Canadian Back-To-Back Loan Proposals

Transcription

1 In This Issue. Canadian Back-To-Back Loan Proposals Fourth Protocol to Canada Uk Treaty Eliminates Withholding Tax On Arm s Length Interest, but Preserves Tax Exemption for Gains on Disposition of Shares and Interests Deriving Value From Canadian Real Property BEPS 2014 Deliverables OECD Releases First Set of Recommendations A report on cross-border developments in Canadian tax law / October 2014

2 1 Canadian Back-To-Back Loan Proposals by: Nigel P.J. Johnston and Gabrielle M.R. Richards The 2014 federal budget included measures (Budget Measures) intended to eliminate the use of back-to-back loans to avoid the thin capitalization rules and/or withholding tax on interest paid to non-arm s length non-residents so as to protect the Canadian tax base from erosion by limiting the extent to which foreign investors may take profits out of their Canadian affiliates without incurring Canadian tax. The thin capitalization rules in the Income Tax Act (Canada) (Act) generally deny the deduction by a corporation or trust 1 of interest payable on outstanding debts to specified non-residents to the extent that a debt-to-equity ratio is exceeded (currently 1.5:1). In the case of a corporation, outstanding debts to specified non-residents consist of debts and obligations owed by the corporation to: i. a non-resident shareholder who, alone or together with persons who not deal at arm s length with such non-resident, owns shares representing 25% of more of the votes or value of the corporation s shares; or ii. a non-resident who does not deal at arm s length with a shareholder who, alone or together with persons who not deal at arm s length with such shareholder, owns shares representing 25% of more of the votes or value of the corporation s shares. Such persons are referred to in this note as Subject Non-Residents. Similar rules apply in determining outstanding debts to specified non-residents of a trust except that the 25% ownership threshold applies only in relation to the value of interests in the trust. The disallowed interest is deemed to be a dividend that is subject to Canadian withholding tax of 25%, subject to reduction under a tax treaty. Although the Act contains a specific anti-avoidance provision to discourage taxpayers from making back-to-back loan arrangements to avoid the thin capitalization rules, as well as the general anti-avoidance rule, the government decided to enhance the existing specific anti-avoidance rule and to introduce a new specific anti-avoidance rule in respect of withholding tax on interest payments. For a discussion of the Budget Measures, please see our publication February 12, 2014 Economic action plan 2014 international tax planning under continued assault. Concern was expressed that the Budget Measures were overly broad and would apply to many ordinary commercial transactions with no tax avoidance purpose, such as where a non-canadian entity that does not deal at arm s length with a Canadian borrower provides security for the Canadian borrower s debt (for example, a secured guarantee). On August 29, 2014, the Department of Finance (Canada) released for consultation draft legislation (August Proposals) which contained significant revisions to the Budget Measures. In certain respects, the August Proposals address concerns expressed regarding the Budget Measures but in other ways may broaden the scope of the rules. 1 The rules apply to non-resident corporations and trusts that carry on business in Canada or that have made an election under section 216 of the Act as well as to Canadian resident corporations and trusts. In the case of a non-resident corporation or trust, special rules apply to determine the equity amount. Specific rules also address debts and obligations owed by partnerships of which a corporation or trust is a partner.

3 2 Thin Capitalization Rules The August Proposals set out the following conditions for the application of the revised back-to-back loan proposals in the context of the thin capitalization rules: 1. a taxpayer has an outstanding obligation (borrower debt) owing to a person or partnership (intermediary); 2. the intermediary is neither a Canadian resident with whom the taxpayer does not deal at arm s length nor a Subject Non-Resident; and 3. the intermediary or a person or partnership that does not deal at arm s length with the intermediary has an outstanding obligation owing to a Subject Non-Resident (intermediary debt) that meets any of the following four conditions: i. recourse in respect of the intermediary debt is limited in whole or in part to the borrower debt, ii. the intermediary debt was entered into on condition that the borrower debt be entered into, iii. the borrower debt was entered into on condition that the intermediary debt be entered into, or iv. it can reasonably be concluded that if the intermediary debt did not exist, all or part of the borrower debt would not be outstanding or its terms or conditions would be different, or 4. the intermediary or a person or partnership that does not deal at arm s length with the intermediary had a specified right in respect of a particular property that was granted directly or indirectly by a Subject Non-Resident and either i. the existence of the specified right is required under the terms and conditions of the borrower debt, or ii. it can reasonably be concluded that if the specified right were not granted, all or a portion of the borrower debt would not be outstanding or its terms and conditions would be different. A specified right in respect of a property means a right to use, mortgage, hypothecate, assign, pledge or in any way encumber, invest, sell or otherwise dispose of, or in any way alienate, the property. The August Proposals contain a safe harbour in that the revised back-to-back loan rules will not apply where the total of the outstanding intermediary debt and the fair market value of property in which a specified right was granted in respect of a borrower debt is less than 25% of the borrower debt. In this situation, the borrower debt is considered not to be funded by the intermediary from the Subject Non-Resident. Further, where the borrower debt is part of a corporate group borrowing from an intermediary, the 25% test also includes amounts outstanding to the intermediary by group members under the same agreement as the borrower debt or a connected agreement where the intermediary has a security interest securing the payment of the borrower debt and the other group debt. The explanatory notes set out examples where relief is available where an intermediary enters into multiple cross-collateralized debts owing to the intermediary by multiple group entities, including a notional cash pooling arrangement. The examples make it clear that a cross-guarantee and a general security interest against all property held by each member of a group, securing payment of debt owing by all group members, will not, in and of themselves, cause the back-to-back loan rules to apply. Rather, cash collateral deposited with a bank or marketable securities provided as security, where the person holding such securities has the right to pledge or assign them (i.e., as a means of raising capital), will generally cause the back-to-back loan rules to apply, subject to the 25% de minimis test.

