Worldwide, trade balances are in a state of flux. Large multi-national enterprises (MNEs) of the world are raking in profits; however, are they paying their fair share of corporate tax or are they resorting to aggressive tax planning?
Governments are looking for ways to recover public deficits by expecting MNEs to pay their “fair share of tax”. The Base Erosion and Profit Shifting (BEPS) Action plans, formulated by OECD over the past couple of years, are a step forward in this direction. These Action plans will undoubtedly have an impact on the international tax planning environment and particularly the M&A sphere.
Who is at risk?
What is the risk?
The need for considering BEPS proposals will arise both at the stage of performing tax due diligence on the Target Group as well as at the time of planning the acquisition/funding structure and even through the holding period. Some of the key aspects, which could arise on the target group under the proposed Action Plans are as below:
- Addressing tax challenges of digital economy (DE)
- Target operating in DE and having an operating model whereby a significant portion of profits are parked in a jurisdiction with reduced tax rate, and reduced level of profit are parked in the jurisdiction where majority customers are based, may be adversely affected upon enactment of this Action plan. It may unfavorably affect the target’s current competitive advantage and require changes to its operating model. Accordingly, the pricing for the deal may have to consider this aspect.
- Neutralizing effects of hybrid mismatch arrangements
- Target having hybrid arrangements (e.g., applying a dividend exemption at the level of payee for payments that are deductible at the level of the payer) in their structure, could suffer an increased Effective Tax Rate (ETR) upon enactment of anti-hybrid rules or incur restructuring costs for unwinding such hybrid arrangements. For example in the Netherlands, participation exemption will not be permitted for hybrid instruments such as Compulsory Convertible Debentures.
- Strengthening CFC rules
- Target groups with significant overseas operations and earning substantial passive incomes (such as dividend, interest, royalty, etc.), which are subject to reduced levels of tax may suffer an increased ETR upon enactment of stricter CFC rules in its head-quarter country and in holding company jurisdictions. This again may impact deal pricing.
- Limiting base erosion via interest deductions and other financial payments
- Target group with significant leverage in high tax territories may suffer an increased ETR upon enactment of tightened thin capitalization rules (disallowance of excessive interest expense as a tax deductible item) and earnings stripping rules.
- Preventing granting of treaty benefits in inappropriate circumstances
- Target group enjoying relief under treaties in spite of having limited substance in such countries may suffer increased cash repatriation and financing costs if treaties are modified or domestic legislation is enacted that overrides existing treaty provisions.
- Transfer pricing aspects
- Target group with significant intangible assets or risks and capital, which are located in or transferred to countries with a low tax rate, could suffer an increased ETR if tax laws are modified in the head-quarter country or in territories where it holds intangible assets or risk and capital.
- Disclosing aggressive tax planning arrangements
- Target groups, which have entered into aggressive or abusive transactions/structure, could suffer an increased ETR if this Action results in increased transparency of such transactions/structures.
- Country By Country Reporting (‘CBCR’)
- Target group with significant overseas operations and related party transactions may be adversely affected by increased tax reporting transparency under CBCR rules.
In the event of coordinated BEPS action, the Target’s tax profile may change materially, resulting in significant tax exposures. Reputational risks could also result from acquiring the target.
How to address the risk?
While performing a tax diligence, it will now be important to:
- Understand existing intercompany holding and financing structure
- Understand in more refined way the commercial rationale/ beneficial ownership of the investment and IP holding companies
- Examine PE risk and tax planning arrangements
- Study transfer pricing policy of Target group
These parameters will help determine that the ETR shows a true picture of the current state of affairs of the target and in ascertaining its future sustainability.
Similarly, while structuring any acquisition, care should be taken that the proposed structure is BEPS proof. For instance where diligence indicates lack of substance at holding company level, the buyer could consider direct acquisition of the operating company. Use of hybrid entities for acquisition or hybrid/debt instruments for funding should be done after studying prevalent jurisdictional laws.
Considering these are early days of BEPS and the extent to which each jurisdiction will embrace the proposed Action plans is unknown, it may be difficult to ascertain exact impact of BEPS on a structure/arrangement. However, if one keeps in mind the guiding principles of the BEPS project viz “Coherence”, “Transparency” and “Substance”, it should be possible to evaluate a structure, which is compliant with the proposed fair and equitable tax policy.
Article includes contribution from Shruti Lohia, Manager, Tax and Regulatory, EY India