Base erosion profit shifting

Base erosion and profit shifting (BEPS) refers to corporate tax planning strategies employed by multinational enterprises (MNEs) to exploit gaps and mismatches in tax rules across different jurisdictions. These strategies allow MNEs to artificially shift profits to low or no-tax locations where they have little or no economic activity, thereby eroding the tax base of higher-tax countries and reducing their overall tax liabilities. BEPS is a significant concern within the broader field of [international taxation].

History and Origin

The concept of base erosion and profit shifting gained prominence in the early 2010s as public and governmental awareness grew regarding the tax planning practices of large multinational corporations. While many BEPS schemes are legal, they often involve complex maneuvers within tax law that exploit discrepancies between national tax systems⁴⁶. This led to a consensus among the G20 countries and the Organisation for Economic Co-operation and Development (OECD) that an international framework was needed to address these issues⁴⁴, ⁴⁵.

In 2013, the OECD, in collaboration with the G20, launched the Base Erosion and Profit Shifting Project (the BEPS Project). This initiative aimed to develop a comprehensive set of measures to counter tax avoidance by MNEs⁴³. The project culminated in October 2015 with a 15-point Action Plan designed to equip governments with tools to prevent international companies from engaging in tax avoidance. The BEPS Project was deemed the first major multinational effort to reform international tax rules since their initial design in the 1920s⁴².

Key Takeaways

• Base erosion and profit shifting (BEPS) involves multinational corporations shifting profits to lower-tax jurisdictions to reduce their tax burden.
• The OECD/G20 BEPS Project aims to develop international rules to combat these tax avoidance strategies.
• BEPS can lead to significant revenue losses for governments, particularly in developing countries.
• The BEPS Action Plan consists of 15 measures designed to improve the coherence, substance, and transparency of international tax rules.
• Ongoing global tax reforms, including BEPS 2.0, seek to implement a global minimum corporate tax rate.

Interpreting Base Erosion Profit Shifting

Base erosion and profit shifting is primarily understood as a set of practices that allow MNEs to minimize their [corporate income tax] obligations. The interpretation of BEPS often focuses on the intent and effect of these strategies:

• Artificial Profit Shifting: BEPS strategies are characterized by the artificial reallocation of profits away from the jurisdictions where economic activity and value creation actually occur. This can involve the use of [intra-group payments] for services, interest, or [royalties], or the strategic location of intellectual property in low-tax regimes⁴¹.
• Erosion of Tax Base: The "base erosion" aspect refers to the reduction of the taxable income in a country, which in turn diminishes the tax revenue that government can collect. The "profit shifting" aspect refers to moving those profits to jurisdictions with more favorable tax rates.
• Fairness and Integrity: The prevalence of BEPS undermines the fairness and integrity of national tax systems, as it can put domestic businesses at a competitive disadvantage and may reduce voluntary tax compliance among other taxpayers⁴⁰.

The OECD estimates that BEPS costs countries between USD 100 billion and USD 240 billion annually in lost revenue, which is equivalent to 4% to 10% of global corporate income tax revenue³⁹. Developing economies are disproportionately affected due to their heavy reliance on corporate income tax, particularly from multinational enterprises³⁶, ³⁷, ³⁸.

Hypothetical Example

Consider a multinational technology company, "GlobalTech Inc.," with its headquarters in Country A, which has a 25% corporate tax rate. GlobalTech Inc. also has a subsidiary, "IP Holdings Ltd.," located in Country B, which has a 5% corporate tax rate and favorable intellectual property (IP) tax regimes.

1. Value Creation in Country A: GlobalTech Inc. develops cutting-edge software in Country A, generating substantial revenue from its global sales.
2. IP Transfer to Country B: To minimize taxes, GlobalTech Inc. sells or licenses its valuable intellectual property, such as patents and trademarks, to IP Holdings Ltd. in Country B for a relatively low price.
3. High Royalties and Fees: IP Holdings Ltd. then charges very high royalty and licensing fees back to GlobalTech Inc. (and its other subsidiaries worldwide) for the use of the IP. These fees are tax-deductible expenses in Country A.
4. Profit Shifting: By deducting these substantial royalty payments, GlobalTech Inc.'s taxable profit in high-tax Country A is significantly reduced, thus eroding Country A's tax base. The profits accumulate in IP Holdings Ltd. in low-tax Country B, where they are taxed at a much lower rate.

This allows GlobalTech Inc. to legally shift profits from Country A, where the core economic activity of developing the software takes place, to Country B, primarily for tax optimization. This is a classic example of base erosion and profit shifting.

Practical Applications

Base erosion and profit shifting is a central focus in the realm of [international tax policy] and corporate governance. Its practical applications primarily involve regulatory efforts and corporate compliance:

• Tax Legislation and Treaties: Governments globally are updating their domestic tax laws and [tax treaties] to incorporate anti-BEPS measures. This includes rules on [transfer pricing], controlled foreign companies (CFCs), and hybrid mismatch arrangements³⁴, ³⁵.
• Country-by-Country Reporting (CbCR): A key outcome of the BEPS Project (Action 13) is the requirement for large MNEs to prepare Country-by-Country Reports. These reports provide tax authorities with aggregate information annually, by tax jurisdiction, relating to the global allocation of the MNE's income, taxes paid, and certain indicators of economic activity. This increases [tax transparency] and helps tax authorities identify potential BEPS risks³², ³³.
• Global Minimum Tax: The ongoing BEPS 2.0 project, an initiative of the OECD/G20 Inclusive Framework, aims to establish a global minimum corporate tax rate, typically set at 15%. This "Pillar Two" initiative seeks to ensure that multinational enterprises pay a minimum level of tax on the profits they generate, regardless of where they are headquartered or operate²⁹, ³⁰, ³¹. As of July 2023, 138 members of the OECD/G20 Inclusive Framework have agreed on an outcome statement, recognizing progress towards a historic reform of the international tax system²⁸.
• Corporate Tax Planning and Compliance: Companies operating internationally must now navigate a more complex and evolving global tax landscape. This necessitates robust [tax compliance] frameworks and often requires a more strategic approach to transfer pricing and intercompany transactions to align with new international standards²⁷.