4 3 As the August Proposals apply to taxation years that begin after 2014, existing loan and security arrangements should be reviewed to determine whether an intermediary or a person or partnership that does not deal at arm s length with an intermediary has a specified right. Although the explanatory notes are helpful in confirming that an intermediary will not be considered to have a specified right in respect of a property solely by virtue of having been granted a security interest in the property, it would be preferable if this exclusion were contained in the legislation itself. TEI has made submissions suggesting that this could be accomplished by defining specified right to exclude a security interest, a newly-defined term in the August Proposals. 2 Subsections 248(4) and 248(5) of the Act provide similar examples by expressly providing that an interest in real property (or a real right in an immovable) do not include an interest as security only (or a security right) derived by virtue of a mortgage (or hypothec), agreement for sale or similar obligation. However, if the obligor defaults such that the intermediary has the right to realize on its security interest by disposing of the property, presumably what was a mere security interest would become a specified interest. Further, in light of the new conditions to the application of the rules ( it can reasonably be concluded that if the intermediary debt did not exist or if the specified right had not been granted, all or a portion of the borrower debt would not have been outstanding or its terms or conditions would have been different ), financing arrangements of all non-resident persons or partnerships who do not deal at arm s length with the borrower need to be scrutinized to determine whether they may affect the borrower debt. The TEI Submissions suggest that it can reasonably be concluded should be replaced with a principal purpose test similar to the one found in paragraph 95(6)(b) of the Act, as these conditions are highly subjective. Moreover, in the authors view, the requirement that the terms of the borrower debt are different because of the existence of the intermediary debt is a very low threshold. Where the back-to-back loan rules apply, all or a portion of the borrower debt is deemed to be outstanding to the Subject Non-Resident creditor in respect of the intermediary debt or grantor of the specified right and not to the intermediary. In the case of multiple intermediary debts and/or particular properties in respect of which specified rights were granted, an allocation rule applies. To the extent that, by reason of the application of the thin capitalization rule, a portion of the interest on the borrower debt is not deductible, that interest is deemed for the purpose of Part XIII of the Act, subject to the application of subsections 214(16) and (17), to be payable to the Subject Non-Resident. Subsection 214(16) generally deems such amount paid by a corporation to be a dividend. Withholding Tax The Act imposes no withholding tax on interest paid by a resident of Canada to a non-resident person with whom the payer deals at arm s length, provided that the interest is not paid on a participating debt obligation. If the payer does not deal at arm s length with the non-resident person, the withholding tax rate is 25%, subject to reduction under a tax treaty. The Budget Measures introduced a specific anti-avoidance rule in respect of withholding tax where certain back-to-back loans are made, which rule largely paralleled the new back-to-back loan rules for purposes of the thin capitalization rules. The August Proposals make similar amendments to the specific anti-avoidance rule. The new rule ensures that Canadian withholding tax applies to a financing arrangement in which a non-resident provides debt funding through an intermediary, instead of directly, to a taxpayer resident in Canada. The new rule only applies if the interposition of the intermediary results in a reduction of the withholding tax that would otherwise have been payable if the interest were paid or credited directly to the non-resident, and not the intermediary. Thus, where the non-resident is a qualifying person under the Canada-U.S. tax treaty, which provides a full exemption from Canadian withholding tax for interest on non-arm s length debt, the new rule would not apply. Interest for purposes of the application of the new rule is determined without reference to any amount disallowed under the thin capitalization rules. 2 See Tax Executives Institute letter dated September 26, 2014 to the Department of Finance (TEI Submissions).

