Beps Explanatory Statement 2015

OECD/G20 Base Erosion and Profit Shifting Project
Explanatory Statement
Addressing base erosion and profit shifting is a key priority of governments around the
globe. In 2013, OECD and G20 countries, working together on an equal footing, adopted a
15-point Action Plan to address BEPS.
Beyond securing revenues by realigning taxation with economic activities and value creation,
the OECD/G20 BEPS Project aims to create a single set of consensus-based international
tax rules to address BEPS, and hence to protect tax bases while offering increased certainty
and predictability to taxpayers. A key focus of this work is to eliminate double non-taxation.
However in doing so, new rules should not result in double taxation, unwarranted compliance
burdens or restrictions to legitimate cross-border activity.
www.oecd.org/tax/beps.htm
OECD/G20 Base Erosion and Profit

Shifting Project
2015 Final Reports
Please cite this publication as:

OECD (2015), Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, OECD.
www.oecd.org/tax/beps-explanatory-statement-2015.pdf
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OECD 2015
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TABLE OF CONTENTS 3
Table of contents
Introduction ........................................................................................................................ 4
Achievements of the BEPS Project ................................................................................... 5
Post-BEPS Environment ................................................................................................... 9
A. Implementation starts now ................................................................................... 9
B. Monitoring implementation and impact ............................................................. 10
C. Designing an inclusive framework ..................................................................... 11
D. Next steps ........................................................................................................... 11
Annex A. Overview of BEPS Package ........................................................................... 13
Action 1
Action 2
Action 3
Action 4
Address the Tax Challenges of the Digital Economy ..................... 13

Neutralise the Effects of Hybrid Mismatch Arrangements ............ 13
Strengthen CFC Rules .................................................................... 13
Limit Base Erosion via Interest Deductions and Other
Financial Payments ......................................................................... 14
Action 5
Counter Harmful Tax Practices More Effectively,
Taking into Account Transparency and Substance......................... 14
Action 6
Prevent Treaty Abuse ..................................................................... 14
Action 7
Prevent the Artificial Avoidance of PE Status ............................... 15
Actions 8-10 Assure that Transfer Pricing Outcomes are in Line with
Value Creation ................................................................................ 15
Action 11
Measuring and Monitoring BEPS ................................................... 16
Action 12
Require Taxpayers to Disclose their Aggressive Tax
Planning Arrangements .................................................................. 16
Action 13
Re-examine Transfer Pricing Documentation ................................ 17
Action 14
Make Dispute Resolution Mechanisms More Effective ................. 17
Action 15
Develop a Multilateral Instrument .................................................. 18
Notes .................................................................................................................................. 19
EXPLANATORY STATEMENT OECD 2015
4 EXPLANATORY STATEMENT
Introduction
1.
International tax issues have never been as high on the political agenda as they are
today. The integration of national economies and markets has increased substantially in
recent years. This has put a strain on the international tax framework, which was designed
more than a century ago. The current rules have revealed weaknesses that create
opportunities for Base Erosion and Profit Shifting (BEPS), thus requiring a bold move by
policy makers to restore confidence in the system and ensure that profits are taxed where
economic activities take place and value is created. In September 2013, G20 Leaders
endorsed the ambitious and comprehensive Action Plan on BEPS. This package of 13
reports, delivered just 2 years later, includes new or reinforced international standards as
well as concrete measures to help countries tackle BEPS. It represents the results of a
major and unparalleled effort by OECD and G20 countries 1 working together on an equal
footing with the participation of an increasing number of developing countries.
2.
The stakes are high. Although measuring the scope of BEPS proves challenging,
the findings of the work performed since 2013 confirm the potential magnitude of the
issue, with estimates indicating that the global corporate income tax (CIT) revenue losses
could be between 4% to 10% of global CIT revenues, i.e. USD 100 to 240 billion
annually. The losses arise from a variety of causes, including aggressive tax planning by
some multinational enterprises (MNEs), the interaction of domestic tax rules, lack of
transparency and coordination between tax administrations, limited country enforcement
resources and harmful tax practices. The affiliates of MNEs in low tax countries report
almost twice the profit rate (relative to assets) of their global group, showing how BEPS
can cause economic distortions. Estimates of the impact of BEPS on developing
countries, as a percentage of tax revenues, are higher than in developed countries given
developing countries greater reliance on CIT revenues. In a globalised economy,
governments need to cooperate and refrain from harmful tax practices, to address tax
avoidance effectively, and provide a more certain international environment to attract and
sustain investment. Failure to achieve such cooperation would reduce the effectiveness of
CIT as a tool for resource mobilisation, which would have a disproportionately harmful
impact on developing countries.
3.
This BEPS package, which includes and consolidates the first seven reports
presented to and welcomed by the G20 Leaders at the Brisbane Summit in 2014, has been
developed and agreed in just two years. This is chiefly because there is an urgent need to
restore the trust of ordinary people in the fairness of their tax systems, to level the playing
field among businesses, and to provide governments with more efficient tools to ensure
the effectiveness of their sovereign tax policies. It was also imperative to move quickly to
try to limit the risks of countries taking uncoordinated unilateral measures which might
weaken key international tax principles which form a stable framework for cross-border
investments. BEPS can result in double non-taxation but addressing BEPS should not
result in double taxation. Double taxation would harm MNEs which have contributed to
boosting trade and investment around the world, supporting growth, creating jobs,
fostering innovation and providing pathways out of poverty. Double taxation would also
increase the cost of capital and could deter investment in the economies concerned.
4.
The level of interest and participation in the work has been unprecedented with
more than 60 countries 2 directly involved in the technical groups and many more
participating in shaping the outcomes through regional structured dialogues. Regional tax
EXPLANATORY STATEMENT 5
organisations such as the African Tax Administration Forum (ATAF), Centre de

rencontre des administrations fiscales (CREDAF) and the Centro Interamericano de
Administraciones Tributarias (CIAT) joined international organisations like the
International Monetary Fund (IMF), the World Bank (WB) and the United Nations (UN),
in contributing to the work. Stakeholder interest including invaluable interactions with
business and civil society saw more than 12 000 pages of comments received on the 23
discussion drafts published and discussed at 11 public consultations, as well as more than
40 000 views of the OECD webcasts on BEPS.
5.
The report Addressing Base Erosion and Profit Shifting (OECD, 2013) concluded
that no single tax rule on its own enables BEPS; it is rather the interplay among different
issues that makes it possible. Domestic laws and rules that are not co-ordinated across
borders, international tax standards that have not always kept pace with the changing
global business environment and a pervasive lack of relevant information at the level of
tax administrations and policy makers combine to provide opportunities for taxpayers to
undertake BEPS strategies. The availability of harmful tax practices was also identified as
a key pressure area.
6.
Out of a shared desire to address BEPS concerns, there is agreement on a
comprehensive package of measures which are designed to be implemented
domestically and through treaty provisions in a coordinated manner, supported by
targeted monitoring and strengthened transparency. The goal is to tackle BEPS structures
by comprehensively addressing their root causes rather than merely the symptoms.
7.
Once the measures are implemented, many schemes facilitating double nontaxation will be curtailed. The implementation of the BEPS package will better align the
location of taxable profits with the location of economic activities and value creation, and
improve the information available to tax authorities to apply their tax laws effectively. In
order to minimise the incidence of double taxation, improving dispute resolution as well
as establishing mechanisms to support and monitor the implementation of the measures
are also a key part of the BEPS reforms.
8.
The BEPS package represents the first substantial and overdue - renovation of
the international tax standards in almost a century. This renovation is necessary not only
to tackle BEPS, but also to ensure the sustainability of the current international
framework for the taxation of cross-border activities and the elimination of double
taxation. The G20 and the OECD have recognised that BEPS by its very nature requires
coordinated responses, which is why countries have invested the resources to participate
in the development of shared solutions. After summarising the achievements to date, this
Explanatory Statement outlines the way forward to ensure an efficient implementation of
the agreed measures and to follow up through an inclusive, targeted monitoring
mechanism.
Achievements of the BEPS Project

9.
For the first time all OECD and G20 countries have worked together on an equal
footing to design common responses to international tax challenges. Further, there has
been unprecedented participation by developing countries in the development of
commonly-agreed international tax standards. The fact that so many countries have
participated in the work and cooperated in the development of changes to the
international tax environment is in itself a significant achievement of the Project.
10.
Moreover, in addition to the work undertaken within the Project, parallel work
has been undertaken that targets the priority BEPS challenges identified by low-income
countries and spelled out in a two-part report to the G20 Development Working Group 3 in
2014. These include issues relating to the availability of transfer pricing comparables
including challenges in the commodities sector, transparent and effective tax incentives,
and indirect transfers of assets. The development of toolkits to help developing countries
address these issues will continue through 2016 and 2017, working with countries in
partnership with regional tax organisations and the IMF, World Bank, and UN.
11.
A comprehensive package of measures has been agreed upon. Countries are
committed to this comprehensive package and to its consistent implementation. These
measures range from new minimum standards to revision of existing standards, common
approaches which will facilitate the convergence of national practices and guidance
drawing on best practices. Minimum standards were agreed in particular to tackle
issues in cases where no action by some countries would have created negative spill
overs (including adverse impacts of competitiveness) on other countries. Recognising the
need to level the playing field, all OECD and G20 countries commit to consistent
implementation in the areas of preventing treaty shopping, Country-by-Country
Reporting, fighting harmful tax practices and improving dispute resolution. Existing
standards have been updated and will be implemented, noting however that not all BEPS
participants have endorsed the underlying standards on tax treaties or transfer pricing. In
other areas, such as recommendations on hybrid mismatch arrangements and best
practices on interest deductibility, countries have agreed a general tax policy direction. In
these areas, they are expected to converge over time through the implementation of the
agreed common approaches, thus enabling further consideration of whether such
measures should become minimum standards in the future. Guidance based on best
practices will also support countries intending to act in the areas of mandatory disclosure
initiatives or controlled foreign company (CFC) legislation. There is agreement for
countries to be subject to targeted monitoring, in particular for the implementation of the
minimum standards. Moreover, it is expected that countries beyond the OECD and G20
will join them to protect their own tax bases and level the playing field.
12.
Model provisions to prevent treaty abuse, including through treaty shopping,
have been developed and will be included in the multilateral instrument that countries
may use to implement the results of the work on tax treaty issues into bilateral tax
treaties. This will impede the use of conduit companies in countries with favourable tax
treaties to channel investments and obtain reduced rates of taxation. Some of these
provisions require additional technical work, which will be finalised in 2016.
13.
Standardised Country-by-Country Reporting and other documentation
requirements will give tax administrations a global picture of where MNE profits, tax and
economic activities are reported, and the ability to use this information to assess transfer
pricing and other BEPS risks, so they can focus audit resources where they will be most
effective. MNEs will report their revenues, pre-tax profits, income tax paid and accrued,
number of employees, stated capital, retained earnings, and tangible assets in each
jurisdiction where they operate. The implementation package provides guidance to ensure
that information is provided to the tax administration in a timely manner, that
confidentiality is preserved and that the information is used appropriately. It is
recommended that the first Country-by-Country Reports be required to be filed for
MNEs fiscal years starting from 1 January 2016. It is acknowledged that some
jurisdictions may need time to follow their particular domestic legislative process in order
to make necessary adjustments to the law. The filing requirement will be on MNEs with
annual consolidated group revenue equal to or exceeding EUR 750 million (or a near
equivalent in domestic currency). Anticipation of this reporting system has already begun
to discourage aggressive tax planning.
14.
A revitalised peer review process will address harmful tax practices,
including patent boxes where they include harmful features, as well as a
commitment to transparency through the mandatory spontaneous exchange of
relevant information on taxpayer-specific rulings which, in the absence of
information exchange, could give rise to BEPS concerns. Agreement on the nexus
approach for preferential intellectual property (IP) regimes requires alignment of the
benefits of these regimes with substantive research and development activity. The
renewal of efforts to address harmful tax practices will reduce the distortionary influence
of taxation on the location of profits from mobile financial and service activities, thereby
encouraging an environment in which fair tax competition can take place.
15.
With the strong political commitment to the effective and timely resolution of
disputes through the mutual agreement procedure (MAP), agreement on a minimum
standard to secure progress on dispute resolution has been reached. This will help
ensure that cross-border tax disputes between countries over the interpretation or
application of tax treaties are resolved in a more effective and timely manner. The Forum
on Tax Administration (FTA), including all OECD and G20 countries along with other
interested countries and jurisdictions on an equal footing, will continue its efforts to
improve MAP through its recently established MAP Forum. This will require the
development of an assessment methodology to ensure the new standard for timely
resolution of disputes is expeditiously met. In parallel, a large group of countries is
committing to move quickly towards mandatory and binding arbitration. It is expected
that rapid implementation of this commitment will be achieved through the inclusion of
arbitration as an optional provision in the multilateral instrument to be developed to
implement the BEPS treaty-related measures. An effective monitoring mechanism will
be established to focus on the improvement of dispute resolutions.
16.
The BEPS Project has also revisited the existing international tax standards to
eliminate double taxation, in order to stop abuses and close BEPS opportunities.
This translates into a set of agreed guidance which reflects the common understanding
and interpretation of provisions based on Article 9 of both the OECD and UN model tax
conventions. Changes to the Transfer Pricing Guidelines will ensure that the transfer
pricing of MNEs better aligns the taxation of profits with economic activity. Outcomes
will be determined in accordance with the actual conduct of related parties in the context
of the contractual terms of the transaction. These and other changes will reduce the
incentive for MNEs to shift income to cash boxes shell companies with few if any
employees and little or no economic activity, which seek to take advantage of low or notax jurisdictions. Specifically, the revised guidelines on transfer pricing address the
situation where a capital-rich member of a group, i.e. a cash box, simply provides assets
such as funding for use by an operating company but performs only limited activities. If
the capital-rich member does not in fact control the financial risks associated with its
funding, then it will be entitled to no more than a risk-free return, or less if, for example,
the transaction is not commercially rational and therefore the guidance on nonrecognition applies. The Transfer Pricing Guidelines are also being modernised in
relation to intangibles. Recognising the difficulty in valuing certain intangibles, an
approach to assure the appropriate pricing of hard-to-value intangibles has been devised
to give countries an additional tool to address the use of information asymmetry between
taxpayers and tax authorities to undervalue intra-group transfers of intangibles.
17.
Changes to the permanent establishment definition have been agreed to
address techniques used to inappropriately avoid the tax nexus, including via
commissionaire arrangements and the artificial fragmentation of business activities. As
indicated in the report on Action 7, follow-up work will be undertaken to provide
additional guidance on profit attribution to the permanent establishments (PEs) resulting
from the changes proposed in that report. Follow-up work will also be needed in 2016 to
incorporate the changes resulting from the report on Action 7 into the Model Tax
Convention through an update of the Model. This follow-up work will allow the
Committee, where necessary, to provide additional clarification on the new treaty
wording introduced by the report and to address any unintended consequences of the
changes resulting from that report, notably by examining an issue related to the global
trading of financial products.
18.
The BEPS package also includes a common approach which will facilitate the
convergence of national practices by interested countries to limiting base erosion
through interest expenses, for example via intra-group and third party loans that
generate excessive deductible interest payments, as well as on domestic legislation and
related treaty provisions where necessary to neutralise hybrid mismatches which
undermine their tax base or the tax base of their partners. Recommendations for the
design of domestic rules and model treaty provisions have been agreed together with
detailed commentary for their implementation. There is also guidance based on best
practices for countries which seek to strengthen their domestic legislation relating to
mandatory disclosure by taxpayers of aggressive or abusive transactions,
arrangements, or structures, and the building blocks of effective Controlled Foreign
Company (CFC) rules.
19.
The past decade has seen the rapid expansion of the digital economy, and today it
is increasingly the economy itself; therefore a ring-fenced solution to the tax challenges it
poses is not appropriate. BEPS risks are however exacerbated by the digital economy,
and the measures developed in the course of the BEPS Project are expected to
substantially address these risks. The key features of the digital economy have in fact
been taken into account across the BEPS Project, in particular the changes to the
permanent establishment definition, the update of the Transfer Pricing Guidelines and the
guidance on CFC rules. In the area of indirect taxes, guidelines have been developed and
implementation mechanisms identified to facilitate VAT collection based on the country
where the consumer is located, which is particularly relevant for online ordering and
delivery of goods and services. The work also considered several options to address the
broader tax challenges raised by the digital economy, including a new nexus in the form
of a significant economic presence. None of these options were recommended at this
stage. This is because, among other reasons, it is expected that the measures developed in
the BEPS Project will have a substantial impact on BEPS issues previously identified in
the digital economy, that certain BEPS measures will mitigate some aspects of the
broader tax challenges, and that consumption taxes will be levied effectively in the
market country. Countries could, however, introduce any of these options in their
domestic laws as additional safeguards against BEPS, provided they respect existing
treaty obligations, or in their bilateral tax treaties. OECD and G20 countries have agreed
to monitor developments and analyse data that will become available over time. On the
basis of the future monitoring work, a determination will also be made as to whether
further work on the options discussed and analysed should be carried out. This
determination should be based on a broad look at the ability of existing international tax
standards to deal with the tax challenges raised by developments in the digital economy.
20.
An innovative mechanism has been launched to update the global network of
more than 3 500 bilateral tax treaties: about 90 countries have joined an ad hoc group to
negotiate a multilateral instrument to implement the treaty-related BEPS measures
which will facilitate the modification of bilateral tax treaties in a synchronised and
efficient manner, without the need to invest resources to bilaterally renegotiate each
treaty. To be concluded by the end of 2016, the multilateral instrument will further
enhance coordination and improve international tax cooperation.
21.
With recent announcements indicating important changes to tax structuring by
some large MNEs, the impact on taxpayer behaviour can already be seen before
implementation is even fully underway. An Action-by-Action summary of the BEPS
package is found in the Annex to this Explanatory Statement.
Post-BEPS Environment
22.
With the adoption of the BEPS package, OECD and G20 countries, as well as all
developing countries that have participated in its development, will lay the foundations of
a modern international tax framework under which profits are taxed where economic
activity and value creation occurs. It is now time to focus on the upcoming challenges,
which include supporting the implementation of the recommended changes in a consistent
and coherent manner, monitoring the impact on double non-taxation and on double
taxation, and designing a more inclusive framework to support implementation and carry
out monitoring.
A. Implementation starts now

23.
Some of the revisions may be immediately applicable such as the revisions to the
Transfer Pricing Guidelines, while others require changes that can be implemented via tax
treaties, including through the multilateral instrument. Some require domestic law
changes, such as the outputs of the work on hybrid mismatches, CFC rules, interest
deductibility, Country-by-Country Reporting, and mandatory disclosure rules, as well as
to align, where necessary, domestic rules on preferential IP regimes with the harmful tax
practices criteria. Countries are sovereign. It is therefore up to them to implement these
changes, and measures may be implemented in different manners, as long as they do not
conflict with their international legal commitments. However, BEPS by its nature requires
coordinated responses, particularly in the area of domestic law measures; it is therefore
expected that they will implement their commitments, and that they will seek consistency
and convergence when deciding upon the implementation of the measures.
24.
Challenges have arisen in the course of the development of the measures: some
countries have enacted unilateral measures, some tax administrations have been more
aggressive, and increasing uncertainty has been denounced by some practitioners as a
result of both the changes in the world economy and the heightened awareness of BEPS.
As noted in the BEPS Action Plan:
the emergence of competing sets of international standards, and the replacement of the
current consensus based framework by unilateral measures, could lead to global tax chaos
marked by the massive re-emergence of double taxation.
25.
Governments recognise these challenges and that consistent implementation
and application are key: options developed to be adaptable to different tax systems
should not result in conflicts between domestic systems; interpretation of the new
standards should not result in increased disputes. Instead, to support an effective and
consistent implementation, OECD and G20 countries agree to continue to work
together in the BEPS Project framework. Initiatives to further ensure consistent and
coordinated implementation are already underway amongst OECD and G20
countries, and beyond. For example, the European Commission has recently published a
Communication on a Fair and Efficient Corporate Tax System in the European Union
which aims to set out how the BEPS measures can be implemented within the EU. The
participation of about 90 countries in the negotiation of the multilateral instrument is also
a strong signal that countries are committed to swift and consistent implementation in a
multilateral context.
26.
OECD and G20 countries will also keep working on an equal footing to
complete the areas which require further work in 2016 and 2017. These include
finalising transfer pricing guidance on the application of transactional profit split methods
and on financial transactions, discussing the rules for the attribution of profits to
permanent establishments in light of the changes to the permanent establishment
definition, and finalising the model provisions and detailed Commentary on the
Limitation on Benefit (LOB) rule with a continued examination of the issues relating to
the broader question of treaty entitlement of investment funds (other than collective
investment funds i.e. non-CIV funds). It will also mean finalising the details of a group
ratio carve-out and special rules for insurance and banking sectors in the area of interest
deductibility and developing a strategy to expand participation of non-OECD, non-G20
countries to the work on harmful tax practices, including the possible revision of the
relevant criteria.
27.
Beyond the finalisation of these actions, OECD and G20 countries will seek to
improve clarity and certainty in the application of the rules and will also consider work in
related areas which have emerged in the course of the work on BEPS.
B. Monitoring implementation and impact

28.
Recognising all the progress made, including in establishing a new OECD-G20
framework for more inclusive deliberations, it appears necessary to further deepen
cooperation and focus on monitoring the implementation and effectiveness of the
measures adopted in the context of the BEPS Project as well as the impact on both
compliance by taxpayers and proper implementation by tax administrations.
29.
OECD and G20 countries agree to keep working on an equal footing to
monitor the implementation of the BEPS measures. The monitoring will consist of an
assessment of compliance in particular with the minimum standards in the form of reports
on what countries have done to implement the BEPS recommendations. It will involve
some form of peer review which will have to be defined and adapted to the different
Actions, with a view to establishing a level playing field by ensuring all countries and
jurisdictions implement their commitments so that no country or jurisdiction would gain
unfair competitive advantages. In addition, a better understanding of how the BEPS
recommendations are implemented in practice could reduce misunderstandings and
disputes between governments. Greater focus on implementation and tax administration
should therefore be mutually beneficial to governments and business, with an important
role to play for the Forum on Tax Administration. Finally, proposed improvements to
data and analysis will help support ongoing evaluation of the quantitative impact of
BEPS, as well as evaluating the impact of the countermeasures developed under the
BEPS Project.
C. Designing an inclusive framework

30.
Globalisation requires that global solutions and a global dialogue be established
which go beyond OECD and G20 countries. The strong interest expressed by developing
countries through their participation in the BEPS Project should be sustained by the
establishment of an even more inclusive framework, which will continue to include
other international organisations and regional tax organisations. Drawing on the
successful experience of the Global Forum on Transparency and Exchange of Information
for Tax Purposes, in early 2016 OECD and G20 countries will work together to design
and propose a more inclusive framework to support and monitor the
implementation of the BEPS package, with countries and jurisdictions participating
on an equal footing. Such work will include consideration of the manner in which nonOECD non-G20 countries and jurisdictions can commit to the agreed standards and their
implementation. It will draw on the mandate from the G20 Finance Ministers and Central
Bank Governors as included in their Communiqu issued in Ankara on 5 September
2015:
The effectiveness of the project will be determined by its widespread and consistent
implementation. We will continue to work on an equal footing as we monitor the
implementation of the BEPS project outcomes at the global level, in particular, the
exchange of information on cross-border tax rulings. We call on the OECD to prepare a
framework by early 2016 with the involvement of interested non-G20 countries and
jurisdictions, particularly developing economies, on an equal footing
D. Next steps
31.
The OECD and G20 countries will extend their cooperation on BEPS until 2020
to complete pending work and ensure an efficient targeted monitoring of the agreed
measures. They will, in early 2016, conceive a framework for monitoring with a view to
better involve other interested countries and jurisdictions.
ANNEX A. OVERVIEW OF THE BEPS PACKAGE 13
Annex A
Overview of BEPS Package
Action 1 Address the Tax Challenges of the Digital Economy

The Action 1 report concludes that the digital economy cannot be ring-fenced as it is
increasingly the economy itself. The report analyses BEPS risks exacerbated in the digital
economy and shows the expected impact of the measures developed across the BEPS
Project. Rules and implementation mechanisms have been developed to help collect
value-added tax (VAT) based on the country where the consumer is located in the case of
cross-border business-to-consumers transactions. These measures are intended to level
the playing field between domestic and foreign suppliers and facilitate the efficient
collection of VAT due on these transactions. Technical options to deal with the broader
tax challenges raised by the digital economy such as nexus and data have been discussed
and analysed. As both the challenges and the potential options raise systemic issues
regarding the existing framework for the taxation of cross-border activities that go
beyond BEPS issues, OECD and G20 countries have agreed to monitor developments and
analyse data that will become available over time. On the basis of the future monitoring
work, a determination will also be made as to whether further work on the options
discussed and analysed should be carried out. This determination should be based on a
broad look at the ability of existing international tax standards to deal with the tax
challenges raised by developments in the digital economy.
Action 2 Neutralise the Effects of Hybrid Mismatch Arrangements

A common approach which will facilitate the convergence of national practices
through domestic and treaty rules to neutralise such arrangements. This will help to
prevent double non-taxation by eliminating the tax benefits of mismatches and to put an
end to costly multiple deductions for a single expense, deductions in one country without
corresponding taxation in another, and the generation of multiple foreign tax credits for
one amount of foreign tax paid. By neutralising the mismatch in tax outcomes, but not
otherwise interfering with the use of such instruments or entities, the rules will inhibit the
use of these arrangements as a tool for BEPS without adversely impacting cross-border
trade and investment.
Action 3 Strengthen CFC Rules

The report sets out recommendations in the form of building blocks of effective
Controlled Foreign Company (CFC) rules, while recognising that the policy objectives of
these rules vary among jurisdictions. The recommendations are not minimum standards,
but they are designed to ensure that jurisdictions that choose to implement them will have
rules that effectively prevent taxpayers from shifting income into foreign subsidiaries. It
identifies the challenges to existing CFC rules posed by mobile income such as that from
intellectual property, services and digital transactions, and allows jurisdictions to reflect
on appropriate policies in this regard. The work emphasises that CFC rules have a
continuing, important role in tackling BEPS, as a backstop to transfer pricing and other
rules.
Action 4 Limit Base Erosion via Interest Deductions and Other Financial
Payments
A common approach to facilitate the convergence of national rules in the area of
interest deductibility. The influence of tax rules on the location of debt within
multinational groups has been established in a number of academic studies and it is wellknown that groups can easily multiply the level of debt at the individual group entity level
via intra-group financing. At the same time, the ability to achieve excessive interest
deductions including those that finance the production of exempt or deferred income is
best addressed in a coordinated manner given the importance of addressing
competitiveness considerations and of ensuring that appropriate interest expense
limitations do not themselves lead to double taxation. The common approach aims at
ensuring that an entitys net interest deductions are directly linked to the taxable income
generated by its economic activities and fostering increased coordination of national rules
in this space.
Action 5 Counter Harmful Tax Practices More Effectively, Taking into

Account Transparency and Substance
Current concerns on harmful tax practices are primarily about preferential regimes
which can be used for artificial profit shifting and about a lack of transparency in
connection with certain rulings. The Action 5 report sets out a minimum standard based
on an agreed methodology to assess whether there is substantial activity in a preferential
regime. In the context of IP regimes such as patent boxes, consensus was reached on the
nexus approach. This approach uses expenditures in the country as a proxy for
substantial activity and ensures that taxpayers benefiting from these regimes did in fact
engage in research and development and incurred actual expenditures on such activities.
The same principle can also be applied to other preferential regimes so that such regimes
would be found to require substantial activities where they grant benefits to a taxpayer to
the extent that the taxpayer undertook the core income-generating activities required to
produce the type of income covered by the preferential regime. In the area of
transparency, a framework has been agreed for mandatory spontaneous exchange of
information on rulings that could give rise to BEPS concerns in the absence of such
exchange. The results of the application of the elaborated substantial activity and
transparency factors to a number of preferential regimes are included in the report.
Action 6 Prevent Treaty Abuse

The Action 6 report includes a minimum standard on preventing abuse including
through treaty shopping and new rules that provide safeguards to prevent treaty abuse and
offer a certain degree of flexibility regarding how to do so. The new treaty anti-abuse
rules included in the report first address treaty shopping, which involves strategies
through which a person who is not a resident of a State attempts to obtain the benefits of a
tax treaty concluded by that State. More targeted rules have been designed to address
other forms of treaty abuse. Other changes to the OECD Model Tax Convention have
been agreed to ensure that treaties do not inadvertently prevent the application of
domestic anti-abuse rules. A clarification that tax treaties are not intended to be used to
generate double non-taxation is provided through a reformulation of the title and
preamble of the Model Tax Convention. Finally, the report contains the policy
considerations to be taken into account when entering into tax treaties with certain low or
no-tax jurisdictions.
Action 7 Prevent the Artificial Avoidance of PE Status

Tax treaties generally provide that the business profits of a foreign enterprise are
taxable in a State only to the extent that the enterprise has in that State a permanent
establishment to which the profits are attributable. The definition of permanent
establishment included in tax treaties is therefore crucial in determining whether a nonresident enterprise must pay income tax in another State. The report includes changes to
the definition of permanent establishment in Article 5 of the OECD Model Tax
Convention, which is widely used as the basis for negotiating tax treaties. These changes
address techniques used to inappropriately avoid the tax nexus, including via replacement
of distributors with commissionaire arrangements or via the artificial fragmentation of
business activities.
Actions 8-10 Assure that Transfer Pricing Outcomes are in Line with
Value Creation
Transfer pricing rules, which are set out in Article 9 of tax treaties based on the
OECD and UN Model Tax Conventions and the Transfer Pricing Guidelines, are used to
determine on the basis of the arms length principle the conditions, including the price,
for transactions within an MNE group. The existing standards in this area have been
clarified and strengthened, including the guidance on the arms length principle and an
approach to ensure the appropriate pricing of hard-to-value-intangibles has been agreed
upon within the arms length principle. The work has focused on three key areas. Action
8 looked at transfer pricing issues relating to controlled transactions involving
intangibles, since intangibles are by definition mobile and they are often hard-to-value.
Misallocation of the profits generated by valuable intangibles has heavily contributed to
base erosion and profit shifting. Under Action 9, contractual allocations of risk are
respected only when they are supported by actual decision-making and thus exercising
control over these risks. Action 10 has focused on other high-risk areas, including the
scope for addressing profit allocations resulting from controlled transactions which are
not commercially rational, the scope for targeting the use of transfer pricing methods in a
way which results in diverting profits from the most economically important activities of
the MNE group, and the use of certain type of payments between members of the MNE
group (such as management fees and head office expenses) to erode the tax base in the
absence of alignment with the value-creation. The combined report contains revised
guidance which responds to these issues and ensures that transfer pricing rules secure
outcomes that better align operational profits with the economic activities which generate
them.
The report also contains guidance on transactions involving cross-border commodity
transactions as well as on low value-adding intra-group services. As those two areas were
identified as of critical importance by developing countries, the guidance will be
supplemented with further work mandated by the G20 Development Working Group,
which will provide knowledge, best practices, and tools for developing countries to price
commodity transactions for transfer pricing purposes and to prevent the erosion of their
tax bases through common types of base-eroding payments.
Action 11 Measuring and Monitoring BEPS

There are hundreds of empirical studies finding evidence of tax-motivated profit
shifting, using different data sources and estimation strategies. While measuring the scope
of BEPS is challenging given the complexity of BEPS and existing data limitations, a
number of recent studies suggest that global CIT revenue losses due to BEPS could be
significant. Action 11 assesses currently available data and methodologies and concludes
that significant limitations severely constrain economic analyses of the scale and
economic impact of BEPS and improved data and methodologies are required. Noting
these data limitations, a dashboard of six BEPS indicators has been constructed, using
different data sources and assessing different BEPS channels. These indicators provide
strong signals that BEPS exists and suggest it has been increasing over time. New OECD
empirical analyses estimate, while acknowledging the complexity of BEPS as well as
methodological and data limitations, that the scale of global corporate income tax revenue
losses could be between USD 100 to 240 billion annually. The research also finds
significant non-fiscal economic distortions arising from BEPS, and proposes
recommendations for taking better advantage of available tax data and improving
analyses to support the monitoring of BEPS in the future, including through analytical
tools to assist countries to evaluate the fiscal effects of BEPS and impact of BEPS
countermeasures for their countries. Going forward, enhancing the economic analysis and
monitoring of BEPS will require countries to improve the collection, compilation and
analysis of data.
Action 12 Require Taxpayers to Disclose their Aggressive Tax Planning

Arrangements
The lack of timely, comprehensive and relevant information on aggressive tax
planning strategies is one of the main challenges faced by tax authorities worldwide.
Early access to such information provides the opportunity to quickly respond to tax risks
through informed risk assessment, audits, or changes to legislation. The Action 12 report
provides a modular framework of guidance drawn from best practices for use by countries
without mandatory disclosure rules which seeks to design a regime that fits those
countries need to obtain early information on aggressive or abusive tax planning
schemes and their users. The recommendations in this report do not represent a minimum
standard and countries are free to choose whether or not to introduce mandatory
disclosure regimes. The framework is also intended as a reference for countries that
already have mandatory disclosure regimes, in order to enhance the effectiveness of those
regimes. The recommendations provide the necessary flexibility to balance a countrys
need for better and more timely information with the compliance burdens for taxpayers. It
also sets out specific best practice recommendations for rules targeting international tax
schemes, as well as for the development and implementation of more effective
information exchange and co-operation between tax administrations.
Action 13 Re-examine Transfer Pricing Documentation

Improved and better-coordinated transfer pricing documentation will increase the
quality of information provided to tax administrations and limit the compliance burden on
businesses. The Action 13 report contains a three-tiered standardised approach to transfer
pricing documentation, including a minimum standard on Country-by-Country Reporting.
This minimum standard reflects a commitment to implement the common template for
Country-by-Country Reporting in a consistent manner. First, the guidance on transfer
pricing documentation requires multinational enterprises (MNEs) to provide tax
administrations with high-level information regarding their global business operations
and transfer pricing policies in a master file that is to be available to all relevant tax
administrations. Second, it requires that detailed transactional transfer pricing
documentation be provided in a local file specific to each country, identifying material
related-party transactions, the amounts involved in those transactions, and the companys
analysis of the transfer pricing determinations they have made with regard to those
transactions. Third, large MNEs are required to file a Country-by-Country Report that
will provide annually and for each tax jurisdiction in which they do business the amount
of revenue, profit before income tax and income tax paid and accrued and other indicators
of economic activities. Country-by-country reports should be filed in the ultimate parent
entitys jurisdiction and shared automatically through government-to-government
exchange of information. In limited circumstances, secondary mechanisms, including
local filing can be used as a backup. An agreed implementation plan will ensure that
information is provided to the tax administration in a timely manner, that confidentiality
of the reported information is preserved and that the Country-by-Country Reports are
used appropriately.
Taken together, these three documentation tiers will require taxpayers to articulate
consistent transfer pricing positions, and will provide tax administrations with useful
information to assess transfer pricing risks, make determinations about where audit
resources can most effectively be deployed, and, in the event audits are called for, provide
information to commence and target audit enquiries. By ensuring a consistent approach to
transfer pricing documentation across countries, and by limiting the need for multiple
filings of Country-by-Country Reports through making use of information exchange
among tax administrations, MNEs will also see the benefits in terms of a more limited
compliance burden.
Action 14 Make Dispute Resolution Mechanisms More Effective

Countries recognize that the changes introduced by the BEPS Project may lead to
some uncertainty, and could, without action, increase double taxation and MAP disputes
in the short term. Recognising the importance of removing double taxation as an obstacle
to cross-border trade and investment, countries have committed to a minimum standard
with respect to the resolution of treaty-related disputes. In particular, this includes a
strong political commitment to the effective and timely resolution of disputes through the
mutual agreement procedure. The commitment also includes the establishment of an
effective monitoring mechanism to ensure the minimum standard is met and countries
make further progress to rapidly resolve disputes. In addition, a large group of countries
has committed to quickly adopt mandatory and binding arbitration in their bilateral tax
treaties.
Action 15 Develop a Multilateral Instrument

Drawing on the expertise of public international law and tax experts, the Action 15
report explores the technical feasibility of a multilateral instrument to implement the
BEPS treaty-related measures and amend bilateral tax treaties. It concludes that a
multilateral instrument is desirable and feasible, and that negotiations for such an
instrument should be convened quickly. Based on this analysis, a mandate has been
developed for an ad-hoc group, open to the participation of all countries, to develop the
multilateral instrument and open it for signature in 2016. So far, about 90 countries are
participating in the work on an equal footing.
NOTES 19
Notes
1.
References to OECD and G20 countries also include Colombia and Latvia.
2.
Albania, Argentina, Australia, Austria, Azerbaijan, Bangladesh, Belgium, Brazil,

Canada, Chile, Colombia, Costa Rica, Peoples Republic of China, Croatia, Czech
Republic, Denmark, Estonia, Finland, France, Georgia, Germany, Greece, Hungary,
Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kenya, Korea, Latvia,
Lithuania, Luxembourg, Malaysia, Mexico, Morocco, Netherlands, New Zealand,
Nigeria, Norway, Peru, Philippines, Poland, Portugal, Russian Federation, Saudi
Arabia, Senegal, Singapore, Slovak Republic, Slovenia, South Africa, Spain, Sweden,
Switzerland, Tunisia, Turkey, United Kingdom, United States and Vietnam.
3.
Available at www.oecd.org/tax/tax-global/report-to-g20-dwg-on-the-impact-of-bepsin-low-income-countries.pdf.
Addressing base erosion and profit shifting is a key priority of governments around the
globe. In 2013, OECD and G20 countries, working together on an equal footing, adopted a
15-point Action Plan to address BEPS.
Beyond securing revenues by realigning taxation with economic activities and value creation,
the OECD/G20 BEPS Project aims to create a single set of consensus-based international
tax rules to address BEPS, and hence to protect tax bases while offering increased certainty
and predictability to taxpayers. A key focus of this work is to eliminate double non-taxation.
However in doing so, new rules should not result in double taxation, unwarranted compliance
burdens or restrictions to legitimate cross-border activity.
OECD/G20 Base Erosion and Profit

Shifting Project
2015 Final Reports
OECD/G20 Base Erosion and Profit Shifting

Project
Addressing the Tax

Challenges of the Digital
Economy
ACTION 1: 2015 Final Report
Addressing the Tax

Challenges of the Digital
Economy, Action 1 2015
Final Report
This document and any map included herein are without prejudice to the status of or
sovereignty over any territory, to the delimitation of international frontiers and boundaries
and to the name of any territory, city or area.

OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report, OECD/G20
Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241046-en
ISBN 978-92-64-24102-2 (print)

ISBN 978-92-64-24104-6 (PDF)
Series: OECD/G20 Base Erosion and Profit Shifting Project

ISSN 2313-2604 (print)
ISSN 2313-2612 (online)
The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use
of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli
settlements in the West Bank under the terms of international law.
Photo credits: Cover ninog Fotolia.com
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OECD 2015
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FOREWORD 3
Foreword
recent years, putting a strain on the international tax rules, which were designed more than a
century ago. Weaknesses in the current rules create opportunities for base erosion and profit
shifting (BEPS), requiring bold moves by policy makers to restore confidence in the system
and ensure that profits are taxed where economic activities take place and value is created.
Following the release of the report Addressing Base Erosion and Profit Shifting in
February 2013, OECD and G20countries adopted a 15-point Action Plan to address
BEPS in September 2013. The Action Plan identified 15actions along three key pillars:
introducing coherence in the domestic rules that affect cross-border activities, reinforcing
substance requirements in the existing international standards, and improving transparency
as well as certainty.
Since then, all G20 and OECD countries have worked on an equal footing and the
European Commission also provided its views throughout the BEPS project. Developing
countries have been engaged extensively via a number of different mechanisms, including
direct participation in the Committee on Fiscal Affairs. In addition, regional tax organisations
such as the African Tax Administration Forum, the Centre de rencontre des administrations
fiscales and the Centro Interamericano de Administraciones Tributarias, joined international
organisations such as the International Monetary Fund, the World Bank and the United
Nations, in contributing to the work. Stakeholders have been consulted at length: in total,
the BEPS project received more than 1400submissions from industry, advisers, NGOs and
academics. Fourteen public consultations were held, streamed live on line, as were webcasts
where the OECD Secretariat periodically updated the public and answered questions.
After two years of work, the 15actions have now been completed. All the different
outputs, including those delivered in an interim form in 2014, have been consolidated into
a comprehensive package. The BEPS package of measures represents the first substantial
renovation of the international tax rules in almost a century. Once the new measures become
applicable, it is expected that profits will be reported where the economic activities that
generate them are carried out and where value is created. BEPS planning strategies that rely
on outdated rules or on poorly co-ordinated domestic measures will be rendered ineffective.
Implementation therefore becomes key at this stage. The BEPS package is designed
to be implemented via changes in domestic law and practices, and via treaty provisions,
with negotiations for a multilateral instrument under way and expected to be finalised in
2016. OECD and G20countries have also agreed to continue to work together to ensure a
consistent and co-ordinated implementation of the BEPS recommendations. Globalisation
requires that global solutions and a global dialogue be established which go beyond
OECD and G20countries. To further this objective, in 2016 OECD and G20countries will
conceive an inclusive framework for monitoring, with all interested countries participating
on an equal footing.
ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY OECD 2015
4 FOREWORD
A better understanding of how the BEPS recommendations are implemented in
practice could reduce misunderstandings and disputes between governments. Greater
focus on implementation and tax administration should therefore be mutually beneficial to
governments and business. Proposed improvements to data and analysis will help support
ongoing evaluation of the quantitative impact of BEPS, as well as evaluating the impact of
the countermeasures developed under the BEPS Project.
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms 9

Executive summary11
Chapter1. I ntroduction to tax challenges of the digital economy 15
Bibliography 18
Chapter2. Fundamental principles of taxation 19
2.1. Overarching principles of tax policy 20
2.2. Taxes on income and consumption 21
2.3. Corporate income tax 22
2.4. Value added taxes and other indirect consumption taxes 28
Bibliography 33
Chapter3. Information and communication technology and its impact on the economy 35
3.1. The evolution of information and communication technology 36
3.2. Emerging and potential future developments 42
3.3. The interactions between various layers of information and communication technology
(ICT): a conceptual overview 46
Bibliography 49
Chapter4. T
he digital economy, new business models and key features 51
4.1. The spread of ICT across business sectors: the digital economy 52
4.2. The digital economy and the emergence of new business models 54
4.3. Key features of the digital economy 64
Bibliography 74
Chapter5. I dentifying opportunities for BEPS in the digital economy 77
5.1. Common features of tax planning structures raising BEPS concerns 78
5.2. BEPS in the context of direct taxation 78
5.3. Opportunities for BEPS with respect to VAT 82
Bibliography 84
Chapter6. T
ackling BEPS in the digital economy 85
6.1. Introduction 86
6.2. Restoring taxation on stateless income 86
6.3. Addressing BEPS issues in the area of consumption taxes 93
6 TABLE OF CONTENTS
6.4. Preliminary conclusions 94
Bibliography 95
Chapter7. B
roader direct tax challenges raised by the digital economy
and the options to address them 97
7.1. The digital economy and the challenges for policy makers 98
7.2. An overview of the tax challenges raised by the digital economy 98
7.3. Nexus and the ability to have a significant presence without being liable to tax 100
7.4. Data and the attribution of value created from the generation of marketable locationrelevant data through the use of digital products and services 102
7.5. Characterisation of income derived from new business models 104
7.6. Developing options to address the broader direct tax challenges of the digital economy 106
Bibliography117
Chapter8. B
roader indirect tax challenges raised by the digital economy and the options
toaddress them 119
8.1. Collection of VAT in the digital economy 120
8.2. Addressing the broader indirect tax challenges of the digital economy 122
Bibliography 129
Chapter9. E
valuation of the broader direct and indirect tax challenges raised by the digital
economy and of the options toaddress them131
9.1. Broader tax challenges and options to address them 132
9.2. Economic incidence of the options to address the broader direct tax challenges 133
9.3. Framework to evaluate the options 134
9.4. Impact of BEPS countermeasures135
9.5. Evaluation 136
9.6. Next steps 138
Bibliography139
Chapter 10. Summary of the conclusions and next steps 141
10.1. The digital economy, its business models, and its key features 142
10.2. BEPS issues in the digital economy and how to address them 144
10.3. Broader tax policy challenges raised by the digital economy 146
10.4. Next steps 149
Bibliography149
AnnexA. Prior work on the digital economy151
A.1. 1996-98: Work leading to the Ottawa Ministerial Conference on Electronic Commerce152
A.2. 1998: The Ottawa Ministerial Conference on Electronic Commerce153
A.3. Post-Ottawa: CFA work and technical advisory groups153
Bibliography165
AnnexB. Typical tax planning structures in integrated business models167
B.1. Online retailer168
B.2. Internet advertising 171
TABLE OF CONTENTS 7
B.3. Cloud computing 175

B.4. Internet app store177
Annex C. The collection of VAT/GST on imports of low value goods 181
C.1. Introduction 182
C.2. Main features of the supply chain for the sale, clearance and delivery of low value goods183
C.3. Key features and assessment of the options for collecting VAT/GST on imports of low
value goods 193
C.4. Supporting enforcement through enhanced mutual administrative cooperation 205
C.5. Summary assessment of the collection models 205
C.6. Overall conclusion 208
AppendixC.A. Test cards for the analysis of the VAT/GST collection models 209
AppendixC.B. Low value import relief Exemption thresholds 217
Bibliography219
AnnexD. OECD international VAT/GST guidelines. Chapter3. Determining the place of
taxation for cross-border supplies of services and intangibles 221
A. The destination principle 222
B. Business-to-business supplies The general rule 224
C. Business-to-consumer supplies The general rules241
D. Business-to-business and business-to-consumer supplies Specific rules 252
Annex1 259
Annex2 268
AnnexE. Economic incidence of the options to address the broader direct tax challenges
ofthedigitaleconomy 275
E.1. Proposals to be analysed 276
E.2. Description of taxes 276
E.3. What is tax incidence analysis? 277
E.4. Tax incidence analysis 277
E.5. Conclusion 283
Figures
Figure3.1
Figure3.2
Figure3.3
Figure3.4
Figure3.5
Figure3.6
Figure4.1
Figure4.2
Figure4.3
Figure4.4
Figure4.5
Figure4.6
Figure4.7
Figure4.8
Figure4.9
Percentage of fibre connections in total fixed broadband subscriptions, June 2014 37

Total fixed, mobile and broadband access paths subscriptions (millions) 38
Personal data 40
Main enablers of the Internet of Things 42
How bitcoins enter circulation and are used in transactions 43
A layered view of ICT 47
Broadband connectivity, by size, 2010 and 2014. 52
Turnover from e-commerce, by size, 2008 and 2012 56
Use of cloud computing by enterprises, 2014 61
Enterprises using cloud computing services by type of services, 2014 61
Customer involvement in product development, 2013 63
Enterprises engaging with customers in product development, 2013 63
Exporters of ICT services, 2013 66
Average annual revenue per employee of the top 250 ICT firms by sector, 2000-11 67
Estimated worldwide data storage 69
8 TABLE OF CONTENTS
Figure4.10 Average data storage cost for consumers 1998-2012 69
Figure4.11 Data mining-related scientific articles, 1995-2014 70
Figure5.1 BEPS planning in the context of income tax 79
FigureB.1 Online retailer169
FigureB.2 Internet advertising173
FigureB.3 Cloud computing176
FigureB.4 Internet app store179
FigureC.1 The role of the express carriers189
FigureC.2 Traditional Collection Model 195
FigureC.3 Purchaser Collection Model 197
FigureC.4 Vendor Collection Model 198
FigureC.5 Intermediary Collection Model 202
Tables
Table8.1 Main features of a simplified registration and compliance regime for
non-resident suppliers 127
TableC.1 Customs and VAT/GST clearance procedures (for goods not submitted to other specific
duties suchas excise) 192
TableC.2 Minimum information available to each stakeholder in the supply chain 193
TableE.1 Description of taxes included in the incidence analysis 277
Boxes
Box1.1
Box2.1
Box4.1
Box7.1
BoxA.1
BoxA.2
BoxA.3
BoxA.4
BoxA.5
BoxC.1
Box3.1
Ottawa Taxation Framework Conditions Principles17

Controlled foreign company (CFC) rules 23
Diversity of revenue models 64
Administrative challenges in the digital economy 105
Ottawa taxation framework conditions Principles152
Commentary on Article5 of the OECD Model Tax Convention 157
Commentary on Article12 Payment for the use of, or the right to use, a copyright159
Change to the Commentary on Article12 Payments for know-how 160
Commentary on Article12 Mixed payments162
The customs procedures on importation of low value goods185
Business Agreement 225
A bbreviations and acronyms 9
Abbreviations and acronyms

ANBPPI
Association des Bureaux pour la Protection de la Proprit Industrielle
API
Application programming interface
ASP
Application service provider
BEPS
Base erosion and profit shifting
BIAC
Business and Industry Advisory Committee to the OECD
BP
Business profit
B2B Business-to-business
B2C Business-to-consumer
CFA
Committee on Fiscal Affairs
CDS
Customs Declaration System
CFC
Controlled foreign company
CIT
Corporate income tax
CPA Cost-per-action
CPC Cost-per-click
CPM Cost-per-mille
C2C Consumer-to-consumer
DDME
Data-Driven Marketing Economy
EC
European Community
GRT
gross receipts tax
HTML
Hypertext Markup Language
HTTP
Hypertext Transfer Protocol
IaaS
Infrastructure as a service
ICT
Information and communication technology
IMAP
Internet Message Access Protocol
IP
Internet Protocol
ISP
Internet service provider
MLE
Multi-location enterprise
MNE
Multinational enterprise
10 Abbreviations and acronyms

NIST
National Institute of Standards and Technology
OECD
Organisation for Economic Co-operation and Development
OTT Over-the-top
PE
Permanent establishment
POP
Post Office Protocol
RFID
Radio Frequency Identification
RKC
Revised Kyoto Convention
SDK
Software development kits
SME
Small and medium enterprise
SMTP
Simple Mail Transfer Protocol
TAG
Technical Advisory Group
TFDE
Task Force on the Digital Economy
UCC
User created content
UCR
Unique Consignment Reference Number
UPU
Universal Postal Union
VAT
Value added tax
VAT/GST
Value added tax/Goods and services tax
VLAN
Virtual local area network
WCO
World Customs Organizations
WP
Working Party
WT
withholding tax
WTO
World Trade Organisation
XaaS
X-as-a Service
XML
Extensible Markup Language
Executive summary 11
Executive summary
Action1 of the base erosion and profit shifting (BEPS) Action Plan deals with the tax
challenges of the Digital Economy.
Political leaders, media outlets, and civil society around the world have expressed
growing concern about tax planning by multinational enterprises (MNEs) that makes use
of gaps in the interaction of different tax systems to artificially reduce taxable income or
shift profits to low-tax jurisdictions in which little or no economic activity is performed.
In response to this concern, and at the request of the G20, the Organisation for Economic
Co-operation and Development (OECD) published an Action Plan on Base Erosion and
Profit Shifting (BEPS Action Plan, OECD, 2013) in July 2013. Action1 of the BEPS Action
Plan calls for work to address the tax challenges of the digital economy.
The Task Force on the Digital Economy (TFDE), a subsidiary body of the Committee
on Fiscal Affairs (CFA) in which non-OECD G20 countries participate as Associates on
an equal footing with OECD countries, was established in September 2013 to develop a
report identifying issues raised by the digital economy and detailed options to address
them by September 2014. The TFDE consulted extensively with stakeholders and analysed
written input submitted by business, civil society, academics, and developing countries. It
issued an interim report in September 2014 and continued its work in 2015. The conclusions
regarding the digital economy, the BEPS issues and the broader tax challenges it raises, and
the recommended next steps are contained in this final report.
The digital economy is the result of a transformative process brought by information
and communication technology (ICT), which has made technologies cheaper, more
powerful, and widely standardised, improving business processes and bolstering innovation
across all sectors of the economy.
Because the digital economy is increasingly becoming the economy itself, it would
be difficult, if not impossible, to ring-fence the digital economy from the rest of the
economy for tax purposes. The digital economy and its business models present
however some key features which are potentially relevant from a tax perspective.
These features include mobility, reliance on data, network effects, the spread of multisided business models, a tendency toward monopoly or oligopoly and volatility. The types
of business models include several varieties of e-commerce, app stores, online advertising,
cloud computing, participative networked platforms, high speed trading, and online
payment services. The digital economy has also accelerated and changed the spread of
global value chains in which MNEs integrate their worldwide operations.
BEPS issues in the digital economy

While the digital economy and its business models do not generate unique BEPS
issues, some of its key features exacerbate BEPS risks. These BEPS risks were
identified and the work on the relevant actions of the BEPS Project was informed by these
12 Executive summary
findings and took these issues into account to ensure that the proposed solutions fully
address BEPS in the digital economy. Accordingly,
It was agreed to modify the list of exceptions to the definition of PE to ensure that
each of the exceptions included therein is restricted to activities that are otherwise
of a preparatory or auxiliary character, and to introduce a new anti-fragmentation
rule to ensure that it is not possible to benefit from these exceptions through the
fragmentation of business activities among closely related enterprises. For example,
the maintenance of a very large local warehouse in which a significant number
of employees work for purposes of storing and delivering goods sold online to
customers by an online seller of physical products (whose business model relies
on the proximity to customers and the need for quick delivery to clients) would
constitute a permanent establishment for that seller under the new standard.
It was also agreed to modify the definition of PE to address circumstances in which
artificial arrangements relating to the sales of goods or services of one company
in a multinational group effectively result in the conclusion of contracts, such that
the sales should be treated as if they had been made by that company. For example,
where the sales force of a local subsidiary of an online seller of tangible products or
an online provider of advertising services habitually plays the principal role in the
conclusion of contracts with prospective large clients for those products or services,
and these contracts are routinely concluded without material modification by the
parent company, this activity would result in a permanent establishment for the
parent company.
The revised transfer pricing guidance makes it clear that legal ownership alone
does not necessarily generate a right to all (or indeed any) of the return that is
generated by the exploitation of the intangible, but that the group companies
performing the important functions, contributing the important assets and
controlling economically significant risks, as determined through the accurate
delineation of the actual transaction, will be entitled to an appropriate return.
Specific guidance will also ensure that the transfer pricing analysis is not weakened
by information asymmetries between the tax administration and the taxpayer in
relation to hard-to-value intangibles, or by using special contractual relationships,
such as a cost contribution arrangement.
The recommendations on the design of effective CFC include definitions of CFC
income that would subject income that is typically earned in the digital economy to
taxation in the jurisdiction of the ultimate parent company.
It is expected that the implementation of these measures, as well as the other measures
developed in the BEPS Project (e.g.minimum standard to address treaty shopping
arrangements, best practices in the design of domestic rules on interest and other deductible
financial payments, application to IP regimes of a substantial activity requirement with a
nexus approach), will substantially address the BEPS issues exacerbated by the digital
economy at the level of both the market jurisdiction and the jurisdiction of the ultimate
parent company, with the aim of putting an end to the phenomenon of so-called stateless
income.
Broader tax challenges raised by the digital economy

The digital economy also raises broader tax challenges for policy makers. These
challenges relate in particular to nexus, data, and characterisation for direct tax purposes,
which often overlap with each other. The digital economy also creates challenges for value
added tax (VAT) collection, particularly where goods, services and intangibles are acquired
by private consumers from suppliers abroad. The TFDE discussed and analysed a number
of potential options to address these challenges, including through an analysis of their
economic incidence, and concluded that:
The option to modify the exceptions to PE status in order to ensure that they are
available only for activities that are in fact preparatory or auxiliary in nature that
was adopted as a result of the work on Action7 of the BEPS Project is expected
to be implemented across the existing tax treaty network in a synchronised and
efficient manner via the conclusion of the multilateral instrument that modifies
bilateral tax treaties under Action15.
The collection of VAT/GST on cross-border transactions, particularly those between
businesses and consumers, is an important issue. Countries are thus recommended
to apply the principles of the International VAT/GST Guidelines and consider the
introduction of the collection mechanisms included therein.
None of the other options analysed by the TFDE, namely (i)a new nexus in the
form of a significant economic presence, (ii)a withholding tax on certain types of
digital transactions, and (iii)an equalisation levy, were recommended at this stage.
This is because, among other reasons, it is expected that the measures developed
in the BEPS Project will have a substantial impact on BEPS issues previously
identified in the digital economy, that certain BEPS measures will mitigate some
aspects of the broader tax challenges, and that consumption taxes will be levied
effectively in the market country.
Countries could, however, introduce any of these three options in their domestic
laws as additional safeguards against BEPS, provided they respect existing treaty
obligations, or in their bilateral tax treaties. Adoption as domestic law measures
would require further calibration of the options in order to provide additional
clarity about the details, as well as some adaptation to ensure consistency with
existing international legal commitments.
Next steps
Given that these conclusions may evolve as the digital economy continues to develop,
it is important to continue working on these issues and to monitor developments over time.
To these aims, the work will continue following the completion of the other follow-up work
on the BEPS Project. This future work will be done in consultation with a broad range of
stakeholders, and on the basis of a detailed mandate to be developed during 2016 in the context
of designing an inclusive post-BEPS monitoring process. A report reflecting the outcome of
the continued work in relation to the digital economy should be produced by 2020.
1. Introduction to tax challenges of the digital economy 15
Chapter1
Introduction to tax challenges of the digital economy
This chapter discusses the background leading to the adoption of the BEPS Action
Plan, including the work to address the tax challenges of the digital economy. It
then summarises the work of the Task Force on the Digital Economy leading to the
production of the report. Finally, it provides an overview of the contents of the report.
16 1. Introduction to tax challenges of the digital economy

1.
Political leaders, media outlets, and civil society around the world have expressed
growing concern about tax planning by multinational enterprises (MNEs) that makes use of
gaps in the interaction of different tax systems to artificially reduce taxable income or shift
profits to low-tax jurisdictions in which little or no economic activity is performed. In response
to this concern, and at the request of the G20, the Organisation for Economic Co-operation and
Development (OECD) published an Action Plan on Base Erosion and Profit Shifting (BEPS
Action Plan, OECD, 2013) in July 2013. The BEPS Action Plan identifies 15 actions to address
BEPS in a comprehensive manner, and sets deadlines to implement those actions.
2.
As noted in the BEPS Action Plan, the spread of the digital economy also poses
challenges for international taxation. The digital economy is characterised by an unparalleled
reliance on intangibles, the massive use of data (notably personal data), the widespread
adoption of multi-sided business models capturing value from externalities generated by
free products, and the difficulty of determining the jurisdiction in which value creation
occurs. This raises fundamental questions as to how enterprises in the digital economy add
value and make their profits, and how the digital economy relates to the concepts of source
and residence or the characterisation of income for tax purposes. At the same time, the fact
that new ways of doing business may result in a relocation of core business functions and,
consequently, a different distribution of taxing rights which may lead to low taxation is not
per se an indicator of defects in the existing system. It is important to examine closely how
enterprises of the digital economy add value and make their profits in order to determine
whether and to what extent it may be necessary to adapt the current rules in order to take into
account the specific features of that industry and to prevent BEPS.
3.
Against this background, the BEPS Action Plan includes the following description
of the work to be undertaken in relation to the digital economy:
Action1 Address the tax challenges of the digital economy

Identify the main difficulties that the digital economy poses for the application
of existing international tax rules and develop detailed options to address these
difficulties, taking a holistic approach and considering both direct and indirect
taxation. Issues to be examined include, but are not limited to, the ability of a
company to have a significant digital presence in the economy of another country
without being liable to taxation due to the lack of nexus under current international
rules, the attribution of value created from the generation of marketable location
relevant data through the use of digital products and services, the characterisation
of income derived from new business models, the application of related source
rules, and how to ensure the effective collection of VAT/GST with respect to the
cross-border supply of digital goods and services. Such work will require a
thorough analysis of the various business models in this sector.
4.
At their meeting in St. Petersburg on 5-6September 2013, the G20 Leaders fully
endorsed the BEPS Action Plan, and issued a declaration that included the following paragraph
related to BEPS:
In a context of severe fiscal consolidation and social hardship, in many countries
ensuring that all taxpayers pay their fair share of taxes is more than ever a priority.
Tax avoidance, harmful practices and aggressive tax planning have to be tackled.
The growth of the digital economy also poses challenges for international taxation.
We fully endorse the ambitious and comprehensive Action Plan originated in the
OECD aimed at addressing base erosion and profit shifting with mechanism to
1. Introduction to tax challenges of the digital economy 17
enrich the Plan as appropriate. We welcome the establishment of the G20/OECD

BEPS project and we encourage all interested countries to participate. Profits
should be taxed where economic activities deriving the profits are performed and
where value is created [] (G20, 2013).
5.
The Task Force on the Digital Economy (TFDE), a subsidiary body of the Committee
on Fiscal Affairs (CFA) was established in September 2013 to carry out the work, with the
aim of developing a report identifying issues raised by the digital economy and possible
actions to address them by September 2014.
6.
The TFDE discussed the scope of the work and heard presentations from experts on
the digital economy. The Task Force also discussed the relevance of the work done in the
past on this topic. In particular, the Task Force discussed the outcomes of the 1998 Ottawa
Ministerial Conference on Electronic Commerce where Ministers welcomed the 1998 CFA
Report Electronic Commerce: Taxation Framework Conditions (OECD, 2001) setting out
the following taxation principles that should apply to electronic commerce.
Box1.1. Ottawa Taxation Framework Conditions Principles

Neutrality: Taxation should seek to be neutral and equitable between forms of electronic
commerce and between conventional and electronic forms of commerce. Business decisions
should be motivated by economic rather than tax considerations. Taxpayers in similar situations
carrying out similar transactions should be subject to similar levels of taxation.
Efficiency: Compliance costs for taxpayers and administrative costs for the tax authorities
should be minimised as far as possible.
Certainty and Simplicity: The tax rules should be clear and simple to understand so that
taxpayers can anticipate the tax consequences in advance of a transaction, including knowing
when, where and how the tax is to be accounted.
Effectiveness and Fairness: Taxation should produce the right amount of tax at the right time.
The potential for tax evasion and avoidance should be minimised while keeping counteracting
measures proportionate to the risks involved.
Flexibility: The systems for taxation should be flexible and dynamic to ensure that they
keep pace with technological and commercial developments.
7.
These principles are still relevant today and, supplemented as necessary, can
constitute the basis to evaluate options to address the tax challenges of the digital economy.
In addition, the Task Force discussed the post-Ottawa body of work and in particular
the work of the Technical Advisory Group on Business Profits (TAG BP) relating to the
attribution of profits to permanent establishments (PEs), the place of effective management
concept and treaty rules in the context of e-commerce. For an overview of this prior work,
please refer to AnnexA.
8.
Considering the importance of stakeholders input, the OECD issued a public
request for input on 22November 2013. Input received was discussed at the second
meeting of the TFDE on 2-3February 2014. The Task Force discussed the evolution and
pervasiveness of the digital economy as well as the key features of the digital economy and
tax challenges raised by them. The Task Force heard presentations from delegates outlining
possible options to address the BEPS and tax challenges of the digital economy and agreed
18 1. Introduction to tax challenges of the digital economy

on the importance of publishing a discussion draft for public comments and input. The
input received was discussed by the Task Force and contributed to the finalisation of an
interim report, which was published in September 2014. In accordance with the interim
report, the Task Force continued its work until September 2015 in order to (i)ensure that
work carried out in other areas of the BEPS Project tackles BEPS issues in the digital
economy, and that it can assess the outcomes of that work; and (ii)continue the work on
the broader tax challenges related to nexus, data, and characterisation, so as to refine the
technical details of the potential options and enable their evaluation in light of the outcomes
of the BEPS project.
9.
This final report first provides an overview of the fundamental principles of
taxation, focusing on the difference between direct and indirect taxes and the concepts
that underlie them as well as double tax treaties (Chapter2). It then examines the evolution
over time of information and communication technology (ICT), including emerging and
possible future developments (Chapter3) and discusses the spread and impact of ICT
across the economy, providing examples of new business models and identifying the key
features of the digital economy (Chapter4). It then provides a detailed description of the
core elements of BEPS strategies in the digital economy (Chapter5) and discusses how
they will be addressed by the measures developed through the work on the BEPS Action
Plan and the OECD work on indirect taxation (Chapter6). It identifies also the broader
tax challenges raised by the digital economy and summarises the potential options to
address them that have been discussed and analysed by the Task Force, both in the areas
of corporate income tax (Chapter7) and of indirect tax (Chapter8). Finally, it provides an
evaluation of the broader direct and indirect tax challenges raised by the digital economy
and of the options to address them (Chapter9), taking into consideration not only the
impact on BEPS issues of the measures developed in the course of the BEPS Project, but
also the economic incidence of the different options to tackle these broader tax challenges.
The conclusions of the Task Force, together with determination of the next steps, are
included at the end of the report (Chapter10).
Bibliography
G20 (2013), Leaders Declaration, St. Petersburg, Russia, https://www.g20.org/sites/default/
files/g20_resources/library/Saint_Petersburg_Declaration_ENG_0.pdf (accessed on
09July 2014).
OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264202719-en.
2. Fundamental principles of taxation 19
Chapter2
Fundamental principles of taxation
This chapter discusses the overarching principles of tax policy that have traditionally
guided the development of tax systems. It then provides an overview of the principles
underlying corporate income tax, focusing primarily on the taxation of cross-border
income both under domestic laws and in the context of tax treaties. Finally, it
provides an overview of the design features of value-added tax (VAT) systems.
20 2. Fundamental principles of taxation
2.1. Overarching principles of tax policy

10. In a context where many governments have to cope with less revenue, increasing
expenditures and resulting fiscal constraints, raising revenue remains the most important
function of taxes, which serve as the primary means for financing public goods such
as maintenance of law and order and public infrastructure. Assuming a certain level of
revenue that needs to be raised, which depends on the broader economic and fiscal policies
of the country concerned, there are a number of broad tax policy considerations that
have traditionally guided the development of taxation systems. These include neutrality,
efficiency, certainty and simplicity, effectiveness and fairness, as well as flexibility. In
the context of work leading up to the report on the Taxation of Electronic Commerce (see
AnnexA for further detail), these overarching principles were the basis for the 1998 Ottawa
Ministerial Conference, and are since then referred to as the Ottawa Taxation Framework
Conditions (OECD, 2001). At the time, these principles were deemed appropriate for
an evaluation of the taxation issues related to e-commerce. Although most of the new
business models identified in Chapter4 did not exist yet at the time, these principles, with
modification, continue to be relevant in the digital economy, as discussed in Chapter8. In
addition to these well-recognised principles, equity is an important consideration for the
design of tax policy.
Neutrality: Taxation should seek to be neutral and equitable between forms of
business activities. A neutral tax will contribute to efficiency by ensuring that
optimal allocation of the means of production is achieved. A distortion, and the
corresponding deadweight loss, will occur when changes in price trigger different
changes in supply and demand than would occur in the absence of tax. In this
sense, neutrality also entails that the tax system raises revenue while minimising
discrimination in favour of, or against, any particular economic choice. This implies
that the same principles of taxation should apply to all forms of business, while
addressing specific features that may otherwise undermine an equal and neutral
application of those principles.
Efficiency: Compliance costs to business and administration costs for governments
Certainty and simplicity: Tax rules should be clear and simple to understand,
so that taxpayers know where they stand. A simple tax system makes it easier
for individuals and businesses to understand their obligations and entitlements.
As a result, businesses are more likely to make optimal decisions and respond to
intended policy choices. Complexity also favours aggressive tax planning, which
may trigger deadweight losses for the economy.
Effectiveness and fairness: Taxation should produce the right amount of tax at
the right time, while avoiding both double taxation and unintentional non-taxation.
In addition, the potential for evasion and avoidance should be minimised. Prior
discussions in the Technical Advisory Groups (TAGs) considered that if there is a
class of taxpayers that are technically subject to a tax, but are never required to pay
the tax due to inability to enforce it, then the taxpaying public may view the tax
as unfair and ineffective. As a result, the practical enforceability of tax rules is an
important consideration for policy makers. In addition, because it influences the
collectability and the administrability of taxes, enforceability is crucial to ensure
efficiency of the tax system.
Flexibility: Taxation systems should be flexible and dynamic enough to ensure

they keep pace with technological and commercial developments. It is important
that a tax system is dynamic and flexible enough to meet the current revenue
needs of governments while adapting to changing needs on an ongoing basis. This
means that the structural features of the system should be durable in a changing
policy context, yet flexible and dynamic enough to allow governments to respond
as required to keep pace with technological and commercial developments, taking
into account that future developments will often be difficult to predict.
11. Equity is also an important consideration within a tax policy framework. Equity
has two main elements; horizontal equity and vertical equity. Horizontal equity suggests
that taxpayers in similar circumstances should bear a similar tax burden. Vertical equity
is a normative concept, whose definition can differ from one user to another. According
to some, it suggests that taxpayers in better circumstances should bear a larger part of the
tax burden as a proportion of their income. In practice, the interpretation of vertical equity
depends on the extent to which countries want to diminish income variation and whether
it should be applied to income earned in a specific period or to lifetime income. Equity is
traditionally delivered through the design of the personal tax and transfer systems.
12. Equity may also refer to inter-nation equity. As a theory, inter-nation equity is
concerned with the allocation of national gain and loss in the international context and
aims to ensure that each country receives an equitable share of tax revenues from crossborder transactions (OECD, 2001). The tax policy principle of inter-nation equity has been
an important consideration in the debate on the division of taxing rights between source
and residence countries. At the time of the Ottawa work on the taxation of electronic
commerce, this important concern was recognised by stating that any adaptation of
the existing international taxation principles should be structured to maintain fiscal
sovereignty of countries, [] to achieve a fair sharing of the tax base from electronic
commerce between countries (OECD, 2001: 228).
13. Tax policy choices often reflect decisions by policy makers on the relative importance
of each of these principles and will also reflect wider economic and social policy considerations
outside the field of tax.
2.2. Taxes on income and consumption

14. Most countries impose taxes on both income and consumption.While income
taxes are levied on net income (i.e.from labour and capital) over an annual tax period,
consumption taxes operate as a levy on expenditure relating to the consumption of goods
and services, imposed at the time of the transaction.
15. There are a variety of forms of income and consumption taxes.Income tax is
generally due on the net income realised by the taxpayer over an income period.In
contrast, consumption taxes find their taxable event in a transaction, the exchange of goods
and services for consideration either at the last point of sale to the final end user (retail
sales tax and VAT), or on intermediate transactions between businesses (VAT) (OECD,
2011), or through levies on particular goods or services such as excise taxes, customs and
import duties.Income taxes are levied at the place of source of income while consumption
taxes are levied at the place of destination (i.e.the importing country).
16. It is also worth noting that the tax burden is not always borne by those who are legally
required to pay the tax.Depending on the price elasticity of the factors of production (which
in turn depends on the preferences of consumers, the mobility of factors of production,

the degree of competition etc.), the tax burden may be shifted and thus both income and
consumption taxes can have a similar tax incidence.In general, it is said that the tax incidence
falls upon capital, labour and/or consumption.For example, if capital were more mobile
than labour and the market is a highly competitive and well-functioning one, most of the tax
burden would be borne by workers.
2.3. Corporate income tax

17. Although the tax base can be defined in a great variety of ways, corporate income
tax (CIT) generally relies on a broad tax base, formulated to encompass all types of income
derived by the corporation whatever their nature,1 which encompasses the normal return
on equity capital in addition to what can be described as pure or economic rents
i.e.what the enterprise earns from particular competitive advantages which may be related
to advantageous production factors (such as natural resources that are easily exploitable
or low labour costs) or advantages related to the market in which the products will be sold
(e.g.a monopolistic position).
18. At the time CIT systems were introduced, one of their primary objectives was to act as
a prepayment of personal income taxes due by the shareholders (i.e.the gap-filling function
(Bird, 2002), also referred to as the deferral justification), thereby preventing potentially
indefinite deferral of personal income tax (Vann, 2010). As a result, the corporate tax base was
seen as a proxy for the return on equity capital. It follows that corporate taxes are generally
imposed on net profits, that is receipts minus expenses. Two basic models, different in their
approach but similar in their practical result, are used to assess this taxable income:
The receipts-and-outgoings system (or profit and loss method): net income is determined
as the difference between all recognised income derived by a corporation in the tax
period and all deductible expenses incurred by the corporation in the same tax period.
The balance-sheet system (or net-worth comparison method): net income is
determined by comparing the value of the net assets in the balance sheet of the
taxpayer at the end of the tax period (plus dividends distributed) with the value of
the net assets in the balance sheet of the taxpayer at the beginning of the tax period.
19. Some countries have achieved substantial uniformity, except for some differences
where the accounting treatment may be vulnerable to manipulations intended to distort
the measurement of taxable income (e.g.denial of deduction of certain expenses, different
method of recognition of capital expenditures, different timing in recognition of gains
on certain fixed assets). In other countries tax and financial accounting are substantially
independent, with tax law provisions addressing to a large extent the treatment of the
transactions entered into by a corporation.
2.3.1. The taxation of cross-border income under domestic corporate income

tax laws
20. It is commonly accepted that there are two aspects to a states sovereignty: the
power over a territory (enforcement jurisdiction) and the power over a particular set of
subjects (political allegiance). This binary nature of sovereignty was strongly rooted
in the minds of the people during the 19th and 20th century and exercised a significant
influence in the fashioning of one States jurisdiction to tax. Conscious that taxes ought
to be confined to taxable subjects and objects that have some sort of connection with the
imposing State, policy makers reached the conclusion that a legitimate tax claim ought
to be either based on the relationship to a person (i.e.a personal attachment) or on the

relationship to a territory (i.e.a territorial attachment) (Schon, 2010; Beale, 1935).
21. Along the same line, the dual nature of sovereignty has also contributed to the
formulation of the realistic doctrine, which is driven by concerns for the enforcement,
administration, collection of taxes and came to limit the traditional notion of sovereignty
(Tadmore, 2007). While a states right to levy income taxes relies on territory or residence,
the realistic doctrine advances that without the power to tax, there is no jurisdiction to tax
and is more concerned with the exercise of taxing rights by the State in an effective manner
(Tadmore, 2007). Under the realistic doctrine, a distinction is made between jurisdiction to
impose taxes and jurisdiction to enforce them, also called the enforcement jurisdiction
(Hellerstein, 2009) and emphasis is placed on practicality over theory.
22. Domestic tax rules for the taxation of cross-border income generally address two
situations: the taxation of outbound investments of resident companies, and the taxation
of inbound investments of non-resident companies. With respect to the former category,
the definition of residence is a key notion. Some countries determine the residence of a
corporation based on formal criteria such as place of incorporation. In other countries,
the residence of a corporation is determined by reference factual criteria such as place of
effective management or similar concepts. Some countries have mixed systems, where
there is both a place of incorporation test and a place of effective management test.
23. With respect to taxation of outbound investments of resident companies, two
broad models can be identified: the worldwide system and the territorial system. It should
be noted that these categories are simplifications, as most countries in practice apply a
combination of both systems.
24. A country employing a worldwide system subjects its residents to tax on their
worldwide income whether derived from sources in or outside its territory. In order to
implement the residence principle, the tax administration in the country of residence has to
Box2.1. Controlled foreign company (CFC) rules

CFC rules provide for the taxation of profits derived by non-resident companies in the hands
of their resident shareholders. They can be thought of as a category of anti-avoidance rules, or
an extension of the tax base, designed to tax shareholders on passive or highly mobile income
derived by non-resident companies in circumstances where, in the absence of such rules, that
income would otherwise have been exempt from taxation (e.g.under a territorial system) or only
taxed on repatriation (e.g.under a worldwide tax system with a deferral regime).
CFC rules vary substantially in approach. In some instances, they seek to reduce tax
incentives to undertake business or investment through a non-resident company. But they
may also include provisions (such as the exclusion of active income) intended to ensure that
certain types of investment in a foreign jurisdiction by residents of the country applying the
CFC regime will be subject to no greater overall tax burden than investment in the same
foreign jurisdiction by shareholders that are not residents. Most systems of CFC rules have
the character of anti-avoidance rules targeting diverted income, and are not intended to deter
genuine foreign investment.
CFC rules require some or all of the foreign companys profits to be included in the income
of the resident shareholder, and thus may also have the effect of protecting the tax base of the
source country by discouraging investments that erode its tax base or that are designed to shift
profit to low-tax jurisdictions.

collect information with respect to the foreign-source income of their residents. As a result,
countries rarely, if ever, adopt pure worldwide systems of taxation. Instead, under most of
these systems foreign-sourced profits of foreign subsidiaries are taxed upon repatriation
(the deferral system), and not on an accrual basis. In addition, the credit for tax paid on
profits generated abroad is usually limited to the amount of taxation that would have
been imposed on the foreign earnings by the residence country, thereby ensuring that the
worldwide system does not impair the residence states taxation of its own domestic source
income.
25. A country applying a territorial CIT system subjects its residents to tax only on the
income derived from sources located in its territory. This means that resident companies
are taxed only on their local income i.e.income deemed to have their source inside the
country. Determining the source of business income is therefore key in a territorial system.
26. With respect to the taxation of inbound investments of non-resident companies,
both a worldwide tax system and a territorial tax system impose tax on income arising
from domestic sources. Hence, the determination of source of the income is key. Sourcing
rules vary from country to country. With respect to business income, the concept of
source under domestic law often parallels the concept of permanent establishment (PE)
as defined under tax treaties. Such income is typically taxed on a net basis. For practical
reasons however, it may be difficult for a country to tax certain items of income derived by
non-resident corporations. It may also be difficult to know what expenses a non-resident
incurred in earning such income. As a result, taxation at source of certain types of income
(e.g.interest, royalties, dividends) derived by non-resident companies commonly occurs
by means of withholding taxes at a gross rate. To allow for the fact that no deductions are
allowed, gross-based withholding taxes are imposed at rates that are usually lower than
standard corporate tax rates.
2.3.2. The taxation of cross-border income under double tax treaties

27. The exercise of tax sovereignty may entail conflicting claims from two or more
jurisdictions over the same taxable amount, which may lead to juridical double taxation,
which is the imposition of comparable taxes in two (or more) states on the same taxpayer
in respect of the same income. Double taxation has harmful effects on the international
exchange of goods and services and cross-border movements of capital, technology and
persons. Bilateral tax treaties address instances of double taxation by allocating taxing
rights to the contracting states. Most existing bilateral tax treaties are concluded on the
basis of a model, such as the OECD Model Tax Convention or the United Nations Model,
which are direct descendants of the first Model of bilateral tax treaty drafted in 1928
by the League of Nations. As a result, while there can be substantial variations between
one tax treaty and another, double tax treaties generally follow a relatively uniform
structure, which can be viewed as a list of provisions performing separate and distinct
functions: (i)articles dealing with the scope and application of the tax treaty, (ii)articles
addressing the conflict of taxing jurisdiction, (iii)articles providing for double taxation
relief, (iv)articles concerned with the prevention of tax avoidance and fiscal evasion, and
(v)articles addressing miscellaneous matters (e.g.administrative assistance).
2.3.2.1. A historical overview of the conceptual basis for allocating taxing rights
28. As global trade increased in the early 20th century, and concerns around instances
of double taxation grew, the League of Nations appointed in the early 1920s four
economists (Bruins et al., 1923) to study the issue of double taxation from a theoretical
and scientific perspective. One of the tasks of the group was to determine whether it is
possible to formulate general principles as the basis of an international tax framework
capable of preventing double taxation, including in relation to business profits.2 In this
context the group identified the concept of economic allegiance as a basis to design such
international tax framework. Economic allegiance is based on factors aimed at measuring
the existence and extent of the economic relationships between a particular state and the
income or person to be taxed. The four economists identified four factors comprising
economic allegiance, namely (i)origin of wealth or income, (ii)situs of wealth or income,
(iii)enforcement of the rights to wealth or income, and (iv)place of residence or domicile
of the person entitled to dispose of the wealth or income.
29. Among those factors, the economists concluded that in general, the greatest weight
should be given to the origin of the wealth [i.e.source] and the residence or domicile of
the owner who consumes the wealth. The origin of wealth was defined for these purposes
as all stages involved in the creation of wealth: the original physical appearance of the
wealth, its subsequent physical adaptations, its transport, its direction and its sale. In other
words, the group advocated that tax jurisdiction should generally be allocated between
the state of source and the state of residence depending on the nature of the income in
question. Under this approach, in simple situations where all (or a majority of) factors of
economic allegiance coincide, jurisdiction to tax would go exclusively with the state where
the relevant elements of economic allegiance have been characterised. In more complex
situations in which conflicts between the relevant factors of economic allegiance arise,
jurisdiction to tax would be shared between the different states on the basis of the relative
economic ties the taxpayer and his income have with each of them.
30. On the basis of this premise, the group considered the proper place of taxation for
the different types of wealth or income. Business profits were not treated separately, but
considered under specific classes of undertakings covering activities nowadays generally
categorised as bricks and mortar businesses, namely Mines and Oil Wells, Industrial
Establishments or Factories, and Commercial Establishments.3 In respect of all those
classes of activities, the group came to the conclusion that the place where income was
produced is of preponderant weight and in an ideal division a preponderant share should
be assigned to the place of origin. In other words, in allocating jurisdiction to tax on
business profits, greatest importance was attached to the nexus between business income
and the various physical places contributing to the production of the income.
31. Many of the reports conclusions proved to be controversial and were not entirely
followed in double tax treaties. In particular, the economists preference for a general
exemption in the source state for all income going abroad as a practical method of
avoiding double taxation4 was explicitly rejected by the League of Nations, who chose
as the basic structure for its 1928 Model the classification and assignment of sources
method i.e.attach full or limited source taxation to certain classes of income and
assign the right to tax other income exclusively to the state of residence. Nevertheless, the
theoretical background enunciated in the 1923 Report has survived remarkably intact and
is generally considered as the intellectual base (Ault, 1992: 567) from which the various
League of Nations models (and consequently virtually all modern bilateral tax treaties)
developed (Avi-Yonah, 1996).
32. Before endorsing the economic allegiance principle, the group of four economists
briefly discussed other theories of taxation, including the benefit principle (called at the
time the exchange theory), and observed that the answers formulated by this doctrine had
to a large extent been supplanted by the theory of ability to pay. Several authors consider

that the decline of the benefit theory is undeniable as far as determination of the amount
of tax liability is concerned, but not in the debate on taxing jurisdiction in an international
context (Vogel, 1988). Under the benefit theory, a jurisdictions right to tax rests on the
totality of benefits and state services provided to the taxpayer that interacts with a country
(Pinto, 2006), and corporations, in their capacity as agents integrated into the economic life
of a particular country, ought to contribute to that countrys public expenditures. In other
words, the benefit theory provides that a state has the right to tax resident and non-resident
corporations who derive a benefit from the services it provides. These benefits can be specific
or general in nature. The provision of education, police, fire and defence protection are
among the more obvious examples. But the state can also provide conducive and operational
legal structures for the proper functioning of business, for example in the form of a stable
legal and regulatory environment, the protection of intellectual property and the knowledgebased capital of the firm, the enforcement of consumer protection laws, or well-developed
transportation, telecommunication, utilities and other infrastructure (Pinto, 2006).
2.3.2.2. Allocation of taxing rights under tax treaties

33. At the time the four economists presented their report, various jurisdictions had
already started addressing juridical double taxation through bilateral and unilateral
measures. The League of Nations Tax Committees built upon the practical experience of
government experts with negotiating and administering contemporary treaties. Partly as a
result of historic path dependence, and partly due to the need for an effective way to allocate
taxing rights between tax systems that may diverge significantly, avoidance of double
taxation was not addressed by an alternative system such as formulary apportionment,
or another system based on the principles identified by the four economists. Instead,
supported by the development of the OECD and UN Model treaties, the international tax
framework developed around a vast network of bilateral tax treaties following the so-called
classification and assignment of sources method, in which different types of income are
subject to different distributive rules. This schedular nature of distributive rules entails a
preliminary step, whereby the income subject to conflicting claims is first classified into
one of the categories of income defined by the treaty. Where an item of income falls under
more than one category of income, double tax treaties resolve the conflict through ordering
rules. Once the income is characterised for treaty purposes, the treaty provides distributive
rules that generally either grant one contracting state the exclusive right to exercise domestic
taxing rights or grant one contracting state priority to exercise its domestic taxing right
while reserving a residual taxing right to the other contracting state.
34. Treaty rules provide that business profits derived by an enterprise are taxable
exclusively by the state of residence unless the enterprise carries on business in the other
state through a PE situated therein. In the latter situation, the source state may tax only the
profits that are attributable to the PE. The PE concept is thus used to determine whether or
not a contracting state is entitled to exercise its taxing rights with respect to the business
profits of a non-resident taxpayer. Special rules apply, however, to profits falling into certain
enumerated categories of income, such as dividends, interest, royalties, and capital gains.
35. The PE concept effectively acts as a threshold which, by measuring the level of
economic presence of a foreign enterprise in a given State through objective criteria, determines
the circumstances in which the foreign enterprise can be considered sufficiently integrated into
the economy of a state to justify taxation in that state (Holmes, 2007; Rohatgi, 2005). A link can
thus reasonably be made between the requirement of a sufficient level of economic presence
under the existing PE threshold and the economic allegiance factors developed by the group of
economists more than 80 years ago. This legacy is regularly emphasised in literature (Skaar,
1991), as well as reflected in the existing OECD Commentaries when it is stated that the PE
threshold has a long history and reflects the international consensus that, as a general rule,
until an enterprise of one State has a permanent establishment in another State, it should not
properly be regarded as participating in the economic life of that other State to such an extent
that the other State should have taxing rights on its profits.5 By requiring a sufficient level of
economic presence, this threshold is also intended to ensure that a source country imposing tax
has enforcement jurisdiction, the administrative capability to enforce its substantive jurisdiction
rights over the non-resident enterprise.
36. The PE definition initially comprised two distinct thresholds: (i)a fixed place through
which the business of the enterprise is wholly or partly carried on or, where no place of
business can be found, (ii)a person acting on behalf of the foreign enterprise and habitually
exercising an authority to conclude contracts in the name of the foreign enterprise. In both
situations a certain level of physical presence in the source jurisdiction is required, either
directly or through the actions of a dependent agent. Some extensions have been made over
time to address changes in business conditions. For example, the development of the service
industry has led to the inclusion in many existing bilateral treaties of an additional threshold
whereby the performance of services by employees (or other persons receiving instructions)
of a non-resident enterprise may justify source-based taxation as soon as the duration of such
services exceeds a specific period of time, irrespective of whether the services are performed
through a fixed place of business (Alessi, Wijnen and de Goede, 2011).
37. Treaty rules on business profits provide that only the profits attributable to the
PE are taxable in the jurisdiction where the PE is located. These are the profits that the PE
would be expected to make if it were a distinct and separate enterprise.
38. By virtue of separate distributive rules which take priority over the PE rule, some
specific items of income may be taxed in the source jurisdiction even though none of the
alternative PE thresholds are met in that country. These include:
Income derived from immovable property (and capital gains derived from the
sale thereof), which generally may be taxed by the country of source where the
immovable property is located.
Business profits that include certain types of payments which, depending on the
treaty, may include dividends, interest, royalties or technical fees, on which the
treaty allows the country of source to levy a limited withholding tax.
39. In the case of outbound payments of dividends, interest, and royalties, countries
commonly impose tax under their domestic law on a gross basis (i.e.not reduced by the
deduction of expenses) by means of a withholding tax. Bilateral tax treaties commonly
specify a maximum rate at which the source state may impose such a withholding tax,
with the residual right to tax belonging to the state of residence.6 However, where the asset
giving rise to such types of income is effectively connected to a PE of the non-resident
enterprise in the same state, the rules for attribution of profits to a PE control (Article10(4),
11(4) and 12(3) of the OECD Model Tax Convention).
40. Where priority is given by bilateral tax treaties to the taxing rights of the source
jurisdiction, the resident state must provide double taxation relief. Two mechanisms are
generally available in bilateral tax treaties, namely the exemption method and the credit
method. But in practice many jurisdictions, and accordingly existing bilateral tax treaties,
use a mixture of these approaches i.e.exemption method for income attributable to a PE,
and credit method for items of income subject to a withholding in relation to business
profits (Rohatgi, 2005).
2.4. Value added taxes and other indirect consumption taxes

41. Value added taxes (VAT) and other consumption taxes are generally designed to
be indirect taxes. While they are generally intended to tax the final consumption of goods
and services, they are collected from the suppliers of these goods and services rather than
directly from the consumers. The consumers bear the burden of these taxes, in principle,
as part of the market price of the goods or services purchased.
42.
Two categories of consumption taxes are generally distinguished (OECD, 2013):

General taxes on goods and services, consisting of VAT and its equivalent in several
jurisdictions, sales taxes and other general taxes on goods and services.
Taxes on specific goods and services, consisting primarily of excise taxes, customs
and import duties, and taxes on specific services (e.g.taxes on insurance premiums
and financial services).
43. This section focuses mainly on VAT, which is the primary form of consumption
tax for countries around the world. The combination of the global spread of VAT and the
rapid globalisation of economic activity, which resulted in increased interaction between
VAT systems, and increasing VAT rates (OECD, 2012) have raised the profile of VAT as a
significant issue in cross-border trade.
2.4.1. Main design features of a VAT

2.4.1.1. Overarching purpose of a VAT A broad-based tax on final consumption
44. The term VAT is used here to cover all value added taxes, by whatever name, in
whatever language, they are known. Note, for instance, that many countries refer to their
value added taxes as a goods and services tax (GST) (e.g.Australia, Canada, India, New
Zealand and Singapore). While there is considerable diversity in the structure of the VAT
systems currently in place, most of these systems are grounded on certain fundamental
design principles that are described in this section, at least in theory if not in practice. The
overarching purpose of a VAT is to impose a broad-based tax on consumption, which is
understood to mean final consumption by households.
45. In principle only private individuals, as distinguished from businesses, engage in the
consumption at which a VAT is targeted. In practice, however, many VAT systems impose
VAT burden not only on final household consumption, but also on various entities that are
involved in non-business activities or in VAT-exempt activities. In such situations, VAT can
be viewed alternatively as treating such entities as if they were end consumers, or as input
taxing the supplies made by such entities on the presumption that the burden of the VAT
imposed will be passed on in the prices of the outputs of those non-business activities.
2.4.1.2. The central design feature of a VAT Staged collection process

46. The central design feature of a VAT, and the feature from which it derives its name,
is that the tax is collected through a staged process. Each business (taxable person) in the
supply chain is responsible for collecting the tax on its outputs (supplies) and remitting the
proportion of tax corresponding to its margin, i.e.the value added, in a particular tax period.
This means that the taxable person remits the difference between the VAT imposed on its
taxed outputs (output tax) and the VAT imposed on its taxed inputs (input tax) for this period.
Thus, the tax is in principle collected on the value added at each stage of production and
distribution. In this respect, the VAT differs from a retail sales tax, which taxes consumption
through a single-stage levy imposed in theory only at the point of final sale.
47. This central design feature of the VAT, coupled with the fundamental principle that
the burden of the tax should not rest on businesses, requires a mechanism for relieving
businesses of the burden of the VAT they pay when they acquire goods or services. There
are two principal approaches to implementing the staged collection process while relieving
businesses of the VAT burden. Under the invoice-credit method, each taxable person
charges VAT at the rate specified for each supply and passes to the customer an invoice
showing the amount of tax charged. If the customer is also a taxable person, it will be able
to credit that input tax against the output tax charged on its sales, each being identified at
the transaction level, remitting the balance to the tax authorities or receiving a refund of
any excess credits. Under the subtraction method, the tax is levied directly on an accountsbased measure of value added, which is determined for each business by subtracting the
taxable persons allowable expenditure on inputs for the tax period from taxable outputs
for that period and applying the tax rate to the resulting amount (Cockfield et al., 2013).
Almost all jurisdictions that operate a VAT use the invoice-credit method, the Japanese
system being the most notable example of a subtraction method consumption tax.
48. VAT exemptions create an important exception to the neutrality of VAT. When
a supply is VAT-exempt, this means that no output tax is charged on the supply and
that the supplier is not entitled to credit the related input tax. Many VAT systems apply
exemptions for activities that are hard to tax (the exemption for financial services being
the most notable example) and/or to pursue distributional objectives (agricultural and fuel
exemptions and exemptions for basic health and education are commonly encountered).
One adverse consequence of VAT exemptions is that they create cascading when applied
in a business-to-business (B2B) context. The business making an exempt supply can be
expected to pass on the uncreditable input tax in the price of this supply, while this hidden
tax can subsequently not be credited by the recipient business.
2.4.2. VAT on cross-border transaction The destination principle

49. The fundamental policy issue in relation to the international application of the VAT
is whether the levy should be imposed by the jurisdiction of origin or by the jurisdiction
of destination. Under the destination principle, tax is ultimately levied only on the final
consumption that occurs within the taxing jurisdiction. Under the origin principle, the tax
is levied in the various jurisdictions where the value was added.
50. Under the destination principle, no VAT is levied on exports and the associated
input tax is refunded to the exporting business (this is often called free of VAT or
zero-rated), while imports are taxed on the same basis and at the same rates as domestic
supplies. Accordingly, the total tax paid in relation to the supply is determined by the rules
applicable in the jurisdiction of its consumption and all revenue accrues to the jurisdiction
where the supply to the final consumer occurs. The application of the destination principle
in VAT thus achieves neutrality in international trade, as there is no advantage in buying
from a low or no-tax jurisdiction, nor do high and/or multiple VAT rates distort the level or
composition of a countrys exports.
51. By contrast, under the origin principle each jurisdiction would levy VAT on the value
created within its own borders. Under an origin-based regime, exporting jurisdictions would
tax exports on the same basis and at the same rate as domestic supplies, while importing
jurisdictions would give a credit against their own VAT for the hypothetical tax that would
have been paid at the importing jurisdictions own rate. This approach runs counter to the

core features of a tax on consumption, in which the revenue should accrue to the jurisdiction
where the final consumption takes place. Under the origin principle, these revenues are shared
amongst jurisdictions where value is added. By imposing tax at the various rates applicable
in the jurisdictions where value is added, the origin principle could influence the economic
or geographical structure of the value chain and undermine neutrality in international trade.
52. For these reasons, there is widespread consensus that the destination principle, with
revenue accruing to the country where final consumption occurs, is preferable to the origin
principle from both a theoretical and practical standpoint. In fact, the destination principle
is the international norm and is sanctioned by World Trade Organisation (WTO) rules.
Footnote1 of the WTOs Agreement on Subsidies and Countervailing Measures provides
that the exemption of an exported product from duties or taxes borne by the like product
when destined for domestic consumption, or the remission of such duties or taxes in
amounts not in excess of those which have accrued, shall not be deemed to be a subsidy.
2.4.3. Implementing the destination principle

53. While the destination principle has been widely accepted as the basis for applying
VAT to international trade, its implementation is nevertheless diverse across jurisdictions.
This can lead to double taxation or unintended non-taxation and to complexity and
uncertainty for businesses and tax administrations. In order to apply the destination
principle, VAT systems must have a mechanism for identifying the destination of supplies.
Because VAT is generally applied on a transaction-by-transaction basis, VAT systems
contain place of taxation rules that address all transactions, building on proxies that
indicate where the good or service supplied is expected to be used by a business in the
production and distribution process (if the supply is made to a business) or consumed (if
the supply is made to a final consumer).
54. The following paragraphs provide a concise overview of the mechanisms for
identifying the destination of a supply, first looking at supplies of goods and subsequently
at supplies of services.
2.4.3.1. Implementing the destination principle Goods

55. The term goods generally means tangible property for VAT purposes. The VAT
treatment of supplies of goods normally depends on the location of the goods at the time of
the transaction and/or their location as a result of the transaction. The supply of a good is
in principle subject to VAT in the jurisdiction where the good is located at the time of the
transaction. When a transaction involves goods being moved from one jurisdiction to another,
the exported goods are generally free of VAT in the sellers jurisdiction (and are freed of any
input VAT via successive businesses deductions of input tax), whilst the imports are subject
to the same VAT as equivalent domestic goods in the purchasers jurisdiction. The VAT on
imports is generally collected from the importer at the same time as customs duties, before
the goods are released from customs control, although in some jurisdictions collection is
postponed until declared on the importers next VAT return. Allowing deduction of the VAT
incurred at importation in the same way as input tax deduction on a domestic supply ensures
neutrality and limits distortions in relation to international trade.
56. Many VAT systems apply an exemption for the importation of relatively low value
goods. These exemptions are generally motivated by the consideration that the administrative
costs of bringing these low value items into the customs system are likely to outweigh the
revenue gained. If these additional costs would be passed on to consumers, the charges could
be disproportionally high compared to the value of the goods. Most OECD countries apply
such a VAT relief arrangement, with thresholds varying widely across countries.
2.4.3.2. Implementing the destination principle Services

57. The VAT legislation in many countries tends to define a service negatively as
anything that is not otherwise defined, or to define a supply of services as anything
other than a supply of goods. While this generally also includes a reference to intangibles,
some jurisdictions regard intangibles as a separate category. For the purposes of this section
references to services include intangibles unless otherwise stated.7
58. A wide range of proxies can be used by VAT systems to identify the place of taxation
of services, including the place of performance of the service, the place of establishment
or actual location of the supplier, the residence or the actual location of the consumer, and
the location of tangible property (for services connected with tangible property, such as
repair services). Many systems use multiple proxies before the place of taxation is finally
determined and may use different rules for inbound, outbound, wholly foreign, and wholly
domestic supplies (Cockfield et al., 2013).
59. The application of these principles for identifying the place of taxation has become
increasingly difficult as volumes of cross-border services are growing. VAT systems
have considerable difficulties to determine where services are deemed to be consumed,
to monitor this and to ensure collection of the tax, particularly where businesses sell
services in jurisdictions where they do not have a physical presence. In practice, broadly
two approaches can be distinguished for applying VAT to cross-border supplies of services
(Ebrill et al., 2001):
The first approach focuses on the jurisdiction where the customer is resident
(established, located). Under this approach, when the customer is resident in
another jurisdiction than the supplier, the supply is free of VAT (zero-rated) in the
jurisdiction of the supplier and is subject to VAT in the jurisdiction of the customer.
In principle, the supplier needs to register in the customers jurisdiction and collect
and remit the tax there. In practice, when the customer is a VAT-registered business,
the VAT is often collected through a reverse charge mechanism. This is a tax
mechanism that switches the liability to pay the tax from the supplier to the customer.
The business customer will generally be able to credit the input tax on the acquired
service immediately against the output tax liability. Some VAT systems therefore do
not require the reverse charge to be made if the customer is entitled to a full input tax
credit in respect of the purchase.
Under the second approach, the supply of the service is subjected to VAT in
the jurisdiction where the supplier is resident (established, located). Supplies of
services are then subject to VAT in the suppliers jurisdiction, even when they are
performed abroad or supplied to foreign customers. Customers that are taxable
businesses are generally able to apply for a refund of the VAT paid on business
inputs in the suppliers jurisdiction, from the tax authorities of that jurisdiction.
60. For B2B supplies, both approaches have ultimately the same effect, in that exported
services are relieved from any VAT burden in the origin country and subject to VAT in the
jurisdiction where the service is deemed to be used by the business customer. The first
approach, which identifies the place of taxation by reference to the location of the customer, is
recommended as the main rule for applying VAT to B2B supplies of services by the OECDs
International VAT/GST Guidelines (OECD, 2014). It was also the recommended approach for

cross-border supplies of services and intangibles that are capable of delivery from a remote
location under the OECDs 2003 E-commerce Guidelines (OECD, 2003a). A key advantage
of this approach is that it avoids the need for cross-border refunds of VAT to businesses
that have acquired services abroad, which often involve considerable administrative and
compliance burden and costs for tax administrations and businesses. In practice, however,
many VAT systems apply the second approach, taxing services by reference to the location of
the supplier, mainly to minimise the risk of fraud through claims of exported services which
are typically difficult to verify.
61. Whereas both approaches lead to a result that is consistent with the destination
principle in a B2B context, the situation is more complicated for business-to-consumer (B2C)
supplies. Implementing the destination principle by zero-rating cross-border supplies to nonresident final consumers and relying on self-assessment by the consumer in its jurisdiction
of residence, is likely to result in widespread non-taxation of these supplies in practice.
While reverse charge methods operate relatively well in a B2B context, they are generally
viewed as ineffectual for B2C supplies. Such a method would require final consumers to
self-assess their VAT liability on services purchased abroad, e.g.through their income tax
returns. The level of voluntary compliance can be expected to be low, as private consumers
have no incentive to voluntarily declare and pay the tax due, unlike taxable persons who can
credit input tax paid against output tax (Lamensch, 2012). Collecting and enforcing this VAT,
which may be small amounts in many cases, from large numbers of people is likely to involve
considerable complexity and costs for tax payers and tax authorities.
62. Most VAT systems therefore tax supplies of services to private consumers in the
jurisdiction where the supplier is resident (established, located). Many jurisdictions that
zero-rate cross-border supplies of services to non-resident customers, limit the application
of this regime to B2B supplies, notably by applying it only to services that are typically
supplied to businesses (advertising, consultancy, etc.) Supplies to foreign private consumers
are then subject to VAT in the suppliers jurisdiction while services acquired from abroad
by resident final consumers are not subject to VAT in the consumers jurisdiction. While
this approach, which effectively results in origin taxation, is likely to be less vulnerable
to fraud, it may create an incentive for suppliers to divert their activities to jurisdictions
where no or a low VAT is applied and to sell remote services into foreign markets VAT-free
or at a low VAT rate. This potential distortion and the associated revenue losses become
increasingly significant as volumes of cross-border supplies of services keep growing.
63. More and more jurisdictions therefore consider ways to implement a destination based
approach for both B2B and B2C cross-border supplies of services, thereby relying on a system
that would require suppliers to collect and remit the tax in line with what was recommended
by the OECDs E-commerce Guidelines. As self-assessment methods are unlikely to offer an
effective solution for collecting the tax at destination in a B2C-context, a system that requires
suppliers to collect and remit the tax may appear the only realistic alternative. This was
notably the conclusion of the OECDs Consumption Tax Guidance Series, which provided
guidance for the implementation of the E-commerce Guidelines (OECD, 2003b-c-d). This
guidance indicated that countries may consider it necessary for non-resident vendors to
register and account for the tax in the jurisdiction of consumption, and it recommended the
use of simplified registration regimes and registration thresholds to minimise the potential
compliance burden. The most notable application of a destination-based approach for taxing
B2C cross-border supplies of services relying on a simplified registration system for nonresident suppliers, is the European Unions One Stop Shop scheme.
Notes
1.
This global approach is generally co-ordinated with specific tax regimes applying to items of
income derived from specific types of assets (e.g.participation shares, patents and trademarks).
2.
Noteworthy, at the time the study was performed most of the industrialised countries had not
yet introduced in their domestic legislation a modern corporate income tax system integrated
with personal income taxes.
3.
Professional earnings were considered separately, unless the concerned activity gives rise to a
branch in another country, in which case the occupation becomes a commercial enterprise and,
according to the economist, ought to fall under the same allocation rule as other businesses.
4.
The predominant argument put forward by the economists to reach a conclusion (i.e.exclusive
taxation in the state of residence) was convenience and practicability.
5.
OECD Commentaries on Art.7, par. 11; see also in relation to service activities, Commentaries
on Art.5, par. 42.11.
6.
These limitations on withholding at source generally do not apply, however, to excessive

payments of interest or royalties to related parties. For instance, paragraph6 of Article11 of
the OECD Model Convention provides that, if there is a special relationship between the payer
and the recipient as a result of which the interest is higher than that which they would have
agreed upon in the absence of such a relationship, the excess part remains taxable according
to the laws of both the source state and the residence state. Similar rules apply with respect to
excessive royalties under paragraph4 of Article12 of the OECD Model Tax Convention.
7.
Many VAT systems define a service negatively as anything that is not otherwise defined,
or a supply of services as anything other than a supply of goods. While this generally also
includes a reference to intangibles, some jurisdictions regard intangibles as a separate category,
and this is explicitly recognised in this report where relevant. It should be noted that the term
intangibles when used for transfer pricing and direct tax purposes has a different meaning
than that used under certain VAT legislations.
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3. Information and communication technology and its impact on the economy 35
Chapter3
Information and communication technology and its impact on the economy
This chapter examines the evolution over time of information and communication
technology (ICT), including emerging and possible future developments. It then
provides a conceptual overview, highlighting interactions between various layers
of information and communication technology.
36 3. Information and communication technology and its impact on the economy
3.1. The evolution of information and communication technology

64. The development of ICT has been characterised by rapid technological progress
that has brought prices of ICT products down rapidly, ensuring that technology can be
applied throughout the economy at low cost. In many cases, the drop in prices caused by
advances in technology and the pressure for constant innovation have been bolstered by
a constant cycle of commoditisation that has affected many of the key technologies that
have led to the growth of the digital economy. As products become successful and reach
a greater market, their features have a tendency to solidify, making it more difficult for
original producers to change those features easily. When features become more stable,
it becomes easier for products to be copied by competitors. This is stimulated further
by the process of standardisation that is characteristic of the ICT sector, which makes
components interoperable, making it more difficult for individual producers to distinguish
their products from others. Unless the original producer can differentiate its product from
the copies (for example, by bundling its product with services or other features that are not
easily duplicated), or otherwise find a way to maintain a dominant position in the market,
it will be forced to compete solely on price or move to other market segments.
65. This process tends to cause prices of the commoditised goods or services to fall,
and innovation to move elsewhere in the value chain. This does not necessarily mean that
every single component of the commoditised product becomes a commodity. A producer
of a component of the overall product can maintain or create a proprietary advantage by
enhancing some elements or subsystems of that component. This can decommoditise
those elements or subsystems of the commoditised product, creating new opportunities at
a different stage of the value chain.
3.1.1. Personal computing devices

66. Early in the life of the digital economy, many manufacturers of computing hardware
used proprietary hardware components, which meant that the computers of different
manufacturers operated on entirely different standards. When the architecture of personal
computers was largely standardised thirty years ago, however, many market participants
started competing on price. That, combined with rapid technological progress, resulted
in substantial drops in the price of personal computing hardware. In the period that
followed, the most successful manufacturers succeeded in large part because their products
integrated best with other products or because they developed the strongest marketing
and distribution strategies, rather than primarily because the hardware they produced was
distinguishable from those of their competitors. As mentioned above, this cycle has been
paralleled at various points throughout the evolution of the digital economy, resulting in
substantial changes in the digital value chain over time.
67. A relatively recent development is the advent of innovative integrated packages
of hardware and software, such as smartphones and tablets (and increasingly, connected
wearable devices). Designing, manufacturing and selling these devices has allowed
companies to improve their position in the value chain and on the market. There appear
to be two major trends that confirm the growing importance of devices. The first trend is
the diversification of devices. Consumers initially accessed the Internet almost exclusively
through personal computers. Now the industry has designed a wide variety of devices
providing access to the web, such as smartphones, tablets, and connected TVs. The second
trend is the growing specialisation in devices of businesses formerly specialised in software
or other parts of the value chain. Several businesses have launched their own tablets
or other devices. These devices allow them to establish a closer relationship with their
customers, allowing them to collect more detailed information so that they may provide
customised service with even more relevance and added value.
68. Over time, hardware devices have both multiplied and diversified in terms of
features and technical characteristics. As shown in Figure3.1, the number of mobile
devices connected to the Internet keeps rising, forming an interconnected infrastructure
colloquially referred to as the Internet of Things (see Section3.2 on discussion of emerging
and potential future developments below). After a long period of personal computer
commoditisation, hardware has regained importance in the value chain. At the same time,
the price of devices continues to fall over time. Devices connected through the Internet
operate within certain standards that accelerate their commoditisation, if only because
individuals own more and more devices that must be synchronised around the same set of
content and data. In addition, connected objects and devices facilitate sales of intangible
goods and services (for example, a connected car becomes a point of sale for services based
on geo-location, including driving assistance). For this reason, a number of businesses
now use hardware devices as loss leaders in their business model, aimed at expanding the
market of customers for goods and services available through those devices, or at otherwise
leveraging their growing network of end users. Assuming these trends continue, it appears
that for many businesses, revenue from connected devices may ultimately flow primarily
from the operation rather than the continued sales of these devices.
Figure3.1. Percentage of fibre connections in total fixed broadband subscriptions, June 2014
Japan
Korea
Sweden
Estonia
Slovak Republic
Norway
Iceland
Slovenia
Czech Republic
Portugal
Denmark
Hungary
Turkey
Luxembourg
Switzerland
United States
Netherlands
Spain
Poland
Canada
Chile
New Zealand
Australia
Finland
Italy
France
Austria
Mexico
Germany
Ireland
0%
10%
20%
30%
40%
50%
60%
70%
80%
12 http://dx.doi.org/10.1787/9789264232440-graph47-en.
Source: OECD (2015), OECD Digital Economy Outlook 2015, OECD Publishing, Paris, http://dx.doi.
org/10.1787/9789264232440-en.

Figure3.2. Total fixed, mobile and broadband access paths subscriptions
(millions)
Fibre
DSL
Cable
Mobile
ISDN
Analogue
2 500
Subscriptions (millions)
2 000
1 500
1 000
500
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
12 http://dx.doi.org/10.1787/comms _ outlook-2013-graph44-en.
Source: OECD (2013a), OECD Communications Outlook 2013, OECD Publishing, Paris,
http://dx.doi.org/10.178/comms_outlook-2013-en.
3.1.2. Telecommunications networks

69. As the Internet turned into a major business phenomenon and adoption rates
accelerated, the network component providers, infrastructure intermediaries, and
Internet service providers (ISPs) that powered and operated the infrastructure of the
telecommunications networks that form the Internet became central to the digital economy.
The interconnection of networks initially gave birth to a specific economy organised
around the status of such infrastructure providers as the primary points of contact with the
ultimate end users, through peering points, data centres, and the data routes that form the
Internet backbone.
70. The strength of ISPs, however, has traditionally been primarily in providing
network access rather than in providing services across these networks. As a result,
unless the ISPs could leverage their control of access to telecommunications networks,
they had difficulty maintaining their status as the sole access point to the end user against
competition from third-party businesses that provided content and services directly to
users over the Internet. The providers of this content (sometimes called over-the-top (OTT)
content), were able to deliver services more responsive to demand. Thus, while ISPs remain
privileged points of contact with end users and have in general been able to maintain high
profit margins, leveraging control of network access was not possible in most cases because
ISPs were generally operating in increasingly competitive markets due to sector regulation
and were essentially local in their reach (although some ISPs operated across borders, and
many, such as mobile network providers, still do).
71. In contrast, OTT content providers could offer an unified experience to users at
scale, since their reach was global, unlike network providers whose reach was limited
to the length of their network. As a result, providers of OTT content increasingly took
on a direct relationship with the end users. The development of open source software
accelerated the pace of innovation on top of the networks. As a consequence, while the
success of OTT content providers has increased aggregate demand for networks, in markets
where there is sufficient competition, prices have declined. While a compelling hardware
device or new network service can still give a particular firm a short term lead and
introduce new business models (such as app stores, for example), experience has shown
that no single player in the value chain can entirely control access to customers as long as
there is sufficient competition.
3.1.3. Software
72. The World Wide Web, initially made of websites and webpages, marked the emergence
of Internet-powered software applications. Software has therefore been regarded from the
beginning as an important component of the value chain. Even some software, however, is
becoming commoditised. This commoditisation has, once again, been driven by standards,
starting with those of the Internet: the Hypertext Transfer Protocol (HTTP), the Hypertext
Markup Language (HTML) and later Extensible Markup Language (XML) data formats,
email exchange protocols such as Simple Mail Transfer Protocol (SMTP), Post Office Protocol
(POP), and Internet Message Access Protocol (IMAP). On top of these standards, communities
ofopen sourcedevelopers needed to accelerate the speed to market and constantly iterate
newer versions of their software. In order to innovate at this pace, they chose to share their
source code rather than redevelop it. Although some major software vendors have countered
the process of commoditisation with innovation and differentiation, large-scale differentiation
and advanced positions have become increasingly difficult to sustain.
73. As growing competition in the development of operating systems, databases, web
servers, and browsers reduced profits in many companies core business, it also created
new opportunities. Just as commoditisation in the hardware market cut profit margins
for traditional manufacturers while creating new opportunities for low-cost low-margin
manufacturers, growing competition in the software market has forced software companies
to become more creative and more responsive to consumers needs, all of which benefited
the consumer.
3.1.4. Content
74. Content gained attention at the end of the 1990s, when content production, consumption
and, above all, indexation appeared to drive the digital economys growth. It saw the rise of first
content portals and then search engines as the main gatekeepers to accessible content on the
Internet. Today, many major players in the digital economy are content providers.
75. The definition of content in that regard is quite large: it includes both copyrighted
content produced by professionals, enterprise-generated content, and non-copyrighted
user-generated content (such as consumer reviews or comments in online forums). The
importance of content flows from the fact that it is important to attract an audience and
provoke interactions between users. In addition, more content updated more frequently
increases a websites visibility in search results. Content has hence been a driving force
behind the advertising industry: it has become a key asset to attract an audience and
monetise it with advertisers. Content has also become a way to advertise in and of itself,
with classification into three categories: owned content (content distributed by the brand
on its own channels), paid content (content distributed by other media in exchange of
a payment by the brand), and earned content (content willingly created and shared by
customers without direct payment by the brand, such as customer product reviews, videos,
and social media sharing).
76. Content is more and more often produced by users, resulting in greater volumes of
content. The success of sites predicated on massive online collaboration by users, such as

Wikipedia and YouTube, has proven that an entire experience can be built around content
primarily generated by individual users. Further, the emergence of the social networking
phenomenon, and the success of major applications in which links and interactions between
users matter more than any primary content put forward to attract an audience show the
same path. Even advertising relies increasingly on user-generated content, through the
concept of earned content, one of the pillars of content marketing. The sophistication of
techniques designed to customise services, including cookies (technical tools used by
businesses to collect user data, notably for commercial purposes such as behavioural
advertising), targeting and retargeting, and collaborative filtering, is also relevant. The
amount of content available online has become so vast that relatively few businesses have
succeeded online by offering premium content, unless they can leverage that content
through a service that prevents competition on volume.
3.1.5. Use of data

77. Users of applications provide businesses with access to substantial amounts of data,
which are often personal and are used in a variety of ways that continue to be developed.1
Collected data can be used not only to customise the experience, but also to generate
productivity and quality gain at scale, through controlled experimentation. Personal data
is acquired in multiple ways; it can be: provided voluntarily by users (for example, when
registering for an online service); observed (for example, by recording Internet browsing
activities, location data, etc.), or inferred (for example, based on analysis of online
activities). Figure3.3, which is non-exhaustive, provides illustrations of the ways in which
Figure3.3. Personal data
Personal
data
Volunteered
e.g. declared
hobbies and
interests,
preferences,
expertise, etc.
Observed
e.g. location
information,
browser history,
shopping habits,
etc.
Inferred
e.g. credit ratings,
profiles built
from online
activities, etc.
Collection/
access
Storage and
aggregation
Mobile phones
ISPs and phone

providers
Blogs and
discussion lists
Social,
professional and
special interest
networks
User-generated
content
Loyalty
schemes
operated by
retailers
Government
agencies
(e.g. tax offices,
property
registries, etc.)
On-line social
networks
Financial
institutions
Medical
practitioners
Smart
appliances
Utility service
providers
Applications
Retailers
Sensors
etc.
etc.
Analysis and
distribution
Retailers and
service
providers
Public
administration
Usage
Businesses
Government and
public sector
agencies
End users
Financial
institutions
Healthcare
providers
Specialised
companies
involved in
online
advertising and
market
research
Data analysts,
providers and
brokers
etc.
Source: OECD, based on World Economic Forum (2011), Personal Data: The Emergence of a New
Asset Class, www3.weforum.org/docs/WEF_ITTC_PersonalDataNewAsset_Report_2011.pdf.
data is collected, stored, analysed, and used. Capacity to collect useful data is increasing
as the number of Internet-connected devices increases. Businesses of all sorts make use of
user data, as it allows them to tailor their offerings to customers. As increasing amounts
of potentially useful data are collected, more and more sophisticated techniques must be
developed in order to collect, usefully process and analyse that data.
3.1.6. Cloud-based processes

78. As a result of the standardisation and commoditisation of different individual
resources, such as hardware, network infrastructure, and software, some businesses have
been able to combine those resources and make them available through the Internet as
services.
79. Centralised hosting of software resources dates back to the 1960s, when mainframe
providers conducted a service bureau business, also referred to as time-sharing or utility
computing. Such services included offering computing power and database storage to
banks and other large organisations from their worldwide data centres. Cloud computing at
scale is the result of several trends related to both technology and business models: growing
availability of high-capacity networks, low-cost computers and storage devices as well as
the widespread adoption of hardware virtualisation, service-oriented architecture, and
utility computing. As a result, value has migrated to new proprietary applications that are
not stand-alone software products, but Internet-based applications that combine executable
code, dynamically updated databases, and user participation. Although the term cloud
computing has become commonplace, these applications have also at various points been
referred to as infoware, computing on demand or pervasive computing.
80. TheX-as-a Service (XaaS) acronym has been introduced to refer tothe trending
transformation of software products from goods to services.The Internet essentially
accelerated a transition from traditional software business to XaaS models. A website is
essentially a software application providing a service delivered over the Internet rather
than provided locally or on-site. The service can be about providing access to content (as
a portal), or about providing access to executable code performing certain features. Thus
the expansion of the Internet broughta new class ofcentralised computing providers,
calledapplication service providers (ASP). ASPs provided businesses with the service
of hosting and managing specialised business applications, with the goal of reducing
costs through central administration and through the ASPs specialisation in a particular
business application.
81. As of today, many business-to-consumer (B2C) applications are also delivered
as software as a service: search engines, social networking applications are mainly used
through a web browser, without any need to download any executable code beforehand.
Although applications continue to be downloaded and installed locally, this is done
primarily when there is a frequent need to use them offline. Even some locally-installed
applications, however, require an Internet connection to provide full functionality. The
growing popularity of smart phones and other devices that use frequently interrupted mobile
Internet connections, however, has made downloading applications prominent again.
82. Focusing on value created through cloud-based processes is particularly useful to
analyse the ultimate development of the Internet of Things (discussed below), which refers
to the Internet as a network connecting individuals, content, and things in everyday lives.
At the centre of this complex network of interconnections are powerful software-powered
processes whose resources can only be stored and executed in the cloud.
3.2. Emerging and potential future developments

83. The rapid technological progress that has characterised the development of ICT has
led to a number of emerging trends and potential developments that may prove influential in
the near future. Although this rapid change makes it difficult to predict future developments
with any degree of reliability, some of these potential developments are discussed below.
3.2.1. Internet of Things

84. While use of the Internet as a digital platform has enabled the creation of the
sharing economy (see below), the ability to connect any smart device or object over time
to a network of networks is enabling the Internet of Things. The term refers to a series
of components of equal importance including machine-to-machine communication, cloud
computing, big data analysis, sensors and actuators, the combination of which leads to
further developments in machine learning and remote control (see Figure3.4).
Figure3.4. Main enablers of the Internet of Things
Autonomous machines
Sensors
Data
Remote
control
Machine
learning
M2M
Cloud
Intelligent systems
Source: OECD (2015), OECD Digital Economy Outlook, OECD

85. The number of devices connected to the Internet is expanding rapidly, but substantial
room for expansion remains. While Cisco has estimated that between 10 and 15billion
devices are currently connected to the Internet, that figure represents less than 1% of the
total devices and things that could ultimately be connected (Evans, 2012). Within the area of
the Organisation for Economic Co-operation and Development (OECD), households alone
currently have approximately 1.8billion connected devices. This figure could reach as many
as 5.8billion by 2017, and as many as 14billion by 2022 (OECD, 2013a). As increasing
numbers of connected devices are developed and sold, the expansion of machine-to-machine
communication appears likely to dramatically expand and improve the ability of businesses
to collect and analyse relevant data.
86. A major feature of the Internet of Things is the widened ability to collect and share
data through powerful information systems connected to a multitude of devices, sensors,
and cloud computing components. The analysis and use of the data collected and transmitted
by connected devices can help individuals and organisations use their resources more
accurately, make informed purchasing decisions, ramp up productivity, and respond faster to
changing environments. As devices increasingly transmit more detailed data, the processing
of this data can be used automatically to change the behaviour of those devices in real time.
It can also make training workers for skilled positions an easier and more cost-effective
process. This trend, so far primarily contained in data-intensive industries such as finance,
advertising, or entertainment, is likely to penetrate more traditional industries in the future.
In addition, while the Internet of Things still generally requires human interaction, remotecontrolled machines and systems combined with machine learning may ultimately lead to
autonomous machines and intelligent systems, in particular robotic machines (see below).
3.2.2. Virtual currencies

87. Recent years have been marked by the appearance and development of virtual
currencies, meaning digital units of exchange that are not backed by government-issued legal
tender. These currencies have taken various forms. Some virtual currencies are specific to a
single virtual economy, such as an online game, where they are used to purchase in-game assets
and services. In some cases, these economy-specific virtual currencies can be exchanged for
real currencies or used to purchase real goods and services, through exchanges which may be
operated by the creators of the game or by third parties.
Figure3.5. How bitcoins enter circulation and are used in transactions
Source: U.S. Government Accountability Office (2013), Virtual Economies and Currencies, Report to
the Committee on Finance, USSenate.

88. Other virtual currencies were developed primarily to allow the purchase of real goods
and services. The most prominent example of this type are the various cryptocurrencies,
including in particular bitcoins, which rely on cryptography and peer-to-peer verification
to secure and verify transactions. Many private operators have chosen to accept payment in
bitcoins.
89. As virtual currencies increasingly acquire real economic value, they raise substantial
policy issues. Some of these stem from the anonymous nature of transactions. In the case
of bitcoins, for example, transactions can be made on an entirely anonymous basis, since
no personally identifying information is required to be provided to acquire or transact in
bitcoins.
3.2.3. Advanced robotics

90. The development of new connected and smart robots is changing manufacturing
profoundly. The increased productivity of new automated factories is already making
it possible for some multinational enterprises (MNEs) that had previously moved
manufacturing offshore to take advantage of lower labour costs to consider moving their
manufacturing activities back to where most of their customers are.
91. Manufacturing will be further changed by the progress in robotics, as robots
have the potential to make factories less labour intensive and force MNEs to think
about production and distribution at the same time. This trend has the potential to be felt
particularly strongly in already machine-intensive industries, as automation increasingly
centres on artificial cognition, sensors, machine learning, and distributed smart networks.
It will also have a potential impact where automation has been scarce so far, especially
in small factories and workshops, because software can help improve security and allow
humans to work alongside automated systems. Also, as robots embed more software
and are connected to cloud-based resources, it will become both easier and cheaper to
programme them, which could lead to lowered prices, making them more accessible
to small and middle-size operations. These lower costs have the potential to bring
manufacturing and other business activities increasingly closer to customers.
92. In the future, progress in artificial intelligence and the emergence of cognitive
computing may expand the influence of robots beyond the manufacturing sector and into
broader segments of the economy, as well as into household applications such as assisting
the elderly or disabled with manual tasks. As robots learn to do jobs that previously were
solely done by humans, they can potentially generate productivity, help lower prices for
customers, contribute to scaling up operations at a global level, and create innovation
opportunities which will lead to the emergence of new activities that will require new skills
and potentially create new jobs.
3.2.4. 3D Printing
93. Advances in 3D printing have the potential to enable manufacturing closer to the
customer, with direct interaction with consumers impacting the design of product features.
As a result, manufacturing could gradually move away from mass production of standardised
products, and instead focus on shorter product lifecycle by adopting a strategy of constant
experimentation at scale. In the healthcare industry, 3D printing of custom health products
such as hearing aid earpieces is already heavily used. In addition, 3D printing has the
potential to reduce environmental impact relative to traditional manufacturing, by reducing
the number of steps involved in production, transportation, assembly, and distribution, and
can reduce the amount of material wasted as well (Manika, 2013). The size of the 3D printing
market is growing rapidly, with further implications for the digital economy. The global
3D printing market is estimated to increase from USD2.2billion in 2012 to USD6billion
by 2017. Many companies are incorporating 3D printing into their R&D activities with the
majority of manufacturers using the technology for prototyping. According to a survey
conducted by PricewaterhouseCoopers in 2014, 25% of manufacturers used 3D printing
technology for prototyping only, and 10% used it for both prototyping and production
of final parts, while just 1% used 3D printing expressly for final product production
(PricewaterhouseCoopers, 2014). As 3D printing continues to advance, it is conceivable that
some manufacturers could eventually transition away from assembling products themselves,
and could instead license plans and specifications to third party manufacturers or even
retailers who will print the products on demand, closer to the customers, but at their own
risks and with a very low margin. Alternatively, consumers may be able to assemble products
themselves by using 3D printers, further increasing the possibility of locating business
activities at a location that is physically remote from the ultimate customer.
3.2.5. The sharing economy and collaborative production

94. The sharing economy, or collaborative consumption, is another potentially significant
trend within the digital economy. The sharing economy refers to peer-to-peer sharing of
goods and services. The sharing economy is not new, but advances in technology have reduced
transaction costs, increased availability of information, and provided greater reliability and
security. Recent years have seen the emergence of numerous innovative sharing applications
using different business models and focusing on one particular service or product, such as cars,
spare rooms, food, clothes, and private jets. Most individuals who participate in the sharing
economy do not do so mainly to make a living, but to entertain relationships with others, to
serve a cause that inspires them, or simply to make ends meet. Because the supplementary
income is a net benefit and often does not involve much quantitative cost-benefit analysis,
amateur providers have a tendency to share their available resources at a lower price than what
a professional might have billed, thus bringing down overall prices, including those of the
professionals. Through time, as certain platforms attract substantial number of individuals,
these platforms become the prime access point for customers on the online market and have
the potential to provide substantial competition for traditional e-commerce applications
operated by professionals, which may cut their profit margins further.
95. While the sharing economy concerns collective consumption, crowdsourcing
and crowdfunding are manifestations of collaborative production. Both large companies
and entrepreneurs make increasing use of these practices, for example, for capital peerto-peer lending. The term crowdfunding is increasingly being used for different types of
platforms, enabling lending, donations or reward-based funding, and equity crowdfunding
(investment). The crowdfunding market has grown strongly over the past years, driven
mainly by non-equity crowdfunding. Crowdfunding is most developed in the United States
and Europe, which accounted for 60% and 35%, respectively, of the market in 2012 (OECD
Outlook, 2015).
3.2.6. Access to government data

96. Governments are making progress at making machine-readable resources, notably
data, publicly available in what has been alternatively labelled as open data policy, open
government or government as a platform. There are three main goals assigned to open
government policies:

Accountability: Making government resources available allows the public to
have direct access to these resources in order to track, document, and evaluate
public policy cost, efficiency, and effectiveness. When it comes to accountability,
open government strategies are meant to providing tools for transparency and to
improving democracy as a whole.
Better performance: Opening government resources also is intended to provide
the means for government agencies to better co-operate with one another using
cross-agency software applications.
Participation of third parties in government business: When government
resources are made available to others outside government, third parties can combine
these resources with their own to create hybrid applications that allow better and
more personalised service.
3.2.7. Reinforced protection of personal data

97. Under most legal systems, personal data supplied by users is protected by privacy
rules and remains the property of those users. Personal data is regarded as an asset owned
by the individual to whom it relates, such that it is considered their choice, rather than
that of the organisation that holds it, to use, exchange, or make this information available.
Data protection rules usually specify what constitutes personal data, how it is gathered,
the standards companies must follow with respect to secure storage and the requirement
to notify individuals of the personal data held and their rights of access to it. In many
countries, rules require adequate data security provisions in regard to transfer of personal
data to third countries. Compliance costs are usually borne by the public authorities,
companies and other organisations that collect data from individuals.
98. As individuals become more sensitive to the use of their personal data and expect
their privacy to be protected, discussions are ongoing in a number of countries to strengthen
applicable laws and regulate data collection and exploitation by organisations (OECD,
2012, 2013b). Increasingly, these rules are imposing requirements as to how and where data
is stored and processed. As exemplified by the bills currently discussed in the European
Union, and in several countries, this trend could lead to a significant change in business
models that rely on the use of personal data. For example, the obligation to make sure an
individual has expressed consent for the collection of anonymous data, notably in cookies,
could affect the user experience while surfing on web pages and make it more difficult to
target or retarget advertising banners or clicks.
3.3. The interactions between various layers of information and communication

technology (ICT): a conceptual overview
99. One way to picture the ICT sector is to focus on interactions between different layers,
each characterised by a mix of both hardware and software. This approach is illustrated in
Figure3.6.
100. At the base lies the infrastructure of the Internet, which consists of the cables, tubes,
routers, switches, and data centres that are designed and manufactured by firms specialised
in network interconnection, and operated by ISPs, carriers, and network operators. Content
delivery network operators, whose goal is to serve content to end users with high availability
and high performance, pay ISPs, carriers, and network operators for hosting servers in their
data centres. Internet protocol (IP) addresses and domain names are managed at this level.
Figure3.6. A layered view of ICT

Users
User Interface
Accessibility
Information
Applications
Software Resources
Infrastructure
101. Immediately above, stored in servers that are located in data centres and organisations
all around the world, are the core software resources that enable organisations to create
applications, which can consist of raw data, digital content, or executable code. These can
include both resources produced by organisations and resources derived from individual
users and collected and stored by organisations for later use.
102. On top of these core resources is a layer of tools providing the fundamental accessibility
necessary to allow software resources to be combined on top of the infrastructure to create
applications usable by individual or business end users. This layer effectively provides the
structure necessary for software applications to take advantage of the underlying infrastructure
and core software resources of the Internet. This accessibility can be provided in many forms.
An operating system that makes it possible to run applications on digital devices, for example,
is one of the most familiar ways in which accessibility is provided: it allows a developer to
design an application to be run on a certain device. The core higher-level protocols that allow
communication of data between applications, such as the HTTP that forms the foundation of
data communication on the World Wide Web, or the SMTP that provides a standard for email
transmission, are another form of accessibility. Other ways to provide accessibility include web
services, application programming interfaces (API), and software development kits (SDKs),
all of which provide ways for applications usable by end users to connect with the resources
necessary to connect to underlying resources.
103. The accessibility layer effectively provides platforms for the creation of applications
that are usable by end users, and that are able to access the core software resources on top
of the infrastructure. Those applications form the fourth layer of the digital economy. An
application is a combination of software resources creating value for the end user through
the provision of goods or services. Applications can fit together or link to one another:
for instance, a web browser is an application, and it gives access to websites that are
themselves web-based applications; an app store is also an application with a value proposal
that is to allow users to discover and purchase other applications. Within the application
layer are applications performing a gatekeeping function, retaining user information and
allowing it to be combined with other resources only when necessary and with the express
consent of the end user. These gatekeeping activities include authentication of users,
payment, and geolocation, all of which involve collection and use of data so sensitive that
a certain level of trust is required between the organisation and the user.

104. The next conceptual layer is the machine-to-human interface layer. An interface
represents the user experience. The interface is displayed through a physical point of
contact that can be either a device or a whole place (such as a store). Devices are of two
kinds: they are generic when they support many applications; they are non-generic when
only one application can run on them. For instance, a computer, a smartphone or a tablet
are generic devices. A connected thermostat is a non-generic device. Certain devices, like
connected cars, were generally non-generic in the early stages of their development, but
become progressively more generic as they are equipped with more accessibility features
(such as an operating system).
105. At the top of the chart, above the layers of functions, sit the users, who can be either
individuals acting in their personal capacity or on behalf of a business. These individuals
interact directly with the interface layer to access applications, either directly or through
the services of another application acting as a gatekeeper.
106. Each layer is provided with hardware resources, software resources, and network
connectivity. Resources can be stored at multiple levels: in data centres at the infrastructure
level; in virtual servers located in the cloud; and on user devices (a computer or a tablet for
instance). The business relationships between the layers are generally relationships between
clients and providers: a company that operates a business in only one layer is generally
paid by a company operating a business in the layer above. For instance, cloud computing
operators that provide accessibility make payments to infrastructure operators and are paid
by application developers. A company operating at the top layer derives payments directly
from its interactions with end users, either by charging them money or through generation
of value that can then be monetised by the company to derive income from another
customer or business. The organisations that are paid at the top level are those operating
connected devices, gate-keeping activities or an application that is tethered neither to a
device nor to a gate-keeping capacity.
107. In general terms, several business models in the digital economy can be described
in terms of vertical integration between layers. For example, traditional web businesses use
software resources (layer2) and rely on open protocols (like HTTP) (layer3) to combine
those resources into a web application (layer4). They pay operators of the bottom layer
to put their application on line, and their interactions with users generate revenue either
directly from the user in the form of payment (which can be received directly or through
a gatekeeping operator), or indirectly through the generation of value that can then be
monetised elsewhere in the business model.
108. These interactions explain why some companies consider it critical to operate at
the top, especially by providing applications performing gatekeeping functions. In fact
gatekeepers are able to collect data from their users, analyse them and eventually make
them available for developers to power even more applications (and collect even more data),
or market them to other companies (advertising). This also explains the creation of large
ecosystems based on a dominant position in the market of gatekeeping, accessibility and
sometimes the operation of devices.
Note
1.
User sensitivity has triggered waves of protest against certain features, practices or terms of
service carried out by some companies with respect to personal data. In reaction, companies
have often rolled back the features and even set up new ones to help their users control and
protect their private information. It is worth noting as well that the collection and use of
personal data is a closely regulated area across the OECD, with most legislation tracking the
main elements of the OECD Privacy Guidelines.
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4. The digital economy, new business models and key features 51
Chapter4
The digital economy, new business models and key features
This chapter discusses the spread of information and communication technology

(ICT) across the economy, provides examples of business models that have emerged
as a consequence of the advances in ICT, and provides an overview of the key
features of the digital economy that are illustrated by those business models.
52 4. The digital economy, new business models and key features
4.1. The spread of ICT across business sectors: the digital economy
109. All sectors of the economy have adopted ICT to enhance productivity, enlarge
market reach, and reduce operational costs. This adoption of ICT is illustrated by the
spread of broadband connectivity in businesses, which in almost all countries of the
Organisation for Economic Co-operation and Development (OECD) is universal for large
enterprises and reaches 90% or more even in smaller businesses.
Figure4.1. Broadband connectivity, by size, 2010 and 2014.
Percentage of enterprises in each employment size class
%
All enterprises, 2014
10-49
50-249
250+
100
90
80
70
60
Ne Fin
th lan
er d
la
nd
Ko s
De re
nm a
Sl ar
o
Sw v k
itz eni
er a
la
Ca nd
na
Lu S da
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Cz em pain
ec bo
h u
Re rg
Co pub
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m
Sw bia
ed
Au e
st n
r
Ne A alia
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Ze ria
al
a
Es nd
t
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Fr m
an
Ir ce
Un G elan
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d
Ki an
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do
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tv
ia
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Slo I ga
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Tu nd
Hu rke
ng y
a
Gr ry
ee
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Ja e
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M n
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ico
50
org/10.1787/9789264232440-en.
110. The widespread adoption of ICT, combined with the rapid decline in price and
increase in performance of these technologies, has contributed to the development of new
activities in both the private and public sector. Together, these technologies have expanded
market reach and lowered costs, and have enabled the development of new products and
services. These technologies have also changed the ways in which such products and
services are produced and delivered, as well as the business models used in companies
ranging from multinational enterprises (MNEs) to start-ups. They also support activity
by individuals and consumers, and have led to the creation of new payment mechanisms
including new forms of digital currencies. The advent of the Internet brought major
changes first to the entertainment, news, advertising, and retail industries. In those
industries, the first major digital players initially started from traditional business models,
adapting them to better end-user equipment (both inside and outside organisations) and
more extensive interconnection through the Internet.
111. For example, online retailers initially adapted the business model of brick-andmortar stores by selling traditional physical goods (for example, books) digitally. Online
intermediaries that allowed the discovery, sale, and purchase of goods and services such as
vehicles, homes, and jobs were another early category. Other digital players specialised in
the online selling of traditional services (for example, online insurance brokers). Retailers
then began selling digital products and services, like downloadable and streaming music
and movies, executable code, games, and services based on data processing, increasingly
blurring the line between goods and services as businesses continued to develop. Online
advertising similarly started from traditional advertising business models, becoming
more sophisticated as the potential of digital technology became fully integrated into the
industry. New online services enabling a sharing and service economy have also appeared,
allowing people to rent out their homes, vehicles and skills to third parties.
112. As technology has advanced and costs of ICT have continued to fall, ICT has
proven to be general-purpose technology that has become embedded in and central to the
business models of firms operating across the economy. Businesses across all sectors are
now able to design and build their operating models around technological capabilities,
in order to improve flexibility and efficiency and extend their reach into global markets.
Businesses across all sectors have changed the way their business is conducted by
taking advantage of advances in communications and data processing capacity to lower
transaction costs and extend their reach into global markets.
113. These advances, coupled with liberalisation of trade policy and reduction in
transportation costs, have expanded the ability of businesses in all sectors to take advantage
of global value chains in which production processes can be geographically dispersed in
locations around the world to take advantage of the features of local markets. For example,
in sectors relying heavily on technology and research and development, design and
production can be managed centrally, while the assembly can be fragmented in different
countries to take advantage of skilled labour and local resources.
114. Sectors as diverse as retail, logistics and education have changed and keep changing
due to the spread of ICT:
Retail: The digital economy has enabled retailers to allow customers to place
online orders (often fulfilled from a local store) and has made it easier for retailers
to gather and analyse data on customers, to provide personalised service and
advertising. It has also enabled retailers to manage logistics and supply stores with
products, which has had a significant, positive impact on productivity.
Transport and Logistics: The logistics sector has been transformed by digital
economy, which enables the tracking of both vehicles and cargo across continents,
the provision of information to customers and facilitates the development of new
operational processes such as Just In Time delivery in the manufacturing sector.
Vehicle telemetry also helps maximise fuel efficiency, ensure efficient use of
the transport network and support fleet maintenance activities. The information
collected by fleets can also be used to create datasets with commercial value.
Financial Services: Banks, insurance providers and other companies, including
non-traditional payment service providers, increasingly enable customers to
manage their finances, conduct transactions and access new products on line,
although they still continue to support branch networks for operations. Better use
of data also allows growth in customer insights and associated products, such as
personalised spending analysis, which can be used to generate advertising revenue.
The digital economy has also made it easier to track indices and manage investment
portfolios and has enabled specialist businesses such as high-frequency trading.
Manufacturing and Agriculture: The digital economy has enhanced design and
development, as well as the ability to monitor production processes in factories and
control robots, which has enabled greater precision in design and development and
ongoing product refinement. The products being produced are also increasingly
knowledge-intensive. In the automobile industry, for example, it is estimated that

90% of new features in cars have a significant software component. On farms,
systems can monitor crops and animals, and soil/environmental quality. Increasingly,
routine processes and agricultural equipment can be managed through automated
systems.
Education: As the digital economy spreads, universities, tutor services and other
education service providers are able to provide courses remotely without the need
for face to face interaction through technologies such as video conferencing and
streaming and online collaboration portals, which enables them to tap into global
demand and leverage brands in a way not previously possible.
Healthcare: The digital economy is revolutionising the healthcare sector, from
enabling remote diagnosis to enhancing system efficiencies and patient experience
through electronic health records. It also allows opportunities for advertising, for
example of drugs and other treatments.
Broadcasting and Media: The digital economy has dramatically changed the
broadcasting and media industry, with increasing broadband access in particular
opening new avenues for delivery of content for traditional media players, while
also enabling the participation in the news media of non-traditional news sources,
and expanding user participation in media through user-generated content and
social networking. The digital economy has also enhanced the ability of companies
to collect and use information about the viewing habits and preferences of
customers, to enable them to better target programming.
115. As digital technology is adopted across the economy, segmenting the digital economy
is increasingly difficult. In other words, because the digital economy is increasingly
becoming the economy itself, it would be difficult, if not impossible, to ring-fence the
digital economy from the rest of the economy. Attempting to isolate the digital economy as
a separate sector would inevitably require arbitrary lines to be drawn between what is digital
and what is not. As a result, the tax challenges and base erosion and profit shifting (BEPS)
concerns raised by the digital economy are better identified and addressed by analysing
existing structures adopted by MNEs together with new business models and by focusing
on the key features of the digital economy and determining which of those features raise or
exacerbate tax challenges or BEPS concerns, and developing approaches to address those
challenges or concerns.
4.2. The digital economy and the emergence of new business models
116. The digital economy has given rise to a number of new business models. Although
many of these models have parallels in traditional business, modern advances in ICT have
made it possible to conduct many types of business at substantially greater scale and over
longer distances than was previously possible. This section discusses several prominent
examples of these new business models. Some of these business models may complement
each other and in some cases overlap with each other (for example, payment services could
be described under e-commerce or under cloud computing). The business models discussed
below are by no means exhaustive. Indeed, just as innovation in the digital economy
allows the rapid development of new business models, it can also quickly cause existing
businesses to become obsolete. The types of business discussed include several varieties
of e-commerce, app stores, online advertising, cloud computing, participative networked
platforms, high speed trading, and online payment services.
4.2.1. Electronic commerce

117. Electronic commerce, or e-commerce, has been defined broadly by the OECD
Working Party on Indicators for the Information Society as the sale or purchase of
goods or services, conducted over computer networks1 by methods specifically designed
for the purpose of receiving or placing of orders. The goods or services are ordered by
those methods, but the payment and the ultimate delivery of the goods or service do not
have to be conducted online. An e-commerce transaction can be between enterprises,
households, individuals, governments, and other public or private organisations (OECD,
2011). E-commerce can be used either to facilitate the ordering of goods or services that are
then delivered through conventional channels (indirect or offline e-commerce) or to order
and deliver goods or services completely electronically (direct or on-line e-commerce).
Although e-commerce covers a broad array of businesses, this section provides an
illustration of some of the more prominent types.
4.2.1.1. Business-to-business models

118. The vast majority of e-commerce consists of transactions in which a business sells
products or services to another business (so-called business-to-business (B2B)) (OECD,
2011). This can include online versions of traditional transactions in which a wholesaler
purchases consignments of goods online, which it then sells to consumers from retail outlets.
It can also include the provision of goods or services to support other businesses, including,
among others: (i)logistics services such as transportation, warehousing, and distribution;
(ii)application service providers offering deployment, hosting, and management of packaged
software from a central facility; (iii)outsourcing of support functions for e-commerce, such
as web-hosting, security, and customer care solutions; (iv)auction solutions services for the
operation and maintenance of real-time auctions via the Internet; (v)content management
services, for the facilitation of website content management and delivery; and (vi)web-based
commerce enablers that provide automated online purchasing capabilities.
4.2.1.2. Business-to-consumer models

119. Business-to-consumer (B2C) models were among the earliest forms of e-commerce.
A business following a B2C business model sells goods or services to individuals acting
outside the scope of their profession. B2C models fall into several categories, including, for
example, so-called pureplay online vendors with no physical stores or offline presence,
click-and-mortar businesses that supplemented existing consumer-facing business with
online sales, and manufacturers that use online business to allow customers to order and
customise directly.
120. The goods or services sold by a B2C business can be tangible (such as a CD of music)
or intangible (i.e.received by consumers in an electronic format). Through digitisation of
information, including text, sound, and visual images, an increasing number of goods and
services can be delivered digitally to customers increasingly remote from the location of the
seller. B2C e-commerce can in many cases dramatically shorten supply chains by eliminating
the need for many of the wholesalers, distributors, retailers, and other intermediaries that
were traditionally used in businesses involving tangible goods. Partly because of this
disintermediation, B2C businesses typically involve high investment in advertising and
customer care, as well as in logistics. B2C reduces transaction costs (particularly search
costs) by increasing consumer access to information. It also reduces market entry barriers, as
the cost of maintaining a website is generally cheaper than installing a traditional brick-andmortar retail shop.
4.2.1.3. Consumer-to-consumer models

121. Consumer-to-consumer (C2C) transactions are becoming more and more common.
Businesses involved in C2C e-commerce play the role of intermediaries, helping individual
consumers to sell or rent their assets (such as residential property, cars, motorcycles, etc.) by
publishing their information on the website and facilitating transactions. These businesses
may or may not charge the consumer for these services, depending on their revenue model.
This type of e-commerce comes in several forms, including, but not limited to: (i)auctions
facilitated at a portal that allows online bidding on the items being sold; (ii)peer-to-peer
systems allowing sharing of files between users; and (iii)classified ads portals providing an
interactive, online marketplace allowing negotiation between buyers and sellers.
4.2.1.4. Growth of e-commerce

122. The Internet facilitates transactions such as ordering goods and services. This
means that many transactions that would have taken place without the Internet can be
conducted more efficiently and at less expense. As a result, the number of firms carrying
out business transactions over the Internet has increased dramatically over the last decade.
123. For example, e-commerce in the Netherlands has increased as a share of total
company revenue from 3.4% in 1999 to 14.1% in 2009. Similarly, between 2004 and 2011
this share increased from 2.7% to 18.5% in Norway and from 2.8% to 11% in Poland.
Based on comparable data, as illustrated in Figure4.2, e-commerce is nearing 20% of total
turnover in Finland, Hungary, and Sweden, and 25% in the Czech Republic (OECD, 2012).
124. In 2014, B2C e-commerce sales were estimated to exceed USD1.4trillion, an
increase of nearly 20% from 2013. B2C sales are estimated to reach USD2.356trillion by
2018, with the Asia-Pacific region expected to surpass North America as the top market
for B2C e-commerce sales in 2015 (Emarketer, 2014). According to the research firm
Frost and Sullivan the B2B online retail market is expected to reach double the size of
the B2C market, generating total revenues of USD6.7 trillion by 2020. Such B2B online
sales will comprise almost 27% of total manufacturing trade, which is estimated to reach
USD25trillion by 2020 (Frost and Sullivan, 2014).
Figure4.2. Turnover from e-commerce, by size, 2008 and 2012
%
45
10-49
50-249
250+
40
35
30
25
20
15
10
5
ITA
GR
C
DN
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M
EX
PO
L
AU
S
U
FR
A
BE
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ES
P
SW
E
NL
D
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T
ES
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AU
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R
GB
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SV
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FI
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OE
CD
HU
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CZ
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LU
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KO
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Source: OECD (2014), Measuring the Digital Economy, OECD Publishing, Paris, http://dx.doi.
org/10.1787/9789264221796-en.
125. The Internet has also expanded the potential reach of smaller businesses, enabling
them to reach markets that would not have been possible to reach without its existence.
So far, however, overall uptake of e-commerce by small and medium enterprise (SMEs)
has been moderate, especially across borders. Among other factors, consumer resistance
to cross-border purchases, trade and regulatory barriers (e.g.high custom administration
costs, high tariffs, inadequate property right protection) and lack of working capital to
finance exports may explain this situation (OECD Outlook, 2015).
4.2.2. Payment services

126. Paying for online transactions traditionally required providing some amount of
financial information, such as bank account or credit card information, to a vendor, which
requires a high degree of trust that is not always present in the case of an unknown vendor,
particularly in the case of a C2C transaction. Online payment service providers help address
this concern by providing a secure way to enable payments online without requiring the
parties to the transaction to share financial information with each other.
127. A payment service provider acts as an intermediary (typically using a softwareas-a-service model) between online purchasers and sellers, accepting payments from
purchasers through a variety of payment methods, including credit card payments or bankbased payments like direct debit or real-time bank transfers, processing those payments,
and depositing the funds to the sellers account. Electronic payment systems offer a number
of benefits for users, such as (i)protection against fraud, since the seller and buyer do not
exchange sensitive information; (ii)faster delivery of payment compared with traditional
payment methods; and (iii)in many cases, the ability to transact in multiple currencies.
Payment service providers typically charge a fee for each transaction completed, which
can be either a fixed charge or a percentage of the value of the transaction, though some
payment service providers also charge monthly fees or setup fees for certain additional
services.
128. A number of other alternative online payment options are in use as well, including:
Cash payment solutions, in which a customer buys online, and pays in cash with
a barcode or payment code at participating shops or settlement agencies, offering a
way for customers unwilling to use other online payment methods to make online
purchases in a secure manner.
E-wallets or cyber-wallets, which are previously charged with credits and can be
spent online as an alternative to the use of a credit card. These are often used for
micropayments because the use of a credit card for frequent small payments is not
economical.
Mobile payment solutions, which encompass all types of technologies that enable
payment using a mobile phone or smartphone, including, among others, mobile
card processing using card readers connected to smartphones, in-app payments for
virtual products, and near-field communications solutions which use short-range
wireless technology to exchange information.
129. As discussed in Chapter3, the digital economy has also given rise to virtual
currencies that can be used to purchase goods and services from businesses that agree to
accept them, acting as an alternative to payment services. In some cases, exchanges have
arisen to allow purchase and sale of these virtual currencies for real currency.
4.2.3. App stores

130. The growth of Internet access through smartphones and tablets has caused an increase
in the frequency of use of online services and the development of application stores, a type of
digital distribution platform for software, often provided as a component of an operating system.
Application stores typically take the form of central retail platforms, accessible through the
consumers device, through which the consumer can browse, view information and reviews,
purchase and automatically download and install the application on his/her device.
131. Accessibility to application stores varies. Some application stores are only usable by
consumers with a particular device. These stores may represent the sole way for users of
that device to obtain applications, or may represent one of several possible means for users
to obtain applications. Some application stores are accessible by consumers of any device
using a particular operating system. Others are usable by consumers with service contracts
with a particular network operator. Finally, certain others are freely accessible and are not
dependent on the type of device, proprietary software, or service provider.
132. App stores will typically include both applications developed by the business
operating the app store (typically, an operating system developer, device manufacturer, or
telecommunications network provider), or by a third-party developer. Applications may
be downloaded for free or for a fee. Free applications may be supported by advertising.
In addition, applications are increasingly moving to a freemium model, in which basic
functionality is provided for free, but customers may pay for additional content or features.
133. An application store will typically feature applications produced by developers in
multiple countries. In addition, while many app stores are targeted at customers in particular
geographic markets, applications are often cross listed on multiple app stores targeted at
multiple geographic regions.
134. Use of application stores is growing rapidly. Gartner, Inc., an information technology
research and advisory company, estimated that downloads from app stores would reach
102billion in 2013, up from 64billion in 2012.
135. Total revenue from app store purchases was expected to exceed USD26billion
in 2013, an increase of 31% over the total in 2012. As noted above, free applications are
becoming increasingly prevalent, and are expected by 2017 to account for 94.5% of total
downloads, with in-app purchases accounting for 48% of total app store revenues.
4.2.4. Online advertising

136. Online advertising uses the Internet as a medium to target and deliver marketing
messages to customers. Internet advertising offers a number of advantages over traditional
advertising. For example, many Internet advertisers have developed sophisticated methods
for segmenting consumers in order to allow more precise targeting of ads. Many Internet
advertising publishers have also developed ways for clients to monitor performance of ads,
tracking how users interact with their brands and learning what is of interest to current and
prospective customers. Online advertising takes a number of forms, the most prominent
of which are display ads, in which an advertiser pays to display ads linked to particular
content or user behaviour, and search engine ads, in which an advertiser pays to appear
among Internet search results.
137. Online advertising involves a number of players, including web publishers, who agree
to integrate advertisements into their online content in exchange for compensation, advertisers,
who produce advertisements to be displayed in the web publishers content and advertising
network intermediaries, who connect web publishers with advertisers seeking to reach an
online audience. Advertising network intermediaries include a range of players, including
search engines, media companies, and technology vendors. These networks are supported by
data exchanges, marketplaces in which advertisers bid for access to data about customers that
has been collected through tracking and tracing of users online activities. These data can be
analysed, combined, and processed by specialist data analysers into a user profile.
138. In advertising-based business models, publishers of content are frequently willing
to offer free or subsidised services to consumers in order to ensure a large enough audience
to attract advertisers. The most successful advertising companies have been those that
combine a large user base with sophisticated algorithms to collect, analyse, and process
user data in order to allow targeted advertisements. While traditional advertising involved
payment for display of ads for a specified period of time, with little way to monitor
visibility or user response, online advertising has given rise to a number of new payment
calculation methods, including cost-per-mille (CPM), in which advertisers pay per thousand
displays of their message to users, cost-per-click (CPC), in which advertisers pay only when
users click on their advertisements, and cost-per-action (CPA), in which advertisers only
pay when a specific action (such as a purchase) is performed by a user.
139. Internet advertising is rapidly growing, both in terms of total revenues and in terms
of share of the total advertising market. PwC estimates that Internet advertising reached
USD135.4billion in 2014. The market for Internet advertising is projected to grow at a
rate of 12.1% per year during the period from 2014 to 2019, reaching USD239.8billion in
2019. Internet advertising would by that point surpass television as the largest advertising
medium. Within the online advertising market, search advertisement holds the greatest
share. Paid search Internet advertising revenue is forecast to grow from USD53.13billion
in 2014 to USD85.41billion in 2019, accounting for over 35% of total Internet advertising
by then, although video and mobile advertising are experiencing rapid growth. While video
Internet advertising only accounted for 4.7% of total Internet advertising revenue in 2014, it
is expected to grow at over 19% a year, rising from USD6.32billion to USD15.39billion in
2019. Similarly, mobile Internet advertising grew from just 5% of total Internet advertising
in 2010 to 16.7% of the global share in 2014 and is expected to increase as mobile devices
continue to proliferate (PwC, 2015).
4.2.5. Cloud computing

140. Cloud computing is the provision of standardised, configurable, on-demand, online
computer services, which can include computing, storage, software, and data management,
using shared physical and virtual resources (including networks, servers, and applications).2
Because the service is provided online using the providers hardware, users can typically
access the service using various types of devices wherever they are located, provided they
have a suitable Internet connection.
141. The resources to which cloud computing customers are granted access are not stored
on a single computer. Instead, they are on many networked computers that are available to
everyone who has access to that cloud of computing resources (which, depending on the
cloud, could be a single organisation, a community of organisations, the general public,
or some combination thereof). The system copies each users data and software to other
servers, which allows it to allocate requests for hardware resources to whatever physical
location is best able to satisfy the demand efficiently. Each user has access to a large amount
of computer resources when needed, and only when needed. This redundancy ensures that
the failure of one machine will not lead to loss of data or software.

142. Cloud computing often provides customers with a cost effective alternative to
purchasing and maintaining their own IT infrastructure, since the cost of the consumer
resources is generally shared among a wide user base. The advantages of cloud computing
are largely driven by economies of scale in setting up the infrastructure and maximising
server usage by sharing space among clients whose needs for space and processing power
may vary on a flexible basis.
143. The most common examples of cloud computing service models are:
Infrastructure-as-a-service: In the most basic cloud-service model, providers of
infrastructure as a service (IaaS) offer computers physical or (more often) virtual
machines and other fundamental computing resources.IaaS clouds often offer
additional resources such as a virtual-machine disk image library, raw (block) and
file-based storage, firewalls, load balancers, Internet Protocol (IP) addresses, virtual
local area networks (VLANs), and software bundles. The customer does not manage
or control the underlying cloud infrastructure, but has control over the operating
system, storage, and deployed applications, and may be given limited control of
select networking components (e.g.host firewalls).
Platform-as-a-service: Platform as a service is a category of cloud computing
services that provides a computing platform and programming tools as a service for
software developers. Software resources provided by the platform are embedded
in the code of software applications meant to be used by end users. The client does
not control or manage the underlying cloud infrastructure, including the network,
servers, operating systems, or storage, but has control over the deployed applications.
Software-as-a-service: A common form of cloud computing in which a provider
allows the user to access an application from various devices through a client
interface such as a web browser (e.g.web-based email). It can be provided either to
business customers (B2B) or individual customers (B2C). Unlike in the old software
vendor models, the code is executed remotely on the servers, thereby freeing the
user of the necessity to upgrade when a new version is available the executed
version is always the latest, which means that new features go instantaneously to
market without friction. The consumer generally does not manage or control the
underlying cloud infrastructure, including the network, servers, operating systems,
storage, or individual application capabilities, with the possible exception of limited
user-specific application configuration settings.
144. Other X-as-a Service (XaaS) concepts include content or data:
Content-as-a-service: Where rights are obtained and software is provided to allow
content to be embedded by purchasers, content can be purchased as a service. This
has been used particularly in the case of user-created content.
Data-as-a-service: Data from multiple sources can be aggregated and managed by
a service provider, so that controlled access to that data can be granted to entities
that may be geographically and organisationally removed from each other, without
each entity needing to develop or acquire the infrastructure necessary to prepare
and process that data.
145. In the consumer markets, many cloud services (e.g.email, photo storage, and social
networks) have been provided free of charge, with revenue generated through advertising
or the sale of data on user behaviour, or on a freemium basis in which basic services are
provided for free and expanded services require payment. Other consumer cloud services,
such as web hosting or hard drive backup, are sold on a monthly subscription basis. In B2B
markets, cloud services are most typically sold by subscription, although pay as you go
models are increasingly available.
146. In recent years, diffusion of different cloud computing applications and services
among businesses has accelerated. For instance in 2014, 22% of companies relied on
cloud computing services. In most countries, uptake is higher among large businesses
compared to SMEs (OECD Outlook, 2015). Further, businesses more frequently invest in
cloud computing services with a high level of sophistication, such as finance/accounting
software, CRM software and computing power, than less sophisticated services such as
emails, office software or file storage, as seen in Figure4.4 (OECD Outlook, 2015).
Figure4.3. Use of cloud computing by enterprises, 2014
%
60
50
40
30
20
10
Ita
l
Sw y
ed
De en
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ar
No k
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la
nd
s
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d
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m
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ai
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Fr
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Au
st
Ge ria
rm
an
Hu y
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ar
y
Gr
ee
ce
Po
la
nd
nd
la
Ice
Fin
la
nd
Source: Eurostat, Information Society Statistics, January 2015 in OECD (2015), Digital Economy Outlook
2015, OECD Publishing Paris, http://dx.doi.org/10.1787/9789264232440-en.
Figure4.4. Enterprises using cloud computing services by type of services, 2014

Buy high CC services (accounting software applications, CRM software, computing power)
Buy only medium CC services (e-mail, office software, storage of files, hosting of the enterprises database)
Buy only low CC services (e-mail, office software, storage of files)
%
80
70
60
50
40
30
20
10
Ita
l
Sw y
ed
De en
nm
ar
No k
r
Ne
w
th ay
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la
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s
Un
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la
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d
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do
m
B
Slo elg
i
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ep
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S
Cz love
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h
Re a
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Es
to
ni
a
Sp
ai
Po n
Lu rtug
xe
al
m
bo
ur
g
Fr
an
ce
Au
st
Ge ria
rm
an
Hu y
ng
ar
y
Gr
ee
ce
Po
la
nd
nd
la
Ice
Fin
la
nd
Source: Eurostat, Information Society Statistics, January 2015, in OECD (2015) Digital Economy Outlook
2015, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264232440-en.
4.2.6. High frequency trading

147. High frequency trading uses sophisticated technology, including complex computer
algorithms, to trade securities at high speed. Large numbers of orders which are typically
fairly small in size are sent into the markets at high speed, with round-trip execution times
measured in microseconds. The parameters for the trades are set with algorithms run on
powerful computers that analyse huge volumes of market data and exploit small price
movements or opportunities for market arbitrage that may occur for only milliseconds.
Typically, a high-frequency trader holds a position open for no more than a few seconds. In
other words, high frequency trading firms profit mostly from small price changes exploited
through small, but frequently executed trades.
148. Because trades are conducted entirely electronically, high frequency trading generally
does not require personnel in the country where the infrastructure used to make trades
is located. The implementation and execution of successful trading strategies depends on
several factors, including the development of algorithms for trading, as well as writing
programmes to monitor losses and performance and to automatically shut down trading to
avoid fast-accruing losses. In addition, high frequency trading depends on the ability to be
faster than competitors, which means that it is extremely sensitive to latency. As a result, the
location of the server is extremely important to the business, with servers located close to the
relevant exchange providing a meaningful advantage over servers located farther away. As a
result, financial institutions offer installation of trading engines directly adjacent to their own
infrastructure, minimising network latency.
4.2.7. Participative networked platforms

149. A participative networked platform is an intermediary that enables users to collaborate
and contribute to developing, extending, rating, commenting on and distributing user-created
content. User created content (UCC) comprises various forms of media and creative works
(written, audio, visual, and combined) created by users. A range of different distribution
platforms have been created, including text-based collaboration formats such as blogs or
wikis, group-based aggregation and social bookmarking sites, social networking sites,
podcasting, and virtual worlds. In general, UCC is created without the expectation of profit.
The participative platform featuring the UCC, however, may monetise the UCC in a variety
of ways, including through voluntary contributions, charging viewers for access on a peritem or subscription basis, advertising-based models, licensing of content and technology to
third parties, selling goods and services to the community, and selling user data to market
research or other firms.
150. Social networking applications are possibly the best known participative networked
platform but the same model is also used in other areas, like fashion design, toy design,
and computer games just to name a few. Collaborative production methods are not yet
widespread in practice for product development, but some firms are using them intensively
and with success, as illustrated below in Figure4.5. The most common practice is to
involve customers via social media and through feedback. In the 28 EU member countries,
almost 10% of enterprises are currently involving customers in the development or
innovation of goods and services (see Figure4.6).
Figure4.5. Customer involvement in product development, 2013

Involve customers in development or innovation of goods or services
Have website allowing to customise or design products
20
18
16
14
12
10
8
6
4
2
Lat
v ia
Au
stri
a
Lux
em
bou
rg
Cze
ch R
epu
blic
Slo
vak
Rep
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ic
Pol
and
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oni
a
Hu
nga
ry
Ge
rm
any
Fra
nce
nm
ar k
De
Bel
giu
m
Ital
y
EU2
ece
Slo
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Gre
Spa
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la
nd
Sw
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n
Por
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Uni
al
ted
Kin
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m
Irel
and
Ne
the
r
lan
d
Note: Unless otherwise stated, sector coverage consists of all activities in manufacturing and non-financial
market services. Only enterprises with ten or more persons employed are considered.
Source: Eurostat, Information Society Statistics, January 2015, in OECD (2015), OECD Digital Economy
Outlook 2015, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264232440-en.
Figure4.6. Enterprises engaging with customers in product development, 2013

Use social media with customers
Have website allowing to customise or design products
Involve customers in development or innovation of goods or services
%
50
45
40
35
30
25
20
15
10
5
Irel
and
Sw
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Uni
n
ted
Kin
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Cyp
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Au
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ch R
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nds
12 http://dx.doi.org/10.1787/9789264232440-graph94-en
Notes: 1. Unless otherwise stated, sector coverage consists of all activities in manufacturing and non-financial
market services. Only enterprises with ten or more persons employed are considered.

2. Note by Turkey: The information in this document with reference to Cyprus relates to the southern
part of the Island. There is no single authority representing both Turkish and Greek Cypriot people
on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting
and equitable solution is found within the context of United Nations, Turkey shall preserve its
position concerning the Cyprus issue.

Note by all the European Union Member States of the OECD and the European Union: The Republic
of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The
information in this document relates to the area under the effective control of the Government of the
Republic of Cyprus.
Source: Eurostat, Information Society Statistics, January 2015, in OECD (2015), OECD Digital Economy
Outlook 2015, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264232440-en.
Box4.1. Diversity of revenue models

The diversity of businesses in the current digital economy is illustrated by the variety of
ways in which businesses turn value into revenue. The most common revenue models include
the following:
i. Advertising-based revenues. One version of this model offers free or discounted digital
content to users in exchange for requiring viewing of paid-for advertisements. Other models
rely on providing advertising through mobile devices based on location or other factors. A
third type concerns social media websites or platforms who typically build up a large online
user community before monetising their captive audience through advertising opportunities.
ii. Digital content purchases or rentals. Users pay per item of download for instance,
e-books, videos, apps, games and music would fall into this category.
iii. Selling of goods (including virtual items). This category, which overlaps to a degree with (i),
would include online retailers of tangible goods but could also cover online gaming, where
users are offered a free or discounted introductory product but are also offered purchasable
access to additional content or virtual items to enhance the experience.
iv. Subscription-based revenues. Examples include annual payments for premium delivery
with online retailers, monthly payments for digital content including news, music, videostreaming, etc. It could also include regular payments for software services and maintenance
such as anti-virus software, data storage, customer help services for operating systems, and
payment for access to the Internet itself.
v. Selling of services. This category overlaps with (iv) but would include traditional services
which can be delivered online such as legal services (e.g.e-conveyancing), financial
services (e.g.brokerage), consultancy services, travel agency etc. It would also include a
large range of B2B services linked to enterprises who provide core Internet access and act
as Internet intermediaries (web hosting, domain registration, payment processing, platform
access, etc.).
vi. Licensing content and technology. Again, this category overlaps with (iv) and (v) but
might typically include access to specialist online content (e.g.publications and journals),
algorithms, software, cloud based operating systems, etc., or specialist technology such as
artificial intelligence systems.
vii. Selling of user data and customised market research. Examples include Internet service
providers (ISPs), data brokers, data analytics firms, telemetrics and data gained from nonpersonal sources.
viii. Hidden fees and loss leaders. There may be instances in integrated businesses where
profits or losses may be attributable to online operations but because of the nature of the
business, cross-subsidy with physical operations occurs and it is difficult to separate and
identify what should be designated as online revenue. An example might include online
banking, which is offered free but is subsidised through other banking operations and fees.
4.3. Key features of the digital economy

151. There are a number of features that are increasingly prominent in the digital
economy and which are potentially relevant from a tax perspective. While these features
may not all be present at the same time in any particular business, they increasingly
characterise the modern economy. They include:
Mobility, with respect to (i)the intangibles on which the digital economy relies
heavily, (ii)users, and (iii)business functions as a consequence of the decreased
need for local personnel to perform certain functions as well as the flexibility in
many cases to choose the location of servers and other resources.
Reliance on data, including in particular the use of so-called big data.

Network effects, understood with reference to user participation, integration and
synergies.
Use of multi-sided business models in which the two sides of the market may be in
different jurisdictions.
Tendency toward monopoly or oligopoly in certain business models relying heavily
on network effects.
Volatility due to low barriers to entry and rapidly evolving technology.
4.3.1. Mobility
4.3.1.1. Mobility of intangibles
152. Development and exploitation of intangibles is a key feature of the digital economy.
This investment in and development of intangibles is a core contributor to value creation
and economic growth for companies in the digital economy. For example, digital companies
often rely heavily on software, and will expend substantial resources on research and
development to upgrade existing software or to develop new software products.
153. This heavy reliance on intangibles can be present even where technology is
incorporated into a business model primarily to manage wholly tangible resources. For
example, an online retailer may develop a multi-layer digital activity to manage a logistic
platform including warehouses and shipping capacity. As businesses evolve, the relative
importance of these intangibles frequently grows, resulting in further concentration of
value in the intangibles. Under existing tax rules, the rights to those intangibles can often be
easily assigned and transferred among associated enterprises, with the result that the legal
ownership of the assets may be separated from the activities that resulted in the development
of those assets.
4.3.1.2. Mobility of users and customers

154. Advances in ICT and the increased connectivity that characterises the digital
economy mean that users are increasingly able to carry on commercial activities remotely
while traveling across borders. An individual can, for example, reside in one country,
purchase an application while staying in a second country, and use the application
from a third country. Challenges presented by the increasing mobility of consumers are
exacerbated by the ability of many consumers to use virtual personal networks or proxy
servers that may, whether intentionally or unintentionally, disguise the location at which the
ultimate sale took place. The fact that many interactions on the Internet remain anonymous
may add to the difficulty of the identity and location of users.
4.3.1.3. Mobility of business functions

155. As noted above, improved telecommunications, information management
software, and personal computing have significantly decreased the cost of organising and
co-ordinating complex activities over long distances. As a result, businesses are increasingly
able to manage their global operations on an integrated basis from a central location that
may be removed geographically from both the locations in which the operations are carried
out and the locations in which their suppliers or customers are located.

156. One impact of these changes has been an expansion of the ability to access remote
markets, which has substantially increased the ability to provide those goods and services
across borders. This has been illustrated by the dramatic growth of international trade
in ICT services in recent years. In particular, since 2000, the share of Computer and
Information services on world exports of services doubled from 3% to 6%, while that of
Telecommunication services increased from 2.2% to 2.3% (OECD, 2013). For the OECD,
the combined share of Computer and Information and Communication services rose from
5.7% to 9.0% of total service exports.
157. Several important shifts in the provision of ICT services have occurred in recent
years. India has quickly become the leading exporter of ICT services, followed by Ireland,
the United States, Germany, and the United Kingdom. China as well became one of the major
exporters. These six countries together represent about 60% of total exports of ICT services.
Figure4.7. Exporters of ICT services, 2013
Percentage shares of total world services exports in USD billions
6
12
10
8
6
4
Value in USD billions
4
1
0.8
0.6
0.4
0.2
0
0.7 0.6 0.6 0.6 0.4 0.4
0.1
Magnified
PO
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%
52 52 38 33 27 17 16 13 12 11 10 10 9
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12 http://dx.doi.org/10.1787/9789264232440-graph5-en
For Denmark, data refer to 2004 instead of 2001. For Chile, Iceland and Israel, data refer to 2012. For
Luxembourg, data refer to 2002 instead of 2001. For Mexico and Switzerland, ICT services only include
communications services.
The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities.
The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and
Israeli settlements in the West Bank under the terms of international law.
org/10.1787/9789264232440-en.
158. In addition, technological advances increasingly make it possible for businesses to

carry on economic activity with minimal need for personnel to be present. In many cases,
businesses are able to increase substantially in size and reach with minimal increases in the
number of personnel required to manage day-to-day operation of the businesses (so-called
scale without mass). This has been particularly true in the case of Internet businesses,
which have in many cases quickly amassed huge numbers of users while maintaining
modest workforces. As a result, the average revenue per employee of top Internet firms,
as shown in Figure4.8, is substantially higher than in other types of businesses within the
ICT sector.
Figure4.8. Average annual revenue per employee of the top 250 ICT firms by sector,
2000-113
USD thousands
1 000
Internet
900
Software
800
Telecommunications
700
600
Semiconductors
500
400
Communications
equipment
300
IT equipment
200
Electronics & components
100
0
IT services
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
12 http://dx.doi.org/10.1787/888932692619
Source: OECD (2012), OECD Internet Economy Outlook 2012, OECD Publishing, Paris, http://dx.doi.
org/10.1787/9789264086463-en.
159. The ability to manage business centrally while maintaining substantial flexibility over
the location of business functions has increased the ability of businesses to spread functions
and assets among multiple different countries. While such globalisation of business among
larger organisations is certainly not a new phenomenon, the spread of the digital economy,
combined with the growing importance of the service component, as well as reductions in
trade costs due to trade and investment liberalisation and regulatory reforms, have helped
to remove logistical barriers and increase the pace at which such globalisation is possible.
Technological advances have also permitted greater integration of worldwide businesses,
which has increased the flexibility of businesses to spread their activities among several
locations worldwide, even if those locations may be distant from each other and from the
physical location of their ultimate customers. In addition to improving the flexibility of larger,
more established organisations, advances in information and communications technology
have made it more possible for even small and mid-sized businesses to reach global markets
from their inception. In short, global interconnectedness has grown to unprecedented levels.
160. Advances in technology have improved access to real-time market information and
business analytics, and have improved communications within and between firms. These
improvements have improved the capacity of businesses to manage their global operations
on an integrated basis, with individual group companies exercising their functions within
a framework of group policies and strategies set by the group as a whole and monitored
centrally. Improved telecommunications, information management software, and personal
computing have significantly decreased the cost of organising and co-ordinating complex
activities over long distances, and enabled the creation of new and more efficient business
models. This integration has made it easier for business to adopt global business models
that centralise functions at a regional or global level, rather than at a country-by-country
level. Even for SMEs, it has now become possible to be micro-multinationals that operate
and have personnel in multiple countries and continents.
161. As worldwide operations have become more integrated, production processes
increasingly take place as part of global value chains in which various stages of production
are spread across multiple different countries, and are performed by a mix of independent

and affiliated suppliers. Businesses are increasingly able to choose the optimal location
for productive activities and assets, even if that location may be distant from the location
of customers or the location of other stages of production. In addition, rapid advances in
information and communication technology have meant that services such as data entry,
information processing, research, and consulting can increasingly be carried out remotely.
These functions can be carried out by related parties, or, if a business determines that it is
more advantageous to outsource the function, by an unrelated service provider.
162. There are limits to this flexibility, however. In general, fragmentation of activities
among multiple locations involves trade-offs between lower costs for the activity itself and
higher transaction and co-ordination costs. In addition, skills and talent remain a critical
resource in the digital economy. Although many functions can be performed with limited
personnel, managers, developers, software architects, and designers, among other key
functions, remain instrumental. As a result, location of many of the substantial functions
of a digital business must occur in locations in which these key people are willing to
work. Further, although digital services can substantially expand the reach of businesses,
these digital services often require a massive investment in infrastructure components.
For example, cloud computing providers must build server farms of interconnected
computers, and while there may be some flexibility as to where these resources are located,
concerns like access to inexpensive and reliable sources of power and cooling may heavily
influence the choice of location. In addition, in many businesses the user experience is
meaningfully improved by proximity to the core infrastructure.
163. The result is that there are often compelling reasons for businesses to ensure that
infrastructure resources are placed as close as possible to where key markets of users are,
so that users experience less latency, shorter lag time, and higher quality. In addition, in
some businesses, the need for a tangible presence in a jurisdiction for regulatory reasons
may also limit choices about where to locate infrastructure and business activities.
4.3.2. Reliance on data and user participation

164. It is common in the digital economy for businesses to collect data about their
customers, users, suppliers, and operations. For example, the use of a product or service by
a user may provide data about the user that has value to the business as an input either in
improving existing products and services or in providing products and services to another
group of customers. Although businesses have always used information about interactions
with customers to improve their business offerings, digital technologies and the shift to a
participatory culture have greatly increased the ability of an enterprise to leverage and
monetise such activities. As a result, data gathered from customers and users has increased
in importance in certain businesses of the digital economy. In certain social networkingfocused business models, for instance, companies frequently report to their investors that
the active collaboration of their users is a key value-driver of the business.
165. Data can include both personalised data and data that is not personalised, and can
be obtained in a number of ways. In the case of personal data, as mentioned in Chapter3
(3.1.5 Use of data), it can be obtained directly from customers (for example, when registering
for an online service), observed (for example, by recording Internet browsing preferences,
location data, etc.), or inferred based on analysis in combination with other data. It is
estimated that sources such as online or mobile financial transactions, social media traffic,
and GPS co-ordinates generate in excess of 2.5 exabytes (billions of gigabytes) of data every
day (World Economic Forum, 2012). The dividing line between personal and non-personal
data is not always clear; however, as data obtained from multiple private and public sources
will frequently be combined in order to create value. A recent study quantifies the value
of the Data-Driven Marketing Economy (DDME) and looks at the revenues generated for
the US economy. The study found that the DDME added USD156billion in revenue to the
United States economy in 2012 and notes that the real value of data is in its application and
exchange across the DDME (Data-Driven Marketing Institute, 2013).
166. Although the use of data to improve products and services is not unique to the
digital economy, the massive use of data has been facilitated by an increase in computing
power and storage capacity and a decrease in data storage cost, as shown in Figures4.9 and
4.10, which has greatly increased the ability to collect, store, and analyse data at a greater
distance and in greater quantities than was possible before. The capacity to collect and
analyse data is rapidly increasing as the number of sensors embedded in devices that are
networked to computing resources increases. For example, while traditional data collection
for utility companies was limited to yearly measurement, coupled with random samplings
throughout the year, smart metering could increase that measurement rate to 15 minute
samples, a 35000 time increase in the amount of data collected (OECD, 2013). This has
manifested itself in particular in the concept of big data, meaning datasets large enough
that they cannot be managed or analysed using typical database management tools. Data
analytics, defined as the use of data storage and process techniques to support decisions, are
becoming a driver for innovation in a number of scientific areas and are used increasingly
in collaborative and crowd-based projects. In this regard, a text search performed on one of
the largest repositories of scientific publications shows that articles related to data mining
doubled during the last decade, as shown in Figure4.11. The value of the ability to obtain
and analyse data, and big data in particular, is increasingly well documented by market
observers.
Figure4.9. Estimated worldwide data

storage
60
9 000
8 000
56.30
HHD
SSD
50
7 000
6 000
40
40
5 000
CAGR 2005-2015: 51%
4 000
3 000
30
20
2 000
CAGR 1998-2012:
-39%
CAGR 2007-12:
-51%
10
1 000
0
20
0
20 5
0
20 6
0
20 7
0
20 8
0
20 9
1
20 0
1
20 1
1
20 2
1
20 3
1
20 4
15
1
0.05
19
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
0
20 6
0
20 7
0
20 8
0
20 9
1
20 0
1
20 1
12
exabytes (billions of gigabytes)
Figure4.10. Average data storage cost for

consumers 1998-2012
Source: OECD (2013), Exploring Data-Driven Innovation as a New Source of Growth: Mapping the Policy
Issues Raised by Big Data, OECD Digital Economy Papers, No.222, OECD Publishing, Paris, http://dx.doi.
org/10.1787/5k47zw3fcp43-en.

Figure4.11. Data mining-related scientific articles, 1995-2014
Per thousand articles
2.5
Text mining (excluding data mining)
Big data (excluding data mining)
Data mining
2
1.5
1
0.5
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
12 http://dx.doi.org/10.1787/888933147825
Source: OECD computations based on on Science Direct repository, www.sciencedirect.com, July 2014, in
OECD (2014) Measuring the Digital Economy: A New Perspective, OECD Publishing, Paris, http://dx.doi.
org/10.1787/9789264221796-en.
167. For example, in a 2011 report on big data, the McKinsey Global Institute estimated
the value that could be created through the analysis and use of big data at USD300billion in
the health sector in the United States and at EUR250billion in the general government sector
in Europe. The same report estimates that use of big data could generate a total consumer
surplus of USD600billion. Big data has substantial application in targeting government aid
and services as well. It has been used, for example, to monitor refugee movements following
natural disasters, in order to ensure that health risks could be accurately predicted and aid
could be well targeted (World Economic Forum, 2012).
168. The McKinsey Global Institute Report notes five broad ways in which leveraging
big data can create value for businesses:
i. Creating transparency by making data more easily accessible in a timely manner
to stakeholders with the capacity to use the data.
ii. Managing performance by enabling experimentation to analyse variability in
performance and understand its root causes.
iii. Segmenting populations to customise products and services.
iv. Improve decision making by replacing or supporting human decision making with
automated algorithms.
v. Improve the development of new business models, products, and services.
4.3.3. Network effects

169. Networks effects refer to the fact that decisions of users may have a direct impact on
the benefit received by other users. A simple example of this is the introduction of the fax
machine. While a single fax machine had no utility by itself, users choosing to purchase a
fax machine received the benefit of the decisions of earlier users to purchase a fax machine,
in the form of the ability to communicate through this new technology with an existing
network of potential counterparties.
170. These network effects are an important feature of many businesses in the digital
economy. Network effects are seen whenever compatibility with other users is important,
even where the primary purpose of a particular technology may not be to interact with
others. For example, a widely-adopted operating system will generally have a larger
amount of software written for it, resulting in a better user experience. These effects are
known as positive externalities, meaning situations in which the welfare of a person is
improved by the actions of other persons, without explicit compensation. For example,
when additional people join a social network, the welfare of the existing users is increased,
even though there is no explicit agreement compensation among the users for this
improvement. Externalities can also be negative. For example, as an increasing number
of persons use a communications network at the same time, congestion may decrease the
value to each user of the network, with no compensation among the affected parties (Easley
and Kleinberg, 2010).
171. Some network effects come from users marginal utility to each other: the more
users there are, the higher the value created is. A simple example is a media sharing site, in
which all content is generated by users, and the experience of users is enhanced as additional
users join and share content. Where a business model encourages interactivity among
users, it tends to encourage these network effects. For example, in certain business models,
network effects come from a competitive advantage gained from the critical mass of buyers
and sellers. A retail site may develop an architecture that encourages users to review and tag
products. These user reviews enhance the ability of users to make informed choices, while
product tagging improves their ability to find products relevant to their interests.
172. Other network effects derive from vertical integration, relying on synergies between
different layers or different applications to create added value and consolidate market
position. This is particularly illustrated by the trend toward the Internet of Things, in
which companies deploy software in many devices and objects, and leverage this web of
infrastructure to sell goods or services either to the owners of those devices or to advertisers.
In this model, hardware and software infrastructure becomes a privileged channel to get in
touch with end users and to create value by monetising their attention (advertising-based
business models), the data that flows from them, or the externalities generated through
network effects, or through selling them goods or services.
4.3.4. Multi-sided business models

173. A multi-sided business model is one that is based on a market in which multiple
distinct groups of persons interact through an intermediary or platform, and the decisions
of each group of persons affects the outcome for the other groups of persons through a
positive or negative externality. In a multi-sided business model, the prices charged to the
members of each group reflect the effects of these externalities. If the activities of one side
create a positive externality for another side (for example more clicks by users on links
sponsored by advertisers), then the prices to that other side can be increased.
174. An example of a multi-sided business model involving positive externalities for
different sides of the market is a payment card system, which will be more valuable to
merchants if more consumers use the card, and more valuable to consumers if more merchants
accept the card. Similarly, an operating system is more valuable to end users if more
developers write software for it, and more valuable to software developers if more potential
software purchasers use the operating system.
175. A negative externality from one side for another side (e.g.displays of intrusive and
unattractive advertising banners) can be offset by a lower price, or even no charge or a

reward for the users. The classic case in which one side experiences negative externalities
from the other sides participation is found in the media industry. In that case, a company
attracts users by providing content (television or radio programming, a magazine, a
trade publication, a phonebook, or a newspaper) for free or at a cost less than the cost of
production. The media company displays advertisements to its readers/listeners/viewers
and earns revenue from advertisers whose ads it displays. Alternatively, it might earn
revenue from selling information about its readers/listeners/viewers to interested parties.
176. The rise of the digital economy made multi-sided business models more prevalent
in a cross-border context. In this regard, two key characteristics of multi-sided business
models in the digital economy should be noted:
Flexibility: The nature of digital information and the infrastructure of the Internet
greatly expand the facility to design and implement multi-sided business models.
Resources such as content, user data, or executable code can be stored to create
value long after they have been produced. This specific nature of digital resources
makes them an asset in business models where the different sides of the market
can be created then dynamically adapted based on evolving technology, the latest
expression of consumer demand, and a firms position on the market. In addition,
as discussed below, digital technology has enhanced the ability to collect, analyse
and manipulate user and market data, which has allowed platforms to enhance the
value to one side of a market of the participation of the other side of the market.
Reach: The digital economy also makes it easier to locate the different sides of the
same business model in different countries. Whereas many traditional multi-sided
business models such as broadcasting paid for by advertising, or shopping malls
were confined to a limited perimeter due to physical constraints or to regulations,
over-the-top businesses in the digital economy can more easily connect two sides
that are located far from one another to maximise value on each side. For instance,
resources designed to collect data can be located near individual users, whereas
the infrastructure necessary to sell this data to paying customers can be located
elsewhere.
177. The digital economy features two prominent categories of multi-sided business
models. First, a business can operate several applications that provide complementary
services. This creates two types of synergy: on the one hand, the various activities pool their
resources such as executable code, content, or user data; on the other hand, the activities
may be put into a package that is more attractive for users. Second, vertical platform
models are used to make resources available for third-party developers so as to attract
their creativity as part of open innovation strategies. A platform is often the result of the
large-scale development of an application that gets commoditised. For example, a company
may develop a social networking service, using internally produced applications to attract
consumers and funding operations through the sale of advertising. The company may
also choose to open an application programming interface (API) which allows developers
to easily implement applications using the platform. Access to the API minimises the
developers initial investment and facilitates their access to the market of consumers that
use the platform. The participation of the developers, in turn, enhances the user experience,
thereby further strengthening the companys position in the marketplace.
4.3.5. Tendency toward monopoly or oligopoly

178. In some markets, particularly where a company is the first actor to gain traction on
an immature market, network effects combined with low incremental costs may enable the
company to achieve a dominant position in a very short time. This ability to gain traction
can be enhanced where a patent or other intellectual property right grants one competitor
the exclusive power to exploit a particular innovation in a particular market. The impact
of these network effects tend to lead to this result, for example, where companies provide
a platform or market in which users on one side of the market prefer to use only a single
provider, so that value to those users is enhanced when a single standard is chosen, and the
price that can be charged to the other side is enhanced because the platform becomes the
only means of access to those users. Ease of adoption of a new platform means that some
players, as a result of customer choices compounded by network effects, have been able to
rise to a dominant market position extremely quickly. In some cases, despite the volatility
outlined below, companies have been able to leverage that market position to secure
dominance. In markets that feature this tendency, network effects are magnified. It should
be noted, however, that in the digital economy, many networks operate simultaneously,
with the result that in many cases competition in a monopolised market may be influenced
by other markets, which combined with the reduced entry barriers, can moderate monopoly
power in the first market.
4.3.6. Volatility
179. Technological progress has led to progress in miniaturisation and a downward trend
in the cost of computing power. In addition, neither an Internet end user nor in many cases
the service provider are required to pay a marginal price for using the network. These
factors, combined with increased performance and capital expenditure have markedly
reduced barriers to entry for new Internet-based businesses. These factors have combined
to foster innovation and the constant development of new business models. As a result, in
short periods of time, companies that appeared to control a substantial part of the market
and enjoyed a dominant position for a short period of time have found themselves rapidly
losing market share to challengers that built their businesses on more powerful technology,
a more attractive value proposal, or a more sustainable business model. Due to the fast
pace of innovation, the few companies that have managed long-term success typically have
done so by investing substantial resources in research and development and in acquiring
start-ups with innovative ideas, launching new features and new products, and continually
evaluating and modifying business models in order to leverage their market position and
maintain dominance in the market.
Notes
1.
E-commerce includes orders made over the Internet, through an extranet (a network where
outside business partners, supplier or customers can have limited access to a portion of enterprise
intranet/network), or through an electronic data interchange (EDI a proprietary electronic
system used for exchanging business data over networks).
2.
Cloud computing is defined in the report of the US National Institute of Standards and Technology
(NIST) as a model for enabling ubiquitous, convenient, on-demand network access to a shared

pool of configurable computing resources (e.g.networks, servers, storage, applications, and
services) that can be rapidly provisioned and released with minimal management effort or service
provider interaction.

According to NIST, the cloud model is composed of five essential characteristics:

On-demand self-service: A user can unilaterally act without requiring human interaction
with each services provider.
Broad network access: Capabilities are available over the network and accessed through
standard mechanisms that promote use by heterogeneous client platforms (e.g.mobile
phones, laptops, and PDAs).
Resource pooling: The providers computing resources (e.g.storage, processing, memory,
network bandwidth, and virtual machines) are pooled to serve multiple users using a multitenant model.
Rapid elasticity: Capabilities can be rapidly and elastically provisioned.
Measured service: resources use can be monitored, controlled, and reported providing
transparency for both the provider and consumer of the utilised service.
The ICT Top 250 list is a well-established list compiled by the OECD since 2002. The sources
used to identify the top ICT firms include Business Weeks Information Technology 100, Software
Magazines Top 50, Forbes 2000, Washington Post 200, Forbes Largest Private Firms, Top 100
Outsourcing, World Top 25 Semiconductors. The list relies on financial reports available publicly.
The OECD defines ICT activities as production of goods or services primarilyintended
to fulfil or enable the function of information processing and communication by electronic
means, including transmission and display and therefore ICT firms are those that produce
the equipment, software and services that enable those activities. Each of the top 250 firms is
classified by ICT industry sector: (i)communication equipment and systems; (ii)electronics;
(iii)semiconductors; (iv)IT equipment and systems; (v)IT services; (vi)software; (vii)Internet;
and (viii)telecommunication services. Note that these figures describe total revenue earned, rather
than net profits.

3.
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Geneva.
5. Identifying opportunities for BEPS in the digital economy 77
Chapter5
Identifying opportunities for BEPS in the digital economy
This chapter provides a general discussion of the common features of tax planning
structures that raise base erosion and profit shifting (BEPS) concerns. It then
provides a detailed description of the core elements of BEPS strategies with respect
to both direct and indirect taxation.
78 5. Identifying opportunities for BEPS in the digital economy
5.1. Common features of tax planning structures raising BEPS concerns

180. As noted in the BEPS Action Plan (OECD, 2013), BEPS concerns are raised by
situations in which taxable income can be artificially segregated from the activities
that generate it, or in the case of value added tax (VAT), situations in which no or an
inappropriately low amount of tax is collected on remote digital supplies to exempt
businesses or multi-location enterprises (MLEs) that are engaged in exempt activities. These
situations undermine the integrity of the tax system and potentially increase the difficulty of
reaching revenue goals. In addition, when certain taxpayers are able to shift taxable income
away from the jurisdiction in which income producing activities are conducted, other
taxpayers may ultimately bear a greater share of the burden. BEPS activities also distort
competition, as corporations operating only in domestic markets or refraining from BEPS
activities may face a competitive disadvantage relative to multinational enterprises (MNEs)
that are able to avoid or reduce tax by shifting their profits across borders.1
181. The Task Force on the Digital Economy (TFDE) discussed a number of tax and
legal structures that can be used to implement business models in the digital economy.
These structures are outlined in AnnexB and show existing opportunities to achieve BEPS.
In many cases, the nature of the strategies used to achieve BEPS in digital businesses is
similar to the nature of strategies used to achieve BEPS in more traditional businesses.
Some of the key characteristics of the digital economy may, however, exacerbate risks of
BEPS in some circumstances, in the context of both direct and indirect taxation. Therefore,
it is necessary to examine closely not only how business models may have evolved in the
digital economy, but also how overall business models can be implemented in an integrated
manner on an international scale from a legal and tax structuring perspective.
182. The following paragraphs consider in more detail how BEPS strategies manifest in
the digital economy. The discussion below is intended to help identify the key elements of
BEPS strategies in the context of direct taxation, and how those strategies take advantage
of the key features of the digital economy. In addition, in the context of VAT, while there is
considerable diversity in the structure of VAT systems and in how they operate in practice,
the discussion below broadly illustrates ways in which the digital economy places pressure
on VAT systems.
5.2. BEPS in the context of direct taxation

183. The February 2013 Report Addressing Base Erosion and Profit Shifting (OECD,
2013b) identifies a number of co-ordinated strategies associated with BEPS in the context
of direct taxation, which can often be broken down into four elements:
Minimisation of taxation in the market country by avoiding a taxable presence,
or in the case of a taxable presence, either by shifting gross profits via trading
structures or by reducing net profit by maximising deductions at the level of the
payer.
Low or no withholding tax at source.
Low or no taxation at the level of the recipient (which can be achieved via low-tax
jurisdictions, preferential regimes, or hybrid mismatch arrangements) with entitlement
to substantial non-routine profits often built-up via intra-group arrangements.
No current taxation of the low-tax profits at the level of the ultimate parent.
Figure5.1. BEPS planning in the context of income tax

Market Country
(High Tax)
Intermediate Country 2
(Low Tax)
Ultimate Residence Country

(High Tax)
Intermediate
Sub 2
Avoid Taxable
Presence
OR
Minimise Assets/
Risks
Maximise Deductions
Local
Activity
Or Sub
Ineffective/No CFC Rules

Maximise Assets
Functions & Risks
Parent Co
Intermediate Country 1
(High Tax)
Low or no
Withholding tax
Minimise Assets/Risks
Maximise Deductions
Intermediate
Sub 1
Low or no
Withholding tax
Preferential Regime
OR
Hybrid Mismatches
OR
Base Eroding Payments
5.2.1. Eliminating or reducing tax in the market country

5.2.1.1. Avoiding a taxable presence
184. In many digital economy business models, a non-resident company may interact with
customers in a country remotely through a website or other digital means (e.g.an application
on a mobile device) without maintaining a physical presence in the country. Increasing
reliance on automated processes may further decrease reliance on local physical presence.
The domestic laws of most countries require some degree of physical presence before
business profits are subject to taxation. In addition, under Articles5 and 7 of the OECD
Model Tax Convention, a company is subject to tax on its business profits in a country of
which it is a non-resident only if it has a permanent establishment (PE) in that country.
Accordingly, such non-resident company may not be subject to tax in the country in which
it has customers.
185. Companies in many industries have customers in a country without a PE in that
country, communicating with those customers via phone, mail, and fax and through
independent agents. That ability to maintain some level of business connection within a
country without being subject to tax on business profits earned from sources within that
country is the result of particular policy choices reflected in domestic laws and relevant
double tax treaties, and is not in and of itself a BEPS issue. However, while the ability of a
company to earn revenue from customers in a country without having a PE in that country
is not unique to digital businesses, it is available at a greater scale in the digital economy
than was previously the case. Where this ability, coupled with strategies that eliminate
taxation in the State of residence, results in such revenue not being taxed anywhere, BEPS
concerns are raised. In addition, under some circumstances, tax in a market jurisdiction
can be artificially avoided by fragmenting operations among multiple group entities in
order to qualify for the exceptions to PE status for preparatory and auxiliary activities, or
by otherwise ensuring that each location through which business is conducted falls below
the PE threshold. Structures of this type raise BEPS concerns.
5.2.1.2. Minimising the income allocable to functions, assets and risks in market
jurisdictions
186. In many cases, an MNE group does maintain a degree of presence in countries
that represent significant markets for its products. In the context of the digital economy,
an enterprise may establish a local subsidiary or a PE, with the local activities structured
in a way that generates little taxable profit. Where these structures accurately reflect the
functions performed in each jurisdiction, the mere fact that business functions needed
to conduct business in a particular country may be more limited in one type of business
than in another does not raise BEPS issues in and of itself. This is true even if tax rates
are among the factors taken into account when deciding to centralise business operations
in a particular location. The ability to allocate functions, assets and risks in a way that
minimises taxation does, however, create incentives to, for example, contractually allocate
them in a way that does not fully reflect the actual conduct of the parties, and that would
not be chosen in the absence of tax considerations. For example, assets, in particular
intangibles, and risks related to the activities carried out at the local level may be allocated
via contractual arrangements to other group members operating in a low-tax environment
in a way that minimises the overall tax burden of the MNE group.
187. Under these structures, there is an incentive for the affiliate in the low-tax environment
to undervalue (typically at the time of the transfer) the transferred intangibles or other hardto-value income-producing assets, while claiming that it is entitled to have large portions of
the MNE groups income allocated to it on the basis of its legal ownership of the undervalued
intangibles, as well as on the basis of the risks assumed and the financing it provides.
Operations in higher tax jurisdictions can be contractually stripped of risk, and can avoid
claiming ownership of intangibles or other valuable assets or holding the capital that funds the
core profit making activities of the group. Economic returns are thus reduced and income is
shifted into low-tax environments.
188. Examples of digital economy structures that can be used to minimise the tax burden
in market jurisdictions through contractual allocation of assets and risks include using a
subsidiary or PE to perform marketing or technical support, or to maintain a mirrored
server to enable faster customer access to the digital products sold by the group, with a
principal company contractually bearing the risks and claiming ownership of intangibles
generated by these activities. A company may, for example, limit risk at the local company
level by limiting capitalisation of that entity so that it is financially unable to bear risk.
In the case of businesses selling tangible products online, a local subsidiary or PE may
maintain a warehouse and assist in the fulfilment of orders. These subsidiaries or PEs will
be taxable in their jurisdiction on the profits attributable to services they provide, but the
amount they earn may be limited. Alternatively, functions allocated to local staff under
contractual arrangements may not correspond with the substantive functions performed by
the staff. For example, staff may not have formal authority to conclude contracts on behalf
of a non-resident enterprise, but may perform functions that indicate effective authority to
conclude those contracts. If the allocations of functions, assets, and risks do not correspond
to actual allocations, or if less-than-arms length compensation is provided for intangibles
of a principal company, these structures may present BEPS concerns.
5.2.1.3. Maximising deductions in market jurisdictions

189. Once a taxable presence in the market country has been established, another common
technique to reduce taxable income is to maximise the use of deductions for payments made
to other group companies in the form of interest, royalties, service fees, etc. In many cases,
MNEs engaging in BEPS practices attempt to reduce taxable income in a source country
by maximising the amount of deductible payments made to affiliates in other jurisdictions.
For example, an affiliate in a low-tax jurisdiction may, due to a favourable credit rating, be
able to borrow money at a low rate. It may then lend money to its subsidiaries in high-tax
jurisdictions at a higher rate, thereby reducing the income of those subsidiaries by the amount
of the deductible interest payments. Alternatively, an affiliate may use hybrid instruments
to create deductible payments for a subsidiary in a source country that result in no inclusion
in the country of residence of the affiliate. Payments (including underpayments) for the use
of intangibles held by low-tax group companies or for services rendered by other group
companies can also be used to reduce taxable income in the market country. These techniques
can be used to reduce the taxable income from the local operations to extremely low amounts.
5.2.2. Avoiding withholding tax

190. A company may be subject to withholding tax in a country in which it is not a
resident if it receives certain payments, including interest or royalties, from payers in that
country. If allowed under a treaty between the jurisdictions of the payer and recipient,
however, a company in the digital economy may be entitled to reduced withholding or
exemption from withholding on payments of profits to a lower-tax jurisdiction in the
form of royalties or interest. Structures that involve treaty shopping by interposing shell
companies located in countries with favourable treaty networks that contain insufficient
protections against treaty abuse raise BEPS concerns.
5.2.3. Eliminating or reducing tax in the intermediate country

191. Eliminating or reducing tax in an intermediate country can be accomplished
through the application of preferential domestic tax regimes, the use of hybrid mismatch
arrangements, or through excessive deductible payments made to related entities in low or
no-tax jurisdictions.
192. Companies may locate functions, assets, or risks in low-tax jurisdictions or countries
with preferential regimes, and thereby allocate income to those locations. While functions
are often located in a particular jurisdiction for non-tax reasons such as access to skilled
labour or necessary resources, as business functions grow increasingly mobile, taxpayers
may increasingly be able to locate functions in a way that takes advantage of favourable tax
regimes.
193. In the context of the digital economy, for example, the rights in intangibles and their
related returns can be assigned and transferred among associated enterprises, and may be
transferred, sometimes for a less-than-arms length price,2 to an affiliate in a jurisdiction
where income subsequently earned from those intangibles is subject to unduly low or no-tax
due to the application of a preferential regime. This creates tax planning opportunities for
MNEs and presents substantial risks of base erosion. Heavy reliance in the digital economy
on intangibles as a source of value may exacerbate the ability to concentrate value-creating
intangibles in this way.
194. Companies may also reduce tax in an intermediate country by generating excessive
deductible payments to related entities that are themselves located in low or no-tax jurisdictions
or otherwise entitled to a low rate of taxation on the income from those payments. For example,
an operating company located in an intermediate jurisdiction may use intangibles held by
another affiliate in a low-tax jurisdiction. The royalties for the use of these intangibles may
be used to effectively eliminate taxable profits in the intermediate jurisdiction. Alternatively,

an entity in an intermediate jurisdiction may make substantial payments to a holding
company located in a low or no-tax jurisdiction for management fees or head office expenses.
Companies may also avoid taxes in an intermediate country by using hybrid mismatch
arrangements to generate deductible payments with no corresponding inclusion in the
country of the payee. Companies may also use arbitrage between the residence rules of the
intermediate country and the ultimate residence country to create stateless income. In addition,
companies may assert that the functions performed, assets used, and risks assumed in the
intermediate country are limited.
5.2.4. Eliminating or reducing tax in the country of residence of the ultimate

parent
195. Broadly speaking, the same techniques that are used to reduce taxation in the
market country can also be used to reduce taxation in the country of the ultimate parent
company of the group or where the headquarters are located. This can involve contractually
allocating risk and legal ownership of mobile assets like intangibles to group entities in
low-tax jurisdictions, while group members in the jurisdiction of the headquarters are
undercompensated for the important functions relating to these risks and intangibles that
continue to be performed in the jurisdiction of the headquarters. In this situation it can be
claimed that a marginal remuneration for the important functions is arms length and that
all the remaining profits should be attributed to the legal owner of movable assets or to the
party that is contractually bearing the risk.
196. In addition, companies may avoid tax in the residence country of their ultimate
parent if that country has an exemption or deferral system for foreign-source income and
either does not have a controlled foreign company (CFC) regime that applies to income
earned by controlled foreign corporations of the parent, or has a regime with inadequate
coverage of certain categories of passive or highly mobile income, including in particular
certain income with respect to intangibles. For example, the parent company may transfer
hard-to-value intangibles to a subsidiary in a low or no-tax jurisdiction, thereby causing
income earned with respect to those intangibles to be allocated to that jurisdiction without
appropriate compensation to the parent company. In some cases, a CFC regime might
permit the residence jurisdiction to tax income from these intangibles. Many jurisdictions,
however, either do not have a CFC regime, have a regime that fails to apply to certain
categories of income that are highly mobile, or have a regime that can be easily avoided
using hybrid mismatch arrangements.
5.3. Opportunities for BEPS with respect to VAT

197. To the extent that Guidelines2 and 4 of the OECDs Guidelines on place of
taxation for B2B supplies of services and intangibles (see Chapter6 and AnnexD below)
are not implemented, under certain conditions opportunities for tax planning by businesses
and corresponding BEPS concerns for governments in relation to VAT may arise with
respect to (i)remote digital supplies to exempt businesses and (ii)remote digital supplies
acquired by enterprises that have establishments (branches) in more than one jurisdiction
(MLE) that are engaged in exempt activities.
5.3.1. Remote digital supplies to exempt businesses

198. VAT is generally not designed to be a tax on businesses as businesses are generally
able to recover any tax they pay on their inputs. Many VAT jurisdictions using the destination
principle for business-to-business (B2B) digital supplies will generally require a business
customer in their jurisdiction to self-assess VAT on acquisitions of remotely delivered
services and intangibles and then allow the business to claim a credit for this self-assessed
VAT. The vast number of cross-border supplies made between businesses (other than
businesses engaged in exempt activities) do not therefore, generally create BEPS concerns.
BEPS concerns in a VAT context could arise however, with respect to offshore digital
supplies made to exempt businesses (e.g.the financial services industry). Where a business
is engaged in VAT-exempt activities, no VAT is levied on the exempt supplies made by the
business, while VAT incurred by the business on the associated inputs is not deductible.
199. For example, a business acquiring a data processing service from a non-resident
supplier would be required to self-assess VAT according to the rules of the jurisdiction in
which it is located and could claim an off-setting credit for this self-assessed VAT (some
jurisdictions may not require the business to self-assess tax as it is entitled to an offsetting
credit). If the business customer is an exempt business, it is still required to self-assess VAT
in these jurisdictions but would not be able to claim a credit for the self-assessed tax. The
exempt business is then input taxed in its residence jurisdiction, where it is assumed to
use the service for making exempt supplies.
200. However, some jurisdictions currently do not require the exempt business to selfassess VAT on the services and intangibles acquired from abroad. In such case, no VAT is
levied on the transaction. BEPS concerns also arise if the data processing services would
be subject to VAT in the jurisdiction where the supplier is resident (established, located).
The VAT would then accrue to the jurisdiction in which the supplier is situated and not
the jurisdiction of the exempt business. This is likely to raise concerns particularly where
this jurisdiction has no VAT or a VAT rate lower than the rate in the jurisdiction of the
exempt business customer. In these cases, the exempt business customer would pay no
VAT or an inappropriately low amount of VAT. The above cases illustrate how an exempt
business could pay no or an inappropriately low amount of VAT when acquiring digital
supplies from suppliers abroad. They also illustrate how domestic suppliers of competing
services could face potential competitive pressures from non-resident suppliers. Domestic
suppliers are required to collect and remit VAT on their supplies of services to domestic
businesses while non-resident suppliers could structure their affairs so that they collect no
or an inappropriately low amount of VAT.
5.3.2. Remote digital supplies to a multi-location enterprise

201. BEPS concerns could also arise in cases where a digital supply is acquired by an MLE.
It is common practice for multinational businesses to arrange for a wide scope of services to
be acquired centrally to realise economies of scale. Typically, the cost of acquiring such a
service or intangible is initially borne by the establishment that has acquired it and, in line with
normal business practice, is subsequently recharged to the establishments using the service or
intangible. The establishments are charged for their share of the service or intangible on the
basis of the internal recharge arrangements, in accordance with corporate tax, accounting and
other regulatory requirements. However, many VAT jurisdictions do not currently apply VAT
to transactions that occur between establishments of one single legal entity.
202. This means that where an establishment of an MLE acquires a service, for instance
data processing services, for use by other establishments in other jurisdictions, no additional

VAT would apply on any internal cost allocations or recharges made within the MLE for
the use of these services by other establishments. On the other hand, the establishment that
acquired the service will be generally entitled to recover any input VAT on the acquisition
of these services if it is a taxable business. In other words, the other establishments using
the data processing services are able to acquire their portion of these services without
incurring any VAT. This is generally not a great concern from a VAT perspective if all of
the establishments of the MLE using the service are taxable businesses. This is because in
this case they have a right to recover any input VAT. However, where the establishments
using the data processing services are exempt businesses, they are not normally entitled to
recover VAT paid on their inputs.
203. Take for example processing of data relating to banking transactions: if an establishment
of a multinational bank would acquire such services directly from a local supplier, it would
generally incur input VAT on these services; it would not be able to deduct this input VAT
as it relates to VAT-exempt activities. Alternatively, this establishment of a multinational
bank could acquire these processing services though another establishment of the same bank
in another country and then reimburse this other establishment for the cost of acquiring
these services on its behalf. This would allow the establishment of this bank to acquire
the processing services without incurring any VAT in the jurisdiction where it is located,
as no VAT is levied on the dealings between establishments of the same legal entity. If the
acquiring establishment would be located in a country without a VAT, the multinational
bank could acquire these services for all its establishments around the world without
incurring any input VAT at all by channelling its acquisitions through its establishment in
a no VAT jurisdiction. VAT-exempt businesses can make substantial VAT savings by using
such channelling structures.
Notes
1.
Such competitive disadvantages may also arise when competing enterprises are subject to
different levels of taxation in their home jurisdictions, although that is beyond the concerns
raised by BEPS.
2.
Even when the country from which the Internet Protocol (IP) is transferred requires that
transfers be made at arms length, taxpayers may take aggressive positions that in fact result in
less than an arms length amount being recorded for tax purposes with respect to the transfer.
Bibliography
OECD (2013a), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2013b), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264192744-en.
6. Tackling BEPS in the digital economy 85
Chapter6
Tackling BEPS in the digital economy
This chapter discusses how work on the actions of the base erosion and profit shifting
(BEPS) Action Plan and in the area of indirect taxation is expected to address BEPS
issues exacerbated by the key features of the digital economy, highlighting how these
features were taken into account to ensure that the measures developed effectively
address BEPS in the digital economy.
86 6. Tackling BEPS in the digital economy
6.1. Introduction
204. Many of the key features of the digital economy, particularly those related to mobility,
generate BEPS concerns in relation to both direct and indirect taxes. For example, the
importance of intangibles in the context of the digital economy, combined with the mobility of
intangibles for tax purposes under existing tax rules, generates substantial BEPS opportunities
in the area of direct taxes. The mobility of users creates substantial challenges and risks in the
context of the imposition of value added tax (VAT). The ability to centralise infrastructure
at a distance from a market jurisdiction and conduct substantial sales into that market from a
remote location, combined with increasing ability to conduct substantial activity with minimal
use of personnel, generates potential opportunities to achieve BEPS by fragmenting physical
operations to avoid taxation.
205. Work on the actions of the BEPS Action Plan (OECD, 2013) has taken into account
these key features in order to ensure that the proposed solutions fully address BEPS in the
digital economy. The following sections describe how the outputs of the BEPS Project, as
well as the work on consumption taxes, are expected to address these BEPS concerns once
implemented.
6.2. Restoring taxation on stateless income

206. Structures aimed at artificially shifting profits to locations where they are taxed at
more favourable rates, or not taxed at all, will be addressed by the work carried out in the
context of the BEPS Project. At the same time, the work on BEPS will increase transparency
between taxpayers and tax administrations and among tax administrations themselves. Risk
assessment processes at the level of the competent tax administration will be enhanced by
measures such as the mandatory disclosure of aggressive tax planning arrangements and
uniform transfer pricing documentation requirements, coupled with a template for countryby-country (CBC) reporting. There are already indications of the impact of such increased
transparency measures and other forthcoming outputs of the BEPS Project on the tax
planning and structuring decisions of multinational enterprise (MNE) groups.
207. The comprehensiveness of the BEPS Action Plan will ensure that, once the different
measures have been implemented in a co-ordinated manner, taxation is more aligned with
the location in which economic activities take place. This will address BEPS issues at the
level of both the market jurisdiction and the jurisdiction of the ultimate parent company,
with the aim of putting an end to the phenomenon of so-called stateless income. BEPS issues
in the market jurisdiction should be addressed by preventing treaty abuse (Action6) and
preventing the artificial avoidance of permanent establishment (PE)status (Action7). BEPS
issues in the ultimate residence jurisdiction should be addressed by strengthening controlled
foreign company (CFC) rules (Action3). Both market and residence BEPS issues should
be addressed by neutralising the effects of hybrid mismatch arrangements (Action2), by
limiting the base erosion via interest deductions and other financial payments (Action4), by
countering harmful tax practices more effectively (Action5), and by ensuring that transfer
pricing outcomes are in line with value creation (Actions8-10). In the context of VAT, under
certain conditions opportunities for tax planning by businesses and corresponding BEPS
concerns for governments may arise to the extent that the OECDs Guidelines on place of
taxation (see AnnexD) for business-to-business (B2B) supplies of services and intangibles
are not implemented.
208. Although all of the elements of the BEPS Action Plan will have an impact on BEPS
in the digital economy, Actions3 (strengthen CFC rules), 7 (prevent the artificial avoidance
of PE status), and 8-10 (assure that transfer pricing outcomes are in line with value creation)
were identified as particularly relevant to the digital economy.
209. In the work on Action3, it was noted that income from digital goods and services
may be particularly mobile due to the importance of intangibles in the provision of such
goods and services.
210. In the context of Action7, it was noted that the work should consider whether
certain activities that were previously considered preparatory or auxiliary for the purposes
of these exceptions may be increasingly significant components of businesses in the digital
economy, and if so, under what circumstances such activities may be considered core
activities, and whether a reasonable, administrable rule to this effect can be developed. The
work would also consider whether and how the definition of PE may need to be modified
to address circumstances in which artificial arrangements relating to the sales of goods or
services of one company in a multinational group effectively result in the conclusion of
contracts, such that the sales should be treated as if they had been made by that company.
211. Finally, in the context of the work on Actions8-10, it was noted that companies in
the digital economy rely heavily on intangibles in creating value and producing income,
and that many BEPS structures adopted by participants in the digital economy involve the
transfer of intangibles or rights in intangibles to tax-advantaged locations, coupled with
the position that these contractual allocations, together with legal ownership of intangibles,
justify large allocations of income to the entity allocated the risk even if it performs little
or no business activity. It was concluded that the BEPS work in the area of transfer pricing
should take these issues in account and should also devote attention to the implications of
the increased integration of MNEs and the spread of global value chains in which various
stages of production are spread across multiple countries, including whether it was possible
to provide simpler and clearer guidance on the application of transfer pricing methods,
including profit splits in the context of global value chains.
6.2.1. Measures that will address BEPS issues in the market jurisdiction
212. A number of measures of the BEPS Action Plan will have the primary effect of
restoring source taxation, in particular with respect to treaty abuse (Action6) and artificial
avoidance of PE status (Action7).
6.2.1.1. Prevent treaty abuse (Action6)

213. The Report Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances (OECD, 2015a) provides model rules to tackle the abuse of tax treaties.
These rules provide for a minimum standard to address treaty shopping arrangements
through which companies are set up in a country in order to take advantage of the treaty
network of that country rather than for carrying on business activities in that country. They
also prevent the use of structures involving the use of dual resident companies that claim to
be resident of a particular treaty country to achieve double non-taxation. Further, the rules
address unintended cases of non-taxation that result from tax treaties, in particular where
countries eliminate double taxation through the exemption method. The report reflects the
further work that has been done with respect to the precise contents of the model provisions
and related Commentary and the implementation of the minimum standard.
214. The denial of treaty benefits in cases that could otherwise inappropriately result in
double non-taxation will ensure that the market country will be able to apply its domestic
law unconstrained by treaty rules aimed at preventing double taxation. This is of relevance

both in cases where the foreign company has claimed not to have a taxable presence in that
country in the form of a PE or when there is indeed a taxable presence in the form of a PE or
a group company, but the relevant taxable income is reduced by deductible payments. In cases
where such deductible payments would be subject to a withholding tax under domestic law,
the market country will be able to apply such a withholding tax without any treaty limitation.
6.2.1.2. Prevent the artificial avoidance of PEstatus (Action7)

215. The treaty definition of PE may limit the application of domestic law rules applicable
to the taxation of the business profits of non-resident companies derived from sources in the
market country. The work done with respect to Action7 was aimed at preventing the artificial
avoidance of the treaty threshold below which the market country may not tax. This work was
identified by the Task Force on the Digital Economy (TFDE) as a key area of focus in order
to ensure that BEPS risks in the digital economy could be addressed. The work therefore took
into account the key features of the digital economy in developing changes to the definition
of PE to ensure that artificial arrangements cannot be used to circumvent the threshold for
exercising taxing rights.
216. The work involved modifying the definition of PE to address circumstances in
which artificial arrangements relating to the sales of goods or services of one company in
a multinational group effectively result in the conclusion of contracts, such that the sales
should be treated as if they had been made by that company. For example, where the sales
force of a local subsidiary of an online seller of tangible products or an online provider of
advertising services habitually plays the principal role in the conclusion of contracts with
prospective large clients for those products or services, and these contracts are routinely
concluded without material modification by the parent company, it will result in a PE for
the parent company even though the subsidiary does not formally conclude those contracts,
and even though the contracts may be standard form contracts. As a result, once the
outcome of this work is implemented, such strategies will no longer be effective.
217. The work also ensures that where essential business activities of an enterprise are
carried on at a given location in a country, the enterprise cannot benefit from the list of
exceptions usually found in the definition of PE. It was therefore agreed to modify Article5
(4) of the OECD Model Tax Convention to ensure that each of the exceptions included
therein is restricted to activities that are otherwise of a preparatory or auxiliary character.
In addition to broader tax challenges (see Chapter7), this raises BEPS issues when the lack
of taxation in the market country is coupled with techniques that reduce or eliminate tax in
the country of the recipient or of the ultimate parent. In addition, a new anti-fragmentation
rule was introduced to ensure that it is not possible to benefit from these exceptions through
the fragmentation of business activities among closely related enterprises. As a result, where
certain activities that were previously granted the benefit of these exceptions have become
increasingly significant components of businesses in the digital economy, such that they
are not preparatory or auxiliary in character, those activities will no longer be entitled to
an exception from PE status. For example, the maintenance of a very large local warehouse
in which a significant number of employees work for purposes of storing and delivering
goods sold online to customers by an online seller of physical products (whose business
model relies on the proximity to customers and the need for quick delivery to clients) would
constitute a PE for that seller. Some countries, however, consider that there is no need to
modify Art.5(4) and that the list of exceptions in subparagraphsa) to d) of paragraph4
should not be subject to the condition that the activities referred to in these subparagraphs
be of a preparatory or auxiliary character. These countries may adopt a different version of
Art.5(4) as long as they include the anti-fragmentation rule referred to above.
6.2.2. Measures that will address BEPS issues in both market and ultimate
parent jurisdictions
218. A number of measures in the BEPS Action Plan will contribute to address BEPS
issues both at the level of the market jurisdiction and at the level of the parent company
jurisdiction. These include the measures developed in the course of the work on Action2
(neutralise the effects of hybrid mismatch arrangements), Action4 (limit base erosion via
interest deductions and other financial payments), Action5 (counter harmful tax practices
more effectively), and Actions8-10 (assure that transfer pricing outcomes are in line with
value creation).
6.2.2.1. Neutralise the effects of hybrid mismatch arrangements (Action2)

219. The BEPS Action Plan notes that hybrid mismatch arrangements can be used
to achieve unintended double non-taxation or long-term tax deferral by, for example,
creating two deductions for a single expense, generating deductions in one jurisdiction
without corresponding income inclusions in another, or misusing foreign tax credit
or participation exemption regimes. In common with other MNEs, digital economy
businesses take advantage of hybrid mismatch arrangements to achieve BEPS by stripping
income from a market or intermediate jurisdiction or by avoiding application of CFC
rules or other anti-abuse regimes. The 2015 Report on Neutralising the Effects of Hybrid
Mismatch Arrangements (OECD, 2015b) sets out recommendations regarding the design
of domestic rules and the development of model treaty provisions to neutralise the effect
of hybrid instruments and entities, and includes detailed commentary explaining how the
recommendations are intended to operate in practice.
6.2.2.2. Limit base erosion via interest deductions and other financial payments
(Action4)
220. The innovation that is essential to success in the digital economy must be financed.
Many large and well-established digital economy players are cash rich and they often
finance new ventures, the acquisition of start-ups, or other assets with intra-group debt. It is
often the case that taxpayers will establish and capitalise entities in low-tax environments
that are then able to engage in transactions with associated enterprises that have the effect of
eroding the tax base. For example, an affiliate in a low-tax environment might be established
to lend to high-tax operating entities. Interest deductions on loans from such low-tax entities
can present BEPS concerns in countries where business operations actually take place.
Where the capital contributed to the low-tax entity to fund these activities is borrowed from
third-party lenders, the base erosion effect of these arrangements may be exacerbated.
221. In other words, existing rules may allow affiliate entities in a low-tax environment to
fund the profit-generating activities of the group with intercompany debt, even though the
MNE group as a whole may be much less heavily leveraged. This ultimately reduces tax at
the level of the market jurisdiction and at the level of the parent company jurisdiction, with
the interest often going untaxed anywhere for a number of reasons (such as the availability
of preferential regimes, the use of hybrid instruments, and the availability of generous
deductions). Existing tax planning arrangements within the integrated global businesses that
also characterise the digital economy take advantage of this type of structuring to achieve
BEPS.
222. The work done with respect to Action4 provides an agreed framework for best
practices in the design of domestic rules, in order to reduce opportunities for BEPS via

interest and other deductible financial payments. This work addresses BEPS in respect
of interest paid to both related parties and third parties and addresses both inbound and
outbound investment scenarios. The framework is based on a fixed ratio rule that limits an
entitys net deductions for interest (and payments economically equivalent to interest) to
a specified percentage of its earnings before interest, taxes, depreciation and amortisation
(EBITDA). To ensure that countries apply a fixed ratio that is low enough to tackle BEPS,
while recognising that not all countries are in the same position, the recommended approach
includes a corridor of possible ratios of between 10 and 30% along with factors that countries
should take into account in setting their fixed ratio within this corridor. Recognising that
some groups are highly leveraged with third party debt for non-tax reasons, the recommended
approach allows the fixed ratio rule to be supplemented by a group ratio rule that allows an
entity with net interest expense above a countrys fixed ratio to deduct interest up to the level
of the net interest/EBITDA ratio of its worldwide group. Alternatively the fixed ratio rule
based on net interest/EBITDA can be supplemented by an equity test, whereby the fixed
ratio rule does not apply if an entity can show that its equity/total assets ratio is equal to or
exceeds that of its group (within a small tolerance). The framework also recommends that
countries introduce targeted rules to address specific risks.
6.2.2.3. Counter harmful tax practices more effectively (Action5)

223. Digital economy companies heavily rely on intangibles to create value and produce
income. Intangibles, and income arising from the exploitation of intangibles, are by
definition geographically mobile. Over the last decade, a number of OECD and non-OECD
countries have introduced regimes which provide for a preferential tax treatment for certain
income arising from the exploitation of intellectual property (IP), generally through a 50%
to 80 % deduction or exemption of qualified IP income.
224. The work undertaken under Action5 has therefore included an examination of
intangible regimes of the type described to determine whether they constitute harmful
preferential tax regimes within the meaning of the OECDs 1998 Report Harmful Tax
Competition: An Emerging Global Issue. Action5 of the BEPS Action Plan also requires
there to be substantial activity for any preferential regime and as a result the existing
substance factor has been elaborated and elevated in importance. In the context of IP
regimes, agreement was reached on thenexus approach which uses expenditures as a
proxy for substantial activity, ensuring that taxpayers can only benefit from IP regimes
where they engaged in research and development and incurred actual expenditures on such
activities.In the context of other preferential regimes, the same principle can be applied,
so that such regimes would be found to meet the substantial activities requirement where
the taxpayer undertook the core income generating activities required to produce the type
of business income covered by the preferential regime. Sixteen IP regimes were evaluated
as part of this work.
6.2.2.4. Assure that transfer pricing outcomes are in line with value creation
(Actions8-10)
225. The BEPS work on transfer pricing addresses BEPS issues that commonly arise
among companies active in the digital economy as well as other taxpayers. Taken together,
the overall objective of the transfer pricing actions is to bring the allocation of income
within a multinational group of companies more directly in line with the location of the
economic activity that gives rise to that income (Aligning Transfer Pricing Outcomes with
Value Creation, OECD, 2015c). This objective is pursued by focusing on key transfer pricing
issues including issues related to (i)the transfer and use of intangibles including hard-tovalue intangibles, and cost contribution arrangements, (ii)delineating the actual transaction
and business risks, and (iii)global value chains and transactional profit split methods.
i. Intangibles, including hard-to-value intangibles, and cost contribution

arrangements
226. A key feature of many BEPS structures adopted by participants in the digital economy
involves the transfer of intangibles or rights in intangibles to tax advantaged locations.
Digital economy companies rely heavily on intangibles in creating value and producing
income. Depending on the local law, transfers of intangibles and rights in intangibles at nonarms length prices can occur in connection with licensing arrangements, cost contribution
arrangements or tax structures that separate deductions relevant to the development of the
intangible from the income associated with it. Transfers of intangibles at non-arms length
prices can occur (i)because of difficulties in valuing transferred intangibles at the time
they are transferred; (ii)because of unequal access to information relating to value between
taxpayers and tax administrations; and (iii)because some arrangements result in the transfer
of hidden or unidentified intangibles without payment.
227. The BEPS work on intangibles addresses these issues by taking several steps.
First, the work provides a broad but clear definition of intangibles for transfer pricing
purposes, and makes clear that that any intangible item for which unrelated parties would
provide compensation upon transfer must be compensated in transfers between associated
enterprises. This will help ensure that transfers of hidden intangibles are not used to shift
income. Second, the work ensures that entities within an MNE group that contribute value
to intangibles either by performing or managing development functions or by bearing and
controlling risks are appropriately rewarded for doing so. Specifically, the revised guidance
ensures that legal ownership alone does not entitle the owner to premium profits, but that
the group companies performing the important functions, contributing assets or assuming
risks related to the development, enhancement, maintenance, protection and exploitation of
intangibles will receive an appropriate return.
228. The work also makes clear that valuation techniques can be used to determine
arms length transfer prices when comparable transfers of intangibles cannot be identified.
In situations where hard-to-value intangibles are transferred, the work ensures that posttransfer profitability of an intangible can be taken into account in the valuation in specified
circumstances in order to balance the availability of information between taxpayers and
tax administrations.
229. Revised guidance on cost contribution agreements (CCA) ensures that such
arrangements are appropriately analysed and produce outcomes that are consistent with
how and where value is created. Specifically, it ensures that the same guidance for valuing
and pricing intangibles, including hard-to-value intangibles, is applicable to CCA as to
other kinds of contractual arrangement. It ensures also that contributions made to CCA,
with specific focus on intangibles, should not be measured at cost where this is unlikely to
provide a reliable basis for determining the value of the relative contributions of participants,
since this may lead to non-arms length results.
ii. Delineating the actual transaction and allocating business risks

230. BEPS structures aimed at shifting income into low-tax environments often feature
a contractual allocation of business risk into a low-tax affiliate. It then may be argued that
these contractual risk allocations, justify large allocations of income to the entity allocated
the risk. The argument entails the assertion that other entities in the group are contractually
insulated from risk so that a low-tax affiliate is entitled to substantial amounts of income
after compensating other low risk group members for their functions. The revised guidance
challenges such assertions by determining that risks contractually assumed by a party
that cannot in fact exercise meaningful and specifically defined control over the risks,
and does not have the financial capacity to assume the risks, will be allocated to the party
that does exercise such control and have the financial capacity to assume the risk. This
revision is part of the requirement to accurately delineate the actual transaction between
the associated enterprises by supplementing, where necessary, the terms of any contract
with the evidence of the actual conduct of the parties. In combination with the proper
application of transfer pricing methods in a way that prevents the allocation of profits to
locations where no contributions are made to these profits, this revised guidance will lead
to the allocation of an appropriate return to group companies performing the important
functions, contributing important assets and controlling economically significant risks, as
determined through the accurate delineation of the actual transaction.
iii. Global value chains and transactional profit split methods

231. When the arms length principle was initially devised, it was common that each
country in which an MNE group did business had its own subsidiary with full functionality
and carrying out a broad range of activities reflecting the groups business as a whole. This
structure was dictated by a number of factors, including slow communications, currency
exchange rules, customs duties, and relatively high transportation costs that made integrated
global supply chains difficult to operate. With the advent of improvements in information
and communication technology (ICT), reductions in many currency and custom barriers,
and the move to digital products and a service based economy, these barriers to integration
broke down and MNE groups began to operate much more as single global firms.
232. Developments in ICT have thus accelerated and changed the spread of global value
chains in which corporate legal structures and individual legal entities become less important
and MNE groups move closer to the economists conception of a single firm operating in a
co-ordinated fashion to maximise opportunities in a global economy. Attention will therefore
be devoted to the implications of this increased integration in MNEs and will evaluate the
need for greater reliance on value chain analyses and transactional profit split methods.
233. The consultation process on the transactional profit split method in the course of the
BEPS Project confirmed that this method can be useful when properly applied to align profits
with value creation in certain circumstances. The further work on the transactional profit split
method will therefore examine their application to highly integrated business operations and
develop profit splitting factors that show strong correlation with value creation. This work
should also address situations where comparables are not available because of the structures
designed by taxpayers and could include revised guidance on the use of profit methods. This
work will be carried out in 2016 and 2017 and may be relevant for highly integrated MNE
groups in the digital economy.
6.2.3. Measures that will address BEPS issues in the jurisdiction of the ultimate
parent
234. The work on designing effective CFC rules may also contribute to restoring taxation
in the jurisdiction of the ultimate parent company. As noted in the BEPS Action Plan, one
source of BEPS concerns is the possibility of creating affiliated non-resident taxpayers and
routing income of resident enterprises through that non-resident affiliate. Although CFC
rules have been introduced in many countries to address this, there remain many jurisdictions
that lack CFC rules. Where CFC rules do exist, they do not always address BEPS in a
comprehensive manner. However, effective CFC rules can reduce the incentive to shift profits
from a source country into a low-tax jurisdiction. The report on Action3, Designing Effective
Controlled Foreign Company Rules (OECD, 2015d) provides recommendations in the form of
six building blocks, including a definition of CFC income which sets out a non-exhaustive list
of approaches or combination of approaches that CFC rules could use for such a definition.
These approaches include categorical, substance, and excess profits analyses which could
be applied on their own or combined with each other. The recommendations are designed to
ensure that jurisdictions that choose to implement them will have effective CFC rules.
235. To address BEPS issues within the digital economy, CFC rules must effectively
address the taxation of mobile income typically earned in the digital economy. Although
CFC rules vary significantly from jurisdiction to jurisdiction, income from digital goods
and services provided remotely is frequently not subject to current taxation under CFC
rules. Accordingly, a MNE in a digital business can earn income in a CFC in a low-tax
jurisdiction by locating key intangibles there and using those intangibles to sell digital
goods and services without that income being subject to current tax, even without the CFC
itself performing significant activities in its jurisdiction. As a result, a digital economy
company may pay little or no tax in the CFC jurisdiction while also avoiding tax in the
source country and the country of ultimate residence.
236. To address this situation, consideration was given to a number of approaches for CFC
rules that could target income typically earned in the digital economy, such as IP income
and income earned from the remote sale of digital goods and services. Such income may
be particularly mobile due to the importance of intangibles in the provision of such goods
and services and the relatively few people required to carry out online sales activities.
Countries can implement these approaches to design CFC rules that would subject income
that is typically earned in the digital economy to taxation in the jurisdiction of the ultimate
parent company. For instance countries could use the categorical analyses to define CFC
income to include types of revenue typically generated in digital economy transactions
such as license fees and certain types of income from sales of digital goods and services.If
countries adopted the excess profits approach this could characterise any excess profits
generated in low tax jurisdictions, which may include profits attributable to IP-related assets,
as CFC income. This approach could potentially limit the use of offshore deferral structures
popular with digital economy MNEs that indefinitely defer foreign income from taxation
in the residence jurisdiction. Both approaches may be combined with a substance analysis
aimed at verifying whether the CFC is engaged in substantial activities in order to accurately
identify and quantify shifted income.
6.3. Addressing BEPS issues in the area of consumption taxes

237. The digitisation of the economy has greatly facilitated the ability of businesses to
acquire a wide range of services and intangibles from suppliers in other jurisdictions around
the world and to structure their operations in a truly global manner. These developments

have allowed exempt businesses to avoid and minimise the amount of unrecoverable VAT
they pay on their inputs. Section5.3 of Chapter5 outlined the BEPS concerns that may arise
from the opportunity for businesses to structure their affairs in such a way that no or an
inappropriately low amount of VAT is borne by exempt businesses on remotely delivered
services and intangibles.
238. The implementation of Guidelines2 and 4 of the OECDs International VAT/GST
Guidelines on place of taxation for business-to-business (B2B) supplies of services and
intangibles (see AnnexD) will minimise BEPS opportunities for supplies of remotely
delivered services and intangibles made to exempt businesses, including exempt entities
that operate through establishments (branches) in multiple jurisdictions (multiple location
entities (MLEs)).
239. Guideline2 recommends that the taxing rights on cross-border supplies of services
and intangibles between businesses be allocated to the jurisdiction where the customer
has located its business establishment and that business customers be required to selfassess VAT on remotely delivered services or intangibles acquired from offshore suppliers
according to the rules of the jurisdiction in which they are located.
240. Guideline4 provides that when a supply is made to a business that is established in
more than one jurisdiction, taxation should accrue to the jurisdiction where the customers
establishment (branch) using the service or intangible is located. These Guidelines set out
the possible mechanisms for tax authorities to achieve the desired result in practice, which
is allocation of the right to levy VAT on B2B services and intangibles to the jurisdiction
where these services are used for business purposes irrespective of how the supply and
acquisition of these services and intangibles were structured.
6.4. Preliminary conclusions

241. As described in Chapter5, while no unique BEPS issues are presented by the digital
economy, many of the key features of the digital economy, particularly those related to
mobility, exacerbate BEPS concerns. These key features have been taken into account
in the work under the BEPS Action Plan to address BEPS in the context of direct taxes,
including in particular the work on CFC rules (Action3), addressing the artificial avoidance
of PE status (Action7) and transfer pricing (Actions8-10). As a result, it is expected that
the implementation of these measures, as well as the other measures developed in the BEPS
Project, will substantially address the BEPS issues exacerbated by the digital economy.
242. To ensure that BEPS can be addressed, implementation must occur quickly. In this
regard, certain measures, such as the revisions to the Transfer Pricing Guidelines will be
immediately applicable, while other measures, such as those relating to CFC rules and
interest deductibility, will require domestic law changes. Several actions, including Action2
(neutralise the effects of hybrid mismatch arrangements), 6 (prevent treaty abuse), 7 (prevent
the artificial avoidance of PE status) and 14 (make dispute resolution mechanisms more
effective) will result in modifications to the OECD Model Tax Convention. To avoid the
need to engage in a series of time-consuming and costly bilateral negotiations in order to
update the global network of more than 3500 bilateral tax treaties to reflect these changes,
88 countries have begun negotiating a multilateral instrument to implement the treaty-related
BEPS measures and modify bilateral tax treaties in a synchronised and efficient manner.
Development of this multilateral instrument is expected to be concluded by the end of 2016.
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OECD (2015d), Designing Effective Controlled Foreign Company Rules, Action3 2015
http://dx.doi.org/10.1787/9789264202719-en.
OECD (1998), Report Harmful Tax Competition: An Emerging Global Issue, www.oecd.
org/tax/transparency/44430243.pdf.
7. Broader direct tax challenges raised by the digital economy and the options to address them 97
Chapter7
Broader direct tax challenges raised by the digital economy
and the options to address them
This chapter discusses the challenges that the digital economy raises for direct
taxation, with respect to nexus, the tax treatment of data, and characterisation
of payments made under new business models, as well as certain administrative
challenges faced by tax administrations in applying the current rules. The chapter
then provides an overview of potential options that have been discussed by the Task
Force on the Digital Economy to address these challenges.
98 7. Broader direct tax challenges raised by the digital economy and the options to address them
7.1. The digital economy and the challenges for policy makers
243. The spread of the digital economy brings about many benefits, for example in terms
of growth, employment and well-being more generally. At the same time it gives rise to a
number of challenges for policy makers. These challenges extend well beyond domestic and
international tax policy and touch upon areas such as international privacy law and data
protection, as well as accounting and regulation.
244. From a strategic tax policy perspective, the uptake of digital technologies may
potentially constrain the options available to policymakers in relation to the overall tax mix.
For decades, companies have contributed to public expenses via a broad range of taxes in
addition to corporate income tax. These taxes include employment taxes, environmental
taxes, property and land taxes. The development of digital technologies has the potential to
enable economic actors to operate in ways that avoid, remove, or significantly reduce, their tax
liability within these bases. This may increase the pressure on a smaller number of taxpayers
to compensate for the related loss of revenues. It also highlights the importance of designing
corporate income and consumption tax systems that promote growth and investment, while
reducing inequality and establishing a level playing field among economic actors.
245. The following sections examine a number of the tax challenges raised by the digital
economy in relation to corporate income tax.
7.2. An overview of the tax challenges raised by the digital economy

246. The evolution of business models in general, and the growth of the digital economy
in particular, have resulted in non-resident companies operating in a market jurisdiction in a
fundamentally different manner today than at the time international tax rules were designed.
For example, while a non-resident company has always been able to sell into a jurisdiction
without a physical presence there, advances in information and communication technology
(ICT) have dramatically expanded the scale at which such activity is now possible. In
addition, traditionally for companies to expand opportunities in a market jurisdiction, a local
physical presence in the form of manufacturing, marketing, and distribution was very often
required. These in-country operations would have engaged operations such as procurement,
inventory management, local marketing, branding and other activities that earned a local
return subject to tax in the market country. Advances in business practices, coupled with
advances in ICT and liberalisation of trade policy, have allowed businesses to centrally
manage many functions that previously required local presence, rendering the traditional
model of doing business in market economies obsolete. The fact that existing thresholds for
taxation rely on physical presence is partly due to the need in many traditional businesses
for a local physical presence in order to conduct substantial sales of goods and services into
a market jurisdiction. It is also due in part to the need to ensure that the source country has
the administrative capability of enforcing its taxing rights over a non-resident enterprise.
The fact that less physical presence is required in market economies in typical business
structures today an effect that can be amplified in certain types of businesses in the ICT
sector therefore raises challenges for international taxation.
247. Other elements of the digital economy have also raised challenges for policy
makers. As noted above, growing reliance in certain new business models on data may
raise tax challenges both in terms of characterisation of and attribution of value from
data, and in terms of the changing ways in which users and customers interact with
businesses. Further, new revenue streams adopted in particular due to the spread of multisided business models or the use of massive computing power and broadband connection
trigger questions regarding the appropriate characterisation of certain transactions and

payments for tax purposes. Finally, digital technologies make it easier to do business across
jurisdictions, as well as enabling consumers to access products and services from anywhere
in the world, generating challenges in terms of collecting the appropriate amounts of
consumption tax.
248. In general terms, in the area of direct taxation, the main policy challenges raised by
the digital economy fall into three broad categories:
Nexus: The continual increase in the potential of digital technologies and the
reduced need in many cases for extensive physical presence in order to carry on
business, combined with the increasing role of network effects generated by customer
interactions, can raise questions as to whether the current rules to determine nexus
with a jurisdiction for tax purposes are appropriate.
Data: The growth in sophistication of information technologies has permitted
companies in the digital economy to gather and use information across borders to
an unprecedented degree. This raises the issues of how to attribute value created
from the generation of data through digital products and services, and of how to
characterise for tax purposes a person or entitys supply of data in a transaction,
for example, as a free supply of a good, as a barter transaction, or some other way.
Characterisation: The development of new digital products or means of delivering
services creates uncertainties in relation to the proper characterisation of payments
made in the context of new business models, particularly in relation to cloud
computing.
249. These challenges raise questions as to whether the current international tax
framework continues to be appropriate to deal with the changes brought about by the digital
economy and the business models that it makes possible, and also relate to the allocation
of taxing rights between source and residence jurisdictions. These challenges also raise
questions regarding the paradigm used to determine where economic activities are carried
out and value is created for tax purposes, which is based on an analysis of the functions
performed, assets used and risks assumed. At the same time, when these challenges create
opportunities for achieving double non-taxation, for example due to the lack of nexus in the
market country under current rules coupled with lack of taxation in the jurisdiction of the
income recipient and of that of the ultimate parent company, they also generate BEPS issues.
250. Although the challenges related to corporate income tax (nexus, data and character)
are distinct in nature, they may overlap with each other. For example, the characterisation
of payments may trigger taxation in the jurisdiction where the payor is resident or
established and hence overlap with the issue of nexus. Similarly, the collection of data from
users located in a jurisdiction may trigger questions regarding whether it should give rise
to nexus with that jurisdiction, and if so, whether and how the income generated from the
use of these data should be attributed to that nexus. It also raises questions regarding how
income from transactions involving data should be characterised for tax purposes.
251. The digital economy also creates challenges for value added tax (VAT) systems,
particularly where goods, services and intangibles are acquired by private consumers from
suppliers abroad. This is partly due to the absence of an effective international framework
to ensure VAT collection in the jurisdiction of consumption. For economic actors, and
in particular small and medium enterprises (SMEs), the absence of an international
standard for charging, collecting and remitting the tax to a potentially large number of tax
authorities, creates difficulties and high compliance costs. From a government viewpoint,
there is a risk of loss of revenue and trade distortion, as well as the challenge of managing
tax liabilities generated by a high volume of low value transactions, which can create a
significant administrative burden but marginal revenues.
252. In addition to these policy challenges, which are further discussed below, the Task
Force on the Digital Economy (TFDE) has also identified a number of administrative
issues raised by the digital economy. These latter issues are outlined in the box at the end
of this chapter.
7.3. Nexus and the ability to have a significant presence without being liable to tax
253. Advances in digital technology have not changed the fundamental nature of the
core activities that businesses carry out as part of a business model to generate profits. To
generate income, businesses still need to source and acquire inputs, create or add value,
and sell to customers. To support their sales activities, businesses have always needed
to carry out activities such as market research, marketing and advertising, and customer
support. Digital technology has, however, had significant impact on how these activities are
carried out, for example by enhancing the ability to carry out activities remotely, increasing
the speed at which information can be processed, analysed and utilised, and, because
distance forms less of a barrier to trade, expanding the number of potential customers that
can be targeted and reached. Digital infrastructure and the investments that support it can
be leveraged today in many businesses to access far more customers than before. As a
result, certain processes previously carried out by local personnel can now be performed
cross-border by automated equipment, changing the nature and scope of activities to be
performed by staff. Thus, the growth of a customer base in a country does not always
need the level of local infrastructure and personnel that would have been needed in a predigital age.
254. This increases the flexibility of businesses to choose where substantial business
activities take place, or to move existing functions to a new location, even if those locations
may be removed both from the ultimate market jurisdiction and from the jurisdictions
in which other related business functions may take place. As a result, it is increasingly
possible for a businesss personnel, IT infrastructure (e.g.servers), and customers each
to be spread among multiple jurisdictions, away from the market jurisdiction. Advances
in computing power have also meant that certain functions, including decision-making
capabilities, can now be carried out by increasingly sophisticated software programmes
and algorithms. For example, contracts can in some cases be automatically accepted by
software programmes, so that no intervention of local staff is necessary. As discussed
below, this is also true in relation to functions such as data collection, which can be done
automatically, without direct intervention of the employees of the enterprise.
255. Despite this increased flexibility, in many cases large multinational enterprises
(MNEs) will indeed have a taxable presence in the country where their customers are
located. As noted in Chapter4, there are often compelling reasons for businesses to ensure
that core resources are placed as close as possible to key markets. This may be because the
enterprise wants to ensure a high quality of service and have a direct relationship with key
clients. It may also be because minimising latency is essential in certain types of business,
or because in certain industries regulatory constraints limit choices about where to locate
key infrastructure, capital, and personnel. It is therefore important not to overstate the
issue of nexus. Nevertheless, the fact that it is possible to generate a large quantity of sales
without a taxable presence should not be understated either and it raises questions about
whether the current rules continue to be appropriate in the digital economy.
256. These questions relate in particular to the definition of permanent establishment

(PE) for treaty purposes, and the related profit attribution rules. It had already been
recognised in the past that the concept of PE referred not only to a substantial physical
presence in the country concerned, but also to situations where the non-resident carried
on business in the country concerned via a dependent agent (hence the rules contained in
paragraphs5 and 6 of Article5 of the OECD Model Tax Convention). As nowadays it is
possible to be heavily involved in the economic life of another country without having a
fixed place of business or a dependent agent therein, concerns are raised regarding whether
the existing definition of PE remains consistent with the underlying principles on which it
was based. For example, the ability to conclude contracts remotely through technological
means, with no involvement of individual employees or dependent agents, raises questions
about whether the focus of the existing rules on conclusion of contracts by persons other
than agents of an independent status remains appropriate in all cases.
257. These concerns are exacerbated in some instances by the fact that in certain business
models, customers are more frequently entering into ongoing relationships with providers
of services that extend beyond the point of sale. This ongoing interaction with customers
generates network effects that can increase the value of a particular business to other
potential customers. For example, in the case of a retail business operated via a website
that provides a platform for customers to review and tag products, the interactions of those
customers with the website can increase the value of the website to other customers, by
enabling them to make more informed choices about products and to find products more
relevant to their interests.
258. Similarly, users of a participative networked platform contribute user-created
content, with the result that the value of the platform to existing users is enhanced as new
users join and contribute. In most cases, the users are not directly remunerated for the
content they contribute, although the business may monetise that content via advertising
revenues (as described in relation to multi-sided business models below), subscription
sales, or licensing of content to third parties. Alternatively, the value generated by user
contributions may be reflected in the value of business itself, which is monetised via the
sale price when the business is sold by its owners. Concerns that the changing nature of
customer and user interaction allows greater participation in the economic life of countries
without physical presence are further exacerbated in markets in which customer choices
compounded by network effects have resulted in a monopoly or oligopoly.
259. These various developments must be understood in light of their relationship to
more traditional ways of doing business. For example, while having a market in a country is
clearly valuable to a seller, this condition by itself has not created a taxing right in the area
of direct taxation to this point. It is also true that data about markets and about customers
has always been a source of value for businesses as illustrated by phenomena such as
frequent flyer programmes, loyalty programmes, the creation and sale of customer lists,
and marketing surveys (in which customers participate for no remuneration), to name a few.
The traditional economy also benefited from network effects in ways that are perhaps
less obvious than the network effect present in social networks. Sellers of fax machines, for
example, were dependent on a sufficiently broad supplier of purchasers in order to ensure
that their product had value. The digital economy has, however, enabled access to markets
with less reliance on physical presence than in the past. In addition, the digital economy
has enabled collection and analysis of data at unprecedented levels, and has enhanced the
impact of customer and user participation in the market, as well as the degree of network
effects. It has been suggested that the lower marginal costs in digital businesses coupled
with increased network effects generated by higher levels of user participation may justify
a change in tax policy. See, e.g.Crmer (2015); Pistone and Hongler (2015). In considering
policy changes to reflect customer interactions to the imposition of income tax, however,
potential impact on traditional ways of doing business must be taken into account in order
to maintain coherence in cross border tax policy. In addition, consideration should be given
both to solutions based on income tax and to solutions focused on indirect taxes.
260. Another specific issue raised by the changing ways in which businesses are conducted
is whether certain activities that were previously considered preparatory or auxiliary (and
hence benefit from the exceptions to the definition of PE) may be increasingly significant
components of businesses in the digital economy. For example, as indicated in Chapter6, if
proximity to customers and the need for quick delivery to clients are key components of the
business model of an online seller of physical products, the maintenance of a local warehouse
could constitute a core activity of that seller. Similarly, where the success of a high-frequency
trading company depends so heavily on the ability to be faster than competitors that the
server must be located close to the relevant exchange, questions may be raised regarding
whether the automated processes carried out by that server can be considered mere
preparatory or auxiliary activities.
261. Although it is true that tax treaties do not permit the taxation of business profits of
a non-resident enterprise in the absence of a PE to which these profits are attributable, the
issue of nexus goes beyond questions of PE under tax treaties. In fact, even in the absence
of the limitations imposed by tax treaties, it appears that many jurisdictions would not
in any case consider this nexus to exist under their domestic laws. For example, many
jurisdictions would not tax income derived by a non-resident enterprise from remote sales
to customers located in that jurisdiction unless the enterprise maintained some degree
of physical presence in that jurisdiction. As a result, the issue of nexus also relates to the
domestic rules for the taxation of non-resident enterprises.
7.4. Data and the attribution of value created from the generation of marketable
location-relevant data through the use of digital products and services
262. Digital technologies enable the collection, storage and use of data, and also enable
data to be gathered remotely and from a greater distance from the market than previously.
Data can be gathered directly from users, consumers or other sources of information, or
indirectly via third parties. Data can also be gathered through a range of transactional
relationships with users, or based on other explicit or implicit forms of agreement with
users. Companies collect data through different methods. These can be proactive, requesting
or requiring users to provide data and using data analytics, or primarily reactive, with the
quantity and nature of the information provided largely within the control of users e.g.social
networking and cloud computing. As set out in Chapter3, data gathered from various
sources is often a primary input into the process of value creation in the digital economy.
Leveraging data can create value for businesses in a variety of ways, including by allowing
businesses to segment populations in order to tailor offerings, to improve the development
of products and services, to better understand variability in performance, and to improve
decision making. The expanding role of data raises questions about whether current nexus
rules continue to be appropriate or whether any profits attributable to the remote gathering
of data by an enterprise should be taxable in the State from which the data is gathered, as
well as questions about whether data is being appropriately characterised and valued for
tax purposes. As noted above, the issue of data collection is not new, although the ability to
collect and categorise data has increased exponentially in large part due to computing power
and the growth of the internet. As a result, addressing the growing role of data would require
consideration of potential impact on more traditional business models as well.
263. While it is clear that many businesses have developed ways to collect, analyse, and
ultimately monetise data, it may be challenging for purposes of an analysis of functions,
assets, and risks, to assign an objective value to the raw data itself, as distinct from the
processes used to collect, analyse, and use that data. For accounting purposes, the value
of data collected by a business, like other self-created intangibles, would generally not
appear on the balance sheet of the business, and would therefore not generally be relevant
for determining profits for tax purposes. Although data purchased from another related
or unrelated business would be treated as an asset in the hands of the buyer (and its
subsequent sale would generate tax consequences), outright sale of data is only one of many
ways in which collection and analysis of data can be monetised. For example, as with other
user contributions, the value of data may be reflected in the value of the business itself,
and may be monetised when the business is sold. Even where data itself is sold, the value of
that data may vary widely depending on the capacity of the purchaser to analyse and make
use of that data. The issue of valuing data as an asset is further complicated by existing
legal questions about the ownership of personal data, and the ability of users to control
whether businesses can access and utilise user data by using digital services anonymously,
or by deleting data stored in local caches. Many jurisdictions have passed data protection
and privacy legislation to ensure that the personal data of consumers is closely protected.
Under most such legislation, this information is considered to be the property of the
individual from which it is derived, rather than an asset owned by a company or a public
good. Economic literature analysing intangibles, in contrast, has tended to embrace modern
business realities and value also assets whose ownership may not be protected by legal
rules (Corrado et al., 2012).
264. The value of data, and the difficulties associated with determining that value, is
also relevant for tax purposes in the cross-border context and triggers questions regarding
whether the remote collection of data should give rise to nexus for tax purposes even in
the absence of a physical presence, and if so (or in the case of an existing taxable presence)
what impact this would have on the application of transfer pricing and profit attribution
principles, which in turn require an analysis of the functions performed, assets used and
risks assumed. The fact that the value of data can impact tax results places pressure on
the valuation of data. Further, the fact that the value of data can impact tax results if
attributable to a PE or if held by a local subsidiary and sold to a foreign enterprise, but not
if collected directly by a foreign enterprise with no PE, places pressure on the nexus issues
and raises questions regarding the location of data collection. This distinction between the
taxation of those with a PE and those without a PE was, of course, present in the traditional
economy as well.
265. In addition, data, including location-specific data, may be collected from customers
or devices in one country using technology developed in a second country. It may then
be processed in the second country and used to improve product offerings or target
advertisements to customers in the first country. Determining whether profit is attributable
to each of these functions and the appropriate allocation of that profit between the first
country and the second country raises tax challenges. These challenges may be exacerbated
by the fact that in practice a range of data may be gathered from different sources and for
different purposes by businesses and combined in various ways to create value, making
tracing the source of data challenging. This data may be stored and processed using cloud
computing, making the determination of the location where the processing takes place
similarly challenging.
266. Additional challenges are presented by the increasing prominence in the digital
economy of multi-sided business models. A key feature of two-sided business models
is that the ability of a company to attract one group of customers often depends on the
companys ability to attract a second group of customers or users. For example, a company
may develop valuable services, which it offers to companies and individuals for free or at
a price below the cost of providing the service, in order to build a user base and to collect
data from those companies and individuals. This data can then be used by the business
to generate revenues by selling services to a second group of customers interested in the
data itself or in access to the first group. For example, in the context of internet advertising
data collected from a group of users or customers can be used to offer a second group of
customers the opportunity to tailor advertisements based on those data. Where the two
groups of customers are spread among multiple countries, challenges arise regarding the
issue of nexus mentioned above and in determining the appropriate allocation of profits
among those countries. Questions may also arise about the appropriate characterisation of
transactions involving data, including assessing the extent to which data and transactions
based on data exchange can be considered free goods or barter transactions, and how they
should be treated for tax and accounting purposes. However, as discussed more generally
above, the location of advertising customers and the location of users are frequently aligned
in practice, such that the value of the user data is reflected in the advertising revenue
generated in a country. The scale of this challenge may, in addition, be mitigated by the fact
that advertising will frequently require a local presence to attract advertisers.
267. The changing relationship of businesses with users/customers in the digital economy
may raise other challenges as well. The current tax rules for allocating income among
different parts of the same MNE require an analysis of functions performed, assets used,
and risks assumed. This raises questions in relation to some digital economy business
models where part of the value creation may lie in the contributions of users or customers in
a jurisdiction. As noted above, the increased importance of users/customers therefore relates
to the core question of how to determine where economic activities are carried out and value
is created for income tax purposes.
7.5. Characterisation of income derived from new business models

268. Products and services can be provided to customers in new ways through digital
technology. The digital economy has enabled monetisation in new ways, as discussed in
Chapters 3 and 4, and this raises questions regarding both the rationale behind existing
categorisations of income and consistency of treatment of similar types of transactions.
269. Prior work by the Treaty Characterisation Technical Advisory Group (TAG),
discussed further in AnnexA examined many characterisation issues related to e-commerce.
Although this work remains relevant, new business models raise new questions about how to
characterise certain transactions and payments for domestic and tax treaty law purposes.1 For
example, although the TAG considered the treatment of application hosting, cloud computing
has developed significantly since that work, and the character of payments for cloud
computing is not specifically addressed in the existing Commentary to the OECD Model Tax
Convention. The question for tax treaty purposes is often whether such payments should be
treated as royalties (particularly under treaties in which the definition of royalties includes
payments for rentals of commercial, industrial, or scientific equipment), fees for technical
services (under treaties that contain specific provisions in that respect), or business profits.
More specifically, questions arise regarding whether infrastructure-as-a-service transactions
should be treated as services (and hence payments characterised as business profits for treaty
purposes), as rentals of space on the cloud service providers servers by others (and hence be
characterised as royalties for purposes of treaties that include in the definition of royalties
payments for rentals of commercial, industrial, or scientific equipment), or as the provision
of technical services. The same questions arise regarding payments for software-as-a-service
or platform-as-a-service transactions.
270. In the future, development and increasing use of 3D printing may also raise
character questions. For example, if direct manufacturing for delivery evolves into a license
of designs for remote printing directly by purchasers, questions may arise as to whether
Box7.1. Administrative challenges in the digital economy

There is a pressing need to consider how investment in skills, technologies and data
management can help tax administrations keep up with the ways in which technology is
transforming business operations. The borderless nature of digital economy produces specific
administrative issues around identification of businesses, determination of the extent of
activities, information collection and verification, and identification of customers. These issues
are outlined below, while possible ways to address them are outlined in the later sections of
this chapter. Further, operational work is underway within the Forum on Tax Administration
to develop a strong voluntary compliance culture and expand the use of modern technology for
self-service delivery purposes (OECD, 2014).

Identification: While global business structures in the digital economy involve

traditional identification challenges, these challenges are magnified in the digital
economy. For example, the market jurisdiction may not require registration or other
identification when overseas businesses sell remotely to customers in the jurisdiction,
or may have issues with implementing registration requirements, as it is often difficult
for tax authorities to know that activities are taking place, to identify remote sellers
and to ensure compliance with domestic rules. Difficulties in identifying remote
sellers may also make ultimate collection of tax difficult.
Determining the extent of activities: Even if the identity and role of the parties
involved can be determined, it may be impossible to ascertain the extent of sales or
other activities without information from the offshore seller, as there may be no sales
or other accounting records held in the local jurisdiction or otherwise accessible by
the local revenue authority. It may be possible to obtain this information from third
parties such as the customers or payment intermediaries, but this may be dependent
on privacy or financial regulation laws.
Information collection and verification: To verify local activity, the market jurisdictions
tax administration may need to seek information from parties that have no operations
in the jurisdiction and are not subject to regulation therein. While exchange of
information can be a very useful tool where the proper legal basis is in place, this is
predicated on knowledge of where the offshore entity is tax resident and information
retained or accessible by the reciprocating tax authority. This can create challenges for
a market jurisdiction revenue authority seeking to independently verify any information
provided by the offshore entity.
Identification of customers: There are in principle a number of ways in which a business

can identify the country of residence of its client and/or the country in which consumption
occurs. These could include freight forwarders or other customs documentation or
tracking of Internet Protocol (IP) and card billing addresses. However, this could be
burdensome for the business and would not work where customers are able to disguise
their location.
and under what circumstances payments by purchasers may be classified as royalties rather
than as business profits, or may be treated as fees for technical services.
271. Under most tax treaties, business profits would be taxable in a country only if
attributable to a PE located therein. In contrast, certain other types of income, such as
royalties, may be subject to withholding tax in the country of the payer, depending on the
terms of any applicable treaty. Whether a transaction is characterised as business profits
or as another type of income, therefore, can result in a different treatment for tax treaty
purposes. There is therefore a need to clarify the application of existing rules to some new
business models.
272. At the same time, when considering questions regarding the characterisation of
income derived from new business models it may be necessary to examine the rationale
behind existing rules, in order to determine whether those rules produce appropriate
results in the digital economy and whether differences in treatment of substantially similar
transactions are justified in policy terms. In this respect, further clarity may be needed
regarding the tax treaty characterisation of certain payments under new business models,
especially cloud computing payments (including payments for infrastructure-as-a-service,
software-as-a-service, and platform-as-a-service transactions). In addition, issues of
characterisation have broader implications for the allocation of taxing rights for direct
tax purposes. For example, if a new type of business is able to interact extensively with
customers in a market jurisdiction and generate business profits without physical presence
that would rise to the level of a PE, and it were determined that the market jurisdiction
should be able to tax such income on a net basis, modifying the PE threshold and associated
profit attribution rules could permit such taxation. Source taxation could also be ensured
by creating a new category of income that is subject to withholding tax. As a result, the
issue of characterisation has significant implications for the issue of nexus.
7.6. Developing options to address the broader direct tax challenges of the digital
economy
273. In the context of its work, the TFDE received and discussed several proposals for
potential options to address the broader direct tax challenges raised by the digital economy,
including novel work carried out by academics (Bloch, 2015; Bourreau, 2015; Brauner,
2015; Crmer, 2015; Hongler, 2015). As there is a substantial overlap between the challenges
related to nexus, data, and characterisation, it was considered that rather than attempting to
individually target them, any potential option should instead focus more generally on the
ability of businesses in the digital economy to (i)derive sales income from a country without
a physical presence, and (ii)use the contributions of users in the value chain (including
through collection and monitoring of data), and monetise these contributions by selling the
data to third parties, by selling targeted ads, by selling the business itself, or in any other way.
274. The options analysed by the TFDE in 2014 included modifications to the exceptions
from PE status, alternatives to the existing PE threshold, the imposition of a withholding
tax on certain types of digital transactions, and the introduction of a tax on bandwidth use.
275. With respect to the exceptions from PE status, work in the context of Action7
of the BEPS Project (preventing the artificial avoidance of PE status) analysed whether
activities that may previously have been preparatory or auxiliary should continue to
benefit from exceptions (contained in Article5(4) of the OECD Model Tax Convention)
to the permanent establishment definition where they have become core components of a
business. As a result of this work, these exceptions have been modified to ensure that they
are available only for activities that are of a preparatory or auxiliary nature.
276. The technical details of the other three options have been developed further and
are presented below. Like the challenges they are intended to address, the impact of these
options overlaps in a number of respects. They have therefore been conceived in a way
that allows them to be either combined into a single option or chosen individually. More
specifically, elements of the three potential options could be combined into a new concept
of nexus for net-basis taxation (a significant economic presence), with the intent to reflect
situations where an enterprise leverages digital technology to participate in the economic
life of a country in a regular and sustained manner without having a physical presence in
that country. In this context, the application of a withholding tax on digital transactions
could be considered as a tool to enforce compliance with net taxation based on this
potential new nexus, while an equalisation levy could be considered as an alternative to
overcome the difficulties raised by the attribution of income to the new nexus.
7.6.1. A new nexus based on the concept of significant economic presence

277. This option would create a taxable presence in a country when a non-resident
enterprise has a significant economic presence in a country on the basis of factors that
evidence a purposeful and sustained interaction with the economy of that country via
technology and other automated tools. These factors would be combined with a factor based
on the revenue derived from remote transactions into the country, in order to ensure that only
cases of significant economic presence are covered, limit compliance costs of the taxpayers,
and provide certainty for cross-border activities. The following sections describe the details
of such an option, together with potential approaches for attributing income to the new nexus.
7.6.1.1. Revenue-based factor

278. As a general matter, revenue that is generated on a sustained basis from a country
could be considered to be one of the clearest potential indicators of the existence of a
significant economic presence. This is based on the assumption that even in multi-sided
business models, and particularly those dependent on network effects, the two markets
are likely to be strongly interrelated, and as a result are likely to besituated in the same
country. To the extent that the country of the users and country of the paying customers
are aligned, the value of an enterprises users and user data would generally be reflected in
the enterprises revenue in a country. In other words, because user data serves to enhance
the value of the services an enterprise offers, a strong user network (and the attendant
user data) is likely to result in enterprises either selling more or enterprises charging more
for its core products/services, or both. Under such circumstances, the revenues earned
from customers in a country are a potential factor for establishing nexus in the form of a
significant economic presence in the country concerned. Revenues will not be sufficient
in isolation to establish nexus but they could be considered a basic factor that, when
combined with other factors, could potentially be used to establish nexus in the form of a
significant economic presence in the country concerned. In addition, the use of revenue as
a basic factor could limit the compliance costs of taxpayers and provides a high degree of
tax certainty for cross-border activities. In developing a revenue factor, consideration was
given to the following technical issues:
Transactions covered. One approach that could be considered in defining a basic
revenue factor is to include only revenues generated from digital transactions
concluded with in-country customers through an enterprises digital platform.
Specifically, these transactions would involve the conclusion of a contract for the sale
(or exchange) of goods and services between two or more parties effectuated through
a digital platform where the contract conclusion primarily relies on automated
systems. Such an approach could however create incentives for particular ways of
doing business with remote customers. For example, such an approach would treat
remote digital transactions differently from mail-order transactions (e.g.catalogue
shopping) and telephone transactions (e.g.sale through call centres). Although in
practice the latter transactions are less likely to enable a business to generate a
significant amount of revenue, all three ways of transacting enable businesses to
engage in sales transactions without physical presence in the country of the customer.
In addition, businesses may leverage digital technology to reach a broader range of
customers in another country without entering into digital transactions (e.g.website
displaying the products but routing the customers to a call centre to perform the final
purchase). Accordingly, to ensure that taxpayers in similar situations carrying out
similar transactions will be subject to similar levels of taxation, it may be preferable
to define the factor so as to include all revenue generated by transactions concluded
by the non-resident enterprise remotely with in-country customers. Potential adverse
effects associated with such a broad scope would in any case be addressed by the
application of the other factors (see further below at 7.6.1.4).
Level of the threshold. The core element of the revenue factor could be the gross
revenues generated from remote transactions concluded with customers in the
country concerned. This amount should be framed in absolute terms and in local
currency, in order to minimise the risk of manipulation. A key objective in setting
the level of threshold would be to set it at a high enough level to minimise the
administrative burden for tax administrations as well as the compliance burden
on and level of uncertainty for the taxpayer, while ensuring that nexus is less
likely to be created in cases in which minimal tax revenue would be collected.
The size of the countrys market might also be a relevant factor in setting the level
of the revenue threshold. Given the relative mobility and flexibility in choosing
the location of automated functions related to revenue-generating activities in
the digital economy, the factor could be applied on a related-group basis rather
than on a separate-entity basis to prevent any risk of artificial fragmentation of
distance selling activities with customers of the same country among a variety
of foreign affiliated entities. This aggregation rule could be introduced as a
rebuttable presumption, with the taxpayer being able to demonstrate that it did
not artificially fragment the distance selling activities in order to manipulate the
revenue threshold.
Administration of the threshold. An accurate application of the revenue threshold
would depend on the ability of the country to identify and measure remote sales
activities of the non-resident enterprise. One possible approach to address this
challenge could be to introduce a mandatory registration system for enterprises that
meet the factors giving rise to a significant economic presence. On the other hand,
it could be difficult for tax authorities to know when activities are taking place
and at what scale, to identify remote sellers, and ultimately to ensure compliance.
Similarly, in the case of transactions concluded and fulfilled entirely online, it may
be difficult for enterprises to identify with certainty the country of residence of
clients. In this respect, regimes introduced to ensure compliance with VAT/GST
rules by non-resident suppliers could prove extremely useful (see also Chapter8
for additional details).
7.6.1.2. Digital factors

279. In the case of brick and mortar businesses, the ability to reach significant numbers
of customers in a country generally depends on a variety of factors, including a stores
location, local marketing and promotion, payment options, and sales and customer service
employees. In the digital economy, the ability to establish and maintain a purposeful and
sustained interaction with users or customers in a specific country via an online presence
depends on analogous factors. A range of digital factors based on the current development
of the digital economy could be used as part of a test for significant economic presence,
including the following:
A local domain name. A non-resident enterprise targeting customers or users in a
country will generally obtain the digital equivalent of a local address where the nonresident enterprise establishes its store front, typically taking the form of a localised
or specialised domain name. For example, while an enterprises home domain name
might be .com, the enterprises site targeting one country would likely use a domain
name reflecting that, in order to make it more likely that a local user would find the
local site. This is reinforced by the need of enterprises to protect their trademarks
by purchasing related domain names, including a local country domain name. In
summary, while it is possible for an enterprise to do business in a country without a
local domain name, the choice to do so carries reputational risk from potential domain
squatting and trademark infringement from not protecting the enterprises business
name, trademarks and trade names across various domains. Accordingly, MNEs doing
substantial cross-border business would very likely operate in a country via a local
domain name. Whether local domain names will remain the predominant method for
accessing markets, however, is uncertain. In the near future, merchants selling camera
equipment globally may, for example, use a generic .camera domain name, thus
reducing the relevance of country specific domain name.
A local digital platform. Non-resident enterprises frequently establish local
websites or other digital platforms in order to present the goods or services being
offered in the light that most appeals to the local users or customers, taking into
account language and cultural norms in particular. Local websites or digital platforms
could include features intended to facilitate interaction by local users and customers
with the sites content, services and functions. Such features include language, local
marketing such as targeted discounts and promotions, and local terms of service
for users and customers that reflect the commercial and legal context of the local
environment. Although some enterprises may elect to only operate only in one
language and not attempt to undertake local marketing or promotional efforts,
establishing a local platform is often critical to attracting meaningful numbers of
local users and customers. Note, however, that local platforms do not necessarily
correspond to political boundary lines.
Local payment options. A non-resident enterprise that maintains a purposeful and
sustained interaction with the economy of a country will frequently ensure that
local customers have a seamless purchasing experience with prices reflected in local
currency, taxes, duties and fees already calculated, with the option of using a local
form of payment to complete the purchase. Integration of local forms of payment into
a sites commercial features is a complicated technical, commercial, and legal exercise
requiring substantial resources, and an enterprise would normally not undertake
such an investment unless it purposefully participates in the countrys economic life.
While this factor may be less relevant in countries that share a common currency, it
generally is a critical commercial requirement in countries that have stringent banking
regulations, currency controls, or low penetration of international credit cards.
7.6.1.3. User-based factors

280. Given the importance of network effects in the digital economy, the user base and
the associated data input may also be important indicators of a purposeful and sustained
interaction with the economy of that another country. A range of factors based on users
could be used to reflect the level of participation in the economic life of a country, namely:
Monthly active users (MAU). One factor reflecting the level of penetration in a
countrys economy is the number of monthly active users (MAU) on the digital
platform that are habitually resident in a given country in a taxable year. The
term MAU refers to registered user who logged in and visited a companys digital
platform in the 30-day period ending on the date of measurement. A factor based
on MAU presents the advantage of measuring the customer/user base in a given
country both in terms of size and level of engagement. Given that little material is
publicly available on the process of defining and identifying MAU, more detailed
metrics would need to be developed in consultation with businesses and IT experts
for the purpose of using this factor, such as how to identify a unique user or what
level of engagement is required for a user to be considered active. Reliability and
veracity of the information would also need to be ensured, to address fraudulent
accounts, multiple accounts, false information volunteered by users, and botproduced data, to name a few.
Online contract conclusion. Another factor indicating the level of participation
of an enterprise in the economic life of a country is the regular conclusion of
contracts. This is the focus of the existing dependent agent PE test contained
in Article5 of the OECD Model which, in broad terms, requires that this contract
conclusion be carried out in the country by a person acting on behalf of the nonresident enterprise. In the digital economy, contracts can frequently be concluded
with customers via a digital platform without the need for the intervention of
local personnel or dependent agents. For example, online platforms providing free
services to their users often specify on their websites that by accessing or using the
products and services of the company the user agrees to the Terms of Service and
each use of the platform results in the conclusion of a legally binding agreement.
The number of contracts concluded through a digital platform with customers or
users that are habitually resident in the country in any taxable year could therefore
be considered an important factor.
Data collected. Another factor which could be considered to reflect an enterprises
level of participation in the economic life of a country is the volume of digital
content collected through a digital platform from users and customers habitually
resident in that country in a taxable year. The focus would be on the origin of
the data collected, irrespective of where that data is subsequently stored and
processed (e.g.data warehouse). The range of data captured by the threshold
would not be confined to personal data, but would cover also, e.g.user created
content, product reviews, and search histories. This core element could be coupled
with proportionality tests, such as whether the volume of digital content collected
exceeds a percentage of the enterprises overall stored digital content. Information
on data collected is increasingly available, reliable and up-to-date, especially if the
factor is focusing on data collected that is effectively stored by the non-resident
enterprise on a server. At the same time, businesses may not necessarily maintain
separate and comprehensive track records of the volume of data collected and
stored on a country-by-country basis. In addition, the volume of data collected (and
stored) from users in a country may not necessarily reflect an effective contribution
to the profits generated by the non-resident enterprise, as the value of raw data is
rather uncertain and particularly volatile.
7.6.1.4. Possible combinations of the revenue factor with the other factors
281. For purposes of this potential option, total revenue in excess of the revenue
threshold would be an indicator of the existence of a significant economic presence.
282. Total revenue, however, may not by itself suffice to evidence a non-resident enterprises
regular and sustained participation in the economic life of a country. To be an appropriate
measure of participation in the economic life of a country, the revenue factor could be combined
with other factors, such as the digital and/or user-based factors that indicate a purposeful and
sustained interaction with the economy of the country concerned. In other words, a link would
have to be created between the revenue-generating activity of the non-resident enterprise and its
significant economic presence in the country. The choice of which factors should be combined
with the revenue factor to ascertain whether a significant economic presence should be deemed
to exist is likely to be driven by the unique features and economic attributes of each market
(e.g.size, local language, currency restrictions, banking system).
283. This concept may be illustrated by an example. If a non-resident enterprise generates
gross revenues above the threshold from transactions with in-country customers concluded
electronically through a localised digital platform where the customer is required to create
a personalised account and utilise the local payment options offered on the site to execute
the purchase, it could be considered that there is a link between the revenue generated from
that country and the digital and/or user-based factors evidencing a significant economic
presence in that country. In contrast, it would be more difficult to find such a link where
a non-resident enterprise generates gross revenues above the threshold from transactions
with in-country customers through in-person negotiation taking place outside of the
market jurisdiction, if the enterprise only maintains a passive website that provides product
information with no functionalities permitting transactions or intensive interaction with
users (including data collection).
7.6.2. Determining the income attributable to the significant economic presence

284. Attribution of profits is a key consideration in developing a nexus based on
significant economic presence. The option outlined in 7.6.1 above would establish nexus for
taxation in cases where an enterprise has no physical presence in the country concerned.
Consideration must therefore be given to what changes to profit attribution rules would
need to be made if the significant economic presence option were adopted, while ensuring
parity to the extent possible between enterprises that are subject to tax due to physical
presence in the market country (i.e.local subsidiary or traditional PE) and those that are
taxable only due to the application of the option.
7.6.2.1. Existing rules and principles

285. A significant economic presence associated with little or no physical presence in
terms of tangible assets and/or personnel in the other country is not likely to involve the
carrying on of any functions of the enterprise in the traditional sense. Unless significant
adjustments are made to the existing rules, therefore, it would not be possible to allocate
any meaningful income to the new nexus.
286. Several adjustments to existing principles were considered during the course of the
work, including allocating business functions handled remotely through automated systems
to the significant economic presence, as well as treating customers and users as performing
certain functions on behalf of an enterprise under certain circumstances. Other substantial
departures from existing rules, such as replacing a functional analysis with an analysis
based on game theory that would allocate profits by analogy with a bargaining process
within a joint venture, were also considered (see Pellefigue, 2015). All such potential
adjustments, however, would require substantial departures from existing standards for
allocating profits within a MNE operating in multiple jurisdictions, which are currently
based on an analysis of the functions, assets and risks of the enterprises concerned. It
was concluded, therefore, that, unless there is a substantial rewrite of the rules for the
attribution of profits, alternative methods would need to be considered.
7.6.2.2. Methods based on fractional apportionment

287. Another approach considered would be to apportion the profits of the whole enterprise
to the digital presence either on the basis of a predetermined formula, or on the basis of
variable allocation factors determined on a case-by-case basis. In the context of a significant
economic presence, the implementation of a method based on fractional apportionment
would require the performance of three successive steps: (1)the definition of the tax base to
be divided, (2)the determination of the allocation keys to divide that tax base, and (3)the
weighting of these allocation keys.
288. It is important to note that the domestic laws of most countries use profit attribution
methods based on the separate accounts of the PE, rather than fractional apportionment. In
addition, fractional apportionment methods would be a departure from current international
standards. Furthermore, pursuing such an approach in the case of application of the
new nexus would produce very different tax results depending on whether business was
conducted through a traditional permanent establishment, a separate subsidiary or the new
nexus. Given those constraints, fractional apportionment methods were not pursued further.
7.6.2.3. Modified deemed profit methods

289. The use of empirical presumption methods such as deemed profit systems is
sometimes a way to avoid profit computations based on the taxpayers accounts in situations
where a high proportion of expenses associated with revenues are incurred overseas, making
it difficult from a practical perspective to audit locally. Deemed profits methods have been
used, for example, in the insurance industry, by applying a coefficient based on the ratio of
profit to gross premiums of resident insurance companies to gross premiums received from
policy holders in the source country.
290. In the context of a nexus based on significant economic presence, one possible
approach would thus be to regard the presence to be equivalent to a physical presence from
which the non-resident enterprise is operating a commercial business and determine the
deemed net income by applying a ratio of presumed expenses to the non-resident enterprises
revenue derived from transactions concluded with in-country customers, hence aligning
it to one of the key factors of the option as described above. Determining an appropriate
ratio would depend on a number of factors, including the industry concerned, the degree of
integration of the particular enterprise, and the type of product and service provided. One
possible approach would thus be to classify taxpayers by industry and apply an industryspecific profit percentage. A more refined approach would be to divide taxpayers within
a given industry into additional classes based on relevant factors (e.g.capital equipment,
turnover, employees), with a specific profit percentage within each band. The determination
of the latter percentage would require an extensive analysis of actual profit margins of
domestic taxpayers operating in the same specific class of industry or type of business.
291. Deemed profit methods are generally perceived as relatively easy to administer and
raise revenue. However, for large MNE groups with complex structures operating in many
lines of business, applying multiple industry-specific presumptive profit margins to the
same significant economic presence presents several practical challenges. Another challenge
relates to the comparability of digital and traditional business models when considering the
applicability of such deemed profit margins. Many digital business models have a different
cost structure than traditional business models, such that adjustments to margins found in
this context are very likely to be required. In addition, application of deemed profit methods
in this context may be considered as a substantial departure from current international
standards, resulting in a tax liability even where there are no actual profits generated through
the significant economic presence. One possible way to mitigate this negative impact would
be to create a rebuttable presumption limited to situations where the foreign taxpayer is able
to demonstrate that its overall activity (or specific line of business related to the activity of
the significant economic presence if it can be ring-fenced from other business activities of the
enterprise) is in a loss-making position at the end of the fiscal year.
7.6.3. A withholding tax on digital transactions

292. A withholding tax on payments by residents (and local PEs) of a country for goods
and services purchased online from non-resident providers has also been considered. This
withholding tax could in theory be imposed as a standalone gross-basis final withholding
tax on certain payments made to non-resident providers of goods and services ordered
online or, alternatively, as a primary collection mechanism and enforcement tool to support
the application of the nexus option described above, i.e.net-basis taxation. Both approaches
raise similar technical issues with respect to the scope of transactions covered and the
collection of the ensuing tax liability. In addition, the application of a standalone final
withholding tax raises specific challenges regarding trade obligations and EU law.
7.6.3.1. Scope of transactions covered

293. The scope of transactions covered by the tax must be clearly defined, so that
taxpayers and withholding agents will know when the tax applies, and to ensure that tax
administrations will be able to ensure compliance. The scope should also be defined as
simply as possible in order to avoid unnecessary complexity and classification disputes.
The need for clarity and simplicity, however, must be balanced against a need to ensure that
similar types of transactions will be taxed similarly, in order to avoid creating incentives
for or against particular ways of structuring them.
294. For this purpose, although listing specific types of transactions covered would provide
a degree of clarity, it would also likely result in disputes over the character of transactions,
particularly as technology continues to advance. Such an approach also could lead to
differences in treatment for tax purposes between economically equivalent transactions
depending on their form. For this reason, a more general definition of covered transactions
appears more appropriate. The tax could be applied, for example, to transactions for goods
or services ordered online (i.e.digital sales transactions), or to all sales operations concluded
remotely with non-residents. The latter would have the advantage of flexibility, and would
ensure tax neutrality between similar ways of doing business, and may reduce disputes over
characterisation. In addition, if withholding is used as a tool to support net-basis taxation, a
broad scope covering all distance selling would be more consistent with the sales threshold
discussed above in the context of a nexus based on significant economic presence.
7.6.3.2. Collection of the tax

295. In practice, the liability to pay a withholding tax on outbound payments is often
shifted from the non-resident enterprise to a local collecting agent, such as the customer
or a third-party payment processing intermediary. For such a mechanism to function
efficiently, the agent responsible for withholding must have access to information about the
covered transactions sufficient to know when the tax will apply, and must be reasonably
expected to comply with its obligation to withhold.
296. In the case of B2B transactions, businesses resident in the source country may
reasonably be expected to comply with the withholding obligation. In the case of B2C
transactions, however, requiring withholding from the payor would be more challenging
as private consumers have little experience nor incentive to declare and pay the tax due.
Moreover, enforcing the collection of small amounts of withholding from large numbers of
private consumers would involve considerable costs and administrative challenges.
297. One possible solution would be to require intermediaries processing the payment
to withhold on the payment in a B2C context. As a practical matter, however, this presents
several technical issues. For example, an intermediary would generally not have access to
transaction-identifying information enabling it to determine its character and hence the
amount of tax due. In practice, it would only see a value without any description of the
underlying transaction, in which case it would not be able to determine with sufficient
certainty when it was required to withhold. The task of the intermediary could be
facilitated if the collection regime is supplemented by a mandatory registration system for
non-resident enterprises whereby all remote sellers of goods and services must designate
a dedicated bank account for all payments received from local customers. In the latter
situation, intermediaries may be required to withhold the tax only for payments made
to these specific bank accounts. However, the application of this approach may pose
challenges in imposing compliance obligations on intermediaries that are situated in
third-countries with no connection to the jurisdiction of the customer, thereby creating
opportunities for tax avoidance strategies.
7.6.3.3. Negative impact of gross-basis taxation and relationship with trade and
other obligations
298. The initial development and hosting of the technology required to provide products
and services online typically requires substantial up-front investment of resources,
including labour and capital. After initial creation of the technology, however, providing
products and services online frequently requires only limited marginal costs for businesses.
Where this is the case, it has been argued that payments made in consideration for digital
goods or services share common features with royalties and fees for technical services,
i.e.that gross revenue is a reliable proxy for net income. In many businesses, however,
providing products and services online will require ongoing expenditures for continued
product development (including maintenance of products and addition of new features),
marketing, and ongoing customer support due to rapid product cycles as technology and
competition evolve. Where this is the case, imposition of withholding tax on gross revenues
will be an imperfect proxy for tax on net income. One potential way to reduce the negative
impact of gross-basis taxation would be to fix the rate at a relatively low amount that would
reflect typical profit margins. Such margins could be determined, for example, on the basis
of a statistical analysis of actual profit margins of local domestic taxpayers operating in the
same specific class of industry or type of business.
299. Assuming that domestic suppliers of similar products are subject to net-basis taxation,
the imposition of a standalone gross-basis final withholding tax on foreign suppliers for remote
sales of goods and services is likely to raise substantial conflicts with trade obligations and
EU law. Trade obligations may differ substantially depending on whether a particular digital
transaction is treated as involving a product, in which case the General Agreement on Tariffs
and Trade (GATT) would apply, or a service, in which case the General Agreement on Trade
in Services (GATS) would apply. Both agreements generally require foreign suppliers of
goods (in the case of GATT) and services (in the case of GATS) to be taxed no less favourably
than domestic suppliers. However, GATS provides broad exceptions for the application of
provisions of tax treaties and for the imposition of direct tax provisions aimed at ensuring the
equitable or effective imposition of direct taxes. In contrast, GATT contains no exceptions to
national treatment obligations, and simply prohibits parties from subjecting imported products
to taxes in excess of those that would apply to similar products produced domestically. Thus,
at least to the extent GATT applies (i.e.to goods delivered physically, and to digital products
considered goods for trade purposes), consideration would need to be given to ways to
preserve national treatment.
300. In addition, for some countries EU law imposes comparable obligations i.e.nondiscrimination between resident and non-resident businesses that would not permit the
application to non-resident suppliers of a gross-basis final withholding tax, even if the rate
is fixed at a very low amount.
301. Given the above issues, a more viable approach could be to use this mechanism as
a back-up mechanism to enforce net-basis taxation on the basis of a significant economic
presence nexus, rather than as a standalone option. Whether the withholding tax is used as
a gross basis payments tax or a collection mechanism for net basis income tax, remittance
of the tax by local businesses would both ensure compliance and facilitate identification of
the covered remote sales. One approach in this regard would be to establish a registration
system for taxpayers that agree to file tax returns and pay tax on their net income, coupled
with a credit system enabling taxpayers to pay any tax due on net income in addition to
the tax withheld, or for taxpayers that are in a loss position on a net basis at the end of the
fiscal year to claim a tax refund. However, such a system would need to take into account
that taxpayers may have an incentive not to file a return where their net tax liability would
be greater than the amount of withholding tax payable.
7.6.4. Introducing an equalisation levy

302. To avoid some of the difficulties arising from creating new profit attribution rules
for purposes of a nexus based on significant economic presence, an equalisation levy
could be considered as an alternative way to address the broader direct tax challenges of the
digital economy. This approach has been used by some countries in order to ensure equal
treatment of foreign and domestic suppliers. For example, in the area of insurance, some
countries have adopted equalisation levies in the form of excise taxes based on the amount
of gross premiums paid to offshore suppliers. Such taxes are intended to address a disparity
in tax treatment between domestic corporations engaged in insurance activities and wholly
taxable on the related profits, and foreign corporations that are able to sell insurance without
being subject to income tax on those profits, neither in the state from where the premiums
are collected nor in state of residence.As discussed below, an equalisation levy could be
structured in a variety of ways depending on its ultimate policy objective. In general, an
equalisation levy would be intended to serve as a way to tax a non-resident enterprises
significant economic presence in a country. In order to provide clarity, certainty and equity
to all stakeholders, and to avoid undue burden on small and medium-sized businesses,
therefore, the equalisation levy would be applied only in cases where it is determined that a
non-resident enterprise has a significant economic presence.
7.6.4.1. Scope of the levy

303. If the policy priority is to tax remote sales transactions with customers in a market
jurisdiction, one possibility is to apply the levy to all transactions concluded remotely with
in-country customers. To target the scope of the levy more closely to the situation in which
a business establishes and maintains a purposeful and sustained interaction with users or
customers in a specific country via an online presence, the levy would be applied only
where the business maintains a significant economic presence as described above.
304. An alternative would be to limit the scope to transactions involving the conclusion
through automated systems of a contract for the sale (or exchange) of goods and services
between two or more parties effectuated through a digital platform. Although this would
create an incentive to choose non-digital means of conducting transactions, it would also
focus more closely on the specific types of transactions that have generated concern. There is
no rule, however, that prevents a broader scope of application. Indeed, focusing too narrowly
on specific types of transactions may limit the flexibility of the levy to accommodate future
developments, which would limit its ultimate effectiveness in addressing the tax disparity
between foreign and domestic suppliers of products through an online presence. The levy
would be imposed on the gross value of the goods or services provided to in-country
customers and users, paid by in-country customers and users, and collected by the foreign
enterprise via a simplified registration regime, or collected by a local intermediary.
305. Alternatively, if the policy priority is to tax the value considered to be directly
contributed by customers and users, then a levy could be imposed on data and other
contributions gathered from in-country customers and users. For that purpose, a number of
options could be available. One option would be to impose a charge based on the average
number of MAU in the country. As noted above, however, measuring MAU accurately
may prove to be challenging. Moreover, the number of MAU of a foreign enterprise may
not be directly related to in-country revenue generated by a foreign enterprise. Setting an
appropriate rate for a levy measured by active users would also be challenging, as the average
value of each user to a non-resident enterprise may vary widely. Another option would be to
base the levy on the volume of data collected from in-country customers and users. Similar to
MAU, however, data may also vary widely in value depending on its content and the purpose
for which it was gathered, and it would be challenging to identify a reliable direct connection
between the in-country revenue and the data collected from in-country customers and users.
7.6.4.2. Potential trade and other issues

306. As is the case with the imposition of a gross-basis final withholding tax, a levy
that applied only to non-resident enterprises would be likely to raise substantial questions
both with respect to trade agreements and with respect to EU law. In order to address
these questions, potential solutions that would ensure equal treatment of domestic and
non-resident enterprises would need to be explored, as discussed above in section7.6.3.3.
Depending on the structure of the levy, one option that could be considered would be to
impose the tax on both domestic and foreign entities. If this approach were to be taken,
however, presumably consideration would also need to be given to ways to mitigate the
potential impact of applying both the corporate income tax and the levy to domestic entities
and foreign entities taxable under existing corporate income tax rules.
7.6.4.3. Relationship with corporate income tax

307. Imposing an equalisation levy raises risks that the same income would be subject to
both corporate income tax and the levy. This could arise either in the situation in which a
foreign entity is subject to the levy at source and to corporate income tax in its country of
residence or in the situation in which an entity is subject to both corporate income tax and
the levy in the country of source. In the case of a foreign entity, for example, if the income
is subject to corporate income tax in the country of residence of the enterprise, the levy
would be unlikely to be creditable against that tax. To address these potential concerns, it
would be necessary to structure the levy to apply only to situations in which the income
would otherwise be untaxed or subject only to a very low rate of tax.
308. Another approach could be to allow a taxpayer subject to both CIT and the levy to
credit the levy against its domestic corporate income tax. Such an approach would ensure
that foreign entities with no nexus for corporate income tax purposes would be subject only
to the levy in the source country, while the tax burden of entities subject to corporate tax
would effectively be limited to the greater of the corporate income tax or the levy.
Note
1.
In addition, the conclusions drawn by the TAG have not been accepted by all countries
participating in the BEPS Project.
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Address the Tax Challenges of the Digital Economy, IBFD White Papers, Amsterdam.
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8. Broader indirect tax challenges raised by the digital economy and the options toaddress them 119
Chapter8
Broader indirect tax challenges raised by the digital economy and the options
toaddress them
This chapter discusses the challenges that the digital economy raises for indirect
taxation, with respect to exemptions for imports of low-valued goods, and remote
digital supplies to consumers. It then describes options to address these challenges.
120 8. Broader indirect tax challenges raised by the digital economy and the options toaddress them
8.1. Collection of VAT in the digital economy

309. Cross-border trade in goods, services and intangibles (which include for VAT purposes
digital downloads) creates challenges for VAT systems, particularly where such products are
acquired by private consumers from suppliers abroad. The digital economy magnifies these
challenges, as the evolution of technology has dramatically increased the capability of private
consumers to shop online and the capability of businesses to sell to consumers around the
world without the need to be present physically or otherwise in the consumers country. This
often results in no or an inappropriately low amount of VAT being levied on these flows, with
adverse effects on countries VAT revenues and on the level playing field between resident and
non-resident vendors. The main tax challenges related to VAT in the digital economy relate to
(i)imports of low value parcels from online sales which are treated as VAT-exempt in many
jurisdictions, and (ii)the strong growth in the trade of services and intangibles, particularly
sales to private consumers, on which often no or an inappropriately low amount of VAT is
levied due to the complexity of enforcing VAT-payment on such supplies.
8.1.1. Exemptions for imports of low valued goods

310. The first challenge regarding collection of VAT arises from the growth that has occurred
in e-commerce and in particular, online purchases of physical goods made by consumers from
suppliers in another jurisdiction. Countries with a VAT collect tax on imports of goods from the
importer at the time the goods are imported using customs collection mechanisms. Many VAT
jurisdictions apply an exemption from VAT for imports of low value goods as the administrative
costs associated with collecting the VAT on the goods is likely to outweigh the VAT that would
be paid on those goods. The value at which the exemption threshold is set varies considerably
from country to country but regardless of the threshold value, many VAT countries have seen a
significant growth in the volume of low value imports on which VAT is not collected.
311. Challenges arise from the ability of businesses to deliberately structure their affairs
to take advantage of a countrys low value thresholds and sell goods to consumers without
the payment of VAT. For example, a domestic business selling low value goods online
to consumers in its jurisdiction would be required to collect and remit that jurisdictions
VAT on its sales. The business could restructure its affairs so that the low value goods are
instead shipped to its consumers from an offshore jurisdiction and therefore qualify under
that VAT jurisdictions exemption for low value importations. Similarly, a business starting
up could structure its operations to deliberately take advantage of the low value exemption
and locate offshore rather than in the jurisdiction in which its customers are located.
312. The exemption for low value imports results in decreased VAT revenues and the
possibility of unfair competitive pressures on domestic retailers who are generally required,
depending for instance on their size, to charge VAT on their sales to domestic consumers.
As a consequence, the concern is not only this immediate loss of revenue and competitive
pressures on domestic suppliers, but also the incentive that is created for domestic suppliers
to locate or relocate to an offshore jurisdiction in order to sell their low value goods free
of VAT. It should also be noted that such relocations by domestic businesses would have
added negative impacts on domestic employment and direct tax revenues.
313. The exemptions for low value imports have therefore become increasingly
controversial in the context of the growing digital economy. The difficulty lies in finding
the balance between the need for appropriate revenue protection and avoidance of distortions
of competition, which tend to favour a lower threshold and the need to keep the cost of
collection proportionate to the relatively small level of VAT collected, which favours a
higher threshold. At the time when most current low value import reliefs were introduced,
internet shopping did not exist and the level of imports benefitting from the relief was
relatively small. Over recent years, many VAT countries have seen a significant and rapid
growth in the volume of low value imports of physical goods on which VAT is not collected
resulting in decreased VAT revenues and growing unfair competitive pressures on domestic
retailers who are required to charge VAT on their sales to domestic consumers.
8.1.2. Remote digital supplies to consumers

314. The second challenge regarding collection of VAT arises from the strong growth
in cross-border business-to-consumer (B2C) supplies of remotely delivered services and
intangibles. The digital economy has increasingly allowed the delivery of such products
by businesses from a remote location to consumers around the world without any direct
or indirect physical presence of the supplier in the consumers jurisdiction. Such remote
supplies of services and intangibles present challenges to VAT systems, as they often
result in no or an inappropriately low amount of VAT being collected and create potential
competitive pressures on domestic suppliers.
315. Consider an example of an online supplier of streaming digital content such as movies
and television shows. The supplies are made mainly to consumers who can access the digital
content through their computers, mobile devices and televisions that are connected to the
Internet. If the supplier is resident in the same jurisdiction as its customers, it would be
required to collect and remit that jurisdictions VAT on the supplies. However, if the supplier
is a non-resident in the consumers jurisdiction, issues may arise.
316. As noted in Chapter2, broadly two approaches are used by countries for applying
VAT to such cross-border supplies of services or intangibles: the first approach allocates
the taxing rights to the jurisdiction where the supplier is resident whereas the second
approach allocates the taxing rights to the jurisdiction where the customer is resident. If
the first approach is applied to the supply of digital content in the example, then this supply
will be subject to VAT in the suppliers jurisdiction at the rate that is applicable in that
jurisdiction. If the jurisdiction of the supplier of the digital content in the example applies
no VAT or a VAT with a lower rate than that of the consumers jurisdiction, then no or an
inappropriately low amount of VAT would be collected on this supply and none of the VAT
revenue would accrue to the jurisdiction where the final consumption takes place.
317. The approach that allocates the taxing rights to the jurisdiction where the customer
is resident would, in principle, result in taxation in the jurisdiction of consumption.
However, under this approach, it is challenging for the private consumers jurisdictions
to ensure an effective collection of the VAT on services and intangibles acquired by
such consumers abroad. One option is to require the private consumer to remit, or selfassess, the VAT in its jurisdiction at the rate applicable in this jurisdiction. However, such
consumer self-assessment mechanism has proven to be largely ineffective and as result, it
is highly likely that no VAT would be paid by the consumer in this scenario. The OECDs
E-commerce Guidelines (OECD, 2003) therefore recommend a mechanism that requires
the non-resident supplier to register, collect and remit VAT according to the rules of the
jurisdiction in which the consumer is resident. This results in the correct amount of VAT
being paid in the jurisdiction of consumption. This approach, however, is dependent on
the non-resident supplier complying with the requirement to register, collect and remit the
VAT. In other words, if taxing rights are allocated to the jurisdiction of consumer residence
without implementing a suitable mechanism to collect the tax in this jurisdiction, it is
unlikely that VAT would be paid.1
318. The example above illustrates how domestic suppliers of competing services could
face potential competitive pressures from non-resident suppliers. Domestic suppliers are
required to collect and remit VAT on their supplies of services and intangibles to their
domestic consumers while the non-resident supplier, depending on the scenario, could
structure its affairs so that it collects and remits no or an inappropriately low amount of
tax. The example also illustrates how an incentive could arise for domestic suppliers to
restructure their affairs so that their supplies of services and intangibles are made from an
offshore location, which could allow them to make the supplies with no or an inappropriately
low amount of VAT. This incentive could arise as a response to competition from nonresident suppliers who are collecting no or an inappropriately low amount of VAT or as
part of a strategy to gain a potential competitive advantage over domestic suppliers who are
charging VAT. Such relocations by domestic businesses are likely to have a negative impact
on domestic employment and direct tax revenues.
319. Against this background, jurisdictions are increasingly looking at ways to ensure
the effective collection of VAT on services and intangibles acquired by resident consumers
from suppliers abroad through a digital platform, in line with the destination principle,
relying primarily on a requirement for non-resident suppliers to register and collect and
remit the tax. Compliance with these requirements is essentially voluntary as the consumers
jurisdictions have limited means to enforce compliance by non-resident non-established
suppliers. The experience in countries that have implemented such an approach suggests that
a significant number of suppliers comply by either registering in the VAT jurisdiction and
collecting and remitting tax on their remotely delivered services, or by choosing to establish
a physical presence in the jurisdiction and effectively becoming a domestic supplier. It has
been suggested that particularly the high-profile operators, which occupy a considerable part
of the market, wish to be seen to be tax-compliant notably for reputational reasons. In the
absence of a system that makes it easy for non-resident businesses to comply and without
having well-functioning means of international co-operation between tax authorities,
however, many non-resident suppliers are likely to fail to register and remit the VAT in the
consumers jurisdiction, without any real possibility for tax authorities to audit and sanction
them. As a result, there is a loss of VAT revenue to these jurisdictions and potentially unfair
competitive pressures on domestic suppliers.
320. It should also be noted that some VAT regimes that allocate taxing rights to the
jurisdiction of the residence or the actual location of the consumer, have not implemented
a mechanism for collecting the VAT on services acquired by private consumers from nonresident suppliers. This has notably been based on the consideration that it would be overly
burdensome on tax administrations to operate such a collection mechanism. As a result, no
VAT is paid on digital supplies imported in these jurisdictions by private consumers. The
strong growth of the digital economy, particularly the growing scale of B2C trade in digital
products, may render this approach increasingly unsustainable.
8.2. Addressing the broader indirect tax challenges of the digital economy
321. The collection of VAT on cross-border transactions concluded through digital media
was identified by the Task Force on the Digital Economy (TFDE) as a key issue that must
be addressed urgently to level the playing field between foreign and domestic suppliers and
to protect countries VAT revenues. The TFDE called for work on these issues by Working
Party No 9 (WP9) of the OECD Committee on Fiscal Affairs (CFA), to be completed by
the end of 2015 with the Associates in the BEPS Project participating on an equal footing
with the OECD countries.
8.2.1. The collection of VAT on imports of low value goods

322. When they implemented the VAT exemption thresholds for imports of low value
goods, jurisdictions generally attempted to find the appropriate balance between the
administrative and compliance costs of taxing low value imports and the revenue loss and
potential competitive distortions that the exemptions may create. However, these exemption
thresholds were generally established before the advent and growth of the digital economy
and a review may therefore be required to ensure that they are still appropriate.
323. If the efficiency of processing imports of low value goods and of collecting the VAT
on such imports could be improved, governments may be in a position to lower these VAT
exemption thresholds and address the issues associated with their operation. Against this
background, WP 9 of the OECD CFA, with the Associates in the BEPS Project participating
on an equal footing with the OECD countries, carried out work on possible options for a
more efficient collection of VAT on imports of low value goods. A report was prepared on
the basis of the outcome of this work outlining and assessing the main available approaches
for improving the efficiency of collecting the VAT on such imports, which could allow
governments to reduce or remove the exemption thresholds should they wish to do so
(the Low Value Imports Report, reproduced in AnnexC). This report does not set forth
recommendations or guidelines but rather provides an analysis of possible approaches for
improving the efficiency of the VAT collection on imports of low value goods. It assesses
the available options or combinations of options for governments to consider depending on
their domestic situation and their exposure to imports of low value goods.
324. The Low Value Imports Report focuses only on the collection of VAT on imports
of low value goods, not on the collection of customs duties. Both the import VAT and the
customs duties are generally collected by customs authorities and most countries also
operate a de minimis threshold for customs duties, which is often higher than the VAT
exemption threshold.2 Against this background, the report explores models for collecting
import VAT that would limit or remove the need for customs authorities to intervene in
the VAT collection for imports that are not subject to customs duties. This is expected to
lower the cost of collection of VAT on low value imports significantly. VAT on imports of
goods above the customs threshold could (continue to) be collected together with customs
duties and taxes under normal customs procedures. It is however recognised that customs
authorities will keep an important role to play, notably for ensuring the safety and security
of the value chain (e.g.detection and prevention of the unlawful movement of illicit and
counterfeited goods).
325. The Low Value Imports Report identifies four broad models for collecting VAT
on low value imports and it assesses their likely performance. These models are: (1)the
traditional collection model; (2)the purchaser collection model; (3)the vendor collection
model; and (4)the intermediary collection model. The distinction between these collection
models is essentially based on the person liable to account for the VAT. The traditional
collection model is the model that is generally applied currently for the collection of duties
and taxes at importation, and that is often combined with a VAT exemption for imports of
low value goods. The other three models present possible alternative approaches for a more
efficient collection of VAT on the importation of low value goods. The operation of these
models and their likely performance are summarised in the following paragraphs.
8.2.1.1. The traditional collection model

326. The traditional collection model, where VAT is assessed at the border for each
imported low value good individually, is generally found not to be an efficient model for
collecting the VAT on imports of low value goods. This is certainly the case in the absence of
electronic data transmission systems to replace the existing paper based and manual processes.
327. The efficiency of the traditional collection model may improve over time, as and when
electronic systems for pre-arrival declaration and electronic tax assessment and payment are
implemented worldwide to replace paper based and manual verification processes. These
new electronic processes are already prevalent in the express carrier environment where they
have resulted in considerable efficiency gains. The consistent use of such electronic systems
would improve the efficiency of the traditional collection model for both tax administrations
and vendors. Their worldwide implementation might allow the removal of the current VAT
exemption thresholds. The Low Value Import Report notes, however, that these systems are
not yet available to process the import of the considerable numbers of low value goods that
are moved by postal services. These electronic processes for the postal environment are still
under development and may only be available in the medium term.
8.2.1.2. The purchaser collection model

328. A model relying on the purchaser to self-assess and pay the VAT on its imports of low
value goods is not likely to provide a sufficiently robust solution for an efficient collection of
the tax. Although the purchaser collection model is likely to involve only limited compliance
burden for vendors, the level of compliance by purchasers is expected to be low and this
model would be highly complex and costly for customs and tax administrations to implement
and operate.
8.2.1.3. The vendor collection model

329. A model requiring the non-resident vendors to charge, collect and remit the VAT
in the country of importation could improve the efficiency of the collection of VAT on low
value imports and thus create opportunities for governments to remove or reduce import
exemption thresholds if they wish to do so. While a vendor collection model would create
additional burden for non-resident vendors, these can be mitigated by complementing
this model with a simplified VAT registration and compliance regime similar to the one
suggested in the context of the OECD International VAT/GST Guidelines on B2C supplies of
services and intangibles (B2C Guidelines). When a vendor supplies both goods and services
into a particular jurisdiction, the registration system applied under the B2C Guidelines could
be used for both kinds of supplies. This would reduce the administrative and compliance
costs of the vendor registration. Going further, possible fast-track processing could be made
available in customs for low value goods that are imported under this model. The Low
Value Imports Report points out that the implementation of such a model is likely to involve
considerable changes to existing customs and tax collection processes and systems, and that
enhanced international and inter-agency (tax and customs administrations) cooperation
would be required to help ensure compliance by non-resident vendors under this model.
8.2.1.4. The intermediary collection model

330. A model where VAT on imports of low value goods would be collected and remitted
by intermediaries on behalf of non-resident vendors could improve the efficiency of the
collection of VAT on such imports and thus create opportunities for governments to
remove or reduce import exemption thresholds, assuming that such intermediaries would
have the required information to assess and remit the right amount of taxes in the country
of importation. The VAT collection by intermediaries would involve minimal compliance
burdens on vendors. It may, however, come at an additional cost that may be passed on
to the purchaser. This model may be particularly effective when the VAT is collected by
intermediaries that have a presence in the country of importation (e.g.express carriers,
postal operators and locally implemented e-commerce platforms). The intermediaries
understanding of local tax and customs rules and procedures could provide benefits to both
vendors and tax administrations. Four main types of intermediaries are identified:
Postal operators: in the postal operators environment, information is limited and
is mostly collected and transmitted on paper forms. Most postal operators do not
have the appropriate systems in place to manage the assessment and collection of
VAT on importation of low value goods. Electronic collection and transmission
processes are being developed but the postal system would still require substantial
adjustment to operate an efficient VAT collection model.
Express carriers: in the express carriers environment, electronic data collection and
transmission systems that enable an efficient collection and remittance of import
VAT are most often already in place and such VAT collection and remittance to the
authorities by express carriers is already common practice. A model whereby nonresident vendors could rely on express carriers to collect and remit the VAT on imports
of low value goods could provide an efficient and effective solution, provided it is
combined with sufficiently simple compliance regimes and with fast-track processing.
Transparent e-commerce platforms: transparent e-commerce platforms are platforms
that provide a trading framework for vendors but that are not parties to the commercial
transaction between the vendor and the purchaser. These platforms generally have
access to the key information that is needed for assessing the VAT due in the country
of importation of low value goods. Some of the leading marketplaces already provide
tax compliance services to their vendors. A model where VAT on imports of low
value goods would be collected and remitted by such transparent e-commerce
platforms on behalf of non-resident vendors could provide an efficient and effective
solution, provided it is combined with sufficiently simple compliance regimes and
with fast-track processing. It is recognised, however, that these e-commerce platforms
may often still need to implement systems changes to ensure a sufficiently efficient
and effective VAT collection and remittance process. When e-commerce platforms
do not have a presence in the country of importation, enhanced international and
inter-agency (tax and customs administrations) cooperation would be required to
help ensure compliance by these platforms.
Financial intermediaries: they do not collect the necessary information for the
assessment and payment of the VAT on low value imports and the development of
a model relying on these intermediaries to collect and remit the import VAT would
involve deep changes in the data collection processes. It is therefore considered
unlikely that financial intermediaries could play a role in a more efficient collection
of VAT on imports of low value goods.
8.2.1.5. Overall conclusion

331. The assessment of the models outlined above suggests that a range of possible
approaches are available for increasing the efficiency of the collection of VAT on low-value
imports for countries to choose from, depending on national policy decisions and specific
circumstances.
332. Jurisdictions could opt for a combination of models. For instance, an optional vendor
collection model could be combined with an intermediary collection model (which may notably
allow small and medium size businesses to comply more easily), whereby the vendor as well
as the intermediary would benefit from a simplified VAT registration and compliance regime
designed and operated in conformity with the system applied under the B2C Guidelines.
Both models could be combined with further simplification arrangements, such as fast-track
processing in customs. To increase compliance, these models could be combined with a fallback rule whereby VAT would be collected under the traditional collection model (possibly
from the final consumer), e.g.if VAT has not been paid either under the vendor or intermediary
collection models. Risks of undervaluation or mis-description by foreign vendors of imported
goods should be considered for the assessment of the models or combination of models.
333. The implementation of these models or a combination of them allow jurisdictions to
remove or lower the VAT exemption thresholds, should they wish to do so.
334. It is recognised that any reform to improve the efficiency of the collection of VAT on
low value imports will need to be complemented with appropriate risk assessment and enhanced
international administrative cooperation between tax authorities to enforce compliance.
8.2.2. The collection of VAT on cross-border business-to-consumer supplies of

services and intangibles
335. Recommended approaches for addressing the key challenge of collecting the VAT on
the sales of digital products to private consumers by non-resident suppliers were developed
by the OECD and G20 in the context of work on the International VAT/GST Guidelines
(the Guidelines). These Guidelines were developed as a future global standard to address
issues of double taxation and unintended non-taxation resulting from inconsistencies in the
application of VAT to international trade. Their scope is not limited to the trade of digital
products and covers trade in services and intangibles more generally. The Guidelines present
a separate solution for business-to-business trade (B2B) and business-to-consumer (B2C)
trade, recognising that VAT systems often employ different mechanisms to collect the tax
for these categories of transactions. The recommended approach for addressing the challenge
of collecting the VAT on the sales of digital products to private consumers by non-resident
suppliers is included in the Guidelines that deal specifically with B2C (see AnnexD).
336. The B2C Guidelines present a set of standards for determining the place of taxation
for B2C supplies of services and intangibles, in accordance with the destination principle.
They provide that the jurisdiction in which the customer has its usual residence has the right
to collect VAT on remote supplies of services and intangibles, including digital supplies by
offshore suppliers. This standard allows suppliers and tax administrations to predict with
reasonable accuracy the place where the services or intangibles are likely to be consumed
while taking into account practical constraints. The implementation of these standards aims
at ensuring that VAT on such supplies in the market jurisdiction applies at the same rate as
for domestic supplies. This ensures the even playing field between domestic and offshore
suppliers, so that there is no tax advantage for foreign companies based in low or no tax
jurisdictions selling to final consumers relative to domestic companies.
337. Regarding the key issue of the collection of VAT in the destination country, the B2C
Guidelines indicate that, at the present time, the most effective and efficient approach to ensure
the appropriate collection of VAT on cross-border B2C supplies is to require the non-resident
supplier to register and account for VAT in the jurisdiction of taxation. The B2C Guidelines
recommend that jurisdictions consider establishing a simplified registration and compliance
regime to facilitate compliance for non-resident suppliers, the main features of which are
outlined in Table8.1. The highest feasible levels of compliance by non-resident suppliers are
likely to be achieved if compliance obligations in the jurisdiction of taxation are limited to
what is strictly necessary for the effective collection of the tax. Appropriate simplification
is particularly important to facilitate compliance for businesses faced with obligations in
multiple jurisdictions. At the same time, in considering simplified registration for VAT
purposes, it is important to underline that registration for VAT purposes is independent from
the determination of whether there is a permanent establishment (PE) for income tax purposes.
Recognising that a proper balance needs to be struck between simplification and the need of
governments to safeguard the revenue, the B2C Guidelines indicate that it is necessary that
jurisdictions take appropriate steps to strengthen international administrative cooperation,
which is a key means to achieve the proper collection and remittance of the tax on cross-border
supplies of services and intangibles by non-resident suppliers.
Table8.1. Main features of a simplified registration and compliance regime for
non-resident suppliers
Registration
procedure
The information requested could be limited to necessary details, which could include:
- Name of business, including the trading name
- Name of contact person responsible for dealing with tax administrations
- Postal and/or registered address of the business and its contact person
- Telephone number of contact person
- Electronic address of contact person
- Web sites URL of non-resident suppliers through which business is conducted in the taxing
jurisdiction
- National tax identification number, if such a number is issued to the supplier in the suppliers
jurisdiction to conduct business in that jurisdiction.
The simplest way to engage with tax administrations from a remote location is by electronic
processes. An on-line registration application could be made accessible on the home page of
the tax administrations web site, preferably available in the languages of the jurisdictions major
trading partners.
Input tax
recovery refunds
Taxing jurisdictions could limit the scope of a simplified registration and compliance regime to the
collection of VAT on B2C supplies of services and intangibles by non-resident suppliers without
making the recovery of input tax available under the simplified regime.
Input tax recovery could remain available for non-resident suppliers under the normal VAT refund
or registration and compliance procedure.
Return procedure
As requirements differ widely among jurisdictions, satisfying obligations to file tax returns in
multiple jurisdictions is a complex process that often results in considerable compliance burdens
for non-resident suppliers.
Tax administrations could consider authorising non-resident businesses to file simplified
returns, which would be less detailed than returns required for local businesses that are entitled
to input tax credits. In establishing the requirements for information under such a simplified
approach, it is desirable to strike a balance between the businesses need for simplicity and
the tax administrations need to verify whether tax obligations have been correctly fulfilled. This
information could be confined to:
- Suppliers registration identification number
- Tax period
- Currency and, where relevant, exchange rate used
- Taxable amount at the standard rate
- Taxable amount at reduced rate(s), if any
- Total tax amount payable.
The option to file electronically in a simple and commonly used format is essential to facilitating
compliance.
Table8.1. Main features of a simplified registration and compliance regime for
non-resident suppliers (continued)
Payments
Use of electronic payment methods is recommended, allowing non-resident suppliers to remit the
tax due electronically.
Jurisdictions could consider accepting payments in the currencies of their main trading partners.
Record keeping
Jurisdictions are encouraged to allow the use of electronic record keeping systems.
Jurisdictions could limit the data to be recorded to what is required to satisfy themselves that the
tax for each supply has been charged and accounted for correctly and relying as much as possible
on information that is available to suppliers in the course of their normal business activity.
This could include the type of supply, the date of the supply, the VAT payable and the information
used to determine the place where the customer has its usual residence.
Taxing jurisdictions could require these records to be made available on request within a
reasonable delay.
Invoicing
Jurisdictions could consider eliminating invoicing requirements for business-to-consumer supplies

that are covered by the simplified registration and compliance regime, in light of the fact that the
customers involved generally will not be entitled to deduct the input VAT paid on these supplies.
If invoices are required, jurisdictions could consider allowing invoices to be issued in accordance
with the rules of the suppliers jurisdiction or accepting commercial documentation that is issued
for purposes other than VAT (e.g.electronic receipts).
It is recommended that information on the invoice remain limited to the data required to administer
the VAT regime (such as the identification of the customer, type and date of the supply(ies), the
taxable amount and VAT amount per VAT rate and the total taxable amount). Jurisdictions could
consider allowing this invoice to be submitted in the language of their main trading partners
Availability of
information
Jurisdictions are encouraged to make available on-line all information necessary to register and
comply with the simplified registration and compliance regime, preferably in the languages of their
major trading partners.
Jurisdictions are also encouraged to make accessible via the Internet the relevant and up-to-date
information that non-resident businesses are likely to need in making their tax determinations. In
particular, this would include information on tax rates and product classification.
Use of third-party
service providers
Compliance for non-resident suppliers could be further facilitated by allowing such suppliers to
appoint a third-party service provider to act on their behalf in carrying out certain procedures, such
as submitting returns.
This could be especially helpful for small and medium enterprises and businesses that are faced
with multi-jurisdictional obligations.
338. Consider an example of online suppliers of streaming digital content such as movies
and television shows. The supplies are made mainly to consumers who can access the digital
content through their computers, mobile devices and televisions that are connected to the
Internet. Suppliers that are established in the same jurisdiction as their customers are required
to collect and remit that jurisdictions VAT on the supplies. If the supplier is a non-resident
in the market jurisdiction, issues may arise in the absence of the standards as set forth in the
B2C Guidelines. If taxing rights on the streaming services were allocated to the suppliers
jurisdiction at the rate applicable in that jurisdiction, then domestic suppliers of competing
services in the market jurisdiction could face potential competitive pressures if the supplier
of the digital content is established in a jurisdiction that applies no VAT or a VAT with a
lower rate than that of the market jurisdiction. In that case, no VAT or an inappropriately
low amount of VAT would be collected and none of the VAT revenue would accrue to the
jurisdiction where the final consumption takes place. On the other hand if taxing rights
were to be allocated to the jurisdiction where the customer is resident but with no suitable
mechanism available to collect the VAT in this jurisdiction, no VAT will actually be paid.
339. Under the B2C Guidelines, it is recommended that (i)the jurisdiction of the usual
residence of the customer will have the right to levy VAT on the supply of the digital
content, (ii)the foreign seller will be required to register for VAT in that market jurisdiction
under a simplified registration and compliance regime, and (iii)the foreign seller will be
required to charge and collect the VAT in that jurisdiction at the same rate as for domestic
supplies. These Guidelines recognise explicitly that it is necessary to reinforce taxing
authorities enforcement capacity through enhanced international co-operation in tax
administration in the field of indirect taxes. They recommend that such co-operation be
enhanced through the development of a common standard for the exchange of information
that is simple, minimises the costs for tax administrations and businesses by limiting the
amount of data that is exchanged, and which can be implemented in a short timeframe.
Notes
1.
While the example deals with streaming movies and TV shows, the same issues arise with most,
if not all supplies of remotely delivered services to consumers, such as cloud computing, gaming,
software downloads.
2.
Most countries operate a de minimis threshold for customs duties, which is essentially regulated
by the World Customs Organizations (WCO) Revised Kyoto Convention (RKC). It provides for
a mandatory de minimis customs duties and taxes relief for small consignments. While this rule
is obligatory for Contracting Parties to the RKC, the RKC does not prescribe the amount of such
a threshold nor does it impose a minimum standard.
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collect VAT on digital supplies? World Journal of VAT Law, Vol.1, Issue 1.
OECD (2013), OECD Communications Outlook 2013, OECD Publishing, Paris, http://
dx.doi.org/10.1787/comms_outlook-2013-en.
OECD (2003), Electronic Commerce-Commentary on Place of Consumption for Business
to Business Supplies (Business Presence), OECD, Paris.
OECD (1998), Electronic Commerce: Taxation Framework Conditions, a report by the
Committee on Fiscal Affairs, page4, www.oecd.org/tax/consumption/1923256.pdf.
9. Evaluation of the broader direct and indirect tax challenges raised by the digital economy 131
Chapter9
Evaluation of the broader direct and indirect tax challenges raised by the
digital economy and of the options toaddress them
This chapter contains an evaluation of the options identified to address the broader
tax challenges raised by the digital economy. The evaluation takes into account
not only the impact on BEPS issues of the measures developed in the course of the
BEPS Project, but also the economic incidence of the different options to tackle
these broader tax challenges.
132 9. Evaluation of the broader direct and indirect tax challenges raised by the digital economy
9.1. Broader tax challenges and options to address them

340. The digital economy triggers systemic questions about the ability of the current
domestic and international tax systems to deal with the changes brought about by advances
in information and communication technology (ICT). These tax policy issues have
implications for the overall design of tax systems. These challenges may therefore have
broader implications than BEPS and the countermeasures developed in the course of the
Project. These include issues related to the allocation of taxing rights among countries as
well as to the tax policy considerations that should be taken into account when weighing
the relative costs and benefits of the various tax solutions. With respect to direct taxes, the
broader tax challenges raised by the digital economy go beyond the question of how to put
an end to double non-taxation, and chiefly relate to the question of how taxing rights on
income generated from cross-border activities in the digital age should be allocated among
countries. With respect to indirect taxes, the challenges chiefly relate to how to ensure that
effective and efficient collection mechanisms are in place.
341. As the potential of digital technologies grows, features such as the heavy reliance
on intangibles, the constant mobility of people, the use of machines and automation, the
ability to reach customers globally without the need for extensive physical presence, and
the changing role of customers in the digital age are continually increasing. These features
raise questions about the paradigm used to determine where economic activities are carried
out and value is generated for direct tax purposes, which is currently based on an analysis
of the functions, assets and risks of the enterprises involved.
342. Several proposals for potential options to address the broader direct tax challenges
were considered by the Task Force on the Digital Economy (TFDE) in 2014, including:
modifications to the exceptions from permanent establishment (PE) status;
alternatives to the existing PE threshold;
the imposition of a withholding tax on certain types of digital transactions; and
the introduction of an excise tax or other levy.
343. One of the initial conclusions of the TFDE was that modifications to the exceptions
from the PE status contained in paragraph4 of Article5 of the OECD Model Tax Convention
should be considered in the context of Action7 of the BEPS Project, whether the application
of the exception raised BEPS issues or broader tax challenges. This was due to the fact that
some activities that were previously preparatory or auxiliary in the context of conventional
business models may have become core functions of certain businesses in the digital
economy. In addition to broader tax challenges, this raises BEPS issues when the lack of
taxation in the market country is coupled with techniques that reduce or eliminate tax in the
country of the recipient or of the ultimate parent.
344. As a result of the Action7 work, it was agreed to modify Article5(4) of the OECD
Model Tax Convention to ensure that the availability of the exceptions to PE status is subject
to the condition that the character of the activity conducted be merely preparatory or auxiliary
in nature, rather than one of the core activities of the enterprise in question. For example, if
proximity to customers and the need for quick delivery to clients are key components of the
business model of an online seller of physical products, the maintenance of a very large local
warehouse in which a significant number of employees work for purposes of storing and
delivering goods sold online to customers would no longer be entitled to an exception from
PE status. This treaty-related measure is expected to be implemented across the existing tax
treaty network in a synchronised and efficient manner via the conclusion of a multilateral
instrument that modifies bilateral tax treaties.
345. The technical details of the other three options were developed over 2015 in a way
that allows them to be applied individually (i.e.a new significant economic presence
nexus for net-basis taxation based with deemed profit attribution methods, the application
of a withholding tax, or an equalisation levy) or combined. The application of these options
would generally allow countries to impose a tax in situations where a foreign enterprise
derives considerable sales income from the country without a physical presence therein,
and/or uses the contributions of in-country users in its value chain, including through
collection and monitoring of data.
346. In relation to indirect taxes, issues arise regarding the ability of VAT systems to
deal with cross-border remote sales transactions between private consumers and foreign
suppliers. In fact, the difficulty of ensuring compliance and collection of VAT on remote
digital supplies of services and intangibles to final consumers is magnified where the
supplier is not present physically or otherwise in the consumers country. Similarly,
countries applying an exemption from VAT for imports of low value goods have seen a
significant growth in the volume of such imports on which VAT is not collected, thereby
generating loss of tax revenue and potential competitive pressures on domestic suppliers.
The work carried out by Working Party No.9 (WP 9) of the OECDs Committee on Fiscal
Affairs (CFA), which is encapsulated in the Guidelines on value added tax/goods and
services tax (VAT/GST Guidelines) and described in Chapter8, has resulted in general
agreement on global standards on the allocation of VAT/GST taxing rights on crossborder transactions as well as in the identification of possible mechanisms supporting the
implementation of these standards in an efficient manner.
347. Once implemented, the new VAT/GST Guidelines will facilitate cross-border digital
transactions being subject to tax in the market country, hence helping level the playing field
between non-resident enterprises and domestic enterprises. Consider the case of online
sellers of streaming digital content such as movies and television shows to consumers who
can access the digital content through their computers, mobile devices and televisions that
are connected to the Internet. Without implementation of the B2C Guidelines, the market
country generally has no nexus or may be unable to require the foreign seller to apply and
remit VAT on such transaction. The result is a gap between the obligation on domestic
enterprises to charge VAT on sales to local customers and that of foreign suppliers. Under
the new B2C Guidelines, the country of the usual residence of the customer generally has
the right, and is provided with mechanisms, to levy VAT on the sale of the digital content
from abroad.
348. To summarise, like the challenges they are intended to address, the impact of
the various options described above overlaps in a number of respects. For instance, both
the new VAT/GST Guidelines and the significant economic presence option would
generally provide the country where the customers are located the right to levy tax. Also,
cognisant of the fact that there are different proposals as to how to approach the broader tax
challenges, and given that many of the options proposed could actually be implemented in
multiple ways, it was agreed that a full evaluation of the relevance, urgency, and scope of
the broader direct tax challenges and of the potential options to address them would benefit
from an analysis of the expected economic incidence of the three options outlined above.
9.2. Economic incidence of the options to address the broader direct tax challenges
349. The analysis focused on the ultimate resting point of the initial change in tax liabilities
under each proposal after taxpayers have responded to the tax changes. Specifically, the
expected economic incidence on consumers, capital owners (including shareholders) and
labour (workers) of the options was analysed in relation to the provision of digital goods and
services by foreign suppliers without a taxable presence in the country of the customer under
current rules. The conclusion is that all three of the tax options would be expected to have
similar economic incidence:1
In the case of a perfectly competitive market for digital goods and services, the
incidence of the various options (and associated tax increase) is likely to be borne in
part by labour, depending on the labour market conditions in the various countries
in which foreign suppliers are located, and in part by consumers in market countries,
assuming that the affected suppliers account for a significant share of worldwide
market output, and depending on the availability of replacement suppliers with
similar pre-tax costs and the availability of substitutes for the affected digital goods
and services.
If the market is imperfectly competitive, however, the various options (and associated
tax increase) are likely to be borne by the equity owners of the affected foreign
suppliers to a greater or lesser extent, depending on the degree to which firms are
price-setters.
350. The details of the economic incidence analysis, including the associated conclusions,
are included in AnnexE.
9.3. Framework to evaluate the options

351. For purposes of evaluating the potential options, the TFDE agreed on a framework
starting from the basic tax principles of neutrality, efficiency, certainty and simplicity,
effectiveness and fairness, flexibility and sustainability, and in light of the overall
proportionality of the changes in relation to the tax challenges they are intended to address. In
evaluating potential options, no single principle can be given greater priority than any other.
Instead, the assessment under the framework shall be based on an overall consideration of the
individual factors that are part of it, and namely:
Neutrality: taxpayers in similar situations carrying out similar transactions should
be subject to similar levels of taxation, in order to avoid introducing distortions
to the market. In other words, the same principles of taxation should apply to all
forms of business, while taking into account specific features that may otherwise
undermine an equal and neutral application of those principles.
Efficiency: the benefits of any reform should outweigh the costs of its adoption,
including transitional and implementation costs. Evaluation of the efficiency of
potential options relative to the existing framework should therefore also take into
account whether the administrative considerations underlying the existing rules are
still applicable, or whether advances in technology may have made those practical
constraints less important.
Certainty and simplicity: tax rules that are easily understood make it easier for
taxpayers to anticipate the tax consequences of transactions, and for administrators
to evaluate compliance. A simple tax system is also likely to involve lower
compliance costs, resulting in a more efficient taxation system.
Effectiveness and fairness: as recognised in the Ottawa framework conditions,
taxes imposed should produce the right amount of tax at the right time. In assessing
the fairness of any proposed options, it is important to consider who may bear the
ultimate tax burden and in what proportion. Effectiveness is important because a
tax system that is difficult to enforce is unlikely to be either equitable or neutral,

and may undermine the public perceptions of the fairness of the whole system in
the long term.
Flexibility and sustainability: options should be evaluated based not only on
whether they address the tax challenges in the current environment, but, to the
extent possible given the difficulty of predicting future developments, on whether
they can be expected to be flexible and dynamic enough to adapt to future
commercial and technological developments.
Proportionality: it is important to evaluate not only whether the proposed options
address those tax challenges, but also what broader impact those options may have.
Potential options shall be tailored to the scope of the particular challenges they are
intended to address.
9.4. Impact of BEPS countermeasures

352. The broader tax challenges raised by the digital economy intersect with several
other BEPS action items.
353. In the direct tax context, BEPS concerns are raised by situations in which taxable
income can be artificially separated from the activities that generate it, resulting in the
ability to reduce or eliminate tax across a whole supply chain, including both market
and residence countries. The work to address the tax challenges of the digital economy
has made clear that while no unique BEPS issues are presented by the digital economy,
the key features of the digital economy do exacerbate BEPS concerns. As outlined in
Chapter6, the key features of the digital economy have been taken into account in the
work under the BEPS Action Plan to address BEPS in the context of direct taxes, including
in particular the work on CFC rules (Action3), addressing the artificial avoidance of PE
status (Action7) and transfer pricing (Actions8-10). As a result, it is expected that the
implementation of these measures will substantially address the BEPS issues previously
identified with respect to the digital economy. The effectiveness of the measures adopted
in the context of the BEPS Project as well as the impact on both compliance by taxpayers
and proper implementation by tax administrations will be monitored through a targeted
mechanism.
354. Although the work to address BEPS is targeted at situations in which tax is reduced
or eliminated in jurisdictions across the whole supply chain, its impact may go beyond
BEPS in certain situations, such as in the case of the work under Action7 to modify the
exceptions to PE status. These changes will address BEPS structures in which a lack of
PE in a market country is coupled with lack of taxation in the country of the recipient or
ultimate parent, but at the same time the rules produced by this work will also apply more
broadly where activities that were previously considered preparatory or auxiliary have now
become core activities in certain business models.
355. Addressing BEPS in the digital economy may also indirectly affect the scope of
the broader tax challenges raised by the digital economy, and hence the evaluation of the
options to address them. For example, concerns about nexus for direct tax purposes relate
to the ability of a non-resident enterprise to derive substantial amounts of income from a
country without a physical presence therein. As noted in Chapter4, however, there can be
compelling reasons for businesses to have a degree of physical presence in a market, in
order to ensure that core resources are placed as close as possible to key markets. Under
the current tax system, however, it is very often possible to use artificial structures to
ensure that this physical presence either does not create a taxable presence or does not
attract significant profits so that the bulk of the profits can then be shifted to a no or lowtax jurisdiction. Implementation of the BEPS measures is expected to have a substantial
impact on this BEPS risk, so that the location of taxable profits will be better aligned
with economic activity and value creation. At the same time, BEPS measures such as
the modification of Article5(4) of the OECD Model Tax Convention are expected to also
mitigate some aspects of the broader tax challenges. As a result, the expected impact of the
BEPS measures needs to be taken into account when evaluating the extent of the broader
tax challenges and the options to address them.
9.5. Evaluation
356. As noted above, the TFDE considered several options to address the broader tax
challenges raised by the digital economy, including modifications to the exceptions from
PE status, alternatives to the existing PE threshold, the imposition of a withholding tax on
certain types of digital transactions and the introduction of an equalisation levy, as well
as the principles and mechanisms developed by WP 9 of the CFA to ensure that VAT is
collected by the country where the customer is located. To evaluate these options, the TFDE
agreed on a framework based on neutrality, efficiency, certainty and simplicity, effectiveness
and fairness, flexibility and sustainability, and proportionality. It also analysed the economic
incidence of the three options aimed at taxing income from the sales of digital goods and
services by foreign suppliers without a PE under current rules, namely the new nexus in
the form of a significant economic presence, the withholding tax on certain types of digital
transactions and the equalisation levy.
357. As regards the different options analysed, the TFDE has concluded that:
available only for activities that are in fact preparatory or auxiliary in nature has
been considered by the TFDE and adopted as part of the work on Action7 of the
BEPS Project. In order to ensure that profits derived from core activities performed
in a country can be taxed in that country, Article5(4) is modified to ensure that each
of the exceptions included therein is restricted to activities that are otherwise of a
preparatory or auxiliary character. In addition, a new anti-fragmentation rule was
introduced to ensure that it is not possible to benefit from these exceptions through the
fragmentation of business activities among closely related enterprises. These changes
to the definition of PE of the OECD Model Tax Convention are included in the
Report Preventing the Artificial Avoidance of PE Status (OECD, 2015) and are now
expected to be implemented across the existing tax treaty network in a synchronised
and efficient manner via the conclusion of the multilateral instrument that modifies
bilateral tax treaties under Action15.2
The collection of VAT/GST on cross-border transactions, particularly those
between businesses and consumers, is an important issue. In this regard,
countries are recommended to apply the principles of the International VAT/GST
Guidelines and consider the introduction of the collection mechanisms included
therein. Implementation packages will be developed to ensure that countries can
implement the International VAT/GST Guidelines in a co-ordinated manner. Work
in this area will be carried out by the WP9, with the Associates in the BEPS Project
participating on an equal footing.
Some aspects of the broader direct tax challenges currently raised by the
digital economy are expected to be mitigated once the BEPS measures are
implemented. This is because once implemented, the BEPS measures are expected
to better align the location of taxable profits with the location of economic activity
and value creation. This will address BEPS and restore both source and residence
taxation in a number of cases where cross-border income would otherwise go untaxed
or would be taxed at very low rates. In addition, even in the modern digital economy
many businesses often still require a local physical presence in order to be present in
a market and maintain a purposeful and sustained interaction with the economy of
that country. In this context, BEPS measures such as the modification of Article5(4)
of the OECD Model Tax Convention, are expected to also mitigate some aspects of
the broader tax challenges. As a consequence, a quick implementation of the BEPS
measures is needed, together with mechanisms to monitor their impact over time.
None of the other options analysed by the TFDE were recommended at this stage.
This is because, among other reasons, it is expected that the measures developed in
the BEPS Project will have a substantial impact on BEPS issues previously identified
in the digital economy, that certain BEPS measures will mitigate some aspects of the
broader tax challenges, and that consumption taxes will be levied effectively in the
market country. The options analysed by the TFDE to address the broader direct tax
challenges, namely the new nexus in the form of a significant economic presence,
the withholding tax on certain types of digital transactions and the equalisation levy,
would require substantial changes to key international tax standards and would require
further work. In the changing international tax environment a number of countries
have expressed a concern about how international standards on which bilateral tax
treaties are based allocate taxing rights between source and residence States. At this
stage, it is however unclear whether these changes are warranted to deal with the
changes brought about by advances in ICT. Taking the above into account, and in the
absence of data on the actual scope of these broader direct tax challenges, the TFDE
did not recommend any of the three options as internationally agreed standards.
Countries could, however, introduce any of the options in their domestic laws
as additional safeguards against BEPS, provided they respect existing treaty
obligations, or in their bilateral tax treaties. The adoption of the options as
domestic law measures could be considered, for example, if a country concludes
that BEPS issues exacerbated by the digital economy are not fully addressed, or to
account for the time lag between agreement on the measures to tackle BEPS at the
international level and their actual implementation and application. The options
may provide broad safeguards against BEPS and ensure that a domestic taxing
right is available for remote transactions involving digital goods and services,
which is currently not the case under most countries domestic laws. Countries
could take this approach with the intent to address their concerns about BEPS
issues in the short term and gain practical experience with the application of the
options over time, fostering coordinated domestic law approaches and informing
possible future discussions. In addition, countries could bilaterally agree to include
any of the options in their tax treaties.
Adoption as domestic law measures would require further calibration of the
options in order to provide additional clarity about the details, as well as some
adaptation to ensure consistency with existing international legal commitments.
Consistency with bilateral tax treaty obligations would have to be ensured, for example
by applying the options solely with respect to residents of non-treaty countries, or in
situations in which benefits of the treaty may be denied due to the application of antiabuse rules that are in conformity with tax treaty obligations.
9.6. Next steps

358. These conclusions may evolve as the digital economy continues to develop,
in particular regarding robotics, the internet of things, 3D printing and the sharing
economy. As technology continues to advance, developments in advanced robotics will make
it increasingly possible to perform complex tasks and take decisions with limited human
intervention. As more devices are connected to the internet, the ability to collect, share, process,
and act on data has been predicted to generate between nearly USD4 trillion to USD11
trillion in economic benefits globally in the year 2025, in the form of profits to device-makers,
efficiencies, new businesses and savings to consumers from better-run products (McKinsey
Global Institute, 2015). Possibilities arising from the ability to monitor and control things in
the physical world electronically are important and require a thorough understanding of where
value is created in the digital economy. Advances in the peer-to-peer sharing economy have
reduced transaction costs, increased availability of information, and provided greater reliability
and security, increasingly providing decentralised alternatives to more traditional business
models. Finally, if current trends regarding the internet of things and 3D printing continue,
flexibility about where business functions take place will continue to increase.
359. It is therefore important to continue working on these issues and to monitor
developments in the digital economy over time. Monitoring will focus primarily on the
following three areas. First, developments in ICT and new business models that have an
impact on international tax policy. Second, the impact of implementation of the BEPS
measures on the tax challenges exacerbated by the digital economy, as part of the wider
post-BEPS monitoring process. Third, any actions taken by countries in the implementation
of the options as domestic law measures or in their bilateral tax treaties, and their impact
over time. Moreover, other relevant developments will be taken into account, notably in the
field of VAT/GST, leveraging on the respective work carried out by WP 9.
360. As part of this future work, it will also be important to review and analyse
data that will become available over time. This will provide a sound basis to ascertain
the concrete extent of the broader direct tax challenges, in particular in relation to nexus.
For example, data collected from remote sellers through simplified VAT/GST regimes,
and statistical analyses of data from the Country-by-Country reporting template will
provide a better indication of the ability of businesses in the digital economy to be able to
participate in the economic life of a country without a taxable presence there. On the basis
of the future monitoring work, a determination will also be made as to whether further
work on the three options discussed and analysed by the TFDE should be carried out. This
determination should be based on a broad look at the ability of existing international tax
standards to deal with the tax challenges raised by developments in the digital economy,
taking into account not just direct taxes, but also indirect taxes, administrative issues,
countries differing levels of development, as well as the impact of any potential change on
cross-border trade and investment.
361. To these aims, the work will continue following the completion of the other
follow-up work on the BEPS Project. This future work will be done in consultation with
a broad range of stakeholders and on the basis of a detailed mandate to be developed during
2016 in the context of designing an inclusive post-BEPS monitoring process. A report
reflecting the outcome of the continued work in relation to the digital economy should be
produced by 2020.
Notes
1
The incidence analysis depends on the specific details of each policy option, including whether
they are applicable to all or only a subset of sellers of digital goods.
2.
Some countries consider that there is no need to modify Art.5(4) and that the list of exceptions
in subparagraphsa) to d) of paragraph 4 should not be subject to the condition that the activities
referred to in these subparagraphs be of a preparatory or auxiliary character. These countries
may adopt a different version of Art.5(4) as long as they include the anti-fragmentation rule
referred to above..
Bibliography
OECD (2015), Preventing the Artificial Avoidance of Permanent Establishment Status,
Action7 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project,
10. Summary of the conclusions and next steps 141
Chapter 10
Summary of the conclusions and next steps
This chapter summarises the conclusions reached with respect to the business
models and key features of the digital economy, BEPS issues in the digital economy,
and the broader tax policy challenges raised by the digital economy. It then describes
the next steps to be undertaken.
142 10. Summary of the conclusions and next steps

362. Action1 of the base erosion and profit shifting (BEPS) Action Plan deals
with the tax challenges of the Digital Economy. Political leaders, media outlets, and
civil society around the world have expressed growing concern about tax planning by
multinational enterprises (MNEs) that makes use of gaps in the interaction of different tax
systems to artificially reduce taxable income or shift profits to low-tax jurisdictions in which
little or no economic activity is performed. In response to this concern, and at the request of
the G20, the Organisation for Economic Co-operation and Development (OECD) published
an Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013) in
July 2013. Action1 of the BEPS Action Plan calls for work to address the tax challenges of
the digital economy. The Task Force on the Digital Economy (TFDE), a subsidiary body of
the Committee on Fiscal Affairs (CFA) in which non-OECD G20 countries participate as
Associates on an equal footing with OECD countries, was established in September 2013
to develop a report identifying issues raised by the digital economy and detailed options
to address them by September 2014. The TFDE consulted extensively with stakeholders
and analysed written input submitted by business, civil society, academics, and developing
countries. It issued an interim report in September 2014 and continued its work in 2015. The
conclusions regarding the digital economy, the BEPS issues and the broader tax challenges
it raises, and the recommended next steps are contained in this final report.
10.1. The digital economy, its business models, and its key features
363. The digital economy is the result of a transformative process brought by
information and communication technology (ICT). The ICT revolution has made
technologies cheaper, more powerful, and widely standardised, improving business
processes and bolstering innovation across all sectors of the economy. For example, retailers
allow customers to place online orders and are able to gather and analyse customer data
to provide personalised service and advertising; the logistics sector has been transformed
by the ability to track vehicles and cargo across continents; financial services providers
increasingly enable customers to manage their finances, conduct transactions and access
new products on line; in manufacturing, the digital economy has enhanced the ability to
remotely monitor production processes and to control and use robots; in the education
sector, universities, tutoring services and other education service providers are able to
provide courses remotely, which enables them to tap into global demand; in the healthcare
sector, the digital economy is enabling remote diagnosis and the use of health records to
enhance system efficiencies and patient experience. The broadcasting and media industry
have been revolutionised, expanding the role in news media of non-traditional news sources,
and expanding user participation in media through user-generated content and social
networking.
364. Because the digital economy is increasingly becoming the economy itself, it
would be difficult, if not impossible, to ring-fence the digital economy from the rest
of the economy for tax purposes. Attempting to isolate the digital economy as a separate
sector would inevitably require arbitrary lines to be drawn between what is digital and what
is not. As a result, the tax challenges and BEPS concerns raised by the digital economy are
better identified and addressed by analysing existing structures adopted by MNEs together
with new business models and by focusing on the key features of the digital economy and
determining which of those features raise or exacerbate tax challenges or BEPS concerns.
Although many digital economy business models have parallels in traditional business,
modern advances in ICT have made it possible to conduct many types of business at
substantially greater scale and over longer distances than was previously possible. These
include several varieties of e-commerce, online payment services, app stores, online
advertising, cloud computing, participative networked platforms, and high-speed trading.
365. The digital economy is in a continuous state of evolution and developments
need to be monitored to evaluate their impact on tax systems. The rapid technological
progress that has characterised the digital economy has led to a number of emerging
trends and potential developments. Although this rapid change makes it difficult to predict
future developments with any degree of reliability, these potential developments should be
monitored closely as they may generate additional challenges for tax policy makers in the
near future. These developments include the Internet of Things, referring to the dramatic
increase in networked devices; virtual currencies, including bitcoin; developments in
advanced robotics and 3D printing, which have the potential to bring manufacturing closer
to consumers, altering where and how value is created within manufacturing supply chains,
as well as the characterisation of business income; the sharing economy which allows
peer-to-peer sharing of goods and services, and collaborative production which allows
crowdsourcing and crowdfunding; increased access to government data, which has the
potential to improve accountability and performance, and to allow participation of third
parties in government business; and reinforced protection of personal data, which is more
widely available in the digital economy.
366. The digital economy and its business models present some key features which
are potentially relevant from a tax perspective. These features include mobility, with
respect to (i)the intangibles on which the digital economy relies heavily, (ii)users, and
(iii)business functions; reliance on data, the massive use of which has been facilitated by
an increase in computing power and storage capacity and a decrease in data storage cost;
network effects, which refer to the fact that decisions of users may have a direct impact on
the benefit received by other users; the spread of multi-sided business models, in which
multiple distinct groups of persons interact through an intermediary or platform, and the
decisions of each group of persons affect the outcome for the other groups of persons
through a positive or negative externality; tendency toward monopoly or oligopoly in
certain business models relying heavily on network effects; and volatility due to lower
barriers to entry into markets and rapidly evolving technology, as well as the speed with
which customers can choose to adopt new products and services at the expense of older
ones.
367. The digital economy has also accelerated and changed the spread of global
value chains in which MNEs integrate their worldwide operations. In the past, it
was common for an MNE group to establish a subsidiary in each country in which it did
business to manage the groups business in that country. This structure was dictated by
a number of factors, including slow communications, currency exchange rules, customs
duties, and relatively high transportation costs that made integrated global supply chains
difficult to operate. Advances in ICT, reductions in many currency and custom barriers,
and the move to digital products and a service-based economy, however, combined to
break down barriers to integration, allowing MNE groups to operate much more as global
firms. This integration has made it easier for business to adopt global business models that
centralise functions at a regional or global level, rather than at a country-by-country level.
Even for small and medium enterprises (SMEs), it has now become possible to be micromultinationals that operate and have personnel in multiple countries and continents. ICT
technologies have been instrumental in this major trend, which was further exacerbated by
the fact that many of the major digital companies are young and were designed from the
beginning to operate on an integrated basis at a global scale.
10.2. BEPS issues in the digital economy and how to address them
368. While the digital economy does not generate unique BEPS issues, some of its key
features exacerbate BEPS risks.The TFDE discussed a number of tax and legal structures
that can be used to implement business models in the digital economy. These structures
highlight existing opportunities to achieve BEPS to reduce or eliminate tax in jurisdictions
across the whole supply chain, including both market and residence countries. For example, the
importance of intangibles in the context of the digital economy, combined with the mobility of
intangibles for tax purposes under existing tax rules, generates substantial BEPS opportunities
in the area of direct taxes. Further, the ability to centralise infrastructure at a distance from
a market jurisdiction and conduct substantial sales of goods and services into that market
from a remote location, combined with increasing ability to conduct substantial activity with
minimal use of personnel, generates potential opportunities to achieve BEPS by fragmenting
physical operations to avoid taxation. Some of the key characteristics of the digital economy
also exacerbate risks of BEPS in the context of indirect taxation, in particular in relation to
businesses that perform value added tax (VAT) exempt activities (exempt businesses).
369. These BEPS risks have been discussed in the context of the BEPS Project, whose
outputs are expected to align taxation with economic activities and value creation, and
are expected to have a substantial impact on the BEPS issues previously identified in
the digital economy. Structures aimed at artificially shifting profits to locations where
they are taxed at more favourable rates, or not taxed at all, are expected to be addressed
by the different measures developed in the context of the BEPS Project. This will help
address BEPS issues and restore taxing rights at the level of both the market jurisdiction
and the jurisdiction of the ultimate parent company. BEPS issues in the market jurisdiction
are expected to be addressed by preventing treaty abuse (Action6) and by preventing
the artificial avoidance of PEstatus (Action7). BEPS issues in the ultimate residence
jurisdiction are expected to be addressed by strengthening controlled foreign company
(CFC) rules (Action3). BEPS issues in both market and residence jurisdictions are expected
to be addressed by neutralising the effects of hybrid mismatch arrangements (Action2), by
limiting the base erosion via interest deductions and other financial payments (Action4),
by countering harmful tax practices more effectively (Action5), and by assuring that
transfer pricing outcomes are in line with value creation (Actions8-10). In addition, risk
assessment processes at the level of the competent tax administration will be enhanced
by measures such as the mandatory disclosure of aggressive tax planning arrangements
(Action12) and standardised transfer pricing documentation requirements coupled with a
template for country-by-country reporting (Action13). In the context of VAT, opportunities
for tax planning by businesses and corresponding BEPS concerns for governments can be
addressed to the extent that the OECDs Guidelines on place of taxation (see AnnexD) for
business-to-business (B2B) supplies of services and intangibles are implemented.
370. Work on the BEPS Project has also examined a number of issues specifically
relevant to the digital economy, its business models and its key features. The TFDE
identified certain specific issues generated by the key features of the digital economy that
warrant attention from a tax perspective. Work on the relevant actions of the BEPS Action
Plan was informed by these findings and took these issues into account to ensure that the
proposed solutions fully address BEPS in the digital economy. Specifically, the BEPS
issues raised by the digital economy include ensuring that core activities in the digital
economy cannot inappropriately benefit from the exception from permanent establishment
(PE) status, and that artificial arrangements relating to sales of goods and services cannot
be used to avoid PE status.
371. The work on Action7 (preventing the artificial avoidance of PEStatus) concluded
that activities previously considered to be merely preparatory or auxiliary in nature for the
purposes of the exceptions usually found in the definition of PE may nowadays correspond to
core business activities of an enterprise, particularly in the digital economy. It was therefore
agreed to modify the list of exceptions contained in Article5 (4) of the OECD Model Tax
Convention to ensure that each of the exceptions included therein is restricted to activities
that are otherwise of a preparatory or auxiliary character, and a new anti-fragmentation
rule was introduced to ensure that it is not possible to benefit from these exceptions through
the fragmentation of business activities among closely related enterprises. For example, the
maintenance of a very large local warehouse in which a significant number of employees
work for purposes of storing and delivering goods sold online to customers by an online seller
of physical products (whose business model relies on the proximity to customers and the need
for quick delivery to clients) would constitute a PE for that seller.
372. In addition, it was agreed to modify the definition of PE contained in Article5(5)
and 5(6) of the OECD Model Tax Convention to address circumstances in which artificial
arrangements relating to the sales of goods or services of one company in a multinational
group effectively result in the conclusion of contracts, such that the sales should be treated
as if they had been made by that company. For example, where the sales force of a local
subsidiary of an online seller of tangible products or an online provider of advertising
services habitually plays the principal role in the conclusion of contracts with prospective
large clients for those products or services, and these contracts are routinely concluded
without material modification by the parent company, this activity would result in a
permanent establishment for the parent company.
10.2.1. The importance of intangibles, the use of data, and the spread of global
value chains, and their impact on transfer pricing rules
373. Companies in the digital economy rely heavily on intangibles in creating value
and producing income. A key feature of many BEPS structures adopted by participants
in the digital economy involves the transfer of intangibles or rights in intangibles to taxadvantaged locations. Further, it is then often argued that these contractual allocations,
together with legal ownership of intangibles, justify large allocations of income to the
entity allocated the risk even if it performs little or no business activity. Often this is
accomplished by arguing that other entities in the group are contractually insulated from
risk so that a low-tax affiliate is entitled to all residual income after compensating other low
risk group members for their functions even if this affiliate has no capacity to control the
risk. The BEPS work in the area of transfer pricing took these issues in account and revised
the guidance for intangibles to clarify that legal ownership alone does not necessarily
generate a right to all (or indeed any) of the return that is generated by the exploitation of
the intangible. The group companies performing the important functions, contributing
important assets and controlling economically significant risks, as determined through
the accurate delineation of the actual transaction, will be entitled to an appropriate return.
Under this guidance, members of the MNE group are to be compensated based on the value
they create through functions performed, assets used and risks assumed in the development,
enhancement, maintenance, protection and exploitation of intangibles. Specific guidance
will also ensure that the analysis is not weakened by information asymmetries between
the tax administration and the taxpayer in relation to hard-to-value intangibles, or by using
special contractual relationships, such as a cost contribution arrangement.
374. In addition, the scope of the work to be done on the practical application of
transactional profit split methods has been agreed. This work will take into account the

conclusions of this report and may be relevant for highly integrated MNEs in the digital
economy. In this context, the work should also address situations where the availability of
comparables is limited, for example due to the specific features of the controlled transactions.
10.2.2. The possible need to adapt CFC rules to the digital economy
375. Although CFC rules vary significantly from jurisdiction to jurisdiction, income
from digital goods and services provided remotely is frequently not subject to current
taxation under CFC rules. Such income may be particularly mobile due to the importance of
intangibles in the provision of such goods and services and the relatively few people required
to carry out online sales activities. The work on Action3 resulted in recommendations in
the form of six building blocks, including a definition of CFC income which sets out a nonexhaustive list of approaches or combination of approaches that CFC rules could use for
such a definition. Countries can implement these approaches to design CFC rules that would
subject income that is typically earned in the digital economy to taxation in the jurisdiction
of the ultimate parent company. For instance, countries could use the categorical analyses
to define CFC income to include types of revenue typically generated in digital economy
transactions such as license fees and certain types of income from sales of digital goods
and services. If countries adopted the excess profits approach this could characterise any
excess profits generated in low tax jurisdictions, which may include profits attributable to
IP-related assets, as CFC income. This approach could potentially limit the use of offshore
deferral structures popular with digital economy MNEs that indefinitely defer foreign
income from taxation in the residence jurisdiction. Both approaches may be combined with
a substance analysis aimed at verifying whether the CFC is engaged in substantial activities
in order to accurately identify and quantify shifted income.
10.3. Broader tax policy challenges raised by the digital economy

376. The digital economy also raises broader tax challenges for policy makers.
These challenges relate in particular to nexus, data, and characterisation for direct tax
purposes. These challenges trigger more systemic questions about the ability of the current
international tax framework to deal with the changes brought about by the digital economy
and the business models that it makes possible and hence to ensure that profits are taxed
in the jurisdiction where economic activities occur and where value is generated. They
therefore have a broad impact and relate primarily to the allocation of taxing rights among
different jurisdictions. These challenges also raise questions regarding the paradigm used
to determine where economic activities are carried out and value is generated for tax
purposes, which is based on an analysis of the functions, assets and risks of the enterprise
involved. At the same time, when these challenges create opportunities for achieving
double non-taxation, for example due to the lack of nexus in the market country under
current rules coupled with lack of taxation in the jurisdiction of the income recipient and
of that of the ultimate parent company, they also generate BEPS issues in the form of
stateless income. In addition, in the area of indirect taxes, the digital economy raises policy
challenges regarding the collection of VAT.
377. The challenges related to nexus, data and characterisation overlap with each
other to a certain extent. Although the challenges related to direct tax are distinct in
nature, they often overlap with each other. For example, the collection of data from users
located in a jurisdiction may trigger questions regarding whether that activity should
give rise to nexus with that jurisdiction and regarding how data should be treated for tax
purposes.
378. Evolving ways of carrying on business raise questions about whether current
nexus rules continue to be appropriate. The continual increase in the potential of digital
technologies and the reduced need in many cases for extensive physical presence in
order to carry on business in a jurisdiction, combined with the increasing role of network
effects generated by customer interactions, raise questions as to whether rules that rely on
physical presence continue to be appropriate. The number of firms carrying out business
transactions over the Internet has increased dramatically over the last decade. In 2014, B2C
e-commerce sales were estimated to exceed USD1.4 trillion, an increase of nearly 20%
from 2013. According to estimates, the size of total worldwide e-commerce, when global
B2B and consumer transactions are added together, equalled USD16 trillion in 2013.
379. Increasing reliance on data collection and analysis, and the growing importance
of multi-sided business models raise questions about valuation of data, nexus, and
profit attribution, as well as characterisation. The appropriate allocation of taxable
income among locations in which economic activities take place and value is created may
not always be clear in the digital economy, particularly in cases where users and customers
become an important component of the value chain, for example in relation to multi-sided
business models and the sharing economy. The growth in sophistication of information
technologies has permitted companies in the digital economy to gather and use information
to an unprecedented degree. This raises the issues of how to attribute value created from the
generation of data through digital products and services, whether remote collection of data
should give rise to nexus for tax purposes, and of ownership and how to characterise for tax
purposes a person or entitys supply of data in a transaction, for example, as a free supply of
a good, as a barter transaction, or some other way.
380. The development of new business models raises questions regarding characterisation
of income. The development of new digital products or means of delivering services creates
uncertainties in relation to the proper characterisation under current rules of payments made
in the context of new business models, particularly in relation to cloud computing. Further,
to the extent that 3D printing becomes increasingly prevalent, it may raise characterisation
questions as well, as direct manufacturing for delivery could effectively evolve into licensing
of designs for remote printing directly by consumers.
381. Cross-border trade in goods, services and intangibles creates challenges for VAT
collection, particularly where such products are acquired by private consumers from
suppliers abroad. This is partly due to the absence of an effective international framework
to ensure VAT collection in the market jurisdiction. For economic actors, and in particular
SMEs, the absence of an international standard for charging, collecting and remitting the
tax to a potentially large number of tax authorities creates large revenue risks and high
compliance costs. For governments, there is a risk of loss of revenue and trade distortion,
and the challenge of managing tax liabilities generated by a high volume of low value
transactions, which can create a significant administrative burden but marginal revenues.
382. The TFDE considered several options to address the broader tax challenges
raised by the digital economy, including modifications to the exceptions from PE status,
alternatives to the existing PE threshold, the imposition of a withholding tax on certain
types of digital transactions and the introduction of an equalisation levy, as well as the
principles and mechanisms developed by WP9 of the CFA to ensure that VAT is collected
by the country where the customer is located. To evaluate these options, the TFDE agreed
on a framework based on neutrality, efficiency, certainty and simplicity, effectiveness and
fairness, flexibility and sustainability, and proportionality. It also analysed the economic
incidence of the three options aimed at taxing income from the sales of digital goods and

services by foreign suppliers without a PE under current rules, namely the new nexus in
the form of a significant economic presence, the withholding tax on certain types of digital
transactions and the equalisation levy.
383. As regards the different options analysed, the TFDE concluded that:
available only for activities that are in fact preparatory or auxiliary in nature
has been considered by the TFDE and adopted as part of the work on Action7
of the BEPS Project.1 It is now expected to be implemented across the existing
tax treaty network in a synchronised and efficient manner via the conclusion of
the multilateral instrument that modifies bilateral tax treaties under Action15.
The collection of VAT/GST on cross-border transactions, particularly those
between businesses and consumers, is an important issue. In this regard,
countries are recommended to apply the principles of the International VAT/GST
Guidelines for the collection of VAT on cross-border B2C supplies of services and
intangibles and consider the introduction of the collection mechanisms included
therein. Moreover, a range of possible approaches for a more efficient collection
of VAT on the importation of low value goods is available to countries that wish
to remove or lower the VAT exemption thresholds.
Some aspects of the broader direct tax challenges currently raised by the digital
economy are expected to be mitigated once the BEPS measures are implemented.
A quick implementation of the BEPS measures is needed, together with
mechanisms to monitor their impact over time.
None of the other three options analysed by the TFDE were recommended
at this stage. This is because, among other reasons, it is expected that the
measures developed in the BEPS Project will have a substantial impact on
BEPS issues previously identified in the digital economy, that certain BEPS
measures will mitigate some aspects of the broader tax challenges, and that
consumption taxes will be levied effectively in the market country.
Countries could, however, introduce any of the options in their domestic laws
as additional safeguards against BEPS, provided they respect existing treaty
obligations, or in their bilateral tax treaties. Adoption as domestic law measures
would require further calibration of the options in order to provide additional
clarity about the details, as well as some adaptation to ensure consistency with
existing international legal commitments.
384. These conclusions may evolve as the digital economy continues to develop, in particular
regarding robotics, the internet of things, 3D printing and the sharing economy and will
depend on the actual impact of other measures on BEPS issues. It is therefore important to
continue working on these issues and to monitor developments in the digital economy over
time. As part of this future work, it will also be important to review and analyse data that will
become available over time. This will provide a sound basis to ascertain the concrete extent of
the broader direct tax challenges, in particular in relation to nexus. On the basis of the future
monitoring work, a determination will also be made as to whether further work on the three
options discussed and analysed by the TFDE should be carried out. This determination should
be based on a broad look at the ability of existing international tax standards to deal with the
tax challenges raised by developments in the digital economy, taking into account not just direct
taxes, but also indirect taxes, administrative issues, countries differing levels of development,
as well as the impact of any potential change on cross-border trade and investment.
10.4. Next steps

385. On this basis, agreement was reached that:
The work will continue following the completion of the other follow-up work on the
BEPS Project. This future work will be done in consultation with a broad range of
stakeholders, and on the basis of a detailed mandate to be developed during 2016
in the context of designing an inclusive post-BEPS monitoring process. A report
reflecting the outcome of the continued work in relation to the digital economy
should be produced by 2020.
WP 1 of the CFA shall clarify the characterisation under current tax treaty rules
of certain payments under new business models, especially cloud computing
payments (including payments for infrastructure-as-a-service, software-as-aservice, and platform-as-a-service transactions,) with the Associates in the BEPS
Project participating on an equal footing with the OECD countries.
Implementation packages will be developed to ensure that countries can implement
the International VAT/GST Guidelines in a co-ordinated manner. Work in this
area will be carried out by the WP 9, with the Associates in the BEPS Project
participating on an equal footing.
Note
1.
Some countries consider that there is no need to modify Art.5(4) and that the list of exceptions
in subparagraphsa) to d) of paragraph4 should not be subject to the condition that the activities
referred to in these subparagraphs be of a preparatory or auxiliary character. These countries
may adopt a different version of Art.5(4) as long as they include the anti-fragmentation rule
referred to above.
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
AnnexA. Prior work on the digital economy 151
AnnexA
Prior work on the digital economy
This annex summarises the content and output of the previous work on electronic
commerce. Specifically, it presents the work that led to the 1998 Ministerial Conference
on Electronic Commerce in Ottawa (Ottawa Conference) and its main outcomes. It
then describes the follow-up work carried out in relation to tax treaty issues and to
consumption tax issues.
152 AnnexA. Prior work on the digital economy
A.1. 1996-98: Work leading to the Ottawa Ministerial Conference on Electronic

Commerce
1.
At its June 1996 meeting, the Committee on Fiscal Affairs (CFA) discussed the
tax implications of the development of communications technologies. After a conference
on electronic commerce organised by the Organisation for Economic Co-operation and
Development (OECD) and the government of Finland in co-operation with the European
Community (EC) Commission, the government of Japan and the Business and Industry
Advisory Committee to the OECD (BIAC) in Turku in November 1997, the CFA adopted a
series of proposals for the preparation of a Ministerial meeting on electronic commerce to
be organised in Ottawa in October 1998. In preparation for that meeting, the CFA adopted
the report: Electronic Commerce: Taxation Framework Conditions (OECD, 2001a), which
drew the following main conclusions:
The widely accepted general tax principles that guide governments in relation to
conventional commerce should also guide them in relation to electronic commerce.
Existing taxation rules can implement these principles.
This approach does not preclude new administrative or legislative measures, or
changes to existing measures, relating to electronic commerce, provided that those
measures are intended to assist in the application of the existing taxation principles,
and are not intended to impose a discriminatory tax treatment of electronic commerce
transactions.
The application of these principles to electronic commerce should be structured to
maintain the fiscal sovereignty of countries, to achieve a fair sharing of the tax base
from electronic commerce between countries and to avoid double and unintentional
non-taxation.
The process of implementing these principles should involve an intensified dialogue
with business and with non-member economies.
BoxA.1. Ottawa taxation framework conditions Principles

Neutrality: Taxation should seek to be neutral and equitable between forms of electronic
commerce and between conventional and electronic forms of commerce. Business decisions
should be motivated by economic rather than tax considerations. Taxpayers in similar situations
carrying out similar transactions should be subject to similar levels of taxation.
Efficiency: Compliance costs for taxpayers and administrative costs for the tax authorities
Certainty and Simplicity: The tax rules should be clear and simple to understand so that
taxpayers can anticipate the tax consequences in advance of a transaction, including knowing
when, where and how the tax is to be accounted.
Effectiveness and Fairness: Taxation should produce the right amount of tax at the right time.
The potential for tax evasion and avoidance should be minimised while keeping counteracting
measures proportionate to the risks involved.
Flexibility: The systems for taxation should be flexible and dynamic to ensure that they
keep pace with technological and commercial developments.
A.2. 1998: The Ottawa Ministerial Conference on Electronic Commerce

2.
At the Ottawa Ministerial Conference on Electronic Commerce, leaders from
governments (29 member countries and 11 non-member countries), heads of major
international organisations, industry leaders, and representatives of consumer, labour and
social interests discussed plans to promote the development of global electronic commerce.
Ministers welcomed the 1998 CFA Report Electronic Commerce: Taxation Framework
Conditions (OECD, 2001a), and endorsed a set of taxation principles (listed in BoxA.1)
which should apply to electronic commerce.
A.3. Post-Ottawa: CFA work and technical advisory groups

3.
At its January 1999 meeting, the CFA decided that the work programme on
electronic commerce would be taken forward by the Committees existing subsidiary bodies,
in their respective areas of responsibility. It also endorsed the establishment of the following
technical advisory groups (TAGs), comprising representatives from OECD governments,
non-OECD governments, business and science, thus comprising a broad range of interests
and expertise:
A consumption tax TAG, to advise on the practical implementation of the Ottawa
principle of taxation in the place of consumption.
A technology TAG, to provide expert technological input to the other TAGs.
A professional data assessment TAG, to advise the feasibility and practicality of
developing internationally compatible information and record-keeping requirements
and tax collection arrangements.
A business profits (BP) TAG, to advise on how the current tax treaty rules for
the taxation of business profits apply in the context of electronic commerce and to
examine proposals for alternative rules.
A treaty characterisation TAG, to advise on the characterisation of various types
of electronic commerce payments under tax treaties with a view to providing
necessary clarifications in the Commentary.
4.
Given the relevance for the current work on the tax challenges of the digital
economy, the sections below describe the main output of the work conducted by the BP
TAG and by the Treaty Characterisation TAG.
A.3.1. The work of the business profits TAG

5.
The work of the BP TAG produced discussion drafts on Attribution of Profit to a
Permanent Establishment Involved in Electronic Commerce Transactions (OECD, 2001b),
released in February 2001, and Place of Effective Management Concept: Suggestions for
Changes to the OECD Model Tax Convention (OECD, 2003a), released in May 2003.
6.
The TAG also produced a report, Treaty Rules and E-Commerce: Taxing Business
Profits in the New Economy (OECD, 2005), which was released in 2005. In that report,
the BP TAG recognised that some aspects of existing international tax rules presented
concerns. The report first examined a number of relatively restricted approaches to address
those concerns in a manner that would not require fundamental changes to international
tax rules, and made recommendations with respect to those alternatives. The report also
discussed more fundamental changes. After summarising the existing treaty rules for

taxing business profits (liability to tax, permanent establishment (PE) concept, computation
of profits, allocation of the tax base between countries), the report presented a critical
evaluation of these rules against a number of specific criteria, which were derived from the
Ottawa framework conditions. In assessing the current principles for taxing business profits
against these criteria, the report highlighted a number of pros and cons of the current rules.
For example, with respect to the important question where business profits originate (the
source issue) the report concluded that business profits should be viewed as originating
from the location of the factors that allow the enterprise to realise business profits. The
report therefore rejected the suggestion that the mere fact that a country provides the market
where an enterprises goods and services are supplied should allow that country to consider
that a share of the profits of the enterprise is derived therefrom.
7.
The BP TAG could, however, not agree on the related issue whether a supplier which
is not physically present in a country may be considered to be using that countrys legal and
economic infrastructure and, if that is the case, whether and to what extent, such use of a
countrys legal and economic infrastructure should be considered to be one factor which
would allow that country to claim source taxing rights on a share of the enterprises profits. In
addition, since the most traditional of business enterprises continue to incorporate electronic
commerce business models, it was found not to be appropriate, nor possible, to design one
set of nexus rules for electronic commerce companies, and another for non-electronic
commerce companies. The final report also gave an overview of the various alternatives to the
current treaty rules for taxing business profits that were discussed. These alternatives ranged
from relatively minor changes to the existing rules to the adoption of complete new ones.
8.
The following alternatives were found to entail relatively minor changes:

Modification of the PE definition to exclude activities that do not involve human
intervention by personnel, including dependent agents: This option would modify
the PE definition to expressly exclude the maintenance of a fixed place of business
used solely for the carrying on of activities that do not involve human intervention
by personnel, including dependent agents.
Modification of the PE definition to provide that a server cannot, in itself,
constitute a PE: According to this alternative, the PE definition would not cover
situations where a fixed place of business is used merely to carry on automated
functions through equipment, data and software such as a server and website.
Modification of the PE definition/interpretation to exclude functions attributable to
software: paragraph4 of Article5 of the OECD Model Tax Convention provides a list
of functions that are specifically excluded from the definition of a PE (the Article5,
paragraph4 exceptions). This option would indirectly expand this list by excluding
functions attributable to software when applying the Article5, paragraph4 exceptions.
Elimination of the existing exceptions in paragraph4 of Article5 or making these
exceptions subject to the overall condition that they be preparatory or auxiliary:
One option would be to eliminate all the exceptions included in paragraph4 of the
definition of PE. A less radical option would be to make all the activities referred
to in the existing exceptions subject to the overall limitation that they be of a
preparatory or auxiliary nature.
Elimination of the exceptions for storage, display or delivery in paragraph4 of
Article5: This option suggested that paragraph4 of Article5 be amended so that
the use of facilities solely for purpose of storage, display or delivery should no
longer be considered not to constitute a PE.
Modification of the existing rules to add a force-of-attraction rule dealing with

electronic commerce: According to this alternative, paragraph1 of Article7 of the
OECD Model Tax Convention would be amended to include a so-called forceof-attraction rule which would deal with electronic commerce operations. The
aim would be to ensure that a country may tax profits derived from selling in that
country, through an enterprises website, products similar to those sold through a
PE that the enterprise has in the country.
Adopting supplementary nexus rules for purposes of taxing profits arising from the
provision of services: The option would be to modify the OECD Model to include
a provision, similar to that already found in the UN Model, that would allow for
the taxation of income from services if the enterprise that provides such services is
present in the other country for that purpose during a certain period of time. The
rationale for the proposal was that service providers are very mobile and that the
income-producing functions take place in foreign countries without the need to set
up a physical facility or use a fixed base of operations.
9.
After having examined these alternatives in light of the comments received, the
report reached the following conclusions:
The option to modify the PE definition to exclude activities that do not involve
human intervention by personnel, including dependent agents would be unlikely
to be adopted and did not need further consideration.
As regards the options to modify the PE definition to provide that a server cannot,
in itself, constitute a PE or to exclude functions attributable to software when
applying the preparatory or auxiliary exception, the BP TAG concluded that while
these options should not be pursued at that time, the application of the current rules
to functions performed with the use of servers and software should be monitored
to determine whether it raises practical difficulties or concerns, which could lead
to further study of these alternatives or combinations or variants thereof.
With respect to the option to eliminate all the existing exceptions in paragraph4 of
Article5, the BP TAG concluded that this option should not be pursued.
As regards the options to make all the existing exceptions in paragraph4 of
Article5 subject to the overall condition that they be preparatory or auxiliary
and to eliminate the exceptions for storage, display and delivery in paragraph4
of Article5, the BP TAG concluded the application of these exceptions should
continue to be monitored to determine whether practical difficulties or concerns
warrant any such changes.
With respect to the option to modify the existing rules to add a force-of-attraction
rule dealing with electronic commerce, the BP TAG concluded that it should not
be pursued.
As regards the option to adopt supplementary nexus rules for purposes of taxing
profits arising from the provision of services, the BP TAG noted that this option
would be examined in the context of the work that the OECD was to undertake on
the application of tax treaties to services.
10. The following alternatives were found to require a fundamental modification of the
existing rules:
Adopting rules similar to those concerning taxation of passive income to allow
source taxation of payments related to some forms of electronic commerce (so as

to subject them to source withholding tax): This alternative encompassed various
approaches under which a withholding tax would be applied on all or certain
cross-border payments related to electronic commerce. The discussion in the BP
TAG focused on a general option under which a final withholding tax would be
applied to electronic commerce payments made from a country, whether or not the
recipient has personnel or electronic equipment in that country.
A new nexus: base eroding payments arising in a country: This option contained
a nexus rule that focuses only on whether the foreign enterprise is receiving a
payment from an in-country payor that the payor may deduct for domestic tax
purposes rather than on where the activities giving rise to the product or service
are located. Under this nexus rule, the source state would be entitled to impose a
withholding tax on all such cross-border payments.
Replacing separate entity accounting and arms length by formulary apportionment
of profits of a common group: According to this alternative, the separate entity
and arms length principles would be replaced by a system based on formulary
apportionment as the international method of allocating and measuring business
profits that countries may tax. Under such formulary apportionment system, a
formula would be used to divide the net profits of a company, or a group of related
companies, doing business in more than one country among the countries where
the corporation (or group) operates.
Adding a new nexus of electronic (virtual) PE: This concept of virtual PE
was a suggestion of an alternative nexus that would apply to electronic commerce
operations. This could be done in various ways, such as extending the definition
to cover so-called virtual fixed places of business, virtual agencies or on-site
business presences. All of them would require a modification of the PE definition
(or the addition of a new nexus rule in treaties).
11. The report concluded that it would not be appropriate to embark on any such changes at
that time. Electronic commerce and other business models resulting from new communication
technologies were not perceived by the BP TAG to justify, by themselves, a dramatic departure
from the current rules. There did not seem to be actual evidence that the communications
efficiencies of the Internet had caused any significant decrease to the tax revenues of capital
importing countries. Also, it was considered that fundamental changes should only be
undertaken if there was a broad agreement that a particular alternative was clearly superior to
the existing rules and none of the alternatives that had been suggested appeared to meet that
condition. It was recognised, however, that there was a need to continue to monitor how direct
tax revenues are affected by changes to business models resulting from new communication
technologies and that some aspects of the existing international rules for taxing business
profits raised concerns. More generally, the report noted that the effect of many of these
alternatives would extend far beyond electronic commerce it would therefore be important to
take account of their impact on all types of business activities when considering them.
A.3.2. CFA work in the area of tax treaties

12. In addition to the work of the TAGs, the CFA directed its Working Parties to discuss
and propose solutions with respect to the issues that had been raised by the TAGs. This
led to some changes to the OECD Model Tax Convention and its Commentary which were
incorporated in the 2003 update. The changes related to the definition of PE and to the
characterisation of payments in particular under the definition of royalties contained in the
Model Tax Convention.
A.3.2.1. Treaty rules for taxing business profits

13. The main content of the changes to the Commentary on Article5 was to provide
that the definition of PE, which is typically defined as a fixed place of business through
which business is conducted, could, under certain conditions, cover servers. In contrast,
the changes to the Commentary rejected the view that a website could be regarded as a PE.
Paragraphs (shown in BoxA.2) were added to the OECD Commentary on Article5 of the
OECD Model Tax Convention in 2003 and are also included in the Commentary to the UN
Model Tax Convention (see paragraphs36-37 of the Commentary on Article5 of the UN
Model Tax Convention).
BoxA.2. Commentary on Article5 of the OECD Model Tax Convention

42.1 There has been some discussion as to whether the mere use in electronic commerce
operations of computer equipment in a country could constitute a permanent establishment.
That question raises a number of issues in relation to the provisions of the Article.
42.2 While a location where automated equipment is operated by an enterprise may constitute
a permanent establishment in the country where it is situated (see below), a distinction needs to
be made between computer equipment, which may be set up at a location so as to constitute a
permanent establishment under certain circumstances, and the data and software which is used
by, or stored on, that equipment. For instance, an Internet website, which is a combination of
software and electronic data, does not in itself constitute tangible property. It therefore does
not have a location that can constitute a place of business as there is no facility such as
premises or, in certain instances, machinery or equipment (see paragraph2 above) as far as the
software and data constituting that website is concerned. On the other hand, the server on which
the website is stored and through which it is accessible is a piece of equipment having a physical
location and such location may thus constitute a fixed place of business of the enterprise that
operates that server.
42.3 The distinction between a website and the server on which the website is stored
and used is important since the enterprise that operates the server may be different from the
enterprise that carries on business through the website. For example, it is common for the
website through which an enterprise carries on its business to be hosted on the server of an
Internet Service Provider (ISP). Although the fees paid to the ISP under such arrangements
may be based on the amount of disk space used to store the software and data required by
the website, these contracts typically do not result in the server and its location being at the
disposal of the enterprise (see paragraph4 above), even if the enterprise has been able to
determine that its website should be hosted on a particular server at a particular location. In
such a case, the enterprise does not even have a physical presence at that location since the
website is not tangible. In these cases, the enterprise cannot be considered to have acquired a
place of business by virtue of that hosting arrangement. However, if the enterprise carrying on
business through a website has the server at its own disposal, for example it owns (or leases)
and operates the server on which the website is stored and used, the place where that server is
located could constitute a permanent establishment of the enterprise if the other requirements
of the Article are met.
42.4 Computer equipment at a given location may only constitute a permanent establishment
if it meets the requirement of being fixed. In the case of a server, what is relevant is not the
possibility of the server being moved, but whether it is in fact moved. In order to constitute
a fixed place of business, a server will need to be located at a certain place for a sufficient
period of time so as to become fixed within the meaning of paragraph1.

(continued)
42.5 Another issue is whether the business of an enterprise may be said to be wholly or
partly carried on at a location where the enterprise has equipment such as a server at its
disposal. The question of whether the business of an enterprise is wholly or partly carried
on through such equipment needs to be examined on a case-by-case basis, having regard
to whether it can be said that, because of such equipment, the enterprise has facilities at its
disposal where business functions of the enterprise are performed.
42.6 Where an enterprise operates computer equipment at a particular location, a
permanent establishment may exist even though no personnel of that enterprise is required at
that location for the operation of the equipment. The presence of personnel is not necessary
to consider that an enterprise wholly or partly carries on its business at a location when no
personnel are in fact required to carry on business activities at that location. This conclusion
applies to electronic commerce to the same extent that it applies with respect to other activities
in which equipment operates automatically, e.g.automatic pumping equipment used in the
exploitation of natural resources.
42.7 Another issue relates to the fact that no permanent establishment may be considered
to exist where the electronic commerce operations carried on through computer equipment at
a given location in a country are restricted to the preparatory or auxiliary activities covered
by paragraph4. The question of whether particular activities performed at such a location fall
within paragraph4 needs to be examined on a case-by-case basis having regard to the various
functions performed by the enterprise through that equipment. Examples of activities which
would generally be regarded as preparatory or auxiliary include:
providing a communications link much like a telephone line between suppliers and
customers;
advertising of goods or services;
relaying information through a mirror server for security and efficiency purposes;
gathering market data for the enterprise;
supplying information.
42.8 Where, however, such functions form in themselves an essential and significant part of
the business activity of the enterprise as a whole, or where other core functions of the enterprise
are carried on through the computer equipment, these would go beyond the activities covered
by paragraph4 and if the equipment constituted a fixed place of business of the enterprise (as
discussed in paragraphs42.2 to 42.6 above), there would be a permanent establishment.
42.9 What constitutes core functions for a particular enterprise clearly depends on
the nature of the business carried on by that enterprise. For instance, some ISPs are in
the business of operating their own servers for the purpose of hosting websites or other
applications for other enterprises. For these ISPs, the operation of their servers in order to
provide services to customers is an essential part of their commercial activity and cannot be
considered preparatory or auxiliary. A different example is that of an enterprise (sometimes
referred to as an e-tailer) that carries on the business of selling products through the
Internet. In that case, the enterprise is not in the business of operating servers and the mere
fact that it may do so at a given location is not enough to conclude that activities performed at
that location are more than preparatory and auxiliary. What needs to be done in such a case is
to examine the nature of the activities performed at that location in light of the business carried
on by the enterprise. If these activities are merely preparatory or auxiliary to the business of

(continued)
selling products on the Internet (for example, the location is used to operate a server that
hosts a website which, as is often the case, is used exclusively for advertising, displaying a
catalogue of products or providing information to potential customers), paragraph4 will
apply and the location will not constitute a permanent establishment. If, however, the typical
functions related to a sale are performed at that location (for example, the conclusion of the
contract with the customer, the processing of the payment and the delivery of the products
are performed automatically through the equipment located there), these activities cannot be
considered to be merely preparatory or auxiliary.
42.10 A last issue is whether paragraph5 may apply to deem an ISP to constitute a
permanent establishment. As already noted, it is common for ISPs to provide the service of
hosting the websites of other enterprises on their own servers. The issue may then arise as to
whether paragraph5 may apply to deem such ISPs to constitute permanent establishments
of the enterprises that carry on electronic commerce through websites operated through
the servers owned and operated by these ISPs. While this could be the case in very unusual
circumstances, paragraph5 will generally not be applicable because the ISPs will not
constitute an agent of the enterprises to which the websites belong, because they will not
have authority to conclude contracts in the name of these enterprises and will not regularly
conclude such contracts or because they will constitute independent agents acting in the
ordinary course of their business, as evidenced by the fact that they host the websites of
many different enterprises. It is also clear that since the website through which an enterprise
carries on its business is not itself a person as defined in Article3, paragraph5 cannot
apply to deem a permanent establishment to exist by virtue of the website being an agent of the
enterprise for purposes of that paragraph.
A.3.2.2. Treaty characterisation issues

14. Amendments to the Commentary on Article12 of the OECD Model Tax Convention
were also made to clarify the delimitation between the application of Articles12 and 7 in
the context of new business models in electronic commerce. These clarifications were
included in the 2013 update and deal with (i)payment for the use of, or the right to use, a
copyright, (ii)payments for know-how, (iii)mixed payments. These paragraphs are also
included in the UN Model Tax Convention (see paragraphs12-16 of the Commentary on
Article12 of the UN Model Tax Convention), although it was noted that some members
disagreed with the conclusions reached regarding the character of several types of payment.
BoxA.3. Commentary on Article12 Payment for the use of, or the right to use,
a copyright
The following paragraphs17.1 to 17.4 are included immediately after paragraph17 of the
Commentary on Article12:
17.1 The principles expressed above as regards software payments are also applicable
as regards transactions concerning other types of digital products such as images, sounds or
text. The development of electronic commerce has multiplied the number of such transactions.
In deciding whether or not payments arising in these transactions constitute royalties, the main
question to be addressed is the identification of that for which the payment is essentially made.
BoxA.3. Commentary on Article12 Payment for the use of, or the right to use,
a copyright (continued)
17.2 Under the relevant legislation of some countries, transactions which permit the
customer to electronically download digital products may give rise to use of copyright by the
customer, e.g.because a right to make one or more copies of the digital content is granted
under the contract. Where the consideration is essentially for something other than for the use
of, or right to use, rights in the copyright (such as to acquire other types of contractual rights,
data or services), and the use of copyright is limited to such rights as are required to enable
downloading, storage and operation on the customers computer, network or other storage,
performance or display device, such use of copyright should not affect the analysis of the
character of the payment for purposes of applying the definition of royalties.
17.3 This is the case for transactions that permit the customer (which may be an enterprise)
to electronically download digital products (such as software, images, sounds or text) for that
customers own use or enjoyment. In these transactions, the payment is essentially for the
acquisition of data transmitted in the form of a digital signal and therefore does not constitute
royalties but falls within Article7 or Article13, as the case may be. To the extent that the act of
copying the digital signal onto the customers hard disk or other non-temporary media involves
the use of a copyright by the customer under the relevant law and contractual arrangements,
such copying is merely the means by which the digital signal is captured and stored. This use
of copyright is not important for classification purposes because it does not correspond to
what the payment is essentially in consideration for (i.e.to acquire data transmitted in the
form of a digital signal), which is the determining factor for the purposes of the definition of
royalties. There also would be no basis to classify such transactions as royalties if, under
the relevant law and contractual arrangements, the creation of a copy is regarded as a use of
copyright by the provider rather than by the customer.
17.4 By contrast, transactions where the essential consideration for the payment is the
granting of the right to use a copyright in a digital product that is electronically downloaded
for that purpose will give rise to royalties. This would be the case, for example, of a book
publisher who would pay to acquire the right to reproduce a copyrighted picture that it
would electronically download for the purposes of including it on the cover of a book that it is
producing. In this transaction, the essential consideration for the payment is the acquisition of
rights to use the copyright in the digital product, i.e.the right to reproduce and distribute the
picture, and not merely for the acquisition of the digital content.
BoxA.4. Change to the Commentary on Article12 Payments for know-how

Paragraph11 of the Commentary on Article12 was replaced by the following paragraphs11
to 11.5 (additions to the existing text of paragraph11 appear in bold italics):
11. In classifying as royalties payments received as consideration for information
concerning industrial, commercial or scientific experience, paragraph2 alludes to the concept
of know-how. Various specialist bodies and authors have formulated definitions of know-how
which do not differ intrinsically. One such definition, given by the Association des Bureaux
pour la Protection de la Proprit Industrielle (ANBPPI), states that know-how is all the
undivulged technical information, whether capable of being patented or not, that is necessary
for the industrial reproduction of a product or process, directly and under the same conditions;
inasmuch as it is derived from experience, know-how represents what a manufacturer cannot
know from mere examination of the product and mere knowledge of the progress of technique.

(continued)
11.1 In the know-how contract, one of the parties agrees to impart to the other, so that
he can use them for his own account, his special knowledge and experience which remain
unrevealed to the public. It is recognised that the grantor is not required to play any part
himself in the application of the formulas granted to the licensee and that he does not
guarantee the result thereof.
11.2 This type of contract thus differs from contracts for the provision of services, in which
one of the parties undertakes to use the customary skills of his calling to execute work himself
for the other party. Payments made under the latter contracts generally fall under Article7.
11.3 The need to distinguish these two types of payments, i.e.payments for the supply
of know-how and payments for the provision of services, sometimes gives rise to practical
difficulties. The following criteria are relevant for the purpose of making that distinction:
Contracts for the supply of know-how concern information of the kind described in
paragraph11 that already exists or concern the supply of that type of information after its
development or creation and include specific provisions concerning the confidentiality of
that information.
In the case of contracts for the provision of services, the supplier undertakes to
perform services which may require the use, by that supplier, of special knowledge, skill and
expertise but not the transfer of such special knowledge, skill or expertise to the other party.
In most cases involving the supply of know-how, there would generally be very
little more which needs to be done by the supplier under the contract other than to supply
existing information or reproduce existing material. On the other hand, a contract for the
performance of services would, in the majority of cases, involve a very much greater level of
expenditure by the supplier in order to perform his contractual obligations. For instance, the
supplier, depending on the nature of the services to be rendered, may have to incur salaries
and wages for employees engaged in researching, designing, testing, drawing and other
associated activities or payments to subcontractors for the performance of similar services.
11.4 Examples of payments which should therefore not be considered to be received
as consideration for the provision of know-how but, rather, for the provision of services,
include:
payments obtained as consideration for after-sales service,
payments for services rendered by a seller to the purchaser under a guarantee,
payments for pure technical assistance,
payments for an opinion given by an engineer, an advocate or an accountant, and
payments for advice provided electronically, for electronic communications with
technicians or for accessing, through computer networks, a trouble-shooting database such
as a database that provides users of software with non-confidential information in response
to frequently asked questions or common problems that arise frequently.
11.5 In the particular case of a contract involving the provision, by the supplier, of
information concerning computer programming, as a general rule the payment will only be
considered to be made in consideration for the provision of such information so as to constitute
know-how where it is made to acquire information constituting ideas and principles underlying
the programme, such as logic, algorithms or programming languages or techniques, where
this information is provided under the condition that the customer not disclose it without
authorisation and where it is subject to any available trade secret protection.

(continued)
11.6 In business practice, contracts are encountered which cover both know-how and the
provision of technical assistance. One example, amongst others, of contracts of this kind is that
of franchising, where the franchisor imparts his knowledge and experience to the franchisee
and, in addition, provides him with varied technical assistance, which, in certain cases, is
backed up with financial assistance and the supply of goods. The appropriate course to take
with a mixed contract is, in principle, to break down, on the basis of the information contained
in the contract or by means of a reasonable apportionment, the whole amount of the stipulated
consideration according to the various parts of what is being provided under the contract,
and then to apply to each part of it so determined the taxation treatment proper thereto. If,
however, one part of what is being provided constitutes by far the principal purpose of the
contract and the other parts stipulated therein are only of an ancillary and largely unimportant
character, then it seems possible to apply to the whole amount of the consideration the
treatment applicable to the principal part. [paragraph45 below includes suggested changes
to this last sentence]
BoxA.5. Commentary on Article12 Mixed payments

The last sentence of paragraph11 of the Commentary on Article12 was replaced by the
following (deletions appear in strikethrough and additions in bold italics):
If, however, one part of what is being provided constitutes by far the principal purpose
of the contract and the other parts stipulated therein are only of an ancillary and largely
unimportant character, then the treatment applicable to the principal part should generally
be applied to the whole amount of the consideration. then it seems possible to apply to the
whole amount of the consideration the treatment applicable to the principal part.
A.3.3. CFA work in the area of consumption taxes

15. This section first looks at the elements of the 1998 Ottawa Taxation Framework
Conditions (OECD, 2001a) specifically related to consumption taxes and discusses the
E-commerce Guidelines (OECD, 2003b) and the Consumption tax guidance papers (OECD
2003c-d-e) that were developed to implement these conditions.
16. The need for an international co-ordination of the application of domestic value added
tax (VAT) systems to international trade first became apparent following the emergence and
strong growth of e-commerce. In the field of consumption taxes, the core elements of the
Taxation Framework Conditions (OECD, 2001a) can be summarised as follows:
Rules for the consumption taxation of cross-border trade should result in taxation
in the jurisdiction where consumption takes place and an international consensus
should be sought on the circumstances under which supplies are held to be
consumed in a jurisdiction.
For the purpose of consumption taxes, the supply of digitised products should not
be treated as a supply of goods.
Where business and other organisations within a country acquire services and
intangibles from suppliers outside the country, countries should examine the use of
reverse charge, self-assessment or other equivalent mechanisms where this would

give immediate protection of their revenue base and of the competitiveness of
domestic suppliers.
17.
These framework conditions were broad statements of general principle which required
further elaboration to facilitate their practical application. As a follow-up to this work, in 2003
the CFA released its E-commerce Guidelines (2003b). The CFA also released the Consumption
Tax Guidance Series (OECD 2003c-e-f) along with these Guidelines, consisting of three papers
providing guidance on the implementation of the Guidelines in practice. These Guidelines and
Guidance papers are summarised in the following sections.
A.3.3.1. The E-commerce Guidelines

18. Destination based taxation of cross-border e-business was the governing principle
of the E-commerce Guidelines (2003b). Under the destination principle, tax is ultimately
levied only on the final consumption within the jurisdiction where such consumption is
deemed to occur. Exports are not subject to tax with refund of input taxes (that is, free of
VAT or zero-rated), and imports are taxed on the same basis and at the same rates as
domestic supplies. The E-commerce Guidelines (2003b)provide that:
For business-to-business transactions, the place of consumption for cross-border
supplies of services and intangibles that are capable of delivery from a remote
location made to a non-resident business recipient should be the jurisdiction in
which the recipient has located its business presence. This was referred to as the
main criterion. The Guidelines (2003b) indicated that countries may, in certain
circumstances, use a different criterion to determine the actual place of consumption,
where the application of the main criterion would lead to a distortion of competition
or avoidance of tax. This was referred to as the override criterion.
For business-to-consumer transactions, the place of consumption for cross-border
supplies of services and intangibles that are capable of delivery from a remote
location made to a non-resident private recipient should be the jurisdiction in which
the recipient has its usual residence.
19. These Guidelines (2003b) were explicitly not applicable to (i)sub-national consumption
taxes, (ii)suppliers who were registered or required to be registered in the customers
jurisdiction, (iii)services that are not capable of direct delivery from a remote location
(such as hotel accommodation, transportation or vehicle rental), (iv)services for which
the place of consumption could be readily identified, (v)services for which the place of
consumption could be more appropriately determined by other criteria, (vi)specific types
of services for which more specific approaches might be needed.
A.3.3.2. The consumption tax guidance papers

20. The CFA released three Consumption Tax Guidance (OECD, 2003c-d-e) papers
along with the E-commerce Guidelines, to support their implementation in practice. These
Guidance papers deal with: (i)Identifying place of taxation for business-to-business supplies
by reference to the customers business presence (OECD, 2003c); (ii)Simplified registration
guidance (OECD, 2003d); and (iii)Verification of customer status and jurisdiction (OECD,
2003e). These papers are briefly summarised below:
Guidance paper on identifying place of taxation by reference to the customers
business presence: the Guidelines on the Definition of Place of Consumption

(OECD, 2003c) described business presence as, in principle, the establishment
(for example, headquarters, registered office, or a branch of the business) of the
recipient to which the supply is made. The Guidance paper on business presence
underlined the importance of contracts in determining the business presence to
which the supply is made. Normal commercial practices as evidenced in the terms
of contracts (e.g.invoicing, terms of payment, use of intellectual property rights),
should normally provide sufficient indicative evidence to assist both business
and revenue administrations in determining the jurisdiction of consumption. The
Guidance paper also discussed the override criterion. It considered the case
where a customer with branches in several jurisdictions that are not entitled to
recover the input tax on a transaction, routed this transaction through branches in
jurisdictions with no or a low VAT, thus avoiding a significant amount of tax.
The Guidance Paper suggested that a pure place of consumption override could
be applied in such a case, according to which a country may require a business
presence in its jurisdiction to account for tax to the extent that the supply is used
in that jurisdiction. In addition, and in order to avoid double taxation, the country
of the business presence that has acquired the supply may then choose to provide
a correction proportionately equivalent to the tax collected by the other country
under the application of this test.
Guidance paper on simplified registration systems (OECD, 2003d): This guidance
paper explored the possible implementation of a system for taxing e-commerce
business-to-consumer (B2C) cross-border transactions in the customers jurisdiction,
based on vendor collection. It considered registration and declaration procedures and
record-keeping requirements and recommended the use of simplified registration
regimes and registration thresholds to minimise the potential compliance burden. It
suggested that governments that implement simplified registration systems consider
using electronic registration and declaration and encourages tax administrations to
review and develop a legal basis to allow for the use of electronic record keeping
systems.
Guidance paper on Verification of Customer Status and Jurisdiction (OECD,
2003e): This Guidance Paper provided practical guidance on mechanisms that may
be used to establish the status (business or private) and jurisdiction of customers,
for low value electronic commerce transactions where vendors do not have an
established relationship with the customer. It does not apply to high value B2B
transactions where the vendor and the customer were assumed to have an established
relationship. In these cases the supplier was assumed to be normally aware of the
customers status and jurisdiction and no additional verification process of the
customers declaration was considered necessary. The Paper concluded that the
status and jurisdiction of a customer should be based on customer self-identification,
supported by a range of other criteria including payment information, tracking and
geo-location software, the nature of the supply and digital certificates.
Bibliography
OECD (2005), Are the Current Treaty Rules for Taxing Business Profits Appropriate for
E-commerce? Final Report, OECD, Paris.
OECD (2003a), Place of Effective Management Concept: Suggestions for Changes to the
OECD Model Tax Convention, OECD, Paris.
OECD (2003b), Consumption Taxation of Cross Border Services and Intangible Property
in the context of E-commerce, Guidelines on the Definition of Place of Consumption,
OECD, Paris.
OECD (2003c), Commentary on Place of Consumption for Business-to-Business Supplies
(Business Presence), OECD, Paris.
OECD (2003d), Simplified Registration Guidance, OECD, Paris.
OECD (2003e), Verification of customer status and jurisdiction, OECD, Paris.
OECD (2003f), Model Tax Convention on Income and on Capital: Condensed Version
2003, OECD Publishing, http://dx.doi.org/10.1787/mtc_cond-2003-en.
OECD (2001a), Taxation and Electronic Commerce: Implementing the Ottawa Taxation
Framework Conditions, OECD Publishing, http://dx.doi.org/10.1787/9789264189799-en.
OECD (2001b), Attribution of Profits to Permanent Establishments, OECD Publishing,
http://dx.doi.org/10.1787/9789264184527-en.
United Nations (2011), United Nations Double Tax Convention between Developed and
Developing Countries, The United Nations, New York.
AnnexB. Typical tax planning structures in integrated business models 167
AnnexB
Typical tax planning structures in integrated business models
The simplified examples below are based on what a number of tax administrations
have observed. They are intended to provide an illustration of ways in which the
implementation of business models through legal and tax structures may place
pressure on the existing international tax framework. They are not exhaustive, and
do not pretend to reflect the full scope of structures that may be used to achieve
base erosion and profit shifting (BEPS).
168 AnnexB. Typical tax planning structures in integrated business models
B.1. Online retailer

1.
RCo Group is a multinational enterprise (MNE) engaged in the online sale of
physical goods and digital products. The websites of the Group display the products offered
in the markets that they serve in local languages and allow customers to acquire these
products on line through credit card payments. Physical products are delivered through
independent courier services. Digital products are downloaded from one of RCo groups
websites to the consumers computer. RCo Group collects data on customer preferences
on the basis of goods purchased, added to a list of favorites, or browsed by customers.
Using sophisticated proprietary software, RCo Group analyses the data it collects in order
to make recommendations of goods to its potential customers and provide personalised
advertising.
2.
All intangibles used in operating the RCo Group websites and fulfilling orders
are developed by employees of RCo, a company resident in StateR. RCo also remotely
co-ordinates the procurement and sale activities of the Group to minimise purchasing
costs, maintain consistency among the various businesses and websites, improve efficiency
of inventory management, and minimise overhead on the payment processing and back
office functions. These co-ordination services are generally provided to regional operating
lower-tier sales subsidiaries in return for a management service fee covering related
expenses plus a markup.
3.
Rights to existing and future intangibles used in operating the websites serving
customers in a region that includes, among others, StateT and StateS (the StateT/S
region) are held by RCo Regional Holding, a subsidiary resident in StateT. RCo Regional
Holding acquired the rights through a cost-sharing arrangement in which it made a buy
in payment to RCo equal to the value of the existing intangibles and agreed to share the
cost of future development (to be performed exclusively by RCo personnel in StateR) on
the basis of the anticipated future benefit from the use of the technology in the StateT/S
region. RCo remains the legal owner of the intangibles from the MNE group and is
responsible for functions pertaining to the registration and defence of Intellectual Property,
RCo Regional Holdings only acquires the rights to commercially exploit the Internet
Protocol (IP) and not the legal ownership of the intangibles. In practice, RCo Regional
Holding does not perform any supervision of the development activities carried out by RCo
in StateR. RCo Regional Holding acts as an IP manager for the T/S region and sublicenses
the intangibles necessary for its various subsidiaries to operate their various country- or
region-targeted websites. RCo Regional Holding also acts as a holding company for all
subsidiaries in the StateT/S region, although in practice, most co-ordination services
continue to be performed at the level of RCo, and RCo Regional Holdings involvement
with the subsidiaries is very limited. RCo Regional Holding has only one employee on its
payroll, and the premises are limited to an office hotel where the company regularly rents
different offices for the purpose of organising board meetings.
4.
Orders from customers in StateS, StateT, and the rest of the StateT/S region are
handled by a subsidiary of RCo Regional Holding, RCo Regional OpCo, also resident in
StateT. RCo Regional OpCo is a hybrid entity that is treated as a company for tax purposes
under the domestic law of StateT, and as a transparent entity under the domestic law of
StateR. RCo Regional OpCo handles the sales, payment processing and settlement and has
legal title to the physical and digital products sold on the websites serving customers in the
StateT/S region. Changes and updates to the websites are done from StateT by employees
of RCo Regional OpCo, who have overall responsibility for managing the various websites
serving customers in the region. These functions are performed with minimal skilled
personnel. Other functions related to the online sale activity rely on automated processes
conducted by sophisticated Internet-powered software applications regularly upgraded by
employees of RCo in StateR. Orders and sales are concluded electronically by customers in
StateT/S region on the basis of standardised contracts, the terms of which are set by RCo,
and require no intervention from RCo Regional OpCo. Mirrors of the websites are hosted
on servers in a number of countries in the region. RCo Regional OpCo staff very rarely
have any contact with customers in the local market jurisdiction.
5.
SCo, a subsidiary of RCo Regional OpCo resident in StateS, provides services to
RCo Regional OpCo in respect of logistics and after sales support with respect to orders
from customers in StateS. Orders for physical goods placed by customers in StateS via the
website managed by RCo Regional OpCo, are generally fulfilled from a warehouse located
in StateS owned and operated by SCo. Where products are not available in a StateS
warehouse, the order is generally fulfilled from the closest warehouse to the customer.
After-sales support is handled by SCo through a call center. Orders for digital products
placed by StateS customers are generally downloaded from servers located in StateS or in
neighbouring countries, depending on network traffic at the time of the transaction. These
servers are owned and operated by third parties through hosting arrangements with RCo
Regional OpCo. SCo is remunerated on a cost-plus basis by RCo Regional OpCo.
6.
The structure used by the RCo Group can be depicted as shown in FigureB.1.
FigureB.1. Online retailer
Performs R&D.
Operates State R Website.
Coordination services for sales and procurement.
Owns local IP.
RCo
(State R)
Right to IP in
State T/S region.
Initial buy-in payment plus

Contractual payments.
Holds stock of regional subsidiaries.
Owns IP for State T/S region.
Sublicenses IP to regional subsidiaries.
RCo Regional
Holding (State T)
License IP
for business in
State T/S region.
ods
r goducts
o
f
nts pro
me tal
Pay d digi
an
State S customers
Management fees
Royalties
RCo
Operates State T/S region websites.

