Technology is driving unprecedented change and disruption across global markets, shaking up established businesses and ushering in new operating models. Companies that have not relied on technology to grow market share or reduce costs are finding that they should adapt or potentially risk being left behind by competitors or new entrants. It’s been estimated that about half of S&P 500 firms in place in 2016 would be replaced in 10 years by brand new businesses and reinvented forms of existing ones.1
Coupled with a dynamic and uncertain global tax and trade landscape, many businesses face significant challenges as they reimagine their operations. But these factors can also offer opportunities to those companies that can embrace innovation and technology for strategic benefit.
Through technology and innovation, companies are bringing new products and services to market while also deploying them internally to boost efficiency and reduce costs. Automation, artificial intelligence, blockchain and other advances are allowing businesses to transform value chains in several important ways:
These developments are combining to reshape business models in many industries, making enterprises more efficient, more customer-focused and more adept at deploying capital and extracting value across their operations. However, the changes may also entail significant shifts in the location of capital, intangible property, employees, suppliers and inventories, as well as changes to the nature of products (e.g., as goods versus services), and all of these can have significant implications from the perspectives of tax and trade.
As with global trade, a focus on value creation is also driving change in the global tax environment. In the post-bricks-and-mortar world, it may not be as easy to assign a location to profits. This has thrown certain international tax concepts into disarray as countries seek to assert their right to tax economic activity that creates value within their borders.
That’s why a tug-of-war over how and where value is created has marked much of the Organisation for Economic Co-operation and Development (OECD)’s efforts to update international tax rules through its base erosion and profit shifting (BEPS) project. From increased tax transparency to minimum tax regimes to economic substance rules and treaty changes, value creation and taxing rights are central to many anti-BEPS measures being developed by the OECD, European Union and individual countries.
These changing international tax concepts mean companies can no longer do tax planning in isolation. Rather, they need to marry tax planning with operational substance, which could require significant changes to business models and structures. Some of the more important recent developments are as follows.
Aligning transfer pricing outcomes with value creation was the focus of the OECD’s work on transfer pricing under Actions 8-10 of the Action Plan on BEPS. Amendments to the OECD guidelines on risk and intangible property (IP) have greatly reduced the ability of international companies to rely on contractual arrangements and funding of development to determine entitlement to profits from IP.
Under the revised guidelines, legal ownership of intangibles does not by itself confer any right to retain returns derived by the international group from exploiting the IP, even when returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible. The goal is to prevent companies with no significant employees or minimal operational activity from earning significant risk- or IP-related returns.
Rather, the guidelines assign value to IP based on its development, enhancement, maintenance, protection and exploitation (DEMPE). This approach aims to compensate group companies for any functions they perform, assets they use and risks they assume in connection with IP. International groups therefore need to evaluate their end-to-end value chains to determine which group companies perform and exercise control over DEMPE functions.
Zero-and low-tax countries and economic substance legislation
In December 2017, the European Union’s (EU) Code of Conduct Group adopted a list of non-cooperative countries.3 Countries could avoid being placed on an EU list by pledging to change their harmful tax practices. This was followed in November 2018 with a paper4 from the OECD’s Forum on Harmful Tax Practices compelling zero-and low-tax countries to require companies to locally perform core income generating activities (CIGA) for IP development. Non-compliant companies would be subject to penalties, including loss of corporate charter — meaning that they would, in effect, no longer exist.
Substance requirements for non-IP income are based on having enough qualified employees and operating expenditures to undertake CIGA. For IP income, in addition to these criteria, substance requires the company to do research and development in the country (for assets such as patents) or branding, marketing and distribution activities (for assets such as trademarks).
Where the IP is acquired from affiliates or by cost sharing, substance also requires:
Most zero-and low-tax countries, including, but not limited to, the Cayman Islands, Bermuda, Barbados, Guernsey and Jersey, have adopted economic substance legislation requiring CIGA and exchange of information. These countries are required to gather and share this information with tax authorities of other countries to support a local allocation of income. Tax authorities around the world are therefore set to gain significant information about what companies are doing in these locations.
