Wednesday 2 December 2015

OECD's Base Erosion and Profit Shifting

We’ve already briefly covered news of the OECD’s Base Erosion and Profit Shifting project and how it will affect the various patent or knowledge box schemes to reduce tax for companies based on profits accrued from intellectual property. The final package was put to the G20 Finance Ministers on 8 October in Lima, Peru, and has been adopted. The wonderfully named "Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance: Action 5” which can be downloaded here contains the full meaty details of the OECD’s view. It’s a document that contains a lot of useful detail and this is a first post to explain thr broad thrust of the project. We’ll try and deal with some particular issues in separate posts over the next few weeks.
The thrust of the project has been to align taxation with substantial (economic) activity and ensure that taxable proits are not “artifically shifted away from the countries where value is created" (see para 24). The report recognises that IP-intensive industries are a key driver of growth and employment and there is no intention to prevent countries from adapting tax incentive for research and dvelopment in their own countries. The report’s thrust is to define the outer limits of an IP regime that grants benefits to R&D, but does not have harmful effects on the collection of tax by other countries.
The report examined various options and concluded that the so-called “modified nexus” approach was the best one to take. The tax benefits can be applied in countries to provide benefits to the income arising out of the intellectual poperty as long as there is a direct nexus or link between the income receiving the benefit and the expenditures contributing to that income. As the report explains, the purpose is to give the taxpaying company a tax reduction for the research and development work that the taxpaying company did itself - and not for R&D work done elsewhere. In other words, a patent or knowledge purchased in from elsewhere would not be entitled to the tax credit.
The report also sets out in detail the concept of qualifying expenditure, which is entitled to the tax credit, and total expenditure which includes elements on which no tax credit can be obtained. Countries will be allowed to define qualifying expenditures as long as these are only related to R&D activities - it should not include interest payments, building costs, etc. Qualifying expenditures do not include payments to third parties to carry out R&D work. 
It is also clear that only patents and similar rights, such as software, will be entitled to the benfits. This will rule out some countries’ schemes that have extended the benefit to design rights, copyrights or trademarks but there may be openings for smaller companies to include further rights.
The overall income that can benefit from the scheme must be derived from the IP asset itself, such as a royalty, capital gains or sale.
It was the introduction of the UK’s scheme that triggered the OECD work, particularly as Germany had objected to the scheme. The report will allow the UK and other countries to continue with their schemes with some minor modifications, and the UK has now published proposals for modification of its scheme. We’ll be interested to see whether Germany does introduce a scheme.  

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