5 4 On the other hand, the test is purely a results test and does not take into account whether a main, or any, purpose was to achieve such result. The other conditions for the application of the back-to-back loan rules in the withholding tax context closely mirror those in respect of thin capitalization including the 25% safe harbour. However, the intermediary may be a resident of Canada with whom the taxpayer does not deal at arm s length and may be any non-resident person, not just a Subject Non-Resident. The specific anti-avoidance rule is therefore broader in its application in respect of withholding tax than in respect of thin capitalization to the extent the intermediary may be any non-resident person. 3 If the conditions of application are met in respect of an amount of interest paid or credited to an intermediary, the payer is deemed to pay interest to the non-resident person to whom the intermediary is indebted or has an obligation to pay an amount or who granted the intermediary a specified right in property. The amount of interest that is deemed to be paid is determined by a formula which takes into account (i) the amount paid by the payer as interest to the intermediary, (ii) the amount of the intermediary debt and value of property in which the intermediary has a specified right, (iii) the amount that is deemed to be a dividend under the thin capitalization rules and (iv) the withholding tax that would have been payable if the interest were paid or credited directly to the non-resident, and not the intermediary, and the amount of withholding tax imposed on the interest actually paid or credited to the intermediary. In determining the withholding tax that would have been payable if the interest were paid or credited directly to the non-resident person, regard will be had to whether the non-resident deals at arm s length with the payer and whether the non-resident is entitled to benefits under a tax treaty, taking into account any relevant limitation of benefits provision. Importantly, the back-to-back rules do not purport to affect the withholding tax required on actual payments of interest to the intermediary. It is interesting to see that this specific anti-avoidance rule, which is in effect a specific anti-treaty shopping measure, was not postponed in the way that the proposed general anti-treaty shopping rule introduced in the Budget Measures was postponed in the August Proposals. The reason for postponing the general anti-treaty measure to await further work by the OECD and G20 in relation to their Base Erosion and Profit Shifting (BEPS) initiative arguably would equally apply. The material released by the OECD on September 16, 2014 in respect of BEPS and treaty abuse, 4 refers to the use of domestic anti-treaty shopping rules, and the need to address the relationship between domestic rules and tax treaty provisions. 5 3 The TEI Submissions suggest that they should not be broader. In the context of the thin capitalization rules, an intermediary that is a Canadian resident that does not deal at arm s length with the borrower would itself be subject to the thin capitalization rules. 4 Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 in the BEPS Action Plan. 5 Ibid, Section A.2.

6 5 Fourth Protocol to Canada Uk Treaty Eliminates Withholding Tax on Arm s Length Interest, but Preserves Tax Exemption for Gains on Disposition of Shares and Interests Deriving Value From Canadian Real Property by: Elaine Buzzell and Nigel P.J. Johnston On July 21, 2014, the governments of Canada and the United Kingdom signed the fourth protocol (Protocol) amending the Convention between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains (Canada-UK Treaty). The Protocol amends fifteen articles of the Canada-UK Treaty and includes provisions eliminating withholding tax on crossborder interest paid to a person with whom the payer deals at arm s length and imposing deadlines for certain transfer pricing adjustments. An Interpretive Protocol provides guidance on the application of the Canada-UK Treaty to UK limited liability partnerships (UK LLPs) and defines certain other terms. Many provisions of the Protocol are consistent with those included in other treaties recently negotiated by the Canadian government. However, as discussed below, it is noteworthy that Article 13 (Capital Gains) was not amended to permit a Contracting State to impose tax on a gain realized on the disposition of a partnership interest, interest in a trust or unlisted share that derives its value, or the greater part of its value, directly or indirectly from immoveable property situated in that State in which a business is carried on by the partnership, trust or company. This article reviews several of the significant amendments to the Canada-UK Treaty contained in the Protocol. Partnerships The Protocol and Interpretive Protocol contain two changes that expand and clarify the application of the Canada-UK Treaty to partnerships. First, the Protocol amends Article 3(1)(c) of the Canada-UK Treaty to provide that the term person includes a partnership. Partnerships were formerly expressly excluded from the definition. As a result of this amendment, a partnership that is liable to entity-level tax in either Canada or the UK could qualify as a resident of a Contracting State based on the test set out in Article 4(1). In Canada, the only partnerships that are liable to tax at the partnership level are SIFT partnerships. However, as a SIFT partnership is liable to tax only on income and gains from non-portfolio property, it is not clear that such a partnership would be a resident of Canada for the purposes of the Canada-UK Treaty. Second, the Interpretive Protocol provides that an item of income or gain that is derived by a UK LLP that has its place of effective management in the UK and that is fiscally transparent for UK tax purposes will be considered to be the income or gain of its members to the extent that such members are residents of the UK. This provision is presumably intended to ensure that a UK LLP that is fiscally transparent for UK tax purposes will be afforded look-through treatment in applying the Canada-UK Treaty to partners that are residents of the UK, regardless of whether the UK LLP is considered a partnership under Canadian tax principles.