Owns physical and digital inventory.
Performs payment processing and settlement.
Regional OpCo
(State T)
Fee (cost-plus basis)

Sco
(State S)
Operates warehouse.
Delivery through courier.
After sales assistance.
7.
The manner in which RCo Groups business activity is structured as a legal matter
has significant consequences for the Groups worldwide tax burden. Due to the contractual
arrangements transferring and assigning the intangibles for the StateT/S region (and
related returns) to RCo Regional Holding and the lack of taxable presence of RCo Regional
Holding in StateS, most of the taxable income generated by the Group is concentrated in
StateT. More specifically, the following paragraphs describe the consequences that would
arise in the different States concerned.
Direct tax consequences in stateS

SCo is allocated minimal taxable income, based on the position that SCos risk and
function profile is limited to routine services provided to RCo Regional OpCo.
All revenues derived from the online sales of products to customers in StateS
are treated as income of RCo Regional OpCo, due to its role as the counterparty
to the transactions. Because RCo Regional OpCo has no physical presence in
StateS, and SCo has no interaction with StateS customers, StateS does not tax the
profits derived from these activities either because it has no right to do so under its
domestic law or because the relevant double tax treaty prevents it from doing so
in the absence of a permanent establishment (PE) of TCo in StateS to which the
income is attributable.
Direct tax consequences in stateT

StateT imposes corporate tax on the profits earned by RCo Regional Holding.
However, by virtue of a preferential regime available in StateT for income derived
from certain intangibles, RCo Regional Holding is entitled to a rate substantially
less than the generally applicable corporate tax rate for the royalties included in its
taxable profits.
StateT imposes corporate tax on the profits earned by RCo Regional OpCo from
its online sale activities. RCo Regional OpCos income, however, is almost entirely
offset by the royalty payments made to RCo Regional Holding for the right to use
the intangibles necessary to operate the regional websites, and the management fees
paid to RCo for co-ordinating sales and procurement.
The payments made by RCo Regional OpCo are not subject to any withholding
since the royalty income is paid to RCo Regional Holding, a company resident in
StateT, and the management fee is paid to RCo, a non-resident company whose
business profits may not be taxed in StateT under the relevant tax treaty. No
withholding is imposed under the relevant double tax treaty on the payments by
RCo Regional Holding to RCo.
Direct tax consequences in stateR

StateR imposes corporate income tax on the profits derived by RCo, including the
buy-in payment received for the transfer of existing intangibles to RCo Regional
Holding. However, because of the absence of a significant track record of RCos
performance at the time of the transaction, RCo may take the position that the
value of those intangibles was very low, so that the actual amount of gain subject
to corporate tax in StateR would be very small.
RCo also receives annual payments from RCo Regional Holding under the cost
sharing arrangement, which may be at a rate much lower than the amount of
royalties received by RCo Regional Holding. In addition, depending on the domestic
law of StateR, RCo may be entitled to R&D tax credits for a significant fraction
of its expenditures, thereby significantly reducing its tax liability for corporate tax
purposes.
Under its controlled foreign company (CFC) rules, StateR would under some
circumstances treat royalties received by RCo Regional Holding as passive income
subject to current taxation in the hands of RCo. However, because RCo Regional
OpCo is treated as a transparent entity for tax purposes in StateR, the income of
RCo Regional OpCo is treated as having been earned directly by RCo Regional
Holding and is therefore treated as active income taxable in StateR only when
paid to RCo. This result would also be reached if StateR imposed tax only on a
territorial basis and did not have CFC rules.
VAT consequences
With respect to value added tax (VAT), the treatment of the business-to-business
(B2B) transactions is relatively straightforward, with the VAT levied either through
the supplying business charging the tax or the recipient business self-assessing it.
The input tax levied would generally be recoverable by the businesses through the
input tax credit mechanism.
The VAT treatment of the supplies to private consumers (business-to-consumer
(B2C)) in StateS will generally be different for supplies of physical products and
supplies of digital products. Supplies by RCo Regional OpCo of physical goods
stored in SCos warehouse to consumers in StateS would be subject to VAT in
StateS. StateS may allow SCo to account for StateS VAT on behalf of RCo
Regional OpCo (e.g.as a fiscal representative). If the physical products would
be shipped to consumers in StateS from abroad, e.g.from StateT, then these
supplies would be zero rated in the exporting state and would be subject to VAT
at the time of importation into StateS. Depending on the value of the goods and
the thresholds operated by StateS, they may qualify for a VAT exemption under
the relief for importations of low value goods. Also the supplies of digital products
to final consumers in StateS should in principle be subject to VAT in StateS, in
accordance with the destination principle. However, StateS will have considerable
difficulty enforcing the payment of the VAT on these supplies, as the supplier is not
resident in StateS and collecting the tax from the final consumers is ineffectual.
While certain jurisdictions operate a mechanism requiring non-resident suppliers to
register and remit the tax on supplies to resident private consumers, it is recognised
that it is often challenging for tax authorities to enforce compliance with such
requirements.
B.2. Internet advertising

8.
The RCo Group provides a number of Internet services (e.g.search engines)
to customers worldwide. Many of these online services are offered free of charge to
consumers, whose use of the online services provides the RCo Group with a substantial
amount of data, including location-based data, data based on online behaviour, and data
based on personal information provided by users. Over the course of many years of
data collection, refinement, processing, and analysis, the RCo Group has developed a
sophisticated algorithm that targets advertisements to those users who are most likely to
be interested in the products advertised. RCo Group derives substantially all of its revenues
from the sale of advertising through its online platform, for a fee that is generally based on
the number of users who click on each advertisement.
9.
The technology used in providing the advertisement services, along with the various
algorithms used to collect and process data in order to target potential buyers were developed
by staff of RCo, the parent company of the Group situated in StateR. The rights to exploit
this technology in the T/S region are owned by a dual resident subsidiary of the group,

XCo. The latter company is incorporated in StateT but effectively managed in StateX. The
technology rights for the T/S region were acquired by XCo under a cost-sharing arrangement
whereby XCo agreed to make a buy in payment equal to the value of the existing
technology and to share the cost of future enhancement of the transferred technology on the
basis of the anticipated future benefit from the use of the technology in the T/S region. In
practice, XCo does not actually perform any supervision of the development activities carried
out by RCo in StateR.
10. XCo licenses all of the rights in the technology used to operate the platform to a
foreign subsidiary resident in StateY, YCo. The latter then sublicenses the technology to
TCo, a company organised and resident in StateT, earning a small spread between the
royalties it receives and the royalties it pays on to XCo. YCo and TCo are hybrid entities
that are treated as corporations for tax purposes in StateY and StateT, but as transparent
for tax purposes in StateR. The physical presence of XCo in StateX is minimal, both in
terms of personnel and tangible assets (equipment, premises, etc.). In fact, neither XCo nor
YCo has any employees on its payroll, and each companys activities are limited to board
meetings taking place in an office hotel where the company regularly rents different
offices.
11. TCo acts as the regional headquarters for the RCo groups operations in the T/S
region, and employs a substantial number of people in managing the groups activities in
that region. It operates the websites offering free online services to consumers in the T/S
region, and serves as the legal counterparty for all sales of advertising in the T/S region.
However the servers that host these websites may be placed throughout the region and/
or located in StateR and operated by RCo. Dependent on the time of the day, different
members of the group may be responsible the maintenance of the website and fixing any
network issues in the region.
12. Advertisement services contracts with TCo can be concluded electronically through
TCos websites on the basis of standard agreements, the terms of which are generally set
by RCo. Advertisers located in the T/S region that wish to purchase advertising targeting
users of RCos products can thus do so directly through a website operated by TCo without
having any interaction with the personnel located in StateT. This advertising is available
to local businesses in the T/S region, whether they are targeting customers in the T/S region
or customers elsewhere.
13. For larger markets and in order to deal with key clients, the group has established
a number of local subsidiaries. To promote the purchase of such advertising by businesses
active in the T/S region, TCo has local affiliates, such as SCo, a company resident in
StateS, whose purpose is to promote the RCo family of products, including in particular
the advertising services offered in the region. Local subsidiaries like SCo provide
education and technical consulting to users and potential advertising clients, as well as
marketing support in order to generate demand for the RCo advertising services. Local
staff members have substantial and ongoing one-on-one interaction with local businesses,
particularly the largest customers in the local market, many of which end up purchasing
advertising. Compensation for the staff is partially based on the number of advertising
contracts concluded between TCo and customers in StateS and the income generated
by TCo from the clients they support. In consideration for its promotion activities and
technical support, TCo pays SCo a fee covering its expenses plus a mark-up. In general,
customers supported by local affiliates such as SCo have no interaction with TCo staff.
14.
FigureB.2. Internet advertising
RCo
(State R)
Performs research & development.

Operates Websites/Online services.
Developed pre-existing IP.
Buy-in payment for pre-existing IP.

Contractual payments for IP from new R&D.
Rights to IP
ce
en
Lic
lty
ya
Ro
XCo
(Board Meetings:
State X
Incorporation: State T)
Sub-licence
YCo
(State Y)
Royalty
Technical Support
Marketing
Promotion
s
fee
ng
tisi
ver
Ad
asis)
lus b
ost-p
c
(
e
Fe
Sco
(State S)
Operates State T/S websites

Counterparty to contracts
TCo
(State T)
State S Clients
15. The manner in which RCos business activity is structured has significant consequences
from a tax perspective. Due to contractual arrangements among the different group companies,
the bulk of the Groups income is allocated to StateX, and only minimal taxable profits are
allocated to StateS, StateR, and StateT. More specifically, the following paragraphs describe
the consequences that would arise in the different States concerned.

SCo is allocated minimal taxable income, based on the position that SCos functions
are limited to those of a service provider.
All revenues from sales of advertising in StateS, including advertising purchased
by StateS residents and other regional customers, are treated as the revenues of
TCo. The lack of authority for SCo staff to legally conclude contracts and the use
of standardised contracts and on line contract acceptance by TCo result in TCo
not being considered to have a PE in StateS. As a result, StateS does not tax the
profits derived from these activities either because it has no right to do so under its
domestic law or because the relevant double tax treaty prevents it from doing so in
the absence of a PE of TCo in StateS to which the income is attributable.

StateT imposes corporate tax on the profits earned by TCo from its various
activities in the T/S region. TCos income, however, is almost entirely offset by the
royalty paid to YCo for its sublicense of the technology used by TCo to provide
Internet services.
This payment is not subject to withholding under the relevant double tax treaty.
StateT does not impose corporate income tax on XCo, due to it not being a resident
under StateTs domestic legislation.
Direct tax consequences in stateY

StateY imposes corporate income tax on the profits of YCo, but those profits are
limited to a small spread between the royalties received by YCo and the royalties
paid by YCo to XCo.
StateY does not impose any withholding on the payment of royalties under its domestic
law.
Direct tax consequences in stateX

StateX does not impose a corporate income tax.

StateR imposes corporate income tax on the profits derived by RCo, notably the
buy-in payment received in consideration for the transfer of pre-existing technology
to XCo and the annual payments received under the cost sharing arrangement.
However, because of the absence of a significant track record of RCos performance
at the time of the transaction, RCo may take the position that the value of those
intangibles was very low, so that the actual amount of gain subject to corporate tax
in StateR would be very small. Further, the annual payment compensation for the
costs supported by RCo for developing the intangibles without any markup could
potentially be at a rate much lower than the amount of royalties received by XCo.
Finally, depending on the domestic law of StateR, RCo may be entitled to R&D tax
credits for a significant fraction of its expenditures, thereby further reducing its tax
liability for corporate tax purposes.
Under its controlled foreign company (CFC) rules, StateR would under some
circumstances treat royalties received by XCo as passive income subject to current
taxation in the hands of RCo. However, because YCo and TCo are considered
for tax purposes as transparent entities in StateR, the latters CFC rules would
disregard the royalty transactions concluded between XCo, YCo and TCo. The
income of YCo and TCo would be considered as having been earned directly by
XCo, and would be treated as active income that would be taxable in StateR only
when paid to RCo.
VAT consequences
With respect to VAT, the treatment of the B2B transactions is relatively straightforward
with the VAT levied either through the supplying business charging the tax or the
recipient business self-assessing it. The input tax levied would generally be recoverable
by the businesses through the input tax credit mechanism. The exception would be
where the business is engaged in making exempt supplies and therefore not entitled to
recover the tax.
The online services provided free of charge by TCo to consumers in the S/T
region have in principle no VAT consequences, unless it is considered that TCo
is providing consumers with Internet services for non-monetary consideration, in
which case the customers State may claim VAT on the fair market value of that
consideration.
B.3. Cloud computing

16. The RCo Group is a developer of software (online games) which it operates on
servers around the world and makes available to customers through various client interfaces
in exchange for subscription fees.
17. The software itself, along with all technology associated with processing payment
and maintaining security of customer data, was developed principally by engineers of
RCo, a company resident in StateR. In addition, RCo remotely co-ordinates marketing and
selling activities in the various regions to minimise costs, maintain consistency among its
various businesses and websites, and improve efficiency. Those co-ordination services are
provided to regional operating lower-tier subsidiaries in return for a management service
fee covering related expenses plus a markup.
18. RCo transferred the employees responsible for the management of the technology
used in operating the client interfaces to PEY, a foreign branch of RCo situated in StateY.
RCo provides the rights to use the software and knowledge associated with the cloud
computing services to various regional subsidiaries through licensing and sub-licensing
arrangements.
19. TCo is a regional operating subsidiary of RCo resident in StateT. Even though
StateTs market is small in relation to RCos business, TCo employs a substantial number
of people to operate the websites used to sell access to RCos hosted software in the T/S
region, which includes StateS and other States. TCo has obtained under a public tender
in StateS all the licenses required to exercise certain regulated activities (online gaming).
Contracts with customers in StateS are concluded electronically through TCos websites
on the basis of standard agreements, the terms of which are set by RCo. TCo manages all
payment processing and security associated with permitting access to the hosted software.
Fees paid by the subscribers are collected through local bank accounts. In addition, TCos
personnel perform all required localisation of the software for use in markets in the StateS.
TCo operates a server farm located in StateT, which is used as the primary datacentre to
run the software, process customer transactions, and store customer data. Mirror servers
owned by third parties (ISPs) are also regularly used in other locations around the world to
ensure the most efficient possible access at all times by customers, as well as to decrease
the risk of loss of data.
20. To promote demand for the use of RCos hosted software in StateS, a very significant
market for RCos business, TCo has a local subsidiary, SCo, whose stated purpose is to

promote the hosted software services in the region and offer online customers care services.
SCo does this both through local advertising and through direct interaction with prospective
customers. SCo is compensated for its activities via a fee calculated on a cost-plus basis.
FigureB.3. Cloud computing
Transfer of IP
Performs research & development.
Owner of WW IP.
RCo
(State R)
PE Y
(State Y)
IP management.
Co-ordination services.
Licence of
IP rights
Sco
(State S)
r Services
Payment fo
Marketing
Promotion
t fees
emen
anag
M
+
ies
Royalt
Tco
(State T)
Se
(Co rvice
st-p
Fee
lus
Bas
is)
Software localisation
Transaction processing
Datacentre / Server
State S Clients
21. The manner in which RCo Groups business activity is structured as a legal matter
has significant consequences for the Groups worldwide tax burden. Due to contractual
arrangements and allocation of key functions most of the profits generated by the Groups
business activity is allocated to StateY, thereby ensuring that minimal tax is being paid in
States S T and R. More specifically, the following paragraphs describe the consequences
that would arise in the different States concerned.

SCo is allocated minimal taxable income, based on the position that its risk and
function profile is limited to routine marketing and customer care services. All
revenues from sales of cloud computing services in StateS are treated as income
of TCo, due to its role as the counterparty to the transactions with local customers
and administrator of the websites. StateS does not tax the profits derived from
these activities because it has no right to do so under its domestic law or because
the relevant double tax treaty prevents it from doing so in the absence of a PE of
TCo in StateS to which the income is attributable.

StateT imposes corporate income tax on the profits derived by TCo from its sales
activities but TCos income is largely offset by the royalty paid to RCo for its license
of the technology used in providing the cloud computing services to customers, as
well as by the management fees paid to RCo for its co-ordination services.
Although the income from the royalties and fees paid by TCo is attributed to the
PE in StateY, StateT does not impose any withholding on those royalties and
fees under the terms of the relevant tax treaty between StateT and StateR, as it
considers the payment to be received by RCo, a resident of StateR.
Direct tax consequences in stateY

StateY imposes corporate income tax on the profits attributable to PEY at a low
rate. In addition, by virtue of a preferential regime available in StateY for income
derived from certain intangibles, the income attributable to the PEY is entitled
to a rate substantially less than the generally applicable corporate tax rate for the
royalties included in its taxable profits.

StateR imposes corporate tax on the profits derived by RCo on a territorial basis.
As a result, and in accordance with the relevant double tax treaty, all the royalty
income and management fees derived by RCo are treated as attributable to PEY
and, as such, excluded from RCos corporate tax base in StateR.The capital gain
derived by RCo from the transfer of the existing technology to PEYis not taxed
in StateR under the rules applicable to cross-border transfers of assets in the
R/Y region. Further, RCo may be entitled to R&D tax credits for a significant
fraction of its R&D expenditures, thereby reducing its tax liability in respect of the
management fees.
StateRs domestic law does not provide for any CFC regime.
VAT consequences
For VAT purposes, as in the previous examples, the VAT on the B2B transactions
will be levied either through the supplying business charging the tax or the recipient
business self-assessing it. The input tax levied would generally be recoverable by the
businesses through the input tax credit mechanism. The exception would be where a
business is engaged in making exempt supplies and therefore not entitled to recover
the tax.
In respect of B2C transactions, TCos supplies to final consumers in StateS
should in principle be subject to VAT in there. However, States S will often have
considerable difficulty in enforcing the collection of VAT on cloud services
acquired from abroad by resident final consumers.
B.4. Internet app store

22. RCo Group is the creator of an operating system for mobile phones and other
portable devices. It maintains a widely used Internet app store, through which users of RCo
Groups phones and devices may pay to download applications (including both applications

developed and owned by RCo Group and by third-party developers) that enhance the
function of their devices. In order to develop and sell applications through RCo Groups
marketplace, third-party developers must use software provided by RCo Group in order to
ensure compatibility with its operating system and consistency with standards set by RCo
Group. Pricing for third-party applications is set by the third-party developers subject to
guidelines set by RCo Group, with the developer receiving 75% of the revenues from sales
through the app store, and RCo Group receiving 25%. Third-party developers may choose
which markets their products will be sold in.
23. The development of the operating system and the Internet app store, as well as selfmade applications sold through the app Store, was performed substantially by employees
of RCo, a company resident in StateR. The development of the third-party applications is
performed around the world, depending on the location of the developers, most of which
are individuals or small businesses.
24. Early in the life of the Group, RCo sold its rights to the technology used in developing
and running its app Store, along with the developing tools and other software used to work
with third-party developers around the world to a subsidiary, TCo, resident in StateT, a very
small market in relation to RCo Groups business. Simultaneously to the sale agreement, RCo
concluded a service agreement whereby it continues to upgrade and develop the technology
used in the app stores for the benefit of TCo in exchange for a fee covering its R&D expenses
plus a markup. All the risks assumed related to the development of the technology were
contractually allocated to TCo, which employs a substantial number of people to operate
the various local versions of the application marketplace (tailored and developed by RCo)
and steer the marketing strategy, but does not perform any supervision of the development
activities carried out by RCo in StateR. The app stores are hosted on servers located in
StateT and owned by TCo or, depending on network traffic at the time of the transaction, on
third-party servers generally located in countries distinct from the country of the customer.
TCo handles all transaction processing with customers and third party developers around the
world (including StateR). Contracts for purchase of applications are concluded electronically,
through automated processes, on the basis of standardised terms set by TCo.
25. In larger markets, TCo has established local affiliates to assist the group with
promoting the RCo operating system and the Internet app store to third-party developers,
sellers and prospective purchasers of mobile devices. These local affiliates, such as SCo,
a company established in StateS, are never formally involved in the sales of specific
applications and/or negotiation of agency agreements with third-party developers, though
some face-to-face interactions may occur with local customers. The remuneration of these
local affiliates is generally based on a fee covering their expenses plus a markup.
26. The manner in which RCos business activity is structured as a legal matter has
significant consequences for the Groups worldwide tax burden. RCo Group takes the
position that due to contractual arrangements an affiliated company resident in StateT,
TCo, is entitled to all residual profits after compensating the other members of the group
for their functions, thereby reducing the groups tax burden to a minimum in the other
States involved. More specifically, the following paragraphs describe the consequences that
would arise in the different States concerned.
FigureB.4. Internet app store
R&D services
RCo
(State R)
Sale of IP
R&D contract
Payment for IP transfer

Service fee for R&D activities
WW IP owner
Manages Local Marketplaces
Transaction processing
Marketing Strategy
TCo
(State T)
App
Pur
cha
ses
Net Amount
Less Agency Fee
WW Clients
Third Party
Developers
Service Fee
(Cost-plus basis)
Marketing
Promotion
SCo
(State S)

SCo is allocated minimal taxable income, based on the position that the function
profile of this local affiliate is limited to providing routine marketing and
promotion services, with no direct selling activity to StateS customers.
All revenues from sales of applications in StateS and StateR are treated as income
of TCo, due to its role as the counterparty to the transactions with local customers
and administrator of local app stores. StateS does not tax the profits derived from
these activities either because it has no right to do so under its domestic law or
because the relevant double tax treaty prevents it from doing so in the absence of a
PE of TCo in StateS to which the income is attributable.

StateT imposes corporate tax on the significant profits earned by TCo, but at a rate
which is roughly 50% of the rates of StateR and StateS.
No withholding is imposed on the various service fees paid by TCo to RCo and
SCo under the relevant double tax treaty.

StateR imposes corporate income tax on the profits derived by RCo, notably the
capital gain derived from the sale of the technology to TCo and the service fee
received for its R&D activities. However, because of the absence of a significant
track record of RCos performance at the time of the transaction, RCo may take
the position that the value of those intangibles was very low, so that the actual
amount of gain subject to corporate tax in StateR would be very small. In addition,
depending on the domestic law of StateR, RCo may be entitled to R&D tax credits
in StateR for a significant fraction of its expenditures, thereby reducing its tax
liability for corporate tax purposes.
StateR imposes corporate tax on a territorial basis and does not have any CFC
rules. As a result, RCo is exempt from tax both on income earned by TCo and on
dividends received from TCo.
VAT consequences
For VAT purposes, as in the previous examples, the VAT on the business-tobusiness transactions will be levied either through the supplying business charging
the tax or the recipient business self-assessing it. The input tax levied would
generally be recoverable by the businesses through the input tax credit mechanism.
The exception would be where a business is engaged in making exempt supplies
and therefore not entitled to recover the tax.
In respect of B2C transactions, TCo will generally be considered as the supplier
of the applications to the consumers for VAT purposes, rather than the third party
developers of these applications. The transactions between TCo and the third party
developers will then be treated as business-to-business supplies, although the
turn-over of many third party developers may remain under the VAT-registration
threshold, in which case these transactions may effectively not be subject to VAT.
TCo would be required to collect and remit StateT VAT on sales of any services
to private consumers in StateT. Supplies to consumers abroad will either be zerorated in StateT or will be subject to StateTs (low) VAT rate. Supplies to such
final consumers in other states should in principle be subject to VAT in these final
consumers state. These consumers states, however, will often have considerable
difficulty enforcing the collection of VAT on supplies of applications to consumers
within their jurisdiction. This may result in consumers in these states being able to
acquire the applications free of VAT or at a lower (foreign) VAT rate than if they
had acquired the product domestically.
Annex C
The collection of VAT/GST on imports of low value goods
This annex contains the text of a report regarding possible approaches for a more
efficient collection of VAT/GST on the import of low-value goods, which could
allow governments to reduce or remove the VAT/GST exemption thresholds for such
imports should they wish to do so.
182 Annex C. The collection of VAT/GST on imports of low value goods
C.1. Introduction
C.1.1. Addressing the tax challenges of the digital economy
1.
BEPS1 Action1 on the tax challenges of the Digital Economy notably called for
work on how to ensure the effective collection of value added tax/goods and services
tax (VAT/GST) with respect to the cross-border supply of digital goods and services. In
response, the Report on Addressing the Tax Challenges of the Digital Economy (the Digital
Economy Report, OECD, 2014) was developed by the Task Force on the Digital Economy
(TFDE) and delivered to G20 Finance Ministers in September 2014. One of the main VAT/
GST challenges that were identified relates to the growing volume of imports of low value
parcels from online sales on which no VAT/GST is collected as a result of relief regimes
for such low value imports that are operated in many jurisdictions. This leads to growing
revenue losses and growing risks of competitive distortion.
2.
The low value import VAT/GST relief regimes were mainly motivated by the
consideration that the costs of collecting the VAT/GST on imported low value items were
likely to outweigh the VAT/GST actually collected. At the time when most of these low
value import reliefs were introduced, Internet shopping did not exist and the level of
imports benefitting from the relief was relatively small. Over recent years, however, many
countries have seen a significant and rapid growth in the volume of low value imports of
physical goods on which VAT/GST is not collected. This has resulted in decreased VAT/
GST revenues and the growing risk of unfair competitive pressures on domestic retailers
who are required to charge VAT/GST on their sales to domestic consumers. It also creates
an incentive for domestic suppliers to relocate to an offshore jurisdiction in order to sell
their low value goods free of VAT/GST.
3.
The Digital Economy Report concluded that governments could be in a position to
remove or lower the exemption threshold for imports of low value goods, if tax authorities
were able to improve the efficiency of processing such low value imports and of collecting
the VAT/GST on such imports.
C.1.2. Scope and objective of this report

4.
This report explores the possible approaches for a more efficient collection of VAT/
GST on the import of low value goods, which may allow governments to reduce or remove
the VAT/GST exemption thresholds, should they decide to do so. The objective of this
report is not to set forth recommendations or guidelines but rather to provide an analysis
of possible approaches for improving the efficiency of the VAT/GST collection. It assesses
the available options or combinations of options for governments to consider depending on
their domestic situation and their exposure to imports of low value goods.
5.
This report focuses only on the collection of VAT/GST on imports of low value
goods, not on the collection of import duties. Most countries operate a de minimis threshold
for customs duties, which is essentially regulated by the World Customs Organizations
(WCO) Revised Kyoto Convention (RKC see Box C.1). It provides for a mandatory
de minimis customs duties and taxes relief for small consignments.2 While this rule is
obligatory for Contracting Parties to the RKC, the RKC does not prescribe the amount of
such a threshold nor does it impose a minimum standard.
6.
Although both the customs duties and the import VAT/GST are generally collected
by customs authorities, the customs duties relief threshold is often higher than the VAT/
GST exemption threshold (e.g.EUR150 for the customs duties relief in the European
Union against EUR10-22 for the EUs VAT relief). Against this background, this report
notably explores models for collecting import VAT/GST that would limit or remove the
need for customs authorities to intervene in the VAT/GST collection for imports that are
not subject to customs duties. This is expected to lower the cost of collection of VAT/
GST on low value imports and could allow jurisdictions to remove or lower the VAT/GST
exemption thresholds, should they wish to do so. VAT/GST on imports of goods above the
customs threshold could (continue to) be collected together with customs duties and taxes
under normal customs procedures.
7.
This report first describes the main features of the typical supply chain for the
sale, the customs clearance and the delivery of small packages and the role of the main
stakeholders in this process (SectionC.2). It then explores the potential options for
the collection of VAT/GST on imports of such low value goods and provides an initial
analysis of their advantages and disadvantages, their limits and the requirements for
their application in practice (SectionC.3). It also briefly describes the potential role of
administrative cooperation on compliance (SectionC.4) and summarises the outcome
of the assessment of the likely performance of the options for the collection of VAT/
GST on imports of low value goods (SectionC.5). It finally draws an overall conclusion
(Section C.6). This assessment is supported by test cards providing more detailed
analysis of the options, appended to this report (AppendixC.A).
C.2. Main features of the supply chain for the sale, clearance and delivery of low value
goods
C.2.1. Challenges
8.
The supply chain for online sales of low value physical goods covers a broad
spectrum of stakeholders starting with the vendor of the goods, an intermediary for
making the secure payment to a vendor abroad through to a domestic transporter making
the final delivery to the purchaser. It is different from the traditional model of importing,
warehousing and then retailing goods. With developments in technology the potential
marketplace has expanded to a truly global level and offers consumers an almost unending
range of options to access the market and assess the value proposition of the goods that
are for sale. Domestic vendors, governments and other traditional stakeholders have made
strides to match these challenges but they are continuing to deal with a range of issues
in the wake of the e-commerce revolution. E-commerce developments have, and still
are, triggering deep changes in the size and the structure of the distance sales to private
consumers.
9.
Business models and supply chain arrangements are changing to meet the new
challenges, remain cost-effective and to respond to growing demand. As customers are
increasingly able to directly access foreign suppliers via the Internet, certain traditional
intermediaries are becoming less prevalent (e.g.wholesalers) while new players emerge
(such as e-commerce platforms and online payment providers) and others are adjusting
(e.g.transporters). User-friendly shopping, buying and payment processes and speed
of delivery through efficient distribution processes are crucial for online vendors. This
requires a smooth interaction between the various stakeholders involved in this process and
an increasingly significant amount of information exchanged between them.
10. These evolutions have also created increasing challenges for the existing tax systems.
A key challenge is the collection of VAT/GST on online purchases of physical goods made
by consumers from suppliers in another jurisdiction. Countries with a VAT/GST in principle

collect this tax on imports of goods from the importer at the time the goods are imported
using customs collection mechanisms. Many jurisdictions apply an exemption from VAT/
GST for the import of low value goods under a certain de minimis threshold, based on the
consideration that the administrative costs associated with collecting the tax are likely to
outweigh the VAT/GST actually collected. When most of these low value import reliefs
were introduced, Internet shopping did not exist and the level of imports benefitting from
the relief was relatively small. Over recent years, however, these exemptions have created
growing pressure on tax revenues and risks of unfair competitive pressures on domestic
retailers that are required to charge VAT/GST on sales to the domestic consumer. It also
creates an incentive for domestic suppliers to relocate to an offshore jurisdiction in order
to sell their low value goods free of VAT/GST. Such relocations may also have negative
impacts on domestic employment and direct tax revenues.
11. The exemptions for low value imports have therefore become increasingly
controversial in the context of the growing digital economy. The difficulty lies in finding
the balance between the need for appropriate revenue protection, avoidance of distortions
of competition, and the need to keep the cost of collection proportionate to the VAT/
GST collected on imports of low value goods. As the VAT/GST exemption thresholds in
many jurisdictions were established before the advent and growth of the digital economy,
countries may need to review their policies on taxing e-commerce to ensure that they are
still effective.
12. If customs and/or tax authorities were to make significant improvements to the
efficiency of processing such low value imports and of collecting the VAT/GST on such
imports, governments would be in a position to lower these thresholds and address the
issues associated with its operation. Many jurisdictions are now looking for alternative and
more efficient ways to collect the VAT/GST on imports of low value goods.
C.2.2. The role of the key stakeholders

13. This section provides an overview of the broad categories of key stakeholders and
describes their respective roles and obligations in the traditional cross-border online sales
and delivery process of low value physical goods. The impact of possible new options for
taxing low value imports on the role of these stakeholders is considered under SectionC.3.
The following categories have been identified:
1. the purchasers;
2. the vendors;
3. the e-commerce platforms;
4. the transporters;
5. the financial intermediaries;
6. the customs/tax administrations.
14. These categories of stakeholders refer to their actual role in the supply chain rather
than to their status or legal form. Their role is described against the background of the
customs procedures for the importation of low value goods, which is outlined in BoxC.1.
BoxC.1. The customs procedures on importation of low value goods

Customs procedures are subject to a number of common standards such as the Revised
Kyoto Conventiona (RKC), the Immediate Release Guidelinesb and the Harmonised System
Nomenclature.c These standards include provisions for providing information to customs
authorities, minimum data requirements, standardised classification of goods, risk-based
approach simplified procedures, rules for the immediate release of specified consignments, etc.
These procedures do not aim solely at collecting taxes but also (and primarily) at facilitating
trade and ensuring border security and protection against unlawful movements of prohibited,
restricted or regulated goods.
Regarding the import of low value goods, the RKC provides for a mandatory de minimis
customs duties and taxes relief for small consignments.d While this rule is obligatory for
Contracting Parties to the RKC,e the RKC does not prescribe the amount of such a threshold
nor does it impose a minimum standard. There could be limited exceptions where duties and
taxes can apply irrespective of value, e.g.excisable goods.
Although they follow a number of common standards, each country has its own customs
clearance procedures in place (a common Customs Code applies to the Member States of the
European Union, which lays down common rules on customs procedures but also leaves them
a certain scope for national rules).f These procedures generally follow similar patterns: when a
low value good is imported, the person liable to pay the duties and taxes is the recipient of the
goods mentioned on the customs declaration (the importer of record or the declarant). Under
the RKC, the declarant is defined as any person who makes a goods declaration or in whose
name such a declaration is made. This person can be the purchaser/consignee or the vendor/
supplier of the goods, depending on the contract established between them. When the vendor is
the importer of record or the declarant, he normally makes an onwards supply to the purchaser
in the country of import and is thus registered for VAT/GST purposes in that country (this case
does not fall within the scope of this report).
A third party can also be designated as a representative of the importer of record or the
declarant for completing the customs procedures and pay the duties and taxes. In this case,
the declaration can be in the name of the person being represented by the third party (direct
representation) or in the third partys own name (indirect representation). In some countries
when a third party acts under direct representation, the person he represents is held responsible;
if the third party acts under indirect representation, it is held responsible. In some instances,
the person and the third party will be considered severally and jointly liable for the payment
of customs debt and the taxes due. In a number of countries, the third party is commonly
registered as a customs broker in the country of import.
Notes
a. World Customs Organizations Revised International Convention on the Simplification and Harmonization
of Customs Procedures the 102 Member States are contracting parties to the RKC, which entered into
force in 2006.
b. Guidelines for the Immediate Release of Consignments by Customs 2014.
c. Harmonized Commodity Description and Coding System generally referred to as Harmonized
System or simply HS is a multipurpose international product nomenclature developed by the WCO.
d. According to Transitional Standard 4.13 of Chapter4 of the General Annex of the RKC: National
legislation shall specify a minimum value and/or a minimum amount of duties and taxes below which
no duties and taxes will be collected.
e. As of June 2015, the number of Contracting Parties to the RKC is 102.
f. The Customs Code (Council Regulation EEC/2913/92), to be replaced with the Union Customs Code
on 1May 2016 (Regulation EU/952/2013).
C.2.2.1. The purchasers

15. The role of purchasers is unique as they are present at the beginning and the end
of the supply chain. They initiate the purchase, authorise the transfer of the funds to the
vendor or to a designated intermediary and in most cases take receipt of the goods from the
local transporter. The purchaser has full information on the product, its value and where it
will be delivered.
16. Purchasers may not always be aware of their position with respect to import taxes
and/or duties, which may result in situations where they face an unexpected claim for the
payment of import taxes and/or duties at the moment of delivery. In such cases, this often
leads to refusal to accept the delivery, creating uncertainties and costs for the vendor and
the transporter who may face customs clearance procedures for the re-exportation of the
returned goods and refunds of taxes and their re-importation in the origin country, if they
are not simply abandoned.
17. Purchasers may be businesses (business-to-business (B2B) supplies) or private
consumers (business-to-consumer (B2C) supplies). This report focuses on options for the
collection of VAT/GST on imports of low value goods by private consumers. This is the
area where domestic retailers, who are required to charge VAT/GST on their domestic
sales, increasingly face the risk of unfair competition from online sales that are made free
of VAT/GST under the import exemption threshold.3 This issue does not normally arise in
a B2B context, where business customers generally have a right to deduct the input tax.
C.2.2.2. The vendors

18. The role of the vendor is to provide the product to the purchaser. Identifying the
vendor in an online sales transaction may not always be straightforward. From a commercial
perspective, the online sale can be concluded (1) through the vendors own website;
(2)through a transparent third-party e-commerce platform, where the product is presented
to the purchaser but the contract is still concluded between the original vendor and the
purchaser, or (3)using a non-transparent third party e-commerce platform, where the
purchaser contracts with the platform itself. The role of transparent and non-transparent
platforms is described further in SectionC.2.2.3 below.
19. Vendors typically collect sets of key data during the selling and delivery process,
which may notably be useful (or necessary) to complete customs and tax obligations in the
country of importation. These key data sets include details of the goods sold; the price paid
for the goods; the place of delivery and the person to whom the goods are being consigned;
the price paid for the transport; the payment details; the delivery mode and tracking data
(including tracking number and carrier/postal operator); and possibly the amount of taxes
due on importation and associated administrative costs when the price charged to the
purchaser includes these costs. The status of the purchaser (business or final consumer)
may also be known, depending on the contractual arrangements and circumstances.
20. Online vendors may potentially face customs and tax obligations and associated
liability risks in all the countries where they make online sales of goods, which generally
have each their own customs and tax procedures, rates and tax relief thresholds (note,
however, that most of these procedures are harmonised for the 28 Member States of the
European Union). This implies potentially high compliance costs, in particular for small
and medium size enterprises (SMEs). This cost may be lower for imports of small value
goods where simplified declarations are available, but the impact of entering a foreign
and unknown jurisdiction extends beyond the basic customs clearance issues and implies
knowledge of local tax rates and thresholds, including the maintenance of this information.
21. Vendors may choose to rely on intermediaries to intervene in the customs and tax
procedures, notably to expedite the delivery. This role is often played by transporters (see
SectionC.2.2.4 below) but can also be played by other third parties such as e-commerce
platforms, and to a lesser extent in the trade of low value goods, by tax representatives.
The intervention of such third parties in the customs clearance process inevitably comes
with a cost, which can be relatively high per imported low value good, particularly when
the turnover in the jurisdiction of destination is low.
22. The situation is simpler for vendors when the liability to pay the duties and taxes
and to deal with the associated compliance obligations in the country of importation is
on the purchaser. However, this may lead to suboptimal customer service and dissatisfied
purchasers since duties and taxes and associated costs are generally collected from them at
the time of delivery, i.e.after the sale has been concluded.
C.2.2.3. The e-commerce platforms

23. E-commerce platforms have developed over time from software that enables
transactions via the Internet into comprehensive, online retail solutions that allow retailers
to target, capture, engage and retain customers, through the traditional web store as well
as via mobile and social media channels. Although their service offering and involvement
in online sales processes may vary and will undoubtedly continue to evolve, this section
describes some of the key services that e-commerce platforms typically provide.
24. E-commerce platforms typically operate the web store where products are displayed
and where purchasers can make their orders. They provide software tools for vendors to
upload their product catalogue to this website and to design shop pages. They operate a
check-out module, which finalises the order, proposes a selection of payment and delivery
methods to the purchaser and completes the necessary security checks to prevent fraud.
Once the order is approved by the vendor, the purchaser is charged for the sale and the
e-commerce platform remits the sales proceeds to the merchant and reports the transactions
on the vendors account pages. The platform may provide additional services to the vendor,
for example advice on consumer protection, data privacy, and tax and customs rules.
E-commerce platforms can also issue invoices on behalf of the vendor according to its
instructions and handle purchasers inquiries. Depending on the contract, the e-commerce
platform may intervene in the return and refund process for rejected goods or leave this to
be handled directly by the vendor. The platform charges a fee for its services to the vendor.
The fee may be based on the value of the item sold and is usually withheld by the platform
from the vendors sales proceeds.
25. The e-commerce platforms typically collect and store considerable amounts of data,
such as the vendor account information (incl. name, address, VAT registration details,
bank details); the purchaser account information (this may include shipping and billing
information and payment instrument details); each vendors product catalogues; the record
of each transaction (this may include the identification of the merchant and the purchaser,
the products sold, the price per product and total price, and the payment method used).
Depending on the contract with the vendor, the platform may keep a record of returned and
refunded goods. This information is captured from data flows between the e-commerce
platform and the vendor and to some extent from data flows between the e-commerce
platform and the purchaser.

26. Most e-commerce platforms are transparent platforms, i.e.they are normally not
parties to the commercial transactions themselves. There is a contract for the provision of
services between the e-commerce platform and the vendor. The contract for the sale itself is
concluded between the vendor and the purchaser. There is no contract between the platform
and the purchaser. The transparent e-commerce platform generally does not play any role
in determining the price of the goods sold: this price (inclusive or exclusive of taxes, duties
and costs) will normally be set by the vendor. The transparent e-commerce platforms do
not intervene in the shipment process. In most cases, the goods will be shipped from the
merchant to the customer by an express carrier or by a postal operator (see SectionC.2.2.4
below).
27. For the purpose of this work non-transparent platforms are those that are deemed
to buy and supply the products themselves. From a VAT/GST perspective, the sale from the
original vendor to the platform and the subsequent resale by the platform to the purchaser
are generally treated as two separate transactions, with each transaction triggering its own
tax compliance obligations. Depending on the contractual arrangements, the non-transparent
platform or the purchaser will face the customs and tax obligations and associated liability
risks in the country of importation.
C.2.2.4. The transporters

28. This section describes the role of transporters in the e-commerce supply chain, their
possible role in the assessment, collection and remittance of duties and taxes at importation
and in the collection of data that can support this customs clearance process.
29. Unlike the trade in services and intangibles, the e-commerce sale of goods to final
consumers generally implies the intervention of a transporter to bring the goods across
borders to the purchaser. In the online trade of low value goods, this task is generally
carried out by an express carrier or by a postal operator. Vendors of low value goods may
also choose to organise the transportation themselves without using intermediaries (e.g.by
renting spaces on flights or on boats), but that still requires them to deal with the customs
clearance and to organise the delivery to the customer in the country of destination. This
option is therefore very marginal in the context of e-commerce trade of low value goods
and is not described in more details below.
C.2.2.4.1. The express carriers

30. Express carriers are specialist integrated service providers who ensure the transport
door-to-door from the vendor to the purchaser, the information management process and,
depending on the contract, the management of tax and customs procedures. They have
control of goods throughout the exportation and importation process.
31. This section describes how the supply chain for express carriers is typically organised,
recognising that this may vary depending on the organisation of individual businesses (see
also Figure C.1). The vendor of the goods contracts with the carrier to transport the sold
goods to their purchaser abroad. The vendor fulfills the order and requests the express
carrier to pick up the goods. The express carrier collects the shipment from the vendor and
the related data, which typically include the nature of the goods, their value and destination
as declared by the vendor. The goods are taken to the express carriers service station and
processed to support their delivery. Data and scanned documents are transmitted in electronic
format to the customs authorities in the country of export and in the country of destination
for customs clearance. This system allows the customs authorities at destination to obtain
information prior to the arrival of a shipment in the country. The shipment is consolidated
with other shipments and delivered to the outbound gateway at the port or airport. The
express carrier performs the export customs clearance and the shipment is dispatched to
the carriers local hub. At this hub, shipments are separated and consolidated with other
shipments for the destination gateway and the goods are transported to the destination. At
the destination gateway, the shipment is cleared. Duties and taxes at importation are paid as
appropriate. The goods are dispatched to the local station for delivery to the purchaser. The
goods are delivered to the purchaser and if required, duties and taxes are collected from the
purchaser.
FigureC.1. The role of the express carriers
Goods flow
Order via
Internet
Vendor/s
Contacts express
carrier for
collection
Information flow
Pick-up/
post
Station/
sorting
Outbound Gateway/
Export Clearance
Shipment data and

digitised paperwork
Delivery
Station
Inbound Gateway/
Import Clearance
Hub
32. Express carriers are most often charged by vendors to complete the customs clearance
procedures and pay the duties and taxes at importation. They have arrangements in place
with customs authorities in most countries around the world allowing them to provide prearrival information and complete customs procedures electronically. As a declarant, they are
responsible for the payment of duties and taxes to the authorities on importation (see BoxC.1.
above). Depending on the contract with the vendor, these duties and taxes may then be either
forwarded to the vendor or charged to the purchaser at the time of delivery. In the latter case,
this may lead to refusals to accept deliveries, creating uncertainties and costs for the vendor
and the transporter (See SectionC.2.2.1 above).
33. In some regions (e.g.Asia-Pacific and Middle-East), small vendors often consolidate
their shipments using a co-loader, who collects the goods and contracts with an express
carrier to ship the goods to the customers. The co-loader also collects information and
supporting documentation from the vendors and passes it to the express carrier. Following
this intervention of the co-loader, the express carrier acts as described above and as
illustrated in FigureC.1.
C.2.2.4.2. The postal operators

34. From a regulatory standpoint, postal operators are subject to Universal Postal
Union4 (UPU) regulations, which provide obligations regarding remittance of mail and
consignments to the addressee and confidentiality of mail. Postal operators may be public
or private companies.

35. The processes operated in the international mail environment generally differ from
those operated by express carriers. This section describes the typical process operated
by postal operators, recognising that these may vary depending on the countries and
possible specific agreements between postal operators involved. The vendor remits the
goods to his local post office and provides the necessary information using specific forms
CN22 or CN23 depending on the value and/or weight of the package.5 This information
remains generally limited to the name and address of the consignee and the description
of the contents of the package, their weight and their value. The postal operator relies on
the sender for the correctness of this information and this may lead to concerns about the
data quality, especially in cases of individual and occasional mailers. These paper forms
are attached to the goods and are generally used by customs authorities as the bases for the
customs clearance process. Although an electronic process is possible, few countries have
the appropriate IT systems in place and the customs clearance process for postal package
is therefore still very much paper based. In such case, there is no advance information sent
to customs authorities in the country of destination allowing these authorities to obtain
information prior to the arrival of a shipment in the country. When the paper form is used,
the only way to assess the customs and tax status and liability of the package is through
an intensive physical process of manually checking each good, in conjunction with the
customs assessment for other risks. After having declared the goods for importation to
the customs authorities, the postal operator in the destination country delivers them to the
addressee.
36. Unlike express carriers, postal operators generally do not complete the tax and
customs procedures. The addressee is liable for the duties and taxes and importation. The
postal operator generally collects these duties and taxes from the addressee at the time of
delivery. This may lead to the refusal to accept the delivery, creating uncertainties and
costs for the postal operator (See SectionC.2.2.1 above).
37. Discussions are currently taking place within the UPU and WCO on a possible
transition from the existing paper-based process to an electronic exchange of information, to
increase efficiency and allow the use of modern risk management tools (see SectionC.2.2.6
below). However, the timing for the implementation of electronic procedures may vary
between countries and there is presently no clear indication as to when this will become
common practice.
C.2.2.5. The financial intermediaries

38. The traditional role of the financial intermediaries consists in the transfer of the
payment from the purchaser to the vendor. In the e-commerce environment, where the
purchaser may have very limited knowledge of the vendor and may fear identity theft and
fraud, the security of the purchasers bank data is a major concern. As a response, financial
intermediaries have developed payment solutions that are only indirectly associated with the
purchasers bank account. These include secure debit cards, which avoid the risk involved
with the vendor storing credit card information, and online payment systems provided by
specialised online payment service providers. Typically, the vendor enters into an agreement
with the payment service provider to facilitate payments from purchasers. Payment made
by purchasers may be made directly to an e-money account with the payment service
provider or directly to the vendors bank account. The system is secured and generally the
vendor does not receive the bank, credit or debit card data of the purchaser. The purchaser
may not always be required to have an account with the payment service provider.
39. During the payment process, the financial intermediary collects and stores data
such as the vendor and the purchaser account information (name, address, bank details).
However, in most cases, the financial intermediary does not collect information about the
nature of the goods being sold or the place where they are delivered.
C.2.2.6. Customs and tax administrations

40. Overall, the role of customs authorities is threefold: trade facilitation, border protection
and the collection of duties and taxes at importation.
41. The trade facilitation role notably includes the collection of trade information
for governments, traders and other interested parties and ensuring a fast and efficient
processing of the customs clearance procedure.6 The border protection role has increased in
the last decades given the increasingly important role of customs authorities in supply chain
safety and security. This border protection role notably includes the detection and prevention
of the unlawful movement of a wide range of prohibited, restricted or regulated goods,
such as illicit drugs, weapons, counterfeit goods and goods of consumer safety concern,
terrorist material, illegal movement of money and products threatening the biosecurity.
Although they still have an important tax collection role to play, the role of the customs
authorities in the collection of import duties has become less prominent over time, as trade
liberalisation has led to the progressive reduction of these duties. Notwithstanding this
diminishing role in tax collection, and regardless of the models used for the collection of
duties and taxes at importation, customs authorities will continue to play its crucial role in
border protection and in the safety and security risk assessment. This role is designed and
carried out independently from tax considerations and it remains further outside the scope
of this report.
42. Customs authorities role with regard to tax collection includes ensuring the correct
assessment, reporting and payment of customs duties, excise, VAT/GST and other possible
taxes payable on imported goods.
43. Unlike the border protection role, the efficiency of the tax collection activity is
often measured by comparing the potential tax revenue with the cost of collection at
the border. Most countries operate a de minimis threshold for customs duties, which is
regulated by the WCOs Revised Kyoto Convention (RKC see BoxC.1. above). While this
rule is obligatory for Contracting Parties to the RKC, no minimum standard is prescribed.
The scope of this obligation will be examined by the WCO in light of e-commerce
developments and the work being done by the OECD on alternate collection models.
Although both the customs duties and the import VAT/GST are generally collected by
customs authorities, the customs duties relief threshold is generally higher than the VAT/
GST exemption threshold (e.g.EUR150 for the customs duties relief in the European
Union against EUR10-22 for the EUs VAT relief see also AppendixC.A to this report).
44. Taxes, excise and customs duties are most often collected by the customs authorities
at the time of importation or of clearance of customs duties. Customs authorities collect the
taxes on behalf of tax administrations and according to the tax rules in place. Appropriate
assessment, collection and control require close cooperation between tax and customs
authorities. The customs clearance procedures vary according to the value of the goods and
the transporter (express carrier or postal operator) that is used to convey the consignments.
These are summarised in TableC.1.

TableC.1. Customs and VAT/GST clearance procedures (for goods not submitted to other specific duties
suchas excise)
Customs declaration
Value
Postal service
(under the UPU)
VAT/GST
Courier firms
Below VAT/GST and customs thresholds
No VAT/GST
No customs duties
Declaration CN 22/CN23
Simplified declaration
Above VAT/GST threshold

(if lower than customs threshold)
VAT/GST payable
No customs duties
Declaration CN 22/CN23
Full or simplified declaration
Declaration CN22 or CN23

(depending on the value) or full/
simplified declaration (depending
on the amount and the country
considered)
Full or simplified declaration
Above customs and VAT/GST thresholds VAT/GST payable

Customs duties payable
Note: This table is partly based on data provided by the report prepared for the European Commission Assessment of the
application and the impact of the VAT exemption for importation of small consignment http://ec.europa.eu/taxation_customs/
taxation/vat/key_documents/reports_published/index_en.htm.
45. Over recent years, the electronic processing of imports in particular in the express
carrier environment has increasingly helped streamline the customs processes in various
jurisdictions so that these processes can be relatively fast. The transition towards electronic
processing of imports is also high on the agenda within the postal environment. The UPU
recently amended its Convention to allow and encourage countries to replace paper forms
with electronic data provision,7 preparing the ground for advanced electronic submission
of data (see SectionC.2.2.4.2.). Also The European Union has launched a multi-annual
strategic plan (2016-2020) for the computerisation of customs8 in the context of the
implementation of the new Union Customs Code that will become applicable from 1May
2016. The objective is to allow for the use of electronic declarations and the pre-arrival
provision of information to customs authorities in order to streamline the customs process.
Although these improvements primarily target the safety and security needs, customs and
tax authorities may use this data collection process to streamline the collection of duties
and taxes. It must be noted, however, that it will most likely take several years before the
transition to electronic processing of imports will be completed worldwide.
C.2.3. The importance of information

46. The information flow between the stakeholders and its capture by the customs or tax
authorities is of paramount importance for the efficient and effective collection and remittance
of taxes at importation. When goods are sold in the e-commerce context, the vendor and
purchaser are the only stakeholders with full knowledge of the description of the goods and
the price paid for their acquisition. The transporter may have some or all the information,
particularly where it processes the customs clearance in the country of destination. However,
the transporter may not be aware of any possible undervaluation or mis-description of the
goods by the vendor. Some information is also collected by e-commerce platforms, when
they are used as an intermediary in the transaction. The payment intermediary collects some
information of the sale, essentially the price paid, the identity of the payer and the payee, but
not the description or physical movement of the goods. TableC.2 provides an overview of the
minimum information that is typically available to each stakeholder in the supply chain of
imports of low value goods. Stakeholders have generally developed sophisticated IT systems
for collecting, processing and storing the necessary business information and any change in
the tax collection method would require adjustments to such systems, which would inevitably
have a cost. The availability of the necessary data for the various stakeholders and its impact
on the possible role of these stakeholders in collecting the import VAT/GST is considered in
further detail in the assessment of the possible models for collecting VAT/GST on low value
imports (see SectionC.3 below).
TableC.2. Minimum information available to each stakeholder in the supply chain
Stakeholder
Nature of
the goods
Value
Country of
destination
Time of import/
delivery
Transportation
data
Taxes and duties

(incl. thresholds)
Purchaser
Yes
Yes
Yes
Yes
Maybe
Maybe
Vendor
Yes
Yes
Yes
Maybe
Yes
Maybe
Some
Yes
Maybe
Maybe
Maybe
Some/Maybe
Transparent e-commerce
platform
Express carrier
Yes
Yes
Yes
Yes
Yes
Yes
Postal operator
Maybe
Maybe
Yes
Yes
Yes
Yes
No
Yes
Maybe
No
No
No
Financial intermediary
C.3. Key features and assessment of the options for collecting VAT/GST on imports
of low value goods
C.3.1. Introduction
47. The taxation of imports of low value goods creates pressure points for all business
stakeholders involved in the supply chain. Key pressure points include the collection and
storage of timely and reliable data to be transmitted to the customs and tax authorities; the
development and management of IT systems to verify and manage the information flows
between the various stakeholders and its transmission to tax and customs authorities;
and managing the liability for completing the correct tax and customs processes and for
remitting the duties and taxes at importation. A key challenge for both administrations and
stakeholders in relation to the imports of low value goods is the different process for the
collection of duties and taxes on importation: whereas the VAT/GST on domestic sales is
simply declared and remitted periodically on the basis of monthly or quarterly returns, the
declaration and payment of such taxes on imports must often be done individually for each
item imported. This places considerable pressures on all stakeholders involved in remitting
and collecting such taxes on importation.
48. This section explores the main options that are currently available for collecting the
VAT/GST on the import of low value goods and assesses the likely performance in light of
a set of evaluation criteria (described in SectionC.3.2 below).
49. Although this report does not look into the safety and security aspects, these will
continue to play an important role and none of the options considered should imply a
degradation of the important role customs authorities play in this area.
50. Based on the available know-how and expertise with respect to low value import
relief regimes and the possible reform of such regimes, four broad models were identified
for collecting VAT/GST on low value imports. The distinction between these collection

models is essentially based on the person liable to account for the VAT/GST. These models
are:
1. the Traditional Collection model;
2. the Purchaser Collection model;
3. the Vendor Collection model; and
4. the Intermediary Collection model.
51. The Traditional Collection model is the model that is generally applied currently for
the collection of duties and taxes at importation, and that is often combined with a VAT/
GST exemption for imports of low value goods. The other three models present possible
alternative approaches for a more efficient collection of VAT/GST on the importation on
low value goods, which could allow countries to reduce or remove the VAT/GST exemption
thresholds for the importation of these goods.
C.3.2. Method for assessing the likely performance of the VAT/GST collection
models
52. The options (collection models) examined in this report are assessed according to
an evaluation framework based on the Ottawa taxation framework.9 Under this evaluation
framework, the performance of the collection models was tested against the following criteria:
Neutrality: Taxpayers in similar situations carrying out similar transactions should
be subject to similar levels of taxation;
Efficiency of compliance and administration: Compliance costs for taxpayers
and administrative costs for tax authorities should be minimised as far as possible;
Certainty and simplicity: The tax and duty rules should be clear and simple to
understand, so that taxpayers can anticipate the tax/duty consequences in advance
of the transaction, including knowing when, where and how the tax/duty is to be
accounted for;
Effectiveness: The reduction/removal of the exemption threshold so that the right
amount of tax is collected in the right place (i.e.country of importation where the
goods are consumed);
Fairness: The potential for tax evasion and avoidance (e.g.undervaluation and
mis-description) should be minimised (while keeping counteracting measures
proportionate to the risks involved);
Flexibility: The systems for the taxation should be flexible and dynamic to ensure
that they keep pace with technological and commercial developments.
53. In addition to the assessment provided under SectionC.3.3 below, Test cards were
compiled, outlining the advantages and disadvantages for each of the collection models
with a high, medium or low score for each of the evaluation criteria. These test cards are
in the AppendixC.A to this report.
54. The description of each separate model under SectionC.3.3 below does not
suggest that models should be considered in isolation from each other. Such models can
be combined to obtain the appropriate result. For instance, an optional Vendor Collection
could be combined with an Intermediary Collection model (to reduce compliance costs
for small and medium size businesses) and traditional customs clearance procedures as a
fall-back rule.
C.3.3. Assessment of the collection models

C.3.3.1. The Traditional Collection model
55. Under the Traditional Collection model, the customs authorities generally determine
the duties and taxes payable on each individual consignment of goods on the basis of the
import customs declaration. In principle, the VAT/GST on imports is collected at the same
time as the customs duties before the goods are released from customs control. Many
countries however do not apply this model to imports of low value goods: they treat these
imports as VAT/GST-exempt based on the consideration that the administrative costs of
identifying and collecting revenue (including costs associated with risk screening) under
this model are likely to outweigh the revenue gained with the revenue collected.
56. The operation of the Traditional Collection model is illustrated in FigureC.2. The
import VAT/GST is generally charged on the basis of the customs value, to which certain
elements may be added such as costs of transport and other ancillary costs, and duties
(though duties will generally not be collected on imports of low value goods sold online, as
these are generally below the dutiable threshold). The person designated as the declarant/
consignee/importer of record on the import declaration is generally liable to account for the
VAT/GST on the import to the customs authority. This traditional approach targets the first
taxing point within the border control, as illustrated in the flow chart below.
FigureC.2. Traditional Collection Model
Finance flow
Supplier
(vendor)
e-Commerce
platform
Goods flow
Transporter
Indirect
e.g. Amazon, ebay
Direct
Downstream (supply)
Customs
Authority
Transporter
Tax (Revenue)
Authority
Financial
Intermediary
Border
Upstream (returns/refunds)
Customs
Authority
Tax (Revenue)
Authority
Transporter
Purchaser
Current taxing point
Financial
Intermediary
57. When goods are imported through express carriers, the relevant data and scanned
documents are most often transmitted in electronic format to the customs authorities
in the country of export and in the country of destination for customs clearance. This
system allows the customs authorities at destination to obtain information prior to the
arrival of a shipment in the country (see SectionC.2.2.4.1 above). Thanks to the electronic
processing, in particular pre-arrival processing and risk assessment implemented by many
administrations, this advance cargo information complemented with advance payment of
duties and taxes allows these to be cleared immediately on arrival without being stopped at
the border for examination or assessment.
58. The situation is different in the postal environment. This process is still predominantly
paper based and relies primarily on the sender in a third country to provide the correct data
(see SectionC.2.2.4.2 above). In the absence of electronic data transmission systems, the
importation through postal operators typically requires that each individual consignment
is stopped at the border so that the necessary information to assess the tax implications
can be captured, liabilities can then be established and the appropriate process to ensure

the payment of duties and taxes be made. Processing and controlling these transactions is
difficult and labour intensive, as relevant customs authorities need to handle each package
manually. This is increasingly difficult to achieve in practice for each individual parcel that
is imported through the postal chain, particularly now that the volume of such goods has
increased massively as a result of the strong growth of Internet shopping.
59. Consignments, in many cases, are not released to the consignee until the liabilities
of taxes and/or duties are discharged. Consignments for which established liabilities of
taxes or duties have not been paid must generally be returned to the consignor. They may
also be considered abandoned or even be destroyed in certain cases.
60. The burdens and the costs associated with paper and manual processing of imports
of low value goods and the low revenue at stake were the main motivations for the
introduction of VAT/GST relief regimes for such imports by countries around the world.
61. However, advances in technology have created opportunities for tax authorities
and businesses to improve the efficiency of tax collection on imports of low value goods.
Over recent years, electronic processing of imports in the express carriers environment has
helped streamline the customs processes in various jurisdictions so that customs processes
can be completed quicker at lower cost. In the international postal environment, electronic
systems that are being developed for safety and security purposes could also be used in
the future for tax purposes (see SectionC.2.2.6 above). An increased take-up of electronic
declarations and the pre-arrival provision of such information would produce cost savings
and improve the efficiency of tax collection at the border, though ensuring the proper
quality of data would remain a challenge.
62. Further VAT/GST rates and tariff simplifications for the declaration of goods could
also be considered, subject to national legislation, to ease the tax assessment and control at
the border and minimise the potential for disputes.
63. The assessment of the Traditional Collection model shows that this model, based
on individual control of each consignment at the border with information provided on
paper forms and tax liabilities established at the time of arrival in the country, is no longer
adapted to the e-commerce environment.
64. On the other hand, new electronic processes developed in the express carriers
environment provide opportunities for substantial efficiency gains (see SectionC.2.2.4.1).
The consistent use of such electronic pre-arrival declaration and assessment systems would
improve the efficiency of compliance and administration, certainty and simplicity for the
vendors (although with an associated cost) and provide flexible, market-based solutions.
65. A wide application of those new electronic processes, including in the postal
environment, might allow the reduction or removal of the current de minimis thresholds
and provide greater neutrality to the system. However, it may take considerable time before
such electronic processes be implemented in the postal environment globally.
C.3.3.2. The Purchaser Collection model

66. Under the Purchaser Collection model, the purchaser would be required to selfassess and pay the VAT/GST on its purchases of low value goods. Standard customs
procedures would apply for goods above the de minimis customs value.
67. Three main options can be distinguished. The first two options are pre-release
options whereas the third option is a post-release approach:
Purchaser pre-registration, whereby the purchaser pre-registers its details with customs
authorities and uses an identifier through the web store checkout process, with
voluntary self-assessment and payment of tax at that point to authorities or at the
point of importation when this could be reconciled to the item;
Real-time purchaser self-assessment on delivery, whereby the purchaser is required
to self-assess its own liability and pay to a delegated authority at the time of release
of the goods;
Post-release purchaser self-assessment, whereby the purchaser is required to
periodically or annually account for the tax through a reporting mechanism such
as a VAT/GST declaration or the income tax return.
68.
This model targets the very end of the chain, i.e.the purchaser, as illustrated below.
FigureC.3. Purchaser Collection Model
Finance flow
Downstream (supply)
Potential taxing point/s
Supplier
(vendor)
e-Commerce
platform
Transporter
Customs
Authority
Transporter
Tax (Revenue)
Authority
Financial
Intermediary
Border
Customs
Authority
Transporter
Purchaser
Tax (Revenue)
Authority
Financial
Intermediary
Self-assessment
VAT/GST
Third-party
donor
69. A major disadvantage of all the elements of this model is that they are based
on self-compliance. The model notably relies on the purchaser to know the exact value
for the calculation of the VAT/GST liability. There is a high likelihood that purchasers
either under-report or not comply if there is no consequence visible to them for doing so.
Additionally, this model requires that all the customers have complete information and
knowledge about the applicable VAT/GST regime (tax base and rates), which may often
not be the case.
70. From a customs and tax administration perspective, this approach would most likely
require the development and implementation of an entirely new administrative process
and information technology system. There may be some limited ability for customs or tax
authorities to use third party data to risk-assess consignees against actual and projected
liabilities through tax gap analysis. This model would increase the administrative burden
considerably and may even be impossible to implement in practice without a de minimis
threshold, as it would effectively require monitoring of almost anyone who can make a
purchase online.
C.3.3.3. The Vendor Collection model

71. Under a Vendor Collection model, the obligation to collect and remit the VAT/GST
relating to imports of low value goods would be on the non-resident vendor.10 The nonresident vendors would be required to register for VAT/GST in the destination jurisdiction
and remit the VAT/GST there (as a registered non-resident vendor).

72. Vendors can be assumed to know or to be able to know with reasonable certainty
the information that is required for a proper collection and remittance of the VAT/GST on
imports of low value goods, i.e.the description of the goods, the jurisdiction to which the
goods are to be sent, the value of the goods including any transport and postal costs and, if
any, customs duties where they are included in the VAT/GST base.
73. Figure C.4 illustrates the possible operation of this model. This figure shows
that various options could be available with respect to the person remitting the tax on
importation and with respect to the time when the tax is collected.
FigureC.4. Vendor Collection Model
Finance flow
Downstream (supply)
VAT/GST collected at point of sale

Supplier
(vendor)
e-Commerce
platform
Transporter
Potential collection point

Direct
Customs
Authority
Transporter
Tax (Revenue)
Authority
Customs
Authority
Tax (Revenue)
Authority
Financial
Intermediary
Transporter
Purchaser
Potential taxing point/s
Financial
Intermediary
74. Under the Vendor Collection model, the vendor would be liable to account for
the VAT/GST on the imported goods. The tax and customs regimes in the jurisdiction of
import must be aligned to avoid multiple taxable events and double taxation or unintended
non-taxation; and to ensure consistency regarding the time at which the VAT/GST is due.
Appropriate synergies should also be ensured between vendors and intermediaries that
may possibly intervene in the sales and delivery process (transparent e-commerce platform,
transporter), to properly identify the party that is liable for the customs clearance and for
the remittance of import VAT/GST and to identify the goods on which import VAT/GST
has been paid.
75. The VAT/GST would be collected at the point of sale and these taxes would be
included in the purchase price of the items sold. The remittance of VAT/GST to the tax
authorities by the vendor could be at a time before, during or after the point of importation.
To ease cost of compliance pressures on the vendor, consideration could be given to only
require submission of periodic returns and remittance of the VAT/GST collected during
the reference period. No VAT/GST would then need to be collected at the border for
consignments that are identified as being sent by a registered non-resident vendor. In case
of refunds of items, an additional simplification could be implemented to allow the vendor
to make the associated adjustments of VAT/GST, so that the purchaser needs only deal with
the vendor. There may be some minor differential approaches under VAT/GST between
jurisdictions to achieve the legal framework for this outcome but the practical application
could be largely indistinguishable for most transactions.
76. A Vendor Collection regime could allow jurisdictions to remove their VAT/GST
relief regimes for low value imports, lower the exemption threshold or, if the supply is
taxed rather than the importation, zero-rate the applicable import threshold. Alternatively,
it could also allow them to replace a de minimis threshold that is calculated per imported
item by a threshold that is calculated at the level of the vendor, although the jurisdictions of
importation may have to track and monitor whether or not foreign vendors have exceeded
their threshold.
77. A key challenge of the Vendor Collection model is to ensure compliance by nonresident vendors. This model may increase the revenue risks for tax authorities given
that it may move away from the traditional customs process of collecting the VAT/GST
at the current point of entry, i.e.at the border.11 To address this challenge, a two-pronged
approach could be adopted whereby, on one hand, compliance is facilitated and encouraged
by simplifying procedures and providing additional incentives for vendors to comply and,
on the other hand, creating a deterrent for non-compliance through the implementation
of a fall-back rule whereby goods for which no VAT/GST has been accounted for under
the Vendor Collection model are stopped at the border and are processed under the
Traditional Collection models. Rules could also be implemented to deter misreporting or
underreporting. The enforcement of compliance under the Vendor Collection model would
be further supported through enhanced international administrative cooperation (see
SectionC.4 below).
78. The following paragraphs look in some further detail at the possible options for
facilitating and encouraging compliance by non-resident vendors. The VAT/GST simplified
procedures proposed below do not apply to safety and security customs procedures, which
will continue to apply in every circumstance.
C.3.3.3.1. Simplified VAT/GST registration and compliance regime

79. Jurisdictions should consider implementing a simplified VAT/GST registration and
compliance regime to facilitate compliance for non-resident vendors under a Vendor Collection
model. Simplification may be particularly important to facilitate compliance for vendors faced
with obligations in multiple jurisdictions. Where compliance procedures are too complex,
their application for non-resident vendors may lead to non-compliance or to certain suppliers
declining to serve customers in certain jurisdictions.
80. Under such a simplified registration and compliance regime, the VAT/GST compliance
obligations in the jurisdiction of importation could be limited to what is strictly necessary
for the effective collection of the tax, without prejudice to the other customs obligations, in
particular with regard to safety and security. It could be designed and operated along the
same principles as the simplified compliance and registration regime that is suggested in the
context of the OECD International VAT/GST Guidelines on business-to-consumer supplies of
services and intangibles (B2C Guidelines). When a vendor supplies both goods and services
into a particular jurisdiction, the registration system applied under the B2C Guidelines could
be used for both kinds of supplies. This would reduce the administrative and compliance costs
of the vendor registration.
81. The simplest way to engage with tax administrations from a remote location is most
likely through electronic processes. Technology can be used to develop a range of electronic
services to support compliance and administration processes, in particular those concerned
with registration, tax returns and declarations and payment of the tax liabilities. Applied
effectively, these technologies can deliver considerable benefits both to tax administrations
and taxpayers (e.g.lower compliance and administrative costs and faster and more accessible
services for taxpayers).
82. The simplified registration and compliance regime for low value imports could be
operated separately from the traditional registration and compliance regime, without the
same rights (e.g.input tax recovery) and obligations (e.g.full reporting) as a traditional

regime. The non-resident vendor could be required to remit the tax online when he receives
payment from the customer or, more simply, to submit periodic online returns and remit
the VAT/GST collected during the reference period. In order to avoid fraud, these vendors
would not be allowed to claim input tax deductions on such VAT/GST returns, but only
under the traditional refund mechanisms available to non-residents. Interaction with
and impact on other systems operating in the customs environment would need to be
considered and addressed.
83. Within regional organisations or customs unions, the registration of the vendor may
be further facilitated by a registration in only one member country. Under such a One Stop
Shop approach (OSS), non-resident vendors of low-value goods register in one member
country and remit the tax there. This member country transfers the tax to the appropriate
country (e.g.the country of final destination of the imported item). Such an OSS has been
operated in the European Union since 2003 with respect to B2C supplies of e-services and
telecommunication, radio and television broadcasting services supplied by non-EU suppliers.12
84. New technologies can be employed to facilitate the processing of the low value goods
that are imported under the simplified registration and compliance regime at the border.
Vendors, transporters, customs and revenue authorities may jointly identify how this can
work best with existing reporting systems so that there is alignment with current business
cross-border practice. Bar code identification, Unique Consignment Reference number
(UCR) and Radio Frequency Identification (RFID) could be used to complement current
systems in the identification of the registered vendors and to verify the proper collection of
the import VAT/GST on these imports. Such electronic processes would reduce delays and
costs along the supply chain, in particular if they are employed consistently across countries.
They could notably support the implementation of a fast-track regime for processing the
low value imports for which import VAT/GST is paid under the Vendor Collection model.
These new technologies could also be used to improve and accelerate the safety and security
controls made by the customs authorities and to reinforce international administrative
cooperation.
C.3.3.3.2. Simplified VAT/GST registration and compliance regime with fast-track

tax processing
85. One way to further limit risks of non-compliance under the Vendor Collection
model is to present it as an option to non-resident vendors and to incentivise the use of
this option by providing fast-track processing of goods to vendors who account for the
VAT/GST under the Vendor Collection model in the country of importation. As speed
of delivery is a crucial factor for online sales, such a fast-track procedure can provide an
incentive for non-resident vendors to opt for the Vendor Collection model and to comply
with it. Imports from vendors that do not register for VAT/GST or that do not comply
with the Vendor Collection regime would be subject to the Traditional Collection model
process. Depending on their cost and availability, a number of IT tools could be used by tax
administrations to verify the appropriate use of the fast track by the vendors.
86. Such a fast-track process would require the implementation of alternative and secure
methods for identification of the relevant goods (i.e.goods for which VAT/GST has already
been accounted for by the vendor or that have been declared by the vendor in a periodic
return). These methods may include, for instance the use of bar codes, stickers, RFID, a
specific classification by the UPU (since the UPU identifies and codifies item attributes),
WCO Unique Consignment Reference Number (UCR), etc.
C.3.3.3.3. Vendor collection under a bulk-shipper scheme

87. Under a bulk-shipper scheme, vendors would lodge only one import declaration for
all low-value consignments that are shipped together instead of having to submit import
declarations for each imported item. Under this model, the consignor would make one single
taxable importation, which would be taxable even if, taken separately, the imported goods
would be below a de minimis threshold. Processing charges by customs and intermediaries
are minimised given that only one import declaration would be submitted as opposed to
many declarations for each individual item (although information for each shipment may
still be requested for safety and security purposes). A bulk-shipper scheme could operate
separately from a direct VAT/GST registration and be exclusive of it. Any bulk shipper
scheme should be consistent with other taxes and duties requirements, including for
shipments consisting of products possibly subject to different VAT/GST rates.
C.3.3.3.4. Overall assessment of the Vendor Collection model

88. The application of a Vendor Collection model could improve the efficiency of the
collection of VAT/GST on the import of low value goods and thus create opportunities for
governments to remove or reduce import VAT/GST exemption thresholds if they wish to do
so.13 This model places additional administrative and compliance costs on tax authorities and
vendors alike but these costs can be minimised through some form of simplified registration
and compliance regimes (it should be noted that customs and security procedures will
continue to apply). In addition to this, the application of fast track processing and One Stop
Shop regimes at regional/national level could facilitate tax compliance obligations by nonresident vendors, including small and medium size vendors.
89. The application of a Vendor Collection model would require changes to the tax
administration and customs procedures in order to ensure the proper registration and
management of non-resident vendors, including the assessment and collection of the import
VAT/GST. This would require robust and capable IT systems to be in place in order to
capture and manage the tax collection. Consideration should also be given to introducing
measures that will mitigate double taxation and unintended non-taxation that may arise from
differences in tax and customs rules. Voluntary registration of non-resident vendors involves
specific non-compliance risks that would need to be addressed by simplification measures but
also with appropriate risk assessment and robust international administrative cooperation.
90. The Vendor Collection model could be made optional and could be combined with
alternative models such as the Traditional Collection model (as a fall-back) and with the use
of intermediaries (see SectionC.3.3.4 below).
C.3.3.4. The Intermediary Collection model

91. Under this approach, the liability to remit the VAT/GST on the imported goods in
the jurisdiction of importation is transferred from the non-resident vendor onto particular
intermediaries14 in the supply chain. Intermediaries may often be better placed to remit the
tax on imports in the jurisdiction of importation. The intermediaries understanding of local
language and of tax rules and procedures could provide benefits to both tax authorities and
vendors, particularly to small and medium enterprises. Under the Intermediary Collection
model, consideration needs to be given to intermediaries ability to collect and remit the
tax prior to the importation, rather than at the time of importation (in which case their
intervention may not increase the efficiency of the collection of import VAT/GST). Simplified
registration and compliance regimes such as those possibly applicable to non-resident vendors

under the Vendor Collection model (see SectionC.3.3.3 above) could also be considered under
the Intermediary Collection model. Managing taxes may require changes in intermediaries
data collection process, both in terms of quantity and quality of data. There is also a risk
element associated with potential tax liability and the respective responsibilities of the vendor
and the intermediaries in this regard should be clearly established. Any proposed model that
would imply a distinct VAT/GST collection system from the customs process should ensure
consistency between both processes to avoid double or unintended non-taxation.
92. This approach may rely on different types of intermediaries: transporters, commercial
agents such as transparent e-commerce platforms and financial intermediaries. Commercial
agents can represent vendors and facilitate accurate VAT/GST collection at the point of sale.
93.
FigureC.5 illustrates the possible operation of the Intermediary Collection model.

FigureC.5. Intermediary Collection Model
Finance flow
Downstream (supply)
VAT/GST equivalent amounts withheld at point of

sale, incorporated with transport charges or
transaction charges
Supplier
(vendor)
e-Commerce
platform
Transporter
Intermediary
Indirect
Direct
Customs
Authority
Transporter
Tax (Revenue)
Authority
Border
Financial
Intermediary
Customs
Authority
Transporter
Purchaser
Tax (Revenue)
Authority
Financial
Intermediary
Potential collection point
C.3.3.4.1. Collection by the postal operators

94. Postal operators may intervene as intermediaries both in the exporting and
importing country, as the liability to account for the VAT/GST may be transferred from
the postal operator in the exporting jurisdiction to the postal operator in the jurisdiction of
importation. The postal operators already collect some information from the sender in the
jurisdiction of origin of the goods and this information is passed on to the postal operator
in the jurisdiction of destination. The information (sender, addressee, description of the
goods, the value and whether they are gifts or commercial items) is currently transmitted
on paper forms attached to the goods (see SectionC.2.2.4.2 above).
95. The intervention of postal operators as intermediaries in the process of collecting VAT/
GST on low-value imports would need to be supported by the use of electronic collection and
transmission processes. This could be provided by the use of Electronic Postal Declarations
(EPD). This is an electronic solution for the customs declaration (an electronic CN 23) for
goods moved by the postal services that is being developed by the UPU and the WCO based
on already developed joint messaging standards. The UPUs Customs Declaration System
(CDS) is already being implemented/piloted by some countries e.g.by Canada.15 Also the
EU is working on the introduction of a simplified declaration for postal items and on the use
electronic data capture in this context. This is an important part of the delivery of upcoming
changes in the European Union Customs Code.16 This mechanism may notably facilitate
the automatic calculation of tax liabilities and the collection of the tax at importation of
electronically declared goods of any value. As a result, the administrative burdens of collecting
the tax for postal operators and governments would be minimised. This would place postal
imports on an equal footing with express and freight goods where electronic procedures
already exist. However, these electronic processes are still under development and may only
be available in the medium term.
96. In the current situation, where information is mostly collected and transmitted on
paper forms, the intervention of postal operators in the VAT/GST collection on imports of
low value goods would not provide a reliable solution.
C.3.3.4.2. Collection by express carriers

97. Express carriers already play an important role in the assessment and collection
of taxes and duties on the importation of low value goods (see SectionC.2.2.4.1 above).
They could therefore be eligible as intermediaries with a liability to account for VAT/GST
at importation. They can generally be expected to know the information that is needed to
support the collection of the VAT/GST (based on the information provided by the vendor)
on the imports of low value goods in the jurisdiction of importation. Fast and easy tax and
customs processes should be in place for compensating the additional burden of accounting
for VAT/GST on low value goods.
98. The VAT/GST collection and remittance by express carriers is already common
practice for goods above the VAT/GST relief threshold and for other taxes and duties. The
difference between the current system and the possible new model to be applied to low
value goods would be the development of a specific VAT/GST declaration and collection
system for the payment of VAT/GST on the import of low value goods. This would allow
for a separate VAT/GST treatment of such low value imports.
C.3.3.4.3. Collection by transparent e-commerce platforms and other commercial

agents that provide a trading framework for vendors
99. Under this approach, transparent e-commerce platforms that provide a trading
framework for vendors but that are not parties to the commercial transaction between
the vendor and the purchaser (see SectionC.2.2.3 above), would remit the VAT/GST on
the low value imports in the jurisdiction of importation. Based on the contract with the
vendor, such e-commerce platforms can perform a role similar to a tax representative that
is liable to remit the VAT/GST to the jurisdiction of importation on behalf of the vendor.
Those e-commerce platforms can have access to the information that is needed to support
the collection of the VAT/GST (location of the vendor, of the purchaser, description of the
goods and their value), based on the information provided by the vendor.
100. Some of the biggest marketplaces already provide such tax compliance services to
their vendors. One of the market leaders provides a global shipping programme, whereby
it collects from the purchaser (1)the price of the item and remits it to the seller, and (2)the
international shipping costs and any import VAT/GST and other duties and remits it to the
international shipping provider (who presumably remits the tax to the tax authorities in the
jurisdiction of importation). Marketplaces will generally offer such services against a fee.
101. For e-commerce platforms to play a role in the tax collection and compliance
process, they would need to have appropriate business and IT processes in place. For
example, the purchasers address collected by the platform and transferred to the merchant
for shipment should be verified as well as the applicable tax treatment in the country of
destination. This also requires the transmission of data to the customs or tax authorities.
Also the merchants status in each destination country should be taken into account.

Finally, the platform will need to transmit the relevant information to the customs and/
or tax authorities and administrative obligations should be completed for the correct
assessment and payment of the tax. The development and maintenance of such appropriate
business and IT system has obviously a cost for the e-commerce platform. Given the
constant development of e-marketplaces, it may well be that such intermediaries may
include such tax compliance services in their service offering to vendors.
102. The VAT/GST collection and remittance by transparent e-commerce platforms for
imports of low value goods would provide greater neutrality to the system but may involve
additional costs when IT systems and processes need to be adjusted. Appropriate systems
should be in place to encourage compliance (similar to those offered to the vendors in the
Vendor Collection model) and customs procedures should be adjusted accordingly. Just as
for the Vendor Collection model, the risks for non-compliance by non-resident e-commerce
platforms may be addressed by the implementation of a fall-back rule whereby goods
for which no VAT/GST has been accounted for under the Intermediary Collection model
are stopped at the border and are processed under the Traditional Collection model. Tax
administrations capacity to enforce compliance would need to be reinforced through
enhanced international administrative cooperation (see SectionC.4 below).
C.3.3.4.4. Collection by financial intermediaries

103. During the payment process, financial intermediaries collect and store data such
as the vendor and the purchaser account information (name, address, bank details).
Information collected by traditional financial institutions, such as retail banks and credit
card companies, will generally be limited to what is necessary to validate the cards
authenticity and/or confirm that sufficient funds are available on the purchasers account
to pay for the purchase. Information collected will generally not include the nature of the
transaction (sale of goods or of services, other transfers), the nature of the goods being
sold, the place where they are delivered or their tax treatment. Emerging new payment
intermediaries may not collect more information, unless they are strongly connected to the
vendor and have access to the sale data.
104. For the payment provider to assume the liability for remitting the VAT/GST on
low value imports from online sales, a number of practical and legal conditions should be
met: the payment provider should be able to collect from the vendor or from the purchaser
the required information for collecting and remitting the appropriate amount of tax in
the jurisdiction of importation and the legal arrangements should be in place to allow
the communication of the information to the tax authorities. The cost of establishing and
managing these embedded tax features in the payment system would have to be recovered
from the vendor or from the purchaser. In addition, legislation, backed by appropriate
regulation, would be required to ensure compliance.
105. The VAT/GST collection and remittance by financial intermediaries would need
deep changes in the data collection and processing systems, since these intermediaries
currently do not collect the relevant information for the assessment and payment of the
VAT/GST and do not have systems in place to support the remittance of the tax in the
jurisdictions of importation. It is therefore unlikely that financial intermediaries could play
a role in a more efficient collection of VAT/GST on imports of low value goods.
C.4. Supporting enforcement through enhanced mutual administrative cooperation

106. It is recognised that any reform to improve the efficiency of the collection of VAT/
GST on low value imports will need to be complemented with enhanced administrative
cooperation between tax authorities to enforce compliance. This cooperation should
include the exchange of information, which would notably be helpful for identifying vendors
and purchasers, for monitoring the value of sales/imports and for assessing whether the
proper amounts of VAT/GST have been collected from purchasers and remitted to the tax
authorities in the jurisdiction of importation.
107. WP9 is developing work on the enhanced administrative cooperation and exchange
of information in the context of its work on the International VAT/GST Guidelines. The
outcome of this work will also be relevant for the operation of regimes for collecting VAT/
GST on the importation of low value goods. It will notably consider how administrative
co-operation and exchange of information arrangements in the customs area could support
the enforcement of regimes for collecting the import VAT/GST on low-value goods. The
WCO has developed a number of instruments and tools supporting exchange of information
(e.g.the Nairobi Convention, the Model Bilateral Agreement on Mutual Assistance and the
Globally Networked Customs (GNC)). Based on these instruments, customs administrations
have entered into bilateral or multilateral agreements/arrangements for the exchange of
information.
C.5. Summary assessment of the collection models

108. SectionC.3 of this report presents four possible models for collecting the VAT/GST
on imports of low value goods and discusses their advantages and disadvantages, their
limits and the requirements for their successful application in practice. The initial analysis
of these models is supported by test cards in the AppendixC.A to this report, which
show the outcome of the assessment of likely performance of these models against a set of
evaluation criteria based on the Ottawa framework principles.
109. The outcome of this assessment should be considered with caution since the performance
of each model is likely to depend on its implementation in practice and on the specific
economic, legal and administrative circumstances of the jurisdiction that implements the
model. Moreover, it is most likely that the solution for a more efficient collection of VAT/
GST on imports of low value goods lies in a combination of approaches rather than in the
implementation of one single model. A detailed assessment should therefore look at the
performance of various combinations of these models rather than at their performance in
isolation. For example, a Vendor Collection model is likely to achieve proper compliance
and administrative efficiency gains only if it is combined with a simplified registration and
compliance regime. Models that provide for the assessment and payment of the VAT/GST
prior to the customs declaration (such as the vendor or e-commerce platform models) would
require the alignment of tax and customs rules to avoid double or unintended non-taxation.
They would also require systems for ensuring the appropriate labelling of the taxed goods
for the customs control and a fall-back rule for cases of non-compliance. Models relying on
voluntary registration would also require appropriate risk assessment tools and international
administrative cooperation to minimise the potential for evasion and avoidance.
110. The analysis presented in this report and in the AppendixC.A provides a high-level
overview of the key potential strengths and weaknesses of the main available models for
collecting the VAT/GST on the imports of low value goods. It is intended to assist governments
and tax administrations in evaluating whether and to what extent the implementation of these

models could improve the efficiency of the collection of the VAT/GST on imports of low value
goods to a level that is considered sufficient to reduce or remove the exemption threshold,
should they wish to do so.
C.5.1. Traditional Collection model

111. The Traditional Collection model, where VAT/GST is assessed at the border for each
imported low value good individually, is generally found not to be an efficient model for
collecting the VAT/GST on imports of low value goods. This is certainly the case in the
absence of electronic data transmission systems. The VAT/GST exemption thresholds for the
import of low value goods, which are implemented as a consequence of the complexity of
the Traditional Collection model, lead to growing VAT/GST revenue losses and increasing
risks of unfair competition between domestic and non-resident vendors. These relief regimes
are also increasingly vulnerable to fraud given the exponential growth of the volume of
imports of low value goods and the practical impossibility of checking the value (above or
below the exemption threshold) of each of the imported items. This results in a system where
effectiveness is not ensured and where neutrality is challenged.
112. The efficiency of the Traditional Collection model may improve over time, as
and when electronic pre-arrival declaration and tax assessment and payment systems are
implemented worldwide to replace paper based and manual verification processes. These
new electronic processes are already used in the express carriers environment where they
have resulted in considerable efficiency gains. The consistent use of such electronic systems
would improve the efficiency of compliance and administration, certainty and simplicity for
the vendors and provide flexible, market-based solutions. Their worldwide implementation
might allow the removal of the current VAT/GST exemption thresholds and provide greater
neutrality to the system. However, these systems are not yet available to process the import
of the considerable numbers of low value goods that are moved by postal services. These
electronic processes for the postal environment are still under development and may only be
available in the medium term.
C.5.2. Purchaser Collection model

113. A model relying on the purchaser to self-assess and pay the VAT/GST on its imports
of low value goods is not likely to provide a sufficiently robust solution for a more efficient
collection of VAT/GST on the imports of low value goods. Although it could simplify the
compliance process for vendors and could create a more neutral environment in theory,
compliance levels are expected to be low while compliance burden for purchasers would
be high and the administrative cost and complexity for customs and tax administrations
would be considerable.
C.5.3. Vendor Collection model

114. A model requiring the non-resident vendors of low value goods to charge, collect and
remit the VAT/GST on the imports of low value goods in the country of importation could
improve the efficiency of the collection process and thus create opportunities for governments
to remove or reduce import VAT/GST exemption thresholds. A Vendor Collection model
would create additional burden for non-resident vendors, which can be mitigated by
complementing it with simplified VAT/GST registration and compliance regimes and possible
fast-track tax processing and bulk shipper schemes to support compliance. In addition, the
implementation of this model would involve considerable systems changes and adjustment of
customs and tax processes to avoid double or unintended non-taxation. The implementation
of appropriate risk assessment methods and the enhanced international and inter-agency (tax
and customs administrations) cooperation would be required to support the compliance by
non-resident vendors under this model.
C.5.4. The Intermediary Collection odel

115. A model where VAT/GST on imports of low value goods would be collected and
remitted by intermediaries on behalf of non-resident vendors could improve the efficiency
of the collection of VAT/GST on low value imports and thus create opportunities for
governments to remove or reduce import VAT/GST exemption thresholds, assuming that
such intermediaries would have the required information to assess and remit the right
amount of taxes in the country of importation. The VAT/GST collection by intermediaries
would involve minimal compliance burdens on vendors but would come at an additional
cost that may be passed on to the purchaser. This model may be particularly effective
when the VAT/GST is collected by intermediaries that have a presence in the country of
importation (e.g.express carriers, postal operators and locally implemented e-commerce
platforms). The intermediaries understanding of local tax and customs rules and
procedures could provide benefits to both vendors and tax administrations.
116. The following paragraphs look more specifically at the possible role of the main
types of intermediaries that could intervene in the collection of VAT/GST on the imports
of low value goods: the postal operators, the express carriers, the e-commerce platforms
and the financial intermediaries.
117. In the postal environment, information is mostly collected and transmitted on
paper forms and minimal data is collected from the other stakeholders. Against this
background, most postal operators do not have the appropriate systems in place to manage
the assessment and collection of VAT/GST on importation of low value goods. Electronic
collection and transmission processes are being developed but the postal system would
still require substantial adjustment to operate an efficient, effective and fair VAT/GST
collection model.
118. In the express carriers environment, electronic data collection and transmission
systems are most often already in place and VAT/GST collection and remittance to the
tax authorities is also already common practice. A model whereby non-resident vendors
rely on express carriers to collect and remit the VAT/GST on imports of low value goods
provides an efficient and effective solution, provided it is combined with sufficiently
simple compliance regimes and with fast-track processing. Given the existing commercial
relationships between the express carriers and the vendors, such a model would provide
certainty and fairness. It must be noted, however, that express carriers must rely in practice
on the correctness of the information provided by the vendors for the assessment of the tax
liability and the associated compliance obligations.
119. Transparent e-commerce platforms already have most of the information that would
be needed for assessing the VAT/GST due in the country of importation of low value
goods. Some of the leading marketplaces already provide tax compliance services to their
vendors. A model where VAT/GST on imports of low value goods would be collected and
remitted by these e-commerce platforms on behalf of non-resident vendors could provide
an efficient and effective solution and thus create opportunities for governments to remove
or reduce import VAT/GST exemption thresholds. However, many transparent e-commerce
platforms would still need to develop and implement considerable systems changes to ensure
appropriate levels of efficiency, certainty and effectiveness. Just as for express carriers,

simplified tax and customs procedures would be needed to ensure an efficient and effective
collection and remittance of VAT/GST on the imports of low value goods. E-commerce
platforms would also have to rely on information provided by the vendors for the assessment
of the tax liability and the associated compliance obligations. When e-commerce platforms
do not have a presence in the country of importation, risk assessment and simplification
measures similar as those mentioned for the Vendor Collection model should be considered.
120. Financial intermediaries do not collect the relevant information for the assessment
and payment of the VAT/GST and the development of a model relying on the payment
system would involve deep changes in the data collection processes. It is therefore unlikely
that financial intermediaries could play a role in a more efficient collection of VAT/GST
on imports of low value goods.
C.6. Overall conclusion

121. The assessment of the models suggest that a range of possible approaches are available
for increasing the efficiency of the collection of VAT/GST on low-value imports for countries
to choose from, depending on national policy decisions and specific circumstances.
122. Jurisdictions could opt for a combination of models. For instance, an optional Vendor
Collection model with a simplified registration and compliance regime could be combined
with an Intermediary Collection model (which may notably allow small and medium
size businesses to comply more easily). Both models could be combined with further
simplification arrangements, such as fast-track processing and/or a bulk-shipper scheme.
To increase compliance, these models could be combined with a fall-back rule whereby
VAT/GST would be collected under the Traditional Collection model (possibly from the
final consumer) e.g.if VAT/GST has not been paid either under the Vendor or Intermediary
Collection models. Risks of undervaluation or mis-description by foreign vendors of
imported goods should be considered for the assessment of the models or combination of
models.
123. The implementation of these models or a combination of them allow jurisdictions to
remove or lower the VAT/GST exemption thresholds, should they wish to do so.
124. It is recognised that any reform to improve the efficiency of the collection of VAT/
GST on low value imports will need to be complemented with appropriate risk assessment
and enhanced international administrative cooperation between tax authorities to enforce
compliance.
AppendixC.A
Test cards for the analysis of the VAT/GST collection models
The findings in these tables are sensitive to the opinions of a sample of tax officials
and businesses. They do not cover every possible element that might be required
in order to fully assess the models considered. Therefore, the information that they
include and the initial assessments made are not presented as, or intended to be,
definitive.
Effectiveness Medium
The VAT/GST exemption thresholds

for imports of low-value goods may be
reduced or removed if appropriate and
consistent electronic processes are
implemented.
If electronic declaration and assessment

systems are consistently used and
appropriate data flows are ensured, the
capacity of the system to collect the right
amount of taxes at the right place would
be considerably improved.
Vendors are facing a plethora of customs In the express carriers environment,

processes and VAT/GST relief thresholds compliance services already exist that
that exist globally.
help vendors to cope with the various tax
and customs obligations.
Medium
The current development of electronic

declaration and assessment systems,
in particular in the express carrier
environment, leads to reasonably
efficient procedures in certain countries/
business models (primarily those that
rely on express couriers for transport/
delivery of the low value goods).
Neutrality is advanced when electronic

declaration and assessment procedures
are in place that allow for the removal
of the VAT/GST relief regimes and for a
reasonably efficient collection of the VAT/
GST on these imports.
Certainty and
simplicity
The Traditional Collection model is

generally combined with a low-value
goods VAT/GST relief, which creates
risks of competitive distortions in the
domestic market.
Advantages
Paper-based procedures and separate

treatment of each individual consignment
create significant administrative and
compliance costs.
The development of electronic
procedures may significantly reduce the
administrative and compliance costs and
speed up customs processes.
Low
Comment
Efficiency of Low
compliance
and
administration
Neutrality
Ranking
Disadvantages
In the absence of appropriate electronic

processes, the cost efficiency of
traditional customs procedures does not
allow the removal of the VAT/GST relief
thresholds.
Pre-arrival information about the goods

is limited particularly in the international
postal environment.
Unexpected charges for the purchaser
when taxes and duties must be paid
on the delivery of the good generate
refusals of the consignment and possible
abandonment of the goods.
The lack of harmonisation of customs
rules and procedures in each
jurisdiction creates uncertainties for the
stakeholders.
In the absence of electronic data

transmission systems, the importation
procedure requires that each individual
consignment is stopped at the border for
manual control of tax liabilities, involving
slow and expensive processes.
The use of intermediaries for completing
procedures and paying VAT/GST at the
border has a cost for the vendor/the
purchaser.
Electronic declaration and assessment

procedures are not generally
implemented. Notably the movement of
low value goods via postal services is
still entirely paper based. The Traditional
Collection model is therefore generally
combined with a low-value goods VAT/
GST relief, which creates risks of
competitive distortions between domestic
and non-resident vendors.
A. Traditional collection model
Techniques regarding the capture and

exchange of information between the
stakeholders are evolving fast.
Customs authorities and postal operators
need to move towards greater and more
consistent use of new technologies.
The consistent development of electronic

processes for improving the flow of
information between the stakeholders
would improve the certainty and
simplicity of the customs processes.
Process efficiencies could be leveraged

from the current approach, especially
for consignment imported through
international post. In particular, the postal
operators in some countries are working
together to drive the take up of electronic
declarations for postal items.
The distortive effect resulting from

current VAT/GST thresholds has
increased with the exponential
development of e-commerce.
The development of electronic
declaration and assessment procedures
may allow the removal of the VAT/GST
relief regimes, but these procedures are
not common practice. Particularly in the
postal environment, the transition from
paper based to electronic procedures is
expected to take several years.
Challenges
Neutrality
Medium
Flexibility
Low
Ranking
Low
Ranking
Fairness
Theoretically neutral as domestic sales

and imports would be subject to the
same level of taxation in the country of
consumption. In practice, however, noncompliance is likely to create distortion
in the jurisdiction of importation. Foreign
small businesses whose sales would
become subject to VAT/GST in the
jurisdiction of destination may be at a
competitive disadvantage compared to
domestic small businesses that remain
under the domestic VAT/GST registration
threshold and whose sales are VAT/GST
exempt.
Comment
Flexibility has improved in the express

carriers environment while progress
is still to be made in the postal
environment.
Comment
The vendor would have no VAT/

GST obligations in the jurisdiction of
importation.
Advantages
Disadvantages
May deter compliant purchasers from

purchasing abroad (if they have for
instance to file a VAT/GST form to
account for the tax on each purchase).
It may also affect domestic
competitiveness as it may create an
incentive for non-compliant customers to
purchase abroad.
Disadvantages
The paper based processes, which are still

often applied, do not provide flexibility.
The Traditional Collection model is generally

combined with a low-value goods VAT/GST
relief, which are vulnerable to fraud through
under declaration or mis-declaration.
It is recognised that such risks of under
declaration or mis-declaration may also exist
in the absence of such exemptions.
B. Purchaser collection model
The electronic systems developed by

express carriers are providing flexible
solutions.
Advantages
A. Traditional collection model (continued)

Challenges
Challenges
Electronic procedures are currently

being developed at the level of
Universal Postal Union (UPU), the
World Customs Organisation (WCO)
and the European Union (EU).
Cooperation between customs

and tax authorities and between
countries may reduce the risk of
non-compliance.
Ranking
Advantages
Disadvantages
Self-assessing the tax would create an

administrative burden for the customer.
The consumer can avoid tax easily
through non-compliance.
Low
Low
Fairness
Flexibility
Certainty and
simplicity
The likelihood that the purchaser would

self-account the VAT/GST is very low.
Tax likely to be applied inconsistently
(if at all) as result of poor compliance.
Compliance is difficult, if not impossible,
to enforce as the entire population is
potentially liable to account for the VAT/
GST.
This option maximises the compliance

challenges as theoretically the whole
resident population is in scope of this
approach. This provides the greatest
number of touch-points of any of the
proposals.
Implementing this option would require
significant investment in systems
changes and new administrative
processes in most countries.
The compliance burden is shifted to the
purchaser who is generally not properly
prepared/equipped for this.
Effectiveness Low
Minimal compliance costs for nonresident vendors.
Uncertainty about procedures and

complexity to comply non-compliance is
likely to cause non-compliance leading to
lost tax revenues. Private consumers are
unlikely to keep track of goods imported
or to be aware of the rules.
It is difficult to foresee whether an

electronic self-declaration system would
allow consumers to comply with their tax
obligations while ensuring an effective
collection of VAT/GST.
Comment
Low
Efficiency of Low
compliance
and
administration
B. Purchaser collection model (continued)

Challenges
It would be very difficult if not impossible
for the tax administration to police such
a regime.
Medium
Low
Medium
(simplified
regime)
Neutrality
Efficiency of
compliance
and
administration
Ranking
Measures to facilitate compliance

for small/micro businesses may
have to be considered.
Foreign small businesses that
would have to account for VAT/GST
in the jurisdiction of destination may
be at a competitive disadvantage
compared to domestic small
businesses that remain under the
domestic VAT/GST registration
threshold.
Comment
Moves some of the tasks involving

the collection of import VAT/GST from
customs authorities onto non-resident
vendors, who are increasingly looking
for technology-facilitated solutions for a
quick/efficient collection and remittance
of such import VAT/GST.
Under an optional Vendor Collection
model with simplified registration and
compliance procedure and fast-track
processing, only the vendor who elects to
do so would have to VAT/GST register in
the country of importation. This creates
an incentive for non-resident to opt for
vendor collection and to comply.
A bulk-shipper scheme would
allow vendors to lodge only one
import declaration for all low-value
consignments shipped together
(instead of for each imported item). All
consignments would be taxed even if,
taken separately, they would be below
the threshold. The operation of one stop
shop systems in groups of countries
may reduce further the compliance
costs.
May even the playing field between

non-resident sellers and domestic
sellers (above the VAT/GST registration
threshold for small businesses).
Advantages
Disadvantages
For tax authorities: significant increase

in registrations and corresponding costs
(especially if extended to payment of
duties) and additional costs to change
customs procedures to remove the
exemption and, in case such regime
would be implemented, to manage fasttracking and receive electronic data in
advance of importation.
May involve significant burdens for nonresident vendors of having to register and
account for tax in every country to which
export to, in the absence of simplified
registration and compliance mechanism.
This may create a disincentive for small
operators to comply. Some suppliers
may also decide not to supply to smaller
markets.
Relies very much on self-compliance

by the vendors. Should therefore be
combined with a fall-back rule based on
the Traditional Collection model: in case
of non-compliance, import VAT/GST is
collected according to the traditional
process. This would require authorities to
operate two methods in parallel (Vendor
Collection + Traditional Collection model)
C. Vendor collection model
Compliance burden should be reduced

for suppliers of having to register for
VAT/GST in every country to which
they export. This can be achieved by
implementing simplified registration and
compliance regimes allowing the vendor
to pay and declare VAT/GST online in the
jurisdiction of importation.
In practice, VAT/GST might have to be
remitted at the time of the payment of
the goods (and thus before goods are
imported) or on a periodic return. Rules
regarding the chargeable event of the
VAT/GST might have to be amended
and secure systems to identify packages
coming from non-resident VAT/GST
registered suppliers may have to be
implemented.
Customs controls for safety and security
will remain applicable, even if VAT/GST
simplified procedures apply.
Challenges
Ranking
Neutrality
Medium
Ranking
Comment
Advantages
This approach would even the playing
field between domestic and non-resident
vendors (including SMEs) assuming
that intermediaries have the required
information to collect and remit the
import VAT/GST.
The postal services environment is not

ready to switch to this model to collect
VAT/GST on imports of low value goods. A
transition to electronic processing is under
preparation but will only be implemented
in the mid (or even long) term.
Most financial intermediaries do not have
relevant information to assess and collect
VAT/GST.
Disadvantages
Medium
Flexibility
D. Intermediary collection model
Enforcing compliance from non-resident

may remain a challenge in the absence
of enhanced international administrative
cooperation.
Potential for undervaluation and misdescription can be minimised.
Disadvantages
Uncertainty around interaction with
customs/excise duties and procedures,
e.g.legal issues over defining who the
importer is.
A simplified compliance mechanism may
involve considerable systems changes.
Optional fast track: customs authorities
may need to implement systems changes
to distinguish goods subject to the fast
track from the others.
Medium
A vendor collection system would

necessarily rely on technological
developments.
Advantages
Fast-track processing would encourage
vendor to register.
Simplified registration and compliance
mechanisms may reduce the compliance
burden for the vendor.
Under the bulk-shipper scheme,
processing charges would be minimised.
Fairness
Comment
May not be attractive (not effective) for

businesses without a fast-track process.
This approach relies on self-compliance
by the vendors. In the absence of a
fall-back rule, non-compliance could
significantly reduce revenues.
Effectiveness Low
Medium
(with fallback rule and
enhanced
administrative
cooperation)
Certainty and Medium

simplicity
High
(simplified
regime)
C. Vendor collection model (continued)

Challenges
Efficient electronic data transmission

and verification should be in place for all
intermediaries that would intervene in
the VAT/GST assessment and collection
process.
Success is likely to depend on the
availability of simplified compliance
mechanisms and incentives such as fasttrack processing.
Challenges
Flexibility can be improved if vendors

have the possibility to choose between a
range of alternative methods.
Since, this regime relies on selfcompliance by the vendors, enforcement

needs to be supported by robust mutual
administrative cooperation and other
control mechanisms.
Ideally, tax authorities should receive

electronically data of shipments in
advance under the simplified registration
and compliance regime.
Effectiveness will notably be influenced
by the frequency of remittance: instant/
transaction wise or consolidated/
monthly/bi-monthly?
The existence of simplified registration

and compliance mechanisms/fast track
will not remove the customs safety and
security controls.
Ranking
Certainty and Medium

simplicity
High
for express
couriers
Low
for financial
intermediaries
Efficiency of Medium
compliance
and
administration
Comment
Some additional burden on

transporters to operate a VAT/GST
collection and remittance system,
but most information systems
already exist for express carriers.
Express carriers already have systems

in place for declaring/paying import VAT/
GST.
Certain e-commerce platforms already
operate tax compliance programmes.
Minimal administrative burdens for

vendors as these are shifted onto
intermediaries.
As only a limited number of
intermediaries are likely to be involved,
this model is broadly efficient for the tax
administration.
Revenue is secured through known
express carriers or designated postal
operators.
Simplified compliance mechanism may
reduce the compliance costs for the
intermediary and make the system more
accessible to SMEs.
Express carriers already use electronic
procedures and could relatively easily
switch to this model to collect VAT/GST
Advantages
Intermediaries have to rely on

information provided by the vendors.
The postal services environment is still
reliant on (often very) limited information
provided by the vendor.
Financial intermediaries do not access to
the necessary information on the nature
and the destination of the goods to
assess the applicable VAT/GST.

very much paper based and reliant on
(often very) limited information provided
by the vendor. The postal environment
is not ready to switch to this model
to collect VAT/GST on imports of low
value goods. A transition to electronic
processing is under preparation but will
only be implemented in the mid (or even
long) term.
Transparent e-commerce platforms
would need to adjust their data collection
and verification process.
Most financial intermediaries do not
have relevant information to assess and
collect VAT/GST.
Additional fees charged by the
intermediaries for the collection and
remittance of VAT/GST may increase
the price of the low value imported
goods. These fees are however expected
to reduce over time as the industry
develops.
There may be a cost to the tax and
customs authorities to adjust their
systems, although administrations are
likely to be able to leverage on the
systems that are already in place to
e-process packages imported through
express carriers.
Disadvantages
D. Intermediary collection model (continued)

Challenges
Not feasible for traditional financial

intermediaries.
When e-commerce platforms do not

have a presence in the country of
importation, risk assessment and
simplification measures similar as those
mentioned for the Vendor Collection
model should be considered.
Flexibility
Medium
An intermediary collection
system would necessarily rely on
technological developments.
Potential for fraud through misdescription and undervaluation is

reduced, if intermediaries have access
to reliable information (which is not the
case for financial intermediaries).
Electronic processes will allow for
computer-assisted auditing using
electronic records, which reduces the
risk of fraud and non-compliance.
Medium
Fairness
Advantages
Rules can be enforced on transporters
(express couriers; postal operators)
since tax administration in country of
importation has jurisdiction over the
transporter.
Express carriers already use electronic
procedures and could relatively easily
switch to this model to collect VAT/GST
Electronic processes will support
more effective audit strategies based
on computer-assisted auditing using
electronic records
Comment
Effectiveness Medium
High
for express
couriers
Low
for financial
intermediaries
Ranking

very much paper based and reliant on
(often very) limited information provided
by the vendor. The postal environment
is not ready to switch to this model
to collect VAT/GST on imports of low
value goods. A transition to electronic
processing is under preparation but will
only be implemented in the mid (or even
long) term.
Transparent e-commerce platforms
would need to adjust their data collection
and verification process.
Most financial intermediaries do not
have relevant information to assess and
collect VAT/GST.

reliant on (often very) limited information
provided by the vendor, which is difficult if
not impossible to verify due to the paper
based and manual verification process.
Financial intermediaries do not have the
appropriate information on the nature and
the destination of the goods to assess the
applicable VAT/GST.
Tax administration in country of

importation do not have jurisdiction
over the intermediary, although mutual
assistance could offset this.
Financial intermediaries do not have
access to the necessary information
on the nature and the destination of the
goods to assess the applicable VAT/GST.
Disadvantages
D. Intermediary collection model (continued)
Intermediaries such as express carriers

have to rely on information provided by
the vendors.
Challenges
AppendixC.B
Low value import relief Exemption thresholds
VAT/GST exemption thresholds for low value imports
This table shows VAT/GST exemption thresholds for low value import items dispatched
by a foreign supplier to a purchaser in a given country. It does not cover other import
scenarios such as imports of goods exchanged between private individuals or imports
of goods in the personal luggage of travellers.
Country
Currencya
Thresholda
Threshold in USD approx.b
Australia
AUD
1000
861
Argentina
USD
25
25
Austria
EUR
22
28
Belgium
EUR
22
28
Brazil
BRL
Canada
CAD
20
18
Chile
CLP
Czech Republic
EUR
22
28
Costa Rica
CRC
Denmark
DKK
80
13
Estonia
EUR
22
28
Finland
EUR
22
28
France
EUR
German
EUR
22
28
Greece
EUR
22
28
Hungary
EUR
22
28
Iceland
ISK
2000
16
Ireland
EUR
22
28
Israel
USD
75
75
Italy
EUR
22
28
Japan
JPY
10000
87
Korea
KRW
150000
138
Latvia
EUR
22
28
Luxembourg
EUR
22
28
Mexico
USD
300
300

Country
Currencya
Thresholda
Threshold in USD approx.b
Netherlands
EUR
22
28
New Zealand
NZD
400
309
Norway
NOK
200
29
Poland
EUR
Portugal
EUR
22
28
Russian Federation
RUB
Saudi Arabia
N/A
N/A
N/A
Singapore
SGD
400
310
Slovak Republic
EUR
22
28
Slovenia
EUR
22
28
South Africa
ZAR
100
Spain
EUR
22
28
Sweden
EUR
22
28
Switzerland
CHF
Turkey
TRY
United Kingdom
GBP
15
24
United States
N/A
N/A
N/A
Uruguay
USD
50 (non-express)
200 (express delivery)
62.5 (goods taxed at standard rate) 65 (goods taxed at standard rate)

200 (goods taxed at reduced rate) 208 (goods taxed at reduced rate)
0
50 (non-express)
200 (express delivery)
Notes: a. A mounts are shown in the currency in which they were provided by delegates (i.e.either in local
currency, EUR or USD).

b. To facilitate cross-country comparison, the amounts have been converted into USD at market rates on
1November 2014. Note that these conversion rates have not been adjusted for purchasing power parity.
The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities.
Source: 2014 Low value imports questionnaire. For the countries that did not respond to the low value imports
questionnaire, the information is based on the 2014 Consumption Tax Trends Publication. (Situation as at
1January 2014).
Notes
1.
The OECD/G20 Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan) was
launched in September 2013 by OECD and G20 countries working on an equal footing. The
Project provides for 15 actions to be delivered by 2015, with a number of actions to be delivered
in 2014.
2.
According to Transitional Standard 4.13 of Chapter4 of the General Annex of the RKC: National
legislation shall specify a minimum value and/or a minimum amount of duties and taxes below
which no duties and taxes will be collected. There could be limited exceptions where duties and
taxes can apply irrespective of value, e.g.excisable goods.
3.
Foreign small businesses that would have to account for VAT/GST on their sales in the
jurisdiction of destination could be at a competitive disadvantage compared to domestic small
businesses that are exempt from the VAT/GST because of their size and that would only incur
VAT/GST on their inputs. However, the focus of this report is on the efficiency in the collection
of VAT/GST on imports only.
4.
The Universal Postal Union (UPU) was established during the second half of the 19th Century.
The UPU Convention and subsidiary regulations facilitate and govern the movement of post
between member countries. The UPU became a specialised agency of the UN in 1948.
5.
Forms CN22 and CN23 used by postal operators for customs clearance are not tax forms. They
are primarily designed for postal customs declaration. However the information contained in
these forms can be used for tax purposes by customs or tax authorities.
6.
WTO Agreement on Trade Facilitation, General Council Decision of 28November 2014,

https://www.wto.org/english/thewto_e/minist_e/mc9_e/nov14dectradfac_e.htm.
7.
Article9 of the UPU Convention was amended to include the principle of complying with
requirements for providing electronic advance data on postal items.
8.
The Electronic Customs Initiative, http://ec.europa.eu/taxation_customs/customs/policy_issues/

electronic_customs_initiative/electronic_customs_legislation/index_en.htm.
9.
OECD (1998), Electronic Commerce: Taxation Framework Conditions, a report by the

Committee on Fiscal Affairs, page4, www.oecd.org/tax/consumption/1923256.pdf.
10.
In this context, vendor includes non-transparent intermediaries where the sale from the original
vendor to the intermediary and the subsequent resale to the purchaser are considered two separate
transactions for VAT/GST purposes.
11.
Within customs unions, once the goods are released into free circulation, it may be difficult
to trace them. This would be particularly challenging for jurisdictions that operate a common
external tariff and a common domestic market, such as Member States of the European Union.
12.
In the EU, an OSS was established for B2C supplies of electronic, telecommunication, radio and
television broadcasting services performed by non-EU suppliers. This system was introduced
in 2003. Briefly, the system works as follows. A non-resident supplier chooses one EU Member
State to register for VAT and to perform all related VAT compliance. When sales to other EU
Member States are performed, the system automatically applies the VAT rate in the EU country
of consumer. At the end of the reporting period, the non-resident supplier submits a declaration
with all sales split per EU jurisdictions. The EU Member State of registration then distributes
the appropriate VAT revenues to each EU Member State of consumption.
13.
Foreign small businesses that would have to account for VAT/GST on their sales in the jurisdiction
of destination could be at a competitive disadvantage compared to domestic small businesses that
are exempt from the VAT/GST because of their size and that would only incur VAT/GST on their
inputs. However, the focus of this report is on the efficiency in the collection of VAT/GST on
imports only.
14.
Non-transparent intermediaries as described in paragraph27 above are not considered in this

section.
15.
https://www.canadapost.ca/cpotools/apps/cdc?execution=e3s1.
16.
The Union Customs Code (UCC) was adopted on 9October 2013 as Regulation (EU) No952/2013
of the European Parliament and of the Council.
Bibliography
OECD (2014), Addressing the Tax Challenges of the Digital Economy, OECD/G20
Base Erosion and Profit Shifting Project, OECD Publishing, Paris, http://dx.doi.
org/10.1787/9789264218789-en.
AnnexD. OECD international VAT/GST guidelines 221
AnnexD
OECD international VAT/GST guidelines
Chapter3
Determining the place of taxation for cross-border supplies of services and
intangibles
This annex contains the chapter of the International VAT/GST Guidelines which deals
specifically with the application of VAT/GST to cross-border supplies of services and
intangibles
222 AnnexD. OECD international VAT/GST guidelines
A. The destination principle

3.1. VAT neutrality in international trade is generally achieved through the implementation
of the destination principle. The destination principle is designed to ensure that tax on
cross-border supplies is ultimately levied only in the jurisdiction where the final consumption
occurs, thereby maintaining neutrality within the VAT system as it applies to international
trade. This principle is set out in Guideline3.1.
Guideline3.1
For consumption tax purposes internationally traded services and intangibles
should be taxed according to the rules of the jurisdiction of consumption.
3.2. In order to apply the destination principle to internationally traded services and
intangibles, VAT systems must have mechanisms for identifying the jurisdiction of
consumption by connecting such supplies to the jurisdiction where the final consumption
of the services or intangibles is expected to take place. VAT systems need place of taxation
rules to implement the destination principle not only for business-to-consumer supplies,
which involve final consumption, but also for business-to-business supplies, even though
such supplies do not involve final consumption. Business-to-business supplies are taxed
under the VATs staged collection process, and, in this context, the place of taxation rules
should facilitate the ultimate objective of the tax, which is to tax final consumption. These
Guidelines set out the recommended approaches that reflect the destination principle for
determining the place of taxation for business-to-consumer and business-to-business crossborder supplies of services and intangibles.
3.3. Place of taxation rules are needed for supplies of goods as well as for supplies of
services and intangibles. Implementing the destination principle with respect to crossborder supplies of goods is facilitated by the existence of border controls or fiscal frontiers.
Implementing the destination principle with respect to international trade in services
and intangibles is more difficult, because the nature of services and intangibles is such
that they cannot be subject to border controls in the same way as goods. The Guidelines
in this chapter therefore concentrate on supplies of services and intangibles.1 They set
out recommended approaches that reflect the destination principle for determining the
jurisdiction of taxation for international supplies of services and intangibles while ensuring
that:
international neutrality is maintained
compliance by businesses involved in these supplies is kept as simple as possible
clarity and certainty are provided for both business and tax administrations
the costs involved in complying with the tax and administering it are minimal, and
barriers to evasion and avoidance are sufficiently robust.
3.4. This chapter should not be read as requiring jurisdictions to literally incorporate
the Guidelines on determining the place of taxation as legal rules in national legislation.
These Guidelines seek to identify common objectives and suggest means for achieving
them with a view to promoting a consistent implementation of the destination principle for
determining the place of taxation for supplies of services and intangibles. It is recognised
that a variety of models for structuring and designing place of taxation rules are operated
by VAT systems around the world. Many systems operate on the basis of a categorisation
approach, in which supplies are divided into categories with a place of taxation specified for
each category. Other models favour an iterative approach, in which the principle underlying
the place of taxation rule is described in more general terms and where a series of rules are
applied consecutively to determine the appropriate place of taxation. These differences in
legal drafting style are generally not absolute and elements of both approaches can be found
in both models. The key common feature among the various VAT design models is that they
generally aim to implement the destination principle, under which the place of taxation rules
are intended to impose tax at the place of consumption. These Guidelines seek to ensure
that these place of taxation rules are applied consistently by promoting an internationally
accepted understanding of what is the place of taxation of internationally traded services
and intangibles and by setting out consistent and effective approaches for determining this
place of taxation with a view to minimising uncertainty, revenue risks, compliance costs and
administrative burdens for tax authorities and businesses.
3.5. The approaches used by VAT systems to implement the destination principle for
business-to-business supplies and the tax collection methods used for such supplies are often
different from those used for business-to-consumer supplies. This distinction is attributable
to the different objectives of taxing business-to-business and business-to-consumer supplies:
taxation of business-to-consumer supplies involves the imposition of a final tax burden,
while taxation of business-to-business supplies is merely a means of achieving the ultimate
objective of the tax, which is to tax final consumption. Thus, the objective of place of
taxation rules for business-to-business supplies is primarily to facilitate the imposition of a
tax burden on the final consumer in the appropriate country while maintaining neutrality
within the VAT system. The place of taxation rules for business-to-business supplies should
therefore focus not only on where the business customer will use its purchases to create
the goods, services or intangibles that final consumers will acquire, but also on facilitating
the flow-through of the tax burden to the final consumer while maintaining neutrality
within the VAT system. The overriding objective of place of taxation rules for businessto-consumer supplies, on the other hand, is to predict, subject to practical constraints, the
place where the final consumer is likely to consume the services or intangibles supplied.
In addition to the different objectives of the place of taxation rules for business-to-business
and business-to-consumer supplies, VAT systems often employ different mechanisms
to enforce and collect the tax for both categories of supplies. These different collection
mechanisms often influence the design of place of taxation rules and of the compliance
obligations for suppliers and customers involved in cross-border supplies. In light of these
considerations, this chapter presents separate Guidelines for determining the place of
taxation for business-to-business supplies and for business-to-consumer supplies. This
should not be interpreted as a recommendation to jurisdictions to develop separate rules or
implement different mechanisms for each type of supply in their national legislation.
3.6. In theory, place of taxation rules should aim to identify the actual place of
business use for business-to-business supplies (on the assumption that this best facilitates
implementation of the destination principle) and the actual place of final consumption for
business-to-consumer supplies. However, these Guidelines recognise that place of taxation
rules are in practice rarely aimed at identifying where business use or final consumption
actually takes place. This is a consequence of the fact that VAT must in principle be
charged at or before the time when the object of the supply is made available for business
use or final consumption. In most cases, at that time the supplier will not know or be
able to ascertain where such business use or final consumption will actually occur. VAT
systems therefore generally use proxies for the place of business use or final consumption
to determine the jurisdiction of taxation, based on features of the supply that are known

or knowable at the time that the tax treatment of the supply must be determined. The
Guidelines in this chapter identify such proxies for determining the place of taxation
of supplies of services and intangibles, both for business-to-business supplies and for
business-to-consumer supplies.
3.7. For the purposes of these Guidelines business-to-business supplies are assumed
to be supplies where both the supplier and the customer are recognised as businesses,
and business-to-consumer supplies are assumed to be supplies where the customer is not
recognised as a business. Such recognition may include the treatment for VAT purposes
specifically or in national law more generally (notably in jurisdictions that have not
implemented a VAT).
3.8. Jurisdictions that implement different approaches for determining the place of
taxation and/or different collection mechanisms for business-to-business supplies and for
business-to-consumer supplies are encouraged to provide clear practical guidance on how
suppliers can establish the status of their customer (business or non-business). Jurisdictions
may consider adopting a requirement for suppliers to provide a customers VAT registration
number, business tax identification number, or other such indicia (e.g.information available
in commercial registers) to establish their customers status. Where a supplier, acting
in good faith and having made reasonable efforts, is not able to obtain the appropriate
documentation to establish the status of its customer, this could lead to a presumption that
this is a non-business customer in which case the rules for business-to-consumer supplies
would apply. To facilitate suppliers identification and verification of their customers
status, jurisdictions are encouraged to consider implementing an easy-to-use process that
would allow suppliers to verify the validity of their customers VAT registration or tax
identification numbers. Where, in respect of some or all types of services, jurisdictions
do not distinguish between business-to-business and business-to-consumer supplies, such
guidance might not be necessary.
B. Business-to-business supplies The general rule

B.1. Defining the general rule
Guideline3.2
For the application of Guideline3.1, for business-to-business supplies, the jurisdiction
in which the customer is located has the taxing rights over internationally traded
services or intangibles.
3.9. By and large, when a business buys in services or intangibles from another
jurisdiction, it does so for the purposes of its business operations. As such, the jurisdiction
of the customers location can stand as the appropriate proxy for the jurisdiction of business
use, as it achieves the objective of neutrality by implementing the destination principle.
This is the jurisdiction where the customer has located its permanent business presence.
3.10. This proxy is referred to in these Guidelines as the general rule for business-tobusiness supplies, as distinguished from specific rules that are covered by Guidelines3.7
and 3.8. According to this general rule, the jurisdiction where the customer is located
has the taxing rights over services or intangibles supplied across international borders.
The supplier makes the supply free of VAT in its jurisdiction but retains the right to full
input tax credit (subject to clearly legislated exceptions in that jurisdiction) on inputs
related to making such international supplies. Only in exceptional and clearly specified
circumstances should the place of taxation vary from this general rule.2
3.11. This section and the following sections provide further guidance on how the
jurisdiction of a customers location can be determined.
Guideline3.3
For the application of Guideline3.2, the identity of the customer is normally
determined by reference to the business agreement.
3.12. Under Guideline3.3, the identity of the customer is normally determined by
reference to the business agreement as it is expected that business agreements reflect
the underlying supply. The business agreement will assist the supplier, the customer and
tax administrations in identifying the nature of the supply and the identity of the parties
to the supply. When supplies are made between separate legal entities with only a single
location, the location of the customer also will be known once the identity of the customer
is determined.3 It is appropriate to first describe business agreement for the purposes of
these Guidelines and explain how tax administrations and businesses may approach the
determination of the business agreement.
Box3.1. Business Agreement
Business agreements consist of the elements that identify the parties to a supply and the rights
and obligations with respect to that supply.a They are generally based on mutual understanding.b
Notes
a. Agreements that do not lead to supplies for tax purposes are not regarded on their own as business
agreements for the purposes of these Guidelines.
b. It is recognised, however, that on occasion supplies may occur without a mutual understanding, e.g.a
court order that imposes obligations on one or more parties. In such cases the imposed agreement
should nevertheless be considered as a business agreement.
3.13. The term business agreement has been adopted for the purpose of these Guidelines
because it is a general concept, rather than a term with a technical meaning, and it is not
specific to any individual jurisdiction. In particular, it is not restricted to a contract (whether
written or in some other format) and is therefore wide in its application, as explained below.
3.14. In order to determine the place of taxation under the general rule, it is necessary to
demonstrate the nature of the supply as well as the identity of the supplier and the customer.
3.15. In many cases, particularly those involving significant sums of money or complex
matters beyond a straightforward supply, it is likely that the parties to a business agreement
will draw up legally enforceable contracts. These contracts will normally specify the parties to
the business agreement and set out their respective rights and obligations. However, contracts
in themselves should not be seen as the only relevant elements of a business agreement.
3.16. Other relevant elements of the business agreement come in many forms and include,
for example, general correspondence, purchase orders, invoices, payment instruments
and receipts. Legislation and business practices in jurisdictions invariably differ and
generally not for tax reasons. They may differ with respect to national laws concerning

contract issues and other commercial requirements. They may also differ between different
industry sectors. It is, therefore, neither possible nor desirable to draw up a prescriptive
or exhaustive list of items that must be present in a business agreement. Rather, these
Guidelines suggest sources of information that would help both tax administrations and
business.
3.17. A business agreement need not be confined to written material. In certain sectors,
relevant elements may be found in the form of audio recordings of telephone conversations
leading to conclusions of agreements to supply or receive services and/or intangibles.
Relevant elements of a business agreement may also be found in electronic form such as
e-mails and on-line ordering records, payment and similar material and formats that are
likely to emerge as new technologies develop.
3.18. It is recognised that business agreements are often not concluded in isolation.
Consequently other agreements, including those not regarded as business agreements
(e.g.agreements that do not involve a supply4), may provide the context of the supplies
made under a particular business agreement. These other agreements may therefore form
a part of the relevant elements of that business agreement.
3.19. In the light of the previous paragraphs, the business agreement in force at the time
the supply is made is the agreement that governs the implementation of the general rule.
3.20. To ease burdens in practice for both tax administrations and business, it is
recommended that jurisdictions take into account the application of Guidelines3.2 and 3.3 in
a way that is consistent with the previous paragraphs. Wherever possible, tax administrations
are encouraged to communicate these approaches and relevant national laws as clearly and
as widely as possible.
B.2. Applying the general rule Supply of a service or intangible to a legal

entity with single location (single location entity SLE)
3.21. In principle, applying the general rule for business-to-business supplies to legal entities5
with a single location (single location entities SLEs) is relatively straightforward. The
Commentary under SectionB.4 provides further practical guidance.
B.3. Applying the general rule Supply of a service or intangible to a legal

entity with multiple locations (multiple location entity MLE)
3.22. When a supply is made to a legal entity that has establishments6 in more than one
jurisdiction (a multiple location entity, MLE), an analysis is required to determine
which of the jurisdictions where this MLE has establishments has taxing rights over the
service or intangible acquired by the MLE.
3.23. In such a case, jurisdictions are encouraged to apply an approach that would ensure
that taxation accrues to the jurisdiction where the customers establishment using the
service or intangible is located.
Guideline3.4
For the application of Guideline3.2, when the customer has establishments in
more than one jurisdiction, the taxing rights accrue to the jurisdiction(s) where
the establishment(s) using the service or intangible is (are) located.
3.24. Use of a service or intangible7 in this context refers to the use of a service or
intangible by a business for the purpose of its business operations. It is irrelevant whether
this use is immediate, continuous, directly linked to an output transaction or supports the
business operations in general.
3.25. A number of possible approaches are currently adopted by jurisdictions to identify
which customers establishment is regarded as using a service or intangible and where this
establishment is located. The following broad categories of approaches can be distinguished:
Direct use approach, which focuses directly on the establishment that uses the
service or intangible.
Direct delivery approach, which focuses on the establishment to which the service
or intangible is delivered.
Recharge method, which focuses on the establishment that uses the service or
intangible as determined on the basis of internal recharge arrangements within
the MLE, made in accordance with corporate tax, accounting or other regulatory
requirements.
3.26. Each of the approaches described above seeks to ensure that taxation of the supply
of a service or intangible to a MLE accrues to the jurisdiction where the customers
establishment that is regarded as using the service or intangibles is located. It is likely that
each of these approaches will have its merits in particular circumstances. The principle
behind any approach should be to achieve a sound balance between the interests of business
(both suppliers and customers) and tax administrations.
B.3.1. Direct use

3.27. Under this approach, taxing rights for the supply of a service or intangible to a MLE
are directly allocated to the jurisdiction of the customers establishment that is regarded as
using this service or intangible.
3.28. This approach may be particularly effective in circumstances where there is obvious
use by an establishment of the customer MLE. It is then relatively straightforward for the
supplier and customer to ensure that this is reflected properly in the business agreement.
In these circumstances, both the supplier and the customer would have the necessary
information to support a proper tax treatment at the time of the supply and the business
agreement would provide an appropriate audit trail to the tax authorities.
3.29. This approach may be more difficult in circumstances where the supplier does
not know, and perhaps cannot know, which customer establishment uses the supply or in
circumstances where the actual use is not known with certainty at the time of the business
agreement. This approach also may not deal adequately with cases where the service or
intangible is used by different establishments in different jurisdictions (multiple use). In
such cases this approach may create considerable compliance difficulties for suppliers and
customers and may affect the efficiency of tax administration and collection.
B.3.2. Direct delivery

3.30. Under this approach, taxing rights for the supply of a service or intangible to a
MLE are directly allocated to the jurisdiction of the customers establishment to which the
supplier delivers the service or intangible.

3.31. The direct delivery approach may provide an effective solution for supplies of
services or intangibles that are likely to be used at the location of the establishment to
which they are delivered (physically supplied, such as catering or on-the-spot training).
In such cases both the supplier and customer are likely to know the location of the
establishment of direct delivery at the time of the supply and are likely to reflect this in
the business agreement. The supplier and the customer would therefore have the necessary
information to support a proper tax treatment at the time of the supply and the business
agreement would provide an appropriate audit trail to the tax authorities.
B.3.3. Recharge method

3.32. This approach requires MLEs to internally recharge the cost of an externally
acquired service or intangible to their establishments that use this service or intangible, as
supported by internal recharge arrangements. Under the recharge method, these internal
recharges are used as a basis for allocating the taxing rights over the external service
or intangible to the jurisdiction where the MLEs establishment using this service or
intangible is located. Further information and guidance on this approach is to be found in
the Commentary under SectionB.5 below.
3.33. This approach may be useful in cases where a service or intangible supplied by an
external supplier to a MLE is acquired by one establishment of this MLE for use wholly
or partially by other establishments located in different jurisdictions (multiple use). It is
common practice for multinational businesses to arrange for a wide scope of services, such
as administrative, technical, financial and commercial services, to be acquired centrally to
realise economies of scale. Typically, the cost of acquiring such a service or intangible is
then initially borne by the establishment that has acquired the service or intangible and, in
line with normal business practice, is subsequently recharged to the establishments using
the service or intangible. The establishments are charged for their share of the service or
intangible on the basis of the internal recharge arrangements, in accordance with corporate
tax, accounting and other regulatory requirements.
3.34. It may be difficult, if not impossible, for a supplier in such a multiple-use scenario
to know which establishments of a MLE will actually use the service or intangible supplied
to this MLE and to ensure a correct VAT treatment in accordance with the location of
these establishments of use (see paragraph3.29 above). Even if the supplier knew where
the service or intangible supplied to a MLE were used, it could be challenging, particularly
in a multiple-use scenario, to implement and administer a system whereby the suppliers
taxing decision depends on the location of the establishments of use.
3.35. The recharge method could offer an effective solution for identifying the place of
taxation of the supply of a service or intangible to a MLE, particularly in multiple-use
scenarios. Under this approach, the supplier would rely on the business agreement with the
MLE to support the proper VAT treatment of the supply to the MLE. It would be for the
customer MLE to ensure the correct VAT treatment of this service or intangible, based on
the internal allocation of the cost to its establishments using this service or intangible. This
would build on existing business processes and information that will generally already be
available for accounting, tax or other regulatory purposes, and would therefore not create
undue compliance burdens. These processes and information should also facilitate the
production of appropriate and reliable audit trails for tax authorities.
3.36. Jurisdictions that consider implementing the recharge method may need to address
a number of potentially complex aspects of this method. These include questions regarding
the scope of this method, acceptable methods for the proper allocation of taxable amounts
to the establishment(s) of use and the timing of the recharges, the impact of internal
recharges on the right to deduct input VAT and questions about documentation requirements
and the process to account for any tax due on internal recharges. Jurisdictions may also
need to take account of tax administration concerns such as the additional number of
transactions that may have to be audited due to the internal recharges. Jurisdictions that
consider implementing this recharge method are encouraged to take these concerns into
careful consideration and to provide clear guidance on the operation of this method. The
Commentary under SectionB.5 below looks at a number of these aspects in further detail.
B.3.4. Conclusion
3.37. Each of the approaches described above seeks to ensure that taxation of the supply
of a service or intangible to a MLE accrues to the jurisdiction where the customers
establishment(s) using the service or intangible is (are) located. These Guidelines do not
aim to set out which approach should be preferred or to rule out alternatives: each approach
is likely to have specific merits in particular circumstances. These approaches are not
mutually exclusive and could be combined according to the information that is available to
the supplier and the customer. It is for jurisdictions to adopt the approach or approaches that
they consider appropriate, taking into account their legal and administrative framework and
practices.
3.38. Any approach should, in principle:
seek to ensure that taxation of the supply of a service or intangible to a MLE accrues
to the jurisdiction(s) where the customers establishment(s) regarded as using the
service or intangible is (are) located; and
achieve a sound balance between the interests of business (both suppliers and
customers) and tax administrations.
3.39. Jurisdictions are encouraged to seek the right balance between the objectives of
protecting tax revenue and of keeping compliance and administrative costs as low as
possible, while minimising distortions of competition. Jurisdictions are also encouraged to
provide clear, accessible and dependable information to increase certainty and to ensure
the correct VAT treatment of the supply of a service or intangible to a MLE, both by the
supplier and by the customer.
3.40. The key objective of these Guidelines is to help reduce uncertainty and risks
of double taxation and unintended non-taxation resulting from inconsistencies in the
application of VAT to international trade. Jurisdictions are therefore encouraged to adopt
an approach that minimises the potential for double taxation or unintended non-taxation.
The more jurisdictions adopt the same approach, the greater the reduction in complexity,
uncertainty and risks of double taxation and unintended non-taxation.
B.4. Commentary on applying the general rule Supply of a service or

intangible to a legal entity with single location (single location entity
SLE)
3.41. For the purposes of this section, the businesses to which the general rule applies
are assumed to be separate legal entities, whether related by common ownership or not.
These legal entities are located solely in their respective jurisdictions and have no business
presence elsewhere.

3.42. Under the general rule for business-to-business supplies, the place of the customers
location serves as a proxy for the jurisdiction of business use. The result of applying this
general rule is that the jurisdiction where the customer is located has the taxing rights over
services and intangibles supplied across international borders.
3.43. In order to support a satisfactory application of the general rule to single location
entities, this section considers its application from the perspectives of the supplier,
customer and tax administrations. Examples1 and 2 in the Annex1 to this chapter provide
relatively straightforward illustrations of how this general rule operates. Examples3, 4
and 5 in the Annex1 illustrate how this general rule is applied in more complex situations.
B.4.1. Supplies to single location entities Supplier

3.44. In a business-to-business environment, it is reasonable to assume that suppliers will
normally have developed a relationship with their customers. This will be particularly so in
cases where supplies of services or intangibles are made on an on-going basis or in cases
where one supply is made and the value of that supply is significant enough to warrant the
development of business agreements such as contracts.
3.45. The principal effect of the general rule on suppliers is that they need to identify and
be able to demonstrate who their customer is in order to make the supply free of VAT in
their jurisdiction if the customer is located outside the suppliers jurisdiction. Once satisfied
that the customer is a business and is located in another jurisdiction, the supplier makes
that supply free of VAT in its jurisdiction as, under the general rule, the taxing rights over
that supply are in the jurisdiction of the customers location.
3.46. In many cases this will be straightforward and can be determined by reference to
the business agreement. The nature of the service or intangible being supplied and the
wording used in any supporting documentation may also contribute to verification of the
international and business nature of the supply.
3.47. To avoid unnecessary burdens on suppliers, it is recommended that the customer be
liable to account for any tax due. This can be achieved through the reverse charge mechanism
(sometimes referred to as tax shift or self-assessment) where that is consistent with the
overall design of the national consumption tax system.8 Accordingly, the supplier should then
not be required to be identified for VAT or account for tax in the customers jurisdiction.
3.48. The general rule applies in any situation where the supplier and customer are
separate legal entities irrespective of whether they are related through any form of common
ownership, management or control.
3.49. The application of the general rule will not be affected by the circumstance that
the supplier (i)supplies a customer who supplies onwards the services or intangibles to a
third party,9 or (ii)directly provides the services or intangibles to a third party that is not
the customer under the business agreement or (iii)is paid by a third party that is not the
customer under the business agreement. This is explained in further detail in the following
paragraphs.
B.4.1.1. The determination of the place of taxation is not affected by any onward
supply
3.50. It is common for multinational businesses to centralise certain procurement activities
in one jurisdiction in order to obtain the economic benefits of single large agreements as
opposed to multiple lower value agreements. These are generally referred to as global
agreements. The central procurement company then supplies onwards the supplies or parts
of the supplies to the various related businesses around the world.
3.51. The onward supply of those services to related businesses will be covered by separate
business agreements entered into between the central procurement company and each of
the related businesses. If the related businesses are the customers under those business
agreements, the taxing rights over these onward supplies will be in the jurisdictions where
these related businesses are located, in accordance with the general rule. If these jurisdictions
operate a reverse charge mechanism, these related businesses will be liable to account for any
VAT at the rate applicable in their jurisdictions.
3.52. The procurement company may well supply a business located in the same
jurisdiction as the original supplier (see Annex1 to this chapter Example3). When one
applies the general rule, the place of taxation should be decided for each supply individually
so that the determination of the place of taxation of services or intangibles for VAT purposes
will not be affected by any subsequent supply or lack of such supply. The supplier should
accordingly determine the identity of the customer by reference to the relevant business
agreement. Where the customer is located in another jurisdiction, the supplier is entitled to
make the supply free of VAT. As long as there is no evasion or avoidance, the fact that the
customer subsequently supplies the services or intangibles onwards to a third party business
is not, in itself, relevant, even where the third party business is located in the jurisdiction of
the supplier.
B.4.1.2. The determination of the place of taxation is not affected by the direct
provision of the services or intangibles to a third party business other than the
customer of the supply
3.53. The supplier may also be required under the terms of the business agreement to
provide services or intangibles directly to a third party (see Annex1 to this chapter
Example3). As long as there is no evasion or avoidance, the customer remains the customer
identified in the business agreement and it is this customers location that determines the
place of taxation. The mere direct provision of the supply to a third party business does not,
in itself, affect that outcome. Accordingly, the general rule should be applied in such a way
that the supplier makes a supply free of VAT to a foreign customer even if the third party
business is located in the same jurisdiction as the supplier.
B.4.1.3. The determination of the place of taxation is not affected by the direction
of the payment flows and the identity and location of the payer
3.54. Particular care may be required where payment flows differ from the flows of
services or intangibles. Typically, a customer pays a supplier for services or intangibles
supplied under a business agreement. However, there may be circumstances where another
party may pay for that supply. For instance, it is common for multinational groups of
businesses to reduce costs by appointing a company within a group to be the paymaster10
responsible for payments under the relevant agreement to pay for services and intangibles
acquired. In such cases, services or intangibles supplied by the supplier or the suppliers
foreign subsidiaries to foreign customers may be paid for by the customers parent
business located in the suppliers jurisdiction, although the supplies may not be made to
the parent business (See Annex1 to this chapter Example5). When the general rule is
applied, the place of taxation should be decided for each supply individually. The direction
of the payment flows and the identity and location of the payer are not, in themselves,
relevant. The payment flows are consideration for the supplies under the relevant business

agreements but do not, in themselves, create additional supplies, alter the supplies, nor
identify the customer or customer location. Accordingly, the supplier makes the supply to
the customer identified in the relevant business agreement and the place of taxation is that
customers location. As long as there is no evasion or avoidance, the supplier is therefore
entitled to make a supply free of VAT to a foreign customer even if that supply is paid by a
third party business located in the same jurisdiction as the supplier.
B.4.2. Supplies to single location entities Customer

3.55. It is recommended that the customer be liable to account for any tax due under the
reverse charge mechanism where that is consistent with the overall design of the national
consumption tax system. Under this procedure, the customer is typically required to
declare the VAT due on the supply received from the foreign supplier as output tax on
the relevant VAT return. The rate to be applied is the rate applicable in the customers
jurisdiction. The customer is then entitled to input tax deduction to the extent allowed
under the rules of its jurisdiction.
3.56. If the customer is entitled to full input tax deduction on the relevant supply, it may
be that local VAT legislation does not require declaration of the output tax under the reverse
charge mechanism. This is an option provided in some jurisdictions and businesses in this
position should ensure that they are aware of their jurisdictions requirements in this respect.
Similarly, some jurisdictions may employ a type of VAT that does not require application of
a reverse charge as it would not suit the nature of the tax as applied. Businesses importing
services and intangibles from a foreign supplier should ensure that they are familiar with
their domestic legislation and administrative practices.
3.57. The customer is obliged to pay any tax due on the supply under the reverse charge
mechanism where that is consistent with the overall design of the national consumption
tax system. The customer is liable to pay even where (i)the customer supplies onwards
the services or intangibles to a third party (ii)the services or intangibles are not directly
provided to the customer or (iii)the customer does not pay for the supply. This is explained
in further detail in the following paragraphs.
supply
3.58. As stated in paragraph3.50, it may be that the customer supplies onwards the
services or intangibles from the foreign supplier as separate supplies (e.g.within a global
agreement). As long as there is no evasion or avoidance, the place of taxation for these
supplies should be decided for each supply individually and the original international
supply is not affected (see Annex1 to this chapter Example3). The general rule continues
to apply. It is likely that the customer when supplying onwards the supplies or parts of
the supplies to related businesses will have entered into business agreements with those
businesses. If the related businesses are the customers under those business agreements,
the taxing rights over these onward supplies will be in the jurisdictions where these related
businesses are located, in accordance with the general rule. If these jurisdictions operate a
reverse charge mechanism, these related businesses will be liable to account for any VAT
at the rate applicable in their jurisdictions.
3.59. As described in paragraph3.53, the customer may, under the terms of the relevant
business agreement, require that the services or intangibles be provided directly to a third
party. Even if that third party is located in a different jurisdiction from that of the customer
identified in the business agreement, the place of taxation remains in the jurisdiction where
the customer identified in the business agreement is located. If this jurisdiction operates
a reverse charge mechanism, this customer identified in the business agreement will be
liable to account for any VAT at the rate applicable in its jurisdiction (see Annex1 to this
chapter Example3).
3.60. As described in paragraph3.54, multinational business groups may appoint a
group member to act as paymaster for services or intangibles supplied to the group (i.e.a
paymaster agreement). Consequently, the customer is not the party who pays the supplier
for the supply under the business agreement. In such situations the direction of the payment
flows and the identity and location of the payer are not, in themselves, relevant. The supply
is to the customer identified in the relevant business agreement and the place of taxation is
that customers location (see Annex1 to this chapter Example5).
B.4.3. Supplies to single location entities Tax administrations

3.61. The growth in international supplies of services and intangibles has led to increased
complexity for tax administrations as well as for businesses. The intangible nature of many
services is such that the comparative simplicity for goods (exports relieved, imports taxed)
cannot be replicated with respect to services and intangibles. It is, therefore, important that
tax administrations make it clear to both businesses and to staff responsible for carrying
out compliance checks and audits what the rules are in their own jurisdiction and that they
should be applied according to the facts of each individual supply.
3.62. Under the general rule supplies of services and intangibles are subject to tax
according to the rules of the jurisdiction where the customer is located. This means that a
supplier of international business-to-business services and intangibles makes such supplies
free of VAT in its jurisdiction. The tax administration of the supplier may require the
supplier to produce evidence that the customer is a business and that this business is located
in another jurisdiction. To minimise compliance burdens on the supplier, tax administrations
are encouraged to provide businesses with clear guidance on the evidence they require.
3.63. It is recommended that the customer be liable to account for any VAT due to its
local tax administration under the reverse charge mechanism where that is consistent
with the overall design of the national consumption tax system. Tax administrations are
encouraged to make businesses aware of the need to account for any tax on imported
services and intangibles from their suppliers in other jurisdictions. The normal domestic
rate applicable to the nature of the services or intangibles involved should be applied. If
the customer is entitled to full input tax credit in respect of this supply, it may be that local
VAT legislation does not require the reverse charge to be declared on the local VAT return.
In such cases tax administrations are encouraged to publicise this to business. Jurisdictions

that require this declaration are likewise encouraged to make it clear that tax is required to
be accounted for in this way.11
3.64. The reverse charge mechanism has a number of advantages. First, the tax authority
in the jurisdiction of business use can verify and ensure compliance since that authority has
personal jurisdiction over the customer. Second, the compliance burden is largely shifted
from the supplier to the customer and is minimised since the customer has full access
to the details of the supply. Third, the administrative costs for the tax authority are also
lower because the supplier is not required to comply with tax obligations in the customers
jurisdiction (e.g.VAT identification, audits, which would otherwise have to be administered,
and translation and language barriers). Finally, it reduces the revenue risks associated with
the collection of tax by non-resident suppliers, whether or not that suppliers customers are
entitled to deduct the input tax.
3.65. The determination of the place of taxation of services or intangibles for VAT
purposes should be decided for each supply individually. As long as there is no evasion or
avoidance, it will, therefore, not be affected by (i)any subsequent onward supply or lack of
such supply, (ii)the direct provision of the services or intangibles to a third party business
other than the customer or (iii)by the direction of the payment flows and the identity and
location of the payer. This is explained in further detail in the following paragraphs.
supply
3.66. As stated in paragraphs3.50 and 3.58, businesses with related separate legal entities in
other jurisdictions may supply onwards the services or intangibles they have bought in within
a global agreement from foreign to other related companies. These supplies should be
subject to the normal VAT rules, including the general rule in respect of international services
and intangibles (see Annex1 to this chapter Example3). Accordingly, it is recommended
that:
the tax administration in the suppliers jurisdiction allow the supplier to make
a supply free of VAT, providing the supplier can identify the customer and
demonstrate that the customer is located abroad
the tax administration in the customers jurisdiction ensures that the customer
accounts for any tax due on the supply from the foreign supplier, using the reverse
charge mechanism where that is consistent with the overall design of the national
consumption tax system.
3.67. As stated in paragraphs3.53 and 3.59, even if some or all of the services or
intangibles are not directly provided in the jurisdiction of the customer but rather are directly
provided in another jurisdiction such as, for instance, the jurisdiction of the supplier or of
a third party business, the general rule continues to apply (see Annex1 to this chapter
Example3). The customers jurisdiction remains the jurisdiction with the taxing rights. For
example, an accountancy firm may have entered into a business agreement with a customer
located in another jurisdiction but may perform much of the work in its own jurisdiction and
also provide its services directly to a third party business. As long as there is no evasion or
avoidance, this does not, in itself, prevent the place of taxation from being the customers
location. Accordingly it is recommended that:
the tax administration in the suppliers jurisdiction does not seek tax from the
supplier based entirely on the fact that the supplier is directly providing the services
or intangibles there, but allows it to make a supply free of VAT to the foreign
customer identified in the business agreement
charge mechanism, even if the services or intangibles were directly provided by a
local third party business.
3.68. Paragraphs3.54 and 3.60 recognise that there may be situations where another party
pays for the supply to the customer in the business agreement (see Annex1 to this chapter
Example5). That third party business is usually referred to in multinational groups as
the group paymaster and may not be supplied with any services or intangibles itself.
Regardless of where that third party business is located, the services or intangibles are
supplied to the customer identified in the relevant business agreement and the taxing rights
belong to the jurisdiction in which that customer is located. Accordingly it is recommended
that:
the tax administration in the suppliers jurisdiction does not seek tax from the
supplier based entirely on the fact that the paymaster third party business is
located there, but allows it to make the supply free of VAT to the foreign customer
identified in the business agreement
charge mechanism, even if the supply is paid for by a third party business.
3.69. The foregoing approach leads to a logical result because supplies are subject to
tax in the jurisdiction in which the services or intangibles are used by the business in
accordance with the destination principle as implemented by the general rule and there is
neither double taxation nor unintended non-taxation in any of the jurisdictions involved.
3.70. Annex1 to this chapter provides examples of how the general rule on place of
taxation for business-to-business supplies of services and intangibles to single location
entities, can be applied in practice.
B.5. Commentary on applying the recharge method under the general rule
Supply of a service or intangible to a legal entity with multiple locations
(multiple location entity MLE)
3.71. Guideline3.4 recommends that taxing rights over a supply of a service or intangible
to a MLE accrue to the jurisdiction(s) where the establishment(s) using the service or
intangible is (are) located. It is recognised that a number of possible approaches could be
used to identify which establishment of the customer MLE is regarded as using a service
or intangible and where this establishment is located. The following broad categories of
approaches can be distinguished:

direct use approach, which focuses directly on the establishment that uses the service
or intangible
direct delivery approach, which focuses on the establishment to which the service
or intangible is delivered
recharge method, which focuses on the establishment that uses the service or
intangible as determined on the basis of internal recharge arrangements within
the MLE, made in accordance with corporate tax, accounting or other regulatory
requirements.
3.72. Paragraphs3.25 to 3.40 provide a broad description of these approaches and their
possible use in practice. This Commentary looks in further detail at the recharge method,
as tax administrations may be less familiar with the possible operation of this method than
with other approaches.
3.73. The recharge method requires MLEs to internally recharge the costs of externally
acquired services or intangibles to their establishments that use these services or intangibles,
as supported by internal recharge arrangements. Under the recharge method, these internal
recharges are used as a basis for allocating the taxing rights over such services or intangibles
to the jurisdiction(s) where the establishment(s) using this service or intangible is (are)
located.
3.74. This can be achieved by following a two-step approach:
The first step follows the business agreement between the external supplier and the
MLE. The taxing rights over the supply to the MLE are allocated to the jurisdiction
of the customer establishment that represents the MLE in the business agreement
with the supplier.
The second step is required when the service or intangible is used wholly or partially
by one or more other establishments than the establishment that has represented
the MLE in the business agreement with the supplier. This second step follows the
internal recharge made by the MLE for allocating the external cost of the service or
intangible to the establishment, or establishments, using this service or intangible.
This internal recharge is used as the basis for allocating the taxing rights over the
service or intangible to the jurisdiction where these establishment(s) of use is (are)
located, by treating this internal recharge of the externally acquired service or
intangible as within the scope of VAT.
3.75. The following sections consider the application of the recharge method from the
perspectives of the supplier, customer and tax administrations. Annex2 to this chapter
provides an example of how the recharge method could be applied in practice.
B.5.1. First step Supply to the MLE

B.5.1.1. Supplier
3.76. As is the case for any supply, the supplier will need to identify and be able to
demonstrate who the customer is and where this customer is located in order to determine
where the taxing rights will accrue.
3.77. Under the first step of the recharge method, the taxing rights are allocated to the
jurisdiction of the establishment that represents the MLE in the business agreement with
the supplier. The various elements of the business agreement with the supplier should
identify this establishment and where it is located. Once satisfied that this establishment is
located in a jurisdiction other than the suppliers, the supplier will be entitled to make the
supply free of VAT in its jurisdiction.
B.5.1.2. Customer
3.78. Where the customers establishment that has represented the MLE in the business
agreement is located in a jurisdiction other than the suppliers, it is recommended that this
establishment be liable for any tax due on the transaction. This can be achieved through
the reverse charge mechanism (also referred to as tax shift or self-assessment) where
this is consistent with the overall design of the national consumption tax system. Under
this procedure, this customers establishment will typically be required to declare the tax
due on the supply received from the foreign supplier as output tax on the relevant VAT
return. The rate to be applied will be the normal domestic rate applicable to the nature of
the service or intangible in the jurisdiction of the customers establishment. The customers
establishment that makes the recharge will deduct the related input tax in line with the
normal rules that ensure VAT neutrality.
3.79. If the customer establishment that has represented the MLE in the business
agreement is entitled to full input tax credit in respect of this supply, it may be that local
VAT legislation does not require the reverse charge to be made.
B.5.1.3. Tax administrations

3.80. The tax administration in the jurisdiction of the supplier will need to know the
nature of the supply as well as the identity of the customer and the jurisdiction in which
the customer is located. Where the service or intangible is supplied to a business located in
another jurisdiction, this supply will be made free of VAT in the jurisdiction of the supplier.
The supplier will therefore need to hold all the relevant information that constitutes the
business agreement to demonstrate the nature of the supply and the identity of the customer.
Where this customer is a MLE, under the recharge method the business agreement will
need to provide evidence of the identity of the establishment that represents the MLE in
the business agreement and the location of this establishment. Tax administrations are
encouraged to provide businesses with clear guidance on the evidence they require.
3.81. The customers establishment that has represented the MLE in the business agreement
with the supplier will account for any VAT due to its local tax administration under the
reverse charge mechanism where that is consistent with the overall design of the national
consumption tax system. Tax administrations are encouraged to make businesses aware of
the need to account for any tax on imported services or intangibles from suppliers in other
jurisdictions, including if these services or intangibles are acquired by an establishment of a
MLE.
3.82. If the customers establishment is entitled to full input tax credit in respect of this
supply, it may be that local VAT legislation would not require the reverse charge to be
made. In such cases tax administrations are also encouraged to publicise this.
B.5.2. Second step Recharge to the establishment(s) of use

B.5.2.1. Supplier
3.83. The external supplier of the service or intangible to the MLE has no involvement in
the recharge of the service or intangible to the customers establishment of use. This is the
sole responsibility of the customer MLE.
B.5.2.2. Customer
3.84. The customers establishment that has entered into the business agreement with
the external supplier will either have acquired the service or intangible for its own use or
will have acquired it wholly or partially for use by other establishments of the customer
MLE. In the latter case, the customer establishment that has represented the MLE in the
business agreement with the external supplier is required to subsequently charge the other
establishment(s) of the MLE using the service or intangible. Under the recharge method,
this internal charge of the external service or intangible is treated as consideration for a
supply within the scope of VAT.
3.85. There will be no recharge if the service or intangible was acquired by an establishment
of the MLE for its own use.
3.86. Whether or not there will be a recharge for a service or intangible acquired by
an establishment of a MLE for use wholly or partially by another establishment of this
MLE in the same jurisdiction, will depend on the internal rules of this jurisdiction. This
Commentary deals only with cross-border supplies of services and intangibles.
3.87. As for any other supply, the establishment of recharge will need to identify and
be able to demonstrate which is the establishment of use and where this establishment is
located.
3.88. Under the recharge method, MLEs will need to have internal arrangements in place
to support and facilitate the internal charges between their different establishments. MLEs
and tax administrations will rely on these internal arrangements to provide them with the
information that would otherwise be covered by a business agreement. These internal
arrangements are hereafter referred to as recharge arrangements for the purpose of the
application of the recharge method.
3.89. The various elements of the recharge arrangement should facilitate the identification
of the establishment of recharge and the establishment(s) of use to which an internal
recharge is made and should provide sufficient information to evidence a consistent and
correct VAT treatment of the recharge.
3.90. This may be straightforward in many cases, particularly where MLEs have adopted
an arrangement where specific services or intangibles acquired externally are recharged as
such to the establishment of use. This may for instance be the case for large expenses that
can be isolated and charged to the establishment of use, for example in installing a new
computer system or performing a major upgrade. Such arrangements are of great practical
convenience, as they allow the service or intangible that is recharged as well as the basis
for the recharge to be clearly identified. MLEs are encouraged to adopt such arrangements
as much as possible for their internal recharges.
3.91. It is recognised however that it will not always be possible to adopt this approach
in practice. This may be the case, for instance, where a service or intangible is acquired
for use by multiple establishments and a separate recording of use by each of the
establishments would be disproportionately burdensome. This may occur where legal

services or marketing services are acquired centrally for several establishments of a MLE.
A detailed analysis of these services and their use by each of the establishments may be
difficult or overly burdensome in certain circumstances. In such cases, MLEs may find it
necessary to use cost allocation or apportionment methods that include a certain degree of
estimation or approximation of the actual use of the service by each establishment.
3.92. Tax administrations that implement the recharge method are encouraged to allow
such cost allocation or apportionment methods where the straightforward recharge for
specific services or intangibles would be disproportionately burdensome and to provide
businesses with clear guidance on the allocation or apportionment approaches that they
consider allowable.
3.93. Such cost allocation or apportionment methods (allocation keys) should be fair
and reasonable, in that they should produce recharges that are commensurate with the
reasonably expected use by the establishments of use, follow sound accounting principles
and contain safeguards against manipulation. Where possible, information that is already
available for accounting and tax and other regulatory purposes should be used. There is
no single solution that would be appropriate in all cases. What is fair and reasonable
depends not only on the type of service but also on the size and structure of a company,
the sector and the complexity of the business environment in which it operates. Whatever
allocation key is used, it should be capable of being justified and applied consistently
without creating undue compliance and administrative burden for businesses and tax
administrations.
3.94. Commonly used allocation keys include: number of employees, square meters
of office space, number of fleet cars, computer usage, advertising expenses, number of
accounting entries, number of invoices processed, etc. A clear, directly measurable allocation
key may not always be available, for example in relation to legal expenses, general systems
maintenance, etc. In such cases, it is not uncommon for costs to be allocated on the basis of
the respective size of the establishments.
3.95. It is important for the proper operation of the recharge method that the relationship
between the initial supply of the service or intangible to the MLE (first step) and the
onward recharge to the establishment(s) of use (second step) does not become obscured.
The objective of the recharge method is to ensure that taxing rights over supplies to an
MLE are effectively allocated to the jurisdiction where the establishment of use is located.
The MLE will therefore be expected to ensure that tax administrations can reasonably
establish the relationship between the initial supply and the recharge and that they can
notably establish the link between the price of the initial supply and the amount of the
recharge, without requiring a recharge on a transaction-by-transaction basis.
3.96. The establishment of recharge will be entitled to make the recharge free of VAT in
its jurisdiction on the basis of the information available in the recharge arrangement, as the
other establishment(s) will be located in other jurisdictions. The elements of the recharge
arrangement should demonstrate which establishment(s) is (are) using the service and its
(their) location in another jurisdiction. It is recommended that the establishment of recharge
issue a document equivalent to an invoice for the recharge to the establishment(s) of use.
3.97. To ensure VAT neutrality for the establishment that makes the recharge, general
input VAT deduction rules should apply for this establishment in respect of the input VAT
on the service or intangible received and subsequently recharged. The application of the
recharge method should not influence the MLEs right to input VAT deduction in respect
of purchases other than the service or intangible to which the recharge method is applied.

3.98. It is recommended that the establishment of use be liable for any tax due on the
recharge. This can be achieved through reverse charge mechanisms (also referred to as tax
shift or self-assessment) where this is consistent with the overall design of the national
consumption tax system. It may be that local VAT legislation does not require the reverse
charge to be made.
3.99. When a service or intangible is used wholly by an establishment other than the one
that represented the MLE in the business agreement, the taxable amount would in principle
be the amount of the recharge that corresponds to the purchase price of the service or
intangible.
3.100. Where the service or intangible is used by several establishments, the taxable
amount for each establishment would in principle be the part of the purchase price of the
service or intangible that is recharged to this establishment on the basis of an acceptable
apportionment or allocation approach.
3.101. The taxable amount should be evidenced by the recharge arrangement. The rate
to be applied would in principle be the normal domestic rate applicable to the nature of
the service or intangible in the jurisdiction of the customers establishment of use. This
customers establishment would then be entitled to deduct input tax to the extent allowed
under the rules of its jurisdiction.
3.102. Where the recharge of a service or intangible purchased from an external supplier
is bundled with an internal cost charge (e.g.salary expense of internally supplied services),
it is for the MLE to separate the cost of the externally purchased service or intangible from
the other costs and to evidence the internal character of these other costs if this would be
necessary to ensure that the recharge method is applied only on the cost of the externally
purchased service or intangible.
B.5.2.3. Tax administrations

3.103. Tax administrations are encouraged to provide clear guidance to businesses on
the operation of the recharge method, including its scope, the allocation or apportionment
approaches that they consider acceptable and the documentation requirements to support
this method, the input VAT deduction rules to ensure VAT neutrality for the establishment
that makes the recharge, the time of taxation rules to be applied to the internal recharge and
the process to account for any tax due on an internal recharge.
3.104. In line with normal audit policies, tax administrations will need an audit trail
that enables them, when necessary, to review commercial documentation down to the
transaction level in order to identifythe nature of the individual service that is recharged
and thus to determine whether the place of taxation, the taxable amount and the applicable
rate of tax are correct.
3.105. This documentation may include a copy of the original invoice from the external
supplier, the allocation method and allocation key used and any other documents or
electronic records that show how the VAT was calculated (e.g.distinction between recharge
of external costs and internal added value), the documentation from the establishment that
makes the recharge requesting payment (i.e.document equivalent to an invoice), accounting
entries and documentation supporting the payment by the establishment of use.
3.106. In cases where the separation of external costs from other costs within an internal
recharge would be necessary to ensure that the recharge method is applied only on the cost
of the externally purchased service or intangible, tax administrations may wish to allow
methods that include a certain degree of approximation, notably if a detailed separation

would be considered disproportionally burdensome (e.g.in view of the limited amounts
involved).
3.107. In addition, it will in principle also be necessary for auditors at the tax administration
in the jurisdiction of use to satisfy themselves that:
Any cross-border recharge of external costs between establishments has been
treated as within the scope of VAT.
Establishments have accounted for VAT correctly on any such recharge, including
where netting has taken place.12
The establishment of use has accounted for VAT as if a recharge arrangement were
in place, in cases where a service has been purchased by another establishment in
a different jurisdiction and the establishment of use has not been recharged even
though this recharge was required.
3.108. Where possible, tax administrations should use information that is already
available for accounting or tax and other regulatory purposes, to avoid creation of new
methodologies and processes purely for VAT purposes.
3.109. It is recommended that any tax due on the internal recharge of a service or intangible
purchased from an external supplier be accounted for by the MLEs establishment of use.
This can be achieved through reverse charge mechanisms where this is consistent with the
overall design of the national consumption tax system. However, it is recognised that local
VAT legislation may not require the reverse charge to be made if the establishment of use is
entitled to full input tax credit in respect of this supply. In such cases, the tax administration
is encouraged to publicise this. Jurisdictions that do require a reverse charge to be made are
likewise recommended to make this clear.
C. Business-to-consumer supplies The general rules

C.1. Introduction
3.110. It is theoretically more straightforward in the business-to-consumer13 context than
in the business-to-business context to implement the destination principle, as set out in
Guideline3.1, to ensure that tax on services and intangibles is ultimately levied only in the
jurisdiction where the final consumption occurs. In the business-to-business context, the
place of taxation rules should facilitate the ultimate goal of taxing business-to-consumer
supplies in the jurisdiction where final consumption occurs, while at the same time
ensuring that the burden of the tax does not rest on either business, unless intentionally
provided by legislation (see Guideline2.1 on VAT neutrality in international trade;
Chapter2 of the International VAT/GST Guidelines). In the business-to-consumer context,
the objective is simply to tax the final consumption in the jurisdiction where it occurs with
the tax burden resting on the final consumer. Accordingly, the primary objective for place
of taxation rules in the business-to-consumer context is to predict with reasonable accuracy
the place where the services or intangibles are likely to be consumed while taking into
account practical constraints, and ideally such place of taxation rules should be simple and
practical for taxpayers to apply, for customers to understand and for tax administrations
to administer.
3.111. Achieving this objective for business-to-consumer supplies of services was reasonably
easy in the past, when consumers typically purchased services from local suppliers and

those supplies generally involved services that could be expected to be consumed in the
jurisdiction where they were performed.14 Consequently, some jurisdictions chose to
implement VAT systems that determined the place of taxation for such services primarily
by reference to the suppliers location, on the assumption that this was where these
services were normally performed and where final consumers were actually located when
consuming the service. A place of taxation rule based on the suppliers location was often
supplemented by a place of taxation rule based on place of performance or other proxies,
for cases in which the suppliers location was a less reliable indicator of the location where
services were likely to be consumed (e.g.entertainment or sporting events). Over time, a
range of services developed for which the suppliers location or the place of performance
was used less often to determine the place of taxation and as a consequence the applicability
of other rules increased, notably referring to the customers location. At the same time, VAT
systems were implemented in certain jurisdictions that determined the place of taxation
using an iterative application of multiple proxies, and such jurisdictions often favoured the
customers location as the key proxy for determining the place of taxation for both businessto-business and business-to-consumer supplies. Still other jurisdictions used a very broad
place of effective consumption rule to determine the place of taxation. As a result of these
different approaches, there was a lack of consistency and clarity about which jurisdiction
should have the right to tax particular supplies of services and intangibles.
3.112. The emergence of the global economy, with its growing reliance on digital supplies,
created further challenges for these traditional approaches to determining the place of
taxation for business-to-consumer supplies of services and intangibles. Advances in
technology and trade liberalisation increasingly enabled businesses to supply services
and intangibles to customers around the world, leading to a strong growth in international
business-to-consumer trade in remotely supplied services and intangibles. These
developments created challenges for VAT systems that used a proxy based on the suppliers
location or the place of performance to determine the place of taxation. Where services or
intangibles can be supplied remotely to customers who may be located anywhere in the
world when they consume the service or intangible, the suppliers location and the place
of performance are less likely to accurately predict the likely place of consumption. Place
of taxation rules based on those proxies are thus unlikely to lead to an appropriate result.
Moreover, often the actual place of performance might be unclear. For example, a technician
in one country might take control of a computer in another country to resolve an issue using
key strokes performed thousands of kilometres from the computer, using information and
communication infrastructure located in a number of different jurisdictions. In such a case,
it could be difficult to reach a consistent conclusion on whether the place of performance is
where the technician is, where the computer is or somewhere in between.
3.113. For supplies of services and intangibles whose consumption bears no necessary
relationship to the location in which the supply is performed and in which the person
performing the supply is located, a rule based on the customers usual residence is
the most appropriate approach for determining the place of taxation in a business-toconsumer context. The place in which customers have their usual residence is used by
VAT systems around the world as a proxy for predicting the place of consumption of many
types of services and intangibles supplied to final consumers. This approach reflects
the presumption that final consumers ordinarily consume services and intangibles in
the jurisdiction where they have their usual residence and it provides a clear connection
to a readily identifiable place. It ensures that the services and intangibles acquired by
final consumers from foreign suppliers are taxed on the same basis and at the same
rate as domestic supplies, in accordance with Guideline2.4 on VAT neutrality in
international trade (see Chapter2 of the International VAT/GST Guidelines). There is
therefore no tax advantage for final consumers in buying from low or no tax jurisdictions.
A place of taxation rule based on the customers usual residence is also reasonably
practical for suppliers to apply, provided that a simplified registration and compliance
regime is available (see SectionsC.3.2 and C.3.3). It is also reasonably practical for tax
administrations to administer, provided that it is supported by effective international
co-operation in tax administration and enforcement (see SectionC.3.4).
3.114. Against this background, two general rules are recommended for determining the
place of taxation for business-to-consumer supplies of services and intangibles:
for supplies that are physically performed at a readily identifiable place and that
are ordinarily consumed at the same time and place where they are physically
performed in the presence of both the person performing the supply and the person
consuming it (on-the-spot supplies), Guideline3.5 recommends a place of taxation
rule based on the place of performance
for supplies that are not covered by Guideline3.5, Guideline3.6 recommends a place
of taxation rule based on the customers usual residence.15
3.115. These general rules effectively result in the allocation of the taxing rights over
business-to-consumer supplies of services and intangibles to the jurisdiction where it can
reasonably be assumed that the final consumer is actually located when consuming the
supply. This is the place where the final consumer consumes the on-the-spot supply, or the
final consumers usual residence where he or she is presumed to consume a remotely supplied
service or intangible.
C.2. Business-to-consumer supplies On-the-spot supplies

3.116. The place of physical performance of the supply is the appropriate proxy to determine
the place of consumption for on-the-spot supplies of services and intangibles to final
consumers. For the purposes of these Guidelines, on-the-spot supplies are services and
intangibles that are normally physically performed at a readily identifiable place and are
ordinarily consumed at the same time and place where they are physically performed,
and that ordinarily require the presence of both the person performing the supply and the
person consuming it. As well as providing a reasonably accurate indication of the place of
consumption, a place of taxation rule based on the place of physical performance is simple
and practical for suppliers to apply and for tax administrations to administer.
Guideline3.5
For the application of Guideline3.1, the jurisdiction in which the supply is physically
performed has the taxing rights over business-to-consumer supplies of services and
intangibles that
are physically performed at a readily identifiable place, and
are ordinarily consumed at the same time as and at the same place where
they are physically performed, and
ordinarily require the physical presence of the person performing the supply
and the person consuming the service or intangible at the same time and
place where the supply of such a service or intangible is physically performed.

3.117. Guideline3.5 is aimed primarily at supplies that are typically consumed at an
identifiable place where they are performed, rather than supplies that can be provided
remotely or that can be consumed at a time and place other than the place of performance.
Examples include services physically performed on the person (e.g.hairdressing, massage,
beauty therapy, physiotherapy); accommodation; restaurant and catering services; entry to
cinema, theatre performances, trade fairs, museums, exhibitions, and parks; attendance at
sports competitions.16
3.118. The final consumption of these supplies ordinarily requires the physical presence
of both the person performing the supply, who is usually the supplier, and the person
consuming it. The application of Guideline3.5 thus results in the allocation of the taxing
rights to the jurisdiction where the final consumer is located when consuming the supply
and where the person performing the supply is located at the time of final consumption.
3.119. On-the-spot supplies can be acquired by businesses as well as by private consumers.
Jurisdictions could therefore adopt the approach that is recommended by Guideline3.5 for
business-to-consumer supplies, as a specific rule in the business-to-business context (see
paragraphs3.165-3.166). Such an approach would relieve suppliers of on-the-spot supplies,
which are often small or medium businesses, of the compliance burden of having to
distinguish between final consumers and businesses when making their taxing decision.17
C.3. Business-to-consumer supplies Supplies of services and intangibles

other than those covered by Guideline3.5
3.120. For supplies of services and intangibles that lack an obvious connection with a
readily identifiable place of physical performance and that are not ordinarily consumed at
the place where they are physically performed in the presence of the person performing
the supply and of the person consuming it, the place of physical performance generally
does not provide a good indication of the likely place of consumption. This includes, for
example, supplies of services and intangibles that are likely to be consumed at some time
other than the time of performance, or for which the consumption and/or performance are
likely to be ongoing, as well as services and intangibles that can easily be provided and
consumed remotely.
3.121. For such business-to-consumer supplies of services and intangibles, the place of usual
residence of the customer is a more appropriate proxy for the jurisdiction of consumption, as
it can be assumed that these types of services and intangibles will ordinarily be consumed in
the jurisdiction where the customer has his or her usual residence.
Guideline3.6
For the application of Guideline3.1, the jurisdiction in which the customer has its
usual residence has the taxing rights over business-to-consumer supplies of services
and intangibles other than those covered by Guideline3.5.
3.122. Examples of supplies of services and intangibles that are not covered by Guideline3.5
could include: consultancy, accountancy and legal services; financial and insurance services;
telecommunication and broadcasting services; online supplies of software and software
maintenance; online supplies of digital content (movies, TV shows, music, etc.); digital data
storage; and online gaming.
C.3.1. Determining the jurisdiction of the usual residence of the customer

3.123. The jurisdiction in which the customer of a business-to-consumer supply has its
usual residence is generally where the customer regularly lives or has established a home.
Such customers are not considered to have their usual residence in a jurisdiction where
they are only temporary, transitory visitors (e.g.as a tourist or as a participant to a training
course or a conference).
3.124. Suppliers should be able to rely on information that is known or that can reasonably
be known at the time when the tax treatment of the supply must be determined, thereby
taking into account the different types of supplies and the circumstances in which such
supplies are typically delivered.
3.125. The evidence available to suppliers about the jurisdiction in which the customer
has its usual residence is likely to depend on the business model, the type and value of
the supplies and on the suppliers delivery model. Particularly in e-commerce, where
activities often involve high volume, low-value supplies that rely on minimal interaction
and communication between the supplier and its customer, it will often be difficult to
determine the customers place of usual residence from an agreement. Jurisdictions should
provide clear and realistic guidance for suppliers on what is required to determine the place
of usual residence of their customers in a business-to-consumer context.
3.126. In the business-to-consumer context, jurisdictions are encouraged to permit suppliers
to rely, as much as possible, on information they routinely collect from their customers in
the course of their normal business activity, as long as such information provides reasonably
reliable evidence of the place of usual residence of their customers. In addition, jurisdictions
could consider adopting rules that, if they are satisfied that a business is following these
principles, this business should expect challenges only where there is misuse or abuse of
such evidence. Any guidance provided by the tax authorities will need to take account of
the law and practice in the relevant jurisdictions, including with regard to the protection of
personal privacy, while maintaining flexibility for businesses.
3.127. Generally, the information provided by the customer may be considered as important
evidence relevant to the determination of the jurisdiction of the customers usual residence.
This could include information collected within business processes (e.g.the ordering
process), such as jurisdiction and address, bank details (notably country of the bank
account), and credit card information. If needed jurisdictions may require that the reliability
of such information be further supported through appropriate indicia of residence. In some
cases, such indicia might be the only indication of the jurisdiction of the customers usual
residence. The available indicia will vary depending on the type of business or product
involved, and might include the contact telephone number, the Internet Protocol address18 of
the device used to download digital content or the customers trading history (which could,
for example, include information on the predominant place of consumption, language of
digital content supplied or billing address). These indicia are likely to evolve over time as
technology and business practices develop.
C.3.2. VAT collection in cases where the supplier is not located in the jurisdiction
of taxation
3.128. The correct charging, collection and remittance of VAT, and the associated reporting
obligations are traditionally the responsibility of suppliers. While requiring suppliers to
carry out these responsibilities is relatively straightforward in cases where the supplier
is located in the jurisdiction of taxation, the matter could be more complex in cases

where a business makes supplies that are taxable in a jurisdiction where it is not located.
According to the traditional approach, the non-resident supplier is required to register in
the jurisdiction of taxation and charge, collect and remit any tax due there. It is recognised,
however, that it can often be complex and burdensome for non-resident suppliers to comply
with such obligations in jurisdictions where they have no business presence, and equally
difficult for tax administrations to enforce and administer them.
3.129. For cross-border business-to-business supplies of services and intangibles that are
taxable in the jurisdiction where the customer is located in accordance with Guideline3.2,
these Guidelines recommend the implementation of a reverse charge mechanism to
minimise the administrative burden and complexity for non-resident suppliers, where this
is consistent with the overall design of the national VAT system. If the customer is entitled
to full input tax credit in respect of this supply, it may be that the local VAT legislation
does not require the reverse charge to be made. The reverse charge mechanism shifts the
liability to pay the tax from the supplier to the customer. Where only business-to-business
supplies are involved, the application of the reverse charge mechanism should relieve the
non-resident supplier of any requirement to be identified for VAT or to account for tax in
the jurisdiction of taxation.
3.130. The reverse charge mechanism does not offer an appropriate solution for collecting
VAT on business-to-consumer supplies of services and intangibles from non-resident
suppliers. The level of compliance with a reverse charge mechanism for business-toconsumer supplies is likely to be low, since private consumers have little incentive to
declare and pay the tax due, at least in the absence of meaningful sanctions for failing to
comply with such an obligation. Moreover, enforcing the collection of small amounts of
VAT from large numbers of private consumers is likely to involve considerable costs that
would outweigh the revenue involved.
3.131. Work carried out by the OECD and other international organisations, as well as
individual country experience, indicate that, at the present time, the most effective and
efficient approach to ensure the appropriate collection of VAT on cross-border businessto-consumer supplies is to require the non-resident supplier to register and account for the
VAT in the jurisdiction of taxation.
3.132. When implementing a registration-based collection mechanism for non-resident
suppliers, it is recommended that jurisdictions consider establishing a simplified registration
and compliance regime to facilitate compliance for non-resident suppliers. The highest
feasible levels of compliance by non-resident suppliers are likely to be achieved if compliance
obligations in the jurisdiction of taxation are limited to what is strictly necessary for the
effective collection of the tax. Appropriate simplification is particularly important to facilitate
compliance for businesses faced with obligations in multiple jurisdictions. Where traditional
registration and compliance procedures are complex, their application for non-resident
suppliers of business-to-consumer services and intangibles would risk creating barriers
that may lead to non-compliance or to certain suppliers declining to serve customers in
jurisdictions that impose such burdens.
3.133. A simplified registration and compliance regime for non-resident suppliers of
business-to-consumer services and intangibles would operate separately from the traditional
registration and compliance regime, without the same rights (e.g.input tax recovery) and
obligations (e.g.full reporting) as a traditional regime. Experience with such simplified
registration and compliance regimes has shown that they provide a practical and relatively
effective solution for securing VAT revenues on business-to-consumer supplies of services
and intangibles by non-resident suppliers, while minimising economic distortions and
preserving neutrality between resident and non-resident suppliers. Such mechanisms allow
tax administrations to capture a significant proportion of tax revenues associated with
supplies to final consumers within their jurisdiction while incurring relatively limited
administrative costs.
3.134. It is recognised that a proper balance needs to be struck between simplification
and the needs of tax administrations to safeguard the revenue. Tax administrations need
to ensure that the right amount of tax is collected and remitted from suppliers with which
they might have no jurisdictional relationship. Against this background, SectionC.3.3
below sets out the possible main features of a simplified registration and compliance
regime for non-resident suppliers of business-to-consumer services and intangibles,
balancing the need for simplification and the need of tax administrations to safeguard
the revenue. This is intended to assist taxing jurisdictions19 in evaluating and developing
their framework for collecting VAT on business-to-consumer supplies of services and
intangibles from non-resident suppliers with a view to increasing consistency among
compliance processes across jurisdictions. Greater consistency among country approaches
will further facilitate compliance, particularly by businesses that are faced with multijurisdictional obligations, reduce compliance costs and improve the effectiveness and
quality of compliance processes. For tax authorities, consistency is also likely to support
the effective international co-operation in tax administration and enforcement.
C.3.3. Main features of a simplified registration and compliance regime for nonresident suppliers
3.135. This section explores the key measures that taxing jurisdictions could take to
simplify the administrative and compliance process of a registration-based collection
regime for business-to-consumer supplies of services and intangibles by non-resident
suppliers.
3.136. This section is intended to assist jurisdictions in evaluating and developing their
framework for collecting VAT on business-to-consumer supplies of services and intangibles
by non-resident businesses and to suggest the possible main features of a simplified
registration and compliance regime. It also considers whether the scope of such a simplified
registration and compliance regime could be extended to cross-border business-to-business
supplies and recalls the proportionality principle as a guiding principle for the operation
of a registration-based collection mechanism for non-resident suppliers. It identifies the
possible simplification measures for each of the following core elements of a simplified
administrative and compliance regime:
Registration
Input tax recovery Refunds
Returns
Payments
Record keeping
Invoicing
Availability of information
Use of third-party service providers.

3.137. This section recognises the important role of technology for the simplification of
administration and compliance. Many tax administrations have taken steps to exploit the
use of technology to develop a range of electronic services to support their operations, in
particular those concerned with tax collection processes and the provision of basic services
to taxpayers. The reasons for this are fairly obvious: applied effectively, these technologies
can deliver considerable benefits both to tax administrations and taxpayers (e.g.lower
compliance and administrative costs and faster and more accessible services for taxpayers).
But the use of technology will be effective only if the core elements of the administrative
and compliance process are sufficiently clear and simple. This section therefore focuses
mainly on possible simplification of administrative and compliance procedures while
devoting less attention to technological features, recognising that these technologies are
likely to continue to evolve over time.
C.3.3.1. Registration procedure

3.138. Simple registration procedures can be an important incentive for non-resident
suppliers to engage with the tax authority of a jurisdiction where they might have no link
other than the supply of services or intangibles to final consumers. The information requested
could be limited to necessary details, which could include:
Name of business, including the trading name
Name of contact person responsible for dealing with tax administrations
Postal and/or registered address of the business and its contact person
Telephone number of contact person
Electronic address of contact person
Web sites URL of non-resident suppliers through which business is conducted in
the taxing jurisdiction
National tax identification number, if such a number is issued to the supplier in the
suppliers jurisdiction to conduct business in that jurisdiction.
3.139. The simplest way to engage with tax administrations from a remote location is most
likely by electronic processes. An on-line registration application could be made accessible
on the home page of the tax administrations web site, preferably available in the languages
of the jurisdictions major trading partners.
C.3.3.2. Input tax recovery Refunds

3.140. It is reasonable for taxing jurisdictions to limit the scope of a simplified registration
and compliance regime to the collection of VAT on business-to-consumer supplies of
services and intangibles by non-resident suppliers without making the recovery of input tax
available under the simplified regime. Where applicable, the input tax recovery could then
remain available for non-resident suppliers under the normal VAT refund or registration
and compliance procedure.
C.3.3.3. Return procedure

3.141. As requirements differ widely among jurisdictions, satisfying obligations to file
tax returns in multiple jurisdictions is a complex process that often results in considerable
compliance burdens for non-resident suppliers. Tax administrations could consider
authorising non-resident businesses to file simplified returns, which would be less detailed
than returns required for local businesses that are entitled to input tax credits. In establishing
the requirements for information under such a simplified approach, it is desirable to strike
a balance between the businesses need for simplicity and the tax administrations need to
verify whether tax obligations have been correctly fulfilled. This information could be
confined to:
Suppliers registration identification number
Tax period
Currency and, where relevant, exchange rate used
Taxable amount at the standard rate
Taxable amount at reduced rate(s), if any
Total tax amount payable.
3.142. The option to file electronically in a simple and commonly used format will be
essential to facilitating compliance. Many tax administrations have already introduced or
are introducing options to submit tax returns electronically.
C.3.3.4. Payments
3.143. The use of electronic payment methods is recommended, allowing non-resident
suppliers to remit the tax due electronically. This not only reduces the burden and the cost
of the payment process for the supplier, but it also reduces payment processing costs for
tax administrations. Jurisdictions could consider accepting payments in the currencies of
their main trading partners.
C.3.3.5. Record keeping

3.144. Tax administrations must be able to review data to ensure that the tax has been charged
and accounted for correctly. Jurisdictions are encouraged to allow the use of electronic record
keeping systems, as business processes have become increasingly automated and paper
documents generally have been replaced by documents in an electronic format. Jurisdictions
could consider limiting the data to be recorded to what is required to satisfy themselves that
the tax for each supply has been charged and accounted for correctly and relying as much as
possible on information that is available to suppliers in the course of their normal business
activity. This could include the type of supply, the date of the supply, the VAT payable and the
information used to determine the place where the customer has its usual residence. Taxing
jurisdictions could require these records to be made available on request within a reasonable
delay.
C.3.3.6. Invoicing
3.145. Invoicing requirements for VAT purposes are among the most burdensome
responsibilities of VAT systems. Jurisdictions could therefore consider eliminating
invoice requirements for business-to-consumer supplies that are covered by the simplified
registration and compliance regime, in light of the fact that the customers involved
generally will not be entitled to deduct the input VAT paid on these supplies.
3.146. If invoices are required, jurisdictions could consider allowing invoices to be
issued in accordance with the rules of the suppliers jurisdiction or accepting commercial

documentation that is issued for purposes other than VAT (e.g.electronic receipts). It
is recommended that information on the invoice remain limited to the data required to
administer the VAT regime (such as the identification of the customer, type and date of the
supply(ies), the taxable amount and VAT amount per VAT rate and the total taxable amount).
Jurisdictions could consider allowing this invoice to be submitted in the languages of their
main trading partners.
C.3.3.7. Availability of information

3.147. Jurisdictions are encouraged to make available on-line all information necessary
to register and comply with the simplified registration and compliance regime, preferably
in the languages of their major trading partners. Jurisdictions are also encouraged to
make accessible via the Internet the relevant and up-to-date information that non-resident
businesses are likely to need in making their tax determinations. In particular, this would
include information on tax rates and product classification.
C.3.3.8. Use of third-party service providers

3.148. Compliance for non-resident suppliers could be further facilitated by allowing such
suppliers to appoint a third-party service provider to act on their behalf in carrying out
certain procedures, such as submitting returns. This could be especially helpful for small
and medium enterprises and businesses that are faced with multi-jurisdictional obligations.
C.3.3.9. Application in a business-to-business context

3.149. The implementation of a simplified registration and compliance regime for nonresident suppliers is recommended primarily in the context of business-to-consumer supplies
of services and intangibles by non-resident suppliers. These Guidelines recommend the
reverse charge mechanism for cross-border business-to-business supplies of services and
intangibles that are taxable in the jurisdiction where the customer is located in accordance
with Guideline3.2. If the customer is entitled to full input tax credit in respect of this supply,
it could be that the local VAT legislation does not require the reverse charge to be made.
Jurisdictions whose general rules do not differentiate between business-to-business and
business-to-consumers supplies in their national legislation may consider allowing the use of
the simplified registration and compliance regime for both types of supplies.
C.3.3.10. Proportionality
3.150. Jurisdictions should aim to implement a registration-based collection mechanism
for business-to-consumer supplies of services and intangibles by non-resident suppliers,
without creating compliance and administrative burdens that are disproportionate to the
revenues involved or to the objective of achieving neutrality between domestic and foreign
suppliers (see also Guideline2.6 on VAT neutrality in international trade; Chapter2 of the
International VAT/GST Guidelines).
3.151. This objective should be pursued primarily through the implementation of simplified
registration and compliance mechanisms that are consistent across jurisdictions and that
are sufficiently clear and accessible to allow easy compliance by non-resident suppliers,
notably by small and medium enterprises. Some jurisdictions have implemented a threshold
of supplies into the jurisdiction of taxation below which non-resident suppliers would be
relieved of the obligation to collect and remit tax in that jurisdiction, with a view to further
reducing compliance costs. Relieving suppliers of the obligation to register in jurisdictions

where their sales are minimal in value may not lead to substantial net losses of revenue
in light of the offsetting expenses of tax administration. The introduction of thresholds
needs to be considered carefully. A balance will need to be struck between minimising
compliance burdens for non-resident suppliers and costs of tax administration while
ensuring that resident businesses are not placed at a competitive disadvantage.
C.3.4. International co-operation to support VAT collection in cases where the

supplier is not located in the jurisdiction of taxation
3.152. While simplification is a key means of enhancing compliance by non-resident
suppliers with a registration-based collection mechanism for cross-border business-toconsumer supplies of services and intangibles, it is necessary to reinforce taxing authorities
enforcement capacity through enhanced international co-operation in tax administration in
the field of indirect taxes.
3.153. Improved international co-operation could focus on the exchange of information
and on assistance in recovery. Mutual administrative assistance is a key means to achieve
the proper collection and remittance of the tax on cross-border supplies of services and
intangibles by non-resident suppliers. It will also be helpful in identifying suppliers,
verifying the status of customers, monitoring the volume of supplies, and ensuring that the
proper amount of tax is charged. The exchange of information between the tax authorities
of the jurisdictions of supply and consumption has a key role to play. This could include the
use of spontaneous exchanges of information.
3.154. Chapter4, SectionB of these Guidelines describes the principal existing OECD
instruments for exchange of information and other forms of mutual administrative
assistance that can assist jurisdictions in strengthening the international administrative
co-operation in the field of indirect taxes. These Guidelines recommend that jurisdictions
take appropriate steps towards making greater use of these and other available legal
instruments for international administrative co-operation to ensure the effective collection
of VAT on cross-border business-to-consumer supplies of services and intangibles by nonresident businesses. Such co-operation could be enhanced through the development of a
common standard for the exchange of information that is simple, minimises the costs for
tax administrations and businesses by limiting the amount of data that is exchanged, and
which can be implemented in a short timeframe. Against this background, the OECDs
Committee on Fiscal Affairs (CFA) intends to conduct work on further, detailed guidance
for the effective exchange of information and other forms of mutual assistance between tax
authorities in the field of indirect taxes.
D. Business-to-business and business-to-consumer supplies Specific rules

D.1. Evaluation framework for assessing the desirability of a specific rule
Guideline3.7
The taxing rights over internationally traded services or intangibles supplied between
businesses may be allocated by reference to a proxy other than the customers location
as laid down in Guideline3.2, when both the following conditions are met:
a. The allocation of taxing rights by reference to the customers location does not
lead to an appropriate result when considered under the following criteria:
Neutrality
Efficiency of compliance and administration
Certainty and simplicity
Effectiveness
Fairness.
b. A proxy other than the customers location would lead to a significantly better
result when considered under the same criteria.
Similarly, the taxing rights over internationally traded business-to-consumer supplies
of services or intangibles may be allocated by reference to a proxy other than the place
of performance as laid down in Guideline3.5 and the usual residence of the customer
as laid down in Guideline3.6, when both the conditions are met as set out in a. and b.
above.
3.155. According to Guideline3.2, the jurisdiction where the customer is located has the
taxing rights over services or intangibles supplied across international borders in a businessto-business context. This is the general rule for determining the place of taxation for
business-to-business supplies of services and intangibles. In a business-to-consumer context,
two general rules are set out in Guidelines3.5 and 3.6 respectively for two main types of
supplies of services and intangibles:
According to Guideline3.5, the jurisdiction in which the supply is physically
performed has the taxing rights over business-to-consumer on-the-spot supplies of
services and intangibles.20
According to Guideline3.6, the jurisdiction in which the customer has its usual
residence has the taxing rights over business-to-consumer supplies of services and
intangibles other than those covered by Guideline3.5.
3.156. It is recognised that these general rules might not give an appropriate tax result in
every situation and, where this is the case, the allocation of taxing rights by reference to
another proxy might be justified. A rule that allocates taxing rights using a proxy other than
those recommended by Guideline3.2 (for business-to-business supplies) or Guidelines3.5
and 3.6 (for business-to consumer supplies), is referred to in these Guidelines as a specific
rule. Such a rule will use a different proxy (e.g.location of movable or immovable tangible
property, actual location of the customer, or place of effective use and enjoyment) to
determine which jurisdiction has the taxing rights over a supply of a service or intangible
that is covered by the rule. Any such specific rule should be supported by clear criteria and
its application should remain limited. Guideline3.7 describes these criteria and sets out
how they may justify the implementation of a specific rule.
3.157. Under Guideline3.7, a two-step approach is recommended to determine whether a
specific rule is justified:
The first step is to test whether the relevant general rule leads to an appropriate
result under the criteria set out under Guideline3.7. Where this is the case, there
is no need for a specific rule. Where the analysis suggests that the relevant general
rule would not lead to an appropriate result, the use of a specific rule might be
justified. In such case, a second step is required.
The second step is to test the proposed specific rule against the criteria of
Guideline3.7. The use of a specific rule will be justified only when this analysis
suggests that it would lead to a significantly better result than the use of the
relevant general rule.
3.158. These Guidelines do not aim to identify the types of supplies of services or
intangibles, nor the particular circumstances or factors, for which a specific rule might
be justified. Rather, they provide an evaluation framework for jurisdictions to assess the
desirability of a specific rule against the background of a constantly changing technological
and commercial environment. The next paragraphs describe this framework in further detail.
3.159. The evaluation framework for assessing the desirability of a specific rule builds on
the overall objective of the Guidelines on place of taxation, as described in paragraph3.3.
In accordance with this objective, the evaluation framework for assessing the desirability
of a specific rule on place of taxation consists of the following criteria:
Neutrality: The six Guidelines on neutrality and their comments (Guidelines2.1 to
2.6; Chapter2 of the International VAT/GST Guidelines).
Efficiency of compliance and administration: Compliance costs for taxpayers and
administrative costs for the tax authorities should be minimised as far as possible.
Certainty and simplicity: The tax rules should be clear and simple to understand
so that taxpayers can anticipate the tax consequences in advance of a transaction,
including knowing when, where and how to account for the tax.
Effectiveness: The tax rules should produce the right amount of tax at the right time
and the right place.
Fairness: The potential for tax evasion and avoidance should be minimised while
keeping counteractive measures proportionate to the risks involved.
3.160. Ensuring that the tax treatment of internationally traded supplies is in accordance
with these criteria requires a consistent definition and implementation of place of taxation
rules. The general rules in Guidelines3.2, 3.5 and 3.6 set out recommended approaches for
ensuring a consistent determination of place of taxation for internationally traded services and
intangibles. The use of specific rules that use different proxies from these main approaches
should be limited to the greatest possible extent, since the existence of specific rules will
increase the risk of differences in interpretation and application between jurisdictions and
thereby increase the risks of double taxation and unintended non-taxation.21
3.161. When assessing the desirability of a specific rule on the basis of the evaluation
framework set out above, one should consider each of the criteria while also recognising
that they form a package. No single criterion can be considered in isolation as the criteria
are all interconnected. For example, neutrality, as described in the Guidelines on neutrality,
and efficiency of compliance and administration are complementary to one another.

Similarly, efficiency depends on the degree of certainty and simplicity, whereas certainty
and simplicity are also fundamental to achieving effectiveness and fairness. It is therefore
unlikely that evaluating the performance of a general rule (or an alternative specific rule)
in a particular scenario would result in a very low ranking when judged against one or two
criteria but in a much higher ranking when judged against the other criteria. Rather, it is
expected that the evaluation will reveal either a good or a poor outcome overall.
3.162. Consequently, it is recommended that jurisdictions consider implementing a
specific rule for the allocation of taxing rights on internationally traded services and
intangibles only if the overall outcome of the evaluation on the basis of the criteria set out
in Guideline3.7 suggests that the relevant general rule would not lead to an appropriate
result and an evaluation on the basis of the same criteria suggests that the proposed specific
rule would lead to a significantly better result.
3.163. While there remains a level of subjectivity as to what is and what is not an appropriate
result and what is a significantly better result, Guideline3.7 provides a framework for
assessing the desirability of a specific rule that should make the adoption of such a rule
more transparent, systematic and verifiable. It is neither feasible nor desirable to provide more
prescriptive instructions on what should be the outcome of the evaluation for all supplies
of services and intangibles. However, the paragraphs below provide further guidance and
specific considerations for particular supplies of services and intangibles for which a specific
rule might be appropriate in some circumstances and conditions. The evaluation should be
considered from the perspective of both businesses and tax administrations.
D.2. Circumstances where a specific rule may be desirable

3.164. It is recognised that the general rules on place of taxation as set out in Guideline3.2,
for business-to-business supplies, and in Guidelines3.5 and 3.6, for business-to-consumer
supplies, will lead to an appropriate result when considered against the criteria set out
in Guideline3.7 in most circumstances. However, the following paragraphs describe a
number of specific circumstances where jurisdictions might find that the application of
these general rules is likely to lead to an inappropriate result when considered against these
criteria and that a specific rule might lead to a significantly better result.
D.2.1. Examples of circumstances where a specific rule might be desirable in a

business-to-business context
3.165. In a business-to-business context, the general rule based on the customers location
might not lead to an appropriate result when considered against the criteria of Guideline3.7
and a specific rule could lead to a significantly better result in situations where all the
following circumstances are met:
particular services or intangibles are typically supplied to both businesses and final
consumers
the service requires, in some way, the physical presence of both the person providing
the supply and the person receiving the supply, and
the service is used at a readily identifiable location.
3.166. If businesses that usually supply services or intangibles to a large number of
customers for relatively small amounts in a short period of time (e.g.restaurant services) were
required to follow the general rule based on the customers location for business-to-business
supplies, it would impose a significant compliance burden on suppliers. Any customer,
business or non-business, could simply state that it was a business located in another country
and request that no VAT be charged. It would put the supplier at considerable risk of having
to bear the under-declared tax if it was subsequently shown that the customer was not a
business located in another country (breach of certainty and simplicity). This would also
make tax administration controls more difficult as evidence of location might be difficult to
produce (breach of efficiency). The same considerations could apply to services that consist
of granting the right to access events such as a concert, a sports game, or even a trade fair
or exhibition that is designed primarily for businesses. If a ticket can be purchased at the
entrance of the building where the event takes place, businesses as well as final consumers
can be recipients of the service. In these cases, under the general rule based on the customers
location for business-to-business supplies, the supplier is confronted with the difficulty and
risk of identifying and providing evidence of the customers status and location. Efficiency,
as well as certainty and simplicity, might then not be met. Fairness could be at risk. The
adoption of a specific rule allocating the taxing rights to the jurisdiction where the event
takes place could lead to a significantly better result when considered against the criteria of
Guideline3.7. In such circumstances, jurisdictions might consider using a proxy based on the
place of physical performance, which would apply both for business-to-business supplies and
business-to-consumer supplies (see Guideline3.5).
D.2.2. Examples of circumstances where a specific rule might be desirable in a

business-to-consumer context
3.167. In a business-to-consumer context, jurisdictions might find that the general rules
set out in Guidelines3.5 and 3.6 do not lead to an appropriate result when considered
against the criteria of Guideline3.7 in certain specific circumstances, where they lead to an
allocation of taxing rights that is inefficient and overly burdensome from an administrative
standpoint (breach of efficiency and of certainty and simplicity) and/or are not sufficiently
accurate in predicting the likely place of final consumption (breach of effectiveness and of
neutrality). For example, this might occur in the following circumstances:
The general rule based on the place of physical performance (Guideline3.5), in
respect of on-the-spot supplies of services and intangibles, might not lead to an
appropriate result when considered against the criteria of Guideline3.7 in cases
where the physical performance occurs in multiple jurisdictions because tax
obligations could arise in multiple jurisdictions (breach of the efficiency and the
certainty and simplicity requirements). An example is the international transport
of persons.
In cases where consumption is most likely to occur somewhere other than in the
customers usual place of residence, the general rule based on the place of the
usual residence of the customer for supplies of services and intangibles not covered
by Guideline3.5 (Guideline3.6) might not be sufficiently accurate in predicting
the place of final consumption (breach of the effectiveness and the neutrality
requirements). Examples could include services and intangibles that are performed
at a readily identifiable location and that require the physical presence of the person
consuming the supply but not the physical presence of the person performing it,
such as the provision of Internet access in an Internet caf or a hotel lobby, the use
of a telephone booth to make a phone call or the access to television channels for
a fee in a hotel room.22 In such cases, it is reasonable to assume that suppliers will
know or are capable of knowing the actual location of the customer at the likely
time of consumption and jurisdictions may then consider using the actual location
of the consumer at the time of the supply as a proxy for place of consumption.
D.3. Special considerations for supplies of services and intangibles directly

connected with tangible property
3.168. Jurisdictions often choose to rely on the location of tangible property for determining
the place of taxation for supplies of services and intangibles connected with tangible
property or with the supply of such property. The business use or final consumption of
such services is then considered to be so connected with the business use or the final
consumption of the tangible property that the location of this tangible property is considered
as the most appropriate place of taxation.
3.169. The following sections look specifically at services and intangibles connected with
immovable property, as this is a particularly complex area where a specific rule is already
applied by many jurisdictions both in a business-to-business context and in a business-toconsumer context (SectionsD.3.1-D.3.4). This is complemented by a section on services
and intangibles connected with movable tangible property, which explains that a rule based
on the location of the movable tangible property might be particularly appropriate for
identifying the place of taxation in a business-to-consumer context (SectionD.3.5).
D.3.1. Specific rule for supplies of services and intangibles directly connected with
immovable property
Guideline3.8
For internationally traded supplies of services and intangibles directly connected
with immovable property, the taxing rights may be allocated to the jurisdiction
where the immovable property is located.
3.170. According to this specific rule, taxing rights are allocated to the jurisdiction where
the immovable property is located.
3.171. This Guideline does not list particular supplies of services and intangibles that may
or may not fall under such a specific rule. Instead, it identifies their common features and
establishes categories of supplies of services and intangibles for which the conditions set
out in Guideline3.7 might be met and for which implementation of such a specific rule
might therefore be justified.
D.3.2. Circumstances where a specific rule for supplies of services and

intangibles directly connected with immovable property might be appropriate
3.172. When internationally traded services and intangibles are directly connected with
immovable property, there may be circumstances where a specific rule allocating the taxing
rights to the jurisdiction where the immovable property is located might be appropriate.
3.173. This is most likely to be the case when there is a supply of services or intangibles
falling within one of the following categories:
the transfer, sale, lease or the right to use, occupy, enjoy or exploit immovable
property
supplies of services that are physically provided to the immovable property itself,
such as constructing, altering and maintaining the immovable property, or
other supplies of services and intangibles that do not fall within the first two
categories but where there is a very close, clear and obvious link or association with
the immovable property.
3.174. The second condition for the implementation of a specific rule under Guideline3.7
requires that such a specific rule would lead to a significantly better result than the relevant
general rule when evaluated against the criteria of Guideline3.7. While it is reasonable to
assume that this second condition is met for the first two categories of supplies identified
above, its fulfilment for the supplies mentioned in the last category above is likely to
require an evaluation as set out in Guideline3.7 before the implementation of a specific
rule can be considered.
D.3.3. Common features of supplies of services and intangibles directly connected

with immovable property
3.175. The supplies of services and intangibles for which Guideline3.8 may apply are
referred to as services directly connected with immovable property. This expression
does not have an independent meaning but aims simply to narrow the scope of the specific
rule in the sense that it contemplates that there should be a very close, clear and obvious
link or association between the supply and the immovable property. This very close, clear
and obvious link or association is considered to exist only when the immovable property
is clearly identifiable.
3.176. For the supply to be considered as directly connected with immovable property,
it is not sufficient that a connection with immovable property be merely one aspect of
the supply among many others: the connection with immovable property must be at the
heart of the supply and must constitute its predominant characteristic. This is particularly
relevant with respect to composite supplies involving immovable property. If a connection
with immovable property is only one part of the supply, this will not be sufficient for the
supply to fall under one of the three categories.
D.3.4. Further description of the supplies of services and intangibles directly

connected with immovable property for which a specific rule might be appropriate
3.177. The transfer, sale, lease, or the right to use, occupy, enjoy or exploit immovable
property, encompasses all kinds of utilisation of immovable property, i.e.supplies of services
and intangibles derived from the immovable property (as opposed to other circumstances
where the supplies are directed to the immovable property). The terms transfer, sale,
lease, and right to use, occupy, enjoy or exploit therefore should not be understood
narrowly within the meaning of national civil laws. It should be noted however, that these
supplies fall under this Guideline only when they are considered to be supplies of services or
intangibles under national law, i.e.when they are not considered to be supplies of goods or of
immovable property.23
3.178. Supplies of services such as the construction, alteration and maintenance of immovable
property cover services that are typically physical in nature, as opposed, for example, to
intellectual services. Such supplies of services are physically provided to immovable property.
These are services that aim to change or maintain the physical status of the immovable
property. Typical cases in practice will include, for example, the construction of a
building24 as well as its renovation or demolition, the painting of a building or even the
cleaning of it (inside or outside).

3.179. In addition to the utilisation of immovable property and services that are physically
performed on immovable property, there might be other supplies of services and intangibles
where there is a very close, clear and obvious link or association with immovable property
and where taxation in the jurisdiction of the immovable property leads to a significantly
better result than the relevant general rule when considered under the criteria defined
in Guideline3.7. When considering the adoption of a specific rule, jurisdictions may in
particular wish to take into account, in addition to the requirement of a very close, clear
and obvious link or association between the supply and the immovable property, whether
such a specific rule has a sufficiently high potential to be manageable and enforceable in
practice. For example, certain intellectual services,25 such as architectural services that
relate to clearly identifiable, specific immovable property, could be considered to have a
sufficiently close connection with immovable property.
D.3.5. Services and intangibles connected with movable tangible property

3.180. Examples of services and intangibles connected with movable property include
services that are physically carried out on specific movable property such as repairing,
altering or maintaining the property, and the rental of specific movable property where
this is considered a service. Jurisdictions might consider implementing an approach based
on the location of movable tangible property for identifying the place of taxation of such
supplies of services and intangibles connected with movable tangible property. Such an
approach ensures that the place of taxation rules for such supplies provide a reasonably
accurate reflection of the place where the consumption of the services or intangibles is
likely to take place and is relatively straightforward for suppliers to apply in practice,
particularly in the case of business-to-consumer supplies. Services or intangibles connected
with movable tangible property supplied to final consumers, such as repair services, will
generally be consumed in the jurisdiction where the property is located. Movable tangible
property that is shipped abroad after the service is performed will generally be subject to
import VAT under standard customs rules when crossing the customs border. This ensures
that the taxing rights accrue to the jurisdiction of consumption when the tangible property
moves across the customs border. Jurisdictions generally complement these rules by giving
temporary VAT relief in the jurisdiction where the supply is performed and where the
movable property is temporarily located, if this property is subsequently exported. This
treatment lies outside the scope of these Guidelines.26
3.181. For business-to-business supplies of services and intangibles connected with
movable property, the application of the general rule based on the customers location will
generally lead to an appropriate result.
Annex1
Examples to illustrate the application of the general rule on place of taxation for
business-to-business supplies of services and intangibles to Single location Entities
The examples in this annex are illustrative of the principles set out in the Guidelines
and consequently are not intended to be exhaustive. The place of taxation of internationally
traded services and intangibles will be determined according to the facts of each individual
supply.
Example1: Supply between 2 separate legal entities
(whether related by common ownership or not)
Country A
Company S
Country B
Service 1
Analyst of retail food markets
Company A
Food retail business
Facts
CompanyS is a business located in CountryA specialising in analysing retail food
markets, CompanyA is a food retail business located in CountryB. Neither CompanyS
nor CompanyA has other establishments for VAT purposes. CompanyA is considering
expanding its retailing activities beyond CountryB and approaches CompanyS. The two
companies enter into a business agreement under which CompanyS will provide an analysis
of market conditions in CountryA to CompanyA. CompanyA will pay CompanyS a sum
of money in return for CompanyS performing its obligations under this business agreement.
Place of taxation
According to the business agreement, CompanyS will be the supplier and CompanyB
will be the customer. There will be a supply of a service provided by the supplier to the
customer for consideration. In accordance with the general rule for business-to-business
supplies (Guideline3.2), the place of taxation will be CountryB, which is the country
where the customer is located.
The result remains the same even where the supplier and customer are two separate
legal entities related by ownership.

Example2: Two separate supplies involving three separate legal entities
Country A
Company S
Country B
Service 2
Analyst of retail food markets
Company T
Marketing company
Service 1
Company A
Food retail business
Facts
As CompanyA subsequently requested CompanyS to also perform studies on its
own market in CountryB, CompanyS engages the services of a marketing company in
CountryB, CompanyT. This company has no ownership connection with CompanyS or
CompanyA.
CompanyT supplies its services of marketing to CompanyS under a business agreement
(Service2). The supply of Service1 between CompanyS and CompanyA (as outlined in
Example1 analysis of the market conditions in CountryA) continues as before.
Place of taxation
According to the business agreement CompanyT is the supplier and CompanyS the
customer. There is a supply of services for consideration. Therefore, in accordance with the
general rule for business-to-business supplies (Guideline3.2), the supply by CompanyT
will be subject to taxation in CountryA because that is the country where the customer is
located. These are two independent supplies and are treated accordingly.
The outcome of Service1 as outlined in Example1 remains unaffected.
Example3: A global agreement
This example illustrates the supplies that occur when a global agreement for a supply
of auditing services is entered into between the parent company of an audit group
and a centralised purchasing company of the group requiring audit services for other
group members in various countries.
Country A
Company A
Parent of Company A group
Service 4
Company S
Parent of Companies T and U
Service 1
Company B
Subsidiary of Company A
Supplier of auditing services

Centralised purchasing company
Service 2
Service 3
Company T
Company U
Subsidiary of Company S
Service 6
Company D
Company C
Service 5
Country B
Country C
Facts
CompanyB is a centralised purchasing company in CountryA. It belongs to a
multinational company group with subsidiaries around the world, notably CompanyD in
CountryB and CompanyC in CountryC. The parent company of CompanyB is CompanyA,
also located in CountryA.
CompanyS in CountryA is the parent company of a multinational auditing company
group with subsidiaries around the world, notably CompanyT in CountryB and
CompanyU in CountryC.
CompanyA Group requires a global auditing service to meet legal requirements for
the companies in CountryA and its subsidiaries in CountriesB and C. The global auditing
service is purchased for the whole group by CompanyB, which therefore concludes a
centralised purchasing agreement with CompanyS to supply auditing services to the whole
CompanyA Group. Payment will follow each business agreement.

The global auditing service is supplied by CompanyS to CompanyB in return for
consideration. While this service includes the supply of all components of the global
agreement, CompanyS is able to actually perform only part of the services itself, namely
the services to CompaniesA and B that are located in CountryA. To be able to fulfil the
rest of the agreement, CompanyS enters into business agreements with its two subsidiaries,
CompanyT and CompanyU, under which these companies supply auditing services to their
parent CompanyS. CompaniesS and T provide these services directly to the subsidiaries
of CompanyA. These subsidiaries, CompaniesC and D, are in the same countries as the
subsidiaries of CompanyA that provide the auditing service to them.
CompanyB enters into separate business agreements with its parent CompanyA
and CompanyAs subsidiaries C and D. Under these business agreements, CompanyB
supplies the auditing services that it has acquired from CompanyS, to CompanyA and to
CompanyAs subsidiaries C and D.
There are six separate business agreements in this example, each leading to a supply
of a service for consideration:
CompanyS is the supplier and CompanyB is the customer under the centralised
purchase agreement (Service1).
CompaniesT and U are the suppliers and CompanyS is the customer under two
different business agreements (Service2 and Service3).
CompanyB is the supplier and CompanyA is the customer under a different agreement
(Service4).
CompanyB is the supplier and CompanyD and CompanyC are the customers
under two different business agreements (Service5 and Service6).
The place of taxation will be decided for each supply individually.
Place of taxation
In accordance with the general rule for business-to-business supplies (Guideline3.2),
the place of taxation for the supply of Service1 between CompanyS and CompanyB
will be CountryA as CompanyB is in CountryA. In accordance with the general rule
for business-to-business supplies (Guideline3.2), the place of taxation for the supply of
Services2 and 3 between CompanyT and CompanyU as suppliers and CompanyS as a
customer is CountryA for both supplies. In accordance with the general rule for businessto-business supplies (Guideline3.2) the place of taxation for the supply of Service4
between CompanyB and CompanyA will be CountryA as CompanyA is in CountryA.
In accordance with the general rule for business-to-business supplies (Guideline3.2), the
place of taxation for the supply of Service5 between CompanyB and CompanyD will be
CountryB because CountryB is the country where the customer is located. In accordance
with the general rule for business-to-business supplies (Guideline3.2), the place of taxation
for the supply of Service6 between CompanyB and CompanyC will be CountryC because
CountryC is the country where the customer is located.
It should be noted that the auditing services by CompanyT and CompanyU are supplied
to CompanyS, while they are provided directly to CompanyD and CompanyC.The fact
that the services are supplied to someone different from those to which the services are
directly provided is not relevant in this example to determine the place of taxation, as the
place of taxation will still be the customer location as determined in accordance with the
general rule for business-to-business supplies (Guideline3.2) and not where or to whom the
services are directly provided.
The reason for this is that, at each stage of this example, all supplies will be subject
to the taxation rules in the jurisdiction where the customer is located and the services
are deemed to be used by the business in accordance with the destination principle as
implemented by the general rule for business-to-business supplies (Guideline3.2). There is
neither double taxation nor unintended non-taxation in CountriesA, B and C. In particular,
the tax that accrues to CountriesB and C reflects the business use of the services in
those countries in accordance with the general rule for business-to-business supplies
(Guideline3.2) that treats customer location as the appropriate proxy for the jurisdiction of
business use thereby implementing the destination principle. There is no reason to depart
from the business agreements e.g.by following the interaction between CompanyT and
CompanyD or between CompanyU and CompanyC.
In developing this example, care has been taken to avoid any stewardship issues that
may exist with respect to CompanyA.27 CompanyA, as the parent, may also be seen as
deriving an element of benefit from the audit activities in CountriesA, B and C, for example
because such audit included an additional review of financial statements under the parent
companys country accounting standards, rather than only per local subsidiary country
accounting standards. Stewardship issues are assumed not to arise in Example3 due to the
inclusion of Service4, where CompanyB supplies auditing services to CompanyA. Further,
any questions concerning valuation for VAT/GST purposes and the possible identification of
supplies existing, other than those shown, are also ignored.

Example4: Alternative global agreement Framework agreement
In this example the parent company of the group requiring audit services enters into
a global agreement described as a framework agreement with the parent company
of the audit group (both in the same country) in order to provide audit services in a
number of countries.28
Country A
Agreement 1
Framework agreement
Company S
Company A
Agreement 2
Service 1
Company T
Company U
Agreement 3
Service 2
Country B
Agreement 4
Service 3
Company B
Company C
Country C
Facts
CompanyA is a parent company in CountryA. It belongs to a multinational company
group with subsidiaries around the world, for example CompanyB in CountryB and
CompanyC in CountryC.
CompanyS is a parent company in CountryA belonging to a multinational auditing
company group with subsidiaries around the world, for example CompanyT in CountryB
and CompanyU in CountryC.
CompanyA Group requires a global auditing service to meet legal requirements for its
companies in CountryA and its subsidiaries in CountriesB and C. CompanyA concludes
a framework agreement with CompanyS (Agreement1). The framework agreement covers
definitions, obligations relating to confidentiality, warranties, due dates for payment and
limitations of liability, that would only apply if and when members of CompanyS and
CompanyA enter into separate agreements referring to this framework agreement. The
agreement also provides that companies that are affiliated with CompanyA and the auditing
companies that are affiliated with CompanyS may enter into business agreements that will
incorporate the terms of the framework agreement by reference.The agreement, however,
does not oblige any member of CompanyA Group or CompanyS Group to enter into such
business agreements.
CompanyA enters into a separate business agreement with CompanyS for the audit of
CompanyA (Agreement2); CompanyB enters into a business agreement with CompanyT
for the audit of CompanyB (Agreement3); and CompanyC enters into a business agreement
with CompanyU for the audit of CompanyC (Agreement4). In each of these three
separate agreements (i.e.Agreements2-4), an article is included where the parties agree to
incorporate the terms included in the framework agreement (Agreement1). Payment will
follow each business agreement.
There are four separate agreements in this example, only three of which constitute
business agreements that lead to supplies of services for consideration:
Agreement1 is not transactional, has no consideration and does not create a supply.
Agreement1 stipulates terms and conditions that become activated only when parties
agree to separate business agreements as specified in the framework agreement.
Under Agreement2, CompanyS is the supplier and CompanyA is the customer
(Service1).
Under Agreement3, CompanyT is the supplier and CompanyB is the customer
(Service2).
Under Agreement4, CompanyU is the supplier and CompanyC is the customer
(Service3).
The place of taxation will be decided for each supply individually.
Place of taxation
In accordance with the general rule for business-to-business supplies (Guideline3.2), the
place of taxation for the supply of Service1 between CompanyS and CompanyA will be
CountryA as CompanyA is in CountryA. In accordance with the general rule for businessto-business supplies (Guideline3.2), the place of taxation for the supply of Service2
between CompanyT and CompanyU will be CountryB as CompanyB is in CountryB.
Further, and again in accordance with the general rule for business-to-business supplies
(Guideline3.2), the place of taxation for the supply of Service3 between CompanyU and
CompanyC will be CountryC as CompanyC is in CountryC.
All three supplies are subject to the taxation rules in the jurisdiction where the
customer is located and is the appropriate proxy for the jurisdiction of business use under
the general rule for business-to-business supplies (Guideline3.2). There is neither double
taxation nor unintended non-taxation in CountriesA, B or C. There is no reason to depart
from the business agreements. In particular, no supplies take place under the framework
agreement (Agreement1) itself in this example. Consequently, no supplies are made under
that agreement and no place of taxation issue arises.

Example5: Alternative global agreement Different flow of payments
This example expands upon example4 by introducing payment flows that are different
from the flows of the services as set out in the underlying business agreement.
Country A
Agreement 1
Framework agreement
Company S
Company A
Agreement 2
Service 1

Payment
Payment
Payment
Company T
Company U
Agreement 3
Service 2
Agreement 4
Service 3
Company B
Country B
Payment
Company C
Payment
Country C
Facts
This example is similar to Example4 except that the CompanyA group has put in
place a system for settling inter-company supplies between group members. As a result,
the CompanyA group decides to reduce the costs associated with cash disbursements
by appointing CompanyA as the common paymaster for the group.29 The framework
agreement in this example is similar to Example4 except that it specifies that the payments
for the services supplied under the locally concluded business agreements will be handled
by CompanyA directly with CompanyS for the whole CompanyA group.
For the audit services supplied under the three business agreements CompanyS,
CompanyT and CompanyU will follow the general invoicing process and issue invoices
respectively to CompanyA, CompanyB and CompanyC. For payment purposes, however,
CompanyS will issue a collective statement (with copies attached of the invoices issued for the
services supplied) to CompanyA. Based on the collective statement CompanyA will pay the
requested amount to CompanyS and will on the same day collect the respective amounts from
CompanyB and CompanyC. Similarly, CompanyS will transfer the respective amounts over
to CompanyT and CompanyU on the same day it receives the payment from CompanyA.
The movements of payment are simply cash or account entries. The payment CompanyA
makes to CompanyS represents consideration for the services supplied from CompanyS to
CompanyA, from CompanyT to CompanyB and from CompanyU to CompanyC.
Place of taxation
The conclusions reached in Example4 about the place of taxation of the supplies made
under the business agreements (Agreements2, 3 and 4) remain valid. The fact that payments
are transferred via CompanyA and CompanyS has no impact on those conclusions.
All supplies under the business agreements are subject to the taxation rules in the
jurisdiction where the customer is located according to the general rule for business-tobusiness supplies (Guideline3.2). There is neither double nor unintended non-taxation in
CountriesA, B or C. There is no reason to depart from the business agreements e.g.by
following the cash flows. The cash flows between CompanyA and its subsidiaries, between
CompanyA and CompanyS, and between CompanyS and its subsidiaries are consideration
for services supplied under the business agreements but do not in themselves create additional
supplies, nor alter the supplies, nor identify the customer or customer location.
Annex2
Example to illustrate the application of the recharge method under the general rule
on place of taxation for business-to-business supplies of services and intangibles to
multiple location Entities
Supply of payroll services
Country A
Country D
Conclusion of contract.
Invoice, Payment
Company E
Head Office
Business agreement
Use of payroll services
Company S
Supplier
of payroll services
Recharges of costs
Country C
Business agreement
Business agreement
Subsidiary
Subsidiary
of Company E
of Company E

Recharge arrangement
Recharge arrangement
Company E
Company E
Establishment
Establishment
Country B
Facts
CompanyE is a multiple location entity located in three different countries: a head
office in CountryD (Head Office) and trading establishments (Establishments) in
CountriesA and B. It is the parent company of a multinational group with subsidiaries
(Subsidiaries) in CountriesA and C. CompanyEs Head Office and Establishments as
well as its Subsidiaries are all registered for VAT purposes.
CompanyE, represented by its Head Office, enters into a business agreement with
SupplierS, located in CountryA, for the supply of payroll management services. In this
example, the payroll management services30 relate to staff of CompanyEs Head Office
and of its Establishments in CountriesA and B and its Subsidiaries in CountryA and C.
At its Head Office, CompanyE has business agreements in place with its Subsidiaries
and recharge arrangements with its Establishments, setting out the terms and conditions
for the transactions between them.
The business agreement between SupplierS and CompanyE establishes a fixed fee
per month if the number of employees is within a given range. The fees for the services
supplied under this business agreement are paid to SupplierS by CompanyEs Head Office
on receipt of an invoice from SupplierS.
The agreed fee is 20000. SupplierS issues an invoice for this amount to the Head
Office of CompanyE, from which it receives payment of the entire amount.
Supplier
SupplierS in CountryA has entered into a business agreement with CompanyE. It
was negotiated and concluded for CompanyE by its Head Office in CountryD, to which
all invoices are addressed and which is responsible for payment. The business agreement
provides the evidence allowing the supplier to supply the service free of VAT and to issue
an invoice to CompanyEs Head Office in CountryD without VAT.
Customer group31
After having represented CompanyE in the business agreement with SupplierS, the
Head Office of CompanyE will typically have set up this supplier within the supplier
master data of its ERP system32 and will have created a cost centre to capture and pool the
relevant costs. In this example, the Head Office has represented CompanyE in a business
agreement to purchase services for its own use and for CompanyEs Establishments
in CountriesA and B and its Subsidiaries in CountriesA and C. The Head Office of
CompanyE will therefore consider the appropriate methodology for allocating the costs
of these services to the Head Office and to its Establishments and Subsidiaries. In this
example, the allocation will be based on the number of employees (or headcount). In this
case headcount presents a fair and reasonable picture of the use of the payroll management
services, by CompanyEs Head Office and its Establishments and Subsidiaries that employ
the staff to which these services relate. Headcount is thus considered as an acceptable cost
allocation key for these services.
The terms and conditions for the cost allocations to the Establishments and Subsidiaries
will be reflected in business agreements between CompanyE and its Subsidiaries and in
the recharge arrangements between the Head Office of CompanyE and its Establishments.
Upon receipt of the invoice from SupplierS, the accounts payable team in the Head
Office of CompanyE will enter this invoice into the cost centre for invoices that have to be
allocated on the basis of headcount for the onward supplies.
Next, the appropriate VAT treatment (coding) will be assigned to this entry. This
is typically based on a decision tree, considering the various possible VAT scenarios.
The conclusion for CompanyEs Head Office in this case will be that the invoice received
from SupplierS should show no VAT and that the Head Office should account for the VAT
in CountryD under a reverse charge mechanism.33 Once approved, the invoice will be
processed for payment by the Head Office directly to SupplierS and the Head Office will
account for the VAT in CountryD under a reverse charge mechanism. CompanyEs Head
Office in CountryD will deduct the related input tax in line with its normal right to deduct.

Next, the Head Office of CompanyE will recharge part of the cost of the payroll
services to the Establishments and Subsidiaries that employ the staff to which these services
relate. This action is usually part of the regular accounting close that would for instance
be run at the end of each month, quarter, semester or accounting year. In many cases, this
will be done on the basis of an allocation key table maintained in the accounting software,
highlighting for each account or range of accounts the percentage to be used to allocate the
amounts that have been identified for recharge earlier in the process. This close out routine
will calculate the amount per Establishment and Subsidiary, produce documentation and
place the accounting entries.
In this example, the allocation key is based on headcount. The Head Office of CompanyE
will identify the number of employees on payroll in each of the relevant Establishments
and Subsidiaries, typically on the basis of budget data. In this example, budget data show
that the Head Office employs 100 staff, the Establishments in CountriesA and B employ
respectively 10 and 30 staff and its Subsidiaries in CountriesA and C respectively have 20
and 40 employees.
The allocation key table will attribute 50% to the Head Office in CountryD, 5% to
the Establishment in CountryA, 15% to the Establishment in CountryB, 10 % to the
Subsidiary in CountryA and 20% to the Subsidiary in CountryC. The accounting system
at the Head Office of CompanyE will produce two invoices for the onward supply to
its Subsidiaries, one for 2000 to the Subsidiary in CountryA and one for 4000 to the
Subsidiary in CountryC.34 Based on the general rule for business-to-business supplies
(Guideline3.2), these invoices will be issued free of VAT since these Subsidiaries are
single location entities located outside CountryD where the Head Office of CompanyE
is located. The accounting system will also generate two internal documents equivalent to
invoices for the allocation of 1000 to its Establishment in CountryA and of 3000 to its
Establishment in CountryB. Under the recharge method, these documents will receive the
same treatment as if they were invoices to a separate legal entity, and will be issued free
of VAT since both Establishments are located outside CountryD where the Head Office of
CompanyE is located.
Upon receipt of the invoices, the Subsidiaries in CountriesA and C will account for the
VAT through the reverse charge. The Establishments in CountriesA and B will account
for VAT through the reverse charge upon receipt of the documents for the costs allocated
to them by their Head Office.
This process will be repeated throughout the accounting year. It may be possible in
certain cases that allocation keys would remain unchanged in the course of the accounting
year, even if the number of employees by entity would fluctuate during that period. In such
a case, companies will typically, at year end, perform a true up calculation. The cost
allocation will then be reconsidered on the basis of the more precise headcount, taking
into account fluctuations in the course of the accounting year. Correcting credit notes or
invoices/documents will then be created for the difference between the amount actually
charged and the amount as calculated on the basis of actual headcount. These additional
invoices or credit notes will follow a VAT treatment similar to the underlying invoices/
documents.
Tax administrations
The supplier in CountryA should hold all the relevant information that constitutes the
business agreement to demonstrate that he has correctly supplied the service free of VAT
to CompanyEs Head Office.
The tax administration in CountryD should be able to ensure that the reverse charge
is brought to account correctly by CompanyEs Head Office on the invoice received from
SupplierS. It should also be able to ensure a correct tax treatment of the recharges made
by CompanyEs Head Office to its Establishments and Subsidiaries. CompanyEs Head
Office should hold all the relevant information that constitutes the business agreement
with SupplierS. It should also hold the business agreements with its Subsidiaries and the
recharge arrangements with its Establishments demonstrating how the recharges were
allocated.
The tax administrations in CountryA, B and C should be able to ensure that the
reverse charge is brought to account correctly by the Subsidiaries and Establishments of
CompanyE on the recharges made by the Head Office. The Subsidiaries should hold all the
relevant information that constitutes their business agreement with CompanyE through its
Head Office and the Establishments should hold the relevant information that constitutes
their recharge arrangement with their Head Office. In particular, the tax administrations
in CountriesA and B should be able to verify that the Establishments have accounted for
tax at the correct time of taxation under the normal domestic rules (e.g.date of internal
recharge documents, date consideration is paid to the Head Office).
In order toaudit the recharges, the tax administrations will needtobe able to see all
the relevant commercial documentation down to transaction level in order to identifythe
nature of the individual service that is recharged and so determine its place of taxation and
the applicable rate.
Notes
1.
For the purposes of these Guidelines, a supply of services or intangibles for VAT purposes
takes place where one party does something for, or gives something (other than something
tangible) to another party or refrains from doing something for another party, in exchange
for consideration. It is recognised that a supply of services or intangibles in one country may in
certain instances be regarded as a supply of goods (or some other category of supply) in another
country. Where this is the case, and while these Guidelines deal only with supplies of services
and intangibles, countries are encouraged to ensure that the rules for identifying the place of
taxation of such supplies lead to a result that is consistent with these Guidelines.
2.
See Guideline3.7.
3.
When a supply is made to a legal entity that has establishments in more than one jurisdiction (a
multiple location entity, MLE), an additional analysis is required to determine which of the
jurisdictions where this MLE has establishments has taxing rights over the service or intangible
acquired by the MLE. See SectionB.3 below.
4.
An illustration of this is the Centralised Purchasing Agreement in Example3 and the Framework
Agreement in Examples4 and 5 in Annex1 to this chapter.

5.
Legal entities can include natural persons and non-commercial institutions such as governments,
non-profit organisations and other institutions. The key point is that such entities, or certain of
their activities, are recognised as businesses in national law. Such recognition may include
the treatment for VAT purposes specifically or in national law more generally (notably in
jurisdictions that have not implemented a VAT). See also paragraph3.7.
6.
For the purpose of these Guidelines, it is assumed that an establishment comprises a fixed
place of business with a sufficient level of infrastructure in terms of people, systems and assets
to be able to receive and/or make supplies. Registration for VAT purposes by itself does not
constitute an establishment for the purposes of these Guidelines. Countries are encouraged to
publicise what constitutes an establishment under their domestic VAT legislation.
7.
Use of a service or intangible in this context differs from the concept of use and enjoyment
existing in some national laws, which can refer to actual use by a customer in a jurisdiction
irrespective of the presence of any customer establishment. See also SectionD. on the use of
specific rules for determining the place of taxation
8.
For the purposes of these Guidelines, the reverse charge mechanism is a tax mechanism that
switches the liability to pay the tax from the supplier to the customer. If the customer is entitled
to full input tax credit in respect of this supply, it may be that local VAT legislation does not
require the reverse charge to be made. Tax administrations are encouraged to publicise their
approach.
9.
For the purposes of these Guidelines, a third party is an entity recognised as a business.
Third party refers to a party other than the supplier or the customer and has no necessary
correlation to its meaning in other contexts, including direct taxation.
10.
This company may be referred to as a paymaster, cash clearing agent, billing agent or some
other such term. These Guidelines use the term paymaster.
11.
In cases where a customer omits to account properly for such a reverse charge, but is still,
nevertheless, entitled to full input tax deduction in respect of that supply, it is recommended
that any penalties that might be applied should be proportionate and linked to the gravity of the
failure made, where the gravity of the failure is a consideration, bearing in mind there is no net
revenue loss.
12.
Netting occurs when establishments that have mutual obligations, e.g.because they have each
made recharges to each other, agree to compensate the value of both obligations and to pay
only the net amount that is still owed by one of the establishments after this compensation.
Where netting has taken place, VAT should in principle be applied on the taxable amount of
each recharge and not just the net value.
13.
For the purposes of the Guidelines, business-to-consumer supplies are assumed to be supplies
where the customer is not recognised as a business. Such recognition may include the treatment
for VAT purposes specifically or in national law more generally (notably in jurisdictions that
have not implemented a VAT). See also paragraphs3.7 and3.8.
14.
This paragraph refers only to supplies of services rather than to supplies of services and
intangibles, because services constituted the overwhelming proportion of such supplies to final
consumers in the past.
15.
Under the general rule for business-to-business supplies of services and intangibles set out in
Guideline3.2 and under the general rule for business-to-consumer supplies of services and
intangibles set out in Guideline3.6, the place of taxation is thus determined by reference to
the customers location. The customers location is determined by reference to the customers
business establishment in the business-to-business context (in accordance with Guideline3.2)
and to the customers usual residence in the business-to-consumer context (in accordance with
Guideline3.6).
16.
Jurisdictions that treat some of these items (such as accommodation and restaurant meals) as
a supply of goods or some other category are encouraged to ensure consistency with these
Guidelines by ensuring that such supplies are taxed at the place where they are performed.
Similarly, where countries treat the supply of a ticket or right of entry as a separate supply, they
are encouraged to determine the place of taxation by reference to place where the underlying
supply of service is performed. See also note1.
17.
This should not be read as requiring countries to adopt such a categorisation approach to
determining the place of taxation. Countries using an iterative approach may choose to use a
series of rules that are applied consecutively to determine the appropriate place of taxation in
an order the leads to the same end result as that recommended by Guideline3.5.
18.
An Internet Protocol address, also known as an IP address, is a numerical label assigned to

each device (e.g.computer, mobile phone) participating in a computer network that uses the
Internet Protocol for communication.
19.
For the purposes of these Guidelines, the taxing jurisdiction is the jurisdiction that is identified
as the place of taxation in accordance with these Guidelines
20.
On-the-spot supplies are services and intangibles that are normally physically performed at a
readily identifiable location and that are ordinarily consumed at the same time and place where
they are physically performed, in the presence of both the person performing the supply and the
person consuming it (see para.3.116).
21.
This should not be taken to suggest that countries must change their law to literally incorporate
Guidelines3.2, 3.5 and 3.6 as legal rules in national legislation. Rather, these Guidelines
recommend what should be the end result of the national place of taxation rules, however they are
described in the relevant laws, without predicting precisely by which means that result is achieved.
22.
The supplies in these examples are performed at a readily identifiable location and require
the physical presence of the person consuming the supply but they do not require the physical
presence of the person performing them. These are therefore not on-the-spot supplies covered
by Guideline3.5 and their place of taxation is in principle determined by reference to the
customers usual residence, in accordance with Guideline3.6.
23.
Other rules will be applicable to such supplies, although they might lead to the same result.
24.
If this is not treated as a supply of goods or of immovable property, for which other rules might
apply, although they could lead to the same result.
25.
The adjective intellectual has a broad meaning and is not limited to regulated professions.
26.
Also the treatment of services that are incidental to the export or import of goods (e.g.packaging,
loading, transport, insurance etc.) is outside the scope of these Guidelines.
27.
Stewardship expenses are broadly the costs incurred by the parent company of the group for
administrative and other services provided to subsidiaries and other affiliates for the benefit of
the parent, as a shareholder, rather than for the individual benefit of the subsidiary or affiliate.
These costs can be incurred directly by the parent orby the subsidiary and passedon to the
parent. Typically, these are treated as expenses which ought to be absorbed by the parent
company because they must be regarded as stewardship or shareholders expenses benefiting
the shareholders or the group as a whole and not a subsidiary or affiliate individually.
28.
The expression framework agreement is used solely to distinguish it from the separate
business agreement for audit services to the parent trading company. The Guidelines do not
attempt to define in any way what a framework agreement might be.
29.
It is recognised that, in some cases, the paymaster function could create a separate supply, or
supplies, between CompanyA and its subsidiaries. For the purposes of this example this is not the
case.
30.
Payroll management services include multiple steps such as data collection, master data input in
systems, tracking of legislation changes, calculation of taxes, issuance of pay sheets, preparation
of accounting entries, preparation of bank transfer files, issue of summary reports, etc.

31.
In the context of this example, the term customer group refers to CompanyE and its
Establishments and Subsidiaries that employ the staff to which the services supplied by SupplierS
relate.
32.
Enterprise resource planning (ERP) systems integrate internal and external management
flows and information across an entire organisation, embracing finance and accounting
functions, manufacturing, sales and services, customer relationship management, etc. ERP
systems automate this activity with an integrated software application. Their purpose is to
facilitate the flow of information between all business functions within an organisation and to
manage the connections to outside stakeholders such as suppliers and customers. See Bidgoli,
Hossein (2004). The Internet Encyclopedia, Volume1, John Wiley &Sons, Inc. p.707.
33.
For the purpose of this example, it is assumed that all countries apply a reverse charge
mechanism that switches the liability to pay the tax from the supplier to the customer. It is
recognised that some countries do not require the customer to account for the tax under the
reverse charge mechanism when entitled to full input tax credit.
34.
See SectionB.4 of Chapter3.
AnnexE. Economic incidence of the options 275
AnnexE
Economic incidence of the options to address the broader direct tax challenges
ofthedigitaleconomy
This annex contains an overview of the expected economic incidence on consumers,

capital owners (including shareholders) and labour (workers) of three options to
address the broader tax challenges of the digital economy.
276 AnnexE. Economic incidence of the options

1.
The key policy question addressed in this annex is: How would the distribution
of the change in tax burden differ under the three tax policy options? To answer this
question, the following sections provide an overview of the expected economic incidence
in open-border economies, but with particular attention paid to the fact that the options
represent tax changes only for foreign providers without a permanent establishment (PE)
making remote sales of digital goods and services to in-country customers. The results are
summarised in terms of the distribution of tax burdens among consumers, capital owners
and labour in both producing and consuming countries.
E.1. Proposals to be analysed

2.
The three tax change options are:

a corporate income tax on the net income generated from remote sales of digital
goods and services to in-country customers by a foreign producer without a PE to
which such income is attributed under current law
an equalisation levy (excise tax) imposed on the remote sales of digital goods and
services to in-country customers by the same providers, and
a withholding tax on the gross receipts from the remote sale of digital goods and
services to in-country customers by the same providers.
E.2. Description of taxes

3.
TableE.1 provides a brief overview of the general characteristics of the three types
of taxes that will be included in the tax incidence analysis. This provides a framework for
comparing the tax types.
4.
Corporate income tax. The corporate income tax (CIT) is levied on the net income
of businesses, calculated as the difference between gross receipts and the costs of generating
the income. In the case of cross-border income, most countries apply a territorial CIT
system in which tax is imposed on income attributable to economic activity within the
country (a source-based tax); a few countries adopt worldwide CIT systems which also tax
resident corporations on their world-wide income (a residence-based tax), though in most
cases taxation of foreign-sourced profits of foreign subsidiaries is deferred until repatriation
with a credit for foreign taxes.
5.
Excise tax. The excise tax is commonly imposed on the sale of specifically listed
products, such as alcohol, tobacco, motor fuels and insurance. It is generally designed as a
tax on final consumption but the seller is responsible for collecting and remitting the tax.
It shares common features with sales taxes, except that an excise tax may not vary with the
price of the product being sold. Instead it may be levied on a specific basis, such as the unit
of weight or volume of products sold. The tax basis is however flexible in practice, and may
include the fair market value of products sold or gross receipts from sales, as presented in
the option discussed above in Chapter7. It can also be designed to impose a tax on a single
stage in the production process (e.g.retail sale in the country where consumption occurs).
6.
Withholding tax. The withholding tax (WT) option described in the Report is a tax,
in concept, that would apply to digital sales to in-country consumers from non-resident
suppliers without a PE. It can be described as a gross receipts tax (GRT) or excise tax on
these sales to consumers. The WT could apply to sales to final consumers only or it could
also apply to business-to-business digital sales.1 As discussed in the Report, the WT could
be collected from financial intermediaries that process the transactions used to pay for the
digital purchases.
TableE.1. Description of taxes included in the incidence analysis

Excise tax
Withholding tax
Type of tax
Net income tax imposed on

corporations
Tax on final consumption
Tax on final consumption
Tax base
Net income of the business

(gross receipts minus costs)
Gross receipts on sales to

customers
Gross receipts on sales to

customers
Geographic concept
Residence (where firm

is headquartered) and/or
source (where economic
activity is located)
Destination (where customer

is located)
Destination (where consumer

is located)
Scope of tax
Applies to 1) income earned

within the taxing country, or
2) world-wide income
Limited to final consumer

purchases
Limited to final consumer

purchases
E.3. What is tax incidence analysis?

7.
Tax incidence analysis is designed to determine who bears the burden of a tax. The
burden of the tax is defined to be the ultimate resting point of the tax after recognising any
tax shifting that might occur after the tax is imposed. Shifting is the process by which the
taxpayers bearing the legal responsibility for paying the tax (legal incidence) alter their
behaviour and, as a result, shift the burden of the tax to other parties though changes in
output or input prices. The final resting point for the tax is the economic incidence of
the tax.
8.
The economic theory of tax incidence starts with the fundamental premise that all
taxes are ultimately borne by individuals. The standard tax incidence analysis identifies
three categories of economic actors that can bear the ultimate burden of a tax: households
as consumers through higher prices for goods and services they buy, workers through
reduced wages and salaries, and capital owners, including shareholders, through lower
returns on capital investments.
9.
The corporate income tax provides an example of the mechanics of tax shifting.
While the CIT is the legal liability of a corporation, in response to the tax the firm may
charge consumers higher prices for the firms output, pay labour less, or reduce the
dividends paid to shareholders on their capital investments. The extent of shifting depends
upon the market conditions faced by the corporation, including how sensitive consumers
are to price changes, the presence of competition, and how responsive the supply of labour
and capital are to changes in compensation and the return on investment. The market
conditions facing the firm paying the CIT will determine whether the tax burden will be
primarily shifted forward to consumers and/or backward to labour and capital.
E.4. Tax incidence analysis

10. This section describes the expected shifting process that determines the expected
economic incidence of each tax option. The more complicated corporate income tax
incidence analysis is discussed first.
11. The amount of taxes to be collected from the excise tax and withholding tax is
assumed to be equivalent to the corporate income tax that would be imposed on the economic
activities of the remote seller sourced to the sales destination country. The incidence results
depend on the specific details of each policy option.
E.4.1. Incidence of the corporate income tax option

12. There is an extensive body of literature on the theory of corporate income tax
incidence, as well as a number of empirical studies estimating key parameters in the tax
shifting process. An important determinant of the incidence of the corporate income tax
is the degree of competition in the market where tax changes occur. The incidence results
will differ between perfectly competitive markets, where sellers take market prices as
given (beyond their control), and imperfectly competitive markets, where sellers have some
control over market prices. Both cases are analysed in this paper.
13. The incidence of a corporate income tax increase will also depend on how extensive
the tax increase is in terms of corporate sector activities subject to the increase. In the
standard corporate income tax incidence analysis, it is assumed that all corporate taxpayers
are subject to the increase in tax. In contrast, the corporate income tax proposal included
in this analysis would increase corporate income tax liability only for foreign corporations
without a PE selling digital goods and services to in-country customers, as domestic
suppliers of such services are currently subject to corporate income tax on such income. In
this case, the tax increase is more accurately analysed as a selective excise tax applying
only to a select group of corporate suppliers selling in a specific market. This dimension
affects the incidence of the corporate income tax increase, compared to the standard
analysis of a broad corporate income tax increase.2
E.4.1.1. Key assumptions

14. The corporate income tax incidence analysis of the extension of the CIT to foreign
providers without a PE selling digital goods and services into a country under current law
is based on the following key assumptions:
The digital goods and services are sold by both foreign corporations without a PE
in the country and currently taxable corporations, including domestic corporations
and foreign corporations with a PE.
There is a worldwide market for capital; labour is substantially less mobile
internationally.
The time horizon for the analysis allows for cross-border adjustments in response
to the tax changes, involving changes in both input and output markets.
Any increase in corporate income tax collections from foreign suppliers of digital
products without a current PE will be part of a CIT balanced budget change (e.g.used
to reduce the countries general corporate income tax rate).3
15. The incidence of tax changes in a single country depends upon what happens to
tax rates in other countries. Relative tax rates determine the degree of shifting across
industries within a single country, as well as shifting across countries. This CIT incidence
analysis assumes that a significant number of countries impose these changes in a global
coordinated step. It does not include an analysis of the expected incidence if only one or
several countries impose the change. Thus, there are not significant relative tax changes
between countries as a result of the coordinated action. However, as explained later, the
size of the tax change may differ by country because of differences in statutory CIT rates.
E.4.1.2. Shifting process

16. The initial imposition of the CIT on remote sellers of digital products without a
PE will increase the CIT liabilities of those firms.4 This is the legal incidence of the tax.
Although their tax payments to a country will increase, the owners of affected providers
may not bear the ultimate burden (economic incidence) of the tax increase. This is due
to the fact that the affected taxpayers are expected to respond to the tax increase by
changing the level of production, the demand for inputs used in production and distribution,
and, potentially output prices, in a process that can result in shifting the tax forward in
consumer prices or backward in lower payments to the key factors of production, labour
and capital.
17. The initial impact of the CIT tax increase on remote sellers of digital products
without a PE is to reduce their after-tax rate of return on capital invested in producing
digital products in the production country. In the short-run, with no change in the beforetax price charged to customers or payments to labour, the after-tax rate-of-return to capital
invested in the production country by those affected companies will fall by the amount of
the tax wedge between the before-tax and after-tax rates of return on the capital invested
in producing digital products. For example, if the pre-tax rate of return is 10% and the CIT
rate to be applied is 20%, the after-tax rate of return will be 8%.
18. With time to adjust to the changes, the suppliers without a PE will respond to the
reduction in the after-tax rate of return through possible output price adjustments, changes
in the level of output and changes in input prices. The types of adjustments will depend
upon the market structure facing the remote sellers without a PE of digital goods and
services. The following sections compare the expected corporate income tax incidence for
two types of markets: perfectly competitive and imperfectly competitive markets.
E.4.1.3. Perfectly competitive market

19. In a perfectly competitive market, producers are viewed as price takers reacting
to a market-determined price that is beyond their control. If the remote suppliers without
a PE of digital goods and services are operating in a competitive market, the adjustment
to the lower after-tax rate of return (relative to other investment opportunities) will occur
through reductions in the affected remote suppliers sales into the market where they dont
have PE. In a competitive market, other suppliers would be expected to replace the sales
reduced by the affected suppliers. Assuming that capital is mobile between industries and
countries, equity investors in the affected remote suppliers will shift capital out of the
production of digital goods and services for the market without PE, and other suppliers
with PE will shift output and capital to produce the replacement sales.5 The shifting will
continue until the pre-tax rate of return on capital used by affected remote increases
sufficiently to restore the after-tax rate of return to the world-wide rate.
20. The new worldwide after-tax rate of return may be relatively unchanged if the
capital shifted away from the remote sellers with no PE is a relatively small share of
worldwide capital.6 If so, the shifted capital will bear little of the burden of the corporate
income tax increase because the after-tax rate of return for equity investors will be almost
unchanged. However, as capital is shifted to other uses, the output level of the foreign
producers of digital goods and services without a PE will be reduced while the output of
other suppliers will increase.
21. The reduced output by the affected foreign suppliers will result in less labour
employed by the affected firms. To the extent that affected foreign producers of digital

goods and services employ specialised labour, it is possible that their wages could be
reduced as labour shifts into other sectors where this type of labour is not as productive.
The magnitude of any wage reduction is expected to vary across countries where the
affected foreign suppliers are located given variations in labour market conditions. To
the extent that wages are reduced, displaced labour would bear a portion of the corporate
income tax increase on remote sellers without a PE.
22. The remaining question is whether the price of digital goods and services will
increase as remote sellers affected by the tax increase reduce their output. The extent to
which market prices in consumer countries increase will depend upon how important the
output of the remote sellers without a PE is relative to the country sales. Assuming that the
affected remote sellers account for a significant share of the worldwide market output, it is
expected that the price of digital goods and services would increase and a portion of the tax
increase would be shifted forward to consumers. The availability of other suppliers with
similar pre-tax costs and the availability of substitutes for the digital goods and services
will be a factor in determining the magnitude of the consumer price increase.
23. As a result, in the case of perfect competition, the incidence of the corporate income
tax increase on remote sellers of digital goods and services is likely to be borne by labour
in the production country and consumers in the market country. The combination of higher
consumer prices in the digital goods and services market and reductions in wages for
workers in affected production countries will reduce the real income of residents in both
production countries and consuming countries. Without further information about the
economic characteristics of the affected remote producers and the overall market for digital
goods and services, the specific labour and consumer shares of the tax increase cannot be
determined.
24. It should be noted that the tax shifting process described above may extend over
a significant period of time. The incidence conclusions should be interpreted as the longrun results after the economic adjustments have occurred. It should also be noted that
producers of digital goods and services, a relatively new industry, may be making excess
profits, beyond a competitive rate of return, in the short- to intermediate-period, even
in a competitive market due to cost efficiencies relative to the marginal supplier. In this
situation, the initial reduction in the after-tax rate of return for capital invested by the
affected foreign producers may not lead to an immediate reduction in their level of sales
and capital. This is because the lower after-tax rate of return may still be higher than
the next best alternative investment of the capital. In this case, capital may temporarily
bear the burden of the tax increase. However, in the long-run (unlike in the example
of an imperfectly competitive market below) these excess profits will be eliminated by
competition and all capital will earn only a competitive rate of return; at this point the
above analysis (assuming perfect competition) would apply.7
E.4.1.4. Imperfectly competitive market

25. The incidence of the corporate income tax increase will differ if the market for
digital goods and services is not perfectly competitive. As used in this analysis, imperfect
competition refers to a market where producers earn excess profits above the competitive
rate of return. In this case, the affected producers are price setters, not price takers, and
the affected foreign suppliers have enough market power to set the price of digital goods
and services sold in the market countries. The lack of competition (at least in the short or
medium term) may be due to unique factors of production, including intangibles, that are
owned or used by the affected producers.
26. In this situation, in response to the higher CIT on the income of foreign suppliers
without a PE, the affected foreign suppliers are less likely to reduce significantly their longrun level of output or capital investment. This is the case because the capital is earning
excess profits above-and-beyond the competitive rate of return. In other words, there may
be no alternative investment that could generate an after-tax rate of return higher than the
after-tax rate of return, including the CIT, earned by the affected producers. In this case,
the increased corporate income tax would be borne primarily by owners of equity capital
invested in the affected foreign producers of digital goods and services without a PE in the
consumer country.8
27. There is one more dimension of the shifting process that should be noted. Given
that CIT rates differ across countries, the extension of the corporate income tax to foreign
sellers without a PE will result in different relative reductions in the after-tax rate of return
on capital in different countries. It is possible that the reduction in the rate of return in
high-tax rate countries may be high enough to drive the after-tax rate of return of affected
digital suppliers down below the competitive worldwide after-tax rate of return.9 If this
happens, there could be a shift away from those high-tax market countries unless prices
of digital goods and services increase to offset the relative tax increases. In this case, a
portion of the tax increase on the remote suppliers could be borne by consumers in the
high-tax countries.
28. In summary, the expected incidence of the corporate income tax increase on foreign
suppliers without a PE of digital goods and services is as follows:
incidence of the corporate income tax increase is likely to be borne by labour in the
affected foreign suppliers production country and consumers in market countries.
Consumers in the market countries are more likely to face higher prices if the
affected suppliers sell a significant percentage in a particular market and there are
not alternative suppliers with similar cost structures or there are not close product
substitutes.
If the market for digital goods and services provided by foreign suppliers without a
PE is characterised as imperfectly competitive, the corporate income tax increase is
likely to be borne principally by the equity owners of the affected foreign suppliers.
E.4.2. Incidence of the excise tax option

29. A second tax policy option identified for analysis is to impose, in place of the
corporate income tax, an excise tax on the gross receipts paid by in-country customers in
consideration for sales of digital products by remote sellers without a PE.10 It is assumed
that the excise tax rate would be calculated to raise an equivalent amount of revenue as the
CIT on the related income of the remote sellers without a PE.11
30. The standard assumption in the incidence analysis of consumption taxes (i.e.taxes
designed to tax final consumption of households) is that a general consumption tax, such
as a VAT, will be passed forward in higher prices to consumers.
31. There are, however, important conditions that need to be satisfied to support this
conclusion. The most important is that the consumption tax increase must be effectively
collected from all sellers of the goods and services, whether domestic or foreign sellers. A
second is that the same tax rate applies to all sellers of the product. Under these conditions,
buyers cannot avoid paying the tax through higher prices by buying from a seller that is
collecting a lower (or no) tax.

32. However, in the case of the proposal to adopt an excise tax equivalent to the CIT
that would be imposed on foreign sellers without a PE, the tax increase is only affecting
a subset of suppliers to the domestic market. Therefore, the degree of shifting of the tax
depends upon the reactions of only a small number of suppliers, remote sellers without a
PE, not responses from all market suppliers.
33. As in the case for the corporate income tax increase discussed above, the ability of
remote suppliers without a PE to shift the excise tax forward to consumers will be influenced
by the degree of competition in the market for digital goods and services. The analysis differs
under the two assumed market possibilities: 1) the market is perfectly competitive, or 2) the
market is imperfectly competitive. As in the case of the corporate income tax incidence
analysis, these are distinguished by the presence or absence of excess profits.
34. If the affected foreign suppliers without a PE are operating in a competitive market,
the initial impact of the excise tax on affected foreign suppliers will be the same reduction
in the after-tax rate of return on capital invested by the affected foreign suppliers, as seen
in the corporate income tax increase case. As the affected foreign suppliers attempt to
increase consumer prices, the relative price of their sales of digital goods and products
in consumer countries will increase. Because their customers can choose from substitute
suppliers and/or alternative goods and services where the price has not increased, the
ability of the affected foreign suppliers to pass the tax on to consumers in higher prices
will be limited. As a result, the tax is not expected to be passed forward in higher prices as
would be the case with a general consumption tax rate increase; any shifting to consumers
will depend on the portion of the market of the affected suppliers and the availability of
alternative suppliers with similar cost structures and the availability of alternative products.
35. As in the case of the CIT increase under perfect competition, capital will have to
shift from the affected foreign suppliers to replacement suppliers or to other industries
and countries. With competitive capital markets, the after-tax rate of return of the affected
digital goods and services providers will have to be pushed back up to the unchanged
worldwide after-tax rate of return though price increases of digital goods and services or
reductions in wages for specialised labour used by the affected foreign suppliers or they
will have to exit the market. Similar to the CIT analysis, the burden of the excise tax is
expected to be borne by labour in the affected foreign suppliers production country and
by consumers in market countries. As noted above, the extent of shifting to consumers will
depend on the portion of the market of the affected suppliers, the availability of alternative
suppliers with similar cost structures, and the availability of alternative products.
36. The incidence of the excise tax will also be similar to the incidence of the corporate
income tax increase on affected foreign suppliers of digital goods and services if the
market is imperfectly competitive. When affected suppliers earn excess profits, the tax
increase is expected to be borne by the equity investors in the affected suppliers through a
reduction in their rates of return, which will still exceed a competitive rate of return.
37. In summary, the conclusion is that the excise tax is expected to have the same
pattern of economic incidence as the extension of the corporate income tax to foreign
suppliers without a PE.
E.4.3. Incidence of the withholding tax option

38. A third option identified for analysis is a withholding tax on the gross receipts from
the sale of digital goods and services by foreign suppliers without a PE. As in the case of
the excise tax, the withholding tax rate would be set to raise an amount of revenue equal
to the CIT that would be paid on the income generated by the remote sales to in-country
customers.
39. The withholding tax is a gross receipts tax on the total sales to in-country consumers
of digital products sold by foreign suppliers without a PE. In other words, it would also
operate as a selective excise tax on the consumption of this category of goods and
services. Because all three of the tax options are operating as selective excise taxes from
an economic standpoint, the incidence of the withholding tax should be the same as the
incidence pattern under the CIT extension and the excise tax.
40. If the market for digital goods and services is competitive, then the burden of the
withholding tax on foreign suppliers without a PE is expected to fall on specialised labour
used by the affected foreign suppliers and consumers of digital products, depending on
the importance of the affected suppliers in the particular market and the availability of
replacement suppliers with similar cost structures and the availability of alternative goods
and services. In the case of imperfectly competitive markets, the withholding tax would be
borne primarily by equity investors in the affected foreign suppliers.12
E.5. Conclusion
41. Given the assumptions described above, the expected economic incidence of the
three tax options for taxing the activities related to the sales of digital goods and services
by foreign suppliers without a PE would be the same.
incidence of the corporate income tax increase is likely to be borne by labour in the
affected foreign suppliers production country and consumers in market countries,
depending on the importance of the affected suppliers in the particular market
and the availability of replacement suppliers with similar cost structures and the
availability of alternative goods and services.
If the market is imperfectly competitive, the corporate income tax increase is likely
to be borne principally by the equity owners of the affected foreign suppliers.
42. It should be noted that there will be a difference in the geographic distributions
of the tax burdens borne by capital owners, labour and consumers. Any portion of a CIT
increase that would be borne by reductions in the income of equity shareholders of foreign
suppliers without a PE will occur in countries where the shareholders are located. The
distribution of the burden on labour will reflect the geographic distribution of production
by the affected suppliers. In contrast, any portion of the tax burden borne by consumers
will be spread over market countries where the foreign producers without a PE have market
power in setting the domestic price of particular digital goods and services. Therefore,
the share of the total worldwide increase in tax burdens borne by consumers, workers and
capital owners will vary from country-to-country.
43. As a final point, further analysis of the economic characteristics of the affected
remote producers and the market for particular digital goods and services would need to be
analysed to determine whether perfect competition or imperfect competition, in the short
and medium term is the most accurate to use in the incidence analysis. The analysis also
does not provide any insights into the distribution of tax burdens by household income
levels. In addition, the incidence results for the three tax policy options depend heavily
upon the key assumptions about the responsiveness of foreign suppliers of digital goods and
services without a PE that will become subject to the alternative tax options.
Notes
1.
This incidence analysis assumes the excise tax and withholding tax only apply to final consumer
sales. If these taxes were applied to business purchases, they could create pyramiding of taxes
with incidence effects beyond the scope of this analysis.
2.
The standard corporate income tax incidence analysis is based on the Harberger Model
of the incidence of changes in a general corporate income tax. For a fairly easy-to-follow
explanation of the model, see Arnold C. Harberger, The ABCs of Corporation Tax Incidence:
Insights into the Open-Economy Case, Chapter2, American Council for Capital Formation,
Policy and Economic Growth (April 1995). In this article, Harberger explains how his original
closed-economy model has to be modified to analyse CIT incidence in the international setting.
William C. Randolph, International Burdens of the Corporate Income Tax, Congressional
Budget Office, Washington, DC. (2006) provides a more detailed analysis of the expected
incidence of the general corporate income tax. Other economic incidence analyses of note
include Alan Auerbach, Who Bears the Corporate Tax? A Review of What We Know, Tax
Policy and the Economy 20 (2006) and Kimberly C. Clausing, Who Pays the Corporate Tax
in a Global Economy?, National Tax Journal, volume 66, no. 1, 2013.
3.
This is a simplifying assumption. Assuming there is no change in overall corporate income

taxes avoids the need to consider possible macroeconomic impacts from the tax options.
4.
To simplify the analysis, it is assumed that the foreign suppliers of digital goods and services
without a PE are not taxable on the income related to the sales in the production country. In
this case, the change in corporate taxes will equal the increase imposed by the consumer
country. If the supplier is subject to a corporate income tax in the production country under a
residence-based tax with credits for taxes paid in other countries, the net change in corporate
income taxes will depend upon the relative size of the tax rates in the production and consumer
countries.
5.
A clientele effect might occur where affected suppliers no longer provide goods and services in
the country and shift output to other countries, while other suppliers with PE shift their output
to the country with no economic effects other than geographic redistribution of the sales.
6.
It should be noted that the average worldwide increase in the CIT is expected to be borne by
worldwide capital. However, under the proposal this increase is expected to be relatively small.
7.
The tax incidence of the corporate tax increase, in theory, can also be affected by what happens
to the additional CIT collected from foreign suppliers of digital goods and services without a
PE. In this analysis, it is assumed that any increased CIT collections will be offset by an equal
decrease in the general CIT rate to hold CIT tax collections constant. This is a simplifying
assumption.
8.
There is a growing body of empirical studies estimating the incidence of the corporate income
tax that supports this view. For a good review of the literature, see William M. Gentry, A
Review of the Evidence on the Incidence of the corporate Income Tax, U.S. Department of
Treasury, OTA Paper 101 (December 2007). The studies suggest that the corporate income tax
imposed on supernormal profits (economic rents) in excess of the normal rate of return is
borne primarily by capital owners.
9.
Given the assumption that total CIT collections are unchanged as a result of the balance budget
adjustment in CIT revenues, there should be no net reduction in the worldwide after-tax rate
of return up to this point. In other words, except for this final possibility, capital investment
in other sectors of the economy should not be affected by the extension of the CIT to foreign
suppliers without a permanent establishment.
10.
In this analysis it is assumed that the excise tax (as well as the withholding tax) is only imposed
on final consumers of digital goods and services purchased from foreign suppliers without
aPE.
11.
The mechanics of determining the amount of the excise tax have not been specified, but would
likely be an industry rate rather than varying by company.
12.
Note that as with the CIT and excise tax options, if the after-tax rate of return of affected digital
suppliers is driven below the competitive worldwide after-tax rate of return, there could be a
shift away from those high-tax market countries unless prices of digital goods and services
increase to offset the relative tax increases. In this case, a portion of the tax increase on the
remote suppliers could be shared with consumers in the high-tax countries.
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(23 2015 28 1 P) ISBN 978-92-64-24102-2 2015
Addressing the Tax Challenges of the Digital

Economy
Addressing base erosion and profit shifting is a key priority of governments around the globe. In 2013, OECD
and G20 countries, working together on an equal footing, adopted a 15-point Action Plan to address BEPS.
This report is an output of Action 1.
Beyond securing revenues by realigning taxation with economic activities and value creation, the OECD/G20
BEPS Project aims to create a single set of consensus-based international tax rules to address BEPS, and
hence to protect tax bases while offering increased certainty and predictability to taxpayers. A key focus of this
work is to eliminate double non-taxation. However in doing so, new rules should not result in double taxation,
unwarranted compliance burdens or restrictions to legitimate cross-border activity.
Contents
Chapter 1. Introduction to tax challenges of the digital economy
Chapter 2. Fundamental principles of taxation
Chapter 3. Information and communication technology and its impact on the economy
Chapter 4. The digital economy, new business models and key features
Chapter 5. Identifying opportunities for BEPS in the digital economy
Chapter 6. Tackling BEPS in the digital economy
Chapter 7. Broader direct tax challenges raised by the digital economy and the options to address them
Chapter 8. Broader indirect tax challenges raised by the digital economy and the options to address them
valuation of the broader direct and indirect tax challenges raised by the digital economy
Chapter 9. E
and of the options to address them
Chapter 10. Summary of the conclusions and next steps
Annex A. Prior work on the digital economy
Annex B. Typical tax planning structures in integrated business models
Annex C. The collection of VAT/GST on imports of low value goods
Annex D. OECD International VAT/GST Guidelines Chapter 3
Annex E. E
conomic incidence of the options to address the broader direct tax challenges of the digital economy
Consult this publication on line at http://dx.doi.org/10.1787/9789264241046-en.

This work is published on the OECD iLibrary, which gathers all OECD books, periodicals and statistical databases.
Visit www.oecd-ilibrary.org for more information.
isbn 978-92-64-24102-2
23 2015 28 1 P

Project
Neutralising the Effects

of Hybrid Mismatch
Arrangements
Neutralising the Effects

of Hybrid Mismatch
Arrangements, Action 2
2015 Final Report

OECD (2015), Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 - 2015 Final Report,
OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241138-en
ISBN 978-92-64-24108-4 (print)

ISBN 978-92-64-24113-8 (PDF)

OECD 2015
FOREwORD 3
Foreword
century ago. weaknesses in the current rules create opportunities for base erosion and profit
February 2013, OECD and G20 countries adopted a 15-point Action Plan to address
BEPS in September 2013. The Action Plan identified 15 actions along three key pillars:
organisations such as the International Monetary Fund, the world Bank and the United
the BEPS project received more than 1 400 submissions from industry, advisers, NGOs and
After two years of work, the 15 actions have now been completed. All the different
2016. OECD and G20 countries have also agreed to continue to work together to ensure a
OECD and G20 countries. To further this objective, in 2016 OECD and G20 countries will
NEUTRALISING THE EFFECTS OF HYBRID MISMATCH ARRANGEMENTS OECD 2015
4 FOREwORD
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms ........................................................................................... 9
Executive summary ......................................................................................................... 11
Part I .................................................................................................................................. 11
Part II ................................................................................................................................ 12
Part I Recommendations for domestic law .................................................................. 13
Introduction to Part I ..................................................................................................... 15
Background ....................................................................................................................... 15
Action 2 of the BEPS Action Plan .................................................................................... 15
Part I recommendations .................................................................................................... 16
Chapter 1 Hybrid Financial Instrument Rule ............................................................. 23
Overview ........................................................................................................................... 25
Recommendation 1.1 - Neutralise the mismatch to the extent the payment gives rise
to a D/NI outcome ............................................................................................................. 27
Recommendation 1.2 - Definition of financial instrument and substitute payment .......... 35
Recommendation 1.3 - Rule only applies to a payment under a financial instrument
that results in a hybrid mismatch ...................................................................................... 40
Recommendation 1.4 - Scope of the rule .......................................................................... 44
Recommendation 1.5 - Exceptions to the rule .................................................................. 44
Chapter 2 Specific recommendations for the tax treatment of financial
instruments ...................................................................................................................... 45
Overview ........................................................................................................................... 45
Recommendation 2.1 - Denial of dividend exemption for deductible payments .............. 46
Recommendation 2.2 - Restriction of foreign tax credits under a hybrid transfer ............ 47
Recommendation 2.3 - Scope ........................................................................................... 47
Chapter 3 Disregarded hybrid payments rule............................................................. 49
Overview ........................................................................................................................... 50
to a D/NI outcome ............................................................................................................. 50
Recommendation 3.2 - Rule only applies to disregarded payments made by a hybrid
payer .................................................................................................................................. 53
Recommendation 3.3 - Rule only applies to payments that result in a hybrid mismatch . 54
6 TABLE OF CONTENTS
Chapter 4 Reverse hybrid rule ..................................................................................... 55
Overview ........................................................................................................................... 55
to a D/NI outcome ............................................................................................................. 56
Recommendation 4.2 - Rule only applies to payment made to a reverse hybrid .............. 59
Recommendation 4.3 - Rule only applies to hybrid mismatches ...................................... 60
Chapter 5 Specific recommendations for the tax treatment of reverse hybrids ..... 63
Overview ........................................................................................................................... 63
Recommendation 5.1 - Improvements to CFC and other offshore investment regimes ... 64
Recommendation 5.2 - Limiting the tax transparency for non-resident investors ............ 64
Recommendation 5.3 - Information reporting for intermediaries ..................................... 65
Chapter 6 Deductible hybrid payments rule ............................................................... 67
Overview ........................................................................................................................... 68
Recommendation 6.1- Neutralise the mismatch to the extent the payment gives rise to
a DD outcome ................................................................................................................... 69
Recommendation 6.2 - Rule only applies to deductible payments made by a hybrid
payer .................................................................................................................................. 74
Chapter 7 Dual-resident payer rule.............................................................................. 77
Overview ........................................................................................................................... 77
Recommendation 7.1 - Neutralise the mismatch to the extent it gives rise to a DD
outcome ............................................................................................................................. 78
Recommendation 7.2 - Rule only applies to deductible payments made by a dual
resident .............................................................................................................................. 80
Chapter 8 Imported mismatch rule .............................................................................. 83
Overview ........................................................................................................................... 83
Recommendation 8.1 - Deny the deduction to the extent the payment gives rise
to an indirect D/NI outcome.............................................................................................. 85
Recommendation 8.2 - Rule only applies to payments that are set-off against a
deduction under a hybrid mismatch arrangement ............................................................. 90
Recommendation 8.3 Definition of imported mismatch payment ................................. 91
Recommendation 8.4 Scope of the rule ......................................................................... 91
Chapter 9 Design principles .......................................................................................... 93
Overview ........................................................................................................................... 94
Recommendation 9.1 - Design principles ......................................................................... 94
Recommendation 9.2 - Implementation and co-ordination ............................................. 100
Chapter 10 Definition of structured arrangement .................................................... 105
Overview ......................................................................................................................... 105
Recommendation 10.1 - General definition .................................................................... 106
Recommendation 10.2 - Specific examples of structured arrangements ........................ 108
Recommendation 10.3 - When taxpayer is not a party to a structured arrangement ...... 110
TABLE OF CONTENTS 7
Chapter 11 Definitions of related persons, control group and acting together ...... 113
Overview ......................................................................................................................... 114
Recommendation 11.1 - General definition .................................................................... 114
Recommendation 11.2 - Aggregation of interests........................................................... 117
Recommendation 11.3 - Acting together ........................................................................ 117
Chapter 12 Other definitions ..................................................................................... 121
Overview ......................................................................................................................... 123
Recommendation 12.1 - Other definitions ...................................................................... 124
Part II Recommendations on treaty issues ................................................................ 133
Introduction to Part II .................................................................................................. 135
Chapter 13 Dual-resident entities ............................................................................... 137
Chapter 14 Treaty provision on transparent entities ............................................... 139
Chapter 15 Interaction between part I and tax treaties ........................................... 145
Rule providing for the denial of deductions.................................................................... 145
Defensive rule requiring the inclusion of a payment in ordinary income ....................... 145
Exemption method .......................................................................................................... 146
Credit method.................................................................................................................. 147
Potential application of anti-discrimination provisions in the OECD Model
Convention ...................................................................................................................... 148
Annex A List of Part I Recommendations.................................................................. 151
Annex B Examples ....................................................................................................... 169
Table
Table 1.1 General Overview of the Recommendations ................................................... 20
ABBREVIATIONS AND ACRONYMS 9

BEPS
Base Erosion and Profit Shifting
CFA
CFC
Controlled Foreign Company
CIV
Collective Investment Vehicle
CRS
Common Reporting Standard (Standard for Automatic Exchange of

Financial Account Information in Tax Matters)
DD
Double deduction
D/NI
Deduction / no inclusion
FIF
Foreign Investment Fund
FTA
Forum on Tax Administration
GAAP
Generally Accepted Accounting Practice
IFRS
International Financial Reporting Standards
JITSIC
Joint International Tax Shelter Information and Collaboration
OECD
PE
Permanent Establishment
REIT
Real Estate Investment Trust
TRACE
Treaty Relief and Compliance Enhancement
WP1
Working Party No.1 on Tax Conventions and Related Questions
WP11
Working Party No.11 on Aggressive Tax Planning
EXECUTIVE SUMMARY 11
Executive summary
Hybrid mismatch arrangements exploit differences in the tax treatment of an entity or

instrument under the laws of two or more tax jurisdictions to achieve double
non-taxation, including long-term deferral. These types of arrangements are widespread and
result in a substantial erosion of the taxable bases of the countries concerned. They have an
overall negative impact on competition, efficiency, transparency and fairness.
With a view to increasing the coherence of corporate income taxation at the international
level, the OECD/G20 BEPS Project called for recommendations regarding the design of
domestic rules and the development of model treaty provisions that would neutralise the tax
effects of hybrid mismatch arrangements. This report sets out those recommendations: Part I
contains recommendations for changes to domestic law and Part II sets out recommended
changes to the OECD Model Tax Convention. Once translated into domestic and treaty law,
these recommendations will neutralise hybrid mismatches, by putting an end to multiple
deductions for a single expense, deductions without corresponding taxation or the generation
of multiple foreign tax credits for one amount of foreign tax paid. By neutralising the
mismatch in tax outcomes, the rules will prevent these arrangements from being used as a tool
for BEPS without adversely impacting cross-border trade and investment.
This report supersedes the interim report Neutralising the Effect of Hybrid Mismatch
Arrangements (OECD, 2014) that was released as part of the first set of BEPS deliverables in
September 2014. Compared to that report, the recommendations in Part I have been
supplemented with further guidance and practical examples to explain the operation of the
rules in further detail. Further work has also been undertaken on asset transfer transactions
(such as stock-lending and repo transactions), imported hybrid mismatches, and the treatment
of a payment that is included as income under a controlled foreign company (CFC) regime.
The consensus achieved on these issues is reflected in the report. As indicated in the
September 2014 report, countries remain free in their policy choices as to whether the hybrid
mismatch rules should be applied to mismatches that arise under intra-group hybrid regulatory
capital. Where one country chooses not to apply the rules to neutralise a hybrid mismatch in
respect of a particular hybrid regulatory capital instrument, this does not affect another
countrys policy choice of whether to apply the rules in respect of the particular instrument.
Part I
Part I of the report sets out recommendations for rules to address mismatches in tax
outcomes where they arise in respect of payments made under a hybrid financial instrument
or payments made to or by a hybrid entity. It also recommends rules to address indirect
mismatches that arise when the effects of a hybrid mismatch arrangement are imported into a
third jurisdiction. The recommendations take the form of linking rules that align the tax
treatment of an instrument or entity with the tax treatment in the counterparty jurisdiction but
otherwise do not disturb the commercial outcomes. The rules apply automatically and there is
a rule order in the form of a primary rule and a secondary or defensive rule. This prevents
12 EXECUTIVE SUMMARY
more than one country applying the rule to the same arrangement and also avoids double
taxation.
The recommended primary rule is that countries deny the taxpayers deduction for a
payment to the extent that it is not included in the taxable income of the recipient in the
counterparty jurisdiction or it is also deductible in the counterparty jurisdiction. If the primary
rule is not applied, then the counterparty jurisdiction can generally apply a defensive rule,
requiring the deductible payment to be included in income or denying the duplicate deduction
depending on the nature of the mismatch.
The report recognises the importance of co-ordination in the implementation and
application of the hybrid mismatch rules to ensure that the rules are effective and to minimise
compliance and administration costs for taxpayers and tax administrations. To this end, it sets
out a common set of design principles and defined terms intended to ensure consistency in the
application of the rules.
Part II
Part II addresses the part of Action 2 aimed at ensuring that hybrid instruments and
entities, as well as dual resident entities, are not used to obtain unduly the benefits of tax
treaties and that tax treaties do not prevent the application of the changes to domestic law
recommended in Part I.
Part II first examines the issue of dual resident entities, i.e. entities that are residents of
two States for tax purposes. It notes that the work on Action 6 will address some of the BEPS
concerns related to the issue of dual resident entities by providing that cases of dual residence
under a tax treaty would be solved on a case-by-case basis rather than on the basis of the
current rule based on the place of effective management of entities. This change, however,
will not address all BEPS concerns related to dual resident entities, domestic law changes
being needed to address other avoidance strategies involving dual residence.
Part II also deals with the application of tax treaties to hybrid entities, i.e. entities that are
not treated as taxpayers by either or both States that have entered into a tax treaty (such as
partnerships in many countries). The report proposes to include in the OECD Model Tax
Convention (OECD, 2010) a new provision and detailed Commentary that will ensure that
benefits of tax treaties are granted in appropriate cases to the income of these entities but also
that these benefits are not granted where neither State treats, under its domestic law, the
income of such an entity as the income of one of its residents.
Finally, Part II addresses potential treaty issues that could arise from the
recommendations in Part I. It first examines treaty issues related to rules that would result in
the denial of a deduction or would require the inclusion of a payment in ordinary income and
concludes that tax treaties would generally not prevent the application of these rules. It then
examines the impact of the recommendations of Part I with respect to tax treaty rules related
to the elimination of double taxation and notes that problems could arise in the case of
bilateral tax treaties that provide for the application of the exemption method with respect to
dividends received from foreign companies. The report describes possible treaty changes that
would address these problems. The last issue dealt with in Part II is the possible impact of tax
treaty rules concerning non-discrimination on the recommendations of Part I; the report
concludes that, as long as the domestic rules that will be drafted to implement these
recommendations are properly worded, there should be no conflict with these nondiscrimination provisions.
PART I. RECOMMENDATIONS FOR DOMESTIC LAW 13
Part I
Recommendations for domestic law
INTRODUCTION TO PART I 15
Introduction to Part I
Background
1.
The role played by hybrid mismatch arrangements in aggressive tax planning has
been discussed in a number of OECD reports. For example, an OECD report on
Addressing Tax Risks Involving Bank Losses (OECD, 2010) highlighted their use in the
context of international banking and recommended that revenue bodies bring to the
attention of their government tax policy officials those situations which may potentially
raise policy issues, and, in particular, those where the same tax loss is relieved in more
than one country as a result of differences in tax treatment between jurisdictions, in order
to determine whether steps should be taken to eliminate that arbitrage/mismatch
opportunity. Similarly the OECD report on Corporate Loss Utilisation through
Aggressive Tax Planning (OECD, 2011) recommended countries consider introducing
restrictions on the multiple use of the same loss to the extent they are concerned with
these results.
2.
As a result of concerns raised by a number of OECD member countries, the
OECD undertook a review with interested member countries to identify examples of tax
planning schemes involving hybrid mismatch arrangements and to assess the
effectiveness of response strategies adopted by those countries. That review culminated in
a report on Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues (Hybrids
Report, OECD, 2012). The Hybrids Report concludes that the collective tax base of
countries is put at risk through the operation of hybrid mismatch arrangements even
though it is often difficult to determine unequivocally which individual country has lost
tax revenue under the arrangement. Apart from impacting on tax revenues, the Hybrids
Report also concluded that hybrid mismatch arrangements have a negative impact on
competition, efficiency, transparency and fairness. The Hybrids Report set out a number
of policy options to address such hybrid mismatch arrangements and concluded that
domestic law rules which link the tax treatment of an entity, instrument or transfer to the
tax treatment in another country had significant potential as a tool to address hybrid
mismatch arrangements. Although such linking rules make the application of domestic
law more complicated, the Hybrids Report noted that such rules are not a novelty as, in
principle, foreign tax credit rules, subject to tax clauses and controlled foreign company
(CFC) rules often do exactly that.
Action 2 of the BEPS Action Plan

3.
Action 2 calls for the development of model treaty provisions and
recommendations regarding the design of domestic rules to neutralise the effects of
hybrid instruments and entities. The Action Item states that this may include:
16 INTRODUCTION TO PART I
(a) Changes to the OECD Model Tax Convention to ensure that hybrid instruments
and entities (as well as dual resident entities) are not used to obtain the benefits of
treaties unduly;
(b) Domestic law provisions that prevent exemption or non-recognition for payments
that are deductible by the payer;
(c) Domestic law provisions that deny a deduction for a payment that is not includible
in income by the recipient (and is not subject to taxation under CFC or similar
rules);
(d) Domestic law provisions that deny a deduction for a payment that is also
deductible in another jurisdiction; and
(e) Where necessary, guidance on co-ordination or tie-breaker rules if more than one
country seeks to apply such rules to a transaction or structure.
Part I recommendations
4.
Part I of this report sets out the recommendations for the design of the domestic
law rules called for under Action 2. It recommends specific improvements to domestic
law, designed to achieve a better alignment between those laws and their intended tax
policy outcomes (specific recommendations) and the introduction of linking rules that
neutralise the mismatch in tax outcomes under a hybrid mismatch arrangement without
disturbing any of the other tax, commercial or regulatory consequences (hybrid mismatch
rules).
5.
In terms of specific changes to domestic law, Chapters 2 and 5 of this report
recommend improvements to domestic law rules that:
(a) Deny a dividend exemption, or equivalent relief from economic double taxation,
in respect of deductible payments made under financial instruments.
(b) Introduce measures to prevent hybrid transfers being used to duplicate credits for
taxes withheld at source.
(c) Alter the effect of CFC and other offshore investment regimes to bring the income
of hybrid entities within the charge to taxation under the laws of the investor
jurisdiction.
(d) Encourage countries to adopt appropriate information reporting and filing
requirements in respect of tax transparent entities established within their
jurisdiction.
(e) Restrict the tax transparency of reverse hybrids that are members of a control
group.
6.
In addition to these specific recommendations, Part I also sets out
recommendations for hybrid mismatch rules that adjust the tax outcomes under a hybrid
mismatch arrangement in one jurisdiction in order to align them with the tax outcomes in
the other jurisdiction. These recommendations target payments under a hybrid mismatch
arrangement that give rise to one of the three following outcomes:
(a) Payments that give rise to a deduction / no inclusion outcome (D/NI outcome),
i.e. payments that are deductible under the rules of the payer jurisdiction and are
not included in the ordinary income of the payee.
(b) Payments that give rise to a double deduction outcome (DD outcome),
i.e. payments that give rise to two deductions in respect of the same payment.
(c) Payments that give rise to an indirect D/NI outcome, i.e. payments that are
deductible under the rules of the payer jurisdiction and that are set-off by the
payee against a deduction under a hybrid mismatch arrangement.
D/NI outcomes
7.
Both payments made under hybrid financial instruments and payments made by
and to hybrid entities can give rise to D/NI outcomes. In respect of such hybrid mismatch
arrangements this report recommends that the response should be to deny the deduction in
the payer jurisdiction. In the event the payer jurisdiction does not neutralise the mismatch,
this report recommends a defensive rule that would require the payment to be included as
ordinary income in the payee jurisdiction. Specific recommendations and
recommendations for hybrid mismatch rules that are designed to address D/NI outcomes
are set out in Chapters 1 to 5.
DD outcomes
8.
As well as producing D/NI outcomes, payments made by hybrid entities can, in
certain circumstances, also give rise to DD outcomes. In respect of such payments this
report recommends that the primary response should be to deny the duplicate deduction in
the parent jurisdiction. A defensive rule, that would require the deduction to be denied in
the payer jurisdiction, would only apply in the event the parent jurisdiction did not adopt
the primary response. Specific recommendations and recommendations for hybrid
mismatch rules designed to address DD outcomes are set out in Chapters 6 and 7.
Indirect D/NI outcomes

9.
Once taxpayers have entered into a hybrid mismatch arrangement between two
jurisdictions without effective hybrid mismatch rules, it is a relatively simple matter for
the effect of that mismatch to be shifted into a third jurisdiction (through the use of an
ordinary loan, for example). Therefore, in order to protect the integrity of the
recommendations, this report further recommends that a payer jurisdiction deny a deduction
for a payment where the payee sets the income from that payment off against expenditure
under a separate hybrid mismatch arrangement. Recommendations for the design and
application of an imported mismatch rule neutralising such indirect D/NI outcomes are
set out in Chapter 8.
Mismatch
10.
The extent of a mismatch is determined by comparing the tax treatment of the
payment under the laws of each jurisdiction where the mismatch arises. A D/NI mismatch
generally occurs when a payment or part of a payment that is treated as deductible under
the laws of one jurisdiction is not included in ordinary income by any other jurisdiction.
A DD mismatch arises to the extent that all or part of the payment that is deductible under
the laws of another jurisdiction is set-off against non-dual inclusion income.
11.
The hybrid mismatch rules focus on payments and whether the nature of that
payment gives rise to a deduction for the payer and ordinary income for the payee. Rules
that entitle taxpayers to a unilateral tax deduction for invested equity without requiring
the taxpayer to make a payment, such as regimes that grant deemed interest deductions
for equity capital, are economically closer to a tax exemption or similar taxpayer specific
concessions and do not produce a mismatch in tax outcomes in the sense contemplated by
Action 2. Such rules, and rules having similar effect, will, however, be considered
separately in the context of the implementation of these recommendations.
12.
The hybrid mismatch rules are not generally intended to pick-up mismatches that
are attributable to differences in the value ascribed to a payment. For example, gains and
losses from foreign currency fluctuations on a loan can be said to give rise to mismatches
in tax outcomes but these mismatches are attributable to differences in the measurement
of the value of payment (rather than its character) and can generally be ignored for the
purposes of the hybrid mismatch rules.
Hybrid element
13.
While cross-border mismatches arise in other contexts (such as the payment of
deductible interest to a tax exempt entity), the only types of mismatches targeted by this
report are those that rely on a hybrid element to produce such outcomes. Some
arrangements exploit differences between the transparency or opacity of an entity for tax
purposes (hybrid entities) and others involve the use of hybrid instruments, which
generally involve a conflict in the characterisation of the instrument (and hence the tax
treatment of the payments made under it). Hybrid instruments and entities can also be
embedded in a wider arrangement or group structure to produce indirect D/NI outcomes.
14.
In most cases the causal connection between the hybrid element and the mismatch
will be obvious. There are some challenges, however, in identifying the hybrid element in
the context of hybrid financial instruments. Because of the wide variety of financial
instruments and the different ways jurisdictions tax them, it has proven impossible, in
practice, for this report to comprehensively identify and accurately define all those
situations where cross-border conflicts in the characterisation of a payment under a
financing instrument may lead to a mismatch in tax treatment. Rather than targeting these
technical differences, the focus of this report is on aligning the treatment of cross-border
payments under a financial instrument so that amounts that are treated as a financing
expense by the issuers jurisdiction are treated as ordinary income in the holders
jurisdiction. Accordingly this report recommends that a financial instrument should be
treated as hybrid where a payment under the instrument gives rise to a mismatch in tax
outcomes and the mismatch can be attributed to the terms of the instrument.
Rule order
15.
In order to avoid the risk of double taxation, Action 2 also calls for guidance on
the co-ordination or tie-breaker rules where more than one country seeks to apply such
rules to a transaction or structure. For this reason the rules recommended in this report
are organised in a hierarchy so that a jurisdiction does not need to apply the hybrid
mismatch rule where there is another rule operating in the counterparty jurisdiction that is
sufficient to neutralise the mismatch. The report recommends that every jurisdiction
introduce all the recommended rules so that the effects of hybrid mismatch arrangements
are neutralised even if the counterparty jurisdiction does not have effective hybrid
mismatch rules.
Scope
16.
Overly broad hybrid mismatch rules may be difficult to apply and administer.
Accordingly, each hybrid mismatch rule has its own defined scope, which is designed to
achieve an overall balance between a rule that is comprehensive, targeted and

administrable.
17.
Table 1.1 provides a general overview of the hybrid mismatch rules recommended
in this report.
Indirect D/NI
DD
D/NI
Mismatch
Deny payer
deduction
Deny resident
deduction
Deductible payment made by

dual resident
Imported mismatch
arrangements
Deny parent
deduction
Deductible payment made by a

hybrid
Restricting tax transparency of intermediate

entities where non-resident investors treat
the entity as opaque
Deny payer
deduction
Improvements to offshore investment regime
Payment made to a reverse

hybrid
Deny payer
deduction
Response
Deny payer
deduction
Proportionate limitation of withholding tax

credits
No dividend exemption for deductible

payments
Specific recommendations on
improvements to domestic law
Members of control group and

structured arrangements
No limitation on response
No limitation on response, defensive

rule applies to control group and
structured arrangements
Control group and structured

arrangements
Control group and structured

arrangements
Related parties and structured

arrangements
Scope
Deny payer deduction
Include as ordinary income
Include as ordinary income
Defensive rule
Recommended hybrid mismatch rule
Table 1.1 General Overview of the Recommendations
Disregarded payment made by

a hybrid
Hybrid financial instrument
Arrangement
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2012), Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues,
OECD Publishing, Paris, www.oecd.org/tax/exchange-of-taxinformation/HYBRIDS_ENG_Final_October2012.pdf.
OECD (2011), Corporate Loss Utilisation through Aggressive Tax Planning, OECD
Publishing, Paris. http://dx.doi.org/10.1787/9789264119222-en.
OECD (2010), Addressing Tax Risks Involving Bank Losses, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264088689-en.
1. HYBRID FINANCIAL INSTRUMENT RULE 23
Chapter 1
Hybrid Financial Instrument Rule
Recommendation 1
1. Neutralise the mismatch to the extent the payment gives rise to a D/NI outcome
The following rule should apply to a payment under a financial instrument that results in a hybrid
mismatch and to a substitute payment under an arrangement to transfer a financial instrument:
(a)
The payer jurisdiction will deny a deduction for such payment to the extent it gives rise to a
D/NI outcome.
(b)
If the payer jurisdiction does not neutralise the mismatch then the payee jurisdiction will
require such payment to be included in ordinary income to the extent the payment gives rise
to a D/NI outcome.
(c)
Differences in the timing of the recognition of payments will not be treated as giving rise to
a D/NI outcome for a payment made under a financial instrument, provided the taxpayer can
establish to the satisfaction of a tax authority that the payment will be included as ordinary
income within a reasonable period of time.
2. Definition of financial instrument and substitute payment

For the purposes of this rule:
(a)
A financial instrument means any arrangement that is taxed under the rules for taxing debt,
equity or derivatives under the laws of both the payee and payer jurisdictions and includes a
hybrid transfer.
(b)
A hybrid transfer includes any arrangement to transfer a financial instrument entered into by
a taxpayer with another person where:
(i) the taxpayer is the owner of the transferred asset and the rights of the
counterparty in respect of that asset are treated as obligations of the taxpayer; and
(ii) under the laws of the counterparty jurisdiction, the counterparty is the owner of
the transferred asset and the rights of the taxpayer in respect of that asset are
treated as obligations of the counterparty.
Ownership of an asset for these purposes includes any rules that result in the taxpayer being
taxed as the owner of the corresponding cash-flows from the asset.
(c)
A jurisdiction should treat any arrangement where one person provides money to another in
consideration for a financing or equity return as a financial instrument to the extent of such
financing or equity return.
(d)
Any payment under an arrangement that is not treated as a financial instrument under the
laws of the counterparty jurisdiction shall be treated as giving rise to a mismatch only to the
extent the payment constitutes a financing or equity return.
24 1. HYBRID FINANCIAL INSTRUMENT RULE
Recommendation 1 (continued)
(e)
A substitute payment is any payment, made under an arrangement to transfer a financial

instrument, to the extent it includes, or is payment of an amount representing, a financing or
equity return on the underlying financial instrument where the payment or return would:
(i) not have been included in ordinary income of the payer;
(ii) have been included in ordinary income of the payee; or
(iii) have given rise to hybrid mismatch;
if it had been made directly under the financial instrument.
3. Rule only applies to a payment under a financial instrument that results in a hybrid
mismatch
A payment under a financial instrument results in a hybrid mismatch where the mismatch can be
attributed to the terms of the instrument. A payment cannot be attributed to the terms of the
instrument where the mismatch is solely attributable to the status of the taxpayer or the
circumstances in which the instrument is held.
4. Scope of the rule

This rule only applies to a payment made to a related person or where the payment is made under a
structured arrangement and the taxpayer is party to that structured arrangement.
5. Exceptions to the rule

The primary response in Recommendation 1.1(a) should not apply to a payment by an investment
vehicle that is subject to special regulation and tax treatment under the laws of the establishment
jurisdiction in circumstances where:
(a)
The tax policy of the establishment jurisdiction is to preserve the deduction for the payment
under the financial instrument to ensure that:
(i) the taxpayer is subject to no or minimal taxation on its investment income; and
(ii) that holders of financial instruments issued by the taxpayer are subject to tax on
that payment as ordinary income on a current basis.
(b)
The regulatory and tax framework in the establishment jurisdiction has the effect that the
financial instruments issued by the investment vehicle will result in all or substantially all of
the taxpayers investment income being paid and distributed to the holders of those financial
instruments within a reasonable period of time after that income was derived or received by
the taxpayer.
(c)
The tax policy of the establishment jurisdiction is that the full amount of the payment is:
(i) included in the ordinary income of any person that is a payee in the
establishment jurisdiction; and
(ii) not excluded from the ordinary income of any person that is a payee under the
laws of the payee jurisdiction under a treaty between the establishment jurisdiction
and the payee jurisdiction.
(d)
The payment is not made under a structured arrangement.
The defensive rule in Recommendation 1.1(b) will continue to apply to any payment made by such
an investment vehicle.
Overview
18.
The policy behind Recommendation 1 is to prevent a taxpayer from entering into
structured arrangements or arrangements with a related party that exploit differences in
the tax treatment of a financial instrument to produce a D/NI outcome. The rule aligns the
tax treatment of payments under a financial instrument by adjusting the amount of
deductions allowed under the laws of the payer jurisdiction, or the amount of income to
be included in the payee jurisdiction, as appropriate, in order to eliminate the mismatch in
tax outcomes. Recommendation 1 applies to three different types of financing
arrangement:
(a) Arrangements that are treated as debt, equity or derivative contracts under local
law (financial instruments).
(b) Arrangements involving the transfer of financial instruments where differences in
the tax treatment of that arrangement result in the same financial instrument being
treated as held by more than one taxpayer (hybrid transfers).
(c) Arrangements involving the transfer of financial instruments where a payment is
made in substitution for the financing or equity return on the transferred asset and
differences between the tax treatment of that payment and the underlying return on
the instrument have the net-effect of undermining the integrity of the hybrid
financial instrument rule (substitute payments).
Arrangements treated as financial instruments under local law

19.
Recommendation 1 is primarily targeted at arrangements that are taxed as debt,
equity or derivative contracts (i.e. financial instruments) under the laws of the payer and
payee jurisdictions. While the Recommendation encourages jurisdictions to extend their
existing rules for taxing financial instruments to cover any arrangement to the extent it
produces an equity or financing return, it is recognised that the final determination of the
type of arrangements falling within the definition of a financial instrument (and therefore
potentially subject to adjustment under the hybrid financial instrument rule) must
ultimately be left to each jurisdiction.
20.
Although Recommendation 1 is described as applying to hybrid financial
instruments, it does not specify the particular features of a financial instrument that
make it hybrid. The wide variety of financial instruments and the different ways they
can be characterised and treated for tax purposes make it impossible to comprehensively
and accurately identify all the situations where a payment under the instrument can give
rise to a hybrid mismatch. Rather the hybrid financial instrument rule focuses on whether
the payment is expected to give rise to a mismatch in tax outcomes and whether that
mismatch is attributable to differences in the way the instrument is taxed under the laws of
the payer and payee jurisdictions.
21.
If the conditions for the application of the hybrid financial instrument rule are
satisfied then the response recommended in the report is to align the tax treatment of the
payments made under the arrangement so that the payer is not entitled to claim a
deduction for the financing or equity return paid under the arrangement unless the
payment is treated as ordinary income of the payee. The mechanics and rule order for the
adjustments are set out in Recommendation 1.1. The primary recommendation is for the
payer jurisdiction to deny a deduction to the extent the payment gives rise to a D/NI
outcome. If the payer jurisdiction does not apply the recommended response, then the

defensive rule calls on the payee jurisdiction to treat the deductible payment as ordinary
income under a financial instrument.
22.
The primary and defensive rules are limited to adjusting the tax consequences that
flow from the difference in the tax treatment of the instrument and should not generally
affect the underlying character of the payment (e.g. whether it is treated as interest or a
dividend) or the quantification or tax treatment of a taxpayers overall gain or loss on the
acquisition or disposal of an asset acquired under a financial instrument.
Hybrid transfers
23.
A hybrid transfer is any arrangement to transfer a financial instrument where, as
a consequence of the economics of the transaction and the way it is structured, the laws of
two jurisdictions take opposing views on who is the owner of the underlying return on the
transferred asset. Payments under a hybrid transfer generally give rise to a D/NI outcome
where one party to the transfer claims a deduction for the underlying financial or equity
return on the transferred asset that is paid (or treated as paid) to the counterparty under
the terms of the hybrid transfer, while the counterparty treats that same payment as a
direct return on the underlying financial instrument itself (and therefore excluded or
exempt from taxation). Recommendation 1 deems this type of asset transfer to be
financial instrument so that the D/NI outcome arising under such an arrangement falls
within the scope of the hybrid financial instrument rule, regardless of how the hybrid
transfer is characterised under local law.
24.
Because hybrid transfers are treated as a type of financial instrument, the same
rules will apply for testing whether the mismatch in tax outcomes is a hybrid mismatch.
A D/NI outcome under a hybrid transfer will only be subject to adjustment under the
hybrid financial instrument rule where the mismatch can be attributed to differences in
the tax treatment of the arrangement under the laws of the payer and payee jurisdictions
and any adjustment required to be made under that rule will be limited to the tax
consequences that flow from that difference in the tax treatment.
Substitute payments
25.
The final category of arrangements that are brought within the scope of
Recommendation 1 are transfers of financial instruments where the transferee receives a
payment in substitution for the financing or equity return on the transferred asset (a
substitute payment) and differences between the tax treatment of substitute payment and
the underlying return on the instrument have the potential to undermine the integrity of
the hybrid financial instrument rule. A substitute payment that gives rise to a D/NI
outcome will be subject to adjustment under the hybrid financial instrument rule where
the underlying financing or equity return on the transferred asset would otherwise have
been taxable in the hands of the transferor or is treated as exempt or excluded from
income in the hands of the transferee or where the transfer has the effect of taking
financial instrument outside of the scope of the hybrid financial instrument rule.
26.
Unlike the other rules in Recommendation 1, which only apply where and to the
extent the mismatch is attributable to the terms of the instrument, the substitute payment
rules apply to any type of D/NI outcome regardless of how it arises.
to a D/NI outcome
27.
The hybrid financial instrument rule applies to substitute payments and payments
under a financial instrument to the extent those payments give rise to a D/NI outcome.
Payment
28.
The definition of payment is set out in further detail in Recommendation 12.
A payment is any transfer of value and includes an amount that is capable of being paid
such as a future or contingent obligation to make a payment. As illustrated in Example
1.13, the definition of payment includes the accrual of a future payment obligation even
when that accrued amount does not correspond to any increase in the payment obligation
during that period. The definition specifically excludes, however, payments that are only
deemed to be made for tax purposes and that do not involve the creation of any new
economic rights between the parties. Thus, as illustrated in Example 1.14, the hybrid
financial instrument rule does not apply to an adjustment resulting from a deemed interest
charge. Such adjustments are made purely for tax purposes and do not correspond to any
present or future transfer of value.
D/NI outcome
29.
A payment gives rise to a D/NI outcome to the extent it is deductible under the
laws of the payer jurisdiction and not included in income under the laws of any
jurisdiction where the payment is treated as being received (the payee jurisdiction). The
hybrid financial instrument rule only looks to the expected tax treatment of the
arrangement, based on the terms of the instrument and the character of the payments
made under it, to determine whether the payment gives rise to a mismatch.
Deductible
30.
A payment will be treated as deductible if, after a proper consideration of the
character of the payment and its tax treatment under the laws of the payer jurisdiction, the
payer is entitled to take the payment into account as a deduction in calculating its taxable
income. A payment under a financial instrument will be treated as deductible to the extent
that payment is treated as a separate deductible item under local law. Deductible
payments made under a financial instrument will generally include interest, as well as:
issue discount and redemption premiums; facilities and lending fees and payments under
a derivative contract to the extent they are treated as separate items of deductible
expenditure.
31.
The concept of deductible also extends to payments that trigger other types of
equivalent tax relief. The meaning of this term is illustrated in Example 1.11 where a
dividend payment gives rise to a tax credit that can be set-off against a tax liability of the
payer or refunded to the shareholder. While such credits are usually provided as a means
of relieving economic double taxation on distributed income, in that example, the
dividend that triggers the credit is not subject to a second layer of tax under the laws of
the payer jurisdiction. The credit is therefore economically equivalent to a deduction in
that, in the absence of any tax at the shareholder level, it will have the effect of reducing
the amount of income under the arrangement that will be subject to the tax at the full rate
in the payer jurisdiction.
Included in ordinary income

32.
Ordinary income refers to those categories of income that are subject to tax at the
taxpayers full marginal rate and that do not benefit from any exemption, exclusion, credit
or other tax relief applicable to particular types of payments (such as indirect credits for
underlying tax on the income of the payer). A payment will be treated as included in
ordinary income to the extent that, after a proper determination of the character and
treatment of the payment under the laws of the payee jurisdiction, the payment is required
to be incorporated as ordinary income into a calculation of the payees taxable income. A
payment of ordinary income under a financial instrument will generally include interest,
dividends and other investment returns that are subject to tax at the payees full marginal
rate. Income is considered subject to tax at the taxpayers full marginal rate, however,
notwithstanding that the tax on the inclusion is reduced by a credit or other equivalent tax
relief granted by the payee jurisdiction for withholding tax or other taxes imposed by the
source jurisdiction on the payment itself.
D/NI outcomes in respect of payments under a financial instrument

33.
Because the hybrid financial instrument rule looks only to the expected tax
treatment of the payment under the laws of the counterparty jurisdiction, rather than its
actual tax treatment in the hands of the counterparty, it is not necessary for the taxpayer
or tax administration to know the counterpartys tax status or how that payment was
actually treated for tax purposes in order to determine whether the payment has given rise
to a mismatch. The application of this principle is illustrated in Example 1.26 where a
trader acquires shares under an asset transfer agreement. That example notes that, the
traders deduction for the acquisition cost of the shares will not be a product of the terms
of the instrument and the character of the payments made under it but rather of the
particular status of the payer. Therefore the fact that transfer agreement may constitute a
hybrid transfer (so that the consideration paid for the shares is treated as payment under a
financial instrument), will not result in the payment being treated as giving rise to a D/NI
outcome in a hybrid financial instrument. The same principle is illustrated in Example
1.29 where a share trader is entitled to interest in respect of the unpaid purchase price
under a share sale agreement. The interest component of the purchase price is treated as
giving rise to a separate deductible expense under the laws of the purchasers jurisdiction
while the share trader treats the entire amount payable under the share sale agreement as
consideration for the sale of the shares. In this case the payment is treated as giving rise to
a mismatch in tax outcomes, even though the payment is, in fact, included by the share
trader in ordinary income as proceeds from the disposal of a trading asset.
D/NI outcomes in respect of substitute payments

34.
The substitute payment rules apply to any actual mismatch in tax outcomes,
regardless of the circumstances in which the deduction arises, including any amount taken
into account in calculating the gain or loss on disposal of a trading asset. The application
of the substitute payment rule is illustrated in Example 1.34 where a trader acquires
shares under a hybrid transfer. Although, in that case, the deduction claimed by the trader
for the payment of the manufactured dividend is not attributable to the terms of the
instrument (and therefore does not give rise to hybrid mismatch under a financial
instrument), the example notes that the payment may still be a substitute payment that is
subject to adjustment under the hybrid financial instrument rule.
Interaction between Recommendation 1.1(a) and Recommendation 2.1

35.
The determination of whether a D/NI outcome has arisen requires a proper
assessment of the legal character of the instrument and tax treatment of the payment in
each jurisdiction. A payment under a hybrid financial instrument will not be treated as
giving rise to a D/NI outcome if the mismatch will be neutralised in the counterparty
jurisdiction by a specific rule designed to align the tax treatment of the payment with tax
policy outcomes applicable to an instrument of that nature. Specific rules of this nature
will include any rules in the payee jurisdiction, consistent with Recommendation 2.1, that
limit the availability of a dividend exemption or equivalent tax relief to payments that are
not deductible for tax purposes. This principle is illustrated in Example 1.1 where a
taxpayer borrows money under an interest bearing loan from a related taxpayer in another
jurisdiction. The borrower is allowed a deduction for the interest paid on the loan while
the holder treats the payment as a dividend. A proper consideration of the character of the
payment and its tax treatment in both jurisdictions will take into account rules in the
payee jurisdiction designed to limit double taxation relief on dividend payments made out
of after-tax profits. Accordingly, if the payee jurisdiction does not extend its dividend
exemption to a payment that is deductible under the laws of the payer jurisdiction, then
no mismatch will arise for the purposes of the hybrid financial instrument rule. Similar
outcomes are identified in Example 1.2, Example 1.3 and Example 1.4.
Inclusion under a CFC regime

36.
The hybrid financial instrument rule is only intended to operate where the
payment gives rise to a mismatch in tax outcomes and is not intended to give rise to
economic double taxation. In certain cases, a payment under a hybrid financial instrument
that gives rise to a D/NI outcome, as between the payer and payee jurisdictions, may be
included in income under a CFC regime. A country aiming to avoid economic double
taxation in these cases should consider how to address the mismatch in tax outcomes
under the hybrid financial instrument rule in light of the fact that the payment has been
included in ordinary income by the shareholder under a CFC regime and determine
whether the CFC inclusion is to be considered as included in ordinary income for the
purposes of determining whether there is a D/NI outcome under the hybrid financial
instrument rule.
37.
Where a country takes into account a CFC inclusion in the parent jurisdiction, a
taxpayer seeking to rely on that inclusion in order to avoid an adjustment under the hybrid
financial instrument rule should only be able to do so in circumstances where it can
satisfy the tax administration that the payment has been fully included under the laws of
the relevant jurisdiction and is subject to tax at the full rate. This will include
demonstrating that:
(a) The payment would ordinarily be required to be brought into account under the
CFC rules in the parent jurisdiction.
(b) The CFC regime actually requires the payment to be attributed to the shareholder
(i.e. the payment does not qualify for an active income exception).
(c) The quantification and timing rules of the CFC regime have actually brought that
payment into account as ordinary income on the shareholders return.
38.
In addition, payments that are treated as exempt from the hybrid financial
instrument rule on the grounds of a CFC inclusion should be eligible for such exemption
only to the extent that the payment:

(a) Has not been treated as reduced or offset by any deduction or other relief other
than in respect of expenditure incurred by the parent under the laws of the parent
jurisdiction.
(b) Does not carry an entitlement to any credit or other relief.
(c) Does not give rise to an imported mismatch.
39.
The application of this principle is illustrated in Example 1.24 where a company
makes an intra-group payment under a hybrid financial instrument. In that example, the
CFC regime in the parent jurisdiction that treats certain items of passive income
(e.g. rents, royalties and interest) derived by controlled foreign entities as CFC income
attributable to shareholders in proportion to their shareholding in the CFC. In that
example the taxpayer is not able to treat an item of CFC income as included in ordinary
income under the laws of the jurisdiction of the parent to the extent that income was
treated as reduced by expenditure incurred by the payee or to the extent that payment was
sheltered by any credit or other relief in the parent jurisdiction. The example also notes
that the taxpayer would further need to satisfy the tax administration that the payment has
not been set-off against a hybrid deduction under an imported mismatch arrangement.
40.
The rules that determine the type, amount and timing of attributed income under a
CFC regime can make the determination of whether an amount has been included in
ordinary income under a CFC regime difficult and fact intensive. Accordingly, when
introducing the hybrid financial instrument rule into local law, countries may wish to
balance the need to avoid double taxation outcomes and the burden of making such a
determination in setting any materiality thresholds that a taxpayer must meet before a
taxpayer can treat a CFC inclusion as reducing the amount of adjustment required under
the rule.
Application of the rule in the case of exemption, reduced rate or credit

41.
A deductible payment will be treated as giving rise to a mismatch whenever the
payee jurisdiction subjects the payment to taxation at a rate that is less than the full
marginal rate imposed on ordinary income, regardless of the form in which such tax relief
is provided. The particular mechanism for securing tax relief in the payee jurisdiction,
whether by exclusion or through exemption, rate reduction, credit or any other method,
should not generally impact on the final outcome under the hybrid financial instrument
rule.
42.
Certain countries tax different types of income at different rates. For example,
business or employment income may be taxed at a different rate from investment income.
These differences should be taken into account in determining whether the payment has
been subject to tax at the taxpayers full marginal rate. In the context of the hybrid
financial instrument rule, the payees full marginal rate is the tax the payee would expect
to pay on ordinary income derived under a financial instrument, so that a mismatch will
not arise, for the purposes of the hybrid financial instrument rule, simply because the
payee jurisdiction taxes income from financial instruments at a lower rate than other types
of income. This is illustrated in Example 1.3 where an interest payment is subject to tax
at a reduced rate of taxation under the laws of the payee jurisdiction. Example 1.3 notes
that if the reduced tax rate is no less than the rate that applies to any other payment of
ordinary income under a financial instrument (such as ordinary interest on a loan) then no
mismatch will arise for the purposes of the hybrid financial instrument rule.
Partial exemption or reduced rate

43.
In those cases where the payee jurisdiction only provides taxpayers with a partial
exemption or reduced rate on a payment under a hybrid financial instrument, the amount
of the deduction that is denied should generally be no more than is necessary to eliminate
the mismatch in tax outcomes between the payer and payee jurisdictions and a deduction
should continue to be allowed to the extent the payment is subject to tax in the payee
jurisdiction at the full rate. The application of this principle is illustrated in Example 1.2,
where the payee jurisdiction provides a partial tax exemption for a payment of interest
under a subordinated loan, and in Example 1.3, where the payment under the hybrid
financial instrument is subject to tax in the payee jurisdiction at 10% of the normal
corporate rate.
44.
Cases of partial tax relief usually arise in the context of debt/equity hybrids where
the payee jurisdiction treats the payment as a dividend and provides for a credit, reduced
rate or partial exemption which does not fully relieve the shareholder from tax on that
dividend. In most cases, these types of payments will be covered by
Recommendation 2.1, which deals with the granting of tax relief for deductible dividends,
so that, in practice, the number of actual cases where the payer jurisdiction will be called
upon to deny the deduction in respect of a payment that is subject to partial relief may, in
fact, be limited.
45.
In the cases of partial dividend relief, the limitation on tax relief in the payee
jurisdiction may be intended to re-capture the benefit of a reduced rate or deferred
taxation at the corporate level or to offset the benefit of other shareholder tax reliefs (such
deductibility of interest expenses). In these cases, a full denial of the deduction will be
more effective at preserving the intended tax policy outcomes in the payee jurisdiction
and achieve a better equality of outcomes with payments under an ordinary equity
instrument. This approach would need to be applied on a jurisdiction by jurisdiction basis,
taking into account the tax policy outcomes in the counterparty jurisdiction, and may be
unnecessary if the payee jurisdiction introduces comprehensive rules restricting taxation
relief for deductible dividends in line with Recommendation 2.1.
Calculating the amount of the adjustment in the case of an underlying foreign

tax credit
46.
Unless the payee jurisdiction has adopted Recommendation 2.1 and denies the
benefit of an underlying foreign tax credit for a deductible dividend, the primary response
under the hybrid financial instrument rule will be to deny a deduction for such a payment
to the extent it is sheltered from tax in the payee jurisdiction.
47.
Unlike other methods of relieving double taxation, which either exempt the
income in the payee jurisdiction or subject it to tax at a reduced rate, foreign tax credits
are sensitive to changes in the calculation of the payers taxable income and differences
in tax rates between jurisdictions. The interaction between the hybrid financial instrument
rule (which ensures a payment is not deductible to the extent it is sheltered from tax by an
underlying foreign tax credit) and the foreign tax credit (which provides the shareholder
with a credit for underlying taxes paid by the company) can also result in a circular
calculation where the denial of a deduction in the payee jurisdiction under the hybrid
financial instrument rule (due to the fact that payment is not included in ordinary income)
increases the amount of tax payable in that jurisdiction, which, in turn, has the effect of
increasing the foreign tax credit available in the payee jurisdiction and reducing the
amount of the payment that is treated as included in ordinary income.

48.
In practice the complexity of foreign tax credit calculations (including the
potential for circularity) can make it difficult for taxpayers to calculate the required
adjustment under the hybrid financial instrument rule. Accordingly, when determining the
amount of the adjustment a taxpayer is required to make in respect of a payment that
carries an entitlement to a foreign tax credit, countries should strike a balance between
rules that are clear and easy to apply and that avoid the risk of double taxation.
Example 1.4 sets out an illustration of the type of adjustment that can be made under a
hybrid financial instrument rule to a payment that is subject to an underlying foreign tax
credit. In that case the payer country denies the deduction only to the extent the credit is
sufficient to shelter the payment from taxation. In that example the potential for
circularity can be avoided if the payee jurisdiction does not allow the crediting of any
increased foreign taxes that arise due to the application of the hybrid financial instrument
rule or if the incremental tax increase does not, in practice, have a material impact on the
amount of the underlying foreign tax credit attributable to the payment.
Nature and extent of the adjustment required

49.
The underlying principle of the hybrid financial instrument rule is to align the tax
treatment of payments under a financial instrument so that a taxpayer cannot claim a
deduction for a financing expense unless that payment is required to be included in
ordinary income in the payee jurisdiction. The primary and secondary rules achieve this
outcome by adjusting the amount of deductions allowed under the laws of the payer
jurisdiction, or the amount of income to be included in the payee jurisdiction, as
appropriate, in order to ensure that the aggregate tax treatment of the arrangement is the
same regardless of the form of instrument used or whether the adjustment is made in the
payee or payer jurisdictions. The adjustment should be no more than is necessary to
neutralise the instruments hybrid effect and should result in an outcome that is
proportionate and that does not lead to double taxation.
No impact on other tax consequences

50.
The adjustment in respect of a payment under a hybrid financial instrument does
not affect the character of the payment made under it. Although the effect of the primary
rule is to deny the payer a deduction, in order to bring the tax treatment of the payment in
line with the tax treatment in the payee jurisdiction, the rule does not require a change to
the character of the instrument or the payment made under the instrument for tax
purposes. This is illustrated in Example 1.1 where the hybrid financial instrument rule
denies the payer a deduction for the interest payment made under a debt/equity hybrid but
does not require the payer jurisdiction to treat the payment as a dividend for tax purposes.
Only adjust tax consequences that are attributable to the terms of the instrument
51.
The adjustment to the tax consequences of a payment under a hybrid financial
instrument should be confined to those that are attributable to the tax treatment of the
instrument itself. The adjustment is not intended to impact on tax outcomes that are solely
attributable to the status of the taxpayer or the context in which the instrument is held.
Example 1.5 and Example 1.8 both describe cases where an adjustment under the
defensive rule in the payee jurisdiction will not impact on the tax position of the taxpayer
because that taxpayer is either not subject to tax on ordinary income or because it derives
that income through an exempt branch. Although the payee may not be subject to any
additional tax liability as a consequence of an adjustment under the secondary rule, the
primary rule can still apply to deny the deduction in the payer jurisdiction if the payment
would be expected to give rise to a mismatch in tax outcomes.
52.
This principle can further be illustrated by contrasting the outcomes described in
Example 1.27 and Example 1.28. In both these examples, the arrangement between the
parties is an asset sale agreement that provides for the payment of the purchase price to be
deferred for one year and for the purchase price to incorporate an adjustment equal to
twelve months of interest on the unpaid purchase price. The purchasers jurisdiction treats
the interest portion of the purchase price as giving rise to a separate deductible payment
for tax purposes while, under the laws of the sellers jurisdiction, the entire purchase price
(including the interest component) is treated as consideration for the transfer of the asset.
As described in Example 1.27, the asset sale agreement is treated as giving rise to a
deductible financing expense for the purchaser and the purchasers jurisdiction should
therefore deny a deduction for that payment under the hybrid financial instrument rule. In
Example 1.28, however, the purchaser acquires the asset as part of its activities as a
trader and is able to include the purchase price as expenditure when calculating any
taxable gain/loss on the asset. Example 1.28 concludes that the hybrid financial
instrument rule should not affect the ability of the trader to take the full amount payable
under the asset transfer agreement into account when calculating the gain or loss on
disposal of the asset. Taxpayers that buy and sell securities in the ordinary course of a
business of dealing or trading in securities (such as securities dealers, banks and brokers)
will treat the net profit or loss on each trade as included in taxable income, or deductible
for tax purposes, as the case may be, regardless of the exact way in which the return on
the transaction is accounted for or the manner in which the transaction is analysed for tax
purposes. In Example 1.34 a financial instrument is acquired by a trader under a hybrid
transfer. Although the payment of the manufactured dividend under the share loan is
deemed to be a payment under a financial instrument, the hybrid financial instrument rule
will only operate to deny a deduction that is attributable to the terms of the instrument
itself and will not prevent a trader from taking the expenditure incurred under the hybrid
transfer into account in calculating the traders overall (taxable) gain or loss on the asset.
Mismatch that is solely attributable to differences in the valuation of a payment

53.
In order for a D/NI outcome to arise, there must be a difference in the way a
payment is measured and characterised under the laws of the payer and payee
jurisdictions. Differences in tax outcomes that are solely attributable to differences in the
value ascribed to a payment (including through the application of transfer pricing) do not
fall within the scope of the hybrid mismatch rule. If the amount of the payment is
characterised and calculated in the same way under the laws of both jurisdictions, then
differences in the value attributed to that amount under the laws of the payer and payee
jurisdictions will not give rise to a D/NI outcome. In certain cases, however, particularly
in the case of more complex financial instruments that incorporate both financing and
equity returns, the way a payment is measured and characterised under local law may
depend on the value attributed to each of its components and this difference in
characterisation may give rise to a mismatch.
54.
A mismatch does not arise simply because of differences resulting from
converting foreign exchange into local or functional currency. This principle is illustrated
in Example 1.17, where a fall in the value of the local currency results in foreign
currency payments under a loan becoming more expensive in local currency terms. Under
local law, the payer is entitled to a deduction for this increased cost. This deduction,
however, is not reflected by a corresponding inclusion in the payee jurisdiction. The

difference in tax treatment does not give rise to a D/NI outcome, however, as the
proportion of the interest and principal payable under the loan is the same under the laws
of both jurisdictions. This principle is also illustrated in Example 1.15. That example
considers the tax treatment of an equity premium that a noteholder receives on the
maturity of a convertible note. The equity premium will not be treated as giving rise to a
D/NI outcome simply because the payer and payee jurisdictions treat the shares received
on conversion as having a different value for tax purposes. Example 1.16 considers a
situation where both the issuer and the holder treat a convertible note as being issued at a
discount representing its equity value. The higher valuation given to the equity value of
the note in the issuers jurisdiction results in the issuer recognising a larger accrued
discount, which results in greater portion of the payments being treated as deductible in
the issuers jurisdiction. The example concludes that, in this case, the way in which the
component elements of the note are valued has a direct impact on the way a payment is
measured and characterised for tax purposes and, accordingly, the difference in tax
outcomes should be treated as giving rise to a mismatch in tax outcomes.
Timing differences
55.
The hybrid financial instrument rule does not generally apply to differences in the
timing of the recognition of payments under a financial instrument. The hybrid financial
instrument rule should apply, however, where the taxpayer is not able to show that the
mismatch in tax outcomes is merely one of timing. Recommendation 1.1(c) therefore
clarifies that a payment will not be treated as giving rise to a D/NI outcome provided the
tax administration can be satisfied that the payment under the instrument is expected to be
included in income within a reasonable period of time.
Application of Recommendation 1.1(c)

56.
A payment should not be treated as giving rise to a mismatch if it will be required
to be included by the payee in ordinary income in an accounting period that commences
within 12 months of the end of the payers accounting period. If the payment does not
meet the requirements of this safe harbour, the payer should still be entitled to a
deduction for the payment if it can establish, to the satisfaction of the tax administration,
that the payee can be expected to include the payment in ordinary income within a
reasonable period of time.
Expected to be included in income

57.
A payment can expected to be included in ordinary income where there was a
reasonable expectation at the time the instrument was issued that the payment would be
made and that such payment would be included in ordinary income by the payee at the
time it was paid. If the terms of the instrument and other facts and circumstances indicate
that the parties placed little commercial significance on whether payment would be made,
or if the terms of the instrument are structured in such a way that such payment, when it is
made, will not be treated as giving rise to ordinary income in the hands of the payee, then
the payment cannot be said to be reasonably expected to be included in income.
Reasonable period of time

58.
The determination of whether this payment will be made within a reasonable
period of time should be based on the time period that might be expected to be agreed
between unrelated parties acting at arms length. This determination should take into
account such factors as the terms of the instrument, the circumstances in which it is held
and the commercial objectives of the parties, taking into account the nature of the accrual
and any contingencies or other commercial factors affecting payment. For example, a
secured loan that is used to finance infrastructure investment may be expected to have
longer payment terms than an unsecured loan that is used to fund working capital.
59.
The application of these principles is illustrated in Example 1.22 in respect of a
subordinated loan where the interest is treated as deductible by the payer in the year it
accrues but is only treated as income by the payee when it is actually paid. In that
example, the lender is a minority shareholder in the borrower and there is a dividend
blocker on the shares that prevents the borrower from making any distributions to its
majority shareholder while there is accrued but unpaid interest on the loan. This type of
contractual term incentivises the payer to make regular interest payments on the loan in
order that it can continue to pay dividends to its majority shareholder and, accordingly, it
can be concluded that the interest payments can be expected to be made within a
reasonable period of time even in circumstances where the term of the loan is indefinite
and interest payments are at the discretion of the borrower.
60.
This outcome can be contrasted with the lending arrangement described in
Example 1.21 where the period over which interest accrues leads the tax administration
to conclude that the parties have placed little commercial significance on whether
payments under the loan will be made. Alternatively, in that example, interest may accrue
over a shorter term but the lender has the power to waive its interest entitlement at any
time before it is actually paid without adverse tax consequences. That example concludes
that the taxpayer will be unable to establish, at the time the interest accrues, that the
payment can reasonably be expected to be included in income within a reasonable period
of time.
Recommendation 1.2 - Definition of financial instrument and substitute payment

61.
Recommendation 1.2 defines when an arrangement should be treated as a
financial instrument and when a payment should be treated as a substitute payment.
Definition of financial instrument to be determined under local law

62.
The underlying policy of Recommendation 1 is to align the tax treatment of the
payments made under a financing or equity instrument so that amounts that are not fully
taxed in the payee jurisdiction are not treated as a deductible expense in the payer
jurisdiction. Accordingly, Recommendation 1.2(c) encourages jurisdictions to treat any
arrangement that produces a financing or equity return as a financial instrument and to tax
those arrangements under the domestic rules for taxing debt, equity or derivatives.
63.
The definitions of equity return and financing return set out in
Recommendation 12.1 provide further detail on the types of payments that should be
brought within the hybrid financial instrument rule under domestic implementing
legislation. These terms are intended to be in line with those used in international and
generally recognised accounting standards and to capture any instrument issued by a
person that provides the holder with a return based on the time-value of money or
enterprise risk.
64.
The hybrid financial instrument rule should not, however, apply to: arrangements
for the supply of services such as lease or licensing agreements; arrangements for the

assumption of non-financial risk (such as insurance) or to asset transfers that do not
incorporate the payment of an equity or financing return.
65.
Notwithstanding that countries should make reasonable endeavours to adopt
similar definitions of financial instrument; there will continue to be cases where it is
difficult to determine whether a contract should be treated as a financial instrument or
some other type of agreement, such as sales contract or a contract for the assumption of
risk. While Recommendation 1.2(c) encourages jurisdictions to ensure that the hybrid
financial instrument rules apply to any arrangement to the extent it produces a financing
or equity return, the rules are not intended to standardise the categories of financial
instrument or to harmonise their tax treatment and, where the dividing line is unclear and
the payment representing the financing or equity return is actually embedded into another
transaction with a different character, it should be left to the laws of each country to
determine whether and to what extent the payment is made under a financial instrument.
Therefore, on the facts of any particular case, the question of whether an arrangement is a
financial instrument (and therefore potentially subject to adjustment under the hybrid
financial instrument rule) should be answered by reference to the domestic tax treatment
of that arrangement.
Application of financial instrument definition to assets transfers

66.
An arrangement that is treated as an asset transfer under local law will not
generally be treated as a financial instrument under Recommendation 1, although, if such
an arrangement is a hybrid transfer or incorporates a substitute payment, it may still be
brought within the scope of the rule (see below). The application of the hybrid financial
instrument rule to an ordinary asset transfer agreement is illustrated in Example 1.26
where the purchase price paid by a trading entity to acquire shares gives rise to a
D/NI outcome due to the fact that the trader is entitled to treat the purchase price as
deductible, while the vendor does not include the payment in ordinary income. Although
the payment gives rise to a D/NI outcome, the asset transfer agreement described in
Example 1.26 does not provide for an equity or financing return and therefore is outside
both the language and intended scope of Recommendation 1.
67.
Example 1.27 provides an illustration of the type of transaction that could be
treated as a financial instrument in one jurisdiction and an asset transfer in another. In this
case the purchase price for the transfer of an asset includes an interest component which
is intended to compensate the payee for the deferral in payment. The buyer treats the
interest portion of the purchase price as giving rise to a separate deductible expense for
tax purposes while the vendor treats the entire amount (including the interest component)
as consideration for the transfer of the asset. In this case the example concludes that the
payment is not subject to adjustment under the hybrid financial instrument rule in the
jurisdiction of the vendor because the arrangement does not fall within the rules for
taxing debt, equity or financial derivatives under local law. From the vendors
perspective, the transaction is indistinguishable from the transaction in Example 1.26. A
further illustration is provided in Example 1.30 where an agreement for the sale and
purchase of shares in an operating subsidiary contains an earn-out arrangement that
provides the vendor with a return based on enterprise risk. While some jurisdictions may
treat this payment as deductible, other jurisdictions would treat this type of earn-out
clause simply as a mechanic for calculating the purchase price for the sale of an asset and
would not treat payments made under such a clause as an equity return under a financial
instrument. It is therefore left to local law to determine whether the equity return is to be
characterised as a return under a financial instrument and brought within the scope of the
hybrid financial instrument rule.
Application of the rule in cases where the counterparty does not treat the
arrangement as a financial instrument
68.
Taxpayers that enter into an arrangement that falls within the scope of the hybrid
financial instrument rule should continue to apply the rule even when the counterparty
does not treat the arrangement as a financial instrument and/or the counterparty jurisdiction
has not implemented the reports recommendations. In such cases, however, the amount of
the adjustment under the rule will be restricted to the amount of equity or financing return under
the instrument. This principle is illustrated in Example 1.25 where the lender provides finance
to a related company under a finance lease. Although the lease is, in substance, a financing
arrangement, the leasee treats the arrangement as an ordinary operating lease and the
payments under the lease as deductible rental payments. The lessor is resident in a
jurisdiction that has implemented the hybrid mismatch rules and, consistent with
Recommendation 1.2, the lessor is required to treat the arrangement as a loan and the
rental payments as periodic payments of interest and principal on that loan. The hybrid
financial instrument rule is, however, only intended to capture mismatches that arise in
respect of the equity or financing return and, accordingly, Recommendation 1.2(d)
restricts the adjustment under the hybrid financial instrument rule to the extent of the
financing return under the instrument.
Certain payments made to acquire a financial instrument treated as made under

that financial instrument
69.
A payment will be treated as made under a financial instrument if the payment is
either required by the instrument or is in consideration for a release from a requirement
under the instrument. The release from a requirement under a financial instrument does
not, however, constitute a payment for the purposes of the hybrid financial iinstruemnt
rule. This principle is illustrated in Example 1.18 and Example 1.20. In Example 1.18
a holder receives a one-off payment in consideration for agreeing to a change in the terms
of a loan. The example concludes that the payment should be treated as a payment made
under the instrument, as it is a payment in consideration for the release from an obligation
under that instrument. In Example 1.20 a parent company forgives a loan owed by one of
its subsidiaries and claims a deduction for the unpaid principal and interest. Although the
release of the debt does not trigger ordinary income for the subsidiary, the resulting D/NI
outcome is not caught by the hybrid financial instrument rule because the release of rights
under a financial instrument is not a payment under that financial instrument.
70.
A payment made by a person in consideration for the transfer of an existing
financial instrument is a payment for the disposal of the instrument rather than a payment
made under it (although the payment to acquire that share or bond may include a
substitute payment or be made under another separate financial instrument). This
principle is illustrated in Example 1.36 in respect of the transfer of a bond that carries the
right to accrued but unpaid interest. The purchaser pays a premium for the bond that
reflects this accrued interest component. The premium is deductible under the laws of the
purchasers jurisdiction and treated as giving rise to an exempt gain under the laws of the
sellers jurisdiction. Although this payment gives rise to a mismatch in tax treatment the
payment will not be treated as a payment under a financial instrument unless the

contract to acquire the bond is otherwise treated as a financial instrument under
Recommendation 1.
71.
A payment made to acquire an instrument should, however, be treated as a
payment made under that instrument if the acquisition discharges, in whole or part,
obligations owed under the instrument or neutralises the economic and tax consequences
for the issuer. This is illustrated in Example 1.19 where an issuer of a bond pays a
premium to buy back a bond from the holder. While the cost of acquiring the bond from
the holder is consideration for the transfer of the bond and not a payment required by the
terms of the bond itself, the payment secures a release from the issuers obligations under
the instrument and will therefore be treated as a payment made under that financial
instrument.
Hybrid transfers
72.
The report recommends that jurisdictions treat certain transfers of financial
instruments (hybrid transfers) as financial instruments within the scope of the hybrid
financial instrument rule even when that jurisdiction would ordinarily treat payments
made under that arrangement as made under an asset transfer agreement. A hybrid
transfer is any arrangement to transfer a financial instrument where, as a consequence of
the economics of the transaction and the way it is structured, the laws of two jurisdictions
take opposing views on whether the transferor and transferee have ownership of the
underlying asset. Ownership, in this context, means the owner of the payment flows on
the underlying asset as opposed to legal ownership of the asset itself.
73.
While a hybrid transfer can arise in the context of an ordinary sale and purchase
agreement where there is a conflict in the determination of the timing of the asset transfer
(see Example 1.37), the hybrid transfer rules are particularly targeted at sale and
re-purchase (repo) and securities lending transactions where the rights and obligations of
the parties are structured in such a way that the transferor remains exposed to the
financing or equity return on the financial instrument transferred under the arrangement.
74.
In the case of repo transaction that gives rise to a hybrid transfer, the transferor is
taxed on the arrangement in accordance with its substance, so that the underlying transfer
is ignored for tax purposes and the payments under the hybrid transfer are treated as
payments under a financial instrument, while the transferee generally respects the legal
arrangements entered into by the parties and treats the hybrid transfer as an asset sale. An
illustration of a repo transaction that is treated as a hybrid transfer is set out in
Example 1.31. In that example the parties enter into a collateralised loan that is
structured as a repo over shares. The transferors jurisdiction taxes the arrangement in
accordance with its substance (treating the purchase price for the shares as a loan and the
transferred shares as collateral for that loan) while the repo is taxed in the transferees
jurisdiction in accordance with its form (the sale and re-purchase of an asset). Both
taxpayers therefore treat themselves as the owner of the subject matter of the repo (the
transferred shares) and the arrangement therefore falls into the definition a hybrid transfer.
75.
Examples of securities lending transactions that give rise to a hybrid transfer are
set out in Example 1.32, Example 1.33 and Example 1.34 and also in Example 2.2. In
these cases the transferee (the borrower under the arrangement) agrees to return the
transferred securities (or their equivalent) plus any dividends or interest received on those
securities during the term of the loan. The transferors jurisdiction taxes the arrangement
in accordance with its substance, disregarding the transfer and treating the transferor as if
it continued to hold the underlying securities, while the transferees jurisdiction treats the
transfer in accordance with its form and taxes the arrangement as the purchase and sale of
securities.
76.
Hybrid transfers generally give rise to a D/NI outcome because one jurisdiction
treats the equity or financing return on the transferred instrument as a deductible expense
under that hybrid transfer, while the other jurisdiction treats that same amount as a return
on the underlying asset (and, accordingly, as excluded or exempt from taxation or eligible
for some other type of tax relief). Therefore, when applying the secondary rule, the payee
may be required to make an adjustment to the tax treatment of the payment on the
underlying instrument even though this payment is not treated by the payee jurisdiction as
a payment under the hybrid transfer itself. Thus, in Example 1.31 the transferee is
required to apply the secondary rule to include a dividend payment on the transferred
share in ordinary income despite the fact that, under local law, this payment would be
regarded as a payment on the underlying shares and not a payment under the repo itself.
In Example 1.32 the transferee under a share-lending transaction makes a deductible
payment of a manufactured dividend. Although the recipient of the manufactured
dividend treats that dividend as having been paid on the underlying shares, the payment is
treated as giving rise to a D/NI outcome under a hybrid financial instrument because of
the deduction claimed by the counterparty to the share loan.
77.
Hybrid transfers are treated as a type of hybrid financial instrument because they
are, in substance, financial instruments rather than asset transfers and they give rise to a
difference in tax treatment that allows them to be used as part of a structured arrangement
to engineer a cross-border mismatch. As with other types of financial instrument, the
hybrid transfer rules do not take into account whether the funds obtained under the
transfer have been invested in assets that generate a taxable or exempt return. The
adjustment that the transferor is required to make in respect of payment under a repo or
stock loan will therefore not be affected by whether the transferor is taxable on the
financing or equity return on the transferred asset. For example, the outcomes described
in Example 1.31 and Example 1.33 are not affected by whether the transferor under the
repo or the share lending arrangement, is taxable on the dividend it receives on the shares.
78.
As hybrid transfers are a type of financial instrument, an adjustment is only
required under the rule if the mismatch in outcomes can be attributed to the tax treatment
of the hybrid transfer under the laws of the payer and payee jurisdictions. An adjustment
to the tax treatment of payments under a hybrid transfer will not affect the ability of a
trading entity to claim a genuine trading loss in respect of the disposal of an asset. This
principle is explained further in Example 1.34 and Example 1.37.
Substitute payments
79.
The other category of asset transfers that are subject to adjustment under
Recommendation 1 are transfers of financial instruments where the payment of a
financing or equity return under that asset transfer gives rise to a D/NI outcome that has
the effect of undermining the integrity of the hybrid financial instrument rules. The
transfer will have this effect where:
(a) the transferor secures a better tax outcome on the payment under the asset transfer
than it would have obtained if it had held onto the underlying instrument;
(b) the transferee treats the payment under the asset transfer as deductible while the
return on the underlying instrument will be treated as exempt or excluded from
income; or

(c) the transfer has the effect of taking instrument outside of the scope of the hybrid
financial instrument rule.
80.
The substitute payments rule neutralises any D/NI outcome in respect of the
payment of a financing or equity return under asset transfer agreement when the transfer
of the underlying financial instrument would give rise to one of the above outcomes.
Under this rule a taxpayer that buys a financial instrument for a consideration that
includes a financing or equity return, will be denied a deduction for the payment if: that
return would have been included in ordinary income of the payee; would not have been
included in ordinary income of the payer or would have given rise to hybrid mismatch if
it had been made directly under the financial instrument.
81.
The substitute payment rules apply to any type of D/NI outcome (regardless of
whether such outcome is attributable to the terms of the instrument, the tax status of the
parties or the context in which the asset is held). The rule is, however, confined to
payments that give rise to a financing or equity return in respect of the underlying
instrument. It would not ordinarily apply, for example, to a payment made to settle a
claim for a breach of warranty under an asset sale agreement.
82.
Example 1.30, Example 1.35, and Example 1.36 explain the application of the
hybrid financial instrument rule to substitute payments. In Example 1.30 the hybrid
financial instrument rule is applied to a purchase price adjustment under a share sale
agreement where differences between the tax treatment of dividends and sale
consideration in the payee/transferor jurisdiction allow the payee/transferor to substitute
what would otherwise have been a taxable dividend for a non-taxable exchange gain.
Example 1.35 illustrates how the substitute payment definition prevents
a payer/transferee manufacturing a deduction for a payment under an asset transfer
agreement when the transferee has no economic loss. Example 1.36 describes a situation
where the transfer of a financial instrument takes the instrument outside the scope of the
hybrid financial instrument rule. In that example the substitute payment definition will
apply to adjust the tax consequences for the parties to the transfer to neutralise any
mismatch in tax outcomes.
Recommendation 1.3 - Rule only applies to a payment under a financial instrument

that results in a hybrid mismatch
83.
Section 1.3 sets out the general rule for determining when a mismatch under a
financial instrument is a hybrid mismatch.
Identifying the mismatch

84.
A mismatch will arise in respect of a payment made under a financial instrument
to the extent that the payment is deductible under the laws of one jurisdiction (the payer
jurisdiction) and not included in ordinary income by a taxpayer under the laws of any
other jurisdiction where the payment is treated as being received (the payee jurisdiction).
85.
The identification of a mismatch as a hybrid mismatch under a financial
instrument is primarily a legal question that requires an analysis of the general rules for
determining the character, amount and timing of payments under a financial instrument in
the payer and payee jurisdictions. In general it will not be necessary for the taxpayer or
tax administration to know precisely how the payments under a financial instrument have
actually been taken into account in the calculation of the counterpartys taxable income in
order to apply the rule. It is expected that taxpayers will know their own tax position in
respect of a payment so that, in practice, a mismatch will be identified by comparing the

actual tax treatment of an instrument in the taxpayer jurisdiction with its expected tax
treatment in the counterparty jurisdiction.
86.
In order to determine whether a payment has given rise to a mismatch, it is
necessary to know the identity of the counterparty and the tax rules applying in the
counterparty jurisdiction. In most cases the counterparty will be the person with the
obligation (or right) to make (or receive) the payment and the counterparty jurisdiction
will be the jurisdiction where that person is tax resident. In certain cases, however, where
the counterparty is transparent or has a taxable presence in more than one jurisdiction, it
may be necessary to look to the laws of more than one jurisdiction to determine whether
the payment will give rise to a mismatch.
Deduction in any jurisdiction sufficient to trigger the application of the rule

87.
A payment that is treated as paid under the laws of more than one jurisdiction
only needs to be deductible under the laws of one jurisdiction in order to trigger a
potential D/NI outcome. This principle is illustrated in Example 1.23 where a hybrid
entity borrows money from a related person in the same jurisdiction under an instrument
that is treated as equity under local law. The hybrid entity is treated as making a
non-deductible/exempt dividend payment for local law purposes but the payment under
the instrument is treated as deductible under the laws of the parent jurisdiction. The
arrangement therefore gives rise to a D/NI outcome even though, as between the direct
payer and payee, there is no mismatch in tax treatment.
88.
In those cases where the payer is transparent, the burden will be on the taxpayer
claiming the benefit of the exemption or relief from taxation to establish, to the
satisfaction of its own tax administration, that the payment has not given rise to a
deduction under the laws of another jurisdiction.
Inclusion in any jurisdiction sufficient to discharge application of the rule

89.
If the payment is brought into account as ordinary income in at least one
jurisdiction, then there will be no mismatch for the rule to apply to. This principle is
illustrated in Example 1.8 which involves the payment of interest to a branch of a
company that is resident in another jurisdiction. In this case it is necessary to also look to
the laws of both the residence and the branch jurisdiction to definitively establish whether
a mismatch has arisen.
90.
It will be the taxpayer who has the burden of establishing, to the reasonable
satisfaction of the tax administration, how the tax treatment of the payment in the other
payee jurisdiction impacts on the amount of the adjustment required under the rule. The
initial burden of proof may be discharged by the taxpayer demonstrating that the payment
has actually been recorded as ordinary income on the tax return in the other jurisdiction.
Mismatch attributable to the terms of the instrument

91.
The hybrid financing instrument rule only applies where the mismatch in tax
treatment is attributable to the terms of the instrument rather than the status of the
taxpayer or the context in which the instrument is held.
92.
Differences in tax treatment that arise from applying different accounting policies
to the same instrument will be treated as attributable to the terms of the instrument if the
differences in accounting outcomes are based on the terms of the instrument itself. This is

illustrated in Example 1.21 in respect of a payment under a bond that carries a contingent
entitlement to interest. The loan is treated as debt under the laws of both the payee and
payer jurisdictions. However, due to differences in the way the interest is accounted for
tax purposes by the two countries, the interest is treated as deductible by the payer in the
year it accrues but is only treated as income by the payee when (and if) such interest is
actually paid. In this case the difference in accounting treatment gives rise to a hybrid
mismatch unless the taxpayer can establish, to the satisfaction of the tax authority, that
the payment will be included in income under the law of payee jurisdiction within a
reasonable period of time.
93.
It is not uncommon for the tax treatment of an instrument to depend on such
factors as whether the issuer and holder are related or on the period an instrument has
been held. Such factors directly affect the relationship between the holder and issuer and
should be treated as part of the terms of the instrument. In Example 1.1 the hybrid
financial instrument rule is applied to a dividend payment, even though the exemption
only applies where the payee has held more than 10% of the shares in the payer for at
least one year prior to the payment date. Example 1.13 provides an illustration of this
principle in respect of a payer where the conditions for deductibility turn, in part, on
whether the payment is made intra-group. The fact that the borrower and lender are
members of the same group is an element of the relationship between the parties and
should therefore be included within the terms of the loan instrument for the purposes of
determining the application of the hybrid financial instrument rule notwithstanding that
there may be no requirement for the loan to be held intra-group.
94.
The terms of the instrument should also include any element directly affecting the
relationship between the payer and the payee and the circumstances in which an
instrument was issued or held if those circumstances are economically and commercially
relevant to the relationship between the parties and affect the tax treatment of the
instrument. This is illustrated in Example 1.12 where all the shareholders subscribe for
debt in proportion to their shareholding in the issuer. Under the laws of the holders
jurisdiction, debt that is issued in proportion to equity is re-characterised as a share and
payments on such debt are treated as exempt dividends. The resulting difference in
characterisation between the jurisdiction of the issuer and the holder gives rise to a
mismatch in tax outcomes. The fact that the shareholder subscribes for debt in proportion
to its shareholding is commercially significant to the relationship between the parties so
that a mismatch in tax outcomes which is dependent on such facts should be treated as
attributable to the terms of the instrument.
Mismatch that is solely attributable to the status of the taxpayer or the context
in which the instrument is held
95.
The test under Recommendation 1.3 for whether a payment under a financial
instrument has given rise to a hybrid mismatch focuses on the ordinary or expected tax
treatment of the instrument. A mismatch that is solely attributable to the status of the
taxpayer or the context in which the financial instrument is held will not be a hybrid
mismatch. One way of testing for whether a mismatch is attributable to the terms of the
instrument is to pose a counterfactual test that asks whether the terms of the instrument
were sufficient to bring about the mismatch in tax outcomes. This can be done by
contrasting the parties actual tax treatment with what it would have been if the
instrument had been held directly and both the payer and payee were ordinary taxpayers
that computed their income and expenditure in accordance with the ordinary rules
applicable to taxpayers of the same type. If the same mismatch would have arisen had the
instrument been directly entered into by a taxpayer of ordinary status, then the mismatch
will be attributable to the terms of the instrument itself rather than the status of the
taxpayer or the context in which the instrument is held.
Tax status of the counterparty

96.
The hybrid financial instrument rule does not apply to mismatches that are solely
attributable to the status of the taxpayer. Where, however, the mismatch can also be
attributed to the tax treatment of the instrument (i.e. the mismatch would have arisen even
in respect of payment between taxpayers of ordinary status) the hybrid financial
instrument rule will continue to apply although the adjustment may not, in practice have
any impact on the tax position of the parties to the arrangement. An example illustrating
the application of this principle is set out in Example 1.5 where a deductible interest
payment is made to a sovereign wealth fund that is a tax exempt entity under the laws of
its own jurisdiction. The rule will not apply if the tax exempt status of the fund is the only
reason for the D/NI outcome. If the hybrid financial instrument rule would ordinarily
apply to such an instrument, however, then it will continue to apply and may result in a
denial of a deduction for an amount paid under the arrangement.
Circumstances in which the instrument is held

97.
The hybrid financial instrument rule does not apply to mismatches that are solely
attributable to the circumstances under which an instrument is held. This principle is
illustrated in Example 1.8 where the payee holds the instrument through a foreign
branch. The fact that the loan is held through a foreign branch is not a term of the
instrument or part of the relationship between the parties. Therefore, if the mismatch
arises solely due to the operation of the branch exemption in the residence country then
the mismatch will not be a hybrid mismatch. The principle is also illustrated in
Example 1.9 where a taxpayer holds a bond issued by a company through a tax exempt
savings account. In that case any mismatch in tax outcomes is not attributable to the terms
of the instrument but the conditions under which the instrument is held.
Payments to a taxpayer in a pure territorial regime

98.
A mismatch in tax treatment that arises in respect of a cross-border payment made
to a taxpayer in a pure territorial tax regime (i.e. a jurisdiction that excludes or exempts
all foreign source income) will not be caught by the hybrid financial instrument rule
because the mismatch in tax outcomes will be attributable to the nature of the payer
(i.e. to the fact that the payer is a non-resident making payments of foreign source
income) rather than the terms of the instrument itself. This principle is illustrated in
Example 1.7 where the payee jurisdiction does not tax income from foreign sources. In
the example, a related non-resident payer makes a payment of deductible interest that is
treated as foreign source income. The resulting mismatch is not attributable to the terms
of the instrument but to the fact that the payee is exempt on all foreign source income.
The mismatch is therefore not caught by the hybrid financial instrument rule. This result
should be contrasted with Example 1.1 where the payee jurisdiction exempts only foreign
dividend payments. In that case, the exemption on foreign source income applies only to
a particular category of income (i.e. dividends) so that the tax exemption turns not only
on the source of the payment but the character of the instrument under the laws of the
payee jurisdiction and, accordingly, the terms of the instrument itself.
Recommendation 1.4 - Scope of the rule

99.
In order to strike a balance between a rule that is clear and comprehensive and
that is properly targeted and administrable, Recommendation 1.4 limits the scope of the
hybrid financial instrument rule to payments made to related persons and under structured
arrangements. See Recommendations 10 and 11 regarding the definition of structured
arrangements and related persons.
Recommendation 1.5 - Exceptions to the rule

100. Recommendation 1.5 provides an exception for entities where the tax policy of
the deduction under the laws of the payer jurisdiction is to preserve tax neutrality for the
payer and payee.
Entities entitled to deduct dividends not within the scope of the hybrid financial
instrument rule
101. In order to preserve its tax neutrality, a jurisdiction may grant an investment
vehicle, such as a mutual fund or real estate investment trust (REIT), the right to deduct
dividend payments. Although the payment of a deductible dividend is likely to give rise
to a mismatch in tax outcomes, such a payment will not generally give rise to a hybrid
mismatch under Recommendation 1 provided any resulting mismatch will be attributable
to the payers tax status rather than the ordinary tax treatment of dividends under the laws
of that jurisdiction. As noted in Example 1.10, however, under Recommendation 2.1 of
the report the payee jurisdiction should not permit a taxpayer to claim an exemption or
equivalent relief from double taxation in respect of a deductible dividend paid by such an
entity.
Application of the exception to securitisation vehicles and other investment

funds
102. In certain cases, the tax neutrality of an investment vehicle depends not on the
particular tax status of the vehicle but on assumptions as to the tax treatment of the
instruments issued by the vehicle. One example of this is a securitisation vehicle or an
infrastructure investment fund that is financed almost entirely by way of borrowing and
where all, or substantially all, of the income is paid out to lenders in the form of
deductible interest. The exception to the hybrid financial instrument rule set out in
Recommendation 1.5 is intended to protect the tax neutrality of these vehicles while
ensuring that they cannot be used to defer or avoid tax at the level of the payee.
Accordingly, the exception applies where the regulatory and tax framework in the
establishment jurisdiction has the effect that the financial instruments issued by the
investment vehicle will result in all or substantially all of the income of the vehicle being
paid and distributed to holders within a reasonable period of time and where the tax
policy of the establishment jurisdiction is that such payments will be subject to tax in the
hands of investors. Recommendation 1.5 specifically notes that the defensive rule in
Recommendation 1.1(b) should continue to apply to such payments on receipt.
2. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF FINANCIAL INSTRUMENTS 45
Chapter 2
Specific recommendations for the tax treatment of
financial instruments
Recommendation 2
1. Denial of dividend exemption for deductible payments
In order to prevent D/NI outcomes from arising under a financial instrument, a dividend exemption
that is provided for relief against economic double taxation should not be granted under domestic
law to the extent the dividend payment is deductible by the payer. Equally, jurisdictions should
consider adopting similar restrictions for other types of dividend relief granted to relieve economic
double taxation on underlying profits.
2. Restriction of foreign tax credits under a hybrid transfer

In order to prevent duplication of tax credits under a hybrid transfer, any jurisdiction that grants
relief for tax withheld at source on a payment made under a hybrid transfer should restrict the
benefit of such relief in proportion to the net taxable income of the taxpayer under the arrangement.

There is no limitation as to the scope of these recommendations.
Overview
103. Recommendation 2 sets out two specific recommendations for changes to the tax
treatment cross-border financial instruments.
(a) Under Recommendation 2.1 the report recommends that countries do not grant a
dividend exemption or equivalent tax relief for payments that are treated as
deductible by the payer.
(b) Under Recommendation 2.2 the report recommends limiting the ability of a
taxpayer to claim relief from foreign withholding tax on instruments that are held
subject to a hybrid transfer.
104.
Rather than simply adjusting the tax treatment of a payment in order to align it
with the tax consequences in another jurisdiction, the purpose of these recommendations
goes further by seeking to bring the treatment of these instruments into line with the tax
policy outcomes that will generally apply to the same instruments in the wholly-domestic
context.
105. The domestic law changes required to implement Recommendation 2 will depend
on the current state of a countrys domestic law. There are a number of different ways of
46 2. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF FINANCIAL INSTRUMENTS

restricting the benefit of double taxation relief and these recommendations only set out
recommended outcomes rather than specifying how such changes ought to be
implemented.
Recommendation 2.1 - Denial of dividend exemption for deductible payments

106. The purpose of a dividend exemption is generally to avoid imposing an additional
layer of taxation at the shareholder level on income that has already been subject to tax at
the entity level. Recommendation 2.1 recommends that jurisdictions that provide payees
with an exemption for dividends, as a mechanism for relieving economic double taxation
on corporate profits, do not extend that exemption to payments that have not borne tax at
the entity level.
107. The operation of this Recommendation is set out in Example 1.1. In that example
a taxpayer borrows money under an interest bearing loan from a related taxpayer in
another jurisdiction. The issuer of the loan is allowed a deduction for the interest while
the holder treats the payment as a dividend. Any mismatch in tax outcomes, however, is
eliminated if the payee jurisdiction prevents the payee from taking advantage of a
dividend exemption in respect of a payment that is deductible under the laws of the payer
jurisdiction. Similar outcomes are identified in Example 1.2, Example 1.3 and
Example 1.4.
Recommendation extends to other types of dividend relief

108. Recommendation 2.1 also encourages countries to consider introducing
restrictions on the availability of other types of double taxation relief for dividends.
Example 1.3 illustrates the potential application of the Recommendation to a deductible
dividend subject to a reduced tax rate, Example 1.4 illustrates the application of the
Recommendation to a payment that is eligible for an underlying foreign tax credit and
Example 2.1 illustrates the possible application of the Recommendation to a payment
that is eligible for a domestic tax credit.
Recommendation applies only to payments characterised as dividends

109. The Recommendation only affects payments that would otherwise qualify for a
dividend exemption or equivalent tax relief and does not deal with other types of noninclusion (such as a payment that is treated as a return of capital under a share). This
principle is illustrated in Example 1.13 where a taxpayer treats a loan from its parent as
having been issued at a discount and accrues this discount as an expense over the life of
the loan. The parent jurisdiction, however, does not adopt the same accounting treatment
as its subsidiary and treats all the payments on the instrument as loan principal or a return
of share capital. A rule limiting double taxation relief on deductible dividend payments
will not apply to the facts of that example, because the payment is not treated as a
dividend under the domestic laws of the payee jurisdiction.
Recommendation applies only to dividends that are deductible by the issuer

110. In determining whether a dividend is deductible for the purposes of
Recommendation 2.1 a taxpayer will generally look to the instrument under which the
payment was made and whether the issuer of that instrument was entitled to a deduction
for such payment. The fact that a dividend triggers a deduction in another jurisdiction for
separate taxpayer due to the existence of a hybrid entity structure or under a hybrid
2. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF FINANCIAL INSTRUMENTS 47
transfer, will not generally trigger a denial of the dividend exemption in the payee
jurisdiction.
111. This principle is illustrated in Example 1.31 where the payment of a dividend on
shares that have been subject to a repo triggers a deduction for the repo counterparty in a
third jurisdiction. The payment, however, does not trigger a deduction for the issuer of the
shares so that the recommended changes to domestic law in Recommendation 2.1 would
not be expected to restrict the holders entitlement to an exemption on the dividend. The
principle is further illustrated in Example 1.23 where a hybrid entity borrows money
from a related person in the same jurisdiction under an instrument that is treated as equity
under local law. The hybrid entity is treated as making a non-deductible payment for local
law purposes but the payment under the instrument is treated as deductible under the laws
of the parent jurisdiction. Recommendation 2.1 would not be expected to restrict the
holders entitlement to an exemption on the dividend as the payment under the hybrid
financial instrument does not trigger a deduction for the issuer of the shares.
Recommendation 2.2 - Restriction of foreign tax credits under a hybrid transfer

112. A hybrid transfer exploits differences between two countries in their rules for
attributing income from an asset with the effect that the same payment is treated as
derived simultaneously by different taxpayers resident in different jurisdictions. Because
there is only one underlying payment, however, the economic benefit of that payment will
be shared between the parties under the terms of the hybrid transfer. Recommendation 2.2
sets out a rule that aligns the rules for granting of foreign withholding tax relief with the
economic benefit of the payment as shared under the terms of the hybrid transfer. It does
this by restricting the amount of the credit in proportion to the net taxable income of the
taxpayer under the arrangement.
113. The operation of this Recommendation is set out in Example 2.2. In that example
a taxpayer borrows securities under an arrangement that generally includes the
requirement to make manufactured payments to the lender of any amounts paid on the
underlying securities during the period of the loan. A hybrid transfer arises because the
lender is treated as continuing to receive payments on the underlying securities. The
borrower, however, also treats itself as receiving the same income on the underlying asset
and is allowed a deduction for the manufactured payments made to the lender. The hybrid
transfer therefore permits both parties to claim withholding tax credits on the payment
which has the effect of lowering their effective tax burden under the instrument. By
limiting the amount of the credit in proportion to the taxpayers net income under the
arrangement the tax treatment is brought into line with the tax treatment of a non-hybrid
financing transaction.
Recommendation 2.3 - Scope

114. The report recommends that those countries applying Recommendations 2.1 and
2.2 should be able to deny the benefit of the exemption or tax credit without any
qualification as to scope
3. DISREGARDED HYBRID PAYMENTS RULE 49
Chapter 3
Disregarded hybrid payments rule
Recommendation 3
The following rule should apply to a disregarded payment made by a hybrid payer that results in a
hybrid mismatch:
(a)
D/NI outcome.
(b)
to a D/NI outcome.
(c)
No mismatch will arise to the extent that the deduction in the payer jurisdiction is set-off
against income that is included in income under the laws of both the payee and the payer
jurisdiction (i.e. dual inclusion income).
(d)
Any deduction that exceeds the amount of dual inclusion income (the excess deduction)
may be eligible to be set-off against dual inclusion income in another period.
2. Rule only applies to disregarded payments made by a hybrid payer

For the purpose of this rule:
(a)
A disregarded payment is a payment that is deductible under the laws of the payer
jurisdiction and is not recognised under the laws of the payee jurisdiction.
(b)
A person will be a hybrid payer where the tax treatment of the payer under the laws of the
payee jurisdiction causes the payment to be a disregarded payment.
3. Rule only applies to payments that result in a hybrid mismatch

A disregarded payment made by a hybrid payer results in a hybrid mismatch if, under the laws of
the payer jurisdiction, the deduction may be set-off against income that is not dual inclusion
income.

This rule only applies if the parties to the mismatch are in the same control group or where the
payment is made under a structured arrangement and the taxpayer is a party to that structured
arrangement.
50 3. DISREGARDED HYBRID PAYMENTS RULE
Overview
115. A deductible payment can give rise to a D/NI outcome where the payment is
made by a hybrid entity that is disregarded under the laws of the payee jurisdiction. Such
disregarded payments can give rise to tax policy concerns where that deduction is
available to be set-off against an amount that is not treated as income under the laws of
the payee jurisdiction (i.e. against income that is not dual inclusion income). The
purpose of the disregarded hybrid payments rule is to prevent a taxpayer from entering
into structured arrangements, or arrangements with members of the same control group,
that exploit differences in the tax treatment of payer to achieve such outcomes.
116. The primary recommendation under the deductible hybrid payments rule is that
the payer jurisdiction should restrict the amount of the deduction that can be claimed for a
disregarded payment to the total amount of dual inclusion income. The defensive rule
requires the payee jurisdiction to include an equivalent amount in ordinary income.
117. An item of income should be treated as dual inclusion income if it is taken into
account as income under the laws of both the payer and payee jurisdictions. It may be
possible to undertake a line by line comparison of each item of income in straightforward
cases where the hybrid payer is party to only a few transactions. In more complex cases
however, countries may wish to adopt a simpler implementation solution for tracking
deductions and items of dual inclusion income, which is based, as much as possible, on
existing domestic rules, administrative guidance, presumptions and tax calculations while
continuing to meet the basic policy objectives of the disregarded hybrid payments rule.
Examples of possible implementation solutions are identified in Chapters 3, 6 and 7 and
described in further detail in the examples.
118. Jurisdictions use different tax accounting periods and have different rules for
recognising when items of income or expenditure have been derived or incurred. These
timing and quantification differences should not be treated as giving rise to mismatches in
tax outcomes under Recommendation 3. Excess deductions that are subject to restriction
in the payer jurisdiction under the disregarded hybrid payments rule may be carried over
to another period, in accordance with the ordinary rules for the treatment of net losses,
and applied against dual inclusion income in that period.
to a D/NI outcome
119.
The Recommendation for disregarded hybrid payments is to neutralise the effect
of the mismatch through the adoption of a linking rule that aligns the tax outcomes for the
payer and payee. This report recommends that the primary response should be to deny the
payer a deduction for payments made under a disregarded payment with the payee
jurisdiction applying a defensive rule that would require a disregarded payment to be
included in ordinary income in the event the payer was located in a jurisdiction that did
not apply the disregarded hybrid payments rule.
120. The hybrid mismatch rule does not apply, however, to the extent the deduction for
the disregarded payment is set-off against dual inclusion income, which is income that
is taken into account as income under the laws of both the payer and payee jurisdictions.
In order to address timing differences in the recognition of deductions for disregarded
payments and dual inclusion income any excess deduction (i.e. net loss) from such
disregarded payments that cannot be set-off against dual inclusion income in the current
period remains eligible to be set-off against dual inclusion income that arises in another
period under the ordinary rules that allow for the carry-forward (or back) of losses to
other taxable periods.
Deductible payments caught by the rule

121. In order to be a disregarded payment, the payment must be deductible under the
laws of the payer jurisdiction. The meaning of deductible and deduction is the same as
that used in the other recommendations in the report and generally covers items of current
expenditure such as service payments, rents, royalties, interest and other amounts that
may be set-off directly against ordinary income. The term does not cover the cost of
acquiring a capital asset or an allowance for depreciation or amortisation.
122. Unlike the hybrid financial instrument rule, which focuses only on the tax
treatment of the instrument, and not on the status of the counterparty or the context in
which the instrument is held, the disregarded hybrid payments rule should only operate to
the extent that the payer is actually entitled to a deduction for a payment under local law.
Accordingly the rule will not apply to the extent the taxpayer is subject to transaction or
entity specific rules that prevent the payment from being deducted (including the hybrid
financial instrument rule).
123. The interaction between Recommendations 1 and 3 is explained in Example 3.2
where a PE in the payer jurisdiction borrows money from the parent of the group. Both
the loan and the interest payment are disregarded under the laws of the payee jurisdiction.
In the example the payer jurisdiction first applies the hybrid financial instrument rule to
determine whether interest on the loan is deductible before any adjustment is made under
the disregarded hybrid payments rule.
No mismatch to the extent the deduction does not exceed dual inclusion income
124. A deductible payment will not be treated as giving rise to a mismatch in tax
outcomes if the deduction does not exceed dual inclusion income. This is illustrated in
Example 3.1 where a hybrid entity (an entity that is treated as a separate taxpayer in its
jurisdiction of establishment but as transparent under the laws of its parent) makes an
interest payment to its non-resident parent that is disregarded under the laws of the parent
jurisdiction. The adjustment under the disregarded hybrid payments rule only operates to
the extent that the interest payment exceeds dual inclusion income for the hybrid entity in
the payer jurisdiction.
Dual inclusion income

125. An item will be dual inclusion income if it is included in income under the laws
of both the payer and payee jurisdictions. The identification of whether an item should be
treated as dual inclusion income is primarily a legal question that requires an comparison
of the treatment of the income under the laws of the payer and payee jurisdictions. An
amount should be treated as dual inclusion income if it is included in income under the
laws of both jurisdictions even if there are differences in the way those jurisdictions value
that item or in the accounting period in which the income is derived. In Example 6.1,
which considers the application of the deductible hybrid payments rule, the parent and
subsidiary jurisdictions use different timing and valuation rules for recognising the
income and expenses of a hybrid entity. In that case, both jurisdictions apply their own
timing and valuation rules for calculating the amount of dual inclusion income and

duplicate deductions arising in each period and the resulting timing difference does not
impact on the operation of the rule.
126. Double taxation relief, such as a domestic dividend exemption granted by the
payer jurisdiction or a foreign tax credit granted by the payee jurisdiction should not
prevent an item from being treated as dual inclusion income where the effect of such
relief is simply to avoid subjecting the income to an additional layer of taxation in either
jurisdiction. Thus, while a payment of dual inclusion income will generally be recognised
as ordinary income under the laws of both jurisdictions, an equity return should still
qualify as dual inclusion income if the payment is subject to an exemption, exclusion,
credit of other type of double taxation relief in the payer or payee jurisdiction that relieves
the payment from economic double taxation. An example of this type of dual inclusion
income is given in Example 6.3 in respect of a structure that produces DD outcomes and
Example 7.1 in respect of the dual resident payer rule. In Example 6.3 the expenses of a
hybrid entity are funded by an intra-group dividend that is exempt from taxation in the
hands of jurisdiction where the dividend is received but included as income under the
laws of its parent. Allowing the hybrid entity a deduction against this type of exempt or
excluded equity return preserves the intended tax policy outcomes in both jurisdictions
and, accordingly, the dividend should be treated as dual inclusion income for the purposes
of disregarded hybrid payments rule even where such dividend carries an entitlement to
an underlying foreign tax credit in the payee jurisdiction. Such double taxation relief may
give rise to tax policy concerns, however, if it has the effect of generating surplus tax
relief that can be used to reduce or offset the tax on non-dual inclusion income. In
determining whether to treat an item of income, which benefits from such double-taxation
relief, as dual-inclusion income, countries should seek to strike a balance between rules
that minimise compliance costs, preserve the intended effect of such double taxation
relief and prevent taxpayers from entering into structures that undermine the integrity of
the rules.
127. A tax administration may treat the net income of a controlled foreign company
that is attributed to a shareholder of that company under a CFC or other offshore
inclusion regime as dual inclusion income if the taxpayer can satisfy the tax
administration that the effect of the CFC regime is to bring such income into tax at the
full rate under the laws of both jurisdictions. Example 6.4 sets out a simplified
calculation to illustrate how income attributed under a CFC regime can be taken into
account in determining the amount of dual inclusion income under a hybrid structure.
Primary response and defensive rule

128. Where a payment gives rise to a D/NI outcome the payer jurisdiction should apply
the recommended response and deny the deduction for the payment to the extent that the
deduction exceeds dual inclusion income. The defensive rule is the mirror image of the
primary recommendation in that the payee jurisdiction recognises the same amount as
ordinary income. The operation of the primary and secondary rules are described in
further detail in Example 3.2.
Carry-forward of deductions to another period

129. Because the hybrid mismatch rules are generally not intended to impact on, or be
affected by, timing differences, the disregarded hybrid payment rules contain a
mechanism that allows the payer jurisdiction to carry-forward (or back if permitted under
local law) a hybrid deduction to a period where it can be set-off against surplus dual
inclusion income. The Recommendation contemplates that the ordinary domestic rules
governing the utilisation of losses would apply to such deductions. Example 6.1 sets out
an example of the operation of the carry-forward of excess deductions.
Implementation solution based on existing domestic rules

130. The disregarded hybrid payments rule caps the aggregate amount of hybrid
deductions that can be claimed to the aggregate amount of dual inclusion income. In
principle Recommendation 3 requires the taxpayer to individually identify the items of
income that arise under the laws of both jurisdictions and to determine which of them
have given rise to dual inclusion income. In those cases where the taxpayer has entered
into a large number of transactions this approach could result in a significant compliance
burden for taxpayers. In order to facilitate implementation and minimise compliance
costs, tax administrations will wish to consider simpler implementation solutions. These
solutions should be designed to produce substantially similar results to those described in
this Chapter while avoiding unnecessary complexity.
131. In the case of the kind of structures covered by Recommendation 3 it will
generally be the case that accounts showing the income and expenditure of the taxpayer
will have been prepared under the laws of both jurisdictions. These accounts will
generally be prepared under local law using domestic tax concepts. Tax administrations
should use these existing sources of information and tax calculations as a starting point
for identifying dual inclusion income. For instance, Example 3.2 contemplates that the
payer jurisdiction might prohibit a hybrid entity from surrendering the benefit of any net
loss to another group member to the extent the entity has made deductible payments that
were disregarded under the laws of payee jurisdiction and introduce other transaction
specific rules that prevent that entity entering into arrangements that stream non-dual
inclusion income to the hybrid entity in order to soak-up unused losses. Example 3.2
further suggests that the payee jurisdiction could use the accounts prepared by the hybrid
payer as a starting point and (after making transaction specific adjustments to determine
the amount of dual inclusion income derived by the hybrid payer) require the payee to
recognise, as ordinary income in each accounting period, the amount of any deductible
intra-group payments to the extent these payments generate a net loss under the laws of
the payer jurisdiction.
Recommendation 3.2 - Rule only applies to disregarded payments made by a hybrid

payer
132. The disregarded hybrid payments rule applies where the reason the deductible
payment is not recognised by the payee is because of the way the payer is treated under
the laws of the payee jurisdiction. Recommendation 3 restricts the scope of the rule to
disregarded payments made by a hybrid payer.
Disregarded payment
133. A disregarded payment is a payment that is not treated as a payment under the
laws of the payee jurisdiction or that is not otherwise taken into account as a receipt for
tax purposes. Example 3.1 and Example 3.2 both provide examples of disregarded
payments. In Example 3.1 the payment is made by a hybrid entity that is disregarded
under the laws of the payee jurisdiction so that a deductible payment made by the hybrid
entity to its immediate owner is similarly disregarded for tax purposes and does not give
rise to income in the hands of the payee. In Example 3.2 the payment is made within the

confines of a tax consolidation regime that treats all transactions and payments between
consolidated group members as disregarded for tax purposes.
Hybrid payer
134. A person making a payment will be treated as a hybrid payer in circumstances
where the tax treatment of the payer, under the laws of the payee jurisdiction, results in
the payment being disregarded for tax purposes in the hands of the payee. The kinds of
arrangements that cause a person to be a hybrid payer under Recommendation 3 will also
generally cause that person to be a hybrid payer under Recommendation 6, which applies
to DD outcomes using hybrid entities.
Recommendation 3.3 - Rule only applies to payments that result in a hybrid

mismatch
135. A deduction for a disregarded payment made by a hybrid payer will give rise to
tax policy concerns where the laws of the payer jurisdiction permit that deduction to be
set-off against an amount that is not dual inclusion income. Accordingly,
Recommendation 3.3 restricts the application of the disregarded hybrid payments rule to
those cases where the deduction may be set-off against dual inclusion income.
136.
There are a number of different techniques that a taxpayer can use in the payer
jurisdiction to set-off a double deduction against non-dual inclusion income. The most
common mechanism used to offset a deduction against non-dual inclusion income will be
the use of a tax consolidation or grouping regime that allows the payer to apply the
benefit of a deduction against the income of another entity within the same group. An
example of this technique is set out in Example 3.2. Other techniques include making an
investment through a reverse hybrid (an entity that is only treated as transparent under the
laws of the payer jurisdiction) so that the resulting income is only brought into account
under the laws of the payer jurisdiction. An example of such a structure is set out in
Example 6.1. Alternatively, as explained in further detail in Example 3.1, the taxpayer
may enter into a financial instrument or other arrangement where payments are only
included in income in the payer jurisdiction. Non-dual inclusion income can also be
set-off via merger-type transactions.
137. Regardless of the mechanism used to achieve the offset, if the effect of the
structure is to create the opportunity for a deduction under a disregarded payment to be
set-off against income that will not be brought into account as ordinary income under the
laws of the payee jurisdiction, this will be sufficient to bring the payment within the
scope of the disregarded hybrid payments rule.

138. Recommendation 3.4 limits the scope of the rule to structured arrangements and
mismatches that arise within a control group. See Recommendations 10 and 11 regarding
the definition of structured arrangements and control group.
4. REVERSE HYBRID RULE 55
Chapter 4
Reverse hybrid rule
Recommendation 4
1. Neutralise the mismatch to the extent the payment gives rise to D/NI outcome
In respect of a payment made to a reverse hybrid that results in a hybrid mismatch the payer
jurisdiction should apply a rule that will deny a deduction for such payment to the extent it gives
rise to a D/NI outcome.
2. Rule only applies to payment made to a reverse hybrid

A reverse hybrid is any person that is treated as a separate entity by an investor and as transparent
under the laws of the establishment jurisdiction.
3. Rule only applies to hybrid mismatches

A payment results in a hybrid mismatch if a mismatch would not have arisen had the accrued
income been paid directly to the investor.

The recommendation only applies where the investor, the reverse hybrid and the payer are
members of the same control group or if the payment is made under a structured arrangement and
the payer is party to that structured arrangement.
Overview
139. A deductible payment made to a reverse hybrid may give rise to a mismatch in tax
outcomes where that payment is not included in ordinary income in the jurisdiction where
the payee is established (the establishment jurisdiction) or in the jurisdiction of any
investor in that payee (the investor jurisdiction). The recommended rule neutralises those
mismatches that arise under a reverse hybrid structure where the mismatch is a result of
both the establishment jurisdiction and the investor jurisdiction treating the payment to
the reverse hybrid as owned by a taxpayer in the other jurisdiction. As for the other
hybrid entity payments rules, the reverse hybrid rule can apply to a broad range of
deductible payments (including interest, royalties, rents and payments for services). The
rule only applies, however:
(a) to payments that are made to a reverse hybrid (as defined under
Recommendation 4); and
(b) where the mismatch in tax outcomes would not have arisen had the payment been
made directly to the investor.
56 4. REVERSE HYBRID RULE

140. A reverse hybrid is any person (including any unincorporated body of persons)
that is treated as transparent under the laws of the jurisdiction where it is established but
as a separate entity (i.e. opaque) under the laws of the jurisdiction of the investor. The
transparency or opacity of an entity must be tested by reference to the payment that is
subject to the reverse hybrid rule. A person will be treated as tax transparent in respect of
a payment where the reverse hybrid attributes or allocates a payment that it has received
to an investor and the effect of such attribution or allocation under the laws of the
establishment jurisdiction is to treat the payment as it would have been treated had it been
paid directly to that investor. The same person will be treated as opaque, from the
perspective of the investor jurisdiction, if the effect of such attribution or allocation is
ignored for tax purposes in the investor jurisdiction.
141. The mismatch in tax outcomes that arises in respect of a payment to a reverse
hybrid will only be treated as a hybrid mismatch where that mismatch would not have
arisen had the attributed payment been made directly to the investor. In order to prevent a
reverse hybrid being inserted into a structure to circumvent the operation of the hybrid
financial instrument rule, the reverse hybrid rule will also apply to the extent a direct
payment would have been subject to adjustment under the primary rule in
Recommendation 1.
142. The recommended response under the reverse hybrid rule is to deny the deduction
on the payment to the extent of any hybrid mismatch.
143. The reverse hybrid rule will only apply where the payer, the reverse hybrid and
the investor are part of the same control group or the payer is a party to a structured
arrangement.
to a D/NI outcome
144. The response recommended in this report is to neutralise the effect of hybrid
mismatches that arise under payments made to reverse hybrids through the adoption of a
linking rule that denies a deduction for such payments to the extent they give rise to a
D/NI outcome. This report only recommends the adoption of the primary response of
denying the payer a deduction for payments made to a reverse hybrid. A defensive rule is
unnecessary given the specific recommendations in Chapter 5 for changes CFC rules and
other offshore investment regimes that would require payments to a reverse hybrid to be
included in income in the investor jurisdiction.
Payment
145. The definition of payment is set out in further detail in Recommendation 12 and
includes any amount that is capable of being paid including a distribution, credit or
accrual. A payment will be treated as deductible if it is applied, or can be applied, to
reduce a taxpayers net income. Deductible payments generally include current
expenditures such as rents, royalties, interest, payments for services and other payments
that may be set-off against ordinary income under the laws of the payer jurisdiction in the
period they are treated as made. The term would not typically cover the cost of acquiring
a capital asset and would not extend to an allowance for a depreciation or amortisation.
146. A payment will give rise to a D/NI outcome under a reverse hybrid rule if it is
deductible under the laws of the payer jurisdiction and if it is allocated or attributed by
the reverse hybrid to the investor in circumstances that give rise to a mismatch in tax
outcomes. The payment does not incorporate any distribution or right to distribution from
the reverse hybrid that occurs as a consequence of making a payment to a reverse hybrid.
While the effect of allocating or attributing a payment to an investor may trigger an
obligation on the part of the reverse hybrid to make a further payment to the investor (for
example, in the form of a distribution), the tax treatment of that distribution will not
generally be relevant to whether a D/NI outcome arises under the rule.
D/NI outcome in respect of a payment to a reverse hybrid

147. A D/NI outcome will arise in respect of a payment to a reverse hybrid to the
extent that the payment is deductible under the laws of one jurisdiction (the payer
Deduction in any jurisdiction sufficient to trigger application of the rule

148. In certain cases, where the payer is transparent or has a taxable presence in more
than one jurisdiction, a payment may be treated as made from more than one jurisdiction.
In these cases, however, the deduction of the payment in the other jurisdiction is not
relevant to the question of whether the payment gives rise to a D/NI outcome under the
laws of the jurisdiction applying the reverse hybrid rule. This principle is illustrated in
Example 4.4 where a payment to a reverse hybrid is made by a hybrid entity. In this case
the example concludes that the hybrid mismatch rule in Recommendation 4 should be
applied in both the parent and subsidiary jurisdictions to neutralise the effect of the
mismatch and the application of the reverse hybrid rule in one jurisdiction does not
impact on its application in the other.
Inclusion in any jurisdiction sufficient to discharge application of the rule

149. If the payment is brought into account as ordinary income in at least one
jurisdiction then there will be no mismatch for the rule to apply to. A payment to a
reverse hybrid will not be treated as giving rise to a D/NI outcome if the mismatch is
neutralised by the investor or the establishment jurisdiction adopting a specific rule
designed to bring into account items of ordinary income paid to a reverse hybrid. This
will include any rules, consistent with Recommendation 5.1, that require a taxpayer in the
investor jurisdiction to take into account, for tax purposes, any item of ordinary income
allocated to that taxpayer by a reverse hybrid (including under a CFC regime) and any
rules in the establishment jurisdiction, consistent with Recommendation 5.2, that deny the
benefit of tax transparency to a non-resident investor or group of investors if they are not
required to take into account, for tax purposes, an item of ordinary income that is
allocated to them by the transparent entity.
CFC inclusion
150. A payment that has been fully attributed to the ultimate parent of the group under
a CFC regime and has been subject to tax at the full rate should be treated as having been
included in ordinary income for the purposes of the reverse hybrid rule. As for
Recommendation 1 and Recommendation 3, the burden is on the taxpayer to establish, to
the satisfaction of the tax administration, the extent to which the payment:
(a) Has been fully included under the laws of the investor jurisdiction and is subject to
tax at the full rate.

(b) Has not been treated as reduced or offset by any deduction or other relief other
than in respect of expenditure incurred by the investor under the laws of the
investor jurisdiction.
(c) Does not carry an entitlement to any credit or other relief.
(d) Does not give rise to an imported mismatch.
151. In Example 4.3 an intra-group services fee is paid to a reverse hybrid, but the
ultimate parent of the group brings the full amount of that payment into account as
ordinary income under its CFC rules. The example concludes that, provided the taxpayer
can establish, to the satisfaction of the tax administration, that the full amount of the
payment has been included in income under the CFC regime of the investor jurisdiction
and is not subject to any deduction, credit or other relief, then the reverse hybrid rule does
not apply because the payment has not given rise to a mismatch in tax outcomes.
Other types of inclusion

152. The same principle is illustrated in Example 1.8 where interest is paid to a branch
of a company that is resident in another jurisdiction. In determining whether the payment
has given rise to a D/NI outcome, Example 1.8 looks to the tax treatment of the payment
under the laws of both the residence and the branch jurisdiction. While Example 1.8
concerns the identification of D/NI outcomes under the hybrid financial instrument rule,
the issues are the same in respect of a determination of D/NI outcomes under the reverse
hybrid rule, and a similar interpretation would apply if the reverse hybrid maintained a
branch in a third jurisdiction and the payment is brought into ordinary income in that
jurisdiction.
Taxation in the establishment jurisdiction on the basis of source

153. Frequently, in the case of transparent intermediaries such as trusts and
partnerships, the establishment jurisdiction will not treat the intermediary as a taxpayer in
its own right. Rather, payments that are made to the intermediary will be treated as having
been made directly by the underlying partners or beneficiaries in accordance with the
allocation mechanics set out in the partnership agreement or trust deed. In these cases
such payments may, nevertheless, be brought into account as ordinary income in the
establishment jurisdiction because the payments are treated as being sourced in that
jurisdiction, either because the payment is made by a person who is a taxpayer in the
establishment jurisdiction or because the partnership or trust has a sufficient taxable
presence in the establishment jurisdiction to give that income a domestic source. In such
cases, provided the establishment jurisdiction taxes such payments on an ordinary basis,
the payments should not generally give rise to a D/NI outcome under the reverse hybrid
rules.
Demonstrating that a payment has not given rise to a D/NI outcome

154. It will be the taxpayer who has the burden of establishing, to the reasonable
satisfaction of the tax administration, how the tax treatment of the payment in the payee
jurisdiction impacts on the amount of the adjustment required under the rule. The initial
burden of proof may be discharged by the taxpayer demonstrating that the payment has
actually been recorded as ordinary income on the tax return in the other jurisdiction.
Deduction should only be denied to the extent of the mismatch

155. The adjustment should be no more than is necessary to neutralise the hybrid effect
that results from inserting the reverse hybrid between the payer and the investor. If part of
the payment remains subject to tax in the investor or establishment jurisdiction then that
part of the payment should not be subject to adjustment under the hybrid financial
instrument rule. This is illustrated in Example 4.2 where a taxpayer makes a payment of
interest to a reverse hybrid, only part of which is treated as exempt income under the laws
of establishment jurisdiction. The example concludes that the payer jurisdiction should
not deny a deduction for that part of the payment that remains subject to tax as ordinary
income under the laws of the establishment jurisdiction.
Treatment of distributions from a reverse hybrid

156. The reverse hybrid rule will apply even if the investor is ultimately taxed on
distributions made by the reverse hybrid. The mere fact that the accrued income of the
reverse hybrid will be taxable as ordinary income when it is distributed to the investor
will not be sufficient to show that the payment does not give rise to a mismatch. The
reverse hybrid rule is intended to neutralise the D/NI outcome that arises at the time the
payment is made to the reverse hybrid. The tax treatment of a separate payment that the
reverse hybrid makes to the investor at some point in the future (and which may or may
not be funded out of the payments caught by the reverse hybrid rule) will generally be too
remote from the mismatch to be taken into account for the purposes of the rule.
Recommendation 4.2 - Rule only applies to payment made to a reverse hybrid

157. A reverse hybrid is any person (which includes an unincorporated body of
persons such as a trust) that is treated as transparent under the laws of the jurisdiction
where it is established but as a separate entity by an investor in that reverse hybrid.
158. An investor is not confined to persons that subscribe money for an interest in a
reverse hybrid and includes any person to whom the reverse hybrid allocates or attributes
a payment.
Establishment jurisdiction
159. The establishment jurisdiction will, in the case of entities that are formed by
incorporation or registration, be the jurisdiction where that person is registered or
established. For entities that can be formed without formal incorporation or registration
requirements (such as partnerships and trusts) the establishment jurisdiction will be the
jurisdiction under which the entity has been created and/or where the directors (or
equivalent) perform their functions.
Transparent treatment in the establishment jurisdiction

160. A person will be treated as transparent under the laws of the establishment
jurisdiction if the laws of that jurisdiction permit or require the person to allocate or
attribute ordinary income to an investor and such allocation or attribution has the effect
that the payment is not included in the income of any other taxpayer.
161. The most basic example of a transparent person is a trust or partnership, which is
not treated as a taxpayer in its own right but where the income derived by that person is
allocated or attributed to the partners or beneficiaries and those partners or beneficiaries

are liable to tax on that income as if they had received it directly. Other tax transparency
regimes, however, may achieve the same effect without triggering a direct tax liability for
the investor. For example, an establishment jurisdiction may permit or require an
intermediary to allocate or attribute items of income to an investor but pay the tax on that
allocated income on the investors behalf and at the investors marginal rate.
Alternatively the regime in the establishment jurisdiction may exempt certain payments
from tax on the grounds that the income is foreign source income allocated or attributed
to a non-resident investor that would not have been subject to tax if the payment had been
received by the investor directly.
162. The types of regimes described above should be treated as transparency regimes if
the effect of allocating or attributing a payment of ordinary income to the investor results
in the payment being taxed under the laws of the establishment jurisdiction as if it had
been paid directly to that investor. Example 4.2 provides an illustration of a transparency
regime where the tax liability falls on the reverse hybrid rather than the investor. In that
example the payee is entitled to claim an exemption for a payment of foreign source
interest on the basis that the interest payment has accrued to the benefit of a non-resident.
The example concludes that the payee is a reverse hybrid and the payment gives rise to a
hybrid mismatch to the extent such payment would have been included in ordinary
income if it had been paid directly to the investor.
Separate entity treatment in the investor jurisdiction

163. In most cases the allocation or attribution of ordinary income by the intermediary
will not have any tax consequences for the investor under the laws of the investor
jurisdiction. If this is the case then the intermediary should be considered opaque under
the laws of the investor jurisdiction.
Recommendation 4.3 - Rule only applies to hybrid mismatches

164. A payment made to a reverse hybrid that gives rise to a D/NI outcome will only
be subject to adjustment under the reverse hybrid rule if that D/NI outcome constitutes a
hybrid mismatch under Recommendation 4.3
165. The identification of a mismatch as a hybrid mismatch under a reverse hybrid
structure is primarily a legal question that requires the general rules in the investor
jurisdiction to be applied to the payment that is made to the reverse hybrid to determine
the character, amount and tax treatment of that payment and whether it would have been
treated as ordinary income if it had been paid directly to the investor.
166. Unlike in the hybrid financial instrument rule, which applies whenever the terms
of the instrument were sufficient to bring about a mismatch in tax outcomes, the reverse
hybrid rule will not apply unless the payment attributed to the investor would have been
included as ordinary income if it had been paid directly to the investor (i.e. the
interposition of the reverse hybrid must have been necessary to bring about the mismatch
in tax outcomes). This is illustrated in Example 4.1 where income is allocated by a
reverse hybrid to a tax exempt entity. In that case the payment would not have been
taxable even if it had been made directly to the investor and the reverse hybrid rule will
not apply to deny the deduction.
Reverse hybrids cannot be used to circumvent the application of

Recommendation 1
167. In order to prevent a reverse hybrid being used to circumvent the operation of the
hybrid financial instrument rule, the reverse hybrid rule will continue to apply to the
extent a direct payment would have been subject to adjustment under the primary rule in
Recommendation 1. An example where this principle might apply is set out in
Example 4.4 where the payment to a reverse hybrid is made under a financial instrument.
In this case, the payer will continue to deny the deduction for the payment because the
hybrid financial instrument rule would have applied in the payer jurisdiction to neutralise
the mismatch in tax outcomes if the payment had been made directly to the investor. The
mismatch in tax outcomes therefore still falls within the language and intent of the rule.

