Readers of a similar age to me may remember the computer game Tetris. In it, a succession of blocks in various shapes falls from the sky, and the player has to manoeuvre each one into a place where it fits, before it hits the ground. Gradually, the blocks fall faster and faster, until the player loses control and an uncontrolled pile of debris forms.
Something like this is happening in treasury tax at the moment. For many years, changes in tax law have drifted into place and it has been possible to adapt a company’s treasury function to accommodate each one. However, there is currently a positive deluge of change, most of it potentially adverse for a group treasury function, and the task of keeping up with it all has become very challenging.
Firstly, the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) programme is wide-reaching. A recent article in The Treasurer discussed the impact on transfer pricing of financing transactions, and BEPS is a big part of it.
However, the programme also introduces a number of other actions that countries are bringing into law, such as limitation on interest deductions, more stringent tests for access to tax treaties (to eliminate withholding taxes) and anti-hybrid rules to prevent one-sided tax deductions.
The EU’s anti-avoidance programme, the Anti Tax Avoidance Directive (ATAD) requires EU member states to enact these BEPS requirements in a prescribed form and adds some additional reporting obligations. These changes largely take effect in January 2019.
Meanwhile, as was widely trumpeted in the press, the US enacted its own tax reform in January 2018. This resulted in a huge change in the tax landscape for groups investing in the US, and for US groups investing overseas.
On top of this legal evolution, changes in technology are adding their own challenges to the tax position of treasury functions. The issues may be practical (if I use a smartphone to approve transactions back in the office while I’m working remotely, at what point have I created a taxable presence abroad?) or technological (if I transact using cryptocurrency rather than US dollars, how does that affect the tax position?).
It’s worth noting, first of all, that most of these issues are not badged as attacking treasury functions, and are often described as anti-avoidance that only applies to the most aggressive taxpayers. However, their actual impact is in many cases far wider, and organisations of all sizes and descriptions will have to consider carefully what the impact may be.
So, let’s step through a few of these issues, and see what sort of fact patterns treasurers should be concerned about.
As noted above, the BEPS programme is not just about transfer pricing. Rather, it is a series of 15 coordinated steps, which OECD member countries are committed to undertaking, to limit various types of activity that are perceived as abusive to the international tax system.
One of these actions of particular relevance to treasurers is the interest limitation. The OECD’s proposal is that the tax deduction for net interest expense in a group of companies should be limited in most cases to 30% of taxable EBITDA. Countries have the option to lighten this limitation in cases where the worldwide group’s consolidated ratio of interest to EBITDA suggests that a higher ratio is appropriate.
The idea is that this prevents groups from overleveraging higher tax territories. For example, for many years, it has been common for multinational groups to maximise the level of debt (whether intragroup or external) in the US, where the tax rate was over 35%, in some cases lending from countries such as Luxembourg, Switzerland or Ireland, where the tax rate is significantly lower.
A rule of this type is now in force in Germany, the UK and the US. Other EU countries are required (by the ATAD) to implement a similar rule by 2022, though some will implement sooner. Other OECD countries will doubtless follow suit. It’s important to note that, unlike the transfer-pricing rules, these rules give no mechanism to exempt income in one territory when the corresponding deduction is lost in another.
Groups therefore need to look carefully at their funding structure and determine whether they will lose tax deductions for interest expense in any territory where they operate. The position is likely to be complex – in the UK, for example, the government introduced a wide-ranging definition of ‘interest’ (encompassing not only interest, discount and other gains and losses on debt and interest rate swaps, but also the ‘forward points’ element of FX derivatives), and also exemptions for companies in the ‘infrastructure’ sector, and a complex system of intercompany reliefs and carry-forwards intended to ensure that the resulting tax cost is shared around a group.
Another outcome from BEPS is the Multilateral Instrument. This is, broadly, a new tax treaty entered into by many countries, and designed to put additional limitations on the use of tax treaties between those countries. The OECD was concerned that companies may obtain favourable rates of withholding tax on intercompany payments of interest or royalties, by artificial use of subsidiaries in countries with favourable tax treaties.
While existing treaties generally have an anti-avoidance clause, it was felt that this was not sufficiently robust. The new Multilateral Instrument deals with this by allowing countries to choose from a menu of more robust anti-avoidance clauses, and deems those clauses to apply to treaties between them.