7 6 Business Profits and Transfer Pricing In general terms, Article 7 (Business Profits) of the Canada-UK Treaty provides that the business profits of an enterprise of a Contracting State are to be taxed only by that State, except where the enterprise carries on business in the other State through a permanent establishment situated therein. In the latter case, the other State is entitled to tax the profits of the enterprise that are attributable to the permanent establishment in that State. Articles 7(2) to (4) set out certain principles that apply to determine the extent to which the profits of an enterprise are attributable to a permanent establishment. The Protocol amends Article 7 in order to conform to Article 7 of the OECD Model Tax Convention on Income and Capital (OECD Model Convention). 1 Both the current and amended versions of Article 7(2) provide that the amount of profit attributable to a particular permanent establishment of an enterprise is to be determined as though the permanent establishment were a separate enterprise engaged in the same or similar activities under the same or similar conditions. The amended version, however, adopts the language of Article 7(2) of the OECD Model Convention and states that the foregoing determination is to be made taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through other parts of the enterprise. The Protocol also introduces new Article 7(3), which provides that, where a Contracting State makes an upward adjustment with respect to the portion of the profits of an enterprise that are attributable to a permanent establishment situated in that State, the other State must make a corresponding downward adjustment to the extent required to eliminate double taxation. The competent authorities of each State are required to consult with each other if necessary to align their assessments of the enterprise. This provision is included in the OECD Model Convention. Article 9(2) of the Canada-UK Treaty provides that where a Contracting State makes a transfer pricing adjustment that it is entitled to make, the other State is required to make an appropriate adjustment to the amount of tax charged by it on the relevant profits of the associated enterprise in that State. However, in general, Article 9(3) provides that the other State is only required to make such adjustment if, within six years from the end of the taxation year (in Canada) or the chargeable period (in the United Kingdom) to which the original adjustment relates, the competent authority of the other State has been notified that the original adjustment has been made or proposed. The Protocol replaces Article 9(3) and provides that a Contracting State cannot make a primary adjustment (an undefined term) to the income of an enterprise after the earlier of: (i) the expiry of the limitation period under domestic law, and (ii) eight years after the end of the taxation year to which the relevant income relates. Dividends Received by Pension Organizations The Protocol amends Article 10 (Dividends) to add two new provisions, Articles 10(3) and (4), to eliminate withholding tax on dividends paid by a resident of a Contracting State to organizations that are constituted and operated exclusively to administer or provide benefits under one or more recognized pension plans. The new withholding tax exemption will apply to any dividend paid by a resident of a Contracting State to such an organization constituted and operated in the other State provided that: (i) the organization is the beneficial owner of the dividend, holds the shares on which the dividend was paid as an investment and is generally exempt from tax in its residence State, (ii) the organization does not directly or indirectly own shares representing more than 10% of the voting power or value of all of the shares of the dividend payer, and (iii) each recognized pension plan provides benefits primarily to individuals who are residents of the other State. 1 As of July 22, 2010.

8 7 Interest One of the most significant changes to be implemented by the Protocol is the introduction of new Article 11(3)(c), which eliminates withholding tax on interest paid by a resident of a Contracting State to a resident of the other State. However, the nil rate of withholding tax does not apply if the beneficial owner of the interest does not deal at arm s length with the payer (unlike the Canada-United States Income Tax Convention (1980)) or if the interest is contingent or dependent on the use of or production from property or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a company (commonly referred to as participating debt interest ). The Interpretive Protocol provides that the determination of whether an interest payer and recipient deal at arm s length generally is to be made in accordance with domestic law. The amendments to Article 11 correspond to recent amendments to the Income Tax Act (Canada) (Tax Act) that generally eliminate Canadian withholding tax on interest (other than participating debt interest) paid to a non-resident with whom the payer deals at arm s length. Clause 212(1)(b)(i)(B) of the Tax Act, however, provides that interest paid by a resident of Canada to a non-resident in respect of a debt obligation owing to a person with whom the payer does not deal at arm s length remains subject to Canadian withholding tax even if the non-resident who receives the interest deals at arm s length with the payer. This provision was enacted in response to the decision in Lehigh Cement Ltd. v. R., 2 in which a corporation loaned money to a borrower with whom it did not deal at arm s length and subsequently sold the interest coupon to a person with whom the borrower dealt at arm s length. The Federal Court of Appeal concluded that interest paid by the borrower to the purchaser of the coupon should be considered to be paid to a person with whom the borrower dealt at arm s length, even though the principal amount of the obligation was owed by the borrower to a person with whom it did not deal at arm s length. The withholding tax exemption in Article 11(3)(c) requires only that the beneficial owner of the interest deal at arm s length with the payer so that the Canada-UK Treaty might eliminate any withholding tax that would otherwise arise pursuant to clause 212(1)(b)(i)(B) in a scenario similar to Lehigh in which a Canadian resident pays interest to a resident of the UK with whom it deals at arm s length but the principal amount of the obligation is owed to a non-arm s length person. However, new Article 11(9) provides that the provisions of Article 11 shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the debt-claim in respect of which the interest is paid to take advantage of Article 11 by means of that creation or assignment. Presumably this provision will limit such planning. Mutual Agreement Procedure The Protocol repeals Article 23 (Mutual Agreement Procedure) (MAP) in its entirety and replaces it with a similar provision that imposes deadlines for certain actions undertaken pursuant to the Canada-UK Treaty. In particular: Under new Article 23(1), a resident of a Contracting State who considers that the actions of one or both competent authorities will result in taxation that does not accord with the principles of the Canada-UK Treaty must request competent authority relief within three years from the first notification of the action resulting in taxation not in accordance with the Canada-UK Treaty. New Article 23(3) provides that a Contracting State cannot make a primary adjustment to the income of a resident of a Contracting State that is subject to tax in the other State after the earlier of: (i) the expiry of the limitation period under domestic law, and (ii) eight years after the end of the taxation year to which the relevant income relates. 2 [2010] 5 C.T.C. 13 (F.C.A.).