168. Recommendation 4.4 limits the scope of the reverse hybrid rule to structured
arrangements and mismatches that arise within a control group. See Recommendations 10
and 11 regarding the definition of structured arrangements and control group.
5. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF REVERSE HYBRIDS 63
Chapter 5
Specific recommendations for the tax treatment of reverse hybrids
Recommendation 5
1. Improvements to CFC and other offshore investment regimes
Jurisdictions should introduce, or make changes to, their offshore investment regimes in order to
prevent D/NI outcomes from arising in respect of payments to a reverse hybrid. Equally
jurisdictions should consider introducing or making changes to their offshore investment regimes in
relation to imported mismatch arrangements.
2. Limiting the tax transparency for non-resident investors

A reverse hybrid should be treated as a resident taxpayer in the establishment jurisdiction if the
income of the reverse hybrid is not brought within the charge to taxation under the laws of the
establishment jurisdiction and the accrued income of a non-resident investor in the same control
group as the reverse hybrid is not brought within the charge to taxation under the laws of the
3. Information reporting for intermediaries

Jurisdictions should introduce appropriate tax filing and information reporting requirements on
persons established within their jurisdiction in order to assist both taxpayers and tax administrations
to make a proper determination of the payments that have been attributed to that non-resident
investor.
Overview
169. Recommendation 5 sets out three specific recommendations for the tax treatment
of reverse hybrids. These recommendations cover the tax treatment of payments made to
a reverse hybrid under the laws of the investor and establishment jurisdiction and
recommendations on tax filing and information requirements in order to assist both
taxpayers and tax administrations to make a proper determination of the payments that
have been attributed to that non-resident investor.
170. These specific recommendations are not hybrid mismatch rules. That is, they do
not adjust the tax consequences of a payment because of differences in its tax treatment in
another jurisdiction. Rather, Recommendation 5 sets out improvements that jurisdictions
could make to their domestic law that will reduce the frequency of hybrid mismatches by
bringing the tax treatment of cross-border payments made to transparent entities into line
with the tax policy outcomes that would generally be expected to apply to payments
between domestic taxpayers.
64 5. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF REVERSE HYBRIDS
Recommendation 5.1 - Improvements to CFC and other offshore investment

regimes
171. Payments made through a reverse hybrid structure will not result in D/NI
outcomes if the income is fully taxed under a CFC, foreign investment fund (FIF) or a
similar anti-deferral rule in the investor jurisdiction that requires the investor to include
its allocated share of any payment of ordinary income made to the intermediary on a
current basis. Recommendation 5.1 therefore recommends that jurisdictions introduce or
extend their offshore investment regimes to require a taxpayer to take into account, for
tax purposes, any item of ordinary income allocated to that taxpayer by a reverse hybrid.
172. There are a number of ways a jurisdiction could go about aligning the tax
treatment of the payment in the investor jurisdiction with its treatment in the
establishment jurisdiction. A jurisdiction may use one or a combination of measures that
could include changes to residency rules, CFC rules and rules that tax a resident investor
on changes in the market value of the investment. When considering changes to their
offshore investment regime, jurisdictions should also take into account the effect of
existing exemptions, safe harbours and thresholds that may reduce the effectiveness of
those regimes in bringing into account income of a reverse hybrid.
173. A reverse hybrid will be transparent under the laws of the establishment
jurisdiction. Such transparency means that the laws of the establishment jurisdiction
permit or require the reverse hybrid to allocate or attribute payments to an investor in
such a way that the payment is not included in the income of any other taxpayer. An
offshore investment regime in the investor jurisdiction could isolate this requirement and
tax investors on the amount of income allocated to that investor. Treating income
allocated by a reverse hybrid as taxable under the laws of the investor jurisdiction would
have the effect of neutralising any hybrid mismatch under a payment to a transparent
entity. Such a rule would ensure that the payer jurisdiction could suspend the application
of the hybrid mismatch rule insofar as payments were allocated to investors in the
Recommendation 5.2 - Limiting the tax transparency for non-resident investors

174. Tax transparency is an effective way for collective investment vehicles to ensure
tax neutrality of outcomes for different investors that are subject to different marginal
rates of taxation. Tax transparency proceeds on the assumption, however, that the income
allocated to the investor will be taxable in the hands of the investor. In the cross-border
context this is not always the case. Recommendation 5.2 is intended to prevent a
non-resident taking advantage of a persons tax transparency in order to achieve a
175. Recommendation 5.2 of the report applies where a tax transparent person is
controlled or otherwise owned by a non-resident investor and that investor is not required
to take into account payments of ordinary income allocated to them by that person. The
rule effectively encourages jurisdictions to turn off their transparency rules when those
rules are primarily used to achieve hybrid mismatches. The Recommendation only
applies in circumstances where:
(a) the person is tax transparent under the laws of the establishment jurisdiction;
(b) the person derives foreign source income or income that is not otherwise subject to
taxation in the establishment jurisdiction;
5. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF REVERSE HYBRIDS 65
(c) all or part of that income is allocated under the laws of the establishment
jurisdiction to a non-resident investor that is in the same control group as that
person.
In these circumstances Recommendation 5.2 provides that the establishment jurisdiction
should treat the reverse hybrid as if it were a resident taxpayer. By treating the entity as a
resident taxpayer, this will eliminate the need to apply the reverse hybrid rule to such
entities and the investor jurisdiction could continue to include such payments in income
under Recommendation 5.1 but provide a credit for any taxes paid in the establishment
jurisdiction on the income that is brought into account under such rules.
Recommendation 5.3 - Information reporting for intermediaries

176. Recommendation 5.3 is intended to encourage jurisdictions to maintain
appropriate reporting and filing requirements for tax transparent entities that are
established within that jurisdiction. This would involve the maintenance of accurate
records of who their investors are, how much of an investment each investor holds in the
entity and the amount of income and expenditure allocated to those investors. These
records should be made available, on request, to both investors and to the tax
administration in the establishment jurisdiction.
177. In Brisbane, the G20 Leaders endorsed the Standard for Automatic Exchange of
Financial Account Information in Tax Matters (the AEOI Standard, OECD 2014a). As
part of this standard, investment entities will be required to provide their local tax
administration with certain information about their investors including the value of each
investors holding at the end of the relevant reporting period. This information will be
automatically exchanged with the tax administration in the investor jurisdiction making it
easier for tax authorities to identify (and identify the amount of) offshore investments
held by resident investors.
178. The legal basis for information exchange between tax administrations is generally
Article 26 of the OECD Model Tax Convention on Income and on Capital (OECD Model
Tax Convention, OECD, 2014b) or The Multilateral Convention on Mutual
Administrative Assistance in Tax Matters, Amended by the 2010 Protocol (Multilateral
Convention, OECD, 2010). This Multilateral Convention provides for all possible forms
of administrative co-operation between States and contains strict rules on confidentiality
and proper use of the information.
179. Furthermore, tax authorities are encouraged to require intermediaries established
in their jurisdiction to maintain records on the investors holding interests in those
intermediaries and the amounts of income and expenditure allocated to those investors
(including the categories of income and expenditure as determined under the relevant tax
or accounting standard).
66 5. SPECIFIC RECOMMENDATIONS FOR THE TAX TREATMENT OF REVERSE HYBRIDS
Bibliography
OECD (2014a), Standard for Automatic Exchange of Financial Account Information in
Tax Matters, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264216525-en.
OECD (2014b), Model Tax Convention on Income and on Capital, condensed version,
OECD Publishing, Paris, http://dx.doi.org/10.1787/mtc_cond-2014-en.
OECD (2010), The Multilateral Convention on Mutual Administrative Assistance in Tax
Matters, Amended by the 2010 Protocol, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264115606-en.
6. DEDUCTIBLE HYBRID PAYMENTS RULE 67
Chapter 6
Deductible hybrid payments rule
Recommendation 6
1. Neutralise the mismatch to the extent the payment gives rise to a DD outcome
The following rule should apply to a hybrid payer that makes a payment that is deductible under the
laws of the payer jurisdiction and that triggers a duplicate deduction in the parent jurisdiction that
results in a hybrid mismatch:
(a)
The parent jurisdiction will deny the duplicate deduction for such payment to the extent it
gives rise to a DD outcome.
(b)
If the parent jurisdiction does not neutralise the mismatch, the payer jurisdiction will deny
the deduction for such payment to the extent it gives rise to a DD outcome.
(c)
No mismatch will arise to the extent that a deduction is set-off against income that is
included in income under the laws of both the parent and the payer jurisdictions (i.e. dual
inclusion income).
(d)
Any deduction that exceeds the amount of dual inclusion income (the excess deduction) may
be eligible to be set-off against dual inclusion income in another period. In order to prevent
stranded losses, the excess deduction may be allowed to the extent that the taxpayer can
establish, to the satisfaction of the tax administration, that the excess deduction in the other
jurisdiction cannot be set-off against any income of any person under the laws of the other
jurisdiction that is not dual inclusion income.
2. Rule only applies to deductible payments made by a hybrid payer

A person will be treated as a hybrid payer in respect of a payment that is deductible under the laws
of the payer jurisdiction where:
(a)
the payer is not a resident of the payer jurisdiction and the payment triggers a duplicate
deduction for that payer (or a related person) under the laws of the jurisdiction where the
payer is resident (the parent jurisdiction); or
(b)
the payer is resident in the payer jurisdiction and the payment triggers a duplicate deduction
for an investor in that payer (or a related person) under the laws of the other jurisdiction (the
parent jurisdiction).

A payment results in a hybrid mismatch where the deduction for the payment may be set-off, under
the laws of the payer jurisdiction, against income that is not dual inclusion income.

The defensive rule only applies if the parties to the mismatch are in the same control group or where
the mismatch arises under a structured arrangement and the taxpayer is party to that structured
arrangement. There is no limitation on scope in respect of the recommended response.
68 6. DEDUCTIBLE HYBRID PAYMENTS RULE
Overview
180. Where a taxpayer makes a payment through a cross-border structure, such as a
dual resident, a foreign branch or a hybrid person, that payment may trigger a DD
outcome where:
(a) the expenditure is required to be taken into account in calculating the taxpayers
net income under the laws of two or more jurisdictions; or
(b) in the case of a payment made by a hybrid person that is treated as transparent by
one of its investors, the payment is also treated as deductible in calculating the net
income of that investor.
181. A DD outcome will give rise to tax policy concerns where the laws of both
jurisdictions permit that deduction to be set-off against an amount that is not treated as
income under the laws of the other jurisdiction (i.e. against income that is not dual
inclusion income). The policy of the deductible hybrid payments rule is to limit a
taxpayers deduction to the amount of dual inclusion income in circumstances where the
deduction that arises in the other jurisdiction is not subject to equivalent restrictions on
deductibility.
182.
Recommendation 6 applies to DD outcomes in respect of expenditure incurred
through a foreign branch or hybrid person. The definition of hybrid payer means that
the deductible hybrid payments rule only applies where a deductible payment in one
jurisdiction (the payer jurisdiction) triggers a duplicate deduction in another jurisdiction
(the parent jurisdiction) because:
(a) the payer is resident in the parent jurisdiction (i.e. the expenditure has been
incurred through a branch); or
(b) an investor in the parent jurisdiction claims a deduction for the same payment
(i.e. the expenditure has been incurred by a hybrid person that is treated as
transparent under the laws of the parent jurisdiction).
183. The primary recommendation under the deductible hybrid payments rule is that
the parent jurisdiction should restrict the amount of duplicate deductions to the total
amount of dual inclusion income. There is no limitation on the scope of the primary
response. The defensive rule, which imposes the same type of restriction in the payer
jurisdiction, will only apply in the event that the effect of mismatch is not neutralised in
the parent jurisdiction and is limited to those cases where the parties to the mismatch are
in the same control group or the taxpayer is party to a structured arrangement.
184. Determining which payments have given rise to a double deduction and which
items are dual inclusion income requires a comparison between the domestic tax
treatment of these items and their treatment under the laws of the other jurisdiction. It
may be possible to undertake a line by line comparison of each item of income or expense
in straightforward cases where the hybrid payer is party to only a few transactions. In
more complex cases, however, where the taxpayer has entered into a significant number
of transactions which give rise to different types of income and expense, countries may
wish to adopt a simpler implementation solution for tracking double deductions and dual
inclusion income. The way in which DD outcomes will arise will differ from one
jurisdiction to the next and countries should choose an implementation solution that is
based, as much as possible, on existing domestic rules, administrative guidance,
presumptions and tax calculations while still meeting the basic policy objectives of the
deductible hybrids payments rule. Examples of possible implementation solutions are

identified in this guidance at Example 6.1 to Example 6.5.
timing differences should not be treated as giving rise to mismatches in tax outcomes
under Recommendation 6. Recommendation 6.1(d) therefore allows excess deductions
that are subject to restriction under the deductible hybrid payments rule to be
carried-forward to another period, in accordance with a jurisdictions ordinary rules for
the treatment of net losses, and applied against dual inclusion income in that period. In
order to prevent stranded losses, jurisdictions may further permit excess deductions to be
set-off against non-dual inclusion income if a taxpayer can show that such deductions
cannot be offset against any income under the laws of the other jurisdiction that is not
dual inclusion income.
Recommendation 6.1- Neutralise the mismatch to the extent the payment gives rise
to a DD outcome
186.
The response recommended in this report is to neutralise the effect of hybrid
mismatches through the adoption of a linking rule that aligns the tax outcomes in the
payer and parent jurisdictions. The hybrid mismatch rule isolates the hybrid element in the
structure by identifying a deductible payment made by a hybrid payer in the payer jurisdiction
and the corresponding duplicate deduction generated in the parent jurisdiction. The primary
response is that the duplicate deduction cannot be claimed in the parent jurisdiction to the extent
it exceeds the claimants dual inclusion income (income brought into account for tax purposes
under the laws of both jurisdictions). A defensive rule applies in the payer jurisdiction to prevent
the hybrid payer claiming the benefit of a deductible payment against non-dual inclusion
income if the primary rule does not apply.
187. In the case of both the primary and defensive rules, the excess deductions can be
offset against dual inclusion income in another period. In order to prevent stranded losses,
it is recommended that excess duplicate deductions should be allowed to the extent that
the taxpayer can establish, to the satisfaction of the tax administration, that the deduction
cannot be set-off against the income of any person under the laws of the other
jurisdiction.

188. The meaning of deductible payment is the same as that used in other
recommendations in the report and generally covers a taxpayers current expenditures
such as service payments, rents, royalties, interest and other amounts that may be set-off
against ordinary income under the laws of the payer jurisdiction in the period they are
treated as made.
189. The determination of whether a payment is deductible requires a proper
assessment of the character and treatment of the payment under the laws of both the payer
and parent jurisdiction. The approach that should be taken to analysing the tax treatment
of the payment is similar to that used for determining mismatches under a financial
instrument, except that Recommendation 6 requires a comparison between the
jurisdictions where the payment is made, rather than the jurisdictions where the payment
is made and received.

190. Unlike the hybrid financial instrument rule, which focuses only on the tax
treatment of the instrument, and not on the status of the counterparty or the context in
which the instrument is held, the deductible hybrid payments rule should only operate to
the extent a taxpayer is actually entitled to a deduction for a payment under local law.
Accordingly the rule will not apply to the extent the taxpayer is subject to transaction or
entity specific rules under the parent or payer jurisdiction that prevent the payment from
being deducted. These restrictions on deductibility may include hybrid mismatch rules
that deny the taxpayer a deduction in order to neutralise a direct or indirect D/NI
outcome.
191. The interaction between Recommendation 6 and other rules that govern the
deductibility of payments is illustrated in Example 6.3 where the parent company
establishes a hybrid subsidiary in another jurisdiction that incurs employment expenses.
Example 6.3 notes that, if the parent is tax exempt under the laws of its own jurisdiction
and it is unable to claim deductions for any of its expenditure then no DD outcome will
arise on these facts. In Example 4.4 a hybrid person makes an interest payment to a
reverse hybrid in the same group. In this case the example concludes that the reverse
hybrid rule in Chapter 3 of the report will apply to the arrangement to deny the deduction
so that there is no scope for the operation of the deductible hybrid payments rule.
Extending the principles of Recommendation 6 to other deductible items

192. As illustrated in Example 6.1, the kind of structures that give rise to DD
outcomes in respect of payments can also be used to generate double deductions for
non-cash items such as depreciation or amortisation. A DD outcome raises the same tax
policy issues, regardless of how the deduction has been triggered, and distinguishing
between deductible items on the basis of whether they are attributable to a payment
would complicate rather than simplify the implementation of these recommendations.
Accordingly when implementing the hybrid mismatch rules into domestic law countries
may wish to apply the principles of Recommendations 6 and 7 to all deductible items
regardless of whether they are attributable to a payment. Example 6.1 provides an
example of the application of the deductible hybrid payments rule to a depreciation
deduction where both the payer and the parent jurisdiction provide for a depreciation
allowance in respect of the same asset.
Determining the existence and amount of a DD outcome

193. The question of whether a payment has given rise to a DD outcome is primarily
a legal question that should be determined by an analysis of the character and tax
treatment of the payment under the laws of the payer and the parent jurisdiction. If the
laws of both jurisdictions grant a deduction for the same payment (or an allowance in
respect of the same asset) then that deduction can be said to give rise to a DD outcome.
194. This principle is applied in Example 6.3 where a taxpayer claims a deduction for
salary and other employment benefits paid to an employee. In order to determine whether
these payments have given rise to a DD outcome, the taxpayer must make a proper
assessment of the facts and circumstances that gave rise to the deduction under local law
and determine whether a deduction has been granted on the same basis in the other
jurisdiction. If, for example, one jurisdiction allows taxpayers a deduction for the value of
share options granted under an employee incentive scheme, but the other jurisdiction does
not, then this item of deductible expenditure will not give rise to a DD outcome. On the
other hand, if one jurisdiction treats a travel subsidy as a deductible allowance, while the
other simply categorises the payment as part of the taxpayers (deductible) salary or
wages, then the payment will still be treated as giving rise to a DD outcome
notwithstanding the different ways in which the payment is described under the laws of
each jurisdiction.
Differences in valuation should not affect the amount treated as giving rise to a
DD outcome
195. If a payment has triggered a deduction under the laws of two or more jurisdictions
then differences between the payer and parent jurisdictions as to the value of that
payment will not generally impact on the extent to which a payment has given rise to a
mismatch in tax outcomes. This principle is illustrated in Example 6.3 where a hybrid
payer allocates share options to an employee. The example concludes that the grant of the
share options should be treated as giving rise to a DD outcome if the laws of the payer
and parent jurisdiction both allow a deduction for the grant of such options. The example
notes that differences between the jurisdictions in the amount of value they ascribe to the
share options will not generally prevent the deductible hybrid payments rule applying to
the entire amount of the deduction under the laws of either jurisdiction.
Differences in timing should not affect the amount treated as giving rise to a DD
outcome
196. The hybrid mismatch rules are not generally intended to impact on mismatches in
the timing of income and expenditure. Equally the operation of the rules is not dependant
on the timing of the deduction or receipt in the other jurisdiction. If a payment will be
deductible under the laws of the other jurisdiction (or if an item of income will be
included under the laws of another jurisdiction) it will be treated as a double deduction
(or dual inclusion income) at the moment it is treated as incurred (or derived) under local
law. This principle is illustrated in Example 6.1 where both the hybrid person and its
immediate parent are entitled to a deduction for the same interest payment. Differences in
timing rules, however, mean that one jurisdiction requires the taxpayer to defer a
deduction for part of the accrued interest expense to the next accounting period. The
resulting difference in timing between the jurisdictions does not prevent the deductible
hybrid payments rule from applying to the whole interest payment in both jurisdictions.

197. An item of income will be dual inclusion income if the same item is included in
income under the laws of the jurisdictions where the DD outcome arises. As for
deductions, the identification of whether an item should be treated as dual inclusion
income is primarily a legal question that requires a comparison of the treatment of that
item under the laws of both jurisdictions. An amount should still be treated as dual
inclusion income even if there are differences between jurisdictions in the way they value
that item or in the accounting period in which that item is recognised for tax purposes.
This principle is applied in Example 6.1 and Example 6.3 where the laws of the parent
and the payer jurisdiction use different timing and valuation rules in the recognition of the
income of a hybrid entity. In this case, both countries apply their own rules for calculating
the amount of dual inclusion income arising in each period and the resulting difference in
measurement does not impact on the operation of the rule.
198.
Double taxation relief, such as a domestic dividend exemption granted by the
payer jurisdiction or a foreign tax credit granted by the payee / parent jurisdiction should

not prevent an item from being treated as dual inclusion income where the effect of such
relief is simply to avoid subjecting that item to an additional layer of taxation in either
jurisdiction. Thus, while a payment must generally be recognised as ordinary income
under the laws of both jurisdictions before it can be treated as dual inclusion income, an
equity return should still qualify as dual inclusion income if the payment is subject to an
exemption, exclusion, credit of other type of double taxation relief in the payer or parent
jurisdiction that relieves the payment from economic double taxation. An example of this
type of dual inclusion income is given in Example 6.3 where the expenses of a hybrid
entity are funded by an intra-group dividend that is exempt from taxation in the
jurisdiction where the dividend is received but included as income under the laws of its
parent. Allowing the hybrid entity a deduction against this type of exempt or excluded
equity return preserves the intended tax policy outcomes in both jurisdictions. The
dividend should be treated as dual inclusion income for the purposes of deductible hybrid
payments rule even where such dividend carries an entitlement to an underlying foreign
tax credit in the parent jurisdiction. Such double taxation relief may give rise to tax policy
concerns, however, if it has the same net effect as allowing for a DD outcome. In
determining whether to treat an item of income, which benefits from such double-taxation
relief, as dual-inclusion income, countries should seek to strike a balance between rules
that minimise compliance costs, preserve the intended effect of such double taxation
relief and prevent taxpayers from entering into structures that undermine the integrity of
the rules.
199. A tax administration may treat the net income of a CFC that is attributed to a
shareholder of that company under a CFC or other offshore inclusion regime as dual
inclusion income if the taxpayer can satisfy the tax administration that such income has
been brought into account as income and subject to tax at the full rate under the laws of
both jurisdictions. Example 6.4 sets out a simplified calculation that illustrates how
income attributed under a CFC regime can be taken into account in determining the
amount of dual inclusion income under a hybrid structure.
To the extent of the mismatch

200. The adjustment should be no more than is necessary to neutralise the hybrid
mismatch and should result in an outcome that is proportionate and that does not lead to
double taxation. When applying the defensive rule, however, the amount of the deduction
that must be denied in order to neutralise the mismatch may exceed the amount of the
deduction that would have been disallowed by the parent jurisdiction in respect of the
same payment. This will be the case, for example, where deductible interest accrued by a
hybrid person is treated as allocated to a number of investors in accordance with their
proportionate interest in the entity. As explained in Example 6.5 a deduction must be
denied for the full amount of the interest payment under the defensive rule in order to
eliminate any mismatch in tax outcomes even though only a portion of the interest
payment is treated as giving rise to a duplicate deduction under the laws of the investors
jurisdiction.
Excess deductions
affected by, timing differences, the deductible hybrids payment rules contain a
mechanism that allows jurisdictions to carry-forward (or back if permitted under local
law) double deductions to a period where they can be set-off against surplus dual
inclusion income. The Recommendation contemplates that the ordinary domestic rules
governing the utilisation of losses would apply to such deductions. Example 6.1 sets out
an example of the operation of the carry-forward of excess deductions.
Stranded losses
202. In certain cases the rule may operate to restrict a deduction in the payer or parent
jurisdiction even though the deduction that arises in the other jurisdiction cannot be used
to offset income in that jurisdiction (because, for example, the business in that jurisdiction
is in a net loss position). In this case it is possible for the rule to generate stranded
losses that cannot be used in one jurisdiction for practical and commercial reasons and
that cannot be used in the other jurisdiction due to the fact that they are caught by
Recommendation 6. Recommendation 6.1(d) provides that a tax administration may
permit those excess deductions to be set-off against non-dual inclusion income if the
taxpayer can establish that the deduction in the other jurisdiction cannot be offset against
any income that is not dual inclusion income. The treatment of stranded losses is
discussed in Example 6.2 where a taxpayer incurs losses in a foreign branch. In that
example, the deductible hybrid payments rule has the potential to generate stranded
losses if the taxpayer abandons its operations in the payer jurisdiction and winds up the
branch at a time when it still has unused carry-forward losses from a prior period. The
example notes that the tax administration may permit the taxpayer to set-off any excess
against non-dual inclusion income provided the taxpayer can establish that the winding
up of the branch will prevent the taxpayer from using those losses anywhere else.
Stranded losses are discussed further in respect of dual resident entities at Example 7.1.
Implementation solution based on existing domestic rules

203. In principle, Recommendation 6 requires the taxpayer to identify the items of
deductible expenditure under the laws of both jurisdictions and to determine which of
those items have given rise to DD outcomes. The rule then caps the aggregate amount of
duplicate deductions that can be claimed to the aggregate amount of dual inclusion
income. Dual inclusion income should, in principle, be identified in the same way (i.e. by
identifying each item of income in the domestic jurisdiction and determining whether and
to what extent those items have been included in income in the other jurisdiction).
204. It may be possible to undertake such a line by line comparison in straightforward
cases, where the hybrid payer or foreign branch is party to only a few transactions, but in
more complex cases, where the taxpayer has entered into a large number transactions
which could all potentially give rise to DD outcomes or dual inclusion income, this kind
of approach could entail a significant compliance burden. In order to facilitate
implementation and minimise compliance costs, tax administrations will wish to consider
an implementation solution that preserves the policy objectives of the deductible hybrids
payments rule and arrives at a substantially similar result but is based, as much as
possible, on existing domestic rules, administrative guidance, presumptions and tax
calculations.
205. In the case of the kind of structures covered by Recommendation 6, it will
generally be the case that accounts have been prepared in both jurisdictions that will show
the income and expenditure of the taxpayer. These accounts will generally be prepared
under local law using domestic tax concepts. Tax administrations should use these

existing sources of information and tax calculations as a starting point for identifying
duplicate deductions and dual inclusion income.
206. For example, a parent jurisdiction that requires the preparation of separate branch
accounts could restrict the ability of the taxpayer to deduct any resulting branch loss from
the income of the parent or parent affiliate. Alternatively the parent jurisdiction could
require the branch to make adjustments to the accounts that have been prepared under the
laws of the payer jurisdiction (eliminating items of income and expenditure that are not
recognised under the law of the parent jurisdiction) to determine whether the activities of
the branch have resulted in a net loss (as determined under parent jurisdictions rules).
207. When applying the defensive rule, and subject to concerns about compliance and
administration costs (especially when numerous items of income and expenditure are
involved), a payer jurisdiction could adjust the income and expenditure of a hybrid person
or branch to eliminate any material items of income or deduction that are not recognised
under the laws of the parent jurisdiction. The payer jurisdiction could deny a deduction to
the extent of any adjusted net loss and prevent the net loss being carried-forward to a
subsequent period in the event of a change in control. Examples of implementation
solutions to address DD outcomes are set out further in Example 6.1 to Example 6.5.
Recommendation 6.2 - Rule only applies to deductible payments made by a hybrid

payer
208. Recommendation 6.2 confines the operation of the deductible hybrid payments
rule to DD outcomes that arise through the use of a foreign branch or hybrid entity.
209. Recommendation 6 does not presuppose that the person making the payment is
regarded as transparent in one jurisdiction and opaque in the other. Paragraph (a) of the
definition of hybrid payer applies in cases such as foreign branch structures where the
payer is treated as transparent under the laws of both jurisdictions. The application of the
deductible hybrid payments rule to a branch is set out in Example 6.2.
210.
Paragraph (b) of Recommendation 6.2 covers those cases where the payer is a
hybrid person, that is to say where the payer is treated as transparent by one of its
investors so that a duplicate deduction arises for that investor in another jurisdiction.
A transparent person in this case can include a disregarded person or one that is treated as
if it were a partnership under the laws of the parent jurisdiction. Example 6.3 sets out an
instance where the rule applies to deductible payment made by a disregarded person and
Example 6.5 illustrates the application of the rule to entities that are treated as
partnerships.

mismatch
211. A DD outcome will give rise to tax policy concerns where the laws of both
jurisdictions permit a deduction for the same payment to be set-off against an amount that
is not dual inclusion income (see Example 6.2). Recommendation 6.3 restricts the
application of the deductible hybrid payments rule to those cases where the deduction
may be set-off against dual inclusion income. It is not necessary for a tax administration
to know whether the deduction has actually been applied against non-dual inclusion
income in the other jurisdiction before it is subject to restriction under the rule.
212. In general, the deduction that arises in the parent jurisdiction will be available to
be set-off against non-dual inclusion income (i.e. other income of the taxpayer) unless the
parent jurisdiction has implemented the deductible hybrid payments rule.
213. The most common mechanism used to offset a double deduction that arises in the
payer jurisdiction will be the use of a tax consolidation or grouping regime that allows a
domestic taxpayer to apply the benefit of a deduction against the income of another
person within the same group. There are a number of ways of achieving this offset. Some
countries permit taxpayers to transfer losses, deductions, income and gains to other group
members. Other jurisdictions simply treat all the group members as a single taxpayer.
Some consolidation regimes permit taxpayers in the same group to make taxable
intra-group payments in order to shift net income around the group. Regardless of the
mechanism used to achieve tax grouping or consolidation, if its effect is to allow a double
deduction to be set-off against income that will not be brought into account under the
laws of the parent jurisdiction that will be sufficient to bring the double deduction within
the scope of the hybrid deductible payments rule.
214. There are a number of other different techniques that a taxpayer can use in the
payer jurisdiction to set-off a double deduction against non-dual inclusion income. These
techniques include having the taxpayer:
(a) make an investment through a reverse hybrid so that the income of the reverse
hybrid is only brought into account under the laws of the payer jurisdiction. An
example of such a structure is set out in Example 6.1.
(b) enter into a financial instrument or other arrangement where payments are
included in ordinary income in the payer jurisdiction but not included in income in
the parent jurisdiction. An example of such a structure is set out in Example 3.1 in
respect of an adjustment under the disregarded hybrid payments rule.
(c) enter into a merger transaction or other corporate re-organisation that permits
losses that have been carried-forward to be offset against the income of other
entities.

215. Recommendation 6.4 limits the scope of the defensive rule to structured
arrangements and mismatches that arise within a control group. See Recommendations 10
and 11 regarding the definition of structured arrangements and control group.
7. DUAL-RESIDENT PAYER RULE 77
Chapter 7
Dual-resident payer rule
Recommendation 7
The following rule should apply to a dual resident that makes a payment that is deductible under the
laws of both jurisdictions where the payer is resident and that DD outcome results in a hybrid
mismatch:
(a)
Each resident jurisdiction will deny a deduction for such payment to the extent it gives rise to
a DD outcome.
(b)
No mismatch will arise to the extent that the deduction is set-off against income that is
included as income under the laws of both jurisdictions (i.e. dual inclusion income).
(c)
establish, to the satisfaction of the tax administration, that the excess deduction cannot be
set-off against any income under the laws of the other jurisdiction that is not dual inclusion
income.
2. Rule only applies to deductible payments made by a dual resident

A taxpayer will be a dual resident if it is resident for tax purposes under the laws of two or more
jurisdictions.

A deduction for a payment results in a hybrid mismatch where the deduction for the payment may
be set-off, under the laws of the other jurisdiction, against income that is not dual inclusion income.

There is no limitation on the scope of the rule.
Overview
216. A payment made by a dual resident taxpayer will trigger a DD outcome where the
payment is deductible under the laws of both jurisdictions where the taxpayer is resident.
Such a DD outcome will give rise to tax policy concerns where one jurisdiction permits
that deduction to be set-off against an amount that is not treated as income under the laws
of the other jurisdiction (i.e. against income that is not dual inclusion income).
78 7. DUAL-RESIDENT PAYER RULE

217. Recommendation 6 applies to DD outcomes in respect of expenditure incurred
through a foreign branch or hybrid person where it is possible to distinguish between the
jurisdiction where the expenditure is actually incurred (the payer jurisdiction) and the
jurisdiction where the duplicate deduction arises due to the resident status or the tax
transparency of the payer (the parent jurisdiction). The distinction between the
parent/payer jurisdictions is not possible in the context of dual resident taxpayers because
it is not possible to reliably distinguish between where the payment is actually made and
where the duplicate deduction has arisen. In this case, therefore, the dual resident payer
rule provides that both jurisdictions should apply the primary rule to restrict the deduction
to dual inclusion income. There is no limitation on the scope of the response under the
dual resident payer rule as the deduction that arises in each jurisdiction is being claimed
by the same taxpayer.
218. As for Recommendation 6, determining which payments have given rise to a
double deduction and which items are dual inclusion income requires a comparison
between the domestic tax treatments of these items in each jurisdiction where the payer is
resident. As discussed in Recommendation 6, countries should choose an implementation
solution that is based, as much as possible, on existing domestic rules, administrative
guidance, presumptions and tax calculations while still meeting the basic policy
objectives of the dual resident payer rule.
timing differences should not be treated as giving rise to mismatches in tax outcomes
under Recommendation 7. Recommendation 7.1(c) allows excess deductions that are
subject to restriction under the deductible hybrid payments rule to be carried over to
another period and jurisdictions may further permit excess losses to be set-off against
non-dual inclusion income if a taxpayer can show that such losses have become stranded.
Recommendation 7.1 - Neutralise the mismatch to the extent it gives rise to a DD

outcome
220.
Recommendation 7.1 identifies the hybrid element in the structure as a deductible
payment made by a dual resident that gives rise to a corresponding duplicate deduction
in the other jurisdiction where the payer is resident. The primary response is that the
deduction cannot be claimed for such payment to the extent it exceeds the payers dual
inclusion income (income brought into account for tax purposes under the laws of both
jurisdictions). As both jurisdictions will apply the primary response there is no need for a
defensive rule.
221. As with other structures that generate DD outcomes, the excess deductions can be
offset against dual inclusion income in another period. In order to prevent stranded losses,
it is recommended that excess duplicate deductions should be allowed to the extent that
the taxpayer can establish, to the satisfaction of the tax administration, that the deduction
cannot be set-off against any income under the laws of the other jurisdiction that is not

222. The meaning of deductible payment is the same as that used in other
recommendations in the report and generally covers a taxpayers current expenditures
such as service payments, rents, royalties, interest and other amounts that may be set-off
against ordinary income under the laws of the payer jurisdiction in the period they are
treated as made.
223. As for Recommendation 6, the determination of whether a payment is deductible
requires a proper assessment of the character and treatment of the payment under the laws
of each jurisdiction where the taxpayer is resident. The rule will not apply to the extent
the taxpayer is subject to transaction or entity specific rules under the laws of either
jurisdiction that prevent the payment from being deducted. These restrictions on
deductibility may include hybrid mismatch rules in one jurisdiction that deny the taxpayer
a deduction in order to neutralise a direct or indirect D/NI outcome.
Extending the principles of Recommendation 7 to other deductible items

224. Dual resident payers can also be used to generate double deductions for non-cash
items such as depreciation or amortisation. As discussed in the guidance to
Recommendation 6.1, DD outcomes raise the same tax policy issues regardless of how
the deduction has been triggered. Distinguishing between deductible items on the basis of
whether or not they are attributable to a payment may complicate rather than simplify the
implementation of these recommendations. Accordingly, when implementing the hybrid
mismatch rules into domestic law, countries may wish to apply the principles of
Recommendation 7 to all deductible items regardless of whether the deduction that arises
is attributable to a payment.
Determining the existence and amount of a DD outcome and dual inclusion

income
225. As discussed in the guidance to Recommendation 6.1, the question of whether a
payment has given rise to a DD outcome is primarily a legal question that should be
determined by an analysis of the character and tax treatment of the payment under the
laws of each residence jurisdiction. If both jurisdictions grant a deduction for the same
payment (or an allowance respect of the same asset) then that deduction can be said to
give rise to a DD outcome. Differences between jurisdictions as to the quantification and
timing of a deduction will not generally impact on the extent to which a payment has
given rise to a mismatch in tax outcomes. A payment should be treated as giving rise to a
double deduction (or dual inclusion income) at the moment it is treated as incurred (or
derived) under local law regardless of when such payment has been treated incurred (or
derived) under the laws of the other jurisdiction.
226. While a payment must generally be recognised as ordinary income under the laws
of both jurisdictions before it can be treated as dual inclusion income, an equity return
should still qualify as dual inclusion income if the payment is subject to an exemption,
exclusion, credit of other type of double taxation relief that relieves the payment from
economic double taxation. An example of this type of dual inclusion income is given in
Example 7.1 in respect of the dual resident payer rule. Such double taxation relief may
give rise to tax policy concerns, however, if it has the same net effect as allowing for a
DD outcome. In determining whether to treat an item of income, which benefits from
such double-taxation relief, as dual-inclusion income, countries should seek to strike a
balance between rules that minimise compliance costs, preserve the intended effect of
such double taxation relief and prevent taxpayers from entering into structures that
undermine the integrity of the rules. As discussed in the guidance to Recommendation
6.1, a tax administration may also treat the net income of a CFC that is attributed to a
shareholder of that company under a CFC or other offshore inclusion regime as dual
80 7. DUAL-RESIDENT PAYER RULE

inclusion income if the taxpayer can satisfy the tax administration that the CFC regime
brings that amount of income into account so that it is subject to tax at the full rate under
the laws of both jurisdictions.
Recommended response
227. Where a payment by a dual resident payer gives rise to a DD outcome, the
jurisdiction where the payer is resident should apply the recommended response to
neutralise the effect of the mismatch by denying the deduction to the extent it gives rise to
a mismatch in tax outcomes. A DD outcome will give rise to a mismatch in tax outcomes
to the extent it is set-off against income that is not dual inclusion income. The adjustment
should be no more than is necessary to neutralise the hybrid mismatch and should result
in an outcome that is proportionate and that does not lead to double taxation.
Example 7.1 illustrates a situation where the simultaneous application of the dual
resident payer rules in both residence jurisdictions has the potential to create double
taxation. As noted in that example, however, structuring opportunities will usually be
available to avoid the risk of double taxation.
Excess deductions
affected by, timing differences both Recommendations 6 and 7 allow jurisdictions to
carry-forward (or -back if permitted under local law) double deductions to a period where
they can be set-off against surplus dual inclusion income. The Recommendations
contemplate that the ordinary domestic rules governing the utilisation of losses would
apply to such deductions.
Stranded losses
229. In certain cases the rule may operate simultaneously to restrict a deduction in both
jurisdictions. In this case it is possible for the rule to generate stranded losses that
cannot be used in either jurisdiction. Recommendation 7.1(c) provides that a tax
administration may permit those excess deductions to be set-off against non-dual
inclusion income if the taxpayer can establish that the deduction that has arisen in the
other jurisdiction cannot be offset against any income that is not dual inclusion income.
Example 7.1 discusses allowances for the use of stranded losses in respect of dual
resident payers.
Recommendation 7.2 - Rule only applies to deductible payments made by a dual

resident
230. Recommendation 7.2 confines the operation of the deductible hybrid payments
rule to DD outcomes that arise through the use of dual resident structures.
231. A person should be treated as a resident of a jurisdiction for tax purposes if it
qualifies as tax resident or is taxable in that jurisdiction on their worldwide net income.
As discussed in Example 7.1, a person will be treated as a resident of a jurisdiction even
if that person forms part of a tax consolidation group which treats that person as
disregarded for local law purposes.

mismatch
232. As for Recommendation 6.3, the dual resident payer rule restricts the application
of the deductible hybrid payments rule to those cases where the other jurisdiction permits
the deduction to be set-off against income that is not dual inclusion income. It is not
necessary for a tax administration to know whether the deduction has actually been
applied against non-dual inclusion income in the other jurisdiction before it applies the
rule in Recommendation 7.
233. The same techniques that a taxpayer can use to trigger a DD outcome that falls
within the scope of Recommendation 6 can also be used to generate hybrid mismatches
under Recommendation 7. These techniques include: the use of tax consolidation
regimes, having the taxpayer make an investment through a reverse hybrid and entering
into a financial instrument or other arrangement where payments are included in income
in one jurisdiction but not the other. An example of the use of a consolidation regime and
of the use of a reverse hybrid structure involving a dual resident entity is given in
Example 7.1.
8. IMPORTED MISMATCH RULE 83
Chapter 8
Imported mismatch rule
Recommendation 8
1. Deny the deduction to the extent the payment gives rise to an indirect D/NI outcome
The payer jurisdiction should apply a rule that denies a deduction for any imported mismatch
payment to the extent the payee treats that payment as set-off against a hybrid deduction in the
payee jurisdiction.
2. Definition of hybrid deduction

Hybrid deduction means a deduction resulting from:
(a)
a payment under a financial instrument that results in a hybrid mismatch;
(b)
a disregarded payment made by a hybrid payer that results in a hybrid mismatch;
(c)
a payment made to a reverse hybrid that results in a hybrid mismatch; or
(d)
a payment made by a hybrid payer or dual resident that triggers a duplicate deduction
resulting in a hybrid mismatch;
and includes a deduction resulting from a payment made to any other person to the extent that
person treats the payment as set-off against another hybrid deduction.
3. Imported mismatch payment

An imported mismatch payment is a deductible payment made to a payee that is not subject to
hybrid mismatch rules.

The rule applies if the taxpayer is in the same control group as the parties to the imported mismatch
arrangement or where the payment is made under a structured arrangement and the taxpayer is party
to that structured arrangement.
Overview
234. The policy behind the imported mismatch rule is to prevent taxpayers from
entering into structured arrangements or arrangements with group members that shift the
effect of an offshore hybrid mismatch into the domestic jurisdiction through the use of a
non-hybrid instrument such as an ordinary loan. The imported mismatch rule disallows
deductions for a broad range of payments (including interest, royalties, rents and
payments for services) if the income from such payments is set-off, directly or indirectly,
against a deduction that arises under a hybrid mismatch arrangement in an offshore
jurisdiction (including arrangements that give rise to DD outcomes). The key objective of
imported mismatch rule is to maintain the integrity of the other hybrid mismatch rules by
84 8. IMPORTED MISMATCH RULE

removing any incentive for multinational groups to enter into hybrid mismatch
arrangements. While these rules involve an unavoidable degree of co-ordination and
complexity, they only apply to the extent a multinational group generates an intra-group
hybrid deduction and will not apply to any payment that is made to a taxpayer in a
jurisdiction that has implemented the full set of recommendations set out in the report.
235.
The imported mismatch rule applies to both structured and intra-group imported
mismatch arrangements and can be applied to any payment that is directly or indirectly
set-off against any type of hybrid deduction. This guidance sets out three tracing and
priority rules to be used by taxpayers and administrations to determine the extent to
which a payment should be treated as set-off against a deduction under an imported
mismatch arrangement. These rules start by identifying the payment that gives rise to a
hybrid mismatch under one of the other chapters in this report (a direct hybrid
deduction) and then determine the extent to which the deductible payment made under
that hybrid mismatch arrangement has been funded (either directly or indirectly) out of
payments made by taxpayers that are subject to the imported mismatch rule (imported
mismatch payments). The tracing and priority rules are summarised below, in the order
in which they should be applied.
Structured imported mismatches

236. If the hybrid deduction is attributable to a payment made under a structured
arrangement it will be treated as giving rise to an imported mismatch to the extent that
deduction is funded out of the payments made under that structured arrangement. This
rule applies a tracing approach to determine to what extent an imported mismatch
payment made under a structured arrangement has been set-off (directly or indirectly)
against a hybrid deduction under the same arrangement.
Direct imported mismatches

237. If the structured imported mismatch rule does not fully neutralise the effect of the
mismatch, the direct imported mismatch rule treats the hybrid deduction as giving rise to
an imported mismatch to the extent that it is directly set-off against payments received
from other members of the group that are subject to the imported mismatch rule. This rule
applies an apportionment approach which prevents the same hybrid deduction giving rise
to an imported mismatch under the laws of more than one jurisdiction.
Indirect imported mismatch rule

238. Finally, if the structured or direct imported mismatch rule does not fully neutralise
the effect of the mismatch, the indirect imported mismatch rule treats any surplus hybrid
deduction as being set-off against imported mismatch payments received indirectly from
members of the same control group. This rule applies a tracing methodology to determine
to what extent the expenditure that gave rise to a surplus hybrid deduction has been
indirectly funded by imported mismatch payments from other group members and an
apportionment approach, which prevents the same surplus hybrid deduction being treated
as set-off against an imported mismatch payment under the laws of more than one
jurisdiction.
239. These three rules are designed to co-ordinate the operation of the imported
mismatch rule within and between jurisdictions so that they can be applied consistently
by each jurisdiction to neutralise the effect of imported mismatch arrangements while
avoiding double taxation and ensuring predictable and transparent outcomes for
taxpayers. The rules contemplate that each member of the group will calculate the amount
of imported mismatch payments and hybrid deductions on the same basis, in order to
prevent differences in the calculation, timing and quantification of payments giving rise
to the risk of over- or under-taxation.
Recommendation 8.1 - Deny the deduction to the extent the payment gives rise to an
indirect D/NI outcome
240.
Imported mismatches rely on the absence of effective hybrid mismatch rules in
offshore jurisdictions in order to generate the mismatch in tax outcomes which can then
be imported into the payer jurisdiction. Therefore the most reliable protection against
imported mismatches will be for all jurisdictions to introduce rules recommended in this
report. Such rules will neutralise the effect of the hybrid mismatch arrangement in the
jurisdiction where it arises and prevent its effect being imported into a third jurisdiction.
241. In order to protect the integrity of the recommendations, however, this report further
recommends the adoption of linking rule that requires the payer jurisdiction to deny a
deduction for a payment to the extent the income from such payment is offset against a
hybrid deduction in the counterparty jurisdiction. The imported mismatch rule has three
basic elements:
(a) a deductible payment, made by a taxpayer that is subject to the hybrid mismatch
rules, and which is included in ordinary income under the laws of the payee
jurisdiction (an imported mismatch payment);
(b) a deductible payment made by a person that is not subject to the hybrid mismatch
rules which directly gives rise to a hybrid mismatch (a direct hybrid deduction);
(c) a nexus between the imported mismatch payment and the direct hybrid deduction
that shows how the imported mismatch payment has been set-off (whether directly
or indirectly) against that hybrid deduction.
Imported mismatch payment

242. The definition of payment used in the imported mismatch rule is the same as that
used for the other recommendations. It is generally broad enough to capture any transfer
of value from one person to another but it does not include payments that are only
deemed to be made for tax purposes and that do not involve the change of any economic
rights between the parties. A payment will only be treated as an imported mismatch
payment if it is both deductible under the laws of the payer jurisdiction and gives rise to
ordinary income under the laws of the payee jurisdiction. Imported mismatch payments
will therefore include rents, royalties, interest and fees paid for services but will not
generally include amounts that are treated as consideration for the disposal of an asset. A
payment made to a person who is not a taxpayer in any jurisdiction 9such as in
Example 1.6) will not be treated as an imported mismatch payment.
Hybrid deduction
243.
A persons hybrid deduction can come from two sources:
(a) payments that directly give rise to a D/NI or DD outcome under one of the hybrid
mismatch arrangements identified in the other chapters in this report. These types
of hybrid deductions are referred to in this guidance as direct hybrid deductions.

(b) hybrid deductions that are surrendered to a group member under a tax grouping
regime or arise as a consequence of making taxable payments to a group member
with surplus hybrid deductions. These types of hybrid deductions are referred to in
this guidance as indirect hybrid deductions.
A hybrid deduction does not arise, however, to the extent a disregarded or deductible
hybrid payment is set-off against dual inclusion income (see Example 8.11 and Example
8.12). The method for calculating a persons hybrid deductions is set out further below.
Nexus between hybrid deduction and imported mismatch payment

244. The third element of the imported mismatch rule is that there must be a nexus, or
chain of transactions and payments, that connects the hybrid deduction of one person with
the imported mismatch payment made by another. This will be relatively easy to establish
in the case of direct imported mismatches where the imported mismatch payment is made
to the person who has the direct hybrid deduction. The tracing exercise will become more
complex, however, where the imported mismatch payment must be traced through a chain
of taxable payments or offsets under a tax grouping regime in order to determine whether
the imported mismatch payment has been set-off against an indirect hybrid deduction
under the indirect imported mismatch rule.
245. A number of different approaches could be adopted for determining whether, and
to what extent, the hybrid deduction has been used to shelter the income on an imported
mismatch payment. Countries applying the imported mismatch rules should, however,
adopt a uniform approach that is clear, easy to administer and apply and that avoids the
risk of double taxation.
Tracing and priority rules

246. This guidance sets out three tracing and priority rules that a jurisdiction should
apply to determine the extent of the adjustment required under the imported mismatch
rule. The rules should be applied (in the following order) by each jurisdiction that has an
imported mismatch rule:
(a) The first rule (the structured imported mismatch rule) identifies whether a direct
hybrid deduction is part of a structured arrangement and, if so, treats that hybrid
deduction as being set-off against any imported mismatch payment that forms part
of the same arrangement and that funds (directly or indirectly) the expenditure that
gave rise to the hybrid deduction.
(b) To the extent the mismatch in tax outcomes has not been neutralised by a
jurisdiction applying the structured imported mismatch rule, the second rule then
looks to see whether the taxpayers hybrid deduction can be directly set-off against
an imported mismatch payment made by a taxpayer that is a member of the same
control group (the direct imported mismatch rule).
(c) Finally the jurisdiction should determine the extent to which any surplus hybrid
deductions can be treated as being indirectly set-off against imported mismatch
payments from other group members under the indirect imported mismatch rule.
247. Each of these rules applies a different approach to determining the nexus between
the imported mismatch payment and the hybrid deduction. The structured imported
mismatch rule applies a tracing approach that starts with the imported mismatch payment
in one jurisdiction and follows the path of payments under the structured arrangement,
through the interconnected entities and payments that make up the arrangement, to
identify whether that imported mismatch payment has directly or indirectly funded
expenditure that gives rise to the hybrid deduction. The direct imported mismatch rule
applies an apportionment rule that looks to the aggregate amount of imported mismatch
payments received by a group member and the aggregate amount of hybrid deductions
incurred by that group member and treats the hybrid deduction as being set-off against the
imported mismatch payment in the same proportion. The indirect imported mismatch rule
applies a combination of tracing and apportionment approaches to determine whether,
and to what extent, an imported mismatch payment made by a taxpayer in one part of the
group can be said to be indirectly set-off against a hybrid deduction of a taxpayer in
another part of the group.
Structured imported mismatch arrangements

248. Where a hybrid deduction has arisen under a structured arrangement it is
necessary to identify all the steps and transactions that form part of the same arrangement
and to identify whether the taxpayer has made a deductible payment under that
arrangement that has been set-off (directly or indirectly) against that hybrid deduction.
The structured imported mismatch rule is applied first because it has a wider scope and
applies to all the payments made under a structured arrangement even if those payments
are not intra-group. The structured imported mismatch arrangement should be applied,
however, whenever a hybrid deduction forms part of a structured arrangement even where
the mismatch in tax outcomes occurs within the confines of a wholly-owned group. For
example, in Example 8.1, a multinational group puts in place a group financing structure
where the first link in the chain of intra-group loans is designed to produce a hybrid
mismatch. In that case, all the intra-group loans and imported mismatch payment flows
under the financing arrangement are treated as part of the same structured arrangement.
249. The tracing approach under the structured imported mismatch rule requires
taxpayers to follow the flow of payments under the structured arrangement through the
tiers of entities and transactions that make up the arrangement to determine if the
taxpayers imported mismatch payment has been directly or indirectly offset against a
hybrid deduction arising under the same arrangement. In general it is expected that a tax
administration will respect both a taxpayers decision to treat a transaction that gives rise
to a hybrid mismatch as forming part of a structured arrangement and the taxpayers
definition of the scope of that structured arrangement provided that treatment and
definition is applied consistently by all the parties to that structured arrangement.
250.
Example 8.1, Example 8.2 and Example 10.5 illustrate the operation of the
structured imported mismatch rule.
Intra-group mismatches
251. Although a hybrid mismatch arrangement that is entered into between two
members of a wholly-owned group may not be designed to shelter income of any
taxpayer other than the immediate parties to the arrangement, any such mismatch has the
net effect of lowering the aggregate tax burden of the group and the combination of intragroup payment flows and the fungible nature of income and expenses for tax purposes
can make it difficult, if not impossible, to determine, which taxpayer in the group has
derived a tax advantage under a hybrid mismatch arrangement. In order to neutralise the
effect of such intra-group mismatches, without giving rise to economic double taxation,

this guidance sets out a direct and indirect imported mismatch rule which should be
applied (in that order) to neutralise the effect of such intra-group mismatches.
Direct imported mismatches

252. The direct imported mismatch rule applies an apportionment approach that
compares the amount of the taxpayers hybrid deductions (including any indirect hybrid
deductions) to the total amount of imported mismatch payments made to that taxpayer by
group entities (as calculated under the law of the taxpayers jurisdiction) and treats each
imported mismatch payment as being set-off against those hybrid deductions in
accordance with that ratio. Calculating the limitation by reference to a ratio determined
under the laws of the payee jurisdiction ensures that each jurisdiction applies the direct
imported mismatch rule on the same basis. The direct imported mismatch rule provides
countries with a simple and comprehensive solution for neutralising the effect of intragroup mismatches while avoiding the risk of economic double taxation. Any remaining
hybrid deductions that are not treated as set-off against direct imported mismatch
payments will be treated as surplus hybrid deductions and allocated in accordance with
the indirect imported mismatch rule described in further detail below.
253. The mechanical steps in the application of the structured and direct imported
mismatch rule are as follows:
(a) The tax manager of the group should determine whether any group entity has
direct hybrid deductions.
(b) If the direct hybrid deduction arises under a transaction that forms part of a
structured arrangement, then those hybrid deductions should be treated as directly
or indirectly set-off against imported mismatch payments made under the same
arrangement.
(c) Any remaining hybrid deductions, together with any indirect hybrid deductions
allocated to that group member in accordance with the indirect imported mismatch
rule (see below), should be treated as directly set-off (pro-rata) against imported
mismatch payments made by a group member.
(d) Hybrid deductions that are not neutralised under the structured or direct imported
mismatch rules are treated as surplus hybrid deductions.
254. Example 8.2 to Example 8.4, and Example 8.6, Example 8.7 and Example
8.10, illustrate the operation of the direct imported mismatch rule.
Indirect imported mismatches

255. If the effect of the hybrid deduction has not been fully neutralised through the
operation of the direct imported mismatch rule, the final step is to determine whether the
surplus hybrid deduction should be allocated to another group member under the indirect
imported mismatch rule.
256. The indirect imported mismatch rule applies a waterfall approach (described
below) to determine to what extent the surplus hybrid deduction has been indirectly
funded from imported mismatch payments made by members of the same group. This
approach incorporates an allocation and tracing methodology to match a taxpayers
surplus hybrid deductions with imported mismatch payments within the group while
ensuring that the rule will not result in the same hybrid deduction being set-off against an
imported mismatch payment under the laws of more than one jurisdiction.
257. The group members surplus hybrid deductions are allocated proportionately
around the group in accordance with taxable payment flows within the group and in a
way that takes into account the extent to which such taxable payments have been funded,
directly or indirectly, out of imported mismatch payments. The resulting offset gives rise
to an indirect hybrid deduction for the group member making the taxable payment. That
indirect hybrid deduction can, in turn, be treated as set-off against an imported mismatch
payment under the direct imported mismatch rule or give rise to a further surplus hybrid
deduction that can be allocated to another group member.
258. The approach starts with a group members surplus hybrid deductions, which
are the total of that group members direct and indirect hybrid deductions that have not
been neutralised by a jurisdiction applying the structured or direct imported mismatch
rule. The group members surplus hybrid deductions are treated as set-off against any
taxable payments received. Taxable payments received by a group member will include
any intra-group payment that is included in ordinary income by that group member and
that is deductible under the laws of the payer jurisdiction (other than an imported
mismatch payment).
259. A taxable payment should be treated as fully set-off against a surplus hybrid
deduction of each group member unless the amount of a payees funded taxable
payments exceeds the amount of the payees surplus hybrid deductions. A funded
taxable payment is any taxable payment that is directly funded out of imported mismatch
payments made by other group entities. In a case where the amount of a payees funded
taxable payments exceeds the amount of the payees surplus hybrid deductions, the
payees surplus hybrid deductions should be treated as set-off against such funded taxable
payments on a pro-rata basis.
260. The mechanical steps in the application of the indirect imported mismatch rule are
as follows:
(a) The tax manager of the group should determine whether any group member has
surplus hybrid deductions.
(b) The surplus hybrid deductions of that group member should be treated as
surrendered to another member of the same tax group or set-off against a taxable
payment made by another group member in accordance with the allocation and
tracing methodology of the waterfall approach. This means that:
In the event the amount of funded taxable payments exceeds the amount of
surplus hybrid deductions, the surplus hybrid deductions should only be treated
as set-off pro rata to the amount of funded taxable payments.
In all other cases the surplus hybrid deduction should be treated as fully
surrendered under the tax grouping regime or fully set-off against each taxable
payment;
(c) The group entity that made the taxable payment or received the benefit of the
group surrender (the payer entity) should then apply the direct imported mismatch
rule and treat those hybrid deductions as set-off against any imported mismatch
payments received from other group members;
(d) Both group entities will have a surplus hybrid deduction to the extent the
mismatch in tax outcomes is not addressed through the application of the direct
imported mismatch rule as described in paragraph (c) above.

261.
The calculation of a group entitys surplus hybrid deduction under paragraph (d)
should be adjusted as necessary to ensure that the application of the indirect imported
mismatch rule does not result in the same hybrid deduction being treated as indirectly setoff against more than one imported mismatch payment.
262. Example 8.5 and Example 8.7 to Example 8.15 illustrate the operation of the
indirect imported mismatch rules.
Losses
263. In order to account for timing differences between jurisdictions and to prevent
groups manipulating that timing in order to avoid the effect of the imported mismatch
rule, a hybrid deduction should be taken to include any net loss that has been
carried-forward to a subsequent accounting period, to the extent that loss results from a
hybrid deduction. An example showing the application of the imported mismatch rule to
losses which have been carried-forward from a prior period is set out in Example 8.11
and Example 8.16. In order to reduce the complexity associated with the need to identify
hybrid deductions that arose prior to the publication of this report any carry-forward loss
from periods ending on or before 31 December 2016, should be excluded from the
operation of this rule.
Co-ordination of imported mismatch rule between jurisdictions

264.
In order to limit compliance costs and the risk of double taxation each country
that implements the recommendations set out in the report should make reasonable
endeavours to implement an imported mismatch rule that adheres to the methodology set
out in this guidance and to apply this methodology in the same way. This will allow the
adjustments required under the imported mismatch rules in each jurisdiction to be
calculated consistently for the whole group and in a way that avoids any unnecessary
duplication of compliance obligations.
265.
It will be the domestic taxpayer who has the burden of establishing, to the
reasonable satisfaction of the tax administration, that the imported mismatch rule has
been properly applied in that jurisdiction. This initial burden may be discharged by
providing the tax administration with copies of the group calculations together with
supporting evidence of the adjustments that have been made under the imported
mismatch rules in other jurisdictions. Tax administrations will generally be relying on the
taxpayer to provide them with these calculations and supporting evidence. In the absence
of such information, a tax administration may consider issuing its own assessment of the
extent to which income from an imported mismatch payment has been directly or
indirectly set-off against a hybrid deduction of another group member.
Recommendation 8.2 - Rule only applies to payments that are set-off against a
deduction under a hybrid mismatch arrangement
266. Recommendation 8.2 defines when a deduction will be treated as a hybrid
deduction for the purposes of the imported mismatch rule.
267. The definition of hybrid deduction includes a payment by a hybrid payer or dual
resident that triggers a duplicate deduction resulting in a hybrid mismatch (i.e. a
deduction that arises under a DD structure). When applying the imported mismatch rule
in the intra-group context the rule applies in such a way that ensures there is no
double-counting of the hybrid deductions that are generated under such a DD structure.
An illustration of a hybrid deduction involving a DD structure is set out in Example 8.12.
Recommendation 8.3 Definition of imported mismatch payment

268. As noted above, the most reliable protection against imported mismatches will be
for jurisdictions to introduce hybrid mismatch rules recommended in this report. Such
rules will address the effect of the hybrid mismatch arrangement in the jurisdiction where
it arises, and therefore prevent the effect of such mismatch being imported into a third
jurisdiction. The imported mismatch rule therefore will not apply to any payment that is
made to a taxpayer in a jurisdiction that has implemented the full set of recommendations
set out in the report.
Recommendation 8.4 Scope of the rule

269. The imported mismatch rule targets both structured arrangements and imported
mismatch arrangements that arise within a control group.
270. An imported mismatch should be treated as structured if the hybrid deduction and
the imported mismatch payment arise under the same arrangement. The definition of
arrangement is set out in Recommendation 12 and includes any agreement, plan or
understanding and all the steps and transactions by which it is carried into effect. A
structured imported mismatch arrangement therefore includes not only those payments
and transactions that give rise to the mismatch but also all the other transactions and
imported mismatch payments that are entered into as part of the same scheme plan or
agreement.
271. An example of the application of the imported mismatch rule to a structured
arrangement is set out in Example 10.5. In that example, a fund that is in the business of
providing loans to medium-sized enterprises enters into negotiations to provide a
company with an unsecured loan that will be used to meet the companies working capital
requirements. The fund uses a subsidiary in a third jurisdiction to make the loan and
finances that loan through the use of a hybrid financial instrument. Neither the fund nor
the subsidiary is resident in a jurisdiction that has introduced the hybrid mismatch rules.
In that example, the financing arrangement is conceived as a single plan that includes
both the loan by the subsidiary to the taxpayer and the transaction between the subsidiary
and the fund that gives rise to the hybrid deduction. The arrangement is therefore a
structured arrangement and the taxpayer should be treated as a party to that structured
arrangement if it is involved in the design or has sufficient information about the
arrangement to understand its operation and effect.
9. DESIGN PRINCIPLES 93
Chapter 9
Design principles
Recommendation 9
1. Design principles
The hybrid mismatch rules have been designed to maximise the following outcomes:
(a)
neutralise the mismatch rather than reverse the tax benefit that arises under the laws of the
jurisdiction;
(b)
be comprehensive;
(c)
apply automatically;
(d)
avoid double taxation through rule co-ordination;
(e)
minimise the disruption to existing domestic law;
(f)
be clear and transparent in their operation;
(g)
provide sufficient flexibility for the rule to be incorporated into the laws of each jurisdiction;
(h)
be workable for taxpayers and keep compliance costs to a minimum; and
(i)
minimise the administrative burden on tax authorities.
Jurisdictions that implement these recommendations into domestic law should do so in a manner
intended to preserve these design principles.
2. Implementation and co-ordination

Jurisdictions should co-operate on measures to ensure these recommendations are implemented and
applied consistently and effectively. These measures should include:
(a)
the development of agreed guidance on the recommendations;
(b)
co-ordination of the implementation of the recommendations (including timing);
(c)
development of transitional rules (without any presumption as to grandfathering of existing

arrangements);
(d)
review of the effective and consistent implementation of the recommendations;
(e)
exchange of information on the jurisdiction treatment of hybrid financial instruments and

hybrid entities;
(f)
endeavouring to make relevant information available to taxpayers (including reasonable

endeavours by the OECD); and
(g)
consideration of the interaction of the recommendations with other Actions under the BEPS
Action Plan including Actions 3 and 4.
94 9. DESIGN PRINCIPLES
Overview
272. The domestic law changes and hybrid mismatch rules recommended in Part I of
the report are designed to be co-ordinated with those in other jurisdictions. Co-ordination
of the rules is important because it ensures predictability of outcomes for taxpayers and
avoids the risk of double taxation. Co-ordination can be achieved by ensuring that
countries implement the recommendations set out in the report consistently and that tax
administrations interpret and apply those rules in the same way.
273. In order to achieve that consistency, Recommendation 9 calls on countries to
implement and apply the rules in a manner that preserves the underlying policy objectives
of the report. The Recommendation further calls on countries to:
(a) agree guidance on how the rules ought to be applied;
(b) co-ordinate the implementation on the rules (primarily as to timing);
(c) agree how the rules should apply to existing instruments and entities that are
caught by the rules when they are first introduced (i.e. transitional arrangements);
(d) undertake a review of the operation of the rules as necessary to determine whether
they are operating as intended;
(e) agree procedures for exchanging information on the domestic tax treatment of
instruments and entities in order to assist tax administrations in applying their
rules to hybrid mismatch arrangements within their jurisdiction;
(f) endeavour to make such information available to taxpayers; and
(g) provide further commentary on the interaction between the recommendations in
the report and the other Items in the BEPS Action Plan (OECD, 2013).
274. The guidance on Recommendation 9.1 sets out and explains the design principles
in further detail and the guidance on Recommendation 9.2 sets out further detail on
achieving co-ordination in the implementation and application of the rules summarised in
the paragraph above.
Recommendation 9.1 - Design principles

275. Although the recommendations in the report are drafted in the form of rules, it is
not intended that countries transcribe them directly into domestic law without adjustment.
It is expected that the recommendations will be incorporated into domestic tax legislation
using existing local law definitions and concepts in a manner that takes into account the
existing legislative and tax policy framework. At the same time, countries should seek to
ensure that these domestic rules, once implemented, will apply to the same arrangements
and entities, and provide for the same tax outcomes, as those set out in the report.
276. The recommendations set out in this report are intended to operate as a
comprehensive and coherent package of measures to neutralise mismatches that arise
from the use of hybrid instruments and entities without imposing undue burdens on
taxpayers and tax administrations.
277. In practice, many of these design principles are complementary. For example,
hybrid mismatch rules that apply automatically will be more clear and transparent in their
operation and reduce administration costs for tax authorities. Rules that minimise
disruption to domestic law will be easier for countries to implement and reduce
compliance costs for taxpayers. Each of these design principles and their implications for
the domestic implementation and application of the rules is discussed in further detail
below.
Rules should target the mismatch rather than focusing on establishing in which
jurisdiction the tax benefit arises
278. The Action Plan simply calls for the elimination of mismatches without requiring
the jurisdiction applying the rule to establish that it has lost tax revenue under the
arrangement. While neutralising the effect of hybrid mismatch arrangements will address
the risks to a jurisdictions tax base, this will not be achieved by capturing additional
revenue under the hybrid mismatch rules themselves, rather the rules are intended to drive
taxpayers towards less complicated and more transparent tax structuring that is easier for
jurisdictions to address with more orthodox tax policy tools. Accordingly the hybrid
mismatch rules apply automatically and without regard for whether the arrangement has
eroded the tax base of the country applying the rule. This approach assures consistency in
the application of the rules (and their outcomes) between jurisdictions and also avoids the
practical and conceptual difficulties in distinguishing between acceptable and
unacceptable mismatches or trying to allocate taxing rights based on the extent to which a
countrys tax base has been eroded through the hybrid mismatch arrangement.
Comprehensive
279. Hybrid mismatch rules that are not comprehensive will create further tax planning
opportunities and additional compliance costs for taxpayers without achieving their
intended policy outcomes. The rules should avoid leaving gaps that would allow a
taxpayer to structure around them. This report recommends that every jurisdiction
introduces a complete set of rules that are sufficient to neutralise the effect of the hybrid
mismatch on a stand-alone basis, without the need to rely on hybrid mismatch rules in the
counterparty jurisdiction.
280. Hybrid mismatch rules that are both comprehensive and widespread will be
subject to some degree of jurisdictional overlap; while it is important to have rules that
are comprehensive and effective, such overlap should not result in double taxation of the
same economic income. For this reason the rules recommended in the report are
organised in a hierarchy that switches-off the effect of one rule where there is another rule
operating in the counterparty jurisdiction that will be sufficient to address the mismatch.
Both primary recommendations and defensive rules are required, however, in order to
comprehensively address the mismatch; the hierarchy simply addresses the risk of
over-taxation in the event the same hybrid mismatch rules apply to the same arrangement
in different jurisdictions.
281. The hybrid mismatch rules apply automatically to a hybrid mismatch arrangement
if it gives rise to a mismatch in tax outcomes that can be attributed to the hybrid element
in the arrangement. Automatic rules are more effective than those that only apply subject
to the exercise of administrative discretion and avoid the need for co-ordination of
responses between tax authorities, which would increase complexity and make the rules
less efficient and consistent in their operation.
Co-ordination of rules to avoid double taxation

282.
Rules that are comprehensive and apply automatically need:
(a) an agreed ordering rule to ensure that they apply consistently and proportionately
in situations where the counterparty jurisdiction does, or does not, have a similar
set of hybrid mismatch rules;
(b) to apply consistently with other rules of the domestic tax system so that the
interaction does not result in double taxation of the same economic income;
(c) to co-ordinate with the rules in a third jurisdiction (such as CFC rules) which
subject payments to taxation in the residence state of the investor.
283. In order to achieve the first of these design outcomes, these recommendations
contain an ordering rule so that one rule is turned-off when the counterparty jurisdiction
with the same set of rules can neutralise the effect of the hybrid mismatch arrangement in
a more efficient and practical way. This ordering rule avoids the need for an express
tie-breaker and achieves the necessary degree of co-ordination without resorting to the
competent authority procedure.
284. Just as the hybrid mismatch rules require co-ordination with hybrid mismatch
rules in other jurisdictions they also must be co-ordinated as between themselves and with
other specific anti-abuse and re-characterisation rules.
Co-ordination between specific recommendations and hybrid mismatch rules

285. The hybrid financial instrument rule and the reverse hybrid rule only operate to
the extent the arrangement gives rise to a D/NI outcome. Such an outcome will not arise
if, after a proper determination of the character and treatment of the payment under the
laws of the payer and payee jurisdictions, a mismatch in tax outcomes has not arisen. This
consideration of the tax consequences in each jurisdiction should include the introduction
of measures to implement the specific recommendations for improvements in domestic
law under Recommendations 2 and 5 respectively.
Co-ordinating the interaction between the hybrid mismatch rules

286. The hybrid mismatch rules set out in this report should generally be applied in the
following order:
(a) Hybrid financial instrument rule (Recommendation 1);
(b) Reverse hybrid rule (Recommendation 4) and disregarded hybrid payments rule
(Recommendation 3);
(c) Imported mismatch rule (Recommendation 8); and
(d) Deductible hybrid payments rule (Recommendation 6) and dual resident entity
rule (Recommendation 7).
287. In Example 4.4 a hybrid entity makes an interest payment to a reverse hybrid in
the same group. The example concludes that the reverse hybrid rule will apply to the
arrangement to deny the deduction so that there is no scope for the operation of the
deductible hybrid payments rule.
288. In Example 3.2 the payer borrows money from its parent and the loan is
attributed to the payers foreign branch. The payment of interest on the loan is deductible
under the laws of the foreign jurisdiction but is not recognised by the payee. The example
considers whether the disregarded hybrid payments rule or the hybrid financial instrument
rule should be applied to neutralise the D/NI outcome. The example concludes that the
payer jurisdiction should apply the hybrid financial instrument rule to deny a deduction
for the interest if the mismatch in the tax treatment of the interest payment can be
attributed to the terms of the instrument between the parties. If the interest payment is not
treated, under the laws of the payer jurisdiction as subject to adjustment under the hybrid
financial instrument rule then the payer jurisdiction should then apply the disregarded
hybrid payments rule to deny the payer a deduction for the interest payment to the extent
the interest expense exceeds the dual inclusion income of the branch.
Co-ordinating the interaction between hybrid mismatch rules and other

transaction specific and other anti-abuse rules
289. The hybrid financial instrument rule applies whenever the mismatch can be
attributed to the terms of the instrument. The fact that the mismatch can also be attributed
to other factors (such as the fact that payee is tax exempt) will not prevent the rule from
applying provided the mismatch would have arisen even in respect of the same payment
between taxpayers of ordinary status. Because the hybrid financial instrument rule is
confined to looking at the tax treatment of the instrument under the laws of the payer and
payee jurisdictions, the rule will operate to make an adjustment in respect of an expected
mismatch in tax outcomes and it will not be necessary for the taxpayer or tax
administration to know precisely how the payments under a financial instrument have
order to apply the rule. This means that transaction specific rules that adjust the tax
treatment of payment based on the status of the taxpayer or the context in which the
instrument is held, will not typically impact on the outcome under the hybrid financial
instrument rule. For example, a taxpayer may be denied a deduction under local law in
respect of interest on a loan, because the proceeds are used to acquire an asset that
generates a tax exempt return. This tax treatment in the payer jurisdiction will not affect
whether the payment is required to be included in income by the payee under the
secondary rule.
290. The hybrid entity rules (Recommendations 3 to 7), however, only operate to the
extent a taxpayer is actually entitled to a deduction for a payment under local law.
Accordingly these rules will not apply to the extent the taxpayer is subject to transaction
or entity specific rules under the parent or payer jurisdiction that prevent the payment
from being deducted.
Interaction between hybrid mismatch rule and general limitations on deductibility

291. In addition to transaction and entity specific rules, jurisdictions may impose
further restrictions on deductibility that limit the overall deduction that can be claimed by
a taxpayer. Such limitations would include a general limitation on interest deductibility
such as a fixed-ratio rule. The hybrid mismatch rules make adjustments in respect of
particular items that are taken into account for the purposes of calculating a taxpayers
overall income or expense and therefore, as a matter of logic, would generally apply
before any such general or overall limitation. This principle is illustrated in Example 9.2
where the loan made to a subsidiary results in the subsidiary becoming subject to an
interest limitation rule in the subsidiarys jurisdiction so that a portion of the interest
expense on the loan is no longer deductible. The tax position of the borrower under a
general interest limitation rule is not relevant to a determination of whether the payment
is deductible for the purposes of the hybrid financial instrument rule. Accordingly the
hybrid mismatch rule treats the interest payments as giving rise to a D/NI outcome,
notwithstanding the partial disallowance of the interest expense under the laws of the
payer jurisdiction.
292. The interaction between the interest limitation rule and the hybrid mismatch rules
should be co-ordinated under domestic law to achieve an overall outcome that avoids
double taxation and is proportionate on an after-tax basis. The mechanism for
co-ordinating the interaction between the two rules will depend on how the interest
limitation rule operates; however, the interaction between these rules should not have the
net effect of denying a deduction twice for the same item of expenditure. Double counting
can generally be avoided by the taxpayer applying the hybrid mismatch rules first and
then applying the interest limitation rule to the extent the remaining deductible interest
expense exceeds the statutory ratio.
CFC inclusion
293. Domestic hybrid mismatch rules that deny a deduction for a payment that is not
includible in income by the recipient should take appropriate account of the fact that the
payment may be subject to taxation under the CFC or other rules operating in the
jurisdiction of the recipients investor.
294. When introducing the hybrid mismatch rules into local law, countries may choose
to set materiality thresholds that a taxpayer must meet before a taxpayer can treat a CFC
inclusion as reducing the amount of adjustments required under the rule. These thresholds
could be based on the percentage of shareholding or the amount of income included under
a CFC regime.
Rules should minimise disruption under existing domestic law

295. The hybrid mismatch rules seek to align the tax treatment of the arrangement in
the affected jurisdictions with as little disruption to domestic law as possible. In order to
minimise the impact on other domestic rules, the hybrid mismatch rules are intended to
do no more than simply reconcile the tax consequences under the arrangement. They do
not need to address the characterisation of the hybrid entity or instrument itself.
296. A country adopting hybrid mismatch rules could choose to go further under
domestic law and re-characterise an instrument, entity or arrangement to achieve
consistency with domestic law outcomes, however, such a re-characterisation approach is
not necessary to align the ultimate tax outcome in both jurisdictions.
Rules should be clear and transparent

297. The outcome envisaged by the report is that each country will adopt a single set of
integrated linking rules that provides for clear and transparent outcomes under the laws of
all jurisdictions applying the same rules. The rules must therefore be drafted as simply
and clearly as possible so that they can be consistently and easily applied by taxpayers
and tax authorities operating in different jurisdictions. This will make it easier for
multinationals and other cross-border investors to interpret and apply the hybrid
mismatch rules, reducing both compliance costs and transactional risk for taxpayers.
Rules should achieve consistency while providing implementation flexibility

298. The rules must be the same in each jurisdiction while being sufficiently flexible
and robust to fit within existing domestic tax systems. To achieve this, hybrid mismatch
rules must strike a balance between providing jurisdiction neutral definitions that can be
applied to the same entities and arrangements under the laws of two jurisdictions while
avoiding a level of detail that would make them impossible to implement under the
domestic laws of a particular jurisdiction.
299. If the same hybrid mismatch rules are to be applied to the same arrangement by
two jurisdictions and they are to co-ordinate the response between them, it will generally
be necessary to ensure that the rules in both jurisdictions operate on the same entities and
payments. For this reason, the implementing legislation should use (where appropriate)
jurisdiction neutral terminology that describes the arrangement by reference to the
mismatch in tax outcomes rather than the mechanism used to achieve it. For example,
there are a number of different mechanisms that can be used to offset a double deduction
against non-dual inclusion income and, in order to achieve consistency in the application
of the hybrid entity rules across all jurisdictions, the deductible or disregarded hybrid
payment rule needs to be articulated without reference to the mechanism by which the
double deduction is achieved.
Rules should minimise compliance costs

300. One of the fundamental principles in the design of any tax rule is that it keeps
compliance costs for taxpayers to a minimum. One of the intended outcomes of the report
is to address any potential compliance costs by dealing with hybrid mismatch
arrangements on a multilateral and co-ordinated basis. For example, in the context of
deductible hybrid payments, rule co-ordination and ordering ensures that the limitation on
deductibility needs to be applied in only one jurisdiction to neutralise the effect of the
hybrid mismatch.
301. Similarly, if countries move from unilateral measures to protect their tax bases to
a more co-ordinated approach, that will not only have the effect of reducing the risk
posed by these structures to the tax base of all countries but it should also lead to an
overall decrease in transaction costs and tax risks for cross-border investors who might
otherwise find themselves exposed to the risk of economic double taxation under a
unilateral hybrid mismatch measure adopted by an individual jurisdiction.
Rules should be easy for tax authorities to administer

302. Once the hybrid mismatch rules are in place they will be applied automatically by
taxpayers when determining their tax liability, and should not raise significant on-going
administration costs for tax authorities. It is expected that in many cases these types of
arrangements will disappear which should reduce the costs associated with identifying
and responding to these structures. The costs to tax administrations in applying and
enforcing the rule will depend, however, on having rules that are clear and transparent so
that they apply automatically with minimal need for the taxpayer or tax administration to
make qualitative judgments about whether an arrangement is within scope.
303. In general the rules are intended to improve the coherence of the international tax
system and remove the incentive for taxpayers to exploit gaps in the international tax
architecture. This should lead to a reduction in tax administration costs. For example, in
the case of the hybrid financial instruments, the alignment of tax outcomes should take
some pressure off the distinction between the use of debt and equity in cross-border
investment. A multilateral and co-ordinated approach also reduces administration costs as
it enables one tax authority to quickly understand the rule being applied in the other
jurisdiction. The work undertaken as part of Action Item 12 on mandatory disclosure and
information exchange (Mandatory Disclosure Rules, OECD, 2015a) should also make it

easier for tax authorities to collect and exchange information on both the structure of
arrangements and the payments made under them.
Recommendation 9.2 - Implementation and co-ordination

304. Recommendation 9.2 sets out further actions that countries should take to ensure
that the rules are interpreted and applied consistently on a cross-border basis.
Guidance
305. This report sets out agreed guidance on the interpretation and application of the
hybrid mismatch rules. Implementing and applying the recommendations in accordance
with this guidance should ensure predictable and proportionate outcomes. This
consistency is important for achieving the overall design objectives, which are to create a
network of domestic rules that comprehensively and automatically neutralise the effect of
cross-border hybrid mismatch arrangements in a way that minimises disruption to
domestic laws and the risk of double taxation. The guidance set out in this report is
intended to provide both taxpayers and tax administrations with a clear and consistent
understanding of how the technical elements of the recommendations are intended to
achieve these outcomes. It is expected that the guidance will be reviewed periodically to
determine whether there is a need for any additions, clarifications, updates or
amendments to the recommendations or the guidance.
Co-ordination of timing in application of the rules

306. Recommendation 9.2(b) calls for countries to develop standards that will allow
them to better co-ordinate the implementation of the recommendations particularly with
regards to the timing issues that can arise where the implementation of hybrid mismatch
rules in one jurisdiction has tax consequences in the counterparty jurisdiction. These
include situations where the introduction of hybrid mismatch rules in the payer
jurisdiction has the effect of releasing the payee from the burden of making adjustments
under the secondary rule or where rules the introduction of new rules governing the
taxation of deductible dividends or reverse hybrids in the payee jurisdiction relieve the
payer from the restrictions on the ability to deduct payments under a hybrid mismatch
arrangement.
307. Complications in determining the amount of the payment caught by the primary
and secondary rule during the switch-over period can be minimised by ensuring that,
when the recommendations are introduced into domestic law they take effect
prospectively and from the beginning of a taxpayers accounting period. In cases where
the parties to the hybrid mismatch arrangement have the same accounting period and
recognise income and expenditure on a similar basis, the switch-over from the secondary
to the primary rule should not generally raise significant issues. However, complexity,
and the risk of double taxation, can arise where the accounting period for the counterparty
commences on a date that is part-way through an existing accounting period (referred to
in this guidance as the switch-over period) and/or there are differences between the two
jurisdictions in the rules for recognising the timing of income and expenditure. In this
case, unless the primary and secondary rules are properly co-ordinated, there is a risk that
both jurisdictions could apply the hybrid mismatch rules to the same payment or to part of
the same payment.
308. When determining the amount of income or expenditure subject to adjustment

under the hybrid financial instrument rule: the secondary rule should apply to any
payment that is treated as made prior to the switch-over period and the primary rule
should apply to any payment that is treated as made during or after the switch-over
period. This approach gives priority to the primary response, while ensuring that the
taxpayer in the secondary jurisdiction does not need to re-open a prior return for a period
when the primary rule was not in effect.
309. This application of the co-ordination rule is illustrated in Example 9.1 where the
payee jurisdiction applies the defensive rule under Recommendation 3.1(b) to include a
disregarded hybrid payment in income. In that example, the payer jurisdiction introduces
hybrid mismatch rules from the beginning of the payers accounting period. Because the
payers accounting period commences part-way through the accounting period of the
payee (the switch-over period), the payee jurisdiction will only apply the secondary rule
during the switch-over period to the extent the mismatch in tax treatment has not been
eliminated under the primary rule in the payer jurisdiction. Example 2.3 provides an
example of how to co-ordinate the hybrid financial instrument rules with rules denying
the benefit of a dividend exemption to a deductible payment. In the example a payment of
interest on a bond issued by a foreign subsidiary is treated as an exempt dividend by the
parent jurisdiction and the subsidiary jurisdiction denies a deduction for this payment
under the hybrid financial instrument rule. However the hybrid financial instrument rule
ceases to apply to the extent the payments are included in ordinary income as a
consequence of the parent jurisdiction amending its domestic law consistent with
Recommendation 2.1.
Transitional rules
310. Recommendation 9.2(c) provides that countries will identify the need for any
transitional measures. The report expressly, however, that there will be no presumption as
to the need to grandfather any existing arrangements.
311. When the hybrid mismatch rules are introduced they should generally apply to all
payments under hybrid mismatch arrangements that are made after the effective date of
the legislation or regulation. This would include applying the rules to arrangements that
are structured even if such structuring occurred before the introduction of the rules. The
effective date for the hybrid mismatch rules should be set far enough in advance to give
taxpayers sufficient time to determine the likely impact of the rules and to restructure
existing arrangements to avoid any adverse tax consequences associated with hybridity.
In order to avoid unnecessary complication and the risk of double taxation, the rules
should generally take effect from the beginning of a taxpayers accounting period and
include the co-ordination rules described above.
312. In general the need for transitional arrangements can be minimised by ensuring
taxpayers have sufficient notice of the introduction of the rules. Given the hybrid
mismatch rules apply to related parties, members of a control group and structured
arrangements it is expected that in most cases taxpayers will be able to avoid any
unintended effects by restructuring their existing arrangements. Jurisdiction specific
grandfathering of existing arrangements should generally be avoided because of its
potential to complicate the rules and lead to inconsistencies in their application. The
effect of such jurisdiction specific grandfathering is also likely to be limited in the
absence of similar carve-outs being put in place in the counterparty jurisdiction.
Review
313. The recommendations in the report are intended to tackle the problem of hybrid
mismatches on a multilateral and co-ordinated basis. All of the hybrid mismatch rules are
linking rules that depend on tax outcomes in the other jurisdiction and certain rules
contain a defensive rule that only applies when the mismatch has not been neutralised by
the primary recommendation in the counterparty jurisdiction. Therefore, when applying
these rules under their domestic laws, tax administrations will be implicitly relying on the
tax outcomes (including any hybrid mismatch rules) applying under the laws of the other
jurisdiction in order to arrive at the right legal and policy outcome. Furthermore, when it
comes to co-ordinating the interaction between the hybrid mismatch rules of two
jurisdictions, tax administrations will need a clear understanding of what the rules in the
counterparty jurisdiction are and how they are intended to operate. This process can be
facilitated by each country that introduces the rules, providing other countries with
notification that they have introduced the rule and information on how they are intended
to operate in the context of their domestic tax system. This information may need to be
updated, from time to time, to reflect changes in domestic law.
Exchange of information
314. Countries have recognised that, in order for the implementation of the hybrid
mismatch rules to be effective, tax administrations will need to have efficient and
effective information exchange processes and to increase the frequency and quality of
their co-operative cross border collaboration. Applying the recommendations in this
report, particularly the imported mismatch rule in Recommendation 8, may require
countries to undertake multi-lateral interventions in relation to cases involving hybrid
mismatch arrangements.
315. Countries have also recognised the need to engage in early and spontaneous
exchanges of information that are foreseeably relevant to the administration or
enforcement of the hybrid mismatch rules. The information that will need to be
exchanged will typically be taxpayer specific and be based on existing legal instruments,
including Double Tax Conventions and Tax Information Exchange Agreements entered
into by the participating countries and the Convention on Mutual Administrative
Assistance in Tax Matters (OECD 2010). The Forum on Tax Administration's (FTA)
Joint International Tax Shelter Information and Collaboration (JITSIC) network also
provides a forum for countries to work more closely and collaboratively on areas of
mutual interest such as hybrid mismatch arrangements including through the sharing of
information about the cross-border tax treatment of entities and instruments and increased
bi-lateral and multi-lateral intervention activity.
Information to taxpayers
316. Publication of this guidance is intended to provide both taxpayers and tax
administrations with a clear and consistent understanding of how the rules are intended to
operate. Countries will continue to make reasonable endeavours to ensure taxpayers have
accurate information on the tax treatment of entities and financial instruments under the
laws of their jurisdiction.
Interaction with Action 4

317. Where a country has introduced a fixed ratio rule, the potential base erosion and
profit shifting risk posed by hybrid mismatch arrangements is reduced, as the overall
level of net interest deductions an entity may claim is restricted. However, this risk is not
eliminated. Within the limits imposed by a fixed ratio rule, there may still be significant
scope for an entity to claim interest deductions in circumstances where a hybrid financial
instrument or hybrid entity is used to give rise to a double deduction or deduction/no
inclusion outcome. Where a group ratio rule applies, there is also a risk that hybrid
mismatch arrangements could be used to increase a groups net third party interest
expense, supporting a higher level of net interest deductions across the group. In order to
address these risks, a country should implement all of the recommendations in this report,
alongside the best practice approach agreed under Action 4 (OECD, 2015b). Rules to
address hybrid mismatch arrangements should be applied by an entity before the fixed
ratio rule and group ratio rule to determine an entitys total net interest expense. Once this
total net interest expense figure has been determined, the fixed ratio rule and group ratio
rule should be applied to establish whether the full amount may be deducted, or to what
extent net interest expense should be disallowed.
Bibliography
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Base Erosion and Profit Shifting Project, OECD Publishing, Paris,
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OECD (2015b), Limiting Base Erosion Involving Interest Deductions and Other
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10. DEFINITION OF STRUCTURED ARRANGEMENT 105
Chapter 10
Definition of structured arrangement
Recommendation 10
1. General Definition
Structured arrangement is any arrangement where the hybrid mismatch is priced into the terms of
the arrangement or the facts and circumstances (including the terms) of the arrangement indicate
that it has been designed to produce a hybrid mismatch.
2. Specific examples of structured arrangements

Facts and circumstances that indicate that an arrangement has been designed to produce a hybrid
mismatch include any of the following:
(a)
an arrangement that is designed, or is part of a plan, to create a hybrid mismatch;
(b)
an arrangement that incorporates a term, step or transaction used in order to create a hybrid
mismatch;
(c)
an arrangement that is marketed, in whole or in part, as a tax-advantaged product where

some or all of the tax advantage derives from the hybrid mismatch;
(d)
an arrangement that is primarily marketed to taxpayers in a jurisdiction where the hybrid

mismatch arises;
(e)
an arrangement that contains features that alter the terms under the arrangement, including
the return, in the event that the hybrid mismatch is no longer available; or
(f)
an arrangement that would produce a negative return absent the hybrid mismatch.
3. When taxpayer is not a party to a structured arrangement

A taxpayer will not be treated as a party to a structured arrangement if neither the taxpayer nor any
member of the same control group could reasonably have been expected to be aware of the hybrid
mismatch and did not share in the value of the tax benefit resulting from the hybrid mismatch.
Overview
318. The hybrid mismatch rules apply to any person who is a party to a structured
arrangement. The purpose of the structured arrangement definition is to capture those
taxpayers who enter into arrangements that have been designed to produce a mismatch in
tax outcomes while ensuring taxpayers will not be required to make adjustments under
106 10. DEFINITION OF STRUCTURED ARRANGEMENT

the rule in circumstances where the taxpayer is unaware of the mismatch and derives no
benefit from it.
319. The test for whether an arrangement is structured is objective. It applies,
regardless of the parties intentions, whenever the facts and circumstances would indicate
to an objective observer that the arrangement has been designed to produce a mismatch in
tax outcomes. The structured arrangement rule asks whether the mismatch has been
priced into the terms of the arrangement or whether the arrangements design and the
surrounding facts and circumstances indicate that the mismatch in tax outcomes was an
intended feature of the arrangement. The test identifies a set of non-exhaustive factors
that indicate when an arrangement should be treated as structured.
320. The structured arrangement definition does not apply to a taxpayer who is not a
party to the arrangement. A person will be a party to an arrangement when that person has
sufficient involvement in the design of the arrangement to understand how it has been
structured and what its tax effects might be. A person will not be a party to a structured
arrangement, however, if that person (or any member of the control group) does not
benefit from, and could not reasonably have been expected to be aware of, the mismatch
arising under a structured arrangement.
Recommendation 10.1 - General definition

321. Recommendation 10.1 sets out the general definition of a structured arrangement.
The test is objective. It is based on what can reasonably be concluded from the terms of
the arrangement and the surrounding facts and circumstances. If the tax benefit of the
mismatch is priced into the arrangement or if a reasonable person, looking at the facts of
the arrangement, would otherwise conclude that it was designed to engineer a mismatch
in tax outcomes, then the arrangement should be caught by the definition regardless of the
actual intention or understanding of the taxpayer when entering into an arrangement. The
fact that an arrangement is structured, however, does not mean that every person with tax
consequences under that arrangement should be treated as a party to it (see
Recommendation 10.3 below).
Definition of arrangement
322. The definition of arrangement will include a number of separate arrangements
that all form part of the same plan or understanding and will include all the steps and
transactions by which that plan or understanding is carried into effect. When looking into
whether a hybrid mismatch has been priced into the terms of the arrangement or
whether the facts and circumstances indicate that [the arrangement] has been designed to
produce a mismatch taxpayers and tax administrations should look to the entire
arrangement rather than simply to the transaction that gives rise to the mismatch in tax
outcomes.
Priced into the arrangement

323. The hybrid mismatch will be priced into the terms of the arrangement if the
mismatch has been factored into the calculation of the return under the arrangement. The
test looks to the actual terms of the arrangement, as they affect the return on the
arrangement, and as agreed between the parties, to determine whether the pricing of the
transaction is different from what would have been agreed had the mismatch not arisen.
This is a legal and factual test that looks only to the terms of the arrangement itself and
the allocation of risk and return under the arrangement rather than taking into account
broader factors such as the relationship between the parties or the circumstances in which
the arrangement was entered into. The test would not, for example, take into account the
consideration paid by a taxpayer to acquire a hybrid financial instrument unless the
instrument is issued and sold as part of the same arrangement.
324. Example 10.1 illustrates a situation where the hybrid mismatch can be described
as priced into the terms of the arrangement. In that example the taxpayer subscribes for
a hybrid financial instrument that provides for what would otherwise be considered a
market rate of return minus an amount that is calculated by reference to the holders tax
saving on the instrument. In this case the example concludes that the mismatch in tax
outcomes is priced into the terms of the instrument and that, accordingly, the arrangement
is a structured arrangement.
325.
The pricing of the arrangement includes more than just the return under the
transaction that gives rise to the hybrid mismatch. Example 10.2 describes a situation
where back-to-back loans are structured through an unrelated intermediary in order to
produce a hybrid mismatch. In that example, the tax benefit under the hybrid mismatch
arrangement is returned to the parent company in the form of an above-market rate of
interest. In such a case, the arrangement includes the back-to-back financing and the tax
consequences of the hybrid mismatch will be considered to have been priced into the
terms of the arrangement in the form of an above market rate of interest on the loan.
Facts and circumstances of the arrangement

326.
The facts and circumstances test is a wider test that looks to: the relationship
between the parties; the circumstances under which the arrangement was entered into; the
steps and transactions that were undertaken to put the arrangement into effect; the terms
of the arrangement itself and the economic and commercial benefits of the transaction; to
determine whether the arrangement can be described as having been designed to produce
a hybrid mismatch. The fact that an arrangement also produces a combination of tax and
commercial benefits does not prevent the arrangement from being treated as structured if
an objective and well informed observer would conclude that part of the explanation for
the design of the arrangement was to generate a hybrid mismatch.
327. Recommendation 10.2 sets out a list of factors that point to the existence of a
structured arrangement. These factors are not exclusive or exhaustive and there may be
other factors in an arrangement that would lead an objective observer to conclude that the
arrangement has been designed to produce a mismatch in tax outcomes.
328. The facts and circumstances test could, for example, take into account any
relationship between the parties that makes it more likely that the arrangement has been
structured. For example, in Example 1.36, two taxpayers are joint shareholders in third
company. One shareholder transfers a bond that has been issued by the subsidiary to the
other shareholder. This transfer relieves the subsidiary company of liability under the
hybrid financial instrument rule. The fact that the parties to the transfer were both
investors in the issuer and the fact that the transaction had the effect of relieving the
issuer from an impending tax liability should be taken into account in considering
whether the arrangement has been designed to produce a mismatch in tax outcomes.
Recommendation 10.2 - Specific examples of structured arrangements

329. The list of factors in Recommendation 10.2 should be used as a guide for
taxpayers and tax administrations as to the kinds of transactions and activities that will
bring a hybrid mismatch arrangement within the structured arrangement definition. In
many cases more than one of the factors may be present in the same arrangement.
Arrangement that is designed or part of a plan to produce a mismatch

330. An arrangement will be part of a plan to produce a hybrid mismatch where a
person with material involvement in, or awareness of, the design of the arrangement (such
as a tax advisor) has identified, before the arrangement was entered into, that it will give
rise to mismatch in tax outcomes. This element will be present if there is a written or oral
advice given in connection with the arrangement, or working papers or documents
produced before the arrangement is entered into, that indicate that the transaction will
give rise to a mismatch. This factor ensures that if a taxpayer is advised of the hybrid
mismatch then the arrangement will be a structured arrangement.
331. An illustration of a structured arrangement that is part of a plan to produce a
mismatch is set out in Example 1.31. In that example a company wishes to borrow
money from an unrelated lender. The lender suggests structuring the loan as a repo
transaction in order to secure a lower tax cost for the parties under the arrangement. The
facts of the arrangement therefore indicate that it has been designed to produce a
mismatch. Furthermore, as indicated in the example, structuring the loan in this way may
result in a lower cost of funds for the borrower which will mean that that the mismatch
has been priced into the terms of the arrangement.
332. In Example 10.2 a tax advisor advises a company to loan money under a hybrid
financial instrument to a subsidiary through an unrelated intermediary in order to avoid
the effect of the related party test under the hybrid financial instrument rule. In this case
the arrangement has been designed to avoid the effect of the related party rules in order to
produce a mismatch in tax outcomes and the arrangement can therefore be described as
having been designed to produce a hybrid mismatch.
An arrangement that uses a term, step or transaction to create a mismatch

333. An arrangement will be structured if it incorporates a term, step or transaction that
has been inserted into the arrangement to achieve a hybrid mismatch. A term, step or
transaction will be treated as inserted into an arrangement to produce a mismatch in tax
outcomes if that mismatch would not have arisen in the absence of that term, step or
transaction and where there was no substantial business, commercial or other reason for
inserting that term into the arrangement or undertaking that step or transaction. An
assessment of purpose of a transaction should take into account other reasonable
alternatives that would have achieved the same effect without triggering a mismatch in
tax outcomes. This factor ensures that a taxpayer does not go out of their way to create a
hybrid mismatch. The factors listed in Recommendation 10.2 do not limit the scope of the
general wording in Recommendation 10.1 so that a hybrid mismatch should still be
treated as structured even if every step in the transaction has a non-tax justification if it is
reasonable to conclude that part of the explanation for the overall design of the
arrangement was to generate a hybrid mismatch.
334. The application of this factor is discussed in Example 10.2 where a company
causes its subsidiary to enter into a hybrid financial instrument with an unrelated
intermediary in order to avoid the effect of the related party test under the hybrid
mismatch rules. In that case the intermediary has been inserted into the financing
arrangement in an attempt to circumvent the effect of the hybrid mismatch rules. There is
no substantial business, commercial or other reason that explains why the financing is
routed through a third party and, accordingly, the use of the intermediary and the back-toback financing structure has been inserted into the structure in order to produce a
mismatch in tax outcomes. In Example 4.2 two individuals wish to make a loan to a
company that is wholly-owned by one of them. Instead of making the loan directly, they
contribute equity to B Co, a reverse hybrid which makes the loan. The example concludes
that the intermediary has been inserted into the financing arrangement in an attempt to
produce a hybrid mismatch. Given the relatively simple nature of the financing
arrangement, there is no substantial business, commercial or other reason for providing
the financing through a reverse hybrid other than to produce a mismatch in tax outcomes.
An arrangement is marketed as a tax advantaged product

335. An arrangement will be treated as marketed as a tax advantaged product if there is
written, electronic or oral communication provided to the parties to the arrangement or
potential parties to the arrangement that identifies the potential tax benefits of the
structure. As indicated in Example 10.3 the marketing material need not specifically refer
to the existence of the hybrid mismatch but must identify an advantage that flows from
the hybrid mismatch arrangement. This could include, for example, material that points
out, to an investor in a double deduction structure, that the investor will be able to claim
the benefit of any losses incurred by the investment vehicle, or, in a D/NI structure that
indicates that the borrower should be entitled to a tax deduction for the payments.
Marketing information would include any information in a prospectus or other offering
documents that are required to be provided to an investor as part of an offer of investment
securities. This factor ensures that tax benefits derived from the hybrid mismatch
arrangement cannot be used to market the arrangement.
An arrangement that is primarily marketed to taxpayers in a particular

jurisdiction
336. In the absence of marketing material, the arrangement should still be considered
structured if, in practice, the arrangement is primarily marketed to taxpayers who will
benefit from the mismatch. The fact that the arrangement is also available to taxpayers in
other jurisdictions who do not benefit from the mismatch will not prevent that transaction
from being treated as part of a structured arrangement if the majority of the arrangements,
by number or value, are entered into with taxpayers located in jurisdictions that do benefit
from the mismatch.
337. In Example 6.1 a company seeking to raise money, approaches several potential
investors that are resident in the same jurisdiction inviting them to make an investment in
the company on particular terms. Differences in the way the jurisdictions of the issuer and
investors treat an instrument of this nature mean that payments under the instrument will
give rise to a hybrid mismatch under the hybrid financial instrument rule. The potential
investors are sent an investment memorandum that includes a summary of the expected
tax treatment of the instrument. The arrangement will be treated as a structured
arrangement because the tax advantages arising under the hybrid mismatch have been
marketed to investors and the investment is primarily marketed to taxpayers in a
jurisdiction that can take advantage of the mismatch. While the issuer will be subject to
the hybrid mismatch rule for as long as the instrument remains outstanding, the example

notes that a subsequent purchaser of the notes may not be required to apply the hybrid
mismatch rule if they do not have sufficient information about the arrangement to
understand its hybrid effect.
Change to the economic return under the instrument

338. Features of an arrangement that alter the economic return for the parties in the
event that the hybrid mismatch is no longer available can evidence that the benefit of the
hybrid mismatch has been priced into the arrangement. The potential presence of this
factor is discussed in Example 10.2 where a company causes its subsidiary to enter into a
hybrid financial instrument with an unrelated intermediary in order to avoid the effect of
the related party test under the hybrid mismatch rules. In that case, it is noted that the
intermediary will typically insist on the structure being unwound in the event the tax
benefit is no longer available. This factor ensures that parties to the structured
arrangement cannot enter into arrangements allocating the risk and benefits of an
adjustment under the hybrid mismatch rules without actually triggering such an
adjustment.
339. It is not unusual for financing arrangements to include provisions dealing with tax
risk (particularly change of law risk). Clauses that permit a lender to increase the cost of
financing due to a change in circumstances beyond the lenders control and clauses that
permit a bond issuer to redeem an instrument for its face value in the event of a change in
tax law, do not necessarily indicate that the parties intended to enter into a structured
arrangement provided the taxpayer can show that such contractual terms would ordinarily
be expected to be found in a financing arrangement of that nature. If, on the other hand,
the evidence suggests that such provisions were inserted primarily to deal with the risk
that the hybrid mismatch rules may apply to the arrangement, then the structured
arrangement rule is likely to apply.
Pre-tax negative return

340. The fact that it would be uneconomic for the taxpayer to enter into the
arrangement but for the benefit under the hybrid mismatch may be evidence that the
arrangement is a structured arrangement. This factor is also related to the pricing of the
arrangement and is intended to prevent a taxpayer from passing the tax benefits under a
hybrid mismatch arrangement to another contracting party. An example of pre-tax
negative return transaction is given in Example 10.2 in respect of a back-to-back loan
structure. In that example, the tax benefit under the hybrid mismatch arrangement is
returned to the parent company in the form of an above-market rate of interest so that, on
the facts of that case, the intermediary is borrowing money at a more expensive rate than
it is earning under the hybrid financial instrument.
Recommendation 10.3 - When taxpayer is not a party to a structured arrangement

341. Recommendation 10.3 excludes a taxpayer from the structured arrangement rule
where the taxpayer is not a party to the structured arrangement.
342. A person will be a party to a structured arrangement when that person has a
sufficient level of involvement in the arrangement to understand how it has been
structured and what its tax effects might be. A taxpayer will not be treated as a party to a
structured arrangement, however, where neither the taxpayer nor any member of the same
control group was aware of the mismatch in tax outcomes or obtained any benefit from
the mismatch.
343. The test for whether a person is a party to structured arrangement is intended to
capture situations where the taxpayer or any member of the taxpayers control group was
aware of the mismatch in tax outcomes and should apply to any person with knowledge
of the arrangement and its tax effects regardless of whether that person has derived a tax
advantage under that arrangement. The policy of the hybrid mismatch rules is to
neutralise the mismatch in tax outcomes by adjusting the tax outcomes in the payer or
payee jurisdiction without the need to consider whether, or to what extent, the person
subject to the adjustment has benefited from that mismatch. While a taxpayer must be
aware of the existence of the hybrid mismatch arrangement in order to make the
adjustment, a tax administration should not be required to establish that the taxpayer has
benefited from the mismatch before requiring that the adjustment be made. The
knowledge test is an objective test based on the information available to the taxpayer and
should not impose an obligation on a taxpayer to undertake additional due diligence on a
commercial transaction over and above what would be expected of a reasonable and
prudent person.
344. Whether a taxpayer is a party to a structured arrangement is likely to have the
most practical significance in the context of payments made to a reverse hybrid or under
an imported mismatch arrangement. In the cases of a reverse hybrid, for example, the
relationship between the investor and the reverse hybrid will often satisfy the conditions
of a structured arrangement. This is particularly the case in respect of investment funds
where investors may look to invest in vehicles that are tax neutral under the laws of the
establishment jurisdiction and to ensure that the investment return will only be taxable on
distribution. While fund structures such as this could be described as having been
designed to create a mismatch in tax outcomes, the payer will not be considered a party to
such an arrangement if it did not benefit from the mismatch (i.e. the payment was at fair
market value) and the payer could not reasonably have been expected to be aware of the
mismatch in tax treatment.
345. This principle is illustrated in Example 4.1 where the use of a reverse hybrid as a
single-purpose lending entity prima facie indicates that the arrangement between the
investor and the reverse hybrid has been engineered to produce a mismatch in tax
outcomes. In that case, however, the payer is not treated as a party to the structured
arrangement because it pays a market rate of interest under the loan and would not have
been expected, as part of its ordinary commercial due diligence, to take into consideration
the tax position of the underlying investor or the tax treatment of the interest payment
under the laws of the investor jurisdiction when making the decision to borrow money
from the reverse hybrid..
346. The outcome described in Example 4.1 can be contrasted with that described
below in Example 10.5 where the hybrid element is introduced into the structure after
financing discussions between the investor and the payer have commenced. In that
example a fund that is in the business of providing loans to medium-sized enterprises
enters into negotiations to provide a company with an unsecured loan that will be used to
meet the companys working capital requirements. The fund uses a subsidiary in a third
jurisdiction to make the loan and finances that loan through the use of a hybrid financial
instrument. Neither the fund nor the subsidiary is resident in a jurisdiction that has
introduced the hybrid mismatch rules. The financing arrangement is conceived as a single
plan that includes both the transaction that gives rise to the original hybrid deduction (the

hybrid financial instrument) and the loan by the subsidiary to the taxpayer. The taxpayer
will be treated as a party to that structured arrangement if it is involved in the design or
has sufficient information about the arrangement to understand its operation and effect. A
taxpayer will not be treated as a party to a structured arrangement, however, where
neither the taxpayer nor any member of the taxpayers control group obtained any benefit
under a hybrid mismatch arrangement or had sufficient information about the
arrangement to be aware of the fact that it gave rise to a mismatch in tax outcomes. The
principle is further illustrated in Example 10.3 where a hybrid financial instrument is
sold to a taxpayer. The example notes that, while the purchaser can be taken to be aware
of its own tax treatment under the financial instrument it would not typically be expected
to enquire into the tax position of the issuer and, provided the instrument was acquired for
its fair market value (and not under the same arrangement that gave rise to the hybrid
mismatch) such a person would not typically be brought within the scope of the
structured arrangement rules.
Arrangements entered into on behalf of a taxpayer

347. When applying the structured arrangement rule, the actions of a taxpayers agent
should be attributed to the taxpayer. Where a transparent entity enters into a hybrid
mismatch arrangement and the tax consequences of a payment under that arrangement are
attributed to the investor, the structured arrangement rule should be applied to the
investor as if the investor was a direct party to that structured arrangement and had
entered into that arrangement on the same basis as the transparent entity. In
Example 10.4 a trust subscribes for an investment in the company on particular terms.
Differences in the way the jurisdiction of the issuer and the jurisdiction of the investors
treat an instrument of this nature mean that payments under the instrument will give rise
to a hybrid mismatch under the hybrid financial instrument rule. Potential investors,
including the trust, are sent an investment memorandum that includes a summary of the
expected tax treatment of the instrument. The payment under the instrument is allocated
by the trust to a beneficiary who has no knowledge of the investment made by the trustee.
In this case, the trusts status as a party to a structured arrangement is attributed to the
beneficiary, together with the payment, so that the payment to the beneficiary is caught
by the hybrid financial instrument rule.
11. DEFINITIONS OF RELATED PERSONS, CONTROL GROUP AND ACTING TOGETHER 113
Chapter 11
Definitions of related persons, control group and acting together
Recommendation 11
1. General definition
For the purposes of these recommendations:
(a)
Two persons are related if they are in the same control group or the first person has a 25% or
greater investment in the second person or there is a third person that holds a 25% or greater
investment in both.
(b)
Two persons are in the same control group if:
(c)
(i) they are consolidated for accounting purposes;

(ii) the first person has an investment that provides that person with effective control
of the second person or there is a third person that holds investments which provides
that person with effective control over both persons;
(iii) the first person has a 50% or greater investment in the second person or there is a
third person that holds a 50% or greater investment in both; or
(iv) they can be regarded as associated enterprises under Article 9.
A person will be treated as holding a percentage investment in another person if that person
holds directly or indirectly through an investment in other persons, a percentage of the voting
rights of that person or of the value of any equity interest in that person.
2. Aggregation of interests
For the purposes of the related party rules a person who acts together with another person in respect
of ownership or control of any voting rights or equity interests will be treated as owning or
controlling all the voting rights and equity interests of that person.
3. Acting together
Two persons will be treated as acting together in respect of ownership or control of any voting rights
or equity interests if:
(a)
they are members of the same family;
(b)
one person regularly acts in accordance with the wishes of the other person;
(c)
they have entered into an arrangement that has material impact on the value or control of any
such rights or interests; or
(d)
the ownership or control of any such rights or interests are managed by the same person or
group of persons.
If a manager of a collective investment vehicle can establish to the satisfaction of the tax authority,
from the terms of any investment mandate, the nature of the investment and the circumstances that
the hybrid mismatch was entered into, that the two funds were not acting together in respect of the
investment then the interest held by those funds should not be aggregated for the purposes of the
acting together test.
114 11. DEFINITIONS OF RELATED PERSONS, CONTROL GROUP AND ACTING TOGETHER
Overview
348. The report treats hybrid financial instruments and hybrid transfers between related
parties as within the scope of the hybrid mismatch rules. Other hybrid mismatch
arrangements are generally treated as within scope of the recommendations where the
parties to the mismatch are members of the same control group.
349. The related party and control group tests apply regardless of the circumstances in
which the hybrid mismatch arrangement was entered into. The principle is illustrated in
Example 1.1 where it is noted that a debt instrument that is acquired by the issuers
parent in an unrelated transaction will still constitute a financial instrument between
related parties and is potentially subject to the application of the hybrid financial
instrument rule notwithstanding that it was not caught by the rule at the time it was
originally issued.
350. Two persons will be treated as related if they form part of the same control group
or if one person has a 25% investment in the other person or a third person has a 25%
investment in both. The test measures both direct and indirect investment, which includes
both voting rights and the value of any equity interests. Persons who are acting together
in respect of the ownership or control of an investment in certain circumstances are
required to aggregate their ownership interests for the purposes of the related party test.
351.
Parties will be treated as members of the same control group if:

(a) they form part of the same consolidated group for accounting purposes or the
provision between them can be regarded as a provision between associated
enterprises under Article 9 of the OECD Model Tax Convention (OECD, 2014);
(b) one person has a 50% investment or effective control of the other person (or a
third person has a 50% or effective control of both).
352. The hybrid mismatch rules also apply to any person who is a party to a
structured arrangement that has been designed to produce a mismatch. For the
discussion of structured arrangements see the guidance to Recommendation 10.
Recommendation 11.1 - General definition

353. Recommendation 11.1 sets out the general definition of related persons and
control group.
Related parties
354. Persons are treated as related parties for the purposes of the hybrid mismatch rules
if they are in the same control group or one person holds a 25% investment in the other or
the same person holds a 25% investment in both. A persons investment in another person
is determined by looking to the percentage of voting rights or of the value of any equity
interests that the first person holds in the second person. The terms voting rights and
equity interests are defined in Recommendation 12.
Voting interests
355. While the measurement of voting interests will be easiest in the context of
corporate entities that issue equity share capital, the term also includes equivalent control
rights in other types of investment vehicles such as partnerships, joint ventures and trusts.
A persons voting interest is the right of that person to participate in the decision-making
concerning a distribution by that person, a change in that persons constitutional structure
or in the appointment of a director. The term director refers to any person who has power,
under the constitutional documents, to manage and control a person (such as the trustee of
a trust).
356. The right to participate in any one of the decision-making functions of a person is
sufficient to constitute a voting right in that person but the right must be conferred under
the constitutional documents of the entity itself. Example 11.1 concerns a trust where the
settlor has the right, under the trust deed, to appoint trustees but has no right to
distributions or to amend the trust deed. In this case the settlor is, nevertheless, treated as
a related party of the trust as the settlor effectively holds 100% of the decision-making
rights concerning any trustee appointment.
357. Example 11.2 concerns a partnership formed between four individuals. All
partners have the same voting rights and an equal share in the profits of the partnership.
In this case each partner should be treated as having a 25% investment in the partnership
and will be considered related to the partnership. The partners will not, however, be
considered related to each other.
358. The rights must be actual decision-making rights rather than rights that might
arise at some point in the future, although contingencies that are procedural in nature and
within the control of the holder can be ignored for these purposes. Thus a convertible
bond holder who can elect, at any time, to convert such bonds into ordinary shares should
be treated as holding voting interests in the issuer on a diluted basis, while a lender who
has the right to appoint a receiver in the event of default under a loan will not be treated
as holding voting rights in the borrower as such rights are contingent on default by the
borrower and are not conferred under the articles of association of the company but by the
terms of the security granted under the loan.
Value of equity interests

359. An instrument should be treated as giving rise to an equity interest if it provides
the holder with an equity return. An equity return means an entitlement to profits or
eligibility to participate in distributions. While the definition of equity return in
Recommendation 12 also includes derivative equity returns, this extended definition does
not apply in the measurement of equity interests for the purposes of the related party and
control tests. An instrument may be treated as an equity interest, even if it is in the form
of a debt instrument, if it confers a right to participate in the profits of the issuer or in any
surplus on liquidation.
360. In the case of a company with only one class of ordinary shares on issue, it should
generally be the case that voting interests and equity interests are held in the same
proportions. Non-voting shares, bonds, warrants or other financial instruments that carry
an entitlement to an equity return and that are widely-held or regularly traded may be
excluded from the measurement of the value of equity interests where the way these
instruments are issued, held or traded does not give rise to significant structuring
concerns.
Indirect holding
361. A person that holds voting rights or equity interest in another person will be
treated as holding a proportionate amount of the voting rights or equity interests held by
that person. Indirect holdings should be measured on a dilution basis so that if Individual
A holds 50% of the voting or equity interests in B Co and B Co holds 50% of the voting
or equity interests in C Co, then A should be treated as holding 25% of the interests C Co.
A more detailed example setting out the calculation of indirect voting rights is set out in
Example 11.3. In that example, A Co owns 100% of voting rights in C Co and 20% of
voting rights in D Co. F Co is owned 20% by C Co and 40% by D Co. A Co is therefore
related to C Co and F Co and F Co is related to D Co, but A Co is not related to D Co
(unless it can be shown that they are members of the same control group).
Control group
362. Two persons should be treated as being in the same control group if they meet one
of the conditions listed in Recommendation 11.1(b).
Consolidation
363. A subsidiary entity should be treated as related to its ultimate parent if the
subsidiary is required to be consolidated, on a line-by-line basis in the parents
consolidated financial statements prepared under International Financial Reporting
Standards (IFRS) or applicable local Generally Accepted Accounting Principles (GAAP).
Effective control
364. Persons are members of the same control group if the first person can effectively
control the second person through an investment in that person or if there is a third person
that has a sufficiently significant investment in both persons that gives it an effective
control over both of them. This will be the case, for example, where a person is a
substantial shareholder in a widely-held company and that shareholding gives that person
effective control over the appointment of directors.
Voting or equity interests

365. Persons are treated as part of the same control group if one person holds at least a
50% investment in the other or the same person holds at least a 50% investment in both.
A percentage investment in another person is to be determined by reference to the
percentage voting rights of that person or of the value of any equity interests of that
person. The measurement of voting and value rights is discussed above.
Associated enterprises
366. Two persons should be regarded as members of the same control group if they are
treated as associated enterprises under Article 9 of the OECD Model Tax Convention
(OECD, 2014). According to Article 9.1 associated enterprises are found where:
(a) An enterprise of a Contracting State participates directly or indirectly in the
management, control or capital of an enterprise of the other Contracting State, or
(b) The same persons participate directly or indirectly in the management control or
capital enterprise of a Contracting State and an enterprise of the other Contracting
State.
367. The OECD Model Tax Convention (OECD, 2014) and the Commentaries do not
establish the threshold or criteria to determine when participation in capital, management
or control is sufficient to make two enterprises associated enterprises within the scope
of Article 9. It is left for countries to set the criteria to assess when the transfer pricing
rules will apply under domestic law and especially as to the meaning of control. The
effect of including associated enterprises within the definition of control group is that the
hybrid mismatch rules should apply to any transaction that is also subject to adjustment
under a countrys transfer pricing rules.
Recommendation 11.2 - Aggregation of interests

368. Recommendation 11.2 defines when a persons equity interests should be
aggregated with those of another person for the purposes of the related party or control
group tests.
Recommendation 11.3 - Acting together

369. The purpose of the acting together requirement is to prevent taxpayers from
avoiding the related party or control group requirements by transferring their voting
interest or equity interests to another person, who continues to act under their direction in
relation to those interests. The other situation targeted by the acting together requirement
is where a taxpayer or group of taxpayers who individually hold minority stakes in an
entity, enter into arrangements that would allow them to act together (or under the
direction of a single controlling mind) to enter into a hybrid mismatch arrangement with
respect to one of them.
370. The acting together test covers voting rights or equity interests held by a single
economic unit such as a family and covers the following three basic scenarios:
(a) where one person is required, or can be expected to act, in accordance with the
wishes of another person in respect of the voting rights or equity interests held by
that first person;
(b) where two or more people agree to act together in respect of voting rights or
equity interests that they hold;
(c) where a person (or people) agree that a third person can act on their behalf in
respect of voting rights or equity interests that they hold.
Members of the same family

371. A person will be deemed to hold any equity or voting interests that are held by the
members of that persons family. Family is defined in Recommendation 12. This test
would include a persons spouse (including civil partner), the relatives of that person and
their spouses. A relative includes grandparents, parents, children, grandchildren and
brothers and sisters (including adopted persons and step-siblings) but it would not include
indirect or non-lineal descendants such as a persons nephew or niece.
Regularly acts in accordance with the wishes of the other person

372. A person will be treated as acting in accordance with the wishes of another person
where the person is legally bound to act in accordance with anothers instructions or if it
can be established that one person is expected to act, or typically acts, in accordance with
anothers instructions. The focus of the test is on the actions of that person in relation to
the voting rights or equity interests. The equity interests or voting rights held by a lawyer
for example, will not be treated as held by the lawyers client under the acting together
test, unless it can be established that such rights or interest are held as part of the lawyer
client relationship.
Entered into an arrangement that has material impact on the value or control of
any such rights or interests
373. One person will be treated as holding the equity or voting interests of another
person if they have entered into an arrangement regarding the ownership or control of
those rights or interests. The test covers both arrangements concerning the exercise of
voting interests (such as the right to participate in any decision-making) and or regarding
beneficial entitlements (such as entitlement to profits or eligibility to participate in
distributions) or arrangements concerning the ownership of those rights (such as
agreements or options to sell such rights). The test is intended to capture arrangements
that are entered into with other investors and does not cover arrangements that are simply
part of the terms of the equity or voting interest or operate solely between the holder and
issuer.
374. The arrangement regarding the ownership or control of voting rights or interests
must have a material impact on the value of those rights or interests. The materiality
threshold prevents an investor having their equity or voting interests treated as part of a
common holding arrangement simply because the investor is a party to a commercially
standard shareholder or investor agreement that does not have a material impact on the
ability of a holder to exercise ownership or control over its equity or voting interest.
375. This point is illustrated in Example 11.4 where an investor is a party to a
shareholders agreement that requires the investor to first offer his equity interest to
existing investors (at market value) before selling to a third party. Such an agreement will
not generally have a material impact on the value of the holders equity interest and
should not be taken into account for the purposes of the acting together requirement.
376. The acting together test does not impose any definitional limits on the content of
the common control arrangement and the acting together test can capture transactions
between otherwise unrelated taxpayers even if the common control arrangement has not
played any direct role in the transaction that has given rise to the mismatch. This is
illustrated by Example 11.4. In that example an unrelated investor acquires a listed
financial instrument issued by a company. Payments under that instrument give rise to a
hybrid mismatch. The fact that an investor is also a minority investor in that company and
has entered into a voting rights agreement with a majority shareholder automatically
brings that investor within the scope of the hybrid financial instrument rule.
The ownership or control of any such rights or interests are managed by the
same person or group of persons
377. This element of the acting together test treats investors as acting together if their
interests are managed by the same person or group of persons. This requirement would
pick up a number of investors whose investments were managed under a common
investment mandate or partners in an investment partnership.
378. This element of the acting together test contains an exception for investors that
are collective investment vehicles where the nature of the investment mandate and the
investment means that two funds under the common control of the same investment
manager will not be treated as acting together if the circumstances in which they make the
investment (including the terms of the investment mandate) mean that the funds should
not be treated as acting together for the purposes of the test. The application of this
exception is illustrated in Example 11.5.
Bibliography
OECD (2014), Model Tax Convention on Income and on Capital, condensed version,
12. OTHER DEFINITIONS 121
Chapter 12
Other definitions
Recommendation 12
1. Definitions
For the purpose of these recommendations:
Accrued income
Accrued income, in relation to any payee and any investor, means income
of the payee that has accrued for the benefit of that investor.
Arrangement
Arrangement refers to an agreement, contract, scheme, plan, or

understanding, whether enforceable or not, including all steps and
transactions by which it is carried into effect. An arrangement may be part
of a wider arrangement, it may be a single arrangement, or it may be
comprised of a number of arrangements.
Collective
investment vehicle
Collective investment vehicle means a collective investment vehicle as

defined in paragraph 4 of the Granting of Treaty Benefits with Respect to
the Income of Collective Investment Vehicles (2010, OECD).
Constitution
Constitution, in relation to any person, means the rules governing the

relationship between the person and its owners and includes articles of
association or incorporation.
D/NI outcome
A payment gives rise to a D/NI outcome to the extent the payment is

deductible under the laws of the payer jurisdiction but is not included in
ordinary income by any person in the payee jurisdiction. A D/NI outcome
is not generally impacted by questions of timing in the recognition of
payments or differences in the way jurisdictions measure the value of that
payment. In some circumstances however a timing mismatch will be
considered permanent if the taxpayer cannot establish to the satisfaction of
a tax authority that a payment will be brought into account within a
reasonable period of time (see Recommendation 1.1(c)).
DD outcome
A payment gives rise to a DD outcome if the payment is deductible under

the laws of more than one jurisdiction.
Deduction
Deduction (including deductible), in respect of a payment, means that, after

a proper determination of the character and treatment of the payment under
the laws of the payer jurisdiction, the payment is taken into account as a
deduction or equivalent tax relief under the laws of that jurisdiction in
calculating the taxpayers net income.
Director
Director, in relation to any person, means any person who has the power
under the constitution to manage and control that person and includes a
trustee.
Distribution
Distribution, in relation to any person, means a payment of profits or gains

by that person to any owner.
122 INTRODUCTION TO PART II
Dual inclusion
income
Dual inclusion income, in the case of both deductible payments and

disregarded payments, refers to any item of income that is included as
ordinary income under the laws of the jurisdictions where the mismatch has
arisen. An item that is treated as income under the laws of both
jurisdictions may, however, continue to qualify as dual inclusion income
even if that income benefits from double taxation relief, such as a foreign
tax credit (including underlying foreign tax credit) or a domestic dividend
exemption, to the extent such relief ensures that income, which has been
subject to tax at the full rate in one jurisdiction, is not subject to an
additional layer of taxation under the laws of either jurisdiction.
Equity interest
Equity interest means any interest in any person that includes an

entitlement to an equity return.
Equity return
Equity return means an entitlement to profits or eligibility to participate in

distributions of any person and, in respect of any arrangement is a return on
that arrangement that is economically equivalent to a distribution or a
return of profits or where it is reasonable to assume, after consideration of
the terms of the arrangement, that the return is calculated by reference to
distributions or profits.
Establishment
jurisdiction
Establishment jurisdiction, in relation to any person, means the jurisdiction

where that person is incorporated or otherwise established.
Family
A person (A) is a member of the same family as another person (B) if B is:
the spouse or civil partner of A;
a relative of A (brother, sister, ancestor or lineal descendant);
the spouse or civil partner of a relative of A;
a relative of As spouse or civil partner;
the spouse or civil partner of a relative of As spouse or civil
partner; or
Financing return
an adopted relative.
Financing return, in respect of any arrangement is a return on that
arrangement that is economically equivalent to interest or where it is
reasonable to assume, after consideration of the terms of the arrangement,
that the return is calculated by reference to the time value of money
provided under the arrangement.
Hybrid mismatch
A hybrid mismatch is defined in paragraph 3 in Recommendations 1, 3, 4,

6 and 7 for the purposes of those recommendations.
Included in ordinary
income
A payment will be treated as included in ordinary income to the extent that,

after a proper determination of the character and treatment of the payment
under the laws of the relevant jurisdiction, the payment has been
incorporated as ordinary income into a calculation of the payees income
under the law of that jurisdiction.
Investor
Investor, in relation to any person, means any person directly or indirectly

holding voting rights or equity interests in that person.
Investor jurisdiction
Investor jurisdiction is any jurisdiction where the investor is a taxpayer.
Mismatch
A mismatch is a DD outcome or a D/NI outcome and includes an expected

mismatch.
Money
Money includes money in any form, anything that is convertible into

money and any provision that would be paid for at arms length.
Offshore investment
regime
An offshore investment regime includes controlled foreign company and

foreign investment fund rules and any other rules that require the investors
accrued income to be included on a current basis under the laws of the
investors jurisdiction.
Ordinary income
Ordinary income means income that is subject to tax at the taxpayers full
marginal rate and does not benefit from any exemption, exclusion, credit or
other tax relief applicable to particular categories of payments (such as
indirect credits for underlying tax on income of the payer). Income is
considered subject to tax at the taxpayers full marginal rate
notwithstanding that the tax on the inclusion is reduced by a credit or other
tax relief granted by the payee jurisdiction for withholding tax or other
taxes imposed by the payer jurisdiction on the payment itself.
Payee
Payee means any person who receives a payment under an arrangement

including through a permanent establishment of the payee.
Payee jurisdiction
Payee jurisdiction is any jurisdiction where the payee is a taxpayer.
Payer
Payer means any person who makes a payment under an arrangement

including through a permanent establishment of the payer.
Payer jurisdiction
Payer jurisdiction is any jurisdiction where the payer is a taxpayer.
Payment
Payment includes any amount capable of being paid including (but not
limited to) a distribution, credit, debit, accrual of money but it does not
extend to payments that are only deemed to be made for tax purposes and
that do not involve the creation of economic rights between parties.
Person
Person includes any natural or legal person or unincorporated body of

persons and a trust.
Taxpayer
Taxpayer, in respect of any jurisdiction, means any person who is subject

to tax in that jurisdiction whether as a resident or by virtue of applicable
source rules (such as maintaining a permanent establishment in that
jurisdiction).
Trust
Trust includes any person who is a trustee of a trust acting in that capacity.
Voting rights
Voting rights means the right to participate in any decision-making

concerning a distribution, a change to the constitution or the appointment
of a director.
Overview
379. The recommendations in the report set out requirements for the design of
domestic laws. The language of the recommendations is not meant to be translated
directly into domestic legislation. Rather countries are expected to implement these
recommendations into domestic law using their own concepts and terminology. At the
same time, in order for the recommended rules to be effective and to avoid double
taxation, they need to be co-ordinated with the rules in other countries. To this end,

Recommendation 12 sets out a common set of defined terms intended to ensure
consistency in the application of the rules.
Recommendation 12.1 - Other definitions

Accrued income
380. The definition of accrued income is used as part of the definition of offshore
investment regime and in Recommendation 5, which sets out specific recommendations
on the treatment of reverse hybrids. The concept of accrued income, in relation to any
investor, includes any amount that is paid to an investment entity that increases the value
of that investors interest in that entity.
Arrangement
381. The term arrangement is used as part of the definition of financial instrument, in
Recommendation 1.2, and as part of the definition of structured arrangement in
Recommendation 10.
Collective investment vehicle

382. The rules on aggregation of ownership interests set out in Recommendation 11.3
of the report, state that two persons will be treated as acting together in respect of their
ownership interest in an entity if the ownership interests are managed by the same person
or group of persons. The rule does not, however, apply to any person that is a collective
investment vehicle if the investment manager can establish to the satisfaction of the tax
authority, from the terms of the investment mandate and the circumstances in which the
investment was made, that two funds were not acting together in respect of the
investment. The definition of collective investment vehicle cross-refers to the definition
set out in the 2010 Report on the Granting of Treaty Benefits with Respect to the Income
of Collective Investment Vehicles.
Constitution
383. The term constitution is used in the definition of director and voting rights. These
terms are used for determining the amount of investment held by one person in another
person for the purposes of the related party and control group tests in Recommendation 11.
D/NI outcome
384. The hybrid mismatch rules in Chapters 1, 3 and 4 of the report neutralise the
effects of mismatches that are D/NI outcomes. A D/NI outcome arises where a payment is
deductible under the laws of one jurisdiction (the payer jurisdiction) and is not included
in ordinary income under the laws of any other jurisdiction where the payment is treated
as being received (the payee jurisdiction).
Differences in valuation
385. A D/NI outcome can arise from differences between tax jurisdictions in the way
they measure the value ascribed to a payment. This principle is illustrated in Example
1.13 and Example 1.16 where a taxpayer treats a loan from its parent as having been
issued at a discount and accrues this discount as an expense over the life of the loan. A
mismatch could arise, on the facts of these examples, if the parent adopted the same
accounting treatment as the subsidiary but attributed a lower value to the discount. In
such a case the amount accrued as a deduction in each accounting period would not be
matched by the same inclusion in the parent jurisdiction.
386. If however, both jurisdictions characterise the payment in the same way and
arrive at the same monetary value for a payment then there will generally be no mismatch
in tax outcomes within the scope of the recommendations (see Example 1.15). While
there may be differences in tax outcomes that arise from the valuation of a payment or in
translating a payment into local currency, these differences in will not give rise to a D/NI
outcome. This principle is illustrated in Example 1.17 where payments of interest and
principal under the loan are payable in a foreign currency. A fall in the value of the local
currency results in the payments under the loan becoming more expensive in local
currency terms. Under local law, the payer is entitled to a deduction for this increased
cost. This deduction, however, is not reflected by a corresponding inclusion in the payee
jurisdiction. The difference in tax treatment does not give rise to a D/NI outcome,
however, as the proportion of the interest and principal payable under the loan is the same
under the laws of both jurisdictions.
Entity located in a no tax jurisdiction

387. The recommendations in the report with respect to D/NI arrangements are not
intended to capture payments made to a person resident in a no-tax jurisdiction. As
illustrated in Example 1.6 a payment will not be treated as giving rise to a D/NI outcome
if it is received by a person who is not subject to tax in any jurisdiction.
DD outcome
388. The hybrid mismatch rules in Chapter 6 and 7 of the report neutralise the effects
of mismatches that are DD outcomes. A DD outcome arises where a payment that is
deductible under the laws of one jurisdiction (the payer jurisdiction) triggers a duplicate
deduction under the laws of another jurisdiction.
Deduction
389. The concept of deduction and deductible refer to an item of expenditure that
is eligible to be offset against a taxpayers ordinary income when that persons liability to
income tax under the laws of the taxpayers jurisdiction. The definition should include
any tax relief that is economically equivalent to a deduction such as a tax credit for
dividends paid.
390. The recommendations focus on whether a payment falls into the category of a
deductible item under the laws of the relevant jurisdiction and the jurisdiction specific
details of the taxpayers net income calculation should not generally affect the question of
whether a payment is deductible for tax purposes. Interest that is capitalised into the cost
of an asset should, for example, be treated as deductible for the purposes of this rule.
391. Under the hybrid mismatch rules a deduction must arise in respect of a
payment. Therefore the starting point in applying the hybrid mismatch rules is to look
for the legal basis for the deduction to determine whether the deduction relates to actual
expenditure or transfer or value rather than it being a purely notional amount for tax
purposes.
Director
392. A director includes a director of a company. The term also applies to anyone,
such as a trustee of a trust, who has been formally appointed under the constituent
documents to manage and control another person. The ability to appoint a director is used
as part of the determination of voting rights. These terms are used for determining the
amount of investment held by one person in another for the purposes of the related party
and control group tests in Recommendation 11.
Distribution
393. The term distribution is used to determine a persons voting rights under the
related party and control group tests in Recommendation 11 and as part of the definition
of equity return, which is used for calculating the amount of a persons equity interest and
for defining what arrangements should be treated as a financial instrument in
Recommendation 1.3.

394. The measurement of dual inclusion income is relevant to determining the amount
of deduction restricted under the hybrid mismatch rules in Chapters 3, 6 and 7 of the
report.
Equity interest
395. An amount of a persons equity interest is used to determine whether they fall
within the related party or control group tests in Recommendation 11.
Equity return
396. The definition of equity return is used for calculating the amount of a persons
equity interest in another person in order to determine whether they fall within the related
party or control group tests in Recommendation 11. The definition is also used to
determine the scope of the term financial instrument in Recommendation 1.2(c).
Establishment jurisdiction
397.
The term establishment jurisdiction is used in Recommendation 1.5 in describing
an exception to the hybrid financial instrument rule and in Recommendation 4 in respect
of the definition of a reverse hybrid. The term refers to the jurisdiction where a person is
incorporated or otherwise established. For entities such as companies that are established
by formal registration this will be the jurisdiction where the entity is registered. For
entities such as partnerships or trusts that may not require formal registration, this will be
the jurisdiction under whose laws the entity is created or operates.
Family
398. The rules on aggregation of ownership interests set out in Recommendation 11.3
of the report, state that two persons will be treated as acting together in respect of their
interest in an entity if they are members of the same family.
399. When introducing this test into domestic law, jurisdictions should ensure that the
applicable test for family captures:
(a) a persons spouse (including civil partner);
(b) a persons brother, sister, child, parent, grandparent or grandchild (i.e. a relative);
(c) anyone who is a relative of that persons spouse or a spouse of a relative.
400. The test should include adopted persons but does not extend to indirect and nonlineal descendants (such as a persons nephew or niece).
Financing return
401. The definition of financing return is used to determine the scope of the term
financial instrument in Recommendation 1.2(c). It includes any arrangement that is
designed to provide a person with a return for the time value of money.
Hybrid mismatch
402. Each recommendation for hybrid mismatch rules contains its own definition of
when a mismatch constitutes a hybrid mismatch. The definition in Recommendation 12
serves as a collective definition for the specific definitions set out in each of the
recommendations.
Included in ordinary income

403. A payment that is included in ordinary income under the laws of the payee
jurisdiction will not give rise to D/NI outcome.
404. The requirement that the payment be included as ordinary income by the payee
means that the payment is required to be incorporated into the payees income tax
calculation as ordinary income. The concept of ordinary income is discussed further
below.
405. A consideration of whether a payment has been included in ordinary income
requires a proper determination of the character and treatment of the payment under the
laws of the counterparty jurisdiction.
A payment treated as included in ordinary income if offset against losses

406. A payment that is offset against deductible expenditure or losses that have been
carried-forward would, on this definition, be treated as having been included in income.
Withholding taxes
407. A country will continue to levy withholding taxes on payments that are subject to
adjustment under the hybrid mismatch rules in accordance with its domestic law and
consistent with its treaty obligations. The function of withholding taxes under the laws of
the payer jurisdiction is generally not to address mismatches in tax outcomes and a
payment should not be treated as included in ordinary income simply because it has been
subject to withholding at source. The primary rule denying the deduction may apply in
cases in which the payer jurisdiction also imposes a withholding tax on the payment as it
is still important to neutralise the hybrid mismatch in those cases. Withholding taxes
alone do not neutralise the hybrid mismatch as withholding taxes, where applicable, often
are imposed with respect to equity instruments.
Investor
408. The definition of investor is incorporated into the recommendations dealing with
hybrid entities as follows:
(a) An entity will be treated as a reverse hybrid under Recommendation 5 where it is
treated as transparent under the laws of its own jurisdiction but as a separate entity
by an investor.
(b) Further a D/NI outcome that arises in respect of a payment made to that reverse
hybrid will be treated as a hybrid mismatch if the D/NI outcome would not have
arisen had the accrued income been paid directly to the investor.
Money
409. The definition of money forms part of the definition of payment. The broad
definition of money means that the term payment will generally include the transfer of
anything that has exchangeable value.
410. A D/NI outcome can arise from differences between tax jurisdictions in the way
they measure the value ascribed to a payment, however, if both jurisdictions arrive at the
same monetary value for a payment then the value attributed to that payment will be the
same. Differences in the valuation of money itself (such as gains and losses from foreign
currency fluctuations) will not give rise to a D/NI outcome provided the proportion of the
interest and principal payable under the loan is the same under the laws of both
jurisdictions.
Offshore investment regime

411. Recommendation 5.1 provides that jurisdictions should introduce, or make
changes to their, offshore investment regimes in order to prevent D/NI outcomes from
arising in respect of payments to a reverse hybrid.
Ordinary income
412. The definition of ordinary income is used to both identify hybrid mismatch
arrangements that produce D/NI outcomes and to neutralise their effect.
A payment will not qualify as ordinary income unless it is taxed at the full
marginal rate
413. A payment will not treated as included in ordinary income if the payee
jurisdiction does not tax the payment at the taxpayers full marginal rate. The definition
of ordinary income excludes any type of income that is subject to preferential tax
treatment regardless of the form in which the tax relief is provided.
414. A payment will not be treated as ordinary income if tax on the payment is relieved
by excluding or exempting all or part of a payment from taxation (see Example 1.1) or
the full payment is subject to tax but at a lower rate (see Example 1.3). Alternatively, the
entire amount of the payment may be taxed at the full tax rate but the jurisdiction may
permit the taxpayer to claim some other form of tax relief that attaches to a payment of
that nature, such as a credit for underlying foreign taxes (see Example 1.4) or a deemed
deduction. Income is considered subject to tax at the taxpayers full marginal rate,
however, notwithstanding that the tax on the inclusion is reduced by a credit or other tax
relief granted by the payee jurisdiction for withholding tax or other taxes imposed by the
source jurisdiction on the payment itself.
A taxpayers full marginal rate is the expected rate of tax on ordinary income
under that arrangement.
415. In the context of the hybrid financial instrument rule, the payees full marginal
rate is the tax the payee would be expect to pay on ordinary income derived under a
financial instrument, so that a mismatch will not arise, for the purposes of the hybrid
financial instrument rule, simply because the payee jurisdiction taxes financial
instruments at a lower rate from other types of income.
Treating a payment as ordinary income under the secondary rule

416. If the arrangement gives rise to a mismatch and the hybrid mismatch rule calls for
an adjustment to be made under the secondary rule, the adjustment is confined to
adjusting the taxation of the payment itself. Changing the tax treatment of the payment
will not necessarily result in an increased tax liability for the payee. As illustrated in
Example 1.5 and Example 1.8 no additional tax liability will arise under the secondary
rule if the payee is not subject to tax on ordinary income or exempt from tax on income
from particular sources.
Payee
417. A payee means any person who receives a payment. The payee will generally be
the person with the legal right to the payment. There may be cases, however, where, due
to tax transparency of the direct recipient, the payment is not included in ordinary income
by the direct payee but is included in the income of an underlying investor. In this case
the taxpayer will have the burden of establishing, to the reasonable satisfaction of the tax
administration, how the tax transparency of the direct recipient and the tax treatment of
the payment by the underlying investor impacts on the amount of the adjustment required
under the rule.
Payee jurisdiction
418. The payee jurisdiction includes any jurisdiction where the payee is a taxpayer. It
therefore includes a non-resident receiving a payment through a PE in the payee
jurisdiction. As illustrated in Example 1.8, a person may therefore receive the same
payment in more than one jurisdiction (i.e. there can be one payee that receives the
payment in two jurisdictions). In such cases the taxpayer will generally have the burden
of establishing, to the reasonable satisfaction of the tax administration, how the tax
treatment in the third jurisdiction impacts on the amount of the adjustment required under
the rule.
419. Although D/NI outcomes most commonly arise where the payer and payee
jurisdictions are different, this is not a requirement of the hybrid mismatch rules.
Example 1.10 illustrates a case where the payer and payee are in the same jurisdiction,
but the arrangement still gives rise to a hybrid mismatch owing to differences in the way
payments are accounted for under the arrangement. Example 1.21 also illustrates a case
where the payer and payee are in the same jurisdiction.
Payer
420. A payer means any person who makes a payment. This will generally be the
person with the legal obligation to the payment. There may be cases, however, where, due
to tax transparency of the direct payer, the payment is treated as made by an underlying
investor. In this case the taxpayer will have the burden of establishing, to the reasonable
satisfaction of the tax administration, how the tax transparency of the payer and the tax
treatment of the payment by the underlying investor impacts on the amount of the
adjustment required under the rule.
Payer jurisdiction
421. The payer jurisdiction includes any jurisdiction where the payer is a taxpayer. It
therefore includes a non-resident making a payment through a PE in the payer
jurisdiction. As illustrated in Example 1.23 and Example 4.4, and as is evident in the
context of DD outcomes a payment may be treated as made by taxpayers in more than
one jurisdiction (i.e. there can be one payer that is treated as making the same payment).
In such cases, the taxpayer will generally have the burden of establishing, to the
reasonable satisfaction of the tax administration, how the tax treatment in the other payer
jurisdiction impacts on the amount of the adjustment required under the rule.. Although,
in the context of DD outcomes, there are, in effect, two payer jurisdictions,
Recommendation 6 uses the terms payer jurisdiction and parent jurisdiction to
distinguish between the jurisdictions where the deduction and the duplicate deduction
arises.
422.
Although mismatches in tax outcomes most commonly arise in cross-border
situations, this is not a requirement of the hybrid mismatch rules. The restrictions on
double deductions apply equally to residents and non-residents and, as discussed above,
in respect of the definition of payee jurisdiction, D/NI outcomes can also arise in
circumstances where the payer and payee are residents of the same jurisdiction.
Payment
423. Payment means a payment of money (which includes moneys worth) made under
the financing instrument and includes a distribution, credit or accrual. It includes an
amount that is capable of being paid and includes any future or contingent obligation to
make a payment. The definition of payment includes notional amounts that accrue in
respect of a future payment obligation even when the amount accrued does not
correspond to any increase in the payment obligation during that period. Where the
context requires, payment should include part of any payment.
424. A payment will be treated as having been made when the relevant payment
obligation is incurred under the laws of the payer jurisdiction or the payment is derived
under the laws of the recipient jurisdiction.
Taxpayer
425. A reference to taxpayer in respect of a jurisdiction should generally include a
person who is tax resident in that jurisdiction and any other person to the extent they are
subject to net income taxation in that jurisdiction through a PE. A person established in a
jurisdiction that does not impose a corporate income tax will not be treated as a taxpayer
of that jurisdiction.
Voting rights
426. An amount of a persons voting rights is used to determine whether they fall
within the related party or control group tests in Recommendation 11.
Bibliography
OECD (2010), Granting of Treaty Benefits with Respect to the Income of Collective
Investment Vehicles , OECD Publishing, Paris, www.oecd.org/tax/treaties/45359261.pdf.
PART II. RECOMMENDATIONS ON TREATY ISSUES 133
Part II
Recommendations on treaty issues
INTRODUCTION TO PART II 135
Introduction to Part II
427. Part II of this report complements Part I and deals with the parts of Action 2 that
indicate that the outputs of the work on that action item may include changes to the
OECD Model Tax Convention (OECD, 2014) to ensure that hybrid instruments and
entities (as well as dual resident entities) are not used to obtain the benefits of treaties
unduly and that stress that [s]pecial attention should be given to the interaction between
possible changes to domestic law and the provisions of the OECD Model Tax
Convention.1
428. This part first examines treaty issues related to dual resident entities (Chapter 13).
It then includes a proposal for a new treaty provision dealing with transparent entities
(Chapter 14). Chapter 15 addresses the issue of the interaction between the
recommendations included in Part I of this report and the provisions of tax treaties.
429. At the outset, it should be noted that a number of treaty provisions resulting from
the work on Action 6 (Preventing Treaty Abuse) may play an important role in ensuring
that hybrid instruments and entities (as well as dual resident entities) are not used to
obtain the benefits of treaties unduly. The following provisions included in the report on
Action 6 may be of particular relevance:
(a) limitation-on-benefits rules;2
(b) rule aimed at arrangements one of the principal purposes of which is to obtain
treaty benefits; 3
(c) rule aimed at dividend transfer transactions (i.e. to subject the lower rate of tax
provided by Art. 10(2)a) or by a treaty provision applicable to pension funds to a
minimum shareholding period); 4
(d) rule concerning a Contracting States right to tax its own residents; 5
(e) anti-abuse rule for permanent establishments situated in third States. 6
Notes
1.
See Action 2 Neutralise the effects of hybrid mismatch arrangements (BEPS Action
Plan, OECD 2013), pp. 15-16.
2.
See paragraph 25 of the report Action 6: Preventing the Granting of Treaty Benefits
in Inappropriate Circumstances (OECD, 2015).
3.
Paragraph 26 of the report on Action 6 (OECD, 2015).
4.
5.
6.
Bibliography
OECD (2015), Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit
Shifting Project, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264241695en.
OECD (2014), Model Tax Convention on Income and on Capital: Condensed Version
2014, OECD Publishing, Paris, http://dx.doi.org/ DOI:10.1787/mtc_cond-2014-en.
13. DUAL-RESIDENT ENTITIES 137
Chapter 13
Dual-resident entities
430. Action 2 refers expressly to possible changes to the OECD Model Tax Convention
(OECD, 2014) to ensure that dual resident entities are not used to obtain the benefits of
treaties unduly.
431. The change to Art. 4(3) of the OECD Model Tax Convention (OECD, 2014) that
will result from the work on Action 61 will address some of the BEPS concerns related to
the issue of dual resident entities by providing that cases of dual treaty residence would
be solved on a case-by-case basis rather than on the basis of the current rule based on
place of effective management of entities, which creates a potential for tax avoidance in
some countries. The new version of Art. 4(3) reads as follows:
3.
Where by reason of the provisions of paragraph 1 a person other than an
individual is a resident of both Contracting States, the competent authorities of
the Contracting States shall endeavour to determine by mutual agreement the
Contracting State of which such person shall be deemed to be a resident for the
purposes of the Convention, having regard to its place of effective management,
the place where it is incorporated or otherwise constituted and any other relevant
factors. In the absence of such agreement, such person shall not be entitled to any
relief or exemption from tax provided by this Convention except to the extent and
in such manner as may be agreed upon by the competent authorities of the
Contracting States.
432. This change, however, will not address all BEPS concerns related to dual resident
entities. It will not, for instance, address avoidance strategies resulting from an entity
being a resident of a given State under that States domestic law whilst, at the same time,
being a resident of another State under a tax treaty concluded by the first State, thereby
allowing that entity to benefit from the advantages applicable to residents under domestic
law without being subject to reciprocal obligations (e.g. being able to shift its foreign
losses to another resident company under a domestic law group relief system while
claiming treaty protection against taxation of its foreign profits). That issue arises from a
mismatch between the treaty and domestic law concepts of residence and since the treaty
concept of residence cannot simply be aligned on the domestic law concept of residence
of each Contracting State without creating situations where an entity would be a resident
of the two States for the purposes of the treaty, the solution to these avoidance strategies
must be found in domestic law. Whilst such avoidance strategies may be addressed
through domestic general anti-abuse rules, States for which this is a potential problem
may wish to consider inserting into their domestic law a rule, already found in the
domestic law of some States,2 according to which an entity that is considered to be a
resident of another State under a tax treaty will be deemed not to be a resident under
domestic law.
138 13. DUAL-RESIDENT ENTITIES

433. Also, the change to Art. 4(3) will not address BEPS concerns that arise from
dual-residence where no treaty is involved. Example 7.1 of the report illustrates a dual
consolidation structure where BEPS concerns arise from the fact that two States consider
the same entity as a resident to which each country applies its consolidation regime. In
such a case, the same BEPS concerns arise whether or not there is a tax treaty between
the two States, which indicates that the solution to such a case needs to be found in
domestic laws. It should be noted, however, that if a treaty existed between the two States
and the domestic law of each State included the provision referred to in the preceding
paragraph, the entity would likely be a resident under the domestic law of only one State,
i.e. the State of which it would be a resident under the treaty.
Notes
1.
Paragraph 48 of the report on Action 6, Preventing the Granting of Treaty Benefits

in Inappropriate Circumstances (OECD, 2015).
2.
See subsection 250(5) of the Income Tax Act of Canada and section 18 of the
Corporation Tax Act 2009 of the United Kingdom.
Bibliography
OECD (2015), Preventing the Granting of Treaty Benefits in Inappropriate
2014, OECD Publishing, Paris. http://dx.doi.org/ DOI:10.1787/mtc_cond-2014-en.
Parliament of the United Kingdom (2009), Corporation Tax Act 2009, United Kingdom.
Available at: www.legislation.gov.uk/ukpga/2009/4/contents (accessed on 15
September 2015).
14. TREATY PROVISION ON TRANSPARENT ENTITIES 139
Chapter 14
Treaty provision on transparent entities
434. The 1999 OECD report on The Application of the OECD Model Tax Convention
to Partnerships (the Partnership Report, OECD, 1999)1 contains an extensive analysis of
the application of treaty provisions to partnerships, including in situations where there is a
mismatch in the tax treatment of the partnership. The main conclusions of the Partnership
Report, which have been included in the Commentary of the OECD Model Tax
Convention (OECD, 2014), seek to ensure that the provisions of tax treaties produce
appropriate results when applied to partnerships, in particular in the case of a partnership
that constitutes a hybrid entity.
435. The Partnership Report (OECD, 1999), however, did not expressly address the
application of tax treaties to entities other than partnerships. In order to address that issue,
as well as the fact that some countries have found it difficult to apply the conclusions of
the Partnership Report, it was decided to include in the OECD Model Tax Convention
(OECD, 2014), the following provision and Commentary, which will ensure that income
of transparent entities is treated, for the purposes of the Convention, in accordance with
the principles of the Partnership report. This will ensure not only that the benefits of tax
treaties are granted in appropriate cases but also that these benefits are not granted where
neither Contracting State treats, under its domestic law, the income of an entity as the
income of one of its residents.
Replace Article 1 of the Model Tax Convention by the following (additions to the
existing text appear in bold italics):
Article 1
PERSONS COVERED
1. This Convention shall apply to persons who are residents of one or both of the
Contracting States.
2.
For the purposes of this Convention, income derived by or through an entity or
arrangement that is treated as wholly or partly fiscally transparent under the tax law of
either Contracting State shall be considered to be income of a resident of a Contracting
State but only to the extent that the income is treated, for purposes of taxation by that
State, as the income of a resident of that State.
Add the following paragraphs 26.3 to 26.16 to the Commentary on Article 1 (other
consequential changes to the Commentary on Article 1 would be required):
Paragraph 2
26.3 This paragraph addresses the situation of the income of entities or arrangements
that one or both Contracting States treat as wholly or partly fiscally transparent for tax
purposes. The provisions of the paragraph ensure that income of such entities or
arrangements is treated, for the purposes of the Convention, in accordance with the
140 14. TREATY PROVISION ON TRANSPARENT ENTITIES

principles reflected in the 1999 report of the Committee on Fiscal Affairs entitled The
Application of the OECD Model Tax Convention to Partnerships.2 That report
therefore provides guidance and examples on how the provision should be interpreted
and applied in various situations.
26.4 The report, however, dealt exclusively with partnerships and whilst the
Committee recognised that many of the principles included in the report could also
apply with respect to other non-corporate entities, it expressed the intention to examine
the application of the Model Tax Convention to these other entities at a later stage. As
indicated in paragraph 37 of the report, the Committee was particularly concerned
with cases where domestic tax laws create intermediary situations where a
partnership is partly treated as a taxable unit and partly disregarded for tax purposes.
According to the report
Whilst this may create practical difficulties with respect to a very limited number
of partnerships, it is a more important problem in the case of other entities such as
trusts. For this reason, the Committee decided to deal with this issue in the context
of follow-up work to this report.
26.5 Paragraph 2 addresses this particular situation by referring to entities that are
wholly or partly treated as fiscally transparent. Thus, the paragraph not only serves
to confirm the conclusions of the Partnership Report but also extends the application
of these conclusions to situations that were not directly covered by the report (subject to
the application of specific provisions dealing with collective investment vehicles, see
paragraphs 6.17 to 6.34 above).
26.6 The paragraph not only ensures that the benefits of the Convention are granted
in appropriate cases but also ensures that these benefits are not granted where neither
Contracting State treats, under its domestic law, the income of an entity or
arrangement as the income of one of its residents. The paragraph therefore confirms
the conclusions of the report in such a case (see, for example, example 3 of the report).
Also, as recognised in the report, States should not be expected to grant the benefits of
a bilateral tax convention in cases where they cannot verify whether a person is truly
entitled to these benefits. Thus, if an entity is established in a jurisdiction from which a
Contracting State cannot obtain tax information, that State would need to be provided
with all the necessary information in order to be able to grant the benefits of the
Convention. In such a case, the Contracting State might well decide to use the refund
mechanism for the purposes of applying the benefits of the Convention even though it
normally applies these benefits at the time of the payment of the relevant income. In
most cases, however, it will be possible to obtain the relevant information and to apply
the benefits of the Convention at the time the income is taxed (see for example
paragraphs 6.29 to 6.31 above which discuss a similar issue in the context of collective
investment vehicles).
26.7 The following example illustrates the application of the paragraph:
Example: State A and State B have concluded a treaty identical to the Model Tax
Convention. State A considers that an entity established in State B is a company
and taxes that entity on interest that it receives from a debtor resident in State A.
Under the domestic law of State B, however, the entity is treated as a partnership
and the two members in that entity, who share equally all its income, are each
taxed on half of the interest. One of the members is a resident of State B and the
other one is a resident of a country with which States A and B do not have a
treaty. The paragraph provides that in such case, half of the interest shall be
considered, for the purposes of Article 11, to be income of a resident of State B.
26.8 The reference to income derived by or through an entity or arrangement has a
broad meaning and covers any income that is earned by or through an entity or
arrangement, regardless of the view taken by each Contracting State as to who derives
that income for domestic tax purposes and regardless of whether or not that entity or
arrangement has legal personality or constitutes a person as defined in subparagraph
1 a) of Article 3. It would cover, for example, income of any partnership or trust that
one or both of the Contracting States treats as wholly or partly fiscally transparent.
Also, as illustrated in example 2 of the report, it does not matter where the entity or
arrangement is established: the paragraph applies to an entity established in a third
State to the extent that, under the domestic tax law of one of the Contracting States, the
entity is treated as wholly or partly fiscally transparent and income of that entity is
attributed to a resident of that State.
26.9 The word income must be given the wide meaning that it has for the purposes
of the Convention and therefore applies to the various items of income that are covered
by Chapter III of the Convention (Taxation of Income), including, for example, profits
of an enterprise and capital gains.
26.10 The concept of fiscally transparent used in the paragraph refers to situations
where, under the domestic law of a Contracting State, the income (or part thereof) of
the entity or arrangement is not taxed at the level of the entity or the arrangement but
at the level of the persons who have an interest in that entity or arrangement. This will
normally be the case where the amount of tax payable on a share of the income of an
entity or arrangement is determined separately in relation to the personal
characteristics of the person who is entitled to that share so that the tax will depend on
whether that person is taxable or not, on the other income that the person has, on the
personal allowances to which the person is entitled and on the tax rate applicable to
that person; also, the character and source, as well as the timing of the realisation, of
the income for tax purposes will not be affected by the fact that it has been earned
through the entity or arrangement. The fact that the income is computed at the level of
the entity or arrangement before the share is allocated to the person will not affect that
result.3 States wishing to clarify the definition of fiscally transparent in their
bilateral conventions are free to include a definition of that term based on the above
explanations.
26.11 In the case of an entity or arrangement which is treated as partly fiscally
transparent under the domestic law of one of the Contracting States, only part of the
income of the entity or arrangement might be taxed at the level of the persons who
have an interest in that entity or arrangement as described in the preceding paragraph
whilst the rest would remain taxable at the level of the entity or arrangement. This, for
example, is how some trusts and limited liability partnerships are treated in some
countries (i.e. in some countries, the part of the income derived through a trust that is
distributed to beneficiaries is taxed in the hands of these beneficiaries whilst the part of
that income that is accumulated is taxed in the hands of the trust or trustees; similarly,
in some countries, income derived through a limited partnership is taxed in the hands
of the general partner as regards that partners share of that income but is considered
to be the income of the limited partnership as regards the limited partners share of the
income). To the extent that the entity or arrangement qualifies as a resident of a
Contracting State, the paragraph will ensure that the benefits of the treaty also apply to
142 14. TREATY PROVISION ON TRANSPARENT ENTITIES

the share of the income that is attributed to the entity or arrangement under the
domestic law of that State (subject to any anti-abuse provision such as a limitation-onbenefits rule).
26.12 As with other provisions of the Convention, the provision applies separately to
each item of income of the entity or arrangement. Assume, for example, that the
document that establishes a trust provides that all dividends received by the trust must
be distributed to a beneficiary during the lifetime of that beneficiary but must be
accumulated afterwards. If one of the Contracting States considers that, in such a case,
the beneficiary is taxable on the dividends distributed to that beneficiary but that the
trustees are taxable on the dividends that will be accumulated, the paragraph will apply
differently to these two categories of dividends even if both types of dividends are
received within the same month.
26.13 By providing that the income to which it applies will be considered to be income
of a resident of a Contracting State for the purposes of the Convention, the paragraph
ensures that the relevant income is attributed to that resident for the purposes of the
application of the various allocative rules of the Convention. Depending on the nature
of the income, this will therefore allow the income to be considered, for example, as
income derived by for the purposes of Articles 6, 13 and 17, profits of an
enterprise for the purposes of Articles 7, 8 and 9 (see also paragraph 4 of the
Commentary on Article 3) or dividends or interest paid to for the purposes of Articles
10 and 11. The fact that the income is considered to be derived by a resident of a
Contracting State for the purposes of the Convention also means that where the
income constitutes a share of the income of an enterprise in which that resident holds
a participation, such income shall be considered to be the income of an enterprise
carried on by that resident (e.g. for the purposes of the definition of enterprise of a
Contracting State in Article 3 and paragraph 2 of Article 21).
26.14 Whilst the paragraph ensures that the various allocative rules of the Convention
are applied to the extent that income of fiscally transparent entities is treated, under
domestic law, as income of a resident of a Contracting State, the paragraph does not
prejudge the issue of whether the recipient is the beneficial owner of the relevant
income. Where, for example, a fiscally transparent partnership receives dividends as
an agent or nominee for a person who is not a partner, the fact that the dividend may
be considered as income of a resident of a Contracting State under the domestic law of
that State will not preclude the State of source from considering that neither the
partnership nor the partners are the beneficial owners of the dividend.
26.15 The paragraph only applies for the purposes of the Convention and does not,
therefore, require a Contracting State to change the way in which it attributes income
or characterises entities for the purposes of its domestic law. In the example in
paragraph 26.7 above, whilst paragraph 2 provides that half of the interest shall be
considered, for the purposes of Article 11, to be income of a resident of State B, this
will only affect the maximum amount of tax that State A will be able to collect on the
interest and will not change the fact that State As tax will be payable by the entity.
Thus, assuming that the domestic law of State A provides for a 30 per cent withholding
tax on the interest, the effect of paragraph 2 will simply be to reduce the amount of tax
that State A will collect on the interest (so that half of the interest would be taxed at 30
per cent and half at 10 per cent under the treaty between States A and B) and will not
change the fact that the entity is the relevant taxpayer for the purposes of State As
domestic law. Also, the provision does not deal exhaustively with all treaty issues that
may arise from the legal nature of certain entities and arrangements and may
therefore need to be supplemented by other provisions to address such issues (such as a
provision confirming that a trust may qualify as a resident of a Contracting State
despite the fact that, under the trust law of many countries, a trust does not constitute a
person).
26.16 As confirmed by paragraph 3, paragraph 2 does not restrict in any way a States
right to tax its own residents. This conclusion is consistent with the way in which tax
treaties have been interpreted with respect to partnerships (see paragraph 6.1
above).This, however, does not restrict the obligation to provide relief of double
taxation that is imposed on a Contracting State by Articles 23 A and 23 B where
income of a resident of that State may be taxed by the other State in accordance with
the Convention, taking into account the application of the paragraph].4
Notes
1.
OECD (1999), The Application of the OECD Model Tax Convention to Partnerships,
Issues in International Taxation, No. 6, OECD Publishing, Paris.
2.
Reproduced in Volume II of the full-length version of the OECD Model Tax

Convention (OECD, 2014) at page R(15)-1.
3.
See paragraphs 37-40 of the Partnership Report.
4.
[Double taxation issues related to the transparent entity provision will be addressed as
part of the work that will be done on the draft proposal included in paragraph 64 of
the report on Action 6.]
Bibliography
OECD (2014), Model Tax Convention on Income and on Capital: Full Version 2014,
OECD (1999), The Application of the OECD Model Tax Convention to Partnerships,
Issues in International Taxation, No. 6, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264173316-en.
15. INTERACTION BETWEEN PART I AND TAX TREATIES 145
Chapter 15
Interaction between part I and tax treaties
436.
Part I of this report includes various recommendations for the domestic law
treatment of hybrid financial instruments and hybrid entity payments. Since Action 2
provides that [s]pecial attention should be given to the interaction between possible
changes to domestic law and the provisions of the OECD Model Tax Convention, it is
necessary to examine treaty issues that may arise from these recommendations.
Rule providing for the denial of deductions

437. Chapter 1 of Part I includes a recommended hybrid mismatch rule under which
the payer jurisdiction will deny a deduction for such payment to the extent it gives rise
to a D/NI outcome to neutralise the effects of hybrid mismatches with respect to a
payment under a financial instrument. This raises the question of whether tax treaties, as
currently drafted, would authorise such a denial of deduction.
438. Apart from the rules of Articles 7 and 24, the provisions of tax treaties do not
govern whether payments are deductible or not and whether they are effectively taxed or
not, these being matters of domestic law. The possible application of the provisions of
Article 24 with respect to the recommendations set out in Part I of this report is discussed
below; as regards Article 7, paragraph 30 of the Commentary on that Article is
particularly relevant:
30. Paragraph 2 [of Article 7] determines the profits that are attributable to a
permanent establishment for the purposes of the rule in paragraph 1 that
allocates taxing rights on these profits. Once the profits that are attributable to a
permanent establishment have been determined in accordance with paragraph 2
of Article 7, it is for the domestic law of each Contracting State to determine
whether and how such profits should be taxed as long as there is conformity with
the requirements of paragraph 2 and the other provisions of the Convention.
Paragraph 2 does not deal with the issue of whether expenses are deductible
when computing the taxable income of the enterprise in either Contracting State.
The conditions for the deductibility of expenses are a matter to be determined by
domestic law, subject to the provisions of the Convention and, in particular,
paragraph 3 of Article 24
Defensive rule requiring the inclusion of a payment in ordinary income

439.
Chapter 1 of Part I also includes a recommended defensive rule under which
[i]f the payer jurisdiction does not neutralise the mismatch then the payee jurisdiction
will require such payment to be included in ordinary income to the extent the payment
gives rise to a D/NI outcome. The provisions of tax treaties could be implicated if such a
146 15. INTERACTION BETWEEN PART I AND TAX TREATIES

rule would seek the imposition of tax on a non-resident whose income would not, under
the provisions of the relevant tax treaty, be taxable in that State. By virtue of the
combination of the definitions of payee and taxpayer in the recommendations (Part I,
Chapter 12), that rule contemplates the imposition of tax by a jurisdiction only in
circumstances where the recipient of the payment is a resident of that jurisdiction or
maintains a permanent establishment in that jurisdiction. Since the allocative rules of tax
treaties generally do not restrict the taxation rights of the State in such circumstances, any
interaction between the recommendation and the provisions of tax treaties will therefore
appear to relate primarily to the rules concerning the elimination of double taxation
(Articles 23 A and 23 B of the OECD Model Tax Convention, OECD, 2014).
440. The following two recommendations included in Part I of this report deal with the
elimination of double taxation by the State of residence:
(a) In order to prevent D/NI outcomes from arising under a financial instrument, a
dividend exemption that is provided for relief against economic double taxation
should not be granted under domestic law to the extent the dividend payment is
deductible by the payer. Equally, jurisdictions should consider adopting similar
restrictions for other types of dividend relief granted to relieve economic double
taxation on underlying profits. [Recommendation 2.1].
(b) In order to prevent duplication of tax credits under a hybrid transfer, any
jurisdiction that grants relief for tax withheld at source on a payment made under a
hybrid transfer should restrict the benefit of such relief in proportion to the net
taxable income of the taxpayer under the arrangement. [Recommendation 2.2].
441. As explained below, these recommendations do not appear to raise any issues
with respect to the application of Articles 23 A and Articles 23 B of the OECD Model
Tax Convention (OECD, 2014).
Exemption method
442. As regards Articles 23 A (Exemption Method), paragraph 2 of that Article
provides that in the case of dividends (covered by Article 10 of the OECD Model Tax
Convention, OECD, 2014), it is the credit method, and not the exemption method, that is
applicable. The Recommendation that a dividend exemption that is provided for relief
against economic double taxation should not be granted under domestic law to the extent
the dividend payment is deductible by the payer should not, therefore, create problems
with respect to bilateral tax treaties that include the wording of Article 23 A.
443. It is recognised, however, that a number of bilateral tax treaties depart from the
provisions of Article 23 A and provide for the application of the exemption method with
respect to dividends received from foreign companies in which a resident company has a
substantial shareholding. This possibility is expressly acknowledged in the OECD Model
Tax Convention (OECD, 2014)(see paragraphs 49 to 54 of the Commentary on Articles
23 A and 23 B).
444. Problems arising from the inclusion of the exemption method in tax treaties with
respect to items of income that are not taxed in the State of source have long been
recognised in the OECD Model Tax Convention (OECD, 2014) (see, for example,
paragraph 35 of the Commentary on Articles 23 A and 23 B). Whilst paragraph 4 of
Article 23 A1 may address some situations of hybrid mismatch arrangements where a
dividend would otherwise be subject to the exemption method, many tax treaties do not
include that provision. At a minimum, therefore, States that wish to follow the above
recommendations included in Part I of this report but that enter into tax treaties providing
for the application of the exemption method with respect to dividends should consider the
inclusion of paragraph 4 of Article 23 A in their tax treaties, although these States should
also recognise that the provision will only provide a partial solution to the problem. A
more complete solution that should be considered by these States would be to include in
their treaties rules that would expressly allow them to apply the credit method, as opposed
to the exemption method, with respect to dividends that are deductible in the payer State.
These States may also wish to consider a more general solution to the problems of
non-taxation resulting from potential abuses of the exemption method, which would be
for States not to include the exemption method in their treaties. Under that approach, the
credit method would be provided for in tax treaties, thereby ensuring the relief of juridical
double taxation, and it would be left to domestic law to provide whether that should be
done through the credit or exemption method (or probably through a combination of the
two methods depending on the nature of the income, as is the case of the domestic law of
many countries). The issue that may arise from granting a credit for underlying taxes
(which is not a feature of Articles 23 A and 23 B of the OECD Model Tax Convention,
OECD, 2014) is discussed below.
Credit method
445. As regards the application of the credit method provided for by paragraph 2 of
Article 23 A and by Article 23 B, the recommendation that relief should be restricted in
proportion to the net taxable income under the arrangement appears to conform to the
domestic tax limitation provided by that method. As noted in paragraphs 60 and 63 of the
Commentary on Articles 23 A and 23 B, Article 23 B leaves it to domestic law to
determine the domestic tax against which the foreign tax credit should be applied (the
maximum deduction) and one would normally expect that this would be the State of
residences tax as computed after taking into account all relevant deductions:
60.
Article 23 B sets out the main rules of the credit method, but does not
give detailed rules on the computation and operation of the credit. ... Experience
has shown that many problems may arise. Some of them are dealt with in the
following paragraphs. In many States, detailed rules on credit for foreign tax
already exist in their domestic laws. A number of conventions, therefore, contain
a reference to the domestic laws of the Contracting States and further provide
that such domestic rules shall not affect the principle laid down in Article 23 B.
63.
The maximum deduction is normally computed as the tax on net income,
i.e. on the income from State E (or S) less allowable deductions (specified or
proportional) connected with such income...
446. It is recognised, however, that double non-taxation situations may arise in the
application of the credit method by reasons of treaty or domestic law provisions that
either supplement, or depart from, the basic approach of Article 23 B (Credit Method) of
the OECD Model Tax Convention (OECD, 2014). One example would be domestic law
provisions that allow the foreign tax credit applicable to one item of income to be used
against the State of residences tax payable on another item of income. Another example
would be where treaty or domestic law provisions provide for an underlying foreign tax
credit with respect to dividends, which may create difficulties with respect to the part of
Recommendation 2.1 according to which jurisdictions should consider adopting similar
restrictions for other types of dividend relief granted to relieve economic double taxation

on underlying profits. These are other situations where Contracting States should ensure
that their tax treaties provide for the elimination of double taxation without creating
opportunities for tax avoidance strategies.
Potential application of anti-discrimination provisions in the OECD Model Tax

Convention
447. The basic thrust of the recommendations set out in Part I of this report is to ensure
that payments are treated consistently in the hands of the payer and the recipient and, in
particular, to prevent a double deduction or deduction without a corresponding inclusion.
These recommendations do not appear to raise any issue of discrimination based on
nationality (Art. 24(1)). They also do not appear to treat permanent establishments
differently from domestic enterprises (Art. 24(3), to provide different rules for the
deduction of payments made to residents and non-residents (Art. 24(4)) or to treat
domestic enterprises differently based on whether their capital is owned or controlled by
residents or non-residents (Art. 24(5)).
448. Some of the domestic law recommendations to neutralise the effects of hybrid
mismatch arrangements that are included in Part I may impact payments to non-residents
more than they will impact payments to residents. This, however, is not relevant for the
purposes of Article 24 as long as the distinction is based on the treatment of the payments
in the hands of the payers and recipients. The fact that a mismatch in the tax treatment of
an entity or payment is less likely in a purely domestic context (i.e. one would expect a
country to be consistent in the way it characterises domestic payments and entities)
cannot be interpreted as meaning that rules that are strictly based on the existence of such
a mismatch are treating payments to non-residents, or to non-resident owned enterprises,
differently from the way payments to residents, or resident-owned enterprises, are treated
under domestic law.
449. The following excerpts from the Commentary on Article 24 are of particular
relevance in that context:
(a) As regards all the provisions of Art. 24: The non-discrimination provisions of the
Article seek to balance the need to prevent unjustified discrimination with the need to
take account of these legitimate distinctions. For that reason, the Article should not be
unduly extended to cover so-called indirect discrimination. (paragraph 1)
Also, whilst the Article seeks to eliminate distinctions that are solely based on
certain grounds, it is not intended to provide foreign nationals, non-residents,
enterprises of other States or domestic enterprises owned or controlled by
non-residents with a tax treatment that is better than that of nationals, residents or
domestic enterprises owned or controlled by residents (paragraph 3)
(b) As regards Art. 24(3): That principle, therefore, is restricted to a comparison between
the rules governing the taxation of the permanent establishments own activities and
those applicable to similar business activities carried on by an independent resident
enterprise. It does not extend to rules that take account of the relationship between an
enterprise and other enterprises (e.g. rules that allow consolidation, transfer of losses or
tax-free transfers of property between companies under common ownership) since the
latter rules do not focus on the taxation of an enterprises own business activities
similar to those of the permanent establishment but, instead, on the taxation of a
resident enterprise as part of a group of associated enterprises. (paragraph 41)
(c) As regards Art 24(4): This paragraph is designed to end a particular form of
discrimination resulting from the fact that in certain countries the deduction of interest,
royalties and other disbursements allowed without restriction when the recipient is
resident, is restricted or even prohibited when he is a non-resident. (paragraph 73)
(d) As regards Art. 24(5): Since the paragraph relates only to the taxation of resident
enterprises and not to that of the persons owning or controlling their capital, it follows
that it cannot be interpreted to extend the benefits of rules that take account of the
relationship between a resident enterprise and other resident enterprises (e.g. rules that
allow consolidation, transfer of losses or tax-free transfer of property between
companies under common ownership). (paragraph 77)
it follows that withholding tax obligations that are imposed on a resident
company with respect to dividends paid to non-resident shareholders but not with
respect to dividends paid to resident shareholders cannot be considered to violate
paragraph 5. In that case, the different treatment is not dependent on the fact that
the capital of the company is owned or controlled by non-residents but, rather, on
the fact that dividends paid to non-residents are taxed differently. (paragraph 78)
450. For these reasons, and subject to an analysis of the precise wording of the
domestic rules that would be drafted to implement the recommendations, the
recommendations set out in Part I of this report would not appear to raise concerns about
a possible conflict with the provisions of Article 24 of the OECD Model Tax Convention
(OECD, 2014).
Notes
1.
4.
The provisions of paragraph 1 [of Article 23 A] shall not apply to income
derived or capital owned by a resident of a Contracting State where the other
Contracting State applies the provisions of this Convention to exempt such income or
capital from tax or applies the provisions of paragraph 2 of Article 10 or 11 to such
income.
Bibliography
ANNEX A. SUMMARY OF PART I RECOMMENDATIONS 151
Annex A
List of Part I Recommendations
Recommendations
Recommendation 1
Hybrid Financial Instrument Rule
Recommendation 2
Specific Recommendations for the Tax Treatment of Financial Instruments
Recommendation 3
Disregarded Hybrid Payments Rule
Recommendation 4
Reverse Hybrid Rule
Recommendation 5
Specific Recommendations for The Tax Treatment of Reverse Hybrids
Recommendation 6
Deductible Hybrid Payments Rule
Recommendation 7
Dual Resident Payer Rule
Recommendation 8
Imported Mismatch Rule
Recommendation 9
Design Principles
Recommendation 10
Definition of Structured Arrangement
Recommendation 11
Definition of Related Persons, Control Group and Acting Together
Recommendation 12
Other Definitions
Recommendation 1
Hybrid financial instrument rule
The following rule should apply to a payment under a financial instrument that results in a hybrid
mismatch and to a substitute payment under an arrangement to transfer a financial instrument:
(a)
D/NI outcome.
(b)
to a D/NI outcome.
(c)
Differences in the timing of the recognition of payments will not be treated as giving rise to
a D/NI outcome for a payment made under a financial instrument, provided the taxpayer can
establish to the satisfaction of a tax authority that the payment will be included as ordinary
income within a reasonable period of time.
2. Definition of financial instrument and substitute payment

For the purposes of this rule:
(a)
A financial instrument means any arrangement that is taxed under the rules for taxing debt,
equity or derivatives under the laws of both the payee and payer jurisdictions and includes a
hybrid transfer.
(b)
A hybrid transfer includes any arrangement to transfer a financial instrument entered into by
a taxpayer with another person where:
(i) the taxpayer is the owner of the transferred asset and the rights of the
counterparty in respect of that asset are treated as obligations of the taxpayer; and
(ii) under the laws of the counterparty jurisdiction, the counterparty is the owner of
the transferred asset and the rights of the taxpayer in respect of that asset are
treated as obligations of the counterparty.
Ownership of an asset for these purposes includes any rules that result in the taxpayer being
taxed as the owner of the corresponding cash-flows from the asset.
(c)
A jurisdiction should treat any arrangement where one person provides money to another in
consideration for a financing or equity return as a financial instrument to the extent of such
(d)
Any payment under an arrangement that is not treated as a financial instrument under the
laws of the counterparty jurisdiction shall be treated as giving rise to a mismatch only to the
extent the payment constitutes a financing or equity return.
(e)
A substitute payment is any payment, made under an arrangement to transfer a financial

instrument, to the extent it includes, or is payment of an amount representing, a financing or
equity return on the underlying financial instrument where the payment or return would:
154 ANNEX A. SUMMARY OF PART I RECOMMENDATIONS
(i) not have been included in ordinary income of the payer;
(ii) have been included in ordinary income of the payee; or
(iii) have given rise to hybrid mismatch;
if it had been made directly under the financial instrument.
3. Rule only applies to a payment under a financial instrument that results in a hybrid
mismatch
A payment under a financial instrument results in a hybrid mismatch where the mismatch can be
attributed to the terms of the instrument. A payment cannot be attributed to the terms of the
instrument where the mismatch is solely attributable to the status of the taxpayer or the
circumstances in which the instrument is held.

This rule only applies to a payment made to a related person or where the payment is made under a
structured arrangement and the taxpayer is party to that structured arrangement.
5. Exceptions to the rule

The primary response in in Recommendation 1.1(a) should not apply to a payment by an investment
vehicle that is subject to special regulation and tax treatment under the laws of the establishment
jurisdiction in circumstances where:
(a)
The tax policy of the establishment jurisdiction is to preserve the deduction for the payment
under the financial instrument to ensure that:
(i) the taxpayer is subject to no or minimal taxation on its investment income; and
(ii) that holders of financial instruments issued by the taxpayer are subject to tax on
that payment as ordinary income on a current basis.
(b)
The regulatory and tax framework in the establishment jurisdiction has the effect that the
financial instruments issued by the investment vehicle will result in all or substantially all of
the taxpayers investment income being paid and distributed to the holders of those financial
instruments within a reasonable period of time after that income was derived or received by
the taxpayer.
(c)
The tax policy of the establishment jurisdiction is that the full amount of the payment is:
(i) included in the ordinary income of any person that is a payee in the
establishment jurisdiction; and
(ii) not excluded from the ordinary income of any person that is a payee under the
laws of the payee jurisdiction under a treaty between the establishment jurisdiction
and the payee jurisdiction.
(d)
The payment is not made under a structured arrangement.
The defensive rule in Recommendation 1.1(b) will continue to apply to any payment made by such
an investment vehicle.
Recommendation 2
Specific recommendations for the tax treatment
of financial instruments
1. Denial of dividend exemption for deductible payments

In order to prevent D/NI outcomes from arising under a financial instrument, a dividend exemption
that is provided for relief against economic double taxation should not be granted under domestic
law to the extent the dividend payment is deductible by the payer. Equally, jurisdictions should
consider adopting similar restrictions for other types of dividend relief granted to relieve economic
double taxation on underlying profits.
2. Restriction of foreign tax credits under a hybrid transfer

In order to prevent duplication of tax credits under a hybrid transfer, any jurisdiction that grants
relief for tax withheld at source on a payment made under a hybrid transfer should restrict the
benefit of such relief in proportion to the net taxable income of the taxpayer under the arrangement.

There is no limitation as to the scope of these recommendations.
Recommendation 3
The following rule should apply to a disregarded payment made by a hybrid payer that results in a
hybrid mismatch:
(a)
D/NI outcome.
(b)
to a D/NI outcome.
(c)
No mismatch will arise to the extent that the deduction in the payer jurisdiction is set-off
against income that is included in income under the laws of both the payee and the payer
jurisdiction (i.e. dual inclusion income).
(d)
Any deduction that exceeds the amount of dual inclusion income (the excess deduction)
may be eligible to be set-off against dual inclusion income in another period.
2. Rule only applies to disregarded payments made by a hybrid payer

For the purpose of this rule:
A disregarded payment is a payment that is deductible under the laws of the payer
(a)
jurisdiction and is not recognised under the laws of the payee jurisdiction.
(b)
A person will be a hybrid payer where the tax treatment of the payer under the laws of the
payee jurisdiction causes the payment to be a disregarded payment.

A disregarded payment made by a hybrid payer results in a hybrid mismatch if, under the laws of
the payer jurisdiction, the deduction may be set-off against income that is not dual inclusion
income.

This rule only applies if the parties to the mismatch are in the same control group or where the
payment is made under a structured arrangement and the taxpayer is a party to that structured
arrangement.
Recommendation 4
Reverse hybrid rule
1. Neutralise the mismatch to the extent the payment gives rise to D/NI outcome
In respect of a payment made to a reverse hybrid that results in a hybrid mismatch the payer
jurisdiction should apply a rule that will deny a deduction for such payment to the extent it gives
rise to a D/NI outcome.
2. Rule only applies to payment made to a reverse hybrid

A reverse hybrid is any person that is treated as a separate entity by an investor and as
transparent under the laws of the establishment jurisdiction.
3. Rule only applies to hybrid mismatches

A payment results in a hybrid mismatch if a mismatch would not have arisen had the accrued
income been paid directly to the investor.

The recommendation only applies where the investor, the reverse hybrid and the payer are
members of the same control group or if the payment is made under a structured arrangement
and the payer is party to that structured arrangement.
Recommendation 5
Specific recommendations for the tax treatment of reverse hybrids
1. Improvements to CFC and other offshore investment regimes

Jurisdictions should introduce, or make changes to, their offshore investment regimes in order to
prevent D/NI outcomes from arising in respect of payments to a reverse hybrid. Equally
jurisdictions should consider introducing or making changes to their offshore investment regimes in
relation to imported mismatch arrangements.
2. Limiting the tax transparency for non-resident investors

A reverse hybrid should be treated as a resident taxpayer in the establishment jurisdiction if the
income of the reverse hybrid is not brought within the charge to taxation under the laws of the
establishment jurisdiction and the accrued income of a non-resident investor in the same control
group as the reverse hybrid is not brought within the charge to taxation under the laws of the
3. Information reporting for intermediaries

Jurisdictions should introduce appropriate tax filing and information reporting requirements on
persons established within their jurisdiction in order to assist both taxpayers and tax administrations
to make a proper determination of the payments that have been attributed to that non-resident
investor.
Recommendation 6
The following rule should apply to a hybrid payer that makes a payment that is deductible under the
laws of the payer jurisdiction and that triggers a duplicate deduction in the parent jurisdiction that
results in a hybrid mismatch:
(a)
The parent jurisdiction will deny the duplicate deduction for such payment to the extent it
gives rise to a DD outcome.
(b)
If the parent jurisdiction does not neutralise the mismatch, the payer jurisdiction will deny
the deduction for such payment to the extent it gives rise to a DD outcome.
(c)
No mismatch will arise to the extent that a deduction is set-off against income that is
included in income under the laws of both the parent and the payer jurisdictions (i.e. dual
inclusion income).
(d)
establish, to the satisfaction of the tax administration, that the excess deduction in the other
jurisdiction cannot be set-off against any income of any person under the laws of the other
jurisdiction that is not dual inclusion income.
2. Rule only applies to deductible payments made by a hybrid payer

A person will be treated as a hybrid payer in respect of a payment that is deductible under the laws
of the payer jurisdiction where:
(a)
the payer is not a resident of the payer jurisdiction and the payment triggers a duplicate
deduction for that payer (or a related person) under the laws of the jurisdiction where the
payer is resident (the parent jurisdiction); or
(b)
the payer is resident in the payer jurisdiction and the payment triggers a duplicate deduction
for an investor in that payer (or a related person) under the laws of the other jurisdiction (the
parent jurisdiction).

A payment results in a hybrid mismatch where the deduction for the payment may be set-off, under
the laws of the payer jurisdiction, against income that is not dual inclusion income.

The defensive rule only applies if the parties to the mismatch are in the same control group or where
the mismatch arises under a structured arrangement and the taxpayer is party to that structured
arrangement. There is no limitation on scope in respect of the recommended response.
Recommendation 7
Dual resident payer rule
The following rule should apply to a dual resident that makes a payment that is deductible under the
laws of both jurisdictions where the payer is resident and that DD outcome results in a hybrid
mismatch:
(a)
Each resident jurisdiction will deny a deduction for such payment to the extent it gives rise to
a DD outcome.
(b)
No mismatch will arise to the extent that the deduction is set-off against income that is
included as income under the laws of both jurisdictions (i.e. dual inclusion income).
(c)
establish, to the satisfaction of the tax administration, that the excess deduction cannot be setoff against any income under the laws of the other jurisdiction that is not dual inclusion
income.
2. Rule only applies to deductible payments made by a dual resident

A taxpayer will be a dual resident if it is resident for tax purposes under the laws of two or more
jurisdictions.

A deduction for a payment results in a hybrid mismatch where the deduction for the payment may
be set-off, under the laws of the other jurisdiction, against income that is not dual inclusion income.

There is no limitation on the scope of the rule.
Recommendation 8
1. Deny the deduction to the extent the payment gives rise to an indirect D/NI outcome
The payer jurisdiction should apply a rule that denies a deduction for any imported mismatch
payment to the extent the payee treats that payment as set-off against a hybrid deduction in the
payee jurisdiction.
2. Definition of hybrid deduction

Hybrid deduction means a deduction resulting from:
(a)
a payment under a financial instrument that results in a hybrid mismatch;
(b)
a disregarded payment made by a hybrid payer that results in a hybrid mismatch;
(c)
a payment made to a reverse hybrid that results in a hybrid mismatch; or
(d)
a payment made by a hybrid payer or dual resident that triggers a duplicate deduction
resulting in a hybrid mismatch;
and includes a deduction resulting from a payment made to any other person to the extent that
person treats the payment as set-off against another hybrid deduction.
3. Imported mismatch payment

An imported mismatch payment is a deductible payment made to a payee that is not subject to
hybrid mismatch rules.

The rule applies if the taxpayer is in the same control group as the parties to the imported mismatch
arrangement or where the payment is made under a structured arrangement and the taxpayer is party
to that structured arrangement.
Recommendation 9
Design principles
1. Design principles
The hybrid mismatch rules have been designed to maximise the following outcomes:
(a)
neutralise the mismatch rather than reverse the tax benefit that arises under the laws of the
jurisdiction;
(b)
be comprehensive;
(c)
apply automatically;
(d)
avoid double taxation through rule co-ordination;
(e)
minimise the disruption to existing domestic law;
(f)
be clear and transparent in their operation;
(g)
provide sufficient flexibility for the rule to be incorporated into the laws of each jurisdiction;
(h)
be workable for taxpayers and keep compliance costs to a minimum; and
(i)
minimise the administrative burden on tax authorities.
Jurisdictions that implement these recommendations into domestic law should do so in a manner
intended to preserve these design principles.
2. Implementation and co-ordination

Jurisdictions should co-operate on measures to ensure these recommendations are implemented and
applied consistently and effectively. These measures should include:
(a)
the development of agreed guidance on the recommendations;
(b)
co-ordination of the implementation of the recommendations (including timing);
(c)
development of transitional rules (without any presumption as to grandfathering of existing

arrangements);
(d)
review of the effective and consistent implementation of the recommendations;
(e)
exchange of information on the jurisdiction treatment of hybrid financial instruments and

hybrid entities;
(f)
endeavouring to make relevant information available to taxpayers (including reasonable

endeavours by the OECD); and
(g)
consideration of the interaction of the recommendations with other Actions under the BEPS
Action Plan including Actions 3 and 4.
Recommendation 10
Definition of structured arrangement
1. General Definition
Structured arrangement is any arrangement where the hybrid mismatch is priced into the terms of
the arrangement or the facts and circumstances (including the terms) of the arrangement indicate
that it has been designed to produce a hybrid mismatch.
2. Specific examples of structured arrangements

Facts and circumstances that indicate that an arrangement has been designed to produce a hybrid
mismatch include any of the following:
(a)
an arrangement that is designed, or is part of a plan, to create a hybrid mismatch;
(b)
an arrangement that incorporates a term, step or transaction used in order to create a hybrid
mismatch;
(c)
an arrangement that is marketed, in whole or in part, as a tax-advantaged product where

some or all of the tax advantage derives from the hybrid mismatch;
(d)
an arrangement that is primarily marketed to taxpayers in a jurisdiction where the hybrid

mismatch arises;
(e)
an arrangement that contains features that alter the terms under the arrangement, including
the return, in the event that the hybrid mismatch is no longer available; or
(f)
an arrangement that would produce a negative return absent the hybrid mismatch.
3. When taxpayer is not a party to a structured arrangement

A taxpayer will not be treated as a party to a structured arrangement if neither the taxpayer nor any
member of the same control group could reasonably have been expected to be aware of the hybrid
mismatch and did not share in the value of the tax benefit resulting from the hybrid mismatch.
Recommendation 11
Definitions of related persons, control group and acting together
1. General definition
For the purposes of these recommendations:
(a)
Two persons are related if they are in the same control group or the first person has a 25% or
greater investment in the second person or there is a third person that holds a 25% or greater
investment in both.
(b)
Two persons are in the same control group if:

(i) they are consolidated for accounting purposes;
(ii) the first person has an investment that provides that person with effective control
of the second person or there is a third person that holds investments which provides
that person with effective control over both persons;
(iii) the first person has a 50% or greater investment in the second person or there is
a third person that holds a 50% or greater investment in both; or
(iv) they can be regarded as associated enterprises under Article 9.
(c)
A person will be treated as holding a percentage investment in another person if that person
holds directly or indirectly through an investment in other persons, a percentage of the voting
rights of that person or of the value of any equity interest in that person.
2. Aggregation of interests
For the purposes of the related party rules a person who acts together with another person in respect
of ownership or control of any voting rights or equity interests will be treated as owning or
controlling all the voting rights and equity interests of that person.
3. Acting together
Two persons will be treated as acting together in respect of ownership or control of any voting rights
or equity interests if:
(a)
they are members of the same family;
(b)
one person regularly acts in accordance with the wishes of the other person;
(c)
they have entered into an arrangement that has material impact on the value or control of any
such rights or interests; or
(d)
the ownership or control of any such rights or interests are managed by the same person or
group of persons.
If a manager of a collective investment vehicle can establish to the satisfaction of the tax authority,
from the terms of any investment mandate, the nature of the investment and the circumstances that
the hybrid mismatch was entered into, that the two funds were not acting together in respect of the
investment then the interest held by those funds should not be aggregated for the purposes of the
acting together test.
Recommendation 12
Other definitions
1. Definitions
For the purpose of these recommendations:
Accrued income
Accrued income, in relation to any payee and any investor, means income
of the payee that has accrued for the benefit of that investor.
Arrangement
Arrangement refers to an agreement, contract, scheme, plan, or

understanding, whether enforceable or not, including all steps and
transactions by which it is carried into effect. An arrangement may be part
of a wider arrangement, it may be a single arrangement, or it may be
comprised of a number of arrangements.
Collective
investment vehicle
Collective investment vehicle means a collective investment vehicle as

defined in paragraph 4 of the Granting of Treaty Benefits with Respect to
the Income of Collective Investment Vehicles (2010, OECD).
Constitution
Constitution, in relation to any person, means the rules governing the

relationship between the person and its owners and includes articles of
association or incorporation.
D/NI outcome
A payment gives rise to a D/NI outcome to the extent the payment is

deductible under the laws of the payer jurisdiction but is not included in
ordinary income by any person in the payee jurisdiction. A D/NI outcome
is not generally impacted by questions of timing in the recognition of
payments or differences in the way jurisdictions measure the value of that
payment. In some circumstances however a timing mismatch will be
considered permanent if the taxpayer cannot establish to the satisfaction of
a tax authority that a payment will be brought into account within a
reasonable period of time (see Recommendation 1.1(c)).
DD outcome
A payment gives rise to a DD outcome if the payment is deductible under

the laws of more than one jurisdiction.
Deduction
Deduction (including deductible), in respect of a payment, means that, after

a proper determination of the character and treatment of the payment under
the laws of the payer jurisdiction, the payment is taken into account as a
deduction or equivalent tax relief under the laws of that jurisdiction in
calculating the taxpayers net income.
Director
Director, in relation to any person, means any person who has the power
under the constitution to manage and control that person and includes a
trustee.
Distribution
Distribution, in relation to any person, means a payment of profits or gains

by that person to any owner.
Dual inclusion
income
Dual inclusion income, in the case of both deductible payments and

disregarded payments, refers to any item of income that is included as
ordinary income under the laws of the jurisdictions where the mismatch has
arisen. An item that is treated as income under the laws of both
jurisdictions may, however, continue to qualify as dual inclusion income
even if that income benefits from double taxation relief, such as a foreign
tax credit (including underlying foreign tax credit) or a domestic dividend
exemption, to the extent such relief ensures that income, which has been
subject to tax at the full rate in one jurisdiction, is not subject to an
additional layer of taxation under the laws of either jurisdiction.
Equity interest
Equity interest means any interest in any person that includes an

entitlement to an equity return.
Equity return
Equity return means an entitlement to profits or eligibility to participate in

distributions of any person and, in respect of any arrangement is a return on
that arrangement that is economically equivalent to a distribution or a
return of profits or where it is reasonable to assume, after consideration of
the terms of the arrangement, that the return is calculated by reference to
distributions or profits.
Establishment
jurisdiction
Establishment jurisdiction, in relation to any person, means the jurisdiction

where that person is incorporated or otherwise established.
Family
A person (A) is a member of the same family as another person (B) if B is:
the spouse or civil partner of A;
a relative of A (brother, sister, ancestor or lineal descendant);
the spouse or civil partner of a relative of A;
a relative of As spouse or civil partner;
the spouse or civil partner of a relative of As spouse or civil
partner; or
an adopted relative.
Financing return
Financing return, in respect of any arrangement is a return on that

arrangement that is economically equivalent to interest or where it is
reasonable to assume, after consideration of the terms of the arrangement,
that the return is calculated by reference to the time value of money
provided under the arrangement.
Hybrid mismatch
A hybrid mismatch is defined in paragraph 3 in Recommendations 1, 3, 4,

6 and 7 for the purposes of those recommendations.
Included in ordinary
income
A payment will be treated as included in ordinary income to the extent that,

after a proper determination of the character and treatment of the payment
under the laws of the relevant jurisdiction, the payment has been
incorporated as ordinary income into a calculation of the payees income
under the law of that jurisdiction.
Investor
Investor, in relation to any person, means any person directly or indirectly

holding voting rights or equity interests in that person.
Investor jurisdiction
Investor jurisdiction is any jurisdiction where the investor is a taxpayer.
Mismatch
A mismatch is a DD outcome or a D/NI outcome and includes an expected

mismatch.
Money
Money includes money in any form, anything that is convertible into

money and any provision that would be paid for at arms length.
Offshore investment
regime
An offshore investment regime includes controlled foreign company and

foreign investment fund rules and any other rules that require the investors
accrued income to be included on a current basis under the laws of the
investors jurisdiction.
Ordinary income
marginal rate and does not benefit from any exemption, exclusion, credit or
other tax relief applicable to particular categories of payments (such as
indirect credits for underlying tax on income of the payer). Income is
considered subject to tax at the taxpayers full marginal rate
notwithstanding that the tax on the inclusion is reduced by a credit or other
tax relief granted by the payee jurisdiction for withholding tax or other
taxes imposed by the payer jurisdiction on the payment itself.
Payee
Payee means any person who receives a payment under an arrangement

including through a permanent establishment of the payee.
Payee jurisdiction
Payee jurisdiction is any jurisdiction where the payee is a taxpayer.
Payer
Payer means any person who makes a payment under an arrangement

including through a permanent establishment of the payer.
Payer jurisdiction
Payer jurisdiction is any jurisdiction where the payer is a taxpayer.
Payment
Payment includes any amount capable of being paid including (but not
limited to) a distribution, credit, debit, accrual of money but it does not
extend to payments that are only deemed to be made for tax purposes and
that do not involve the creation of economic rights between parties.
Person
Person includes any natural or legal person or unincorporated body of

persons and a trust.
Taxpayer
Taxpayer, in respect of any jurisdiction, means any person who is subject

to tax in that jurisdiction whether as a resident or by virtue of applicable
source rules (such as maintaining a permanent establishment in that
jurisdiction).
Trust
Trust includes any person who is a trustee of a trust acting in that capacity.
Voting rights
Voting rights means the right to participate in any decision-making

concerning a distribution, a change to the constitution or the appointment
of a director.
ANNEX B. EXAMPLES 169
Annex B
Examples
EXAMPLE 1.1 171
List of examples
Hybrid financial instrument rule

Example 1.1
Interest payment under a debt/equity hybrid
Example 1.2
Interest payment under a debt/equity hybrid eligible for partial exemption
Example 1.3
Interest payment under a debt/equity hybrid that is subject to a reduced rate
Example 1.4
Interest payment eligible for an underlying foreign tax credit
Example 1.5
Interest payment to an exempt person
Example 1.6
Interest payment to a person established in a no-tax jurisdiction
Example 1.7
Interest payment to a taxpayer resident in a territorial tax regime
Example 1.8
Interest payment to a tax exempt PE
Example 1.9
Interest payment to a person holding instrument through tax-exempt account
Example 1.10
Deductible dividends paid by a special purpose entity
Example 1.11
Tax relief equivalent to a deduction
Example 1.12
Debt issued in proportion to shares re-characterised as equity
Example 1.13
Accrual of deemed discount on interest free loan
Example 1.14
Deemed interest on interest-free loan
Example 1.15
Differences in value attributable to share premium paid under mandatory

convertible note
Example 1.16
Differences in valuation of discount on issue of optional convertible note
Example 1.17
No mismatch with respect to measurement of foreign exchange differences
Example 1.18
Payment in consideration for an agreement to modify the terms of a debt

instrument
Example 1.19
Payment in consideration for the cancellation of a financial instrument
Example 1.20
Release from a debt obligation not a payment
Example 1.21
Mismatch resulting from accrual of contingent interest liability
Example 1.22
No mismatch resulting from accrual of contingent interest liability
Example 1.23
Payment by a hybrid entity under a hybrid financial instrument
Example 1.24
Payment included in ordinary income under a CFC regime
Example 1.25
Payment under a lease only subject to adjustment to extent of financing return
172 EXAMPLE 1.1

Example 1.26
Consideration for the purchase of a trading asset
Example 1.27
Interest component of purchase price
Example 1.28
Interest paid by a trading entity
Example 1.29
Interest paid to a trading entity
Example 1.30
Purchase price adjustment for retained earnings
Example 1.31
Loan structured as a share repo
Example 1.32
Share lending arrangement
Example 1.33
Share lending arrangement where transferee taxable on underlying dividend
Example 1.34
Share lending arrangement where manufactured dividend gives rise to a

trading loss
Example 1.35
Share lending arrangement where neither party treats the arrangement as

a financial instrument
Example 1.36
Deduction for premium paid to acquire a bond with accrued interest
Example 1.37
Manufactured dividend on a failed share trade
Specific recommendations for the tax treatment of financial instruments

Example 2.1
Application of Recommendation 2.1 to franked dividends
Example 2.2
Application of Recommendation 2.2 to a bond lending arrangement
Example 2.3
Co-ordination of hybrid financial instrument rule and

Recommendation 2.1

Example 3.1
Disregarded hybrid payment structure using disregarded entity and a

hybrid loan
Example 3.2
Disregarded hybrid payment using consolidation regime and tax grouping
Reverse hybrid rule

Example 4.1
Use of reverse hybrid by a tax exempt entity
Example 4.2
Application of Recommendation 4 to payments that are partially

excluded from income
Example 4.3
Recommendation 4 and payments that are included under a CFC regime
Example 4.4
Interaction between Recommendation 4 and Recommendation 6

Example 6.1
Accointing for valuation and timing differences
Example 6.2
Whether DD may be set off against dual inclusion income
Example 6.3
Double deduction outcome from the grant of share options

EXAMPLE 1.1 173
Example 6.4
Calculating dual inclusion income under a CFC regime
Example 6.5
DD outcome under a loan to a partnership
Dual-resident payer rule

Example 7.1
DD outcome using a dual resident entity

Example 8.1
Structured imported mismatch rule
Example 8.2
Structured imported mismatch rule and direct imported mismatch rule
Example 8.3
Application of the direct imported mismatch rule
Example 8.4
Apportionment under direct imported mismatch rule
Example 8.5
Application of the indirect imported mismatch rule
Example 8.6
Payments to a group member that is subject to the imported mismatch rules
Example 8.7
Direct imported mismatch rule applies in priority to indirect imported

mismatch rule
Example 8.8
Surplus hybrid deduction exceeds funded taxable payments
Example 8.9
Surplus hybrid deduction does not exceed funded taxable payments
Example 8.10
Application of the imported mismatch rule to loss surrender under a tax

grouping arrangement
Example 8.11
Payment of dual inclusion income not subject to adjustment under

imported mismatch rule
Example 8.12
Imported mismatch rule and carry-forward losses
Example 8.13
Deductible hybrid payments, reverse hybrids and the imported hybrid

mismatch rule
Example 8.14
Deductible hybrid payments, tax grouping and imported hybrid

mismatch rules
Example 8.15
Interaction between double deduction and imported mismatch rule
Example 8.16
Carry-forward of hybrid deductions under imported mismatch rules
Design principles
Example 9.1
Co-ordination of primary/secondary rules
Example 9.2
Deduction for interest payment subject to a general limitation
Definition of structured arrangements

Example 10.1
Hybrid mismatch priced into the terms of the arrangement
Example 10.2
Back-to-back loans structured through an unrelated intermediary
Example 10.3
Arrangement marketed as a tax-advantaged product
174 EXAMPLE 1.1

Example 10.4
Beneficiary of a trust party to a structured arrangement
Example 10.5
Imported mismatch arrangement
Definition of related persons, control group and acting together

Example 11.1
Application of related party rules to assets held in trust
Example 11.2
Related parties and control groups - partners in a partnership
Example 11.3
Related parties and control groups - calculating vote and value interests
Example 11.4
Acting together - aggregation of interests under a shareholders

agreement
Example 11.5
Acting together - rights or interests managed together by the same

person/s
EXAMPLE 1.1 175
Example 1.1
Interest payment under a debt/equity hybrid
Facts
1.
In the example illustrated in the figure below, A Co (a company resident in
Country A) owns all the shares in B Co (a company resident in Country B). A Co lends
money to B Co. The loan carries a market rate of interest which is payable every six
months in arrears. Payments of interest and principal under the loan are subordinated to
the ordinary creditors of B Co and can be suspended in the event B Co fails to meet
certain solvency requirements.
A Co
Interest / Dividend
Loan
B Co
2.
The loan is treated as a debt instrument under the laws of Country B but as an
equity instrument (i.e. a share) under the laws of Country A and interest payments on the
loan are treated as a deductible expense under Country B law but as dividends under
Country A law. Country A exempts dividends paid by a foreign company if that
shareholder has held more than 10% of the shares in the company in the 12 month period
immediately prior to when the dividend is paid.
Question
3.
Whether the interest payments fall within the scope of the hybrid financial
instrument rule and, if so, to what extent an adjustment is required in accordance with that
rule.
176 EXAMPLE 1.1
Answer
4.
If Country A applies Recommendation 2.1 to deny A Co the benefit of tax
exemption for a deductible dividend then no mismatch will arise for the purposes of the
5.
If Country A does not apply Recommendation 2.1 then the payment of interest
will give rise to a hybrid mismatch within the scope of the hybrid financial instrument
rule and Country B should deny B Co a deduction for the interest paid to A Co. If
Country B does not apply the recommended response, then Country A should treat the
interest payments as ordinary income.
Analysis
Recommendation 2.1 will apply to deny A Co the benefit of the dividend
exemption for the payment
6.
Recommendation 2.1 states that a dividend exemption, which is granted by the
payee jurisdiction to relieve double taxation, should not apply to payments that are
deductible by the payer. As, in this case, the entire interest payment is deductible under
Country B law, no part of the interest payment should be treated as eligible for exemption
under Country A law.
7.
If the dividend exemption in Country A does not extend to deductible dividends
then no mismatch will arise for the purposes of the hybrid financial instrument rule. The
determination of whether a payment gives rise to a D/NI outcome requires a proper
consideration of the character of the payment and its tax treatment in both jurisdictions.
This will include the effect of any rules in Country A, consistent with Recommendation
2.1, excluding deductible dividends from the benefit of a tax exemption.
If Country A does not apply Recommendation 2.1 then the payment will give
rise to a hybrid mismatch that is within the scope of the hybrid financial
instrument rule
8.
Assuming that Country A has not implemented Recommendation 2.1, and the
dividend exemption continues to apply in Country A, then the payment of interest will
give rise to a D/NI outcome, which can be attributed to differences in the tax treatment of
the subordinated loan under Country A and Country B law.
9.
The subordinated loan meets the definition of a financial instrument under
Recommendation 1 because it is characterised and taxed as a debt instrument in
Country B and as an equity instrument in Country A.
10.
A Co and B Co are also related parties (A Co owns 100% of B Co) so that the
hybrid financial instrument falls within the scope of the hybrid financial instrument rule.
Note that, because A Co and B Co are related parties, the circumstances in which the
parties enter into the financial instrument does not affect whether the hybrid financial
instrument rule is within the scope of Recommendation 1. If, for example, the
subordinated loan was purchased by A Co from an unrelated party in an unconnected
transaction, the mismatch in tax outcomes under the loan would still be treated as a
hybrid mismatch between related parties for the purposes of Recommendation 1.
EXAMPLE 1.1 177
Primary recommendation deny the deduction in the payer jurisdiction

11.
Country B should deny the deduction to the extent the interest payment is not
included in ordinary income under the laws of Country A. The adjustment is limited to
neutralising the mismatch in tax outcomes. Recommendation 1 does not further require,
for example, that Country B change the tax character of the payment in order to align it
with the tax outcomes in the payee jurisdiction by treating it as a dividend for tax
purposes.
Defensive rule require income to be included in the payee jurisdiction

12.
If Country B does not apply the recommended response, then the Country A
should treat the deductible payment as ordinary income. As with the primary
recommendation, the adjustment required under the defensive rule is limited to
neutralising the mismatch in tax outcomes and does not require Country A to
re-characterise the loan as debt or treat the payment as interest for tax purposes.
178 EXAMPLE 1.2
Example 1.2
Interest payment under a debt/equity hybrid eligible for partial exemption
Facts
1.
The facts of this example are the same as Example 1.1 except that Country A
provides a partial tax exemption for foreign dividends paid by a controlled foreign entity.
A table summarising the tax treatment of the instrument is set out below. In this table it is
assumed that B Co has 100 of income for the period and makes a payment of 50 to A Co.
A Co has no income for the period other than the payment under the subordinated loan.
The corporate tax rate in both countries is 30%.
A Co
B Co
Tax
Book
Income
Dividend received
Tax
Income
50
Expenditure
Other income
Net return
Tax to pay (30%)

After-tax return
100
100
(50)
(50)
Expenditure
Interest paid
Taxable income
Book
50
5
Net return
Taxable income
50
50
(1.5)
Tax to pay (30%)
(15)
48.5
After-tax return
35
2.
Under Country B law, the payment to A Co is treated as a deductible interest
which means that B Cos taxable income is equal to its pre-tax net return. Under Country
A law, however, the payment is treated as a dividend and A Co is entitled to a tax
exemption for 90% of the payment received. The net effect of this difference in the
characterisation of the instrument for tax purposes can be illustrated by comparing it to
the tax treatment of an ordinary interest or dividend payment under the laws of Country A
and B.
EXAMPLE 1.2 179
Loan
Share
Hybrid
B Co
Income
100
100
100
Expenditure
(50)
(50)
(50)
Tax (at 30%)
(15)
(30)
(15)
After-tax return
35
20
35
A Co
Income
50
50
50
Expenditure
Tax (at 30%)
(15)
(1.5)
(1.5)
After-tax return
Combined after-tax return
35
48.5
48.5
70
68.5
83.5
3.
This comparison shows the net tax benefit to the parties of making a payment
under the subordinated loan is between 13.5 and 15 (depending on whether the final
outcome is compared to a dividend or interest payment).
Question
4.
Whether the tax treatment of the payments under the subordinated loan falls
within the scope of the hybrid financial instrument rule and, if so, to what extent an
adjustment is required under that rule?
Answer
5.
The payment under the subordinated loan will give rise to a mismatch in tax
outcomes unless Country A applies Recommendation 2.1 to prevent A Co claiming the
benefit of a partial dividend exemption in respect of a deductible payment.
6.
Country B should deny B Co a deduction for a portion of the interest payable
under the subordinated loan equal to the amount that is fully exempt from taxation under
Country A law. If Country B does not apply the recommended response, then Country A
should treat the entire payment as ordinary income.
Analysis
rise to a hybrid mismatch
7.
Assuming Country A has not applied Recommendation 2.1 to prevent A Co
claiming the benefit of the partial exemption, the payment will give rise to a mismatch in
tax outcomes. This mismatch is attributable to the terms of the instrument because it is
attributable to a difference in the way the loan is characterised under Country A and
Country B laws.
180 EXAMPLE 1.2

8.
The primary recommendation under the hybrid financial instrument rule is that
Country B deny the deduction to the extent it gives rise to a D/NI outcome. The effect of
the adjustment should be to align the tax treatment of the payments made under the
instrument so that the amounts that are treated as a financing expense in the payer
jurisdiction are limited to the amounts that are fully taxed in the payee jurisdiction. The
adjustment should result in a proportionate outcome that minimises the risk of double
taxation. This can be achieved by only denying a deduction for the portion of the interest
payment that is effectively exempt from taxation in the payee jurisdiction. Because 10%
of the payment made to A Co is taxed at A Cos full marginal rate, B Co may continue to
deduct an equivalent portion of the interest payment under Country B law. A table setting
out the amount of the required adjustment is set out below.
A Co
B Co
Tax
Book
Tax
Income
Dividend received
Income
5
50
Expenditure
Other income
Net return
Tax to pay
After-tax return
100
100
(5)
(50)
Expenditure
Interest paid
Taxable income
Book
50
5
Net return
Taxable income
(1.5)
Tax to pay
48.5
After-tax return
50
95
(28.5)
21.5
9.
Under Country B law the deduction is denied to the extent the payment is treated
as exempt in Country A. Because the exemption granted in Country A only extends to
90% of the payment made under the instrument, the hybrid financial instrument rule still
allows B Co to deduct 10% of the payment made to A Co. The adjustment has the net
effect of bringing a sufficient amount of income into tax, under the laws of the payer and
payee jurisdictions, to ensure that all the income under the arrangement is subject to tax at
the taxpayers full marginal rate.

10.
If Country B does not apply the recommended response, then A Co should treat
the entire amount of the deductible payment as ordinary income under Country A law.
A table setting out the amount of the required adjustment is set out below.
EXAMPLE 1.2 181
A Co
B Co
Tax
Book
Income
Dividend received
Tax
Income
50
50
Expenditure
Other income
Net return
Tax to pay
After-tax return
100
100
(50)
(50)
Expenditure
Interest paid
Taxable income
Book
50
50
Net return
Taxable income
(15)
35
Tax to pay
After-tax return
50
50
(15)
35
11.
Under Country A law the entire amount of the payment is treated as ordinary
income and subject to tax at the taxpayers full marginal rate. As with the adjustment
made under the primary recommendation this has the net effect of bringing the total
amount of the income under the arrangement into tax under the laws of either the payer or
payee jurisdiction and, because the tax rates in Country A and B are the same, produces
the same net tax outcome as an adjustment under the primary rule.
182 EXAMPLE 1.3
Example 1.3
Interest payment under a debt/equity hybrid that is subject to a reduced rate
Facts
1.
The facts of this example are the same as Example 1.1 except that amounts that
are characterised as dividends under Country A law are subject to tax at a reduced rate.
A table summarising the tax treatment of the interest payment under the laws of Country
A and Country B is set out below.
2.
In this table it is assumed that B Co has income of 100 for the period and makes a
payment of 40 under the subordinated loan. A Co has no income for the period other than
the payment under the loan. The corporate tax rate is 20% in Country B and 40% in
Country A, however Country A taxes dividends at 10% of the normal corporate rate
(i.e. 4%).
A Co
B Co
Tax
4%
Book
Income
40
40
Expenditure
Other income
Net return
Tax to pay
After-tax return
100
100
(40)
(40)
Expenditure
Interest paid
Income taxable at full rate
Book
40%
Income
Dividend received
Tax
40
4
Net return
Taxable income
(1.6)
Tax to pay
38.4
After-tax return
60
60
(12)
48
3.
Under Country B law, the payment to A Co is treated as deductible interest,
which means that B Cos taxable income and pre-tax net return are the same. Under
Country A law, however, the payment is treated as a dividend. A Co is subject to a
reduced rate of taxation on dividend income (4%), which leaves A Co with an after-tax
return of 38.4. The net effect of this difference in the characterisation of the instrument
for tax purposes can be illustrated by comparing the tax treatment of this payment to that
of an ordinary interest or dividend payment under the laws of Country A and B.
EXAMPLE 1.3 183
Loan
Share
Hybrid
B Co
Income
100
100
100
Expenditure
(40)
(40)
(40)
Tax (at 20%)
(12)
(20)
(12)
After-tax return
48
40
48
A Co
Income
40
40
40
Expenditure
Tax (at 40%)
(16)
(1.6)
(1.6)
After-tax return
24
38.4
38.4
72
78.4
86.4
4.
This comparison shows the net tax benefit to the parties of making a payment
under the subordinated loan is between 8 and 14.4 (depending on whether the final
outcome is compared to a dividend or interest payment).
Question
5.
within the scope of the hybrid financial instrument rule and, if so, to what extent an
adjustment is required under that rule?
Answer
6.
No mismatch will arise for the purposes of the hybrid financial instrument rule
(and therefore no adjustment will be required under that rule) if the reduced rate of
taxation applicable to the payment under the subordinated loan is the same rate that is
applied to ordinary income derived by A Co under all types of financial instruments.
7.
Assuming, however, that the reduced rate in Country A is less than the general
rate applied to other types of income under a financial instrument then, unless Country A
applies Recommendation 2.1 to prevent A Co claiming the benefit of the reduced rate for
dividends, the payment under the loan will give rise to a mismatch in tax outcomes. The
mismatch will be a hybrid mismatch because it is attributable to the way the subordinated
loan is characterised under Country A and Country B laws.
8.
Country B should therefore deny B Co a deduction for a portion of the interest
payable under the subordinated loan. The amount that remains eligible to be deducted
should equal the amount of income that is effectively subject to tax at the full marginal
rate in the payee jurisdiction. If Country B does not apply the recommended response,
then Country A should treat the entire payment as ordinary income subject to tax at the
full rate.
184 EXAMPLE 1.3
Analysis
A payment made under the financial instrument will not give rise to a mismatch
if the payment is subject to tax at A Cos full marginal rate
9.
marginal rate and does not benefit from any exemption, exclusion, credit or other tax
relief applicable to particular categories of payments. Accordingly, the payment under
the subordinated loan will not give rise to a mismatch in tax treatment if the payment is
subject to tax at A Cos full marginal rate.
10.
In the context of the hybrid financial instrument rule, A Cos full marginal rate is
the rate of tax A Co would be expected to pay on ordinary income derived under a
financial instrument. A mismatch will not arise, for the purposes of the hybrid financial
instrument rule, simply because Country A taxes income from financial instruments at a
lower rate than other types of income.
11.
If, therefore, the reduced rate of taxation applicable to the payment under the
subordinated loan applies to all payments of ordinary income under a financial
instrument, then no mismatch arises for the purposes of the hybrid financial instrument
rule and no adjustment is required to be made to the tax treatment of the payment under
Country A or B laws.
12.
If, however, the reduced rate of 4% applies only to dividends then, assuming
Country A has not applied Recommendation 2.1 to prevent A Co claiming the benefit of
the reduced rate, the payment will give rise to a mismatch in tax outcomes that is
attributable to the terms of the instrument.

13.
Country B deny the deduction to the extent it gives rise to a D/NI outcome. This can be
achieved by denying a deduction for a portion of the interest payment up to the amount
that is effectively exempt from taxation in the payee jurisdiction. Because of the reduced
rate in Country A, only 10% of the payment made to A Co is effectively taxed at the full
rate and B Cos deduction should be restricted to a corresponding amount. A table
showing the amount of the required adjustment is set out below.
EXAMPLE 1.3 185
A Co
B Co
Tax
4%
Book
Tax
Book
40%
Income
Income
Dividend received
40
40
Expenditure
Other income
100
100
(4)
(40)
Expenditure
Interest paid
Net return
40
Income taxable at full rate
Tax to pay
After-tax return
Net return
60
Taxable income
(1.6)
Tax to pay
38.4
After-tax return
96
(19.2)
40.8
14.
Country B should deny a deduction for 90% of the payment made under the
instrument because the reduced rate of tax is only sufficient to cover 10% of the payment at
normal corporate rates. This adjustment has the net effect of bringing a sufficient amount of
income into tax, under the laws of the payer and payee jurisdictions, to ensure that all the
income under the arrangement is subject to tax at the taxpayers full marginal rate.

15.
If Country B does not apply the recommended response, then A Co should be
required to treat the entire amount of the deductible payment as ordinary income under
Country A law. A table setting out the amount of the required adjustment is set out below.
A Co
4% Tax
B Co
40% Tax
Book
Income
Dividend received
Tax
Income
40
40
Expenditure
Other income
Net return
Tax to pay
After-tax return
100
100
(40)
(40)
Expenditure
Interest paid
Income subject to tax at

effective rate of 40%
Book
40
40
Net return
Taxable income
(16)
24
Tax to pay
After-tax return
60
60
(12)
48
16.
income and subject to tax at the taxpayers full marginal rate (40%). The adjustment has
the net effect of bringing a sufficient amount of income into tax, under the laws of the
payer and payee jurisdictions, to ensure that all the income under the arrangement is
subject to tax at the taxpayers full marginal rate in each jurisdiction.
186 EXAMPLE 1.3

17.
The differences between the total aggregate tax liability under the primary and
secondary rule are explained by reference to different amounts of income brought into
account in each jurisdiction under the rule and differences in tax rate between the payer
and payee jurisdictions.
EXAMPLE 1.4 187
Example 1.4
Interest payment eligible for an underlying foreign tax credit
Facts
1.
The facts of this example are the same as Example 1.1 except that the tax relief
granted by Country A is in the form of a tax credit for underlying foreign taxes paid by its
subsidiary. The credit is granted in proportion to the amount of pre-tax retained earnings
that are distributed to the shareholder by way of dividend. A table summarising the
treatment of a payment under the laws of Country A and Country B is set out below. In
this table it is assumed that B Co derives income of 100 for the period. B Co makes a
payment of 40 to A Co under the subordinated loan. A Co has no other income for the
period. The corporate tax rate in Country B is 20% and in Country A is 35%.
A Co
B Co
Tax
Book
Income
Tax
Book
Income
Dividend received
40
40
Expenditure
Other income
Net return
40
40
Tax (35%)
(14)
Tax credit
4.8
Tax to pay
After-tax return
100
(40)
(40)
Expenditure
Interest paid
Taxable income
100
Net return
Taxable income
(9.2)
30.8
Tax to pay (at 20%)

After-tax return
60
60
(12)
48
2.
Under Country B law, the payment to A Co is treated as deductible interest which
means that B Cos taxable income is equal to its net return. Under Country A law,
however, the payment is treated as a dividend and A Co is entitled to a foreign tax credit
for the underlying foreign tax paid on the dividend. The formula for determining the
amount of the credit granted under Country A law for underlying foreign taxes can be
expressed as follows:
188 EXAMPLE 1.4

Total amount of tax paid by B Co
Total amount of dividend from B Co

B Cos retained earnings + taxes paid + B Co distributions
Assuming the B Co has no historical earnings and has not previously made any
distributions, the simplified formula set out above produces an underlying foreign tax
credit that is equal to 4.8 (= 12 x 40/100) leaving A Co with a total Country A tax to pay
of 9.2.
3.
Note that this formula for calculating foreign taxes has been simplified for the
purpose of demonstrating the effect of the hybrid financial instrument rule in the context
of a dividend that qualifies for a credit for underlying foreign taxes. In practice, the
amount of underlying foreign tax paid on distributions of retained earnings can be more
accurately calculated by determining the historical amount of tax paid on the subsidiarys
after-tax retained earnings. The jurisdiction granting the credit will treat the dividend as
grossed-up by the amount of the foreign tax credit attached to the dividend and may
operate a tax credit pooling system that tracks the retained earnings of each subsidiary
and the amount of tax that has been borne by those earnings and treats the foreign tax
credits attached to previous dividends as reducing the available pool of foreign tax
credits.
4.
The net effect of the difference in the characterisation of the payment made under
the instrument can be illustrated by comparing it to the tax treatment of an ordinary
interest or dividend payment under the laws of Country A and B. This comparison shows
the net tax benefit to the parties of making a payment under the subordinated loan is 4.8.
Loan
Share
Hybrid
B Co
Income
100
100
100
Expenditure
(40)
(40)
(40)
Tax (at 20%)
(12)
(20)
(12)
After-tax return
48
Income
40
48
A Co
40
40
40
(14)
(6)
(9.2)
Expenditure
Tax (at 35%)
After-tax return
26
34
30.8
74
74
78.8
5.
In theory, because a credit for underlying foreign taxes only imposes incremental
tax on distributed profit, the aggregate tax burden borne by a dividend and an interest
payment is the same regardless of the difference in tax rates between the payer and payee
jurisdictions. Hence, in this simplified example, the total retained earnings of A Co and B
Co are unaffected by whether the payment is characterised as a dividend or as interest. In
practice, however, differences in the way the payer and payee jurisdictions calculate
income for tax and foreign tax credit purposes and restrictions on the utilisation of tax
credits in the payee jurisdiction will impact on the amount of tax paid on the dividend in
the payee jurisdiction (and therefore on the equality of tax treatment between dividends
EXAMPLE 1.4 189
and interest) in much the same way as they will under a partial exemption or reduced rate
system.
Question
6.
within the scope of the hybrid financial instrument rule and, if so, what adjustments are
required under the rule?
Answer
7.
If Country A applies Recommendation 2.1 to deny A Co the benefit of tax credit
for a deductible dividend then no mismatch will arise for the purposes of the hybrid
8.
If Country A does not apply Recommendation 2.1 then the payment under the
subordinated loan will give rise to a mismatch in tax outcomes to the extent that the credit
shelters the dividend from tax under the laws of Country A.
9.
Country B should deny B Co a deduction for a portion of the interest payable
under the subordinated loan. The amount that remains eligible to be deducted following
the adjustment should equal the amount of income that will be effectively subject to tax at
the full marginal rate in the payee jurisdiction after application of the tax credit.
10.
the entire payment as ordinary income under the secondary rule and deny A Co the
benefit of any tax credit.
Analysis
Recommendation 2.1 will apply to deny A Co the benefit of the tax credit
11.
Credits, such as those granted by Country A, which are designed to relieve the
payee from economic double taxation of dividend income, fall within
Recommendation 2.1. That Recommendation states that jurisdictions should consider
denying the benefit of such double taxation relief in the case of payments that are
deductible by the payer. Accordingly, no part of the interest payment should be treated as
eligible for a credit for underlying taxes in the payee jurisdiction where that payment is
deductible under the laws of the payer jurisdiction. If Country A maintains a pooling
system for foreign tax credits then any credits that are denied under the application of the
defensive rule should be left in the pool.
12.
The determination of whether a payment gives rise to a D/NI outcome requires a
proper consideration of the character of the payment and its tax treatment in both
jurisdictions. This will include the effect of any rules in Country A, consistent with
Recommendation 2.1, that exclude deductible dividends from the benefit of any double
tax relief. Therefore, if Country A withdraws the benefit of the underlying foreign tax
credit for the dividends paid by B Co, on the grounds that such dividend payments are
deductible under Country B law, then no mismatch will arise for the purposes of the
190 EXAMPLE 1.4
A payment made under the financial instrument will give rise to a hybrid
mismatch
13.
On the assumption that Country A has not implemented the restrictions on
double-tax relief that are called for under Recommendation 2.1, the payments of interest
under the subordinated loan will give rise to a D/NI outcome as the payments are
deductible under the laws of Country B and not included in ordinary income in the payee
jurisdiction (because such payments benefit from a credit under Country A law). This
mismatch will be a hybrid mismatch because the tax treatment in Country A that gives
rise to the D/NI outcome is attributable to a difference in the characterisation of the loan
under Country A and B laws.

14.
Country B deny the deduction for a payment to the extent it gives rise to a D/NI outcome.
The effect of the adjustment should be to align the tax treatment of the payments made
under the instrument so that amounts that are treated as a financing expense in the payer
jurisdiction do not exceed the amounts that are taxed as ordinary income in the payee
jurisdiction. The adjustment should result in an outcome that is proportionate and
minimises the risk of double taxation.
15.
This can be achieved by denying a deduction for the interest payment to the extent
it is fully sheltered from tax under the laws of Country A. Of the payment made to A Co,
65.7% (i.e. 9.2/14) is taxed at the full rate of tax applicable to ordinary income in Country
A and Country B should allow for a similar portion of the interest payment to be
deducted. A table setting out the effect of this adjustment is set out below.
A Co
B Co
Tax
Book
Tax
Income
Book
Income
Dividend received
40
40
Expenditure
Other income
Net return
40
40
Tax (35%)
(14)
Tax credit
4.8
Tax to pay
After-tax return
100
(26.29)
(40)
Expenditure
Interest paid
Taxable income
100
Net return
Taxable income
(9.2)
30.8
Tax to pay (at 20%)

After-tax return
60
73.71
(14.74)
45.26
16.
Under Country B law the deduction is denied to the extent the payment is not
subject to tax at the payees full marginal rate in the payee jurisdiction. A Cos tax
liability on the payment is 9.20 which at the 35% tax rate indicates that 26.29 (i.e.
9.2/0.35) of the payment was taxable as ordinary income in Country A.
EXAMPLE 1.4 191
17.
The adjustment has the net effect of bringing a sufficient amount of income into
tax, under the laws of the payer and payee jurisdictions, to ensure that all the income
under the arrangement is subject to tax at the taxpayers full marginal rate. While the
adjustment results in a lower overall effective tax rate for the arrangement than would
have occurred under a normal dividend this is explained by reference to the different
amounts of income brought into account, and differences in tax rate between, the payer
and payee jurisdictions.
18.
In this simplified example it is assumed that the effect of the increase in taxation
in Country B, resulting from the application of the hybrid financial instrument rule, is not
taken into account for the purposes of calculating the amount of the tax credit in Country
A. This may be because Country A expressly prohibits the crediting of increased foreign
taxes that arise due to the application of the hybrid financial instrument rule or because,
in practice, the incremental tax increase does not have a material impact on the amount of
the payment brought into taxation as ordinary income in Country A.

19.
If Country B does not apply the recommended response, then Country A should
treat the entire amount of the deductible payment as ordinary income and deny A Co the
benefit of the foreign tax credit. A table setting out the amount of the required adjustment
is set out below.
A Co
B Co
Tax
Book
Income
Tax
Book
Income
Dividend received
40
40
Expenditure
Other income
Net return
40
40
Tax (35%)
(14)
Tax credit
Tax to pay
After-tax return
100
(40)
(40)
Expenditure
Interest paid
Taxable income
100
Net return
Taxable income
(14)
26
Tax to pay (at 20%)

After-tax return
60
60
(12)
48
20.
income and subject to tax at the taxpayers full marginal rate without a credit for
underlying taxes. The adjustment has the net effect of bringing a sufficient amount of
income into tax, under the laws of the payer and payee jurisdictions, to ensure that all the
income under the arrangement is subject to tax at the taxpayers full marginal rate. As for
the adjustment under Recommendation 2.1, Country A should treat any credits that are
denied under the application of the defensive rule as left in the pool and available for
distribution at a future date.
192 EXAMPLE 1.5
Example 1.5
Interest payment to an exempt person
Facts
1.
In this example the facts are the same as in Example 1.1 except that both
jurisdictions treat the subordinated loan as a debt instrument. A Co is a sovereign wealth
fund established under Country A law that is exempt from tax on all income. A Co is
therefore not taxable on the interest payment.
A Co
Interest
Loan
B Co
Question
2.
within the scope of the hybrid financial instrument rule and, if so, what adjustments are
required under the rule?
Answer
3.
The payment of interest under the loan gives rise to a mismatch in tax outcomes
as it is deductible under Country B law but is not included in ordinary income under
Country A law. This D/NI outcome will not, however, be treated as a hybrid mismatch
unless it can be attributed to the terms of the instrument.
4.
If the mismatch in tax outcomes would not have arisen had the interest been paid
to a taxpayer of ordinary status, then the mismatch will be solely attributable to A Cos
status as a tax exempt entity, and cannot be attributable to the terms of the instrument
EXAMPLE 1.5 193
itself. In such a case the mismatch in tax outcomes will not be caught by the hybrid
financial instrument rule. If the terms of the instrument would have been sufficient, on
their own, to bring about a mismatch in tax outcomes (i.e. the payment would not have
been included in interest even if it had been made to an ordinary taxpayer) then the
mismatch will be treated as a hybrid mismatch and subject to adjustment under the hybrid
5.
While the application of the hybrid financial instrument rule could result in the
denial of a deduction under Country B law, the application of the secondary rule in
Country A will not result in any additional tax liability for A Co because A Co is not
taxable on ordinary income.
Analysis
A payment made under the financial instrument may give rise to a hybrid
mismatch
6.
The mismatch in tax outcomes under the instrument will be treated as a hybrid
mismatch when the outcome is attributable to the tax treatment of the instrument, rather
than the tax treatment of the entity receiving the payment or the circumstances under
which it is held. On the facts of this example the exemption is most likely to be
attributable to A Cos special status as a tax exempt entity, however, if the terms of the
instrument would have been sufficient, on their own, to bring about a D/NI outcome, then
the mismatch should be treated as a hybrid mismatch for the purposes of these rules.
7.
The guidance to Recommendation 1 notes that one way of testing for whether a
mismatch is attributable to the terms of the instrument is to ask whether the same
mismatch would have arisen between taxpayers of ordinary status. The test looks to what
the tax treatment of the instrument would have been if both the payer and payee were
ordinary resident taxpayers that computed their income and expenditure in accordance
with the rules applicable to all taxpayers of the same type. If the payment of interest
would not have been expected to be treated as ordinary income under this counterfactual
then the mismatch should be treated as attributable to the terms of the instrument and
potentially subject to adjustment under the hybrid financial instrument rule.

8.
In the event the mismatch is determined to be a hybrid mismatch, Country B
should apply its hybrid mismatch rule to deny B Co a deduction for the payment made
under the hybrid financial instrument to the extent of that mismatch. This deduction
would be denied notwithstanding that the D/NI outcome would have arisen if the
instrument had not been a hybrid financial instrument.

9.
While Country A should also treat the loan as a hybrid financial instrument the
application of the defensive rule will not have any tax impact on A Co. Although, in
theory A Co would be required to treat the interest payments as ordinary income, this
will not result in any additional tax liability for A Co because A Co is exempt from tax on
all income.
194 EXAMPLE 1.6
Example 1.6
Interest payment to a person established in a no-tax jurisdiction
Facts
1.
The facts of this example are the same as in Example 1.1 except that Country A
(the laws under which A Co is established) does not have a corporate tax system and
A Co does not have a taxable presence in any other jurisdiction. A Co is therefore not
liable to tax in any jurisdiction on payments of interest under the loan.
Question
2.
Whether the interest payments under the loan fall within the scope of the hybrid
financial instrument rule?
Answer
3.
The interest payment does not give rise to a mismatch within the language or
intended scope of the hybrid financial instrument rule.
Analysis
4.
Recommendation 1 only applies to payments that give rise to a D/NI outcome.
While the interest payment is deductible under the laws of Country B, a mismatch will
only arise in respect of that payment if it is not included in income by a payee in a payee
jurisdiction. In this case, however, the recipient of the interest payment is not a taxpayer
in any jurisdiction and, accordingly, there is no payee jurisdiction where the payment can
be included in income. The payment of interest under the loan therefore does not fall
within the language or intended scope of the hybrid financial instrument rule.
EXAMPLE 1.7 195
Example 1.7
Interest payment to a taxpayer resident in a territorial tax regime
Facts
1.
The facts of this example are the same as in Example 1.1 except that Country A
administers a pure territorial tax system and does not tax income unless it has a domestic
source. Interest income paid by a non-resident is treated as foreign source income and is
exempt from taxation unless the payment can be attributed to a PE maintained by B Co in
Country A. As B Co has no PE in Country A, the interest is not subject to tax in the hands
of A Co.
Question
2.
Whether the interest payments under the loan fall within the scope of the hybrid
Answer
3.
The mismatch is not attributable to the terms of the instrument but to the fact that
A Co is exempt from tax on foreign source income of any description. The mismatch is
thus not caught by the hybrid financial instrument rule.
Analysis
A payment made under the financial instrument gives rise to a mismatch
4.
The payment of interest is deductible under the laws of the payer jurisdiction
(Country B) but not included in income under the laws of the payee jurisdiction
(Country A). Note that this outcome is to be contrasted with that under Example 1.6
where the payment is made to an entity established in a no-tax jurisdiction. In that case
the payment does not give rise to a mismatch in tax outcomes as the payment is not
treated as received under the laws of any payee jurisdiction. In this case Country A
does maintain a corporate tax system and A Co is a taxpayer in that jurisdiction. There is
therefore both payer and a payee jurisdictions that can be tested for the purposes of
determining whether a D/NI outcome has arisen.
Mismatch is not a hybrid mismatch

5.
Although the payment gives rise to a D/NI outcome the resulting mismatch is not
a hybrid mismatch because it is not attributable to the terms of the instrument but to the
fact that A Co is exempt on foreign source income of any description. There is no change
that could be made to the terms of the instrument that would result in payments under the
196 EXAMPLE 1.7

instrument becoming taxable. Note that this outcome is to be contrasted with Example
1.1 where the payee jurisdiction exempts only dividend payments. In that case, it is both
the source of the payment and the terms of the instrument that give rise to the dividend
treatment (and hence the exemption) in the payee jurisdiction.
EXAMPLE 1.8 197
Example 1.8
Interest payment to a tax exempt PE
Facts
1.
In the example illustrated below, A Co, a company resident in Country A lends
money to C Co (a wholly-owned subsidiary) through a PE in Country B. Country A, B
and C all treat the loan as a debt instrument for tax purposes. Payments of interest under
the loan are deductible under Country C law but not included in income under Country A
law. Country A provides an exemption for income derived through a foreign PE.
A Co
Country B
PE
Interest
Loan
C Co
Question
2.
In what circumstances will the payment of interest under the loan be treated as
giving rise to a hybrid mismatch subject to adjustment under the hybrid financial
instrument rule?
198 EXAMPLE 1.8
Answer
3.
The payment of interest under the loan will only give rise to a D/NI outcome if
the payment is not treated as ordinary income under both Country A and Country B laws.
If a payment of deductible interest is not expected to be included in ordinary income
under the laws of one of the payee jurisdictions (either Country A or B) then a tax
administration may treat the payment as giving rise to a D/NI outcome unless the
taxpayer can satisfy the tax authority that the payment has been included in ordinary
income in the other jurisdiction.
4.
A deductible payment that gives rise to a mismatch in tax outcomes will be
treated as within the scope of the hybrid financial instrument rule if the mismatch can be
attributed to the tax treatment of the instrument under the laws of either Country A or
Country B. If, for example, the mismatch could be attributed to the fact that either
jurisdiction treats the interest on the loan as an exempt dividend then the hybrid financial
instrument rule would apply to the instrument. The arrangement should not be treated as
falling within the scope of the hybrid financial instrument rule, however, if the mismatch
would not have arisen in respect of a loan that had been entered into directly by a payee
resident in either Country A or B.
5.
If the interest payment falls within the scope of the hybrid financial instrument
rule then the recommended response is to deny the deduction for that payment under
Country C law. The application of the secondary rule in Country A will not, however,
result in any additional tax liability if A Co is not taxable on ordinary income derived
through a foreign PE.
Analysis
No mismatch arises if the interest payment is included in ordinary income
under either Country A or Country B law
6.
A D/NI outcome will only arise where a payment that is deductible under the laws
of one jurisdiction (the payer jurisdiction) is not included in ordinary income under the
laws of any other jurisdiction where the payment is treated as being received (the payee
jurisdiction). In order for a jurisdiction to link the tax treatment of a payment in one
jurisdiction with the tax consequences in another it is therefore necessary to identify the
taxpayers and jurisdictions where the payment is made and received. In most cases the
payee will be the legal entity with the right to receive the payment (in this case, A Co)
and the payee jurisdiction will be the jurisdiction where that entity is resident (in this
case, Country A). However where the payment is received through a tax transparent
structure such as a PE, it will be necessary to look to the laws of the PE jurisdiction (in
this case, Country B) to definitively establish whether a mismatch has arisen.
7.
The facts of the example do not state whether the interest payment is treated as
included in ordinary income under Country B law. Assuming, however, the tax treatment
of the payment in Country B cannot be established, the deductible interest payments on
the loan should be treated as giving rise to a D/NI outcome to the extent such payments
are not included in ordinary income under the laws of Country A. It will be the taxpayer
who has the burden of establishing, to the reasonable satisfaction of the tax
administration, how the tax treatment in Country B impacts on the amount of the
adjustment required under the rule. If the taxpayer can establish, to the satisfaction of its
own tax administration, that the full amount of the interest payment is expected to be
EXAMPLE 1.8 199
included in ordinary income under the laws of another jurisdiction then the taxpayer
should not be required to make an adjustment under the hybrid financial instrument rule.
Mismatch may be a hybrid mismatch

8.
The mismatch will be treated as a hybrid mismatch to the extent it can be
attributed to differences in the tax treatment of the instrument under the laws of the payer
and payee jurisdictions. The test for hybridity, in the financial instrument context, looks
to whether the terms of the instrument were sufficient to bring about the mismatch under
the laws of the relevant jurisdictions. Thus, if the mismatch arose because either Country
A or B treated the interest on the loan as an exempt dividend, then the hybrid financial
instrument rule would apply.
9.
A mismatch in outcomes will not be treated as a hybrid mismatch, however, if it
is solely attributable to the circumstances in which the instrument is held. If, for example,
the interest payment is exempt in Country A only because A Co has made the loan
through the foreign PE then the resulting mismatch in tax outcomes will not be treated a
hybrid mismatch for the purposes of the rule.
10.
One way of testing whether the mismatch is attributable to the terms of the
instrument, rather than the status of the taxpayer or the context in which the instrument is
held, is to ask whether the mismatch would have arisen had the instrument been held
directly by an ordinary taxpayer that computed its income and expenditure under the
ordinary rules applicable to taxpayers of the same type. If a mismatch would still have
arisen in these circumstances then the mismatch should be treated as a hybrid mismatch
within the scope of the rule.
Application of the hybrid financial instrument rule under Country C law

11.
If Country C determines that the loan is caught by the rule, then Country C should
apply the primary recommendation and deny C Co a deduction for the interest to the
extent of that mismatch.
12.
C Co may be able to establish, however, that, notwithstanding the hybrid
mismatch between Country A and C, the payment has, in fact, been included in income
under the laws of a third jurisdiction (Country B). If the taxpayer can reasonably satisfy
the tax administration that the interest payments are in fact included in income under
Country B law, then, in fact, no D/NI outcome arises and the hybrid financial instrument
rule should not apply.
Application of the hybrid financial instrument rule under Country B law

13.
If Country C does not apply the recommended response, Country B may treat the
interest payment as ordinary income under the secondary rule.
Application of the hybrid financial instrument rule under Country A law

14.
In no event will the hybrid financial instrument rule in Country A result in any
additional tax liability for A Co. This is either because:
(a) the mismatch will not be attributable the terms of the instrument but to the special
tax treatment granted under Country A law for income derived through a foreign
PE (in which case the instrument is not a hybrid financial instrument under
Country A law); or
200 EXAMPLE 1.8

(b) the instrument will be treated as a hybrid financial instrument but the response
under the hybrid financial instrument rule (treating the payment as ordinary
income) will not result in any increase in tax liability for A Co as all ordinary
income derived through a foreign PE is exempt from income under Country A
law.
EXAMPLE 1.9 201
Example 1.9
Interest payment to a person holding instrument through tax-exempt account
Facts
1.
In the example illustrated in the figure below, A is an individual resident in
Country A and B Co is a company resident in Country B. Individual A subscribes for a
bond issued by B Co that pays regular interest.
A
Interest
Loan
B Co
2.
The bond is treated as a debt instrument under the laws of both Country A and B.
B Co is entitled to a deduction for the interest payments and these payments would
usually be treated as ordinary income in Country A. In this case, however, the bond is
held by A through a tax exempt personal savings account that entitles A to an exemption
on any income and gains in respect of assets held in the account. The saving account is
available only to individuals and there are limits on the amount and type of assets that can
be put into the account.
Question
3.
rule?
Whether the arrangement falls within the scope of the hybrid financial instrument
202 EXAMPLE 1.9
Answer
4.
The instrument does not fall within the scope of the hybrid financial instrument
rule because the mismatch is attributable to the circumstances in which the bond is held
and cannot be attributed to the terms of the instrument.
Analysis
There is no payment made under the financial instrument that gives rise to a
hybrid mismatch
5.
The hybrid financial instrument rule only applies where the mismatch can be
attributed to terms of the instrument. In this example B Cos interest payments result in
D/NI outcome, however this mismatch is caused by the fact that A holds the instrument
through a savings account that, under Country A law, entitles A to an exemption in
respect of the interest payment on the bond. The mismatch would not have arisen if the
bond was held directly by A, rather than through the savings account. Because the
mismatch is attributable to the context in which the instrument is held rather than the
nature of the instrument itself, it falls outside the intended scope of the hybrid financial
instrument rule.
EXAMPLE 1.10 203
Example 1.10
Deductible dividends paid by a special purpose entity
Facts
1.
Country A) owns 25% of the shares in B Co. B Co is a Real Estate Investment Trust
(REIT) that earns most of its income from real estate investments. B Co pays a dividend
to A Co. The dividend is not required to be included in ordinary income under Country A
law.
Other
investors
75 %
A Co
Dividend
25 %
B Co
(REIT)
2.
Under the laws of Country B, a REIT is granted a special tax status, which is only
available to entities that invest in certain classes of assets and that derive certain kinds of
income. Entities that meet the criteria to become a REIT and have elected to take
advantage of this special tax status are entitled to a deduction for the dividends they pay
their investors. This dividend deduction is intended to ensure that there is only one level
of taxation (at the shareholder level) in respect of the investments made by the REIT.
3.
The REIT will generally be required to meet certain distribution requirements
(intended to ensure that all the income of the REIT is distributed to investors within a
reasonable period of time) and there may also be restrictions on the type of persons that
can invest in the REIT and the amount of shares of the REIT that the investor can hold.
204 EXAMPLE 1.10
Question
4.
Whether the dividend payment falls within the scope of the hybrid financial
instrument rule?
Answer
5.
The deductibility of the dividend turns on B Cos special tax status as REIT not
on the terms of the instrument. Therefore the dividend does not fall within the scope of
the hybrid financial instrument rule.
Analysis
Recommendation 2.1 will apply to the dividend
6.
Recommendation 2.1 states that a dividend exemption, which is granted by the
payee jurisdiction to relieve double taxation, should not apply to payments that are
deductible by the payer. As, in this case, the entire interest payment is deductible by
B Co, no part of the interest payment should be treated as eligible for exemption under
Country A law. Recommendation 2.1 should apply notwithstanding the payment will not
be treated as subject to adjustment under the hybrid financial instrument rule (see below).
Deductible dividend does not give rise to a hybrid mismatch as deduction

attributable to special status of REIT
7.
The payment of a deductible dividend will not give rise to a hybrid mismatch
under Recommendation 1 provided the deduction is attributable to the tax status of the
REIT rather than the ordinary tax treatment of dividends under the laws of that
jurisdiction.
8.
The guidance to Recommendation 1 notes that one way of testing for whether a
mismatch is attributable to the terms of the instrument is to ask whether the same
mismatch would have arisen between taxpayers of ordinary status. If dividend payments
are not ordinarily deductible under Country B law, then the mismatch that arises in this
case should be treated as attributable to the particular status of the payer rather than the
tax treatment of the instrument.
EXAMPLE 1.11 205
Example 1.11
Tax relief equivalent to a deduction
Facts
1.
In this example A Co, a company resident in Country A owns all the shares of B
Co a company resident in Country B. B Co derives operating income which is subject to
corporation tax under the laws of Country B. B Co pays a dividend to A Co. A Co is not
subject to tax on the dividend under the laws of Country B (as A Co is not a Country B
taxpayer) and Country A provides for an exemption for dividends paid by a foreign
company. A Co is therefore not subject to tax on the dividend under either Country A or
Country B law.
2.
Under Country B law, the payment of a dividend triggers a tax credit equal to
90% of the corporate tax paid on the distributed income. This refund may be in the form
of a credit against B Cos tax liability or may be paid as an additional amount directly to
the shareholder. The figure below illustrates the tax consequences where Country B
provides B Co with a tax credit for dividends paid.
A Co
Dividend
(70)
Credit (18.9)
Ordinary
Income
(100)
B Co
Tax Administration
Tax (30)
3.
As illustrated in the figure above, B Co derives 100 of operating income which is
subject to tax at a 30% corporate rate and that the remaining income is distributed as a
dividend. Payment of the dividend, however, allows B Co to claim a tax credit equal to
90% of the corporate tax rate on the dividend. The table below sets out the net tax
consequences for both A Co and B Co where Country B law provides for a tax credit in
respect of dividends paid.
206 EXAMPLE 1.11

A Co
B Co
Tax
Book
Tax
Income
Book
Income
Ordinary income
Dividend received
100
100
70
Expenditure
Expenditure
Dividend paid
Net return
70
Taxable income
Tax on net income
(70)
Net return
30
Taxable income
0
100
Tax on net income (30%)
(30)
Credit
18.9
Tax to pay
After-tax return
70
(11.1)
After-tax return
18.9
4.
As can be seen from the above table the net effect of the tax credit granted under
Country B law is that B Co pays 30% tax on the undistributed income (0.3 x 30 = 9) and
3% tax on the amount that has been distributed (0.03 x 70 = 2.1).
5.
The figure and table below illustrate the tax consequences that apply where
Country B provides A Co with a refundable credit in respect of the dividend paid by
B Co.
A Co
Refundable tax
credit (27)
Dividend
(70)
Ordinary
Income
(100)
B Co
Tax Administration
Tax (30)
6.
As in the fact pattern illustrated in the first page of this example, B Co derives
100 of operating income which is subject to tax at a 30% corporate rate with the
remainder of the income distributed to A Co as a dividend. In this case, however,
Country B provides A Co with a refundable tax credit in respect of the dividend paid. As
A Co is not subject to tax on the dividend under the laws of Country B, it is entitled to
claim a full refund for the unutilised credit. The formula for calculating the amount of the
refundable credit that can be attached to the dividend is as follows:
EXAMPLE 1.11 207
0.9 x tax rate in Country B
(amount of distribution x
1
1 tax rate in Country B
7.
Applying this formula to the distribution, A Co is entitled to a credit equal to
(0.27 x (70 x 1/0.7) = 27. The table below illustrates the net tax consequences for both
A Co and B Co where Country B law provides shareholders with a refund of 90% of the
corporate tax paid on a dividend distribution.
A Co
B Co
Tax
Book
Tax
Income
Book
Income
Dividend received
70
Refundable Tax Credit
27
Ordinary income
100
100
Expenditure
Dividend paid
Net return
Taxable income
Tax on net income
After-tax return
97
0
Net return
Taxable income
0
97
(70)
Tax on net income

After-tax return
30
100
(30)
0
8.
This refundable credit mechanism ensures that the net amount of Country B tax
paid on B Cos distributed income is 3% (i.e. 10% of the normal corporate rate). Because
the dividend is not subject to tax in Country A the net effect of this credit is that only 3%
of the income under the arrangement is subject to tax under either Country A or B law.
Question
9.
Whether the dividend falls within the scope of the hybrid financial instrument rule
and, if so, to what extent an adjustment is required to be made in accordance with the
rule.
Answer
10.
In either case, the dividend gives rise to tax relief that is equivalent to a deduction
under Country B law and the dividend payment should, therefore, be treated as falling
within the scope of the hybrid financial instrument rule.
11.
When making an adjustment under Country A law, A Co should take into account
the fact that only 10% of the amount distributed has been subject to tax as ordinary
income due to the tax relief granted under Country B law.
208 EXAMPLE 1.11
Analysis
Tax credit or refund treated as equivalent tax relief under Country B law
12.
A payment will be treated as deductible under the laws of the payer jurisdiction if
it is applied, or can be applied, to reduce a taxpayers net income. While B Cos dividend
payment cannot be deducted directly from B Cos income, the concept of deductible,
for the purposes of the hybrid mismatch rules, also extends to payments that trigger other
types of equivalent tax relief. The tax credit or refund granted to B Co or its
shareholder is equivalent to granting B Co a deduction for a dividend payment because it
has the same net effect of reducing the overall amount of tax payable on B Cos net
operating income.
13.
The laws of some countries permit domestic companies to attach imputation or
franking credits to dividends that have been paid out of tax-paid income. Taxpayers in the
same jurisdiction can then apply this credit against the resulting tax liability on the
dividend in order to protect themselves from economic double taxation. In such a case,
however, the recognition of the credit is premised on the dividend being treated as taxable
income in that jurisdiction. In this example the dividend is not subject to tax under the
laws of Country B, so that allowing B Co or its shareholder to take the benefit of the
credit in these circumstances has the effect, not of avoiding double taxation, but of
cancelling the corporation tax previously paid on the underlying income.
Mismatch in tax outcomes arises under a financial instrument

14.
The dividend gives rise to a D/NI outcome that is attributable to the terms of the
instrument. In contrast to Example 1.10, where the difference in tax treatment is a result
of the special tax status of the payer, the refund or credit is part of the ordinary rules
governing the tax treatment of dividends in Country B and, accordingly, the mismatch is
one that would arise between taxpayers of ordinary status.
Adjustment required
15.
When determining the amount of adjustment required under the hybrid financial
instrument rule under Country A law, Country A should take into account all amounts
received (including the amount of any refunds paid directly to A Co) and should adjust
the amount of income eligible to benefit from the dividend exemption consistently with
the principles set out in Example 1.2 to 1.4 so that the amount of the payment that
remains eligible for tax relief in Country A should equal the amount of income that is
effectively subject to tax at the full marginal rate in Country B.
16.
In this case 10% of the payment remains subject to tax at the full corporate rate
under Country B law and therefore 90% of the payment should be treated as ordinary
income under Country A law. The table below sets out the adjustment required where
Country B law provides B Co with a tax credit for dividends paid.
17.
For the purposes of this calculation it is assumed that the corporate tax rate in
Country A is 30%. A Co is required to treat 90% of the dividend paid as taxable income
which results in a 18.9 tax liability.
EXAMPLE 1.11 209
A Co
B Co
Tax
Book
Tax
Income
Book
Income
Ordinary income
Dividend received
63
100
100
70
Expenditure
Expenditure
Dividend paid
Net return
70
Taxable income
63
Tax on net income
(18.9)
After-tax return
Net return
30
Taxable income
(18.9)
Tax to pay
(70)
51.1
100
Tax on net income
(30)
Tax credit
18.9
Tax to pay
(11.1)
After-tax return
18.9
18.
The table below sets out the adjustment for A Co where Country B law permits
B Co to attach a refundable tax credit to the dividend paid to A Co.
A Co
B Co
Tax
Book
Tax
Income
Dividend received
Refundable Tax Credit
Book
Income
90
70
27
Expenditure
Ordinary income
100
Expenditure
Dividend paid
Net return
Taxable income
Tax to pay
After-tax return
100
97
90
Net return
Taxable income
(27)
70
(70)
Tax to pay
After-tax return
30
100
(30)
0
210 EXAMPLE 1.12
Example 1.12
Debt issued in proportion to shares re-characterised as equity
Facts
1.
In the example illustrated in the figure below, B Co 2 is a company resident in
Country B whose shares are held by B Co 1 (another entity resident in Country B) and
A Co (an entity resident in Country A). A Co owns 75% of the ordinary shares in B Co 2
with B Co 1 owning the remaining 25%.
2.
B Co 2 is in need of 2 000 of additional financing. Both of its shareholders agreed
to debt finance B Co 2 in proportion to their shareholding, i.e. A Co and B Co 1
subscribed 1 500 and 500 respectively for a loan that pays regular interest at a fixed rate.
A Co
Interest / Dividend
75%
B Co 1
Loan
25%
B Co 2
Interest
Loan
3.
Country B treats the loan in accordance with its form and allows B Co 2 a
deduction for the interest payments in accordance with the normal rules applicable to debt
financing in Country B. B Co 2 is allowed a deduction for these interest payments and
B Co 1 includes those payments in its ordinary income.
4.
The laws of Country A, however, re-characterise a debt instrument as equity
(i.e. shares) when the debt is issued by a company to its shareholder for an amount that is
calculated by reference to the shareholders equity in the issuer. Accordingly, the loan
held by A Co is treated as a share in Country A and the interest payments on the loan are
treated as an exempt dividend.
EXAMPLE 1.12 211
Question
5.
Whether the mismatch in tax outcomes that arises in respect of the interest
payments from B Co 2 to A Co, fall within the scope of the hybrid financial instrument
rule?
Answer
6.
The interest payment will give rise to a mismatch unless Country A denies the
benefit of the dividend exemption for the deductible interest payments in accordance with
Recommendation 2.1.
7.
The fact that the debt is issued to each holder in proportion to their equity in the
company is a commercially significant element of the debt financing transaction that
impacts on the tax treatment of the payments made under it. These circumstances in
which the debt was issued should therefore be considered to be part of the terms of the
instrument and the resulting mismatch should be treated as a hybrid mismatch within the
scope of the rule.
Analysis
Recommendation 2.1 will apply to deny A Co the benefit of the dividend
exemption for the payment
8.
The loan is treated as a share under the domestic laws of Country A and interest
payments on the loan are treated as exempt dividends. Recommendation 2.1 states that, in
order to prevent D/NI outcomes arising under a debt / equity hybrid, countries should
deny the benefit of a dividend exemption for deductible payments. Accordingly, in this
case, A Co should tax the interest payments from B Co 2 as ordinary income.
rise to a hybrid mismatch that is within the scope of the hybrid financial
instrument rule
9.
If Country A does not implement Recommendation 2.1 into its domestic law, the
hybrid financial instrument rule will apply.
10.
Recommendation 1 only applies to a financial instrument entered into with a
related party. The loan meets the definition of financial instrument as it is treated as a
debt instrument in Country B and as an equity instrument in Country A. A Co and B Co 2
are related parties as A Co holds 75% of the shares in B Co 2.
A payment made under the loan will give rise to a hybrid mismatch
11.
The interest paid by B Co 2 to A Co is deductible under Country B law and
treated as an exempt dividend in the hands of A Co. The interest payments therefore give
rise to a mismatch. This mismatch will be treated as a hybrid mismatch if the difference
in tax outcomes is attributable to the terms of the instrument. The terms of the instrument
should be construed broadly, going beyond the rights and obligations of the loan and the
relationship between the parties to include the circumstances in which the instrument is
issued or held if those circumstances are commercially or economically significant to the
212 EXAMPLE 1.12

relationship between the parties and affect the tax treatment of the payments made under
the instrument.
12.
The cause of the mismatch in this example is the fact that debt has been issued to
shareholders in proportion to their equity. The issue of debt in proportion to equity is
commercially and economically different from the issue of debt to a third party, or to
shareholders in different proportions, and is likely to impact on the commercial terms of
that debt. Therefore the circumstances in which the debt was issued should be treated as
part of the terms of the instrument and the resulting mismatch as a hybrid mismatch.
Application of the primary and secondary response

13.
Country B should deny the interest deduction to the extent that it is not included
in the ordinary income of A Co. If Country B does not apply the recommended response,
Country A should treat the interest payments received by A Co as ordinary income.
EXAMPLE 1.13 213
Example 1.13
Accrual of deemed discount on interest free loan
Facts
1.
In the example illustrated in the figure below, A Co 1 (a company resident in
Country A) establishes a subsidiary in the same jurisdiction (A Co 2). A Co 1 provides
A Co 2 with a total capital of 40, 12.5% of which is provided in the form of share capital
and the rest by way interest free loan. The loan is repayable in full at the end of five
years.
A Co 1
Interest free loan
A Co 2
Operating
income
2.
The loan is treated as a debt instrument under the laws of Country A. However,
due to the particular tax accounting treatment adopted by A Co 2 in respect of interest
free loans made by another group member, A Co 2 is required to split the loan into two
separate components for accounting purposes: a non-interest bearing loan, which A Co 2
is treated as having issued to A Co 1 at a discount, and a deemed equity contribution
equal to the amount of that discount. The amount that A Co 2 treats as received for the
interest free loan is based on an arms length valuation. The table below sets out a
simplified illustration of how the loan and deemed equity contribution might be reflected
on A Co 2s balance sheet.
214 EXAMPLE 1.13

A Co 2 Assets, Liabilities and Equity
Assets
40
Fixed assets
Year 0
Liabilities
40
20
Shareholder loan
Equity
20
20
Share capital
Other equity
15
3.
In this case A Co 2 has treated the interest free loan of 35 as an equity
contribution of 15 and a loan of 20. In each accounting period A Co 2 will be required to
accrue a portion of the deemed discount on the loan as an expense for accounting
purposes and to treat this expense as funded out of A Co 1s deemed equity contribution.
The table below provides a simplified illustration of how A Co 2 might account for the
accrued liability under the shareholder loan as at the end of Year 1:
A Co 2 Assets. Liabilities and Equity
Assets
45
Current assets (cash)
Cash
Operating Income
40
Year 1
23
Shareholder loan
Equity
Book / Tax
Income
5
Fixed assets
Liabilities
A Co 2 - Income
Expenses
23
22
Accrued liability on shareholder

loan
Net return
Share capital
Other equity
17
(3)
4.
In this case A Co 2 treats the deemed discount as accruing on a straight-line basis so
that, at the end of Year 1 the shareholder loan is recorded on the balance sheet as 23 (an
increase of 3). Country A law permits this deemed increase in liabilities to be treated as a
current expense in Year 1 so that, while A Co has operating income of 5 in that year its
accounts show a net return (and increase in equity) of only 2. Applying the same accounting
treatment in each of the following years will permit the entire discount to be expensed over
the life of the loan so that, at maturity, the shareholder loan will be recorded on the companys
balance sheet at its face amount.
5.
A Co 1 adopts a different tax accounting treatment from A Co 2 and does not split the
interest-free loan into equity and debt components. Accordingly the accrued liability recorded
in A Co 2s accounts in each year is not recognised by A Co 1. On repayment of the loan the
entire amount paid by A Co 2 is simply treated as a non-taxable return of loan principal.
EXAMPLE 1.13 215
Question
6.
rule?
Answer
7.
Country A should deny A Co 2 a deduction under the hybrid financial instrument
rule as the amount which is expensed by A Co 2 in each accounting period gives rise to a
D/NI outcome and this mismatch in tax outcomes is attributable to different approaches
taken to the accounting and tax treatment of the instrument by the payer and payee under
the laws of the same jurisdiction
Analysis
The accrued obligation under the loan should be treated as a payment
8.
A payment includes an amount that is capable of being paid and includes any
future or contingent obligation to make a payment. The definition specifically excludes,
however, payments that are only deemed to be made for tax purposes and that do not
involve the creation of economic rights between the parties. As described in Chapter 1 of
the report, this exception for deemed payments is only intended to exclude regimes, such
as those that grant deemed interest deductions for equity capital, where the tax deduction
is not linked to any payment obligation of the issuer. In this example, A Co 2s deduction
in each accounting period is in respect of its repayment obligation under the loan.
Although the deduction granted to A Co 2 in each accounting period does not correspond
to any increase in A Co 2s liabilities during that period, it does arise in respect of a
repayment obligation and it therefore falls within the definition of a payment for the
purposes of the rule.
Payment gives rise to a hybrid mismatch

9.
The D/NI outcome that arises in this case is the result of A Co 2s entitlement to a
deduction in each accounting period for the annual increase in loan liabilities recorded on
its balance sheet. This deduction is not matched by a corresponding income inclusion for
A Co 1 because A Co 1 does not treat the loan as having been split into equity and debt
components. The ability of A Co 1 and A Co 2 to apply different accounting (and, by
extension, tax) treatments to the same instrument means that the mismatch is attributable
to differences in the tax treatment of the instrument under the laws of the same
jurisdiction.
10.
Note that a mismatch could still arise, on the facts of this example, if A Co 1
adopted the same accounting treatment as A Co 2 but attributed a lower value to the
equity portion of the loan. In such a case the entitlement to a deduction in each
accounting period for the annual increase in loan liabilities would not be matched by an
inclusion of the same amount in Country A. While differences in the value attributed to a
payment under the laws of the payer and payee jurisdictions will not generally give rise to
a D/NI outcome, in this case, the valuation of the respective components of an instrument
has a direct impact on the character of the payments made under it (see further the
analysis in Example 1.16)
216 EXAMPLE 1.13

11.
The particular accounting treatment taken by A Co 2 only applies to interest-free
loans from a group member. The accounting treatment (and, by extension the mismatch in
tax outcomes) would not have arisen if the loan had been entered into between unrelated
taxpayers of ordinary status. The terms of the instrument should be given a broad
meaning and may include any aspect of the relationship between the parties. The fact that
a loan is from a group member should therefore be treated as part of the terms of the loan
notwithstanding that there may be no legal requirement for the loan to be held
intra-group.
EXAMPLE 1.14 217
Example 1.14
Deemed interest on interest-free loan
Facts
12.
The facts of this Example are the same as Example 1.13 except that the interest
free loan is made to a foreign subsidiary (B Co) and the laws of Country B allow B Co to
claim a deduction for tax purposes as if it had paid interest on the loan at a market rate.
13.
The laws of Country A treat the loan as a debt instrument or equity instrument
and there is no corresponding adjustment in Country A. On repayment of the loan the
entire amount is treated as a non-taxable return of loan principal or return of capital.
Question
14.
rule?
Answer
15.
The arrangement does not fall within the scope of the hybrid financial instrument
rule because there is no payment under the loan that gives rise to a deduction for tax
purposes in Country B.
218 EXAMPLE 1.14
Analysis
There is no payment made under the financial instrument that gives rise to a
hybrid mismatch
16.
Recommendation 1 only applies to D/NI outcomes that arise in respect of
payments. The definition specifically excludes payments that are only deemed to be made
for tax purposes and that do not involve the creation of economic rights between the
parties. In this example B Cos deduction in each accounting period arises in respect of an
amount that is not capable of being paid. Accordingly there is no payment under the
financial instrument that gives rise to a D/NI outcome.
EXAMPLE 1.15 219
Example 1.15
Differences in value attributable to share premium paid under mandatory
convertible note
Facts
1.
Country A) owns all the shares in B Co (a company resident in Country B). A Co
subscribes for a five year zero-coupon convertible note with a principal amount of 100.
A Co
Zero-coupon
convertible note
B Co
2.
The zero-coupon note automatically converts into shares of B Co at the maturity
date. The equity premium that arises on the conversion of the note is treated as deductible
by B Co and is included in ordinary income by A Co. The value of the equity premium is
calculated by Country A to be 15, while Country B values the equity premium at 30.
Question
3.
Whether any portion of the deduction for the equity premium under Country B
law gives rise to a hybrid mismatch within the scope of the hybrid financial instrument
rule?
Answer
4.
No adjustment is required under the hybrid financial instrument rule as the
difference in valuation of the equity premium does not give rise to a hybrid mismatch.
220 EXAMPLE 1.15
Analysis
No mismatch in respect of differences in the valuation of a payment
5.
The mismatch in tax outcomes in this case is not a mismatch within the meaning
of the hybrid financial instrument rule. This is because the difference in outcome is
merely attributable to the differences in the valuation of a payment and it does not relate
to any difference in characterisation of the payment between the two countries.
EXAMPLE 1.16 221
Example 1.16
Differences in valuation of discount on issue of optional convertible note
Facts
1.
The facts of this example are the same as those in Example 1.15 except that
zero-coupon note can be converted into shares of B Co at the option of A Co. Both
Country B and Country A laws bifurcate the instrument for tax purposes. Country B treats
A Co as having paid 80 for a zero-coupon note and 20 in exchange for the share option.
Accordingly the note is treated as issued at a discount and B Co is entitled to accrue the
amount of that discount as a deduction for tax purposes over the term of the loan.
Country A adopts the same tax treatment but treats A Co as having paid 90 for the note
and 10 for the share option.
Question
2.
Whether the adjustment under Country B law for the deductible costs attributable
to the convertible note gives rise to a hybrid mismatch within the scope of the hybrid
Answer
3.
The difference in valuation has a direct impact on the characterisation of the
payments made under the instrument and therefore gives rise to a hybrid mismatch.
Analysis
The accrued obligation under the loan should be treated as a payment
4.
A payment includes an amount that is capable of being paid and includes any
future or contingent obligation to make a payment. In this example, B Cos deduction in
each accounting period is in respect of its contingent repayment obligation under the loan.
Although the deduction does not correspond to any increase in A Co 2s liabilities during
that period, it does arise in respect of a repayment obligation and it therefore falls within
the definition of a payment for the purposes of the rule (see analysis in Example 1.13)
The difference in the valuation of the option component results in a difference

in the character of the underlying payments
5.
In order for the deductible payment to give rise to a D/NI outcome there must be
a difference in the way the payment is measured and characterised under the laws of the
payer and payee jurisdictions. If the amount of the payment is characterised and
calculated in the same way under the laws of both jurisdictions, then differences in the
222 EXAMPLE 1.16

value attributed to that amount under the laws of the payer and payee jurisdictions will
not give rise to a D/NI outcome. Differences in tax outcomes that are solely attributable
to differences in the value ascribed to a payment (including through the application of
transfer pricing) do not fall within the scope of the hybrid mismatch rule (see Example
1.15).
6.
In certain cases, however, particularly in the case of more complex financial
instruments that are treated as incorporating both financing and equity returns, the way
the separate components of the instrument are measured, and therefore the character of
the payments under local law, may be dependent on the value attributed to each of those
components. In such a case, where the valuation of the components of a financial
instrument has a direct impact on the characterisation of the payments made under it,
differences in valuation may give rise to a mismatch.
7.
In this case both the issuer and the holder treat a convertible note as being issued
at discount representing its equity value. The higher valuation given to the equity value of
the note in the issuers jurisdiction, results in the issuer recognising a larger accrued
discount, which, in turn, results in greater portion of the payments being treated as
deductible in the issuer jurisdiction. In this case, the way in which the component
elements of the note are valued has a direct impact on the way the payments under the
instrument are characterised for tax purposes and, accordingly, the difference in valuation
should be treated as giving rise to a mismatch in tax outcomes.
EXAMPLE 1.17 223
Example 1.17
No mismatch with respect to measurement of foreign exchange differences
Facts
1.
Country A) owns all the shares in B Co (a company resident in Country B). A Co
provides B Co with an ordinary loan. Interest on the loan is payable every year in arrears
at a market rate and the principal on the loan is payable at maturity. The loan is treated as
a debt instrument under the laws of both Country A and B and the countries take a
consistent position on the characterisation of the payments made under the loan. The
interest payable on the loan is deductible in Country B and included in ordinary income
under the laws of Country A.
A Co
Interest
Foreign
Currency
Loan
B Co
2.
The interest and principal under the loan are payable in Currency A. The value of
Currency B falls in relation to Currency A while the loan is still outstanding so that
payments of interest and principal under the loan become more expensive in Currency B
terms. Under the Country B law, B Co is entitled to a deduction for this increased cost.
There is no similar adjustment required under Country A law.
Question
3.
Whether the adjustment under Country B law for the increase in costs attributable
to the fall in the value of Currency B gives rise to a hybrid mismatch within the scope of
the hybrid financial instrument rule?
224 EXAMPLE 1.17
Answer
4.
While the fall in the value of Currency B gives rise to a deduction under
Country B law that is not reflected by a corresponding inclusion in Country A, this
difference does not give rise to a D/NI outcome provided the proportion of the interest
and principal payable under the loan is the same under the laws of both jurisdictions.
Gains and losses that result from converting foreign exchange into local or functional
currency are attributable to the way jurisdictions measure the value of money rather than
the value of the payment itself.
Analysis
The foreign currency adjustment does not give rise to a mismatch
5.
In this case both Country A and B characterise the payments in the same way (as
either principal or interest) and take the same view as to the proportion of interest and
principal payable under the loan. The difference in tax treatment in this case does not
arise because the tax systems of the two countries characterise the payments in different
ways or arrive at a different value for the payments made under the loan. Rather, once the
character and amount have been determined, the laws of one jurisdiction require the value
of the payment to be translated into local currency. This type of currency translation
difference, which is a difference in the way jurisdictions measure the value of money
(rather than the underlying character or amount of a payment), should not be treated as
giving rise to a mismatch.
EXAMPLE 1.18 225
Example 1.18
Payment in consideration for an agreement to modify the terms of a debt
instrument
Facts
1.
In the example illustrated in the figure below B Co is a company resident in
Country B. B Co borrows money from its immediate parent A Co, a company resident in
Country A. The loan has a 5 year term and pays a high fixed rate of interest. B Co makes
a one-off arms-length payment to A Co in consideration for A Co agreeing to lower the
interest rate on the loan. The effect of this adjustment is to reduce the value of the loan as
recorded in A Cos accounts.
A Co
Payment in
consideration for
change to loan terms
Loan
B Co
Question
2.
Whether the payment in consideration for the agreement to change to the terms of
the loan falls within the scope of the hybrid financial instrument rule?
Answer
3.
B Cos payment should be treated as a payment made under the loan itself. The
payment will give rise to a hybrid mismatch to the extent it is treated as deductible under
the laws of Country B and is not included in ordinary income under Country A law.
Although A Cos surrender or discharge of rights under the loan may be thought of as a
226 EXAMPLE 1.18

transfer of value, it should not be considered a payment under the loan within the scope of
the hybrid financial instrument rule.
Analysis
The amount paid in consideration for agreeing to a change in the terms of the
loan is a payment under a financial instrument
4.
The determination of whether a payment is made under a financial instrument
can usually be made by looking to the terms of the instrument and considering whether
that payment is either required under the instrument or is in consideration for the release
from a requirement under the instrument. In this case the payment is made in
consideration for agreeing to a release from the obligation to make certain payments
under the loan and should therefore be treated as a payment under the instrument.
The payment will give rise to a hybrid mismatch if it is not treated as ordinary
income under Country A law
5.
The payment under a financial instrument will give rise to a mismatch in tax
outcomes if it is deductible under the laws of Country B and not treated as ordinary
income under the laws of Country A. The example does not state whether A Co treats the
one-off payment as ordinary income. If, however, Country A law does not require a
taxpayer to bring this type of payment into ordinary income, the mismatch in tax
outcomes should be treated as a hybrid mismatch because it arises due to differences in
the way Country A and Country B laws characterise such payments for tax purposes.
6.
It may be the case that A Co is not required to bring the payment into account as
ordinary income until the end of the loan term. If this is the case the reasonableness of the
timing difference would need to be tested in accordance with Recommendation 1.1(c).
Release of obligations under the loan is not a payment

7.
A Cos agreement to surrender or modify rights under the loan may be thought of
as a transfer of value to B Co but it should not be treated as a payment under the loan
itself. Any deduction that A Co may claim for the reduction in the value of the loan due to
such surrender or discharge does not, therefore, fall within the scope of the hybrid
financial instrument rule. Accordingly, the deduction that may be granted under
Country A law for the reduction in the value of the loan is not a payment under the loan
and does not fall within the scope of the hybrid financial instrument rule.
EXAMPLE 1.19 227
Example 1.19
Payment in consideration for the cancellation of a financial instrument
Facts
1.
This example illustrated in the figure below is the same as Example 1.18 except
that B Co buys the subordinated loan at premium to the amount that would have been
payable on maturity. This acquisition results in a deemed cancellation of the loan. B Co
treats the premium as deductible expenditure while A Co treats it as a gain on the disposal
of the loan.
A Co
Purchase price
Transfer
of loan
B Co
Question
2.
Whether the consideration paid to acquire the loan falls within the scope of the
hybrid financial instrument rule and, if so, to what extent an adjustment is required to be
made in accordance with that rule.
Answer
3.
The consideration for the transfer of the loan should be treated as made under a
financial instrument because the transfer has the effect of discharging B Cos obligations
under the loan. Unless Country A law treats the amount paid as ordinary income, the
hybrid financial instrument will apply to neutralise the effect of the resulting mismatch.
228 EXAMPLE 1.19
Analysis
The consideration for the transfer is deemed to be a payment under a financial
instrument
4.
A payment made by a person to acquire an existing financial instrument will not
generally be treated as a payment made under that instrument. Where, however, the
payment is consideration for discharging, in whole or part, the issuers obligations under
the instrument, the payment should be treated as caught by the rule. In this case, B Cos
acquisition of the loan from A Co has the effect of cancelling B Cos obligations under
the instrument and, accordingly, the consideration paid for the transfer of the loan should
be treated as a payment made under the instrument itself.
The payment will give rise to a hybrid mismatch

5.
As the payment of a premium is deductible under the laws of Country B, the
payment will give rise to a mismatch unless it is required to be included as ordinary
income under Country A law. If Country A law dealing with the taxation of these types of
instruments requires any gain on the disposal of such a loan to be brought into account as
ordinary income for tax purposes, then the payment should not give rise to a mismatch. If,
however, the gain is excluded or exempt from tax, or A Co is taxable on the proceeds of
disposal solely due to its particular tax status or the context in which the instrument is
held (for example, A Co holds the loan as trading asset), then the payment should be
treated as giving rise to a mismatch. The mismatch that arises will be a hybrid mismatch
as it is due to differences in the way in which the laws of Country A and Country B
characterise redemption payments under a financial instrument.

6.
Country B should deny a deduction for the premium paid to A Co for the release
of its obligations under the loan. If Country B does not apply the recommended response,
then Country A should treat the premium as ordinary income.
EXAMPLE 1.20 229
Example 1.20
Release from a debt obligation not a payment
Facts
1.
This example illustrated in the figure below is the same as Example 1.19 except
that B Co gets into financial difficulties and is unable to make payments of interest and
principal on the loan. A Co agrees to forgive the loan and releases B Co from the
obligation to make any further payments of principal and accrued interest. The amount of
debt forgiven is treated as deductible under Country A law but is not treated as income by
B Co.
Question
2.
Whether the D/NI outcome, which arises with respect to the restructuring of the
loan, falls within the scope of the hybrid financial instrument rule?
Answer
3.
Although the forgiveness of debt is a transfer of value from A Co to B Co, it is
not a payment under a financial instrument. Accordingly A Cos deduction does not fall
within the scope of the hybrid financial instrument rule.
Analysis
4.
The hybrid financial instrument rule applies only to payments made under a
financial instrument. A payment will be treated as made under a financial instrument if it
is made in discharge, satisfaction or release of an obligation under that financial
instrument. The discharge, satisfaction or release of the obligation itself should not be
treated as a payment even though such release may give rise to a transfer of value
between the parties.
5.
Accordingly the deduction granted under Country A law is in respect of the
release of an obligation under a financial instrument, not a payment under it, and does not
fall within the scope of the hybrid financial instrument rule.
230 EXAMPLE 1.21
Example 1.21
Mismatch resulting from accrual of contingent interest liability
Facts
1.
In the example illustrated in the figure below, A Co 1 owns all the shares in A Co
2. Both companies are resident in Country A. A Co 1 provides A Co 2 with a
subordinated loan. The terms of the loan provide for interest that is payable at maturity or,
if earlier, at the discretion of A Co 2. The loan has a long maturity date (50 years) and
A Co 1 may waive its entitlement to interest at any time prior to payment.
A Co 1
Contingent
interest
Loan
A Co 2
2.
The loan is treated as debt under the laws of Country A but A Co 1 and A Co 2
adopt different accounting policies in respect of the loan. The effect of this difference in
accounting treatment is that interest payments on the loan are treated as deductible by
A Co 2 in the year the interest accrues but will only be treated as income by A Co 1 when
(and if) such interest is actually paid. Furthermore, if A Co 1 waives its entitlement to
accrued interest at any point prior to payment, this waiver will be treated by A Co 2 as a
deemed equity contribution to A Co 2 and will therefore not trigger a recapture of interest
deductions previously claimed.
EXAMPLE 1.21 231
Question
3.
Will the accrued but unpaid interest give rise to a hybrid mismatch under the
hybrid financial instrument rule?
Answer
4.
The terms of the loan are such that the taxpayer will be unable establish, to the
satisfaction of the tax authority, that the payment will be made, or can be expected to be
made, within a reasonable period of time. Accordingly the fact that the accrued interest is
deductible for A Co 2 but not included in income by A Co 1 should be treated as giving
rise to a mismatch for tax purposes. This mismatch in tax outcomes arises due to different
ways in which A Co 1 and A Co 2 account for the payments of interest under the loan.
Accordingly the deduction for the contingent interest will be treated as giving rise to a
hybrid mismatch under the hybrid financial instrument rule.
Analysis
The accrued interest is a payment under a financial instrument
5.
Recommendation 1 only applies to payments made under a financial instrument.
The definition of payment under the hybrid mismatch rules includes an accrual of an
amount even if it is in respect of a contingent obligation.
Taxpayer unable to establish that the payment can reasonably be expected to be

included in income
6.
The accounting treatment adopted by A Co 2 allows A Co 2 to recognise the
interest as a deductible expense (i.e. as having been paid) in the year it accrues, however
the conditions under which A Co 2 is entitled to claim a deduction are not sufficient to
bring the interest into ordinary income in the hands of A Co 1. The mere fact that interest
is deductible by one party when it accrues, but will not be included in ordinary income by
the recipient until it is actually paid, does not necessarily mean that it will be treated as
giving rise to a mismatch in tax outcomes. In this case, however, the maturity date and
payment terms of the instrument, together with the fact that the loan is held intra-group,
indicate that the parties have placed little commercial significance on the payment of the
accrued interest under the loan.
7.
Even if the loan had a significantly shorter maturity date, A Co 1 still has the
power to waive its entitlement to interest at any time before the interest is actually paid
without such waiver giving rise to any adverse tax or economic consequences for A Co 1
or A Co 2.
8.
Accordingly the taxpayers in this example will be unable to satisfy its tax
administration at the time the loan is issued that it is reasonable to expect that the
amounts treated as a deductible payment by A Co 2 will be included as ordinary income
under the accounting method adopted by A Co 1. The mismatch in tax outcomes that
arises under the loan should therefore be treated as falling within the scope of the hybrid
232 EXAMPLE 1.21
Mismatch in tax outcomes will be a hybrid mismatch

9.
The ability of A Co 1 and A Co 2 to apply different accounting (and, by
extension, tax) treatments to the same instrument means that the mismatch is attributable
to differences in the tax treatment of the instrument under the laws of the same
jurisdiction.
Primary response
10.
Country A should deny A Co 2 a deduction for the accrued interest on the loan. If
Country A introduces a rule that defers A Co 2s entitlement to a deduction until the
interest is actually paid then that may have the effect of bringing such interest payments
within the operation of the safe harbour described in the guidance to Recommendation
1.1 and the primary response will no longer apply.
EXAMPLE 1.22 233
Example 1.22
No mismatch resulting from accrual of contingent interest liability
Facts
1.
In the example illustrated in the figure below, A Co 1 owns 30% of the shares in
B Co (a company established and tax resident in Country B). The rest of the shares are
owned by A Co 2 (an unrelated company). B Co makes an investment in an infrastructure
asset that is not expected to produce returns for a number of years. As part of the funding
for this arrangement, A Co 1 provides B Co with a subordinated loan.
A Co 1
A Co 2
30%
Loan
70%
Contingent
interest
B Co
2.
Interest accrues on the loan at a fixed rate. The terms of the loan, however,
provide that interest will only be paid at the end of the term of the loan (15 years) or at
the discretion of B Co and only if certain solvency requirements are met. Furthermore
there is a dividend-blocker on the shares issued by B Co that prevents B Co from
making any distributions to its shareholders while there is accrued but unpaid interest on
the loan.
3.
The loan is treated as debt under the laws of both countries, however, due to
differences in the way interest is accounted for tax purposes by the two countries, the
interest is treated as deductible by B Co in the year it accrues but will only be treated as
income by A Co 1 when it is actually paid.
234 EXAMPLE 1.22
Question
4.
Will the accrued but unpaid interest give rise to a hybrid mismatch under the
Answer
5.
The fact that the accrued interest can reasonably be expected to be paid and that
the payment terms are reasonable in the circumstances should mean that the tax
administration will not treat the accrued interest as giving rise to a hybrid mismatch.
Analysis
It can reasonably be expected that the payment will be made within a
reasonable period of time
6.
The hybrid financial instrument rule is not intended to pick up differences in the
timing of recognition of payments under a financial instrument. A mismatch in tax
outcomes will be treated as simply giving rise to a timing difference (outside the scope of
the hybrid financial instrument rule) if the taxpayer can establish, to the satisfaction of the
tax administration, that it is reasonable to expect payment to be made (i.e. included in
ordinary income) within a reasonable period of time.
7.
In this case, interest payments are not required to be made until maturity and only
if the borrower meets certain solvency requirements. Although the period of maturity is
long (15 years) the facts of this example, including the fact that the interests of the debt
and equity holders are not aligned, suggest that, in practice, the parties have placed real
commercial significance on the requirement to make payments under the loan and that
they expect, at the time the arrangement is entered into, that the outstanding principal and
interest under the loan will be paid.
8.
The time period for the payment of interest will be treated as reasonable if it is
what might be expected to be agreed between unrelated parties acting at arms length.
This determination should take into account such factors as the terms of the instrument,
the circumstances in which it is held and the commercial objectives of the parties,
including the nature of the accrual and any contingencies or other commercial factors
affecting payment. In this case: the nature of the underlying investment (infrastructure);
the competing and potentially divergent interests of the parties (bearing in mind that the
holder is only a minority equity holder) and the contractual protections for the payee,
such as the dividend blocker on the shares, are all factors indicative of an arrangement on
arms length terms.
EXAMPLE 1.23 235
Example 1.23
Payment by a hybrid entity under a hybrid financial instrument
Facts
1.
In the example illustrated in the figure below B Co 1, a company resident in
Country B, is a wholly-owned subsidiary of A Co, a company resident in Country A.
B Co 1 is disregarded for the purposes of Country A law. B Co 1 borrows money from
B Co 2 another wholly-owned subsidiary resident in the same jurisdiction.
A Co
Interest / Dividend
Dividend
B Co 1
B Co 2
Loan
2.
Country B treats the loan as an equity instrument. Accordingly it does not allow B
Co 1 a deduction for the payment and treats the payment as an exempt dividend in the
hands of B Co 2. The loan is, however, treated as a debt instrument under Country A law
and, because B Co 1 is a disregarded entity, the interest payable on the loan is treated as
deductible by A Co under the laws of Country A.
Question
3.
Whether the interest payment is subject to adjustment under the hybrid financial
instrument rule and, if so, what adjustments are required under the rule?
236 EXAMPLE 1.23
Answer
4.
The interest payment is caught by the hybrid financial instrument rule.
5.
Country A should deny A Co the deduction for the interest payable under the
loan. If Country A does not apply the recommended response then Country B should treat
the interest payments on the loan as ordinary income.
Analysis
The arrangement is a financial instrument
6.
The loan meets the definition of a financial instrument because it is treated as an
equity instrument under the laws of Country B and a debt instrument under the laws of
Country A.
The payment gives rise to a hybrid mismatch

7.
A D/NI outcome arises where a payment that is deductible under the laws of one
jurisdiction (Country A) is not included in ordinary income under the laws of any other
jurisdiction where the payment is treated as being received (Country B). The mismatch is
a hybrid mismatch as it is attributable to differences in the tax treatment of the loan under
the laws of the payee and payer jurisdictions.

8.
Country A deny the deduction to the extent it gives rise to a D/NI outcome.

9.
If Country A does not apply the recommended response, then Country B should
treat the deductible payment as ordinary income in the hands of B Co 2, under the laws of
Country B.
EXAMPLE 1.24 237
Example 1.24
Payment included in ordinary income under a CFC regime
Facts
1.
In the example illustrated in the figure below, C Co is a company resident in
Country C and a member of the ABC Group. C Co makes a payment of 30 under a hybrid
financial instrument to B Co, another group company resident in Country B. In addition
to receiving this payment from C Co, B Co also derives income from other sources and
incurs expenses, including interest on a loan from Bank.
A Co
Operating
income (340)
B Co
Expenses (55)
Payment (30)
Asset
Hybrid
financial
instrument
C Co
2.
A Co, the parent of the group, resident in Country A, is subject to a CFC regime
in Country A that attributes certain types of passive income derived by controlled foreign
entities to resident shareholders in proportion to their shareholding in that entity.
Countries A and C have introduced the recommendations set out in this report.
238 EXAMPLE 1.24

3.
A simplified table below illustrates the net tax positions of A Co and B Co in the
period the payment under the hybrid financial instrument was made.
B Co
A Co
Tax
Book
Tax
Income
Active income
Passive income (including
rents, interest and royalties)
Payment under hybrid
financial instrument
Income
280
280
60
60
30
Expenditure
CFC income
80.4
Foreign tax credit
27.6
Expenditure
Interest expense
(10)
(10)
Depreciation
(15)
Employment expenses
(45)
(45)
Net return
Taxable income
315
270
Net return
Taxable income
Tax (at 30%)
Tax credit
Tax to pay (at 40%)

After-tax return
Book
(108)
207
Tax to pay
After-tax return
0
108
(32.4)
27.6
(4.8)
(4.8)
4.
B Co derives 340 of taxable income for the period (including 60 of passive
income such as rents, royalties and interest). The payment of 30 under the hybrid
financial instrument is excluded from the calculation of B Cos income under Country B
law. B Co incurs 70 of expenses (including tax depreciation) giving it taxable income of
270 which is taxable at the ordinary corporate rate of 40%.
5.
A Cos only income for the same period is the income of B Co that is attributed
under Country As CFC regime. As set out in the table above, an amount of 80.4 is
brought into account for tax purposes as ordinary income and subject to tax at the full
corporate rate (30%) together with a credit of 27.6 for underlying taxes paid in
Country B.
Question
6.
How should the inclusion of CFC income under Country A law impact on the
application of the hybrid financial instrument rule in Country C?
Answer
7.
A taxpayer seeking to rely on a CFC inclusion in the parent jurisdiction, in order
to avoid an adjustment under the hybrid financial instrument rule, should only be able to
do so in circumstances where it can satisfy the tax administration that the payment will be
EXAMPLE 1.24 239
fully included under the laws of the relevant jurisdiction and subject to tax at the full rate.
In this case the taxpayer will be required to establish that:
(a) the payment under the hybrid financial instrument is of a type that is required to
be brought into account as ordinary income under the CFC rules in Country A
(and does not benefit from any exemption under those rules, such as an active
income or de-minimis exemption); and
(b) the payment is or will be brought into account as ordinary income on A Cos
return under the quantification and timing rules of the CFC regime in Country A.
8.
The facts of this example state that the parent of the group (A Co) is subject to a
CFC regime that attributes certain types of passive income derived by controlled foreign
entities to resident shareholders, The example does not, however, provide any further
detail on whether, and to what extent, the payment under the hybrid financial instrument
has been brought into account under the rules of that CFC regime. Accordingly, there is
insufficient information, on the facts of this example, for a tax administration to conclude
that relief should be provided from any adjustment under the hybrid financial instrument
rule.
9.
If the taxpayer can demonstrate, by reference to both the laws of Country A and
the tax returns filed under Country A law that the payment is or will be included under
the laws of the CFC regime in that jurisdiction then a jurisdiction in the position of
Country C seeking to avoid the risk of economic double taxation under the hybrid
financial instrument rule should consider whether relief should be granted from the
application of the hybrid financial instrument rule in light of the CFC inclusion in
Country A. Relief from the application of the hybrid financial instrument rule should only
be granted, however, to the extent that the payment has not been treated as reduced or
offset by any deduction incurred in the payee jurisdiction (Country B) and does not carry
an entitlement to any credit or other relief under the laws of the parent jurisdiction
(Country A).
10.
Finally, in order for an amount that is included in ordinary income under the laws
of Country A to be eligible for relief from the operation of the hybrid financial instrument
rule in Country C, the taxpayer may need to establish that the income has not been set-off
against a hybrid deduction under the laws of Country A. In this case the requirement will
be satisfied because Country A has implemented the recommendations set out in this
report.
Analysis
Inclusion of income under a CFC regime may give rise to economic double
taxation
11.
Recommendation 1.1 states that jurisdictions should consider how to address the
mismatch in tax outcomes under the hybrid financial instrument rule in cases where the
payment under a hybrid financial instrument has been included in ordinary income by the
shareholder under a CFC regime and whether any relief should be granted from the
operation of that rule in cases where denying a deduction for a payment that is included in
income under a CFC regime may give rise to the risk of economic double taxation.
12.
A CFC regime often focuses on certain categories of income derived by a foreign
entity that are required to be attributed to a shareholder in a CFC. These categories,
however, will often be defined by reference to the local tax law of the shareholders
240 EXAMPLE 1.24

jurisdiction and will not necessarily correspond to the same categories, timing and
quantification rules of the payer and payee jurisdictions. Before a payment can be treated
as included in ordinary income under a CFC or other offshore inclusion regime, the
taxpayer must be able to show that the payment under the hybrid financial instrument,
which has given rise to the D/NI outcome, falls within a category of payments that is
required to be brought into account as income of the shareholder under a CFC regime and
does not qualify for any exception (such as a de-minimis exception or an exemption for
active income).
13.
On the face of the tax calculations above there is nothing that shows the
relationship between the excluded payment received by B Co under the hybrid financial
instrument and the amount included in CFC income under Country A law. In fact, the
simplified accounts shown above provide no evidence that the amount of CFC income
recognised by A Co is attributable to the payment made under the hybrid financial
instrument. In this case, the taxpayer would therefore need to adduce additional evidence
both to satisfy the tax administration that the CFC regime actually required the payment
under the hybrid financial instrument to be included as CFC income and when and to
what extent the payment would be recognised as CFC income in the hands of the
shareholder. If, for example, all the income of a CFC from a particular period is attributed
to a shareholder on the final day of the CFCs accounting period, then the shareholder
would need to satisfy the tax administration that it holds or will be holding those shares
on the attribution date.
Payment only treated as included to the extent it has not been reduced or offset
by any deduction
14.
CFC regimes typically require the net income of a CFC from particular sources or
activities to be brought into account and subject to tax at the shareholder level. In this
case B Co has a number of deductions that are offset against its net income. The example
gives no information on whether or to what extent those deductions are also taken into
account for the purposes of calculating A Cos attributed income from a CFC.
15.
If Country As CFC regime treats the amount of the payment under the hybrid
financial instrument as reduced by deductible expenditure incurred by B Co then only the
net amount of CFC income attributable to the payment should be treated as having been
brought into account as ordinary income under the laws of the Country A.
16.
For example, the CFC regime of Country A may require the full amount of
passive income derived by B Co and the payment under the hybrid financial instrument to
be brought into account as CFC income under Country A law (i.e. 60 + 30 = 90) but it
may permit a deduction to be taken against such CFC income for a proportionate amount
of B Cos expenses, other than depreciation (i.e. a deduction equal to 55 x 55/315 = 9.6)
resulting in a net CFC inclusion of 80.4 (plus foreign tax credits). In this case a
jurisdiction may take the view that the portion of the payment under the hybrid financial
instrument actually included in income is 26.8 (= 30 (30/90 x 9.6).
Payment only treated as included to the extent it has not been sheltered by any
credit for underlying taxes
17.
Country As CFC regime further treats attributed income as carrying a right to
underlying foreign tax credits. In this case the payment that is attributed CFC income
EXAMPLE 1.24 241
under the laws of Country A should not be treated as included in ordinary income under
Country A law to the extent the payment is sheltered by such tax credits.
18.
For example, the CFC regime of Country A may allow A Co to claim an
underlying tax credit in proportion to the effective rate of tax on the (adjusted) income of
B Co (i.e. a tax credit equal to 80.4 x (108 / 315) = 27.5). The effect of this tax credit is to
shelter 85% of the tax liability on the amount of income included under the CFC regime
of Country A. Applying this percentage to the amount of the payment under the hybrid
financial instrument that is actually included under Country A law (26.8) a tax authority
may conclude that the total amount of the payment under the hybrid financial instrument
that has been included in income under this example is ((1 0.85) x 26.8 = 4).
242 EXAMPLE 1.25
Example 1.25
Payment under a lease only subject to adjustment to extent of financing
return
Facts
1.
The arrangement illustrated in the figure below involves a company resident in
Country A (A Co) which obtains financing from a related company resident in Country B
(B Co). To secure the financing A Co transfers a piece of equipment to B Co. B Co then
leases that equipment back to A Co on terms that give A Co both the right and obligation
to acquire the equipment for an agreed value at the end of the lease.
Rent
A Co
B Co
Asset
transfer
Lease
Asset
2.
Country B treats the arrangement as a finance lease, pursuant to which, A Co is
treated as the owner of asset and the arrangement between the parties is treated as a loan,
with the payments of rental under the lease treated as payments of interest and principal
on the loan.
3.
Country A treats the arrangement in accordance with its form (i.e. as an ordinary
lease) and the payments on the lease as deductible payments of rent. The effect of this
arrangement is that a certain portion of the rental payments give rise to a D/NI outcome
because they are deductible for the purposes of Country A law but are not included in
ordinary income for the purposes of Country B law (because they are characterised as
periodic payments of purchase price or repayments of principal).
EXAMPLE 1.25 243
Question
4.
Is the arrangement subject to adjustment under the hybrid financial instrument
rule and, if so, to what extent?
Answer
5.
Under Country A law the hybrid financial instrument rule does not apply because
the arrangement is not a hybrid transfer and is not otherwise treated as a financial
instrument under local law.
6.
The arrangement is treated as a debt instrument in Country B and B Co will
therefore be required to apply the hybrid financial instrument rule to the payments under
the lease. However, only the financing return is subject to adjustment under the rule. In
this case the financing return is fully taxable under Country B law, so B Co should not be
required to make any adjustment under the hybrid financial instrument rule.
Analysis
Whether arrangement is a financial instrument to be determined by reference to
its domestic tax treatment
7.
Jurisdictions are expected to use their own domestic tax concepts and terminology
to define the arrangements covered by the hybrid financial instrument rule. This local law
definition should generally include any financing arrangement, such a finance lease,
where one party (B Co) provides money (including moneys worth) to another in
consideration for a financing return. On the facts of any particular case, however, the
question of whether an arrangement is a financial instrument (and, therefore, potentially
subject to adjustment under the hybrid financial instrument rule) should be answered
solely by reference to the domestic tax treatment of that arrangement.
Rule does not apply under laws of Country A

8.
In this case Country A treats the arrangement as an agreement for the supply of
services (i.e. lease) and the arrangement is not taxed under the rules for taxing debt,
equity or derivatives. As the agreement is not a hybrid transfer and does not give rise to a
substitute payment (as it does not involve the transfer of a financial instrument) the
payments under the lease will not be subject to adjustment under the hybrid financial
instrument rule in Country A.
No adjustment required under laws of Country B

9.
The hybrid financial instrument rule is only intended to capture mismatches that
arise in respect the equity or financing return paid under a financial instrument.
Accordingly, in this case, where the counterparty does not treat the payments under the
arrangement as payments under a financial instrument, the hybrid financial instrument
rule should only apply to the extent of the equity or financing return. Payments under the
arrangement that are treated under Country B law as purchase price or repayment of
principal should, therefore, not be subject to adjustment under the rule. In this case the
financing return on the lease will be fully taxable in Country B under ordinary law, so the
hybrid financial instrument rule will generally not result in any net adjustment for B Co.
244 EXAMPLE 1.26
Example 1.26
Consideration for the purchase of a trading asset
Facts
1.
Country A) transfers shares to B Co. B Co pays fair market value for the shares. The
share transfer occurs on the same day as the payment. B Co acquires the shares as part of
its activities as a trader and will be able to include the purchase price as expenditure when
calculating any taxable gain/loss on the disposal of the shares.
Purchase price
B Co
(trader)
A Co
Share
transfer
Shares
Question
2.
Does the payment give rise to a D/NI outcome under the hybrid financial
instrument rule?
Answer
3.
The asset sale agreement is not a financial instrument as it does not provide for a
financing or equity return. The payment under the asset transfer agreement is not a
substitute payment as it does not include, or contain an amount representing, a financing
or equity return. Accordingly the transaction does not fall within the scope of the hybrid
EXAMPLE 1.26 245
Analysis
The asset transfer agreement is not a financial instrument
4.
The hybrid financial instrument rule is not intended to apply to asset transfers
unless the transfer is a hybrid transfer or incorporates a substitute payment.
5.
This asset transfer agreement does not fall within the definition of a financial
instrument. It does not produce a return that is economically equivalent to interest, as the
exchange of value occurs on the same day, and does not provide any party with an
entitlement to an equity return (other than the return to B Co from holding the transferred
asset).
6.
The asset transfer agreement is not a hybrid transfer (and therefore does not fall
within the extended definition of a hybrid financial instrument) as it does not give rise to
a situation where both parties are treated as holding the transferred shares at the same
time. Furthermore, even if the asset transfer was treated as a hybrid transfer, the purchase
price deduction claimed by the trader in this case should not be treated as falling within
the scope of the hybrid financial instrument rule as such a deduction is not the product of
differences between jurisdictions in the tax treatment of asset transfer agreement but
rather because the underlying asset is held by A Co and B Co in different capacities
(i.e. by A Co as a capital asset and by B Co as a trading asset).
Purchase price does not include a substitute payment

7.
Because the purchase price contains no element of an equity or financing return it
should not be treated as a substitute payment under an asset transfer agreement.
246 EXAMPLE 1.27
Example 1.27
Interest component of purchase price
Facts
1.
The example illustrated in the figure below is the same as Example 1.26 except
that the agreement provides that consideration payable under the share sale agreement
will be deferred for one year. The purchase price of the shares is their fair market value
on the date of the agreement plus an adjustment equivalent to a market-rate of interest on
the unpaid purchase price. Country B allows B Co to treat the interest portion of the
purchase price as giving rise to a separate deductible expense for tax purposes while,
under Country A law, the entire purchase price (including the interest component) is
treated as consideration for the transfer of the asset.
Purchase price + interest
A Co
B Co
Transfer
Shares
Question
2.
To what extent does the hybrid financial instrument rule apply to adjust the
ordinary tax consequences for A Co and B Co in respect of the purchase price?
Answer
3.
The asset sale agreement is treated under Country B law as giving rise to a
deductible financing expense. Country B law should therefore treat the payment as within
the scope of the hybrid financial instrument rule. Country A law does not treat the
payment as ordinary income under a financial instrument. The interest payment thus gives
rise to a mismatch which is attributable to the different ways in which the asset transfer
EXAMPLE 1.27 247
agreement is characterised under the laws of Country A and Country B. Therefore B Co

should be denied a deduction for the adjustment under the hybrid financial instrument
rule.
4.
Unless the asset transfer falls within the definition of a hybrid transfer, the hybrid
financial instrument rule will not apply in Country A as Country A law does not treat the
arrangement between the parties as a financial instrument.
5.
The payment of interest under the asset sale agreement is not a substitute payment
as the interest payment does not represent a financing or equity return on the underlying
shares.
Analysis
The contract is not subject to the hybrid financial instrument rule in Country A
unless it constitutes a hybrid transfer
6.
While jurisdictions are encouraged to ensure that the hybrid financial instrument
rules apply to any arrangement that produces a financing or equity return, the rules are
not intended to standardise the categories of financial instrument or to harmonise their tax
treatment and, in the present case, where the financing component of the arrangement is
actually embedded into the calculation of the purchase price for an asset transfer
agreement, it should be left to Country A law to determine whether the consideration paid
under the share sale agreement should be taxed as a payment under a financial instrument.
7.
The arrangement between the parties is treated as an asset transfer agreement
under Country A law and the interest portion of the purchase price is not separately taxed
under the rules for taxing debt, equity or derivatives. Accordingly the hybrid financial
instrument rule will not apply in Country A.
8.
The payment under the arrangement would be deemed to be a financial instrument
under Country A law, however, if the way the transaction is structured results in both
A Co and B Co being treated as the owner of the transferred shares at the same time. In
such a case the payment of the interest component under the asset transfer agreement
would be required to be treated, under Country A law as a deductible payment under a
financial instrument that would give rise to a hybrid mismatch for tax purposes.
The substitute payment rule does not apply in Country A

9.
The substitute payments rules in Recommendation 1.2(e) neutralise any D/NI
outcome in respect of certain payments made under an asset transfer agreement. The rule
only applies, however, to a taxpayer that transfers a financial instrument for a
consideration that includes an amount representing a financing or equity return on the
underlying instrument. In this case the interest paid under the asset transfer agreement has
not been calculated by reference to the return on the underlying asset. Accordingly the
interest payment does not fall within the scope of the substitute payments rule.
The interest component of the purchase price is subject to the hybrid financial
instrument rule in Country B
10.
B Co does not treat the interest portion of the purchase price as subsumed within
the sale consideration but rather treats it as a separate and deductible financing cost. As
such, the payment falls to be taxed under the rules for taxing debt or financial derivatives
248 EXAMPLE 1.27

in Country B and should therefore be treated as falling within the scope of the hybrid
11.
The interest payment gives rise to a D/NI outcome because the payment has no
independent significance under Country A law and is simply treated as a component of
the purchase price paid for the shares. This mismatch in tax outcomes is attributable to
the differences in the tax treatment of the share sale agreement under Country A and
Country B laws and is therefore a hybrid mismatch subject to adjustment under the hybrid
financial instrument rule in Country B.
12.
In a case where the counterparty to the arrangement does not treat the adjustment
as a payment under a financial instrument, the amount of the adjustment should be limited
to the portion that is treated, under Country B law, as giving rise to a financing or equity
return.
EXAMPLE 1.28 249
Example 1.28
Interest paid by a trading entity
Facts
1.
This Example is the same as Example 1.27 except that B Co acquires the asset as
part of its activities as a trader and is entitled to include the purchase price as expenditure
when calculating its (taxable) return on the asset.
Question
2.
Answer
3.
The adjustments required under the hybrid financial instrument rule are the same
as set out in Example 1.27, however, denying a deduction for the interest component of
the purchase price paid by B Co (i.e. the deduction that is attributable to the terms of the
instrument) should not affect B Cos ability to take the full amount payable under the
asset transfer agreement into account when calculating any taxable gain or loss on the
acquisition and disposal of the asset.
Analysis
The interest component of the purchase price is a payment that is subject to the
hybrid financial instrument rule in Country B
4.
As described in further detail in the analysis part of Example 1.27, Country B law
treats the payment as a separate and deductible financing cost and, as such, the payment
should be treated as falling within the scope of the hybrid financial instrument rule to the
extent it gives rise to a D/NI outcome.
The adjustment under Country B law should not affect the ability of B Co to
claim a deduction for the expenditure incurred in acquiring a trading asset
5.
A taxpayers net return from trading or dealing in securities in the ordinary course
of business will often be subject to tax as ordinary income. The income, expenses, profits,
gains and losses from buying, holding and selling those securities will be included in, or
deducted from, taxable income, as the case may be, regardless of what the ordinary rules
would otherwise be for taxing payments under those instruments or how those amounts
are accounted for on the balance sheet or income statement. The hybrid financial
instrument rule should not prevent the trader from being able to claim a deduction for an
250 EXAMPLE 1.28

expense incurred in respect of the acquisition of a trading asset in the ordinary course of
its business provided the taxpayer is fully taxable on the net return from those trading
activities.
6.
In general, therefore, the deduction that a trader is entitled to claim for the cost of
acquiring an asset in the ordinary course of its trade should not be affected by the
application the hybrid financial instrument rule. The deduction claimed by the trading
entity will not be attributable to the terms of instrument under which payment is made but
rather because the traders particular status entitles it to bring all expenditure into account
for tax purposes.
7.
Even in cases where the trader would ordinarily rely on the particular tax
character of the payment to determine its tax consequences (such as in respect of the
payment of interest) the trader should be able to continue to deduct that payment,
notwithstanding the operation of the hybrid financial instrument rule, provided that
deduction is consistent with the taxpayers status as a trader. Therefore, in the present
case, the denial of the interest deduction under the hybrid financial instrument rules
should not affect the ability of a trader to claim a deduction for the consideration paid to
acquire the financial instrument.
EXAMPLE 1.29 251
Example 1.29
Interest paid to a trading entity
Facts
1.
The facts of this example are the same as Example 1.27 except that A Co sells the
asset as part of its activities as a trader and is required to bring the entire amount of the
payment into account as ordinary income when calculating its (taxable) return on the
asset.
Question
2.
Answer
3.
The adjustments required under the hybrid financial instrument rule are the same
as set out in Example 1.27. The fact that A Co may treat the amount of interest paid
under the asset sale agreement as taxable gain should not affect the amount of the
adjustment required under Country B law.
Analysis
The interest component of the purchase price is a deductible payment under a
hybrid financial instrument
4.
As described in further detail in the Analysis of Example 1.27, Country B law
treats the interest portion of the payment as a separate and deductible financing cost and,
as such, it should be treated as a deductible payment under a financial instrument for the
purposes of Country B law.
The interest component of the purchase price is not included in ordinary

income under Country A law
5.
The interest component of the purchase price should not be treated as payment
under a financial instrument that has given rise to ordinary income under the laws of
Country A, even though A Co may be required to bring all or a portion of the
consideration for the disposal of that asset into account as ordinary income for tax
purposes.
6.
In determining whether a payment under a financial instrument has given rise to a
mismatch in tax outcomes the hybrid financial instrument rule looks only to the expected
252 EXAMPLE 1.29

tax treatment of the payment under the laws of the counterparty jurisdiction rather than its
actual tax treatment in the hands of the counterparty. The fact that A Co is a trader and
may include by the payment in ordinary income as proceeds from the disposal of trading
assets will not impact on the determination of whether the terms of the instrument and the
payments made under it are expected to give rise to a D/NI outcome.
EXAMPLE 1.30 253
Example 1.30
Purchase price adjustment for retained earnings
Facts
1.
Country A) transfers shares in C Co, a wholly-owned subsidiary resident in Country C, to
B Co, a company resident in Country B, under a share sale agreement. B Co pays fair
market value for the shares. While the share transfer occurs on the same day as the
payment the sale takes place part-way through C Cos accounting period.
2.
A Co is entitled to an adjustment to the purchase price. The amount of the
adjustment will be calculated by reference to the operating income of C Co at the end of
the accounting period. This adjustment is treated as a deductible expense under
Country B law while A Co treats the payment as consideration from the disposal of a
capital asset and subject to tax at preferential rates.
Purchase price
+ earnings adjustment
A Co
B Co
Share
transfer
C Co
Question
3.
Does the adjustment payment fall within the scope of the hybrid financial
instrument rule?
254 EXAMPLE 1.30
Answer
4.
The hybrid financial instrument rule should be applied in Country B to deny a
deduction for the payment if the payment is made under a structured arrangement.
5.
While the hybrid financial instrument rule will not generally apply in Country A
(because A Co does not treat the payment as made under a financial instrument) the
payment constitutes the payment of an equity return on the transferred shares that could
be subject to adjustment under the substitute payment rules.
Analysis
Whether the asset transfer agreement should be treated as a financial
instrument should be determined under local law
6.
The share sale contract could fall within the definition of financial instrument for
the purposes of the hybrid financial instrument rule because it provides A Co with an
equity based return. The report encourages countries to take reasonable endeavours to
ensure that the hybrid mismatch rules apply to instruments that produce a financing or
equity return in order to ensure consistency in the application of the rules. The intention
of the rules, however, is not to achieve harmonization in the way financial instruments are
treated for tax purposes and, in hard cases, it should be left to local laws to determine the
dividing line between financing instrument and other types of arrangement provided this
is consistent with the overall intent of the rules.
Application of the hybrid financial instrument rule in Country B

7.
Country B law does not treat the adjustment to the purchase price as subsumed
within the consideration for the share sale but rather treats it as a separate deductible
expense. The adjustment payment is in respect of an equity return under a financial
instrument and should therefore be treated as a payment under a financial instrument
under Country B law.
8.
The adjustment payment gives rise to a D/NI outcome because the payment has
no independent significance under Country A law and is simply treated as a component of
the purchase price. The payment should be treated as giving rise to a D/NI outcome
regardless of whether A Co is required to treat consideration from a share sale as ordinary
income (see the analysis in Example 1.29). This mismatch in tax outcomes is attributable
to the differences in the tax treatment of the share sale agreement under Country A and
Country B laws and is therefore a hybrid mismatch subject to adjustment under the hybrid
financial instrument rule in Country B.
9.
Where, as in this case, one country treats the arrangement as a financial
instrument and the other does not, the adjustment made by the country applying the rule
should be limited to the portion of the payment that is treated as giving rise to the equity
return.
Application of the substitute payment rule in Country A

10.
A Co does not treat the payment as made under a financial instrument (because
the entire amount payable is treated under Country A law as consideration for the sale of
shares).
EXAMPLE 1.30 255
11.
If the hybrid financial instrument rule does not apply in Country B to neutralise
the mismatch in tax outcomes the payment may still, however, be caught by the substitute
payments rule in Recommendation 1.2(e). Under this rule, a taxpayer that sells a financial
instrument for a consideration that includes an amount representing an equity return on
the underlying instrument (a substitute payment), is required to include such payment in
income if the substitute payment is deductible under the laws of the counterparty
jurisdiction and the underlying equity return would have been taxable if it had been paid
directly under the financial instrument. Therefore, in this example, if A Co would have
treated a dividend from C Co as ordinary income, the payment would be treated as a
substitute payment and subject to adjustment under those rules.
256 EXAMPLE 1.31
Example 1.31
Loan structured as a share repo
Facts
1.
In the example illustrated in the figure below, A Co, a company resident in
Country A, wishes to borrow money from B Co, an unrelated lender resident in Country
B. B Co suggests structuring the loan as a sale and repurchase transaction (repo) in order
to provide B Co with security for the loan and to secure a B Co with a lower tax cost (and
therefore a lower financing cost for the parties) under the arrangement.
2.
Under the repo, A Co transfers shares to B Co under an arrangement whereby
A Co (or an affiliate) will acquire those shares at a future date for an agreed price that
represents a financing return minus any distributions received on the B Co shares during
the term of the repo.
A Co
B Co
Share transfer
Repo
Dividend (70)
Shares
3.
This type of financing arrangement can be described as a net paying repo. This
is because B Co (the lender under the arrangement and the temporary holder of the shares
during the term of the repo) does not pay the dividends that it receives on the underlying
shares across to A Co (the economic owner of the shares). Rather those dividends are
retained by B Co as part of its overall return under the financing arrangement.
4.
In this example it is assumed that Country B taxes the arrangement in accordance
with its form. B Co is taxed as if it were the beneficial owner of the dividends that are
paid on the underlying shares and is entitled to claim the benefit of exemption in respect
of such dividends under Country B law. Country A taxes the arrangement in accordance
with its economic substance. For Country A tax purposes, the repo is treated as a loan to
EXAMPLE 1.31 257
A Co that is secured against the transferred shares. A Co is regarded as the owner of the
shares under Country A law with the corresponding entitlement to dividends that are paid
on those shares during the life of the repo. Under Country As tax system, A Co is taxed
on the dividend, grossed up for underlying (deemed-paid) tax on the profits out of which
the dividend is paid and credit is given for that underlying tax. Because, however, this
repo is a net paying repo, where the lender retains the dividend as part of the agreed
return on the loan, A Co is also treated as incurring a deductible financing expense equal
to the amount of the dividend retained by B Co.
5.
Assume that the amount B Co initially pays for the shares is 2 000. The term of
the repo is one year and the agreed financing return is 3.5%. A Co would therefore
normally be obliged to buy back the shares for 2 070. In this case, however, B Co
receives and retains a dividend of 70 on the shares which means that the repurchase price
of the shares is 2 000 (although the net cost of the repo for A Co is 70). Below is a table
setting out the tax position of A Co and B Co under this structure.
A Co
B Co
Tax
Book
Tax
Income
Book
Income
Dividend
70
70
Gross up for deemed tax

paid
30
Expenditure
Dividend
70
Expenditure
Expenditure under repo
(70)
Net return
(70)
0
Taxable income
30
Tax (30%) on
net income
(9)
Tax credit
30
Net return
Taxable income
Tax benefit
21
After-tax return
21
Tax to pay
After-tax return
70
0
0
70
6.
As illustrated in the table above, B Co receives a dividend of 70 which is treated
as tax exempt under Country B law. The dividend exactly matches B Cos contractual
entitlement to the return under the repo. B Co acquires the shares and disposes of them at
the same price and accordingly has no gain that might otherwise be subject to tax in
Country B.
7.
A Co also includes this dividend in its own income tax calculation together with
an indirect foreign tax credit of 30. A Co is entitled however, to deduct the net
expenditure under the repo (including the dividend retained by B Co). This deduction
may be because the laws of Country A characterise the repo as a loan (i.e. a financial
instrument) and treat the amount of the dividend that is paid to, and retained by, B Co as
interest under that loan or because Country A law treats the net return from these types of
arrangements (i.e. share repos) as giving rise to an allowable loss or taxable gain, so that,
given the nature of the arrangement between the parties, the amount of the dividend that
258 EXAMPLE 1.31

is paid to, and retained by, B Co will be taken into account as deduction in calculating
A Cos taxable income.
8.
While, from A Cos perspective, the arrangement may give rise to an outcome
that is not materially different from an ordinary loan, the arrangement generates a tax
benefit for B Co in that, A Cos financing costs are paid for by a dividend of 70 that is not
included in ordinary income by B Co due to the operation of the dividend exemption in
Country B.
Question
9.
rule and, if so, to what extent an adjustment is required to be made in accordance with
that rule.
Answer
10.
The repo is a hybrid transfer and the payment of the dividend on the underlying
shares gives rise to a D/NI outcome as between the parties to the repo. Country A treats
the dividend paid on the transferred shares as a deductible expense under the repo while
Country B treats the same payment as a return on the underlying shares (and, accordingly,
as exempt from taxation). This resulting mismatch is a hybrid mismatch because it is
attributable to the difference in the way Country A and B characterise and treat the
payments made under the repo.
11.
Although A Co and B Co are not related parties, the arrangement was designed to
produce the mismatch in tax outcomes and therefore falls within the scope of the hybrid
financial instrument rule. Accordingly Country A should deny a deduction for the
financing costs under the arrangement. In the event that Country A does not apply the
recommended response under the hybrid financial instrument rule, the financing return
should be included in ordinary income under the laws of Country B.
Analysis
Recommendation 2.1 does not apply to the arrangement.
12.
It may be the case that Country B has implemented rules, consistent with
Recommendation 2.1 that would remove the benefit of a dividend exemption in cases
where the payment is deductible for tax purposes. In this case, however,
Recommendation 2.1 will not generally apply, as this rule only looks to the tax treatment
of the payment under the laws of the issuers jurisdiction and whether the issuer was
entitled to a deduction for such payment. Because the dividend is not deductible for the
issuer but for A Co (the counterparty to the repo) changes to domestic law recommended
in Recommendation 2.1 would not generally restrict B Cos entitlement to an exemption
on the dividend.
The arrangement is a financial instrument under Country A law

13.
Country A either characterises the dividend that is paid to B Co under the terms
of the repo as interest on a loan or otherwise allows taxpayers to bring into account the
net expenditure under this type of arrangement as a deduction in calculating A Cos
EXAMPLE 1.31 259
taxable income. Accordingly the repo should be treated as falling within the hybrid
financial instrument rule under Country A law.
The arrangement is a hybrid transfer under Country B law

14.
The repo is a hybrid transfer because:

(a) under the laws of Country B, B Co is the owner of the shares and A Cos rights in
those shares are treated as B Cos obligation to sell the shares back to A Co; and
(b) under the laws of Country A, A Co is the owner of the shares while B Cos rights
in those shares are treated as a security interest under a loan.
Therefore, even if the repo is characterised as simple asset transfer agreement under the
laws of Country B, the payments that are made under the repo must be treated as made
under a financial instrument for purposes of the hybrid financial instrument rule in
Country B and will be subject to an adjustment to the extent they give rise to a mismatch
in tax outcomes that is attributable to the terms of the instrument.
The payment under the repo gives rise to a hybrid mismatch

15.
The hybrid financial instrument rule applies when a deductible payment under a
financial instrument is not included in ordinary income under the laws of the payee
jurisdiction and the mismatch in tax outcomes is attributable to the terms of the
instrument.
16.
In this case, the repo transaction is treated as a financial instrument under
Country A law. The payment that gives rise to the D/NI outcome is the dividend on the
transferred shares that is retained by B Co under the repo. This dividend is treated as a
deductible expense of A Co and is not included in ordinary income under the laws of
Country B. This difference in tax outcomes is attributable to differences between
Country A and B laws in the tax treatment of the repo.
17.
Although, under local law, B Co would ordinarily have treated the payment that
gives rise to the D/NI outcome as a separate payment on the underlying shares (and not a
payment under the repo itself), because, in this case, the asset transfer arrangement
constitutes a hybrid transfer, B Co is required to take into account the way that payment is
characterised under the laws of Country A.
A mismatch would still arise even if dividend was treated as ordinary income
under Country A law
18.
On the facts of this example, the dividend on the underlying shares is treated
under Country A law as carrying a right to credit for underlying taxes paid by the issuer
and is therefore not included in ordinary income when it is treated as received by A Co.
As with other types of financial instrument, however, the hybrid transfer rules do not take
into account whether the funds A Co obtains under the repo have been invested in assets
that generate ordinary income. The adjustment that is required to be made under the
hybrid financial instrument rule will therefore not be affected by whether A Co treats the
dividend on the transferred shares as ordinary income.
The arrangement is structured

19.
The facts state that one of the reasons for structuring the loan as a repo is to
secure a lower tax cost for the parties under the arrangement. The facts of the
260 EXAMPLE 1.31

arrangement indicate that it has been designed to produce a mismatch. In this case, where
the parties to the repo are unrelated, the parties will have agreed a lower financing rate
than they would have agreed if the return on the repo had been taxable in Country B.
Adjustment under Country A law

20.
Country A should deny A Co a deduction for the financing expenses under the repo to the
extent such expenses are not included in ordinary income.
Adjustment under Country B law

21.
While Country B does not treat the repo as a financial instrument for domestic
law purposes, the arrangement will, nevertheless, fall within the scope of the hybrid
financial instrument rule under Country B law because it is a hybrid transfer. If the
mismatch in tax outcomes is not neutralised by Country A denying a deduction for the
financing expense under the repo then this amount should be treated as included in
income under Country B law.
EXAMPLE 1.32 261
Example 1.32
Share lending arrangement
Facts
1.
The figure below illustrates a share lending arrangement. A share loan is similar
to the repo (described in Example 1.31) in that shares are transferred to a temporary
holder (the borrower) under an arrangement to return those shares at a later date so that
the transferor (the lender) continues to be exposed to the full risk and return of holding
the shares through the obligations owed by the counterparty under the asset transfer
agreement. The difference between a repo and a share lending arrangement is that the
original transfer of the shares is not for a defined amount of consideration. Instead the
borrowers obligation is to transfer the same or identical securities back to the lender at a
later date.
Return on
collateral (20)
Share transfer
B Co
A Co
Dividend (70)
Repo
Manufactured
dividend (70)
Shares
2.
The lender of shares will wish to protect itself from the risk of a default by the
borrower so, in most commercial share-lending transactions, the lender will require the
borrower to post collateral of value at least equal to the value of the borrowed shares.
Often this collateral is in the form of investment grade debt securities. Commercial
securities lending arrangements will provide for the borrower to receive a return on the
posted collateral and for the lender to be paid a fee which may be taken out of the income
on the collateral.
3.
Under both share lending and repo transactions it is possible or even intended
that a payment of interest or dividend will arise during the course of the stock loan or
repo. If the shares are not returned to the lender before a dividend is paid on the shares,
262 EXAMPLE 1.32

the lender will generally demand a manufactured payment from the borrower
equivalent to what would otherwise have been payable on the underlying shares. This
situation can be contrasted with that of a net-paying repo, described in Example 1.31,
where the re-purchase price is defined in the agreement and is reduced by any dividend or
interest payments paid to and retained by the temporary holder of the securities.
4.
A common reason for undertaking a securities lending transaction is that the
borrower has agreed to sell the shares short (i.e. shares the borrower does not have) and
needs to deliver these shares to the purchaser. The borrower anticipates that the shares
will be able to be acquired back at a later date for a lower price and can then be
transferred back to the lender realising a gain reflecting the difference between the sales
proceeds and the subsequent market purchase price, as reduced by any cost of the share
lending arrangement. In this example, B Co borrows shares under a share loan from A Co
(a member of the same control group) intending to sell the shares short. In this case,
however, the subsequent disposal of the shares does not take place and B Co ends up
holding the shares over a dividend payment date. B Co is therefore required to make a
manufactured dividend payment to A Co equal to the amount of the dividend received on
the underlying shares. A simplified illustration of the tax consequences of such an
arrangement is set out below:
A Co
B Co
Tax
Book
Tax
Income
Fee paid by B Co
Interest on collateral
Exempt dividend
Income
5
25
25
70
Expenditure
Interest paid by A Co
Dividend on borrowed shares
(25)
Net return
Taxable income
25
25
70
(5)
(5)
(70)
(70)
Expenditure
Fee paid to A Co
Interest paid to B Co
Book
(25)
75
Manufactured dividend
Net return
Taxable income
20
(50)
5.
During the terms of the loan A Co earns interest on the collateral posted by B Co.
A Co pays both the collateral and the interest earned on this collateral back to B Co at the
end of the transaction minus a fee. B Co retains the borrowed shares over a dividend
payment date and makes a manufactured payment of that dividend to A Co. B Co is
entitled to claim the benefit of an exemption on the underlying dividend but is entitled to
treat the manufactured dividend as a deductible expense. This deduction may be because
the laws of Country B specifically grant a deduction for manufactured dividends or
because Country B law treats the net return from these types of arrangements (i.e. share
loans) as giving rise to an allowable loss or taxable gain, so that, given the nature of the
arrangement between the parties, the amount paid to A Co under the share loan will be
taken into account as deduction in calculating A Cos taxable income.
6.
Country A law disregards the transfer of the shares under the arrangement and
treats A Co as if it continued to hold the shares during the term of the share loan. The
manufactured dividend payment is treated as if it were an exempt dividend on the
EXAMPLE 1.32 263
underlying share so that A Co has no net tax to pay under the arrangement (other than on
the stock-lending fee it receives from B Co).
7.
The net effect of this arrangement is that B Co has incurred a net deductible
expense of 70 for the payment of the manufactured dividend which is not included in
ordinary income by A Co. The total income under the arrangement (including the
dividend received and the interest earned on the collateral) is 95, however, for tax
purposes, the transaction generates a net loss of 50 for B Co and A Co is only taxable on
the share lending fee.
Question
8.
rule and, if so, to what extent an adjustment is required to be made in accordance with
that rule.
Answer
9.
The share loan is a hybrid transfer and the payment of the manufactured dividend
under the share loan gives rise to a D/NI outcome. The payments under the repo give rise
to a deduction in Country B that is attributable to the terms of the arrangement between
the parties, while Country A treats the same payment as a return on the underlying shares
(and, accordingly, as exempt from taxation). Therefore the mismatch in tax outcomes
should be treated as a hybrid mismatch because it is attributable to differences in the way
Country A and B characterise and treat the payments under a share loan.
10.
Furthermore, on the facts of this example the manufactured payment will be a
substitute payment so that the manufactured payment will be brought within the scope of
the hybrid financial instrument rule even in a case where the deduction claimed by B Co
is not attributable to the tax treatment of payments on the share loan but to the acquisition
and disposal of the underlying shares.
11.
A Co and B Co are related parties and the arrangement therefore falls within the
scope of the hybrid financial instrument rule. Accordingly Country B should deny a
deduction for the financing costs under the arrangement regardless of the basis for the
deduction claimed by B Co. In the event that Country B does not apply the recommended
response under the hybrid financial instrument rule, the financing return should be
included in ordinary income under the laws of Country A.
Analysis
Recommendation 2.1 does not apply to the arrangement
12.
It may be the case that Country A has implemented rules, consistent with
Recommendation 2.1 that would remove the benefit of a dividend exemption in cases
where the payment is deductible for tax purposes. In this case, however,
Recommendation 2.1 will not generally apply, as this rule only looks to the tax treatment
of the payment under the laws of the issuers jurisdiction and whether the issuer was
entitled to a deduction for such payment. In this case the dividend is not deductible for the
issuer but for B Co (the counterparty to the repo) and, accordingly, the changes to
domestic law recommended in Recommendation 2.1 would not generally restrict A Cos
entitlement to an exemption on the dividend.
264 EXAMPLE 1.32
The arrangement is a financial instrument under Country B law

13.
The deduction that B Co claims for the manufactured dividend does not result
from a trading loss on the borrowed shares (contrast the facts in Example 1.34), rather,
the deduction is attributable to the tax treatment of payments under a share loan. A
taxpayer in Country B will be entitled to deduct the manufactured dividend regardless of
its particular status or the way it deals with the underlying shares. In such a case, where
Country B specifically grants taxpayers a deduction for manufactured dividend payments,
Country B should treat such amounts as paid under a financial instrument and potentially
The arrangement is a hybrid transfer that should be treated as a financial

instrument under Country A law
14.
While Country A ignores the existence of the share loan and does not treat it as a
financial instrument for domestic law purposes, the arrangement will, nevertheless, fall
within the scope of the hybrid financial instrument rule because it is an asset transfer
agreement where:
(a) under the laws of Country A, A Co is treated as the owner of the shares with
B Cos rights in the shares being treated as a loan made by A Co; and
(b) under the laws of Country B, B Co is the owner of the shares under the transfer
and A Cos rights in those shares are treated as B Cos obligation to transfer the
shares back to A Co.
The share loan is therefore a hybrid transfer within the scope of the hybrid financial
instrument rule notwithstanding that the arrangement is not treated as a financial
instrument under Country A law.
The payment under the share loan gives rise to a hybrid mismatch
15.
The hybrid financial instrument rule applies when a deductible payment under a
financial instrument is not included in ordinary income under the laws of the payee
jurisdiction and the mismatch in tax outcomes is attributable to the terms of the
instrument.
16.
In this case, the share lending transaction is treated as a financial instrument under
Country B law. The payment that gives rise to the D/NI outcome is the manufactured
dividend which is treated as a deductible expense by B Co and is not included in ordinary
income under the laws of Country A. This difference in tax outcomes is attributable to
differences between Country A and B laws in the tax treatment of the share loan.
17.
Although under local law, A Co would ordinarily have treated the manufactured
dividend payment that gives rise to the D/NI outcome as a separate payment on the
underlying shares (and not a payment under the share loan itself), because, in this case,
the asset transfer arrangement constitutes a hybrid transfer, A Co is required to take into
account the way that payment is characterised under the laws of Country B.
A mismatch would still arise even if dividend was treated as ordinary income
under Country B law
18.
On the facts of this example, the dividend on the underlying shares is treated as
exempt under Country B law. As with other types of financial instrument, however, the
EXAMPLE 1.32 265
hybrid transfer rules are not affected by whether the funding provided under the share
loan has been invested in assets that generate an ordinary income return. The adjustment
that is required to be made under the hybrid financial instrument rule will therefore not be
dependent on the tax treatment of the dividend under the laws of Country A. This
principle is illustrated in Example 1.33.
Tax treatment of B Co in the event payment of manufactured dividend gives rise

to a trading loss
19.
The adjustment that is required to be made under the hybrid financial instrument
rule is generally confined to adjusting those tax consequences that are attributable to the
tax treatment of the instrument itself. The adjustment is not intended to impact on tax
outcomes that are solely attributable to the status of the taxpayer or the context in which
the instrument is held. Thus, as set out in further detail in Example 1.34, the denial of the
deduction in Country B under the hybrid financial instrument rule should not generally
impact on the position of a financial trader in relation to the taxation of any net gain or
loss in respect of its share trading business.
20.
Note, however, in this case, that manufactured dividend is a substitute payment
that falls within the scope of Recommendation 1.2(e) as it is a payment of an amount
representing an equity return on the underlying shares. The substitute payment rules apply
to any type of D/NI outcome regardless of whether such outcome is attributable to the
terms of the instrument, the tax status of the parties or the context in which the asset is
held. Unlike the rules applying to hybrid mismatches under a financial instrument, the
substitute payment rules are only triggered, however, where differences between the tax
treatment of the substitute payment and the underlying return on the instrument have the
potential to undermine the integrity of the hybrid financial instrument rule. In particular, a
substitute payment that gives rise to a D/NI outcome will be subject to adjustment where
the underlying financing or equity return on the transferred asset is treated as exempt or
excluded from income in the hands of the transferee. On these facts, therefore, where the
underlying dividend paid to B Co is tax exempt, the payment of the manufactured
dividend will be treated as giving rise to a mismatch in tax outcomes regardless of the
basis for the deduction claimed under Country B law.
Adjustment under Country B law

21.
Country B should deny a deduction for the manufactured dividend to the extent the
dividend is not included in ordinary income under Country A law.
Adjustment under Country A law

22.
While Country A does not treat the repo as a financial instrument for domestic
law purposes, the arrangement will, nevertheless, fall within the scope of the hybrid
financial instrument rule under Country A law, either because it is a hybrid transfer or
because the dividend is a substitute payment. If the mismatch in tax outcomes is not
neutralised by Country B denying a deduction for the manufactured dividend under the
share loan then this amount should be treated as included in income under Country A law.
266 EXAMPLE 1.33
Example 1.33
Share lending arrangement where transferee taxable on underlying dividend
Facts
1.
In this example the facts are the same as in Example 1.32 except that the dividend
paid on the underlying shares is treated as taxable under Country B law. A simplified
illustration of the tax consequences of such an arrangement is set out below.
A Co
B Co
Tax
Book
Tax
Income
Fee paid by B Co
Exempt dividend
Income
5
25
25
70
Expenditure
Dividend on borrowed shares
(25)
Net return
Taxable income
25
25
70
70
(5)
(5)
(70)
(70)
Expenditure
Fee paid to A Co
Book
(25)
75
Net return
Taxable income
20
20
2.
As in Example 1.32, Country A law disregards the transfer of the shares under
the arrangement and treats A Co as if it continued to hold the shares during the term of
the share loan. The manufactured dividend payment is treated as if it were an exempt
dividend on the underlying shares so that A Co has no net tax to pay under the
arrangement (other than on the stock-lending fee).
3.
Under Country B law, B Co is treated as deriving a taxable dividend on the
borrowed shares and is entitled to a deduction for the manufactured dividend it pays to
A Co. B Co is also taxable on the interest paid on the collateral and thus has a net return
equal to its taxable income.
4.
The net effect of this arrangement, both from a tax and economic standpoint, and
after taking into account the tax treatment of the underlying dividend received by B Co, is
that both parties are left in the same position as if the transaction had not been entered
into (save that A Co derives a stock-lending fee).
Question
5.
Whether the share lending arrangement falls within the scope of the hybrid
EXAMPLE 1.33 267
Answer
6.
The share loan is a hybrid transfer and the payment of the manufactured dividend
under the share loan gives rise to a D/NI outcome. Country B treats the manufactured
dividend as a separate deductible expense while Country A treats the same payment as a
return on the underlying shares (and, accordingly, as exempt from taxation). Therefore
the mismatch in tax outcomes should be treated as a hybrid mismatch because it is
attributable to differences in the way Country A and B characterise and treat the
payments made under the hybrid transfer.
7.
As with other types of financial instrument, the hybrid transfer rules do not take
into account whether the funds obtained under the transfer have been invested in assets
that generate a taxable or exempt return. The adjustment that the transferor is required to
make in respect of payment under a repo or stock loan is not be affected by the fact that
B Co is taxable on the underlying dividend.
8.
No adjustment will be required, however, under the hybrid financial instrument
rule in Country B, if B Co is a trader that acquires the shares as part of a share dealing
business, provided B Co will be subject to tax on the net return from the acquisition,
holding and disposal of that asset. Although the manufactured dividend is a substitute
payment that gives rise to a D/NI outcome, no adjustment will be required under the
substitute payment rule as B Co is taxable on the dividend it receives on the underlying
shares and A Co would not ordinarily have been required to include that dividend in
income.
9.
In this case, the arrangement is unlikely to be a structured arrangement (as both
parties are left in the same after-tax position as if the transaction had not been entered
into). Therefore the hybrid financial instrument rule will generally only apply where
A Co and B Co are related parties.
Analysis
The payment under the share loan gives rise to a hybrid mismatch
10.
As discussed further in Example 1.32, the share lending arrangement is treated as
a financial instrument under Country B law and a hybrid transfer under Country A law
and the payment of a manufactured dividend gives rise to a D/NI outcome that is
attributable to the terms of the instrument. Accordingly the analysis that applies to this
arrangement is the same as set out in Example 1.32 and the payment should be treated as
11.
Although, on the facts of this case, the transaction does not generate a tax
advantage for either A Co or B Co, this is because B Co retained the borrowed shares and
derived a taxable return on the underlying dividend. The underlying policy of
Recommendation 1 is to align the tax treatment of the payments made under a financing
or equity instrument so that amounts that are not fully taxed in the payee jurisdiction are
not treated as a deductible expense in the payer jurisdiction. The operation of the hybrid
financial instrument rule looks only to the expected tax treatment of the payments under
the instrument and does not take into account whether the income funding the expenditure
under the arrangement is subject to tax in the payer jurisdiction. B Co is no different
position from what it would have been had it borrowed money from A Co under an
ordinary hybrid financial instrument and invested the borrowed funds in an asset that
generates a taxable return.
268 EXAMPLE 1.33
Tax treatment of B Co in the event payment of manufactured dividend gives rise

to a trading loss
12.
The adjustment that is required to be made under the hybrid financial instrument
rule is, however, generally confined to adjusting those tax consequences that are
attributable to the tax treatment of the instrument itself. The adjustment is not intended to
impact on tax outcomes that are solely attributable to the status of the taxpayer or the
context in which the instrument is held. Thus, as set out in further detail in Example 1.34,
the denial of the deduction in Country B under the hybrid financial instrument rule should
not generally impact on the position of a financial trader in relation to the taxation of any
net gain or loss in respect of its share trading business
13.
Furthermore the manufactured dividend is not a substitute payment that falls
within the scope of Recommendation 1.2(e) as the dividend on the underlying shares is
both taxable as ordinary income under Country B law and treated as exempt under
Country A law. Therefore, if B Co is a trader that acquires the shares as part of its trade, it
should be permitted to take the manufactured dividend into account as a deduction when
calculating its net income.
EXAMPLE 1.34 269
Example 1.34
Share lending arrangement where manufactured dividend gives rise to a
trading loss
Facts
1.
This example has the same facts as Example 1.33 except that B Co is a share
trader that, under Country B law, is required to include the net return from its trading
activities in income. B Co borrows shares from A Co (a member of the same control
group) in order to sell them short. During the term of the share loan B Co is required to
make a manufactured dividend payment to A Co. B Co then acquires the same shares on
the market and returns them to A Co to satisfy its obligations under the share lending
arrangement.
2.
As noted in Example 1.32, a common reason for undertaking a securities lending
transaction is that the borrower has agreed to sell the shares short (i.e. shares the
borrower does not have) and needs to deliver these shares to the purchaser. The borrower
anticipates that the shares will be able to be acquired back at a later date for a lower price
and can then be transferred back to the lender realising a gain reflecting the difference
between the sales proceeds and the subsequent market purchase price, as reduced by any
cost of the share lending arrangement. In this example B Co may have expected the value
of the shares to fall, first once the shares become ex-dividend and subsequently still
further reflecting its bearish view on the shares, in the event the value of the shares
does not fall and B Co ends up repurchasing the shares for an amount equal to the original
proceeds from the short sale. A simplified illustration of the tax consequences of such an
arrangement is set out below:
A Co
B Co
Tax
Book
Income
Fee paid by B Co
Exempt dividend
Tax
Income
25
25
70
Expenditure
(25)
Net return
Taxable income
25
25
(5)
(5)
(70)
(70)
Expenditure
Fee paid to A Co
Book
(25)
75
Net expenditure under share loan

Net return
Taxable income
65
(50)
270 EXAMPLE 1.34

3.
In this case, B Co borrows the shares from A Co and sells them to an unrelated
party for their market value of 1 000. B Co eventually acquires these shares back, in this
case, at the same price (1 000) and returns them to A Co to close-out the transaction.
B Co incorporates the cost of the manufactured dividend into the calculation of its overall
taxable gain or loss on the share trade as follows:
B Co
Proceeds from the on-market sale of borrowed shares
1 000
Additional amount paid to A Co in respect of manufactured dividend
(70)
Cost of re-acquiring shares on-market
(1 000)
Total return on trade
(70)
4.
B Co has made a total loss on the share trade of 70 which, when added to the
income derived on the posted collateral, gives B Co a loss for the period. A Co treats the
manufactured dividend as an exempt return on the underlying share.
Question
5.
Whether the share lending arrangement falls within the scope of the hybrid
Answer
6.
Although the share loan is treated as a hybrid transfer, the adjustment to be made
under the hybrid financial instrument rule should not affect B Cos deduction for the
manufactured dividend to the extent Country B law requires that payment to be taken into
account in calculating B Cos (taxable) return on the overall trade.
7.
The manufactured dividend will, however, constitute a substitute payment subject
to adjustment under Recommendation 1.2(e), if Country B law would not have treated
B Co as subject to tax at the full rate on the underlying dividend.
Analysis
Manufactured dividend gives rise to a trading loss and is not treated as a
deductible payment under a financial instrument
8.
The hybrid financial instrument rule is not generally intended to impact on a
countrys domestic rules for taxing the gain or loss on the acquisition and disposal of
property. Similarly, a trading entity should be entitled to take into account all the amounts
paid or received in respect of the acquisition, holding or disposal of a trading asset for the
purposes of calculating its net income from its trading activities even where such amounts
are paid or received under a financial instrument such as a share loan.
9.
The policy basis for the deduction claimed by B Co in this case is not the fact that
the payment constitutes a financing expense but rather the fact that all the expenditure
needs to be taken into account in order to calculate the overall return on the trade. The
deduction is thus, not attributable to the terms of the instrument, but rather to the
EXAMPLE 1.34 271
taxpayers particular tax treatment and the nature of the underlying asset that is the
subject matter of the trade.
10.
The hybrid financial instrument rule should not operate to restrict the ability of
the trading entity to claim a deduction in respect of a payment under a financial
instrument provided the payment is made as part of that trading activity and the taxpayer
will be fully taxable on the net return from that trading activity. The precise mechanism
by which the trader obtains the benefit of the deduction should not affect the traders
entitlement to claim such deduction provided the net return from the acquisition, holding
and disposal of the shares will be subject to tax as ordinary income.
Manufactured dividend could be a substitute payment subject to adjustment

under Recommendation 1
11.
The manufactured dividend is a payment of an equity return under an asset
transfer agreement that gives rise to a D/NI outcome and may therefore fall within the
scope of the substitute payment rules. While, in this case, Recommendation 1.2(e)(ii) will
not apply (as the example indicates that Country A law would treat the underlying
dividend as exempt) the rule could still apply if the laws of Country B would otherwise
have treated the dividend on the underlying shares as exempt or eligible for some other
type of tax relief. The fact that B Co does not actually receive a dividend on the
underlying shares does not impact on the application of the substitute payment rules
which look to the expected tax outcome under the arrangement based on the character of
the arrangement and the payments made under it rather than the actual outcome under the
trade.
272 EXAMPLE 1.35
Example 1.35
Share lending arrangement where neither party treats the arrangement as a
Facts
1.
These facts are the same as in Example 1.34 except that both jurisdictions respect
the legal form of the transaction (as a sale and repurchase of securities) so that neither
jurisdiction treats the share loan as a financial instrument for tax purposes. A simplified
illustration of the tax consequences of such an arrangement is set out below:
A Co
B Co
Tax
Book
Tax
Income
Fee paid by B Co
Income
5
25
25
Gain on share loan
70
Expenditure
(25)
Net return
Taxable income
25
25
(5)
(5)
(70)
(70)
Expenditure
Fee paid to A Co
Book
(25)
75
Loss on share loan

Net return
Taxable income
65
(50)
2.
As in Example 1.34, B Co borrows the shares from A Co and sells them short
to an unrelated party for their market value of 1 000. During the period of the share loan,
B Co is required to pay a manufactured dividend to A Co. B Co eventually buys back the
shares for the same price and returns them to A Co to close-out the transaction. During
the terms of the loan A Co earns interest on the collateral. It pays both the collateral and
the interest on that collateral back to B Co at the end of the transaction minus a fee.
3.
Rather than treating the manufactured dividend as a separate deductible item, both
A Co and B Co treat it as an adjustment to the cost of acquiring the shares. The total
return from the share lending transaction for A Co and B Co can be calculated as follows:
EXAMPLE 1.35 273
A Co
Market value of shares lent
1 000
Proceeds from the on market sale of borrowed

shares
Additional amount paid to A Co in respect of
manufactured dividend
B Co
(1 000)
1 000
70
Cost of re-acquiring shares on-market
(70)
(1 000)
Market value of shares returned
(1 000)
1 000
Total return on trade
70
(70)
4.
B Cos loss on the share trade is deductible under Country B law while the gain
on the share trade is treated as an excluded return under Country A law
Question
5.
Does the hybrid financial instrument rule apply to neutralise the mismatch in tax
outcomes under this arrangement?
Answer
6.
Recommendation 1.2(e) will apply to neutralise the mismatch in tax outcomes if
A Co would have been required to treat the dividend paid on the underlying shares as
ordinary income or B Co would have been exempt on the underlying dividend.
Analysis
Manufactured payment is not treated as a payment under a financial
instrument
7.
Both Country A and B treat the share loan as a genuine sale so that the payment is
not treated, under either Country A or Country B law, as a payment that is subject to the
local law rules for taxing debt, equity or derivatives. Furthermore the asset transfer is not
treated as a hybrid transfer subject to adjustment under the hybrid financial instrument
rule. Accordingly, neither Country A nor Country B will apply the hybrid financial
instrument rule to adjust the tax treatment of the payment.
Adjustment required to extent there is a mismatch in the tax treatment of the

dividend and the manufactured dividend.
8.
An asset transfer arrangement such as this will give rise to tax policy concerns
where the transfer results in the parties obtaining a better tax outcome, in aggregate, than
they would have obtained had the transferor received a direct payment of the underlying
9.
If the asset transfer agreement effectively allows A Co to substitute what would
otherwise have been a taxable dividend on the shares for a non-taxable gain, or if B Co
would have been entitled to an exemption on the underlying dividend then
Recommendation 1.2(e) will apply to adjust the D/NI outcome between the parties to
prevent these type of arrangements undermining the integrity of the hybrid financial
instrument rule.
274 EXAMPLE 1.36
Example 1.36
Deduction for premium paid to acquire a bond with accrued interest
Facts
1.
Country A) and B Co (a company resident in Country B) each own 50% of the ordinary
shares in C Co (a company resident in Country C). C Co issues a bond to B Co. The bond
is treated as a debt instrument under the laws of Country C, but as an equity instrument
(i.e. a share) under the laws of Country B. Interest payments on the loan are deductible in
Country C but treated as exempt dividends under Country B law. B Co subsequently
transfers the bond to A Co.
Purchase price + premium
A Co
B Co
Loan transfer
50%
50%
Interest
C Co
Loan
2.
The bond is issued for its principal amount of 20 million and has an interest rate
of 12% which is paid in two equal instalments throughout the year. A Co acquires the
bond from B Co part-way through an interest period under an ordinary contract of sale. A
Co pays a premium of 0.8 million to acquire the bond which represents the accrued but
unpaid interest on the bond. Under Country A law the bond premium can be deducted
against interest income whereas, under Country B law, the premium is treated as an
excluded capital gain. A table setting out the tax treatment of A Co, B Co and C Co in
respect of the sale and purchase of the bond is set out below:
EXAMPLE 1.36 275
A Co
Net taxable
income
B Co
C Co
Interest coupon
1.2
Interest coupon
Bond premium
(0.8)
Bond premium
0.4
Interest coupon
(1.2)
(1.2)
3.
As illustrated in the table above, the interest payment of 1.2 million gives rise to a
deduction for C Co and income for A Co. A Co is, however, entitled to a deduction of 0.8
million for the premium paid on the bond. B Co does not receive any interest on the bond
and treats the premium paid for the bond by A Co as an (exempt) gain on the disposal of
an asset. In aggregate the arrangement gives rise to a deduction (for C Co) of 1.2 million
and net income (for A Co) of 0.4 million.
Question
4.
Does the hybrid financial instrument rule operate to neutralise the mismatch in tax
outcomes under this arrangement.
Answer
5.
The premium paid for the bond is a substitute payment within the meaning of
Recommendation 1.2(e). Accordingly, if the bond transfer agreement was entered into as
part of a structured transaction, the hybrid financial instrument rule should apply to adjust
the tax treatment of the consideration paid for the bond to the extent necessary to
neutralise the mismatch in tax outcomes.
Analysis
The bond is a financial instrument but a payment of interest under the bond
does not give rise to a hybrid mismatch.
6.
While the payment of interest on the bond gives rise to a deduction within the
scope of the hybrid financial instrument rule, the full amount of that payment is included
in ordinary income under Country A law. Therefore the payment of interest under the
bond does not give rise to a mismatch in tax outcomes.
7.
While the purchase price premium is deductible under Country A law and not
included in ordinary income under Country B law, this payment is not a payment under
the bond but rather a payment to acquire the bond and such a payment will only give rise
a mismatch in tax outcomes under the hybrid financial instrument rule if the contract to
acquire the bond is treated as a financial instrument or a hybrid transfer.
The contract to acquire the bond is not a financial instrument

8.
In this case, the asset transfer is described as an ordinary contract of sale so that
neither Country A nor Country B law tax the premium paid for the bond as a separate
financing return. The contract to acquire the bond is therefore not a financial instrument
that falls within the language or intent of Recommendation 1.
276 EXAMPLE 1.36
The premium is a substitute payment

9.
Although neither party to the arrangement treats the sale contract as a financial
instrument, the consideration for the sale of the bond includes an amount representing a
financing or equity return on the underlying financial instrument that falls within the
Recommendation 1.2(e). In this case the premium represents the accrued financing return
on the underlying instrument. If that financing return had been paid directly to the
transferor it would have given rise to a hybrid mismatch under Recommendation 1.
Accordingly the payment of the premium should be treated as giving rise to a mismatch
that is subject to adjustment under the hybrid financial instrument rule.
Adjustment required if the arrangement is a structured arrangement

10.
The hybrid financial instrument rule applies to arrangements entered into with a
related person or where the payment is made under a structured arrangement and the
taxpayer is party to that structured arrangement. In this case the fact that A Co and B Co
both own shares in C Co does not make them related parties for the purposes of the
Recommendation 10. The arrangement will be a structured arrangement, however, if the
facts and circumstances, including the joint shareholding in C Co, indicate that the
arrangement was designed to produce the mismatch in tax outcomes.
EXAMPLE 1.37 277
Example 1.37
Manufactured dividend on a failed share trade
Facts
1.
The figure below illustrates a situation where a trading entity (A Co) has acquired
or borrowed shares from an unrelated third party and on-sells these shares to B Co. The
transferred shares carry an entitlement to a declared but unpaid dividend (i.e. the shares
are sold to B Co cum-dividend). Because of a processing error, however, the shares are
delivered after the dividend record date is set, so that the dividend is, in fact, paid to
A Co. On the date the (non-deductible) dividend is actually paid A Co receives the
dividend (even though it holds no shares) and pays the dividend across to B Co to whom
it had agreed to sell the shares cum-dividend, but delivered the shares ex-dividend.
A Co
(trader)
B Co
Share
transfer
Dividend
Shares
2.
Under Country A law, A Co would be treated as the owner of the shares at the
time the dividend is paid and, in the case of a taxpayer of normal status, a dividend
exemption would apply. A Co is, however, a financial trader and accordingly the
dividend is incorporated into the calculation of A Cos overall (taxable) return on the
acquisition, holding and disposal of the shares. The dividend is therefore treated as
ordinary income of A Co and the manufactured dividend is treated as a deductible trading
expense. Under Country B law, B Co is also treated as the owner of the shares and treats
the manufactured dividend as an exempt dividend on the underlying shares. The
manufactured payment thus gives rise to a D/NI outcome.
278 EXAMPLE 1.37
Question
3.
Does the payment of the manufactured dividend fall within the scope of the
Answer
4.
Although the asset transfer agreement is a hybrid transfer, the manufactured
dividend does not fall within the scope of the hybrid financial instrument rule because the
D/NI outcome is solely attributable to the different tax status of the counterparties, in
particular, because B Co is a financial trader, and all of its gains, receipts, expenses and
losses are taken into account in computing profits taxable as ordinary income. Further the
payment of the manufactured dividend is not a substitute payment that has the effect of
avoiding a hybrid mismatch on the underlying instrument because the ordinary tax
treatment of the payer and payee have been preserved under the arrangement and the
dividend is not tax-deductible for the issuer.
5.
Recommendation 2.2 will apply to the arrangement to limit the ability of A Co to
benefit from any withholding tax credits on the underlying dividend.
Analysis
6.
While both parties to this arrangement would ordinarily treat this arrangement as
an asset transfer, and therefore outside the scope of the hybrid financial instrument rule,
the arrangement is a hybrid transfer (which is deemed to be a financial instrument for the
purposes of these rules) because it is an asset transfer agreement where:
(a) under the laws of Country A, A Co is the owner of the shares and B Cos rights in
those shares are treated as A Cos obligation to transfer the dividend to B Co; and
(b) under the laws of Country B, B Co is the owner of the shares while A Cos rights
in those shares are treated as arising under the asset transfer agreement with B Co.
Ownership in this context includes any rules that result in the taxpayer being taxed as the
cash-flows from the underlying asset.
7.
Although the arrangement is a hybrid transfer, the D/NI outcome that arises under
the hybrid transfer is not attributable to the terms of the instrument (but to A Cos status
as a trader) and will therefore not give rise to a hybrid mismatch. Because the underlying
dividend is both taxable for A Co and exempt for B Co, the substitute payment rules also
do not apply. If, however, the tax regime in Country A had unusual features, which meant
that the dividend on the underlying shares was not taxable in Country A or if the
arrangement had been deliberately structured as broken trade in order to allow B Co to
receive an exempt return of purchase price rather than a taxable dividend on the
underlying share, then the payment may be treated as a substitute payment caught by the
EXAMPLE 2.1 279
Example 2.1
Application of Recommendation 2.1 to franked dividends
Facts
1.
In the example illustrated in the figure below, A Co is a company established and
tax resident in Country A. A Co has a PE in Country B. Country A does not tax the net
income of a foreign PE. A Co issues a bond to investors in Country A through the PE in
Country B. The bond is issued for its principal amount and pays accrued interest every six
months. The loan is subordinated to the ordinary creditors of A Co and payments of
interest and principal can be suspended in the event A Co fails to meet certain solvency
requirements. Some of the bonds issued by A Co are acquired by unrelated investors on
the open market.
A Co
Investors
Interest / Dividend
Country B
PE
2.
The bond is treated as a debt instrument under the laws of Country B and as an
equity instrument under the laws of Country A. Country B grants a deduction to the PE
for payments made under the bond. Country A treats the payments as a dividend paid by a
resident company to a resident shareholder. Country A taxes dividends at the taxpayers
marginal rate but also permits the paying company to attach an franking credit, which
the shareholder can credit against the tax liability on the dividend.
280 EXAMPLE 2.1
Question
3.
Whether an interest payment under the bond falls within the scope of the hybrid
financial instrument rule and, if so, whether an adjustment is required to be made in
accordance with that rule.
Answer
4.
Under Recommendation 2.1, A Co should be prevented from attaching an
imputation credit to the payment made under the bond.
5.
If Country A does not apply Recommendation 2.1, Country B may be able to
deny the PE of A Co a deduction for the interest payment if the investors are related
parties or the loan was issued as part of a structured arrangement.
Analysis
Country A should apply Recommendation 2.1 to prevent A Co attaching an
imputation credit to the payment on the bond
6.
Recommendation 2.1 states that jurisdictions should not grant dividend relief for a
deductible payment. Recommendation encourages countries to limit the availability of tax
relief on dividends to prevent such tax relief being claimed where the profits out of which
the distribution is made have not borne underlying tax. In the present case, the payment
made under the bond has been paid out of such pre-tax income because:
(a) the payment was deductible under the laws of Country B; and
(b) while not deductible under Country A law, the profits out of which the payment is
made were not subject to tax in Country A (due to the operation of the branch
exemption).
The effect of Recommendation 2.1 is therefore that Country A, should prevent A Co from
attaching an imputation credit to the payment made under the bond.
mismatch
7.
If Country A does not apply Recommendation 2.1 then there is still scope for
Country B to apply Recommendation 1 on the grounds that the payment is deductible
under the laws of Country B but sheltered from taxation as ordinary income in
Country A.
8.
As the investors are not related, the hybrid financial instrument rule will only
apply if the payment is made under a structured arrangement. In this case the loan itself
may not have any features indicating that it was designed to produce a mismatch in tax
outcomes. It is possible, however, that the tax benefits of the mismatch were marketed to
the original investors in Country A or that the bond was primarily marketed to investors
who could take advantage of the mismatch in tax outcomes. If this is the case then the
A Co and those investors are likely to be party to the structured arrangement as they can
reasonably be expected to be aware of the mismatch and have shared in the value of the
tax benefit (through a return on the instrument that was calculated by reference to the
benefit of the imputation credit).
EXAMPLE 2.2 281
Example 2.2
Application of Recommendation 2.2 to a bond lending arrangement
Facts
1.
The figure below illustrates a securities loan that is similar to the structure
described in Example 1.32 except that the instrument loaned under the arrangement is a
bond rather than a share. B Co is the borrower under the arrangement with obligations
that include the requirement for B Co to pay A Co the amount of any interest payments
that are paid on the underlying bonds (net of any withholding taxes) during the period of
the loan (the manufactured interest payment). The net economic effect of this
arrangement is that A Co continues to be exposed to the full risk and return of holding the
bonds, through the obligations owed by B Co under the arrangement.
Manufactured
interest (90)
A Co
B Co
Interest (90)
Bond loan
Bonds
2.
A simplified tax calculation showing the net effect of this arrangement is set out
below. In this example it is assumed that the payment of 100 of interest on the bond is
subject to 10% withholding tax and this tax is creditable against B Cos tax liability. B Co
makes a manufactured payment of the interest payment (reduced by withholding tax) to
A Co.
282 EXAMPLE 2.2

A Co
B Co
Tax
Book
Tax
Income
Book
Income
Manufactured interest
90
90
Amounts withheld
10
Interest
Amounts withheld
90
90
10
(90)
(90)
Expenditure
Net return
Taxable income
Tax on income (30%)
Tax credit
Tax to pay
After-tax return
90
100
Net return
Taxable income
(30)
10
(20)
70
0
10
Tax on income (30%)
(3)
Tax credit
10
Tax benefit
After-tax return
7
7
3.
Both A Co and B Co are treated as receiving an interest payment of 100 subject
to foreign withholding taxes of 10%. B Cos taxable income (after the payment of the
manufactured dividend payment) is 10. Despite taxing only the net income under the
arrangement Country B still allows a credit for the whole of the withholding tax thus
generating an excess credit that is eligible to bee set-off against Country B tax on other
income (or certain other classes of income).
4.
Ordinarily it would be expected that a payment of interest under the bond would
generate a net taxation (in either Country A or B) of 20 (i.e. 30 of tax payable in the
country of residence minus a credit for 10 of withholding tax). Because, however, in this
example, both A Co and B Co have claimed tax credits in respect of the same payment
the aggregate tax liability for both parties under the arrangement is 13 including a surplus
7 tax credit for B Co which (it is assumed) may be used against other income.
5.
In this example the arrangement is not the product of a mismatch, as both
Country A and B treat all amounts received under the arrangement as ordinary income,
nevertheless the hybrid transfer permits A Co and B Co to double-dip on withholding tax
credits to lower their effective tax under the instrument.
Question
6.
Whether a securities lending arrangement falls within the scope of
Recommendation 2.2 and, if so, to what extent an adjustment is required to be made in
accordance with that rule.
Answer
7.
The arrangement is a hybrid transfer that does not give rise to a D/NI outcome.
Any jurisdiction that grants relief for tax withheld at source on a payment made under a
hybrid transfer should restrict the benefit of the relief to the net taxable income of the
taxpayer under the arrangement.
EXAMPLE 2.2 283
The arrangement is a hybrid transfer

8.
The securities lending arrangement falls within the definition of a hybrid transfer
because, under the laws of Country A, A Co is the owner of the bond and B Cos rights of
in the bond are characterised as obligations owed to A Co, while, under the laws of
Country B, B Co is the owner of the bond and A Cos ownership rights are treated as
obligations of B Co.
Recommendation 2(2) applies to restrict the amount of foreign tax credits under
a hybrid transfer
9.
Recommendation 2.2 states that, "in order to prevent duplication of tax credits
under a hybrid transfer, any jurisdiction that grants relief for tax withheld at source on a
payment made under a hybrid transfer should restrict the benefit of such relief in
proportion to the net taxable income of the taxpayer under the arrangement."
10.
The credit should be allowed in each jurisdiction only up to amount of net income
under the arrangement. A simplified tax calculation showing the net effect of these
adjustments is set out below.
A Co
B Co
Tax
Book
Tax
Income
Book
Income
90
90
Amounts withheld
10
Interest
Amounts withheld
90
90
10
(90)
(90)
Expenditure
Net return
Taxable income
Tax on income (30%)
Tax credit
Tax to pay
After-tax return
90
100
Net return
Taxable income
(30)
Tax on income (30%)
10
Tax credit
(20)
70
Tax to pay
After-tax return
0
10
(3)
3
0
0
11.
Limiting the credit to the extent of the taxpayers net income under the
arrangement has no effect on A Cos tax position in this example as A Cos net income
from the arrangement is equal to the gross amount of the payment. The calculation
continues to allow for to a duplication of credits under the laws of Country B, but only to
the extent necessary to shelter the income in respect of the payment that has been
withheld at source.
284 EXAMPLE 2.3
Example 2.3
Co-ordination of hybrid financial instrument rule and
Recommendation 2.1
Facts
1.
Country A) owns all the shares in B Co (a company resident in Country B). A Co lends
money to B Co under a loan that pays accrued interest every 12 months on 1 October
each year. The loan is subordinated to the ordinary creditors of B Co and payments of
interest and principal can be suspended in the event B Co fails to meet certain solvency
requirements.
A Co
Interest / Dividend
Loan
B Co
2.
The bond is treated as a debt instrument under the laws of Country B but as an
equity instrument (i.e. a share) under the laws of Country A. Accordingly interest
payments on the loan are treated as dividends under Country A law. Under its domestic
law Country A generally exempts foreign dividends.
3.
In Year 2 Country B introduces hybrid mismatch rules so that the deduction for
the interest payment is denied in that year. One year later Country A amends its domestic
law in line with Recommendation 2.1 so that the benefit of a dividend exemption for a
deductible payment is no longer available under Country A law.
EXAMPLE 2.3 285
Question
4.
What proportion of the payment is required to be brought into account under the
hybrid mismatch rule by A Co and B Co in Years 2 to 4 of the arrangement?
Answer
5.
The payer jurisdiction applying the primary response under the hybrid financial
instrument rule in a period when the payee jurisdiction introduces domestic changes in
accordance with Recommendation 2.1 (the switch-over period), should cease to apply the
primary response to the extent the mismatch is neutralised by the introduction of the
domestic law changes in the payee jurisdiction. The payer jurisdiction should continue,
however, to make the adjustment required under the hybrid financial instrument rule for
periods prior to the switchover period. Accordingly:
(a) Country B should deny B Co a deduction for a payment to the extent it gives rise
to a mismatch in an accounting period that ends on or before the effective date of
the domestic law changes in Country A but should grant B Co relief for any
payment made during the switch-over period to the extent the mismatch is
neutralised due to the operation of the new rules in Country A.
(b) Country A will apply the domestic law changes to the payment at the time it is
treated as received although Country A should take into account the effect of any
adjustments that were made under the hybrid financial instrument rule in Country
B for periods ending on or before the effective date of the domestic law changes in
Country A.
Analysis
No application of the hybrid financial instrument rule where mismatch is
neutralised consistent with Recommendation 2.1
6.
A payment under a hybrid financial instrument will not be treated as giving rise
to a D/NI outcome if the mismatch is neutralised in the counterparty jurisdiction by a
specific rule designed to align the tax treatment of the payment with tax policy outcomes
applicable to an instrument of that nature. Specific rules of this nature include any rules in
the payee jurisdiction, consistent with Recommendation 2.1, that limit the availability of a
dividend exemption or equivalent tax relief to payments that are not deductible for tax
purposes. Accordingly, if and when Country A introduces rules that deny the benefit of
an exemption for a deductible dividend payment, Country B should cease to apply the
primary response under the hybrid financial instrument rule.
Co-ordination between the hybrid financial instrument rule and

Recommendation 2.1
7.
Complications in the application of the rule and a risk of double taxation could
arise, however, in situations where the payee jurisdiction applies the rules under
Recommendation 2.1 to a payment that has already been subject to adjustment under the
hybrid financial instrument rule in the payer jurisdiction. While the hybrid financial
instrument rule will not apply to a payment that is included in ordinary income under the
laws of Country A, equally, in order to minimise disruption to the rules in Country B and
to avoid the need to calculate split periods or re-open old tax returns, Country B should
286 EXAMPLE 2.3

continue to apply the hybrid financial instrument rule to any payment in a period prior to
the switch-over period.
8.
A table setting out the effect of these adjustments in Years 2 to 4 is set out below.
The table shows the accrued interest under the loan in each calendar year and the income
tax consequences applying to payments made under the loan. In this table it is assumed
that the interest payment is 100 each year and that B Co and A Co have no other income
or expenditure. Country B and Country A both calculate income and expenditure for tax
purposes on a calendar year basis.
Country A
Country B
A Co
B Co
Tax
Book
Income
Total
Tax
Book
Income
0
Dividend
100
Operating income
Year 2
100
100
(100)
Expenditure
Interest
100
Net return
0
Taxable income
100
Taxable income
Country A
Country B
A Co
B Co
Tax
Book
Income
Dividend
Net return
100
100
Total
Tax
Book
Income
75
100
Operating income
Year 3
100
100
(100)
(100)
Expenditure
Interest
100
Net return
Taxable income
75
Net return
Taxable income
100
75
EXAMPLE 2.3 287
Country A
Country B
A Co
B Co
Tax
Book
Income
Dividend
Total
Tax
Book
Income
100
75
Operating income
Year 4
100
100
(100)
Expenditure
Interest
75
Net return
Taxable income
100
Net return
Taxable income
75
100
9.
In Year 2, Recommendation 2.1 has not yet been introduced into Country A law
so that a deduction for the entire amount of the interest payment is denied under
Country B law.
10.
In Year 3, Recommendation 2.1 is introduced into Country A law from the
beginning of that year.
(a) Country B does not apply the hybrid financial instrument rule in Year 3 as the
entire amount of the payment for that period will be subject to taxation as ordinary
income in Country A;
(b) The amount of the income included under Recommendation 2.1 should not
include a payment to the extent it has been already subject to adjustment under the
hybrid financial instrument rule in a prior period. Because Country B allows for
interest expenses to be claimed on an accrual basis, a deduction for 25% of the
interest payment has already been denied by Country B in the prior year (Year 2),
accordingly the amount Country A treats as a deductible dividend should be
reduced by the same proportion.
11.
In Year 4 the loan matures and the final payment of accrued interest on the loan is
paid on 1 October of Year 4. The hybrid financial instrument rule does not apply in
Country B as the interest payment will be caught by Recommendation 2.1. The
exemption is denied for the full amount of the interest payment (100) in Country A,
effectively triggering an additional 25 of taxable income in the hands of B Co and
reversing out the timing advantage that arose in the previous year due to the differences in
the timing of the recognition of payments.
288 EXAMPLE 3.1
Example 3.1
Disregarded hybrid payment structure using a disregarded entity and a
hybrid loan
Facts
1.
In the example illustrated in the figure below, A Co establishes B Co 1 as the
holding company for its operating subsidiary (B Co 2). B Co 1 is a hybrid entity (i.e. an
entity that is treated as a separate entity for tax purposes in Country B but as a
disregarded entity under Country A law). B Co 2 is treated as a separate taxable entity
under Country A and B laws.
A Co
Interest
(200)
Loan
B Co 1
Interest
(300)
Operating
income (400)
Hybrid loan
B Co 2
2.
B Co 1 borrows money from A Co. B Co 1 on-lends that money under a hybrid
loan. Interest payments on the loan are treated as ordinary income under Country B law
but treated as exempt dividends under Country A law. A table setting out the combined
net income position for A Co and the Country B Group is set out below.
EXAMPLE 3.1 289
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Interest paid by B Co 1
Tax
Book
Income
0
200
300
300
(200)
(200)
Expenditure
Interest paid to A Co
Net return
100
100
Taxable income
B Co 2
Income
Operating Income
400
400
(300)
(300)
Expenditure
Interest under hybrid loan
200
Net return
Taxable income
100
Net return
Taxable income
100
3.
Because B Co 1 is a disregarded entity under Country A law, the interest on the
loan between A Co and B Co 1 is disregarded for tax purposes and does not give rise to
taxable income in Country A. Although the payment of interest on the hybrid loan is
recognised under Country A law it is treated as an exempt dividend for tax purposes and
is not taken into account in calculating A Cos taxable income for the period. Accordingly
A Co recognises no taxable income under this structure.
4.
Under Country B law B Co 2 has 400 of operating income and is entitled to a
deduction of 300 on the hybrid loan. B Co 1 recognises the interest payment on the hybrid
loan but is further entitled to a deduction of 200 on the disregarded interest payment to
A Co. Accordingly, in aggregate, the Country B Group recognises 200 of taxable income
under this structure on a net return of 400.
Question
5.
Are the tax outcomes described above subject to adjustment under the hybrid
mismatch rules?
Answer
6.
For both Country A and Country B, the hybrid financial instrument rule will not
apply to the interest payment on the hybrid loan because the interest payment does not
give rise to a D/NI outcome (as it is included in income under the laws of Country B).
290 EXAMPLE 3.1

However, the fact that B Co 1 is disregarded as a separate entity under the laws of
Country B means that the deductible interest payment that B Co 1 makes to A Co is
disregarded under Country A law and, accordingly, will be caught by the disregarded
hybrid payments rule in Recommendation 3.
7.
In the event that Country B does not apply the primary rule under
Recommendation 3.1 to the interest payment made by B Co 1, then Country A should
include the full amount of that interest payment in ordinary income under the defensive
rule set out at Recommendation 3.2.
Analysis
Interest payment on the hybrid loan is not subject to adjustment under the
hybrid financial instrument rule
8.
Although the loan can be described as hybrid in the sense that payments on the
loan are treated as deductible interest under the laws of Country B and exempt dividends
under the laws of Country A, the loan does not give rise to a mismatch falling within the
hybrid financial instrument rule because the interest is included in income under the laws
of Country B.
The disregarded hybrid payments rule will apply to deny B Co 1 a deduction for
the disregarded interest payment
9.
In this case B Co 1 is a hybrid payer because both the payer and the payment are
disregarded under the laws of Country A. Accordingly Country B should apply the
primary recommendation to deny B Co 1 a deduction for the interest payment to the
extent that payment exceeds dual inclusion income. The payment of interest on the hybrid
loan does not constitute dual inclusion income because it is not included in ordinary
income under the laws of Country A. Therefore the full amount of the interest deduction
should be denied under Country B law. The table below illustrates the net effect of this
adjustment.
EXAMPLE 3.1 291
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Tax
Book
Income
0
200
300
300
(200)
Expenditure
Net return
100
300
Taxable income
B Co 2
Income
Operating Income
400
400
(300)
(300)
Expenditure
200
Net return
Taxable income
100
Net return
Taxable income
100
10.
B Co 1 is denied a deduction for the entire amount of the disregarded interest
payment. The net effect of the adjustment is that the entire return under the arrangement
is brought into account under Country B law.
In the event Country B does not make any adjustment A Co will treat the
interest payment as ordinary income
11.
If the disregarded hybrid payments rule is not applied to the payment in
Country B then Country A should apply the rule to require the interest payment to be
included in ordinary income. The table below illustrates the net effect of Country A
making an adjustment under the disregarded hybrid payments rule.
292 EXAMPLE 3.1

Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Income
Book
Income
200
200
300
300
(200)
(200)
Expenditure
Net return
100
100
Taxable income
B Co 2
Income
Operating Income
400
400
(300)
(300)
Expenditure
200
Net return
Taxable income
200
100
Net return
Taxable income
100
12.
A Co is required to bring into account, as ordinary income, the full amount of the
interest payment so that the taxable income of A Co and B Co under the arrangement is
equal to their net return under the arrangement.
Implementation solutions
13.
B Co 1 is likely to prepare separate accounts showing all the amounts of income
and expenditure that are subject to tax under Country B law. Country B could require B
Co 1 to maintain a cumulative total of all the items of income that were dual inclusion
income and prohibit B Co 1 from claiming deductions for a disregarded payment to the
extent they exceeded this cumulative amount.
14.
A Co will have information (obtained under Country B law) on the deductions
that B Co 1 has claimed in Country B for intra-group payments and information (under
Country A law) of the amount of B Co 1s net income that is attributed to A Co. Country
A could require A Co to recognise ordinary income to the extent the former amount (the
amount of deductions claimed by B Co 1 for disregarded payments) exceeds the latter
(the amount of B Co 1s net income that is attributed to A Co under Country A law).
EXAMPLE 3.2 293
Example 3.2
Disregarded hybrid payment using consolidation regime and tax grouping
Facts
1.
In the example set out in the figure below, A Co 1 forms a consolidated group
with its wholly-owned subsidiary A Co 2. The effect of tax consolidation under Country
law is that all transactions and payments between group members are disregarded for tax
purposes. A Co 2 establishes a PE in Country B. The PE holds all of the shares in B Co.
The PE is consolidated with B Co for tax purposes under Country B law.
A Co 1
Interest
(300)
A Co 2
Loan
PE
Operating
income (200)
B Co
Operating
income (200)
294 EXAMPLE 3.2

2.
A Co 2 borrows money from A Co 1. This loan is attributed to A Co 2s PE in
Country B. The payment of interest on the loan is deductible under Country B law but is
not recognised by A Co 1. A table setting out the combined net income position for
Country A Group and Country B Group is set out below.
Country A
Country B
A Co 1
A Co 2 and B Co combined
Tax
Book
Tax
Income
Interest paid by A Co 2
Operating income of A Co 2
Book
Income
0
300
200
Operating income of A Co 2 and B Co
400
400
(300)
(300)
Expenditure
Interest paid by A Co 2 to A Co 1 under
loan
Net return
Taxable income
Tax on income (30%)
Tax to pay
After-tax return
300
200
Net return
Taxable income
(60)
Tax on income (30%)

(60)
240
Tax to pay
After-tax return
100
100
(30)
(30)
70
3.
The only item of income recognised for tax purposes under Country A law is the
operating income of the A Co 2s PE. This income is subject to tax at a 30% rate under
Country A law. Under Country B law the 300 of interest paid by A Co 2 to A Co 1 is
treated as deductible against the income of the Country B Group leaving the group with
net taxable income of $100 which is subject to Country B tax at a 30% rate. The net effect
of this structure is, therefore, that the entities in the AB Group derive a total net return of
400 but have taxable income of 300.
Question
4.
Are the tax outcomes described above subject to adjustment under the hybrid
mismatch rules?
Answer
5.
Country B should apply the hybrid financial instrument rule to deny a deduction
for the interest paid by A Co 2 to A Co 1 if the mismatch in the tax treatment of the
interest payment can be attributed to the terms of the instrument between the parties. If
the interest payment is not treated, under Country B law, as subject to adjustment under
the hybrid financial instrument rule then Country B will apply the disregarded hybrid
payments rule to deny A Co 2 a deduction for the interest payment to the extent the
interest expense exceeds dual inclusion income.
6.
In the event the deduction for the interest payment is not subject to adjustment
under Country B law then Country A should treat the interest payment as included in
income to the extent it exceeds dual inclusion income.
EXAMPLE 3.2 295
Analysis
Interest payment is potentially subject to adjustment under the hybrid financial
instrument rule
7.
Under Country B law, the interest payment is a deductible payment to a related
party that gives rise to a mismatch in tax outcomes and will fall within the scope of the
hybrid financial instrument rule if the mismatch can be attributed to differences in the tax
treatment of the loan under the laws of Country A and B.
8.
The fact that the loan and the interest payment itself may not be recognised under
County A law, due to the operation of the tax consolidation regime in Country A, does
not impact on whether the interest payment can be subject to adjustment under the hybrid
financial instrument rule in Country B. The identification of a mismatch as a hybrid
mismatch under a financial instrument is primarily a legal question that requires an
analysis of the general rules for determining the character, amount and timing of
payments under a financial instrument in the payer and payee jurisdictions. The hybrid
financial instrument rule is designed so that it is not necessary for the taxpayer or tax
administration to know precisely how the payments under a financial instrument have
order to apply the rule.
9.
The table below illustrates the net effect on the Country A Group and Country B
Group of denying a deduction for the interest payment under the hybrid financial
instrument rule.
Country A
Country B
A Co 1
Tax
Book
Tax
Income
Book
Income
0
300
200
Operating income of A Co 2 and B

Co
400
400
(300)
Expenditure
Interest paid by A Co 2 to A Co 1
under loan
Net return
Taxable income
Tax on income (30%)
Credit for taxes paid by A Co 2 in
Country B
Tax to pay
After-tax return
300
200
Net return
Taxable income
(60)
Tax on income (30%)
100
400
(120)
60
(0)
300
Tax to pay
After-tax return
(120)
(20)
10.
The effect of Country B denying a deduction for the full amount of the interest
payment made by A Co 2 is that all the income arising under the arrangement will be
subject to tax under Country B law. The tax charge triggered in Country B by the
296 EXAMPLE 3.2

adjustment under the hybrid financial instrument rule means that A Co 1 benefits from a
credit for taxes paid by A Co 2.
The disregarded hybrid payments rule will apply to deny the Country B Group a
deduction for the interest payment
11.
If the interest payment is not treated, under the laws of Country B as subject to
adjustment under the hybrid financial instrument rule then Country B should apply the
disregarded hybrid payments rule to deny the deduction for the interest payment if the
payment falls within the description of a disregarded payment made by a hybrid payer.
12.
In this case A Co 2 is a hybrid payer making a disregarded payment because it is a
member of the same group under the tax consolidation regime in Country A and that
regime treats all transactions and payments between consolidated group members as
disregarded for tax purposes. Accordingly Country B should apply the primary
recommendation to deny a deduction for the interest payment made by A Co 2 to A Co 1
to the extent that payment exceeds dual inclusion income. The table below illustrates the
net effect of Country B making an adjustment under the disregarded hybrid payments rule
for both groups.
Country A
Country B
A Co 1
Tax
Book
Tax
Income
Book
Income
0
300
200
400
400
(200)
(300)
Expenditure
under loan
Net return
Taxable income
Tax on income (30%)
Country B
Tax to pay
After-tax return
300
200
Net return
Taxable income
(60)
Tax on income (30%)
100
200
(60)
0
(60)
240
Tax to pay
After-tax return
(60)
40
13.
A Co 2 is denied a deduction for the disregarded interest payment (300) to the
extent the payment exceeds dual inclusion income (200). The net effect of the adjustment
is that the full amount of the income under the arrangement is brought into account under
Country A and B laws.
EXAMPLE 3.2 297
In the event Country B does not make any adjustment A Co 1 will treat the
amount that gives rise to a DD outcome as included in income under Country A
law
14.
If the disregarded hybrid payments rule is not applied to the payment in
Country B then Country A should apply the rule to require the payment to be included in
ordinary income to the extent of the mismatch. The table below illustrates the net effect
of Country A making an adjustment under the disregarded hybrid payments rule.
Country A
Country B
A Co 1
Tax
Book
Tax
Income
Book
Income
100
300
200
400
400
(300)
(300)
Expenditure
under loan
Net return
Taxable income
Tax on income (30%)
Country B
Tax to pay
After-tax return
300
300
Net return
Taxable income
(90)
Tax on income (30%)
100
100
(30)
0
(90)
210
Tax to pay
After-tax return
(30)
70
15.
A Co 1 is required to bring into account, as ordinary income, the amount by
which the interest deduction (300) exceeds A Co 2s dual inclusion income (200). The net
effect of the adjustment is that the full amount of the income under the arrangement is
brought into account under Country A and B laws.
16.
Country B is likely to require A Co 2 to prepare separate accounts for the PE
showing all the amounts of income and expenditure that are subject to tax under
Country B law. Country B could prohibit an entity in the position of A Co 2 from
utilising the benefit of the PE loss to the extent the PE has made deductible payments that
were disregarded under Country A law. This solution may require further transaction
specific rules that prevent A Co 2 entering into arrangements to stream non-dual inclusion
income to the PE to soak-up unused losses.
17.
The Country A Group will have information on the deductions that A Co 2 has
claimed in Country B for intra-group payments and the amount of the PEs loss as
calculated under Country B law. Country A could require a taxpayer in the position of
A Co 1 to recognise as ordinary income in each accounting period, A Co 2s deductible
intra-group payments to the extent they gave rise to a net loss for Country B tax purposes.
This solution may require further transaction specific adjustments to the calculation of the
298 EXAMPLE 3.2

PEs net loss under Country B law which are designed to back-out material items that
were treated as income under Country B law but would not be included under Country A
law.
EXAMPLE 4.1 299
Example 4.1
Use of reverse hybrid by a tax exempt entity
Facts
1.
In the example illustrated in the figure below, B Co is an entity incorporated in
Country B that is treated as transparent for Country B tax purposes. Entities such as B Co
are required under Country B law to maintain a shareholder register which must be made
available to members of the public on request. In this case, B Co is wholly-owned by
A Co, which treats B Co as a separate taxable person. A Co is exempt from tax under
Country A law.
2.
Borrower Co (a company resident in Country B) borrows money from B Co on
arms length and standard commercial terms and at a market interest rate. The
arrangement is not marketed to Borrower Co as a tax-advantaged financing arrangement
and Borrower Co is not provided with any information about the owners of B Co. The
interest payments on the loan are deductible for the purposes of Country B law but not
included in income by either B Co or A Co.
A Co
Interest
B Co
Borrower Co
Loan
Question
3.
Are the interest payments made by Borrower Co to B Co caught by the reverse
hybrid rule?
300 EXAMPLE 4.1
Answer
4.
The payments are not caught by the reverse hybrid rule because the mismatch in
tax outcomes is not a hybrid mismatch. Furthermore the arrangement is not within the
scope of the reverse hybrid rule because Borrower Co, A Co and B Co are not part of the
same control group and Borrower Co is not party to a structured arrangement.
Analysis
Mismatch is not a hybrid mismatch
5.
In this case the receipt of the interest payment is not recognised under the laws of
either Country A or B and therefore the payment gives rise to a D/NI outcome, however
the mismatch will not be treated as a hybrid mismatch unless the payment would have
been included in ordinary income if it had been made directly to the investor.
6.
Unlike in the hybrid financial instrument rule, which applies whenever the terms
of the instrument were sufficient to bring about a mismatch in tax outcomes, the reverse
hybrid rule will not apply unless the payment attributed to the investor would have been
included as ordinary income if it had been paid directly to the investor (i.e. the
interposition of the reverse hybrid must have been necessary to bring about the mismatch
in tax outcomes). In this case, where income is allocated by a reverse hybrid to a tax
exempt entity, the payment would not have been taxable even if it had been made directly
to the investor and the reverse hybrid rule should therefore not apply to deny the
deduction.
Arrangement is not in scope

7.
If A Co were not a tax exempt entity under the laws of Country A, so that the
interest payment would have been included in ordinary income if it had been made
directly to A Co, then mismatch in tax outcomes would be treated as giving rise to a
hybrid mismatch. As Borrower Co is not part of the same control group as A Co and
B Co, the hybrid mismatch would only fall within the scope of the reverse hybrid rule
under Country B law if it was made under a structured arrangement and Borrower Co was
a party to that structured arrangement.
8.
The facts and circumstances of this case would prima facie indicate a structured
arrangement between A Co and B Co. In particular, the use of B Co as single purpose
entity to make this loan appears to be an additional step inserted into the lending
arrangement to produce the mismatch in tax outcomes. Borrower Co, however, should not
be treated as a party to that structured arrangement, unless it (or any member of Borrower
Cos control group) obtained a benefit under the hybrid mismatch or had sufficient
information about the arrangement to be aware of the fact that it gave rise to a mismatch.
9.
In this case, the loan is on arms length and standard commercial terms and
Borrower Co pays a market rate of interest. While Borrower Co might be aware (or in
certain cases should be aware) of B Cos tax transparency, Borrower Co would not be
expected, as part of its ordinary commercial due diligence, to take into account the tax
treatment of A Co or whether the interest payment will be treated as ordinary income
under the laws of Country A when borrowing money on standard terms from an unrelated
party. In this case, in particular, Borrower Co derives no benefit from the mismatch and is
not provided with information that would make it aware of the fact that the payment gives
EXAMPLE 4.1 301
rise to a mismatch in tax outcomes. Importantly, the test for whether a person is a party to
structured arrangement is not intended to impose an obligation on that person to
undertake additional due diligence on a commercial transaction over and above what
would be expected of a reasonable and prudent person. Accordingly, even if A Co were
not treated as an exempt entity under the laws of Country A, Borrower Co should not be
treated as party to any structured arrangement between B Co and A Co.
10.
In contrast, however, and consistent with the analysis in, Example 10.5, if
Borrower Co was originally approached by A Co for a loan and A Co proposed
structuring the loan through a reverse hybrid in order to secure an improved tax outcome,
the entire financing arrangement, including the loan to Borrower Co, would be treated as
part of a single structured arrangement and Borrower Co will be treated as a party to that
arrangement provided it had sufficient involvement in the design of the arrangement to
understand how it had been structured and to anticipate what its tax effects would be.
302 EXAMPLE 4.2
Example 4.2
Application of Recommendation 4 to payments that are partially excluded
from income
Facts
1.
In the example illustrated in the figure below, two individuals, one resident in
Country A (Individual A) and one in Country B (Individual B) intend to make a loan to
A Co, a company wholly owned by Individual A. Rather than make the loan directly, A
and B contribute equity to B Co, an entity incorporated in Country B. B Co loans money
to A Co and A Co makes a deductible interest payment on the loan.
50%
Interest
A Co
B
50%
Loan
B Co
EXAMPLE 4.2 303
2.
Under Country B law half the payment is attributed to Individual A and is exempt
from tax as foreign source income of a non-resident. The other half of the payment is
attributed to Individual B and is subject to tax at the full marginal rate applicable to
interest income. Country A has implemented the hybrid financial instrument rules.
Question
3.
To what extent is the interest payment made by A Co to B Co caught by the
reverse hybrid rule in Country A.
Answer
4.
The interest payment is made to a reverse hybrid. The payment of interest is
deductible under the laws of the payer jurisdiction but the allocation of half the interest
payment to a non-resident means that the payment is not fully included in ordinary
income under the laws of Country B.
5.
Provided the interest payment allocated to A would have been taxable if it had
been made directly, then Country A should apply Recommendation 4 to the interest
payment to deny A Co a deduction for half the interest payment.
Analysis
B Co is a reverse hybrid
6.
A reverse hybrid is any person that is treated as transparent under the laws of the
jurisdiction where it is established but as a separate entity by its investor. In this case the
establishment jurisdiction is Country B (the country where B Co is incorporated). B Co is
a resident taxpayer for Country B purposes and is treated as an ordinary company under
the laws of Country A. However, under the laws of the jurisdiction where it is
established, B Co is entitled to claim the benefit of an exemption from foreign source
interest if that interest is allocated or attributed to a non-resident investor. This type of
regime falls within the definition of a transparent regime because the laws of Country B
permit or require B Co to allocate or attribute ordinary income to an investor
(Individual A) and that allocation or attribution has the effect that the payment is subject
to tax under the laws of the establishment jurisdiction at the investors marginal rate. The
allocation of the payment to individual A has no impact on As tax treatment in
Country A.
Payment gives rise to a partial D/NI outcome

7.
A D/NI outcome will arise in respect of a payment to a reverse hybrid to the
In this case only half the payment is included in ordinary income under Country B law
(and no amount of the payment is included in income under Country A law).
8.
The adjustment under the reverse hybrid rule should result in an outcome that is
proportionate and that does not lead to double taxation. In this case the payer jurisdiction
should only deny a deduction for that part of the payment that is exempt from taxation
under the laws of the establishment jurisdiction.
304 EXAMPLE 4.2
Arrangement is in scope
9.
In this case the payer (A Co), the reverse hybrid (B Co) and the investor (A) are
all part of the same control group because A holds at least 50% of them both. Even if As
holding in B Co was lower than 50%, the example suggests that B Co was inserted into
the structure in order to produce the mismatch in tax outcomes. A Co would generally be
considered a party to this structured arrangement as it is wholly-owned by one of the
people responsible for the design of the arrangement.
EXAMPLE 4.3 305
Example 4.3
Recommendation 4 and payments that are included under a CFC regime
Facts
1.
In the example illustrated in the figure below, A Co is a company resident in
Country A which owns all of the shares in B Co (a company resident in Country B). B Co
has established a reverse hybrid under the laws of Country D (D Co). D Co receives a
services payment from C Co (a company resident in Country C and member of the same
group).
A Co
B Co
C Co
Services payment
D Co
2.
Country As CFC regime treats services income paid by a related party as
attributable income and subjects such income to taxation at the full marginal rate
applicable to income of that nature. D Co has no other items of income or expenditure.
306 EXAMPLE 4.3
Question
3.
Does Recommendation 4 apply in Country C to deny the deduction for the
services payment made by C Co to D Co?
Answer
4.
The services payment does not give rise to a D/NI outcome as the payment is
included in income under laws of Country A. Provided C Co can demonstrate to the tax
authorities in Country C that such a payment has been attributed to A Co under the
Country A CFC regime and will be subject to tax as ordinary income without the benefit
of any deduction, credit or other tax relief then the services payment should not be treated
as giving rise to a D/NI outcome under Recommendation 4.
Analysis
D/NI outcome in respect of a payment to a reverse hybrid
5.
Accordingly if the services payment is brought into account as ordinary income in at least
one jurisdiction then there will be no mismatch for the rule to apply to.
6.
A payment that has been fully attributed to the ultimate parent of the group under
a CFC regime and has been subject to tax at the full rate should be treated as having been
included in ordinary income for the purposes of the reverse hybrid rule. In this case A Co
includes the full amount of the intra-group services fee as ordinary income under its CFC
rules. D Co has no other income so no question arises as to whether the full amount of
such income has been attributed under A Cos CFC rules. The reverse hybrid rule
therefore does not apply in such a case because the payment has not given rise to a
EXAMPLE 4.4 307
Example 4.4
Interaction between Recommendation 4 and Recommendation 6
Facts
1.
In the example illustrated in the figure below, A Co 1 and A Co 2 are companies
resident in Country A. A Co 1 owns all the shares in A Co 2 and in B Co (a company
resident in Country B).
2.
A Co 2 has established C Co in Country C. C Co is treated as a disregarded entity
for the purposes of Country C law but as a separate company for Country A purposes.
Country A does not have any CFC or equivalent rules that would treat interest derived by
a foreign controlled entity as attributable to its shareholder for tax purposes.
3.
B Co has established a hybrid subsidiary in Country D (D Co 1). D Co 1 is
consolidated for tax purposes with D Co 2 (another subsidiary of B Co.). C Co makes a
loan to D Co 1. Country B and Country D have both introduced hybrid mismatch rules.
A Co 1
A Co 2
B Co
Interest
C Co
D Co 1
Loan
D Co 2
308 EXAMPLE 4.4
Question
4.
Does Recommendation 4 (reverse hybrid rule) or Recommendation 6 (deductible
hybrid payments rule) apply in Country B or D to deny the deduction for the interest
payment under the loan?
Answer
5.
The interest payment is made to a reverse hybrid and will give rise to a hybrid
mismatch under Recommendation 4. Both B Co and D Co 1 are treated as payers under
the hybrid mismatch rule and therefore both should deny a deduction for the interest
payment under Recommendation 4.
6.
As Recommendation 4 operates to deny the deduction in both Country B and D
there is no scope for the application of the deductible hybrid payments rule under
Recommendation 6.
Analysis
C Co is a reverse hybrid
7.
A reverse hybrid is any person that is treated as transparent under the laws of the
jurisdiction where it is established but as a separate entity by its investor (A Co 2). In this
case the establishment jurisdiction is Country C (the country where C Co is incorporated).
C Co is disregarded for Country C tax purposes, which means that all the income of C Co
is treated as being derived directly by A Co 2 (its immediate parent). C Co is treated as a
separate entity for tax purposes under Country A law so that the income allocated to
A Co 2 under Country C law is not taken into account as ordinary income in Country A.
Payment gives rise to a D/NI outcome in Country D and Country B

8.
jurisdiction) and is not included in ordinary income by a taxpayer under the laws of any
9.
As the payment is treated as made in both Country D and Country B both
jurisdictions should apply the reverse hybrid rule. The tax treatment of the payment in the
other payer jurisdiction is not relevant to the question of whether the payment gives rise
to a D/NI outcome under the laws of the jurisdiction that is applying the rules.
Mismatch is a hybrid mismatch

10.
A payment made to a reverse hybrid that gives rise to a D/NI outcome will be
subject to adjustment under the reverse hybrid rule if that D/NI outcome would not have
arisen had the payment been made directly to the investor. The identification of a
mismatch as a hybrid mismatch under a reverse hybrid structure requires an analysis of
how the payment would have been taxed under the laws of the investor jurisdiction. A
payment of interest to C Co will be treated as giving rise to a mismatch if that payment
would ordinarily have been taxable under Country A law.
11.
Furthermore, in order to prevent a reverse hybrid being used to circumvent the
operation of the hybrid financial instrument rule, the reverse hybrid rule will apply if an
EXAMPLE 4.4 309
interest payment made to A Co 2 would have been subject to adjustment under the
primary rule in Recommendation 1. If, for example, the loan would have been treated as
an equity instrument (i.e. a share) under Country A law and payments of interest treated
as exempt dividends then D Co 1 and B Co will continue to deny the deduction for the
payment.
No scope for the application of Recommendation 6

12.
Because the effect of Recommendation 4 is to deny a deduction for the interest
payment, the arrangement does not give rise to a DD outcome that falls within
Recommendation 6.
310 EXAMPLE 6.1
Example 6.1
Accounting for timing and valuation differences
Facts
1.
In the example illustrated in the figure below, A Co owns all of the shares in a
hybrid subsidiary in Country B (B Co 1). B Co 1 has borrowed money from a local bank
and holds depreciable property. B Co 1 also owns all of the shares in B Co 2.
Operating Income
(Year 1 = 250)
(Year 2 = 250)
A Co
Operating Income
(Year 1 = 250)
(Year 2 = 250)
B Co 1
Bank
Interest
(Year 1 = 200)
(Year 2 = 200)
Asset
Operating Income
(Year 1 = 250)
(Year 2 = 250)
B Co 2
2.
B Co 1 is treated as a disregarded entity under Country A law but as a resident
taxpayer in Country B so that all of B Co 1s income and expenditure are fully taxable in
both countries. B Co 2 is a reverse hybrid that is treated as a separate entity, for the
purposes of Country A law, but disregarded under Country B law. Because of the
EXAMPLE 6.1 311
differences between Country A and Country B law in the characterisation of B Co 2, all

of B Co 2s income is treated as derived by B Co 1 (and is subject to tax under Country B
law) but none of this income is brought into account under Country A law.
3.
B Co 1 and B Co 2 each derive 500 of operating income over a two year period.
Due to the way the arrangement has been structured, B Co 1s income and expenses
(including depreciation allowances) are treated as taxable income and deductible
expenditure under Country A and Country B laws. However differences in the way
Country A and Country B recognise the amount and the timing of such income and
expenditure mean that these items are recognised in different amounts and in different
periods. In particular:
(a) Under the laws of Country A, 20% of B Co 1s operating income for the two year
period is treated as derived in Year 1 (100) and 80% in Year 2 (400). Country A
law also requires 50% of the interest expense accrued by B Co 1 in Year 1 (100) to
be recognised in Year 2. Tax incentives in Country A also allow A Co to claim a
larger depreciation allowance for the property held by B Co 1.
(b) Under Country B law, 60% of the income of B Co 1 (300) is treated as derived in
Year 1 and 40% (200) in Year 2. The interest expense and depreciation deductions
are, however, spread evenly over the two accounting periods.
4.
Tables setting out the combined net income position for the AB Group for Years
1 and 2 are set out below.
Country A
Country B
A Co
B Co 1 and B Co 2 Combined
Tax
Book
Income
Tax
Book
Income
Operating income of A Co
250
250
Operating income of B Co 1
100
Year 1
Expenditure
300
250
250
250
Expenditure
(100)
(200)
(200)
Depreciation
(180)
Depreciation
(120)
(120)
Net return
Taxable income
250
70
Net return
Taxable income
180
230
312 EXAMPLE 6.1

Country A
Country B
A Co
Tax
Book
Tax
Income
Book
Income
250
250
400
Year 2
Expenditure
200
250
250
250
Expenditure
(300)
(200)
(200)
Depreciation
(180)
Depreciation
(120)
(120)
Net return
Taxable income
250
170
Net return for Years 1 & 2

Taxable income for Years 1 & 2
Net return
Taxable income
180
130
500
240
360
360
Country B law
5.
In Year 1 B Co 1 and B Co 2 are treated, on a combined basis, as deriving a total
of 550 of income and incurring 320 of deductions for tax purposes resulting in net taxable
income of 230. In the following year, the Country B group recognises 100 less of
operating income than in the previous year but has the same amount of deductions
resulting in net taxable income of 130 for that year.
Country A law
6.
Differences under Country A law in the recognition of timing of payments mean
that Country A treats B Co 1 as only having derived 100 of operating income in Year 1
and having incurred 100 of interest expense. A Co is, however, entitled to a higher
amount of depreciation than is available under Country B law. The net effect of these
differences is that A Co is treated as deriving 70 of net taxable income in Year 1. In
Year 2 Country A law requires A Co to recognise the additional income and expenses,
effectively reversing out the timing differences that arose in Year 1. A Co continues to
claim depreciation deductions at the higher rate leaving it with net taxable income for the
period of 170.
7.
The entities in this structure have an aggregate net return of 860 over the two year
period while the net taxable income recognised under the arrangement is only 600. This
indicates that up to 260 of double deductions are being set-off against non-dual inclusion
income.
Question
8.
How should the deductible hybrid payments rule be applied to neutralise the
effect of the hybrid mismatch under this structure?
EXAMPLE 6.1 313
Answer
9.
The laws of both Country A and B grant a deduction for the same payment (and
for depreciation on the same asset) and accordingly these deductions give rise to a DD
outcome. Similarly the income of B Co 1 should be treated as dual inclusion income
under the laws of both jurisdictions as the item is included in ordinary income under the
laws of the other jurisdiction.
10.
The recommended response under the deductible hybrid payments rule is that the
parent jurisdiction should deny the duplicate deduction to the extent it gives rise to a
hybrid mismatch. In this case the application of the rule would result in Country A
denying a deduction for 180 in Year 1 (being the amount by which A Cos interest and
depreciation deductions exceed the amount of A Cos dual inclusion income) but
Country A may allow that excess deduction to be carried-forward into Year 2 to be set-off
against dual inclusion income that arises in the following year.
11.
In the event Country A does not apply the primary response, Country B would
deny a deduction to the extent it gives rise to a hybrid mismatch. In this case, the rule
would result in Country B denying 20 of deductions in Year 1 (being the amount by
which B Co 1s interest and depreciation deductions exceed the amount of B Co 1s dual
inclusion income). Country B may allow that excess deduction to be carried-forward into
subsequent years to be set-off against future dual inclusion income.
12.
While it may be possible in straightforward cases to undertake a line by line
comparison of each item of income and expenditure, tax administrations may choose to
adopt an implementation solution for the deductible hybrid payments rule that preserves
the policy objectives of the rule and arrives at a substantially similar result but is based, as
much as possible, on existing domestic rules and tax calculations.
Analysis
The interest deduction and depreciation allowance give rise to a DD outcome
13.
B Co 1 is a hybrid payer because; although it is resident in Country B (the payer
jurisdiction), the interest payments and depreciation allowances trigger a duplicate
deduction for A Co (an investor in B Co 1). These payments will be treated as giving rise
to a double deduction to the extent they exceed dual inclusion income.
Determination of DD outcomes under Country A law and application of the

primary response
14.
The primary response under Recommendation 6 is that the parent jurisdiction (in
this case Country A) should deny the duplicate deduction that is available under local law
to the extent it exceeds dual inclusion income. The only item of income recognised under
Country A law that is also treated as ordinary income under Country B law is the
operating income of B Co 1. Accordingly, the amount of the deduction denied under the
primary response in Year 1 is 180. Denying a deduction for this amount will cause A Co
to recognise net income in Year 1 of 250.
15.
Country A may permit A Co to carry-forward the excess deduction into the
subsequent year so that it can be set-off against surplus dual inclusion income in the
subsequent year. The calculation of these adjustments is illustrated in the table below.
Example 6.1 Table 2
314 EXAMPLE 6.1

Country A
Calculation of adjustment under Country A

law
A Co
Tax
Book
Income
Tax
Book
250
250
100
Year 1
Adjustment
(100)
180
Expenditure
Double deductions
(100)
100
Depreciation
(180)
Depreciation
180
Net return
250
Taxable income
250
Adjustment
Country A
Tax
Book
Income
Tax
(180)
Carry
forward
Book
250
250
100
Year 2
Adjustment
180
Calculation of adjustment under Country A

law
A Co
(400)
80
Expenditure
Double deductions
(100)
300
Depreciation
(180)
Depreciation
180
Net return
Taxable income
Carry
forward
250
250
Adjustment
80
(260)
16.
A Co is denied a deduction for 180 in Year 1 and 80 in Year 2. The net effect of
applying the deductible hybrid payments rule over the two year period is that A Co will
be fully taxable on its non-dual inclusion income from its own activities over the two year
period and will have an excess deduction to carry-forward that effectively represents the
net loss (for tax purposes) arising from B Co 1s operations.
Defensive rule
17.
The defensive rule under Recommendation 6 is that the payer jurisdiction (in this
case Country B) should deny the duplicate deduction that is available under local law to
the extent it exceeds dual inclusion income. In this example, the only item of income that
is recognised under Country B law that will also be treated as ordinary income under
Country A law is the operating income of B Co 1. Accordingly the amount of the
deduction denied under the primary response in Year 1 is 20. Denying a deduction for
this amount will cause B Co 1 to recognise net income in Year 1 of 250.
EXAMPLE 6.1 315
18.
Country B may permit B Co 1 to carry-forward the excess deduction into the
subsequent year so that it can be set-off against surplus dual inclusion income in the
subsequent year. The effect of these adjustments is illustrated in the table below.
Country B
Calculation of adjustment under Country B

law
Tax
Book
Income
Tax
Carry
forward
Book
300
250
250
250
Year 1
Adjustment
(300)
20
Expenditure
Double deductions
(200)
(200)
200
Depreciation
(120)
(120)
Depreciation
120
Net return
180
Taxable income
250
Adjustment
Country B
Calculation of adjustment under Country B

law
Tax
20
Book
Income
Tax
Carry
forward
Book
Year 2
200
250
250
250
Adjustment
120
Expenditure
(200)
Double deductions
(200)
(200)
200
Depreciation
(120)
(120)
Depreciation
120
Net return
Taxable income
(20)
180
250
Adjustment
120
(140)
19.
The net effect of applying the deductible hybrid payments rule over the two year
period is that B Co 1 will be taxable on its non-dual inclusion income from B Co 2 (500)
over the two year period and will have an excess deduction to carry-forward that
effectively represents the net loss (for tax purposes) arising from B Co 1s operations.
20.
In structures such as this it will generally be the case that tax returns have been
prepared under the laws of both jurisdictions which will show the income and expenditure
as determined under local law using domestic tax concepts. Tax administrations may use
316 EXAMPLE 6.1

these existing sources of information and tax calculations as a starting point for
identifying duplicate deductions and dual inclusion income.
21.
For example, Country A could require A Co to separately identify the items of
income and deduction that are derived and incurred through B Co 1 and deny A Co a
deduction to the extent of any adjusted net loss under such calculation. When applying
the defensive rule, Country B could require the losses of B Co 1 to be applied only
against income of B Co 1 and apply a loss-continuity rule that prevents B Co 1 from
carrying any such losses forward in the event of a change of control.
EXAMPLE 6.2 317
Example 6.2
Whether DD may be set off against dual inclusion income
Facts
1.
In the example illustrated in the figure below, A Co establishes a PE in
Country B. The PE borrows money from a local bank. Interest on the loan is deductible in
both Country A and Country B. The PE has no other income.
A Co
Interest
Country B
PE
Bank
Loan
Question
2.
PE?
Does the deductible hybrid payments rule apply to the interest payment by the
Answer
3.
The interest payment will be subject to the deductible hybrid payments rule
unless:
(a) the rules in Country B prevent the payment from being set-off against income that
is not dual inclusion income; or
(b) the taxpayer can establish, to the satisfaction of the tax administration, that the
deduction has given rise to a stranded loss (i.e. the deduction cannot be set-off
against the income of any person under the laws of the other jurisdiction).
318 EXAMPLE 6.2
Analysis
A Co is a hybrid payer making a payment that gives rise to a DD outcome
4.
A Co falls within the definition of a hybrid payer as A Co is a non-resident
making a payment of interest, which is deductible under the laws of Country B (the payer
jurisdiction) and which triggers a duplicate deduction for A Co under the laws of
Country A (the parent jurisdiction).
5.
While income of the PE would presumably be taxable under the laws of both
Country A and B, on the facts of this example, the payment will give rise to a DD
outcome because the PE has no other income against which the deduction can be off-set.
DD outcome will give rise to a hybrid mismatch if deduction is capable of being

set-off against non-dual inclusion income under Country B law
6.
A payment results in a hybrid mismatch under the deductible hybrid payments
rule where the deduction for that payment may be set-off against income that is not dual
inclusion income. It is not necessary for a tax administration to know how the deduction
has been used in the other jurisdiction before it applies the rule.
7.
Under Country A law the interest deduction will automatically be eligible to be
set-off against income of A Co, which may not have a source in Country B. Therefore,
unless Country A applies the primary response under the deductible hybrid payments
rule, the interest deduction may be set-off against non-dual inclusion income in that
jurisdiction. Under Country B law the interest payment will give rise to a net loss.
Whether this loss may be set-off in the future against non-dual inclusion income under
Country B law will depend on the Country B rules governing the utilisation of losses and
other interactions between Country A and B laws.
8.
The PE may, for example, be able to join a tax grouping regime that would allow
the benefit of the loss to be used against the income of another group member.
Alternatively the PE may be able to structure an investment through a reverse hybrid in
order to derive income that is only brought into account under the laws of the payer
jurisdiction or it may be able to enter into a financial instrument or other arrangement
where payments on the instrument will not be included in ordinary income in the parent
jurisdiction. Unless the taxpayer can show that the interaction between Country A and B
laws makes it practically impossible to utilise the deduction against anything other than
dual inclusion income, the deduction should be treated as giving rise to a hybrid
mismatch under Recommendation 6.3.
Application of the primary response

9.
In this case the jurisdiction that should apply the primary response under the
deductible hybrid payments rule is Country A. Country A should prevent A Co from
offsetting the deduction against A Cos other income and require A Co to apply the
excess deduction against dual inclusion income in another period in accordance with
Country A law.
Application of the defensive rule

10.
In the event Country A does not apply the primary response, Country B should
prevent the PE from taking advantage of any structuring opportunities that would allow
EXAMPLE 6.2 319
the deduction for the payment to be set-off against income that is not dual inclusion
income.
Treatment of stranded losses

11.
Because the primary rule operates to restrict a deduction in the parent
jurisdiction, even in circumstances where the deduction has not been utilised in the payer
jurisdiction, the deductible hybrid payments rule has the potential to generate stranded
losses. This could occur, for example where A Co abandons its operations in Country B
and winds up the PE in Country B at a time when it still has unused carry-forward losses
from a prior period. In this case, Recommendation 6.1(d)(ii) provides that Country As
tax administration may permit those excess deductions to be set-off against non-dual
inclusion income under the laws of Country A at that time provided the taxpayer can
establish that the winding up of the PE in Country B will prevent A Co from using those
losses in Country B.
12.
If Country A requires A Co to prepare separate accounts for the PE showing the
items of income and expenditure that are brought into account under Country A law then
Country A could restrict the taxpayers ability to deduct any net loss of the PE from the
income of any member of the parent group. If, on the other hand, A Co is not required to
prepare separate accounts for the branch, it could use the tax return and filing information
in Country B to determine the net loss of the branch for Country B purposes, and after
making adjustments for material items or amounts of income and expenditure that are not
recognised under the law of the parent jurisdiction, deny A Co a deduction to the extent
of any net loss as calculated under the rules of the parent jurisdiction.
13.
Country B will likely require the branch to prepare separate accounts showing all
the amounts of income and expenditure that are subject to tax under Country B law.
Country B could prohibit the branch from surrendering the benefit of any deductions to
any other group member and implement other transaction specific rules designed to
prevent taxable income from being shifted into the branch to soak up any net losses. Loss
continuity rules may prevent the economic benefit of the carry-forward losses being used
against dual inclusion income of another taxpayer.
320 EXAMPLE 6.3
Example 6.3
Double deduction outcome from the grant of share options
Facts
1.
holding company for its operating subsidiary (B Co 2). B Co 1 is a hybrid entity (i.e. an
entity that is treated as a separate entity for tax purposes in Country B but as a
disregarded entity under Country A law). B Co 1 and B Co 2 are members of the same tax
group under Country B law which means that the net loss of B Co 1 can be set-off against
the net income of B Co 2.
A Co
Grant of share options
(FMV = 30)
Operating
Income (120)
Salary (30)
B Co 1
Dividend
(30)
Employee
B Co 2
Operating
income (210)
Other
expenses (90)
2.
B Co 1 has a single employee. The employee is entitled to an annual salary (paid
by B Co 1) The salary cost is funded by a dividend payment from B Co 2 that is excluded
from taxation under Country B law. The employee also participates in a share incentive
EXAMPLE 6.3 321
scheme which provides the employee with an option to acquire shares in A Co at a

discount to their market value. The market value of the share options is treated as a
deductible employment expense. Below is a table setting out the tax position in respect of
A Co, B Co 1 and B Co 2 under this structure.
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Income
Operating income (A Co)
Book
Income
120
Dividend from B Co 2
120
30
Expenditure
30
Expenditure
Salary and wages
(30)
Salary and wages
(30)
(30)
Share option grant
(30)
(30)
Share option grant
(15)
Net return
Taxable income (loss)
(45)
Loss surrender to B Co 2
45
Loss carry forward
0
B Co 2
Income
Operating Income
210
210
(90)
(90)
(30)
(45)
Expenditure
Operating expenses
Dividend paid to B Co 1
Loss surrender
Net return
Taxable income
90
90
Net return
Taxable income
90
75
Result under Country B law

3.
B Co 1 is treated as incurring 45 of employment expenses. The cash portion of
these expenses (i.e. the salary and wages) is funded by an exempt dividend from B Co 2.
B Co 1s net loss is surrendered to B Co 2 under the tax grouping regime of Country B
and is applied against that companys net income. B Co 2 has 75 of taxable income after
taking into account expenses and the benefit of the loss surrendered by B Co 1.
322 EXAMPLE 6.3
Result under Country A law

4.
A Co earns 120 of operating income from its activities in Country A. A Co also
treats the dividend paid by B Co 2, to fund B Co 1s employment expenses, as ordinary
income for tax purposes. Country A grants a deduction for the salary and wages and the
value of the share options but uses a different valuation methodology for calculating the
share option expense that results in a higher deduction.
5.
The entities in this structure have a total net return of 180 under the arrangement
but the aggregate taxable income under the arrangement is 165. This indicates that at least
15 of double deductions are being set-off against non-dual inclusion income.
Question
6.
What adjustments should be made to tax returns of the AB group under the
deductible hybrid payments rule?
Answer
7.
In this case Country A should apply the primary response under the deductible
hybrid payments rule and require A Co to carry-forward 30 of deductions into another
period to be set-off against future dual inclusion income. In the event Country A does not
apply the primary response, Country B should deny B Co a deduction of 15.
Analysis
The payment of the salary gives rise to a DD outcome
8.
The question of whether a payment has given rise to a DD outcome is primarily
a legal question that should be determined by an analysis of the character and tax
treatment of the payment under the laws of both jurisdictions. This requires an assessment
of the legal basis for the deduction in one jurisdiction and a comparison with the tax
outcomes in the other jurisdiction to determine whether a deduction has been granted in
respect of the same circumstances and on the same basis. If both jurisdictions grant a
deduction for the same expenditure item, then that deduction should be treated as giving
rise to a DD outcome. The labels that are ascribed to each category of payment (e.g.
travel subsidy, meal allowance, or wages) are less significant than identifying what the
deduction is for (i.e. employment expenses). If one jurisdiction treats a travel subsidy as a
separate deductible allowance, while the other simply treats it as part of the taxpayers
salary or wages, then the payment will still be treated as giving rise to a DD outcome
notwithstanding the different ways in which the payment is described under the laws of
each jurisdiction.
9.
In this case, both Country A and B treat salary or wages as deductible and
accordingly such a payment will generally give rise to a DD outcome. Under the
deductible hybrid payments rule the breakdown of salary and wages into its specific
components (e.g. meal allowances, wages) is not important provided both jurisdictions
are granting a deduction for the same expense. The final conclusion that a payment has
given rise to a DD outcome should only be made, however after the application of any
transaction or entity specific rules that prevent the deduction being claimed under the
laws of either jurisdiction. No DD outcome would arise, for example, if A Co was a tax
exempt entity that was not entitled to claim deductions for any type of expenditure.
EXAMPLE 6.3 323
The grant of the share options will give rise to a DD outcome

10.
If the laws of both Country A and B treat the granting of the share options as a
deductible expense then the grant of the shares will be treated as giving rise to a DD
outcome to the extent of the deduction in each jurisdiction. Although there are differences
between Country A and B in how the share options are valued this will generally not
impact on the extent to which a payment has given rise to a mismatch in tax outcomes.
The payment of the dividend gives rise to dual inclusion income

11.
While a payment must generally be recognised as ordinary income under the laws
of both jurisdictions before it can be treated as dual inclusion income, a payment that is
treated as ordinary income in the parent jurisdiction should still qualify as dual inclusion
income if the payment is subject to taxation relief in the payer jurisdiction in order to
relieve the payment from economic double taxation. In this case, the dividend paid by
B Co 2 to B Co 1 is treated as an exempt intra-group dividend. The dividend is not
deductible for B Co 2 and therefore does not trigger any further deductible expense under
the laws of the payer jurisdiction and cannot be used to erode the tax base of Country B.
Allowing the dividend recipient a deduction against this type of exempt or excluded
equity return preserves the intended tax policy outcomes in both Country A and Country
B and accordingly the dividend should be treated as dual inclusion income for the
purposes of the deductible hybrid payments rule even where such dividend carries an
entitlement to an underlying foreign tax credit in the parent jurisdiction. Such double
taxation relief may give rise to tax policy concerns, however, if it has the same net effect
as allowing for a DD outcome. In determining whether to treat an item of income, which
benefits from such double-taxation relief, as dual-inclusion income, countries should seek
to strike a balance between rules that minimise compliance costs, preserve the intended
effect of such double taxation relief and prevent taxpayers from entering into structures
that undermine the integrity of the rules.
Application of the primary response

12.
In this case the jurisdiction that should apply the primary response under the
deductible hybrid payments rule is Country A. Country A should deny A Cos duplicate
deductions to the extent it gives rise to a mismatch in tax outcomes. The duplicate
deduction will not give rise to a mismatch to the extent it does not exceed dual inclusion
income as determined under the laws of the parent jurisdiction. In this case, the total
amount of duplicate deduction incurred by A Co is 60 and A Cos dual inclusion income
is 30. The total amount of adjustment that should be made under the deductible hybrid
payments rule is therefore 30.
324 EXAMPLE 6.3

Country A
Calculation of adjustment under Country A law
A Co
Tax
Book
Income
Tax
Carry
forward
Book

Adjustment
120
120
30
(30)
30
Expenditure
Double deductions
Salary and wages
(30)
Share option grant
(30)
(30)
Salary and wages
30
Share option grant
30
Income
Net return
90
Taxable income
120
Adjustment
30
(30)
Application of the defensive rule

13.
In the event Country A does not apply the primary response, Country B should
deny B Co a deduction for the payment to the extent necessary to prevent the deduction
from being set-off against income that is not dual inclusion income. While the dividend
paid by B Co 2 to B Co 1 is treated as exempt income under Country B law, this payment
should be included in the calculation of dual inclusion income as it is included in income
under the laws of Country A. In this case, the total amount of duplicate deduction
incurred by B Co is (45) and A Cos dual inclusion income is 30. The total amount of
adjustment required under the deductible hybrid payments rule under Country B law is
15.
Country B
Calculation of adjustment under Country B law
B Co 1
Tax
Book
Income
Book
Adjustment
Tax
Carry
forward
30
(30)
15
Expenditure
Double deductions
Salary and wages
(30)
Share option grant
(15)
(30)
Salary and wages
30
Share option grant
15
Income
Net return
0
(30)
Adjustment
15
(15)
EXAMPLE 6.3 325
14.
In this case, given that B Co has no income and incurs a limited amount of
expenses, it may be possible for both Country A and B to make a direct comparison
between the tax treatment of the employment expenses in both countries to determine
whether and to what extent they give rise to a DD outcome. When applying the
deductible hybrid payments rule, the tax administration in Country B should take into
account, as dual inclusion income, any payment that is eligible for exclusion, exemption
other forms of tax relief in order to avoid economic double taxation provided such
payment is included in income under Country A law.
326 EXAMPLE 6.4
Example 6.4
Calculating dual inclusion income under a CFC regime
Facts
1.
holding company for its operating subsidiary (B Co 2).
Operating
income (120)
A Co
B Co 1
Bank
Interest (60)
Operating
& investment
income (210)
B Co 2
Expenses (90)
2.
B Co 1 is a hybrid entity (i.e. an entity that is treated as a separate entity for tax
purposes in Country B but as a disregarded entity under Country A law). B Co 1 and
B Co 2 are members of the same tax group under Country B law so that any net loss of
B Co 1 can be surrendered under the grouping regime to be set-off against the income of
B Co 2. B Co 1 borrows money from a local bank. The interest on the loan is treated as a
deductible expense under both Country A and B laws.
EXAMPLE 6.4 327
3.
B Co 2 is treated as a separate taxable entity by both A Co and B Co 1. Certain
items of income derived by B Co 2 are, however, attributed to A Co under Country As
CFC regime. B Co 2 has funds on deposit with the same bank and earns interest income
which is subject to tax in the hands of B Co 2. Below is a table setting out the tax position
in respect of the AB Group under this structure.
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Income
Income
120
120
Attributed CFC Income from B Co 2
30
Tax credit on attributed CFC Income
(60)
Expenditure
Expenditure
Net return
120
Taxable income
Tax on income (30%)
Book
96
Interest paid
(60)
Net return
(60)
(60)
(60)
(28.8)
Credit for underlying foreign taxes

Tax to pay
After-tax return
(22.8)
60
Loss carry forward
97.2
B Co 2
Income
Operating Income
Interest Income
180
180
30
30
(90)
(90)
(60)
Expenditure
Operating expenses
Loss surrender
Net return
Taxable income
Tax on income (20%)
Tax to pay
After-tax return
120
60
(12)
(12)
108

4.
B Co 1 incurs 60 of interest expenses. The net loss resulting from this interest
expense is surrendered under the tax grouping regime of Country B and applied against
328 EXAMPLE 6.4

the income of B Co 2. B Co 2 has 60 of taxable income after taking into account expenses
and the benefit of the loss surrendered by B Co 1.

