subject to an additional uplift in certain circumstances) with respect to the group’s leverage ratio. This may allow for highly leveraged sectors of the economy that might operate outside the “fixed ratio corridor.”
The report recognizes that the banking and insurance industries have unique financing requirements and refers to revised guidance for these industries, to be published by the end of 2016. There is currently no indication that further guidance will be developed for the asset management industry. The proposed rules are intended to be applied to financial activities with no regulatory requirement as well as regulated and unregulated investment vehicles.
Over the past two years, the wealth and asset management industry has made a considerable effort to share information with the relevant OECD working parties about fund structures and common asset management business models. The final reports released reflect that effort, but the work 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 industry will need to continue its work to help ensure that decision makers are well informed before making policy choices that may impact managers, funds and their investors.