9 8 Exchange of Information and Assistance in Collection of Taxes The Protocol proposes to add to the Canada-UK Treaty new Articles 24 (Exchange of Information) and 24A (Assistance in Collection of Taxes), which effectively adopt articles 26 and 27 of the OECD Model Convention. These provisions have become standard in Canada s tax treaties. Taxation of Seconded Employees The Canada-UK Treaty provides that remuneration from employment derived by a resident of a Contracting State may be taxed by the other State if the employment is exercised in the other State. However, such remuneration is taxable only in the residence State if (i) the recipient is present in the source State for a period or periods not exceeding in the aggregate 183 days in the calendar year concerned, (ii) the remuneration is paid by, or on behalf of, an employer who is not a resident of the source State, and (iii) the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the source State. The Protocol will amend the first condition such that the employee can only be present in the source State for a period or periods not exceeding in the aggregate 183 days in any 12 month period commencing or ending in the fiscal year concerned. This will affect numerous longer secondments that straddle a calendar year end. Capital Gains The Protocol does not amend Article 13 (Capital Gains) of the Treaty to delete Article 13(7)(b), which provides that, for purposes of determining whether a partnership interest, interest in a trust or unlisted share derives its value, or the greater part of its value, directly or indirectly from immovable property situated in a State, immovable property does not include real property (other than rental property) in which a business is carried on by the partnership, trust or company. Canada imposes tax on capital gains realized by a non-resident on the disposition of taxable Canadian property which is defined to include certain shares, interests in trusts and partnership interests where, in general, at any particular time during the 60-month period that ends at the time of disposition, more than 50% of the fair market value of the share or interest was derived directly or indirectly from real or immovable property situated in Canada and/or Canadian resource property and/or timber resource property and/or options or rights in such property. Article 13(5) of the Canada-UK Tax Treaty allows a Contracting State to impose tax on a gain realized by a resident of the other State on the disposition of a partnership interest, interest in a trust or unlisted share that derives its value, or the greater part of its value, directly or indirectly, from immovable property situated in the Contracting State. Article 13(6), however, provides that Article 13(5) does not apply if the alienator, or the alienator and persons related to or connected with him, owned less than 10% of each class of shares of the company or trust interests or partnership interests entitling them to less than 10% of the income and capital of the trust or partnership. A UK resident that disposes of a share, interest in a trust or partnership interest that would otherwise be taxable Canadian property but which derives its value principally from Canadian real property in which a business is carried on (e.g., a mine or oil or gas well), can rely on Article 13(8) to exempt any gain arising on the disposition from Canadian tax. Finance was reported to have previously stated that it no longer considered this broad business property exemption to align with its policy objectives and, accordingly, it would seek to ensure that the definitions of real or immovable property in Canada s tax treaties parallel the OECD Model Convention provisions and the taxable Canadian property definition in the Tax Act. The recent treaty with Hong Kong and (unratified) treaty with New Zealand, for example, are consistent with this policy. This objective was not realized in the Protocol but it is unclear whether this indicates a change in policy or is merely the result of horse trading in treaty negotiations.