5.
A Co earns 120 of net operating income from its activities in Country A and is
entitled to claim the 60 of interest expenses incurred by B Co 1. A Co is also attributed,
under the Country As CFC regime, a gross amount of 30 interest derived by B Co 2
together with tax on that income of 6. This attributed income is brought into account as
ordinary income and subject to tax at the full corporate rate after taking into account a
credit for underlying taxes paid in Country B.
6.
The total net return for the group is 180 while the net income for the group is 156
(including 6 of foreign tax credits).
Question
7.
What adjustments should be made to tax returns of A Co and B Co 1 under the
deductible hybrid payments rule?
Answer
8.
A tax administration may treat the net income of a controlled foreign company
(CFC) that is attributed to a shareholder of that company under a CFC or other offshore
inclusion regime as dual inclusion income if the taxpayer can satisfy the tax
administration that such income has been calculated on the same basis and is treated as
ordinary income that is subject to tax at the full rate under the laws of both jurisdictions.
Such income will be eligible to be treated as dual inclusion income even if it carries with
it an entitlement to credit for underlying foreign taxes that shelters a liability to tax in the
parent jurisdiction.
Analysis
Attributed income under a CFC regime can give rise to dual inclusion income.
9.
In this simplified example, where there is a single item of interest income that is
brought into account under the laws of both jurisdictions, the amount of attributed CFC
income that may be treated as dual inclusion income is the amount recognised as ordinary
income under the laws of Country A (including the benefit of any tax credits). The table
below shows the effect of an adjustment under the deductible hybrids payment rule taking
into account the operation of the CFC regime under Country A law.
EXAMPLE 6.4 329
Country A
A Co
Tax
Book
Income
120
120
30
(36)
Expenditure
Net return
Taxable income
Tax on income (30%)
Tax to pay
After-tax return
120
120
(36)
6
(30)
90
10.
The effect of this adjustment is that Country A permits A Co 1 to deduct the
interest expense to the extent that interest is set-off against amounts that are included in
income under Country As CFC regime. The total amount of income brought into account
under Country A and B laws is equal to 180. The reduced final level of tax in Country A
(25%) is the result of Country A continuing to provide the benefit of a tax credit on dual
inclusion income, despite the fact that the net dual inclusion income under Country A law
is nil (after that income has been set-off against a duplicate deduction).
11.
Under Country B law, the amount of income that is considered to be dual
inclusion income is the 30 of interest income derived by B Co 2. Accordingly, this
amount of loss should be treated as eligible for surrender under Country B law. The table
below shows the effect of the adjustment on the tax position of B Co 2.
330 EXAMPLE 6.4

Country B
Calculation of adjustment under

Country B law
B Co 2
Tax
Book
Tax
Income
Carry
forward
Book
Adjustment
30
Interest income
Expenditure
(30)
Double deductions
(60)
Net return
(60)
60
(60)
Taxable income
(30)
Loss carry forward
Adjustment
30
(30)
30
0
B Co 2
Income
Operating Income
Interest Income
180
180
30
30
(90)
(90)
(30)
Expenditure
Operating expenses
Loss surrender
Net return
Taxable income
Tax on income (20%)
Tax to pay
After-tax return
120
90
(18)
(18)
102
12.
Country B permits B Co 1 to surrender 30 of losses to B Co 2 (i.e. the amount
that is included in ordinary income under Country As CFC regime, ignoring the effect of
any credits). The effect of this adjustment is that Country A and B will include an
aggregate of 180 of income under the arrangement in addition to the foreign tax credit.
13.
In cases where dual inclusion income carries a right to a tax credit for an
underlying foreign taxes the parent jurisdiction could further choose to restrict the amount
of the foreign tax credit to the tax liability of the net dual inclusion income under the
arrangement. An illustration of the effect of these CFC changes is set out below:
EXAMPLE 6.4 331
Country A
A Co
Tax
Book
Income
120
120
30
(36)
Expenditure
Net return
Taxable income
Tax on income (30%)
Tax to pay
After-tax return
120
120
(36)
0
(36)
84
14.
Adjusting the entitlement to foreign tax credits in this way would protect Country
A from using double deduction structures to bring up tax credits without a corresponding
income item. Denying the foreign tax credit in these cases would make it easier for a
taxpayer to establish that the income attributed under the CFC regime is, in fact, dual
inclusion that has been calculated on the same basis in both jurisdictions and is subject to
tax in both jurisdictions at the full rate.
332 EXAMPLE 6.5
Example 6.5
DD outcome under a loan to a partnership
Facts
1.
In the example illustrated in the figure below, B Partnership is a hybrid entity that
is 25% owned by A Co (a company resident in Country A). The partnership has no
income. A Co lends money to B Partnership.
A Co
25%
Interest
(1 000)
Other
investors
75%
B Partnership
B Sub 1
EXAMPLE 6.5 333
2.
The tax laws of Country A treat B Partnership as a transparent entity so that a
proportionate share of the items of income, gain and expenditure derived and incurred by
B Partnership are allocated (under Country A law only) through the partnership to A Co
in accordance with A Cos interest in the partnership. B Partnership is consolidated with
B Sub 1, which is treated as a separate taxable entity under Country B law.
3.
The interest payment is treated as a deductible expense under Country B law and
can be surrendered against income of B Sub 1 under Country Bs tax grouping regime.
Under Country A law, however, both the income from interest payment and the deduction
from the interest expense are set-off against each other on the same tax return so that only
net 75% of the interest payment (effectively the portion of the interest cost economically
borne by the other investors) is included in A Cos income. If the interest payment under
the loan is 1 000 and the partnership has no other income then a simplified tax calculation
for A Co (assuming a corporate tax rate of 30%) can be illustrated as follows:
Country A
A Co
Tax
Book
Income
Interest
1 000
1 000
(250)
Expenditure
Interest
Net return
Taxable income
Tax to pay (33%)
After-tax return
1000
750
(250)
750
4.
While A Co receives a net return of 1 000, its taxable income under the
arrangement is reduced by the portion of the interest expense on the loan that is allocated
to A Co under Country A law. The net effect of this allocation is that A Co is taxable on
the net return under the arrangement at a rate of 25% rather than the statutory rate of
33%.
Question
5.
Does Recommendation 6 apply to deny the deduction for any portion of the
interest payment under the loan?
Answer
6.
The interest payment falls within the deductible hybrid payments rule because the
interest payment by the B Partnership gives rise to a deduction in Country B that may be
set-off against income of B Sub 1 (under the tax grouping regime of Country B) and a
duplicate deduction for A Co (an investor in B Partnership). Accordingly, under the
primary rule, the duplicate deduction in Country A should be denied to the extent that
exceeds the investors dual inclusion income. A Cos dual inclusion income in this
example is nil as the interest paid on the loan is not subject to tax in Country A.
334 EXAMPLE 6.5

Accordingly, Country A should deny a deduction for the full amount of the interest
expense.
7.
In the event that Country A does not apply the primary response under
Recommendation 6, Country B should apply the defensive rule to restrict a deduction for
the interest payment to the extent it gives rise to a duplicate deduction under Country A
law and to the extent the interest payment is not set-off against dual inclusion income.
Because B Partnership and A Co are not members of the same control group, the
defensive rule will only apply, however, to the extent the mismatch arises under a
structured arrangement and B Partnership is a party to that arrangement. The amount of
the deduction denied under the defensive rule is the entire amount of the interest payment
(i.e. 1 000) as that is the amount necessary to eliminate the mismatch in tax outcomes.
Analysis
B Partnership is a hybrid payer making a payment that gives rise to a DD
outcome
8.
The partnership falls within the definition of a hybrid payer as it is tax resident
in Country B and makes a deductible payment in that jurisdiction that triggers a duplicate
deduction for an investor in the partnership (A Co) under the laws of another jurisdiction
(Country A). If the partnership had other income this would likely be dual inclusion
income that could be offset against the deduction under the laws of both jurisdictions. In
this case, however, the partnership derives no other income and, accordingly, the entire
amount of the interest payment gives rise to a DD outcome.
If mismatch is not neutralised under Country A law then Country B should

deny a deduction for the interest payment under the secondary rule
9.
In the case of hybrid entities such as partnerships, the parent jurisdiction is the
jurisdiction where the partner is resident (Country A), Country A should therefore deny
the full amount of the deduction (250) in order to neutralise the mismatch in tax
outcomes.
10.
In the event Country A does not apply the primary rule, Country B should deny
the deduction to the extent necessary to neutralise the mismatch. This will result in a
deduction being denied for the full amount of the interest payment (1 000), because any
deduction incurred by the partnership in these circumstances, that is in excess of dual
inclusion income, will give rise to a mismatch in tax outcomes due to the tax transparency
of the partnership under Country A law.
Secondary rule will not apply unless B Partnership is a party to structured

arrangement
11.
The secondary rule will not apply unless the mismatch arises within the confines
of a control group or under a structured arrangement and the payer is a party to that
structured arrangement. A payer will not be a party to a structured arrangement if it could
not reasonably have been expected to be aware of the hybrid mismatch and did not share
in the value of the tax benefit arising from it. In this case the partnership would not
necessarily be expected to be aware of the tax treatment adopted by A Co (because B
Partnership is not treated as transparent under the law of County B) and unless the pricing
EXAMPLE 6.5 335
of the loan reflects the benefit of the resulting mismatch the partnership will not be
treated as sharing in the value of the tax benefit.
12.
In this case, the easiest way of preventing a double deduction being set-off against
non-dual inclusion income under Country A law would be for Country A to prevent A Co
from claiming any net loss from the partnership. Country B could restrict the ability of
the partnership to surrender the benefit of any resulting net loss under Country Bs tax
grouping regime and impose further transaction specific rules that prevent B Partnership
from entering into transactions designed to stream non-dual inclusion income to the
partnership in order to soak-up unused losses.
336 EXAMPLE 7.1
Example 7.1
DD outcome using a dual resident entity
Facts
1.
In the example illustrated in the figure below A Co 1 owns all of the shares in
A Co 2. A Co 2 is resident for tax purposes in both Country A and Country B. A Co 1 is
consolidated with A Co 2 under Country A law. A Co 2 acquires all the shares in B Co.
B Co is a reverse hybrid that is treated as a separate entity, for the purposes of Country A
law, but disregarded under Country B law.
A Co 1
Operating
Income (300)
Interest (150)
A Co 2
B Co
Bank
Operating
Income (350)
2.
A Co 2 borrows money from a bank. Interest on the loan is deductible in both
Country A and Country B. A Co 2 has no other income or expenditure. A table setting out
the combined net income position for the AB Group is set out below.
EXAMPLE 7.1 337
Country A
Country B
A Co 1
A Co 1 and B Co Combined
Tax
Book
Income
300
Operating income of B Co
350
350
(150)
(150)
Expenditure
(150)
Net return
Taxable income
Book
Income
300
Expenditure
Interest paid by A Co 2 to bank
Tax
300
150

Net return
Taxable income
200
200
3.
Country As tax consolidation regime permits A Co 2s interest payment (150) to
be directly set-off against the operating income of A Co 1 leaving A Co 1 with 150 of
taxable income. Under Country B law, the taxable income of B Co is treated as derived
by A Co 2 and is set-off against A Co 2s interest deduction, leaving the Country B
Group with taxable income of 200. The net effect of this structure is, therefore, that the
entities in the AB Group derive a net return of 500 of net income but only have taxable
income of 350.
Question
4.
Are the tax outcomes described above subject to adjustment under the dual
resident payer rule?
Answer
5.
Both Country A and B should apply the dual resident payer rule to deny the
benefit of the interest deduction. While having both countries apply the same rule to the
same payment raises the risk of double taxation there is no reliable way of ordering the
application of the rules and structuring alternatives are available which can prevent
double taxation from arising.
6.
If the dual resident ceases to be a dual resident excess deductions may be able to
be applied against non-dual inclusion income under the rule in Recommendation 7.1 (c)
dealing with stranded losses.
Analysis
Application of the dual resident payer rule
7.
A Co 2 is a dual resident entity and the interest payment triggers deductions under
the laws of both jurisdictions where A Co 2 is resident. A person should be treated as a
resident of a jurisdiction for tax purposes if they qualify as tax resident in that jurisdiction
or they are taxable in that jurisdiction on their worldwide net income. A person will be
treated as a resident of a jurisdiction even if that person forms part of a tax consolidation
group which treats that person as a disregarded entity for local law purposes. Thus, if the
tax consolidation regime in Country A was to treat all the taxpayers in the same
338 EXAMPLE 7.1

consolidated group as a single taxpayer and to disregard the transactions between them,
A Co 2 would still be treated as a resident of Country A for the purposes of the rule.
8.
A Co 2 has no other income so that the deduction gives rise to a DD outcome
under the laws of both Country A and B. The tax consolidation regime in Country A and
the ability of A Co 2 to invest in a reverse hybrid under Country B law mean that, in each
case, the DD outcome gives rise to a hybrid mismatch. Accordingly, both Country A and
B, should deny the interest deduction under the dual resident payer rule. A table setting
out the combined effect of these adjustments is set out below.
Country A
Calculation of adjustment under Country A law
A Co 1
Tax
Book
Tax
Income
Book
300
Adjustment
150
300
Expenditure
Double deductions
(150)
Net return
300
Taxable income
150
Adjustment
150
(150)
Calculation of adjustment under Country B law
Carry
forward
300
Country B
A Co 1 and B Co
Tax
Book
Income
350
Adjustment
150
Book
350
Expenditure
Tax
Double deductions
(150)
Net return
Taxable income
Carry
forward
(150)
200

Adjustment
150
150
(150)
350
9.
As can be seen from the above table, the net effect of applying the dual resident
payer rules in both jurisdictions is to increase the aggregate amount of taxable income to
650. This is in excess of the actual net income under the arrangement. Structuring
opportunities are available to A Co 2, however, that will eliminate the net tax burden.
A Co 2 could, for example, loan the borrowed money to A Co 1 at an equivalent rate of
interest. As illustrated in the table below, the effect of on-lending the money will be to
create dual inclusion income that will eliminate the mismatch in tax outcomes.
EXAMPLE 7.1 339
Country A
Country B
A Co 1
Tax
Book
Income
Tax
Book
Income
300
300
Expenditure
350
350
150
150
(150)
(150)
Expenditure
(150)
(150)
Net return
150
Taxable income
150
Net return
300
Taxable income
300
10.
The net effect of on-lending the money to A Co 1 is to create an amount of dual
inclusion income that is equal to the double deduction thus eliminating any mismatch in
tax outcomes under the laws of both jurisdictions and ensuring the aggregate net income
under the arrangement is subject to tax under the laws of both jurisdictions. Although this
interest payment is not taxable under Country A law (because it would be a payment
made between members of a consolidated group) it would meet the definition of dual
inclusion income because, in this case, the effect of consolidation is to relieve the payee
from the economic double taxation on the same income.
11.
An alternative way of escaping the effect of the over-taxation under the rule
would be to pay a dividend from B Co that was taxable under the laws of Country A.
Although this dividend would not be taxable under Country B law (because it would be a
payment made by a disregarded entity) it would meet the definition of dual inclusion
income because it is excluded from taxation under the laws of Country B in order to
relieve the payee from the effects of double taxation. This will be the case even where the
parent jurisdiction recognises a tax credit for underlying foreign taxes paid on the
distribution. The effect of paying a dividend to A Co 2 is illustrated in the table below.
Country A
Country B
A Co 1
Tax
Book
Income
Dividend paid by B Co
300
300
350
350
(150)
(150)
Expenditure
(150)
150
Net return
Taxable income
Book
Income
Expenditure
Tax
300
300
Net return
Taxable income
200
200
340 EXAMPLE 7.1

12.
The effect of dividend is to create an additional amount of dual inclusion income
under Country A law that is equal to the interest deduction thus eliminating any mismatch
in tax outcomes under the laws of Country A. Although the dividend is not taken into
account under Country B law the dividend is still considered to be dual inclusion income
because the exclusion granted under Country B law simply protects the taxpayer in
Country B from double taxation on the same economic income.
Treatment of stranded losses

13.
As with the deductible hybrid payments rule, the dual resident payer rule has the
potential to generate stranded losses in circumstances where it restricts the deduction in
both jurisdictions or where the deduction that arises in the other jurisdiction is unable to
be utilised for commercial reasons. Stranded losses could arise, for example under the
laws of Country A if the operating income of B Co was insufficient to cover the interest
obligations on the bank loan. If a dual resident entity with excess deductions under the
dual resident payer rule abandons its dual resident status, the residence jurisdiction may
release those excess losses and allow them to be set-off against non-dual inclusion
income if the residence jurisdiction is satisfied that the taxpayer can no longer take
advantage of any carry-forward losses in the other jurisdiction.
14.
Countries may choose to prevent dual resident entities joining any tax
consolidation or other grouping regime and may introduce transaction specific rules
designed to prevent such entities from streaming non-dual inclusion income to a dual
resident entity to soak-up unused losses.
EXAMPLE 8.1 341
Example 8.1
Structured imported mismatch rule
Facts
1.
Country A) is the parent of the ABCDE Group. A Co provides financing to B Co (a
wholly-owned subsidiary of A Co resident in Country B) under a hybrid financial
instrument. Interest payments on the loan are deductible under Country B law but not
included in ordinary income under Country A law. B Co on-lends the money provided
under the hybrid financial instrument to C Co and D Co (companies that are resident in
Country C and D respectively). C Co on-lends money to E Co (a wholly-owned
subsidiary of C Co resident in Country E).
A Co
Hybrid financial
instrument
Interest
(120)
Loan
Loan
B Co
C Co
Loan
E Co
Interest
(80)
Interest
(40)
D Co
342 EXAMPLE 8.1

2.
All loans are made as part of the same intra-group financing arrangement. The
figure above illustrates the group financing structure and the total gross amount of interest
payments made in each accounting period under this structure. E Co (the shaded entity) is
the only group entity resident in a country that has implemented the recommendations set
out in the report.
Question
3.
Whether the interest payments made by E Co to C Co are subject to adjustment
under the imported mismatch rule and, if so, the amount of the adjustment required under
that rule.
Answer
4.
E Cos imported mismatch payment and the payment under the hybrid financial
instrument that gives rise to a hybrid deduction are payments made under the same
structured imported mismatch arrangement. Country E should, therefore, deny the full
amount of the interest deduction under the structured imported mismatch rule. See the
flow diagram at the end of this example which outlines of the steps to be taken in
applying the structured imported mismatch rule.
Analysis
The interest payment made by E Co and the payment giving rise to the hybrid
deduction are part of the same structured arrangement
5.
In this case the money raised under the hybrid financing instrument has been onlent to other group companies as part of the same financing arrangement. All the lending
transactions and associated payments made under the group financing arrangement
(including the loan to E Co) should be treated as part of the same structured arrangement.
Accordingly, the payment made by B Co under the hybrid financial instrument, which
gives rise to the hybrid deduction, and the imported mismatch payment made by E Co,
which is subject to adjustment under the imported mismatch rules in Country E, should be
treated as made under the same structured arrangement.
Country E should deny the full amount of the interest deduction under the
structured imported mismatch rule
Step 1 B Cos payment under the hybrid financial instrument gives rise to a
direct hybrid deduction
6.
A Co has provided financing to B Co under a hybrid financial instrument.
Interest payments on that financial instrument are deductible under Country B law but not
included in ordinary income under Country A law. The interest payments therefore give
rise to a direct hybrid deduction for B Co of 120.
Step 2 the imported mismatch payment and the hybrid deduction are part of the
same structured arrangement
7.
The payment made by B Co under the hybrid financial instrument and the
imported mismatch payment made by E Co are treated as part of the same structured
EXAMPLE 8.1 343
arrangement (see analysis above). The structured imported mismatch rule requires the
payer jurisdiction to deny a deduction under an imported mismatch payment to the extent
the income from such payment is offset (directly or indirectly) against a hybrid deduction
under the same structured arrangement.
8.
The taxpayer should apply a tracing approach to determine the extent to which the
imported mismatch payment has been indirectly offset against that hybrid deduction. The
tracing approach requires E Co to trace the chain of payments that give rise to offsetting
income and expenditure under the structured arrangement through tiers of intermediate
entities to determine the extent to which the payment has directly or indirectly funded the
hybrid deduction. The mechanical steps involved in tracing the payment flows are
described below:
(a) B Cos payment to A Co under the hybrid financial instrument gives rise to a
hybrid deduction of (120). C Co has made a cross-border payment to B Co under
the same arrangement of (80). The lower of these two numbers (i.e. 80) is treated
as the amount of C Cos indirect hybrid deduction under an imported mismatch
arrangement.
(b) C Cos indirect hybrid deduction under the imported mismatch arrangement is 80,
E Cos cross-border payment to C Co under the same arrangement is 40. The
lower of these two numbers (i.e. 40) is treated as the amount of E Cos indirect
hybrid deduction under the imported mismatch arrangement. Country E should
therefore deny 40 of deduction under the imported mismatch rule.
344 EXAMPLE 8.1
Flow Diagram 1 (Example 8.1)

Neutralising hybrid deduction under the structured and direct imported mismatch rule
Step 1:
Identify a group
member with a
direct hybrid
deduction.
D/NI or DD outcome under

Recommendation 3, 6, 7.
D/NI outcome under

Recommendation 1, 4.
Reduce the amount of hybrid

deduction by any amount of
A group members direct hybrid deduction is equal to the sum of the above two items.
Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.
Is that hybrid deduction made under a structured arrangement?

Yes
No
Identify all the payments made under that structured arrangement and deny a
deduction for any imported mismatch payment (i) that is made under the same
arrangement and (ii) that funds (directly or indirectly) the hybrid deduction.
If the group member has direct hybrid deductions that have not been neutralised under
Step 2 above then add these direct hybrid deductions to the amount of any indirect hybrid
deductions as calculated under Flow Diagram 2.
Has the group member received one or more imported mismatch payments from any
other group member (payer)?
Yes
imported mismatch payments

hybrid deductions
imported mismatch payments <

hybrid deductions
The payer is denied a deduction for

any imported mismatch payment to
the extent payment is treated as setoff against a hybrid deduction in
accordance with the apportionment
rule.
The payer is denied a deduction for any

imported mismatch payment.
No further imported mismatch.
The group member has surplus hybrid

deductions that should be allocated under
indirect imported mismatch rule. See
Flow Diagram 2.
No
EXAMPLE 8.2 345
Example 8.2
Structured imported mismatch rule and direct imported mismatch rule
Facts
1.
The facts are the same as in Example 8.1 except that B Co already has an existing
funding arrangement in place with D Co that is unconnected with the group financing
structure and that C Co, D Co and E Co (the shaded entities) are all resident in
jurisdictions that have implemented the recommendations set out in the report. The figure
below illustrates the total gross interest payments made in each accounting period under
the groups financing structure.
A Co
Hybrid
financial
instrument
Interest
(120)
Loan
Loan
B Co
C Co
Loan
E Co
Interest
(80)
Interest
(40)
Interest
(80)
D Co
346 EXAMPLE 8.2
Question
2.
Whether the interest payments made by C Co, D Co or E Co are subject to
adjustment under the imported mismatch rule and, if so, the amount of the adjustment
required under the rule.
Answer
3.
The structured imported mismatch rule will apply in Country C to deny the full
amount of C Cos interest deduction.
4.
The interest payment made by D Co should not be treated as made under a
structured arrangement unless the D Co loan and the other group financing arrangements
were entered into as part of the same overall scheme, plan or understanding. Country D
should, however, apply the direct imported mismatch rule to deny half of the interest
payment paid to B Co (i.e. 40 of deductions should be denied under Country D law).
5.
The interest payment made by E Co is made to a payee that is subject to the
hybrid mismatch rules. The payment is therefore not an imported mismatch payment and
is not subject to adjustment under Recommendation 8.
6.
See the flow diagram at the end of this example which outlines of the steps to be
taken in applying the imported mismatch rule.
Analysis
No application of the imported mismatch rule in Country E
7.
The imported mismatch rule will not apply to any payment made to a payee that is
a taxpayer in a jurisdiction that has implemented the full set of recommendations set out
in the report. The hybrid mismatch rules in Country C will neutralise the effect of any
hybrid mismatch arrangements entered into by C Co (including the effect of any imported
mismatch arrangements) so that the income from any payment made by E Co to C Co
will not be offset against a hybrid deduction.
D Cos interest payment is not made under a structured imported mismatch

arrangement
8.
The interest payments made by C Co are treated as paid under a structured
imported mismatch arrangement because the hybrid financial instrument and the loan
between C Co and B Co are part of the same group financing arrangement. The loan
between C Co and D Co was in place before the hybrid financial arrangement was entered
into and, unless that loan could be shown to be part of the same scheme plan or
understanding as the financing arrangements put in place for the rest of the group, then
the interest payment made by D Co should be treated as outside the scope of the
structured imported mismatch rules.
EXAMPLE 8.2 347
The interest payments made by C Co and D Co should be subject to adjustment

under the structured and direct imported mismatch rule
Step 1 B Cos payment under the hybrid financial instrument gives rise to a
9.
The interest payments under the hybrid financial instrument give rise to a direct
hybrid deduction for B Co of 120.
Step 2 B Cos hybrid deduction and C Cos imported mismatch payment are part
of the same structured arrangement
10.
The payment made by B Co under the hybrid financial instrument and the
imported mismatch payment made by C Co should be treated as part of the same
structured arrangement (see the analysis in Example 8.1 above).
11.
The structured imported mismatch rule requires the payer jurisdiction to deny a
deduction for an imported mismatch payment to the extent the income from such payment
is offset (directly or indirectly) against a hybrid deduction under the same structured
arrangement. In this case B Co has a hybrid deduction of 120 and C Co has made a
cross-border payment to B Co under the same arrangement of 80. Accordingly the full
amount of the imported mismatch payment is treated as set-off against the hybrid
deduction under the structured imported mismatch rule.
Step 3 B Cos remaining hybrid deductions should be treated as set-off against

the imported mismatch payment made by D Co
12.
The direct imported mismatch rule should be applied in Country D to deny D Co
a deduction for the interest payment made to B Co to the extent that the income from that
payment is off-set against any remaining hybrid deductions.
13.
The guidance to the imported mismatch rule sets out an apportionment formula
which can be used to determine the extent to which an imported mismatch payment has
been directly set-off against any remaining hybrid deductions. The formula is as follows:
Imported mismatch payment made by payer
Total amount of remaining hybrid deductions incurred

Total amount of imported mismatch payments received
14.
On the facts of this example the ratio of remaining hybrid deductions to imported
mismatch payments is 40/80 so that half the imported mismatch payments made by D Co
to B Co are subject to adjustment under the direct imported mismatch rule.
348 EXAMPLE 8.2

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Identify all the payments made under that structured arrangement and deny a
deduction for any imported mismatch payment (i) that is made under the same
arrangement and (ii) that funds (directly or indirectly) the hybrid deduction.
Step 2 above then add these direct hybrid deductions to the amount of any indirect
hybrid deductions as calculated under Flow Diagram 2.
Yes

hybrid deductions

hybrid deductions

rule.


Flow Diagram 2.
No
EXAMPLE 8.3 349
Example 8.3
Application of the direct imported mismatch rule
1.
The figure below sets out the financing arrangements for companies that are
members of the same group. In this case A Co has lent money to C Co. C Co has lent
money to B Co and D Co and B Co and D Co have lent money to their subsidiaries. Each
company is tax resident in different jurisdiction.
A Co
Hybrid financial
instrument
Payment
(200)
C Co
Loan
D Co
B Co
Loan
E Co
Loan
Interest
(300)
Loan
F Co
Loan
G Co
Loan
H Co
2.
As illustrated in the diagram, the loan between A Co and C Co is a hybrid
financial instrument. The hybrid financial instrument is not, however, entered into as part
of a wider structured arrangement. The hybrid deduction arising under the hybrid
financial instrument is 200. D Co (the shaded entity) is the only entity in the group that is
350 EXAMPLE 8.3

resident in a country that has implemented the recommendations set out in the report.
D Co makes a deductible intra-group interest payment to C Co of 300.
Question
3.
Whether the interest payment made by D Co is subject to adjustment under the
imported mismatch rule and, if so, the amount of the adjustment required under the rule.
Answer
4.
Country D should deny D Co a deduction for two-thirds (i.e. 200) of the interest
paid to C Co. See the flow diagram at the end of this example which outlines of the steps
to be taken in applying the imported mismatch rule.
Analysis
D Cos interest payments should be subject to adjustment under the direct
imported mismatch rule
Step 1 C Cos payment under the hybrid financial instrument gives rise to a
5.
hybrid deduction for C Co of 200.
Step 2 the structured imported mismatch rule does not apply

6.
The facts of this example assume that the hybrid financial instrument is not
entered into as part of a wider structured arrangement. Therefore the structured imported
mismatch rule does not apply.
Step 3 The imported mismatch payment made by D Co is treated as set-off

against C Cos hybrid deduction under the direct imported mismatch rule
7.
a deduction for the interest payment to the extent C Co offsets the income from that
payment against any hybrid deductions. The guidance to the imported mismatch rule sets
out an apportionment formula which can be used to determine the extent to which an
imported mismatch payment has been directly set-off against the hybrid deduction of a
counterparty. The formula is as follows:

8.
In this case C Co receives only one imported mismatch payment (from D Co).
Accordingly the amount of D Cos imported mismatch payment that should be treated as
set-off against the hybrid deduction (and therefore the amount of deduction disallowed
under Country D law) is calculated as follows:
Imported mismatch payments made
by D Co
C Cos hybrid deduction

x
Imported mismatch payments received by C Co
300
200
x
300
= 200
EXAMPLE 8.3 351

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Identify all the payments made under that structured arrangement and deny a deduction
for any imported mismatch payment (i) that is made under the same arrangement and (ii)
that funds (directly or indirectly) the hybrid deduction.
hybrid deductions
Yes

hybrid deductions

rule.


Flow Diagram 2.
No
352 EXAMPLE 8.4
Example 8.4
Apportionment under direct imported mismatch rule
1.
The facts as set out in the diagram below are the same as in Example 8.3, except
that both B Co and D Co (the shaded entities) are resident in a country that has
implemented the recommendations set out in the report. B Co makes a deductible
intra-group interest payment to C Co of 100 and D Co makes a deductible intra-group
interest payment to C Co of 300.
A Co
Hybrid financial
instrument
Payment
(200)
C Co
Loan
Interest
(100)
D Co
B Co
Loan
E Co
Loan
Interest
(300)
Loan
F Co
Loan
G Co
Loan
H Co
EXAMPLE 8.4 353
Question
2.
Whether the interest payments made by B Co or D Co are subject to adjustment
the rule.
Answer
Country B and Country D should deny their taxpayers a deduction for half (i.e. 50 and
150 respectively) of the interest paid to C Co. See the flow diagram at the end of this
example which outlines of the steps to be taken in applying the imported mismatch rule.
Analysis
The interest payments made by B Co and D Co should be subject to adjustment
under the direct imported mismatch rule
3.

4.
Step 3 the imported mismatch payments made by B Co and D Co are treated as

set-off against C Cos hybrid deduction under the direct imported mismatch rule
5.
The direct imported mismatch rule should be applied, in both Country B and
Country D, to deny B Co and D Co (respectively) deductions for the interest payments
made to C Co to the extent these payments are offset against any hybrid deductions. The
guidance to the imported mismatch rule sets out an apportionment formula which can be
used to determine the extent to which an imported mismatch payment has been directly
set-off against a counterpartys hybrid deductions. The formula is as follows:

6.
In this case the proportion of each imported mismatch payment that should be
treated as set-off against a hybrid deduction (and therefore subject to adjustment under
the laws imported mismatch rules in the payer jurisdiction) is calculated as follows:
200
=
100 + 300
200
=
400
1
=
7.
Applying this ratio under the direct imported mismatch rules of Country B and
Country D, the amount of interest deduction denied under Country B law will be 50
354 EXAMPLE 8.4

(i.e. 1/2 x 100) and the amount of interest deduction denied under Country D law will be
150 (i.e. 1/2 x 300).
Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Yes

hybrid deductions

hybrid deductions

rule.


Flow Diagram 2.
No
EXAMPLE 8.5 355
Example 8.5
Application of the indirect imported mismatch rule
1.
The facts illustrated in the figure below are the same as in Example 8.3, except
that G Co (the shaded entity) is the only group entity resident in a jurisdiction that has
implemented the recommendations set out in the report. G Co makes a deductible
intra-group interest payment to D Co of 200 and D Co makes a deductible intra-group
interest payment to C Co of 300
A Co
Hybrid financial
instrument
Payment
(200)
C Co
Loan
Loan
Interest
(300)
D Co
B Co
Interest
(200)
Loan
E Co
Loan
F Co
Loan
G Co
Loan
H Co
356 EXAMPLE 8.5
Question
2.
Whether the interest payment made by G Co is subject to adjustment under the
Answer
3.
Country G should deny G Co a deduction for all (i.e. 200) of the interest paid to
D Co. See the flow diagrams at the end of this example which outline the steps to be
taken in applying the imported mismatch rule.
Analysis
C Cos hybrid deduction is not set-off against an imported mismatch payment
under the structured or direct imported mismatch rule
4.

5.
Step 3 the direct imported mismatch rules does not apply

6.
In this case the direct imported mismatch rule does not apply as the group entities
that are directly funding the hybrid deduction (i.e. B Co and D Co) are resident in
jurisdictions that have not implemented the imported mismatch rules.
The interest payments made by G Co should be subject to adjustment under the

indirect imported mismatch rule
7.
As C Cos hybrid deduction has not been neutralised under the structured or
direct imported mismatch rule, the indirect imported mismatch rule applies to determine
the extent to which C Cos surplus hybrid deduction should be treated as giving rise to an
indirect hybrid deduction for another group member.
Step 1 C Co has surplus hybrid deductions of 200

8.
In this case the total amount of C Cos surplus hybrid deduction will be the
amount of the direct hybrid deduction that is attributable to payments under the hybrid
financial instrument (200) minus any amount of hybrid deduction that has been
neutralised under either the structured or direct imported mismatch rules (0).
EXAMPLE 8.5 357
Step 2 C Cos surplus hybrid deduction are fully set-off against funded taxable
payments
9.
C Co must first treat that surplus hybrid deduction as being offset against funded
taxable payments received from group entities. A taxable payment will be treated as a
funded taxable payment to the extent the payment is directly funded out of imported
mismatch payments made by other group entities. In this case G Co makes an imported
mismatch payment of 200 to D Co and, accordingly, two-thirds (i.e. 200/300) of the
taxable payments that D Co makes to C Co should be treated as funded taxable payments.
10.
In this case the funded taxable payment by D Co (200) is equal to the total
amount of C Cos surplus hybrid deduction (200). C Co is therefore treated as setting-off
all of its surplus hybrid deduction against funded taxable payments which results in D Co
having an indirect hybrid deduction of 200.
Step 3 C Co has no remaining surplus hybrid deduction

11.
C Cos surplus hybrid deduction is fully set-off against funded taxable payments
and C Co therefore has no remaining surplus hybrid deduction to be set-off against other
taxable payments.
Step 4 D Cos indirect hybrid deduction is neutralised in accordance with the

direct imported mismatch rule
12.
The indirect hybrid deduction incurred by D Co under Step 2 above is treated as
being set-off against imported mismatch payments made by G Co. The amount of
deduction that is treated as set-off against G Cos imported mismatch payment is
calculated on the same basis as under the direct imported mismatch rule:
Imported mismatch payments made
by G Co
D Cos hybrid deduction

x
Imported mismatch payments received by D Co
200
=
200
200
= 200
358 EXAMPLE 8.5

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Yes

hybrid deductions

hybrid deductions

rule.


deductions that should be allocated
under indirect imported mismatch rule.
See Flow Diagram 2.
No
EXAMPLE 8.5 359

Allocating surplus hybrid deduction under the indirect imported mismatch rule
Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
Identify those group members with surplus hybrid deductions. See Flow Diagram 1 for
details.
Has the group member surrendered any deduction to, or received a taxable payment
from, another group member (payer)?
No
Should any of those surrenders to, or taxable payments from, the payer be treated as
funded taxable payments?
Yes
funded taxable payments
surplus hybrid deductions
Treat the surplus hybrid deduction as
surrendered or set-off against funded
taxable payments on a pro-rata basis
to calculate each payers indirect
hybrid deduction. Apply Step 4
below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
Yes

< surplus hybrid deductions
Treat the surplus hybrid deduction as fully
surrendered or set-off against all funded
taxable payments to calculate each payers
indirect hybrid deduction. Apply Step 4
below.
Treat the (remaining) surplus hybrid deduction as surrendered to or set-off against any
(remaining) taxable payments made by any group member (payer).
The payer has an indirect hybrid deduction equal to the lesser of: (i) the amount of taxable
payments by that payer; or (ii) the remaining surplus hybrid deduction as calculated
above. Apply Step 4 below.
Any allocation should ensure that a surplus hybrid deduction is not directly or indirectly
set-off against more than one imported mismatch payment.
The payers indirect hybrid deduction should be neutralised in accordance with the
procedure set out in Step 3 of Flow Diagram 1.
No
360 EXAMPLE 8.6
Example 8.6
Payments to a group member that is subject to the imported mismatch rules
1.
that D Co, G Co and H Co (the shaded entities) are all resident in jurisdictions that have
implemented the recommendations set out in the report. G Co and H Co each make a
deductible intra-group interest payment to D Co of 400 and D Co makes a deductible
intra-group interest payment to C Co of 300. C Cos hybrid deduction is 400.
A Co
Hybrid financial
instrument
Payment
(400)
C Co
Loan
Interest
(400)
B Co
Loan
E Co
Loan
Interest
(300)
Loan
F Co
Interest
(400)
D Co
Loan
G Co
Loan
H Co
EXAMPLE 8.6 361
Question
2.
Whether the interest payments made by G Co, H Co or D Co are subject to
Answer
3.
Country D should deny D Co a deduction for all (i.e. 300) of the interest paid to
C Co. No adjustment is required under the imported mismatch payments made by G Co
and H Co as these payments are made to a taxpayer that is subject to the imported
mismatch rule under the laws of its own jurisdiction. See the flow diagrams at the end of
this example which outline the steps to be taken in applying the imported mismatch rule.
Analysis
No application of the imported mismatch rule in Country G or H
4.
The imported mismatch rule will not apply to any payment made to a payee that is
a taxpayer in a jurisdiction that has implemented the full set of recommendations set out
in the report. The ability of D Co to generate direct or indirect hybrid deductions is
eliminated through the hybrid mismatch rules in Country D, so that the income from any
imported mismatch payment made by G Co or H Co cannot be offset against an indirect
hybrid deduction incurred by D Co.
D Cos interest payments should be subject to adjustment under the imported

mismatch rule
5.

6.
Step 3 the imported mismatch payment made by D Co is treated as set-off

7.
payment against any hybrid deductions. In this case C Co receives only one imported
mismatch payment (from D Co) which is less than the amount of C Cos hybrid
deductions. D Co should therefore be denied a deduction for the full amount of the
imported mismatch payment and C Co will have surplus hybrid deductions that would be
eligible to be allocated in accordance with the indirect imported mismatch rule.
362 EXAMPLE 8.6

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Yes

hybrid deductions

hybrid deductions

rule.


See Flow Diagram 2.
No
EXAMPLE 8.7 363
Example 8.7
Direct imported mismatch rule applies in priority to indirect imported
mismatch rule
1.
that D Co, E Co and F Co (the shaded entities) are all resident in jurisdictions that have
implemented the recommendations set out in the report. E Co and F Co each make a
deductible intra-group interest payment to B Co of 100 and D Co makes a deductible
intra-group interest payment to C Co of 200. C Cos hybrid deduction is 200.
A Co
Hybrid financial
instrument
Payment
(200)
C Co
Loan
Interest
(100)
Interest
(200)
B Co
Loan
E Co
Loan
Interest
(200)
D Co
Interest
(100)
Loan
F Co
Loan
G Co
Loan
H Co
364 EXAMPLE 8.7
Question
2.
Whether the interest payment made by E Co, F Co or D Co is subject to
Answer
3.
Country D should deny D Co a deduction for all (i.e. 200) of the interest paid to
C Co. C Co has no surplus hybrid deduction so that the application of the indirect
imported mismatch rule in Country E and Country F does not result in any denial of a
deduction for E Co or F Co. See the flow diagram at the end of this example which
outlines of the steps to be taken in applying the imported mismatch rule.
Analysis

mismatch rule
4.
hybrid deduction for B Co of 200.

5.

6.
payment against any hybrid deductions. The guidance to the imported mismatch rule sets
imported mismatch payment has been directly set-off against a counterpartys hybrid
deductions. The formula is as follows:

7.
In this case C Co receives only one imported mismatch payment (from D Co).
Accordingly the amount of D Cos imported mismatch payment that should be treated as
set-off against the hybrid deduction (and therefore the amount of deduction disallowed
under Country D law) is calculated as follows:
EXAMPLE 8.7 365
Imported mismatch
payments made by D Co

200
200
200
= 200
8.
Under this formula, all of C Cos hybrid deductions are treated as set-off against
imported mismatch payments. C Co therefore has no surplus hybrid deductions and there
is no scope to apply the indirect imported mismatch rule.
366 EXAMPLE 8.7

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

Yes
No
Yes

hybrid deductions

hybrid deductions

rule.


Flow Diagram 2.
No
EXAMPLE 8.8 367
Example 8.8
Surplus hybrid deduction exceeds funded taxable payments
1.
that D Co, E Co and F Co (the shaded entities) are all resident in jurisdictions that have
implemented the recommendations set out in the report. E Co makes a deductible
intra-group interest payment to B Co of 50 while F Co makes a deductible intra-group
interest payment to B Co of 150. D Co makes a deductible intra-group interest payment to
C Co of 200 and B Co makes a payment of 500. C Cos hybrid deduction is 500.
A Co
Hybrid financial
instrument
Payment
(500)
C Co
Interest
(500)
Loan
B Co
Interest
(50)
Loan
E Co
Interest
(200)
D Co
Interest
(150)
Loan
F Co
Loan
Loan
G Co
Loan
H Co
368 EXAMPLE 8.8
Question
2.
Whether the interest payment made by D Co, E Co, or F Co is subject to
Answer
3.
Countries D, E and F should deny D Co, E Co and F Co (respectively) a
deduction for all the imported mismatch payments made by those taxpayers. C Co and
B Co each are treated as having a remaining hybrid deduction of 100. See the flow
diagrams at the end of this example which outline the steps to be taken in applying the
imported mismatch rule.
Analysis
mismatch rule
4.

5.

6.
payment against any hybrid deductions. In this case C Co receives only one imported
mismatch payment (from D Co) which is less than the amount of C Cos hybrid
deductions. D Co should therefore be denied a deduction for the full amount of the
The interest payments made by E Co and F Co should be subject to adjustment

under the indirect imported mismatch rule
7.
As C Cos hybrid deduction has not been fully neutralised under the structured or
EXAMPLE 8.8 369

8.
In this case C Cos surplus hybrid deduction will be the amount of hybrid
deduction that is attributable to payments under the hybrid financial instrument (500)
minus any amount of hybrid deduction that has been neutralised under either the
structured or direct imported mismatch rules (200).
Step 2 C Cos surplus hybrid deduction are set-off against funded taxable
payments
9.
mismatch payments made by other group entities. In this case B Co receives an imported
mismatch payment of 50 from E Co and 150 from F Co and, accordingly, two fifths
(i.e. 200/500 of the taxable payments that B Co makes to C Co should be treated as
funded taxable payments.
10.
In this case the funded taxable payment by B Co (200) is less than the total
amount of C Cos surplus hybrid deduction (300). C Co therefore treats its surplus hybrid
deduction as fully set-off against the funded taxable payment made by B Co which results
in B Co having an indirect hybrid deduction of 200.
Step 3 C Cos remaining surplus hybrid deductions are treated as set-off against
any remaining taxable payments
11.
C Co has a remaining surplus hybrid deduction of 100. This remaining surplus
hybrid deduction should be treated as fully set-off against the remaining taxable payments
made by B Co. This deemed offset will generate a further indirect hybrid deduction of
100 for B Co. Care should be taken, however, when applying the imported mismatch rule
to ensure that the attribution of hybrid deductions under this step does not result in the
same hybrid deduction being treated as offset against more than one imported mismatch
payment. Any reduction in C Cos remaining surplus hybrid deduction (for example, as a
consequence of the receiving an additional imported mismatch payment) should therefore
be reflected in a corresponding adjustment to the amount of B Cos indirect hybrid
deduction.
Step 4 B Cos indirect hybrid deduction is neutralised in accordance with the

12.
B Co treats indirect hybrid deduction as being set-off against imported mismatch
payments made by E Co and F Co. The calculation is the same as under the direct
imported mismatch rule. The proportion of deduction that E Co and F Co should be
denied on their respective imported mismatch payments is 100% because B Cos indirect
hybrid deductions are at least equal to the amount of imported mismatch payments it
receives from E Co and F Co.
370 EXAMPLE 8.8

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
Yes

hybrid deductions

hybrid deductions

rule.


See Flow Diagram 2.
No
EXAMPLE 8.8 371

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
hybrid deduction. Apply Step 4 below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
Yes

below.
No
372 EXAMPLE 8.9
Example 8.9
Surplus hybrid deduction does not exceed funded taxable payments
1.
that E Co, F Co and G Co (the shaded entities) are all resident in jurisdictions that have
implemented the recommendations set out in the report. E Co and F Co make deductible
intra-group interest payment to B Co of 200 and B Co makes a deductible intra-group
interest payment to C Co of 500. G Co makes a deductible intra-group interest payment to
D Co of 200 and D Co makes a deductible intra-group interest payment to C Co of 200.
C Cos hybrid deduction is 400.
A Co
Hybrid financial
instrument
Payment
(400)
C Co
Loan
Interest
(500)
B Co
Interest
(200)
Loan
E Co
Interest
(200)
Loan
F Co
Loan
Interest
(200)
D Co
Interest
(200)
Loan
G Co
Loan
H Co
EXAMPLE 8.9 373
Question
2.
Whether the interest payment made by E Co, F Co or G Co is subject to
Answer
3.
Countries E, F and G should deny their taxpayers a deduction for two-thirds (133)
of the interest payments. See the flow diagrams at the end of this example which outline
the steps to be taken in applying the imported mismatch rule.
Analysis
C Cos hybrid deduction is not set-off against an imported mismatch payment
4.

5.

6.
that are directly funding the hybrid deduction (i.e. B Co and D Co) are resident in
jurisdictions that have not implemented the imported mismatch rules.
The interest payments made by E Co, F Co and G Co should be subject to

adjustment under the indirect imported mismatch rule
7.
As C Cos hybrid deduction has not been neutralised under the structured or

8.
In this case C Cos surplus hybrid deduction will be the amount of hybrid
374 EXAMPLE 8.9
Step 2 C Cos surplus hybrid deduction are set-off against funded taxable
payments
9.
mismatch payments made by other group entities. In this case the interest payments of
200 that B Co receives from E Co and F Co, and the payment of 200 that D Co receives
from G Co, are imported mismatch payments and, accordingly, four fifths (i.e. 400/500 of
the taxable payments that B Co makes to C Co and all (i.e. 200/200) of the interest
payments C Co receives from D Co should be treated as funded taxable payments.
10.
In this case the funded taxable payment received by C Co (600) exceeds C Cos
surplus hybrid deduction (400). C Co therefore treats its surplus hybrid deduction as
set-off against the funded taxable payments on a pro-rata basis. C Cos hybrid deduction
must be apportioned between the taxable payments made by B Co and D Co so that B Co
has an indirect hybrid deduction of 267 and D Co has an indirect hybrid deduction of 133,
calculated as follows:
Funded taxable payments made by payer
Funded taxable payments received by C Co
C Co's surplus hybrid deduction

11.
C Cos surplus hybrid deduction is fully set-off against funded taxable payments
and C Co therefore has no remaining surplus hybrid deduction to be set-off against other
taxable payments.
Step 4 B Co and D Cos indirect hybrid deduction is neutralised in accordance

with the direct imported mismatch rule
12.
B Cos indirect hybrid deduction should be treated as set-off against the imported
mismatch payments made by E Co and F Co. The calculation is the same as under the
direct imported mismatch rule. The guidance to the direct imported mismatch rule sets
imported mismatch payment has been directly set-off against a counterpartys indirect
hybrid deduction. The formula is as follows:
B Cos hybrid deductions
267
Imported mismatch payments received by B Co
267
200 + 200
400
2
=
Therefore two-thirds of the imported mismatch payments made by E Co and F Co are

subject to adjustment under the imported mismatch rule.
13.
The calculation with respect to G Cos imported mismatch payment is the same.
D Cos indirect hybrid deduction should be treated as set-off against that imported
mismatch payments using the same apportionment formula. The proportion of deduction
that G Co should be denied on its imported mismatch payment is calculated as follows:
D Cos hybrid deductions
133
Imported mismatch payments received by D Co
200
2
=
EXAMPLE 8.9 375
14.
Applying these ratios under the direct imported mismatch rules of Country E, F
and G the amount of interest deduction denied under the laws of each Country will be
.
Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
hybrid deductions
Yes

hybrid deductions

rule.


See Flow Diagram 2.
No
376 EXAMPLE 8.9

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
Yes

below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
No

below.
EXAMPLE 8.10 377
Example 8.10
Application of the imported mismatch rule to loss surrender under a tax
grouping arrangement
Facts
1.
Country A), B Co 1 and B Co 2 (companies resident in Country B) and C Co (a company
resident in Country C) are all members of the ABC group. Companies B Co 1 and B Co 2
are members of the same tax group for the purposes of Country B law. These tax
grouping rules allow one company to surrender a loss to another group member.
A Co
Hybrid financial
instrument
Payment
(100)
B Co 1
Interest
(100)
B Co 2
C Co
Operating
Income (100)
Loan
2.
C Co receives operating income of 100 and makes an interest payment of 100 to
B Co 2. B Co 1 makes interest payment of 100 to A Co under a hybrid financial
378 EXAMPLE 8.10

instrument. The payments of interest under the hybrid financial instrument are treated as
deductible interest payments under Country B law but as exempt dividends under
Country A law. The hybrid financial instrument is not, however, entered into as part of a
wider structured arrangement.
3.
Country B treats the hybrid financial instrument as an ordinary debt instrument
and grants B Co 1 a deduction for interest paid on the loan. This interest payment is not
included in A Cos ordinary income. This discrepancy in tax treatment results in a hybrid
mismatch giving rise to a D/NI outcome and a net loss for B Co 1. That loss is
surrendered by B Co 1 to B Co 2 under the tax grouping rule and set-off against the
income from the interest payment received from C Co. The table below illustrates the
effect of this transaction for the members of the ABC group.
Country A Law
Country B Law
A Co
B Co 1
Tax
Book
Income
Tax
Book
(100)
(100)
Income
0
Dividend
100
Expenditure
Interest paid
100
Net return
0
Taxable income
Net return
(100)
(100)
100
Loss carry-forward
Country C Law
0
B Co 2
C Co
Tax
Book
100
100
Income
Ordinary income
Interest
100
100
Expenditure
(100)
(100)
Loss surrender from B Co 1

0
Net return
Taxable income
Book
Income
Expenditure
Interest
Tax
(100)
100
Net return
Taxable income
4.
C Co (the shaded entity) is the only group entity resident in a Country that has
implemented the recommendations set out in the report.
EXAMPLE 8.10 379
Question
5.
Whether the interest payments made by C Co are subject to adjustment under the
imported mismatch rule, and, if so, the amount of the adjustment required under the rule?
Answer
6.
The payment of interest by C Co is subject to adjustment under the imported
mismatch rule because B Co 1s hybrid deduction is indirectly set-off against the interest
income paid by C Co to B Co 2. Country C should therefore deny C Co a deduction for
all the interest paid to B Co 2. See the flow diagrams at the end of this example which
outline the steps to be taken in applying the imported mismatch rule.
Analysis
B Co 1s hybrid deduction is not set-off against an imported mismatch payment
Step 1 B Co 1s payment under the hybrid financial instrument gives rise to a
7.
hybrid deduction for B Co 1 of 100.

8.
Step 3 the direct imported mismatch rule does not apply

9.
In this case the direct imported mismatch rule does not apply as B Co 1 does not
directly receive any imported mismatch payments from another group member.
The interest payments made by C Co should be subject to adjustment under the

10.
As B Co 1s hybrid deduction has not been neutralised under the structured or
the extent to which B Co 1s surplus hybrid deduction should be treated as giving rise to
an indirect hybrid deduction for another group member.
Step 1 B Co 1 has surplus hybrid deductions of 100

11.
In this case B Co 1s surplus hybrid deduction will be the amount of hybrid
380 EXAMPLE 8.10
Step 2 B Co 1s surplus hybrid deduction are treated as fully set-off against

12.
B Co 1 has surrendered a loss of 100 to B Co 2. This loss surrender is treated in
the same way as a funded taxable payment because it is treated as set-off against an
imported mismatch payment. In this case the amount of the loss surrender is equal to the
income from the imported mismatch payment and so 100% of the amount surrendered
should be treated as set-off against a funded taxable payment under the indirect imported
mismatch rule.
Step 3 B Co 1 has no remaining surplus hybrid deduction

13.
B Co 1s surplus hybrid deduction is fully set-off against funded taxable
payments and B Co 1 therefore has no remaining surplus hybrid deduction to be set-off
against other taxable payments.
Step 4 B Co 2s indirect hybrid deduction is neutralised in accordance with the

14.
B Co 2 treats indirect hybrid deduction as being set-off against imported
mismatch payments made by C Co. The amount of deduction that is treated as set-off
against C Cos imported mismatch payment is calculated on the same basis as under the
direct imported mismatch rule:
Imported mismatch payments
made by C Co
B Co 2s hybrid deduction
x
100
Imported mismatch payments received by B Co = 100 x

100
2
= 100
C Co should therefore be denied a deduction of 100.
EXAMPLE 8.10 381

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
hybrid deductions
Yes

hybrid deductions

rule.


See Flow Diagram 2.
No
382 EXAMPLE 8.10

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
Yes


below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
No

below.
EXAMPLE 8.11 383
Example 8.11
Payment of dual inclusion income not subject to adjustment
under imported mismatch rule
Facts
1.
The figure below sets out the financing arrangements for companies that are
members of the ABCD group. A Co is resident in Country A and is the parent company
of the group. B Co 1, C Co and D Co are all direct subsidiaries of A Co and are resident
in Country B, Country C and Country D respectively. B Co 2 is a wholly-owned
subsidiary of B Co 1 and is also resident in Country B.
2.
All companies are treated as separate tax entities in all jurisdictions, except that
B Co 1 is a hybrid entity (i.e. an entity that is treated as a separate entity for tax purposes
in Country B but as a disregarded entity under Country A law).
Interest
(Year 1 = 200)
(Year 2 = 200)
A Co
Loan
Operating income
(Year 1 = 100)
(Year 2 = 300)
B Co 1
C Co
Interest
(Year 1 = 100)
(Year 2 = 300)
Interest
(Year 1 = 100)
(Year 2 = 100)
Loan
B Co 2
D Co
Operating income
(Year 1 = 100)
(Year 2 = 100)
Loan
384 EXAMPLE 8.11

3.
A Co has lent money to B Co 1. B Co 1 has lent money to C Co and B Co 2 has
lent money to D Co. Each of these financing arrangements are entered into independently
and do not form part of single scheme, plan or understanding.
4.
Because B Co 1 is a hybrid entity, the interest payments it makes to A Co are
deductible under Country B law, but not recognised as income by A Co under Country A
law. For the same reason, interest payments by C Co to B Co 1 are included in the income
of both A Co and B Co 1 under the laws of Country A and Country B respectively
(i.e. the interest payment gives rise to dual inclusion income). B Co 1 and B Co 2 are
members of the same tax group for tax purposes under Country B law, which means that
the net loss of B Co 1 can be set-off against any net income of B Co 2. All jurisdictions
impose corporate tax at the rule of 30%.
Tax position before applying the imported mismatch rule

5.
The tables below set out the tax position in respect of the ABCD group under this
structure as at the end of the first year.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Interest paid by C Co to B Co 1
Boo
k
Tax
Income
200
100
Interest paid by C Co
100
100
(200)
(200)
Expenditure
Net return
(100)
Taxable income
(100)
Year 1
100
Loss carry-forward
B Co 2
Income
Interest paid by D Co
100
100
(100)
Expenditure
Loss surrender
Net return
Taxable income
200
100
Net return
Taxable income
100
0
EXAMPLE 8.11 385
Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Book
Income
Operating income
100
100
Year 1
Expenditure
Operating income
100
100
(100)
(100)
Expenditure
Interest paid to B Co 1
(100)
(100)
Net return
Taxable income
Net return
Taxable income
6.
The tables below set out the tax position in respect of the ABCD Group under this
structure as at the end of the second year.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Tax
Book
Income
-
200
300
300
300
(200)
(200)
Expenditure
Net return
200
Net return
100
Year 2
Taxable income
300
Taxable income
100
Tax on income (30%)
(90)
Tax on income (30%)
(30)
Credit for tax paid in Country B
30
Tax to pay
(60)
Tax to pay
After-tax return
140
After-tax return
(30)
70
B Co 2
Income
100
Net return
Taxable income
100
100
100
386 EXAMPLE 8.11

Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Operating income
Income
300
300
Year 2
Expenditure
Book
Operating income
100
100
(100)
(100)
Expenditure
(300)
Net return
Taxable income
(300)
0
0
Net return
Taxable income
0
0

7.
A Co has taxable income of 100 and 300 in Years 1 and 2 respectively. Under
Country A law, A Co is entitled to a foreign tax credit in Year 2 for taxes paid by B Co 1
in Country B so that the amount of ordinary income derived by A Co is 200.

8.
In Year 1, B Co 1 has a net loss of 100 while B Co 2 has net income of 100. B Co
1s net loss is surrendered through Country Bs tax grouping regime and applied against
B Co 2s net income so that the group is treated, under Country B law, as having net
income of zero for that year. In Year 2, B Co 1 has net income of 100 (interest income of
300 and a deduction of 200) and B Co 2 has net income of 100.
Result under Country C and D law

9.
Country C and D have income that is equal to their expenses and therefore have
no net income in either of the two years.
Mismatch in tax outcomes

10.
In aggregate the ABCD Group generates a net return of 600 over the two years.
The total amounts of taxable income recognised in each jurisdiction is also 600, but 100
of this is income that is sheltered by foreign tax credits. Accordingly, the total amount of
ordinary income recognised under the structure is 500.
Question
11.
Whether the interest payments made by C Co and D Co are subject to adjustment
the rule.
EXAMPLE 8.11 387
Answer
12.
As the interest payments made by C Co to B Co 1 are dual inclusion income, they
are not treated as set-off against a hybrid deduction and therefore no adjustment is
required for the payments made by C Co under the imported mismatch rule.
13.
Indirect imported mismatch rule applies to interest payments from D Co to
B Co 2. Country D should therefore deny D Co a deduction for all (100) of the interest
paid to B Co 2 in Year 1 but no adjustment is required in Year 2. See the flow diagrams at
the end of this example which outline the steps to be taken in applying the imported
mismatch rule.
Analysis
Interest payments made by B Co 1 are not made under a structured
arrangement
14.
The loan between A Co and B Co 1 is independent of the other intra-group
financing arrangements. Unless such loan was entered into as part of wider scheme, plan
or understanding that was intended to import the effect of a mismatch in tax outcomes
into Country C or D, then the interest payment made by B Co 1 to A Co should not be
treated as made under a structured imported mismatch arrangement.
The interest payments by C Co to B Co 1 are not offset against a hybrid

deduction
15.
As explained in the facts above, the interest payments made by B Co 1 to A Co
give rise to a D/NI outcome under the disregarded payments rule. However, a hybrid
mismatch does not arise under the disregarded hybrid payments rule to the extent the
deductions attributable to such payment are set-off against dual inclusion income. In this
case, C Cos interest payments to B Co 1 are dual inclusion income and therefore cannot
be treated as giving rise to an imported mismatch. Hence, no adjustment is required for
the payments made by C Co in either year under the imported mismatch rule.

Step 1 B Co 1s disregarded hybrid payment gives rise to a direct hybrid
deduction
16.
The interest payment B Co 1 makes to A Co is a disregarded hybrid payment.
Any deduction claimed for that payment will be a direct hybrid deduction to the extent it
exceeds the payers dual inclusion income. In this case, the disregarded interest payment
made by B Co 1 in Year 1 (200) exceeds Co 1s dual inclusion for that year (100) and
accordingly B Co 1 has a hybrid deduction in Year 1 of 100.

17.
The facts of this example assume that the disregarded hybrid payment is not
made under a wider structured imported mismatch arrangement. Therefore the structured
imported mismatch rule does not apply.
388 EXAMPLE 8.11
Step 3 the direct imported mismatch rule does not apply

18.
The interest payment made by D Co in Year 1 should be subject to adjustment

19.

20.
deduction that arises under the hybrid mismatch arrangement (100) minus any amount
that has been neutralised under either the structured or direct hybrid mismatch rules (0).
Step 2 B Co 1s surplus hybrid deduction are treated as fully set-off against

21.
the same way as a funded taxable payment because the surrendered hybrid deduction is
set-off against an imported mismatch payment. In this case the amount of the loss
surrender is equal to the imported mismatch payment and so 100% of the amount
surrendered should be treated as set-off against a funded taxable payment under the
indirect imported mismatch rule.

22.
B Co 1s surplus hybrid deduction is fully set-off against funded taxable
payments and B Co 1 therefore has no remaining surplus hybrid deduction to be set-off
against other taxable payments.

23.
B Co 2 treats the indirect hybrid deduction as being set-off against imported
mismatch payments made by C Co. The amount of deduction that is treated as set-off
against C Cos imported mismatch payment is calculated on the same basis as under the
direct imported mismatch rule:
Imported mismatch payments
made by D Co
x
Imported mismatch payments received by B Co 2
100
=
100
100
= 100
C Co should therefore be denied a deduction of 100.
Tax position after applying the imported mismatch rule

24.
The effect of the adjustment under the imported mismatch rule is to deny D Co a
deduction for the entire amount of the interest payment in Year 1. This brings the total
ordinary income under the structure into line with the aggregate income under the
EXAMPLE 8.11 389
arrangement. The tables below sets out the tax position of the ABCD Group, as at the end
of the first year, after applying the imported mismatch rule.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Tax
Book
Income
200
100
100
100
(200)
(200)
Expenditure
Net return
(100)
Taxable income
(100)
Year 1
100
Loss carry-forward
B Co 2
Income
100
100
(100)
Expenditure
Loss surrender
Net return
200
Taxable income
100
Net return
100
Taxable income
Country C Law
Country D Law
C Co
D Co
Tax
Book
Income
Operating income
Year 1
100
100
(100)
(100)
Operating income
100
100
(100)
Expenditure
Net return
Taxable income
Book
Income
Expenditure
Tax
0
0
Net return
Taxable income
0
100
390 EXAMPLE 8.11

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
Yes

hybrid deductions

hybrid deductions

rule.


See Flow Diagram 2.
No
EXAMPLE 8.11 391

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
taxable payments on a pro-rata basis to
calculate each payers indirect hybrid
deduction. Apply Step 4 below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
Yes

below.
No
392 EXAMPLE 8.12
Example 8.12
Imported mismatch rule and carry-forward losses
Facts
1.
The facts are the same as in Example 8.11 except that B Co 1s net loss is not
surrendered to B Co 2 in the first year. The tables below set out the tax position in respect
of each member of the ABCD Group under this structure as at the end of the first year.
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Income
Book
Income
-
200
100
100
100
(200)
(200)
Expenditure
Net return
(100)
Year 1
(100)
B Co 2
Income
Net return
Taxable income
200
100
100
Net return
Taxable income
100
100
100
EXAMPLE 8.12 393
Country C Law
Country D Law
C Co
D Co
Tax
Book
Income
Tax
Book
Income
Operating income
100
100
Year 1
Expenditure
Operating income
100
100
(100)
(100)
Expenditure
(100)
Net return
(100)
Taxable income
Net return
Taxable income
2.
The tables below set out the tax position in respect of each member of the ABCD
Group under this structure as at the end of the second year.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Tax
Book
Income
-
200
300
300
300
(200)
(200)
Expenditure
Net return
200
Year 2
Taxable income
300
Tax on income (30%)
(90)
Net return
100
Taxable income
100
Loss carry forward
(100)
Adjusted income
Tax to pay
(90)
Tax to pay
After-tax return
110
After-tax return
0
0
100
B Co 2
Income
100
Net return
Taxable income
100
100
100
394 EXAMPLE 8.12

Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Operating income
Income
300
300
Year 2
Expenditure
Book
Operating income
100
100
(100)
(100)
Expenditure
(300)
Net return
Taxable income
(300)
0
0
Net return
Taxable income
0
0

3.
A Co has net income of 100 and 300 in Years 1 and 2 respectively. A treats these
amounts as ordinary income.

4.
In Year 1, B Co 1 has a net loss of 100 (interest income of 100 and a deduction of
200), while B Co 2 has net income of 100. B Co 1s net loss is carried-forward to the
subsequent year and set-off against dual inclusion income in Year 2. Accordingly in
Year 2, B Co 1 has an adjusted taxable income of 0 (interest income of 300, a deduction
of 200 and a carry-forward loss of 100) and B Co 2 has net income of 100.
Result under Country C and D law

5.
Country C and D have income that is equal to their expenses and therefore have
no net income in either of the two years.
Question
6.
Whether the interest payments made by D Co are subject to adjustment under the
Answer
7.
Because B Co 1 does not surrender its Year 1 loss to B Co 2 under the tax
grouping regime, B Co 2s income from the imported mismatch payment is not set-off
against any hybrid deduction. Accordingly, no adjustment is required for the payments
made by C Co or D Co under the indirect imported mismatch rule. See the flow diagrams
at the end of this example which outline the steps to be taken in applying the imported
mismatch rule.
EXAMPLE 8.12 395
Analysis
arrangement
8.
The loan between A Co and B Co 1 is independent of the other intra-group
financing arrangements. Unless such loan was entered into as part of wider scheme, plan
or understanding that was intended to import the effect of a mismatch in tax outcomes
into Country C or D, then the interest payment made by B Co 1 to A Co should not be

Step 1 B Co 1s disregarded hybrid payment gives rise to a direct hybrid
deduction
9.
The interest payment B Co 1 makes to A Co is a disregarded hybrid payment.
exceeds the payers dual inclusion income. In this case, the disregarded interest payments
made by B Co 1 in Year 1 (200) exceed B Co 1s dual inclusion for that year (100) and
accordingly B Co 1 has a hybrid deduction in Year 1 of 100.

10.
The facts of this example assume that the disregarded hybrid payment is not
made under a wider structured imported mismatch arrangement. Therefore the structured

11.
The interest payment made by D Co in Year 1 should be subject to adjustment

12.

13.
deduction that arises under the hybrid mismatch arrangement (100) minus any amount of
hybrid deduction that has been neutralised under either the structured or direct imported
mismatch rules (0).
396 EXAMPLE 8.12
Step 2 B Co 1s surplus hybrid deduction is not surrendered or set-off against a

taxable payment from any group member
14.
B Co 1s surplus hybrid deduction is not surrendered under the tax grouping
regime or set-off against the taxable payment of any group member. Therefore the hybrid
deduction is not treated as giving rise to any indirect hybrid deduction for any other group
member. B Co 1, however, has a surplus hybrid deduction that is converted into a net loss
that is carried-forward into the subsequent period. The carried-forward loss should be
treated as giving rise to a hybrid deduction in that period (see the analysis in Example
8.15). In this case, however, because the hybrid deduction has arisen in respect of a
disregarded payment and is offset against dual inclusion income in the following year the
net effect of the hybrid deduction is neutralised and no imported mismatch arises in
Year 2. The carry-forward of the net loss eliminates the foreign tax credit that would
otherwise be available to A Co in Year 2, bringing the aggregate amount of ordinary
income under the structure into line with the overall group profit.
EXAMPLE 8.12 397

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
hybrid deductions
Yes

hybrid deductions

rule.


See Flow Diagram 2.
No
398 EXAMPLE 8.12

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
Yes


hybrid deduction. Apply Step 4 below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
No

below.
EXAMPLE 8.13 399
Example 8.13
Deductible hybrid payments, reverse hybrids and the imported hybrid
mismatch rule
Facts
1.
The figure below sets out the intra-group financing arrangements for companies
that are members of the ABCD group. A Co is the parent of the group and is resident in
Country A. B Co 1 and C Co are both direct subsidiaries of A Co and are resident in
Country B and C respectively. B Co 2, a company resident in Country B, is a
wholly-owned subsidiary of B Co 1 and D Co, a company resident in Country D, is a
subsidiary of C Co.
A Co
Interest
(100)
C Co
Interest
(150)
Operating
Income
(100)
Operating
Income
(100)
B Co 1
Interest
(100)
D Co
B Co 2
Bank
400 EXAMPLE 8.13

2.
B Co 1 is a hybrid entity, i.e. an entity that is treated as a separate entity for tax
purposes in Country B and as a disregarded entity in Country A. B Co 2 is a reverse
hybrid entity, which means that it is treated as a separate entity under the tax laws of both
Country A and D but as a disregarded entity for the purposes of Country B law.
3.
The funding arrangements for the group are illustrated in the figure above. Each
of these financing arrangements are entered into independently and do not form part of
single scheme, plan or understanding. C Co pays interest of 100 on the loan from A Co
and D Co pays interest of 100 on the loan from B Co 2. B Co 1 pays interest of 150 on the
loan funding it receives from Bank. The table below illustrates the net income and
expenditure of the entities in the group.
Country A
Country B
A Co
Tax
Book
Tax
Income
Income
100
100
Expenditure
(150)
Net return
100
(50)
(150)
(150)
(50)
Taxable income
(50)
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Book
Income
100
100
Expenditure
Operating income
100
100
(100)
(100)
Expenditure
(100)
Net return
Taxable income
100
Net return
Country C Law
100
Expenditure
Operating income
Book
(100)
0
0
Net return
Taxable income
0
0
4.
Because B Co 1 is treated as a transparent entity for the purposes of Country A
law, the tax positions of A Co and B Co 1 are combined. The combination of A Co and
B Co 1 accounts mean that the payment of 150 made by B Co 1 to Bank is deductible in
both Country A and Country B (a DD outcome). For the purposes of Country B law, the
positions of B Co 1 and B Co 2 are combined, because B Co 2 is a reverse hybrid and
thus the payment of 100 that B Co 2 receives from C Co is treated as if it was received
directly by B Co 1. This payment is not, however, dual inclusion income.
EXAMPLE 8.13 401
5.
Country C and Country D have implemented the full set of recommendations set
out in the report. For the purposes of this example it is assumed that the structured
Question
6.
under the imported mismatch rule, and, if so, the amount of the adjustment required under
the rule.
Answer
7.
Country C and Country D should apply the direct imported mismatch rule to
deny a deduction for half the interest payments made by C Co and D Co respectively. See
the flow diagram at the end of this example which outlines the steps to be taken in
applying the imported mismatch rule.
Analysis
arrangement
8.
B Co 1s loan from the Bank is independent of the intra-group financing
arrangements. Unless such loan was entered into as part of wider scheme, plan or
understanding that was intended to import the effect of a mismatch in tax outcomes into
Country C or D, then the interest payment made by B Co 1 to the Bank should not be
Payment of interest by C Co and D Co are offset against the same hybrid

deduction
9.
B Co 1 makes a deductible hybrid payment of 150 that gives rise to a DD
outcome. The resulting hybrid deduction is automatically set-off against income on
interest paid by C Co to A Co and on the interest paid by D Co to B Co 2. Because,
however, this is a double deduction structure, the payments made by C Co and D Co are
effectively set-off against the same hybrid deduction and both these payments should be
taken into account when applying the apportionment approach under the direct imported
mismatch rule.
The interest payments made by C Co and D Co should be subject to adjustment

under the imported mismatch rule
Step 1 B Co 1s deductible hybrid payment gives rise to a direct hybrid
deduction under both Country A law and Country B law
10.
The interest payment B Co 1 makes to the Bank is a deductible hybrid payment.
exceeds the payers dual inclusion income. In this case the deductible payment is not
reduced by any dual inclusion income so that B Co 1s interest payment gives rise to a
direct hybrid deduction of 150 under both Country A and Country B law.
402 EXAMPLE 8.13

11.
The facts of this example assume that the deductible hybrid payment is not made
under a structured imported mismatch arrangement. Therefore the structured imported
Step 3 the imported mismatch payments made by C Co and D Co D Co should

be treated as set-off against the same hybrid deduction under the direct imported
mismatch rule
12.
The direct imported mismatch rule should be applied in both Country C and
Country D to deny C Co and D Co (respectively) deductions for the interest payments
made to A Co and B Co 2 (respectively). Because Country C and Country D are applying
the direct imported mismatch rule to the same hybrid deduction, those countries should
apply an apportionment approach to determine the extent to which the imported mismatch
payment has been set-off against the same hybrid deduction.
13.
The guidance to the imported mismatch rule sets out an apportionment formula
which can be used to determine the extent to which an imported mismatch payment has
been directly set-off against a counterpartys hybrid deductions. The formula is as
follows:

14.
As observed above, in this case the same hybrid deduction is set-off against two
imported mismatch payments (from C Co and D Co) and the amount of those payments
that should be treated as set-off against the hybrid deduction is calculated as follows:
150
Imported mismatch payments received by A Co and B Co 2
100 + 100
150
200
3
=
15.
Applying this ratio under the imported mismatch rules of Country C and Country
D, the amount of interest deduction denied under Country C law will be
mount of interest deduction denied under Country D law
will be
The net income of the companies in the group after application of the imported mismatch
rule is presented in the table below.
EXAMPLE 8.13 403
Country A
Country B
A Co
Tax
Book
Tax
Income
Income
100
100
Expenditure
(150)
Net return
100
(50)
(150)
(150)(50)
Taxable income
(50)
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Book
Income
100
100
Expenditure
Operating income
100
100
(25)
(100)
Expenditure
(25)
Net return
Taxable income
100
Net return
Country C Law
100
Expenditure
Operating income
Book
(100)
0
75
Net return
Taxable income
0
75
404 EXAMPLE 8.13

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
Yes

hybrid deductions

hybrid deductions

rule.


Flow Diagram 2.
No
EXAMPLE 8.14 405
Example 8.14
Deductible hybrid payments, tax grouping and imported hybrid mismatch
rules
Facts
1.
The facts illustrated in the figure below are the same as Example 8.13 except that
B Co 2 is not a reverse hybrid but a member of the same tax group for the purposes of
Country B tax law. Members of a tax group calculate their income (or loss) on a separate
entity basis but are able to surrender any net loss to another group member and set it off
against that group members income arising in the same accounting period. The group
structure and financing arrangements are illustrated in the figure below.
A Co
Interest
(100)
C Co
Interest
(150)
Operating
Income
(100)
Operating
Income
(100)
B Co 1
Interest
(100)
D Co
B Co 2
Bank
406 EXAMPLE 8.14

2.
The net income accounts of the entities in the ABCD group are the same as in
Example 8.13 and are set out in the table below. Unlike in the example above, B Co 1
and B Co 2 accounts are not combined.
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Book
(150)
(150)-
Income
100
100
Expenditure
Expenditure
(150)
Net return
100
(50)
Net return
(150)
(150)
100
Loss carry forward
(50)
B Co 2
Income
100
100
Expenditure
Loss surrender
(100)
Net return
100
Taxable income
Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Operating income
100
100
(100)
(100)
Operating income
100
100
(100)
(100)
Expenditure
Net return
Taxable income
Book
Income
Expenditure
0
0
Net return
Taxable income
0
0
EXAMPLE 8.14 407
Question
3.
under the imported mismatch rule, and, if so, the amount of the adjustment required under
the rule.
Answer
4.
Country C should apply the direct imported mismatch rule to deny a deduction for
all of the interest payments made by C Co. Country D should apply the indirect imported
mismatch rule to deny a deduction for half the interest payment made by D Co. See the
flow diagram at the end of this example which outlines the steps to be taken in applying
the imported mismatch rule.
Analysis
5.
B Co 1s loan from the Bank is independent of the other group financing
Payments of interest by C Co and D Co are offset against the same hybrid

deduction.
6.
B Co 1 makes a deductible hybrid payment of 150 that gives rise to a DD
outcome. The resulting hybrid deduction is set-off against income on interest paid by
C Co to A Co and on the interest paid by D Co to B Co 2 (after having been surrendered
under the tax grouping regime in Country B). Because, however, this is a double
deduction structure, the payments made by C Co and D Co are effectively set-off against
the same hybrid deduction. Accordingly, the tax consequences attaching to the imported
mismatch payment in Country C should be taken into account when applying the indirect
imported mismatch rule in Country D.
The interest payment made by C Co should be subject to adjustment under the

7.
direct hybrid deduction of 150 under both Country A and Country B law.

8.
408 EXAMPLE 8.14
Step 3 B Co 1s hybrid deductions should be treated as set-off against the

imported mismatch payment made by C Co
9.
This hybrid deduction is automatically set-off against income on the interest C Co
pays to A Co (see the analysis in Example 8.13). In this case the amount of A Cos hybrid
deduction (150) is greater than the imported mismatch payment made by C Co (100).
Therefore, the whole of the deduction claimed by C Co should be denied under the direct
imported mismatch rule leaving a surplus hybrid deduction of 50.
The interest payment made by D Co should be subject to adjustment under the

10.
deduction that is attributable to the deductible hybrid payment (150) minus any amount of
mismatch rules (100).
Step 2 B Co 1s surplus hybrid deduction are set-off against funded taxable

payments
11.
the same way as a funded taxable payment because B Co 2 is a direct recipient of an
imported mismatch payment. In this case B Co 1 does not receive any other taxable
payments so the remaining surplus hybrid deduction should therefore be treated as fully
surrendered to B Co 2.

12.
As B Co 1s surplus hybrid deduction is set-off against an imported mismatch
payment, B Co 1 has no remaining surplus hybrid deductions

13.
B Co 2 should treat the resulting indirect hybrid deduction as being set-off against
imported mismatch payments made by D Co. The calculation is the same as under the
direct imported mismatch rule and the proportion of the deduction for the interest
payment that should be denied is calculated as follows:
50
100
1
=
Therefore half the interest payment made by D Co should be subject to adjustment under
the imported mismatch rule. The tables below illustrate the net income accounts of the
group entities after application of the imported mismatch rules.
EXAMPLE 8.14 409
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Book
Income
100
100
Expenditure
Expenditure
(150)
Net return
100
(50)
(150)
Net return
(150)
(150)
(150)
100
Loss carry forward
(50)
B Co 2
Income
100
100
Expenditure
Loss surrender
(100)
Net return
100
Taxable income
Country C Law
Country D Law
C Co
D Co
Tax
Book
Income
Operating income
100
Operating income
100
100
(50)
(100)
Expenditure
0
Net return
Taxable income
Book
Income
100
Expenditure
Tax
(100)
0
100
Net return
Taxable income
0
50
410 EXAMPLE 8.14

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
Yes

hybrid deductions

hybrid deductions

rule.


See Flow Diagram 2.
No
EXAMPLE 8.14 411

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
Yes

below.
No
412 EXAMPLE 8.15
Example 8.15
Interaction between double deduction and imported mismatch rule
Facts
1.
The figure below sets out the intra-group financing arrangements for companies
that are members of the ABCDE Group. A Co is the parent of the group and is resident in
Country A. B Co 1 and C Co are direct subsidiaries of A Co and are resident in
Country B and Country C respectively. D Co (a company resident in Country D) is a
direct subsidiary of C Co and E Co (a company resident in Country E) is a direct
subsidiary of E Co. B Co 2 is a wholly-owned subsidiary of B Co 1 and is also resident
in Country B.
A Co
Interest
(300)
Loan
Interest
(300)
C Co
Interest
(300)
Operating
income
(300)
B Co 1
Bank
Loan
Loan
D Co
B Co 2
Interest
(200)
E Co
Operating
income
(200)
Loan
EXAMPLE 8.15 413
2.
All companies are treated as separate tax entities in all jurisdictions, except that
B Co 1 is a hybrid entity (i.e. an entity that is treated as a separate entity for tax purposes
in Country B but as a disregarded entity under Country A law).
3.
A Co has lent money to C Co, and C Co has on-lent that money to D Co. B Co 1
borrowed money from a local bank. B Co 2 lent money to E Co. Each of D Co and E Co
receives operating income. Each of these financing arrangements are entered into
independently and do not form part of single scheme, plan or understanding. The figure
above illustrates the operating income and the total gross interest payments for each
group entity.
4.
Because B Co 1 is a hybrid entity, the interest payments made to the local bank
are deductible by both A Co and B Co 1 under the laws of Country A and Country B
respectively. B Co 1 and B Co 2 are members of the same tax group for tax purposes
under Country B law, which means that the net loss of B Co 1 can be surrendered to
set-off against any net income of B Co 2.
Tax position before applying the imported mismatch rule

5.
Below is a table setting out the tax position in respect of the ABCDE group
(before the application of any imported mismatch rule).
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Book
Income
300
300
Expenditure
Expenditure
(300)
Net return
Taxable income
300
(300)
Net return
(300)
(300)
(300)
200
Loss carry forward
(100)
B Co 2
Income
200
200
Expenditure
Loss surrender
(200)
Net return
Taxable income
200
0
414 EXAMPLE 8.15

Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Book
Income
300
300
Expenditure
Operating income
300
300
(300)
(300)
Expenditure
(300)
(300)
Net return
Taxable income
Net return
Taxable income
0
0
Country E Law
E Co
Tax
Cash
Income
Operating income
200
200
(200)
(200)
Expenditure
Net return
Taxable income
0
0

6.
300).
A Co has net taxable income of zero (interest income of 300 and a deduction of

7.
B Co 1 has a net loss for tax purposes of 300 (a deduction of 300), while B Co 2
has net income of 200. B Co 1s net loss is surrendered through the tax grouping regime
and applied against, and to the extent of, B Co 2s net income.
Result under Country C, D and E law

8.
C Co, D Co and E Co have income that is equal to their expenses and therefore
have no net income in either of the two years.
Mismatch in tax outcomes

9.
In aggregate the arrangement generates a net return for the ABCDE Group of 200,
however the total net taxable income recognised under this structure is nil. Country D and
Country E have implemented the recommendations set out in this report.
EXAMPLE 8.15 415
Question
10.
Whether the interest payments made by D Co and E Co are subject to adjustment
the rule.
Answer
11.
Indirect imported mismatch rule applies to the interest payment of 200 from E Co
to B Co 2, and the interest payment of 300 from D Co to C Co. As a result of
apportionment of surplus hybrid deduction of 300 between those payments, Country D
should deny D Co a deduction for 180 of the interest paid to C Co, and Country E should
deny E Co a deduction for 120 of the interest paid to B Co 2. See the flow diagrams at the
end of this example which outline the steps to be taken in applying the imported
mismatch rule.
Analysis
arrangement
12.
B Co 1s loan from the Bank is independent of the intra-group financing
The hybrid deduction is not set-off against an imported mismatch payment

13.
direct hybrid deduction of 300 under both Country A and Country B laws.

14.

15.
that are recipients of the loss surrender or that are directly funding the hybrid deduction
(i.e. B Co 2 and C Co) are resident in jurisdictions that have not implemented the
imported mismatch rules.
416 EXAMPLE 8.15
The interest payments made by D Co and E Co should be subject to adjustment

16.
Step 1 B Co 1 and A Co have surplus hybrid deductions of 300

17.
A group members surplus hybrid deduction will be the amount of hybrid
deduction that is attributable to deductible hybrid payment (300) minus any amount of
mismatch rules (0).
Step 2 Surplus hybrid deduction is set-off against funded taxable payments

18.
Both B Co 1 and A Co must first treat the surplus hybrid deduction as being
surrendered or offset against funded taxable payments received from group entities
calculated as follows:
(a) A taxable payment will be treated as a funded taxable payment to the extent the
payment is directly funded out of imported mismatch payments made by other
group entities. In this case the interest payments of 300 that A Co receives from
C Co constitute funded taxable payments.
(b) B Co 1 has surrendered a loss of 200 to B Co 2. This loss surrender is treated in
the same way as a funded taxable payment because B Co 2 is a direct recipient of
an imported mismatch payment.
Accordingly the total amount of funded taxable payments is equal to 500.
19.
In this case the amount of funded taxable payments (500) exceeds the amount of
the surplus hybrid deduction (300). Both A Co and B Co 1 should therefore treat the
surplus hybrid deduction as set-off pro rata against the funded taxable payments and the
loss surrendered to B Co 2 under the tax grouping regime. Therefore:
(a) B Co 2 has indirect hybrid deduction of 120 (i.e. 300/500 x 200).
(b) C Co has indirect hybrid deduction of 180 (i.e. 300/500 x 300).

20.
C Cos surplus hybrid deduction has been surrendered or fully set-off against
funded taxable payments and C Co therefore has no remaining surplus hybrid deduction
to be set-off against other taxable payments.
Step 4 B Co 2 and C Cos indirect hybrid deductions are neutralised in

accordance with the direct imported mismatch rule
21.
B Co 2 should treat the resulting indirect hybrid deduction as being set-off
against imported mismatch payments made by D Co. The calculation is the same as under
the direct imported mismatch rule and the proportion of the deduction for the interest
payment that should be denied is calculated as follows:
EXAMPLE 8.15 417
120
3
=
200
Therefore D Co should be denied a deduction for (3/5 x 200) = 120 under the imported
mismatch rule.
22.
The calculation with respect to E Co is the same. C Co treats indirect hybrid
deduction as being set-off against imported mismatch payments made by E Co.
Calculation is the same as under the direct imported mismatch rule and the proportion of
deduction that G Co should be denied on its IM payments is calculated as follows:
180
3
=
300
Therefore D Co should be denied a deduction for (3/5 x 300) = 180 under the imported
mismatch rule.
23.
The table below sets out tax position in respect of the ABCDE group (after the
application of any imported mismatch rule).
Country A
Country B
A Co
B Co 1
Tax
Book
Tax
Book
Income
300
300
(300)
Expenditure
Expenditure
Net return
Taxable income
300
0
(300)
Net return
(300)-
(300)
(300)
200
Loss carry forward
(100)
B Co 2
Income
200
200
Expenditure
Loss surrender
(200)
Net return
Taxable income
100
0
418 EXAMPLE 8.15

Country C Law
Country D Law
C Co
D Co
Tax
Book
Tax
Income
Book
Income
300
300
Expenditure
Operating income
300
300
(120)
(300)
Expenditure
(300)
(300)
Net return
Taxable income
Net return
Taxable income
300
180
Country E Law
E Co
Tax
Cash
Income
Operating income
200
200
(80)
(200)
Expenditure
Net return
Taxable income
0
120
EXAMPLE 8.15 419

Step 1:
Identify a group
member with a
direct hybrid
deduction.

D/NI outcome under


Step 2:
Neutralise hybrid
deduction under
the structured
imported
mismatch rule.
Step 3:
Neutralise hybrid
deduction under
the direct
imported
mismatch rule.

No
Yes
hybrid deductions
Yes

hybrid deductions

rule.


See Flow Diagram 2.
No
420 EXAMPLE 8.15

Step 1:
Identify a group
member with a
surplus hybrid
deduction.
Step 2:
Determine the
extent to which
surplus hybrid
deduction has
been
surrendered to,
or set-off against
funded taxable
payments from,
other group
members.
details.
No
Yes
Yes


below.
Step 3:
Allocate the
remaining
surplus hybrid
deduction
against any
remaining
taxable
payments.
Step 4:
Neutralise
indirect hybrid
deduction under
the direct
imported
mismatch rule.
No

below.
EXAMPLE 8.16 421
Example 8.16
Carry-forward of hybrid deductions under imported mismatch rules
Facts
1.
In the example illustrated in the figure below, A Co wholly owns B Co, which, in
turn, wholly owns C Co. A Co, B Co and C Co are resident in Country A, Country B and
Country C respectively.
A Co
Interest / Dividend
(Year 1 = 100)
(Year 2 = 100)
Hybrid financial
Instrument
B Co
Interest
(Year 2 = 200)
Loan
(Year 2)
C Co
2.
In Year 1, A Co lends money to B Co under a hybrid financial instrument. Interest
payments under the hybrid financial instrument are treated as deductible interest expenses
under Country B law but treated as exempt dividends under Country A law. The
payments are equal to 100 each year. At the end of the first year B Co has a net-loss
carry-forward of 100.
422 EXAMPLE 8.16

3.
In Year 2, B Co lends money to C Co under an ordinary loan. The interest
payable under the loan in Year 2 is 200.
4.
Only Country C has implemented the recommendations set out in the report.
Question
5.
Whether the interest payments made by C Co are subject to adjustment under the
Answer
6.
B Co carries over a hybrid deduction of 100 from Year 1. The direct imported
mismatch rule applies to the interest payment of 200 from C Co to B Co and Country C
should deny C Co a deduction for all the interest paid to B Co.
Analysis
Application of direct imported mismatch rule to interest payments from C Co to
B Co
7.
As explained in the facts above, the interest payments by B Co to A Co in Year 1
give rise to a D/NI outcome under a hybrid financial instrument. B Cos hybrid deduction
is carried-forward to Year 2 and set-off against interest income paid by C Co in the
following year. The direct imported mismatch rule applies to the full interest payment
from C Co to B Co since this payment (of 200) is directly set-off against a deduction for
the interest paid under the hybrid financial instrument in both Year 1 (100) and Year 2
(100).
EXAMPLE 9.1 423
Example 9.1
Co-ordination of primary/secondary rules
Facts
1.
In the example illustrated in the figure below, A Co holds all the shares of a
foreign subsidiary (B Co). B Co is a hybrid entity that is disregarded for Country A tax
purposes. B Co borrows from A Co and pays interest on the 5 year loan. Interest is
payable in arrears every 12 months on 1 October each year.
A Co
Interest
Loan
B Co
B Sub 1
2.
B Co is treated as transparent under the laws of Country A and (because A Co is
the only shareholder in B Co) Country A simply disregards the separate existence of
B Co. Disregarding B Co means that the loan (and by extension the interest on the loan)
between A Co and B Co is ignored under the laws of Country A. Under the laws of
Country B, B Co and B Sub 1 form part of the same tax group which allows B Co to
424 EXAMPLE 9.1

surrender the tax benefit of the interest deduction to B Sub 1 where it can be set-off
against non-dual inclusion income.
3.
In Year 2 of the arrangement, Country A implements the hybrid mismatch rules
so that the interest payment is included in the income of A Co through the operation of
the disregarded hybrid payments rule set out in Recommendation 3. This income in
Country A is recognised on an accrual basis. In Year 3 of the arrangement, Country B
also implements the hybrid mismatch rules to take effect from the beginning of Country
Bs tax year commencing in Year 4. The tax year for Country A is the calendar year
(1 January to 31 December) while B Cos tax year runs from on 1 July to 30 June of the
following year.
Question
4.
What proportion of the payment is required to be brought into account under the
hybrid mismatch rule by A Co and B Co in Years 3 to 5 of the arrangement?
Answer
5.
A jurisdiction applying the secondary or defensive rule in a period when the
counterparty jurisdiction introduces hybrid mismatch rules (the switch-over period),
should cease to apply the defensive rule to the extent the mismatch is neutralised by the
introduction of the primary rule in the counterparty jurisdiction. This should not affect the
adjustments made under the secondary rule in periods prior to the switch-over period.
Accordingly:
(a) Country A should:
require A Co to include a payment in ordinary income to the extent it gives rise
mismatch in an accounting period that begins on or after the introduction of the
hybrid mismatch rules in Country A; and
grant A Co relief for any payment made during the switch-over period to the
extent the mismatch is neutralised due to the operation of the primary rule in
Country B.
(b) Country B should apply the primary rule to the amount that is treated as paid,
under its laws, after the commencement of hybrid mismatch rules in Country B
while taking into account any payment that has previously been included in
income under the laws of Country A in a prior accounting period.
Analysis
Defensive rule applies only where the mismatch is not neutralised in payer
jurisdiction
6.
Recommendation 3.1(b) provides that a disregarded payment made by a hybrid
payer must be included in ordinary income to the extent it gives rise to a D/NI outcome.
This rule only applies, however, to the extent the mismatch in tax outcomes has not been
neutralised in the payer jurisdiction. Accordingly, if and when Country B introduces
hybrid mismatch rules to deny a deduction for the disregarded hybrid payment,
Country A should cease to apply the defensive rule.
EXAMPLE 9.1 425
Co-ordination of the primary and secondary rules

7.
Complications in the application of the rule and a risk of double taxation could
arise, however, in situations where the counterparty jurisdiction introduces hybrid
mismatch rules from a date that is part way through the taxpayers accounting period (the
switch-over period). In order to ensure the primary and secondary rules are properly
co-ordinated without causing undue disruption to the domestic rules of the counterparty,
the payer and payee jurisdictions should apply the co-ordination rules as follows:
(a) The secondary or defensive rule will apply to any amount that is treated as paid,
under the laws of the payee jurisdiction (Country A), in a period prior to the
commencement of the switch-over period.
(b) The primary rule will apply to any amount that is treated as paid, under the laws
of the payer jurisdiction (Country B), during the switch-over period (after taking
into account any amounts caught by the secondary rule in accordance with
paragraph (a) above).
(c) Any other payments that give rise to a hybrid mismatch and that are not captured
by paragraph (b) above will be caught by the application of the secondary rule.
8.
A table setting out the effect of these adjustments in Years 3 to 5 is set out below.
The table shows the payments of accrued interest income or expense under the loan in
each calendar year and the income tax consequences applying to payments made under
the loan. In this table it is assumed that the interest payment is 100 each year. and that
B Co and A Co have no other income or expenditure other than the disregarded hybrid
payment. Both countries tax income and expenditure under a debt instrument on an
accrual basis.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Total
Tax
Book
Income
100
100
Year 2
Expenditure
Net return
Taxable income
100
100
(100)
(100)
Net return
Taxable income
(100)
(100)
0
0
426 EXAMPLE 9.1

Country A
Country B
A Co
B Co 1
Tax
Book
Income
Total
Tax
Book
Income
50
100
Year 3
Expenditure
Net return
100
Taxable income
50
(50)
Net return
(100)
(50)
Country A
Country B
A Co
B Co
Tax
Book
Income
(100)
0
0
Total
Tax
Book
Income
75
Year 4
Expenditure
Net return
Taxable income
75
0
(75)
Net return
Taxable income
(75)
0
0
0
9.
In Year 3, 100 of interest accrues on the loan. The primary rule has not yet been
introduced into Country B law so the entire amount of accrued interest is included in
income under Country A law (see para 7(a) above).
10.
In Year 4, the primary rule is introduced in Country B and takes effect from the
beginning of Country Bs tax year (which commences on 1 July).
(a) In this case, Country B will apply the primary response under its own law with no
adjustment (see para 7(b) above). Because Country B recognises expenditure
under a financial instrument on an accrual basis for tax purposes:
the interest that accrues after the commencement of the rules will be subject to
the adjustment under the primary rule; and
the portion of the interest payment that has accrued prior to the commencement
of the hybrid mismatch rules (50) will be outside the application of the primary
rule as it will be treated as derived in a prior tax year.
(b) Country A should apply the secondary rule to the extent the mismatch has not
been eliminated by the primary rule in Country B (see para 7(c) above). This
means that Country A should continue to apply the secondary rule for the
EXAMPLE 9.1 427
switch-over period to the extent the deduction for the payment has not been denied
under Country B law.
If, in practice, it would be unduly burdensome to require A Co to determine the actual
amount of the payment that has been subject to adjustment under the primary rule, the
amount of the payment falling within the scope of the secondary rule can be calculated
based on the amount accrued under Country A law for the switch-over period where the
primary rule will not apply (in this case 1 January to 30 June). This will result in only half
the accrued interest payment being recognised as income in Country A under the hybrid
mismatch rule.
11.
In Year 5, the loan matures and the final payment of accrued interest on the loan
is paid. The secondary rule does not apply in Country A as all the payments made under
the instrument are caught by the primary rule in Country B.
Differences in the timing in the recognition of payments

12.
The above table was calculated on the assumption that both Country A and B
apply the same rules regarding the recognition of income and expenditure under a
financial instrument. However differences between jurisdiction in the timing of the
recognition of income and expenditure will impact on the amounts caught by the primary
and secondary rules. The effect of these differences can be illustrated by changing the
facts of this example so that, rather than granting deductions on an accrual basis,
Country B only grants deductions for interest when such amounts are actually paid. A
table setting out the effect of these adjustments in Years 3 to 5 based on this modified
assumption is set out below.
Country A
Country B
A Co
B Co 1
Tax
Book
Income
Total
Tax
Book
(100)
(100)
Income
100
100
Year 2
Expenditure
Net return
Taxable income
100
100
(100)
Net return
Taxable income
(100)
0
0
428 EXAMPLE 9.1

Country A
Country B
A Co
B Co 1
Tax
Book
Income
Total
Tax
Book
Income
100
Year 3
Expenditure
Net return
100
Taxable income
(25)
Net return
(100)
(25)
Country A
Country B
A Co
B Co
Tax
Book
Income
(100)
0
(25)
Total
Tax
Book
Income
75
Year 4
Expenditure
Net return
Taxable income
75
0
25
Net return
Taxable income
(75)
(75)
25
0
25
13.
As above, the table shows the payments of accrued interest under the loan in each
calendar year and the income tax consequences applying to those payments for the same
period. It is assumed that the interest payment is 100 each year (paid on 1 October of each
year) and that B Co and A Co have no other income or expenditure other than the
disregarded hybrid payment.
14.
In Year 3 the primary rule has not yet been introduced into Country B law so that
the entire amount of the payment is included in income under Country A law (see para
7(a) above).
15.
In Year 4 the primary rule is introduced in Country B and takes effect from the
beginning of Country Bs tax year (which commences on 1 July).
(a) In this case, the amount of the deduction denied under the primary rule should not
include a payment to the extent it has been already subject to adjustment under the
secondary rule in a prior period. Because Country A recognises income under a
financial instrument on an accrual basis, 25% of the interest payment has already
been included in income in Year 3 (see para 7(b) above).
EXAMPLE 9.1 429
(b) Country A does not apply the secondary rule for the switch-over period as the
entire amount of the payment for that period is caught by the primary rule under
Country B law (see para 7(c) above).
16.
In Year 5 the loan matures and the final payment of accrued interest on the loan is
paid. The secondary rule does not apply in Country A as all the payments made under the
instrument are caught by the primary rule in Country B. The primary rule in country B
denies a deduction for the full amount of the interest payment (100) effectively triggering
an additional 25 of taxable income in the hands of B Co and reversing out the timing
advantage that arose in the previous year due to the differences in the timing of the
recognition of payments.
430 EXAMPLE 9.2
Example 9.2
Deduction for interest payment subject to a general limitation
Facts
1.
Country A) owns all the shares in B Co (a company resident in Country B). A Co has
invested 2.5 million by way of equity and 7.5 million by way of debt. The debt is in the
form of two interest bearing loans that pay regular arms length interest at an annual rate
of 10% per year. The senior loan is for a principal amount of 5 million and the
subordinated loan is for a principal amount of 2.5 million.
A Co
Interest / Dividend
Loan
B Co
2.
The subordinated loan is treated as an equity instrument (i.e. a share) under the
laws of Country A and payments of interest are treated as dividends. Country A exempts
foreign dividends under its domestic law and has not introduced a specific restriction on
this exemption in accordance with Recommendation 2.1. The subordinated loan is treated
as a debt instrument under the laws of Country B and interest payments on the loan are
generally treated as deductible.
3.
Country B has introduced a thin capitalisation rule which disallows interest
deductions on debt to the extent the debt to equity ratio of the debtor exceeds 2:1. B Co
has a debt to equity ratio of 3:1 accordingly one-third of the interest expenses incurred by
B Co will be subject to limitation under the Country B thin capitalisation rule.
EXAMPLE 9.2 431
Question
4.
Whether the interest payments under the subordinated loan fall within the scope
of the hybrid financial instrument rule and, if so, what adjustments are required under the
rule?
Answer
5.
Payments of interest under the loan will give rise to a D/NI outcome that is a
hybrid mismatch. This will be the case even if, as a technical matter, the deductibility of
the interest is limited under the thin capitalisation rule.
6.
Country B should deny a deduction for the payment to the extent it gives rise to a D/NI
outcome. Accordingly B Co should be denied a deduction for the interest paid on the
subordinated loan. The interaction between the interest limitation rule and the hybrid
financial instrument rule is a matter for domestic law implementation however the
interaction between these rules should not result in the hybrid financing instrument rule
being used to deny a deduction for interest under a non-hybrid loan.
7.
If Country B does not apply the recommended response, then Country A should
treat the entire interest payment on the subordinated loan as ordinary income in order to
neutralise the D/NI outcome.
Analysis
The arrangement is a financial instrument between related parties
8.
Recommendation 1 only applies to payments made under a financial instrument.
The loan meets the definition of a financial instrument because it is treated as an equity
instrument in Country A and a debt instrument in Country B. B Co is a wholly-owned
subsidiary of A Co and therefore A Co and B Co are related parties.
mismatch
9.
As with Example 1.1, the D/NI outcome that arises in this case is the result of
B Cos entitlement to a deduction for the interest paid to A Co and the fact that the
interest payment is treated as an exempt dividend in the hands of A Co. The hybrid
financial instrument rule looks to the terms of the arrangement and its expected tax
treatment and not to the detail of how the payments under a financial instrument have
actually been taken into account by the parties to the arrangement. The fact that a
taxpayer is subject to a general interest limitation, based on overall leverage or interest
expense, will not, generally be relevant to a tax analysis based on the terms of the
instrument. This will be the case even if it is the subordinated loan that triggered the
interest limitation rule.

10.
In this case the interest payments made by B Co to A Co are treated as exempt
dividends under the tax laws of Country A. A full denial of the deduction will therefore
be required in order to neutralise the D/NI outcome.
432 EXAMPLE 9.2

11.
The adjustment is limited to neutralising the mismatch in tax outcomes. In order
to avoid double taxation under the hybrid financial instrument rule the interaction
between the interest limitation rule and the hybrid financial instrument rule should be
co-ordinated to achieve an overall outcome that is proportionate on an after-tax basis. The
mechanism for co-ordinating the interaction between the two rules is a matter for
domestic law however the interaction between these rules should not result in the hybrid
financing instrument rule being used to deny a deduction for interest under a non-hybrid
loan.

12.
the deductible payment as ordinary income under Country A law. Country A should not
restrict the application of the rule to reflect the fact that a portion of the interest paid
under the subordinated loan may be subject to the interest limitation rule unless it is
Country Bs general policy to permit taxpayers to re-characterise interest receipts that are
treated as non-deductible under an interest limitation rule.
EXAMPLE 10.1 433
Example 10.1
Hybrid mismatch priced into the terms of the arrangement
Facts
1.
Country A) and B Co (a company resident in Country B) are unrelated parties. A Co
lends 0.3 million to B Co under a loan that pays annual interest. The bond is treated as a
debt instrument under the laws of Country B but as an equity instrument (i.e. shares)
under the laws of Country A. Under its domestic law Country A generally exempts
foreign dividends. Hence, the payment results a D/NI outcome that is a hybrid mismatch.
A Co
Interest / Dividend
Loan
B Co
2.
Formula for calculating interest payment on the debt instrument provides for a
discount to the market rate of interest which is calculated by reference to the corporation
tax rate in Country A (i.e. the interest formula is equal to market rate x (1 tax rate)).
This means that while an expected market rate of interest on the loan might be 6%
(i.e. 18 000 each year) the rate of interest on the hybrid financial instrument (assuming a
corporate tax rate of 30% in Country A) would be 12 600 each year.
Question
3.
Whether the parties have entered into a structured arrangement within the
meaning of Recommendations 1 and 10?
434 EXAMPLE 10.1
Answer
4.
The tax benefit is priced into the terms of the hybrid financial instrument and
therefore the instrument is a structured arrangement.
Analysis
Tax outcome is priced into the terms of the instrument
5.
Recommendation 10.1 explains that an arrangement will be treated as structured
where the tax benefit arising from a hybrid mismatch is priced into the terms of the
instrument. In this case, the terms of the instrument explicitly provide for a formula that
discounts what would otherwise have been a market interest rate by the amount of the tax
benefit under the loan.
Taxpayer is a party to the structured arrangement

6.
A Co and B Co are parties to the arrangement because they are direct parties to
the financial instrument. The fact that the tax benefit is priced into the calculation of the
interest rate means that they can reasonably be expected to be aware of its tax
consequences.
EXAMPLE 10.2 435
Example 10.2
Back-to-back loans structured through an unrelated intermediary
Facts
1.
In the example illustrated in the figure below, B Co (a company resident in
Country B) is a wholly-owned subsidiary of A Co (a company resident in Country A).
A Co intends to provide subordinated debt financing to B Co, but is advised that this
arrangement would be caught by the hybrid mismatch rules in Country B as A Co and
B Co are related parties.
2.
A Co is advised to organise the financing through C Co, an independent third
party which is also resident in Country A. C Cos loan to B Co will be funded by a
back-to-back loan arrangement. By structuring the financing in this way, the hybrid
financial instrument is between unrelated parties. The domestic law of Country C treats
the loan between C Co and B Co as equity, whereas the domestic law of Country B treats
that loan as an ordinary debt instrument.
Loan
A Co
Interest
(115)
C Co
Operating
income
(260)
Interest
100
B Co
Operating
income
(340)
436 EXAMPLE 10.2

3.
The table below illustrates the tax consequences to the parties of entering into the
above arrangement.
Country A Law
Country B Law
A Co
B Co
Tax
Book
Income
Tax
Book
Income
115
115
Operating income
Expenditure
Payment to C Co under hybrid financial
instrument
Net return
115
Taxable income
115
Tax to pay (at 20%)
After-tax return
92
340
(100)
(100)
Net return
Taxable income
(23)
340
Tax to pay (at 20%)
After-tax return
240
240
(48)
192
Country C Law
C Co
Tax
Book
Income
Operating income
Payment from B Co under hybrid financial
instrument
260
260
100
(115)
(115)
Expenditure
Interest paid to A Co1
Net return
Taxable income
Tax to pay (at 20%)
After-tax return
245
145
(29)
216
4.
Under the arrangement B Co claims a deduction of 100 for a payment of interest
under the hybrid financial instrument. This payment is treated as an exempt dividend
under Country C law and is not brought into account as income by C Co. C Co pays a
deductible amount of 115 of interest to A Co which is recognised as income under
Country A law. The net effect of the payment under the hybrid financial instrument is to
decrease the overall taxable income under the arrangement by the amount of the payment
(100) with the value of the resulting tax benefit (20) being shared between C Co and A
Co under the interest payable on the loan.
EXAMPLE 10.2 437
Question
5.
Whether the payments under the hybrid financial instrument should be treated as
entered into under a structured arrangement within the meaning of Recommendations 1
and 10.
Answer
6.
The interest payments under the hybrid financial instrument should be treated as
being made under a structured arrangement as:
(a) the tax benefit arising from the mismatch has been priced into the terms of the
arrangement;
(b) the facts and circumstances indicate that the arrangement was designed to create a
hybrid mismatch; and
(c) the parties have introduced an unnecessary step into the structure to create the
mismatch.
7.
Further, in cases such as this, it is likely that the terms of the arrangement will
contain provisions that allow the arrangement to be unwound, at no cost to the
terminating party, in the event the tax benefit under the structure is no longer available.
Analysis
The mismatch is priced into the terms of the instrument
8.
The test of whether the mismatch is priced into the arrangement looks to the terms
of the arrangement. This includes both the hybrid financial instrument and the loan from
A Co to C Co.
9.
In this case C Co appears to be paying an above-market rate of interest on the
loan. This interest rate is intended to provide A Co with the benefit of the mismatch in tax
outcomes. The pricing of the tax benefit arising from the mismatch into the arrangement
would further be indicated by the fact that C Cos return on the arrangement is pre-tax
negative and if there are terms that permit the structure to be unwound if the tax benefit is
no longer available.
The facts and circumstances indicate that there is a structured arrangement

10.
As stated in Recommendation 10.1, the determination of whether the hybrid
mismatch was priced into the arrangement can be made on the basis of the terms of the
underlying instrument or the facts and circumstances of the arrangement. This case
contains a number of factors listed in Recommendation 10.2 that point to the existence of
a structured arrangement.
The arrangement was designed to create a hybrid mismatch

11.
In this scenario A Co was advised before the arrangement was entered into, to
lend the money to its subsidiary through an unrelated intermediary in order to avoid the
effect of the related party test under the hybrid financial instrument rule in Country B.
Therefore, it can be said that the arrangement was designed in such a way as to allow
438 EXAMPLE 10.2

A Co to take advantage of the hybrid mismatch without implicating the hybrid mismatch
rules.
The arrangement uses a step to create a hybrid mismatch

12.
The arrangement contains an additional step or steps (i.e. the back-to-back loan
arrangement) that have the effect of avoiding the related party rules and where there is no
obvious business, commercial or other reason that could explain why the financing is
routed through a third party.
Pre-tax negative return

13.
C Co receives 100 of interest from B Co under the hybrid financial instrument but
is required to pay an 115 of interest to A Co under the back to back loan entered into as
part of the same arrangement. This structure only makes economic sense for C Co if the
20 of tax benefit from the hybrid mismatch is factored in to the overall return.
Change to the terms under the arrangement in the event the hybrid mismatch is no
longer available
14.
If the terms of the arrangement allow one or both parties to terminate the
arrangement in the event the tax benefits of the transaction are no longer available, that
will also be a strong indicator of the arrangement having structured to produce a D/NI
outcome.
EXAMPLE 10.3 439
Example 10.3
Arrangement marketed as a tax-advantaged product
Facts
1.
In the example illustrated in the figure below, C Co (a company resident in
Country C) subscribes for bonds issued by B Co (an unrelated company resident in
Country B). Due to the differences in treatment of the underlying instrument under the
respective laws of Country A and Country B, the interest payments give rise to a hybrid
mismatch resulting in a D/NI outcome.
Purchase price
C Co
A Co
B Co
Loan
2.
C Co subscribed for these bonds after receiving an investment memorandum that
included a summary of the expected tax treatment of the instrument (including the fact
that payments on the instrument will be eligible for tax relief in Country A). A similar
investment memorandum was sent to a number of other potential investors in Country A.
Subsequently, C Co sells the bond to A Co, an unrelated company resident in Country A.
Question
3.
Whether the payments under the hybrid financial instrument should be treated as
made under a structured arrangement within the meaning of Recommendations 1 and 10,
and whether A Co is a party to that structured arrangement.
440 EXAMPLE 10.3
Answer
4.
The original issue of the bonds will give rise to a structured arrangement because
the facts indicate that bond has been marketed as a tax-advantaged product and has been
primarily marketed to persons who can benefit from the mismatch. C Co is a party to that
arrangement because it acquires the bond on initial issuance. On the other hand, A Co
may not be a party to the structured arrangement if it pays market value for the bond and
could not reasonably have been expected to be aware of the mismatch in tax treatment.
Analysis
Marketed as a tax advantaged product
5.
The investment memorandum includes a description of the expected tax
consequences for the holder including a reference to the fact that payments on the
instrument will be eligible for tax relief in Country A. This is evidence that the instrument
has been marketed to investors as a tax advantaged product.
Marketed to a class of investors

6.
In this case, in order to avoid the definition of a structured arrangement the issuer
would further need to show that the instrument had not been primarily marketed to
investors in jurisdictions that could benefit from the mismatch in tax outcomes. If the
majority of the investors by both number and value are located in jurisdictions where the
tax benefit does not arise, then this will be evidence that the arrangement has been
widely-marketed to a diverse group of investors.
C Co is a party to the structured arrangement

7.
C Co is a party to the structured arrangement because it can be reasonably
expected to have been aware of the mismatch at the time it subscribed for the bonds.
A Co may not be a party to the structured arrangement

8.
A Co may not be aware of the mismatch in tax outcomes if it acquires the bond
from C Co on arms-length terms and at a market price.
EXAMPLE 10.4 441
Example 10.4
Beneficiary of a trust party to a structured arrangement
Facts
1.
In the example illustrated in the figure below, a trust established in Country A
subscribes for an investment that gives rise to a hybrid mismatch and has been marketed
by the issuer as a tax advantaged product (see Example 10.3). The trust is transparent for
tax purposes and allocates the payment to a beneficiary who is a resident of Country A.
The beneficiary has no knowledge of the investment made by the trustee.
Beneficiary
Trust
Interest
Hybrid
financial
instrument
B Co
442 EXAMPLE 10.4
Question
2.
Whether the beneficiary is a party to the structured arrangement within the
meaning of Recommendation 10.3?
Answer
3.
The beneficiary is a party to the arrangement because the tax consequences
arising to the trust are attributed to its beneficiaries.
Analysis
4.
Although the beneficiary is not a direct party to the arrangement tax consequences
of the investment are imputed to the beneficiary under the laws of Country A. These tax
consequences should include the fact that the trust subscribed for the investment under
conditions that gave rise to a hybrid mismatch.
EXAMPLE 10.5 443
Example 10.5
Imported mismatch arrangement
Facts
1.
In the example illustrated in the figure below, a fund resident in Country A, which
is in the business of lending money to medium-sized enterprises (Fund), enters into
negotiations to provide an unsecured loan to Borrower Co, a company resident in Country
C, to fund Borrower Cos working capital requirements.
2.
Once negotiations for the loan have commenced, C Co and the Fund receive tax
advice that the subordinated terms of the loan mean that it will be treated as an equity
instrument (i.e. a share) under Country A law, but as debt under Country C law. In order
to avoid the negative effects of the hybrid mismatch rules in Country C, the Fund
structures the loan through a back-to-back arrangement with a wholly-owned subsidiary
in Country B. Country B also treats these types of subordinated loan as debt but it has not
implemented the hybrid mismatch rules. The loan between the Fund and B Co therefore
produces a mismatch in tax outcomes and the whole lending arrangement gives rise to an
imported mismatch under Country C law.
Fund
Payment
Hybrid financial
instrument
B Co
Loan
Interest
Borrower Co
444 EXAMPLE 10.5
Question
3.
Whether Borrower Co is a party to the structured arrangement within the meaning
of Recommendation 10.3?
Answer
4.
Borrower Co should be treated as a party to the structured arrangement.
Analysis
5.
Borrower Co should be treated as party to the structured financing arrangement if
it has sufficient involvement in the design of the arrangement to understand its mechanics
and anticipate its tax effects.
6.
In contrast to the facts described in Example 4.1, Borrower Co is already
engaged in financing discussion with A Co at the time the potential for hybrid tax
treatment is identified by the parties. The potential impact of the hybrid financial
instrument rule is then mitigated by introducing another entity (B Co) into the lending
structure. While Borrower Co may not know the precise details of the financing
arrangements between A Co and B Co, Borrower Co (or a member of Borrower Cos
control group) can reasonably be expected to be aware of the fact that B Co and A Co are
affiliates and that funding for the loan has come indirectly from A Co. Borrower Co is
also aware that B Co has been inserted into the structure for tax reasons, notably to avoid
Borrower Co losing its interest deduction under the hybrid financial instrument rule.
Therefore, although Borrower Co has no direct involvement or knowledge of the hybrid
financial instrument between A Co and B Co, it has sufficient involvement in the overall
design of the arrangement to understand how the arrangement has been structured (as a
back-to-back financing arrangement through an intermediary); and to anticipate what the
tax outcomes will be for the parties to the arrangement (avoiding denial of the deduction
in Country C while preserving the tax outcomes under Country A law).
EXAMPLE 11.1 445
Example 11.1
Application of related party rules to assets held in trust
Facts
1.
In the example that is illustrated in the figure below, Individual A is the settlor of
a trust that is established for the benefit of As immediate family. Under the trust deed,
the settlor has no vested or contingent beneficial entitlement to the income or assets of the
trust or the power to amend the trust deed but the settlor is entitled to appoint trustees to
the trust. A appoints an independent bank to act as a trustee of the trust. The trust owns all
of the ordinary shares in A Co. A enters into a hybrid financial instrument with A Co.
Beneficiaries
Settlor
As family
Trust
Hybrid
financial
Instrument
A Co
446 EXAMPLE 11.1
Question
2.
Is A related to A Co for the purposes of Recommendation 11?
Answer
3.
The trust holds all the voting and equity interests in A Co and A is either treated
as having an indirect voting interest in A Co (through As right to appoint trustees to the
trust) or is deemed to hold an indirect equity interest in A Co (because the beneficiaries of
the trust are A Cos immediate family). Further A may be considered related to A Co if
the facts of the case indicate that trust is under the effective control of A.
Analysis
The trust owns all the voting and equity interests in A Co.
4.
Although the trust may be transparent for tax purposes, it is treated as a person
under the related party rules in Recommendation 11. The trust holds all the ordinary
shares in A Co which will give the trust 100% of the voting and equity interests in the
company.
A is treated as having 100% of the voting interests in the trust

5.
As settlor of the trust, A has the sole right, under the terms of the trust deed, to
appoint trustees, which is one of the enumerated voting rights described in the related
party rules. The fact that the constitutional documents (in this case the trust deed) do not
give A the power to authorise distributions or alter the terms of the trust, does not affect
the conclusion that A holds 100% of the voting interests in the trust.
As family are treated as holding 100% of the equity interests in the trust
6.
As the named beneficiaries of the trust, As family are treated as the holders of the
equity interests in the trust. Under the acting together test in Recommendation 11.3.
A is deemed to hold any equity interests that are held by his family.
A is the indirect holder of the voting and equity interests in A Co

7.
The measurement of a persons voting and value interests in another person
includes interests that are held indirectly through others. As the holder (or deemed holder)
of the voting and equity interests in the trust A is deemed to hold, indirectly, all of the
voting and equity interests in A Co.
A could be treated as holding a direct voting or equity interest if A and the

trustee can be shown to be acting together.
8.
Subject to more precise facts, A can also be considered to be directly related to
A Co if it can be shown that the trustee effectively acts in accordance to As instructions.
EXAMPLE 11.2 447
Example 11.2
Related parties and control groups - partners in a partnership
Facts
1.
In the example illustrated in the figure below A, B, C and D are four partners in a
partnership resident in Country B. All the decision in the partnership require unanimous
vote. All the partners have the same voting rights and equal share in the profits of the
partnership. The partnership is treated as tax transparent under the laws of Country B.
Partners
Partnership
40%
Other
investors
60%
Hybrid
financial
instrument
A Co
2.
The partnership has a substantial shareholding in a company resident in Country
A (A Co). The partnership lends money to A Co. The way this loan is taxed under
Country A and B laws gives rise to a mismatch in tax outcomes.
448 EXAMPLE 11.2
Question
3.
11?
Whether the partners are related to A Co for the purposes of Recommendation
Answer
4.
The partners are treated as directly related to A Co because, in this case, each
partner is treated as acting together with the other partners in respect of the partnerships
substantial shareholding in A Co.
Analysis
The partners indirect holding in A Co is insufficient to bring that partner
within the related party rule
5.
Although the partnership is transparent for tax purposes, it is treated as a person
under the related party rules in Recommendation 11. The partnership holds 40% of the
ordinary shares in A Co which will give the partnership 40% of the voting and equity
interests in the company. This holding will be attributed equally to the partners in the
partnership in proportion to their voting and value interest in the partnership. In this case,
however, this leaves each partner with only a 10% indirect holding in A Co which is
insufficient to bring that partner within the related party rules.
Each partner is treated as having a direct holding in A Co under the acting

together test
6.
In this case, the shares in A Co are held by a person that is treated as transparent
under Country B law so that the shares in A Co, and the payments made under the
financial instrument, are treated as made directly to the partners in accordance with their
interest in the partnership. In this case where the ownership or control of the shares in
A Co are managed by the partnership and where that management or control has a
connection with the arrangement that has given rise to the mismatch (because both the
equity interest and the financial instrument are held by the same person) each partner will
be treated as holding the shares of the other partners under the acting together test in
Recommendation 11.3(d) and accordingly will be treated as holding sufficient shares in
A Co to bring that partner within the scope of the related party rule.
The partners are not related to each other

7.
Although the partners are related to the partnership and to A Co they are not
related to each other. There is no third person who holds at least a 25% investment in two
or more partners nor can they be said to be in the same control group within the meaning
of Recommendation 11.1(b).
EXAMPLE 11.3 449
Example 11.3
Related parties and control groups - calculating vote and value interests
Facts
1.
In this example illustrated in the figure below, A Co is the ultimate parent of a
group. It has two wholly-owned subsidiaries B Co and C Co and has a holding of 20% of
the ordinary shares in D Co. B Co has a holding of 25% of the ordinary shares in E Co.
C Co and D Co have a 20% and 40% holding in F Co (respectively).
A Co
Other
investors
100%
B Co
25%
100%
C Co
20%
20%
D Co
40%
Other
investors
Other
investors
E Co
F Co
Question
2.
Which entities in this group structure are related within the meaning of
Recommendation 11?
450 EXAMPLE 11.3
Answer
3.
A Co, B Co, C Co, E Co and F Co are related parties. D Co is related to F Co but
not to any other group member (unless, for example, D Cos other ordinary shares are
widely-held).
Analysis
Related parties through direct shareholding
4.
A Co is related to B Co and C Co through its 100% direct holding of shares. On
the same basis D Co is related to F Co.
Related parties through indirect holding

5.
A Co is related to E Co through an indirect holding of 25% of E Cos voting and
value interests. A Co is also related to F Co as it holds an indirect 28% investment in
F Co.
Related parties due to membership in the same control group

6.
A Co does not hold, directly or indirectly, more than 25% of the voting or value
interests in D Co. But A Co may be related to D Co if they are both found to be in the
same control group. This particular case could fall within the second test in
Recommendation 11.1(b) if A Co holds an investment that gives it an effective control
over D Co. If, for example, the shareholding of D Co is otherwise widely-held, except for
the 20% holding by A Co, then A Co may have effective control of D Co even with a
minority stake.
EXAMPLE 11.4 451
Example 11.4
Acting together - aggregation of interests under a shareholders agreement
Facts
1.
In the example illustrated in the figure below A Co and a number of other
investors, including C, hold together 100% of equity and voting rights in B Co. A Co is a
majority shareholder with 40% holding and the other investors each own 5% of shares in
B Co. The shareholders entered into a shareholders agreement that provides the majority
shareholder with a first right of refusal on any disposal of the shares and drag-along and
tag-along provisions in the event that an offer is made for a majority of the shares in the
company.
Transfer of the
A Co
Third Party
Other
investors
40%
55%
B Co
5%
2.
B Co issues a financial instrument that is purchased from an unrelated third party
by C (one of the minority shareholders). This instrument results in a hybrid mismatch
giving rise to a D/NI outcome.
Question
3.
Whether the investors in B Co are acting together, within the sense of
Recommendation 11.3(c) such that C should be treated as related to B Co.
452 EXAMPLE 11.4
Answer
4.
Provisions that are commonly found in a shareholders agreement and that do not
have a material impact on the value or control of the interests held by a shareholder will
not be treated as common control agreements within the meaning of Recommendation
11.3(c).
5.
If the shareholders agreement does have a material impact on the value of Cs
shareholding, C will be treated as a related party under the acting together test in respect
of the acquisition of the financial instrument even if there is no link or connection
between the shareholders agreement and the transaction that gave rise to the hybrid
mismatch.
Analysis
Shareholders agreement is on standard terms
6.
The right to buy C Cos shares at market value, as well as the drag along and tag
along rights are relatively standard terms in a shareholders agreement for a closely-held
company. These types of provisions will not generally have a material impact on the
value of the holders equity interest and therefore should not be taken into account for the
purposes of the acting together requirement.
No nexus required between transactions giving rise to the mismatch and the
common control arrangement
7.
The acting together test does not impose any definitional limits on the content of
the common control arrangement and the acting together test can capture transactions
between otherwise unrelated taxpayers even if the common control arrangement has not
played any role in the transaction that has given rise to the mismatch. Thus, if the
shareholders agreement does have a material impact on the value of Cs shareholding,
C will be treated as a related party under the acting together test in respect of the
acquisition of the financial instrument even if there is no link or connection between the
shareholders agreement and the transaction that gave rise to the hybrid mismatch.
EXAMPLE 11.5 453
Example 11.5
Acting together - rights or interests managed together by the same person/s
Facts
1.
In the example illustrated in the figure below, a widely-held investment
partnership provides additional financing to A Co, a company in which it already has an
80% holding. The terms of this loan agreement result in a mismatch in tax outcomes for
one investor in that partnership.
Partners
Partnership
80%
Hybrid
financial
instrument
A Co
2.
The terms of the partnership agreement give the general partner the primary right
to decide on the investments of the partnership. The general partner when making its
decisions must act in good faith and in the best interest of all the partners.
454 EXAMPLE 11.5
Question
3.
Whether the partner is related to A Co through the aggregation of interests rule
under Recommendation 11.3?
Answer
4.
In this instance the partner that is a party to a hybrid financial instrument will be
treated as related to A Co through the aggregation of interest rule in Recommendation
11.3(d). This will be the case even where it cannot be said that the partnership is acting
together with all the other partners in respect of the mismatch in tax outcomes.
Analysis
5.
Consistent with the analysis in Example 11.2, where the shares and debt are held
by the same investment partnership the joint management or control of the equity interest
will result in each partner being treated as holding the shares of the other partners under
the acting together test in Recommendation 11.3(d).
6.
The fact that the partnership is widely-held and otherwise meets the test for a CIV
does not permit the partnership to rely on the exclusion to Recommendation 11.3(d)
because that exception only applies to investors that are CIVs and not investors in a CIV.

AND DEVELOPMENT

(23 2015 29 1 P) ISBN 978-92-64-24108-4 2015
Neutralising the Effects of Hybrid Mismatch

Arrangements
Contents
Part I. Recommendations for domestic law
Introduction
Chapter 1. Hybrid financial instrument rule
Chapter 2. Specific recommendations for the tax treatment of financial instruments
Chapter 3. Disregarded hybrid payments rule
Chapter 4. Reverse hybrid rule
Chapter 5. Specific recommendations for the tax treatment of reverse hybrids
Chapter 6. Deductible hybrid payments rule
Chapter 7. Dual-resident payer rule
Chapter 8. Imported mismatch rule
Chapter 9. Design principles
Chapter 10. Definition of structured arrangement
Chapter 11. Definitions of related persons, control group and acting together
Chapter 12. Other definitions
Part II. Recommendations on treaty issues
Introduction
Chapter 13. Dual-resident entities
Chapter 14. Treaty provision on transparent entities
Chapter 15. Interaction between Part I and tax treaties
Annex A. Summary of Part I recommendations
Annex B. Examples

isbn 978-92-64-24108-4
23 2015 29 1 P

Project
Designing Effective
Rules
Designing Effective
Controlled Foreign
Company Rules, Action 3
2015 Final Report

OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 - 2015 Final Report,
http://dx.doi.org/10.1787/9789264241152-en
ISBN 978-92-64-24114-5 (print)

ISBN 978-92-64-24115-2 (PDF)

OECD 2015
FOREwORD 3
Foreword
DESIGNING EFFECTIVE CONTROLLED FOREIGN COMPANY RULES OECD 2015
4 FOREwORD
TABLE OF CONTENTS 5
Table of contents
Executive summary ........................................................................................................... 9
Introduction ..................................................................................................................... 11
Chapter 1 Policy considerations and objectives .......................................................... 13
1.1 Shared policy considerations .................................................................................... 13
1.2 Specific policy objectives ......................................................................................... 15
Chapter 2
Rules for defining a CFC............................................................................ 21
2.1 Recommendations .................................................................................................... 21

2.2 Explanation ............................................................................................................... 21
Chapter 3 CFC exemptions and threshold requirements .......................................... 33
3.2 Explanation ............................................................................................................... 33
Chapter 4 Definition of CFC income............................................................................ 43
4.1 Recommendation ...................................................................................................... 43
4.2 Explanation ............................................................................................................... 43
Chapter 5
Rules for computing income ...................................................................... 57

5.2 Explanation ............................................................................................................... 57
Chapter 6 Rules for attributing income ....................................................................... 61
6.2 Explanation ............................................................................................................... 61
Chapter 7
Rules to prevent or eliminate double taxation ......................................... 65

7.2 Explanation ............................................................................................................... 66
Figures
Figure 2.1 Modified hybrid mismatch rule ....................................................................... 23
Figure 2.2 Control interest held by unrelated parties acting in concert ............................ 26
Figure 2.3 Control interest held by related parties ............................................................ 27
Figure 2.4 Calculation of indirect control interest ............................................................ 29
Figure 3.1 De minimis test ................................................................................................ 35
Figure 5.1 Loss limitation ................................................................................................. 58
Figure 5.2 Loss limitation with pre-existing passive limitation ........................................ 59
Figure 7.1 Interaction of CFC rules .................................................................................. 67
Abbreviation and acronyms

BEPS
CFA
CFC
Controlled foreign companies
ECJ
European Court of Justice
EEA
European Economic Area
ETR
Effective tax rate
FBE
Foreign Business Establishment
IFRS
IP
Intellectual Property
MNC
Multinational corporation
MNE
OECD
PE
R&D
Research and Development
SGI
Socit de Gestion Industrielle
UK
United Kingdom
US
United States
EXECUTIVE SUMMARY 9
Executive summary
Controlled foreign company (CFC) rules respond to the risk that taxpayers with a
controlling interest in a foreign subsidiary can strip the base of their country of residence
and, in some cases, other countries by shifting income into a CFC. Without such rules,
CFCs provide opportunities for profit shifting and long-term deferral of taxation.
Since the first CFC rules were enacted in 1962, an increasing number of jurisdictions
have implemented these rules. Currently, 30 of the countries participating in the
OECD/G20 Base Erosion and Profit Shifting (BEPS) Project have CFC rules, and many
others have expressed interest in implementing them. However, existing CFC rules have
often not kept pace with changes in the international business environment, and many of
them have design features that do not tackle BEPS effectively.
In response to the challenges faced by existing CFC rules, the Action Plan on Base
Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013) called for the development
of recommendations regarding the design of CFC rules. This is an area where the OECD
has not done significant work in the past, and this report recognises that by working
together countries can address concerns about competiveness and level the playing field.
This report sets out recommendations in the form of building blocks. These
recommendations are not minimum standards, but they are designed to ensure that
jurisdictions that choose to implement them will have rules that effectively prevent
taxpayers from shifting income into foreign subsidiaries. The report sets out the following
six building blocks for the design of effective CFC rules:
Definition of a CFC CFC rules generally apply to foreign companies that are
controlled by shareholders in the parent jurisdiction. The report sets out
recommendations on how to determine when shareholders have sufficient
influence over a foreign company for that company to be a CFC. It also provides
recommendations on how non-corporate entities and their income should be
brought within CFC rules.
CFC exemptions and threshold requirements Existing CFC rules often only
apply after the application of provisions such as tax rate exemptions,
anti-avoidance requirements, and de minimis thresholds. The report recommends
that CFC rules only apply to controlled foreign companies that are subject to
effective tax rates that are meaningfully lower than those applied in the parent
jurisdiction.
Definition of income Although some countries existing CFC rules treat all the
income of a CFC as CFC income that is attributed to shareholders in the parent
jurisdiction, many CFC rules only apply to certain types of income. The report
recommends that CFC rules include a definition of CFC income, and it sets out a
non-exhaustive list of approaches or combination of approaches that CFC rules
could use for such a definition.
Computation of income The report recommends that CFC rules use the rules
of the parent jurisdiction to compute the CFC income to be attributed to
shareholders. It also recommends that CFC losses should only be offset against
the profits of the same CFC or other CFCs in the same jurisdiction.
Attribution of income The report recommends that, when possible, the

attribution threshold should be tied to the control threshold and that the amount of
income to be attributed should be calculated by reference to the proportionate
ownership or influence.
Prevention and elimination of double taxation One of the fundamental policy

issues to consider when designing effective CFC rules is how to ensure that these
rules do not lead to double taxation. The report therefore emphasises the
importance of both preventing and eliminating double taxation, and it
recommends, for example, that jurisdictions with CFC rules allow a credit for
foreign taxes actually paid, including any tax assessed on intermediate parent
companies under a CFC regime. It also recommends that countries consider relief
from double taxation on dividends on, and gains arising from the disposal of, CFC
shares where the income of the CFC has previously been subject to taxation under
a CFC regime.
Because each country prioritises policy objectives differently, the recommendations

provide flexibility to implement CFC rules that combat BEPS in a manner consistent with
the policy objectives of the overall tax system and the international legal obligations of
the country concerned. In particular, this report recognises that the recommendations
must be sufficiently adaptable to comply with EU law, and it sets out possible design
options that could be implemented by EU Member States. Once implemented, the
recommendations will ensure that countries will have effective CFC rules that address
BEPS concerns.
INTRODUCTION 11
Introduction
1.
Action 3 of the Action Plan on Base Erosion and Profit Shifting (BEPS Action
Plan, OECD, 2013) recognises that groups can create non-resident affiliates to which they
shift income and that these affiliates may be established wholly or partly for tax reasons
rather than for non-tax business reasons.1 Controlled foreign company (CFC) and other
anti-deferral rules combat this by enabling jurisdictions to tax income earned by foreign
subsidiaries where certain conditions are met. However, some countries do not currently
have CFC rules and others have rules that do not always counter BEPS situations in a
comprehensive manner. Action 3 calls for the development of recommendations
regarding the design of controlled foreign company rules. The objective was to develop
recommendations for CFC rules that are effective in dealing with base erosion and profit
shifting.
2.
CFC rules have existed in the international tax context for over five decades, and
dozens of countries have implemented these rules. This report considers all the
constituent elements of CFC rules and breaks them down into the building blocks that
are necessary for effective CFC rules. These building blocks would allow countries
without CFC rules to implement recommended rules directly and countries with existing
CFC rules to modify their rules to align more closely with the recommendations, and they
include:
1. Rules for defining a CFC (including definition of control)
2. CFC exemptions and threshold requirements
3. Definition of CFC income
4. Rules for computing income
5. Rules for attributing income
6. Rules to prevent or eliminate double taxation.
3.
Before discussing these six building blocks, this report first addresses the policy
considerations to be considered in the context of Action 3. These include shared policy
considerations that all jurisdictions consider when designing CFC rules as well as
different policy objectives that are linked to the overall domestic tax systems of
individual jurisdictions. Shared policy considerations include the role of CFC rules as a
deterrent measure; how CFC rules complement transfer pricing rules; the need to balance
effectiveness with reducing administrative and compliance burdens; and the need to
balance effectiveness with preventing or eliminating double taxation. When addressing
these policy considerations, jurisdictions prioritise their policy objectives differently
depending, in part, on whether they have worldwide or territorial tax systems2 and
whether they are Member States of the European Union. These policy issues are all
briefly considered in Chapter 1. The following chapters then set out the building blocks.
The recommendations discussed in this report are designed to combat base erosion and
12 INTRODUCTION
profit shifting. It is recognised that some countries are concerned about long-term deferral
and that recommendations need to provide sufficient flexibility so that jurisdictions can
design CFC rules that combat BEPS in a way that is consistent with both their
international legal obligations and the policy objectives of their domestic tax systems.
4.
The work on CFCs is being co-ordinated with the work on other Actions,
including Action 1 (Addressing the tax challenges of the digital economy), Action 2
(hybrid mismatch arrangements), Action 4 (Interest deductions), Action 5 (Countering
harmful tax practices), and Actions 8-10 (Transfer pricing).
Notes
1.
Non-tax business reasons could include, for example, the availability of employees,
increased resources, or a more favourable legal environment. CFC rules are not by
definition limited to situations where CFCs are controlled by companies, and
jurisdictions should consider designing CFC rules to apply in situations where
individuals control foreign entities.
2.
In reality, jurisdictions tax systems are almost never purely worldwide nor purely
territorial but fall within a spectrum between these two.
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
1. POLICY CONSIDERATIONS AND OBJECTIVES 13
Chapter 1
Policy considerations and objectives
5.
This chapter sets out a high level policy framework for CFC rules. Because CFC
rules fit within a jurisdictions overall system of tax, the design and objectives of CFC
rules can differ from one jurisdiction to another because they reflect different policy
choices. The chapter therefore first introduces the policy considerations that underlie all
CFC rules and then lists several policy objectives that jurisdictions may prioritise
differently.
1.1 Shared policy considerations

6.
Depending on their design, CFC rules tax parent companies based on some or all
of the income of some or all of their foreign subsidiaries. For most countries, they are
used to prevent shifting of income either from the parent jurisdiction or from the parent
and other tax jurisdictions. However, countries could also be concerned about long-term
deferral. All CFC rules share some general policy considerations, including (i) their role
as a deterrent measure; (ii) how they complement transfer pricing rules; (iii) the need to
balance effectiveness with reducing administrative and compliance burdens; and (iv) the
need to balance effectiveness with preventing or eliminating double taxation.
1.1.1 Deterrent effect

7.
CFC rules are generally designed to act as a deterrent. In other words, CFC rules
are not primarily designed to raise tax on the income of the CFC. Instead, they are
designed to protect revenue by ensuring profits remain within the tax base of the parent
or, in the case of CFC regimes that also target the stripping of third countries bases
(foreign-to-foreign stripping), other group companies, typically by preventing
taxpayers from shifting income into CFCs. CFC rules will, of course, raise some revenue
by taxing the income of CFCs, but there is likely to be a reduction in the income shifted
to CFCs after the implementation of CFC rules. In common with other rules designed to
change taxpayer behaviour, CFC rules may not exclusively have the effect that their
design suggests. For example, the design of CFC rules suggests that they grant secondary
taxing rights to the residence jurisdiction. In reality, however, if CFC rules effectively tax
profits at a sufficiently high rate, they may also increase taxing opportunities in source
jurisdictions by reducing or eliminating the tax incentives for multi-national enterprises
(MNEs) to shift income into subsidiaries in low-tax jurisdictions.
14 1. POLICY CONSIDERATIONS AND OBJECTIVES
1.1.2 Interaction with transfer pricing rules

8.
Transfer pricing rules are intended to adjust the taxable profits of associated
enterprises to eliminate distortions arising whenever the prices or other conditions of
transactions between those enterprises differ from what they would have been if the
enterprises had been unrelated. Because controlled foreign company rules by definition
address related parties (as the companies that are captured by such rules are controlled by
another party), jurisdictions often also use these rules to combat the adjusted prices
charged between related parties. In other words, CFC rules are seen as a way for a parent
jurisdiction to capture income earned by a foreign subsidiary that may not have been
earned had the original pricing of the income-creating asset been set correctly. CFC rules
are thus often referred to as backstops to transfer pricing rules.1 That terminology,
however, is misleading, in that CFC rules do not always complement transfer pricing
rules. CFC rules may target the same income as transfer pricing rules in some situations,
but it is unlikely that either CFC rules or transfer pricing rules in practice eliminate the
need for the other set of rules. Instead, while CFC rules may capture some income that is
not captured by transfer pricing rules (and vice versa), neither set of rules fully captures
the income that the other set of rules intends to capture.
9.
Transfer pricing rules, which generally rely on a facts and circumstances analysis
and focus primarily on payments between related parties, do not remove the need for CFC
rules. CFC rules are generally more mechanical and more targeted than transfer pricing
rules, and many CFC rules automatically attribute certain categories of income that is
more likely to be geographically mobile and therefore easy to shift into a low-tax foreign
jurisdiction, regardless of whether the income was earned from a related party. CFC rules
therefore play a unique role in the international tax system. Transfer pricing rules should
generally apply before CFC rules, but even after the completion of the BEPS work on
transfer pricing under the BEPS Action Plan, there will still be situations where income
allocated to a CFC could be subject to CFC rules. For example, current work on transfer
pricing may allow a funding return to be allocated to a low-function cash box that just
provided financing.2 If that cash box were a low-tax foreign subsidiary and a country
were to choose to subject that return to CFC taxation, this choice would be consistent
with the BEPS Action Plan. CFC rules can also be used after the application of transfer
pricing rules to address situations where the transfer pricing rules were implemented or
applied in a way that is inconsistent with the goals of the Action Plan on Base Erosion
and Profit Shifting (BEPS Action Plan, OECD, 2013).3
1.1.3 Effectively preventing avoidance while reducing administrative and

compliance burdens
10.
A third policy consideration is how to achieve effective rules that do not unduly
increase compliance costs and administrative burdens. Although one of the benefits of
CFC rules can be their relatively mechanical application, CFC rules that are entirely
mechanical may not be as effective as rules that allow more flexibility.4 However,
flexibility can also create uncertainty, which may affect the costs of both applying and
complying with CFC rules. CFC rules must strike a balance between the reduced
complexity inherent in mechanical rules and the effectiveness of more subjective rules.
This policy consideration is reflected most clearly in rules on defining income. In that
context, although an approach that attributes income based purely on its formal
classification may reduce administrative and compliance burdens, such an approach may
be less effective, and countries with existing CFC rules have generally opted to combine
this approach with less mechanical substance analyses to ensure that the income that is
attributed in fact arises from base erosion and profit shifting. Concerns about the
administrative burden of substance-based rules can, however, be reduced by including
suitably targeted CFC exemptions such as an exemption for companies that are not
subject to a lower rate of tax.
1.1.4 Avoiding double taxation

11.
An additional consideration is how to avoid double taxation. As CFC rules
effectively subject the income of a foreign subsidiary to taxation in the parent
jurisdiction, they can lead to double taxation if, for example, the subsidiary is also subject
to taxation in the CFC jurisdiction. Double taxation concerns can be limited by
incorporating tax rate exemptions, which are discussed in the next section, into CFC
rules. Existing CFC rules also seek to prevent double taxation through provisions such as
foreign tax credits. These provisions are outlined in the discussion of the sixth building
block in Chapter 7.
1.2 Specific policy objectives

12.
Whilst the above policy objectives are consistent among most jurisdictions with
CFC rules, individual jurisdictions may design CFC rules to achieve a variety of other
policy objectives. This is inevitable given that CFC rules are part of a jurisdictions
general system of taxation and the underlying systems vary. As a result, CFC rules also
vary significantly in how they prioritise different policy objectives. Two fundamental
differences that can affect the design of CFC rules are (i) whether a jurisdiction has a
worldwide tax system or a territorial tax system and (ii) whether a jurisdiction is a
Member State of the European Union.
1.2.1 Worldwide and territorial systems

13.
If a jurisdiction has a worldwide tax system, its CFC rules could apply broadly to
any income that is not being currently taxed in the parent jurisdiction and still remain
consistent with the parent jurisdictions overall tax system. If, however, a jurisdiction has
a territorial tax system, it may be more consistent for its CFC rules to apply narrowly and
only subject income that should have been taxed in the parent jurisdiction to CFC
taxation. In reality, jurisdictions tax systems are almost never purely worldwide nor
purely territorial but fall within a spectrum between these two. This may influence the
policy choices that jurisdictions make in terms of how they address international
competitiveness and how they address base stripping.
1.2.1.1 Striking a balance between taxing foreign income and maintaining

competitiveness
14.
In designing CFC rules, a balance must be struck between taxing foreign income
and the competitiveness concerns inherent in rules that tax the income of foreign
subsidiaries. CFC rules raise two primary types of competitiveness concerns. First,
jurisdictions with CFC rules that apply broadly may find themselves at a competitive
disadvantage relative to jurisdictions without CFC rules (or with narrower CFC rules)
because foreign subsidiaries owned by resident companies will be taxed more heavily
than locally owned companies in the foreign jurisdiction. This competitive disadvantage
may in turn lead to distortions, for instance it may impact on where groups choose to
locate their head office or increase the risk of inversions, and it may also impact on

ownership or capital structures where groups attempt to avoid the impact of CFC rules.5
CFC rules can therefore run the risk of restricting or distorting real economic activity.
Second, multinational enterprises resident in countries with robust CFC rules may find
themselves at a competitive disadvantage relative to multinational enterprises resident in
countries without such rules (or with CFC rules that apply to a significantly lower rate or
narrower base). This competitiveness concern arises because the foreign subsidiaries of
the first MNEs will be subject to a higher effective tax rate on the income of those
subsidiaries than the foreign subsidiaries of the second MNEs due to the application of
CFC rules, even when both subsidiaries are operating in the same country.
15.
To address these concerns, jurisdictions with territorial systems are more likely to
tax only income that was clearly diverted from the parent jurisdiction, thereby prioritising
competitiveness. In contrast, jurisdictions with worldwide systems are more likely to tax
more income under CFC rules, thereby prioritising taxation of foreign income. Because
existing tax systems are almost never pure worldwide systems nor pure territorial
systems, CFC rules typically exempt so-called active income that is, or is more likely to
be, linked to real economic activity in the foreign subsidiary. This approach may not be
entirely effective in combatting BEPS, but, in developing recommendations for the design
of CFC rules, the balance between taxing foreign income and maintaining
competitiveness needs to be kept in mind.
16.
Another way to maintain competitiveness would be to ensure that more countries
implement similar CFC rules. This is therefore a space where countries working
collectively and adopting similar rules could reduce the competitiveness concerns that
individual countries may have when considering whether to implement CFC rules.
1.2.1.2 Preventing base stripping

17.
Where CFC rules are intended to prevent group companies from shifting income
to CFCs, this does not necessarily mean that CFC rules only protect the base of the parent
jurisdiction. CFC rules can either focus only on protecting the parent jurisdictions base
or protect against both stripping of the parent jurisdictions base and foreign-to-foreign
stripping. Rules that focus on stripping of the parent jurisdiction define CFC income to
include only that income that has been diverted or shifted from the parent jurisdiction,
while those that focus on foreign-to-foreign stripping include any income that could have
been earned in any jurisdiction other than the CFC jurisdiction. Under the first type of
rule, which focuses on stripping of the parent jurisdictions base, income of the CFC that
was separated from activities that took place in a third country would not be subject to
CFC taxation. Under the second type of rule, which also includes foreign-to-foreign
stripping, this same income would be subject to CFC taxation. 6
18.
CFC rules that focus only on parent jurisdiction stripping may not be as effective
against BEPS arrangements for two reasons. First, it may not be possible to determine
which countrys base has been stripped (for example, in the case of stateless income).
Second, even if it were possible to determine which countrys base was stripped, the
BEPS Action Plan aims to prevent erosion of all tax bases, including those of third
countries. This issue may be of particular relevance for developing countries because
there may be more of an incentive to structure through low-tax jurisdictions in the
absence of CFC rules that focus on foreign-to-foreign stripping.7
1.2.2 CFC rules within the European Union

19.
A particular competitiveness concern may arise in the context of the European
Union. Since 2006,8 it is generally acknowledged that the European Court of Justices
(ECJ) case law imposes limitations on CFC rules that apply within the European Union.
Therefore, whilst recommendations developed under this Action Item need to be broad
enough to be effective in combatting BEPS they also need to be adaptable, where
necessary, to enable EU members to comply with EU law. This policy consideration
affects all jurisdictions, including those that are not Member States of the European
Union, because recommendations that are inconsistent with EU law would mean that
Member States could not adopt those recommendations to apply within the European
Union. This in turn would mean that multinational groups that are based in jurisdictions
that are not EU Member States could be at a competitive disadvantage compared to
multinational groups that are based in Member States since the latter groups would not be
subject to equally robust CFC rules.
20.
In Cadbury Schweppes9 and subsequent cases, the ECJ has stated that CFC rules
and other tax provisions that apply to cross-border transactions and that are justified by
the prevention of tax avoidance must specifically target wholly artificial arrangements
which do not reflect economic reality and whose only purpose would be to obtain a tax
advantage.10 The ECJs jurisprudence applies to all Member States of the European
Union and the European Economic area (EEA),11 and it applies when the parent
jurisdiction and the CFC jurisdiction are both within the EEA.
21.
The aim of this report is to set out recommendations for effective CFC rules that
can be implemented in all jurisdictions. Where recommendations are made, they are the
same for EU Member States and non-EU Member States. However, where there are
options, EU Member States will need to ensure that they make choices that are consistent
with EU law.12
22.
Although the determination of how to comply with EU treaty freedoms is the
decision of each individual EU Member State, in designing CFC rules, EU Member
States could potentially consider the following when implementing adaptable and durable
CFC rules:
Including a substance analysis that would only subject taxpayers to CFC rules if
the CFCs did not engage in genuine economic activities. Some Member States
have already modified their CFC rules so that they do not apply to genuine
economic activities and are therefore consistent with their understanding of the
ECJs wholly artificial arrangements limitation.
Applying CFC rules equally to both domestic subsidiaries and cross-border

subsidiaries. A CFC rule will only be found inconsistent with the freedom of
establishment if the rule itself discriminates against non-residents. This was made
clear in Cadbury Schweppes, where the ECJ focused on the difference in
treatment under UK CFC rules between a UK controlled company and a
non-resident controlled company. The Court explained this focus by stating:
That difference in treatment creates a tax disadvantage for the resident company
to which the legislation on CFCs is applicable. Even taking into account [] the
fact referred to by the national court that such a resident company does not pay,
on the profits of a CFC within the scope of application of that legislation, more
tax than that which would have been payable on those profits if they had been

made by a subsidiary established in the United Kingdom, the fact remains that
under such legislation the resident company is taxed on profits of another legal
person. That is not the case for a resident company with a subsidiary taxed in the
United Kingdom or a subsidiary established outside that Member State which is
not subject to a lower level of taxation.13
Therefore, if a CFC rule treats domestic subsidiaries the same as cross-border
subsidiaries, it arguably should not be treated as discriminatory under the case law of
the ECJ, and no justification is needed. Such an approach would attribute the allocable
income of any controlled company, whether foreign or domestic, to its resident
shareholders.14
Applying CFC rules to transactions that are partly wholly artificial. Even if a
direct tax rule in a EU Member State is found to implicate the freedom of
establishment and to discriminate, it may still be upheld if it is justified and
proportionate. Although earlier CFC cases found CFC rules in EU Member States
to be justified and proportionate only if they were limited to wholly artificial
arrangements, two more recent developments in the ECJs analysis suggest that
CFC rules may now be justified and proportionate even if they apply beyond
wholly artificial arrangements. The first development is that cases have suggested
that rules may be justified by the need to prevent tax avoidance if they are
targeted at arrangements that are not wholly artificial. In Thin Cap Group
Litigation, for example, the ECJ stated that, in determining whether thin cap
legislation was justified by the need to prevent abusive practices, the Court should
determine whether the transaction in question represents, in whole or in part, a
purely artificial arrangement, the essential purpose of which is to circumvent the
tax legislation of that Member State.15 This wording suggests that a CFC rule in
a EU Member State that targets income earned by a CFC that is not itself wholly
artificial may be justified so long as the transaction giving rise to the income is at
least partly artificial.
Designing CFC rules to explicitly ensure a balanced allocation of taxing power.

The ECJ has suggested that Member State tax provisions may not be restricted to
wholly artificial arrangements if they are justified by a reason other than the need
to prevent tax avoidance. In both SGI16 and Oy AA,17 for example, the ECJ stated
that the rules in question could be justified notwithstanding the fact that they were
not restricted to wholly artificial arrangements because they were justified by the
need to maintain a balanced allocation of taxing rights. In SGI, the ECJ clarified
that this justification may be accepted, in particular, where the system in
question is designed to prevent conduct capable of jeopardising the right of a
Member State to exercise its tax jurisdiction in relation to activities carried out in
its territory.18 Although the Court has not yet found that CFC rules are justified
by the need to maintain a balanced allocation of taxing rights, these cases suggest
that CFC rules could be permitted to apply more broadly if they could be
explained by the need for a Member State to tax profits arising from activities
carried out in its territory.
Notes
1.
See, e.g., Fleming, J. Clifton Jr., Peroni, Robert J. and Shay, Stephen E., Worse than
Exemption, 59 Emory L.J. 79 (2009).
2.
See the 2015 Report on Action 8-10: Aligning Transfer Pricing Outcomes With Value
Creation (OECD, 2015) which allocates a risk-free financial return to an entity that
lacks the ability to control risks.
3.
CFC rules also interact with rules other than transfer pricing rules. In the 2014
Deliverable on Neutralising the Effects of Hybrid Mismatch Arrangements (OECD,
2014), for example, Recommendation 5 recognised the importance of CFC rules
when it encouraged jurisdictions to improve their CFC rules to prevent
deduction/no-inclusion outcomes arising in respect of payments to a reverse hybrid.
4.
Entirely mechanical CFC rules also may not be compatible with EU law for the
reasons set out later in this chapter.
5.
There is a perception that robust CFC rules can lead to inversions, that is, that groups
will change the residence of the parent company to escape the effect of CFC rules.
However, whilst it is likely that CFC rules will increase the risk of inversions, they
will not be the only factor and other issues such as tax rate and the general system of
taxation (e.g., worldwide or territorial) will also play a role. For this reason
inversions, and the rules that some countries have adopted to combat them, are not
covered in this report, but countries may want to consider them as a separate matter.
6.
Rules that allow companies to elect whether their subsidiaries are treated as
partnerships or corporations also narrow the focus of CFC rules, with the result that
they do not prevent foreign-to-foreign stripping. The modified hybrid mismatch rule
discussed in Chapter 2, however, is designed to eliminate the effect of such an
election for CFC rules and may therefore reduce the availability of this option.
7.
For more on the effect of Action Item 3 and the other action items on developing
countries, see the BEPS Action Plan and the BEPS Report, both of which refer to the
knock-on effect of CFC rules on source countries.
8.
In 2006, the European Court of Justice issued its opinion in Cadbury Schweppes plc
and Cadbury Schweppes Overseas Ltd v. Commissioners of Inland Revenue,
C-196/04. This case considered the compatibility of Member State CFC rules with the
EU treaty freedoms.
9.
Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd v. Commissioners of

Inland Revenue, C-196/04. More recent cases have echoed the decision in Cadbury
Schweppes. In Itelcar Automveis de Aluguer Lda. v. Fazenda Pblica, Case
C-282/12 (3 October 2013), the ECJ made it clear that a national measure restricting
the fundamental EU freedoms may be justified where it specifically targets wholly
artificial arrangements which do not reflect economic reality and the sole purpose of
which is to avoid the tax normally payable on the profits generated by activities
carried out on the national territory. In Itelcar the ECJ went on to say that it is
apparent from the case-law of the Court that, where rules are predicated on an
assessment of objective and verifiable elements for the purposes of determining
whether a transaction represents a wholly artificial arrangement entered into for tax
reasons alone, they may be regarded as not going beyond what is necessary to prevent
tax evasion and avoidance, if, on each occasion on which the existence of such an
arrangement cannot be ruled out, those rules give the taxpayer an opportunity, without
subjecting him to undue administrative constraints, to provide evidence of any
commercial justification that there may have been for that transaction.
10.
Haribo Lakritzen Hans Riegel BetriebsgmbH and sterreichische Salinen AG v.

Finanzamt Linz, Joined Cases C-436/08 and C-437/08, paragraph 165.
11.
The ECJs jurisprudence applies to countries that are not Member States of the
European Union to the extent that it interprets the fundamental freedoms protected by
the Agreement on the European Economic Area.
12.
Countries that are not Member States of the European Union could also implement
the modifications adopted by EU Member States.
13.
Cadbury Schweppes, paragraph 45.
14.
At least one jurisdiction already applies such an approach. Denmarks legislation has
the effect that there is no different treatment, no matter whether the parent company
owns a subsidiary resident in Denmark, a foreign subsidiary resident in the EU/EEA
or a foreign subsidiary resident outside the EU/EEA.
15.
Test Claimants in the Thin Cap Group Litigation v. Commissioners of Inland

Revenue, C-524/04, paragraph 81 (emphasis added).
16.
Socit de Gestion Industrielle (SGI) v. Belgian State, C-311/08 (21 January 2010)
(holding that the freedom of establishment did not prevent Member States from
requiring profit adjustments in the case of non-arms length transactions involving
non-resident parties).
17.
Oy AA, C-231/05 (18 July 2007) (holding that the freedom of establishment did not
prevent Member States from limiting interest deductions for intra-group transfers to
payments made to resident companies).
18.
SGI, paragraph 60.
Bibliography
Fleming J. Clifton Jr, Peroni Robert J. and Shay Stephen E. (2009), Worse than
Exemption, 59 Emory L.J. 79 (2009).
OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD
http://dx.doi.org/10.1787/9789264202719-en.
2. RULES FOR DEFINING A CFC 21
Chapter 2
Rules for defining a CFC
23.
In order to establish whether CFC rules apply, a jurisdiction must consider two
questions: (i) whether a foreign entity is of the type that would be considered a CFC and
(ii) whether the parent company has sufficient influence or control over the foreign entity
for the foreign entity to be a CFC.
2.1 Recommendations
24.
In the context of whether an entity is of the type that would be considered a CFC,
the recommendation is to broadly define entities that are within scope so that, in addition
to including corporate entities, CFC rules could also apply to certain transparent entities
and permanent establishments (PEs) if those entities earn income that raises BEPS
concerns and those concerns are not addressed in another way. A further recommendation
is to include a form of hybrid mismatch rule to prevent entities from circumventing CFC
rules through different tax treatment in different jurisdictions.
25.
In the context of control, the recommendation is that CFC rules should at least
apply both a legal and an economic control test so that satisfaction of either test results in
control. Countries may also include de facto tests to ensure that legal and economic
control tests are not circumvented. A CFC should be treated as controlled where residents
(including corporate entities, individuals, or others) hold, at a minimum, more than 50%
control, although countries that want to achieve broader policy goals or prevent
circumvention of CFC rules may set their control threshold at a lower level. This level of
control could be established through the aggregated interest of related parties or unrelated
resident parties or from aggregating the interests of any taxpayers that are found to be
acting in concert. Additionally, CFC rules should apply where there is either direct or
indirect control.
2.2 Explanation
2.2.1 Entity considerations
26.
Although CFC rules would appear based on their name only to apply to corporate
entities, many countries include trusts, partnerships and PEs in limited circumstances to
ensure that companies in the parent jurisdiction cannot circumvent CFC rules just by
changing the legal form of their subsidiaries.
27.
Transparent entities such as partnerships should not be treated as CFCs to the
extent that their income is already taxed in the parent jurisdiction on a current basis.
However, if a transparent entity earns income that raises BEPS concerns and that is not
22 2. RULES FOR DEFINING A CFC

taxed in the parent jurisdiction, CFC rules could apply in one of two ways. First, CFC
rules could treat the transparent entity as a CFC to ensure that CFC income did not escape
CFC taxation due to different entity treatment in the CFC jurisdiction. This situation
could arise if, for example, an entity that was a taxable entity under the laws of the parent
jurisdiction was a partnership under the laws of the CFC jurisdiction. Second, CFC rules
could subject the income of a transparent entity that was owned by a CFC to tax as
income of the CFC to ensure that the CFC could not shift income to the transparent entity
in order to avoid CFC rules.
28.
PEs may need to be subject to CFC rules in two circumstances. First, CFC rules
should be broad enough to potentially apply to a situation where a foreign entity has a PE
in another country. Second, where a parent jurisdiction exempts the income of a PE1, the
income of that PE could potentially raise the same concerns as income arising in a foreign
subsidiary. Where this is the case, the parent jurisdiction could address this either by
denying the exemption or by applying CFC rules to the PE.
29.
A further issue that arises in determining which entities could be CFCs is how to
treat hybrid tax planning in situations where the parent jurisdictions rules concerning
characterisation of instruments and entities results in payments that might otherwise be
attributed under CFC rules being ignored or treated as being outside the scope of CFC
rules. For example, entity classification rules in the parent jurisdiction can allow the payer
and payee in a multinational group to be treated as the same entity for CFC purposes so
that a deductible intra-group payment between these entities is not taken into account
under the parents CFC rules. These rules ultimately exclude income that would
otherwise be attributable as CFC income and they have this effect because they do not
recognise certain entities. To the extent that the payment is deductible in the payers
jurisdiction this gives rise to foreign to foreign base erosion issues.
30.
It is recommended that countries address this issue. One way to do so could be to
consider a modified hybrid mismatch rule that requires an intragroup payment to a CFC
to be taken into account in calculating the parent companys CFC income.2 A possible
approach would take an intragroup payment into account if:
The payment is not included in CFC income.
The payment would have been included in CFC income if the parent jurisdiction
had classified the entities and arrangements in the same way as the payer or payee
jurisdiction.
31.
The example below explains how this rule might operate. In the structure
illustrated below, A Co, a company resident in Country A, holds all the shares of B Co, a
company resident in Country B. B Co, in turn, holds all the shares in C Co, a company
resident in Country C. Country A and Country C are high tax jurisdictions while Country
B is a low tax jurisdiction. C Co is a disregarded entity for Country A tax purposes. C Co
borrows money from B Co, and because C Co is treated as transparent under the laws of
Country A, the payment of interest to B Co is ignored under the laws of Country A and
therefore not included within the calculation of CFC income for Country A purposes.
Note that this example would not currently be caught by the rules recommended under
Action Item 2 as this payment does not create a hybrid mismatch under the rules of either
Country B or Country C, which are the residence jurisdictions of the counterparties.
Instead, it only creates a hybrid mismatch under the laws of Country A, which is the
country that treats C Co as transparent.
Figure 2.1
High tax
Modified hybrid mismatch rule
A Co
Country A
Country B
Low tax
B Co
Interest
Loan
Country C
High tax
C Co
32.
The interest payment is a deductible intra-group payment. The reason it is not
included in the calculation of CFC income is due to the treatment of the payer under the
laws of the parent jurisdiction. Under the rule set out above, the payment would be
included as an item of interest paid by another CFC when calculating A Cos CFC
income.
33.
While the example illustrated above involves a conflict in entity classification, a
similar result can be achieved using a loan that is treated as equity for Country A
purposes (so that the interest payment is characterised under Country As CFC rules as an
exempt dividend). The effect can also be achieved by exploiting differences in the
treatment of residence for tax purposes. For example, Country A, applying its own rules
on tax residency, could treat B Co as tax resident in Country C so that the interest
payment is ignored under a same country exception,3 under which Country As CFC rules
do not include income in CFC income if it was received from taxpayers resident in the
CFC jurisdiction. As these arrangements all rely on a conflict in the characterisation of
the entity or instrument they would also be caught under the rule outlined above.
2.2.2 Control
34.
The definition of control requires two different determinations: (i) the type of
control that is required and (ii) the level of that control.
2.2.2.1 Type of control

35.
Control can be established in various ways, which are outlined below.
Legal control generally looks at a residents holding of share capital to determine

the percentage of voting rights held in a subsidiary. Legal control is a relatively
mechanical test that is easy for both tax administrations and taxpayers to apply
and reflects the fact that a sufficient degree of voting rights should enable
residents to elect the board of directors or an equivalent body responsible for the
affairs of the foreign entity and thus ensure that a CFC acts in accordance with
their instructions. However, corporate law often provides a large degree of
flexibility in designing the share structure of a corporation, thus enabling the use
of artificial share terms and structures to circumvent the control requirement. A
focus on legal control is therefore likely to be too narrow, and most countries also
use a concept of economic control. Although tests that consider the entitlement to
acquire shares, and therefore voting rights, through certain contingent rights such
as options may help mitigate some of the weaknesses of legal control.
Economic control focuses on rights to the profits, as well as capital and assets of
a company in certain circumstances such as dissolution or liquidation. Such a test
recognises that a resident can control an entity through an entitlement to the
underlying value of the company even where they do not hold the majority of the
shares. This entitlement may result from rights to the proceeds in the event of a
disposal of the entitys share capital or the entitys assets on a winding up. It may
also include rights to a distribution of profits other than on a disposal or winding
up. Economic control is also a relatively mechanical test that focuses on facts that
can be objectively assessed. It does add some complexity but in reality those with
a majority stake in a company are likely to be aware of that fact and may have
other reporting obligations in respect of that controlled relationship. However,
economic control rules may be circumvented, most obviously by means of group
reorganisations involving the insertion of a new group holding company. In such
situations, both legal and economic control may change even though there is little
or no change in the underlying business or the level of decision-making and
business control exercised by the previous parent.
De facto control can look at similar factors to those considered by many countries
when considering where a company is resident for tax purposes. For instance,
countries can look at who takes the top-level decisions regarding the affairs of the
foreign company or who has the ability to direct or influence its day-to-day
activities. Another approach could focus on any particular contractual ties with
the CFC that permit taxpayers to exert a dominant influence over it. However, a
de facto control test generally operates as an anti-avoidance rule to ensure that
other control tests are not circumvented. De facto control tests therefore require a
significant analysis of the facts and circumstances and some subjective
assessment of these. If applied in all cases, this will lead to added costs,
complexity and uncertainty for taxpayers. In addition, based on countries
experience in operating residence rules, the type of criteria mentioned above may
also be relatively easy to avoid and therefore difficult for a tax administration to
prove.
Control based on consolidation can look at whether a non-resident company is

consolidated in the accounts of a resident company based on accounting
principles (e.g. International Financial Reporting Standards, or IFRS). This is not
fundamentally different from the approaches mentioned above. In fact, like the
legal and de facto control tests, accounting principles also refer to criteria such as
voting rights or other rights to exercise a dominant influence over another entity,
but they use these criteria to establish whether or not an entity should be
consolidated. For example, under IFRS 10 a taxpayer should consolidate any
entity if, for instance, it has rights that give the power to direct the activities that
most significantly affect the subsidiarys returns. The power may be based on
voting rights in relevant areas of the subsidiarys business activity or generally on
a controlling influence over the subsidiary which effectively tests legal and de
facto control.
36.
The above approaches are often combined to prevent circumvention and to ensure
that rules operate effectively. Based on the above analysis, a control test should focus on
a combined approach that includes at least legal and economic control. Both of these tests
are reasonably mechanical and so should limit the administrative and compliance burden
involved. However, countries could also consider supplementing these tests with either a
de facto test or a test based on consolidation for accounting purposes. Both of these, but
particularly a broad de facto test, could increase complexity and compliance costs.
Therefore countries that are attracted to using one of the latter two tests to address
specific problems (such as those raised by inversions) may find that these problems could
be better addressed with separate targeted provisions rather than through an extension of
the concept of control for CFC purposes.
2.2.2.2 Level of control

37.
Once a CFC regime has established what actually confers control, the next
question is how much control is enough for the CFC rules to apply. If the aim is to catch
all situations where the controlling party has the ability to shift profits to a foreign
company, then, as a minimum, CFC rules would need to capture situations where resident
taxpayers have a legal or economic interest in the foreign entity of more than 50%. Some
existing rules find control when the parent owns exactly 50%, but the majority of rules
require more than 50% control. Because owning 50% or less could still allow parent
companies to exert influence in certain situations, jurisdictions are free to lower their
control threshold below 50%.4
38.
The determination of whether this 50% threshold has been met is straightforward
when control is held by a single resident shareholder. Shareholders can exert influence in
other situations, however, and existing rules generally attempt to capture these instances
as well with their control rules. The general principle underlying control tests is that
minority shareholders that are acting together to exert influence should have their
interests aggregated when determining whether the control test has been met. Whether or
not minority shareholders are acting together can be determined in at least three ways,
and it is recommended that jurisdictions adopt one of these approaches to ensure that
minority shareholders who are in fact exerting influence are taken into account when
determining whether there is control.
39.
The first way of determining whether minority shareholders are acting together is
to apply an acting-in-concert test, which applies a fact-based analysis to determine
whether the shareholders are in fact acting together to influence the CFC. If they are, their
interests will be aggregated to determine whether the CFC is subject to CFC rules. This
approach is not very common because it creates significant administrative and
compliance burdens, but one of its advantages is that it may more accurately identify
when shareholders are in fact acting together than a more mechanical test. An example of
how an acting-in-concert test would work is illustrated below.

Figure 2.2
Control interest held by unrelated parties acting in concert
C Co
35%
Country C
A Co
Country A
Acting in concert
35%
B Co
Country B
30%
CFC
40.
C Co, A Co and B Co are all unrelated parties. Country As CFC rules require a
controlling interest of more than 50% before they can be applied. There is no other
resident taxpayer in Country A so unless Country A has an acting-in-concert rule that
aggregates the interest of both residents and non-residents, and the acting in concert rule
can be shown to apply, then there will be no attribution of the income of CFC to A Co. As
mentioned above, an acting-in-concert rule would add complexity and compliance costs,
especially where it is applied to both residents and non-residents. However, it could also
prevent circumvention of CFC rules.5
41.
The second way that some rules determine whether minority shareholders are
acting together is to look to the relationship of the parties. If rules only include the
interests of related parties when determining whether the 50% threshold has been met,
this would eliminate the need for a fact-based acting-in-concert test, but it will apply
more narrowly since it focuses more directly on the profit shifting opportunities created
by structures involving related parties. However, since BEPS structures often involve
wholly owned subsidiaries or at least subsidiaries owned by related parties, a focus on
related parties may still capture most structures that raise BEPS concerns.6 An example of
how a related party test would work is illustrated below.
Figure 2.3
100%
Control interest held by related parties
Parent
100%
A Co 1
A Co 2
Country A
30%
40%
B Co
30%
Country B
CFC
42.
A Co 1 and A Co 2 are unrelated residents in Country A. For Country As CFC
rules to apply, related parties or residents that act in concert must hold an aggregate
interest in the CFC of more than 50%. Parent Co splits the interest in CFC between
A Co 1 and B Co, in order to circumvent the control requirement in country A. If,
however, Country A applied a related party rule that aggregates the interests of related
parties to determine control, then A Co 1 would be found to be a controlling shareholder
because of the shared ownership between A Co 1 and B Co, which are both owned by
Parent. This would mean that 30% of the income of CFC would be attributed to A Co 1.
No income would be attributed to A Co 2. The same outcome is likely to arise under an
acting-in-concert test. Whether or not income is attributed to B Co would depend on the
rules in operation in Country B but if they operated the same form of related party rule,
then 30% of the income of CFC would also be attributed to B Co.
43.
The third way that CFC rules determine whether minority shareholders are
exerting influence over the CFC is to impose a concentrated ownership requirement. In
the United States, for example, the interests, of all residents, in the CFC are aggregated so
long as each interest is higher than 10%. This approach leads to the interests of a
concentrated group of residents being considered, and it also eliminates the need for
separate rules for attribution, since the 10% threshold for control can also be used to
determine which residents will have income allocated to them. Alternatively, a
concentrated ownership requirement could require that ownership be divided between a
small number of resident shareholders (e.g. 5 or fewer), regardless of their ownership
percentage, but this may raise administrative and compliance concerns. CFC rules that
aggregate all interests above a low threshold (e.g. 10%), or that focus just on the number

of owners, may not always accurately identify whether taxpayers are in reality acting
together.
44.
A concentrated ownership rule can be illustrated with reference to Figure 2.3
above. If Country A expanded its control requirement and applied its rules where there
were a small group of resident shareholders, in this situation A Co 1 and A Co 2, then the
CFC rules would apply and 30% of the income of CFC would be attributed to A Co 1 and
40% to A Co 2. This would prevent circumvention of the rules but would attribute
income to A Co 2. This might not be a concern in the context of a 40% holding but a test
that focuses on a small group of residents would potentially attribute profits to A Co 2
even if it was not acting in concert with A Co 1 and had no real ability to transfer income
or profits to the CFC.
45.
Including the interests of non-resident taxpayers in any of these three approaches
could add to the complexity of the control provisions but such an addition could be
considered if countries were concerned about either related or unrelated parties acting
together to try and circumvent the CFC control provisions.7 The recommendations above
therefore do not recommend that non-residents are also taken into account in determining
the level of control, but, as with all recommendations, the recommendation included in
this document only establishes a minimum, and jurisdictions with different policy aims
could include non-resident interests when determining whether the 50% threshold (or any
lower threshold) was met. If jurisdictions chose this option, limiting taxation of resident
taxpayers to their actual share of CFC income (rather than the aggregated amount) should
eliminate any concerns about double taxation.
46.
Regardless of which of the three approaches is taken, control should be defined to
include both direct and indirect control as profit-shifting opportunities also arise where a
subsidiary is held indirectly through an intermediate holding company. If CFC rules do
not apply to indirect holdings then they can be very easily sidestepped. The example
below illustrates one of the questions raised by indirect control, which is whether a level
of indirect control that falls below the control threshold should still lead to a finding of
control if the control threshold is met at each level in the chain of ownership.
Figure 2.4
Calculation of indirect control interest
Parent
70%
A Co
60%
CFC
47.
In this example, Parent has a 70% interest in A Co, which holds a 60% interest in
CFC. There is therefore more than 50% control at each tier, but Parent itself only has an
interest of 42% (70% x 60%) of CFC. Despite this limited legal control, A Co has enough
economic control to influence CFC and Parent has enough economic control to influence
A Co, so it is recommended that CFC rules should find Parent to have sufficient influence
over CFC to meet the control threshold since the control threshold is met at each level in
the chain of ownership.8 The amount of income attributed to Parent should, however, be
limited to its actual economic interest of 42%.
48.
Although including both direct and indirect control in the control analysis could
arguably increase the potential for double taxation if all countries were to introduce CFC
rules, this situation should be addressed with rules to reduce or eliminate double
taxation.9
49.
Determining whether a company in the parent jurisdiction has control also
requires a rule determining when control should be established as well as what types of
entities can be considered to have control. On the first question, many rules determine
control based on how much of an economic or legal interest was held at the end of the
year, but jurisdictions concerned about circumvention of this rule can also include antiabuse provisions or a test that looks at whether the parent company had the necessary
level of control at any point during the year. On the second question, in order to ensure
that all situations where resident shareholders have the opportunity to shift income into a
foreign subsidiary are captured, CFC rules should consider the interests held by all
resident taxpayers, rather than limiting this inquiry to corporate entities or other limited
groups.
Notes
1.
This includes a branch as defined under domestic law that equates to a PE.
2.
This is not the only way to tackle this issue. A jurisdiction that implements an excess
profits approach similar to that described in Chapter 4, for example, may not need an
additional rule to address these types of hybrid mismatches if such an approach does
not ignore the income earned in situations such as those illustrated in Figure 2.1.
3.
Several countries including the United States have exceptions in their CFC rules for
payments made between companies in the same country.
4.
Some CFC rules recognise that control can be exercised below 50% ownership. For
instance, New Zealands CFC rules find that the control threshold has been met when
a New Zealand resident owns 40% or more of the foreign subsidiary. Note that a
much lower control threshold may raise EU legal concerns for Member States' CFC
rules, even if they do not apply to CFCs in other Member States. This is because, as
the control threshold is reduced, CFC rules may implicate not just the freedom of
establishment but the free movement of capital, which applies to Member State rules
that are discriminatory toward residents of third countries as well as residents of other
Member States. This concern would only arise when the threshold is reduced below
the level of significant influence.
5.
A similar scenario to that above could arise where there is a joint venture. Some
countries have specific rules to deal with joint ventures. Under the UK CFC rules, a
UK resident 40% joint venture partner would be treated as having control if there is a
non-UK resident that holds at least 40% and no more than 55% of the legal and
economic interest in the joint venture. This rule has a similar effect to an
acting-in-concert type rule.
6.
This may not capture all structures that raise BEPS concerns, however, and other
action items have recognised that unrelated parties may act together to achieve a
certain outcome. The work on hybrid mismatch arrangements, for example, includes
structured arrangements involving unrelated parties.
7.
Non-resident taxpayers whose interests could possibly be included could include

family members of resident shareholders or board members of domestic parent
companies.
8.
For example, once control is established at a level, some CFC rules deem the control
at that level to be 100% for the purpose of determining the level of indirect control at
the next level.
9.
See infra Chapter 7.
Bibliography
International Accounting Standards Board (2011), International Financial Reporting
Standards 10: Consolidated Financial Statements, London, 2011.
3. CFC EXEMPTIONS AND THRESHOLD REQUIREMENTS 33
Chapter 3
CFC exemptions and threshold requirements
50.
CFC exemptions and threshold requirements can be used to limit the scope of
CFC rules by excluding entities that are likely to pose little risk of base erosion and profit
shifting and instead focusing attention on cases that are higher-risk because they exhibit
some characteristic or behaviour that means there is a greater chance of profit shifting.
These provisions can therefore both help make CFC rules more targeted and effective and
also reduce the overall level of administrative burden by ensuring that certain companies
are not affected by the rules, although these companies may still need to satisfy certain
reporting requirements to show that they meet any requirements for these provisions.
3.1 Recommendations
51.
The recommendation is to include a tax rate exemption that would allow
companies that are subject to an effective tax rate that is sufficiently similar to the tax rate
applied in the parent jurisdiction not to be subject to CFC taxation. The effect of this tax
rate exemption would be to subject all CFCs with an effective tax rate meaningfully
below the rate applied in the parent jurisdiction to CFC rules. This exemption could be
combined with a list such as a white list.
3.2 Explanation
52.
Three different types of CFC exemptions and threshold requirements were
considered by the countries involved in this work:
1. A set de minimis amount below which the CFC rules would not apply
2. An anti-avoidance requirement which would focus CFC rules on situations where
there was a tax avoidance motive or purpose
3. A tax rate exemption where CFC rules would only apply to CFCs resident in
countries with a lower tax rate than the parent company.
3.2.1 De minimis threshold

53.
A de minimis threshold could reduce administrative burdens and make CFC rules
more targeted and effective by ensuring that certain companies are not subject to the
rules.1 Many countries rules already include a de minimis threshold under which income
that would otherwise be treated as CFC income is not included in the taxable income of
the parent company if it falls under a certain ceiling. Generally, countries provide an
entity-based exemption where the entitys attributable income is less than either a certain
percentage of the CFCs income or a fixed amount of the CFCs income or where the
34 3. CFC EXEMPTIONS AND THRESHOLD REQUIREMENTS

taxable profits are less than a fixed amount. Some rules also include a separate cap for
certain types of profits that present a higher risk of being diverted. The UK rules, for
example, use two different thresholds with a much higher de minimis threshold applying
to CFCs that can show that they do not earn much income that is likely to be highly
mobile.
54.
One possible way that de minimis thresholds can be circumvented is through
fragmentation, under which companies split their income amongst multiple subsidiaries,
each of which falls below the threshold. Countries current rules often include safeguards
to protect against such circumvention. Although this may add some complexity to the
rules, countries experience has shown that these safeguards may not necessarily be
inconsistent with the thresholds purpose of reducing administrative and compliance
burdens. For example, the de minimis test under the United States rules includes a general
anti-abuse rule which looks at the income of two or more controlled foreign corporations
in aggregate and treats it as the income of a single corporation if a principal purpose for
separately organising, acquiring, or maintaining such multiple corporations is to prevent
income from being treated as attributable under the de minimis test. Although such an
anti-abuse rule increases the potential administrative burden of the de minimis threshold,
this increased burden is counteracted in the US rule with a rebuttable presumption that
automatically treats the income of multiple CFCs as that of a single corporation if the
CFCs are related persons and carry on a business previously conducted by a single CFC
or carry on a business as partners in a related partnership. Under the German rules, the
general de minimis test is subject to the condition that the attributable income must not
exceed the same amount at the level of the CFC and at the level of the shareholder. This
means that even if the attributable income of one CFC does not exceed the threshold, the
CFC may still be subject to CFC rules if the same threshold is exceeded by adding all of a
taxpayers shareholdings in several CFCs. Examples of these two different types of
anti-fragmentation rules are set out below.
55.
In Figure 3.1, A Group rearranges its operations to ensure that profits that
previously arose in a single CFC are split between three CFCs in different territories.
After the reorganisation, A Co is the sole shareholder of three controlled foreign
corporations. CFC1, CFC2 and CFC3 all have the same taxable year, and they are
partners in a foreign entity in Country C classified as a partnership (FP). For their current
taxable years, each of the CFCs derives part of its attributable income from the foreign
partnership and part from other activities undertaken separately.
Figure 3.1
De minimis test
A Co
CFC1
CFC2
CFC3
FP
Attributable income
Attributable income
Attributable and
non-attributable income
56.
Under the de minimis test in Country A, attributable CFC income is not taken
into account for the purposes of residence taxation if the sum of the attributable CFC
income is less than the lesser of 5% of total income or 1 000 000. Based on the figures in
the table below, the attributable income derived by each CFC for its current taxable year,
including income derived from the foreign partnership, is less than five percent of the
gross income of each CFC or is less than 1 000 000.
CFC 1
CFC 2
CFC 3
Gross income
3 000 000
7 000 000
11 000 000
5% of gross income
150 000
350 000
550 000
Attributable income
140 000
348 000
547 000
57.
Therefore, without the application of an anti-abuse rule, each CFC would be
treated as having no attributable income after the application of the de minimis test.
58.
If, however, Country A were to have either an anti-abuse rule similar to the US
rule or an anti-fragmentation rule similar to the German rule, A Co would be subject to
CFC taxation on the income earned by its foreign subsidiaries. If Country A has an antiDESIGNING EFFECTIVE CONTROLLED FOREIGN COMPANY RULES OECD 2015

abuse rule that treats the income of all three CFCs as the income of one CFC for the
purposes of calculating the de minimis threshold if the CFCs are related persons (or if the
principal purpose for separately organising, acquiring, or maintaining such multiple
corporations is to prevent income from being treated as attributable under the de minimis
test), then the attributable income is aggregated. The sum of the attributable income of the
CFCs is 1 035 000, so it exceeds the 1 000 000 de minimis threshold and will be taken
into account under Country As CFC rules. If, instead, Country A has a rule that the
attributable income at the level of the shareholder must not exceed the attributable income
at the level of the CFC, the de minimis threshold would also be overcome because the
attributable income at the level of the shareholder is 1 035 000, while it is significantly
less at the level of the CFCs.
59.
Therefore, although there is no general recommendation under this building block
for or against de minimis thresholds, if jurisdictions choose to implement such a
threshold, best practice would be to combine this with an anti-fragmentation rule.
3.2.2 Anti-avoidance requirement

60.
An anti-avoidance threshold requirement would only subject transactions and
structures that were the result of tax avoidance to CFC rules. This could narrow the
effectiveness of CFC rules as preventative measures, and it could also increase the
administrative and compliance burdens of CFC rules if it were administrated as an
up-front rule. Additionally, an anti-avoidance rule should not be necessary if the rules
defining the income within the scope of a CFC regime are properly targeted. An
anti-avoidance requirement is therefore not considered further in this report, but this is
not intended to imply that an anti-avoidance requirement can never play a role in CFC
rules that tackle base erosion and profit shifting.
3.2.3 Tax rate exemption

61.
Most CFC rules include a tax rate exemption that exempts CFCs subject to a tax
rate above a certain level. Such an exemption is included for two reasons. First, this
approach means that the rules only apply to companies that benefit from low foreign
taxes and therefore pose the greatest risk of profit shifting. Second, a focus on low-tax
CFCs can provide greater certainty for taxpayers and reduce the overall administrative
burden. A tax rate exemption can, however, mean that CFC rules do not prevent all base
erosion and profit shifting since they still allow erosion of the parent jurisdictions base to
high or medium-tax jurisdictions, so a few jurisdictions do not include such an
exemption.
62.
There are different ways for jurisdictions to determine when a CFC has paid a low
rate of tax. Jurisdictions may require taxpayers to apply a comparative approach on a caseby-case basis, or they may use a black list or white list to simplify the process. Using a list
generally eliminates the need for a case-by-case analysis of a CFCs tax rate and is a way of
communicating whether jurisdictions apply a lower level of tax. The use of black or white
lists can make it easier for tax administrations to determine when CFC rules do and do not
apply and for taxpayers to know whether they will be subject to CFC rules, and the use of
lists such as a white list is included in the recommendation under this building block. The
United Kingdom, for example, has a white list that excludes CFCs located in listed
jurisdictions which are sufficiently similar in terms of tax base and tax rate to the United
Kingdom, provided that several other conditions are also met.2 Finland issues a list of tax
treaty countries (not including EU Member States) to be considered low-tax based on
nominal tax rates and tax incentives but only regards a company in those countries as a
CFC if the company itself pays less than three-fifths of the taxes that would have been paid
in Finland. This approach therefore sets a presumption that a CFC is lowly taxed, but that
presumption must be supported with an actual comparison of taxes paid. Sweden applies a
similar approach under which countries are broken into three categories: (i) countries where
no entities would be CFCs; (ii) countries where entities without CFC income would not be
CFCs while entities with CFC income would be compared against the tax rate exemption;
and (iii) countries where all income will be compared against the tax rate exemption.
Australia applies a white list approach under which companies resident in countries with an
income tax system comparable to Australias tax system are not subject to CFC taxation.
CFCs in a listed jurisdiction are therefore exempt from Australias CFC rules unless they
are subject to a concessional tax regime.
63.
Tax rate exemptions require that the rate at which the CFC was taxed be below a
given benchmark. Tax rate exemptions apply one of two benchmarks. They either compare
the tax rate in the CFC jurisdiction to a particular fixed rate that is considered low-tax or
they compare the tax rate in the CFC jurisdiction to a portion or percentage of the parent
countrys own rate. Both approaches are equally relevant within the context of designing
rules to combat BEPS as both recognise that the incentive to shift profits will be greater
where there is a significant differential between effective tax rates.
64.
Under the first approach, countries would need to set a fixed tax rate below which
their CFC rules would potentially apply. An example of such an approach would be the
German CFC rules, which define any level of taxation below 25% as low taxation. The
second approach instead calculates the tax rate exemption based on a percentage of the tax
that would have been paid to the parent jurisdiction, which thereby includes both tax rate
and tax base in the analysis. The UK and Finnish CFC rules provide examples of this
approach. Under UK law, there is no low taxation if the local tax amount is at least 75%
of the corresponding UK tax. As mentioned above, under the Finnish rules, a low-tax
regime is considered to exist if the company itself pays less than three-fifths of the taxes
that would have been paid in Finland. Whichever approach is adopted, the benchmark
should be meaningfully lower than the tax rate in the country applying the CFC rules. Most
CFC rules apply benchmarks that are at the most 75% of the statutory corporate tax rate.
65.
Once the benchmark has been set, CFC rules must determine the tax rate in the
CFC jurisdiction in order to compare this to the benchmark. Current CFC rules do this in
one of two ways. They either compare the benchmark to: (i) the nominal (or statutory) tax
rate in the CFC jurisdiction; or (ii) the effective3 tax rate of the CFC. Although using the
statutory tax rate may reduce administrative complexity and compliance costs, the
recommendation is to use the effective rate. This latter approach takes into account the
tax base or other tax provisions that may increase or reduce the effective rate paid by the
CFC and therefore is likely to create a much more accurate comparison than focusing on
the statutory tax rate. Using the effective tax rate, however, means that whether the tax
rate exemption has been met must be determined in two steps. First, there must be a
calculation of the effective tax rate, which requires determining both how much tax the
CFC paid and how much income the CFC earned. Second, the effective tax rate must be
compared to the benchmark.
66.
The determination of the effective tax rate is typically based on the ratio of the
actual tax paid in the CFC jurisdiction to the total taxable income either computed
according to the rules of the parent/shareholders country or according to an international
accounting standard such as International Financial Reporting Standards (IFRS). This

method generally recognises that even in a situation where the statutory tax rate is not
considered a low tax rate, low taxation may occur as a result of (i) reducing the tax base;
or (ii) lowering the tax burden by subsequent rebates of taxes paid or through
non-enforcement of taxes.4 This can be illustrated in the following two examples.
a) Example 1: A CFC in Country C generates 80 000 of income in one year.
Country A applies its CFC rules if the effective tax rate applied to the CFC was below a
fixed rate of 25% taking into account the tax base as computed under Country As rules.
Country C allows an exemption of 20% when computing the taxable income to promote
investments.
Calculation of actual tax paid in Country C:
Income in Country C
80 000
Exemption (20%)
16 000
Taxable income
64 000
Corporate tax due (30%)
19 200
Actual tax paid
19 200
Income in Country C:
Income in Country C5
80 000
Effective tax rate calculation:

19 200/80 000
24%
b) Example 2: A CFC in Country C generates 80 000 of income in one year.

Country A applies its CFC rules if the effective tax rate applied to the CFC was below a
fixed rate of 25% taking into account the tax base as computed under Country As rules.
Country C does not provide for an exemption to promote investments. However,
according to Country Cs rules, shareholders of the CFC may claim a refund in the
amount of 20% of the corporate income tax paid by the CFC upon distribution of
dividends. The dividends would be tax exempt in Country A.
Calculation of actual tax paid in Country C:
Income
80 000
Taxable income
80 000
Corporate tax due (30%)
24 000
Refund upon distribution (20% of 24 000)
4 800
Actual tax paid
19 200
Income in Country C:
Income in Country C6
80,000
Effective tax rate calculation:

19 200/80 000
24%
67.
In both Example 1 and Example 2, the tax rate exemption does not apply because
the effective tax rate is below the fixed rate of 25%. The calculation of the effective tax
rate should therefore ensure that situations such as those illustrated in Example 1 and
Example 2 are subject to CFC rules, and the discussion below provides ways to ensure
this.
68.
The calculation of the effective tax rate uses a fraction where the numerator is the
actual tax paid and the denominator is the CFCs income. Although the determination of
the actual tax paid could require proof that tax was in fact collected and not refunded, the
definition of the numerator could be more straightforward if it instead focuses just on the
final tax burden (including, for example, subsequent rebates of taxes paid and
non-enforcement of taxes). The numerator could also include all taxes paid by the CFC
that are comparable to the corporate income tax in the parent jurisdiction.
69.
Compared to calculating the actual tax paid, the determination of what to include
in the total taxable income (i.e., the denominator) may be more problematic. If the
denominator were to refer to the foreign tax base, the effective tax rate would equal the
statutory tax rate of the CFC jurisdiction,7 which would undermine the purpose of the
effective tax rate calculation. The denominator should therefore be either the tax base in
the parent jurisdiction had the CFC income been earned there or the tax base computed
according to an international accounting standard such as IFRS, with adjustments made to
reflect the tax base reductions that result in low taxation of the CFC income.8
70.
In theory, the effective tax rate calculation could find a higher effective tax rate
than the statutory tax rate in the CFC jurisdiction if the base calculated under the rules of
the parent jurisdiction is smaller than that calculated under the rules of the CFC
jurisdiction. In reality, however, this situation is unlikely to occur much in practice as
groups would not structure themselves into jurisdictions where the advantage of a low
statutory tax rate is entirely or partially set off by a tax disadvantage in the tax base
computation (e.g. non-deductible expenditures).
71.
The effective tax rate computation could also be influenced by the unit used for
the calculation. Country rules generally calculate the effective tax rate on a
company-by-company basis, but it could in theory be computed either narrowly or
broadly. A narrow approach could, for example, calculate the effective tax rate for each
item of income earned by a company. Computing the effective tax rate on a narrower
basis allows jurisdictions to apply the tax rate exemption just to the income that has been
defined as attributable income under CFC rules. For example, if royalties were subject to
taxation under a jurisdictions definition of CFC income, the tax rate exemption would
apply more precisely to that income provided that the effective tax rate was computed
narrowly for each type of income. This may also more directly address situations where
only certain types of income benefit from a low tax rate, while others are subject to
regular taxation. Calculating the effective tax rate on a narrower basis would, however,
increase both the administrative complexity and compliance burden associated with the
tax rate exemption. A broad approach could calculate the effective tax rate on a companyby-company or country-by-country basis. A country-by-country approach would
aggregate the income of all entities of a group in a single country to calculate the
effective tax rate. These broader approaches would reduce the administrative complexity
and compliance burden compared to the narrow approach, but calculating the tax rate
exemption on a country-by-country basis would add complexity compared to doing so on
a company-by-company basis because it would require aggregating the calculations for
all the CFCs in each jurisdiction rather than just calculating the effective tax rate for each
CFC. If CFC jurisdictions exempt Permanent Establishments (PEs) from taxation, the
effective tax rate of permanent establishments of a CFC should be calculated separately

from that of the CFC to ensure that the tax rates of the PE and CFC cannot be blended to
inappropriately exempt income of a CFC.
Notes
1.
A de minimis threshold could also eliminate the need for a special rule for exempting
working capital under a transactional approach. See infra Chapter 4.
2.
These conditions are that there cannot be more than insignificant amounts of certain
defined types of income that are not effectively taxed in the CFCs territory of
residence, that none of the CFCs income has been generated using IP that has been
effectively transferred from a UK related party in the previous six years, and that the
CFC is not involved in any arrangement intended to create a UK tax advantage for
any person.
3.
The effective tax rate may be computed as an average of the effective tax rates over
several years.
4.
However, where jurisdictions do not apply a substance analysis as discussed in

Chapter 4 they may choose to adjust the calculation of the effective tax rate so that
situations where a lower tax burden is justified under commonly agreed standards
such as the nexus approach agreed under Action 5 are not considered to affect the
effective tax rate calculation for the purposes of applying a CFC regime.
5.
The income is calculated according to Country As rules. All other calculations in this
table are calculated using Country Cs rules since they were used to determine the tax
actually paid to Country C.
6.
The income is calculated according to Country As rules. All other calculations in this
table are calculated using Country Cs rules since they were used to determine the tax
actually paid to Country C.
7.
This is, of course, only true if there are no rebates and the tax was in fact collected
and enforced.
8.
This tax base would require a determination of how to treat loss carry forwards of the
CFC from previous years and any losses permitted in a consolidation or group relief
regime. If CFC legislation uses the rules of the parent jurisdiction to calculate taxable
income, they could also deal with losses in accordance with the rules of the parent
jurisdiction (this could mean that a consolidation regime in the CFC jurisdiction
would be ignored for purposes of CFC taxation by the parent jurisdiction). If, instead,
they use a common standard, then there would need to be a common rule for how
losses should be used to calculate taxable income.
Most countries generally apply their own rules to compute the tax base of the CFC. In
principle, however, not all differences in computing the tax base of the CFC under the
rules in the CFC and the parent jurisdiction raise the policy concerns that are typically
associated with preferential tax provisions or practices that could shrink the tax base
for certain income and therefore have the effect of significantly reducing the taxes
paid by the CFC. In theory, therefore, CFC rules could take account of only those
differences that raise such policy concerns when calculating the tax base of the CFC.
For example, if the tax base in the parent jurisdiction is higher than that in the CFC
jurisdiction only because of timing differences in accounting, this may not need to be
reflected in the denominator. A participation exemption also may not fall within the
scope of tax advantages that are considered in determining the denominator because it
is typically granted to eliminate double taxation and not to reduce the actual tax
burden. However, the denominator should take into account any differences that are a
result of a tax advantage in the CFC jurisdiction insofar as this is merely aimed at
attracting offshore capital and therefore increases the risk of profit shifting. A
notional interest deduction that has this aim may be an example of such a tax
advantage. While it may make sense in theory to differentiate between tax base
definitions that implicate the policy concerns underlying CFC rules and those that do
not, the only rules that would be likely to make this differentiation are those that start
with the tax base calculated under the rules of the CFC jurisdiction and then adjust
this upward to reflect the rules of the parent jurisdiction.
4. DEFINITION OF CFC INCOME 43
Chapter 4
Definition of CFC income
72.
This chapter discusses the third CFC building block, which focuses on the
definition of CFC income. Once a foreign company has been determined to be a CFC, the
next question is whether the income earned by the CFC is of the type that raises concerns
and should be attributed to shareholders or controlling parties. CFC rules therefore need
to define attributable income, which is also referred to here as CFC income.
4.1 Recommendation
73.
This report recommends that CFC rules should include a definition of income that
ensures that income that raises BEPS concerns is attributed to controlling shareholders in
the parent jurisdiction. At the same time, it recognises the need for flexibility to ensure
that jurisdictions can design CFC rules that are consistent with their domestic policy
frameworks. Jurisdictions are free to choose their rules for defining CFC income,
including from among the measures set out in the explanation section below. This choice
is likely to be dependent on the degree of BEPS risk a jurisdiction faces.
4.2 Explanation
74.
This section provides a non-exhaustive list of approaches that CFC rules could
use to attribute income that raises BEPS concerns, which may include, among other
things, income earned by CFCs that are holding companies, income earned by CFCs that
provide financial and banking services, income earned by CFCs that engage in sales
invoicing, income from IP assets, income from digital goods and services, and income
from captive insurance and re-insurance.1 These approaches could be applied on their
own or combined with each other. CFC rules generally include income that has been
separated from the underlying value creation to obtain a reduction in tax. Existing CFC
rules use a variety of factors to identify income that raises these concerns. For example,
some focus on whether the income is of a type that is more likely to be geographically
mobile; some focus on whether the income was earned from or with the assistance of
related parties; some focus on the source of the income; and some focus on the level of
activity in the CFC. Depending on their policy priorities, different jurisdictions with CFC
rules focus on different factors.
75.
Regardless of which approach a jurisdiction applies, CFC rules should, at a
minimum, capture the funding return allocated under transfer pricing rules to a lowfunction cash box if that cash box meets the requirements in the previous building blocks
(although under CFC regimes that focus on preventing stripping from the parent
jurisdiction, the extent of inclusion may depend on how much of the income has been
44 4. DEFINITION OF CFC INCOME

shifted from the parent jurisdiction).2 However, as mentioned in Chapter 1, different
jurisdictions use CFC rules to achieve different policy outcomes, and an approach that
focuses only on funding returns would not be consistent with the policy goals of all
jurisdictions. The analyses set out below provide a number of options that could apply
more narrowly or that could apply more broadly.3 Jurisdictions could also apply a fullinclusion system, which would target income raising BEPS concerns by treating all
income earned by a CFC as CFC income regardless of its character. Full-inclusion
systems also aim to prevent long-term deferral of taxation, which is relevant in the
context of worldwide tax systems.
4.2.1 Categorical analysis

76.
Existing CFC rules generally apply an analysis that divides income into categories
and attributes income differently depending on how it is categorised. Jurisdictions define
categories differently depending on which factors or indicia they find most relevant: (i)
legal classification, (ii) relatedness of parties, and (iii) source of the income. However,
not all income in these categories necessarily raises BEPS concerns.
4.2.1.1 Legal classification

77.
Jurisdictions generally first categorise income according to its legal classification,
focusing on categories such as the following:4
dividends
interest
insurance income
royalties and IP income
sales and services income.
78.
Jurisdictions that apply a categorical approach based on legal classification
separate out these categories of income because they are more likely to be geographically
mobile and therefore are likely to raise the concerns that CFC rules are designed to
address.
Dividends The general concern underlying the treatment of dividends is that

dividends could be used to shift purely passive income (i.e. income that does
not arise from any underlying activity) into a CFC. However, dividend income
typically does not raise such concerns in at least three situations. First, if the
dividends were paid out of active income of an affiliate, those dividends may not
raise BEPS concerns. Second, many countries now exempt certain dividend
income from taxation more generally, and it may not trigger any BEPS concerns
to exempt dividends earned by the CFC if those dividends would have been
exempted from taxation in the parent jurisdiction had they been earned by the
parent company. Third, if the CFC is in the active trade or business of dealing in
securities, then dividends paid to that CFC may again not raise concerns if they
are linked to the CFCs trade or business.
Interest The general concern underlying the treatment of interest and financing
income is that this income is easy to shift and therefore could have been shifted
by the parent into the CFC, possibly leading to overleveraging of the parent and
overcapitalisation of the CFC. Interest and financing income is more likely to
raise this concern when it has been earned from related parties, when the CFC is
overcapitalised, when the activities contributing to the interest were located
outside the CFC jurisdiction, or when the income was not earned from an active
financing business. Rules designed to attribute this income should recognise that
regulated entities are subject to capitalisation and other requirements, so any rules
on overcapitalisation should take account of such requirements and should not
attribute income just because an entity is required to maintain a certain level of
capital for non-tax purposes.
Insurance income The general concern underlying the treatment of income

from the insurance of risks is that profits can be shifted away from jurisdictions in
which those risks are located and into a low-tax jurisdiction. Insurance income is
more likely to raise these concerns in the following three cases: (i) the CFC was
overcapitalised relative to comparable companies in the business of providing
insurance; (ii) the policy holder, annuitant, beneficiary, or location of the risks
insured were outside the jurisdiction; or (iii) the insurance income was derived
from contracts or policies with a related party, particularly if the related party also
received a deduction for the payment of the insurance premium. However, income
earned by a regulated entity in an insurance group may not raise the same
concerns because the regulatory environment sets restrictions in terms of risks and
capital.5
Royalties and Intellectual Property (IP) income The general concern

underlying the treatment of royalties and other income from IP is that, since IP
assets are highly mobile, the income from these assets can easily be diverted from
the location where the value of the assets was created. IP income (including
income from digital goods and services6) raises several challenges for CFC rules:
IP income is particularly easy to manipulate because it can be exploited and
distributed in many different forms, all of which may have different
formalistic classifications under the CFC rules of different countries. For
instance, income from IP could be embedded in income from sales and
therefore treated as active sales income under the CFC rules of some
countries.
IP assets are often hard to value because there are often no exact comparables,
and the cost base of these assets may be an inaccurate measure of the income
they can generate.7
Income that is directly earned from the underlying IP asset is often difficult to
separate from the income that is earned from associated services or products.
CFC rules that use a categorical analysis based on legal classification often attempt to
address the concerns raised by IP income by separating out royalties and treating them
as attributable. Given the challenges above, however, dividing according to legal
classification on its own is not enough to attribute all income that does in fact arise out
of IP and that raises BEPS concerns.
Sales and services income Income that arises from the sale of goods that were
produced in the CFC jurisdiction or from services that were provided in the CFC
jurisdiction generally does not raise any concerns about BEPS. Income from sales
and services does, however, raise concerns in at least two contexts: (i) invoicing
companies; and (ii) IP income. Invoicing companies raise concerns because they

earn sales and services income for goods and services that they have purchased
from related parties and to which they have added little or no value. As discussed
above, income from IP that was shifted into the CFC and to which the CFC has
added little to no value is commonly considered as sales and services income and
could again escape CFC inclusion. Categorical analyses based on legal
classification therefore may not attribute income that raises BEPS concerns if they
exclude all sales and services income without taking account of these two
situations.
4.2.1.2 Relatedness of parties

79.
Some jurisdictions focus on the party from whom income was earned rather than
(or along with) the legal classification of the income. Many existing CFC rules include
income if it was earned from a related party on the grounds that income is more easily,
and more likely to be, shifted in that situation. Some jurisdictions apply a very broad
related party test that includes both income from sales to a related party and income from
a sale of a good originally purchased from a related party. Another version of a related
party rule would apply to income from goods that were developed in conjunction with a
related party (e.g., intellectual property that was developed with a related party or as part
of a cost-sharing agreement with a related party).8 All of these use the relatedness of
parties as an indicator that income was shifted into the CFC, but they differ based on how
much involvement by a related party is enough to ensure that income is attributed.
4.2.1.3 Source of income

80.
Some existing CFC rules also categorise income based on where the income was
earned. This approach can take the form of either an anti-base-stripping rule or a sourcecountry rule, and the underlying principle is that income that was earned from activities
undertaken in the CFC jurisdiction is less likely to raise concerns about profit shifting,
while income that was earned from another jurisdiction is more likely to raise such
concerns. Anti-base-stripping rules treat income as CFC income if it was earned for sales
to a related or unrelated party located in the parent jurisdiction or for services or
investments located in the parent jurisdiction. In keeping with the fact that different
jurisdictions prioritise different policy objectives, jurisdictions with anti-base-stripping
rules may focus on different types of base stripping. In jurisdictions that are focused
primarily on preventing the stripping of the parent jurisdictions base, only income
generated in the parent jurisdiction will be categorised as CFC income, although this
raises the question of how to determine whether income was shifted from the parent
jurisdiction. In jurisdictions that are focused on preventing both parent stripping and
foreign-to-foreign stripping, however, CFC rules could treat any income generated in a
jurisdiction other than the CFC jurisdiction as CFC income. This broader approach would
be harder to manipulate than a narrower rule that focuses on just the parent jurisdiction,
but it may attribute income that has genuinely been earned from activities carried out by
the CFC. Such a situation could arise, for example, where a foreign company that
previously had customers in the parent jurisdiction became a CFC when it was purchased
as part of a merger or acquisition. A broad anti-base-stripping rule could also take the
form of a source-country rule, which excludes highly mobile income from CFC income if
it was earned in the CFC jurisdiction.
4.2.2 Substance analysis

81.
A substance analysis looks to whether the CFC engaged in substantial activities in
determining what income is CFC income. Many existing CFC rules apply a substance
analysis of some sort, and many Member States of the European Union combine a
categorical approach with a carve-out for genuine economic activities. Substance analyses
can use a variety of proxies to determine whether the CFCs income was separated from
the underlying substance, including people, premises, assets, and risks. Regardless of
which proxies they consider, substance analyses are generally asking the same
fundamental question, which is whether the CFC had the ability to earn the income itself.
Substance analyses could be combined with the categorical or excess profits analysis, and
most existing substance analyses apply alongside more mechanical rules and are not
stand-alone rules. Although such rules add to the complexity of CFC rules, they may be
more able to accurately identify and quantify shifted income.
82.
A substance analysis can apply as either a threshold test or a proportionate
analysis. Under a threshold (or all-or-nothing) test, a set amount of activity (as
identified through one or more proxies) would allow all income of the CFC to be
excluded. A CFC that had not engaged in this amount of activity would have all of its
income included in CFC income. Under a proportionate analysis, CFC income would
only exclude the amount of income that was proportionate to the amount of activity that
the CFC had undertaken. For example, if the CFC had undertaken 75% of the activity that
would have to in fact be performed to earn the CFCs income, then 25% of its income
would be treated as CFC income. This could increase the administrative complexity and
compliance costs of the rules,9 but it should prevent businesses from locating just the
right type and amount of activity in a CFC to ensure that its profits are excluded by the
CFC rules of its parent jurisdiction. One further advantage of applying a substance test on
a proportionate basis is that it is more likely to comply with EU law because it would
allow CFC rules to attribute only the income that does not arise from genuine economic
activities
83.
As discussed in Chapter 1, one of the policy considerations underlying the design
of CFC rules is how to limit administrative and compliance burdens while not creating
opportunities for avoidance. Substance analyses highlight this consideration since they
typically rely on more qualitative measures than categorical analyses, and they are often
included in CFC rules because they may be more accurate than a purely mechanical
approach. Their inclusion, however, could lead to increased administrative and
compliance burdens. This is because they require an analysis of the CFCs facts and
circumstances. However, the incremental burden may be small because this analysis may
be similar to that required for transfer pricing purposes. Where this analysis reveals that
the CFC has insufficient substance, some or all of its profits, even after any transfer
pricing adjustments, may be included in CFC income.
84.
However, substance analyses can be designed to address these concerns and to
apply more mechanically while still increasing the accuracy of purely objective analyses.
One possible response would be to use a substance analysis only for certain narrow
categories of income, so that income in other categories was either automatically included
or automatically excluded depending on its categorisation. This approach could, at
minimum, not apply a substance test to categories of income that jurisdictions considered
to be automatically attributable because of their mobility, the relatedness of parties, or
their source. A second response would be to apply a substance analysis as a threshold test

instead of as a proportionate test. A third response would be to consider objective factors
such as expenditures rather than factors that are harder to measure.10
85.
Recognising the concerns about complexity and interactions with transfer pricing
rules, there are many different ways that a jurisdiction could design a substance analysis
that is consistent with the jurisdictions policy objectives, including the options listed
below:
One option would be a threshold test that applies a facts and circumstances
analysis to determine whether the employees of the CFC have made a substantial
contribution to the income earned by the CFC. 11 This option could be designed to
include certain safe harbours, ratios, or other more mechanical tests that
determine whether there has been a substantial contribution.
A second option would look at all the significant functions performed by entities
within the group to determine whether the CFC is the entity which would be most
likely to own particular assets, or undertake particular risks, if the entities were
unrelated. 12 If this were a threshold test, it would treat as CFC income all income
of a CFC that fell below the threshold of significant functions (or exclude all
income of a CFC that had the required functions). If it were a proportionate test, it
would treat as CFC income only that income that the CFC did not have the
significant functions necessary to earn.
A third option would consider whether the CFC had the necessary business
premises and establishment in the CFC jurisdiction to actually earn the income
and whether the CFC had the necessary number of employees with the requisite
skills in the CFC jurisdiction to undertake the majority of the CFCs core
functions.13 If applied as a threshold test, this would attribute all the income of a
CFC that did not have the necessary people and premises (or exclude all the
income of a CFC that did have the necessary people and premises). If applied as a
proportionate test, this would treat as CFC income all the income that the CFC did
not have the people and premises to earn.
A fourth option that would be a variation on the third option and that would
maintain consistency with work done in other areas of the BEPS Project would
use the nexus approach that was developed in the context of Action Item 5 to
ensure that preferential IP regimes require substantial activity.14 CFC rules could
include a version of the nexus approach as a substance analysis, under which
income earned by the CFC that met the requirements of the nexus approach would
not be included in CFC income, while all other income from qualifying IP assets
as defined by the nexus approach would be treated as CFC income. Under this
version of the nexus approach, all IP income from qualifying IP assets would be
attributed unless the taxpayer could show that the income would qualify for
benefits under a nexus-compliant IP regime in the CFC jurisdiction. If the CFC
jurisdiction did not operate a nexus-compliant IP regime, then this could apply to
all income arising from a qualifying IP asset that was either acquired from or
developed with a related party, and all such income would be attributed unless the
taxpayer could show that it would qualify for benefits under the terms of the
nexus approach itself. As this option would only apply to income arising from
qualifying IP assets, it may need to be combined with another substance analysis
for other types of income (including other IP income).
86.
Substance analyses generally increase the accuracy of CFC rules, but this
increased accuracy must be weighed against the increased complexity and expense of
more fact-intensive substance analyses. Depending on their policy objectives, some
jurisdictions may prioritise accuracy over simplicity, but others may design their rules to
make their substance analyses more mechanical and less complex.
4.2.3 Excess profits analysis

87.
Another approach to defining income is an excess profits analysis, which is not
a feature of any existing CFC rules. This would characterise income in excess of a
normal return earned in low tax jurisdictions as CFC income. Such an approach could,
for instance, be relevant in the context of IP income as generally taxpayers cannot expect
to earn a profit in excess of the normal returns from simply purchasing and selling and
providing services or manufacturing, unless those activities involve the use of IP. In
certain situations, intangibles and risk-shifting transactions among related parties could be
susceptible to systematic mispricing, leading to a profit in excess of the normal returns
that would not occur if the same transactions were undertaken with unrelated parties. This
should mean that an excess profits approach will tend to apply to income from intangibles
and risk shifting.
88.
Depending on their policy objectives, jurisdictions could include a specific entry
criterion so that the excess profits approach would only apply in situations in which the
CFC made use of intangible property acquired from or developed by or with the
assistance of a related party, which means this approach could be combined with
categorical analyses. Alternatively, this approach could be combined with a prove-out
under which the excess profits approach would apply to all CFCs unless they could show
that they did not make use of any intangible property acquired from or developed by or
with the assistance of a related party.15 Jurisdictions with different policy objectives
could, however, not apply an entry criterion or a kick-out and could instead apply the
excess profits analysis to all income earned by the CFC.
89.
The proposed excess profits analysis calculates the normal return and then
subtracts this normal return from the income earned by the CFC. The difference is the
excess return, all of which is treated as CFC income. The normal return means the return
that a normal investor would expect to make with respect to an equity investment. This
normal return could be calculated using the following formula:
normal return = (rate of return) x (eligible equity)
90.
This formula requires a determination, first, of what rate of return to use and,
second, of how to calculate eligible equity.
Rate of return In terms of rate of return, normal investors are unlikely to accept
a risk-free rate of return with respect to an investment with an uncertain income
stream. The normal rate of return with respect to an equity investment therefore
should be a risk-inclusive rate of return that equals the risk-free rate of return
plus a premium reflecting the risk associated with an equity investment, although
some jurisdictions may use the risk-free rate of return depending on their policy
objectives. Economic studies often estimate the risk-inclusive rate as being
approximately 8% to 10%, although this varies by industry, leverage, and
jurisdiction.16
Eligible equity As the excess profits approach is intended to provide an

exemption for normal returns from assets used in connection with the actual
functions carried out in a low-tax jurisdiction, then only equity invested in assets
used in the active conduct of a trade or business, including IP assets, should be
treated as eligible equity. As income subject to taxation under other CFC rules in
the parent jurisdiction would not be included in total returns, jurisdictions could
exclude from eligible equity any equity invested in assets that produced income
that had been subject to taxation under other CFC rules in the parent
jurisdiction.17
91.
The normal return would then be subtracted from all income earned by the CFC
that was not subject to taxation under other CFC rules in the parent jurisdiction. The
excess would be included in CFC income.
92.
For an example of how the excess profits analysis would work, imagine that Sub
B, located in Country B, is a wholly owned subsidiary of Parent, which is located in
Country A. Sub B uses its manufacturing facilities in Country B to manufacture and
distribute Product B, which uses IP purchased from Parent. In Year 1, Sub B spent
600 000 to purchase the rights to IP developed by Parent, and Sub B also invested a total
of 500 000 in its manufacturing facilities. For book purposes, the acquisition of the IP and
the investment in manufacturing facilities result in assets on the balance sheet with a
value equal to the acquisition costs. Both the IP and the manufacturing facilities are used
in Sub Bs active trade or business of manufacturing and distributing Product B. In Year
2, Sub B earned 700 000 in profits from sales of Product B.18 To determine whether Sub
B has attributable income, the excess profits analysis would calculate normal returns
using the following formula:
normal return = (rate of return) x (eligible equity)
93.
If the rate of return for the excess profits approach had been set at 10%, then that
formula would show that the normal return was 110 000 per year. (This is because
110 000 = 10% x (600 000 + 500 000.) The excess returns would then be calculated by
subtracting 110,000 from Sub Bs profits. Sub Bs excess returns for Year 2 would
therefore be 590 000, and all of this income would be treated as attributable income.
94.
An excess profits approach would not rely on formal classification to determine
whether income was included; it would not be necessary to consider where or from
whom, or from which activities income was earned; and it should not lead to income that
does not raise BEPS concerns sheltering income that does. However, the mechanical
nature of this approach must be weighed against whether it could target shifted income
with sufficient accuracy and challenges with quantifying the normal return. Depending on
policy objectives, some countries that prioritise accuracy over a mechanical rule consider
that the excess profits approach must be combined with a mandatory substance-based
exclusion. Other countries may consider that excluding a normal return on eligible equity
is an effective method for identifying CFC income. Because of these concerns, there is no
consensus on whether the excess profits approach should be combined with a mandatory
substance-based exclusion.
4.2.4 Transactional and entity approaches

95.
Regardless of which type of analysis they use to define CFC income,
jurisdictions need to determine whether to apply this analysis on an entity-by-entity basis
or on a transactional basis, which would attribute individual streams of income. Under the
entity approach, an entity that does not earn a certain amount or percentage of attributable
income or an entity that engages in certain activities will be found not to have any
attributable income, even if some of its income would be of an attributable character.
Under the transactional approach, in contrast, the character of each stream of income is
assessed to determine whether that stream of income is attributable. The difference
between the two approaches is that, under the entity approach, either all or none of the
income will be included depending on whether the majority falls within the definition of
CFC income. Under the transactional approach, some income can still be included even if
the majority does not fall within the definition of CFC income, and some income can be
excluded even if the majority does fall within this definition.
96.
The entity approach may reduce administrative burdens in certain situations
because, once tax administrations have determined either that a certain amount of income
earned by an entity is attributable or that the entity engaged in a certain level of activity,
CFC rules are either applicable or not and no further analysis needs to be undertaken. The
entity approach could also reduce taxpayer compliance costs and increase certainty
because taxpayers know that they will only be subject to CFC tax if a significant portion
of their income falls within the definition of attributable income. The entity approach thus
reduces the chances that a taxpayer will be subject to CFC rules if CFC income makes up
only a small portion of its overall income. However, the main disadvantage of the entity
approach is that, by subjecting either all or none of an entitys income to CFC rules, it is
both over-inclusive and under-inclusive. An entity that earns enough CFC income will
have all its income attributed (including income that would not otherwise be attributable),
while an entity with some income that would otherwise be included may be able to escape
CFC rules by swamping that income with income that is not subject to the CFC rules. For
example, an entity that engages primarily in activities that generate active income may be
able to shield a large amount of passive income from CFC rules.19 Also, the entity
approach may not reduce administrative burdens significantly, since this approach still
requires taxpayers to determine whether individual streams of income are attributable or
not, but they may not have to make this determination for all income streams once they
have determined whether they fall above or below the entity threshold.
97.
The transactional approach may increase administrative burdens and compliance
costs relative to the entity approach, and it may require tax administrations to consider a
larger number of companies under their CFC rules, depending on how other elements of
those rules are designed. For instance, if CFC rules set too high a threshold when
considering if a CFC is lowly taxed and apply a proportionate substance analysis, they
may bring a large number of companies within the scope of CFC rules and this may be
compounded if they also apply CFC rules on a transactional basis. Despite these
disadvantages, the transactional approach is generally more accurate at attributing
income. As a transactional approach requires consideration of each stream of income to
determine whether it falls within the definition of CFC income it is better able to target
specific types of income more effectively than the entity approach. It is also possible to
attribute only that income that raises BEPS concerns, and this greater proportionality
suggests that the transactional approach may be more consistent with both the goals of
Action Item 3 and EU law.20 Transactional approaches may, however, require a threshold
to ensure that active businesses that hold a cash surplus do not have to treat the income
from that cash surplus as CFC income. This threshold could be a bright-line de minimis
threshold. In Australia, for example, none of the income of a CFC is attributed if 5% or
less of that CFCs income is passive income. Alternatively, CFC rules could require a

functional analysis to determine how much otherwise attributable income is in fact being
held as a cash surplus. The first type of threshold would reduce administrative burdens
and compliance costs but may not be accurate in all situations, while the second type of
threshold would be more accurate but would increase administrative burdens and
compliance costs.21
Notes
1.
Some of these categories of income are discussed in greater detail in paragraph 78.
2.
See the 2015 Report on Action 8-10: Aligning Transfer Pricing Outcomes With Value
Creation (OECD, 2015) which allocates a risk-free financial return to an entity that
lacks the ability to control risks.
3.
Note that not all of these analyses automatically capture the funding return allocated
to a low-function cash box, but they could all be designed to do so. The categorical
analysis, for example, could be designed to include such a funding return in a
category that was automatically attributed, regardless of the legal classification of the
funding return.
4.
Jurisdictions could also include other categories of income, such as rents and leasing
fees.
5.
For example, CFC rules that attribute insurance income could exclude income from
reinsurance activities that meet all or most of the following features:
6.
The reinsurance contract is priced on arms-length terms.

There is diversification and pooling of risk in the reinsurer.
The economic capital position of the group has improved as a result of
diversification and there is therefore a real economic impact for the group as a
whole.
Both the insurer and reinsurer are regulated entities with broadly similar
regulatory regimes and regulators that require evidence of risk transfer and
appropriate capital levels.
The original insurance involves third party risks outside the group.
The CFC has the requisite skills and experience at its disposal, including
employees in the CFC or a related service company with senior underwriting
expertise.
The CFC has a real possibility of suffering losses.
The digital economy cannot generally be defined separately from other parts of the
economy, but the value of digital goods and services is typically due to intellectual
property. In the context of both general IP income and digital goods and services,
there is not always an identifiable IP asset, but income earned in both contexts is
typically due to IP of some sort. Income from digital goods and services is therefore
not considered a separate category of income but rather a subset of IP income in this
report.
7.
See Public Discussion Draft on BEPS Action Item 8: Hard-to-Value Intangibles

(OECD, 4 June 2015), available at www.oecd.org/ctp/transfer-pricing/discussiondraft-beps-action-8-hard-to-value-intangibles.pdf. At paragraph 9, the Discussion
Draft defines hard-to-value intangibles to include intangibles or rights in intangibles
for which, at the time of their transfer in a transaction between associated enterprises,
(i) no sufficiently reliable comparables exist; and (ii) there is a lack of reliable
projections of future cashflows or income expected to be derived from the five
transferred intangible, or the assumptions used in valuing the intangible are highly
uncertain.
8.
Such a rule was proposed by the US administration as part of its definition of foreign
base company digital income in 2015.
9.
As discussed below, a proportionate substance analysis that considers more

mechanical factors, such as expenditures, may not raise these same administrative and
compliance issues. More mechanical proportionate approaches, however, are looking
at proxies for substantial activities, so they may not always be accurate in their
attribution.
10.
These possible responses, particularly the first and second, may be less appropriate
for Member States of the European Union.
11.
One example of this first option is the U.S. CFC rules. Under the substantial
contribution test that applies to sales income earned by a CFC, income from the sale
of personal property that would normally be treated as attributable will not be
attributable if the facts and circumstances evince that the controlled foreign
corporation makes a substantial contribution through the activities of its employees to
the manufacture, production, or construction of the personal property sold. 26 CFR
1.954-3(a)(4)(iv)(a). The test then provides a list of seven activities that could indicate
that the CFC did make a substantial contribution, all of which essentially consider
whether the CFC was engaged in actual value creation. These activities include (1)
oversight and direction of the activities or process pursuant to which the property is
manufactured, produced, or constructed; (2) activities that are considered in
determining whether the products were substantially transformed or if the assembly or
conversion of component parts into a final product are substantial in nature and
generally considered to constitute the manufacture, production, or construction of
property; (3) material selection, vendor selection, or control of the raw materials,
work-in-process or finished goods; (4) management of manufacturing costs or
capacities (for example, managing the risk of loss, cost reduction or efficiency
initiatives associated with the manufacturing process, demand planning, production
scheduling, or hedging raw material costs); (5) control of manufacturing related
logistics; (6) quality control (for example, sample testing or establishment of quality
control standards); and (7) developing, or directing the use or development of,
product design and design specifications, as well as trade secrets, technology, or other
intellectual property for the purpose of manufacturing, producing, or constructing the
personal property. 26 CFR 1.954-3(a)(4)(iv)(b). The Regulations then provide
examples to illustrate how this facts and circumstances test would apply.
12.
An example of the second option can be found in the UKs CFC rules, which has used
the concepts and guidance developed by the OECD for Article 7 to identify the
groups significant people functions associated with each asset, so that it can be
determined whether the CFC undertakes those functions.
13.
An example of the third option is the South African foreign business establishment
test. Under this test, income of a CFC is not attributable if it is produced by a foreign
business establishment (FBE) that operates at arms length. FBEs are places of
business with a physical structure that are used (or will continue to be used) for at
least one year. These places of business must be where the business of the CFC is
undertaken and they must be suitably equipped and staffed with managerial and
operational employees who render services for the purpose of conducting the CFCs
primary operations.
14.
The nexus approach applies a proportionate analysis to income, under which the
proportion of income that may benefit from an IP regime is the same proportion as
that between qualifying expenditures (i.e. expenditures incurred for Research and
Development (R&D) undertaken by the CFC or unrelated parties) and overall
expenditures (i.e. qualifying expenditures plus acquisition costs and expenditures
incurred for R&D undertaken by related parties). Under the nexus approach, R&D
expenditures are used as a proxy for substantial activities, and they provide a more
mechanical way of determining whether the CFC had the necessary people to earn the
IP income itself.
15.
If either of these provisions were included, intangible property would be defined

broadly to mean something which is not a physical asset or a financial asset, which is
capable of being owned or controlled for use in commercial activities, and which
increases the value received by the company, over and above normal returns. Under
this definition, intangible property should include intangibles that are not legally
protected, such as trade secrets, know-how, customer lists, management systems,
networks, data, goodwill, and other similar items. This approach could be combined
with a source country rule, which would allow income that was earned from the
market of the CFC jurisdiction (e.g., from customers in the CFC jurisdiction or for
services provided in the CFC jurisdiction) to be excluded from the excess profits
calculation.
16.
The risk-free rate of return varies by country, and it can generally be calculated by
reference to an average of the government bond rate over several years. Although it
may at first appear sensible to use the risk-free rate of return in the CFC jurisdiction,
the principle underlying CFC rules is that the parent company has the influence to
determine where the CFC is located (and whether income is shifted to it). The parent
company is therefore likely to make its investment decisions based on the rate of
return in the parent jurisdiction. The risk-free rate of return used to calculate the riskinclusive rate of return could therefore be based on that in the parent jurisdiction. The
equity premium represents the additional expected return an investor requires in order
to be compensated for the uncertainty of the return from a particular investment.
Economic analysis has not conclusively determined what an appropriate equity
premium would be, but it varies across industries and depends on the leverage of the
company, and it is often calculated as being between 3% and 7%.
17.
In terms of how to calculate the equity invested in these assets, one option would be
to use the book value of eligible assets less the liabilities apportioned to the eligible
equity. Book value may sometimes be a more accurate measure than historic costs,
but in other cases, assets are expensed as they are created and therefore not
recognised on the balance sheet at all. Another option would be to use tax basis or tax
acquisition cost for the valuation, as determined under the law of the parent
jurisdiction. Liabilities would need to be apportioned, most likely based on relative
asset values or earnings, potentially with the ability to trace liabilities associated with
non-recourse debt.
18.
For ease of calculation, this example assumes that there are no liabilities apportioned
to the manufacturing facilities.
19.
EU Member States may need to consider whether an entity approach is consistent

with EU law.
20.
Although the European Court of Justice (ECJ) has not yet considered genuine
economic activities on a transaction-by-transaction basis, it appears that CFC rules
that attribute income on a transactional basis would be more narrowly focused on
income that raises concerns and therefore may be more consistent with EU law.
21.
Some jurisdictions combine these two approaches into a hybrid approach and first
determine whether an entity has a sufficient amount of attributable income to be
treated as a CFC before assessing whether specific items of income are to be
attributed. Japans CFC rules provide an example of such a hybrid approach, under
which certain entities are excluded from CFC taxation due to the type of income and
activities, but certain streams of income earned by those entities may still be subject
to CFC taxation. Because this approach ultimately considers different streams of
income rather than just attributing all the income of an entity, it is essentially a
version of a transactional approach.
Bibliography
OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD
5. RULES FOR COMPUTING INCOME 57
Chapter 5
Rules for computing income
98.
This chapter sets out recommendations for the fourth CFC building block on
computing income. Once CFC rules have determined that income is attributable, they
must then consider how much income to attribute.
5.1 Recommendations
99.
Computing the income of a CFC requires two different determinations: (i) which
jurisdictions rules should apply; and (ii) whether any specific rules for computing CFC
income are necessary. The recommendation for the first determination is to use the rules
of the parent jurisdiction to calculate a CFCs income. The recommendation for the
second determination is that, to the extent legally permitted, jurisdictions should have a
specific rule limiting the offset of CFC losses so that they can only be used against the
profits of the same CFC or against the profits of other CFCs in the same jurisdiction.
5.2 Explanation
100. The first recommendation focuses on rules that are used to calculate taxable
income. Four options were considered to arrive at the first recommendation.
1. One option would be to apply the law of the parent jurisdiction (i.e., the
jurisdiction that is applying the CFC rules), which would be logically consistent
with BEPS concerns particularly if CFC rules focus on the erosion of the parent
jurisdictions tax base. This option would also reduce costs for the tax
administration. Jurisdictions could achieve a broadly similar outcome by starting
with the income calculated according to the rules of the CFC jurisdiction and then
adjusting the income in line with the rules of the parent jurisdiction.
2. A second option would be to use the CFC jurisdictions rules for computing
income, but this would be inconsistent with the goals of Action Item 3 as using
the CFC jurisdictions rules may allow for less income to be attributed. This could
also create complexity and increase the administration costs for the tax
administration that would have to apply unfamiliar rules.
3. A third option would be to allow taxpayers to choose either jurisdictions
computational rules, but this is likely to create opportunities for tax planning.
4. A final option would be to compute income using a common standard. For
example, some jurisdictions instruct taxpayers to use the International Financial
Reporting Standards (IFRS). The advantage of this option is that it could in theory
lead to international consistency as all CFCs and parent jurisdictions would be
58 5. RULES FOR COMPUTING INCOME

using the same rules for calculating CFC income, regardless of the residence of
either the CFC or the parent. Since most countries do not currently use such
standards when calculating taxable income, however, this option may increase
both administrative and compliance costs if taxpayers have to recalculate the
income of the CFC according to standards that are applied by neither the parent
jurisdiction nor the CFC jurisdiction.
101. Based on this analysis, the first option is recommended because it is consistent
with the goals of the BEPS Action Plan (OECD, 2013) and it reduces administrative
costs.
102. In arriving at the second recommendation, the question of how to treat losses was
considered. Most issues involving losses can be addressed by reference to pre-existing
domestic laws in the parent jurisdiction.1 These include questions about whether the use
of losses should be limited to offset against profits of a similar character, which would
mean that, for example, passive losses of a CFC could only be used against passive
profits if that limit applied in domestic laws on losses.
103. Another issue is whether CFC losses should only be offset against CFC profits or
whether they can also be used against profits in the parent company. Most existing CFC
rules only allow the losses of the CFC to be offset against the profits of that CFC or CFCs
in the same jurisdiction, and this is the recommended approach since allowing CFC losses
to be offset against the profits of parent companies or CFCs in other jurisdictions could
encourage manipulation of losses in the CFC jurisdiction.2 However this may not be an
issue that is already dealt with in rules that apply in the domestic context, so a separate
CFC-specific rule may be required. A rule that prevents CFC losses being set off against
non-CFC profits could apply alongside a rule that limits the offset of losses to similar
types of profits so that passive losses of a CFC could only be offset against passive profits
of that same CFC. Any concerns about over-taxation resulting from this approach could
be mitigated by allowing CFC losses to be carried forwards or backwards for use against
profits arising in other years if such treatment is otherwise permitted under the laws of the
parent jurisdiction3.
104. The recommendation on loss limitation can be illustrated with the following
example. Parent is a resident in Country A and Sub B is a wholly owned subsidiary in
Country B that is a CFC. Country A has CFC rules. In year 1, Parent earns 1000 and Sub
B earns 500 of CFC income. Parent has 200 in losses and Sub B has 1000 in losses. This
is illustrated in Figure 5.1.
Figure 5.1
Loss limitation
Parent
1000 income
200 losses
Country A
Country B
500 CFC income
Sub B
1000 losses
5. RULES FOR COMPUTING INCOME 59
105. If Country As CFC rules do not limit the losses of Sub B to the income of Sub B,
then Parent will only be taxed on 300 because the full 1200 of losses will be offset against
the full 1500 of income. If, however, Country As CFC rules do limit the losses of Sub B
to the income of Sub B, then Parent will be taxed on 800 (1000 - 200), and no income
will be attributed to Parent from Sub B because all of Sub Bs attributable income will be
offset by the losses, and the remaining 500 could potentially, depending on Country As
CFC rules, be carried forward to be used against Sub Bs future income. This limit will
prevent use of CFCs to reduce the taxable income in the parent jurisdiction.
106. If Country A already has a rule that does not permit passive losses to offset active
income, this rule can be combined with the recommended loss limitation as shown in
Figure 5.2.
Figure 5.2
Loss limitation with pre-existing passive limitation

1000 passive income
Parent
200 active losses
Country A
Country B
500 passive CFC income
Sub B
1000 passive losses
107. If all of Parents income is passive and all of Parents losses are active, while all
of Sub Bs income and losses are passive, Parent would be taxed on 1000 of its income.
This is because Parents active losses could not be used against its passive income and
because Sub Bs passive losses would offset all of its passive income, and the excess
passive losses could not be used to offset Parents income under the CFC loss limitation
rule.
108. Another concern is potential loss importation. This concern could arise if a CFC
has losses that date from before its characterisation as a CFC or if another activity bearing
losses is transferred to the CFC to soak up profits. If losses are only available to be offset
against CFC profits then the fact that the CFC incurred losses in prior years may not be a
problem. However, there may be concerns if the activity of the CFC has changed and
there is evidence that either profits or losses have been shifted to the CFC to reduce the
amount of income that is ultimately taxed. Many countries have domestic law provisions
designed to prevent tax avoidance that deal with these situations and these could equally
be applied to the CFCs computation of income.
60 5. RULES FOR COMPUTING INCOME
Notes
1.
Using domestic law provisions to answer questions about the treatment of specific
items such as losses would create complications if CFC income is generally
calculated using the laws of a different jurisdiction but this is another reason
supporting the use of the parent jurisdictions rules and the first recommendation
above.
2.
Jurisdictions could also implement rules permitting parent company losses to be used
against CFC profits. This situation is less likely to raise BEPS concerns since this
would lead to fewer losses in the parent company and fewer profits in the CFC.
3.
Member States of the European Union should determine whether a restriction of CFC
losses would be consistent with the fundamental freedoms of the European Union as
considered in Chapter 1.
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
6. RULES FOR ATTRIBUTING INCOME 61
Chapter 6
Rules for attributing income
109. This chapter sets out recommendations for the fifth CFC building block on
attributing income. Once the amount of CFC income has been calculated, the next step is
determining how to attribute that income to the appropriate shareholders in the CFC.
6.1 Recommendations
110. Income attribution can be broken into five steps: (i) determining which taxpayers
should have income attributed to them; (ii) determining how much income should be
attributed; (iii) determining when the income should be included in the returns of the
taxpayers; (iv) determining how the income should be treated; and (v) determining what
tax rate should apply to the income.
111.
The recommendations for these steps are as follows:
1. The attribution threshold should be tied to the minimum control threshold when
possible, although countries can choose to use different attribution and control
thresholds depending on the policy considerations underlying CFC rules.
2. The amount of income to be attributed to each shareholder or controlling person
should be calculated by reference to both their proportion of ownership and their
actual period of ownership or influence (influence could for instance be based on
ownership on the last day of the year if that accurately captures the level of
influence).
3. and 4. Jurisdictions can determine when income should be included in taxpayers
returns and how it should be treated so that CFC rules operate in a way that is
coherent with existing domestic law.
5. CFC rules should apply the tax rate of the parent jurisdiction to the income.1
6.2 Explanation
112. In arriving at the above recommendations, each of the five steps was considered
in greater detail.
6.2.1 Which taxpayers should income be attributed to?

113.
In order to attribute income correctly, jurisdictions must first determine to whom the
income is to be attributed. Many existing CFC rules tie this determination to the earlier
determination of control, so that, if a taxpayer met the minimum control threshold, then that
taxpayer would also have income attributed to it. In jurisdictions that apply a concentrated
62 6. RULES FOR ATTRIBUTING INCOME

ownership rule, CFC income is generally attributed not just to taxpayers who meet the overall
control threshold but also to all resident taxpayers who have the minimum level of control
(e.g., 10%) to be considered when calculating whether the control threshold has been met.
The benefits of tying the attribution threshold to the minimum control threshold include
administrative simplicity and reduced compliance burdens. This also ensures that taxpayers
have enough influence to gather information on the activities and income of the CFC.
However, using control rules to determine attribution could potentially lead to
under-inclusion if it is believed that a minority ownership could in fact have sufficient
influence over the business decisions of a CFC to raise Base Erosion and Profit Shifting
(BEPS) concerns, but this disadvantage can be reduced if the control rules aggregate the
interests of minority shareholders or otherwise do not limit control to majority owners.
114. Some CFC rules may, however, use a different rule to determine which taxpayers
have CFC income attributed to them, based on the theory that the amount of ownership
that is sufficient for control may not be the same as the level that is sufficient for
attribution. Jurisdictions that want to deter even minority investments in CFCs may use a
lower attribution threshold, while those that are instead focused on deterring investments
by residents that can influence the CFC may set their attribution threshold higher than
their control threshold, particularly if their control threshold considers concentrated
ownership. Further, CFC rules that look at de facto control or otherwise establish control in a
less mechanical way may need to have different control and attribution tests to ensure that the
correct taxpayers have income attributed to them. Although having separate rules for
attribution and control may in theory create additional compliance costs or administrative
burdens, actual attribution of profits may only occur relatively infrequently due to the
deterrent nature of CFC rules. Best practice would therefore be either to tie the attribution
threshold to the control threshold or to use another attribution threshold that attributed income
to, at minimum, taxpayers who could influence the CFC.
6.2.2 How much income should be attributed?

115. Once CFC rules have determined which taxpayers will have income attributed to
them, they must then determine how much of that income to attribute. All existing CFC rules
attribute income in proportion to each taxpayers ownership, but they differ in how they treat
taxpayers whose ownership lasted for only a portion of the year. Some jurisdictions attribute
the entire portion of income based on ownership on the last day of the year. Whilst this could
lead to inaccurate attribution and could create opportunities for tax planning, this may
accurately capture whether or not the taxpayer was able to influence the CFC if voting or
other power is determined based on ownership on the last day of the year or if there are other
anti-abuse rules to prevent inappropriate under-attribution of profits. Other jurisdictions
attribute income based on the period of ownership, which results in taxpayers being taxed on
an amount that is similar to their actual share of the CFC profits. In addition, applying such a
rule appears unlikely to add significant compliance costs in practice.2 Either of these
approaches to determining how much income should be attributed can qualify as best practice
so long as the determination based on the last day of the year accurately captures the
taxpayers influence.3
116. Attribution rules should also ensure that it is not possible to attribute more than 100%
of the income of the CFC. This situation could arise, for example, where legal control and
economic control together led to more than 100% control. Any rule designed to prevent overattribution, however, should include anti-avoidance provisions to ensure that it is not used to
prevent taxpayers from having an amount attributed to them that accurately captures their
influence.
6. RULES FOR ATTRIBUTING INCOME 63
6.2.3 When should the income be included in tax returns?

117. Many existing CFC rules specify that the attributed income must be included in the
taxpayers taxable income for the taxable year in which the end of the CFCs accounting
period ends, although some countries have slightly different rules for determining the year in
which the attributed income should be included. Koreas CFC rules, for example, state that
the attributed income will be included on the return for the taxable year to which the 60th
day from the end of the CFCs fiscal year belongs. Both approaches seem equally effective
at combatting BEPS, so there is no recommendation for this step and countries are free to
adopt provisions that ensure that CFC rules are coherent with general domestic law
provisions.
6.2.4 How should the income be treated?

118. A further question to be answered when attributing income to taxpayers is how that
income will be treated in the parent jurisdiction. Existing CFC rules take several different
approaches, including treating attributed income as a deemed dividend or treating it as having
been earned by the taxpayer directly (i.e., the CFC is essentially treated as a partnership or
flow-through entity but only for the purposes of attributing CFC income). If attributed income
is treated as a deemed dividend, then the tax treatment can build on existing dividend rules
with which taxpayers and tax administrations are already familiar. However jurisdictions may
not want to treat attributed income as a deemed dividend for all tax purposes and therefore the
limit of any deeming will need to be made clear. In contrast, treating attributed income as if
it were earned directly by shareholders of the CFC is likely to reduce the need for any
separate characterisation rules since the income will be characterised according to existing
domestic rules. Both approaches seem equally appropriate in terms of dealing with BEPS and
therefore the question of how to treat attributed income could be left for jurisdictions to decide
in a manner that is coherent with domestic law.
6.2.5 What tax rate should apply to CFC income?

119. Finally, attribution of income raises the question of how that income is taxed once it is
attributed. Whilst existing CFC rules subject CFC income to taxation at the rate that would
apply to the parent company in the parent jurisdiction, a second option would be to apply a
top-up tax. A top-up tax, which builds closely on the concept of a minimum tax, would only
subject CFC income to the difference between the tax paid and a set threshold. This threshold
could be tied to the tax rate exemption used to determine whether CFC rules apply to a given
CFC, or it could be an entirely separate threshold. A top-up tax would set a floor for the rate at
which CFC income is taxed.
120. To illustrate how a top-up tax could work, imagine a parent jurisdiction with a flat
30% statutory tax rate and a CFC rule that applied only to CFCs that were subject to an
effective tax rate of less than 12%. If the parent jurisdiction applied a top-up tax to a CFC that
was subject to a 0% effective tax rate, it would only tax the CFC income at 12%, instead of its
normal rate of 30%. This approach could mean that Multinational Corporations (MNCs)
located in higher-tax jurisdictions with CFC rules would not be at a competitive disadvantage
relative to MNCs located in some lower-tax jurisdictions. However, they would remain at a
competitive disadvantage compared to both MNCs located in jurisdictions with CFC rules but
with a tax rate below the top-up tax rate and MNCs located in jurisdictions without CFC
rules. The top-up tax would also not necessarily eliminate incentives to shift profits away
from higher tax jurisdictions. For instance, in the example above, MNCs located in the parent
jurisdiction would have a considerable incentive to shift their income into the CFC
64 6. RULES FOR ATTRIBUTING INCOME

jurisdiction because the maximum rate at which they would be taxed on their CFC income
would be 12%, so 18 percentage points lower than the rate that would apply if their income
were earned in the parent jurisdiction. The top-up tax may therefore not be consistent with all
policy objectives that jurisdictions use their CFC rules to achieve. For some jurisdictions,
however, it could be seen as a middle way that would enable jurisdictions to address some
degree of competitiveness concerns. If the level set for the top-up tax rate was the same as that
as the tax rate exemption, it may also make CFC rules more internally consistent.
Notes
1.
To limit competitiveness concerns, countries could also consider a top-up tax. This
may be more appropriate where a more approximate or mechanical rule could
potentially capture active income. See paragraphs 119-120 for a more detailed
explanation of a top-up tax.
2.
It is assumed that such a rule would attribute income if the taxpayer held an interest in
the CFC for a portion of the year but did not hold that interest on the last day of the
year. If not, the recommended rule could be combined with a rule for imputing CFC
income when CFC shares are disposed of in the middle of the year.
3.
One possible way of capturing influence would be to combine a rule that considers
ownership on the last day of the year with reporting requirements on ownership
throughout the year.
7. RULES TO PREVENT OR ELIMINATE DOUBLE TAXATION 65
Chapter 7
Rules to prevent or eliminate double taxation
121. This chapter sets out recommendations for the sixth and final CFC building block
on rules to prevent or eliminate double taxation. As discussed in Chapter 1, one of the
fundamental policy considerations raised by CFC rules is how to ensure that these rules
do not lead to double taxation, which could pose an obstacle to international
competitiveness, growth and economic development.
7.1 Recommendations
122. CFC rules should include provisions to ensure that the application of these rules
does not lead to double taxation. There are at least three situations where double taxation
may arise: (i) situations where the attributed CFC income is also subject to foreign
corporate taxes; (ii) situations where CFC rules in more than one jurisdiction apply to the
same CFC income; and (iii) situations where a CFC actually distributes dividends out of
income that has already been attributed to its resident shareholders under the CFC rules or
a resident shareholder disposes of the shares in the CFC. However, double taxation
concerns could arise in other situations, for instance where there has been a transfer
pricing adjustment between two jurisdictions and a CFC charge arises in a third
jurisdiction.1 CFC rules should be designed to ensure that these and other situations do
not lead to double taxation.
123. The recommendation for addressing the first two situations is to allow a credit for
foreign taxes actually paid, including CFC tax assessed on intermediate companies. The
actual tax paid (this can also include withholding taxes) should include all taxes borne by
the CFC that are taxes on income that have not qualified for other relief, and that are not
higher than the taxes due on the same income in the parent jurisdiction. The
recommendation for addressing the third situation is to exempt dividends and gains on
disposition of CFC shares from taxation if the income of the CFC has previously been
subject to CFC taxation, but the precise treatment of such dividends and gains can be left
to individual jurisdictions so that provisions are coherent with domestic law. It is left to
individual jurisdictions to address other situations giving rise to double taxation, but the
overall recommendation for this building block is to design CFC rules to ensure that they
do not lead to double taxation.
66 7. RULES TO PREVENT OR ELIMINATE DOUBLE TAXATION
7.2 Explanation
7.2.1 Issues with respect to relief for foreign corporate taxes
124. Perhaps the most obvious situation where the application of CFC rules may lead
to double taxation is the one mentioned above under point (i) where the CFC income is
subject to taxation in the CFC jurisdiction as well as to CFC taxation in the parent or
controlling parties jurisdiction.
125. Most jurisdictions address the situation where the CFC income is subject to
taxation in both the CFC jurisdiction and the parent jurisdiction by providing for an
indirect foreign tax credit that credits taxes that were incurred by a different taxpayer.
This approach eliminates double taxation more comprehensively than the deduction
method as it directly sets off the foreign tax against domestic tax rather than reducing the
tax base to which the residence tax applies. Given that the purpose of a CFC regime is to
assert taxing rights over income that has been shifted to another jurisdiction, the
exemption method is not an appropriate method for granting relief in this context since it
would undermine the application of CFC rules. An indirect foreign tax credit is generally
limited to the amount of effective double taxation. This is addressed in most countries
rules by limiting relief to the lesser of the domestic tax or the foreign tax actually paid.
The focus on the actual tax paid ensures that relief is not given if the foreign tax is subject
to a refund or reimbursement claim. The actual tax paid (this can also include withholding
taxes) should include all taxes borne by the CFC that are equivalent to taxes on income,
that have not qualified for other relief, and that are not higher than the taxes due on the
same income in the parent jurisdiction.
7.2.2 Issues with respect to relief for CFC taxation in multiple jurisdictions
126. Additional issues may arise when the income and profits arising in a CFC are
taxed under the CFC rules operating in more than one jurisdiction, and this scenario may
become more common in the future. If, for example, a subsidiary is treated as a CFC
under the rules operating in multiple jurisdictions, then the subsidiarys income could
potentially be taxed by the CFC jurisdiction and by any other jurisdiction that considers
the subsidiary to be a CFC. Again an indirect foreign tax credit could be applied in this
situation but in order to provide such a credit countries may need to change their double
taxation relief provisions in order for CFC tax paid in an intermediate country to qualify
as a foreign tax eligible for relief. There should also be a hierarchy of rules to determine
which countries should have priority, and this hierarchy could prioritise the CFC rules of
the jurisdiction whose resident shareholder is closer to the CFC in the chain of ownership.
127.
This rule hierarchy is illustrated in Figure 7.1.
Figure 7.1
Interaction of CFC rules
A Parent
Country A
B Sub
Country B
Country C
C Sub
Income
128. In this situation, C Sub is both a direct CFC of B Sub and an indirect CFC of A
Parent, and B Sub is also a CFC of A Parent. If both Country A and Country B have CFC
rules, there should be a rule hierarchy to determine which countrys CFC rules will apply
first.
129. Figure 7.1 could raise two different issues, depending on the tax rates of Country
A and Country B. If Country C has a tax rate of 10%, Country B has a tax rate of 20%,
and Country A has a tax rate of 30%, then both Country B and Country A will want to
collect their full amount of tax, potentially only giving a credit for Country Cs tax. If the
income of C Sub is 100, this would mean that Country A would want to collect 20 (i.e.,
30 minus 10) and Country B would want to collect 10 (i.e., 20 minus 10). The rule
hierarchy suggested above, where Country Bs rules apply prior to Country As rules,
would require that Country A provide a tax credit for taxes paid to both Country C and
Country B. This would mean that Country C would collect 10, Country B would collect
10 (i.e., 20 minus 10), and Country A would also collect 10 (i.e., 30 minus 20)2.
130. If, in contrast, Country C still has a tax rate of 10% and Country A still has a tax
rate of 30%, but Country B has a tax rate of 40%, then Country A would no longer collect
any taxes if it granted a tax credit for taxes paid to Country B. Although this may raise
concerns from the perspective of Country A, this is likely to be consistent with the
principle underlying Country As CFC rules as C Sub would be fully taxed on its income
at a tax rate greater than that in Country A. Also, if Country B has a tax rate that is higher
than the tax rate in Country A, it is less likely that the tax base that has been eroded is that
of Country A. It is more likely that in this situation, if it were to exist, it would be
Country Bs tax base that was being eroded. It would therefore be appropriate for Country
A not to apply its CFC rules if the profits of C Sub are taxed at an equivalent or higher
effective tax rate in the jurisdiction of an intermediate party. The recommended rule
hierarchy in both situations is therefore for Country A to apply its CFC rules only after
Country B has applied its CFC rules (or to provide a credit for CFC taxes paid to Country
B, which may be simpler).
68 7. RULES TO PREVENT OR ELIMINATE DOUBLE TAXATION
7.2.3 Relief for subsequent dividends and capital gains

131. The third situation in which CFC taxation could lead to double taxation is where
(i) the CFC actually makes distributions out of the CFC income or (ii) resident taxpayers
of a CFC dispose of their CFC shares. With regards to the first scenario, most
jurisdictions provide some type of relief for subsequent dividends paid by a CFC. In the
majority of these jurisdictions, the dividends will qualify for the regular participation
exemption for foreign dividends. If CFC rules require a level of control that is at least
equal to the same percentage of shareholding as the participation exemption, then the
participation exemption is likely to apply. Therefore an additional relief provision will
only be necessary if there is no participation exemption or the participation exemption
does not apply. In these cases, most jurisdictions apply a separate provision that also
exempts the dividends even if they do not qualify for the normal participation exemption
(or if there is no general participation exemption).
132. There may however be difficulties with the exemption method if only part of the
CFC income has been attributed to a resident taxpayer or if a CFC is indirectly held
through another non-resident company which does not have attributable CFC income. In
these cases it may be hard to determine whether dividends have, in fact, been paid out of
attributed CFC income and are therefore subject to double taxation. To address these
difficulties, countries tend to adopt relatively mechanical approaches that assume that
dividends are likely to have been paid out of previously attributed CFC income. These
approaches include, for example, limiting the dividend exemption to the amount of profits
generated by the CFC during the tax years when CFC rules have applied.
133. A further issue that arises with regards to the first scenario occurs when the CFC
jurisdiction applies withholding taxes when the dividend is paid out. Since these
withholding taxes represent income taxation at the level of the CFC jurisdiction, it may be
appropriate to provide relief for withholding taxes paid in respect of the CFC income.3
134. With regards to the second scenario, double taxation may also arise where the
shares of a CFC are disposed of and the taxpayer holding the shares has previously been
taxed on undistributed income of the CFC. Following the logic above in respect of
dividends, countries may choose not to tax subsequent gains realised by a taxpayer in
respect of the shares of a CFC to the extent that the same amounts have previously been
taxed under CFC rules operating in the taxpayers jurisdiction. However, given countries
different approaches to taxing gains on assets, the mechanism for providing relief is likely
to vary to accommodate the specific tax features in each jurisdiction, and this
recommendation does not mean that countries that do not otherwise exempt gains on
disposition should change their overall rules to comply with this recommendation for
CFC rules.
7.2.4 Other situations

135. The report recognises that double taxation can also arise in other ways, for
instance through the interaction of CFC rules and transfer pricing rules. These are not
new issues but countries will need to consider whether their existing double taxation
relief provisions are effective in relieving all instances of double tax.4
7.2.5 Tax treaty provisions on the elimination of double taxation

136. The way in which a country should eliminate double taxation that may result from
its CFC rules also needs to take account of that countrys tax treaty obligations.
137. The elimination of double taxation found in bilateral tax treaties may vary
considerably from the wording of Articles 23 A and 23 B of the Model Tax Convention
on Income and on Capital: Condensed Version (OECD, 2010). States should therefore
carefully review the relevant provisions of their tax treaties when designing their CFC
regimes in order to make sure that they are not inadvertently required to apply the
exemption method to income that they wish to tax under these regimes.
Notes
1.
In certain circumstances, the interaction of CFC rules and transfer pricing rules could
give rise to double taxation issues. Whilst such circumstances may not be common, it
is important that countries rules contain provisions to eliminate any double taxation
that would otherwise result.
2.
This analysis assumes that Country A does not have a tax rate exemption or that the
cut-off for Country As tax rate exemption is greater than 20%.
3.
The relief for withholding tax in a tax treaty situation is discussed in the Commentary
of the OECD Model Tax Convention in paragraph 39 of Article 10.
4.
For example, Parent A resident in Country A owns two subsidiaries, Sub B resident in
Country B and Sub C resident in Country C. A transfer pricing adjustment is made
between B and C resulting in higher profits in C. If Country A applies its CFC rules to
both B and C it will need to give relief for the reduced foreign tax paid in B and the
increased tax paid in C. In practice it seems more likely that where there are transfer
pricing adjustments they will decrease the profits of a CFC and increase the profits of
a more highly taxed subsidiary that is outside the scope of CFC rules. Therefore
countries will need to be aware of any subsequent adjustments to the tax paid by a
CFC to ensure that they do not provide relief for tax that has been repaid, and they
should make it possible to reassess CFC taxation in similar situations even if the
statute of limitation for such reassessments has passed.
Bibliography
2010, OECD Publishing, Paris, http://dx.doi.org/10.1787/mtc_cond-2010-en.

AND DEVELOPMENT

(23 2015 30 1 P) ISBN 978-92-64-24114-5 2015-01
Designing Effective Controlled Foreign Company

Rules
Contents
Introduction
Chapter 1. Policy considerations and objectives
Chapter 2. Rules for defining a CFC
Chapter 3. CFC exemptions and threshold requirements
Chapter 4. Definition of CFC income
Chapter 5. Rules for computing income
Chapter 6. Rules for attributing income
Chapter 7. Rules to prevent or eliminate double taxation

isbn 978-92-64-24114-5
23 2015 30 1 P
9HSTCQE*cebbef+

Project
Limiting Base Erosion

Involving Interest Deductions
and Other Financial Payments
Limiting Base Erosion

Involving Interest
Deductions and Other
Financial Payments,
Action 4 2015 Final
Report

OECD (2015), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241176-en
ISBN 978-92-64-24116-9 (print)

ISBN 978-92-64-24117-6 (PDF)

OECD 2015
ord
ore
Foreword
century ago. eaknesses in the current rules create opportunities for base erosion and profit
organisations such as the International Monetary Fund, the orld Bank and the United
LIMITING BASE EROSION INVOLVING INTEREST DEDUCTIONS AND OTHER FINANCIAL PAYMENTS OECD 2015
ord
ore
4F

TABLE OF CONTENTS 5
Table of contents

Introduction ..................................................................................................................... 15
Use of interest and payments economically equivalent to interest for base erosion and
profit shifting .................................................................................................................... 15
BEPS Action Plan and interest expense ............................................................................ 18
Existing approaches to tackle base erosion and profit shifting involving interest ............ 19
European Union law issues ............................................................................................... 22
Chapter 1 Recommendations for a best practice approach ....................................... 25
Chapter 2 Interest and payments economically equivalent to interest ..................... 29
Chapter 3 Who a best practice approach should apply to ......................................... 33
Entities which are part of a multinational group ............................................................... 33
Entities which are part of a domestic group ...................................................................... 34
Standalone entities which are not part of a group ............................................................. 34
De minimis threshold ........................................................................................................ 35
Chapter 4 Applying a best practice approach based on the level of interest expense
or debt .............................................................................................................................. 37
Applying the best practice approach to limit the level of interest expense or debt in an
entity ................................................................................................................................. 37
Applying the best practice approach to limit an entitys gross interest expense or net
interest expense ................................................................................................................. 38
An option to exclude certain public-benefit projects ........................................................ 39
Chapter 5 Measuring economic activity using earnings or asset values ................... 43
Measuring economic activity using earnings .................................................................... 43
Measuring economic activity using asset values .............................................................. 44
Proposed approach ............................................................................................................ 45
Chapter 6 Fixed ratio rule ............................................................................................. 47
Aim of a fixed ratio rule.................................................................................................... 47
Operation of a fixed ratio rule ........................................................................................... 47
Setting a benchmark fixed ratio ........................................................................................ 48
Changes over time ............................................................................................................. 54
Chapter 7 Group ratio rule ........................................................................................... 57
Aim of a group ratio rule................................................................................................... 57
Option to apply different group ratio rules, or no group ratio rule ................................... 58
Obtaining financial information on a group ...................................................................... 58
Definition of a group ......................................................................................................... 59
6 TABLE OF CONTENTS
Operation of a group ratio rule .......................................................................................... 60
Stage 1: Determine the groups net third party interest/EBITDA ratio ............................ 60
Stage 2: Apply the groups ratio to an entitys EBITDA .................................................. 63
Addressing the impact of loss-making entities on the operation of a group ratio rule...... 65
Chapter 8 Addressing volatility and double taxation ................................................. 67
Measuring economic activity using average EBITDA ..................................................... 67
Carry forward and carry back of disallowed interest and unused interest capacity .......... 68
Chapter 9 Targeted rules .............................................................................................. 71
Aim of targeted rules......................................................................................................... 71
Targeted rules to prevent avoidance of the general rules .................................................. 72
Targeted rules to address other base erosion and profit shifting risks .............................. 72
Definition of "related parties" and "structured arrangements" .......................................... 73
Chapter 10 Applying the best practice approach to banking and insurance
groups ............................................................................................................................... 75
Chapter 11 Implementing the best practice approach ............................................... 79
Implementation and co-ordination .................................................................................... 79
Transitional rules............................................................................................................... 79
Separate entity and group taxation systems ...................................................................... 80
Interaction of the best practice approach with hybrid mismatch rules under Action 2 ........ 81
Interaction of the best practice approach with controlled foreign company rules under
Action 3 ............................................................................................................................. 81
Interaction of the best practice approach with other rules to limit interest deductions ..... 82
Interaction of the best practice approach with withholding taxes ..................................... 82
Annex A. European Union Law issues.......................................................................... 85
Annex B. Data on companies affected by a benchmark fixed ratio at different
levels ................................................................................................................................. 87
Annex C. The equity escape rule ................................................................................... 91
Annex D. Examples ........................................................................................................ 93
Boxes
Box 1.
Example of the impact of tax on the location of interest expense ................ 16
Figures
Figure 1.1
Figure D.1
Figure D.2
Figure D.3
Figure D.4
Figure D.5
Figure D.6
Overview of the best practice approach ....................................................... 25

Applying factors to set a benchmark fixed ratio within the corridor .......... 100
Companies held by an individual................................................................ 102
Companies held by a limited partnership ................................................... 103
Joint venture entity controlled by an investing group ................................ 104
Joint venture entity which is not controlled by any investing group .......... 105
Holding structure headed by an investment entity ..................................... 106
TABLE OF CONTENTS 7
Tables
Table B.1
Table B.2
Table B.3
Table B.4
Table D.1
Table D.2
Table D.3
Table D.4
Table D.5
Table D.6
Table D.7
Table D.8
Table D.9
Table D.10
Table D.11
Table D.12
Tabulations for multinational and non-multinational companies, excluding

companies with negative EBITDA, 2009-2013 ........................................... 87
Tabulations for multinational and non-multinational companies, excluding
companies with negative EBITDA, average for 2009-2013 ........................ 88
Tabulations for multinational and non-multinational companies,
excluding companies with negative EBITDA, average for 2009-2013 ....... 88
Tabulations for large cap and small cap multinational companies,
excluding companies with negative EBITDA, 2009-2013 ........................... 89
How the best practice approach may be combined with other interest
limitation rules .............................................................................................. 95
Application of the best practice approach and other interest
limitation rules .............................................................................................. 95
Operation of the fixed ratio rule ................................................................... 97
Impact of losses on the operation of the fixed ratio rule .............................. 98
Operation of a group ratio rule based on a net third party
interest/EBITDA ratio ................................................................................ 100
Applying a group's ratio to an entity's tax-EBITDA or
accounting-EBITDA................................................................................... 107
The impact of losses on the operation of a group ratio rule ....................... 109
Applying an upper limit on interest capacity.............................................. 110
Groups with negative consolidated EBITDA ............................................. 111
Excluding loss-making entities from the calculation of group EBITDA
for a profitable group .................................................................................. 112
for a loss-making group .............................................................................. 113
Fixed ratio rule using EBITDA based on a three year average ................... 114
BEPS
BIAC
Business and Industry Advisory Committee
CFC
CIV
Collective Investment Vehicle
EBIT
Earnings before interest and taxes
EBITDA
Earnings before interest, taxes, depreciation and amortisation
EU
European Union
GAAP
Generally Accepted Accounting Principles
IFRS
JV
Joint Venture
OECD
PwC
PricewaterhouseCoopers
TFEU
Treaty on the Functioning of the European Union
USD
United States Dollar
Executive summary
It is an empirical matter of fact that money is mobile and fungible. Thus,

multinational groups may achieve favourable tax results by adjusting the amount of debt
in a group entity. The influence of tax rules on the location of debt within multinational
groups has been established in a number of academic studies and it is well known that
groups can easily multiply the level of debt at the level of individual group entities via
intra-group financing. Financial instruments can also be used to make payments which
are economically equivalent to interest but have a different legal form, therefore escaping
restrictions on the deductibility of interest. Base Erosion and Profit Shifting (BEPS) risks
in this area may arise in three basic scenarios:
Groups placing higher levels of third party debt in high tax countries.
Groups using intragroup loans to generate interest deductions in excess of the
groups actual third party interest expense.
Groups using third party or intragroup financing to fund the generation of tax
exempt income.
To address these risks, Action 4 of the Action Plan on Base Erosion and Profit
Shifting (BEPS Action Plan, OECD, 2013) called for recommendations regarding best
practices in the design of rules to prevent base erosion through the use of interest
expense. This report analyses several best practices and recommends an approach which
directly addresses the risks outlined above. The recommended approach is based on a
fixed ratio rule which limits an entitys net deductions for interest and payments
economically equivalent to interest to a percentage of its earnings before interest, taxes,
depreciation and amortisation (EBITDA). As a minimum this should apply to entities in
multinational groups. To ensure that countries apply a fixed ratio that is low enough to
tackle BEPS, while recognising that not all countries are in the same position, the
recommended approach includes a corridor of possible ratios of between 10% and 30%.
The report also includes factors which countries should take into account in setting their
fixed ratio within this corridor. The approach can be supplemented by a worldwide group
ratio rule which allows an entity to exceed this limit in certain circumstances.
Recognising that some groups are highly leveraged with third party debt for non-tax
reasons, the recommended approach proposes a group ratio rule alongside the fixed ratio
rule. This would allow an entity with net interest expense above a countrys fixed ratio to
deduct interest up to the level of the net interest/EBITDA ratio of its worldwide group.
Countries may also apply an uplift of up to 10% to the group's net third party interest
expense to prevent double taxation. The earnings-based worldwide group ratio rule can
also be replaced by different group ratio rules, such as the "equity escape" rule (which
compares an entitys level of equity and assets to those held by its group) currently in
place in some countries. A country may also choose not to introduce any group ratio rule.
If a country does not introduce a group ratio rule, it should apply the fixed ratio rule to
entities in multinational and domestic groups without improper discrimination.
The recommended approach will mainly impact entities with both a high level of net
interest expense and a high net interest/EBITDA ratio, in particular where the entitys
ratio is higher than that of its worldwide group. This is a straightforward approach and
ensures that an entitys net interest deductions are directly linked to the taxable income
generated by its economic activities. An important feature of the fixed ratio rule is that it
only limits an entitys net interest deductions (i.e. interest expense in excess of interest
income). The rule does not restrict the ability of multinational groups to raise third party
debt centrally in the country and entity which is most efficient taking into account
non-tax factors such as credit rating, currency and access to capital markets, and then
on-lend the borrowed funds within the group to where it is used to fund the groups
economic activities.
The recommended approach also allows countries to supplement the fixed ratio rule
and group ratio rule with other provisions that reduce the impact of the rules on entities or
situations which pose less BEPS risk, such as:
A de minimis threshold which carves-out entities which have a low level of net
interest expense. Where a group has more than one entity in a country, it is
recommended that the threshold be applied to the total net interest expense of the
local group.
An exclusion for interest paid to third party lenders on loans used to fund
public-benefit projects, subject to conditions. In these circumstances, an entity
may be highly leveraged but, due to the nature of the projects and the close link to
the public sector, the BEPS risk is reduced.
The carry forward of disallowed interest expense and/or unused interest capacity
(where an entitys actual net interest deductions are below the maximum
permitted) for use in future years. This will reduce the impact of earnings
volatility on the ability of an entity to deduct interest expense. The carry forward
of disallowed interest expense will also help entities which incur interest expenses
on long-term investments that are expected to generate taxable income only in
later years, and will allow entities with losses to claim interest deductions when
they return to profit.
The report also recommends that the approach be supported by targeted rules to
prevent its circumvention, for example by artificially reducing the level of net interest
expense. It also recommends that countries consider introducing rules to tackle specific
BEPS risks not addressed by the recommended approach, such as where an entity without
net interest expense shelters interest income.
Finally, the report recognises that the banking and insurance sectors have specific
features which must be taken into account and therefore there is a need to develop
suitable and specific rules that address BEPS risks in these sectors.
Further technical work will be conducted on specific areas of the recommended
approach, including the detailed operation of the worldwide group ratio rule and the
specific rules to address risks posed by banking and insurance groups. This work is
expected to be completed in 2016.
The amount of intragroup interest and payments economically equivalent to interest is
also affected by transfer pricing rules. Revisions to Chapter I of the Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations under Actions 8-10 of
the BEPS Action Plan (OECD, 2013), contained in the OECD Report Aligning Transfer
Pricing Outcomes with Value Creation (OECD, 2015), limit the amount of interest
payable to group companies lacking appropriate substance to no more than a risk-free
return on the funding provided and require group synergies to be taken into account when
evaluating intragroup financial payments. Further work on the transfer pricing aspects of
financial transactions will be undertaken during 2016 and 2017.
A co-ordinated implementation of the recommended approach will successfully
impact on the ability of multinational groups to use debt to achieve BEPS outcomes. To
ensure the recommended approach remains effective in tackling BEPS involving interest,
the implementation, operation and impact of the approach will be monitored over time, to
allow for a comprehensive and informed review as necessary.
INTRODUCTION 15
Introduction
Use of interest and payments economically equivalent to interest for base erosion
and profit shifting
1.
The use of third party and related party interest is perhaps one of the most simple of
the profit-shifting techniques available in international tax planning. The fluidity and
fungibility of money makes it a relatively simple exercise to adjust the mix of debt and
equity in a controlled entity. Against this background, Action 4 of the Action Plan on Base
Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013) calls for the:
[development of] recommendations regarding best practices in the design of rules
to prevent base erosion through the use of interest expense, for example through the
use of related-party and third-party debt to achieve excessive interest deductions or
to finance the production of exempt or deferred income, and other financial
payments that are economically equivalent to interest payments. The work will
evaluate the effectiveness of different types of limitations. In connection with and in
support of the foregoing work, transfer pricing guidance will also be developed
regarding the pricing of related party financial transactions, including financial
and performance guarantees, derivatives (including internal derivatives used in
intra-bank dealings), and captive and other insurance arrangements. The work will
be co-ordinated with the work on hybrids and CFC rules.
2.
Most countries tax debt and equity differently for the purposes of their domestic
law. Interest on debt is generally a deductible expense of the payer and taxed at ordinary
rates in the hands of the payee. Dividends, or other equity returns, on the other hand, are
generally not deductible and are typically subject to some form of tax relief (an exemption,
exclusion, credit, etc.) in the hands of the payee. While, in a purely domestic context, these
differences in treatment may result in debt and equity being subject to a similar overall tax
burden, the difference in the treatment of the payer creates a tax-induced bias, in the
cross-border context, towards debt financing. The distortion is compounded by tax planning
techniques that may be employed to reduce or eliminate tax on interest income in the
jurisdiction of the payee.
3.
In the cross-border context, the main tax policy concerns surrounding interest
deductions relate to the debt funding of outbound and inbound investment by groups. Parent
companies are typically able to claim relief for their interest expense while the return on
equity holdings is taxed on a preferential basis, benefiting from a participation exemption,
preferential tax rate or taxation only on distribution. On the other hand, subsidiary entities
may be heavily debt financed, using excessive deductions on intragroup loans to shelter
local profits from tax. Taken together, these opportunities surrounding inbound and
outbound investment potentially create competitive distortions between groups operating
internationally and those operating in the domestic market. This has a negative impact on
capital ownership neutrality, creating a tax preference for assets to be held by multinational
groups rather than domestic groups.1 In addition, as identified in the BEPS Action Plan
(OECD, 2013), when groups exploit these opportunities, it reduces the revenues available to
16 INTRODUCTION
governments and affects the integrity of the tax system. The use of interest deductions to
fund income which is exempt or deferred for tax purposes, and obtaining relief for interest
deductions greater than the actual net interest expense of the group, can also contribute to
other forms of base erosion and profit shifting. These include the use of intragroup loans to
generate deductible interest expense in high tax jurisdictions and interest income in low or
no tax jurisdictions; the development of hybrid instruments which give rise to deductible
interest expense but no corresponding taxable income; and the use of loans to invest in
assets which give rise to a return that is not taxed or is taxed at a reduced rate. Box 1 below
contains simple examples of how a multinational group can generate a benefit based on the
location of its debt, in both outbound and inbound investment scenarios.
Box 1. Example of the impact of tax on the location of interest expense2
These examples assume no restriction on the ability of a group to obtain deductions for its
interest expense, for example under transfer pricing or thin capitalisation rules.
Outbound investment
Consider a simple group structure, including two companies (A Co and B Co). A Co is resident
in a country with a 35% rate of corporate income tax, which exempts foreign source dividends from
tax. B Co is resident in a country with a 15% corporate tax rate.
3
B Co borrows USD 100 from a third party bank at an interest rate of 10%. B Co uses these
funds in its business and generates additional operating profit of USD 15. After deducting the USD
10 interest cost, B Co has a pre-tax profit of USD 5 and a post-tax profit of USD 4.25.
Alternatively, A Co could borrow the USD 100 from the bank and contribute the same amount
to B Co as equity. In this case, B Co has no interest expense and its full operating profit of USD 15 is
subject to tax. B Co now has a pre-tax profit of USD 15 and a post-tax profit of USD 12.75.
Assuming A Co can set its interest expense against other income, A Co has a pre-tax cost of USD 10
and a post-tax cost of USD 6.50. Taken together, A Co and B Co have a total pre-tax profit from the
transaction of USD 5 and a total post-tax profit of USD 6.25.
As a result of transferring the interest expense from B Co to A Co, the group is now subject to a
negative effective rate of taxation (i.e. the groups post-tax profit exceeds its pre-tax profit).
Inbound investment
A similar result can also be achieved in an inbound investment context.
In this case, A Co is resident in a country with a 15% rate of corporate income tax and B Co is
resident in a country with a 35% corporate tax rate.
B Co borrows USD 100 from a third party bank at an interest rate of 10%. B Co uses these funds
in its business and generates additional operating profit of USD 15. After deducting the USD 10
interest cost, B Co has a pre-tax profit of USD 5 and a post-tax profit of USD 3.25.
A Co could also replace USD 50 of existing equity in B Co with a loan of the same amount, at
an interest rate of 10% (the same rate as on the loan from the third party bank). In this case, B Co has
a pre-tax and post-tax profit of nil. A Co has interest income on its loan to B Co, and has a pre-tax
profit of USD 5 and a post-tax profit of USD 4.25. The group has reduced its effective tax rate from
35% to 15% by shifting profit from B Co to A Co.
Taking this one step further, A Co could replace USD 100 of existing equity in B Co with a loan
of the same amount. Assuming B Co can set its interest expense against other income, as a result of
this transaction B Co now has a pre-tax loss of USD 5 and a post-tax loss of USD 3.25. A Co
receives interest income from B Co, and has a pre-tax profit of USD 10 and a post-tax profit of USD
8.50. Taken together, A Co and B Co have a pre-tax profit of USD 5 and a post-tax profit of USD
5.25. As a result of thinly capitalising B Co and shifting profit to A Co, the group is now subject to a
negative effective rate of taxation.
INTRODUCTION 17
4.
The ongoing existence of international debt shifting has been established in a
number of academic studies which show that groups leverage more debt in subsidiaries
located in high tax countries (Men et al., 2011; Huizinga, Laeven and Nicodeme, 2008;
Mintz and Weichenrieder, 2005; Desai, Foley and Hines, 2004). Debt shifting does not
only impact developed countries, but is also an issue for developing countries which,
according to academic research, are even more prone to these risks (Fuest, Hebous and
Riedel, 2011). Academics have shown that thin capitalisation is strongly associated with
multinational groups (Taylor and Richardson, 2013), and that foreign-owned businesses
use more debt than comparable domestically-owned businesses (Egger et al., 2010).
Additional debt is provided through both intragroup and third party debt (Men et al.,
2011), with intragroup loans typically used in cases where the borrowing costs on third
party debt are high (Buettner et al., 2012). Academics have also looked at the
effectiveness of thin capitalisation rules and illustrated that such rules have the effect of
reducing the total debt of subsidiaries (Blouin et al., 2014; Buettner et al., 2012). Where
thin capitalisation rules apply solely to interest deductions on intragroup debt, these rules
are effective in reducing intragroup debt but then lead to an increase in third party debt,
although this may not be to the same extent (Buettner et al., 2012).
5.
The impact of interest limitation rules on investment has also been the subject of
academic studies and the topic has been approached using both theoretical models and
empirical analysis. Analysing the impact of interest limitation rules on investment from a
theoretical standpoint, academics suggest that such rules would increase effective capital
costs thus reducing real investment (Ruf and Schindler, 2012) The theoretical approach is
supported by studies which suggest that certain countries set lenient thin capitalisation
rules in order to protect foreign direct investment (Haufer and Runkel, 2012). The limited
empirical analysis that has been done does not, however, support this theory. Two studies,
both analysing the effect of German interest limitation rules on investment, find no
significant evidence of a reduction of investment in relation to either thin capitalisation
rules (Weichenrieder and Windischbauer, 2008) or interest barrier rules based on a ratio
of interest expense to income (Buslei and Simmler, 2012).4 This lack of empirical support
may be due to a number of factors including the fact that multinational groups may avoid
the application of the interest limitation rule by using loopholes in the legislation or by
adjusting their capital structure (Ruf and Schindler, 2012). Therefore, there does not seem
to be enough empirical evidence to reach conclusions on the actual impact of interest
limitation rules on foreign investment.
6.
Countries have introduced a wide range of rules to address issues of base erosion
and profit shifting involving third party and intragroup interest. These include general
interest limitation rules which put an overall limit on the level of interest deductions that
an entity can claim, as well as targeted rules which address specific planning risks. Where
general interest limitation rules have been used, in some countries they have focused on
inbound investment situations only, while in others rules have attempted to address both
inbound and outbound situations. The main types of rules applied by countries are
considered later in this introduction. These approaches have been successful to varying
degrees, but there is a sense that unilateral action by countries is failing to tackle some of
the issues at the heart of this problem. Partly, this is because the fungibility of money and
the flexibility of financial instruments have made it possible for groups to bypass the
effect of rules and replicate similar benefits using different tools. This has led to countries
repeatedly introducing new rules, or amending existing ones, creating layers of
complexity without addressing the key underlying issues. There is also a concern that a
robust approach to restrict interest deductions by a single country could adversely impact
18 INTRODUCTION
the attractiveness of the country to international business and the ability of domestic
groups to compete globally.
7.
It has therefore become increasingly apparent that a consistent approach utilising
international best practices would be a more effective and efficient way of addressing
concerns surrounding the use of interest in base erosion and profit shifting. This approach
should encourage groups to adopt funding structures whereby: (i) the net interest expense
of an entity is linked to the overall net interest expense of the group; and (ii) the
distribution of a groups net interest expense should be linked to income-producing
activities. Groups should also benefit from a consistent approach between countries.
Similar rules based on the same principles should make the operation of rules more
predictable, enabling groups to plan their capital structures with greater confidence. It
could also make it possible to introduce group-wide systems and processes to produce
required information, making compliance with rules in multiple countries simpler and
cheaper. A consistent approach should remove distortions, reduce the risk of unintended
double taxation and, by removing opportunities for base erosion and profit shifting,
improve fairness and equality between groups.
BEPS Action Plan and interest expense

8.
In 2012, the G20 called on the Organisation for Economic Co-operation and
Development (OECD) to analyse the issue of base erosion and profit shifting and develop
an action plan to address these issues in a co-ordinated and comprehensive manner. The
BEPS Action Plan (OECD, 2013) was delivered by the OECD in July 2013 and contains
15 actions. Several of these address different aspects of base erosion and profit shifting
using interest. Arrangements using hybrid financial instruments or hybrid entities to
generate two tax deductions for the same payment, or payments which are deductible in
the payer but are not taxed as ordinary income in the recipient, are addressed through
model rules developed under Action 2 (Neutralise the effects of hybrid mismatch
arrangements). Work under Action 3 (Strengthen CFC rules) has developed
recommendations regarding the design of controlled foreign company (CFC) rules, which
among other things should help to address the issue of interest income in controlled
companies in low tax jurisdictions. Action 4 (Limit base erosion via interest deductions
and other financial payments), which is the focus of this report, makes recommendations
for best practices in the design of rules to address base erosion and profit shifting using
interest and payments economically equivalent to interest, by aligning interest deductions
with taxable economic activity. Action 4 also refers to the development of transfer pricing
guidance for related party financial transactions, which will be carried out as a separate
project to be completed by 2017. This work should in no way impede countries from
implementing the best practice approach contained in this report. Revisions to Chapter I
of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
under Actions 8-10 (Intangibles; Risks and capital; and Other high risk transactions) limit
the amount of interest payable to group companies lacking appropriate substance to no
more than a risk-free return on the funding provided and require group synergies to be
taken into account when evaluating intragroup financial payments.
9.
Action 4 is focused on the use of third party, related party and intragroup debt to
achieve excessive interest deductions or to finance the production of exempt or deferred
income. A best practice approach to tackling these issues should apply to all forms of
interest and payments equivalent to interest, to ensure that groups in an equivalent
position are treated consistently and to reduce the risk of a rule being avoided by a group
INTRODUCTION 19
structuring its borrowings into a different legal form. Base erosion and profit shifting can
arise from arrangements using third party debt (e.g. where one entity or country bears an
excessive proportion of the groups total net third party interest expense) and intragroup
debt (e.g. where a group uses intragroup interest expense to shift taxable income from
high tax to low tax countries). It can also occur where payments are made to a lender
outside a country or within the same country. For example, within a country base erosion
and profit shifting may arise as a result of interest paid to a third party under a structured
arrangement, or where interest is paid to a group entity in the same country which makes
a corresponding payment to a foreign lender. In order to be effective in tackling base
erosion and profit shifting, a best practice approach should therefore apply to all of these
situations.
Existing approaches to tackle base erosion and profit shifting involving interest
10.
The recommendations in this report are the result of significant work which
explored the advantages and disadvantages of different types of rules. This included a
review of countries experiences as to how rules operate in practice and impacts on
taxpayer behaviour. It also included an analysis of empirical data on the leverage of
groups and entities in countries which do and do not currently apply rules to limit interest
deductions, and the results of academic studies.
11.
Rules currently applied by countries fall into six broad groups, with some
countries using a combined approach that includes more than one type of rule:
1. Arms length tests, which compare the level of interest or debt in an entity with
the position that would have existed had the entity been dealing entirely with third
parties.
2. Withholding tax on interest payments, which are used to allocate taxing rights to a
source jurisdiction.
3. Rules which disallow a specified percentage of the interest expense of an entity,
irrespective of the nature of the payment or to whom it is made.
4. Rules which limit the level of interest expense or debt in an entity with reference
to a fixed ratio, such as debt/equity, interest/earnings or interest/total assets.
5. Rules which limit the level of interest expense or debt in an entity with reference
to the groups overall position.
6. Targeted anti-avoidance rules which disallow interest expense on specific
transactions.
12.
An arms length test requires consideration of an individual entitys
circumstances, the amount of debt that the entity would be able to raise from third party
lenders and the terms under which that debt could be borrowed. It allows a tax
administration to focus on the particular commercial circumstances of an entity or a group
but it can be resource intensive and time consuming for both taxpayers and tax
administrations to apply. Also, because each entity is considered separately after
arrangements are entered into, the outcomes of applying a rule can be uncertain, although
this may be reduced through advance agreements with the tax administration. An
advantage of an arms length test is that it recognises that entities may have different
levels of interest expense depending on their circumstances. However, some countries
with experience of applying such an approach in practice expressed concerns over how
20 INTRODUCTION
effective it is in preventing base erosion and profit shifting, although it could be a useful
complement to other rules (e.g. in pricing the interest income and expense of an entity,
before applying interest limitation rules). In particular, countries have experience of
groups structuring intragroup debt with equity-like features to justify interest payments
significantly in excess of those the group actually incurs on its third party debt.
Additionally, an arms length test does not prevent an entity from claiming a deduction
for interest expense which is used to fund investments in non-taxable assets or income
streams, which is a base erosion risk specifically mentioned as a concern in the BEPS
Action Plan (OECD, 2013).
13.
Withholding taxes are primarily used to allocate taxing rights to a source country,
but by imposing tax on cross-border payments they may also reduce the benefit to groups
from base erosion and profit shifting transactions. Withholding tax has the advantage of
being a relatively mechanical tool which is easy to apply and administer. However, unless
withholding tax is applied at the same rate as corporate tax, opportunities for base erosion
and profit shifting would remain. In fact, in some cases withholding taxes can drive base
erosion and profit shifting behaviour, where groups enter into structured arrangements to
avoid imposition of a tax or generate additional tax benefits (such as multiple entities
claiming credit with respect to tax withheld). Where withholding tax is applied, double
taxation can be addressed by giving credit in the country where the payment is received,
although the effectiveness of this is reduced if credit is only given up to the amount of tax
on net income. This can impose a significant cost on groups not engaged in base erosion
and profit shifting, if an entity suffers withholding tax on its gross interest receipts, but is
unable to claim a credit for this because its taxable income is reduced by interest expense.
In practice, where withholding tax is applied the rate is often reduced (sometimes to zero)
under bilateral tax treaties. It would also be extremely difficult for European Union (EU)
Member States to apply withholding taxes on interest payments made within the
European Union due to the Interest and Royalty Directive.5 In addition, there are broader
policy reasons why some countries do not currently apply withholding tax to interest
payments, which could make the introduction of new taxes difficult. Taken together,
these factors mean that in many situations withholding taxes would not be a suitable tool
for completely tackling the base erosion and profit shifting risks which are the subject of
this report. However, countries may still continue to apply withholding tax alongside the
best practice.
14.
Rules which disallow a percentage of all interest paid by an entity in effect
increase the cost of all debt finance above any de minimis threshold. Therefore, entities
with a relatively low leverage will be subject to the same proportionate disallowance as
similar entities with very high levels of debt. This approach is likely to be more effective
in reducing the general tax preference for debt over equity, than in targeting base erosion
and profit shifting involving interest.
15.
For the reasons set out above, the rules in groups 1 to 3, on their own, do not
address all of the aims of Action 4 set out in the BEPS Action Plan (OECD, 2013). As
such, they are not considered to be best practices in tackling base erosion and profit
shifting involving interest and payments economically equivalent to interest if they are
not strengthened with other interest limitation rules. However, these rules may still have a
role to play within a countrys tax system alongside a best practice approach, either in
supporting those rules or in meeting other tax policy goals. Therefore, after introducing
the best practice approach, a country may also continue to apply an arms length test,
withholding tax on interest, or rules to disallow a percentage of an entitys total interest
INTRODUCTION 21
expense, so long as these do not reduce the effectiveness of the best practice in tackling
base erosion and profit shifting.
16.
The best practice approach set out in this report is based on a combination of
some or all of the rules in groups 4 to 6 above. A general limit on interest deductions
would restrict the ability of an entity to deduct net interest expense based on a fixed
financial ratio. This could be combined with a rule to allow the entity to deduct more
interest up to the groups equivalent financial ratio where this is higher. If a country does
not introduce a group ratio rule, it should apply the fixed ratio rule to entities in
multinational and domestic groups without improper discrimination. These general rules
should be complemented by targeted rules to address planning to reduce or avoid the
effect of the general rules, and targeted rules can also be used to tackle specific risks not
covered by the general rules. This approach should provide effective protection for
countries against base erosion and profit shifting involving interest, but should not
prevent businesses from raising the debt finance necessary for their business and
commercial investments.
17.
Rules which limit interest expense by reference to a fixed ratio are relatively easy
to apply and link the level of interest expense to a measure of an entitys economic
activity. These rules are currently applied by a number of countries. However, the way in
which existing rules are designed is not always the most effective way to tackle base
erosion and profit shifting. The majority of countries applying fixed ratio rules link
interest deductibility to the level of equity in an entity, typically through thin
capitalisation rules based on a debt/equity test. The main advantage of such a test is that it
is relatively easy for tax administrations to obtain relevant information on the level of
debt and equity in an entity and it also provides a reasonable level of certainty to groups
in planning their financing. However, set against these advantages are a number of
important disadvantages. A rule which limits the amount of debt in an entity still allows
significant flexibility in terms of the rate of interest that an entity may pay on that debt.
Also, an equity test allows entities with higher levels of equity capital to deduct more
interest expense, which makes it relatively easy for a group to manipulate the outcome of
a test by increasing the level of equity in a particular entity. An illustration of this is
included as Example 1 in Annex D. It was therefore agreed by countries involved in this
work that fixed ratio debt/equity tests should not be included as a general interest
limitation rule within a best practice approach to tackle base erosion and profit shifting,
although again this is not intended to suggest that these tests cannot play a role within an
overall tax policy to limit interest deductions.
18.
In recent years, countries have increasingly introduced fixed ratio tests based on
an entitys interest/earnings ratio, which is a better tool to combat base erosion and profit
shifting. In these tests, the measure of earnings used is typically earnings before interest,
taxes, depreciation and amortisation (EBITDA). Most countries presently use a tax
measure of EBITDA. However, there remains a general view that in many cases
multinational groups are still able to claim total interest deductions significantly in excess
of the groups actual third party interest expense. Available data, discussed in Chapter 6,
shows that the majority of publicly traded multinational groups with positive EBITDA
have a net third party interest/EBITDA ratio below 10%, based on consolidated financial
reporting information.
19.
Rules which directly compare the level of interest expense or debt of an entity to
that of its group are less common, but are applied by a small number of countries. These
group ratio tests currently typically operate by reference to debt/equity ratios. However,
22 INTRODUCTION
in many cases the amount of equity in an entity may at best only be an indirect measure
of its level of activity and as already mentioned can be subject to manipulation.
20.
Targeted rules can complement a general interest limitation rule and are therefore
a component of the best practice approach. Many countries have targeted anti-avoidance
rules and these can be an effective response to specific base erosion and profit shifting
risks. However, as new base erosion and profit shifting opportunities are exploited,
further targeted rules may be required and so there is a tendency over time for more rules
to be introduced, resulting in a complex system and increased administration and
compliance costs. An approach which includes an effective general interest limitation rule
should reduce the need for additional targeted rules, although some will be required to
address specific risks. However, these targeted rules should operate consistently with the
general interest limitation rules recommended in this report.
European Union law issues

21.
Throughout this work, EU law requirements imposed on Member States of the
European Union have been considered, and in particular the need for recommended
approaches to be in accordance with EU treaty freedoms, directives and State aid
regulations. Although countries outside the European Union are not required to comply
with these obligations, the need for a consistent international approach outlined above
means that any approach which cannot be fully implemented by the 28 EU Member
States is unlikely to be effective in tackling the global issue of base erosion and profit
shifting. Specific issues related to EU treaty freedoms, directives and State aid rules and
possible approaches to deal with them are set out in Annex A of this report.
Notes
1.
A domestic group is a group which operates wholly within a single country.
2.
The first part of this example is adapted from Graetz (2008).
3.
All monetary amounts in this example are denominated in United States dollars
(USD). This is an illustrative example only, and is not intended to reflect a real case
or the position in a particular country.
4.
Weichenrieder and Windischbauer (2008) analysed the effect of the 1994 introduction
and the 2001 tightening of Germanys former thin capitalisation rule. Buslei and
Simmler (2012) analysed the effect of the introduction of Germanys current interest
limitation rule in 2008.
5.
Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation

applicable to interest and royalty payments made between associated companies of
different Member States [2003] OJ L157/49.
INTRODUCTION 23
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Structure, IMF Working Paper, No. 14/12, International Monetary Fund,
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24 INTRODUCTION
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company responses - Experience from German legislation, CESifo Working Paper,
No. 2456.
1. RECOMMENDATIONS FOR A BEST PRACTICE APPROACH 25
Chapter 1
Recommendations for a best practice approach
22.
The critical objective of the work on Action 4 is to identify coherent and
consistent solutions to address base erosion and profit shifting using interest and
payments economically equivalent to interest. In constructing the best practice approach
described in this report, a focus has been placed on the need for an approach that provides
an effective solution to the risks countries face and which is robust against planning to
avoid or reduce its application or effect. At the same time, this is balanced by the need for
an approach to be reasonably straightforward for groups and tax authorities to apply. A
short outline of the best practice approach is set out below. Detail on each element of the
approach is included in later chapters.
Figure 1.1
Overview of the best practice approach
De minimis monetary threshold to remove low risk entities

Optional
Based on net interest expense of local group
Fixed ratio rule
Allows an entity to deduct net interest expense up to a benchmark net interest/EBITDA ratio
Relevant factors help a country set its benchmark ratio within a corridor of 10%-30%
Group ratio rule
Allows an entity to deduct net interest expense up to its groups net interest/EBITDA ratio,
where this is higher than the benchmark fixed ratio
Option for a country to apply an uplift to a groups net third party interest expense of up to 10%
Option for a country to apply a different group ratio rule or no group ratio rule
Carry forward of disallowed interest /unused interest capacity and/or carry back of disallowed interest
Optional
Targeted rules to support general interest limitation rules and address specific risks
Specific rules to address issues raised by the banking and insurance sectors
23.
The best practice approach is based around a fixed ratio rule which limits an
entitys net interest deductions to a fixed percentage of its profit, measured using earnings
before interest, taxes, depreciation and amortisation (EBITDA) based on tax numbers.
This is a straightforward rule to apply and ensures that an entitys interest deductions are
directly linked to its economic activity. It also directly links these deductions to an
26 1. RECOMMENDATIONS FOR A BEST PRACTICE APPROACH

entitys taxable income, which makes the rule reasonably robust against planning. As
described in Chapter 5, although EBITDA is the recommended measure of earnings to be
used, the best practice allows a country the flexibility to introduce rules based on earnings
before interest and taxes (EBIT). In limited cases, a country may apply a fixed ratio rule
based on asset values rather than earnings. Chapter 6 includes factors which a country
should take into account in setting the benchmark ratio for a fixed ratio rule, within a
corridor of 10% to 30%.
24.
A fixed ratio rule provides a country with a level of protection against base
erosion and profit shifting, but it is a blunt tool which does not take into account the fact
that groups operating in different sectors may require different amounts of leverage, and
even within a sector some groups are more highly leveraged for non-tax reasons. If a
benchmark fixed ratio is set at a level appropriate to tackle base erosion and profit
shifting, it could lead to double taxation for groups which are leveraged above this level.
Therefore, countries are encouraged to combine a robust and effective fixed ratio rule
with a group ratio rule which allows an entity to deduct more interest expense in certain
circumstances. A group ratio rule may be introduced as a separate provision from the
fixed ratio rule, or as an integral part of an overall rule including both fixed ratio and
group ratio tests.
25.
Chapter 7 includes a description of a group ratio rule, which allows an entity that
exceeds the benchmark fixed ratio to deduct interest expense up to the net third party
interest/EBITDA ratio of its group, where this is higher. In calculating the groups ratio, a
country may also apply an uplift of up to 10% to the groups net third party interest
expense (i.e. its third party interest expense after deducting third party interest income).
Under this approach, only net interest expense which takes an entitys net
interest/EBITDA ratio above the higher of the benchmark fixed ratio and the groups ratio
is disallowed. This rule should complement the fixed ratio rule and provide a robust
response to base erosion and profit shifting involving interest expense. However,
countries may also apply different group ratio rules, including those using asset-based
ratios, so long as these rules only permit an entity to exceed the benchmark fixed ratio
where it is able to demonstrate that a relevant financial ratio is in line with that of its
group. A country may also decide to apply a fixed ratio rule in isolation. Where a country
does not apply a group ratio rule, it should apply the fixed ratio rule consistently to
entities in multinational and domestic groups, without improper discrimination. In all
cases, under the best practice approach a country should implement the fixed ratio rule
using a benchmark ratio which is sufficiently low to address base erosion and profit
shifting.
26.
In order to remove entities which pose the lowest risk from the scope of a general
interest limitation rule, a country may apply a de minimis threshold based on a monetary
value of net interest expense. Entities falling below this threshold may deduct interest
expense without restriction. Where a group has more than one entity in a country, the
threshold should take into account the total net interest expense of the entire local group,
including all entities in that country. Where a rule is applied at the level of an individual
entity, a country should consider including anti-fragmentation rules to prevent a group
avoiding the application of an interest limitation rule by establishing a number of entities,
each of which falls below the threshold.
27.
Rules which link interest deductions to EBITDA raise issues where an entitys
interest expense and earnings arise in different periods. This may be the result of
volatility in earnings which means the ability of an entity to deduct interest changes from
1. RECOMMENDATIONS FOR A BEST PRACTICE APPROACH 27
year to year, or because an entity has incurred interest expense to fund an investment
which will give rise to earnings in a later period. To reduce the effect of these issues, a
country may permit entities to carry forward disallowed interest expense or unused
interest capacity for use in future periods, or carry back disallowed interest expense into
earlier periods. It is suggested countries consider imposing limits on these carry forwards
and carry backs.
28.
A fixed ratio rule and group ratio rule should provide an effective framework to
tackle most base erosion and profit shifting involving interest and payments economically
equivalent to interest. These general interest limitation rules should be supplemented by
targeted rules, which protect the integrity of the general interest limitation rules and deal
with specific base erosion and profit shifting risks which remain.
29.
Particular features of the banking and insurance industries mean that the fixed
ratio rule and the group ratio rule set out in this report are unlikely to be effective in
addressing base erosion and profit shifting involving interest in these sectors. As
discussed in Chapter 10, further work will be conducted, to be completed in 2016, to
identify targeted rules to deal with the base erosion and profit shifting risks posed by
banks and insurance companies.
30.
It is recommended that, as a minimum, the best practice approach in this report
should apply to all entities that are part of a multinational group. Countries may also
apply the best practice approach more broadly to include entities in a domestic group
and/or standalone entities which are not part of a group. In certain cases countries may be
required to do so. In this regard, Annex A includes a summary of EU law issues,
including factors that should be taken into account by EU Member States.
31.
The best practice approach set out in this report should provide an effective
solution to base erosion and profit shifting involving interest and payments economically
equivalent to interest. However, countries are free to apply stricter rules than those set out
in this report either for the purposes of combating base erosion and profit shifting or to
achieve other tax policy goals. For example, the best practice approach may be
supplemented by additional general or targeted interest limitation rules which a country
has identified as appropriate to address the risks it faces. It is also recognised that a
country may have interest limitation rules that carry out broader policy aims, such as
reducing the tax bias in favour of debt finance, and that it will want to retain these, or a
country may introduce rules to achieve such aims. An illustration of how the best practice
approach may be combined with other interest limitation rules is included as Example 2
in Annex D. Finally, when implementing a best practice approach, each country will need
to take into account any obligations under its constitution (such as the equal treatment of
taxpayers), as well as the specific features of its overall tax system. This may impact, for
example, the application of a de minimis threshold, the operation of a fixed ratio rule and
group ratio rule, and the use of carry forwards. How the fixed ratio rule and group ratio
rule may be applied by countries with separate entity taxation or group taxation systems
is considered in Chapter 11.
32.
The remainder of this report discusses the structure and operation of the best
practice approach in more detail, focusing on the following aspects:
interest and payments economically equivalent to interest
who a best practice approach should apply to
applying a best practice approach based on the level of interest expense or debt
28 1. RECOMMENDATIONS FOR A BEST PRACTICE APPROACH

measuring economic activity using earnings or asset values
a fixed ratio rule
a group ratio rule
addressing volatility and double taxation
targeted rules
applying the best practice approach to banking and insurance groups
implementing the best practice approach.
2. INTEREST AND PAYMENTS ECONOMICALLY EQUIVALENT TO INTEREST 29
Chapter 2
Interest and payments economically equivalent to interest
33.
Interest cost is treated as a tax deductible expense in most countries, but each
country applies its own approach to determine what expenses are treated as interest and
therefore deductible for tax purposes. It is not the aim of this report to recommend a
definition of interest that is applied by all countries for all tax purposes. Differences will
continue to exist between countries as to the items treated as deductible interest expense
and countries will continue to use their own definitions of interest for other tax purposes,
such as for withholding taxes. However, in identifying best practices for the design of
rules to address base erosion and profit shifting, there are benefits in countries taking a
broadly consistent approach to the items that should be covered by such rules, improving
certainty for business and ensuring a coherent approach to tackling the issue across
countries. This chapter therefore sets out the items which should be the subject of a best
practice rule to tackle base erosion and profit shifting.
34.
At its simplest, interest is the cost of borrowing money. However, if a rule
restricted its focus to such a narrow band of payments,1 it would raise three broad issues:
It would fail to address the range of base erosion and profit shifting risks that
countries face in relation to interest deductions and similar payments.
It would reduce fairness by applying a different treatment to groups that are in the
same economic position but use different forms of financing arrangements.
Its effect could be easily avoided by groups re-structuring loans into other forms
of financing arrangement.
35.
To address these issues, rules to tackle base erosion and profit shifting using
interest should apply to interest on all forms of debt as well as to other financial payments
that are economically equivalent to interest. Payments that are economically equivalent to
interest include those which are linked to the financing of an entity and are determined by
applying a fixed or variable percentage to an actual or notional principal over time. A rule
should also apply to other expenses incurred in connection with the raising of finance,
including arrangement fees and guarantee fees. This chapter includes a non-exhaustive
list of examples of the types of payment that should be covered by a rule, but it is left to
each country to determine how this should be reflected within its domestic law, taking
into account existing definitions of interest and other payments. In deciding whether a
payment is economically equivalent to interest, the focus should be on its economic
substance rather than its legal form.
36.
A best practice rule to address base erosion and profit shifting using interest
expense should therefore apply to: (i) interest on all forms of debt; (ii) payments
economically equivalent to interest; and (iii) expenses incurred in connection with the
raising of finance. These should include, but not be restricted to, the following:
30 2. INTEREST AND PAYMENTS ECONOMICALLY EQUIVALENT TO INTEREST

payments under profit participating loans
imputed interest on instruments such as convertible bonds and zero coupon bonds
amounts under alternative financing arrangements, such as Islamic finance
the finance cost element of finance lease payments
capitalised interest included in the balance sheet value of a related asset, or the
amortisation of capitalised interest
amounts measured by reference to a funding return under transfer pricing rules,
where applicable
notional interest amounts under derivative instruments or hedging arrangements
related to an entitys borrowings
certain foreign exchange gains and losses on borrowings and instruments
connected with the raising of finance
guarantee fees with respect to financing arrangements
arrangement fees and similar costs related to the borrowing of funds.
37.
It is recognised that foreign exchange gains and losses on instruments to hedge or
take on a currency exposure connected with the raising of finance are not generally
economically equivalent to interest. A country may however wish to treat some or all
foreign exchange gains and losses on these instruments as economically equivalent to
interest, in line with local tax rules and to reflect the economics of the currency exposure.
38.
Throughout this report, references to interest should also be taken to include
amounts economically equivalent to interest, unless the context clearly requires
otherwise. Similarly, where the report refers to a groups or entitys interest income, this
includes receipts of amounts economically equivalent to interest based on the definition
and examples in this chapter.
39.
The best practice approach does not apply to payments which are not interest,
economically equivalent to interest or incurred in connection with the raising of finance.
Therefore in general, the rules set out in this report should not limit deductions for items
such as:
foreign exchange gains and losses on monetary items which are not connected
with the raising of finance
amounts under derivative instruments or hedging arrangements which are not
related to borrowings, for example commodity derivatives
discounts on provisions not related to borrowings
operating lease payments
royalties
accrued interest with respect to a defined benefit pension plan.
40.
However, any payment (including those listed above) may be subject to limitation
under the best practice approach where they are used as part of an arrangement which,
taken as a whole, gives rise to amounts which are economically equivalent to interest.
2. INTEREST AND PAYMENTS ECONOMICALLY EQUIVALENT TO INTEREST 31
41.
An illustration of how this definition could be applied in practice is included as
Example 3 in Annex D.
42.
Where a country has a rule which grants a deemed deduction by applying a
specified percentage to the equity capital of an entity, these deemed deductions are not
treated as being interest or a payment economically equivalent to interest for the purposes
of this report. These rules and rules having similar effect should be considered further by
the OECD in separate work.
Notes
1.
Throughout this report, references to payments also include accruals of income or

expense.
3. WHO A BEST PRACTICE APPROACH SHOULD APPLY TO 33
Chapter 3
Who a best practice approach should apply to
43.
Base erosion and profit shifting arise in a range of scenarios, including within a
group, with related parties outside a group and through the use of structured arrangements
with third parties.1 The best practice approach addresses the risks posed by each of these
scenarios, although different rules may be used to address different types of risk. For the
purposes of considering which entities these rules should apply to, entities have been
categorised into three types: entities which are part of a multinational group; entities
which are part of a domestic group; and standalone entities which are not part of a group.
It is recommended that, as a minimum, the best practice approach in this report should
apply to all entities that are part of a multinational group. Countries may also apply the
best practice approach more broadly to include entities in a domestic group and/or
standalone entities which are not part of a group.2
Entities which are part of a multinational group

44.
As set out in the BEPS Action Plan (OECD, 2013), the deductibility of interest
can raise base erosion and profit shifting concerns in both inbound and outbound
investment scenarios. Therefore, it is recommended that as a minimum a fixed ratio rule
as described in Chapter 6 should apply to all entities which are part of a multinational
group.
45.
An entity is part of a group if the entity is directly or indirectly controlled by a
company, or the entity is a company which directly or indirectly controls one or more
other entities. A group is a multinational group where it operates in more than one
jurisdiction, including through a permanent establishment.
46.
Where a country applies a group ratio rule alongside the fixed ratio rule, it may
wish to use a consistent definition between both rules to reduce the risk that an entity
subject to the fixed ratio rule is unable to apply the group ratio rule. In this case, the
country may instead determine that an entity is part of a group where: (i) the entity is
included on a line-by-line basis in the consolidated financial statements of any company;
or (ii) the entity would be included on a line-by-line basis in the consolidated financial
statements of any company, if that company prepared consolidated financial statements in
accordance with any of the accounting standards accepted by the country in applying the
group ratio rule (as described in Chapter 7).
47.
Where a group has more than one entity in a particular country, the country may
apply the fixed ratio rule and group ratio rule to the position of each entity separately, or
to the overall position of all group entities in the same country (i.e. the local group).3
Applying a rule to the overall position of the local group would avoid the scenario where
a highly leveraged entity incurs an interest disallowance even though the interest expense
of the local group as a whole falls within the limit permitted.
34 3. WHO A BEST PRACTICE APPROACH SHOULD APPLY TO

48.
If the benchmark fixed ratio is set at an appropriate level, a fixed ratio rule should
to a large extent address base erosion and profit shifting concerns involving payments by
entities which are part of a multinational group. To ensure the fixed ratio rule is effective
in tackling base erosion and profit shifting, it is recommended that all entities which are
subject to the fixed ratio rule are also subject to targeted provisions which address
planning to reduce the impact of the rule. However, there may be specific risks which are
not dealt with by the fixed ratio rule and it is recommended that countries consider
introducing targeted rules to deal with these risks. The role of targeted rules within the
best practice is discussed in Chapter 9.
Entities which are part of a domestic group

49.
Entities in multinational groups pose the main base erosion and profit shifting
risk. Therefore, it may be appropriate for a country to restrict the application of a fixed
ratio rule to these entities. However, a country may choose to apply a fixed ratio rule
more broadly, to include entities in domestic groups (i.e. groups which operate wholly
within a single country). This may be part of a broad approach to tackle base erosion and
profit shifting in all types of entity, or may be in order to meet other policy goals, such as
to avoid competition issues between domestic and multinational groups, to reduce the
general tax bias in favour of funding with debt over equity, or to comply with
constitutional obligations for the equal treatment of taxpayers. In particular, countries
which are EU Member States would need to take into account EU law considerations in
designing their domestic rules, to ensure they are compliant with EU law.
50.
Where a country applies a fixed ratio rule and a group ratio rule to entities which
are part of a domestic group, it may apply the rules either to each entity individually or to
the overall position of the domestic group. In either case, the fixed ratio rule should to a
large extent address base erosion and profit shifting concerns involving interest.
However, there may be specific risks which are not dealt with by the fixed ratio rule and
it is recommended that countries consider introducing targeted rules, discussed in
Chapter 9, to address these risks.
51.
Where a country does not apply a fixed ratio rule to entities in a domestic group,
it will be exposed to base erosion and profit shifting risks, in particular involving interest
paid to related parties and third parties under structured arrangements. In this case, a
country should consider addressing these risks using targeted rules as described in
Chapter 9.
Standalone entities which are not part of a group

52.
A standalone entity is any entity which is not part of a group. The fact that a
standalone entity is not part of any group means that the nature and level of base erosion
and profit shifting risk that a standalone entity poses is often different to that posed by
entities in a group. In many cases standalone entities are small entities, owned directly by
an individual, where there are no other entities under common control. In these cases, due
to the entitys small size and lack of related parties, the risk of base erosion and profit
shifting involving interest is likely to be relatively low. However, in other cases,
standalone entities may be large entities held under complex holding structures involving
trusts or partnerships, where there are a number of entities under the control of the same
investors. In these cases the level of base erosion and profit shifting risk may be similar to
that posed by a group structure. In both scenarios, where base erosion and profit shifting
3. WHO A BEST PRACTICE APPROACH SHOULD APPLY TO 35
involving interest does occur, it will arise as a result of payments to related parties and
third parties.
53.
A country should apply rules to address base erosion and profit shifting risks
posed by standalone entities. A country may apply the fixed ratio rule to standalone
entities or, recognising the differences between the risks posed by entities in groups and
standalone entities, it may tackle risks posed by standalone entities using different rules.
In either case, standalone entities should be subject to targeted rules to address specific
risks, discussed in Chapter 9. EU Member States would need to take into account EU law
considerations in designing their domestic rules, to ensure they are compliant with EU
law. Such considerations should be taken into account when designing domestic rules in
order to limit their possible negative impact on situations not involving base erosion or
profit shifting.
De minimis threshold
54.
While the main policy goal of the best practice approach set out in this report is to
address base erosion and profit shifting using interest, it is recognised that certain entities
may pose a sufficiently low risk that excluding them from a fixed ratio rule and group
ratio rule would be appropriate. Excluding these entities from the fixed ratio rule and
group ratio rule would mean that a best practice approach can focus on entities which
pose material base erosion and profit shifting risk, reducing compliance costs for other
entities. Reducing the number of entities covered would also reduce the costs of
administering a rule and would allow a tax authority to focus its resources on entities
which pose the greatest risk.
55.
Countries may therefore introduce a de minimis threshold to exclude low risk
entities from the scope of the fixed ratio rule and group ratio rule. It is recommended that
such a threshold should be based on the total net interest expense of all entities in the
local group. Where a country wishes to apply a threshold based on the net interest
expense of each entity separately, it is important that these rules are not abused.
Therefore, a country should consider introducing anti-fragmentation rules to prevent a
group avoiding an interest limitation rule by establishing multiple entities, each of which
falls below the threshold.
56.
A de minimis threshold based on net interest expense should be relatively simple
to apply and would ensure that highly-leveraged entities are required to apply a general
interest limitation rule regardless of their size. A country should set the level of a de
minimis threshold to reflect a number of factors, including the local economic and interest
rate environment, as well as relevant tax or legal considerations. This may be reviewed
and updated periodically to reflect changes in these factors.
36 3. WHO A BEST PRACTICE APPROACH SHOULD APPLY TO
Notes
1.
The terms "related party" and "structured arrangement" are defined in Chapter 9.
2.
There may be cases where a country is required to apply the fixed ratio rule more
broadly, for example to entities in domestic groups. For instance, countries may need
to take into account any constitutional issues which could have a direct impact on
interest limitation rules. In addition, Annex A includes a summary of EU law issues,
including factors that should be taken into account by EU Member States.
3.
Chapter 11 includes a summary of different approaches that a country may use in

applying a fixed ratio rule to a local group, depending upon the structure of its tax
system.
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
4. APPLYING A BEST PRACTICE APPROACH BASED ON THE LEVEL OF INTEREST EXPENSE OR DEBT 37
Chapter 4
Applying a best practice approach based on the level of
interest expense or debt
57.
A key cause of base erosion and profit shifting is the ability of a group to
artificially separate taxable income from the underlying activities that drive value
creation. Therefore, one of the aims of the best practice approach set out in this report is
to link the amount of interest deductions in an entity to the level of its taxable economic
activity.
Applying the best practice approach to limit the level of interest expense or debt in
an entity
58.
A general interest limitation rule may operate directly, by restricting the amount
of interest an entity may deduct for tax purposes, or indirectly, by restricting the amount
of debt with respect to which an entity may claim deductions for interest. In considering
which approach to include in the best practice recommendation, a number of factors have
been taken into account. These include the following:
Base erosion and profit shifting using interest is driven by the level of tax
deductible expense incurred by an entity. A rule which directly limits the level of
interest deductions an entity may claim addresses this.
A rule which limits the level of debt in an entity will not necessarily address base
erosion and profit shifting risks where an excessive rate of interest is applied to a
loan. Therefore, such a rule would need to have a further mechanism to identify
the maximum interest on the permitted level of debt. This could be done by
applying an arms length test or apportioning an entitys actual interest expense,
but these approaches add a step to the operation of a rule and increase complexity.
A best practice approach should apply to base erosion and profit shifting
involving interest and payments economically equivalent to interest. However, for
some payments economically equivalent to interest, there may be no existing
requirement for an entity to separately recognise a debt linked to the payment. It
should therefore be easier for entities and tax authorities to identify and value the
payments of interest (and economically equivalent payments) for which tax relief
is being claimed.
The level of debt in an entity may vary throughout a period, which means that the
amount of debt on a particular date, or even an average for the period, may not be
representative of an entitys true position. On the other hand, the level of interest
expense in an entity will reflect all changes in borrowings throughout the period.
This is therefore likely to give a more accurate picture of the entitys actual
position over the period.
38 4. APPLYING A BEST PRACTICE APPROACH BASED ON THE LEVEL OF INTEREST EXPENSE OR DEBT
A rule based on the level of debt in an entity could take into account the fact that
two entities with the same amount of debt may for commercial reasons be subject
to different rates of interest (e.g. taking into account the currency of borrowings
and credit risk). This could also be done under a rule that directly limits an
entitys interest expense (e.g. by taking a groups actual level of interest expense
into account).
The level of debt in an entity is under the control of the entitys management and
so is generally predictable. The amount of interest expense, however, may vary
reflecting changes in interest rates. This means that a rule that directly limits the
level of interest expense could make it difficult for an entity to enter into longterm borrowings if there is a risk that interest rates could increase and it would
suffer an interest disallowance in future periods.
59.
Taking these factors into account, and given the key policy objective is to tackle
base erosion and profit shifting involving interest and payments economically equivalent
to interest, the best practice set out in this report includes rules which directly limit the
level of interest expense that an entity may deduct for tax purposes. It also includes
features, such as the group ratio rule, which should address some of the possible issues
this raises. For example, if a group represents a greater credit risk and is required to pay a
higher rate of interest on its third party debt, a group ratio rule will take this into account
in setting a limit on tax deductions for entities within the group. As set out in the
Introduction, a country may continue to apply an arms length test alongside the best
practice approach. For example, this could ensure that the amount of interest expense
claimed by an entity is in accordance with the arms length principle, but this amount is
then subject to limitation under the best practice approach in this report.
Applying the best practice approach to limit an entitys gross interest expense or net
interest expense
60.
Another key question is whether a general interest limitation rule should apply to
the interest an entity incurs on its borrowings without any offset for interest income
(gross interest expense) or after offsetting the interest income it receives (net interest
expense).
61.
A gross interest rule has the benefit of simplicity and is also likely to be more
difficult for groups to avoid through planning. However, a gross interest rule could lead
to double taxation where each entity is subject to tax on its full gross interest income, but
part of its gross interest expense is disallowed.
62.
A net interest rule would reduce the risk of double taxation, as an entitys interest
income would be set against its interest expense before the interest limitation is applied. It
would also allow an entity to raise third party debt and on-lend borrowed funds within its
group, without the entity incurring a disallowance of part of its gross interest expense.
Taking into account these considerations, the general interest limitation rules contained in
this report apply to an entitys net interest expense paid to third parties, related parties and
intragroup, after offsetting interest income.1 Rules should apply to all of an entitys net
interest expense, as discussed in Chapter 2, to ensure that a broad range of base erosion
and profit shifting risks are addressed, including where excessive third party interest
expense is incurred in a high tax country.
63.
However, the fact that an entity has a relatively low net interest expense does not
mean that base erosion and profit shifting is not taking place. For example, an entity with
net interest income could use interest expense to shelter this income from tax. An entity
may also disguise other forms of taxable income as interest income, reducing the level of
net interest expense to which the rule can apply. Therefore, it is recommended that
countries supplement the general interest limitation rules with targeted provisions which
disallow gross interest expense in specific situations identified as posing base erosion and
profit shifting risk. This is discussed in Chapter 9. Rules which apply to limit an entitys
net interest expense will also have no impact on entities which, because of their business
model, are typically receivers of net interest income. This arises in particular in the
banking and insurance sectors, which are discussed in Chapter 10.
An option to exclude certain public-benefit projects

64.
The best practice approach set out in this report places a general limit on the level
of net interest expense that an entity may deduct for tax purposes. The fixed ratio rule
should be applied consistently to all interest paid to third parties, related parties and group
entities. However, as an exception to this general principle, a country may choose to
exclude interest expense incurred on specific third party loans meeting the conditions set
out below from the scope of the fixed ratio rule and group ratio rule. Except as set out in
this report, other exclusions should not be applied.
65.
In some countries, privately-owned public-benefit assets may be large-scale assets
financed using a high proportion of debt. However, because of the nature of the assets and
the close connection with the public sector, some such financing arrangements present
little or no base erosion or profit shifting risk.
66.
Taking account of the specific circumstances of the public sector, a country may
exclude certain amounts with respect to third party loans linked to specific assets when
calculating an entitys net interest expense which is subject to limitation under the best
practice approach. To ensure this approach is tightly targeted only on those projects
which do not pose a base erosion or profit shifting risk, the following conditions must be
met:
An entity (the operator) establishes a project to provide (or upgrade), operate
and/or maintain assets on a long-term basis, lasting not less than 10 years, and
these assets cannot be disposed of at the discretion of the operator.
A public sector body or a public benefit entity (the grantor),2 contractually or
otherwise obliges the operator to provide goods or services in which there is a
general public interest.3 This provision must be subject to specific controls or a
regulatory framework in addition to rules applying generally to companies or
other commercial entities within a jurisdiction.
Interest is payable by the operator on a loan or loans obtained from and owed to
third party lenders on non-recourse terms, so that the lender only has recourse to
and a charge over the assets and income streams of the specific project.
Arrangements involving recourse to other assets, guarantees from other group
companies or which otherwise seek to offer recourse beyond the project assets
would not qualify for the exclusion.
The loan or loans made to the operator do not exceed the value or estimated value
of the assets at acquisition or once constructed, unless additional investment is
made to maintain or increase their value. Subject to minimal and incidental
40 4. APPLYING A BEST PRACTICE APPROACH BASED ON THE LEVEL OF INTEREST EXPENSE OR DEBT
lending to a third party (such as a bank deposit), none of the funds should be
on-lent.
The operator, the interest expense, the project assets and income arising from the
project are all in the same country, where the income must be subject to tax at
ordinary rates.4 Where the project assets are held in a permanent establishment,
the exclusion will only apply to the extent that income arising from the project is
subject to tax at ordinary rates in the country applying the exclusion.
Similar projects of the operator or similar projects of other entities of the
operators group are not substantially less leveraged with third-party-debt, taking
into account project maturities.
67.
Countries making use of the exclusion may impose additional rules before
allowing an exclusion to apply, in order to prevent the exclusion being used by businesses
not engaged in projects which deliver public benefits. These might include a requirement
that obtaining the exclusion is not a main purpose of structuring the financing
arrangements to meet the other conditions of the exclusion. Countries making use of the
exclusion should publish full information about the scope of domestic legislation and the
circumstances in which it can be used, and should also introduce mechanisms to provide
for spontaneous exchange of information relating to the entities benefiting from the
exclusion and investors in these with all relevant jurisdictions. The framework in Chapter
5 of the OECD Report Countering Harmful Tax Practices More Effectively, Taking into
Account Transparency and Substance (OECD, 2015) would be used to determine the
jurisdictions with which to spontaneously exchange such information. Countries adopting
the exclusion should monitor its operation with a view to assisting in the review referred
to below. Such countries should require taxpayers to clearly disclose any use of this
exclusion.
68.
Where this exclusion applies, a country applying the exclusion should also take
steps to ensure that the project earnings and assets, and related interest expense, are not
used to permit further interest deductions for the entity or other group entities in the
country. Therefore, the country should adjust the operation of the fixed ratio rule and
group ratio rule, so that where an entity benefits from this exclusion:
Any earnings arising from the project (and/or the project assets) are excluded
from the calculation of earnings or asset values under the fixed ratio rule and
group ratio rule.
The interest expense which has been excluded from limitation should not be
included in the group's net third party interest expense when applying the group
ratio rule.
69.
There is also a risk that interest which benefits from this exclusion will be used to
increase the level of net interest deductions for group entities in other countries in which a
group ratio rule is applied. Therefore, in applying the group ratio rule, a country may
exclude any third party interest expense which benefits from an exclusion in any other
country. Similarly, project earnings and assets may be excluded from the calculation of
group earnings or asset values. Countries may obtain information on whether the
exclusion has been applied using the exchange of information provisions contained in
applicable international agreements. A country may also choose not to require the
adjustments in this paragraph, in order to minimise complexity.
70.
The design and operation of this exclusion will be included in the initial review of
the best practice, to be conducted by no later than the end of 2020. This will include
consideration of how the exclusion is being used, to ensure it is not giving rise to base
erosion or profit shifting risks. Following this review, the exclusion may be revised or
removed.
71.
EU law issues are considered in Annex A.
Notes
1.
The term "related party" is defined in Chapter 9.
2.
A public benefit entity will typically be an entity whose primary objective is to

provide goods or services for the general public, community or social benefit and
where any equity is provided with a view to supporting the entitys primary objectives
rather than to provide a financial return to equity holders. The definition of a public
benefit entity used by a country may be contained in law or a relevant applicable
accounting standard.
3.
Assets that provide goods and services in which there is a general public interest
would generally refer to assets that are public goods.
4.
Countries which are Member States of the European Union would need to take into
account EU law considerations in designing their domestic rules.
Bibliography
OECD (2015), Countering Harmful Tax Practices More Effectively, Taking into Account
Transparency and Substance, Action 5 - 2015 Final Report, OECD/G20 Base Erosion
and Profit Shifting Project, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264241190-en.
5. MEASURING ECONOMIC ACTIVITY USING EARNINGS OR ASSET VALUES 43
Chapter 5
Measuring economic activity using earnings or asset values
72.
Fixed ratio rules and group ratio rules restrict the ability of an entity to deduct
interest expense based on an objective measure of its economic activity. Work to develop a
best practice approach has focused on earnings and asset values, as the measures which
most clearly reflect the level of activity and value creation within a multinational group.
Measuring economic activity using earnings

73.
As highlighted in the previous chapter, a goal of the BEPS project is to address
practices that artificially separate taxable income from the activities that generate it. For most
entities it is expected that there should be a clear correlation between earnings and taxable
income. Therefore, measuring economic activity using earnings should be the most effective
way to ensure that the ability to deduct net interest expense is matched with the activities that
generate taxable income and drive value creation. In addition, depending upon the definition
of earnings used, this is a useful indicator of an entitys ability to meet its obligations to pay
interest, and therefore is one of the key factors used in determining the amount of debt an
entity is able to borrow.
74.
Another benefit of an earnings-based approach is that it makes a general interest
limitation rule more robust against planning. Where the level of deductible interest expense in
an entity is linked to earnings, a group can only increase net interest deductions in a particular
country by increasing earnings in that country. Similarly, any restructuring to move profits out
of a country will also reduce net interest deductions in the country. On the assumption that an
increase in earnings will also give rise to an increase in taxable income, it is unlikely that the
level of earnings will be manipulated in order to increase the interest deductions in a country.
75.
The BEPS Action Plan (OECD, 2013) specifically requires the development of rules
to address base erosion and profit shifting using interest expense to fund tax exempt or tax
deferred income. A third important benefit of an approach using earnings is that the definition
of earnings can be adapted to exclude income which is subject to favourable tax treatment. An
obvious example would be dividend income, which in many countries is exempt from tax or
is taxed at a reduced rate (subject to conditions such as a minimum holding requirement).
76.
The main disadvantage of earnings as a measure of economic activity is that an
entitys earnings may be relatively volatile and there is a limit to the extent this can be
controlled by a group. This means that under an earnings-based rule it may be hard for an
entity to anticipate the level of net interest expense that will be permitted from year to year.
This could make it difficult for an entity to calculate a cost of debt for long term projects,
without knowing the extent to which its interest cost will be deductible. To an extent, these
issues may be addressed in the design of a best practice approach, for example by allowing an
entity to measure economic activity using the average earnings over a number of periods or
44 5. MEASURING ECONOMIC ACTIVITY USING EARNINGS OR ASSET VALUES

by permitting an entity to carry forward disallowed interest expense and unused capacity to
deduct interest. These approaches are discussed in Chapter 8.
77.
A particular aspect of earnings volatility is the possibility that an entity may be in a
negative earnings (i.e. loss-making) position. Under an earnings-based approach, an entity
with negative earnings will be unable to deduct its net interest expense in the current period.
In principle, this could mean that an entity with losses could be required to pay taxes as a
result of an interest disallowance. However, this risk could be reduced depending upon the
definition of earnings used, and whether this is based on tax or accounting information. Other
mechanisms, such as the carry forward of disallowed interest expense, should enable a
loss-making entity to retain the benefit of interest deductions and claim relief once it returns to
profit.
Definition of earnings
78.
In terms of the definition of earnings to be used, earnings before interest, taxes,
depreciation and amortisation (EBITDA) and earnings before interest and taxes (EBIT) are
both possible options. In either, non-taxable income such as branch profits or dividend
income that benefit from a participation exemption should not be included in the calculation
of earnings. Appropriate adjustments should also be made for taxable branch profits and
dividend income to the extent that they are shielded from tax by foreign tax credits, in order
to address the base erosion and profit shifting issues which are the subject of this report.1
EBITDA is the most common measure of earnings currently used by countries with
earnings-based tests. By excluding the two major non-cash costs in a typical income
statement (depreciation of fixed assets and amortisation of intangible assets), EBITDA is a
guide to the ability of an entity to meet its obligations to pay interest. It is also a measure of
earnings which is often used by lenders in deciding how much interest expense an entity
can reasonably afford to bear. On the other hand, using EBITDA potentially favours entities
operating in sectors with high levels of fixed asset investment. This is because EBITDA
does not include the write-down of capitalised costs such as investment in plant and
machinery, whereas it does take into account revenue costs which are the majority of the
cost base for entities in other sectors. Data suggests that, across all industry sectors, average
gross interest/EBIT ratios based on information taken from consolidated financial
statements are approximately 40% higher than average gross interest/EBITDA ratios,
although there can be significant variation between different industry sectors.
Measuring economic activity using asset values

79.
The main benefit of an assets-based approach to measuring economic activity is that
in general asset values are typically more stable (except in the case of revaluations and
write-downs, and assets which are carried at fair value under accounting rules). This means
that using asset values as a basis for measuring economic activity within a group should
give rise to a relatively steady and predictable limit on the level of interest relief that can be
claimed. This would improve certainty for groups and could also reduce compliance costs.
In addition, an approach based on asset values would mean that entities with losses would
still be able to deduct an amount of net interest expense, which may not be possible under
an earnings-based approach.
80.
In order to provide an accurate measure of an entitys economic activity, an
assets-based rule should take into account the value of those assets which drive the creation
of value for the group. These would include assets such as land and buildings, plant and
equipment, intangible assets, and financial assets which give rise to income other than
5. MEASURING ECONOMIC ACTIVITY USING EARNINGS OR ASSET VALUES 45
interest, but excluding assets which give rise to non-taxable income (such as equity
holdings which give rise to tax exempt dividends). However, a key issue surrounding an
assets-based approach for the purposes of applying a fixed ratio rule is achieving a
consistent and acceptable model for valuing each of these classes of assets. In terms of
tangible assets, such as land and buildings and plant and equipment, a requirement to use
market values of assets would be impractical and impose an excessive compliance burden
on groups. However, an amortised historic cost valuation could give rise to inconsistencies
depending upon the age of assets and is subject to influence by decisions of management,
for instance on depreciation periods and the timing of revaluations and write downs.
Historic cost is also unlikely to represent the actual value an asset contributes to a groups
economic activity. Intangible assets including trademarks and patents can be a groups most
valuable assets. However, accounting standards often impose stringent requirements on
groups before they are able to recognise an intangible asset on their balance sheet,
particularly where the asset has been internally created. This means that for a number of
large groups, an approach to limiting interest deductions based on asset values for
accounting purposes will not directly take into account the groups most valuable assets
(although intangible assets may be indirectly reflected to the extent they give rise to
earnings which are not distributed and so are included in retained earnings within equity). A
specific area of difference in the treatment of assets under accounting standards is in the
recognition of financial assets including derivative balances, and in particular the ability of
groups to report positions on a gross or net basis. This can result in a significant difference
in the value of a groups total assets and under some accounting standards is left to the
discretion of a groups management, subject to conditions being met. These issues are in
particular a problem in applying a fixed ratio rule based on asset values as in these cases a
fixed benchmark ratio is applied to asset values which can vary significantly based on the
accounting standards and policies applied by different groups. Concerns over the
recognition and valuation of assets may be less of an issue in applying a group ratio rule, so
long as a consistent approach is taken at entity and group level.
Proposed approach
81.
On balance and taking into account the above factors, it appears that for a fixed ratio
rule earnings is the most appropriate measure of economic activity, for groups operating in the
majority of sectors and in different countries. In applying a group ratio rule, the differences
between an earnings-based and an assets-based approach are less significant. This is reflected
in the best practice approach set out in this report.
82.
It is recommended that a fixed ratio rule should measure earnings using EBITDA.
However, a country may apply a fixed ratio rule which measures earnings using EBIT, so
long as the other elements of the rule are consistent with the best practice in this report. Where
a country applies a fixed ratio rule based on EBIT, the benchmark net interest/EBIT ratio used
should be equivalent to the appropriate benchmark net interest/EBITDA ratio described in
Chapter 6, taking into account where the particular country would be placed within the
corridor based on the factors in that chapter. In considering whether a benchmark net
interest/EBIT ratio is equivalent to a net interest/EBITDA ratio, a country should take into
account differences between average EBIT and EBITDA figures for the major sectors in its
economy.
83.
Where the economy of a particular country is highly reliant on heavily capitalised
groups whose activities rely on tangible fixed assets with long depreciation periods, earnings
should still be a suitable measure of economic activity for the purposes of applying a fixed
46 5. MEASURING ECONOMIC ACTIVITY USING EARNINGS OR ASSET VALUES

ratio rule. However, in this case asset values may exceptionally be used as an acceptable
alternative. Where a country applies a fixed ratio rule based on asset values, other elements of
the rule should be consistent with the best practice approach. For example, the rule should
apply to limit net interest expense payable to third parties and group entities located within the
country and in other countries. The assets included in a valuation should include the main
categories of assets which drive economic activity in a group but should exclude assets which
give rise to non-taxable income such as dividends which qualify for a participation
exemption. Asset values may be based on accounting or tax numbers, but this should be
applied consistently. The benchmark net interest/assets ratio should be equivalent to the
appropriate benchmark net interest/EBITDA ratio described in Chapter 6, taking into account
where the particular country would be placed within the corridor based on the factors in that
chapter. In considering whether a benchmark net interest/assets ratio is equivalent to a net
interest/EBITDA ratio, a country may take into account the number of groups affected and the
overall level of net interest expense disallowed.
84.
Where a country applies a fixed ratio rule and group ratio rule both based on earnings,
it is recommended that either EBITDA or EBIT be used for both rules. As described in
Chapter 7, a country may also apply a fixed ratio rule based on earnings alongside a group
ratio rule based on asset values, so long as the group ratio rule only permits an entity to
exceed the benchmark fixed ratio where it is able to demonstrate that a relevant financial ratio
(such as equity/total assets) is in line with that of its group.
Notes
1.
Where branch profits benefit from a participation exemption, the entitys EBITDA or
EBIT should be reduced by an amount equal to the EBITDA or EBIT of the branch.
Where branch profits are taxed, an entitys EBITDA or EBIT should be reduced by an
amount equal to part of the branchs EBITDA or EBIT, in proportion to the extent
that the tax on branch profits is sheltered by tax credits. For example, under one
possible approach, if 25% of the entitys tax liability on the branch profits is sheltered
by tax credits, the entitys EBITDA or EBIT should be reduced by an amount equal to
25% of the EBITDA or EBIT of the branch.
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
6. FIXED RATIO RULE 47
Chapter 6
Fixed ratio rule
Aim of a fixed ratio rule

85.
The premise underlying the fixed ratio rule is that an entity should be able to
deduct interest expense up to a specified proportion of EBITDA, ensuring that a portion
of an entitys profit remains subject to tax in a country. A fixed ratio rule can apply to all
entities, including those in a multinational group, a domestic group and standalone
entities. The underlying benchmark fixed ratio is determined by a countrys government
and applies irrespective of the actual leverage of an entity or its group. Interest paid to
third parties, related parties1 and group entities is deductible up to this fixed ratio, but any
interest which takes the entitys ratio above this benchmark is disallowed.
86.
The key advantage of a fixed ratio rule is that it is relatively simple for companies
to apply and tax administrations to administer. On the other hand, a fixed ratio rule does
not take into account the fact that groups operating in different sectors may require
different amounts of leverage, and even within a sector groups may adopt different
funding strategies for non-tax reasons. Applying a fixed ratio rule differently to groups in
different sectors would inevitably make a rule more complex to administer, in particular
where a sector cannot be easily defined or where a group has activities across more than
one sector. The option to exclude interest funding certain public-benefit projects
described in Chapter 4 may help to address these issues for some entities. However, in
general, a country should apply the fixed ratio rule consistently, using the same
benchmark fixed ratio, to groups in all sectors (with the exception of groups in the
banking and insurance sectors, which are considered in Chapter 10, for which targeted
rules are being considered).
87.
However, groups in certain sectors may benefit from economic rent that means
they are able to generate high levels of EBITDA, which under the general approach
described in this report could give rise to relatively high levels of net interest deductions.
A country may therefore choose to apply a fixed ratio rule more strictly to groups in these
sectors. For example, groups in sectors which benefit from economic rents may be subject
to a lower benchmark fixed ratio, or the calculation of entity EBITDA may be adjusted to
strip out the effect of the economic rent.
Operation of a fixed ratio rule

88.
Fixed ratio rules apply a predetermined benchmark fixed ratio to the earnings of
an entity or a local group to calculate the maximum deductible interest expense.2
Calculating the amount of any interest expense disallowance under a fixed ratio rule
involves a three step process: firstly, calculating the appropriate measure of EBITDA;
secondly, applying the statutory benchmark fixed ratio to an entitys EBITDA to
48 6. FIXED RATIO RULE

determine the maximum deductible interest expense; and thirdly, comparing this with the
actual interest expense of the entity. The calculation of EBITDA should be based on
values that are determined under the tax rules of the country applying the rule. The use of
tax figures to calculate entity EBITDA has a number of advantages. Firstly, the rule
should be reasonably straightforward to apply and audit. Secondly, using tax numbers
reduces the risk that an entity with negative EBITDA is required to pay taxes as a result
of an interest disallowance. Finally, linking interest deductions to taxable earnings means
it is more difficult for a group to increase the limit on net interest deductions without also
increasing the level of taxable income in a country.
Step 1: Calculating the measure of earnings

89.
An entitys EBITDA should be calculated by adding back to its taxable income,
the tax values for: (i) net interest expense and net payments equivalent to interest
payments as defined in Chapter 2; and (ii) depreciation and amortization. Tax exempt
income, such as exempt dividend income or foreign earnings that are tax exempt, should
not form part of the entitys EBITDA figure. The rationale behind excluding exempt
dividend income is to address concerns related to the outbound investment scenario as
described in Action 4.
Step 2: Applying the statutory benchmark fixed ratio to earnings

90.
Following the calculation of the entitys EBITDA, the statutory benchmark fixed
ratio will be applied to the EBITDA figure. The result determines the maximum amount
of interest expense that the entity is allowed to deduct for tax purposes.
Step 3: Comparing maximum deductible interest expense with actual interest

expense
91.
In the last step, the maximum amount that the entity is allowed to deduct for tax
purposes is then compared with the entitys actual net interest expense.
92.
Net interest expense in excess of the maximum allowable amount is disallowed.
An illustration of how a fixed ratio rule might operate in practice is included as Example
4 in Annex D. This example also illustrates the potential advantages and disadvantages of
applying a fixed ratio rule at the level of the local group.
Setting a benchmark fixed ratio

93.
An effective fixed ratio rule requires a country to set the benchmark fixed ratio at
a level which is appropriate to tackle base erosion and profit shifting. At the same time, it
is recognised that countries differ in terms of both their economic environment and the
presence of other targeted tax rules which specifically address base erosion and profit
shifting risk involving interest. There are many factors which could affect the
competitiveness of countries to attract investment, including the tax rate, composition of
the tax base and interest deductibility rules. Therefore, without an agreed best practice
approach, there is a risk that competitiveness concerns would drive countries to adopt
benchmark fixed ratios at a high level which would allow more interest expense to be
deducted and reduce the effectiveness of the rule in tackling base erosion and profit
shifting.
A corridor of benchmark fixed ratios

94.
In order to address base erosion and profit shifting risks, by co-ordinating the
approach to setting a benchmark fixed ratio between countries and reduce the risk that
countries will be driven to apply a ratio at a level which is too high to address base
erosion and profit shifting risks, it is recommended that countries set their benchmark
fixed ratio within a best practice range or "corridor".
95.
In setting a best practice corridor, the key aim is to identify a range of benchmark
fixed ratios which:
allows the majority of groups to deduct an amount equivalent to their net third
party interest expense (assuming net interest expense is spread around the group
in accordance with accounting-EBITDA)
limits the extent to which groups can use intragroup interest expense to claim total
net interest deductions in excess of their net third party interest expense.
96.
Financial data provided to the OECD by BIAC/PwC3 illustrates the proportion of
publicly traded multinational groups with positive EBITDA that would in principle be
able to deduct an amount equivalent to their net third party interest expense, if a
benchmark fixed ratio is set at different levels. This assumes that a groups net interest
expense is spread around the group in accordance with EBITDA. Groups with negative
EBITDA are not included in this analysis, as the impact of a fixed ratio rule on an entity
with negative EBITDA is the same irrespective of the level at which a benchmark fixed
ratio is set. The numbers below are based on average figures over the period 2009 to
2013:4
At a benchmark fixed ratio of 10%, 62% of these groups would in principle be
able to deduct all of their net third party interest expense.
97.
Once a benchmark fixed ratio exceeds 30%, the rate at which more groups are
able to deduct all of their net third party interest expense increases more slowly.
However, at this level, a significant proportion of groups may have an incentive to
increase the level of intragroup debt in order to claim net interest deductions in excess of
their net third party interest expense. For example, based on the financial data referred to
in the paragraph above, around half of publicly traded multinational groups with positive
EBITDA have a net third party interest/EBITDA ratio of 5% or below. Therefore, at a
benchmark fixed ratio of 30%, there is a risk that these groups could deduct up to six
times their actual net third party interest, assuming there are no impediments to the use of
intragroup debt. This risk increases if a benchmark fixed ratio is set above this level. On
the basis of this analysis, and balancing the goals of allowing most groups to deduct their
net third party interest expense and limiting the risk that groups will deduct more than this

amount, it is recommended that countries applying a fixed ratio rule based on a net
interest/EBITDA ratio set their benchmark fixed ratio within a corridor of 10% to 30%.
As set out in Chapter 11, this corridor may be revised following an initial review of the
best practice, to be completed by no later than the end of 2020.
98.
Within the best practice corridor, a majority of groups with positive EBITDA
should in principle be able to deduct all of their net third party interest expense. A country
could also include other elements of the best practice approach to enable entities in
groups with a net third party interest/EBITDA ratio above the benchmark fixed ratio to
deduct more net interest expense, where they pose a low risk of base erosion and profit
shifting. For example, a group ratio rule may be used to allow an entity which exceeds the
benchmark fixed ratio to deduct more net interest expense up to the level of the groups
net third party interest/EBITDA ratio where this is higher. A country may also apply a de
minimis threshold to exclude from the scope of a fixed ratio rule and group ratio rule
entities with low net interest expense.
Factors to assist countries in setting a benchmark fixed ratio

99.
It is recommended that countries set their benchmark fixed ratio within the
corridor of 10% to 30%. However, it should be recognised that countries differ in terms
of their legal framework and economic circumstances and, in setting a benchmark fixed
ratio within the corridor which is suitable for tackling base erosion and profit shifting, a
country should therefore take into account a number of factors, including the following:
1. A country may apply a higher benchmark fixed ratio if it operates a fixed ratio
rule in isolation, rather than operating it in combination with a group ratio rule.
2. A country may apply a higher benchmark fixed ratio if it does not permit the carry
forward of unused interest capacity or carry back of disallowed interest expense.
3. A country may apply a higher benchmark fixed ratio if it applies other targeted
rules that specifically address the base erosion and profit shifting risks to be dealt
with under Action 4.
4. A country may apply a higher benchmark fixed ratio if it has high interest rates
compared with those of other countries.
5. A country may apply a higher benchmark fixed ratio, where for constitutional or
other legal reasons (e.g. EU law requirements) it has to apply the same treatment
to different types of entities which are viewed as legally comparable, even if these
entities pose different levels of risk.
6. A country may apply different fixed ratios depending upon the size of an entitys
group.
100.
These factors are considered in more detail below.
A country may apply a higher benchmark fixed ratio if it operates a fixed ratio
rule in isolation, rather than operating it in combination with a group ratio rule
101. Where a country operates a fixed ratio rule alongside a group ratio rule, an entity
which exceeds the fixed ratio may be able to deduct more net interest expense up to the
relevant financial ratio of its group. The country is therefore able to apply a benchmark
fixed ratio at a lower level, relying on the group ratio rule to moderate the impact of this
on entities in groups which are highly leveraged. On the other hand, where a country
introduces a fixed ratio rule without a group ratio rule, it may apply a higher benchmark
fixed ratio.
A country may apply a higher benchmark fixed ratio if it does not permit the carry
forward of unused interest capacity or carry back of disallowed interest expense
102. Unused interest capacity is the amount by which an entitys net interest expense is
below the maximum amount permitted under the fixed ratio rule. As discussed in Chapter
8, where a country permits unused interest capacity to be carried forward, this could give
rise to a tax asset which may be monetised by increasing the entitys net interest expense
or by reducing its EBITDA. As these behaviours should not be encouraged by a rule to
tackle base erosion and profit shifting, a country which allows the carry forward of
unused interest capacity should apply a lower benchmark fixed ratio to reduce this
incentive. Similarly, a country which permits the carry back of disallowed interest
expense, which gives rise to the same risk, should also apply a lower benchmark fixed
ratio. The weight which should be attached to this factor would depend upon the extent to
which a country incorporates the restrictions discussed in Chapter 8. A country which
does not allow either a carry forward of unused interest capacity or a carry back of
disallowed interest expense may apply a higher benchmark fixed ratio.
A country may apply a higher benchmark fixed ratio if it applies other targeted
rules that specifically address the base erosion and profit shifting risks to be dealt
with under Action 4
103. Action 4 focuses on the development of best practices in the design of rules to
prevent base erosion and profit shifting through the use of third party, related party and
intragroup interest, including payments economically equivalent to interest, to achieve
excessive interest deductions or finance the production of exempt or deferred income.
The recommended best practice approach includes the fixed ratio rule described in this
chapter, but it is recognised that other targeted interest limitation rules may also be
effective in tackling some of these risks. For example, a country may have a targeted rule
which disallows all interest expense used to fund tax exempt income. Where a country
has targeted rules which specifically address the base erosion and profit shifting risks to
be dealt with under Action 4, and it applies these rules in practice, these may reduce
pressure on the fixed ratio rule meaning that a higher benchmark fixed ratio could be
applied. The extent to which this factor supports a higher benchmark fixed ratio depends
upon the extent to which the specific base erosion and profit shifting risks involving
interest and targeted by Action 4 are addressed. Where a country does not have other
rules which specifically deal with the base erosion and profit shifting risks targeted by
Action 4, it should apply a lower benchmark fixed ratio.
A country may apply a higher benchmark fixed ratio if it has high interest rates
compared with those of other countries
104. The net interest/EBITDA ratio of entities which raise third party debt locally can
be impacted by a number of factors, including the level of a countrys interest rates.
Where a countrys interest rates are high relative to those in other countries, the country
may recognise this by applying a higher benchmark fixed ratio. This is not intended to
favour entities operating in a high interest rate country, but simply recognises the fact that
these entities are likely to be subject to a higher cost of funds. The extent to which this
factor supports a higher benchmark fixed ratio depends upon the extent to which interest

rates are higher than those in other countries. However, a country with high interest rates
may still apply a low benchmark fixed ratio. For example, where a country applies the
same benchmark fixed ratio to all entities, including those in large groups which are less
likely to be exposed to differences in interest rates between countries, it may decide that it
is not appropriate for its high interest rate to be taken into account when setting the ratio.
Where a country has low interest rates compared with other countries, it should apply a
lower benchmark fixed ratio. In comparing its interest rates with those of other countries,
a country may take into account one or more relevant rates, such as the central bank rate,
the long-term government bond rate and the average corporate bond rate for entities with
a good credit rating (for example, equivalent to a credit rating of "A" or above). Whether
a particular interest rate is high or low must be judged in comparison with other countries
and will change over time as interest rates move. Currently, it is suggested that a longterm government bond rate that is above 5% may be considered to be high.
A country may apply a higher benchmark fixed ratio, where for constitutional or
other legal reasons (e.g. EU law requirements) it has to apply the same treatment
to different types of entities which are viewed as legally comparable, even if these
entities pose different levels of risk
105. As set out in Chapter 3, the main base erosion and profit risk involving interest is
posed by entities in multinational groups. Therefore, within the best practice approach, a
country may restrict the application of the fixed ratio rule to these entities. However, in
some cases, constitutional or legal requirements mean that a country is also required to
apply the fixed ratio rule to other entities which are seen as legally comparable, including
entities in domestic groups and/or standalone entities which may pose less risk of base
erosion and profit shifting involving interest. In this case, because the country is required
to apply the same treatment to entities which are legally comparable, including those
which pose less base erosion and profit shifting risk, the country may apply a benchmark
fixed ratio at a higher level within the corridor. In such situations, a country may
alternatively decide to apply a lower ratio in order to ensure that base erosion and profit
shifting involving interest is addressed, even though this would also be applied to entities
which pose less risk.
A country may apply different fixed ratios depending upon the size of an entitys
group
106. In general, entities in large groups are in a different position to other entities when
raising third party debt. For example, large groups are more likely to raise third party debt
centrally, they may have better access to global capital markets, and they may have
greater bargaining power with lenders. Large groups also often have sophisticated
treasury functions to manage the financial position of the group, including its interest
cost. This has two important implications for the application of a fixed ratio rule to
entities in large groups compared with other entities:
Firstly, the analysis of financial data provided to the OECD during the public
consultation on Action 4 indicates that large groups tend to have lower net third
party interest/EBITDA ratios compared with other groups. For example, a
benchmark fixed ratio of 30% would allow around 95% of publicly traded
multinational groups with market capitalisation of USD 5 billion or above and
with positive EBITDA to deduct all of their net third party interest expense,
compared with around 85% of groups of all sizes. Therefore, to create a level
playing field, a country may apply one benchmark fixed ratio to entities in large
groups, and a higher benchmark fixed ratio to other entities.
Secondly, because large groups are more likely to raise third party debt centrally,
they are less likely to be exposed to differences in interest rates in the countries in
which they operate. Therefore, in setting a benchmark fixed ratio to apply to
entities in large groups, a country should not take into account whether its interest
rate is higher or lower than those in other countries (i.e. factor 4 above should not
be taken into account).
107. Where a country applies a different benchmark fixed ratio to entities in large
groups compared with other entities, the definition of a large group should be based on
the position of an entitys worldwide group and not only the local group including entities
in the country. Although the data referred to above defined a large group based on market
capitalisation, it is not recommended that this definition be used to set a benchmark fixed
ratio. For privately held groups, a definition based on market capitalisation could not be
applied. For publicly held groups, market capitalisation depends on many factors other
than the groups level of economic activity. It is therefore suggested that a countrys
definition of a large group should be based on group consolidated revenue or group
assets. Information on a groups consolidated revenue or assets may be obtained from the
groups consolidated financial statements or directly from entities in the group where
consolidated financial statements are not prepared. Information provided for the purposes
of Country-by-Country reporting (Transfer Pricing Documentation and Country-byCountry Reporting (OECD, 2015)) may be used as a risk assessment tool to identify
groups which may exceed this threshold, although this information should not be used by
itself in order to apply a lower benchmark fixed ratio. Where a country applies different
benchmark fixed ratios to entities in large groups and to other entities, it should include
provisions to accommodate groups which cross the threshold, for example through a
merger or divestiture. Such transitional provisions should be available for at most three
years, to give groups an opportunity to adjust their capital structures.
Other factors that may be taken into account

108. When setting a benchmark fixed ratio within the corridor of 10% to 30%,
countries may also take into account other relevant factors in addition to those set out
above. For example:
A country may apply a higher ratio within the corridor where data shows that
there are high levels of net interest expense or debt due to economic or business
policies and not due to base erosion and profit shifting.
A country may apply a higher ratio within the corridor where it applies a
macro-economic policy to encourage third party lending not related to base
erosion and profit shifting, to increase investment (e.g. in infrastructure).
A country may apply either a higher ratio or a lower ratio within the corridor
where this is justified by local data on the external gearing of its domestic groups
or the worldwide gearing of multinational groups operating in the country. This
local data may for instance be based on tax rather than accounting figures.
A country may apply a lower ratio within the corridor where it wishes to apply a
stricter approach to tackling base erosion and profit shifting involving interest.

109. However, a country should not take into account any factor which is inconsistent
with this report, which introduces competition issues or which fails to take into account
the level of base erosion and profit shifting risk involving interest in that country. For
example:
A country should not apply a higher ratio where it has high levels of net interest
expense or debt compared to those in other countries, which does not have a
non-tax justification.
A country should not apply a higher ratio due to a policy of attracting
international investment into a country through lenient interest limitation rules.
Applying factors to set a benchmark fixed ratio within the best practice corridor
110. It is recommended that a country uses the factors in this chapter, along with other
relevant factors, to set its benchmark fixed ratio within the recommended corridor. A
country may develop its own approach as to how to apply the factors in setting a ratio,
including applying a different weighting to each factor depending upon the extent to
which it applies. In all cases, a country is able to choose to apply a lower benchmark
fixed ratio within the corridor.
111. Illustrations of ways in which a country could use the factors to set its benchmark
fixed ratio within the recommended corridor are included as Example 5 in Annex D.
These are intended to illustrate possible ways in which a country could apply the factors
in this chapter, but are not exhaustive and a different approach may be used.
Changes over time

112. Interest rates change over time and given interest rates are currently at a low level
compared with long term averages, it may be necessary for a benchmark ratio to reflect
changing interest rate environments. At the same time, however, countries need to
consider that an entitys capacity to serve its interest payments is independent of the
interest rate environment and that an increase in interest rates should typically result in
reduced levels of debt. In this context, academic studies have found that corporate
taxpayers issue more debt when interest rates are at a low level compared with
historically higher rates (Barry et al., 2008).
113. Countries are therefore not expected to change the benchmark fixed ratio over
time, but they may choose to change the ratio where there is a significant change in
interest rates. For example, academic studies suggest that a countrys credit rating, which
influences the interest rates a country has to pay, has a significant impact on the credit
rating for corporate bonds (Borensztein, Cowan and Valenzuela, 2007). This suggests that
where a countrys credit rating undergoes a significant change the benchmark fixed ratio
may also be adjusted. However, to provide taxpayers with stable benchmark fixed ratios,
countries should consider making changes only on an exceptional basis.
114. Additionally, where a country opts to make adjustments to the benchmark fixed
ratio the country should ensure that the ratio moves down as well as up. For example, say
a country operates an interest/EBITDA fixed ratio rule with a benchmark fixed ratio of
15%. As a result of an economic crisis domestic interest rates increase sharply, increasing
the interest rates for local businesses. To reflect this increase the government raises the
benchmark fixed ratio from 15% to 20%. At the same time, the government makes
provision that when the interest rates return to pre-crisis levels the benchmark fixed ratio
will automatically drop down to 15%.
Notes
1.
2.

system.
3.
On 18 December 2014, the OECD released a Public Discussion Draft on Action 4 (see
Public Discussion Draft - BEPS Action 4: Interest deductions and other financial payments
(www.oecd.org/ctp/aggressive/discussion-draft-action-4-interest-deductions.pdf). As part of
their response, BIAC provided financial data based on an analysis performed by
PricewaterhouseCoopers (PwC) of net interest/EBITDA ratios for public companies
(see "Comments received on Public Discussion Draft BEPS Action 4: Interest
deductions
and
other
financial
payments
Part
1"
page
179
www.oecd.org/ctp/aggressive/public-comments-action-4-interest-deductions-otherfinancial-payments-part1.pdf). Following the public consultation PwC provided updated
figures, included in Annex B.
4.
See Table B.3 in Annex B.
Bibliography
Barry, C.B. et al. (2008), Corporate debt issuance and the historical level of interest
rates, Financial Management, Vol. 37, Financial Management Association
International, pp. 413-430.
Borensztein, E., K. Cowan and P. Valenzuela (2007), Sovereign Ceilings Lite? The
Impact of Sovereign Ratings on Corporate Ratings in Emerging Market Economies,
IMF Working Paper, No. 07/75, International Monetary Fund, Washington, DC.
OECD (2015), Transfer Pricing Documentation and Country-by-Country Reporting,
Action 13 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project,
7. GROUP RATIO RULE 57
Chapter 7
Group ratio rule
Aim of a group ratio rule

115. Under the recommended fixed ratio rule, an entity or local group can deduct net
interest expense up to a fixed percentage of its EBITDA.1 However, a fixed ratio rule
does not take into account the fact that groups in different sectors may be leveraged
differently and, even without a sector bias, some groups are simply more highly
leveraged. Therefore, if a fixed ratio rule is introduced in isolation, groups which have a
net third party interest/EBITDA ratio above the benchmark fixed ratio would be unable to
deduct all of their net third party interest expense. To reduce the impact on more highly
leveraged groups, it is recommended that countries consider combining a fixed ratio rule
as described in Chapter 6, with a group ratio rule. This would allow an entity in a highly
leveraged group to deduct net interest expense in excess of the amount permitted under
the fixed ratio rule, based on a relevant financial ratio of the worldwide group. This
means that the benchmark fixed ratio can be kept low, in particular for entities in large
multinational groups, making sure the fixed ratio rule is effective in combating base
erosion and profit shifting, while the group ratio rule compensates for the blunt operation
of such a rule.
116.
A group ratio rule may be introduced as a separate additional provision, or as an
integral part of an overall rule including a fixed ratio rule. For example, where a country
applies an approach based on an entitys net interest/EBITDA ratio, a single rule could
provide that an entity can deduct up to the higher of the benchmark fixed ratio and the
groups ratio. The decision to implement the fixed ratio rule and group ratio rule
separately or as parts of a single rule may depend upon how a country intends the
different elements to operate. For example, a single rule with two parts may be easier to
apply if a country determines that both the fixed ratio and group ratio elements should use
the same calculation of entity EBITDA based on tax numbers, and the same carry
forward/carry back provisions
117. This chapter contains a description of a best practice rule which allows an entity
which exceeds the benchmark fixed ratio to deduct net interest expense up to its groups
net third party interest/EBITDA ratio, if this is higher. Where the net interest/EBITDA
ratio of an entity exceeds that of its group, the entity can claim deductions up to its
groups ratio. Only net interest expense which exceeds both the benchmark fixed ratio
and the ratio of its group should be disallowed. While a rule based on a net third party
interest/EBITDA ratio should be effective in tackling base erosion and profit shifting, it is
recognised that some groups are subject to legal or practical constraints that limit their
ability to align net interest expense and EBITDA in each entity. For these groups, some of
the elements within the best practice approach, such as applying an uplift to net third
58 7. GROUP RATIO RULE

party interest expense (discussed in the section on Calculation of net third party interest
expense below), and carry forward/carry back provisions (discussed in Chapter 8), may
reduce the impact of these constraints. Simple illustrations of how a group ratio rule in
this form would allow an entity which exceeds the benchmark fixed ratio to deduct more
interest expense up to its groups net third party interest/EBITDA ratio are included in
Example 6 in Annex D. It is recognised that to date no country applies a group ratio rule
based on this approach. Therefore, this report sets out a framework for a group ratio rule
using a net third party interest/EBITDA ratio, but further technical work on the design
and operation of such a rule will be undertaken and completed in 2016.
Option to apply different group ratio rules, or no group ratio rule

118. A number of countries currently apply a fixed ratio rule in combination with a
group ratio rule using an assets-based ratio, such as equity/total assets. For example,
under the "equity escape" rule applied in Finland and Germany (described in Annex C),
the fixed ratio rule based on net interest/EBITDA does not apply if an entity can show
that its equity/total assets ratio is equal to or exceeds that of its group (within a small
tolerance). This approach has a stricter outcome for many groups as, where an entity is
more highly leveraged than its group, it remains subject to the fixed ratio rule whereas,
under the net third party interest/EBITDA rule described in this chapter, only net interest
that exceeds both the benchmark fixed ratio and the groups ratio is disallowed. However,
for a loss-making entity, the equity escape rule could be more generous, as the entity may
still deduct its net interest expense if it can demonstrate that the requirements of the rule
are met. Where a country applies a group ratio rule which differs from the net third party
interest/EBITDA rule in this report, the countrys rule is included in the best practice so
long as it only permits an entity to exceed the benchmark fixed ratio based on a relevant
financial ratio of its group (such as equity/total assets).
119. There will be cases where countries decide to apply a fixed ratio rule in isolation,
without a group ratio rule. This could be because a country wishes to reduce the tax bias
between funding using debt or equity for all entities; or where, for constitutional or other
reasons, a country wants to apply the same benchmark fixed ratio to all entities, without
reference to the leverage position of the wider group. Where a country does not apply a
group ratio rule, it should apply the fixed ratio rule consistently to entities in
multinational and domestic groups, without improper discrimination.
120. Whether a country applies the group ratio rule described in this chapter, a
different group ratio rule, or no group ratio rule, in all cases, a best practice approach
must include a fixed ratio rule with a benchmark fixed ratio set within the corridor and
based on the factors described in Chapter 6.
Obtaining financial information on a group

121. The group ratio rule requires an entity to be able to determine the net third party
interest/EBITDA ratio of its worldwide group. This means that an entity must obtain
information on its group which can be audited by its local tax authority, reducing the need
for the local tax authority to obtain information from tax authorities in other countries.
Therefore, it is important that a best practice approach be designed with this need in
mind, so that a rule can be reasonably simple to apply by groups and tax authorities.
Where an entity is unable to obtain information on its group necessary to apply the group
ratio rule, it can still apply the fixed ratio rule and deduct interest up to the benchmark
fixed ratio.
122. Consolidated financial statements provide the most reliable source of financial
information on a worldwide group. Therefore, where possible, the group information
required to apply a group ratio rule should be taken from a groups consolidated financial
statements. A national tax authority will typically not be in a position to confirm the
accuracy of group financial data, and so it is recommended that consolidated financial
statements should be audited by an independent regulated accountant. However, a country
may allow unaudited financial statements to be used so long as these are subject to some
form of reliable independent confirmation, or are reviewed by the tax authority.
123. It is recommended that, as a minimum, countries should accept consolidated
financial statements prepared under local Generally Accepted Accounting Principles
(GAAP) and the most common accounting standards used by large listed multinational
groups (i.e. International Financial Reporting Standards (IFRS), Japanese GAAP and US
GAAP). In order to enable non-listed groups to prepare a single set of consolidated
financial statements for use in all countries in which they operate, countries should
consider accepting consolidated financial statements prepared under other accounting
standards, but it is left to each country to determine which accounting standards to accept
(e.g. taking into account the geographical region and main sources of foreign investment).
124. For most listed groups and many unlisted groups, audited consolidated financial
statements will be available from public sources including the groups website. In other
cases, consolidated financial statements will need to be provided directly to the tax
authority by entities in a group. In some cases, a tax authority may wish to use exchange
of information provisions in applicable international agreements to confirm with the tax
authority in the country of the groups parent company that the consolidated financial
statements they have been provided with are the same as those provided by the parent, to
ensure the group is using the same consolidated numbers in different countries.
Definition of a group
125. Given consolidated financial statements provide the most complete and objective
source of financial information on multinational groups, a practical and workable
definition of a group is one that is based on a consolidated group for financial accounting
purposes. Therefore, for the purposes of applying a group ratio rule, a group includes a
parent company and all entities which are fully consolidated on a line-by-line basis in the
parents consolidated financial statements.
126. In general, the parent should be the top level company in a holding structure.
Where a group prepares consolidated financial statements at different levels (e.g. for local
reporting or regulatory purposes), the group will be based on the consolidated financial
statements prepared by the top level company (i.e. the highest level of consolidation). A
group cannot be headed by an individual or entity other than a company. A group does
not include entities which are included in the consolidated financial statements but are not
fully consolidated on a line-by-line basis. In other words, it does not include entities
which are included using equity accounting, proportionate consolidation or at fair value.
In limited situations, an entity may be controlled by a company but not consolidated in
that companys consolidated financial statements. This may arise for example where the
company is an investment entity which makes investments for the purposes of capital
appreciation and/or investment income, and may account for these investments at fair

value. In these situations, even though the controlled entity is not the top level company
in the holding structure, it may be the parent of a separate group (including itself and any
entities that it includes in its consolidated financial statements). Illustrations of how this
definition would apply to groups in different scenarios are included as Example 7 in
Annex D.
127. As set out in Chapter 9, a group ratio rule should be supported by a targeted rule
to address the risk that a group ratio could be inflated using interest paid to a related party
outside the group.2 A targeted rule should be an effective solution to this risk, and also
has the benefit that only groups which make interest payments to related parties would be
required to make an adjustment under the rule. However, a country may choose to
address this risk by including specified related parties, such as those under the common
control of an individual or non-corporate entity, within the definition of a group. This
approach is currently taken by some countries which apply a group ratio rule based on an
equity/total assets ratio. A country may also address this risk by excluding all interest
paid to related parties from the calculation of the groups net third party interest expense
(as set out in the section Calculation of net third party interest expense below).
128. Where a country applies the best practice approach to the position of the local
group rather than to each entity separately, attention will need to be paid to issues arising
from differences between a group for financial reporting purposes (which in broad terms
is based on a 50% control test) and a group for tax purposes (which is usually based on a
higher level of control). A countrys local group for the purposes of applying the group
ratio rule may therefore include entities which are not included in a group for other tax
purposes. Where this is the case, the interaction with, for example, tax consolidation, loss
surrender and profit contribution rules may need to be considered. These issues are
considered in Chapter 11.
Operation of a group ratio rule

129. Determining the amount of net interest expense deductible under a group ratio
rule involves a two stage test.
1. Determine the groups net third party interest/EBITDA ratio
Net third party interest expense / Group EBITDA = Group ratio
2. Apply the groups ratio to an entitys EBITDA
Group ratio x Entity EBITDA = Limit on net interest deductions
Stage 1: Determine the groups net third party interest/EBITDA ratio

130. The first stage in applying the group ratio rule is to calculate the worldwide
groups net third party interest/EBITDA ratio. To ensure that a rule is as straightforward
as possible for a group to apply and for tax authorities to audit, this should be based on
information which can be obtained from the groups consolidated financial statements.
Calculation of net third party interest expense

131. As described in Chapter 2, a best practice approach should address base erosion
and profit shifting involving interest and payments economically equivalent to interest.
Accounting standards vary in their treatment of a groups financial income and expenses,
but most take a broad approach which includes interest and payments economically
equivalent to interest. It is therefore recommended that when calculating a groups net
third party interest/EBITDA ratio, net third party interest expense should be based on
financial accounting figures.
132. Within this approach, a groups net third party interest expense could be
determined in three ways. These represent increasing degrees of accuracy but, at the same
time, increasing degrees of complexity.
Approach 1: Using unadjusted financial reporting figures

133. The most straightforward approach to determining net third party interest expense
would be to take income and expense figures directly from a groups consolidated
financial statements without adjustment. Depending upon the accounting standards and
policies applied, these may be described as interest income and expense, finance income
and expense, or a similar term. This would be a simple approach to apply which in many
cases should provide effective protection against serious base erosion and profit shifting.
However, a risk remains as using unadjusted figures could mean that a groups net third
party interest expense may be overstated or understated, resulting in a limit on an entitys
net interest deductions which is too high (giving rise to possible base erosion and profit
shifting) or too low (giving rise to double taxation). This approach would also mean that a
groups net third party interest expense would vary depending on the accounting
standards applied, and the ability for interest income or expense to be included in a
different line of the groups income statement. For example, in some cases accounting
standards allow flexibility for certain items of income and expense to be recognised in
operating profit, in finance income and expense, or as a separate item on the face of the
consolidated income statement. Finally, using unadjusted figures could result in
significant volatility in a groups net third party interest expense, for example where a
group preparing consolidated financial statements under IFRS includes fair value
movements on financial assets and liabilities within finance income and expense.
Approach 2: Using financial reporting figures adjusted for certain amounts

134. Rather than using figures taken directly from a groups consolidated financial
statements without adjustment, a country could require an entity to make adjustments to
include or exclude certain payments. This would result in a slightly more complex rule,
but one which addresses some of the differences between accounting standards and more
accurately reflects the amounts described in Chapter 2. Possible adjustments which a
country could require an entity to make in determining net third party interest expense
include the following:
The removal of payments which are not economically equivalent to interest.
This could include (i) dividend income, (ii) gains and losses on the disposal of
financial instruments, (iii) fair value gains and losses on financial instruments,
and (iv) notional interest amounts which do not include actual payments of
interest. In many cases these amounts may be identified in a groups consolidated
financial statements.

The addition of capitalised interest. Capitalised interest is included in the
balance sheet valuation of an asset and is not included in the groups finance
expense. The amount of interest capitalised in a year will often be identified in a
groups consolidated financial statements. An adjustment for capitalised interest
may be made in the period where the interest is incurred, or as it is amortised over
the life of the related asset.
The addition of interest income or expense recognised within a different
category of income or expense. This could include interest income which is
included within gross revenue, or interest expense which is included within cost
of sales or in the tax line. In some cases these amounts may not be identified in a
groups consolidated financial statements, and will need to be obtained from
underlying financial information. Groups may be able to introduce processes to
identify these payments more easily, in particular where this would mean an
increase in total net third party interest expense.
135. Where a country applies this approach, it could require an entity to have the
amount of each adjustment to be confirmed by an independent regulated accountant.
Alternatively a tax authority may conduct its own enquiries to confirm the adjustments.
Approach 3: Using a financial reporting valuation of interest and other payments

specified in Chapter 2
136. The most accurate, but potentially the most complex, approach would be to
require an entity to provide a valuation of the amounts included in the definition of
interest and payments economically equivalent to interest set out in Chapter 2, based on
the amounts included in its groups consolidated financial statements.
137. In most cases this should give substantially the same value for net third party
interest expense as under Approach 2. However, where there is a difference between the
items included in a groups finance income and expense and those included in the
definition contained in Chapter 2, which is not represented by adjustments set out above,
this approach should give the more precise and targeted result. On the other hand, it may
be more difficult for this value of net third party interest expense to be confirmed directly
using a groups consolidated financial statements and so this approach should only be
used if a country is confident that it is able to audit a groups underlying books and
records.
Proposed approach
138. The calculation of net third party interest income should be based on figures taken
from a groups consolidated financial statements. While the use of unadjusted figures is
currently considered an acceptable approach, there are risks that net third party interest
expense could be overstated or understated and it is likely that most countries will wish to
make some adjustments to these figures, although in the interests of simplicity these
adjustments should be kept to a minimum. Further work is required to assess the
feasibility of each of the above approaches, how information may be obtained from
financial statements prepared under different accounting standards and, where
adjustments to financial reporting figures are to be made, what amounts should be
included and excluded from net third party interest expense.
139. Under all three approaches, a country can choose to allow an uplift of net third
party interest expense of up to 10%. This would reduce the risk that all of a groups actual
net third party interest expense is not taken into account. It would also reduce the impact
of constraints which mean that, even in the long term, a group may not be able to
precisely align its net interest expense and EBITDA. An illustration of how an uplift
could be applied is included in Example 6c in Annex D.
140. As discussed above in the section on Definition of a group, under a group ratio
rule there is a risk that a groups net third party interest expense may be inflated using
interest paid to related parties outside the group. This would have the effect of increasing
the groups net third party interest/EBITDA ratio, and increase the limit on net interest
deductions applicable to each group entity. A country may address this risk by providing
that net third party interest expense should exclude any payments made to related parties.
Alternatively, where a country allows interest paid to related parties to be included in net
third party interest expense, it should introduce targeted rules as described in Chapter 9 to
ensure that these payments are not used to reduce the effectiveness of the rule in tackling
base erosion and profit shifting.
Calculation of group EBITDA

141. EBITDA is an objective measure of economic activity in a group, which can be
applied to groups operating in most sectors (with the exception of the banking and
insurance sectors, which are considered in Chapter 10). EBITDA is not generally
included on the face of a groups consolidated income statement, but for the purposes of
applying a group ratio rule, it should be calculated using figures which are readily
available from a groups consolidated financial statements.
142. Within a best practice, as a starting point group EBITDA should be profit before
tax plus net third party interest expense, depreciation and amortisation (including
impairment charges). To avoid double counting, where net third party interest expense
has been adjusted to include capitalised interest (or the amortisation of capitalised
interest), depreciation and amortisation should be adjusted to strip out any amounts that
represent the amortisation of interest included in the value of capitalised assets. Further
work will be conducted to refine the definition of group EBITDA, including for example
whether or not it should exclude items such as dividend income (and whether this should
be dependent on if the dividends would be taxable if received in the country applying the
rule), other finance income and expense not included in net third party interest expense,
one-off items resulting from restructurings and mergers, and the share of profit from
associates and joint venture entities which are included in the consolidated financial
accounts under equity accounting but are not part of the group for group ratio rule
purposes.3
Stage 2: Apply the groups ratio to an entitys EBITDA

143. Once a groups net third party interest expense and EBITDA have been
established, it is possible to calculate the groups net third party interest/EBITDA ratio.
This ratio may then be applied to the EBITDA of an individual entity within a group to
determine the limit on net interest deductions that may be claimed under a group ratio
rule. Within the best practice, a country may provide for entity EBITDA to be calculated
using either tax or accounting principles. A summary of how to determine an entitys taxEBITDA and accounting-EBITDA under a best practice approach is set out below. More
detail, including illustrations of how these approaches may give rise to different results, is
included in Example 8 in Annex D.
Determining an entitys tax-EBITDA

144. An entitys tax-EBITDA is equal to its taxable profit after adding back tax values
for net interest expense, depreciation and amortisation. These values are determined
under the tax rules of the country applying the rule. Non-taxable income such as branch
profits or dividend income that benefit from a participation exemption should not be
included within tax-EBITDA. Appropriate adjustments should also be made for taxable
branch profits and dividend income to the extent that they are shielded from tax by foreign
tax credits, to address the base erosion and profit shifting issues which are the subject of this
report. A groups net third party interest/EBITDA ratio can be applied to an entitys
tax-EBITDA to give a tax-based limit on net interest deductions. This limit is compared
directly to the entitys net interest expense for tax purposes to determine the amount
which may be deducted.
145. Determining EBITDA using tax principles is consistent with the approach
recommended for calculating entity earnings under the fixed ratio rule. It is also
straightforward for groups to apply and tax authorities to audit, and as an approach to
tackle base erosion and profit shifting it has the benefit that an entitys interest deductions
are linked to its level of taxable income. This means that where an entitys taxable
income is higher than its accounting income, its ability to deduct interest expense will be
correspondingly greater. Similarly, if an entity undertakes planning to reduce its taxable
income, it will be able to deduct less net interest expense. Where a country applies the
group ratio rule to the position of the local group, rather than to each entity separately, the
local groups tax-EBITDA should be reasonably straightforward to calculate, by
aggregating the tax-EBITDA of each entity (with adjustment where a local group
includes entities which have different periods for tax purposes).
Determining an entitys accounting-EBITDA

146. An entitys accounting-EBITDA should be determined using the same formula as
for group EBITDA. However, any income which is not subject to tax, such as dividends
or branch profits which fall within a participation exemption, should be excluded. This is
to ensure that an entity does not attract a higher level of interest capacity as a result of
receiving tax exempt income, which could give rise to base erosion and profit shifting.
147. In principle, an entitys accounting-EBITDA should be based on financial
reporting figures prepared under the same accounting rules as used in the consolidated
financial statements. However, for many groups this would impose a significant burden,
as entity financial statements may only currently be prepared under local GAAP.
Therefore, in light of the fact that for groups in most sectors the elements of EBITDA are
recognised and valued in a broadly consistent way under the main accounting standards,
countries should consider accepting entity EBITDA prepared under local GAAP as a
practical alternative. In deciding whether to accept entity EBITDA prepared under local
GAAP, a country may consider the extent to which local GAAP is aligned with IFRS and
other major accounting standards.
148. In determining an entitys accounting-EBITDA, it is also recommended that no
adjustments should be made to strip out the profit or loss arising from intragroup
transactions. This will mean that in some cases the aggregate EBITDA of the entities in a
group may exceed the consolidated EBITDA of the group as a whole. This may arise, for
example, where one entity in a group recognises the profit arising on the sale of goods to
another group entity, but the purchase price is not included in the second entitys cost of
sales as the goods have not yet been sold outside the group. However, this approach
should ensure that the EBITDA of each entity reflects its level of economic activity, even
where this is a result of dealing within its group. Where a country applies the group ratio
rule to the position of a local group as a whole, the accounting-EBITDA of the entities in
the local group should be aggregated. In this case, to the extent intragroup transactions
within the local group do not offset against each other, these may be eliminated.
149. A groups net third party interest/EBITDA ratio can be applied to an entitys
accounting-EBITDA to give an accounts-based limit on net interest expense. This limit
could be compared directly to the entitys net interest expense for tax purposes, to
determine how much may be deducted. Alternatively, the accounts-based limit may be
adjusted to take into account differences between the entitys net interest expense for
accounting and tax purposes. A possible approach to achieve this is set out in Example 8c
in Annex D.
Addressing the impact of loss-making entities on the operation of a group ratio rule
150. In general, under a group ratio rule an entity is able to claim deductions for
interest expense up to the net third party interest/EBITDA ratio of its group. However
there are two scenarios, both of which may arise as a result of the presence of lossmaking entities within a group, which mean that this general approach needs to be
limited.
151. The first scenario concerns a group which has a positive EBITDA, but this
includes the results of a loss-making entity. The impact of this is that group EBITDA is
reduced and the groups net third party interest/EBITDA ratio is increased. Under a group
ratio rule, this would increase the capacity of profitable entities in the group to deduct
interest expense, possibly to an extent that exceeds the actual net interest expense of the
entire group. Where a carry forward of unused interest capacity is permitted, this interest
capacity could be used to shelter interest deductions in future periods. This is illustrated
by Example 9a in Annex D. This risk could be dealt with in part by a general principle
that places an upper limit on the interest capacity of any entity applying the group ratio
rule, equal to the net third party interest expense of the entire group. This upper limit
should not mean that an entitys net interest deductions are lower than they would have
been under the group ratio rule if group EBITDA had not been reduced by losses. This
approach does not remove the risk that the total net interest deductions of all group
entities could exceed the groups actual net third party interest expense. However, it
should prevent an individual entity receiving a very high level of interest capacity that
could be used for base erosion and profit shifting purposes. How this upper limit would
operate is shown in Example 9b in Annex D.
152. The second scenario concerns groups which have negative EBITDA at a
consolidated level, but which include some profitable entities. In this situation, it is not
possible to calculate a meaningful net third party interest/EBITDA for the group, as the
ratio will be negative. However, a profitable entity within the group is still making a
positive contribution to the groups results, which should be recognised. In this case,
under the best practice approach an entity with positive EBITDA which is part of a lossmaking group could receive interest capacity equal to the lower of the entitys actual net
interest expense and the net third party interest expense of the group. As shown in
Example 9c in Annex D, this allows the entity to deduct its actual net interest expense,
subject to an upper limit based on the actual net interest expense of its group. Given in
these circumstances a group ratio cannot be calculated, this is the most straightforward
way of linking an entitys interest deductibility to the position of its group.