Since these rules are already in effect and the consequences of non-compliance are severe, many companies are reviewing their organizational structures to determine why a particular entity is being used and whether it still makes sense. These rules could therefore alter how international groups use, manage and operate offshore companies in the future.
In addition, many European countries have proposed or adopted anti-zero- and low-tax measures in line with this trend. These measures include, for example, the United Kingdom’s 20 percent tax on IP holding companies in tax havens and the Netherlands’ controlled foreign company rules for IP companies located in tax havens5.
Reallocating taxing rights via BEPS 2.0
The first round of BEPS negotiations, commonly known as BEPS 1.0, culminated with the release of sweeping proposals that led to widespread adoption of not only country-by-country reporting and other transparency measures but also rules that upset common tax planning structures involving hybrids, tax treaties and low-tax jurisdictions.
However, when it comes to the taxation of cross-border transactions in the digital domain, there was a sense that the work was incomplete. BEPS 2.0 is being undertaken to address tax issues of “scale without mass” — that is, the increasing ability of companies to reach markets without traditional nexus and therefore no tax liability.
Further, some countries believe current international tax rules fall short because:
The BEPS 2.0 talks to date make it possible that taxing rights will be allocated differently in the future, potentially based on an expanded concept of nexus, as well as a formula that recognizes the value of markets and that takes into account routine activities versus value-building DEMPE functions.
A second possible outcome of BEPS 2.0 is a global anti-base erosion proposal that could limit the influence of direct taxes on investment and business location decisions. The proposal would do this by applying a form of minimum tax at the parent level, or by denying deductions and treaty benefits, when companies book profits in jurisdictions that levy income tax at rates below a certain threshold rate.
The OECD expects to achieve consensus on the BEPS 2.0 proposals by the end of 2020. Looking ahead, international companies may need to adapt to a new international tax framework that incorporates both a new concept of taxable presence as well as a global minimum tax.
While the effects of global tax reforms on business processes and structures are long-term, global trade tensions are creating costs and, in some locations, opportunities in the short term. In particular, the current wave of protective trade practices has seen the US, EU, China and other countries engage in escalating tariff disputes, with ripple effects across the globe. Many items that were low-tariff, or even tariff-free, into these countries are now subject to higher tariffs at the border. These new costs directly affect the cost of goods sold, which then affects the company’s profits.
The 2019 Tariff Impact Study from KPMG in the US revealed that the respondents expected to mitigate the financial impact of tariffs by an average of 59 percent. Indeed, depending on the specific imported items, manufacturing processes, supply chain flows and customer requirements, there are steps companies can take to help reduce costs through:
Companies often apply multiple different mitigation approaches to various products, contractual terms and supply chains to help reduce costs across their business.
Companies that also invest in flexible supply chain planning may be able to react to tariff implications more efficiently in the long term. For example, the tariffs imposed by the US on goods from China have led some companies in the country to move south to lower-cost jurisdictions such as Malaysia, Indonesia, and Taiwan. Others have adopted dual and multi-origin plans, allowing their businesses to optimize markets, depending on the current tariff, free trade agreements and geopolitical factors.
As technology, trade and global tax fuel operational change, all parts of the business are affected — from organizational design, delivery models and business processes to frameworks for technology, data and governance. Tax and trade teams should be deeply involved in planning to ensure potential tax and trade implications are considered.
With today’s volatile tax and trade environment, planning for technology-driven operational changes should take into account, among other things, tax risks and opportunities. These include potential tariff implications, trade agreements, transfer prices, economic substance, intangible property holdings, permanent establishment considerations, withholding taxes and tax treaty relief.
For example, it may be prudent to involve tax and trade professionals when planning or observing changes in areas such as:
A multi-functional approach can help determine that solutions resolving commercial issues do not inadvertently create costly tax or trade problems. Companies that use technology and innovation to navigate changes in business while undertaking tax and trade planning stand to benefit by:
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