The evolution of the OECD’s concept of a harmful tax practice or regime from the 1998 report to the approach the OECD is taking under BEPS Action 5
Introduction: The OECD’s concept of harmful tax practices has evolved significantly, from its initial identification in the 1998 report to the current approach under BEPS Action 5. This evolution highlights the OECD’s efforts to address tax competition issues, improve transparency, and ensure substantial economic activity within tax regimes.
Harmful Tax Competition (HTC) mainly arises when a Taxpayer exploits the difference in existing legal administrations (Rohatgi).
The 1998 Report: Laying the Foundation
The OECD 1998 Report mentioned that HTC affected the fair allocation of tax revenue and eroded the tax base of other countries. According to the report, Preferential Tax Regimes (PTR) is harmful when capital is redirected from one revenue to another due to ‘aggressive bidding’.
1998 Report was the first report that set out the four key factors to recognize Tax Havens (TH) and eight other factors which were primarily used to find if a PTR was harmful (HPTR) or not. To oppose HPTR, the report provided a general framework and timetable under which countries must report and abolish harmful features of the regime. It was initially criticised by the OECD itself as there was a lack of ‘global playing field’ and the main issues were the lack of transparency with regards to the proceedings of the forum and the economic depression in THs.
Follow-up Progress Reports: Refining the Approach
There were a few follow-up progress reports which further dealt with issues surrounding HPTR as
i) The June Report (2000 Report) identified 47 ‘Potential’ HPTR countries in the OECD while 35 jurisdictions were identical to the four key factors, labelling them as THs.
ii) The second progress report (OECD, 2002a) identified uncooperative THs
iii) Development of ‘general guidance’ to aid member states in the review of any current or future PTR. ‘Application’ of transparency and exchange of information, ring-fencing and transfer pricing were consolidated to form an application note (OECD 2004a).
iv) Progress Report on eliminating harmful aspects of a PTR in OECD Countries. Of the earlier 47 potential HPTR countries, none were found to be ‘harmful’ with respect to the 1998 Report (OECD 2004b).
v) OECD 2006 Report finally concluded that none of the 47 Regimes was harmful with Luxembourg being the exception. It is worth mentioning that Luxembourg holding Company 1929 was finally removed from the list of HPTR after it ended its regime in 2010, so no HPTR were found in the 2010 Report.(Miller)
The Forum on Harmful Tax Practices (FHTP): A New Chapter
The original report had also laid down a foundation for the work in the area of HPTR as Tax issues were carried through the Global Forum on Taxation (created in 2000) which was later known as the Forum on Harmful Tax Practice (FHTP). It remains relevant as it deals with HTP with respect to’ geographical mobile activities’ including intangibles. With regards to its work on TH, all the THs were taken of the ‘black-list’ after signing Tax Information Exchange Agreements (TIEAs) and it could even be regarded as a success, mainly due to the proliferation of the TIEAs and acceptance of Art 26 of the model in their DTC. The 2010 Report further mentioned that zero or low tax rates are not enough to constitute a TH status.
BEPS Action 5: A Comprehensive Strategy
BEPS Action 5 intends to improve the transparency through a compulsory exchange of tax rulings, and it specifically requires substantial activity for a PTR. Its main concern is to make sure of that no profit is shifted from the source and follows the test in the 1998 Report (regime encourages purely tax-driven arrangements involving no substantial activities).
FHTP reviewed over 43 PTR and 16 of them were IP regimes. With regards to the IP regimes, a ‘nexus approach’ was adopted as the taxpayer benefitted from it only ‘to the extent’ where engagement with the R&D directly relates to the benefit and gives rise to IP income. The same ‘nexus principle’ is followed for proving substantial activity for all PTR in relation to a core income-generating property. (De Broe)
The aspect of transparency is another requirement to tackle HTP. OECD has observed that normal tax ruling practices can attract international mobile capital to a jurisdiction with the potential to contribute to HTP. The central element is a compulsory exchange of information to ensure that tax authorities rulings do not constitute to HTP.
The FHTP is committed by Action 5 to “revamp” the work on HTP. It does so mainly by application of methods to define the Substantial activity requirement mentioned earlier. It does so by a ‘peer-review process’ for TPR involving a total of 3. In order to find out if it is actually harmful, by determining if the TPR is within the scope of the FHTP. It is deemed to be in scope if tax incentives are applicable from ‘geographical mobile activities.’ We also need to find out any preferential treatment (e.g. Reduced tax rate) in the TPR while comparing it with the general principles of the tax administration. (Miller)
The five key factors are: the regime imposes no or low effective tax rates. The regime is ring-fenced from the domestic economy, meaning that the regime is not available to residents, or taxpayers within the regime do not benefit from the tax incentives if transactions are carried out with residents. There is no effective exchange of information with respect to the regime and the fifth key factor, the substantial activity requirement, as elaborated in the Action 5 Report is not met.
The final step determines if the HTPR is actually harmful by consideration of the economic factors. Even if a regime has been determined potentially harmful, there is a possibility that it is not actually harmful. It is possible if it does not appear to give rise to any harmful economic effects. We can assess it through the total number of taxpayers and the income amount benefiting from the regime. (Schwarz)
Action 5 has set out further work like the application of the agreed transparency framework and further development of a method to increase participation outside the OECD countries as several underlying concerns require monitoring and development to restrict HTPR.(Tax Issues) It is worth mentioning that OECD has reviewed over 255 regimes globally and harmful tax regimes are almost entirely eliminated. (OECD/G20 Inclusive Framework on BEPS Progress report July 2018 – May 2019). However, we must note that it is a soft legal instrument and corporation giants like Google and Apple can safely circumvent it.
Conclusion: BEPS Action 5 marks a pivotal step in combating harmful tax practices, emphasizing transparency, substantial activity requirements, and economic impact assessments. While significant progress has been made in identifying and eliminating harmful regimes, ongoing efforts are essential to address emerging challenges and ensure global tax fairness.
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