153. An alternative approach would be to exclude loss-making entities from the
calculation of a groups EBITDA. This would remove the risk that any entity would
receive an excessive amount of interest capacity. However, in general it would not be
possible to obtain information on loss-making entities within a group from the
consolidated financial statements. It may be possible for an entity to provide this
information directly to a countrys tax authority, but it may be very difficult for the tax
authority to confirm the accuracy of this information and ensure that all loss-making
entities in a group have been identified and excluded. Illustrations of how this approach
could operate in practice are shown in Examples 9d and 9e in Annex D.
154. Further work will be conducted on the impact of losses on the operation of a
group ratio rule, and the feasibility of different approaches to address this impact. Issues
surrounding the impact of losses on a group ratio rule only arise where the rule uses an
earnings-based ratio. Where a different rule is applied such as one based on an
equity/total assets ratio, there should be no need to have specific provisions to deal with
the effect of losses.
Notes
1.

system.
2.
3.
For financial reporting purposes, "associates" are entities over which a group has
significant influence, but this influence is not sufficient for the group to exercise
control. In broad terms, this is typically where a group controls between 20% and
50% of the voting power in the entity.
8. ADDRESSING VOLATILITY AND DOUBLE TAXATION 67
Chapter 8
Addressing volatility and double taxation
155. An important issue under a best practice approach which links net interest
deductions to the level of an entitys EBITDA is how to deal with volatility in earnings
which impacts an entitys ability to deduct its interest expense. Where earnings volatility
or mismatches in the timing of interest expense and EBITDA result in an entity exceeding
the benchmark fixed ratio under a fixed ratio rule, the group ratio rule described in
Chapter 7 may provide a solution by allowing the entity to deduct net interest expense up
to the groups net third party interest/EBITDA ratio where this is higher. This could also
be achieved using a group ratio rule based on an equity/total assets ratio, such as an
"equity escape rule" described in Annex C, which could also be used by an entity with
negative EBITDA if it is able to demonstrate that the requirements of the rule are met.
Otherwise, these issues may be addressed to an extent by using average EBITDA over a
number of years or by permitting an entity to carry disallowed interest expense and
unused interest capacity for use in earlier or later periods.
Measuring economic activity using average EBITDA

156. Rather than linking an entitys ability to deduct net interest expense to economic
activity in a single year, the impact of short term volatility could be reduced through the
use of average figures. For example, under a fixed ratio rule the ratio could be applied to
the average of EBITDA in the current year and, say, the previous two years. In this case,
the impact of a single year fall in EBITDA would be spread over a three year period, with
the lower earnings in one year offset against higher earnings in other years. The use of
averaging within a group ratio rule would be more complicated, as it would need to be
used in calculating the EBITDA of the group as well as of each entity. This would give
rise to additional issues that would need to be considered, such as how to deal with cases
where the composition of a group changes during the period used for calculating the
average. However, the use of averaging could reduce the impact of losses on the
operation of a rule, in particular where an entity is only in a loss-making position for one
or two years.
157. The use of averaging could provide an entity with some protection against short
term volatility, but would provide no protection against longer term volatility outside of
the period used for calculating an average. Averaging would also not help an entity which
incurs interest expense to fund a project or investment that gives rise to EBITDA more
than, say, two years later.
158. Overall, the use of averages is likely to make a rule more complex but it could
help address volatility. Therefore, this is an option that countries may choose to apply
under the best practice approach. However, to reduce the risk of arbitrage it is suggested
that an election to use average figures should apply to all entities in a local group. An
68 8. ADDRESSING VOLATILITY AND DOUBLE TAXATION

illustration of how three year averaging could be applied to a fixed ratio rule is included
as Example 10 in Annex D.
Carry forward and carry back of disallowed interest and unused interest capacity
159. Where a payment of interest relates to a specific transaction intended to give rise
to base erosion or profit shifting, or the entity consistently has a level of net interest
expense in excess of the benchmark fixed ratio and group ratio, a permanent disallowance
of net interest expense may be an appropriate result. However, there may be cases where
the amount of interest expense in an entity exceeds that which is allowable merely as a
result of a timing mismatch which will correct in a future period. This may arise, for
example, where an entity incurs interest expense to fund a project or investment that will
give rise to earnings in a future period. There may also be cases where an entitys
EBITDA fluctuates for reasons outside of its control, for example as a result of changing
market conditions, increasing or reducing the amount of net interest expense it may
deduct for tax. In addition, under a group ratio rule, the amount of net interest expense
that an entity can deduct may be impacted by volatility in EBITDA elsewhere in the
group. In these cases, a permanent disallowance of interest expense would introduce a
level of uncertainty for groups which could make long term planning difficult and which
a country may view as undesirable. A permanent disallowance of interest expense may
also result in double taxation, if the lender is taxed on the corresponding interest income.
160. Both a fixed ratio rule and a group ratio rule establish a limit on the ability of an
entity to deduct net interest expense (i.e. its interest capacity). Except in cases where an
entitys interest capacity precisely matches its net interest expense, the operation of a rule
will result in an entity either incurring an interest disallowance (i.e. where its net interest
expense exceeds the maximum permitted), or having unused interest capacity (i.e. where
its net interest expense is below the maximum permitted). Allowing disallowed interest
expense and unused interest capacity to be used in other periods through carry forward or
carry back provisions would have clear benefits for entities, reducing the risk of a
permanent disallowance of interest expense where interest expense and EBITDA arise in
different periods. From a countrys perspective, this could also support a policy that the
level of an entitys net interest deductions should be linked to its level of earnings over
time.
161. Under the best practice approach, there is no requirement for a country to allow
an entity to carry forward or carry back disallowed interest expense or unused interest
capacity. However, a country may choose to allow an entity:
to carry forward disallowed interest expense only
to carry forward disallowed interest expense and unused interest capacity
to carry forward and carry back disallowed interest expense.
162. An entitys disallowed interest expense that may be carried forward or carried
back under these provisions will generally be the deductible net interest expense that is in
excess of the amount permitted under the fixed ratio rule and group ratio rule. Interest
expense disallowed under targeted rules will generally relate to transactions or
arrangements which give rise to specific base erosion and profit shifting risks, and should
not be available for carry forward or carry back.
8. ADDRESSING VOLATILITY AND DOUBLE TAXATION 69
163. Where a country allows an entity to carry forward unused interest capacity, this
may be limited to the amount by which an entitys net interest expense is below that
permitted under the fixed ratio rule only. Alternatively, a country may allow the carry
forward of unused interest capacity based on the level of net interest permitted under the
group ratio rule. This would reduce the impact of volatility in group earnings on an
entitys ability to deduct net interest expense, and is consistent with the principle of
allowing a group to deduct an amount equivalent to its net third party interest expense. In
either case, a carry forward of unused interest capacity could allow an entity that has
already deducted all of its net interest expense to build up a potentially significant carry
forward.
164. Allowing disallowed interest expense and unused interest capacity to be carried
forward or back and used in other periods does introduce potential base erosion and profit
shifting risks. This is particularly the case for unused interest capacity, where a long or
unlimited carry forward could give rise to a sizeable tax asset which can only be realised
either by increasing the level of the entitys net interest expense, or by reducing the level
of EBITDA in a future period, neither of which should be incentivised by a rule to tackle
base erosion and profit shifting. Similar concerns exist with respect to carry backs of
disallowed interest expense. On the other hand, a long or unlimited carry forward of
disallowed interest expense could encourage an entity to increase its interest expense up
to the maximum amount permitted, in the knowledge that if it exceeds the amount of
interest allowed in a year, the surplus may be deducted in future periods. However, this
risk is not judged to be as significant as the risks associated with a carry back of
disallowed interest expense or carry forward of unused interest capacity, as these latter
types of carry over provisions offer greater possibility of immediate monetisation.
165. Therefore, where carry forwards or carry backs are permitted, a country may
consider imposing limits in terms of time and/or value. This is particularly important with
respect to a carry forward of unused interest capacity and carry back of disallowed
interest expense, which give rise to greater potential base erosion and profit shifting risks.
Limits on carry forwards and carry backs could include the following:
The number of years for which disallowed interest expense or unused interest
capacity may be carried forward, or disallowed interest expense may be carried
back, could be limited.
The value of carry forwards could reduce over time (e.g. by 10% each year).
The value of a carry forward or carry back could be capped at a fixed monetary
amount.
The amount of a carry forward or carry back that may be used in a single year
could be limited (e.g. providing that no more than 50% of current net interest
expense may be set against unused interest capacity carried forward from
previous years).
Carry forwards should be reset to zero in certain circumstances, following normal
practice applied to loss carry forwards (e.g. where a company changes ownership
and also changes the nature of its economic activity).
166. Where a country applies a fixed ratio rule in combination with a group ratio rule,
it may apply a single carry forward provision to deal with disallowed interest under both
rules. Alternatively, a country could impose different limits depending upon whether
interest expense is disallowed under the fixed ratio rule or the group ratio rule. However,
70 8. ADDRESSING VOLATILITY AND DOUBLE TAXATION

this approach is likely to be considerably more complex to apply and administer. For
example, groups may be required to maintain a separate carry forward pool under each
rule. The country would also need to consider how disallowed interest carried forward in
each pool can be used (e.g. whether one pool should be used first, or whether interest
disallowed under one rule may only be set against interest capacity arising under the same
rule).
167. Where a country applies interest limitation rules to the position of the local group
rather than each entity separately, it should also consider how this will impact any carry
forward or carry back provisions (e.g. whether an entity should be able to utilise
disallowed interest expense carried forward from a period prior to the time it joined the
group).
9. TARGETED RULES 71
Chapter 9
Targeted rules
Aim of targeted rules

168. Targeted interest limitation rules include any provisions which apply to restrict
interest deductions on payments made under specific transactions or arrangements. These
may be contrasted with general interest limitation rules, such as the fixed ratio rule and
group ratio rule, which impose an overall limit on an entitys interest deductions. A
number of countries do not currently apply any general interest limitation rule and rely
solely on targeted rules. One benefit of such an approach is that it reduces the risk that a
rule could negatively impact on entities which are already appropriately capitalised and
also avoids any incentive for groups to increase the level of net interest expense of local
entities up to the level allowed under a fixed ratio rule. The use of targeted rules also
allows countries to address specific areas of concern, potentially minimising compliance
costs for entities, in particular those which do not engage in base erosion or profit
shifting. However, such an approach has drawbacks. Most importantly, to some extent
targeted rules will always be a reactive response, requiring countries to be aware of
specific base erosion and profit shifting risks as they emerge. There is a risk that some
groups may consider all arrangements not covered by targeted rules to be acceptable,
meaning that over time new targeted rules may be required. Targeted rules also require
active application, meaning the tax administration must be able to recognise situations
where a rule could apply, often as part of a complex transaction, and then engage with a
group to determine the correct result. Overall, an approach based entirely on targeted
rules may result in a large number of rules which will increase complexity, as well as
increasing compliance and administrative costs. If the rules are not comprehensive then
they are unlikely to deal with all base erosion and profit shifting risks. On the other hand,
an approach which uses a general rule supplemented by targeted rules in key areas should
provide countries with the comfort that the main risks posed by base erosion and profit
shifting are addressed, while ensuring that groups are able to obtain relief for their real
net third party interest expense.
169. While the best practice approach in this report recommends general interest
limitation rules, it is recognised that targeted rules can also provide an effective solution
to some base erosion and profit shifting risk. This chapter sets out a number of specific
risks that may not be addressed by the fixed ratio rule and group ratio rule, where targeted
rules may be required. Countries may also continue to apply existing targeted and general
interest limitation rules, where these address specific risks. For example, a country may
apply a thin capitalisation rule based on a fixed debt/equity ratio to disallow interest on
excessive debt in addition to the fixed ratio rule and this could apply to disallow interest
even where an entity does not exceed the level of net interest expense permitted under the
fixed ratio rule.
72 9. TARGETED RULES
170. The impact of a targeted rule applying to an arrangement will vary depending
upon the nature of the arrangement and the risk the rule is intended to address. In some
cases it may be appropriate for a rule to deny a deduction for a gross interest payment
under a transaction. In other cases it may be more appropriate for a rule to apply to part of
a payment, or to net interest payments after taking into account income under the same
transaction. Where the result of a transaction is to increase the level of net third party
interest expense under a group ratio rule, a rule may simply operate to disregard this
increase, with no specific disallowance.
Targeted rules to prevent avoidance of the general rules

171. A best practice approach should be robust against attempts to avoid the effect of a
rule. A fixed ratio rule (and group ratio rule where applied) should therefore be supported
by targeted rules to counteract planning undertaken by groups to reduce the impact of
these rules. To achieve this, it is recommended that countries also introduce targeted rules
to address the following risks:
An entity with net interest expense enters into an arrangement to reduce the net
interest expense subject to the fixed ratio rule (e.g. by converting interest expense
into a different form of deductible expense, or by converting other taxable income
into a form which is economically equivalent to interest).
An entity which is part of a group enters into an arrangement with a related party
or third party in order to increase the level of net third party interest expense
under the group ratio rule (e.g. by making a payment to a related party or to a
third party under a structured arrangement, or by converting interest income into a
different form).
A group is restructured to place an unincorporated holding entity at the top of the
structure, to create two groups. This may be to prevent a fixed ratio rule applying
(e.g. in a country where the rule does not apply to standalone entities) or to
separate the original group into two parts for group ratio rule purposes.
172. The above risks may be addressed by standalone rules, specific provisions within
the fixed ratio rule and group ratio rule, or by other tax rules (such as, for example, a
countrys general anti-avoidance rule). These rules should be applicable to all entities
which are subject to the fixed ratio rule, and group ratio rule where this applies. The
terms "related party" and "structured arrangement" are defined below.
Targeted rules to address other base erosion and profit shifting risks
173. The fixed ratio rule and group ratio rule described in this report provide an
effective solution to tackle most base erosion and profit shifting involving interest and
payments economically equivalent to interest. However, as set out in Chapter 3, in certain
situations, a country may restrict application of the fixed ratio rule and group ratio rule to
entities in multinational groups. Therefore, targeted rules may be required to address base
erosion and profit shifting risks posed by entities which are not subject to the general
interest limitation rules. Even where the fixed ratio rule and group ratio rule apply, a
number of specific base erosion and profit shifting risks remain. Therefore, it is
recommended that countries consider introducing rules to address the risks listed below:
An entity which would otherwise have net interest income enters into an
arrangement which involves the payment of interest to a group entity outside the
9. TARGETED RULES 73
country or a related party to reduce the level of interest income subject to tax in
the country.
An entity makes a payment of interest on an "artificial loan", where no new
funding is raised by the entity or its group.
An entity makes a payment of interest to a third party under a structured
arrangement, for instance under a back-to-back arrangement.
An entity makes a payment of interest to a related party, which is excessive or is
used to finance the production of tax exempt income.
An entity makes a payment of interest to a related party, which is subject to no or
low taxation on the corresponding interest income.
174. Rules to address the risks above should ideally be applicable to all entities,
irrespective of whether they are also subject to the fixed ratio rule and group ratio rule.
However, these rules are particularly important where an entity is not subject to a fixed
ratio rule as described in Chapter 6.
Definition of "related parties" and "structured arrangements"

175. A number of the specific risks listed above refer to transactions with or payments
made to a related party or to a third party under a structured arrangement.
Related parties
176. An entity which is part of a group may also be related to individuals or entities
which are not part of the group, but where a significant relationship exists. For the
purposes of this report, two persons (including individuals and entities) are related if they
are not in the same group but they meet any of the following conditions:
The first person has an investment that provides that person with effective control
of the second person or there is a third person that holds investments which
provide that person with effective control over both persons.
The first person has a 25% or greater investment in the second person or there is a
third person that holds a 25% or greater investment in both.
They can be regarded as associated enterprises under Article 9.
177. A person will be treated as holding a percentage investment in another person if
that person holds directly or indirectly through an investment in other persons, a
percentage of the voting rights of that person or of the value of any equity interests of that
person.
178. For the purposes of this related party definition, a person who acts together with
another person in respect of the ownership or control of any voting rights or equity
interests will be treated as owning or controlling all of those voting rights and equity
instruments.
179. Two persons will be treated as acting together in respect of ownership or control
of any voting rights or equity interests if they meet any of the following conditions:
They are members of the same family.
74 9. TARGETED RULES
One person regularly acts in accordance with the wishes of the other person in
respect of ownership or control of such rights or interests.
They have entered into an arrangement that has material impact on the value or
control of any such rights or interests.
They each directly or indirectly hold debt in the entity in proportion to their
voting rights or equity interests.
The ownership or control of any such rights or interests is managed by the same
person or group of persons. In respect of any taxpayer that is a collective
investment vehicle (CIV), if the investment manager can establish to the
satisfaction of the tax authority from the terms of the investment mandate and the
circumstances in which the investment was made that two funds were not acting
together in respect of the investment, then the interests held by those funds should
not be aggregated under this part of the "acting together" test.
180. For these purposes a CIV is any vehicle which is widely held, holds a diversified
portfolio of securities and is subject to investor-protection regulation in the country in
which it is established. It is left to countries to determine the types of vehicle which
would meet this definition. For example, countries may consider certain types of CIVs to
be widely-held if their shares or units are listed for quotation on a stock exchange or can
be readily purchased or sold by the public (i.e. the purchase or sale of shares or units is
not implicitly or explicitly restricted to a limited group of investors). However, a country
may apply a different test to determine whether a CIV is widely held.
Structured arrangements
181. Targeted rules may also apply where an entity makes a payment of interest to a
third party under a structured arrangement. A structured arrangement is any arrangement
where the entity, its group and its related parties, taken together, do not bear the entire
cost of the interest payment.
182. An example of a structured arrangement would be a "back-to-back" arrangement
whereby an entity makes a payment of interest to a third party in circumstances where the
third party also makes a payment to the entity, a member of the entitys group or a related
party of the entity. This second payment may be in a form other than interest.
10. APPLYING THE BEST PRACTICE APPROACH TO BANKING AND INSURANCE GROUPS 75
Chapter 10
Applying the best practice approach to banking and insurance groups
183. In developing a best practice approach to combat base erosion and profit shifting
involving interest, a number of particular features of groups in the banking and insurance
sectors need to be taken into account.
184. An important consideration is that the role interest plays in a banking or insurance
business is different to that in other sectors. Banks and insurance companies hold
financial assets and liabilities as an integral part of their main business activities. In
addition, financial sector businesses in most countries are subject to strict regulations
which impose restrictions on their capital structure. In 2011, Basel III introduced a
leverage ratio standard intended to constrain leverage in the banking sector, helping to
mitigate risks which in the past have damaged the financial system and the economy.1
The Solvency II Directive introduces a similar system for insurers in the European
Union.2 It should be noted however that, although banking and insurance groups are
subject to regulation, not all entities within a group are subject to the same obligations
and the treatment of branches in particular must be taken into account.
185. Despite the restrictions imposed by regulatory requirements, a number of studies
have found that the leverage of banks is influenced on average by corporate taxes to the
same extent as for groups in other sectors. The influence of tax on leverage is reduced
where a bank is capital constrained, but in practice many groups hold a buffer of capital
above the minimum amount required by regulations (Heckemeyer and de Mooij, 2013;
Keen and de Mooij, 2012).
186. Base erosion and profit shifting by banking and insurance groups could
potentially take a number of forms. These include: regulated entities holding a regulatory
capital buffer (including a debt component) above the level required to support existing
business; routing regulatory capital and ordinary debt issued within a group through
intermediate entities in low tax countries, placing excessive interest deductions in
branches, which do not need to be separately capitalised for regulatory purposes, and in
non-regulated entities; using deductible interest expense to fund assets which are tax
exempt or taxed on a preferential basis; and the use of hybrid financial instruments and
hybrid entities.
187. Banks and insurance companies typically hold buffers of regulatory capital above
the minimum level required, and there are significant commercial drivers to maintain
these buffers (e.g. connected to credit rating and cost of capital). Holding capital above
the minimum required by regulations allows a group to accommodate changing capital
needs, but also provides some opportunities for base erosion and profit shifting.
188. The fixed ratio rule and group ratio rule set out in this report are unlikely to be
effective in addressing these base erosion and profit shifting risks for a number of
reasons. In particular, banking and insurance groups are important sources of debt
76 10. APPLYING THE BEST PRACTICE APPROACH TO BANKING AND INSURANCE GROUPS
funding for groups in other sectors and as such many are net lenders by a significant
margin. This means that the main operating companies in these groups, and the groups
overall, will often have net interest income rather than net interest expense. As the fixed
ratio rule and group ratio rule apply to limit the level of an entitys net interest expense,
these rules would have no impact on important entities within banking and insurance
groups. In addition, the fact that interest income is a major part of a bank or insurance
companys income means that EBITDA would not be a suitable measure for economic
activity across a group in these sectors. Finally, the financial statements of banking and
insurance groups typically differ from those of groups in other sectors, which in particular
could impact the operation of a group ratio rule. As a fixed ratio rule and group ratio rule
in this report are unlikely to address base erosion and profit shifting in the banking and
insurance sectors, countries may consider excluding entities in groups operating in these
sectors from the scope of these rules, in which case they should introduce targeted rules
addressing base erosion and profit shifting in these sectors (as discussed below).
189. Any exclusion should not apply to treasury companies, captive insurance
companies or other non-regulated entities which carry out quasi-banking or other
financial activities where there are no regulatory restraints, or to investment vehicles
whether or not regulated. These entities should remain subject to the rules contained in
the best practice approach.
190. It is not intended that entities operating in the banking and insurance sectors, or
regulated banking or insurance entities within non-financial groups, should be exempted
from the best practice approach to tackle base erosion and profit shifting involving
interest. Instead, in order to tackle base erosion and profit shifting by groups in all
sectors, it is essential that a best practice approach includes rules which are capable of
addressing risks posed by different entities. Further work will therefore be conducted to
be completed in 2016, to identify best practice rules to deal with the potential base
erosion and profit shifting risks posed by banks and insurance companies, taking into
account the particular features of these sectors. This will include work on regulated
banking and insurance activities within non-financial groups (such as groups operating in
the manufacturing or retail sector). In particular, it is crucial that any recommended
interest limitation rules do not conflict with or reduce the effectiveness of capital
regulation intended to reduce the risk of a future financial crisis. Where a country applies
the fixed ratio rule set out in this report to entities in banking and insurance groups, the
country should still apply the specific best practice rules to be designed to address the
base erosion and profit shifting risks posed by these sectors.
Notes
1.
The Third Basel Accord is a comprehensive set of reform measures, agreed upon by
members of the Basel Committee on Banking Supervision, to strengthen the
regulation, supervision and risk management of the banking sector
(www.bis.org/bcbs/index.htm?m=3%7C14, accessed on 3 September 2015).
10. APPLYING THE BEST PRACTICE APPROACH TO BANKING AND INSURANCE GROUPS 77
2.
Directive 2009/138/EC of the European Parliament and of the Council of 25

November 2009 on the taking-up and pursuit of the business of Insurance and
Reinsurance (Solvency II) [2009] OJ L335/1.
Bibliography
Heckemeyer, J. and R. de Mooij (2013), Taxes and Corporate Debt: Are Banks any
Different?, IMF Working Paper, No. 13/221, International Monetary Fund,
Washington, DC.
Keen, M. and R. de Mooij (2012), Debt, Taxes and Banks, IMF Working Paper, No.
12/48, International Monetary Fund, Washington, DC.
11. IMPLEMENTING THE BEST PRACTICE APPROACH 79
Chapter 11
Implementing the best practice approach
Implementation and co-ordination

191. This report includes recommendations for a best practice approach to tackle base
erosion and profit shifting involving interest. As set out in Chapter 1, a country may
supplement this approach with other general or targeted interest limitation rules, either to
address base erosion and profit shifting risks it faces or to achieve wider tax policy aims.
192. Further work will be conducted on particular areas of the best practice approach
for instance guidance on the detailed operation of the group ratio rule. Work will also be
conducted on the design of special rules to address base erosion and profit shifting in the
banking and insurance sectors, taking into account the specific issues that groups
operating in these sectors face. This work will be completed in 2016.
193. The design and content of the best practice approach set out in this report,
including the corridor for setting a benchmark fixed ratio and the optional exclusion for
interest funding certain public-benefit projects, will initially be reviewed by countries
involved in the BEPS Project by no later than the end of 2020. This review will include
consideration of the experience of countries which have introduced rules in accordance
with the best practice and the impact on the behaviour of groups. The review will also
consider any additional available data that could assist in assessing the effectiveness of
the agreed corridor. To this end, countries are encouraged to collect tax data on the level
of net interest expense and EBITDA of entities and local groups in that country, as well
as those of multinational groups operating in the country where available. Following this
review, elements of the best practice may be revised.
Transitional rules
194. The best practice approach set out in the report should address base erosion and
profit shifting involving interest. However, it is recognised that any rule to limit tax
deductions for an entitys interest expense could involve a significant cost for some
entities. Therefore, it is expected that a country introducing a fixed ratio rule and group
ratio rule would give entities reasonable time to restructure existing financing
arrangements before the rules come into effect.
195. A country may also apply transitional rules which exclude interest on certain
existing loans from the scope of the rules, either for a fixed period or indefinitely. In this
case it is recommended that these transitional rules are primarily restricted to interest on
third party loans entered into before the rules were announced. Interest on any loans
entered into after the announcement of the new rules should not benefit from any
transitional provisions. Alternatively, a country may apply no transitional rules.
80 11. IMPLEMENTING THE BEST PRACTICE APPROACH
Separate entity and group taxation systems

196. Countries currently apply corporate tax systems which include different types of
group taxation and separate entity taxation. The best practice approach described in this
report should be compatible with any system, although in some cases specific provisions
within the best practice approach may require adjustment.
Countries applying separate entity taxation systems

197. Where a country taxes each entity within a group separately, the fixed ratio rule
and group ratio rule may be applied in any of the following three ways at the discretion of
the country:
The fixed ratio rule and group ratio rule may be applied separately to each entity
based on its EBITDA.
The country may treat entities within a tax group as a single entity for the
purposes of applying the fixed ratio rule and group ratio rule. For example, the
benchmark fixed ratio would be applied to the tax groups total tax-EBITDA.
Interest capacity would then be allocated within the tax group in accordance with
rules developed by the country, which may include allowing a group to determine
the allocation of interest capacity between entities. To prevent abuse, transactions
within the tax group which do not net off may be stripped out of the tax groups
"entity EBITDA". Under this option, entities which are in the same financial
reporting group, but which are not part of the same tax group, would continue to
be treated as separate entities and would apply the fixed ratio rule and group ratio
rule independently.
The country may treat all entities in the country which are part of the same
financial reporting group as a single entity for the purposes of applying the fixed
ratio rule and group ratio rule. Transactions within the financial reporting group
which do not net off may be excluded from "entity EBITDA" to prevent abuse.
This option may be particularly relevant for a country with a group ratio rule,
which applies to entities in a financial reporting group. However, as this could in
effect allow the transfer of interest capacity between entities which are not in a tax
group, the country may need to consider whether this raises any policy concerns
(such as inconsistency with existing loss surrender, profit contribution or similar
rules). The operation of other provisions such as carry forwards and carry backs
would need to be considered, for example whether an entity should be able to
benefit from attributes carried forward from a period before it joined the financial
reporting group.
Countries applying group taxation systems

198. Where a country taxes entities on a group or consolidated basis, the fixed ratio
rule and group ratio rule may be applied in any of the following ways at the discretion of
the country:
The country may treat entities within the consolidated tax group as a single entity
for the purposes of applying the fixed ratio rule and group ratio rule. For example,
the benchmark fixed ratio would be applied to the consolidated tax groups total
tax-EBITDA, and the amount of interest capacity applied to calculate the
permitted net interest deductions for the consolidated tax group as a whole. Under
this option, entities which are in the same financial reporting group, but which are
not part of the same consolidated tax group, would continue to be treated as
separate entities and would apply the fixed ratio rule and group ratio rule
independently.
The country may treat all entities in the country which are part of the same
financial reporting group as a single entity for the purposes of applying the fixed
ratio rule and group ratio rule. Transactions within the financial reporting group
which do not net off may be excluded from "entity EBITDA" to prevent abuse.
This option may be particularly relevant for a country with a group ratio rule,
which applies to entities in a financial reporting group. However, as this could in
effect allow the transfer of interest capacity between a consolidated tax group and
an entity outside of that group, the country may need to consider whether this
raises any policy concerns. The operation of other provisions such as carry
forwards and carry backs would need to be considered, for example whether an
entity should be able to benefit from attributes carried forward from a period
before it joined the financial reporting group.
Interaction of the best practice approach with hybrid mismatch rules under Action 2
199.
Where a country has introduced a fixed ratio rule, the potential base erosion and
profit shifting risk posed by hybrid mismatch arrangements is reduced, as the overall
level of net interest deductions an entity may claim is restricted. However, this risk is not
eliminated. Within the limits imposed by a fixed ratio rule, there may still be significant
scope for an entity to claim interest deductions in circumstances where a hybrid financial
instrument or hybrid entity is used to give rise to a double deduction or deduction/no
inclusion outcome. Where a group ratio rule applies, there is also a risk that hybrid
mismatch arrangements could be used to increase a groups net third party interest
expense, supporting a higher level of net interest deductions across the group. In order to
address these risks, a country should implement all of the recommendations under
Action 2, alongside the best practice approach in this report.
200. Rules to address hybrid mismatch arrangements should be applied by an entity
before the fixed ratio rule and group ratio rule to determine an entitys total net interest
expense. Once this total net interest expense figure has been determined, the fixed ratio
rule and group ratio rule should be applied to establish whether the full amount may be
deducted, or to what extent net interest expense should be disallowed.
201. The OECD Report, Neutralising the Effects of Hybrid Mismatch Arrangements
(OECD, 2014) stated that rules which grant deemed interest deductions for equity capital,
or have similar effect, would not be considered under Action 2, but should be considered
further either separately or in the context of Action 4. As set out in Chapter 2, deemed
deductions which are calculated by applying a specified percentage to the equity capital
of an entity are not treated as being interest or a payment economically equivalent to
interest for the purposes of this report. However, these rules should be considered further
by the OECD in separate work.
Interaction of the best practice approach with controlled foreign company rules
under Action 3
202. The fixed ratio rule and group ratio rule should be effective in addressing base
erosion and profit shifting involving excessive interest deductions and interest used to
82 11. IMPLEMENTING THE BEST PRACTICE APPROACH

finance the production of tax exempt income. A country may also introduce controlled
foreign company (CFC) rules in accordance with the recommendations under Action 3
(Designing Effective Controlled Foreign Companies Rules (OECD, 2015)), to address
situations where an entity makes an interest payment which is deductible under the fixed
ratio rule and group ratio rule, but the payment is made to a CFC which is subject to a
low rate of tax.
203. Where a country applies CFC rules alongside interest limitation rules, CFC
income which is subject to tax on the parent company may be included in the calculation
of the parents EBITDA when applying the fixed ratio rule and group ratio rule. Where
this CFC income includes interest income or expense, the country should consider
including the interest in the calculation of the parents net interest expense and excluding
that interest from the calculation of the parents EBITDA.
204. The best practice approach in this report should also reduce the pressure on a
countrys CFC rules, by encouraging groups to spread net interest expense between group
entities so that there is a greater link to taxable economic activity. This should reduce the
level of net interest income arising in CFCs, as groups are likely to reduce the level of
intragroup interest payments, and increase the alignment of net interest expense and
EBITDA within the group.
Interaction of the best practice approach with other rules to limit interest
deductions
205. As described in this report, a country may apply the fixed ratio rule and group
ratio rule together with targeted rules to tackle specific base erosion and profit shifting
risks, including the risks discussed in Chapter 9 as well as other risks identified by the
country. A country may also apply other general interest limitation rules, such as arms
length rules, rules to disallow a percentage of all interest expense and thin capitalisation
rules.
206. It is suggested that in most cases, these targeted and general interest limitation
rules should be applied before the fixed ratio rule and group ratio rule. However, the
ultimate decision as to the order in which to apply interest limitation rules is left to
countries, taking into account the design of its rules and the risks they are intended to
address.
Interaction of the best practice approach with withholding taxes

207. Withholding tax on interest is typically imposed in order to allocate taxing rights
over income to a source country, although it is recognised that an effect of withholding
taxes may be to reduce the benefits to groups of base erosion and profit shifting involving
interest. Where a country applies withholding tax to payments of interest, this should in
no way be impacted by the application of the fixed ratio rule, group ratio rule or targeted
rules described in this report. Where the best practice approach limits an entitys net
interest deductions, leading to an interest disallowance, there is no intention that the
interest expense disallowed should be re-characterised for any other purpose. Therefore,
to the extent a payment would be subject to withholding tax under a countrys tax law,
this would continue to apply. Where a country currently re-characterises disallowed
interest, for example as a dividend payment, it may continue to apply this treatment but
this is not part of the best practice approach in this report.
208. Where an entity receives interest net of withholding tax, and the country of the
recipient allows a credit for this tax, the entity will typically be subject to tax on a gross
amount of interest income including an amount representing the tax withheld. This
treatment is not changed as a result of any aspect of the best practice approach. Therefore,
where an entity would currently be able to claim credit for withholding tax on its interest
income, this should not change following the introduction of the fixed ratio rule and
group ratio rule.
Bibliography
OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 - 2015
Publishing, Paris, paragraph 4, http://dx.doi.org/10.1787/9789264218819-en.
ANNEX A. EUROPEAN UNION LAW ISSUES 85
Annex A
European Union Law issues
209. This annex includes a brief outline of EU law issues that EU Member States
should take into account in implementing the best practice approach in this report.
EU treaty freedoms
210. The treaty freedoms that need to be considered in the context of interest limitation
rules are the freedom of establishment, and the free movement of capital. The freedom of
establishment applies to cases where the shareholder would be able to exercise a
significant influence over the entity,1 while the free movement of capital applies to cases
where the shareholder acquired the shares for the sole purpose of making a financial
investment without participating in the decision making process of the entity. In addition,
the freedom to provide services, which also has to be analysed from the perspective of
both the service provider and recipient, may also need to be considered.
211. The scope of an interest limitation rule determines which freedom applies and
there are a number of approaches that the countries involved in this work have discussed
in order to avoid any restriction of EU treaty freedoms. In this respect, consideration
should also be given to the circumstances in which EU Member States could justify a
restriction of EU treaty freedoms, for example:
the need to preserve the balanced allocation between EU Member States of the
power to impose taxes
the need to prevent tax avoidance and to combat artificial arrangements.
EU directives
212. There are two EU directives with relevance to interest deduction limitation rules
within the European Union: the Parent Subsidiary Directive2 and the Interest and Royalty
Directive.3 The Parent Subsidiary Directive eliminates cross-border withholding taxes on
dividend payments made by a subsidiary to a parent company and also eliminates double
taxation of such income at the level of the parent company. The directive may be relevant
in cases where excessive interest is re-qualified as a dividend. In such cases, the
re-qualified interest should be granted the benefits of the Parent Subsidiary Directive.
213. The Interest and Royalty Directive provides that interest and royalty payments
arising in an EU Member State shall be exempt from any taxes imposed on those
payments in that State, whether by deduction at source or by assessment. Disallowing a
deduction for excessive interest could be considered as taxation of interest and, thus, fall
within the scope of the directive. However, the Court of Justice of the European Union
clarified that the directive only concerns the tax position of the interest creditor.4 It seems
86 ANNEX A. EUROPEAN UNION LAW ISSUES

to follow that the deductibility of interest expenses at the level of the debtor entity may
therefore be restricted.
EU State aid
214. EU State aid issues may arise if interest deductibility rules include specific
exceptions for particular entities or sectors. The relevant treaty provision considers "any
aid granted by a Member State or through State resources in any form whatsoever which
distorts or threatens to distort competition by favouring certain undertakings or the
production of certain goods shall, in so far as it affects trade between Member States" as
being in conflict with the treaty.5
215. The European Commission has provided guidance on how it will apply the State
aid provisions in relation to direct business taxation.6 According to this guidance an
exception to a specific tax rule without any justification is considered State aid. However,
the EU treaty provides EU Member States with options to introduce exceptions to the
State aid provisions, for instance categories of State aid may be specified as being
deemed compliant with the treaty.7
Notes
1.
So far the Court of Justice of the European Union has not provided clarity on what
significant influence means. In Beker (Case C-168/11) the Court highlighted that
shareholding below 10% does not give a significant influence, and in Itelcar (Case C282/12) and Kronos (Case C-47/12) the Court pointed out that shareholding above
10% does not necessarily imply that the holder exerts significant influence. In this
respect, attention should also be given to other case law referred to in these decisions.
2.
Council Directive 2003/123/EC of 22 December 2003 amending Directive

90/435/EEC on the common system of taxation applicable in the case of parent
companies and subsidiaries of different Member States [2003] OJ L007/41.
3.
Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation

applicable to interest and royalty payments made between associated companies of
different Member States [2003] OJ L157/49.
4.
Scheuten Solar Technology (Case C-397/09).
5.
Article 107 of the Treaty on the Functioning of the European Union (TFEU).
6.
Commission notice on the application of the State aid rules to measures relating to
direct business taxation [1998] OJ C384/3.
7.
Article 107(3)(e) TFEU.
59%
47%
37%
29%
24%
20%
16%
13%
11%
9%
8%
7%
6%
6%
5%
5%
4%
4%
4%
3%
6,472
Non-MNC
2009
56%
41%
30%
23%
18%
14%
12%
9%
8%
7%
6%
5%
5%
4%
4%
3%
3%
3%
3%
3%
10,911
MNC
57%
44%
34%
27%
22%
17%
14%
12%
9%
8%
7%
6%
5%
5%
4%
4%
4%
3%
3%
3%
6,675
Non-MNC
2010
51%
35%
25%
19%
14%
11%
9%
7%
6%
5%
4%
4%
3%
3%
3%
2%
2%
2%
2%
2%
11,372
MNC
57%
44%
35%
28%
23%
19%
16%
13%
11%
9%
8%
7%
6%
5%
5%
5%
4%
4%
3%
3%
6,631
Non-MNC
2011
52%
37%
27%
20%
16%
13%
11%
9%
7%
6%
5%
4%
4%
4%
3%
3%
3%
3%
2%
2%
11,165
MNC
Source: PwC calculations based on consolidated financial statement information from Standard & Poor's GlobalVantage database.
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
Observations
Percent of EBITDA
limit on net interest
deductibility
57%
45%
36%
29%
25%
20%
17%
14%
12%
11%
9%
8%
7%
6%
5%
5%
5%
4%
4%
4%
6,547
Non-MNC
Percentage of companies affected by interest deduction limitation

2012
54%
39%
29%
23%
18%
15%
12%
11%
9%
8%
7%
6%
5%
5%
5%
4%
4%
3%
3%
3%
11,015
MNC
56%
43%
34%
28%
22%
19%
16%
13%
11%
10%
9%
7%
7%
6%
6%
5%
5%
5%
4%
4%
6,523
Non-MNC
2013
Table B.1 Tabulations for multinational and non-multinational companies, excluding companies with negative EBITDA, 2009-2013
Data on companies affected by a benchmark fixed ratio at different levels
Annex B
53%
38%
29%
23%
18%
14%
12%
10%
8%
7%
6%
6%
5%
5%
4%
4%
4%
3%
3%
3%
10,908
MNC
ANNEX B. DATA ON COMPANIES AFFECTED BY A BENCHMARK FIXED RATIO AT DIFFERENT LEVELS 87
57%
45%
35%
28%
23%
19%
16%
13%
11%
9%
8%
7%
6%
6%
5%
5%
4%
4%
4%
3%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
53%
38%
28%
22%
17%
13%
11%
9%
8%
7%
6%
5%
4%
4%
4%
3%
3%
3%
3%
3%
MNC
43%
55%
65%
72%
77%
81%
84%
87%
89%
91%
92%
93%
94%
94%
95%
95%
96%
96%
96%
97%
Non-MNC
Average 2009-2013
Source: OECD Secretariat calculations based on data in Table B.1.
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
Percent of EBITDA limit

on net interest
deductibility
47%
62%
72%
78%
83%
87%
89%
91%
92%
93%
94%
95%
96%
96%
96%
97%
97%
97%
97%
97%
MNC
Table B.2 includes the companies affected by a particular fixed ratio. Table B.3 includes the companies that in principle are not affected. Taken together, numbers from these tables for a particular ratio should add to 100%.
Table B.3 assumes that net interest expense is spread around a group in accordance with EBITDA. In practice there may be barriers which prevent a group achieving this.
Source: OECD Secretariat calculations based on data in Table B.1.
Non-MNC
Average 2009-2013
Percentage of companies that would in principle be able to deduct an amount

equivalent to their net third party interest expense
Percentage of companies affected by interest deduction limitation
Percent of EBITDA limit

on net interest
deductibility
Table B.3 Tabulations for multinational and non-multinational

companies, excluding companies with negative EBITDA,
average for 2009-2013
Table B.2 Tabulations for multinational and non-multinational

companies, excluding companies with negative EBITDA,
average for 2009-2013
88 ANNEX B. DATA ON COMPANIES AFFECTED BY A BENCHMARK FIXED RATIO AT DIFFERENT LEVELS
57%
42%
32%
24%
19%
15%
12%
10%
9%
7%
6%
6%
5%
4%
4%
4%
4%
3%
3%
3%
8,745
Small Cap
2009
56%
35%
20%
13%
8%
6%
4%
3%
3%
2%
2%
1%
1%
1%
1%
1%
0%
0%
0%
0%
872
Large Cap
51%
36%
26%
20%
15%
12%
10%
8%
6%
5%
5%
4%
3%
3%
3%
3%
2%
2%
2%
2%
9,453
Small Cap
2010
51%
27%
15%
9%
5%
3%
2%
2%
1%
1%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
1,018
Large Cap
52%
37%
28%
21%
17%
14%
11%
9%
8%
7%
6%
5%
4%
4%
4%
3%
3%
3%
3%
3%
9,765
Small Cap
2011
48%
27%
15%
8%
5%
3%
2%
1%
1%
1%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
949
Large Cap
Source: PwC calculations based on consolidated financial statement information from Standard & Poor's GlobalVantage database.
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
Observations
Percent of EBITDA
limit on net interest
deductibility
54%
40%
30%
24%
19%
16%
13%
11%
10%
8%
7%
6%
6%
5%
5%
4%
4%
4%
4%
3%
9,794
Small Cap
2012
Percentage of multinational companies affected by interest deduction limitation
53%
27%
16%
10%
6%
4%
2%
2%
1%
1%
1%
1%
1%
1%
0%
0%
0%
0%
0%
0%
1,050
Large Cap
53%
39%
30%
24%
19%
15%
12%
10%
9%
8%
7%
6%
6%
5%
5%
4%
4%
4%
3%
3%
9,635
Small Cap
2013
54%
28%
17%
10%
7%
4%
3%
2%
1%
1%
1%
1%
1%
0%
0%
0%
0%
0%
0%
0%
1,157
Large Cap
Table B.4 Tabulations for large cap and small cap multinational companies, excluding companies with negative EBITDA, 2009-2013
ANNEX B. DATA ON COMPANIES AFFECTED BY A BENCHMARK FIXED RATIO AT DIFFERENT LEVELS 89
ANNEX C. THE EQUITY ESCAPE RULE 91
Annex C
The equity escape rule
216. The equity escape rule is currently applied by a number of countries, including
Germany and Finland. The description below is based on the rule applied by Germany.
217. Under this approach, the fixed ratio rule does not apply to entities that are part of
a group, if the entity can demonstrate that its equity/total assets ratio is equal to (within a
tolerance of two percentage points) or higher than the equivalent group ratio. Where an
entitys ratio is lower than that of the group, the entity remains subject to the fixed ratio
rule. Under this approach, an entity which is leveraged more highly than its group cannot
deduct interest expense up to its groups ratio.
218. For these purposes, a group exists if an entity may be consolidated with other
entities under IFRS, or the financial or business decisions of the entity may be controlled
together with those of other entities. A group also exists where entities are held or
controlled by an individual or unincorporated entity.
219. The equity escape test should be based on audited consolidated financial
statements of a group prepared in accordance with IFRS. However, audited financial
statements drawn up in accordance with the commercial law of an EU Member State or
US GAAP may be used if no IFRS financial statements are prepared. The requirement to
prepare audited consolidated financial statements applies even where the group comprises
entities under the control of an individual or unincorporated entity.
220. Entity financial statements should be prepared under the same accounting rules as
the consolidated financial statements. Otherwise, a reconciliation must be prepared of the
entity financial statements to the accounting standards used by the group, and this must be
reviewed by an accountant. For purposes of determining the entitys equity ratio, all
assets and liabilities must be valued using the same method as in the consolidated
financial statements.
221.
Therefore, an entitys equity figure must also be adjusted for the following items:
to add goodwill included in the consolidated financial statements to the extent
attributable to the business enterprise
to adjust the valuation of assets and debts (valued at the amounts reported in the
consolidated financial statements)
to deduct equity not carrying voting rights (with the exception of preference
shares)
to deduct equity investments in other group entities.
222.
An entitys total assets figure is adjusted for the following items:
92 ANNEX C. THE EQUITY ESCAPE RULE

to add goodwill included in the consolidated financial statements to the extent
attributable to the business enterprise
to adjust the valuation of assets and debts (valued at the amounts reported in the
consolidated financial statements)
to deduct equity investments in other group entities
to deduct financial claims which are not included in the consolidated financial
statements but which are matched by liabilities of at least the same amount.
223. Anti-avoidance rules in Germany also require that, in applying the rule, an
entitys equity and total assets figures are adjusted to deduct contributions made over the
last six months prior to the relevant balance sheet date to the extent these are matched by
withdrawals or distributions during the first six months after the relevant balance sheet
date.
224. Even where the requirements of the equity escape rule are met, an entity which is
part of a group remains subject to the fixed ratio rule unless the entity can demonstrate
that interest payments on related-party loans from shareholders outside the group do not
exceed 10% of the groups total net interest expense. A loan is a related party loan if it is
from (i) a 25% shareholder (including direct and indirect shareholdings), (ii) an entity
related to a shareholder, or (iii) any entity where there is recourse to a 25% shareholder.
ANNEX D. EXAMPLES 93
Annex D
Examples
Example 1 Thin capitalisation rule based on a fixed debt/equity ratio

225. A simple group structure includes two companies, Parent and Subsidiary.
Subsidiary is resident in a country which applies a thin capitalisation rule based on a fixed
debt/equity ratio of 1.5/1. In Year 1, Subsidiary has total debt from Parent of USD 750
million and total equity of USD 375 million.1 On the intragroup debt, Subsidiary pays
interest at a rate of 2%, or USD 15 million. As Subsidiarys debt/equity ratio of 2/1
exceeds the benchmark fixed ratio of 1.5/1, Subsidiary will incur an interest disallowance
of USD 3.75 million. Subsidiary therefore has total interest deductions of USD 11.25
million.
226. To avoid this disallowance recurring, in Year 2 Subsidiary issues additional
equity of USD 125 million to Parent. Subsidiary uses the funds received to make a loan to
Parent of USD 125 million. The loan is on a short term basis at an interest rate of 1% and
Subsidiary receives interest income of USD 1.25 million. Subsidiarys debt/equity ratio is
now in line with the benchmark fixed ratio of 1.5/1 and so Subsidiary does not incur any
interest disallowance. Subsidiary now has total net interest deductions of USD 13.75
million.
227. In Year 3, Subsidiary issues a further USD 100 million of equity and USD 150
million of debt to Parent. The new debt is on a medium term and bears interest at 2%.
Subsidiary makes a new loan of USD 250 million to Parent on a short term basis at a rate
of 1%. Subsidiarys debt/equity ratio is in line with the benchmark fixed ratio and
Subsidiary incurs no interest disallowance. Subsidiary now has total net interest
deductions of USD 14.25 million.
228. Finally, in Year 4, Subsidiary restructures USD 450 million of its existing debt
into a long term subordinated loan with an arms length interest rate of 5%. Subsidiarys
debt/equity ratio is in line with the benchmark fixed ratio and Subsidiary incurs no
interest disallowance. Subsidiary now has total net interest deductions of USD 27.75
million.
229. Between Year 1 and Year 4, Subsidiarys net interest deductions have increased
from USD 11.25 million to USD 27.75 million, with no increase in underlying economic
activity. Between Year 2 and Year 4, Subsidiary was fully compliant with the thin
capitalisation rule based on a fixed debt/equity ratio.
230. However, this type of arrangement may contravene the general anti-avoidance
rule of a country.
94 ANNEX D. EXAMPLES
Example 2: Combining the best practice approach with other interest limitation
rules
231. As set out in Chapter 1, a country may apply other interest limitation rules
alongside those recommended in this report, either to tackle specific base erosion and
profit shifting risks, or to achieve other tax policy goals. This is just one example of the
way in which a country may apply the best practice approach alongside other rules but
this is not the only approach available to countries.
232. In this example, Country X decides that a comprehensive approach to limiting an
entitys interest deductions should comprise four parts. The first three of these are aimed
at addressing base erosion and profit shifting involving interest. The fourth is included to
achieve broader tax policy goals:
1. A fixed ratio rule which limits an entitys net interest deductions to 20% of
EBITDA. This rule applies to all entities which are part of a multinational group
or a domestic group. In this particular case, Country X does not apply the fixed
ratio rule to standalone entities (although as stated in Chapter 3, a country may
also choose to apply the fixed ratio rule to all entities, including standalone
entities).
2. A group ratio rule, which allows an entity which is subject to the fixed ratio rule
to deduct net interest expense up to the net third party interest/EBITDA ratio of
its group, where this is higher than 20%.
3. Targeted rules to address specific base erosion and profit shifting risks involving
interest. These rules are used to tackle base erosion and profit shifting risks
involving interest posed by standalone entities. Some targeted rules are also used
to prevent abuse of the general interest limitation rules by entities which are part
of a multinational group or a domestic group.
4. An upper limit on the net interest expense of all entities (including all group
entities and standalone entities) of 30% of EBITDA. This additional rule is not
aimed at tackling base erosion and profit shifting involving interest but is used to
reduce the existing tax bias in favour of debt funding over equity.
233.
This approach is summarised in Table D.1 below.
Table D.1
How the best practice approach may be combined with other interest limitation rules
Entities in
multinational
groups
Entities in domestic
groups
Standalone entities
Fixed ratio rule (20% of

EBITDA)
Group ratio rule
Targeted rules to address

specific risks
Upper limit on net interest
deductions (30% of EBITDA)
234. The application of these rules by Country X to five example companies is set out
below.
Table D.2
Application of the best practice approach and other interest limitation rules
A Co
USD
B Co
USD
C Co
USD
D Co
USD
E Co
USD
EBITDA
100 million
100 million
100 million
100 million
100 million
Net interest expense
(15 million)
(28 million)
(33 million)
(30 million)
(35 million)
Group net third party

interest/EBITDA ratio
10%
25%
35%
n/a
n/a
235. A Co is a company in a multinational group. A Co has net interest expense of

USD 15 million and EBITDA of USD 100 million. Because A Co has a net
interest/EBITDA ratio of below 20%, it is able to deduct all of its net interest expense. No
targeted rules apply.
236. B Co is a company in a multinational group. B Co has net interest expense of
USD 28 million and EBITDA of USD 100 million. Because B Co has a net
interest/EBITDA ratio in excess of 20%, the fixed ratio rule would apply to restrict B
Cos net interest deductions to USD 20 million. However, because B Co is part of a group
which has a net third party interest/EBITDA ratio of 25%, B Co is able to apply the group
ratio rule and deduct net interest expense of USD 25 million. USD 3 million of interest
expense is disallowed. No targeted rules apply.
237. C Co is a company in a domestic group. C Co has net interest expense of USD 33
million and EBITDA of USD 100 million. Because C Co has a net interest/EBITDA ratio
in excess of 20%, the fixed ratio rule would apply to restrict C Cos net interest
deductions to USD 20 million. However, C Co is part of a group which has a net third
party interest/EBITDA ratio of 35%, and so is able to apply the group ratio rule and
deduct more net interest expense. Because the group ratio exceeds the upper limit on net
interest deductions, C Cos net interest deductions are limited to 30% of EBITDA.
Therefore, C Co can deduct net interest expense of USD 30 million. USD 3 million of
interest expense is disallowed. No targeted rules apply.
238. D Co is a standalone entity and is not part of any group. D Co is controlled by an
individual who owns 100% of the ordinary shares in the company. D Co has net interest
expense of USD 30 million and EBITDA of USD 100 million. This net interest expense
includes USD 5 million paid on an arrangement giving rise to base erosion and profit
shifting (such as an "artificial loan" where no new funding is raised by D Co). Because D
Co is a standalone entity, it is not subject to the fixed ratio rule. Instead, D Co is subject
to targeted rules which deal with the specific base erosion and profit shifting risks posed
by standalone entities and to the upper limit on net interest deductions of 30% of
EBITDA. Therefore, D Co is able to deduct USD 25 million of its net interest expense.
USD 5 million is disallowed.
239. E Co is a standalone entity and is not part of any group. E Co has net third party
interest expense of USD 35 million and EBITDA of USD 100 million. Because E Co is a
standalone entity, it is not subject to the fixed ratio rule. However, it is subject to targeted
rules to address specific base erosion and profit shifting risks (although none of those
apply in this situation) and is also subject to the upper limit on net interest deductions of
30% of EBITDA. Therefore, E Co is able to deduct USD 30 million of its net interest
expense. USD 5 million of interest expense is disallowed.
240. In introducing any interest limitation rules, or combination of rules, a country
may need to take into account other legal or constitutional obligations. For example,
countries which are EU Member States should consider the requirements of EU law.
Example 3: Interest and payments economically equivalent to interest

241.
In 2015, A Co and its subsidiary B Co enter into the following arrangements:
1. A Co issues USD 50 million of bonds carrying a fixed interest rate of 5%.

2. A Co enters into an interest rate swap with a third party bank (Bank), under which
A Co receives fixed rate payments and pays floating rate payments on a notional
principal of USD 50 million.
3. B Co borrows USD 10 million from Bank at a floating interest rate.
4. B Cos borrowing from Bank is covered by a guarantee from A Co. In return, B
Co pays a guarantee fee to A Co.
5. B Co also obtains a short term credit facility with Bank whereby it can borrow up
to USD 500 000 for small periods at short notice. B Co pays an arrangement fee
for this facility.
6. B Co enters into a finance lease for new plant and machinery for use in its
business, payments under which include an interest element.
7. A Co enters into an operating lease for new office equipment.
8. B Co enters into a contract to provide 10 million widgets per year to Customer for
the next three years. This contract is covered by a performance guarantee from A
Co, in return for which B Co pays a guarantee fee to A Co.
9. B Co buys a series of aluminium futures contracts to protect itself against

movements in the price of aluminium, a key ingredient in the manufacture of
widgets.
10. A Co declares and pays a dividend of USD 1 million to holders of its ordinary
shares.
242. The amounts payable by A Co and B Co under 1, 2, 3, 4, 5 and 6 are all interest
on a debt, payments economically equivalent to interest, or expenses incurred in
connection with the raising of finance. These payments are therefore subject to the fixed
ratio rule and the group ratio rule. The amounts payable under 7, 8, 9 and 10 do not fall
within these categories (based on this specific fact pattern) and are not subject to these
rules.
Example 4: Fixed ratio rule (benchmark net interest/EBITDA ratio of 15%)

Table D.3
Operation of the fixed ratio rule

Single entity taxation
Group taxation
A1 Co
USD
A2 Co
USD
Total
USD
A1 Co + A2 Co
USD
70m
10m
80m
80m
+ net interest expense
+ 10m
+ 50m
+ 60m
+ 60m
+ depreciation and amortisation
+ 20m
+ 40m
+ 60m
+ 60m
= tax-EBITDA
= 100m
= 100m
= 200m
= 200m
x benchmark fixed ratio
x 15%
x 15%
x 15%
= maximum allowable deduction
= 15m
= 15m
= 30m
35m
35m
30m
Taxable income/(losses) before

applying the fixed ratio rule
Disallowed interest expense
243. In Table D.3, A1 Co and A2 Co incur a total disallowance of USD 30 million

where the fixed ratio rule is applied at the level of the local group (e.g. under a group
taxation regime). However, where they are taxed separately under a separate entity
taxation regime, they incur a total disallowance of USD 35 million (which arises in A2
Co). This is because A1 Co is not fully utilising its capacity to absorb interest deductions
and it is assumed that there are no rules in place to permit the surrender of interest
capacity from A1Co to A2Co. The example illustrates the potential advantage of applying
the rule at the level of the local group (although this may also be achieved if rules did
allow the surrender of interest capacity within the group). However, depending on the
individual situation of each group member the application of the rule at the group level
may also be disadvantageous as shown in the example below.
Table D.4
Impact of losses on the operation of the fixed ratio rule

Single entity taxation
Group taxation
A3 Co
USD
A4 Co
USD
Total
USD
A3 Co + A4 Co
USD
Taxable income/(losses) before

applying the fixed ratio rule
100m
(150m)
(50m)
(50m)
+ 20m
+ 20m
+ 40m
+ 40m
+ depreciation and amortisation
+ 30m
+ 30m
+ 60m
+ 60m
= tax-EBITDA
= 150m
= (100m)
= 50m
= 50m
x benchmark fixed ratio
x 15%
x 15%
x 15%
= 22.5m
=0
= 7.5m
20m
20m
32.5m
= maximum allowable deduction

244. Where one of the group entities is in a loss-making position and the fixed ratio rule
is applied at the level of the local group, the total disallowance incurred is greater than if
the rule would be applied at the level of each single entity. In Table D.4, A3 Co and A4
Co incur a total disallowance of USD 32.5 million where they are taxed under a group
taxation regime. However, where they are taxed separately under a separate entity
taxation regime, they incur a total disallowance of USD 20 million (which arises in A4
Co). This is because the loss in A4 Co partially reduces A3 Cos capacity to absorb
interest deductions.
Example 5: Applying factors to set a benchmark fixed ratio within the corridor
245. As set out in Chapter 6, it is recommended that a country uses the factors in that
chapter, along with other relevant factors, to set its benchmark fixed ratio within the
recommended corridor of 10% to 30%. This example illustrates some possible ways in
which this might be done, based on three countries which intend to introduce a fixed ratio
rule: Country A, Country B and Country C. This is not meant to be an exhaustive list of
possible approaches.
246.
Country A considers each of the factors in Chapter 6:
1. It intends to introduce the fixed ratio rule alongside a group ratio rule.
2. It intends to allow entities to carry back disallowed interest expense for a period
of three years.
3. It has no other tax rules which address the risks to be addressed by Action 4.
4. It does not have a high interest rate compared with other countries.
5. There is no legal or constitutional requirement for the same treatment to be
applied to different types of entity.
6. It does not intend to apply different fixed ratios depending on the size of an
entitys group.
247. In addition, Country A conducts its own analysis and concludes that groups
operating in the country typically have low net third party interest/EBITDA ratios.
Country A also wishes to apply a strict approach to tackle base erosion and profit shifting
involving interest.
248. Country A determines that factors 1 to 5, as well as the additional factors, suggest
a lower benchmark fixed ratio, while no factors suggest a higher ratio. Therefore, it
concludes that it should set its benchmark fixed ratio towards the lower end of the
corridor, within the illustrative range included in Figure D.1.
249.
Country B considers each of the factors in Chapter 6:
1. It intends to introduce the fixed ratio alongside a group ratio rule.

2. It intends to allow entities to carry forward unused interest capacity without
limitation.
3. It has other tax rules which specifically tackle a number of the risks to be
addressed by Action 4 but not all of these risks.
4. It has a slightly high interest rate compared with other countries.
5. There is a legal requirement to apply the same fixed ratio to entities in
multinational groups, entities in domestic groups and standalone entities.
6. It intends to apply one benchmark fixed ratio to entities in large groups, and a
different benchmark fixed ratio to other entities.
250.
Country B does not take into account any other factors in addition to the above.
251. Country B determines that two factors (1 and 2) suggest a lower benchmark fixed
ratio, while three factors (3 to 5) suggest a higher benchmark fixed ratio. Country B also
decides to apply a lower weighting to factors 3 and 4 because (i) although some of the
base erosion and profit shifting risks to be addressed by Action 4 are dealt with by other
tax rules, some of these risks remain, and (ii) although it has a slightly higher interest rate
compared with other countries, this is not significantly higher.
252. Therefore, Country B concludes that it should not set its benchmark fixed ratio for
most entities towards the top of the corridor, but rather within the illustrative range
indicated in Figure D.1. In addition, recognising that large groups tend to have a lower
net third party interest/EBITDA ratio than other groups, Country B decides to apply a
lower ratio to entities in large groups.
253.
Country C considers each of the factors in Chapter 6:
1. It intends to introduce the fixed ratio in isolation, without a group ratio rule.
2. It does not intend to allow entities to carry forward unused interest capacity or
carry back disallowed interest expense.
3. It has other tax rules that tackle all of the issues to be addressed under Action 4.
4. It has a high interest rate compared with those of other countries.
5. There is a constitutional requirement to apply the same fixed ratio to entities in
multinational groups, entities in domestic groups and standalone entities.
6. It does not intend to apply different fixed ratios depending on the size of an
entitys group.

254. In addition, Country C applies a macro-economic policy to encourage third party
lending not related to base erosion and profit shifting, to increase investment.
255. Country C determines that factors 1 to 5, as well as the additional factor, suggest a
higher benchmark fixed ratio while no factors suggest a lower ratio. Therefore, it
concludes that it may set its benchmark fixed ratio at any place in the corridor, from 10%
to 30%.
Figure D.1
Applying factors to set a benchmark fixed ratio within the corridor
10%
30%
Country A
All entities
Country B
Entities in large groups
Other entities
Country C
All entities
Example 6: Operation of a group ratio rule based on a net third party

256. Examples 6a to 6c below illustrate how, in a simple case, a group ratio rule based
on a net third party interest/EBITDA ratio could enable an entity which exceeds the
benchmark fixed ratio to deduct more interest up to its groups net third party
interest/EBITDA ratio.
257. In these examples, A Co is an entity resident in Country A. Country A applies a
fixed ratio rule as described in Chapter 6, with a benchmark fixed ratio of 20%. A Co is
part of a multinational group (Group). The net interest expense and EBITDA of A Co and
Group are set out in the Table D.5.
Table D.5
Operation of a group ratio rule based on a net third party interest/EBITDA ratio
USD
EBITDA
USD
A Co
(10 million)
30 million
Group
(100 million)
400 million
Example 6a Country A applies a fixed ratio rule in isolation

258. In this example, Country A applies a fixed ratio rule with a benchmark fixed ratio
of 20%. Country A does not apply a group ratio rule.
259. A Cos interest capacity is calculated by applying the benchmark fixed ratio of
20% to its EBITDA of USD 30 million. A Co therefore has interest capacity of
USD 6 million. Out of its total net interest expense of USD 10 million, USD 6 million
may be deducted and USD 4 million is disallowed.
Example 6b Country A applies a fixed ratio rule alongside a group ratio rule
260. In this example, Country A applies a fixed ratio rule with a benchmark ratio of
20%, and also a group ratio rule based on a net third party interest/EBITDA ratio. Under
the group ratio rule, Country A does not apply any uplift to a groups net third party
interest expense.
261. Under the fixed ratio rule, A Cos interest capacity is calculated by applying the
benchmark fixed ratio of 20% to its EBITDA of USD 30 million. A Co therefore has
interest capacity under the fixed ratio rule of USD 6 million.
262. Under the group ratio rule, A Co first calculates its groups net third party
interest/EBITDA ratio, based on the groups net third party interest expense of
USD 100 million and group EBITDA of USD 400 million. The groups ratio is therefore
25%. A Co applies the group ratio to its EBITDA of USD 30 million. A Co therefore has
interest capacity under the fixed ratio rule of USD 7.5 million.
263. A Cos interest capacity is greater under the group ratio rule and so this rule
applies. Out of A Cos total net interest expense of USD 10 million, USD 7.5 million may
be deducted and USD 2.5 million is disallowed.
Example 6c Country A applies a fixed ratio rule alongside a group ratio rule,
with a 10% uplift to net third party interest expense
264. In this example, Country A applies a fixed ratio rule with a benchmark ratio of
20%, and also a group ratio rule based on a net third party interest/EBITDA ratio. Under
the group ratio rule, Country A applies a 10% uplift to a groups net third party interest
expense.
265. Under the fixed ratio rule, A Cos interest capacity is calculated by applying the
benchmark fixed ratio of 20% to its EBITDA of USD 30 million. A Co therefore has
interest capacity under the fixed ratio rule of USD 6 million.
266. Under the group ratio rule, A Co first calculates its groups net third party
interest/EBITDA ratio. This is based on the groups adjusted net third party interest
expense of USD 110 million (after applying an uplift of 10% to the groups actual net
third party interest expense of USD 100 million) and group EBITDA of USD 400 million.
The groups ratio is therefore 27.5%. A Co applies the group ratio to its EBITDA of USD
30 million. A Co therefore has interest capacity under the fixed ratio rule of
USD 8.25 million.
267. A Cos interest capacity is greater under the group ratio rule and so this rule
applies. Out of A Cos total net interest expense of USD 10 million, USD 8.25 million
may be deducted and USD 1.75 million is disallowed.
Example 7: Definition of a group under a group ratio rule

268. The Examples 7a to 7e below show how a group is determined for the purposes of
applying a group ratio rule, based on different fact patterns.
Example 7a Companies held by an individual

Figure D.2
Companies held by an individual
Group A
Group B
A Co
OpCo A1
B Co
OpCo A2
OpCo B1
OpCo B2
269. In Figure D.2, an individual owns the majority of the share capital in two
companies, A Co and B Co, each of which has a number of subsidiaries. A Co and B Co
are the top level company in their respective holding structures (i.e. no company exercises
control over them). An individual cannot be the parent of a group. Therefore, for the
purposes of applying the group ratio rule, two groups exist. Group A includes A Co and
all entities included in A Cos consolidated financial statements, while Group B includes
B Co and all entities included in B Cos consolidated financial statements.
270. In applying a group ratio rule, it is also necessary to identify which individuals
and entities are related to a group, as this may be relevant in the calculation of the groups
net third party interest expense. In this example, Group A is related to the individual, as
well as to the entities in Group B. Similarly, Group B is related to the individual and to
the entities in Group A.
Example 7b Companies held by a limited partnership

271. Non-corporate vehicles such as limited partnerships cannot be the parent of a
group for the purposes of a group ratio rule. A corporate group held under such a
structure may be treated as a group, but this group will not include the limited
partnership, any funds set up by the limited partnership to hold investments, or other
corporate groups held under the structure. This is illustrated in Figure D.3, where Group
A, Group B and Group C are treated as separate groups when applying a group ratio rule.
However, the limited partnership, the sub-funds and Treasury Company would not form
part of any group for these purposes.
Figure D.3
Companies held by a limited partnership
Limited Partnership
Fund 1
Group A
Treasury
Company
Fund 2
Group B
Parent A
OpCo A1
OpCo A2
Group C
Parent B
OpCo B1
OpCo B2
Parent C
OpCo C1
OpCo C2
272. Although the limited partnership, the sub-funds and Treasury Company are not
part of a group for group ratio rule purposes, they would be treated as related to each of
Group A, Group B and Group C. Similarly, entities in each of the three groups would be
treated as related to each other (so entities in Group A are related to entities in Group B
and Group C, and so on).
Example 7c Joint venture entity controlled by an investing group

Figure D.4
Joint venture entity controlled by an investing group
Group B
Group A
Parent A
Parent B
JV Partner A
JV Partner B
55%
45%
JV Co
C Co
273. Where a joint venture entity is controlled by one of the joint venture partners, the
joint venture entity will typically be included in the consolidated financial statements of
the controlling group. It will therefore form part of this group for the purposes of
applying a group ratio rule. This is shown in Figure D.4, where JV Partner A holds a 55%
stake in JV Co. In this case, JV Co and its subsidiaries will be part of Group A for the
purposes of applying a group ratio rule.
274. JV Partner B and JV Co are not part of the same group. However, JV Partner B
holds an investment of greater than 25% in JV Co and so the two entities are related
parties (as per the definition of related party in Chapter 9).
Example 7d - Joint venture entity which is not controlled by any investing group
Figure D.5
Joint venture entity which is not controlled by any investing group
Group A
Group B
Parent A
Parent B
JV Partner A
JV Partner B
50%
50%
JV Co
C Co
Group C
275. Where no investor has overall control of a joint venture entity, each investing
group will generally include the joint venture in its consolidated financial statements
using equity accounting. The joint venture entity is not consolidated into either investing
group and will not form part of these groups for the purposes of a group ratio rule. This is
shown in Figure D.5, where JV Partner A and JV Partner B each hold 50% stakes in JV
Co, and no other arrangements exist which give control to one of the investors. JV Co and
its subsidiary will not be part of either Group A or Group B. Instead, JV Co and its
subsidiary will form a separate group (Group C). However, JV Co will be related to both
JV Partner A and JV Partner B.
Example 7e Holding structure headed by an investment entity

Figure D.6
Holding structure headed by an investment entity
Group A
Parent A
(Investment entity)
Group B
Group C
Parent B
Subsidiary B
Subsidiary A
Parent C
Subsidiary C
276. In Figure D.6, Parent A is a company which is an investment entity, and which
directly controls three companies. Parent A is the top level company in the structure.
277. Subsidiary A provides services connected with Parent As investment activities,
and is consolidated into Parent As consolidated financial statements.
278. Parent B and Parent C are held by Parent A for the purposes of capital
appreciation and investment income. As such, they are recognised in Parent As
consolidated financial statements as investments and carried at fair value.
279. Parent A and Subsidiary A form a group (Group A) for the purposes of applying
the group ratio rule. Parent B and Parent C are not members of Group A. Instead, each of
these companies forms a separate group with their respective subsidiaries (Group B and
Group C).
Example 8: Applying a group's ratio to an entitys tax-EBITDA or accountingEBITDA

280. As set out in Chapter 7, when applying a group ratio rule an entitys EBITDA
may be calculated using tax or accounting principles. Each of these approaches has
advantages and disadvantages, which are considered in Examples 8a-8c below, based on
the following scenario.
Table D.6
Applying a group's ratio to an entity's tax-EBITDA or accounting-EBITDA

Financial reporting
Tax

USD
EBITDA
USD

USD
EBITDA
USD
Group
(100 million)
1 billion
n/a
n/a
A Co
(20 million)
100 million
(18 million)
80 million
Group net third party interest/EBITDA ratio = (USD 100 million / USD 1 billion) x 100 = 10%
Example 8a - Determining EBITDA using tax principles

281. In this example, A Cos interest capacity is calculated by applying the groups net
third party interest/EBITDA ratio of 10%, to A Cos tax-EBITDA of USD 80 million.
This limit can be applied directly to A Cos net interest expense for tax purposes. Out of
A Cos total net interest expense of USD 18 million, USD 8 million is tax deductible and
USD 10 million is disallowed.
282. The calculation of EBITDA using tax principles is consistent with that
recommended under the fixed ratio rule. It is also straightforward for groups to apply and
tax authorities to audit, and as an approach to tackle base erosion and profit shifting it has
the benefit that an entitys interest deductions are linked to its level of taxable income.
This means that where an entitys taxable income is higher than its accounting income, its
ability to deduct interest expense will be correspondingly greater. Similarly, if an entity
undertakes planning to reduce its taxable income, it will be able to deduct less net interest
expense.
Example 8b - Determining EBITDA using accounting principles

283. In this example, A Cos interest capacity is calculated by applying the groups net
third party interest/EBITDA ratio of 10%, to A Cos accounting-EBITDA of
USD 100 million. This limit can be applied directly to A Cos net interest expense for tax
purposes. Out of A Cos total net interest expense of USD 18 million, USD 10 million is
tax deductible and USD 8 million is disallowed.
284. Under this approach interest capacity is calculated using only accounting
information. This is straightforward for groups to apply and tax authorities to audit.
However, a possible concern remains if there is a significant difference between the
calculation of net interest expense under tax and accounting rules. For example, an entity
could incur a significant interest disallowance if the definition of interest it applies for tax
purposes is wider than that for accounting purposes (because interest capacity has been
calculated using the narrower accounting definition).
Example 8c Adjusting an accounts-based limit on deductions for differences in

tax and accounting definitions of interest
285. This example illustrates an approach to reduce the impact of differences between
an entitys net interest expense for tax purposes and for accounting purposes. Under this

approach, the accounts-based limit on interest deductions calculated in Example 8b is
compared with the entities net interest expense for accounting purposes, to determine
what percentage falls within the limit. Where this figure is 100% (i.e. all of the entitys
accounting net interest expense is within the limit), then all of the entitys net interest
expense for tax purposes is deductible, with no disallowance. Where the percentage is
less than 100%, the corresponding percentage of the entitys net interest expense for tax
purposes is deductible, with the remainder disallowed (i.e. if 90% of the entitys
accounting net interest expense falls within the limit, 90% of the entitys tax net interest
expense would be deductible).
286. Applying this approach to A Co, the groups net third party interest/EBITDA ratio
of 10% is applied to A Cos accounting-EBITDA of USD 100 million to produce an
accounts-based limit on net interest expense of USD 10 million. This limit is compared
with A Cos net interest expense for accounting purpose of USD 20 million, 50% of
which falls within the limit. This percentage is then applied to A Cos net interest expense
for tax purposes. Therefore, out of A Cos total net interest expense for tax purposes of
USD 18 million, USD 9 million is deductible and USD 9 million is disallowed.
287. Compared with the accounts-based approach in Example 8b, this would mean, for
example, where an entitys net interest expense for tax purposes exceeds that for
accounting purposes, it would receive a correspondingly higher interest capacity.
Alternatively, where an entitys net interest expense for tax purposes is lower than that for
accounting purposes, its interest capacity would be reduced. In effect, the accounts-based
limit on deductions is flexed to take into account differences between net interest expense
for tax and accounting purposes.
Example 9: Dealing with loss-making entities within a group

Example 9a The impact of losses on the operation of a group ratio rule
Table D.7
The impact of losses on the operation of a group ratio rule

A Co
USD
B Co
USD
C Co
USD
Group
USD
EBITDA
100 million
10 million
(100 million)
10 million
Net interest
(20 million)
(2 million)
10 million
(12 million)

120%
Interest capacity
120 million
12 million
Deductible interest expense
(20 million)
(2 million)
Unused interest capacity
100 million
10 million
288. In Table D.7, A Co has EBITDA of USD 100 million and net interest expense of
USD 20 million. B Co has EBITDA of USD 10 million and net interest expense of USD
2 million. However, C Co has a negative EBITDA (i.e. losses) of USD 100 million and
receives net interest income of USD 10 million. Therefore, looking at the group as a
whole, the group has total EBITDA of USD 10 million and a net interest expense of
USD 12 million. The groups net third party interest/EBITDA ratio is 120%.
289. This very high group ratio causes two problems. Firstly, in the current year A Co
receives interest capacity of USD 120 million, which is higher than the groups actual net
third party interest expense. This means that in principle the company could deduct more
net interest than the total net third party interest expense of the group. Secondly, even
after deducting their current year net interest expense, A Co and B Co still have a high
level of unused interest capacity. If a rule allows the carry forward of unused interest
capacity, this could be carried into future periods and used to shelter further interest
deductions.
290. In a sense, this issue arises because C Co (which has a negative EBITDA of
USD 100 million) is not required to recognise negative interest capacity of
USD 120 million. If this was the case, then the interest capacity of the group as a whole
would equal the groups net third party interest expense of USD 12 million. However, the
recognition of negative interest capacity in loss-making entities is not recommended as
part of the best practice approach.
Example 9b Applying an upper limit on interest capacity

Table D.8
Applying an upper limit on interest capacity

A Co
USD
B Co
USD
C Co
USD
Group
USD
EBITDA
100 million
10 million
(100 million)
10 million
Net interest
(20 million)
(2 million)
10 million
(12 million)

120%
Interest capacity
12 million
12 million
(12 million)
(2 million)
(8 million)
10 million
291. In Table D.8, the group is in the same position as in Example 9a. However, the
interest capacity of A Co is now subject to limitation equal to the groups actual net third
party interest expense. Therefore, A Cos interest capacity is limited to USD 12 million
(i.e. the groups total net third party interest expense). A Co is able to deduct net interest
expense of USD 12 million, and may carry forward disallowed interest expense of
USD 8 million into future periods, if this is permitted under a rule.
292. As before, B Co receives interest capacity of USD 12 million and is able to
deduct its full net interest expense of USD 2 million. It is also able to carry forward
unused interest capacity of USD 10 million, if this is permitted by a countrys rule. As
discussed in in Chapter 7, it is suggested that countries consider limiting the scope of any
carry forward, and in particular those of unused interest capacity, by time and/or value.
293. Note that if the groups EBITDA had not been reduced by losses in C Co, the
groups net third party interest/EBITDA ratio would have been approximately 10.9% (i.e.
USD 12 million/USD 110 million). In this case, A Co would have been able to deduct
approximately USD 10.9 million of net interest expense. Therefore, the upper limit on
interest capacity has not restricted net interest deductions in A Co to below the level that
would have been permitted had the losses in C Co not arisen.
Example 9c Groups with negative consolidated EBITDA

Table D.9
Groups with negative consolidated EBITDA

A Co
USD
B Co
USD
C Co
USD
Group
USD
EBITDA
100 million
10 million
(120 million)
(10 million)
Net interest
(20 million)
(2 million)
10 million
(12 million)

n/a
Interest capacity
12 million
2 million
(12 million)
(2 million)
(8 million)
294. In Table D.9, Co has losses of USD 120 million. The group has an overall loss
(negative consolidated EBITDA) of USD 10 million, which means it is not possible to
calculate a meaningful group ratio. A Co and B Co therefore receive interest capacity
equal to the lower of their net interest expense and the groups net third party interest
expense.
295. A Co has net interest expense of USD 20 million, which exceeds the groups net
third party interest expense of USD 12 million. A Cos interest capacity is therefore USD
12 million. A Co is able to deduct net interest expense of USD 12 million, and may carry
forward disallowed interest expense of USD 8 million into future periods, if this is
permitted.
296. B Co has net interest expense of USD 2 million, which is lower than the groups
net third party interest expense of USD 12 million. B Cos interest capacity is therefore
USD 2 million. B Co may deduct its entire interest expense of USD 2 million. There is no
unused interest capacity.
Example 9d Excluding loss-making entities from the calculation of group

EBITDA for a profitable group
Table D.10

for a profitable group
A Co
USD
B Co
USD
C Co
USD
Group
USD
EBITDA
100 million
10 million
(100 million)
110 million
Net interest
(20 million)
(2 million)
10 million
(12 million)

10.9%
Interest capacity
10.9 million
1.1 million
(10.9 million)
(1.1 million)
(9.1 million)
(0.9 million)
297. This example is based on the same fact pattern as Example 9a. In this case, the
negative EBITDA in C Co has been disregarded in calculating the groups EBITDA.
Therefore, the group now has EBITDA of USD 110 million, rather than USD 10 million.
This means that the groups interest/EBITDA ratio is now reduced to 10.9%.
298. The effect of this is that A Co has interest capacity of USD 10.9 million and B Co
has interest capacity of USD 1.1 million. These total USD 12 million, which is equal to
the groups net third party interest expense. By disregarding C Cos losses, the group
ratio rule now operates to ensure that the group is able to deduct an amount equal to its
actual net third party interest expense. However, it may be very difficult for the tax
authorities in the countries of A Co and B Co to accurately establish the existence and
value of the negative EBITDA in C Co. Therefore, it may not be feasible for a country to
apply this approach in practice.
Example 9e Excluding loss-making entities from the calculation of group EBITDA

for a loss-making group
Table D.11

for a loss-making group
A Co
USD
B Co
USD
C Co
USD
Group
USD
EBITDA
100 million
10 million
(120 million)
110 million
Net interest
(20 million)
(2 million)
10 million
(12 million)

10.9%
Interest capacity
10.9 million
1.1 million
(10.9 million)
(1.1 million)
(9.1 million)
(0.9 million)
299. This example is based on the same fact pattern as in Example 9c. However, in this
case the negative EBITDA in C Co is disregarded in calculating the groups EBITDA.
Therefore, rather than being unable to calculate a meaningful group net third party
interest/EBITDA ratio, the group now has a net third party interest/EBITDA ratio of
10.9%.
300. A Co now has interest capacity of USD 10.9 million and B Co has interest
capacity of USD 1.1 million. In total, these come to USD 12 million, which is equal to the
groups net third party interest expense. By disregarding C Cos losses, the group is able
to deduct an amount equal to its actual net third party interest expense. However, in
practice it may be very difficult for the tax authorities in the countries of A Co and B Co
to accurately establish the existence and value of the negative EBITDA in C Co.
Example 10: Fixed ratio rule using EBITDA based on a three year average
301. Table D.12 illustrates how the negative impact of a temporary fall in profits under
a fixed ratio rule may be mitigated through the use of a three year moving average of the
EBITDA of an entity.
Table D.12 Fixed ratio rule using EBITDA based on a three year average
Year (current tax year = t)
t-2
t-1
t+1
t+2
t+3
USD
USD
USD
USD
USD
USD
Using current year tax-EBITDA

Taxable income
before applying the
fixed ratio rule
380m
350m
100m
300m
320m
300m
+ 100m
+ 100m
+ 100m
+ 100m
+ 100m
+ 100m
+ depreciation and
amortisation
+ 50m
+ 50m
+ 50m
+ 50m
+ 50m
+ 50m
= tax-EBITDA
= 530m
= 500m
= 250m
= 450m
= 470m
= 450m
x benchmark fixed
ratio
x 30%
x 30%
x 30%
x 30%
x 30%
x 30%
= maximum allowable
deduction
= 159m
= 150m
= 75m
= 135m
= 141m
= 135m
25m
Disallowed interest
expense
Using three year average tax-EBITDA

Average tax-EBITDA
of current year + 2
previous years
427m
400m
390m
457m
x benchmark fixed
ratio
x 30%
x 30%
x 30%
x 30%
= maximum allowable
deduction
= 128m
= 120m
= 117m
= 137m
Disallowed interest
expense
302. In the upper part of the table the excessive interest is calculated by using the
current year tax-EBITDA. In year t the entity suffers a temporary fall in profits and as a
result USD 25 million of interest expense is non-deductible. The entity may be able to
carry forward this disallowed interest expense for use in future periods, if this is
permitted. The lower part of the table illustrates the effect of using the moving average
tax-EBITDA of the last three years to calculate the maximum allowable interest
deduction. As a result of using the three year average the temporary fall in profits is
spread over a three year period. The impact of this is that the entity is able to deduct all of
its interest expense in year t, and has a lower maximum allowable deduction in years t+1
and t+2 compared to the base case.
Notes
1.
All monetary amounts in this annex are denominated in United States dollars (USD).
These are illustrative examples only, and are not intended to reflect real cases or the
position in a particular country.

AND DEVELOPMENT

(23 2015 31 1 P) ISBN 978-92-64-24116-9 2015
Limiting Base Erosion Involving Interest Deductions

and Other Financial Payments
Contents
Introduction
Chapter 1. Recommendations for a best practice approach
Chapter 2. Interest and payments economically equivalent to interest
Chapter 3. Who a best practice approach should apply to
Chapter 4. Applying a best practice approach based on the level of interest expense or debt
Chapter 5. Measuring economic activity using earnings or asset values
Chapter 6. Fixed ratio rule
Chapter 7. Group ratio rule
Chapter 8. Addressing volatility and double taxation
Chapter 9. Targeted rules
Chapter 10. Applying the best practice approach to banking and insurance groups
Chapter 11. Implementing the best practice approach
Annex A. European Union law issues
Annex B. Data on companies affected by a benchmark fixed ratio at different levels
Annex C. The equity escape rule
Annex D. Examples

isbn 978-92-64-24116-9
23 2015 31 1 P
OECD/G20BaseErosionandProfitShifting
Project
CounteringHarmfulTax
PracticesMoreEffectively,
TakingintoAccount
TransparencyandSubstance
ACTiOn5:2015FinalReport
Countering Harmful Tax

Practices More
Effectively, Taking into
Account Transparency
and Substance, Action 5
2015 Final Report

OECD (2015), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and
Substance, Action 5 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD
Publishing, Paris.
http://dx.doi.org/10.1787/9789264241190-en
ISBN 978-92-64-24118-3 (print)

ISBN 978-92-64-24119-0 (PDF)

OECD 2015
FOREwORD 3
Foreword
COUNTERING HARMFUL TAX PRACTICES MORE EFFECTIVELY, TAKING INTO ACCOUNT TRANSPARENCY AND SUBSTANCE OECD 2015
4 FOREwORD
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms ................................................................................................................... 7
Executive summary................................................................................................................................... 9
Chapter 1. Introduction and background ........................................................................................... 11
Chapter 2. Overview of the OECDs work on harmful tax practices ............................................... 15
Chapter 3. Framework under the 1998 Report for determining whether a regime is a
harmful preferential regime
19
Chapter 4. Revamp of the work on harmful tax practices: Substantial activity requirement ....... 23
I.
II.
III.
Introduction ............................................................................................................................... 23
Substantial activity requirement in the context of IP regimes ................................................... 24
Substantial activity requirement in the context of non-IP regimes............................................ 37
Chapter 5. Revamp of the work on harmful tax practices: Framework for improving
transparency in relation to rulings
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
45
Introduction ............................................................................................................................... 45
Rulings covered by the spontaneous exchange framework ....................................................... 47
Jurisdictions receiving the information ..................................................................................... 52
Application of the framework to rulings ................................................................................... 53
Information subject to the exchange.......................................................................................... 54
Practical implementation questions ........................................................................................... 54
Reciprocity ................................................................................................................................ 55
Confidentiality of the information exchanged ........................................................................... 55
Best practices............................................................................................................................. 56
Chapter 6. Review of OECD and associate country regimes............................................................. 61

I.
II.
III.
IV.
V.
Introduction ............................................................................................................................... 61
Conclusions on sub-national regimes and when they are in scope............................................ 61
Conclusions reached on regimes reviewed................................................................................ 62
Regimes relating to disadvantaged areas ................................................................................... 65
Downward adjustments ............................................................................................................. 65
Chapter 7. Further work of the FHTP ................................................................................................ 67

I.
II.
III.
Ongoing work including monitoring ......................................................................................... 67

Development of a strategy to expand participation to third countries ....................................... 68
Consideration of revisions or additions to the existing FHTP criteria ...................................... 68
Annex A.
Example of a transitional measure for tracking and tracing ......................................... 71
Annex B.
Spontaneous exchange on taxpayer-specific rulings under the framework .................. 73
Annex C.
Template and instruction sheet for information exchange ............................................. 74
6 TABLE OF CONTENTS
Tables
Table 5.1
Table 6.1
Table 6.2
Table A.1
Summary of the countries with which information should be exchanged ............................ 53

IP regimes .............................................................................................................................. 63
Non-IP regimes ..................................................................................................................... 64
Taxpayer Q's expenditures .................................................................................................... 71
AOA
Authorised OECD approach
APA
Advance pricing arrangement
ATR
Advance tax ruling
BEPS
CAN
Consolidated application note
CFA
CFC
CRS
Common Reporting Standard (Standard for Automatic Exchange of

Financial Account Information)
EOI
Exchange of information
EU
European Union
FATF
Financial Action Task Force
FHTP
Forum on Harmful Tax Practices
IP
Intellectual property
MAC
Convention on Mutual Administrative Assistance in Tax Matters
MNE
OECD
PE
R&D
Research and development
TIN
Taxpayer identification number
TP
Transfer pricing
EXECUTIVE SUMMARY 9
Executive summary
More than 15 years have passed since the publication of the Organisation for
Economic Co-operation and Developments (OECD) 1998 Report Harmful Tax
Competition: An Emerging Global Issue and the underlying policy concerns expressed
then are as relevant today as they were then. Current concerns are primarily about
preferential regimes that risk being used for artificial profit shifting and about a lack of
transparency in connection with certain rulings. The continued importance of the work on
harmful tax practices was highlighted by the inclusion of this work in the Action Plan on
Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013), whose Action 5
committed the Forum on Harmful Tax Practices (FHTP) to:
Revamp the work on harmful tax practices with a priority on improving
transparency, including compulsory spontaneous exchange on rulings related to
preferential regimes, and on requiring substantial activity for any preferential
regime. It will take a holistic approach to evaluate preferential tax regimes in the
BEPS context. It will engage with non-OECD members on the basis of the
existing framework and consider revisions or additions to the existing
framework.
In 2014, the FHTP delivered an initial progress report, which is incorporated into and
superseded by this final report. The main focus of the FHTPs work has been on agreeing
and applying a methodology to define the substantial activity requirement to assess
preferential regimes, looking first at intellectual property (IP) regimes and then other
preferential regimes. The work has also focused on improving transparency through the
compulsory spontaneous exchange of certain rulings that could give rise to BEPS
concerns in the absence of such exchanges.
Requiring substantial activity for preferential regimes

Countries agreed that the substantial activity requirement used to assess preferential
regimes should be strengthened in order to realign taxation of profits with the substantial
activities that generate them. Several approaches were considered and consensus was
reached on the nexus approach. This approach was developed in the context of IP
regimes, and it allows a taxpayer to benefit from an IP regime only to the extent that the
taxpayer itself incurred qualifying research and development (R&D) expenditures that
gave rise to the IP income. The nexus approach uses expenditure as a proxy for activity
and builds on the principle that, because IP regimes are designed to encourage R&D
activities and to foster growth and employment, a substantial activity requirement should
ensure that taxpayers benefiting from these regimes did in fact engage in such activities
and did incur actual expenditures on such activities. This same principle can also be
applied to other preferential regimes so that such regimes would be found to require
substantial activities where they grant benefits to a taxpayer to the extent that the taxpayer
undertook the core income-generating activities required to produce the type of income
covered by the preferential regime.
Improving transparency
In the area of transparency, a framework covering all rulings that could give rise to
BEPS concerns in the absence of compulsory spontaneous exchange has been agreed. The
framework covers six categories of rulings: (i) rulings related to preferential regimes; (ii)
cross border unilateral advance pricing arrangements (APAs) or other unilateral transfer
pricing rulings; (iii) rulings giving a downward adjustment to profits; (iv) permanent
establishment (PE) rulings; (v) conduit rulings; and (vi) any other type of ruling where
the FHTP agrees in the future that the absence of exchange would give rise to BEPS
concerns. This does not mean that such rulings are per se preferential or that they will in
themselves give rise to BEPS, but it does acknowledge that a lack of transparency in the
operation of a regime or administrative process can give rise to mismatches in tax
treatment and instances of double non-taxation. For countries which have the necessary
legal basis, exchange of information under this framework will take place from 1 April
2016 for future rulings and the exchange of certain past rulings will need to be completed
by 31 December 2016. The Report also sets out best practices for cross-border rulings.
Review of preferential regimes

A total of 43 preferential regimes have been reviewed, out of which 16 are IP
regimes. The Report contains the results of the application of the existing factors in the
1998 Report, as well as the elaborated substantial activity and transparency factors, to the
preferential regimes of members and associates. However, the elaborated substantial
activity factor has so far only been applied to IP regimes. In respect of substantial activity
the IP regimes reviewed were all considered inconsistent, either in whole or in part, with
the nexus approach as described in this report. This reflects the fact that, unlike other
aspects of the work on harmful tax practices, the details of this approach were only
finalised during the BEPS Project while the regimes had been designed at an earlier point
in time. Countries with such regimes will now proceed with a review of possible
amendments of the relevant features of their regimes. The FHTPs work on reviewing
preferential regimes will continue, recognising also that regimes that were assessed
before the substantial activity requirement was elaborated may need to be reassessed.
Next steps
The elements of a strategy to engage with countries other than OECD Members and
BEPS Associates in order to achieve a level playing field and avoid the risk that the work
on harmful tax practices could displace regimes to third countries is outlined in the
Report, together with the status of discussions on the revisions or additions to the existing
framework. These aspects of the work will be taken forward in the context of the wider
objective of designing a more inclusive framework to support and monitor the
implementation of the BEPS measures.
An ongoing monitoring and review mechanism covering preferential regimes,
including IP regimes, and the transparency framework has been agreed and will now be
put in place.
1. INTRODUCTION AND BACKGROUND 11
Chapter 1
Introduction and background
1.
At its June 2013 meeting, the Committee on Fiscal Affairs (CFA) of the
Organisation for Economic Co-operation and Development (OECD) approved the Action
Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013a) which was
subsequently endorsed by the G20 Finance Ministers at their July 2013 meeting and by
the G20 Leaders at their September 2013 meeting. In response to the call in the report
Addressing Base Erosion and Profit Shifting (BEPS Report, OECD, 2013b) to develop
solutions to counter harmful regimes more effectively, taking into account factors such
as transparency and substance,1 Action 5 of the BEPS Action Plan commits the Forum
on Harmful Tax Practices (FHTP) to the following:2
Revamp the work on harmful tax practices with a priority on improving
transparency, including compulsory spontaneous exchange on rulings related to
preferential regimes, and on requiring substantial activity for any preferential
regime. It will take a holistic approach to evaluate preferential tax regimes in the
BEPS context. It will engage with non-OECD members on the basis of the
existing framework and consider revisions or additions to the existing
framework. (OECD, 2013a)
2.
As is clear from Action 5, work in this area is not new. In 1998, the OECD
published the report Harmful Tax Competition: An Emerging Global Issue (1998 Report,
OECD, 1998). This report laid the foundations for the OECDs work in the area of
harmful tax practices and created the FHTP to take forward this work. It was published in
response to a request by Ministers to develop measures to counter harmful tax practices
with respect to geographically mobile activities, such as financial and other service
activities, including the provision of intangibles. The nature of those types of activities
makes it very easy to shift them from one country to another. Globalisation and
technological innovation have further enhanced that mobility. The goal of the OECDs
work in the area of harmful tax practices is to secure the integrity of tax systems by
addressing the issues raised by regimes that apply to mobile activities and that unfairly
erode the tax bases of other countries, potentially distorting the location of capital and
services. Such practices can also cause undesired shifts of part of the tax burden to less
mobile tax bases, such as labour, property, and consumption, and increase administrative
costs and compliance burdens on tax authorities and taxpayers.
3.
The work on harmful tax practices is not intended to promote the harmonisation
of income taxes or tax structures generally within or outside the OECD, nor is it about
dictating to any country what should be the appropriate level of tax rates. Rather, the
work is about reducing the distortionary influence of taxation on the location of mobile
financial and service activities, thereby encouraging an environment in which free and
fair tax competition can take place. This is essential in moving towards a level playing
12 1. INTRODUCTION AND BACKGROUND

field and a continued expansion of global economic growth. Countries have long
recognised that a race to the bottom would ultimately drive applicable tax rates on
certain sources of income to zero for all countries, whether or not this is the tax policy a
country wishes to pursue, and combating harmful tax practices is an interest common to
OECD and non-OECD countries alike. There are obvious limitations to the effectiveness
of unilateral actions against such practices. By agreeing a set of common criteria and
promoting a co-operative framework, the work not only supports the effective fiscal
sovereignty of countries over the design of their tax systems but it also enhances the
ability of countries to react against the harmful tax practices of others.
4.
More than 15 years have passed since the publication of the 1998 Report but the
underlying policy concerns expressed in the 1998 Report have not lost their relevance. In
certain areas, current concerns may be less about traditional ring-fencing but instead
relate to across the board corporate tax rate reductions on particular types of income (such
as income from financial activities or from the provision of intangibles). The fact that
preferential regimes continue to be a pressure area is highlighted by their inclusion in the
BEPS Report3 and Action 5 of the BEPS Action Plan.4
5.
Under Action 5, the FHTP is to deliver the following three outputs:
First, finalisation of the review of member and associate country preferential

regimes
Second, a strategy to expand participation to third countries
Third, consideration of revisions or additions to the existing framework.
6.
In September 2014 the OECD released an initial progress report of the FHTPs
progress on these outputs, Countering Harmful Tax Practices More Effectively, Taking
into Account Transparency and Substance (2014 Progress Report, OECD, 2014). This
report is the final report on Action 5, and it incorporates and supersedes the 2014
Progress Report.
Notes
1.
See Chapter 5 of the BEPS Report Addressing concerns related to base erosion and
profit shifting, p. 53.
2.
See Action 5 of the BEPS Action Plan Counter harmful tax practices more
effectively, taking into account transparency and substance, p. 18.
3.
See Chapter 5 of the BEPS Report Addressing concerns related to base erosion and
profit shifting, p. 48.
4.
See Action 5 of the BEPS Action Plan Counter harmful tax practices more
effectively, taking into account transparency and substance, p. 17.
1. INTRODUCTION AND BACKGROUND 13
Bibliography
Transparency and Substance, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789
264218970-en.
OECD (2013a), Action Plan on Base Erosion and Profit Shifting, OECD Publishing,
http://dx.doi.org/10.1787/9789264192744-en.
OECD (1998), Harmful Tax Competition: An Emerging Global Issue, OECD Publishing,
2. OVERVIEW OF THE OECDS WORK ON HARMFUL TAX PRACTICES 15
Chapter 2
Overview of the OECDs work on harmful tax practices
7.
The 1998 Report (OECD, 1998) divided the work on harmful tax practices into
three areas: (i) preferential regimes in OECD countries, (ii) tax havens and (iii) nonOECD economies. The 1998 Report set out four key factors and eight other factors to
determine whether a preferential regime is potentially harmful1 and four key factors used
to define tax havens.2 The 1998 Report was followed by four progress reports:
a) The first report, issued in June (2000 Report, OECD, 2001), outlined the progress
made and, among other things, identified 47 potentially harmful regimes within
OECD countries as well as 35 jurisdictions found to have met the tax haven
criteria (in addition to the six jurisdictions meeting the criteria that had made
advance commitments to eliminate harmful tax practices).
b) A second progress report was released in 2001 (OECD, 2002a). It made several
important modifications to the tax haven aspect of the work. Most importantly, it
provided that in determining which jurisdictions would be considered as
uncooperative tax havens, commitments would be sought only with respect to the
principles of effective exchange of information and transparency.
c) Between 2000 and 2004, generic guidance, or application, notes were
developed to assist member countries in reviewing existing or future preferential
regimes and in assessing whether any of the factors in the 1998 Report are
present. Application notes were developed on transparency and exchange of
information, ring-fencing, transfer pricing, rulings, holding companies, fund
management, and shipping. The separate application notes were combined into a
single Consolidated Application Note (CAN, OECD, 2004a).
d) In early 2004, the OECD issued another report (2004 Report, OECD, 2004b)
which focused mainly on the progress made with respect to eliminating harmful
aspects of preferential regimes in OECD countries. In addition to the 47 regimes
identified in 2000, the report included determinations on holding companies and
similar preferential regimes. A number of regimes that had been introduced since
the initial identification of potentially harmful regimes in 2000 were also
considered but none of these regimes were found to be harmful within the
meaning of the 1998 Report.
e) Finally, a report on OECD country preferential regimes was issued in September
2006 (OECD, 2006). Of the 47 regimes initially identified as potentially harmful
in the 2000 Report, 46 were abolished, amended or found not to be harmful
following further analysis. Only one preferential regime was found to be actually
harmful and legislation was subsequently enacted by the relevant country to
abolish this regime.
16 2. OVERVIEW OF THE OECDS WORK ON HARMFUL TAX PRACTICES

8.
Over time, the work relating to the tax haven aspects was increasingly carried out
through the Global Forum on Taxation (Global Forum), which was created in the early
2000s to engage in a dialogue with non-OECD countries on tax issues. The jurisdictions
that had committed to the principles of effective exchange of information on request and
transparency were invited to participate in the Global Forum, along with OECD
countries, to further articulate the principles of effective exchange of information on
request and transparency and to ensure their implementation. In 2002, the Global Forum
developed the Agreement on Exchange of Information in Tax Matters (OECD, 2002b),
and in 2005 it agreed standards on transparency relating to availability and reliability of
information. Since 2006, the Global Forum has published annual assessments of progress
in implementing the standards.3
9.
In September 2009, the Global Forum was renamed the Global Forum on
Transparency and Exchange of Information for Tax Purposes, and was restructured to
expand its membership and its mandate and to improve its governance.4 Subsequently,
the CFA decided to restructure the bodies responsible for Exchange of Information (EOI)
by creating Working Party No. 10 on Exchange of Information and Tax Compliance to
take over the responsibilities of Working Party No. 8 on Tax Avoidance and Evasion, as
well as the EOI matters previously addressed by the FHTP.5 Going forward, the work of
the FHTP has therefore focused on preferential tax regimes and on defensive measures in
respect of such regimes (other than any such measures related to a lack of EOI or
transparency).
Notes
1.
Those factors and the process for determining whether a regime is a harmful
preferential regime under the framework of the 1998 Report are described below
under Chapter 3, Section II.
2.
The four key factors to define a tax haven were: (i) no or nominal tax on the
relevant income; (ii) lack of effective exchange of information; (iii) lack of
transparency; (iv) no substantial activities. No or nominal tax is not sufficient in itself
to classify a jurisdiction as a tax haven.
3.
The relevant reports can be accessed on

www.oecd.org/tax/transparency/keypublications.htm.
4.
Information on the Global Forum on Transparency and Exchange of Information for

Tax Purposes and its work is available at: www.oecd.org/tax/transparency.
5.
Defensive measures related to a lack of exchange of information on request or

transparency fall within the mandate of Working Party No. 10 on Exchange of
Information and Tax Compliance. Action 5, however, requests the FHTP to
[r]evamp the work on harmful tax practices with a priority on improving
transparency, and under this mandate, the FHTP has considered the ruling regimes in
member and associate countries and developed a general best practices framework for
the design and operation of ruling regimes, as described below under Chapter 5.
the
following
webpage:
2. OVERVIEW OF THE OECDS WORK ON HARMFUL TAX PRACTICES 17
Bibliography
OECD (2006), The OECDs Project on Harmful Tax Practices: 2006 Update on Progress
in Member Countries, OECD, www.oecd.org/ctp/harmful/37446434.pdf.
OECD (2004a), Consolidated Application Note: Guidance in Applying the 1998 Report to
Preferential Tax Regimes, OECD, www.oecd.org/ctp/harmful/30901132.pdf.
OECD (2004b), Harmful Tax Practices: The 2004 Progress Report, OECD,
www.oecd.org/ctp/harmful/30901115.pdf.
OECD (2002a), The OECDs Project on Harmful Tax Practices: The 2001 Progress
Report, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264033993-en.
OECD (2002b), Agreement on Exchange of Information in Tax Matters, OECD
OECD (2001), Towards Global Tax Co-operation: Progress in Identifying and
Eliminating Harmful Tax Practices, OECD Publishing, Paris, http://dx.doi.org/
10.1787/9789264184541-en.
3. FRAMEWORK UNDER THE 1998 REPORT FOR DETERMINING WHETHER A REGIME IS A HARMFUL PREFERENTIAL REGIME 19
Chapter 3
Framework under the 1998 Report for
determining whether a regime is a harmful preferential regime
10.
This Chapter describes the framework under the 1998 Report (OECD, 1998) for
determining whether a regime is a harmful preferential regime. This involves three stages:
a) Consideration of whether a regime is within the scope of work of the FHTP and
whether it is preferential;
b) Consideration of the four key factors and eight other factors set out in the 1998
Report to determine whether a preferential regime is potentially harmful;
c) Consideration of the economic effects of a regime to determine whether a
potentially harmful regime is actually harmful.
A.
Consideration of whether a regime is within the scope of work of the

FHTP and whether it is preferential
Scope of work of the FHTP

11.
To be within the scope of the 1998 Report, the regime must, firstly, apply to
income from geographically mobile activities, such as financial and other service
activities, including the provision of intangibles. Preferential regimes designed to attract
investment in plant, building and equipment are outside the scope of the 1998 Report.1
12.
Secondly, the regime must relate to the taxation of the relevant income from
geographically mobile activities. Hence, the work is mainly concerned with business
taxation. Consumption taxes are explicitly excluded.2 Business taxes may be levied at
national, federal or central government level (national taxes) and/or at sub-national,
sub-federal or decentralised level (sub-national taxes). Sub-national taxes include taxes
levied at state, regional, provincial or local level. In the course of the current review, the
question arose as to whether regimes offering tax benefits at sub-national level alone
(sub-national regimes) are within the scope of the FHTPs work. This is discussed in
Chapter 6.
Preferential tax treatment

13.
In order for a regime to be considered preferential, it must offer some form of tax
preference in comparison with the general principles of taxation in the relevant country.
A preference offered by a regime may take a wide range of forms, including a reduction
in the tax rate or tax base or preferential terms for the payment or repayment of taxes.
Even a small amount of preference is sufficient for the regime to be considered
preferential. The key point is that the regime must be preferential in comparison with the
general principles of taxation in the relevant country, and not in comparison with
20 3. FRAMEWORK UNDER THE 1998 REPORT FOR DETERMINING WHETHER A REGIME IS A HARMFUL PREFERENTIAL REGIME
principles applied in other countries. For example, where the rate of corporate tax applied
to all income in a particular country is 10%, the taxation of income from mobile activities
at 10% is not preferential, even though it may be lower than the rate applied in other
countries.
B.
Consideration of the four key factors and eight other factors set out in
the 1998 Report to determine whether a preferential regime is
potentially harmful
14.
Four key factors and eight other factors are used to determine whether a
preferential regime within the scope of the FHTPs work is potentially harmful.3 A
reference to substantial activity is already included in the eight other factors so this is not
a new concept. The eight other factors generally help to spell out, in more detail, some of
the key principles and assumptions that should be considered in applying the key factors
themselves.
15.
The four key factors are:

a) The regime imposes no or low effective tax rates on income from geographically
mobile financial and other service activities.
b) The regime is ring-fenced from the domestic economy.
c) The regime lacks transparency (for example, the details of the regime or its
application are not apparent, or there is inadequate regulatory supervision or
financial disclosure).
d) There is no effective exchange of information with respect to the regime.4
16.
The eight other factors are:

a) An artificial definition of the tax base.
b) Failure to adhere to international transfer pricing principles.
c) Foreign source income exempt from residence country taxation.
d) Negotiable tax rate or tax base.
e) Existence of secrecy provisions.
f) Access to a wide network of tax treaties.
g) The regime is promoted as a tax minimisation vehicle.
h) The regime encourages operations or arrangements that are purely tax-driven and
involve no substantial activities.
17.
In order for a regime to be considered potentially harmful, the first key factor, no
or low effective tax rate, must apply. This is a gateway criterion. Where a regime offers
tax benefits at both national and sub-national level, the question of whether the regime
meets the low or no effective tax rate factor is, generally, determined based on the
combined effective tax rate for both the national and sub-national levels. The reduction in
national taxes alone may, in some cases, be considered sufficient to determine that
entities benefiting from the regime are subject to a low or no effective tax rate. The
application of the no or low effective tax rate factor to regimes offering tax benefits at
sub-national level alone is discussed in Chapter 6.
3. FRAMEWORK UNDER THE 1998 REPORT FOR DETERMINING WHETHER A REGIME IS A HARMFUL PREFERENTIAL REGIME 21
18.
Where a regime meets the no or low effective tax rate factor, an evaluation of
whether that regime is potentially harmful should be based on an overall assessment of
each of the other three key factors and, where relevant, the eight other factors. Where
low or zero effective taxation and one or more of the remaining factors apply, a regime
will be characterised as potentially harmful.
C.
Consideration of the economic effects of a regime to determine whether

a potentially harmful regime is actually harmful
19.
A regime that has been identified as being potentially harmful based on the above
factor analysis may be considered not to be actually harmful if it does not appear to have
created harmful economic effects.
20.
The following three questions can be helpful in making this assessment:
Does the tax regime shift activity from one country to the country providing the
preferential tax regime, rather than generate significant new activity?
Is the presence and level of activities in the host country commensurate with the
amount of investment or income?
Is the preferential regime the primary motivation for the location of an activity?5
21.
Following consideration of its economic effects, a regime that has created harmful
effects will be categorised as a harmful preferential regime.
22.
Where a preferential regime has been found to be actually harmful, the relevant
country is given the opportunity to abolish the regime or remove the features that create
the harmful effect. Other countries may take defensive measures to counter the effects of
the harmful regime, while at the same time continuing to encourage the country applying
the regime to modify or remove it.6 It is recognised that countries defensive measures
may also apply in situations which do not involve harmful preferential regimes as defined
in the 1998 Report. The 1998 Report does not affect countries right to use such measures
in such situations.7
22 3. FRAMEWORK UNDER THE 1998 REPORT FOR DETERMINING WHETHER A REGIME IS A HARMFUL PREFERENTIAL REGIME
Notes
1.
See paragraph 6 of 1998 Report, p. 8.
2.
3.
See paragraphs 59-79 of 1998 Report, pp. 25-34.
4.
Note that in assessing transparency and effective exchange of information factors, the
FHTP looks specifically at how a particular regime measures up against those factors.
It does not attempt to revisit the work of the Global Forum, which has a broader and
more general focus on transparency and effective exchange of information more
generally. However, to the extent that the work of the Global Forum highlights certain
issues with respect to a particular regime, these are taken into account in the FHTPs
evaluations.
5.
See paragraphs 80-84 of 1998 Report for more details on each of those questions, pp.
34-35.
6.
7.
See paragraph 98 of 1998 Report which states this principle with respect to controlled
foreign company (CFC) rules specifically, p. 41.
Bibliography
OECD (1998), Harmful Tax Competition: An Emerging Global Issue, OECD
4. REVAMP OF THE WORK ON HARMFUL TAX PRACTICES: SUBSTANTIAL ACTIVITY REQUIREMENT 23
Chapter 4
Revamp of the work on harmful tax practices:
Substantial activity requirement
23.
To counter harmful regimes more effectively, Action 5 of the BEPS Action Plan
(OECD, 2013) requires the FHTP to revamp the work on harmful tax practices, with a
priority and renewed focus on requiring substantial activity for any preferential regime
and on improving transparency, including compulsory spontaneous exchange on rulings
related to preferential regimes. This Chapter describes the work carried out by the FHTP
in the first of these two priority areas. The discussion on substantial activity in this
Chapter builds on and incorporates the discussion in the 2014 Progress Report (OECD,
2014) to ensure that all discussions of the nexus approach are combined in one report.
This Chapter is therefore fully self-standing and contains all the guidance on the nexus
approach and its application in the context of regimes which provide a preferential tax
treatment for certain income arising from qualifying intellectual property (IP regimes).
I.
Introduction
24.
Action 5 specifically requires substantial activity for any preferential regime.
Seen in the wider context of the work on BEPS, this requirement contributes to the
second pillar of the BEPS Project, which is to align taxation with substance by ensuring
that taxable profits can no longer be artificially shifted away from the countries where
value is created. The framework set out in the 1998 Report (OECD, 1998) already
contains a substantial activity requirement. This requirement is grounded in particular in
the twelfth factor (i.e. the eighth other factor) set out in the 1998 Report. This factor looks
at whether a regime encourages purely tax-driven operations or arrangements and states
that many harmful preferential tax regimes are designed in a way that allows taxpayers
to derive benefits from the regime while engaging in operations that are purely tax-driven
and involve no substantial activities. The 1998 Report contains limited guidance on how
to apply this factor.
25.
The substantial activity factor has been elevated in importance under Action 5,
which mandates that this factor be elaborated in the context of BEPS. This factor will
then be considered along with the four key factors when determining whether a
preferential regime within the scope of the FHTPs work is potentially harmful. The
FHTP considered various approaches to applying the substantial activity factor in the
context of IP regimes. There is a clear link between this work and statements in the BEPS
Action Plan that current concerns in the area of harmful tax practices may be less about
traditional ring-fencing and instead relate to corporate tax rate reductions on particular
types of income, such as income from the provision of intangibles.1 All IP regimes in
OECD countries and associate countries have been reviewed at the same time as part of
the current review and none of these regimes had been reviewed as part of the earlier
24 4. REVAMP OF THE WORK ON HARMFUL TAX PRACTICES: SUBSTANTIAL ACTIVITY REQUIREMENT

work. The elaborated substantial activity requirement can therefore be applied without
needing to re-assess IP regimes previously reviewed. Under Action 5, the substantial
activity requirement applies to all preferential regimes within scope, including non-IP
regimes, and the FHTP has also considered this aspect.
II.
Substantial activity requirement in the context of IP regimes

26.
Regimes that provide for a tax preference on income relating to IP raise the baseeroding concerns that are the focus of the FHTPs work. At the same time, it is
recognised that IP-intensive industries are a key driver of growth and employment and
that countries are free to provide tax incentives for research and development (R&D)
activities, provided that they are granted according to the principles agreed by the FHTP.
The approach adopted by the FHTP to requiring substantial activity is therefore not
intended to recommend any particular IP regime, but it is instead designed to describe the
outer limits of an IP regime that grants benefits to R&D but does not have harmful effects
on other countries. The FHTP makes no recommendation on the introduction of IP
regimes and jurisdictions remain free to decide whether or not to implement an IP regime.
IP regimes that provide benefits to a narrower set of income, IP assets, expenditures, or
taxpayers than that outlined below would also be consistent with the FHTPs approach.
27.
The FHTP considered three different approaches to requiring substantial activities
in an IP regime. The first approach was a value creation approach that required taxpayers
to undertake a set number of significant development activities. This approach did not
have any support over the other two. The second approach was a transfer pricing
approach that would allow a regime to provide benefits to all the income generated by the
IP if the taxpayer had located a set level of important functions in the jurisdiction
providing the regime, if the taxpayer is the legal owner of the assets giving rise to the tax
benefits and uses the assets giving rise to the tax benefits, and if the taxpayer bears the
economic risks of the assets giving rise to the tax benefits. A few countries supported the
transfer pricing approach, but many countries raised a number of concerns with the
transfer pricing approach, which is why the work of the FHTP did not focus further on
this approach. The third approach was the nexus approach, which has been agreed by the
FHTP and endorsed by the G20.2
28.
This approach looks to whether an IP regime makes its benefits conditional on the
extent of R&D activities of taxpayers receiving benefits. The approach seeks to build on
the basic principle underlying R&D credits and similar front-end tax regimes that apply
to expenditures incurred in the creation of IP. Under these front-end regimes, the
expenditures and benefits are directly linked because the expenditures are used to
calculate the tax benefit. The nexus approach extends this principle to apply to backend tax regimes that apply to the income earned after the creation and exploitation of the
IP. Thus, rather than limiting jurisdictions to IP regimes that only provide benefits
directly to the expenditures incurred to create the IP, the nexus approach also permits
jurisdictions to provide benefits to the income arising out of that IP, so long as there is a
direct nexus between the income receiving benefits and the expenditures contributing to
that income. This focus on expenditures aligns with the underlying purpose of IP regimes
by ensuring that the regimes that are intended to encourage R&D activity only provide
benefits to taxpayers that in fact engage in such activity.
29.
Expenditures therefore act as a proxy for substantial activities. It is not the amount
of expenditures that acts as a direct proxy for the amount of activities. It is instead the
proportion of expenditures directly related to development activities that demonstrates
real value added by the taxpayer and acts as a proxy for how much substantial activity the
taxpayer undertook. The nexus approach applies a proportionate analysis to income,
under which the proportion of income that may benefit from an IP regime is the same
proportion as that between qualifying expenditures and overall expenditures. In other
words, the nexus approach allows a regime to provide for a preferential rate on IP-related
income to the extent it was generated by qualifying expenditures. The purpose of the
nexus approach is to grant benefits only to income that arises from IP where the actual
R&D activity was undertaken by the taxpayer itself. This goal is achieved by defining
qualifying expenditures in such a way that they effectively prevent mere capital
contribution or expenditures for substantial R&D activity by parties other than the
taxpayer from qualifying the subsequent income for benefits under an IP regime.
30.
If a company only had one IP asset and had itself incurred all of the expenditures
to develop that asset, the nexus approach would simply allow all of the income from that
IP asset to qualify for benefits. Once a companys business model becomes more
complicated, however, the nexus approach also by necessity becomes more complicated,
because the approach must determine a nexus between multiple strands of income and
expenditure, only some of which may be qualifying expenditures. In order to address this
complexity, the nexus approach apportions income according to a ratio of expenditures.
The nexus approach determines what income may receive tax benefits by applying the
following calculation:

31.
The ratio in this calculation (the nexus ratio) only includes qualifying and
overall expenditures incurred by the entity. It therefore does not consider all expenditures
ever incurred in the development of the IP asset. As will be explained in the following
discussions of qualifying expenditures and overall expenditures, a qualifying taxpayer
that did not acquire the IP asset or outsource the development of that IP asset to a related
party would therefore have a ratio of 100%, which would apply to the entitys overall
income from the IP asset. This in turn means that the nexus approach was not designed to
disadvantage arrangements where different entities are engaged in activities contributing
to the development of IP assets.3
32.
Where the amount of income receiving benefits under an IP regime does not
exceed the amount determined by the nexus approach, the regime has met the substantial
activity requirement. The remainder of this section provides further guidance on the
application of the nexus approach and the above calculation.
A.
Qualifying taxpayers
33.
Qualifying taxpayers would include resident companies, domestic permanent
establishments (PEs) of foreign companies, and foreign PEs of resident companies that
are subject to tax in the jurisdiction providing benefits. The expenditures incurred by a PE
cannot qualify income earned by the head office as qualifying income if the PE is not
operating at the time that income is earned.4
B.
IP assets
34.
Under the nexus approach as contemplated, the only IP assets that could qualify
for tax benefits under an IP regime are patents and other IP assets that are functionally
equivalent to patents if those IP assets are both legally protected5 and subject to similar
approval and registration processes, where such processes are relevant. IP assets that are
functionally equivalent to patents are (i) patents defined broadly, (ii) copyrighted
software, and (iii) in certain circumstances set out below, other IP assets that are nonobvious, useful, and novel.
35.
For purposes of the first category of functionally equivalent assets, patents that
qualify under the nexus approach are not just patents in a narrow sense of the word but
also utility models, IP assets that grant protection to plants and genetic material, orphan
drug designations, and extensions of patent protection. Utility models, irrespective of
their designation under domestic law (e.g. petty patents, innovation patents, short
term patents), are generally provided to incremental inventions, have a less rigorous
patent process, and provide patent protection for a shorter time period. IP assets that grant
protection to plants and genetic material would include plant breeders rights, which grant
exclusive control over new varieties of plants. Orphan drug designations are provided by
government agencies for certain pharmaceuticals that are developed to treat rare diseases
or diseases that are not likely to lead to significant profits and these designations grant
exclusive rights to the innovations. Extensions of patent protection such as supplementary
protection certificates extend the exclusive right of certain patents for pharmaceuticals
and plant protection products, and they recognise that the time needed to research and
develop these IP assets is generally longer than the time needed to research and develop
other IP assets and therefore justifies that the protected life of the asset should extend past
the duration of the patent. Therefore, IP assets in the first category cover patents in the
broad sense, including the extension of patent protection.
36.
Copyrighted software6 shares the fundamental characteristics of patents, since it
is novel, non-obvious, and useful. It arises from the type of innovation and R&D that IP
regimes are typically designed to encourage, and taxpayers in the software industry are
unlikely to outsource the development of their core software to unrelated parties.
Copyrighted software therefore is the second category of functionally equivalent assets,
but other copyrighted assets are not included in the definition of functionally equivalent
IP assets because they do not arise out of the same type of R&D activities as software.
37.
Qualifying IP assets can also include IP assets that do not fall into either of the
first two categories but that share features of patents (i.e. are non-obvious, useful, and
novel), are substantially similar to the IP assets in the first two categories, and are
certified as such in a transparent certification process by a competent government agency
that is independent from the tax administration. Such a certification process must also
provide for full transparency on the types of assets covered. The only taxpayers that may
qualify for such benefits are those that have no more than EUR 50 million (or a near
equivalent amount in domestic currency) in global group-wide turnover and that do not
themselves earn more than EUR 7.5 million per year (or a near equivalent amount in
domestic currency) in gross revenues from all IP assets, using a five-year average for both
calculations.7 Jurisdictions that provide benefits to income from the third category of IP
assets should notify the FHTP that they provide such benefits and should provide
information on the applicable legal and administrative framework. They should provide
information to the FHTP on the number of each type of IP asset included in the third
category, the number of taxpayers benefiting from the third category, and the aggregate
amount of IP income arising from the third category of IP assets that qualifies for the IP
regime. Jurisdictions would also need to spontaneously exchange information on
taxpayers benefiting from the third category of IP assets, using the framework set out in
Chapter 5.8 The FHTP will proceed to a review of the third category of IP assets no later
than 2020.
38.
The nexus approach focuses on establishing a nexus between expenditures, these
IP assets, and income. Under the nexus approach, marketing-related IP assets such as
trademarks can never qualify for tax benefits under an IP regime.9
C.
Qualifying expenditures
39.
Qualifying expenditures must have been incurred by a qualifying taxpayer, and
they must be directly connected to the IP asset. Jurisdictions will provide their own
definitions of qualifying expenditures, and such definitions must ensure that qualifying
expenditures only include expenditures that are incurred for the purpose of actual R&D
activities. They would include the types of expenditures that currently qualify for R&D
credits under the tax laws of multiple jurisdictions.10 They would not include interest
payments, building costs, acquisition costs, or any costs that could not be directly linked
to a specific IP asset.11 However, where expenditures for general and speculative R&D
cannot be included in the qualifying expenditures of a specific IP asset to which they have
a direct link, they could be divided pro rata across IP assets or products. Qualifying
expenditures will be included in the nexus calculation at the time they are incurred,
regardless of their treatment for accounting or other tax purposes. In other words,
expenditures that are not fully deductible in the year in which they were incurred because
they are capitalised will still be included in full in the nexus ratio starting in the year in
which they were incurred. This timing rule only applies for purposes of the nexus ratio,
and it is not intended to change any timing rules in jurisdictions domestic tax rules.
40.
When calculating qualifying expenditures, jurisdictions may permit taxpayers to
apply a 30% up-lift to expenditures that are included in qualifying expenditures. This
up-lift may increase qualifying expenditures but only to the extent that the taxpayer has
non-qualifying expenditures. In other words, the increased amount of qualifying
expenditures may not exceed the taxpayers overall expenditures. This is illustrated in the
examples below:
Example A: The taxpayer itself incurred qualifying expenditures of 100, it

incurred acquisition costs of 10, and it paid 40 for the R&D expenditures of a
related party. The initial amount of qualifying expenditures is therefore 100, and
the maximum up-lift will be 30 (i.e. 100 x 30%). The taxpayer can only increase
its qualifying expenditures to 130 if its overall expenditures are equal to or greater
than 130. Overall expenditures in this example are equal to 150, so the up-lift can
increase qualifying expenditures to 130. IP income will therefore be multiplied by
130/150 (or 86.7%).
Example B: The taxpayer itself incurred qualifying expenditures of 100, it

incurred acquisition costs of 5, and it paid 20 for the R&D expenditures of a
related party. The maximum up-lift would again increase qualifying expenditures
to 130, but the taxpayer in this example only has 125 of overall expenditures. The
up-lift can therefore only increase qualifying expenditures to 125, and IP income
will therefore be multiplied by 125/125 (or 100%).

41.
The purpose of the up-lift is to ensure that the nexus approach does not penalise
taxpayers excessively for acquiring IP or outsourcing R&D activities to related parties.
The up-lift still ensures that taxpayers only receive benefits if they themselves undertook
R&D activities, but it acknowledges that taxpayers that acquired IP or outsourced a
portion of the R&D to a related party may themselves still be responsible for much of the
value creation that contributed to IP income.
D.
Overall expenditures
42.
Overall expenditures should be defined in such a way that, if the qualifying
taxpayer incurred all relevant expenditures itself, the ratio would allow 100% of the
income from the IP asset to benefit from the preferential regime. This means that overall
expenditures must be the sum of all expenditures that would count as qualifying
expenditures if they were undertaken by the taxpayer itself. This in turn means that any
expenditures that would not be included in qualifying expenditures even if incurred by the
taxpayer itself (e.g. interest payments, building costs, and other costs that do not represent
actual R&D activities) cannot be included in overall expenditures and hence do not affect
the amount of income that may benefit from an IP regime. IP acquisition costs are an
exception, since they are included in overall expenditures and not in qualifying
expenditures. Their exclusion is consistent with the principle of what is included in
overall expenditures, however, because they are a proxy for expenditures incurred by a
non-qualifying taxpayer. Overall expenditures therefore include all qualifying
expenditures, acquisition costs, and expenditures for outsourcing that do not count as
qualifying expenditures.
43.
The nexus approach therefore does not include all expenditures ever incurred in
the development of an IP asset in overall expenditures. Instead, it only adds two things to
qualifying expenditures: expenditures for related-party outsourcing and acquisition
costs.12 The nexus ratio can therefore be written as:
+
+ + +
44.
In this version of the nexus ratio, a represents R&D expenditures incurred by the
taxpayer itself, b represents expenditures for unrelated-party outsourcing, c represents
acquisition costs, and d represents expenditures for related-party outsourcing. This means
that the only way that the ratio can be decreased from 100% is if the taxpayer outsourced
the R&D to related parties or acquired the R&D. Expenditures for unsuccessful R&D will
typically not be included in the nexus ratio, which is consistent with the purposes of IP
regimes that grant benefits to income, since unsuccessful R&D by definition does not
generate any income. If, however, R&D expenditures were incurred by the taxpayer or
outsourced to unrelated parties in connection with a larger R&D project that produced an
income-generating IP asset, then an IP regime may also include all such R&D
expenditures in qualifying expenditures and not just those R&D expenditures that, with
the benefit of hindsight, directly contributed to IP income. These expenditures could be
treated the same as general or speculative R&D and either divided pro rata across IP
assets or included in qualifying expenditures if a direct link between the IP asset and the
expenditures could be established. As in the context of qualifying expenditures, overall
expenditures will be included in the nexus calculation at the time they are incurred,
regardless of their treatment for accounting or other tax purposes. This timing rule only
applies for purposes of the nexus ratio, and it is not intended to change any timing rules in
jurisdictions tax rules insofar as they apply for other purposes, including the computation
of overall income derived from the IP asset.13
45.
Often, overall expenditures will be incurred prior to the production of income that
could qualify for benefits under the IP regime. The nexus approach is an additive
approach, and the calculation requires both that qualifying expenditures include all
qualifying expenditures incurred by the taxpayer over the life of the IP asset and that
overall expenditures include all overall expenditures incurred over the life of the IP
asset. These numbers will therefore increase every time a taxpayer incurs expenditure that
would qualify for either category. The proportion of the cumulative numbers will then
determine the percentage to be applied to overall income earned each year.
E.
Overall income
46.
Jurisdictions will define overall income consistent with their domestic laws on
income definition after the application of transfer pricing rules. The definition that they
choose should comply with the following principles:
Income benefiting from the regime should be proportionate

47.
Overall income should be defined in such a way that the income that benefits
from the regime is not disproportionately high given the percentage of qualifying
expenditures undertaken by qualifying taxpayers. This means that overall income should
not be defined as the gross income from the IP asset, since such a definition could allow
100% of the net income of qualifying taxpayers to benefit even when those taxpayers had
not incurred 100% of qualifying expenditures. Overall income should instead be
calculated by subtracting IP expenditures allocable to IP income and incurred in the year
from gross IP income earned in the year.14
Overall income should be limited to IP income

48.
Overall income should only include income that is derived from the IP asset. This
may include royalties, capital gains and other income from the sale of an IP asset, and
embedded IP income from the sale of products and the use of processes directly related to
the IP asset. Jurisdictions that choose to grant benefits to embedded IP income must
implement a consistent and coherent method for separating income unrelated to IP (e.g.
marketing and manufacturing returns) from the income arising from IP. One method that
would achieve this outcome could, for example, be based on transfer pricing principles.15
F.
Outsourcing
49.
The nexus approach is intended to ensure that, in order for a significant proportion
of IP income to qualify for benefits, a significant proportion of the actual R&D activities
must have been undertaken by the qualifying taxpayer itself. The nexus approach would
allow all qualifying expenditures for activities undertaken by unrelated parties (whether
or not they were within the jurisdiction) to qualify, while all expenditures for activities
undertaken by related parties again, whether or not they were within the jurisdiction
would not count as qualifying expenditures.16
50.
As a matter of business practice, unlimited outsourcing to unrelated parties should
not provide many opportunities for taxpayers to receive benefits without themselves
engaging in substantial activities because, while a company may outsource the full
spectrum of R&D activities to a related party, the same is typically not true of an

unrelated party. Since the vast majority of the value of an IP asset rests in both the R&D
undertaken to create it and the information necessary to undertake such R&D, it is
unlikely that a company will outsource the fundamental value-creating activities to an
unrelated party, regardless of where that unrelated party is located.17 Allowing only
expenditures incurred by unrelated parties to be treated as qualifying expenditures thus
achieves the goal of the nexus approach to only grant tax benefits to income arising from
the substantive R&D activities in which the taxpayer itself engaged that contributed to the
income. Jurisdictions could narrow the definition of unrelated parties to include only
universities, hospitals, R&D centres and non-profit entities that were unrelated to the
qualifying taxpayer. Where a payment is made through a related party to an unrelated
party without any margin, the payment will be included in qualifying expenditures.
51.
Jurisdictions could also only permit unrelated outsourcing up to a certain
percentage or proportion (while still excluding outsourcing to related parties from the
definition of qualifying expenditures). As explained above, business realities typically
mean that a company will not outsource more than an insubstantial amount of R&D
activities to an unrelated party, so both a prohibition on outsourcing to any related parties
and that same prohibition combined with a cap that prohibits outsourcing to unrelated
parties beyond an insubstantial amount should have the equivalent effect of limiting
qualifying expenditures to those expenditures incurred to support fundamental R&D
activities by the taxpayer.
G.
Treatment of acquired IP
52.
The basic principle underlying the treatment of acquired IP by the nexus approach
is that only the expenditures incurred for improving the IP asset after it was acquired
should be treated as qualifying expenditures. In order to achieve this, the nexus approach
would exclude acquisition costs from the definition of qualifying expenditures, as
mentioned above, and only allow expenditures incurred after acquisition to be treated as
qualifying expenditures. Acquisition costs would, however, be included in overall
expenditures. Acquisition costs would include, among other expenditures, those that were
incurred to obtain rights to research.18 Acquisition costs (or, in the case of licensing,
royalties or license fees) are a proxy for overall expenditures incurred prior to acquisition.
Therefore, no expenditures incurred by any party prior to acquisition will be included in
either qualifying expenditures or overall expenditures.19 In the context of related party
acquisitions, the arms length price must be used to determine acquisition costs. Given
that taxpayers may have an incentive to undervalue transfers between related parties into
IP regimes, any related party acquisitions will require that taxpayers prepare
documentation substantiating the arms length price, including documentation on the
overall expenditures that the related party transferor incurred. Acquisitions include any
transfer of rights regardless of whether a payment was actually made.
H.
Tracking of income and expenditures
53.
Since the nexus approach depends on there being a nexus between expenditures
and income, it requires jurisdictions wishing to introduce an IP regime to mandate that
taxpayers that want to benefit from an IP regime must track expenditures, IP assets, and
income to ensure that the income receiving benefits did in fact arise from the
expenditures that qualified for those benefits. If a taxpayer has only one IP asset that it
has fully self-developed and that provides all of its income, this tracking should be fairly
simple, since all qualifying expenditures incurred by that company will determine the
benefits to be granted to all the IP income earned by that company. Once a company has
more than one IP asset or engages in any degree of outsourcing or acquisition, however,
tracking becomes essential. Tracking must also ensure that taxpayers have not
manipulated the amount of overall expenditures to inflate the amount of income that may
benefit from the regime. This means that taxpayers will need to be able to track the link
between expenditures and income and provide evidence of this to their tax
administrations. Not engaging in such tracking will not prevent taxpayers from earning IP
income in a jurisdiction, but it will prevent them from benefiting from a preferential IP
regime.
54.
The main complexity associated with tracking arises from the fact that a
preferential rate is applied to certain IP income, which is a function of the regime rather
than the nexus approach, and existing IP regimes suggest that taxpayers are willing to
comply with certain often complex requirements when an optional tax benefit is made
conditional on such requirements. Because the nexus approach will standardise the
requirements of IP regimes across jurisdictions, it may in the long term reduce the overall
complexity that taxpayers that are benefiting from multiple IP regimes currently face.
55.
The fundamental principle underlying the nexus approach is that income should
only benefit from an IP regime to the extent that the taxpayer itself incurred the R&D
expenditures that contributed to that IP. If the taxpayer instead acquired the IP or
outsourced the R&D to a related party, the income that arose from acquired IP or
outsourced R&D should not benefit from an IP regime. The nexus approach was designed
to require a link between expenditures, IP assets, and IP income, and taxpayers must track
to IP assets. However, where such tracking would be unrealistic and require arbitrary
judgements, jurisdictions may also choose to allow the application of the nexus approach
so that the nexus can be between expenditures, products arising from IP assets, and
income. Such an approach would require taxpayers to include all qualifying expenditures
linked to the development of all IP assets that contributed to the product in qualifying
expenditures and to include all overall expenditures linked to the development of all IP
assets that contributed to the product in overall expenditures. This aggregate ratio
would then be applied to overall income from the product that was directly linked to all
the underlying IP assets. This approach would be consistent with the nexus approach in
cases where multiple IP assets are incorporated into one product, but jurisdictions must
ensure that this product-based approach requires accurate tracking of all qualifying and
overall expenditure at the level of the product and that benefits expire at a fair and
reasonable time (e.g. the average life of all IP assets).
56.
The product-based approach acknowledges that R&D activities often may not be
structured on an IP-asset-by-IP-asset basis and it may then be consistent with the nexus
approach to track and trace to products. This is because R&D programmes and projects
are generally focused on answering research questions or solving technical problems and
it is only in a subsequent stage that there is any discussion of how to provide legal
protection to the results of these projects. Often, the results of these projects will
contribute to multiple IP assets. Where this is the case, forcing an allocation of R&D
expenditures between or among different IP assets would require taxpayers to arbitrarily
divide research projects along lines that did not exist at the time the projects were
undertaken.
57.
In using the product-based approach, jurisdictions should apply a purposive
definition of products, under which the meaning of the product to which taxpayers track
and trace cannot be so large as to include all the IP income or expenditures of a taxpayer
engaged in a complex, IP-based business with multiple products and R&D projects or so

small as to require taxpayers to track and trace to a category that is entirely unrelated to
innovation or business practices. For a company that produces multiple components for
one type of product, which it then sells, for instance a truck, a product definition that
permitted tracking and tracing to that truck, and allowing the taxpayer to allocate all its
R&D expenditures and IP income to that one final product, would be too broad because
the R&D and related IP assets underlying the different value driving components would
not sufficiently overlap. For a company that for example produces hinges that are used in
hundreds of industries, however, a product definition that required the taxpayer to track
and trace to the specific type of hinge built for a specific type of truck would be too
narrow as it would require the taxpayer to track and trace to a level of detail that did not
relate to the actual innovation. In the first situation (whole truck), it would be more
appropriate for the taxpayer to track and trace to the components. In the second situation
(hinges), it would be more appropriate for the taxpayer to track to the groups of hinges
that shared the same IP rather than to the products in which they are used. This also
means that it would not be appropriate to require tracking by individual products if they
had only minor variations but contained the same IP (e.g. medicines that are produced in
different colours, dosages, or sizes). The definition of products can therefore include
product families such as components for printer or computer producers, active
compounds for the chemical industry, and therapeutic areas or narrower disease
categories for the pharmaceutical industry.20 In applying the product-based approach,
jurisdictions should prevent taxpayers from tracking to a grouping that is so broad that it
would include all the expenditures and income of an entity, but taxpayers may track to
products (including product families) when these groupings include all the IP assets that
arose from overlapping expenditures and contributed to overlapping streams of income.
58.
A taxpayer that uses the product-based approach must provide documentation that
the taxpayer was engaged in a sufficiently complex IP-related business that tracking to
individual IP assets would be unrealistic and based on arbitrary judgements. To prevent
manipulation, a taxpayer that tracks and traces to products (including product families)
should be able to justify to a tax authority the appropriateness of this approach with
reference to objective and verifiable information, for example the commonality of
scientific, technological, or engineering challenges underlying the R&D expenditures and
income, demonstrate its consistency with the organisation of R&D activities within the
group and also apply the approach consistently over time.
59.
Examples of tracking and tracing to IP assets or products arising from those IP
assets are provided below. All examples assume that the taxpayers are resident in
jurisdictions with IP regimes that are consistent with the nexus approach.
Example A: Company A produces plastic lids for travel mugs. Company A has
two patents, one of which applies to plastic lids for coffee mugs and one of which
applies to plastic lids for tea mugs. The R&D responsible for the two patents was
undertaken by different project teams of Company A employees. Company A is
therefore an example of a taxpayer that would need to track and trace to IP assets.
If it did not already do so, it would need to set up a tracking system that tracked
income of coffee mugs and tea mugs separately.
Example B: Company B produces hundreds of different types of printers, which

are divided and managed along three different product families: large
printer/copier combinations for office use, small personal printers for home use,
and photo printers for professional-quality digital photos. Each product family
contains several distinct product types. Company B engages in R&D to develop
the printers, and this R&D contributes to 250 patents. 100 patents are relevant to
all three product families, 50 are relevant only to the larger printer/copier
combinations, 50 are relevant only to the small personal printers and 50 are
relevant only to the photo printers. Company Bs employees track their research
time according to which product family they are working on or whether they are
engaged in general or speculative R&D. Company B is therefore an example of a
taxpayer that would need to track and trace to product families. If it did not
already do so, it would need to set up a tracking system that tracked income of the
three product families separately. The expenditures incurred to develop the 100
general patents would be divided across the product families, and the expenditures
that are only relevant to individual product families would be allocated only to
those product families. It would not be appropriate to track and trace to either IP
assets or product types because Company Bs R&D is shared across product
families, so tracking and tracing to individual products could over-allocate
expenditures to one individual printer or under-allocate expenditures to another
individual printer.
Example C: Company C is a pharmaceutical company which has thousands of

patents and which produces hundreds of pharmaceutical products. Each patent
contributes to multiple products, and each product uses multiple patents.
Company C manages and tracks its R&D, including its employees time, along
the four different diseases that its products treat. The R&D undertaken for one
disease generally does not overlap with the R&D undertaken for another disease,
and the diseases are dissimilar enough that products for one disease are not used
to treat another disease. Company Cs expenditures cannot be tracked to
individual products (since R&D expenditures would have to be divided across
multiple products which could only be done on an arbitrary basis). Company Cs
income cannot be tracked to individual patents (because income for one product
would have to be divided across multiple patents, requiring arbitrary allocations).
Company C would therefore need to track and trace to the diseases that Company
Cs products are designed to treat. If it does not already do so, it would need to set
up a tracking system that tracked IP income from products that treat the four
diseases separately.
60.
The nexus approach was designed to apply a cumulative ratio of qualifying
expenditures and overall expenditures, but, as a transitional measure, jurisdictions could
allow taxpayers to apply a ratio where qualifying expenditures and overall expenditures
were calculated based on a three- or five-year rolling average. Taxpayers would then need
to transition from using the three- to five-year average to using a cumulative ratio. An
example of how this transition could take place is included in Annex A. Jurisdictions that
choose to implement a transitional measure must include anti-avoidance measures to
prevent taxpayers from manipulating such a measure. These measures should ensure
(i) that taxpayers that previously benefited from a grandfathered regime could not use a
transitional measure in a new regime and (ii) that acquisition costs and outsourcing
expenditures paid to related parties were included in both the transitional ratio and the
cumulative ratio.
61.
The nexus approach mandates that jurisdictions include several documentation
requirements. Jurisdictions may draft their own specific guidance on these documentation
requirements, but they must require at least the following forms of documentation from
any taxpayer benefiting from the IP regime:
I.
If the taxpayer is not tracking directly to the IP asset but is instead tracking to
products, the taxpayer must provide documentation showing the complexity of its
IP business model and providing justification for using the product-based
approach.
The taxpayer must show that it had a qualifying IP asset (either because the
income and expenditures are being tracked to that IP asset or because the product
was produced using that IP asset).
In calculating net IP income, taxpayers must reduce the amount of IP income by

any deductions or other tax reductions that arose from the same IP asset (or
product). Taxpayers must therefore provide documentation of all relevant
deductions and other tax reductions and show why such benefits, if any, were not
used to reduce the amount of IP income benefiting from an IP regime.
Taxpayers that incur expenditures for general or speculative R&D must either
show a link between such expenditures and the IP asset or product or provide an
explanation for how such expenditures were divided pro rata across IP assets or
products.
The taxpayer must show that both qualifying expenditures and overall
expenditures were tracked according to the same IP asset or product as the income
and it must provide documentation on this tracking to show that the expenditures
and income were linked.
If the taxpayer acquired an IP asset from a related party, the taxpayer must
prepare documentation substantiating the arms length price. This should include
documentation on the overall expenditures that the related party transferor
incurred.
Grandfathering and safeguards
62.
Consistent with the work so far in the area of harmful tax practices, the FHTP
agreed in the 2014 Progress Report to draft further guidance on grandfathering, building
in particular on paragraph 12 of the 2004 Report (OECD, 2004a), where it says the
Committee decided that where a regime is in the process of being eliminated it shall be
treated as abolished if (1) no new entrants are permitted into the regime, (2) a definite
date for complete abolition of the regime has been announced, and (3) the regime is
transparent and has effective exchange of information. Jurisdictions have agreed to
refrain from adopting new measures that would be inconsistent with the nexus approach
or extending the scope of or strengthening existing measures that are inconsistent with the
nexus approach.
63.
No new entrants will be permitted in any existing IP regime not consistent with
the nexus approach after 30 June 2016. If a new regime consistent with the nexus
approach takes effect before 30 June 2016, no new entrants will be permitted in the
existing IP regime after the new IP regime has taken effect. The FHTP recognised that
countries will need time for any legislative process, but it agreed that any legislative
process necessary to bring a regime into line with the nexus approach must commence in
2015.
64.
For the purposes of grandfathering, new entrants include both new taxpayers
not previously benefiting from the regime and new IP assets owned by taxpayers already
benefiting from the regime. It is understood that taxpayers that may benefit from
grandfathered regimes are only those that fully meet all substantive requirements of the
regime and have been officially approved by the tax administration, if required at that
point in time. They therefore do not include taxpayers that have only applied for the
regime. Taxpayers that have been approved by the tax administration but the IP assets of
which have not yet received official approval may, however, benefit from grandfathering
if they have applied for IP protection in the jurisdiction of the IP regime but have not yet
received official approval because of the length of time of the jurisdictions approval
process.
65.
Jurisdictions are also permitted to introduce grandfathering rules that will allow
all taxpayers benefiting from an existing regime to keep such entitlement until a second
specific date (abolition date). The period between the two dates should not exceed 5
years (so the latest possible abolition date would be 30 June 2021). After that date, no
more benefits stemming from the respective old regimes may be given to taxpayers.
66.
In order to mitigate the risk that new entrants will seek to avail themselves of
existing regimes with a view to benefiting from grandfathering, jurisdictions should
implement the following safeguards:
J.
Enhanced transparency for new entrants entering the regime after 6 February
2015 by requiring spontaneous exchange of information on the identity of new
entrants benefiting from a grandfathered regime, regardless of whether a ruling is
provided, no later than the earlier of (i) three months after the date on which the
information becomes available to the competent authority of the jurisdiction
providing benefits under the IP regime (and jurisdictions should put in place
appropriate systems to ensure that this information is transmitted to the competent
authority without undue delay), or (ii) one year after the tax return was filed with
the jurisdiction providing benefits under the IP regime.
Measures that would allow IP assets to benefit from grandfathered regimes not
consistent with the nexus approach after 31 December 2016 unless they are
acquired directly or indirectly from related parties after 1 January 2016 and they
do not qualify for benefits at the time of such acquisition under an existing backend IP regime. Such measures prevent taxpayers that would not otherwise
benefit from a grandfathered regime from using related-party acquisitions to shift
IP assets into existing regimes in order to take advantage of the grandfathering
provision. At the same time, they also permit taxpayers that acquire IP assets from
related parties to benefit from grandfathering if this acquisition takes place as part
of a domestic or international business restructuring intended to transfer IP assets
to regimes that are being modified to comply with the nexus approach.
Rebuttable presumption
67.
Jurisdictions could treat the nexus ratio as a rebuttable presumption.21 In the
absence of other information from a taxpayer, a jurisdiction would determine the income
receiving tax benefits based on the nexus ratio. Taxpayers would, however, have the
ability to prove that more income should be permitted to benefit from the IP regime in
exceptional circumstances where taxpayers that have undertaken substantial qualifying
R&D activity in developing a qualifying IP asset or product can establish that the
application of the nexus fraction leads to an outcome where the level of income eligible
for a preferential IP regime is not commensurate with the level of their R&D activity.
Exceptional circumstances could include, for instance, a complete or partial write down
of acquired IP in the taxpayers financial statements or other instances of an exceptional

nature where a taxpayer can demonstrate that it engaged in greater value creating activity
than is reflected in the nexus calculation. If a jurisdiction chooses to treat the nexus ratio
as a rebuttable presumption, any adjustments to the nexus ratio must result in outcomes
that are commensurate with the level of the taxpayers R&D activity, consistent with the
fundamental principle of the nexus approach. A determination of the application of the
rebuttable presumption should be reviewed on an annual basis to determine the continued
presence of the exceptional circumstances. Such a review can take the form of a ruling
with annual reviews or it can be achieved by other means. In any event, a tax
administration must hold contemporaneous documentation showing that the taxpayer has
met the requirements set out below in paragraph 68 and any other requirements that may
be required under domestic law.
68.
A jurisdiction that chooses to treat the nexus ratio as a rebuttable presumption
would need to limit the situations where the ratio could be rebutted to those that meet, at a
minimum, the following requirements:
The taxpayer first uses the nexus ratio to establish the presumed amount of
income that could qualify for tax benefits.
The nexus ratio set out above (excluding the up-lift) equals or exceeds 25%.
The taxpayer demonstrates that because of exceptional circumstances the

application of the nexus ratio would result in an outcome that was inconsistent
with the principle of the nexus approach. The taxpayer specifies and provides
evidence as to the exceptional circumstances.
69.
Within these limitations, the design of the rebuttable presumption would be
determined by jurisdictions that choose to implement it, but this version of the nexus
approach will require greater record-keeping on the part of taxpayers, and jurisdictions
would need to establish monitoring procedures and notify the FHTP of the circumstances
in which they would allow the nexus ratio to be treated as a rebuttable presumption.
Jurisdictions would further need to report on the legal and administrative framework for
permitting taxpayers to rebut the nexus ratio, and, on an annual basis, the overall number
of companies benefiting from the IP regime, the number of cases in which the rebuttable
presumption is used, the number of such cases in which the jurisdiction spontaneously
exchanged information, the aggregated value of income receiving benefits under the IP
regime (differentiated between income benefiting from the nexus ratio and income
benefiting from the rebuttable presumption), and a list of the exceptional circumstances,
described in generic terms and without disclosing the identity of the taxpayer, that
permitted taxpayers to rebut the nexus ratio in each case. This would permit the FHTP to
monitor whether jurisdictions were only permitting taxpayers to rebut the nexus ratio in
exceptional circumstances. Regardless of whether taxpayers rebut the nexus ratio in the
context of a ruling, jurisdictions would also need to spontaneously exchange, on the basis
of information exchange instruments, the contemporaneous documentation it has received
from the taxpayer in order to fulfil the requirements for rebutting the nexus ratio set out
above. In the context of rulings, jurisdictions would use the framework set out in Chapter
5. Outside the context of rulings, the framework of Chapter 5 would be used to determine
the jurisdictions with which to spontaneously exchange such information. A jurisdiction
may either exchange the contemporaneous documentation received or may use the
template in Annex C and include the information to be exchanged in summary box 7.22
III.
Substantial activity requirement in the context of non-IP regimes

70.
Action 5 requires substantial activity not only for IP regimes but for all
preferential regimes. The FHTP has therefore considered the application of the substantial
activity requirement to other preferential regimes that have been identified and reviewed
by the FHTP since the 1998 Report. A more detailed consideration of how this
requirement would apply to specific regimes would need to take place in the context of
the specific category of regime being considered. The discussion below sets out the
principle that will apply in the context of non-IP regimes.23
71.
Because IP regimes are designed to encourage R&D activities and contribute to
growth and employment, the principle underlying the substantial activity requirement in
the context of IP regimes is only to permit taxpayers that did in fact engage in such
activities and did incur actual expenditures on such activities to benefit from the regimes.
In the context of other preferential regimes, the same principle can also be applied so that
such regimes would only be found to meet the substantial activity requirement if they also
granted benefits only to qualifying taxpayers24 to the extent those taxpayers undertook the
core income generating activities required to produce the type of business income covered by
the preferential regime.
72.
When applied to IP regimes, the substantial activity requirement establishes a link
between expenditures, IP assets, and IP income. Expenditures are a proxy for activities,
and IP assets are used to ensure that the income that receives benefits does in fact arise
from the expenditures incurred by the qualifying taxpayer. The effect of this approach is
therefore to link income and activities. When applied to other regimes, the substantial
activity requirement should also establish a link between the income qualifying for
benefits and the core activities necessary to earn the income. As set forth in the 1998
Report, the core activities at issue in non-IP regimes are geographically mobile activities
such as financial and other service activities.25 These activities may not require anything
to link them to income because service activities could be seen as contributing directly to
the income that receives benefits.
73.
The determination of what constitutes the core activities necessary to earn the
income depends on the type of regime. Even where regimes are aimed at a similar type of
income there can be a wide variation in the application of different countries regimes, so
a more detailed consideration of the relevant core activities would need to be undertaken
at the time and in the context of a specific regime being considered. However, a brief
description of the type of activities that might be required for the different types of
preferential regime is set out below.
A.
Headquarters regimes
74.
Headquarters regimes grant preferential tax treatment to taxpayers that provide
certain services such as managing, co-ordinating or controlling business activities for a
group as a whole or for group members in a specific geographical area. These regimes
may raise concerns about ring-fencing or because they provide for an artificial definition
of the tax base where the profits of an entity are determined based on a cost-plus basis
but certain costs are excluded from the basis or particular circumstances are not taken into
account. These features could be addressed by the existing factors, but these regimes
could also raise concerns in respect of substance.
75.
The core income-generating activities in a headquarters company could include
the key activities giving rise to the particular type of services income received by the

company. For example, they could include taking relevant management decisions,
incurring expenditures on behalf of group entities, and co-ordinating group activities.
B.
Distribution and service centre regimes
76.
Distribution centre regimes provide preferential tax treatment to entities whose
main or only activity is to purchase raw materials and finished products from other group
members and re-sell them for a small percentage of profits. Service centre regimes
provide preferential tax treatment to entities whose main or only activity is to provide
services to other entities of the same group. A concern with such regimes is that they may
have ring-fencing features. In addition, they may raise concerns that they permit an
artificial definition of the tax base. Although these concerns may be addressed through
the existing factors, concerns with respect to substance could remain.
77.
The core income-generating activities in a distribution or service centre company
could include activities such as transporting and storing goods; managing the stocks and
taking orders; and providing consulting or other administrative services.
C.
Financing or leasing regimes
78.
Financing and leasing regimes are regimes which provide a preferential tax
treatment to financing and leasing activities. The main concerns underlying these regimes
include, among others, ring-fencing considerations and an artificial definition of the tax
base. Again, those concerns could be addressed through the existing factors.
79.
The core income-generating activities in a financing or leasing company could
include agreeing funding terms; identifying and acquiring assets to be leased (in the case
of leasing); setting the terms and duration of any financing or leasing; monitoring and
revising any agreements; and managing any risks.
D.
Fund management regimes
80.
Fund management regimes grant preferential tax treatment to income earned by
fund managers26 for the management of funds. In exchange for its services, the fund
manager receives compensation that is computed on the basis of a pre-agreed formula.
The focus is not the taxation of the income or gains of the fund itself or of the investors in
a fund but the income earned by fund managers from the management of the fund.27 The
remuneration of the fund manager and how and where this is taxed may raise issues of
transparency and these could in part be dealt with by the compulsory spontaneous
exchange of rulings.
81.
In terms of substantial activity the core income-generating activities for a fund
manager could include taking decisions on the holding and selling of investments;
calculating risks and reserves; taking decisions on currency or interest fluctuations and
hedging positions; and preparing relevant regulatory or other reports for government
authorities and investors.
E.
Banking and insurance regimes
82.
Banking and insurance regimes provide preferential tax treatment to banking and
insurance activities. The main concern is linked to the benefits that they provide to
income from foreign activities. If benefits are only provided to foreign income, then this
could be addressed through the existing ring-fencing factor. In terms of substance, the
regulatory environment, where applicable, should already ensure that a business is
capable of bearing risk and undertaking its activity. However, in the context of insurance,
it may be more difficult to easily identify those activities and regimes that raise concerns
in respect of substance versus those that do not because of the possibility that risks may
have been re-insured.
83.
The core income-generating activities for banking companies depend on the type
of banking activity undertaken, but they could include raising funds; managing risk
including credit, currency and interest risk; taking hedging positions; providing loans,
credit or other financial services to customers; managing regulatory capital; and preparing
regulatory reports and returns. The core income-generating activities for insurance
companies could include predicting and calculating risk, insuring or re-insuring against
risk, and providing client services.
F.
Shipping regimes
84.
Shipping regimes provide a preferential tax treatment to shipping activities and
are designed taking into considerations significant non-tax considerations. In addition to
issues of ring-fencing and transparency already discussed in the CAN (OECD, 2004b),
they may also raise concerns under the substantial activity analysis where they permit the
separation of shipping income from the core activities that generate it.
85.
The core income-generating activities for shipping companies could include
managing the crew (including hiring, paying, and overseeing crewmembers); hauling and
maintaining ships; overseeing and tracking deliveries; determining what goods to order
and when to deliver them; and organising and overseeing voyages.
G.
Holding company regimes
86.
Holding company regimes can be broadly divided into two categories: (i) those
that provide benefits to companies that hold a variety of assets and earn different types of
income (e.g. interest, rents, and royalties) and (ii) those that apply only to companies that
hold equity participations and earn only dividends and capital gains. In the context of
(i) above, to the extent that holding company regimes provide benefits to companies that
earn income other than dividends and capital gains, the substantial activity requirement
should require qualifying taxpayers to have engaged in the core activities associated with
those types of income.
87.
Holding companies that fall within category (ii) above and that provide benefits
only to dividends and capital gains, however, raise different policy considerations than
other preferential regimes in that they primarily focus on alleviating economic double
taxation. They therefore may not in fact require much substance in order to exercise their
main activity of holding and managing equity participations. These regimes could,
however, raise policy concerns that are not directly related to substance. Countries
concerns about holding company regimes are often related to transparency and their
inability to identify the beneficial owner of the dividends. Related concerns include
whether holding companies enable the payer and payee to benefit from treaty benefits in
circumstances that would not otherwise qualify for benefits and whether holding
company regimes are ring-fenced. Some of these concerns may already be addressed in
other work or under other existing factors. For instance:
Exchange of Information: The international standard on information exchange

upon request covers not only the exchange of information but also the availability
of information, including ownership, banking, and account information. The work

on monitoring this standard is carried out by the Global Forum on Transparency
and Exchange of Information on Tax Purposes. Under its revised terms of
reference, the Global Forum has incorporated the principles of the Financial
Action Task Force (FATF) standard of beneficial ownership and as a result
countries will be assessed on their ability to provide information on beneficial
ownership where relevant and where this forms part of a request for exchange of
information.
Action 6 to prevent treaty abuse: The result of this Action takes the form of new
model treaty provisions and recommendations regarding the design of domestic
rules to prevent the granting of treaty benefits in inappropriate circumstances. The
work done under this Action should address concerns about the use of holding
companies to receive treaty benefits.
Action 2 to neutralise the effects of hybrid mismatch arrangements: The result of

this Action takes the form of new model treaty provisions and recommendations
regarding the design of domestic rules to neutralise the effect of hybrid
instruments and entities. The work done under this Action has led to a
recommendation to deny a dividend exemption and other types of relief granted to
relieve economic double taxation on deductible payments. This could again
address some of the concern that dividend income can go untaxed.
Ring-fencing: If countries are concerned that equity holding companies are

providing benefits to income only from foreign companies and that this income is
not already taxed anywhere or the regime is otherwise targeting foreign investors,
this concern is already addressed under the existing ring-fencing factor.28
Other work: Such as the work done under Action 3 of the BEPS Action Plan to
strengthen controlled foreign company (CFC) rules.
88.
Once these other policy considerations have been addressed, there should be less
of a concern that these regimes are used for BEPS. Therefore, to the extent that holding
company regimes provide benefits only to equity holding companies, the substantial
activity factor requires, at a minimum, that the companies receiving benefits from such
regimes respect all applicable corporate law filing requirements and have the substance
necessary to engage in holding and managing equity participations (for example, by
showing that they have both the people and the premises necessary for these activities).
This precludes the possibility of letter box and brass plate companies from benefiting
from holding company regimes.
Notes
1.
See p. 17 of the BEPS Action Plan. See also Chapter 1 above.
2.
For details on the agreement, see Action 5: Agreement on Modified Nexus Approach
for IP Regimes (OECD, 2015).
3.
For example, Company A, Company B, and Company C together develop IP Asset D

in Year 1. Company A is in a jurisdiction with an IP regime. Company A contributes
30% of the R&D and 3 000 of the R&D funding, Company B contributes 30% of the
R&D and 3 000 of the R&D funding, and Company C contributes 40% of the R&D
and 4 000 of the R&D funding. IP Asset D produces 100 000 of IP income in Year 2,
and 30 000 of this IP income is allocated to Company A. If Company A did not pay to
outsource to a related company or to acquire any IP assets, then the nexus ratio that
would apply to that 30 000 before the up-lift is 3 000/3 000 (or 100%). The entire
30 000 would therefore qualify for the IP regime in Company As jurisdiction.
4.
Jurisdictions with IP regimes should ensure that the same IP asset is not allocated to
both the head office and the foreign PE (e.g. because they apply the authorised OECD
approach (AOA)).
5.
For this purpose, legal protection includes exclusive rights to use the IP asset, legal
remedies against infringement, trade secret law, and contractual and criminal
protections against use of the IP asset or unauthorised disclosure of information
related to the IP asset.
6.
Although some jurisdictions provide patent protection for software, not all
jurisdictions do so. Many taxpayers that produce software must therefore copyright it
instead of relying on patent protection. Including copyrighted software in the
definition of functionally equivalent IP assets also ensures that the different treatment
of software under the patent laws of different jurisdictions does not affect whether or
not income from software could benefit from IP regimes.
7.
The determination of whether a taxpayer meets these two requirements should be

made on an annual basis, using a five-year average that changes every year. The
reference to EUR 50 million in global group-wide turnover does not mean that these
requirements only apply to groups. Stand-alone entities that want to qualify for
benefits using the third category of IP assets must also meet these two requirements.
8.
The information on the use of the third category of IP assets would then be included
in the summary box 7 of the template set out in Annex C.
9.
IP regimes that must be assessed under the nexus approach include regimes that grant
benefits to any IP assets. Regimes that grant benefits to IP assets that are not
qualifying IP assets for purposes of the nexus approach would be found not to meet
the substantial activity requirement.
10.
Qualifying expenditures could therefore include salary and wages, direct costs,
overhead costs directly associated with R&D facilities, and cost of supplies so long as
all of these costs arise out of activities undertaken to advance the understanding of
scientific relations or technologies, address known scientific or technological

obstacles, or otherwise increase knowledge or develop new applications.
11.
Building costs or other non-separable capital costs would not be included because it
would be impossible to establish a direct link between the cost of an entire building
and different IP assets created in that building.
12.
See Sections II.F and II.G of this Chapter for an explanation of why expenditures for
related-party outsourcing and acquisition costs are included in overall expenditures
and not in qualifying expenditures.
13.
See Section II.E of this Chapter below.
14.
IP expenditures will be calculated by applying the ordinary domestic tax law

provisions (i.e. not using specific provisions in IP regimes). Jurisdictions may limit
expenditures allocable to IP income to ensure that the use of such expenditures is
consistent with domestic legislation. Jurisdictions should also use any tax losses
associated with the IP income in a manner that is consistent with domestic legislation
and that does not allow the diversion of those losses against income that is taxed at
the ordinary rate.
15.
Such a method would need to be based on transfer pricing principles as updated

through the report on Actions 8-10 of the BEPS Action Plan.
16.
Jurisdictions that are not Member States of the European Union (EU) could modify
this limitation to include all qualifying expenditures for activities undertaken by both
unrelated parties and resident related parties in the definition of qualifying
expenditures.
17.
Outsourcing is different from the buying in of components from a party that owns the
IP to those components, and this reference to the likelihood of outsourcing to
unrelated parties does not refer to the likelihood of buying components from unrelated
parties.
18.
Jurisdictions with IP regimes need to ensure that taxpayers are not able to circumvent
this treatment of acquisition costs by acquiring entities that own IP assets.
19.
Jurisdictions that are not Member States of the EU could modify this limitation so that
the acquisition of a taxpayer that incurred qualifying expenditures in the jurisdiction
providing the IP regime allowed those expenditures to be included in the qualifying
expenditures of the acquirer (while either including the acquisition costs in overall
expenditures or including all the overall expenditures of the transferor in the overall
expenditures of the acquirer if the transferor has engaged in complete tracking and
tracing to ensure that all overall expenditures are included).
20.
Therapeutic or therapy areas include classes of diseases, such as cardiology,

oncology, or respiratory diseases. Narrower disease categories would be subsets of
therapeutic areas, such as breast cancer and lung cancer instead of the broader
therapeutic area of oncology.
In certain industries that produce services or other outputs other than products,
product families could include functional equivalents as long as these groupings
include only those IP assets that arose from overlapping expenditures and contributed
to overlapping streams of income.
21.
Taxpayers in jurisdictions that treat the nexus ratio as a rebuttable presumption would
have to choose between the up-lift and the rebuttable presumption. In other words,
taxpayers could not both rebut the nexus ratio and benefit from the 30% up-lift.
Taxpayers must choose between the up-lift and rebutting the nexus ratio on the basis
of IP asset, product, or product family, and taxpayers may not choose based on a
narrower grouping than that used for tracking and tracing.
22.
Any further information could be requested on the basis of applicable information

exchange instruments.
23.
These regimes include (i) holding company regimes, (ii) headquarters regimes,
(iii) distribution centre regimes, (iv) service centre regimes, (v) financing and leasing
regimes, (vi) fund management regimes, (vii) banking regimes, (viii) insurance
regimes and (ix) shipping company regimes.
24.
Qualifying taxpayers would have the same definition as that set out in the context
of IP regimes. See paragraph 33 above. This definition includes resident companies,
domestic PEs of foreign companies, and foreign PEs of resident companies that are
subject to tax in the jurisdiction providing benefits.
25.
26.
A fund manager is a legal or natural person that provides management services,

including making decisions on investments, to an investment fund or its investors.
27.
See paragraph 261 of the CAN, p. 73. The work of the FHTP is focused on fund
management and not the taxation of the fund itself.
28.
According to paragraph 65 of the CAN, p. 21, the ring-fencing factor is not

implicated in connection with measures designed to eliminate or mitigate double
taxation but it must have some features to ensure that it only applies where double
taxation may arise. In the context of holding company regimes paragraph 244 of the
CAN, pp. 68-69, adds that:
the holding company regime must, therefore, provide for the operation of
effective measures to achieve this objective. Such measures may include, for
instance, subject to tax clauses, controlled foreign company legislation (or
similar rules that apply at the time of distribution of dividends or disposition of
shares), the use of exemptions methods in the context of income tax
conventions following the OECD Model Convention with Respect to Taxes on
Income and on Capital (hereafter the OECD Model Tax Convention), or the
use of anti-abuse measures. (OECD, 2004b)
44 5. REVAMP OF THE WORK ON HARMFUL TAX PRACTICES: FRAMEWORK FOR IMPROVING TRANSPARENCY IN RELATION TO RULINGS
Bibliography
OECD (2015), Action 5: Agreement on Modified Nexus Approach for IP Regimes,
OECD, www.oecd.org/ctp/beps-action-5-agreement-on-modified-nexus-approach-forip-regimes.pdf.
Transparency and Substance, OECD Publishing, Paris, http://dx.doi.org/10.1787/
9789264218970-en.
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2004a), Harmful Tax Practices: The 2004 Progress Report, OECD,
www.oecd.org/ctp/harmful/30901115.pdf.
OECD (2004b), Consolidated Application Note: Guidance in Applying the 1998 Report
to Preferential Tax Regimes, OECD, www.oecd.org/ctp/harmful/30901132.pdf.
5. REVAMP OF THE WORK ON HARMFUL TAX PRACTICES: FRAMEWORK FOR IMPROVING TRANSPARENCY IN RELATION TO RULINGS 45
Chapter 5
Revamp of the work on harmful tax practices:
Framework for improving transparency in relation to rulings
I.
Introduction
89.
The second priority under Action 5 for revamping the work on harmful tax
practices is to improve transparency, including the compulsory spontaneous exchange of
information on certain rulings. This work contributes to the third pillar of the BEPS
Project which has the objective of ensuring transparency while promoting increased
certainty and predictability.
90.
The FHTP decided to take forward the work on improving transparency in three
steps:
a) The first step focused on developing a framework for compulsory spontaneous
information exchange in respect of rulings related to preferential regimes. This
framework was set out in the FHTPs 2014 Progress Report (OECD, 2014a) and
has been modified, and it is now superseded by the guidance in this report. The
2014 Progress Report made it clear that the framework would be dynamic and
flexible and that further work would be undertaken.
b) In the second step of the work, the FHTP has considered whether transparency
can be further improved and has considered the ruling regimes in OECD and
associate countries. This work, which included a questionnaire completed by
OECD and associate countries on existing ruling practices, has informed further
developments of the framework on the compulsory spontaneous exchange of
information. It has led to the conclusion that the requirement to undertake
compulsory spontaneous information exchange should generally cover all
instances in which the absence of exchange of a ruling may give rise to BEPS
concerns. This approach builds on the fact that Action 5 is not limited to
exchanging information on rulings related to preferential regimes but allows for
broader transparency. In this context, the FHTP focuses on specific instances
where the absence of exchanges can cause BEPS concerns rather than suggesting
that in all such instances the country providing the ruling operates a preferential
regime. This also reflects the fact that a meaningful transparency discipline may
have to go wider than the related substantive discipline. For instance, there is no
suggestion that a unilateral advance pricing arrangements (APAs) program is by
itself a preferential regime. However, a preferential regime, especially one of an
administrative nature, may be operated, in whole or in part, via an APA or
advance tax ruling (ATR) regime. In such cases, it is only once information on the
ruling is exchanged that a fully informed decision can be made. Rather than
engaging in a line drawing exercise that would have been very challenging in
practice and would have put the issuing tax administration in the difficult position
of having to determine the nature of its own regime, the FHTP opted for
simplicity and clarity. In so doing, the FHTP also noted that under Action 13 on
transfer pricing documentation APAs and ATRs are to be included in the local
and the master file and felt that the spontaneous exchange of key information on
such APAs and ATRs between tax administrations would provide a useful crosscheck with the information provided by the taxpayer.
c) In a third step, the FHTP developed a general best practices framework for the
design and operation of ruling regimes.
91.
Combining the first and the second steps described above, this Chapter sets out
the agreed OECD framework for the compulsory spontaneous exchange of information in
respect of rulings. This includes six categories of taxpayer-specific rulings which in the
absence of compulsory spontaneous exchange of information could give rise to BEPS
concerns. These six categories are (i) rulings relating to preferential regimes;
(ii) unilateral APAs or other cross-border unilateral rulings in respect of transfer pricing;
(iii) cross-border rulings providing for a downward adjustment of taxable profits;
(iv) permanent establishment (PE) rulings; (v) related party conduit rulings; and (vi) any
other type of ruling agreed by the FHTP that in the absence of spontaneous information
exchange gives rise to BEPS concerns. This does not mean that such rulings or the legal
or administrative procedures under which they are given represent preferential regimes.
Instead it reflects countries concerns that a lack of transparency can lead to BEPS, if
countries have no knowledge or information on the tax treatment of a taxpayer in a
specific country and that tax treatment affects the transactions or arrangements
undertaken with a related taxpayer resident in their country. The availability of timely and
targeted information, contained in a template discussed below in Section V of this
Chapter and Annex C, is essential to enable tax administrations to quickly identify risk
areas.
92.
The framework was designed with a view to finding a balance between ensuring
that the information exchanged is relevant to other tax administrations and that it does not
impose an unnecessary administrative burden on either the country exchanging the
information or the country receiving it. The framework builds on the guidance contained
in the CAN (OECD, 2004) and also takes into account the Convention on Mutual
Administrative Assistance in Tax Matters (MAC, OECD, 2010a)1 and the European
Unions Council Directive 2011/16/EU of 15 February 2011 on administrative
cooperation in the field of taxation (including its work on spontaneous information
exchange in the context of transfer pricing and cross-border rulings). These sources all
have a common goal in that they seek to encourage spontaneous information exchange in
circumstances where it is assumed that information obtained by one country will be of
interest to another country.
93.
Whilst it is recognised that rulings are a useful tool for both tax administrations
and taxpayers, providing for certainty and predictability and thus avoiding tax disputes
from even arising, concerns over transparency are not new and ruling regimes have been
an area of focus since the start of the OECDs work on harmful tax practices. There is
extensive guidance in the CAN on transparency. As the 1998 Report (OECD, 1998) and
the CAN make clear, transparency is often relevant in connection with rulings, including
unilateral APAs and administrative practices more widely, where spontaneous
notification may be required. Ruling regimes can also be used to attract internationally
mobile capital to a jurisdiction and they have the potential to do this in a manner that
contributes to, or constitutes, a harmful tax practice.
94.
This Chapter deals with the following: (i) which rulings are covered; (ii) which
countries information needs to be exchanged with; (iii) application of the framework to
past and future rulings; (iv) information subject to the exchange; (v) practical
implementation issues; (vi) reciprocal approach to exchange of information;
(vii) confidentiality of the information exchanged; and (viii) recommendations on best
practices in respect of rulings.
II.
Rulings covered by the spontaneous exchange framework

A.
Definition of a ruling
95.
Rulings are any advice, information or undertaking provided by a tax authority
to a specific taxpayer or group of taxpayers concerning their tax situation and on which
they are entitled to rely.2
96.
Whilst the terms of a ruling may be relied upon by the taxpayer, this is typically
subject to the condition that the facts on which the ruling is based have been accurately
presented and that the taxpayer abides by the terms of the ruling. This definition is wide
and includes both general rulings and taxpayer-specific rulings. However, the framework
for compulsory spontaneous exchange of information only applies to taxpayer-specific
rulings.
97.
Taxpayer-specific rulings are rulings that apply to a specific taxpayer and on
which that taxpayer is entitled to rely. Such rulings can be given both pre-transaction (this
includes ATRs or clearances and APAs) and post-transaction, in each case in response to
a ruling request by the taxpayer. The definition of rulings therefore excludes, for
example, any statement or agreement reached as a result of an audit carried out after a
taxpayer has filed its tax return or accounts. This does not however, exclude any ruling or
agreement, on the treatment of future profits, given as a result of an audit if that ruling
falls within any of the categories set out in this report.
98.
Advance tax rulings are specific to an individual taxpayer and provide a
determination of the tax consequences of a proposed transaction on which the particular
taxpayer is entitled to rely. Advance tax rulings may come in a variety of forms and may
include rulings or clearances that are given as part of a statutory process or an
administrative practice, including rulings that are given informally. They frequently
determine whether, and in some cases how, particular law and administrative practice will
be applicable to a proposed transaction undertaken by a specific taxpayer. Such rulings
may also provide a determination of whether or how a general ruling applies to the facts
and circumstances of a particular taxpayer. Typically, the taxpayer concerned will make
an application for a ruling before undertaking the transaction concerned, although some
regimes provide guidance to taxpayers after a transaction has been carried out and these
post-transaction rulings will also be covered. The ruling will provide a determination of
the tax consequences of the relevant transaction on which the taxpayer is entitled to rely,
assuming that the facts are as described in the advance tax ruling request. Such rulings are
tailor-made for the taxpayer concerned as they take into account the factual situation of
the taxpayer and are thus not directly applicable to other taxpayers (although, when
published in anonymised or redacted form, such rulings may provide guidance to
taxpayers with similar facts and circumstances3). This category of rulings could include,
for example, rulings on transfer pricing matters that fall short of an advance pricing
arrangement. It may also include a view or determination of the future tax treatment of
the taxpayer on which they are entitled to rely.
99.
Advance pricing arrangements are defined in the OECD Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations (TP Guidelines,
OECD, 2010b) as an arrangement that determines, in advance of controlled transactions,
an appropriate set of criteria for the determination of the transfer pricing for those
transactions over a fixed period of time.4 They provide taxpayers with certainty about
how transfer pricing rules apply to future transactions within the scope of the APA. They
normally do this by determining an appropriate set of criteria (e.g. method, comparables
and appropriate adjustments thereto and critical assumptions as to future events) for the
determination of the transfer pricing.5
100. The TP Guidelines distinguish APAs from other rulings procedures, such as
advance tax rulings, in the following way:
The APA differs from the classic ruling procedure, in that it requires the detailed
review and to the extent appropriate, verification of the factual assumptions on
which the determination of legal consequences is based, before any such
determinations can be made. Further the APA provides for a continual
monitoring of whether the factual assumptions remain valid throughout the
course of the APA period. (OECD, 2010b)6
101. APAs may be unilateral, bilateral or multilateral. Bilateral and multilateral APAs
are concluded between two or more tax authorities under the mutual agreement procedure
of the applicable tax treaties. Typically, the associated enterprises applying for an APA
provide documentation to the tax authorities concerning the industry, markets and
countries to be covered by the agreement, together with details of their proposed
methodology, any transactions that may serve as comparables, and a functional analysis
of the contribution of each of the relevant enterprises. Because APAs govern the
methodology for the determination of transfer prices for future years, they necessitate
assumptions or predictions about future events.
102. General rulings apply to groups or types of taxpayers or may be given in relation
to a defined set of circumstances or activities, rather than applying to a specific taxpayer.
They typically provide guidance on the position of the tax authority on such matters as
the interpretation of law and administrative practice7 and on their application to taxpayers
generally, to a specified group of taxpayers or to specified activities. This guidance
typically applies to all taxpayers that engage in activities or undertake transactions that
fall within the scope of the ruling. Such rulings are often published and can be applied by
taxpayers to their relevant activities or transactions without them needing to make an
application for a specific ruling. The framework does not apply to general rulings but the
best practices do apply.
B.
Taxpayer-specific rulings related to preferential regimes
103. The FHTP has already agreed to a framework, described in the FHTPs 2014
Progress Report in respect of the compulsory exchange of information on rulings related
to preferential regimes. A filter approach is used for such rulings so that there is an
obligation to spontaneously exchange information on cross-border taxpayer-specific
rulings related to regimes that (i) are within the scope of the work of FHTP; (ii) are
preferential; and (iii) meet the low or no effective tax rate factor.8 Where rulings are given
in respect of these regimes there will be an obligation to spontaneously exchange

information.
104. The obligation to spontaneously exchange information arises for rulings related to
any such preferential regime. That is, a regime does not need to have been reviewed or
found to be potentially or actually harmful within the meaning of the 1998 Report for the
obligation to arise. Therefore, the obligation will also apply to any ruling (as defined) in
connection with preferential regimes that have not yet been reviewed or that have been
reviewed but that have not been found to be potentially or actually harmful and that have
therefore been cleared.
105. Countries that have preferential regimes that have not yet been reviewed by the
FHTP will need to self-assess and take a view on whether the filters are satisfied. Where
this is the case, the obligation to spontaneously exchange information arises immediately,
without the FHTP first needing to formally review the relevant regime. In case of doubt
as to the applicability of the filters, it is recommended that the relevant country
spontaneously exchange information. The expectation is that a country that has a
preferential regime which has not yet been reviewed by the FHTP will in the meantime
self-refer this regime for review by the FHTP.
106. As the framework now includes six categories of rulings some of the procedures
that were described in the FHTPs 2014 Progress Report have been modified and
simplified and this report supersedes the 2014 Progress Report.
C.
Cross-border unilateral APAs and any other cross-border unilateral tax

rulings (such as ATRs) covering transfer pricing or the application of
transfer pricing principles
107. Unilateral APAs are APAs established between a tax administration of one
country and a taxpayer in its country.
108. Other cross-border unilateral tax rulings covering transfer pricing or the
application of transfer pricing principles cover, for example, ATRs on transfer pricing
issues that fall short of an APA, for instance, because the ruling is limited to addressing
questions of a legal nature based on facts presented by a taxpayer (unlike an APA which
generally deals with factual issues) or because the ruling is binding only for a particular
transaction (unlike an APA, which usually covers several transactions, several types of
transactions on a continuing basis, or all of a taxpayers international transactions for a
given period of time).
109. Unilateral APAs and other unilateral tax rulings are in the scope of covered
rulings, not because they are preferential but because, in the absence of transparency, they
can create distortions and may give rise to BEPS concerns and either directly or indirectly
impact on the tax position in another country. In some countries, unilateral APAs can
adjust profits both upwards and downwards from the starting position. In addition
unilateral APAs can set a future transfer pricing methodology or a future pricing or profit
apportionment structure. If the terms of such agreements are not available to the tax
administrations dealing with related taxpayers then there can be mismatches in how two
ends of a transaction are priced and taxed with the result that profits go untaxed resulting
in base erosion or profit shifting concerns.
110. There is an interaction between the obligation to spontaneously exchange
information on this category of rulings and the transfer pricing documentation
requirements under Action 13. In particular, the master file will contain a list and brief
description of the MNE group's existing unilateral APAs and other tax rulings relating to
the allocation of income among countries. The local file will contain a copy of existing
unilateral and bilateral/multilateral APAs and other tax rulings to which the local
jurisdiction is not a party and which are related to the relevant material controlled
transactions.
111. However, the obligation to spontaneously exchange information on unilateral
APAs and other transfer pricing rulings could potentially cover a wider range of transfer
pricing rulings than those captured in the local file and the master file. For example, only
rulings related to relevant material controlled transactions will be contained in the local
file which creates a higher threshold than that required under Action 5. Also, certain
information in the local file may be subject to local materiality thresholds so certain
taxpayers may not be required to produce a local file.
112. Lastly, those two sets of obligations are mutually reinforcing, allowing tax
administrations to cross-check the information reported by taxpayers against the
information exchanged from another tax administration and vice versa. This dual
requirement may also give rise to additional information which could help tax
administrations identify cases where they want to formulate a request for an additional
exchange of information with another tax authority.
D.
Cross-border rulings providing for a unilateral downward adjustment to

the taxpayers taxable profits that is not directly reflected in the
taxpayers financial/commercial accounts
113. This covers, for example, informal capital or similar rulings, to the extent not
already covered by Section II.C above. The CAN specifically refers to advance tax
rulings or unilateral APAs providing for a downward adjustment that is not reflected in
the companys financial accounts as being examples that could result in a lack of
transparency where the tax authority does not notify the other tax authority of the
existence of the ruling. Moreover, the 2000 Report (OECD, 2001) recognised that
regimes that allow negative adjustments to profits could be preferential regimes.9
114. A regime that provides for negative adjustments to profits has the potential to
result in no or low taxation and MNEs have the incentive to shift profits. This incentive
exists where the downward adjustment is predictable, for example, where it is part of a
ruling or other administrative practice. In such cases, effective exchange of information is
particularly important in order to give other countries the opportunity to apply their
transfer pricing rules. In many cases the affected country will not be able to determine
that such an adjustment has been made because, for example, the adjustment is made in a
domestic tax computation without being reflected in an enterprises accounts or it is made
retrospectively.10
115. Excess profits rulings, informal capital rulings and other similar rulings recognise
the contribution of capital or an asset, generally by the parent company or another related
party, and provide an adjustment that reduces the taxable profits, for instance, through a
deemed interest deduction in the case of an interest free loan. An example of this would
be where the price paid by a subsidiary to its parent company is stated to be lower than
the arms length price and this is done intentionally to favour the subsidiary. In such
circumstances a country may make a downward adjustment to the subsidiarys taxable
profits to reflect the price that it would have paid had the transaction been undertaken at
arms length. The downward adjustment will reflect the difference between the actual
price paid and the arms length price so that in the companys tax computations (but not
in the companys commercial/statutory accounts), the difference will be treated as having

been paid by the subsidiary to its parent. This will create a tax deduction and reduce the
subsidiarys effective tax rate, but there is unlikely to be any corresponding additional
taxation in the parent company jurisdiction unless it is aware of the adjustment and its
amount. Further, it has been agreed that countries where an informal capital contribution
or excess profits regime can lead to downward adjustments and that do not require
taxpayers to obtain a ruling to benefit from this regime, will ensure that the tax
administration is aware of all cases where the regime has been utilised. Information on
those cases will also be provided to other relevant tax authorities.
116. This category of ruling is neither intended to cover downward adjustments made
following audits of filed accounts and returns where there is no separate ruling nor
unilateral relief for items such as foreign tax credits.
E.
Permanent establishment (PE) rulings, i.e. rulings concerning the

existence or absence of, and/or the attribution of profits to, a
permanent establishment by the country giving the ruling
117. This covers rulings, to the extent not already covered by Section II.C above,
which explicitly determine or decide on the existence or absence of a PE (either inside or
outside of the country giving the ruling) or any ruling that provides for how much profit
will be attributed to a PE.
F.
Related party conduit rulings
118. To the extent not already covered by Section II.C above, this includes rulings,
covering arrangements involving cross-border flows of funds or income through an entity
in the country giving the ruling, whether those funds or income flow to another country
directly or indirectly (i.e. through another domestic entity first).
119. Indirect conduit arrangements include, for example, arrangements whereby a
lower tier domestic entity receives cross-border income payments (i.e. an interest
payment on a loan) from underlying operating companies, which it then pays to a higher
tier domestic entity as an interest payment on a loan, leaving a small taxable margin in the
lower tier entity. The higher tier entity is treated as a tax transparent entity under
domestic law and only has non-resident partners thereby avoiding taxation. The effect of
this is an interest deduction in the underlying operating companies with no corresponding
income pick-up in domestic entities (except the small margin) or in the non-resident
partners.
G.
Any other type of ruling that in the absence of spontaneous information

exchange gives rise to BEPS concerns
120. If at a later date, the FHTP agrees, this category could be used for any other type
of ruling that, in the absence of compulsory spontaneous exchange of information, gives
rise to BEPS concerns. This language is intended to give the FHTP flexibility in the
future to broaden the obligation to spontaneously exchange to additional categories of
rulings. This would only therefore apply where the FHTP subsequently agrees that other
rulings give rise to similar concerns as the rulings already included within the framework
and should therefore be added.
III.
Jurisdictions receiving the information

121. As a general rule, exchange of information on rulings for the six categories need
to take place with:
a) The countries of residence of all related parties with which the taxpayer enters
into a transaction for which a ruling is granted or which gives rise to income from
related parties benefiting from a preferential treatment (this rule also applies in a
PE context); and
b) The residence country of the ultimate parent company and the immediate parent
company.
122. The related party threshold has been set at 25% but the FHTP agreed that this is to
be kept under review. Accordingly, two parties would be considered related if the first
person has a 25% or greater investment in the second person or there is a third person that
holds a 25% or greater investment in both. A person will be treated as holding a
percentage investment in another person if that person holds directly or indirectly through
an investment in other persons, a percentage of the voting rights of that person or of the
value of any equity interests of that person.
123. The general two-part rule above applies in the case of (i) shipping company
regimes; (ii) banking regimes; (iii) insurance regimes; (iv) financing and leasing regimes;
(v) fund management regimes; (vi) headquarters regimes; (vii) distribution centre
regimes; (viii) service centre regimes; (ix) IP regimes; (x) holding company regimes; and
(xi) other miscellaneous regimes identified as preferential regimes by the FHTP.
124. The same two-part exchange rule applies for (i) cross-border unilateral APAs and
any other cross-border unilateral tax rulings and (ii) cross-border rulings providing for a
unilateral downward adjustment. For PE rulings, the information is exchanged with the
residence country of the head office, or the country of the PE, as the case may be, and the
residence country of the ultimate parent company and the immediate parent company. For
conduit rulings, the information is exchanged with (i) the country of residence of any
related party making payments to the conduit (directly or indirectly); (ii) the country of
residence of the ultimate beneficial owner (which in most cases will be the ultimate
parent company) of payments made to the conduit; and (iii) to the extent not already
covered by (ii), the residence country of (a) the ultimate parent company and (b) the
immediate parent company.
125. The table below summarises the countries with which information should be
exchanged, with respect to all the rulings discussed above. The first column of the table
describes what rulings are covered by the obligation to spontaneously exchange and the
second column sets out with which countries information needs to be exchanged.
Table 5.1 Summary of the countries with which information should be exchanged
1.
What rulings are covered?

Rulings related to a preferential regime
Shipping company regimes, banking regimes,

insurance regimes, financing and leasing
regimes, fund management regimes,
headquarters regimes, distribution centre
regimes, service centre regimes, IP regimes,
holding company regimes, and other
miscellaneous
regimes
identified
as
preferential regimes by the FHTP
2.
3.
4.
Cross-border unilateral APAs and any

other cross-border unilateral tax ruling
(such as an ATR) covering transfer
pricing or the application of transfer
pricing principles
Cross-border rulings giving a unilateral

downward adjustment to the taxpayers
taxable profits in the country giving the
ruling
PE rulings
With which country does information need to be exchanged?

i. The countries of residence of all related parties (a 25%
threshold would apply), with which the taxpayer enters into a
transaction for which a preferential treatment is granted or
which gives rise to income from related parties benefiting
from a preferential treatment (this rule also applies in a PE
context); and
ii. The residence country of (a) the ultimate parent company
and (b) the immediate parent company.
i. The countries of residence of all related parties with whom
the taxpayer enters into transactions that are covered by the
APA or cross-border unilateral tax ruling; and
i. The countries of residence of all related parties with whom
the taxpayer enters into transactions covered by the ruling.
and (b) the immediate parent company
i. The residence country of the head office, or the country of
the PE, as the case may be; and
5.
Related party conduit rulings
i. The country of residence of any related party making

payments to the conduit (directly or indirectly);
ii. The country of residence of the ultimate beneficial owner
(which in most cases will be the ultimate parent company) of
payments made to the conduit; and
iii. To the extent not already covered by ii), the residence
country of (a) the ultimate parent company and (b) the
immediate parent company.
IV.
Application of the framework to rulings11

Past rulings
126. The obligation to spontaneously exchange applies not only to future rulings, but
also to past rulings that relate to earlier years. It has been agreed that information on
rulings that have been issued on or after 1 January 2010 and were still in effect as from
1 January 2014 must be exchanged.
127. In order to exchange with the relevant countries identified in Section III above,
jurisdictions will need to be able to identify related parties, the ultimate parent, the
immediate parent, and/or the ultimate beneficial owner, as the case may be. For past
rulings there will be many cases (such as unilateral APAs and other cross-border transfer
pricing rulings) where much of the information, especially in relation to related parties, is
available. Also, information on immediate and ultimate parent entities will typically be in
the possession of the tax administration. However, this may not be the case in respect of
all relevant related parties, for instance, in connection with rulings relating to IP regimes,
or where an APA has focused on the transfer pricing methodology rather than specific
transactions. In these cases, countries may not have routinely identified related parties
who undertake transactions.
128. Where a ruling does not contain sufficient information to enable identification of
all the relevant countries with which the information needs to be exchanged, a country is
not expected to contact the taxpayer but can instead use best efforts to identify the
countries with which to exchange information on the ruling. This requires a tax
administration to check the information that it has in its possession, for instance, in the
rulings or the wider taxpayer file, including any relevant transfer pricing documentation.
Where such information is not already in the possession of the tax administration but is
available from sources easily accessible to the tax administration (e.g. a corporate registry
system) tax administrations would be expected to extend their efforts to such sources.
Future rulings
129. For future rulings, countries will need to take the necessary measures to ensure
they have, or are able to obtain, information that identifies the countries they must
exchange with. For future rulings, this may mean that countries will need to amend their
ruling practices to require taxpayers to provide that information as part of the ruling
process. Given that countries that issue rulings covered by this report may need to amend
their ruling practices, future rulings will only be those issued on or after 1 April 2016.
V.
Information subject to the exchange

130. Another aspect of the FHTPs work is to balance the need for greater transparency
with not placing too great an administrative burden on tax administrations. As such, a
two-step process for exchanging information has been agreed. Under the first step a tax
administration provides a summary and some basic information on the ruling. This is
done using the template set out at Annex C.12 Use of a common template streamlines and
simplifies the process.
131. The information required to complete the template essentially documents the
decision making process that needs to be undertaken by the tax administration that has
issued the ruling (i) to determine whether the ruling is covered by the framework; and
(ii) to determine with which country it should be exchanged. It does this in a format
where entries are largely numeric or use check boxes including drop-down menus if an
electronic version is used. It is therefore designed to create minimal extra burden or delay
for the issuing tax administration while serving as a useful filter, easily understood in all
languages, on the basis of which receiving tax administrations can determine whether to
request the ruling itself which would then happen in a second step.
VI.
Practical implementation questions

132. The 2014 Progress Report anticipated that the framework set out in that report
would apply following the FHTPs 2014 autumn meeting. However, the application of
the framework for compulsory spontaneous exchange of information has not yet begun
because the inclusion of additional categories of rulings increases the volume of
information that will need to be exchanged. This has therefore required more
consideration of the implementation process and the practical implementation issues set
out below.
Method of exchange for future rulings exchange on a regular basis

133. Where a country has provided a ruling that is subject to the obligation to
spontaneously exchange it must exchange the relevant information on that ruling with any
affected country as quickly as possible and no later than three months after the date on
which the ruling becomes available to the competent authority of the country that granted
the ruling. Countries must also put in place appropriate systems to ensure that rulings are
transmitted to their competent authority without undue delay.
134. However, where a delay is caused by a legal impediment (for example, because of
a legal requirement to notify the taxpayer, an appeal filed by the taxpayer against the
exchange of information or other judicial procedure), the three month time limit is
extended but the relevant country should exchange without undue delay once the legal
impediment ceases to exist.
Method of exchange for past rulings

135. Information on past rulings that were issued on or after 1 January 2010 and were
still in effect as from 1 January 2014 will also need to be exchanged. This also applies to
rulings that have been modified during this period. This process should be completed by
the end of 2016.13 Countries can apply a phased approach to the exchange of past rulings
if desired, as long as the exchange of information on rulings is completed by the end of
2016.
VII.
Reciprocity
136. There are a number of benefits associated with a reciprocal approach to exchange
of information. However, the benefits of reciprocity do not appear to have any relevance
where the legal system or administrative practice of only one country provides for a
specific procedure. Accordingly, a country that has granted a ruling that is subject to the
obligation to spontaneously exchange information cannot invoke the lack of reciprocity as
an argument for not spontaneously exchanging information with an affected country,
where the affected country does not grant, and therefore cannot exchange, rulings which
are subject to the obligation to spontaneously exchange information.14 This assumes of
course that the affected country is committed to applying the framework and to
spontaneously exchanging information if it were to grant rulings which would trigger the
obligation to spontaneously exchange information.
VIII. Confidentiality of the information exchanged

137. Both the country exchanging information and its taxpayers have a legal right to
expect that information exchanged pursuant to the framework remains confidential. The
receiving country must therefore have the legal framework necessary to protect
information exchanged.
138. All treaties and exchange of information instruments contain provisions regarding
tax confidentiality and the obligation to keep information exchanged confidential. Under
those provisions, information may only be used for certain specified purposes and
disclosed to certain specified persons. Information exchange partners may suspend or
limit the scope of the exchange of information if appropriate safeguards are not in place
or if there has been a breach in confidentiality and they are not satisfied that the situation
has been appropriately resolved.
139. Domestic laws must be in place in the receiving country to protect confidentiality
of tax information, including information exchanged. Effective penalties must apply for
unauthorised disclosures of confidential information exchanged.
140. Information exchanged pursuant to this framework may be used only for tax
purposes or other purposes permitted by the relevant information exchange instrument. If
domestic law allows for a broader use of the information than the applicable instrument, it
is expected that international provisions and instruments will prevail over provisions of
domestic law.
IX.
Best practices15
141. The following best practices are intended to reinforce the transparency
advancements made in the OECD framework for compulsory spontaneous exchange of
information on rulings. They are applicable to both general and taxpayer specific crossborder rulings,16 except where appropriate distinctions are made between taxpayerspecific rulings, APAs and general rulings. When no distinction is made, the best
practices apply to all cross-border rulings which fall within the definition of a ruling set
out in this Chapter.17
A.
Process of granting a ruling

a) Official rules and administrative procedures for rulings should be identified in
advance and published, and they should include: (i) the conditions for the
applicability of the ruling process; (ii) the grounds for denying a ruling; (iii) the
fee structure, if applicable; (iv) the legal consequences of obtaining a ruling;
(v) possible sanctions for incomplete or false information provided by a taxpayer;
(vi) the conditions for revoking, cancelling or revising a ruling; and (vii) any other
guidance that is deemed necessary in order to make the rules sufficiently
comprehensive and clear to taxpayers and their advisors.
b) Tax rulings should be issued, and any administrative discretion in granting a
ruling should be exercised, only within the limits of, and in accordance with, the
countrys relevant domestic tax law and administrative procedures, and should be
limited to determining how that law and/or any administrative procedures apply to
one or more specific operations or transactions intended, planned or undertaken
by the taxpayer.
c) Tax rulings should respect applicable international obligations that are
incorporated into domestic tax law, for instance, obligations under relevant
bilateral treaties.
d) Tax rulings should be issued in writing.
e) Tax rulings should only be issued by the competent government office or
authority in charge of this task. Where a ruling is granted by another government
office, it should be subject to approval by the competent office.
f) It is recommended that at least two officials are involved in the decision to grant a
ruling or there is at least a two-level review process for the decision, in particular
in cases where the applicable rules and administrative procedures explicitly refer
to discretion or the exercise of judgement by one of the relevant officials.
g) Tax rulings should be binding on the tax authority (to the extent permitted by
domestic law18), provided that the applicable legislation and administrative
procedures and the factual information on which the ruling is based do not change
after the ruling has been granted.
h) Taxpayers should apply for a ruling in writing and provide a full description of
the underlying operations or transactions for which a ruling is requested. The
information should be included in a file supporting the ruling application (the
ruling file). The ruling file should also include information on the methods and
facts for determining the key elements of the tax authoritys view (e.g. transfer
prices, mark-ups, interest rates, profit margins). There will often be very specific
documentation requirements for APAs or other rulings that relate to transfer
pricing. Any additional information or relevant facts which are brought to the
attention of the tax authority (i.e. in meetings or oral presentations) should be
recorded in writing and also be included in the ruling file.
i) Information concerning the applicant (including taxpayers name, tax residency,
tax identification number, commercial register number for corporations and
companies) and tax advisor/tax consultant involved should be included in the
ruling file and/or the ruling itself.
j) Before taking a decision, the person/s providing the ruling should check that the
description of the facts and circumstances is sufficient and justifies the envisaged
outcome of the ruling. They should also check that the ruling outcome is
consistent with any previous rulings concerning similar legal issues and factual
circumstances.
B.
Term of the ruling and subsequent audit/checking procedure

a) APAs should only be for a fixed period of time and should be subject to review
before being extended.
b) Taxpayers should notify the tax authority about any material changes in the facts
or circumstances on which a taxpayer-specific ruling (including an APA) was
based, as soon as possible so that the tax administration can assess whether to
exchange this information with another country. As part of this notification
process, taxpayers should notify tax administrations of any material changes to
the related parties with which they transact (for transactions covered by the
ruling) and any other changes which would impact on who information should be
exchanged with.
c) Effective administrative procedures should be in place to periodically verify that
the factual information relied upon and assumptions made when granting
taxpayer-specific rulings remain relevant throughout the period of validity of the
ruling. This may be particularly necessary in the case of APAs where any
underlying assumptions and decisions could be affected by changes in economic
circumstances.
d) Rulings should be subject to revision, revocation or cancellation, as the case may
be, in the following circumstances:
C.
1.
if the taxpayer makes a misrepresentation or omission in applying for the

ruling that calls into question the validity of the ruling;
2.
if the relevant laws change;
3.
if there is a relevant and significant change (i) in the facts or circumstances

upon which the ruling was based or (ii) in the validity of the assumptions
made.
Publication and exchange of information

a) General rulings should be published and made easily accessible to other tax
administrations and taxpayers. Ideally, general rulings should be published on the
tax administrations website. If not published in full, the website should contain
short summaries with links to where the ruling is accessible in full. Also, the
published general rulings should be accompanied with a short overview in one of
the official languages of the OECD. Publication should take place as soon as it is
practicable after the ruling is granted and where possible within six months.
b) For taxpayer-specific rulings, where the ruling issued falls within the scope of the
OECD framework for compulsory spontaneous exchange of information on
rulings or other applicable commitment to exchange (e.g. under EU law or
bilateral treaty), the relevant authority should transmit that ruling to their
competent authority without undue delay, in order for that competent authority to
exchange information on the ruling with any relevant country as quickly as
possible and no later than three months after that in which the ruling becomes
available to it (subject to any legal impediments).
Notes
1.
For information on the MAC, see: www.oecd.org/tax/exchange-of-taxinformation/conventiononmutualadministrativeassistanceintaxmatters.htm.
2.
This definition was included in paragraph 161 of the CAN, p. 47, and was also
included in 2014 Progress Report, p. 41.
3.
In their anonymised or redacted form, such rulings fall within the category of general
rulings, unless they are in fact written in response to a taxpayer-specific ruling
request. Of course, in their non-anonymised, non-redacted form, such rulings fall
within the category of taxpayer-specific rulings.
4.
APAs may determine the attribution of profit in accordance with Article 7 of the
OECD Model Tax Convention on Income and on Capital: Condensed Version 2014
(OECD Model Tax Convention, OECD, 2014b) as well as transfer pricing between
associated enterprises. Such APAs would also fall within the scope of the definition
of ruling for the purposes of the obligation to spontaneously exchange on rulings.
5.
See the definition of APA in the first sentence of paragraph 4.123 of the TP
Guidelines, p. 168.
6.
See paragraph 3 of the Annex to Chapter IV of the TP Guidelines, p. 330.
7.
Law and administrative practice includes statutory law (including relevant treaty
provisions), case law, regulations, administrative instructions and practice.
8.
See Section III of this Chapter.
9.
See paragraph 152 of the CAN, p. 45.
10.
See paragraph 153 of the CAN, p. 45.
11.
Countries that do not currently have the necessary legal framework in place for
spontaneous exchange of information on rulings covered in this Chapter will need to
put in place such a framework in order to comply with the obligations under Action 5.
In such cases the timelines contained in this section are subject to a country's legal
framework. This also takes into account the entry into force and effective date of
application of provisions of the relevant exchange of information instruments.
12.
The OECD will translate the template into an XML schema with related user guide
that can be used for larger transfers of templates.
13.
Regarding the timelines contained in this section see footnote 11.
14.
See OECD Model Tax Convention, paragraph 15.1 of the Commentary on Article 26,
p. 427, which sets out the principle in the context of information exchange on request.
15.
In order to follow the best practices, changes in domestic legislation or current ruling
practice may be required.
16.
All references in the best practices section to general rulings mean cross-border
general rulings. A ruling will be considered to be a cross-border ruling where it falls
within one of the six categories in Table 5.1.
17.
See paragraph 95 above which references the definition of a ruling.
18.
Tax rulings may not be binding where a tax authority made a mistake in the
interpretation or application of the law, where it has withdrawn its ruling by written
notice that has prospective effect only, or where a ruling contravenes countries
international obligations.
Bibliography
European Union (2011), Council Directive 2011/16/EU of 15 February 2011, http://eurlex.europa.eu/legal-content/EN/TXT/?uri=celex:32011L0016 (accessed 20 July 2015).
OECD (2014a), Countering Harmful Tax Practices More Effectively, Taking into Account
Transparency and Substance, OECD Publishing, Paris, http://dx.doi.org/10.1787/
9789264218970-en.
OECD (2014b), Model Tax Convention on Income and on Capital: Condensed Version
OECD (2010a), The Multilateral Convention on Mutual Administrative Assistance in Tax
Matters Amended by the 2010 Protocol, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264115606-en.
OECD (2010b), OECD Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations 2010, OECD Publishing, Paris, http://dx.doi.org/10.1787/tpg2010-en.
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Eliminating Harmful Tax Practices, OECD Publishing, Paris, http://dx.doi.org/
10.1787/9789264184541-en.
6. REVIEW OF MEMBER AND ASSOCIATE COUNTRY REGIMES 61
Chapter 6
Review of OECD and associate country regimes
I.
Introduction
142. The current review of OECD country regimes commenced in late 2010 with the
preparation of a preliminary survey of preferential tax regimes in OECD countries, based
on publicly available information and without any judgement as to the potential
harmfulness of any of the regimes included. Further regimes were subsequently added to
the review process based on OECD countries self-referrals and referrals by other OECD
countries.
143. Each OECD country was requested to provide a description of its regimes, along
with a self-review using a standard template. The self-reviews were followed by
extensive analysis and peer reviews. The reviews were based on the principles and factors
set out in the 1998 Report (OECD, 1998) and, where necessary, relevant economic
considerations. With the adoption of the BEPS Action Plan (OECD, 2013), G20 countries
joined the OECD countries on an equal footing in the FHTP work. The reviews were
extended to cover both OECD and associate countries and advanced as follows:
IP regimes: As all the IP regimes of both OECD and associate countries have
been considered together, they have been considered not only in light of the
factors as previously applied but also in light of the elaborated substantial activity
factor described in Chapter 4 of this Report.
Non-IP regimes: As the current review commenced before the publication of the
BEPS Action Plan, all of the regimes of both OECD and associate countries have
been assessed against the factors as previously applied so that there is a consistent
approach applied to similar types of regimes such as those for holding companies.
With regard to non-IP regimes, the elaborated substantial activity factor has not
yet been applied but the FHTP is planning to do this.
Rulings: FHTP has agreed a framework which will be applied to rulings provided
by both OECD and associate countries.
144. Different aspects of the FHTPs work place different requirements on countries in
respect of specific regimes. For instance, even if an IP regime is consistent with the nexus
approach set out in Chapter 4, a country would still need to exchange any rulings related
to that regime under the framework set out in Chapter 5.
II.
Conclusions on sub-national regimes and when they are in scope

145. In the course of the current review, the question arose as to whether sub-national
regimes offering tax benefits at sub-national level alone are within the scope of the
FHTPs work. Given that the no or low effective tax rate gateway factor looks at the
62 6. REVIEW OF MEMBER AND ASSOCIATE COUNTRY REGIMES

combined effective tax rate for both the national and sub-national levels, a sub-national
regime will fall outside the scope of the FHTPs work where the tax rate at the national
level or the sub-national level fails to meet the no or low effective tax factor on its own.
146. The 1998 Report does not, however, preclude sub-national regimes from the
FHTPs scope of work as a matter of principle, and there is nothing in the history of the
FHTPs work precluding sub-national regimes from the scope of its work. In addition, it
would be inconsistent with the 1998 Reports broader objective of establishing a level
playing field1 to exclude regimes offering tax benefits at the sub-national level alone
from the scope of the FHTPs work, particularly where the tax rate at sub-national level
represents (or could represent, in the case of a discretionary tax rate) a significant portion
of the combined effective tax rate. Bearing this in mind, the FHTP agreed to include subnational regimes within the scope of its work where both of the following two criteria are
satisfied:
a) The national government is ultimately responsible for the general design of the
relevant regime and leaves limited discretion to the sub-national government as to
whether or not to introduce the regime and/or as to the key features of the regime.
The rationale is that in such a case, there is no fundamental difference between
the relevant regime and regimes enacted and administered at national level;
b) The tax rate at sub-national level represents (or could represent, in the case of a
discretionary tax rate) a significant portion of the combined tax rate and the
combined effective tax rate for both the national and sub-national levels meets the
no or low effective tax factor.
III.
Conclusions reached on regimes reviewed

147. The review process of the FHTP includes the following 43 preferential regimes.
The tables below identify the country and the name of the regime and provide the
conclusion reached.
Table 6.1 IP regimes

Country
1.
Belgium
2.
Peoples Republic of China
3.
Colombia
4.
France
5.
6.
7.
Hungary
Israel
Italy
8.
Luxembourg
9.
Netherlands
10.
Portugal
11.
Spain
12.
Spain Basque Country
13.
Spain Navarra
14.
15.
16.
Switzerland Canton of
Nidwalden
Turkey
United Kingdom
Regime
Patent income deduction
Reduced rate for high & new tech
enterprises
Software regime
Reduced rate for long term capital gains
and profits from the licensing of IP rights
IP regime for royalties and capital gains
Preferred company regime
Patent box
Partial exemption for income/gains
derived from certain IP rights
Innovation box
Partial exemption for income from
certain intangible property
certain intangible assets
Conclusion
See the paragraph

following this table.
Licence box
Technology development zones
Patent box
148. The IP regimes listed in Table 6.1 were all considered under the criteria in the
1998 Report as well as the elaborated substantial activity factor. Those regimes are
inconsistent, either in whole or in part, with the nexus approach as described in this
report. This reflects the fact that, unlike other aspects of the work on harmful tax
practices, the details of this approach were only finalised in this report while the regimes
had been designed at an earlier point in time. Countries with such regimes will now
proceed with a review of possible amendments of the relevant features of their regimes.2
Where no amendments are made, the FHTP will proceed to the next steps in its review
process.

Table 6.2 Non-IP regimes
17.
18.
19.
Argentina
Australia
Brazil
Country
Regime
Promotional regime for software industry
Conduit foreign income regime
PADIS - Semiconductors Industry
20.
Canada
Life insurance business regime
21.
Peoples Republic of China
22.
23.
Colombia
Greece
24.
India
25.
India
26.
India
27.
India
28.
29.
30.
31.
Indonesia
Indonesia
Indonesia
Indonesia
32.
Japan
33.
Japan
34.
Latvia
35.
Luxembourg
36.
Luxembourg
37.
South Africa
38.
South Africa
39.
Switzerland Cantonal level
40.
Mixed company regime
41.
Holding company regime
42.
Switzerland Federal level
Commissionaire ruling regime
43.
Turkey
Shipping regime
Reduced rate for advanced technology

service enterprises
Foreign portfolio investment regime
Offshore engineering and construction
Deductions in respect of certain incomes
of offshore banking units and
international financial services centre
Special provisions in respect of newly
established units in special economic
zones
Special provisions relating to income of
shipping companies tonnage tax
scheme
Taxation of profit and gains of life
insurance business
Public/listed company regime
Investment allowance regime
Special economic zone regime
Tax holiday regime
Special zones for international
competitiveness development
Measures for the promotion of research
and development
Shipping taxation regime
Private asset management company
(Socit de gestion de patrimoine
familial)
Investment company in risk capital
(Socit dinvestissement en capital
risque) regime
Headquarter company
Exemption of income in respect of ships
used in international shipping
Auxiliary company regime (previously
referred to as domiciliary company
regime)
Conclusion
Not harmful
Not harmful
Not harmful
Potentially harmful but not
actually harmful
Not harmful
Not harmful3
Amended
Not harmful
Not harmful
Not harmful
Not harmful
Under review
Under review
Under review
Under review
Not harmful4
Not harmful5
Not harmful
Not harmful6
Not harmful7
Potentially harmful but not
actually harmful
Not harmful
In the process of being
eliminated8
eliminated9
eliminated10
eliminated11
Not harmful12
149. This Report also establishes the meaning of substantial activities in the context of
non-IP regimes, but as mentioned above this analysis has not yet been applied to the
regimes. The FHTP will carry out further work to consider in which instances it may be
necessary to revisit regimes in light of the agreed substantial activity factor as it applies to
non-IP regimes.
IV.
Regimes relating to disadvantaged areas

150. Certain countries (e.g. Switzerland13 and Latvia14) have introduced tax incentive
regimes designed to encourage development in disadvantaged areas. Whilst they do not
specifically provide a preferential treatment for income from IP, they may include (or do
not specifically exclude) such income. The FHTP has considered that those regimes,
provided they meet certain conditions, do not pose a high risk of BEPS but should be
monitored. These regimes will not be further reviewed unless there is an indication of
adverse economic effects. To be considered as such a low risk regime applying to
disadvantaged areas, the following cumulative conditions would need to be met: (i) the
preferential tax treatment is only applicable to a relatively small area (in terms of surface
and/or population) selected by reference to the low level structural, economic and social
development in the region relative to the country as a whole; (ii) the regime is mainly
designed to create new jobs and attract tangible investments and has not been designed to
attract IP income or other mobile income; (iii) an entity has to meet significant substance
requirements in order to access the preferential tax treatment (e.g. it has to show the
generation of new employment, assets and investments); and (iv) the country agrees to
keep relevant data (such as the number of entities benefiting from the regime, their sector
of activity and the aggregated amount of exempted income) to allow monitoring of the
impact of the regime as relevant under the FHTP criteria.
V.
Downward adjustments
151. The FHTP considered informal capital and excess profit regimes. The FHTP
agreed that a lack of transparency was the main concern with such regimes. It was
therefore agreed that in addition to exchanging information on rulings for downward
adjustments, information should also be exchanged on downward adjustments where
there is no ruling issued. On this basis, the FHTP considered that at this time, it was not
necessary to further review these regimes, but that it would be appropriate to monitor the
impact of the exchange of information.
Notes
1.
See paragraph 8 of the 1998 Report, pp. 8-9.
2.
Given its particular features the Chinese regime for High and New Technology will
often be more restrictive than the nexus approach and there are only limited
circumstances in which income may benefit in excess of the amount computed under
the nexus approach.
3.
This conclusion was reached by the FHTP without reaching any conclusion that
Colombias regime was within the scope of the work of the FHTP.
4.
This regime was considered prior to the approval of the BEPS Action Plan.
5.
See footnote 4.
6.
See footnote 4.
7.
This conclusion was reached by the FHTP without reaching any conclusion that
Luxembourgs regime was within the scope of the work of the FHTP.
8.
On 5 June 2015, the Swiss Government has submitted a bill for approval in
Parliament, wherein it has proposed to abolish the regime (as well as the following
three regimes). Subject to the Swiss parliamentary/constitutional approval process,
the intention is for the new Federal legislation to be completed by 1 January 2017,
followed by a two-year period for the 26 Cantons to revise their laws accordingly.
9.
See footnote 8.
10.
See footnote 8.
11.
See footnote 8.
12.
See footnote 4.
13.
Swiss relief for newly established or re-designed enterprises.
14.
Latvia taxation regime related with the taxpayers investments in special economic
zones and free ports (Special economic zones).
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
7. FURTHER WORK OF THE FORUM ON HARMFUL TAX PRACTICES 67
Chapter 7
Further work of the FHTP
152. This Chapter sets out the next steps in the work of the FHTP. The next steps fall
into three broad categories: (i) the ongoing work, including monitoring of preferential
regimes and the application of the agreed transparency framework, (ii) further
development of a strategy to expand participation to third countries, and
(iii) considerations of revisions or additions to the existing FHTP criteria.
I.
Ongoing work including monitoring

153. Chapters 4 and 5 respectively set out the application of the substantial activities
analysis to preferential regimes and the framework for enhanced transparency on rulings.
The next steps in this area will include the following.
IP regimes: The FHTP will monitor preferential IP regimes, and countries should
update the FHTP on the legislative progress made in respect of changes to their
existing legislation. Existing IP regimes listed in Table 6.1 in Chapter 6 must be
amended to comply with the nexus approach (and, if jurisdictions choose to
benefit from grandfathering, to comply with the safeguards related to
grandfathering and new entrants set out in Chapter 4). Future monitoring will
consider any such amendments, and, where no amendments are made to existing
IP regimes, the FHTP will move to the next stage of the review process. Chapter 4
provides that, in certain circumstances, countries may permit the use of the nexus
ratio as a rebuttable presumption. In these circumstances, certain forms of
enhanced transparency and monitoring, set out in Chapter 4, will become
applicable, and the FHTP will monitor the implementation and application of the
requirements set out in that Chapter. Jurisdictions must also inform the FHTP if
they provide benefits under their IP regimes to the third category of IP assets set
out in Chapter 4. Finally, Chapter 6 recognises that some regimes designed to
promote development in disadvantaged areas will need to be monitored and that
countries will be required to keep data on the companies benefitting from those
regimes.
Non-IP regimes: The FHTP will monitor preferential non-IP regimes, noting also
that to date the substantial activity factor has only been applied to IP regimes. If
countries have concerns about substantial activities in other preferential regimes,
these will also need to be reviewed under the elaborated substantial activity
factor.
Transparency Framework: Chapter 5 provides a framework for improving

transparency in relation to rulings. Information on future rulings should start to be
exchanged from 1 April 2016 and countries have until the end of 2016 to
exchange information on past rulings.1 An ongoing monitoring and review
68 7. FURTHER WORK OF THE FORUM ON HARMFUL TAX PRACTICES

mechanism will be put in place to ensure countries compliance with the
obligation to spontaneously exchange information under the framework. This will
involve an annual review by the FHTP starting at the beginning of 2017. As part
of that process the FHTP will also evaluate the effectiveness of the framework
and whether the scope of the rulings covered, and the information provided by tax
administrations, appropriately balances the need to identify BEPS risks with the
administrative burden for the sending and receiving jurisdictions. As part of the
review process countries that provide taxpayer-specific rulings that fall within the
framework will be expected to provide statistical information that includes the
following: (i) the total number of spontaneous exchanges sent under the
framework, (ii) the number of spontaneous exchanges sent by category of ruling,
and (iii) for each exchange, which country or countries information was
exchanged with. Countries should also provide details of the cases where they had
insufficient information to identify all the countries that they needed to exchange
with and therefore applied a best efforts approach. This information should be
broken down by category of ruling and should include a brief description of the
efforts undertaken to identify relevant related parties.
II.
Development of a strategy to expand participation to third countries

154. The need for global solutions to shared challenges is at the heart of the BEPS
Project. For this reason, all OECD and G20 countries have worked on an equal footing
with the direct participation of an increasing number of developing countries. Action 5 of
the BEPS Action Plan (OECD, 2013) explicitly recognised the need to involve third
countries and requested the FHTP to develop a strategy to engage non-OECD/ non-G20
countries into the work on harmful tax practices. This is needed to ensure a level playing
field and avoid the risk of harmful tax practices being simply displaced to third countries,
but also entails involvement and engagement with third countries whether they have
preferential regimes or they are otherwise concerned with the work. Against this
backdrop the FHTP agreed on the following elements of an engagement strategy with
third countries:
III.
The FHTPs engagement should include third countries that have preferential
regimes, as well as other countries that have a stake in the work.
As part of the engagement, the FHTP will communicate the purpose and
objectives of its work also setting out the level of involvement and participation
of third countries.
Additional work will be carried out to implement the engagement strategy in 2016
in the context of the wider objective of designing a more inclusive framework to
support and monitor the implementation of the BEPS measures.
Consideration of revisions or additions to the existing FHTP criteria

155. The current framework for considering preferential regimes is described in
Chapter 3 and uses four key factors and eight other factors to determine whether a
preferential regime is potentially harmful. Two of the existing factors (transparency and
substantial activity) have already been elaborated as a result of the work on the first
output of Action 5. The OECD and G20 countries involved in the FHTP therefore
consider that it is too early to accurately identify areas in which the existing criteria might
fall short because the impact of the work on substance and transparency cannot yet be
7. FURTHER WORK OF THE FORUM ON HARMFUL TAX PRACTICES 69
fully evaluated. In addition the benefits of involving third countries in this aspect of the
work are recognised.
156. Nevertheless, some areas have been identified as ones that could benefit from
further consideration once the FHTP is better able to identify the impact of the other
outputs considered in this report. These include the fifth factor set out in the 1998 Report
(OECD, 1998) and the application of the ring-fencing factor.
157. The fifth factor which can assist in identifying harmful preferential regimes is an
artificial definition of the tax base. This recognises that rather than offering a
preferential tax rate a country can attract mobile income by having a narrow definition of
the tax base that subjects less income to tax. This can be achieved, for example, by
exempting certain categories of income or by allowing deductions for expenses that are
deemed to have been incurred. The 1998 Report notes that such measures may also suffer
from a lack of transparency. Some countries have suggested that this factor could also be
elevated in importance, as has been done with the twelfth factor; however, the
transparency framework set out in Chapter 5 may address many of the transparency
concerns raised by such regimes.
158. Ring-fencing is one of the key factors in the 1998 Report and it applies (i) where a
regime implicitly or explicitly excludes resident taxpayers from taking advantage of its
benefits or (ii) where an entity that benefits from the regime is explicitly or implicitly
prohibited from operating in the domestic market. Further guidance on the application of
the ring-fencing factor is contained in the CAN (OECD, 2004), which envisages that the
ring-fencing factor could apply where the tax result for a wholly domestic transaction is
in practice different from that arising for a cross border transaction. In this context it has
been suggested that the application of the ring-fencing factor to such scenarios could be
made clearer.
Note
1.
Countries that do not currently have the necessary legal framework in place for
spontaneous exchange of information on rulings covered in Chapter 5 will need to put
in place such a framework in order to comply with the obligations under Action 5. In
such cases the timelines for spontaneous exchange of information on rulings will be
subject to a country's legal framework. This also takes into account the entry into
force and effective date of application of provisions of the relevant exchange of
information instruments.
70 7. FURTHER WORK OF THE FORUM ON HARMFUL TAX PRACTICES
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2004), Consolidated Application Note: Guidance in Applying the 1998 Report to
ANNEX A. EXAMPLE OF A TRANSITIONAL MEASURE FOR TRACKING AND TRACING 71
Annex A
Example of a transitional measure for tracking and tracing
1.
Country P implements an IP regime in 2016 that requires tracking and tracing.
Taxpayer Q is a technology company that sells products which use multiple IP assets that
Taxpayer Q has developed. Prior to 2016, Taxpayer Q did not track and trace either
expenditures or income to individual IP assets or products, but Taxpayer Q does have
information on the overall R&D expenditures that Taxpayer Q itself incurred, as well as
its overall expenditures for related party outsourcing and its overall acquisition costs for
2014 and 2015. Taxpayer Q can then track and trace to product families starting in 2016.
Taxpayer Qs expenditures are listed below:
Table A.1 Taxpayer Q's expenditures
2014
2015
2016
2017
2018
All qualifying expenditures (i.e. all R&D expenditures incurred by Taxpayer

Q): 5 000
All overall expenditures (i.e. all R&D expenditures incurred by Taxpayer Q,
all expenditures for related party outsourcing, and all acquisition costs):
10 000
All qualifying expenditures: 3 000
All overall expenditures: 3 000
Qualifying expenditures for Product Family A: 400
Qualifying expenditures for Product Family B: 1 600
Overall expenditures for Product Family A: 2 400
Overall expenditures for Product Family B: 2 600
Qualifying expenditures for Product Family A: 1 300
Qualifying expenditures for Product Family B: 700
Overall expenditures for Product Family A: 2 000
Overall expenditures for Product Family B: 1 000
Qualifying expenditures for Product Family A: 800
Qualifying expenditures for Product Family B: 200
Overall expenditures for Product Family A: 800
Overall expenditures for Product Family B: 800
2.
If Country P allows the use of a three-year average as a transitional measure,
the nexus ratio would be calculated as follows. In 2016, Taxpayer Q therefore calculates
the nexus ratio using the average of all of its R&D expenditures over three years. The
ratio for 2016 would be 10 000/18 000 before applying the up-lift. For purposes of
calculating the three-year average, this ratio does not include any expenditures incurred
72 ANNEX A. EXAMPLE OF A TRANSITIONAL MEASURE FOR TRACKING AND TRACING

before 2014, even if the R&D to create IP Asset Q began before that time, and it uses all
expenditures because Taxpayer Q had not yet begun tracking and tracing to product
families in 2016. At the same time, Taxpayer Q starts tracking and tracing the
expenditures incurred to continue developing IP Asset Q. In 2017, Taxpayer Q would
again calculate the nexus ratio using the average of all of its R&D expenditures because it
did not yet have three years of expenditures tracked to product families. The ratio for
2017 would be 7 000/11 000 before applying the up-lift. In 2018 and all following years,
Taxpayer Q would transition to a cumulative approach using expenditures for product
families since it would now have three years of expenditures that were tracked by product
family. The ratio for Product Family A in 2018 would therefore be 2 500/5 200 before
applying the up-lift, and all subsequent qualifying and overall expenditures for Product
Family A will be added to that ratio in future years. The ratio for Product Family B in
2018 would be 2 500/4 400 before applying the up-lift, and all subsequent qualifying and
overall expenditures for Product Family B will be added to that ratio in future years.
3.
This Annex provides only one example of how a transitional measure could be
designed to ensure that taxpayers had sufficient time to adapt to tracking and tracing
requirements while still complying with the general principles of the nexus approach.
Country P could, for example, allow the use of a five-year average, which would then
permit Taxpayer Q to calculate the nexus ratio based on all qualifying and overall
expenditures in 2019 and 2020 as well as in 2016, 2017, and 2018.
Exchange with the

residence country of
the ultimate parent
and the immediate
parent company and
the residence
country of all related
parties with which the
taxpayer enters into
a transaction for
which a preferential
treatment is granted
or which gives rise to
income from related
parties benefiting
from a preferential
treatment.
yes
Exchange with the
the ultimate parent
and the immediate
parent company and
the residence
a transaction for
which it is given a
unilateral downward
adjustment not
directly reflected in
the taxpayers
accounts.
no
yes
Exchange with the

the ultimate parent
and the immediate
parent company and
either the residence
country of the head
office or the country
where the permanent
establishment is
established.
no yes
It is a permanent
establishment ruling?
Exchange with the

the ultimate parent,
of the immediate
parent company, of
any related party
making the payments
to the conduit and of
the ultimate
beneficial owner of
payments made to
the conduit.
no
It is a related party
conduit ruling?
No obligation to spontaneously exchange information on the ruling.
Exchange with the

the ultimate parent
and the immediate
parent company and
the residence
a transaction that is
covered by the APA
or cross border
unilateral ruling.
no
no
yes
It is a cross-border
ruling related to a
preferential regime?
ruling providing for a
unilateral downward
adjustment not
directly reflected in
the taxpayers
accounts? 1
yes
Currently not
operational
category.
no
It is any other type of

ruling that in the
absence of
spontaneous
information
exchange gives rise
to BEPS concerns?
1. As explained in paragraph 115, it has been agreed that in certain circumstances information will be provided to other relevant tax authorities even where there is no ruling.
yes
unilateral APA and
any other crossborder unilateral tax
ruling (such as ATR)
covering TP
principles?
Is there a taxpayer-specific ruling giving rise to BEPS concerns in the absence

of compulsory spontaneous information exchange because:
Annex B Spontaneous exchange on taxpayer-specific rulings under the framework
ANNEX B. SPONTANEOUS EXCHANGE ON TAXPAYER-SPECIFIC RULINGS UNDER THE FRAMEWORK 73
74 ANNEX C. TEMPLATE AND INSTRUCTION SHEET FOR INFORMATION EXCHANGE
Annex C
Template and instruction sheet for information exchange
All fields are mandatory unless otherwise indicated.
1. Ruling reference number, if any.
2. Identification of the taxpayer and where appropriate the group of companies to which it
belongs.
Taxpayer identification number (TIN) or other tax
reference number
Legal name of the entity
Street
Building (optional)
Suite (optional)
Floor (optional)
District Name (optional)
Address
Post Office Box (optional)

Post Code
City
Country
State/Province/Canton
(optional)
Taxpayers main business activity (optional)

Name of multinational enterprise (MNE) group, if
different
ANNEX C. TEMPLATE AND INSTRUCTION SHEET FOR INFORMATION EXCHANGE 75
3. Date of issuance.
4. Accounting periods/tax years covered by the ruling.
5. Type of ruling issued. Please check the appropriate box.

Relating to preferential regime
Unilateral advance pricing arrangement (APA) or other transfer pricing (TP) ruling
Downward adjustment ruling
Permanent establishment (PE) ruling
Conduit ruling
6. Additional information regarding the ruling and the taxpayer (optional).
Transaction amount, if any
Entitys annual turnover
Profit of the entity

7. Short summary of the issue covered by the ruling ideally provided in one of the official
languages of the Organisation for Economic Co-operation and Development (OECD) or other
language bilaterally agreed. Where this is not possible this can be provided in the native
language of the sending jurisdiction.
8. Reason for exchange with the recipient jurisdiction.

Ultimate parent
Immediate parent
Related party with which the taxpayer enters into a transaction for which a preferential
treatment is granted or which gives rise to income benefiting from a preferential
treatment
Related party with whom the taxpayer enters into a transaction covered by the ruling
Related party making payments to a conduit (directly or indirectly)
Ultimate beneficial owner of income from a conduit arrangement
Head office of permanent establishment (PE) country
9. Details of the entities in the recipient jurisdiction.

Name of entity
Address
TIN or other tax reference

number, where available
1.
2.
3.

Instruction Sheet for the Template on Exchange of Information on Rulings
All fields are mandatory unless otherwise indicated.
1. Ruling reference number, if any.
The ruling reference number should be provided, if it is available.
2. Identification of the taxpayer and where appropriate the group of companies to which it
belongs.
This box includes all the information necessary to identify the taxpayer and determine its
association with a multinational enterprise (MNE) group. In line with the Organisation Party
block from the Common Reporting Standard (CRS) the following fields are required: taxpayer
identification number (TIN) or other tax reference number, legal name of the entity (i.e. name
of the taxpayer), and address. Within the address field only the street, post code, city and
country where the taxpayer is registered are mandatory fields.
Taxpayers main business activity field is optional and intended to be a drop-down menu with a
list of predefined industry sector codes when used in an application that allows for such
functionality.
Name of MNE group, if different aims to provide information on the association of the taxpayer
with the MNE group to which it belongs. In some cases the name of the subsidiary may differ
from the name of the MNE group making it more difficult to identify the connection between the
taxpayer and the MNE group.
3. Date of issuance.
The date on which the ruling was issued is to be inserted in the box. This will generally be the
date shown on the ruling or in certain countries where the ruling is held by the tax
administrations, it could be the date provided on any written confirmation given to the taxpayer.
4. Accounting periods/tax years covered by the ruling.
This box may have a drop-down menu with the accounting periods/tax years covered by the
ruling.
5. Type of ruling given.
These boxes identify the type of ruling that needs to be exchanged. All relevant boxes should be
ticked so if a ruling combines several different elements, for instance, a unilateral advance
pricing arrangement (APA) and an agreement on the tax treatment of a permanent establishment
(PE), then both boxes should be ticked.
6. Further information on the ruling and taxpayer.
These boxes are intended to provide some form of materiality filter to help tax administrations
decide if they want to include further information. These boxes are optional, therefore there is no
obligation to obtain such information.
Transaction amount is the monetary value of the transaction. The entitys annual turnover is the
volume of business of an enterprise as contained in the profits and loss account. It is usually
measured by reference to gross receipts, or gross amounts due, from the sale of goods or services
by the entity. The profit of the entity is net profit reflecting the difference between gross receipts
from business transactions and deductible business expenses.
Where Box 6 of the template is completed this should include the latest figures available from
either the rulings file or the taxpayer file and should specify the currency, which should be the
currency used in any document made available to the tax administration when it issued the ruling.
For example, the transaction amount would be the latest figure for a specific transaction that is
covered by the ruling.
7. Short summary of the issue covered by the ruling.
In this box the tax administration should provide a short summary of the issue covered in the
ruling and should include a description of the transaction or activity covered by the ruling and
any other information that could help the receiving tax administration risk-assess the potential
base erosion and profit shifting (BEPS) risks posed by the ruling. For example, in the case of a
unilateral APA the summary could set out the type of transaction or income covered and the
transfer pricing methodology agreed. As the summary is intended to be high-level it should not
generally include details of specific provisions in a countrys tax code. The information in the
box should ideally be written in one of the official languages of the Organisation for Economic
Co-operation and Development (OECD) or other language bilaterally agreed. Where this is not
possible this can be provided in the native language of the sending jurisdiction.
8. Reason for exchange with the recipient jurisdiction.
The information provided in this field will tell the recipient jurisdiction why it is receiving the
ruling. The recipient jurisdiction must be one of the relevant jurisdictions under the framework.
The precise reason for the exchange will be indicated by the box ticked.
9. Details of the entities in the recipient jurisdiction.
This box provides further information on any entities to which the ruling relates and that are
resident in the recipient jurisdiction. There is the ability to identify more than one entity where a
ruling relates to more than one entity in that jurisdiction. The name of the entity and the address
are mandatory and the TIN or other tax reference number should be provided where such
information is available.

AND DEVELOPMENT

(23 2015 32 1 P) ISBN 978-92-64-24118-3 2015-01
OECD/G20BaseErosionandProfitShiftingProject
CounteringHarmfulTaxPracticesMoreEffectively,
TakingintoAccountTransparencyandSubstance
Contents
Chapter 1. Introduction and background
Chapter 2. Overview of the OECDs work on harmful tax practices
Chapter 3. Framework under the 1998 Report for determining whether a regime is a harmful preferential regime
Chapter 4. Revamp of the work on harmful tax practices: Substantial activity requirement
Chapter 5. Revamp of the work on harmful tax practices: Framework for improving transparency
in relation to rulings
Chapter 6. Review of OECD and associate country regimes
Chapter 7. Further work of the FHTP
Annex A. Example of a transitional measure for tracking and tracing
Annex B. Spontaneous exchange on taxpayer-specific rulings under the framework
Annex C. Template and instruction sheet for information exchange

iSBn978-92-64-24118-3
232015321P
9HSTCQE*cebbid+

Project
Preventing the Granting

of Treaty Benefits in
Inappropriate Circumstances
Preventing the Granting

of Treaty Benefits
in Inappropriate
Circumstances, Action 6
2015 Final Report

OECD (2015), Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015
Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241695-en
ISBN 978-92-64-24120-6 (print)

ISBN 978-92-64-24169-5 (PDF)

OECD 2015
Foreword 3
Foreword
PREVENTING THE GRANTING OF TREATY BENEFITS IN INAPPROPRIATE CIRCUMSTANCES OECD 2015
4 Foreword
TABLE OF CONTENTS 5
Table of contents

Executive summary 9
Introduction 13
A. Treaty provisions and/or domestic rules to prevent the granting of treaty benefits in
inappropriate circumstances17
1. Cases where a person tries to circumvent limitations provided by the treaty itself17
a) Treaty shopping17
i) Limitation-on-benefits rule20
ii) Rules aimed at arrangements one of the principal purposes of which is to obtain
treaty benefits 54
b) Other situations where a person seeks to circumvent treaty limitations69
i) Splitting-up of contracts 69
ii) Hiring-out of labour cases69
iii) Transactions intended to avoid dividend characterisation 69
iv) Dividend transfer transactions 70
v) Transactions that circumvent the application of Article13(4) 71
vi) Tie-breaker rule for determining the treaty residence of dual-resident persons other
than individuals72
vii) Anti-abuse rule for permanent establishments situated in third States75
2. Cases where a person tries to abuse the provisions of domestic tax law using treaty benefits78
a) Application of tax treaties to restrict a Contracting States right to tax its own residents86
b) Departure or exit taxes89
B. Clarification that tax treaties are not intended to be used to generate double non-taxation 91
C. Tax policy considerations that, in general, countries should consider before
decidingtoenterintoatax treaty with another country 94
Bibliography 101

BEPS
CIV
Collective investment vehicles
LOB Limitation-on-benefits
OECD
PPT
Principal purposes test
REIT
Real Estate Investment Trust
RIC
Regulated Investment Company
VCLT
Vienna Convention on the Law of Treaties
Executive summary 9
Executive summary
Action6 of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project identifies
treaty abuse, and in particular treaty shopping, as one of the most important sources of
BEPS concerns.
Taxpayers engaged in treaty shopping and other treaty abuse strategies undermine tax
sovereignty by claiming treaty benefits in situations where these benefits were not intended
to be granted, thereby depriving countries of tax revenues. Countries have therefore agreed
to include anti-abuse provisions in their tax treaties, including a minimum standard to
counter treaty shopping. They also agree that some flexibility in the implementation of
the minimum standard is required as these provisions need to be adapted to each countrys
specificities and to the circumstances of the negotiation of bilateral conventions.
SectionA of this report includes new treaty anti-abuse rules that provide safeguards
against the abuse of treaty provisions and offer a certain degree of flexibility regarding
how to do so.
These new treaty anti-abuse rules first address treaty shopping, which involves
strategies through which a person who is not a resident of a State attempts to obtain benefits
that a tax treaty concluded by that State grants to residents of that State, for example by
establishing a letterbox company in that State. The following approach is recommended to
deal with these strategies:
First, a clear statement that the States that enter into a tax treaty intend to avoid
creating opportunities for non-taxation or reduced taxation through tax evasion or
avoidance, including through treaty shopping arrangements will be included in tax
treaties (this recommendation is included in SectionB of the report).
Second, a specific anti-abuse rule, the limitation-on-benefits (LOB) rule, that limits
the availability of treaty benefits to entities that meet certain conditions will be
included in the OECD Model Tax Convention. These conditions, which are based
on the legal nature, ownership in, and general activities of the entity, seek to ensure
that there is a sufficient link between the entity and its State of residence. Such
limitation-on-benefits provisions are currently found in treaties concluded by a
few countries and have proven to be effective in preventing many forms of treaty
shopping strategies.
Third, in order to address other forms of treaty abuse, including treaty shopping
situations that would not be covered by the LOB rule described above, a more
general anti-abuse rule based on the principal purposes of transactions or
arrangements (the principal purposes test or PPT rule) will be included in the
OECD Model Tax Convention. Under that rule, if one of the principal purposes of
transactions or arrangements is to obtain treaty benefits, these benefits would be
denied unless it is established that granting these benefits would be in accordance
with the object and purpose of the provisions of the treaty.
The report recognises that each of the LOB and PPT rules has strengths and weaknesses
and may not be appropriate for, or accord with the treaty policy of, all countries. Also, the
domestic law of some countries may include provisions that make it unnecessary to combine
these two rules to prevent treaty shopping.
Given the risk to revenues posed by treaty shopping, countries have committed to
ensure a minimum level of protection against treaty shopping (the minimum standard).
That commitment will require countries to include in their tax treaties an express statement
that their common intention is to eliminate double taxation without creating opportunities
for non-taxation or reduced taxation through tax evasion or avoidance, including through
treaty shopping arrangements. Countries will implement this common intention by
including in their treaties: (i)the combined approach of an LOB and PPT rule described
above, (ii)the PPT rule alone, or (iii)the LOB rule supplemented by a mechanism that
would deal with conduit financing arrangements not already dealt with in tax treaties.
SectionA also includes new rules to be included in tax treaties in order to address other
forms of treaty abuse. These targeted rules address (1)certain dividend transfer transactions
that are intended to lower artificially withholding taxes payable on dividends; (2)transactions
that circumvent the application of the treaty rule that allows source taxation of shares of
companies that derive their value primarily from immovable property; (3)situations where
an entity is resident of two Contracting States, and (4)situations where the State of residence
exempts the income of permanent establishments situated in third States and where shares,
debt-claims, rights or property are transferred to permanent establishments set up in countries
that do not tax such income or offer preferential treatment to that income.
The report recognises that the adoption of anti-abuse rules in tax treaties is not sufficient
to address tax avoidance strategies that seek to circumvent provisions of domestic tax laws;
these must be addressed through domestic anti-abuse rules, including through rules that will
result from the work on other parts of the Action Plan. The report includes changes to the
OECD Model Tax Convention aimed at ensuring that treaties do not inadvertently prevent
the application of such domestic anti-abuse rules. This is done by expanding the parts of the
Commentary of the OECD Model Tax Convention that already deal with this issue and by
explaining that the inclusion of the PPT rule in treaties, which will incorporate the principle
already included in the Commentary of the OECD Model Tax Convention, will provide a
clear statement that the Contracting States intend to deny the application of the provisions
of their treaties when transactions or arrangements are entered into in order to obtain the
benefits of these provisions in inappropriate circumstances.
The report also addresses two specific issues related to the interaction between treaties
and domestic anti-abuse rules. The first issue relates to the application of tax treaties to
restrict a Contracting States right to tax its own residents. A new rule will codify the
principle that treaties do not restrict a States right to tax its own residents (subject to
certain exceptions). The second issue deals with so-called departure or exit taxes,
under which liability to tax on some types of income that has accrued for the benefit of a
resident (whether an individual or a legal person) is triggered in the event that the resident
ceases to be a resident of that State. Changes to the Commentary of the OECD Model Tax
Convention will clarify that treaties do not prevent the application of these taxes.
SectionB of the report addresses the part of Action6 that asked for clarification that
tax treaties are not intended to be used to generate double non-taxation. This clarification
is provided through a reformulation of the title and preamble of the Model Tax Convention
that will clearly state that the joint intention of the parties to a tax treaty is to eliminate
double taxation without creating opportunities for tax evasion and avoidance, in particular
through treaty shopping arrangements.
SectionC of the report addresses the third part of the work mandated by Action6, which
was to identify the tax policy considerations that, in general, countries should consider
before deciding to enter into a tax treaty with another country. The policy considerations
described in that section should help countries explain their decisions not to enter into tax
treaties with certain low or no-tax jurisdictions; these policy considerations will also be
relevant for countries that need to consider whether they should modify (or, ultimately,
terminate) a treaty previously concluded in the event that a change of circumstances (such as
changes to the domestic law of a treaty partner) raises BEPS concerns related to that treaty.
This final version of the report supersedes the interim version issued in September
2014. A number of changes have been made to the rules proposed in the September 2014
report. As noted at the beginning of the report, however, additional work will be required
in order to fully consider proposals recently released by the United States concerning the
LOB rule and other provisions included in the report. Since the United States does not
anticipate finalising its new model tax treaty until the end of 2015, the relevant provisions
included in this report will need to be reviewed afterwards and will therefore be finalised
in the first part of 2016. An examination of the issues related to the treaty entitlement of
certain types of investment funds will also continue after September 2015 with a similar
deadline.
The various anti-abuse rules that are included in this report will be among the changes
proposed for inclusion in the multilateral instrument that will implement the results of the
work on treaty issues mandated by the OECD/G20 BEPS Project.
I ntroduction 13
Introduction
1. At the request of the G20, the OECD published its Action Plan on Base Erosion
and Profit Shifting (BEPS Action Plan, OECD, 2013) in July 2013. The BEPS Action Plan
includes 15actions to address BEPS in a comprehensive manner and sets deadlines to
implement these actions.
2. The BEPS Action Plan identifies treaty abuse, and in particular treaty shopping, as one
of the most important sources of BEPS concerns. Action6 (Prevent Treaty Abuse) describes
the work to be undertaken in this area. The relevant part of the Action Plan reads as follows:
Existing domestic and international tax rules should be modified in order to
more closely align the allocation of income with the economic activity that
generates that income:
Treaty abuse is one of the most important sources of BEPS concerns. The
Commentary on Article1 of the OECD Model Tax Convention already includes
a number of examples of provisions that could be used to address treaty-shopping
situations as well as other cases of treaty abuse, which may give rise to double nontaxation. Tight treaty anti-abuse clauses coupled with the exercise of taxing rights
under domestic laws will contribute to restore source taxation in a number of cases.
Action6 Prevent treaty abuse
Develop model treaty provisions and recommendations regarding the design
of domestic rules to prevent the granting of treaty benefits in inappropriate
circumstances. Work will also be done to clarify that tax treaties are not intended to
be used to generate double non-taxation and to identify the tax policy considerations
that, in general, countries should consider before deciding to enter into a tax treaty
with another country. The work will be co-ordinated with the work on hybrids.
3. This report is the result of the work carried on in the three different areas identified
by Action6:
A. Develop model treaty provisions and recommendations regarding the design
of domestic rules to prevent the granting of treaty benefits in inappropriate
circumstances.
B. Clarify that tax treaties are not intended to be used to generate double non-taxation.
C. Identify the tax policy considerations that, in general, countries should consider
before deciding to enter into a tax treaty with another country.
4. The conclusions of the work in these three different areas of work correspond respectively
to Sections A, B and C of this report. These conclusions take the form of changes to the OECD
Model Tax Convention (in this report, all changes that are proposed to the existing text of the
Model Tax Convention appear in bold italics for additions and strikethrough for deletions).
14 I ntroduction
5. These changes reflect the agreement that the OECD Model should be amended to
include the minimum level of protection against treaty abuse, including treaty shopping,
described in the Executive summary and paragraph22below, as this minimum level of
protection is necessary to effectively address BEPS.
6. When examining the model treaty provisions included in this report, it is also
important to note that these are model provisions that need to be adapted to the specificities
of individual States and the circumstances of the negotiation of bilateral conventions. For
example:
Some countries may have constitutional restrictions or concerns based on EU law
that prevent them from adopting the exact wording of the model provisions that are
recommended in this report.
Some countries may have domestic anti-abuse rules that effectively prevent some of
the treaty abuses described in this report and, to the extent that these rules conform
with the principles set out in this report (and, in particular, in SectionA.2) and offer
the minimum protection referred to in paragraph22below, may not need some of
the rules proposed in this report.
Similarly, the courts of some countries have developed various interpretative tools
(e.g.economic substance, substance-over-form) that effectively address various
forms of domestic law and treaty abuses and these countries might not require the
general treaty-abuse provision included in subsection A.1(a)(ii) below or might
prefer a more restricted form of that provision.
The administrative capacity of some countries might prevent them from applying
certain detailed treaty rules and might require them to opt for more general antiabuse provisions.
For these reasons, a number of the model provisions included in this report offer
alternatives and a certain degree of flexibility. There is agreement, however, that these
alternatives aim to reach a common goal, i.e.to ensure that States incorporate in their treaties
sufficient safeguards to prevent treaty abuse, in particular as regards treaty shopping. For that
reason, the report recommends a minimum level of protection that should be implemented
(see paragraph22 below).
Further work to be done

7. Additional work needs to be done on certain issues related to the contents of this
report.
8. First, at the end of May 2015, the United States released, for public comments to
be sent by 15September 2015, a new version of its limitation-on-benefits (LOB) rule
and of other provisions of its model tax treaty that are similar to provisions included
in this report.1 When these new United States provisions were discussed, it was agreed
that they should be further examined once finalised by the United States in the light of
the comments that will be received on them. For that reason, the parts of this report that
include the LOB rule, its Commentary and provisions similar to those that were released
by the United States in May 2015 will need to be reviewed after the adoption of this report.
The work on those provisions and the relevant part of the Commentary will be finalised
in the first part of 2016, which will allow them to be considered as part of the negotiation
of the multilateral instrument that will implement the results of the work on treaty issues
mandated by the BEPS Action Plan.
I ntroduction 15
9. Second, paragraph5of the previous version of this report indicated that further work
was needed with respect to the policy considerations relevant to the treaty entitlement of
collective investment vehicles (CIVs) and non-CIV funds. As a result of the follow-up
work on these issues and of the comments received from stakeholders, it was concluded
that there was general support for the conclusions included in the 2010 OECD Report The
Granting of Treaty Benefits with Respect to the Income of Collective Investment Vehicles
and that since subparagraph2f ) of the LOB rule included in this report dealt with the
application of the LOB to CIVs in a way that reflected the conclusions of the 2010 CIV
Report, there was no need for additional changes to the report on Action6 in order to
address issues related to collective investment vehicles, even though it was also agreed that
the implementation of the recommendations of the TRACE project were important for the
practical application of these conclusions.
10. The same conclusion could not be reached, however, as regards the policy considerations
relevant to the treaty entitlement of non-CIV funds and further work is needed in that area.
11. That work will first confirm the conclusions of the 2008 OECD report Tax Treaty
Issues Related to REITs, which deals with the treaty entitlement of Real Estate Investment
Trusts (REITs). Whilst the conclusions of the 2010 CIV Report have been confirmed as
part of the work on Action6, this has not been done with respect to the 2008 REIT Report.
It is therefore agreed to make the following change in the final version of the Commentary
of the LOB rule to be produced in 2016:
Add the following footnote to the first part of paragraph31of the Commentary on
subparagraph2f) of the LOB rule included in paragraph16of the Report on Action6
(the additional footnote appears in bold italics):
31. As indicated in the footnote to subparagraphf ), whether a specific rule
concerning collective investment vehicles (CIVs) should be included in paragraph2,
and, if so, how that rule should be drafted, will depend on how the Convention
applies to CIVs and on the treatment and use of CIVs in each Contracting State.1
Whilst no such rule will be needed with respect to an entity that would otherwise
constitute a qualified person under other parts of paragraph2, Such a specific
rule will frequently be needed since a CIV may not be a qualified person entitled
to treaty benefits under either the other provisions of paragraph2or under
paragraph3, because, in many cases
[Footnote 1] See also paragraphs67.1 to 67.7 of the Commentary on Article10
and the report Tax Treaty Issues Related to REITs which deal with the treaty
entitlement of Real Estate Investment Trusts (REITs). With respect to the application
of the definition of resident of a Contracting State to REITs, see paragraphs8-9
of the report Tax Treaty Issues Related to REITs.
12. Additional work will also ensure that a pension fund should be considered to be
a resident of the State in which it is constituted regardless of whether that pension fund
benefits from a limited or complete exemption from taxation in that State. This will be
done through changes to the OECD Model Tax Convention, to be also finalised in the
first part of 2016, that will ensure that outcome for funds that will meet a definition of
recognised pension fund which will likely include the following elements:
the definition will refer to entities or arrangement established in a State and
constituted and operated exclusively or almost exclusively to administer or provide
retirement or similar benefits to individuals;
16 I ntroduction
the entities or arrangements to which the definition will apply will need to be
treated as separate persons under the taxation laws of that State;
in order to cover only funds that the tax law recognises as pension funds, these
entities will need to be regulated as pensions funds by the State in which they are
established;
the definition will also need to cover entities and arrangements that are constituted
and operated exclusively or almost exclusively to invest funds for the benefit
of entities or arrangements that will themselves qualify as recognised pension
funds.
13. That definition will need to be accompanied by detailed Commentary that will
explain some of these requirements, in particular the requirement that a pension fund be
regulated as such. Consultation with stakeholders will be necessary to ensure that the
definition and its Commentary cover the main forms of pension funds that currently exist.
14. As regards the broader question of the treaty entitlement of non-CIV funds, the
OECD recognises the economic importance of these funds and the need to ensure that
treaty benefits be granted where appropriate. The new treaty provision on transparent
entities that is included in Part2 of the Report on Action2 (Neutralising the Effects of
Hybrid Mismatch Arrangements, OECD, 2015a) will be beneficial for non-CIV funds
that use entities that one or the two Contracting States treat as fiscally transparent since
income derived through such entities that will be taxed in the hands of the investors in
these entities will generally receive treaty entitlement at the level of these investors even
if these investors are residents of third States. Also, the possible inclusion of a derivative
benefits provision in the LOB rule to be finalised in the first part of 2016 will likely also
address some of the concerns regarding the treaty entitlement of non-CIV funds in which
there are non-resident investors. Notwithstanding this, however, there is a need to continue
to examine issues related to the treaty entitlement of non-CIV funds to ensure that the
new treaty provisions that are being considered adequately address the treaty entitlement
of non-CIVs. The continued examination of these issues would also address two general
concerns that governments have about granting treaty benefits with respect to non-CIVs:
that non-CIVs may be used to provide treaty benefits to investors that are not themselves
entitled to treaty benefits and that investors may defer recognition of income on which
treaty benefits have been granted. This work, which will also benefit from consultation
with stakeholders, will need to be completed in the first part of 2016 in order to be relevant
for the negotiation of the multilateral instrument.
SECTION A 17
A.
Treaty provisions and/or domestic rules to prevent the granting of treaty

benefits in inappropriate circumstances
15. In order to determine the best way to prevent the granting of treaty benefits in
inappropriate circumstances, it was found useful to distinguish two types of cases:
1. Cases where a person tries to circumvent limitations provided by the treaty itself.
2. Cases where a person tries to circumvent the provisions of domestic tax law using
treaty benefits.
16. Since the first category of cases involve situations where a person seeks to
circumvent rules that are specific to tax treaties, it is unlikely that these cases will be
addressed by specific anti-abuse rules found in domestic law. Although a domestic general
anti-abuse rule could prevent the granting of treaty benefits in these cases, a more direct
approach involves the drafting of anti-abuse rules to be included in treaties. The situation
is different in the second category of cases: since these cases involve the avoidance of
domestic law, they cannot be addressed exclusively through treaty provisions and require
domestic anti-abuse rules, which raises the issue of the interaction between tax treaties and
these domestic rules.
1. Cases where a person tries to circumvent limitations provided by the treaty

itself
a)
Treaty shopping
17. The first requirement that must be met by a person who seeks to obtain benefits
under a tax treaty is that the person must be a resident of a Contracting State, as defined
in Article4 of the OECD Model Tax Convention. There are a number of arrangements
through which a person who is not a resident of a Contracting State may attempt to obtain
benefits that a tax treaty grants to a resident of that State. These arrangements are generally
referred to as treaty shopping. Treaty shopping cases typically involve persons who are
residents of third States attempting to access indirectly the benefits of a treaty between two
Contracting States.2
18. The OECD has previously examined the issue of treaty shopping in different
contexts:
The concept of beneficial owner was introduced in the Model Tax Convention in
1977 in order to deal with simple treaty shopping situations where income is paid to
an intermediary resident of a treaty country who is not treated as the owner of that
income for tax purposes (such as an agent or nominee). At the same time, a short
new section on Improper Use of the Convention (which included two examples
of treaty shopping) was added to the Commentary on Article1 and the Committee
indicated that it intended to make an in-depth study of such problems and of other
ways of dealing with them.
18 SECTION A
That in-depth study resulted in the 1986 reports on Double Taxation and the Use of
Base companies and Double Taxation and the Use of Conduit Companies,3 the issue
of treaty shopping being primarily dealt with in the latter report.
In 1992, as a result of the report on Double Taxation and the Use of Conduit
Companies, various examples of provisions dealing with different aspects of treaty
shopping were added to the section on Improper Use of the Convention in the
Commentary on Article1. These included the alternative provisions currently
found in paragraphs13 to 19 of the Commentary on Article1 under the heading
Conduit company cases.
In 2003, as a result of the report Restricting the Entitlement to Treaty Benefits4
(which was prepared as a follow-up to the 1998 Report Harmful Tax Competition:
an Emerging Global Issue),5 new paragraphs intended to clarify the meaning of
beneficial owner in some conduit situations were added to the Commentary on
Articles10, 11 and 12 and the section on Improper Use of the Convention was
substantially extended to include additional examples of anti-abuse rules, including
a comprehensive limitation-on-benefits provision based on the provision found in
the 1996 US Model6 as well as a purpose-based anti-abuse provision based on UK
practice and applicable to Articles10, 11, 12 and 21.7
Finally, additional work on the clarification of the beneficial owner concept,
which resulted in changes to the Commentary on Articles10, 11 and 12 that were
included in the Model Tax Convention through the 2014 Update, has allowed the
OECD to examine the limits of using that concept as a tool to address various
treaty-shopping situations. As indicated in paragraph12.5 of the Commentary on
Article10, [w]hilst the concept of beneficial owner deals with some forms of
tax avoidance (i.e.those involving the interposition of a recipient who is obliged
to pass on the dividend to someone else), it does not deal with other cases of treaty
shopping and must not, therefore, be considered as restricting in any way the
application of other approaches to addressing such cases.
19. A review of the treaty practices of OECD and non-OECD countries shows that
countries use different approaches to try to address treaty shopping cases not already
dealt with by the provisions of the Model Tax Convention. Based on the advantages and
limitations of these approaches, it is recommended that the following three-pronged
approach be used to address treaty shopping situations:
First, a clear statement that the Contracting States, when entering into a treaty, wish
to prevent tax avoidance and, in particular, intend to avoid creating opportunities
for treaty shopping will be included in tax treaties (see SectionB of this report).
Second, a specific anti-abuse rule based on the limitation-on-benefits provisions
included in treaties concluded by the United States and a few other countries (the
LOB rule) will be included in the OECD Model. Such a specific rule will address
a large number of treaty shopping situations based on the legal nature, ownership
in, and general activities of, residents of a Contracting State (see subsection A.1(a)
(i) below).
Third, in order to address other forms of treaty abuse, including treaty shopping
situations that would not be covered by the LOB rule described in the preceding
bullet point (such as certain conduit financing arrangements), a more general antiabuse rule based on the principal purposes of transactions or arrangements (the
principal purposes test or PPT rule) will be included in the OECD Model. That
SECTION A 19
rule will incorporate the principles already reflected in paragraphs9.5, 22, 22.1
and 22.2 of the Commentary on Article1, according to which the benefits of a tax
treaty should not be available where one of the principal purposes of arrangements
or transactions is to secure a benefit under a tax treaty and obtaining that benefit
in these circumstances would be contrary to the object and purpose of the relevant
provisions of the tax treaty (see subsection A.1(a)(ii) below).
20. The combination of the LOB and the PPT rules described above recognises that each
rule has strengths and weaknesses. For instance, the variousprovisions of the LOB rule are
based on objective criteria that providemore certainty than the PPT rule, which requires
a case-by-case analysis based on what can reasonably be considered to be one of the
principal purposes of transactions or arrangements. For that reason, the LOB rule is useful
as a specific anti-abuse rule aimed at treaty shopping situations that can be identified
on the basis of criteria based on the legal nature, ownership in, and general activities
of, certain entities. The LOB rule, however, only focusses on treaty shopping and does
not address other forms of treaty abuses; it also does not address certain forms of treaty
shopping, such as conduit financing arrangements, through which a resident of Contracting
State that would otherwise qualify for treaty benefits is used as an intermediary by persons
who are not entitled to these benefits.
21. The combination of an LOB rule and a PPT rule may not be appropriate or necessary
for all countries. For instance, as mentioned in paragraph6above, some countries may
have domestic anti-abuse rules, or the courts of some countries may have developed
various interpretative tools (e.g.economic substance or substance-over-form), that
effectively address various forms of domestic law and treaty abuses and these countries
might not require the general treaty anti-abuse provision included in subsection A.1(a)(ii)
below or might prefer a more restricted form of that provision. It is also recognised that the
LOB rule will need to be adapted to reflect certain constraints or policy choices concerning
other aspects of a bilateral tax treaty between two Contracting States (e.g.constitutional
restrictions or concerns based on EU law or policy choices concerning the treatment of
collective investment vehicles).
22. As long as the approach that countries adopt effectively addresses treaty abuses
along the lines of this report, some flexibility is therefore possible. At a minimum,
however, countries should agree to include in their tax treaties an express statement that
their common intention is to eliminate double taxation without creating opportunities for
non-taxation or reduced taxation through tax evasion or avoidance, including through
treaty shopping arrangements (see SectionB); they should also implement that common
intention through either the combined approach described in paragraph19 (subject to the
necessary adaptations referred to in paragraph6above), the inclusion of the PPT rule or
the inclusion of the LOB rule supplemented by a mechanism (such as a treaty rule that
might take the form of a PPT rule restricted to conduit arrangements or domestic anti-abuse
rules or judicial doctrines that would achieve a similar result) that would deal with conduit
arrangements not already dealt with in tax treaties.
23. Countries commit to adopt in their bilateral treaties measures that implement the
minimum standard described in the preceding paragraph if requested to do so by other
countries that have made the same commitment and that will request the inclusion of
these measures. Whilst the way in which this minimum standard will be implemented
in each bilateral treaty will need to be agreed to between the Contracting States, this
commitment applies to existing and future treaties. Since the conclusion of a new treaty
and the modification of an existing treaty depend on the overall balance of the provisions
20 SECTION A
of a treaty, however, this commitment should not be interpreted as a commitment to
conclude new treaties or amend existing treaties within a specified period of time. Also, if
a country is not itself concerned by the effect of treaty-shopping on its own taxation rights
as a State of source, it will not be obliged to apply provisions such as the LOB or the PPT
as long as it agrees to include in a treaty provisions that its treaty partner will be able to
use for that purpose. Whilst the minimum standard will be included in the multilateral
instrument that will be negotiated pursuant to Action15 of the BEPS Action Plan, which
will provide an effective way to implement it swiftly, this may not be sufficient to ensure
its implementation since participation in the multilateral instrument is not mandatory and
two countries that are parties to an existing treaty may have different preferences as to how
the minimum standard should be met; monitoring of the implementation of the minimum
standard will therefore be necessary.
24. Other changes included in this report will also assist in preventing treaty shopping.
For instance, the new specific treaty anti-abuse rules included in subsection A.1(b) will
deal with some specific forms of treaty shopping, such as strategies aimed at using a
permanent establishment located in a low-tax jurisdiction in order to take advantage of
the exemption method applicable by a Contracting State. SectionC, which includes tax
policy considerations that, in general, States should consider before deciding to enter into
a tax treaty with another country, may also contribute to the reduction of treaty shopping
opportunities. Conversely, the approach described in paragraph19above is not restricted to
treaty shopping cases and will also contribute to preventing the granting of treaty benefits
in other inappropriate circumstances, this being particularly the case of the general treaty
anti-abuse provision referred to at the end of that paragraph.
i)
Limitation-on-benefits rule
25. As indicated in paragraph19, a specific anti-abuse rule aimed at treaty shopping,

the LOB rule, will be included in the OECD Model. That rule will be based on provisions
already found in a number of tax treaties, including primarily treaties concluded by the
United States but also some treaties concluded by Japan and India. The detailed LOB
provisions and related Commentary included below reflect the detailed provision that was
included in the first version of this report released in September 2014 as modified as a
result of subsequent work on various aspects of that provision, including the addition of
a simplified version of the rule released in May 2015. At the end of May 2015, however,
the United States released a new version of the LOB rule included in its model treaty8 for
public comments to be sent by 15September 2015. When that new version was discussed,
it was agreed that it should be further examined once finalised by the United States in
the light of the comments that will be received on it. For that reason, the detailed LOB
provisions below and the Commentary on these provisions will need to be reviewed.
The simplified LOB provisions will also require further work and Commentary on those
provisions will be drafted. The final version of the provisions and the Commentary will be
produced in the first part of 2016, which will allow the new provisions to be considered as
part of the negotiation of the multilateral instrument that will implement the results of the
work on treaty issues mandated by the BEPS Action Plan. The following should therefore
be considered as a draft subject to changes:
SECTION A 21
ARTICLE X
ENTITLEMENT TO BENEFITS9
[1.10 [Provision that would deny treaty benefits to a resident of a Contracting State
who is not a qualified person as defined in paragraph2]
2.
[Definition of situations where a resident would be a qualified person, which
would cover
a) an individual;
b) a Contracting State, its political subdivisions and entities that it wholly
owns;
c) certain publicly-listed entities and their affiliates
d) certain charities and pension funds
e) other entities that meet certain ownership requirements
f ) certain collective investment vehicles]
3.
[Provision that would provide treaty benefits to certain income derived by a
person that is not a qualified person if the person is engaged in the active conduct
of a business in its State of residence and the income is derived in connection with,
or is incidental to, that business]
4.
[Provision that would provide treaty benefits to a person that is not a
qualified person if at least more than an agreed proportion of that entity is owned
by certain persons entitled to equivalent benefits]
5.
[Provision that would allow the competent authority of a Contracting State to
grant certain treaty benefits to a person where benefits would otherwise be denied
under paragraphs1 to 4]
6.
[Definitions applicable for the purposes of paragraphs1 to 5]
Add the following new Commentary on Article [X] to the Commentary of the OECD
Model Tax Convention:
[COMMENTARY ON ARTICLE [X]
CONCERNING THE ENTITLEMENT TO TREATY BENEFITS
Preliminary remarks
1.
As explained in the footnote to the Article, Article [X] reflects the
intention of the Contracting States to eliminate double taxation without creating
opportunities for non-taxation or reduced taxation through tax evasion or
avoidance, including through treaty shopping arrangements. The drafting of this
Article will depend on how the Contracting States decide to do so. Depending on
their own circumstances, States may wish to adopt only the general anti-abuse
rule of paragraph7of the Article, may prefer instead to adopt the detailed version
of paragraphs1 to 6 that is described below, which they would supplement by a
mechanism that would address specific conduit arrangements, or may prefer to
22 SECTION A
include in their treaty the general anti-abuse rule of paragraph7together with
any variation of paragraphs1 to 6 described below.
2. A State may prefer the last approach described above because it
combines the flexibility of a general rule that can prevent a large number of
abusive transactions with the certainty of a more automatic rule that prevent
transactions that are known to cause treaty shopping concerns and that can be
easily described by reference to certain features (such as the foreign ownership
of an entity). That last approach is reflected in the simplified version of
paragraphs1 to 6 reproduced below, which should only be used in combination
with the general rule of paragraph7. Such a combination should not be construed
in any way as restricting the scope of the general anti-abuse rule of paragraph7:
a transaction or arrangement should not be considered to be outside the scope of
paragraph7simply because the specific anti-abuse rules of paragraphs1 to 6,
which only deal with certain cases of treaty shopping that can be easily identified
by certain of their features, are not applicable.
3.
A State may, however, prefer to deal with treaty-shopping without the
general anti-abuse rule of paragraph7, relying instead on the specific antiabuse rules of paragraphs1 to 6, together with a mechanism that will address
conduit arrangements that would escape the application of these paragraphs.
This may be the case of a State whose domestic law includes strong anti-abuse
rules that are sufficient to deal with other forms of treaty abuses. States that
adopt that approach will need to ensure that the version of paragraph1to 6
that they include in their bilateral conventions is sufficiently robust to prevent
most forms of treaty shopping. For this reason, the paragraphs below provide
different versions of the provisions of paragraphs1 to6, the more robust version
of these paragraphs mentioned above being referred to as the detailed version.
States that do not wish to include paragraph7for the reasons explained in this
paragraph should adopt the detailed version, as opposed to the simplified
version, subject to any adaptations referred to in the Commentary below.
3.1 This Article contains provisions that are intended to prevent various forms
of treaty shopping through which persons who are not residents of a Contracting
State might establish an entity that would be a resident of that State in order to
reduce or eliminate taxation in the other Contracting State through the benefits
of the tax treaty concluded between these two States. Allowing persons who are
not directly entitled to treaty benefits (such as the reduction or elimination of
withholding taxes on dividends, interest or royalties) to obtain these benefits
indirectly through treaty shopping would frustrate the bilateral and reciprocal
nature of tax treaties. If, for instance, a State knows that its residents can
indirectly access the benefits of treaties concluded by another State, it may have
little interest in granting reciprocal benefits to residents of that other State
through the conclusion of a tax treaty. Also, in such a case, the benefits that
would be indirectly obtained may not be appropriate given the nature of the tax
system of the former State; if, for instance, that State does not levy an income tax
on a certain type of income, it would be inappropriate for its residents to benefit
from the provisions of a tax treaty concluded between two other States that grant
a reduction or elimination of source taxation for that type of income and that
were designed on the assumption that the two Contracting States would tax such
income.
SECTION A 23
3.2 The provisions of the Article seek to deny treaty benefits in the case
of structures that typically result in the indirect granting of treaty benefits to
persons that are not directly entitled to these benefits whilst recognising that in
some cases, persons who are not residents of a Contracting State may establish
an entity in that State for legitimate business reasons. Although these provisions
apply regardless of whether or not a particular structure was adopted for treatyshopping purposes, the Article allows the competent authority of a Contracting
State to grant treaty benefits where the other provisions of the Article would
otherwise deny these benefits but the competent authority determines that the
structure did not have as one of its principal purposes the obtaining of benefits
under the Convention.
3.3 The Article restricts the general scope of Article1, according to which
the Convention applies to persons who are residents of a Contracting State.
Paragraph1 of the Article provides that a resident of a Contracting State shall
not be entitled to the benefits of the Convention unless it constitutes a qualified
person under paragraph2or unless benefits are granted under the provisions
of paragraphs3, 4 or 5. Paragraph2 determines who constitutes a qualified
person by reference to the nature or attributes of various categories of persons;
any person to which that paragraph applies is entitled to all the benefits of
the Convention. Under paragraph3, a person is entitled to the benefits of the
Convention with respect to an item of income even if it does not constitute a
qualified person under paragraph2as long as that item of income is derived
in connection with the active conduct of a trade or business in that persons State
of residence (subject to certain exceptions). Paragraph4 is a derivative benefits
rule that allows certain entities owned by residents of third States to obtain treaty
benefits provided that these residents would have been entitled to equivalent
benefits if they had invested directly. Paragraph5 includes the provisions that
allow the competent authority of a Contracting State to grant treaty benefits
where the other provisions of the Article would otherwise deny these benefits.
Paragraph6 includes a number of definitions that apply for the purposes of the
Article.
Provision denying treaty benefits to a resident of a Contracting State who is not a
qualified person
Simplified version
1. Except as otherwise provided in this Article, a resident of a Contracting
State shall be entitled to the benefits that would otherwise be accorded by this
Convention only if such resident is a qualified person.
Detailed version
1. Except as otherwise provided in this Article, a resident of a Contracting
State shall not be entitled to a benefit that would otherwise be accorded
by this Convention (other than a benefit under paragraph3of Article4,
paragraph2of Article9 or Article25), unless such resident is a qualified
person, as defined in paragraph2, at the time that the benefit would be
accorded.
24 SECTION A
Commentary on the detailed version
4.
Paragraph1 provides that a resident of a Contracting State, as defined
under Article4, will be entitled to the benefits otherwise accorded to residents
of a Contracting State under the Convention only if it constitutes a qualified
person under paragraph2or unless benefits are otherwise granted under
paragraphs3, 4 or 5. The benefits otherwise accorded to a resident of a
Contracting State under the Convention include all limitations to the Contracting
States taxing rights under Articles6 through 21, the elimination of double
taxation provided by Article23 and the protection afforded to residents of a
Contracting State under Article24. The Article does not, however, restrict the
availability of treaty benefits under paragraph3of Article4, paragraph2of
Article9 or Article25 or under the few provisions of the Convention that do not
require that a person be a resident of Contracting State in order to enjoy the
benefits of those provisions (e.g.the provisions of paragraph1of Article24, to
the extent that they apply to nationals who are not residents of either Contracting
State).
5.
Paragraph1 does not extend in any way the scope of the benefits granted
by the Convention. Thus, a resident of a Contracting State who constitutes a
qualified person under paragraph2must still meet the conditions of the other
provisions of the Convention in order to obtain these benefits (e.g.that resident
must be the beneficial owner of dividends in order to benefit from the provisions
of paragraph2of Article10) and these benefits may be denied or restricted under
applicable anti-abuse rules.
6.
Paragraph1 applies at any time when the Convention would otherwise
provide a benefit to a resident of a Contracting State. Thus, for example, it
applies at the time when income to which Article6 applies is derived by a resident
of a Contracting State, at the time that dividends to which Article10 applies are
paid to a resident of a Contracting State or at any time when profits to which
Article7 applies are made. The paragraph requires that, in order to be entitled
to the benefit provided by the relevant provision of the Convention, the resident
of the Contracting State must be a qualified person, within the meaning of
paragraph2, at the relevant time. In some cases, however, the definition of
qualified person requires that a resident of a Contracting State must satisfy
certain conditions over a period of time in order to constitute a qualified
person at a given time.
Situations where a resident is a qualified person
Simplified version
2. For the purposes of this Article, a resident of a Contracting State shall
be a qualified person if the resident is either:
Detailed version
2. A resident of a Contracting State shall be a qualified person at a time
when a benefit would otherwise be accorded by the Convention if, at that
time, the resident is:
SECTION A 25

7.
Paragraph2 has six subparagraphs, each of which describes a category
of residents that are qualified persons.
8.
It is intended that the provisions of paragraph2will be self-executing.
Unlike the provisions of paragraph5, discussed below, claiming benefits under
paragraph2does not require advance competent authority ruling or approval.
The tax authorities may, of course, on review, determine that the taxpayer has
improperly interpreted the paragraph and is not entitled to the benefits claimed.
Individuals
a) an individual;
9.
Subparagraph2a) provides that any individual who is a resident of a
Contracting State will be a qualified person. As explained in paragraph35below,
under some treaty provisions, a collective investment vehicle must be treated as
an individual for the purposes of applying the relevant treaty; where that is the
case, such a collective investment vehicle will therefore constitute a qualified
person by virtue of subparagrapha).
Governments
Simplified version
b) that Contracting State, any political subdivision or local authority
thereof, the central bank thereof or a person that is wholly owned,
directly or indirectly, by that State or any political subdivision or local
authority thereof;
Detailed version
b)
a Contracting State, or a political subdivision or local authority thereof,

or a person that is wholly-owned by such State, political subdivision or
local authority;

10. Subparagraph2b) provides that the Contracting States and any
political subdivision or local authority thereof constitute qualified persons. The
subparagraph applies to any part of a State, such as an agency or instrumentality
that does not constitute a separate person. The last part of the subparagraph
provides that a separate legal person which constitutes a resident of a Contracting
State and is wholly-owned by a Contracting State, or a political subdivision
or local authority thereof, will also be a qualified person and, therefore, will
be entitled to all the benefits of the Convention whilst it qualifies as such. The
wording of the subparagraph may need to be adapted to reflect the different legal
nature that State-owned entities, such as sovereign wealth funds, may have in
the Contracting States as well as the different views that these States may have
concerning the application of Article4 to these entities (see paragraphs6.35 to
6.39 of the Commentary on Article1 and paragraphs8.5 to 8.7 of the Commentary
on Article4).
26 SECTION A
Publicly-traded companies and entities
Simplified version
c)
a company, if the principal class of its shares is regularly traded on one

or more recognised stock exchanges;
d) a person other than a company, if its beneficial interests are regularly

traded on one or more recognised stock exchanges;
Detailed version
c)
a company or other entity, if, throughout the taxable period that includes
that time
i) the principal class of its shares (and any disproportionate class
of shares) is regularly traded on one or more recognised stock
exchanges, and either:
A) its principal class of shares is primarily traded on one or more
recognised stock exchanges located in the Contracting State of
which the company or entity is a resident; or
B) the companys or entitys primary place of management and
control is in the Contracting State of which it is a resident; or
ii) at least 50per cent of the aggregate voting power and value of
the shares (and at least 50per cent of any disproportionate class
of shares) in the company or entity is owned directly or indirectly
by five or fewer companies or entities entitled to benefits under
subdivision i) of this subparagraph, [provided that, in the case of
indirect ownership, each intermediate owner is a resident of either
Contracting State];

11. Subparagraphc) recognises that, as a general rule, because the shares
of publicly-traded companies and of some entities are generally widely-held,
these companies and entities are unlikely to be established for treaty shopping.
The provisions of subdivision i) apply to publicly-traded companies and entities
and the provisions of subdivision ii) apply to subsidiaries of publicly-traded
companies and entities. As indicated in subparagraphh) of paragraph6, for the
purposes of subparagraphc), the term shares covers comparable interests in
entities, other than companies, to which the subparagraph applies; this includes,
for example, publicly-traded units of a trust.
12. Subdivision i) provides that a company or entity resident in a Contracting
State constitutes a qualified person at a time when a benefit is provided by the
Convention if, throughout the taxable period that includes that time, the principal
class of its shares, and any disproportionate class of shares, is regularly traded
on one or more recognised stock exchanges, provided that the company or entity
also satisfies at least one of the following additional requirements: first, the
companys or entitys principal class of shares is primarily traded on one or
more recognised stock exchanges located in the Contracting State of which the
company or entity is a resident or, second, the companys or entitys primary
place of management and control is in its State of residence. These additional
SECTION A 27
requirements take account of the fact that whilst a publicly-traded company or

entity may be technically resident in a given State, it may not have a sufficient
relationship with that State to justify allowing such a company or entity to obtain
the benefits of treaties concluded by that State. Such a sufficient relationship
may be established by the fact that the shares of the publicly-traded company
or entity are primarily traded in recognised stock exchanges situated in the
State of residence of the company or entity; given the fact that the globalisation
of financial markets means that shares of publicly-listed companies that are
residents of some States are often traded on foreign stock exchanges, the
alternative test provides that this sufficient relationship may also be established
by the fact that the company or entity is primarily managed and controlled in its
State of residence.
13. A company or entity whose principal class of shares is regularly traded
on a recognised stock exchange will nevertheless not qualify for benefits under
subparagraphc) of paragraph2if it has a disproportionate class of shares that
is not regularly traded on a recognised stock exchange.
14. The terms recognised stock exchange, principal class of shares and
disproportionate class of shares are defined in paragraph6 (see below). As
indicated in these definitions, the principal class of shares of a company must
be determined after excluding special voting shares which are issued as a means
of establishing a dual listed company arrangement, which is also defined in
paragraph6.
15. The regular trading requirement can be met by trading of issued shares
on any recognised exchange or exchanges located in either State. Trading on
one or more recognised stock exchanges may be aggregated for purposes of this
requirement; a company or entity could therefore satisfy this requirement if its
shares are regularly traded, in whole or in part, on a recognised stock exchange
located in the other Contracting State.
16. Subdivision (i)A) includes the additional requirement that the shares
of the company or entity be primarily traded in one or more recognised stock
exchanges located in the State of residence of the company or entity. In general,
the principal class of shares of a company or entity are primarily traded on
one or more recognised stock exchanges located in the State of residence of that
company or entity if, during the relevant taxation year, the number of shares in
the companys or entitys principal class of shares that are traded on these stock
exchanges exceeds the number of shares in the companys or entitys principal
class of shares that are traded on established securities markets in any other
State. Some States, however, consider that the fact that shares of a company or
entity resident in a Contracting State are primarily traded on recognised stock
exchanges situated in other States (e.g.in a State that is part of the European
Economic Area within which rules relating to stock exchanges and securities
create a single market for securities trading) constitutes a sufficient safeguard
against the use of that company or entity for treaty-shopping purposes; States
that share that view may modify subdivision (i)A) accordingly.
17. Subdivision (i)B) provides the alternative requirement applicable to a
company or entity whose principal class of shares is regularly traded on recognised
stock exchanges but not primarily traded on recognised stock exchanges situated
in the State of residence of the company or entity. Such a company or entity may
28 SECTION A
claim treaty benefits if its primary place of management and control (as defined
in subparagraphd) of paragraph6) is in its State of residence.
18. The conditions of subparagraphc) must be satisfied throughout the
taxable period of the company or entity. This does not require that the shares of
the company or entity be traded on the relevant stock exchanges each day of the
relevant period. For shares to be considered as regularly traded on one or more
stock exchanges throughout the taxable period, it is necessary that more than a
very small percentage of the shares be actively traded during a sufficiently large
number of days included in that period. The test would be met, for example, if
10per cent of the average number of outstanding shares of a given class of shares
of a company were traded during 60 days of trading taking place in the taxable
period of the company. The phrase taxable period in subparagraphs c) and
e) refers to the period for which an annual tax return must be filed in the State
of residence of the company or entity. If the Contracting States have a concept
corresponding to taxable period in their domestic law, such as taxable year,
they are free to replace the reference to taxable period by that other concept.
19. A company resident in a Contracting State is entitled to all the benefits
of the Convention under subdivision ii) of subparagraphc) of paragraph2if
five or fewer publicly-traded companies described in subdivision i) are the direct
or indirect owners of at least 50per cent of the aggregate vote and value of
the companys shares (and at least 50per cent of any disproportionate class of
shares). If the publicly-traded companies are indirect owners, however, each of
the intermediate companies must be a resident of one of the Contracting States.
Some States, however, consider that this last requirement is unduly restrictive
and prefer to omit it.
20. Thus, for example, a company that is a resident of a Contracting State,
all the shares of which are owned by another company that is a resident of the
same State, would qualify for benefits under the Convention if the principal
class of shares (and any disproportionate classes of shares) of the parent
company are regularly and primarily traded on a recognised stock exchange in
that Contracting State. Such a subsidiary would not qualify for benefits under
subdivision ii), however, if the publicly-traded parent company were a resident
of a third State, for example, and not a resident of one of the Contracting States.
Furthermore, if a parent company in one of the Contracting States indirectly
owned the bottom-tier company through a chain of subsidiaries, each such
subsidiary in the chain, as an intermediate owner, must be a resident of either
Contracting State in order for the subsidiary to meet the test in subdivision ii). As
explained in the previous paragraph, however, some States consider that, in the
case of publicly-listed companies, the condition that each subsidiary in the chain
must be a resident of either Contracting State is not necessary in order to prevent
treaty shopping; these States therefore prefer to omit that additional condition.
Charitable organisations and pension funds
Detailed version
d) a person, other than an individual, that
i) is a [list of the relevant non-profit organisations found in each
Contracting State],
SECTION A 29
ii) is a recognised pension fund, provided that more than 50per cent
of the beneficial interests in that person are owned by individuals
resident of either Contracting State, or more than [__ per cent]
of the beneficial interests in that person are owned by individuals
resident of either Contracting State or of any other State with
respect to which the following conditions are met
A) individuals who are residents of that other State are entitled to
the benefits of a comprehensive convention for the avoidance
of double taxation between that other State and the State from
which the benefits of this Convention are claimed, and
B) with respect to income referred to in Articles10 and 11 of this
Convention, if the person were a resident of that other State
entitled to all the benefits of that other convention, the person
would be entitled, under such convention, to a rate of tax with
respect to the particular class of income for which benefits are
being claimed under this Convention that is at least as low as the
rate applicable under this Convention; or
iii) was constituted and is operated to invest funds for the benefit of
persons referred to in subdivision ii), provided that substantially all
the income of that person is derived from investments made for the
benefit of these persons;
21. Subparagraph2d) provides rules under which certain non-profit
organisations and pension funds that qualify as resident of a Contracting State (see
paragraphs8.6 and 8.7 of the Commentary on Article4) will be entitled to all the
benefits of the Convention.
22. Entities listed in subdivision i) automatically qualify for treaty benefits
without regard to the residence of their beneficiaries or members. These entities
would generally correspond to those that are exempt from tax in their State of
residence and that are constituted and operated exclusively to fulfil certain social
functions (e.g.charitable, scientific, artistic, cultural, or educational).
23. Under subdivision ii), a resident pension fund will qualify for treaty
benefits if more than 50per cent of the beneficial interests in that person are
owned by individuals resident of either Contracting State or if more than a
certain percentage of these beneficial interests, to be determined during bilateral
negotiations, are owned by such residents or by individuals who are residents
of third States provided that, in the latter case, two additional conditions are
met: first, these individuals are entitled to the benefits of a comprehensive tax
convention concluded between that third State and the State of source and,
second, that convention provides for a similar or greater reduction of source
taxes on interest and dividends derived by pension funds of that third State. For
purposes of this provision, the term beneficial interests in that person should
be understood to refer to the interests held by persons entitled to receive pension
benefits from the fund. Some States, however, consider that the risk of treaty
shopping by recognised pension funds does not warrant the costs of compliance
inherent in requiring funds to identify the treaty residence and entitlement of the
30 SECTION A
individuals entitled to receive pension benefits. States that share that view may
modify subdivision(ii) accordingly.
24. Subdivision iii) constitutes an extension of the rule of subdivision ii)
applicable to pension funds. It applies to so-called funds of funds, which
are funds which do not directly provide pension benefits to residents of either
Contracting State but are constituted and operated to invest funds of pension
funds that are themselves pension funds qualifying for benefits under subdivision
ii). Subdivision iii) only applies, however, if substantially all the income of such
a fund of funds is derived from investments made for the benefit of pension
funds qualifying for benefits under subdivision ii).
Ownership / Base Erosion
Simplified version
e) a person other than an individual, provided that persons who are
residents of that Contracting State and are qualified persons by reason
of subparagraphs a) to d) own, directly or indirectly, more than 50per
cent of the beneficial interests of the person
Detailed version
e)
a person other than an individual, if

i) on at least half the days of the taxable period, persons who are
residents of that Contracting State and that are entitled to the
benefits of this Convention under subparagrapha), b) or d), or
subdivision i) of subparagraphc), of this paragraph own, directly
or indirectly, shares representing at least 50per cent of the
aggregate voting power and value (and at least 50per cent of any
disproportionate class of shares) of the person, [provided that, in the
case of indirect ownership, each intermediate owner is a resident of
that Contracting State], and
ii) less than 50per cent of the persons gross income for the taxable
period, as determined in the persons Contracting State of residence,
is paid or accrued, directly or indirectly, to persons who are not
residents of either Contracting State entitled to the benefits of this
Convention under subparagrapha), b) or d), or subdivision i) of
subparagraphc), of this paragraph in the form of payments that are
deductible for purposes of the taxes covered by this Convention in
the persons Contracting State of residence (but not including arms
length payments in the ordinary course of business for services or
tangible property);

25. Subparagraph2e) provides an additional method to qualify for treaty
benefits that applies to any form of legal entity that is a resident of a Contracting
State. The test provided in subparagraphe), the so-called ownership and base
erosion test, is a two-part test; both parts must be satisfied for the resident to be
entitled to treaty benefits under subparagraph2e).
SECTION A 31
26. Under subdivision i), which is the ownership part of the test, 50per cent or
more of each class of shares in the person must be owned, directly or indirectly,
on at least half the days of the persons taxable period, by persons who are
residents of the Contracting State of which that person is a resident and that
are themselves entitled to treaty benefits under subparagraphs a), b) or d), or
subdivision i) of subparagraphc). In the case of indirect owners, however, each
of the intermediate owners must be a resident of that Contracting State. Some
States, however, consider that this last requirement is unduly restrictive and
prefer to omit it.
27. Whilst subdivision i) will typically be relevant in the case of private
companies, it may also apply to an entity such as a trust that is a resident
of a Contracting State and that otherwise satisfies the requirements of this
subdivision. According to subparagraphh) of paragraph6, the reference to
shares, in the case of entities that are not companies, means interests that
are comparable to shares; this would generally be the case of the beneficial
interests in a trust. For the purposes of subdivision i), the beneficial interests in
a trust will be considered to be owned by its beneficiaries in proportion to each
beneficiarys actuarial interest in the trust. The interest of a beneficiary entitled
to the remaining part of a trust will be equal to 100per cent less the aggregate
percentages held by income beneficiaries. A beneficiarys interest in a trust will
not be considered to be owned by a person entitled to benefits under the other
provisions of paragraph2if it is not possible to determine the beneficiarys
actuarial interest. Consequently, if it is not possible to determine the actuarial
interest of the beneficiaries in a trust, the ownership test under subdivision
i) cannot be satisfied, unless all possible beneficiaries are persons entitled to
benefits under the other subparagraphs of paragraph2.
28. Subdivision ii), which constitutes the base erosion part of the test, is
satisfied with respect to a person if less than 50per cent of the persons gross
income for the taxable period, as determined under the tax law in the persons
State of residence, is paid or accrued to persons who are not residents of either
Contracting State entitled to benefits under subparagraphs a), b) or d), or
subdivision i) of subparagraphc), in the form of payments deductible for tax
purposes in the payers State of residence.
29. For the purposes of the test in subdivision ii), deductible (i.e.baseeroding) payments do not include arms-length payments in the ordinary course
of business for services or tangible property. To the extent they are deductible
from the taxable base under the tax law in the persons State of residence,
trust distributions constitute such base-eroding payments. Depreciation and
amortisation deductions, which do not represent payments or accruals to other
persons, are not taken into account for the purposes of subdivision ii). Income
that is subjected to full taxation in the State of source should not be considered
to be a base-eroding payment even if it is deductible by the payer. For example,
the payment of a group contribution that may be made by a company that is a
resident of a Contracting State to the permanent establishment, situated in the
same State, of a non-resident company that is part of the same group should
not be taken into account as such a payment would be taxable in the same State
where it would be deducted.
32 SECTION A
30. The ownership and base erosion tests included in subparagraphe) require
a determination for each taxable period of the entity; when these tests are met
for a given taxable period, the entity constitutes a qualified person at any time
within that taxable period. The taxable period to which subparagraphe) refers is
determined by the taxation law of the State of residence of the entity.
Collective investment vehicles subparagraph2f)
Detailed version
f)
[possible provision on collective investment vehicles]1

[Footnote 1] This subparagraph should be drafted (or omitted) based on how
collective investment vehicles are treated in the Convention and are used and
treated in each Contracting State: see the Commentary on the subparagraph
and paragraphs6.4 to 6.38 of the Commentary on Article1.

31. As indicated in the footnote to subparagraphf), whether a specific
rule concerning collective investment vehicles (CIVs) should be included in
paragraph2, and, if so, how that rule should be drafted, will depend on how
the Convention applies to CIVs and on the treatment and use of CIVs in each
Contracting State. Such a specific rule will frequently be needed since a CIV may
not be a qualified person under either the other provisions of paragraph2or 3,
because, in many cases
the interests in the CIV are not publicly-traded (even though these
interests are widely distributed);
these interests are held by residents of third States;
the distributions made by the CIV are deductible payments, and
the CIV is used for investment purposes rather than for the active
conduct of a business within the meaning of paragraph3.
32. Paragraphs6.8 to 6.34 of the Commentary on Article1 discuss various
factors that should be considered for the purpose of determining the treaty
entitlement of CIVs and these paragraphs are therefore relevant when determining
whether a provision on CIVs should be included in paragraph2and how it should
be drafted. These paragraphs include alternative provisions that may be used
to deal adequately with the CIVs that are found in each Contracting State. As
explained below, the use of these provisions may make it unnecessary to include a
specific rule on CIVs in paragraph2, although it will be important to make sure
that, in such a case, the definition of equivalent beneficiary, if the term is used
for the purposes of one of these alternative provisions, is adapted to reflect the
definition included in paragraph6.
33. If it is included, subparagraphf) will address cases where a Contracting
State agrees that CIVs established in the other Contracting State constitute
residents of that other State under the analysis in paragraphs6.9 to 6.12 of
the Commentary on Article1 (such agreement may be evidenced by a mutual
agreement as envisaged in paragraph6.16 of the Commentary on Article1 or
may result from judicial or administrative pronouncements). The provisions of
SECTION A 33
the Article, including subparagraphf), are not relevant with respect to a CIV
that does not qualify as a resident of a Contracting State under the analysis in
paragraphs6.9 to 6.12 of the Commentary on Article1. Also, the provisions of
subparagraphf) are not relevant where the treaty entitlement of a CIV is dealt
with under a treaty provision similar to one of the alternative provisions in
paragraphs6.17, 6.21, 6.26, 6.27 and 6.32 of the Commentary on Article1.
34. As explained in paragraphs6.19 and 6.20 of the Commentary on Article1,
Contracting States wishing to address the issue of CIVs entitlement to treaty
benefits may want to consider the economic characteristics, including the
potential for treaty shopping, of the different types of CIVs that are used in each
Contracting State.
35. As a result of that analysis, they may conclude that the tax treatment of
CIVs established in the two States does not give rise to treaty-shopping concerns
and decide to include in their bilateral treaty the alternative provision in
paragraph6.17 of the Commentary on Article1, which would expressly provide
for the treaty entitlement of CIVs established in each State and, at the same time,
would ensure that they constitute qualified persons under subparagrapha) of
paragraph2of the Article (because a CIV to which that alternative provision
would apply would be treated as an individual). In such a case, subparagraphf)
should be omitted. States that share the view that CIVs established in the two
States do not give rise to treaty shopping concerns but that do not include in their
treaty the alternative provision in paragraph6.17 of the Commentary on Article1
should ensure that any CIV that is a resident of a Contracting State should
constitute a qualified person. In that case, subparagraphf) should be drafted as
follows:
f) a CIV [a definition of CIV would be included in subparagraphf) of
paragraph6];
36. The Contracting States could, however, conclude that CIVs present the
opportunity for residents of third States to receive treaty benefits that would not
have been available if these residents had invested directly and, for that reason,
might prefer to draft subparagraphf) in a way that will ensure that a CIV that
is a resident of a Contracting State will constitute a qualified person but only
to the extent that the beneficial interests in the CIV are owned by equivalent
beneficiaries. In that case, subparagraphf) should be drafted as follows:
f) a collective investment vehicle, but only to the extent that, at that
time, the beneficial interests in the CIV are owned by residents of
the Contracting State in which the collective investment vehicle is
established or by equivalent beneficiaries.
37. That treatment corresponds to the treatment that would result from the
inclusion in a tax treaty of a provision similar to the alternative provision in
paragraph6.21 of the Commentary on Article1. As explained in paragraphs6.18
to 6.24 of the Commentary on Article1, the inclusion of such an alternative
provision would provide a more comprehensive solution to treaty issues arising in
connection with CIVs because it would address treaty-shopping concerns whilst,
at the same time, clarifying the tax treaty treatment of CIVs in both Contracting
States. If that alternative provision is included in a tax treaty, subparagraphf)
would not be necessary as regards the CIVs to which that alternative provision
would apply: since that alternative provision provides that a CIV to which it
34 SECTION A
applies shall be treated as an individual (to the extent that the beneficial interests
in that CIV are owned by equivalent beneficiaries), that CIV will constitute a
qualified person under subparagrapha) of paragraph2of the Article.
38. The approach described in the preceding two paragraphs, like the
approach in paragraphs6.21, 6.26 and 6.28 of the Commentary on Article1,
makes it necessary for the CIV to make a determination, when a benefit is
claimed as regards a specific item of income, regarding the proportion of holders
of interests who would have been entitled to benefits had they invested directly.
As indicated in paragraph6.29 of the Commentary on Article1, however, the
ownership of interests in CIVs changes regularly, and such interests frequently
are held through intermediaries. For that reason, the CIV and its managers
often do not themselves know the names and treaty status of the beneficial
owners of interests. It would therefore be impractical for the CIV to collect
such information from the relevant intermediaries each time the CIV receives
income. Accordingly, Contracting States should be willing to accept practical
and reliable approaches that do not require such daily tracing. As indicated in
paragraph6.31 of the Commentary on Article1, the proportion of investors in
the CIV is likely to change relatively slowly even though the identity of individual
investors will change daily. For that reason, the determination of the extent to
which the beneficial interests in a CIV are owned by equivalent beneficiaries
should be made at regular intervals, the determination made at a given time
being applicable to payments received until the following determination. This
corresponds to the approach described in paragraph6.31 of the Commentary on
Article1, according to which:
it would be a reasonable approach to require the CIV to collect from
other intermediaries, on specified dates, information enabling the CIV
to determine the proportion of investors that are treaty-entitled. This
information could be required at the end of a calendar or fiscal year or,
if market conditions suggest that turnover in ownership is high, it could
be required more frequently, although no more often than the end of
each calendar quarter. The CIV could then make a claim on the basis
of an average of those amounts over an agreed-upon time period. In
adopting such procedures, care would have to be taken in choosing the
measurement dates to ensure that the CIV would have enough time to
update the information that it provides to other payers so that the correct
amount is withheld at the beginning of each relevant period.
39. Another view that Contracting States may adopt regarding CIVs is that
expressed in paragraph6.26 of the Commentary on Article1. Contracting States
that adopt that view may wish to draft subparagraphf) so that a CIV that is a
resident of a Contracting State would only constitute a qualified person to the
extent that the beneficial interests in that CIV are owned by residents of the
Contracting State in which the CIV is established. In that case, subparagraphf)
should be drafted as follows:
f) a collective investment vehicle, but only to the extent that, at that time,
the beneficial interests in the collective investment vehicle are owned
by residents of the Contracting State in which the collective investment
vehicle is established.
SECTION A 35
Since the inclusion of the alternative provision in paragraph6.26 of the

Commentary on Article1 would achieve the same result with respect to the
CIVs to which it would apply, subparagraphf) would not be necessary, if that
alternative provision is included in a treaty, as regards the CIVs to which that
provision would apply.
40. A variation on the preceding approach would be to consider that a CIV
that is a resident of a Contracting State should constitute a qualified person
if the majority of the beneficial interests in that CIV are owned by individuals
who are residents of the Contracting State in which the CIV is established. This
result could be achieved by omitting subparagraphf) and simply relying on the
application of subparagraph2) e) (the so-called ownership and base erosion test).
41. Another possible view that the Contracting States could adopt would be
to conclude that the fact that a substantial proportion of the CIVs investors are
treaty-eligible is adequate protection against treaty shopping, and thus that it is
appropriate to provide an ownership threshold above which benefits would be
provided with respect to all income received by a CIV. An alternative provision
that would ensure that result is included in paragraph6.27 of the Commentary
on Article1 and subparagraphf) would not be necessary, if the Contracting
States include that provision in their bilateral treaty, with respect to the CIVs to
which the provision would apply. If that provision is not included in the treaty,
the scope of subparagraphf) could be broadened in order to achieve a similar
result by referring to a collective investment vehicle, but only if [ ] per cent of
the beneficial interests in the collective investment vehicle are owned by residents
of the Contracting State in which the collective investment vehicle is established
and equivalent beneficiaries.
42. Similarly, the Contracting States may use the alternative provision in
paragraph6.32 of the Commentary on Article1 where they consider that a
publicly-traded collective investment vehicle cannot be used effectively for
treaty shopping because the shareholders or unit holders of such a collective
investment vehicle cannot individually exercise control over it. In such case,
subparagraphf) would not be necessary with respect to the CIVs to which the
alternative provision would apply. States that share that view but that have not
included the alternative provision in their treaty could draft subparagraphf) to
read:
f) a collective investment vehicle if the principal class of shares in
the collective investment vehicle is listed and regularly traded on a
recognised stock exchange.
43. Finally, as explained in paragraph6.25 of the Commentary on Article1,
States that share the concern described in that paragraph about the potential
deferral of taxation that could arise with respect to a CIV that is subject to no
or low taxation and that may accumulate its income rather than distributing it
on a current basis may wish to negotiate provisions that extend benefits only to
those CIVs that are required to distribute earnings currently. Depending on their
drafting, such provisions may render subparagraphf) unnecessary.
36 SECTION A
Active conduct of a business
Simplified version
4. a) A resident of a Contracting State that is neither a qualified person
nor entitled under paragraph3to a benefit that would otherwise be
accorded by this Convention with respect to an item of income shall
nevertheless be entitled to such benefit if the resident is carrying on
a business in the first-mentioned Contracting State (other than the
business of making or managing investments for the residents own
account, unless the business is carried on by a bank, an insurance
company, a registered securities dealer or any other institution agreed
upon by the Contracting States) and that item of income is derived in
connection with, or is incidental to, that business.

b) If a resident of a Contracting State derives an item of income from a

business carried on by that resident in the other Contracting State,
or derives an item of income arising in the other Contracting State
from a related enterprise of the resident, the conditions described in
subparagrapha) shall be considered to be satisfied with respect to
such item of income only if the business carried on by the resident in
the first-mentioned Contracting State is substantial in relation to the
business carried on by the resident or related enterprise in the other
Contracting State. Whether a business is substantial for the purpose of
this subparagraph shall be determined on the basis of all the facts and
circumstances.
c)
For the purposes of this paragraph, the business carried on by a
partnership in which a person is a partner and the business carried on
by related enterprises of a person shall be deemed to be carried on by
such person.
Detailed version
3. a) A resident of a Contracting State will be entitled to benefits of this
Convention with respect to an item of income derived from the other
Contracting State, regardless of whether the resident is a qualified
person, if the resident is engaged in the active conduct of a business
in the first-mentioned Contracting State (other than the business
of making or managing investments for the residents own account,
unless these activities are banking, insurance or securities activities
carried on by a bank or [list financial institutions similar to banks that
the Contracting States agree to treat as such], insurance enterprise
or registered securities dealer respectively), and the income derived
from the other Contracting State is derived in connection with, or is
incidental to, that business.

b) If a resident of a Contracting State derives an item of income from a

business activity conducted by that resident in the other Contracting
State, or derives an item of income arising in the other Contracting
State from an associated enterprise, the conditions described in
subparagrapha) shall be considered to be satisfied with respect to such
item only if the business activity carried on by the resident in the firstmentioned Contracting State is substantial in relation to the business
SECTION A 37
activity carried on by the resident or associated enterprise in the other

Contracting State. Whether a business activity is substantial for the
purposes of this paragraph will be determined based on all the facts
and circumstances.

c) For purposes of applying this paragraph, activities conducted by

persons connected to a person shall be deemed to be conducted by such
person. A person shall be connected to another if one possesses at least
50per cent of the beneficial interest in the other (or, in the case of a
company, at least 50per cent of the aggregate vote and value of the
companys shares or of the beneficial equity interest in the company) or
another person possesses at least 50per cent of the beneficial interest
(or, in the case of a company, at least 50per cent of the aggregate
voting power and value of the companys shares or of the beneficial
equity interest in the company) in each person. In any case, a person
shall be considered to be connected to another if, based on all the
relevant facts and circumstances, one has control of the other or both
are under the control of the same person or persons.

44. Paragraph3 sets forth an alternative test under which a resident of a
Contracting State may receive treaty benefits with respect to certain items of
income that are connected to an active business conducted in its State of residence.
This paragraph recognises that where an entity resident of a Contracting State
actively carries on business activities in that State, including activities conducted
by connected persons, and derives income from the other Contracting State in
connection with, or incidental to, such business activities, granting treaty benefits
with respect to such income does not give rise to treaty-shopping concerns
regardless of the nature and ownership of the entity. The paragraph will provide
treaty benefits in a large number of situations where benefits would otherwise be
denied under paragraph1because the entity is not a qualified person under
paragraph2.
45. A resident of a Contracting State may qualify for benefits under
paragraph3whether or not it also qualifies under paragraph2. Under the activeconduct test of paragraph3, a person (typically a company) will be eligible for
treaty benefits if it satisfies two conditions: (1)it is engaged in the active conduct
of a business in its State of residence; and (2)the payment for which benefits
are sought is related to the business. In certain cases, an additional requirement
that the business be substantial in size relative to the activity in the source State
generating the income must be met.
46. Subparagrapha) sets forth the general rule that a resident of a
Contracting State engaged in the active conduct of a business in that State may
obtain the benefits of the Convention with respect to an item of income derived
from the other Contracting State. The item of income, however, must be derived
in connection with, or be incidental to, that business.
47. The term business is not defined and, under the general rule of
paragraph2of Article3, must therefore be given the meaning that it has under
domestic law. An entity generally will be considered to be engaged in the active
conduct of a business only if persons through whom the entity is acting (such
38 SECTION A
as officers or employees of a company) conduct substantial managerial and
operational activities.
48. The business of making or managing investments for the residents own
account will be considered to be a business only when the relevant activities
are part of banking, insurance or securities activities conducted by a bank or
financial institution that the Contracting States would consider to be similar to
a bank (such as a credit union or building society), an insurance enterprise or
a registered securities dealer respectively. Such activities conducted by a person
other than a bank (or financial institution agreed to by the Contracting States),
insurance enterprise or registered securities dealer will not be considered to be
the active conduct of a business, nor would they be considered to be the active
conduct of a business if conducted by a bank (or financial institution agreed to
by the Contracting States), insurance enterprise or registered securities dealer
but not as part of the enterprises banking, insurance or dealer business. Since a
headquarters operation is in the business of managing investments, a company
that functions solely as a headquarters company will not be considered to be
engaged in the active conduct of a business for purposes of paragraph3.
49. An item of income is derived in connection with a business if the incomeproducing activity in the State of source is a line of business that forms a part
of or is complementary to the business conducted in the State of residence by
the income recipient.
50. A business activity generally will be considered to form part of a business
activity conducted in the State of source if the two activities involve the design,
manufacture or sale of the same products or type of products, or the provision of
similar services. The line of business in the State of residence may be upstream,
downstream, or parallel to the activity conducted in the State of source. Thus, the
line of business may provide inputs for a manufacturing process that occurs in
the State of source, may sell the output of that manufacturing process, or simply
may sell the same sorts of products that are being sold by the business carried on
in the State of source. The following examples illustrate these principles:
Example1: ACO is a company resident of StateA and is engaged in an
active manufacturing business in that State. ACO owns 100per cent
of the shares of BCO, a company resident of StateB. BCO distributes
ACOs products in StateB. Since the business activities conducted
by the two companies involve the same products, BCOs distribution
business is considered to form a part of ACOs manufacturing business.
Example2: The facts are the same as in Example1, except that
ACO does not manufacture products. Rather, ACO operates a large
research and development facility in StateA that licenses intellectual
property to affiliates worldwide, including BCO. BCO and other
affiliates then manufacture and market the ACO-designed products
in their respective markets. Since the activities conducted by ACO and
BCO involve the same product lines, these activities are considered to
form a part of the same business.
51. For two activities to be considered to be complementary, the activities
need not relate to the same types of products or services, but they should be
part of the same overall industry and be related in the sense that the success
or failure of one activity will tend to result in success or failure for the other.
SECTION A 39
Where more than one business is conducted in the State of source and only one
of the businesses forms a part of or is complementary to a business conducted
in the State of residence, it is necessary to identify the business to which an item
of income is attributable. Royalties generally will be considered to be derived
in connection with the business to which the underlying intangible property is
attributable. Dividends will be deemed to be derived first out of profits of the
treaty-benefited business, and then out of other profits. Interest income may be
allocated under any reasonable method consistently applied.
Example3. CCO is a company resident of StateC that operates an
international airline. DCO is a wholly-owned subsidiary of CCO
resident of StateD. DCO operates a chain of hotels in StateD that are
located near airports served by flights operated by CCO. CCO frequently
sells tour packages that include air travel to StateD and lodging at
DCOs hotels. Although both companies are engaged in the active
conduct of a business, the businesses of operating a chain of hotels and
operating an airline are distinct businesses. Therefore DCOs business
does not form a part of CCOs business. DCOs business, however, is
considered to be complementary to CCOs business because these two
businesses are part of the same overall industry (travel) and the links
between these activities tend to make them interdependent.
Example4. The facts are the same as in Example3, except that
DCO owns an office building in the other Contracting State instead
of a hotel chain. No part of CCOs business is conducted through
the office building. DCOs business is not considered to form a part
of or to be complementary to CCOs business. They are engaged in
distinct businesses in separate industries, and there is no economic
dependence between the two operations.
Example5. ECO is a company resident of StateE. ECO produces
and sells flowers in StateE and other countries. ECO owns all the
shares of FCO, a company resident of StateF. FCO is a holding
company that is not engaged in a business. FCO owns all the shares
of three companies that are resident of StateF: GCO, HCO and ICO.
GCO distributes ECOs flowers under the ECO trademark in StateF.
HCO markets a line of lawn care products in StateF under the ECO
trademark. In addition to being sold under the same trademark,
GCOs and HCOs products are sold in the same stores and sales
of each companys products tend to generate increased sales of the
others products. ICO imports fish from StateE and distributes it to
fish wholesalers in StateF. For purposes of paragraph3, the business
of GCO forms a part of the business of ECO, the business of HCO is
complementary to the business of ECO, and the business of ICO is
neither part of nor complementary to that of ECO.
Example6. JCO is a company resident of StateJ. JCO produces and sells
baby food in StateJ and other countries. JCO acquires all the shares
of KCO, a company resident of StateK that produces and distributes
jam and similar food products. JCO and KCO are both involved in
the food industry, the products resulting from the businesses activities
carried on by these companies are sold in the same stores and sales of
40 SECTION A
each companys products would be affected by any incident related to
the quality of any of their products. For purposes of paragraph3, the
business of KCO is complementary to the business of JCO.
52. An item of income derived from the State of source is incidental to the
business carried on in the State of residence if production of the item facilitates
the conduct of the business in the State of residence. An example of incidental
income is income derived from the temporary investment of working capital of a
resident of one Contracting State.
53. Subparagraphb) of paragraph3states a further condition to the general
rule in subparagrapha) in cases where the business generating the item of
income in question is carried on either by the person deriving the income or by
any associated enterprises. Subparagraphb) states that the business carried on in
the State of residence, under these circumstances, must be substantial in relation
to the activity in the State of source. The substantiality requirement is intended
to prevent a narrow case of treaty-shopping abuses in which a company attempts
to qualify for benefits by engaging in de minimis connected business activities in
the treaty State of which it is resident (i.e.activities that have little economic cost
or effect with respect to the companys business as a whole).
54. The determination of substantiality is made based upon all the facts and
circumstances and takes into account the comparative sizes of the businesses
in each Contracting State, the nature of the activities performed in each
Contracting State, and the relative contributions made to that business in each
Contracting State. In any case, in making each determination or comparison,
due regard will be given to the relative sizes of the economies and the markets in
the two Contracting States.
Example7. LCO is a pharmaceutical company resident of StateL. LCO
is engaged in an active manufacturing business in StateL and also
conducts research and development in StateL. All the shares of LCO
are owned by OCO, a company resident of StateO. LCO has developed
different anti-malaria drugs which are produced, under LCOs patents
and trademarks, by MCO, a subsidiary of LCO which is a resident
of StateM. LCO sells these drugs, along with the other drugs that it
manufactures, in StateL and other States where malaria is almost nonexistent. MCO pays a royalty to LCO for the use of the IP. Taking into
account the nature of the business activities performed in StateL and
StateM and the relative contribution made to the trade or business in
each state, the royalty payment is entitled to treaty benefits. Due regard
is also given to the relative small size of the market of anti-malaria drugs
in StateL (where the drugs are primarily sold to people who travel to
parts of the world where malaria is widespread) compared to the market
for such products in StateM. Given the nature of the market for the
drug in each country as well as all the other facts and circumstances,
the business activity carried on by LCO in StateL may be considered
substantial in relation to the business activity carried on by MCO in
StateM.
Example8: PCO, a company resident of StateP, a developing
country, has developed a line of luxury cosmetics that incorporate
ingredients from plants that are primarily found in StateP. PCO is
SECTION A 41
the owner of patents, trade names and trademarks for these cosmetics.
PCOs shares are held in equal proportion by three shareholders:
a company that is a resident of StateP, another company that is a
resident of StateQ and a third company that is a resident of StateR.
PCO harvests and conditions the plants in StateP. The plants are
then shipped to StateS (a large affluent country where there is an
important demand for luxury cosmetics) where they are transformed
into cosmetics by SCO, a subsidiary of PCO that is a resident of
StateS. The cosmetics are distributed in StateS by another subsidiary,
TCO, which is also a resident of StateS, under trade names and
trademarks licensed to TCO by PCO. The cosmetics are labelled
made in StateS. Due to the relatively small size of the economy of
StateP compared to the size of the economy of StateS, the business
activity carried on by PCO in StateP is substantial in relation to the
business activity carried on by SCO and TCO in StateS.
55. The determination in subparagraphb) also is made separately for each
item of income derived from the State of source. It is therefore possible that a
person would be entitled to the benefits of the Convention with respect to one
item of income but not with respect to another. If a resident of a Contracting
State is entitled to treaty benefits with respect to a particular item of income
under paragraph3, the resident is entitled to all benefits of the Convention
insofar as they affect the taxation of that item of income in the State of source.
56. The application of the substantiality requirement only to income from
associated enterprises focuses only on potential abuse cases, and does not
hamper certain other kinds of non-abusive activities, even though the income
recipient resident in a Contracting State may be very small in relation to the
entity generating income in the other Contracting State. For example, if a
small research firm in one State develops a process that it licenses to a very
large, unrelated, pharmaceutical manufacturer in another State, the size of the
research firm in the first State would not have to be tested against the size of the
manufacturer. Similarly, a small bank of one State that makes a loan to a very
large unrelated company operating a business in the other State would not have
to pass a substantiality test to receive treaty benefits under paragraph3.
57. Subparagraphc) of paragraph3provides special attribution rules for
purposes of applying the substantive rules of subparagraphs a) and b). Thus, these
rules applyfor purposes of determining whether a personmeets the requirements
in subparagrapha) that it be engaged in the active conduct of a businessand
that theitem of income is derived in connection with that active business, and
for making the comparison required by the substantiality requirement in
subparagraphb). Subparagraphc) attributes to a person activities conducted
by persons connected to such person. A person (X) is connected to another
person (Y) if X possesses 50per cent or more of the beneficial interest in Y (or if
Y possesses 50per cent or more of the beneficial interest in X). For this purpose,
X is connected to a company if X owns shares representing 50per cent or more
of the aggregate voting power and value of the company or 50per cent or more of
the beneficial equity interest in the company. X also is connected to Y if a third
person possesses 50per cent or more of the beneficial interest in both X and Y.
For this purpose, if X or Y is a company, the threshold relationship with respect
to such company or companies is 50per cent or more of the aggregate voting
42 SECTION A
power and value or 50per cent or more of the beneficial equity interest. Finally,
X is connected to Y if, based upon all the facts and circumstances, X controls Y, Y
controls X, or X and Y are controlled by the same person or persons.
Derivative benefits
Simplified version
3. A resident of a Contracting State that is not a qualified person shall
nevertheless be entitled to a benefit that would otherwise be accorded by this
Convention with respect to an item of income if persons that are equivalent
beneficiaries own, directly or indirectly, more than 75per cent of the beneficial
interests of the resident.
Detailed version
[4. A company that is a resident of a Contracting State shall also be entitled
to a benefit that would otherwise be accorded by this Convention if, at the
time when that benefit would be accorded:
a) at least 95per cent of the aggregate voting power and value of its
shares (and at least 50percent of any disproportionate class of shares)
is owned, directly or indirectly, by seven or fewer persons that are
equivalent beneficiaries, provided that in the case of indirect ownership,
each intermediate owner is itself an equivalent beneficiary, and
b) less than 50per cent of the companys gross income, as determined in
the companys State of residence, for the taxable period that includes
that time, is paid or accrued, directly or indirectly, to persons who are
not equivalent beneficiaries, in the form of payments (but not including
arms length payments in the ordinary course of business for services
or tangible property) that are deductible for the purposes of the taxes
covered by this Convention in the companys State of residence.]11
58. Paragraph4 sets forth a derivative benefits test that is potentially applicable
to all treaty benefits, although the test is applied to individual items of income. In
general, this derivative benefits test entitles certain companies that are residents of
a Contracting State to treaty benefits if the owner of the company would have been
entitled to at least the same benefit had the income in question flowed directly to
that owner. To qualify under this paragraph, the company must meet an ownership
test and a base erosion test.
59. Subparagrapha) sets forth the ownership test. Under this test, seven or
fewer equivalent beneficiaries must own shares representing at least 95per cent
of the aggregate voting power and value of the company and at least 50per cent
of any disproportionate class of shares. Ownership may be direct or indirect. The
term equivalent beneficiary is defined in subparagraphf) of paragraph6.
60. Subparagraphb) sets forth the base erosion test. A company meets this
base erosion test if less than 50percent of its gross income (as determined in the
companys State of residence) for the taxable period that includes the time when
the benefit would be accorded is paid or accrued, directly or indirectly, to a person
or persons who are not equivalent beneficiaries in the form of payments deductible
SECTION A 43
for tax purposes in the companys State of residence. These amounts do not
include arms length payments in the ordinary course of business for services or
tangible property. This test is the same as the base erosion test in subparagraphe)
(ii) of paragraph2, except that the test in subparagraphb) focuses on base eroding
payments to persons who are not equivalent beneficiaries.
61. Some States consider that the provisions of paragraph4create unacceptable
risks of treaty shopping with respect to payments that are deductible in the State of
source. These States prefer to restrict the scope of paragraph4to dividends, which
are typically not deductible. States that share that view are free to amend the first
part of the paragraph so that it reads as follows:
4. A company that is a resident of a Contracting State shall also be
entitled to a benefit that would otherwise be accorded under Article10 of this
Convention if, at the time when that benefit would be accorded:
Discretionary relief
Simplified version
5. A resident of a Contracting State that is neither a qualified person nor
entitled under paragraph3or 4 to a benefit that would otherwise be accorded
by this Convention with respect to an item of income shall nevertheless be
entitled to such benefit if the competent authority of the Contracting State
from which the benefit is being claimed, upon request from that resident,
determines, in accordance with its domestic law or administrative practice,
that the establishment, acquisition or maintenance of the resident and the
conduct of its operations are considered as not having as one of its principal
purposes the obtaining of such benefit. The competent authority of the
Contracting State to which such request has been made by a resident of the
other Contracting State shall consult with the competent authority of that
other State before rejecting the request.
Detailed version
5. If a resident of a Contracting State is not entitled, under the preceding
provisions of this Article, to all benefits provided under this Convention,
the competent authority of the Contracting State that would otherwise have
granted benefits to which that resident is not entitled shall nevertheless
treat that resident as being entitled to these benefits, or benefits with
respect to a specific item of income or capital, if such competent authority,
upon request from that resident and after consideration of the relevant
facts and circumstances, determines that the establishment, acquisition or
maintenance of the resident and the conduct of its operations did not have as
one of its principal purposes the obtaining of benefits under this Convention.
The competent authority of the Contracting State to which the request has
been made will consult with the competent authority of the other State before
rejecting a request made under this paragraph by a resident of that other
State.
62. Paragraph5 provides that where, under paragraphs1 to 4 of the Article,
a resident of one of the Contracting States is not entitled to all benefits of the
44 SECTION A
Convention in a Contracting State, that resident may request the competent
authority of that State to grant these benefits. In such a case, the competent
authority will grant these benefits if, after considering the relevant facts and
circumstances, it determines that neither the establishment, acquisition, or
maintenance of the resident, nor the conduct of its operations, had as one of its
principal purposes the obtaining of benefits under the Convention.
63. Through this paragraph, a resident that is not entitled to the benefits
of the Convention under paragraphs1 through 4 but who has a substantial
relationship to its State of residence, taking into account considerations in
addition to those addressed through the objective tests in paragraphs1 through
4, may be able to obtain treaty benefits where the allowance of benefits would not
otherwise be contrary to the purposes of the Convention. In the case of a resident
subsidiary company with a parent in a third State, whilst the fact that the relevant
withholding rate provided in the Convention is not lower than the corresponding
withholding rate in the tax treaty between the State of source and the third State
would be a relevant factor, that fact would not, in itself, be sufficient to establish
that the conditions for granting the discretionary relief are met. Similarly,
where a foreign company is engaged in a mobile business such as financing, or
where the domestic law of a Contracting State provides a special tax treatment
for certain activities conducted in special zones or offshore (e.g.licensing
intangibles) those factors will not be evidence of a non-tax business reason for
locating in that State. In such cases, additional favourable business factors must
be present to establish a substantial relationship to that State. Paragraph5 also
provides that the competent authority of the State to which the request is made
will consult with the competent authority of the other State before refusing to
exercise its discretion to grant benefits to a resident of that other State.
64. In order to be granted benefits under paragraph5, the person must
establish, to the satisfaction of the competent authority of the State from which
benefits are being sought, that there were clear non-tax business reasons for its
formation, acquisition, or maintenance and for the conduct of its operation in the
other Contracting State. What the purposes are for the establishment, acquisition
or maintenance of a person and the conduct of its operations are questions of
fact which can only be answered by considering all relevant circumstances on
a case by case basis. It is not necessary to find conclusive proof of intent, but
the competent authority must be able to conclude, after an objective analysis
of the relevant facts and circumstances, that none of the principal purposes
for the establishment, acquisition or maintenance of the person and the
conduct of its operations was to obtain benefits under the Convention. Whilst
it should not be lightly assumed that obtaining benefits under a convention
was one of these principal purposes, a person should not expect to obtain relief
under paragraph5by merely asserting that its establishment, acquisition or
maintenance and the conduct of its operations were not undertaken to obtain the
benefits of the Convention. All of the evidence must be provided to the competent
authority in order to enable it to determine whether this is the case.
65. The reference to one of the principal purposes in paragraph5means
that obtaining benefits under a tax treaty need not be the sole or dominant
purpose for the establishment, acquisition or maintenance of the person and
the conduct of its operations. It is sufficient that at least one of the principal
purposes was to obtain treaty benefits. Where the competent authority
SECTION A 45
determines, having regard to all relevant facts and circumstances, that obtaining
benefits under the Convention was not a principal consideration and would not
have justified the establishment, acquisition or maintenance of the person and
the conduct of its operations, it shall treat that person as being entitled to these
benefits, or benefits with respect to a specific item of income or capital. Where,
however, the establishment, acquisition or maintenance of the person and the
conduct of its operations is carried on for the purpose of obtaining similar
benefits under a number of treaties, it should not be considered that obtaining
benefits under other treaties will prevent the obtaining of benefits under one
treaty from being considered a principal purpose for these operations.
65.1 The competent authority that receives a request for relief under
paragraph5should process that request expeditiously.
66. Although such a request will usually be made by a resident of a Contracting
State to the competent authority of the other Contracting State, there may be cases
in which a resident of a Contracting State may request the competent authority
of its own State of residence to grant relief under paragraph5. This would be the
case if the treaty benefits that are requested are provided by the State of residence,
such as the benefits of the provisions of Articles23A and 23B concerning the
elimination of double taxation. In such cases, the paragraph does not require the
competent authority to consult the competent authority of the other State before
denying the request.
67. The paragraph grants broad discretion to the competent authority and, as
long as the competent authority has exercised that discretion in accordance with
the requirements of the paragraph, it cannot be considered that the decision of
the competent authority is an action that results in taxation not in accordance
with the provisions of the Convention (see paragraph1of Article25). The
paragraph does require, however, that the competent authority must consider the
relevant facts and circumstances before reaching a decision and must consult the
competent authority of the other Contracting State before rejecting a request to
grant benefits. The first requirement seeks to ensure that the competent authority
will consider each request on its own merits whilst the requirement that the
competent authority of the other Contracting State be consulted should ensure
that Contracting States treat similar cases in a consistent manner and can justify
their decision on the basis of the facts and circumstances of the particular case.
This consultation process does not, however, require that the competent authority
to which the request has been presented obtain the agreement of the competent
authority that is consulted. The determination that neither the establishment,
acquisition or maintenance of the resident making the request, nor the conduct
of its operations, had as one of its principal purposes the obtaining of benefits
under the Convention is a matter that is left to the discretion of the competent
authority to which the request is made. Once it has determined that this is the
case, the competent authority is required to grant benefits but it may then grant
all of the benefits of the Convention to the taxpayer making the request, or it may
grant only certain benefits. For instance, it may grant benefits only with respect
to a particular item of income in a manner similar to paragraph3. Further, the
competent authority may establish conditions, such as setting time limits on the
duration of any relief granted.
46 SECTION A
68. The request for a determination under paragraph5may be presented
before (e.g.through a ruling request) or after the establishment, acquisition or
maintenance of the person for whom the request is made. Where the request is
made after such establishment, acquisition or maintenance, any benefits granted
by the competent authority may be allowed retroactively.
69. Whilst it is impossible to provide a detailed list of all the facts and
circumstances that would be relevant to the determination referred to in paragraph5,
examples of such facts and circumstances include the history, structure, ownership
and operations of the resident that makes the request, whether that resident is a long
standing entity that was recently acquired by non-residents for non-tax reasons,
whether the resident carries on substantial business activities, whether the residents
income for which the benefits are requested is subject to double taxation and whether
the establishment or use of the resident gives rise to non-taxation or reduced taxation
of the income.
69.1 To reduce the resource implications of having to consider requests for
discretionary relief, and to discourage vexatious requests, Contracting States may
find it useful to publish guidelines on the types of cases that it considers will and
will not qualify for discretionary relief. However, any administrative conditions
that a Contracting State imposes on applicants should not deter persons making
requests where they consider that they have a reasonable prospect of satisfying a
competent authority that benefits should be granted.
Definitions
Simplified version
6.
For the purposes of this Article:
Detailed version
6.
For purposes of the preceding provisions of this Article:
69.2 Paragraph6 includes a number of definitions that apply for the purposes
of the Article. These definitions supplement the definitions included in Articles3,
4 and 5 of the Convention, which apply throughout the Convention.
The term recognised stock exchange
Simplified version
b)
the term recognised stock exchange means:

i) any stock exchange established and regulated as such under the laws
of either Contracting State; and
ii) any other stock exchange agreed upon by the competent authorities
of the Contracting States;
Detailed version
a) the term recognised stock exchange means:
i) [list of stock exchanges agreed to at the time of signature]; and
ii) any other stock exchange agreed upon by the competent authorities
of the Contracting States;
SECTION A 47

70. The definition of recognised stock exchange first includes stock exchanges
that both Contracting States agree to identify at the time of the signature of the
Convention. Although this would typically include stock exchanges established in
the Contracting States on which shares of publicly listed companies and entities that
are residents of these States are actively traded, the stock exchanges to be identified
in the definition need not be established in one of the Contracting States. This
recognises that the globalisation of financial markets and the prominence of some
large financial centres have resulted in the shares of many public companies being
actively traded on more than one stock exchange and on stock exchanges situated
outside the State of residence of these companies.
71. The definition also allows the competent authorities of the Contracting
States to supplement, through a subsequent agreement, the list of stock
exchanges identified in the definition at the time of signature of the Convention.
71.1 The stock exchanges to be included in the definition should impose listing
requirements that ensure that shares of entities listed on that stock exchange
are genuinely publicly traded. The following factors should be considered
when determining whether a stock exchange should be listed in the definition
or subsequently added to that list through the competent authority agreement
referred to in the preceding paragraph:
What are the requirements/standards with respect to listing a company
on the stock exchange?
What are the requirements/standards in order to continue to be listed
on the stock exchange, including minimum financial standards?
What are the annual/interim disclosure and/or filing requirements for
companies whose shares are traded on the stock exchange?
What is the volume of shares traded on the stock exchange in a
calendar year?
Do the rules governing the stock exchange ensure active trading of
listed stocks? If so, how?
A
re the companies listed on the stock exchange required to disclose on
an ongoing basis financial information and information on events that
may have a material impact on their financial situations?
Is information on the trading volume and overall shareholding of the
companies listed on the stock exchange publicly available?
Does the stock exchange impose any minimum size requirements, such
as minimum capitalisation or number of employees, for companies
whose shares are traded on the exchange?
Does the stock exchange impose a required minimum percentage of
public ownership? If so, what is the minimum amount?
For a company to trade on the stock exchange, are the shares of
companies required to be freely negotiable and fully paid for?
Is the stock exchange required to disclose the share prices of its listed
companies within a certain timeframe?
48 SECTION A
Is the stock exchange regulated or supervised by a government
authority of the country in which it is located?
[In the case of a new stock exchange to be added to an existing list:]
Why would a company prefer to list on the new exchange rather than
on another exchange, including those exchanges that are already
recognised stock exchanges in the tax treaty? For example, are there
lesser corporate governance and financial disclosure requirements?
[In the case of a new stock exchange to be added to an existing list:]
Does the new stock exchange provide a more efficient vehicle for
raising capital and, if so, why?
The term principal class of shares
Simplified version
a)
the term principal class of shares means the class or classes of shares
of a company which represents in the aggregate a majority of the voting
power of the company;
Detailed version
b) the term principal class of shares means the ordinary or common
shares of the company, provided that such class of shares represents
the majority of the voting power and value of the company. If no single
class of ordinary or common shares represents the majority of the
aggregate voting power and value of the company, the principal class
of shares are those classes that in the aggregate represent a majority
of the aggregate voting power and value of the company. In the case
of a company participating in a dual listed company arrangement, the
principal class of shares will be determined after excluding the special
voting shares which were issued as a means of establishing that dual
listed company arrangement.
72. The definition of the term principal class of shares refers to the
ordinary or common shares of a company but only if these shares represent
the majority of the voting rights as well as of the value of the company. If a
company has only one class of shares, it will naturally constitute its principal
class of shares. If a company has more than one class of shares, it is necessary
to determine which class or classes constitute the principal class of shares,
which will be the class of shares, or any combination of classes of shares,
that represent, in the aggregate, a majority of the voting power and value of
the company. Although in a particular case involving a company with several
classes of shares it is conceivable that more than one group of classes could be
identified that would represent the majority of the voting power and value of the
company, it is only necessary to identify one such group that meets the conditions
of subparagraphc) of paragraph2in order for the company to be entitled to
treaty benefits under that provision (benefits will not be denied to the company
even if a second group of shares representing the majority of the voting power
and value of the company, but not satisfying the conditions of subparagraphc) of
paragraph2, could be identified).
SECTION A 49
73. The last part of the definition provides an exception applicable to

companies that participate in a dual listed company arrangement, as defined in
paragraph g). In the case of these companies, special voting shares issued for
the purposes of implementing that dual listed company arrangement must not be
taken into account for the purposes of determining the principal class of shares
of these companies.
The term disproportionate class of shares
Detailed version only
c) the term disproportionate class of shares means any class of shares
of a company resident in one of the Contracting States that entitles
the shareholder to disproportionately higher participation, through
dividends, redemption payments or otherwise, in the earnings generated
in the other Contracting State by particular assets or activities of the
company;
74. Under the definition of the term disproportionate class of shares,
which is relevant for the purposes of paragraph4and subparagraphs c) and
e) of paragraph2, a company has a disproportionate class of shares if it has
outstanding shares that are subject to terms or other arrangements that entitle
the holder of these shares to a larger portion of the companys income derived
from the other Contracting State than that to which the holder would be entitled
in the absence of such terms or arrangements. Thus, for example, a company
resident in one Contracting State has a disproportionate class of shares if
some of the outstanding shares of that company are tracking shares that
pay dividends based upon a formula that approximates the companys return
on its assets employed in the other Contracting State. This is illustrated by the
following example:
Example: ACO is a company resident of StateA. ACO has issued
common shares and preferred shares. The common shares are listed
and regularly traded on the principal stock exchange of StateA.
The preferred shares have no voting rights and entitle their holders
to receive dividends equal in amount to interest payments that ACO
receives from unrelated borrowers in StateB. The preferred shares
are owned entirely by a single shareholder who is a resident of a third
State with which StateB does not have a tax treaty. The common
shares account for more than 50per cent of the value of ACO and
for 100per cent of the voting power. Since the owner of the preferred
shares is entitled to receive payments corresponding to ACOs
interest income arising in StateB, the preferred shares constitute a
disproportionate class of shares and because these shares are not
regularly traded on a recognised stock exchange, ACO will not qualify
for benefits under subparagraphc) of paragraph2.
The term primary place of management and control
d) a companys primary place of management and control will be in the
Contracting State of which it is a resident only if executive officers and
50 SECTION A
senior management employees exercise day-to-day responsibility for
more of the strategic, financial and operational policy decision making
for the company (including its direct and indirect subsidiaries) in that
Contracting State than in any other State and the staff of such persons
conduct more of the day-to-day activities necessary for preparing and
making those decisions in that Contracting State than in any other
State;
75. The term primary place of management and control is relevant for the
purposes of subparagraphc) of paragraph2. This term must be distinguished
from the concept of place of effective management, which was used, before
[date of the next update], in paragraph3of Article4 and in various provisions,
including Article8, applicable to the operation of ships and aircraft. The
concept of place of effective management was interpreted by some States as
being ordinarily the place where the most senior person or group of persons
(for example a board of directors) made the key management and commercial
decisions necessary for the conduct of the companys business. The concept
of the primary place of management and control, by contrast, refers to the
place where the day-to-day responsibility for the management of the company
(and its subsidiaries) is exercised. A companys primary place of management
and control will be situated in the State of residence of that company only if
the executive officers and senior management employees exercise day-today responsibility for more of the strategic, financial and operational policy
decision making for the company (including direct and indirect subsidiaries) in
that State than in the other State or any third State, and the staff that support
the management in making those decisions are also based in that State. Thus,
the test looks to the overall activities of the relevant persons to see where those
activities are conducted. In most cases, it will be a necessary, but not a sufficient,
condition that the headquarters of the company (that is, the place at which the
chief executive officer and other top-level executives normally are based) be
located in the Contracting State of which the company is a resident.
76. In order to determine a companys primary place of management
and control, it is necessary to determine which persons are to be considered
executive officers and senior management employees. In some countries, it will
not be necessary to look beyond the executives who are members of the board of
directors (i.e.the so-called inside directors). That will not always be the case,
however; in fact, the relevant persons may be employees of subsidiaries if those
persons make the strategic, financial and operational policy decisions. Moreover,
it would be necessary to take into account any special voting arrangements that
result in certain persons making certain decisions without the participation of
other persons.
The term collective investment vehicle
e)
[possible definition of collective investment vehicle];1

[Footnote 1: A definition of the term collective investment vehicle should
be added if a provision on collective investment vehicles is included in
paragraph2 (see subparagraph2f)).];
SECTION A 51
77. As indicated in the footnote to subparagraphe), a definition of collective

investment vehicle should be included if a provision dealing with collective
investment vehicles is included in subparagraphf) of paragraph2. That
definition should identify the collective investment vehicles of each Contracting
State to which that provision is applicable and could be drafted as follows:
the term collective investment vehicle means, in the case of [StateA],
a [] and, in the case of [StateB], a [], as well as any other investment
fund, arrangement or entity established in either Contracting State which
the competent authorities of the Contracting States agree to regard as a
collective investment vehicle for purposes of this paragraph;
78. As explained in paragraph6.22 of the Commentary on Article1, it is
intended that the open parts of that definition would include cross-references
to relevant tax or securities law provisions of each State that would identify the
CIVs to which subparagraphf) of paragraph2should apply.
The term equivalent beneficiary1
Simplified version
c) the term equivalent beneficiary means any person who would be
entitled to an equivalent or more favourable benefit with respect to an
item of income accorded by a Contracting State under the domestic law
of that Contracting State, this Convention or any other international
instrument as the benefit to be accorded to that item of income under
this Convention, provided that, if that person is a resident of neither
of the Contracting States, the first-mentioned Contracting State has a
convention for the effective and comprehensive exchange of information
relating to tax matters in effect with the state of which that person is
a resident. For the purposes of determining whether a person is an
equivalent beneficiary with respect to dividends, the person shall be
deemed to hold the same capital, shares or voting powers, as the case
may be, of the company paying the dividends as the company claiming
the benefit with respect to the dividends holds those of the company
paying the dividends.
Detailed version
[ f) the term equivalent beneficiary means a resident of any other State,
but only if that resident
i) A) would be entitled to all the benefits of a comprehensive
convention for the avoidance of double taxation between
that other State and the State from which the benefits of
this Convention are claimed under provisions analogous to
subparagrapha), b) or d), or subdivision i) of subparagraphc),
of paragraph2of this Article, provided that if such convention
does not contain a comprehensive limitation on benefits article,
the person would be entitled to the benefits of this Convention by
reason of subparagrapha), b), subdivision i) of subparagraphc),
or subparagraphd) of paragraph2of this Article if such person
were a resident of one of the Contracting States under Article4
of this Convention; and
52 SECTION A

B) with respect to income referred to in Articles10, 11 and 12 of this

Convention, would be entitled under such convention to a rate
of tax with respect to the particular class of income for which
benefits are being claimed under this Convention that is at least
as low as the rate applicable under this Convention; or
ii) is a resident of a Contracting State that is entitled to the benefits

of this Convention by reason of subparagrapha), b) or d), or
subdivision i) of subparagraphc), of paragraph2of this Article.]
[Footnote 1: The inclusion of a definition of equivalent beneficiary will
depend on whether paragraph4is included and whether that phrase is used in
subparagraphf) of paragraph2dealing with collective investment vehicles.]