Limitations and Criticisms

Despite the widespread efforts to combat base erosion and profit shifting, the BEPS project and its outcomes have faced several limitations and criticisms:

• Complexity and Implementation Challenges: The new rules and frameworks introduced by the BEPS project, particularly Pillar Two's global minimum tax, are highly complex. This complexity can pose significant implementation challenges for both tax authorities and multinational enterprises, especially in jurisdictions with limited administrative capacity²⁵, ²⁶.
• Effectiveness in Curbing Profit Shifting: Some analyses suggest that the overall impact of the initial BEPS Project (BEPS 1.0) in significantly reducing global tax avoidance and profit shifting has been limited. For instance, some estimates indicate that tax revenue losses due to profit shifting may have even increased in the initial years after anti-BEPS measures were implemented²⁴. Critics, such as the BEPS Monitoring Group, have raised concerns that the proposals may not curb corporate tax abuse to a significant degree and that benefits for lower-income countries are questionable²³.
• Impact on Developing Countries: While BEPS disproportionately affects developing countries, some argue that the solutions proposed by the OECD/G20 BEPS Project may not fully address their specific needs. Developing nations often rely heavily on corporate income tax and may find the complex rules challenging to implement. Furthermore, some research, including by the International Monetary Fund (IMF), suggests that the benefits of the OECD's proposals for many non-OECD countries might be small at best²⁰, ²¹, ²².
• Potential for Double Taxation: The evolving international tax landscape and the implementation of new rules under BEPS 2.0 may increase the risk of [double taxation] for multinational enterprises, as different jurisdictions interpret and apply the new standards¹⁹.
• Political Will and Unilateral Actions: The success of BEPS reforms relies heavily on multilateral cooperation and consistent implementation across jurisdictions. Political shifts or unilateral actions by major economies, such as the potential withdrawal from certain aspects of the global tax deal, could create fragmentation and undermine the effectiveness of the international framework¹⁸.

Base Erosion Profit Shifting vs. Tax Avoidance

While the terms "base erosion and profit shifting" (BEPS) and "[tax avoidance]" are closely related and often used interchangeably in general discourse, there is a nuanced distinction, particularly in a regulatory context.

Base Erosion and Profit Shifting (BEPS) specifically refers to legal tax planning strategies used by multinational enterprises to exploit gaps and mismatches in tax rules to artificially shift profits to low- or no-tax jurisdictions. It describes a particular set of corporate behaviors that reduce taxable income in higher-tax countries where economic activity occurs. The OECD's BEPS Project focuses on these specific cross-border tax challenges.

Tax Avoidance, on the other hand, is a broader term that encompasses any legal strategy employed by individuals or corporations to reduce their tax liability. This can include taking advantage of legitimate deductions, credits, or exemptions provided in tax law. While BEPS is a form of tax avoidance, not all tax avoidance constitutes BEPS. For example, an individual contributing to a [retirement account] to reduce their current taxable income is engaging in tax avoidance, but this is not BEPS. BEPS specifically targets aggressive tax planning by MNEs that is considered harmful to the integrity of national tax bases.

FAQs

What is the main goal of the BEPS project?

The main goal of the OECD/G20 BEPS Project is to ensure that profits are taxed where economic activities generating those profits take place and where value is created¹⁶, ¹⁷. It aims to combat tax avoidance by multinational enterprises by equipping governments with rules and instruments to address base erosion and profit shifting¹⁵.

Is base erosion and profit shifting legal?

Many of the strategies employed in base erosion and profit shifting are technically legal, as they exploit loopholes and inconsistencies in existing international and domestic tax laws¹⁴. However, these practices are often viewed as "aggressive tax planning" and are considered unfair or harmful to national tax systems¹³. The BEPS Project aims to close these loopholes and create a more coherent international tax framework.

How does BEPS affect developing countries?

Base erosion and profit shifting disproportionately affects developing countries because they often rely more heavily on corporate income tax as a source of government revenue¹¹, ¹². When multinational enterprises shift profits out of these countries, it leads to significant losses in vital tax revenues, hindering their ability to fund public services and sustainable development⁷, ⁸, ⁹, ¹⁰.

What is the difference between BEPS 1.0 and BEPS 2.0?

BEPS 1.0 refers to the initial 15-point Action Plan released by the OECD in 2015, which focused on addressing various aspects of base erosion and profit shifting, such as hybrid mismatches, treaty abuse, and transfer pricing documentation⁵, ⁶. BEPS 2.0 is the ongoing initiative, primarily addressing the tax challenges arising from the digitalization of the economy. It consists of two pillars: Pillar One, which reallocates taxing rights to market jurisdictions, and Pillar Two, which establishes a global minimum corporate tax rate (generally 15%) for large multinational enterprises¹, ², ³, ⁴.