10 9 Coming Into Force The Protocol remains subject to ratification by both Canada and the UK before coming into force. In Canada, the withholding tax provisions will come into force on January 1 of the calendar year after the Protocol is ratified and the other provisions will apply to taxation years beginning after that date. 3 3 Protocol, Article XVI(1)(a). Beps 2014 Deliverables Oecd Releases First Set of Recommendations by: TJ Kang and Brian O Neill Canada and other members of the Organisation for Economic Co-operation and Development (OECD) and the G-20 are engaged in a project to address base erosion and profit shifting (BEPS) strategies used by multinational enterprises (MNEs) and are working to achieve the goals set out in the OECD s Action Plan on Base Erosion and Profit Shifting (Action Plan), which was first announced in July The Action Plan includes 15 items to address BEPS in a coordinated and comprehensive manner. In the 2014 Canadian federal budget, the federal government reiterated its commitment to continue to improve the integrity of Canada s international tax rules and that it is actively involved in the work of the OECD and the G-20 in this regard. For additional and more detailed comments on Budget 2014, see Economic Action Plan 2014 International Tax Planning Under Continued Assault. On September 16, 2014, the OECD released its first set of recommendations, focusing on 7 of the 15 items set out in the Action Plan. Since the release, the OECD issued, on October 1, 2014, a revised calendar for stakeholders consultation, setting out a timeline for the completion of discussion drafts and public consultations as part of the Action Plan, with a number of relevant deadlines occurring in the balance of 2014 and throughout This article briefly summarizes the first set of OECD recommendations, which were arrived at through consensus of 44 countries (including all OECD members, OECD accession countries, and G-20 countries) and consultation with developing countries, business, NGOs, and other stakeholders. The next outputs of the BEPS project are due to be delivered by the OECD by the end of Given the interconnectedness of all 15 of the Action Plan items, 4 of the 2014 deliverables discussed below (Actions 2, 6, 8, and 13) remain in draft form and Action 5 is only an interim report. Each of these items will be further refined throughout the balance of 2014 and 2015, including to address technical issues and interaction with the 2015 deliverables. Actions 1 and 15, however, are considered final.

11 10 Action 1: Addressing the Tax Challenges of the Digital Economy The goal of Action 1 is to understand the key features of the digital economy, together with its attendant BEPS issues and how to address them. The report acknowledges that it is likely impossible to ring-fence the digital economy as a component of the broader economy and that, rather, the digital economy is increasingly becoming the economy itself. Further, the report stresses a need to continually evaluate and monitor advances in the digital economy and their impact on tax systems. The report points to several specific areas of technological developments that may generate additional challenges for tax policy makers in the near future: the so-called Internet of Things (i.e., networked devices); virtual currencies (such as bitcoin); developments in advanced robotics and 3D printing (which may shift manufacturing closer to end consumers, altering value creation centres in supply chains and the characterisation of business income); peer-to-peer sharing of goods and services; increased access to government data; and reinforced protection of personal data, which is more widely available in the digital economy. The development of the recommendations on Action 1 involved the creation, in September 2013, of the Task Force on the Digital Economy (TFDE), a subsidiary body of the Committee on Fiscal Affairs (CFA) involving both OECD and non-oecd G-20 members, which undertook extensive consultation with stakeholders prior to reaching its conclusions. The TFDE considers the BEPS issues relating to the digital economy to be primarily exacerbations of existing BEPS risks as opposed to unique ones and, accordingly, the ongoing work on each of the other Action Plan items will include consideration of the impact of the digital economy on those issues. However, the TFDE did comment on the following specific issues and future action items linked to the digital economy: The solutions to BEPS will need to ensure that core activities cannot inappropriately benefit from the exceptions to permanent establishment (PE) status in tax treaties, and that artificial arrangements relating to sales of goods and services cannot be used to avoid PE status. This is because functions considered auxiliary to traditional business models are becoming increasingly significant components of businesses in the digital economy. For example, there may be circumstances in which the maintenance of a local warehouse may constitute a core activity such that it should be outside the scope of the exceptions in Article 5 of the OECD Model Tax Convention. In this regard, work in the context of Action 7 will be expanded to consider whether the scope of the PE exemption should be narrowed to exclude certain preparatory or auxiliary activities that are core components of the business. The solutions to BEPS will need to be guided by an understanding of the importance of intangibles, the use of data, and the spread of global value chains, and their impact on transfer pricing, in light of the fact that companies in the digital economy rely heavily on intangibles in creating value and producing income. There is a concern that an MNE in a digital business can earn income in a controlled foreign company (CFC) in a low-tax jurisdiction by locating key intangibles there and using those intangibles to sell digital goods and services without that income being subject to current tax, even if the CFC itself does not perform significant activities in its jurisdiction. In making CFC recommendations under the Action Plan, consideration will be given to CFC rules that target income typically earned in the digital economy, such as income earned from the remote sale of digital goods and services.