79. The definition of equivalent beneficiary is relevant for the purposes
of the derivative benefits test in paragraph4but may also be relevant for the
purposes of subparagraphf) of paragraph2depending on how that rule is
drafted.
80. Under the definition, a person may qualify as an equivalent beneficiary
in two alternative ways.
81. Under the first alternative, a person may be an equivalent beneficiary
because it is entitled to equivalent benefits under a tax treaty between the State
of source and a third State in which the person is a resident. This alternative
has two requirements. Under the first requirement in subdivision i)A), the
person must be entitled to equivalent benefits under an applicable tax treaty.
To satisfy that requirement, the person must be entitled to all the benefits of a
comprehensive tax treaty between the Contracting State from which benefits of
the Convention are claimed and a third State under provisions that are analogous
to the rules in subparagraphs a), b) or d), or subdivision i) of subparagraphc), of
paragraph2. If the treaty in question does not have a comprehensive limitation
on benefits article, this requirement is met only if the person would be entitled
to treaty benefits under the tests in subparagraphs a), b) or d), or subdivision i)
of subparagraphc), of paragraph2if that person were a resident of one of the
Contracting States.
82. The second requirement in subdivision i)B) applies only with respect to
benefits applicable to dividends, interest and royalties. Under that additional
requirement, the person must be entitled to a rate of tax that is at least as low as
the tax rate that would apply under the Convention to such income. Thus, the
rates to be compared are: (1)the rate of tax that the source State would have
imposed if a resident of the other Contracting State who is a qualified person
were the beneficial owner of the income; and (2)the rate of tax that the source
State would have imposed if the third State resident received the income directly
from the source State.
83. The requirement in subdivision i)A) that a person be entitled to all the
benefits of a comprehensive tax treaty eliminates those persons that qualify for
benefits with respect to only certain types of income. Assume, for example, that
company CCO, a resident of StateC, is the parent of ACO, a company resident
of StateA. CCO is engaged in the active conduct of a business in StateC and,
SECTION A 53
for that reason, would be entitled to the benefits of a treaty between StateC and
StateB if it received dividends directly from a StateB subsidiary of ACO. This,
however, is not sufficient for the purposes of the application of subdivision i)B)
of the treaty between StateA and StateB. Also, CCO cannot be an equivalent
beneficiary if it qualifies for benefits only with respect to certain income as
a result of a derivative benefits provision in the treaty between StateA and
StateC. However, it would be possible to look through CCO to its own parent
company in order to determine whether that parent company is an equivalent
beneficiary.
84. The second alternative for satisfying the equivalent beneficiary test
in subdivision ii) is available only to residents of one of the Contracting States.
These residents are equivalent beneficiaries if they are eligible for treaty benefits
by reason of subparagraphs a), b) or d), or subdivision i) of subparagraphc), of
paragraph2. Thus, an individual resident of one Contracting State will be an
equivalent beneficiary without regard to whether the individual would have been
entitled to receive the same benefits if he had received the income directly. This
second alternative clarifies that ownership by certain residents of a Contracting
State would not disqualify a company from qualifying for treaty benefits under
paragraph4. Thus, for example, if 90per cent of a company resident of StateA
is owned by five companies that are resident in StateC and that satisfy the
requirements of subdivision i) of the definition, and 10per cent of the company
is owned by an individual resident of StateA or StateB, then the company still
can satisfy the requirements of subparagrapha) of paragraph4.
The term dual listed company arrangement
g) the term dual listed company arrangement means an arrangement
pursuant to which two publicly listed companies, while maintaining
their separate legal entity status, shareholdings and listings, align
their strategic directions and the economic interests of their respective
shareholders through:
i) the appointment of common (or almost identical) boards of directors,
except where relevant regulatory requirements prevent this;
ii) management of the operations of the two companies on a unified
basis;
iii) equalised distributions to shareholders in accordance with an
equalisation ratio applying between the two companies, including
in the event of a winding up of one or both of the companies;
iv) the shareholders of both companies voting in effect as a single
decision-making body on substantial issues affecting their combined
interests; and
v) cross-guarantees as to, or similar financial support for, each others
material obligations or operations except where the effect of the
relevant regulatory requirements prevents such guarantees or
financial support;
54 SECTION A
85. The term dual listed company arrangement is relevant for the purposes
of the definition of the term principal class of shares, which itself is relevant
for the purposes of the provisions of subparagraphc) of paragraph2under which
certain publicly-listed companies are qualified persons.
86. The definition refers to an arrangement, adopted by certain publicly-listed
companies, that reflect a commonality of management, operations, shareholders
rights, purpose and mission through a series of agreements between two parent
companies, each with its own stock exchange listing, together with special
provisions in their respective articles of association including in some cases,
for example, the creation of special voting shares. Under these structures, the
position of the parent company shareholders is, as far as possible, the same as
if they held shares in a single company, with the same dividend entitlement and
same rights to participate in the assets of the dual listed companies in the event
of a winding up. The various parts of the definition refer to the various features
that identify these arrangements.
The term shares
h) with respect to entities that are not companies, the term shares means
interests that are comparable to shares.
87. The Article does not contain an exhaustive definition of the term shares,
which, under paragraph2of Article3, should generally have the meaning which it
has under the domestic law of the State that applies the Article. Subparagraphh),
however, provides that the term shares, when used in the Article with respect to
entities that do not issue shares (e.g.trusts), refers to interests that are comparable
to shares. These will typically be beneficial interests that entitle their holders to a
share of the income or assets of the entity.]
The term related enterprise
Simplified version only
d)
A person shall be a related enterprise of another if, on the basis of all the
facts and circumstances, one has control of the other or both are under
the control of the same person or persons.
Mode of application to be determined by the competent authorities

Simplified version only
7. The competent authorities of the Contracting States may by mutual
agreement settle the mode of application of this Article.
ii) Rules aimed at arrangements one of the principal purposes of which is to

obtain treaty benefits
26. As previously indicated, the following rule, which incorporates principles already
recognised in the Commentary on Article1 of the OECD Model Tax Convention, provides
a more general way to address treaty avoidance cases, including treaty-shopping situations,
such as certain conduit financing arrangements, that are not covered by the specific
SECTION A 55
anti-abuse rule in subsection A.1(a)(i) above (the Commentary on the new rule includes a
number of changes that were made to the Commentary included in the first version of this
Report released in September 2014):
ARTICLE X
ENTITLEMENT TO BENEFITS
[Paragraphs1 to 6: see subsection A.1(a)(i) above]
7.
Notwithstanding the other provisions of this Convention, a benefit
under this Convention shall not be granted in respect of an item of income or
capital if it is reasonable to conclude, having regard to all relevant facts and
circumstances, that obtaining that benefit was one of the principal purposes of
any arrangement or transaction that resulted directly or indirectly in that benefit,
unless it is established that granting that benefit in these circumstances would
be in accordance with the object and purpose of the relevant provisions of this
Convention.
Commentary
1.
Paragraph7 mirrors the guidance in paragraphs9.5, 22, 22.1 and 22.2
of the Commentary on Article1. According to that guidance, the benefits of a
tax convention should not be available where one of the principal purposes of
certain transactions or arrangements is to secure a benefit under a tax treaty
and obtaining that benefit in these circumstances would be contrary to the
object and purpose of the relevant provisions of the tax convention. Paragraph7
incorporates the principles underlying these paragraphs into the Convention
itself in order to allow States to address cases of improper use of the Convention
even if their domestic law does not allow them to do so in accordance with
paragraphs22 and 22.1 of the Commentary on Article1; it also confirms the
application of these principles for States whose domestic law already allows them
to address such cases.
2.
The provisions of paragraph7have the effect of denying a benefit under
a tax convention where one of the principal purposes of an arrangement or
transaction that has been entered into is to obtain a benefit under the convention.
Where this is the case, however, the last part of the paragraph allows the person
to whom the benefit would otherwise be denied the possibility of establishing that
obtaining the benefit in these circumstances would be in accordance with the
object and purpose of the relevant provisions of this Convention.
3.
Paragraph7 supplements and does not restrict in any way the scope or
application of the provisions of paragraphs1 to 6 (the limitation-on-benefits
rule): a benefit that is denied in accordance with these paragraphs is not a
benefit under the Convention that paragraph7would also deny. Moreover,
the guidance provided in the Commentary on paragraph7should not be used to
interpret paragraphs1 to 6 and vice-versa.
4.
Conversely, the fact that a person is entitled to benefits under paragraphs1
to 6 does not mean that these benefits cannot be denied under paragraph7.
Paragraphs1 to 6 are rules that focus primarily on the legal nature, ownership
56 SECTION A
in, and general activities of, residents of a Contracting State. As illustrated by
the example in the next paragraph, these rules do not imply that a transaction or
arrangement entered into by such a resident cannot constitute an improper use of
a treaty provision.
5.
Paragraph7 must be read in the context of paragraphs1 to 6 and of the
rest of the Convention, including its preamble. This is particularly important for
the purposes of determining the object and purpose of the relevant provisions
of the Convention. Assume, for instance, that a public company whose shares
are regularly traded on a recognised stock exchange in the Contracting State
of which the company is a resident derives income from the other Contracting
State. As long as that company is a qualified person as defined in paragraph2,
it is clear that the benefits of the Convention should not be denied solely on the
basis of the ownership structure of that company, e.g.because a majority of the
shareholders in that company are not residents of the same State. The object and
purpose of subparagraph2c) is to establish a threshold for the treaty entitlement
of public companies whose shares are held by residents of different States. The
fact that such a company is a qualified person does not mean, however, that
benefits could not be denied under paragraph7for reasons that are unrelated
to the ownership of the shares of that company. Assume, for instance, that such
a public company is a bank that enters into a conduit financing arrangement
intended to provide indirectly to a resident of a third State the benefit of lower
source taxation under a tax treaty. In that case, paragraph7would apply to deny
that benefit because subparagraph2c), when read in the context of the rest of
the Convention and, in particular, its preamble, cannot be considered as having
the purpose, shared by the two Contracting States, of authorising treaty-shopping
transactions entered into by public companies.
6.
The provisions of paragraph7establish that a Contracting State may
deny the benefits of a tax convention where it is reasonable to conclude, having
considered all the relevant facts and circumstances, that one of the principal
purposes of an arrangement or transaction was for a benefit under a tax treaty
to be obtained. The provision is intended to ensure that tax conventions apply
in accordance with the purpose for which they were entered into, i.e.to provide
benefits in respect of bona fide exchanges of goods and services, and movements
of capital and persons as opposed to arrangements whose principal objective is
to secure a more favourable tax treatment.
7.
The term benefit includes all limitations (e.g.a tax reduction, exemption,
deferral or refund) on taxation imposed on the State of source under Articles6
through 22 of the Convention, the relief from double taxation provided by
Article23, and the protection afforded to residents and nationals of a Contracting
State under Article24 or any other similar limitations. This includes, for example,
limitations on the taxing rights of a Contracting State in respect of dividends,
interest or royalties arising in that State, and paid to a resident of the other
State (who is the beneficial owner) under Article10, 11 or 12. It also includes
limitations on the taxing rights of a Contracting State over a capital gain derived
from the alienation of movable property located in that State by a resident of the
other State under Article13. When a tax convention includes other limitations
(such as a tax sparing provision), the provisions of this Article also apply to that
benefit.
SECTION A 57
8. The phrase that resulted directly or indirectly in that benefit is

deliberately broad and is intended to include situations where the person who
claims the application of the benefits under a tax treaty may do so with respect
to a transaction that is not the one that was undertaken for one of the principal
purposes of obtaining that treaty benefit. This is illustrated by the following
example:
TCo, a company resident of StateT, has acquired all the shares and debts
of SCo, a company resident of StateS, that were previously held by SCos
parent company. These include a loan made to SCo at 4per cent interest
payable on demand. StateT does not have a tax convention with StateS
and, therefore, any interest paid by SCo to TCo is subject to a withholding
tax on interest at a rate of 25per cent in accordance with the domestic law
of StateS. Under the StateR-StateS tax convention, however, there is no
withholding tax on interest paid by a company resident of a Contracting
State and beneficially owned by a company resident of the other State;
also, that treaty does not include provisions similar to paragraphs1 to 6.
TCo decides to transfer the loan to RCo, a subsidiary resident of StateR,
in exchange for three promissory notes payable on demand on which
interest is payable at 3.9per cent.
In this example, whilst RCo is claiming the benefits of the StateR-StateS treaty
with respect to a loan that was entered into for valid commercial reasons, if the
facts of the case show that one of the principal purposes of TCo in transferring
its loan to RCo was for RCo to obtain the benefit of the StateR-StateS treaty,
then the provision would apply to deny that benefit as that benefit would result
indirectly from the transfer of the loan.
9.
The terms arrangement or transaction should be interpreted broadly
and include any agreement, understanding, scheme, transaction or series of
transactions, whether or not they are legally enforceable. In particular they
include the creation, assignment, acquisition or transfer of the income itself,
or of the property or right in respect of which the income accrues. These terms
also encompass arrangements concerning the establishment, acquisition or
maintenance of a person who derives the income, including the qualification
of that person as a resident of one of the Contracting States, and include steps
that persons may take themselves in order to establish residence. An example
of an arrangement would be where steps are taken to ensure that meetings of
the board of directors of a company are held in a different country in order to
claim that the company has changed its residence. One transaction alone may
result in a benefit, or it may operate in conjunction with a more elaborate series
of transactions that together result in the benefit. In both cases the provisions of
paragraph7may apply.
10. To determine whether or not one of the principal purposes of any person
concerned with an arrangement or transaction is to obtain benefits under the
Convention, it is important to undertake an objective analysis of the aims and
objects of all persons involved in putting that arrangement or transaction in place
or being a party to it. What are the purposes of an arrangement or transaction is
a question of fact which can only be answered by considering all circumstances
surrounding the arrangement or event on a case by case basis. It is not necessary
to find conclusive proof of the intent of a person concerned with an arrangement
58 SECTION A
or transaction, but it must be reasonable to conclude, after an objective analysis
of the relevant facts and circumstances, that one of the principal purposes of
the arrangement or transaction was to obtain the benefits of the tax convention.
It should not be lightly assumed, however, that obtaining a benefit under a
tax treaty was one of the principal purposes of an arrangement or transaction
and merely reviewing the effects of an arrangement will not usually enable a
conclusion to be drawn about its purposes. Where, however, an arrangement can
only be reasonably explained by a benefit that arises under a treaty, it may be
concluded that one of the principal purposes of that arrangement was to obtain
the benefit.
11. A person cannot avoid the application of this paragraph by merely
asserting that the arrangement or transaction was not undertaken or arranged
to obtain the benefits of the Convention. All of the evidence must be weighed to
determine whether it is reasonable to conclude that an arrangement or transaction
was undertaken or arranged for such purpose. The determination requires
reasonableness, suggesting that the possibility of different interpretations of the
events must be objectively considered.
12. The reference to one of the principal purposes in paragraph7means
that obtaining the benefit under a tax convention need not be the sole or
dominant purpose of a particular arrangement or transaction. It is sufficient
that at least one of the principal purposes was to obtain the benefit. For example,
a person may sell a property for various reasons, but if before the sale, that
person becomes a resident of one of the Contracting States and one of the
principal purposes for doing so is to obtain a benefit under a tax convention,
paragraph7could apply notwithstanding the fact that there may also be other
principal purposes for changing the residence, such as facilitating the sale of the
property or the re-investment of the proceeds of the alienation.
13. A purpose will not be a principal purpose when it is reasonable to
conclude, having regard to all relevant facts and circumstances, that obtaining
the benefit was not a principal consideration and would not have justified
entering into any arrangement or transaction that has, alone or together with
other transactions, resulted in the benefit. In particular, where an arrangement is
inextricably linked to a core commercial activity, and its form has not been driven
by considerations of obtaining a benefit, it is unlikely that its principal purpose
will be considered to be to obtain that benefit. Where, however, an arrangement
is entered into for the purpose of obtaining similar benefits under a number of
treaties, it should not be considered that obtaining benefits under other treaties
will prevent obtaining one benefit under one treaty from being considered a
principal purpose for that arrangement. Assume, for example, that a taxpayer
resident of StateA enters into a conduit arrangement with a financial institution
resident of StateB in order for that financial institution to invest, for the ultimate
benefit of that taxpayer, in bonds issued in a large number of States with which
StateB, but not StateA, has tax treaties. If the facts and circumstances reveal
that the arrangement has been entered into for the principal purpose of obtaining
the benefits of these tax treaties, it should not be considered that obtaining a
benefit under one specific treaty was not one of the principal purposes for that
arrangement. Similarly, purposes related to the avoidance of domestic law should
not be used to argue that obtaining a treaty benefit was merely accessory to such
purposes.
SECTION A 59
14. The following examples illustrate the application of the paragraph (the
examples included in paragraph19below should also be considered when
determining whether and when the paragraph would apply in the case of conduit
arrangements):
Example A: TCo, a company resident of StateT, owns shares of SCo, a
company listed on the stock exchange of StateS. StateT does not have
a tax convention with StateS and, therefore, any dividend paid by SCo
to TCo is subject to a withholding tax on dividends of 25per cent in
accordance with the domestic law of StateS. Under the StateR-StateS
tax convention, however, there is no withholding tax on dividends
paid by a company resident of a Contracting State and beneficially
owned by a company resident of the other State. TCo enters into an
agreement with RCo, an independent financial institution resident
of StateR, pursuant to which TCo assigns to RCo the right to the
payment of dividends that have been declared but have not yet been
paid by SCo.
In this example, in the absence of other facts and circumstances
showing otherwise, it would be reasonable to conclude that one of the
principal purposes for the arrangement under which TCo assigned
the right to the payment of dividends to RCo was for RCo to obtain the
benefit of the exemption from source taxation of dividends provided
for by the StateR-StateS tax convention and it would be contrary to
the object and purpose of the tax convention to grant the benefit of
that exemption under this treaty-shopping arrangement.
Example B: SCo, a company resident of StateS, is the subsidiary
of TCo, a company resident of StateT. StateT does not have a tax
convention with StateS and, therefore, any dividend paid by SCo
to TCo is subject to a withholding tax on dividends of 25per cent in
accordance with the domestic law of StateS. Under the StateR-StateS
tax convention, however, the applicable rate of withholding tax
on dividends paid by a company of StateS to a resident of StateR
is 5per cent. TCo therefore enters into an agreement with RCo, a
financial institution resident of StateR and a qualified person under
subparagraph3a) of this Article, pursuant to which RCo acquires
the usufruct of newly issued non-voting preferred shares of SCo for
a period of three years. TCo is the bare owner of these shares. The
usufruct gives RCo the right to receive the dividends attached to these
preferred shares. The amount paid by RCo to acquire the usufruct
corresponds to the present value of the dividends to be paid on the
preferred shares over the period of three years (discounted at the rate
at which TCo could borrow from RCo).
showing otherwise, it would be reasonable to conclude that one of the
principal purposes for the arrangement under which RCo acquired
the usufruct of the preferred shares issued by SCo was to obtain the
benefit of the 5per cent limitation applicable to the source taxation
of dividends provided for by the StateR-StateS tax convention and
it would be contrary to the object and purpose of the tax convention
60 SECTION A
to grant the benefit of that limitation under this treaty-shopping
arrangement.
Example C: RCo, a company resident of StateR, is in the business of
producing electronic devices and its business is expanding rapidly. It
is now considering establishing a manufacturing plant in a developing
country in order to benefit from lower manufacturing costs. After a
preliminary review, possible locations in three different countries are
identified. All three countries provide similar economic and political
environments. After considering the fact that StateS is the only one of
these countries with which StateR has a tax convention, the decision
is made to build the plant in that State.
In this example, whilst the decision to invest in StateS is taken in the
light of the benefits provided by the StateR-StateS tax convention,
it is clear that the principal purposes for making that investment and
building the plant are related to the expansion of RCos business and
the lower manufacturing costs of that country. In this example, it
cannot reasonably be considered that one of the principal purposes for
building the plant is to obtain treaty benefits. In addition, given that
a general objective of tax conventions is to encourage cross-border
investment, obtaining the benefits of the StateR-StateS convention
for the investment in the plant built in StateS is in accordance with
the object and purpose of the provisions of that convention.
Example D: RCo, a collective investment vehicle resident of StateR,
manages a diversified portfolio of investments in the international
financial market. RCo currently holds 15per cent of its portfolio in
shares of companies resident of StateS, in respect of which it receives
annual dividends. Under the tax convention between StateR and
StateS, the withholding tax rate on dividends is reduced from 30per
cent to 10per cent.
RCos investment decisions take into account the existence of tax
benefits provided under StateRs extensive tax convention network.
A majority of investors in RCo are residents of StateR, but a number
of investors (the minority investors) are residents of States with which
StateS does not have a tax convention. Investors decisions to invest
in RCo are not driven by any particular investment made by RCo,
and RCos investment strategy is not driven by the tax position of
its investors. RCo annually distributes almost all of its income to its
investors and pays taxes in StateR on income not distributed during
the year.
In making its decision to invest in shares of companies resident
of StateS, RCo considered the existence of a benefit under the
StateR-StateS tax convention with respect to dividends, but this
alone would not be sufficient to trigger the application of paragraph7.
The intent of tax treaties is to provide benefits to encourage crossborder investment and, therefore, to determine whether or not
paragraph7applies to an investment, it is necessary to consider the
context in which the investment was made. In this example, unless
RCos investment is part of an arrangement or relates to another
SECTION A 61
transaction undertaken for a principal purpose of obtaining the

benefit of the Convention, it would not be reasonable to deny the
benefit of the StateR-StateS tax treaty to RCo.
Example E: RCo is a company resident of StateR and, for the last 5
years, has held 24per cent of the shares of company SCo, a resident of
StateS. Following the entry-into-force of a tax treaty between StatesR
and S (Article10 of which is identical to Article10 of this Model),
RCo decides to increase to 25per cent its ownership of the shares of
SCo. The facts and circumstances reveal that the decision to acquire
these additional shares has been made primarily in order to obtain the
benefit of the lower rate of tax provided by Article10(2)a) of the treaty.
In that case, although one of the principal purposes for the transaction
through which the additional shares are acquired is clearly to obtain
the benefit of Article10(2)a), paragraph7would not apply because it
may be established that granting that benefit in these circumstances
would be in accordance with the object and purpose of Article10(2)
a). That subparagraph uses an arbitrary threshold of 25per cent for
the purposes of determining which shareholders are entitled to the
benefit of the lower rate of tax on dividends and it is consistent with
this approach to grant the benefits of the subparagraph to a taxpayer
who genuinely increases its participation in a company in order to
satisfy this requirement.
Example F: TCO is a publicly-traded company resident of StateT.
TCOs information technology business, which was developed in
StateT, has grown considerably over the last few years as a result
of an aggressive merger and acquisition policy pursued by TCOs
management. RCO, a company resident of StateR (a State that has
concluded many tax treaties providing for no or low source taxation
of dividends and royalties), is the family-owned holding company of a
group that is also active in the information technology sector. Almost
all the shares of RCO are owned by residents of StateR who are
relatives of the entrepreneur who launched and developed the business
of the RCO group. RCOs main assets are shares of subsidiaries
located in neighbouring countries, including SCO, a company resident
of StateS, as well as patents developed in StateR and licensed to these
subsidiaries. TCO, which has long been interested in acquiring the
business of the RCO group and its portfolio of patents, has made an
offer to acquire all the shares of RCO.
showing otherwise, it would be reasonable to conclude that the
principal purposes for the acquisition of RCO are related to the
expansion of the business of the TCO group and do not include the
obtaining of benefits under the treaty between StatesR and S. The
fact that RCO acts primarily as a holding company does not change
that result. It might well be that, after the acquisition of the shares of
RCO, TCOs management will consider the benefits of the tax treaty
concluded between StateR and StateS before deciding to keep in RCO
the shares of SCO and the patents licensed to SCO. This, however,
62 SECTION A
would not be a purpose related to the relevant transaction, which is the
acquisition of the shares of RCO.
Example G: TCO, a company resident of StateT, is a publicly-traded
company resident of StateT. It owns directly or indirectly a number
of subsidiaries in different countries. Most of these companies carry
on the business activities of the TCO group in local markets. In one
region, TCO owns the shares of five such companies, each located
in different neighbouring States. TCO is considering establishing a
regional company for the purpose of providing group services to these
companies, including management services such as accounting, legal
advice and human resources; financing and treasury services such
as managing currency risks and arranging hedging transactions, as
well as some other non-financing related services. After a review of
possible locations, TCO decides to establish the regional company,
RCO, in StateR. This decision is mainly driven by the skilled labour
force, reliable legal system, business friendly environment, political
stability, membership of a regional grouping, sophisticated banking
industry and the comprehensive double taxation treaty network of
StateR, including its tax treaties with the five States in which TCO
owns subsidiaries, which all provide low withholding tax rates.
In this example, merely reviewing the effects of the treaties on future
payments by the subsidiaries to the regional company would not enable
a conclusion to be drawn about the purposes for the establishment of
RCO by TCO. Assuming that the intra-group services to be provided by
RCO, including the making of decisions necessary for the conduct of
its business, constitute a real business through which RCO exercises
substantive economic functions, using real assets and assuming
real risks, and that business is carried on by RCO through its own
personnel located in StateR, it would not be reasonable to deny the
benefits of the treaties concluded between StateR and the five States
where the subsidiaries operate unless other facts would indicate that
RCO has been established for other tax purposes or unless RCO enters
into specific transactions to which paragraph7would otherwise
apply (see also example F in paragraph15below with respect to the
interest and other remuneration that RCO might derive from its group
financing activities).
Example H: TCO is a company resident of StateT that is listed on the
stock exchange of StateT. It is the parent company of a multinational
enterprise that conducts a variety of business activities globally
(wholesaling, retailing, manufacturing, investment, finance, etc.).
Issues related to transportation, time differences, limited availability
of personnel fluent in foreign languages and the foreign location of
business partners make it difficult for TCO to manage its foreign
activities from StateT. TCO therefore establishes RCO, a subsidiary
resident of StateR (a country where there are developed international
trade and financial markets as well as an abundance of highlyqualified human resources), as a base for developing its foreign
business activities. RCO carries on diverse business activities such as
wholesaling, retailing, manufacturing, financing and domestic and
SECTION A 63
international investment. RCO possesses the human and financial

resources (in various areas such as legal, financial, accounting,
taxation, risk management, auditing and internal control) that are
necessary to perform these activities. It is clear that RCOs activities
constitute the active conduct of a business in StateR.
As part of its activities, RCO also undertakes the development of new
manufacturing facilities in StateS. For that purpose, it contributes
equity capital and makes loans to SCO, a subsidiary resident of StateS
that RCO established for the purposes of owning these facilities. RCO
will receive dividends and interest from SCO.
In this example, RCO has been established for business efficiency
reasons and its financing of SCO through equity and loans is part of
RCOs active conduct of a business in StateR. Based on these facts
and in the absence of other facts that would indicate that one of the
principal purposes for the establishment of RCO or the financing of
SCO was the obtaining of the benefits of the treaty between StatesR
and S, paragraph7would not apply to these transactions.
Example I: RCO, a company resident of StateR, is one of a number
of collective management organisations that grant licenses on behalf
of neighbouring right and copyright holders for playing music in
public or for broadcasting that music on radio, television or the
internet. SCO, a company resident of StateS, carries on similar
activities in StateS. Performers and copyright holders from various
countries appoint RCO or SCO as their agent to grant licenses and
to receive royalties with respect to the copyrights and neighbouring
rights that they hold; RCO and SCO distribute to each right holder
the amount of royalties that they receive on behalf of that holder
minus a commission (in most cases, the amount distributed to each
holder is relatively small). RCO has an agreement with SCO through
which SCO grants licenses to users in StateS and distributes royalties
to RCO with respect to the rights that RCO manages; RCO does the
same in StateR with respect to the rights that SCO manages. SCO has
agreed with the tax administration of StateS that it will process the
royalty withholding tax on the payments that it makes to RCO based
on the applicable treaties between StateS and the State of residence of
each right holder represented by RCO based on information provided
by RCO since these right holders are the beneficial owners of the
royalties paid by SCO to RCO.
In this example, it is clear that the arrangements between the right
holders and RCO and SCO, and between SCO and RCO, have been
put in place for the efficient management of the granting of licenses
and collection of royalties with respect to a large number of small
transactions. Whilst one of the purposes for entering into these
arrangements may well be to ensure that withholding tax is collected
at the correct treaty rate without the need for each individual right
holder to apply for a refund on small payments, which would be
cumbersome and expensive, it is clear that such purpose, which serves
to promote the correct and efficient application of tax treaties, would
64 SECTION A
be in accordance with the object and purpose of the relevant provisions
of the applicable treaties.
Example J: RCO is a company resident of StateR. It has successfully
submitted a bid for the construction of a power plant for SCO, an
independent company resident of StateS. That construction project
is expected to last 22 months. During the negotiation of the contract,
the project is divided into two different contracts, each lasting 11
months. The first contract is concluded with RCO and the second
contract is concluded with SUBCO, a recently incorporated whollyowned subsidiary of RCO resident of StateR. At the request of SCO,
which wanted to ensure that RCO would be contractually liable for
the performance of the two contracts, the contractual arrangements
are such that RCO is jointly and severally liable with SUBCO for the
performance of SUBCOs contractual obligations under the SUBCOSCO contract.
showing otherwise, it would be reasonable to conclude that one of
the principal purposes for the conclusion of the separate contract
under which SUBCO agreed to perform part of the construction
project was for RCO and SUBCO to each obtain the benefit of the
rule in paragraph3of Article5 of the StateR-StateS tax convention.
Granting the benefit of that rule in these circumstances would be
contrary to the object and purpose of that paragraph as the time
limitation of that paragraph would otherwise be meaningless.
15. In a number of States, the application of the general anti-abuse rule found
in domestic law is subject to some form of approval process. In some cases, the
process provides for an internal acceleration of disputes on such provisions
to senior officials in the administration. In other cases, the process allows for
advisory panels to provide their views to the administration on the application of
the rule. These types of approval processes reflect the serious nature of disputes
in this area and promote overall consistency in the application of the rule.
States may wish to establish a similar form of administrative process that would
ensure that paragraph7is only applied after approval at a senior level within the
administration.
16. Also, some States consider that where a person is denied a treaty benefit
in accordance with paragraph7, the competent authority of the Contracting
State that would otherwise have granted this benefit should have the possibility
of treating that person as being entitled to this benefit, or to different benefits
with respect to the relevant item of income or capital, if such benefits would have
been granted to that person in the absence of the transaction or arrangement that
triggered the application of paragraph7. In order to allow that possibility, such
States are free to include the following additional paragraph in their bilateral
treaties:
8. Where a benefit under this Convention is denied to a person under
paragraph7, the competent authority of the Contracting State that would
otherwise have granted this benefit shall nevertheless treat that person
as being entitled to this benefit, or to different benefits with respect to
a specific item of income or capital, if such competent authority, upon
SECTION A 65
request from that person and after consideration of the relevant facts and
circumstances, determines that such benefits would have been granted to
that person in the absence of the transaction or arrangement referred to
in paragraph7. The competent authority of the Contracting State to which
the request has been made will consult with the competent authority of
the other State before rejecting a request made under this paragraph by a
resident of that other State.
17. For the purpose of this alternative provision, the determination that benefits
would have been granted in the absence of the transaction or arrangement referred
to in paragraph7and the determination of the benefits that should be granted
are left to the discretion of the competent authority to which the request is made.
The alternative provision grants broad discretion to the competent authority
for the purposes of these determinations. The provision does require, however,
that the competent authority must consider the relevant facts and circumstances
before reaching a decision and must consult the competent authority of the other
Contracting State before rejecting a request to grant benefits if that request was
made by a resident of that other State. The first requirement seeks to ensure
that the competent authority will consider each request on its own merits whilst
the requirement that the competent authority of the other Contracting State be
consulted if the request is made by a resident of that other State should ensure that
Contracting States treat similar cases in a consistent manner and can justify their
decision on the basis of the facts and circumstances of the particular case. This
consultation process does not, however, require that the competent authority to
which the request was presented obtain the agreement of the competent authority
that is consulted.
18. The following example illustrates the application of this alternative
provision. Assume that an individual who is a resident of StateR and who owns
shares in a company resident of StateS assigns the right to receive dividends
declared by that company to another company resident of StateR which owns
more than 10per cent of the capital of the paying company for the principal
purpose of obtaining the reduced rate of source taxation provided for in
subparagrapha) of paragraph2of Article10. In such a case, if it is determined
that the benefit of that subparagraph should be denied pursuant to paragraph7,
the alternative provision would allow the competent authority of StateS to grant
the benefit of the reduced rate provided for in subparagraphb) of paragraph2of
Article10 if that competent authority determined that such benefit would have
been granted in the absence of the assignment to another company of the right to
receive dividends.
19. For various reasons, some States may be unable to accept the rule included
in paragraph7. In order to effectively address all forms of treaty-shopping,
however, these States will need to supplement the limitation-on-benefits rule of
paragraphs1 to 6 by rules that will address treaty-shopping strategies commonly
referred to as conduit arrangements that would not be caught by these
paragraphs. These rules would deal with such conduit arrangements by denying
the benefits of the provisions of the Convention, or of some of them (e.g.those of
Articles7, 10, 11, 12 and 21), in respect of any income obtained under, or as part
of, a conduit arrangement. They could also take the form of domestic anti-abuse
rules or judicial doctrines that would achieve a similar result. The following are
examples of conduit arrangements that would need to be addressed by such rules
66 SECTION A
as well as examples of transactions that should not be considered to be conduit
arrangements for that purpose:
Example A: RCO a publicly-traded company resident of StateR,
owns all of the shares of SCO, a company resident of StateS. TCo,
a company resident of StateT, which does not have a tax treaty with
StateS, would like to purchase a minority interest in SCO but believes
that the domestic withholding tax on dividends levied by StateS would
make the investment uneconomic. RCO proposes that SCO instead
issue to RCO preferred shares paying a fixed return of 4per cent plus
a contingent return of 20per cent of SCOs net profits. The maturity
of the preferred shares is 20 years. TCo will enter into a separate
contract with RCO pursuant to which it will pay to RCO an amount
equal to the issue price of the preferred shares and will receive from
RCO after 20 years the redemption price of the shares. During the 20
years, RCO will pay to TCO an amount equal to 3.75per cent of the
issue price plus 20per cent of SCOs net profits.
This arrangement constitutes a conduit arrangement that should be
addressed by the rules referred to above because one of the principal
purposes for RCO participating in the transaction was to achieve a
reduction of the withholding tax for TCO.
Example B: SCO, a company resident of StateS, has issued only one
class of shares that is 100per cent owned by RCO, a company resident
of StateR. RCO also has only one class of shares outstanding, all of
which is owned by TCO, a company resident of StateT, which does not
have a tax treaty with StateS. RCO is engaged in the manufacture of
electronics products, and SCO serves as RCOs exclusive distributor
in StateS. Under paragraph3of the limitation-of-benefits rule, RCO
will be entitled to benefits with respect to dividends received from
SCO, even though the shares of RCO are owned by a resident of a
third country.
This example refers to a normal commercial structure where RCO and
SCO carry on real economic activities in StatesR and S. The payment
of dividends by subsidiaries such as SCO is a normal business
transaction. In the absence of evidence showing that one of the
principal purposes for setting up that structure was to flow-through
dividends from SCO to TCO, this structure would not constitute a
conduit arrangement.
Example C: TCO, a company resident of StateT, which does not have
a tax treaty with StateS, loans 1000000 to SCO, a company resident
of StateS that is a wholly-owned subsidiary of TCO, in exchange
for a note issued by SCO. TCO later realises that it can avoid the
withholding tax on interest levied by StateS by assigning the note
to its wholly-owned subsidiary RCO, a resident of StateR (the treaty
between StatesR and S does not allow source taxation of interest in
certain circumstances). TCO therefore assigns the note to RCO in
exchange for a note issued by RCO to TCO. The note issued by SCO
pays interest at 7per cent and the note issued by RCO pays interest at
6per cent.
SECTION A 67
The transaction through which RCO acquired the note issued by

SCO constitutes a conduit arrangement because it was structured to
eliminate the withholding tax that TCO would otherwise have paid to
StateS.
Example D: TCO, a company resident of StateT, which does not
have a tax treaty with StateS, owns all of the shares of SCO, a
company resident of StateS. TCO has for a long time done all of its
banking with RCO, a bank resident of StateR which is unrelated to
TCO and SCO, because the banking system in StateT is relatively
unsophisticated. As a result, TCO tends to maintain a large deposit
with RCO. When SCO needs a loan to fund an acquisition, TCO
suggests that SCO deal with RCO, which is already familiar with
the business conducted by TCO and SCO. SCO discusses the loan
with several different banks, all on terms similar to those offered by
RCO, but eventually enters into the loan with RCO, in part because
interest paid to RCO would not be subject to withholding tax in StateS
pursuant to the treaty between StatesS and R, whilst interest paid to
banks resident of StateT would be subject to tax in StateS.
The fact that benefits of the treaty between StateR and S are available
if SCO borrows from RCO, and that similar benefits might not be
available if it borrowed elsewhere, is clearly a factor in SCOs decision
(which may be influenced by advice given to it by TCO, its 100per
cent shareholder). It may even be a decisive factor, in the sense that,
all else being equal, the availability of treaty benefits may swing the
balance in favour of borrowing from RCO rather than from another
lender. However, whether the obtaining of treaty benefits was one of
the principal purposes of the transaction would have to be determined
by reference to the particular facts and circumstances. In the facts
presented above, RCO is unrelated to TCO and SCO and there is no
indication that the interest paid by SCO flows through to TCO one
way or another. The fact that TCO has historically maintained large
deposits with RCO is also a factor that indicates that the loan to SCO
is not matched by a specific deposit from TCO. On the specific facts
as presented, the transaction would therefore likely not constitute a
conduit arrangement.
If, however, RCOs decision to lend to SCO was dependent on TCO
providing a matching collateral deposit to secure the loan so that RCO
would not have entered into the transaction on substantially the same
terms in the absence of that deposit, the facts would indicate that TCO
was indirectly lending to SCO by routing the loan through a bank of
StateR and, in that case, the transaction would constitute a conduit
arrangement.
Example E: RCO, a publicly-traded company resident of StateR, is the
holding company for a manufacturing group in a highly competitive
technological field. The manufacturing group conducts research in
subsidiaries located around the world. Any patents developed in a
subsidiary are licensed by the subsidiary to RCO, which then licenses
the technology to its subsidiaries that need it. RCO keeps only a small
68 SECTION A
spread with respect to the royalties it receives, so that most of the profit
goes to the subsidiary that incurred the risk with respect to developing
the technology. TCO, a company located in a State with which
StateS does not have a tax treaty, has developed a process that will
substantially increase the profitability of all of RCOs subsidiaries,
including SCO, a company resident of StateS. According to its usual
practice, RCO licenses the technology and sub-licenses the technology
to its subsidiaries. SCO pays a royalty to RCO, substantially all of
which is paid to TCO.
In this example, there is no indication that RCO established its
licensing business in order to reduce the withholding tax payable
in StateS. Because RCO is conforming to the standard commercial
organisation and behaviour of the group in the way that it structures
its licensing and sub-licensing activities and assuming the same
structure is employed with respect to other subsidiaries carrying out
similar activities in countries which have treaties which offer similar
or more favourable benefits, the arrangement between SCO, RCO and
TCO does not constitute a conduit arrangement.
Example F: TCO is a publicly-traded company resident of StateT,
which does not have a tax treaty with StateS. TCO is the parent of a
worldwide group of companies, including RCO, a company resident of
StateR, and SCO, a company resident of StateS. SCO is engaged in
the active conduct of a trade or business in StateS. RCO is responsible
for coordinating the financing of all of the subsidiaries of TCO. RCO
maintains a centralised cash management accounting system for TCO
and its subsidiaries in which it records all intercompany payables
and receivables. RCO is responsible for disbursing or receiving any
cash payments required by transactions between its affiliates and
unrelated parties. RCO enters into interest rate and foreign exchange
contracts as necessary to manage the risks arising from mismatches
in incoming and outgoing cash flows. The activities of RCO are
intended (and reasonably can be expected) to reduce transaction
costs and overhead and other fixed costs. RCO has 50 employees,
including clerical and other back office personnel, located in StateR;
this number of employees reflects the size of the business activities of
RCO. TCO lends to RCO 15million in currency A (worth 10million
in currency B) in exchange for a 10-year note that pays 5per cent
interest annually. On the same day, RCO lends 10million in currency
B to SCO in exchange for a 10-year note that pays 5per cent interest
annually. RCO does not enter into a long-term hedging transaction
with respect to these financing transactions, but manages the interest
rate and currency risk arising from the transactions on a daily, weekly
or quarterly basis by entering into forward currency contracts.
In this example, RCO appears to be carrying on a real business
performing substantive economic functions, using real assets and
assuming real risks; it is also performing significant activities with
respect to the transactions with TCO and SCO, which appear to be
typical of RCOs normal treasury business. RCO also appears to be
bearing the interest rate and currency risk. Based on these facts and in
SECTION A 69
the absence of other facts that would indicate that one of the principal
purposes for these loans was the avoidance of withholding tax in
StateS, the loan from TCO to RCO and the loan from RCO to SCO do
not constitute a conduit arrangement.
b)
Other situations where a person seeks to circumvent treaty limitations
27. Apart from the requirement that a person be a resident of a Contracting State, other
conditions must be satisfied in order to obtain the benefit of certain provisions of tax
treaties. In certain cases, it may be possible to enter into transactions for the purposes
of satisfying these conditions in circumstances where it would be inappropriate to grant
the relevant treaty benefits. Although the general anti-abuse rule in subsection A.1(a)
(ii) above will be useful in addressing such situations, targeted specific treaty anti-abuse
rules generally provide greater certainty for both taxpayers and tax administrations. Such
rules are already found in some Articles of the Model Tax Convention (see, for example,
Articles13(4) and 17(2)). In addition, the Commentary suggests the inclusion of other
anti-abuse provisions in certain circumstances (see, for example, paragraphs16 and 17 of
the Commentary on Article10). Other anti-abuse provisions are found in bilateral treaties
concluded by OECD and non-OECD countries.
28. The following are examples of situations with respect to which specific treaty antiabuse rules may be helpful and proposals for changes intended to address some of these
situations.
i)
Splitting-up of contracts
29. Paragraph18 of the Commentary on Article5 indicates that [t]he twelve-month

threshold [of Article5(3)] has given rise to abuses; it has sometimes been found that
enterprises (mainly contractors or subcontractors working on the continental shelf or engaged
in activities connected with the exploration and exploitation of the continental shelf) divided
their contracts up into several parts, each covering a period less than twelve months and
attributed to a different company which was, however, owned by the same group.
30. The addition to the OECD Model of the PPT rule included in this Report will help
address this issue, as shown by example J of the Commentary on that rule. In addition,
the Report on Action7 (Preventing the Artificial Avoidance of Permanent Establishment
Status, OECD, 2015b)12 puts forward changes to the Commentary on Article5 that will also
deal with the issue.
ii)
Hiring-out of labour cases
31. Hiring-out of labour cases, where the taxpayer attempts to obtain inappropriately
the benefits of the exemption from source taxation provided for in Article15(2), are dealt
with in paragraphs8.1 to 8.28 of the Commentary on Article15. It was concluded that the
guidance already found in these paragraphs, and in particular the alternative provision
found in paragraph8.3 of that Commentary, dealt adequately with this type of treaty abuse.
iii) Transactions intended to avoid dividend characterisation

32. In some cases, transactions may be entered into for the purpose of avoiding domestic
law rules that characterise a certain item of income as a dividend and to benefit from a
treaty characterisation of that income (e.g.as capital gain) that prevents source taxation.
70 SECTION A
33. As part of its work on hybrid mismatch arrangements, Working Party 1 has examined
whether the treaty definitions of dividends and interest could be amended, as is done in
some treaties, in order to permit the application of domestic law rules that characterise an
item of income as such. Although it was concluded that such a change would have a very
limited impact with respect to hybrid mismatch arrangements, it was decided to further
examine the possibility of making such changes after the completion of the work on the
BEPS Action Plan.
iv) Dividend transfer transactions

34. In these transactions, a taxpayer entitled to the 15per cent portfolio rate of
Article10(2)b) seeks to obtain the 5per cent direct dividend rate of Article10(2)a) or the
0per cent rate that some bilateral conventions provide for dividends paid to pension funds
(see paragraph69of the Commentary on Article18).
35. Paragraphs16 and 17 of the Commentary on Article10 deal with transactions
through which a taxpayer tries to access the lower rate of 5per cent applicable to dividends:
16. Subparagraph
a) of paragraph2does not require that the company receiving
the dividends must have owned at least 25per cent of the capital for a relatively long
time before the date of the distribution. This means that all that counts regarding the
holding is the situation prevailing at the time material for the coming into existence
of the liability to the tax to which paragraph2applies, i.e.in most cases the situation
existing at the time when the dividends become legally available to the shareholders.
The primary reason for this resides in the desire to have a provision which is
applicable as broadly as possible. To require the parent company to have possessed
the minimum holding for a certain time before the distribution of the profits could
involve extensive inquiries. Internal laws of certain OECD member countries provide
for a minimum period during which the recipient company must have held the shares
to qualify for exemption or relief in respect of dividends received. In view of this,
Contracting States may include a similar condition in their conventions.
17. The reduction envisaged in subparagrapha) of paragraph2should not
be granted in cases of abuse of this provision, for example, where a company
with a holding of less than 25per cent has, shortly before the dividends become
payable, increased its holding primarily for the purpose of securing the benefits
of the abovementioned provision, or otherwise, where the qualifying holding was
arranged primarily in order to obtain the reduction. To counteract such manoeuvres
Contracting States may find it appropriate to add to subparagrapha) a provision
along the following lines:
provided that this holding was not acquired primarily for the purpose of
taking advantage of this provision.
36. It was concluded that in order to deal with such transactions, a minimum shareholding
period should be included in subparagrapha) of Article10(2), which should therefore be
amended to read as follows:
a) 5per cent of the gross amount of the dividends if the beneficial
owner is a company (other than a partnership) which holds directly
at least 25per cent of the capital of the company paying the dividends
throughout a 365 day period that includes the day of the payment of the
dividend (for the purpose of computing that period, no account shall
be taken of changes of ownership that would directly result from a
SECTION A 71
corporate reorganisation, such as a merger or divisive reorganisation,

of the company that holds the shares or that pays the dividend);
37. It was also concluded that additional anti-abuse rules should be included in Article10
to deal with cases where certain intermediary entities established in the State of source are
used to take advantage of the treaty provisions that lower the source taxation of dividends.
38. For example, paragraph67.4 of the Commentary on Article10 includes an alternative
provision that may be included to prevent access to
the 5per cent rate in the case of dividends paid by a domestic REIT to a nonresident portfolio investor, and
both the 5per cent and the 15per cent rates in the case of dividends paid by a
domestic REIT to a non-resident investor who holds directly or indirectly more
than 10per cent of the REITs capital.
39. Another example, found in U.S. treaty practice, is a provision that denies the
application of the 5per cent rate in the case of dividends paid to a non-resident company
by a U.S. Regulated Investment Company (RIC) even if that non-resident company holds
more than 10per cent of the shares of the RIC.
40. Based on these examples, where the domestic law of a Contracting State allows the
possibility that portfolio investments in shares of companies of that State be made through
certain collective investment vehicles which are established in that State and which do not
pay tax on their investment income so that a non-resident investor in such a vehicle is able
to access the lower treaty rate applicable to dividends with respect to distributions made
by that collective investment vehicle, it is recommended that a specific anti-abuse rule be
included in Article10. Such a rule might be drafted along the following lines:
Subparagraph2a) shall not apply to dividends paid by a resident of [name of the
State] that is a [description of the type of collective investment vehicle to which that
rule should apply]
v)
Transactions that circumvent the application of Article13(4)
41. Article13(4) allows the Contracting State in which immovable property is situated to
tax capital gains realised by a resident of the other State on shares of companies that derive
more than 50per cent of their value from such immovable property.
42. Paragraph28.5 of the Commentary on Article13 already provides that States may
want to consider extending the provision to cover not only gains from shares but also gains
from the alienation of interests in other entities, such as partnerships or trusts, which would
address one form of abuse. It was agreed that Article13(4) should be amended to include
such wording.
43. There might also be cases, however, where assets are contributed to an entity shortly
before the sale of the shares or other interests in that entity in order to dilute the proportion
of the value of these shares or interests that is derived from immovable property situated
in one Contracting State. In order to address such cases, it was agreed that Article13(4)
should be amended to refer to situations where shares or similar interest derive their value
primarily from immovable property at any time during a certain period as opposed to at
the time of the alienation only.
72 SECTION A
44. The following revised version of paragraph4of Article13 incorporates these changes:
4.
Gains derived by a resident of a Contracting State from the alienation of
shares or comparable interests, such as interests in a partnership or trust, may be
taxed in the other Contracting State if, at any time during the 365 days preceding
the alienation, these shares or comparable interests derived deriving more than
50per cent of their value directly or indirectly from immovable property, as defined
in Article6, situated in that the other State may be taxed in that other State.
vi) Tie-breaker rule for determining the treaty residence of dual-resident

persons other than individuals
45. One of the key limitations on the granting of treaty benefits is the requirement that
a person be a resident of a Contracting State for the purposes of the relevant tax treaty.
Under Article4(1) of the OECD Model Tax Convention, the treaty residence of a person
is dependent on the domestic tax laws of each Contracting State, which may result in a
person being resident of both States. In such cases, Article4(2) determines a single treaty
residence in the case of individuals. Article4(3), which does the same for persons other
than individuals, provides that the dual-resident person shall be deemed to be a resident
only of the State in which its place of effective management is situated.
46. When this rule was originally included in the 1963 Draft Convention, the OECD
Fiscal Committee expressed the view that it may be rare in practice for a company, etc.
to be subject to tax as a resident in more than one State13 but because that was possible,
special rules as to the preference were needed.
47. The 2008 Update to the OECD Model Tax Convention introduced an alternative
version of Article4(3) (see paragraphs24 and 24.1 of the Commentary on Article4)
according to which the competent authorities of the Contracting States shall, having regard
to a number of relevant factors, endeavour to determine by mutual agreement the State of
which the person is a resident for the purposes of the Convention. When that alternative
was discussed, the view of many countries was that cases where a company is a dualresident often involve tax avoidance arrangements. For that reason, the current rule found
in Article4(3) should be replaced by the alternative found in the Commentary, which
allows a case-by-case solution of these cases.
48. The following are the changes that will be made to the OECD Model Tax Convention in
order to implement that decision (these changes take account of modifications that were made
to the Commentary included in the first version of this Report released in September 2014):
Replace paragraph3of Article4 of the Model Tax Convention by the following:
3. Where by reason of the provisions of paragraph1a person other than an
individual is a resident of both Contracting States, then it shall be deemed to be
aresident only of the State in which its place of effective management is situated.
the competent authorities of the Contracting States shall endeavour to determine
by mutual agreement the Contracting State of which such person shall be
deemed to be a resident for the purposes of the Convention, having regard to its
place of effective management, the place where it is incorporated or otherwise
constituted and any other relevant factors. In the absence of such agreement,
such person shall not be entitled to any relief or exemption from tax provided by
this Convention except to the extent and in such manner as may be agreed upon
by the competent authorities of the Contracting States.
SECTION A 73
Replace paragraphs21 to 24.1 of the Commentary on Article4 by the following:

21. This paragraph concerns companies and other bodies of persons, irrespective
of whether they are or not legal persons. Cases where a company, etc. is subject
to tax as a resident in more than one State may occur if, for instance, one State
attaches importance to the registration and the other State to the place of effective
management. So, in the case of companies, etc., also, special rules as to the
preference must be established.
22. When paragraph3was first drafted, it was considered that iTt would
not be an adequate solution to attach importance to a purely formal criterion like
registration. and preference was given to a rule based on the place of effective
management, which was intended to be based on Therefore paragraph3attaches
importance to the place where the company, etc. was is actually managed.
23. The formulation of the preference criterion in the case of persons other
than individuals was considered in particular in connection with the taxation of
income from shipping, inland waterways transport and air transport. A number of
conventions for the avoidance of double taxation on such income accord the taxing
power to the State in which the place of management of the enterprise is situated;
other conventions attach importance to its place of effective management, others
again to the fiscal domicile of the operator. In [2014], however, the Committee on
Fiscal Affairs recognised that although situations of double residence of entities
other than individuals were relatively rare, there had been a number of tax
avoidance cases involving dual resident companies. It therefore concluded that
a better solution to the issue of dual residence of entities other than individuals
was to deal with such situations on a case-by-case basis.
24. As a result of these considerations, the current version of paragraph3provides
that the competent authorities of the Contracting States shall endeavour to resolve
by mutual agreement cases of dual residence of a person other than an individual.
the place of effective management has been adopted as the preference criterion for
persons other than individuals. The place of effective management is the place where
key management and commercial decisions that are necessary for the conduct of the
entitys business as a whole are in substance made. All relevant facts and circumstances
must be examined to determine the place of effective management. An entity may
have more than one place of management, but it can have only one place of effective
management at any one time.
24.1 Some countries, however, consider that cases of dual residence of persons
who are not individuals are relatively rare and should be dealt with on a caseby-case basis. Some countries also consider that such a case-by-case approach
is the best way to deal with the difficulties in determining the place of effective
management of a legal person that may arise from the use of new communication
technologies. These countries are free to leave the question of the residence of these
persons to be settled by the competent authorities, which can be done by replacing
the paragraph by the following provision:
3. Where by reason of the provisions of paragraph1a person other than an
individual is a resident of both Contracting States, the competent authorities
of the Contracting States shall endeavour to determine by mutual agreement
the Contracting State of which such person shall be deemed to be a resident
for the purposes of the Convention, having regard to its place of effective
management, the place where it is incorporated or otherwise constituted and
74 SECTION A
any other relevant factors. In the absence of such agreement, such person
shall not be entitled to any relief or exemption from tax provided by this
Convention except to the extent and in such manner as may be agreed upon
by the competent authorities of the Contracting State.
Competent authorities having to apply paragraph3such a provision to determine
the residence of a legal person for purposes of the Convention would be expected
to take account of various factors, such as where the meetings of the persons its
board of directors or equivalent body are usually held, where the chief executive
officer and other senior executives usually carry on their activities, where the
senior day-to-day management of the person is carried on, where the persons
headquarters are located, which countrys laws govern the legal status of the person,
where its accounting records are kept, whether determining that the legal person
is a resident of one of the Contracting States but not of the other for the purpose
of the Convention would carry the risk of an improper use of the provisions of the
Convention etc. Countries that consider that the competent authorities should not
be given the discretion to solve such cases of dual residence without an indication
of the factors to be used for that purpose may want to supplement the provision to
refer to these or other factors that they consider relevant. [the next sentence has been
moved to new paragraph24.2; the last sentence of the paragraph has been moved
to new paragraph24.3 ]
24.2 Also, since the A determination under paragraph3application of the
provision would will normally be requested by the person concerned through the
mechanism provided for under paragraph1of Article25, the. Such a request may
be made as soon as it is probable that the person will be considered a resident of
each Contracting State under paragraph1. Due to the notification requirement
in paragraph1of Article25, it should in any event be made within three years
from the first notification to that person of taxation measures taken by one or
both States that indicate that reliefs or exemptions have been denied to that
person because of its dual-residence status without the competent authorities
having previously endeavoured to determine a single State of residence under
paragraph3. The competent authorities to which a request for determination of
residence is made under paragraph3should deal with it expeditiously and should
communicate their response to the taxpayer as soon as possible.
24.3 Since the facts on which a decision will be based may change over time, the
competent authorities that reach a decision under that provision should clarify which
period of time is covered by that decision.
24.4 The last sentence of paragraph3provides that in the absence of a
determination by the competent authorities, the dual-resident person shall not
be entitled to any relief or exemption under the Convention except to the extent
and in such manner as may be agreed upon by the competent authorities. This
will not, however, prevent the taxpayer from being considered a resident of each
Contracting State for purposes other than granting treaty reliefs or exemptions to
that person. This will mean, for example, that the condition in subparagraphb)
of paragraph2of Article15 will not be met with respect to an employee of that
person who is a resident of either Contracting State exercising employment
activities in the other State. Similarly, if the person is a company, it will be
considered to be a resident of each State for the purposes of the application of
Article10 to dividends that it will pay.
SECTION A 75
24.52 Some States, however, consider that it is preferable to deal with cases
of dual residence of entities through the rule based on the place of effective
management that was included in the Convention before [next update]. These
States also consider that this rule can be interpreted in a way that prevents it
from being abused. States that share that view and that agree on how the concept
of place of effective management should be interpreted are free to include in
their bilateral treaty the following version of paragraph3:
Where by reason of the provisions of paragraph1a person other than
an individual is a resident of both Contracting States, then it shall be
deemed to be aresident only of the State in which its place of effective
management is situated.
vii) Anti-abuse rule for permanent establishments situated in third States

49. Paragraph32 of the Commentary on Article10, paragraph25of the Commentary
on Article11 and paragraph21of the Commentary on Article12 refer to potential abuses
that may result from the transfer of shares, debt-claims, rights or property to permanent
establishments set up solely for that purpose in countries that offer preferential treatment
to the income from such assets. Where the State of residence exempts, or taxes at low rates,
profits of such permanent establishments situated in third States, the State of source should
not be expected to grant treaty benefits with respect to that income.
50. The last part of paragraph71of the Commentary on Article24 deals with that
situation and suggests that an anti-abuse provision could be included in bilateral
conventions to protect the State of source from having to grant treaty benefits where
income obtained by a permanent establishment situated in a third State is not taxed
normally in that State:
71. Another question that arises with triangular cases is that of abuses. If the
Contracting State of which the enterprise is a resident exempts from tax the profits
of the permanent establishment located in the other Contracting State, there is a
danger that the enterprise will transfer assets such as shares, bonds or patents to
permanent establishments in States that offer very favourable tax treatment, and
in certain circumstances the resulting income may not be taxed in any of the three
States. To prevent such practices, which may be regarded as abusive, a provision
can be included in the convention between the State of which the enterprise is
a resident and the third State (the State of source) stating that an enterprise can
claim the benefits of the convention only if the income obtained by the permanent
establishment situated in the other State is taxed normally in the State of the
permanent establishment.
51. It was concluded that a specific anti-abuse provision should be included in the Model
Tax Convention to deal with that and similar triangular cases where income attributable to
the permanent establishment in a third State is subject to low taxation.
52. The provision and related Commentary included below, which were intended to be
used for that purpose, were included in the first version of this Report that was released
in September 2014. Subsequent work, however, revealed that changes were required
with respect to different aspects of that provision. At the end of May 2015, the United
States released a new version of a similar provision14 for public comments to be sent by
15September 2015. When that new version was discussed, it was agreed that it should be
further examined once finalised by the United States in the light of the comments that will
76 SECTION A
be received on it. For that reason, the provision below and its Commentary will need to
be reviewed and the final version of the provision and its Commentary will therefore be
produced in the first part of 2016, which will allow the new provision to be considered as
be considered as a draft subject to changes:
[Where
a) an enterprise of a Contracting State derives income from the other Contracting
State and such income is attributable to a permanent establishment of the
enterprise situated in a third jurisdiction, and
b) the profits attributable to that permanent establishment are exempt from tax
in the first-mentioned State
the tax benefits that would otherwise apply under the other provisions of the
Convention will not apply to any item of income on which the tax in the third
jurisdiction is less than 60per cent of the tax that would be imposed in the
first-mentioned State if the income were earned or received in that State by the
enterprise and were not attributable to the permanent establishment in the third
jurisdiction. In such a case
c) any dividends, interest, or royalties to which the provisions of this paragraph
apply shall remain taxable according to the domestic law of the other State
but the tax charged in that State shall not exceed [rate to be determined] per
cent of the gross amount thereof, and
d) any other income to which the provisions of this paragraph apply shall remain
taxable according to the domestic law of the other State, notwithstanding any
other provision of the Convention.
The preceding provisions of this paragraph shall not apply if the income derived
from the other State is
e) derived in connection with or is incidental to the active conduct of a business
carried on through the permanent establishment (other than the business of
making, managing or simply holding investments for the enterprises own
account, unless these activities are banking, insurance or securities activities
carried on by a bank, insurance enterprise or registered securities dealer,
respectively), or
f) royalties that are received as compensation for the use of, or the right to use,
intangible property produced or developed by the enterprise through the
Commentary on the provision
1. As mentioned in paragraph32of the Commentary on Article10,
paragraph25of the Commentary on Article11 and paragraph21of the
Commentary on Article12, potential abuses may result from the transfer of
shares, debt-claims, rights or property to permanent establishments set up
solely for that purpose in countries that do not tax such investment income or
offer preferential treatment to the income from such assets. Where the State
of residence exempts the investment income of such permanent establishments
situated in third States, the State of source should not be expected to grant treaty
SECTION A 77
benefits with respect to such income. The proposed paragraph, which applies
where a Contracting State exempts the investment income of enterprises of that
State that are attributable to permanent establishments situated in a third State,
provides that treaty benefits will not be granted in such cases. That rule does not
apply to profits that are derived in connection with, or that are incidental to, the
active conduct of a business through the permanent establishment, excluding
an investment business that is not carried by a bank, insurance enterprise or
securities dealer; it also does not apply if the income received from the State of
source constitutes royalties received as compensation for the use of, or the right
to use, intangible property produced or developed by the enterprise through the
2.
In any case where benefits are denied under this paragraph, the enterprise
that derives the relevant income should have access to the discretionary relief
provision of paragraph5of Article [X] in order to ensure that benefits may be
granted where the establishment, acquisition or maintenance of the permanent
establishment and the conduct of its operations did not have as one of its
principal purposes the obtaining of benefits under this Convention. This result
could be achieved by including this provision into Article [X].
3.
Some States may prefer a more comprehensive solution that would not be
restricted to situations where an enterprise of a Contracting State is exempt, in
that State, on the profits attributable to a permanent establishment situated in a
third State. In such a case, the provision would be applicable in any case where
income derived from one Contracting State that is attributable to a permanent
establishment situated in a third State is subject to combined taxation, in the
State of the enterprise and the State of the permanent establishment, at an
effective rate that is less than the 60per cent threshold. The following is an
example of a provision that could be used for that purpose:
Notwithstanding the other provisions of this Convention, where an enterprise
of a Contracting State derives income from the other Contracting State and
that income is attributable to a permanent establishment of that enterprise
that is situated in a third State, the tax benefits that would otherwise apply
under the other provisions of this Convention will not apply to that income
if the profits of that permanent establishment are subject to a combined
aggregate effective rate of tax in the first-mentioned Contracting State
and third State that is less than 60percent of the general rate of company
tax applicable in the first-mentioned Contracting State. Any dividends,
interest or royalties to which the provisions of this paragraph apply shall
remain taxable in the other Contracting State at a rate that shall not exceed
15percent of the gross amount thereof. Any other income to which the
provisions of this paragraph apply shall remain taxable according to the laws
of the other Contracting State notwithstanding any other provision of this
Convention. The provisions of this paragraph shall not apply if:
a) in the case of royalties, the royalties are received as compensation
for the use of, or the right to use, intangible property produced or
developed by the enterprise through the permanent establishment; or
b) in the case of any other income, the income derived from the other
Contracting State is derived in connection with, or is incidental to,
the active conduct of a business carried on in the third State through
78 SECTION A
the permanent establishment (other than the business of making,
managing or simply holding investments for the enterprises own
account, unless these activities are banking, insurance or securities
activities carried on by a bank, insurance enterprise or registered
securities dealer, respectively).]
2. Cases where a person tries to abuse the provisions of domestic tax law
using treaty benefits
53. Many tax avoidance risks that threaten the tax base are not caused by tax treaties but may
be facilitated by treaties. In these cases, it is not sufficient to address the treaty issues: changes
to domestic law are also required. Avoidance strategies that fall into this category include:
Thin capitalisation and other financing transactions that use tax deductions to
lower borrowing costs;
Dual residence strategies (e.g.a company is resident for domestic tax purposes but
non-resident for treaty purposes);
Transfer mispricing;
Arbitrage transactions that take advantage of mismatches found in the domestic law
of one State and that are
- related to the characterisation of income (e.g.by transforming business profits
into capital gain) or payments (e.g.by transforming dividends into interest);
- related to the treatment of taxpayers (e.g.by transferring income to tax-exempt
entities or entities that have accumulated tax losses; by transferring income
from non-residents to residents);
- related to timing differences (e.g.by delaying taxation or advancing deductions).
Arbitrage transactions that take advantage of mismatches between the domestic
laws of two States and that are
- related to the characterisation of income;
- related to the characterisation of entities;
- related to timing differences.
Transactions that abuse relief of double taxation mechanisms (by producing income
that is not taxable in the State of source but must be exempted by the State of
residence or by abusing foreign tax credit mechanisms).
54. The work on other aspects of the Action Plan, in particular Action2 (Neutralise the
effects of hybrid mismatch arrangements), Action3 (Strengthen CFC rules), Action4 (Limit
base erosion via interest deductions and other financial payments) and Actions8, 9 and 10
dealing with Transfer Pricing has addressed many of these transactions. The main objective
of the work aimed at preventing the granting of treaty benefits with respect to these
transactions is to ensure that treaties do not prevent the application of specific domestic
law provisions that would prevent these transactions.15 Granting the benefits of these treaty
provisions in such cases would be inappropriate to the extent that the result would be the
avoidance of domestic tax. Such cases include situations where it is argued that
Provisions of a tax treaty prevent the application of a domestic GAAR;
Article24(4) and Article24(5) prevent the application of domestic thin-capitalisation
rules;
SECTION A 79
Article7 and/or Article10(5) prevent the application of CFC rules;

Article13(5) prevents the application of exit or departure taxes;
Article24(5) prevents the application of domestic rules that restrict tax consolidation
to resident entities;
Article13(5) prevents the application of dividend stripping rules targeted at
transactions designed to transform dividends into treaty-exempt capital gains;
Article13(5) prevents the application of domestic assignment of income rules (such
as grantor trust rules).
55. The Commentary on the Articles of the OECD Model already addresses a number
of these issues. For instance, it deals expressly with CFC rules (paragraph23of the
Commentary on Article1 provides that treaties do not prevent the application of such
rules). It also refers to thin capitalisation rules (paragraph3of the Commentary on
Article9 suggests that treaties do not prevent the application of such rules insofar as their
effect is to assimilate the profits of the borrower to an amount corresponding to the profits
which would have accrued in an arms length situation). It does not, however, address a
number of other specific domestic anti-abuse rules.
56. Paragraphs22 and 22.1 of the Commentary on Article1 provide a more general
discussion of the interaction between tax treaties and domestic anti-abuse rules. These
paragraphs conclude that a conflict would not occur in the case of the application of certain
domestic anti-abuse rules to a transaction that constitutes an abuse of the tax treaty:
22. Other forms of abuse of tax treaties (e.g.the use of a base company) and
possible ways to deal with them, including substance-over-form, economic
substance and general anti-abuse rules have also been analysed, particularly as
concerns the question of whether these rules conflict with tax treaties []
22.1 Such rules are part of the basic domestic rules set by domestic tax laws for
determining which facts give rise to a tax liability; these rules are not addressed
in tax treaties and are therefore not affected by them. Thus, as a general rule and
having regard to paragraph9.5, there will be no conflict. []
57. Paragraph9.5 of the Commentary on Article1 offers the following guidance as to
what constitutes an abuse of the provisions of a tax treaty:
A guiding principle is that the benefits of a double taxation convention should
not be available where a main purpose for entering into certain transactions or
arrangements was to secure a more favourable tax position and obtaining that more
favourable treatment in these circumstances would be contrary to the object and
purpose of the relevant provisions.
58. As indicated in subsection A.1, a new general anti-abuse rule that will incorporate
the principle already recognised in paragraph9.5 of the Commentary on Article1 will
be included in the OECD Model. The incorporation of that principle into tax treaties will
provide a clear statement that the Contracting States want to deny the application of the
provisions of their treaty when transactions or arrangements are entered into in order to
obtain the benefits of these provisions in inappropriate circumstances. The incorporation
of that principle into a specific treaty provision does not modify, however, the conclusions
already reflected in the Commentary on Article1 concerning the interaction between
treaties and domestic anti-abuse rules; such conclusions remain applicable, in particular
with respect to treaties that do not incorporate the new general anti-abuse rule.
80 SECTION A
59. The following revised version of the section on Improper use of the Convention
currently found in the Commentary on Article1 will reflect that conclusion and will better
articulate the relationship between domestic anti-abuse rules and tax treaties:
Improper use of the Convention
7.
The principal purpose of double taxation conventions is to promote, by
eliminating international double taxation, exchanges of goods and services,
and the movement of capital and persons. As confirmed in the preamble of the
Convention, it is also part of the purposes of tax conventions to prevent tax
avoidance and evasion.
8.
The extension of the network of tax conventions increases the risk of
abuse by facilitating the use of arrangements aimed at securing the benefits of
both the tax advantages available under certain domestic laws and the reliefs
from tax provided for in these conventions.
9.
This would be the case, for example, if a person (whether or not a
residentof a Contracting State), acts through a legal entity created in a State
essentially to obtain treaty benefits that would not be available directly. Another
case would be an individual who has in a Contracting State both his permanent
home and all his economic interests, including a substantial shareholding
in a company of that State, and who, essentially in order to sell the shares
and escape taxation in that State on the capital gains from the alienation (by
virtue of paragraph5of Article13), transfers his permanent home to the other
ContractingState, where such gains are subject to little or no tax.
Addressing tax avoidance through tax conventions
10. Paragraph7 of Article [X] [the PPT rule] and the specific treaty antiabuse rules included in tax conventions are aimed at these and other transactions
and arrangements entered into for the purpose of obtaining treaty benefits in
inappropriate circumstances. [rest of previous paragraph1has been moved to
paragraph19] Where, however, a tax convention does not include such rules, the
question may arise whether the benefits of the tax convention should be granted
when transactions that constitute an abuse of the provisions of that convention
are entered into.
11. Many States address that question by taking account of the fact that taxes
are ultimately imposed through the provisions of domestic law, as restricted
(and in some rare cases, broadened) by the provisions of tax conventions. Thus,
any abuse of the provisions of a tax convention could also be characterised as
an abuse of the provisions of domestic law under which tax will be levied. For
these States, the issue then becomes whether the provisions of tax conventions
may prevent the application of the anti-abuse provisions of domestic law, which
is the question addressed in paragraphs19 to 26.8 below. As explained in these
paragraphs, as a general rule, there will be no conflict between such rules and
the provisions of tax conventions.
12. Other States prefer to view some abuses as being abuses of the convention
itself, as opposed to abuses of domestic law. These States, however, then consider
that a proper construction of tax conventions allows them to disregard abusive
transactions, such as those entered into with the view to obtaining unintended
benefits under the provisions of these conventions. This interpretation results from
SECTION A 81
the object and purpose of tax conventions as well as the obligation to interpret them
in good faith (see Article31 of the Vienna Convention on the Law of Treaties).
13. Under both approaches, therefore, it is agreed that States do not have
to grant the benefits of a double taxation convention where arrangements that
constitute an abuse of the provisions of the convention have been entered into.
14. It is important to note, however, that it should not be lightly assumed that
a taxpayer is entering into the type of abusive transactions referred to above.
A guiding principle is that the benefits of a double taxation convention should
not be available where a main purpose for entering into certain transactions or
arrangements was to secure a more favourable tax position and obtaining that more
favourable treatment in these circumstances would be contrary to the object and
purpose of the relevant provisions. That principle applies independently from the
provisions of paragraph7of Article [X] [the PPT rule], which merely confirm it.
15. The potential application of these principles or of paragraph7of Article
[X] does not mean that there is no need for the inclusion, in tax conventions,
of specific provisions aimed at preventing particular forms of tax avoidance.
Where specific avoidance techniques have been identified or where the use of
such techniques is especially problematic, it will often be useful to add to the
Convention provisions that focus directly on the relevant avoidance strategy.
Also, this will be necessary where a State which adopts the view described in
paragraph11above believes that its domestic law lacks the anti-avoidance rules
or principles necessary to properly address such strategy.
16. For instance, some forms of tax avoidance have already been expressly
dealt with in the Convention, e.g.by the introduction of the concept of beneficial
owner (in Articles10, 11, and 12) and of special provisions such as paragraph2of
Article17 dealing with so-called artiste-companies. Such problems are also
mentioned in the Commentaries on Article10 (paragraphs17 and 22), Article11
(paragraph12) and Article12 (paragraph7).
17. Also, in some cases, claims to treaty benefits by subsidiary companies,
in particular companies established in tax havens or benefiting from harmful
preferential regimes, may be refused where careful consideration of the facts
and circumstances of a case shows that the place of effective management of
a subsidiary does not lie in its alleged state of residence but, rather, lies in the
state of residence of the parent company so as to make it a resident of that latter
state for domestic law purposes (this will be relevant where the domestic law of
a state uses the place of management of a legal person, or a similar criterion, to
determine its residence).
18. Careful consideration of the facts and circumstances of a case may also
show that a subsidiary was managed in the state of residence of its parent in such
a way that the subsidiary had a permanent establishment (e.g.by having a place
of management) in that state to which all or a substantial part of its profits were
properly attributable.
Addressing tax avoidance through domestic anti-abuse rules and judicial doctrines
19. Domestic anti-abuse rules and judicial doctrines may also be used to
address transactions and arrangements entered into for the purpose of obtaining
treaty benefits in inappropriate circumstances. These rules and doctrines may
82 SECTION A
also address situations where transactions or arrangements are entered into for
the purpose of abusing both domestic laws and tax conventions.
20. For these reasons, domestic anti-abuse rules and judicial doctrines play an
important role in preventing treaty benefits from being granted in inappropriate
circumstances. The application of such domestic anti-abuse rules and doctrines,
however, raises the issue of possible conflicts with treaty provisions, in particular
where treaty provisions are relied upon in order to facilitate the abuse of domestic
law provisions (e.g.where it is claimed that treaty provisions protect the taxpayer
from the application of certain domestic anti-abuse rules). This issue is discussed
below in relation to specific legislative anti-abuse rules, general legislative antiabuse rules and judicial doctrines.
Specific legislative anti-abuse rules
21. Tax authorities seeking to address the improper use of a tax treaty may
first consider the application of specific anti-abuse rules included in their
domestic tax law.
22. Many specific anti-abuse rules found in domestic law apply primarily in
cross-border situations and may be relevant for the application of tax treaties.
For instance, thin capitalisation rules may apply to restrict the deduction of baseeroding interest payments to residents of treaty countries; transfer pricing rules
(even if not designed primarily as anti-abuse rules) may prevent the artificial
shifting of income from a resident enterprise to an enterprise that is resident of
a treaty country; exit or departure tax rules may prevent the avoidance of capital
gains tax through a change of residence before the realisation of a treaty-exempt
capital gain; dividend stripping rules may prevent the avoidance of domestic
dividend withholding taxes through transactions designed to transform dividends
into treaty-exempt capital gains; and anti-conduit rules may prevent certain
avoidance transactions involving the use of conduit arrangements.
23. Generally, where the application of provisions of domestic law and of
those of tax treaties produces conflicting results, the provisions of tax treaties
are intended to prevail. This is a logical consequence of the principle of pacta
sunt servanda which is incorporated in Article26 of the Vienna Convention on
the Law of Treaties. Thus, if the application of specific anti-abuse rules found in
domestic law were to result in a tax treatment that is not in accordance with the
provisions of a tax treaty, this would conflict with the provisions of that treaty
and the provisions of the treaty should prevail under public international law.1
[Footnote to paragraph23:] 1. Under Article60 of the Vienna Convention on the
Law of Treaties [a] material breach of a bilateral treaty by one of the parties entitles
the other to invoke the breach as a ground for terminating the treaty or suspending
its operation in whole or in part.
24. As explained below, however, such conflicts will often be avoided and each
case must be analysed based on its own circumstances.
25. First, a treaty may specifically allow the application of certain types of
specific domestic anti-abuse rules. For example, Article9 specifically authorises
the application of domestic rules in the circumstances defined by that Article.
Also, many treaties include specific provisions clarifying that there is no conflict
or, even if there is a conflict, allowing the application of the domestic rules.
SECTION A 83
This would be the case, for example, for a treaty rule that expressly allows the
application of a thin capitalisation rule found in the domestic law of one or both
Contracting States.
26. Second, many provisions of the Convention depend on the application
of domestic law. This is the case, for instance, for the determination of the
residence of a person (see paragraph1of Article4), the determination of what is
immovable property (see paragraph2of Article6) and the determination of when
income from corporate rights might be treated as a dividend (see paragraph3of
Article10). More generally, paragraph2of Article3 makes domestic rules
relevant for the purposes of determining the meaning of terms that are not
defined in the Convention. In many cases, therefore, the application of specific
anti-abuse rules found in domestic law will have an impact on how the treaty
provisions are applied rather than produce conflicting results. This would be
the case, for example, if a domestic law provision treats the profits realised by a
shareholder when a company redeems some of its shares as dividends: although
such a redemption could be considered to constitute an alienation for the purposes
of paragraph5of Article13, paragraph28of the Commentary on Article10
recognises that such profits will constitute dividends for the purposes of Article10
if the profits are treated as dividends under domestic law.
26.1 Third, the application of tax treaty provisions in a case that involves
an abuse of these provisions may be denied under paragraph7of Article [X]
[the PPT rule] or, in the case of a treaty that does not include that paragraph,
under the principles put forward in paragraphs13 and 14 above. In such a
case, there will be no conflict with the treaty provisions if the benefits of the
treaty are denied under both paragraph7of Article [X] (or the principles in
paragraphs13 and 14 above) and the relevant domestic specific anti-abuse rules.
Domestic specific anti-abuse rules, however, are often drafted with reference
to objective facts, such as the existence of a certain level of shareholding or a
certain debt-equity ratio. Whilst this facilitates their application and provides
greater certainty, it may sometimes result in the application of such a rule in
a case where the rule conflicts with a provision of the Convention and where
paragraph7does not apply to deny the benefits of that provision (and where
the principles of paragraphs13-14 above also do not apply). In such a case,
the Convention will not allow the application of the domestic rule to the extent
of the conflict. An example of such a case would be where a domestic law rule
that StateA adopted to prevent temporary changes of residence for tax purposes
would provide for the taxation of an individual who is a resident of StateB on
gains from the alienation of property situated in a third State if that individual
was a resident of StateA when the property was acquired and was a resident of
StateA for at least seven of the 10 years preceding the alienation. In such a case,
to the extent that paragraph5of Article13 would prevent the taxation of that
individual by StateA upon the alienation of the property, the Convention would
prevent the application of that domestic rule unless the benefits of paragraph5of
Article13 could be denied, in that specific case, under paragraph7or the
principles in paragraphs13-14 above.
26.2 Fourth, the application of tax treaty provisions may be denied under
judicial doctrines or principles applicable to the interpretation of the treaty
(see paragraph26.5 below). In such a case, there will be no conflict with the
treaty provisions if the benefits of the treaty are denied under both a proper
84 SECTION A
interpretation of the treaty and as result of the application of domestic specific
anti-abuse rules. Assume, for example, that the domestic law of StateA provides
for the taxation of gains derived from the alienation of shares of a domestic
company in which the alienator holds more than 25per cent of the capital if that
alienator was a resident of StateA for at least seven of the 10 years preceding the
alienation. In year 2, an individual who was a resident of StateA for the previous
10 years becomes a resident of StateB. Shortly after becoming a resident of
StateB, the individual sells the totality of the shares of a small company that he
previously established in StateA. The facts reveal, however, that all the elements
of the sale were finalised in year 1, that an interest-free loan corresponding
to the sale price was made by the purchaser to the seller at that time, that the
purchaser cancelled the loan when the shares were sold to the purchaser in
year 2 and that the purchaser exercised de facto control of the company from
year 1. Although the gain from the sale of the shares might otherwise fall under
paragraph5of Article13 of the StateA-StateB treaty, the circumstances of the
transfer of the shares are such that the alienation in year2 constitutes a sham
within the meaning given to that term by the courts of StateA. In that case, to the
extent that the sham transaction doctrine developed by the courts of StateA does
not conflict with the rules of interpretation of treaties, it will be possible to apply
that doctrine when interpreting paragraph5of Article13 of the StateA-StateB
treaty, which will allow StateA to tax the relevant gain under its domestic law
rule.
General legislative anti-abuse rules
26.3 Many countries have included in their domestic law a legislative antiabuse rule of general application intended to prevent abusive arrangements
that are not adequately dealt with through specific anti-abuse rules or judicial
doctrines.
26.4 The application of such general anti-abuse rules also raises the question of
a possible conflict with the provisions of a tax treaty. In the vast majority of cases,
however, no such conflict will arise. Conflicts will first be avoided for reasons
similar to those presented in paragraphs25 and 26 above. In addition, where the
main aspects of these domestic general anti-abuse rules are in conformity with the
principle of paragraph14above and are therefore similar to the main aspects of
paragraph7of Article [X], which incorporates this guiding principle, it is clear
that no conflict will be possible since the relevant domestic general anti-abuse
rule will apply in the same circumstances in which the benefits of the Convention
would be denied under paragraph7, or, in the case of a treaty that does not
include that paragraph, to the guiding principle in paragraph14above.
Judicial doctrines that are part of domestic law
26.5 In the process of interpreting tax legislation in cases dealing with tax
avoidance, the courts of many countries have developed a number of judicial
doctrines or principles of interpretation. These include doctrines such as
substance over form, economic substance, sham, business purpose, steptransaction, abuse of law and fraus legis. These doctrines and principles of
interpretation, which vary from country to country and evolve over time based on
refinements or changes resulting from subsequent court decisions, are essentially
views expressed by courts as to how tax legislation should be interpreted. Whilst
SECTION A 85
the interpretation of tax treaties is governed by general rules that have been
codified in Articles31 to 33 of the Vienna Convention on the Law of Treaties,
these general rules do not prevent the application of similar judicial doctrines and
principles to the interpretation of the provisions of tax treaties. If, for example,
the courts of one country have determined that, as a matter of legal interpretation,
domestic tax provisions should apply on the basis of the economic substance of
certain transactions, there is nothing that prevents a similar approach from being
adopted with respect to the application of the provisions of a tax treaty to similar
transactions. This is illustrated by the example in paragraph26.2 above.
26.6 As a general rule and having regard to paragraph14, therefore, the
preceding analysis leads to the conclusion that there will be no conflict between
tax conventions and judicial anti-abuse doctrines or general domestic anti-abuse
rules. For example, to the extent that the application of a general domestic antiabuse rule or a judicial doctrine such as substance over form or economic
substance results in a recharacterisation of income or in a redetermination
of the taxpayer who is considered to derive such income, the provisions of the
Convention will be applied taking into account these changes.
26.7 Whilst these rules do not conflict with tax conventions, there is agreement
that member countries should carefully observe the specific obligations
enshrined in tax treaties to relieve double taxation as long as there is no clear
evidence that the treaties are being abused.
Controlled foreign company provisions
26.8 A significant number of countries have adopted controlled foreign
company provisions to address issues related to the use of foreign base companies.
Whilst the design of this type of legislation varies considerably among countries,
a common feature of these rules, which are now internationally recognised as
a legitimate instrument to protect the domestic tax base, is that they result in a
Contracting State taxing its residents on income attributable to their participation
in certain foreign entities. It has sometimes been argued, based on a certain
interpretation of provisions of the Convention such as paragraph1of Article7
and paragraph5of Article10, that this common feature of controlled foreign
company legislation conflicted with these provisions. Since such legislation
results in a State taxing its own residents, paragraph3of Article1 confirms that
it does not conflict with tax conventions. The same conclusion must be reached in
the case of conventions that do not include a provision similar to paragraph3of
Article1; for the reasons explained in paragraphs14 of the Commentary on
Article7 and 37 of the Commentary on Article10, the interpretation according
to which these Articles would prevent the application of controlled foreign
company provisions does not accord with the text of paragraph1of Article7 and
paragraph5of Article10. It also does not hold when these provisions are read in
their context. Thus, whilst some countries have felt it useful to expressly clarify,
in their conventions, that controlled foreign companies legislation did not conflict
with the Convention, such clarification is not necessary. It is recognised that
controlled foreign company legislation structured in this way is not contrary to the
provisions of the Convention.
60. Two specific issues related to the interaction between treaties and specific domestic
anti-abuse rules are discussed below. The first issue deals with domestic anti-abuse rules
found in the domestic law of one State that are aimed at preventing avoidance arrangements
86 SECTION A
entered into by residents of that State. The second issue, which is indirectly related to the
first one, deals with the application of tax treaties to so-called departure or exit taxes.
a) Application of tax treaties to restrict a Contracting States right to tax its own
residents
61. The majority of the provisions included in tax treaties are intended to restrict the right
of a Contracting State to tax the residents of the other Contracting State. In some limited
cases, however, it has been argued that some provisions that are aimed at the taxation of
non-residents could be interpreted as limiting a Contracting States right to tax its own
residents. Such interpretations have been rejected in paragraph6.1 of the Commentary
on Article1, which deals with a Contracting States right to tax partners who are its own
residents on their share of the income of a partnership that is treated as a resident of the
other Contracting State, as well as in paragraph23of the same Commentary, which
addresses the case of controlled foreign companies rules (see also paragraph14of the
Commentary on Article7, which deals with the same issue).
62. It was concluded that the principle reflected in paragraph6.1 of the Commentary
on Article1 should be applicable to the vast majority of the provisions of the Model Tax
Convention in order to prevent interpretations intended to circumvent the application of a
Contracting States domestic anti-abuse rules (as illustrated by the example of controlled
foreign companies rules). This corresponds to the practice long followed by the United
States in its tax treaties, where a so-called saving clause16 confirms the Contracting
States right to tax their residents (and citizens, in the case, of the United States)
notwithstanding the provisions of the treaty except those, such as the rules on relief of
double taxation, that are clearly intended to apply to residents.
63. The following changes will be made to the Model Tax Convention as a result of that
decision:
Add the following paragraph3to Article1:
3.
This Convention shall not affect the taxation, by a Contracting State, of its
residents except with respect to the benefits granted under paragraph3of Article7,
paragraph2of Article9 and Articles19, 20, 23A [23B], 24 and 25 and28.
Add the following paragraphs26.17 to 26.21 to the Commentary on Article1 (other
consequential changes to the Commentary would be required):
26.17 Whilst some provisions of the Convention (e.g.Articles23A and 23B)
are clearly intended to affect how a Contracting State taxes its own residents,
the object of the majority of the provisions of the Convention is to restrict the
right of a Contracting State to tax the residents of the other Contracting State.
In some limited cases, however, it has been argued that some provisions could
be interpreted as limiting a Contracting States right to tax its own residents in
cases where this was not intended (see, for example, paragraph23above, which
addresses the case of controlled foreign companies provisions).
26.18 Paragraph3 confirms the general principle that the Convention does
not restrict a Contracting States right to tax its own residents except where this
is intended and lists the provisions with respect to which that principle is not
applicable.
SECTION A 87
26.19 The exceptions so listed are intended to cover all cases where it is
envisaged in the Convention that a Contracting State may have to provide treaty
benefits to its own residents (whether or not these or similar benefits are provided
under the domestic law of that State). These provisions are:
Paragraph3 of Article7, which requires a Contracting State to grant
to an enterprise of that State a correlative adjustment following an
initial adjustment made by the other Contracting State, in accordance
with paragraph2of Article7, to the amount of tax charged on the
profits of a permanent establishment of the enterprise.
Paragraph2 of Article9, which requires a Contracting State to grant
to an enterprise of that State a corresponding adjustment following an
initial adjustment made by the other Contracting State, in accordance
with paragraph1of Article9, to the amount of tax charged on the
profits of an associated enterprise.
Article19, which may affect how a Contracting State taxes an individual
who is resident of that State if that individual derives income in respect
of services rendered to the other Contracting State or a political
subdivision or local authority thereof.
Article20, which may affect how a Contracting State taxes an
individual who is resident of that State if that individual is also a
student who meets the conditions of that Article.
Articles23A and 23B, which require a Contracting State to provide
relief of double taxation to its residents with respect to the income that
the other State may tax in accordance with the Convention (including
profits that are attributable to a permanent establishment situated
in the other Contracting State in accordance with paragraph2of
Article7).
Article24, which protects residents of a Contracting State against
certain discriminatory taxation practices by that State (such as rules
that discriminate between two persons based on their nationality).
Article25, which allows residents of a Contracting State to request
that the competent authority of that State consider cases of taxation
not in accordance with the Convention.
Article28, which may affect how a Contracting State taxes an
individual who is resident of that State when that individual is a
member of the diplomatic mission or consular post of the other
Contracting State.
26.20 The list of exceptions included in paragraph3should include any other
provision that the Contracting States may agree to include in their bilateral
convention where it is intended that this provision should affect the taxation, by
a Contracting State, of its own residents. For instance, if the Contracting States
agree, in accordance with paragraph27of the Commentary on Article18, to
include in their bilateral convention a provision according to which pensions
and other payments made under the social security legislation of a Contracting
State shall be taxable only in that State, they should include a reference to that
provision in the list of exceptions included in paragraph3.
88 SECTION A
26.21 The term resident, as used in paragraph3and throughout the
Convention, is defined in Article4. Where, under paragraph1of Article4, a
person is considered to be a resident of both Contracting States based on the
domestic laws of these States, paragraphs2 and 3 of that Article determine a single
State of residence for the purposes of the Convention. Thus, paragraph3does not
apply to an individual or legal person who is a resident of one of the Contracting
States under the laws of that State but who, for the purposes of the Convention, is
deemed to be a resident only of the other Contracting State.
64. During the work on the above new provision, a number of issues related to relief of
double taxation were discussed. It was agreed that, as a matter of principle, Articles23A
and 23B of the OECD Model only required a Contracting State to relieve double taxation
when income was taxable in the other State under treaty provisions allowing that other
State to tax the relevant income as the State of source or as a State where there is a
permanent establishment to which that income is attributable. The following draft proposal
for changes to Articles23A and 23B was put forward during the last stages of that work
in order to confirm that principle. It is intended to finalise the work on that draft proposal
in the first part of 2016, which will allow changes that could result from that work to be
considered as part of the negotiation of the multilateral instrument that will implement the
results of the work on treaty issues mandated by the BEPS Action Plan:
Replace paragraph1of Article23A as follows:
1. Where a resident of a Contracting State derives income or owns capital
which may be taxed in the other Contracting State in accordance with the
provisions of this Convention (except to the extent that these provisions allow
taxation by that other State solely because the income is also income derived
by a resident of that State), may be taxed in the other Contracting State, the firstmentioned State shall, subject to the provisions of paragraphs2 and 3, exempt such
income or capital from tax.
Replace paragraph1of Article23B as follows:
1. Where a resident of a Contracting State derives income or owns capital
which may be taxed in the other Contracting State in accordance with the
provisions of this Convention (except to the extent that these provisions allow
taxation by that other State solely because the income is also income derived
by a resident of that State), may be taxed in the other Contracting State, the firstmentioned State shall allow:
a) as a deduction from the tax on the income of that resident, an amount
equal to the income tax paid in that other State;
b) as a deduction from the tax on the capital of that resident, an amount
equal to the capital tax paid in that other State.
Such deduction in either case shall not, however, exceed that part of the income tax
or capital tax, as computed before the deduction is given, which is attributable, as
the case may be, to the income or the capital which may be taxed in that other State.
SECTION A 89
Add the following paragraph11.1 to the Commentary on Articles23A and 23B (other
consequential changes to the Commentary may be required):
11.1 In some cases, the same income or capital may be taxed by each Contracting
State as income or capital of one of its residents. This may happen where, for
example, one of the Contracting States taxes the worldwide income of an entity
that is a resident of that State whereas the other State views that entity as fiscally
transparent and taxes the members of that entity who are residents of that other
State on their respective share of the income. The phrase (except to the extent
that these provisions allow taxation by that other State solely because the income
is also income derived by a resident of that State) clarifies that in such cases,
both States are not reciprocally obliged to provide relief for each others tax levied
exclusively on the basis of the residence of the taxpayer and that each State is
therefore only obliged to provide relief of double taxation to the extent that taxation
by the other State is in accordance with provisions of the Convention that allow
taxation of the relevant income as the State of source or as a State where there is
a permanent establishment to which that income is attributable, thereby excluding
taxation that would solely be in accordance with paragraph3of Article1. Whilst
this result would logically follow from the wording of Articles23A and 23B even
in the absence of that phrase, the addition of the phrase removes any doubt in this
respect.
b)
Departure or exit taxes
65. In a number of States, liability to tax on some types of income that have accrued for
the benefit of a resident (whether an individual or a legal person) is triggered in the event
that the resident ceases to be a resident of that State. Taxes levied in these circumstances
are generally referred to as departure taxes or exit taxes and may apply, for example,
to accrued pension rights and accrued capital gains.
66. To the extent that the liability to such a tax arises when a person is still a resident of
the State that applies the tax and does not extend to income accruing after the cessation
of residence, nothing in the Convention, and in particular in Articles13 and 18, prevents
the application of that form of taxation. Thus, tax treaties do not prevent the application
of domestic tax rules according to which a person is considered to have realised pension
income, or to have alienated property for capital gain tax purposes, immediately before
ceasing to be a resident. The provisions of tax treaties do not govern when income is
realised for domestic tax purposes (see, for example, paragraphs3 and 7 to 9 of the
Commentary on Article13); also, since the provisions of tax treaties apply regardless
of when tax is actually paid (see, for example, paragraph12.1 of the Commentary on
Article15), it does not matter when such taxes become payable, The application of such
taxes, however, creates risks of double taxation where the relevant person becomes
a resident of another State which seeks to tax the same income at a different time,
e.g.when pension income is actually received or when assets are sold to third parties.
This problem, which is the result of that person being a resident of two States at different
times and of these States levying tax upon the realisation of different events, is discussed
in paragraphs4.1 to 4.3 of the Commentary on Article23A and 23B. As indicated in
paragraph4.3 of that Commentary, which addresses a similar example where two States of
residence tax the benefit arising from an employee stock-option at different times:
The mutual agreement procedure could be used to deal with such a case. One
possible basis to solve the case would be for the competent authorities of the two
90 SECTION A
States to agree that each State should provide relief as regards the residence-based
tax that was levied by the other State on the part of the benefit that relates to
services rendered during the period while the employee was a resident of that other
State.
67. Based on that approach, a possible basis for solving double taxation situations arising
from the application of departure taxes would be for the competent authorities of the two
States involved to agree, through the mutual agreement procedure, that each State should
provide relief as regards the residence-based tax that was levied by the other State on the
part of the income that accrued while the person was a resident of that other State. This
would mean that the new State of residence would provide relief for the departure tax
levied by the previous State of residence on income that accrued whilst the person was a
resident of that other State, except to the extent that the new State of residence would have
had source taxation rights at the time that income was taxed (i.e.as a result of paragraphs2
or 4 of Article13). States wishing to provide expressly for that result in their tax treaties
are free to include provisions to that effect.
SECTION B 91
B.
Clarification that tax treaties are not intended to be used to generate double
non-taxation
68. The second part of the work mandated by Action6 was to clarify that tax treaties
are not intended to be used to generate double non-taxation.
69. The existing provisions of tax treaties were developed with the prime objective of
preventing double-taxation. This was reflected in the title proposed in both the 1963 Draft
Double Taxation Convention on Income and Capital and the 1977 Model Double Taxation
Convention on Income and Capital, which was:
Convention between (StateA) and (StateB) for the avoidance of double taxation
with respect to taxes on income and on capital
70. In 1977, however, the Commentary on Article1 was modified to provide expressly
that tax treaties were no intended to encourage tax avoidance or evasion. The relevant part
of paragraph7of the Commentary read as follows:
The purpose of double taxation conventions is to promote, by eliminating international
double taxation, exchanges of goods and services, and the movement of capital and
persons; they should not, however, help tax avoidance or evasion.
71. In 2003, that paragraph was amended to clarify that the prevention of tax avoidance
was also a purpose of tax treaties. Paragraph7 now reads as follows:
The principal purpose of double taxation conventions is to promote, by eliminating
international double taxation, exchanges of goods and services, and the movement
of capital and persons. It is also a purpose of tax conventions to prevent tax
avoidance and evasion.
72. In order to provide the clarification required by Action6, it has been decided to state
clearly, in the title recommended by the OECD Model Tax Convention, that the prevention
of tax evasion and avoidance is a purpose of tax treaties. It has also been decided that
the OECD Model Tax Convention should recommend a preamble that provides expressly
that States that enter into a tax treaty intend to eliminate double taxation without creating
opportunities for tax evasion and avoidance. Given the particular concerns arising
from treaty shopping arrangements, it has also been decided to refer expressly to such
arrangements as one example of tax avoidance that should not result from tax treaties. The
following are the changes that will be made to the OECD Model Tax Convention as a result
of the work on this aspect of Action6:
Replace the Title of the Convention (including its footnote) by the following:
Convention between (StateA) and (StateB) for the elimination of double
taxation with respect to taxes on income and on capital and the prevention of tax
evasion and avoidance Convention between (StateA) and (StateB) with respect to
taxes on income and on capital1
1. States wishing to do so may follow the widespread practice of including
in the title a reference to either the avoidance of double taxation or to both
the avoidance of double taxation and the prevention of fiscal evasion.
92 SECTION B
Replace the heading Preamble to the Convention (including its footnote) by the following:
PREAMBLE TO THE CONVENTION1
1. The Preamble of the Convention shall be drafted in accordance with the
constitutional procedure of both Contracting States.
PREAMBLE TO THE CONVENTION
(StateA) and (StateB),
Desiring to further develop their economic relationship and to enhance their
cooperation in tax matters,
Intending to conclude a Convention for the elimination of double taxation with
respect to taxes on income and on capital without creating opportunities for
non-taxation or reduced taxation through tax evasion or avoidance (including
through treaty-shopping arrangements aimed at obtaining reliefs provided in this
Convention for the indirect benefit of residents of third States)
Have agreed as follows:
73. The clear statement of the intention of the signatories to a tax treaty that appears in the
above preamble will be relevant to the interpretation and application of the provisions of that
treaty. According to the basic rule of interpretation of treaties in Article31(1) of the Vienna
Convention on the Law of Treaties (VCLT), [a] treaty shall be interpreted in good faith in
accordance with the ordinary meaning to be given to the terms of the treaty in their context
and in the light of its object and purpose [emphasis added]. Article31(2)17 VCLT confirms
that, for the purpose of this basic rule, the context of the treaty includes its preamble.18
74. The above changes to the Title and Preamble will be supplemented by the following
changes to the Introduction to the OECD Model Tax Convention:
Replace paragraphs2 and 3 of the Introduction by the following:
2.
It has long been recognised among the member countries of the Organisation
for Economic Co-operation and Development that it is desirable to clarify,
standardise, and confirm the fiscal situation of taxpayers who are engaged
in commercial, industrial, financial, or any other activities in other countries
through the application by all countries of common solutions to identical cases of
double taxation. These countries have also long recognised the need to improve
administrative co-operation in tax matters, notably through exchange of
information and assistance in collection of taxes, for the purpose of preventing
tax evasion and avoidance.
3.
These are this is the main purposes of the OECD Model Tax Convention
on Income and on Capital, which provides a means of settling on a uniform basis
the most common problems that arise in the field of international juridical double
taxation. As recommended by the Council of the OECD,1 member countries,
when concluding or revising bilateral conventions, should conform to this Model
Convention as interpreted by the Commentaries thereon and having regard to
the reservations contained therein and their tax authorities should follow these
Commentaries, as modified from time to time and subject to their observations
thereon, when applying and interpreting the provisions of their bilateral tax
conventions that are based on the Model Convention.
[Footnote to paragraph3] 1.
See Annex.
SECTION B 93
Replace paragraph16of the Introduction by the following:

16. In both the 1963 Draft Convention and the 1977 Model Convention, the title
of the Model Convention included a reference to the elimination of double taxation.
In recognition of the fact that the Model Convention does not deal exclusively
with the elimination of double taxation but also addresses other issues, such as
the prevention of tax evasion and avoidance as well as non-discrimination, it was
subsequently decided, in 1992, to use a shorter title which did not include this
reference. This change has been was made both on the cover page of this publication
and in the Model Convention itself. However, it is was understood that the practice
of many member countries is was still to include in the title a reference to either the
eliminationof double taxation or to both the elimination of double taxation and the
prevention of fiscal evasion since both approaches emphasised these important
purposes of the Convention.
16.1 As a result of work undertaken as part of the OECD Action Plan on
Base Erosion and Profit Shifting, in [year] the Committee decided to amend the
title of the Convention and to include a preamble. The changes made expressly
recognise that the purposes of the Convention are not limited to the elimination
of double taxation and that the Contracting States do not intend the provisions
of the Convention to create opportunities for non-taxation or reduced taxation
through tax evasion and avoidance. Given the particular base erosion and profit
shifting concerns arising from treaty-shopping arrangements, it was also decided
to refer expressly to such arrangements as one example of tax avoidance that
should not result from tax treaties, it being understood that this was only one
example of tax avoidance that the Contracting States intend to prevent.
16.2 Since the title and preamble form part of the context of the Convention1
and constitute a general statement of the object and purpose of the Convention,
they should play an important role in the interpretation of the provisions of the
Convention. According to the general rule of treaty interpretation contained in
Article31(1) of the Vienna Convention on the Law of Treaties, [a] treaty shall be
interpreted in good faith in accordance with the ordinary meaning to be given to
the terms of the treaty in their context and in the light of its object and purpose.
[Footnote to paragraph16.2:] 1. See Art.31(2) VCLT.
94 SECTION C
C.
Tax policy considerations that, in general, countries should consider before

decidingtoenterintoatax treaty with another country
75. The third part of the work mandated by Action6 was to identify the tax policy
considerations that, in general, countries should consider before deciding to enter into a tax
treaty with another country.
76. It was agreed that having a clearer articulation of the policy considerations that, in
general, countries should consider before deciding to enter into a tax treaty could make it
easier for countries to justify their decisions not to enter into tax treaties with certain low
or no-tax jurisdictions. It was also recognised, however, that there are also many non-tax
factors that can lead to the conclusion of a tax treaty and that each country has a sovereign
right to decide to enter into tax treaties with any jurisdiction with which it decides to do so.
77. In the course of the work on this aspect of Action6, it was decided that the results
of that work should reflect the fact that many of the tax policy considerations relevant
to the conclusion of a tax treaty are also relevant to the question of whether to modify
(or, ultimately, terminate) a treaty previously concluded in the event that a change of
circumstances (such as changes to the domestic law of a treaty partner) raises BEPS
concerns related to that treaty.
78. The following changes will be made to the Introduction of the OECD Model Tax
Convention as a result of the work on this aspect of Action6:
Insert the following paragraphs and new heading immediately after paragraph15in
the Introduction to the OECD Model Convention (existing section C of the Introduction
would become sectionD):
C. Tax policy considerations that are relevant to the decision of whether to enter into
a tax treaty or amend an existing treaty
15.1 In 1997, the OECD Council adopted a recommendation that the Governments
of member countries pursue their efforts to conclude bilateral tax treaties with
those member countries, and where appropriate with non-member countries,
with which they had not yet entered into such conventions. Whilst the question
of whether or not to enter into a tax treaty with another country is for each
State to decide on the basis of different factors, which include both tax and
non-tax considerations, tax policy considerations will generally play a key role
in that decision. The following paragraphs describe some of these tax policy
considerations, which are relevant not only to the question of whether a treaty
should be concluded with a State but also to the question of whether a State
should seek to modify or replace an existing treaty or even, as a last resort,
terminate a treaty (taking into account the fact that termination of a treaty often
has a negative impact on large number of taxpayers who are not concerned by the
situations that result in the termination of the treaty).
15.2 Since a main objective of tax treaties is the avoidance of double taxation
in order to reduce tax obstacles to cross-border services, trade and investment,
SECTION C 95
the existence of risks of double taxation resulting from the interaction of the
tax systems of the two States involved will be the primary tax policy concern.
Such risks of double taxation will generally be more important where there is
a significant level of existing or projected cross-border trade and investment
between two States. Most of the provisions of tax treaties seek to alleviate double
taxation by allocating taxing rights between the two States and it is assumed that
where a State accepts treaty provisions that restrict its right to tax elements of
income, it generally does so on the understanding that these elements of income
are taxable in the other State. Where a State levies no or low income taxes,
other States should consider whether there are risks of double taxation that
would justify, by themselves, a tax treaty. States should also consider whether
there are elements of another States tax system that could increase the risk of
non-taxation, which may include tax advantages that are ring-fenced from the
domestic economy.
15.3 Accordingly, two States that consider entering into a tax treaty should
evaluate the extent to which the risk of double taxation actually exists in crossborder situations involving their residents. A large number of cases of residencesource juridical double taxation can be eliminated through domestic provisions
for the relief of double taxation (ordinarily in the form of either the exemption
or credit method) which operate without the need for tax treaties. Whilst these
domestic provisions will likely address most forms of residence-source juridical
double taxation, they will not cover all cases of double taxation, especially if
there are significant differences in the source rules of the two States or if the
domestic law of these States does not allow for unilateral relief of economic
double taxation (e.g.in the case of a transfer pricing adjustment made in another
State).
15.4 Another tax policy consideration that is relevant to the conclusion of a
tax treaty is the risk of excessive taxation that may result from high withholding
taxes in the source State. Whilst mechanisms for the relief of double taxation
will normally ensure that such high withholding taxes do not result in double
taxation, to the extent that such taxes levied in the State of source exceed the
amount of tax normally levied on profits in the State of residence, they may have
a detrimental effect on cross-border trade and investment.
15.5 Further tax considerations that should be taken into account when
considering entering into a tax treaty include the various features of tax treaties
that encourage and foster economic ties between countries, such as the protection
from discriminatory tax treatment of foreign investment that is offered by the
non-discrimination rules of Article24, the greater certainty of tax treatment for
taxpayers who are entitled to benefit from the treaty and the fact that tax treaties
provide, through the mutual agreement procedure, together with the possibility
for Contracting States of moving to arbitration, a mechanism for the resolution
of cross-border tax disputes.
15.6 An important objective of tax treaties being the prevention of tax
avoidance and evasion, States should also consider whether their prospective
treaty partners are willing and able to implement effectively the provisions of tax
treaties concerning administrative assistance, such as the ability to exchange
tax information, this being a key aspect that should be taken into account when
deciding whether or not to enter into a tax treaty. The ability and willingness of
96 SECTION C
a State to provide assistance in the collection of taxes would also be a relevant
factor to take into account. It should be noted, however, that in the absence of
any actual risk of double taxation, these administrative provisions would not, by
themselves, provide a sufficient tax policy basis for the existence of a tax treaty
because such administrative assistance could be secured through more targeted
alternative agreements, such as the conclusion of a tax information exchange
agreement or the participation in the multilateral Convention on Mutual
Administrative Assistance in Tax Matters.1
[Footnote to paragraph15.6:] Available at www.oecd.org/ctp/exchange-of-taxinformation/ENG-Amended-Convention.pdf
79. As already mentioned, many of the tax policy considerations relevant to the
conclusion of a tax treaty are also relevant to the question of whether to modify (or,
ultimately, terminate) a treaty previously concluded and certain changes to the domestic
law of a treaty partner that are made after the conclusion of a tax treaty may raise BEPS
concerns in relation to that treaty. In addition, when negotiating a tax treaty, a State may be
concerned that certain features of the domestic law of the State with which it is negotiating
may raise BEPS concerns even if these concerns may not be sufficient to justify not
entering into a tax treaty with that State.
80. A State that has such BEPS concerns with respect to certain features of the domestic
law of a prospective treaty partner or with respect to changes that might be made after
the conclusion of a tax treaty may want to protect its tax base against such risks and may
therefore find it useful to include in its treaties provisions that would restrict treaty benefits
with respect to taxpayers that benefit from certain preferential tax rules or with respect to
certain drastic changes that could be made to a countrys domestic law after the conclusion
of a treaty.
81. The following two proposals seek to achieve this objective. These proposals were
first released for comments in May 2015. At about the same time, however, the United
States released new versions of similar proposals19 for public comments to be sent by
15September 2015. When these new versions of the United States proposals were
discussed, it was agreed that they should be further examined once finalised by the United
States in the light of the comments that will be received on them. For that reason, the
proposals below will need to be reviewed and, if necessary, finalised in the first part of
2016, which will allow any decision reached on these proposals to be taken into account as
be considered as draft proposals to be further discussed:
[Proposal 1 New treaty provisions on special tax regimes
New definition of special tax regime to be included in Article3 (General
Definitions)
X) the term special tax regime with respect to an item of income or
profit means any legislation, regulation or administrative practice that
provides a preferential effective rate of taxation to such income or profit,
including through reductions in the tax rate or the tax base. With regard
to financing income, the term special tax regime includes notional
interest deductions that are allowed without regard to liabilities for such
SECTION C 97
interest. However, the term shall not include any legislation, regulation
or administrative practice:
i)
the application of which does not disproportionately benefit interest,

royalties or other income, or any combination thereof;
ii) except with regard to financing income, that satisfies a substantial

activity requirement;
iii) that is designed to prevent double taxation;
iv) that implements the principles of Article7 (Business Profits) or
Article9 (Associated Enterprises);
v)
that applies to persons which exclusively promote religious, charitable,

scientific, artistic, cultural or educational activities;
vi) that applies to persons substantially all of the activity of which is to

provide or administer pension or retirement benefits;
vii) that facilitates investment in widely-held entities that hold real
property (immovable property), a diversified portfolio of securities,
or any combination thereof, and that are subject to investor-protection
regulation in the Contracting State in which the investment entity is
established; or
viii) that the Contracting States have agreed shall not constitute a special
tax regime because it does not result in a low effective rate of
taxation;
Protocol provisions
With reference to subparagraph X) of paragraph1of Article3 (General
Definitions):
The term special tax regime shall include:
a) in the case of _______:
i) [list relevant specific legislation, regulations and/or administrative
practices in the Contracting State];
b) in the case of _______:
practices in the Contracting State].
With reference to subdivision viii) of subparagraph (X) of paragraph1of Article3
(General Definitions):
The term special tax regime shall not include:
a) in the case of _______:
practices in the Contracting State];
b) in the case of _______:
practices in the Contracting State].
98 SECTION C
New Provisions for Articles11, 12 and 21
New provision for Article11 (Interest)
Interest arising in a Contracting State and beneficially owned by a resident of
the other Contracting State may be taxed in the first-mentioned Contracting
State in accordance with domestic law if such resident is subject to a special tax
regime with respect to interest in its Contracting State of residence at any time
during the taxable period in which the interest is paid.
New provision for Article12 (Royalties)
Royalties arising in a Contracting State and beneficially owned by a resident
of the other Contracting State may be taxed in the first-mentioned Contracting
State in accordance with domestic law if such resident is subject to a special tax
regime with respect to royalties in its Contracting State of residence at any time
during the taxable period in which the royalties are paid.
New provision for Article21 (Other income)
Other income arising in a Contracting State and beneficially owned by a
resident of the other Contracting State may be taxed in the first-mentioned
Contracting State in accordance with domestic law if such resident is subject
to a special tax regime with respect to other income in its Contracting State of
residence at any time during the taxable period in which the other income is
paid.]
[Proposal 2 New general treaty rule intended to make a tax treaty responsive to
certain future changes in a countrys domestic tax laws
1.
If at any time after the signing of this Convention, either Contracting State
provides an exemption from taxation to resident companies for substantially all
foreign source income (including interest and royalties), the provisions of Articles10
(Dividends), 11 (Interest), 12 (Royalties) and 21 (Other Income) may cease to have
effect pursuant to paragraph3of this Article for payments to companies resident of
either Contracting State.
2.
If at any time after the signing of this Convention, either Contracting State
provides an exemption from taxation to resident individuals for substantially
all foreign source income (including interest and royalties), the provisions of
Articles10, 11, 12 and 21 may cease to have effect pursuant to paragraph3of this
Article for payments to individuals resident of either Contracting State.
3.
If the provisions of either paragraph1or paragraph2of this Article are
satisfied, a Contracting State may notify the other Contracting State through
diplomatic channels that it will cease to apply the provisions of Articles10, 11,
12 and 21. In such case, the provisions of such Articles shall cease to have effect
in both Contracting States with respect to payments to resident individuals or
companies, as appropriate, six months after the date of such written notification,
and the Contracting States shall consult with a view to concluding amendments to
this Convention to restore the balance of benefits provided.]
Notes 99
Notes
1.
See www.treasury.gov/press-center/press-releases/Pages/jl10057.aspx.
2.
Cases where a resident of the Contracting State in which income originates seeks to obtain
treaty benefits (e.g.through a transfer of residence to the other Contracting State or through the
use of an entity established in that other State) could also be considered to constitute a form of
treaty shopping and are addressed by the recommendations included in this report.
3.
Reproduced at page R(5)-1 and R(6)-1 of the full version of the Model.
4.
Reproduced at page R(17)-1 of the full version of the Model.
5.
See, in particular, Recommendation 9 of the Report:

that countries consider including in their tax conventions provisions aimed at restricting
the entitlement to treaty benefits for entities and income covered by measures constituting
harmful tax practices and consider how the existing provisions of their tax conventions can
be applied for the same purpose; that the Model Tax Convention be modified to include
such provisions or clarifications as are needed in that respect.
6.
Paragraph20 of the Commentary on Article1.
7.
Paragraph21.4 of the Commentary on Article1.
8.
See www.treasury.gov/resource-center/tax-policy/treaties/Documents/Treaty-Limitation-onBenefits-5-20-2015.pdf
9.
The drafting of this Article will depend on how the Contracting States decide to implement
their common intention to eliminate double taxation without creating opportunities for nontaxation or reduced taxation through tax evasion or avoidance, including through treaty
shopping arrangements. This could be done either through the adoption of paragraph7only,
through the adoption of the detailed version of paragraphs1 to 6 that is described in the
Commentary on Article [X] together with the implementation of an anti-conduit mechanism as
described in paragraph [x] of that Commentary, or through the adoption of paragraph7together
with any variation of paragraphs1 to 6 described in the Commentary on Article [X].
10.
Paragraphs1 to 6 and the Commentary thereon are in square brackets pending their finalisation.
11.
One assumption that led to the inclusion of paragraph4was that Action5 (Counter harmful
tax practices more effectively, taking into account transparency and substance) and Action8
(Intangibles) of the BEPS Action Plan will address BEPS concerns that may arise from a
derivative benefits provision that would apply not only to dividends but also to base-eroding
payments such as royalties. The inclusion of paragraph4will therefore need to be examined
based on the outcome of the work on these Action items and on alternative means of addressing
those BEPS concerns such as the measure on special tax regimes described in SectionC of
this Report.
12.
Paragraph16 of that report.
13.
Paragraph23 of the Commentary on Article4 of the 1963 Draft Convention.
14.
See
www.treasury.gov/resource-center/tax-policy/treaties/Documents/Treaty-ExemptPermanent-Establishments-5-20-2015.pdf.
100 Notes
15.
Under the principles of public international law, as codified in Articles26 and 27 of the Vienna
Convention on the Law of Treaties (VCLT), if the application of a domestic anti-abuse rule has
the effect of allowing a State that is party to a tax treaty to tax an item of income that that State
is not allowed to tax under the provisions of the treaty, the application of the domestic antiabuse rule would conflict with the provisions of the treaty and these treaty provisions should
prevail.
16.
The saving clause and its exceptions read as follows in the US Model:
4. Except to the extent provided in paragraph5, this Convention shall not affect the taxation
by a Contracting State of its residents (as determined under Article4 (Resident)) and its
citizens. Notwithstanding the other provisions of this Convention, a former citizen or
former long-term resident of a Contracting State may be taxed in accordance with the
laws of that Contracting State.
5. T
he provisions of paragraph4shall not affect:
a)
the benefits conferred by a Contracting State under paragraph2of Article9
(Associated Enterprises), paragraph7of Article13 (Gains), subparagraphb) of
paragraph1, paragraphs2, 3 and 6 of Article17 (Pensions, Social Security, Annuities,
Alimony, and Child Support), paragraph3of Article18 (Pension Funds), and
Articles23 (Relief From Double Taxation), 24 (NonDiscrimination), and 25 (Mutual
Agreement Procedure); and
b)
the benefits conferred by a Contracting State under paragraph1of Article18
(Pension Funds), Articles19 (Government Service), 20 (Students and Trainees), and
27 (Members of Diplomatic Missions and Consular Posts), upon individuals who are
neither citizens of, nor have been admitted for permanent residence in, that State.
17.
2.
The context for the purpose of the interpretation of a treaty shall comprise, in addition
to the text, including its preamble and annexes:
(a) Any agreement relating to the treaty which was made between all the parties in
connexion with the conclusion of the treaty;

(b) Any instrument which was made by one or more parties in connexion with the
conclusion of the treaty and accepted by the other parties as an instrument related to the
treaty.
18.
The Commentary on the 1966 Draft of the Vienna Convention on the Law of Treaties notes
that the International Court of Justice has more than once had recourse to the statement of the
object and purpose of the treaty in the preamble in order to interpret a particular provision
(Draft Articles on the Law of Treaties with commentaries, Report of the International Law
Commission to the General Assembly, Yearbook of the International Law Commission, 1966,
vol. II, p.221).
19.
See www.treasury.gov/resource-center/tax-policy/treaties/Documents/Treaty-Special-TaxRegimes-5-20-2015.pdf and www.treasury.gov/resource-center/tax-policy/treaties/Documents/

Treaty-Subsequent-Changes-in-Law-5-20-2015.pdf.
Bibliography 101
Bibliography
OECD (2015a), Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 2015
OECD (2015b), Preventing the Artificial Avoidance of Permanent Establishment Status,
Action 7 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project,
OECD (2014), Preventing the Granting of Treaty Benefits in Inappropriate Circumstances,
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2012), Model Tax Convention on Income and on Capital 2010 (Full Version),
OECD (2010), The Granting of Treaty Benefits with Respect to the Income of Collective
Investment Vehicles, OECD, Paris, www.oecd.org/ctp/treaties/45359261.pdf.
OECD (2008), Tax Treaty Issues Related to REITs, OECD, Paris, www.oecd.org/tax/
treaties/39554788.pdf.

AND DEVELOPMENT

(23 2015 33 1 P) ISBN 978-92-64-24120-6 2015
Preventing the Granting of Treaty Benefits in

Inappropriate Circumstances
Contents
Introduction
A. Treaty provisions and/or domestic rules to prevent the granting of treaty benefits in inappropriate
circumstances
B. Clarification that tax treaties are not intended to be used to generate double non-taxation
C. Tax policy considerations that, in general, countries should consider before deciding to enter
into a tax treaty with another country

isbn 978-92-64-24120-6
23 2015 33 1 P

Project
Preventing the Artificial

Avoidance of Permanent
Establishment Status
Preventing the Artificial

Avoidance of Permanent
Establishment Status,
Action 7 2015 Final
Report

OECD (2015), Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7 - 2015 Final
Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241220-en
ISBN 978-92-64-24121-3 (print)

ISBN 978-92-64-24122-0 (PDF)

OECD 2015
FOREwORD 3
Foreword
PREVENTING THE ARTIFICIAL AVOIDANCE OF PERMANENT ESTABLISHMENT STATUS OECD 2015
4 FOREwORD
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms ................................................................................................................ 7
Executive summary................................................................................................................................ 9
Background .......................................................................................................................................... 13
A.
Artificial avoidance of PE status through commissionnaire arrangements and similar

strategies ...................................................................................................................................... 15
B.
Artificial avoidance of PE status through the specific activity exemptions.......................... 28

1.
2.
C.
Other strategies for the artificial avoidance of PE status ....................................................... 42

1.
2.
D.
List of activities included in Art. 5(4) ................................................................................ 28

Fragmentation of activities between closely related parties ............................................... 39
Splitting-up of contracts ..................................................................................................... 42
Strategies for selling insurance in a State without having a PE therein ............................. 44
Profit attribution to PEs and interaction with action points on transfer pricing ................. 45
Notes ...................................................................................................................................................... 46
Bibliography ......................................................................................................................................... 46

BEPS
MNE
OECD
PE
PPT
Principal Purposes Test
EXECUTIVE SUMMARY 9
Executive summary
Tax treaties generally provide that the business profits of a foreign enterprise are
taxable in a State only to the extent that the enterprise has in that State a permanent
establishment (PE) to which the profits are attributable. The definition of PE included in
tax treaties is therefore crucial in determining whether a non-resident enterprise must pay
income tax in another State.
The Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD,
2013a) called for a review of that definition to prevent the use of certain common tax
avoidance strategies that are currently used to circumvent the existing PE definition, such
as arrangements through which taxpayers replace subsidiaries that traditionally acted as
distributors by commissionnaire arrangements, with a resulting shift of profits out of the
country where the sales took place without a substantive change in the functions
performed in that country. Changes to the PE definition are also necessary to prevent the
exploitation of the specific exceptions to the PE definition currently provided for by Art.
5(4) of the OECD Model Tax Convention (2014), an issue which is particularly relevant
in the digital economy.
This report includes the changes that will be made to the definition of PE in Article 5
of the OECD Model Tax Convention, which is widely used as the basis for negotiating
tax treaties, as a result of the work on Action 7 of the BEPS Action Plan.
Together with the changes to tax treaties proposed in the Report on Action 6
(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, OECD,
2015a), the changes recommended in this report will restore taxation in a number of cases
where cross-border income would otherwise go untaxed or would be taxed at very low
rates as result of the provisions of tax treaties. Taken together, these tax treaty changes
will enable countries to address BEPS concerns resulting from tax treaties, which was a
key focus of the work mandated by the BEPS Action Plan.
Artificial avoidance of PE status through commissionnaire arrangements and

similar strategies
A commissionnaire arrangement may be loosely defined as an arrangement through
which a person sells products in a State in its own name but on behalf of a foreign
enterprise that is the owner of these products. Through such an arrangement, a foreign
enterprise is able to sell its products in a State without technically having a permanent
establishment to which such sales may be attributed for tax purposes and without,
therefore, being taxable in that State on the profits derived from such sales. Since the
person that concludes the sales does not own the products that it sells, that person cannot
be taxed on the profits derived from such sales and may only be taxed on the
remuneration that it receives for its services (usually a commission). A foreign enterprise
that uses a commissionnaire arrangement does not have a permanent establishment
because it is able to avoid the application of Art. 5(5) of the OECD Model Tax
Convention, to the extent that the contracts concluded by the person acting as a
commissionnaire are not binding on the foreign enterprise. Since Art. 5(5) relies on the
formal conclusion of contracts in the name of the foreign enterprise, it is possible to avoid
the application of that rule by changing the terms of contracts without material changes in
the functions performed in a State. Commissionnaire arrangements have been a major
preoccupation of tax administrations in many countries, as shown by a number of cases
dealing with such arrangements that were litigated in OECD countries. In most of the
cases that went to court, the tax administrations arguments were rejected.
Similar strategies that seek to avoid the application of Art. 5(5) involve situations
where contracts which are substantially negotiated in a State are not formally concluded
in that State because they are finalised or authorised abroad, or where the person that
habitually exercises an authority to conclude contracts constitutes an independent agent
to which the exception of Art. 5(6) applies even though it is closely related to the foreign
enterprise on behalf of which it is acting.
As a matter of policy, where the activities that an intermediary exercises in a country are
intended to result in the regular conclusion of contracts to be performed by a foreign
enterprise, that enterprise should be considered to have a taxable presence in that country
unless the intermediary is performing these activities in the course of an independent
business. The changes to Art. 5(5) and 5(6) and the detailed Commentary thereon that are
included in section A of the report address commissionnaire arrangements and similar
strategies by ensuring that the wording of these provisions better reflect this underlying
policy.
Artificial avoidance of PE status through the specific exceptions in Art. 5(4)

When the exceptions to the definition of permanent establishment that are found in
Art. 5(4) of the OECD Model Tax Convention were first introduced, the activities
covered by these exceptions were generally considered to be of a preparatory or auxiliary
nature.
Since the introduction of these exceptions, however, there have been dramatic
changes in the way that business is conducted. This is outlined in detail in the Report on
Action 1 (Addressing the Tax Challenges of the Digital Economy, OECD, 2015b).
Depending on the circumstances, activities previously considered to be merely
preparatory or auxiliary in nature may nowadays correspond to core business activities. In
order to ensure that profits derived from core activities performed in a country can be
taxed in that country, Article 5(4) is modified to ensure that each of the exceptions
included therein is restricted to activities that are otherwise of a preparatory or auxiliary
character. The modifications are found in section B of the report.
BEPS concerns related to Art. 5(4) also arise from what is typically referred to as the
fragmentation of activities. Given the ease with which multinational enterprises
(MNEs) may alter their structures to obtain tax advantages, it is important to clarify that it
is not possible to avoid PE status by fragmenting a cohesive operating business into
several small operations in order to argue that each part is merely engaged in preparatory
or auxiliary activities that benefit from the exceptions of Art. 5(4). The anti-fragmentation
rule proposed in section B will address these BEPS concerns.
Other strategies for the artificial avoidance of PE status

The exception in Art. 5(3), which applies to construction sites, has given rise to
abuses through the practice of splitting-up contracts between closely related enterprises.
The Principal Purposes Test (PPT) rule that will be added to the OECD Model Tax
Convention as a result of the adoption of the Report on Action 6 (Preventing the Granting
of Treaty Benefits in Inappropriate Circumstances)1 will address the BEPS concerns
related to such abuses. In order to make this clear, the example put forward in section C
of this report will be added to the Commentary on the PPT rule. For States that are unable
to address the issue through domestic anti-abuse rules, a more automatic rule will be
included in the Commentary as a provision that should be used in treaties that do not
include the PPT or as an alternative provision to be used by countries specifically
concerned with the splitting-up of contracts issue.
Follow-up, including on issues related to attribution of profits to PEs

The changes to the definition of PE that are included in this report will be among the
changes proposed for inclusion in the multilateral instrument that will implement the
results of the work on treaty issues mandated by the BEPS Action Plan.
Also, in order to provide greater certainty about the determination of profits to be
attributed to the PEs that will result from the changes included in this report and to take
account of the need for additional guidance on the issue of attribution of profits to PEs,
follow-up work on attribution of profits issues related to Action 7 will be carried on with
a view to providing the necessary guidance before the end of 2016, which is the deadline
for the negotiation of the multilateral instrument.
BACKGROUND 13
Background
1.
At the request of the G20, the OECD published the report Addressing Base
Erosion and Profit Shifting (BEPS Report, OECD, 2013b) in February 2013. The BEPS
Report identifies the root causes of BEPS and notes that tax planning leading to BEPS
turns on a combination of coordinated strategies. The following paragraph from the BEPS
Report relates to the current treaty definition of permanent establishment:
It had already been recognised way in the past that the concept of permanent
establishment referred not only to a substantial physical presence in the country
concerned, but also to situations where the non-resident carried on business in the
country concerned via a dependent agent (hence the rules contained in paragraphs 5 and
6 of Article 5 of the OECD Model Tax Convention). Nowadays it is possible to be
heavily involved in the economic life of another country, e.g. by doing business with
customers located in that country via the internet, without having a taxable presence
therein (such as substantial physical presence or a dependent agent). In an era where
non-resident taxpayers can derive substantial profits from transactions with customers
located in another country, questions are being raised as to whether the current rules
ensure a fair allocation of taxing rights on business profits, especially where the profits
from such transactions go untaxed anywhere.
2.
Following up on the BEPS Report, the OECD published its BEPS Action Plan in
July 2013. The BEPS Action Plan identifies 15 actions to address BEPS in a
comprehensive manner and sets deadlines to implement these actions. It deals with
avoidance strategies related to the permanent establishment concept as follows:
(ii) Restoring the full effects and benefits of international standards
[]
The definition of permanent establishment (PE) must be updated to prevent abuses.
In many countries, the interpretation of the treaty rules on agency-PE allows contracts
for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in
a country by the sales force of a local subsidiary of that foreign enterprise without the
profits from these sales being taxable to the same extent as they would be if the sales
were made by a distributor. In many cases, this has led enterprises to replace
arrangements under which the local subsidiary traditionally acted as a distributor by
commissionnaire arrangements with a resulting shift of profits out of the country
where the sales take place without a substantive change in the functions performed in
that country. Similarly, MNEs may artificially fragment their operations among
multiple group entities to qualify for the exceptions to PE status for preparatory and
ancillary activities.
14 BACKGROUND
Action 7 Prevent the Artificial Avoidance of PE Status
Develop changes to the definition of PE to prevent the artificial avoidance of PE
status in relation to BEPS, including through the use of commissionnaire
arrangements and the specific activity exemptions. Work on these issues will also
address related profit attribution issues.
3.
The BEPS Report and the BEPS Action Plan recognise that the current definition
of permanent establishment must be changed in order to address BEPS strategies. The
BEPS Action Plan also recognises that in the changing international tax environment, a
number of countries have expressed a concern about how international standards on
which bilateral tax treaties are based allocate taxing rights between source and residence
States. The BEPS Action Plan indicates that whilst actions to address BEPS will restore
both source and residence taxation in a number of cases where cross-border income
would otherwise go untaxed or would be taxed at very low rates, these actions are not
directly aimed at changing the existing international standards on the allocation of taxing
rights on cross-border income.
4.
This report includes the changes that will be made to Article 5 of the OECD
Model Tax Convention and the Commentary thereon as a result of the work on Action 7
of the BEPS Action Plan. It should be noted that these changes are prospective only and,
as such, do not affect the interpretation of the former provisions of the OECD Model Tax
Convention and of treaties in which these provisions are included, in particular as regards
the interpretation of existing paragraphs 4 and 5 of Article 5.
SECTION A 15
A. Artificial avoidance of PE status through commissionnaire arrangements and

similar strategies
5.
A commissionnaire arrangement may be loosely defined as an arrangement
through which a person sells products in a given State in its own name but on behalf of a
foreign enterprise that is the owner of these products. Through such an arrangement, a
foreign enterprise is able to sell its products in a State without having a permanent
establishment to which such sales may be attributed for tax purposes; since the person
that concludes the sales does not own the products that it sells, it cannot be taxed on the
profits derived from such sales and may only be taxed on the remuneration that it receives
for its services (usually a commission).
6.
BEPS concerns arising from commissionnaire arrangements may be illustrated by
the following example, which is based on a court decision that dealt with such an
arrangement and found that the foreign enterprise did not have a permanent
establishment:
- XCO is a company resident of State X. It specialises in the sale of medical
products.
- Until 2000, these products are sold to clinics and hospitals in State Y by YCO, a
company resident of State Y. XCO and YCO are members of the same
multinational group.
- In 2000, the status of YCO is changed to that of commissionnaire following the
conclusion of a commissionnaire contract between the two companies. Pursuant to
the contract, YCO transfers to XCO its fixed assets, its stock and its customer base
and agrees to sell in State Y the products of XCO in its own name, but for the
account of and at the risk of XCO.
- As a consequence, the taxable profits of YCO in State Y are substantially reduced.
7. Similar strategies that seek to avoid the application of Art. 5(5) involve situations
where contracts which are substantially negotiated in a State are not concluded in that
State because they are finalised or authorised abroad, or where the person that habitually
exercises an authority to conclude contracts constitutes an independent agent to which
the exception of Art. 5(6) applies even though it is closely related to the foreign enterprise
on behalf of which it is acting.
8.
It is clear that in many cases commissionnaire arrangements and similar strategies
were put in place primarily in order to erode the taxable base of the State where sales took
place. Changes to the wording of Art. 5(5) and 5(6) are therefore needed in order to
address such strategies.
9.
As a matter of policy, where the activities that an intermediary exercises in a
country are intended to result in the regular conclusion of contracts to be performed by a
foreign enterprise, that enterprise should be considered to have a sufficient taxable nexus
in that country unless the intermediary is performing these activities in the course of an
independent business. The changes to Art. 5(5) and 5(6) and the detailed Commentary
that appear below will address commissionnaire arrangements and similar strategies by
ensuring that the wording of these provisions better reflect this policy. Such changes,
however, are not intended to address BEPS concerns related to the transfer of risks
between related parties through low-risk distributor arrangements. In these arrangements,
16 SECTION A
sales generated by a local sales workforce are attributed to a resident taxpayer, which is
not the case in the situations that the changes to Art. 5(5) and 5(6) are intended to address.
Given this difference, BEPS concerns related to low-risk distributor arrangements are
best addressed through the work on Action 9 (Risks and Capital) of the BEPS Action
Plan.
CHANGES TO PARAGRAPHS 5 AND 6 OF ARTICLE 5
Replace paragraphs 5 and 6 of Article 5 by the following (changes to the existing
text of Article 5 appear in bold italics for additions and strikethrough for deletions):
5.
Notwithstanding the provisions of paragraphs 1 and 2 but subject to the
provisions of paragraph 6, where a person other than an agent of an independent
status to whom paragraph 6 applies is acting in a Contracting State on behalf of
an enterprise and has, and habitually exercises, in a Contracting State, an authority
to conclude contracts, in doing so, habitually concludes contracts, or habitually
plays the principal role leading to the conclusion of contracts that are routinely
concluded without material modification by the enterprise, and these contracts are
a) in the name of the enterprise, or
b) for the transfer of the ownership of, or for the granting of the right to use,
property owned by that enterprise or that the enterprise has the right to use,
or
c) for the provision of services by that enterprise,
that enterprise shall be deemed to have a permanent establishment in that State in
respect of any activities which that person undertakes for the enterprise, unless the
activities of such person are limited to those mentioned in paragraph 4 which, if
exercised through a fixed place of business, would not make this fixed place of
business a permanent establishment under the provisions of that paragraph.
6.
An enterprise shall not be deemed to have a permanent establishment in a
Contracting State merely because it carries on business in that State through a
broker, general commission agent or any other agent of an independent status,
provided that such persons are acting in the ordinary course of their business.
a) Paragraph 5 shall not apply where the person acting in a Contracting State
on behalf of an enterprise of the other Contracting State carries on business
in the first-mentioned State as an independent agent and acts for the
enterprise in the ordinary course of that business. Where, however, a
person acts exclusively or almost exclusively on behalf of one or more
enterprises to which it is closely related, that person shall not be considered
to be an independent agent within the meaning of this paragraph with
respect to any such enterprise.
b) For the purposes of this Article, a person is closely related to an enterprise
if, based on all the relevant facts and circumstances, one has control of the
other or both are under the control of the same persons or enterprises. In
any case, a person shall be considered to be closely related to an enterprise
if one possesses directly or indirectly more than 50 per cent of the beneficial
interest in the other (or, in the case of a company, more than 50 per cent of
SECTION A 17
the aggregate vote and value of the companys shares or of the beneficial
equity interest in the company) or if another person possesses directly or
indirectly more than 50 per cent of the beneficial interest (or, in the case of
a company, more than 50 per cent of the aggregate vote and value of the
companys shares or of the beneficial equity interest in the company) in the
person and the enterprise.
Proposed changes to the Commentary on Article 5
Replace paragraphs 31 to 39 of the Commentary on Article 5 by the following
(changes to the existing text of the Commentary appear in bold italics for
additions and strikethrough for deletions):
Paragraph 5
31. It is a generally accepted principle that an enterprise should be treated as
having a permanent establishment in a State if there is under certain conditions
a person acting for it, even though the enterprise may not have a fixed place of
business in that State within the meaning of paragraphs 1 and 2. This provision
intends to give that State the right to tax in such cases. Thus paragraph 5
stipulates the conditions under which an enterprise is deemed to have a
permanent establishment in respect of any activity of a person acting for it. The
paragraph was redrafted in the 1977 Model Convention to clarify the intention
of the corresponding provision of the 1963 Draft Convention without altering its
substance apart from an extension of the excepted activities of the person.
32. Persons whose activities may create a permanent establishment for the
enterprise are so-called dependent agents i.e. persons, whether or not employees
of the enterprise, who act on behalf of the enterprise and are not doing so in the
course of carrying on a business as an independent agents falling under
paragraph 6. Such persons may be either individuals or companies and need not
be residents of, nor have a place of business in, the State in which they act for the
enterprise. It would not have been in the interest of international economic
relations to provide that the maintenance of any dependent person any person
undertaking activities on behalf of the enterprise would lead to a permanent
establishment for the enterprise. Such treatment is to be limited to persons who in
view of the scope of their authority or the nature of their activity involve the
enterprise to a particular extent in business activities in the State concerned.
Therefore, paragraph 5 proceeds on the basis that only persons habitually
concluding contracts that are in the name of the enterprise or that are to be
performed by the enterprise, or habitually playing the principal role leading to
the conclusion of such contracts which are routinely concluded without
material modification by the enterprise, having the authority to conclude
contracts can lead to a permanent establishment for the enterprise maintaining
them. In such a case the persons actions on behalf of the enterprise, since they
result in the conclusion of such contracts and go beyond the mere promotion or
advertising, are sufficient to conclude that has sufficient authority to bind the
enterprises participatesion in athe business activity in the State concerned. The
use of the term permanent establishment in this context presupposes, of course,
that the conclusion of contracts by that person, or as a direct result of the
actions of that person, makes use of this authority takes place repeatedly and not
merely in isolated cases.
18 SECTION A
32.1 For paragraph 5 to apply, all the following conditions must be met:
a person acts in a Contracting State on behalf of an enterprise;
in doing so, that person habitually concludes contracts, or habitually

plays the principal role leading to the conclusion of contracts that are
routinely concluded without material modification by the enterprise,
and
these contracts are either in the name of the enterprise or for the
transfer of the ownership of, or for the granting of the right to use,
property owned by that enterprise or that the enterprise has the right to
use, or for the provision of services by that enterprise.
32.2 Even if these conditions are met, however, paragraph 5 will not apply if
the activities performed by the person on behalf of the enterprise are covered by
the independent agent exception of paragraph 6 or are limited to activities
mentioned in paragraph 4 which, if exercised through a fixed place of
business, would be deemed not to create a permanent establishment. This last
exception is explained by the fact that since, by virtue of paragraph 4, the
maintenance of a fixed place of business solely for the purposes of preparatory
or auxiliary activities is deemed not to constitute a permanent establishment, a
person whose activities are restricted to such purposes should not create a
permanent establishment either. Where, for example, a person acts solely as a
buying agent for an enterprise and, in doing so, habitually concludes purchase
contracts in the name of that enterprise, paragraph 5 will not apply even if that
person is not independent of the enterprise as long as such activities are
preparatory or auxiliary (see paragraph 22.5 above).
32.3 A person is acting in a Contracting State on behalf of an enterprise when
that person involves the enterprise to a particular extent in business activities in
the State concerned. This will be the case, for example, where an agent acts for
a principal, where a partner acts for a partnership, where a director acts for a
company or where an employee acts for an employer. A person cannot be said
to be acting on behalf of an enterprise if the enterprise is not directly or
indirectly affected by the action performed by that person. As indicated in
paragraph 32, the person acting on behalf of an enterprise can be a company;
in that case, the actions of the employees and directors of that company are
considered together for the purpose of determining whether and to what extent
that company acts on behalf of the enterprise.
32.4 The phrase concludes contracts focusses on situations where, under
the relevant law governing contracts, a contract is considered to have been
concluded by a person. A contract may be concluded without any active
negotiation of the terms of that contract; this would be the case, for example,
where the relevant law provides that a contract is concluded by reason of a
person accepting, on behalf of an enterprise, the offer made by a third party to
enter into a standard contract with that enterprise. Also, a contract may, under
the relevant law, be concluded in a State even if that contract is signed outside
that State; where, for example, the conclusion of a contract results from the
acceptance, by a person acting on behalf of an enterprise, of an offer to enter
SECTION A 19
into a contract made by a third party, it does not matter that the contract is
signed outside that State. In addition, a person who negotiates in a State all
elements and details of a contract in a way binding on the enterprise can be
said to conclude the contract in that State even if that contract is signed by
another person outside that State.
32.5 The phrase or habitually plays the principal role leading to the
conclusion of contracts that are routinely concluded without material
modification by the enterprise is aimed at situations where the conclusion of a
contract directly results from the actions that the person performs in a
Contracting State on behalf of the enterprise even though, under the relevant
law, the contract is not concluded by that person in that State. Whilst the
phrase concludes contracts provides a relatively well-known test based on
contract law, it was found necessary to supplement that test with a test focusing
on substantive activities taking place in one State in order to address cases
where the conclusion of contracts is clearly the direct result of these activities
although the relevant rules of contract law provide that the conclusion of the
contract takes place outside that State. The phrase must be interpreted in the
light of the object and purpose of paragraph 5, which is to cover cases where
the activities that a person exercises in a State are intended to result in the
regular conclusion of contracts to be performed by a foreign enterprise, i.e.
where that person acts as the sales force of the enterprise. The principal role
leading to the conclusion of the contract will therefore typically be associated
with the actions of the person who convinced the third party to enter into a
contract with the enterprise. The phrase therefore applies where, for example, a
person solicits and receives (but does not formally finalise) orders which are
sent directly to a warehouse from which goods belonging to the enterprise are
delivered and where the enterprise routinely approves these transactions. It
does not apply, however, where a person merely promotes and markets goods or
services of an enterprise in a way that does not directly result in the conclusion
of contracts. Where, for example, representatives of a pharmaceutical
enterprise actively promote drugs produced by that enterprise by contacting
doctors that subsequently prescribe these drugs, that marketing activity does
not directly result in the conclusion of contracts between the doctors and the
enterprise so that the paragraph does not apply even though the sales of these
drugs may significantly increase as a result of that marketing activity.
32.6 The following is another example that illustrates the application of
paragraph 5. RCO, a company resident of State R, distributes various products
and services worldwide through its websites. SCO, a company resident of State
S, is a wholly-owned subsidiary of RCO. SCOs employees send emails, make
telephone calls to, or visit large organisations in order to convince them to buy
RCOs products and services and are therefore responsible for large accounts
in State S; SCOs employees, whose remuneration is partially based on the
revenues derived by RCO from the holders of these accounts, use their
relationship building skills to try to anticipate the needs of these account
holders and to convince them to acquire the products and services offered by
RCO. When one of these account holders is persuaded by an employee of SCO
to purchase a given quantity of goods or services, the employee indicates the
price that will be payable for that quantity, indicates that a contract must be
20 SECTION A
concluded online with RCO before the goods or services can be provided by
RCO and explains the standard terms of RCOs contracts, including the fixed
price structure used by RCO, which the employee is not authorised to modify.
The account holder subsequently concludes that contract online for the
quantity discussed with SCOs employee and in accordance with the price
structure presented by that employee. In this example, SCOs employees play
the principal role leading to the conclusion of the contract between the account
holder and RCO and such contracts are routinely concluded without material
modification by the enterprise. The fact that SCOs employees cannot vary the
terms of the contracts does not mean that the conclusion of the contracts is not
the direct result of the activities that they perform on behalf of the enterprise,
convincing the account holder to accept these standard terms being the crucial
element leading to the conclusion of the contracts between the account holder
and RCO.
32.7 The wording of subparagraphs a), b) and c) ensures that paragraph 5
applies not only to contracts that create rights and obligations that are legally
enforceable between the enterprise on behalf of which the person is acting and
the third parties with which these contracts are concluded but also to contracts
that create obligations that will effectively be performed by such enterprise
rather than by the person contractually obliged to do so.
32.8 A typical case covered by these subparagraphs is where contracts are
concluded with clients by an agent, a partner or an employee of an enterprise
so as to create legally enforceable rights and obligations between the enterprise
and these clients. These subparagraphs also cover cases where the contracts
concluded by a person who acts on behalf of an enterprise do not legally bind
that enterprise to the third parties with which these contracts are concluded but
are contracts for the transfer of the ownership of, or for the granting of the
right to use, property owned by that enterprise or that the enterprise has the
right to use, or for the provision of services by that enterprise. A typical
example would be the contracts that a commissionnaire would conclude with
third parties under a commissionnaire arrangement with a foreign enterprise
pursuant to which that commissionnaire would act on behalf of the enterprise
but in doing so, would conclude in its own name contracts that do not create
rights and obligations that are legally enforceable between the foreign
enterprise and the third parties even though the results of the arrangement
between the commissionnaire and the foreign enterprise would be such that the
foreign enterprise would directly transfer to these third parties the ownership or
use of property that it owns or has the right to use.
32.9 The reference to contracts in the name of in subparagraph a) does not
restrict the application of the subparagraph to contracts that are literally in the
name of the enterprise; it may apply, for example, to certain situations where
the name of the enterprise is undisclosed in a written contract.
32.10 The crucial condition for the application of subparagraphs b) and c) is
that the person who habitually concludes the contracts, or habitually plays the
principal role leading to the conclusion of the contracts that are routinely
concluded without material modification by the enterprise, is acting on behalf
of an enterprise in such a way that the parts of the contracts that relate to the
SECTION A 21
transfer of the ownership or use of property, or the provision of services, will

be performed by the enterprise as opposed to the person that acts on the
enterprises behalf.
32.11 For the purposes of subparagraph b), it does not matter whether or not
the relevant property existed or was owned by the enterprise at the time of the
conclusion of the contracts between the person who acts for the enterprise and
the third parties. For example, a person acting on behalf of an enterprise might
well sell property that the enterprise will subsequently produce before
delivering it directly to the customers. Also, the reference to property covers
any type of tangible or intangible property.
32.12 The cases to which paragraph 5 applies must be distinguished from
situations where a person concludes contracts on its own behalf and, in order
to perform the obligations deriving from these contracts, obtains goods or
services from other enterprises or arranges for other enterprises to deliver such
goods or services. In these cases, the person is not acting on behalf of these
other enterprises and the contracts concluded by the person are neither in the
name of these enterprises nor for the transfer to third parties of the ownership
or use of property that these enterprises own or have the right to use or for the
provision of services by these other enterprises. Where, for example, a
company acts as a distributor of products in a particular market and, in doing
so, sells to customers products that it buys from an enterprise (including an
associated enterprise), it is neither acting on behalf of that enterprise nor
selling property that is owned by that enterprise since the property that is sold
to the customers is owned by the distributor. This would still be the case if that
distributor acted as a so-called low-risk distributor (and not, for example, as
an agent) but only if the transfer of the title to property sold by that low-risk
distributor passed from the enterprise to the distributor and from the
distributor to the customer (regardless of how long the distributor would hold
title in the product sold) so that the distributor would derive a profit from the
sale as opposed to a remuneration in the form, for example, of a commission.
32.1 Also, the phrase authority to conclude contracts in the name of the
enterprise does not confine the application of the paragraph to an agent who
enters into contracts literally in the name of the enterprise; the paragraph applies
equally to an agent who concludes contracts which are binding on the enterprise
even if those contracts are not actually in the name of the enterprise. Lack of
active involvement by an enterprise in transactions may be indicative of a grant
of authority to an agent. For example, an agent may be considered to possess
actual authority to conclude contracts where he solicits and receives (but does
not formally finalise) orders which are sent directly to a warehouse from which
goods are delivered and where the foreign enterprise routinely approves the
transactions.
33. The authority to conclude contracts referred to in paragraph 5 must cover
contracts relating to operations which constitute the business proper of the
enterprise. It would be irrelevant, for instance, if the person had authority to
concluded employment contracts engage employees for the enterprise to assist
that persons activity for the enterprise or if the person were authorised to
concluded, in the name of the enterprise, similar contracts relating to internal
22 SECTION A
operations only. Moreover, whether or not a the authority has to be person
habitually exercised concludes contracts or habitually plays the principal role
leading to the conclusion of contracts that are routinely concluded without
material modification by the enterprise in the other State;should be determined
on the basis of the commercial realities of the situation. A person who is
authorised to negotiate all elements and details of a contract in a way binding on
the enterprise can be said to exercise this authority in that State, even if the
contract is signed by another person in the State in which the enterprise is
situated or if the first person has not formally been given a power of
representation. The mere fact, however, that a person has attended or even
participated in negotiations in a State between an enterprise and a client will not
be sufficient, by itself, to conclude that the person has exercised in that State an
authority to concluded contracts or played the principal role leading to the
modification by the enterprise in the name of the enterprise. The fact that a
person has attended or even participated in such negotiations could, however, be
a relevant factor in determining the exact functions performed by that person on
behalf of the enterprise. Since, by virtue of paragraph 4, the maintenance of a
fixed place of business solely for purposes listed in that paragraph is deemed not
to constitute a permanent establishment, a person whose activities are restricted
to such purposes does not create a permanent establishment either.
33.1 The requirement that an agent must habitually exercise an authority to
conclude contracts or play the principal role leading to the conclusion of
contracts that are routinely concluded without material modification by the
enterprise reflects the underlying principle in Article 5 that the presence which
an enterprise maintains in a Contracting State should be more than merely
transitory if the enterprise is to be regarded as maintaining a permanent
establishment, and thus a taxable presence, in that State. The extent and
frequency of activity necessary to conclude that the agent is habitually
exercising concluding contracts or playing the principal role leading to the
modification by the enterprise contracting authority will depend on the nature of
the contracts and the business of the principal. It is not possible to lay down a
precise frequency test. Nonetheless, the same sorts of factors considered in
paragraph 6 would be relevant in making that determination
34. Where the requirements set out in paragraph 5 are met, a permanent
establishment of the enterprise exists to the extent that the person acts for the
latter, i.e. not only to the extent that such a person exercises the authority to
concludes contracts or plays the principal role leading to the conclusion of
contracts that are routinely concluded without material modification by the
enterprise.in the name of the enterprise.
35. Under paragraph 5, only those persons who meet the specific conditions
may create a permanent establishment; all other persons are excluded. It should
be borne in mind, however, that paragraph 5 simply provides an alternative test
of whether an enterprise has a permanent establishment in a State. If it can be
shown that the enterprise has a permanent establishment within the meaning of
paragraphs 1 and 2 (subject to the provisions of paragraph 4), it is not necessary
to show that the person in charge is one who would fall under paragraph 5.
SECTION A 23
35.1 Whilst one effect of paragraph 5 will typically be that the rights and
obligations resulting from the contracts to which the paragraph refers will be
allocated to the permanent establishment resulting from the paragraph (see
paragraph 21 of the Commentary on Article 7), it is important to note that this
does not mean that the entire profits resulting from the performance of these
contracts should be attributed to the permanent establishment. The
determination of the profits attributable to a permanent establishment resulting
from the application of paragraph 5 will be governed by the rules of Article 7;
clearly, this will require that activities performed by other enterprises and by
the rest of the enterprise to which the permanent establishment belongs be
properly remunerated so that the profits to be attributed to the permanent
establishment in accordance with Article 7 are only those that the permanent
establishment would have derived if it were a separate and independent
enterprise performing the activities that paragraph 5 attributes to that
Paragraph 6
36. Where an enterprise of a Contracting State carries on business dealings
through a broker, general commission agent or any other agent of an independent
status agent carrying on business as such, it cannot be taxed in the other
Contracting State in respect of those dealings if the agent is acting in the ordinary
course of his that business (see paragraph 32 above). Although it stands to reason
that The activities of such an agent, who representsing a separate and
independent enterprise, cannot constitute a should not result in the finding of a
permanent establishment of the foreign enterprise, paragraph 6 has been inserted
in the Article for the sake of clarity and emphasis.
37. A person will come within the scope of paragraph 6, i.e. he will not
constitute a permanent establishment of the enterprise on whose behalf he acts
only if:
he is independent of the enterprise both legally and economically, and
he acts in the ordinary course of his business when acting on behalf of the
enterprise.
37. The exception of paragraph 6 only applies where a person acts on behalf
of an enterprise in the course of carrying on a business as an independent
agent. It would therefore not apply where a person acts on behalf of an
enterprise in a different capacity, such as where an employee acts on behalf of
her employer or a partner acts on behalf of a partnership. As explained in
paragraph 8.1 of the Commentary on Article 15, it is sometimes difficult to
determine whether the services rendered by an individual constitute
employment services or services rendered by a separate enterprise and the
guidance in paragraphs 8.2 to 8.28 of the Commentary on Article 15 will be
relevant for that purpose. Where an individual acts on behalf of an enterprise
in the course of carrying on his own business and not as an employee, however,
the application of paragraph 6 will still require that the individual do so as an
independent agent; as explained in paragraph 38.7 below, this independent
status is less likely if the activities of that individual are performed exclusively
or almost exclusively on behalf of one enterprise or closely related enterprises.
24 SECTION A
38. Whether a person acting as an agent is independent of the enterprise
represented depends on the extent of the obligations which this person has vis-vis the enterprise. Where the persons commercial activities for the enterprise are
subject to detailed instructions or to comprehensive control by it, such person
cannot be regarded as independent of the enterprise. Another important criterion
will be whether the entrepreneurial risk has to be borne by the person or by the
enterprise the person represents. In any event, the last sentence of subparagraph
a) of paragraph 6 provides that in certain circumstances a person shall not be
considered to be an independent agent (see paragraphs 38.6 to 38.11 below).
38.2 The following considerations should be borne in mind when determining
whether an agent to whom that last sentence does not apply may be considered
to be independent.
38.1 In relation to the test of legal dependence, iIt should be noted that, where
the last sentence of subparagraph a) of paragraph 6 does not apply because a
subsidiary does not act exclusively or almost exclusively for closely related
enterprises, the control which a parent company exercises over its subsidiary in
its capacity as shareholder is not relevant in a consideration of the dependence or
otherwise of the subsidiary in its capacity as an agent for the parent. This is
consistent with the rule in paragraph 7 of Article 5 (see also paragraph 38.11
below). But, as paragraph 41 of the Commentary indicates, the subsidiary may be
considered a dependent agent of its parent by application of the same tests which
are applied to unrelated companies.
38.23 An independent agent will typically be responsible to his principal for the
results of his work but not subject to significant control with respect to the
manner in which that work is carried out. He will not be subject to detailed
instructions from the principal as to the conduct of the work. The fact that the
principal is relying on the special skill and knowledge of the agent is an
indication of independence.
38.34 Limitations on the scale of business which may be conducted by the agent
clearly affect the scope of the agents authority. However such limitations are not
relevant to dependency which is determined by consideration of the extent to
which the agent exercises freedom in the conduct of business on behalf of the
principal within the scope of the authority conferred by the agreement.
38.45 It may be a feature of the operation of an agreement that an agent will
provide substantial information to a principal in connection with the business
conducted under the agreement. This is not in itself a sufficient criterion for
determination that the agent is dependent unless the information is provided in
the course of seeking approval from the principal for the manner in which the
business is to be conducted. The provision of information which is simply
intended to ensure the smooth running of the agreement and continued good
relations with the principal is not a sign of dependence.
38.56 Another factor to be considered in determining independent status is the
number of principals represented by the agent. As indicated in paragraph 38.7,
independent status is less likely if the activities of the agent are performed wholly
or almost wholly on behalf of only one enterprise over the lifetime of the
SECTION A 25
business or a long period of time. However, this fact is not by itself

determinative. All the facts and circumstances must be taken into account to
determine whether the agents activities constitute an autonomous business
conducted by him in which he bears risk and receives reward through the use of
his entrepreneurial skills and knowledge. Where an agent acts for a number of
principals in the ordinary course of his business and none of these is predominant
in terms of the business carried on by the agent, dependence may exist if the
principals act in concert to control the acts of the agent in the course of his
business on their behalf.
38.67 An independent agent Persons cannot be said to act in the ordinary course
of their own its business as such when it performs activities that are unrelated
to the business of an agent if, in place of the enterprise, such persons perform
activities which, economically, belong to the sphere of the enterprise rather than
to that of their own business operations. Where, for example, a commission agent
not only sells the goods or merchandise of the enterprise in his own name but also
habitually acts, in relation to that enterprise, as a permanent agent having an
authority to conclude contracts, he would be deemed in respect of this particular
activity to be a permanent establishment, since he is thus acting outside the
ordinary course of his own trade or business (namely that of a commission
agent), unless his activities are limited to those mentioned at the end of
paragraph 5 company that acts as a distributor for a number of companies to
which it is not closely related also acts as an agent for a closely related
enterprise, the activities that the company undertakes as a distributor will not
be considered to be part of the activities that the company carries on in the
ordinary course of its business as an agent and will therefore not be relevant in
determining whether the company is independent from the closely related
enterprise on behalf of which it is acting.
38.8 In deciding whether or not particular activities fall within or outside the
ordinary course of business of an agent, one would examine the business
activities customarily carried out within the agents trade as a broker, commission
agent or other independent agent rather than the other business activities carried
out by that agent. Whilst the comparison normally should be made with the
activities customary to the agents trade, other complementary tests may in
certain circumstances be used concurrently or alternatively, for example where
the agents activities do not relate to a common trade.
38.7 The last sentence of subparagraph a) provides that a person is not
considered to be an independent agent where the person acts exclusively or
almost exclusively for one or more enterprises to which it is closely related.
That last sentence does not mean, however, that paragraph 6 will apply
automatically where a person acts for one or more enterprises to which that
person is not closely related. Paragraph 6 requires that the person must be
carrying on a business as an independent agent and be acting in the ordinary
course of that business. Independent status is less likely if the activities of the
person are performed wholly or almost wholly on behalf of only one enterprise
(or a group of enterprises that are closely related to each other) over the
lifetime of that persons business or over a long period of time. Where,
however, a person is acting exclusively for one enterprise, to which it is not
26 SECTION A
closely related, for a short period of time (e.g. at the beginning of that persons
business operations), it is possible that paragraph 6 could apply. As indicated in
paragraph 38.5, all the facts and circumstances would need to be taken into
account to determine whether the persons activities constitute the carrying on
of a business as an independent agent.
38.8 The last sentence of subparagraph a) applies only where the person acts
exclusively or almost exclusively on behalf of closely related enterprises. This
means that where the persons activities on behalf of enterprises to which it is
not closely related do not represent a significant part of that persons business,
that person will not qualify as an independent agent. Where, for example, the
sales that an agent concludes for enterprises to which it is not closely related
represent less than 10 per cent of all the sales that it concludes as an agent
acting for other enterprises, that agent should be viewed as acting exclusively
or almost exclusively on behalf of closely related enterprises.
38.9 Subparagraph b) explains the meaning of the concept of a person
closely related to an enterprise for the purpose of the Article. That concept is
to be distinguished from the concept of associated enterprises which is used
for the purposes of Article 9; although the two concepts overlap to a certain
extent, they are not intended to be equivalent.
38.10 The first part of subparagraph b) includes the general definition of a
person closely related to an enterprise. It provides that a person is closely
related to an enterprise if, based on all the relevant facts and circumstances,
one has control of the other or both are under the control of the same persons
or enterprises. This general rule would cover, for example, situations where a
person or enterprise controls an enterprise by virtue of a special arrangement
that allows that person to exercise rights that are similar to those that it would
hold if it possessed directly or indirectly more than 50 per cent of the beneficial
interests in the enterprise. As in most cases where the plural form is used, the
reference to the same persons or enterprises at the end of the first sentence of
subparagraph b) covers cases where there is only one such person or
enterprise.
38.11 The second part of subparagraph b) provides that the definition of
person closely related to an enterprise is automatically satisfied in certain
circumstances. Under that second part, a person is considered to be closely
related to an enterprise if either one possesses directly or indirectly more than
50 per cent of the beneficial interests in the other or if a third person possesses
directly or indirectly more than 50 per cent of the beneficial interests in both
the person and the enterprise. In the case of a company, this condition is
satisfied where a person holds directly or indirectly more than 50 per cent of
the aggregate vote and value of the companys shares or of the beneficial equity
interest in the company.
38.12 The rule in the last sentence of subparagraph a) and the fact that
subparagraph b) covers situations where one company controls or is controlled
by another company does not restrict in any way the scope of paragraph 7 of
Article 5. As explained in paragraph 41.1 below, it is possible that a subsidiary
will act on behalf of its parent company in such a way that the parent will be
deemed to have a permanent establishment under paragraph 5; if that is the
SECTION A 27
case, a subsidiary acting exclusively or almost exclusively for its parent will be
unable to benefit from the independent agent exception of paragraph 6.
This, however, does not imply that the parent-subsidiary relationship
eliminates the requirements of paragraph 5 and that such a relationship could
be sufficient in itself to conclude that any of these requirements are met.
39. According to the definition of the term permanent establishment an
insurance company of one State may be taxed in the other State on its insurance
business, if it has a fixed place of business within the meaning of paragraph 1
or if it carries on business through a person within the meaning of paragraph 5.
Since agencies of foreign insurance companies sometimes do not meet either of
the above requirements, it is conceivable that these companies do large-scale
business in a State without being taxed in that State on their profits arising from
such business. In order to obviate this possibility, various conventions concluded
by OECD member countries before [next update] include a provision which
stipulates that insurance companies of a State are deemed to have a permanent
establishment in the other State if they collect premiums in that other State
through an agent established there other than an agent who already constitutes
a permanent establishment by virtue of paragraph 5 or insure risks situated in
that territory through such an agent. The decision as to whether or not a provision
along these lines should be included in a convention will depend on the factual
and legal situation prevailing in the Contracting States concerned. Also, the
changes to paragraphs 5 and 6 made in [next update] have addressed some of
the concerns that such a provision is intended to address. Frequently, therefore,
such a provision will not be contemplated. In view of this fact, it did not seem
advisable to insert a provision along these lines in the Model Convention.
28 SECTION B
B. Artificial avoidance of PE status through the specific activity exemptions

10.
Art. 5(4) of the OECD Model Tax Convention includes a list of exceptions (the
specific activity exemptions) according to which a permanent establishment is deemed
not to exist where a place of business is used solely for activities that are listed in that
paragraph.
1.
List of activities included in Art. 5(4)
11.
The October 2011 and 2012 discussion drafts on the clarification of the PE
definition2 included a proposed change to paragraph 21 of the Commentary on Article 5
according to which, under the current wording of Article 5, paragraph 4 applies
automatically where one of the activities listed in subparagraphs a) to d) is the only activity
carried on at a fixed place of business. The Working Group that produced that proposal,
however, invited Working Party 1 to examine whether the conclusion that subparagraphs
a) to d) are not subject to the extra condition that the activities referred therein be of a
preparatory or auxiliary nature is appropriate in policy terms. This reflected the views of
some delegates who argued that the proposed interpretation did not appear to conform
with what they considered to be the original purpose of the paragraph, i.e. to cover only
preparatory or auxiliary activities.
12.
Regardless of the original purpose of the exceptions included in subparagraphs a)
to d) of paragraph 4, it is important to address situations where these subparagraphs give
rise to BEPS concerns. It is therefore agreed to modify Art. 5(4) as indicated below so
that each of the exceptions included in that provision is restricted to activities that are
otherwise of a preparatory or auxiliary character. It is also recommended to provide the
additional Commentary guidance below which clarifies the meaning of the phrase
preparatory or auxiliary using a number of examples.
13.
Some States, however, consider that BEPS concerns related to Art. 5(4)
essentially arise where there is fragmentation of activities between closely related parties
and that these concerns will be appropriately addressed by the inclusion of the antifragmentation rule in section 2 below. These States therefore consider that there is no
need to modify Art. 5(4) as suggested below and that the list of exceptions in
subparagraphs a) to d) of paragraph 4 should not be subject to the condition that the
activities referred to in these subparagraphs be of a preparatory or auxiliary character. As
indicated in the Commentary below, States that share that view may adopt a different
version of Art. 5(4) as long as they include the anti-fragmentation rule referred to in
section 2.
MAKING ALL THE SUBPARAGRAPHS OF ART. 5(4) SUBJECT TO A
PREPARATORY OR AUXILIARY CONDITION
Replace paragraph 4 of Article 5 by the following (changes to the existing text of
the paragraph appear in bold italics of additions and strikethrough for
deletions):
4. Notwithstanding the preceding provisions of this Article, the term
permanent establishment shall be deemed not to include:
a) the use of facilities solely for the purpose of storage, display or
delivery of goods or merchandise belonging to the enterprise;
SECTION B 29
b) the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of storage, display or delivery;
c) the maintenance of a stock of goods or merchandise belonging to the
enterprise solely for the purpose of processing by another enterprise;
d) the maintenance of a fixed place of business solely for the purpose of
purchasing goods or merchandise or of collecting information, for the
enterprise;
e) the maintenance of a fixed place of business solely for the purpose of
carrying on, for the enterprise, any other activity of a preparatory or
auxiliary character;
f) the maintenance of a fixed place of business solely for any
combination of activities mentioned in subparagraphs a) to e),
provided that the overall activity of the fixed place of business
resulting from this combination is of a preparatory or auxiliary
character,
provided that such activity or, in the case of subparagraph f), the overall
activity of the fixed place of business, is of a preparatory or auxiliary character.
Replace paragraphs 21 to 30 of the existing Commentary on Article 5 (changes
to the existing text of the Commentary appear in bold italics of additions and
strikethrough for deletions):
Paragraph 4
21. This paragraph lists a number of business activities which are treated as
exceptions to the general definition laid down in paragraph 1 and which are not ,
when carried on through fixed places of business, are not sufficient for these
places to constitute permanent establishments, even if the activity is carried on
through a fixed place of business. The final part of the paragraph provides that
these exceptions only apply if the listed activities have a preparatory or
auxiliary character. The common feature of these activities is that they are, in
general, preparatory or auxiliary activities. This is laid down explicitly in the
case of the exception mentioned inSince subparagraph e) applies to any activity
that is not otherwise listed in the paragraph (as long as that activity has a
preparatory or auxiliary character), the provisions of the paragraph which
actually amounts to a general restriction of the scope of the definition of
permanent establishment contained in paragraph 1 and, when read with that
paragraph, provide a more selective test, by which to determine what constitutes
a permanent establishment. To a considerable degree, these provisions it limits
theat definition in paragraph 1 and excludes from its rather wide scope a number
of forms of business organisations which, although they are carried on through a
fixed place of business fixed places of business which, because the business
activities exercised through these places are merely preparatory or auxiliary,
should not be treated as permanent establishments. It is recognised that such a
place of business may well contribute to the productivity of the enterprise, but
the services it performs are so remote from the actual realisation of profits that it
is difficult to allocate any profit to the fixed place of business in question. [the
last two sentences and the last part of the preceding one have been moved from
paragraph 23 to this paragraph] Moreover subparagraph f) provides that
30 SECTION B
combinations of activities mentioned in subparagraphs a) to e) in the same fixed
place of business shall be deemed not to be a permanent establishment, subject to
the condition, expressed in the final part of the paragraph, provided that the
overall activity of the fixed place of business resulting from this combination is
of a preparatory or auxiliary character. Thus the provisions of paragraph 4 are
designed to prevent an enterprise of one State from being taxed in the other State,
if it only carries on in that other State, activities of a purely preparatory or
auxiliary character in that State. The provisions of paragraph 4.1 (see below)
complement that principle by ensuring that the preparatory or auxiliary
character of activities carried on at a fixed place of business must be viewed in
the light of other activities that constitute complementary functions that are
part of a cohesive business and which the same enterprise or closely related
enterprises carry on in the same State.
21.124. It is often difficult to distinguish between activities which have a
preparatory or auxiliary character and those which have not. The decisive
criterion is whether or not the activity of the fixed place of business in itself
forms an essential and significant part of the activity of the enterprise as a whole.
Each individual case will have to be examined on its own merits. In any case, a
fixed place of business whose general purpose is one which is identical to the
general purpose of the whole enterprise, does not exercise a preparatory or
auxiliary activity.
21.2 As a general rule, an activity that has a preparatory character is one that
is carried on in contemplation of the carrying on of what constitutes the
essential and significant part of the activity of the enterprise as a whole. Since
a preparatory activity precedes another activity, it will often be carried on
during a relatively short period, the duration of that period being determined
by the nature of the core activities of the enterprise. This, however, will not
always be the case as it is possible to carry on an activity at a given place for a
substantial period of time in preparation for activities that take place
somewhere else. Where, for example, a construction enterprise trains its
employees at one place before these employees are sent to work at remote work
sites located in other countries, the training that takes place at the first location
constitutes a preparatory activity for that enterprise. An activity that has an
auxiliary character, on the other hand, generally corresponds to an activity
that is carried on to support, without being part of, the essential and significant
part of the activity of the enterprise as a whole. It is unlikely that an activity
that requires a significant proportion of the assets or employees of the
enterprise could be considered as having an auxiliary character.
21.3 Subparagraphs a) to e) refer to activities that are carried on for the
enterprise itself. A permanent establishment, however, would therefore exists if
such activities were performed on behalf of other enterprises at the same fixed
place of business the fixed place of business exercising any of the functions
listed in paragraph 4 were to exercise them not only on behalf of the enterprise to
which it belongs but also on behalf of other enterprises. If, for instance, an
advertising agency enterprise that maintained an office for the advertising of its
own products or services were also to engage in advertising for on behalf of
other enterprises at that location, itthat office would be regarded as a permanent
establishment of the enterprise by which it is maintained.
SECTION B 31
22. Subparagraph a) relates only to the case in which an enterprise acquires the
use of to a fixed place of business constituted by facilities used by an enterprise
for storing, displaying or delivering its own goods or merchandise. Whether the
activity carried on at such a place of business has a preparatory or auxiliary
character will have to be determined in the light of factors that include the
overall business activity of the enterprise. Where, for example, an enterprise of
State R maintains in State S a very large warehouse in which a significant
number of employees work for the main purpose of storing and delivering
goods owned by the enterprise that the enterprise sells online to customers in
State S, paragraph 4 will not apply to that warehouse since the storage and
delivery activities that are performed through that warehouse, which represents
an important asset and requires a number of employees, constitute an essential
part of the enterprises sale/distribution business and do not have, therefore, a
preparatory or auxiliary character. Subparagraph b) relates to the stock of
merchandise itself and provides that the stock, as such, shall not be treated as a
permanent establishment if it is maintained for the purpose of storage, display or
delivery. Subparagraph c) covers the case in which a stock of goods or
merchandise belonging to one enterprise is processed by a second enterprise, on
behalf of, or for the account of, the first-mentioned enterprise. The reference to
the collection of information in subparagraph d) is intended to include the case of
the newspaper bureau which has no purpose other than to act as one of many
tentacles of the parent body; to exempt such a bureau is to do no more than to
extend the concept of mere purchase.
22.1 Subparagraph a) would cover, for instance, a bonded warehouse with
special gas facilities that an exporter of fruit from one State maintains in
another State for the sole purpose of storing fruit in a controlled environment
during the custom clearance process in that other State. It would also cover a
fixed place of business that an enterprise maintained solely for the delivery of
spare parts to customers for machinery sold to those customers. Paragraph 4
would not apply, however, where A permanent establishment could also be
constituted if an enterprise maintaineds a fixed place of business for the delivery
of spare parts to customers for machinery supplied to those customers and, in
addition, where, in addition, it for the maintainenances or repairs of such
machinery, as this would goes beyond the pure delivery mentioned in
subparagraph a) of paragraph 4 and would not constitute preparatory or
auxiliary activities Ssince these after-sale activities constitute organisations
perform an essential and significant part of the services of an enterprise vis--vis
its customers., their activities are not merely auxiliary ones [the preceding two
sentences have been moved from paragraph 25 to this paragraph].
22.226.1 Issues may arise concerning the application of the definition of
permanent establishment to Another example is that of facilities such as cables
or pipelines that cross the territory of a country. Apart from the fact that income
derived by the owner or operator of such facilities from their use by other
enterprises is covered by Article 6 where theythese facilities constitute
immovable property under paragraph 2 of Article 6, the question may arise as to
whether subparagraph a) paragraph 4 applies to them. Where these facilities are
used to transport property belonging to other enterprises, subparagraph a), which
is restricted to delivery of goods or merchandise belonging to the enterprise that
32 SECTION B
uses the facility, will not be applicable as concerns the owner or operator of these
facilities. Subparagraph e) also will not be applicable as concerns that enterprise
since the cable or pipeline is not used solely for the enterprise and its use is not
of preparatory or auxiliary character given the nature of the business of that
enterprise. The situation is different, however, where an enterprise owns and
operates a cable or pipeline that crosses the territory of a country solely for
purposes of transporting its own property and such transport is merely incidental
to the business of that enterprise, as in the case of an enterprise that is in the
business of refining oil and that owns and operates a pipeline that crosses the
territory of a country solely to transport its own oil to its refinery located in
another country. In such case, subparagraph a) would be applicable. An
additionalA separate question is whether the cable or pipeline could also
constitute a permanent establishment for the customer of the operator of the
cable or pipeline, i.e. the enterprise whose data, power or property is transmitted
or transported from one place to another. In such a case, the enterprise is merely
obtaining transmission or transportation services provided by the operator of the
cable or pipeline and does not have the cable or pipeline at its disposal. As a
consequence, the cable or pipeline cannot be considered to be a permanent
establishment of that enterprise.
22.3 Subparagraph b) relates to the maintenance of a stock of goods or
merchandise belonging to the enterprise stock of merchandise itself and
provides that the stock, as such, shall not be treated as a permanent establishment
if it is maintained for the purpose of storage, display or delivery. This
subparagraph is irrelevant in cases where a stock of goods or merchandise
belonging to an enterprise is maintained by another person in facilities
operated by that other person and the enterprise does not have the facilities at
its disposal as the place where the stock is maintained cannot therefore be a
permanent establishment of that enterprise. Where, for example, an
independent logistics company operates a warehouse in State S and
continuously stores in that warehouse goods or merchandise belonging to an
enterprise of State R, the warehouse does not constitute a fixed place of
business at the disposal of the enterprise of State R and subparagraph b) is
therefore irrelevant. Where, however, that enterprise is allowed unlimited
access to a separate part of the warehouse for the purpose of inspecting and
maintaining the goods or merchandise stored therein, subparagraph b) is
applicable and the question of whether a permanent establishment exists will
depend on whether these activities constitute a preparatory or auxiliary
activity.
22.4 Subparagraph c) covers the situation case in which where a stock of goods
or merchandise belonging to one enterprise is processed by a second enterprise,
on behalf of, or for the account of, the first-mentioned enterprise. As explained
in the preceding paragraph, the mere presence of goods or merchandise
belonging to an enterprise does not mean that the fixed place of business
where these goods or merchandise are stored is at the disposal of that
enterprise. Where, for example, a stock of goods belonging to RCO, an
enterprise of State R, is maintained by a toll-manufacturer located in State S
for the purposes of processing by that toll-manufacturer, no fixed place of
business is at the disposal of RCO and the place where the stock is maintained
SECTION B 33
cannot therefore be a permanent establishment of RCO. If, however, RCO is

allowed unlimited access to a separate part of the facilities of the tollmanufacturer for the purpose of inspecting and maintaining the goods stored
therein, subparagraph c) will apply and it will be necessary to determine
whether the maintenance of that stock of goods by RCO constitutes a
preparatory or auxiliary activity. This will be the case if RCO is merely a
distributor of products manufactured by other enterprises as in that case the
mere maintenance of a stock of goods for the purposes of processing by
another enterprise would not form an essential and significant part of RCOs
overall activity. In such a case, unless paragraph 4.1 applies, paragraph 4 will
deem a permanent establishment not to exist in relation to such a fixed place of
business that is at the disposal of the enterprise of State R for the purposes of
maintaining its own goods to be processed by the toll-manufacturer.
22.5 The first part of subparagraph d) relates to the case where premises are
used solely for the purpose of purchasing goods or merchandise for the
enterprise. Since this exception only applies if that activity has a preparatory or
auxiliary character, it will typically not apply in the case of a fixed place of
business used for the purchase of goods or merchandise where the overall
activity of the enterprise consists in selling these goods and where purchasing
is a core function in the business of the enterprise. The following examples
illustrate the application of paragraph 4 in the case of fixed places of business
where purchasing activities are performed:
Example 1: RCO is a company resident of State R that is a large

buyer of a particular agricultural product produced in State S,
which RCO sells from State R to distributors situated in different
countries. RCO maintains a purchasing office in State S. The
employees who work at that office are experienced buyers who
have special knowledge of this type of product and who visit
producers in State S, determine the type/quality of the products
according to international standards (which is a difficult process
requiring special skills and knowledge) and enter into different
types of contracts (spot or forward) for the acquisition of the
products by RCO. In this example, although the only activity
performed through the office is the purchasing of products for
RCO, which is an activity covered by subparagraph d), paragraph
4 does not apply and the office therefore constitutes a permanent
establishment because that purchasing function forms an essential
and significant part of RCOs overall activity.
Example 2: RCO, a company resident of State R which operates a

number of large discount stores, maintains an office in State S
during a two-year period for the purposes of researching the local
market and lobbying the government for changes that would allow
RCO to establish stores in State S. During that period, employees
of RCO occasionally purchase supplies for their office. In this
example, paragraph 4 applies because subparagraph f) applies to
the activities performed through the office (since subparagraphs d)
and e) would apply to the purchasing, researching and lobbying
activities if each of these was the only activity performed at the
34 SECTION B
office) and the overall activity of the office has a preparatory
character.
22.6 The second part of subparagraph d) relates to a fixed place of business
that is used solely to collect information for the enterprise. An enterprise will
frequently need to collect information before deciding whether and how to
carry on its core business activities in a State. If the enterprise does so without
maintaining a fixed place of business in that State, subparagraph d) will
obviously be irrelevant. If, however, a fixed place of business is maintained
solely for that purpose, subparagraph d) will be relevant and it will be
necessary to determine whether the collection of information goes beyond the
preparatory or auxiliary threshold. Where, for example, an investment fund
sets up an office in a State solely to collect information on possible investment
opportunities in that State, the collecting of information through that office
will be a preparatory activity. The same conclusion would be reached in the
case of an insurance enterprise that sets up an office solely for the collection of
information, such as statistics, on risks in a particular market and in the case
of a newspaper bureau set up in a State solely to collect information on
possible news stories without engaging in any advertising activities: in both
cases, the collecting of information will be a preparatory activity.
23. Subparagraph e) applies to provides that a fixed place of business
maintained solely for the purpose of carrying on, for the enterprise, any
activity that is not expressly listed in subparagraphs a) to d); as long as that
activity through which the enterprise exercises solely an activity which has for
the enterprise a preparatory or auxiliary character, that place of business is
deemed not to be a permanent establishment. The wording of this subparagraph
makes it unnecessary to produce an exhaustive list of exceptions the activities to
which the paragraph may apply, the examples listed in subparagraphs a) to d)
being merely common examples of activities that are covered by the paragraph
because they often have a preparatory or auxiliary character. Furthermore, this
subparagraph provides a generalised exception to the general definition in
paragraph 1 [(the following part of the paragraph has been moved to paragraph
21): and, when read with that paragraph, provides a more selective test, by
which to determine what constitutes a permanent establishment. To a
considerable degree it limits that definition and excludes from its rather wide
scope a number of business activities which, although they are carried on
through a fixed place of business, should not be treated as permanent
establishments. It is recognised that such a place of business may well contribute
to the productivity of the enterprise, but the services it performs are so remote
from the actual realisation of profits that it is difficult to allocate any profit to the
fixed place of business in question.] Examples are fixed places of business solely
for the purpose of advertising or for the supply of information or for scientific
research or for the servicing of a patent or a know-how contract, if such activities
have a preparatory or auxiliary character. [that last sentence has been moved to
paragraph 23]
24. It is often difficult to distinguish between activities which have a
preparatory or auxiliary character and those which have not. The decisive
criterion is whether or not the activity of the fixed place of business in itself
forms an essential and significant part of the activity of the enterprise as a whole.
SECTION B 35
Each individual case will have to be examined on its own merits. In any case, a
fixed place of business whose general purpose is one which is identical to the
general purpose of the whole enterprise, does not exercise a preparatory or
auxiliary activity [the preceding three sentences have been moved to paragraph
21.1]. Examples of places of business covered by subparagraph e) are fixed
places of business used solely for the purpose of advertising or for the supply of
information or for scientific research or for the servicing of a patent or a knowhow contract, if such activities have a preparatory or auxiliary character [this
sentence currently appears at the end of paragraph 23]. Paragraph 4 would not
apply, however, This would not be the case, where, for example, if a fixed place
of business used for the supply of information would does not only give
information but would also furnishes plans etc. specially developed for the
purposes of the individual customer. Nor would it be the case apply if a research
establishment were to concern itself with manufacture [these two sentences
currently appear at the end of paragraph 25]. Similarly, Wwhere, for example,
the servicing of patents and know-how is the purpose of an enterprise, a fixed
place of business of such enterprise exercising such an activity cannot get the
benefits of paragraph 4 subparagraph e). A fixed place of business which has the
function of managing an enterprise or even only a part of an enterprise or of a
group of the concern cannot be regarded as doing a preparatory or auxiliary
activity, for such a managerial activity exceeds this level. If an enterprises with
international ramifications establishes a so-called management office in a
States in which theyit maintains subsidiaries, permanent establishments, agents
or licensees, such office having supervisory and coordinating functions for all
departments of the enterprise located within the region concerned, subparagraph
e) will not apply to that management office because a permanent
establishment will normally be deemed to exist, because the management office
may be regarded as an office within the meaning of paragraph 2. Where a big
international concern has delegated all management functions to its regional
management offices so that the functions of the head office of the concern are
restricted to general supervision (so-called polycentric enterprises), the regional
management offices even have to be regarded as a place of management within
the meaning of subparagraph a) of paragraph 2. Tthe function of managing an
enterprise, even if it only covers a certain area of the operations of the concern,
constitutes an essential part of the business operations of the enterprise and
therefore can in no way be regarded as an activity which has a preparatory or
auxiliary character within the meaning of subparagraph e) of paragraph 4.
25. A permanent establishment could also be constituted if an enterprise
maintains a fixed place of business for the delivery of spare parts to customers
for machinery supplied to those customers where, in addition, it maintains or
repairs such machinery, as this goes beyond the pure delivery mentioned in
subparagraph a) of paragraph 4. Since these after-sale organisations perform an
essential and significant part of the services of an enterprise vis--vis its
customers, their activities are not merely auxiliary ones. Subparagraph e) applies
only if the activity of the fixed place of business is limited to a preparatory or
auxiliary one. This would not be the case where, for example, the fixed place of
business does not only give information but also furnishes plans etc. specially
developed for the purposes of the individual customer. Nor would it be the case
if a research establishment were to concern itself with manufacture.
36 SECTION B
26. Moreover, subparagraph e) makes it clear that the activities of the fixed
place of business must be carried on for the enterprise. A fixed place of business
which renders services not only to its enterprise but also directly to other
enterprises, for example to other companies of a group to which the company
owning the fixed place belongs, would not fall within the scope of
subparagraph e).
26.1 Another example is that of facilities such as cables or pipelines that cross
the territory of a country. Apart from the fact that income derived by the owner
or operator of such facilities from their use by other enterprises is covered by
Article 6 where they constitute immovable property under paragraph 2 of
Article 6, the question may arise as to whether paragraph 4 applies to them.
Where these facilities are used to transport property belonging to other
enterprises, subparagraph a), which is restricted to delivery of goods or
merchandise belonging to the enterprise that uses the facility, will not be
applicable as concerns the owner or operator of these facilities. Subparagraph e)
also will not be applicable as concerns that enterprise since the cable or pipeline
is not used solely for the enterprise and its use is not of preparatory or auxiliary
character given the nature of the business of that enterprise. The situation is
different, however, where an enterprise owns and operates a cable or pipeline
that crosses the territory of a country solely for purposes of transporting its own
property and such transport is merely incidental to the business of that enterprise,
as in the case of an enterprise that is in the business of refining oil and that owns
and operates a pipeline that crosses the territory of a country solely to transport
its own oil to its refinery located in another country. In such case,
subparagraph a) would be applicable. An additional question is whether the cable
or pipeline could also constitute a permanent establishment for the customer of
the operator of the cable or pipeline, i.e. the enterprise whose data, power or
property is transmitted or transported from one place to another. In such a case,
the enterprise is merely obtaining transmission or transportation services
provided by the operator of the cable or pipeline and does not have the cable or
pipeline at its disposal. As a consequence, the cable or pipeline cannot be
considered to be a permanent establishment of that enterprise.
27. As already mentioned in paragraph 21 above, paragraph 4 is designed to
provide for exceptions to the general definition of paragraph 1 in respect of fixed
places of business which are engaged in activities having a preparatory or
auxiliary character. Therefore, according to subparagraph f) of paragraph 4, the
fact that one fixed place of business combines any of the activities mentioned in
subparagraphs a) to e) of paragraph 4 does not mean of itself that a permanent
establishment exists. As long as the combined activity of such a fixed place of
business is merely preparatory or auxiliary, a permanent establishment should be
deemed not to exist. Such combinations should not be viewed on rigid lines, but
should be considered in the light of the particular circumstances. The criterion
preparatory or auxiliary character is to be interpreted in the same way as is set
out for the same criterion of subparagraph e) (see paragraphs 24 and 25 above).
States which want to allow any combination of the items mentioned in
subparagraphs a) to e), disregarding whether or not the criterion of the
preparatory or auxiliary character of such a combination is met, are free to do so
by deleting the words provided to character in subparagraph f).
SECTION B 37
27.1 Subparagraph f) is of no importance in a case where an enterprise

maintains several fixed places of business within the meaning of
subparagraphs a) to e) provided that they are separated from each other locally
and organisationally, as in such a case each place of business has to be viewed
separately and in isolation for deciding whether a permanent establishment
exists. Places of business are not separated organisationally where they each
perform in a Contracting State complementary functions such as receiving and
storing goods in one place, distributing those goods through another etc. An
enterprise cannot fragment a cohesive operating business into several small
operations in order to argue that each is merely engaged in a preparatory or
auxiliary activity.
28. The fixed places of business mentioned into which paragraph 4 applies do
not cannot be deemed to constitute permanent establishments so long as theirthe
business activities performed through those fixed places of business are
restricted to the activities referred to in that paragraph functions which are the
prerequisite for assuming that the fixed place of business is not a permanent
establishment. This will be the case even if the contracts necessary for
establishing and carrying on these business activities are concluded by those in
charge of the places of business themselves. The conclusion of such contracts
by these employees will not constitute a permanent establishment of the
enterprise under The employees of places of business within the meaning of
paragraph 4 who are authorised to conclude such contracts should not be
regarded as agents within the meaning of paragraph 5 as long as the conclusion
of these contracts satisfies the conditions of paragraph 4 (see paragraph 33
below). A case in point would be a research institution An example would be
where the manager of which a place of business where preparatory or auxiliary
research activities are conducted of which is authorised to concludes the
contracts necessary for establishing and maintaining that place of business the
institution and who exercises this authority within the framework as part of the
activities carried on at that location functions of the institution. A permanent
establishment, however, exists if the fixed place of business exercising any of the
functions listed in paragraph 4 were to exercise them not only on behalf of the
enterprise to which it belongs but also on behalf of other enterprises. If, for
instance, an advertising agency maintained by an enterprise were also to engage
in advertising for other enterprises, it would be regarded as a permanent
establishment of the enterprise by which it is maintained.
29. If, under paragraph 4, a fixed place of business under paragraph 4 is
deemed not to be a permanent establishment, this exception applies likewise to
the disposal of movable property forming part of the business property of the
place of business at the termination of the enterprises activity at that place in
such installation (see paragraph 11 above and paragraph 2 of Article 13).
SinceWhere, for example, the display of merchandise during a trade fair or
convention is excepted under subparagraphs a) and b), the sale of thate
merchandise at the termination of thea trade fair or convention is covered by
subparagraph e) as such sale is merely an auxiliary activitythis exception. The
exception does not, of course, apply to sales of merchandise not actually
displayed at the trade fair or convention.
38 SECTION B
30. Where paragraph 4 does not apply because aA fixed place of business
used by an enterprise both for activities that are listed in that which rank as
exceptions of (paragraph 4) is also used and for other activities that go beyond
what is preparatory or auxiliary, that place of business constitutes a single
permanent establishment of the enterprise and the profits attributable to the
permanent establishment with respect to as regards both types of activities may
be taxed in the State where that permanent establishment is situated. This
would be the case, for instance, where a store maintained for the delivery of
goods also engaged in sales.
30.1 Some States consider that some of the activities referred to in paragraph
4 are intrinsically preparatory or auxiliary and, in order to provide greater
certainty for both tax administrations and taxpayers, take the view that these
activities should not be subject to the condition that they be of a preparatory or
auxiliary character, any concern about the inappropriate use of these
exceptions being addressed through the provisions of paragraph 4.1. States
that share that view are free to amend paragraph 4 as follows (and may also
agree to delete some of the activities listed in subparagraphs a) to d) below if
they consider that these activities should be subject to the preparatory or
auxiliary condition in subparagraph e)):
4. Notwithstanding the preceding provisions of this Article, the term
permanent establishment shall be deemed not to include:
a)
the use of facilities solely for the purpose of storage, display or

delivery of goods or merchandise belonging to the enterprise;
b)
the maintenance of a stock of goods or merchandise belonging

to the enterprise solely for the purpose of storage, display or
delivery;
the maintenance of a stock of goods or merchandise belonging
to the enterprise solely for the purpose of processing by another
enterprise;
c)
d)
e)
f)
the maintenance of a fixed place of business solely for the

purpose of purchasing goods or merchandise or of collecting
information, for the enterprise;
the maintenance of a fixed place of business solely for the
purpose of carrying on, for the enterprise, any activity not listed
in subparagraphs a) to d), provided that this activity has a
preparatory or auxiliary character, or
the maintenance of a fixed place of business solely for any
combination of activities mentioned in subparagraphs a) to e),
provided that the overall activity of the fixed place of business
resulting from this combination is of a preparatory or auxiliary
character.
SECTION B 39
2.
Fragmentation of activities between closely related parties
14.
Paragraph 27.1 of the Commentary on Article 5 currently deals with the
application of Art. 5(4)f) in the case of what has been referred to as the fragmentation of
activities:
27.1 Subparagraph f) is of no importance in a case where an enterprise maintains several
fixed places of business within the meaning of subparagraphs a) to e) provided that they
are separated from each other locally and organisationally, as in such a case each place of
business has to be viewed separately and in isolation for deciding whether a permanent
establishment exists. Places of business are not separated organisationally where they
each perform in a Contracting State complementary functions such as receiving and
storing goods in one place, distributing those goods through another etc. An enterprise
cannot fragment a cohesive operating business into several small operations in order to
argue that each is merely engaged in a preparatory or auxiliary activity.
15.
Given the ease with which subsidiaries may be established, the logic of the last
sentence ([a]n enterprise cannot fragment a cohesive operating business into several
small operations in order to argue that each is merely engaged in a preparatory or
auxiliary activity) should not be restricted to cases where the same enterprise maintains
different places of business in a country but should be extended to cases where these
places of business belong to closely related enterprises. Some BEPS concerns related to
Art. 5(4) will therefore be addressed by the rule proposed below which will take account
not only of the activities carried on by the same enterprise at different places but also of
the activities carried on by closely related enterprises at different places or at the same
place. This new rule is the logical consequence of the decision to restrict the scope of Art.
5(4) to activities that have a preparatory and auxiliary character because, in the absence
of that rule, it would be relatively easy to use closely related enterprises in order to
segregate activities which, when taken together, go beyond that threshold.
NEW ANTI-FRAGMENTATION RULE
Add the following new paragraph 4.1 to Article 5:
4.1 Paragraph 4 shall not apply to a fixed place of business that is used or
maintained by an enterprise if the same enterprise or a closely related enterprise
carries on business activities at the same place or at another place in the same
Contracting State and
a)
that place or other place constitutes a permanent establishment for the
enterprise or the closely related enterprise under the provisions of this
Article, or
b)
the overall activity resulting from the combination of the activities
carried on by the two enterprises at the same place, or by the same
enterprise or closely related enterprises at the two places, is not of a
preparatory or auxiliary character,
provided that the business activities carried on by the two enterprises at the same
place, or by the same enterprise or closely related enterprises at the two places,
constitute complementary functions that are part of a cohesive business
operation.
40 SECTION B
Proposed changes to the Commentary on Article 5 (changes to the existing text of
the Commentary appear in bold italics for additions and strikethrough for deletions)
Replace existing paragraph 27.1 of the Commentary on Article 5 by the following:
27.1 Unless the anti-fragmentation provisions of paragraph 4.1 are applicable
(see below), Ssubparagraph f) is of no importance in a case where an enterprise
maintains several fixed places of business within the meaning of
subparagraphs a) to e) provided that they are separated from each other locally
and organisationally, as in such a case each place of business has to be viewed
separately and in isolation for deciding whether a permanent establishment exists.
Places of business are not separated organisationally where they each perform
in a Contracting State complementary functions such as receiving and storing
goods in one place, distributing those goods through another etc. An enterprise
cannot fragment a cohesive operating business into several small operations in
order to argue that each is merely engaged in a preparatory or auxiliary activity.
Add the following new paragraphs to the Commentary on Article 5:
Paragraph 4.1
30.2
The purpose of paragraph 4.1 is to prevent an enterprise or a group of
closely related enterprises from fragmenting a cohesive business operation into
several small operations in order to argue that each is merely engaged in a
preparatory or auxiliary activity. Under paragraph 4.1, the exceptions provided
for by paragraph 4 do not apply to a place of business that would otherwise
constitute a permanent establishment where the activities carried on at that
place and other activities of the same enterprise or of closely related
enterprises exercised at that place or at another place in the same State
constitute complementary functions that are part of a cohesive business
operation. For paragraph 4.1 to apply, however, at least one of the places
where these activities are exercised must constitute a permanent establishment
or, if that is not the case, the overall activity resulting from the combination of
the relevant activities must go beyond what is merely preparatory or auxiliary.
30.3 The concept of closely related enterprises that is used in paragraph 4.1
is defined in subparagraph b) of paragraph 6 of the Article (see paragraphs
38.8 to 38.10 below).
30.4 The following examples illustrate the application of paragraph 4.1:
Example A: RCO, a bank resident of State R, has a number of

branches in State S which constitute permanent establishments. It
also has a separate office in State S where a few employees verify
information provided by clients that have made loan applications
at these different branches. The results of the verifications done by
the employees are forwarded to the headquarters of RCO in State
R where other employees analyse the information included in the
loan applications and provide reports to the branches where the
decisions to grant the loans are made. In that case, the exceptions
of paragraph 4 will not apply to the office because another place
(i.e. any of the other branches where the loan applications are
made) constitutes a permanent establishment of RCO in State S
SECTION B 41
and the business activities carried on by RCO at the office and at

the relevant branch constitute complementary functions that are
part of a cohesive business operation (i.e. providing loans to clients
in State S).
Example B: RCO, a company resident of State R, manufactures

and sells appliances. SCO, a resident of State S that is a whollyowned subsidiary of RCO, owns a store where it sells appliances
that it acquires from RCO. RCO also owns a small warehouse in
State S where it stores a few large items that are identical to some
of those displayed in the store owned by SCO. When a customer
buys such a large item from SCO, SCO employees go to the
warehouse where they take possession of the item before delivering
it to the customer; the ownership of the item is only acquired by
SCO from RCO when the item leaves the warehouse. In this case,
paragraph 4.1 prevents the application of the exceptions of
paragraph 4 to the warehouse and it will not be necessary,
therefore, to determine whether paragraph 4, and in particular
subparagraph 4 a), applies to the warehouse. The conditions for
the application of paragraph 4.1 are met because
SCO and RCO are closely related enterprises;
SCOs store constitutes a permanent establishment of SCO

(the definition of permanent establishment is not limited to
situations where a resident of one Contracting State uses or
maintains a fixed place of business in the other State; it
applies equally where an enterprise of one State uses or
maintains a fixed place of business in that same State); and
The business activities carried on by RCO at its warehouse

and by SCO at its store constitute complementary functions
that are part of a cohesive business operation (i.e. storing
goods in one place for the purpose of delivering these goods
as part of the obligations resulting from the sale of these
goods through another place in the same State).
42 SECTION C
C. Other strategies for the artificial avoidance of PE status

1.
Splitting-up of contracts
16.
The splitting-up of contracts in order to abuse the exception in paragraph 3 of
Article 5 is discussed in paragraph 18 of the Commentary on Art. 5:
18. The twelve month threshold has given rise to abuses; it has sometimes been
found that enterprises (mainly contractors or subcontractors working on the continental
shelf or engaged in activities connected with the exploration and exploitation of the
continental shelf) divided their contracts up into several parts, each covering a period
less than twelve months and attributed to a different company which was, however,
owned by the same group. Apart from the fact that such abuses may, depending on the
circumstances, fall under the application of legislative or judicial anti-avoidance rules,
countries concerned with this issue can adopt solutions in the framework of bilateral
negotiations.
17. The Principal Purposes Test (PPT) rule that will be added to the OECD Model Tax
Convention as a result of the adoption of the Report on Action 6 (Preventing the Granting
of Treaty Benefits in Inappropriate Circumstances)3 will address the BEPS concerns
related to the abusive splitting-up of contracts. In order to make this clear, the following
example will be added to the Commentary on the PPT rule. For States that are unable to
address the issue through domestic anti-abuse rules, a more automatic rule will also be
included in the Commentary as a provision that should be used in treaties that would not
include the PPT or as an alternative provision to be used by countries specifically
concerned with the splitting-up of contracts issue.
CHANGES DEALING WITH THE SPLITTING-UP OF CONTRACTS
1. Add the following example to the Commentary on the PPT rule proposed in the Report on
Action 6:
Example J: RCo is a company resident of State R. It has successfully submitted a bid for
the construction of a power plant for SCO, an independent company resident of State S.
That construction project is expected to last 22 months. During the negotiation of the
contract, the project is divided into two different contracts, each lasting 11 months. The
first contract is concluded with RCO and the second contract is concluded with SUBCO,
a recently incorporated wholly-owned subsidiary of RCO resident of State R. At the
request of SCO, which wanted to ensure that RCO would be contractually liable for the
performance of the two contracts, the contractual arrangements are such that RCO is
jointly and severally liable with SUBCO for the performance of SUBCOs contractual
obligations under the SUBCO-SCO contract.
In this example, in the absence of other facts and circumstances showing otherwise, it
would be reasonable to conclude that one of the principal purposes for the conclusion of
the separate contract under which SUBCO agreed to perform part of the construction
project was for RCO and SUBCO to each obtain the benefit of the rule in paragraph 3 of
Article 5 of the State R-State S tax convention. Granting the benefit of that rule in these
circumstances would be contrary to the object and purpose of that paragraph as the time
limitation of that paragraph would otherwise be meaningless.
SECTION C 43
2. Replace paragraph 18 of the Commentary on paragraph 3 of Article 5 by the following

(consequential changes will be required to paragraphs 42.45-42.48 of the Commentary):
18. The twelve month test applies to each individual site or project. In determining how
long the site or project has existed, no account should be taken of the time previously spent
by the contractor concerned on other sites or projects which are totally unconnected with it.
A building site should be regarded as a single unit, even if it is based on several contracts,
provided that it forms a coherent whole commercially and geographically. Subject to this
proviso, a building site forms a single unit even if the orders have been placed by several
persons (e.g. for a row of houses). [rest of the paragraph is moved to paragraph 18.1]
18.1 The twelve month threshold has given rise to abuses; it has sometimes been found
that enterprises (mainly contractors or subcontractors working on the continental shelf or
engaged in activities connected with the exploration and exploitation of the continental
shelf) divided their contracts up into several parts, each covering a period of less than
twelve months and attributed to a different company which was, however, owned by the
same group. Apart from the fact that such abuses may, depending on the circumstances,
fall under the application of legislative or judicial anti-avoidance rules, countries
concerned with this issue can adopt solutions in the framework of bilateral negotiations.
these abuses could also be addressed through the application of the anti-abuse rule of
paragraph 7 of Article [X], as shown by example J in paragraph [14] of the Commentary
on Article [X]. Some States may nevertheless wish to deal expressly with such abuses.
Moreover, States that do not include paragraph 7 of Article [X] in their treaties should
include an additional provision to address contract splitting. Such a provision could, for
example, be drafted along the following lines:
For the sole purpose of determining whether the twelve month period referred to in
paragraph 3 has been exceeded,
a)
where an enterprise of a Contracting State carries on activities in the other

Contracting State at a place that constitutes a building site or construction or
installation project and these activities are carried on during periods of time
that do not last more than twelve months, and
b)
connected activities are carried on at the same building site or construction or

installation project during different periods of time, each exceeding 30 days,
by one or more enterprises closely related to the first-mentioned enterprise,
these different periods of time shall be added to the period of time during which the
first-mentioned enterprise has carried on activities at that building site or
construction or installation project.
The concept of closely related enterprises that is used in the above provision is defined
in subparagraph b) of paragraph 6 of the Article (see paragraphs 38.8 to 38.10 below).
18.2 For the purposes of the alternative provision found in paragraph 18.1, the
determination of whether activities are connected will depend on the facts and
circumstances of each case. Factors that may especially be relevant for that purpose
include:
whether the contracts covering the different activities were concluded with
the same person or related persons;
44 SECTION C
whether the conclusion of additional contracts with a person is a logical
consequence of a previous contract concluded with that person or related
persons;
whether the activities would have been covered by a single contract absent
tax planning considerations;
whether the nature of the work involved under the different contracts is the
same or similar;
whether the same employees are performing the activities under the
different contracts.
2.
Strategies for selling insurance in a State without having a PE therein
18.
As part of the work on Action 7, BEPS concerns related to situations where a
large network of exclusive agents is used to sell insurance for a foreign insurer were also
examined. It was ultimately concluded, however, that it would be inappropriate to try to
address these concerns through a PE rule that would treat insurance differently from other
types of businesses and that BEPS concerns that may arise in cases where a large network
of exclusive agents is used to sell insurance for a foreign insurer should be addressed
through the more general changes to Art. 5(5) and 5(6) in section A of this report.
SECTION D 45
D.
Profit attribution to PEs and interaction with action points on transfer
pricing
19.
The work on Action 7 that was done with respect to attribution of profit issues
focussed on whether the existing rules of Art. 7 of the OECD Model Tax Convention
would be appropriate for determining the profits that would be allocated to PEs resulting
from the changes included in this report. The conclusion of that work is that these
changes do not require substantive modifications to the existing rules and guidance
concerning the attribution of profits to a permanent establishment under Article 7 but that
there is a need for additional guidance on how the rules of Article 7 would apply to PEs
resulting from the changes in this report, in particular for PEs outside the financial sector.
There is also a need to take account of the results of the work on other parts of the BEPS
Action Plan dealing with transfer pricing, in particular the work related to intangibles,
risk and capital.
20.
Realistically, however, work on attribution of profit issues related to Action 7
could not be undertaken before the work on Action 7 and Actions 8-10 had been
completed. For that reason, and based on the many comments that have stressed the need
for additional guidance on the issue of attribution of profits to PEs, follow-up work on
attribution of profits issues related to Action 7 will be carried on after September 2015
with a view to providing the necessary guidance before the end of 2016, which is the
deadline for the negotiation of the multilateral instrument that will implement the results
of the work on treaty issues mandated by the BEPS Action Plan.
46 NOTES AND BIBLIOGRAPHY
Notes
1
See paragraph 14 of the Commentary on the PPT rule included in paragraph 26 of that
Report.
See www.oecd.org/tax/treaties/48836726.pdf (2011 discussion draft)

www.oecd.org/ctp/treaties/PermanentEstablishment.pdf (2012 discussion draft).
See paragraph 14 of the Commentary on the PPT rule included in paragraph 26 of the
Report on Action 6.
and
Bibliography
OECD (2015a), Preventing the Granting of Treaty Benefits in Inappropriate

OECD (2015b), Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015
OECD (2013a), Action Plan on Base Erosion and Profit Shifting, OECD Publishing,
http://dx.doi.org/10.1787/9789264192744-en.

AND DEVELOPMENT

(23 2015 34 1 P) ISBN 978-92-64-24121-3 2015-01
Preventing the Artificial Avoidance of Permanent

Establishment Status
Contents
Background
A. Artificial avoidance of PE status through commissionnaire arrangements and similar strategies
B. Artificial avoidance of PE status through the specific activity exemptions
C. Other strategies for the artificial avoidance of PE status
D. Profit attribution to PEs and interaction with action points on transfer pricing

isbn978-92-64-24121-3
23 2015 34 1 P
9HSTCQE*cebcbd+

Project
Aligning Transfer Pricing

Outcomes with Value
Creation
ACTIONS 8-10: 2015 Final Reports
Aligning Transfer Pricing

Outcomes with Value
Creation, Actions 8 10
2015 Final Reports

OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 - 2015 Final Reports,
http://dx.doi.org/10.1787/9789264241244-en
ISBN 978-92-64-24123-7 (print)

ISBN 978-92-64-24124-4 (PDF)

OECD 2015
Foreword 3
Foreword
ALIGNING TRANSFER PRICING OUTCOMES WITH VALUE CREATION OECD 2015
4 Foreword
TABLE OF CONTENTS 5
Table of contents

Executive summary 9
Guidance for Applying the Arms Length Principle 13
Revisions to Section D of Chapter I of the Transfer Pricing Guidelines 13
D.1. Identifying the commercial or financial relations 15
D.2. Recognition of the accurately delineated transaction 38
D.3. Losses 40
D.4. The effect of government policies 41
D.5. Use of customs valuations 43
D.6. Location savings and other local market features 43
D.7. Assembled workforce 46
D.8. MNE group synergies 47
Commodity Transactions 51
Additions to ChapterII of the Transfer Pricing Guidelines 51
Scope of Work for Guidance on the Transactional Profit Split Method 55
Part I: Current guidance on transactional profit split method and public consultation 57
PartII: Scope of revisions of the guidance on the transactional profit split method 59
Intangibles 63
Revisions to ChapterVI of the Transfer Pricing Guidelines 63
A. Identifying intangibles 67
B. Ownership of intangibles and transactions involving the development, enhancement,
maintenance, protection and exploitation of intangibles 73
C. Transactions involving the use or transfer of intangibles 88
D. Supplemental guidance for determining arms length conditions in cases involving
intangibles 92
Additional Guidance in ChapterII of the Transfer Pricing Guidelines Resulting from
theRevisions to ChapterVI116
Annex to ChapterVI Examples to illustrate the guidance on intangibles 117
6 TABLE OF CONTENTS
Low Value-adding Intra-group Services 141
Revisions to ChapterVII of the Transfer Pricing Guidelines141
A. Introduction143
B. Main issues 144
C. Some examples of intra-group services 152
D. Low value-adding intra-group services 153
Cost Contribution Arrangements161
Revisions to ChapterVIII of the Transfer Pricing Guidelines161
A. Introduction163
B. Concept of a CCA163
C. Applying the arms length principle 166
D. CCA entry, withdrawal or termination174
E. Recommendations for structuring and documenting CCAs175
Annex to ChapterVIII Examples to illustrate the guidance on cost contribution arrangements177
Bibliography 183
Notes185

BEPS
CCA
Cost contribution arrangement
CFC
CRO
Contract research organisation
CUP
Comparable uncontrolled price
G20
Group of twenty
HTVI
Hard-to-value intangibles
IT
Information technology
MAP
Mutual agreement procedure
MNE
OECD
R&D
TNMM
Transactional net margin method
UN
United Nations
VAT
Value added tax
WACC
Weighted average cost of capital
WP6
Working party No.6 on the Taxation of Multinational Enterprises
Executive summary 9
Executive summary
Over several decades and in step with the globalisation of the economy, world-wide
intra-group trade has grown exponentially. Transfer pricing rules, which are used for
tax purposes, are concerned with determining the conditions, including the price, for
transactions within an MNE group resulting in the allocation of profits to group companies
in different countries. The impact of these rules has become more significant for business
and tax administrations with the growth in the volume and value of intra-group trade. As
the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013)
identified, the existing international standards for transfer pricing rules can be misapplied
so that they result in outcomes in which the allocation of profits is not aligned with the
economic activity that produced the profits. The work under Actions8-10 of the BEPS
Action Plan has targeted this issue, to ensure that transfer pricing outcomes are aligned
with value creation.
The arms length principle is used by countries as the cornerstone of transfer pricing
rules. It is embedded in treaties and appears as Article9(1) of the OECD and UN Model
Tax Conventions. A shared interpretation of the principle by many of those countries is
set out in the OECDs Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations (hereafter: Transfer Pricing Guidelines) first published as the Report
on Transfer Pricing and Multinational Enterprises in 1979, revised and published as
Guidelines in 1995, with a further update in 2010. The principle requires that transactions
between associated enterprises are priced as if the enterprises were independent, operating
at arms length and engaging in comparable transactions under similar conditions and
economic circumstances. Where the conditions of the transaction are different to those
between third parties in comparable circumstances, adjustments to the profits may be
needed for tax purposes. The arms length principle has proven useful as a practical
and balanced standard for tax administrations and taxpayers to evaluate transfer prices
between associated enterprises, and to prevent double taxation. However, with its perceived
emphasis on contractual allocations of functions, assets and risks, the existing guidance
on the application of the principle has also proven vulnerable to manipulation. This
manipulation can lead to outcomes which do not correspond to the value created through
the underlying economic activity carried out by the members of an MNE group. Therefore,
the BEPS Action Plan required the guidance on the arms length principle to be clarified
and strengthened and, furthermore, if transfer pricing risks remain after clarifying and
strengthening the guidance, the BEPS Action Plan foresaw the possibility of introducing
special measures either within or beyond the arms length principle.
This work on transfer pricing under the BEPS Action Plan has focused on three key
areas. Work under Action8 looked at transfer pricing issues relating to transactions
involving intangibles, since misallocation of the profits generated by valuable intangibles
has contributed to base erosion and profit shifting. Work under Action9 considered the
contractual allocation of risks, and the resulting allocation of profits to those risks, which
may not correspond with the activities actually carried out. Work under Action9 also
addressed the level of returns to funding provided by a capital-rich MNE group member,
where those returns do not correspond to the level of activity undertaken by the funding
company. Work under Action10 focused on other high-risk areas, including the scope for
addressing profit allocations resulting from transactions which are not commercially rational
for the individual enterprises concerned (re-characterisation), the scope for targeting the
use of transfer pricing methods in a way which results in diverting profits from the most
economically important activities of the MNE group, and neutralising the use of certain
types of payments between members of the MNE group (such as management fees and
head office expenses) to erode the tax base in the absence of alignment with value creation.
This Report contains revised guidance which responds to these issues and ensures
that the transfer pricing rules secure outcomes that see operational profits allocated to
the economic activities which generate them. It represents an agreement of the countries
participating in the OECD/G20 BEPS Project. For countries that formally subscribe to the
Transfer Pricing Guidelines, the guidance in this Report takes the form of amendments to
the Transfer Pricing Guidelines. Therefore this Report also reflects how the changes will
be incorporated in those Guidelines.1
To achieve this objective, the revised guidance requires careful delineation of the
actual transaction between the associated enterprises by analysing the contractual relations
between the parties in combination with the conduct of the parties. The conduct will
supplement or replace the contractual arrangements if the contracts are incomplete or
are not supported by the conduct. In combination with the proper application of pricing
methods in a way that prevents the allocation of profits to locations where no contributions
are made to these profits, this will lead to the allocation of profits to the enterprises that
conduct the corresponding business activities. In circumstances where the transaction
between associated enterprises lacks commercial rationality, the guidance continues to
authorise the disregarding of the arrangement for transfer pricing purposes.
The revised guidance includes two important clarifications relating to risks and
intangibles.
Risks are defined as the effect of uncertainty on the objectives of the business. In all of
a companys operations, every step taken to exploit opportunities, every time a company
spends money or generates income, uncertainty exists, and risk is assumed. No profitseeking business takes on risk associated with commercial opportunities without expecting
a positive return. This economic notion that higher risks warrant higher anticipated returns
made MNE groups pursue tax planning strategies based on contractual re-allocations of
risks, sometimes without any change in the business operations. In order to address this,
the Report determines that risks contractually assumed by a party that cannot in fact
exercise meaningful and specifically defined control over the risks, or does not have the
financial capacity to assume the risks, will be allocated to the party that does exercise such
control and does have the financial capacity to assume the risks.
For intangibles, the guidance clarifies that legal ownership alone does not necessarily
generate a right to all (or indeed any) of the return that is generated by the exploitation
of the intangible. The group companies performing important functions, controlling
economically significant risks and contributing assets, as determined through the accurate
delineation of the actual transaction, will be entitled to an appropriate return reflecting the
value of their contributions. Specific guidance will ensure that the analysis is not weakened
by information asymmetries between the tax administration and the taxpayer in relation
to hard-to-value intangibles, or by using special contractual relationships, such as a cost
contribution arrangement.
The revised guidance also addresses the situation where a capital-rich member of the
group provides funding but performs few activities. If this associated enterprise does not
in fact control the financial risks associated with its funding (for example because it just
provides the money when it is asked to do so, without any assessment of whether the party
receiving the money is creditworthy), then it will not be allocated the profits associated
with the financial risks and will be entitled to no more than a risk-free return, or less if, for
example, the transaction is not commercially rational and therefore the guidance on nonrecognition applies.
Finally, the guidance ensures that pricing methods will allocate profits to the most
important economic activities. It will no longer be possible to allocate the synergistic
benefits of operating as a group to members other than the ones contributing to such
synergistic benefits. For example, discounts that are generated because of the volume of
goods ordered by a combination of group companies will need to be allocated to these
group companies. As part of the Report, a mandate is included for follow-up work to be
done on the transactional profit split method, which will be carried out during 2016 and
finalised in the first half of 2017. This work should lead to detailed guidance on the ways
in which this method can usefully and appropriately be applied to align transfer pricing
outcomes with value creation, including in the circumstances of integrated global value
chains.
The guidance is linked in a holistic way with other Actions. As mentioned above,
this guidance will ensure that capital-rich entities without any other relevant economic
activities (cash boxes) will not be entitled to any excess profits. The profits the cash box
is entitled to retain will be equivalent to no more than a risk-free return. Moreover, if this
return qualifies as interest or an economically equivalent payment, then those already
marginal profits will also be targeted by the interest deductibility rules of Action4. In
addition, it will become extremely difficult to structure the payments to the country where
the cash box is tax-resident in a way that avoids withholding taxes, due to the guidance
provided on preventing treaty abuse (Action6). Finally, a cash box with limited or no
economic activities is likely to be the target of CFC rules (Action3). With that, the holistic
approach provided by the BEPS Action Plan will secure that the role of cash boxes in BEPS
strategies is seriously discouraged.
This holistic approach to tackling BEPS behaviour is supported by the transparency
requirements agreed under Action13. Transfer pricing analysis depends on access to
relevant information. The access to the transfer pricing documentation provided by
Action13 will enable the guidance provided in this Report to be applied in practice, based
on relevant information on global and local operations in the master file and local file. In
addition, the Country-by-Country Report will enable better risk assessment practices by
providing information about the global allocation of the MNE groups revenues, profits,
taxes, and economic activity.
In addition to improving access to relevant transfer pricing information through
Action13, this report also contains guidance on transactions involving commodities as well
as on low value-adding intra-group services. As BEPS creates additional transfer pricing
challenges for developing countries and these two areas were identified by them as being
of critical importance, this guidance will be supplemented with further work mandated by
the G20 Development Working Group, which will provide knowledge, best practices, and
tools for developing countries to use to price commodity transactions for transfer pricing
purposes and to prevent the erosion of their tax bases through common types of baseeroding payments.
Transfer pricing depends on a facts and circumstances analysis and can involve
subjective interpretations of these facts and circumstances. In order to address the risk
of double taxation, the work under Action14 to improve the effectiveness of dispute
resolution mechanisms includes a new minimum standard providing for access to the
Mutual Agreement Procedure of Article25 of the Model Tax Convention for all transfer
pricing cases. In addition, the 20 countries which have made the commitment to mandatory
binding arbitration under Action14 have specified that they will allow access to arbitration
for transfer pricing cases so that double taxation will be eliminated.
The work under Actions8-10 of the BEPS Action Plan will ensure that transfer pricing
outcomes better align with value creation of the MNE group. Moreover, the holistic
nature of the BEPS Action Plan will ensure that the role of capital-rich, low-functioning
entities in BEPS planning will become less relevant. As a consequence, the goals set by
the BEPS Action Plan in relation to the development of transfer pricing rules have been
achieved without the need to develop special measures outside the arms length principle.
Further work will be undertaken on profit splits and financial transactions. Special
attention is given in the Report to the needs of developing countries. This new guidance
will be supplemented with further work mandated by the G20 Development Working
Group, following reports by the OECD on the impact of base erosion and profit shifting
in developing countries. Finally, the interaction with Action14 on dispute resolution will
ensure that the transfer pricing measures included in this Report will not result in double
taxation.
GUIDANCE FOR APPLYING THE ARMS LENGTH PRINCIPLE
Revisions to SectionD of ChapterI of the Transfer Pricing Guidelines

Summary
The guidance set out in this chapter of the Report responds to the mandate under
Actions8-10 of the BEPS Action Plan requiring the development of transfer pricing rules
which create transfer pricing outcomes in line with value creation. More specifically,
Actions9 and 10 mandate the development of:
(i)rules to prevent BEPS by transferring risks among, or allocating excessive capital
to, group members. This will involve adopting transfer pricing rules or special measures
to ensure that inappropriate returns will not accrue to an entity solely because it has
contractually assumed risks or has provided capital. The rules to be developed will also
require alignment of returns with value creation.
(ii)rules to prevent BEPS by engaging in transactions which would not, or would
only very rarely, occur between third parties. This will involve adopting transfer pricing
rules or special measures to: (i)clarify the circumstances in which transactions can be
recharacterised.
The guidance ensures that:
actual business transactions undertaken by associated enterprises are identified,
and transfer pricing is not based on contractual arrangements that do not reflect
economic reality
contractual allocations of risk are respected only when they are supported by actual
decision-making
capital without functionality will generate no more than a risk-free return, assuring
that no premium returns will be allocated to cash boxes without relevant substance
tax administrations may disregard transactions when the exceptional circumstances
of commercial irrationality apply.
In combination, the changes make a key contribution to aligning transfer pricing
outcomes with the value creating activities performed by the members of an MNE group.
These revisions will update the Transfer Pricing Guidelines so that they provide
guidance for taxpayers and tax administrations to follow in performing a transfer pricing
analysis. The revisions emphasise the importance of accurately delineating the actual
14 Guidance for Applying the Arms Length Principle
transaction between the associated enterprises by supplementing, where necessary, the

terms of any contract with the evidence of the actual conduct of the parties. The transaction
is not simply delineated by what is set out in a contract.
The assumption of risk by a party to a transaction can significantly affect the pricing of
that transaction at arms length. The revisions expand the guidance on identifying specific
risks and their impact, and provide an analytical framework to determine which associated
enterprise assumes risk for transfer pricing purposes. To assume a risk for transfer pricing
purposes, the associated enterprise needs to control the risk and have the financial capacity
to assume the risk.
Finally, the guidance helps to accurately determine the actual contributions made
by an associated enterprise that solely provides capital. Where the capital provider does
not exercise control over the investment risks that may give rise to premium returns, that
associated enterprise should expect no more than a risk-free return.
Taken together, these aspects of the revised guidance ensure that a transfer pricing
analysis is based on an accurate delineation of what the associated enterprises actually
contribute in the transaction, and not on contractual terms, including contractual
assumption of risk, that are not in practice performed. The guidance provides a basis
for any transfer pricing analysis, but in so doing it also addresses some of the key BEPS
challenges: allocating risks on paper does not in itself shift profits.
Ordinarily the actual arrangements should then be priced in accordance with guidance
provided in other chapters of the Transfer Pricing Guidelines. However, the revisions in
this chapter reinforce the need for tax administrations to be able to disregard transactions
between associated enterprises when the exceptional circumstances of commercial
irrationality apply. The guidance emphasises that the mere fact that the transaction may
not be seen between independent parties does not mean that it should not be recognised.
Instead, the key question is whether the actual transaction possesses the commercial
rationality of arrangements that would be agreed between unrelated parties under
comparable economic circumstances.
In summary, the revisions respond to the mandate to prevent inappropriate returns to
capital and misallocation of risk by encouraging thoroughness in determining the actual
arrangements between the associated enterprises so that pricing takes into account the
actual contributions of those parties, including risks actually assumed, and by authorising
the non-recognition of transactions which make no commercial sense.
The current provisions of ChapterI, SectionD of the Transfer Pricing Guidelines

are deleted in their entirety and replaced by the following language.
D.1. Identifying the commercial or financial relations

1.33 As stated in paragraph1.6 a comparability analysis is at the heart of the
application of the arms length principle. Application of the arms length principle is based
on a comparison of the conditions in a controlled transaction with the conditions that
would have been made had the parties been independent and undertaking a comparable
transaction under comparable circumstances. There are two key aspects in such an analysis:
the first aspect is to identify the commercial or financial relations between the associated
enterprises and the conditions and economically relevant circumstances attaching to those
relations in order that the controlled transaction is accurately delineated; the second aspect
is to compare the conditions and the economically relevant circumstances of the controlled
transaction as accurately delineated with the conditions and the economically relevant
circumstances of comparable transactions between independent enterprises. This section of
ChapterI provides guidance on identifying the commercial or financial relations between
the associated enterprises and on accurately delineating the controlled transaction. This
first aspect of the analysis is distinct from the second aspect of considering the pricing of
that controlled transaction under the arms length principle. ChaptersII and III provide
guidance on the second aspect of the analysis. The information about the controlled
transaction determined under the guidance in this section is especially relevant for steps2
and 3 of the typical process of a comparability analysis set out in paragraph3.4.
1.34 The typical process of identifying the commercial or financial relations between
the associated enterprises and the conditions and economically relevant circumstances
attaching to those relations requires a broad-based understanding of the industry
sector in which the MNE group operates (e.g.mining, pharmaceutical, luxury goods)
and of the factors affecting the performance of any business operating in that sector.
The understanding is derived from an overview of the particular MNE group which
outlines how the MNE group responds to the factors affecting performance in the sector,
including its business strategies, markets, products, its supply chain, and the key functions
performed, material assets used, and important risks assumed. This information is likely to
be included as part of the master file as described in ChapterV in support of a taxpayers
analysis of its transfer pricing, and provides useful context in which the commercial or
financial relations between members of the MNE group can be considered.
1.35 The process then narrows to identify how each MNE within that MNE group
operates, and provides an analysis of what each MNE does (e.g.a production company,
a sales company) and identifies its commercial or financial relations with associated
enterprises as expressed in transactions between them. The accurate delineation of the
actual transaction or transactions between the associated enterprises requires analysis
of the economically relevant characteristics of the transaction. These economically
relevant characteristics consist of the conditions of the transaction and the economically
relevant circumstances in which the transaction takes place. The application of the
arms length principle depends on determining the conditions that independent parties
would have agreed in comparable transactions in comparable circumstances. Before
making comparisons with uncontrolled transactions, it is therefore vital to identify the
economically relevant characteristics of the commercial or financial relations as expressed
in the controlled transaction.

1.36 The economically relevant characteristics or comparability factors that need to be
identified in the commercial or financial relations between the associated enterprises in
order to accurately delineate the actual transaction can be broadly categorised as follows:
The contractual terms of the transaction (D.1.1).
The functions performed by each of the parties to the transaction, taking into
account assets used and risks assumed, including how those functions relate to
the wider generation of value by the MNE group to which the parties belong, the
circumstances surrounding the transaction, and industry practices (D.1.2).
The characteristics of property transferred or services provided (D.1.3).
The economic circumstances of the parties and of the market in which the parties
operate (D.1.4).
The business strategies pursued by the parties (D.1.5).
This information about the economically relevant characteristics of the actual transaction
should be included as part of the local file as described in ChapterV in support of a
taxpayers analysis of its transfer pricing.
1.37 Economically relevant characteristics or comparability factors are used in two
separate but related phases in a transfer pricing analysis. The first phase relates to the
process of accurately delineating the controlled transaction for the purposes of this chapter,
and involves establishing the characteristics of the transaction, including its terms, the
functions performed, assets used, and risks assumed by the associated enterprises, the nature
of the products transferred or services provided, and the circumstances of the associated
enterprises, in accordance with the categories set out in the previous paragraph. The extent to
which any one of the characteristics categorised above is economically relevant in a particular
transaction depends on the extent to which it would be taken into account by independent
enterprises when evaluating the terms of the same transaction were it to occur between them.
1.38 Independent enterprises, when evaluating the terms of a potential transaction, will
compare the transaction to the other options realistically available to them, and they will
only enter into the transaction if they see no alternative that offers a clearly more attractive
opportunity to meet their commercial objectives. In other words, independent enterprises
would only enter into a transaction if it is not expected to make them worse off than their
next best option. For example, one enterprise is unlikely to accept a price offered for its
product by an independent commercial enterprise if it knows that other potential customers
are willing to pay more under similar conditions, or are willing to pay the same under
more beneficial conditions. Independent enterprises will generally take into account any
economically relevant differences between the options realistically available to them (such
as differences in the level of risk) when valuing those options. Therefore, identifying the
economically relevant characteristics of the transaction is essential in accurately delineating
the controlled transaction and in revealing the range of characteristics taken into account by
the parties to the transaction in reaching the conclusion that the transaction adopted offers a
clearly more attractive opportunity to meet commercial objectives than alternative options
realistically available. In making such an assessment, it may be necessary or useful to assess
the transaction in the context of a broader arrangement of transactions, since assessment
of the options realistically available to third parties is not necessarily limited to the single
transaction, but may take into account a broader arrangement of economically related
transactions.
1.39 The second phase in which economically relevant characteristics or comparability

factors are used in a transfer pricing analysis relates to the process set out in ChapterIII
of making comparisons between the controlled transactions and uncontrolled transactions
in order to determine an arms length price for the controlled transaction. To make such
comparisons, taxpayers and tax administrations need first to have identified the economically
relevant characteristics of the controlled transaction. As set out in ChapterIII, differences in
economically relevant characteristics between the controlled and uncontrolled arrangements
need to be taken into account when establishing whether there is comparability between the
situations being compared and what adjustments may be necessary to achieve comparability.
1.40 All methods that apply the arms length principle can be tied to the concept that
independent enterprises consider the options realistically available to them and in comparing
one option to another they consider any differences between the options that would
significantly affect their value. For instance, before purchasing a product at a given price,
independent enterprises normally would be expected to consider whether they could buy an
equivalent product on otherwise comparable terms and conditions but at a lower price from
another party. Therefore, as discussed in ChapterII, PartII, the comparable uncontrolled
price (CUP) method compares a controlled transaction to similar uncontrolled transactions
to provide a direct estimate of the price the parties would have agreed to had they resorted
directly to a market alternative to the controlled transaction. However, the method becomes
a less reliable substitute for arms length transactions if not all the characteristics of these
uncontrolled transactions that significantly affect the price charged between independent
enterprises are comparable. Similarly, the resale price and cost plus methods compare the
gross profit margin earned in the controlled transaction to gross profit margins earned
in similar uncontrolled transactions. The comparison provides an estimate of the gross
profit margin one of the parties could have earned had it performed the same functions for
independent enterprises and therefore provides an estimate of the payment that party would
have demanded, and the other party would have been willing to pay, at arms length for
performing those functions. Other methods, as discussed in ChapterII, PartIII, are based
on comparisons of net profit indicators (such as profit margins) between independent and
associated enterprises as a means to estimate the profits that one or each of the associated
enterprises could have earned had they dealt solely with independent enterprises, and
therefore the payment those enterprises would have demanded at arms length to compensate
them for using their resources in the controlled transaction. Where there are differences
between the situations being compared that could materially affect the comparison,
comparability adjustments must be made, where possible, to improve the reliability of the
comparison. Therefore, in no event can unadjusted industry average returns themselves
establish arms length prices.
1.41 For a discussion of the relevance of these factors for the application of particular
pricing methods, see the consideration of those methods in ChapterII.
D.1.1. The contractual terms of the transaction

1.42 A transaction is the consequence or expression of the commercial or financial
relations between the parties. The controlled transactions may have been formalised in
written contracts which may reflect the intention of the parties at the time the contract
was concluded in relation to aspects of the transaction covered by the contract, including
in typical cases the division of responsibilities, obligations and rights, assumption of
identified risks, and pricing arrangements. Where a transaction has been formalised by the
associated enterprises through written contractual agreements, those agreements provide
the starting point for delineating the transaction between them and how the responsibilities,

risks, and anticipated outcomes arising from their interaction were intended to be divided
at the time of entering into the contract. The terms of a transaction may also be found in
communications between the parties other than a written contract.
1.43 However, the written contracts alone are unlikely to provide all the information
necessary to perform a transfer pricing analysis, or to provide information regarding the
relevant contractual terms in sufficient detail. Further information will be required by
taking into consideration evidence of the commercial or financial relations provided by
the economically relevant characteristics in the other four categories (see paragraph1.36):
the functions performed by each of the parties to the transaction, taking into account
assets used and risks assumed, together with the characteristics of property transferred or
services provided, the economic circumstances of the parties and of the market in which
the parties operate, and the business strategies pursued by the parties. Taken together, the
analysis of economically relevant characteristics in all five categories provides evidence of
the actual conduct of the associated enterprises. The evidence may clarify aspects of the
written contractual arrangements by providing useful and consistent information. If the
contract neither explicitly nor implicitly (taking into account applicable principles of contract
interpretation) addresses characteristics of the transaction that are economically relevant,
then any information provided by the contract should be supplemented for purposes of the
transfer pricing analysis by the evidence provided by identifying those characteristics.
1.44 The following example illustrates the concept of clarifying and supplementing the
written contractual terms based on the identification of the actual commercial or financial
relations. CompanyP is the parent company of an MNE group situated in CountryP.
CompanyS, situated in CountryS, is a wholly-owned subsidiary of CompanyP and
acts as an agent for CompanyPs branded products in the CountryS market. The agency
contract between CompanyP and CompanyS is silent about any marketing and advertising
activities in CountryS that the parties should perform. Analysis of other economically
relevant characteristics and in particular the functions performed, determines that
CompanyS launched an intensive media campaign in CountryS in order to develop brand
awareness. This campaign represents a significant investment for CompanyS. Based on
evidence provided by the conduct of the parties, it could be concluded that the written
contract may not reflect the full extent of the commercial or financial relations between the
parties. Accordingly, the analysis should not be limited by the terms recorded in the written
contract, but further evidence should be sought as to the conduct of the parties, including
as to the basis upon which CompanyS undertook the media campaign.
1.45 If the characteristics of the transaction that are economically relevant are inconsistent
with the written contract between the associated enterprises, the actual transaction should
generally be delineated for purposes of the transfer pricing analysis in accordance with the
characteristics of the transaction reflected in the conduct of the parties.
1.46 In transactions between independent enterprises, the divergence of interests
between the parties ensures (i)that contractual terms are concluded that reflect the
interests of both of the parties, (ii)that the parties will ordinarily seek to hold each other
to the terms of the contract, and (iii)that contractual terms will be ignored or modified
after the fact generally only if it is in the interests of both parties. The same divergence
of interests may not exist in the case of associated enterprises or any such divergences
may be managed in ways facilitated by the control relationship and not solely or mainly
through contractual agreements. It is, therefore, particularly important in considering
the commercial or financial relations between associated enterprises to examine whether
the arrangements reflected in the actual conduct of the parties substantially conform
to the terms of any written contract, or whether the associated enterprises actual
conduct indicates that the contractual terms have not been followed, do not reflect a
complete picture of the transactions, have been incorrectly characterised or labelled by
the enterprises, or are a sham. Where conduct is not fully consistent with economically
significant contractual terms, further analysis is required to identify the actual transaction.
Where there are material differences between contractual terms and the conduct of the
associated enterprises in their relations with one another, the functions they actually
perform, the assets they actually use, and the risks they actually assume, considered in the
context of the contractual terms, should ultimately determine the factual substance and
accurately delineate the actual transaction.
1.47 Where there is doubt as to what transaction was agreed between the associated
enterprises, it is necessary to take into account all the relevant evidence from the
economically relevant characteristics of the transaction. In doing so one must bear in mind
that the terms of the transaction between the enterprises may change over time. Where
there has been a change in the terms of a transaction, the circumstances surrounding the
change should be examined to determine whether the change indicates that the original
transaction has been replaced through a new transaction with effect from the date of
the change, or whether the change reflects the intentions of the parties in the original
transaction. Particular care should be exercised where it appears that any changes may
have been triggered by knowledge of emerging outcomes from the transaction. Changes
made in the purported assumption of a risk when risk outcomes are known do not involve
an assumption of risk since there is no longer any risk, as discussed in paragraph1.78.
1.48 The following example illustrates the concept of differences between written
contractual terms and conduct of the parties, with the result that the actual conduct of the
parties delineates the transaction. CompanyS is a wholly-owned subsidiary of CompanyP.
The parties have entered into a written contract pursuant to which CompanyP licenses
intellectual property to CompanyS for use in CompanySs business; CompanyS agrees
to compensate CompanyP for the licence with a royalty. Evidence provided by other
economically relevant characteristics, and in particular the functions performed, establishes
that CompanyP performs negotiations with third-party customers to achieve sales for
CompanyS, provides regular technical services support to CompanyS so that CompanyS
can deliver contracted sales to its customers, and regularly provides staff to enable CompanyS
to fulfil customer contracts. A majority of customers insist on including CompanyP as joint
contracting party along with CompanyS, although fee income under the contract is payable to
CompanyS. The analysis of the commercial or financial relations indicates that CompanyS
is not capable of providing the contracted services to customers without significant support
from CompanyP, and is not developing its own capability. Under the contract, CompanyP has
given a licence to CompanyS, but in fact controls the business risk and output of CompanyS
such that it has not transferred risk and function consistent with a licensing arrangement, and
acts not as the licensor but the principal. The identification of the actual transaction between
CompanyP and CompanyS should not be defined solely by the terms of the written contract.
Instead, the actual transaction should be determined from the conduct of the parties, leading
to the conclusion that the actual functions performed, assets used, and risks assumed by the
parties are not consistent with the written licence agreement.
1.49 Where no written terms exist, the actual transaction would need to be deduced
from the evidence of actual conduct provided by identifying the economically relevant
characteristics of the transaction. In some circumstances the actual outcome of commercial
or financial relations may not have been identified as a transaction by the MNE, but
nevertheless may result in a transfer of material value, the terms of which would need to be

deduced from the conduct of the parties. For example, technical assistance may have been
granted, synergies may have been created through deliberate concerted action (as discussed
in section D.8), or know-how may have been provided through seconded employees
or otherwise. These relations may not have been recognised by the MNE, may not be
reflected in the pricing of other connected transactions, may not have been formalised
in written contracts, and may not appear as entries in the accounting systems. Where the
transaction has not been formalised, all aspects would need to be deduced from available
evidence of the conduct of the parties, including what functions are actually performed,
what assets are actually used, and what risks are actually assumed by each of the parties.
1.50 The following example illustrates the concept of determining the actual transaction
where a transaction has not been identified by the MNE. In reviewing the commercial or
financial relations between CompanyP and its subsidiary companies, it is observed that
those subsidiaries receive services from an independent party engaged by CompanyP.
CompanyP pays for the services, the subsidiaries do not reimburse CompanyP directly
or indirectly through the pricing of another transaction and there is no service agreement
in place between CompanyP and the subsidiaries. The conclusion is that, in addition to a
provision of services by the independent party to the subsidiaries, there are commercial or
financial relations between CompanyP and the subsidiaries, which transfer potential value
from CompanyP to the subsidiaries. The analysis would need to determine the nature of
those commercial or financial relations from the economically relevant characteristics in
order to determine the terms and conditions of the identified transaction.
D.1.2. Functional analysis

1.51 In transactions between two independent enterprises, compensation usually will
reflect the functions that each enterprise performs (taking into account assets used and
risks assumed). Therefore, in delineating the controlled transaction and determining
comparability between controlled and uncontrolled transactions or entities, a functional
analysis is necessary. This functional analysis seeks to identify the economically significant
activities and responsibilities undertaken, assets used or contributed, and risks assumed
by the parties to the transactions. The analysis focuses on what the parties actually do and
the capabilities they provide. Such activities and capabilities will include decision-making,
including decisions about business strategy and risks. For this purpose, it may be helpful to
understand the structure and organisation of the MNE group and how they influence the
context in which the MNE operates. In particular, it is important to understand how value
is generated by the group as a whole, the interdependencies of the functions performed by
the associated enterprises with the rest of the group, and the contribution that the associated
enterprises make to that value creation. It will also be relevant to determine the legal rights
and obligations of each of the parties in performing their functions. While one party may
provide a large number of functions relative to that of the other party to the transaction, it is
the economic significance of those functions in terms of their frequency, nature, and value
to the respective parties to the transactions that is important.
1.52 The actual contributions, capabilities, and other features of the parties can influence
the options realistically available to them. For example, an associated enterprise provides
logistics services to the group. The logistics company is required to operate warehouses with
spare capacity and in several locations in order to be able to cope in the event that supply
is disrupted at any one location. The option of greater efficiency through consolidation of
locations and reduction in excess capacity is not available. Its functions and assets may,
therefore, be different to those of an independent logistics company if that independent
service provider did not offer the same capabilities to reduce the risk of disruption to supply.
1.53 Therefore, the process of identifying the economically relevant characteristics of

the commercial or financial relations should include consideration of the capabilities of
the parties, how such capabilities affect options realistically available, and whether similar
capabilities are reflected in potentially comparable arms length arrangements.
1.54 The functional analysis should consider the type of assets used, such as plant and
equipment, the use of valuable intangibles, financial assets, etc., and the nature of the assets
used, such as the age, market value, location, property right protections available, etc.
1.55 The functional analysis may show that the MNE group has fragmented highly
integrated functions across several group companies. There may be considerable
interdependencies between the fragmented activities. For example, the separation into
different legal entities of logistics, warehousing, marketing, and sales functions may
require considerable co-ordination in order that the separate activities interact effectively.
Sales activities are likely to be highly dependent on marketing, and fulfilment of sales,
including the anticipated impact of marketing activities, would require alignment with
stocking processes and logistics capability. That required co-ordination may be performed
by some or all of the associated enterprises performing the fragmented activities,
performed through a separate co-ordination function, or performed through a combination
of both. Risk may be mitigated through contributions from all the parties, or risk mitigation
activities may be undertaken mainly by the co-ordination function. Therefore, when
conducting a functional analysis to identify the commercial or financial relations in
fragmented activities, it will be important to determine whether those activities are highly
interdependent, and, if so, the nature of the interdependencies and how the commercial
activity to which the associated enterprises contribute is co-ordinated.
D.1.2.1. Analysis of risks in commercial or financial relations2

1.56 A functional analysis is incomplete unless the material risks assumed by each party
have been identified and considered since the actual assumption of risks would influence
the prices and other conditions of transactions between the associated enterprises. Usually,
in the open market, the assumption of increased risk would also be compensated by
an increase in the expected return, although the actual return may or may not increase
depending on the degree to which the risks are actually realised. The level and assumption
of risk, therefore, are economically relevant characteristics that can be significant in
determining the outcome of a transfer pricing analysis.
1.57 Risk is inherent in business activities. Enterprises undertake commercial activities
because they seek opportunities to make profits, but those opportunities carry uncertainty
that the required resources to pursue the opportunities either will be greater than expected
or will not generate the expected returns. Identifying risks goes hand in hand with
identifying functions and assets and is integral to the process of identifying the commercial
or financial relations between the associated enterprises and of accurately delineating the
transaction or transactions.
1.58 The assumption of risks associated with a commercial opportunity affects the
profit potential of that opportunity in the open market, and the allocation of risks assumed
between the parties to the arrangement affects how profits or losses resulting from the
transaction are allocated at arms length through the pricing of the transaction. Therefore,
in making comparisons between controlled and uncontrolled transactions and between
controlled and uncontrolled parties it is necessary to analyse what risks have been
assumed, what functions are performed that relate to or affect the assumption or impact of
these risks and which party or parties to the transaction assume these risks.

1.59 This section provides guidance on the nature and sources of risk relevant to a
transfer pricing analysis in order to help identify relevant risks with specificity. In addition,
this section provides guidance on risk assumption under the arms length principle. The
detailed guidance provided in this section on the analysis of risks as part of a functional
analysis covering functions, assets, and risks, should not be interpreted as indicating that
risks are more important than functions or assets. The relevance of functions, assets and
risks in a specific transaction will need to be determined through a detailed functional
analysis. The expanded guidance on risks reflects the practical difficulties presented
by risks: risks in a transaction can be harder to identify than functions or assets, and
determining which associated enterprise assumes a particular risk in a transaction can
require careful analysis.
1.60 The steps in the process set out in the rest of this section for analysing risk in a
controlled transaction, in order to accurately delineate the actual transaction in respect to
that risk, can be summarised as follows:
1) Identify economically significant risks with specificity (see SectionD.1.2.1.1).
2) Determine how specific, economically significant risks are contractually assumed by
the associated enterprises under the terms of the transaction (see SectionD.1.2.1.2).
3) Determine through a functional analysis how the associated enterprises that are
parties to the transaction operate in relation to assumption and management of
the specific, economically significant risks, and in particular which enterprise or
enterprises perform control functions and risk mitigation functions, which enterprise
or enterprises encounter upside or downside consequences of risk outcomes, and
which enterprise or enterprises have the financial capacity to assume the risk (see
SectionD.1.2.1.3).
4) Steps2-3 will have identified information relating to the assumption and management
of risks in the controlled transaction. The next step is to interpret the information and
determine whether the contractual assumption of risk is consistent with the conduct
of the associated enterprises and other facts of the case by analysing (i)whether
the associated enterprises follow the contractual terms under the principles of
SectionD.1.1; and (ii)whether the party assuming risk, as analysed under (i),
exercises control over the risk and has the financial capacity to assume the risk (see
SectionD.1.2.1.4).
5) Where the party assuming risk under steps1-4(i) does not control the risk or does
not have the financial capacity to assume the risk, apply the guidance on allocating
risk (see SectionD.1.2.1.5).
6) The actual transaction as accurately delineated by considering the evidence of
all the economically relevant characteristics of the transaction as set out in the
guidance in SectionD.1, should then be priced taking into account the financial
and other consequences of risk assumption, as appropriately allocated, and
appropriately compensating risk management functions (see SectionD.1.2.1.6).
1.61 In this section references are made to terms that require initial explanation and
definition. The term risk management is used to refer to the function of assessing and
responding to risk associated with commercial activity. Risk management comprises three
elements: (i)the capability to make decisions to take on, lay off, or decline a risk-bearing
opportunity, together with the actual performance of that decision-making function, (ii)the
capability to make decisions on whether and how to respond to the risks associated with the
opportunity, together with the actual performance of that decision-making function, and
(iii)the capability to mitigate risk, that is the capability to take measures that affect risk
outcomes, together with the actual performance of such risk mitigation.
1.62 Some risk management functions can be undertaken only by the party performing
functions and using assets in creating and pursuing commercial opportunities, while other
risk management functions can be undertaken by a different party. Risk management
should not be thought of as necessarily encompassing a separate function, requiring
separate remuneration, distinct from the performance of the activities that optimise profits.
For example, the development of intangibles through development activities may involve
mitigating risks relating to performing the development according to specifications at the
highest possible standards and on time; the particular risks might be mitigated through
the performance of the development function itself. For example, if the contractual
arrangement between the associated enterprises is a contract R&D arrangement that is
respected under the requirements of this section, remuneration for risk mitigation functions
performed through the development activity would be incorporated into the arms length
services payment. Neither the intangible risk itself, nor the residual income associated with
such risk, would be allocated to the service provider. See also Example1 in paragraph1.83.
1.63 Risk management is not the same as assuming a risk. Risk assumption means
taking on the upside and downside consequences of the risk with the result that the party
assuming a risk will also bear the financial and other consequences if the risk materialises.
A party performing part of the risk management functions may not assume the risk that
is the subject of its management activity, but may be hired to perform risk mitigation
functions under the direction of the risk-assuming party. For example, the day-to-day
mitigation of product recall risk may be outsourced to a party performing monitoring of
quality control over a specific manufacturing process according to the specifications of the
party assuming the risk.
1.64 Financial capacity to assume risk can be defined as access to funding to take
on the risk or to lay off the risk, to pay for the risk mitigation functions and to bear the
consequences of the risk if the risk materialises. Access to funding by the party assuming
the risk takes into account the available assets and the options realistically available to
access additional liquidity, if needed, to cover the costs anticipated to arise should the risk
materialise. This assessment should be made on the basis that the party assuming the risk
is operating as an unrelated party in the same circumstances as the associated enterprise,
as accurately delineated under the principles of this section. For example, exploitation of
rights in an income-generating asset could open up funding possibilities for that party.
Where a party assuming risk receives intra-group funding to meet the funding demands
in relation to the risk, the party providing the funding may assume financial risk but does
not, merely as a consequence of providing funding, assume the specific risk that gives rise
to the need for additional funding. Where the financial capacity to assume a risk is lacking,
then the allocation of risk requires further consideration under step5.
1.65 Control over risk involves the first two elements of risk management defined in
paragraph1.61; that is (i)the capability to make decisions to take on, lay off, or decline
a risk-bearing opportunity, together with the actual performance of that decision-making
function and (ii)the capability to make decisions on whether and how to respond to the
risks associated with the opportunity, together with the actual performance of that decisionmaking function. It is not necessary for a party to perform the day-to-day mitigation, as
described in (iii)in order to have control of the risks. Such day-to-day mitigation may be
outsourced, as the example in paragraph1.63 illustrates. However, where these day-today mitigation activities are outsourced, control of the risk would require capability to

determine the objectives of the outsourced activities, to decide to hire the provider of the
risk mitigation functions, to assess whether the objectives are being adequately met, and,
where necessary, to decide to adapt or terminate the contract with that provider, together
with the performance of such assessment and decision-making. In accordance with this
definition of control, a party requires both capability and functional performance as
described above in order to exercise control over a risk.
1.66 The capability to perform decision-making functions and the actual performance of
such decision-making functions relating to a specific risk involve an understanding of the
risk based on a relevant analysis of the information required for assessing the foreseeable
downside and upside risk outcomes of such a decision and the consequences for the
business of the enterprise. Decision-makers should possess competence and experience
in the area of the particular risk for which the decision is being made and possess an
understanding of the impact of their decision on the business. They should also have
access to the relevant information, either by gathering this information themselves or by
exercising authority to specify and obtain the relevant information to support the decisionmaking process. In doing so, they require capability to determine the objectives of the
gathering and analysis of the information, to hire the party gathering the information and
making the analyses, to assess whether the right information is gathered and the analyses
are adequately made, and, where necessary, to decide to adapt or terminate the contract
with that provider, together with the performance of such assessment and decision-making.
Neither a mere formalising of the outcome of decision-making in the form of, for example,
meetings organised for formal approval of decisions that were made in other locations,
minutes of a board meeting and signing of the documents relating to the decision, nor the
setting of the policy environment relevant for the risk (see paragraph1.76), qualifies as the
exercise of a decision-making function sufficient to demonstrate control over a risk.
1.67 References to control over risk should not necessarily be taken to mean that the
risk itself can be influenced or that the uncertainty can be nullified. Some risks cannot
be influenced, and are a general condition of commercial activity affecting all businesses
undertaking that activity. For example, risks associated with general economic conditions
or commodity price cycles are typically beyond the scope of an MNE group to influence.
Instead control over risk should be understood as the capability and authority to decide to
take on the risk, and to decide whether and how to respond to the risk, for example through
the timing of investments, the nature of development programmes, the design of marketing
strategies, or the setting of production levels.
1.68 Risk mitigation refers to measures taken that are expected to affect risk outcomes.
Such measures may include measures that reduce the uncertainty or measures that reduce
the consequences in the event that the downside impact of risk occurs. Control should not
be interpreted as requiring risk mitigation measures to be adopted, since in assessing risks
businesses may decide that the uncertainty associated with some risks, including risks that
may be fundamental to their core business operations, after being evaluated, should be
taken on and faced in order to create and maximise opportunities.
1.69 The concept of control may be illustrated by the following examples. CompanyA
appoints a specialist manufacturer, CompanyB to manufacture products on its behalf. The
contractual arrangements indicate that CompanyB undertakes to perform manufacturing
services, but that the product specifications and designs are provided by CompanyA, and
that CompanyA determines production scheduling, including the volumes and timing of
product delivery. The contractual relations imply that CompanyA bears the inventory
risk and the product recall risk. CompanyA hires CompanyC to perform regular quality
controls of the production process. CompanyA specifies the objectives of the quality
control audits and the information that CompanyC should gather on its behalf. CompanyC
reports directly to CompanyA. Analysis of the economically relevant characteristics
shows that CompanyA controls its product recall and inventory risks by exercising its
capability and authority to make a number of relevant decisions about whether and how to
take on risk and how to respond to the risks. Besides that CompanyA has the capability
to assess and take decisions relating to the risk mitigation functions and actually performs
these functions. These include determining the objectives of the outsourced activities, the
decision to hire the particular manufacturer and the party performing the quality checks,
the assessment of whether the objectives are adequately met, and, where necessary, to
decide to adapt or terminate the contracts.
1.70 Assume that an investor hires a fund manager to invest funds on its account.3
Depending on the agreement between the investor and the fund manager, the latter may
be given the authority to make portfolio investments on behalf of the investor on a dayto-day basis in a way that reflects the risk preferences of the investor, although the risk
of loss in value of the investment would be borne by the investor. In such an example, the
investor is controlling its risks through four relevant decisions: the decision about its risk
preference and therefore about the required diversification of the risks attached to the
different investments that are part of the portfolio, the decision to hire (or terminate the
contract with) that particular fund manager, the decision of the extent of the authority it
gives to the fund manager and objectives it assigns to the latter, and the decision of the
amount of the investment that it asks this fund manager to manage. Moreover, the fund
manager would generally be required to report back to the investor on a regular basis as
the investor would want to assess the outcome of the fund managers activities. In such
a case, the fund manager is providing a service and managing his business risk from his
own perspective (e.g.to protect his credibility). The fund managers operational risk,
including the possibility of losing a client, is distinct from his clients investment risk. This
illustrates the fact that an investor who gives to another person the authority to perform
risk mitigation activities such as those performed by the fund manager does not necessarily
transfer control of the investment risk to the person making these day-to-day decisions.
D.1.2.1.1. Step1: Identify economically significant risks with specificity

1.71 There are many definitions of risk, but in a transfer pricing context it is appropriate
to consider risk as the effect of uncertainty on the objectives of the business. In all of a
companys operations, every step taken to exploit opportunities, every time a company
spends money or generates income, uncertainty exists, and risk is assumed. A company
is likely to direct much attention to identifying uncertainties it encounters, in evaluating
whether and how business opportunities should be pursued in view of their inherent risks,
and in developing appropriate risk mitigation strategies which are important to shareholders
seeking their required rate of return. Risk is associated with opportunities, and does not
have downside connotations alone; it is inherent in commercial activity, and companies
choose which risks they wish to assume in order to have the opportunity to generate
profits. No profit-seeking business takes on risk associated with commercial opportunities
without expecting a positive return. Downside impact of risk occurs when the anticipated
favourable outcomes fail to materialise. For example, a product may fail to attract as much
consumer demand as projected. However, such an event is the downside manifestation of
uncertainty associated with commercial opportunities. Companies are likely to devote
considerable attention to identifying and managing economically significant risks in
order to maximise the positive returns from having pursued the opportunity in the face of

risk. Such attention may include activities around determining the product strategy, how
the product is differentiated, how to identify changing market trends, how to anticipate
political and social changes, and how to create demand. The significance of a risk depends
on the likelihood and size of the potential profits or losses arising from the risk. For
example, a different flavour of ice-cream may not be the companys sole product, the
costs of developing, introducing, and marketing the product may have been marginal, the
success or failure of the product may not create significant reputational risks so long as
business management protocols are followed, and decision-making may have been effected
by delegation to local or regional management who can provide knowledge of local tastes.
However, ground-breaking technology or an innovative healthcare treatment may represent
the sole or major product, involve significant strategic decisions at different stages, require
substantial investment costs, create significant opportunities to make or break reputation,
and require centralised management that would be of keen interest to shareholders and
other stakeholders.
1.72 Risks can be categorised in various ways, but a relevant framework in a transfer
pricing analysis is to consider the sources of uncertainty which give rise to risk. The
following non-exclusive list of sources of risk is not intended to suggest a hierarchy
of risk. Neither is it intended to provide rigid categories of risk, since there is overlap
between the categories. Instead, it is intended to provide a framework that may assist in
ensuring that a transfer pricing analysis considers the range of risks likely to arise from
the commercial or financial relations of the associated enterprises, and from the context in
which those relations take place. Reference is made to risks that are externally driven and
those that are internally driven in order to help clarify sources of uncertainty. However,
there should be no inference that externally driven risks are less relevant because they
are not generated directly by activities. On the contrary, the ability of a company to face,
respond to and mitigate externally driven risks is likely to be a necessary condition for a
business to remain competitive. Importantly, guidance on the possible range of risk should
assist in identifying material risks with specificity. Risks which are vaguely described
or undifferentiated will not serve the purposes of a transfer pricing analysis seeking to
delineate the actual transaction and the actual allocation of risk between the parties.
a) Strategic risks or marketplace risks. These are largely external risks caused by the
economic environment, political and regulatory events, competition, technological
advance, or social and environmental changes. The assessment of such uncertainties
may define the products and markets the company decides to target, and the
capabilities it requires, including investment in intangibles and tangible assets, as
well as in the talent of its human capital. There is considerable potential downside,
but the upside is also considerable if the company identifies correctly the impact of
external risks, and differentiates its products and secures and continues to protect
competitive advantage. Examples of such risks may include marketplace trends, new
geographical markets, and concentration of development investment.
b) Infrastructure or operational risks. These are likely to include the uncertainties
associated with the companys business execution and may include the effectiveness
of processes and operations. The impact of such risks is highly dependent on the
nature of the activities and the uncertainties the company chooses to assume. In
some circumstances breakdowns can have a crippling effect on the companys
operations or reputation and threaten its existence; whereas successful management
of such risks can enhance reputation. In other circumstances, the failure to bring a
product to market on time, to meet demand, to meet specifications, or to produce to
high standards, can affect competitive and reputational position, and give advantage
to companies which bring competing products to market more quickly, better exploit
periods of market protection provided by, for example, patents, better manage
supply chain risks and quality control. Some infrastructure risks are externally
driven and may involve transport links, political and social situations, laws and
regulations, whereas others are internally driven and may involve capability and
availability of assets, employee capability, process design and execution, outsourcing
arrangements, and IT systems.
c) Financial risks. All risks are likely to affect a companys financial performance,
but there are specific financial risks related to the companys ability to manage
liquidity and cash flow, financial capacity, and creditworthiness. The uncertainty
can be externally driven, for example by economic shock or credit crisis, but can
also be internally driven through controls, investment decisions, credit terms, and
through outcomes of infrastructure or operational risks.
d) Transactional risks. These are likely to include pricing and payment terms in a
commercial transaction for the supply of goods, property, or services.
e) Hazard risks. These are likely to include adverse external events that may cause
damages or losses, including accidents and natural disasters. Such risks can often
be mitigated through insurance, but insurance may not cover all the potential loss,
particularly where there are significant impacts on operations or reputation.
1.73 Determining the economic significance of risk and how risk may affect the pricing
of a transaction between associated enterprises is part of the broader functional analysis of
how value is created by the MNE group, the activities that allow the MNE group to sustain
profits, and the economically relevant characteristics of the transaction. The analysis of risk
also helps to determine comparability under the guidance in ChapterIII. Where potential
comparables are identified, it is relevant to determine whether they include the same level
of risks and management of risks. The economic significance of risk may be illustrated by
the following two situations.
1.74 In the first situation the MNE group distributes heating oil to consumers. Analysis
of the economically relevant characteristics establishes that the product is undifferentiated,
the market is competitive, the market size is predictable, and players are price-takers. In
such circumstances, the ability to influence margins may be limited. The credit terms
achieved from managing the relationship with the oil suppliers fund working capital and
are crucial to the distributors margin. The impact of the risk on cost of capital is, therefore,
significant in the context of how value is created for the distribution function.
1.75 In the second situation, a multinational toy retailer buys a wide range of products
from a number of third-party manufacturers. Most of its sales are concentrated in the last
two months of the calendar year, and a significant risk relates to the strategic direction of
the buying function, and in making the right bets on trends and determining the products
that will sell and in what volumes. Trends and the demand for products can vary across
markets, and so expertise is needed to evaluate the right bets in the local market. The effect
of the buying risk can be magnified if the retailer negotiates a period of exclusivity for a
particular product with the third-party manufacturer.
1.76 Control over a specific risk in a transaction focusses on the decision-making of
the parties to the transaction in relation to the specific risk arising from the transaction.
This is not to say, however, that in an MNE group other parties may not be involved in
setting general policies that are relevant for the assumption and control of the specific risks
identified in a transaction, without such policy-setting itself representing decision making.

The board and executive committees of the group, for example, may set the level of risk
the group as a whole is prepared to accept in order to achieve commercial objectives, and
to establish the control framework for managing and reporting risk in its operations. Line
management in business segments, operational entities, and functional departments may
identify and assess risk against the commercial opportunities, and put in place appropriate
controls and processes to address risk and influence the risk outcomes arising from dayto-day operations. The opportunities pursued by operational entities require the ongoing
management of the risk that the resources allocated to the opportunity will deliver the
anticipated return. For example, finished product inventory risk in a supply transaction
between two associated enterprises may be controlled by the party with the capability
to determine the production volumes together with the performance of that decisionmaking. The way that inventory risk in the transaction between two associated enterprises
is addressed may be subject to policy-setting elsewhere in the MNE group about overall
levels of working capital tied up in inventory, or co-ordination of appropriate minimum
stocking levels across markets to meet strategic objectives. This wider policy-setting
however cannot be regarded as decisions to take on, lay off, decline, or mitigate the specific
inventory risk in the example of the product supply transaction in this paragraph.
D.1.2.1.2. Step2: Contractual assumption of risk

1.77 The identity of the party or parties assuming risks may be set out in written contracts
between the parties to a transaction involving these risks. A written contract typically sets
out an intended assumption of risk by the parties. Some risks may be explicitly assumed
in the contractual arrangements. For example, a distributor might contractually assume
accounts receivable risk, inventory risk, and credit risks associated with the distributors
sales to unrelated customers. Other risks might be implicitly assumed. For example,
contractual arrangements that provide non-contingent remuneration for one of the parties
implicitly allocate the outcome of some risks, including unanticipated profits or losses, to
the other party.
1.78 A contractual assumption of risk constitutes an ex ante agreement to bear some or
all of the potential costs associated with the ex post materialisation of downside outcomes
of risk in return for some or all of the potential benefit associated with the ex post
materialisation of positive outcomes. Importantly, ex ante contractual assumption of risk
should provide clear evidence of a commitment to assume risk prior to the materialisation
of risk outcomes. Such evidence is a very important part of the tax administrations transfer
pricing analysis of risks in commercial or financial relations, since, in practice, an audit
performed by the tax administration may occur years after the making of such up-front
decisions by the associated enterprises and when outcomes are known. The purported
assumption of risk by associated enterprises when risk outcomes are certain is by definition
not an assumption of risk, since there is no longer any risk. Similarly, ex post reallocations
of risk by a tax administration when risk outcomes are certain may, unless based on the
guidance elsewhere in these Guidelines and in particular SectionD.1.2.1, be inappropriate.
1.79 It is economically neutral to take on (or lay off) risk in return for higher (or lower)
anticipated nominal income as long as the net present value of both options are equal.
Between unrelated parties, for example, the sale of a risky income-producing asset may
reflect in part a preference of the seller to accept a lower but more certain amount of
nominal income and to forego the possibility of higher anticipated nominal income it might
earn if it instead retained and exploited the asset. In a without-recourse debt factoring
arrangement between independent enterprises, for example, the seller discounts the face
value of its receivables in return for a fixed payment, and so accepts a lower return but has
reduced its volatility and laid off risk. The factor will often be a specialised organisation
which has the capability to decide to take on risk and to decide on how to respond to the
risk, including by diversifying the risk and having the functional capabilities to mitigate
the risk and generate a return from the opportunity. Neither party will expect to be worse
off as a result of entering into the arrangement, essentially because they have different risk
preferences resulting from their capabilities in relation to the specific risk. The factor is
more capable of managing the risk than the seller and terms acceptable to both parties can
be agreed.
1.80 However, it does not follow that every contractual exchange of potentially higher but
riskier income for lower but less risky income between associated enterprises is automatically
arms length. The rest of the steps set out in this section describe the information required
to determine how the associated enterprises operate in relation to the assumption and
management of risk leading to the accurate delineation of the actual transaction in relation to
risk.
1.81 The assumption of risk has a significant effect on determining arms length pricing
between associated enterprises, and it should not be concluded that the pricing arrangements
adopted in the contractual arrangements alone determine which party assumes risk.
Therefore, one may not infer from the fact that the price paid between associated enterprises
for goods or services is set at a particular level, or by reference to a particular margin,
that risks are borne by those associated enterprises in a particular manner. For example, a
manufacturer may claim to be protected from the risk of price fluctuation of raw material
as a consequence of its being remunerated by another group company on a basis that takes
account of its actual costs. The implication of the claim is that the other group company
bears the risk. The form of remuneration cannot dictate inappropriate risk allocations. It
is the determination of how the parties actually manage and control risks, as set out in the
remaining steps of the process of analysing risk, which will determine the assumption of
risks by the parties, and consequently dictate the selection of the most appropriate transfer
pricing method.
D.1.2.1.3. Step3: Functional analysis in relation to risk

1.82 In this step the functions in relation to risk of the associated enterprises that are
parties to the transaction are analysed. The analysis provides information about how
the associated enterprises operate in relation to the assumption and management of the
specific, economically significant risks, and in particular about which enterprise or
enterprises perform control functions and risk mitigation functions, which enterprise
or enterprises encounter upside or downside consequences of risk outcomes, and which
enterprise or enterprises have the financial capacity to assume the risk. This step is
illustrated by the following examples and conclusions are drawn from these examples in
subsequent paragraphs of SectionD.1.2.
Example1
1.83 CompanyA seeks to pursue a development opportunity and hires a specialist company,
CompanyB, to perform part of the research on its behalf. Under step1 development risk has
been identified as economically significant in this transaction, and under step2 it has been
established that under the contract CompanyA assumes development risk. The functional
analysis under step3 shows that CompanyA controls its development risk through exercising
its capability and authority in making a number of relevant decisions about whether and how
to take on the development risk. These include the decision to perform part of the development

work itself, the decision to seek specialist input, the decision to hire the particular researcher,
the decision of the type of research that should be carried out and objectives assigned to it,
and the decision of the budget allocated to CompanyB. CompanyA has mitigated its risk by
taking measures to outsource development activities to CompanyB which assumes the day-today responsibility for carrying out the research under the control of CompanyA. CompanyB
reports back to CompanyA at predetermined milestones, and CompanyA assesses the
progress of the development and whether its ongoing objectives are being met, and decides
whether continuing investments in the project are warranted in the light of that assessment.
CompanyA has the financial capacity to assume the risk. CompanyB has no capability to
evaluate the development risk and does not make decisions about CompanyAs activities.
CompanyBs risk is mainly to ensure it performs the research activities competently and it
exercises its capability and authority to control that risk through making decisions about the
processes, expertise, and assets it needs. The risk CompanyB assumes is distinct from the
development risk assumed by CompanyA under the contract, and which is controlled by
CompanyA based on the evidence of the functional analysis.
Example2
1.84 CompanyB manufactures products for CompanyA. Under step1 capacity utilisation
risk and supply chain risk have been identified as economically significant in this transaction,
and under step2 it has been established that under the contract CompanyA assumes these
risks. The functional analysis under step3 provides evidence that CompanyB built and
equipped its plant to CompanyAs specifications, that products are manufactured to technical
requirements and designs provided by CompanyA, that volume levels are determined
by CompanyA, and that CompanyA runs the supply chain, including the procurement
of components and raw materials. CompanyA also performs regular quality checks of
the manufacturing process. CompanyB builds the plant, employs and trains competent
manufacturing personnel, and determines production scheduling based on volume levels
determined by CompanyA. Although CompanyB has incurred fixed costs, it has no ability
to manage the risk associated with the recovery of those costs through determining the
production units over which the fixed costs are spread, since CompanyA determines volumes.
CompanyA also determines significant costs relating to components and raw materials and
the security of supply. The evaluation of the evidence concludes that CompanyB performs
manufacturing services. Significant risks associated with generating a return from the
manufacturing activities are controlled by CompanyA. CompanyB controls the risk that it
fails to competently deliver services. Each company has the financial capacity to assume its
respective risks.
Example3
1.85 CompanyA has acquired ownership of a tangible asset and enters into contracts
for the use of the asset with unrelated customers. Under step1 utilisation of the tangible
asset, that is the risk that there will be insufficient demand for the asset to cover the costs
CompanyA has incurred, has been identified as an economically significant risk. Under
step2 it is established that CompanyA has a contract for the provision of services with
another group company, CompanyC; the contract does not address the assumption of
utilisation risk by the owner of the tangible asset, CompanyA. The functional analysis
under step3 provides evidence that another group company, CompanyB, decides that
investment in the asset is appropriate in light of anticipated commercial opportunities
identified and evaluated by CompanyB and its assessment of the assets anticipated useful
life; CompanyB provides specifications for the asset and the unique features required to
respond to the commercial opportunities, and arranges for the asset to be constructed in
accordance with its specifications, and for CompanyA to acquire the asset. CompanyC
decides how to utilise the asset, markets the assets capabilities to third-party customers,
negotiates the contracts with these third party customers, assures that the asset is delivered
to the third parties and installed appropriately. Although it is the legal owner of the asset,
CompanyA does not exercise control over the investment risk in the tangible asset, since
it lacks any capability to decide on whether to invest in the particular asset, and whether
and how to protect its investment including whether to dispose of the asset. Although it
is the owner of the asset, CompanyA does not exercise control over the utilisation risk,
since it lacks any capability to decide whether and how to exploit the asset. It does not
have the capability to assess and make decisions relating to the risk mitigation activities
performed by other group companies. Instead, risks associated with investing in and
exploiting the asset, enhancing upside risk and mitigating downside risk, are controlled
by the other group companies. CompanyA does not have control over the economically
significant risks associated with the investment in and exploitation of the asset. The
functional contribution of the legal owner of the asset is limited to providing financing for
an amount equating to the cost of the asset. However, the functional analysis also provides
evidence that CompanyA has no capability and authority to control the risk of investing
in a financial asset. CompanyA does not have the capability to make decisions to take on
or decline the financing opportunity, or the capability to make decisions on whether and
how to respond to the risks associated with the financing opportunity. CompanyA does not
perform functions to evaluate the financing opportunity, does not consider the appropriate
risk premium and other issues to determine the appropriate pricing of the financing
opportunity, and does not evaluate the appropriate protection of its financial investment.
CompaniesA, B and C all have financial capacity to assume their respective risks.
D.1.2.1.4. Step4: Interpreting steps1-3

1.86 Carrying out steps1-3 involves the gathering of information relating to the
assumption and management of risks in the controlled transaction. The next step is to
interpret the information resulting from steps1-3 and to determine whether the contractual
assumption of risk is consistent with the conduct of the parties and the other facts of the
case by analysing (i)whether the associated enterprises follow the contractual terms under
the principles of SectionD.1.1; and (ii)whether the party assuming risk, as analysed under
(i), exercises control over the risk and has the financial capacity to assume risk.
1.87 The significance of step4 will depend on the findings. In the circumstances of
Examples1 and 2 above, the step may be straightforward. Where a party contractually
assuming a risk applies that contractual assumption of risk in its conduct, and also both
exercises control over the risk and has the financial capacity to assume the risk, then there
is no further analysis required beyond step4(i) and (ii) to determine risk assumption.
CompaniesA and B in both examples fulfil the obligations reflected in the contracts and
exercise control over the risks that they assume in the transaction, supported by financial
capacity. As a result step4(ii) is satisfied, there is no need to consider step5, and the next
step to consider is step6.
1.88 In line with the discussion in relation to contractual terms (see SectionD.1.1),
it should be considered under step4(i) whether the parties conduct conforms to the
assumption of risk contained in written contracts, or whether the contractual terms have
not been followed or are incomplete. Where differences exist between contractual terms
related to risk and the conduct of the parties which are economically significant and would
be taken into account by third parties in pricing the transaction between them, the parties

conduct in the context of the consistent contractual terms should generally be taken as the
best evidence concerning the intention of the parties in relation to the assumption of risk.
1.89 Consider for example, a manufacturer, whose functional currency is US dollars,
that sells goods to an associated distributor in another country, whose functional currency
is euros, and the written contract states that the distributor assumes all exchange rate risks
in relation to this controlled transaction. If, however, the price for the goods is charged by
the manufacturer to the distributor over an extended period of time in euros, the currency
of the distributor, then aspects of the written contractual terms do not reflect the actual
commercial or financial relations between the parties. The assumption of risk in the
transaction should be determined by the actual conduct of the parties in the context of
the contractual terms, rather than by aspects of written contractual terms which are not
in practice applied. The principle can be further illustrated by Example7 in the annex to
ChapterVI, where there is an inconsistency between the contractual assumption of risk
and the conduct of the parties as evidenced by the bearing of costs relating to the downside
outcome of that risk.
1.90 Under step4(ii) it should be determined whether the party assuming the risk under
the contract, taking into account whether the contractual terms have been applied in the
conduct of the parties under step4(i), controls the risk and has the financial capacity to
assume the risk. If all the circumstances set out in Example1 remain the same except for
the fact that the contract between CompanyA and CompanyB allocates development
risk to CompanyB, and if there is no evidence from the conduct of the parties under
step4(i) to suggest that the contractual allocation of risk is not being followed, then
CompanyB contractually assumes development risk but the facts remain that CompanyB
has no capability to evaluate the development risk and does not make decisions about
CompanyAs activities. CompanyB has no decision-making function which allows it
to control the development risk by taking decisions that affect the outcomes of that risk.
Based on the information provided in Example1, the development risk is controlled by
CompanyA. The determination that the party assuming a risk is not the party controlling
that risk means that further consideration is required under step5.
1.91 If the circumstances of Example2 remain the same except for the fact that, while
the contract specifies that CompanyA assumes supply chain risks, CompanyB is not
reimbursed by CompanyA when there was a failure to secure key components on time,
the analysis under step4(i) would show that contractual assumption of risk has not been
followed in practice in regard to that supply chain risk, such that CompanyB in fact
assumes the downside consequences of that risk. Based on the information provided in
Example2, CompanyB does not have any control over the supply chain risk, whereas
CompanyA does exercise control. Therefore, the party assuming risk as analysed under
step4(i), does not under step4(ii) exercise control over that risk, and further consideration
is required under step5.
1.92 In the circumstances of Example3, analysis under step4(i) shows that the assumption
of utilisation risk by CompanyA is consistent with its contractual arrangements with
CompanyC, but under step4(ii) it is determined that CompanyA does not control risks that
it assumes associated with the investment in and exploitation of the asset. CompanyA has no
decision-making function which allows it to control its risks by taking decisions that affect
the outcomes of the risks. Under step4(ii) the party assuming risk does not control that risk,
and further consideration is required under step5.
1.93 In some cases, the analysis under step3 may indicate that there is more than one MNE
that is capable of exercising control over a risk. However, control requires both capability and
functional performance in order to exercise control over a risk. Therefore, if more than one
party is capable of exercising control, but the entity contractually assuming risk (as analysed
under step4(i)) is the only party that actually exercises control through capability and
functional performance, then the party contractually assuming the risk also controls the risk.
1.94 Furthermore, in some cases, there may be more than one party to the transaction
exercising control over a specific risk. Where the associated enterprise assuming risk (as
analysed under step4(i) controls that risk in accordance with the requirements set out in
paragraphs1.65-1.66, all that remains under step4(ii) is to consider whether the enterprise
has the financial capacity to assume the risk. If so, the fact that other associated enterprises
also exercise control over the same risk does not affect the assumption of that risk by the
first-mentioned enterprise, and step5 need not be considered.
1.95 Where two or more parties to the transaction assume a specific risk (as analysed
under step4(i)), and in addition they together control the specific risk and each has the
financial capacity to assume their share of the risk, then that assumption of risk should be
respected. Examples may include the contractual assumption of development risk under
a transaction in which the enterprises agree jointly to bear the costs of creating a new
product.
1.96 If it is established that the associated enterprise assuming the risk as analysed under
step4(i) either does not control the risk or does not have the financial capacity to assume
the risk, then the analysis described under step5 needs to be performed.
1.97 In light of the potential complexity that may arise in some circumstances when
determining whether an associated enterprise assuming a risk controls that risk, the test of
control should be regarded as being met where comparable risk assumptions can be identified
in a comparable uncontrolled transaction. To be comparable those risk assumptions require
that the economically relevant characteristics of the transactions are comparable. If such
a comparison is made, it is particularly relevant to establish that the enterprise assuming
comparable risk in the uncontrolled transaction performs comparable risk management
functions relating to control of that risk to those performed by the associated enterprise
assuming risk in the controlled transaction. The purpose of the comparison is to establish
that an independent party assuming a comparable risk to that assumed by the associated
enterprise also performs comparable risk management functions to those performed by the
associated enterprise.
D.1.2.1.5. Step5: Allocation of risk

1.98 If it is established in step4(ii) that the associated enterprise assuming the risk
based on steps1 4(i) does not exercise control over the risk or does not have the financial
capacity to assume the risk, then the risk should be allocated to the enterprise exercising
control and having the financial capacity to assume the risk. If multiple associated
enterprises are identified that both exercise control and have the financial capacity to
assume the risk, then the risk should be allocated to the associated enterprise or group of
associated enterprises exercising the most control. The other parties performing control
activities should be remunerated appropriately, taking into account the importance of the
control activities performed.
1.99 In exceptional circumstances, it may be the case that no associated enterprise can be
identified that both exercises control over the risk and has the financial capacity to assume
the risk. As such a situation is not likely to occur in transactions between third parties, a
rigorous analysis of the facts and circumstances of the case will need to be performed, in

order to identify the underlying reasons and actions that led to this situation. Based on that
assessment, the tax administrations will determine what adjustments to the transaction
are needed for the transaction to result in an arms length outcome. An assessment of the
commercial rationality of the transaction based on SectionD.2 may be necessary.
D.1.2.1.6. Step6: Pricing of the transaction, taking account of the consequences of

risk allocation
1.100 Following the guidance in this section, the accurately delineated transaction should
then be priced in accordance with the tools and methods available to taxpayers and tax
administrations set out in the following chapters of these Guidelines and taking into
account the financial and other consequences of risk-assumption, and the remuneration
for risk management. The assumption of a risk should be compensated with an appropriate
anticipated return, and risk mitigation should be appropriately remunerated. Thus, a taxpayer
that both assumes and mitigates a risk will be entitled to greater anticipated remuneration
than a taxpayer that only assumes a risk, or only mitigates, but does not do both.
1.101 In the circumstances of Example1 in paragraph1.83, CompanyA assumes and
controls the development risk and should bear the financial consequences of failure and enjoy
the financial consequences of success. CompanyB should be appropriately rewarded for the
carrying out of its development services, incorporating the risk that it fails to do so competently.
1.102 In the circumstances of Example2 in paragraph1.84, the significant risks
associated with generating a return from the manufacturing activities are controlled by
CompanyA, and the upside and downside consequences of those risks should therefore
be allocated to CompanyA. CompanyB controls the risk that it fails to competently
deliver services, and its remuneration should take into account that risk, as well as its
funding costs for the acquisition of the manufacturing plant. Since the risks in relation to
the capacity utilisation of the asset are controlled by CompanyA, CompanyA should be
allocated the risk of under-utilisation. This means that the financial consequences related
to the materialisation of that risk including failure to cover fixed costs, write-downs, or
closure costs should be allocated to CompanyA.
1.103 The consequences of risk allocation in Example3 in paragraph1.85 depend on
analysis of functions under step3. CompanyA does not have control over the economically
significant risks associated with the investment in and exploitation of the asset, and those
risks should be aligned with control of those risks by CompaniesB and C. The functional
contribution of CompanyA is limited to providing financing for an amount equating to the
cost of the asset that enables the asset to be created and exploited by CompaniesB and C.
However, the functional analysis also provides evidence that CompanyA has no capability
and authority to control the risk of investing in a financial asset. CompanyA does not have
the capability to make decisions to take on or decline the financing opportunity, or the
capability to make decisions on whether and how to respond to the risks associated with the
financing opportunity. CompanyA does not perform functions to evaluate the financing
opportunity, does not consider the appropriate risk premium and other issues to determine
the appropriate pricing of the financing opportunity, and does not evaluate the appropriate
protection of its financial investment. In the circumstances of Example3, CompanyA
would not be entitled to any more than a risk-free return4 as an appropriate measure of the
profits it is entitled to retain, since it lacks the capability to control the risk associated with
investing in a riskier financial asset. The risk will be allocated to the enterprise which has
control and the financial capacity to assume the risk associated with the financial asset. In
the circumstances of example, this would be CompanyB. CompanyA does not control the
investment risk that carries a potential risk premium. An assessment may be necessary of
the commercial rationality of the transaction based on the guidance in SectionD.2 taking
into account the full facts and circumstances of the transaction.
1.104 Guidance on the relationship between risk assumption in relation to the provision
of funding and the operational activities for which the funds are used is given in
paragraphs6.60-6.64. The concepts reflected in these paragraphs are equally applicable to
investments in assets other than intangibles.
1.105 A party should always be appropriately compensated for its control functions in
relation to risk. Usually, the compensation will derive from the consequences of being
allocated risk, and therefore that party will be entitled to receive the upside benefits and to
incur the downside costs. In circumstances where a party contributes to the control of risk,
but does not assume the risk, compensation which takes the form of a sharing in the potential
upside and downside, commensurate with that contribution to control, may be appropriate.
1.106 The difference between ex ante and ex post returns discussed in particular in
SectionD of ChapterVI arises in large part from risks associated with the uncertainty
of future business outcomes. As discussed in paragraph1.78 the ex ante contractual
assumption of risk should provide clear evidence of a commitment to assume risk prior to
the materialisation of risk outcomes. Following the steps in this section, the transfer pricing
analysis will determine the accurate delineation of the transaction with respect to risk,
including the risk associated with unanticipated returns. A party which, under these steps,
does not assume the risk, nor contributes to the control of that risk, will not be entitled to
unanticipated profits (or required to bear unanticipated losses) arising from that risk. In the
circumstances of Example3 (see paragraph1.85), this would mean that neither unanticipated
profits nor unanticipated losses will be allocated to CompanyA. Accordingly, if the asset
in Example3 were unexpectedly destroyed, resulting in an unanticipated loss, that loss
would be allocated for transfer pricing purposes to the company or companies that control
the investment risk, contribute to the control of that risk and have the financial capacity to
assume that risk, and that would be entitled to unanticipated profits or losses with respect to
the asset. That company or companies would be required to compensate CompanyA for the
return to which it is entitled as described in paragraph1.103.
D.1.3. Characteristics of property or services

1.107 Differences in the specific characteristics of property or services often account,
at least in part, for differences in their value in the open market. Therefore, comparisons
of these features may be useful in delineating the transaction and in determining the
comparability of controlled and uncontrolled transactions. Characteristics that may be
important to consider include the following: in the case of transfers of tangible property, the
physical features of the property, its quality and reliability, and the availability and volume
of supply; in the case of the provision of services, the nature and extent of the services; and
in the case of intangible property, the form of transaction (e.g.licensing or sale), the type
of property (e.g.patent, trademark, or know-how), the duration and degree of protection,
and the anticipated benefits from the use of the property. For further discussion of some
of the specific features of intangibles that may prove important in a comparability analysis
involving transfers of intangibles or rights in intangibles, see SectionD.2.1 of ChapterVI.
1.108 Depending on the transfer pricing method, this factor must be given more or less
weight. Among the methods described at ChapterII of these Guidelines, the requirement
for comparability of property or services is the strictest for the comparable uncontrolled
price method. Under the comparable uncontrolled price method, any material difference

in the characteristics of property or services can have an effect on the price and would
require an appropriate adjustment to be considered (see in particular paragraph2.15).
Under the resale price method and cost plus method, some differences in the characteristics
of property or services are less likely to have a material effect on the gross profit margin
or mark-up on costs (see in particular paragraphs2.23 and 2.41). Differences in the
characteristics of property or services are also less sensitive in the case of the transactional
profit methods than in the case of traditional transaction methods (see in particular
paragraph2.69). This however does not mean that the question of comparability in
characteristics of property or services can be ignored when applying transactional profit
methods, because it may be that product differences entail or reflect different functions
performed, assets used and/or risks assumed by the tested party. See paragraphs3.18-3.19
for a discussion of the notion of tested party.
1.109 In practice, it has been observed that comparability analyses for methods based
on gross or net profit indicators often put more emphasis on functional similarities than
on product similarities. Depending on the facts and circumstances of the case, it may be
acceptable to broaden the scope of the comparability analysis to include uncontrolled
transactions involving products that are different, but where similar functions are undertaken.
However, the acceptance of such an approach depends on the effects that the product
differences have on the reliability of the comparison and on whether or not more reliable
data are available. Before broadening the search to include a larger number of potentially
comparable uncontrolled transactions based on similar functions being undertaken, thought
should be given to whether such transactions are likely to offer reliable comparables for the
controlled transaction.
D.1.4. Economic circumstances

1.110 Arms length prices may vary across different markets even for transactions involving
the same property or services; therefore, to achieve comparability requires that the markets
in which the independent and associated enterprises operate do not have differences that
have a material effect on price or that appropriate adjustments can be made. As a first
step, it is essential to identify the relevant market or markets taking account of available
substitute goods or services. Economic circumstances that may be relevant to determining
market comparability include the geographic location; the size of the markets; the extent of
competition in the markets and the relative competitive positions of the buyers and sellers; the
availability (risk thereof) of substitute goods and services; the levels of supply and demand
in the market as a whole and in particular regions, if relevant; consumer purchasing power;
the nature and extent of government regulation of the market; costs of production, including
the costs of land, labour, and capital; transport costs; the level of the market (e.g.retail or
wholesale); the date and time of transactions; and so forth. The facts and circumstances
of the particular case will determine whether differences in economic circumstances have
a material effect on price and whether reasonably accurate adjustments can be made to
eliminate the effects of such differences. More detailed guidance on the importance in a
comparability analysis of the features of local markets, especially local market features that
give rise to location savings, is provided in SectionD.6 of this chapter.
1.111 The existence of a cycle (e.g.economic, business, or product cycle) is one of the
economic circumstances that should be identified. See paragraph3.77 in relation to the use
of multiple year data where there are cycles.
1.112 The geographic market is another economic circumstance that should be identified.
The identification of the relevant market is a factual question. For a number of industries,
large regional markets encompassing more than one country may prove to be reasonably
homogeneous, while for others, differences among domestic markets (or even within
domestic markets) are very significant.
1.113 In cases where similar controlled transactions are carried out by an MNE group
in several countries and where the economic circumstances in these countries are in
effect reasonably homogeneous, it may be appropriate for this MNE group to rely on a
multiple-country comparability analysis to support its transfer pricing policy towards this
group of countries. But there are also numerous situations where an MNE group offers
significantly different ranges of products or services in each country, and/or performs
significantly different functions in each of these countries (using significantly different
assets and assuming significantly different risks), and/or where its business strategies and/
or economic circumstances are found to be significantly different. In these latter situations,
the recourse to a multiple-country approach may reduce reliability.
D.1.5. Business strategies

1.114 Business strategies must also be examined in delineating the transaction and in
determining comparability for transfer pricing purposes. Business strategies would take into
account many aspects of an enterprise, such as innovation and new product development,
degree of diversification, risk aversion, assessment of political changes, input of existing
and planned labour laws, duration of arrangements, and other factors bearing upon the
daily conduct of business. Such business strategies may need to be taken into account when
determining the comparability of controlled and uncontrolled transactions and enterprises.
1.115 Business strategies also could include market penetration schemes. A taxpayer
seeking to penetrate a market or to increase its market share might temporarily charge a
price for its product that is lower than the price charged for otherwise comparable products
in the same market. Furthermore, a taxpayer seeking to enter a new market or expand (or
defend) its market share might temporarily incur higher costs (e.g.due to start-up costs
or increased marketing efforts) and hence achieve lower profit levels than other taxpayers
operating in the same market.
1.116 Timing issues can pose particular problems for tax administrations when evaluating
whether a taxpayer is following a business strategy that distinguishes it from potential
comparables. Some business strategies, such as those involving market penetration or
expansion of market share, involve reductions in the taxpayers current profits in anticipation
of increased future profits. If in the future those increased profits fail to materialise because
the purported business strategy was not actually followed by the taxpayer, the appropriate
transfer pricing outcome would likely require a transfer pricing adjustment. However legal
constraints may prevent re-examination of earlier tax years by the tax administrations. At
least in part for this reason, tax administrations may wish to subject the issue of business
strategies to particular scrutiny.
1.117 When evaluating whether a taxpayer was following a business strategy that temporarily
decreased profits in return for higher long-run profits, several factors should be considered.
Tax administrations should examine the conduct of the parties to determine if it is
consistent with the purported business strategy. For example, if a manufacturer charges
its associated distributor a below-market price as part of a market penetration strategy,
the cost savings to the distributor may be reflected in the price charged to the distributors
customers or in greater market penetration expenses incurred by the distributor. A market
penetration strategy of an MNE group could be put in place either by the manufacturer or
by the distributor acting separately from the manufacturer (and the resulting cost borne

by either of them), or by both of them acting in a co-ordinated manner. Furthermore,
unusually intensive marketing and advertising efforts would often accompany a market
penetration or market share expansion strategy. Another factor to consider is whether
the nature of the relationship between the parties to the controlled transaction would
be consistent with the taxpayer bearing the costs of the business strategy. For example,
in arms length transactions a company acting solely as a sales agent with little or no
responsibility for long-term market development would generally not bear the costs of
a market penetration strategy. Where a company has undertaken market development
activities at its own risk and enhances the value of a product through a trademark or trade
name or increases goodwill associated with the product, this situation should be reflected
in the analysis of functions for the purposes of establishing comparability.
1.118 An additional consideration is whether there is a plausible expectation that following
the business strategy will produce a return sufficient to justify its costs within a period of
time that would be acceptable in an arms length arrangement. It is recognised that a business
strategy such as market penetration may fail, and the failure does not of itself allow the
strategy to be ignored for transfer pricing purposes. However, if such an expected outcome
was implausible at the time of the transaction, or if the business strategy is unsuccessful but
nonetheless is continued beyond what an independent enterprise would accept, the arms
length nature of the business strategy may be doubtful and may warrant a transfer pricing
adjustment. In determining what period of time an independent enterprise would accept,
tax administrations may wish to consider evidence of the commercial strategies evident in
the country in which the business strategy is being pursued. In the end, however, the most
important consideration is whether the strategy in question could plausibly be expected to
prove profitable within the foreseeable future (while recognising that the strategy might fail),
and that a party operating at arms length would have been prepared to sacrifice profitability
for a similar period under such economic circumstances and competitive conditions.
D.2. Recognition of the accurately delineated transaction

1.119 Following the guidance in the previous section, the transfer pricing analysis will
have identified the substance of the commercial or financial relations between the parties,
and will have accurately delineated the actual transaction by analysing the economically
relevant characteristics.
1.120 In performing the analysis, the actual transaction between the parties will have
been deduced from written contracts and the conduct of the parties. Formal conditions
recognised in contracts will have been clarified and supplemented by analysis of the
conduct of the parties and the other economically relevant characteristics of the transaction
(see SectionD.1.1). Where the characteristics of the transaction that are economically
significant are inconsistent with the written contract, then the actual transaction will have
been delineated in accordance with the characteristics of the transaction reflected in the
conduct of the parties. Contractual risk assumption and actual conduct with respect to
risk assumption will have been examined taking into account control over the risk (as
defined in paragraphs1.65-1.68) and the financial capacity to assume risk (as defined
in paragraph1.64), and consequently, risks assumed under the contract may have been
allocated in accordance with the conduct of the parties and the other facts on the basis
of steps4 and 5 of the process for analysing risk in a controlled transaction as reflected
in Sections D.1.2.1.4 and D.1.2.1.5. Therefore, the analysis will have set out the factual
substance of the commercial or financial relations between the parties and accurately
delineated the actual transaction.
1.121 Every effort should be made to determine pricing for the actual transaction as
accurately delineated under the arms length principle. The various tools and methods
available to tax administrations and taxpayers to do so are set out in the following chapters
of these Guidelines. A tax administration should not disregard the actual transaction or
substitute other transactions for it unless the exceptional circumstances described in the
following paragraphs1.122-1.125 apply.
1.122 This section sets out circumstances in which the transaction between the parties
as accurately delineated can be disregarded for transfer pricing purposes. Because nonrecognition can be contentious and a source of double taxation, every effort should be
made to determine the actual nature of the transaction and apply arms length pricing to
the accurately delineated transaction, and to ensure that non-recognition is not used simply
because determining an arms length price is difficult. Where the same transaction can be
seen between independent parties in comparable circumstances (i.e.where all economically
relevant characteristics are the same as those under which the tested transaction occurs
other than that the parties are associated enterprises) non-recognition would not apply.
Importantly, the mere fact that the transaction may not be seen between independent parties
does not mean that it should not be recognised. Associated enterprises may have the ability
to enter into a much greater variety of arrangements than can independent enterprises, and
may conclude transactions of a specific nature that are not encountered, or are only very
rarely encountered, between independent parties, and may do so for sound business reasons.
The transaction as accurately delineated may be disregarded, and if appropriate, replaced
by an alternative transaction, where the arrangements made in relation to the transaction,
viewed in their totality, differ from those which would have been adopted by independent
enterprises behaving in a commercially rational manner in comparable circumstances,
thereby preventing determination of a price that would be acceptable to both of the parties
taking into account their respective perspectives and the options realistically available
to each of them at the time of entering into the transaction. It is also a relevant pointer
to consider whether the MNE group as a whole is left worse off on a pre-tax basis since
this may be an indicator that the transaction viewed in its entirety lacks the commercial
rationality of arrangements between unrelated parties.
1.123 The key question in the analysis is whether the actual transaction possesses the
commercial rationality of arrangements that would be agreed between unrelated parties
under comparable economic circumstances, not whether the same transaction can be
observed between independent parties. The non-recognition of a transaction that possesses
the commercial rationality of an arms length arrangement is not an appropriate application
of the arms length principle. Restructuring of legitimate business transactions would be a
wholly arbitrary exercise the inequity of which could be compounded by double taxation
created where the other tax administration does not share the same views as to how the
transaction should be structured. It should again be noted that the mere fact that the
transaction may not be seen between independent parties does not mean that it does not
have characteristics of an arms length arrangement.
1.124 The structure that for transfer pricing purposes, replaces that actually adopted
by the taxpayers should comport as closely as possible with the facts of the actual
transaction undertaken whilst achieving a commercially rational expected result that
would have enabled the parties to come to a price acceptable to both of them at the time the
arrangement was entered into.
1.125 The criterion for non-recognition may be illustrated by the following examples.
Example1
1.126 CompanyS1 carries on a manufacturing business that involves holding substantial
inventory and a significant investment in plant and machinery. It owns commercial
property situated in an area prone to increasingly frequent flooding in recent years.
Third-party insurers experience significant uncertainty over the exposure to large claims,
with the result that there is no active market for the insurance of properties in the area.
CompanyS2, an associated enterprise, provides insurance to CompanyS1, and an annual
premium representing 80% of the value of the inventory, property and contents is paid by
CompanyS1. In this example S1 has entered into a commercially irrational transaction
since there is no market for insurance given the likelihood of significant claims, and
either relocation or not insuring may be more attractive realistic alternatives. Since the
transaction is commercially irrational, there is not a price that is acceptable to both S1 and
S2 from their individual perspectives.
1.127 Under the guidance in this section, the transaction should not be recognised. S1 is
treated as not purchasing insurance and its profits are not reduced by the payment to S2;
S2 is treated as not issuing insurance and therefore not being liable for any claim.
Example2
1.128 CompanyS1 conducts research activities to develop intangibles that it uses to create
new products that it can produce and sell. It agrees to transfer to an associated company,
CompanyS2, unlimited rights to all future intangibles which may arise from its future work
over a period of twenty years for a lump sum payment. The arrangement is commercially
irrational for both parties since neither CompanyS1 nor CompanyS2 has any reliable means to
determine whether the payment reflects an appropriate valuation, both because it is uncertain
what range of development activities CompanyS1 might conduct over the period and also
because valuing the potential outcomes would be entirely speculative. Under the guidance in
this section, the structure of the arrangement adopted by the taxpayer, including the form of
payment, should be modified for the purposes of the transfer pricing analysis. The replacement
structure should be guided by the economically relevant characteristics, including the
functions performed, assets used, and risks assumed, of the commercial or financial relations
of the associated enterprises. Those facts would narrow the range of potential replacement
structures to the structure most consistent with the facts of the case (for example, depending on
those facts the arrangement could be recast as the provision of financing by CompanyS2, or as
the provision of research services by CompanyS1, or, if specific intangibles can be identified,
as a licence with contingent payments terms for the development of those specific intangibles,
taking into account the guidance on hard-to-value intangibles as appropriate).
D.3. Losses
1.129 When an associated enterprise consistently realizes losses while the MNE group as
a whole is profitable, the facts could trigger some special scrutiny of transfer pricing issues.
Of course, associated enterprises, like independent enterprises, can sustain genuine losses,
whether due to heavy start-up costs, unfavourable economic conditions, inefficiencies,
or other legitimate business reasons. However, an independent enterprise would not be
prepared to tolerate losses that continue indefinitely. An independent enterprise that
experiences recurring losses will eventually cease to undertake business on such terms. In
contrast, an associated enterprise that realizes losses may remain in business if the business
is beneficial to the MNE group as a whole.
1.130 The fact that there is an enterprise making losses that is doing business with
profitable members of its MNE group may suggest to the taxpayers or tax administrations
that the transfer pricing should be examined. The loss enterprise may not be receiving
adequate compensation from the MNE group of which it is a part in relation to the benefits
derived from its activities. For example, an MNE group may need to produce a full range
of products and/or services in order to remain competitive and realize an overall profit, but
some of the individual product lines may regularly lose revenue. One member of the MNE
group might realize consistent losses because it produces all the loss-making products
while other members produce the profit-making products. An independent enterprise
would perform such a service only if it were compensated by an adequate service charge.
Therefore, one way to approach this type of transfer pricing problem would be to deem the
loss enterprise to receive the same type of service charge that an independent enterprise
would receive under the arms length principle.
1.131 A factor to consider in analysing losses is that business strategies may differ from
MNE group to MNE group due to a variety of historic, economic, and cultural reasons.
Recurring losses for a reasonable period may be justified in some cases by a business
strategy to set especially low prices to achieve market penetration. For example, a producer
may lower the prices of its goods, even to the extent of temporarily incurring losses, in
order to enter new markets, to increase its share of an existing market, to introduce new
products or services, or to discourage potential competitors. However, especially low
prices should be expected for a limited period only, with the specific object of improving
profits in the longer term. If the pricing strategy continues beyond a reasonable period,
a transfer pricing adjustment may be appropriate, particularly where comparable data
over several years show that the losses have been incurred for a period longer than that
affecting comparable independent enterprises. Further, tax administrations should not
accept especially low prices (e.g.pricing at marginal cost in a situation of underemployed
production capacities) as arms length prices unless independent enterprises could be
expected to have determined prices in a comparable manner.
D.4. The effect of government policies

1.132 There are some circumstances in which a taxpayer will consider that an arms
length price must be adjusted to account for government interventions such as price
controls (even price cuts), interest rate controls, controls over payments for services or
management fees, controls over the payment of royalties, subsidies to particular sectors,
exchange control, anti-dumping duties, or exchange rate policy. As a general rule, these
government interventions should be treated as conditions of the market in the particular
country, and in the ordinary course they should be taken into account in evaluating the
taxpayers transfer price in that market. The question then presented is whether in light of
these conditions the transactions undertaken by the controlled parties are consistent with
transactions between independent enterprises.
1.133 One issue that arises is determining the stage at which a price control affects the
price of a product or service. Often the direct impact will be on the final price to the
consumer, but there may nonetheless be an impact on prices paid at prior stages in the
supply of goods to the market. MNEs in practice may make no adjustment in their transfer
prices to take account of such controls, leaving the final seller to suffer any limitation
on profit that may occur, or they may charge prices that share the burden in some way
between the final seller and the intermediate supplier. It should be considered whether or
not an independent supplier would share in the costs of the price controls and whether an

independent enterprise would seek alternative product lines and business opportunities.
In this regard, it is unlikely that an independent enterprise would be prepared to produce,
distribute, or otherwise provide products or services on terms that allowed it no profit.
Nevertheless, it is quite obvious that a country with price controls must take into account
that those price controls will affect the profits that can be realised by enterprises selling
goods subject to those controls.
1.134 A special problem arises when a country prevents or blocks the payment of an
amount which is owed by one associated enterprise to another or which in an arms length
arrangement would be charged by one associated enterprise to another. For example,
exchange controls may effectively prevent an associated enterprise from transferring
interest payments abroad on a loan made by another associated enterprise located in a
different country. This circumstance may be treated differently by the two countries
involved: the country of the borrower may or may not regard the untransferred interest as
having been paid, and the country of the lender may or may not treat the lender as having
received the interest. As a general rule, where the government intervention applies equally
to transactions between associated enterprises and transactions between independent
enterprises (both in law and in fact), the approach to this problem where it occurs between
associated enterprises should be the same for tax purposes as that adopted for transactions
between independent enterprises. Where the government intervention applies only to
transactions between associated enterprises, there is no simple solution to the problem.
Perhaps one way to deal with the issue is to apply the arms length principle viewing the
intervention as a condition affecting the terms of the transaction. Treaties may specifically
address the approaches available to the treaty partners where such circumstances exist.
1.135 A difficulty with this analysis is that often independent enterprises simply would
not enter into a transaction in which payments were blocked. An independent enterprise
might find itself in such an arrangement from time to time, most likely because the
government interventions were imposed subsequent to the time that the arrangement
began. But it seems unlikely that an independent enterprise would willingly subject itself
to a substantial risk of non-payment for products or services rendered by entering into
an arrangement when severe government interventions already existed unless the profit
projections or anticipated return from the independent enterprises proposed business
strategy are sufficient to yield it an acceptable rate of return notwithstanding the existence
of the government intervention that may affect payment.
1.136 Because independent enterprises might not engage in a transaction subject to
government interventions, it is unclear how the arms length principle should apply. One
possibility is to treat the payment as having been made between the associated enterprises,
on the assumption that an independent enterprise in a similar circumstance would have
insisted on payment by some other means. This approach would treat the party to whom
the blocked payment is owed as performing a service for the MNE group. An alternative
approach that may be available in some countries would be to defer both the income and the
relevant expenses of the taxpayer. In other words, the party to whom this blocked payment
was due would not be allowed to deduct expenses, such as additional financing costs, until
the blocked payment was made. The concern of tax administrations in these situations is
mainly their respective tax bases. If an associated enterprise claims a deduction in its tax
computations for a blocked payment, then there should be corresponding income to the
other party. In any case, a taxpayer should not be permitted to treat blocked payments due
from an associated enterprise differently from blocked payments due from an independent
enterprise.
D.5. Use of customs valuations

1.137 The arms length principle is applied, broadly speaking, by many customs
administrations as a principle of comparison between the value attributable to goods
imported by associated enterprises, which may be affected by the special relationship
between them, and the value for similar goods imported by independent enterprises.
Valuation methods for customs purposes however may not be aligned with the OECDs
recognised transfer pricing methods. That being said, customs valuations may be useful
to tax administrations in evaluating the arms length character of a controlled transaction
transfer price and vice versa. In particular, customs officials may have contemporaneous
information regarding the transaction that could be relevant for transfer pricing purposes,
especially if prepared by the taxpayer, while tax authorities may have transfer pricing
documentation which provides detailed information on the circumstances of the transaction.
1.138 Taxpayers may have competing incentives in setting values for customs and tax
purposes. In general, a taxpayer importing goods may be interested in setting a low price
for the transaction for customs purposes so that the customs duty imposed will be low.
(There could be similar considerations arising with respect to value added taxes, sales
taxes, and excise taxes.) For tax purposes, however, a higher price paid for those same
goods would increase the deductible costs in the importing country (although this would
also increase the sales revenue of the seller in the country of export). Cooperation between
income tax and customs administrations within a country in evaluating transfer prices is
becoming more common and this should help to reduce the number of cases where customs
valuations are found unacceptable for tax purposes or vice versa. Greater cooperation
in the area of exchange of information would be particularly useful, and should not be
difficult to achieve in countries that already have integrated administrations for income
taxes and customs duties. Countries that have separate administrations may wish to
consider modifying the exchange of information rules so that the information can flow
more easily between the different administrations.
D.6. Location savings and other local market features

1.139 Paragraphs1.110, 1.112 and 6.120 indicate that features of the geographic market in
which business operations occur can affect comparability and arms length prices. Difficult
issues can arise in evaluating differences between geographic markets and in determining
appropriate comparability adjustments. Such issues may arise in connection with the
consideration of cost savings attributable to operating in a particular market. Such savings
are sometimes referred to as location savings. In other situations comparability issues can
arise in connection with the consideration of local market advantages or disadvantages that
may not be directly related to location savings.
D.6.1. Location savings

1.140 Paragraphs9.148 9.153 discuss the treatment of location savings in the context
of a business restructuring. The principles described in those paragraphs apply generally
to all situations where location savings are present, not just in the case of a business
restructuring.
1.141 Pursuant to the guidance in paragraphs9.148 9.153, in determining how location
savings are to be shared between two or more associated enterprises, it is necessary to
consider (i)whether location savings exist; (ii)the amount of any location savings; (iii)the

extent to which location savings are either retained by a member or members of the MNE
group or are passed on to independent customers or suppliers; and (iv)where location
savings are not fully passed on to independent customers or suppliers, the manner in which
independent enterprises operating under similar circumstances would allocate any retained
net location savings.
1.142 Where the functional analysis shows that location savings exist that are not passed
on to customers or suppliers, and where comparable entities and transactions in the local
market can be identified, those local market comparables will provide the most reliable
indication regarding how the net location savings should be allocated amongst two or more
associated enterprises. Thus, where reliable local market comparables are available and
can be used to identify arms length prices, specific comparability adjustments for location
savings should not be required.
1.143 When reliable local market comparables are not present, determinations regarding
the existence and allocation of location savings among members of an MNE group, and
any comparability adjustments required to take into account location savings, should be
based on an analysis of all of the relevant facts and circumstances, including the functions
performed, risks assumed, and assets used of the relevant associated enterprises, in the
manner described in paragraphs9.148 9.153.
D.6.2. Other local market features

1.144 Features of the local market in which business operations occur may affect the arms
length price with respect to transactions between associated enterprises. While some such
features may give rise to location savings, others may give rise to comparability concerns
not directly related to such savings. For example, the comparability and functional
analysis conducted in connection with a particular matter may suggest that the relevant
characteristics of the geographic market in which products are manufactured or sold,
the purchasing power and product preferences of households in that market, whether the
market is expanding or contracting, the degree of competition in the market and other
similar factors affect prices and margins that can be realised in the market. Similarly, the
comparability and functional analysis conducted in connection with a particular matter
may suggest that the relative availability of local country infrastructure, the relative
availability of a pool of trained or educated workers, proximity to profitable markets, and
similar features in a geographic market where business operations occur create market
advantages or disadvantages that should be taken into account. Appropriate comparability
adjustments should be made to account for such factors where reliable adjustments that will
improve comparability can be identified.
1.145 In assessing whether comparability adjustments for such local market features
are required, the most reliable approach will be to refer to data regarding comparable
uncontrolled transactions in that geographic market between independent enterprises
performing similar functions, assuming similar risks, and using similar assets. Such
transactions are carried out under the same market conditions as the controlled transaction,
and, accordingly, where comparable transactions in the local market can be identified,
specific adjustments for features of the local market should not be required.
1.146 In situations where reasonably reliable local market comparables cannot be identified,
the determination of appropriate comparability adjustments for features of the local market
should consider all of the relevant facts and circumstances. As with location savings, in each
case where reliable local market comparables cannot be identified, it is necessary to consider
(i)whether a market advantage or disadvantage exists, (ii)the amount of any increase or
decrease in revenues, costs or profits, vis--vis those of identified comparables from other
markets, that are attributable to the local market advantage or disadvantage, (iii)the degree to
which benefits or burdens of local market features are passed on to independent customers or
suppliers, and (iv)where benefits or burdens attributable to local market features exist and are
not fully passed on to independent customers or suppliers, the manner in which independent
enterprises operating under similar circumstances would allocate such net benefits or burdens
between them.
1.147 The need for comparability adjustments related to features of the local market in
cases where reasonably reliable local market comparables cannot be identified may arise in
several different contexts. In some circumstances, market advantages or disadvantages may
affect arms length prices of goods transferred or services provided between associated
enterprises.
1.148 In other circumstances, a business restructuring or the transfer of intangibles
between associated enterprises may make it possible for one party to the transaction to gain
the benefit of local market advantages or require that party to assume the burden of local
market disadvantages in a manner that would not have been possible in the absence of the
business restructuring or transfer of the intangibles. In such circumstances, the anticipated
existence of local market advantages and disadvantages may affect the arms length price
paid in connection with the business restructuring or intangible transfer.
1.149 In conducting a transfer pricing analysis it is important to distinguish between
features of the local market, which are not intangibles, and any contractual rights, government
licences, or know-how necessary to exploit that market, which may be intangibles. Depending
on the circumstances, these types of intangibles may have substantial value that should be
taken into account in a transfer pricing analysis in the manner described in ChapterVI,
including the guidance on rewarding entities for functions, assets and risks associated with
the development of intangibles contained in SectionBof ChapterVI. In some circumstances,
contractual rights and government licences may limit access of competitors to a particular
market and may therefore affect the manner in which the economic consequences of local
market features are shared between parties to a particular transaction. In other circumstances,
contractual rights or government licences to access a market may be available to many or all
potential market entrants with little restriction.
1.150 For example, a country may require a regulatory licence to be issued as a precondition for conducting an investment management business in the country and may
restrict the number of foreign-owned firms to which such licences are granted. The
comparability and functional analysis may indicate that qualifying for such a licence
requires demonstrating to appropriate government authorities that the service provider
has appropriate levels of experience and capital to conduct such a business in a reputable
fashion. The market to which such a licence relates may also be one with unique features.
It may, for example be a market where the structure of pension and insurance arrangements
gives rise to large cash pools, a need to diversify investments internationally, and a
resulting high demand for quality investment management services and knowledge of
foreign financial markets that can make the provision of such services highly lucrative.
The comparability analysis may further suggest that those features of the local market
may affect the price that can be charged for certain types of investment management
services and the profit margins that may be earned from providing such services. Under
these circumstances, the intangible in question (i.e.the regulatory licence to provide
investment management services) may allow the party or parties holding the licence
to extract a greater share of the benefits of operating in the local market, including the

benefits provided by unique features of that market, than would be the case in the absence
of the licensing requirement. However, in assessing the impact of the regulatory licence, it
may be important in a particular case to consider the contributions of both the local group
member in the local market and other group members outside the local market in supplying
the capabilities necessary to obtain the licence, as described in SectionB of ChapterVI.
1.151 In a different circumstance, the comparability and functional analysis may suggest
that a government issued business licence is necessary as a pre-condition for providing a
particular service in a geographic market. However, it may be the case that such licences
are readily available to any qualified applicant and do not have the effect of restricting the
number of competitors in the market. Under such circumstances, the licence requirement
may not present a material barrier to entry, and possession of such a licence may not have
any discernible impact on the manner in which the benefits of operating in the local market
are shared between independent enterprises.
D.7. Assembled workforce

1.152 Some businesses are successful in assembling a uniquely qualified or experienced
cadre of employees. The existence of such an employee group may affect the arms length
price for services provided by the employee group or the efficiency with which services
are provided or goods produced by the enterprise. Such factors should ordinarily be taken
into account in a transfer pricing comparability analysis. Where it is possible to determine
the benefits or detriments of a unique assembled workforce vis--vis the workforce of
enterprises engaging in potentially comparable transactions, comparability adjustments
may be made to reflect the impact of the assembled workforce on arms length prices for
goods or services.
1.153 In some business restructuring and similar transactions, it may be the case that an
assembled workforce is transferred from one associated enterprise to another as part of
the transaction. In such circumstances, it may well be that the transfer of the assembled
workforce along with other transferred assets of the business will save the transferee
the time and expense of hiring and training a new workforce. Depending on the transfer
pricing methods used to evaluate the overall transaction, it may be appropriate in such
cases to reflect such time and expense savings in the form of comparability adjustments
to the arms length price otherwise charged with respect to the transferred assets. In
other situations, the transfer of the assembled workforce may result in limitations on the
transferees flexibility in structuring business operations and create potential liabilities if
workers are terminated. In such cases it may be appropriate for the compensation paid in
connection with the restructuring to reflect the potential future liabilities and limitations.
1.154 The foregoing paragraph is not intended to suggest that transfers or secondments
of individual employees between members of an MNE group should be separately
compensated as a general matter. In many instances the transfer of individual employees
between associated enterprises will not give rise to a need for compensation. Where
employees are seconded (i.e.they remain on the transferors payroll but work for the
transferee), in many cases the appropriate arms length compensation for the services of
the seconded employees in question will be the only payment required.
1.155 It should be noted, however, that in some situations, the transfer or secondment of
one or more employees may, depending on the facts and circumstances, result in the transfer
of valuable know-how or other intangibles from one associated enterprise to another. For
example, an employee of CompanyA seconded to CompanyB may have knowledge of a secret
formula owned by CompanyA and may make that secret formula available to CompanyB for
use in its commercial operations. Similarly, employees of CompanyA seconded to CompanyB
to assist with a factory start-up may make CompanyA manufacturing know-how available
to CompanyB for use in its commercial operations. Where such a provision of know-how or
other intangibles results from the transfer or secondment of employees, it should be separately
analysed under the provisions of ChapterVI and an appropriate price should be paid for the
right to use the intangibles.
1.156 Moreover, it should also be noted that access to an assembled workforce with
particular skills and experience may, in some circumstances, enhance the value of
transferred intangibles or other assets, even where the employees making up the workforce
are not transferred. Example23 in the annex to ChapterVI illustrates one fact pattern
where the interaction between intangibles and access to an assembled workforce may be
important in a transfer pricing analysis.
D.8. MNE group synergies

1.157 Comparability issues, and the need for comparability adjustments, can also arise
because of the existence of MNE group synergies. In some circumstances, MNE groups
and the associated enterprises that comprise such groups may benefit from interactions
or synergies amongst group members that would not generally be available to similarly
situated independent enterprises. Such group synergies can arise, for example, as a result
of combined purchasing power or economies of scale, combined and integrated computer
and communication systems, integrated management, elimination of duplication, increased
borrowing capacity, and numerous similar factors. Such group synergies are often
favourable to the group as a whole and therefore may heighten the aggregate profits earned
by group members, depending on whether expected cost savings are, in fact, realised, and
on competitive conditions. In other circumstances such synergies may be negative, as when
the size and scope of corporate operations create bureaucratic barriers not faced by smaller
and more nimble enterprises, or when one portion of the business is forced to work with
computer or communication systems that are not the most efficient for its business because
of group wide standards established by the MNE group.
1.158 Paragraph7.13 of these Guidelines suggests that an associated enterprise should
not be considered to receive an intra-group service or be required to make any payment
when it obtains incidental benefits attributable solely to its being part of a larger MNE
group. In this context, the term incidental refers to benefits arising solely by virtue of group
affiliation and in the absence of deliberate concerted actions or transactions leading to that
benefit. The term incidental does not refer to the quantum of such benefits or suggest that
such benefits must be small or relatively insignificant. Consistent with this general view
of benefits incidental to group membership, when synergistic benefits or burdens of group
membership arise purely as a result of membership in an MNE group and without the
deliberate concerted action of group members or the performance of any service or other
function by group members, such synergistic benefits of group membership need not be
separately compensated or specifically allocated among members of the MNE group.
1.159 In some circumstances, however, synergistic benefits and burdens of group
membership may arise because of deliberate concerted group actions and may give an
MNE group a material, clearly identifiable structural advantage or disadvantage in the
marketplace over market participants that are not part of an MNE group and that are
involved in comparable transactions. Whether such a structural advantage or disadvantage
exists, what the nature and source of the synergistic benefit or burden may be, and whether

the synergistic benefit or burden arises through deliberate concerted group actions can only
be determined through a thorough functional and comparability analysis.5
1.160 For example, if a group takes affirmative steps to centralise purchasing in a single
group company to take advantage of volume discounts, and that group company resells the
items it purchases to other group members, a deliberate concerted group action occurs to
take advantage of group purchasing power. Similarly, if a central purchasing manager at the
parent company or regional management centre performs a service by negotiating a group
wide discount with a supplier on the condition of achieving minimum group wide purchasing
levels, and group members then purchase from that supplier and obtain the discount,
deliberate concerted group action has occurred notwithstanding the absence of specific
purchase and sale transactions among group members. Where a supplier unilaterally offers
one member of a group a favourable price in the hope of attracting business from other group
members, however, no deliberate concerted group action would have occurred.
1.161 Where corporate synergies arising from deliberate concerted group actions do
provide a member of an MNE group with material advantages or burdens not typical
of comparable independent companies, it is necessary to determine (i)the nature of the
advantage or disadvantage, (ii)the amount of the benefit or detriment provided, and
(iii)how that benefit or detriment should be divided among members of the MNE group.
1.162 If important group synergies exist and can be attributed to deliberate concerted
group actions, the benefits of such synergies should generally be shared by members of
the group in proportion to their contribution to the creation of the synergy. For example,
where members of the group take deliberate concerted actions to consolidate purchasing
activities to take advantage of economies of scale resulting from high volume purchasing,
the benefits of those large scale purchasing synergies, if any exist after an appropriate
reward to the party co-ordinating the purchasing activities, should typically be shared by
the members of the group in proportion to their purchase volumes.
1.163 Comparability adjustments may be warranted to account for group synergies.
Example1
1.164 P is the parent company of an MNE group engaging in a financial services business.
The strength of the groups consolidated balance sheet makes it possible for P to maintain
an AAA credit rating on a consistent basis. S is a member of the MNE group engaged in
providing the same type of financial services as other group members and does so on a
large scale in an important market. On a stand-alone basis, however, the strength of Ss
balance sheet would support a credit rating of only Baa. Nevertheless, because of Ss
membership in the P group, large independent lenders are willing to lend to it at interest
rates that would be charged to independent borrowers with an A rating, i.e.a lower interest
rate than would be charged if S were an independent entity with its same balance sheet, but
a higher interest rate than would be available to the parent company of the MNE group.
1.165 Assume that S borrows EUR50million from an independent lender at the market
rate of interest for borrowers with an A credit rating. Assume further that S simultaneously
borrows EUR50million from T, another subsidiary of P, with similar characteristics as the
independent lender, on the same terms and conditions and at the same interest rate charged
by the independent lender (i.e.an interest rate premised on the existence of an A credit
rating). Assume further that the independent lender, in setting its terms and conditions, was
aware of Ss other borrowings including the simultaneous loan to S from T.
1.166 Under these circumstances the interest rate charged on the loan by T to S is an arms
length interest rate because (i)it is the same rate charged to S by an independent lender in
a comparable transaction; and (ii)no payment or comparability adjustment is required for
the group synergy benefit that gives rise to the ability of S to borrow from independent
enterprises at an interest rate lower than it could were it not a member of the group because
the synergistic benefit of being able to borrow arises from Ss group membership alone and
not from any deliberate concerted action of members of the MNE group.
Example26
1.167 The facts relating to Ss credit standing and borrowing power are identical to those
in the preceding example. S borrows EUR50million from Bank A. The functional analysis
suggests that Bank A would lend to S at an interest rate applicable to A rated borrowers
without any formal guarantee. However, P agrees to guarantee the loan from Bank A in
order to induce Bank A to lend at the interest rate that would be available to AAA rated
borrowers. Under these circumstances, S should be required to pay a guarantee fee to P
for providing the express guarantee. In calculating an arms length guarantee fee, the fee
should reflect the benefit of raising Ss credit standing from A to AAA, not the benefit
of raising Ss credit standing from Baa to AAA. The enhancement of Ss credit standing
from Baa to A is attributable to the group synergy derived purely from passive association
in the group which need not be compensated under the provisions of this section. The
enhancement of Ss credit standing from A to AAA is attributable to a deliberate concerted
action, namely the provision of the guarantee by P, and should therefore give rise to
compensation.
Example3
1.168 Assume that CompanyA is assigned the role of central purchasing manager
on behalf of the entire group. It purchases from independent suppliers and resells to
associated enterprises. CompanyA, based solely on the negotiating leverage provided by
the purchasing power of the entire group is able to negotiate with a supplier to reduce the
price of widgets from USD200 to USD110. Under these circumstances, the arms length
price for the resale of widgets by CompanyA to other members of the group would not be
at or near USD200. Instead, the arms length price would remunerate CompanyA for its
services of coordinating purchasing activity. If the comparability and functional analysis
suggests in this case that in comparable uncontrolled transactions involving a comparable
volume of purchases, comparable coordination services resulted in a service fee based on
CompanyAs costs incurred plus a mark-up equating to a total service fee of USD6 per
widget, then the intercompany price for the resale of the widgets by CompanyA would
be approximately USD116. Under these circumstances, each member of the group would
derive benefits attributable to the group purchasing power of approximately USD84 per
widget. In addition, CompanyA would earn USD6 per widget purchased by members of
the group for its service functions.
Example4
1.169 Assume facts similar to those in Example3, except that instead of actually purchasing
and reselling the widgets, CompanyA negotiates the discount on behalf of the group and
group members subsequently purchase the widgets directly from the independent supplier.
Under these circumstances, assume that the comparability analysis suggests that CompanyA
would be entitled to a service fee of USD5 per widget for the coordinating services that it

performed on behalf of other group members. (The lower assumed service fee in Example4
as compared to Example3 may reflect a lower level of risk in the service provider following
from the fact that it does not take title to the widgets or hold any inventory.) Group members
purchasing widgets would retain the benefit of the group purchasing discount attributable to
their individual purchases after payment of the service fee.
Example5
1.170 Assume a multinational group based in CountryA, has manufacturing subsidiaries
in CountryB and CountryC. CountryB has a tax rate of 30% and CountryC has a tax rate
of 10%. The group also maintains a shared services centre in CountryD. Assume that the
manufacturing subsidiaries in CountryB and CountryC each have need of 5000widgets
produced by an independent supplier as an input to their manufacturing processes. Assume
further that the CountryD shared services company is consistently compensated for its
aggregate activities by other group members, including the CountryB and CountryC
manufacturing affiliates, on a cost plus basis, which, for purposes of this example, is
assumed to be arms length compensation for the level and nature of services it provides.
1.171 The independent supplier sells widgets for USD10 apiece and follows a policy of
providing a 5% price discount for bulk purchases of widgets in excess of 7500units. A
purchasing employee in the CountryD shared services centre approaches the independent
supplier and confirms that if the CountryB and CountryC manufacturing affiliates
simultaneously purchase 5000widgets each, a total group purchase of 10000widgets,
the purchase discount will be available with respect to all of the group purchases. The
independent supplier confirms that it will sell an aggregate of 10000widgets to the MNE
group at a total price of USD95000, a discount of 5% from the price at which either of the
two manufacturing affiliates could purchase independently from the supplier.
1.172 The purchasing employee at the shared services centre then places orders for the
required widgets and requests that the supplier invoice the CountryB manufacturing
affiliate for 5000widgets at a total price of USD50000 and invoice the CountryC
manufacturing affiliate for 5000widgets at a total price of USD45000. The supplier
complies with this request as it will result in the supplier being paid the agreed price of
USD95000 for the total of the 10000widgets supplied.
1.173 Under these circumstances, CountryB would be entitled to make a transfer pricing
adjustment reducing the expenses of the CountryB manufacturing affiliate by USD2500.
The transfer pricing adjustment is appropriate because the pricing arrangements misallocate
the benefit of the group synergy associated with volume purchasing of the widgets. The
adjustment is appropriate notwithstanding the fact that the CountryB manufacturing
affiliate acting alone could not purchase widgets for a price less than the USD50000 it
paid. The deliberate concerted group action in arranging the purchase discount provides
a basis for the allocation of part of the discount to the CountryB manufacturing affiliate
notwithstanding the fact that there is no explicit transaction between the CountryB and
CountryC manufacturing affiliates.
COMMODITY TRANSACTIONS
Additions to ChapterII of the Transfer Pricing Guidelines

Summary
This chapter of the Report contains new guidance in respect of commodity transactions,
to be inserted immediately following paragraph2.16 of the 2010 Transfer Pricing Guidelines.
Action10 of the BEPS Action Plan instructs the G20 and the OECD countries to
develop transfer pricing rules to provide protection against common types of base eroding
payments. Under this mandate, the G20 and OECD countries have examined the transfer
pricing aspects of cross-border commodity transactions between associated enterprises
(commodity transactions). The outcome of this work is an improved framework for the
analysis of commodity transactions from a transfer pricing perspective which should lead
to greater consistency in the way that tax administrations and taxpayers determine the
arms length price for commodity transactions and should ensure that pricing reflects value
creation.
ChapterII of the Transfer Pricing Guidelines has been amended to include new
guidance especially applicable to commodity transactions. These provisions draw from
experiences of countries that have introduced domestic rules aimed at pricing commodity
transactions. The new guidance includes:
Clarification of the existing guidance on the application of the comparable
uncontrolled price (CUP) method to commodity transactions. The new guidance
states that (i)the CUP method would generally be an appropriate transfer pricing
method for commodity transactions between associated enterprises; (ii)quoted
prices can be used under the CUP method, subject to a number of considerations,
as a reference to determine the arms length price for the controlled commodity
transaction; and (iii)reasonably accurate comparability adjustments should be
made, when needed, to ensure that the economically relevant characteristics of the
controlled and uncontrolled transactions are sufficiently comparable.
A new provision on the determination of the pricing date for commodity transactions.
This provision should prevent taxpayers from using pricing dates in contracts that
enable the adoption of the most advantageous quoted price. It allows tax authorities
to impute, under certain conditions, the shipment date (or any other date for which
evidence is available) as the pricing date for the commodity transaction.
52 Commodity Transactions
The guidance developed under other BEPS actions is also relevant in dealing with
issues relating to commodity transactions. In particular, the revised standards for transfer
pricing documentation (Action13 of the BEPS Action Plan) and the guidance in the chapter
Guidance for Applying the Arms length Principle (Action9 of the BEPS Action Plan).
This new guidance will be supplemented with further work mandated by the G20
Development Working Group, following reports by the OECD on the impact of base
erosion and profit shifting (BEPS) in developing countries.7 The outcome of this work
will provide knowledge, best practices and tools for commodity-rich countries in pricing
commodity transactions for transfer pricing purposes.
The following paragraphs are added to ChapterII of the Transfer Pricing Guidelines,
immediately following paragraph2.16.
2.16A Subject to the guidance in paragraph2.2 for selecting the most appropriate transfer
pricing method in the circumstances of a particular case, the CUP method would generally
be an appropriate transfer pricing method for establishing the arms length price for the
transfer of commodities between associated enterprises. The reference to commodities
shall be understood to encompass physical products for which a quoted price is used as a
reference by independent parties in the industry to set prices in uncontrolled transactions.
The term quoted price refers to the price of the commodity in the relevant period
obtained in an international or domestic commodity exchange market. In this context, a
quoted price also includes prices obtained from recognised and transparent price reporting
or statistical agencies, or from governmental price-setting agencies, where such indexes are
used as a reference by unrelated parties to determine prices in transactions between them.
2.16B Under the CUP method, the arms length price for commodity transactions may
be determined by reference to comparable uncontrolled transactions and by reference to
comparable uncontrolled arrangements represented by the quoted price. Quoted commodity
prices generally reflect the agreement between independent buyers and sellers in the
market on the price for a specific type and amount of commodity, traded under specific
conditions at a certain point in time. A relevant factor in determining the appropriateness
of using the quoted price for a specific commodity is the extent to which the quoted price
is widely and routinely used in the ordinary course of business in the industry to negotiate
prices for uncontrolled transactions comparable to the controlled transaction. Accordingly,
depending on the facts and circumstances of each case, quoted prices can be considered as
a reference for pricing commodity transactions between associated enterprises. Taxpayers
and tax administrations should be consistent in their application of the appropriately
selected quoted price.
2.16C For the CUP method to be reliably applied to commodity transactions, the
economically relevant characteristics of the controlled transaction and the uncontrolled
transactions or the uncontrolled arrangements represented by the quoted price need to be
comparable. For commodities, the economically relevant characteristics include, among
others, the physical features and quality of the commodity; the contractual terms of the
controlled transaction, such as volumes traded, period of the arrangements, the timing
and terms of delivery, transportation, insurance, and foreign currency terms. For some
commodities, certain economically relevant characteristics (e.g.prompt delivery) may lead
to a premium or a discount. If the quoted price is used as a reference for determining the
arms length price or price range, the standardised contracts which stipulate specifications
on the basis of which commodities are traded on the exchange and which result in a
quoted price for the commodity may be relevant. Where there are differences between the
conditions of the controlled transaction and the conditions of the uncontrolled transactions
or the conditions determining the quoted price for the commodity that materially affect
the price of the commodity transactions being examined, reasonably accurate adjustments
should be made to ensure that the economically relevant characteristics of the transactions
are comparable. Contributions made in the form of functions performed, assets used and
risks assumed by other entities in the supply chain should be compensated in accordance
with the guidance provided in these Guidelines.
2.16D In order to assist tax administrations in conducting an informed examination
of the taxpayers transfer pricing practices, taxpayers should provide reliable evidence
54 Commodity Transactions
and document, as part of their transfer pricing documentation, the price-setting policy
for commodity transactions, the information needed to justify price adjustments based
on the comparable uncontrolled transactions or comparable uncontrolled arrangements
represented by the quoted price and any other relevant information, such as pricing
formulas used, third party end-customer agreements, premia or discounts applied, pricing
date, supply chain information, and information prepared for non-tax purposes.
2.16E A particularly relevant factor for commodity transactions determined by reference
to the quoted price is the pricing date, which refers to the specific time, date or time period
(e.g.a specified range of dates over which an average price is determined) selected by the
parties to determine the price for commodity transactions. Where the taxpayer can provide
reliable evidence of the pricing date agreed by the associated enterprises in the controlled
commodity transaction at the time the transaction was entered into (e.g.proposals and
acceptances, contracts or registered contracts, or other documents setting out the terms of
the arrangements may constitute reliable evidence) and this is consistent with the actual
conduct of the parties or with other facts of the case, in accordance with the guidance in
SectionD of ChapterI on accurately delineating the actual transaction, tax administrations
should determine the price for the commodity transaction by reference to the pricing
date agreed by the associated enterprises. If the pricing date specified in any written
agreement between the associated enterprises is inconsistent with the actual conduct of
the parties or with other facts of the case, tax administrations may determine a different
pricing date consistent with those other facts of the case and what independent enterprises
would have agreed in comparable circumstances (taking into considerations industry
practices). When the taxpayer does not provide reliable evidence of the pricing date agreed
by the associated enterprises in the controlled transaction and the tax administration
cannot otherwise determine a different pricing date under the guidance in SectionD of
ChapterI, tax administrations may deem the pricing date for the commodity transaction
on the basis of the evidence available to the tax administration; this may be the date of
shipment as evidenced by the bill of lading or equivalent document depending on the
means of transport. This would mean that the price for the commodities being transacted
would be determined by reference to the average quoted price on the shipment date,
subject to any appropriate comparability adjustments based on the information available
to the tax administration. It would be important to permit resolution of cases of double
taxation arising from application of the deemed pricing date through access to the mutual
agreement procedure under the applicable Treaty.
SCOPE OF WORK FOR GUIDANCE ON

THE TRANSACTIONAL PROFIT SPLIT METHOD
Summary
Action10 of the BEPS Action Plan invites clarification of the application of transfer
pricing methods, in particular the transactional profit split method, in the context of global
value chains.
In order to determine the matters relating to the application of the transactional profit
split method for which clarification would be useful, the OECD released a discussion draft
on 16December 2014, which raised a number of questions based on scenarios developed
from the use of profit splits encountered in practice by some delegates to Working Party
No.6. That discussion draft did not include revised guidance. Comments on the discussion
draft from interested parties extended to around 500 pages, and a public consultation on
19-20March 2015 attracted considerable interest.
Some of the key themes emerging from the consultation process and subsequent discussion
within WP6 included the need to reflect on clarifying, improving, and strengthening the
guidance on when it is appropriate to apply a transactional profit split method and how to do
so, since experiences indicate that this method may not be straightforward for taxpayers to
apply, and may not be straightforward for tax administrations to evaluate. Nevertheless, the
consultation process confirmed that transactional profit splits can offer a useful method which
has the potential when properly applied, to align profits with value creation in accordance with
the arms length principle and the most appropriate method, particularly in situations where
the features of the transaction makes the application of other transfer pricing methodologies
problematic.
Improved guidance needs to clarify the circumstances in which transactional profit
splits are the most appropriate method for a particular case and to describe what approaches
can be taken to split profits in a reliable way. The guidance on transactional profit splits
also needs to take into account changes to the transfer pricing guidance in pursuit of
other BEPS actions, including changes in relation to the guidance on applying the arms
length principle in the section on performing a robust functional analysis and identifying
and allocating risks, in the section on synergies; and to the guidance on intangibles. The
guidance should take into account the conclusions of the Report on Addressing the Tax
Challenges of the Digital Economy (OECD, 2015), developed in relation to BEPS Action1,
which noted that attention should be paid to the consequences of greater integration of
business models as a result of the digitised economy, and the potential role for profit splits
to account for such integration.8 In addition, the guidance should reflect further work being
undertaken to develop approaches to transfer pricing in situations where the availability
of comparables is limited, for example due to the specific features of the controlled
transaction; and clarify how in such cases, the most appropriate method should be selected.
This concerns work mandated by the G20 Development Working Group, following reports
56 Scope of Work for Guidance on the Transactional Profit Split Method
by the OECD on the impact of BEPS in developing countries,9 including the development
of a toolkit for low income countries to address challenges these countries face due to the
lack of comparables.
The clarification and strengthening of the guidance on transactional profit splits, set
out in this Report, together with the development of useful illustrations of the situations
in which transactional profits splits can reliably be applied and how they can be applied to
produce arms length outcomes, requires proper consideration of the matters raised during
the initial consultation and further consultation on draft guidance. This paper sets out the
proposed scope of that work.
This Report will form the basis for draft guidance to be developed by WP6 during 2016
and expected to be finalised in the first half of 2017. A discussion draft of guidance will be
released for public comments and a public consultation will be held in May 2016.
Part I: Current guidance on transactional profit split method and public consultation
Current guidance
1.
The current guidance on the application of the transactional profit split method in
ChapterII, PartIII, SectionC of the Transfer Pricing Guidelines indicates that the main
strength of the method is that it can provide solutions for highly integrated operations for
which a one-sided method would not be appropriate, such as global trading of financial
instruments. The current guidance also states that transactional profit split methods may be
found to be the most appropriate method in situations where both parties to the transaction
make unique and valuable contributions, for example in the form of unique intangibles (see
paragraph2.109).
2.
The guidance makes the point that where each party makes unique and valuable
contributions, reliable comparables information may be insufficient to apply another
method. The guidance stresses that the selection of a transactional profit split method
should be determined in accordance with the overall guidance for method selection at
paragraph2.2 of the Guidelines (see paragraphs2.109 and 3.39).
3.
While the guidance on splitting profits provides a number of examples of
potential allocation keys, it focusses on asset-based and cost-based allocation keys (see
paragraphs2.134-139). There is tentative mention of an approach which splits profits so
that each party achieves the same return on capital (paragraph2.145).
4.
ChapterVI of the Transfer Pricing Guidelines, Special Considerations for Intangibles,
makes a number of references to the transactional profit split method and to situations where
the current guidance on its application may need to be clarified. For example, the guidance
suggests:
In some cases profit splits or valuation techniques may be useful for evaluating
arms length allocations of profit in situations involving the outsourcing of
important functions where information on comparable uncontrolled transactions
is unavailable.10
Where no information on comparable uncontrolled transactions is available, a
transactional profit split method is a method that may be useful in situations
involving the pricing of transfers of intangibles.11 This may include the transfer of
partially developed intangibles; or the transfer of all, or limited rights in a fully
developed intangible.
5.
Furthermore, aspects of ChapterI of the Transfer Pricing Guidelines may prompt
consideration of transactional profit splits, but specific guidance has not yet been provided.
Areas of particular interest in this regard include situations where multiple parties exercise
control over a risk such that a sharing in the potential upside and downside of the risk may
be appropriate, and the sharing of group synergies arising from deliberate concerted group
action.
Scope of revised guidance

6.
The revised guidance should follow the current structure in ChapterII of the
Transfer Pricing Guidelines, but should clarify and supplement the following matters.
Practical application should be illustrated through examples.
Most appropriate method

7.
The December 2014 discussion draft on the use of transactional profit splits stated
that the consideration of transactional profit splits did not imply any changes to the guidance
for selecting the most appropriate method set out in paragraph2.2 of the Guidelines.
Nevertheless, comments on the discussion draft pointed to significant concerns at the
potential for transactional profit split methods to be misused, particularly in cases where
the nature of the transaction itself, based on the functional analysis of the parties, suggests
that a sharing of combined profits would not be expected at arms length. Concerns were
expressed that the profit split method would be used in the absence of reliable comparables,
without considering whether the profit split method was itself appropriate.
Highly integrated business operations

8.
While the current Guidelines state that transactional profit split methods may be
found to be the most appropriate method where business operations are highly integrated,
integration alone may be insufficient to warrant the use of such a method. All MNE
groups are integrated to a greater or lesser degree, and so it is unclear how the criterion of
integration should be applied.
Unique and valuable contributions

9.
The existing guidance on the application of transactional profit split methods
notes that such methods may be the most appropriate method in situations where both
parties to the transaction make unique and valuable contributions. However, there is little
further guidance in the current Guidelines about what constitutes a unique and valuable
contribution aside from an example where intangibles are contributed by both parties to
the transaction.
10. Some commentators on the December discussion draft suggested that unique
contributions could be defined as those which cannot be benchmarked by reference to
uncontrolled transactions, and valuable contributions could be defined as those which
are expected to yield future economic benefits. Others went further and proposed that
valuable contributions could be those which contribute to a key source of competitive
advantage. A number of commentators on the December discussion draft supported
the notion that the sharing of significant risks could constitute a unique and valuable
contribution and hence may result in the conclusion that a transactional profit split method
is the most appropriate to the circumstances.
Synergistic benefits
11.
The December discussion draft included a scenario describing a multisided digital
economy business model. A number of commentators and Working Party No.6 delegates
consider that the scenario, rather than illustrating a specific feature of the digital economy,
instead simply demonstrates the effect of synergistic benefits. In such cases, both parts
of the business may make significant contributions towards the key value driver(s) of
the MNE group. The guidance on group synergies provides that, where the synergistic
benefits arise as a result of deliberate concerted action, such benefits must be shared by
group members in proportion to their contribution to the creation of the synergy.12 While
it may, in some circumstances be possible to benchmark the contributions of each part
of the business, such a process may not be able to account for the potentially significant
integration benefits which are achieved by the two parts acting in concert.
Profit splitting factors

12. The over-arching objective of the BEPS Actions8-10 is to ensure that transfer
pricing outcomes are in line with economic value creation. Such an objective is achieved
by accurately delineating the actual transaction and pricing it in accordance with the most
appropriate method. The December discussion draft noted that transactional profit split
methods could make a contribution to achieving this aim and asked about experiences
in using various approaches to splitting profits that might indicate ways of ensuring both
greater objectivity and alignment with value creation in circumstances where application
of the transactional profit split method is appropriate.
13. While there is general agreement that the splitting of profits should be based on a
functional analysis of the parties contributions, the mechanism by which the value of those
contributions is quantified is not always clear. Possible mechanisms that are used in practice
to various extents include invested capital, costs, surveys of functional contributions,
weighting of factors, as well as equalised expected rates of return. Commentators observed
advantages and disadvantages in these mechanisms, based on issues such as availability of
information, measurability, subjectivity, and practicality, and the observations emphasise the
current lack of guidance on what is a key aspect of applying a profit split how the profits
should reliably be split.
Use of profit split to determine TNMM range, or converting to a royalty

14.
The December discussion draft raised questions about the use of profit splits to vary
the range of results derived from a TNMM analysis by reference to increase or decrease
in consolidated profits achieved by the parties to the transaction. The draft also raised
a question about using a profit split to determine the expected share of profits, and then
converting the analysis to a running royalty. Some commentators also felt that these were
useful suggestions.
PartII: Scope of revisions of the guidance on the transactional profit split method
Most appropriate method
The guidance on transactional profit splits and selecting the most appropriate
method should emphasise the point made at paragraph2.2 of the current Guidelines
that the nature of the transaction, determined in accordance with the guidance in
SectionD of ChapterI, is a vital consideration for the selection of the most appropriate
transfer pricing method even in the absence of information on reliable, comparable
uncontrolled transactions. The sharing of profits or losses under a profit split may
in some circumstances reflect a fundamentally different commercial relationship
between the parties, in particular concerning risk allocation, to the paying of a fee for
goods or services. In cases where the delineation of the actual transaction is such that
a share of profits would be unlikely to represent an arms length outcome, the revised

guidance will emphasise the need to use and adjust the best available comparables
rather than selecting a profit split method. An appropriate method using inexact
comparables is likely to be more reliable in such cases than an inappropriate use of the
transactional profit split method. As such, the guidance on how the most appropriate
method standard should be applied in such difficult cases will be expanded. Selecting
the most appropriate method is particularly acute where there is a lack of reliable
comparables data, as is very often the case in developing countries, and is relevant to
the work mandated by the G20 Development Working Group on the development of
toolkits to help low income countries address the challenge of the lack of comparables.
Highly integrated business operations

Additional guidance will be provided on when significant integration of business
operations may lead to the conclusion that a transactional profit split is the most
appropriate method. To this end, the guidance should refer to the relevance of a
value chain analysis in understanding the context of the controlled transaction(s).
As part of this analysis, it may be helpful to distinguish between sequential
integration of a global value chain (which may involve the parties performing
different activities linked through transactions between them in a coherent value
chain, and which may not warrant the use of a profit split without taking into
account further features of the arrangements) and parallel integration, which may
involve the parties performing similar activities relating to the same revenues,
costs, assets, or risks, within the value chain or at a stage in the value chain. The
reference to global trading of financial instruments in the current Guidelines,
which may involve parallel activities on the same asset, revenue stream, and risks,
suggests that the current Guidelines envisaged that splitting the combined profits
arising from this type of parallel integration may be appropriate.
Unique and valuable contributions

Additional guidance and examples will be provided to clarify what is meant by
unique and valuable contributions in order to distinguish those circumstances
when transactional profit split methods are likely to be the most appropriate
method. Additional guidance on unique and valuable contributions other than in
the form of intangibles will be provided.
Taking into account revisions to the guidance on intangibles, guidance will be
provided to clarify the selection of a transactional profit split as the most appropriate
method in cases involving the performance of important functions relating to the
development, enhancement, maintenance, protection or exploitation of intangibles,
i.e.when do such functions constitute unique and valuable contributions for the
purposes of identifying the most appropriate transfer pricing method.
In developing this guidance due regard should be given to situations where
independent enterprises make use of profit split models in comparable transactions.
Synergistic benefits
Additional guidance will be provided on the circumstances to take into account
in determining whether a transactional profit split method could be the most
appropriate method for dealing with scenarios with significant group synergies,
and how such profit split methods could be applied.
Profit splitting factors

Additional guidance will be provided that explains how to fulfil the need for a strong
correlation between profit allocation factors and the creation of value in order to ensure
an outcome that is consistent with the arms length principle. Various mechanisms
should be explained in detail, with examples of their application. In addition, the
sensitivities and practical application of the various mechanisms, including the
capability independently to verify the underlying data, should be compared, in order
that guidance is provided about the appropriate application of the mechanisms.
Use of profit split to determine TNMM range, royalty rates and other payment
forms
Additional guidance will be provided on the circumstances to take into account in
evaluating whether a transactional profit split method can be used to support results
under a TNMM, or to determine royalty rates, or in other ways that are practical,
respect the form of the contractual arrangements, and help simplify pricing outcomes.
I ntangibles 63
INTANGIBLES
Revisions to ChapterVI of the Transfer Pricing Guidelines

Summary
This chapter of the Report provides guidance specially tailored to determining arms
length conditions for transactions that involve the use or transfer of intangibles under
Article9 of the OECD Model Tax Convention. In doing so, the guidance contained in this
chapter addresses the opportunities for base erosion and profit shifting resulting from the
transfer of intangibles among members of an MNE group. Under this guidance, members
of the MNE group are to be compensated based on the value they create through functions
performed, assets used and risks assumed in the development, enhancement, maintenance,
protection and exploitation of intangibles. Tax administrations are given new tools to tackle
the problem of information asymmetry to assist in determining the appropriate pricing
arrangements for intangibles, and valuation techniques are recognised as useful tools when
pricing transactions involving intangibles.
The guidance was developed under Action8 of the OECD/G20 BEPS Project, which
requested the development of rules to prevent BEPS by moving intangibles among
group members by (i)adopting a broad and clearly delineated definition of intangibles;
(ii)ensuring that profits associated with the transfer and use of intangibles are appropriately
allocated in accordance with (rather than divorced from) value creation; (iii)developing
transfer pricing rules or special measures for transfers of hard-to-value intangibles.
This chapter places the guidance on intangibles within the wider context of the
guidance on accurately delineating the transaction and the analysis of risks contained in the
first chapter of this Report relating to Guidance on Applying the Arms Length Principle,
which is relevant in dealing with the difference between anticipated and actual returns to
intangibles.
The framework for analysing risks contained in the chapter Guidance on Applying the
Arms Length Principle depends on a very specific and meaningful control requirement,
which takes into account both the capability to perform relevant decision-making functions
together with the actual performance of such functions. If an associated enterprise
contractually assuming a specific risk does not exercise control over that risk nor has
the financial capacity to assume the risk, then the framework contained in the chapter
Guidance on Applying the Arms Length Principle determines that the risk will be
allocated to another member of the MNE group that does exercise such control and has
the financial capacity to assume the risk. This control requirement is used in this chapter
64 I ntangibles
to determine which parties assume risks in relation to intangibles, but also for assessing
which member of the MNE group in fact controls the performance of outsourced functions
in relation to the development, enhancement, maintenance, protection and exploitation of
the intangible.
The guidance refers to the treatment of the return to funding contained in the chapter
Guidance on Applying the Arms Length Principle, and ensures that funding of the
development, enhancement, maintenance, protection or exploitation of an intangible by an
entity that does not perform any of the important functions in relation to the intangible and
does not exercise control over the financial risk will generate no more than a risk-free return.
In relation to arms length pricing when valuation is highly uncertain at the time of the
transaction, the guidance recognises that third parties may adopt different approaches for
taking account of uncertainties that are relevant for the value of an intangible, including to
conclude a contract based on contingent payments dependent on the actual results achieved.
The guidance also takes into account that, because of information asymmetries, it proves
difficult for a tax administration to evaluate the reliability of the information on which the
taxpayer priced the transaction, especially in relation to intangibles with a highly uncertain
value at the time of the transfer. To address these challenges, an approach to pricing hardto-value intangibles has been developed which allows the taxpayer to demonstrate that
its pricing is based on a thorough transfer pricing analysis and leads to an arms length
outcome, while the approach at the same time protects the tax administrations from the
negative effects of information asymmetry. It does so by ensuring that tax administrations
can consider ex post outcomes as presumptive evidence about the appropriateness of the ex
ante pricing arrangements, and the taxpayer cannot demonstrate that the uncertainty has
been appropriately taken into account in the pricing methodology adopted. Guidance on the
implementation of this approach will be provided during 2016, and the practical application
of the exemptions, including the measurement of materiality and time periods contained in
the current exemptions, will be reviewed by 2020 in the light of further experience.
In summary, the guidance contained in this chapter ensures that:
Legal ownership of intangibles by an associated enterprise alone does not determine
entitlement to returns from the exploitation of intangibles;
Associated enterprises performing important value-creating functions related to
the development, maintenance, enhancement, protection and exploitation of the
intangibles can expect appropriate remuneration;
An associated enterprise assuming risk in relation to the development, maintenance,
enhancement, protection and exploitation of the intangibles must exercise control
over the risks and have the financial capacity to assume the risks, in accordance
with the guidance on risks in SectionD.1.2 of the chapter Guidance on Applying
the Arms Length Principle, including the very specific and meaningful control
requirement;
Entitlement of any member of the MNE group to profit or loss relating to differences
between actual and expected profits will depend on which entity or entities
assume(s) the risks that caused these differences and whether the entity or entities
are performing the important functions in relation to the development, enhancement,
maintenance, protection or exploitation of the intangibles or contributing to the
control over the economically significant risks and it is determined that arms length
remuneration of these functions would include a profit sharing element;
I ntangibles 65
An associated enterprise providing funding and assuming the related financial

risks, but not performing any functions relating to the intangible, could generally
only expect a risk-adjusted return on its funding;
If the associated enterprise providing funding does not exercise control over the
financial risks associated with the funding, then it is entitled to no more than a
risk-free return;
The guidance on the situations in which valuation techniques can appropriately be
used is expanded;
A rigorous transfer pricing analysis by taxpayers is required to ensure that transfers
of hard-to-value intangibles are priced at arms length.
66 I ntangibles
The current provisions of ChapterVI of the Transfer Pricing Guidelines are deleted
in their entirety and are replaced by the following language.
6.1 Under Article9 of the OECD Model Tax Convention, where the conditions made or
imposed in the use or transfer of intangibles between two associated enterprises differ from
those that would be made between independent enterprises, then any profits that would,
but for those conditions, have accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the profits of that enterprise and taxed
accordingly.
6.2 The purpose of this ChapterVI is to provide guidance specially tailored to
determining arms length conditions for transactions that involve the use or transfer of
intangibles. Article9 of the OECD Model Tax Convention is concerned with the conditions
of transactions between associated enterprises, not with assigning particular labels to
such transactions. Consequently, the key consideration is whether a transaction conveys
economic value from one associated enterprise to another, whether that benefit derives
from tangible property, intangibles, services or other items or activities. An item or
activity can convey economic value notwithstanding the fact that it may not be specifically
addressed in ChapterVI. To the extent that an item or activity conveys economic value, it
should be taken into account in the determination of arms length prices whether or not it
constitutes an intangible within the meaning of paragraph6.6.
6.3 The principles of ChaptersIIII of these Guidelines apply equally to transactions
involving intangibles and those transactions which do not. Under those principles, as is the
case with other transfer pricing matters, the analysis of cases involving the use or transfer
of intangibles should begin with a thorough identification of the commercial or financial
relations between the associated enterprises and the conditions and economically relevant
circumstances attaching to those relations in order that the actual transaction involving
the use or transfer of intangibles is accurately delineated. The functional analysis should
identify the functions performed, assets used, and risks assumed13 by each relevant member
of the MNE group. In cases involving the use or transfer of intangibles, it is especially
important to ground the functional analysis on an understanding of the MNEs global
business and the manner in which intangibles are used by the MNE to add or create value
across the entire supply chain. Where necessary, the analysis should consider, within the
framework of SectionD.2 of ChapterI, whether independent parties would have entered
into the arrangement and if so, the conditions that would have been agreed.
6.4 In order to determine arms length conditions for the use or transfer of intangibles
it is important to perform a functional and comparability analysis in accordance with
SectionD.1 of ChapterI, based on identifying the intangibles and associated risks in
contractual arrangements and then supplementing the analysis through examination of
the actual conduct of the parties based on the functions performed, assets used, and risks
assumed, including control of important functions and economically significant risks.
Accordingly the next section, SectionA, provides guidance on identifying intangibles.
SectionB examines legal ownership and other contractual terms, together with guidance
on the evaluation of the conduct of the parties based on functions, assets and risks.
SectionC outlines some typical scenarios involving intangibles, and SectionD provides
guidance on determining arms length conditions including the application of pricing
methods and valuation techniques, and provides an approach to determining arms length
conditions for a specific category of hard-to-value intangibles. Examples illustrating the
guidance are contained in the annex to this chapter.
I ntangibles 67
A.
Identifying intangibles
A.1. In general
6.5 Difficulties can arise in a transfer pricing analysis as a result of definitions of the
term intangible that are either too narrow or too broad. If an overly narrow definition of
the term intangible is applied, either taxpayers or governments may argue that certain
items fall outside the definition and may therefore be transferred or used without separate
compensation, even though such use or transfer would give rise to compensation in
transactions between independent enterprises. If too broad a definition is applied, either
taxpayers or governments may argue that the use or transfer of an item in transactions
between associated enterprises should require compensation in circumstances where no
such compensation would be provided in transactions between independent enterprises.
6.6 In these Guidelines, therefore, the word intangible is intended to address something
which is not a physical asset or a financial asset,14 which is capable of being owned or
controlled for use in commercial activities, and whose use or transfer would be compensated
had it occurred in a transaction between independent parties in comparable circumstances.
Rather than focusing on accounting or legal definitions, the thrust of a transfer pricing
analysis in a case involving intangibles should be the determination of the conditions that
would be agreed upon between independent parties for a comparable transaction.
6.7
Intangibles that are important to consider for transfer pricing purposes are not always
recognised as intangible assets for accounting purposes. For example, costs associated with
developing intangibles internally through expenditures such as research and development
and advertising are sometimes expensed rather than capitalised for accounting purposes
and the intangibles resulting from such expenditures therefore are not always reflected
on the balance sheet. Such intangibles may nevertheless be used to generate significant
economic value and may need to be considered for transfer pricing purposes. Furthermore,
the enhancement to value that may arise from the complementary nature of a collection of
intangibles when exploited together is not always reflected on the balance sheet. Accordingly,
whether an item should be considered to be an intangible for transfer pricing purposes under
Article9 of the OECD Model Tax Convention can be informed by its characterisation for
accounting purposes, but will not be determined by such characterisation only. Furthermore,
the determination that an item should be regarded as an intangible for transfer pricing
purposes does not determine or follow from its characterisation for general tax purposes, as,
for example, an expense or an amortisable asset.
6.8 The availability and extent of legal, contractual, or other forms of protection may
affect the value of an item and the returns that should be attributed to it. The existence of
such protection is not, however, a necessary condition for an item to be characterised as an
intangible for transfer pricing purposes. Similarly, while some intangibles may be identified
separately and transferred on a segregated basis, other intangibles may be transferred only in
combination with other business assets. Therefore, separate transferability is not a necessary
condition for an item to be characterised as an intangible for transfer pricing purposes.
6.9 It is important to distinguish intangibles from market conditions or local market
circumstances. Features of a local market, such as the level of disposable income of
households in that market or the size or relative competitiveness of the market are not
capable of being owned or controlled. While in some circumstances they may affect the
determination of an arms length price for a particular transaction and should be taken
into account in a comparability analysis, they are not intangibles for the purposes of
ChapterVI. See SectionD.6 of ChapterI.
68 I ntangibles
6.10 The identification of an item as an intangible is separate and distinct from the process
for determining the price for the use or transfer of the item under the facts and circumstances
of a given case. Depending on the industry sector and other facts specific to a particular case,
exploitation of intangibles can account for either a large or small part of the MNEs value
creation. It should be emphasised that not all intangibles deserve compensation separate from
the required payment for goods or services in all circumstances, and not all intangibles give
rise to premium returns in all circumstances. For example, consider a situation in which an
enterprise performs a service using non-unique know-how, where other comparable service
providers have comparable know-how. In that case, even though know-how constitutes an
intangible, it may be determined under the facts and circumstances that the know-how does
not justify allocating a premium return to the enterprise, over and above normal returns
earned by comparable independent providers of similar services that use comparable nonunique know-how. See SectionD.1.3 of ChapterI. See also paragraph6.17 for a definition of
unique intangibles.
6.11 Care should be taken in determining whether or when an intangible exists and whether
an intangible has been used or transferred. For example, not all research and development
expenditures produce or enhance an intangible, and not all marketing activities result in the
creation or enhancement of an intangible.
6.12 In a transfer pricing analysis of a matter involving intangibles, it is important to
identify the relevant intangibles with specificity. The functional analysis should identify
the relevant intangibles at issue, the manner in which they contribute to the creation of
value in the transactions under review, the important functions performed and specific
risks assumed in connection with the development, enhancement, maintenance, protection
and exploitation of the intangibles and the manner in which they interact with other
intangibles, with tangible assets and with business operations to create value. While it
may be appropriate to aggregate intangibles for the purpose of determining arms length
conditions for the use or transfer of the intangibles in certain cases, it is not sufficient to
suggest that vaguely specified or undifferentiated intangibles have an effect on arms length
prices or other conditions. A thorough functional analysis, including an analysis of the
importance of identified relevant intangibles in the MNEs global business, should support
the determination of arms length conditions.
A.2. Relevance of this chapter for other tax purposes

6.13 The guidance contained in this chapter is intended to address transfer pricing
matters exclusively. It is not intended to have relevance for other tax purposes. For
example, the Commentary on Article12 of the OECD Model Tax Convention contains
a detailed discussion of the definition of royalties under that Article (paragraphs8 to
19). The Article12 definition of royalties is not intended to provide any guidance on
whether, and if so at what price, the use or transfer of intangibles would be remunerated
between independent parties. It is therefore not relevant for transfer pricing purposes.
Moreover, the manner in which a transaction is characterised for transfer pricing purposes
has no relevance to the question of whether a particular payment constitutes a royalty
or may be subjected to withholding tax under Article12. The concept of intangibles for
transfer pricing purposes and the definition of royalties for purposes of Article12 of the
OECD Model Tax Convention are two different notions that do not need to be aligned. It
may occur that a payment made between associated enterprises may be regarded as not
constituting a royalty for purposes of Article12, and nevertheless be treated for transfer
pricing purposes as a payment to which the principles of this chapter may apply. Examples
could include certain payments related to goodwill or ongoing concern value. It may also
I ntangibles 69
occur that a payment properly treated as a royalty under Article12 of a relevant Treaty may
not be made in remuneration for intangibles for purposes of this chapter. Examples could
include certain payments for technical services. Similarly, the guidance in this chapter is
not intended to have relevance for customs purposes.
6.14 The guidance in this chapter is also not relevant to recognition of income, capitalisation
of intangible development costs, amortisation, or similar matters. Thus, for example, a country
may choose not to impose tax on the transfer of particular types of intangibles under specified
circumstances. Similarly, a country may not permit amortisation of the cost of certain acquired
items that would be considered intangibles under the definitions in this chapter and whose
transfer may be subjected to tax at the time of the transfer in the transferors country. It is
recognised that inconsistencies between individual country laws regarding such matters can
sometimes give rise to either double taxation or double non-taxation.
A.3. Categories of intangibles

6.15 In discussions of transfer pricing issues related to intangibles, it is sometimes the
case that various categories of intangibles are described and labels applied. Distinctions
are sometimes made between trade intangibles and marketing intangibles, between soft
intangibles and hard intangibles, between routine and non-routine intangibles, and
between other classes and categories of intangibles. The approach contained in this chapter
for determining arms length prices in cases involving intangibles does not turn on these
categorisations. Accordingly, no attempt is made in these Guidelines to delineate with
precision various classes or categories of intangibles or to prescribe outcomes that turn on
such categories.
6.16 Certain categories of intangibles are, however, commonly referred to in discussions
of transfer pricing matters. To facilitate discussions, definitions of two such commonly used
terms, marketing intangibles and trade intangibles are contained in the Glossary and
referred to from time to time in the discussion in these Guidelines. It should be emphasised
that generic references to marketing or trade intangibles do not relieve taxpayers or tax
administrations from their obligation in a transfer pricing analysis to identify relevant
intangibles with specificity, nor does the use of those terms suggest that a different approach
should be applied in determining arms length conditions for transactions that involve either
marketing intangibles or trade intangibles.
The Glossary of these Guidelines is amended by deleting the definition of the term
marketing intangible and replacing that definition with the following language:
Marketing intangible
An intangible (within the meaning of paragraph6.6) that relates to marketing activities,
aids in the commercial exploitation of a product or service, and/or has an important
promotional value for the product concerned. Depending on the context, marketing
intangibles may include, for example, trademarks, trade names, customer lists, customer
relationships, and proprietary market and customer data that is used or aids in marketing
and selling goods or services to customers.
70 I ntangibles
6.17 In certain instances these Guidelines refer to unique and valuable intangibles. Unique
and valuable intangibles are those intangibles (i)that are not comparable to intangibles used
by or available to parties to potentially comparable transactions, and (ii)whose use in business
operations (e.g.manufacturing, provision of services, marketing, sales or administration) is
expected to yield greater future economic benefits than would be expected in the absence of the
intangible.
A.4. Illustrations
6.18 This section provides illustrations of items often considered in transfer pricing
analyses involving intangibles. The illustrations are intended to clarify the provisions of
SectionA.1., but this listing should not be used as a substitute for a detailed analysis. The
illustrations are not intended to be comprehensive or to provide a complete listing of items
that may or may not constitute intangibles. Numerous items not included in this listing
of illustrations may be intangibles for transfer pricing purposes. The illustrations in this
section should be adapted to the specific legal and regulatory environment that prevails
in each country. Furthermore, the illustrations in this section should be considered and
evaluated in the context of the comparability analysis (including the functional analysis)
of the controlled transaction with the objective of better understanding how specific
intangibles and items not treated as intangibles contribute to the creation of value in the
context of the MNEs global business. It should be emphasised that a generic reference to
an item included in the list of illustrations does not relieve taxpayers or tax administrations
from their obligation in a transfer pricing analysis to identify relevant intangibles with
specificity based on the guidance of SectionA.1.
A.4.1. Patents
6.19 A patent is a legal instrument that grants an exclusive right to its owner to use a
given invention for a limited period of time within a specific geography. A patent may
relate to a physical object or to a process. Patentable inventions are often developed through
risky and costly research and development activities. In some circumstances, however,
small research and development expenditures can lead to highly valuable patentable
inventions. The developer of a patent may try to recover its development costs (and earn
a return) through the sale of products covered by the patent, by licensing others to use the
patented invention, or by an outright sale of the patent. The exclusivity granted by a patent
may, under some circumstances, allow the patent owner to earn premium returns from the
use of its invention. In other cases, a patented invention may provide cost advantages to
the owner that are not available to competitors. In still other situations, patents may not
provide a significant commercial advantage. Patents are intangibles within the meaning of
SectionA.1.
A.4.2. Know-how and trade secrets

6.20 Know-how and trade secrets are proprietary information or knowledge that assist
or improve a commercial activity, but that are not registered for protection in the manner
of a patent or trademark. Know-how and trade secrets generally consist of undisclosed
information of an industrial, commercial or scientific nature arising from previous
experience, which has practical application in the operation of an enterprise. Know-how
and trade secrets may relate to manufacturing, marketing, research and development, or
any other commercial activity. The value of know-how and trade secrets is often dependent
on the ability of the enterprise to preserve the confidentiality of the know-how or trade
I ntangibles 71
secret. In certain industries the disclosure of information necessary to obtain patent

protection could assist competitors in developing alternative solutions. Accordingly, an
enterprise may, for sound business reasons, choose not to register patentable know-how,
which may nonetheless contribute substantially to the success of the enterprise. The
confidential nature of know-how and trade secrets may be protected to some degree by
(i)unfair competition or similar laws, (ii)employment contracts, and (iii)economic and
technological barriers to competition. Know-how and trade secrets are intangibles within
the meaning of SectionA.1.
A.4.3. Trademarks, trade names and brands

6.21 A trademark is a unique name, symbol, logo or picture that the owner may use
to distinguish its products and services from those of other entities. Proprietary rights in
trademarks are often confirmed through a registration system. The registered owner of
a trademark may exclude others from using the trademark in a manner that would create
confusion in the marketplace. A trademark registration may continue indefinitely if the
trademark is continuously used and the registration appropriately renewed. Trademarks
may be established for goods or services, and may apply to a single product or service, or
to a line of products or services. Trademarks are perhaps most familiar at the consumer
market level, but they are likely to be encountered at all market levels. Trademarks are
intangibles within the meaning of SectionA.1.
6.22 A trade name (often but not always the name of an enterprise) may have the same
force of market penetration as a trademark and may indeed be registered in some specific
form as a trademark. The trade names of certain MNEs may be readily recognised, and
may be used in marketing a variety of goods and services. Trade names are intangibles
within the meaning of SectionA.1.
6.23 The term brand is sometimes used interchangeably with the terms trademark and
trade name. In other contexts a brand is thought of as a trademark or trade name imbued
with social and commercial significance. A brand may, in fact, represent a combination of
intangibles and/or other items, including among others, trademarks, trade names, customer
relationships, reputational characteristics, and goodwill. It may sometimes be difficult or
impossible to segregate or separately transfer the various items contributing to brand value.
A brand may consist of a single intangible, or a collection of intangibles, within the meaning
of SectionA.1.
A.4.4. Rights under contracts and government licences

6.24 Government licences and concessions may be important to a particular business
and can cover a wide range of business relationships. They may include, among others,
a government grant of rights to exploit specific natural resources or public goods (e.g.a
licence of bandwidth spectrum), or to carry on a specific business activity. Government
licences and concessions are intangibles within the meaning of SectionA.1. However,
government licences and concessions should be distinguished from company registration
obligations that are preconditions for doing business in a particular jurisdiction. Such
obligations are not intangibles within the meaning of SectionA.1.
6.25 Rights under contracts may also be important to a particular business and can cover
a wide range of business relationships. They may include, among others, contracts with
suppliers and key customers, and agreements to make available the services of one or more
employees. Rights under contracts are intangibles within the meaning of SectionA.1.
72 I ntangibles
A.4.5. Licences and similar limited rights in intangibles

6.26 Limited rights in intangibles are commonly transferred by means of a licence or
other similar contractual arrangement, whether written, oral or implied. Such licensed
rights may be limited as to field of use, term of use, geography or in other ways. Such
limited rights in intangibles are themselves intangibles within the meaning of SectionA.1.
A.4.6. Goodwill and ongoing concern value

6.27 Depending on the context, the term goodwill can be used to refer to a number of
different concepts. In some accounting and business valuation contexts, goodwill reflects
the difference between the aggregate value of an operating business and the sum of the
values of all separately identifiable tangible and intangible assets. Alternatively, goodwill
is sometimes described as a representation of the future economic benefits associated
with business assets that are not individually identified and separately recognised. In
still other contexts goodwill is referred to as the expectation of future trade from existing
customers. The term ongoing concern value is sometimes referred to as the value of the
assembled assets of an operating business over and above the sum of the separate values
of the individual assets. It is generally recognised that goodwill and ongoing concern
value cannot be segregated or transferred separately from other business assets. See
paragraphs9.93 to 9.95 for a discussion of the related notion of a transfer of all of the
elements of an ongoing concern in connection with a business restructuring.
6.28 It is not necessary for purposes of this chapter to establish a precise definition of
goodwill or ongoing concern value for transfer pricing purposes or to define when goodwill
or ongoing concern value may or may not constitute an intangible. It is important to
recognise, however, that an important and monetarily significant part of the compensation
paid between independent enterprises when some or all of the assets of an operating
business are transferred may represent compensation for something referred to in one or
another of the alternative descriptions of goodwill or ongoing concern value. When similar
transactions occur between associated enterprises, such value should be taken into account
in determining an arms length price for the transaction. When the reputational value
sometimes referred to by the term goodwill is transferred to or shared with an associated
enterprise in connection with a transfer or licence of a trademark or other intangible that
reputational value should be taken into account in determining appropriate compensation.
If features of a business such as a reputation for producing high quality products or
providing high quality service allow that business to charge higher prices for goods or
services than an entity lacking such reputation, and such features might be characterised
as goodwill or ongoing concern value under one or another definition of such terms,
such features should be taken into account in establishing arms length prices for sales of
goods or the provision of services between associated enterprises whether or not they are
characterised as goodwill. In other words, labelling a contribution of value from one party
to another as goodwill or ongoing concern value does not render such contribution noncompensable. See paragraph6.2.
6.29 The requirement that goodwill and ongoing concern value be taken into account
in pricing transactions in no way implies that the residual measures of goodwill derived
for some specific accounting or business valuation purposes are necessarily appropriate
measures of the price that would be paid for the transferred business or licence rights,
together with their associated goodwill and ongoing concern value, by independent
parties. Accounting and business valuation measures of goodwill and ongoing concern
value do not, as a general rule, correspond to the arms length price of transferred
I ntangibles 73
goodwill or ongoing concern value in a transfer pricing analysis. Depending on the facts
and circumstances, however, accounting valuations and the information supporting such
valuations can provide a useful starting point in conducting a transfer pricing analysis.
The absence of a single precise definition of goodwill makes it essential for taxpayers
and tax administrations to describe specifically relevant intangibles in connection with a
transfer pricing analysis, and to consider whether independent enterprises would provide
compensation for such intangibles in comparable circumstances.
A.4.7. Group synergies

6.30 In some circumstances group synergies contribute to the level of income earned by
an MNE group. Such group synergies can take many different forms including streamlined
management, elimination of costly duplication of effort, integrated systems, purchasing
or borrowing power, etc. Such features may have an effect on the determination of arms
length conditions for controlled transactions and should be addressed for transfer pricing
purposes as comparability factors. As they are not owned or controlled by an enterprise,
they are not intangibles within the meaning of SectionA.1. See SectionD.8 of ChapterI
for a discussion of the transfer pricing treatment of group synergies.
A.4.8. Market specific characteristics

6.31 Specific characteristics of a given market may affect the arms length conditions
of transactions in that market. For example, the high purchasing power of households in a
particular market may affect the prices paid for certain luxury consumer goods. Similarly,
low prevailing labour costs, proximity to markets, favourable weather conditions and the
like may affect the prices paid for specific goods and services in a particular market. Such
market specific characteristics are not capable, however, of being owned or controlled,
and are therefore not intangibles within the meaning of SectionA.1., and should be taken
into account in a transfer pricing analysis through the required comparability analysis. See
SectionD.6 of ChapterI for guidance regarding the transfer pricing treatment of market
specific characteristics.
B.
Ownership of intangibles and transactions involving the development,

enhancement, maintenance, protection and exploitation of intangibles
6.32 In transfer pricing cases involving intangibles, the determination of the entity or
entities within an MNE group which are ultimately entitled to share in the returns derived
by the group from exploiting intangibles is crucial.15 A related issue is which entity or
entities within the group should ultimately bear the costs, investments and other burdens
associated with the development, enhancement, maintenance, protection and exploitation
of intangibles. Although the legal owner of an intangible may receive the proceeds from
exploitation of the intangible, other members of the legal owners MNE group may have
performed functions, used assets,16 or assumed risks that are expected to contribute to the
value of the intangible. Members of the MNE group performing such functions, using such
assets, and assuming such risks must be compensated for their contributions under the
arms length principle. This SectionB confirms that the ultimate allocation of the returns
derived by the MNE group from the exploitation of intangibles, and the ultimate allocation
of costs and other burdens related to intangibles among members of the MNE group, is
accomplished by compensating members of the MNE group for functions performed,
74 I ntangibles
assets used, and risks assumed in the development, enhancement, maintenance, protection
and exploitation of intangibles according to the principles described in ChaptersIIII.
6.33 Applying the provisions of ChaptersIIII to address these questions can be highly
challenging for a number of reasons. Depending on the facts of any given case involving
intangibles the following factors, among others, can create challenges:
i) A lack of comparability between the intangible related transactions undertaken
between associated enterprises and those transactions that can be identified between
independent enterprises;
ii) A lack of comparability between the intangibles in question;
iii) The ownership and/or use of different intangibles by different associated enterprises
within the MNE group;
iv) The difficulty of isolating the impact of any particular intangible on the MNE
groups income;
v) The fact that various members of an MNE group may perform activities relating
to the development, enhancement, maintenance, protection and exploitation of
an intangible, often in a way and with a level of integration that is not observed
between independent enterprises;
vi) The fact that contributions of various members of the MNE group to intangible
value may take place in years different than the years in which any associated
returns are realised; and
vii) The fact that taxpayer structures may be based on contractual terms between
associated enterprises that separate ownership, the assumption of risk, and/or
funding of investments in intangibles from performance of important functions,
control over risk, and decisions related to investment in ways that are not observed
in transactions between independent enterprises and that may contribute to base
erosion and profit shifting.
Notwithstanding these potential challenges, applying the arms length principle and the
provisions of ChaptersIIII within an established framework can, in most cases, yield an
appropriate allocation of the returns derived by the MNE group from the exploitation of
intangibles.
6.34 The framework for analysing transactions involving intangibles between associated
enterprises requires taking the following steps, consistent with the guidance for identifying
the commercial or financial relations provided in SectionD.1 of ChapterI:
i) Identify the intangibles used or transferred in the transaction with specificity
and the specific, economically significant risks associated with the development,
enhancement, maintenance, protection, and exploitation of the intangibles;
ii) Identify the full contractual arrangements, with special emphasis on determining legal
ownership of intangibles based on the terms and conditions of legal arrangements,
including relevant registrations, licence agreements, other relevant contracts, and
other indicia of legal ownership, and the contractual rights and obligations, including
contractual assumption of risks in the relations between the associated enterprises;
iii) Identify the parties performing functions (including specifically the important
functions described in paragraph6.56), using assets, and managing risks related
to developing, enhancing, maintaining, protecting, and exploiting the intangibles
I ntangibles 75
by means of the functional analysis, and in particular which parties control any
outsourced functions, and control specific, economically significant risks;
iv) Confirm the consistency between the terms of the relevant contractual arrangements
and the conduct of the parties, and determine whether the party assuming
economically significant risks under step4 (i) of paragraph1.60, controls the risks
and has the financial capacity to assume the risks relating to the development,
enhancement, maintenance, protection, and exploitation of the intangibles;
v) Delineate the actual controlled transactions related to the development, enhancement,
maintenance, protection, and exploitation of intangibles in light of the legal
ownership of the intangibles, the other relevant contractual relations under relevant
registrations and contracts, and the conduct of the parties, including their relevant
contributions of functions, assets and risks, taking into account the framework for
analysing and allocating risk under SectionD.1.2.1 of ChapterI;
vi) Where possible, determine arms length prices for these transactions consistent
with each partys contributions of functions performed, assets used, and risks
assumed, unless the guidance in SectionD.2 of ChapterI applies.
B.1. Intangible ownership and contractual terms relating to intangibles

6.35 Legal rights and contractual arrangements form the starting point for any transfer
pricing analysis of transactions involving intangibles. The terms of a transaction may be
found in written contracts, public records such as patent or trademark registrations, or in
correspondence and/or other communications among the parties. Contracts may describe
the roles, responsibilities and rights of associated enterprises with respect to intangibles.
They may describe which entity or entities provide funding, undertake research and
development, maintain and protect intangibles, and perform functions necessary to exploit
the intangibles, such as manufacturing, marketing and distribution. They may describe
how receipts and expenses of the MNE associated with intangibles are to be allocated
and may specify the form and amount of payment to all members of the group for their
contributions. The prices and other conditions contained in such contracts may or may not
be consistent with the arms length principle.
6.36 Where no written terms exist, or where the facts of the case, including the conduct
of the parties, differ from the written terms of any agreement between them or supplement
these written terms, the actual transaction must be deduced from the facts as established,
including the conduct of the parties (see SectionD.1.1 of ChapterI). It is, therefore, good
practice for associated enterprises to document their decisions and intentions regarding
the allocation of significant rights in intangibles. Documentation of such decisions and
intentions, including written agreements, should generally be in place at or before the
time that associated enterprises enter into transactions leading to the development,
enhancement, maintenance, protection, or exploitation of intangibles.
6.37 The right to use some types of intangibles may be protected under specific intellectual
property laws and registration systems. Patents, trademarks and copyrights are examples of
such intangibles. Generally, the registered legal owner of such intangibles has the exclusive
legal and commercial right to use the intangible, as well as the right to prevent others from
using or otherwise infringing the intangible. These rights may be granted for a specific
geographic area and/or for a specific period of time.
6.38 There are also intangibles that are not protectable under specific intellectual
property registration systems, but that are protected against unauthorised appropriation
76 I ntangibles
or imitation under unfair competition legislation or other enforceable laws, or by contract.
Trade dress, trade secrets, and know-how may fall under this category of intangibles.
6.39 The extent and nature of the available protection under applicable law may vary
from country to country, as may the conditions on which such protection is provided. Such
differences can arise either from differences in substantive intellectual property law between
countries, or from practical differences in local enforcement of such laws. For example, the
availability of legal protection for some intangibles may be subject to conditions such as
continued commercial use of the intangible or timely renewal of registrations. This means
that in some circumstances or jurisdictions, the degree of protection for an intangible may
be extremely limited either legally or in practice.
6.40 The legal owner will be considered to be the owner of the intangible for transfer
pricing purposes. If no legal owner of the intangible is identified under applicable law
or governing contracts, then the member of the MNE group that, based on the facts and
circumstances, controls decisions concerning the exploitation of the intangible and has the
practical capacity to restrict others from using the intangible will be considered the legal
owner of the intangible for transfer pricing purposes.
6.41 In identifying the legal owner of intangibles, an intangible and any licence relating to
that intangible are considered to be different intangibles for transfer pricing purposes, each
having a different owner. See paragraph6.26. For example, CompanyA, the legal owner of a
trademark, may provide an exclusive licence to CompanyB to manufacture, market, and sell
goods using the trademark. One intangible, the trademark, is legally owned by CompanyA.
Another intangible, the licence to use the trademark in connection with manufacturing,
marketing and distribution of trademarked products, is legally owned by CompanyB.
Depending on the facts and circumstances, marketing activities undertaken by CompanyB
pursuant to its licence may potentially affect the value of the underlying intangible legally
owned by CompanyA, the value of CompanyBs licence, or both.
6.42 While determining legal ownership and contractual arrangements is an important
first step in the analysis, these determinations are separate and distinct from the question
of remuneration under the arms length principle. For transfer pricing purposes, legal
ownership of intangibles, by itself, does not confer any right ultimately to retain returns
derived by the MNE group from exploiting the intangible, even though such returns may
initially accrue to the legal owner as a result of its legal or contractual right to exploit
the intangible. The return ultimately retained by or attributed to the legal owner depends
upon the functions it performs, the assets it uses, and the risks it assumes, and upon the
contributions made by other MNE group members through their functions performed,
assets used, and risks assumed. For example, in the case of an internally developed
intangible, if the legal owner performs no relevant functions, uses no relevant assets, and
assumes no relevant risks, but acts solely as a title holding entity, the legal owner will not
ultimately be entitled to any portion of the return derived by the MNE group from the
exploitation of the intangible other than arms length compensation, if any, for holding title.
6.43 Legal ownership and contractual relationships serve simply as reference points
for identifying and analysing controlled transactions relating to the intangible and for
determining the appropriate remuneration to members of a controlled group with respect
to those transactions. Identification of legal ownership, combined with the identification
and compensation of relevant functions performed, assets used, and risks assumed by all
contributing members, provides the analytical framework for identifying arms length
prices and other conditions for transactions involving intangibles. As with any other type of
transaction, the analysis must take into account all of the relevant facts and circumstances
I ntangibles 77
present in a particular case and price determinations must reflect the realistic alternatives of
the relevant group members. The principles of this paragraph are illustrated by Examples1
to 6 in the annex to ChapterVI.
6.44 Because the actual outcomes and manner in which risks associated with the
development or acquisition of an intangible will play out over time are not known with
certainty at the time members of the MNE group make decisions regarding intangibles, it
is important to distinguish between (a)anticipated (or ex ante) remuneration, which refers
to the future income expected to be derived by a member of the MNE group at the time of
a transaction; and (b)actual (or ex post) remuneration, which refers to the income actually
earned by a member of the group through the exploitation of the intangible.
6.45 The terms of the compensation that must be paid to members of the MNE group that
contribute to the development, enhancement, maintenance, protection and exploitation of
intangibles is generally determined on an ex ante basis. That is, it is determined at the time
transactions are entered into and before risks associated with the intangible play out. The
form of such compensation may be fixed or contingent. The actual (ex post) profit or loss
of the business after compensating other members of the MNE group may differ from these
anticipated profits depending on how the risks associated with the intangible or the other
relevant risks related to the transaction or arrangement actually play out. The accurately
delineated transaction, as determined under SectionD.1 of ChapterI, will determine which
associated entity assumes such risks and accordingly will bear the consequences (costs or
additional returns) when the risks materialise in a different manner to what was anticipated
(see paragraphsSectionB.2.4).
6.46 An important question is how to determine the appropriate arms length remuneration
to members of a group for their functions, assets, and risks within the framework established
by the taxpayers contractual arrangements, the legal ownership of intangibles, and the
conduct of the parties. SectionB.2 discusses the application of the arms length principle to
situations involving intangibles. It focuses on the functions, assets and risks related to the
intangibles. Unless stated otherwise, references to arms length returns and arms length
remuneration in SectionB.2 refer to anticipated (ex ante) returns and remuneration.
B.2. Functions, assets, and risks related to intangibles

6.47 As stated above, a determination that a particular group member is the legal owner
of intangibles does not, in and of itself, necessarily imply that the legal owner is entitled
to any income generated by the business after compensating other members of the MNE
group for their contributions in the form of functions performed, assets used, and risks
assumed.
6.48 In identifying arms length prices for transactions among associated enterprises,
the contributions of members of the group related to the creation of intangible value should
be considered and appropriately rewarded. The arms length principle and the principles
of ChaptersIIII require that all members of the group receive appropriate compensation
for any functions they perform, assets they use, and risks they assume in connection with
the development, enhancement, maintenance, protection, and exploitation of intangibles.
It is therefore necessary to determine, by means of a functional analysis, which member(s)
perform and exercise control over development, enhancement, maintenance, protection,
and exploitation functions, which member(s) provide funding and other assets, and
which member(s) assume the various risks associated with the intangible. Of course, in
each of these areas, this may or may not be the legal owner of the intangible. As noted in
paragraph6.133, it is also important in determining arms length compensation for functions
78 I ntangibles
performed, assets used, and risks assumed to consider comparability factors that may
contribute to the creation of value or the generation of returns derived by the MNE group
from the exploitation of intangibles in determining prices for relevant transactions.
6.49 The relative importance of contributions to the creation of intangible value by
members of the group in the form of functions performed, assets used and risks assumed
will vary depending on the circumstances. For example, assume that a fully developed and
currently exploitable intangible is purchased from a third party by a member of a group
and exploited through manufacturing and distribution functions performed by other group
members while being actively managed and controlled by the entity purchasing the intangible.
It is assumed that this intangible would require no development, may require little or no
maintenance or protection, and may have limited usefulness outside the area of exploitation
intended at the time of the acquisition. There would be no development risk associated
with the intangible, although there are risks associated with acquiring and exploiting the
intangible. The key functions performed by the purchaser are those necessary to select the
most appropriate intangible on the market, to analyse its potential benefits if used by the
MNE group, and the decision to take on the risk-bearing opportunity through purchasing
the intangible. The key asset used is the funding required to purchase the intangible. If the
purchaser has the capacity and actually performs all the key functions described, including
control of the risks associated with acquiring and exploiting the intangible, it may be
reasonable to conclude that, after making arms length payment for the manufacturing and
distribution functions of other associated enterprises, the owner would be entitled to retain
or have attributed to it any income or loss derived from the post-acquisition exploitation of
the intangible. While the application of ChaptersIIII may be fairly straightforward in such
a simple fact pattern, the analysis may be more difficult in situations in which:
i) Intangibles are self-developed by a multinational group, especially when such
intangibles are transferred between associated enterprises while still under
development;
ii) Acquired or self-developed intangibles serve as a platform for further development;
or
iii) Other aspects, such as marketing or manufacturing are particularly important to
value creation.
The generally applicable guidance below is particularly relevant for, and is primarily concerned
with, these more difficult cases.
B.2.1. Performance and Control of Functions

6.50 Under the principles of ChaptersIIII, each member of the MNE group should
receive arms length compensation for the functions it performs. In cases involving
intangibles, this includes functions related to the development, enhancement, maintenance,
protection, and exploitation of intangibles. The identity of the member or members of
the group performing functions related to the development, enhancement, maintenance,
protection, and exploitation of intangibles, therefore, is one of the key considerations in
determining arms length conditions for controlled transactions.
6.51 The need to ensure that all members of the MNE group are appropriately
compensated for the functions they perform, the assets they contribute and the risks they
assume implies that if the legal owner of intangibles is to be entitled ultimately to retain
all of the returns derived from exploitation of the intangibles it must perform all of the
functions, contribute all assets used and assume all risks related to the development,
I ntangibles 79
enhancement, maintenance, protection and exploitation of the intangible. This does not
imply, however, that the associated enterprises constituting an MNE group must structure
their operations regarding the development, enhancement, maintenance, protection or
exploitation of intangibles in any particular way. It is not essential that the legal owner
physically performs all of the functions related to the development, enhancement,
maintenance, protection and exploitation of an intangible through its own personnel in
order to be entitled ultimately to retain or be attributed a portion of the return derived by
the MNE group from exploitation of the intangibles. In transactions between independent
enterprises, certain functions are sometimes outsourced to other entities. A member of
an MNE group that is the legal owner of intangibles could similarly outsource functions
related to the development, enhancement, maintenance, protection or exploitation of
intangibles to either independent enterprises or associated enterprises.
6.52 Where associated enterprises other than the legal owner perform relevant functions
that are anticipated to contribute to the value of the intangibles, they should be compensated
on an arms length basis for the functions they perform under the principles set out in
ChaptersIIII. The determination of arms length compensation for functional contributions
should consider the availability of comparable uncontrolled transactions, the importance of
the functions performed to the creation of intangible value, and the realistically available
options of the parties. The specific considerations described in paragraphs6.53 to 6.58
should also be taken into account.
6.53 In outsourcing transactions between independent enterprises, it is usually the case
that an entity performing functions on behalf of the legal owner of the intangible that relate
to the development, enhancement, maintenance, protection, and exploitation of the intangible
will operate under the control of such legal owner (as discussed in paragraph1.65). Because
of the nature of the relationships between associated enterprises that are members of an
MNE group, however, it may be the case that outsourced functions performed by associated
enterprises will be controlled by an entity other than the legal owner of the intangibles. In
such cases, the legal owner of the intangible should also compensate the entity performing
control functions related to the development, enhancement, maintenance, protection, and
exploitation of intangibles on an arms length basis. In assessing what member of the MNE
group in fact controls the performance of the relevant functions, principles apply analogous
to those for determining control over risk in SectionD.1.2.1 of ChapterI. Assessing the
capacity of a particular entity to exert control and the actual performance of such control
functions will be an important part of the analysis.
6.54 If the legal owner neither controls nor performs the functions related to the
development, enhancement, maintenance, protection or exploitation of the intangible, the
legal owner would not be entitled to any ongoing benefit attributable to the outsourced
functions. Depending on the facts, the arms length compensation required to be provided by
the legal owner to other associated enterprises performing or controlling functions related
to the development, enhancement, maintenance, protection, or exploitation of intangibles
may comprise any share of the total return derived from exploitation of the intangibles. A
legal owner not performing any relevant function relating to the development, enhancement,
maintenance, protection or exploitation of the intangible will therefore not be entitled to any
portion of such returns related to the performance or control of functions relating to the
development, enhancement, maintenance, protection or exploitation of the intangible. It is
entitled to an arms length compensation for any functions it actually performs, any assets it
actually uses and risks it actually assumes. See SectionsB.2.2 to B.2.3. In determining the
functions it actually performs, assets it actually uses and the risks it actually assumes the
guidance in SectionD.1.2 of ChapterI is especially relevant.
80 I ntangibles
6.55 The relative value of contributions to development, enhancement, maintenance,
protection, and exploitation of intangibles varies depending on the particular facts of the
case. The MNE group member(s) making the more significant contributions in a particular
case should receive relatively greater remuneration. For example, a company that merely
funds research and development should have a lower anticipated return than if it both funds
and controls research and development. Other things being equal, a still higher anticipated
return should be provided if the entity funds, controls, and physically performs the research
and development. See also the discussion of funding in SectionB.2.2.
6.56 In considering the arms length compensation for functional contributions of various
members of the MNE group, certain important functions will have special significance.
The nature of these important functions in any specific case will depend on the facts and
circumstances. For self-developed intangibles, or for self-developed or acquired intangibles
that serve as a platform for further development activities, these more important functions may
include, among others, design and control of research and marketing programmes, direction of
and establishing priorities for creative undertakings including determining the course of bluesky research, control over strategic decisions regarding intangible development programmes,
and management and control of budgets. For any intangible (i.e.for either self-developed
or acquired intangibles) other important functions may also include important decisions
regarding defence and protection of intangibles, and ongoing quality control over functions
performed by independent or associated enterprises that may have a material effect on the
value of the intangible. Those important functions usually make a significant contribution
to intangible value and, if those important functions are outsourced by the legal owner in
transactions between associated enterprises, the performance of those functions should be
compensated with an appropriate share of the returns derived by the MNE group from the
exploitation of intangibles.
6.57 Because it may be difficult to find comparable transactions involving the outsourcing
of such important functions, it may be necessary to utilise transfer pricing methods not
directly based on comparables, including transactional profit split methods and ex ante
valuation techniques, to appropriately reward the performance of those important functions.
Where the legal owner outsources most or all of such important functions to other group
members, attribution to the legal owner of any material portion of the return derived
from the exploitation of the intangibles after compensating other group members for their
functions should be carefully considered taking into account the functions it actually
performs, the assets it actually uses and the risks it actually assumes under the guidance
in SectionD.1.2 of ChapterI. Examples16 and 17 in the annex to ChapterVI illustrate the
principles contained in this paragraph.
6.58 Because the important functions described in paragraph6.56 are often instrumental
in managing the different functions performed, assets used, and risks assumed that are key
to the successful development, enhancement, maintenance, protection, or exploitation of
intangibles, and are therefore essential to the creation of intangible value, it is necessary
to carefully evaluate transactions between parties performing these important functions
and other associated enterprises. In particular, the reliability of a one-sided transfer pricing
method will be substantially reduced if the party or parties performing significant portions
of the important functions are treated as the tested party or parties. See Example6.
I ntangibles 81
B.2.2. Use of Assets

6.59 Group members that use assets in the development, enhancement, maintenance,
protection, and exploitation of an intangible should receive appropriate compensation for doing
so. Such assets may include, without limitation, intangibles used in research, development
or marketing (e.g.know-how, customer relationships, etc.), physical assets, or funding.
One member of an MNE group may fund some or all of the development, enhancement,
maintenance, and protection of an intangible, while one or more other members perform all
of the relevant functions. When assessing the appropriate anticipated return to funding in
such circumstances, it should be recognised that in arms length transactions, a party that
provides funding, but does not control the risks or perform other functions associated with
the funded activity or asset, generally does not receive anticipated returns equivalent to those
received by an otherwise similarly-situated investor who also performs and controls important
functions and controls important risks associated with the funded activity. The nature and
amount of compensation attributable to an entity that bears intangible-related costs, without
more, must be determined on the basis of all the relevant facts, and should be consistent with
similar funding arrangements among independent entities where such arrangements can be
identified. See the guidance in ChapterI, SectionD.1.2.1.6, and in particular Example3 in
paragraphs1.85 and 1.103, which illustrate a situation where the party providing funding does
not control the financial risk associated with the funding.
6.60 Funding and risk-taking are integrally related in the sense that funding often
coincides with the taking of certain risks (e.g.the funding party contractually assuming
the risk of loss of its funds). The nature and extent of the risk assumed, however, will
vary depending on the economically relevant characteristics of the transaction. The risk
will, for example, be lower when the party to which the funding is provided has a high
creditworthiness, or when assets are pledged, or when the investment funded is low risk,
compared with the risk where the creditworthiness is lower, or the funding is unsecured,
or the investment being funded is high risk. Moreover, the larger the amount of the funds
provided, the larger the potential impact of the risk on the provider of the funding.
6.61 Under the principles of SectionD.1.2 of ChapterI, the first step in a transfer pricing
analysis in relation to risks is to identify the economically significant risks with specificity.
When identifying risks in relation to an investment with specificity, it is important to
distinguish between the financial risks that are linked to the funding provided for the
investments and the operational risks that are linked to the operational activities for which
the funding is used, such as for example the development risk when the funding is used
for developing a new intangible. Where a party providing funding exercises control over
the financial risk associated with the provision of funding, without the assumption of,
including the control over, any other specific risk, it could generally only expect a riskadjusted return on its funding.
6.62 The contractual arrangements will generally determine the terms of the funding
transaction, as clarified or supplemented by the economic characteristics of the transaction
as reflected in the conduct of the parties.17 The return that would generally be expected by
the funder should equal an appropriate risk-adjusted return. Such return can be determined,
for example, based on the cost of capital or the return of a realistic alternative investment
with comparable economic characteristics. In determining an appropriate return for the
funding activities, it is important to consider the financing options realistically available
to the party receiving the funds. There may be a difference between the return expected
by the funder on an ex ante basis and the actual return received on an ex post basis. For
example, when the funder provides a loan for a fixed amount at a fixed interest rate, the
82 I ntangibles
difference between the actual and expected returns will reflect the risk playing out that the
borrower cannot make some or all of the payments due.
6.63 The extent and form of the activities that will be necessary to exercise control
over the financial risk attached to the provision of funding will depend on the riskiness of
the investment for the funder, taking into account the amount of money at stake and the
investment for which these funds are used. In accordance with the definition of control
as reflected in paragraphs1.65 and 1.66 of these Guidelines, exercising control over a
specific financial risk requires the capability to make the relevant decisions related to the
risk bearing opportunity, in this case the provision of the funding, together with the actual
performance of these decision making functions. In addition, the party exercising control
over the financial risk must perform the activities as indicated in paragraph1.65 and 1.66
in relation to the day-to-day risk mitigation activities related to these risks when these are
outsourced and related to any preparatory work necessary to facilitate its decision making,
if it does not perform these activities itself.
6.64 When funding is provided to a party for the development of an intangible, the
relevant decisions relating to taking on, laying off or declining a risk bearing opportunity
and the decisions on whether and how to respond to the risks associated with the
opportunity, are the decisions related to the provision of funding and the conditions of the
transaction. Depending on the facts and circumstances, such decisions may depend on an
assessment of the creditworthiness of the party receiving the funds and an assessment of
how the risks related to the development project may impact the expectations in relation to
the returns on funding provided or additional funding required. The conditions underlying
the provision of the funding may include the possibility to link funding decisions to key
development decisions which will impact the funding return. For example, decisions may
have to be made on whether to take the project to the next stage or to allow the investments
in costly assets. The higher the development risk and the closer the financial risk is related
to the development risk, the more the funder will need to have the capability to assess
the progress of the development of the intangible and the consequences of this progress
for achieving its expected funding return, and the more closely the funder may link the
continued provision of funding to key operational developments that may impact its
financial risk. The funder will need to have the capability to make the assessments regarding
the continued provision of funding, and will need to actually make such assessments,
which will then need to be taken into account by the funder in actually making the relevant
decisions on the provision of funding.
B.2.3. Assumption of Risks

6.65 Particular types of risk that may have importance in a functional analysis relating
to transactions involving intangibles include (i)risks related to development of intangibles,
including the risk that costly research and development or marketing activities will prove to
be unsuccessful, and taking into account the timing of the investment (for example, whether
the investment is made at an early stage, mid-way through the development process, or at
a late stage will impact the level of the underlying investment risk); (ii)the risk of product
obsolescence, including the possibility that technological advances of competitors will
adversely affect the value of the intangibles; (iii)infringement risk, including the risk that
defence of intangible rights or defence against other persons claims of infringement may
prove to be time consuming, costly and/or unavailing; (iv)product liability and similar
risks related to products and services based on the intangibles; and (v)exploitation risks,
uncertainties in relation to the returns to be generated by the intangible. The existence and
I ntangibles 83
level of such risks will depend on the facts and circumstances of each individual case and
the nature of the intangible in question.
6.66 The identity of the member or members of the group assuming risks related to the
development, enhancement, maintenance, protection, and exploitation of intangibles is an
important consideration in determining prices for controlled transactions. The assumption
of risk will determine which entity or entities will be responsible for the consequences if
the risk materialises. The accurate delineation of the controlled transaction, based on the
guidance in SectionD.1 of ChapterI, may determine that the legal owner assumes risks or
that, instead, other members of the group are assuming risks, and such members must be
compensated for their contributions in that regard.
6.67 In determining which member or members of the group assume risks related to
intangibles, the principles of SectionD.1.2 of ChapterI apply. In particular, steps1 to
5 of the process to analyse risk in a controlled transaction as laid out in paragraph1.60
should be followed in determining which party assumes risks related to the development,
enhancement, maintenance, protection, and exploitation of intangibles.
6.68 It is especially important to ensure that the group member(s) asserting entitlement
to returns from assuming risk actually bear responsibility for the actions that need to be
taken and the costs that may be incurred if the relevant risk materialises. If costs are borne
or actions are undertaken by an associated enterprise other than the associated enterprise
assuming the risk as determined under the framework for analysing risk reflected in
paragraph1.60 of these guidelines, then a transfer pricing adjustment should be made
so that the costs are allocated to the party assuming the risk and the other associated
enterprise is appropriately remunerated for any activities undertaken in connection with the
materialisation of the risk. Example7 in the annex to ChapterVI illustrates this principle.
B.2.4. Actual, ex post returns

6.69 It is quite common that actual (ex post) profitability is different than anticipated
(ex ante) profitability. This may result from risks materialising in a different way to what
was anticipated through the occurrence of unforeseeable developments. For example, it
may happen that a competitive product is removed from the market, a natural disaster
takes place in a key market, a key asset malfunctions for unforeseeable reasons, or that a
breakthrough technological development by a competitor will have the effect of making
products based on the intangible in question obsolete or less desirable. It may also happen
that the financial projections, on which calculations of ex ante returns and compensation
arrangements are based, properly took into account risks and the probability of reasonably
foreseeable events occurring and that the differences between actual and anticipated
profitability reflects the playing out of those risks. Finally, it may happen that financial
projections, on which calculations of ex ante returns and compensation arrangements are
based, did not adequately take into account the risks of different outcomes occurring and
therefore led to an overestimation or an underestimation of the anticipated profits. The
question arises in such circumstances whether, and if so, how the profits or losses should
be shared among members of an MNE group that have contributed to the development,
enhancement, maintenance, protection, and exploitation of the intangible in question.
6.70 Resolution of this question requires a careful analysis of which entity or entities
in the MNE group in fact assume the economically significant risks as identified when
delineating the actual transaction (see SectionD.1 of ChapterI). As this analytical
framework indicates, the party actually assuming the economically significant risks may
or may not be the associated enterprise contractually assuming these risks, such as the
84 I ntangibles
legal owner of the intangible, or may or may not be the funder of the investment. A party
which is not allocated the risks that give rise to the deviation between the anticipated and
actual outcomes under the principles of Sections D.1.2.1.4 to D.1.2.1.6 of ChapterI will
not be entitled to the differences between actual and anticipated profits or required to bear
losses that are caused by these differences if such risk materialises, unless these parties are
performing the important functions as reflected in paragraph6.56 or contributing to the
control over the economically significant risks as established in paragraph1.105, and it is
determined that arms length remuneration of these functions would include a profit sharing
element. In addition, consideration must be given to whether the ex ante remuneration
paid to members of the MNE group for their functions performed, assets used, and risks
assumed is, in fact, consistent with the arms length principle. Care should be taken
to ascertain, for example, whether the group in fact underestimated or overestimated
anticipated profits, thereby giving rise to underpayments or overpayments (determined on
an ex ante basis) to some group members for their contributions. Transactions for which
valuation is highly uncertain at the time of the transaction are particularly susceptible to
such under or overestimations of value. This is further discussed in SectionD.4.
B.2.5. Some implications from applying Sections B.1 and B.2

6.71
If the legal owner of an intangible in substance:
performs and controls all of the functions (including the important functions
described in paragraph6.56) related to the development, enhancement, maintenance,
protection and exploitation of the intangible;
provides all assets, including funding, necessary to the development, enhancement,
maintenance, protection, and exploitation of the intangibles; and
assumes all of the risks related to the development, enhancement, maintenance,
protection, and exploitation of the intangible,
then it will be entitled to all of the anticipated, ex ante, returns derived from the MNE
groups exploitation of the intangible. To the extent that one or more members of the MNE
group other than the legal owner performs functions, uses assets, or assumes risks related to
the development, enhancement, maintenance, protection, and exploitation of the intangible,
such associated enterprises must be compensated on an arms length basis for their
contributions. This compensation may, depending on the facts and circumstances, constitute
all or a substantial part of the return anticipated to be derived from the exploitation of the
intangible.
6.72 The entitlement of any member of the MNE group to profit or loss relating to
differences between actual (ex post) and a proper estimation of anticipated (ex ante)
profitability will depend on which entity or entities in the MNE group in fact assumes the
risks as identified when delineating the actual transaction (see SectionD.1 of ChapterI). It
will also depend on the entity or entities which are performing the important functions as
reflected in paragraph6.56 or contributing to the control over the economically significant
risks as established in paragraph1.105, and for which it is determined that an arms length
remuneration of these functions would include a profit sharing element.
I ntangibles 85
B.3. Identifying and determining the prices and other conditions for the controlled
transactions
6.73 Undertaking the analysis described in SectionD.1 of ChapterI, as supplemented by
this Chapter, should facilitate a clear assessment of legal ownership, functions, assets and
risks associated with intangibles, and an accurate identification of the transactions whose
prices and other conditions require determination. In general, the transactions identified by
the MNE group in the relevant registrations and contracts are those whose prices and other
conditions are to be determined under the arms length principle. However, the analysis
may reveal that transactions in addition to, or different from, the transactions described in
the registrations and contracts actually occurred. Consistent with SectionD.1 of ChapterI,
the transactions (and the true terms thereof) to be analysed are those determined to have
occurred consistent with the actual conduct of the parties and other relevant facts.
6.74 Arms length prices and other conditions for transactions should be determined
according to the guidance in ChaptersIIII, taking into account the contributions to
anticipated intangible value of functions performed, assets used, and risks assumed at the
time such functions are performed, assets are used, or risks are assumed as discussed in
this SectionB of this chapter. SectionD of this chapter provides supplemental guidance on
transfer pricing methods and other matters applicable in determining arms length prices
and other conditions for transactions involving intangibles.
B.4. Application of the foregoing principles in specific fact patterns

6.75 The principles set out in this SectionB must be applied in a variety of situations
involving the development, enhancement, maintenance, protection, and exploitation of
intangibles. A key consideration in each case is that associated enterprises that contribute
to the development, enhancement, maintenance, protection, or exploitation of intangibles
legally owned by another member of the group must receive arms length compensation
for the functions they perform, the risks they assume, and the assets they use. In evaluating
whether associated enterprises that perform functions or assume risks related to the
development, enhancement, maintenance, protection, and exploitation of intangibles have
been compensated on an arms length basis, it is necessary to consider (i)the level and nature
of the activity undertaken; and (ii)the amount and form of compensation paid. In assessing
whether the compensation provided in the controlled transaction is consistent with the arms
length principle, reference should be made to the level and nature of activity of comparable
uncontrolled entities performing similar functions, the compensation received by comparable
uncontrolled entities performing similar functions, and the anticipated creation of intangible
value by comparable uncontrolled entities performing similar functions. This section
describes the application of these principles in commonly occurring fact patterns.
B.4.1. Development and enhancement of marketing intangibles

6.76 A common situation where these principles must be applied arises when an
enterprise associated with the legal owner of trademarks performs marketing or sales
functions that benefit the legal owner of the trademark, for example through a marketing
arrangement or through a distribution/marketing arrangement. In such cases, it is necessary
to determine how the marketer or distributor should be compensated for its activities.
One important issue is whether the marketer/distributor should be compensated only for
providing promotion and distribution services, or whether the marketer/distributor should
also be compensated for enhancing the value of the trademarks and other marketing
intangibles by virtue of its functions performed, assets used, and risks assumed.
86 I ntangibles
6.77 The analysis of this issue requires an assessment of (i)the obligations and rights
implied by the legal registrations and agreements between the parties; (ii)the functions
performed, the assets used, and the risks assumed by the parties; (iii)the intangible
value anticipated to be created through the marketer/distributors activities; and (iv)the
compensation provided for the functions performed by the marketer/distributor (taking
account of the assets used and risks assumed). One relatively clear case is where a
distributor acts merely as an agent, being reimbursed for its promotional expenditures
and being directed and controlled in its activities by the owner of the trademarks and
other marketing intangibles. In that case, the distributor ordinarily would be entitled
to compensation appropriate to its agency activities alone. It does not assume the risks
associated with the further development of the trademark and other marketing intangibles,
and would therefore not be entitled to additional remuneration in that regard.
6.78 When the distributor actually bears the cost of its marketing activities (for example,
when there is no arrangement for the legal owner to reimburse the expenditures), the
analysis should focus on the extent to which the distributor is able to share in the potential
benefits deriving from its functions performed, assets used, and risks assumed currently
or in the future. In general, in arms length transactions the ability of a party that is not
the legal owner of trademarks and other marketing intangibles to obtain the benefits of
marketing activities that enhance the value of those intangibles will depend principally on
the substance of the rights of that party. For example, a distributor may have the ability to
obtain benefits from its functions performed, assets used, and risks assumed in developing
the value of a trademark and other marketing intangibles from its turnover and market share
when it has a long-term contract providing for sole distribution rights for the trademarked
product. In such a situation the distributors efforts may have enhanced the value of its
own intangibles, namely its distribution rights. In such cases, the distributors share of
benefits should be determined based on what an independent distributor would receive in
comparable circumstances. In some cases, a distributor may perform functions, use assets
or assume risks that exceed those an independent distributor with similar rights might incur
or perform for the benefit of its own distribution activities and that create value beyond that
created by other similarly situated marketers/distributors. An independent distributor in such
a case would typically require additional remuneration from the owner of the trademark
or other intangibles. Such remuneration could take the form of higher distribution profits
(resulting from a decrease in the purchase price of the product), a reduction in royalty
rate, or a share of the profits associated with the enhanced value of the trademark or other
marketing intangibles, in order to compensate the distributor for its functions, assets, risks,
and anticipated value creation. Examples8 to 13 in the annex to ChapterVI illustrate in
greater detail the application of this SectionB in the context of marketing and distribution
arrangements.
B.4.2. Research, development and process improvement arrangements

6.79 The principles set out in the foregoing paragraphs also apply in situations involving the
performance of research and development functions by a member of an MNE group under a
contractual arrangement with an associated enterprise that is the legal owner of any resulting
intangibles. Appropriate compensation for research services will depend on all the facts and
circumstances, such as whether the research team possesses unique skills and experience
relevant to the research, assumes risks (e.g.where blue sky research is undertaken), uses
its own intangibles, or is controlled and managed by another party. Compensation based on a
reimbursement of costs plus a modest mark-up will not reflect the anticipated value of, or the
arms length price for, the contributions of the research team in all cases.
I ntangibles 87
6.80 The principles set out in this section similarly apply in situations where a member
of an MNE group provides manufacturing services that may lead to process or product
improvements on behalf of an associated enterprise that will assume legal ownership of
such process or product improvements. Examples14 to 17 in the annex to ChapterVI
illustrate in greater detail the application of this SectionB in the context of research and
development arrangements.
B.4.3. Payments for use of the company name

6.81 Questions often arise regarding the arms length compensation for the use of group
names, trade names and similar intangibles. Resolution of such questions should be based
on the principles of this SectionB and on the commercial and legal factors involved. As
a general rule, no payment should be recognised for transfer pricing purposes for simple
recognition of group membership or the use of the group name merely to reflect the fact of
group membership. See paragraph7.12
6.82 Where one member of the group is the owner of a trademark or other intangible for
the group name, and where use of the name provides a financial benefit to members of the
group other than the member legally owning such intangible, it is reasonable to conclude
that a payment for use would have been made in arms length transactions. Similarly,
such payments may be appropriate where a group member owns goodwill in respect of
the business represented by an unregistered trademark, use of that trademark by another
party would constitute misrepresentation, and the use of the trademark provides a clear
financial benefit to a group member other than that owning the goodwill and unregistered
trademark.
6.83 In determining the amount of payment with respect to a group name, it is important to
consider the amount of the financial benefit to the user of the name attributable to use of that
name, the costs and benefits associated with other alternatives, and the relative contributions
to the value of the name made by the legal owner, and the entity using the name in the form
of functions performed, assets used and risks assumed. Careful consideration should be given
to the functions performed, assets used, and risks assumed by the user of the name in creating
or enhancing the value of the name in its jurisdiction. Factors that would be important in a
licence of the name to an independent enterprise under comparable circumstances applying
the principles of ChaptersIIII should be taken into account.
6.84 Where an existing successful business is acquired by another successful business
and the acquired business begins to use a name, trademark or other branding indicative of
the acquiring business, there should be no automatic assumption that a payment should be
made in respect of such use. If there is a reasonable expectation of financial benefit to the
acquired company from using the acquiring companys branding, then the amount of any
payment should be informed by the level of that anticipated benefit.
6.85 It may also be the case that the acquiring business will leverage the existing position
of the acquired business to expand the business of the acquirer in the territory of operation
of the acquired business by causing the acquired business to use the acquirers branding. In
that case, consideration should be given to whether the acquirer should make a payment to
or otherwise compensate the acquired business for the functions performed, risks assumed,
and assets used (including its market position) in connection with expanded use of the
acquirers name.
88 I ntangibles
C.
Transactions involving the use or transfer of intangibles

6.86 In addition to identifying with specificity the intangibles involved in a particular
transfer pricing issue, and identifying the owner of such intangibles, it is necessary to
identify and properly characterise, at the beginning of any transfer pricing analysis involving
intangibles, the specific controlled transactions involving intangibles. The principles of
ChapterI apply in identifying and accurately delineating transactions involving the use
or transfer of intangibles. In addition to the guidance on identifying the actual transaction
(SectionD.1 of ChapterI) and on business restructurings (ChapterIX, especially PartII),
SectionC of this chapter outlines some typical scenarios that may be useful in ascertaining
whether intangibles or rights in intangibles are involved in a transaction. See Example19.
The characterisation of a transaction for transfer pricing purposes has no relevance for
determinations under Article12 of the OECD Model Tax Convention. See, e.g.paragraphs8
to 19 of the Commentary to Article12 of the OECD Model Tax Convention.
6.87 There are two general types of transactions where the identification and examination
of intangibles will be relevant for transfer pricing purposes. These are: (i)transactions
involving transfers of intangibles or rights in intangibles; and (ii)transactions involving the
use of intangibles in connection with the sale of goods or the provision of services.
C.1. Transactions involving transfers of intangibles or rights in intangibles

C.1.1. Transfers of intangibles or rights in intangibles
6.88 Rights in intangibles themselves may be transferred in controlled transactions. Such
transactions may involve a transfer of all rights in the intangibles in question (e.g.a sale
of the intangible or a perpetual, exclusive licence of the intangible) or only limited rights
(e.g.a licence or similar transfer of limited rights to use an intangible which may be subject
to geographical restrictions, limited duration, or restrictions with respect to the right to use,
exploit, reproduce, further transfer, or further develop). The principles of ChaptersIIII apply
to transactions involving the transfer of intangibles or rights in intangibles. Supplemental
guidance regarding the determination of arms length conditions for such transactions is also
contained in Sections D.1, D.2 and D.3 of this chapter.
6.89 In transactions involving the transfer of intangibles or rights in intangibles, it is
essential to identify with specificity the nature of the intangibles and rights in intangibles
that are transferred between associated enterprises. Where limitations are imposed on the
rights transferred, it is also essential to identify the nature of such limitations and the full
extent of the rights transferred. It should be noted in this regard that the labels applied
to transactions do not control the transfer pricing analysis. For example, in the case of a
transfer of the exclusive right to exploit a patent in CountryX, the taxpayers decision to
characterise the transaction either as a sale of all of the CountryX patent rights, or as a
perpetual exclusive licence of a portion of the worldwide patent rights, does not affect the
determination of the arms length price if, in either case, the transaction being priced is
a transfer of exclusive rights to exploit the patent in CountryX over its remaining useful
life. Thus, the functional analysis should identify the nature of the transferred rights in
intangibles with specificity.
6.90 Restrictions imposed in licence and similar agreements on the use of an intangible
in the further development of new intangibles or new products using the intangibles are
often of significant importance in a transfer pricing analysis. It is therefore important
in identifying the nature of a transfer of rights in intangibles to consider whether the
I ntangibles 89
transferee receives the right to use the transferred intangible for the purpose of further
research and development. In transactions between independent enterprises, arrangements
are observed where the transferor/licensor retains the full right to any enhancements of
the licensed intangible that may be developed during the term of the licence. Transactions
between independent enterprises are also observed where the transferee/licensee retains
the right to any enhancements it may develop, either for the term of its licence or in
perpetuity. The nature of any limitations on further development of transferred intangibles,
or on the ability of the transferee and the transferor to derive an economic benefit from
such enhancements, can affect the value of the rights transferred and the comparability
of two transactions involving otherwise identical or closely comparable intangibles. Such
limitations must be evaluated in light of both the written terms of agreements and the
actual conduct of the affected parties.
6.91 The provisions of SectionD.1.1 of ChapterI apply in identifying the specific nature
of a transaction involving a transfer of intangibles or rights in intangibles, in identifying
the nature of any intangibles transferred, and in identifying any limitations imposed by the
terms of the transfer on the use of those intangibles. For example, a written specification
that a licence is non-exclusive or of limited duration need not be respected by the tax
administration if such specification is not consistent with the conduct of the parties.
Example18 in the annex to ChapterVI illustrates the provisions of this paragraph.
C.1.2. Transfers of combinations of intangibles

6.92 Intangibles (including limited rights in intangibles) may be transferred individually
or in combination with other intangibles. In considering transactions involving transfers of
combinations of intangibles, two related issues often arise.
6.93 The first of these involves the nature and economic consequences of interactions
between different intangibles. It may be the case that some intangibles are more valuable in
combination with other intangibles than would be the case if the intangibles were considered
separately. It is therefore important to identify the nature of the legal and economic
interactions between intangibles that are transferred in combination.
6.94 For example, a pharmaceutical product will often have associated with it three
or more types of intangibles. The active pharmaceutical ingredient may be protected by
one or more patents. The product will also have been through a testing process and a
government regulatory authority may have issued an approval to market the product in a
given geographic market and for specific approved indications based on that testing. The
product may be marketed under a particular trademark. In combination these intangibles
may be extremely valuable. In isolation, one or more of them may have much less value.
For example, the trademark without the patent and regulatory marketing approval may
have limited value since the product could not be sold without the marketing approval and
generic competitors could not be excluded from the market without the patent. Similarly,
the value of the patent may be much greater once regulatory marketing approval has been
obtained than would be the case in the absence of the marketing approval. The interactions
between each of these classes of intangibles, as well as which parties performed functions,
bore the risks and incurred the costs associated with securing the intangibles, are therefore
very important in performing a transfer pricing analysis with regard to a transfer of the
intangibles. It is important to consider the relative contribution to value creation where
different associated enterprises hold rights in the intangibles used.
6.95 A second and related issue involves the importance of ensuring that all intangibles
transferred in a particular transaction have been identified. It may be the case, for
90 I ntangibles
example, that intangibles are so intertwined that it is not possible, as a substantive matter,
to transfer one without transferring the other. Indeed, it will often be the case that a
transfer of one intangible will necessarily imply the transfer of other intangibles. In such
cases it is important to identify all of the intangibles made available to the transferee
as a consequence of an intangibles transfer, applying the principles of SectionD.1 of
ChapterI. For example, the transfer of rights to use a trademark under a licence agreement
will usually also imply the licensing of the reputational value, sometimes referred to as
goodwill, associated with that trademark, where it is the licensor who has built up such
goodwill. Any licence fee required should consider both the trademark and the associated
reputational value. Example20 in the annex to ChapterVI illustrates the principles of this
paragraph.
6.96 It is important to identify situations where taxpayers or tax administrations may
seek to artificially separate intangibles that, as a matter of substance, independent parties
would not separate in comparable circumstances. For example, attempts to artificially
separate trademarks or trade names from the goodwill or reputational value that is factually
associated with the trademark or trade name should be identified and critically analysed.
Example21 in the annex to ChapterVI illustrates the principles of this paragraph.
6.97 It should be recognised that the process of identifying all of the intangibles
transferred in a particular transaction is an exercise of identifying, by reference to written
agreements and the actual conduct of the parties, the actual transactions that have been
undertaken, applying the principles of SectionD.1 of ChapterI.
C.1.3. Transfers of intangibles or rights in intangibles in combination with other

business transactions
6.98 In some situations intangibles or rights in intangibles may be transferred in
combination with tangible business assets, or in combination with services. It is important
in such a situation to determine whether intangibles have in fact been transferred in
connection with the transaction. It is also important that all of the intangibles transferred in
connection with a particular transaction be identified and taken into account in the transfer
pricing analysis. Examples23 to 25 in the annex to ChapterVI illustrate the principles of
this paragraph.
6.99 In some situations it may be both possible and appropriate to separate transactions
in tangible goods or services from transfers of intangibles or rights in intangibles for
purposes of conducting a transfer pricing analysis. In these situations, the price of a
package contract should be disaggregated in order to confirm that each element of the
transaction is consistent with the arms length principle. In other situations transactions
may be so closely related that it will be difficult to segregate tangible goods or service
transactions from transfers of intangibles or rights in intangibles. Reliability of available
comparables will be an important factor in considering whether transactions should
be combined or segregated. In particular, it is important to consider whether available
comparables permit accurate evaluation of interactions between transactions.
6.100 One situation where transactions involving transfers of intangibles or rights
in intangibles may be combined with other transactions involves a business franchise
arrangement. Under such an arrangement, one member of an MNE group may agree to
provide a combination of services and intangibles to an associated enterprise in exchange
for a single fee. If the services and intangibles made available under such an arrangement
are sufficiently unique that reliable comparables cannot be identified for the entire service/
intangible package, it may be necessary to segregate the various parts of the package of
I ntangibles 91
services and intangibles for separate transfer pricing consideration. It should be kept in
mind, however, that the interactions between various intangibles and services may enhance
the value of both.
6.101 In other situations, the provision of a service and the transfer of one or more
intangibles may be so closely intertwined that it is difficult to separate the transactions for
purposes of a transfer pricing analysis. For example, some transfers of rights in software
may be combined with an undertaking by the transferor to provide ongoing software
maintenance services, which may include periodic updates to the software. In situations
where services and transfers of intangibles are intertwined, determining arms length
prices on an aggregate basis may be necessary.
6.102 It should be emphasised that delineating the transaction as the provision of products
or services or the transfer of intangibles or a combination of both does not necessarily
dictate the use of a particular transfer pricing method. For example, a cost plus approach
will not be appropriate for all service transactions, and not all intangibles transactions
require complex valuations or the application of profit split methods. The facts of each
specific situation, and the results of the required functional analysis, will guide the manner
in which transactions are combined, delineated and analysed for transfer pricing purposes,
as well as the selection of the most appropriate transfer pricing method in a particular case.
The ultimate objective is to identify the prices and other relevant conditions that would be
established between independent enterprises in comparable transactions.
6.103 Moreover, it should also be emphasised that determinations as to whether transactions
should be aggregated or segregated for analysis usually involve the delineation of the actual
transaction undertaken, by reference to written agreements and the actual conduct of the
parties. Determinations regarding the actual transaction undertaken constitute one necessary
element in determining the most appropriate transfer pricing method in the particular case.
C.2. Transactions involving the use of intangibles in connection with sales of

goods or performance of services
6.104 Intangibles may be used in connection with controlled transactions in situations
where there is no transfer of the intangible or of rights in the intangible. For example,
intangibles may be used by one or both parties to a controlled transaction in connection
with the manufacture of goods sold to an associated enterprise, in connection with the
marketing of goods purchased from an associated enterprise, or in connection with the
performance of services on behalf of an associated enterprise. The nature of such a
transaction should be clearly specified, and any relevant intangibles used by either of the
parties in connection with such a controlled transaction should be identified and taken
into account in the comparability analysis, in the selection and application of the most
appropriate transfer pricing method for that transaction, and in the choice of the tested
party. Supplemental guidance regarding the determination of arms length conditions for
transactions involving the use of intangibles in connection with the sale of goods or the
provision of services is contained in Sections D.1 and D.4 of this chapter.
6.105 The need to consider the use of intangibles by a party to a controlled transaction
involving a sale of goods can be illustrated as follows. Assume that a car manufacturer
uses valuable proprietary patents to manufacture the cars that it then sells to associated
distributors. Assume that the patents significantly contribute to the value of the cars.
The patents and the value they contribute should be identified and taken into account
in the comparability analysis of the transaction consisting in the sales of cars by the car
manufacturer to its associated distributors, in selecting the most appropriate transfer
92 I ntangibles
pricing method for the transactions, and in selecting the tested party. The associated
distributors purchasing the cars do not, however, acquire any right in the manufacturers
patents. In such a case, the patents are used in the manufacturing and may affect the value
of the cars, but the patents themselves are not transferred.
6.106 As another example of the use of intangibles in connection with a controlled
transaction, assume that an exploration company has acquired or developed valuable
geological data and analysis, and sophisticated exploratory software and know-how. Assume
further that it uses those intangibles in providing exploration services to an associated
enterprise. Those intangibles should be identified and taken into account in the comparability
analysis of the service transactions between the exploration company and the associated
enterprise, in selecting the most appropriate transfer pricing method for the transaction,
and in selecting the tested party. Assuming that the associated enterprise of the exploration
company does not acquire any rights in the exploration companys intangibles, the intangibles
are used in the performance of the services and may affect the value of services, but are not
transferred.
D.
Supplemental guidance for determining arms length conditions in cases

involving intangibles
6.107 After identifying the relevant transactions involving intangibles, specifically
identifying the intangibles involved in those transactions, identifying which entity or
entities legally own the intangibles as well as those that contribute to the value of the
intangibles, it should be possible to identify arms length conditions for the relevant
transactions. The principles set out in ChaptersIIII of these Guidelines should be applied in
determining arms length conditions for transactions involving intangibles. In particular, the
recommended nine-step process set out in paragraph3.4 can be helpful in identifying arms
length conditions for transactions involving intangibles. As an essential part of applying the
principles of ChapterIII to conduct a comparability analysis under the process described in
paragraph3.4, the principles contained in Sections A, B, and C of this ChapterVI should be
considered.
6.108 However, the principles of ChaptersIIII can sometimes be difficult to apply to
controlled transactions involving intangibles. Intangibles may have special characteristics
that complicate the search for comparables, and in some cases make pricing difficult to
determine at the time of the transaction. Further, for wholly legitimate business reasons,
due to the relationship between them, associated enterprises might sometimes structure
a transaction involving intangibles in a manner that independent enterprises would not
contemplate. See paragraph1.11. The use or transfer of intangibles may raise challenging
issues regarding comparability, selection of transfer pricing methods, and determination of
arms length conditions for transactions. This SectionD provides supplemental guidance
for use in applying the principles of ChaptersIIII to determine arms length conditions for
controlled transactions involving intangibles.
6.109 SectionD.1 provides general supplemental guidance related to all transactions
involving intangibles. SectionD.2 provides supplemental guidance specifically related
to transactions involving the transfer of intangibles or rights in intangibles. SectionD.3
provides supplemental guidance regarding transfers of intangibles or rights in intangibles
whose value is highly uncertain at the time of the transfer. SectionD.4 provides an approach
to pricing hard-to-value intangibles. SectionD.5 provides supplemental guidance applicable
to transactions involving the use of intangibles in connection with the sale of goods or the
provision of services in situations where there is no transfer of rights in the intangibles.
I ntangibles 93
D.1. General principles applicable in transactions involving intangibles

6.110 SectionD of ChapterI and ChapterIII contain principles to be considered and a
recommended process to be followed in conducting a comparability analysis. The principles
described in those sections of the Guidelines apply to all controlled transactions involving
intangibles.
6.111 In applying the principles of the Guidelines related to the content and process of
a comparability analysis to a transaction involving intangibles, a transfer pricing analysis
must consider the options realistically available to each of the parties to the transaction.
6.112 In considering the options realistically available to the parties, the perspectives of
each of the parties to the transaction must be considered. A comparability analysis focusing
only on one side of a transaction generally does not provide a sufficient basis for evaluating
a transaction involving intangibles (including in those situations for which a one-sided
transfer pricing method is ultimately determined).
6.113 While it is important to consider the perspectives of both parties to the transaction
in conducting a comparability analysis, the specific business circumstances of one of the
parties should not be used to dictate an outcome contrary to the realistically available
options of the other party. For example, a transferor would not be expected to accept a price
for the transfer of either all or part of its rights in an intangible that is less advantageous
to the transferor than its other realistically available options (including making no transfer
at all), merely because a particular associated enterprise transferee lacks the resources to
effectively exploit the transferred rights in the intangible. Similarly, a transferee should not
be expected to accept a price for a transfer of rights in one or more intangibles that would
make it impossible for the transferee to anticipate earning a profit using the acquired rights
in the intangible in its business. Such an outcome would be less favourable to the transferee
than its realistically available option of not engaging in the transfer at all.
6.114 It will often be the case that a price for a transaction involving intangibles can be
identified that is consistent with the realistically available options of each of the parties.
The existence of such prices is consistent with the assumption that MNE groups seek to
optimise resource allocations. If situations arise in which the minimum price acceptable
to the transferor, based on its realistically available options, exceeds the maximum price
acceptable to the transferee, based on its realistically available options, it may be necessary
to consider whether the actual transaction should be disregarded under the criterion for nonrecognition set out in SectionD.2 of ChapterI, or whether the conditions of the transaction
should otherwise be adjusted. Similarly, if situations arise in which there are assertions that
either the current use of an intangible, or a proposed realistically available option (i.e.an
alternative use of the intangible), does not optimise resource allocations, it may be necessary
to consider whether such assertions are consistent with the true facts and circumstances of the
case. This discussion highlights the importance of taking all relevant facts and circumstances
into account in accurately delineating the actual transaction involving intangibles.
D.2. Supplemental guidance regarding transfers of intangibles or rights in

intangibles
6.115 This section provides supplemental guidance regarding specific issues arising in
connection with the transfer between associated enterprises of intangibles or rights in
intangibles. Such transactions may include sales of intangibles as well as transactions
that are economically equivalent to sales. Such transactions could also include a licence
of rights in one or more intangibles or a similar transaction. This section is not intended
94 I ntangibles
to provide comprehensive guidance with regard to the transfer pricing treatment of
such intangibles transfers. Rather, it supplements the otherwise applicable provisions of
ChaptersIIII, and the guidance in Sections A, B, C, and D.1 of this chapter, in the context
of transfers of intangibles or rights in intangibles, by providing guidance with regard to
certain specific topics commonly arising in connection with such transfers.
D.2.1. Comparability of intangibles or rights in intangibles

6.116 In applying the provisions of ChaptersIIII to transactions involving the transfer of
intangibles or rights in intangibles, it should be borne in mind that intangibles often have
unique characteristics, and as a result have the potential for generating returns and creating
future benefits that could differ widely. In conducting a comparability analysis with regard
to a transfer of intangibles, it is therefore essential to consider the unique features of the
intangibles. This is particularly important where the CUP method is considered to be
the most appropriate transfer pricing method, but also has importance in applying other
methods that rely on comparables. In the case of a transfer of an intangible or rights in an
intangible that provides the enterprise with a unique competitive advantage in the market,
purportedly comparable intangibles or transactions should be carefully scrutinised. It is
critical to assess whether potential comparables in fact exhibit similar profit potential.
6.117 Set out below is a description of some of the specific features of intangibles that
may prove important in a comparability analysis involving transfers of intangibles or rights
in intangibles. The following list is not exhaustive and in a specific case consideration of
additional or different factors may be an essential part of a comparability analysis.
D.2.1.1. Exclusivity
6.118 Whether the rights in intangibles relevant to a particular transaction involving
the transfer of intangibles or rights in intangibles are exclusive or non-exclusive can be
an important comparability consideration. Some intangibles allow the legal owner of the
intangible to exclude others from using the intangible. A patent, for example, grants an
exclusive right to use the invention covered by the patent for a period of years. If the party
controlling intangible rights can exclude other enterprises from the market, or exclude them
from using intangibles that provide a market advantage, that party may enjoy a high degree
of market power or market influence. A party with non-exclusive rights to intangibles will
not be able to exclude all competitors and will generally not have the same degree of market
power or influence. Accordingly, the exclusive or non-exclusive nature of intangibles or
rights in intangibles should be considered in connection with the comparability analysis.
D.2.1.2. Extent and duration of legal protection

6.119 The extent and duration of legal protection of the intangibles relevant to a particular
transfer can be an important comparability consideration. Legal protections associated
with some intangibles can prevent competitors from entering a particular market. For
other intangibles, such as know-how or trade secrets, available legal protections may have
a different nature and not be as strong or last as long. For intangibles with limited useful
lives, the duration of legal protections can be important since the duration of the intangible
rights will affect the expectation of the parties to a transaction with regard to the future
benefits from the exploitation of the intangible. For example, two otherwise comparable
patents will not have equivalent value if one expires at the end of one year while the other
expires only after ten years.
I ntangibles 95
D.2.1.3. Geographic scope

6.120 The geographic scope of the intangibles or rights in intangibles will be an important
comparability consideration. A global grant of rights to intangibles may be more valuable
than a grant limited to one or a few countries, depending on the nature of the product, the
nature of the intangible, and the nature of the markets in question.
D.2.1.4. Useful life

6.121 Many intangibles have a limited useful life. The useful life of a particular intangible
can be affected by the nature and duration of the legal protections afforded to the
intangible, as noted above. The useful life of some intangibles can also be affected by the
rate of technological change in an industry and by the development of new and potentially
improved products. It may also be the case that the useful life of particular intangibles can
be extended.
6.122 In conducting a comparability analysis, it will therefore be important to consider
the expected useful life of the intangibles in question. In general, intangibles expected to
provide market advantages for a longer period of time will be more valuable than similar
intangibles providing such advantages for a shorter period of time, other things being
equal. In evaluating the useful life of intangibles it is also important to consider the use
being made of the intangible. The useful life of an intangible that forms a base for ongoing
research and development may extend beyond the commercial life of the current generation
product line based on that intangible.
D.2.1.5. Stage of development

6.123 In conducting a comparability analysis, it may be important to consider the stage of
development of particular intangibles. It is often the case that an intangible is transferred
in a controlled transaction at a point in time before it has been fully demonstrated that the
intangible will support commercially viable products. A common example arises in the
pharmaceutical industry, where chemical compounds may be patented, and the patents
(or rights to use the patents) transferred in controlled transactions, well in advance of the
time when further research, development and testing demonstrates that the compound
constitutes a safe and effective treatment for a particular medical condition.
6.124 As a general rule, intangibles relating to products with established commercial
viability will be more valuable than otherwise comparable intangibles relating to products
whose commercial viability is yet to be established. In conducting a comparability analysis
involving partially developed intangibles, it is important to evaluate the likelihood that
further development will lead to commercially significant future benefits. In certain
circumstances, industry data regarding the risks associated with further development can be
helpful to such evaluations. However, the specific circumstances of any individual situation
should always be considered.
D.2.1.6. Rights to enhancements, revisions, and updates

6.125 Often, an important consideration in a comparability analysis involving intangibles
relates to the rights of the parties with regard to future enhancements, revisions and updates
of the intangibles. In some industries, products protected by intangibles can become
obsolete or uncompetitive in a relatively short period of time in the absence of continuing
development and enhancement of the intangibles. As a result, having access to updates
96 I ntangibles
and enhancements can be the difference between deriving a short term advantage from the
intangibles and deriving a longer term advantage. It is therefore necessary to consider for
comparability purposes whether or not a particular grant of rights in intangibles includes
access to enhancements, revisions, and updates of the intangibles.
6.126 A very similar question, often important in a comparability analysis, involves
whether the transferee of intangibles obtains the right to use the intangibles in connection
with research directed to developing new and enhanced intangibles. For example, the right
to use an existing software platform as a basis for developing new software products can
shorten development times and can make the difference between being the first to market
with a new product or application, or being forced to enter a market already occupied by
established competitive products. A comparability analysis with regard to intangibles
should, therefore, consider the rights of the parties regarding the use of the intangibles in
developing new and enhanced versions of products.
D.2.1.7. Expectation of future benefit

6.127 Each of the foregoing comparability considerations has a consequence with
regard to the expectation of the parties to a transaction regarding the future benefits to be
derived from the use of the intangibles in question. If for any reason there is a significant
discrepancy between the anticipated future benefit of using one intangible as opposed to
another, it is difficult to consider the intangibles as being sufficiently comparable to support
a comparables-based transfer pricing analysis in the absence of reliable comparability
adjustments. Specifically, it is important to consider the actual and potential profitability of
products or potential products that are based on the intangible. Intangibles that provide a basis
for high profit products or services are not likely to be comparable to intangibles that support
products or services with only industry average profits. Any factor materially affecting the
expectation of the parties to a controlled transaction of obtaining future benefits from the
intangible should be taken into account in conducting the comparability analysis.
D.2.2. Comparison of risk in cases involving transfers of intangibles or rights in

intangibles
6.128 In conducting a comparability analysis involving the transfer of intangibles or
rights in intangibles, the existence of risks related to the likelihood of obtaining future
economic benefits from the transferred intangibles must be considered, including the
allocation of risk between the parties which should be analysed within the framework set
out in SectionD.1.2 of ChapterI. The following types of risks, among others, should be
considered in evaluating whether transfers of intangibles or combinations of intangibles are
comparable, and in evaluating whether the intangibles themselves are comparable.
Risks related to the future development of the intangibles. This includes an
evaluation of whether the intangibles relate to commercially viable products,
whether the intangibles may support commercially viable products in the future,
the expected cost of required future development and testing, the likelihood that
such development and testing will prove successful and similar considerations. The
consideration of development risk is particularly important in situations involving
transfers of partially developed intangibles.
Risks related to product obsolescence and depreciation in the value of the intangibles.
This includes an evaluation of the likelihood that competitors will introduce products
I ntangibles 97
or services in the future that would materially erode the market for products
dependent on the intangibles being analysed.
Risks related to infringement of the intangible rights. This includes an evaluation
of the likelihood that others might successfully claim that products based on the
intangibles infringe their own intangible rights and an evaluation of the likely
costs of defending against such claims. It also includes an evaluation of the
likelihood that the holder of intangible rights could successfully prevent others
from infringing the intangibles, the risk that counterfeit products could erode the
profitability of relevant markets, and the likelihood that substantial damages could
be collected in the event of infringement.
Product liability and similar risks related to the future use of the intangibles.
D.2.3. Comparability adjustments with regard to transfers of intangibles or

rights in intangibles
6.129 The principles of paragraphs3.47 to 3.54 relating to comparability adjustments apply
with respect to transactions involving the transfer of intangibles or rights in intangibles. It
is important to note that differences between intangibles can have significant economic
consequences that may be difficult to adjust for in a reliable manner. Particularly in
situations where amounts attributable to comparability adjustments represent a large
percentage of the compensation for the intangible, there may be reason to believe, depending
on the specific facts, that the computation of the adjustment is not reliable and that the
intangibles being compared are in fact not sufficiently comparable to support a valid transfer
pricing analysis. If reliable comparability adjustments are not possible, it may be necessary
to select a transfer pricing method that is less dependent on the identification of comparable
intangibles or comparable transactions.
D.2.4. Use of comparables drawn from databases

6.130 Comparability, and the possibility of making comparability adjustments, is
especially important in considering potentially comparable intangibles and related royalty
rates drawn from commercial databases or proprietary compilations of publicly available
licence or similar agreements. The principles of SectionA.4.3.1 of ChapterIII apply fully
in assessing the usefulness of transactions drawn from such sources. In particular, it is
important to assess whether publicly available data drawn from commercial databases and
proprietary compilations is sufficiently detailed to permit an evaluation of the specific
features of intangibles that may be important in conducting a comparability analysis. In
evaluating comparable licence arrangements identified from databases, the specific facts
of the case, including the methodology being applied, should be considered in the context
of the provisions of paragraph3.38.
D.2.5. Selecting the most appropriate transfer pricing method in a matter involving
the transfer of intangibles or rights in intangibles
6.131 The principles of these Guidelines related to the selection of the most appropriate
transfer pricing method to the circumstances of the case are described in paragraphs2.1 to
2.11. Those principles apply fully to cases involving the transfer of intangibles or rights in
intangibles. In selecting the most appropriate transfer pricing method in a case involving
a transfer of intangibles or rights in intangibles, attention should be given to (i)the nature
of the relevant intangibles, (ii)the difficulty of identifying comparable uncontrolled
98 I ntangibles
transactions and intangibles in many, if not most, cases, and (iii)the difficulty of applying
certain of the transfer pricing methods described in ChapterII in cases involving the
transfer of intangibles. The issues discussed below are particularly important in the
selection of transfer pricing methods under the Guidelines.
6.132 In applying the principles of paragraphs2.1 to 2.11 to matters involving the transfer
of intangibles or rights in intangibles, it is important to recognise that transactions structured
in different ways may have similar economic consequences. For example, the performance
of a service using intangibles may have very similar economic consequences to a transaction
involving the transfer of an intangible (or the transfer of rights in the intangible), as either
may convey the value of the intangible to the transferee. Accordingly, in selecting the most
appropriate transfer pricing method in connection with a transaction involving the transfer
of intangibles or rights in intangibles, it is important to consider the economic consequences
of the transaction, rather than proceeding on the basis of an arbitrary label.
6.133 This chapter makes it clear that in matters involving the transfer of intangibles or
rights in intangibles it is important not to simply assume that all residual profit, after a
limited return to those providing functions, should necessarily be allocated to the owner
of intangibles. The selection of the most appropriate transfer pricing method should be
based on a functional analysis that provides a clear understanding of the MNEs global
business processes and how the transferred intangibles interact with other functions, assets
and risks that comprise the global business. The functional analysis should identify all
factors that contribute to value creation, which may include risks borne, specific market
characteristics, location, business strategies, and MNE group synergies among others. The
transfer pricing method selected, and any adjustments incorporated in that method based
on the comparability analysis, should take into account all of the relevant factors materially
contributing to the creation of value, not only intangibles and routine functions.
6.134 The principles set out in paragraphs2.11, 3.58 and 3.59 regarding the use of more
than one transfer pricing method apply to matters involving the transfer of intangibles or
rights in intangibles.
6.135 Paragraphs3.9 to 3.12 and paragraph3.37 provide guidance regarding the aggregation
of separate transactions for purposes of transfer pricing analysis. Those principles apply fully
to cases involving the transfer of intangibles or rights in intangibles and are supplemented
by the guidance in SectionC of this chapter. Indeed, it is often the case that intangibles may
be transferred in combination with other intangibles, or in combination with transactions
involving the sale of goods or the performance of services. In such situations it may well be
that the most reliable transfer pricing analysis will consider the interrelated transactions in
the aggregate as necessary to improve the reliability of the analysis.
D.2.6. Supplemental guidance on transfer pricing methods in matters involving

the transfer of intangibles or rights in intangibles
6.136 Depending on the specific facts, any of the five OECD transfer pricing methods
described in ChapterII might constitute the most appropriate transfer pricing method to
the circumstances of the case where the transaction involves a controlled transfer of one or
more intangibles. The use of other alternatives may also be appropriate.
6.137 Where the comparability analysis identifies reliable information related to
comparable uncontrolled transactions, the determination of arms length prices for a transfer
of intangibles or rights in intangibles can be determined on the basis of such comparables
after making any comparability adjustments that may be appropriate and reliable.
I ntangibles 99
6.138 However, it will often be the case in matters involving transfers of intangibles or
rights in intangibles that the comparability analysis (including the functional analysis)
reveals that there are no reliable comparable uncontrolled transactions that can be used to
determine the arms length price and other conditions. This can occur if the intangibles in
question have unique characteristics, or if they are of such critical importance that such
intangibles are transferred only among associated enterprises. It may also result from a
lack of available data regarding potentially comparable transactions or from other causes.
Notwithstanding the lack of reliable comparables, it is usually possible to determine the
arms length price and other conditions for the controlled transaction.
6.139 Where information regarding reliable comparable uncontrolled transactions cannot
be identified, the arms length principle requires use of another method to determine the
price that uncontrolled parties would have agreed under comparable circumstances. In
making such determinations, it is important to consider:
The functions, assets and risks of the respective parties to the transaction.
The business reasons for engaging in the transaction.
The perspectives of and options realistically available to each of the parties to the
transaction.
The competitive advantages conferred by the intangibles including especially the
relative profitability of products and services or potential products and services
related to the intangibles.
The expected future economic benefits from the transaction.
Other comparability factors such as features of local markets, location savings,
assembled workforce, and MNE group synergies.
6.140 In identifying prices and other conditions that would have been agreed between
independent enterprises under comparable circumstances, it is often essential to carefully
identify idiosyncratic aspects of the controlled transaction that arise by virtue of the
relationship between the parties. There is no requirement that associated enterprises
structure their transactions in precisely the same manner as independent enterprises might
have done. However, where transactional structures are utilised by associated enterprises
that are not typical of transactions between independent parties, the effect of those
structures on prices and other conditions that would have been agreed between uncontrolled
parties under comparable circumstances should be taken into account in evaluating the
profits that would have accrued to each of the parties at arms length.
6.141 Care should be used, in applying certain of the OECD transfer pricing methods in
a matter involving the transfer of intangibles or rights in intangibles. One sided methods,
including the resale price method and the TNMM, are generally not reliable methods for
directly valuing intangibles. In some circumstances such mechanisms can be utilised to
indirectly value intangibles by determining values for some functions using those methods
and deriving a residual value for intangibles. However, the principles of paragraph6.133
are important when following such approaches and care should be exercised to ensure that
all functions, risks, assets and other factors contributing to the generation of income are
properly identified and evaluated.
6.142 The use of transfer pricing methods that seek to estimate the value of intangibles
based on the cost of intangible development is generally discouraged. There rarely is any
correlation between the cost of developing intangibles and their value or transfer price once
developed. Hence, transfer pricing methods based on the cost of intangible development
should usually be avoided.
100 I ntangibles
6.143 However, in some limited circumstances, transfer pricing methods based on the
estimated cost of reproducing or replacing the intangible may be utilised. Such approaches
may sometimes have valid application with regard to the development of intangibles used
for internal business operations (e.g.internal software systems), particularly where the
intangibles in question are not unique and valuable intangibles. Where intangibles relating
to products sold in the marketplace are at issue, however, replacement cost valuation
methods raise serious comparability issues. Among other concerns, it is necessary to
evaluate the effect of time delays associated with deferred development on the value of the
intangibles. Often, there may be a significant first mover advantage in having a product on
the market at an early date. As a result, an identical product (and the supporting intangibles)
developed in future periods will not be as valuable as the same product (and the supporting
intangibles) available currently. In such a case, the estimated replacement cost will not
be a valid proxy for the value of an intangible transferred currently. Similarly, where an
intangible carries legal protections or exclusivity characteristics, the value of being able
to exclude competitors from using the intangible will not be reflected in an analysis based
on replacement cost. Cost based valuations generally are not reliable when applied to
determine the arms length price for partially developed intangibles.
6.144 The provisions of paragraph2.9A related to the use of rules of thumb apply to
determinations of a correct transfer price in any controlled transaction, including cases
involving the use or transfer of intangibles. Accordingly, a rule of thumb cannot be used to
evidence that a price or apportionment of income is arms length, including in particular
an apportionment of income between a licensor and a licensee of intangibles.
6.145 The transfer pricing methods most likely to prove useful in matters involving
transfers of one or more intangibles are the CUP method and the transactional profit split
method. Valuation techniques can be useful tools. Supplemental guidance on the transfer
pricing methods most likely to be useful in connection with transfers of intangibles is
provided below.
D.2.6.1. Application of the CUP Method

6.146 Where reliable comparable uncontrolled transactions can be identified, the
CUP method can be applied to determine the arms length conditions for a transfer of
intangibles or rights in intangibles. The general principles contained in paragraphs2.13
to 2.20 apply when the CUP method is used in connection with transactions involving
the transfer of intangibles. Where the CUP method is utilised in connection with the
transfer of intangibles, particular consideration must be given to the comparability of the
intangibles or rights in intangibles transferred in the controlled transaction and in the
potential comparable uncontrolled transactions. The economically relevant characteristics
or comparability factors described in SectionD.1 of ChapterI should be considered. The
matters described in SectionsD.2.1 to D.2.4 of this chapter are of particular importance
in evaluating the comparability of specific transferred intangibles and in making
comparability adjustments, where possible. It should be recognised that the identification
of reliable comparables in many cases involving intangibles may be difficult or impossible.
6.147 In some situations, intangibles acquired by an MNE group from independent
enterprises are transferred to a member of the MNE group in a controlled transaction
immediately following the acquisition. In such a case the price paid for the acquired
intangibles will often (after any appropriate adjustments, including adjustments for
acquired assets not re-transferred) represent a useful comparable for determining the arms
length price for the controlled transaction under a CUP method. Depending on the facts
I ntangibles 101
and circumstances, the third party acquisition price in such situations will have relevance
in determining arms length prices and other conditions for the controlled transaction, even
where the intangibles are acquired indirectly through an acquisition of shares or where the
price paid to the third party for shares or assets exceeds the book value of the acquired
assets. Examples23 and 26 in the annex to ChapterVI illustrate the principles of this
paragraph.
D.2.6.2. Application of transactional profit split methods18

6.148 In some circumstances, a transactional profit split method can be utilised to
determine the arms length conditions for a transfer of intangibles or rights in intangibles
where it is not possible to identify reliable comparable uncontrolled transactions for
such transfers. SectionC of ChapterII contains guidance to be considered in applying
transactional profit split methods. That guidance is fully applicable to matters involving the
transfer of intangibles or rights in intangibles. In evaluating the reliability of transactional
profit split methods, however, the availability of reliable and adequate data regarding
combined profits, appropriately allocable expenses, and the reliability of factors used to
divide combined income should be fully considered.
6.149 Transactional profit split methods may have application in connection with the
sale of full rights in intangibles. As with other applications of the transactional profit split
method, a full functional analysis that considers the functions performed, risks assumed
and assets used by each of the parties is an essential element of the analysis. Where a
transactional profit split analysis is based on projected revenues and expenses, the concerns
with the accuracy of such projections described in SectionD.2.6.4.1 should be taken into
account.
6.150 It is also sometimes suggested that a profit split analysis can be applied to transfers
of partially developed intangibles. In such an analysis, the relative value of contributions to
the development of intangibles before and after a transfer of the intangibles in question is
sometimes examined. Such an approach may include an attempt to amortise the transferors
contribution to the partially developed intangible over the asserted useful life of that
contribution, assuming no further development. Such approaches are generally based on
projections of cash flows and benefits expected to arise at some future date following the
transfer and the assumed successful completion of further development activities.
6.151 Caution should be exercised in applying profit split approaches to determine
estimates of the contributions of the parties to the creation of income in years following the
transfer, or an arms length allocation of future income, with respect to partially developed
intangibles. The contribution or value of work undertaken prior to the transfer may bear no
relationship to the cost of that work. For example, a chemical compound with potentially
blockbuster pharmaceutical indications might be developed in the laboratory at relatively
little cost. In addition, a variety of difficult to evaluate factors would need to be taken
into account in such a profit split analysis. These would include the relative riskiness and
value of research contributions before and after the transfer, the relative risk and its effect
on value, for other development activities carried out before and after the transfer, the
appropriate amortisation rate for various contributions to the intangible value, assumptions
regarding the time at which any potential new products might be introduced, and the value
of contributions other than intangibles to the ultimate generation of profit. Income and
cash flow projections in such situations can sometimes be especially speculative. These
factors can combine to call the reliability of such an application of a profit split analysis
into question. See SectionD.4 on hard-to-value intangibles.
102 I ntangibles
6.152 Where limited rights in fully developed intangibles are transferred in a licence
or similar transaction, and reliable comparable uncontrolled transactions cannot be
identified, a transactional profit split method can often be utilised to evaluate the respective
contributions of the parties to earning combined income. The profit contribution of the
rights in intangibles made available by the licensor or other transferor would, in such a
circumstance, be one of the factors contributing to the earning of income following the
transfer. However, other factors would also need to be considered. In particular, functions
performed and risks assumed by the licensee/transferee should specifically be taken
into account in such an analysis. Other intangibles used by the licensor/transferor and
by the licensee/transferee in their respective businesses should similarly be considered,
as well as other relevant factors. Careful attention should be given in such an analysis
to the limitations imposed by the terms of the transfer on the use of the intangibles by
the licensee/transferee and on the rights of the licensee/transferee to use the intangibles
for purposes of ongoing research and development. Further, assessing contributions of
the licensee to enhancements in the value of licensed intangibles may be important. The
allocation of income in such an analysis would depend on the findings of the functional
analysis, including an analysis of the relevant risks assumed. It should not be assumed
that all of the residual profit after functional returns would necessarily be allocated to the
licensor/transferor in a profit split analysis related to a licensing arrangement.
D.2.6.3. Use of valuation techniques

