Michael Ford (post until Oct. 31/19)
Tax

Profit shifting concerns 'overstated' given corporate objectives

Concerns raised by the Organization for Economic Co-operation and Development (OECD) about the risks that base erosion or profit shifting create for international investment and the tax system are overstated, as countries already know how to compete for mobile capital within the context of the existing rules, Calgary tax and fiduciary services lawyer Dennis Nerland tells AdvocateDaily.com.

As Nerland, a founding partner of Shea Nerland Law and leader of the firm's tax and estate planning practice, explains, the OECD began raising concerns in 2013 about the serious risk that base erosion and profit shifting (BEPS) pose to global investment and to the integrity of the tax system. As the OECD notes, BEPS refers to business strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations.

“As a result, they declared a pressing need to address BEPS by creating a comprehensive action plan to combat it, including developing proposals to put an end to hybrid mismatch arrangements and intra group financing and the resulting arbitrage,” he explains.

The comprehensive package of measures under the BEPS Action Plan were developed and agreed to in just two years, says the OECD. They have been designed “to be implemented domestically and through tax treaty provisions in a co-ordinated manner,” through the involvement of more than 100 countries, jurisdictions and regional tax organizations.

The BEPS plan sets out 15 actions to “equip governments with domestic and international instruments to address tax avoidance, ensuring that profits are taxed where economic activities generating the profits are performed and where value is created.”

For individual countries, Nerland explains, the goal is clear: to curb tax abuse without curbing foreign investment.

“The current arsenal of tools enabling them to achieve this are their various thin capitalization rules, denial of interest deductibility rules, and their withholding tax rates on interest.”

However, he notes, the concerns adopted and expressed by the OECD about BEPS are overstated, based on both macroeconomic evidence, and the bottom-up motivations of international corporations, as currently governed by existing rules.

“The OECD makes the case that BEPS is a key priority of governments around the globe, and so its Committee on Fiscal Affairs has brought together 44 countries to develop its 15-Point Comprehensive Action Plan with the goal of providing comprehensive and coherent solutions through recommended changes to both domestic rules and bilateral treaties.”

However, he explains, this is “really hard” to do.

“This requires changes to, in a perfect world, 1,062 bilateral treaties and 44 complicated domestic tax regimes. In essence there are about 75,000 trilateral relationships and three million interrelated bi, tri and quadrilateral relationships being affected. In a world fraught with geopolitical tension and in a world where countries compete for investment with their tax systems, alignment of their relationships will be extremely difficult,” says Nerland.

Secondly, he adds, in today's world, the rate of change due to global communication, innovation, and risk appetite is accelerating.

“This makes a complete solution exponentially harder to get done. And even if it works now, will it have any sort of lasting effect?”

So, is the OECD’s focus on BEPS justified? Nerland says empirical data clearly suggests that either there is something wrong with the academic studies on the issue, or the problem is severely exaggerated.

“The reasons that the multinational income shifting elasticity is so low is not from a lack of imagination or profit motive, but because the existing rules are so complex and the current enforcement regimes so hawkish that planning of this sort is extremely difficult to conceive, cumbersome to operate and costly to implement, operate and to be attacked on,” he says.

“In other words, after adjusting for costs and risk, corporations are looking at too modest profits, if any at all, to make such planning worthwhile —unless the dollars are very large, where thin margins start to make sense.”

There is a pattern, observable over time, of source countries eliminating withholding tax on interest, adds Nerland.

“If hybrids and the like were responsible for significant tax leakage, one might expect to see an attempt to counter this through such taxes. But that is not the case, in fact it is the reverse.”

A comparison of withholding tax rates in 2004 to those in 2014 for roughly 80 per cent of the world's GDP shows that source countries actually compete for mobile international capital and this is one way they do it, says Nerland.

“Withholding tax rates on interest are at odds with expressed OECD concerns. Source countries are competitive. They know how to compete for mobile capital within the context of the existing rule set,” he adds.

Ultimately, Nerland explains, “question whether a complete BEPS solution would have the effect of placing further downward pressure on general corporate tax rates.

"This would amplify the other side of the elasticity curve, resulting in a recovery — optimistically speaking — of up to one per cent of lost tax revenue, but giving up many multiples of this to domestic and international companies alike, as a competitive response in order to compete for mobile international capital, thus really causing a disruption to their corporate tax revenue generation.”

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