12 11 The collection of VAT in business-to-consumer (B2C) transactions is a pressing issue that needs to be addressed urgently to protect tax revenue and to level the playing field between foreign suppliers relative to domestic suppliers. Further work on this issue is expected to be completed by the end of The CFA is to consider and clarify the characterization under current tax treaty rules of certain payments under new business models (e.g., cloud computing). Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements The draft recommendations for Action 2 are split into two parts: Part I, which provides recommendations for domestic rules to neutralize the effect of hybrid mismatch arrangements, and Part II, which sets out recommended changes to the OECD Model Tax Convention to deal with transparent entities, including hybrid entities. The recommendations are aimed at hybrid mismatches, which, generally speaking, are arrangements that, as a result of the different tax treatment or characterization in two jurisdictions of a particular financial instrument, asset transfer, or entity, achieve double non-taxation or long term deferral outcomes that may not have been intended by either country. For example, a common type of hybrid financial instrument is an instrument that is considered a debt in one country and a share in another so that a payment under the instrument is deductible when it is paid, but treated as a tax-exempt dividend in the country of receipt. With respect to recommendations for domestic rules, generally, the report recommends measures to address hybrid mismatches by: denying a dividend exemption for the relief of economic double taxation in respect of deductible payments made under financial instruments; introducing measures to prevent hybrid transfers being used to duplicate credits for taxes withheld at source; improving CFC and other offshore investment regimes to bring the income of hybrid entities within the charge to taxation under the investor jurisdiction and the imposition of information reporting requirements on such intermediaries to facilitate the ability of offshore investors and tax administrations to apply such rules; and implementing rules restricting the tax transparency of reverse hybrids that are members of a controlled group. More specifically, the recommendations advocate for domestic rules targeting payments under hybrid mismatch arrangements that (i) are deductible under the rules of the payer jurisdiction and not included in the ordinary income of the payee or a related investor (referred to as deduction / no inclusion or D/NI outcomes), or (ii) give rise to duplicate deductions for the same payment (referred to as double deduction or DD outcomes). The report recommends a two-tiered response with a primary rule as well as a defensive measure that would apply if the other jurisdiction has not adopted the primary rule. As an example, the primary response to a D/NI outcome involving a hybrid financial instrument would be to deny the payer a deduction in respect of the payment and, as a defensive measure, if the payer jurisdiction does not neutralize the mismatch, then the payee jurisdiction would require the amount to be included in ordinary income. As an example, where a payment by a hybrid entity to its parent gives rise to a DD outcome, the primary response would be to deny the duplicate deduction in the parent jurisdiction and, as a defensive measure, if the parent jurisdiction does not neutralize the mismatch, then the payer jurisdiction would deny the deduction for such payment.

13 12 The report also provides comments as to the intended scope of the recommended domestic rules, which indicate that the primary targets are arrangements involving related parties, controlled groups, and certain structured arrangements. Proposed definitions for these terms are set out in the report. In terms of recommended changes to the OECD Model Tax Convention, the report recommends: replacing Article 4(3) to provide that cases of dual treaty residence would be solved on a case-by-case basis (i.e., by mutual agreement between the competent authorities of the two states in issue) rather than the current rule, which is based on the place of effective management and has the potential for tax avoidance in some countries; and add a new provision that will ensure that income of transparent entities is treated in accordance with the principles of the 1999 OECD report on The Application of the OECD Model Tax Convention to Partnerships. The report notes that the proposed rule will not only ensure that the benefits of tax treaties are granted in appropriate cases but also that these benefits are not granted where neither contracting state treats, under its domestic law, the income of an entity as the income of one of its residents. Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance The OECD s work on harmful tax competition began more than 15 years ago with a 1998 report entitled Harmful Tax Competition: An Emerging Global Issue. The interim report on Action 5 confirms that the OECD s Forum on Harmful Tax Practices (FHTP) is committed to revamping this work, with a priority on improving transparency. Under Action 5, the FHTP has three deliverables: (i) finalization of the review of member country preferential regimes ; (ii) a strategy to expand participation to non-oecd member countries; and (iii) consideration of revisions or additions to the existing framework established by the FHTP for assessing whether a particular preferential regime is harmful. In connection with the first deliverable, the interim report provides an update on two priority areas, the first being a renewed focus on requiring substantial activity for any preferential regime. The second priority area is the development of a framework for compulsory spontaneous exchange of rulings related to preferential regimes (i.e., the exchange of taxpayer-specific rulings related to preferential regimes and which that taxpayer is entitled to rely upon). To the extent countries have the legal framework to start exchanging information covered by the framework, it is the intention that this apply from the end of The FHTP s work is primarily concerned with tax regimes that apply to income from geographically mobile activities, such as financial and other service activities, including the provision of intangibles, and more specifically to regimes that offer some form of tax preference in comparison with the general principles of taxation in the relevant country (e.g., a reduction in the tax rate or tax base or preferential terms for the payment or repayment of taxes). A review of preferential regimes of OECD member countries commenced in late 2010 and the review of preferential regimes of associate countries commenced in late 2013; several aspects of this review are ongoing. However, the review process has so far identified 30 preferential regimes, some of which have been determined to be not harmful, and many of which are still under review. The next steps in respect of Action 5 will be to complete this review and then to engage with non-oecd member countries on the same basis.