6.153 In situations where reliable comparable uncontrolled transactions for a transfer
of one or more intangibles cannot be identified, it may also be possible to use valuation
techniques to estimate the arms length price for intangibles transferred between associated
enterprises. In particular, the application of income based valuation techniques, especially
valuation techniques premised on the calculation of the discounted value of projected
future income streams or cash flows derived from the exploitation of the intangible being
valued, may be particularly useful when properly applied. Depending on the facts and
circumstances, valuation techniques may be used by taxpayers and tax administrations as
a part of one of the five OECD transfer pricing methods described in ChapterII, or as a
tool that can be usefully applied in identifying an arms length price.
6.154 Where valuation techniques are utilised in a transfer pricing analysis involving
the transfer of intangibles or rights in intangibles, it is necessary to apply such techniques
in a manner that is consistent with the arms length principle and the principles of
these Guidelines. In particular, due regard should be given to the principles contained
in ChaptersIIII. Principles related to realistically available options, economically
relevant characteristics including assumption of risk (see SectionD.1 of ChapterI) and
aggregation of transactions (see paragraphs3.9 to 3.12) apply fully to situations where
valuation techniques are utilised in a transfer pricing analysis. Furthermore, the rules of
these Guidelines on selection of transfer pricing methods apply in determining when such
techniques should be used (see paragraphs2.1 to 2.11). The principles of Sections A, B, C,
and D.1 of this chapter also apply where use of valuation techniques is considered.
6.155 It is essential to consider the assumptions and other motivations that underlie
particular applications of valuation techniques. For sound accounting purposes, some
valuation assumptions may sometimes reflect conservative assumptions and estimates
of the value of assets reflected in a companys balance sheet. This inherent conservatism
can lead to definitions that are too narrow for transfer pricing purposes and valuation
approaches that are not necessarily consistent with the arms length principle. Caution
should therefore be exercised in accepting valuations performed for accounting purposes
I ntangibles 103
as necessarily reflecting arms length prices or values for transfer pricing purposes
without a thorough examination of the underlying assumptions. In particular, valuations of
intangibles contained in purchase price allocations performed for accounting purposes are
not determinative for transfer pricing purposes and should be utilised in a transfer pricing
analysis with caution and careful consideration of the underlying assumptions.
6.156 It is not the intention of these Guidelines to set out a comprehensive summary of
the valuation techniques utilised by valuation professionals. Similarly, it is not the intention
of these Guidelines to endorse or reject one or more sets of valuation standards utilised
by valuation or accounting professionals or to describe in detail or specifically endorse
one or more specific valuation techniques or methods as being especially suitable for
use in a transfer pricing analysis. However, where valuation techniques are applied in a
manner that gives due regard to these Guidelines, to the specific facts of the case, to sound
valuation principles and practices, and with appropriate consideration of the validity of the
assumptions underlying the valuation and the consistency of those assumptions with the
arms length principle, such techniques can be useful tools in a transfer pricing analysis
where reliable comparable uncontrolled transactions are not available. See, however,
paragraphs6.142 and 6.143 for a discussion of the reliability and application of valuation
techniques based on intangible development costs.
6.157 Valuation techniques that estimate the discounted value of projected future cash
flows derived from the exploitation of the transferred intangible or intangibles can be
particularly useful when properly applied. There are many variations of these valuation
techniques. In general terms, such techniques measure the value of an intangible by the
estimated value of future cash flows it may generate over its expected remaining lifetime.
The value can be calculated by discounting the expected future cash flows to present
value.19 Under this approach valuation requires, among other things, defining realistic and
reliable financial projections, growth rates, discount rates, the useful life of intangibles,
and the tax effects of the transaction. Moreover it entails consideration of terminal values
when appropriate. Depending on the facts and circumstances of the individual case, the
calculation of the discounted value of projected cash flows derived from the exploitation of
the intangible should be evaluated from the perspectives of both parties to the transaction
in arriving at an arms length price. The arms length price will fall somewhere within the
range of present values evaluated from the perspectives of the transferor and the transferee.
Examples27 to 29 in the annex to ChapterVI illustrate the provisions of this section.
D.2.6.4. Specific areas of concern in applying methods based on the discounted

value of projected cash flows
6.158 When applying valuation techniques, including valuation techniques based on
projected cash flows, it is important to recognise that the estimates of value based on
such techniques can be volatile. Small changes in one or another of the assumptions
underlying the valuation model or in one or more of the valuation parameters can lead to
large differences in the intangible value the model produces. A small percentage change
in the discount rate, a small percentage change in the growth rates assumed in producing
financial projections, or a small change in the assumptions regarding the useful life of
the intangible can each have a profound effect on the ultimate valuation. Moreover, this
volatility is often compounded when changes are made simultaneously to two or more
valuation assumptions or parameters.
6.159 The reliability of the intangible value produced using a valuation model is particularly
sensitive to the reliability of the underlying assumptions and estimates on which it is
104 I ntangibles
based and on the due diligence and judgment exercised in confirming assumptions and in
estimating valuation parameters.
6.160 Because of the importance of the underlying assumptions and valuation parameters,
taxpayers and tax administrations making use of valuation techniques in determining
arms length prices for transferred intangibles should explicitly set out each of the
relevant assumptions made in creating the valuation model, should describe the basis for
selecting valuation parameters, and should be prepared to defend the reasonableness of
such assumptions and valuation parameters. Moreover, it is a good practice for taxpayers
relying on valuation techniques to present as part of their transfer pricing documentation
some sensitivity analysis reflecting the consequential change in estimated intangible value
produced by the model when alternative assumptions and parameters are adopted.
6.161 It may be relevant in assessing the reliability of a valuation model to consider
the purposes for which the valuation was undertaken and to examine the assumptions
and valuation parameters in different valuations undertaken by the taxpayer for non-tax
purposes. It would be reasonable for a tax administration to request an explanation for
any inconsistencies in the assumptions made in a valuation of an intangible undertaken
for transfer pricing purposes and valuations undertaken for other purposes. For example,
such requests would be appropriate if high discount rates are used in a transfer pricing
analysis when the company routinely uses lower discount rates in evaluating possible
mergers and acquisitions. Such requests would also be appropriate if it is asserted that
particular intangibles have short useful lives but the projections used in other business
planning contexts demonstrate that related intangibles produce cash flows in years beyond
the useful life that has been claimed for transfer pricing purposes. Valuations used by
an MNE group in making operational business decisions may be more reliable than those
prepared exclusively for purposes of a transfer pricing analysis.
6.162 The following sections identify some of the specific concerns that should be
taken into account in evaluating certain important assumptions underlying calculations
in a valuation model based on discounted cash flows. These concerns are important
in evaluating the reliability of the particular application of a valuation technique.
Notwithstanding the various concerns expressed above and outlined in detail in the
following paragraphs, depending on the circumstances, application of such a valuation
technique, either as part of one of the five OECD transfer pricing methods or as a useful
tool, may prove to be more reliable than application of any other transfer pricing method,
particularly where reliable comparable uncontrolled transactions do not exist.
D.2.6.4.1.
Accuracy of financial projections
6.163 The reliability of a valuation of a transferred intangible using discounted cash flow
valuation techniques is dependent on the accuracy of the projections of future cash flows
or income on which the valuation is based. However, because the accuracy of financial
projections is contingent on developments in the marketplace that are both unknown and
unknowable at the time the valuation is undertaken, and to this extent such projections are
speculative, it is essential for taxpayers and tax administrations to examine carefully the
assumptions underlying the projections of both future revenue and future expense.
6.164 In evaluating financial projections, the source and purpose of the projections can be
particularly important. In some cases, taxpayers will regularly prepare financial projections
for business planning purposes. It can be that such analyses are used by management of the
business in making business and investment decisions. It is usually the case that projections
prepared for non-tax business planning purposes are more reliable than projections
I ntangibles 105
prepared exclusively for tax purposes, or exclusively for purposes of a transfer pricing
analysis.
6.165 The length of time covered by the projections should also be considered in
evaluating the reliability of the projections. The further into the future the intangible in
question can be expected to produce positive cash flows, the less reliable projections of
income and expense are likely to be.
6.166 A further consideration in evaluating the reliability of projections involves whether
the intangibles and the products or services to which they relate have an established
track record of financial performance. Caution should always be used in assuming that
past performance is a reliable guide to the future, as many factors are subject to change.
However, past operating results can provide some useful guidance as to likely future
performance of products or services that rely on intangibles. Projections with respect
to products or services that have not been introduced to the market or that are still in
development are inherently less reliable than those with some track record.
6.167 When deciding whether to include development costs in the cash flow projections
it is important to consider the nature of the transferred intangible. Some intangibles may
have indefinite useful lives and may be continually developed. In these situations it is
appropriate to include future development costs in the cash flow forecasts. Others, for
example a specific patent, may already be fully developed and, in addition not provide a
platform for the development of other intangibles. In these situations no development costs
should be included in the cash flow forecasts for the transferred intangible.
6.168 Where, for the foregoing reasons, or any other reason, there is a basis to believe that
the projections behind the valuation are unreliable or speculative, attention should be given
to the guidance in SectionD.3 and D.4.
D.2.6.4.2.
Assumptions regarding growth rates
6.169 A key element of some cash flow projections that should be carefully examined
is the projected growth rate. Often projections of future cash flows are based on current
cash flows (or assumed initial cash flows after product introduction in the case of partially
developed intangibles) expanded by reference to a percentage growth rate. Where that
is the case, the basis for the assumed growth rate should be considered. In particular, it
is unusual for revenues derived from a particular product to grow at a steady rate over a
long period of time. Caution should therefore be exercised in too readily accepting simple
models containing linear growth rates not justified on the basis of either experience with
similar products and markets or a reasonable evaluation of likely future market conditions.
It would generally be expected that a reliable application of a valuation technique based
on projected future cash flows would examine the likely pattern of revenue and expense
growth based on industry and company experience with similar products.
D.2.6.4.3.
Discount rates
6.170 The discount rate or rates used in converting a stream of projected cash flows into a
present value is a critical element of a valuation model. The discount rate takes into account
the time value of money and the risk or uncertainty of the anticipated cash flows. As small
variations in selected discount rates can generate large variations in the calculated value of
intangibles using these techniques, it is essential for taxpayers and tax administrations to
give close attention to the analysis performed and the assumptions made in selecting the
discount rate or rates utilised in the valuation model.
106 I ntangibles
6.171 There is no single measure for a discount rate that is appropriate for transfer pricing
purposes in all instances. Neither taxpayers nor tax administrations should assume that a
discount rate that is based on a Weighted Average Cost of Capital (WACC) approach or any
other measure should always be used in transfer pricing analyses where determination of
appropriate discount rates is important. Instead the specific conditions and risks associated
with the facts of a given case and the particular cash flows in question should be evaluated
in determining the appropriate discount rate.
6.172 It should be recognised in determining and evaluating discount rates that in
some instances, particularly those associated with the valuation of intangibles still in
development, intangibles may be among the most risky components of a taxpayers
business. It should also be recognised that some businesses are inherently more risky than
others and some cash flow streams are inherently more volatile than others. For example,
the likelihood that a projected level of research and development expense will be incurred
may be higher than the likelihood that a projected level of revenues will ultimately be
generated. The discount rate or rates should reflect the level of risk in the overall business
and the expected volatility of the various projected cash flows under the circumstances of
each individual case.
6.173 Since certain risks can be taken into account either in arriving at financial projections
or in calculating the discount rate, care should be taken to avoid double discounting for risk.
D.2.6.4.4.
Useful life of intangibles and terminal values
6.174 Valuation techniques are often premised on the projection of cash flows derived
from the exploitation of the intangible over the useful life of the intangible in question. In
such circumstances, the determination of the actual useful life of the intangible will be one
of the critical assumptions supporting the valuation model.
6.175 The projected useful life of particular intangibles is a question to be determined
on the basis of all of the relevant facts and circumstances. The useful life of a particular
intangible can be affected by the nature and duration of the legal protections afforded the
intangible. The useful life of intangibles also may be affected by the rate of technological
change in the industry, and by other factors affecting competition in the relevant economic
environment. See paragraphs6.121 and 6.122.
6.176 In some circumstances, particular intangibles may contribute to the generation of
cash flow in years after the legal protections have expired or the products to which they
specifically relate have ceased to be marketed. This can be the case in situations where
one generation of intangibles forms the base for the development of future generations of
intangibles and new products. It may well be that some portion of continuing cash flows
from projected new products should properly be attributed to otherwise expired intangibles
where such follow on effects exist. It should be recognised that, while some intangibles
have an indeterminate useful life at the time of valuation, that fact does not imply that nonroutine returns are attributable to such intangibles in perpetuity.
6.177 In this regard, where specific intangibles contribute to continuing cash flows
beyond the period for which reasonable financial projections exist, it will sometimes be
the case that a terminal value for the intangible related cash flows is calculated. Where
terminal values are used in valuation calculations, the assumptions underlying their
calculation should be clearly set out and the underlying assumptions thoroughly examined,
particularly the assumed growth rates.
I ntangibles 107
D.2.6.4.5.
Assumptions regarding taxes
6.178 Where the purpose of the valuation technique is to isolate the projected cash flows
associated with an intangible, it may be necessary to evaluate and quantify the effect of
projected future income taxes on the projected cash flows. Tax effects to be considered
include: (i)taxes projected to be imposed on future cash flows, (ii)tax amortisation
benefits projected to be available to the transferee, if any, and (iii)taxes projected to be
imposed on the transferor as a result of the transfer, if any.
D.2.7. Form of payment

6.179 Taxpayers have substantial discretion in defining the form of payment for transferred
intangibles. In transactions between independent parties, it is common to observe payments
for intangibles that take the form of a single lump sum. It is also common to observe
payments for intangibles that take the form of periodic payments over time. Arrangements
involving periodic payments can be structured either as a series of instalment payments
fixed in amount, or may take the form of contingent payments where the amount of
payments depends on the level of sales of products supported by the intangibles, on
profitability, or on some other factor. The principles of SectionD.1.1 of ChapterI should be
followed in evaluating taxpayer agreements with regard to the form of payment.
6.180 In evaluating the provisions of taxpayer agreements related to the form of payment,
it should be noted that some payment forms will entail greater or lesser levels of risk to
one of the parties. For example, a payment form contingent on future sales or profit will
normally involve greater risk to the transferor than a payment form calling for either
a single lump-sum payment at the time of the transfer or a series of fixed instalment
payments, because of the existence of the contingency. The chosen form of the payment
must be consistent with the facts and circumstances of the case, including the written
contracts, the actual conduct of the parties, and the ability of the parties to bear and
manage the relevant payment risks. In particular, the amount of the specified payments
should reflect the relevant time value of money and risk features of the chosen form of
payment. For example, if a valuation technique is applied and results in the calculation of a
lump-sum present value for the transferred intangible, and if a taxpayer applies a payment
form contingent on future sales, the discount rate used in converting the lump-sum
valuation to a stream of contingent payments over the useful life of the intangible should
reflect the increased risk to the transferor that sales may not materialise and that payments
would therefore not be forthcoming, as well as the time value of money consequences
arising from the deferral of the payments to future years.
D.3. Arms length pricing of transactions involving intangibles for which

valuation is highly uncertain at the time of the transaction
6.181 Intangibles or rights in intangibles may have specific features complicating the
search for comparables and in some cases making it difficult to determine the value of
an intangible at the time of the transaction. When valuation of an intangible or rights in
an intangible at the time of the transaction is highly uncertain, the question arises as to
how arms length pricing should be determined. The question should be resolved, both by
taxpayers and tax administrations, by reference to what independent enterprises would
have done in comparable circumstances to take account of the valuation uncertainty in
the pricing of the transaction. To this aim, the guidance and recommended process in
SectionD of ChapterI and the principles in ChapterIII as supplemented by the guidance
in this chapter for conducting a comparability analysis are relevant.
108 I ntangibles
6.182 Depending on the facts and circumstances, there is a variety of mechanisms that
independent enterprises might adopt to address high uncertainty in the valuation of the
intangible at the time of the transaction. For example, one possibility is to use anticipated
benefits (taking into account all relevant economic factors) as a means for establishing the
pricing at the outset of the transaction. In determining the anticipated benefits, independent
enterprises would take into account the extent to which subsequent developments are
foreseeable and predictable. In some cases, independent enterprises might find that
subsequent developments are sufficiently predictable and therefore the projections of
anticipated benefits are sufficiently reliable to fix the pricing for the transaction at the
outset on the basis of those projections.
6.183 In other cases, independent enterprises might find that pricing based on anticipated
benefits alone does not provide adequate protection against the risks posed by the high
uncertainty in valuing the intangible. In such cases independent enterprises might, for
instance, adopt shorter-term agreements, include price adjustment clauses in the terms of the
agreement, or adopt a payment structure involving contingent payments to protect against
subsequent developments that might not be sufficiently predictable. For these purposes, a
contingent pricing arrangement is any pricing arrangement in which the quantum or timing
of payments is dependent on contingent events, including the achievement of predetermined
financial thresholds such as sales or profits, or of predetermined development stages
(e.g.royalty or periodic milestone payments). For example, a royalty rate could be set to
increase as the sales of the licensee increase, or additional payments could be required
at such time as certain development targets are successfully achieved. For a transfer of
intangibles or rights in intangibles at a stage when they are not ready to be commercialised
but require further development, payment terms adopted by independent parties on initial
transfer might include the determination of additional contingent amounts that would
become payable only on the achievement of specified milestone stages in their further
development.
6.184 Also, independent enterprises may determine to assume the risk of unpredictable
subsequent developments. However, the occurrence of major events or developments
unforeseen by the parties at the time of the transaction or the occurrence of foreseen
events or developments considered to have a low probability of occurrence which change
the fundamental assumptions upon which the pricing was determined may lead to
renegotiation of the pricing arrangements by agreement of the parties where it is to their
mutual benefit. For example, a renegotiation might occur at arms length if a royalty rate
based on sales for a patented drug turned out to be vastly excessive due to an unexpected
development of an alternative low-cost treatment. The excessive royalty might remove
the incentive of the licensee to manufacture or sell the drug at all, in which case the
licensee will have an interest in renegotiating the agreement. It may be the case that
the licensor has an interest in keeping the drug on the market and in retaining the same
licensee to manufacture or sell the drug because of the skills and expertise of the licensee
or the existence of a long-standing co-operative relationship between them. Under these
circumstances, the parties might prospectively renegotiate to their mutual benefit all or part
of the agreement and set a lower royalty rate. In any event, whether renegotiation would
take place, would depend upon all the facts and circumstances of each case.
6.185 If independent enterprises in comparable circumstances would have agreed on the
inclusion of a mechanism to address high uncertainty in valuing the intangible (e.g.a price
adjustment clause), the tax administration should be permitted to determine the pricing
of a transaction involving an intangible or rights in an intangible on the basis of such
mechanism. Similarly, if independent enterprises in comparable circumstances would have
I ntangibles 109
considered subsequent events so fundamental that their occurrence would have led to a
prospective renegotiation of the pricing of a transaction, such events should also lead to a
modification of the pricing of the transaction between associated enterprises.
D.4. Hard-to-value intangibles (HTVI)

6.186 A tax administration may find it difficult to establish or verify what developments
or events might be considered relevant for the pricing of a transaction involving the transfer
of intangibles or rights in intangibles, and the extent to which the occurrence of such
developments or events, or the direction they take, might have been foreseen or reasonably
foreseeable at the time the transaction was entered into. The developments or events
that might be of relevance for the valuation of an intangible are in most cases strongly
connected to the business environment in which that intangible is developed or exploited.
Therefore, the assessment of which developments or events are relevant and whether
the occurrence and direction of such developments or events might have been foreseen
or reasonably foreseeable requires specialised knowledge, expertise and insight into the
business environment in which the intangible is developed or exploited. In addition, the
assessments that are prudent to undertake when evaluating the transfer of intangibles or
rights in intangibles in an uncontrolled transaction, may not be seen as necessary or useful
for other than transfer pricing purposes by the MNE group when a transfer takes place
within the group, with the result that those assessments may not be comprehensive. For
example, an enterprise may transfer intangibles at an early stage of development to an
associated enterprise, set a royalty rate that does not reflect the value of the intangible at
the time of the transfer, and later take the position that it was not possible at the time of the
transfer to predict the subsequent success of the product with full certainty. The difference
between the ex ante and ex post value of the intangible would therefore be claimed by
the taxpayer to be attributable to more favourable developments than anticipated. The
general experience of tax administrations in these situations is that they may not have the
specific business insights or access to the information to be able to examine the taxpayers
claim and to demonstrate that the difference between the ex ante and ex post value of the
intangible is due to non-arms length pricing assumptions made by the taxpayer. Instead,
tax administrations seeking to examine the taxpayers claim are largely dependent on
the insights and information provided by that taxpayer. These situations associated with
information asymmetry between taxpayers and tax administrations can give rise to transfer
pricing risk. See paragraph6.191.
6.187 In these situations involving the transfer of an intangible or rights in an intangible
ex post outcomes can provide a pointer to tax administrations about the arms length nature
of the ex ante pricing arrangement agreed upon by the associated enterprises, and the
existence of uncertainties at the time of the transaction. If there are differences between the
ex ante projections and the ex post results which are not due to unforeseeable developments
or events, the differences may give an indication that the pricing arrangement agreed upon
by the associated enterprises at the time the transaction was entered into may not have
adequately taken into account the relevant developments or events that might have been
expected to affect the value of the intangible and the pricing arrangements adopted.
6.188 In response to the considerations discussed above, this section contains an approach
consistent with the arms length principle that tax administrations can adopt to ensure
that tax administrations can determine in which situations the pricing arrangements as
set by the taxpayers are at arms length and are based on an appropriate weighting of the
foreseeable developments or events that are relevant for the valuation of certain hard-tovalue intangibles, and in which situations this is not the case. Under this approach, expost
110 I ntangibles
evidence provides presumptive evidence as to the existence of uncertainties at the time of
the transaction, whether the taxpayer appropriately took into account reasonably foreseeable
developments or events at the time of the transaction, and the reliability of the information
used ex ante in determining the transfer price for the transfer of such intangibles or
rights in intangibles. Such presumptive evidence may be subject to rebuttal as stated in
paragraphs6.193 and 6.194, if it can be demonstrated that it does not affect the accurate
determination of the arms length price. This situation should be distinguished from the
situation in which hindsight is used by taking ex post results for tax assessment purposes
without considering whether the information on which the ex post results are based could or
should reasonably have been known and considered by the associated enterprises at the time
the transaction was entered into.
6.189 The term hard-to-value intangibles (HTVI) covers intangibles or rights in intangibles
for which, at the time of their transfer between associated enterprises, (i)no reliable
comparables exist, and (ii)at the time the transactions was entered into, the projections
of future cash flows or income expected to be derived from the transferred intangible, or
the assumptions used in valuing the intangible are highly uncertain, making it difficult to
predict the level of ultimate success of the intangible at the time of the transfer.
6.190 Transactions involving the transfer or the use of HTVI in paragraph6.189 may
exhibit one or more of the following features:
The intangible is only partially developed at the time of the transfer.
The intangible is not expected to be exploited commercially until several years
following the transaction.
The intangible does not itself fall within the definition of HTVI in paragraph6.189
but is integral to the development or enhancement of other intangibles which fall
within that definition of HTVI.
The intangible is expected to be exploited in a manner that is novel at the time of
the transfer and the absence of a track record of development or exploitation of
similar intangibles makes projections highly uncertain.
The intangible, meeting the definition of HTVI under paragraph6.189, has been
transferred to an associated enterprise for a lump sum payment.
The intangible is either used in connection with or developed under a CCA or similar
arrangements.
6.191 For such intangibles, information asymmetry between taxpayer and tax administrations,
including what information the taxpayer took into account in determining the pricing of the
transaction, may be acute and may exacerbate the difficulty encountered by tax administrations
in verifying the arms length basis on which pricing was determined for the reasons discussed
in paragraph6.186. As a result, it will prove difficult for a tax administration to perform a
risk assessment for transfer pricing purposes, to evaluate the reliability of the information on
which pricing has been based by the taxpayer, or to consider whether the intangible or rights
in intangibles have been transferred at undervalue or overvalue compared to the arms length
price, until ex post outcomes are known in years subsequent to the transfer.
6.192 In these circumstances, the tax administration can consider ex post outcomes as
presumptive evidence about the appropriateness of the ex ante pricing arrangements.
However, the consideration of ex post evidence should be based on a determination that such
evidence is necessary to be taken into account to assess the reliability of the information on
which ex ante pricing has been based. Where the tax administration is able to confirm the
I ntangibles 111
reliability of the information on which ex ante pricing has been based, notwithstanding the
approach described in this section, then adjustments based on ex post profit levels should
not be made. In evaluating the ex ante pricing arrangements, the tax administration is
entitled to use the ex post evidence about financial outcomes to inform the determination
of the arms length pricing arrangements, including any contingent pricing arrangements,
that would have been made between independent enterprises at the time of the transaction,
considering the guidance in paragraph6.185. Depending on the facts and circumstances of
the case and considering the guidance in SectionB.5 of ChapterIII, a multi-year analysis of
the information for the application of this approach may be appropriate.
6.193 This approach will not apply to transactions involving the transfer or use of HTVI
falling within the scope of paragraph6.189, when at least one of the following exemptions
applies:
i) The taxpayer provides:
1. Details of the ex ante projections used at the time of the transfer to determine
the pricing arrangements, including how risks were accounted for in calculations
to determine the price (e.g.probability-weighted), and the appropriateness
of its consideration of reasonably foreseeable events and other risks, and the
probability of occurrence; and,
2. Reliable evidence that any significant difference between the financial
projections and actual outcomes is due to: a) unforeseeable developments or
events occurring after the determination of the price that could not have been
anticipated by the associated enterprises at the time of the transaction; or b) the
playing out of probability of occurrence of foreseeable outcomes, and that these
probabilities were not significantly overestimated or underestimated at the time
of the transaction;
ii) The transfer of the HTVI is covered by a bilateral or multilateral advance pricing
arrangement in effect for the period in question between the countries of the
transferee and the transferor.
iii) Any significant difference between the financial projections and actual outcomes
mentioned in i)2 above does not have the effect of reducing or increasing the
compensation for the HTVI by more than 20% of the compensation determined at
the time of the transaction.
iv) A commercialisation period of five years has passed following the year in which
the HTVI first generated unrelated party revenues for the transferee and in
which commercialisation period any significant difference between the financial
projections and actual outcomes mentioned in i)2 above was not greater than 20%
of the projections for that period.20
6.194 The first exemption means that, although the ex post evidence about financial
outcomes provides relevant information for tax administrations to consider the
appropriateness of the ex ante pricing arrangements, in circumstances where the taxpayer
can satisfactorily demonstrate what was foreseeable at the time of the transaction and
reflected in the pricing assumptions, and that the developments leading to the difference
between projections and outcomes arose from unforeseeable events, tax administrations
will not be entitled to make adjustments to the ex ante pricing arrangements based on
ex post outcomes. For example, if the evidence of financial outcomes shows that sales of
products exploiting the transferred intangible reached 1000 a year, but the ex ante pricing
arrangements were based on projections that considered sales reaching a maximum of only
112 I ntangibles
100 a year, then the tax administration should consider the reasons for sales reaching such
higher volumes. If the higher volumes were due to, for example, an exponentially higher
demand for the products incorporating the intangible caused by a natural disaster or some
other unexpected event that was clearly unforeseeable at the time of the transaction or
appropriately given a very low probability of occurrence, then the ex ante pricing should
be recognised as being at arms length, unless there is evidence other than the ex post
financial outcomes indicating that price setting did not take place on an arms length basis.
6.195 It would be important to permit resolution of cases of double taxation arising from
application of the approach for HTVI through access to the mutual agreement procedure
under the applicable Treaty.
D.5. Supplemental guidance for transactions involving the use of intangibles in

connection with the sale of goods or the provision of services
6.196 This section provides supplemental guidance for applying the rules of ChaptersI
III in situations where one or both parties to a controlled transaction uses intangibles in
connection with the sale of goods or the provision of services, but where no transfer of
intangibles or interests in intangibles occurs. Where intangibles are present, the transfer
pricing analysis must carefully consider the effect of the intangibles involved on the prices
and other conditions of controlled transactions.
D.5.1. Intangibles as a comparability factor in transactions involving the use of

intangibles
6.197 The general rules of SectionD.1 of ChapterI and ChapterIII also apply to guide the
comparability analysis of transactions involving the use of intangibles in connection with
a controlled transaction involving the sale of goods or the provision of services. However,
the presence of intangibles may sometimes raise challenging comparability issues.
6.198 In a transfer pricing analysis where the most appropriate transfer pricing method is
the resale price method, the cost-plus method, or the transactional net margin method, the
less complex of the parties to the controlled transaction is often selected as the tested party.
In many cases, an arms length price or level of profit for the tested party can be determined
without the need to value the intangibles used in connection with the transaction. That
would generally be the case where only the non-tested party uses intangibles. In some cases,
however, the tested party may in fact use intangibles notwithstanding its relatively less
complex operations. Similarly, parties to potentially comparable uncontrolled transactions
may use intangibles. Where either of these is the case, it becomes necessary to consider
the intangibles used by the tested party and by the parties to potentially comparable
uncontrolled transactions as one comparability factor in the analysis.
6.199 For example, a tested party engaged in the marketing and distribution of goods
purchased in controlled transactions may have developed marketing intangibles in its
geographic area of operation, including customer lists, customer relationships, and
customer data. It may also have developed advantageous logistical know-how or software
and other tools that it uses in conducting its distribution business. The impact of such
intangibles on the profitability of the tested party should be considered in conducting a
comparability analysis.
6.200 It is important to note, however, that in many cases where the tested party uses
such intangibles, parties to comparable uncontrolled transactions will also have the
same types of intangibles at their disposal. Thus, in the distribution company case, an
I ntangibles 113
uncontrolled entity engaged in providing distribution services in the tested partys industry
and market is also likely to have knowledge of and contacts with potential customers,
collect customer data, have its own effective logistical systems, and in other respects have
similar intangibles to the tested party. Where that is the case, the level of comparability
may be sufficiently high that it is possible to rely on prices paid or margins earned by the
potential comparables as an appropriate measure of arms length compensation for both the
functions performed and the intangibles owned by the tested party.
6.201 Where the tested party and the potential comparable have comparable intangibles,
the intangibles will not constitute unique and valuable intangibles within the meaning of
paragraph6.17, and therefore no comparability adjustments will be required with regard
to the intangibles. The potential comparable will, in these circumstances, provide the best
evidence of the profit contribution of the tested partys intangibles. If, however, either the
tested party or the potential comparable has and uses in its business unique and valuable
intangibles, it may be necessary either to make appropriate comparability adjustments or
to revert to a different transfer pricing method. The principles contained in SectionsD.2.1
to D.2.4 apply in evaluating the comparability of intangibles in such situations.
6.202 It is appropriate for both taxpayers and tax administrations to exercise restraint
in rejecting potential comparables based on the use of intangibles by either the parties to
potentially comparable transactions or by the tested party. Potential comparables should
generally not be rejected on the basis of the asserted existence of unspecified intangibles or
on the basis of the asserted significance of goodwill. If identified transactions or companies
are otherwise comparable, they may provide the best available indication of arms length
pricing notwithstanding the existence and use by either the tested party or the parties to
the potentially comparable transactions of relatively insignificant intangibles. Potentially
comparable transactions should be disregarded on the basis of the existence and use of noncomparable intangibles only where the intangibles in question can be clearly and distinctly
identified and where the intangibles are manifestly unique and valuable intangibles.
D.5.2. Determining arms length prices for transactions involving the use of
intangibles in connection with the sale of goods or the performance of services
6.203 The principles of ChaptersIIII apply in determining arms length prices for
transactions involving the use of intangibles in connection with sales of goods or the
performance of services. Two general categories of cases can arise. In the first category
of cases, the comparability analysis, including the functional analysis, will reveal the
existence of sufficiently reliable comparables to permit the determination of arms length
conditions for the transaction using a transfer pricing method based on comparables. In the
second category of cases, the comparability analysis, including the functional analysis, will
fail to identify reliable comparable uncontrolled transactions, often as a direct result of the
use by one or both parties to the transaction of unique and valuable intangibles. Transfer
pricing approaches to these two categories of cases are described below.
D.5.2.1. Situations where reliable comparables exist

6.204 It will often be the case that, notwithstanding the use of intangibles by one or both
parties to a controlled sale of goods or provision of services, reliable comparables can be
identified. Depending on the specific facts, any of the five OECD transfer pricing methods
described in ChapterII might constitute the most appropriate transfer pricing method
where the transaction involves the use of intangibles in connection with a controlled sale
of goods or provision of services and reliable comparables are present.
114 I ntangibles
6.205 Where the tested party does not use unique and valuable intangibles, and where
reliable comparables can be identified, it will often be possible to determine arms length
prices on the basis of one-sided methods including the CUP, resale price, cost plus and
TNMM methods. The guidance in ChaptersIIII will generally be sufficient to guide the
determination of arms length prices in such situations, without the need for a detailed
analysis of the nature of the intangibles used by the other party to the transaction.
6.206 The principles described in SectionsD.2.1 to D.2.4 of this chapter should be applied
in determining whether the use of intangibles by the tested party will preclude reliance on
identified comparable uncontrolled transactions or require comparability adjustments. Only
when the intangibles used by the tested party are unique and valuable intangibles will the
need arise to make comparability adjustments or to adopt a transfer pricing method less
dependent on comparable uncontrolled transactions. Where intangibles used by the tested
party are not unique and valuable intangibles, prices paid or received, or margins or returns
earned by parties to comparable uncontrolled transactions may provide a reliable basis for
determining arms length conditions.
6.207 Where the need to make comparability adjustments arises because of differences in
the intangibles used by the tested party in a controlled transaction and the intangibles used
by a party to a potentially comparable uncontrolled transaction, difficult factual questions
can arise in quantifying reliable comparability adjustments. These issues require thorough
consideration of the relevant facts and circumstances and of the available data regarding the
impact of the intangibles on prices and profits. Where the impact on price of a difference in
the nature of the intangibles used is clearly material, but not subject to accurate estimation,
it may be necessary to utilise a different transfer pricing method that is less dependent on
identification of reliable comparables.
6.208 It should also be recognised that comparability adjustments for factors other than
differences in the nature of the intangibles used may be required in matters involving the
use of intangibles in connection with a controlled sale of goods or services. In particular,
comparability adjustments may be required for matters such as differences in markets,
locational advantages, business strategies, assembled workforce, corporate synergies and
other similar factors. While such factors may not be intangibles as that term is described
in SectionA.1 of this chapter, they can nevertheless have important effects on arms length
prices in matters involving the use of intangibles.
D.5.2.2. Situations where reliable comparables do not exist

6.209 In some circumstances where reliable uncontrolled transactions cannot be identified,
transactional profit split methods may be utilised to determine an arms length allocation
of profits for the sale of goods or the provision of services involving the use of intangibles.
One circumstance in which the use of transactional profit split methods may be appropriate
is where both parties to the transaction make unique and valuable contributions to the
transaction.
6.210 SectionC of ChapterII contains guidance to be considered in applying transactional
profit split methods. That guidance is fully applicable to matters involving the use of
intangibles in connection with the sale of goods or the provision of services in controlled
transactions.
6.211 In applying a profit split method in a case involving the use of intangibles, care
should be taken to identify the intangibles in question, to evaluate the manner in which
those intangibles contribute to the creation of value, and to evaluate other income producing
I ntangibles 115
functions performed, risks assumed and assets used. Vague assertions of the existence and
use of unspecified intangibles will not support a reliable application of a profit split method.
6.212 In appropriate circumstances, transfer pricing methods or valuation techniques
not dependent on the identification of reliable comparable uncontrolled transactions may
also be utilised to determine arms length conditions for the sale of goods or the provision
of services where intangibles are used in connection with the transaction. The alternative
selected should reflect the nature of the goods or services provided and the contribution of
intangibles and other relevant factors to the creation of value.
116 I ntangibles
Additional Guidance in ChapterII of

the Transfer Pricing Guidelines Resulting from
theRevisions to ChapterVI
The following language is inserted following paragraph2.9.
2.9A The application of a general rule of thumb does not provide an adequate substitute
for a complete functional and comparability analysis conducted under the principles of
ChaptersIIII. Accordingly, a rule of thumb cannot be used to evidence that a price or an
apportionment of income is arms length.
I ntangibles 117
The provisions of the annex to ChapterVI of the Transfer Pricing Guidelines are
deleted in their entirety and are replaced by the following language.
Annex to ChapterVI Examples to illustrate the guidance on intangibles

Example1
1.
Premiere is the parent company of an MNE group. CompanyS is a wholly owned
subsidiary of Premiere and a member of the Premiere group. Premiere funds R&D and
performs ongoing R&D functions in support of its business operations. When its R&D
functions result in patentable inventions, it is the practice of the Premiere group that all
rights in such inventions be assigned to CompanyS in order to centralise and simplify
global patent administration. All patent registrations are held and maintained in the name
of CompanyS.
2.
CompanyS employs three lawyers to perform its patent administration work and
has no other employees. CompanyS does not conduct or control any of the R&D activities
of the Premiere group. CompanyS has no technical R&D personnel, nor does it incur
any of the Premiere groups R&D expense. Key decisions related to defending the patents
are made by Premiere management, after taking advice from employees of CompanyS.
Premieres management, and not the employees of CompanyS, controls all decisions
regarding licensing of the groups patents to both independent and associated enterprises.
3.
At the time of each assignment of rights from Premiere to CompanyS, CompanyS
makes a nominal EUR100 payment to Premiere in consideration of the assignment
of rights to a patentable invention and, as a specific condition of the assignment,
simultaneously grants to Premiere an exclusive, royalty free, patent licence, with full
rights to sub-licence, for the full life of the patent to be registered. The nominal payments
of CompanyS to Premiere are made purely to satisfy technical contract law requirements
related to the assignments and, for purposes of this example, it is assumed that they do
not reflect arms length compensation for the assigned rights to patentable inventions.
Premiere uses the patented inventions in manufacturing and selling its products throughout
the world and from time to time sublicenses patent rights to others. CompanyS makes
no commercial use of the patents nor is it entitled to do so under the terms of the licence
agreement with Premiere.
4.
Under the agreement, Premiere performs all functions related to the development,
enhancement, maintenance, protection and exploitation of the intangibles except for
patent administration services. Premiere contributes and uses all assets associated with
the development and exploitation of the intangible, and assumes all or substantially all
of the risks associated with the intangibles. Premiere should be entitled to the bulk of the
returns derived from exploitation of the intangibles. Tax administrations could arrive at
an appropriate transfer pricing solution by delineating the actual transaction undertaken
between Premiere and CompanyS. Depending on the facts, it might be determined that
taken together the nominal assignment of rights to CompanyS and the simultaneous grant
of full exploitation rights back to Premiere reflect in substance a patent administration
service arrangement between Premiere and CompanyS. An arms length price would
be determined for the patent administration services and Premiere would retain or be
allocated the balance of the returns derived by the MNE group from the exploitation of the
patents.
118 I ntangibles
Example2
5.
The facts related to the development and control of patentable inventions are the
same as in Example1. However, instead of granting a perpetual and exclusive licence of its
patents back to Premiere, CompanyS, acting under the direction and control of Premiere,
grants licences of its patents to associated and independent enterprises throughout the
world in exchange for periodic royalties. For purposes of this example, it is assumed that
the royalties paid to CompanyS by associated enterprises are all arms length.
6.
CompanyS is the legal owner of the patents. However, its contributions to the
development, enhancement, maintenance, protection, and exploitation of the patents are
limited to the activities of its three employees in registering the patents and maintaining the
patent registrations. The CompanyS employees do not control or participate in the licensing
transactions involving the patents. Under these circumstances, CompanyS is only entitled to
compensation for the functions it performs. Based on an analysis of the respective functions
performed, assets used, and risks assumed by Premiere and CompanyS in developing,
enhancing, maintaining, protecting, and exploiting the intangibles, CompanyS should not
be entitled ultimately to retain or be attributed income from its licensing arrangements over
and above the arms length compensation for its patent registration functions.
7.
As in Example1 the true nature of the arrangement is a patent administration
service contract. The appropriate transfer pricing outcome can be achieved by ensuring
that the amount paid by CompanyS in exchange for the assignments of patent rights
appropriately reflects the respective functions performed, assets used, and risks assumed
by Premiere and by CompanyS. Under such an approach, the compensation due to
Premiere for the patentable inventions is equal to the licensing revenue of CompanyS less
an appropriate return to the functions CompanyS performs.
Example3
8.
The facts are the same as in Example2. However, after licensing the patents to
associated and independent enterprises for a few years, CompanyS, again acting under the
direction and control of Premiere, sells the patents to an independent enterprise at a price
reflecting appreciation in the value of the patents during the period that CompanyS was
the legal owner. The functions of CompanyS throughout the period it was the legal owner
of the patents were limited to performing the patent registration functions described in
Examples1 and 2.
9.
Under these circumstances, the income of CompanyS should be the same as
in Example2. It should be compensated for the registration functions it performs, but
should not otherwise share in the returns derived from the exploitation of the intangibles,
including the returns generated from the disposition of the intangibles.
Example4
10. The facts related to the development of the patents are the same as described in
Example3. In contrast to Example1, CompanyS in this example has employees capable of
making, and who actually make, the decision to take on the patent portfolio. All decisions
relating to the licensing programme were taken by CompanyS employees, all negotiations
with licensees were undertaken by CompanyS employees, and CompanyS employees
monitored compliance of independent licensees with the terms of the licenses. It should be
assumed for purposes of this example that the price paid by CompanyS in exchange for
the patents was an arms length price that reflected the parties respective assessments of
I ntangibles 119
the future licensing programme and the anticipated returns to be derived from exploitation
of the patents as of the time of their assignment to CompanyS. For the purposes of this
example, it is assumed that the approach for hard-to-value intangibles in SectionD.4 does
not apply.
11. Following the assignments, CompanyS licensed the patents to independent
enterprises for a few years. Thereafter the value of the patents increases significantly because
of external circumstances unforeseen at the time the patents were assigned to CompanyS.
CompanyS then sells the patents to an unrelated purchaser at a price exceeding the price
initially paid by CompanyS to Premiere for the patents. CompanyS employees make all
decisions regarding the sale of the patents, negotiate the terms of the sale, and in all respects
manage and control the disposition of the patents.
12. Under these circumstances, CompanyS is entitled to retain the proceeds of the sale,
including amounts attributable to the appreciation in the value of the patents resulting from
the unanticipated external circumstances.
Example5
13. The facts are the same as in Example4 except that instead of appreciating, the
value of the patents decreases during the time they are owned by CompanyS as a result of
unanticipated external circumstances. Under these circumstances, CompanyS is entitled
to retain the proceeds of the sale, meaning that it will suffer the loss.
Example6
14.
In Year 1, a multinational group comprised of CompanyA (a countryA corporation)
and CompanyB (a countryB corporation) decides to develop an intangible, which is
anticipated to be highly profitable based on CompanyBs existing intangibles, its track
record and its experienced research and development staff. The intangible is expected
to take five years to develop before possible commercial exploitation. If successfully
developed, the intangible is anticipated to have value for ten years after initial exploitation.
Under the development agreement between CompanyA and CompanyB, CompanyB will
perform and control all activities related to the development, enhancement, maintenance,
protection and exploitation of the intangible. CompanyA will provide all funding associated
with the development of the intangible (the development costs are anticipated to be
USD100million per year for five years), and will become the legal owner of the intangible.
Once developed, the intangible is anticipated to result in profits of USD550million per
year (years 6 to 15). CompanyB will license the intangible from CompanyA and make
contingent payments to CompanyA for the right to use the intangible, based on returns of
purportedly comparable licensees. After the projected contingent payments, CompanyB
will be left with an anticipated return of USD200million per year from selling products
based on the intangible.
15. A functional analysis by the countryB tax administration of the arrangement
assesses the functions performed, assets used and contributed, and risks assumed by
CompanyA and by CompanyB. The analysis through which the actual transaction is
delineated concludes that although CompanyA is the legal owner of the intangibles, its
contribution to the arrangement is solely the provision of funding for the development of
an intangible. This analysis shows that CompanyA contractually assumes the financial
risk, has the financial capacity to assume that risk, and exercises control over that risk
in accordance with the principles outlined in paragraphs6.63 and 6.64. Taking into
120 I ntangibles
account CompanyAs contributions, as well as the realistic alternatives of CompanyA
and CompanyB, it is determined that CompanyAs anticipated remuneration should
be a risk-adjusted return on its funding commitment. Assume that this is determined to
be USD110million per year (for Years 6 to 15), which equates to an 11% risk-adjusted
anticipated financial return.21 CompanyB, accordingly, would be entitled to all remaining
anticipated income after accounting for CompanyAs anticipated return, or USD440million
per year (USD550million minus USD110million), rather than USD200million per year
as claimed by the taxpayer. (Based on the detailed functional analysis and application of
the most appropriate method, the taxpayer incorrectly chose CompanyB as the tested party
rather than CompanyA).
Example7
16. Primero is the parent company of an MNE group engaged in the pharmaceutical
business and does business in countryM. Primero develops patents and other intangibles
relating to ProductX and registers those patents in countries around the world.
17.
Primero retains its wholly owned countryN subsidiary, CompanyS, to distribute
ProductX throughout Europe and the Middle East on a limited risk basis. The distribution
agreement provides that Primero, and not CompanyS, is to bear product recall and product
liability risk, and provides further that Primero will be entitled to all profit or loss from
selling ProductX in the territory after providing CompanyS with the agreed level of
compensation for its distribution functions. Operating under the contract, CompanyS
purchases ProductX from Primero and resells ProductX to independent customers in
countries throughout its geographical area of operation. In performing its distribution
functions, CompanyS follows all applicable regulatory requirements.
18. In the first three years of operations, CompanyS earns returns from its distribution
functions that are consistent with its limited risk characterisation and the terms of the
distribution contract. Its returns reflect the fact that Primero, and not CompanyS, is
entitled to retain income derived from exploitation of the intangibles with respect to
ProductX. After three years of operation, it becomes apparent that ProductX causes
serious side effects in a significant percentage of those patients that use the product and it
becomes necessary to recall the product and remove it from the market. CompanyS incurs
substantial costs in connection with the recall. Primero does not reimburse CompanyS for
these recall related costs or for the resulting product liability claims.
19. Under these circumstances, there is an inconsistency between Primeros asserted
entitlement to returns derived from exploiting the ProductX intangibles and its failure
to bear the costs associated with the risks supporting that assertion. A transfer pricing
adjustment would be appropriate to remedy the inconsistency. In determining the
appropriate adjustment, it would be necessary to determine the true transaction between
the parties by applying the provisions of SectionD.1 of ChapterI. In doing so, it would be
appropriate to consider the risks assumed by each of the parties on the basis of the course
of conduct followed by the parties over the term of the agreement, the control over risk
exercised by Primero and CompanyS, and other relevant facts. If it is determined that
the true nature of the relationship between the parties is that of a limited risk distribution
arrangement, then the most appropriate adjustment would likely take the form of an
allocation of the recall and product liability related costs from CompanyS to Primero.
Alternatively, although unlikely, if it is determined on the basis of all the relevant facts
that the true nature of the relationship between the parties includes the exercising control
over product liability and recall risk by CompanyS, and if an arms length price can be
I ntangibles 121
identified on the basis of the comparability analysis, an increase in the distribution margins
of CompanyS for all years might be made to reflect the true risk allocation between the
parties.
Example8
20. Primair, a resident of countryX, manufactures watches which are marketed in many
countries around the world under the R trademark and trade name. Primair is the registered
owner of the R trademark and trade name. The R name is widely known in countries
where the watches are sold and has obtained considerable economic value in those markets
through the efforts of Primair. R watches have never been marketed in countryY, however,
and the R name is not known in the countryY market.
21.
In Year 1, Primair decides to enter the countryY market and incorporates a wholly
owned subsidiary in countryY, CompanyS, to act as its distributor in countryY. At the
same time, Primair enters into a long-term royalty-free marketing and distribution agreement
with CompanyS. Under the agreement, CompanyS is granted the exclusive right to market
and distribute watches bearing the R trademark and using the R trade name in countryY
for a period of five years, with an option for a further five years. CompanyS obtains no
other rights relating to the R trademark and trade name from Primair, and in particular is
prohibited from re-exporting watches bearing the R trademark and trade name. The sole
activity of CompanyS is marketing and distributing watches bearing the R trademark and
trade name. It is assumed that the R watches are not part of a portfolio of products distributed
by CompanyS in countryY. CompanyS undertakes no secondary processing, as it imports
packaged watches into countryY ready for sale to the final customer.
22. Under the contract between Primair and CompanyS, CompanyS purchases the
watches from Primair in countryY currency, takes title to the branded watches and performs
the distribution function in countryY, incurs the associated carrying costs (e.g.inventory
and receivables financing), and assumes the corresponding risks (e.g.inventory, credit
and financing risks). Under the contract between Primair and CompanyS, CompanyS
is required to act as a marketing agent to assist in developing the market for R watches
in countryY. CompanyS consults with Primair in developing the countryY marketing
strategy for R watches. Primair develops the overall marketing plan based largely on its
experience in other countries, it develops and approves the marketing budgets, and it makes
final decisions regarding advertising designs, product positioning and core advertising
messages. CompanyS consults on local market issues related to advertising, assists in
executing the marketing strategy under Primairs direction, and provides evaluations of the
effectiveness of various elements of the marketing strategy. As compensation for providing
these marketing support activities, CompanyS receives from Primair a service fee based on
the level of marketing expenditure it incurs and including an appropriate profit element.
23. Assume for the purpose of this example that, based upon a thorough comparability
analysis, including a detailed functional analysis, it is possible to conclude that the price
CompanyS pays Primair for the R watches should be analysed separately from the
compensation CompanyS receives for the marketing it undertakes on behalf of Primair.
Assume further that based upon identified comparable transactions, the price paid for the
watches is arms length and that this price enables CompanyS to earn an arms length level
of compensation from selling the watches for the distribution function it performs, the
assets it uses and the risks it assumes.
24. In Years 1 to 3, CompanyS embarks on a strategy that is consistent with its agreement
with Primair to develop the countryY market for R watches. In the process, CompanyS
122 I ntangibles
incurs marketing expenses. Consistent with the contract, CompanyS is reimbursed by
Primair for the marketing expenses it incurs, and is paid a mark-up on those expenses. By the
end of Year 2, the R trademark and trade name have become well established in countryY.
The compensation derived by CompanyS for the marketing activities it performed on
behalf of Primair is determined to be arms length, based upon comparison to that paid to
independent advertising and marketing agents identified and determined to be comparable as
part of the comparability analysis.
25. Under these circumstances, Primair is entitled to retain any income derived from
exploiting the R trademark and trade name in the countryY market that exceeds the arms
length compensation to CompanyS for its functions and no transfer pricing adjustment is
warranted under the circumstances.
Example9
26.
The facts in this example are the same as in Example8, except as follows:
Under the contract between Primair and CompanyS, CompanyS is now obligated
to develop and execute the marketing plan for countryY without detailed control of
specific elements of the plan by Primair. CompanyS bears the costs and assumes
certain of the risks associated with the marketing activities. The agreement between
Primair and CompanyS does not specify the amount of marketing expenditure
CompanyS is expected to incur, only that CompanyS is required to use its best
efforts to market the watches. CompanyS receives no direct reimbursement from
Primair in respect of any expenditure it incurs, nor does it receive any other indirect
or implied compensation from Primair, and CompanyS expects to earn its reward
solely from its profit from the sale of R brand watches to third party customers
in the countryY market. A thorough functional analysis reveals that Primair
exercises a lower level of control over the marketing activities of CompanyS than
in Example8 in that it does not review and approve the marketing budget or design
details of the marketing plan. CompanyS bears different risks and is compensated
differently than was the case in Example8. The contractual arrangements between
Primair and CompanyS are different and the risks assumed by CompanyS are
greater in Example9 than in Example8. CompanyS does not receive direct cost
reimbursements or a separate fee for marketing activities. The only controlled
transaction between Primair and CompanyS in Example9 is the transfer of the
branded watches. As a result, CompanyS can obtain its reward for its marketing
activities only through selling R brand watches to third party customers.
As a result of these differences, Primair and CompanyS adopt a lower price for
watches in Example9 than the price for watches determined for purposes of
Example8. As a result of the differences identified in the functional analysis,
different criteria are used for identifying comparables and for making comparability
adjustments than was the case in Example8. This results in CompanyS having a
greater anticipated total profit in Example9 than in Example8 because of its higher
level of risk and its more extensive functions.
27. Assume that in Years 1 through 3, CompanyS embarks on a strategy that is

consistent with its agreement with Primair and, in the process, performs marketing functions
and incurs marketing expenses. As a result, CompanyS has high operating expenditures and
slim margins in Years 1 through 3. By the end of Year 2, the R trademark and trade name
have become established in countryY because of CompanySs efforts. Where the marketer/
distributor actually bears the costs and associated risks of its marketing activities, the issue
I ntangibles 123
is the extent to which the marketer/distributor can share in the potential benefits from those
activities. Assume that the enquiries of the countryY tax administrations conclude, based
on a review of comparable distributors, that CompanyS would have been expected to have
performed the functions it performed and incurred its actual level of marketing expense if
it were independent from Primair.
28. Given that CompanyS performs the functions and bears the costs and associated
risks of its marketing activities under a long-term contract of exclusive distribution rights
for the R watches, there is an opportunity for CompanyS to benefit (or suffer a loss) from
the marketing and distribution activities it undertakes. Based on an analysis of reasonably
reliable comparable data, it is concluded that, for purposes of this example, the benefits
obtained by CompanyS result in profits similar to those made by independent marketers
and distributors bearing the same types of risks and costs as CompanyS in the first
few years of comparable long-term marketing and distribution agreements for similarly
unknown products.
29. Based on the foregoing assumptions, CompanySs return is arms length and its
marketing activities, including its marketing expenses, are not significantly different than
those performed by independent marketers and distributors in comparable uncontrolled
transactions. The information on comparable uncontrolled arrangements provides the best
measure of the arms length return earned by CompanyS for the contribution to intangible
value provided by its functions, risks, and costs. That return therefore reflects arms
length compensation for CompanySs contributions and accurately measures its share of
the income derived from exploitation of the trademark and trade name in countryY. No
separate or additional compensation is required to be provided to CompanyS.
Example10
30. The facts in this example are the same as in Example9, except that the market
development functions undertaken by CompanyS in this Example10 are far more
extensive than those undertaken by CompanyS in Example9.
31.
Where the marketer/distributor actually bears the costs and assumes the risks of its
marketing activities, the issue is the extent to which the marketer/distributor can share in
the potential benefits from those activities. A thorough comparability analysis identifies
several uncontrolled companies engaged in marketing and distribution functions under
similar long-term marketing and distribution arrangements. Assume, however, that the
level of marketing expense CompanyS incurred in Years 1 through 5 far exceeds that
incurred by the identified comparable independent marketers and distributors. Assume
further that the high level of expense incurred by CompanyS reflects its performance of
additional or more intensive functions than those performed by the potential comparables
and that Primair and CompanyS expect those additional functions to generate higher
margins or increased sales volume for the products. Given the extent of the market
development activities undertaken by CompanyS, it is evident that CompanyS has made a
larger functional contribution to development of the market and the marketing intangibles
and has assumed significantly greater costs and assumed greater risks than the identified
potentially comparable independent enterprises (and substantially higher costs and risks
than in Example9). There is also evidence to support the conclusion that the profits
realised by CompanyS are significantly lower than the profit margins of the identified
potentially comparable independent marketers and distributors during the corresponding
years of similar long-term marketing and distribution agreements.
124 I ntangibles
32. As in Example9, CompanyS bears the costs and associated risks of its marketing
activities under a long-term contract of exclusive marketing and distribution rights for the
R watches, and therefore expects to have an opportunity to benefit (or suffer a loss) from
the marketing and distribution activities it undertakes. However, in this case CompanyS
has performed functions and borne marketing expenditures beyond what independent
enterprises in potentially comparable transactions with similar rights incur for their own
benefit, resulting in significantly lower profit margins for CompanyS than are made by
such enterprises.
33. Based on these facts, it is evident that by performing functions and incurring
marketing expenditure substantially in excess of the levels of function and expenditure of
independent marketer/distributors in comparable transactions, CompanyS has not been
adequately compensated by the margins it earns on the resale of R watches. Under such
circumstances it would be appropriate for the countryY tax administration to propose
a transfer pricing adjustment based on compensating CompanyS for the marketing
activities performed (taking account of the risks assumed and the expenditure incurred)
on a basis that is consistent with what independent enterprises would have earned in
comparable transactions. Depending on the facts and circumstances reflected in a detailed
comparability analysis, such an adjustment could be based on:
Reducing the price paid by CompanyS for the R brand watches purchased from
Primair. Such an adjustment could be based on applying a resale price method
or transactional net margin method using available data about profits made by
comparable marketers and distributors with a comparable level of marketing and
distribution expenditure if such comparables can be identified.
An alternative approach might apply a residual profit split method that would
split the combined profits from sales of R branded watches in countryY by first
giving CompanyS and Primair a basic return for the functions they perform and
then splitting the residual profit on a basis that takes into account the relative
contributions of both CompanyS and Primair to the generation of income and the
value of the R trademark and trade name.
Directly compensating CompanyS for the excess marketing expenditure it has
incurred over and above that incurred by comparable independent enterprises
including an appropriate profit element for the functions and risks reflected by those
expenditures.
34. In this example, the proposed adjustment is based on CompanySs having performed
functions, assumed risks, and incurred costs that contributed to the development of the
marketing intangibles for which it was not adequately compensated under its arrangement
with Primair. If the arrangements between CompanyS and Primair were such that
CompanyS could expect to obtain an arms length return on its additional investment during
the remaining term of the distribution agreement, a different outcome could be appropriate.
Example11
35.
The facts in this example are the same as in Example9, except that CompanyS now
enters into a three-year royalty-free agreement to market and distribute the watches in the
countryY market, with no option to renew. At the end of the three-year period, CompanyS
does not enter into a new contract with Primair.
36. Assume that it is demonstrated that independent enterprises do enter into short-term
distribution agreements where they incur marketing and distribution expenses, but only
I ntangibles 125
where they stand to earn a reward commensurate with the functions performed, the assets
used, and the risks assumed within the time period of the contract. Evidence derived from
comparable independent enterprises shows that they do not invest large sums of money in
developing marketing and distribution infrastructure where they obtain only a short-term
marketing and distribution agreement, with the attendant risk of non-renewal without
compensation. The potential short-term nature of the marketing and distribution agreement
is such that CompanyS could not, or may not be able to, benefit from the marketing and
distribution expenditure it incurs at its own risk. The same factors mean that CompanySs
efforts may well benefit Primair in the future.
37. The risks assumed by CompanyS are substantially higher than in Example9
and CompanyS has not been compensated on an arms length basis for bearing these
additional risks. In this case, CompanyS has undertaken market development activities
and borne marketing expenditures beyond what comparable independent enterprises with
similar rights incur for their own benefit, resulting in significantly lower profit margins
for CompanyS than are made by comparable enterprises. The short term nature of the
contract makes it unreasonable to expect that CompanyS has the opportunity of obtaining
appropriate benefits under the contract within the limited term of the agreement with
Primair. Under these circumstances, CompanyS is entitled to compensation for its at
risk contribution to the value of the R trademark and trade name during the term of its
arrangement with Primair.
38. Such compensation could take the form of direct compensation from Primair to
CompanyS for the anticipated value created through the marketing expenditures and
market development functions it has undertaken. Alternatively, such an adjustment could
take the form of a reduction in the price paid by CompanyS to Primair for Rwatches
during Years1 through3.
Example12
39.
The facts in this example are the same as in Example9 with the following additions:
By the end of Year3, the Rbrand is successfully established in the countryY market
and Primair and CompanyS renegotiate their earlier agreement and enter into a
new long-term licensing agreement. The new agreement, which is to commence
at the beginning of Year4, is for five years with CompanyS having an option for
a further five years. Under this agreement, CompanyS agrees to pay a royalty to
Primair based on the gross sales of all watches bearing the R trademark. In all other
respects, the new agreement has the same terms and conditions as in the previous
arrangement between the parties. There is no adjustment made to the price payable
by CompanyS for the branded watches as a result of the introduction of the royalty.
CompanySs sales of Rbrand watches in Years4 and 5 are consistent with earlier
budget forecasts. However, the introduction of the royalty from the beginning of
year4 results in CompanySs profit margins declining substantially.
40. Assume that there is no evidence that independent marketers/distributors of similar

branded products have agreed to pay royalties under similar arrangements. CompanySs
level of marketing expenditure and activity, from Year4 on, is consistent with that of
independent enterprises.
41. For transfer pricing purposes, it would not generally be expected that a royalty
would be paid in arms length transactions where a marketing and distribution entity
obtains no rights for transfer pricing purposes in trademarks and similar intangibles
126 I ntangibles
other than the right to use such intangibles in distributing a branded product supplied by
the entity entitled to the income derived from exploiting such intangibles. Furthermore,
the royalty causes CompanySs profit margins to be consistently lower than those of
independent enterprises with comparable functions performed, assets used and risks
assumed during the corresponding years of similar long-term marketing and distribution
arrangements. Accordingly, a transfer pricing adjustment disallowing the royalties paid
would be appropriate based on the facts of this example.
Example13
42. The facts in this example are the same as those set out in Example10 with the
following additions:
At the end of Year3, Primair stops manufacturing watches and contracts with a
third party to manufacture them on its behalf. As a result, CompanyS will import
unbranded watches directly from the manufacturer and undertake secondary
processing to apply the R name and logo and package the watches before sale to the
final customer. It will then sell and distribute the watches in the manner described
in Example10.
As a consequence, at the beginning of Year4, Primair and CompanyS renegotiate
their earlier agreement and enter into a new long term licensing agreement.
The new agreement, to start at the beginning of Year4, is for five years, with
CompanyS having an option for a further five years.
Under the new agreement, CompanyS is granted the exclusive right within countryY
to process, market and distribute watches bearing the R trademark in consideration for
its agreement to pay a royalty to Primair based on the gross sales of all such watches.
CompanyS receives no compensation from Primair in respect of the renegotiation of
the original marketing and distribution agreement. It is assumed for purposes of this
example that the purchase price CompanyS pays for the watches from the beginning
of Year4 is arms length and that no consideration with respect to the R name is
embedded in that price.
43. In connection with a tax audit conducted by countryY tax administrations in
Year6, it is determined, based on a proper functional analysis, that the level of marketing
expenses CompanyS incurred during Years1 through 3 far exceeded those incurred by
independent marketers and distributors with similar long term marketing and distribution
agreements. It is also determined that the level and intensity of marketing activity
undertaken by CompanyS exceeded that of independent marketers and distributors,
and that the relatively greater activity has been successful in expanding volumes and/or
increasing the Primair groups overall margins from sales in countryY. Given the extent
of the market development activities undertaken by CompanyS, including its strategic
control over such activities, it is evident from the comparability and functional analysis
that CompanyS has assumed significantly greater costs and assumed greater risks than
comparable independent enterprises. There is also evidence that the individual entity
profit margins realised by CompanyS are significantly lower than the profit margins of
comparable independent marketers and distributors during the corresponding years of
similar long-term marketing and distribution arrangements.
44. The countryY audit also identifies that in Years4 and 5, CompanyS bears the
costs and associated risks of its marketing activities under the new long-term licensing
arrangement with Primair, and because of the long-term nature of the agreement,
I ntangibles 127
CompanyS may have an opportunity to benefit (or suffer a loss) from its activities.
However, CompanyS has undertaken market development activities and incurred
marketing expenditure far beyond what comparable independent licensees with similar
long-term licensing agreements undertake and incur for their own benefit, resulting in
significantly lower anticipated profit margins for CompanyS than those of comparable
enterprises.
45. Based on these facts, CompanyS should be compensated with an additional return
for the market development functions it performs, the assets it uses and the risks it assumes.
For Years1 through 3, the possible bases for such an adjustment would be as described in
Example10. For Years4 and 5 the bases for an adjustment would be similar, except that
the adjustment could reduce the royalty payments from CompanyS to Primair, rather than
the purchase price of the watches. Depending on the facts and circumstances, consideration
could also be given to whether CompanyS should have received compensation in
connection with the renegotiation of the arrangement at the end of Year3 in accordance
with the guidance in PartII of ChapterIX.
Example14
46. Shuyona is the parent company of an MNE group. Shuyona is organised in and
operates in countryX. The Shuyona group is involved in the production and sale of
consumer goods. In order to maintain and, if possible, improve its market position, ongoing
research is carried out by the Shuyona group to improve existing products and develop
new products. The Shuyona group maintains two R&D centres, one operated by Shuyona
in countryX and the other operated by CompanyS, a subsidiary of Shuyona operating in
countryY. The Shuyona R&D centre is responsible for the overall research programme
of Shuyona group. The Shuyona R&D centre designs research programmes, develops and
controls budgets, makes decisions as to where R&D activities will be conducted, monitors
the progress on all R&D projects and, in general, controls the R&D function for the MNE
group, operating under strategic direction of Shuyona group senior management.
47.
The CompanyS R&D centre operates on a separate project by project basis to carry
out specific projects assigned by the Shuyona R&D centre. Suggestions of CompanyS R&D
personnel for modifications to the research programme are required to be formally approved
by the Shuyona R&D centre. The CompanyS R&D centre reports on its progress on at least
a monthly basis to supervisory personnel at the Shuyona R&D centre. If CompanyS exceeds
budgets established by Shuyona for its work, approval of Shuyona R&D management
must be sought for further expenditures. Contracts between the Shuyona R&D centre and
the CompanyS R&D centre specify that Shuyona will bear all risks and costs related to
R&D undertaken by CompanyS. All patents, designs and other intangibles developed by
CompanyS research personnel are registered by Shuyona, pursuant to contracts between
the two companies. Shuyona pays CompanyS a service fee for its research and development
activities.
48. The transfer pricing analysis of these facts would begin by recognising that Shuyona
is the legal owner of the intangibles. Shuyona controls and manages both its own R&D
work and that of CompanyS. It performs the important functions related to that work
such as budgeting, establishing research programmes, designing projects and funding and
controlling expenditures. Under these circumstances, Shuyona is entitled to returns derived
from the exploitation of the intangibles developed through the R&D efforts of CompanyS.
CompanyS is entitled to compensation for its functions performed, assets used, and
risks assumed. In determining the amount of compensation due CompanyS, the relative
128 I ntangibles
skill and efficiency of the CompanyS R&D personnel, the nature of the research being
undertaken, and other factors contributing to value should be considered as comparability
factors. To the extent transfer pricing adjustments are required to reflect the amount a
comparable R&D service provider would be paid for its services, such adjustments would
generally relate to the year the service is provided and would not affect the entitlement of
Shuyona to future returns derived from exploiting intangibles derived from the CompanyS
R&D activities.
Example15
operates exclusively in countryX. The Shuyona group is involved in the production and
sale of consumer goods. In order to maintain and, if possible, improve its market position,
ongoing research is carried out by the Shuyona group to improve existing products and
develop new products. The Shuyona group maintains two R&D centres, one operated by
Shuyona in countryX, and the other operated by CompanyS, a subsidiary of Shuyona,
operating in countryY.
50. The Shuyona group sells two lines of products. All R&D with respect to product
line A is conducted by Shuyona. All R&D with respect to product line B is conducted
by the R&D centre operated by CompanyS. CompanyS also functions as the regional
headquarters of the Shuyona group in North America and has global responsibility for
the operation of the business relating to product line B. However, all patents developed
through CompanyS research efforts are registered by Shuyona. Shuyona makes no or only
a nominal payment to CompanyS in relation to the patentable inventions developed by the
CompanyS R&D centre.
51. The Shuyona and CompanyS R&D centres operate autonomously. Each bears its
own operating costs. Under the general policy direction of Shuyona senior management,
the CompanyS R&D centre develops its own research programmes, establishes its own
budgets, makes determinations as to when R&D projects should be terminated or modified,
and hires its own R&D staff. The CompanyS R&D centre reports to the product line B
management team in CompanyS, and does not report to the Shuyona R&D centre. Joint
meetings between the Shuyona and CompanyS R&D teams are sometimes held to discuss
research methods and common issues.
52. The transfer pricing analysis of this fact pattern would begin by recognising that
Shuyona is the legal owner/registrant of intangibles developed by CompanyS. Unlike the
situation in Example14, however, Shuyona neither performs nor exercises control over the
research functions carried out by CompanyS, including the important functions related
to management, design, budgeting and funding that research. Accordingly, Shuyonas
legal ownership of the intangibles does not entitle it to retain or be attributed any income
related to the product line B intangibles. Tax administrations could arrive at an appropriate
transfer pricing outcome by recognising Shuyonas legal ownership of the intangibles but
by noting that, because of the contributions of CompanyS in the form of functions, assets,
and risks, appropriate compensation to CompanyS for its contributions could be ensured
by confirming that CompanyS should make no royalty or other payment to Shuyona for the
right to use any successfully developed CompanyS intangibles, so that the future income
derived from the exploitation of those intangibles by CompanyS would be allocated to
CompanyS and not to Shuyona.
53. If Shuyona exploits the product line B intangibles by itself, Shuyona should provide
appropriate compensation to CompanyS for its functions performed, assets used and
I ntangibles 129
risks assumed related to intangible development. In determining the appropriate level

of compensation for CompanyS, the fact that CompanyS performs all of the important
functions related to intangible development would likely make it inappropriate to treat
CompanyS as the tested party in an R&D service arrangement.
Example16
operates exclusively in CountryX. The Shuyona group is involved in the production and
sale of consumer goods. In order to maintain and, if possible, improve its market position,
ongoing research is carried out by the Shuyona group to improve existing products and
develop new products. The Shuyona group maintains two R&D centres, one operated by
Shuyona in countryX, and the other operated by CompanyS, a subsidiary of Shuyona,
operating in countryY. The relationships between the Shuyona R&D centre and the
CompanyS R&D centre are as described in Example14.
55.
In Year1, Shuyona sells all rights to patents and other technology related intangibles,
including rights to use those intangibles in ongoing research, to a new subsidiary, CompanyT,
organised in countryZ. CompanyT establishes a manufacturing facility in countryZ and
begins to supply products to members of the Shuyona group around the world. For purposes
of this example, it is assumed that the compensation paid by CompanyT in exchange for the
transferred patents and related intangibles is based on a valuation of anticipated future cash
flows generated by the transferred intangibles at the time of the transfer.
56. At the same time as the transfer of patents and other technology related intangibles,
CompanyT enters into a contract research agreement with Shuyona and a separate
contract research agreement with CompanyS. Pursuant to these agreements, CompanyT
contractually agrees to bear the financial risk associated with possible failure of future
R&D projects, agrees to assume the cost of all future R&D activity, and agrees to pay
Shuyona and CompanyS a service fee based on the cost of the R&D activities undertaken
plus a mark-up equivalent to the profit mark-up over cost earned by certain identified
independent companies engaged in providing research services.
57. CompanyT has no technical personnel capable of conducting or supervising the
research activities. Shuyona continues to develop and design the R&D programme related
to further development of the transferred intangibles, to establish its own R&D budgets,
to determine its own levels of R&D staffing, and to make decisions regarding whether to
pursue or terminate particular R&D projects. Moreover, Shuyona continues to supervise
and control the R&D activities in CompanyS in the manner described in Example14.
58. The transfer pricing analysis begins by identifying the commercial or financial
relations between the parties and the conditions and economically relevant circumstances
attaching to those relations in order that the controlled transaction is accurately delineated
under the principles of ChapterI, SectionD.1. Key assumptions in this example are that
CompanyT functions as a manufacturer and performs no activities in relation to the
acquisition, development or exploitation of the intangibles and does not control risks
in relation to the acquisition of the intangibles or to their further development. Instead,
all development activities and risk management functions relating to the intangibles are
performed by Shuyona and CompanyS, with Shuyona controlling the risk. A thorough
examination of the transaction indicates that it should accurately be delineated as the
provision of financing by CompanyT equating to the costs of the acquired intangibles and
the ongoing development. A key assumption in this example is that, although CompanyT
contractually assumes the financial risk and has the financial capacity to assume that risk,
130 I ntangibles
it does not exercise control over that risk in accordance with the principles outlined in
paragraphs6.63 and 6.64. As a result, in addition to its manufacturing reward, CompanyT
is entitled to no more than a risk-free return for its funding activities. (For further guidance
see SectionD.1 of ChapterI, and in particular paragraph1.103.)
Example17
59.
CompanyA is a fully integrated pharmaceutical company engaged in the discovery,
development, production and sale of pharmaceutical preparations. CompanyA conducts
its operations in countryX. In conducting its research activities, CompanyA regularly
retains independent Contract Research Organisations (CROs) to perform various R&D
activities, including designing and conducting clinical trials with regard to products
under development by CompanyA. However, such CROs do not engage in the blue sky
research required to identify new pharmaceutical compounds. Where CompanyA does
retain a CRO to engage in clinical research activities, research personnel at CompanyA
actively participate in designing the CROs research studies, provide to the CRO results
and information derived from earlier research, establish budgets and timelines for CRO
projects, and conduct ongoing quality control with respect to the CROs activities. In such
arrangements, CROs are paid a negotiated fee for services and do not have an ongoing
interest in the profits derived from sales of products developed through their research.
60. CompanyA transfers patents and related intangibles related to ProductM, an early
stage pharmaceutical preparation believed to have potential as a treatment for Alzheimers
disease to CompanyS, a subsidiary of CompanyA operating in countryY (the transaction
relates strictly to the existing intangibles and does not include compensation for future
R&D services of CompanyA). It is assumed for purposes of this example that the payment
of CompanyS for the transfer of intangibles related to ProductM is based on a valuation of
anticipated future cash flows. CompanyS has no technical personnel capable of designing,
conducting or supervising required ongoing research activities related to ProductM.
CompanyS therefore contracts with CompanyA to carry on the research programme
related to ProductM in the same manner as before the transfer of intangibles to CompanyS.
CompanyS agrees to fund all of the ongoing ProductM research, assume the financial risk
of potential failure of such research, and to pay for CompanyAs services based on the cost
plus margins earned by CROs like those with which CompanyA regularly transacts.
61. The transfer pricing analysis of these facts begins by recognising that, following
the transfer, CompanyS is the legal owner of the ProductM intangibles under relevant
contracts and registrations. However, CompanyA continues to perform and control
functions and to manage risks related to the intangibles owned by CompanyS, including
the important functions described in paragraph6.56, and is entitled to compensation for
those contributions. Under these circumstances, CompanyAs transactions with CROs
are not comparable to the arrangements between CompanyS and CompanyA related to
ProductM and may not be used as a benchmark for the arms length compensation required
to be provided to CompanyA for its ongoing R&D activity with respect to the ProductM
intangibles. CompanyS does not perform or control the same functions or control the same
risks in its transactions with CompanyA, as does CompanyA in its transactions with the
CROs.
62. While CompanyS is the legal owner of the intangibles, it should not be entitled to
all of the returns derived from the exploitation of the intangibles. Because CompanyS lacks
the capability to control research related risks, CompanyA should be treated as bearing
a substantial portion of the relevant risk and CompanyA should also be compensated for
I ntangibles 131
its functions, including the important functions described in paragraph6.56. CompanyA

should be entitled to larger returns than the CROs under these circumstances.
63. A thorough examination of the transaction in this example may show that it should
accurately be delineated as the provision of financing by CompanyS equating to the
costs of the acquired intangibles and the ongoing development. As a result, CompanyS
is entitled to only a financing return. The level of the financing return depends on the
exercising of control over the financing risk in accordance with the guidance in SectionD.1
of ChapterI and the principles outlined in paragraphs6.63 and 6.64. CompanyA would be
entitled to retain the remaining income or losses.
Example18
64. Primarni is organised in and conducts business in countryA. CompanyS is
an associated enterprise of Primarni. CompanyS is organised in and does business in
countryB. Primarni develops a patented invention and manufacturing know-how related
to ProductX. It obtains valid patents in all countries relevant to this example. Primarni
and CompanyS enter into a written licence agreement pursuant to which Primarni grants
CompanyS the right to use the ProductX patents and know-how to manufacture and sell
ProductX in countryB, while Primarni retains the patent and know-how rights to ProductX
throughout Asia, Africa, and in countryA.
65. Assume CompanyS uses the patents and know-how to manufacture ProductX in
countryB. It sells ProductX to both independent and associated customers in countryB.
Additionally, it sells ProductX to associated distribution entities based throughout Asia
and Africa. The distribution entities resell the units of ProductX to customers throughout
Asia and Africa. Primarni does not exercise its retained patent rights for Asia and Africa
to prevent the sale of ProductX by CompanyS to the distribution entities operating in Asia
and Africa.
66. Under these circumstances, the conduct of the parties suggests that the transaction
between Primarni and CompanyS is actually a licence of the ProductX patents and knowhow for countryB, plus Asia and Africa. In a transfer pricing analysis of the transactions
between CompanyS and Primarni, CompanySs licence should be treated as extending
to Asia and Africa, and should not be limited to countryB, based on the conduct of the
parties. The royalty rate should be recalculated to take into account the total projected sales
by CompanyS in all territories including those to the Asian and African entities.
Example19
67. CompanyP, a resident of countryA conducts a retailing business, operating
several department stores in countryA. Over the years, CompanyP has developed special
know-how and a unique marketing concept for the operation of its department stores.
It is assumed that the know-how and unique marketing concept constitute intangibles
within the meaning of SectionA of ChapterVI. After years of successfully conducting
business in countryA, CompanyP establishes a new subsidiary, CompanyS, in countryB.
CompanyS opens and operates new department stores in countryB, obtaining profit
margins substantially higher than those of otherwise comparable retailers in countryB.
68. A detailed functional analysis reveals that CompanyS uses in its operations
in countryB, the same know-how and unique marketing concept as the ones used by
CompanyP in its operations in countryA. Under these circumstances, the conduct of the
parties reveals that a transaction has taken place consisting in the transfer from CompanyP
132 I ntangibles
to CompanyS of the right to use the know-how and unique marketing concept. Under
comparable circumstances, independent parties would have concluded a license agreement
granting CompanyS the right to use in countryB, the know-how and unique marketing
concept developed by CompanyP. Accordingly, one possible remedy available to the tax
administration is a transfer pricing adjustment imputing a royalty payment from CompanyS
to CompanyP for the use of these intangibles.
Example20
69. Ilcha is organised in countryA. The Ilcha group of companies has for many years
manufactured and sold ProductQ in countriesB and C through a wholly owned subsidiary,
CompanyS1, which is organised in countryB. Ilcha owns patents related to the design of
ProductQ and has developed a unique trademark and other marketing intangibles. The
patents and trademarks are registered by Ilcha in countriesB and C.
70. For sound business reasons, Ilcha determines that the groups business in countriesB
and C would be enhanced if those businesses were operated through separate subsidiaries in
each country. Ilcha therefore organises in countryC a wholly owned subsidiary, CompanyS2.
With regard to the business in countryC:
CompanyS1 transfers to CompanyS2 the tangible manufacturing and marketing
assets previously used by CompanyS1 in countryC.
Ilcha and CompanyS1 agree to terminate the agreement granting CompanyS1 the
following rights with relation to ProductQ: the right to manufacture and distribute
ProductQ in countryC; the right to use the patents and trademark in carrying
out its manufacturing and distribution activities in countryC; and, the right to
use customer relationships, customer lists, goodwill and other items in countryC
(hereinafter, the Rights).
Ilcha enters into new, long-term licence agreements with CompanyS2 granting it
the Rights in countryC.
The newly formed subsidiary thereafter conducts the ProductQ business in countryC,
while CompanyS1 continues to conduct the ProductQ business in CountryB.
71. Assume that over the years of its operation, CompanyS1 developed substantial
business value in countryC and an independent enterprise would be willing to pay for that
business value in an acquisition. Further assume that, for accounting and business valuation
purposes, a portion of such business value would be treated as goodwill in a purchase
price allocation conducted with regard to a sale of CompanyS1s countryC business to an
independent party.
72. Under the facts and circumstances of the case, there is value being transferred to
CompanyS2 through the combination of (i)the transfer of part of CompanyS1s tangible
business assets to CompanyS2 in countryC, and (ii)the surrendering by CompanyS1 of
the Rights and the subsequent granting of the Rights by Ilcha to CompanyS2. There are
three separate transactions:
the transfer of part of CompanyS1s tangible business assets to CompanyS2 in
countryC;
the surrendering by CompanyS1 of its rights under the licence back to Ilcha; and
the subsequent granting of a licence by Ilcha to CompanyS2.
I ntangibles 133
For transfer pricing purposes, the prices paid by Ilcha and by CompanyS2 in connection
with these transactions should reflect the value of the business which would include
amounts that may be treated as the value of goodwill for accounting purposes.
Example21
73. Frsta is a consumer goods company organised and operating in countryA. Prior to
Year1, Frsta produces ProductY in countryA and sells it through affiliated distribution
companies in many countries around the world. ProductY is well recognised and attracts
a premium compared to its competitors, to which Frsta is entitled as the legal owner and
developer of the trademark and related goodwill giving rise to that premium.
74. In Year2, Frsta organises CompanyS, a wholly owned subsidiary, in countryB.
CompanyS acts as a super distributor and invoicing centre. Frsta continues to ship
ProductY directly to its distribution affiliates, but title to the products passes to CompanyS,
which reinvoices the distribution affiliates for the products.
75.
Beginning in Year2, CompanyS undertakes to reimburse the distribution affiliates
for a portion of their advertising costs. Prices for ProductY from CompanyS to the
distribution affiliates are adjusted upward so that the distribution affiliate operating profit
margins remain constant notwithstanding the shift of advertising cost to CompanyS.
Assume that the operating profit margins earned by the distribution affiliates are arms
length both before and after Year2 given the concurrent changes in product pricing and
the reimbursement of advertising costs. CompanyS performs no functions with regard to
advertising nor does it control any risk related to marketing the products.
76. In Year3, the prices charged by Frsta to CompanyS are reduced. Frsta and
CompanyS claim such a reduction in price is justified because CompanyS is now entitled
to income related to intangibles. It asserts that such income is attributable to intangibles in
respect of ProductY created through the advertising costs it has borne.
77. In substance, CompanyS has no claim to income derived from the exploitation
of intangibles with respect to ProductY. It performs no functions, assumes no risk, and
in substance bears no costs related to the development, enhancement, maintenance or
protection of intangibles. Transfer pricing adjustments to increase the income of Frsta in
Year3 and thereafter would be appropriate.
Example22
78. CompanyA owns a government licence for a mining activity and a government
licence for the exploitation of a railway. The mining licence has a standalone market value
of 20. The railway licence has a standalone market value of 10. CompanyA has no other
net assets.
79. Birincil, an entity which is independent of CompanyA, acquires 100% of the
equity interests in CompanyA for 100. Birincils purchase price allocation performed for
accounting purposes with respect to the acquisition attributes 20 of the purchase price to
the mining licence; 10 to the railway licence; and 70 to goodwill based on the synergies
created between the mining and railway licences.
80. Immediately following the acquisition, Birincil causes CompanyA to transfer its
mining and railway licences to CompanyS, a subsidiary of Birincil.
134 I ntangibles
81. In conducting a transfer pricing analysis of the arms length price to be paid by
CompanyS for the transaction with CompanyA, it is important to identify with specificity
the intangibles transferred. As was the case with Birincils arms length acquisition of
CompanyA, the goodwill associated with the licences transferred to CompanyS would
need to be considered, as it should generally be assumed that value does not disappear, nor
is it destroyed as part of an internal business restructuring.
82. As such, the arms length price for the transaction between CompaniesA and S
should take account of the mining licence, the railway licence, and the value ascribed to
goodwill for accounting purposes. The 100 paid by Birincil for the shares of CompanyA
represents an arms length price for those shares and provides useful information regarding
the combined value of the intangibles.
Example23
83. Birincil acquires 100% of the equity interests in an independent enterprise,
CompanyT for 100. CompanyT is a company that engages in research and development
and has partially developed several promising technologies but has only minimal sales.
The purchase price is justified primarily by the value of the promising, but only partly
developed, technologies and by the potential of CompanyT personnel to develop further
new technologies in the future. Birincils purchase price allocation performed for
accounting purposes with respect to the acquisition attributes 20 of the purchase price to
tangible property and identified intangibles, including patents, and 80 to goodwill.
84. Immediately following the acquisition, Birincil causes CompanyT to transfer all
of its rights in developed and partially developed technologies, including patents, trade
secrets and technical know-how to CompanyS, a subsidiary of Birincil. CompanyS
simultaneously enters into a contract research agreement with CompanyT, pursuant to
which the CompanyT workforce will continue to work exclusively on the development
of the transferred technologies and on the development of new technologies on behalf of
CompanyS. The agreement provides that CompanyT will be compensated for its research
services by payments equal to its cost plus a mark-up, and that all rights to intangibles
developed or enhanced under the research agreement will belong to CompanyS. As a result,
CompanyS will fund all future research and will assume the financial risk that some or
all of the future research will not lead to the development of commercially viable products.
CompanyS has a large research staff, including management personnel responsible for
technologies of the type acquired from CompanyT. Following the transactions in question,
the CompanyS research and management personnel assume full management responsibility
for the direction and control of the work of the CompanyT research staff. CompanyS
approves new projects, develops and plans budgets and in other respects controls the ongoing
research work carried on at CompanyT. All companyT research personnel will continue to
be employees of CompanyT and will be devoted exclusively to providing services under the
research agreement with CompanyS.
85. In conducting a transfer pricing analysis of the arms length price to be paid by
CompanyS for intangibles transferred by CompanyT, and of the price to be paid for
ongoing R&D services to be provided by CompanyT, it is important to identify the specific
intangibles transferred to CompanyS and those retained by CompanyT. The definitions and
valuations of intangibles contained in the purchase price allocation are not determinative
for transfer pricing purposes. The 100 paid by Birincil for the shares of CompanyT
represents an arms length price for shares of the company and provides useful information
regarding the value of the business of CompanyT. The full value of that business should be
I ntangibles 135
reflected either in the value of the tangible and intangible assets transferred to CompanyS
or in the value of the tangible and intangible assets and workforce retained by CompanyT.
Depending on the facts, a substantial portion of the value described in the purchase price
allocation as goodwill of CompanyT may have been transferred to CompanyS together
with the other CompanyT intangibles. Depending on the facts, some portion of the value
described in the purchase price allocation as goodwill may also have been retained by
CompanyT. Under arms length transfer pricing principles, CompanyT should be entitled
to compensation for such value, either as part of the price paid by CompanyS for the
transferred rights to technology intangibles, or through the compensation CompanyT is paid
in years following the transaction for the R&D services of its workforce. It should generally
be assumed that value does not disappear, nor is it destroyed, as part of an internal business
restructuring. If the transfer of intangibles to CompanyS had been separated in time from
the acquisition, a separate inquiry would be required regarding any intervening appreciation
or depreciation in the value of the transferred intangibles.
Example24
86. Zhu is a company engaged in software development consulting. In the past Zhu has
developed software supporting ATM transactions for client Bank A. In the process of doing
so, Zhu created and retained an interest in proprietary copyrighted software code that is
potentially suitable for use by other similarly situated banking clients, albeit with some
revision and customisation.
87. Assume that CompanyS, an associated enterprise of Zhu, enters into a separate
agreement to develop software supporting ATM operations for another bank, Bank B.
Zhu agrees to support its associated enterprise by providing employees who worked on
the Bank A engagement to work on CompanySs Bank B engagement. Those employees
have access to software designs and know-how developed in the Bank A engagement,
including proprietary software code. That code and the services of the Zhu employees
are utilised by CompanyS in executing its Bank B engagement. Ultimately, Bank B is
provided by CompanyS with a software system for managing its ATM network, including
the necessary licence to utilise the software developed in the project. Portions of the
proprietary code developed by Zhu in its Bank A engagement are embedded in the software
provided by CompanyS to Bank B. The code developed in the Bank A engagement and
embedded in the Bank B software would be sufficiently extensive to justify a claim of
copyright infringement if copied on an unauthorised basis by a third party.
88. A transfer pricing analysis of these transactions should recognise that CompanyS
received two benefits from Zhu which require compensation. First, it received services
from the Zhu employees that were made available to work on the Bank B engagement.
Second, it received rights in Zhus proprietary software which was utilised as the
foundation for the software system delivered to Bank B. The compensation to be paid by
CompanyS to Zhu should include compensation for both the services and the rights in the
software.
Example25
89. Prathamika is the parent company of an MNE group. Prathamika has been engaged
in several large litigation matters and its internal legal department has become adept at
managing large scale litigation on behalf of Prathamika. In the course of working on such
litigation, Prathamika has developed proprietary document management software tools
unique to its industry.
136 I ntangibles
90. CompanyS is an associated enterprise of Prathamika. CompanyS becomes involved
in a complex litigation similar to those with which the legal department of Prathamika
has experience. Prathamika agrees to make two individuals from its legal team available
to CompanyS to work on the CompanyS litigation. The individuals from Prathamika
assume responsibility for managing documents related to the litigation. In undertaking this
responsibility they make use of the document management software of Prathamika. They
do not, however, provide CompanyS the right to use the document management software in
other litigation matters or to make it available to CompanyS customers.
91. Under these circumstances, it would not be appropriate to treat Prathamika as
having transferred rights in intangibles to CompanyS as part of the service arrangement.
However, the fact that the Prathamika employees had experience and available software
tools that allowed them to more effectively and efficiently perform their services should
be considered in a comparability analysis related to the amount of any service fee to be
charged for the services of the Prathamika employees.
Example26
92. Osnovni is the parent company of an MNE Group engaged in the development and
sale of software products. Osnovni acquires 100% of the equity interests in CompanyS,
a publicly traded company organised in the same country as Osnovni, for a price equal to
160. At the time of the acquisition, CompanyS shares had an aggregate trading value of
100. Competitive bidders for the CompanyS business offered amounts ranging from 120
to 130 for CompanyS.
93. CompanyS had only a nominal amount of fixed assets at the time of the acquisition.
Its value consisted primarily of rights in developed and partially developed intangibles
related to software products and its skilled workforce. The purchase price allocation
performed for accounting purposes by Osnovni allocated 10 to tangible assets, 60 to
intangibles, and 90 to goodwill. Osnovni justified the 160 purchase price in presentations
to its Board of Directors by reference to the complementary nature of the existing products
of the Osnovni group and the products and potential products of CompanyS.
94. CompanyT is a wholly owned subsidiary of Osnovni. Osnovni has traditionally
licensed exclusive rights in all of its intangibles related to the European and Asian markets
to CompanyT. For purposes of this example it is assumed that all arrangements related to
the historic licences of European and Asian rights to CompanyT prior to the acquisition of
CompanyS are arms length.
95. Immediately following the acquisition of CompanyS, Osnovni liquidates CompanyS,
and thereafter grants an exclusive and perpetual licence to CompanyT for intangible rights
related to the CompanyS products in European and Asian markets.
96. In determining an arms length price for the CompanyS intangibles licensed to
CompanyT under the foregoing arrangements, the premium over the original trading
value of the CompanyS shares included in the acquisition price should be considered. To
the extent that premium reflects the complementary nature of Osnovni group products
with the acquired products in the European and Asian markets licensed to CompanyT,
CompanyT should pay an amount for the transferred CompanyS intangibles and rights in
intangibles that reflects an appropriate share of the purchase price premium. To the extent
the purchase price premium is attributable exclusively to product complementarities outside
of CompanyTs markets, the purchase price premium should not be taken into account in
determining the arms length price paid by CompanyT for CompanyS intangibles related
I ntangibles 137
to CompanyTs geographic market. The value attributed to intangibles in the purchase

price allocation performed for accounting purposes is not determinative for transfer pricing
purposes.
Example27
97.
CompanyA is the Parent of an MNE group with operations in countryX. CompanyA
owns patents, trademarks and know-how with regard to several products produced and
sold by the MNE group. CompanyB is a wholly owned subsidiary of CompanyA. All
of CompanyBs operations are conducted in countryY. CompanyB also owns patents,
trademarks and know-how related to ProductM.
98. For sound business reasons related to the coordination of the groups patent
protection and anti-counterfeiting activities, the MNE group decides to centralise ownership
of its patents in CompanyA. Accordingly, CompanyB sells the ProductM patents to
CompanyA for a lump-sum price. CompanyA assumes responsibility to perform all
ongoing functions and it assumes all risks related to the ProductM patents following the
sale. Based on a detailed comparability and functional analysis, the MNE group concludes
that it is not able to identify any comparable uncontrolled transactions that can be used to
determine the arms length price. CompanyA and CompanyB reasonably conclude that the
application of valuation techniques represents the most appropriate transfer pricing method
to use in determining whether the agreed price is consistent with arms length dealings.
99. Valuation personnel apply a valuation method that directly values property and
patents to arrive at an after-tax net present value for the ProductM patent of 80. The
analysis is based on royalty rates, discount rates and useful lives typical in the industry in
which ProductM competes. However, there are material differences between ProductM
and the relevant patent rights related to ProductM, and those typical in the industry. The
royalty arrangements used in the analysis would therefore not satisfy the comparability
standards required for a CUP method analysis. The valuation seeks to make adjustments
for these differences.
100. In conducting its analysis, CompanyA also conducts a discounted cash flow
based analysis of the ProductM business in its entirety. That analysis, based on valuation
parameters typically used by CompanyA in evaluating potential acquisitions, suggests that
the entire ProductM business has a net present value of 100. The 20 difference between
the 100 valuation of the entire ProductM business and the 80 valuation of the patent on its
own appears to be inadequate to reflect the net present value of routine functional returns
for functions performed by CompanyB and to recognise any value for the trademarks
and know-how retained by CompanyB. Under these circumstances further review of the
reliability of the 80 value ascribed to the patent would be called for.
Example28
101. CompanyA is the Parent company of an MNE group with operations in countryS.
CompanyB is a member of the MNE group with operations in countryT, and CompanyC
is also a member of the MNE group with operations in countryU. For valid business
reasons the MNE group decides to centralise all of its intangibles related to business
conducted outside of countryS in a single location. Accordingly, intangibles owned by
CompanyB are sold to CompanyC for a lump sum, including patents, trademarks, knowhow, and customer relationships. At the same time, CompanyC retains CompanyB to
act as a contract manufacturer of products previously produced and sold by CompanyB
138 I ntangibles
on a full-risk basis. CompanyC has the personnel and resources required to manage the
acquired lines of business, including the further development of intangibles necessary to
the CompanyB business.
102. The MNE group is unable to identify comparable uncontrolled transactions that can
be used in a transfer pricing analysis of the arms length price to be paid by CompanyC to
CompanyB. Based on a detailed comparability and functional analysis, the MNE group
concludes that the most appropriate transfer pricing method involves the application of
valuation techniques to determine the value of the transferred intangibles. In conducting its
valuation, the MNE group is unable to reliably segregate particular cash flows associated
with all of the specific intangibles.
103. Under these circumstances, in determining the arms length compensation to be
paid by CompanyC for the intangibles sold by CompanyB, it may be appropriate to value
the transferred intangibles in the aggregate rather than to attempt a valuation on an asset by
asset basis. This would particularly be the case if there is a significant difference between
the sum of the best available estimates of the value of individually identified intangibles
and other assets when valued separately and the value of the business as a whole.
Example29
104. Pervichnyi is the parent of an MNE group organised and doing business in countryX.
Prior to Year1, Pervichnyi developed patents and trademarks related to ProductF. It
manufactured ProductF in countryX and supplied the product to distribution affiliates
throughout the world. For purposes of this example assume the prices charged to distribution
affiliates were consistently arms length.
105. At the beginning of Year1, Pervichnyi organises a wholly owned subsidiary,
CompanyS, in countryY. In order to save costs, Pervichnyi transfers all of its production
of ProductF to CompanyS. At the time of the organisation of CompanyS, Pervichnyi sells
the patents and trademarks related to ProductF to CompanyS for a lump sum. Under these
circumstances, Pervichnyi and CompanyS seek to identify an arms length price for the
transferred intangibles by utilising a discounted cash flow valuation technique.
106. According to this valuation analysis, Pervichnyi could have generated after tax
residual cash flows (after rewarding all functional activities of other members of the MNE
group on an arms length basis) having a present value of 600 by continuing to manufacture
ProductF in CountryX. The valuation from the buyers perspective shows that CompanyS
could generate after tax residual cash flows having a present value of 1100 if it owned the
intangibles and manufactured the product in countryY. The difference in the present value
of Pervichnyis after tax residual cash flow and the present value of CompanySs after tax
residual cash flow is attributable to several factors.
107. Another option open to Pervichnyi would be for Pervichnyi to retain ownership of
the intangible, and to retain CompanyS or an alternative supplier to manufacture products
on its behalf in countryY. In this scenario, Pervichnyi calculates it would be able to
generate after tax cash flow with a present value of 875.
108. In defining arms length compensation for the intangibles transferred by Pervichnyi
to CompanyS, it is important to take into account the perspectives of both parties, the
options realistically available to each of them, and the particular facts and circumstances
of the case. Pervichnyi would certainly not sell the intangibles at a price that would yield
an after tax residual cash flow with a present value lower than 600, the residual cash flow
it could generate by retaining the intangible and continuing to operate in the manner it
I ntangibles 139
had done historically. Moreover there is no reason to believe Pervichnyi would sell the
intangible for a price that would yield an after tax residual cash flow with a present value
lower than 875. If Pervichnyi could capture the production cost savings by retaining
another entity to manufacture on its behalf in a low cost environment, one realistically
available option open to it would be to establish such a contract manufacturing operation.
That realistically available option should be taken into account in determining the selling
price of the intangible.
109. CompanyS would not be expected to pay a price that would, after taking into
account all relevant facts and circumstances, leave it with an after tax return lower than it
could achieve by not engaging in the transaction. According to the discounted cash flow
valuation, the net present value of the after tax residual cash flow it could generate using
the intangible in its business would be 1100. A price might be negotiated that would give
Pervichnyi a return equal to or greater than its other available options, and give CompanyS
a positive return on its investment considering all of the relevant facts, including the
manner in which the transaction itself would be taxed.
110. A transfer pricing analysis utilising a discounted cash flow approach would have
to consider how independent enterprises dealing at arms length would take into account
the cost savings and projected tax effects in setting a price for the intangibles. That price
should, however, fall in the range between a price that would yield Pervichnyi after tax
residual cash flow equivalent to that of its other options realistically available, and a price
that would yield CompanyS a positive return to its investments and risks, considering the
manner in which the transaction itself would be taxed.
111. The facts of this example and the foregoing analysis are obviously greatly oversimplified
by comparison to the analysis that would be required in an actual transaction. The analysis
nevertheless reflects the importance of considering all of the relevant facts and circumstances
in performing a discounted cash flow analysis, evaluating the perspectives of each of the
parties in such an analysis, and taking into consideration the options realistically available to
each of the parties in performing the transfer pricing analysis.
LOW VALUE-ADDING INTRA-GROUP SERVICES
Revisions to ChapterVII of the Transfer Pricing Guidelines

Summary
Action10 of the BEPS Action Plan instructs the G20 and OECD countries to develop
transfer pricing rules to provide protection against common types of base eroding
payments, such as management fees and head office expenses.
This chapter of the Report introduces an elective, simplified approach for low valueadding services. Besides that, it introduces some changes and clarifications to other
paragraphs of ChapterVII of the Transfer Pricing Guidelines. Sections A to C and the
changes to some of the paragraphs in these sections are included in this Report to provide
context to the new SectionD on low value-adding intra-group services of ChapterVII of
the Transfer Pricing Guidelines.22
SectionD on low value-adding intra-group services provides guidance on achieving the
necessary balance between appropriately allocating to MNE group members charges for
intra-group services in accordance with the arms length principle and the need to protect
the tax base of payor countries. In particular this Report proposes an elective, simplified
approach which:
Specifies a wide category of common intra-group services which command a very
limited profit mark-up on costs;
Applies a consistent allocation key for all recipients for those intra-group services;
and
Provides greater transparency through specific reporting requirements including
documentation showing the determination of the specific cost pool.
The approach aims to guarantee payor countries that the system through which the
costs are allocated leads to an equal treatment for all associated enterprises that are
operating in similar circumstances. Moreover, the approach aims to guarantee that no
overpricing takes place due to general agreement on the categories of costs included
in the cost base and general agreement on the moderate mark-up of 5% that should be
charged. Finally, the transparency of the approach makes clear to payor countries whether
intermediary companies, that may have no or low functionality and may aim to inflate the
intra-group service charges, have been interposed.
142 Low Value-adding Intra-group Services
The guidance provides that, because of the construction of the elective, simplified
approach, the benefits test by the payor country is simplified and moderated. If the elective,
simplified approach is applied, the assumption that businesses are only willing to incur
costs if there is a business reason to do so and the assurance that the approach leads to an
equal treatment of these costs for MNE group members in similar circumstances, replaces
the detailed testing of the benefits received that is customary for other intra-group service
charges. This approach allows tax administrations to free up resources for identifying
and examining transfer pricing cases where the risk of encountering BEPS issues is more
substantial.
Nevertheless, a number of countries have indicated that excessive charges for intragroup management services and head office expenses constitute one of their major
BEPS challenges. In order to give comfort to these countries that the elective, simplified
approach will not lead to base-eroding payments, the approach indicates that countries
considering implementing the approach may do so in combination with the introduction of
a threshold. If the payments for low-value adding intra-group services required under the
approach exceed this threshold, then the tax administrations may perform a full transfer
pricing analysis that would include requiring evidence demonstrating the detailed benefits
received. In combination with the G20 Development Working Group mandate given to
International Organisations on the development of toolkits which can be implemented by
developing countries and which will protect these countries from base-eroding payments,
the objective of this measure will assist developing countries in protecting their tax base
from excessive intra-group service charges.
In order for the simplified approach as discussed in this chapter of the Report to be
effective it must be adopted and applied on a geographic scale that is as broad as possible
and it must be respected in both intra-group service provider and intra-group service
recipient countries. Acknowledging the importance of both swift and broad introduction,
the countries participating in the BEPS project have agreed to a two-step approach for
implementation. The first step consists of a large group of countries enabling this elective
mechanism by endorsing its applicability in their countries before 2018. The second step
recognises that further analysis of the design of the threshold and other implementation
issues of concern to some countries would be helpful in order to achieve even more
widespread adoption of the simplified approach. Therefore, follow-up work on the design
of the threshold and other implementation issues will be undertaken. This work will be
finalised before the end of 2016 and will allow additional countries to join the group of
countries already enabling the elective mechanism. As part of the follow up work on
implementation, clarity will be provided about the countries joining the safe harbour
approach to low value-adding intra-group services. Currently, the significant majority of
the BEPS Associate Countries have indicated that they will enable the simplified approach
as soon as the introduction of such an approach is feasible in their domestic situation. The
other BEPS Associate Countries have indicated that they are considering the introduction
of the approach, but that for them the final decision is dependent on the outcomes of the
follow up work on implementation.
The current provisions of ChapterVII of the Transfer Pricing Guidelines are

deleted in their entirety and replaced by the following language.
A. Introduction
7.1
This chapter discusses issues that arise in determining for transfer pricing purposes
whether services have been provided by one member of an MNE group to other members
of that group and, if so, in establishing arms length pricing for those intra-group services.
The chapter does not address except incidentally whether services have been provided in
a cost contribution arrangement, nor, in such a case, the appropriate arms length pricing.
Cost contribution arrangements are the subject of ChapterVIII.
7.2 Nearly every MNE group must arrange for a wide scope of services to be available
to its members, in particular administrative, technical, financial and commercial services.
Such services may include management, coordination and control functions for the whole
group. The cost of providing such services may be borne initially by the parent, by one
or more specially designated group members (a group service centre), or other group
members. An independent enterprise in need of a service may acquire the services from
a service provider who specialises in that type of service or may perform the service for
itself (i.e.in-house). In a similar way, a member of an MNE group in need of a service
may acquire it from independent enterprises, or from one or more associated enterprises
in the same MNE group (i.e.intra-group), or may perform the service for itself. Intragroup services often include those that are typically available externally from independent
enterprises (such as legal and accounting services), in addition to those that are ordinarily
performed internally (e.g.by an enterprise for itself, such as central auditing, financing
advice, or training of personnel). It is not in the interests of an MNE group to incur costs
unnecessarily, and it is in the interest of an MNE group to provide intra-group services
efficiently. Application of the guidance in this chapter should ensure that services are
appropriately identified and associated costs appropriately allocated within the MNE group
in accordance with the arms length principle.
7.3 Intra-group arrangements for rendering services are sometimes linked to
arrangements for transferring goods or intangibles (or the licensing thereof). In some
cases, such as know-how contracts containing a service element, it may be very difficult
to determine where the exact border lies between the transfer of intangibles or rights in
intangibles and the provision of services. Ancillary services are frequently associated
with the transfer of technology. It may therefore be necessary to consider the principles
for aggregation and segregation of transactions in ChapterIII where a mixed transfer of
services and property is involved.
7.4 Intra-group services may vary considerably among MNE groups, as does the
extent to which those services provide a benefit, or an expected benefit, to one or more
group members. Each case is dependent upon its own facts and circumstances and the
arrangements within the group. For example, in a decentralised group, the parent company
may limit its intra-group activity to monitoring its investments in its subsidiaries in its
capacity as a shareholder. In contrast, in a centralised or integrated group, the board of
directors and senior management of the parent company may make important decisions
concerning the affairs of its subsidiaries, and the parent company may support the
implementation of these decisions by performing general and administrative activities for
its subsidiaries as well as operational activities such as treasury management, marketing,
and supply chain management.
B.
Main issues
7.5 There are two issues in the analysis of transfer pricing for intra-group services. One
issue is whether intra-group services have in fact been provided. The other issue is what
the intra-group charge for such services for tax purposes should be in accordance with the
arms length principle. Each of these issues is discussed below.
B.1. Determining whether intra-group services have been rendered

B.1.1. Benefits test
7.6 Under the arms length principle, the question whether an intra-group service has
been rendered when an activity is performed for one or more group members by another
group member should depend on whether the activity provides a respective group member
with economic or commercial value to enhance or maintain its business position. This
can be determined by considering whether an independent enterprise in comparable
circumstances would have been willing to pay for the activity if performed for it by an
independent enterprise or would have performed the activity in-house for itself. If the
activity is not one for which the independent enterprise would have been willing to pay or
perform for itself, the activity ordinarily should not be considered as an intra-group service
under the arms length principle.
7.7 The analysis described above quite clearly depends on the actual facts and
circumstances, and it is not possible in the abstract to set forth categorically the activities
that do or do not constitute the rendering of intra-group services. However, some guidance
may be given to elucidate how the analysis would be applied for some common types of
services undertaken in MNE groups.
7.8 Some intra-group services are performed by one member of an MNE group to
meet an identified need of one or more specific members of the group. In such a case, it
is relatively straightforward to determine whether a service has been provided. Ordinarily
an independent enterprise in comparable circumstances would have satisfied the identified
need either by performing the activity in-house or by having the activity performed by
a third party. Thus, in such a case, an intra-group service ordinarily would be found to
exist. For example, an intra-group service would normally be found where an associated
enterprise repairs equipment used in manufacturing by another member of the MNE group.
It is essential, however, that reliable documentation is provided to the tax administrations
to verify that the costs have been incurred by the service provider.
B.1.2. Shareholder activities

7.9 A more complex analysis is necessary where an associated enterprise undertakes
activities that relate to more than one member of the group or to the group as a whole.
In a narrow range of such cases, an intra-group activity may be performed relating to
group members even though those group members do not need the activity (and would
not be willing to pay for it were they independent enterprises). Such an activity would
be one that a group member (usually the parent company or a regional holding company)
performs solely because of its ownership interest in one or more other group members,
i.e.in its capacity as shareholder. This type of activity would not be considered to be an
intra-group service, and thus would not justify a charge to other group members. Instead,
the costs associated with this type of activity should be borne and allocated at the level
of the shareholder. This type of activity may be referred to as a shareholder activity,
distinguishable from the broader term stewardship activity used in the 1979 Report.
Stewardship activities covered a range of activities by a shareholder that may include the
provision of services to other group members, for example services that would be provided
by a coordinating centre. These latter types of non-shareholder activities could include
detailed planning services for particular operations, emergency management or technical
advice (trouble shooting), or in some cases assistance in day-to-day management.
7.10 The following are examples of costs associated with shareholder activities, under
the standard set forth in paragraph7.6:
a) Costs relating to the juridical structure of the parent company itself, such as meetings
of shareholders of the parent, issuing of shares in the parent company, stock exchange
listing of the parent company and costs of the supervisory board;
b) Costs relating to reporting requirements (including financial reporting and audit)
of the parent company including the consolidation of reports, costs relating to the
parent companys audit of the subsidiarys accounts carried out exclusively in the
interest of the parent company, and costs relating to the preparation of consolidated
financial statements of the MNE (however, in practice costs incurred locally by the
subsidiaries may not need to be passed on to the parent or holding company where
it is disproportionately onerous to identify and isolate those costs);
c) Costs of raising funds for the acquisition of its participations and costs relating
to the parent companys investor relations such as communication strategy
with shareholders of the parent company, financial analysts, funds and other
stakeholders in the parent company;
d) Costs relating to compliance of the parent company with the relevant tax laws;
e) Costs which are ancillary to the corporate governance of the MNE as a whole.
In contrast, if for example a parent company raises funds on behalf of another group
member which uses them to acquire a new company, the parent company would generally
be regarded as providing a service to the group member. The 1984 Report also mentioned
costs of managerial and control (monitoring) activities related to the management and
protection of the investment as such in participations. Whether these activities fall within
the definition of shareholder activities as defined in these Guidelines would be determined
according to whether under comparable facts and circumstances the activity is one that an
independent enterprise would have been willing to pay for or to perform for itself. Where
activities such as those described above are performed by a group company other than
solely because of an ownership interest in other group members, then that group company
is not performing shareholder activities but should be regarded as providing a service to the
parent or holding company to which the guidance in this chapter applies.
B.1.3. Duplication
7.11 In general, no intra-group service should be found for activities undertaken by one
group member that merely duplicate a service that another group member is performing
for itself, or that is being performed for such other group member by a third party. An
exception may be where the duplication of services is only temporary, for example, where
an MNE group is reorganising to centralise its management functions. Another exception
would be where the duplication is undertaken to reduce the risk of a wrong business
decision (e.g.by getting a second legal opinion on a subject). Any consideration of possible
duplication of services needs to identify the nature of the services in detail, and the reason

why the company appears to be duplicating costs contrary to efficient practices. The fact
that a company performs, for example, marketing services in-house and also is charged for
marketing services from a group company does not of itself determine duplication, since
marketing is a broad term covering many levels of activity. Examination of information
provided by the taxpayer may determine that the intra-group services are different,
additional, or complementary to the activities performed in-house. The benefits test would
then apply to those non-duplicative elements of the intra-group services. Some regulated
sectors require control functions to be performed locally as well as on a consolidated basis
by the parent; such requirements should not lead to disallowance on grounds of duplication.
B.1.4. Incidental benefits

7.12 There are some cases where an intra-group service performed by a group member such
as a shareholder or coordinating centre relates only to some group members but incidentally
provides benefits to other group members. Examples could be analysing the question whether
to reorganise the group, to acquire new members, or to terminate a division. These activities
could constitute intra-group services to the particular group members involved, for example
those members who may make the acquisition or terminate one of their divisions, but they
may also produce economic benefits for other group members not directly involved in the
potential decision since the analysis could provide useful information about their own business
operations. The incidental benefits ordinarily would not cause these other group members to
be treated as receiving an intra-group service because the activities producing the benefits
would not be ones for which an independent enterprise ordinarily would be willing to pay.
7.13 Similarly, an associated enterprise should not be considered to receive an intragroup service when it obtains incidental benefits attributable solely to its being part of a
larger concern, and not to any specific activity being performed. For example, no service
would be received where an associated enterprise by reason of its affiliation alone has a
credit-rating higher than it would if it were unaffiliated, but an intra-group service would
usually exist where the higher credit rating were due to a guarantee by another group
member, or where the enterprise benefitted from deliberate concerted action involving
global marketing and public relations campaigns. In this respect, passive association should
be distinguished from active promotion of the MNE groups attributes that positively
enhances the profit-making potential of particular members of the group. Each case must
be determined according to its own facts and circumstances. See SectionD.8 of ChapterI
on MNE group synergies.
B.1.5. Centralised services

7.14 Other activities that may relate to the group as a whole are those centralised in the
parent company or one or more group service centres (such as a regional headquarters
company) and made available to the group (or multiple members thereof). The activities
that are centralised depend on the kind of business and on the organisational structure
of the group, but in general they may include administrative services such as planning,
coordination, budgetary control, financial advice, accounting, auditing, legal, factoring,
computer services; financial services such as supervision of cash flows and solvency, capital
increases, loan contracts, management of interest and exchange rate risks, and refinancing;
assistance in the fields of production, buying, distribution and marketing; and services in staff
matters such as recruitment and training. Group service centres also often carry out order
management, customer service and call centres, research and development or administer
and protect intangible property for all or part of the MNE group. These types of activities
ordinarily will be considered intra-group services because they are the type of activities that
independent enterprises would have been willing to pay for or to perform for themselves.
B.1.6. Form of the remuneration

7.15 In considering whether a charge for the provision of services would be made between
independent enterprises, it would also be relevant to consider the form that an arms length
consideration would take had the transaction occurred between independent enterprises
dealing at arms length. For example, in respect of financial services such as loans, foreign
exchange and hedging, all of the remuneration may be built into the spread and it would not
be appropriate to expect a further service fee to be charged if such were the case. Similarly,
in some buying or procurement services a commission element may be incorporated in the
price of the product or services procured, and a separate service fee may not be appropriate.
7.16 Another issue arises with respect to services provided on call. The question
is whether the availability of such services is itself a separate service for which an
arms length charge (in addition to any charge for services actually rendered) should be
determined. A parent company or one or more group service centres may be on hand to
provide services such as financial, managerial, technical, legal or tax advice and assistance
to members of the group at any time. In that case, a service may be rendered to associated
enterprises by having staff, equipment, etc., available. An intra-group service would exist
to the extent that it would be reasonable to expect an independent enterprise in comparable
circumstances to incur standby charges to ensure the availability of the services when
the need for them arises. It is not unknown, for example, for an independent enterprise to
pay an annual retainer fee to a firm of lawyers to ensure entitlement to legal advice and
representation if litigation is brought. Another example is a service contract for priority
computer network repair in the event of a breakdown.
7.17 These services may be available on call and they may vary in amount and
importance from year to year. It is unlikely that an independent enterprise would incur
stand-by charges where the potential need for the service was remote, where the advantage
of having services on-call was negligible, or where the on-call services could be obtained
promptly and readily from other sources without the need for stand-by arrangements.
Thus, the benefit conferred on a group company by the on-call arrangements should be
considered, perhaps by looking at the extent to which the services have been used over
a period of several years rather than solely for the year in which a charge is to be made,
before determining that an intra-group service is being provided.
7.18 The fact that a payment was made to an associated enterprise for purported
services can be useful in determining whether services were in fact provided, but the mere
description of a payment as, for example, management fees should not be expected to be
treated as prima facie evidence that such services have been rendered. At the same time,
the absence of payments or contractual agreements does not automatically lead to the
conclusion that no intra-group services have been rendered.
B.2. Determining an arms length charge

B.2.1. In general
7.19 Once it is determined that an intra-group service has been rendered, it is necessary,
as for other types of intra-group transfers, to determine whether the amount of the charge,
if any, is in accordance with the arms length principle. This means that the charge for

intra-group services should be that which would have been made and accepted between
independent enterprises in comparable circumstances. Consequently, such transactions
should not be treated differently for tax purposes from comparable transactions between
independent enterprises, simply because the transactions are between enterprises that
happen to be associated.
B.2.2. Identifying actual arrangements for charging for intra-group services

7.20 To identify the amount, if any, that has actually been charged for services, a tax
administration will need to identify what arrangements, if any, have actually been put in
place between the associated enterprises to facilitate charges being made for the provision
of services between them.
B.2.2.1 Direct-charge methods

7.21 In certain cases, the arrangements made for charging for intra-group services can
be readily identified. These cases are where the MNE group uses a direct-charge method,
i.e.where the associated enterprises are charged for specific services. In general, the directcharge method is of great practical convenience to tax administrations because it allows the
service performed and the basis for the payment to be clearly identified. Thus, the directcharge method facilitates the determination of whether the charge is consistent with the
arms length principle.
7.22 An MNE group may be able to adopt direct charging arrangements, particularly
where services similar to those rendered to associated enterprises are also rendered to
independent parties. If specific services are provided not only to associated enterprises
but also to independent enterprises in a comparable manner and as a significant part of
its business, it could be presumed that the MNE has the ability to demonstrate a separate
basis for the charge (e.g.by recording the work done, the fee basis, or costs expended in
fulfilling its third party contracts). As a result, MNEs in such a case are encouraged to
adopt the direct-charge method in relation to their transactions with associated enterprises.
It is accepted, however, that this approach may not always be appropriate if, for example,
the services to independent parties are merely occasional or marginal.
B.2.2.2 Indirect-charge methods

7.23 A direct-charge method for charging for intra-group services can be difficult
to apply in practice. Consequently, some MNE groups have developed other methods
for charging for services provided by parent companies or group service centres. In
such cases, MNE groups may find they have few alternatives but to use cost allocation
and apportionment methods which often necessitate some degree of estimation or
approximation, as a basis for calculating an arms length charge following the principles in
SectionB.2.3 below. Such methods are generally referred to as indirect-charge methods and
should be allowable provided sufficient regard has been given to the value of the services to
recipients and the extent to which comparable services are provided between independent
enterprises. These methods of calculating charges would generally not be acceptable where
specific services that form a main business activity of the enterprise are provided not only
to associated enterprises but also to independent parties. While every attempt should be
made to charge fairly for the service provided, any charging has to be supported by an
identifiable and reasonably foreseeable benefit. Any indirect-charge method should be
sensitive to the commercial features of the individual case (e.g.the allocation key makes
sense under the circumstances), contain safeguards against manipulation and follow sound
accounting principles, and be capable of producing charges or allocations of costs that
are commensurate with the actual or reasonably expected benefits to the recipient of the
service.
7.24 In some cases, an indirect-charge method may be necessary due to the nature of the
service being provided. One example is where the proportion of the value of the services
rendered to the various relevant entities cannot be quantified except on an approximate or
estimated basis. This problem may occur, for example, where sales promotion activities
carried on centrally (e.g.at international fairs, in the international press, or through other
centralised advertising campaigns) may affect the quantity of goods manufactured or sold
by a number of affiliates. Another case is where a separate recording and analysis of the
relevant services for each beneficiary would involve a burden of administrative work that
would be disproportionately heavy in relation to the activities themselves. In such cases, the
charge could be determined by reference to an allocation among all potential beneficiaries
of the costs that cannot be allocated directly, i.e.costs that cannot be specifically assigned
to the actual beneficiaries of the various services. To satisfy the arms length principle,
the allocation method chosen must lead to a result that is consistent with what comparable
independent enterprises would have been prepared to accept.
7.25 The allocation should be based on an appropriate measure of the usage of the
service that is also easy to verify, for example turnover, staff employed, or an activity based
key such as orders processed. Whether the allocation method is appropriate may depend on
the nature and usage of the service. For example, the usage or provision of payroll services
may be more related to the number of staff than to turnover, while the allocation of the
stand-by costs of priority computer back-up could be allocated in proportion to relative
expenditure on computer equipment by the group members.
7.26 When an indirect-charge method is used, the relationship between the charge and
the services provided may be obscured and it may become difficult to evaluate the benefit
provided. Indeed, it may mean that the enterprise being charged for a service itself has
not related the charge to the service. Consequently, there is an increased risk of double
taxation because it may be more difficult to determine a deduction for costs incurred on
behalf of group members if compensation cannot be readily identified, or for the recipient
of the service to establish a deduction for any amount paid if it is unable to demonstrate
that services have been provided.
B.2.2.3 Form of the compensation

7.27 The compensation for services rendered to an associated enterprise may be included
in the price for other transfers. For instance, the price for licensing a patent or know-how
may include a payment for technical assistance services or centralised services performed
for the licensee or for managerial advice on the marketing of the goods produced under the
licence. In such cases, the tax administration and the taxpayers would have to check that
there is no additional service fee charged and that there is no double deduction.
7.28 In identifying arrangements for charging any retainer for the provision of on call
services (as discussed in paragraphs7.16 and 7.17), it may be necessary to examine the
terms for the actual use of the services since these may include provisions that no charge is
made for actual use until the level of usage exceeds a predetermined level.
B.2.3. Calculating the arms length compensation

7.29 In trying to determine the arms length price in relation to intra-group services, the
matter should be considered both from the perspective of the service provider and from the
perspective of the recipient of the service. In this respect, relevant considerations include
the value of the service to the recipient and how much a comparable independent enterprise
would be prepared to pay for that service in comparable circumstances, as well as the costs
to the service provider.
7.30 For example, from the perspective of an independent enterprise seeking a service,
the service providers in that market may or may not be willing or able to supply the service
at a price that the independent enterprise is prepared to pay. If the service providers can
supply the wanted service within a range of prices that the independent enterprise would
be prepared to pay, then a deal will be struck. From the point of view of the service
provider, a price below which it would not supply the service and the cost to it are relevant
considerations to address, but they are not necessarily determinative of the outcome in
every case.
B.2.3.1 Methods
7.31 The method to be used to determine arms length transfer pricing for intra-group
services should be determined according to the guidelines in ChaptersI, II, and III. Often,
the application of these guidelines will lead to use of the CUP or a cost-based method
(cost plus method or cost-based TNMM) for pricing intra-group services. A CUP method
is likely to be the most appropriate method where there is a comparable service provided
between independent enterprises in the recipients market, or by the associated enterprise
providing the services to an independent enterprise in comparable circumstances. For
example, this might be the case where accounting, auditing, legal, or computer services are
being provided subject to the controlled and uncontrolled transactions being comparable.
A cost based method would likely be the most appropriate method in the absence of a CUP
where the nature of the activities involved, assets used, and risks assumed are comparable
to those undertaken by independent enterprises. As indicated in ChapterII, PartII, in
applying the cost plus method, there should be a consistency between the controlled and
uncontrolled transactions in the categories of cost that are included. In exceptional cases,
for example where it may be difficult to apply the CUP method or the cost-based methods,
it may be helpful to take account of more than one method (see paragraph2.11) in reaching
a satisfactory determination of arms length pricing.
7.32 It may be necessary to perform a functional analysis of the various members of
the group to establish the relationship between the relevant services and the members
activities and performance. In addition, it may be necessary to consider not only the
immediate impact of a service, but also its long-term effect, bearing in mind that some
costs will never actually produce the benefits that were reasonably expected when they
were incurred. For example, expenditure on preparations for a marketing operation might
prima facie be too heavy to be borne by a member in the light of its current resources; the
determination whether the charge in such a case is arms length should consider expected
benefits from the operation and the possibility that the amount and timing of the charge
in some arms length arrangements might depend on the results of the operation. The
taxpayer should be prepared to demonstrate the reasonableness of its charges to associated
enterprises in such cases.
7.33 Where a cost based method is determined to be the most appropriate method to
the circumstances of the case, the analysis would require examining whether the costs
incurred by the group service provider need some adjustment to make the comparison of
the controlled and uncontrolled transactions reliable.
7.34 When an associated enterprise is acting only as an agent or intermediary in the
provision of services, it is important in applying a cost based method that the return or
mark-up is appropriate for the performance of an agency function rather than for the
performance of the services themselves. In such a case, it may not be appropriate to
determine arms length pricing as a mark-up on the cost of the services but rather on the
costs of the agency function itself. For example, an associated enterprise may incur the costs
of renting advertising space on behalf of group members, costs that the group members
would have incurred directly had they been independent. In such a case, it may well be
appropriate to pass on these costs to the group recipients without a mark-up, and to apply a
mark-up only to the costs incurred by the intermediary in performing its agency function.
B.2.3.2 Considerations on including a profit element

7.35 Depending on the method being used to establish an arms length charge for intragroup services, the issue may arise whether it is necessary that the charge be such that it
results in a profit for the service provider. In an arms length transaction, an independent
enterprise normally would seek to charge for services in such a way as to generate profit,
rather than providing the services merely at cost. The economic alternatives available to the
recipient of the service also need to be taken into account in determining the arms length
charge. However, there are circumstances (e.g.as outlined in the discussion on business
strategies in ChapterI) in which an independent enterprise may not realise a profit from
the performance of services alone, for example where a suppliers costs (anticipated or
actual) exceed market price but the supplier agrees to provide the service to increase its
profitability, perhaps by complementing its range of activities. Therefore, it need not always
be the case that an arms length price will result in a profit for an associated enterprise that
is performing an intra-group service.
7.36 For example, it may be the case that the market value of intra-group services is not
greater than the costs incurred by the service provider. This could occur where, for example,
the service is not an ordinary or recurrent activity of the service provider but is offered
incidentally as a convenience to the MNE group. In determining whether the intra-group
services represent the same value for money as could be obtained from an independent
enterprise, a comparison of functions and expected benefits would be relevant to assessing
comparability of the transactions. An MNE group may still determine to provide the service
intra-group rather than using a third party for a variety of reasons, perhaps because of other
intra-group benefits (for which arms length compensation may be appropriate). It would
not be appropriate in such a case to increase the price for the service above what would be
established by the CUP method just to make sure the associated enterprise makes a profit.
Such a result would be contrary to the arms length principle. However, it is important to
ensure that all benefits to the recipient are properly taken into account.
7.37 While as a matter of principle tax administrations and taxpayers should try to
establish the proper arms length pricing, it should not be overlooked that there may be
practical reasons why a tax administration in its discretion exceptionally might be willing
to forgo computing and taxing an arms length price from the performance of services in
some cases, as distinct from allowing a taxpayer in appropriate circumstances to merely
allocate the costs of providing those services. For instance, a cost-benefit analysis might
indicate the additional tax revenue that would be collected does not justify the costs and
administrative burdens of determining what an appropriate arms length price might be in

some cases. In such cases, charging all relevant costs rather than an arms length price may
provide a satisfactory result for MNEs and tax administrations. This concession is unlikely
to be made by tax administrations where the provision of a service is a principal activity of
the associated enterprise, where the profit element is relatively significant, or where direct
charging is possible as a basis from which to determine the arms length price.
C.
Some examples of intra-group services

7.38 This section sets forth several examples of transfer pricing issues in the provision
of intra-group services. The examples are provided for illustrative purposes only. When
dealing with individual cases, it is necessary to explore the actual facts and circumstances
to judge the applicability of any transfer pricing method.
7.39 One example involves debt-factoring activities, where an MNE group decides to
centralise the activities for economic reasons. For example, it may be prudent to centralise
the debt-factoring activities to better manage liquidity, currency and debt risks and to
provide administrative efficiencies. A debt-factoring centre that takes on this responsibility
is performing intra-group services for which an arms length charge should be made. A
CUP method could be appropriate in such a case.
7.40 Another example of an activity that may involve intra-group services is manufacturing
or assembly operations. The activities can take a variety of forms including what is
commonly referred to as contract manufacturing. In some cases of contract manufacturing
the producer may operate under extensive instruction from the counterparty about what to
produce, in what quantity and of what quality. In some cases, raw materials or components
may be made available to the producer by the counterparty. The production company may
be assured that its entire output will be purchased, assuming quality requirements are met.
In such a case the production company could be considered as performing a low-risk service
to the counterparty, and the cost plus method could be the most appropriate transfer pricing
method, subject to the principles in ChapterII.
7.41 Research is similarly an example of an activity that may involve intra-group services.
The terms of the activity can be set out in a detailed contract with the party commissioning
the service, commonly known as contract research. The activity can involve highly skilled
personnel and vary considerably both in its nature and in its importance to the success of
the group. The actual arrangements can take a variety of forms from the undertaking of
detailed programmes laid down by the principal party, extending to agreements where the
research company has discretion to work within broadly defined categories. In the latter
instance, the additional functions of identifying commercially valuable areas and assessing
the risk of unsuccessful research can be a critical factor in the performance of the group
as a whole. It is therefore crucial to undertake a detailed functional analysis and to obtain
a clear understanding of the precise nature of the research, and of how the activities are
being carried out by the company, prior to consideration of the appropriate transfer pricing
methodology. The consideration of options realistically available to the party commissioning
the research may also prove useful in selecting the most appropriate transfer pricing method.
See SectionB.2 of ChapterVI.
7.42 Another example of intra-group services is the administration of licences. The
administration and enforcement of intangible property rights should be distinguished from
the exploitation of those rights for this purpose. The protection of a licence might be handled
by a group service centre responsible for monitoring possible licence infringements and for
enforcing licence rights.
D.
Low value-adding intra-group services

7.43 This section provides specific guidance relating to a particular category of intragroup services referred to as low value-adding intra-group services. SectionD.1 contains
the definition of low value-adding intra-group services. SectionD.2 sets out an elective,
simplified approach for the determination of arms length charges for low value-adding
intra-group services, including a simplified benefits test. SectionD.3 contains guidance on
documentation and reporting requirements that should be met by an MNE group electing
to apply this simplified approach. Finally, SectionD.4 addresses some issues with regard
to the levying of withholding taxes on charges for low value-adding intra-group services.
In summary, the simplified approach recognises that the arms length price for low valueadding intra-group services is closely related to costs, allocates the costs of providing each
category of such services to those group companies which benefit from using those services,
and then applies the same mark-up to all categories of services. MNE groups not electing to
apply the simplified approach set out in this section should address transfer pricing issues
related to low-value-adding services under the provisions of Sections A and B, above.
D.1. Definition of low value-adding intra-group services

7.44 This section discusses the definitional issues related to low value-adding intragroup services for applying the elective, simplified approach discussed under SectionD.2.
It starts by indicating the characteristics that services must have in order to qualify as lowvalue-adding intra-group services for applying the elective, simplified approach. It then
identifies a series of activities that do not qualify as low value-adding intra-group services
for the elective, simplified approach. Finally it contains a list of examples of services that
likely would have the characteristics to qualify as low value-adding intra-groups services
for the application of the simplified approach.
7.45 Low value-adding intra-group services for the purposes of the simplified approach
are services performed by one member or more than one member of an MNE group on
behalf of one or more other group members which
are of a supportive nature
are not part of the core business of the MNE group (i.e.not creating the profit-earning
activities or contributing to economically significant activities of the MNE group)
do not require the use of unique and valuable intangibles and do not lead to the
creation of unique and valuable intangibles, and
do not involve the assumption or control of substantial or significant risk by the service
provider and do not give rise to the creation of significant risk for the service provider.
7.46 The guidance in this section is not applicable to services that would ordinarily
qualify as low value-adding intra-group services where such services are rendered to
unrelated customers of the members of the MNE group. In such cases it can be expected
that reliable internal comparables exist and can be used for determining the arms length
price for the intra-group services.
7.47 The following activities would not qualify for the simplified approach outlined in
this section:
services constituting the core business of the MNE group
research and development services (including software development unless falling
within the scope of information technology services in 7.49)

manufacturing and production services
purchasing activities relating to raw materials or other materials that are used in the
manufacturing or production process
sales, marketing and distribution activities
financial transactions
extraction, exploration, or processing of natural resources
insurance and reinsurance
services of corporate senior management (other than management supervision of
services that qualify as low value-adding intra-group services under the definition
of paragraph7.45).
7.48 The fact that an activity does not qualify for the simplified approach, as defined
under paragraph7.45, should not be interpreted to mean that that activity generates high
returns. The activity could still add low value, and the determination of the arms length
charge for such activity, if any, should be determined according to the guidance set out in
paragraphs7.1 to 7.42.
7.49 The following bullet points provide examples of services that would likely meet the
definition of low value-adding services provided in paragraph7.45:
accounting and auditing, for example gathering and reviewing information for use
in financial statements, maintenance of accounting records, preparation of financial
statements, preparation or assistance in operational and financial audits, verifying
authenticity and reliability of accounting records, and assistance in the preparation
of budgets through compilation of data and information gathering
processing and management of accounts receivable and accounts payable, for
example compilation of customer or client billing information, and credit control
checking and processing
human resources activities, such as
- staffing and recruitment, for example hiring procedures, assistance in evaluation
of applicants and selection and appointment of personnel, on-boarding new
employees, performance evaluation and assistance in defining careers, assistance
in procedures to dismiss personnel, assistance in programmes for redundant
personnel;
- training and employee development, for example evaluation of training needs,
creation of internal training and development programmes, creation of management
skills and career development programmes;
- remuneration services, for example, providing advice and determining policies
for employee compensation and benefits such as healthcare and life insurance,
stock option plans, and pension schemes; verification of attendance and
timekeeping, payroll services including processing and tax compliance;
- developing and monitoring of staff health procedures, safety and environmental
standards relating to employment matters;
monitoring and compilation of data relating to health, safety, environmental and
other standards regulating the business
information technology services where they are not part of the principal activity of
the group, for example installing, maintaining and updating IT systems used in the
business; information system support (which may include the information system
used in connection with accounting, production, client relations, human resources
and payroll, and email systems); training on the use or application of information
systems as well as on the associated equipment employed to collect, process and
present information; developing IT guidelines, providing telecommunications
services, organising an IT helpdesk, implementing and maintaining of IT security
systems; supporting, maintaining and supervising of IT networks (local area
network, wide area network, internet)
internal and external communications and public relations support (but excluding
specific advertising or marketing activities as well as development of underlying
strategies)
legal services, for example general legal services performed by in-house legal
counsel such as drafting and reviewing contracts, agreements and other legal
documents, legal consultation and opinions, representation of the company (judicial
litigation, arbitration panels, administrative procedures), legal research and legal
as well as administrative work for the registration and protection of intangible
property
activities with regard to tax obligations, for example information gathering and
preparation of tax returns (income tax, sales tax, VAT, property tax, customs and
excise), making tax payments, responding to tax administrations audits, and giving
advice on tax matters
general services of an administrative or clerical nature
7.50 The following examples illustrate an important element of the definition of low
value-adding intra-group services, namely, that they should not include services which are
part of the MNEs core business. Services that may seem superficially similar in nature (in
the example, credit risk analysis) may or may not be low value-adding intra-group services
depending on the specific context and circumstances. The examples also illustrate the point
that services may not qualify as low value-adding intra-group services because in their
specific context they create significant risk or unique and valuable intangibles.
a) CompanyA, situated in countryA, is a shoe manufacturer and wholesale distributor
of shoes in the North-West region. Its wholly-owned subsidiary B, situated
in countryB, is a wholesale distributor in the South-East region of the shoes
manufactured by A. As part of its operations, A routinely performs a credit risk
analysis on its customers on the basis of reports purchased from a credit reporting
agency. A performs, on behalf of B, the same credit risk analysis with respect
to Bs customers, using the same methods and approaches. Under the facts and
circumstances, it could be reasonably concluded that the service A performs for B
is a low value-adding intra-group service.
b) CompanyX is a subsidiary of a worldwide investment banking group. CompanyX
performs credit risk analysis with respect to potential counterparties for transactions
involving financial derivatives contracts and prepares credit reports for the
worldwide investment banking group. The credit analyses performed by CompanyX
are utilised by the group in establishing the prices of financial derivatives for the
groups clients. The personnel of CompanyX have developed special expertise
and make use of internally developed, confidential credit risk analysis models,

algorithms and software. Under the facts and circumstances of this case, it could not
be concluded that the service CompanyX performs for the worldwide investment
banking group is a low value-adding intra-group service.
7.51 The definition of low value-adding intra-group services refers to the supportive
nature of such services, which are not part of the core business of the MNE group. The
provision of low value-adding intra-group services may, in fact, be the principal business
activity of the legal entity providing the service, e.g.a shared service centre, provided
these services do not relate to the core business of the group. As an example, assume that
an MNE is engaged in the development, production, sale and marketing of dairy products
worldwide. The group established a shared services company, the only activity of which is
to act as a global IT support service centre. From the perspective of the IT support service
provider, the rendering of the IT services is the companys principal business activity.
However, from the perspective of the service recipients, and from the perspective of the
MNE group as a whole, the service is not a core business activity and may therefore qualify
as a low value-adding intra-group service.
D.2. Simplified determination of arms length charges for low value-adding

intra-group services
7.52 This subsection sets out the elements of a simplified charge mechanism for low
value-adding intra-group services. This simplified method is premised on the proposition
that all low value-adding service costs incurred in supporting the business of MNE group
members should be allocated to those members. The basic benefits of using the simplified
approach include: (1)reducing the compliance effort of meeting the benefits test and in
demonstrating arms length charges; (2)providing greater certainty for MNE groups that
the price charged for the qualifying activities will be accepted by the tax administrations
that have adopted the simplified approach when the conditions of the simplified approach
mentioned in paragraph7.45 have been met; and (3)providing tax administrations with
targeted documentation enabling efficient review of compliance risks. An MNE group
electing to adopt this simplified method would as far as practicable apply it on a consistent,
group wide basis in all countries in which it operates.
7.53 Where a tax administration has not adopted the simplified approach, and as a
consequence the MNE group complies with the local requirements in that jurisdiction, such
compliance would not disqualify the MNE group from the application of the simplified
approach to other jurisdictions. In addition, not all MNE groups are vertically integrated
and may instead have regional or divisional sub-groups with their own management and
support structures. Therefore, MNE groups may elect to adopt the simplified method
at the level of a sub-holding company and apply it on a consistent basis across all
subsidiaries of that sub-holding company. When the MNE group elects for and applies
the simplified approach, charges for low value-adding intra-group services that are or
have been determined in conformity with the guidance in this subsection are determined
to be in accordance with the arms length principle. A possible alternative approach for
dealing with the issues discussed in this subsection would be the use of Cost Contribution
Arrangements, covered in ChapterVIII.
D.2.1. Application of the benefits test to low value-adding intra-group services

7.54 As discussed in paragraph7.6, under the arms length principle an obligation
to pay for an intra-group service arises only where the benefits test is satisfied, i.e.the
activity must provide the group member expected to pay for the service with economic
or commercial value to enhance or maintain its commercial position, which in turn is

determined by evaluating whether an independent enterprise in comparable circumstances
would have been willing to pay for the activity if performed for it by an independent
enterprise or would have performed the activity in-house for itself. However, because of
the nature of the low value-adding intra-group services discussed in this section, such
determinations may be difficult or may require greater effort than the amount of the
charge warrants. Tax administrations should therefore generally refrain from reviewing
or challenging the benefits test when the simplified approach has been applied under the
conditions and circumstances discussed in this section and in particular in conformity with
the documentation and reporting discussed in SectionD.3 below.
7.55 While low value-adding intra-group services may provide benefits to all recipients of
those services, questions may arise about the extent of the benefits and whether independent
parties would have been willing to pay for the service or perform it themselves. Where the
MNE group has followed the guidance of the simplified approach the documentation and
reporting discussed in SectionD.3 below, it should provide sufficient evidence that the
benefits test is met given the nature of low value-adding intra-group services. In evaluating
the benefits test, tax administrations should consider benefits only by categories of services
and not on a specific charge basis. Thus, the taxpayer need only demonstrate that assistance
was provided with, for example, payroll processing, rather than being required to specify
individual acts undertaken that give rise to the costs charged. Provided such information
outlined in paragraph7.64 is made available to the tax administration, a single annual invoice
describing a category of services should suffice to support the charge, and correspondence
or other evidence of individual acts should not be required. With regard to low value-adding
intra-group services that benefit only one recipient entity in the MNE group, it is expected
that the benefits to the service recipient will be capable of separate demonstration.
D.2.2. Determination of cost pools

7.56 The initial step in applying the simplified approach to low value-adding intra-group
services is for the MNE group to calculate, on an annual basis, a pool of all costs incurred
by all members of the group in performing each category of low value-adding intra-group
services. The costs to be pooled are the direct and indirect costs of rendering the service
as well as, where relevant, the appropriate part of operating expenses (e.g.supervisory,
general and administrative). The costs should be pooled according to category of services,
and should identify the accounting cost centres used in creating the pool. Pass-through
costs in the cost pool should be identified for the purposes of applying paragraph7.61. The
cost pool should exclude costs that are attributable to an in-house activity that benefits
solely the company performing the activity (including shareholder activities performed by
the shareholding company).
7.57 As a second step, the MNE group should identify and remove from the pool those
costs that are attributable to services performed by one group member solely on behalf
of one other group member. In creating a pool of payroll costs, for example, if group
companyA provides payroll services solely to group companyB the relevant costs should
be separately identified and omitted from the pool. However, if group companyA performs
payroll services for itself as well as for companyB, the relevant costs should remain within
the pool.
7.58 At this stage in the calculation, the MNE group has identified a pool of costs
associated with categories of low value-adding services which are provided to multiple
members of the MNE group.
D.2.3. Allocation of low value-adding service costs

7.59 The third step in this simplified charge method for low value-adding intra-group
service costs is to allocate among members of the group the costs in the cost pool that
benefit multiple members of the group. The taxpayer will select one or more allocation
keys to apply for this purpose based on the following principles. The appropriate allocation
key or keys will depend on the nature of the services. The same allocation key or keys
must be used on a consistent basis for all allocations of costs relating to the same category
of services. In accordance with the guidance in paragraph7.24, the allocation key or keys
selected with respect to costs for each relevant category of services should reasonably
reflect the level of benefit expected to be received by each recipient of the particular
service. As a general rule, the allocation key or keys should reflect the underlying need
for the particular services. By way of examples, the allocation key for services related to
people might employ each companys share of total group headcount, IT services might
employ the share of total users, fleet management services might employ the share of total
vehicles, accounting support services might employ the share of total relevant transactions
or the share of total assets. In many cases, the share of total turnover may be a relevant key.
7.60 The examples of allocation keys provided in the previous paragraph are not intended
to be an exhaustive list. Depending on the facts and circumstances more sophisticated
allocation keys might be used. However, a balance should be struck between theoretical
sophistication and practical administration, bearing in mind that the costs involved are not
generating high value for the group. In this context, there may be no need to use multiple
allocation keys if the taxpayer can explain the reasons for concluding that a single key
provides a reasonable reflection of the respective benefits. For reasons of consistency,
the same allocation key or keys should be applied in determining the allocation to all
recipients within the group of the same type of low value-adding intra-group services, and
it is expected that the same reasonable key will be used from year to year unless there is
a justified reason to change. Tax administrations and taxpayers should also bear in mind
that changing the reasonable allocation key can give rise to considerable complexities. It is
expected that the taxpayer will describe in its documentation (see paragraph7.64 below)
the reasons for concluding that the allocation key produces outcomes which reasonably
reflects the benefits likely to be derived by each service recipient.
D.2.4. Profit mark-up

7.61 In determining the arms length charge for low value-adding intra-group services,
the MNE provider of services shall apply a profit mark-up to all costs in the pool with
the exception of any pass-through costs as determined under paragraphs2.93 and 7.34.
The same mark-up shall be utilised for all low value-adding services irrespective of the
categories of services. The mark-up shall be equal to 5% of the relevant cost as determined
in SectionD.2.2. The mark-up under the simplified approach does not need to be justified
by a benchmarking study. The same mark-up may be applied to low value-adding intragroup services performed by one group member solely on behalf of one other group
member, the costs of which are separately identified under the guidance in paragraph7.57.
It should be noted that the low value-adding intra-group services mark-up should not,
without further justification and analysis, be used as benchmark for the determination of
the arms length price for services not within the definition of low value-adding intra-group
services, nor for similar services not within the elective, simplified scheme.
D.2.5. Charge for low value-adding services

7.62 Subject to the provisions of paragraph7.55, the charge for services to any member
of the electing MNE group shall be the sum of (i)the costs incurred by another group
member in providing services specifically to the member under the second step as
detailed in paragraph7.57, plus the selected profit mark-up, and (ii)the share of pooled
costs allocated to the member under the third step as detailed in paragraph7.59 using
the selected allocation key, plus the selected profit mark-up. The charge is payable to the
group member that incurred the costs in the pool, and where there is more than one group
member incurring those costs, in proportion to each members share of the pooled costs.
D.2.6. Threshold for the application of the simplified approach

7.63 Tax administrations adopting the simplified approach to low-value-adding intragroup services set out in this section may include an appropriate threshold to enable
them to review the simplified approach in cases where the threshold is exceeded. Such
a threshold might, for example, be based on fixed financial ratios of the recipient party
(e.g.proportion of intra-group services costs to total costs or turnover or pre-intra-group
service charge profit) or be determined by reference to a group-wide ratio of total service
costs to turnover of the MNE group or some other appropriate measure. Where such a
threshold is adopted, the tax administration would not be obliged to accept the simplified
approach if the level of low-value-adding intra-group service fees exceeds the threshold and
may require a full functional analysis and comparability analysis including the application
of the benefits test to specific service charges.
D.3. Documentation and reporting

7.64 An MNE group electing for application of this simplified methodology shall prepare
the following information and documentation and make it available upon request to the tax
administration of any entity within the group either making or receiving a payment for low
value-adding intra-group services.
A description of the categories of low value-adding intra-group services provided;
the identity of the beneficiaries; the reasons justifying that each category of
services constitute low value-adding intra-group services within the definition set
out in SectionD.1; the rationale for the provision of services within the context of
the business of the MNE; a description of the benefits or expected benefits of each
category of services; a description of the selected allocation keys and the reasons
justifying that such allocation keys produce outcomes that reasonably reflect the
benefits received, and confirmation of the mark-up applied;
Written contracts or agreements for the provision of services and any modifications
to those contracts and agreements reflecting the agreement of the various members
of the group to be bound by the allocation rules of this section. Such written
contracts or agreements could take the form of a contemporaneous document
identifying the entities involved, the nature of the services, and the terms and
conditions under which the services are provided;
Documentation and calculations showing the determination of the cost pool as
described in SectionD.2.2, and of the mark-up applied thereon, in particular a
detailed listing of all categories and amounts of relevant costs, including costs of
any services provided solely to one group member;
Calculations showing the application of the specified allocation keys.
D.4. Levying of withholding tax on charges for low value-adding intra-group

services
7.65 The levying of withholding taxes on the provision of low value-adding intra-group
services can prevent the service provider recovering the totality of the costs incurred for
rendering the services. When a profit element or mark-up is included in the charge of the
services, tax administrations levying withholding tax are encouraged to apply it only to the
amount of that profit element or mark-up.
Cost Contribution Arrangements 161
COST CONTRIBUTION ARRANGEMENTS
Revisions to ChapterVIII of the Transfer Pricing Guidelines

Summary
Cost Contribution Arrangements (CCAs) are special contractual arrangements
among business enterprises to share the contributions and risks involved in the joint
development, production or the obtaining of intangibles, tangible assets or services with
the understanding that such intangibles, tangible assets or services are expected to create
benefits for the individual businesses of each of the participants. If contributions to and
benefits of the CCA are not valued appropriately, this will lead to profits being shifted away
from the location where the value is created through the economic activities performed.
Action8 of the BEPS Action Plan covers the transfer pricing of intangibles and requires
the development of rules to prevent BEPS by moving intangibles among group members
without arms length compensation, as well as an update to the guidance on CCAs. The
guidance contained in this chapter deals with that latter part of Action8 and will replace
the guidance currently in ChapterVIII of the Transfer Pricing Guidelines.
This chapter of the Report provides general guidance for determining whether the
conditions established by associated enterprises for transactions covered by a CCA are
consistent with the arms length principle. In doing so, the guidance contained in this
chapter addresses some of the opportunities for BEPS resulting from the use of CCAs.
Parties performing activities under arrangements with similar economic characteristics
should receive similar expected returns, irrespective of whether the contractual arrangement
in a particular case is termed a CCA. The guidance ensures that CCAs cannot be used to
circumvent the new guidance on the application of the arms length principle in relation
to transactions involving the assumption of risks, or on intangibles. The analysis of CCAs
follows the framework set out in that guidance to ensure that:
The same analytical framework for delineating the actual transaction, including
allocating risk, is applicable to CCAs as to other kinds of contractual arrangements.
The same guidance for valuing and pricing intangibles, including hard-to-value
intangibles, is applicable to CCAs as to other kinds of contractual arrangements.
The analysis of CCAs is based on the actual arrangements undertaken by associated
enterprises and not on contractual terms that do not reflect economic reality.
162 Cost Contribution Arrangements
An associated enterprise can only be a participant to the CCA if there is a

reasonable expectation that it will benefit from the objectives of the CCA activity
and it exercises control over the specific risks it assumes under the CCA and has
the financial capacity to assume those risks.
Contributions made to a CCA, with specific focus on intangibles, should not be
measured at cost where this is unlikely to provide a reliable basis for determining
the value of the relative contributions of participants, since this may lead to nonarms length results.
In summary the guidance ensures that CCAs are appropriately analysed and produce
outcomes that are consistent with how and where value is created.
The current provisions of ChapterVIII of the Transfer Pricing Guidelines are

deleted in their entirety and replaced by the following language.
A. Introduction
8.1 This chapter discusses cost contribution arrangements (CCAs) between two or more
associated enterprises. The purpose of the chapter is to provide some general guidance for
determining whether the conditions established by associated enterprises for transactions
covered by a CCA are consistent with the arms length principle. The analysis of the
structure of such arrangements should be informed by the provisions of this chapter and
other provisions of these Guidelines and should be based on an adequate documentation of
the arrangement.
8.2 SectionB provides a general definition and overview of the concept of CCAs,
and SectionC gives guidance as to the application of the arms length principle to CCAs.
SectionC includes guidance on how to measure contributions to a CCA, whether balancing
payments are needed (i.e.payments between participants to adjust their proportionate
shares of contributions), and guidance on how contributions and balancing payments
should be treated for tax purposes. It also addresses the determination of participants in
the CCA and issues related to the entry or withdrawal of participants, and the termination
of CCAs. Finally, SectionD discusses suggestions for structuring and documenting CCAs.
B.
Concept of a CCA
B.1. In general
8.3 A CCA is a contractual arrangement among business enterprises to share the
contributions and risks involved in the joint development, production or the obtaining
of intangibles, tangible assets or services with the understanding that such intangibles,
tangible assets or services are expected to create benefits for the individual businesses
of each of the participants. A CCA is a contractual arrangement rather than necessarily a
distinct juridical entity or fixed place of business of all the participants. A CCA does not
require the participants to combine their operations in order, for example, to exploit any
resulting intangibles jointly or to share the revenues or profits. Rather, CCA participants
may exploit their interest in the outcomes of a CCA through their individual businesses.
The transfer pricing issues focus on the commercial or financial relations between the
participants and the contributions made by the participants that create the opportunities to
achieve those outcomes.
8.4 As indicated in SectionD.1 of ChapterI, the delineation of the actual transaction
undertaken forms the first phase in any transfer pricing analysis. The contractual
agreement provides the starting point for delineating the actual transaction. In this
respect, no difference exists for a transfer pricing analysis between a CCA and any
other kind of contractual arrangement where the division of responsibilities, risks, and
anticipated outcomes as determined by the functional analysis of the transaction is the
same. The guidance on identifying the other economically relevant characteristics is
equally applicable to CCAs as to any other type of contractual arrangement, including an
assessment as to whether the parties contractually assuming risks are actually assuming
these risks based on the framework for analysing risk set out in paragraph1.60 of these
Guidelines. As a consequence, parties performing activities under arrangements with

similar economic characteristics should receive similar expected returns, irrespective of
whether the contractual arrangement in a particular case is termed a CCA. However, there
are specific characteristics of CCAs that warrant special consideration.
8.5 A key feature of a CCA is the sharing of contributions. In accordance with the
arms length principle, at the time of entering into a CCA, each participants proportionate
share of the overall contributions to a CCA must be consistent with its proportionate
share of the overall expected benefits to be received under the arrangement. Further, in
the case of CCAs involving the development, production or obtaining of intangibles or
tangible assets, an ownership interest in any intangibles or tangible assets resulting from
the activity of the CCA, or rights to use or exploit those intangibles or tangible assets, is
contractually provided for each participant. For CCAs for services, each participant is
contractually entitled to receive services resulting from the activity of the CCA. In either
case, participants may exploit the interest, rights or entitlement without paying additional
consideration (other than the contributions and balancing payments described in Sections
C.4 and C.5, respectively) to any party for such interest, rights or entitlement.
8.6 Some benefits of the CCA activity can be determined in advance, whereas others
will be uncertain. Some types of CCA activities will produce current benefits, while
others have a longer time frame or may not be successful. Nevertheless, in a CCA there
is always an expected benefit that each participant seeks from its contribution, including
the attendant rights to have the CCA properly administered. Each participants interest
in the results of the CCA activity should be established from the outset, even where the
interest is inter-linked with that of other participants, e.g.because legal ownership of
developed intangibles or tangible assets may be vested in only one of them but all of them
have certain rights to use or exploit the intangibles or tangible assets as provided in the
contractual arrangements (for example, perpetual, royalty-free licences for the territory in
which the individual participant operates).
8.7 In some cases CCAs can provide helpful simplification of multiple transactions
(bearing in mind that the tax consequences of transactions are determined in accordance
with applicable local laws). In a situation where associated enterprises both perform
activities for other group members and simultaneously benefit from activities performed
by other group members, a CCA can provide a mechanism for replacing a web of separate
intra-group arms length payments with a more streamlined system of netted payments,
based on aggregated benefits and aggregated contributions associated with all the covered
activities (see also paragraphs3.9 to 3.17 of these Guidelines). A CCA for the sharing
in the development of intangibles can eliminate the need for complex cross-licensing
arrangements and associated allocation of risk, and replace them with a more streamlined
sharing of contributions and risks, with ownership interests of the resulting intangible(s)
shared in accordance with the terms of the CCA. However, the streamlining of flows that
may result from the adoption of a CCA does not affect the appropriate valuation of the
separate contributions of the parties.
8.8 As an illustration of a CCA, take the example of an MNE group which manufactures
products through three enterprises which each operate a production site and have their own
R&D teams engaged in various projects to improve production processes. Those three
enterprises enter into a CCA aimed at generating production process improvements, and
as a result pool their expertise and share the risks. Since the CCA grants each participant
rights to the outcomes of the projects, the CCA replaces the cross-licensing arrangements
that may have resulted in the absence of a CCA and if the enterprises had individually
developed certain intangibles and granted rights to one another.
B.2. Relationship to other chapters

8.9 As indicated in paragraph8.4, there is no difference in the analytical framework
for analysing transfer prices for CCAs compared to analysing other forms of contractual
relations. The guidance in SectionD of ChapterI is relevant to the analysis of all
transactions between associated enterprises, and applies to identify the economically
relevant characteristics of the commercial or financial relations between the parties
as expressed in a CCA. The contractual terms of the CCA provide the starting point
for delineating the transaction between the parties and how the responsibilities, risks,
and anticipated outcomes were intended to be allocated at the time of entering into the
arrangements. However, as set out in that guidance, the evidence of the conduct of the
parties may clarify or supplement aspects of the agreement. The framework for analysing
risk in SectionD.1.2.1 of ChapterI is relevant to determining whether parties assume
risks under the CCA, as discussed in SectionC.2 of this chapter, and the consequences
for providing funding without assuming risk or performing other functions. ChapterVI
provides guidance regarding the determination of arms length conditions for transactions
that involve the use or transfer of intangibles. Paragraphs6.60 to 6.64 give relevant guidance
on exercising control over the financial risk if the funding is used for investment in R&D
projects. The guidance in Sections D.3 and D.4 of ChapterVI on hard-to-value intangibles
is equally applicable to CCAs. ChapterVII provides guidance on issues that arise in
determining for transfer pricing purposes whether services have been provided by a member
of an MNE group to other members of that group and, if so, in establishing arms length
prices for those intra-group services. This chapters objective is to provide supplementary
guidance on situations where resources and skills are pooled and the consideration received
is, in part or whole, the reasonable expectation of mutual benefits. Thus, the provisions of
ChaptersVI and VII, and indeed all the other chapters of these Guidelines, will continue
to apply to the extent relevant, for instance in measuring the value of a contribution to a
CCA as part of the process of determining the proportionate shares of contributions. MNEs
are encouraged to observe the guidance of this chapter in order to ensure that their CCAs
operate in accordance with the arms length principle.
B.3. Types of CCAs

8.10 Two types of CCAs are commonly encountered: those established for the joint
development, production or the obtaining of intangibles or tangible assets (development
CCAs); and those for obtaining services (services CCAs). Although each particular
CCA should be considered on its own facts and circumstances, key differences between
these two types of CCAs will generally be that development CCAs are expected to create
ongoing, future benefits for participants, while services CCAs will create current benefits
only. Development CCAs, in particular with respect to intangibles, often involve significant
risks associated with what may be uncertain and distant benefits, while services CCAs
often offer more certain and less risky benefits. These distinctions are useful because the
greater complexity of development CCAs may require more refined guidance, particularly
on the valuation of contributions, than may be required for services CCAs, as discussed
below. However, the analysis of a CCA should not be based on superficial distinctions: in
some cases, a CCA for obtaining current services may also create or enhance an intangible
which provides ongoing and uncertain benefits, and some intangibles developed under a
CCA may provide short-term and relatively certain benefits.
8.11 Under a development CCA, each participant has an entitlement to rights in the
developed intangible(s) or tangible asset(s). In relation to intangibles, such rights often take

the form of separate rights to exploit the intangible in a specific geographic location or for a
particular application. The separate rights obtained may constitute actual legal ownership;
alternatively, it may be that only one of the participants is the legal owner of the property
but the other participants have certain rights to use or exploit the property. In cases where
a participant has such rights in any property developed by the CCA, there is no need for
a royalty payment or other further consideration for the use of the developed property
consistent with the interest to which the participant is entitled under the CCA (however, the
contributions of a participant may need to be adjusted if they are not proportionate to their
expected benefits; see SectionC.5).
C.
Applying the arms length principle

C.1. In general
8.12 For the conditions of a CCA to satisfy the arms length principle, the value of
participants contributions must be consistent with what independent enterprises would
have agreed to contribute under comparable circumstances given their proportionate share
of the total anticipated benefits they reasonably expect to derive from the arrangement.
What distinguishes contributions to a CCA from any other intra-group transfer of property
or services is that part or all of the compensation intended by the participants is the
expected mutual and proportionate benefit from the pooling of resources and skills. In
addition, particularly for development CCAs, the participants agree to share the upside and
downside consequences of risks associated with achieving the anticipated CCA outcomes.
As a result, there is a distinction between, say, the intra-group licensing of an intangible
where the licensor has borne the development risk on its own and expects compensation
through the licensing fees it will receive once the intangible has been fully developed, and
a development CCA in which all parties make contributions and share in the consequences
of risks materialising in relation to the development of the intangible and decide that each
of them, through those contributions, acquires a right in the intangible.
8.13 The expectation of mutual and proportionate benefit is fundamental to the
acceptance by independent enterprises of an arrangement for sharing the consequences
of risks materialising and pooling resources and skills. Independent enterprises would
require that the value of each participants proportionate share of the actual overall
contributions to the arrangement is consistent with the participants proportionate share
of the overall expected benefits to be received under the arrangement. To apply the arms
length principle to a CCA, it is therefore a necessary precondition that all the parties to
the arrangement have a reasonable expectation of benefit. The next step is to calculate
the value of each participants contribution to the joint activity, and finally to determine
whether the allocation of CCA contributions (as adjusted for any balancing payments made
among participants) accords with their respective share of expected benefits. It should be
recognised that these determinations are likely to bear a degree of uncertainty, particularly
in relation to development CCAs. The potential exists for contributions to be allocated
among CCA participants so as to result in an overstatement of taxable profits in some
countries and the understatement of taxable profits in others, measured against the arms
length principle. For that reason, taxpayers should be prepared to substantiate the basis of
their claim with respect to the CCA (see SectionE).
C.2. Determining participants

8.14 Because the concept of mutual benefit is fundamental to a CCA, it follows that
a party may not be considered a participant if the party does not have a reasonable
expectation that it will benefit from the objectives of the CCA activity itself (and not
just from performing part or all of the subject activity), for example, from exploiting
its interest or rights in the intangibles or tangible assets, or from the use of the services
produced through the CCA. A participant therefore must be assigned an interest or rights
in the intangibles, tangible assets or services that are the subject of the CCA, and have
a reasonable expectation of being able to benefit from that interest or those rights. An
enterprise that solely performs the subject activity, for example performing research
functions, but does not receive an interest in the output of the CCA, would not be
considered a participant in the CCA but rather a service provider to the CCA. As such, it
should be compensated for the services it provides on an arms length basis external to the
CCA. See paragraph8.18. Similarly, a party would not be a participant in a CCA if it is not
capable of exploiting the output of the CCA in its own business in any manner.
8.15 A party would also not be a participant in a CCA if it does not exercise control over
the specific risks it assumes under the CCA and does not have the financial capacity to
assume these risks, as this party would not be entitled to a share in the output that is the
objective of the CCA based on the functions it actually performs. The general principles
set out in ChapterI of these guidelines on the assumption of risks apply to situations
involving CCAs. Each participant makes particular contributions to the CCA objectives,
and contractually assumes certain risks. Guidance under SectionD.1 of ChapterI on
delineating the actual transaction will apply to the transfer pricing analysis in relation to
these risks. This also means that a party assuming risks under a CCA based on an analysis
under step4(i) of the framework for analysing risks in paragraph1.60 (assumes the
risk under the CCA) must control the specific risks it assumes under the CCA and must
have the financial capacity to assume these risks. In particular, this implies that a CCA
participant must have (i)the capability to make decisions to take on, lay off, or decline the
risk-bearing opportunity presented by participating in the CCA, and must actually perform
that decision-making function and (ii)the capability to make decisions on whether and how
to respond to the risks associated with the opportunity, and must actually perform that
decision-making function. While it is not necessary for the party to perform day-to-day
risk mitigation activities in relation to activities of the CCA, in such cases, it must have the
capability to determine the objectives of those risk mitigation activities to be performed by
another party, to decide to entrust that other party to provide the risk mitigation functions,
to assess whether the objectives are being adequately met, and, where necessary, to decide
to adapt or terminate the arrangement, and must actually perform such assessment and
decision-making. In accordance with the principles of prudent business management, the
extent of the risks involved in the arrangement will determine the extent of capability
and control required. The guidance in paragraphs6.60 to 6.64 is relevant for assessing
whether a party providing funding has the functional capability to exercise control over
the financial risk attached to its contributions to the CCA and whether it actually performs
these functions. See Examples4 and 5 in the annex to this chapter for an illustration of this
principle.
8.16 To the extent that specific contributions made by participants to a CCA are different
in nature, e.g.the participants perform very different types of R&D activities or one of
the parties contributes property and another contributes R&D activities, the guidance
in paragraph6.64 is equally applicable. This means that the higher the development risk
attached to the development activities performed by the other party and the closer the risk

assumed by the first party is related to this development risk, the more the first party will
need to have the capability to assess the progress of the development of the intangible and
the consequences of this progress for achieving its expected benefits, and the more closely
this party may need to link its actual decision-making required in relation to its continued
contributions to the CCA to key operational developments that may impact the specific
risks it assumes under the CCA. A development CCA in which benefits are uncertain and
distant is likely to give rise to greater risks than does a services CCA in which benefits are
current.
8.17 As described in the previous paragraphs, it is not necessary for the CCA
participants to perform all of the CCA activities through their own personnel. In some
cases, the participants in a CCA may decide to outsource certain functions related to
the subject activity to a separate entity that is not a participant under the standard of
paragraph8.14 above. In such situations, the participants to the CCA should individually
meet the requirements on exercising control over the specific risks they assume under the
CCA. Such requirements include exercising control over the outsourced functions by at
least one of the participants to the CCA. In circumstances in which the objective of the
CCA is to develop an intangible, at least one of the participants to the CCA should also
exercise control over the important development, enhancement, maintenance, protection
and exploitation functions that are outsourced. When the contribution of a participant to
the CCA consists of activities other than controlling the outsourced functions, the guidance
in paragraph8.15 is relevant for assessing whether this party has the functional capability
to exercise control over the specific risks it assumes under the CCA, in particular if these
risks are closely linked to the outsourced functions.
8.18 In cases where CCA activities are outsourced, an arms length charge would be
appropriate to compensate the entity for services or other contributions being rendered
to the CCA participants. Where the entity is an associated enterprise of one or more of
the CCA participants, the arms length charge would be determined under the general
principles of ChaptersIIII, including inter alia consideration of functions performed,
assets used, and risks assumed, as well as the special considerations affecting an arms
length charge for services and/or in relation to any intangibles, as described in ChapterVII
and ChapterVI (including the guidance on hard-to-value intangibles).
C.3. Expected benefits from the CCA

8.19 The relative shares of expected benefits might be estimated based on the anticipated
additional income generated or costs saved or other benefits received by each participant as
a result of the arrangement. An approach that is frequently used in practice, most typically
for services CCAs, would be to reflect the participants proportionate shares of expected
benefits using a relevant allocation key. The possibilities for allocation keys include sales
(turnover), profits, units used, produced, or sold; number of employees, and so forth.
8.20 To the extent that a material part or all of the benefits of a CCA activity are
expected to be realised in the future and not solely in the year the costs are incurred,
most typically for development CCAs, the allocation of contributions will take account
of projections about the participants shares of those benefits. The use of projections
may raise problems for tax administrations in verifying the assumptions based on which
projections have been made and in dealing with cases where the projections vary markedly
from the actual results. These problems may be exacerbated where the CCA activity ends
several years before the expected benefits actually materialise. It may be appropriate,
particularly where benefits are expected to be realised in the future, for a CCA to provide
for possible adjustments of proportionate shares of contributions over the term of the CCA
on a prospective basis to reflect changes in relevant circumstances resulting in changes in
relative shares of benefits. In situations where the actual shares of benefits differ markedly
from projections, tax administrations might be prompted to enquire whether the projections
made would have been considered acceptable by independent enterprises in comparable
circumstances, taking into account all the developments that were reasonably foreseeable
by the participants, without using hindsight. When the expected benefits of a CCA consist
of a right in an intangible that is hard to value at the start of the development project or
if pre-existing intangibles that are hard to value are part of the contributions to the CCA
project, the guidance in Sections D.3 and D.4 of ChapterVI on hard-to-value intangibles is
applicable to value the contributions of each of the participants to the CCA.
8.21 If an arrangement covers multiple activities, it will be important to take this into
account in choosing an allocation method, so that the value of contributions made by
each participant is properly related to the relative benefits expected by the participants.
One approach (though not the only one) is to use more than one allocation key. For
example, if there are five participants in a CCA, one of which cannot benefit from certain
services activities undertaken within the CCA, then in the absence of some form of setoff or reduction in contribution, the contributions associated with those activities might
be allocated only to the other four participants. In this case, two allocation keys might
be used to allocate the contributions. Whether any particular allocation key or keys are
appropriate depends on the exact nature of the CCA activity and the relationship between
the allocation key(s) and the expected benefits. The guidance in ChapterVII on the use
of indirect methods of determining an arms length charge for services (paragraphs7.237.26) may be helpful in this regard. In contrast, the three enterprises operating production
sites in the illustration of a CCA in paragraph8.8 are all anticipated to benefit from the
multiple projects to improve production processes, and may adopt an allocation key based
on, for example, relative size of production capacity. If one of the enterprises chooses not
to implement the outcome of a particular project, this should not affect the relative share of
benefits or the allocation key used. However, in such circumstances careful consideration
should be given to the reason the enterprise chose not to implement the outcome, whether
it ever had any reasonable intention of so doing, whether the expected benefits should have
been adapted as the CCA arrangement developed and when its intention changed.
8.22 Whatever the method used to evaluate participants relative shares of expected
benefits, adjustments to the measure used may be necessary to account for differences
between the respective shares of expected and actual benefits received by the participants.
The CCA should require periodic reassessment of contributions vis--vis the revised share
of benefits to determine whether the future contributions of participants should be adjusted
accordingly. Thus, the allocation key(s) most relevant to any particular CCA may change
over time leading to prospective adjustments. Such adjustments may reflect either the fact
that the parties will have more reliable information about foreseeable (but uncertain) events
as time passes, or the occurrence of unforeseeable events.
C.4. The value of each participants contribution

8.23 For the purpose of determining whether a CCA satisfies the arms length principle
i.e.whether each participants proportionate share of the overall contributions to the CCA
is consistent with the participants proportionate share of the overall expected benefits it
is necessary to measure the value of each participants contributions to the arrangement.

8.24 Contributions to a CCA may take many forms. For services CCAs, contributions
primarily consist of the performance of the services. For development CCAs, contributions
typically include the performance of development activities (e.g.R&D, marketing), and
often include additional contributions relevant to the development CCA such as pre-existing
tangible assets or intangibles. Irrespective of the type of CCA, all contributions of current or
pre-existing value must be identified and accounted for appropriately in accordance with the
arms length principle. Since the value of each participants relative share of contributions
should accord with its share of expected benefits, balancing payments may be required
to ensure this consistency. The term contributions as used in this Chapter includes
contributions of both pre-existing and current value made by participants to a CCA.
8.25 Under the arms length principle, the value of each participants contribution should
be consistent with the value that independent enterprises in comparable circumstances
would have assigned to that contribution. That is, contributions must generally be assessed
based on their value at the time they are contributed, bearing in mind the mutual sharing of
risks, as well as the nature and extent of the associated expected benefits to participants in
the CCA, in order to be consistent with the arms length principle. In determining the value
of contributions to a CCA the guidance elsewhere in these Guidelines should be followed.
8.26 In valuing contributions, distinctions should be drawn between contributions of
pre-existing value and current contributions. For example, in a CCA for the development
of an intangible, the contribution of patented technology by one of the participants
reflects a contribution of pre-existing value which is useful towards the development
of the intangible that is the objective of the CCA. The value of that technology should
be determined under the arms length principle using the guidance in ChapterIIII and
ChapterVI, including, where appropriate, the use of valuation techniques as set out in
that Chapter. The current R&D activity under the development CCA performed by one
or more associated enterprises would constitute a current contribution. The value of
current functional contributions is not based on the potential value of the resulting further
application of the technology, but on the value of the functions performed. The potential
value of the resulting further application of the technology is taken into account through
the value of pre-existing contributions and through the sharing of the development risk
in proportion to the expected share of benefits by the CCA participants. The value of the
current contributions should be determined under the guidance in ChaptersIIII, VI and
VII. As noted in paragraph6.79, compensation based on a reimbursement of cost plus a
modest mark-up will not reflect that anticipated value of, or the arms length price for, the
contribution of the research team in all cases.
8.27 While all contributions should be measured at value (but see paragraph8.28 below),
it may be more administrable for taxpayers to pay current contributions at cost. This may
be particularly relevant for development CCAs. If this approach is adopted, the pre-existing
contributions should recover the opportunity cost of the ex ante commitment to contribute
resources to the CCA. For example, a contractual arrangement (i.e.the CCA) that commits
an existing R&D workforce to undertake work for the benefit of the CCA should reflect the
opportunity cost of alternative R&D endeavours (e.g.the present value of the arms length
mark-up over R&D costs) in the pre-existing contributions, while contributing current
activities at cost (see Example1A in the annex to this chapter).
8.28 Whereas it cannot be assumed that the value of pre-existing contributions corresponds
to costs, it is sometimes the case that cost could be used as a practical means to measure
relative value of current contributions. Where the difference between the value and costs
is relatively insignificant, for practical reasons, current contributions of a similar nature
may be measured at cost in such cases for services CCAs. However, in other circumstances
(for example where contributions provided by the participants vary in nature and include a
mixture of service types and/or intangibles or other assets) measuring current contributions
at cost is unlikely to provide a reliable basis for determining the value of the relative
contributions of participants, and may lead to non-arms length results. For development
CCAs, the measurement of current contributions at cost (apart from the administrative
guidance in paragraph8.27) will generally not provide a reliable basis for the application
of the arms length principle. See Examples1-3 in the annex to this chapter for illustration
of this guidance. Where uncontrolled arrangements are claimed to be comparable to the
arrangements between the associated enterprises in the CCA, and those uncontrolled
arrangements provide for contributions to be made at cost, it is important to consider the
comparability of all of the economically relevant characteristics of the transactions in the
broader context of the arrangement, including the impact of any broader arrangement of
economically related transactions which may exist between the parties to the uncontrolled
transaction, and the sharing of risks. Particular attention should be paid to whether other
payments are made in the uncontrolled arrangements; for example, stage payments or
compensating contributions may be made in addition to the reimbursement of costs.
8.29 Since contributions are based on expected benefits, this generally implies that
where a cost reimbursement basis for valuing current contributions is permitted, the
analysis should initially be based on budgeted costs. This does not necessarily mean
fixing the costs, since the budget framework may accommodate variability arising from
factors such as varying demand levels (for instance budgeted costs may be expressed as a
fixed percentage of actual sales). Additionally, there are likely to be differences between
budgeted costs and actual costs during the term of the CCA. In an arms length situation,
the terms agreed between the parties are likely to set out how such differences should be
treated since, as stated in paragraph2.96, independent parties are not likely to use budgeted
costs without agreeing what factors are taken into account in setting the budget and how
unforeseen circumstances are to be treated. Attention should be paid to the reason for any
significant differences between budgeted costs and actual costs, since the difference may
point to changes in the scope of activities which may not benefit all the participants in
the same way as the activities originally scoped. In general terms, however, where cost
is found to be an appropriate basis for measuring current contributions, it is likely to be
sufficient to use actual costs as the basis for so doing.
8.30 It is important that the evaluation process recognises all contributions made by
participants to the arrangement. This includes contributions made by one or more parties
at the inception of the CCA (such as contributions of pre-existing intangibles) as well as
contributions made on an ongoing basis during the term of the CCA. Contributions to be
considered include property or services that are used solely in the CCA activity, but also
property or services (i.e.shared property or services) that are used partly in the CCA
activity and also partly in the participants separate business activities. It can be difficult
to measure contributions that involve shared property or services, for example where a
participant contributes the partial use of assets such as office buildings and IT systems or
performs supervisory, clerical, and administrative functions for the CCA and for its own
business. It will be necessary to determine the proportion of the assets used or services
that relate to the CCA activity in a commercially justifiable way with regard to recognised
accounting principles and the actual facts, and adjustments, if material, may be necessary
to achieve consistency when different jurisdictions are involved. Once the proportion is
determined, the contribution can be measured in accordance with the principles in the rest
of this chapter.

8.31 For development CCAs, contributions in the form of controlling and managing
the CCA, its activities and risks, are likely to be important functions, as described in
paragraph6.56, in relation to the development, production, or obtaining of the intangibles or
tangible assets and should be valued in accordance with the principles set out in ChapterVI.
8.32 The following scenario illustrates the guidance on determining participants, the
share of benefits, and the value of contributions.
8.33 CompanyA based in countryA and CompanyB based in countryB are members
of an MNE group and have concluded a CCA to develop intangibles. CompanyB has
entitlement under the CCA to exploit the intangibles in countryB, and CompanyA has
entitlement under the CCA to exploit the intangibles in the rest of the world. The parties
anticipate that CompanyA will have 75% of total sales and CompanyB 25% of total
sales, and that their share of expected benefits from the CCA is 75:25. Both A and B
have experience of developing intangibles and have their own research and development
personnel. They each control their development risk under the CCA within the terms set out
in paragraphs8.14 to 8.16. CompanyA contributes pre-existing intangibles to the CCA that
it has recently acquired from a third-party. CompanyB contributes proprietary analytical
techniques that it has developed to improve efficiency and speed to market. Both of these
pre-existing contributions should be valued under the guidance provided in ChaptersIIII
and VI. Current contributions in the form of day-to-day research will be performed 80%
by CompanyB and 20% by CompanyA under the guidance of a leadership team made up
of personnel from both companies in the ratio 90:10 in favour of CompanyA. These two
kinds of current contributions should separately be analysed and valued under the guidance
provided in ChaptersIIII and VI. When the expected benefits of a CCA consist of a right
in an intangible that is hard to value at the start of the development project or if pre-existing
intangibles that are hard to value are part of the contributions to the CCA project, the
guidance in Sections D.3 and D.4 of ChapterVI on hard-to-value intangibles is applicable
to value the contributions of each of the participants to the CCA.
C.5. Balancing payments

8.34 A CCA will be considered consistent with the arms length principle where
the value of each participants proportionate share of the overall contributions to the
arrangement (taking into account any balancing payments already made) is consistent
with the participants share of the overall expected benefits to be received under the
arrangement. Where the value of a participants share of overall contributions under
a CCA at the time the contributions are made is not consistent with that participants
share of expected benefits under the CCA, the contributions made by at least one of the
participants will be inadequate, and the contributions made by at least one other participant
will be excessive. In such a case, the arms length principle would generally require that an
adjustment be made. This will generally take the form of an adjustment to the contribution
through making or imputing a (further) balancing payment. Such balancing payments
increase the value of the contributions of the payor and decrease that of the payee.
8.35 Balancing payments may be made by participants to top up the value of the
contributions when their proportionate contributions are lower than their proportionate
expected benefits. Such adjustments may be anticipated by the participants upon entering
into the CCA, or may be the result of periodic re-evaluation of their share of the expected
benefits and/or the value of their contributions (see paragraph8.22).
8.36 Balancing payments may also be required by tax administrations where the value of
a participants proportionate contributions of property or services at the time the contribution
was made has been incorrectly determined, or where the participants proportionate
expected benefits have been incorrectly assessed, e.g.where the allocation key when fixed or
adjusted for changed circumstances was not adequately reflective of proportionate expected
benefits. Normally the adjustment would be made by a balancing payment from one or more
participants to another being made or imputed for the period in question.
8.37 In the case of development CCAs, variations between a participants proportionate
share of the overall contributions and that participants proportionate share of the overall
expected benefits may occur in a particular year. If that CCA is otherwise acceptable and
carried out faithfully, having regard to the recommendations of SectionE, tax administrations
should generally refrain from making an adjustment based on the results of a single fiscal
year. Consideration should be given to whether each participants proportionate share of the
overall contributions is consistent with the participants proportionate share of the overall
expected benefits from the arrangement over a period of years (see paragraphs3.75-3.79).
Separate balancing payments might be made for pre-existing contributions and for current
contributions, respectively. Alternatively, it might be more reliable or administrable to make
an overall balancing payment relating to pre-existing contributions and current contributions
collectively. See Example4 in the annex to this chapter.
8.38 In the example in paragraph8.33, the participants, CompaniesA and B, expect to
benefit from the CCA in the ratio 75:25. In the first year the value of their pre-existing
contributions is 10million for CompanyA and 6million for CompanyB. As a result, a
net balancing payment is required to be made to CompanyB by CompanyA of 2million
(i.e.4.5million from CompanyA to CompanyB less 2.5million from CompanyB to
CompanyA) in order to increase CompanyAs contribution to 12million (75% of the total
contributions) and reducing CompanyBs contribution to 4million (25% of the total).
C.6. Accurately delineating the actual transaction

8.39 As indicated in paragraph8.9, the economically relevant characteristics of the
arrangement identified under the guidance in SectionD of ChapterI may indicate that the
actual transaction differs from the terms of the CCA purportedly agreed by the participants.
For example, one or more of the claimed participants may not have any reasonable expectation
of benefit from the CCA activity. Although in principle the smallness of a participants share
of expected benefits is no bar to eligibility, if a participant that is performing all of the subject
activity is expected to have only a small fraction of the overall expected benefits, it may be
questioned whether the reality of the arrangements for that party is to pool resources and
share risks or whether the appearance of sharing in mutual benefits has been constructed to
obtain more favourable tax results. The existence of significant balancing payments arising
from a material difference between the parties proportionate shares of contributions and
benefits may also give rise to questions about whether mutual benefits exist or whether
the arrangements should be accurately delineated, taking into account all the economically
relevant characteristics, as a funding transaction.
8.40 As indicated in paragraph8.33, the guidance in ChapterVI on hard-to-value
intangibles may equally apply in situations involving CCAs. This will be the case if the
objective of the CCA is to develop a new intangible that is hard to value at the start of the
development project, but also in valuing contributions involving pre-existing intangibles.
Where the arrangements viewed in their totality lack commercial rationality in accordance
with the criteria in SectionD.2 of ChapterI, the CCA may be disregarded.
C.7. The tax treatment of contributions and balancing payments

8.41 Contributions, including any balancing payments, by a participant to a CCA
should be treated for tax purposes in the same manner as would apply under the general
rules of the tax system(s) applicable to that participant if the contributions were made
outside a CCA, to carry on the activity that is the subject of the CCA. The character of the
contribution will depend on the nature of the activity being undertaken by the CCA, and
will determine how it is recognised for tax purposes.
8.42 In services CCAs, a participants contribution to the CCA will often give rise to benefits
in the form of cost savings (in which case there may not be any income generated directly by the
CCA activity). In development CCAs, the expected benefits to participants may not accrue until
some time after contributions are made, and therefore there will be no immediate recognition
of income to the participants on their contributions at the time they are made.
8.43 Any balancing payment should be treated as an addition to the contribution of
the payor and as a reduction in the contribution of the recipient. As with contributions
generally, the character and tax treatment of any balancing payments will be determined
in accordance with domestic laws, including applicable tax treaties.
D.
CCA entry, withdrawal or termination

8.44 Changes in the membership of a CCA will generally trigger a reassessment of the
proportionate shares of participants contributions and expected benefits. An entity that
becomes a participant in an already active CCA might obtain an interest in any results of
prior CCA activity, such as completed or work-in-progress intangibles or tangible assets. In
such cases, the previous participants effectively transfer part of their respective interests in
the results of the prior CCA activity to the new entrant. Under the arms length principle,
any such transfer of intangibles or tangible assets must be compensated based on an arms
length value for the transferred interest. Such compensation is referred to in this chapter as
a buy-in payment.
8.45 The amount of a buy-in payment should be determined based upon the value (i.e.the
arms length price) of the interest in the intangibles and/or tangible assets the new entrant
obtains, taking into account the new entrants proportionate share of the overall expected
benefits to be received under the CCA. There may also be cases where a new participant
brings existing intangibles or tangible assets to the CCA, and that balancing payments
may be appropriate from the other participants in recognition of this contribution. Any
balancing payments to the new entrant could be netted against any buy-in payments
required, although appropriate records must be kept of the full amounts of the separate
payments for tax administration purposes.
8.46 Similar issues could arise when a participant leaves a CCA. In particular, a
participant that leaves a CCA may dispose of its interest in the results, if any, of past CCA
activity (including work in progress) to the other participants. Any such transfer should be
compensated according to the arms length principle. Such compensation is referred to in
this chapter as a buy-out payment.
8.47 The guidance in ChaptersIIII and VI is fully applicable to determining the
arms length amount of any buy-in, buy-out or balancing payments required. There may
be instances where no such payments are required under the arms length principle. For
example, a CCA for the sharing of administrative services would generally only produce
benefits to participants on a current basis, rather than any valuable on-going results.
8.48 Buy-in and buy-out payments should be treated for tax purposes in the same manner
as would apply under the general rules of the tax system(s) (including conventions for the
avoidance of double taxation) applicable to the respective participants as if the payment
were made outside a CCA as consideration for the acquisition or disposal of the interest in
the results of the prior CCA activity.
8.49 When a CCA terminates, the arms length principle requires that each participant
retains an interest in the results, if any, of the CCA activity consistent with their
proportionate share of contributions to the CCA throughout its term (adjusted by any
balancing payments actually made, including those made as a result of the termination), or
is appropriately compensated for any transfer of that interest to other participants.
E.
Recommendations for structuring and documenting CCAs

8.50 Generally, a CCA between controlled parties should meet the following conditions:
a) The participants would include only enterprises expected to derive mutual and
proportionate benefits from the CCA activity itself (and not just from performing
part or all of that activity). See paragraph8.14.
b) The arrangement would specify the nature and extent of each participants interest
in the results of the CCA activity, as well its expected respective share of benefits.
c) No payment other than the CCA contributions, appropriate balancing payments and
buy-in payments would be made for the particular interest or rights in intangibles,
tangible assets or services obtained through the CCA.
d) The value of participants contributions would be determined in accordance with
these Guidelines and, where necessary, balancing payments should be made to
ensure the proportionate shares of contributions align with the proportionate shares
of expected benefits from the arrangement.
e) The arrangement may specify provision for balancing payments and/ or changes
in the allocation of contributions prospectively after a reasonable period of time to
reflect material changes in proportionate shares of expected benefits among the
participants.
f) Adjustments would be made as necessary (including the possibility of buy-in and
buy-out payments) upon the entrance or withdrawal of a participant and upon
termination of the CCA.
8.51 The transfer pricing documentation standard set out in ChapterV requires reporting
under the master file of important service arrangements and important agreements related
to intangibles, including CCAs. The local file requires transactional information including
a description of the transactions, the amounts of payments and receipts, identification
of the associated enterprises involved, copies of material intercompany agreements, and
pricing information including a description of reasons for concluding that the transactions
were priced on an arms length basis. It would be expected that in order to comply with
these documentation requirements, the participants in a CCA will prepare or obtain
materials about the nature of the subject activity, the terms of the arrangement, and
its consistency with the arms length principle. Implicit in this is that each participant
should have full access to the details of the activities to be conducted under the CCA, the
identity and location of the other parties involved in the CCA, the projections on which the
contributions are to be made and expected benefits determined, and budgeted and actual

expenditures for the CCA activity, at a level of detail commensurate with the complexity
and importance of the CCA to the taxpayer. All this information could be relevant and
useful to tax administrations in the context of a CCA and, if not included in the master
file or local file, taxpayers should be prepared to provide it upon request. The information
relevant to any particular CCA will depend on the facts and circumstances. It should be
emphasised that the information described in this list is neither a minimum compliance
standard nor an exhaustive list of the information that a tax administration may be entitled
to request.
8.52 The following information would be relevant and useful concerning the initial terms
of the CCA:
a) a list of participants
b) a list of any other associated enterprises that will be involved with the CCA activity
or that are expected to exploit or use the results of the subject activity
c) the scope of the activities and specific projects covered by the CCA, and how the
CCA activities are managed and controlled
d) the duration of the arrangement
e) the manner in which participants proportionate shares of expected benefits are
measured, and any projections used in this determination
f) the manner in which any future benefits (such as intangibles) are expected to be
exploited
g) the form and value of each participants initial contributions, and a detailed
description of how the value of initial and ongoing contributions is determined
(including any budgeted vs actual adjustments) and how accounting principles are
applied consistently to all participants in determining expenditures and the value
of contributions
h) the anticipated allocation of responsibilities and tasks, and the mechanisms for
managing and controlling those responsibilities and tasks, in particular, those
relating to the development, enhancement, maintenance, protection or exploitation
of intangibles or tangible assets used in the CCA activity
i) the procedures for and consequences of a participant entering or withdrawing from
the CCA and the termination of the CCA
j) any provisions for balancing payments or for adjusting the terms of the arrangement
to reflect changes in economic circumstances.
8.53 Over the duration of the CCA term, the following information could be useful:
a) any change to the arrangement (e.g.in terms, participants, subject activity), and the
consequences of such change
b) a comparison between projections used to determine the share of expected benefits
from the CCA activity with the actual share of benefits (however, regard should be
had to paragraph3.74)
c) the annual expenditure incurred in conducting the CCA activity, the form and value
of each participants contributions made during the CCAs term, and a detailed
description of how the value of contributions is determined.
Annex to ChapterVIII Examples to illustrate the guidance on

cost contribution arrangements
Example1
1.
Example1 illustrates the general principle that contributions should be assessed at
value (i.e.based on arms length prices) in order to produce results that are consistent with
the arms length principle.
2.
CompanyA and CompanyB are members of an MNE group and decide to enter into
a CCA. CompanyA performs Service1 and CompanyB performs Service2. CompanyA
and CompanyB each consume both services (that is, CompanyA receives a benefit from
Service2 performed by CompanyB, and CompanyB receives a benefit from Service1
performed by CompanyA).
3.
Assume that the costs and value of the services are as follows:
Costs of providing Service1 (cost incurred by CompanyA)
100 per unit
Value of Service1 (i.e.the arms length price that CompanyA would charge CompanyB for the provision
of Service1)
120 per unit
Costs of providing Service2 (cost incurred by CompanyB)
100 per unit
Value of Service2 (i.e.the arms length price that CompanyB would charge CompanyA for the provision
of Service2)
105 per unit
4.
In Year1 and in subsequent years, CompanyA provides 30units of Service1 to
the group and CompanyB provides 20units of Service2 to the group. Under the CCA, the
calculation of costs and benefits are as follows:
Cost to CompanyA of providing services (30units * 100 per unit)
3000
(60% of total costs)
Cost to CompanyB of providing services (20units * 100 per unit)
2000
Total cost to group
5000
Value of contribution made by CompanyA (30units * 120 per unit)
3600
(63% of total contributions)
Value of contribution made by CompanyB (20units * 105 per unit)
2100
Total value of contributions made under the CCA
5700
CompanyA and CompanyB each consume 15units of Service1 and 10units of Service2:
Benefit to CompanyA:
Service1: 15units * 120 per unit
1800
1050
Total
2850
(50% of total value of 5700)
Benefit to CompanyB
1800
1050
Total
2850
5.
Under the CCA, the value of CompanyA and CompanyBs contributions should
each correspond to their respective proportionate shares of expected benefits, i.e.50%.

Since the total value of contributions under the CCA is 5700, this means each party must
contribute 2850. The value of CompanyAs in-kind contribution is 3600 and the value
of CompanyBs in-kind contribution is 2100. Accordingly, CompanyB should make a
balancing payment to CompanyA of 750. This has the effect of topping up CompanyBs
contribution to 2850; and offsets CompanyAs contribution to the same amount.
6.
If contributions were measured at cost instead of at value, since CompaniesA and
B each receive 50% of the total benefits, they would have been required contribute 50%
of the total costs, or 2500 each, i.e.CompanyB would have been required to make a 500
(instead of 750) balancing payment to A.
7.
In the absence of the CCA, CompanyA would purchase 10units of Service2 for the
arms length price of 1050 and CompanyB would purchase 15units of Service1 for the
arms length price of 1800. The net result would be a payment of 750 from CompanyB to
CompanyA. As can be shown from the above, this arms length result is only achieved in
respect of the CCA when contributions are measured at value.
Example1A
8.
The facts are the same as Example1. In accordance with the guidance in
paragraph8.27, an alternative way to achieve the identical result under Example1 is
through the use of a two-step process as set out below.
9.
Step1 (contributions measured at cost): CompanyA should bear 50% of the total
cost of 5000, or 2500. The cost of CompanyAs in-kind contribution is 3000. CompanyB
should bear 50% of the total cost, or 2500. The cost of CompanyBs in-kind contribution
is 2000. CompanyB should thus make an additional payment to CompanyA of 500. This
reflects a balancing payment associated with current contributions.
10. Step2 (accounting for additional contributions of value to the CCA): CompanyA
produces 20 of value above costs per unit. CompanyB produces 5 of value above costs per
unit. CompanyA consumes 10units of Service2 (50 of value over cost), and CompanyB
consumes 15units of Service1 (300 of value over cost). Accordingly, CompanyA should
be compensated 250 for the additional 250 of value that it contributes to the CCA. This
reflects a balancing payment associated with pre-existing contributions.
11.
The two-step method provides for a sharing of costs plus a separate and additional
payment to the participant that makes an additional contribution of value to the arrangement.
In general, the additional contribution of value might reflect pre-existing contributions, such
as intangibles owned by one of the participants, that are relevant to the purpose of the CCA.
Thus, the two-step method might be most usefully applied to development CCAs.
Example2
12. The facts are the same as Example1, except that the per-unit value of Service1 is
103 (that is, both Service1 and Service2 are low-value services). Assume, therefore, that
the calculation of the costs and value of the services is as follows:
3000
2000
(40% of total costs
Total cost to group
5000
3090
(59.5% of total contributions)
2100
(40.5% of total contributions)
5190
1545
1050
Total
2595
Benefit to CompanyB
1545
1050
Total
2595
13. Under the CCA, the value of CompanyA and CompanyBs contributions should
each correspond to their respective proportionate shares of expected benefits, i.e.50%.
Since the total value of contributions under the CCA is 5190, this means each party must
contribute 2595. The value of CompanyAs in-kind contribution is 3090. The value
of CompanyBs in-kind contribution is 2100. Accordingly, CompanyB should make a
balancing payment to CompanyA of 495. This has the effect of topping up CompanyBs
contribution to 2595; and offsets CompanyAs contribution to the same amount.
14. In this example, since all contributions to the CCA are low-value services, for
practical reasons, contributions may be valued at cost since this will achieve results which
are broadly consistent with the arms length principle. Under this practical approach,
the cost of CompanyAs in-kind contribution is 3000; the cost of CompanyBs in-kind
contribution is 2000; and each participant should bear the costs associated with 50% of
the total cost of contributions (2500). Accordingly, CompanyB should make a balancing
payment to CompanyA of 500.
Example3
15.
The facts are the same as Example1, except that the per-unit value of Service2 is 120
(that is, both Service1 and Service2 are equally valuable, and neither are low-value services).
3000
2000
Total cost to group
5000
3600
2400
6000
1800
1200
Total
3000
Benefit to CompanyB
1800
1200
Total
3000

16.
Under the CCA, the value of CompanyA and CompanyBs contributions should each
correspond to their respective proportionate shares of expected benefits i.e.50%. Since the
total value of contributions under the CCA is 6000, this means each party must contribute
3000. The value of CompanyAs in-kind contribution is 3600. The value of CompanyBs
in-kind contribution is 2400. Accordingly, CompanyB should make a balancing payment to
CompanyA of 600. This has the effect of topping up CompanyBs contribution to 3000;
and offsets CompanyAs contribution to the same amount. Example3 illustrates that, in
general, assessing contributions at cost will not result in an arms length outcome even in
those situations in which the arms length mark-up on the cost of contributions is identical.
Example4
17.
CompanyA and CompanyB are members of an MNE group and decide to undertake
the development of an intangible through a CCA. The intangible is anticipated to be highly
profitable based on CompanyBs existing intangibles, its track record and its experienced
research and development staff. CompanyA performs, through its own personnel, all the
functions expected of a participant in a development CCA obtaining an independent right
to exploit the resulting intangible, including functions required to exercise control over the
risks it contractually assumes in accordance with the principles outlined in paragraphs8.14
to 8.18. The particular intangible in this example is expected to take five years to develop
before possible commercial exploitation and if successful, is anticipated to have value for ten
years after initial exploitation.
18. Under the CCA, CompanyA will contribute to funding associated with the
development of the intangible (its share of the development costs are anticipated to be
USD100million per year for five years). CompanyB will contribute the development
rights associated with its existing intangibles, to which CompanyA is granted rights under
the CCA irrespective of the outcome of the CCAs objectives, and will perform all activities
related to the development, maintenance, and exploitation of the intangible. The value of
CompanyBs contributions (encompassing the performance of activities as well as the
use of the pre-existing intangibles) would need to be determined in accordance with the
guidance in ChapterVI and would likely be based on the anticipated value of the intangible
expected to be produced under the CCA, less the value of the funding contribution by
CompanyA.
19. Once developed, the intangible is anticipated to result in global profits of
USD550million per year (Years6 to 15). The CCA provides that CompanyB will have
exclusive rights to exploit the resulting intangible in countryB (anticipated to result in
profits of USD220million per year in Years6 to 15) and CompanyA will have exclusive
rights to exploit the intangible in the rest of the world (anticipated to result in profits of
USD330million per year).
20. Taking into account the realistic alternatives of CompanyA and CompanyB
it is determined that the value of CompanyAs contribution is equivalent to a riskadjusted return on its R&D funding commitment. Assume that this is determined to be
USD110million per year (for Years6 to 15).23 However, under the CCA CompanyA
is anticipated to reap benefits amounting to USD330million of profits per year in
Years6 to 15 (rather than USD110million). This additional anticipated value in the
rights CompanyA obtains (that is, the anticipated value above and beyond the value of
CompanyAs funding investment) reflects the contribution of CompanyBs pre-existing
contributions of intangibles and R&D commitment to the CCA. CompanyA needs to pay
for this additional value it receives. Accordingly, balancing payments from CompanyA
to CompanyB to account for the difference are required. In effect, CompanyA would
need to make a balancing payment associated with those contributions to CompanyB
equal in present value, taking into account the risk associated with this future income, to
USD220million per year anticipated in Years6 to 15.
Example5
21.
The facts are the same as in Example4 except that the functional analysis indicates
CompanyA has no capacity to make decisions to take on or decline the risk-bearing
opportunity represented by its participation in the CCA, or to make decisions on whether
and how to respond to the risks associated with the opportunity. It also has no capability to
mitigate the risks or to assess and make decisions relating to the risk mitigation activities
of another party conducted on its behalf.
22. In accurately delineating the transactions associated with the CCA, the functional
analysis therefore indicates that CompanyA does not control its specific risks under the
CCA in accordance with the guidance in paragraph8.15 and consequently is not entitled to
a share in the output that is the objective of the CCA.
BIBLIOGRAPHY 183
Bibliography
OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 2015 Final
Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris,
http://dx.doi.org/10.1787/9789264241046-en.
OECD (2014), Model Tax Convention on Income and on Capital: Condensed Version 2014,
OECD (2014), Reports to G20 Development Working Group on the Impact of BEPS in Low
Income Countries, OECD, Paris, www.oecd.org/tax/tax-global/report-to-g20-dwg-onthe-impact-of-beps-in-low-income-countries.pdf.
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2010), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations 2010, OECD Publishing, Paris, http://dx.doi.org/10.1787/tpg-2010-en.
OECD (2010), Report on the Attribution of Profits to Permanent Establishments, www.oecd.
org/ctp/transfer-pricing/45689524.pdf.
United Nations (2011), Model Double Taxation Convention between Developed and
Developing Countries, www.un.org/esa/ffd/documents/UN_Model_2011_Update.pdf.
Notes 185
Notes
1.
Brazil provides for an approach in its domestic legislation that makes use of fixed margins
derived from industry practices and considers this in line with the arms length principle. Brazil
will continue to apply this approach and will use the guidance in this report in this context.
When Brazils Tax Treaties contain Article9, paragraph1 of the OECD and UN Model Tax
Conventions and a case of double taxation arises that is captured by this Treaty provision,
Brazil will provide access to MAP in line with the minimum standard of Action14.
2.
The guidance in this chapter, and in this section on risk in particular, is not specific to any
particular industry sector. While the basic concept that a party bearing risks must have the ability
to effectively deal with those risks applies to insurance, banking, and other financial services
businesses, these regulated sectors are required to follow rules prescribing arrangements for
risks, and how risks are recognised, measured, and disclosed. The regulatory approach to risk
allocation for regulated entities should be taken into account and reference made as appropriate
to the transfer pricing guidance specific to financial services businesses in the Report on the
Attribution of Profits to Permanent Establishments (OECD, 2010).
3.
Further guidance will be provided on the economically relevant characteristics for determining
the arms length conditions for financial transactions. This work will be undertaken in 2016
and 2017.
4.
CompanyA could potentially be entitled to less than a risk-free return if, for example, the
transaction is disregarded under SectionD.2.
5.
In light of differences in local law, some countries consider a deliberate concerted action to
always constitute a transaction, while others do not. However, the consensus view is that, in either
scenario, a deliberate concerted action involves one associated enterprise performing functions,
using assets, or assuming risks for the benefit of one or more other associated enterprises, such
that arms length compensation is required. See, e.g.Example5 at paragraphs1.170-1.173.
6.
Example2 should not be viewed as providing comprehensive transfer pricing guidance on

guarantee fees in respect of financial transactions. Further guidance will be provided on
transfer pricing for financial transactions including identifying the economically relevant
characteristics for determining arms length conditions. This work will be undertaken in 2016
and 2017.
7.
OECD (2014), Reports to G20 Development Working Group on the Impact of BEPS in Low
Income Countries, OECD, Paris, www.oecd.org/tax/tax-global/report-to-g20-dwg-on-the-impactof-beps-in-low-income-countries.pdf.
8.
OECD (2015), Addressing the Tax Challenges of the Digital Economy, Chapter6, paragraph231.
9.
See note 7.
10.
See the section on Intangibles in this Report, paragraph6.57.
11.
Ibid, SectionD.2.6.2 of ChapterVI.
12.
See SectionD.8 of ChapterI under Guidance for Applying the Arms Length Principle in this
Report.
13.
The assumption of risks refers to the outcome of the determination of which associated
enterprise assumes a specific risk under the guidance provided in SectionD.1.2.1 of ChapterI,
186 Notes
taking into account control over risk and financial capacity to assume the risk. Contractual
assumption of risk refers to the allocation of risk in contracts between the parties.
14.
As used in this paragraph, a financial asset is any asset that is cash, an equity instrument,
a contractual right or obligation to receive cash or another financial asset or to exchange
financial assets or liabilities, or a derivative. Examples include bonds, bank deposits, stocks,
shares, forward contracts, futures contracts, and swaps.
15.
As used herein, exploitation of an intangible includes both the transfer of the intangible or
rights in the intangible and the use of the intangible in commercial operations.
16.
As used in this SectionB, the use of assets includes the contribution of funding and/or capital
to the development, enhancement, maintenance, protection or exploitation of intangibles. See
paragraph6.59.
17.
Further guidance will be provided on the economically relevant characteristics for determining
the arms length conditions for financial transactions, including when the funding is used for
project finance, in particular investments in the development of intangibles. This work will be
undertaken in 2016 and 2017.
18.
SectionD.2.6.2 of ChapterVI is likely to be revised to reflect the outcome of the work on the
application of transactional profit split methods, mandated by Action10 of the BEPS Action
Plan. This work will be undertaken in 2016 and 2017.
19.
In the case of a financial valuation based on projections, the analysis will often be based on
projections of cash flows. Accrual based measures of income, such as those determined for
accounting or tax purposes, may not properly reflect the timing of cash flows which can create
a difference in outcome between an income and a cash flow based approach. However, in light
of a number of considerations, the use of income projections rather than cash flow projections
may, in some cases, yield a more reliable result in a transfer pricing context as a practical
matter. Care must be taken, however, to assure that either income or cash flow measures are
applied in a consistent manner and in appropriate circumstances. References to cash flow
in this document should therefore be read broadly to include both cash flow and income
measures, appropriately applied.
20.
In some business sectors it is not unusual for an intangible to be transferred with a contingent
clause relating to a second, or further, use. In respect of the type of intangibles where this
occurs, the time period begins again with the new commercialisation.
21.
For purposes of this example, it is not necessary to derive these results. The example assumes
that making a funding investment of USD100million per year for five years in a project
with this level of risk should earn at arms length anticipated profits of USD110million per
year for the following ten years. This corresponds to an 11% return on funding.
22.
SectionD is the sole part of the guidance reflected in this chapter that should be considered
part of the transfer pricing outcomes following from Actions8-10 of the BEPS Action Plan as
endorsed by all BEPS Associate Countries.
23.
For purposes of this example, it is not necessary to derive these results. The example assumes
that making a funding investment of USD100million per year for five years in a project
with this level of risk should earn at arms length anticipated profits of USD110million per
year for the following ten years. The results used herein are included for the purposes of
demonstrating the principles illustrated in this example only and no guidance as to the level of
arms length returns to participants in CCAs should be inferred.

AND DEVELOPMENT

(23 2015 35 1 P) ISBN 978-92-64-24123-7 2015
Aligning Transfer Pricing Outcomes with Value

Creation
This report is an output of Actions 8-10.
Contents
Guidance for Applying the Arms Length Principle
Commodity Transactions
Scope of Work for Guidance on the Transactional Profit Split Method
Intangibles
Low Value-adding Intra-group Services
Cost Contribution Arrangements
Consult this publication on line at http://dx.doi.org/10.1787/9789264241244-en

isbn 978-92-64-24123-7
23 2015 35 1 P

Project
Measuring and Monitoring

BEPS
Measuring
and Monitoring BEPS,
Action 11 - 2015 Final
Report

OECD (2015), Measuring and Monitoring BEPS, Action 11 - 2015 Final Report, OECD/G20 Base Erosion and
Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241343-en
ISBN 978-92-64-24133-6 (print)

ISBN 978-92-64-24134-3 (PDF)

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use
of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli
References to "countries" should be read as including all jurisdictions.
OECD 2015
acknowledgement of OECD as source and copyright owner is given. All requests for public or commercial use and translation rights should
be submitted to rights@oecd.org. Requests for permission to photocopy portions of this material for public or commercial use shall be
addressed directly to the Copyright Clearance Center (CCC) at info@copyright.com or the Centre franais dexploitation du droit de copie (CFC)
at contact@cfcopies.com.
Foreword 3
Foreword
MEASURING AND MONITORING BEPS OECD 2015
4 Foreword
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms .......................................................................................... 11
Chapter 1. Assessment of existing data sources relevant for BEPS analysis ........... 17
1.1 Introduction............................................................................................................ 18
1.2 Potential criteria for evaluating available data for BEPS research ........................ 18
1.3 Currently available data for BEPS analysis ........................................................... 24
1.4 Initial assessment of currently available data for analysing BEPS ........................ 26
Chapter 2. Indicators of base erosion and profit shifting ............................................ 41
2.1 Introduction............................................................................................................ 42
2.2 Indicator concept.................................................................................................... 42
2.3 Indicators as a component of Action 11................................................................. 43
2.4 Guidelines for indicators ........................................................................................ 44
2.5 A significant caution .............................................................................................. 45
2.6 Six indicators of BEPS .......................................................................................... 46
2.7 General structure of the indicators ......................................................................... 47
2.8 Disconnect between financial and real economic activities................................... 48
2.9 Profit rate differentials within top global MNEs ................................................... 52
2.10 MNE vs. comparable non-MNE effective tax rate differentials....................... 57
2.11 Profit shifting through intangibles ....................................................................... 60
2.12 Profit shifting through interest ............................................................................. 63
2.13 Possible future BEPS indicators with new data ................................................... 65
2.14 Indicators considered but not included ................................................................ 67
2.15 Summary .............................................................................................................. 68
Annex 2.A1. Formulas for calculating indicators ........................................................ 71
Chapter 3. Towards measuring the scale and economic impact of BEPS
and countermeasures....................................................................................................... 79
3.1 Overview ................................................................................................................ 81
3.2 Key issues in measuring and analysing BEPS ....................................................... 82
3.2.1 Defining BEPS ......................................................................................... 82
3.2.2 The counterfactual for BEPS analysis .................................................. 83
3.2.3 Separating BEPS from real economic activity ......................................... 84
3.2.4 Separating BEPS from non-BEPS preferences ........................................ 86
3.2.5 Measuring the appropriate tax rate for BEPS analysis ............................. 86
3.3 What we know about BEPS and the effect of countermeasures ............................ 88
3.3.1 General profit shifting analysis ................................................................ 88
3.3.2 Incentives for BEPS ................................................................................. 96
3.3.3 BEPS and developing countries ............................................................... 98
3.3.4 Estimating the scale (fiscal effects) of BEPS ........................................... 99
6 TABLE OF CONTENTS
3.3.5
3.3.6
3.3.7
Global estimate of the revenue loss from BEPS .................................... 101

Some other fiscal estimate studies.......................................................... 103
The extent of BEPS behaviours and possible dynamic effects if
not curtailed ............................................................................................ 106
3.3.8 Effects of BEPS countermeasures .......................................................... 106
3.3.9 Impact of existing unilateral BEPS-related countermeasures ................ 110
3.3.10 Economic impacts of BEPS and BEPS countermeasures ...................... 110
3.3.11 Important considerations in the economic analysis of BEPS
and BEPS countermeasures .................................................................... 110
3.3.12 Expected incidence of CIT changes in response to BEPS
countermeasures ..................................................................................... 112
3.3.13 Economic efficiency and growth ............................................................ 117
3.3.14 Increasing government competition on tax bases and attracting
economic activity ................................................................................... 122
3.4 Future areas for economic research to better measure the scale and
economic impact of BEPS with better data ......................................................... 122
Annex 3.A1. Economic implications of multinational tax planning ........................ 135
Annex 3.A2. A toolkit for estimating the country-specific fiscal effects of
BEPS countermeasures ....................................................................... 193
Chapter 4 . Towards better data and tools for monitoring BEPS in the future ....... 249
4.1 Introduction.......................................................................................................... 250
4.2 Background .......................................................................................................... 251
4.3 Classification of analytical tools to turn data into insights .................................. 256
4.4 A classification of the types of data ..................................................................... 258
4.5 Data collected in response to the Action Plan in the future ................................. 260
4.6 Recommendations ................................................................................................ 262
4.7 Conclusion ........................................................................................................... 265
Tables
Table 1.1.
Table 1.2.
Table 2.1.
Table 2.2.
Table 2.3.
Table 2.4.
Table 3.1.
Table 3.2.
Table 3.3.
Table 3.4.
Table 3.5.
Overview of the current data sources .................................................... 24

Regional distribution of MNE subsidiaries in ORBIS by
location of subsidiary and group headquarters, compared
with regional distribution of top 500 MNE groups and GDP,
2011 ....................................................................................................... 30
Indicator 1: Concentration of foreign direct investment
relative to GDP ...................................................................................... 51
Indicator 3: High profit rates of MNE affiliates in lower-tax
locations ................................................................................................ 57
Indicator 4: Effective tax rates of MNE affiliates compared
to non-MNE entities with similar characteristics .................................. 59
Estimated annual indicator values ......................................................... 62
Data sources, estimation strategies and results from recent
profit shifting studies ............................................................................. 94
Standard deviation of OECD tax rates, 2003 and 2013......................... 98
Estimates of global and developing country fiscal effects
from BEPS........................................................................................... 101
Ranking of key location factors of MNE operations ........................... 119
Summary R&D tax wedge with MNE tax planning............................ 120
TABLE OF CONTENTS 7
Table 3.A1.1.
Table 3.A1.2.
Table 3.A1.3.
Table 3.A2.1.
Table 3.A2.2.
Table 3.A2.3.
Table 3.A2.4.
Tax treatment of intellectual property in selected OECD and

G20 countries, 2014 ............................................................................ 152
Profit shifting and mismatches reduce the effective tax rate
of MNEs .............................................................................................. 157
Economic implications of international tax planning:
summary of main findings................................................................... 181
Government fiscal estimates of BEPS-related measures..................... 194
Elasticity estimates of the responsiveness of intra-firm
exports and imports to corporate income tax rate differentials ........... 207
NIE by the non-financial corporate sector .......................................... 219
Potential data sources for CFC income ............................................... 228
Figures
Figure 1.1.
Figure 2.1.
Figure 2.2.
Figure 2.3.
Figure 2.4.
Figure 2.5.
Figure 2.6.
Figure 3.1.
Figure 3.2.
Figure 3.A1.1.
Figure 3.A1.2.
Figure 3.A1.3.
Figure 3.A1.4.
Figure 3.A1.5.
Figure 3.A1.6.
Figure 3.A1.7
Figure 3.A1.8.
Figure 3.A1.9.
Figure 3.A1.10.
Figure 3.A1.11.
Figure 3.A1.12.
Figure 3.A1.13.
Figure 3.A1.14.
Example of non-arms length transfer pricing affecting

National Accounts and firm-level reports ............................................. 28
Future path of BEPS measurement ....................................................... 44
relative to GDP ...................................................................................... 51
Indicator 2: High profit rates of low-taxed affiliates of top
global MNEs ......................................................................................... 56
Indicator 4: Effective tax rates of MNE affiliates relative to
non-MNE entities with similar characteristics ...................................... 60
Indicator 5: Concentration of royalty receipts relative to
R&D spending ....................................................................................... 62
Indicator 6: Interest to income ratios of MNE affiliates in
locations with above average statutory tax rates ................................... 64
Incentive to engage in BEPS: Corporate income tax rate
variation within OECD countries .......................................................... 96
Incentive to engage in BEPS: Corporate income tax rate on
patent income variation within OECD countries .................................. 97
Issues covered by the analysis ............................................................. 137
Corporate tax rates and tax revenues................................................... 138
Empirical approach on profit shifting: Illustrative example................ 147
Trends in international tax planning, 2000-2010 ................................ 150
Distribution of patents across countries .............................................. 151
The effect of preferential tax treatment on the number of
patent applications ............................................................................... 153
Illustrative classification of anti-avoidance rules ................................ 159
Production of the accounting, bookkeeping, auditing and tax
consultancy industry ............................................................................ 160
Illustrative tax revenue effects of international tax planning
in hypothetical cases............................................................................ 164
Illustrative tax revenue effects depending on the strictness of
anti-avoidance rules............................................................................. 165
Revenue effects of tax planning: accounting for uncertainties............ 167
Mark-up rate and international tax planning ....................................... 170
MNE group external leverage and international tax planning............. 174
Share of inward FDI stock explained by tax rate differences
between countries ................................................................................ 176
8 TABLE OF CONTENTS
Figure 3.A1.15 Tax planning reduces the effect of corporate taxes on tax
planning MNEs investment................................................................ 178
Figure 3.A2.1. Potential approach to undertaking a fiscal estimate ............................ 196
Figure 3.A2.2. Intra-firm transactions as a percent of selected trade statistics ........... 204
Figure 3.A2.3. Potential steps to follow once data availability has been
determined ........................................................................................... 213
Figure 4.1.
Future path of BEPS measurement ..................................................... 252
Figure 4.2.
Data important for analysis of BEPS and countermeasures ................ 258
Boxes
Box 1.1.
Box 1.2.
Box 1.3.
Box 2.1.
Box 2.2.
Box 2.3.
Box 2.4.
Box 2.5.
Box 2.6.
Box 2.7.
Box 2.8.
Box 2.9.
Box 3.1.
Box 3.2.
Box 3.3.
Box 3.4.
Box 3.A1.1.
Box 3.A1.2.
Box 3.A1.3.
Box 3.A1.4.
Box 3.A1.5.
Box 3.A1.6.
Box 3.A1.7.
Box 3.A1.8.
Box 3.A1.9.
Criteria for assessing data ..................................................................... 19

Public enquiries reveal data missing from many academic
studies .................................................................................................... 31
Some current best practices in using available data for BEPS
analysis .................................................................................................. 33
relative to GDP ...................................................................................... 50
How should economic activity be defined? .......................................... 52
Indicator 2: High profit rates of low-taxed affiliates of top
global MNEs ......................................................................................... 55
Indicator 3: High profit rates of MNE affiliates in lower-tax
locations ................................................................................................ 57
Indicator 4: Effective tax rates of MNE affiliates compared
to non-MNE entities with similar characteristics .................................. 58
Indicator 5: Concentration of royalty receipts relative to
R&D spending ....................................................................................... 61
Indicator 6: Interest-to-income ratios of MNE affiliates in
locations with above average statutory tax rates ................................... 64
Future Indicator A: Profit rates relative to ETRs, MNE
domestic vs. global operations .............................................................. 66
Future Indicator B: Differential rates of return on FDI related
to SPEs .................................................................................................. 67
Alternative points of comparisons - Alternative
counterfactuals ................................................................................... 84
Different tax variables used in BEPS and tax policy analyses .............. 86
Different approaches used to estimate profit shifting............................ 91
Other empirical analyses of BEPS fiscal effects ................................. 104
Summary of main findings .................................................................. 135
Disclaimer on the data used in the empirical analysis ......................... 141
Empirical approach: Assessing tax planning based on firmlevel data ............................................................................................. 147
Empirical approach: Location of patents............................................. 154
Empirical approach: Manipulation of the location of external
debt ...................................................................................................... 155
Anti-avoidance rules ........................................................................... 158
The impact of book/tax differences and tax credits on tax
revenue estimates ................................................................................ 162
Main uncertainties surrounding the tax revenue estimates.................. 166
Empirical approach: Tax planning and competition ........................... 171
TABLE OF CONTENTS 9
Box 3.A1.10.
Box 3.A1.11.
Box 3.A1.12.
Box 4.1.
Box 4.2.
Empirical approach: Tax planning and group external

leverage ............................................................................................... 173
Cross-country differences in taxes and location of investment ........... 177
Empirical approach: Investment and tax planning .............................. 179
Some best practices in data availability for tax analysis of
corporate tax and MNEs ...................................................................... 253
Case studies of tax administrations' collaborations with
qualified researchers ............................................................................ 256
ACE
Allowance for corporate equity
AETR
Average effective tax rate
AMNE
Activities of multinational enterprises database
AMTR
Applicable marginal tax rate
ATAF
African Tax Administration Forum
B2C
Business-to-consumer
BEA
Bureau of Economic Analysis
BEPS
BMD3
Benchmark Definition of Foreign Direct Investment, Third Edition
BMD4
Benchmark Definition of Foreign Direct Investment, Fourth Edition
BOP
Balance of payments
BvD
Bureau van Dijk
CbCR
Country-by-Country Reporting
CDIS
Co-ordinated Direct Investment Survey
CFA
CFC
Controlled foreign corporations
CIAT
Inter-American Centre of Tax Administrations
CIT
CTJ
Citizens for Tax Justice
EBIT
Earnings before interest and taxes
EBITDA
Earnings before interest, taxes, depreciation and amortization
ECJ
European Court of Justice
EITI
Extractive Industries Transparency Initiative
ETR
Effective tax rate
EPO
European Patent Office
EU
European Union
FDI
Foreign direct investment
FISIM
Financial services indirectly measured
12 ABBREVIATIONS AND ACRONYMS

FL-ATR
Forward-looking average effective tax rates
FL-METR
Forward-looking marginal effective tax rate
G20
Group of Twenty
GAAP
Generally Accepted Accounting Principles
GAAR
General anti-avoidance rules
GIE
Gross interest expense
GDP
Gross domestic product
GOS
Gross operating surplus
HMRC
Her Majestys Revenue and Customs
ICTD
Sussex University International Centre for Tax and Development
IFRS
IMF
International Monetary Fund
IP
Intellectual property
IRS
Internal Revenue Service
JCT
United States Congressional Joint Committee on Taxation
KBC
Knowledge based capital
LOB
Limitation-on-benefits
MAP
MiDi
Micro database on direct investment
MNE
MTR
Marginal tax rate
NA
National Accounts
NGO
Non-government organisation
NIE
NOS
Net operating surplus
NSO
National statistical office
OECD
PCT
Patent Co-Operation Treaty
PE
PPT
Principal purposes test
R&D
SAAR
Specific anti-avoidance rules
SOI
Statistic of Income Division
SPE
Special purpose entity
STAN
Structural Analysis Database
STR
Statutory tax rate
TFDE
Task Force on the Digital Economy
UNCTAD
United Nations Conference on Trade and Development
USTPO
United States Patent and Trademark Office
VAT
Value-added tax
WHT
Withholding tax
WIOD
World Input-Output Database
WP
Working Party
WTO
World Trade Organization
Executive summary
The adverse fiscal and economic impacts of base erosion and profit shifting (BEPS)
have been the focus of the OECD/G20 BEPS Project since its inception. While anecdotal
evidence has shown that tax planning activities of some multinational enterprises (MNEs)
take advantage of the mismatches and gaps in the international tax rules, separating
taxable profits from the underlying value-creating activity, the Addressing Base Erosion
and Profit Shifting report (OECD, 2013) recognised that the scale of the negative global
impacts on economic activity and government revenues have been uncertain.
Although measuring the scale of BEPS proves challenging given the complexity of
BEPS and the serious data limitations, today we know that the fiscal effects of BEPS are
significant. The findings of the work performed since 2013 highlight the magnitude of the
issue, with global corporate income tax (CIT) revenue losses estimated between 4% and
10% of global CIT revenues, i.e. USD 100 to 240 billion annually. Given developing
countries greater reliance on CIT revenues, estimates of the impact on developing
countries, as a percentage of GDP, are higher than for developed countries.
In addition to significant tax revenue losses, BEPS causes other adverse economic
effects, including tilting the playing field in favour of tax-aggressive MNEs, exacerbating
the corporate debt bias, misdirecting foreign direct investment, and reducing the financing
of needed public infrastructure.
Six indicators of BEPS activity highlight BEPS behaviours using different sources of
data, employing different metrics, and examining different BEPS channels. When
combined and presented as a dashboard of indicators, they confirm the existence of
BEPS, and its continued increase in scale in recent years.
The profit rates of MNE affiliates located in lower-tax countries are higher than
their groups average worldwide profit rate. For example, the profit rates reported
by MNE affiliates located in lower-tax countries are twice as high as their groups
worldwide profit rate on average.
The effective tax rates paid by large MNE entities are estimated to be 4 to 8
percentage points lower than similar enterprises with domestic-only operations,
tilting the playing-field against local businesses and non-tax aggressive MNEs,
although some of this may be due to MNEs greater utilisation of available country
tax preferences.
Foreign direct investment (FDI) is increasingly concentrated. FDI in countries
with net FDI to GDP ratios of more than 200% increased from 38 times higher than
all other countries in 2005 to 99 times higher in 2012.
The separation of taxable profits from the location of the value creating activity
is particularly clear with respect to intangible assets, and the phenomenon has
grown rapidly. For example, the ratio of the value of royalties received to spending
on research and development in a group of low-tax countries was six times higher
than the average ratio for all other countries, and has increased three-fold between
2009 and 2012. Royalties received by entities located in these low-tax countries
accounted for 3% of total royalties, providing evidence of the existence of BEPS,
though not a direct measurement of the scale of BEPS.
Debt from both related and third-parties is more concentrated in MNE affiliates
in higher statutory tax-rate countries. The interest-to-income ratio for affiliates of
the largest global MNEs in higher-tax rate countries is almost three times higher
than their MNEs worldwide third-party interest-to-income ratio.
Along with new empirical analysis of the fiscal and economic effects of BEPS and
hundreds of existing empirical studies that find the existence of profit shifting through
transfer mispricing, strategic location of intangibles and debt, as well as treaty abuse,
these BEPS indicators confirm that profit shifting is occurring, is significant in scale and
likely to be increasing, and creates adverse economic distortions. Furthermore, empirical
analysis indicates that BEPS adversely affects competition between businesses, levels and
location of debt, the location of intangible investments, and causes fiscal spillovers
between countries and wasteful and inefficient expenditure of resources on tax
engineering. The empirical analysis in this report, along with several academic studies,
confirms that strong anti-avoidance rules reduce profit shifting in countries that have
implemented them.
However, these indicators and all analyses of BEPS are severely constrained by the
limitations of the currently available data. The available data is not comprehensive across
countries or companies, and often does not include actual taxes paid. In addition to this,
the analyses of profit shifting to date have found it difficult to separate the effects of
BEPS from real economic factors and the effects of deliberate government tax policy
choices. Improving the tools and data available to measure BEPS will be critical for
measuring and monitoring BEPS in the future, as well as evaluating the impact of the
countermeasures developed under the BEPS Action Plan.
While recognising the need to maintain appropriate safeguards to protect the
confidentiality of taxpayer information, this report makes a number of recommendations
that will improve the analysis of available data. Some of the information needed to
improve the measurement and monitoring of BEPS is already collected by tax
administrations, but not analysed or made available for analysis. The focus of the reports
recommendations in this area is on improved access to and enhanced analysis of existing
data, and new data proposed to be collected under Actions 5, 13 and, where implemented,
Action 12 of the BEPS Project.
The report recommends that the OECD work with governments to report and analyse
more corporate tax statistics and to present them in an internationally consistent way. For
example, statistical analyses based upon Country-by-Country Reporting data have the
potential to significantly enhance the economic analysis of BEPS. These improvements in
the availability of data will ensure that governments and researchers will, in the future, be
better able to measure and monitor BEPS and the actions taken to address BEPS.
1. ASSESSMENT OF EXISTING DATA SOURCES RELEVANT FOR BEPS ANALYSIS 17
Chapter 1
Assessment of existing data sources relevant for BEPS analysis
Key points:
This chapter assesses a range of existing data sources with specific reference to the
availability and usefulness of existing data for the purposes of developing indicators
and undertaking an economic analysis of the scale and impact of BEPS and BEPS
countermeasures.
This chapter concludes that the significant limitations of existing data sources mean
that, at present, attempts to construct indicators or undertake an economic analysis of
the scale and impact of BEPS are severely constrained and, as such, should be heavily
qualified.
While there are several different private data sources and aggregated official sources
currently available to researchers, they are all affected by various limitations that
affect their usefulness for the purposes of analysing the scale and impact of BEPS and
BEPS countermeasures.
One of the key challenges with currently available data sources is that it is difficult for
researchers to disentangle real economic effects from the effects of BEPS-related
behaviours.
Private firm-level financial account databases are useful, but are not comprehensive in
their coverage, have significant limitations in their representativeness in some
countries, do not include all MNE entities and/or all of their associated financial
information, and do not have information about taxes actually paid.
Some of the limitations of the currently available data also affect the ability of
individual governments to analyse how BEPS impacts their economies and tax
revenues.
While tax return data covering all subsidiaries of MNEs are potentially the most
useful form of data, most countries do not have or make such data available for the
purposes of economic and statistical analysis, even on an anonymised or confidential
basis. For example, it is difficult to determine the share of total corporate income tax
paid by MNEs, relative to purely domestic companies, as currently very few countries
make such data available.
Recent parliamentary and government enquiries have shed new light on the tax affairs
of some high profile MNEs. While this information represents a rich and emerging
source of evidence of the existence of BEPS, such information relates to the activities
of a small number of MNEs and is of limited use in undertaking a broader analysis. In
some cases, this information is not included in the available firm-level financial
account databases, which highlights the inadequacy of relying exclusively upon them.
Separating real economic effects from tax effects requires both data and estimation
methodologies, since even with good data, BEPS is not observable and must be
estimated. Nevertheless, more comprehensive and more detailed data regarding MNEs
is needed to provide more accurate assessments of the scale and impact of BEPS.
18 1. ASSESSMENT OF EXISTING DATA SOURCES RELEVANT FOR BEPS ANALYSIS
1.1 Introduction
1.
Assessing currently available data is an important part of BEPS Action 11.
Having a proper understanding of the available data and its limitations is a fundamental
issue for the development of indicators showing the scale and economic impact of BEPS,
as well as for the development of economic analyses of the scale and impact of BEPS and
2.
It cannot be overemphasised that the results obtained from any analysis are only
as robust as the data and methodology underpinning them. This is particularly true in the
case of analysing BEPS, since BEPS involves multinational enterprises (MNEs) that can
establish intra-group arrangements that achieve no or low taxation by shifting profits
away from jurisdictions where the activities creating the profits are taking place. These
intra-group cross-border arrangements are often very complex, involving multiple related
entities, and related party transactions are typically not separately identifiable (and
available) in tax or financial account databases.
3.
Hence, it is crucial to establish an understanding of the currently available data
what is available; the coverage and representativeness of that data; whether it is tax return
or financial account data; whether it is macro or micro-level data; its reliability and
robustness (what quality control measures are in place for the data collection); whether it
is comparable across jurisdictions; and who has access to it.
4.
This chapter provides an initial assessment of the data currently available for
analysing BEPS and BEPS countermeasures, which is relevant to both the development
of potential indicators and the undertaking of refined economic and statistical analyses. It
is important to note that most analyses, including government policy analyses and
decisions, are made with partial information. For policymakers, using available data to
conduct some analysis is better than working without empirical-based evidence at all, but
such analyses must also recognise the limitations of currently available data and how
those limitations may affect the reported results.
5.
The purpose of the assessment undertaken in this chapter is to describe what is
available, as well as outline the benefits and limitations of the different types of data.
Based on this assessment, Action 11 also involves the identification of new types of tools
and data that should be collected in the future. New data could include capitalising on
existing data that is currently unavailable, either due to confidentiality reasons or because
it is not currently processed or analysed, as well as additional information needed for
monitoring BEPS in the future, taking into account ways to reduce administrative costs
for tax administrations and businesses. A detailed discussion of potential new tools and
data is set out in Chapter 4.
1.2 Potential criteria for evaluating available data for BEPS research
6.
An assessment requires establishing a set of criteria to be used for evaluating the
different types of data with respect to their usefulness for analysing BEPS. Having a
thorough understanding of the available data will provide a solid base for working
towards best practices in future data collection to 'fill the gaps' and strive for more
comprehensive data and comparability across countries, recognising the trade-offs
between the objectives of improved tax policy analysis and the need to minimise
administrative costs for tax administrations and businesses.
7.
Box 1.1 briefly outlines a set of criteria that could be considered.

Box 1.1. Criteria for assessing data

Coverage/Representativeness BEPS is a global issue and significant profit shifting may occur
through small entities with large profits but with little economic activity. Determining the
coverage and representativeness of the underlying data is critical to assessing the results of any
analysis. Most databases are limited to individual countries or a region, and there is no truly
comprehensive global database of MNE activity.
Usefulness for separating real economic effects from tax effects Separating BEPS-related
activity from real economic activity is important, but must be estimated. National Accounts and
macroeconomic statistics, such as foreign direct investment data, combine both real and BEPSrelated activity. Firm-level data provides researchers with more information to attempt to more
accurately separate BEPS-related activities from a firms real economic activities.
Ability to focus on specific BEPS activity BEPS is driven by practices that artificially
segregate taxable income from the real economic activities that generate it. A MNEs financial
profile can be very different between financial and tax accounts. Differences in financial and
taxable income can be large, and the country of taxation can differ from the firms country of
incorporation. In some cases, specific tax information may be available for a limited number of
MNEs from specific parliamentary enquiries.
Level of detail As BEPS behaviours involve cross-border transactions, typically between
related parties, information on related and unrelated party transactions should be used when
available. Affiliate-level information should supplement worldwide consolidated group
information when available. Different types of foreign direct investment data should be used
when available.
Timeliness Access to timely information enables policymakers to monitor and evaluate the
changes in the BEPS environment and the effects of legislation. If the time lag is too long,
empirical analysis may be more of an historical assessment, rather than an analysis of recent
developments.
Access Many BEPS behaviours cannot be identified as specific entries on tax returns or
financial accounts. Analysis of the data is required to separate BEPS behaviours from real
economic activity. Thus, policymakers need economic analyses of BEPS and BEPS
countermeasures, rather than just compilations of descriptive statistics. The extent to which
access to data is provided to statisticians and economists within government, and potentially
outside of government, with strict confidentiality rules, represents an important policy issue.
8.
Coverage/Representativeness: BEPS is a global issue so comprehensive coverage
across all countries would be ideal. Many macro-level aggregate data are available for
most countries. Coverage of the entities that form part of MNEs is an important issue. A
number of firm-level databases are available for individual countries, and the few private
global databases are increasing coverage across multiple countries.
9.
Even where data for a particular country exists, coverage issues may continue to
complicate a rigorous assessment of BEPS. One aspect concerns the coverage of financial
information for the entities included in the firm-level databases. Missing financial
information may have an equally detrimental effect on an analysis as if the entity were
not included in the database. Aggregation of financial information in respect of entities
within MNE groups can also distort and limit the analysis.
10.
Incomplete coverage of firms for any number of reasons means that the data
collected may be from a non-random sample and so, potentially, a non-representative
sample of firms. Extrapolating results beyond a non-random sample has limitations which

may be partially addressed by weighting or sensitivity analysis. This is likely to be a
significant issue in the analysis of BEPS because of the potential concentration of BEPS
in certain types of entities (e.g. located in low or no-tax countries). This is particularly
problematic if those entities engaging in more BEPS-related behaviours are more likely to
avoid or minimise the disclosure of relevant financial information.
11.
Tax return information is generally filed only for entities that have a taxable
presence in a country. Some countries may require foreign-owned companies that have a
physical presence in the country, but not a tax presence, to register with a designated
body. Many countries tax administrations do not have information about the other
affiliates of a MNE group, other than those with a permanent establishment in the
country. For example, in South Africa, a foreign company that is physically present in
South Africa must register as an external company with the Companies and Intellectual
Property Commission. External companies do not have to file annual financial reports
with the Commission, but the South African Revenue Service could obtain a list of these
companies from the Commission. Many countries have entered into bilateral or
multilateral Double Taxation Agreements and Exchange of Information Agreements that
enable them to exchange information as well as conduct simultaneous or joint audits on a
taxpayer.
12.
Usefulness for separating real economic effects from tax effects: BEPS is a tax
issue with financial and economic ramifications. As noted below, BEPS affects the
reported taxes, but also affects many non-tax variables, including macroeconomic
aggregates, such as gross domestic product (GDP) or foreign direct investment (FDI), and
firm-level/group financial information, such as reported financial profits or tax return
information.
13.
Estimating the effects of BEPS requires disentangling real economic activity
across countries from tax-related (and specifically BEPS-related) behaviours across
countries. In fact, there are three different categories of effects that ideally would be
separately estimated: (i) real economic activity across countries independent of tax; (ii)
real economic activity across countries influenced by differences in non-BEPS-affected
tax rates (e.g. responsiveness of capital investment to a change in a countrys effective tax
rate); and (iii) BEPS-related activities across countries that include financial flows, legal
contracts and structuring to shift profits away from where value is generated. In some
cases, the structuring involves placing just enough economic activity (staff and functions
for example) in a jurisdiction to attempt to justify the tax minimisation strategy. Only
category (iii) effects should be attributed to BEPS.
14.
Macroeconomic aggregates, such as FDI include both real and BEPS-related
investment and returns, which are difficult or impossible to separate. In their current
reporting of FDI, most countries have not been able to separate FDI related to real
investment (greenfield and expansion investment) from financial transactions (mergers
and acquisitions and the accumulation of reinvested earnings). While BEPS behaviours
are more likely to be concentrated in the latter, there could be instances where, for
example, a small operational facility (greenfield investment) is set up in a foreign
jurisdiction with the main purpose of justifying a BEPS arrangement under current
national rules. In addition, financial transactions may take place for legitimate business
reasons and should not be automatically associated with BEPS.
15.
The International Monetary Fund (IMF)1 recently conducted a project on bilateral
asymmetries in FDI reporting for the Co-ordinated Direct Investment Survey (CDIS). The
project confirmed that methodological differences and insufficient data coverage are the
main reasons for bilateral asymmetries. Bilateral data on transactions other than FDI are
also important for analysing BEPS, for example trade in goods and services, royalty
payments and payments/receipts for services (e.g. legal, management and accounting
services). Coverage of bilateral flows between non-OECD/G20 countries and countries
with low corporate tax rates is often missing.2 Bilateral information does not provide
analysts with a view of the full chain of a transaction including the origin, transit points
and the final destination.3 Being able to see more than the first destination is important
given that many flows are routed via special purpose entities (SPEs) for tax-motivated
reasons.
16.
The 4th edition of the OECD Benchmark Definition of Foreign Direct Investment
(BMD4) recommends that countries explicitly separate FDI statistics on SPEs and nonSPEs for reporting purposes, which will result in more meaningful measures of real FDI.
Separate reporting of flows through SPEs also identifies particular financial flows, which
in some cases have facilitated BEPS behaviours. With the implementation of the latest
standards, nine countries (in addition to the four that have done so for several years) have
now reported data separating resident SPEs. More data will become available as more
countries are included in the new OECD database of FDI statistics later in 2015.4
17.
Micro-level data makes separating real and BEPS-related effects more likely,
since individual firm data allows adjustment for industry, size of company, situation in
the MNE group, and other non-BEPS tainted variables. In other words, analysis with
micro-level data makes it possible to identify and control for more, but not necessarily all,
non-tax characteristics of both affiliated firms and MNE groups that could affect BEPS.
18.
Ability to focus on specific BEPS activity: Differences between tax return and
financial account data represent an important limitation affecting the use of non-tax
financial account information for analysis of tax policy issues generally and BEPS
specifically. This is likely to be amplified in instances where an entitys financial profile
reported for accounting purposes does not correlate with its economic value-add in the
jurisdiction in which it resides (particularly for subsidiaries of foreign headquartered
MNEs and unlisted domestically headquartered MNEs). There are three main examples
of such book/tax differences. Firstly, book/tax income differences can include permanent
exemption of intragroup dividends and timing differences such as accelerated tax
depreciation. Companies in a MNE group report financial profits that include exempt
intragroup dividends. Differences between the tax consolidation rules and the statutory
accounting consolidation rules can affect consolidated accounts.
19.
A second book/tax difference relevant to BEPS analysis is the tax residence of the
company compared to the country of incorporation, where financial reporting is required.5
Due to differences in international tax rules, some companies have tax residence in a
country other than the country of incorporation, or in some cases companies have been
able to exploit mismatches between the tax laws of different countries with the result
being that they are not tax residents of any country. Also, financial accounts generally do
not show the sales or income of an entity across different countries, so analyses generally
assign all of the sales and income to the country of incorporation. For example, a branch
of a company could be earning income in a low-tax rate country, yet it is reported as
income of the company incorporated in a high-tax country, thus distorting both the
location of profits and the measure of the tax rate.
20.
A third book/tax difference is the actual tax variable. Financial statement accounts
under International Financial Reporting Standards (IFRS) or Generally Accepted
Accounting Principles (GAAP) include tax expense, which is an accrual measure of tax

associated with current year income, and which includes both current and deferred
income tax expense.6 For a constantly growing company, deferred income tax expense
may also accumulate over long periods, resulting in a near zero effective tax rate. For
example, if three subsidiaries of a MNE are operating in different countries, all of which
have accelerated tax depreciation allowances for capital spending, an expansion in capital
investment over a ten year period could result in a build-up of significant deferred tax
liabilities (for accounting purposes). Also, deferred tax expense can accumulate into
deferred tax assets (e.g. tax credit carry forwards) or deferred tax liabilities (e.g.
accelerated depreciation), which are affected by changes in future statutory tax rates. The
total tax expense will be affected by a one-off change in the year that statutory tax rates
are changed, due to a re-evaluation of the deferred tax asset or liability. Cash income tax
payments are sometimes reported, but cash tax payments may reflect tax from current and
prior years and potentially interest and penalties. A further discrepancy could arise if the
amount of tax reflected in financial statements includes amounts that would not ordinarily
be regarded as tax on profits. For example, where resource royalties are treated as a tax
expense rather than (or as well as) a deductible cost of inputs.
21.
In addition, many BEPS strategies cannot be observed directly in financial
(accounting) statements, as they rely on heterogeneous classification of legal forms,
financing contracts and companies residence by tax authorities.7
22.
Current tax return information is not a panacea for all the problems facing an
analysis of BEPS. Individual country tax administrators or their tax policy analysis
agencies with access to tax return information will only have information included in the
tax returns filed in their country. In many cases, this will not include returns for other
entities of the worldwide group that do not have to file returns in the country. Detailed
information about intra-group related party transactions may not be included since it may
not have been requested or may not be required for the computation of tax liability (the
latter limitation being legally binding for tax authorities in some countries with respect to
the information that can be requested). An additional issue is that all of the information
reported on corporate income tax returns may not be included in a database processed
from the tax returns (e.g. often only information specific to the calculation of tax liability
is included, so information from the balance sheet, which could be helpful in the analysis
of BEPS, may not be processed).
23.
Level of detail: The use of firm-level financial account and tax return data is more
likely to allow for the separation of real economic activity from BEPS and focusing on
specific BEPS behaviours. With respect to financial account data, the use of
unconsolidated financial account data in combination with consolidated financial account
data provides further insights. Where available, information on related party transactions
should be used in analysing BEPS. For example, group worldwide leverage and interest
expense ratios only include external third-party borrowing. Related party borrowing,
which is a significant BEPS channel, does not show up in the consolidated group
worldwide financial accounts. Related party borrowing is reflected in unconsolidated
affiliates financial accounts, but is generally not separately reported in financial
accounts. Concerning tax return data, using micro-level data to understand the
heterogeneity of individual firms and BEPS behaviours is preferable to aggregated tax
statistics where deviations from the average are masked.
24.
Timeliness of the information: Access to timely information will enable
policymakers to respond faster in countering new BEPS channels that may arise over
time. If the time lag is too long, the analysis undertaken will be of more historical interest
than for policy action purposes. Financial statement information is publicly available
annually, often 2-4 months after the firms fiscal year has closed. Tax return information
is often not filed until late the following year, and the processing of the tax return
information for analysis purposes is often two years after the calendar year.
25.
Access to the information: MNEs file tax and regulatory reports with
governments, and those tax reports are available to the tax administration agency. In
many countries, the confidentiality of the tax return data prevents any sharing of the
information beyond the tax administration agency. Thus government tax policy analysis
outside of the tax administration may be limited to specific requests for anonymised
records or aggregate statistics. Non-government access to corporate tax return records is
typically not permitted, except for a few countries and only for strictly controlled research
projects with strict confidentiality rules. Aggregate corporate tax return data is published
by a number of countries, including information by industry and for certain taxpayer
attributes such as total assets or total revenue. Based on information collected in a recent
OECD Committee on Fiscal Affairs (CFA) WP2 on Tax Policy Analysis and Tax
Statistics (WP2) survey, only eight of the 37 respondent countries were able to provide
data on MNEs share of corporate income tax revenues.
26.
Other data issues: There are many other data issues that reduce the signal-tonoise ratio (real information content) of any empirical tax policy analysis. Analysis must
be undertaken with available data, but the analysts and users of the analysis should be
aware of the data limitations. A few of the additional data issues related to BEPS analysis
include:
Balance sheets typically reflect purchased intangibles only, since for both tax and
financial accounting most expenditures for intangible investments are deducted
immediately (expensed) rather than capitalised;
Intangibles are not limited to intellectual property, such as patents, trademarks and
copyrights, but may also include other important items, such as trade names,
brands, assembled workforce, and managerial systems, that are important to take
into account when considering the sources of real economic activity and value
creation;
Headline statutory tax rates are often not the tax rate applicable at the margin of
BEPS behaviour, due to specific country tax rules or administrative practices;
Effective tax rates, both tax paid and financial tax expense, can also reflect specific
non-BEPS related incentives, such as R&D tax credits;
Available data may be collected through a sampling process to reduce the burden
on respondents and the processing costs, but this raises issues of appropriate
weighting;
Existing data collection and processing may capture previous profit shifting
structures and transactions, but may not capture recent and new structures and
transactions to shift profits; and
Recent data may be impacted by the financial crisis and changing macroeconomic
conditions and may not be directly comparable to previous conditions.
1.3 Currently available data for BEPS analysis

27.
Table 1.1 below provides an overview of 11 different types of data sources that
have been used to analyse BEPS. It is based on responses to the Action 11 Request for
Input, as well as discussions with academics and CFA WP2 delegates. The data sources
range from macro aggregate statistics to micro firm/group level statistics; tax return data;
financial account statistics; and detailed reports of individual MNEs.
Table 1.1. Overview of the current data sources
National Accounts
(NA)
Balance of
Payments (BOP)
MACRO
Foreign Direct
Investment (FDI)
Trade
This information measures the economic activity in a country and

includes variables such as operating surplus, which may be used in
BEPS analysis. It is easily accessible from international
organisations, such as the OECD and the IMF. However, the
underlying information used to construct the data is itself tainted by
BEPS behaviours - meaning that even widely used measures such
as GDP will be distorted by a BEPS component that is difficult to
disentangle. There are significant definitional differences between
National Accounts and tax data.
BOP statistics include all monetary transactions between a country
and the rest of the world, including payments for exports and imports
of goods, services, financial capital and financial transfers. This
encompasses information on flows widely used to shift profits, such
as purchases and sales of trading stock and services, royalties and
interest. It is accessible (from the IMF and the World Bank, for
example), but does not distinguish between transactions respecting
the arm's length principle and manipulated transactions.
FDI statistics cover all cross-border stocks and flows between
enterprises forming part of the same group, including (i) direct
investment (equity or debt) positions; (ii) direct investment financial
flows (equity, reinvestment of earnings, debt); and (iii) direct
investment income flows (dividends, distributed branch profits,
interest). The IMF only reports on FDI positions, not flows, and the
amount of information available from individual countries differs. The
OECD has statistics on FDI positions, income and flows, but there
are currently gaps and inconsistencies.
While not directly related to the scale / revenue loss attributed to
BEPS, FDI data depicts intra-group cross-border transactions that
can provide at least indirect evidence of profit shifting by analysing
the disconnect between the amount of FDI and the size of the
economy, or the concentration of FDI in countries with a low effective
tax burden on corporations. There are several issues with FDI data,
including bilateral asymmetries in the capturing of the same FDI
transaction and different types of transactions (e.g. greenfield
investment, mergers & acquisitions, intra-group financing). There is
also no distinction between real and purely financial investment,
which would allow for a comparison that is highly relevant for an
analysis of BEPS. Changes in data coverage over time can affect
trends in macroeconomic variables, e.g. FDI.
Aggregate data on bilateral trade by product can be used to analyse
profit shifting through mispricing. This is accessible from the United
Nations Comtrade database and the OECD database on intermediate
trade in goods and services. There can be large discrepancies
between figures reported for the same bilateral trade flow by the
importing and exporting country (and non-trivial measurement issues
concerning quantity and current price trade data). In addition, any reinvoicing arrangements using low-tax jurisdictions as conduits in the
supply chain to extract a margin will distort the pricing between
suppliers and related party purchasers.
The CEPALSTAT database covers some Latin American countries,

but there is no differentiation between related and non-related
parties. The raw underlying customs data (expanded on in the micro
data section) used for merchandise trade statistics may also show, in
some countries, separate figures for trade between affiliated parties.
There is no database equivalent to Comtrade for trade in services, an
important element for BEPS analysis. Trade in services by country is
usually available with data segregated by royalty payments and
entrepreneurial services, among others, but the availability of data
and the level of detail differ between countries. In addition, the
service component of trade flows (which includes royalties and other
payments for the use of IP) is likely to be underestimated due to the
underreporting and mispricing of IP.
There often appears to be some difficulty in practice in how National
Statistics Offices differentiate between payments recorded as trade in
services and payments recorded as primary income flows in the
BOP, which can result in significant differences in bilateral trade
statistics.
Corporate income
tax (CIT) revenue
MICRO
Customs (trade)
data
Company financial
information from
public / proprietary
databases
Aggregate tax revenue data is accessible from international

organisations (OECD Revenue Statistics, IMF Government Finance
Statistics and World Bank Global Development Indicators) and often
from National Accounts and tax authorities. It is typically used to
estimate CIT-to-GDP ratios, for example, as well as implicit tax rates
(ratios of CIT revenues to a proxy CIT base taken from the National
Accounts). However, the biggest drawback is comparability across
countries, particularly between developed and developing countries.
Often, there is no clear distinction between national and subnational
revenue, the relative size of the corporate taxed sector, or between
resource and non-resource revenue. The lack of detail and
consistency is an important issue for developing countries and,
because BEPS involves cross-border transactions with all countries,
comparable data for both developed and developing countries, is
critical.
Recently available data from the International Centre for Tax and
Development (ICTD) improves comparability of data for developing
8
countries. The OECD Revenue Statistics presents a unique set of
detailed and internationally comparable tax data in a common format
for all OECD countries from 1965 onwards. The Revenue Statistics
has been expanded to include non-OECD countries in other regions
which enhances comparability across a wider range of countries.
Customs data is a useful source for understanding the mispricing of
traded goods and services. This is an important component for
understanding transfer pricing behaviour by related parties. As noted
in the macro-section, the service component of trade flows (which
includes royalties and other payments for the use of IP) is likely to be
underestimated due to the underreporting and mispricing of IP.
Availability of such data is country specific and not available in many
countries. Studies in France and the United States have measured
pricing differences between related and non-related parties, by
country of destination and product characteristics.
This information can be sourced from published financial statements
of MNEs, open-access sources such as OpenCorporates, and
commercial databases (e.g. Bureau van Dijk (Bvd) ORBIS and
Amadeus, S&P Compustat Global Vantage, Bloomberg, Oriana,
Osiris, OneSource, Mergent, Alibaba.com, SPARK, DataGuru.in,
Ruslana). Companies (at least public companies) are typically
obliged to publish financial statements (consolidated and/or
unconsolidated). Problems with the suitability of this data for BEPS
analysis include: different reporting requirements for accounting and
MICRO (continued)
Company financial
information from
government
databases
Tax return CIT
information
Tax audit
information
Detailed specific
company tax
information
tax purposes, no distinction between related party and independent

party transactions, coverage that is far from comprehensive, and the
heterogeneity of reporting across countries and companies.
Databases that consolidate companies balance sheet and income
account data are improving their coverage over time, but still have
9
weak coverage of developing countries in particular , but also of
10
some OECD countries , such as Germany. This is because data
availability in larger datasets depends on underlying national sources.
A further drawback is the level of consolidation available for some
countries. Company financial statements are used in research on
11
profit shifting through debt financing, for example . An important
limitation in these studies is the limited country coverage and
comparability across countries.
Detailed financial information is available (although with limitations
applying to access) from publicly administered databases such as the
United States Bureau of Economic Analysis and German
Bundesbank MiDi database. In some other countries, access to data
via research centres or via controlled remote-access/execution is
also being considered.
A range of financial and tax information is available to tax authorities
as companies are required to file a tax return. The extent of
information reported to the tax administration varies across countries.
In some countries, there are strict rules limiting the reported
information to that required for the calculation of tax liability only; in
other countries, companies are required to file broader information
used for risk analysis such as data on foreign subsidiaries. Many
governments do not report corporate tax revenues separately for
MNEs and purely domestic companies from tax returns, and have no
systematic data regarding intra-group transactions.
Some countries publish tax statistics that show the data in aggregate
or by sector. Full access to the detailed micro-level company tax data
is generally restricted to tax authorities, made available often on
specific request for tax policy analysis, and in a few countries to
outside researchers under strict confidentiality conditions.
Information from audits of tax return filings, both assessments and
settlements, has been cited as a potential source of information about
BEPS. This source of information is generally not available for tax
policy analysis, even on an aggregated basis,
The specifics of individual MNEs tax situations are becoming public
through legislative enquiries, such as in the United Kingdom, the
United States and more recently Australia. More granular tax
information than what is available from the MNEs financial
statements or from global databases (for these companies) has
become available.
The European Commission has also launched a series of in-depth
investigations into specific tax rulings and regimes that could be
considered as EU State Aid to MNEs.
1.4 Initial assessment of currently available data for analysing BEPS

28.
Analysis of BEPS requires identifying where MNE behaviours or arrangements
achieve no or low taxation by shifting profits away from jurisdictions where the
activities creating those profits take place. No or low taxation is not per se a cause of
concern, but it becomes so when it is associated with practices that artificially segregate
taxable income from the activities that generate it. This description of BEPS is
important in assessing the currently available data.
29.
Firm-level data is needed for the best analysis of BEPS. Among the economic
community, there is general agreement that the increased availability and use of firmMEASURING AND MONITORING BEPS OECD 2015
level data is an important improvement in analysing BEPS. Earlier studies of macro

aggregate-level statistics found very large reported effects of profit shifting due to tax rate
differentials, but aggregate-level statistics are less able to separate real economic activity
from BEPS behaviours. Dharmapala (2014) presents a good summary of the existing
economic empirical literature and how micro-level analysis better refines the analysis of
profit shifting. Academic estimates of the responsiveness of profit shifting to tax rate
differentials are generally lower from firm-level financial data than from macro level data
or tax return data.
30.
As mentioned earlier, publicly-available, private-source micro data has limitations
in analysing BEPS. The proprietary databases integrate publicly-available financial
information reported to various governmental agencies. The coverage and completeness
of the data varies significantly across countries. In addition, the available financial
information reflects accounting concepts, not tax return concepts. As a result, these
databases still provide only indirect information about the presence of BEPS (tax return
data would provide a more direct source of information and could be used in conjunction
with relevant financial accounts databases). In addition, the ability of researchers using
this firm-level data to isolate BEPS depends critically upon the empirical methods used to
control for any differences in profitability explained by real economic factors.
31.
National Accounts statistics, such as FDI and royalty payments, can provide some
insights into transactions that can be part of arrangements to shift profits, so can thus be
potential indicators of the scale of BEPS, but better estimates of the scale and economic
effects of BEPS require micro-level data (importantly, the same micro data used to create
the National Accounts). Improving the data and analysis of BEPS is also important for
sound, evidence-based fiscal and monetary policies government policymakers (fiscal)
and central banks (monetary) rely heavily on macroeconomic statistics that are currently
tainted by BEPS behaviours (Lipsey, 2010).
32.
Figure 1.1 illustrates how BEPS behaviours affect corporate tax payments and
company financial accounts, and also countries National Accounts. Company A is
located in Country A that has a statutory tax rate of 30%, while Company B, its affiliate,
is located in Country B with a statutory tax rate of 10%. Company B sells goods to
Company A for 150 that would have been sold for 100 to an independent party. As a
result, the sales in Company B are overstated by 50 while the purchases in Company A
are overstated by 50. This has ramifications for the value added measures in the National
Accounts by overstating value added in Country B and understating valued added in
Country A. This example shows how BEPS behaviours can distort GDP figures across
countries. Only very few National Statistical Offices are able to adjust even partly for this
distortion, especially in cases concerning payments for (if recorded) and transfers of
intellectual property. The extent to which currently available data is tainted by BEPS is
likely to be reduced over time, ultimately leading to more accurate statistics.

Figure 1.1. Example of non-arms length transfer pricing affecting National Accounts and
firm-level reports
33.
More complete information about global MNE activity is needed to analyse
BEPS. The analysis of BEPS would benefit from seeing the complete picture of the
activities of the MNE and its related entities. In particular, the ability to identify the
financial and taxation impacts of the activities of related entities relative to the economic
contributions made to the global value chain by the entities in each jurisdiction. Many tax
administrations currently only receive tax returns for the MNE entities required to file
taxes in their country. They might not have access to information about related party
affiliates undertaking transactions with the taxpayer in their country. The incomplete
picture can often result in BEPS behaviours not being transparent for identification and
quantification. Similarly, an incomplete picture of a MNEs financial arrangements can
obscure BEPS behaviours from researchers using financial accounts.
34.
Incomplete coverage of a MNEs economic activity across countries is
particularly problematic for analysis of BEPS if the coverage is non-random. In that case,
the sample of business entities may not be representative of the overall population. The
potential for non-representativeness in analysing BEPS is likely to occur in two particular
situations.
35.
First, if the missing businesses or activities are in either high-tax rate or low-tax
rate countries. Since BEPS typically involves profit shifting from high-tax to low-tax or
no-tax rate countries, arrangements to segregate profits from real economic activity
would be most likely to show up in those entities. For example, large reported profits in
no-tax countries, where there is little if any real economic activity or value creation would
be a result of BEPS.
36.
Second, entities engaged in BEPS behaviours may be less likely to report any
corporate holdings, offshore structures or activity that could highlight their BEPS actions
to tax authorities or publicly available sources, where their activities may become subject
to media and public attention. This may be because there is often discretion in some of
the public reporting (e.g. materiality exceptions), or the penalties for non-reporting may
be small relative to the benefits of avoiding disclosure of tax and financial information
that may include evidence of BEPS behaviours. Hoopes (2015) summarises academic
research on issues of disclosure and transparency, including several studies12 with regard
to geographic/segment reporting, which have found selective disclosure particularly by
tax aggressive MNEs.
37.
It should also be noted that some MNEs are voluntarily becoming more
transparent in their tax reporting. The driving forces behind this include the Extractive
Industries Transparency Initiative (EITI), requirements by the European Commission,
increasing public and government scrutiny that may affect reputation, and good
governance motives.
38.
An additional concern about incomplete coverage and lack of representation
arises if BEPS behaviours differ across countries (e.g. R&D intensive countries may be
more susceptible to BEPS behaviours involving intangibles while other countries may be
more affected by financial restructuring13), but the available data is not sufficiently
representative of the population such that it can capture the differences. Lack of
representation has been noted by Cobham and Loretz (2014)14 with respect to tax policy
analysis of developing countries. A recent IMF analysis concluded that developing
countries are likely to have significantly higher BEPS concerns than developed countries
due to lower tax administrative capacity to stop BEPS behaviours. Also, many studies of
profit shifting are based on the Amadeus database, which includes only European
countries, so the results may not be applicable to non-European countries.
39.
The most comprehensive (and widely-used by researchers) global database is the
proprietary BvD ORBIS database. It is an extensive database of almost 100 million
financial accounts from many countries, and is being continually updated, expanded and
improved. Although a useful global database, it has limitations,15 and is based upon
financial account rather than tax return data. With respect to its representativeness for the
purposes of BEPS empirical analysis, Cobham and Loretz (2014) note the Eurocentric
nature of the sample and its weakness in coverage of low-income countries. Table 1.2 is a
summary of the Cobham and Loretz data analysis, plus a comparison to the geographic
distribution of both the Fortune Global 500 MNE groups and GDP.

Table 1.2. Regional distribution of MNE subsidiaries in ORBIS by location of subsidiary and
group headquarters, compared with regional distribution of top 500 MNE groups and GDP,
2011
Location of the group headquarters

Europe
North America
Australasia
Latin & Central America & Caribbean
Middle East & Africa
Total
% Representation by location of subsidiary
Fortune Global 500
Europe
208,048
28,901
9,303
3,910
2,349
252,511
Location of Subsidiary
Latin &
Central
North
America & Middle East
America Australasia Caribbean
& Africa
9,933
3,451
1,465
835
23,095
2,363
803
125
4,624
20,318
276
84
556
432
672
11
297
75
32
567
38,505
26,639
3,248
1,622
Total
223,732
55,287
34,605
5,581
3,320
322,525
78%
12%
8%
1%
1%
100%
29%
28%
41%
3%
0%
100%
%
Representation
by location of
group
headquarter
69%
17%
11%
2%
1%
100%
GDP
27%
24%
34%
8%
7%
100%
Notes:
1. Regional distribution of top 500 companies in 2014 (Fortune Magazine)
2. GDP from IMF (current 2011 prices; 2011 used to compare with latest year used by Cobham and Loretz from Orbis)
Source: Cobham, A. & Loretz, S. 2014. International distribution of the corporate tax base: Implications of
different apportionment factors under unitary taxation
40.
For example, Table 1.2 shows that MNEs headquartered in Europe accounted for
69% of the affiliates in the ORBIS database; in comparison, MNEs from the rest of the
world accounted for only 31%. Of the total affiliates with key financial information
included, 78% were in Europe, while 22% were located in the rest of the world. This is
only a summary of the number of firms, and does not indicate how representative the
database is in terms of economic activity or taxes. The lack of representative data is likely
to be worse for developing countries. Furthermore, it does not indicate whether actual
data is available for all the firms included.
41.
Many academic studies have observed and estimated the existence of profit
shifting (including profit shifting from specific BEPS channels) with limited financial
account data, and in a few cases using tax return data, as described in Chapter 3.
Importantly, these studies find that BEPS is occurring and the extent of BEPS is large and
statistically significant. The limitations of the currently available data are problematic in
estimating the global scale and economic impact of BEPS. There is concern that sample
selection may result in underestimation of findings on aggregate profit shifting.16 Other
studies include both BEPS and individual tax evasion in their analyses of BEPS and are
thus likely to overstate the scale of BEPS.
42.
Recent public enquiries by legislative and/or parliamentary committees, such as in
the United Kingdom, the United States, and more recently Australia, into the tax
strategies of some high profile MNEs, have shed significant light on the tax affairs of the
affected parent companies and their affiliates.17 In addition, The European Commission
has launched a series of in-depth investigations into specific tax regimes that could be
considered as EU State Aid to MNEs.18 Investigative journalism has also brought much
useful information into the public domain.
43.
What is striking is that when one looks into the micro data available, much of this
newly revealed information does not appear to be visible either because certain
affiliates are not included or, where they are included, the financial information is
missing. This reveals a clear disconnect between the information revealed through
targeted public enquiries of some MNEs and the limited available tax information for
those same MNEs from consolidated financial statements. Box 1.2 explains this further.
Box 1.2. Public enquiries reveal data missing from many academic studies
Evidence emerging from several recent public enquiries into the tax affairs of a number of high
profile MNEs reveals clear deficiencies in the available data sources used by researchers in
analysing BEPS. The public enquiries revealed new information on the earnings, structure and
tax affairs of parent companies and their affiliates. The table below shows an example of one of
the MNEs reported pre-tax income.
The parent company, X, located in a high-tax jurisdiction, reported between 29 and 43 percent of
pre-tax earnings for the years 2009 to 2011. Xs affiliate, Y, located in a low-tax jurisdiction,
earned nearly two-thirds of the groups total pre-tax income in 2010 and 2011, and half of the
total in 2009.
Global Distribution of Specific MNE reported Earnings:
Pre-tax income
Entity
X (Parent)
Location
High tax
country
Low tax
country
2011
2010
2009
31
29
43
64
65
50
Other
Total
100
100
100
Y (Affiliate)
While Affiliate Y earned the majority of the pre-tax income, it paid virtually no taxes to any
government for these three years. Due to different rules for determining tax residence, a key
entity incorporated in the low-tax country was not taxable in any country. Thus, several tens of
billions of the parents local currency were only taxed at a 0.06% tax rate over three years.
In a micro database used by many researchers to analyse BEPS, the financial information for the
key affiliate (Y) in the low tax country was missing. This reveals a clear disconnect between the
information revealed through targeted public enquiries of some MNEs and the incomplete
available financial information for those same MNEs from financial accounts. Much of the
important information for tax analysis is simply absent. The fact that such observed instances of
BEPS are not visible in firm-level financial account databases highlights concerns regarding the
reliability and representativeness of one of the most frequently used existing data sources.
44.
Additional analysis of tax return information is needed. As noted above,
significant differences exist between tax return information and financial accounts, which
make financial account information problematic as a sole source for analysing BEPS,
even if it was comprehensive.
45.
Tax return information submitted to individual countries is also not
comprehensive in terms of the full picture of the MNE group, but it is less likely to be
subject to underreporting due to the significant financial penalties for tax noncompliance. Tax return data will have accurate information about the country of tax
residence, taxable income, tax paid, tax credits, and tax consolidation, which reduces
significant noise present in financial accounts. Information obtained from tax audits can
identify new types of BEPS behaviours, and could potentially be used if compiled and
analysed systematically to monitor BEPS behaviours in the future.19

46.
Although significant data from tax returns is provided to tax administrations by
companies, much of the data is not processed and incorporated in databases for tax policy
analysis purposes. In a survey by the OECD CFA WP2, a majority of countries cited lack
of data as the key constraint in analysing BEPS. Most of the 37 respondent countries
reported that corporate tax returns are in a database, although corporate tax data for tax
policy analysis is often available in aggregate form or upon request for individual
companies. Only eight countries were able to report the aggregate corporate income tax
collections from MNEs. Thus, although corporate tax return data has been provided by
companies to government tax administrations, it is not currently available in easily
accessible form for tax policy analysis.
47.
Making the most of available information and identifying gaps. Companies and
governments are being required to do more with less under tight budgetary constraints.
Compliance burdens and tax administrative costs are significant, and additional
information should only be requested and processed if the benefits exceed the costs.
Information collection where possible should be aligned to current recordkeeping and
reporting of MNE business to assure better data integrity and minimise compliance costs.
48.
Much of the academic work that has been done and the interest shown in doing
more is constrained by lack of access to micro data that is representative of entities in an
individual country or across countries, and that is not missing critical information. This is
equally true in some instances for government analysts, who could do more tax policy
analysis with access to better data, but in many countries the degree of granularity (for
example, separating MNEs from purely domestic corporations) is not sufficient, and
availability of disaggregated data is quite different across countries.
49.
In many cases, information has been provided by businesses to tax
administrations, but the data are not processed and are not presently available for tax
policy analysis. The amount and detail of data currently made available for tax policy
analysis of BEPS behaviours differs across countries. Policy making could be better
informed with knowledge of, for example, corporate taxable income, income subject to
lower statutory tax rate or exemptions, corporate tax credits, and withholding tax bases
and revenues. The lack of distinction in the data between (i) MNEs (inbound / outbound)
and domestic-only corporations, and (ii) related and third party transactions, is also a
significant limitation in some countries. With increasing use of electronically filed tax
returns, the cost of processing the filed information will be reduced, but will still be
significant for many countries. Nonetheless, maximising the information and insight from
currently provided data, based on best practices in several countries would be beneficial.
The Action 11 Request for Input and the CFA WP2 survey identified what could be
considered as some best practices to improve data collection, processing, and economic
analysis in several countries, which are briefly described in Box 1.3.
Box 1.3. Some current best practices in using available data for BEPS analysis
Germany The Deutsche Bundesbank houses the Micro database on Direct Investment (MiDi),
which is a full census of foreign firms affiliates in Germany. It covers directly or indirectly
owned foreign affiliates of German parent companies above a certain size and ownership
threshold, including affiliates in developing countries. It contains unconsolidated (sometimes
consolidated) balance sheet data at the firm level, ownership variables (links between affiliates
and parent company), as well as other useful information such as liabilities to shareholders and
(or) affiliates; total balance sheet of affiliates and parent company; and shares in the assets and
liability positions of non-residents. The data includes profit after tax, but does not include other
income statement information, such as taxes or income/expense information for analysing
specific BEPS channels. The MiDi data is confidential and available only on site at the Research
Centre at the Central Office of the Deutsche Bundesbank in Frankfurt for approved research
projects and under strict confidentiality rules.
Sweden Government analysts in Sweden have access to detailed, anonymised taxpayer
information from filed tax returns. The firm-level information also includes balance sheet
information, the number of domestic employees, employee compensation, and the value of
tangible and intangible assets. The data distinguishes between MNEs and purely domestic firms,
with a further breakdown available by sectors. Information on foreign source income and related
party transactions (e.g. controlled foreign corporations), and the amount of R&D expenditures
undertaken in the country is not captured in tax returns. A useful practice that could be replicated
in other countries is using information available from other sources, such as commercial sources
to supplement the governments database. However, the Swedish data lacks detailed income
information on foreign subsidiaries.
Latin America Some tax authorities, such as in Argentina, request companies to present
special forms with information relating to transactions with related parties as well as with
entities located in non-cooperative jurisdictions, and non-related parties. The information covers
trade in goods and specifies prices, volumes and trading partners. Some Latin American
countries share data extracted from these forms (e.g. effective tax rates, intragroup transactions,
and transactions with parties located in tax havens) with international organisations, such as the
Inter-American Centre of Tax Administrations (CIAT), upon request, even if they are not shared
with the public. This suggests that there are opportunities for international organisations to
construct comparable data for developing countries20.
United States The United States Bureau of Economic Analysis (BEA) surveys both UNITED
STATES headquartered firms (and their affiliates abroad) and subsidiaries in the United States
of foreign headquartered firms. Both surveys are done on an annual basis with more detailed
benchmark surveys done every five years. MNE firms operating in the United States are required
by law to respond to these surveys, but the survey information is not shared with tax or financial
reporting authorities to enable verification, and confidentiality is assured. The aggregated data
are publicly available, and the micro data can be accessed by non-government researchers under
strict confidentiality rules. The current data does not enable full consolidation, can include some
double counting of affiliated entities, and does not identify hybrid securities that can be used for
shifting income. The data for each affiliate includes the country of location of its physical assets
as well as its country of incorporation, though neither of these are necessarily its country of tax
residence.
Box 1.3. Some current best practices in using available data for BEPS analysis
(continued)
The United States Internal Revenue Service (IRS) collects tax return information on controlled
foreign corporations (CFCs) of United States parents, plus tax return information on United
States subsidiaries of foreign parents. Some of the tax return data is compiled and tabulated for
published aggregate tables, and compiled micro data is available for certain government analysts
as well as certain approved non-government researchers. While most corporate micro data for
analysis are stratified random samples, in the international area micro data is more likely to be
for the population of multinational corporations. This enables a relatively complete picture of all
the CFCs of United States parents though some information on lower tiers may be missing. Data
are reported by country of incorporation and therefore the country of reporting for some entities,
particularly hybrid or stateless entities, does not necessarily reflect the country of tax residence.
For United States subsidiaries with foreign parents, data are generally limited to United States
activity. The CFC data is important in tax policy analysis particularly because it includes
linkages with affiliated entities.
50.
In 2011, the OECD Expert Group for International Collaboration on Microdata
Access was formed to examine the challenges for cross-border collaboration with micro
data. The resulting 2014 report21 notes: The challenge in the 21st Century is to change
practices in access to micro data so that the access services can cross borders and
support trans-national analysis and policy making. This is necessary to reflect the
increasingly international (global) reach and impact of comparative analysis and shared
policy making.
51.
Instead of suggesting new legislation, substantial new infrastructure, or new
technology for doing so, the report seeks smarter deployment of what already exists in
most OECD countries. Of course, in the micro-level tax return data context for BEPS,
data collection, dissemination and access is still not ideal. The report highlights the
importance of comparability and thus working towards homogeneity in data collection
across countries. It states that regional and international shared policy making needs the
support of evidence drawn from comparative analysis and/or the combined data of the
national parties to the collaboration. Working with available firm/group-level financial
statements, for example, reveals the heterogeneity across reporting standards for
accounting purposes worldwide. The level of detail (and whether this is provided
geographically or by segment) in which groups choose to report certain items like sales,
assets, profits and employees differs widely. There are also vast differences in the
mandatory information required by different tax authorities.
52.
It is important to emphasise that in most cases BEPS must be estimated rather
than directly observed from tax returns, financial accounts or customs records. For
example, identifying deviations from arms length pricing is a highly fact-intensive
analysis. Analysis of customs data for individual product pricing must distinguish
between sales to related parties and third-parties, and analysis of relatively unique
transfers of intangible assets requires analysis of comparable transactions. Comparisons
of profits and effective tax rates across thousands of companies require sophisticated
statistical analysis to truly separate tax aspects from real economic activity. Simple
descriptive statistics can only provide indications, rather than correlation or causation, of
potential BEPS behaviours, and statistical analysis of large databases may also only be
able to provide rough measures or indications of BEPS due to current data limitations.
Nonetheless, analysis of available data by statistical and economic analysis will provide
additional insights beyond descriptive statistics.
53.
Processed corporate tax return information for MNEs and their foreign affiliates
have been analysed by governments and, in some countries, academic researchers.
Linkage of tax return information with other business administrative records within
governments could increase the insights from existing data. However, access to existing
tax return information for tax analysis purposes is not always possible. In addition, many
government tax policy agencies and tax administrations have limited resources to conduct
empirical statistical and economic analysis. Some countries provide good examples of
what can be achieved as there are co-operative research programmes between government
and academics for analysis of data under strictly controlled and confidential
circumstances by academics with specific research programmes. This promotes robust
economic and statistical analysis based on access to firm-level data.
54.
Although having a large database with many observations is helpful for statistical
analysis, such a database may exclude important available information. Sometimes the
quality and depth of an analysis is more insightful than the quantity of observations
providing a non-random and/or less in-depth analysis. Thus, although examples of BEPS
behaviours by some major MNEs should not be extrapolated to all MNEs, detailed
information from public enquiries should be considered. Existing databases used for
economic analysis of BEPS should be checked to see if identified cases of BEPS are
included in the data. Finally, this assessment of the currently available data for economic
analysis of BEPS and potential countermeasures has identified significant data
limitations, data issues, and in some cases data gaps in the various data sources currently
available for analysing BEPS and BEPS countermeasures.
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1.
IMF (2014), Coordinated Direct Investment Survey: Project on bilateral asymmetries.
2.
BEPS Monitoring Group, submission to Action 11 Public Consultation, May 2015.
3.
Cederwall, E. (2015), Making Sense of Profit Shifting: Jack Mintz. Tax Foundation.
4.
OECD 2015. Implementing the latest international standards for compiling foreign
direct investment statistics: How multinational enterprises channel investments
through multiple countries.
5.
Koch, R. & Oestreicher, A. (2014), in response to the OECD BEPS Action 11

Request for Input.
6.
For financial accounting purposes, the objective is to record both current-year and
future-year tax liabilities (tax expense) associated with the current-year economic
activities of a firm. This differs from actual, current-year tax payments that may have
been generated by prior-year economic activities and do not include the future tax
payments from current-year economic activities. See Hanlon (2003) and Lisowsky
(2010).
7.
Koch & Oestreicher (2014).
8.
Prichard, Cobham and Goodall (2014).
9.
See e.g. Cobham & Loretz, (2014).
10.
See Weyzig (2014).
11.
E.g. Weyzig (2014), Buettner and Wamser (2007), Huizinga et al. (2008).
12.
Hope et al. (2013) examined firms responses to a United States accounting rule
change in 1998, which allowed firms to stop providing segment reporting at the
geographic level. The analysis found that firms that discontinued geographic segment
reporting were those that had lower effective tax rates, consistent with firms interest
in not reporting information that would potentially reveal tax avoidance behaviour. In
a similar paper, Akamah et al. (2014) find that firms with operations in tax havens are
more likely to aggregate their geographic segment disclosures.
13.
Cederwall, E. (2015), Making Sense of Profit Shifting: Jack Mintz. Tax Foundation.
14.
Cobham and Loretz (2014) use the largest commercially available database of
company balance sheets, ORBIS. Using a dataset of over 200,000 individual
companies in over 25,000 corporate, they state coverage is severely limited among
developing countries, and increasingly so for lower-income countries, and where
there are non-random reasons for information to be missing (e.g. accounts in low-tax
jurisdictions are less likely to be included in the dataset), this will result in systematic
biases to the results.2014
15.
In response to the OECD (2014) BEPS Action 11 Request for Input, Reinald Koch
and Andreas Oestreicher list some of the limitations: there is no distinction between
interest and dividend income, or between intra-group and third party transactions; the
publishers of the data rely on extent to which companies publish reports; there are
missing companies in the data as well as missing financial information from
companies that are included; it is not a random sample as it depends on information
released by business sector; and it can be assumed that information is lacking in
particular for entities that are used for tax planning purposes.
16.
Beer and Loeprick (2013) estimate profit shifting, and find significant effects, but
note the selection criterion reduced their sample by more than 60%, possibly
resulting in a bias as incomplete accounting information may be correlated to less
transparent corporate governance and more aggressive tax optimization. Such a bias
would likely result in an underestimation of findings on aggregate profit shifting.
17.
Commons Select Committee on Tax avoidance and evasion in the United Kingdom
(2015); House of Lords Select Committee on Economic Affairs (2013); The
Permanent Subcommittee on Investigations in the United States (2013); Inquiry into
Tax Disputes in Australia (2014).
18.
European Commission (2014).
19.
Michael Durst, submission to Action 11 Public Consultation, May 2015.
20.
BEPS Monitoring Group, submission to Action 11 Request for Input, September 2014
21.
(OECD 2014), OECD Expert Group for International Collaboration on Microdata

Access: Final Report.
2. INDICATORS OF BASE EROSION AND PROFIT SHIFTING 41
Chapter 2
Indicators of base erosion and profit shifting
Key points:
While there is a large and growing body of evidence of the existence of BEPS,
through empirical analysis and specific information relating to the affairs of certain
MNEs that has emerged from numerous legislative and parliamentary enquiries, the
scale of BEPS and changes in BEPS over time are difficult to measure.
This chapter presents six indicators to assist in tracking the scale and economic impact
of BEPS over time, while noting the strengths and limitations of each indicator. The
six indicators point to a disconnect between financial and real economic activities,
profit rate differentials within top global MNEs, tax rate differentials between MNEs
and comparable non-MNEs and profit shifting through intangibles and interest.
The use of any indicators to identify the scale and economic impact of BEPS can only
provide general indications and the interpretation of any such indicators must be
heavily qualified by numerous caveats.
While no single indicator is capable of providing a complete picture of the existence
and scale of BEPS, a collection of indicators or a dashboard of indicators can
provide broad insights into the scale and economic impact of BEPS and provide
assistance to policymakers in monitoring changes in BEPS over time.
This chapter also provides calculations for the indicators, using samples of existing
available data. The data used to produce these calculations are affected by the
considerable limitations of existing available data sources described in detail in
Chapter 1. As a result, the indicators are illustrative rather than definitive, as the
insights that can be discerned from these indicators are greatly affected by the
limitations of the existing available data.
Future access to more comprehensive and improved data would allow much greater
insight to be obtained from the use of these indicators as well as two potential
indicators that could be constructed with improved future data.
The six BEPS indicators show strong indications of BEPS behaviours using different
sources of data, employing different metrics, and examining different BEPS channels.
When combined and presented as a dashboard of indicators, they provide evidence of
the existence of BEPS, and its continued increase in scale. Improved data availability
can provide better insights in the future.
42 2. INDICATORS OF BASE EROSION AND PROFIT SHIFTING
2.1 Introduction
55.
One of the key components of Action 11 is the development of indicators that
can be used to identify the scale and economic impact of BEPS, to track changes in BEPS
over time and to monitor the effectiveness of measures implemented to reduce BEPS.
56.
The first step in developing useful indicators of BEPS is defining the concept.
BEPS relates to arrangements that achieve no or low taxation by shifting profits away
from the jurisdictions where the activities creating those profits take place or by
exploiting gaps in the interaction of domestic tax rules where corporate income is not
taxed at all. No or low taxation is not per se a cause of BEPS, but becomes so when it is
associated with practices that artificially segregate taxable income from the activities that
generate it. The important distinguishing characteristic of BEPS is tax planning strategies
that result in a disconnect between the geographic assignment of taxable profits and the
location of the underlying real economic activities that generate these profits. As a result
of this disconnect, MNEs may be able to shift profits from higher-taxed countries to
lower-taxed countries without a corresponding material change in the way the taxpayer
operates, including where products and services are produced, sales and distribution
occur, research and development is undertaken, and how the taxpayers capital and labour
are used. In some cases, BEPS involves placing just enough economic activity in a
jurisdiction to attempt to justify the tax planning strategy.
57.
An overriding objective in the construction and analysis of BEPS indicators in
Action 11 is to develop metrics that help portray the extent of practices that artificially
segregate taxable income from the activities that generate it.
2.2 Indicator concept

58.
Dictionary definitions of indicators include:

An index that provides an indication, especially of trends
A meter or gauge measuring and recording variation
A device to attract attention, such as a warning light
An instrument that displays certain operating conditions such as temperature
A pointer on a dial showing pressure or speed
59.
As with any gauge, the degree of precision depends on the available information
and the accuracy of the measurement tools. Given currently available data and distortions
caused in that data by BEPS which is being measured, at this stage BEPS indicators can
only provide some general insights into the scale and economic impact of BEPS, but will
necessarily lack the precision that may become possible if more comprehensive and
improved data sources were to be used in the future (see Chapter 1 for a detailed
assessment of the limitations of currently available data). More refined analysis and
estimates of BEPS, based on multi-variate statistical estimation, are possible with
currently available data, but also involve significant uncertainties and limitations (see
Chapter 3 for a detailed examination of the approaches to undertaking such estimation).
Over time, the proposed indicators will provide a general sense of the trend in a number
of key metrics associated with BEPS behaviours.
60.
The concept followed in developing the BEPS indicators has been to create a
dashboard of indicators that provides an indication of the scale of BEPS and help
policymakers monitor changes in the scale of BEPS over time. The indicators are crude
proxies for a more refined and sophisticated estimate of the dimensions of BEPS. Given
currently available data, indicators are probably the appropriate approach to showing
consistent trends on the general scale of BEPS. Multiple indicators can help identify
trends regarding the scale of BEPS and changes in BEPS and specific BEPS behaviours.
An important requirement of an indicator is that it provides more signal than noise in
measuring the scale of BEPS. To the extent that various potential indicators provide the
same signal (i.e. a high correlation) on the same dimension, then only the clearest
indicator should be used.
61.
While no single indicator can be used to provide a complete picture of the scale or
economic impact of BEPS, if a number of separate indicators referring to different
dimensions are pointing in the same direction, they may provide more solid information
on the presence of and trends in BEPS.
2.3 Indicators as a component of Action 11

62.
The following chart provides an overview of the different analyses carried out
under Action 11. This chapter presents six BEPS indicators that can be developed from
current data, which is identified as the current state category in the chart. Also included
here is the analysis of the scale and economic impact of BEPS that is addressed in
Chapter 3 on the economic analysis of BEPS. The current data limitations are a
significant challenge to the development of both indicators and economic analyses. Even
within tax administrations there is limited information on the operations of MNEs. In a
recent country survey conducted by the Committee on Fiscal Affairs WP2 on BEPSrelated research, only eight countries, out of 37 respondents, could report the total amount
of tax revenue collected from MNEs operating in their country.
63.
Over time, to the extent that new data sources become available, it is expected
that more accurate estimates of the scale and economic impact of BEPS and the impact of
countermeasures will be possible. Many of the indicators in this chapter have been
developed not only with existing available data in mind, but with a view towards how
such indicators could be enhanced if more comprehensive and improved data were to
become available in the future. The future state in the chart represents what would be
considered the next step in the development of more effective BEPS indicators and
estimation methodologies. In this future state, many of the indicators would provide
even more insight and more targeted indicators and deeper economic analyses could be
developed from the emergence of new data sources. In the ideal state, the indirect
indicators of BEPS would evolve into more accurate, direct estimates of BEPS and the
effectiveness of the BEPS counter-measures. In the ideal state, additional and more
comprehensive information derived from actual tax return data would be necessary to
achieve the most precise estimations of BEPS and its economic impact.1
64.
One important outcome of developing BEPS indicators with currently available
data is a clearer understanding of the usefulness and limitations of the current data. These
insights are discussed in more detail in Chapter 1s assessment of current data. Such an
understanding is helpful in informing any consideration of what future new data might be
needed.

Figure 2.1. Future path of BEPS measurement
Current State
Indicators of
BEPS with
available data
Analyses of
economic
impact of BEPS
and countermeasures with
available data
Future State
New and
refined
indicators with
better data
Refined
analyses of
economic
impact of BEPS
better data
Ideal
True measures of
BEPS and
countermeasures
Signal-to-noise ratio expected to increase as data quality increases

2.4 Guidelines for indicators
65.
The following are specific guidelines that were used in developing BEPS
indicators:
66.
A number of different indicators should be included to form a dashboard of
BEPS indicators. Multiple indicators showing the general scale of BEPS and particular
BEPS channels are needed given limitations in currently available data. The six indicators
include indicators based on both macro (aggregate) and micro (firm-level) data. Certain
indicators will be more useful than others for understanding the effectiveness of different
67.
Alternatives should be considered for summarising indicators. A single
indicator may provide information on both the level of BEPS and changes in BEPS over
time. A ratio may be the most effective way to indicate the level, while trends or changes
in time may be more effectively presented as an index with reference to an initial year
value of the indicator.
68.
Financial and tax flows should be related to economic activity. The most useful
indicators of the general scale of BEPS should link BEPS-related financial and tax flows
to measures of real economic activity, such as GDP, sales, employment or the amount of
capital used by firms. In other words, in constructing indicators to be used in evaluating
BEPS, it is important to distinguish between shifts in profits among countries that reflect
changes in real economic activity and BEPS-related transfers of profits that are not in
response to changes in the location of real economic factors, labour and capital, that
produce the income. It should be understood, however, that any indicator of BEPS, such
as income relative to assets, sales, operating expenses or employment or any other
economic measure will vary across countries for a number of reasons unrelated to BEPS.
The economic sources of variation in profits relative to assets, for example, include
differences in the ratio of capital to labour used in different businesses and locations,
differences in market conditions, differences in profitability over the economic cycle, and
differences in factor productivity.
69.
Indicators should distinguish between BEPS and real economic effects of
current-law corporate income tax features. Indicators should focus on tax shifting due to
BEPS, not real economic responses to tax rate differences that reflect the impact of
current-law provisions adopted by legislators, including incentives to expand business
operations in their country. Legislated or discretionary tax incentives can have an
important impact on reported corporate income tax payments that reflect the location of
real economic activity. The challenge in developing indicators is distinguishing between
the economic effects and BEPS. However, artificial cross-border arrangements to exploit
legislated differences in tax structures, including statutory tax rate differences, are
considered BEPS.
70.
The BEPS indicators should be able to be refined with potential new data
sources. The initial indicators are based on currently available data for a large number of
countries. New methodologies and data sources will be identified going forward to
analyse the scale of BEPS and the effectiveness of countermeasures to reduce BEPS. In
some cases the initial indicators could be calculated from new data sources which could
provide more targeted and accurate information for estimating BEPS.
71.
Bad indicators should be avoided; caveats should be highlighted. Almost as
important as developing effective indicators of BEPS is the need to avoid using poor,
imprecise and misleading indicators. Indicators should have a high signal-to-noise ratio.
In other words, indicators should provide a high ratio of information about BEPS
behaviours relative to real economic effects and other non-BEPS factors. Any indicator
will have limitations which should be highlighted. All indicators will require careful
interpretation in analysing BEPS.
72.
Indicators should be simple, clear and timely. Indicators will be used by
policymakers, so they should be simple, clear and well-described. However, their caveats
and limitations should also be clearly noted. Where possible, indicators should not have
significant time lags.
73.
Indicators should be adaptable to extended uses. The initial indicators focus on
the global perspective, but some indicators should have the potential to be extended to be
used by individual countries or for specific industries. The development of disaggregated
indicators should be considered for future analysis.
2.5 A significant caution

74.
One of the biggest challenges to developing and interpreting indicators is that
BEPS taints available measures of real economic activity such as corporate income tax
bases, financial accounting statements, and even national aggregate measures of
economic activity in the corporate sector. This is a serious limitation that is difficult to
overcome with current data and methodologies available for measuring BEPS.
75.
The data used to measure most of the indicators unavoidably mix the influence of
real economic activities, corporate income tax policies adopted to encourage business
development, and BEPS.
76.
It is important to note that each indicator provides a single perspective of the scale
or composition of BEPS based on currently available data. The indicators are not
equivalent to coefficients in regression equations used to measure the responsiveness of
BEPS to corporate income tax rate differentials. A regression equation is designed to take
into consideration or control for the simultaneous impacts of other economic variables
on BEPS. However, in most cases, the indicators do provide high-level controls for
some of the major non-BEPS factors through the use of ratios of tax variables to

economic measures and differentials in tax measures between affiliates and their MNE
worldwide group measures.
77.
These limitations must be kept in mind in interpreting the information that each
indicator or combination of indicators provides in helping portray the magnitude of BEPS
and evaluating progress over time in reducing BEPS. It may be the case that, in the future,
new and better data sources may help overcome some of these data limitations.
2.6 Six indicators of BEPS

78.
Six BEPS Action 11 indicators are described in this section. The discussion for
each indicator includes a description, the rationale for the indicator and the data source
that can be used to estimate the indicator. Calculations of the indicators use existing
available data. The data used to produce these calculations are affected by the
considerable limitations of existing available data sources outlined in detail in Chapter 1.
As a result, the indicators are designed to be illustrative rather than definitive, as the
insights that can be discerned from these examples are greatly affected by the limitations
of the existing available data. Each indicator also contains a statement of some of the
important issues in estimating and interpreting the indicator, including limitations which
might be considered a type of user-warning.
79.
This chapter presents six specific indicators in the following five categories:
A. Disconnect between financial and real economic activities

1. Concentration of high levels of foreign direct investment (FDI) relative to GDP
B.
Profit rate differentials within top (e.g. top 250) global MNEs
2. Differential profit rates compared to effective tax rates
3. Differential profit rates between low-tax locations and worldwide MNE
operations
C.
MNE vs. comparable non-MNE effective tax rate differentials

4. Effective tax rates of large MNE affiliates relative to non-MNE entities with
similar characteristics
D. Profit shifting through intangibles

5. Concentration of high levels of royalty receipts relative to research and
development (R&D) spending
E.
Profit shifting through interest

6. Interest expense to income ratios of MNE affiliates in high-tax locations
80.
In addition, two possible additional indicators are discussed that could be
estimated from improved future data when it becomes available.
81.
Indicators 1 and 5 are based on macro-level data on a country-by-country basis.
Indicators 2-4 and 6 are calculated from MNE, firm-level financial information from the
ORBIS database2 for unconsolidated affiliates and/or worldwide consolidated groups.
82.
In order to partly distinguish between BEPS and real economic impacts, most of
the indicators are constructed using various comparison groups, such as different groups
of countries, different groups of MNE affiliates or worldwide MNE measures vs. affiliate
measures. The objective is to compare measures where BEPS is likely to be relatively
important to measures that are more likely to reflect real economic activities. The use of
these comparison groups is designed to increase the signal-to-noise ratio of the indicators.
2.7 General structure of the indicators

83.
This section discusses general advantages, limitations, issues and possible
extensions that apply generally to the indicators. In addition, there are more specific
comments about these dimensions in the introduction to the indicator categories. Finally,
there are additional considerations that are discussed for specific indicators.
2.7.1 General advantages

84.
Some of the advantages of using indicators include the following:

Indicators can be calculated historically and on an annual basis to track the
direction of changes in BEPS over time.
Some indicators can be updated relatively quickly from data available on a timely
basis.
Indicators can be calculated in the future with more accurate, comprehensive
data, while still tracking indicators using existing data.
Indicators can be calculated, refined and extended by academic and other
researchers to improve the indicators ability to measure BEPS. This will
contribute to the transparency of the process.
Use of multiple indicators recognises that there is no single metric currently
available to precisely measure the scale of BEPS and changes in BEPS over time.
When multiple indicators provide similar results, there may be more substantial
evidence of the presence of profit shifting.
2.7.2 General limitations

85.
While there may be additional limitations that apply to a particular indicator, there
are several important limitations that apply more broadly to all of the indicators. These
limitations need to be included in any discussion of the indicator results.
Non-tax economic factors are likely to explain a portion of the observed crosscountry and over-time variations in the indicators of BEPS. For example, both
firm-level and aggregate data will be influenced by the economic cycle, which
may contribute to the variation of the indicators over time, independent of
BEPS. Factors such as the size of a country, the level of its GDP per capita or
its GDP growth could explain a part of the observed variation across countries.
The indicators must be evaluated with this key limitation in mind. For example,
Indicator 1 based on FDI data needs to be interpreted with more caution than the
other indicators because attracting high levels of real FDI may be a result of an
attractive investment climate in the recipient country.
There are important limitations related to the availability and quality of the
reported data: missing affiliates in financial data, incomplete data, variation in
how data is reported by country, changes in the way aggregate variables are
measured over time (FDI, for example).
2.7.3 General extensions

86.
There are common options for extending the indicator analysis that apply to all
indicators:
Indicators are designed so that they can be calculated with currently available
data or with new data sources that become available in the future. As more
accurate and disaggregated data becomes available, the ratio of signal-to-noise
for individual indicators is likely to improve.
One possibility for extension could be a combination of tax return information
available to tax administrations with the publicly available financial information
used in estimating the firm-level indicators. Tax administrations could use the
combined information to estimate specific indicators and track the impact of
BEPS countermeasures over time.
87.
In developing specific indicators, single global indicators could be extended to
specific countries or industries (e.g. firm-level data could be analysed by major industry).
This disaggregation, if permitted by the data, could help control for some of the variation
in real economic factors.
88.
The following sections describe each of the six specific indicators, as well as the
two possible future indicators using future data. Annex 2.A1 shows formulas for
calculating the indicators.
2.8 Disconnect between financial and real economic activities

89.
The indicator in this category uses macro (aggregate) data to develop an indirect
indicator of BEPS using foreign direct investment (FDI) data.
90.
FDI measures cross-border investments by a resident of one country (direct
investor) in an enterprise (direct investment enterprise) in another country. Importantly,
the investments being measured are those representing a lasting interest in the
investment enterprise. The included investments are between affiliates with at least a 10%
ownership link. In other words, FDI measures investments by related parties.
91.
The indicator uses FDI stocks (positions) that represent the cumulative annual net
investments of foreign direct investors in a country. In theory, the stock reflects all prior
annual investments and disinvestments in a country. FDI stocks can be broken down to
debt and equity direct investments.
2.8.1 Specific considerations for indicators of financial and economic

disconnects
2.8.1.1 Strengths
Indicator based on important global economic variables which include BEPS
financial flows.
Measures previously cited by many BEPS researchers.
Can be easily explained.
2.8.1.2 Limitations
FDI information includes financial stocks, as well as stocks related to real
economic activities. The indicator has to be carefully evaluated in reaching
conclusions about the presence of BEPS. In addition, not all BEPS behaviours
are captured by FDI statistics.
Countries report transactions related to BEPS, such as transactions with special
purpose entities, in different ways. This introduces cross-country variations in
FDI based on reporting differences.
2.8.1.3 Issues
FDI is measured relative to GDP. However, other measures of real economic
activity, such as trade flows (both imports and exports), and annual capital
formation could be used in constructing the indicator.
Indicator 1: Concentration of foreign direct investment relative to GDP
Description: This macro-economic indicator is the ratio of the stock of FDI to a
countrys GDP, a measure of real economic activity. The indicator compares the FDI
ratio in countries with relatively high values of FDI to GDP ratios to the same ratio in the
rest of the included countries. Two versions of the FDI measure are presented.
The first is net FDI equal to the FDI stock in a country owned by foreign investors from
OECD countries minus the domestically-owned FDI stock invested in OECD countries.
Countries with high ratios of net FDI to GDP could be characterised as countries that are
the ultimate destination of the inward FDI that are significantly above the average.
The second FDI measure is gross inward FDI. Countries with high ratios of gross FDI to
GDP include both ultimate destinations (countries with high ratios of net FDI to GDP)
and conduits (countries with low ratios of net FDI to GDP) with the inward or flowthrough FDI that are significantly above the average.
Both versions of the indicator are presented below and show similar differences between
the high-ratio countries and the remaining countries and similar trends.
Rationale: FDI measures cross-border investments among related enterprises. The stock
of FDI includes investment related to both BEPS and real economic activity. Significantly
high concentrations of FDI to GDP in a country or group of countries may provide an
indication of BEPS.
Data source: OECD Foreign Direct Investment Statistics. The data is the inward and
outward FDI stock from and to OECD countries. The FDI stock data is available for 214
countries identified in the OECD database.
Box 2.1. Indicator 1: Concentration of foreign direct investment relative to GDP

Background: FDI financial flows related to BEPS are expected to result in a relatively high
ratio of FDI stocks to GDP.
Description: This indicator compares the average net or gross FDI stocks per euro of GDP in
the countries with relatively high ratios of FDI to GDP. In the case of the net FDI calculation,
the countries with relatively high ratios are those with ratios over 50% of GDP; for the gross FDI
calculation, relatively high ratios are defined as ratios in excess of 200% of GDP. The indicator
is the weighted average value of the FDI ratio for the countries with the highest ratios divided by
the weighted average ratio for the remaining countries. The countries in the 2012 rankings are
used to calculate the prior-year indicator values.
Data used: OECD Foreign Direct Investment Statistics. The FDI stock variables are total
inbound and outbound FDI positions to and from OECD countries. The FDI stock is available
for 214 countries in the OECD database (in 2012). The source is OECD FDI Statistics 2014. As
a result of the transition from the 3rd edition of the Benchmark Definition of FDI (BMD3) to the
4th edition (BMD4), the data on bilateral FDI positions for 2013 and 2014 is not yet available
for all OECD countries.
Results:
Both the net and gross FDI indicators more than doubled between 2005 and 2012
showing similar profiles over the period.
The 2012 value of the net FDI indicator shows that the amount of net FDI per euro of
GDP in the top group of countries was, on average, 99 times higher than the average
ratio for the remaining countries. The top group of countries are mostly countries with
no or low corporate income tax rates or preferential tax regimes. The top group for the
gross FDI indicator also includes countries that are often characterised as conduit
countries for FDI.
The indicator shows a concentration of FDI in a select group of countries that is
disproportionate to the real economic activity (as measured by GDP) in these countries.
There are 14 countries in 2012 with net FDI/GDP ratios above 50%; 13 countries have
gross ratios above 200%.
The top group of countries in 2012 for the net FDI indicator has an average net FDI
stock that is twice as high as GDP; for the gross FDI indicator, the average gross FDI is
four times the size of GDP.
In 2012, the high-ratio countries accounted for 29% of gross FDI positions and 49% of
net FDI positions.
Figures 2.2 A and B show the average (weighted by GDP) net and gross FDI to GDP ratios for
the countries with relatively high ratios and the remaining countries. The indicator is the ratio of
these two figures, shown in the graphs as the height of the two arrows in 2005 and 2012.
Box 2.1. Indicator 1: Concentration of foreign direct investment relative to GDP

(continued)
Figure 2.2. Indicator 1: Concentration of foreign direct investment relative to GDP
A. Net FDI
Remaining countries
High-ratio countries
250%
500%
200%
400%
Gross FDI to GDP ratio
Gross FDI to GDP ratio
B. Gross FDI
150%
100%
99 times higher
50%
0%
2005
2006
2007
300%
200%
100%
38 times higher
2008
2009
2010
2011
2012
Remaining countries
0%
2005
27 times higher
13 times higher
2006
2007
2008
2009
2010
2011
2012
Table 2.1 presents the values for both versions of Indicator 1 for 2005-2012.
Table 2.1. Indicator 1: Concentration of foreign direct investment relative to GDP
Year
2005
2006
2007
2008
2009
2010
2011
2012
Indicator 1 Net FDI

37.6
36.3
37.4
31.9
41.9
44.9
43.1
99.2
Indicator 1 Gross FDI

13.0
13.9
15.9
17.4
18.9
21.1
23.4
26.7
Caveats:
FDI positions include both real investment and purely financial transactions, including
mergers and acquisitions, unrelated to current economic activity. Only a portion of the
financial transactions may be related to BEPS. The indicator cannot distinguish
between BEPS and other transactions related to real economic activity, but a high
indicator may flag potential BEPS.
The mixture of BEPS and real economic activity may vary between developing and
developed countries. For example, developing countries with attractive investment
climates may have relatively high FDI stock/GDP ratios. This needs to be taken into
consideration in interpreting variations in the indicator across countries.
FDI stock is not as closely related to BEPS as FDI income, but the FDI income to GDP
ratio is much more volatile than the FDI stock to GDP ratio and it is also more affected
by the economic cycle.
The indicator can be refined as new information becomes available, such as the separate
reporting of FDI for special purpose entities and mergers and acquisitions.
Availability of data on bilateral FDI flows is not constant over time.
2.9 Profit rate differentials within top global MNEs

2.9.1 Overview
92.
The two indicators in this category are calculated using unconsolidated affiliate
and consolidated worldwide group financial statement information. Each of the two
indicators is constructed as a relative measure. For example, the indicators compare profit
rates (defined as a ratio of pre-tax income to a measure of economic activity, such as a
firms assets) of firms or a group of firms in lower-tax and higher-tax locations
determined by effective tax rates (i.e. income tax expense divided by pre-tax income).3
93.
The use of ratios of profit to measures of economic activity recognises that BEPS
is characterised by a disconnect between where profit is reported and where the economic
activity generating that profit occurs.
94.
The denominator in the profit rate, the economic activity variable, could be
measured by various inputs (e.g. assets, employment, labour compensation, operating
expenditures) or a measure of output (e.g. sales). The indicators presented here use assets
to measure economic activity, while recognising that other factors can contribute to
economic value added including intangible assets which generally may not be included in
reported total assets or may be understated.
Box 2.2. How should economic activity be defined?
There is no single best measure (conceptually or reported) from publicly-available firm data that
summarises where the economic activity (value added) of a firm occurs for use in the profit
rate calculations. While value added by a company is the most comprehensive measure of the
economic activity of a firm, it can only be calculated indirectly from data available from
financial statements. In the public reports, all of the metrics are reported where the entity is
incorporated, not where the assets and employment are located, or where the customers are
located:
Assets are most directly related to the use of capital that generates the income subject
to the corporate income tax. However, asset measures in financial statements
generally tend to significantly understate the value of intangible assets, a major
contributor to MNE worldwide income. Firm assets also exclude the value of public
infrastructure and other government provided services which are part of a fullyspecified production function. Assets include those financed by both equity and debt,
while corporate income tax is generally on net equity income.
Employment and labour compensation are directly related to labour costs, a second
component of value added created by the capital and labour used by a firm. However,
labour costs are subtracted in determining net income and are not in the taxable
corporate net income base.
Sales may be an indirect measure of the contribution of both labour and capital to
value added, but it includes revenue paid to suppliers in addition to the income paid to
capital and labour. Sales are the firms total sales, but are not reported where the
customers are located. It should also be noted that the value of sales can be distorted
by BEPS through transfer pricing.
Operating expenditures may be a useful measure of economic functions in some cases
such as service industries. The value may be distorted by BEPS through transfer
pricing.
95.
The indicators in this category differ primarily in the groups of firms used to
compare profit rates. The different groups used in the two indicators are: 1) MNE
affiliates in higher-tax and lower-tax countries, and 2) combined affiliates in lower-tax
countries vs. the MNEs worldwide operations. For each indicator, tax variables are used
to either identify groups or to compare profit rates directly to effective tax rates (ETRs) in
the calculation of the indicators.
2.9.2 Specific considerations for profit rate indicators

2.9.2.1 Strengths
Indicators use backward-looking financial ETRs, not headline statutory tax rates
which often overstate the marginal tax rate on shifted profits.
Firm-level data can be used to help control for non-BEPS influences that are
specific to an unconsolidated affiliate or entity, although non-tax factors will
affect the indicator.
Using both MNE group and affiliate-level data in calculating an indicator holds
many of the MNE-specific, non-tax factors constant, which assists in
segregating BEPS effects from real economic effects.
Based on the theory of profit shifting driven by tax rate differentials across
locations, this construct is similar to the approach used in academic studies of
income shifting opportunities.
2.9.2.2 Limitations
Measures are dependent on available financial reporting data, so may not have
information for all affiliates and may have limited geographic coverage.
Financial statement data is primarily limited to public corporations, not
privately-held corporations or partnerships.
The profit rate is calculated based only on assets, and is not adjusted for
functions and risks.
The calculations of profit rates require information on tax expense, pre-tax
income and assets. The availability of this information may vary for MNE
affiliates within a single country, as well as across countries due to variations in
reporting requirements.
Information on the economic factors has data issues (e.g. most intangibles are
not in total assets).
The tax variable (average effective tax rates) is calculated from reported
financial statement income tax expense (current tax expense plus deferred tax
expense), not actual taxes paid or tax liability on current-year income.
These indicators provide only indirect evidence of BEPS. Reported tax expense
(or actual taxes paid, if available) already includes the effects of BEPS and nonBEPS, resulting in lower reported taxes in higher-tax countries and higher
reported taxes in lower-tax countries. The net reduction in worldwide taxes of
MNEs, either from shifting income among countries with different tax rates or
from the net reduction of reported worldwide taxable income, is not directly
measured in the indicator.

Publicly-available information is based on accounting data, not tax variables.
Data from the country of incorporation may not align with the country of tax
residence.
2.9.2.3 Issues
Averages may obscure the behaviour of a subset of companies that are
undertaking BEPS. Where available, the distribution of the indicator values
could be examined for the influence of significant outliers. Comments on the
discussion draft suggested evaluating the databases on a case-by-case basis to
remove outliers that have relatively large values that distort the indicator
measures, but cautioned removing outliers given the somewhat arbitrary
methods used to identify and remove outliers.
2.9.2.4 Possible extensions

Where available, substitute tax data compiled by tax administrations for firmlevel financial statement data.
Expand to a larger list of top corporations.
Include a random sample of smaller companies from similar sectors. This could
provide additional insights into differences in BEPS behaviour by size of firms.
If data is available, disaggregate by country or industry.
Conditional on data availability, alternative measures of economic activity, such
as labour compensation, employees, operating expenditures or sales could be
used in calculating profit rates.
A significant number of firms in the financial report databases report negative
annual profits that produce negative ETRs. The indicator values could be
calculated with and without the negative values. When comparing different
profit groups, alternative indicators such as the ETRs for each group could be
calculated.
Indicator 2: High profit rates of low-taxed affiliates of top global MNEs
Description: This indicator shows the percentage of income earned by affiliates in lowertax countries with higher profit rates, by comparing the profit rate (i.e. profits/assets) to
the ETR (i.e. tax expense/profit) of MNE affiliates for top global MNEs.
For each affiliate, a profit rate differential is compared to the affiliates ETR differential.
The profit rate differential is the difference between the affiliates profit rate and its MNE
group worldwide profit rate; the ETR differential is the difference between the affiliates
ETR and its MNE group worldwide ETR.
Lower-tax affiliates are affiliates with ETRs that are less than the MNE groups ETR
and higher-profit affiliates have profit rates that exceed the worldwide MNE groups
profit rates. Indicator 2 focuses on the percentage of total reported income being earned
by those lower-tax, higher-profit affiliates.
Rationale: When BEPS occurs, it is expected that the profit rate differential in lower-tax
affiliates will be positive. In other words, profit rates of the lower-tax affiliates will
exceed the worldwide profit rate of the MNE. In terms of ETRs, it is expected that the
ETR differential will be negative, where BEPS is occurring, because the affiliates ETR
will be less than the MNEs worldwide ETR.
Data source: Unconsolidated affiliate and worldwide consolidated group financial
statement information for the top 250 global MNEs reporting information is used to
calculate the indicator.
Box 2.3. Indicator 2: High profit rates of low-taxed affiliates of top global MNEs
Background: BEPS involves shifting profits from affiliates in high-tax countries to affiliates in
low-tax countries.
Description: This indicator summarises the relationship between the profitability of MNE
affiliates in a country and their ETRs. The indicator is equal to the share of total pre-tax income
in the sample reported by affiliates in higher-profit, lower-tax countries. In Figure 2.3, the
affiliates that are in the lower-tax, higher-profit category are represented by the shaded area in
the southeast quadrant of the graph.
Data used: The calculation uses unconsolidated affiliate and worldwide consolidated group
financial information on tax expense, pre-tax profits, and assets from financial reports for 250 of
the top global MNEs (by sales) and their affiliates. The calculations are done for over 2,300
country-level affiliate groups that include over 10,000 affiliates. Financial groups are not
included.
Results:
In 2011, lower-tax, higher-profit affiliates accounted for 45% of the total income
reported by all affiliates in the sample. 45% is the value of the indicator. These affiliates
accounted for 33% of total affiliates.
The affiliate groups in the northwest quadrant, higher ETRs and lower profit rates,
accounted for only 7% of the total income. If BEPS is occurring, a portion of the
income in this quadrant and in the northeast quadrant may have been shifted to the
southeast quadrant (lower-tax, higher-profit affiliates).
The value of the indicator increased by 32% between 2007 and 2011.
Figure 2.3 explains the indicator in terms of the four quadrants in the diagram. The lower-right
quadrant is the area indicating potential BEPS. This is the quadrant that includes affiliate groups
with lower ETRs and higher profits, relative to the worldwide MNE measures. The figure also
identifies the percentage of total affiliate pre-tax income reported in each quadrant. For example,
affiliate groups in the southeast quadrant account for 45% of the total income in 2011.
Box 2.3. Indicator 2: High profit rates of low-taxed affiliates of top global MNEs
(continued)
Higher ETR / higher profits
7% of total income
profit rate = 6%
22% of total income

profit rate = 18%
26% of total income

profit rate = 10%
45% of total income

profit rate = 22%
Lower ETR / lower profits
Lower ETR / higher profits
Higher ETR / lower profits
Negative
Effective tax rate differential
Positive
Figure 2.3. Indicator 2: High profit rates of low-taxed affiliates of top global MNEs
Negative
Positive
Profit rate differential
Caveats:
While the indicator partially controls for differences in the profitability of affiliates,
by comparing them to their MNEs worldwide profitability, it cannot differentiate
between higher profit rates due to BEPS and higher profit rates possibly needed to
ensure competitive after-tax rates of return on investments.
The indicator does not control for or hold constant other factors that influence BEPS,
including variation in affiliate characteristics, such as size and industry.
Indicator 3: High profit rates of MNE affiliates in lower-tax locations

Description: This indicator compares the profit rate (i.e. profits/assets) of top global
MNE affiliates in low-tax rate jurisdictions with the MNEs worldwide profit rate. Lowtax countries are defined as countries with the lowest affiliate ETRs, accounting for 20%
of the MNE groups worldwide assets.4
Rationale: This indicator uses both group and firm-level financial data of the largest
global MNEs to show the extent to which reported profits differ between low-tax rate
locations and the profit rate of the worldwide group.
An index number above one shows that affiliates in low-tax rate countries have higher
reported profit rates than the worldwide rate for their MNE group, which could be an
indication that profit shifting into low-tax rate locations is occurring. A higher number is
a stronger indication.
Data source: Financial information of top 250 non-financial MNEs and their affiliates.
Box 2.4. Indicator 3: High profit rates of MNE affiliates in lower-tax locations
Background: The presence of BEPS is expected to result in relatively high profit rates in
relatively low-tax locations. Indicator 3 defines relatively low-tax locations in terms of the
country-by-country distribution of a MNE groups worldwide assets.
Description: This indicator compares the profitability of a MNEs affiliates in lower-tax
countries to the profitability of the MNEs worldwide operations. Affiliates ETRs (weighted by
assets) are calculated for each country where a MNE has affiliates; countries are ranked by ETR
for each MNE. Profit rates are calculated for lower-tax locations, defined as countries with the
lowest ETRs that account for 20% of the MNE groups worldwide assets. The relative
profitability of a MNEs affiliates in lower-tax countries is the profit rate in these countries
divided by the MNEs worldwide profit rate. The indicator is the weighted (by assets) average
profit rate ratio over all MNEs in the sample.
Data used: The calculation uses financial information on tax expense, pre-tax profits, and assets
from financial reports for 250 of the top global MNEs and their affiliates. The calculations are
done for over 170 MNE groups and their 10 000 affiliates.
Results:
In 2011 profit rates of affiliates in lower-tax countries of 171 of the largest MNEs
were on average almost twice as high as their worldwide MNE groups profit rates
(ratio of 2.0).
For the same year, the top 25% of the MNE affiliates, ranked by relative profit rates,
had ratios exceeding 2.4; the ratio exceeded 4.4 for the top 10% of the MNE affiliates.
The indicator increased by 3% between 2007 and 2011.
Table 2.2 summarises descriptive statistics for 2007 and 2011.
Table 2.2. Indicator 3: High profit rates of MNE affiliates in lower-tax locations
2007
2011
Indicator 3
1.9
2.0
Highest 25% have ratios above
1.9
2.4
Highest 10% have ratios above
3.2
4.4
Caveats:
Relatively high profit rates in lower-tax countries may reflect differences in real
economic activity for affiliates in lower-tax countries relative to the MNEs
worldwide operations, but a significantly higher profit rate in lower-tax countries is a
potential indication of BEPS.
There are MNEs in the database that may have relatively low indicator values because
of missing affiliates with relatively high profit rates. In these cases, the potential for
BEPS may be understated.
2.10 MNE vs. comparable non-MNE effective tax rate differentials

96.
The indicator in this category compares the backward-looking effective tax rates
(ETRs) for large affiliates of MNEs with the ETR of non-MNE entities with similar
characteristics. Indicator 4 uses affiliate-level unconsolidated financial statement data.

Indicator 4: Effective tax rates of large MNE affiliates relative to non-MNE entities
with similar characteristics
Description: Indicator 4 compares the ETRs of large MNE affiliates with non-MNE
entities with similar characteristics in the same country. The indicator measures the extent
to which large MNE affiliates have lower ETRs than comparable non-MNE entities.
This indicator shows the estimated ETR differential, due to mismatches between tax
systems (e.g. hybrid mismatch arrangements), national preferential tax treatments if
MNEs use them to a different extent than non-MNE entities, and/or profit shifting in
cases where profit shifting does not proportionally change financial tax expenses and
reported pre-tax profits. The estimated ETR differential controls for a number of firm
characteristics, including profitability, country, industry, size, patenting activity and
position in the corporate group. The ETR equals tax expense divided by reported net
income. Large firms are defined as firms with more than 250 employees.
If negative, the indicator would show that large MNE affiliates have lower ETRs than
comparable non-MNE entities. This is a possible indication of BEPS.
Rationale: In the presence of some BEPS behaviours, the taxable income of MNE
affiliates in high-tax countries is expected to be reduced relative to the affiliates reported
financial income, such as the use of hybrid mismatch arrangements enabling double
deductions or deduction with non-inclusion. MNEs may also have the ability to take
advantage of domestic tax preferences to a greater degree than domestic-only firms due to
strategic location of economic activity. MNEs profit shifting out of a country may reduce
its tax expense proportionately more than the reduction in its reported pre-tax profits. As
a result, the MNEs affiliates taxes (and ETRs) could be lower than the taxes (and ETRs)
of non-MNE affiliates that do not have the same opportunities for cross-border tax
planning.
Data source: MNE and non-MNE unconsolidated financial information from the ORBIS
database.
Box 2.5. Indicator 4: Effective tax rates of MNE affiliates compared to non-MNE
entities with similar characteristics
Background: MNEs may have greater opportunities for reducing their taxes due to BEPS than
domestic affiliates with similar characteristics. If MNE affiliates are able to take advantage of
differences in international tax systems or take greater advantage of domestic tax preferences,
then MNE affiliates in a country would have lower reported ETRs (tax expense/assets) than
comparable domestic-only firms.
Description: This indicator uses unconsolidated financial data to estimate the difference
between the ETR of large MNE affiliates and the ETRs of non-MNE entities with similar
characteristics. The indicator is the multi-variate regression coefficient of a dummy variable for
large MNEs in an equation estimating ETRs of individual entities. Similar non-MNE entities are
based on the multi-variate regression analysis, controlling for company-specific factors,
including industry, country, size, presence of patents, and position in the corporate group
(headquarters, other parent or non-parent entity)
Data used: Unlike the other indicators, this indicator is estimated using a regression equation for
mismatches and preferential tax treatments, described in Annex 3.A1.
entities with similar characteristics (continued)
Results:
The value of the indicator in 2010 was -3.3. This indicates that, on average, large
MNE affiliates had ETRs that were 3.3 percentage points lower than comparable nonMNE entities. The indicator is statistically significant from 0.
Since 2003, the indicator has shown that, on average, a large MNE affiliate ETR
differential over domestic firms with similar characteristics fluctuating around the
level of -3 percentage points, with these fluctuations not being significant from a
statistical point of view.
Table 2.3 presents the estimates of the indicator for 2000 through to 2010. Figure 2.4 provides a
graph of the indicator value over the 2000-2010 period.
Table 2.3. Indicator 4: Effective tax rates of MNE affiliates compared to non-MNE entities
with similar characteristics (in percentage points)
Year
Indicator 4
2000
-3.9
2001
-4.5
2002
-3.6
2003
-2.7
2004
-3.2
2005
-3.0
2006
-2.9
2007
-3.2
2008
-3.3
2009
-2.8
2010
-3.3
entities with similar characteristics (continued)
Figure 2.4. Indicator 4: Effective tax rates of MNE affiliates relative to non-MNE entities
with similar characteristics (in percentage points)
MNE minus non-MNE ETR differential
-1
-2
-3
-4
-5
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Caveats:
Unobserved and inherent differences between MNE affiliates and domestic entities
that are not related to tax planning (e.g. capital intensity, productivity) may also
influence their relative ETRs. In some countries, entities with similar characteristics
may not exist to compare to large MNE affiliates operating in the country.
The indicator includes some non-BEPS behaviours, such as the decision to carry out
substantial activity in a country to benefit from certain preferential tax treatments (e.g.
R&D tax subsidies, investment tax credits).
As discussed in Chapter 1, the available firm-level financial data has limitations in
terms of country representativeness, the use of financial, rather than actual, tax
payment data, and some missing entities and observations with incomplete financial
information. The results are dependent on the specific individual firm database used
as well as the regression specification.
2.11 Profit shifting through intangibles

97.
The indicator in this category provides an indirect measure of BEPS related to
intangible property. The indicator is based on macro-data on royalty payments.
Indicator 5: Concentration of royalty receipts relative to R&D spending
Description: This indicator combines balance of payments information on royalty
payments received by businesses in a country and information on the countrys current
R&D expenditures.5 The indicator compares the average ratio of royalties received to
R&D expenditures for a group of high-ratio countries to the average ratio for the other
countries in the sample.
Rationale: Transferring intellectual property from a higher-tax country where R&D takes
place to a lower-tax country is one channel facilitating BEPS. A high value of the
indicator suggests that the income stream from intellectual property received in the highratio countries is significantly higher, relative to other countries, than would be expected
given the actual R&D expenditures in these countries, which may indicate BEPS.
Data source: Balance of payments and R&D expenditures from the World Bank, World
Development Indicators.
Box 2.6. Indicator 5: Concentration of royalty receipts relative to R&D spending
Background: The transfer of intellectual property (IP) from high-tax countries where it is
developed to low-tax countries after development may facilitate BEPS. It results in lower royalty
receipts per euro of R&D spending in the country where the IP was developed and higher
receipts per euro of R&D spending in the country to which the IP was transferred.
Description: This indicator compares royalties received to R&D spending in the countries with
ratios in excess of 50% to the average ratio in the remaining countries. The composition of the
high-ratio countries is based on the 2011 values and kept constant in the other years.
Significantly above average royalty/R&D spending values may indicate BEPS.
Data used: Balance of payments and R&D expenditures from the World Bank, World
Development Indicators. The data includes 59 countries in 2011 with 4 countries having ratios
above 50%.
Results:
In 2011, the high-ratio countries received EUR 1.04 of royalties per EUR 1 of R&D
spending. The remaining countries received only EUR 0.18 of royalties per EUR 1 of
R&D spending.
As a result, the royalties/R&D spending ratio for the top group of countries was
almost six times larger than the same figure for the remaining countries included in
the sample.
The indicator value doubled between 2005 and 2012, due to the increase in royalty
receipts of the high-ratio countries.
In 2011, high-ratio country royalties accounted for 3% of royalties for the 59
countries examined. The indicator evidences the existence of BEPS, but is not a
measure of the scale of BEPS. Even with the low share of high-ratio countries the
indicator still provides evidence of the existence of BEPS.
Figure 2.5 shows Indicator 5 over the 2005-2012 period. The diagram compares the values of the
royalties to R&D spending ratios for the countries with the highest royalty/R&D ratios to the
same ratio for the remaining countries for which data is available.
Box 2.6. Indicator 5: Concentration of royalty receipts relative to R&D spending

(continued)
Figure 2.5. Indicator 5: Concentration of royalty receipts relative to R&D spending
Remaining countries
1.2
Royalty receips to R&D ratio
1.0
0.8
6 times higher
0.6
0.4
3 times higher
0.2
0.0
2005
2006
2007
2008
2009
2010
2011
2012
Source: World Bank, World Development Indicators.
Table 2.4 lists the estimated annual indicator values.

Table 2.4. Estimated annual indicator values
Year
2005
2006
2007
2008
2009
2010
2011
2012
Indicator 5
2.8
2.5
2.6
2.5
2.7
4.3
5.8
5.8
Caveats:
The composition of the group of remaining countries varies as data availability varies
over time. The number of countries with data available to calculate this indicator
ranged from 32 to 69. However, the value of the indicator does not change
significantly if it is calculated only for countries for which data is available in all
years in the 2005-2011 period.
Countries vary in whether they report royalties based on country of incorporation or
tax residence. For example, countries with many conduit companies typically do not
consider such companies to be part of the domestic economy and do not include data
on these companies in their reporting.
A limitation of this indicator is that current income from intellectual property could be
the result of R&D expenditures in prior years. The indicator currently does not
include any adjustment for this time lag.

Royalties include more than just charges for the use of patents, e.g. they also include
payments related to trademarks, copyrights, computer software and cinematographic
works. Thus, the royalties do not only come from R&D activities.
R&D expenditures include both public and private expenditures.
2.12 Profit shifting through interest

98.
The indicator in this category measures the use of interest payments on debt of
MNEs and their affiliates, which may be a source of BEPS.
Indicator 6: Interest expense to income ratios of MNE affiliates in countries with
above average statutory tax rates
Description: This indicator shows the above-average interest-to-income ratio by MNE
affiliates with relatively high interest-to-income ratios located in higher-tax countries.
The interest-to-income ratio is defined as interest paid divided by EBITDA.6 Interest to
income ratio differentials are calculated for each affiliate of the top 250 global MNEs.
The interest-to-income ratio differential is the difference between an affiliates interestto-income ratio (which includes both third-party and related-party interest) and its MNE
groups worldwide consolidated interest-to-income ratio. Higher-tax countries are defined
as countries with combined national and subnational statutory tax rates (STRs) above the
average (weighted by EBITDA) for all included MNE affiliates.
The affiliates are divided into four quadrants based on their interest-to-income ratios and
their statutory tax rates. An excess ratio is calculated for each quadrant. This ratio is the
difference between the weighted average interest-to-income ratio of affiliates in the
quadrant and the weighted average interest-to-income ratio of all affiliates in the sample
(i.e. affiliates in all four quadrants). The indicator is the excess ratio in the northeast
quadrant (i.e. the excess ratio of affiliates with a high interest-to-income ratio and a high
statutory tax rate). When BEPS occurs through interest deductions, it is expected that the
interest-to-income ratio differential in countries with STRs above the average will be
positive. In other words, the ratio of interest-to-income of the affiliates will exceed the
worldwide MNE groups interest-to-income ratio.
Rationale: The strategic allocation of debt to facilitate excessive interest deductions is
one of the BEPS channels used by MNEs to reduce their worldwide tax liability. This
indicator shows what is the excess ratio of affiliates with positive interest-to-income ratio
differentials located in countries with STRs greater than the average STR. Affiliates with
relatively high interest-to-income ratios have combined external and internal interest paid
to income ratios that exceed the average ratio (with external interest paid only) for the
worldwide MNE group. With BEPS, a large share of total interest paid is expected to be
reported by affiliates with interest to income ratios above their worldwide groups ratio
and located in countries with STRs above the weighted average.
Data source: Unconsolidated affiliate and consolidated MNE group financial statement
information was used to estimate the indicator, where information was available.
Box 2.7. Indicator 6: Interest-to-income ratios of MNE affiliates in locations

with above average statutory tax rates
Background: The presence of above-average interest-to-income ratios of affiliates located in
countries with statutory tax rates (STRs) above the weighted average indicates BEPS through
excess interest deductions that shift income from higher-tax to lower-tax countries.
Description: This indicator measures the excess interest-to-income ratio reported by MNE
affiliates with relatively high interest-to-income ratios located in countries with STRs above the
weighted average.
Data used: The indicator value was calculated using affiliate-level and consolidated financial
information on interest paid and EBITDA for over 10 000 affiliates of the top 250 global MNEs.
The STRs of the affiliates are from OECD information on national plus subnational statutory
corporate income tax rates.
Results:
For the affiliates with high interest-to-income ratios in higher tax rate countries, the
interest-to-income ratio was 29% in 2011. In other words, interest expense accounted
for 29% of their pre-tax income before interest, depreciation and amortisation
expenses. This ratio exceeds the average interest-to-income ratio of (10%) for all of
those affiliates by 19 percentage points, which is the value of the indicator. The
affiliates are represented in the shaded, northeast quadrant of Figure 2.6.
45% of the total interest expense of all affiliates in the sample in 2011 was attributable
to affiliates with interest-to-income ratios in excess of their MNEs worldwide
consolidated ratio, and located in countries with STRs above the average.
High STR / low interest-to-income ratio High STR / high interest-to-income ratio
18% of total interest
interest-to-income ratio = 5%
excess ratio = -5 percentage points

excess ratio = 19 percentage points
excess ratio = -7 percentage points

excess ratio = 6 percentage points

Average
Below average
Statutory tax rate
Above average
Figure 2.6. Indicator 6: Interest to income ratios of MNE affiliates in locations with
above average statutory tax rates
Low STR / low interest-to-income ratio Low STR / high interest-to-income ratio
Below average
Average
Above average
Interest-to-income ratio differential
Box 2.7. Indicator 6: Interest-to-income ratios of MNE affiliates in locations with

above average statutory tax rates (continued)
Caveats:
The indicator is calculated using gross interest expense as reported in financial
statements. If additional data becomes available, net interest expense could be used in
the calculation. Financial firms are not included in the calculation of this indicator.
The interest expense-to-income ratio is designed to measure one channel of BEPS, the
use of excess interest expense deductions to shift profits from higher-tax to lower-tax
locations. It is not an indicator of other BEPS behaviours.
The indicator focuses on affiliates related-party and third-party interest expense
relative to their groups third party interest expense. It does not control for the general
corporate tax issue of the double taxation of corporate equity and the deductibility of
interest expense.
2.13 Possible future BEPS indicators with new data

99.
The six indicators presented in the previous sections are based on currentlyavailable data. Future data sources could be used to estimate additional indicators of
BEPS. The following two indicators are examples.
Future Indicator A: Profit rates compared to effective tax rates for MNE domestic
(headquarter) and foreign operations
Description: This indicator could compare the profit rate (i.e. profits/assets) differential
between the MNEs domestic operations in the jurisdiction of its headquarters and the
MNEs foreign operations to the MNEs ETR (i.e. income tax paid/pre-tax profits)
differential between domestic and foreign operations.7 The differentials are measured as
the difference between the domestic and foreign values; both differentials can be positive
or negative.
Rationale: This indicator could use worldwide consolidated financial statement
information for both domestic and foreign operations of the top global MNEs. It could
show the extent to which the reported profitability of domestic operations is less than the
profitability of the MNEs foreign operations in countries where the ETR on domestic
operations is higher than the ETR on foreign operations, and vice versa. A negative
correlation between the profit rates and ETRs is an indication of BEPS.
Data source: The profit rates and ETRs could be calculated with improved future MNE
data. Currently, different financial reporting requirements on tax expense by country lack
consistency, so information is limited to reporting MNEs and varies by country.
Box 2.8. Future Indicator A: Profit rates relative to ETRs, MNE domestic vs.
global operations
Example: Illustrative calculations for this indicator have not been made due to current data
limitations.
Caveats:
This indicator requires worldwide financial reporting data for both domestic and
foreign MNE operations. Publicly available MNE financial reports vary significantly
in how, and if, the worldwide information is reported separately for domestic and
foreign operations. This limits the number of MNEs that can be included in this
indicator using currently available public financial reports.
The profitability of domestic and foreign operations will vary by the composition of
activities that may involve different degrees and types of capital and labour intensity.
Future Indicator B: Differential rates of return on FDI investment related to special

purpose entities (SPEs)
Description: This macro-economic indicator could measure the extent to which FDI
inward positions (i.e. cumulative stock of FDI investments in a country owned by foreign
investors) are coming from countries with significant outbound FDI through SPEs,
serving as investment conduits. These are countries with relatively large shares of FDI
outward investment stocks accounted for by special purpose entities (SPEs). SPEs are
legal entities that tend to have few employees and real resources located in a country, but
are used to raise capital or hold assets and liabilities related to MNE investments in other
countries.
Rationale: FDI measures cross-border investments among related enterprises. The
expectation is that the more significant are inflows of FDI into SPEs, the greater is the
possibility for BEPS. Recent research by the United Nations Conference on Trade and
Development (UNCTAD) has found that equity income on the inward stock of FDI is
reduced the greater the share of that inward FDI coming through tax havens and SPEs.8
The share of FDI through SPEs and a lower rate of return on such investment could be an
indication of BEPS.
The indicator could compare the rate of return on inward equity FDI in countries with
relatively high exposure to FDI from investment conduit countries to the equity rate of
return in other countries. The equity rate of return equals the equity income outflows
(dividends and reinvested earnings) from the host country to the host countrys inward
stock of FDI. This is a measure of the profitability of the FDI investment. Investment
conduit countries could be defined as those with relatively high percentages of outward
FDI stocks accounted for by SPEs.9
Data source: OECD Foreign Direct Investment Statistics. The data is the inward and
outward FDI stock from and to OECD countries. The OECD, Benchmark Definition of
Foreign Direct Investment, 4th Edition, recommends that countries report FDI investment
separately for SPEs to facilitate analysis of capital in transit going through SPEs.
However, at this time detailed bilateral FDI data for SPEs is only available for a limited
number of countries. This indicator can be estimated when the separate SPE data is
reported for a greater number of countries.
Box 2.9. Future Indicator B: Differential rates of return on FDI related to SPEs
Example: Illustrative calculations for this indicator have not been made due to data limitations.
Caveats:
FDI statistics for SPEs will be reported for an increasing number of countries
beginning with data published in 2015. The impact of expanded coverage will affect
changes in the value of the indicator unrelated to changes in BEPS. This needs to be
recognised in the interpretation of this indicator as a measure of changes in BEPS
over time.
While investment related to BEPS is expected to be a significant portion of SPE
investment, there will also be non-BEPS related SPE investment.
Additional analysis will be needed to determine the criteria for including countries in
the top group of home countries that is characterised as investing countries with
relatively high ratios of SPE-related FDI.
The indicator only measures profit shifting that is facilitated by direct investment
relationships.
2.14 Indicators considered but not included

100. A number of additional indicators were examined but not included in the indicator
dashboard. In addition, there were suggestions for possible indicators that could not be
estimated due to the lack of currently available data. Examples of indicators that were
considered but not included are:
Profit rate differentials for global MNEs, high-tax vs. low-tax locations.
Forward-looking average effective tax rates for representative taxpayers based
on financial characteristics of corporate income tax filers. It was not clear how
impacts of BEPS on the representative taxpayers could be aggregated to derive
an indicator metric.
Forward-looking average or marginal effective tax rates for hypothetical
taxpayers on new investments.
Concentration of high levels of FDI flows relative to GDP (inflow of FDI
owned by OECD foreign investors into a country/the countrys GDP).
Concentration of high levels of FDI income relative to GDP (inflow of FDI
income from OECD countries to a recipient country divided by the recipient
countrys GDP).
Concentration of high levels of royalty payments (royalty payments
received/GDP in receiving country).
Concentration of FDI leverage.

Concentration of high levels of patents developed outside of country (patents
owned by residents of a country that have been invented in another country/total
patents filed in the country).
Tax gap measures based on the comparison of national income account
corporate data and reported taxable corporate income taxes. This measure is
currently only available for several countries and includes the impact of
significant non-BEPS factors.
BEPS estimates based on extrapolations of current-law tax audit assessments
using a definition of no or low-tax rate countries based on statutory corporate
income tax rates.
101. The main reasons these indicators were not included were problems with the data
that was available and/or difficulty in distinguishing between real economic effects and
BEPS.
2.15 Summary
102. This chapter presents six indicators and a further two potential indicators to assist
with the measurement and monitoring of BEPS. These indicators are intended to be
viewed like a meter or a gauge, capable of measuring trends and variations over time and
acting as warning lights that might point to the existence of BEPS. No single indicator
is capable of providing the complete picture, but by presenting a dashboard of BEPS
indicators this report provides new insights regarding the presence and scale of BEPS.
103. As with any gauge, the degree of precision depends on the available information
and the accuracy of the measurement tools. Given the state of currently available data, the
indicators presented can only provide some general insights into the scale and economic
impact of BEPS, but lack the precision that may become possible if more comprehensive
and improved data sources, supported by sophisticated statistical analysis, become
available in the future.
104. As a dashboard, the indicators provide a signal that BEPS exists, is likely to be
increasing in scale, and that better data availability is needed to refine economic analysis
of BEPS and the BEPS Action Plans countermeasures in the future. While the indicators
are high-level rather than refined economic analyses, and have significant data limitations
and caveats, all six indicators presented in this chapter show the expected sign or trend
indicative of the presence of BEPS.
105.
The indicators presented include:

Indicator 1 is based on FDI relative to GDP and shows that both the net and
gross FDI stocks relative to GDP of a group of countries with high-ratios (above
50% for net and above 200% for gross) have continued to grow in recent years
when compared with the average of all other countries. The net FDI to GDP
ratio of those countries increased from 38 times higher than all other countries
in 2005 to 99 times higher in 2012.
Indicators 2 and 3 show that lower ETRs are correlated with higher profit rates
amongst affiliates. Indicator 2 shows that 45% of the income of the largest
global MNEs was reported by affiliates with below-average ETRs and above
average profit rates. These affiliates represented only 33% of total affiliates in
the MNE. The value of the indicator increased 32% between 2007 and 2011.
Indicator 3 shows that reported profit rates of MNE affiliates in lower-tax
countries were, on average, almost twice as high as their groups worldwide
profit rate.
Indicator 4 estimates the ETRs, by calculating the reported tax expense as a
percentage of reported profits, of large MNE affiliates relative to non-MNE
entities with similar characteristics. Between 2000 and 2010, the ETRs for large
MNE entities (with more than 250 employees) was estimated to be between 2.7
to 4.5 percentage points lower than similar non-MNE ETRs.
Indicator 5 shows that royalties received relative to R&D expenditures in a
group of countries with ratios above 50% are six times higher than for the
average of all other countries, up from three times higher in 2009.
Indicator 6 shows the concentration of high interest-to-income ratios in higher
statutory tax rate countries. It shows that the largest global MNEs affiliates
with high interest-to-EBITDA ratios, located in high-tax countries have an
interest-to-EBITDA ratio almost three times higher than their groups
worldwide unrelated-party interest-to-EBITDA ratio.
106. Two additional indicators are also described that could be calculated when new
data become available: a comparison of profit rates and ETRs of MNE domestic
(headquarter) and foreign operations, and differential rates of return on FDI investment
from special purpose entities.
107. Economic analysis of the scale and economic impact of BEPS and the
effectiveness of potential BEPS countermeasures are presented in the next chapter, which
complement the high level indications of the six BEPS Indicators.
Notes
1.
References to the future state and ideal state are not presented as proposed or
inevitable stages, but are designed to highlight that improvements in the data sources
available would also lead to improvements in the accuracy of BEPS indicators and
economic analyses.
2.
The firm-level financial information is for a sample of the 250 largest global nonfinancial MNEs, as measured by sales. It includes financial information in 2007 and
2011 from both the MNE consolidated and affiliates unconsolidated financial
statements.
3.
The tax expense measure includes taxes that are based on income, including corporate
income taxes and withholding taxes based on income.
4.
Indicators 2 and 3 measure potential profit shifting in different ways. Indicator 2 uses
individual affiliate observations in the calculations; Indicator 3 aggregates all of a
MNEs affiliates at the country level. The two indicators also differ in how low-tax
locations are defined. Indicator 2 defines low-tax as locations of affiliates with ETRs
less than the MNE groups worldwide ETR; Indicator 3 defines low-tax as countries
with the lowest ETRs accounting for 20% of assets.
5.
Research and development expenditures include current (operating) plus capital

expenditures (both public and private) for R&D activities performed within a country,
regardless of the source of funding. Royalty receipts are payments for the use of
property rights (including patents, trademarks, industrial processes and franchises)
and licensing charges. Royalties may not be directly related to the measure of R&D
spending, such as brands developed from marketing investments.
6.
EBITDA is pre-tax income before any deductions for interest paid, corporate income
taxes, depreciation and amortization. Net interest expense (interest expense minus
interest income) could not be calculated from the available affiliate-level data.
7.
Domestic operations include the parent company and its affiliates operating in the
same country as the parent.
8.
Future Indicator B is a modified version of an indicator suggested by UNCTAD

researchers in their Action 11 Public Consultation submission. See UNCTAD draft
working paper, FDI, Tax and Development (3/20/2015) for a detailed discussion of
methods for identifying countries that serve as investment conduits, including tax
havens and SPEs. The UNCTAD analysis of the fiscal impact of profit shifting on
developing countries used actual bilateral FDI information for SPEs in only four
reporting countries.
9.
Preliminary data reported in OECD, How Multinational Enterprises Channel

Investments Through Multiple Countries (February 2015), shows that three out of the
nine included countries have inward FDI positions accounted for by resident SPEs
that exceed 50% of all inward FDI.
Annex 2.A1
Formulas for calculating indicators
Indicator 1A:
1.
Year 2012 was chosen as a base year for Indicator 1. OECD FDI Statistics was
the source of data on FDI.
2.
An inward FDI position of partner country i (iFDIi) is calculated as the sum of
outward FDI positions from all available OECD countries to partner country i in 2012
where oFDIpi,j is the outward FDI position reported by OECD country j to partner
country i and N is the number of OECD countries1.
3.
An outward FDI position of partner country i (oFDIi) is calculated as the sum of
inward FDI positions from all available OECD countries to partner country i in 2012
where iFDIpi,j is the outward FDI position reported by OECD country j to partner country
i and N is the number of OECD countries.
4.
A net FDI position of partner country i (net FDIi) is calculated as the difference
between its inward FDI position and its outward FDI position.
5.
The net FDI to GDP ratio is calculated for each partner country i.
6.
A group of high-ratio partner countries with a net FDI to GDP ratio above 50%
are selected. The weighted average net FDI to GDP ratio for the high-ratio countries (net
FDI to GDP ratiohigh) is calculated. The weighted average net FDI to GDP ratio for the
remaining partner countries (net FDI to GDP ratiorest) is calculated where n is the total
number of partner countries reported by OECD countries and m is the number of highratio countries.

7.
The indicator for 2012 is calculated as the ratio of the net FDI to GDP ratio of the
high-ratio countries to the net FDI to GDP ratio of the remaining countries.
8.
Steps 2 to 7 are repeated for other years with the same high-ratio countries
identified in 2012.
Indicator 1B:
1.
Year 2012 was chosen as a base year for Indicator 1. OECD FDI Statistics was
the source of data on FDI.
2.
An inward FDI position of partner country i (iFDIi) is calculated as the sum of
outward FDI positions from all available OECD countries to partner country i in 2012
where oFDIpi,j is the outward FDI position reported by OECD country j to partner
country i and N is the number of OECD countries2.
3.
The gross FDI to GDP ratio is calculated for each partner country i.
4.
A group of high-ratio partner countries with a gross FDI to GDP ratio above
200% are selected. The weighted average gross FDI to GDP ratio for the high-ratio
countries (gross FDI to GDP ratiohigh) is calculated. The weighted average gross FDI to
GDP ratio for the remaining partner countries (gross FDI to GDP ratiorest) is calculated
where n is the total number of partner countries reported by OECD countries and m is the
number of high-ratio countries.
5.
The indicator for 2012 is calculated as the ratio of the gross FDI to GDP ratio of
the high-ratio countries to the gross FDI to GDP ratio of the remaining countries.
6.
identified in 2012.
Indicator 2:
A.
For all affiliates of MNE 1 and a given year, profit rate differentials are calculated as
follows.
1.
For affiliate i, the profit rate (profit ratei,MNE1) is calculated as pre-tax income of
affiliate i divided by assets of affiliate i.
2.
The global profit rate for MNE 1 (profit rateg,MNE1) is calculated as MNEs
consolidated pre-tax income divided by MNEs consolidated assets.
3.
The profit rate differential of affiliate i (profit rate diffi,MNE1) is calculated as the
difference between the affiliate is profit rate and MNE 1s global profit rate.
B.
For all affiliates of MNE 1 and the given year, effective tax rate differentials are
calculated as follows.
1.
For affiliate i, the effective tax rate (ETRi,MNE1) is calculated as affiliate is tax
expense divided by affiliates is pre-tax income.
2.
The global effective tax rate for MNE 1 (ETRg,MNE1) is calculated as MNE 1s
consolidated tax expense divided by MNE 1s consolidated pre-tax income.
3.
The effective rate differential of affiliate i (ETR diffi,MNE1) is calculated as the
difference between the affiliate is ETR and MNE 1s global ETR.
C
Steps A and B are repeated for all MNEs in the sample.
D.
Affiliates with profit rates differentials greater than zero and ETR differentials
less than zero are selected.
E.
The indicator for the given year is calculated as the sum of pre-tax income of
affiliates selected in step D divided by the sum of pre-tax income of all affiliates where k
is the number of all MNEs in the sample, ni is the number of affiliates of MNEi and mi is
the number of affiliates of MNEi selected in step D.
Indicator 3:
A.
For MNE 1 and a given year, the profit rate differential is calculated as follows.
1.
For country i where MNE 1 has affiliates, the sum of assets (assetsi,MNE1), the sum
of pre-tax income (pre-tax incomei,MNE1), and the sum of tax expenses (tax expensei,MNE1)
of all MNE 1s affiliates in country i are calculated where assetsj,i,MNE1 is assets of MNE
1s affiliate j in country i (similarly for pre-tax income and tax expense) and ni is the
number of MNE 1s affiliates in country i.
2.
The profit rate of MNE 1 country group of affiliates in country i (profit ratei,MNE1)
is calculated as the sum of pre-tax income of MNE 1s affiliates in country i divided by
the sum of assets in MNE 1s affiliates in country i.
3.
MNE 1s global profit rate (profit rateg,MNE1) is calculated as MNE 1s
consolidated pre-tax income divided by MNE 1s consolidated assets.
4.
The effective tax rate of MNE 1s country group of affiliates in country i
(ETRi,MNE1) is calculated as the sum of tax expenses of MNE 1s affiliates in country i
divided by the sum of pre-tax income of MNE 1s affiliates in country i.
5.
The countries where MNE 1 has affiliates are ranked by their effective tax rate.
Low-tax countries are defined as countries with the lowest ETRs that account for 20% of
the assets of the MNE. The average profit rate (weighted by assets) of low-tax countries
is then calculated; m is the number of low-tax countries and n is the number of all
countries where MNE 1 has affiliates.3
6.
MNE 1s profit rate differential (profit rate diffMNE1) is then calculated as the ratio
of MNE 1s profit rate in low tax countries divided by MNE 1s global profit rate.
B.
Steps 1 to 6 are repeated for all MNEs in the sample.
C.
The indicator for the given year is the average profit rate differential (weighted by
assets) for all MNEs in the sample where k is the number of MNEs in the sample and
assetsg,MNEi is consolidated assets of MNE i.
Indicator 4:
Indicator 4 uses firm-level unconsolidated financial data and ownership information from
the ORBIS database compiled by Bureau Van Dijk and processed by the OECD Statistics
Directorate.
The sample consists of entities in both multinational and non-multinational groups in 46
countries (all OECD and G20 countries, OECD accession countries Colombia and Latvia
as well as Malaysia and Singapore) over 2000-2010. Micro-firms (less than 10
employees), loss-making firms and standalone firms (i.e. firms that are not part of a
corporate group) are excluded. The sample has 2 046 838 observations.
Indicator 4 is the regression coefficient
individual entities in the sample:
in the following equation estimating ETRs of
,
is the effective tax rate of entity f (operating in country c and industry i
where
and member of a MNE or domestic group) in year t, measured as tax expenses over
is a dummy equal to one when firm f has more than
reported profit.
is a dummy equal to one when firm f has up to
250 employees.
is a dummy equal to one when a company is part of a
250 employees.
is a vector of firm characteristics, including the position of the
multinational group.
firm in the group and a dummy for patenting groups.
The regression analysis based on the whole sample shows that the estimated difference
between the ETR of large MNE entities and the ETR of comparable domestic (i.e. nonmultinational) groups is 3.3 percentage points (i.e. 3 = -0.033) and was estimated for
each individual year. The adjusted R-squared is 0.186.
Indicator 5:
1.
Year 2011 was chosen as a base year for Indicator 6. World Bankss World
Development Indicators was the source of data on royalty receipts (charges for the use of
intellectual property) and R&D expenditures.
2.
For each country i, the ratio of royalty receipts to domestic R&D expenditure was
calculated.
3.
A group of high-ratio countries with a royalty to R&D ratio above 50% are
selected. The weighted average royalty to R&D ratio for the high-ratio countries (royalty
to R&D ratiohigh) is calculated. The weighted average royalty to R&D ratio for the
remaining countries (royalty to R&D ratiorest) is calculated where n is the total number of
countries for which data is available and m is the number of high-ratio countries.
4.
The indicator for 2011 is calculated as the ratio of royalty to R&D ratio of the
high-ratio countries to the royalty to R&D ratio of the remaining countries.
5.
identified in 2011.

Indicator 6:
A.
For MNE 1s affiliate 1 and a given year, an interest-to-income ratio differential is
1.
The interest-to-income ratio of affiliate 1 (interest-to-income ratio1,MNE1) is
calculated as interest expense (to both third parties and related parties) divided by
EBITDA (earnings before interest, taxes, depreciation and amortisation).
2.
MNE 1s global interest-to-income ratio (interest-to-income ratiog,MNE1) is
calculated as MNE 1s interest expense divided by MNE 1s EBITDA from consolidated
accounts.
3.
Affiliate 1s interest-to-income ratio differential (interest-to-income ratio
diff1,MNE1) is calculated as affiliate 1s interest-to-income ratio minus MNE 1s global
interest-to-income ratio.
B.
For MNE 1s affiliate 1 and the given year, a combined CIT rate differential is
1.
The worldwide average combined CIT rate (weighted by EBITDA) of all
affiliates of all MNEs (CIT ratew) is calculated where CIT rate1,MNE1 is the combined CIT
rate in the country of affiliate 1 of MNE 1, k is the number of MNEs in the sample and ni
is the number of affiliates of MNE i.
2.
The combined CIT rate differential of MNE 1s affiliate 1 (CIT rate diff1,MNE1) is
calculated as the difference between the combined CIT rate in the country of MNE 1s
affiliate 1 and the worldwide average combined CIT rate.
C.
Steps A and B are repeated for all affiliates and all MNEs in the sample.
D.
Affiliates with both the interest-to-income ratio differential and the combined CIT
rate differential greater than zero are selected.
E.
The indicator for the given year is calculated as the difference between the
weighted average interest-to-income ratio of affiliates selected in step D and the weighted
average interest-to-income ratio of all affiliates in the sample (both averages weighted by
EBITDA) where k is the number of all MNEs in the sample, ni is the number of affiliates
of MNEi and mi is the number of affiliates of MNEi selected in step D.
Notes
1.
If the partner country is an OECD country, only FDI positions from the other 33
OECD countries are taken into account.
2.
If the partner country is an OECD country, only FDI positions from the other 33
OECD are taken into account.
3.
The total assets accounted for by low-tax countries, will not be exactly 20%. In that
case, the last country to be included in the low-tax countries would cause the sum of
low-tax countries assets exceed 20% of total MNEs assets. The last country is then
not assigned a weight equal to its assets. Instead, it is assigned a lower weight. This
weight is set such that the sum of assets of all low-tax countries is equal to exactly
20% of the sum of total MNEs assets. For example, the two low-tax countries are A
and B. A has an ETR of 11% and assets equal to 15% of total MNEs assets; B has an
ETR of 12% and assets equal to 10% of total MNEs assets. In that case, B is
assigned a weight of half of its assets equal to 5% of total MNEs assets (15% + 5% =
20%).
3. TOWARDS MEASURING THE SCALE AND ECONOMIC IMPACT OF BEPS AND COUNTERMEASURES 79
Chapter 3
Towards measuring the scale and economic impact of BEPS and
countermeasures
Key points:
There is a large and growing body of evidence of the existence of BEPS, stemming
from hundreds of empirical analyses and specific information relating to the tax
affairs of certain MNEs that has emerged from numerous legislative and
parliamentary enquiries. However, measuring the scale and economic impact of BEPS
proves challenging given the complexity of BEPS and the serious data limitations.
This chapter summarises the available empirical analyses of profit shifting and the
effects of previously implemented anti-avoidance countermeasures. Recent research
has focused on specific types of BEPS behaviours, mostly on transfer mispricing and
debt shifting, but also on treaty abuse, controlled foreign corporation rules, hybrid
mismatch arrangements, and disclosure rules, but more empirical analysis is needed in
all of these areas.
No empirical studies comprehensively cover global MNE activity. In particular, most
studies are constrained by a lack of data relating to MNE entities in many countries,
and where information regarding MNE entities is available it is often incomplete.
Statistical analyses based upon data collected under the Action 13 Country-byCountry Reports have the potential to significantly enhance the economic analysis of
BEPS. However, even with additional data and sophisticated estimation
methodologies, researchers of the scale, prevalence and intensity of BEPS will still
have difficulty in fully separating BEPS from real economic activity and from nonBEPS tax preferences.
Several recent studies have presented estimates of the scale of BEPS globally or for
individual countries. All of these studies show significant fiscal effects using different
types of data and different estimation methodologies. An OECD analysis of financial
accounts from a cross-country database estimates the global corporate income tax
revenue losses to be in the range of 4% to 10% of corporate income tax revenues, i.e.
USD 100 to 240 billion annually at 2014 levels. The studies estimating the fiscal
effects on developing countries, as a percentage of their GDP, find that these effects
are higher than in developed countries, given the greater reliance on CIT revenues and
often weaker tax enforcement capabilities of developing countries, but in some cases
these studies also include revenue lost from non-BEPS behaviours.
BEPS anti-avoidance measures previously implemented by countries have been found
to be effective, in countries fiscal estimates, in academic studies, and in OECD
research, to reduce tax planning. Thus, countries with higher statutory corporate tax
rates do not necessarily have higher fiscal losses from BEPS if they have strict antiavoidance rules. International co-ordination of those rules will increase the
effectiveness of BEPS countermeasures while reducing the cost of compliance for
businesses.
80 3. TOWARDS MEASURING THE SCALE AND ECONOMIC IMPACT OF BEPS AND COUNTERMEASURES
BEPS causes significant economic distortions. Empirical analyses, including OECD
research, find that BEPS involves MNEs manipulating the location of external and
internal debt; reduces the effective tax rate on intangible investments, thereby
distorting the types of investments made; affects the location of patent registrations,
and to a lesser extent actual R&D activity; affects the location of different types and
forms of foreign direct investment; and creates tax base and policy spillovers between
countries.
OECD research finds that BEPS reduces the effective tax rate of large MNE entities
by 4 to 8 percentage points on average compared to similarly-situated domestic-only
affiliates, providing a competitive advantage in product and capital markets. The
reduction in effective tax rates is larger for very large firms and firms with patents.
This research also finds that MNE tax planning may allow certain MNEs to increase
their market power, resulting in more concentrated markets.
Analyses of BEPS make comparisons of current business activity with some
alternative or counterfactual. The counterfactual could be a hypothetical world
without BEPS or a hypothetical world without co-ordinated multilateral action.
When evaluating BEPS countermeasures, the estimated counterfactual of the effects
of implementing countermeasures can be compared with current law rules and
revenues.
The extent of BEPS-induced distortions will depend on who currently benefits from
BEPS: whether the tax savings from BEPS are passed along in lower consumer prices,
higher wages to workers, or to higher returns to capital owners. The reduction in
corporate tax liabilities enjoyed by MNEs engaging in BEPS is unlikely to have the
same economic effects as a general reduction in corporate income taxes.
BEPS countermeasures will increase taxes paid by MNEs engaging in BEPS, but
other businesses and households will benefit from lower taxes or increased public
infrastructure or increased government services, and indirectly through a more levelplaying field. The effects on all businesses and households need to be included in
analyses of countermeasures. Analysis needs to consider who benefits from BEPS,
since if BEPS increases the after-tax economic rents of MNEs engaging in BEPS,
countermeasures may not affect some of their investment decisions.
Additional research on MNEs investment decisions, determinants of profitability,
business tax preferences, and total business taxes is needed to enhance the economic
analysis of BEPS and BEPS countermeasures.
3.1 Overview
108. A survey of the academic and empirical literature reveals over one hundred
studies have found the presence of BEPS. A recent review of the empirical literature by
Dharmapala (2015) does not report a single empirical study not finding some evidence of
BEPS. Another review of the academic literature by Riedel (2015) concludes: Existing
studies unanimously report evidence in line with tax-motivated profit shifting (despite
using different data sources and estimation strategies).1
109. A common theme of these studies has been the finding that profits are being
shifted from high-tax countries to low-tax countries and that there is substantial evidence
of a disconnect between the jurisdictions where MNEs are recording their taxable
profits and the locations where the economic activities that generate these profits are
taking place. The studies find empirical evidence of BEPS through various channels,
including through: transfer pricing, the strategic location of debt and intangible assets,
treaty abuse, and the use of hybrid mismatch arrangements. Government analyses,
academic studies, and OECD research presented in Annex 3.A1 have all found that
certain measures enacted to address BEPS activity have been effective in protecting the
revenue bases of the countries implementing these measures.2
110. While the various academic, government and empirical studies undertaken find
BEPS is occurring, there is less certainty over the scale or extent to which it is occurring.
Scale is defined as the magnitude of the change in overall tax receipts due to BEPS. To
date, most studies have focused on individual countries or individual BEPS channels
rather than attempt to achieve a comprehensive global estimate of the scale of BEPS
activity. Riedel (2015) reports that the estimates of profit shifting range from less than 5%
to more than 30% of the income earned by MNEs in high-tax countries being shifted to
lower-tax countries. While most of the studies focus on shifting financial profits (not
taxable income) and do not include instances of stateless income,3 such a large range
shows the significant uncertainty surrounding the estimation of the magnitude of BEPS.
Due to differences in pre-tax profits reported in financial statements and taxable income,
plus tax credits, the percentage change in corporate tax revenues could be even higher
than the percentage change in pre-tax reported profits.
111. The two key challenges facing any attempt to undertake an economic analysis of
BEPS that arrives at credible estimates relate to the availability of data and the
methodology employed for estimating the scale of BEPS. While Chapter 1 discusses the
significant limitations of currently available data, this chapter focuses on the
methodological issues involved in undertaking economic analyses of the scale and
economic impact of BEPS and BEPS countermeasures. It should be noted that few of the
academic estimates of profit shifting attempt to estimate the total tax benefits to MNEs or
revenues lost to governments from BEPS.
112. Even with the Action 13 Country-by-Country Reports of MNE global taxes and
economic activity, measures of the scale of BEPS will require sophisticated estimation
techniques to separate BEPS from real economic activity and from non-BEPS tax
incentives. Measurement of BEPS and countermeasures will not be available from
extracting a single line from a tax return or Country-by-Country Report, but will need to
be estimated, and such estimation not only requires better tax and non-tax information,
but also requires further refinement of the methodologies applied to future economic
analyses.
113. This chapter starts with a discussion of the key issues in measuring BEPS, its
economic effects, and the effectiveness of BEPS countermeasures. Significant progress
has been made in the last few years in the analysis of BEPS, but given the complexity of
BEPS and the serious data limitation, more progress is needed to provide a more precise
and a more complete understanding of BEPS behaviours. The chapter outlines what we
do know from the empirical studies including some new OECD research, as well as what
we do not currently know about the scale and economic impacts of BEPS. The chapter
concludes with a number of areas where future economic research with better data will be
important in enhancing our understanding of the scale and impact of BEPS and the
effectiveness of BEPS countermeasures.
3.2 Key issues in measuring and analysing BEPS

114. Several analytical issues in measuring BEPS are important to consider when
evaluating existing empirical analysis of BEPS and how to better monitor BEPS in the
future. This section discusses the definition of BEPS, the comparison points against
which BEPS is measured, issues of separating BEPS from real economic activity,
separating BEPS from non-BEPS government tax incentives, and the appropriate tax rate
to use in analysing BEPS.
3.2.1 Defining BEPS

115. For the purposes of empirically analysing the scale of BEPS, it is important to
define BEPS behaviours as clearly as possible. It is useful to highlight the description of
BEPS from the July 2013 Action Plan on Base Erosion and Profit Shifting4:
BEPS relates chiefly to instances where the interaction of different tax rules leads to
double non-taxation or less than single taxation. It also relates to arrangements that
achieve no or low taxation by shifting profits away from the jurisdictions where the
activities creating those profits take place. No or low taxation is not per se a cause of
concern, but it becomes so when it is associated with practices that artificially segregate
taxable income from the activities that generate it. In other words what creates tax policy
concerns is that, due to gaps in the interaction of different tax systems, and in some cases
because of the application of bilateral tax treaties, income from cross-border activities
may go untaxed anywhere, or be only unduly lowly taxed.
116. The above description helps focus the scope of BEPS. BEPS is about international
tax avoidance, i.e. exploiting differences in different countries tax systems. Tax evasion
by individuals or corporate non-compliance with domestic tax rules does not constitute
BEPS. Purely domestic tax avoidance is not part of the BEPS project.
117. MNEs taking advantage of differences in countries tax rates does not amount to
BEPS on its own. However, artificial arrangements put in place to exploit these
differences do amount to BEPS. With the growing reliance of modern business on
intangible property and risk management as part of global value chains, it becomes more
difficult to identify where the activities creating profits take place without better data and
careful transfer pricing analysis of individual transactions. Working with currently
available data and the difficulties of measuring where value is created are both
fundamental difficulties associated with measuring the scale of BEPS.
118. If economic functions, assets and risks are effectively relocated to another country
to take advantage of a low tax rate or tax credit, this does not constitute BEPS. Such
activities are considered to be responses to real economic competition as well as tax
competition where, for example, an entity responds to a tax incentive to invest in a

greenfield project that entails building a factory. This is different from, for example,
arrangements that highly leverage affiliates in a high-tax rate country to shift profits
through related party debt to an affiliate in a low-taxed country. BEPS is often the result
of: transfers or acquisitions of intangible or mobile assets for less than full market value;
the over-capitalisation of low-tax rate group companies; the excessive-leveraging of hightax rate group companies; and contractual allocations of risk to low-tax jurisdictions in
structures and transactions that would be unlikely to occur between unrelated parties.
119. Many countries have specific legislated domestic tax rules which provide tax
credits, tax deductions or tax exemptions for selected activities, such as research and
development, investments in alternative energy, and contributions to charitable activities,
among many others. These domestic incentives which reduce corporations average tax
rates and which encourage greater activity are not BEPS. However, if domestic incentives
are designed to encourage artificial schemes without economic substance, then those
schemes would be considered BEPS behaviours.
120. One possible definition of BEPS could refer to the specific BEPS channels
identified in the various actions set out in the BEPS Action Plan. By defining BEPS with
reference to the individual BEPS channels, the scale would draw upon the consensus
reflected in the BEPS Action Plan. Estimation of the scale of each of the BEPS channels
would be closely related to what individual governments would estimate for the fiscal and
economic impacts of their countrys implementation of specific BEPS Actions.
3.2.2 The counter-factual for BEPS analysis

121. A second key issue for any analysis of BEPS and countermeasures requires a
comparison between an observed world (i.e. current law) and a counterfactual. When
estimating the scale of BEPS, this involves comparing current reported profits, taxes, and
economic activity in a world with BEPS with a hypothetical world without BEPS. As no
such point of comparison can be observed, empirical analysis must estimate the
counterfactual.
122. Three alternative BEPS counterfactuals are described in Box 3.1, being described
as: (i) a world today without BEPS, (ii) a future world without co-ordinated multilateral
action, and (iii) a future world with proposed countermeasures. Analysing these
hypothetical states of the world requires estimating something that cannot be observed.
The comparison is only as good as the estimation of the counterfactual.
123. The first counterfactual, a world without BEPS, is used in analysing the scale of
BEPS. The other two comparisons can be used to analyse BEPS countermeasures. For
example, the revenue effect of a proposed countermeasure is the difference between a
world with the countermeasure and the position under current law. When analysing the
effect of increased disclosure rules compared to a world without co-ordinated multilateral
action where many countries have different disclosure rules, there could be lower
compliance costs with co-ordinated disclosure rules, even if there are higher compliance
costs compared to current law.
Box 3.1. Alternative points of comparisons - Alternative counterfactuals

Analyses will arrive at different estimates of BEPS depending on the comparison point against
which they are measured. Several possible counterfactuals are possible when considering BEPS.
World without BEPS: This is a hypothetical that is not observable and has to be estimated.
Many empirical studies estimate the amount of profit shifting as the difference between reported
profits and estimated true profits. True profits are estimated based on available measures of
real economic activity, which are described in a later section. To the extent that true profits
cannot be estimated with precision, then the estimated amount of shifted profits could be biased
and lack precision. In this case, the estimate is based on what would have happened today
without BEPS.
World without Co-ordinated Multilateral Action: This is a hypothetical of what would happen
in the future if co-ordinated multilateral actions of the type proposed in the BEPS Action Plan
did not occur, so BEPS would be unconstrained except by unilateral actions of countries. This
requires estimating what MNEs would do without a collective focus and approach to reducing
BEPS and what governments would do without consistent adoption of BEPS countermeasures
and rules. In this case, the estimate is based on what would be expected to occur in the absence
of co-ordinated, multilateral action.
World with Proposed Countermeasures: This is a hypothetical world of what would happen in
the future if the countermeasures are implemented. For estimating the effects of policy changes,
analysts generally compare specific proposed BEPS Actions relative to current law. A change in
the rules regarding limitations on interest deductions will compare the taxes expected to be
collected based on the specific interest limitation proposal with the current tax collections based
on a countrys current interest deduction rules. In this case, the estimate is based on what would
happen in terms of tax collections from a specific BEPS proposal.
3.2.3 Separating BEPS from real economic activity

124. Measuring BEPS requires the identification of the effects of practices that
artificially segregate taxable income from the activities that generate it. Companies locate
more economic activity in countries with favourable business conditions (e.g. stable
social and political environment, access to customers, strong public infrastructure, and
low tax rates, etc.). As noted earlier, actions by MNEs taking advantage of differences in
countries tax rates do not amount to BEPS on their own. Thus, simple comparisons of
profitability and economic location, including in some of the BEPS indicators, may not
fully separate BEPS from the location of real economic activity.
125.
However, there are many different and competing perspectives on where profits
should be considered to be created for the purposes of differentiating between BEPS and
real economic activity. This lack of agreement typically arises over differing views
regarding the approach to be taken on two key questions, namely:
What activity generates profits? and
Where are the activities that generate profits located geographically?
126. This lack of agreement was recently noted by Doug Shackelford who commented
that: Since we rely on the financial accounting system to guide us about the timing of
income and deductions and since accountants cannot measure people, marketing, R&D
and similar costs very well, we in the tax community also struggle to recognize income
and deductions in an intangibles-based economy. Our problem is magnified because we
not only need to know what to recognize and when to recognize it, but we need to know
where to recognize it, i.e. which jurisdiction.5 This lack of agreement and empirical
evidence over where such activity is located is an important source of uncertainty in
terms of measuring BEPS.
127. What activities generate profits? One difficulty that arises from a review of the
empirical economic literature is that there is no agreement on what economic activities
generate profits, which is critical to measuring BEPS. Some analysts argue that profits are
generated where the factors of production (labour and capital) are located, whereas other
analysts argue that profits are generated where sales occur. Some other analysts argue that
profits are generated based on a combination of labour, capital and sales. Current tax
rules generally use a fact specific approach based on a companys functions, assets and
risks.
128. The conceptual problem is exacerbated by how capital, sales and labour are
typically measured. The value of total assets generally does not include the value of
intangible capital assets, which are important generators of value especially in todays
economy, but are also highly mobile. Investments in intangible assets, such as R&D
expenditures, are generally deducted or expensed in the year of the investment for
financial statement accounting, and thus are not included in the value of total assets,
except for certain intangibles acquired in an acquisition or purchase. Sales are often
measured in the countries where the sales have originated (i.e. origin or production
location) rather than where the final consumers are located (i.e. destination or
consumption location). Labour is often measured by the number of employees, but this
measure may not distinguish between full-time and part-time employees, or differences in
productivity or value added per labour hour. A MNEs labour presence may be measured
by total employee compensation, but similar to sales, employees often work in multiple
jurisdictions during a year, not just in the jurisdiction of incorporation.
129. Where are profits generated? Just as there is no agreement on the specification of
the activities that generate profit, there is considerable disagreement over the key question
of where profits are generated. Many of the existing economic studies implicitly define
the location where the activities creating profits take place in the methodologies
employed in their empirical analyses. For example, some economic studies use a profit
rate (measured as profit-to-sales, profit-to-employees or profits-to-assets) to test whether
financial statement profit is shifted between affiliates based on tax rate differentials.
130. Most of these economic studies use regression analyses to measure BEPS due to
tax rate differentials, with other non-tax variables as explanatory variables to explain the
creation of real economic profits. The economic studies define real economic profits by
reference to the measure used in the profit ratio (e.g. sales or assets) and by the
explanatory variables (e.g. tangible capital, size, headquarters location, industry, presence
of patents, etc.).
131. To estimate where economic value creation takes place, one has to construct a
specification of the production function for the entity. In the case of transfer pricing,
consideration of the production function is usually referred to as the functions, risks and
capital of the MNE. A production function would not only take into account the usual
factors of production: low-skill labour, high-skill labour and physical capital; but research
and development (R&D) and other intangible capital, public infrastructure; industry
agglomeration effects; and synergies with other entities in the MNE. Thus, the typical
empirical specification of profits does not take into account all relevant components of
the production function. Omitted variables in the analyses will have at least two effects:
the explanatory power of the regression will be weaker and the estimates of tax shifting
responsiveness may be affected by the omitted variables.
132. Additional research is needed in the area of estimating the contributions to real
economic contributions to profits, since it is essential to the separation of BEPS from real
economic activity. Recent research by Corrado et al. (2012) finds that investment in
intangible assets is a significant percentage of companies total capital expenditures, and
a significant contribution to labour productivity. Intangible investments between 1995
and 2009 were 118% of tangible investments in the United States and 62% of tangible
investments in the EU15.6 Better incorporation of intangibles assets (and not just patents
or R&D) and also risk management is needed.
3.2.4 Separating BEPS from non-BEPS tax preferences

133.
Measuring BEPS also requires separating the effects of MNEs undertaking BEPS
from the effects of MNEs using non-BEPS tax preferences. As noted earlier, domestic tax
incentives which reduce corporations average tax rates and which encourage real activity
are not BEPS. Many countries provide tax credits or lower rates for R&D and many other
socially desirable activities. As long as those tax preferences are not artificial schemes
without economic substance, then analyses should attempt to separate the effects of
MNEs using non-BEPS tax preferences from the effects of BEPS.
134.
This issue is not sufficiently addressed by empirical studies because data
limitations are such that most studies use headline statutory tax rates or average effective
tax rates. As noted below, tax rate differentials between countries are significantly larger
and growing faster when special tax rates are included in the analysis. Currently,
information about the magnitude of countries tax incentives is generally not available to
enable analysts to separate the two effects.
3.2.5 Measuring the appropriate tax rate for BEPS analysis

135. Before describing some of the key existing economic studies of BEPS and BEPS
countermeasures, it is useful to review the different tax variables used in the analyses.
Box 3.2 describes how the many different tax variables are calculated and the different
types of analyses they are used for.
Box 3.2. Different tax variables used in BEPS and tax policy analyses
Empirical analyses of BEPS, particularly regression analyses, use tax rate differentials to
estimate potential BEPS responses. There are a number of different tax rates used by policy
analysts and each of the tax variables has limitations, which are important to understand.
Statutory corporate tax rates are generally thought of as the appropriate measure of the tax
incentive for shifting taxable profits between countries. For example, if EUR 100 of taxable
income is shifted from a country with a 25% statutory corporate tax rate to a country with a 0%
tax rate, then the MNEs tax liability would be reduced by EUR 25. However, in many cases
statutory tax rates are not the correct measure of the tax benefit from BEPS. This is because
some countries have various tax provisions that may result in a different tax rate from the
statutory tax rate being applied to the shifted income. For instance, countries with allowances for
corporate equity provide a deduction for notional interest on equity and, therefore, provide less
incentive to use interest expense to shift profits. In some cases, countries with high headline
statutory tax rates may have significantly lower tax rates on special types of income (e.g. income
generated by intangible assets) and this may mean that, even though the country has a high
headline statutory corporate tax rate, income may be shifted into the country rather than out of
the country. Withholding taxes may also be payable or avoided on flows associated with BEPS.
Box 3.2. Different tax variables used in BEPS and tax policy analyses (continued)
Marginal tax rates (MTR) applicable to the shifted income would be the ideal measure for BEPS
analysis, but are often not known. In some cases the MTR is the same as the headline statutory
tax rate or a special statutory tax rate, but in others it may be a negotiated rate as part of an
administrative ruling.
Effective tax rates (ETRs) come in a number of variations and are useful for different types of
analyses.
Backward-looking average effective tax rates (AETR) are also used to measure the effects of
BEPS, but often are inexact measures of the incentives to shift taxable income. AETRs may be
closer to what companies actually pay in tax and reflect all aspects of the corporate tax system.
However, they are a backward-looking metric, reflecting historical tax effects (e.g. depreciation
from prior investments, loss deductions from prior years taken against current year taxable
income, etc.) and non-BEPS tax provisions (e.g. R&D and energy tax credits). AETRs are often
computed from financial statement data, and thus identify the country of incorporation not tax
residence, and computed from accounting tax expense, rather than tax liability or cash taxes
paid, and which can include taxes paid in other countries, as described in Chapter 1.
Forward-looking marginal and average effective tax rates (FL-METRs and FL-ATRs) are
calculated using hypothetical companies to illustrate the tax on a future investment. FL-METRs
are used to analyse domestic investment incentives at the margin, but are increasingly recognised
as inappropriate for measuring MNEs decisions on the location of high-return intangible assets.7
FL-ATRs illustrate the tax on the total return or economic profit of an investment, particularly
for investments earning above a competitive return, for purposes of considering the location of
that investment across different countries. Hypothetical companies are fact-specific and difficult
to weight to be representative of the whole economy, plus they do not capture all of the
important tax aspects of the corporate tax structure, particularly international tax rules.
Other tax rates. In evaluating the level of taxes paid by selected groups of taxpayers or specific
taxpayers, some analyses and press articles report a ratio of taxes paid to sales, and may even
call it an effective tax rate. Sometimes a low ratio is the basis for concluding that a MNE is
artificially shifting profits out of a country. This interpretation illustrates the confusion caused by
mixing tax base concepts. The corporate income tax is a tax on a companys equity income, not
a tax on sales (consumption). The appropriate measure for evaluating the burden of an income
tax is taxes divided by income, not the ratio of taxes to sales. A low ratio of taxes to sales may
simply reflect the fact that a firm operates in a low profit margin industry, where sales are high
relative to profits. In contrast to net income, the amount of sales has to cover payments to labour
and lenders, as well as intermediate purchases from other firms.
Tax policy analysts are still grappling with which tax rate(s) should be used to empirically
estimate the effects of BEPS. Sensitivity analysis, such as running regressions with different tax
rate measures, can be used to determine if the choice of tax rate makes a significant difference.
136. In addition to the tax rate used in the analysis, another methodological issue
relates to the question of determining the appropriate way to calculate the tax rate
differential (i.e. the differential between one MNE entitys tax rate compared to the
average tax rate of other entities in the MNE group). A number of empirical studies
compare affiliates tax rate to the MNE parents tax rate. That captures shifting between
parents and affiliates. Other studies compare an affiliates tax rate to the tax rate of the
group. That captures inter-affiliate shifting but in some cases does not include shifting
with the parent. Some of the studies compare the entitys tax rate to the other related
entities average tax rate, either a simple unweighted average or weighted by revenue, but
shifting may be disproportionately undertaken with the lowest tax rate affiliates. In fact,
all of the shifting may be undertaken with one entity based in a zero tax rate country. This
issue requires additional exploration to improve the measurement of BEPS tax rate
differentials.
3.3 What we know about BEPS and the effect of countermeasures

137. This section describes the empirical analyses of overall profit shifting, estimates
of the fiscal effects of BEPS, the empirical analyses of the effects of BEPS
countermeasures and particular channels of BEPS, and the economic impacts of BEPS
and countermeasures.
3.3.1 General profit shifting analyses

138. A burgeoning empirical literature on BEPS is continuing and reports significant
BEPS occurring due to tax rate differentials. The bibliography has a select listing of
articles and reports. Recent surveys of the literature on profit shifting by Dharmapala
(2014) and Riedel (2014) and a meta-analysis of profit shifting by Heckemeyer and
Overesch (2013) analysing prior empirical studies report significant BEPS among MNEs.
A review of the various general profit shifting analyses illustrates the range of databases,
tax and other variables, and methodologies used.
139. The range of studies previously undertaken use many different types of data,
including individual firm-level financial statement data, national aggregate statistics,
confidential government company surveys, export and import pricing data, and in some
cases corporate tax returns. Recent studies have increasingly examined specific BEPS
channels, such as interest deductibility and transfer pricing.
140. Most of the analyses are limited to a single country or MNEs headquartered in a
single country, where access to company surveys, corporate tax returns, or company trade
data are made available to researchers on a confidential basis, or based on analyses of
MNE affiliates in multiple countries from a limited number of financial databases. For
instance, a number of studies have used confidential information from MNEs
headquartered in Germany and the United States and their global affiliates, based on
mandatory investment surveys from the German Bundesbank and the United States
Bureau of Economic Analysis. Similar data unfortunately is not available for other
countries, and thus the results from these studies are specific to those countries MNEs,
and would not necessarily be representative for other countries due to differences in tax
rates and tax rules, differences in the industry mix and other country differences.
141. Several studies of customs and trade data identify non-arms length intra-group
pricing, but those have also been with individual country data. Extrapolation of the BEPS
found in those studies beyond the specific countries the subject of the analyses rests on a
critical assumption that the BEPS behaviours studied are of similar magnitude in other
countries.
142. Academic studies have also taken advantage of the availability of cross-country
databases of company financial records. Many economic analyses have used the
Amadeus database which is limited to European companies. Similar to individual country
analyses, the results from these studies are specific to Europe, and are unlikely to be
representative for other countries. More recently, a number of academic studies have
turned to global databases such as ORBIS. These have the advantage of including more
than just European countries, but as described in Chapter 1 the coverage while large in
total number of entities is significantly limited in the countries covered and the entities
with full financial information. Various analyses have taken different approaches, with
some analysing profit shifting from parents to affiliates and others analysing profit
shifting between unconsolidated affiliated entities.
143. While academic studies have increasingly focused on individual company data,
several international organisations have used macroeconomic data to estimate the effects
of BEPS. These studies focus on the effects of tax haven countries and FDI through
special purpose entities. Although macroeconomic data cannot capture detailed firm-level
behaviour, it can capture some dimensions of BEPS which may not be reflected in microdata due to its incomplete coverage. One limitation with using macro data, such as
foreign direct investment data, is it includes the impact of taxes on both real economic
activity and BEPS.
144. Most academic studies have not applied their estimates of profit shifting based on
the sample data to provide an estimate of the fiscal effects. Fiscal estimates require
significantly more information than just the average responsiveness of financial profits to
a change in tax rates. Financial statement profits generally differ from taxable income due
to differences in accounting and tax rules. Companies with negative taxable income in a
given year generally cannot receive a tax refund in that year, but must carry forward any
tax losses to future years. Further, the relationship between income and tax liability is not
proportional due to the extensive use of tax credits in many countries.
145. Two recent studies provide useful summaries of the empirical analysis of BEPS.
Dharmapala (2014) summarises the empirical literature of profit shifting analyses and
reports that the more recent empirical literature finds the estimated magnitude of BEPS to
be smaller than that found in earlier studies. The change seems mainly due to the
increasing recent use of micro firm level data, which is able to hold more non-tax factors
constant, compared to aggregate data across countries. Riedel (2015) reports that existing
studies unanimously report evidence in line with tax-motivated profit shifting, but there is
a wide range of profit shifting estimates from 5-30% of MNE profits.
146. Notable examples of general analyses of profit shifting using firm-specific data
are Grubert (2012), Huizinga and Laeven (2008), Heckmeyer and Overesch (2013),
OECD Annex 1, and Dowd, Landefeld and Moore of the United States Congressional
Joint Committee on Taxation (JCT) (2015). Grubert (2012) uses a sample of United
States corporate tax return data of large non-financial United States-based MNEs to
investigate the role of taxation in the large increase in the foreign share of total income of
United States MNEs between 1996 and 2002. The paper finds that companies with lower
foreign effective tax rates have higher foreign profit margins and lower domestic profit
margins. The analysis finds that introduction of the check-the-box regulation in 1997
accounted for a significant fraction of the reduction in the foreign effective tax rates. The
analysis shows that R&D intensity reduces foreign effective tax rates, indirectly
indicating that the strategic location of intangible assets can facilitate BEPS.
147. Huizinga and Laeven (2008) analyse the Amadeus database of European MNEs
unconsolidated affiliate financial account information to investigate profit shifting
incentives due to international tax differences. They were the first to take a portfolio
approach to MNE behaviour, using as a tax variable the average of bilateral differences in
statutory tax rates between companies in the same group. The analysis uses earnings
before interest and taxes as the dependent variable. Considering both tax differentials
among foreign affiliates and tax differentials between parents and foreign affiliates, they
find evidence of profit shifting, both among foreign subsidiaries and between parent
companies and their affiliates abroad. Finally, they estimate the associated revenue
implications for each country by comparing the actual profit shifting outcome to a
theoretical benchmark without profit shifting. They find a semi-elasticity of reported
profits with respect to the top statutory tax rate of -1.3.
148. Heckemeyer and Overesch (2013) conduct a meta-analysis of available profit
shifting analyses and report a tax semi-elasticity of subsidiary pre-tax profits of -0.8,
where a 10 percentage point increase in the tax variable reduces financial statement
profits by 8 percent. The analysis uses multiple estimates from individual studies and is
heavily weighted to studies of European companies. The analysis does not separately
estimate the effects of the different types of data, such as financial account, investment
survey, and tax return data.
149. New research in Annex 3.A1 uses the ORBIS database of unconsolidated
affiliates financial accounts to analyse profit shifting and differences between MNE
affiliates and similarly-situated domestic companies. The analysis finds that between
2000 and 2010 an affiliates statutory headline tax rate that is one percentage point above
its MNE group average is associated with a lower reported profit by about 1 percent on
average, a semi-elasticity around -1.0. A second analysis finds that large MNE entities
(with more than 250 employees) have an estimated 2 to 5 percentage points lower
effective tax rate on average than comparable domestic-only companies, which reflects
the exploitation of mismatches between tax systems and the relative use of domestic tax
preferences. Combining the two estimates, BEPS is found to reduce the ETR of large
MNEs entities by a range of 4 to 8 percentage points. The analysis also finds that
existing tax anti-avoidance rules have a positive effect on reducing profit shifting.
150. Dowd, Landefeld, and Moore (2015), three economists of the United States Joint
Committee on Taxation, analyse United States tax return data for foreign controlled
corporations of United States parent MNEs and find significant non-linear effects of
profit-shifting. They find a linear estimate of the semi-elasticity is -1.3, but the study also
finds 4 to 7 times higher elasticities for profit shifting to low-tax affiliates. Despite
working with actual tax return data, missing data8 and consolidation issues (e.g. affiliates
in zero tax rate countries report some taxes paid to other countries) could affect the
results.
151. Dharmapala (2014) has noted that the estimates of tax responsiveness from
academic studies often seem small relative to the large fraction of net income in tax
havens. These are not necessarily contradictory, since the former measure the effects of
small marginal changes (i.e. in tax rate differentials) rather than the absolute levels of tax
rate differences of 20% or 30% compared to 0%.9 Thus, econometric estimates of
marginal changes may understate the actual effects of large tax rate differentials.
152. Table 3.1 presents a number of profit shifting economic analyses using individual
company information. All of these empirical studies are attempting to measure the effect
of profit shifting due to tax rate differentials, separating profit shifting from the effects of
real economic activity. Differences in the data, variables used, and methodology used
(Box 3.3) explain why good empirical analyses yield different results, but all show strong
evidence of profit shifting. The median elasticity among the 20 studies is -1.0.
Box 3.3. Different approaches used to estimate profit shifting

Since the seminal articles on estimating profit shifting by Grubert and Mutti (1991) and Hines
and Rice (1994), an increasing number of empirical analyses of profit shifting have been
conducted with individual company (micro-level) data. Analysis of micro data enables
researchers to avoid aggregation issues and more importantly to better take account of firm level
measures of economic factors explaining company profitability. The estimates of profit shifting
attributable to tax differences from analyses since 2007 show a wide range of semi-elasticities
from -0.4 to -3.7. The analyses suggest that a 10 percentage point lower corporate tax rate could
reduce profit shifting by 4% to 37%, holding all other factors constant and these studies do not
take into account countries current anti-avoidance rules.
Although a common general approach is taken, the statistical regression analyses use different
data sources, different data variables and different estimation techniques. Differences in the
results can be due to any number of these factors.
Type of data: The micro-data empirical analyses use three types of data: financial accounts,
confidential company investment surveys, and tax return data. Financial account data reports tax
expense rather than actual taxes paid, which can differ due to deferred taxes and includes taxes
paid to countries other than the country of incorporation.
Coverage by country: Depending on the database used, MNE entities analysed differ across
studies. Many studies use a European entity database, so only include European affiliates of
worldwide parents. Several studies analyse entities around the world, but only affiliates of
United States parent MNEs, while Weichenrieder analyses German affiliates of foreign parent
MNEs. Recently several studies have analysed entities worldwide through the use of the ORBIS
database, but as noted in Chapter 1, this database is not comprehensive particularly outside of
Europe and is especially weak in developing countries.
Coverage by MNE relationships: Studies differ in the type of MNE entities included. Some limit
the analysis to unconsolidated entities, while others include both affiliates as well as parents. The
OECD analysis takes advantages of ownership links to affiliated companies to include the
statutory tax rate of the linked affiliates, even if the linked entities do not have financial
information included in the database.
Estimated profit variable: Most studies use some variant of profit as the dependent variable,
while a few use broader capital income measures such as return on assets and total factor
productivity. The measures of profits include pre-tax profit, post-tax profit, and earnings before
interest and taxes (EBIT). Some studies normalise pre-tax profits as a ratio of sales or assets.
Tax rate variable: A key predictive variable is the tax rate. Most studies use either the statutory
headline tax rate or an average effective tax rate. Often the top marginal tax rate is the incentive
at the margin for shifted income, but in many countries special lower tax rates apply to certain
types of income, especially highly mobile income. Other studies use average effective tax rates
to reflect special lower rates as well as other tax incentives or negotiated rates which can
significantly reduce the applicable tax rate below the headline statutory tax rate. Several studies
use a composite tax rate variable that weights tax rate differentials by revenue to control for
different opportunities to shift income.
Tax rate differential variables: Profit shifting depends on differences in tax rates across
countries. Profit shifting can also occur between countries with similar statutory tax rates where
one entity has tax losses, and thus a lower effective tax rate. Some studies calculate tax rate
differentials between the affiliates and the parent; others calculate the differential between
affiliates using an average rate for the other affiliates; while other studies simply use the absolute
tax rate of the entity.
Box 3.3. Different approaches used to estimate profit shifting (continued)
Explanatory economic variables: Separating profit shifting from real economic activity
contributions to reported profits is important. Most studies include a variety of measures of real
economic activity to isolate the tax effect. Most studies use available metrics of capital and/or
labour, additional variables such as population, unemployment, inflation, trade and corruption
indices, and GDP related measures to account for macroeconomic differences in the countries in
which the MNE entities are operating. The capital measure only includes reported total assets or
tangible/fixed assets, and thus does not include other potential contributors to firm profit, such as
intangible assets of the MNE group, public infrastructure, social capital, etc. It should be noted
that the explanatory economic variables used are quite different from the arms length pricing
measures based on functions, risks and assets of the MNE entities or uncontrolled comparable
prices. No studies to date have used both affiliate and group data to estimate the entities shares
of the MNE group profit due to data limitations.
Fixed effects (dummy) variables: Most of the empirical studies use fixed effects variables to
hold constant factors unique to the individual entity, individual year, industry or country. Ideally,
the regressions would include specific economic measures for these dimensions, but due to data
or conceptual limitations, simple one-zero dummy variables are often used to capture those
important effects.
Linear vs. non-linear tax effects: Analysts must choose a specification of the regression equation
of how tax rates affect profit shifting. Most analysts choose a semi-log elasticity measure where
the percentage change in profits is a function of a percentage point change in the chosen tax rate
variable. Alternatively, the estimate can be calculated with a simple elasticity, where the
percentage change in profits is a function of the percentage change in the chosen tax rate. The
two types of estimates can be presented as equivalents by calculating the semi-log elasticity
equivalent for the simple elasticity at the average of the tax rate. The Hines/Rice analysis
suggested that a non-linear specification could be used, but most empirical analyses have
conducted linear specifications. The United States JCT economists analysis cites a -1.3 linear
semi-elasticity, but their preferred speciation is non-linear and ranges from -0.8 to -9.5
depending on the level of the effective tax rate faced by the affiliate.
Semi-elasticity vs. elasticity: Most analyses use a semi-elasticity measure (based on a log-linear
specification) where the percentage change in profits is a function of a percentage point change
in the chosen tax rate variable. Alternatively, the estimate can be calculated with a standard
elasticity (based on a log-log specification), where the percentage change in profits is a function
of the percentage change in the chosen tax rate. The main advantage of the semi-elasticity is that
it is straightforward to interpret; an x percent change in profits for a one percentage point change
in the tax rate. Elasticity specifications can capture a changing responsiveness depending on the
absolute level of the tax variable. A semi-elasticity equivalent can be calculated for the elasticity
specification at the average of the tax rate.
Cost of tax planning / Linear vs. non-linear tax effects: Economic theory suggests two reasons
for a non-linear relation between tax rates and profit shifting: fixed cost of tax planning and
convex concealment costs. These effects are not mutually exclusive. Convex concealment costs
arise when the cost of shifting increases with the absolute amount of profits shifted. This implies
that the effect on pre-tax profits will be smaller at higher absolute levels of the tax rate
differential. If tax planning is associated with fixed costs, higher tax semi-elasticities would be
expected at higher absolute levels of the tax rate differential. Although Hines and Rice (1994)
found evidence of a non-linear relationship, most subsequent empirical analyses have reported
only linear specifications. Grubert and Mutti (1991) found evidence of fixed tax planning costs.
Dowd, Landefeld and Moore (2015) find a strong non-linear relationship with semi-elasticities
ranging from -0.8 to -9.5 depending on the level of the effective tax rate faced by the affiliate,
which provides empirical support of fixed costs of tax planning and for testing non-linear
specifications.
Box 3.3. Different approaches used to estimate profit shifting (continued)

Methodologies: Given the significant differences in the empirical analyses of profit shifting,
recent research has included meta analyses which use other studies results and differences as
described above to attempt to summarise the available analyses. One meta-study reports
significant profit shifting responses, but the results are dependent on the underlying data used
and the particular methodologies of the underlying studies. Some studies are included multiple
times because different variants of the same data and approach are included, and the majority of
studies are based on European entities and financial statement information. An alternative
methodology based on a temporary change in profits, rather than tax rate differentials, by
Dharmapala and Riedel (2013) has been used, but they note that the methodology is unlikely to
capture longer-term planning opportunities, such as transfer pricing.
Time period: Huizinga and Laeven analyse a single year, 1999, while most analyses use multiple
years but with different time periods, such as Weichenrieder (1996-2003) and Beer and Loeprick
(2003-2011). If BEPS is changing over time, the time period used will affect the estimated
responsiveness.
Many of the studies in Table 3.1 include a number of sensitivity analyses and alternative
specifications, providing important additional insights beyond just a single tax rate elasticity. For
example, the OECD profit shifting analysis in Annex 3.A1 tested the sensitivity of different
dependent variables (i.e. pre-tax profit to employment, operating profit to total assets) and
different fixed effects (i.e. country and country interacted with time fixed effects), and the profit
shifting elasticity was found to be robust.
Table 3.1 Data sources, estimation strategies and results from recent profit shifting studies
Authors
Year
Semielasticity
Dischinger
2007
-0.7
Huizinga and Laeven
2008
-1.3
Dependent
Variable
pre-tax
profit
pre-tax
profit
GDP
ADD
Fixed Effects
Firm
Time
x
x
Azemar
2010
-1.0
pre-tax
profit
Becker and Riedel
2012
-0.7
pre-tax
profit
Blouin, Robinson and

Seidman
2012
-0.5
pre-tax
profit
Dischinger, Knoll and Riedel
2013
-0.5
Dharmapala and Riedel
2013
-1.1
pre-tax
profit
pre-tax
profit
Markle
2015
-0.9
pre-tax
profit
Dowd, Landefeld and Moore

at United States Joint
Committee on Taxation
2015
-1.3
pre-tax
profit
Clausing
2015
-2.4
pre-tax
profit
Schwarz
2009
-3.5
Grubert
2012
-1.6
OECD
2015
-1.0
Loretz and Mokkas
2011
-1.1
pre-tax
profit to
sales
pre-tax
profit to
sales
pre-tax
profit to
assets
post-tax
profit
x
x
Ind.
Rsquared
Time
Period
STR
affiliate to parent
0.76
19952005
STR
affiliate to parent
0.68
1999
US-STR
and
foreign
ETR
no
0.81
19922000
STR
affiliate to parent
N/A
19952006
STR
foreign aff. to
US parent
0.60
19822005
STR
affiliate to parent
0.14
STR
no
0.21
affiliate to group
Coverage
EU
entities
EU
entities
foreign
aff. of US
parents
19952005
19952005
EU
entities
foreign
aff. of US
parents
EU
entities
EU
entities
0.83
20042008
worldwide
entities
Data
FS
FS
TR
FS
IS
FS
FS
composite
var. based
on STR
STR and
ETR
no
0.46
20022010
ETR
foreign aff. to
US parent
0.64
19832011
ETR
no
0.28
19992001
change in
foreign
ETR
no
N/A
1996,
2004
STR
affiliate to group
0.03
20002010
worldwide
entities
FS
STR
no
0.01
20022009
EU
entities
FS
Tax rate
differential
Tax
variable
x
x
Ctry.
x
x
foreign
aff. of US
parents
foreign
aff. of US
parents
foreign
aff. of US
parents
foreign
aff. of US
parents
FS
TR
IS
IS
TR
Table 3.1 Data sources, estimation strategies and results from recent profit shifting studies (continued)
Authors
Year
Semielasticity
Dependent
Variable
GDP
ADD
Lohse and Riedel
2013
-0.4
EBIT
Beer and Loeprick
2013
-1.0
EBIT
Beuselinck, Deloof and

Vanstraelen
2014
-1.6
EBIT
Maffini and Mokkas
2011
-1.0
total factor
prod.
Weichenrieder
2009
-0.5
return on
assets
Heckemeyer and
Overesch
2013
-0.8
pre-tax
profit and
EBIT
Fixed Effects
Tax
variable
Tax rate
differential
Rsquared
STR
affiliate to parent
0.16
STR
affiliate to group
0.06
composite
var. based
on STR
affiliate to parent
STR
Firm
Time
Ind.
x
x
Ctry.
Time
Period
Coverage
19992009
20032011
EU
entities
worldwide
entities
0.71
19982009
EU
entities
no
0.10
19982004
STR
German affiliate
to parent
0.52
19962003
worldwide
entities
German
aff. of
foreign
par.
STR and
ETR
various
N/A
various
various
Data
FS
FS
FS
FS
IS
meta
Note: Studies estimating tax semi-elasticities of profit shifting published after 2006. In case of no preferred estimate, the baseline specification was used. C stands for tangible
capital, L for employee compensation, ADD for additional variables; a x indicates that corresponding control variables have been included. In the last column FS
indicates financial statement data, IS investment survey, and TR tax return data.
3.3.2 Incentives for BEPS

153. Much of the discussion of BEPS has focused on tax elasticities of profit shifting
or on the declining corporate tax rates among OECD countries over the last twenty years.
This might lead some to conclude that the incentive to engage in BEPS behaviours has
declined. However, profit shifting is based on tax rate differentials between MNE entities
in two countries, not the level of CIT rates. The incentive to shift income from an entity
in a country with a 40% tax rate to a related entity in a country with a 20% tax rate is the
same as the incentive to shift income from an entity in a country with a 30% tax rate to a
related entity in a country with a 10% tax rate. In both cases, there is a tax avoidance of
20% of the amount of profit shifted.
154. Tax rate differentials can be measured by the statistical concept of standard
deviation, reflecting the distance of individual countries CIT rates from the average CIT
rate. Figure 3.1. shows the average CIT rate and the standard deviation of CIT rates in
OECD countries between 1998 and 2013. The tax rates and standard deviation are
weighted by foreign direct investment to focus the analysis more closely on MNE crossborder activity and BEPS. The average OECD CIT rate declined on average from 34.5%
in 2003 to 30.1% in 2013. In contrast, the standard deviation of CIT rates increased from
5.6 in 2003 to 7.0 in 2013, i.e. by 25%.
Figure 3.1. Incentive to engage in BEPS: Corporate income tax rate variation within OECD
countries
FDI weighted standard deviation (left axis)
FDI weighted average (right axis)
10
40
35
30
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
25
Weighted by the average inward and outward FDI position. Source: OECD Tax Database, OECD FDI
Statistics.
155. Most empirical studies analyse the effects of statutory headline tax rates. The
incentives for BEPS are based not only on headline statutory CIT rate differentials. Many
countries have preferential tax treatment for certain types of income. For example, the
strategic location of intangibles is a significant BEPS strategy, and the incentives to
engage in BEPS behaviour are increased when there are preferential tax rates on patent
income without economic nexus requirements. Figure 3.2. shows the average CIT rate on
patent income and the standard deviation in OECD countries. In 2013, eight OECD
countries had patent boxes. The remaining OECD countries applied their headline CIT
rates on patent income. Again, the tax rates are weighted by FDI to narrow the focus
towards MNE cross-border activity and BEPS.
156. The average CIT rate on patent income is lower and declined more than the
average headline CIT rate. The standard deviation of CIT rates on patent income is higher
and increased more than that of CIT headline rates. The standard deviation increased
sharply in 2007 when Belgium and the Netherlands introduced their patent boxes. The
weighted standard deviation of CIT rates on patent income in OECD countries increased
from 8.6 in 2003 to 11.8 in 2013, i.e. by 38%.
Figure 3.2. Incentive to engage in BEPS: Corporate income tax rate on patent income
variation within OECD countries
FDI weighted standard deviation (left axis)
FDI weighted average (right axis)
16
40
12
30
20
10
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Weighted by the average inward and outward FDI position.