Treasurers should consider the potential application of this to payments of interest between companies, particularly where the recipient is not in the head office territory. For example, a group with an ultimate parent in a country outside Europe may commonly run intercompany finance or cash pooling from a European treasury centre.
The most common new anti-avoidance clause allows treaty benefits (ie favourable withholding tax rates) to be withdrawn where ‘one of the principle purposes’ of the recipient being in a territory is access to that territory’s tax treaties. Treasurers should consider, for their current and future intercompany loans, how they would demonstrate the good, commercial, non-tax reasons for the treasury centre being located where it is. How would they demonstrate to the satisfaction of a sceptical tax authority that tax was not a significant factor?
The anti-hybrid arm of the BEPS rules also adds complexity. Hybrid in this context is not necessarily the thing that a treasurer would think of as hybrid. Rather, it refers to any instrument or entity that arbitrages different tax systems by its legal form.
Examples include instruments such as cross-border profit participation instruments that may give rise to tax deductions for the borrower, but an exempt dividend receipt for the lender; or entities that are seen as a taxable company in one territory’s tax system, but as a pass-through transparent entity in another. Broadly, the new BEPS rule says that, where these features exist, any tax deduction that is not mirrored by taxable income, is disallowed.
In many cases, these types of transaction are easily identified and well known to the groups who use them. However, the more difficult issues for treasurers arise from the fact that a branch operation is deemed to be a hybrid, on the grounds that for one territory it is a taxable entity, and for another it may not be. Consequently, groups with the very common international treasury footprint of a treasury company in one territory (such as Switzerland or Luxembourg) and the key treasury people and functions in another territory (such as the US or the UK) will have to look very closely at this rule.
Regardless of whether the location of people and functions would normally constitute a taxable branch under local law, if the entity is not in fact taxed on all its receipts from elsewhere, the effect may well be a material additional tax cost. This is notwithstanding the fact that the arrangement may well be driven entirely by commercial considerations, and would not typically be seen as planning around the rules of any territory until now. The mere fact that income paid to the branch is not taxable is sufficient to trigger the anti-hybrid rule in any territory that enacts it.
Again, this is part of the package of BEPS measures that the UK has already introduced, and other EU territories will introduce in 2019. Australia is drafting similar law, and other OECD territories are expected to follow suit.
As the US has not signed up to the BEPS measures, its tax reform has taken a slightly different path. The headline was, of course, the reduction in the US corporation tax rate from 35% to 21%. However, there is a broader, and potentially more challenging, impact on all groups that deal with a US company, whether it is the group parent or a subsidiary.
Firstly, the existing interest limitation rules have been amended to limit interest deductions to 30% of EBITDA. This is broadly consistent with the BEPS measures.
Secondly, the new Base Erosion and Anti-Abuse Tax measure is designed to prevent groups from obtaining excessive tax deductions in the US. Broadly, it limits the tax deductions for intercompany payments (whether interest, royalties or other costs) where the effect of those payments is to produce an overall loss in the US. Groups with US operations need to consider the effect of this on their intercompany arrangements.
Thirdly, there is a large change in the environment for US groups with overseas subsidiaries. The existing Subpart F rules, which pick up low tax offshore profits unless they meet certain exemptions, have been supplemented by a wider Global Intangible Low-Taxed Income regime, which broadly picks up all profits other than those that represent a return on tangible assets.
The effect is a significant change to the taxation of worldwide subsidiaries of US groups, and many groups are reconsidering their financing and treasury arrangements as a result. In particular, the incentive to manage significant treasury centres and investments outside the US has reduced in many cases.
The above changes are all changes of tax law that have an impact on treasury. They are in themselves enough to keep a treasurer’s hands full. However, treasurers need to be mindful of the commercial and accounting environment in which they operate.
There are a number of other changes that can have significant impact, from changes in accounting (for example, IFRS 16, which impacts on the accounting and tax treatment of operating leases) to changes in technology. As mentioned above, cryptocurrency and how to tax it is exercising many minds in tax authorities around the world.
To return to the original Tetris analogy – those blocks are arriving faster and faster, and it is increasingly challenging to fit them all into place.
Graham Robinson is a partner with PwC and a member of the ACT’s policy & technical team