14 13 Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances On March 14, 2014, the OECD issued a public discussion draft on Action 6 and thereafter received a number of comments, which are available on the OECD s website. The September 16, 2014 version of the recommendations on Action 6 advocate a treaty-based approach to addressing the issue of treaty abuse and includes a number of alternatives which may be adopted as part of the OECD Model Tax Convention. The report indicates that there is agreement that, whichever alternative is adopted, there is a common goal to ensure that states incorporate in their treaties sufficient safeguards to prevent treaty abuse, in particular in respect of treaty shopping. The report recommends a minimum level of protection whereby countries would agree to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. In addition, the report advocates that such common intention be implemented either through the use of a specific anti-abuse rule based on the limitationon-benefits provisions similar to those used in U.S. tax treaties (the LOB rule), supplemented by a mechanism to address certain conduit financing arrangements, and/or a more general anti-abuse rule based on the principal purposes of transactions or arrangements (the PPT rule). The PPT rule would deny treaty benefits if one of the principal purposes of an arrangement or transaction is to obtain the treaty benefit, unless granting that benefit would be in accordance with the object and purpose of the relevant treaty provisions. The report includes draft versions of the LOB and PPT rules and outlines the strengths and weaknesses of each, noting that they may not be appropriate for all countries (e.g., due to constitutional or EU law restrictions). It is anticipated that a final version of Action 6 will be released in September It is worth noting that Canada has been actively addressing this issue through domestic legislation and tax treaties. The general anti-avoidance rule (GAAR) contained in Canada s domestic tax legislation already provides that it may be applied to deny a benefit arising from a misuse or abuse of any of Canada s tax treaties. The 2014 Canadian federal budget proposed an additional domestic rule addressing treaty shopping, but on August 29, 2014, the federal government announced that it is deferring action on this initiative and will instead await further work by the OECD and G-20 in relation to BEPS. Also, the recently in-force Canada-Hong Kong tax treaty includes PPT rules with respect to the payment of dividends, interest, and royalties. Action 8: Guidance on Transfer Pricing Aspects of Intangibles Action 8 proposes to develop rules to prevent BEPS by moving intangibles among group members, which will involve adopting a clear definition of intangibles, ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with value creation, developing transfer pricing rules or special measures for transfers of hard to value intangibles, and updating the guidance on cost contribution arrangements. The Action Plan contemplates continuing work on the transfer pricing rules, including under Actions 9 (risks and capital) and 10 (other high-risk transactions), in Accordingly, the report on Action 8 remains in draft form, with some of its elements being merely interim drafts of guidance which have not yet been fully agreed by delegates.

15 14 The most interesting aspect of the report is the apparent willingness to go beyond the arm s length principle and consider special measures in order to identify effective responses to certain concerns. Key among these are the following special measures, which will be considered during the course of 2015: providing tax administrations with authority in appropriate instances to apply rules based on actual results to price transfers of hard to value intangibles and potentially other assets; limiting the return to entities whose activities are limited to providing funding for the development of intangibles, and potentially other activities, for example by treating such entities as lenders rather than equity investors under some circumstances; requiring contingent payment terms and/or the application of profit split methods for certain transfers of hard to value intangibles; and requiring application of rules analogous to those applied under Article 7 of the OECD Model Tax Convention to certain situations involving excessive capitalisation of low function entities. No decision has been made with respect to the adoption of any special measures. The report notes that the work on Action 8, together with ongoing BEPS work, will be part of a coordinated and coherent response to transfer pricing generally. Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting Action 13 advocates enhancements to transparency for tax administrations by providing them with more information to conduct transfer pricing risk assessments and examinations. This is noted in the draft report to be an essential part of tackling the [BEPS] problem. The recommendations, if adopted, would require MNEs to report for each tax jurisdiction in which they do business: (i) the amount of revenue, profit before income tax, and income tax paid and accrued; (ii) their total employment, capital, retained earnings, and tangible assets in each tax jurisdiction; and (iii) an identification of each entity within the group doing business in a particular tax jurisdiction and an indication of the business activities each entity engages in. A standardized approach to transfer pricing documentation comprising a three-tiered structure is recommended. Specifically, the recommended documentation would consist of: a master file containing standardized information relevant for all MNE group members; a local file referring specifically to material transactions of the local taxpayer; and a country-by-country report containing certain information relating to the global allocation of the MNE s income and taxes paid together with certain indicators of the location of economic activity within the MNE group. The report includes as Annexes, templates for the above files with descriptions of the types of information that are proposed to be included in each. The structure of the proposed documentation and types of information to be reported are indicative of an intention to equip tax administrations with the information necessary to determine whether a significant amount of income is being allocated within an MNE group to low-tax jurisdictions in which there is little business substance (e.g., due to lack of employees, assets, etc.). In the report, the OECD acknowledges that the recommended mechanisms are new and untested. Accordingly, the transfer pricing documentation standards and country-by-country reporting standards are to be revisited no later than the end of 2020.