Source: OECD Tax Database, OECD FDI Statistics. European Commission (2015)
157. Further refinement of these measures is possible, but they clearly show the
incentives for engaging in BEPS behaviours, such as the strategic location of intangibles,
has been increasing over the past 11 years. Finally, the incentive to shift profits to
countries with zero tax rates still remains strong even with lower average tax rates.
Reducing taxes to zero from 10% or 20% still creates a large tax rate differential effect,
which is why there is BEPS shifting to zero rate countries from all positive tax rate
countries.
158. When analysing BEPS it is important to refine the measurement as closely as
possible to the affected economic activity. Table 3.2 shows that a simple unweighted
standard deviation of statutory tax rates in OECD countries does not show an increase in
the incentive for BEPS. However, when the tax rate differentials are weighted by GDP
they show a significant increase. When they are weighted by FDI and trade, both
measures of MNE activity, they are even higher and the percentage change over the past
eleven years is also higher.10 The standard deviation of CIT rates on patent income is
much higher than simply using the statutory headline tax rate.
Table 3.2. Standard deviation of OECD tax rates, 2003 and 2013
Unweighted
GDP weighted
FDI weighted
Trade weighted
Statutory headline tax rates

2003
6.5
2013
5.8
4.7
5.6
5.6
6.6
7.0
6.6
CIT rates on patent incomes

2003
8.5
7.2
8.6
8.3
2013
8.4
10.0
11.8
10.7
159. A similar analysis using bilateral tax rate differentials shows a similar large
incentive effect to undertake BEPS. Using FDI positions as weights11, there is a wide
variation ranging from 11% for the United States to -18% for Ireland between OECD
countries in 2012. Since 2000, the differentials have increased from 3% in the United
States and -13% in Ireland. Germanys FDI-weighted bilateral tax rate difference
declined from 16% in 2000 to 0% in 2014. Using shares of each trading countrys total
exports of goods accounted for by a trading partner as weights, there is a wide range of
tax rate differentials between OECD countries, ranging from 14% for the United States to
-16% for Ireland.
160. This type of information on tax rate differentials, the key explanatory variable in
empirical studies of BEPS, should be reported in empirical studies of profit shifting. The
tax rate differentials are as important as the elasticity estimate in the studies if the results
are used to estimate the fiscal impact of BEPS. It should also be noted that incomplete
coverage of countries in the underlying databases, whether using macroeconomic or firmlevel data, will affect the weighted average of the STRs in the comparison countries. If
countries (or firms in countries) with relatively high positive tax rate differentials are
underrepresented, the implicit global tax rate differential will be understated.
3.3.3 BEPS and developing countries

161. Due to limitations of the available data, both in terms of quality and quantity, as
noted in Fuest and Riedel (2010), empirical research of profit shifting in developing
countries is quite limited. Attempting to fill the gap on developing country studies of
BEPS, Fuest, Hebous and Riedel (2011) empirically examine income shifting from
developing countries by focusing on related party loans. Distinguishing between German
MNE affiliates in developed and developing countries, the results show that related party
debt in developing countries is significantly more sensitive to changes in corporate tax
rates than in developed countries. The study concludes that profit shifting, measured
relative to current CIT collections, is about twice as large in developing countries as in
developed economies. The IMF (2014) study on international tax spillovers uses a rough
comparison of corporate tax efficiency, which suggests that revenue losses as a percent of
CIT revenues in developing countries could be several multiples of those in developed
countries, due to weaker enforcement resources.
162. Many studies focusing on developing countries do not separate the revenue lost
from BEPS behaviours from individual tax evasion and illicit financial flows. Developing
countries have higher ratios of CIT to GDP, so their revenue base is potentially more at
risk from BEPS behaviours than developed countries, and loss of CIT revenue could lead
to critical underfunding of public investment that could help promote economic growth.
In a report by the African Tax Administration Forum, African tax administrations find
that transfer-pricing abuse is a major obstacle not only to effective revenue mobilisation,
but also to development and poverty alleviation, and that most countries lack the
necessary skills to identify and analyse complex cases.12 Better understanding of the
economic effects of BEPS on developing countries is important for the design of tax
policies that account for country differences in tax systems and levels of enforcement
capabilities.
163. A recent working paper by UNCTAD13 provides a tax and investment perspective
on the tax consequences of FDI for developing economies. Investment is important to
sustainable growth of developing countries, which must be considered when reducing
profit shifting out of those economies. Again, how the potential additional tax revenues
from reducing BEPS behaviours are used by developing counties will be important to the
future effects of countermeasures on their inbound FDI.
164. The UNCTAD empirical analysis investigates the role of investment as one of the
enablers of tax avoidance, highlighting the use of special purpose entities (SPEs), tax
havens and the role of offshore investment hubs as major players in foreign direct
investment in developing countries. It states: The root-cause of the outsized role of
offshore hubs in global corporate investments is tax planning. The analysis is based on
an approach which maps aggregate corporate international investments between direct
investor and recipient jurisdictions based on bilateral flows in or coming from SPEs and
tax havens. It finds a relatively larger effect of SPE and tax haven investment in
developing countries.
3.3.4 Estimating the scale (fiscal effects) of BEPS

165. In addition to existing data limitations, the need to develop a clear methodology
for measuring BEPS was the second most cited problem facing government tax policy
analysts, according to the country survey conducted by the CFAs WP2, and by numerous
commentators on the Action 11 discussion draft. All studies of the scale of BEPS attempt
to measure how the actual amount of corporate tax paid across countries differs from the
counterfactual of a world without BEPS behaviours.
166. A number of studies have sought to compare the geographic location of profits
reported by MNEs, which are affected by BEPS behaviours, with a counterfactual of a
world without BEPS, where the location of profits is aligned with the location of the
economic activity that generated those profits. Without specifying individual BEPS
behaviours, these studies take an aggregate approach (not based on specific BEPS
channels) and examine the effect of profit shifting due to differences in tax rates, which
are not otherwise explained by the available measures of real economic activity. These
studies were initially undertaken with country macroeconomic variables, but now
increasingly take advantage of available firm-level data, enabling closer linkage of
differences in profitability across firms based on firm-specific tax and non-tax factors,
albeit with the significant data limitations of currently available firm-level data.
167. Analyses estimating the effect of tax rate differentials without refining the
estimates for BEPS behaviours (i.e. artificial strategies segregating taxable income from
the activity that generates it) will have a tendency to overestimate the scale of BEPS. This
is because BEPS is not due to tax differentials per se, but rather to specific taxpayer
strategies segregating taxable income from the activities that create that value. Tax rate
differentials using AETRs reflect non-BEPS tax reductions, such as from R&D tax credits
or accelerated depreciation, thus resulting in an overestimate of the scale of BEPS.
Implementation of transfer pricing rules allows a range (acceptable within inter-quartiles)
within which acceptable prices can be set, which are not reflected in tax rate differentials.
Due to other factors, particularly data limitations and incomplete specification of the
underlying production function, estimates from tax rate differences may underestimate
the scale of BEPS.14
168. Another approach uses aggregate macroeconomic country measures to take into
account tax rate differences or institutional differences. These studies take advantage of
country-specific details, such as the amount of country FDI from SPEs or tax havens, or
the statutory tax rates of tax havens and other countries. These studies are unlikely to
fully separate BEPS from real economic activity and non-BEPS tax preferences.
169. Another approach measures specific BEPS behaviours. A recent survey of the
academic literature by Riedel (2015) states: The most convincing empirical evidence has
been presented by academic studies that investigate specific profit shifting channels as
their empirical tests are more direct and offer less room for results being driven by
mechanisms unrelated to income shifting.15 Examples include quantifying the effects of
non-arms length transfer pricing, excessive interest deductions, and treaty abuse.
Measuring specific BEPS behaviours enables researchers to use different types of data
sources, such as trade data to analyse transfer pricing, leverage rates of affiliated
companies to analyse excessive interest, or bilateral investment flows to analyse treaty
abuse. BEPS behaviours are driven by differences in tax rates and/or differences between
tax systems that can be exploited to reduce taxation through artificial schemes.
170. While measuring specific BEPS Actions is a more direct approach, many of the
same data and methodological issues arise. Estimating the revenue effects of specific
BEPS Actions requires consideration of the interactions between different BEPS channels
(e.g. possible overlap or complementarities) in producing a total BEPS estimate. For
example, the tax challenges of the digital economy (Action 1) are being addressed
through the other Actions, in particular the work on artificial avoidance of permanent
establishment, transfer pricing and CFC rules.
171. At the individual country level, the BEPS Actions approach may be estimated by
governments using their own administrative databases, which will often include tax return
data. Proposed BEPS countermeasures are not expected to eliminate 100% of the impact
of BEPS behaviours out of consideration of administrative costs for tax administrations
and businesses. See Annex 3.B1 for a description of how governments could use this
approach to measure individual BEPS Actions.
172. There are a limited number of other estimates of global fiscal effects of BEPS or
the fiscal effects of BEPS for developing countries. A recent study16 uses aggregate
country data on investment through offshore investment centres and tax havens to
estimate the fiscal effects for developing countries and globally. Several non-government
organisations (NGOs) have published figures which are often multi-year estimates based
on trade or total corporate tax numbers, but do not attempt to separate real economic
activity from BEPS behaviours, and often include estimates of individual income tax
evasion or non-compliance.
173. Given the many uncertainties associated with global estimates of the scale and
economic impacts of BEPS, no single empirical estimate will be definitive, but such
estimates are generally of more value for policymakers than extrapolating from more
narrow studies involving a limited number of companies or countries. By laying out the
approaches taken, the research can be further refined as improvements in available data
and methodologies become available.
174. Table 3.3 shows the range of global estimates from a new OECD estimate of the
global revenue loss from BEPS (described below), as well as from two other analyses.
The estimates range from 4% to 10% of global CIT revenue for the global revenue loss,
and from 7.5-14% of developing countries CIT revenue. It should be noted that the
UNCTAD estimates do not include the full effects of trade mispricing.17
Table 3.3. Estimates of global and developing country fiscal effects from BEPS
Fiscal estimate approach
Scope
OECD aggregate tax rate differential

Global
Other Estimates
IMF CIT efficiency 2014
Global
UNCTAD offshore investment matrix
Global
2015
IMF CIT efficiency 2014
Developing countries
UNCTAD offshore investment matrix
Developing countries
2015
* Only includes investment-related BEPS: not trade mispricing.
Range USD (billions)

100-240 (4-10% of CIT)
Year (level)
2014
5% of CIT
200 (8% of CIT)*
13% of CIT
66-120 (7.5-14% of
CIT)*
2012
2012
3.3.5 Global estimate of the revenue loss from BEPS

175. Annex 3.A1 presents a global estimate of the revenue loss from BEPS based on
both an analysis of profit shifting due to tax rate differentials and an analysis of
differences in effective tax rates between large MNE affiliates and comparable domestic
companies reflecting mismatches between tax systems and tax preferences. The analysis
is based on data from the ORBIS database of financial accounts from 2000 to 2010. The
ORBIS database has the largest set of financial accounts, with the limitations described in
Chapter 1.
176. The global revenue analysis starts with two key empirical findings. First, the
analysis estimates the semi-elasticity of reported profits to tax rate differentials between
unconsolidated affiliates statutory headline tax rates and their MNE group average tax
rate (taking the unweighted average of the other affiliates statutory tax rate). The
analysis extends prior analyses of the ORBIS database by taking into account ownership
linkages, including linkages with affiliates that do not report financial information but
have information on the affiliates country of incorporation, so can include their statutory
tax rate. This enables the inclusion of many low-tax rate country affiliates as part of the
unweighted group average tax rate. The analysis finds a semi-elasticity of reported profits
to the tax rate differential on average of about -1.0. The analysis is based on 1.2 million
records between 2000 and 2010, although coverage is limited in a number of countries.
177. Second, the analysis estimates that average effective tax rates of large MNEs
(with more than 250 employees) are on average 2 to 5 percentage points lower than
comparable entities in domestic-only (i.e. non-multinational) groups. This difference
could be due to MNEs ability to exploit mismatches between tax systems, such as hybrid
mismatch arrangements, and a greater ability to take advantage of preferential tax
treatment to reduce their tax liability, such as tax concessions to attract foreign direct
investment by MNEs. The analysis is based on 2.0 million records between 2000 and
2010. As a result of both profit shifting, mismatches between tax systems and relative use
of domestic tax preferences, the ETR of large MNE entities is estimated to be lower on
average by 4 to 8 percentage points compared to similarly-situated domestic-only
affiliates. This differential is even higher among very large firms and MNEs with patents.
178. A revenue loss estimate requires a number of important parameters and
assumptions to extrapolate from one database to a global estimate. As the available data
have limitations in representativeness and coverage in a number of countries, only a
global estimate based on global parameters was produced. The revenue loss arises from
two effects: profit shifting due to tax rate differentials and differences in average effective
tax rates for large affiliates due to mismatches between tax systems and tax preferences.
The combination of the two effects results in estimates of the net18 global corporate tax
revenues lost from BEPS at 4-10% of corporate tax revenues, or USD 100-240 billion at
2014 levels. These estimates are based on the specific database, methodology and
assumptions used as described below and in more detail in Annex 3.A1.
179.
The estimate of profit shifting is calculated on the following equation:
180. The key parameters used are the responsiveness of the profit-to-asset ratio to tax
rate differentials estimated from the ORBIS database with a particular regression
specification for profitable entities (-0.1); the average profit-to-asset ratio (6.2%) from
ORBIS data; an average tax rate differential between affiliates (3.6%) from ORBIS data;
MNEs share of profits (59%) with the ORBIS data and supplemented with aggregate tax
return tabulations for several countries; tax credits as percent of before-credit corporate
tax collections (19%) from an OECD survey19; and an estimate of USD 2.3 trillion of
after-credit corporate tax collections in 2014, adjusted for expected growth from 2011.
181. The estimate is based on a number of assumptions. The estimated semi-elasticities
of reported profits to tax rate differentials of -1.0 for all MNE entities and -1.6 for
profitable MNE entities is assumed to be the same for the MNEs outside the ORBIS
sample as the MNEs in the sample; the tax variable is assumed to accurately capture
profit shifting, based on the specification of the regression and the variables used; tax
revenue changes are assumed to be proportional to the amount of profit shifting; noncorporate businesses are assumed not to be engaged in BEPS; ORBIS relationships for
tax rate differentials and asset/profit ratio are assumed to be the same for MNEs outside
the ORBIS sample as the MNEs in the sample; differences in any of these relationships
across countries are assumed to not significantly affect the global estimate; and the
average profit shifting response to tax rate differentials between 2000 and 2010 is
assumed to be the same for 2014.
182. The estimate of the mismatches between tax systems and the relative use of
domestic tax preferences is calculated by the following equation:
CIT revenue lost from MNE mismatches between tax systems and preferential tax
treatment = Average ETR difference between large MNE entities and comparable
domestic entities MNEs share of total profits Share of large MNEs estimated
global CIT revenues
183. The key variables different from the profit shifting equation are the average ETR
difference between large MNE entities and comparable domestic entities estimated from
the ORBIS database with a particular regression specification (3.25%) and the share of
large MNEs as a percentage of all MNEs in the ORBIS sample (93%).
184. The estimate is based on some additional assumptions. The estimate of a ETR
differential between large MNEs and comparable domestic entities is assumed to be the
same for the MNEs outside the ORBIS sample as the MNEs in the sample; the
differential tax rate variable is assumed to not include non-BEPS tax preferences
available to both MNEs and domestic companies; tax revenue changes are assumed to be
proportional to the amount of the estimated ETR differential; and the average ETR
difference between 2000 and 2010 is assumed to be the same for 2014.
185. Some factors may lead to an underestimation of the revenue loss (e.g. missing
entities engaged in significant BEPS, different weighting in estimation20), while other
factors may lead to an overestimate (e.g. not controlling for country-fixed effects21).
Recognising these uncertainties, a range of the global revenue estimates is presented. The
range from 4% to 10% of CIT revenues takes into account a 95% confidence interval
around the tax sensitivity estimates22 and the upper bound assumes that firms outside the
sample have a 50% higher tax planning intensity than firms in the sample. The coverage
rate of ORBIS with the OECD STAN Business Demography Statistics was an average
32%, weighted by corporate tax collections.
3.3.6 Some other fiscal estimate studies

186. As described earlier, three other studies have estimated the fiscal effects of BEPS
on a global basis and also for developing countries, while other studies have estimated the
fiscal effects for different groups of countries. Their results were included in Table 3.3
and are briefly described in Box 3.4.
187. Individual countries have made government fiscal estimates of prior legislation
enacting unilateral BEPS countermeasures. In most cases, the fiscal estimates are ex ante
estimates made at the time of the legislative enactment, rather than ex post analyses of the
enacted legislation, and may not include behavioural effects. In several countries, recent
limitations on excessive interest deductions were estimated to increase corporate income
tax revenues by 3-9 percent.
188. A number of countries do not estimate the fiscal effects of base protection
measures, since they are intended to preserve existing revenue rather than to increase
revenue above prior projections. This is another example of the key issue of what the
counterfactual comparison should be. If the BEPS-type countermeasure is not enacted,
then the revenue base would not be protected and revenue would decline. Once the
projected revenue is reduced for the uncorrected BEPS problem, then countermeasure
legislation would result in higher revenue. Under either scenario, BEPS countermeasures
are important for ensuring corporations reduce their BEPS-related tax planning activities
through artificial arrangements which separate taxable income from where the value is
created.
189. Academic researchers have general chosen not to extend their estimates of the
profit shifting responses to producing fiscal estimates. Bach (2103), Clausing (2009) and
Vicard (2015) are exceptions that have taken the additional steps to extend empirical
estimates of elasticities to the magnitude of revenue foregone by governments.
Box 3.4. Other empirical analyses of BEPS fiscal effects

International Monetary Fund. The IMF in 2014 as part of their Spillover of International
Taxation report estimated the spillover effects of profit shifting, and reports an unweighted
average revenue loss across all countries in the sample of 5 percent of current CIT revenue, but
almost 13 percent in the non-OECD countries.23 The calculation is based on differences in
countries corporate income tax efficiency ratio (i.e. a countrys estimated tax base relative to a
measure of capital income from national accounts) compared to the average ratio in the sample
countries. The analysis assumes that all of the variation in cross-country CIT efficiency ratios is
attributable to profit shifting. The estimate does not separate non-BEPS tax incentives or adjust
for differences in compliance or enforcement, nor does it include tax haven countries.
Counterintuitively, the calculation estimates that the United States is a beneficiary of corporate
income tax profit shifting.
UNCTAD. In the World Investment Report 2015, UNCTAD estimates the revenue losses for
developing countries due to profit shifting range from USD 66 billion to USD 122 billion in
2012. The rate of return on FDI is estimated to be 1-1.5 percentage points lower for each 10%
share of inward investment stock originating from offshore investment hubs and tax havens. The
report cites the massive and still growing use of offshore investment hubs by MNEs. The
estimated shifted profits from offshore investment hubs multiplied by an average tax rate
provide an estimate of potential revenue loss. The shifted profits are estimated to be around 50%
of the currently reported profits of MNEs.24 When extending the analysis to all countries, the
estimated revenue loss is USD 200 billion, or approximately 10% of current CIT revenue. The
report notes that the estimated revenue losses are mostly confined to those associated with tax
avoidance schemes that have a direct investment relationship, and states that Trace mispricing
does not require a direct investment link. The results do not include several key BEPS channels.
United States Congressional Joint Committee on Taxation (JCT). The JCT in modelling a major
United States tax reform proposal calibrated their dynamic general equilibrium model for
corporate profit shifting. They set the level of current profit shifting at approximately 20% of the
corporate tax base in 2013, consistent with the middle point of estimates of this shifting under
present law.25 Since tax collections are not proportional to the tax base due to tax credits, the
effect on corporate taxes would be larger than the 20% or USD 70 billion.
United States JCT economists. Using United States tax returns for foreign affiliates of United
States parents, the analysis not only estimated the tax responsiveness of profit shifting to tax
rates, but also did a simulation of the effects on reported profits if six countries with low tax rates
increased their rates to 17%.26 The study estimates that over USD 110 billion of reported profits
would no longer be reported in those six low tax countries as a result of reduce profit shifting by
United States affiliates in those countries.
MSCI. MSCI updated an analysis of the largest global companies and the difference between
their reported taxes and an estimate of the tax liability based on where they generate revenues.27
The report found that 22% of the companies had effective tax rates 10 percentage points below
the weighted average statutory tax rate of the countries in which they generate revenues.
Between 2009 and 2013, the analysis estimates that just 243 companies paid USD 82 billion
annually less taxes that their peers on the MSCI World Index and also below the average
statutory tax rate of the countries in which they generate revenues. The analysis did not attempt
to separate non-BEPS tax incentives which reduce companies ETRs, and the analysis uses sales
to allocate financial report income between countries.
Box 3.4. Other empirical analyses of BEPS fiscal effects (continued)

Christian Aid. In 2009, Christian Aid estimated that trade mispricing in non-EU countries
reduced tax revenues by USD 122 billion per year.28 Trade mispricing is defined to include
mispricing between both MNEs and unrelated parties that shifts income out of developing
countries. The estimate is based on bilateral trade data, at the product level, for the EU countries
and the United States Mispricing is calculated using reported prices that fall outside of the interquartile range (assumed to represent arms length prices) in the data. These price differences are
summed for exports and imports from and to developing countries to estimate the capital
(income) shifting from non-EU countries to EU countries and the United States. The CIT
revenue loss for developing countries is calculated using the top marginal tax rate. The analysis
does not include any adjustments for possible quality differences in bilateral product trades and
does not incorporate information on special tax rates that may apply in developing countries on
specific activities. The analysis does not include mispricing between EU countries and the United
States that could be shifting income into a developing country in response to tax rate
differentials. The analysis does not separate developing country revenue loss estimates for trade
among MNE entities, the type of mispricing classified as BEPS.
Oxfam. Oxfam estimates that African countries lost USD 11 billion in CIT tax revenue in 2010
due to trade mispricing.29 The estimate, which is based on a study by the High Level Panel on
Illicit Financial Flows, found MNEs were responsible for around USD 40 billion of trade
mispricing in Africa. Trade mispricing is not only due to tax avoidance, but also tax evasion,
avoiding customs duties, or money laundering.
Bach: A 2013 German business income study compares the German corporate income tax base
derived from the national accounts with the tax base reported in the tax statistics to provide an
estimate of the possible erosion of the corporate income tax base.30 The study makes a number of
detailed adjustments in the national accounts profit figures to derive a modified corporate
income base. The modifications reflect the institutional details of the German business income
tax system, as well as the differences between corporate tax and national accounts concepts. The
study calculates the difference between the tax base measure reported in the tax statistics and the
modified national account tax base to examine possible tax base erosion. For taxpayers with
positive income, the comparison suggests that the tax statistics base is 21% lower than the
corresponding national accounts income. The author is careful to point out that the measured
difference in the tax bases cannot be interpreted as largely due to BEPS behaviours. Additional
analysis using empirical studies of BEPS and country-specific information on trade, interest and
balance of payments flows is needed to determine what percentage of the tax base difference is
related to international profit shifting.
Clausing. A regression analysis is used to estimate the semi-elasticity (responsiveness) of gross
profits reported by United States MNE entities in foreign countries to effective tax rate
differentials between foreign affiliates and their United States parent, based on survey data on
foreign activities of United States MNEs aggregated at the country level.31 The estimated semielasticity (-3.3) is used to eliminate the influence of the tax rate differential on overseas
profitability. The difference in reported and adjusted profitability is assumed to be the effect on
overseas profits due to profit shifting. A portion of this change is attributed to the United States
using estimates of United States and foreign activities of the MNEs. Multiplying the resulting
change by an effective United States tax rate produces a best estimate USD 90 billion lost
from profit shifting from United States MNEs in 2008, which represents 30% of United States
federal corporate income tax collections. A lower bound estimate, using a different data series,
found a USD 57 billion loss, or 19% of CIT revenues.
Box 3.4. Other empirical analyses of BEPS fiscal effects (continued)

Vicard. The study estimates profit shifting through transfer pricing for French MNEs.32 Firmlevel export and import data from customs trade data, combined with ownership information for
MNE entities, is used to estimate intra-firm trade and price differentials between transactions
between related affiliates and unrelated parties. The estimates are done by product and
destination country. A regression analysis explaining these price differentials finds that a one
percentage point increase in the relative statutory tax rate in France reduces (increases) relative
export (import) prices to related parties by 0.22% (0.24%). Based on these semi-elasticity
values, the study estimates that mispricing of MNE trade with related parties reduced French
CIT payments of these MNEs by an average of 10%, or USD 8 billion in 2008. The study also
finds that the lost revenue has increased over time as the tax rate differential has widened.
3.3.7 The extent of BEPS behaviours and possible dynamic effects if not
curtailed
190. Another dimension to the scale of BEPS is the question of How widespread is
BEPS activity among corporations? A number of studies have found evidence that profit
shifting is widespread across the corporate MNE sector, but several recent papers (Davies
et al., 2014; Egger et al., 2014) report significant BEPS behaviours by a limited number
of large MNEs with affiliates in a small number of jurisdictions. The answer to this
question has implications for the design of BEPS countermeasures. More research is
needed in this area.
191. Another aspect is the dynamic nature of BEPS. Even if BEPS is not widespread
now, it could become much more widespread if nothing is done on an internationally-coordinated basis. Competitive pressures through pricing and acquisitions give MNEs using
BEPS an advantage in lower costs to take market share from companies or acquire
companies that do not use BEPS to lower their costs. As seen recently in the case of
corporate inversions, a significant change in corporate tax behaviour minimising taxes
can occur suddenly even when legal arrangements under current law had existed for
years.
3.3.8 Effects of BEPS countermeasures

192. A number of empirical studies are focusing on individual BEPS issues and the
effects of existing BEPS countermeasures. These studies often provide some insight into
the scale of the particular BEPS channel, but also the effects of current or proposed BEPS
countermeasures. The existing countermeasures are unilateral, individual country, antiavoidance rules, which would have different effects than a uniform multilateral
countermeasure.
193. It is important in assessing the effectiveness of the BEPS countermeasures
(described below) to take into account the level of enforcement. Some countries may
choose not to enforce certain regulatory rules strongly for tax competitiveness reasons.
Other countries may not have the resources or capacity to fully enforce their existing laws
and regulations.33
Neutralising the effects of hybrid mismatch arrangements (Action 2)

194. Hybrid mismatch arrangements have been discussed descriptively in a number of
papers, but have not been empirically estimated. Grubert (2012) attempted to evaluate the
effect of check-the-box and hybrid structures on foreign effective tax rates. The hybrid
variable was based on whether a CFC owned a disregarded entity or not. Several
countries have estimated the effects of proposed legislation addressing hybrids, although
the estimates are relatively small due to behavioural effects of shifting activity to other
tax minimisation strategies. The OECD analysis in Annex 3.A1 finds that affiliates of
large MNEs have average effective tax rates 2 to 5 percentage points lower than
similarly situated affiliates of domestic-only groups in the same country, which could be
partially attributable to hybrid mismatch arrangements. The analysis does not find
statistically significant different effective tax rates between small (defined as affiliates
with less than 250 employees) MNEs and similar small domestic affiliates.
Strengthening CFC rules (Action 3)
195. Two recent empirical studies examine the effect of consolidated foreign company
tax rules on MNE behaviour.
196. Ruf and Weichenrieder (2013) use the German Micro-database Direct Investment
(MiDi) data on German MNEs to investigate the effect of the change of Germanys CFC
legislation in response to a decision by the European Court of Justice (ECJ). The ECJ
ruled that German CFC legislation infringed on the freedom of establishment within the
European Union, and thus could not be applied to CFCs in EU countries. The analysis
found that after the liberalising CFC legislation, passive investments in low-tax European
countries increased compared to low-tax non-European countries, signalling that the prior
CFC rules limited shifting of passive investments of German MNEs.
197. Markle and Robinson (2012a) investigate whether CFC rules, bilateral tax treaties
and withholding taxes affect the tax behaviour of MNEs. Using ORBIS and
COMPUSTAT data, they find that CFC legislation as well as other measures reduces the
activity of affiliates in tax haven countries. Markle and Robinson (2012b) find 44
percent of the 7,600 MNEs in their global sample have a tax haven subsidiary. They find
that the existence and scope of CFC rules is associated with lower tax haven use in those
countries.
Limit base erosion via interest deductions (Action 4)
198. Several studies have found that MNEs strategic placement of debt and the
associated interest deductions are sensitive to tax differentials and tax interest limitations.
199. Desai, Foley and Hines (2004) use United States Bureau of Economic Analysis
investment survey data to identify the determinants of the capital structure of foreign
affiliates of United States MNEs. They find that higher tax rates increase the use of both
external and internal debt for United States foreign affiliates, with a more intense effect
on internal debt. They control for a credit market imperfection proxy, as companies might
increase their internal debt to total debt ratio, not only with the objective of shifting profit
through interest expenses, but also in order to overcome credit market imperfections.
They find that companies in countries with a less developed credit market borrow
relatively more from related parties (in particular from parent companies). They find that
Ten percent higher local tax rates are associated with 2.8% higher debt/asset ratios, with
internal borrowing being particularly sensitive to taxes. Using German firm-level data,
Moen et al. (2011) find evidence of both internal and external debt shifting and estimate
that they are of about equal relevance.
200. Huizinga, Laeven and Nicodme (2008) use the European Amadeus database to
test whether differences in taxation among countries have a statistically significant effect
on the firms capital structure and on internal debt. They include both marginal effective
tax rates and an indicator of the tax incentive to shift debt (calculated as the sum of
international tax differences weighted by local assets), and find a statistically significant
effect on firms leverage, indicating that debt shifting might occur, not only between
parent and subsidiaries, but also among foreign subsidiaries. They find an increase of the
effective tax rate by 0.06 in the subsidiary country has a positive international effect on
leverage in the subsidiary country of 0.4%.
201. Weichenrieder (2015) describes the growing literature on rules limiting the
deductibility of interest, including studies of German inbound FDI (Weichenrieder &
Windischbauer (2008) and Overesch & Wamser (2010)); German outbound FDI
(Buettner et al. (2012)), and United States outbound FDI (Blouin et al. (2014)). Two
papers evaluated the German interest barrier rule introduced in 2008, which limits the
deductibility of interest generally to 30% of EBITDA. Using the DAFNE database for
German companies, Buslei and Simmler (2012) consider how the rule affected firms
capital structure, investment and profitability. The results show a strong behavioural
response by firms to avoid the limited deductibility of interest expenses, successfully
broadening the tax base in the short-term. Affected firms decreased their debt-to-assets
ratios and there was no evidence of a negative (short-term) effect on investment. Dreler
and Scheuering (2012) analysed how German firms subject to the interest barrier rule
adjusted their debt-to-assets ratios and their net interest payments compared to a control
group. Their analysis shows that the interest barrier resulted in firms lowering their debtto-assets ratios and their net interest payments, but principally by reducing external debt
rather than related party debt.
202. The OECD analysis in Annex 3.A1 finds evidence of strategic placement of
external (third-party) debt in MNE consolidated groups due to tax rate differentials within
the group. A one percentage point higher statutory corporate tax rate of an affiliate than
the average in the MNE group is associated with a 1.3% higher external debt/equity ratio
for that affiliate. The analysis does not include the location of intra-group debt.
Prevent treaty abuse (Action 6)
203. Empirical analyses of tax treaty issues are limited and often are included with
other BEPS behaviours or are specific to particular countries. One recent simulation
analysis, Vant Reit and Lejour (2014), shows the potential reduction in withholding
taxes due to treaty shopping, but the analysis is not based on actual taxpayer behaviour.
204. The analysis examines bilateral tax rates on cross-border dividends between 108
countries (3,244 country pairs) and shows that indirect routes (treaty shopping) are
cheaper than direct routes for 67% of the country pairs. 21% of the country pairs have a
zero effective tax rate without treaty shopping, but 54% when treaty shopping is possible.
Treaty shopping is estimated to reduce the withholding effective tax rate by more than 5
percentage points from nearly 8% to 3%. A simulated removal of tax havens from any
double tax relief (other than foreign tax credit) shows an increase in the world average
effective withholding tax rate by 0.14 percentage points.
Assure that transfer pricing outcomes are in line with value creation (Actions 8-10)
205. Transfer pricing has been identified as a major BEPS issue with four actions
identified in the BEPS Action Plan specifically dedicated to addressing BEPS through
this channel. Transfer pricing, particularly through the shifting of intangible assets, is
discussed in the general BEPS analyses. Four key studies focus specifically on transfer
pricing.
206. Clausing (2003) investigates the effect of host country statutory and effective tax
rates on inter-company trade in goods. Using data on intra-firm transactions from the
United States Bureau of Labor Statistics, the analysis finds that low foreign statutory tax
rates are correlated with lower export prices and higher import prices relative to thirdparty transactions. The analysis finds a tax rate 1% lower in the country of
destination/origin is associated with intra-firm export prices that are 1.8% lower and
intra-firm import prices that are 2.0% higher, relative to non-intra-firm goods. Several
other studies using price-based comparisons of related-party and third-party imports and
exports show significant tax effects, including a recent study of French 1999 trade data by
Davies et al. (2014).
207. Grubert (2003) analysing data from United States MNEs tax returns for United
States MNEs finds that United States controlled foreign corporations (CFCs) located in
countries with relatively low and relatively high statutory CIT rates engage in
significantly greater volumes of inter-affiliate transactions. This is consistent with BEPS
related activity. The analysis finds that R&D intensive companies engage in greater
volumes of such intra-company trade.
208. Mutti and Grubert (2009) analyse United States MNEs tax return data to
investigate whether the United States check-the-box regulation has encouraged the
relocation of intangible assets abroad. They provide evidence of a substantial migration of
intangible assets abroad, in particular to low tax countries through hybrid entities and
cost-sharing agreements. Moreover, descriptive statistics show that royalty payments
among foreign affiliates increased sharply in the period considered, from entities in hightax countries to entities in low-tax countries.
209. Karkinsky and Riedel (2012) focus on the effect of statutory tax rates and other
tax-related variables (such as binding CFC rules and withholding tax on royalties) on the
number of MNEs patent applications. They build a unique dataset of European firms
merging Amadeus financial statement database with PATSTAT information. They find
that low tax rates increase the probability that the firm applies for a patent in low-tax
locations. This result is similar to a study by Griffith, Miller and OConnell (2011).
210. The OECD analysis in Annex 3.A1 finds that the tax sensitivity of profit shifting
is almost twice as large among MNE groups with patents as for non-patenting MNE
groups, controlling for a number of factors affecting firms profitability. A separate
analysis, which uses combination of data on patents from PATSTAT and firm
characteristics from ORBIS financial account data, suggests that preferential tax
treatment of patents increases both patents invested in other countries as well as R&D
activities.
Benefits of better disclosure (Actions 5, 11, 12 and 13)
211. Hoopes (2015) provides a survey of a number of studies that have analysed the
effects of disclosure issues. A paper by Dyreng, Hoopes and Wilde (2014) finds empirical
evidence suggesting that U.K. public companies decreased tax avoidance and reduced the
use of subsidiaries in tax haven countries when there was increased public disclosure.
Several studies (Lohse et al., 2012; Lohse and Riedel, 2012; Annex 3.A1) find empirical
evidence of reduced profit shifting from tougher transfer pricing documentation rules.
Increased transparency of government tax rules (Action 5) will reduce a non-tax rate
competition, with greater disclosure of government rulings involving potential base
erosion.
212. Announcements of future legislative changes can affect corporate taxpayer
behaviours even before specific legislative measures have been enacted. Some
corporations are already changing their international tax structures due to the progress of
the BEPS Project and expected changes by governments.34
3.3.9 Impact of existing unilateral BEPS-related countermeasures

213. Several academic studies find that anti-avoidance countermeasures have reduced
profit shifting through transfer pricing documentation (Lohse and Riedel, 2012) and
interest limitations (Blouin et al., 2014). These studies show positive effects of current
law unilateral measures, which could be shifting BEPS behaviours away from the
countries with anti-avoidance rules to countries without the anti-avoidance rules. The
OECD analysis in Annex 3.A1 combines four anti-avoidance measures (different levels
of transfer pricing documentation, different levels of interest limitations, the presence of
controlled foreign corporate (CFC) rules, and the presence of general anti-avoidance rules
(GAAR)), as well as the level of withholding taxes (taking into account tax treaties), in a
single metric. The analysis uses the metric in 2005 for an analysis of profit shifting across
OECD and G20 economies over the 2000-2010 period and finds that profit shifting is
negatively correlated with the metric. These analyses suggest that countries with higher
statutory tax rates do not necessarily have higher fiscal losses from BEPS if they have
strict anti-avoidance measures.
3.3.10 Economic impacts of BEPS and BEPS countermeasures

214. The scale of BEPS, in terms of the fiscal effects on government revenues, is
important, but there are other economic effects of BEPS. The scale of the fiscal effects is
an important intermediate input to the analysis of the other economic effects. Changes in
corporate income taxes due to BEPS behaviours and countermeasures result in real
economic effects, including effects on the incidence (or economic burden) of taxes, debt
bias and strategic location of debt, differential taxation of companies, investment and
economic growth, and tax competition between countries (spillover effects).
3.3.11 Important considerations in the economic analysis of BEPS and BEPS

countermeasures
215. By definition, BEPS behaviours involve artificial shifting of taxable income from
the location where the activities creating those profits takes place, and when the
interaction of different tax rules leads to double non-taxation or less than single taxation.
In some cases, MNEs may undertake minimal economic activity as part of artificial
arrangements that shift profits away from where the value is created simply to claim tax
benefits under current national tax rules.
216. Addressing BEPS will increase effective tax rates of tax aggressive MNEs, which
can have economic effects on the location of economic activity. Effective tax rates of
those companies will be closer to countries statutory corporate tax rates when BEPS
countermeasures are implemented. Differences in countries statutory and effective

corporate tax rates will continue to exist after the BEPS Project, but they will not be
reduced due to artificial BEPS arrangements. When evaluating the economic effects of
BEPS, several important issues need to be factored into any analysis.
217. First, the economic effects of unilateral tax policy changes by an individual
country are very different from the economic effects of internationally co-ordinated
multilateral changes, such as those proposed under the BEPS Action Plan. If all countries
(or the vast majority of countries where real economic activity takes place) adopt similar
countermeasures, then MNEs will not be able to change the location of their BEPSrelated activities to avoid them. Currently, if one country were to adopt tough BEPS
countermeasures, then MNEs could move their activities to continue BEPS behaviours
elsewhere.
218. Second, economic analyses of BEPS countermeasures should be considered in a
budget-neutral context. For purposes of a budget-neutral analysis, any potential additional
tax revenues from BEPS countermeasures could be assumed to lower taxes on other
economic actors or be used to invest in public infrastructure or services. Any tax increase
will have some adverse effects, but BEPS is a structural, not a macroeconomic, tax policy
change: BEPS countermeasures are designed to close unintended loopholes, not to change
GDP. Adverse effects from companies experiencing tax increases could be offset by
positive effects from companies, investors, and consumers experiencing tax decreases or
benefits from increased public infrastructure or services. Budget-neutral assumptions are
used in many tax policy analyses to isolate structural tax effects. Similarly, the effect on
one group of businesses is only part of the overall effect, since other businesses and
households will benefit when BEPS is corrected.
219. Third, the effects of BEPS countermeasures are different than changes in
corporate tax rates or other general tax changes. Increasing corporate income taxation by
ending artificial schemes by a self-selecting group of tax aggressive MNEs is not
necessarily adverse to economic growth since it would reduce differential taxation across
businesses and eliminate tax-induced competitive advantages. Individual MNEs abilities
to achieve significant corporate tax reductions due to BEPS behaviours distorts a number
of resource allocation margins, and shifts talent to tax planning rather than more
productive activities.35 Depending on market conditions, much of the tax benefits from
BEPS behaviours for many companies may simply be a product of rent-seeking, rather
than a reduction in the marginal cost of investment capital.36
220. Fourth, the prevalence of BEPS behaviours among MNEs will affect the degree
and types of distortions caused by BEPS. The MNE sector is heterogeneous, and is also
likely to be with respect to engaging in BEPS. If BEPS is engaged in by most MNEs, the
economic effects will be more widespread than if BEPS is principally concentrated and
most intensively used by a small group of MNEs or in particular industries. The economic
effects of BEPS, if limited to a select group of MNEs versus being more prevalent, will
cause additional distortions between companies (even within the MNE sector), across
industries, and across types of investment. Distortions from tax rate differentials are often
ranked by the ease of responding to tax rate differentials: tax planning taking into account
timing issues such as around fiscal years or tax rate changes is easiest, followed by tax
planning involving financial accounting and mobility of legal contracts (which includes
BEPS), then mobility across jurisdictions of real economic activity, and the most difficult
changes are in the level of total economic activity.37 Shifting profits is much easier than
shifting or increasing real economic activity.
221. Fifth, economic analyses and estimates of BEPS and BEPS countermeasures are
subject to significant uncertainty, given the difficulty of disentangling BEPS activity from
MNEs real economic activity and non-BEPS tax preferences, plus the significant
limitations of currently available data. Multiple approaches finding large magnitudes
provide greater certainty of the general scale of BEPS than individual studies using one
methodology and relying upon a single data source. Any statistical estimate has a range of
error given the sample used and the unexplained variance of the underlying economic
activity. Extrapolation beyond the sample from which an analysis is conducted is a
further source of bias since it is not known whether the missing companies have the same
behaviours as the included companies.
222. Sixth, although the incidence of corporate taxes is still widely debated, most
analyses conclude that corporate income tax falls on both capital and labour, varying in
the degree of capital mobility, openness of the economy, and the extent to which the
corporations are earning competitive returns or economic rents.38 Since BEPS is not a
general CIT rate reduction, but a self-selected tax reduction of some MNEs, the burden of
BEPS countermeasures would not be the same as the burden of a general corporate tax
policy change. Not all of the corporate tax increase on MNEs engaging in BEPS will
affect their investment decisions, since some could fall on economic rents or be passed
forward or backward to other economic actors.
223. Seventh, it is important to account for taxpayer behaviours. If the BEPS
countermeasures are not adopted by most countries or if there are other tax avoidance
mechanisms not addressed by the BEPS countermeasures with which MNEs could avail
themselves, then the positive gains from the BEPS Project would be reduced. If BEPS is
reduced, tax rate differentials for some MNEs could increase resulting in shifts of real
economic activity, plus tax competition affecting real economic activity could increase.
Additional economic research on the mobility of real economic activity (research and
expenditure, physical investment, employees) is needed, since current measures of
mobility are often on the mobility of income, which reflects significant BEPS behaviours.
224. Finally, a comprehensive analysis of the economic impacts of BEPS
countermeasures would also include an evaluation of the net change in the taxpayer
compliance costs, the effectiveness of tax administration enforcement. The analysis
would identify any unintended double taxation from inconsistent implementation of tax
treaties and improvements in dispute resolution through the mutual agreement procedure.
225. The global fiscal and economic impacts of BEPS and BEPS countermeasures are
important, and initial estimates based on currently available data, tools and methodologies
are helpful to policymakers. While current modelling of BEPS and countermeasures is
not done comprehensively or with a full general-equilibrium model due to data and
conceptual limitations, the economic impact analyses show BEPS distorts many business
decisions. Analyses by each countrys tax policy and statistical offices using more
detailed information about their economies and tax systems will be necessary to fully
assess the effects of the BEPS Action Plan on individual countries.
3.3.12 Expected incidence of CIT changes in response to BEPS

countermeasures
226. The economic effects of BEPS and BEPS countermeasures will depend on the
difference in the distribution of income tax burdens with current BEPS behaviours and
after the potential BEPS countermeasures are adopted. This analysis focuses on the
change in tax burdens due to the potential BEPS countermeasures.
227. Tax incidence analysis is designed to determine who bears the burden of a tax.
The burden of a tax is defined to be the ultimate resting point of the tax after recognising
any tax shifting that might occur after the tax is imposed. Tax shifting is the process by
which taxpayers bearing the legal responsibility for paying the tax (legal incidence)
alter their behaviour and, as a result, shift the burden of the tax to other parties (e.g.
consumers, workers and capital owners) through changes in output or input prices. The
final resting point for a tax is the economic incidence of the tax. Thus, the economic
incidence or burden of a tax can be very different than the initial legal incidence of the
tax.39
228. The extent of tax shifting from BEPS countermeasures will depend on a number
of factors, including how the additional tax revenues from the BEPS countermeasures are
used by the government: which taxes are changed, what type of spending is changed,
and/or the extent to which governments budget balances are changed. The extent of tax
shifting also depends on the market conditions faced by MNEs engaging in BEPS: how
sensitive consumers are to price changes, the presence of competition, and how
responsive the supply of labour and capital are to changes in compensation and the return
on investment.40
229. There are several assumptions used in this analysis to identify the economic
incidence of changes in global corporate income taxes as a result of the implementation
of the BEPS countermeasures. Any analysis of the economic incidence of BEPS
countermeasures requires making assumptions about these issues.
All countries adopt the recommended BEPS countermeasure. If a significant
amount of economic activity is not subject to the countermeasure, then the
conclusions would be different. This is consistent with a longer-run perspective
on the incidence of the tax changes.
Capital is mobile across industries within a country and between countries in the
medium term (3-10 years), while labour is less mobile.
The impact on global economic activity from the implementation of the BEPS
countermeasures will depend primarily upon the average worldwide change in
total CIT collections and the global after-tax rate of return on capital
investment.
The impact on economic activity in any single country will depend on how the
after-tax rate of return in the country initially changes relative to the worldwide
after-tax rate of return as a result of the BEPS countermeasures.
Countries CIT rates remain constant.
230. Based on the fiscal impact estimates of the impact of the BEPS countermeasures,
there will be a net worldwide increase in corporate income tax collections. However,
while most countries will have higher corporate tax collections from the BEPS
countermeasures, some countries could experience decreases in CIT collections as a
result of BEPS countermeasures that align taxable income with the location where the
economic activity generating that income is located. Given the global net CIT tax
increase, the following discussion describes the tax shifting process in terms of where the
burden of any additional taxes collected will fall.
231. In the short run, the net increase in CIT revenues will lower the after-tax rate of
return on capital investments of the firms currently engaging in BEPS behaviours. An
important question relates to the extent to which capital would be reallocated in response
to reducing BEPS and its effect on the after-tax rate of return of companies that have been
engaging in BEPS. The answer depends upon the extent to which BEPS behaviours have
increased their after-tax rates of return (relative to what they would be without BEPS), as
well as the market conditions in which they operate.
232. MNEs that have used BEPS to reduce their CIT revenues have been able to
reduce, on average, effective tax rates in those countries (most often in countries with
weak anti-avoidance rules and above-average statutory or effective tax rates). While
MNEs take these ETRs into consideration when making initial location investment
decisions, BEPS can result in increases in the after-tax rates of return of those companies
without necessarily increasing the level of their existing capital investments. OECD
research presented in Annex 3.A1 finds in industries with a high concentration of MNEs
with affiliates in no-tax countries the responsiveness of investment to tax rates is less than
other firms investments. This is because tax-planning MNEs can achieve lower taxes
through artificial arrangements without changing the location of the value-creation and
real economic activity. With BEPS countermeasures, the availability of this form of doit-yourself tax relief will be substantially reduced. As a result, the after-tax rates of
return of those companies will be reduced.
233. If after-tax rates of return are reduced of companies engaging in BEPS in some
countries as a result of the BEPS countermeasures, what will be the impact on real
investment and economic activities in those industries and those countries? The answer to
this question is complicated, and depends, to a significant degree, on whether the affected
MNEs are operating in competitive or imperfect markets and on the time horizon for the
analysis.
234. If the MNEs paying higher taxes are operating in competitive markets (i.e.
earning just the required rate of return on their capital at the margin, which means zero
economic rent), the standard CIT incidence analysis would predict that in the long run
they will reallocate capital from the high-tax industries and countries with lower after-tax
rates of return to other industries and countries that now offer higher after-tax rates of
return. In the process there will be less real economic activity in the relatively high-tax
industries and countries and more real economic activity in the lower-tax industries and
countries. The shifting process will end when the after-tax rate of return is equalized at
the new, lower after-tax rate of return on all worldwide capital that reflects the higher
global CIT tax wedge due to the net increase in global CIT taxes from implementing
the BEPS countermeasures.
235. In the competitive market case, in the long run after sufficient time for real capital
to be reallocated, the expected impact of the higher global CIT is:
Capital owners will bear most of the burden of the average global net tax
increase due to the adoption of BEPS countermeasures. In the adjustment
process, capital may be reallocated across industries and countries with
associated impacts on consumer prices and labour compensation. However, the
burden of the overall net increase will be borne by capital owners located in all
countries and all industries because reallocations of capital cannot avoid this
incremental burden.41 To the extent the increase in corporate tax reduces the
after-tax rate of return to all capital, a lower return to saving and investment in
the long run could reduce overall global capital investment and thus the
productivity of labour with some proportion shifted to labour in the form of
lower wages.
Industries and countries with above-average corporate income tax increases

may experience lower levels of capital investment needed to offset any
reduction in the after-tax rates of returns that exceed the worldwide average
reduction.
The burden of this differential CIT increase will be borne primarily by labour
through wages, consumers through higher prices for goods and services due to
the reduction in the industries or countries capital stock and level of
production, and capital owners of land.
Industries and countries with below-average CIT increases may experience
higher levels of capital investment as they gain capital relative to the industries
and countries with above average CIT increases. Labour in those industries and
countries will benefit from higher wages and lower consumer prices for goods
and services as the capital stock and output is expanded.42
236. There are several reasons why the theoretical incidence analysis of BEPS
countermeasures may overstate the potential real economic impacts over the medium
term.
The simplified, theoretical tax incidence model assumes the time horizon is long
enough to allow the reallocation of real capital across borders. In fact, it takes
many years for the reallocation of real economic resources to occur across
industries or countries. Capital mobility is high when capital is measured in
terms of legal contracts or ownership claims, but capital mobility is much lower
and slower when it involves actual geographic relocation of research scientists
and physical capital. Tax incidence models have little to say about the dynamics
of the adjustment process over time, and measures of the speed of mobility of
real capital and specialised labour between countries are lacking in the
empirical literature. In the transition to reallocation, the capital owners who
previously benefited from the lower effective tax rates achieved by BEPS
behaviours in countries will bear the burden of the CIT increase. In other words,
while the elasticity of investment to changes in after-tax rates of return increases
the longer the time period, there is limited empirical evidence on how the
elasticity changes over time.
Many MNEs engaging in BEPS do not operate in perfectly competitive markets.
An important reason for this is the increasing importance of the contribution of
intangible property to MNE net income.43 Unique intangible capital, not only
intellectual property but also brands and economic competencies, can generate
excess economic returns over a long period of time.44 Due to these excess
returns to capital, MNEs facing lower after-tax rates of return may still be
earning more than the next-best alternative investment after the adoption of the
BEPS countermeasures. Thus, the tax increases from BEPS countermeasures
may have little or no effect on those companies marginal investment
decisions.45
If MNEs are earning excess economic returns, there will be minimal
reallocation of real investments in response to the BEPS countermeasures.46 As
a result, there would be little shifting of the burden to consumers or labour. In
this specific case, capital would bear almost all of burden of the tax on
economic rents over a long period of time and there would be no significant
reallocation of capital among countries.
237. Economic incidence, particularly of the CIT in a global economy, is still an
unresolved issue for economists. The economic incidence of unilateral measures
increasing the cost of capital for business in one country relative to other countries with
mobile capital in competitive markets would fall on the fixed factors. The economic
incidence analysis of co-ordinated, multilateral BEPS countermeasures in the presence of
imperfect competition, however, may lead to significantly different conclusions compared
to the analysis of unilateral measures in competitive markets.
3.3.13 Economic efficiency and growth

238. Economic efficiency and growth are critically important to all countries. This
section discusses the effects of BEPS on capital structures, tax differentials between
companies, effects on investment decisions, effects on patent registrations and R&D
spending, and effects from uncertainty and compliance costs.
239. The OECDs Tax Policy Reform and Economic Growth (2010) ranked corporate
income tax as the most harmful to economic growth. Some have expressed concern that
BEPS countermeasures would increase effective corporate tax rates on some MNEs, with
adverse economic effects resulting. The BEPS project proposes structural tax reforms that
close unintended interactions of different country tax rules with internationally-coordinated rules. Any additional corporate tax revenue from BEPS countermeasures would
enable the lowering of taxes on taxpayers or increased government spending, if the
specific tax effects on macroeconomic growth are a concern.
240. In the presence of BEPS, effective tax rates are reduced relative to statutory tax
rates. With BEPS countermeasures, ETRs of MNEs engaging in BEPS will move closer
to applicable statutory tax rates. The change in these companies ETRs can impact their
real economic activity at different margins, but depends on a number of factors, including
the economic incidence of the BEPS countermeasures, the use of the revenues, and the
responsiveness of real economic activity to both effective marginal tax rates and effective
average tax rates. The effect of curtailing BEPS profit shifting will vary among countries
depending upon the relative importance of BEPS-engaging MNEs, current anti-avoidance
rules, the structure of the economy and the degree of cross-border intra-firm transactions.
241. The above discussion of the economic incidence of CIT in a global economy with
less than competitive markets due to unique intangibles, and in particular the benefits of
self-help CIT reductions from BEPS behaviours, suggests that just because CIT increases
for MNEs engaging in BEPS does not mean their marginal cost-of-capital for investment
will increase proportionally. Further, CIT is not the only business tax affecting FDI and
investment; other source based taxation, include withholding taxes, property taxes, nonrefundable or deferred value added tax refunds on business inputs, environmental taxes,
etc. factor in companies location decisions. Thus, a 10% increase in corporate income
tax will have less than a 10% increase in total source-based business taxation of the
MNEs activity. Standard cost-of-capital calculations do not include other source-based
business taxes, often have relatively low real rates of return for equity capital
investments, and assume no economic rents.
242. Differential tax rates across companies. Economic distortions occur when the tax
rules create an uneven playing field across industries and companies. Many countries
report backward-looking ETRs which vary significantly across different industries due to
tax rules which are used more by certain industries, such as accelerated depreciation or
research and development tax credits, or which have special industry tax rules. Tax
revenue reductions from BEPS are also likely to vary from industry to industry. For
example, the ability to move intangible assets and the income associated with intangible
assets without changing the location of where the value was created is a significant source
of BEPS and is likely to occur in some industries more than others. This can create
economic distortions across industries from varying ETRs. Many of the empirical
analyses find stronger profit shifting responses to taxes for companies that have patents,
where the MNE has intangibles, or are in industries with extensive intangibles.
Annex 3.A1 shows that the ETR differential is higher among MNEs with patents, since
they have a higher profit-shifting intensity and can take greater advantage of tax
preferences, such as for R&D, than domestic firms by the strategic placement of R&D
and patents.
243. MNEs can take advantage of both domestic tax planning and BEPS to lower their
effective tax rates below the rates of domestic competitors, providing them with an
advantage in gaining market share through lower consumer prices or their ability to
acquire domestic companies. Egger, Eggert and Winner (2010) and Annex 3.A1 find
effective tax rates of MNEs or their affiliates are lower than comparable domestic
corporations or their affiliates. Annex 3.A1 estimates that BEPS reduces the effective tax
rate of large affiliates of MNEs by 4 to 8 percentage points on average compared to
similarly-situated domestic-only affiliates, due to both profit shifting, mismatches
between tax systems and domestic tax preferences.47 The differential is larger for MNEs
affiliates with more than 1,000 employees and MNEs with patents. Identifying
comparable MNE and domestic-only companies may not be possible given inherent
differences between companies operating multi-nationally and those operating only
domestically.48 Identifying even somewhat comparable companies is a challenge,
particularly for smaller countries, but statistical techniques, such as propensity score
matching and regression analysis, have been used.
244. Academic studies have generally not analysed the economic implications of tax
planning on competition between companies. The OECD analysis in Annex 3.A1 assesses
if industries with a strong presence of tax-planning MNEs are more concentrated and if
MNE groups engaged in tax planning obtain different price mark-ups as compared to
other firms with similar characteristics. The empirical analysis suggests that industries
with a strong presence of MNEs are more concentrated. The empirical analysis also finds
that MNE groups with an affiliate in a no-corporate-tax-country are associated with
higher price mark-ups (pre-tax operating profit divided by turnover), controlling for other
factors affecting mark-ups such as size, productivity, leverage, presence of patents and
exposure to foreign competition. Sikes and Verrecchia (2014) find a negative effect on
firms cost of capital in economies where a significant proportion of firms engage in tax
avoidance, with the most burdensome effect on firms that do not engage in tax avoidance.
245. BEPS-induced distortions in the location of corporate debt. Economic efficiency
is also affected by BEPS effects on MNEs capital structure. A number of studies show
BEPS occurring through excessive interest deductions, with both related-party and
external debt. As interest deductions are taken in high-tax rate countries, and interest
income is attributed to in low or no-tax countries, the after-tax cost of debt is reduced.
Differences in the tax treatment of debt and equity can be exploited in the cross-border
context. Thus, debt shifting exacerbates the existing tax bias towards corporate debt
financing.
246. A bias toward corporate debt and a bias against corporate equity already exist in
most corporate tax systems. Corporate interest is deductible and generally taxed at the
interest recipient level. Corporate equity income in the form of retained earnings and
dividends are taxed at the entity level and generally again at the investor level, although a
number of countries provide reliefs to dividends and capital gains. Debt shifting by
MNEs exacerbates the corporate tax bias by effectively increasing the tax benefit from
interest deductions through the strategic location of both external and internal debt to
high-tax countries. Use of hybrid mismatch arrangements can result in multiple layers of
borrowing within a MNE group with multiple interest deductions, or deductions of
interest in one country but the payment is treated as an exempt dividend in another
country. Increased external and internal debt shifting thus increases the overall level of
debt bias.
247. Proposals to reduce the debt bias through notional allowances for corporate equity
(ACE) have been implemented in several countries. MNEs can shift their capital structure
to maximise tax benefits from external and internal debt in high tax countries without
interest limitations, while increasing their equity contributions in countries with an ACE
system.
248. BEPS-induced distortions in the location of patents. Numerous studies show that
BEPS affects the location of FDI and patents, since taxable income can be segregated
from where the value is created. This can affect the location of some employment and
physical capital to justify claims for the desired tax treatment. This varies depending on
the tax treatment, generally in the form of a preferential IP regime, on offer, and the
activity requirement needed to qualify for such treatment. The analysis in Annex 3.A1
which uses a combination of data on patents from PATSTAT and firm characteristics
from the ORBIS database, finds tax rate differences affect the location of patent
registrations. A recent European Commission study finds that lower tax rates on certain
intangible income encourages greater connection between residence of inventors and the
location of registration of patents if the rules require such connection. Otherwise the
lower tax rate encourages shifting of patent registrations and taxable income without a
significant shift in real economic activity.49
249. Future studies of the effects of taxes on the location of real R&D investment
expenditures and research engineers and scientists are needed. Studies examining R&D
effects have looked at the location of the registration of patents and whether an investor
associated with the patent resides in the country, but have not analysed actual R&D
activity.50 Such studies would need to account for existing R&D tax credits and
deductions of more than 100% of R&D expenditures, plus personal income taxes on the
inventors as well as non-tax factors such as agglomeration effects and countries public
R&D investments.
250. Effects on the location of real economic activity. Taxes matter in location
decisions as shown in a number of empirical analyses. De Mooij (2008) did a metaanalysis of which finds that effective marginal tax rates and average marginal tax rates,
rather than statutory tax rates, have significant effects on FDI. He reports a -0.4 semielasticity of effective marginal tax rate effect on the intensive margin of FDI (increases
within an individual country), while finding a -0.65 semi-elasticity of the effective
average tax rate on the extensive margin of FDI (changes between countries). It should be
noted that FDI includes more than just greenfield investments and business expansions,
but also reinvested earnings and merger and acquisitions. Estimates of the responsiveness
of real economic activity could be understated if companies can currently achieve tax
benefits without moving real economic activity.
251. Linking real economic activity to tax benefits for patent income or for any type of
income or economic activity will more closely align taxable income with actual economic
activity. Providing tax benefits associated with a type of income or behaviour without any
such requirement that real or substantial activity occur is likely to achieve a countrys
policy goal of generating significantly more of the economic activity in their country, but
is likely to result in MNEs engaging in BEPS. Increasing the link through measures to
counter harmful tax practices and through assuring transfer pricing outcomes are in line
with value creation will result in higher taxes on companies currently doing profit
shifting. Aligning taxable income with real economic activity will result in more taxable
income being reported by companies currently engaging in profit shifting in the
jurisdictions where the economic activity giving rise to that income actually occurs.
Aligning taxable income with real economic activity will not mean that companies will
pay less attention to countries statutory tax rates, but instead tax rates will be taken into
account when decisions about the actual location or relocation of the real activities and
function that generate income are being made. The analysis in Annex 3.A1 finds support
for the hypothesis that tax planning MNEs investment is currently less sensitive to tax
rates than other firms investment since tax planning MNEs can reduce their ETRs
through artificial arrangements without changing the location of their real economic
activity.
252. While taxes affect location and investment decisions, they are not the only factor
MNEs take into account. It is important for researchers to estimate the effects of all
business taxes, not just corporate income taxes, and taking into account the effects of
non-tax factors. Table 3.4 summarises key factors determining the location of MNE
operations from two business surveys. The right column shows the ranking from a World
Bank survey of almost 200 decision makers of the largest MNEs. The left column shows
the ranking from a recent EY report of European decision-makers.
Table 3.4. Ranking of key location factors of MNE operations
Europe 2014
Worldwide 2002
Stable social and political environment
Access to customers
Ease of doing business
Potential productivity increase for their company
Cost of labour
Reliability and quality of infrastructure and utilities
Ability to hire technical professionals
Ability to hire management staff
Ability to hire skilled labourers
10
Crime and safety
Level of corruption
National taxes
11
Local taxes
17
Telecommunications infrastructure
Labour relations and unionisation
10
19
Note: The ranking for Europe comes from the EY Attractiveness Survey 2014 and the worldwide from the
Foreign Direct Investment Survey by the World Bank 2002. Local labour skill level was number 6 and
corporate taxation number 8 in the EY survey. Factors that could not be matched are marked with a minus
sign.
165. The table shows similar rankings about key location factors of MNE operations in
Europe and worldwide. A stable social and political environment and access to
customers rank at the top of both lists. The cost of labour and the qualification of
potential employees are also very important. National and local taxation are ranked 8th or
lower, and do not appear to be as important as many other factors.51 Nonetheless, when
tax differences are large or when other factors are fairly similar across locations, taxes
will affect business location decisions, as reflected in the empirical studies.
166. BEPS-induced distortions of types of investment. BEPS distorts the allocation of
investment and capital resources, favouring types of capital that are most conducive to
BEPS behaviours.52 Table 3.5 shows an illustrative marginal effective tax rate calculation
for knowledge based capital (KBC) from the OECD Supporting Investment in Knowledge
Capital, Growth and Innovation (2013). The analysis calculated a tax wedge, difference
between the pre-tax required hurdle rate of return on R&D at the margin and the aftertax required rate of return to the investor. The R&D tax wedge for domestic licensing and
production, or for a companys own-use in production, is 16 percentage points. The R&D
tax wedge becomes a negative 32 percentage points with the transfer of the KBC to an
offshore holding company with a substantially lower effective tax rate. Instead of the
income from the KBC investment bearing some tax, albeit much lower than the statutory
tax rate, the tax treatment of the income from the KBC becomes a significant subsidy as a
result of BEPS behaviours.
Table 3.5. Summary R&D tax wedge with MNE tax planning
R&D tax wedge
No R&D tax credit
(percentage points)
R&D tax wedge

5% R&D tax credit
(percentage points)
Own-use / Domestic license and production
16.2
6.1
Foreign license and production (territorial

system)
11.7
2.0
Transfer of KBC to offshore holding

company,
foreign
production,
80%
domestic inclusion
-3.0
-11.5
Transfer of KBC to offshore holding

company,
foreign
production,
20%
domestic inclusion
-32.4
-38.4
R&D cost-sharing agreement with offshore

holding
company,
foreign
contract
manufacturing, domestic tax base shifting
of 200% of production costs
-14.5
-17.3
Source: OECD (2013b). Key assumptions.
167. Another economic distortion and economic efficiency effect occurs when the tax
system favours one type of company over another. This results when MNEs engaging in
BEPS are able to reduce their ETR due to BEPS compared to MNEs not engaging in
BEPS and compared to domestic-only companies. MNEs have an inherent advantage
over domestic-only companies in being able to strategically place activity in jurisdictions
that offer special domestic tax incentives, such as R&D investment expenditures. Those
differences, which can result in differential effective tax rates, are not BEPS behaviours.
168. MNEs can take advantage of BEPS behaviours to artificially segregate taxable
income from the activity creating that income to reduce the MNE groups overall
effective tax rate (i.e. the affiliate in a country will face the same statutory tax rate as a
domestic only group, but will have less or more taxable income in that country due to
profit shifting).53 The overall groups effective tax rate can be lowered, which can provide
a potential competitive advantage in terms of cost savings compared to less aggressive tax
planning MNEs or domestic only companies without multinational tax planning
opportunities. The tax savings from BEPS behaviours can enable tax planning MNEs to
have a competitive advantage in obtaining favourable financing, in making acquisitions,
and in lowering product prices.
3.3.14 Increasing government competition on tax bases and attracting economic

activity
169. The BEPS project proposes a structural reform of the international corporate tax
system. The set of reforms, as recommended by the Action Plan, represent a multilateral
effort to address unintended interactions among national corporate tax systems. While the
implementation of the BEPS countermeasures will increase net global corporate tax
revenue, individual countries may be affected differently. It is therefore important to
understand how fiscal externalities or spillover effects from one jurisdictions tax rules
and practices affect other countries tax revenues and domestic tax policies.
170. Countries compete for FDI and employment through domestic government
policies including tax policy. They compete not only on headline statutory tax rates, R&D
tax credits, but increasingly on tax base changes.54 Revenue losses from BEPS arise from
both aggressive tax planning by some MNEs and tax competition between some
governments. The tax competition and spillover economic literature is increasing as
countries both compete for their national interest as well as find situations, such as BEPS,
where multilateral co-operation is important.55
171. National corporate tax policies can have a fiscal impact on other countries through
several interrelated channels. As highlighted by BEPS related research reviewed
previously, significant cross-border fiscal effects may arise through tax-induced changes
in FDI patterns and financing structures of MNEs. On the one hand, this leads to direct
tax base fiscal spillover effects as changes in real economic activity and profit shifting
affect other countries corporate tax bases. However, the anticipation of adverse fiscal
effects may also induce governments strategic tax policy changes as a response to tax
policies in other countries. Strategic tax spillover effects may lead, in the worst case, to
excessive tax competition (race to the bottom) and corresponding reductions in revenue
and government services and public investment.
172. A 2014 IMF paper assesses the fiscal effects from direct and strategic spillovers
by linking tax bases and statutory CIT rates for 103 countries over the period 1980 to
2013. Results from a panel data analysis show strong and significant evidence for direct
tax spillovers, implying that a one percentage point reduction in the CIT rate of all other
countries reduces a countrys tax base on average by 3.7 percent. While these effects
account only for real economic activity, disentangling the effects from profit shifting
yields results of similar magnitude and even higher significance. A separate analysis for
developing countries shows that direct spillover effects are two to three times larger than
in OECD countries.
173. To quantify strategic spillover effects, the IMF analysis applies the approach of
Devereux et al. (2008), relating foreign statutory (or effective) CIT rates to domestic
rates. While the estimates based on effective tax rates do not provide statistically
significant results, strategic setting of statutory tax rates is supported by the evidence. The
analysis confirms the negative effect of foreign CIT statutory rates on domestic tax bases.
Specifically, a one percentage point reduction in CIT statutory rates in all other countries
yields a 6.5 percent decrease in the CIT base of the average country and a simultaneous
reduction in the domestic CIT rate by 0.5 percentage points. This strategic decrease of the
CIT rate leads to an increase in the CIT base by 4 percent and a net base loss of
2.5 percent.
174. The presence of fiscal externalities implies that unilateral approaches to
international tax policy issues are likely to lead to inefficient outcomes at the global level.
Countries enacting unilateral countermeasures may protect their tax bases, while shifting
base erosion activity to other countries.56 Countries that encourage tax base shifting with
BEPS-facilitation attributes, such as lack of transparency, combined with a low or no
corporate tax,57 can reduce tax revenues in other countries and overall through both direct
and strategic spillover effects.
3.4 Future areas for economic research to better measure the scale and economic
impact of BEPS with better data
175. The mandate for Action 11 included developing an economic analysis of the scale
and impact of BEPS (including spillover effects across countries) and actions to address
it. This chapter summarises the current understanding of the scale and impact of BEPS
based on academic studies, other international organisations analyses, as well as some
new OECD research. Progress is being made in better understanding BEPS and
countermeasures, and the economic analysis show that BEPS is significant and affects
many economic decisions of both taxpayers and governments. The issue of BEPS and
appropriate geographic allocation of income and expenses relative to measures of value
creating activities is important not only to the current corporate income tax, but also
would affect other taxes proposed by some academics such as a business cash-flow tax or
a comprehensive business income tax.
176. The current body of empirical research into the fiscal and economic impacts of
BEPS demonstrates that the stakes are high, but there is still much further research
needed to be undertaken. Chapter 1 has illustrated how currently available data is affected
by many limitations, and this chapter outlined many methodological challenges
confronted by BEPS researchers. Chapter 2 includes BEPS Indicators that can be refined
with better data and more sophisticated analysis of that data. Annex 3.A1 provides
empirical estimates of the economic effects of tax planning based on financial account
data, which could be refined with better data. Annex 3.A2 provides a toolkit for analysing
the fiscal effects of specific BEPS countermeasures, which is often a strong starting point
for analysis of other economic effects. Chapter 4 makes recommendations on how better
use could be made of current and future data and recommends tools to monitor and
evaluate the effectiveness and economic impact of the actions taken to address BEPS in
the future. This chapter identified a number of areas for future BEPS analysis that have
not been undertaken or that are limited by current data. A number of areas for future
research beyond the Action 11 mandate but which will add to the understanding of BEPS
and MNEs are highlighted, since better data alone will not be sufficient for the best
possible analysis of BEPS.
177.
The following are some of the areas where additional analysis is needed:
The prevalence and intensity of BEPS. How pervasive are BEPS behaviours? Is
BEPS limited to a small number of MNEs or more widespread? Are some
MNEs more intensively exploiting BEPS than other MNEs, and if so why (e.g.
costs of tax planning, corporate governance, risk profile)?58 Would largely
unrestricted BEPS encourage smaller MNEs to start engaging in BEPS and
encourage domestic companies to go global for the BEPS tax benefits?
Differences in the profitability of MNEs vs. comparable domestic entities. Are
there inherent economic differences between MNEs and domestic entities which
make comparisons of ETR difficult? If so, how can competitiveness between
MNEs and domestic entities be evaluated?
Factors contributing to group profitability. What contributes to the profitability
of a global consolidated MNE? How much can be explained by tangible capital,
labour and/or sales compared to other factors such as different types of
intangible assets, public infrastructure, country risk diversification, etc.
Factors contributing to affiliate profitability. What contributes to the
profitability of individual MNE entities? How can functions, assets and risks be
incorporated in future analyses of BEPS, since they are the basis of arms length
pricing? How much can be explained simply by tangible capital, labour and/or
sales compared to other factors such as the intangible assets of their global
MNE, public infrastructure, labour force qualities and stability in a country,
etc.? How can these other factors which may change over time be incorporated
more fully than just dummy variables?
Other tax factors in location decisions. Corporate taxes are only one sourcebased tax affecting location decisions. How do these other business taxes affect
MNEs tax decisions? How can measures of profit shifting separate the effects
of non-BEPS tax preferences from BEPS?
Effects of uncertainty, reputation and compliance costs, and disclosure.
Companies face the equivalent of implicit taxes from uncertainty, reputation59
and compliance costs. Can these be measured and included in the economic
analysis of taxes and BEPS? What effects do disclosures to tax administrations
have?60
Mobility of different types of labour and capital. How mobile are different
forms of real economic activity, such as top level executives, R&D scientists,
production workers, back-office workers, buildings, equipment, different types
of intangible assets, etc.?
Governments strategic behaviours. How do different institutional settings
affect countries co-operative versus competitive behaviours? How multilateral
do agreements need to be to achieve effective co-operative outcomes?
178. The analysis of BEPS and countermeasures has advanced since 2013, providing
more evidence of BEPS and insights into specific BEPS channels and potential effects of
BEPS countermeasures. As analysts can only observe the current world with BEPS, any
analysis of BEPS and countermeasures must estimate a comparison point, whether it be a
world without BEPS, a future world without co-ordinated multilateral action, or a future
world with proposed countermeasures. Future analysis of BEPS, MNEs BEPS
behaviours, and tax competition with improved estimation methodologies are needed to
complement improvements in the available data relevant for analysing BEPS and BEPS
countermeasures.
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Notes
1.
Several commentators on the discussion draft noted the possibility of academic

publication bias, where empirical studies not finding statistically significant effects
of profit shifting are not published in academic journals.
2.
Several of the studies referred to later in the chapter describe the effects of some
existing BEPS counter-measures, including interest limitations. Several countries
reported in the survey by the OECD CFA Working Party No.2 revenue from interest
limitations ranging from 3-9% of corporate income tax revenues.
3.
Kleinbard (2011).
4.
OECD (2013), page 10.
5.
See Fryt et al. (2015).
6.
Corrado et al. (2012).
7.
Devereux and Griffith (1998).
8.
A number of tax returns are not included in the analysis because the compilation of
the database did not distinguish between zeros and not reported. Thus, some cash
boxes with no employees or tangible assets could have been excluded from the
analysis due to missing data.
9.
Dharmapala (2014), pp. 28-29.
10.
The FDI weighted standard deviation presented has the FDI weights changing each
year as FDI changes. Using the 2003-2013 average FDI positions as a constant weight
for all years shows the same trend.
11.
FDI includes both real economic activity and BEPS, so is not an ideal measure, but
information about special purpose entities and other conduit financing and the
ultimate destination of some FDI is not available.
12.
Monkam, N. (2012).
13.
UNCTAD (2015), World Investment Report.
14.
Different methodologies, variable used and data sources can explain different
estimates. Some microdata profit shifting studies explain a very small amount of the
variation in profitability across affiliates.
15.
Riedel (2015).
16.
UNCTAD (2015).
17.
UNCTAD (2015), World Investment Report (pp. 201): The profit shifting and tax
revenue losses estimated here are mostly confined to those associated with tax
avoidance schemes that exploit a direct investment relationship through equity or
debt. Trade mispricing does not require a direct investment link: MNEs can shift
profits between any two affiliates based in jurisdictions with different tax rates.
18.
Tax rate differentials are both positive and negative so BEPS involves some
redistribution of revenue across countries. Because BEPS involves shifting of profits
from entities subject to marginal tax rates higher than to the entities receiving the
shifted income, profit shifting is not a zero-sum game: it involves significant global
revenue losses. Individual country estimates are not done due to data limitations and
the complexity of individual countries tax rules.
19.
Averages are weighted by share of corporate tax collections after tax credits in 20052010 among the countries included in the analysis. For the final profit shifting fiscal
estimate, actual corporate tax collections after tax credits are adjusted upward by 23%
to more accurately reflect the taxable income base affected by profit shifting, based
on a CFA/WP2 survey of corporate tax credits, principally at 2011 levels.
20.
A sensitivity test shows the effect of an alternative tax rate differential and weighting
factor. The tax rate differential calculated for the MNE entities in the ORBIS database
could be changed to the tax rate differential between countries weighted by their
macro-level goods export trade. Bilateral trade in goods exports is an important area
of transfer mispricing, although comparable data for related party exports are not
available for many countries. Services including royalties have larger tax rate
differentials, but service export data are not comprehensive. A second adjustment
could weight country tax rate differentials by corporate taxes before credits, rather
than corporate taxes after credits. Those two adjustments result in the global corporate
tax revenue loss ranging from 6% to 14% of CIT. Leaving the revenue loss from
mismatches and tax preferences aside, the two changes produce an estimate of
corporate revenue loss just from profit shifting in the same range as the base case.
21.
The analysis in Annex 3.A1 tested the sensitivity of the profit shifting tax
responsiveness for country fixed effects. The regression coefficient was one-third
lower than the baseline estimate. Country fixed effects are used to hold non-tax
factors constant across counties, but the estimates of the tax relationship is then based
only on variation in tax rates within countries over time, since between country
variation in tax rates are captured by the country fixed effects. When using the profit
shifting estimate with country fixed effects, the global corporate tax revenue loss
ranges from 3% to 8% of CIT. Country fixed effects are already used in the
mismatches and tax preferences regression estimate.
22.
The 95% confidence interval is roughly two standard deviations from the mean. The
profit shifting estimates standard error is 0.0164 and the ETR differential estimates
standard error is 0.0026.
23.
IMF (2014), pp. 20 and 61-65.
24.
UNCTAD, World Investment Report (2015), pp. 201-204 and Annex II pp. 24-26.
25.
United States Joint Committee on Taxation (2014).
26.
Dowd, Landefeld and Moore (2015).
27.
MSCI (2015).
28.
Christian Aid (2009).
29.
Oxfam (2015).
30.
Bach (2013).
31.
Clausing (2011).
32.
Vicard (2015).
33.
Annex 3.A1.
34.
Scottmay (2015).
35.
Slemrod and Wilson (2009) and Dharmapala (2014).
36.
Cederwall (2015).
37.
Slemrod (2010).
38.
See Fuest (2015).
39.
See Clausing (2012), Gravelle (2010), Harberger (1995) and Harberger (2006).
40.
The standard corporate income tax incidence analysis is based on the Harberger
Model of the incidence of changes in a general corporate income tax. For a fairly
easy-to-follow explanation of the model, see Harberger (1995). In this article,
Harberger explains how his original closed-economy model has to be modified to
analyse CIT incidence in the international setting. Randolph (2006) provides a more
detailed analysis of the expected incidence of the general corporate income tax.
41.
It has been noted that the incidence effects outlined in this section are similar in
nature to the new view of the incidence of a property in open-border local
economies. See Mieszkowski and Zodrow (1986). In this view, property owners bear
the burden of an average tax rate across jurisdictions with above and below-average
tax rates creating excise tax effects in different jurisdictions that shift the remaining
portion of the burden to households. See Gravelle (2010).
42.
This result under perfect competition is fundamentally the same result that would be
expected from an increase in the CIT in a closed-border economy, except that the
reallocations of capital occur between the corporate and non-corporate sectors only,
not across borders. Harberger (2006) made this point, noting: if all countries (or a
set of big countries making up most of the world economy) choose to move their CIT
rates in more-or-less parallel fashion, then the appropriate [incidence] model is one of
a closed economy. (p.7).
43.
Corrado et al. (2009) and Corrado et al. (2012).
44.
Cronin et al. (2012) estimate that 63% of the total returns to capital is excess profits,
while only 37% is a normal return.
45.
Clausing (2012) discusses how the presence of economic rents would increase the
burden of CIT on owners of capital. She also notes empirical studies of the incidence
of the CIT in the international setting are tainted by the presence of BEPS as MNEs
can reduce effective tax rates through the shifting of profits unrelated to changes in
the international allocation of capital. In this case, there may be a minimal tax burden
on capital to be shifted. Voget (2015) cites some empirical studies that could imply
that some of the multinationals rents are location specific and relatively immobile.
46.
Devereux and Griffith (1998) note that MNEs facing discrete investment choices with
finite capital will choose location decisions based on the average effective tax rate,
rather than the marginal effective tax rate on investment. This incidence analysis
assumes companies have access to capital when earning excess returns, and thus
would still be earning more than the next-best alternative investment.
47.
The estimated range includes two effects: 1) a range of -2.5% to -5.0% around the
estimated average -3.25% lower effective tax rates due to mismatches between tax
systems and domestic tax preferences, and 2) a range of -1.5% to -3.5%% due to
profit shifting of all MNEs. The latter estimate multiples the estimated -2.8% to -7.5%
reduction in global CIT revenue from profit shifting alone times the estimated 59% of
MNEs share of profits divided by the average weighted effective tax rate of 30% in
the countries included in the analysis.
48.
Several studies do not report finding statistical differences, although the studies differ
in the companies analysed and have different methodologies. See Markle and
Shackelford (2012), Dyreng and Markle (2014) and UNCTAD (2015). The Annex 1
estimate finds a statistically significant difference between large MNEs and similarly
situated domestic-only large affiliates. It does not find a statistically-significant
difference between large MNEs, small MNEs and small domestic-only affiliates.
49.
50.
Akcigit et al. (2015) analyse the international mobility of inventors and personal
income taxation, and report inventors who are employed by MNEs are more likely to
take advantage of personal income tax differentials.
51.
It is possible that company officials place less importance on national taxes currently
due to the availability of BEPS.
52.
Chen and Mintz (2008).
53.
Hanlon and Heitzman (2010) discusses how many tax planning activities reduce both
financial reported profits and taxable income (conforming planning), and thus do
not affected measured ETRs. Only non-conforming planning where taxable income
or taxes are reduced but reported profits are not results in lower ETRs. For instance,
increased interest deductions reduce both reported profits and taxable income, while
exempt dividends do not affect reported profits, but reduce taxable income.
54.
55.
See Genschel and Schwarz (2011) and Keen and Konrad (2014).
56.
De Mooij (2011).
57.
Hebous and Ruf (2015).
58.
The tax accounting literature has begun work in this area but limited by available
financial statement information. For example, see Armstrong et al. (2015).
59.
Mintz and Venkatachalam (2015).
60.
See Hoopes (2015) for current summary of literature.
Annex 3.A1
Economic implications of multinational tax planning
Box 3.A1.1. Summary of main findings
This annex provides robust evidence of tax planning by multinational enterprises (MNEs). The
analysis is based on a sample of data that are considered to be the best available cross-country
firm-level information. Yet, the data have significant limitations in their representativeness in
some countries, do not include all MNE entities and are based upon financial accounts rather
than tax returns.
The focus of this annex is broader than the OECD/G20 Base Erosion and Profit Shifting (BEPS)
Project.1 The BEPS Project focuses on instances where the interaction of different tax rules
leads to double non-taxation or less than single taxation and it also relates to arrangements that
achieve no or low taxation by shifting profits away from the jurisdictions where the activities
creating those profits take place. The analysis contained in this study assesses the fiscal and
economic implications of international differences in statutory and effective corporate tax rates
and as such it also covers domestic tax incentives.
Tax planning is widespread among MNEs and entails tax revenue losses.
Robust empirical evidence shows that MNEs engage in international tax
planning. MNEs shift profit from higher to lower-tax rate countries. Large MNEs also
exploit mismatches between tax systems (e.g. differences in the tax treatment of
certain entities, instruments or transactions) and preferential tax treatment for certain
activities or incomes to reduce their tax burden.
Transfer price manipulation, strategic allocation of intangible assets and
manipulation of internal and external debt levels are important profit shifting
channels.
The empirical patent analysis suggests that preferential tax treatment of
intellectual property (IP) influences the location of intangible assets. Preferential
IP regimes attract research activities and the ownership of patents invented in other
countries. Preferential regimes may also encourage the relabeling of certain incomes to
benefit from the regime.
Tax planning reduces the effective tax rate of large MNEs by 4-8 percentage
points on average. The reduction is even greater for very large firms and firms
intensive in the use of intangible assets. Small MNEs also engage in tax planning but
to a lesser extent.
The net tax revenue loss from tax planning is estimated at 4-10% of global
corporate tax revenues. These estimates based on 2000-10 data are surrounded by
uncertainty and should be interpreted with caution.
Box 3.A1.1. Summary of main findings (continued)
Strict anti-avoidance rules reduce tax planning. Strict anti-avoidance rules, such as
transfer pricing, interest deductibility, GAARs and CFCs rules, are found to reduce
profit shifting. However, complex rules generate compliance costs for all firms,
hampering profitability, as well as administrative and enforcement costs for tax
authorities. These costs could be reduced by international co-ordination.
Tax planning effects on economic efficiency are unclear.
Tax planning may allow certain MNEs to increase their market power, resulting in
more concentrated markets. The reduced competitive pressure may entail welfare losses.
However, these losses may be partially offset by the associated reallocation of resources
to high-productivity MNEs.
The possibility to manipulate the location of internal and external debt lowers the
cost of debt for MNE groups and can compound the debt-bias present in most
tax systems. Even so, domestic firms have on average higher external leverage than
MNE groups. Information on internal debt is not available.
International tax planning reduces effective tax rates and the effect of crosscountry corporate tax differences on the location of investment by tax planning
MNEs. However, this is achieved at the cost of additional distortions (e.g. uneven
playing field between tax-planning MNEs and other firms) as compared with a situation
in which corporate tax rates were cut across the board.
Introduction
The design of corporate tax systems influences the behaviour of multinational enterprises
(MNEs). International differences in taxation can lead MNEs to locate a larger share of
their economic activity in lower-tax countries. In addition, it can lead to international tax
planning by MNEs to reduce their tax burden. MNEs may locate profits in lower-tax
countries, independently of where the profit-generating activity takes place, for example
by manipulating the price of intra-group transactions or the location of external and
related-party debt. They may also exploit differences in the tax treatment of certain
entities or instruments (henceforth called mismatches between tax systems) or
preferential tax treatment for certain activities or incomes to reduce their tax burden. In
some cases, MNEs may also defer repatriation of profits from abroad indefinitely to avoid
taxes. This raises a number of fiscal, redistributive and economic efficiency concerns,
which are discussed in this study (see Figure 3.A1.1 for an overview).
Figure 3.A1.1. Issues covered by the analysis
This annex provides an estimate of tax planning based on financial account data from the
largest commercially-available firm-level database (ORBIS).2 The study estimates the
relationship between tax rate differentials and profit shifting using financial account data.
It is well known that the legal accounting standards for firms differ between public
financial accounting and confidential tax accounting (e.g. Lisowsky, 2010) and improved
access to data, especially tax return data, would enable refined estimates of the effects of
tax planning. In the absence of such data, this study relies on the best cross-country firmlevel financial account data currently available.
The study looks at both fiscal and efficiency issues related to tax planning behaviour by
MNEs. Tax planning affects the distribution of tax bases and revenues among countries,
thereby entailing fiscal considerations. By reducing the effective corporate tax rate of
certain MNEs relatively to other MNEs and domestic firms, tax planning may also distort
competition and lead to efficiency losses (e.g. if domestic firms are hindered from
growing). Tax planning opportunities may also be one factor altering firms financing
decisions by reinforcing the debt bias present in most countries tax system at the expense
of equity financing, with potential effects on firms investment choices and bankruptcy
risks at the MNE group level.
The location of MNE investments in tangible and intangible assets depends, among other
factors (e.g. labour taxation, regulations, access to market, agglomeration effects, labour
force skills, quality of infrastructure, etc.), on corporate taxation. All else equal, countries
with lower tax rates or preferential tax regimes for certain investments attract more
foreign investment including R&D investments than higher-tax countries. These
investments can create technological spillovers, with positive effects for productivity and
growth (and in turn reduce such positive spillovers in higher-tax countries) (e.g.
Blomstrm and Kokko, 1998; Markusen and Venables, 1999). They can also influence
trade patterns (Dahlby, 2011).
Globalisation and the ongoing integration of world capital markets may further increase
the mobility of corporate tax bases and the sensitivity of investment to international tax
differences (Braconier et al., 2014). This may intensify tax competition. Indeed,
evidence suggests that an increasing mobility of capital is associated with lower statutory
corporate tax rates (Devereux et al., 2008; OECD, 2009; Arnold et al., 2011; IMF, 2014),
which is consistent with the reduction in corporate tax rates that occurred over the past
decades (Figure 3.A1.3, Panel A). Even so, corporate tax revenues of OECD countries
have remained fairly stable on average as a share of GDP, suggesting that in many
countries a broadening of the base has accompanied the cuts in the rate (Figure 3.A1.2,
Panel B). In some countries, the corporate tax base was supported by an increase in the
profit rate and also possibly by substitution effects between personal and corporate
income tax.
Figure 3.A1.2 Corporate tax rates and tax revenues
Panel A: Statutory corporate tax rate, %3
2014
2000
60
50
40
30
20
10
0
Panel B: Corporate tax revenues in OECD countries, % of GDP4

Unweighted average of OECD countries
Weighted average of OECD countries
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Source: OECD Tax Database and KPMG.
Assessing tax planning of MNEs

Main tax planning channels
Tax planning, as defined in this annex, is somewhat broader than BEPS behaviours
identified in the OECD/G20 BEPS Action Plan (OECD, 2013). The BEPS project focuses
on instances where the interaction of different tax rules leads to double non-taxation or
less than single taxation and it also relates to arrangements that achieve no or low
taxation by shifting profits away from the jurisdictions where the activities creating those
profits take place (OECD, 2013).
In this study, tax planning refers to situations in which there is a disconnection between
the location of profits and the real activity generating them. It also includes situations
where the effective tax rate (ETR) of MNEs is artificially reduced compared to that of
similar domestic firms due to exploitation of tax planning schemes involving loopholes
in tax systems and preferential tax treatment. Some behaviours included in the measure of
tax planning in this study are not BEPS behaviours, such as the decision to carry out
substantial activity in a country to benefit from certain preferential tax treatments (e.g.
R&D tax subsidies). This reflects the limitations of the available data, which make it
impossible to disentangle certain BEPS from non-BEPS behaviours. Still, most tax
planning channels covered by the analysis in this study overlap with BEPS behaviours
and represent artificial financial flows that are not related to the location of real activity.
Below is a non-exhaustive and simplified description of the tax planning channels
covered in the analysis in this study:
Profit shifting channels: MNEs have different ways to reduce their corporate tax
burden by locating in lower-tax rate countries their profit generated in higher-tax rate
countries.5
Transfer price optimisation: Optimising the price of transactions between
related entities within the range of possible market-based so-called arms
length prices to achieve tax advantages. For example, by selecting a low price
in the range for rights, products and services transferred from high to low-tax
entities or vice versa.
Allocation of intangibles, assets and risks: Allocating through intra-group
arrangements the ownership of income producing intangibles, assets and risks in
low-tax countries to divert profit from high-tax countries. Operational functions
are more difficult to re-locate and the main value-creating activities which
manage and exploit those intangibles, assets and risks may be performed in
higher-tax locations under contract to the legal owner.
Manipulation of the location of debt: Interest payments on debt are generally
deductible from taxable income. Locating MNE external and internal debt (and
the associated interest payments) in an entity in a higher-tax rate country allows
offsetting profits and reducing tax payments of this entity.
Mismatches between tax systems, including preferential tax treatment and
negotiated tax rates: MNEs may exploit differences in the tax treatment of entities,
instruments, or transfers between countries to reduce their corporate tax burden
(OECD, 2014b). This is possible even in the absence of a difference between
statutory tax rates. MNEs may also be able to reduce their tax burden via preferential
tax treatment and negotiated firm-specific reduced tax rates.
Hybrid instruments and transfers: Instruments which are treated differently
in two countries, for example as debt in one country and as equity in another
country. This can result in an interest deduction in the first country and nontaxable income in the second country (as the income is treated as a tax-exempt
dividend).
Hybrid entities: The same entity can be treated differently in two countries for
tax purpose. For instance, an entity may be considered as tax resident by no
country (so called stateless entities) and in this way achieve double nontaxation of profit. Alternatively, an entity can be treated as a non-taxable entity
such as a partnership (where the partners are taxed instead of the entity itself) in
one country and a taxable entity in another. This can result in a deduction in the
first country and non-inclusion of the income in the second country.
Preferential tax treatment: MNEs may shift certain incomes to benefit from
special tax treatment offered by some countries (or areas within them), such as
for intellectual property (e.g. patent boxes) or financial services. Domestic firms
can also benefit from preferential tax treatment, but to a lesser extent than
MNEs since they cannot shift incomes across borders to enjoy these treatments
on a larger scale.6
Negotiated tax rates: Firm-specific reduced tax rates for individual MNEs
through negotiation between the MNE and the tax authority.
Tax planning schemes are often complex and can involve several of these channels in
combination. To take this complexity into account, this study relies on a systematic topdown approach. It first focuses on where profits of MNEs are reported (profit shifting),
and second it assesses the effective taxation of reported profits in each country
(mismatches between tax systems, including preferential tax regimes). This ensures
consistency and that there is no double-counting between the two. The exploitation of
preferential tax regimes and negotiated tax rates are included in the mismatches analysis
since they cannot be disentangled from them with the available data.
The approach also takes into account potential interactions between profit shifting and
mismatches between tax systems. For instance, if profits are shifted to a country to enjoy
a preferential tax treatment, the ETR differential resulting from this treatment is applied
to the complete tax base (i.e. including the shifted profits) when assessing the fiscal
implications of tax planning.
MNEs engage in international tax planning

The empirical analysis, covering a large sample of firms from 46 countries (mainly
OECD and G20) based on financial accounts data, supports the hypothesis that MNEs
engage in international tax planning. This confirms the existing anecdotal insights, case
studies of specific firms and findings from other firm-level studies. These studies most
often cover only one specific country or only European countries and are based on
much smaller samples of firms (e.g. Huizinga and Leaven, 2008; Clausing, 2009; Fuest
and Riedel, 2010; Heckemeyer and Overesch, 2013). Both profit shifting and the
exploitation of mismatches between tax systems (including the exploitation of

preferential tax treatment) are found to be important tax planning strategies.7
Profit shifting analyses in the literature rely either on financial account data (e.g. the
ORBIS database or its regional subsamples) or tax returns (e.g. Grubert, 2012 for the
United States), the latter being only available at the country level and on a nonharmonised and confidential basis (Dharmapala, 2014). The analysis in this report is
based on commercially-available financial account data that offers the advantage of wide
cross-country coverage and largely consistent accounting rules across countries (see
Box 3.A1.2 for details on the data). However, one caveat is that reported profits in
financial accounts may differ from taxable profits due to divergence in accounting
standards and tax planning.8 More specifically, reported profit can differ from taxable
profit due to differences in the timing of recognition of income and expenses (e.g.
different capital depreciation rules), in the definition of income (e.g. Hanlon, 2003;
Boynton et al., 2014), because taxable profit may reflect past losses being carried forward
or because tax residence of an affiliate is different from its country of incorporation.
Nevertheless, profit reported in financial accounts and taxable profit is expected to be
generally affected in the same direction by profit shifting, justifying the use of reported
profit as a proxy for taxable profit. Still, differences in profits and taxes reported in
financial accounts and tax returns are a limitation of currently available firm-level
information.
Box 3.A1.2. Disclaimer on the data used in the empirical analysis
Measuring tax planning of multinationals poses a number of data challenges. Data from tax
reports are confidential and not available on a cross-country basis. In addition, in most countries
tax data do not include information on group activities, profits and tax payments abroad, which
is necessary to properly assess profit shifting. In the absence of consistent tax data, this study
relies on the ORBIS database (commercialised by Bureau Van Dijk), which is generally
considered as the most comprehensive commercially-available data on (listed and non-listed)
firms financial accounts and ownership structures (Fuest and Riedel, 2012; Dharmapala, 2014).
The ORBIS database and coverage of the sample
The ORBIS data is based on financial accounts of firms as reported to institutions such as
business registers, chambers of commerce or local credit institutions. These data have been
cleaned and checked by the OECD Statistics Directorate to ensure consistency across countries
(Ragoussis and Gonnard, 2012) and further reviewed for this project by removing implausible
values and outliers. The final sample consists of 1.2 million observations of unconsolidated
MNE accounts over the period 2000-2010 in 46 countries. Although the economies themselves
cover about 90% of world GDP, the coverage in the sample varies meaningfully across
countries. Hence a smaller fraction of the activity is likely to be accounted for in countries with
low representation. See below for more details on coverage. Additionally, MNEs links to
countries outside of the sample (including no-corporate-tax countries) are also taken into
account. The MNE group identification iterates on the direct ownership information in ORBIS to
account for missing information on the final owner of a firm. Two firms are assumed to be
linked if one owns the other with a share of at least 50%. MNEs account for an important share
of large firms and profits in many countries, particularly in smaller (more open) economies
(Figure below).
Box 3.A1.2. Disclaimer on the data used in the empirical analysis (continued)
Distribution of firms in the sample, by firm type9,10,11
Panel A: As a share of total number of firms (only firms with more than 250 employees)
%
100
MNEs
Domestics groups
Standalone firms
Type not identified
90
80
70
60
50
40
30
20
10
0
Panel B: As a share of reported pre-tax profits (only profitable firms)

%
MNEs
Domestics groups
Standalone firms
Type not identified
100
90
80
70
60
50
40
30
20
10
0
* Peoples Republic of China.
Quality of the sample and of the MNE group identification
The coverage of firms with available financial account data varies across countries. Compared
with the actual population of firms (when data on the actual population is available), the
coverage is above 50% in most European countries and less than 10% in most non-European
countries. However, it is limited in some countries, including the United States, New Zealand
and Chile (see Figure below). The distribution of observations across industries is somewhat
higher in manufacturing than in services.
Representativeness of the final sample
Number of firms in the final ORBIS sample, as a share of the total in STAN business demography
statistics, 200612
Panel A: by country
Percent
100
All firms
Large firms (250+ employees)
90
80
70
60
50
40
30
20
10
0
Note: The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli
authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East
Jerusalem and Israeli settlements in the West Bank under the terms of international law.
Panel B: by industry
Percent
All firms
Large firms (250+ employees)
60
50
40
30
20
Real estate and

business services
Finance and
insurance
Transport and
communications
Hotels and
restaurants
Wholesale and
retail trade
Construction
Utilities
Manufacturing
(other)
Motor vehicles
Electrical and
optical equipment
Machinery and
other equipment
Metallic products
Other non-metallic
mineral products
Petroleum
products
Pulp and paper
Wood
Leather
Textiles
Food and tobacco
Mining
10
Source: OECD calculations based on the ORBIS database and OECD STAN business demography
statistics.
For an average MNE group, more than 50% of the worldwide activity is covered, which is a
higher share that in other recent studies (e.g. Huizinga and Laeven, 2008). An issue is the lack of
financial data in certain no-corporate-tax countries. This is mitigated by the methodological
approach, which only relies on links to these countries being identified, not on the availability of
financial accounts in these countries. Still not all links are identified in ORBIS. It is difficult to
assess the magnitude and importance of the missing links due to general lack of data on actual
links. Nevertheless, an important number of links to no-corporate tax countries is identified (see
Figure below). For example, among the top-500 United States firms (Fortune 500 list for 2013),
Citizens for Tax Justice (CTJ, 2014) identify 362 firms having links to tax havens. Of these
362 firms, 266 (i.e. 72%) are in the ORBIS sample. Among these 266 firms, at least one tax
haven link is identified in ORBIS in 184 cases, i.e. 69% of the times (this represents just over
half of top United States firms with tax haven links).
Given that financial reporting requirements are usually stricter for large firms, the coverage of
the data is generally better for these firms. This would suggest that the coverage of MNE entities
is better than average as they are generally large entities, although entities in large MNE groups
can be small. It is possible that MNEs heavily involved in tax planning or using complex
schemes (e.g. stateless entities for tax purposes) opt not to disclose their financial accounts to
business registers if the repercussion of not complying with reporting is limited. This may result
in under-sampling of such firms, which may bias the results when there are non-random
reasons for information to be missing (e.g. accounts in low-tax jurisdictions are less likely to be
included in the dataset) (Cobham and Loretz, 2014). This issue is addressed in the sensitivity
analysis.
Finally, the current OECD-ORBIS database includes data up to 2010 and the analysis is based
on the 2000-10 period. Since then, tax planning behaviours may have changed reflecting factors
such as the growing importance of the digital economy and changes in anti-avoidance rules
against tax planning and in global value chains. In addition, corporate tax rates have been cut in
some countries.
Identified links to no-corporate-tax countries of entities in the sample
Share of large MNE entities in the sample having links to countries not taxing corporate
income13,14
Panel A: by country of headquarters
As a share of total number of large MNE entities, %
70
60
50
40
30
20
10
0
Panel B: by industry
As a share of total number of large MNEs entities, %
60
50
40
30
20
Real estate and

business services
Finance and
insurance
Transport and
communications
Hotels and
restaurants
Construction
Wholesale and
retail trade
Utilities
Manufacturing
(other)
Motor vehicles
Electrical and
optical equipment
Machinery and
other equipment
Metallic products
Other non-metallic
mineral products
Petroleum products
and chemicals
Pulp and paper
Wood
Leather
Textiles
Food and tobacco
Mining
10
Profit shifting
The empirical strategy to identify profit shifting is to compare the profitability (measured
as the ratio of pre-tax profit to total assets or employment) of MNE entities with similar
characteristics (e.g. size, industry, etc.), but different opportunities to shift profits (see
Box 3.A1.3 for details and Figure 3.A1.3, Panel A). These opportunities depend on the
location of the other entities in the corporate group. Entities with links to lower-tax rate
countries have opportunities to shift profits abroad, while entities with links to higher-tax
rate countries may receive profits from abroad. In this study, the profit shifting
opportunity of a MNE entity is measured by the difference between the statutory
corporate tax rate in the country of this entity and the average (unweighted) statutory tax
rate in the countries where its corporate group operates.15,16,17 Links to countries outside
the sample, including no-corporate-tax countries, are taken into account even in cases of
missing financial information of the particular entity.
The estimated profit shifting elasticity implies that a one percentage point (or about 3%)
higher statutory corporate tax rate than the average in the corporate group is associated
with a reduction in reported profits of about 1% (Figure 3.A1.3, Panel B). This sensitivity
is slightly higher than the estimate of a 0.8% reduction in corporate profits based on a
meta-analysis of existing firm-level studies (Heckemeyer and Overesch, 2013). The two
different measures of profitability (pre-tax profits to total assets or employment) yield
similar results.
In addition, results are robust to a number of variants: (i) using different fixed-effects
structures (e.g. country and country-interacted-with-time fixed-effects); (ii) restricting the
sample to EU countries; (iii) restricting the sample to manufacturing firms; (iv) restricting
the sample to sub-periods; (v) re-sampling observations to adjust for the relatively low
representation of certain countries in the analysis; (vi) dropping all entities having at least
one subsidiary, i.e. keeping the lowest tier in the corporate structure, (to avoid any
potential bias involving dividends paid by subsidiaries); (vii) using forward-looking
effective tax rates instead of statutory rates; (viii) excluding from the tax variable links to
countries with below-average score on rule of law or regulatory quality indicators;
(ix) using a 90% ownership threshold (instead of 50%) in the identification of corporate
groups.18 Robustness of the results to extrapolation beyond the sample is an issue that is
addressed via sensitivity analysis (see below).
Figure 3.A1.3 Empirical approach on profit shifting: Illustrative example19
Box 3.A1.3. Empirical approach: Assessing tax planning based on firm-level data
The strategy to assess profit shifting is to compare the profitability of MNE entities with similar
characteristics except for their links to countries with different tax rates. The hypothesis is that
MNEs with links to lower-tax rate countries would report relatively low profits in entities
located in higher-tax countries compared with similar firms that have no such links. In practice,
the estimated equation is as follows:
,
where
is the profitability (the ratio of reported pre-tax profits to total assets
or employment) of firm f (operating in MNE group g, country c and industry i) in year t.
is a vector of determinants of true profitability, which includes both firm-specific characteristics
(size, position in the group, presence of patents in the group) and macroeconomic variables
(GDP growth, exchange rate, inflation, GDP per capita).
is
the difference between the statutory tax rate in country c and year t and the unweighted average
of the statutory tax rates in the countries where the multinational group g operates. Statutory
rates are national averages (i.e. they do not reflect regional differences in rates) and do not take
into account tax holidays. The tax sensitivity of profits is measured by the coefficient , which is
expected to be negative if profits are shifted to lower-tax rate countries. , are respectively
time and industry fixed-effects to control for unobserved (non-tax) factors affecting
profitability.*
Excluding country fixed-effects in the baseline estimation may bias the estimated tax sensitivity
(upwards or downwards) since some unobserved country-specific factors may be captured by the
tax sensitivity. However, such fixed-effects may also capture some profit shifting, which would
result in underestimating profit shifting (Clausing, 2009; Buettner and Wamser, 2013). The
results are qualitatively robust to including both country and country-interacted-with-time fixedeffects, although the tax sensitivity would be reduced by about 30%.
The strategy to assess (jointly) mismatches between tax systems and preferential tax treatment is
to compare the effective tax rate (ETR) of a multinational entity in a given country to the ETR of
a domestic (i.e. non-MNE) entity with similar characteristics. The ETR considered is the ratio of
tax expenses over the profit reported in the financial statements of the firm, at an unconsolidated
level (i.e. for each entity in the group). One caveat is that tax expenses reported in financial
accounts are likely to differ from tax liabilities in tax data, for example due to differences in the
inclusion of deferred tax expenses, other book/tax differences and differences in the tax
residence of the affiliate.
The hypothesis is that if a multinational entity exploits mismatches to reduce its tax burden, it
may report a high profit in its financial statements, but its taxable profit (and thus its tax burden)
would be lower, for example because of the use of a hybrid instrument or entity. A hybrid
instrument can result in an interest deduction in one country as it is treated as debt in this country
and a non-taxable income in another country where it is treated as equity. As compared to a
standard debt instrument, this would lead to a lower ETR (as measured with financial account
data) in the receiving country. However, there would be no visible difference in financial
accounts as compared to a standard equity instrument. The use of a hybrid entity will generally
result in a lower ETR, as it can allow a MNE entity to report profits in a higher-tax rate country
while paying the tax rate of a lower-rate (or no-tax) country. Another example is a dual resident
entity which may claim more than one tax deduction for the same interest expense, thereby
reducing its ETR. The effective tax rate of MNE entities can also be reduced by the exploitation
of preferential tax treatment for certain activities or incomes (e.g. shifting patents to a patent-box
country), to the extent that they benefit more than domestic firms, or because of negotiated tax
rates. One caveat is that unobserved and inherent differences between MNE and domestic
entities that are not related to tax planning (e.g. capital intensity) may also influence their
relative ETRs.
Exploiting mismatches between tax systems may involve complex schemes with important fixed
costs, suggesting that only large MNEs may engage in it. To account for this, the empirical
approach is to compare the effective tax rate of multinational and domestic entities among
different size classes. The estimated equation is as follows:
,
where
is the effective tax rate of firm f (operating in country c and industry i) in year t,
measured as tax expenses over reported profit.
and
are
respectively dummies for large (over 250 employees, in line with the EU definition) and small
entities.
is a dummy equal to one when a company is part of a multinational group.
is a vector of firm-specific controls (position in the group, presence of patents,
profitability). The coefficients
and
measure the ETR differential between small
(respectively large) MNEs and comparable domestic firms. The hypothesis is that these
coefficients should be negative if MNEs exploit mismatches between tax systems and
preferential tax treatment to reduce their tax burden. and
are dummies for industry and for
country-interacted-with-time, which capture the effect of countries having different (and timevarying) tax rates.
________________________________________
*
Estimating profitability of individual affiliates is very difficult with available data, as reflected
in only 1.5% of the variance across affiliates being actually explained. This is common among
cross-sectional firm-level studies with many observations (see for example Beer and Loeprick,
2014). It reflects the intrinsic volatility of the profit rate, which is largely driven by (unobserved)
firm-specific factors. If profitability is not captured by the non-tax variables, the estimated tax
responsiveness could be affected.
Mismatches between tax systems and preferential tax treatment

Mismatches between tax systems have not received as much academic attention as profit
shifting and little is known about their magnitude.20 They are more difficult to identify
than profit shifting, since a mismatch can exist in any pair of tax systems (and can be
aggravated by the use of a third country in a tax planning strategy) regardless of their
statutory tax rate. The hypothesis is that by exploiting mismatches between tax systems,
for example in the form of hybrid entities or instruments, MNEs can reduce their effective
tax rate (ETR) as measured with financial account data. The empirical strategy is to
compare the effective tax rate (ETR) of a MNE entity on its reported profit to the ETR of
an entity in a domestic group with similar characteristics (see Box 3.A1.3 for details).
Differences in ETR between MNEs and domestic entities with similar characteristics may
also capture negotiated lower tax rates for MNEs. In addition, they reflect preferential tax
treatment of certain activities and incomes if MNEs have structured their activities to
benefit more from this treatment than domestic firms (e.g. by shifting their patents to
countries with preferential treatment of patent income).
One caveat is that tax expenses reported in financial accounts can differ from actual tax
liabilities or cash taxes paid. Financial tax expenses include both current and deferred tax
expenses, and can be affected by changes in countries tax rates on deferred tax assets and
liabilities. In contrast, tax accounting does not include the deferred tax expense.
The empirical analysis shows that the ETR of large (with more than 250 employees)
MNE entities is on average 3.3 percentage points lower than that of comparable large
domestic groups, even after controlling for a number of factors affecting firms ETR
(size, industry, position in the group, presence of patents, profitability, etc.). There is no
such difference among smaller firms (less than 250 employees), which may reflect the
existence of large fixed costs of setting up schemes to exploit mismatches between tax
systems (e.g. complex structures or financial instruments, tax and legal advice).
Possibilities to negotiate reduced tax rates and to exploit preferential tax treatment may
also be greater among large firms. As the empirical results for profit shifting, the results
are robust to a number of variants using the available sample of firms.
Trends in international tax planning

Changes in tax planning intensity can only be assessed over 2000-2010 with the available
firm-level data. The empirical analysis suggests no clear trend over this period
(Figure 3.A1.4). One possible explanation is that a potential increase in the tax planning
intensity due to increasing globalisation and greater reliance on intangible assets has been
offset by stricter anti-avoidance rules (see section 2.5).
Figure 3.A1.4 Trends in international tax planning, 2000-2010
Panel A: Profit shifting
Point estimate: profit shifting
95% confidence interval
Profit shifting elasticity (impact on profit of a one percentage point tax rate differential)
3%
2%
1%
0%
-1%
-2%
-3%
-4%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Panel B: Mismatches between tax systems including preferential tax treatment

Point estimate: mismatches
95% confidence interval
ETR differential (percentage points)

0
-1
-2
-3
-4
-5
-6
-7
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Note: Panel A shows that in 2000 a one percentage point higher statutory corporate tax rate than the average
in the corporate group is associated with a reduction in reported profits of about 1.9%. Panel B shows that in
2000 the ETR of large MNE entities is on average close to 4 percentage points lower than that of comparable
large domestic groups. The year estimates are obtained by interacting the tax planning sensitivities described
in Box 3.A1.3 with a year dummy.
Identifying the main tax planning channels

The empirical approach in this study estimates the overall magnitude of tax planning as it
is difficult to separate and quantify each channel such as transfer price manipulation and
strategic location of external and internal debt. Nevertheless, it is possible with the
available data to identify certain channels and certain types of MNEs engaging more
intensively in tax planning.
Intangible assets are an important tax planning channel

MNEs can shift profits by locating intangible assets (e.g. patents, property rights, brands,
know-how, etc.) and their associated revenues in lower-tax countries. This is facilitated
by intangible assets (and the associated revenues) being easier to shift and more difficult
to price and thus more susceptible to transfer price manipulation than other assets. Indeed,
the share of patents that have been shifted, i.e. patents where the inventor is located in a
different country than the MNE entity applying for the patent protection, varies
significantly across countries (Figure 3.A1.5). Still, this can reflect factors other than
taxes, such as outsourcing of R&D activities. More generally, patent data do not capture
all types of intangible assets.
Figure 3.A1.5 Distribution of patents across countries
Panel A: Shifted and non-shifted patents as % of worldwide patents, 1998-201121
Shifted patents (patents invented in other countries)
Non-shifted patents (patents invented in the country)
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
United States
Japan
Germany
France
United
Kingdom
Netherlands Switzerland
Korea
Canada
Italy
Other
countries
Panel B: Shifted patents as % of total patents in each country, 1998-201122

Percent
90
80
70
60
50
40
30
20
10
0
Note: The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The
use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli
* Peoples Republic of China.
Source: PATSTAT Database.
An increasing number of countries have preferential tax treatment of the income from
intellectual activities (so-called patent boxes or IP-boxes) (see Table 3.A1.1). In
some countries, but not all, the preferential tax treatment is conditional on activity
requirements and does not apply to acquired intellectual property unless it is further
developed in the buying country (Evers et al. 2013; PWC, 2013).23
Table 3.A1.1 Tax treatment of intellectual property in selected OECD and G20 countries,
201424
Country
Corporate Patent box

tax rate
rate
Acquired intellectual
Year of
property
introduction
Qualifying intellectual property
Belgium
34
6.8
Patents, Supplementary Protection Certificates
Yes, if further
developed
2007
China1
33
0-12.5
Patents, process innovation
na
2008
France
34.4
15.5
Patents, extended patent certificats, patentable inventions,

manufacturing processes associated w ith patents,
improvements of patents
Yes, under certain

conditions
2001
Hungary
19
9.5
Patents, industrial designs, trademarks, copyrights, know how , business secrets
Yes
2003
Luxembourg
29.2
5.84
Patents, designs, trademarks, brands, domain names

copyrights on softw are
Yes
2008
Netherlands
25
Patents, Intellectual propert from R&D projects
Yes, if further
developed
2007
Patents, industrial designs or other protected intellectual

property rights
Yes, if transfer complies

w ith transfer pricing
rules and country not
considered a tax haven
2014
Patents, secret formulas and procedures, plans, models
Yes, under certain

conditions
2008
Portugal
Spain2
Sw itzerland
(Niedw alden)
31.5
30
50% of
gross
income
exempted
60% of
patent
income
exempted
21.1
8.8
Patents, secret formulas and processes, trademarks,

copyrights, softw are, know -how
Yes
2011
Turkey (Technology
development zones)
20
20
Patents, licences, Intellectual propert from R&D projects
No
2001
United Kingdom
21
10
Patents, Supplementary Protection Certificates, certain

other rights similar to patents
Yes, if further
developed
2013
Notes:
1. Peoples Republic of China.
2. The corporate rate is reduced to 28% in 2015 and 25% in 2016 and onwards.
Source: Evers et al. (2013) and PWC (2013).
The empirical strategy to assess the tax sensitivity of the location of patents is to compare
patent applications of MNE entities with similar characteristics except for their links to
countries with different tax rates (Box 3.A1.4).25 The hypothesis is that MNEs with links
to countries with a lower effective tax rate on patent income (statutory rate or reduced
rate for patents) would apply for fewer patents in entities located in higher-tax countries
as compared to similar firms that have no such links. Similarly to the profit shifting
analysis, taxes are measured by the difference between the corporate tax rate or the
preferential tax rate on intellectual property income in the country of an entity and the
average (unweighted) tax rate in the countries where the group operates. The analysis
considers the impact of taxes on both shifted and non-shifted patents. Non-shifted patents
are used as a proxy for R&D activities.
The empirical analysis suggests that preferential tax treatment attracts both patents
invented in other countries and R&D activities. For instance, a 5 percentage point cut in
the preferential tax rate on patent income is associated with an increase of 17% in the
number of shifted patents, which represents a 2% increase in the total (shifted and nonshifted) number of patents. The same tax rate cut is also associated with an increase of
5% in the number of non-shifted patents, corresponding to a 4% increase in the total
number of patents (Figure 3.A1.6). The relative importance of these two effects is likely
to vary with the design of the preferential tax treatment, such as activity requirements.
Figure 3.A1.6 The effect of preferential tax treatment on the number of patent applications
Change in patent applications induced by a 5 percentage point cut in the preferential tax rate on patent income
Percent
20
18
16
14
12
10
8
% of
shifted
patents
% of total
number of
patents
4
2
0
Shifted patents (invented in another country)
% of nonshifted
patents
% of total
number of
patents
Non-shifted patents (proxy for R&D activities)
1. Shifted (non-shifted) patents are patents where the inventor is located in a different (the same) country
than the MNE entity applying for the patent protection. A 5 percentage point cut in the preferential tax
rate on patent income is associated with an increase of 17% in the number of shifted patents, which
corresponds to 2% of all (shifted and non-shifted) patents. The effect is evaluated for an average country
where the share of shifted patents is 11% (weighted average of available countries).
Box 3.A1.4. Empirical approach: Location of patents

The empirical approach to assess tax sensitivity of patent location is to compare the patent
applications of MNE entities with similar characteristics except for their link to countries with
different tax rates. The hypothesis is that MNEs with links to lower-tax countries would apply
for relative fewer patents in entities located in higher-tax countries compared with other similar
firms that have no such links. In practice, the estimated equation is as follows:
where
world of firm
is the number of patent applications to the three main patent offices in the
(belonging to group g operating in country
and industry ) in year .
is the difference
between the effective tax rate on patent income in the home country and the average effective
tax rate on patent income in the group. The effective tax rate on patent income is the patent-box
tax rate if a patent box exists; otherwise it is the statutory tax rate.
are
vectors of control variables, including: the entitys lagged depreciated stock of patent
applications, the concentration of researchers and statutory corporate tax rates (both defined in
differential terms relatively to the MNE group average, in the same way as the tax variable),
entity size dummies, headquarter dummy, parent dummy, MNE group size, R&D subsidies at
home and on average in the countries where the group operates.
and
are industry,
country and time fixed-effects. In a second step, the effect of preferential tax treatment is
separated from the effect of statutory corporate tax rates by interacting the effective tax rate with
a dummy variable identifying whether the country has a patent box or not. The model is
estimated successively for all, shifted and non-shifted patents.
The patent data is sourced from the OECD PATSTAT data matched with ORBIS data for firm
characteristics. The sample consists of entities in 25 countries covering the years 2004-10. The
equation is estimated using a negative binomial model, which is a non-linear model suited for
high-variance count data, such as patent numbers.
Consistent with this, the profit shifting analysis confirms that profit shifting is
significantly stronger the tax sensitivity is about twice as large among MNE groups
with patents than for non-patenting MNE groups. Moreover, all else equal, patenting
firms are found to have a lower ETR than non-patenting firms, which reflects the
existence of preferential treatment for intellectual property and R&D tax credits in some
countries. This difference is larger for MNEs than for domestic firms, suggesting that
MNEs benefit more from these tax incentives by shifting patents and R&D investments to
countries with preferential treatment for patent income and R&D investments.
MNEs manipulate the location of debt

One profit shifting strategy of MNEs is to locate external and internal debt in higher-tax
rate countries, which allows MNEs to reduce their tax burden by deducting interest
payments from taxable profits at a higher rate.26 A number of studies have analysed the
sensitivity of MNEs capital structure to corporate taxation and find that firms leverage
depends on domestic and international taxation (e.g. Huizinga et al., 2008; Dischinger et
al., 2010; Buettner and Wamser, 2013). Using German firm-level data, Men et al. (2011)
find evidence of both internal and external debt shifting and estimate that they are of
about equal relevance.
An in-depth analysis of MNEs allocation of external debt (i.e. third-party debt to credit
institutions), relying on a similar approach as the profit shifting analysis, confirms that
MNEs tend to locate external debt in higher-tax rate countries (see Box 3.A1.5).
Specifically, the estimated debt-manipulation elasticity implies that a one percentage
point higher statutory corporate tax rate of an entity than the average in the MNE group is
associated with a 1.3% higher external debt for this entity. For the average entity, this
would translate into a reduction in profit by about 0.2% (as compared to an overall
reduction of 1% for profit shifting as a whole), accounting for 20% of overall estimated
profit shifting. This is a lower-bound estimate, as the analysis only focuses on third-party
debt and does not include the location of intra-group debt, which has been shown to be a
significant tax planning channel (Buettner et al., 2012). In the financial account data used
in this study, intra-group debt cannot be isolated.
Box 3.A1.5. Empirical approach: Manipulation of the location of external debt
The strategy to assess manipulation of the location of debt draws on Huizinga et al. (2008) and is
similar to the profit shifting analysis. The idea is that the observed debt of an entity is the sum of
a true and a manipulated debt. Manipulated debt would generally be positive in higher-tax rate
countries and negative in lower-tax rate countries. The strategy is to compare the leverage of
MNE entities with different opportunities to manipulate (i.e. shift or receive) debt, controlling
for other characteristics influencing true debt. Manipulation opportunities are assessed based
on the location of the other firms in the group and the statutory tax rate in these locations. A
lower tax rate than the group average is assumed to be associated with shifting of debt to highertax rate countries, while a higher tax rate would be associated with receiving debt. Reflecting
this strategy, the baseline equation is:
where
is the leverage (i.e. external debt-to-equity) ratio of MNE entity f, which is
part of MNE group g and operates in country c and industry i, in year t. Debt refers to debt owed
to financial institutions, as reported in an entitys financial accounts sourced from the ORBIS
database. Importantly, it does not include intra-group debt, reflecting data limitations.
is the difference between the statutory tax rate in country
c and the unweighted average of the statutory tax rates in the countries where the multinational
group of f operates. A positive
would indicate that debt is located in higher-tax countries.
is a vector of determinants of true debt including firm-specific controls such as size,
position in the group (headquarters, other parent entity or non-parent entity) and the number of
countries where its MNE group operates. Country or industry-specific controls are: GDP growth,
value-added growth in the industry, development level (GDP per capita) and size of the credit
sector (measured by private credit as a share of GDP and the share of employment in the finance
industry). and are respectively time and industry fixed-effects.
Another way to assess the relative importance of profit shifting channels is to compare
the tax sensitivity of pre-tax profit with the sensitivity of operating profit (i.e. profit
before interest expenses and financial income). The tax sensitivity of pre-tax profit
captures all profit shifting channels (transfer pricing, location of intangibles, location of
debt, interest rate manipulation, etc.), while the tax sensitivity of operating profit does not
include the location of debt and interest rate manipulation. For example, if the tax
sensitivity of pre-tax profit were twice as large as the one of operating profit, debt
manipulation would represent half of overall profit shifting. The empirical analysis does
not find a statistically significant difference between the tax sensitivity of operating profit
and that of total pre-tax profit. One caveat is that pre-tax profit includes financial income,
i.e. interest income and dividends received. However, results are robust to dropping all
entities with at least one identified subsidiary, which are the principal ones receiving
dividends.
Summing up, the analysis suggests that transfer price manipulation, artificial allocation of
legal ownership of intangible assets and manipulation of debt levels are important profit
shifting channels. This is in line with recent literature findings (Heckemeyer and
Overesch 2013; Buettner and Wamser, 2013).27
Treaty abuse is a way of implementing tax planning

MNE groups present in many countries have greater tax planning opportunities. Indeed,
they have access to a broader range of (potentially mismatching) tax systems and pairs of
bilateral tax treaties, creating scope for treaty abuse. The empirical evidence suggests
that both profit shifting and the exploitation of mismatches between tax systems are
significantly more frequent among MNEs present in more than five countries. Their profit
shifting propensity is more than twice as high as other MNEs and their propensity to
exploit mismatches about 1.5 times higher
Overall effect of tax planning on the effective tax rate of MNEs

As a result of both profit shifting and mismatches between tax systems, the effective tax
rate of large (more than 250 employees) MNE entities is on average 4-8 percentage
points lower than that of domestic group entities with similar characteristics along a
number of dimensions (Table 3.A1.2). This differential is even higher among very large
firms (more than 1 000 employees). The differential is also higher among patenting
MNEs, which have a higher profit-shifting intensity than other MNEs and take greater
advantage of tax incentives for R&D than domestic firms (by locating R&D and patents
strategically). In contrast, the ETR differential is lower for smaller (non-patenting) MNE
entities, as small MNEs appear to exploit profit shifting opportunities but not mismatches
between tax systems.
Overall, the results suggest that there are two categories of tax planning MNEs. A first
category is large MNE groups engaged in complex schemes often involving the
exploitation of mismatches between tax systems, preferential tax treatment, abuse of
bilateral tax treaties and profit shifting to low-or-no-tax countries. The empirical analysis
suggests that tax planning can greatly reduce the effective corporate tax rates of these
groups. The other category is smaller MNEs shifting profit via manipulation of the price
of intra-group transactions and the location of debt, but not engaging in more complex tax
schemes. This reduces their tax burden, but to a lesser extent than that of the first
category.
Table 3.A1.2 Profit shifting and mismatches reduce the effective tax rate of MNEs1
Average differential in the effective tax rate between MNEs and domestic groups with similar characteristics
Percentage point
Induced by:
Profit shifting
Small MNE entity (<250
employees)
as compared to a small non-MNE
(domestic) entity
Large MNE entity (250+
employees)
as compared to a large non-MNE
(domestic) entity
Mismatches between
tax systems and
preferential tax
treatment
Total
-2.0
[-1 to -3]
0.0
-2.0
[-1 to -3]
-2.0
[-1 to -3]
-3.3
[-2 to -5]
-5.3
[-4 to -8]
1.
The ranges around the average differential are computed using the sensitivity assumptions described in
section 3.1.
Anti-avoidance rules can mitigate international tax planning

A variety of anti-avoidance rules exist in most countries to prevent tax planning
strategies. Common ones include rules that hinder the manipulation of the price of
transactions between related firms (transfer-pricing rules), rules that limit base erosion via
interest deduction (e.g. thin-capitalisation and interest-to-earnings rules), specific rules
applying to MNE income generated in foreign countries (controlled foreign company
rules) and general and other specific anti-avoidance rules (GAAR and SAAR) (see
Box 3.A1.6).
Withholding taxes on interest, royalties and dividends (i.e. taxes levied on these kinds of
payments to non-resident entities) can influence cross-border tax planning opportunities
even though they are not strictly speaking anti-avoidance rules. Withholding taxes
influence firms incentives to shift profit when they are levied at higher rates on payments
made to residents of lower-tax rate countries. For instance, withholding taxes on interest
income and royalties can discourage profit shifting via strategic allocation of debt and
intangible assets, as they reduce the after-tax income of the firm in the receiving country.
Box 3.A1.6. Anti-avoidance rules
Some of the main anti-avoidance rules in domestic tax systems in OECD and G20 economies are
(OECD, 2013):
Transfer price rules require that cross-border transactions between related firms
should be valued at market price (so-called arms length principle). When no
comparable transaction exists, different valuation methods can be used, for instance
based on cost plus a fixed mark-up or using economic models to split the relevant
profit among entities.
Thin capitalisation rules and rules limiting interest deductibility disallow the
deduction of certain interest expenses when the debt-to-equity or the interest-toearnings ratio of the debtor is considered excessive. These rules apply either to total or
related-party debt.
Controlled foreign company (CFC) rules aim at eliminating the deferral of tax on
certain income by using lower-tax foreign affiliates or the exemption on certain
mobile foreign source income.
General or other specific anti-avoidance rules prohibit aggressive tax avoidance, for
instance, by denying tax benefits from a transaction that lacks economic substance.
Anti-hybrid rules link the domestic tax treatment of instruments or entities with the
tax treatment in the foreign country, thus eliminating the mismatch between tax
systems. For instance, they may deny the deduction of interest if treated as nontaxable dividend in the recipient country.
A number of academic studies have classified countries according to the degree of strictness on
specific anti-avoidance rules, such as transfer pricing regulations and rules against debt
manipulation (e.g. Lohse et al., 2012; Lohse and Riedel, 2012; Blouin et al., 2014). However,
there exists no classification of the overall strictness of the anti-avoidance stance.
Building upon these studies, a new, though limited, classification on the strictness of antiavoidance and withholding taxes among OECD and G20 countries is developed in this study.
Detailed tax rules vary significantly between countries and the classification aims at grouping
countries along the key dimensions of anti-avoidance that are relatively easy to quantify and
compare across countries, using simple and mechanical rules. The classification focuses on: (i)
requirements regarding transfer pricing documentation; (ii) rules that limit interest deductions
(i.e. thin capitalisation and interest-to-earnings rules); (iii) existence of a GAAR; and (iv)
existence of a CFC rule. The classification also considers the level of withholding taxes on
interests, dividends and royalties as they can influence MNEs incentives to shift profit. Within
the European Union, withholding taxes are set to zero by law.
On transfer pricing, interest deductibility and withholding taxes, the classification is based on a
0-1-2 scale, which captures the broad strictness of rules but may miss important country-specific
details. On GAAR and CFC rules, a simpler 0-1 scale based on the existence of a rule is used,
reflecting the difficulty to classify these country-specific rules in a harmonised way. The overall
classification sums the 5 components. As a result, the classification runs from 0 to 8.
A caveat to this classification is that some aspects of anti-avoidance rules that are more difficult
to compare across countries as well as country-specific details and enforcement practices (e.g.
frequency of tax audits, penalties in case of non-compliance) are not captured. In addition, the
classification does not distinguish between territorial and worldwide tax systems.
Information on some of the main anti-avoidance rules and withholding taxes among
OECD and G20 countries is the basis for a new, though limited, composite anti-avoidance
classification outlined in Box 3.A1.6 and presented in Figure 3.A1.7. This grouping
builds upon earlier classification efforts in the literature (Lohse et al., 2012; Lohse and
Riedel, 2012; Blouin et al., 2014). According to this grouping of countries, anti-avoidance
rules appear to be comparatively strict in countries with relatively high corporate tax
rates. This may reflect that, in countries with relatively high tax rates, firms have stronger
incentives to avoid taxes, prompting governments to introduce stricter regulations.
A few existing studies have assessed the role of specific anti-avoidance rules for firms
behaviour, such as the impact of transfer pricing regulations on profit shifting (e.g. Lohse
and Riedel, 2012) and the effect of thin capitalisation rules on firms capital structure
(e.g. Blouin et al., 2014). Generally, these studies find that individual anti-avoidance
measures can reduce tax planning. However, there is no evidence of the overall impact of
anti-avoidance rules and their implementation on tax planning.
Based on the slightly broader, but still limited, anti-avoidance classification presented in
Figure 3.A1.7, the estimates in this study suggest that relatively stricter anti-avoidance
rules are associated with lower profit shifting across OECD and G20 economies.28 For
instance, an increase in the strictness of anti-avoidance rules from moderate to relatively
strict is associated with a reduction in profit shifting from that country by about one half.
The empirical analysis also provides evidence that rules that limit base erosion via
interest deductions are associated with reduced debt manipulation.
Figure 3.A1.7 Illustrative classification of anti-avoidance rules
Distribution of countries by degree of strictness of anti-avoidance rules and withholding taxes
2005
2014
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Weak
Moderate
Relatively strict
Very strict
Note: 15% of countries in the sample (which includes all OECD and G20 countries) had very strict antiavoidance rules in 2014. A very strict anti-avoidance rule corresponds to a score of 7-8 on the 0-8 indicator
of anti-avoidance and withholding taxes described in Box 3.A1.6. A score of 8 is defined as the combination
of strict documentation requirements on transfer pricing, a strict rule against debt manipulation, existence of a
GAAR and a CFC rule as well as relatively high withholding taxes on interest, dividends and royalties. A
relatively strict rule corresponds to a score of 5-6, a moderate to 3-4 and weak to 0-2. The indicator
does not reflect the enforcement of existing rules.
Both tax planning and anti-avoidance entail compliance costs, reducing firms
profitability
Complex tax codes result in wasted resources for firms and tax administrations and can
contribute to deter foreign investment. International tax planning also involves a
collective waste of resources due to the costs associated with setting up complex tax
schemes (e.g. tax and legal advice). One indication of resources spent on tax planning is
the share of production of the tax consultancy industry in overall output
(Figure 3.A1.8). Still, this indication is rough as this production category also includes
non-tax-related activities, such as regular accounting and bookkeeping activities, the size
of which varies across countries, depending among other things on industry structure.
One reason for the complexity of the tax system is that governments react to tax planning
by some firms with anti-avoidance legislation that increases the administrative cost of all
firms. For instance, Slemrod et al. (2007) suggests that tax complexity in the United
Kingdom has increased mainly because of a significant volume of anti-avoidance
legislation was added to the tax code. Consistent with this, the empirical analysis shows
that anti-avoidance rules mitigate profit shifting, but are also associated with significantly
lower average (pre-tax) profitability. The lower profitability may reflect resources spent
on tax compliance. This adverse effect on average profitability is robust to controlling for
the income level of a country, burdensome regulations in other areas and the statutory
corporate tax rate. Compliance costs for firms as well as administration and enforcement
costs for tax authorities are important to the assessment of the overall cost-benefit of antiavoidance rules. Co-ordinating anti-avoidance rules across countries could reduce
compliance costs for MNEs.
Figure 3.A1.8 Production of the accounting, bookkeeping, auditing and tax consultancy
industry29
% of GDP, 2011
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Note by Turkey: The information in this document with reference to Cyprus relates to the southern part of
the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island.
Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is
found within the context of the United Nations, Turkey shall preserve its position concerning the Cyprus
issue.
Note by all the European Union Member States of the OECD and the European Union: The Republic of
Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in
this document relates to the area under the effective control of the Government of the Republic of Cyprus.
Source: Eurostat, BEA, OECD calculations.
Fiscal and economic implications of international tax planning

International tax planning affects both the size of the global corporate tax revenues and
the distribution of tax bases and revenues across countries.30 As the lost revenues would
have been used to finance welfare or efficiency-enhancing public expenditures or to
reduce other distortive taxes, such redistribution has real effects. Tax planning can also
affect real activity in several other ways. As compared to a situation where tax planning
would not be possible, tax planning MNEs have a lower tax burden, which may give them
a competitive advantage over other firms. Also, the possibility to manipulate the location
of internal and external debt reduces the effective cost of debt for MNEs, which can lead
them to take on higher overall leverage. In addition, tax planning opportunities lessen the
importance of corporate tax rates in shaping the allocation of MNEs investment (both
tangible and intangible) across countries.
Fiscal implications
Profit shifting redistributes corporate tax bases across countries and results in global tax
revenue losses as shifted profits are taxed at a lower average rate than they would have
been in the absence of profit shifting. While profit shifting entails gains or losses at the
country level depending on the characteristics of tax systems, in the case of mismatches
between tax systems (including preferential tax treatment) there are generally no gains in
terms of tax revenues, but there can be ambiguity as to who has lost revenue. For
example, both parties concerned by a scheme involving a hybrid security may (or may
not) claim that they lost revenues. Another difficulty is to identify the most frequent
schemes and countries involved in these mismatches.
The revenue effects are presented for hypothetical combinations of tax bases and tax rate
differentials between tax rates faced by the average MNE entity in the home country and
the tax rate faced by this hypothetical MNE on average in the other countries where it
operates. They should be seen as illustrative and ranges reflecting the many uncertainties
of the analysis are provided. The revenue estimates are based on the average tax planning
propensity (both for profit shifting and mismatches) estimated over the full sample of
countries, in combination with different hypothetical tax rate differentials and tax bases
(i.e. the share of MNE profits in total corporate profits). It is important to note that the
average propensity leaves aside certain country-specific differences in tax planning
intensity, for example resulting from the strictness and enforcement of rules against tax
planning.
Illustrative results for hypothetical cases

A number of assumptions are required to translate the estimated tax planning propensity
into estimated effects on corporate tax revenues. One assumption is the share of MNEs in
taxable profits, which in many countries is not readily available from tax statistics. Based
on the sample of firm-level financial account data used in this study, this share ranges
between 40% and 80% in most OECD and G20 countries. The revenue effects of tax
planning are also based on the assumption that corporate tax revenues change in
proportion with reported financial profits. This is an approximation because of potential
differences between reported and taxable profits due to, inter alia, book/tax differences
and tax credits. The effect of book/tax differences on the estimated revenue effects is
ambiguous (Box 3.A1.7). By contrast, taking into account tax credits would increase the
revenue effects where such tax credits are significant. Information on tax credits is
limited and the available data suggest that they can vary substantially across countries and
over time. The assumption in this hypothetical example is that tax credits represent 15%
of CIT revenues before tax credits. Another key assumption is that firms outside the
sample have similar structures and behave in a similar way as firms in the sample.
Sensitivity analysis to this assumption is presented below.
Box 3.A1.7. The impact of book/tax differences and tax credits on tax
revenue estimates
There exist few estimates of the difference between book and taxable profits. In the United
States, the difference was volatile over 2006-10. Excluding the crisis-year 2008, the difference
was relatively small on average over the period (Boynton et al., 2014; see Figure below). This
pattern would suggest that differences in the timing of recognition of income and expenses are
an important driver of book/tax differences (see Section 2.2 above on the sources of book/tax
differences). In Germany, financial profits were 10% lower than taxable profits in 2009, with the
difference being largest among firms engaged in corporate restructuring, but the corresponding
information is not available for other years (Zinn and Spengel, 2012).
Book/tax differences in the United States1
Pre-tax book income
Taxable income
USD billion
1000
900
800
700
600
500
400
300
200
100
0
2006
2007
2008
2009
2010
Source: Boynton et al. (2014). Data is for SEC 10-K corporations.
Book/tax differences can affect the estimation of the average tax planning propensity, which is
based on financial account rather than tax data. Book/tax differences that are independent of tax
planning (e.g. timing differences) likely create noise in the estimation, but are unlikely to bias
the estimated tax sensitivity in any direction. In contrast, certain book/tax differences result from
tax planning schemes (e.g. a dual residence scheme leading to the same interest expense being
deducted in more than one country). These schemes would reduce taxable income relatively to
book income (Lisowsky, 2010). Such schemes are not identified in the profit shifting analysis,
but they are captured in the empirical analysis of mismatches between tax systems, which
focuses on how reported profits are taxed.
Box 3.A1.7. The impact of book/tax differences and tax credits on tax
revenue estimates (continued)
Book/tax differences can also affect tax revenue estimates for a given tax-sensitivity of reported
profits. Indeed, these differences imply that corporate tax revenues may not change
proportionately with profits reported in financial accounts. For example, if taxable profit is
systematically lower (respectively higher) than book profit, shifting 5% of book profit would
amount to shifting more (respectively less) than 5% of taxable profit and thus lead to a revenue
loss greater (respectively smaller) than 5% of revenues.
Similarly, the existence of tax credits, if they are unaffected by profit shifting, can influence
revenue estimates. Taking tax credits into account would increase estimated revenue effects (see
Table below).
Illustrative example of the effect of book/tax differences and tax credits
No tax
planning
Tax
planning
Share of tax
planning
(1) Financial account profit

(2) Taxable profit (assuming 10% lower tax than
book profits)
105.0
100.0
5.0%
94.5
89.5
5.6%
Tax rate
30%
30%
(3) Tax before credits
28.4
26.9
(4) Tax credits (assuming 15% of tax before credit)
4.0
4.0
(5) Tax after credits
24.3
22.8
5.6%
6.6%
Note: Profit shifting is assumed to reduce financial account (i.e. reported) profit by 5% (line 1). Assuming
that taxable profits are 10% lower than financial profits, then profit shifting represents 5.6% of taxable
profit (line 2). Assuming that tax credits represent 15% of tax before credits and are unaffected by profit
shifting, revenue losses from profit shifting, revenue losses would represent 6.2% of tax revenues rather
than 5% (line 5).
Based on these assumptions, illustrative tax revenue effects of tax planning in

hypothetical cases are presented in Figure 3.A1.9. These estimates represent average
effects for different combinations of statutory tax rate differentials and tax bases (i.e.
shares of MNEs profits in total corporate profits). Clearly, actual tax revenue effects in a
given country can deviate substantially from these hypothetical estimates. Indeed, the
estimates rely on the observation that MNE entities that face higher-tax rate differentials
tend to have more links to lower-tax rate countries and thus more profit-shifting
opportunities than entities that face lower-tax rate differentials. However, profit shifting
opportunities may differ from these averages, for instance because of differences in the
strictness and enforcement of anti-avoidance rules. The extent of losses from mismatches
between tax systems and preferential tax treatment can also differ from the cross-country
average because of differences in tax rules as well as specific anti-avoidance rules
(Figure 3.A1.10.). Thus, countries with higher statutory tax rates do not necessarily have
higher revenue losses from multinational tax planning. In order to estimate the scale of
profit shifting, it is necessary to consider real economic activity by companies in each
country, such as FDI. Estimates are shown in Figures 3.A1.9 and 3.A1.11, but it should be
noted that the scale of revenue loss cannot be explained only by corporation tax rate
differentials. Especially when countries have effectively implemented substantive antiavoidance tax rules, as shown in Figure 3.A1.10, the relationship between corporation tax
rates and the scale of revenue loss by multinational tax planning could be significantly
different from the results shown in Figures 3.A1.9 and 3.A1.11.
Figure 3.A1.9 Illustrative tax revenue effects of international tax planning in hypothetical
cases
Panel A: As a share of corporate income tax revenues
%
25
20
Profit shifting
Share of MNEs: 75%
Share of MNEs: 50%
15
10
5
0
-5
-10
-15
-20
Tax rate differential
Panel B: As a share of GDP31

%
0.8
0.6
Profit shifting
Share of MNEs: 50%
Share of MNEs: 75%
0.4
0.2
0.0
-0.2
-0.4
-0.6
Note: For a country in which the average resident MNE would face a 10 percentage point higher tax rate than
the average tax rate in the other countries where this MNE group operates and with a 50% share of MNEs in
total corporate profits, the tax revenue loss from tax planning would represent on average about 11% of CIT
revenues (or about 0.3% of GDP), most of which from profit shifting. These averages are presented as an
illustration of the magnitude of tax planning. However, actual country-specific tax revenue effects can vary
widely around these averages for many reasons, including cross-country differences in the strictness of antiavoidance rules against tax planning and other country-specific tax rules.
Figure 3.A1.10 Illustrative tax revenue effects depending on the strictness of anti-avoidance
rules
Example assuming a 6 percentage point tax rate differential between the resident rate and the average rate in
the countries where the MNE groups operate
%
10
Profit shifting
Share of MNEs: 50%
Share of MNEs: 75%
5
0
-5
-10
-15
-20
Strictness of anti-avoidance rules and withholding taxes
Note: For an average country with a 6 percentage point tax rate differential, a 50% share of MNEs in total
corporate profits and weak anti-avoidance rules, the tax revenue loss from tax planning would represent on
average about 12% of CIT revenues. The effect of anti-avoidance rules on the profit shifting intensity is
estimated by refining the equation presented in Box 3.A1.3. The refinement consists of interacting the tax rate
differential with the classification of anti-avoidance strictness. The resulting effect is positive, suggesting that
profit shifting is reduced when anti-avoidance rules are relatively strict. The potential effect of anti-avoidance
rules on mismatches between tax systems is not included since it could not be established empirically with the
available data.
The revenue effects are surrounded by a number of uncertainties (Box 3.A1.8). Some
factors may lead to an underestimation of revenue effects, such as the potential lack of
financial or ownership information on certain entities involved in the most complex tax
schemes. More generally, unknown tax planning schemes of MNEs may not be
captured, although the empirical approach (based on the location of activity, profits and
tax expenses) does not require knowing the details of schemes to estimate tax planning.
On the other hand, certain assumptions may lead to an overestimation, such as not
controlling for country fixed-effects in the estimation of the profit shifting sensitivity.
Box 3.A1.8. Main uncertainties surrounding the tax revenue estimates

Factors potentially leading to underestimating the revenue effects:
Lack of financial or ownership information on some firms involved in complex tax
schemes (e.g. specific case of stateless entities for tax purposes, which may be less
likely to report financial accounts than normal entities), thereby leading to their
under-representation in the sample.
The cleaning of the data (e.g. dropping outliers) may have led to certain observations
of extreme tax planning behaviour being excluded.
Factors potentially leading to overestimating the revenue effects:
The empirical specification does not include country-specific fixed-effects and some
not-controlled-for country-specific factors may be captured by the tax sensitivity.
With country fixed-effects, the estimated profit shifting elasticity is about 30% lower.
Inclusion of legislated tax incentives such as R&D tax credits or negotiated tax
preferences, if MNEs exploit these incentives to a greater extent than similar domestic
firms. These are not considered as BEPS behaviours.
Factors with ambiguous impact on the revenue effects:
Corporate group structure is not exogenous to profitability. High-profitability MNE
groups are more likely to set up affiliates in lower-tax countries, so as to shift profits
there. Despite shifting part of their profits, these groups still report relatively high
profits in higher-tax rate countries because of high true profitability. Based on the
comparison with an average (less profitable) firm, the profits shifted by these groups
may be underestimated. However, a symmetric effect exists in lower-tax rate
countries, where these high-profitability groups may report relatively high profits not
only because of profit shifting, but also because of higher true profitability. Thus,
the overall effect on the tax sensitivity is ambiguous.
Corporate tax revenues are assumed to change proportionately with financial reported
profits. This may not always be the case because of differences between financial and
taxable profits as well as tax credits (see Box 3.A1.7).
Corporate tax rates have recently been cut in some countries. This may lead to smaller
losses (or larger gains) in these countries. It also leads to larger losses (or smaller
gains) in other countries which have not cut tax rates.
Reflecting these uncertainties, the revenue effects incorporate sensitivity to the following
two sources of variation (Figure 3.A1.11): (i) taking a 95% confidence interval around the
tax sensitivity estimate; and (ii) assuming that firms outside the sample have a 50%
higher tax sensitivity than firms in the sample, where the sample coverage is assessed
against the population of firms from the OECD Business Demography Statistics database
(the weighted average of coverage is about 40%).32
Figure 3.A1.11 Revenue effects of tax planning: accounting for uncertainties

Panel A: Sensitivity to the estimated tax planning intensity33
95% confidence interval on estimated tax planning propensity
% of CIT revenues
30
Share of MNEs: 50%
Share of MNEs: 75%
20
10
0
-10
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
10 p.p.
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
-30
10 p.p.
-20
Panel B: Sensitivity to the tax planning intensity of firms outside the sample34
Tax planning propensity of MNEs outside the sample:
100%-150% of propensity of firms in the sample
% of CIT revenues
30
Share of MNEs: 50%
Share of MNEs: 75%
20
10
0
-10
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
10 p.p.
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
-30
10 p.p.
-20
Panel C: Combined sensitivity
Combined sensitivity (A+B)
% of CIT revenues
30
Share of MNEs: 75%
Share of MNEs: 50%
20
10
0
-10
1.
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
10 p.p.
-10 p.p.
-6 p.p.
-2 p.p.
2 p.p.
6 p.p.
-30
10 p.p.
-20
The revenue effect is based on the assumption that firms outside the sample have the same tax elasticity
(i.e. profit shifting elasticity and average tax differential) as firms in the sample. The sensitivity
analysis assumes a 50% higher tax elasticity of firms outside the sample relative to firms in the sample.
The assumption is that 50% of firms are covered in the hypothetical country.
Global tax revenue loss

An estimate of the global revenue loss from tax planning is calculated based on the
weighted average of the relevant parameters for the countries covered in this study. The
weights are based on corporate tax revenues. Since only MNEs can shift profits
internationally, tax revenue losses are proportional to the share of MNEs in corporate
profits times the average extent of profit shifting by MNEs (i.e. the estimated tax
sensitivity applied to the average tax rate differential). More precisely, the parameters
underlying the global revenue loss are based on: (i) the share of MNEs in profits in
financial account data complemented with tax data collected as part of the work on
Action 11 (the weighted average is 59%); (ii) the average tax rate differential based on
the actual links of MNE entities to other countries with different tax rates (the weighted
average differential is 3.6 percentage points35); and (iii) tax credits as a share of pre-tax
profits (the weighted average is 17%).36
Factoring in the uncertainties described above, the estimated total net revenue loss for the
countries included in this study is in the interval of 4% to 10% of corporate tax revenues
(Figure 3.A1.11). Globally, this corresponds to an accumulated revenue loss of about
USD 0.9-2.1 trillion over the last ten years (2005-14) or about USD 100-240 billion in
2014.37 Of these, about two-thirds are due to profit shifting and one-third to mismatches
between tax systems and preferential tax treatment. A recent report by the IMF gives an
estimate that falls in this range for the overall revenue loss, with an analysis based on
macroeconomic data and comparing gross operating surplus with actual corporate income
tax revenues (IMF, 2014). Based on FDI data, a preliminary report by UNCTAD
estimates to around USD 100 billion the annual tax revenue loss from international tax
planning through offshore investment for developing countries, a number of which are
part of OECD or G20 (UNCTAD, 2015).
Competition implications
Tax planning can distort competition among firms and entail efficiency losses. Indeed, as
shown above, the effective corporate tax rate of large tax planning MNEs can be sizeably
lower than the rate of some other firms. This lower effective tax rate can give rise to an
unintended competitive advantage of MNEs compared to other firms as it reduces the
firms tax costs (Overesch, 2009; OECD, 2013). This cost advantage can allow the MNE
to gain market shares by reducing its price in line with its costs at least in the short term.
In the longer term, once the MNE has gained a dominant market position, it may
ultimately increase prices to raise profits. Alternatively, if the MNE is pursuing a strategy
of competing on attributes other than the price (e.g. quality, service and branding), it may
use the cost savings to further differentiate its products to achieve a larger market share
and eventually a higher price and profit than its competitors (Porter, 1980). Finally, as tax
planning reduces the cost of MNEs relative to other firms (entrants), MNEs can raise
entry barriers by, for example, using the tax savings on spending on advertising and R&D
(Sutton, 1991). Overall, the expected effect of tax planning is to increase the market share
and after-tax profitability of tax planning MNEs at the expense of other firms.
Assessing the potential distortion to competition is difficult and little empirical evidence
exists. This study uses a combination of firm and industry-level data to investigate if
industries with a large share of MNEs with tax planning opportunities are more
concentrated than other industries (see Box 3.A1.9). One way to assess the impact of tax
planning on industry concentration is to compare it across countries having different antiavoidance rules. The idea is that tax planning is more frequent when anti-avoidance is
less strict, resulting in more concentrated industries than elsewhere. Controlling for other
country and industry characteristics, this analysis suggests that industries with a strong
presence of MNEs are less concentrated when anti-avoidance rules are stricter. Industry
concentration is measured as the market share of the 10 largest entities divided by the
market share of the 100 largest entities in an industry and country. For example, in an
industry with a high share of MNEs among top-10 firms (the 75th percentile of the
distribution), increasing anti-avoidance strictness by two notches (see Figure 3.A1.7)
would reduce the combined market share of the ten largest firms in the industry by about
6 percentage points.
The study also investigates the implications of tax planning for price mark-ups of MNE
groups using firm-level data (see Box 3.A1.9). Mark-ups are proxied by pre-tax operating
profit divided by turnover, in line with Aghion et al. (2005). Along with the increased
market concentration, estimates show that engaging in tax planning is associated with
higher price mark-ups controlling for other factors affecting mark-ups such as size,
productivity, leverage, presence of patents and exposure to foreign competition. For
example, the mark-up of a MNE group is about 10% higher than that of a domestic firm,
while the mark-up of a tax-planning MNE is up to 23% higher (Figure 3.A1.12, left
panel). The effect is reduced in countries with stricter anti-avoidance rules against tax
planning (Figure 3.A1.12, right panel). One caveat to these analyses is that the causality
is unclear as more profitable firms may choose to set up affiliates in lower-tax countries
(leading them to be identified as tax planners), suggesting that the results should be
interpreted with caution.
Figure 3.A1.12 Mark-up rate and international tax planning
Mark-up rate premium over a non-multinational corporate group with similar characteristics1
%
%
25
25
20
20
15
15
10
10
Average MNE
group
MNE group with a

link to a nocorporate-tax
country
MNE group
operating in 20
countries
Average MNE
group
MNE group facing MNE group facing

moderate anti- relatively strict antiavoidance
avoidance
Notes:
1. The differences in mark-up between different types of firms are statistically significant at a 5% level.
2. The average MNE group operates in five countries. MNE groups operating in many countries have been
shown to engage more intensively in international tax planning.
Distortions of competition lead to welfare losses as consumers face higher prices in some
markets than otherwise. It can also, under certain circumstances, reduce innovation
(Aghion et al., 2005; Gilbert, 2006). Reduced competitive pressures can also curb
innovation incentives for MNEs themselves as it reduces the incentives to innovate to
stay ahead of competitors (Aghion et al., 2005). Differences in the effective tax rate
between MNEs and other firms may also contribute to a suboptimal allocation of capital
in the economy as, by providing rates of return artificially altered by tax distortions,
MNEs may crowd out investment by other (potentially more productive) MNEs and
domestic firms.
Yet, MNEs are in general more productive and exposed to competition than other firms
(e.g. Helpman et al., 2004; Bloom et al., 2012) and they can generate positive
technological and productivity spillovers to other firms. If tax planning MNEs are more
productive than the firms they crowd out, the overall effect on efficiency is unclear.
Box 3.A1.9. Empirical approach: Tax planning and competition

The empirical approach to investigate if tax planning affects competition explores two avenues:
(i) assessing if industries with a strong presence of tax-planning MNEs are more concentrated;
and (ii) assessing if MNE groups engaged in tax planning obtain different price mark-ups as
compared to other firms with similar characteristics. The analysis draws on firm-level data from
the ORBIS database to measure market concentration, mark-ups and the propensity of MNE
groups to engage in international tax planning.
The estimated market concentration equation is:
where
is the market concentration of industry i in country c, measured as the
combined market share (based on turnover) of the 10 largest entities (based on unconsolidated
accounts) in industry i and country c, divided by the combined market share of the 100 largest
entities in the same industry and country. The analysis is based on 28 industries in 28 OECD and
G20 countries. Tax planning intensity (
is measured by the market
share of MNE entities among top-10 firms in the industry multiplied by the strictness of antiavoidance rules in country c. The idea is that tax planning is more intense in industries with a
large share of MNEs, but less so in countries with relatively strict anti-avoidance rules. and
are dummies for industry and country, which capture common characteristics of certain
industries and countries.
The estimated mark-up equation is:
where
is the mark-up rate of the MNE group g (consolidated accounts), which
operates in industry i, in year t with headquarters in country c. The mark-up rate is proxied by
the Lerner index or price-cost margin, measured as operating profit divided by turnover, in line
with Aghion et al. (2005). The tax planning propensity (
) is measured by
four proxy variables: (i) a dummy variable for multinational (as opposed to domestic) groups;
(ii) a dummy variable for MNE groups with links to no-corporate-tax countries; (iii) the number
of countries where a MNE group operates; (iv) the average anti-avoidance strictness (as
measured by the indicator defined in Box 3.A1.6) in the countries where the group operates. The
control vector
is a set of group-specific variables potentially influencing the mark-up rate,
including size, productivity, leverage, presence of patents (as a measure of innovative activities)
and exposure to foreign competition (proxied by the average import penetration in markets
where the group is active).
and
are industry, year and country of headquarters fixedeffects.
All four measures of tax planning intensity have advantages and disadvantages. Comparing
MNEs and domestic firms (option i) poses the issue of potential unobserved differences between
them, although the extensive set of control variables included should minimise this issue.
Comparing tax-planning MNEs (e.g. with links to no-tax countries, option ii) to other MNEs can
pose reverse causality issues since ex ante more profitable MNEs have more incentives then
other MNEs to set up affiliate in low-tax countries. The number of countries where a MNE
operates (option iii) is also subject to reverse causality, since profitable firms are more likely to
expand to other countries than other firms. Finally, MNE groups facing relatively strict antiavoidance rules against tax planning (option iv) may have lower mark-up than other groups
because of the compliance costs implied by these rules. Despite these limitations, the results are
consistent across the various specifications, which supports the initial hypothesis that tax
planning distorts competition.
Manipulation of the location of related and third-party debt: Implications for

group leverage
In most OECD countries, the corporate tax system influences corporate financing
decisions by favouring debt over equity, since interest payments on debt are generally
deductible from taxable profits while dividends payments are not (de Mooij, 2012).38 This
can affect productivity if it distorts the allocation of investment towards firms that can
raise debt easily over those that have to rely on equity finance, such as knowledge-based
innovative firms investing in intangible assets (Arnold et al., 2011). This is an argument
for advocating that corporate tax systems should aim at treating debt and equity-financed
investment equally.39
International tax planning may compound this debt bias (e.g. de Mooij 2011).40 The
possibility to locate external and internal debt in entities in higher-tax rate countries
lowers the marginal cost of debt at the MNE group level, which could lead MNE groups
to increase their overall leverage.41 Indeed, relying on group-level information on MNEs
overall external debt (consolidated debt at the corporate group level), the empirical
analysis provides evidence that this overall leverage is sensitive to the possibility to locate
external and internal debt in higher-tax rate countries an area that has not yet been
explored in the literature (see Box 3.A1.10). Group external leverage is found to be
sensitive to the tax rates in the highest tax rate countries in the MNE group (e.g. the
average of the two highest tax rates) and thus to the effective cost of debt in these
countries. This suggests that MNE groups with the possibility to manipulate the location
of debt have higher overall leverage as compared to other MNE groups.
Box 3.A1.10. Empirical approach: Tax planning and group external leverage
The idea is to assess the sensitivity of MNE groups overall external leverage to changes in tax
rates in the different countries where they operate. These changes can affect the location of
group debt, but also its overall level by altering the effective cost of debt for the group. Overall
group leverage is expected to be sensitive to the tax rate in the country of headquarters, where an
important share of group debts is generally located, and in the higher-tax rate countries in the
group, where MNE groups have been shown to shift debts.
The estimated equation is as follows:
,
where
is the external (i.e. consolidated) debt-to-equity ratio of the MNE group g, with
headquarters in country c, in year t. is the sensitivity of leverage to the statutory tax rate in the
headquarters country (
) and
the sensitivity to the average of the two highest tax rates
among the countries where the group operates (
). In alternative specifications, the
average tax rate among all countries where the group operates and the average of the two lowest
tax rates are also considered.
is a set of firm-specific and macroeconomic control variables
(e.g. profitability, GDP growth, interest rates).
and
are respectively time and group fixedeffects.
The source of data is consolidated financial accounts of MNE groups from the ORBIS database,
over 2000-2010. The number of observations is about 15 000 group-year pairs, covering most
OECD and G20 countries. Results are robust to: (i) replacing the average of the two highest tax
rates in the group by the highest tax rate, or the average of the three highest; (ii) restricting the
sample to EU countries; (iii) excluding financial firms.
For example, a MNE group with relatively high debt manipulation opportunities (e.g. the
average of the two highest tax rates in the group is 40%, as compared to 35% for the
average MNE) has 8% higher external leverage (Figure 3.A1.13, left panel). This finding
is robust to a number of variants, such as adding control variables for macroeconomic
developments or restricting the sample to only EU countries or non-financial firms. In
addition, relatively strict thin capitalisation and interest-to-earnings rules against debt
manipulation are found to lower the propensity of MNE groups to increase their external
leverage through debt manipulation.
Figure 3.A1.13 MNE group external leverage and international tax planning
Leverage (external consolidated debt-to-equity) as compared to an average MNE group1
20
20
18
18
16
16
14
14
12
12
10
10
On average
Strict rules against No rules against debt

debt manipulation in manipulation in debtdebt-receiving
receiving countries
countries
MNE group with high debt-manipulation opportunities
All firms
Large firms only
Domestic firm with characteristics (size, profitability,

presence of patents) comparable to the average MNE
1. All differences are significant at a 5% level.

2. MNE groups with high debt-manipulation opportunities are groups facing a 5 percentage point higher
statutory tax rate on average in the two highest-rate countries where they operate as compared to the
average MNE group. For the average MNE group, this average is 35%, while for high debt-manipulation
opportunities groups it is 40% (which corresponds to the 90th percentile of the distribution of this
variable).
The empirical evidence suggests that strategic location of debt (internal and external) can
increase the total debt of MNE groups. Yet, the external leverage of the average MNE
group is found to be lower than that of the average domestic firm with comparable
characteristics (Figure 3.A1.13, right panel), in line with most of the empirical literature
(e.g. Burgman, 1996). This suggests that manipulation of the location of debt is not
among the main determinants of MNE groups external debt level, as it does not increase
the average external leverage of MNEs above the average of domestic firms. Moreover,
MNEs tend to have more diversified income streams as compared to domestic firms,
making them less vulnerable to adverse income shocks (e.g. Baker and Riddick, 2013).
Despite the additional external leverage induced by debt manipulation, the average MNE
is therefore less likely than a domestic firm to have external debt levels that make it
vulnerable to income shocks.
International tax differences, tax planning and the location of investments

Without differences in corporate tax rates and tax systems across countries, investment
would be determined and located purely according to economic rates of return (assuming
perfect mobility of capital and no other policy differences between countries). However,
tax rates and systems differ and this creates distortions. Corporate income taxes affect
firms investment by reducing the after-tax return on investment. Indeed, recent OECD
work found that corporate taxes reduce firms investment, except for small and young
firms (OECD, 2009; Arnold et al., 2011). Taxes can also affect firms investment choices
by favouring projects with a high after-tax rather than pre-tax return on capital (e.g.
projects that can be more highly financed by debt). This may result in resources not being
allocated to the most efficient projects or countries. In situations with tax distortions, tax
planning may affect the impact of these distortions on investment and its location by
reducing the effective cost of investing in high-tax countries.
International tax differences affect the location of foreign investment

Cross-country differences in corporate taxation influence the location of foreign
investments and MNEs foreign subsidiaries. Foreign investment, particularly investment
in innovative activities, can generate knowledge spillovers with implications for human
capital and productivity. Foreign investment can also increase competition from foreign
firms in the domestic market, with positive productivity effects. There is a vast literature,
including past OECD work, suggesting an adverse effect of host country corporate tax
rate on foreign investment (Hajkova et al., 2006; OECD, 2007a; Feld and Heckemeyer,
2011). But corporate taxes are only one among many factors affecting firms location
choice (e.g. labour and product market regulation, size of the market, labour taxes,
infrastructure, etc.). Its influence appears relatively small, for instance in comparison with
labour taxes (Hajkova et al., 2006).
An example illustrates the effect of cross-country differences in corporate taxes for
foreign investment, based on a tax sensitivity estimated on bilateral data on foreign direct
investment (FDI) stocks (see Box 3.A1.11). More specifically, the sensitivity of FDI to
corporate taxes is taken from past empirical OECD work, which controls for other
determinants of FDI (e.g. income level, GDP, market size, distance between countries,
product market regulation, employment protection legislation, labour taxes etc.). This
estimate implies that a one percentage point increase in the corporate tax rate differential
between two countries results in a 1.5% decrease in the gross bilateral FDI stock in the
higher-tax rate country (Hajkova et al., 2006). Alternatively, an estimate based on a metaanalysis by Feld and Heckemeyer (2011) is used, with a tax sensitivity of 3 instead of 1.5.
This higher sensitivity is because the meta-analysis does not control for the effect of
policy determinants (other than corporate taxes) on FDI.
One caveat is that the available FDI statistics and the estimated tax sensitivity of FDI are
distorted by international tax planning, for instance by large flows of interest income
between countries. This is because the bilateral FDI statistics cannot separate investment
income reflecting real activity from financial flows stemming from profit shifting.42 Even
so, the illustration gives an indication of the importance of taxes for foreign investment.
Based on these data and sensitivity, a tax-adjusted FDI stock is computed assuming that
the statutory corporate tax rate at home is equal to the one in the host country for all pair
of countries. For many pairs of countries this would involve a large tax change. In most
countries, FDI positions explained by existing differences in corporate taxes account for
less than 15% of inward FDI (based on the conservative OECD estimate of the
sensitivity) (Figure 3.A1.14).43
Figure 3.A1.14 Share of inward FDI stock explained by tax rate differences between
countries1,2
Average 2006-2011
Percent
50
Elasticity of -3
Elasticity of -1.5
40
30
20
10
0
-10
-20
-30
-40
Statutory tax rate

< 15%
15% - 20%
20% - 25%
25% - 30%
30% - 35%
> 35%
1. A positive figure indicates that the existing tax differences contribute positively to FDI. For example,
without tax differences with other countries the FDI stock in a country with a tax rate below 15% would
be about 20-40 percent lower (depending on the elasticity) than the actual stock.
2. The estimates are based on differences in statutory tax rates (the most widely available across countries).
The estimates are similar when based on forward-looking effective tax rates instead of statutory tax rates.
In addition to differences in statutory corporate tax rates, preferential tax regimes (e.g. for
intangible assets) and other characteristics of tax systems may influence the location of
FDI. A potentially important factor is whether the home country of a MNE exempts
foreign-source dividends from tax (i.e. territorial/source tax system) or subjects them to
domestic tax while giving a credit for taxes paid in the host country (i.e.
worldwide/residence taxation). Existing studies do not find a significant difference in the
tax sensitivity of FDI under alternative tax systems (e.g. Hajkova et al., 2006). This may
reflect tax deferrals and other tax planning strategies of MNEs as well as in practice that
most countries do not have a pure territorial or worldwide system. A pure territorial
system would tax all investments into a specific country in the same way regardless of
home country, but would tax investment of the same MNE differently across countries. A
pure worldwide system would do the opposite: it would tax investment of a MNE at home
or abroad similarly, while treating investment of different MNEs into one country
dissimilarly. Recently, there has been a trend towards territorial systems among OECD
and G20 countries.
Box 3.A1.11. Cross-country differences in taxes and location of investment

The illustration relies on existing estimates of the sensitivity of FDI stocks to corporate taxation.
Based on these tax sensitivities, a hypothetical bilateral FDI position in absence of differences
between home and host statutory tax rates is computed for all pair of countries (estimates are
similar when using forward-looking effective tax rates for a subsample of countries). The
difference between actual and hypothetical inward FDI in a country reflects bilateral FDI
positions, the assumed tax sensitivity and bilateral tax differences:
Bilateral gross FDI stocks are drawn from the OECD International Direct Investment database,
covering 34 reporting countries and more than 200 partner countries over the period 2006-2011.
In the statistics, foreign direct investment consists of capital shares and reserves, including
retained profits, as well as net positions of loans, trade credits and securities.
The location of R&D activity and intangible assets are also influenced by taxation. As
discussed, MNEs may locate income associated with patents and other intellectual
property to countries with lower tax rate or preferential tax treatment on such income.
However, MNEs do not locate the ownership of intellectual property only based on taxes.
They often co-locate the ownership of intellectual property with the associated R&D
activity (Griffith et al., 2014). Indeed, the empirical analysis suggests that R&D activities
(proxied by patents where the inventor is located in the same country as the firm applying
for the patent protection) are sensitive to tax rate differentials (see Box 3.A1.4).
Tax planning reduces the effect of tax rate differences on the location of
investment by tax planning MNEs
Existing evidence, including recent OECD work, shows that a higher effective corporate
tax rate in a country reduces firms investment in that country (e.g. OECD, 2009;
Djankov et al., 2010; Arnold et al., 2011). However, the possibility for MNEs with links
to low-tax countries to reduce their effective tax rates by tax planning may make the
location of their investment less sensitive to cross-country differences in tax rates. Thus,
testing if (controlling for other factors affecting investment) the effects of high corporate
tax rates on investment are weaker for such MNEs than for other similar firms without
links to low-tax countries is an indirect way to verify the existence of tax planning.44,45
International tax planning may reduce the effect of relatively high corporate taxation on
tangible and intangible investment of tax planning MNEs, but at the cost of introducing
distortions that are related to both the implied tax revenue losses and to the uneven
playing field generated by differential effective taxation of different types of firms. Thus,
across-the-board corporate rate reductions and base broadening would have more
beneficial effects on the economy than self-helped reductions in effective tax rates by
selected MNEs via tax planning behaviour.
Industry and firm-level evidence across a large set of OECD and G20 countries confirms
that, while increases in corporate taxes tend to reduce firms investment in a typical
industry, the reduction in investment is lower in industries with a large share of tax
planning MNEs (see Box 3.A1.12). For instance, a 5 percentage point increase in the
effective (forward-looking) marginal corporate tax rate46 would reduce investment on
average across industries by about 5% in the long term (Figure 3.A1.15, Panel A).
However, in industries with a high concentration of MNEs with profit shifting incentives,
this effect would be nearly halved. This supports the hypothesis that tax-planning MNEs
investment is less sensitive to tax rates than other firms investment. This is because taxplanning MNEs can achieve lower taxes through artificial arrangements without changing
the location of the value-creating real economic activity. Moreover, stricter antiavoidance rules against tax planning are found to raise the sensitivity of investment to tax
rate changes (Figure 3.A1.15, Panel B).
Figure 3.A1.15 Tax planning reduces the effect of corporate taxes on tax planning
MNEs investment
Estimated long-term change in investment after a 5 percentage point increase in the corporate tax
rate47
Panel A: Across industries

0
Panel B: Strictness of rules against tax

planning: industries with high MNE share
(75th percentile)
0
-1
-1
-2
-2
-3
-3
-4
-4
-5
-6
-5
Low
(25th percentile)
Median
High
(75th percentile)
Share of MNEs with profit shifting incentives in the industry
-6
Moderate
strictness
Average effect
Relatively strict
Strictness of rules against international tax planning
Box 3.A1.12. Empirical approach: Investment and tax planning

The effect of corporate taxes on investment is estimated with a similar strategy as in OECD
(2009) (for details, see Schwellnus and Arnold, 2008; Vartia, 2008). The idea is to estimate an
investment equation based on a neo-classical investment model (Hall and Jorgenson, 1967) to
assess the impact of a tax rate change on firms having different tax planning incentives and
opportunities. The analysis is conducted both at the industry and the firm-level. The industry
level offers a better measure of investment, while the firm level offers a better measure of tax
planning incentives. The two approaches give consistent results.
At the industry-level, the estimated equation is as follows:
where
is the investment rate (investment divided by lagged capital stock) in country
c, industry i and year t, sourced from the World Input-Output Database (WIOD).
is the
forward-looking effective marginal tax rate from the Oxford Centre for Business Taxation
(results with the average effective rate are consistent but less statistically significant).
is the number of MNE entities with profit shifting incentives
among the 100 largest firms in country c and in industry i sourced from the firm-level database
(ORBIS). An entity is considered as having profit shifting incentives if it faces a higher tax rate
in its home country than the average (unweighted) in its corporate group, in line with the profit
shifting analysis (Box 3.A1.3). The coefficient reflects the tax sensitivity of the average firm,
while reflects whether industries with a high concentration of profit-shifting MNEs are more
sensitive than other industries.
is the value-added growth of the industry a
high-growth industry is expected to have a higher investment rate.
and
are respectively
fixed-effects for country-interacted-with-industry and time.
The sample consists of 30 industries in 29 countries over 1997-2009. The equation is estimated
either with ordinary least squares or a generalised method of moments estimator that avoids the
potential bias induced by the simultaneous use of the lagged dependent variable and fixedeffects. Results are consistent between the two estimation methods.
At the firm-level, the estimated equation is as follows:
where
is the investment rate of firm f operating in country c, industry i and year t.
The investment rate is measured as the change in fixed assets (at book value), net of depreciation
(also at book value) and divided by lagged fixed assets, sourced from the ORBIS database. This
measure is similar to Gal (2013). The effective tax rate and value-added growth variables are
identical to the industry level analysis.
is the difference
between the statutory tax rate in country i and year t and the average (unweighted) among the
countries where the MNE group of f operates.
and
are firm and time fixed-effects. The
sample consists of about 50 000 observations of MNE entity accounts in 18 OECD countries
over ten years (2001-2010).
International tax competition

In an integrated global economy, countries may compete over mobile capital (tangible
and intangible) by lowering effective and statutory corporate tax rates. One rationale for
lowering tax rates is that it can attract foreign investment and increase domestic
investments, with positive effects on growth. These investments can, in turn, create
additional activity (e.g. employment opportunities, investment by intermediate suppliers,
etc.), which further adds to growth and tax revenues.
One clear prediction from the tax competition literature is a reduction in tax rates, with a
race to the bottom in the extreme case of a small open economy with perfect capital
mobility (Devereux and Lorentz, 2012; Keen and Konrad, 2012). To the extent that the
corporate tax is considered as more distortive than other taxes, a certain degree of tax
competition may enhance economic efficiency. However, tax competition may also lower
public spending and taxes below their efficient level and cause welfare losses, although
this depends on what is considered the optimal level of public service provision (e.g.
Wilson, 1999). Overall, in practice it is difficult to determine at what point tax
competition produces negative effects for growth and welfare.
The empirical literature confirms that tax competition took place in past decades, as
countries have responded to lower corporate tax rates elsewhere by reducing their own
rates (Devereux and Sorensen, 2006; IMF, 2014). Furthermore, tax competition over
corporate tax bases may have induced indirect spillovers on other tax bases. Pressures to
reduce the corporate rate may have created pressures to reduce the top personal income
tax rate because of the possibility to incorporate to reduce tax payments (OECD, 2009;
Arnold et al., 2011; IMF, 2014). One marked change in taxation over the past decades is a
reduction in top personal income tax rates and in progressivity in income taxes in OECD
countries (OECD, 2009).
Tax planning provides incentives for tax competition as countries compete to attract
profits generated by MNEs activities elsewhere. This form of tax competition is not
always transparent as it can occur through preferential regimes rather than on statutory
rates. However, in the absence of tax planning, tax competition may not necessarily be
less intensive. This is because the sensitivity of real investment to taxes may increase,
as shown earlier. For instance, the estimates obtained with the methodology presented in
Box 3.A1.12 suggest that the sensitivity of industry-level investment to the effective
corporate tax rate would increase by about 30% if tax planning would be halved. In the
absence of tax planning, higher-tax rate countries could become less attractive investment
destinations for certain MNEs and may ultimately compete more fiercely to attract
investment. At the same time, the additional tax revenues obtained in the short run by
tackling tax planning could be used to reduce tax rates across the board or finance public
spending, which could support private investment over the longer term.
Overall effect on efficiency and growth

International tax planning affects economic efficiency in several ways (Table 3.A1.3).
Assessing the overall economic efficiency effect of tax planning is not easy as opposing
factors are at play. One way to investigate this effect is to empirically examine if
industries with a larger share of tax planning MNEs grow differently from other
industries. Empirical analysis investigating if value-added growth differs across industries
depending on the presence of tax planning MNEs, controlling for other factors affecting
industry growth, yielded no clear evidence of a (positive or negative) impact of the
presence of tax planning MNEs on industry growth.
Table 3.A1.3 Economic implications of international tax planning: summary of main

findings
Negative welfare effect
Positive welfare effect
Fiscal implications
Tax planning leads to tax revenue

losses. The lost tax revenues could
have been used to finance welfare
or efficiency-enhancing public
expenditures or to reduce other
distortive taxes. Tax planning may
also undermine the legitimacy of
the tax system and reduce tax
compliance among a wider set of
taxpayers.
Competition
between firms
Tax planning allows certain MNEs

to increase their market power,
resulting in more concentrated
markets and higher price mark-ups.
The reduced competitive pressure
may hamper innovation and result
in consumer welfare losses.
Welfare losses may be partially

offset by the associated
reallocation of resources to highproductivity MNEs.
Debt
The possibility to manipulate

internal and external debt location
reduces the effective cost of debt
for MNEs and can lead them to
take on higher overall external
leverage.
Investment
Tax planning reduces effective tax

rates at the cost of additional
distortions (e.g. unlevel playing
field between tax-planning MNEs
and other firms) as compared with
a situation in which corporate tax
rates were cut across the board.
Tax planning reduces effective tax

rates and the associated drag on
investment for tax planning
MNEs. Tax planning also reduces
the effect of cross-country
corporate tax differences on the
location of investment by tax
planning MNEs.
Tax competition
Tax planning provides incentives

for tax competition as countries
compete to attract profits generated
by MNEs activities elsewhere.
In the absence of tax planning, tax

competition may not necessarily be
less intensive, because the
sensitivity of real investment to
taxes may increase.
In any case, the welfare implications of tax planning go beyond economic efficiency. Tax
planning redistributes corporate tax bases across countries, leading to revenue losses in
higher-tax rate countries. These losses will either lead to lower government expenditures
(which may reduce welfare) or may need to be offset by raising other distortive taxes on
less mobile tax bases, which may entail a welfare loss. More broadly, tax planning may
undermine the legitimacy of the tax system and reduce tax compliance among a wider set
of taxpayers. This may hamper governments ability to mobilise fiscal revenues due to
lack of trust and perception of unfairness of the tax system. In turn, this can generate
large compliance and administrative costs.
Discussion and concluding remarks

Corporate income taxes entail distortions and have been found to be more harmful for
economic growth compared to other taxes at least at their observed level (OECD, 2007b;
OECD, 2009; Arnold et al. 2011). Nevertheless, most countries levy corporate taxes. One
reason is that the corporate tax plays a role as a backstop to the personal income tax. In
the absence of a corporate tax, business income would not be taxed until it is realised as
dividends or capital gains, which are often not subject to tax. By levying corporate
income tax, governments reduce the opportunities for shareholders, especially nonresident, to shelter their income from taxation. In this area, new standards for automatic
exchange of financial account information between countries (OECD, 2014d) may
increase the possibility of taxing part of the corporate income at the personal level.
Another argument for levying corporate income tax is that it could be designed to tax
only economic rents (i.e. profits above a normal rate of return), in which case the
economic distortions induced by the tax would be small (OECD, 2008).48,49
Globalisation creates additional challenges for corporate tax systems. Most corporate
income tax systems were designed during a time when cross-border transactions,
international trade and MNEs were less important than today. The issue is how to allocate
the worldwide income of firms across the countries in which they are active. Provisions to
deal with international trade and avoid double taxation or non-taxation of income have
gradually been added to domestic tax systems. Nonetheless, as discussed, MNEs can
often exploit the differences between tax systems to reduce their tax burden, with
significant revenue losses for governments and globally.
This study provides robust evidence of such tax planning by MNEs. It highlights that
international tax planning significantly reduces corporate tax revenues globally, though
there is large uncertainty around the magnitude of the overall loss due to limitations in the
currently available data. MNEs shift profit from higher to lower-tax rate countries. Large
MNEs also exploit mismatches between tax systems and preferential tax treatment to
reduce their tax burden. Transfer price manipulation, strategic allocation of intangible
assets and manipulation of internal and external debt levels are found to be important
profit shifting channels. Aside from its fiscal implications, tax planning is found to have
effects on economic efficiency through various channels, including by affecting the
sensitivity of the location of tax-planning MNEs tangible and intangible investments.
Stricter anti-avoidance rules such as comprehensive documentation requirements on
transfer pricing, rules against debt manipulation, GAARs and CFC rules as well as higher
withholding taxes are associated with reduced tax planning, but also with higher
compliance costs for firms. Co-ordinating anti-avoidance rules across countries could
reduce these costs.
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Zinn, B. and C. Spengel (2012), Book/tax Conformity: Empirical Evidence from
Germany, ZEW Discussion Paper, No. 12-051.
Notes
1.
This annex was prepared by the OECD Economics Department in co-operation with
the Centre for Tax Policy and Administration and has been approved by the OECDs
Economic Policy Committee and the Committee on Fiscal Affairs.
2.
More information about the ORBIS database is included in Box 3.A1.2.
3.
The tax rate is the sum of the national and sub-national tax rate. For non-OECD
countries, data are sourced from KPMG and refer to 2000 (Russian Federation refers
to 2001 instead of 2000) and 2013.
4.
The weighted average excludes Mexico due to missing data.
5.
In the case of e-commerce or the sale of online services, there can be an ambiguity
over where the profit of a firm is generated. For example, a firm may conduct
substantial sales of goods and services in a market from a remote location and with
minimal use of personnel (OECD, 2014a). As it is not possible to ring-fence the
digital economy from the rest of the economy, no separate analysis was conducted of
profit shifting associated with the digital economy. The assumption underlying the
empirical analysis is that the location of assets (including purchased intangible assets
reported in financial accounts) or employees represents a relevant proxy for the true
activity of a firm.
6.
MNEs may also shift certain activities (e.g. R&D activities) to benefit from
preferential tax treatment on the related income. This is not considered as BEPS, but
is included in the empirical analysis as it cannot be disentangled from BEPS channels
with the available data. It was agreed in the BEPS Project that the preferential
treatment of intellectual property should be coupled with substantial activity
requirements to prevent harmful tax competition (OECD, 2014c).
7.
In worldwide taxation systems, the location of headquarters determines the tax rate
applying to worldwide profits. Thus, MNEs have an incentive to locate their
headquarters in lower-tax countries (so-called tax inversion). However, the empirical
analysis found no conclusive evidence that MNE headquarters are predominantly
located in high or low-tax countries.
8.
In some cases, reported and taxable profits differ because a firm exploits mismatches
between tax systems to reduce its taxable profit (e.g. by deducting the same expense
in more than one country) and thus its tax burden (Lisowsky, 2010). Such tax
planning situations cannot be identified by analysing the location of profits using
financial account data, but they are captured in the empirical analysis of mismatches
between tax systems, which focuses on how reported profits are taxed.
9.
MNEs are firms belonging to corporate groups present in at least two countries.
Domestic groups are firms in corporate groups present in only one country.
Standalone firms are firms belonging to no group (i.e. with no affiliate and no
parent company). Not identified firms are assigned in different categories by the
identification algorithm depending on the ownership threshold (i.e. 50% or 90%)
chosen to link companies. All business forms (corporations, limited liability
partnerships, etc.) are included in ORBIS data.
10.
The share of domestic groups and MNEs appears implausibly low in the Netherlands,
which probably reflects missing ownership links in the ORBIS database for this
country. This may also be the case for other countries.
11.
The data are based on the ORBIS sample used in the analysis and may not be
representative of the underlying population, particularly for specific countries.
12.
Only countries covered in the OECD STAN business demography statistics database
are presented. Large firms are firms with more than 250 employees. When the
number of employees is not available in ORBIS, turnover or total assets are used as
alternative size measures (with respective thresholds of EUR 50 million and EUR 43
million, in line with the EU definition). Brazil and Iceland refers to manufacturing,
Japan is 2012 in STAN as compared to 2009 in ORBIS (large firms is 50+
employees), Iceland 2005, Brazil 2008 and Switzerland 2009.
13.
A MNE entity is considered as having a link to a given country if at least one entity in
its corporate group is present in this country. A MNE entity is considered as large if it
has more than 250 employees. The figures presented are computed based on all
observations in the ORBIS sample used in this study over the period 2000-2010.
Countries with less than 1200 observations of large MNE entities are not presented.
14.
The data are based on the ORBIS sample used in the analysis and may not be
representative of the underlying population, particularly for specific countries.
15.
The statutory corporate tax is usually considered as the relevant tax rate on shifted
profits (Gravelle, 2014). Lower effective tax rates (for example because of
preferential tax treatment) are captured in the second part of the empirical analysis
(mismatches between tax systems).
16.
Using a weighted average is not straightforward. Weights based on activity levels

may not reflect profit shifting possibilities as profits can be shifted to entities where
the group has little activity. Weights based on profits or sales can pose endogeneity
problems even in the case of lagging the relevant variable as there is a high
correlation between past and current profits and sales.
17.
In an alternative specification, the tax variable is split to assess separately profit

shifting to no-tax countries and shifting between countries with positive (but
different) tax rates. The result suggests that both types of profit shifting occur, with
the profit shifting propensity (relative to tax rate differentials) being stronger between
countries with positive tax rates.
18.
A 50% threshold is commonly used in the tax literature for defining corporate groups
(e.g. Huizinga and Laeven, 2008; Maffini and Mokkas, 2011). The rationale is that
profit shifting would generally not take place between two companies that are not
under the same control. By contrast, foreign direct investment statistics use a 10%
ownership threshold.
19.
The empirical approach is to compare in a regression analysis the profitability of

MNE entities with different opportunities to shift profits, such as entities 1A and 2A.
The entity 1A is expected to receive profits from other group members since it has a
lower tax rate than them. In contrast, the entity 2A is expected to shift profits to other
group members. The estimated tax sensitivity implies that a 1 percentage point
statutory tax rate differential is associated with 1% higher (or lower) profit. This
means that entity 1A is assumed to receive profits representing about 5% of its total
profit, while entity 2A is assumed to shift about 10% of its profit. Details of the
methodology are presented in Box 3.A1.3.
20.
A few papers (e.g. Markle and Shackelford, 2011) include the effect of mismatches in
their estimates, but without disentangling them from profit shifting.
21.
Shifted (non-shifted) patents are patents where the inventor is located in a different
(the same) country than the MNE entity applying for the patent protection. For
example, the United States accounts for 42% of global patent applications, out of
which 35% are invented in the country and 7% are invented in another country.
Worldwide patent applications refer to the sum of patent applications (shifted and
non-shifted) made by the 38 countries included in the analysis (see Panel B). Patent
applications refer to applications to two major patent offices (i.e. the United States
Patent and Trademark Office (USTPO) and the European Patent Office (EPO)) and
patents filed under the Patent Co-Operation Treaty (PCT).
22.
For example, in about 85% of patent applications in Luxembourg, the inventor is

located outside Luxembourg.
23.
It was agreed in the BEPS Project that the preferential treatment of intellectual
property should be coupled with substantial activity requirements to prevent
harmful tax competition (OECD, 2014c).
24.
Existing intellectual property regimes in the OECD and G20 that do not meet the
agreed standard for substantial activity should close to new entrants in June 2016 and
stop operating in June 2021 (G20 communiqu, February 2015).
25.
The patent protection may cover different countries than the one where the applying
firm is located depending on the patent office where the patent is registered.
26.
MNEs also have incentives to deviate from market interest rates on internal debt in
order to shift profit. However, interest payments between related entities are generally
regulated by the arms length principle as other internal transactions.
27.
Heckemeyer and Overesch (2013), based on a meta-analysis of 25 studies, estimate

that debt manipulation accounts for about 30% of total profit shifting.
28.
The indicator is compiled for 2005 and 2014. In the empirical analysis, the value for
2005 is used, which corresponds to the middle of the sample period.
29.
The figure shows the percentage of GDP devoted to accounting, tax preparation,
bookkeeping and payroll services, as a proxy for tax consultancy industry. It includes
services unrelated to tax, but also excludes economic resources devoted to tax
including tax legal services and corporations in-house tax staffs.
30.
The effect of international tax planning on other taxes and social contributions goes
beyond the scope of this study. If international tax planning results from artificial
financial flows and does not affect the location of real economic activity, the impact
on other taxes and social contributions should be limited.
31.
Figures as a share of GDP assume that CIT revenues represent 3% of GDP, which is
close to the OECD average.
32.
For Russian Federation, where no data is available in the OECD Business

Demography Statistics database, a coverage rate of 70% is assumed. This corresponds
to the average across European countries where comparison is possible. For nonEuropean countries where no data is available in the OECD Business Demography
Statistics database, a coverage rate of 5% is assumed.
33.
The range is based on sensitivity around the point estimate of the tax planning
sensitivity. The sensitivity analysis assumes a 95% confidence interval (i.e. about two
standard errors on each side) around the point estimate of the profit shifting and
mismatch estimates.
34.
The revenue effect is based on the assumption that firms outside the sample have the
same tax elasticity (i.e. profit shifting elasticity and average tax differential) as firms
in the sample. The sensitivity analysis assumes a 50% higher tax elasticity of firms
outside the sample relative to firms in the sample. The assumption is that 50% of
firms are covered in the hypothetical country.
35.
In the hypothetical example, the average tax rate differential corresponds to a

statutory tax rate of 33%, which broadly corresponds to the weighted average of
statutory tax rates over 2005-09 in OECD and G20 countries.
36.
Data on tax credits is limited and the data used in this study were provided to the
OECD as part of the work on Action 11 and most often refer to the year 2011. A
caveat is that tax credits are volatile and that relying on data for only one year may
not to be representative of the general size of tax credits.
37.
The underlying assumption is that non-OECD and non-G20 countries lose on average
4-10% of corporate tax revenues, which is the same as the countries in the sample. On
average in non-OECD non-G20 countries, corporate tax revenues as a share of GDP
is about 50% higher than in countries in the sample (data on corporate tax revenues
for these countries is sourced from available national sources and the IMF).
38.
Other factors including the taxation of capital at the personal level can also affect
financing decisions.
39.
One option is to allow tax deductibility for the opportunity cost of equity finance (socalled allowance for corporate equity, ACE) as introduced in Belgium and Italy over
the past decade. Another option is to remove interest deductibility altogether (socalled comprehensive business income tax, CBIT). These options are discussed
extensively in the literature (e.g. OECD, 2007; de Mooij, 2012).
40.
With complete markets and perfect information, there is no optimal debt-to-equity

choice of firms (Modigliani and Miller, 1958). In reality, capital markets suffer from
informational imperfections and non-neutral taxation. In a second-best world, changes
in leverage due to taxation can either mitigate or exacerbate pre-existing distortions
(de Mooij, 2011).
41.
Manipulating the location of group debt may increase bankruptcy risks of the entities
where debt is located if there is no perfect risk sharing within the group. However,
MNE entities are generally thought to benefit from explicit or implicit guarantee from
their parents (see Huizinga et al., 2008, footnote 9).
42.
New international guidelines for compiling FDI statistics are currently being
implemented. These guidelines recommend, among other things, to identify capital
being channelled through special purpose entities, which are known to be used for tax
planning. Once these data are available, the effect of tax differentials on FDI can be
refined
by
excluding
activities
of
special
entities
(see
www.oecd.org/daf/inv/oecdimplementsnewinternationalstandardsforcompilingfdistati
stics.htm).
43.
In the case of location of investment, the relevant tax rate is the effective tax rate, as it
takes into account the generosity of tax depreciation allowance of the investment and
other tax provisions. The results presented in this study rely on statutory rates since
effective tax rates are only available for a limited set of countries. However, the
findings are robust to using effective rates for a smaller set of countries.
44.
Few studies exist on the role of international tax planning for investment and most of
the existing ones focus on one specific country, such as the United States or Germany
(Grubert 2003; Overesch, 2009).
45.
Using tax data for the United States, Grubert (2003) shows that R&D-intensive MNEs
are more likely than other MNEs to invest in countries with either very high or very
low tax rates. Investments in very-low-tax countries may serve in the setting up of
tax-planning schemes. Investment in very-high-tax countries are attractive for taxplanning MNEs, since tax-planning allows them to avoid most of the high tax burden
that non-tax-planning firms have to face in these countries.
46.
Forward looking marginal tax rates are sourced from the Centre for the Oxford Centre
for Business Taxation. They derive from modelling a hypothetical investment project
taking into account all relevant tax provisions. By construction, they do not include
the effect of international tax planning.
47.
The corporate tax rate considered is the marginal forward-looking effective tax rate.
All differences in the reaction of investment to tax rate changes are significant at a
5% level.
48.
Dynamic inconsistency and lack of commitment in government policy may be

another possible explanation for positive capital taxation as the policy maker has an
incentive to tax capital once the investments is done to raise revenue (e.g. Kydland
and Prescott, 1977; Piketty and Saez, 2012).
49.
Another justification for capital income taxes is that they can provide insurance
against future poor labour market outcomes (see Golosov et al., 2006). In a setting
when there is uncertainty about individuals future skills (productivity) and leisure is
a normal good, more savings today, all else equal, will reduce work incentives later
on. Thus, discouraging savings through capital income taxation increase the
governments ability to provide insurance against future labour market risks.
Annex 3.A2
A toolkit for estimating the country-specific fiscal effects of BEPS
countermeasures
Introduction
When countries consider introducing BEPS countermeasures, estimates of the fiscal and
economic effects may be needed. Tax policy analysts can provide government officials
and other stakeholders with evidence-based analysis of the fiscal and economic effects of
options to curtail BEPS behaviours.
The BEPS Action Plan states that It is important to identify the types of data that
taxpayers should provide to tax administrators, as well as the methodologies that can be
used to analyse these data and to assess the likely economic implications of BEPS
behaviours and actions taken to address BEPS. Action 11 also involves ensuring that
tools are available to monitor and evaluate the effectiveness and economic impact of the
actions taken to address BEPS on an ongoing basis.1
This annex is intended to provide government tax administration and tax policy offices,
as well as other stakeholders, with a toolkit of methodological approaches that could be
used to estimate the fiscal effects of BEPS countermeasures. The fiscal effects estimates,
which may incorporate taxpayer behaviour, are often an important starting point for
analysis of other economic effects of legislative changes. While the toolkit discusses each
of the BEPS Actions separately, the general estimation approach will be familiar to most
government policy analysts responsible for analysing proposed tax legislation.
In a recent survey of the academic literature, Riedel (2014) notes: The most convincing
empirical evidence has been presented by academic studies that investigate specific profit
shifting channels as their empirical tests are more direct and offer less room for results
being driven by mechanisms unrelated to income shifting. This is an important insight in
the discussion of the fiscal effects of BEPS countermeasures, and many of these empirical
studies analysing specific profit shifting channels have been drawn upon in constructing
the methodological approaches in this annex.
The toolkit presented in this annex focuses on practical approaches that tax policy
analysts could use to estimate the fiscal effects of BEPS countermeasures for their
country. Given that each country has different data and will begin from different starting
points, several alternative approaches are often suggested. Some countries may introduce
the full suite of BEPS countermeasures, while others may introduce selected BEPS
countermeasures. For this reason, the proposed methodologies are distinguished by
action. This is in line with the scope of Action 11 of the BEPS Action Plan.2
Government estimates of the fiscal effects of domestic tax law changes are not new, and
some countries have already estimated the fiscal effects of certain BEPS-related tax
policy measures. It is worth noting that individual country fiscal effects from unilateral
measures do not take into account spillover effects in other countries. For example,
implementing an interest limitation rule will reduce debt and interest deductions in the
implementing country, but affected MNEs could shift debt and interest deductions to
other countries with weaker rules. The effect on global BEPS and global revenue would
be very different in respect of multilateral BEPS countermeasures compared to unilateral
measures.
A number of governments view the closure of loopholes as base protection measures and,
as a result, do not estimate the associated fiscal effects. This is also the case for many of
the BEPS-related countermeasures, which may be treated as measures that protect
forecasted budget revenue, not as incremental new revenue to the current-law revenue
projections.3 Thus, while a number of BEPS-related countermeasures have been enacted
over the past ten years, they have sometimes been seen as measures to protect the tax
base, and have not been officially scored as raising revenue relative to current tax
projections.
Some countries have estimated the fiscal effects of BEPS-related countermeasures
enacted or proposed. Table 3.A2.1 provides a summary of the fiscal estimates of BEPSrelated countermeasures in selected countries as a percentage of their total corporate
income tax (CIT) revenue. The revenue effects are approximate because the total CIT
revenue does not always refer to the same year for which the revenue estimates were
computed. Moreover, some revenue estimates refer to a period, but the number of years
included is not always explicitly stated. Measures that were implemented in prior years
may yield different fiscal estimates if estimated today or in future where general
macroeconomic conditions may be different. For interest limitation rules in particular,
because some of the fiscal estimates were introduced during a period of higher interest
rates; introducing them in the current interest rate environment may result in a lower
estimate. The fiscal estimates also depend on whether a country has implemented other
policy measures simultaneously and how the estimates of these measures may have been
integrated to avoid overlapping. Also, if these countries had existing countermeasures in
place, then the fiscal estimate would only be for the incremental revenue effect of the new
interest limitation rule, not the effect of the countrys total interest limitation rule. The
estimate would also be sensitive to the macroeconomic conditions at the time of
introduction.
Table 3.A2.1. Government fiscal estimates of BEPS-related measures
Country
Measure
Denmark
France
Germany
Limited interest deductibility

Hybrid mismatch arrangements
Higher taxes on relocation abroad and more
appropriate transfer pricing
Limited interest deductibility
Interest deduction rules for internal debt
Tax information exchange agreements
Avoidance schemes using the transfer of
corporate profits
Hybrid mismatch arrangements
Restrict deductions for excess interest of
members of financial reporting groups and defer
the deduction of interest expense related to
deferred income
Tax currently excess returns associated with
transfers of intangibles offshore
Norway
Sweden
United Kingdom
United States
Year of enactment
(unless stated
otherwise)
2007
2014
Annual revenue effect as a

percentage of total corporate
income tax revenue
5.2%
0.9%
2008
8.6%
2014
2013
2010
3.4%
8.5%
0.6%
2014
0.3%
2017
0.2%
Proposal (2015)
for enactment 2016
4.0%
Proposal (2015)
for enactment 2016
1.1%
Source: OECD Committee on Fiscal Affairs WP2 Country Survey

Analysing the fiscal effects of BEPS countermeasures provides a number of benefits.

Fiscal estimates provide policymakers with at least a magnitude of the potential effects of
policy actions, rather than relying on limited information relating to a select group of
taxpayers or arrangements. Estimation and modelling requires analysts to make estimates
and assumptions more explicit, even though key data may be incomplete. Understanding
the limitations of the data can help improve available data over time. Fiscal estimation
can provide important inputs to broader economic analysis of legislated changes by
measuring the incentive effects, the level of the affected activities, and the potential
taxpayer behavioural responses. For example, policy proposal or impact assessment
documents produced by the ministry of finance and revenue authority in the United
Kingdom, as well as policy costings provided in the United States, often include wideranging information and analysis in respect of tax policy proposals.4 The information
depends on the particular policy, but generally includes an overview of the current law
and the proposed change under consideration; why government intervention is necessary;
the policy objectives and intended effects; the alternate policy options and the basis for
the recommended option; benefits and costs to government and other economic actors;
additional factors, such as competition effects; and potential for behavioural responses.
General approach to undertaking a fiscal estimate

The following steps are important components of a revenue estimation exercise and could
be used as a guide for estimating the fiscal effects of any new tax policy measure. This
approach is likely to be particularly useful in the BEPS context as new countermeasures
or improvements of existing countermeasures are proposed and enacted. It is important to
recognise that all countries are different when it comes to the level of detail in respect of
taxpayer data collected, and access to that data by tax policy analysts. For this reason, the
most appropriate methodology will vary from country to country. Figure 3.A2.1 provides
an overview of a potential approach that can be used in undertaking a fiscal estimate. This
is followed by an explanation of each step.
Understanding the proposed change

Carefully evaluating and understanding the proposed legislative change is important. It is
necessary to identify the key elements of the proposed change that are likely to have the
greatest fiscal effect and can be captured with available data. It may be appropriate to
place less reliance on policy design features that are more detailed and less likely to have
a material effect on the fiscal estimate. Attempting to make a highly refined estimate with
limited data and uncertainty about taxpayers behaviours may not be worthwhile. While
details matter, not all of them are important for incorporation in the economic analysis
and identifying the key elements of the proposal is necessary for a reasonable estimate of
the effect. Smaller issues could be referenced as potentially having an upward or
downward bias on the revenue estimate.
The proposal needs to be compared to current law, regulations and practices as current
practice will determine the counterfactual against which the countermeasure is measured.
In many instances, BEPS countermeasures will be incremental to those measures already
in place, such as thin capitalisation rules, transfer pricing rules and general anti-avoidance
rules (GAAR). Some countries may already have legislation that is similar to or stronger
than the proposed countermeasures, in which case the countermeasure, considered in
isolation to other changes, may have no incremental effect on future revenues. It will also
be important to determine the appropriate counterfactual and whether proposed
countermeasures will be revenue protecting or revenue raising in nature.
Figure 3.A2.1. Potential approach to undertaking a fiscal estimate
Identifying relevant and available data
Understanding available economic and statistical analyses
Measuring the magnitude of the tax base affected

Deciding on the applicable marginal tax rates for the type of
income shifted
Measuring and incorporating potential behavioural effects
Measuring timing effects
Potential interactions with other countermeasures
Forecasting into the future
Identifying relevant and available data

Identifying the most relevant, currently available data is critical to the fiscal estimate. In
some cases, such as individual income tax changes, tax analysts may have detailed tax
return data which can be quickly used to simulate tax policy changes. In the business and
corporate tax area, the data is typically much less available given the volatility of business
income, the complexity of business structures, and the need to adjust for the carryforward of tax losses, making the projection of corporate taxes more difficult than
personal income taxes. The available data for international tax analysis of MNEs and
BEPS is severely limited. However, it is common practice for government analysts of
business tax policy changes to draw on databases from a variety of sources, not just from
tax return information.
The availability of data will determine, to a large extent, the potential methodology that
can be pursued. In the BEPS context, the best case scenario is having access to microlevel tax return information that highlights whether entities are affiliated with a MNE and
distinguishes between related-party and unrelated-party transactions. Even tax return data
may not have all of the information needed for the estimate and would need to be
supplemented with other information.
Financial account micro-data may also be useful in the absence of tax return information.
Extrapolation from the available financial account data to the universe of affected
taxpayers will be necessary, especially given the missing data problems with available
databases. Macroeconomic data may help calibrate financial account data and assist in an
extrapolation. Caution must be exercised when interpreting the results from financial
accounts due to the differences between tax expense reported for accounting purposes and
the actual tax paid by a business. A good strategy would be to understand the potential
sources of discrepancy and make suitable adjustments.
In the absence of a database of financial account micro-data, an alternative would be to
analyse a statistical sample, or the financial statements of the top MNEs in the country. It
is important to note that a statistical sample would be preferable to focusing on a
concentrated group of MNEs. While focusing on the top MNEs may capture a significant
proportion of the total economic activity affected, extrapolating beyond this group may
result in an overestimate of the fiscal effect. Using a true statistical sample of taxpayers
that would be affected by a policy measure would provide a better representation of the
economy and thus a better sample from which to extrapolate. The number of groups
chosen for the sample will depend on domestic factors and should have a good
representation across sectors to adequately reflect sectorial contribution to GDP and
whether certain sectors are more affected than others by the countermeasure(s) proposed.
If no micro-data is available, macro-data can be used. It is possible to find data on many
of the transactions that are likely to be affected by BEPS, including imports/exports,
sales, interest receipts and payments, and dividends and royalties. These are often
available in national accounts and balance of payments (BOP) data. It is also possible that
the data is available for bilateral exports/imports and/or FDI with other countries.
If no macro-data relevant to the countermeasure is available for the country, analogous
data from similar economies could be sourced, as well as information from empirical
studies. Some empirical studies have useful information on issues that relate directly to
BEPS behaviours.
Understanding available economic and statistical analyses

When estimating the fiscal effects of a tax policy measure, there is often an array of
literature and/or empirical studies available that have already investigated issues relating
to the measure being enacted, and which can provide useful insights to tax policy
analysts. In the BEPS-specific context, consulting existing studies that analyse certain
tax-motivated behaviour, or which contain analyses on BEPS countermeasures in other
countries, can add valuable insights to the estimation exercise. There are a number of
empirical analyses of BEPS behaviours by MNEs, including in relation to transfer
pricing, interest expense and treaty shopping. These analyses are important sources of
information and can often assist analysts in refining a fiscal estimate. Some studies may
show the behavioural responses to tax differentials or in relation to a specific measure
that was implemented, while others provide useful information on relationships between
variables that are integral to particular BEPS Actions (e.g. internal and external debt).
Another example is an academic study that provides a better understanding of all treaty
networks and those country routes that are likely to be profitable from a tax planning
perspective.
Measuring the magnitude of the tax base affected

Quantifying the magnitude of the tax base affected by a policy measure is a key element
that often requires assumptions and judgement. It involves drawing on the relevant and
available data and making necessary adjustments, after understanding the relationships
between key variables. In the BEPS context, it is also critical to understand the various
incentives to engage in BEPS behaviours as these will also affect the size of the affected
tax base. Combining the knowledge from the prior steps effectively will enable an
informed determination of the size of the tax base that is likely to be affected by the
policy measure.
Deciding on the applicable marginal tax rate for the type of income shifted
Once the affected tax base has been calculated, it will be necessary to determine the
applicable tax rate to apply to the estimated change in the tax base. This will depend on
the type of income stream, whether the expansion in the tax base will be taxed at the
margin, and the specific rules implemented. The simplest tax rate to use is the headline
statutory tax rate, but in many cases (particularly in the BEPS context) this may not be the
best choice given that many countries have special regimes that have substantially lower
statutory CIT rates on certain income. For example, patent box regimes reduce the CIT
rate on IP-related income and some countries have special arrangements with taxpayers
that result in negligible tax liabilities. Effective tax rates may not be appropriate either; if
an increase in the tax base should be taxed at the margin, an effective tax rate (ETR)
would understate the fiscal effect in situations where investment allowances and tax
credits reduce the ETR.
The starting point would be the applicable marginal tax rate (AMTR), which is the rate
applied to an increase in taxable income as it would be taxed at the margin. Downward
adjustments may be required for a variety of reasons. For example, businesses in an
assessed loss position for tax purposes would not have their current tax liability affected
by an incremental increase in taxable income. Having access to micro-data would not
require an adjustment as the exact AMTR would be applied in the micro-simulation
model. However, in recognition of the fact that a certain portion of firms would be in a
tax loss position, a fiscal estimate relying on macro-data would require a downward
adjustment in the statutory marginal tax rate. If no adjustment is made, it is likely to result
in an overestimate of the fiscal effect.
Measuring and incorporating potential behavioural effects

It will be necessary to get a good understanding of the incentives for BEPS both prior to
and subsequent to the enactment of proposed countermeasures. Incentives to engage in
BEPS behaviours post-enactment are important for a dynamic estimate of the fiscal
effects of the countermeasure(s) being analysed. It is also important to recognise that
behavioural effects are not isolated to taxpayers. Behavioural effects can also occur as a
result of domestic governments reaction to other foreign governments tax law changes
and macroeconomic behavioural effects from these changes. However, for the purposes
of this annex, only taxpayer behaviours are discussed.
Significant behavioural effects should be included to the extent data and available
research allow. Since firms engage in profit maximising behaviour, tax policy analysts
can assume that one of the routes firms use to achieve this objective is minimising their
tax liability. Closing a loophole may result in MNEs finding alternate methods of eroding
the tax base or shifting profits out of the country. This is important to recognise in a fiscal
estimate as estimated increases in CIT revenue may not arise if MNEs find alternate
methods to minimise their tax liability.
A simplifying assumption often used in tax policy analysis of smaller tax changes, as
opposed to major tax reforms, is that the change will not have a significant
macroeconomic effect. Since any business tax increase from reducing BEPS would result
in lower taxes to other actors, increased government spending, or a reduction in the
governments budget deficit, overall macroeconomic effects are unlikely to be significant
given the offsetting effects. If significant macroeconomic effects are anticipated, the tax
administration and tax policy offices would generally work with other government offices
to estimate the overall budget effect.
Including behavioural responses for unilateral measures is different to doing so for
multilateral action as discussed in the introduction. There are multiple empirical studies
on taxpayer responses to tax rate differentials and specific tax policy changes that have
been implemented, all of which can provide useful insights to analysts.
There are also factors outside of the legislated policy change that need to be factored into
a fiscal estimate. In the lead up to introducing new legislation announced, many countries
have processes in place that could include the release of a discussion document to seek
public comments; parliamentary sessions; and engagement with taxpayers. The time
taken for these processes can result in taxpayers changing their behaviour to avoid being
affected by the new legislation. This is something that could be factored into behavioural
responses.
The level of enforcement is also important. Weak enforcement could render a good policy
measure ineffective if taxpayers can easily avoid paying the taxes due. For this reason, it
may be appropriate to factor in a measure of expected effectiveness in terms of how
successful the revenue authority will be at enforcing the countermeasure.
Measuring timing effects

Most governments estimate the fiscal effects of proposed legislation over several future
years based on macroeconomic forecasts by other government offices. The effect of
proposed changes depends on the timing of the implementation, phase-ins and any
transition rules. Timing may also be affected by carry-forward rules, i.e. if deductions are
disallowed in the current year, but become available in later years, such as with net
operating loss carry-overs. Some proposals may have an effect on revenues before
legislation is enacted or comes into effect if taxpayers react in advance of proposed
legislation.

Recognising interactions between countermeasures is important to prevent doublecounting from overlapping countermeasures or under-counting due to synergies between
countermeasures. In large tax reform proposals, government analysts are routinely
required to address the issue of overlap. They do this directly when considering the
different provisions of a large tax reform, and also often use a revenue-estimating
convention called stacking. Stacking sets the order in which individual tax provisions
of a tax package are estimated. For example, for a tax reform that includes both a tax rate
change and a tax base change, the estimates of individual provisions will depend on the
stacking order. If a tax rate reduction is stacked first, it will apply to the current-law tax
base and thus result in a lower revenue estimate for the rate change than if a tax base
increase is stacked first. The estimate of the tax effect of the larger tax base would also be
smaller since it would apply to the lower tax rate. Alternatively, if the tax base increase is
stacked first against the higher current-law tax rate, then its revenue effect would be
larger, as would the tax rate reductions tax effects, since the lower rate will be applied
against the proposed larger tax base. In either case, the combined effect can be estimated
accurately; stacking affects the size of the individual components, not the total, while
reducing potential double-counting.
Stacking is important in estimating the fiscal effect of multiple policy measures to
eliminate double counting. A few examples of potential overlaps in the BEPS context
include: (1) if transfer pricing changes are stacked first, taxable income will be more
appropriately taxed where the value is created based on the new transfer pricing rules, so
taxable income that might be affected by Action 3 or Action 7 if implemented in isolation
will have already been included in the Actions 8-10 transfer pricing fiscal estimates; (2)
As both Action 4 and transfer pricing rules affect interest payments, caution will need to
be exercised in terms of distinguishing between the correct pricing of interest (or
payments equivalent to interest) and interest resulting from excessive leverage; and (3)
while Action 2 would raise revenue by eliminating hybrid mismatch arrangements
relative to current law in isolation, Action 4 and Action 6s fiscal effects could pick up
most of the fiscal effects that Action 2 would otherwise have generated. Thus, stacking
and potentially treating some countermeasures as integrity measures, which increase the
effectiveness of other countermeasures, can significantly reduce the possibility of doublecounting.
Synergies between multiple countermeasures are expected to have a more powerful effect
on reducing BEPS behaviours than individual countermeasures in isolation. Thus, the
sum of the parts may be less than the effect of the combined package. Countries could
consider the likely effectiveness of the individual countermeasures as a specific parameter
to be used in the estimate, as highlighted in the discussion of behavioural effects. The
effectiveness parameter includes not only the coverage of the proposed legislation, but
also the expected enforcement of the legislation. This parameter can be adjusted for
certain countermeasures to incorporate potential synergistic effects, with possible
sensitivity analysis around that adjustment.
Forecasting into the future

Fiscal estimates often require an extrapolation of the likely fiscal effects in the years
following the year a new policy measure is implemented. Projecting into the future
requires a reliance on GDP forecasts for the country and an estimation of how CIT
revenues are likely to increase relative to GDP. This would involve analysing the
responsiveness of CIT revenues relative to changes in GDP in prior years, as well as other
factors that are likely to influence CIT revenues, such as the business cycle and whether
there is a lag between when profits are reported and when tax revenues are reported.
Potential Methodologies by Action Item

Potential approaches to estimating the fiscal effects of individual Actions are set out
below. The approaches pursued by countries will differ for many reasons, one of which is
the availability of data. One country may have detailed tax return information that enables
micro-simulations on a proposed countermeasure, while another country may have to rely
more on macro-data. For this reason, two different routes are suggested for some of the
Actions, depending on whether micro-data is available. There are areas of commonality
though; for example, all countries will have to grapple with the question of likely
behavioural responses and how to incorporate them into their estimates. Deciding on
which approach is best and having learnt from best practices in other countries,
government policy analysts can tailor the proposed methodologies to their domestic
circumstances.
Since empirical studies have focused more on transfer pricing and the tax-motivated debt
bias relative to other BEPS behaviours, the proposed methodologies for the individual
Actions are arranged accordingly. The most comprehensive methodologies are provided
for Actions 8-10 and 13 (transfer pricing) and Action 4 (interest limitation rules).
Approaches to estimating the fiscal effects of the other Actions will also discuss the fiscal
estimation issues involved in respect of those countermeasures and highlight potential
available data. These Actions will contribute to addressing BEPS more effectively
through increased disclosure, reducing harmful tax practices, improving dispute
resolution, and speeding up the implementation of the treaty changes. In some cases,
some of these Actions are designed as integrity measures complementing other Actions;
such Actions will often enhance the effectiveness of other Actions such as transfer pricing
rules and interest limitations.
Actions 8-10 and 13 (Transfer Pricing)
The overall objective of Actions 8-10 is the improved allocation of corporate taxable
income to the countries where the economic activity generating the profits occurs.
Specific objectives of the three Actions include developing rules that prevent BEPS
caused by moving intangibles among group members (Action 8); transferring risks
among, or allocating excessive capital to, group members (Action 9); and engaging in
transactions which would not, or would only very rarely, occur between third parties
(Action 10).
Understanding the proposed changes
The following changes or clarifications in the transfer pricing guidance will reduce the
size of BEPS related to transfer mispricing and are particularly relevant to a fiscal
estimate:
Increased specificity in delineating the actual transactions in the context of a MNE
groups economic activities and commercial and financial relations between the
associated enterprises. This includes ensuring that both contractual arrangements
and the actual conduct of the parties are taken into account in delineating the actual
transaction for which it needs to be determined whether the conditions, including
the price, are at arms length;
Providing for the possible non-recognition of transactions when they lack the
commercial rationality of arrangements between unrelated parties;
Strengthening the identification of risk in order to determine which associated
enterprise assumes the risk for transfer pricing purposes. This includes ensuring
that the assumption of risk by an entity is consistent with the exercising of control
over the risk and with the financial capacity to assume the risk and is not only
determined by the contractual assumption of risk;
Providing for a more detailed evaluation of the activities related to the
development, enhancement, maintenance, protection and exploitation of
intangibles, and the allocation of profits generated by these intangibles in line with
the importance of these functions;
Provisions requiring that synergistic benefits deriving from membership of a MNE
group are appropriately allocated through arms length prices to members of the
group contributing to the benefits;
More detailed guidance on the pricing of transactions, including pricing of low
value-adding services and commodities; and
Introduction of measures to address the asymmetry of information between
taxpayers and tax administrations, such as in the cases of hard-to-value intangibles
and the timing of commodity transactions, thus preventing mispricing of
transactions involving such intangibles and commodities.
In addition, Action 13 will enhance the relevance of transfer pricing documentation, and
provide information about the MNE groups global allocation of revenues and activities.
Mandatory Country-by-Country Reporting will provide more information to tax
administrations to conduct risk assessments.
Data and methodology
Estimating the scale of transfer pricing-related BEPS and the effect of Actions 8-10 and
13 involves two distinct steps. First, an estimate is required of the net impact (increase or
decrease) on CIT collections of BEPS relating to the mispricing of transactions. This
estimate has two significant components: (1) the mispricing of transactions that are
observed in a countrys trade in goods and services data, and (2) BEPS-related
transactions that are misallocated in the trade data for specific countries. An example of
the second category would be missing royalty payments to a country that creates IP from
in-country R&D expenditures, if BEPS attributes the value of the IP (and related income
streams) to another country through transfer prices that are not in line with the location of
activities that created the IP. Both aspects of the fiscal impact of BEPS should be
included in the revenue estimates.
Second, an estimate of the overall impact of the proposed changes in transfer pricing rules
and guidance presented in the Report on Actions 8-10 (Aligning Transfer Pricing
Outcomes with Value Creation, OECD, 2015a) can be applied to the estimated scale of
BEPS from mispricing to determine the expected changes in CIT revenues attributable to
the implementation of the BEPS Actions. The purpose of the second step is to prepare a
revenue estimate of the expected change in CIT revenues due to the adoption and
implementation of the revised transfer pricing guidance. The extent of the changes
adopted, as well as the timing of their implementation will vary from country to country.
The suggested methodology addresses: (a) mispricing of goods and services transactions
between MNE entities, and (b) mispricing of interest payments among MNE entities.5
The methodology described is based on country-specific, macroeconomic data on trade
and interest flows to estimate the scale of BEPS and the fiscal effects of the guidance in
the Report on Actions 8-10. Where other data, including firm-level micro-data or more
disaggregated macro-data, is available for the country, analysts should take advantage of
this. If information, such as that obtained from audits, is available, alternative
methodologies may be appropriate.
a.
Mispricing of goods and services
The estimation exercise begins with data on trade in goods and services, which includes
the combined effects of mispricing of goods and services. In the presence of BEPS, it is
expected that trade among MNE entities results in underreporting of profits in countries
with marginal tax rates higher than the domestic countrys marginal tax rate and overreporting of profits in countries with lower marginal tax rates. This profit shifting occurs
through the mispricing of transfer prices on MNE intra-firm trade flows of both exports
and imports.
Detailed macroeconomic data on the total amount of annual exports and imports by
country (for both goods and services, where available), as well as bilateral export and
import flows with countries trading partners, is available from the OECD International
Trade Account data and IMF Direction of Trade Statistics.6 To the extent that more
detailed information from a national statistics office is available for individual countries,
analysts should take advantage of such information.
The international trade data includes both goods and services for OECD and G20
countries, but data for service flows may be limited for other countries. Separate
estimates of mispricing should be prepared for goods and for services when the data is
available. International trade transactions in services include a number of components
that may be affected by BEPS.
Revenue estimators need to understand what is included in the trade data. For example,
recent changes to the international standards for reporting balance of payments statistics
currently being implemented will expand available information on a countrys trade in
services related to intangible property. The new standards call for the capitalisation of
R&D expenditures. This will provide a basis for reporting the value of transfers of the
ownership of intangibles produced by R&D expenditures as a component of trade in
R&D services. However, many intangible asset values are significantly greater than the
capitalised value of their inputs, so potential shifted income may need to be adjusted from
the reported trade value. This is in addition to the already included services data on the
payments for the use of intellectual property.7 In countries that have not yet adopted this
change, the transfer of ownership rights in intangible property is unlikely to be included
in the trade in services category.
Estimators must also consider potential transfer pricing adjustments to currently reported
bilateral trade data. An example would be the potential reallocation of royalties paid by
an operating affiliate in one country to a tax haven entity, which may not be fully
reflected in royalties paid by the tax haven entity to the entity in the country actually
conducting the R&D. In this triangular conduit trade example, actual trade data would not
accurately reflect the expected income distribution.
Adjusting trade data to reflect MNE intra-firm transactions
Because BEPS mispricing occurs between MNE entities, it is necessary to reduce total
trade flows to those that are potentially subject to mispricing among related companies.
This requires estimating several key parameters:
The percentage of international transactions accounted for by corporations subject
to the CIT;8
The percentage of the resulting trade flows accounted for by MNEs (i.e. the trade
flows excluding exports/imports by domestic companies to/from unrelated parties);
and
The share of MNE trade transactions that represent transactions among related
MNE entities.
There are several possible sources of information that could provide a basis for estimating
these ratios. The first is tax return information of taxpayers identified as MNEs. The
relative size of their taxable income or taxes paid, compared to other business taxpayers
in the country, is a possible starting point. In addition, specific countries may conduct
surveys of MNEs and other corporations that collect information on their activities, such
as data on Activities of Multinational Enterprises (AMNE) that identifies intra-firm
transactions.9 Customs data and other national statistics could be used. If this type of
information is not available for the country, reported ratios from other countries with
similar economies and trade patterns could be used for the estimates.
Figure 3.A2.2 provides examples of the values for the key trade-related parameters for the
limited number of countries that report this information.
The aggregate trade amounts can be multiplied by the above fractions to estimate the
percentage of total trade accounted for by transactions between MNE entities.10
Figure 3.A2.2. Intra-firm transactions as a percent of selected trade statistics
Intra-firm exports as % of total manufacturing exports
Intra-firm trade in goods as % of total trade
Intra-firm trade in services as % of total private services trade
Intra-firm exports as % of total exports by majority-owned affiliates
70%
60%
50%
65%
64%
57%
49%
48%
51%
50%
47%
43%
39%
40%
32%
30%
24%
22%
18%
20%
10%
10%
0%
Canada
Finland
Israel
Italy
Japan
Netherlands
Poland
Sweden
United States
Source: Lanz and Miroudot (2011)

Notes:
1. The data is derived from AMNE and trade data for different years. In respect of intra-firm exports as a
percentage of total exports by affiliates, data are for the year 2008 for Italy and the United States; 2007 for
Israel, Japan, and Poland; 2006 for Finland; 2002 for Sweden and the Netherlands; 1994 for Canada. Data for
Israel and Poland refer to the manufacturing sector only.
2. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities.
Adjusting for potential double counting

The resulting trade amounts determined in the prior step are the potential export and
import flows that may be subject to BEPS-related transfer mispricing. However, there is
one additional adjustment that could be made in determining the extent of BEPS
mispricing. Increasingly, global value chains result in multiple cross-border transactions
among MNE entities. As intermediate products and services move across borders through
global supply chains, the value added in each country at each step in the production and
distribution chain accumulates in the gross trade flows.11 A portion of the trade flows
represent MNE intra-firm sales. The question is how this pyramiding affects the
accuracy of BEPS mispricing estimates based on the trade data.
While it is true that the intermediate goods and services lead to gross trade flows that
overstate the value added contribution in each country in the supply chain, it does not
necessarily follow that mispricing would only apply to the new value added by each
country in the supply chain. Mispricing may still be based on the gross value of sales, not
the smaller amount of in-country value added.
If a country determines that the use of gross trade data overstates the potential base for
transfer mispricing, an adjustment could be made to reduce the trade figures to address
this issue. For example, a country could reduce gross exports of goods by an estimated
percentage of the export that is accounted for by imports of intermediate goods from
other countries. A possible source for this percentage is the OECD Trade in Value Added
database that includes an estimate of foreign value added as a percent of a countrys
exports.12 This percentage ranges from 14% to 59% for OECD countries with a simple
average of 30%. If a country is excluded from the OECD database, an estimate could be
based on the figures for other countries with similar economies and trade patterns.
Trade-weighted marginal tax rate differentials

Profit shifting through transfer mispricing takes advantage of differences in marginal tax
rates of related companies in different countries. Empirical studies have estimated the
sensitivity of transfer prices to tax rate differentials independent of real economic factors.
Applying the empirical results requires information on tax rate differentials.
The tax rate differentials are key variables used to estimate the degree of over or
underreporting of profits due to BEPS. Since transfer pricing occurs at the margin
(affecting the incremental income shifted), the appropriate tax rate is that applicable to
the shifted (marginal) income, or the AMTR. The marginal tax rate is different to an
average historical effective tax rate that could reflect non-marginal tax elements such as
accelerated depreciation or tax credits. The marginal tax rate may be a countrys top
(headline) statutory tax rate, but for certain types of income the marginal rate may be a
special lower tax rate or an administratively-negotiated lower rate. For instance, a number
of countries have special lower rates for income from certain intangible assets (patent
boxes) or other activities. These special lower rates can increase or decrease the tax rate
differentials and thus result in greater incentives for transfer mispricing in the absence of
safeguards to prevent this.13 In most empirical studies, analysts have used headline
statutory tax rates or average historical effective tax rates. More careful attention to
AMTRs is needed in BEPS analyses of the expected revenue effects of countermeasures.
A trade-weighted value of AMTRs between a country and its trading partners can be
estimated using pairwise trade flow data.14 The tax rate differential for a country is equal
to the home country AMTR minus the weighted average AMTR given each countrys
bilateral trade flows.15 If data is available, the trade-weighted AMTRs should be
calculated separately for exports and imports of goods and services.16 This assumes that a
dollar of shifted profits is taxed at the AMTRs.
It is possible that transfer mispricing could occur between related entities in two countries
with the same headline statutory tax rate, either due to special tax rates or if one of the
entities is in a net operating loss position. Transferring additional income from a
profitable entity to a net operating loss entity would reduce current taxes as well as reduce
the present value of taxes of the two related entities. The tax reduction could be a
permanent reduction in tax equal to the statutory tax rate if the entity with the net
operating loss would be unable to use those net operating losses in a future year due to
carry-forward limitations.
For reference, the global weighted (by exports for the OECD and G20 countries) average
tax rate differential, using 2014 statutory tax rates and 2012 trade flows, was
3.3 percentage points, implying a net shifting out of profits and thus decrease in corporate
tax revenues.17 Depending on the home countrys AMTR relative to its trading partners,
the AMTR differential could be negative, in which case the country could be benefitting
from taxable income being shifted into the country with a coincident increase in corporate
tax revenues. If the AMTR differential is positive, the country could be experiencing a
shifting out of taxable income with a coincident decrease in corporate tax revenues.
Countries with AMTRs in excess of the weighted average of their trading partners had a
weighted average differential of 4.6 percentage points. The average tax rate differential
for the group of countries with home country AMTRs less than their trading partners was
-1.3 percentage points.
Transfer pricing responsiveness to tax rate differentials (elasticities)

To translate the tax rate differentials into BEPS impacts, the differentials need to be
multiplied by an estimate of the responsiveness (elasticity) of export and import prices to
tax rate differentials. These semi-elasticities are estimates of the percentage change in
trade prices in response to a one percentage point change in tax rate differentials, holding
other factors constant.18
Table 3.A2.2 presents the elasticity estimates from specific empirical studies of the
responsiveness of export and import prices for products to CIT rate differentials. The
country and dataset used, time period covered, tax variable used, and estimated elasticity
are shown for each study. There is a wide range of semi-elasticities (concentrated in the 0.65 to -1.6 range) varying by country, data availability and methodology. If feasible,
countries should conduct their own empirical studies to determine a country-specific
semi-elasticity. Alternatively, estimates from other countries with similar tax systems and
economic structures could be used. Care should be taken to ensure the results are
reasonable by, for example, seeing that the estimate of income shifted generally does not
exceed any available estimates of profit margins.
A different elasticity may be applicable for goods and services. Some empirical studies
have found that the responsiveness to tax rates is higher for entities with significant
intangible assets, so mispricing of hard-to-value intangibles may be easier than
mispricing physical goods.19 Empirical analyses have also found larger mispricing among
more highly differentiated physical goods.20 The growth in importance of intellectual
property within manufacturing and the production of products is making the distinction
between goods and services in international trade increasingly unclear. For example, the
price of exports of goods may reflect a price for the good itself plus an embedded, but not
separately stated, charge for the use of intangible property, a service component. In this
case, the transfer price of the good may include an element of BEPS related to the
mispricing of the use of the intangible property that was produced in another country in
earlier steps in the production chain.
Table 3.A2.2. Elasticity estimates of the responsiveness of intra-firm exports and imports to
corporate income tax rate differentials
Time
Period
Tax
Variable
United States exporters arm's-length and

intrafirm prices
1993-2000
STR
-0.65 to -1.6
semi-elasticities
Clausing (2003)
United States international trade

transaction data
1997-1999
STR
-1.8 to -2.0
elasticities
Clausing (2006)
United States intrafirm trade balances by

country
1982-2000
STR
-1.3
semi-elasticity
Overesch (2006)
German MNE balance sheet data for

intrafirm sales
1996-2003
STR
-1.45
semi-elasticity
Davies, Martin, Parenti and

Toubal (2014)
French exporter's arm's - length and

intrafirm prices
1999
EATR
-0.24 elasticity
Vicard (2015)
French exporter's arm's- length and

intrafirm prices
2000-2014
STR
-0.23
semi-elasticity
Cristea and Nguyen (2014)
Exports of Danish manufacturing firms
1999-2006
STR
-0.64 to -0.82
semi-elasticities
Study
Data
Bernard, Jensen and Schott

(2006)
Elasticity
Notes: STR is statutory tax rate; EATR is the backward-looking average tax rate.
To calculate the percentage difference in the trade prices of exports and imports due to
BEPS mispricing, the appropriately determined semi-elasticity value could be multiplied
by the applicable differential tax rates in each country, before applying the resulting
percentage to an estimated value of exports and imports with related parties in each
country that are potentially subject to BEPS-related mispricing. The first part can be
represented as:
Percentage difference in trade prices = (semi-elasticity) x (AMTRhome weighted average
AMTRtrade partners)
For example, with a semi-elasticity of -1 and an AMTR differential of +5 percentage
points, there could be a 5 percent reduction in trade prices.
With the simplifying assumption that there is no change in quantities traded as a result of
the mispricing of exports and imports, the estimated percentage change in prices is equal
to the percentage change in the value of trade. This calculation provides an estimate of
the BEPS-related change in the value of imports and exports of goods and services due to
the mispricing of observed transactions. In other words, it is an estimate of the change in
value that would result if the BEPS incentive due to the tax rate differentials did not exist,
assuming the estimated elasticities reflect only BEPS after accounting for real economic
effects.
The final fiscal estimate assumption is that a one unit change in exports and imports
translates into a one unit change in the CIT base. The resulting estimated change in a
countrys CIT tax base can then be multiplied by the AMTR to derive an initial estimate
of the potential maximum annual CIT revenue impact of BEPS mispricing of reported
goods and services. An adjustment would be required to recognise that a portion of firms
may be in an assessed loss position for tax purposes.
Mispricing related to intellectual property

An important component of BEPS-related mispricing is the possible under-pricing
(relative to arms length prices) of the transfer of intangible assets from a higher to a
lower-tax country. If under-pricing occurs, income (such as buy-in payments at the
time of transfer or buy-in related royalty payments) for the entity in the higher-tax
country will be understated as a result of the mispricing of the intangible transfer. In
addition, the level of ongoing royalty payments to the affiliate for the use of intangibles
may be mispriced.
The transfer pricing methodology for services would include an estimate of the
mispricing of the related-party transfers of IP and royalty flows to the extent that these
transactions are reported in a countrys trade in services statistics. A significant trade in
services category is charges for the use of intellectual property. This includes charges
(i.e. royalties and license fees) for the use of intangibles, including industrial processes,
computer software, trademarks and other intellectual property.21
It is likely that this service category does not record all of the current-law payments for
intangibles due to limitations in reporting coverage and in the classification of
transactions. To the extent that transactions involving intangibles are underreported in the
trade in services data, the estimating methodology will understate the amount of
transactions potentially subject to BEPS.
Given the importance of intangible transactions in facilitating BEPS, the estimating
methodology can be extended by analysing the trade in charges for intellectual property
separately from other trade in services categories. If country-specific information is
available on the extent of mispricing of the services from intangibles or the transfers of
IP, based on taxpayer audits or empirical studies for example, this factor can be
multiplied by the reported IP trade in services amount to derive a more accurate estimate
of BEPS related to the intangibles. The more general elasticity approach would then be
applied to the remaining trade in services categories.
It should be noted that the above methodology does not directly address the reallocation
of revenue as a result of transfer pricing adjustments to the amount of observed royalties,
or as a result of non-recognition of the transfer of intangibles for transfer pricing purposes
under certain circumstances. The methodology, based on observed flows of services
(including payments for intellectual property), would not pick up this revenue gain (or
loss) due to the transfer pricing adjustments which reallocate the profits for tax purposes.
In this situation, revenue estimators should make a separate estimate of the impacts of the
reallocation. Ex post audit experience may provide a basis for identifying the expected
tax base change associated with this impact. The estimated change in the base would be
multiplied by the AMTR to determine the revenue impact.
b.
Mispricing of interest payments
BEPS can also result from overstating interest paid on intra-firm loans by entities in
higher-tax countries and understating interest paid by entities in lower-tax countries. The
trade flow data used to estimate the BEPS impacts of trade mispricing does not include
interest payments and receipts.22
The IMF Co-ordinated Direct Investment Survey (CDIS) database provides data on BOP
statistics for FDI payments and receipts of interest between related parties that could be
used for estimating the revenue impact of interest payment mispricing. The data is for the
interest component of the direct investment category of primary income international

transactions. By definition, this data is limited to transactions among MNEs.23
The potential estimating methodology for the mispricing of interest payments follows that
suggested for the mispricing of trade in goods and services:
A weighted (by interest flows) average tax rate differential is calculated from the
bilateral country information on interest payments and receipts of FDI interest;
The tax rate differential is multiplied by an estimated semi-elasticity of the interest
mispricing to tax rate differentials of other countries to estimate the degree of
interest mispricing among MNE entities. The literature suggests that this semielasticity may be less than that for goods and services. If an elasticity estimate from
the literature is used, the elasticity should be adjusted for any country-specific
distinguishing factors such as relative transfer pricing rules or enforcement levels;
The resulting change in interest payments and receipts is assumed to result in an
equivalent change in interest expense/income and the CIT base; and
The change in the CIT base is multiplied by the AMTR to determine the currentlaw revenue impact of BEPS profit shifting through the mispricing of interest.
It is important to note that there are other categories of possible mispricing induced by tax
rate differentials, such as captive insurance payments and hedging transactions. Transfers
to take advantage of unused net operating losses may not be induced by tax rate
differentials, but also result in profit shifting. If there is country-specific information on
the amount of these transfers, analysts should consider this information in estimating
BEPS.
Although much international trade is undertaken by MNE corporations, increasingly noncorporate (or entity-level taxed) businesses are operating globally. Thus, transfer
mispricing could also have adverse effects on other taxes, including personal income
taxes, value-added taxes, and customs duties.
c.
Combined fiscal estimate
Combining the fiscal estimates for the mispricing of goods, services and interest
payments provides an aggregate estimate of the net revenue impact of BEPS under the
current law (the scale of BEPS). This provides a starting point (or counterfactual) for
estimating the expected fiscal impact of the revised transfer pricing guidance in the
Report on Actions 8-10.
The first step in estimating the budget impacts of the combined guidance requires
specifying the proposed or adopted administrative and legal changes that will better
address transfer-pricing related BEPS. Each Action could have a different effect, or could
be estimated jointly. The next step requires determining what percentage of current BEPS
would be eliminated due to the revised transfer pricing guidance. In other words, what is
the change in tax revenues that can be expected from the revised guidance? The following
should be considered in estimating these fiscal impacts.
Adjusting for possible ranges of arms length prices

Important institutional features of the transfer pricing compliance system may affect the
size of expected collections from eliminating mispricing. For example, taxpayers provide
a range of estimates for arms length prices chosen to reflect comparable transactions
among unrelated parties. Tax administrations generally accept transfer pricing estimates
that fall within a range (e.g. inter-quartile) of the estimates. As a result, some of the
estimated transfer mispricing may still fall within the acceptable transfer pricing range
and not result in a change in taxable income. A second possibility is that audit resources
are targeted on cases involving large expected outcomes. An adjustment factor could be
applied to the estimate of collections from eliminating mispricing to account for such
institutional features of the transfer pricing compliance system.
Additional adjustments
The initial estimate of transactions at risk of mispricing could be reduced for
certain types of trade considered to be less subject to mispricing;
The extent to which existing anti-avoidance rules are already effective in the
country should be factored into the fiscal impact estimates. An adjustment should
be made to reflect the relative strength of the countrys rules compared to the rules
implicit in the elasticity estimate used and the revised guidance that is
implemented; and
The country-specific impacts of the revised guidance will also depend upon the
timing of its implementation. This will affect the change in revenues calculated on
an annual basis.
Possible sources of information to estimate the adjustments include:
Input from income tax auditors and tax administrators on the potential impacts of
the changes on both voluntary compliance and audit results;
Revenue estimates prepared by estimators in other countries, including early
adopters of the revised guidance;
Results from empirical studies of profit shifting with different levels of transfer
pricing rules and enforcement levels; and
The first Country-by-Country Reports (CbCRs) will be filed for 2016 calendar year
filers no later than 31 December 2017. Enhanced transfer pricing documentation,
including CbCR information for MNEs with entities in the country, will thus be
available for statistical analysis following the filing of these reports and will
provide increased information for transfer pricing risk assessment. CbCR
information will provide an additional resource for improving the marginal tax rate
differential estimate with individual group data and for assessing this key
percentage.
Similar to evaluating the scale of BEPS and the effects of other BEPS Actions, the fiscal
effects of Actions 8, 9, 10 and 13 will not show up in a line on a future tax return. They
will need to be estimated based on available evidence. The effects of the Actions will
result in reduced mispricing as reported on the filed tax return, with a secondary effect of
more effective enforcement against any remaining misreporting. Ex post evaluation of the
estimated fiscal effects can involve conducting further empirical studies or examining
future literature on estimated profit shifting and changes in transfer pricing assessments
and settlements adjusted for levels of enforcement and other changes.

The fiscal effect estimate for the mispricing of interest interacts with the estimates of the
fiscal effects of the countermeasures in the Report on Action 4 (Limiting Base Erosion
Involving Interest Deductions and Other Financial Payments, OECD, 2015b). The
transfer pricing revenue impacts in this section assume that the separate fiscal effects of
countermeasures to reduce the strategic shifting of debt to high-tax countries are
accounted for in the estimates of Action 4 countermeasures.
Action 4 (Interest Limitation Rules)
The objective of Action 4 is to reduce BEPS involving interest expense and other
financial payments that are economically equivalent to interest expense. Action 4 calls for
a best practice interest limitation rule for better aligning interest expense deductions with
where the activities creating profits takes place.
Understanding the proposed best practice approach
In estimating the fiscal effect for individual countries of introducing the best practice
interest limitation approach, it is important to encompass the key factors that are likely to
drive a change in tax revenue. The main elements of the approach that are important for
the fiscal estimate are:
A fixed ratio rule: this limits an entitys net interest expense (NIE) to a fixed
percentage of EBITDA24. The Report on Action 4 includes factors which a country
should take into account in setting the benchmark ratio, within a corridor of 10% to
30%.
A group ratio rule is encouraged in combination with a fixed ratio rule: this would
allow an entity to deduct more interest expense in certain circumstances25 but not
more than the groups total external interest expense.
Entities that will be subject to the rule: the fixed ratio rule should apply to taxable
corporate and non-corporate entities (including permanent establishments) and, as a
minimum, to entities that form part of a MNE group.26 Where a group has more
than one entity in a particular country, the country may apply the fixed ratio rule to
the position of each entity separately, or to the overall position of all group entities
in the same country. In addition, countries can determine whether to apply the rule
to entities which are part of a domestic group and/ or stand-alone entities which are
not part of a group.27
Reducing the impact on certain entities: countries may apply a de minimis
threshold to exclude entities with low NIE.
Definition of NIE: for entities affected by the rule, NIE encompasses net interest
payments to third parties, related entities and entities within the same group,
regardless of whether the recipient is domestic or foreign. It also includes financial
payments that are economically equivalent to interest, such as those which are
linked to the financing of an entity that are determined by applying a fixed or
variable percentage to an actual or notional principal over time The methodologies
set out in the annex focus on NIE as captured in the National Accounts.28
Definition of EBITDA: for the fixed ratio rule, the best practice approach
recommends using an EBITDA based on tax numbers; and for the group ratio rule
a country may provide for entity EBITDA to be calculated using either tax or
accounting principles.
Possible additional design features: allowing carry-forward of disallowed interest
expense and/or unused interest capacity for use in future periods, or carry-back of
disallowed interest expense into earlier periods.
Specific rules to address issues raised by the banking and insurance sectors will be
developed, with this work to be completed in 2016.
Since countries may opt for different fixed ratios and supplement the fixed ratio with
additional design features of the best practice approach, some of which are outlined
above, the design of the interest limitation rules introduced in each country will influence
the estimation approach. In addition, countries differ in the level of detailed taxpayer data
that government tax policy analysts have access to. The following section outlines a
methodology (key steps, parameters, and assumptions) that may assist in estimation. The
methodology is separated into two potential approaches one using micro-data from tax
returns or financial reports and the other using a macro-approach. The approaches can be
used to estimate the change in fiscal cash collections on a year-by-year basis.
Estimating the fiscal effect of interest limitation rules requires calculating the extent to
which the CIT base will be broadened by limiting interest deductions, and applying the
appropriate marginal tax rate to the increase in the base.29 It is important to take into
account the countrys existing excessive interest deduction countermeasures to determine
the incremental effect of the new rule. Also, it is important to recognise that taxpayers
may change their behaviour in response to interest limitation rules, which would result in
an adjustment to the static estimate. The magnitude of the behavioural response will
depend on the design of the rule and the extent to which interest limitations are
implemented on a multilateral basis, as well as non-tax determinants of capital structure,
such as prevailing interest rates.
With regard to a counterfactual, some countries may have existing countermeasures to
address excessive interest deductions in place, while others may not. For purposes of this
analysis, the starting point assumes no existing interest limitation rules: asset-based rules
(thin capitalisation rules) or interest limitation rules. If there are such rules, the amount of
revenue currently collected from those rules should be determined if possible from tax
returns, and then can be subtracted from the estimate relative to no interest limitation, to
estimate the incremental effect of the new rules. Countries with existing countermeasures
could opt to use current-law as the counterfactual in the estimation exercise.
Figure 3.A2.3 outlines the basic steps for estimating the fiscal effects of Action 4,
depending on whether micro or macro-level data will be used. The steps for each
approach are explained subsequently.
Figure 3.A2.3 Potential steps to follow once data availability has been determined
What data is available for tax policy analysis?
Only entities
forming part of a
MNE group?
(A) Micro-data
(B) Macro-data
Which entities will

the Action 4 rule
apply to?
Determine total
amount of NIE in
the country
Only entities
forming part of
MNE & Domestic
groups?
All entities
(including standalone)?
Considerations for
focusing on
affected entities
Determine NIE
subject to rule
Adjustments:
- de-minimis rule
(if applicable)
- positive EBITDA
Adjustments:
- Internal interest
- de-minimis rule
(if applicable)
- positive EBITDA
Determine EBITDA
for affected entities
Apply fixed ratio

rule
Apply fixed ratio

rule
Effect of a groupratio rule

(if applicable)
Effect of a groupratio rule

(if applicable)
Applying a MTR to
the change in the
estimated tax base
Applying a MTR to
the change in the
estimated tax base
Dynamic effects:
- carry-forward
(if applicable)
- behavioural
considerations
Dynamic effects:
- carry-forward
(if applicable)
- behavioural
considerations
a.
Micro-data approach
Ideally, government tax policy analysts in each country would have access to business tax
returns to simulate the effects of the proposed interest limitation rule to obtain a static
fiscal effect, taking into account the different provisions of the countermeasure and the
AMTR of the additional income for different taxpayers. Individual company information
with NIE, EBITDA, and taxable (or financial) income can be used to estimate the static
fiscal effect for different fixed ratios, different de minimis rules, and different types of
taxpayers affected. The effect of a group ratio rule, the effect of a carry-forward / carryback rule, and behavioural effects would have to be separately estimated as adjustments
to the static revenue effect.
If tax return information is not available, but individual company financial information is
available, detailed simulations are possible, although adjustments for differences between
financial account information and tax bases will need to be considered. Also, given
potential lack of complete information from public financial accounts, macro-data for
total interest receipts and payments recorded in the country could help extrapolate the
micro-data to a total estimate.
Entities that will be subject to the rule

The first step is to determine which entities will be affected by the fixed ratio rule in the
country. Given that the Action 4 best practice approach could have different impacts in
addressing BEPS involving interest in the financial sector and other sectors, it will be
necessary to focus only on entities in those sectors that are affected by the rule.30 It will
also be necessary to isolate the entities that the rule will apply to, e.g. only entities that
form part of a MNE group, entities that form part of either a MNE or domestic group, or
all entities including stand-alone entities. Based on the recommended approach, an entity
belongs to a group if it is directly / indirectly controlled by a company, or the entity is a
company which directly or indirectly controls one or more other entities. The ability to
identify if the entity is part of a group will be important in determining which entities
should be retained for micro-data analysis purposes. This may be problematic if, for
example, taxpayer information does not provide the necessary information to distinguish
whether or not an entity is directly controlled by a company. If the rule applies widely,
including to standalone entities which are not part of a group, there would be no need to
make this distinction. If relying on financial account micro-data, it is useful to note that
control may be defined differently for financial reporting purposes, although where an
entity is consolidated into a groups financial statements this will typically indicate that
the entity is part of the group.
Determining NIE subject to the rule

Once the affected entities have been established, the amount of NIE paid by those entities
will need to be determined to estimate the portion that would exceed the fixed ratio. The
excess represents the estimated increase in the CIT base, prior to any adjustments. It is
important to clarify what is included in NIE. Firstly NIE includes net interest payments
by affected entities to (1) entities forming part of the same group, (2) related entities, and
(3) third parties. It therefore pertains to both external and internal interest payments.
Some countries have a group taxation regime that allows entities forming part of a group
to file their tax returns jointly, as well as jointly compute tax calculations (e.g. setting off
assessed losses between companies), while other countries require entity-level tax
liability calculations and filing. This may be a consideration when calculating internal
versus external interest. If information is collected on an unconsolidated basis, total NIE

would reflect both internal and external NIE. If information is collected on a consolidated
basis, internal interest payments would need to be estimated and added.
The Report on Action 4 recommends that countries also apply the rule to financial
payments equivalent to interest payments to mitigate the likelihood of avoidance by
taxpayers recharacterising interest payments into other forms similar to interest. For this
reason, it will be necessary to determine whether micro-data is also available for
capitalised interest on depreciable assets, the interest element of finance lease payments
and imputed interest on convertible bonds, for example. A non-exhaustive list of
examples is included in the Report on Action 4. Incorporating such interest payments into
the micro-simulation exercise is likely to result in an upward adjustment to NIE.
Adjustments
Once affected entities and total NIE have been determined, certain adjustments may need
to be incorporated. If the country legislates a de minimis threshold, all entities falling
below the threshold that would benefit from the carve-out will need to be dropped from
the population in the micro-simulation model. As part of the Action 4 best practice, it is
recommended that such a threshold be based on the total NIE of all entities in the local
group to avoid the possibility of fragmentation by establishing multiple entities, each of
which falls below the threshold.
Determining the appropriate measure of EBITDA

At this point, there would be an estimate of total NIE paid by entities that would be
affected by the rule. As NIE is the numerator in the fixed ratio rule, it will be necessary to
establish EBITDA for each affected entity. The best practice approach recommends that
the calculation of EBITDA be based on values that are determined under the tax rules of
the country. An entitys EBITDA should be calculated by adding back to its taxable
income, the tax values for: net interest expense and net payments equivalent to interest
payments, as well as depreciation and amortisation.31
This will enable the calculation of a NIE/EBITDA ratio for each affected entity, i.e. the
maximum amount that the entity would be allowed to deduct for tax purposes.
Applying the fixed ratio rule

The next step involves calculating the actual NIE that exceeds the fixed ratio (maximum
level of NIE/EBITDA). The excess interest would be disallowed as a deduction from
taxable income, resulting in an expansion in the corporate tax base. More than one fixed
ratio could be simulated to estimate the effects of different ratios.
Effect of a group ratio rule

The Report on Action 4 sets out a framework for a group ratio rule. Further work on the
design and operation of the rule will be conducted in 2016. If a group ratio rule is
implemented in addition to the fixed ratio rule, this would be to the advantage of
taxpayers and, to the extent that groups ratios exceed the fixed ratio, would result in a
reduction in total NIE affected. The Report on Action 4 notes that a country which
introduces a group ratio rule may want to have a lower fixed ratio.32
Applying an AMTR to the estimated increase in the tax base to arrive at a static
estimate
A micro-simulation model allows an appropriate tax rate to be calculated for each entity,
which could be applied to the estimated increase in the CIT base. Since any increase in
the corporate tax base will be taxed at the margin, the marginal tax rate is the most
appropriate measure.33 Using the top statutory tax rate may not be appropriate if there are
lower tax rates on certain taxpayers and/or accumulated tax credits or offsetting losses
that would lower the effective tax rate applied. It would be most appropriate to use the
effective tax rate calculated from the micro-simulation and note that it may be a
conservative estimate.
Incorporating behavioural effects

After estimating the static effects of the interest limitation rule, there are some
considerations to take into account for a dynamic estimate, including the potential of
carry-forward or carry-back rules and predictions on how taxpayers are likely to respond.
If, for example, the country is considering a carry-forward of disallowed interest, the
initial year effect would be unchanged from the static fiscal effect, but future years cash
collections would be lower due to additional interest deductions claimed from the carryforward. Similarly, if the country is considering a carry-forward of unused interest
capacity, that would be equivalent to increasing the effective fixed ratio for those
companies, thereby reducing future years cash collections. In modelling the timing of
cash collections when carry-forwards are allowed, the stock of unused interest or interest
capacity should be estimated and then the projected usage of that capacity over time
should be estimated. Information about the volatility of interest-to-EBITDA ratios over
time by individual companies through panel time-series data would be optimal to
incorporate into the modelling.
There are likely to be behavioural responses to the introduction of interest limitation
rules. Companies could respond to the rules by:
Substituting equity (new equity or retained earnings) for debt;
Relocating internal debt among affiliates within the domestic or MNE group.
Apart from countries that have an allowance for corporate equity (ACE) system,
substituting equity for debt would have a similar effect to the disallowance of interest.
Countries with an ACE system would need to consider the design and whether there is
potential for entities to receive a greater benefit from being able to deduct payments on
equity as opposed to debt. If this is the case, the revenue effect could be close to zero. If
entities switch to equity funding, it would be necessary to consider whether the decrease
in lending could impact tax revenue on interest income if the counterparty lenders are tax
resident in the country, as interest income would decrease with a decline in borrowing.
This could be offset by an increase in dividend income, which could increase withholding
tax (WHT) revenues.
Taxpayers could react by shifting internal debt to affiliates with lower NIE/EBITDA
ratios, or to affiliates in jurisdictions where interest limitation rules are not binding. The
degree of potential shifting is likely to be influenced by both tax and non-tax factors,
including the design (and strictness) of the interest limitation rule; whether multilateral
action is taken; the prevailing interest rate climate; and how flexible groups are given that
they may have central financing functions and the transaction costs associated with
shifting debt could be high.
Substituting equity for debt or shifting debt from the implementing country to another
country would result in a revenue increase for the implementing country. Only if the
shifting of debt is between entities within the same country, would the behavioural effect
reduce the implementing countrys revenue effect.
Since interest deduction limitations would result in an increase in the tax base, affected
entities would experience an increase in their effective tax rate. Empirical studies
showing behavioural responses to changes in tax rate differentials could provide some
insights into the potential behavioural effects that may arise due to the enactment of
countermeasures.
Ruf and Schindler (2012) summarise empirical evidence on the German interest
limitation rules introduced in 2008. Buslei and Simmler (2012) and Dreler and
Scheuering (2012) find that firms respond by reducing debt-to-asset ratios.
b.
Macro-data approach
If individual company tax return or financial information is not available for the analysis,
then a macro-level approach can be attempted. The steps set out below offer a potential
estimation strategy that countries could pursue.
Determining total NIE in the country

The first step involves estimating total NIE for firms that would be affected by the
proposal. There may be different possibilities according to data sources available in the
country:
Aggregate tax data on interest receipts and payments (Revenue Authority).
Aggregate financial account data on interest receipts and payments that may be
broken down by sector (National Statistics Office).
Aggregate financial account data on interest receipts and payments for the nonfinancial corporate sector (National Accounts).
If the Revenue Authority publishes aggregate information on interest payments and
receipts, this is a good starting point. This information may be published for
individuals/households and/or corporations, and may be broken down by sector. Drawing
solely on data for entities subject to the CIT would result in an underestimate given that
the best practice approach has a wider application, i.e. it includes non-corporate taxable
entities, many of which may be subject to taxation at the individual/household level.
There may be studies or other sources of data which could provide an idea of the portion
of personal income taxpayers that are likely to be engaged in business activities. In
addition, including all sectors could result in an overestimate, but this would also depend
on whether sectors other than the financial sector are excluded. The financial sector
generally receives more interest income than it pays and so may not result in an
overestimate.
Some countries may have aggregate financial account data by sector available. This
would provide aggregate NIE by sector, which is useful given that the Action 4 best
practice could differ in its impact in addressing BEPS involving interest in the financial
sector and other sectors. It will be important to determine which entities are included in
the statistics in order to compare with the entities that will be affected by the rule.
Depending on the design of the interest limitation rule, the affected entities in the data
may be over or underrepresented.
If none of the abovementioned options is available, aggregate financial account data may
be available for the non-financial corporate sector in the National Accounts most likely
produced by the central bank or National Statistics Office. The firms included in the nonfinancial corporate sector differ across countries and it will be necessary to check the
approach taken in the country. Some countries, for example, include quasi-corporations
in this classification.34 In the European Union (EU), only 7 out of 28 member countries
(Cyprus35, France, Hungary, Luxembourg, Romania, Slovak Republic and Spain) do not
employ the concept of quasi-corporation in their national accounts and, among the
remaining 21 member countries, only the Netherlands allocates all quasi-corporations to a
single institutional sector (i.e. the household sector). Hence, 20 out 28 EU member
countries have quasi-corporations in both their household and corporate sectors. Outside
the EU, there are also differing approaches, for example the United States does not use
the quasi-corporation concept, while South Africa does.
The OECD publishes data on interest payments and receipts for most OECD member
countries, as well as two non-OECD countries, one of which is a G20 country.
Table 3.A2.3 provides the NIE figure for these countries in 2012.36 The data provided for
the majority of countries has been adjusted for financial services indirectly measured
(FISIM), which estimates the difference between the higher interest rate that borrowers
pay in return for the financial service and the reference rate.37 Where information is
available, it is indicated whether quasi-corporations are included in the non-financial
sector.
The NIE figures in Table 3.A2.3 could be an over or under-estimate of affected NIE,
depending on how the interest limitation rules are designed. This will depend on which
entities are included in the National Accounts data compared to those affected by the rule.
With respect to the former, there are two important considerations: whether quasicorporations are included in the non-financial corporate sector, and whether interest
payments and receipts are recorded on a legal entity or enterprise group basis. This will
determine whether the aggregate NIE figure includes / excludes related party interest
payments. If it is based on the legal entity, NIE would include intra-group interest
payments and it will not be necessary to make an adjustment.
Table 3.A2.3. NIE by the non-financial corporate sector in billions of USD (2012)
Country
OECD
Austria
Belgium
Chile*
Czech Republic
Denmark*
Estonia
Finland
France
Germany
Greece
Hungary
Ireland
Italy
Japan*
Korea*
Mexico*
Netherlands
New Zealand
Portugal
Slovak Republic*
Slovenia
Spain
Sweden
Switzerland
United Kingdom
United States
Non-OECD
Colombia*
South Africa*
Entities included in non-financial

corporate sector
USD bn
Incl. quasi-corp
Incl. quasi-corp
Incl. quasi-corp
Only corp
8
5
5
4
2
1
7
59
19
6
4
9
47
(9)
30
44
13
8
7
1
1
49
17
9
46
350
Incl. quasi-corp
7
4
Incl. quasi-corp
Incl. quasi-corp
Incl. quasi-corp
Incl. quasi-corp
Only corp
Incl. quasi-corp
Incl. quasi-corp
corp
Incl. quasi-corp
Incl. quasi-corp
Only corp
Incl. quasi-corp
Only corp
Incl. quasi-corp
Only corp
Incl. quasi-corp
* Countries where the figure adjusted for FISIM was not available
Source: OECD National Accounts Database
An additional consideration in estimating total NIE is whether the available data includes
financial payments equivalent to interest. Interest expense may be capitalised into the cost
of goods sold, embedded in purchases from other businesses, lease payments, payments
under profit participating loans or under alternative financing arrangements, such as
Islamic finance; or imputed on instruments such as convertible bonds and zero coupon
bonds.38 Focusing purely on interest expense would likely yield a conservative estimate.
Depending on the definition of interest in the country, this could be mentioned as a likely
source of downward bias or if information is available, an upward adjustment could be
made to the change in the tax base.
Considerations for focusing on affected entities

Even though aggregate data does not allow distinction between stand-alone entities and
those that belong to a domestic or MNE group, the design of the rule (i.e. which entities it
would apply to) would influence the estimate of the fiscal effect.
There are a few scenarios which may require adjustments for affected entities. Examples
of where an adjustment would be necessary include:
The interest limitation rule could only apply to entities forming part of a MNE
group, but aggregate NIE data includes all non-financial corporations. This would
result in both an over and under-estimate of the change in tax base an overestimate in the sense that many corporations may not be part of a MNE group and an
under-estimate in the sense that non-corporate entities may be part of a MNE group.
The interest limitation rule would apply to entities forming part of a group (MNE
and domestic) and stand-alone entities; however only aggregate NIE data from
National Accounts is available which covers non-financial corporations, but
excludes quasi-corporations. This would result in an under-estimate of the change in
tax base.
While there may not be any micro-data to draw on, there are potential other sources that
could be used to gauge the share of MNEs operating in the economy. For example, if the
central bank or National Statistics Office produces data on net or gross operating surplus
(NOS/GOS), it may be possible to find out the share of this that is attributable to MNEs
and use this information to assist with applying a factor to aggregate NIE data
(recognising that the share of NOS or GOS may not be directly linked to the share of
NIE).
An additional strategy to find out more about MNE and domestic groups, as well as large
stand-alone corporates, is analysing the financial statements of the top 25/50/100
groups/companies operating in the domestic jurisdiction as the largest groups are likely to
have the biggest interest deductions, or alternatively a stratified statistical sample could
be used. Deciding on an appropriate number of firms/groups will depend on the size of
the economy and other domestic factors, such as whether there is an appropriate
representation of sectors in the sample chosen. This could provide an indication of the
total external NIE if considered on a consolidated basis, or total (internal and external)
NIE if financial statements are published on an unconsolidated basis. This would provide
a useful comparison to NIE published in National Accounts data.
Adjustments
If an adjustment is required to add internal interest, a parameter will be required that
extrapolates from external NIE to total NIE. This would be necessary, for example, if
relying on aggregate National Accounts data that collects information based on the
enterprise group as opposed to legal entity as it would only include external NIE.
Estimates of internal interest to total interest could be taken from empirical studies.
Although not ideal, basing an adjustment for internal interest on the academic literature
may be more accurate than implicitly assuming zero internal interest by MNE affiliates.
The current literature, based on two datasets the German Bundesbank MiDi dataset and
the United States Bureau of Economic Analysis (BEA) dataset, finds the internal/external
debt ratio averages around 0.4, while internal/total debt is approximately 0.3.39 It should
be noted that both Germany and the United States have higher than average statutory
corporate tax rates, and thus may have higher internal debt ratios than countries with
lower statutory corporate tax rates.
Implementing a de minimis rule to exclude entities from the rule requires a downward
adjustment to the total NIE estimate. There may be information on small and mediumsized enterprises that is based on employees or turnover, which could be useful in making
an adjustment.40 Smaller firms may have higher interest ratios than larger firms, and
academic studies find that domestic-only firms have higher interest ratios than similar
sized MNE firms. However, if domestic-only firms are smaller than MNEs on average,
the percentage of NIE above the de minimis threshold may be lower than the average for
all firms.
Given that a fixed ratio rule would only affect entities in a tax-paying position, a
downward adjustment could be made to reflect this. It is important to consider this in
conjunction with the de minimis threshold as many of those in an assessed loss position
may fall below the de minimis threshold. Even though micro-data may not be available,
the Revenue Authority may produce aggregate statistics showing the portion of
corporations in an assessed loss position. This could assist in deciding on a suitable factor
for adjusting downwards, and could be more refined if the statistics are done by taxable
income groups.
Applying the fixed ratio rule

This requires a determination of how much NIE would exceed the fixed ratio
(NIE/EBITDA) and is challenging to do without access to any micro-data. Relying on
financial statements of the top groups / corporations would be a good starting point,
although this would be based on financial account, not tax, data. In addition, if relying on
published consolidated information, this would exclude intra-group interest payments.
Nevertheless, it may provide some assistance in making a reasonable assumption on the
amount of NIE that would exceed the fixed ratio.
A further consideration is the likely heterogeneity of the NIE/EBITDA ratios within a
MNE group. Micro-data for large non-financial MNEs shows that 45% of affiliates gross
interest expense (GIE) is in excess of their groups GIE/EBITDA ratio. Affiliates GIE
will include both internal and external interest as it is based on unconsolidated data,
whereas group ratios only include external interest from consolidated data. Judgement
will be required on whether to make an adjustment for this variation of fixed ratios within
a group, which could be combined with an extrapolation to include internal interest.
Effect of a group ratio rule

For incorporating a group ratio rule, the approach will be the same as under the microapproach above.
Applying an AMTR
Once the increase in the tax base (total NIE in excess of the NIE/EBITDA ratio) has been
estimated, it will be necessary to apply an AMTR to the increase in the tax base. Given
that the base broadening effect of interest limitation rules will result in more taxable
income being taxed at the margin, the statutory tax rates may be a suitable starting
point.41

The ability to carry forward either affected interest deductions or excess capacity results
in a timing issue that will need to be factored into the annual estimates.
For behavioural considerations, the approach will be the same as under the microapproach above.
Other countries fiscal estimates of excess interest countermeasures
In addition to other countermeasures, Table 3.A2.1 provides the fiscal estimate of
unilateral interest countermeasures in selected countries as a percentage of their total
corporate tax revenue. Measures that were estimated or implemented in prior years would
likely yield higher fiscal estimates compared with estimates produced today as these prior
measures were introduced during a period of higher interest rates. The point in the
business cycle at which the measure was estimated (and implemented) is also important
as the revenue effects are shown as a percentage of CIT revenues, which are volatile
across the cycle. The fiscal estimate also depends on whether a country implemented
other policy measures simultaneously that may have influenced the fiscal estimate for
interest countermeasures (e.g. depending on the order in which the estimates were
stacked). Also, if these countries had existing interest limitations rules, then the fiscal
estimate would be for only the incremental revenue effect of the new interest limitation,
not the effect of the countrys total interest limitation.
If implementing more than one BEPS countermeasure simultaneously, revenue estimates
would need to take into account interactions of the various provisions. The Actions in
respect of transfer pricing address the mispricing of interest, while Action 4 is focused on
curbing interest deductions resulting from excessive leveraging. If both the transfer
pricing guidance and interest limitation countermeasures are adopted, care will need to be
taken to remove potential mispricing corrections from the Action 4 fiscal estimate.
Action 4 could also interact with the measures proposed under Action 2 (hybrid mismatch
arrangements). Hybrid mismatch arrangement countermeasures may lead to the
disallowance of certain interest expense deductions, which could reduce the interest-toEBITDA ratio of firms affected by hybrid countermeasures. If data becomes available
about reduced interest deductions from hybrid mismatch arrangements, or an estimate of
that is made for another proposal, then it could be factored into the total NIE affected.
Action 1 (Address the Tax Challenges of the Digital Economy)
The Report on Action 1 (Addressing the Tax Challenges of the Digital Economy, OECD,
2015c) examines a number of tax policy issues specifically linked to the digital economy,
its business models, and its key features. It notes that because the digital economy is
increasingly becoming the economy itself, it would not be feasible to ring-fence the
digital economy from the rest of the economy for tax purposes. Although the digital
economy does not generate unique BEPS issues, some of its key features exacerbate
BEPS risks. These risks are addressed in the BEPS Action Plan in the context of the work
on Actions 3 (Strengthening CFC Rules), 7 (Preventing the Artificial Avoidance of PE
Status), and 8-10 (Ensure that Transfer Pricing Outcomes are in Line with Value
Creation).
The Task Force on the Digital Economy (TFDE) discussed and analysed several potential
options to address these broader tax challenges raised by the digital economy issues.
Specifically, they are considering three tax policy options for more effectively imposing
taxes on activities related to foreign sellers without a PE in the country. The three tax
policy options are:
Modifications to the PE threshold and associated profit attribution rules for the CIT
on the net income generated from remote sales of digital goods and services to incountry customers by a foreign producer without PE status under current law;
The introduction of an excise tax on certain types of digital transactions; and
The imposition of a WHT on the gross receipts from certain types of digital
transactions.
Recommendations for enabling the collection of value-added tax (VAT) in business-toconsumer (B2C) digital transactions is included as part of the OECD International
VAT/GST Guidelines, which will protect tax revenue.
Fiscal estimation issues
For estimating the direct tax fiscal effects of modifications to the permanent
establishment threshold that affects remote sellers of digital goods and services, the
approach will be the same as that described for the fiscal estimate of Action 7 below.
Estimating the fiscal effects of introducing an excise tax or the imposition of a WHT on
certain types of digital transactions would follow the revenue estimating procedures
outlined above in the section discussing the general approach to undertaking a fiscal
estimate. Both taxes would be based on gross receipts of the identified transactions;
therefore, the tax base should be similar under either proposal.
The first step in estimating the fiscal effects of adopting one of the alternative tax
proposals would be to estimate the amount of existing sales for each type of eligible
digital transactions that would be subject to the new excise or WHTs. Industry reports or
country-specific estimates from public databases, such as the Eurostat e-commerce
statistics, could be used to estimate the potential tax base, although the amount would
need to be separated between the sales of remote sellers without a current PE from sales
of remote sellers with a current PE.
It would be important to distinguish between sales to final customers (households) and
intermediate sales to businesses in estimating the base. Potential behavioural responses
should also be considered, such as reductions in the digital transactions in response to
higher tax-inclusive prices along with substitution away from digital transactions from
remote sellers without a current PE to alternative transactions (both digital and nondigital) from sellers with a PE. The resulting estimate of the change in the tax base would
be multiplied by the applicable tax rates to determine the expected fiscal effects.
Finally, estimates of the fiscal effects of indirect tax changes through the collection of
VAT in B2C transactions would be based on the expansion of the VAT tax base
multiplied by the applicable VAT rates. Substitution of non-digital transactions for digital
transactions would not affect the expected collections (except for scenarios where
different VAT rates would apply).
Action 2 (Hybrid Mismatch Arrangements)
Hybrid mismatch arrangements are transactions which exploit cross-border differences in
the treatment of instruments and entities to produce a mismatch in tax outcomes. A
mismatch is either two deductions of the same payment (i.e. a double deduction (DD)
outcome) or a deductible payment that is not included in the tax base by the recipient (i.e.
a deduction/no inclusion (D/NI) outcome). Part I of the Report on Action 2 (Neutralising
the Effects of Hybrid Mismatch Arrangements, OECD, 2015d) sets out recommendations
for domestic rules intended to neutralise DD and D/NI outcomes for hybrid financial
instruments (such as instruments which are considered debt in one country and equity in
another) and hybrid entities (such as entities and arrangements that are considered
fiscally transparent in one country and fiscally opaque in another). Part I of the Report on
Action 2 further contains an imported mismatch rule that applies to both structured and
intra-group arrangements and that can be applied to any payment that is directly or
indirectly set-off against any type of hybrid deduction.
In the case of direct and indirect D/NI outcomes, part I of the Report sets out
recommendations for rules to deny a deduction in the payer jurisdiction as a primary rule
and, in the case of DD outcomes, the primary recommended rule is to deny a deduction in
the parent jurisdiction. The hybrid mismatch rules also have secondary recommended
rules that apply in the counterparty jurisdiction in the event that the primary rule is not
applied.
Part II of the Report on Action 2 sets out recommended changes to the OECD Model Tax
Convention aimed at ensuring that hybrid instruments and entities, as well as dual
resident entities, are not used to obtain unduly the benefits of tax treaties and that tax
treaties to not prevent the application of the changes to domestic law recommended in
part I.
Potential data
An economic analysis of hybrid mismatch arrangements requires detailed company-level
data. It requires not only information on transactions between related parties but also on
their tax treatment in both the payer and recipient jurisdictions. Such data is rarely
available through public sources, and only available to tax administrations making extra
efforts to identify such arrangements, including requesting additional information from
taxpayers. Estimates by government analysis would require information from tax
administration audit teams about the number and scale of existing hybrid mismatch
arrangements in the country.
Other countries fiscal estimates
Several countries have introduced or proposed countermeasures intended to address DD
and D/NI outcomes for which annual fiscal estimates have been made:
France introduced in January 2014 measures limiting deductibility of interest if it is
subject to a low tax rate at the level of the beneficiary. The estimated revenue effect
is an increase in CIT revenue by 0.9%.
The United Kingdom proposed in December 2014 measures in line with the Action 2
recommendations. The estimated revenue effect is an increase in CIT revenue by
0.2%.
The United States proposed measures limiting deductibility of interest and royalties
if there is no corresponding inclusion at the level of the recipient in the foreign
jurisdiction. The estimated revenue effect is an increase in CIT revenue by 0.04%.42
These estimates assume a large behavioural response due to MNEs ability to restructure
their financial arrangements around unilateral countermeasures. For example, rules that
deny a deduction for payments under a particular cross-border financing arrangement that
give rise to a D/NI outcome may simply encourage taxpayer groups to enter into the same
arrangement under the laws of another jurisdiction and then use a back-to-back loan
structure to import the effect of the mismatch into domestic law, thus converting a direct
D/NI outcome into an indirect D/NI outcome that is outside the scope of the countrys
rules.
The expected behavioural response to unilateral action by one country is the main reason
for the low estimated revenue effects. The recommendations under Action 2 are intended
to prevent taxpayers from obtaining any advantage under any jurisdiction in respect of
these types of arrangements, making them more effective than unilateral and uncoordinated action. If hybrid mismatch recommendations are implemented in many
countries simultaneously with a rule to address indirect D/NI outcomes, there will be
significantly less opportunity for companies to restructure their financial affairs to avoid
the effect of the recommended rules. Thus, hybrid arrangements would be expected to
increase corporate revenues by more than that generated from unilateral actions, provided
multilateral co-ordinated implementation of Action 2 occurs. The revenue from
implementation of the Action 2 recommendations is not expected to come from
disallowed deductions or disallowed exemptions under the hybrid mismatch rules
themselves, but rather from MNEs ceasing to structure themselves and their transactions
in such a way as to exploit mismatches, and thus not claiming the deductions or
benefitting from exempt income.
Rules recommended under Action 9 on transfer pricing of risk and capital and Action 4
on interest deductibility would decrease the benefit of many hybrid mismatch
arrangements by limiting possibilities of achieving tax reduction via interest payments. In
addition, the combination of hybrid mismatch arrangement rules with treaty abuse rules
will reduce tax planning opportunities, and thus will have a greater effect together than
the sum of the individual effects.
Action 3 (Controlled Foreign Corporation Rules)
The Report on Action 3 (Designing Effective Controlled Foreign Company Rules, OECD,
2015e) provides guidance based on best practices for the building blocks of effective CFC
rules, while recognising that the policy objectives of these rules vary among jurisdictions.
It identifies the challenges to existing CFC rules posed by mobile income, such as that
from intellectual property, services and digital transactions, and allows jurisdictions to
reflect on appropriate policies in this regard. The report emphasises that CFC rules have a
continuing, important role in tackling BEPS, as a backstop to transfer pricing and other
rules.
CFC rules are designed to protect a countrys tax base by preventing shifting of mobile or
passive income to a CFC. In the case of parents in territorial tax countries, CFC rules
prevent the shifting of particular income to benefit from exempt foreign source income.
In the case of parents in the countries that have a worldwide tax system with deferral,
CFC rules prevent the shifting of particular income to benefit from deferral of such
income.
The Report on Action 3 recommends that, in addition to corporate entities, CFC rules
could also apply to partnerships, trusts and permanent establishments when those entities
raise BEPS concerns, which could occur if they are either owned by CFCs or treated in
the parent jurisdiction as taxable entities separate from their owners.
A tax rate exemption is recommended, pursuant to which CFC rules would not apply if
the CFCs effective tax rate were higher than a set threshold.43 The Report on Action 3
notes that resident shareholders should only be taxed on income earned by a foreign
company if they appear to have had some input in how, when and where that income was
earned. The Report on Action 3 recommends that CFC rules should at least apply both a
legal and an economic control test so that satisfaction of either test results in control, and
a CFC should be treated as controlled where residents directly or indirectly hold 50% or
more of the voting rights, but the report allows the option for a lower control threshold if
countries want to achieve broader policy goals or prevent circumvention of CFC rules.
Once an entity has been identified as a CFC, it is necessary to determine which income
will be attributable to shareholders or controlling parties.44 The Report on Action 3
describes multiple approaches to determining CFC income. CFC rules generally define
attributable income in the context of income earned by CFCs raise BEPS concerns, which
may include, among other things, income earned by CFCs that are holding companies,
provide financial and banking services, engage in sales invoicing, as well as income from
IP assets, digital goods and services, and captive insurance and re-insurance. The report
describes three approaches: a categorical analysis, a substance analysis, and an excess
profits analysis. Regardless of which approach is followed, the country will also need to
decide whether the approach applies to entities or transactions. The Report on Action 3
notes that the transactional approach may be more consistent with both the goals of the
BEPS Project and European Union law.
Depending on the definition of CFC income used in the country, the following types of
income are often included in CFC rules:
Dividends paid out of passive income that is not actively managed by the CFC.
Interest and other financing income, unless the CFC had the required substance to
earn the income and was not overcapitalised.
Specific service income, unless the CFC had the required substance to earn the
income, including:
Insurance income that was earned from a related party or where the parties to
the insurance contract or the risks insured are located outside the CFC
jurisdiction
Sales and services income
Royalties and other IP income
Once the level of CFC income has been determined, a tax rate is applied. CFC income is
generally subject to the tax rate of the parent company in the parent jurisdiction. The
Report on Action 3 also describes an option referred to as a top-up tax, which would
only subject CFC income to the difference between the tax paid in the CFCs jurisdiction
and a threshold rate.
The fiscal analysis begins with the specific CFC rules adopted by a country. The Report
on Action 3 sets out recommendations in the form of building blocks, but acknowledges
that jurisdictions will have different policy objectives for their CFC rules. Therefore these
recommendations are not minimum standards, but they are designed to ensure that
jurisdictions that choose to implement them will have rules that effectively prevent
taxpayers from shifting income into foreign subsidiaries.

The analysis should identify the key elements outlined above to ensure that, where data
permits, the appropriate income streams attributable to the appropriate entities are
captured by the fiscal estimation exercise.
Estimating the amount of CFC income affected

If tax return information is available that identifies whether a domestic entity has a CFC,
as well as the income earned by the CFC that should be attributable to the parent
company, a micro-simulation exercise would be possible as all the CFC income could be
identified and the appropriate tax rate calculated on an entity basis. For many countries, it
may be the case that tax return information does not provide analysts with the necessary
level of detail, such as disaggregated income sources defined as CFC income.
In such instances, a potential solution would be to identify income flows from passive
assets held by entities in countries where the tax rate is lower than the tax rate threshold
put in place for CFC rules. This would be similar to the strategy used by Ruf and
Weichenrieder (2012; 2013) who analysed passive assets held by firms that were at least
90% owned by a German parent. The analysis was based on the MiDi dataset from the
German Bundesbank, which provides balance sheet information on affiliates of German
MNEs. Many countries may not have access to similar data which, in the absence of
micro-data from tax returns, would require using macroeconomic data.
Relying on macroeconomic data could be done with some assumptions. It would be
necessary to (1) identify those countries where CFCs tax rates are likely to be below the
threshold set for the tax rate exemption; (2) determine which types of income would be
subject to the parent countrys CFC rules and identify possible data; (3) assume the
portion of these income streams that would be earned by CFCs controlled by domestic
parent companies; and (4) assume the portion of the income that would be classified as
CFC income. If information on income flows is not available, but balance sheet
information is available, it may be possible to impute income from passive assets held
using an assumed rate of return.
Table 3.A2.4 outlines potential data from five macro-economic sources that might be
used to estimate CFC income.
Table 3.A2.4. Potential data sources for CFC income
Potential CFC income
Description
Potential Source
Dividends
Dividend income that should be

classified as CFC income is likely to
include dividend income from FDI
equity holdings
Balance of payments data
Interest & other

financing
Interest income that should be

include:
Lending to other
affiliates (could be an
overleveraged parent)
Bond holdings (portfolio
investment)
Bank deposits (reflected
in reinvested earnings)
Balance of payments data
Insurance income
Insurance income that should be

include insurance income from a
related party or where the parties to
the insurance contract or the risks
insured were located outside the
CFC jurisdiction, unless the CFC had
the required substance to earn the
income.
Insurance income is captured in Trade in Services, which is

recorded on a bilateral basis in the BOP, but is generally not
broken down by disaggregated service items or affiliation.45
Sales and services

income
Sales and services income that

should be classified as CFC income
is likely to occur as a result of the
digital economy and/or when a CFC
adds very little value but sells a
good/service
Data on the value of purchases and sales via the internet (and/or
networks other than the internet) of companies by country (EU,
2010-2014)
http://ec.europa.eu/eurostat/web/informationsociety/data/database
United States data on measuring the electronic economy:
www.census.gov/econ/estats/
European Multi-Channel Online Trade Association:
www.emota.eu/#!statistics/ccor
Income from IP,

including royalties
Income from IP that should be

classified as CFC income includes
payments that reflect the returns on
intellectual property.
Ownership of acquired patent rights
is another potential source for
information given that payments for
the use of IP are grouped with other
service payments in the trade data.
These payments are captured in Trade and Services as

described for insurance income and, for the majority of countries;
it is not possible to separate the different service items.
Applying an appropriate tax rate

Once there is an estimate of CFC income, it will be necessary to apply an appropriate tax
rate either that of the parent country or a minimum tax depending on the design of the
CFC rules. The tax rate should be an AMTR since the additional CFC income would be
incremental to the existing taxable income.46
Empirical literature
There are some empirical studies that examine the effect of CFC rules on MNE
behaviour. The results generally show that the presence of CFC rules dissuade MNEs
from using low-tax jurisdictions. Markle and Robinson (2012) investigate whether CFC
rules, bilateral tax treaties and WHTs affect the tax behaviour of MNEs. Using ORBIS
and COMPUSTAT data, the findings suggest that both the taxing of foreign profits
(through a credit or worldwide system) and the presence of CFC rules reduce the
likelihood of a MNE using a tax haven. In addition, the wider the scope of income that is
subject to CFC rules, the lower the likelihood that a MNE uses tax havens.
Ruf and Weichenrieder analysed the German CFC rules in two separate analyses. Both
analyses are based on the German Bundesbank Micro-database Direct Investment (MiDi)
data on German MNEs (outbound investment)47. The 2012 analysis investigates the effect
of German CFC rules on the location of passive assets within German multinationals. The
analysis investigates whether exceeding the tax rate threshold has an impact on the
allocation of passive investment and finds that German CFC rules have a significant and
predictable impact on multinational financing and are effective in limiting the shifting of
passive assets. While passive investments make up a significant fraction of German
outbound FDI, they found German CFC rules are effective in restricting investments in
low-tax jurisdictions.
Their 2013 study investigates the effect of the change of Germanys CFC legislation in
response to a decision by the European Court of Justice (ECJ), which ruled that German
CFC legislation infringed on the freedom of establishment within the European Union,
and thus could not be applied to CFCs in EU countries. The analysis found that after
liberalising CFC legislation in response to the ruling, passive investments in low-tax
European countries increased compared to low-tax non-European countries, signalling
that the prior CFC rules limited shifting of passive investments of German MNEs to other
EU countries.
There are interactions between CFC rules and transfer pricing rules. If, for example, CFC
rules apply a sufficiently high rate of tax, certain transfer pricing outcomes may become
irrelevant to the MNE as the benefit of engaging in transfer pricing manipulation would
be removed. If proposed at the same time, a careful assessment of the likely interactions
and overlap between the two countermeasures would be appropriate.
Action 5 (Harmful Tax Practices)
Current concerns on harmful tax practices are primarily about preferential regimes which
can be used for artificial profit shifting, and a lack of transparency in connection with
certain rulings. The Report on Action 5 (Countering Harmful Tax Practices More
Effectively, Taking into Account Transparency and Substance, OECD, 2015f) sets out an
agreed methodology to assess whether there is substantial activity in a preferential
regime. In the context of IP regimes, consensus was reached on the nexus approach.
The nexus approach uses expenditure as a proxy for activity and allows a taxpayer to
benefit from an IP regime only to the extent that the taxpayer incurred qualifying R&D
expenditures that gave rise to IP income. The same principle can also be applied to other
preferential regimes so that such regimes are found to require substantial activity where
the taxpayer undertook the core income-generating activities.
In the area of transparency, a framework has been agreed for the compulsory spontaneous
exchange of information on rulings that could give rise to BEPS concerns in the absence
of such exchange. The results of the application of the existing factors applied by the
Forum on Harmful Tax Practices (FHTP), and the elaborated substantial activity and
transparency factors, to a number of preferential regimes are included in the Report on
Action 5.
The work of the FHTP and the agreed approach on substantial activities will have
positive impacts on CIT collections as the use of preferential tax rate regimes will be
restricted to taxpayers with sufficient economic activities in the country. This will be
expected to lead to an increase in taxes in the country with such a regime, as well as other
countries.
In a country with a fiscal regime favouring geographically mobile income, Action 5 and
the application of the elaborated substantial activity factor will reduce harmful tax
practices and be expected to result in an increase in tax revenue, assuming no change in
the base, due to the application of a higher general tax rate to the income that no longer
qualifies for a preferential tax regime. Reduced harmful tax practices will help reduce
BEPS and will be expected to lead to an increase in corporate tax bases and tax
collections in other countries.
Empirical evidence
Several studies show that corporate tax rates are an important factor for patent location
decisions and IP boxes have a strong effect on attracting patent registrations; it is
recognised, however, that patent locations may not mirror the location of R&D activities.
The studies use the number of patent applications as the dependent variable and the
corporate tax rate as one of the explanatory variables. For example, Karkinsky and Riedel
(2012), based on data from the European Patent Office (EPO) for a number of European
countries over the 1978-2007 period, estimate a semi-elasticity of -3.8 to -3.5; that is, a 1
percentage point decrease in the rate of corporate tax translates into a 3.5 to 3.8% increase
in patent applications in that country.
Griffith, Miller and OConnell (2014), based on data from the EPO on patents located in
14 European countries, estimate semi-elasticities that range from -3.9 to -0.5. They also
simulated the impact of the enactment of a new IP box on tax revenue and found that they
result in losses in government revenues because they do not attract enough IP income to
offset the revenue loss from the preferential tax rate application on current IP income.
While empirical studies show high responsiveness of MNEs to shifting mobile income,
the responsiveness of shifting real economic activity is significantly smaller. DeMooij
and Ederveen (2008) use a meta-analysis of other empirical studies to estimate an
extensive FDI investment margin of -0.65, which is considerably smaller than the
elasticities estimated for patent registrations. Similarly, a European Commission (2015)
working paper reports relatively low estimates of the responsiveness of research and
development expenditures.
A nexus requirement will reduce the amount of mobile income shifted as a result of
preferential tax regimes, and will reduce BEPS associated with harmful tax practices.
As a response to Action 5, countries will remove or amend certain preferential tax
regimes. The effect on the country with an existing harmful tax practice can be estimated
by the change in the tax base and the application of the higher general tax rate.
Revenue increases to other countries will more likely occur in the future as income
shifting is reduced due to the reduction of harmful tax practices. One possible approach to
estimating the fiscal effect would be to estimate the increase in the average AMTR,
compared to what the average AMTR would have been with harmful tax practices, and
use the methodology described in the transfer pricing Actions.48
The potential revenue gained from increased transparency due to the exchange of
information will also be difficult to estimate, partly because the fiscal effects will depend
upon the actions of other governments and the effect of reductions in harmful tax
practices on relative marginal tax rates that create profit shifting incentives.
To the extent that additional information is received by a country as a result of the
compulsory spontaneous exchange of information on rulings, tax administration auditors
could provide insights on the potential revenue effects in the country.
Potential interactions with other BEPS Actions
There are potential overlaps with other BEPS Actions. Rules recommended under Action
8 on transfer pricing of intangibles would require any transactions which result in the
shifting of income to take advantage of tax rate differentials are to be in accordance with
the arms length principle.
Action 6 (Prevent Treaty Abuse)
The Report on Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances, OECD, 2015g) includes a minimum standard on preventing treaty abuse
including through treaty shopping and new rules that provide safeguards to prevent treaty
abuse and offer a certain degree of flexibility regarding how to do so. The new treaty
abuse rules address treaty shopping which involves strategies through which a person
who is not a resident of a country attempts to obtain the benefits of a treaty concluded by
that country e.g. WHT reductions, through an intermediary established in that state. More
targeted rules have been designed to address other forms of treaty abuse.
Tax treaties are intended to reduce or eliminate double taxation of international income
flows, including cross-border dividends, royalties and interest. In general, these income
flows can be subject to several levels of taxation: CIT in the host country on profits
realised in that country that are subsequently distributed as dividends, WHTs on
international income flows, or CIT to be paid in the recipient country subject to double
taxation relief, such as foreign tax credits or dividend participation exemptions.
The part of the Report on Action 6 that deals with treaty shopping provides that the
OECD Model Tax Convention will include:
A new preamble for tax treaties according to which tax treaties are not intended to
create opportunities for tax evasion and avoidance, in particular through treaty
shopping.
A limitation-on-benefits (LOB) rule or a principal purposes test (PPT).
While the LOB rule addresses treaty-shopping situations based on the legal nature,
ownership in, and general activities of, residents of a Contracting State, the PPT rule
focusses on transactions, denying treaty benefits where one of the principal purposes for a
transaction or arrangement was to obtain treaty benefits. Although the rules target treaty
shopping differently, they would both allow treaty benefits to be granted to intermediaries
in some cases, primarily where sufficient income-earning activities are exercised by these
entities. There is agreement that, in these cases, the establishment of intermediaries is not
motivated by treaty shopping considerations.
Tax optimising MNEs make use of treaty networks to minimise their WHT payments by
establishing intermediaries in conduit countries. While the simplest case involves only
one intermediary, tax planning may involve the routing of international income flows via
a chain of several conduit entities located in different countries. The effects of treaty
shopping on country-level revenues, therefore, depend on the position of the country
(within which the entity is located) in the treaty network. In principle, estimation requires
not only information on statutory WHT rates, double taxation relief methods and existing
tax treaties, but also on possible interactions across the treaty network.
Tax avoidance induces a diversion of international income flows, for instance through
Special Purpose Entities (SPEs), which may not be captured by existing data sources. As
a result, revenue effects may differ by country depending on its position in the treaty
network and the routing of international investment flows.
An evaluation of the countrys existing treaty network could be an initial step in the
analysis of the fiscal effects of treaty shopping. Tax treaties are designed to reduce double
taxation and stimulate reciprocal investment. The number of tax treaties and the amount
of treaty-related tax reductions do not per se provide insights about the existence or the
fiscal effect of treaty shopping. However, an indication about a countrys exposure to
treaty shopping may be obtained by identifying, first, potential conduit countries within
its network and, second, total outbound payments to relevant entities. UNCTAD (2015)
developed such an approach based on the bilateral corporate (inward) investment stock
from the IMF CDIS. As a first step, conduit countries may be identified by a set of
observable characteristics such as, for instance, low WHT rates, generous relief methods,
preferential tax regimes and a large number of treaty links. Second, outbound payments to
these countries can be retrieved from the CDIS. If bilateral SPE data is available, flows to
SPEs in other countries may also be included. The sum of these outbound payments is an
upper-bound estimate of the flows affected by treaty shopping.
The estimation of the fiscal effects of Action 6 countermeasures is dependent on available
data sources. Countries where data on international income flows and WHT revenues are
available will have a better empirical basis for their estimate. This approach is described
in subsection (a). If this information is not available, estimation procedures will have to
rely on other, often much less specific, data sources and results will therefore be less
certain, as described in subsection (b).
a.
Fiscal estimation based on country-specific data
Estimating the fiscal effects of Action 6 based on country-specific data requires

information on the following key variables:
Outflows of dividends, royalties and interest (by partner country);
WHT bases if there are exemptions (by income type);
WHT revenues (by income type); and
Reduced treaty tax rates (by income type and country).
Although data on international flows of dividends, royalties and interest are publicly
available from various sources, bilateral flows reported in these databases are typically
incomplete due to confidentiality reasons.49 The required information on income flows
and WHTs may, in some countries, be available from the Central Bank or other public
institutions.
Using this data, a fiscal estimate can be calculated by drawing upon of the following
elements:
Definition of the tax bases, accounting for exemptions and tax treaties;
Weighted average WHT rate under current law;
Outgoing dividend, royalty and interest payments affected by treaty shopping;
and
Weighted average WHT rate under the adoption of Action 6 countermeasures.
The first step in estimating the effects of treaty abuse countermeasures would be to derive
an estimate of the tax base for each of the income types. It may be necessary to make a
downward adjustment to the tax base to account for potential WHT exemptions, before
applying an appropriate tax rate. If the tax base is not affected by tax treaties, the
weighted average tax rate can be computed by weighting the bilateral tax rates (standard
or reduced) by the income flow associated with the respective country-pairs. This is
straightforward if outflows and tax rates are available by partner country. Otherwise,
additional information, for instance, FDI stocks, can be used to determine the weights. If
tax treaties affect the definition of the tax base, then a similar approach can be used.
Exempted income flows which may become subject to taxation due to the
countermeasures could be treated as zero-rated and included in the tax base.
To estimate the effect of the countermeasures an additional assumption about the
expected increases in the average WHT rate need to be made. While this will entail
estimation (i.e. with regard to the effectiveness of the countermeasures), available data on
bilateral income flows may be used to provide empirical guidance. It has been suggested,
for instance, that an initial evaluation of the treaty network may help identify potential
conduit countries. Provided data on income flows to these countries is available, the
magnitude of the affected outflows can be estimated. If bilateral income flows to conduit
countries are not observed, other variables, such as e.g. FDI stocks, may be used as an
approximation. Separate FDI data series on SPEs may also be drawn upon to obtain a
more comprehensive picture of the relevant outflows (see UNCTAD, 2015, for a detailed
description).
As treaty benefits will be denied for transactions motivated by treaty shopping under the
Action 6 recommendations, the respective income flows will be reallocated for tax
purposes. Outflows to conduit countries, for instance, may now be treated as if they were
payments to the ultimate counterparty. The increase in the average WHT rate can be
captured by an adjustment in the weights associated with each country pair. Since the
final destination of the income flow in the counterfactual scenario remains unknown, a
proportional increase in the weights of all non-conduit countries could be a reasonable
starting point. Possible feedback based on audit experiences may also be used at this step.
Based on this approach, the affected outbound payments as well as the weighted average
WHT rates under current law and Action 6 can be approximated. Since potential effects
of the countermeasures on exempted income flows have been accounted for, the
approximated tax base does not change in the Action 6 countermeasure fiscal estimate.
The estimated revenue change equals the change in the weighted average WHT rate times
the total outbound payments estimated to be affected by treaty shopping.
b.
Fiscal estimation based on publicly available data
The approach presented in this section provides an example of how results from recent
academic publications can be combined with publicly available data sources to derive an
initial estimate. The following information is required:
Outbound payments of dividends, royalties and interest from BOP statistics;
Reduced treaty tax rates on royalties and interest; and
Country-level tax revenue estimates from the network analysis by Vant Riet
and Lejour (2014)50
BOP statistics include outgoing flows between related parties for dividends and interest
(BOP, current account, primary income, direct investment income). However, royalty
flows are not reported in the section on direct investment income but as a part of the
goods and services section (BOP, current account, goods and services, charges for
intellectual property). These flows include royalty flows between related and unrelated
parties. While dividend and interest flows from portfolio investments are separated in the
BOP data, further adjustments are necessary to isolate royalty flows between related and
unrelated parties.
Publicly available data can be combined with results from a recent publication which
provides information on country-level tax revenue effects with and without treaty
shopping. Vant Riet and Lejour (2014) use a network approach to map the tax incentive
structure faced by MNEs. The analysis includes 108 jurisdictions and builds on country
level information on CIT, WHTs and double taxation relief methods. In addition,
information on treaty benefits from existing bilateral tax treaties are used to calculate the
tax minimising indirect payment route between all possible pairs of countries.
The analysis shows that the FDI-weighted world average tax rate on dividend flows,
taking unilateral double tax relief and bilateral tax treaties into account, is around 11%.51
Comparing taxation on indirect and direct routes shows that treaty shopping reduces the
FDI-weighted world average by an upper bound of 44% (i.e. to 4.8%). While the world
average effect may not be indicative for individual countries, the paper also includes a
more detailed table providing revenue effects from WHT by country. Potential countrylevel WHT revenues with and without treaty shopping are reported as a percent of total
outgoing dividend flows. Based on this information, a fiscal estimate of the maximum
effect that could be obtained by eliminating treaty shopping can be derived by
multiplying the results with corresponding outflows of FDI dividends. Information at the
country level may be helpful to scale the upper bound estimate to a realistic estimate of
the fiscal effects for the country.
Two sets of additional assumptions could be necessary for an analysis of the fiscal effects
of Action 6 countermeasures. First, the results from the network analysis only include the
effects from dividend payments between related parties. To account for the effects from
royalty and interest payments, the revenue results from dividends could be applied to
other income flows. This can be done by calculating the proportional reduction of
statutory WHT rates on dividends that result from bilateral treaties and treaty shopping
(i.e. indirect routing) respectively. Applying these proportions to statutory rates on
royalties and interest may give a first approximation of the corresponding tax reductions
on other outbound payments. In addition, the results may also be expanded to include
income flows from portfolio investment. Although the treatment of portfolio dividends in
tax treaties is typically different from the treatment of dividends between related parties, a
similar approximation may be feasible, depending on the specific country context.
Common assumptions needed for both approaches

The fiscal estimates described in this section identify only an upper bound of the effects
of treaty shopping. They assume that all MNEs use the tax-minimising route to channel
international income flows. The estimates also do not correct for conduit arrangements
that have non-tax related economic substance (e.g. in cases where regional holding
companies are established in third countries to minimise transaction costs arising from
language or time-zone differences).

MNEs may provide more substance to regional holding companies to satisfy LOB and
PPT rules. In both cases, assumptions are needed to identify (a) the proportion to which
conduit arrangements are supported by economic substance and (b) the effectiveness of
the countermeasures. The first assumption should be based on further empirical evidence
from the country-level, if possible. The second will depend on the countermeasures which
are already in place, the capacity of the tax administration, and interactions with other
countermeasures.
Both of the estimation procedures provide only a static estimate assuming that the amount
and direction of outbound payments is unchanged. However, adoption of Action 6
countermeasures is likely to affect the composition of inbound and outbound income
flows, thus leading to further effects on WHT revenues. For instance, if the multilateral
adoption of Action 6 countermeasures leads to an increase in source country taxation,
repatriation becomes less profitable and profits may therefore be reinvested in the source
country or invested in other countries. The resulting dynamic effects on the composition
of international income flows are not included in the proposed approaches. A more
comprehensive analysis of this issue would need to be undertaken on a country-specific
basis with available country-level data.
Action 6 interacts with Action 2 on hybrid mismatch arrangements as arrangements that
are designed to exploit differences in tax treatment of instruments and entities are also
often structured so as to take advantage of treaty benefits. Since zero-tax countries
generally do not have treaties with other countries, Action 6 will provide a backstop to
Action 2, further strengthening the elimination of BEPS through hybrid mismatch
arrangements.
Action 7 (Permanent Establishment)
Tax treaties generally provide that the business profits of a foreign enterprise are taxable
in a country only to the extent that the enterprise has a permanent establishment (PE) in
that country to which the profits are attributable. The definition of PE included in tax
treaties is therefore crucial in determining whether a non-resident enterprise must pay
income tax in another country. The Report on Action 7 (Preventing the Artificial
Avoidance of Permanent Establishment Status, OECD, 2015h) includes changes to the
definition of PE in the OECD Model Tax Convention, which is widely used as the basis
for negotiating tax treaties. These changes address business models which do not create
tax nexus in the source state, including commissionaire arrangements instead of
distributors or the artificial fragmentation of business activities.
The specific PE provisions being dealt with under Action 7 include the agency-PE rule
and the specific exceptions. The recommendations will also address the issue of profit
attribution once a PE is established, but these recommendations have not been finalised.
The specific Action 7 recommendations to reduce the artificial avoidance of PE status
include:
Changes to the agency-PE rule to ensure that where the activities that an
intermediary exercises in a country are intended to result in the regular
conclusion of contracts to be performed by a foreign enterprise, that enterprise
will be considered to have a PE in the country unless the intermediary is
performing these activities in the course of an independent business;
Restricting all the exceptions to the PE rules to activities which are otherwise of
a preparatory or auxiliary character;
A new anti-fragmentation rule; and
Changes dealing with the splitting-up of contracts.
Estimating the fiscal effects of Action 7 countermeasures will be difficult because the
determination of a PE is fact-specific. It will be necessary to focus the analysis on MNEs
with activities likely affected by a redefinition, such as commissionaire arrangements, to
get a rough measure of the potential magnitude of the activity affected. One possible
route would be to work together with relevant staff, including auditors, at the revenue
authority, to understand the previous cases of PE audits and current investigations, as well
as how the revised definition would affect the PE status of those and other companies.
Once examples or a sample of potentially affected companies are identified, that sample
can be extrapolated to the potential total economic activity affected by the Action 7
countermeasures in the country.
If it is possible to estimate the magnitude of the economic activities by the PEs being
analysed, profits would need to be allocated between the PE and related parties. Further
guidance with regard to this step of the estimation procedure can be obtained from the
revised transfer pricing guidelines and the additional guidance on attribution of profits
that will be developed in 2016.
Lowering PE thresholds implies that MNEs may now be subject to tax in locations where
PE status was previously avoided. Economic activity previously subject to tax in another
jurisdiction will now be subject to tax in the PE jurisdiction such that tax revenues could
potentially decrease in one jurisdiction and increase in another.

As a consequence, MNEs may restructure their operations in line with the change in tax
rate differentials. In some cases this may induce the MNE group to carry on the same
activities through local subsidiaries or, in extreme cases, to discontinue some or all of its
activities in a country. To the extent these reduced activities are then performed by local
subcontractors or other firms with a PE in the country, there may be an increase in
corporate tax collections. Measuring the shifted amount of additional economic activity
and associated income as a result of the change in the definition of PE will be a difficult
exercise. The amount of additional revenue in the PE jurisdiction will be the estimated
increase in taxable income times the AMTR of that activity.
To monitor the fiscal effects of the BEPS countermeasure, audit results and new CIT
information could be tracked after a countrys adoption of Action 7s countermeasures. If
the information is available for specific taxpayers, a net figure for revenue changes
should be calculated, including tax increases for taxpayers where new measures give rise
to PE status and the tax increases from economic activities of other in-country firms with
a PE that would be increased when the artificial avoidance of PE status has been
eliminated. Similar monitoring could be done for the jurisdiction where the income was
previously reported.
Action 7 will have important linkages to Action 2 and 6, and the transfer pricing changes.
Together with changes to tax treaties proposed in the Reports on Actions 2 and 6, the
changes will lead to an increase in taxation in a number of cases where cross-border
income would otherwise have been untaxed or would be taxed at very low rates as a
result of the current provisions in tax treaties.
The BEPS countermeasures recommended by Action 7 are linked to the revised transfer
pricing guidance of Actions 8-10. With the revised guidelines in effect, transactions
between a company with newly established PE and related parties are to be priced at
arms length. Where some of the income from the operations of a newly established PE
may have been shifted to a tax haven in the past, the income will now be assigned to
where the economic activity generating that income is located.
Action 11 (Measuring and Monitoring BEPS)
The Report on Action 11 (Measuring and Monitoring BEPS, OECD, 2015i) includes an
assessment of existing data sources relevant for BEPS analysis; indicators of BEPS; an
initial economic analysis of BEPS and countermeasures (and the issues surrounding an
economic analysis in the BEPS context); as well as recommendations for future data and
tools necessary to better understand BEPS behaviours and monitor these behaviours and
BEPS countermeasures over time. The issues raised and findings from the analysis of the
scale and economic impact of BEPS and countermeasures will improve the understanding
and visibility of these issues with policymakers and media. In addition, Action 11
highlights best practices in data collection and dissemination that could assist
policymakers in more countries to have a better understanding of BEPS behaviours in
their countries over time.
The measuring and monitoring of BEPS, such as that in the Report on Action 11, will
provide increased transparency. Action 11 increases transparency with its macro analysis
of the scale of BEPS and countermeasures, which complements the increased
transparency of the individual company information of the other Actions. Action 11 will
complement the increased transparency of Actions 5, 12 and 13.While not having a direct
effect on corporate tax revenues, Action 11 will have an indirect effect through an
improved understanding of the fiscal effects of BEPS behaviours by tax policy makers,
tax administrations, taxpayers, the media and the public. The analysis of BEPS
behaviours could highlight particular areas for increased tax enforcement, as well as raise
the reputation costs of tax avoidance. With a better understanding of the BEPS
behaviours and their potential fiscal and economic effects, Action 11 could contribute to
prompting a more comprehensive implementation of BEPS countermeasures, which
would result in tighter rules to counter BEPS. While not feasible to estimate a separate
fiscal effect of Action 11, it may increase the willingness of policymakers to take action
and improve the effectiveness of audit enforcement.
Action 12 (Disclosure of Aggressive Tax Planning Arrangements)
The Report on Action 12 (Mandatory Disclosure Rules, OECD, 2015j) includes
recommendations for the design and implementation of mandatory disclosure regimes for
potentially aggressive or abusive international tax planning strategies. The policy
objectives include providing tax administrations with early information on tax planning
strategies and deterring taxpayers from engaging in aggressive tax planning
arrangements. The elements of Action 12 include:
A modular design of mandatory disclosure rules;
A focus on international tax schemes; and
The design of enhanced models of information sharing among countries.
Adoption of the Action 12 countermeasure will result in countries having the option to
adopt new mandatory disclosure regimes or expanding existing regimes. The disclosure
information will allow tax administrations to more effectively enforce existing domestic
tax rules, as well as other BEPS countermeasures. As one transparency component of the
BEPS project, Action 12s recommendations will increase the effectiveness of a countrys
enforcement efforts and will discourage taxpayers from taking aggressive tax positions in
the first place.
Although implementation of new or expanded disclosure of aggressive tax planning
arrangements would be expected to increase total corporate tax collections, it would be
difficult ex ante to estimate the incremental improvement given the uncertainty of the
behavioural effects of audit enforcement and taxpayer reactions. The empirical literature
has focused more on the effects on financial reporting rather than actual taxes paid. Ex
post, analysts could work with the audit teams to identify the increased effectiveness of
audits and settlements on transactions identified through the increased disclosure.
Action 14 (Dispute Resolution Mechanisms)
The recommendations developed as a result of the work on Action 14 are intended to
improve the effectiveness and efficiency of the mutual agreement procedure (MAP) in
resolving treaty-related disputes; it is an important complement to the BEPS
countermeasures, which could introduce elements of tax uncertainty, as well as the
potential for unintended double taxation. The Report on Action 14 (Making Dispute
Resolution Mechanisms More Effective, OECD, 2015k) specifically includes:
Adoption of a minimum standard with respect to the resolution of treaty-related
disputes, intended to ensure the full implementation of treaty obligations related
to MAP, the implementation of administrative processes to promote the
prevention and timely resolution of treaty-related disputes, and that taxpayers
that meet the requirements of the MAP article can access the MAP; and
A commitment by 20 countries (that accounted for 90% of outstanding MAP
cases at the end of 2013) to provide for mandatory binding MAP arbitration in
their bilateral tax treaties.
If there is inconsistency in the implementation of the BEPS countermeasures there is the
possibility that an unintended increase in double taxation could result in higher income
tax collections than expected from the intended reduction in BEPS. This could be a
potential component of the net revenue effect of other BEPS countermeasures.
Action 14 is designed to mitigate such unintended tax increases. The fiscal effect of an
improved dispute resolution mechanism could be a decrease in the estimated net income
tax revenues from other countermeasures. To the extent that improvements to the MAP
and/or a MAP arbitration mechanism apply with respect to existing disputes, the disputes
may be settled more quickly and a change in revenue could result from additional tax
payments or refunds of previously collected amounts. A future change in tax collections
from existing disputes might depend on whether countries require corporations to pay
taxes on the disputed amounts.
It would be difficult to estimate the effect in advance of actual experience with
improvements to the MAP and MAP arbitration. The results of a strengthened dispute
resolution process, in terms of tax adjustments, could be tracked to provide an ex post
estimate of the reduction in revenues due to the decrease in potential double taxation.
Action 15 (Multilateral Instrument)
The Report on Action 15 (Developing a Multilateral Instrument to Modify Bilateral Tax
Treaties, OECD, 2015l) explores the feasibility of a multilateral instrument to modify tax
treaties so as to implement the treaty-related BEPS measures and amend bilateral tax
treaties. This is designed to significantly reduce the costs and time associated with
bilateral treaty renegotiations for countries that choose to sign the instrument. A mandate
has been developed for an ad-hoc group, open to the participation of all countries on an
equal footing, to develop the multilateral instrument and open it for signature in 2016. So
far, 88 countries are participating in the work on an equal footing.
Where countries sign the multilateral instrument to modify their tax treaties, this could
lead to an acceleration in the implementation of countermeasures and bring forward the
fiscal effects. To the extent that the adoption of new countermeasures would require
amendments to treaties which could require many years, the multilateral instrument may
enable those amendments to take place quicker. If the multilateral instrument leads to the
faster implementation of countermeasures then this will lead to a commensurate
acceleration of the fiscal effects.
Summary
This annex provides potential approaches that could be used by government tax policy
analysts to estimate the fiscal effects of BEPS countermeasures for their respective
countries. A general approach is described before potential approaches are explained for
the individual BEPS Actions. The proposed methodologies are set out according to the
individual countermeasures of the BEPS Action Plan. Some methodologies are more
comprehensive than others given the variation in data availability; the extent of insights
from empirical studies; and depending on the design of the countermeasures. Countries
will have different datasets and some may be more useful for particular BEPS
countermeasures than others. It is recognised that estimating the fiscal effects of BEPS
countermeasures may rely on applicable tax return data, financial account micro-data,
macro-data (aggregated from tax return or financial accounts), a combination of micro
and macro-data sources, or in some cases to data analogous to the country. Where
possible, multiple approaches based on different sources of data are described.
As better data becomes available both as a result of CbCR and countries recognising the
need to draw on taxpayer micro-data to make more informed and evidence-based tax
policy decisions tax policy analysts will be in a better position to evaluate and monitor
trends in BEPS behaviours and the effect of countermeasures.
An important consideration is the evaluation of ex post estimates relative to ex ante
estimates. Separating the effects of unexpected macroeconomic changes from unexpected
taxpayer behaviours from technical estimation issues can provide valuable learning to tax
policy analysts as they assess the underlying causes in cases of large differences. Even
small differences do not necessarily mean that all assumptions ex ante were correct.
Evaluation of past estimates can improve understanding of key parameters, including
behavioural changes.
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Notes
1.
Page 21 of the OECD (2013) Action Plan on Base Erosion and Profit Shifting.
2.
Page 21 of the OECD (2013) Action Plan on Base Erosion and Profit Shifting:
further work needs to be done to monitor the impact of measures taken under the
Action Plan to address BEPS. This should include outcome-based techniques, which
look at measures of the allocation of income across jurisdictions relative to measures
of value creating activities, as well as techniques that can be used to monitor the
specific issues identified in the Action Plan.
3.
Based on discussions by Delegates of the OECDs Committee on Fiscal Affairs

Working Party No.2, and participating country Delegates.
4.
See, for example, impact assessments on the HMRC website (available at

www.hmrc.gov.uk/ria/#full) or Department of the Treasury (2015), (available at
www.treasury.gov/resource-center/tax-policy/Documents/General-ExplanationsFY2016.pdf).
5.
The reduction in the CIT tax base due to the location of debt in entities in higher-tax
countries is not included in the transfer pricing revenue impact estimating
methodology. It should be included in the revenue impact analysis for Action 4
dealing with the allowance of interest deductions related to third-party and relatedparty loans.
6.
The data includes detailed information on goods and services flows, by trade partner,
and is available for the OECD and G20 countries. Information on trade in goods is
available for additional countries from IMF data. Trade amounts would have to be
imputed for the missing services trade data for selected countries.
7.
For a detailed description of what is included in the trade in goods and services data,
see IMF, Sixth Edition of the Balance of Payments and International Investment
Position Manual (BPM6), available at
www.imf.org/external/pubs/ft/bop/2007/bopman6.htm.
8.
Note that the methodology is described in terms of CIT revenue impacts. The BEPS
countermeasures would apply to all business income. To the extent that BEPS affects
business profits reported on individual income tax returns and information is
available, this additional revenue impact could be included in the BEPS impact
calculations.
9.
See OECD, Activities of Multinational Enterprises (AMNE) database.
10.
The share of trade accounted for by transactions between MNE entities is available
for a limited number of countries. See Lanz and Miroudot (2011), as well as data on
MNE activities from specific countries, including the United States and Germany.
11.
The trade amounts may include round-trip transactions among entities. For
example, goods in process may be exported from an affiliate in country A to an
affiliate in country B for further processing. The finished product may then be
returned to the affiliate in country A as an import into country A. The full amounts of
both the export from country A and import into country A are included in the estimate
of mispricing. National account statisticians are addressing this issue of double
counting from the perspective of creating more accurate measures of trade flows that
affect a domestic economy. See the OECD, Trade in Value-Added: Concepts,
Methodologies, and Challenges (Joint OECD-WTO Note).
12.
See the OECD, Trade in Value-Added: Concepts, Methodologies, and Challenges

(Joint OECD-WTO Note).
13.
One method of reducing this incentive is to require a greater level of in-country real
activity (R&D, for example) to qualify for the special rates.
14.
In calculating the trade-weighted AMTR, the AMTR for each of a countrys trading
partners identified in the bilateral trade data is multiplied by the share of a countrys
total worldwide exports or imports accounted for by the trading partner.
15.
Alternatively, the calculations could be done at the level of trade flows between a
country and each of the countrys trading partners. In this case, it is not necessary to
calculate a weighted average STR for among all trading partners.
16.
The AMTRs would generally be the applicable tax rates for combined national and
sub-national CIT rates.
17.
These calculations use headline statutory tax rates except lower special tax rates that
apply to royalty income in selected countries.
18.
Although the value of the semi-elasticity is constant for all AMTR tax rate differential
calculations, it does result in variations in the elasticity of response to these tax rate
differentials. In other words, the larger the percentage change in tax rate differences,
the higher the percentage change in export and import prices. Elasticities of trade
pricing could be used for elasticities of net income to the extent that non-tax rate
factors are fully specified and accurately measured in a regression equation. The
percentage change in trade prices would affect net income due to tax rate differentials
in the same way that net income is affected by tax rate differentials, over and above
the estimated effect of non-tax factors. An extra dollar of revenue from trade
mispricing results in an extra dollar of net income, similar to an extra dollar of net
income from other profit shifting.
19.
Sebastian Beer and Jan Loeprick, Profit shifting: drivers of transfer mis(pricing) and
the potential of countermeasures, International Tax Public Finance, published online
17 May 2014, find that profit shifting responsiveness is higher for subsidiaries with
higher ratios of intangible to total assets. Matthias Dischinger and Nadine Riedel,
Corporate taxes and the location of intangible assets within multinational firms,
Journal of Public Economics 95 (2011) also find that an affiliates pre-tax income
response is more sensitive to tax rate differentials for groups with high ratios of
intangibles to sales. See also the results discussed in Annex 1.
20.
See for example, Andrew B. Bernard, J. Bradford Jensen, Peter K. Scott, Transfer
Pricing by U.S.-Based Multinational Firms, National Bureau of Economic Research,
Working Paper 12493, August 2006.
21.
While royalty payments for the use of intellectual property are included in the charges
for the use of intellectual property category, the value of sales of the outcome of R&D
are reported in the other business services category. These transactions, including the
sale of intangible property among MNE entities, are included in the trade in services
flows that are the beginning point for the transfer pricing revenue analysis.
22.
The financial services in the service trade data include brokerage, underwriting, credit
card and management and advisory services. Interest payments and receipts are
included in the primary income accounts.
23.
The data is captured for those entities where there is at least a 10% ownership link.
24.
As per paragraph 82 of the Report on Action 4, it is recommended that a fixed ratio

rule should measure earnings using EBITDA. However, a country may apply a fixed
ratio rule which measures earnings using EBIT, so long as the other elements of the
rule are consistent with the best practice in this report. Since EBITDA is the
recommended approach, the approach outlined for the fiscal estimate will refer to
EBITDA. If the country opts for EBIT in the design of interest limitation rules, the
fiscal estimate should be based on EBIT.
25.
As per paragraph 24 of the Report on Action 4, countries are encouraged to combine a

robust and effective fixed ratio rule with a group ratio rule which allows an entity to
deduct more interest expense in certain circumstances. A group ratio rule may be
introduced as a separate provision from the fixed ratio rule, or as an integral part of an
overall rule including both fixed ratio and group ratio tests.
26.
An entity is part of a group if it is directly/indirectly controlled by a company, or the

entity is a company which directly or indirectly controls one or more other entities. A
group is considered to be multinational if it operates in more than one jurisdiction,
including through a permanent establishment.
27.
Countries which are European Union (EU) Member States would need to take into
account EU law considerations in designing their domestic rules, to ensure they are
compliant with EU law. The Report on Action 4 includes an annex detailing the
necessary considerations.
28.
The Action 4 best practice approach refers to a non-exhaustive list of examples.

Details matter and each country would need to determine whether the definition of
interest used for an interest limitation rule as per the best practice approach is
appropriately captured in the fiscal effect calculations. If it is impossible to
incorporate all payments equivalent to interest, it could be noted that the fiscal effect
may be understated.
29.
The interest limitation would apply to all business, irrespective of legal form. The
description will refer to CIT, but would be equally applicable to personal income tax
base changes of non-corporate businesses and their owners.
30.
Further work will be conducted, to be completed in 2016, to identify targeted rules to

deal with the base erosion and profit shifting risks posed by banks and insurance
companies.
31.
Please see the Report on Action 4 for a discussion on why tax exempt income, such as
exempt dividend income or foreign earnings that are tax exempt, should not form part
of the entitys EBITDA figure. The rationale behind excluding exempt dividend
income is to address concerns related to the outbound investment scenario as
described in Action Item 4.
32.
See paragraph 115 of the Report on Action 4.
33.
See the discussion on applicable marginal tax rates in the transfer pricing section
(Actions 8-10 & 13).
34.
Quasi-corporations are unincorporated corporations that keep a complete set of

accounts so they can be separated. If the unincorporated enterprise does not keep a
complete set of accounts then it is classified within the household sector.
35.
Note by Turkey: The information in this document with reference to Cyprus

relates to the southern part of the Island. There is no single authority representing
both Turkish and Greek Cypriot people on the Island. Turkey recognizes the Turkish
Republic of Northern Cyprus. Until a lasting and equitable solution is found within
the context of United Nations, Turkey shall preserve its position concerning the
Cyprus issue.
Note by all the European Union Member States of the OECD and the European
Union: The Republic of Cyprus is recognized by all members of the United Nations
with the exception of Turkey. The information in this document relates to the area
under the effective control of the Government of the Republic of Cyprus.
36.
NIE is calculated by subtracting interest receipts from interest payments and

multiplying by an average exchange rate for 2012 where applicable.
37.
Banks generate service income by lending at a higher rate of interest than they
borrow. This is considered a service for bringing the lenders and borrowers together.
Since depositors receive a lower rate of interest than the reference rate, the interest
received is increased by the amount of the difference between the reference rate and
the rate that depositors actually receive. Depositors immediately use this increase in
income to purchase the service. Conversely, borrowers pay a higher rate of interest
(than the reference rate), some of which reflects payments for a service. The National
Accounts subtract the difference between the higher rate that borrowers pay and the
reference rate. Again this difference is immediately used by borrowers to purchase
this service.
38.
See list provided in description of key issues for Action 4.
39.
Schindler et al. (2013), Blouin et al. (2014) and Wamser et al (2015).
40.
The Business and Industry Advisory Committee to the OECD presented numbers in
the Action 4 Focus Group meetings showing the distribution of large public firms by
different external interest ratios.
41.
Please see the discussion on applicable marginal tax rates in the transfer pricing
section (Actions 8-10 & 13)
42.
This estimate is stacked after many other proposals such that some of the revenue
effects are reflected in other estimates.
43.
Action 3 notes that this method generally recognises that even in a situation where the
statutory tax rate is not considered a low tax rate, low taxation may occur as a result
of (1) reducing the tax base or (2) lowering the tax burden by subsequent rebates of
taxes paid or through non-enforcement of taxes.
44.
Determining attributable income would be unnecessary for countries that opt for a
full-inclusion system, i.e. once an entity is classified as a CFC, all income is treated as
CFC income, which is relevant in the context of worldwide tax systems.
45.
There are exceptions: United States intra-firm imports and exports are collected for
disaggregated service items, and both Canada and the United States break down
services trade by affiliation (Lanz & Miroudot, 2011).
46.
See discussion on the applicable marginal tax rate (AMTR) in the section on transfer
pricing (Actions 8-10 & 13).
47.
In the case of the 2012 study, the data was supplemented with information on national
characteristics from the World Bank Development Indicators and with tax rate
information from PWC, the Bureau of Tax Policy Research at the University of
Michigan, KPMG, and other sources.
48.
Please see the discussion on applicable marginal tax rates in the transfer pricing
section (Actions 8-10 & 13).
49.
The sources include the IMF Balance of Payments Statistics and the OECD
International Direct Investment Database. In compiling and presenting FDI statistics,
compilers in many countries may encounter the possibility of confidential data
occurring in the results to be disseminated. FDI information can be regarded as being
confidential in a primary sense for a number of reasons: (i) if a compiler declares it to
be confidential, (ii) if there is only one or at most two entities giving rise to the
information, or (iii) if the contribution of a particular enterprise (or even two
enterprises) dominate(s) the contributions of all other entities (OECD, 2008).
50.
The applicable information can be found in Table B6 of the paper.
51.
Note that this result refers to the combined remaining tax rate, potentially including
CIT in the recipient country, depending on the relief method.
4. TOWARDS BETTER DATA AND TOOLS FOR MONITORING BEPS IN THE FUTURE 249
Chapter 4
Towards better data and tools for monitoring BEPS in the future
Key points:
The limitations of currently available data and the complexity of BEPS mean that
improved data and tools are necessary if the global community is to obtain a clearer
picture of the scale and impact of BEPS and properly monitor the effectiveness of the
measures implemented under the BEPS project.
Given the large, and soon to be expanded, volume of data in the hands of tax
administrations, this reports recommendations focus on the need for governments to
work more closely together to make better use of data that is already (or has been
agreed, as part of the BEPS project, to be) collected. In particular, statistical analyses
based upon data collected under the Action 13 Country-by-Country Reports have the
potential to significantly enhance the economic analysis of BEPS.
This report makes the following recommendations:
The OECD should work with all OECD members and BEPS Associates (including
all G20 countries) and any country willing to participate to publish, on a regular
basis, a new Corporate Tax Statistics publication, which would compile a range of
data and statistical analyses relevant to the economic analysis of BEPS in an
internationally consistent format. Among other information, this publication would
include aggregated and anonymised statistical analyses prepared by governments
based on the data collected under the Action 13 Country-by-Country Reports.
The OECD should work with all OECD members, BEPS Associates and any
willing participating governments to produce periodic reports on the estimated
revenue impacts of proposed and enacted BEPS countermeasures.
The OECD should continue to produce and refine analytical tools and BEPS
Indicators to monitor the scale and economic impact of BEPS and to evaluate the
effectiveness and economic impact of BEPS countermeasures.
Governments should improve the public reporting of business tax revenue
statistics, particularly for MNEs.
Governments should continue to make improvements in non-tax data relevant to
BEPS with wider country coverage, such as for FDI associated with resident SPEs,
trade in services and intangible investments.
Governments should consider current best practices and explore new approaches to
collaborating on BEPS research with academics and other researchers.
Governments should encourage more research on MNE activity within tax
administrations, tax policy offices, national statistical offices (NSO), and by
academic researchers, to improve the understanding of BEPS, and to better
separate BEPS from real economic effects and non-BEPS tax preferences.
250 4. TOWARDS BETTER DATA AND TOOLS FOR MONITORING BEPS IN THE FUTURE
Monitoring BEPS in the future will require that governments make better use of the data
that is already (or has been agreed, as part of the BEPS project, to be) collected.
Additional and more in-depth analysis of BEPS and the publication of statistical results
and aggregate tabulations of MNE taxes and activities by individual countries will also
be important to evaluating the effectiveness of BEPS countermeasures.
4.1 Introduction
268. The limitations of currently available data and current estimation methodologies
mean that improved data and tools will be necessary if the global community is to obtain
a clearer picture of the scale and impact of BEPS and properly monitor the effectiveness
of the measures implemented under the BEPS project.
269. Chapter 1 included an assessment of currently available data, which concluded
that the significant limitations of existing data sources mean that, at present, attempts to
construct indicators or undertake economic analyses of the scale and impact of BEPS are
severely constrained and thus must be heavily qualified. More comprehensive and more
detailed data regarding MNEs is needed to provide a more accurate assessment of the
scale and impact of BEPS.
270. Chapters 2 and 3 noted the difficulties in constructing BEPS indicators as well as
undertaking economic analysis with the currently available data. At present, in addition to
the data limitations, there is also a lack of detailed information on countries tax rules and
aggregate tax bases, which are all needed for improved cross-country economic analyses
of BEPS and the effects of BEPS countermeasures. Economic analyses must separate
BEPS behaviours from both the effects of real economic factors as well as the effects of
non-BEPS tax preferences such as R&D tax incentives and other legislated special rates,
deductions and exemptions.
271. Governments, and in particular tax administrations, already collect an array of
information regarding the tax affairs of MNEs and their affiliates. The scope and value of
this information will be increased as a result of the work undertaken as part of Action 5
(spontaneous exchange of rulings), Action 13 (transfer pricing documentation), and
where implemented, Action 12 (disclosure of aggressive tax planning arrangements).
While the need to improve the economic and fiscal analysis of BEPS requires greater
access to this data, any recommendations around the availability of data in the future must
take into account the need to protect the confidentiality of taxpayer information and
minimise the administrative burden for governments and taxpayers.
272. Given the large, and soon to be expanded, volume of data in the hands of tax
administrations, this reports recommendations focus on the need for governments to
make better use of data that is already (or has been agreed, as part of the BEPS project, to
be) collected and share best practices. Tax administrations can maximise the benefits of
available information by increasing access to this data for research purposes under strict
confidentiality rules. In addition, as statisticians continue to improve National Accounts
with the measurement of foreign direct investment (FDI) through special purpose entities
(SPEs) and other conduits, more disaggregation of bilateral trade in services data
including payments for intellectual property and management services, and the
measurement of intangible investments, these changes will provide further assistance to
future economic analysis of BEPS.
273. The tools to be used to analyse and publish data in the future should be developed
in a consistent and co-ordinated way so that when better data becomes available in the
future it can be analysed and published in its most meaningful form. Increased analysis
and publication of statistical results, particularly in the form of aggregate tabulations of
taxes and activities of MNEs by individual countries will be important in better
understanding BEPS.
274. Analyses of BEPS countermeasures may be useful for individual countries as they
consider enactment and implementation, as well as monitoring the effects of
countermeasures on BEPS going forward. Countries will differ in terms of the specific
BEPS countermeasures adopted (some already have implemented certain BEPS
countermeasures) and in the timing of their implementation. Improvements in the data
and tools for analysis of BEPS and BEPS countermeasures are critical for policymakers,
and those improvements will need to be undertaken by individual countries as well as
international organisations.
4.2 Background
275. The future path of BEPS measurement is clearly dependent on increasing the
quality and relevance of data available to improve indicators and economic analyses of
BEPS, as shown in Figure 4.1. In the current state of BEPS analysis, analysts are
generally exploiting the available data, although some of the data already being collected
are not currently being compiled for analysis and access is often limited. While there are
some new and innovative types of analysis of BEPS being undertaken, all analyses are
constrained by significant data limitations. The academic community has demonstrated its
creativity in examining new dimensions of BEPS to explore with currently available data,
but there are diminishing returns to working with the current data, particularly non-tax
return data.
276. The objective is that, in the future, better data will allow new and more refined
indicators as well as refined economic analysis of BEPS and the effectiveness of BEPS
countermeasures. Better data has a number of different dimensions.
More relevant BEPS information (i.e. total MNE tax payments by country, tax
residence of the entity rather than simply country of incorporation, related party
transactions and structures).
More coverage of companies, countries, and MNE relationships.
More complete set of companies (e.g. fewer missing entities and groups
and better coverage across all countries).
More complete information from currently available company tax and nontax records (e.g. fewer missing financial variables).1
Clear identification of MNE companies on tax return forms, both domestic
companies of foreign MNE parents and domestic parents of foreign
affiliates. Improved linkages between related entities and the overall MNE
group information.
Expanded linkages between tax and other financial information.
Increased access to available data for government analysts and academic
researchers under strict confidentiality and access requirements.
Increased data consistency across countries.
More timely information with shorter time lags.
277. Initiatives could be taken in the areas described above that would improve the
available data, increase the signal-to-noise ratio in future BEPS analyses, and help
separate BEPS from other factors.
Figure 4.1. Future path of BEPS measurement
Current State
Indicators of
BEPS with
available data
Analyses of
economic
impact of BEPS
available data
Future State
New and
refined
indicators with
better data
Refined
analyses of
economic
impact of BEPS
better data
Ideal
True measures of
BEPS and
countermeasures
Signal-to-noise ratio expected to increase as data quality increases

278. Existing arrangements, in relation to the collection, analysis, publication and
provision of access to tax data, differ across countries. When considering existing data,
three key issues must be considered: availability, coverage, and international consistency.
Each of these is discussed in the next section.
4.2.1 Availability and access to data for BEPS analysis
279. The first key issue is the availability of current data. Governments, and in
particular, tax administrations, already collect a vast array of information regarding the
tax affairs of MNEs and their affiliates. Tax data is collected for the principal function of
tax administration and government tax policy consideration and advice. Government
analysts within tax administrations, and often within other government tax policy offices2,
generally have the ability to research and analyse the individual tax return data collected
to help develop and evaluate government tax policy and inform advice.
280. In some countries, a significant portion of the tax return information is compiled
into databases and is available for tax policy analysis. Often, aggregated tax data will be
provided by individual countries to international and regional organisations so that the
data can be compiled in a consistent manner for cross-country comparison and analysis,
such as the OECDs annual Revenue Statistics publication. The data is aggregated so as to
ensure that the confidentiality of taxpayer information is preserved.
281. Access to more detailed tax return data can in some countries be granted to
researchers and academics. In some cases, qualified researchers may be engaged directly
by government under strict confidentiality rules to assist the government in its analysis of
the tax data for tax administration and tax policy purposes. In some countries, tax policy
analysts can request access to tax return data, under strict confidentiality rules and other
conditions of access, to conduct their own research or special studies of tax return
information for the purposes of tax policy or economic analysis.
282. Box 4.1 outlines some examples of best practices concerning data availability for
the purpose of tax analysis of corporate tax and MNEs. As can be seen from the examples
of best practices, an important factor in the availability of current data is whether data that
has been provided to tax administrations is compiled into an electronic database that is
easily accessible by government tax analysts. Increased electronic filing of corporate
income tax returns will make the compilation of more data less resource intensive for tax
administrations.
283. While electronic filing systems are helpful, where information is not collected in a
standardised format, compilation will involve searching for the specific data item (often
with different terminology across different datasets) and then sorting into standardised
categories. Unless there is a tax form which taxpayers are required to complete, it is likely
that the information will not be compiled for tax policy analysis without requiring
significant extra resources and effort.3 Additional information requested on tax returns
that may not be required for the calculation of tax liability, such as information on
balance sheets or specific income and expense items may not be completed by taxpayers
with the same degree of care and diligence.
Box 4.1. Some best practices in data availability for tax analysis of corporate tax
and MNEs
Published aggregated tables of MNE tax data: The United States Internal Revenue Service
publishes special tabulations every other year of information from foreign affiliates of United
States MNEs (information Form 5471 including Schedule M) and from domestic affiliates of
foreign MNEs (Form 5472). The tables present aggregated totals of the components of taxable
income and deductions by country and industry, including in the case of Form 5472 detailed
aggregated transactions with related parties.
Information on cross-border related party transactions: The Australian Taxation Office requires
certain taxpayers to complete an annual international dealings schedule, which contains a
specific section on international related party transactions.4 The specific section is required to be
completed where the total amount of their international related party transactions exceeds
AUD 2 million. In addition, for the countries with the three largest related party transaction
totals, the taxpayer is asked to specify the country and detail the activity type and the aggregate
transaction amount (expenses/losses plus revenue/gains). The schedule also requires notification
of restructures, dealings in intangibles, derivatives transactions and information on the number
of CFCs in each country and an explanation of thin capitalisation arrangements on the Australian
side.
Access to qualified academic researchers under strict confidentiality rules: 15 OECD countries5
currently have special programs that provide qualified academics with access to corporate tax
return data for analysis under strict confidentiality rules. These programs enable sophisticated
empirical analysis of tax return data, complementing analysis of non-tax return data, while
maximising the benefit of existing data. See case study box of these programs.
Quantifying corporate tax preferences: A number of countries regularly publish the fiscal cost of
special tax rates, deductions, exemptions and credits in their corporate income tax. Although
there can be conceptual and measurement issues with some preferences, most corporate tax
preferences are readily measurable such as corporate tax credits, special low tax rates, and
deductions in excess of 100% of expenditures.
Box 4.1. Some best practices in data availability for tax analysis of corporate tax
and MNEs (continued)
Analysis of MNE investments: The German Bundesbank, the Japan External Trade
Organisation, and the United States Bureau of Economic Analysis conduct special surveys of the
multinational affiliates operations. While not tax focused, the information from these surveys
has provided academic researchers operating under strict confidentiality rules with an important
source of data about MNE behaviours. Concerns about MNE response rates have limited any
matching of these investment surveys with tax return information.
Aggregate audit analyses: Several countries report on their corporate audit and enforcement
activities, including amounts assessed and assessments collected. These analyses have not
separated MNEs from other corporations, and generally do not separately report by type of
assessment, such as specific BEPS behaviours. Several commentators on the Action 11 Public
Discussion Document suggested aggregated data from audits and examinations would aid in the
analysis of BEPS.
International and regional tax statistics: Consistent, comparable, and quality-checked tax
statistics are extremely important for policymakers and other tax stakeholders. The OECD
Revenue Statistics and Tax Policy Database provide detailed information on a comparable basis
for OECD countries and an increasing number of non-OECD countries in its regional
publications.
Matching available databases: Separating BEPS behaviours from real economic effects will
require data on real economic variables. Several tax administrations, policy offices and other
researchers supplement corporate tax return information with other databases to maximise the
available information. The Australia Taxation Office compares and contrasts corporate tax return
data with the databases of external agencies and organisations in order to ensure compliance
with tax obligations.6
Better utilisation of technology in collection and compilation of taxpayer data: Access to and
compilation of taxpayer data could be eased by the use of a digital system to collect and store it.
Brazil has unified tax and book-keeping information through a digital system; the Sistema
Pblico de Escriturao Digital, at the federal, state and municipal levels. In addition, Japans
Kokuzei Sogo Kanri system links all regional tax information for analysis.
Focus on data quality: Data quality can be enhanced by dedicated personnel focused on
improving the accuracy and completeness of data obtained from tax forms. The Department of
Finance, the Canada Revenue Agency and Statistics Canada have established a joint committee
for data quality, supported by working groups with subject matter specialists in areas including:
corporation and individual reporting, partnership and trust reporting, international reporting, and
sales tax reporting. The working groups meet regularly to address issues that arise, discuss
information technology system and/or form changes that are necessary to reflect legislative
amendments, and develop ways to improve data quality.
Statistical sampling: Even with electronic records, statistical sampling can be a useful tool to
examine tax return data too voluminous to approach with other techniques, such as quality
assurance and imputations. Statistics compiled by the United States Internal Revenue Service
(IRS) Statistics of Income (SOI) Division are generally based on statistical sampling. Returns are
assigned to sampling classes (or strata) based on criteria including the form type filed, various
income factors or other measures of economic size, and industry. Statistical samples are then
selected from each stratum and can be extrapolated to population totals.
4.2.2 Coverage of data for BEPS analysis

284. The assessment of existing data in Chapter 1 outlined a number of current
coverage issues that need to be addressed to better analyse BEPS. Some of the issues will
be addressed by the additional information required under Actions 5, 13 and, where
implemented, Action 12 of the BEPS project. These will potentially lead to significant
improvements in the scope of tax data available to governments, including details of the
entire MNE group and all of its entities by country of tax jurisdiction. These future data
collected from the Action Plan are described later in this chapter.
285. Coverage of data also includes information that national tax administrations have,
but is not presently compiled and analysed. For example, an important missing element is
the corporate and other tax payments of MNEs in countries. Many countries do not
currently analyse their corporate income tax return information on this important
dimension. Other taxes paid by MNEs (i.e. withholding taxes, non-refundable VAT on
business inputs, property taxes) can affect location decisions, so are important for
separating BEPS corporate income tax effects from other non-BEPS policy factors.
286. Information on non-BEPS corporate tax policies that reduce taxes of MNEs, and
also domestic companies, are needed to separate the effects of BEPS from other factors.
Many countries have tax expenditure analyses which quantify the tax lost from special
preferences, concessions and tax credits. Although there are conceptual and measurement
issues with tax expenditures, estimates of corporate tax credits, special tax rates, and
deductions in excess of 100% of expenditures are generally not affected by these issues,
and would be more amenable to international comparisons. More information on business
tax preferences by MNEs and domestic-only businesses would aid BEPS analysis in the
future.
4.2.3 Internationally consistent analyses of BEPS
287. As important as it is for individual countries to undertake their own analyses and
publish their own country-specific statistics, it is also important to improve BEPS
analysis at the global level. Better BEPS economic analysis at the global level requires
data with more comprehensive country and industry coverage by type of taxpayer.
288. The benefits of those individual country analyses can be maximised if national
statistics are available and compiled in a consistent and reliable manner to facilitate crosscountry analyses. BEPS is a global issue, and if it is reduced in one jurisdiction but then
shifted to another jurisdiction through tax planning, then total BEPS has not been
reduced. It will be important to monitor BEPS statistics on an international basis, with as
many countries volunteering to share data as possible and, preferably in an internationally
consistent format.
289. International statistics on FDI, trade and many other economic measures are
compiled, analysed and published by a number of international organisations as well as
by some academic organisations. The OECD Tax Database and OECD Revenue Statistics
currently provide tax rate information for OECD countries and detailed revenue statistics
for over 50 countries on a consistent, standardised, and quality-assured basis. More
comprehensive cross-country tax data, particularly on business taxes and BEPS-related
metrics, would be important for improving international analyses of BEPS.
Box 4.2. Case studies of tax administrations' collaborations with qualified

researchers
Fourteen OECD countries, and a number of non-OECD countries, have special programs to
allow access to tax return information under strict confidentiality rules to qualified researchers.
Three of the programs are described below.
Canada: Statistics Canada houses the Canadian Centre for Data Development and Economic
Research, which maintains business-related micro datasets, including income tax returns filed by
all corporations. In order to respect taxpayer confidentiality, researchers do not have access to
the names of tax filers or direct access to the data. Researchers are only able to access the data
from Statistics Canadas offices in Ottawa. Data analysis programs must be developed using a
synthetic dataset in which firm entries are interchanged to prevent researchers from identifying
specific firms.
United Kingdom: The United Kingdoms revenue authority, Her Majestys Revenue and
Customs (HMRC), currently allows access to tax return information under certain conditions.
The HMRC Datalab is a secure environment where legally authorised researchers can access,
free of charge, confidential taxpayer and de-identified data to undertake research that serves one
of the HMRCs functions and benefits the wider research community. There is ongoing
collaboration with other United Kingdom Research Data Centres and international connections
have been made as part of the Data without Boundaries project. Projects on corporation tax have
outnumbered those on other forms of taxation, and research has provided lessons on which to
draw for future policy analysis. There are some challenges that the HMRC is working on
resolving, including legislative restrictions to data access; a continually evolving landscape that
requires adaptation; public perceptions on data sharing; balancing resources; and different
working cultures and expectations. As of May 2015, 47 projects had been approved, 60
researchers trained, and more than 30 publications have been published by Datalab researchers.
United States: The United States IRS SOI Division endeavours to increase the use of its tax
micro data by researchers outside the Federal government with its Joint Statistical Research
Program. Researchers who apply and are selected partner with SOI staff on projects that advance
the understanding of how existing taxes affect people, businesses, and the economy, and provide
new understanding of taxpayer behaviour that can aid in the administration of the United States
tax system. Such research can lead to the development of new datasets useful for future tax
administration research, as well as new tabulations that can be released to the public. Research
papers are made available to the public as working papers and may also be submitted for
publication in economic or statistical journals. SOI staff participate in all phases of selected
projects, including research, analysis, and presentation of findings.
4.3 Classification of analytical tools to turn data into insights

290. Data alone will not increase the understanding of BEPS. Analytical tools must be
used to provide insights from those data. Analytical tools range from descriptive statistics
(e.g. ratios of FDI to GDP, effective tax rates) to aggregate tabulations (e.g. ETRs by
industry or country), to indicators (e.g. effective marginal or average tax rates, indicators
included in Chapter 2), to multivariate statistical analyses (e.g. measuring relationships
while holding other factors constant), to economic modelling (e.g. revenue effects of
proposed measures and effectiveness evaluations). Enhanced data would enable all of the
tools to increase the understanding of BEPS and the effects of BEPS countermeasures.
Descriptive statistics can provide significant insights, particularly if they are put
in context, such as FDI relative to a measure of the countrys overall economic
activity. Better data can expand the number of descriptive statistics and refine
existing statistics. Future improvements in FDI special purpose entity data

would make it feasible to construct one of the potential future indicators in
Chapter 2. Better data can be used to calibrate MNE ETRs in each country, such
as the extent to which MNEs are reporting income in zero-corporate tax
countries.
Aggregated tabulations are an important resource for analysing and
understanding BEPS by external stakeholders given confidentiality
considerations. Aggregate tabulations can overcome many confidentiality
issues, by providing confidentiality and anonymity, while showing detailed
information about groups of similar corporations. The United States IRS
publishes detailed tabulations from tax forms filed by foreign affiliates of
United States parents and United States affiliates of foreign parents, by country
and industry.7 More sophisticated statistical analysis can be undertaken based
on aggregated tabulations, although more limited than statistical analysis with
individual taxpayer data. Aggregated tabulations showing the percent of foreign
source income from selected no-tax countries is often cited in policy debates.8
Aggregate tabulations could also improve the understanding of differences
between tax and financial records.
Indicators will also be improved with better data, as discussed in Chapter 2. In
addition, better data can assist in improving effective tax rate measures.
Effective marginal and average tax rates of hypothetical companies can
illustrate the effects of different countermeasures. One of the difficulties of
effective tax rates in the international tax area is calibrating the measures to
different groups, rather than to just a few hypothetical firms. Isolating the
impacts of the tax policy settings of a particular country presents another
difficulty. Better data can help calibrate effective tax rate metrics for policy
analysis of BEPS countermeasures.
Multivariate statistical analysis is a powerful analytic tool, but generally
requires individual taxpayer data, which for tax return analysis raises
confidentiality issues, or many years and/or countries for macroeconomic data.
Statistical analysis of individual taxpayer data allows the effect of individual
factors, such as taxes, to be analysed holding other factors (e.g. economic
determinants of profit) constant. Although statistical analysis of individual tax
returns may not be possible beyond tax administrations without expanded
access that ensures taxpayer confidentiality, the results of statistical analyses
could be released publicly while addressing confidentiality concerns. This
occurs regularly with both tax and non-tax corporate data in several countries,
both by government researchers and in some countries under special programs
for qualified academic researchers.
Economic modelling often uses the other analytical tools to evaluate the fiscal
and economic impacts of tax policy changes. Annex 3.A1 uses multivariate
statistical analysis to analyse a number of economic effects of BEPS.
Annex 3.A2 provides a toolkit for deriving an estimate of the fiscal effects of
the individual BEPS Action Plan countermeasures for individual countries.
Economic modelling could be used to evaluate the effectiveness and economic
impact of actions to address BEPS.
291. Advances in the use of analytical and monitoring tools are being made by
researchers alongside improvements in the available data. Academic researchers have
extended empirical analyses through meta-analyses of multiple empirical studies of the
same phenomena and by analysing BEPS through tax rate differentials between affiliates
or between parent entities. Continued improvement in analytical techniques and
approaches, such as analysing MNE entities share of profitability and economic activity
of the entire MNE group are promising approaches.
4.4 A classification of the types of data

292. A classification of the types of data can help form the basis of recommendations
regarding new tools and data under Action 11. The BEPS Action Plan makes it clear that
any recommendations should have regard to the need to protect the confidentiality of
taxpayers and minimise the administrative costs to governments and taxpayers.
293.
It is also worth noting that some of the potential recommendations that could be
made regarding data and monitoring tools for the future may involve matters within the
domain of tax policy and tax administration, and some will relate more generally to the
work and responsibilities of national statistical offices and other non-tax government
agencies and institutions. These are all important distinctions that should be borne in
mind when considering the range of potential recommendations regarding new tools and
data for BEPS analysis.
294. Figure 4.2 shows a schematic of data important for analysis of BEPS and BEPS
countermeasures. Data can be divided into categories, starting with tax and non-tax data.
Data can then be divided into data already (or soon to be) collected and data not collected.
Currently collected data is likely to be available sooner than data that is scheduled to be
collected under new arrangements proposed under other Actions of the BEPS project.
Changes in processing currently collected data, however, could take several years to
implement and complete.
Figure 4.2. Data important for analysis of BEPS and countermeasures
Tax Data
Data already
(or to be)
collected
No confidentiality issues or
issues overcome
Non-Tax Data
Data not
already
collected [7]
Data already
(or to be)
collected
Data not
already
collected
Possible confidentiality
issues
Currently
compiled
Not currently
compiled [4]
Issues can be
overcome [5]
Currently
analysed
Not currently
analysed [3]
What
measures?
Currently
published [1]
Not currently
published [2]
Access: who?
Confidentiality
is a barrier [6]
Access: what
form?
295. Data already being collected can be divided between data that does not involve
any confidentiality issues (or where those issues have already been overcome) and data
that has potential confidentiality issues. If there are possible confidentiality issues, then
those data can be divided into those where confidentiality issues might be overcome and
those where confidentiality issues will continue to be a barrier to access. Where there are
current confidentiality issues that might be overcome, consideration must be given to
determining what types of measures (e.g. legislative, administrative, etc.) are necessary to
address those confidentiality concerns, and then who might gain access (e.g. other
government analysts, academic researchers) and in what form would that access be
granted. In response to a questionnaire circulated by WP2 of the Committee on Fiscal
Affairs in June 2015, 17 of the 38 country respondents indicated that their tax
administrations provide access to information on payments between related parties from
tax return data to other government tax policy analysts.9 In 16 of the 38 respondent
countries, tax administrations allow access to corporate tax data to qualified academic
researchers and national statistical offices under strict confidentiality rules.
296. If data is collected and does not have confidentiality issues, there are still issues of
whether the data is compiled such that it can be analysed without excessive resource
costs. New electronic search technologies can now help pull information from openended text, but these processes still remain labour intensive. Resource constraints may
prevent even compiled data from being analysed. Tax administrations may have many
other priorities that take precedence before tax policy analysis is undertaken. Finally,
when data is analysed, it may not be published for a wider audience, again due to
resource constraints or other limitations. A number of tax administrations compile,
analyse and publish aggregated tables of corporate tax data without confidentiality issues.
297. Figure 4.2 specifically identifies seven categories of tax data, where future actions
may be considered to improve the available data and analysis of BEPS. A number of
potential future actions are identified below for each of the seven data groups, ranging
from consideration of additional metrics and analyses for tax data already collected,
analysed and published to focusing efforts on other groups of data when tax or non-tax
data has confidentiality issues.
1) Tax data already collected without confidentiality issues, currently compiled,
analysed and published
Consider additional metrics and analyses (e.g. specific analyses of MNEs,
expanded access to researchers under confidentiality arrangements)
Consider standardised formats for international comparability
2) Tax data already collected without confidentiality issues, currently compiled and
analysed, but not published
Consider additional metrics and analyses (e.g. specific analyses of MNEs,
expanded access to research under confidentiality arrangements, merging
databases)
Consider publishing analyses, and in standardised formats for international
comparability
3) Tax data already collected without confidentiality issues, already compiled but not
analysed
Consider additional analyses of the compiled data, and publication (e.g. specific
analyses of MNEs, expanded access to research under confidentiality
arrangements, merging databases)
4) Tax data already collected without confidentiality issues, not currently compiled
Consider which data is most useful for analysis (e.g. their benefits) and the cost
of compilation (e.g. specific analyses of MNEs, merging databases)
Consider processes to reduce compilation costs (e.g. statistical sampling)
Consider how data may be compiled in standardised formats for international
comparability
5) Tax data already collected, but possible confidentiality issues which may be
overcome
Consider what measures need to be taken to overcome confidentiality barriers
Consider who could have access (e.g. government tax policy analysts)
Consider what form the access could take (e.g. aggregated anonymised
tabulations)
6) Tax data already collected, but confidentiality is a barrier
Consider available alternatives to maximise benefit of data within
confidentiality limits (e.g. aggregated anonymised tabulations, access to
qualified researchers under strict confidentiality rules)
7) Tax data not already (or not agreed to be) collected
Focus on maximising the analysis and publication of tax data already collected
298. Monitoring BEPS in the future will require taking better advantage of currently
available (and soon to be provided) data in the hands of tax administrations. Increased
analysis and publication of statistical results and aggregated tabulations of MNE taxes
and activities by individual countries will be important to evaluating the effectiveness and
economic impact of BEPS countermeasures and ensuring that BEPS is properly
monitored in the future.
4.5 Data collected in response to the Action Plan in the future

299. The scope and value of information collected by governments will be enhanced as
a result of the work undertaken as part of Action 5 (spontaneous exchange of rulings),
Action 13 (transfer pricing documentation) and, where implemented, Action 12
(disclosure of aggressive tax planning arrangements) of the BEPS Action Plan. In
particular, the additional information from Action 13 will provide governments with more
information on MNE groups allocations of their global economic activities and the
amounts of taxes they pay in each country.
300. The Action 13 Country-by-Country Reports (CbCR) will be important for
improving high-level transfer pricing risk assessments. The Report on Action 13
(Transfer Pricing Documentation and Country-by-Country Reporting, OECD, 2015)
states that CbCR may also be used by tax administrations in evaluating other BEPS
related risks and where appropriate for economic and statistical analysis.10 While the use
of CbCR data is restricted to governments, statistical analyses based on the data included in
the CbCR have the potential to greatly improve future BEPS analyses. The conventional
statistical and economic analyses examining profit rates of individual affiliates based on
economic factors as well as tax rate differentials could be improved. Unlike analyses of
financial statement data, the statistical analyses based on CbCR data will be able to use
actual income taxes paid to the tax jurisdiction of the entities, and will include all entities
of the MNE group.11 The CbCR will be required of MNE groups with annual
consolidated group revenue in the preceding year of EUR 750 million or more, which is
estimated to exclude 85-90% of MNE groups while still covering MNE groups
responsible for approximately 90% of global corporate revenues.
301.
One of the benefits of CbCR is that there is a standard reporting template for
filing which will maintain consistent reporting rules across countries as a means of
limiting taxpayer compliance costs. The standard reporting template and its conversion to
electronic files will also enable less costly compilation of the included data by tax
administrations. MNEs will also file a master file, which provides an overview of the
MNE group business and its overall transfer pricing policies, and a local file, which
provides more detailed information relating to specific intercompany transactions. The
local file will include important information about transactions between related parties,
such as interest and royalties.12 This information would be helpful to analyse BEPS, but
will not be provided in a standard template. Tax administrations will have access to the
data, but it will require more resources to extract and compile the information.
302. The first CbCR will be filed for 2016 calendar year filers no later than
31 December 2017. Thus, some CbCR data will be available for statistical analysis as
early as the end of 2017. However, more complete data for 2016 will not be available
until later. Tax administrations and government tax policy analysts will want to be ready
to quickly analyse the data when it becomes available.13
303. Statistical analysis in the form of aggregated and anonymised tabulations based
on CbCR data would provide governments with a complete view of the largest MNEs
global activities for the first time. These statistical analyses would not disclose individual
taxpayer specific information, and any publication would depend on the countrys
confidentiality rules. In addition, governments should consider other immediate
compilation, analysis, publication and access improvements in other MNE corporate data
for analysing BEPS and BEPS countermeasures in the meantime. Increased benefits
could be obtained from the publication of such data in aggregated and anonymised form,
especially if such analyses are tabulated using a format that is consistent across countries.
To achieve such consistency, greater co-ordination between governments would be
required.
304. Given confidentiality considerations, tax administrations and some government
offices are the only ones with access to tax return information of MNEs operating in their
countries.14 When the first CbCR become available to governments in 2017, access to the
reports will be limited to those government offices. During the public consultations on the
Action 11 discussion draft, a number of commenters suggested that a formal repository or
global database of MNE CbCR should be created. Given concerns around confidentiality,
there are no plans for such an approach,15 however, there would clearly be considerable
benefit for BEPS analysis in developing an internationally co-ordinated approach to
compiling the results of statistical analyses that are aggregated, anonymised, and based
upon global CbCR data.
4.6 Recommendations
305. It is clear from the assessment of current data that analyses of BEPS with non-tax
return information provide an incomplete picture. Using publicly available non-tax return
data has shown the presence and significance of BEPS, but has not provided clear
measures of the scale and scope of BEPS. Non-tax return information does not have
complete coverage, and those companies that are missing or not reporting financial
information may be undertaking significant BEPS. Non-tax return information does not
allow the separation of BEPS impacts from the impacts of non-BEPS tax preferences. For
example, ETRs could be reduced by enacted tax incentives and special tax rates, as well
as BEPS behaviours.
306. Thus, better analysis of BEPS in the future will require more analysis of tax return
data by individual countries tax administrations and/or their tax policy offices. Given the
large, and soon to be expanded, volume of data in the hands of tax administrations, this
reports recommendations focus on the need for governments to work more closely
together to make better use of data that is already (or has been agreed, as part of the BEPS
project, to be) collected. Consistent with this approach, this report makes the following
recommendations:16
Recommendation 1
The OECD should work with all OECD members, BEPS Associates and any country willing to
participate to publish, on a regular basis, a new Corporate Tax Statistics publication, which
would compile a range of data and statistical analyses relevant to the economic analysis of BEPS
in an internationally consistent format. Among other information, this publication would include
aggregated and anonymised statistical analyses prepared by governments based on the data
collected under the Action 13 Country-by-Country Reports.
307. The OECD, through WP2 of the Committee on Fiscal Affairs, should work with
OECD members, BEPS Associates and any willing participating countries to develop
appropriate data classification guidelines and a standardised reporting template and
process, which will allow for the compilation and publication on a regular basis of
internationally consistent and comparable corporate tax statistics, which could include the
following:
Total corporate/business tax revenues collected by governments
MNE share of corporate/business tax collected
Breakdown of business taxes by industry/sector
Summaries of countries statistical aggregated analyses based on data obtained
from CbCR
Key income and expense items of the corporate tax base
Identification and quantification of tax credits, special low tax rates, and other
tax preferences
Corporate withholding taxes
308. These statistics would be provided in an aggregated and anonymised form to
ensure that taxpayer confidentiality is strictly preserved.
309.
Current cross-country analyses of corporate tax systems often use a crude
measure of the corporate tax base, by dividing corporate tax collections by the headline
statutory tax rate. This significantly understates the corporate taxable income by ignoring
corporate tax credits and special low tax rates, and could be improved with additional
information on corporate tax preferences.
Recommendation 2
The OECD should work with all OECD members, BEPS Associates and any willing
participating governments to produce periodic reports on the estimated revenue impacts of
proposed and enacted BEPS countermeasures.
310. The OECD, through WP2 of the Committee on Fiscal Affairs, should work with
participating governments to develop a standardised reporting template and process,
which will support the publication of periodic reports on the estimated revenue impacts of
proposed and enacted countermeasures.
311. These reports could monitor the expected revenue impacts of proposed reforms
and the estimated revenue impact of enacted reforms. Improved metrics of existing and
future BEPS countermeasures could be developed for cross-country research by analysts.
Recommendation 3
The OECD should continue to produce and refine analytical tools and BEPS Indicators to
monitor the scale and economic impact of BEPS and to evaluate the effectiveness and economic
impact of BEPS countermeasures.
312. Chapter 2 presents a dashboard of BEPS Indicators. While these indicators are
not intended to precisely measure the scale of BEPS, they do provide clear indications of
the existence of BEPS and with improved data and further refinement over time may
prove useful in monitoring trends and changes in BEPS.
313. As further data becomes available, not only will this lead to refinements in the
indicators presented, but may also allow for new and enhanced indicators to be
constructed, including those indicators identified in Chapter 2 as possible future
indicators.
314. Annex 3.A2 presents a toolkit for analysing the fiscal effects of BEPS
countermeasures for governments to use in their consideration of estimating future
revenue effects. The toolkit could be expanded to include the availability of statistical
analyses based on data collected under Action 13s Country-by-Country Reports. The
toolkit could also be refined with the shared experience of government estimators and
analysts who have estimated the effects of countermeasures in different countries.
Recommendation 4
Governments should improve the public reporting of business tax statistics, particularly for
MNEs.
315. Many countries currently do not separately identify MNEs for statistical reporting
of business tax statistics. The Action 13 Country-by-Country Reports will identify large
MNEs present in a country. Separate business tax statistics for in-bound MNEs (domestic
affiliates of foreign parents), out-bound MNEs (domestic parents with foreign affiliates)
as well as domestic-only businesses may be able to be compiled. Special tabulations from
the local files of the Country-by-Country Reports may provide more detail about MNEs
tax situation beyond the information in the standardised reports.
316. In the case of a large number of countries, including many low-income and
developing countries, there is a need for the improved compilation and publication of
basic, and expanded, revenue statistics. Increased information about incentives provided
to MNEs may also provide a starting point for an evaluation of their effectiveness.
317. Research on BEPS has been hampered by the lack of basic, quality revenue
statistical data. This is a fact for all countries, but is especially the case for developing
countries, where studies by academic researchers have highlighted the importance of
being able to access more information on BEPS in developing countries. Increased
technical assistance and support from developed countries should be provided. The
OECD Revenue Statistics and Regional Revenue Statistical publications provide a
possible template for the collection of data for countries that do not currently publish
regular, comparable and internationally consistent revenue statistics.
Recommendation 5
Governments should continue to make improvements in non-tax data relevant to BEPS, such as
by broadening country coverage and improving data on FDI associated with resident SPEs, trade
in services and intangible investments.
318. While CbCR has the potential to greatly enhance micro-level tax data of MNEs,
continued improvement in non-tax macroeconomic data and micro-level data will assist
future analysis of BEPS. Recent analyses of trade data, investment and FDI data have
provided important insights to the analysis of BEPS. Wider coverage of countries
included in these international statistics would be beneficial.
319. The Benchmark Definition of Foreign Direct Investment, 4th edition (BMD4)
recommends that countries include transactions with Special Purpose Entities (SPEs) in
their FDI statistics to ensure comparability with other countries. It also provides guidance
on compiling FDI statistics that exclude transactions with SPEs, but does not recommend
specific identification of SPEs and other conduits. These statistics enable policymakers to
assess the impact of FDI into their economies because the statistics will better reflect FDI
into businesses with a real presence in the economy. These statistics also better measure
outward investment from countries by removing funds that pass through their economy
but originate elsewhere. Additional countries reporting SPEs would enable improved
analyses.
320. Improvements in the measurement of intangibles investments, including the
capitalisation of investments in research and development, will enable researchers to
better identify the contributors to profitability and the scale of their contribution. Detailed
analyses of trade statistics and investment surveys have been used by researchers to
analyse BEPS, but have been limited to only a few countries.
Recommendation 6
Governments should consider current best practices and explore new approaches to collaborating
on BEPS research with academics and other researchers. Governments should encourage more
research on MNE activity within tax administrations, tax policy offices, national statistical
offices, and by academic researchers, to improve the understanding of BEPS, and to better
separate BEPS from real economic effects and non-BEPS tax preferences.
321. Research by academics, national statistical offices17 and other tax policy analysts
is important to advancing the progress of the economic analysis of MNEs, BEPS and any
BEPS countermeasures. There are numerous examples of best practices, many of which
have been set out earlier in this chapter, where governments have made tax return data
available
to
researchers
under
strict
confidentiality
and
access
requirements. Governments should look to existing best practices and consider options
for improving collaboration with academics and researchers in the future.
322. In many countries, the collection of business statistics data used in compiling
national accounts makes no distinction between whether the firms are foreign affiliates or
domestically owned. Where available, the data shows significant differences across these
categories of firms.
323. Since separating real economic effects from BEPS is important, non-tax research
is needed on a number of issues, including:
What contributes to value added by businesses and particularly MNEs
The measurement and contributions to value of intangible assets
Understanding sources of differences between MNEs and domestic-only
companies
Non-tax determinants of MNE location decisions
4.7 Conclusion
324. The recommendations made in this report, combined with new statistical analyses
possible based on data from Actions 5, 13, and, where implemented, Action 12 will
enable policymakers in the future to have stronger economic analyses of BEPS and the
effects of BEPS countermeasures.
325. More information about BEPS will be needed to monitor the effects of the BEPS
program in the future, since BEPS is a global problem and individual country tax
administrations have the best data. Better data and tools for analysing BEPS are critical to
separating the effects of BEPS from real economic activity and non-BEPS tax
preferences.
326. Better data and improved analyses should be a priority to ensure that all
stakeholders have a better understanding of the fiscal and economic effects of BEPS, and
the impact of BEPS countermeasures and their effectiveness over time. Improved data
and analysis will assist policy makers by underpinning future decisions with an even
stronger evidence base and will, over time; help build greater trust and confidence among
all taxpayers in the effectiveness of the international tax rules.
Bibliography
Keightley, M. P. and J. M. Stupak (2015), Corporate Tax Base Erosion and Profit
Shifting (BEPS): An Examination of the Data, United States Congressional Research
Report.
Mahoney, L. and R. Miller (2013), Controlled Foreign Corporations, United States
Internal Revenue Service Statistics of Income SOI Bulletin, Winter 2013.
McDonald, M. (2008), Income shifting from transfer pricing: Further evidence from tax
return data, United States Department of the Treasury, Office of Tax Analysis, OTA
Technical Working Paper 2.
Sullivan, M. A. (2010), Transfer Pricing Issues in a Global Economy, Testimony before
the UNITED STATES House of Representatives Ways and Means Committee, July
22, 2010.
Notes
1.
Many financial statement databases include observations for companies but without
accompanying financial information. Several government tax policy analysts have
noted that tax return information that is not specifically required for the tax liability
calculation are not as complete as the tax return lines for the tax liability calculation,
such as balance sheet data on assets and liabilities or data on information returns.
2.
Based on June 2015 survey responses of 30 OECD countries, just over half of the
countries tax policy offices have access to individual company tax return
information.
3.
Statistical sampling is used by some tax administrations to reduce the cost of

compiling information while maintaining a representative sample. In some cases,
analysis of the top 100 or 500 companies can provide significant insights, since they
often account for a large percentage of the total tax under consideration.
4.
www.ato.gov.au/uploadedFiles/Content/MEI/downloads/International-dealingsschedule-2015.pdf.
5.
The OECD countries that grant access to tax return data, under strict confidentiality
conditions, to qualified (non-government) researchers include: Belgium, Canada,
Finland, France, Germany, Ireland, Italy, Korea, Netherlands, New Zealand, Sweden,
Switzerland, the United Kingdom and the United States. South Africa also grants
access to these data to researchers.
6.
Another example can be found in McDonald (2008), Income Shifting from Transfer
Pricing: Further Evidence from Tax Return Data, where Compustat data was merged
with tax return records in order to add financial information for United States parents
of CFCs.
7.
Lee Mahoney and Randy Miller, Controlled Foreign Corporations, United States
Internal Revenue Service Statistics of Income SOI Bulletin, Winter 2013.
8.
Martin A. Sullivan, Transfer Pricing Issues in a Global Economy, testimony before

the United States House of Representatives Ways and Means Committee, July 22,
2010. Mark P. Keightley and Jeffrey M. Stupak, Corporate Tax Base Erosion and
Profit Shifting (BEPS): An Examination of the Data, United States Congressional
Research Report, April 30, 2015.
9.
Questionnaire conducted by Working Party No.2 of the Committee on Fiscal Affairs

in June 2015. The 29 OECD country respondents were: Australia, Austria, Belgium,
Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Hungary,
Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New
Zealand, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey,
United Kingdom and United States. The other country respondents were: Argentina,
Brazil, Bulgaria, Colombia, India, Latvia, the Philippines, Singapore and South
Africa.
10.
Paragraph 25 of the Action 13 2015 Deliverable: Guidance on Transfer Pricing

Documentation and Country-by-Country Reporting.
11.
Country-by-Country Reporting will include for each jurisdiction:

Total revenue, plus unrelated party revenue and third-party revenue
Profit/loss before income tax
Income tax paid on a cash basis
Income tax accrued for the current year
Stated capital
Accumulated earnings
Number of employees
Tangible assets other than cash and cash equivalents
Listing of constituent entities resident in the tax jurisdiction, the tax
jurisdiction or incorporation if different than the jurisdiction of residence,
and main business activity by category
It is mandated that countries participating in the BEPS project will carefully review
the implementation of these new standards and will reassess no later than the end of
2020 whether modifications to the content of these reports should be made to require
reporting of additional or different data. Ibid, p.5.
12.
Other related party transactions that have been analysed for BEPS issues, include
dividends, cost sharing, property right, sales of stock in trade, and serve transactions.
13
When calculating effective tax rates (e.g. income tax paid as a percent of profit), it
will be important to separate firms with positive profits from firms with losses,
otherwise the aggregated effective tax rates will be overstated.
14.
45% of OECD countries reported special programs to enable qualified academic

researchers access to corporate tax data under strict confidentiality rules.
15.
Implementation of CbCR has a specific framework of only government-togovernment exchanges.
16.
It is noted that countries, especially those with a more decentralised tax system, will
need sufficient time to analyse and/or implement the recommendations set out in this
chapter.
17.
National statistical offices are making advances in the development and collection of
economic data that will assist researchers in measuring and monitoring BEPS. As
reported in the summary of a recent conference on national accounts organized by the
Conference of European Statisticians, national statistical offices are developing
additional data sources to measure economic activities of MNEs and global value
chains. Examples of new developments include integrating data from multiple
sources, both macro and micro, disaggregating FDI statistics, and extending trade
statistics, such as trade in value added, to more accurately measure the influence of
international trade on domestic economies.

AND DEVELOPMENT

(23 2015 36 1 P) ISBN 978-92-64-24133-6 2015
Measuring and Monitoring BEPS

Beyond securing revenues by realigning taxation with economic activities and value creation, the OECD/
G20 BEPS Project aims to create a single set of consensus-based international tax rules to address BEPS,
and hence to protect tax bases while offering increased certainty and predictability to taxpayers. A key focus
of this work is to eliminate double non-taxation. However in doing so, new rules should not result in double
taxation, unwarranted compliance burdens or restrictions to legitimate cross-border activity.
Contents
Chapter 1. Assessment of existing data sources relevant for BEPS analysis
Chapter 2. Indicators of base erosion and profit shifting
Chapter 3. Towards measuring the scale and economic impact of BEPS and countermeasures
Chapter 4. Towards better data and tools for monitoring BEPS in the future

isbn 978-92-64-24133-6
23 2015 36 1 P

Project
Mandatory Disclosure Rules

Mandatory Disclosure
Rules, Action 12 2015
Final Report

OECD (2015), Mandatory Disclosure Rules, Action 12 - 2015 Final Report, OECD/G20 Base Erosion and
Profit Shifting Project, OECD Publishing, Paris.
http://dx.doi.org/10.1787/9789264241442-en
ISBN 978-92-64-24137-4 (print)

ISBN 978-92-64-24144-2 (PDF)

OECD 2015
FOREWORD 3
Foreword
MANDATORY DISCLOSURE RULES OECD 2015
4 FOREWORD
TABLE OF CONTENTS 5
Table of contents
Executive summary 9
Introduction 13
Action12 13
Work to date on this issue 14
What this report covers 15
Bibliography 15
Chapter1. Overview of mandatory disclosure17
Objectives 18
Basic elements of mandatory disclosure 18
Design principles 19
Comparison with other disclosure initiatives 20
Co-ordination with other disclosure and compliance tools 22
Effectiveness of mandatory disclosure 23
Bibliography 30
Chapter2. Options for a model mandatory disclosure rule31
Who has to report 33
What has to be reported 36
Hallmarks 39
When information is reported 49
Other obligations to be placed on the promoters or users 53
Consequences of compliance and non-compliance 56
Procedural/tax administration matters 60
Bibliography 66
Chapter3. International tax schemes 67
Application of existing disclosure rules 68
Recommendation on an alternative approach to the design of a disclosure regime for international
tax schemes 70
Example intra-group imported mismatch arrangement 75
Bibliography 78
Chapter4. Information sharing 79
Developments in information exchange 80
Transparency and information exchange under the Action Plan 80
Expansion and reorganisation of the JITSIC Network under the FTA 81
Exchange of information on aggressive tax planning and other BEPS risks 82
Bibliography 82
6 TABLE OF CONTENTS
AnnexA. Further discussion on availability in the United Kingdom 83
AnnexB. Compatibility between self-incrimination and mandatory disclosure 85
AnnexC. Interaction of penalty regimes and disclosure requirement 87
AnnexD. Information power in the UK DOTAS regime 89
AnnexE. Comparison between different countries with mandatory disclosure rules 91
Figures
Figure1.1 Gifting tax shelters participants and donations (Canada, 2006-13) 28
Figure1.2 Annual disclosure by hallmark type (South Africa, 2009-14) 28
Figure3.1 Intra-group imported mismatch arrangement 75
Table
Table1.1 Comparison of Mandatory Disclosure Rules (MDR) with other regimes 24
Boxes
Box2.1
Box2.2
Box2.3
Box2.4
Box2.5
Box2.6
Box2.7
Box2.8
Box2.9
Box2.10
Box2.11
Options for who has to report 33

Draft definition of promoter or advisor in applicable legislation 35
Multi-step or single step approach to defining the scope of a disclosure regime 37
Hallmarks for confidentiality 42
Hallmarks for contingency fee/premium fee 43
Options for designing generic hallmarks 45
Hallmarks for loss transaction 48
Options for timing of promoter disclosure 49
Options for identifying scheme users 53
Draft disclosure form A (for scheme user) 62
Draft disclosure form B (for scheme promoter or advisor) 62

ATP
Aggressive Tax Planning
BEPS
CAD
Canadian Dollar
CFA
CRA
Canada Revenue Agency
DD
Double Deduction
D/NI
Deduction/No Inclusion
DOTAS
Disclosure of Tax Avoidance Schemes (UK Legislation)
EUR Euro
FTA
GAAR
General Anti-Avoidance Rule
GBP
Great Britain Pound
HMRC
HM Revenue and Customs (United Kingdom)
IRC
Internal Revenue Code (United States)
IRS
Internal Revenue Service
JITSIC
Joint International Tax Shelter Information and Collaboration Network
MDR
MNE
Multinational Enterprise
OECD
OTSA
Office of Tax Shelter Analysis
RTAT
Reporting of Tax Avoidance Transactions
SARS
South African Revenue Service
SEC
Securities and Exchange Commission
SPOC
Single Point of Contact
SRN
Scheme Reference Number
TOI
Transaction of Interest
TS
Tax Shelter
UK
United Kingdom
8 Abbreviations and acronyms

US
United States of America
USD
United States Dollar
VAT Value Added Tax

WP11
Working Party No.11 on Aggressive Tax Planning
ZAR
South African Rand
Executive summary 9
Executive summary
The lack of timely, comprehensive and relevant information on aggressive tax planning
strategies is one of the main challenges faced by tax authorities worldwide. Early access
to such information provides the opportunity to quickly respond to tax risks through
informed risk assessment, audits, or changes to legislation or regulations. Action12 of
the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013)
recognised the benefits of tools designed to increase the information flow on tax risks
to tax administrations and tax policy makers. It therefore called for recommendations
regarding the design of mandatory disclosure rules for aggressive or abusive transactions,
arrangements, or structures taking into consideration the administrative costs for tax
administrations and businesses and drawing on experiences of the increasing number of
countries that have such rules.
This Report provides a modular framework that enables countries without mandatory
disclosure rules to design a regime that fits their need to obtain early information
on potentially aggressive or abusive tax planning schemes and their users. The
recommendations in this Report do not represent a minimum standard and countries are
free to choose whether or not to introduce mandatory disclosure regimes. Where a country
wishes to adopt mandatory disclosure rules, the recommendations provide the necessary
flexibility to balance a countrys need for better and more timely information with the
compliance burdens for taxpayers. The Report also sets out specific recommendations
for rules targeting international tax schemes, as well as for the development and
implementation of more effective information exchange and co-operation between tax
administrations.
Design principles and key objectives of a mandatory disclosure regime

Mandatory disclosure regimes should be clear and easy to understand, should
balance additional compliance costs to taxpayers with the benefits obtained by the tax
administration, should be effective in achieving their objectives, should accurately identify
the schemes to be disclosed, should be flexible and dynamic enough to allow the tax
administration to adjust the system to respond to new risks (or carve-out obsolete risks),
and should ensure that information collected is used effectively.
The main objective of mandatory disclosure regimes is to increase transparency by
providing the tax administration with early information regarding potentially aggressive
or abusive tax planning schemes and to identify the promoters and users of those schemes.
Another objective of mandatory disclosure regimes is deterrence: taxpayers may think
twice about entering into a scheme if it has to be disclosed. Pressure is also placed on the
tax avoidance market as promoters and users only have a limited opportunity to implement
schemes before they are closed down.
Mandatory disclosure regimes both complement and differ from other types of
reporting and disclosure obligations, such as co-operative compliance programmes, in that
they are specifically designed to detect tax planning schemes that exploit vulnerabilities
in the tax system, while also providing tax administrations with the flexibility to choose
thresholds, hallmarks and filters to target transactions of particular interest and perceived
areas of risk.
Key design features of a mandatory disclosure regime

In order to successfully design an effective mandatory disclosure regime, the
following features need to be considered: who reports, what information to report, when
the information has to be reported, and the consequences of non-reporting. In relation to
the above design features, the Report recommends that countries introducing mandatory
disclosure regimes:
impose a disclosure obligation on both the promoter and the taxpayer, or impose the
primary obligation to disclose on either the promoter or the taxpayer;
include a mixture of specific and generic hallmarks, the existence of each of them
triggering a requirement for disclosure. Generic hallmarks target features that are
common to promoted schemes, such as the requirement for confidentiality or the
payment of a premium fee. Specific hallmarks target particular areas of concern
such as losses;
establish a mechanism to track disclosures and link disclosures made by promoters
and clients as identifying scheme users is also an essential part of any mandatory
disclosure regime. Existing regimes identify these through the use of scheme
reference numbers and/or by obliging the promoter to provide a list of clients.
Where a country places the primary reporting obligation on a promoter, it is
recommended that they also introduce scheme reference numbers and require,
where domestic law allows, the production of client lists;
link the timeframe for disclosure to the scheme being made available to taxpayers
when the obligation to disclose is imposed on the promoter; link it to the
implementation of the scheme when the obligation to disclose is imposed on the
taxpayer;
introduce penalties (including non-monetary penalties) to ensure compliance with
mandatory disclosure regimes that are consistent with their general domestic law.
Coverage of international tax schemes

There are a number of differences between domestic and cross-border schemes that
make the latter more difficult to target with mandatory disclosure regimes. International
schemes are more likely to be specifically designed for a particular taxpayer or transaction
and may involve multiple parties and tax benefits in different jurisdictions, which can make
these schemes more difficult to target with domestic hallmarks. In order to overcome these
difficulties, the Report recommends that:
Countries develop hallmarks that focus on the type of cross-border BEPS outcomes
that cause them concern. An arrangement or scheme that incorporates such a
cross-border outcome would only be required to be disclosed, however, if that
arrangement includes a transaction with a domestic taxpayer that has material tax
consequences in the reporting country and the domestic taxpayer was aware or
ought to have been aware of the cross-border outcome.
Taxpayers that enter into intra-group transactions with material tax consequences
are obliged to make reasonable enquiries as to whether the transaction forms part of
an arrangement that includes a cross-border outcome that is specifically identified
as reportable under their home jurisdictions mandatory disclosure regime.
The application of these recommendations is illustrated in the Report with an example
dealing with an imported hybrid mismatch arrangement of the type covered in the 2015
OECD/G20 BEPS report Neutralising the Effects of Hybrid Mismatch Arrangements
(OECD, 2015).
Enhancing information sharing

Transparency is one of the three pillars of the OECD/G20 BEPS Project and a number
of measures developed in the course of the Project will give rise to additional information
being shared with, or between, tax administrations. The expanded Joint International Tax
Shelter Information and Collaboration Network (JITSIC Network) of the OECD Forum
on Tax Administration provides an international platform for an enhanced co-operation
and collaboration between tax administrations, based on existing legal instruments, which
could include co-operation on information obtained by participating countries under
mandatory disclosure regimes.
I ntroduction 13
Introduction
1. Governments need timely access to relevant information in order to identify and
respond to tax risks posed by tax planning schemes. Access to the right information at
an early stage allows tax administrations to improve the speed and accuracy of their risk
assessment over a simple reliance on voluntary compliance and audit. At the same time,
early identification of taxpayer compliance issues also gives tax authorities more flexibility
in responding to tax risk and allows tax policy officials to make timely and informed
decisions on appropriate legislative or regulatory responses to protect tax revenues.
2. A number of countries have therefore introduced disclosure initiatives to give them
timely information about taxpayer behaviour and to facilitate the early identification of
emerging policy issues. These initiatives include: rulings, penalty reductions for voluntary
disclosure and the use of co-operative compliance programmes and additional reporting
obligations as well as mandatory disclosure regimes. The objective of these initiatives is
to either require or incentivise taxpayers and their advisers to provide tax authorities with
relevant information about taxpayer compliance that is more detailed and timely than the
information recorded on a tax return.
3. Mandatory disclosure regimes differ from these other disclosure and compliance
initiatives in that they are specifically designed to require taxpayers and promoters to
provide tax administrations with early disclosure of potentially aggressive or abusive
tax planning arrangements if they fall within the definition of a reportable scheme
set out under that regime. Mandatory disclosure therefore has a number of advantages
when compared to other forms of disclosure initiative and allows tax administrations to
obtain information much earlier in the tax compliance process (in certain cases before
the structures have even been implemented). This can enable an accelerated response
(statutory, administrative or regulatory) to transactions that are considered to be tax
avoidance.
4. Mandatory disclosure regimes also provide the flexibility of a modular approach that
allows tax administrations to select hallmarks and to apply thresholds and filters in order to
focus the disclosure obligation on particular areas of perceived risk. The modular elements
of the regime can be customised to fit with existing disclosure and compliance rules; to
accommodate changing tax policy priorities and to minimise the compliance burden on
taxpayers.
Action12
5. The BEPS Action Plan recognises that one of the key challenges faced by tax
authorities is a lack of timely, comprehensive and relevant information on potentially
aggressive or abusive tax planning strategies. The Action Plan on Base Erosion and Profit
Shifting (BEPS Action Plan, OECD, 2013a) notes that the availability of such information
is essential to enable governments to quickly identify areas of tax policy and revenue
14 I ntroduction
risk. While audits remain a key source of information on tax planning, they suffer from a
number of constraints as tools for the early detection of tax planning schemes. Action12
notes the usefulness of disclosure initiatives in addressing these issues and calls on OECD
and G20 member countries to:
Develop recommendations regarding the design of mandatory disclosure rules
for aggressive or abusive transactions, arrangements, or structures, taking into
consideration the administrative costs for tax administrations and businesses
and drawing on experiences of the increasing number of countries that have such
rules. The work will use a modular design allowing for maximum consistency but
allowing for country specific needs and risks. One focus will be international tax
schemes, where the work will explore using a wide definition of tax benefit in
order to capture such transactions. The work will be co-ordinated with the work
on co-operative compliance. It will also involve designing and putting in place
enhanced models of information sharing for international tax schemes between tax
administration (OECD, 2013a).
6.
Action12 therefore identifies three key outputs:

recommendations for the modular design of mandatory disclosure rules;
a focus on international tax schemes and consideration of a wide definition of tax
benefit to capture relevant transactions;
designing and putting in place enhanced models of information sharing for
international tax schemes.
7. Action12 provides that the recommendations for the design of mandatory disclosure
rules should allow maximum consistency between countries while being sensitive to
country specific needs and risks and the costs for tax administrations and business. The
design recommendations should also take into account the role played by other compliance
and disclosure initiatives such as co-operative compliance.
Work to date on this issue

8. The OECD issued a report on transparency and disclosure initiatives in 2011 (Tackling
Aggressive Tax Planning through Improved Transparency and Disclosure, OECD, 2011). The
2011 Report explained the importance of timely, targeted and comprehensive information to
counter aggressive tax planning; provided an overview of disclosure initiatives introduced
in certain OECD countries (including mandatory disclosure) and discussed those countries
experiences regarding such initiatives. The 2011 Report recommended countries review the
disclosure initiatives outlined in the report with a view to evaluating the introduction of
those best suited to their particular needs and circumstances.
9. In 2013 the OECD issued a report on co-operative compliance programmes
(Co-operative Compliance: A Framework: From Enhanced Relationship to Co-Operative
Compliance, OECD, 2013b). This 2013 Report (OECD, 2013b) was a follow-up to a 2008
Study on the Role of Tax Intermediaries (OECD, 2008), which encouraged tax authorities
to establish enhanced relationships with their large business taxpayers. Under co-operative
compliance programmes, taxpayers agree to make full disclosure of material tax issues and
transactions they have undertaken to enable tax authorities to understand their tax impact.
Co-operative compliance relationships allow for a joint approach to tax risk management
and compliance and can result in more effective risk assessment and better use of resources
by the tax administration. The 2013 Report (OECD, 2013b) noted the number of countries
I ntroduction 15
that had developed co-operative compliance programmes since the publication of the 2008
Study and concluded that the value of such programmes was now well-established.
10. Both mandatory disclosure and co-operative compliance are intended to improve
transparency, risk assessment and ultimately taxpayer compliance. They do this is in
different ways and may be aimed at different taxpayer populations, for instance co-operative
compliance programmes often focus on the largest corporate taxpayers. However, as
mentioned later in this report, mandatory disclosure can reinforce the effectiveness of a
co-operative compliance regime by ensuring that there is a level playing field in terms of
the disclosure and tax transparency required from all taxpayers.
What this report covers

11. This report provides an overview of mandatory disclosure regimes, based on the
experiences of countries that have such regimes, and sets out recommendations for a
modular design of a mandatory disclosure regime. The recommended design utilises a
standard framework to ensure maximum consistency while preserving sufficient flexibility
to allow tax administrations to control the quantity and type of disclosure. This report
also sets out recommendations for a mandatory disclosure regime designed to capture
international tax schemes. The report is divided into four chapters:
Chapter1 provides an overview of the key features of a mandatory disclosure
regime and considers its interaction with other disclosure initiatives and
compliance tools.
Chapter2 sets out both the framework and features for the modular design of a
mandatory disclosure regime.
Chapter3 looks at international transactions and considers how these could best be
captured by a mandatory disclosure regime.
Chapter4 considers exchange of information in the context of international
schemes.
Bibliography
OECD (2013a), Action Plan on Base Erosion and Profit Shifting, OECD, Paris, http://
dx.doi.org/10.1787/9789264202719-en.
OECD (2013b), Co-operative Compliance: A Framework: From Enhanced Relationship to
Co-operative Compliance, OECD, Paris, http://dx.doi.org/10.1787/9789264200852-en.
OECD (2011), Tackling Aggressive Tax Planning through Improved Transparency and
Disclosure, OECD, Paris, www.oecd.org/ctp/exchange-of-tax-information/48322860.
pdf.
OECD (2008), Study into the Role of Tax Intermediaries, OECD, Paris, http://dx.doi.
org/10.1787/9789264041813-en.
1. Overview of mandatory disclosure 17
Chapter1
Overview of mandatory disclosure
18 1. Overview of mandatory disclosure
Objectives
12. The main purpose of mandatory disclosure rules is to provide early information
regarding potentially aggressive or abusive tax planning schemes and to identify the
promoters1 and users of those schemes. Early detection from obtaining quick and relevant
information enhances tax authorities effectiveness in their compliance activities. As a
result, some of the resources that would otherwise be dedicated to detecting tax avoidance,
for example through audit, can be redeployed to review and respond to scheme disclosures.
In addition early information can enable tax administrations to quickly respond to changes
in taxpayer behaviour through operational policy, legislative or regulatory changes.
13. Another objective of mandatory disclosure rules is deterrence. A reduction in
the promotion and use of tax avoidance can be achieved by altering the economics of
tax avoidance. Taxpayers may think twice about entering into a scheme if it has to be
disclosed and they know that the tax authorities may take a different position on the tax
consequences of that scheme or arrangement.
14. Mandatory disclosure rules also place pressure on the tax avoidance market as
promoters and users only have a limited opportunity to implement schemes before they are
closed down. In order to enhance the effect of a disclosure regime it is therefore important
that countries tax administration and legislative systems can react rapidly to close down
opportunities for tax avoidance.
15. Whilst countries have reported some different experiences with respect to the
deterrence effect, the objectives of existing different mandatory disclosure rules can be
summarised as follows:
to obtain early information about potentially aggressive or abusive tax avoidance
schemes in order to inform risk assessment;
to identify schemes, and the users and promoters of schemes in a timely manner;
to act as a deterrent, to reduce the promotion and use of avoidance schemes.
16. A discussion of the effectiveness of mandatory disclosure in achieving these
objectives is set out below.
Basic elements of mandatory disclosure

17. In order to achieve the objectives set out above, mandatory disclosure regimes have
to address a number of basic design questions which determine their scope and application
as follows:
Who has to report: Mandatory disclosure rules can require disclosure from
taxpayers (the users) and/or planners (promoters or advisors) of potential avoidance
schemes.
What has to be reported: This can be broken down into two different questions:
- Countries first need to decide what types of schemes and arrangements should
be disclosed under the regime (i.e.the definition of what is a reportable
scheme). As noted later in this report, the fact that a scheme is reportable does
not automatically mean that it involves tax avoidance. Some of the hallmarks
described herein have generally been linked to abusive tax transactions, but
may also be found in legitimate transactions. In addition it is unlikely that
a disclosure regime will be designed to pick up all tax avoidance, instead

disclosure is likely to be targeted on the areas of avoidance and aggressive tax
planning that are perceived to give rise to the greatest risks.
- Countries also need to determine what information needs to be disclosed about
a reportable scheme. This involves striking a balance between ensuring the
information is clear and useful and avoiding undue compliance burdens for
taxpayers.
When information is reported: The purpose of mandatory disclosure rules is
to provide the tax administration with early information on certain tax planning
schemes and their users. The determination of when promoters and/or users are
required to make a disclosure is therefore key to achieving that goal.
What other obligations (if any) should be placed on promoters and/or scheme
users: For instance countries might require users of schemes to report a unique
identification number on their return in order to identify users of disclosed
schemes. Disclosure rules can also require promoters to provide clients lists to the
tax administration.
What are the consequences of non-compliance: Non-compliance with disclosure
rules generally triggers penalties. In addition, countries may apply other sanctions
to enforce mandatory disclosure rules and deter non-compliance.
What are the consequences of disclosure: Mandatory disclosure regimes need
to be clear about the consequences of disclosure for the taxpayer and advisor. In
particular countries should make it clear that reporting a scheme does not mean that
the scheme is accepted by the tax administration or that it will not be challenged.
How to use the information collected: Mandatory disclosure regimes should
provide relevant information about tax avoidance schemes so, in addition to
defining the scope of the rules as mentioned above, countries need to consider how
to make full use of the information collected in order to improve compliance.
Design principles
18. The specific approach taken to introducing mandatory disclosure rules will vary
from country to country. Nevertheless, the text below considers the key design principles.
Mandatory disclosure rules should be clear and easy to understand

19. Mandatory disclosure rules should be drafted as clearly as possible to provide
taxpayers with certainty about what is required by the regime. Lack of clarity and certainty
can lead to inadvertent failure to disclose (and the imposition of penalties), which may
increase resistance to such rules from taxpayers. Additionally, a lack of clarity could result
in a tax administration receiving poor quality or irrelevant information.
Mandatory disclosure rules should balance additional compliance costs to

taxpayers with the benefits obtained by the tax administration.
20. As mandatory disclosure rules impose an obligation to disclose certain transactions
on taxpayers and/or promoters they will increase upfront compliance costs. Such rules,
however, will provide tax administrations with better information on avoidance transactions

and should enable them to use their resources more efficiently. This better targeting, or
improved risk assessment, could also bring benefits to taxpayers as enquiries will be
focused on areas of real concern to the tax administration.
21. The scope and extent of any disclosure obligation is key in terms of achieving a
balance. Unnecessary or additional requirements will increase taxpayer costs and may
undermine a tax administrations ability to effectively use the data provided.
Mandatory disclosure rules should be effective in achieving the intended policy

objectives and accurately identify relevant schemes
22. As mentioned above the key objective of a mandatory disclosure regime is to
obtain early notification of avoidance schemes and their users and promoters. Any rules
therefore need to be drafted so that they capture sufficient information on the schemes
and arrangements a tax administration is concerned about. In addition they should
provide information to enable identification of users and promoters. It is impractical for a
mandatory disclosure regime to target all transactions that raise tax avoidance concerns
and the identification of hallmarks is a key factor to setting the scope of the rules.
However the hallmarks will need to reflect specific country needs or risks.
Information collected under mandatory disclosure should be used effectively

23. A tax administration needs to implement effective procedures for making best use
of the information disclosed by taxpayers. This means setting up a process to review
disclosures and identify the potential tax policy and revenue implications. Once issues
have been identified, effective communication within the tax administration is necessary
to ensure these issues are fully understood and addressed. While this may entail the
commitment of additional resources, this cost could be offset by resource savings from
quicker and more efficient identification of emerging tax policy and revenue issues.
Comparison with other disclosure initiatives

24. A number of countries operate information or compliance initiatives in addition to or
instead of having a mandatory disclosure regime. The other types of disclosure initiatives
used by tax administrations to collect taxpayer compliance information are described
in further detail in the Report on Tackling Aggressive Tax Planning through Improved
Transparency and Disclosure (2011 Report, OECD, 2011) and include:
Rulings regimes that enable taxpayers to obtain a tax authoritys view on how
the tax law applies to a particular transaction or set of circumstances and provides
taxpayers with some degree of certainty on the tax consequences. Rulings can,
at least in part, play a similar role to disclosure regimes in that a taxpayer will
typically apply for a ruling in anticipation of entering into a transaction. The
usefulness of rulings regimes as a source of information on transactions involving
tax avoidance may however be limited where the tax administration does not rule
on transactions that involve abusive or aggressive tax planning schemes because
taxpayers will have no incentive to apply for such rulings.
Additional reporting obligations that require taxpayers to disclose particular
transactions, investments or tax consequences usually as part of the return filing
process.
Surveys and Questionnaires that are used by some tax administrations to gather
information from certain groups of taxpayers with a view to undertaking risk
assessments.
Voluntary disclosure as means of reducing taxpayer penalties.
Co-operative compliance programmes where participating taxpayers agree to
make full and true disclosure of material tax issues and transactions and provide
sufficient information to understand the transaction and its tax impact.
A comparative summary of these information disclosure initiatives is set out in Table1.1.
25. In each case, the objective of these disclosure initiatives is, to a greater or lesser
extent, to require, or incentivise taxpayers and their advisers to provide tax authorities with
relevant information on taxpayer behaviour that is either more detailed, or more timely,
than the information recorded on a tax return. These other disclosure and compliance
initiatives have different objectives to mandatory disclosure and are not exclusively focused
on identifying the tax policy and revenue risks raised by aggressive tax planning. They
therefore typically lack the broad scope of a mandatory disclosure regime (capturing any
type of tax or taxpayer) or the focus on obtaining specific information about promoters,
taxpayers and defined schemes. The key feature that distinguishes mandatory disclosure
from these other types of reporting obligations is that mandatory disclosure regimes are
specifically designed to detect tax planning schemes that exploit vulnerabilities in the tax
system while also providing tax administrations with the flexibility to choose thresholds,
hallmarks and filters in order to target transactions of particular interest and perceived
areas of risk. A more detailed discussion of the key differences between mandatory
disclosure regimes and other types of disclosure initiative is set out below.
Mandatory disclosure applies to a broader range of persons

26. Because mandatory disclosure regimes apply to all taxpayers (both large and small)
and not simply those who choose to disclose through a voluntary compliance measure,
they have a broad scope and can capture the largest possible set of taxpayers, tax types
and transactions. Mandatory disclosure regimes also include third parties involved in the
design, marketing, or implementation of tax planning schemes. In contrast to voluntary
disclosure initiatives, which only incentivise a taxpayer to disclose details of their
tax planning arrangements, mandatory disclosure is compulsory, so that any scheme
targeted by the regime is required to be disclosed by all taxpayers and their advisers.
Ruling regimes, for example, can provide tax administrations with useful information
on transactions being undertaken by taxpayers and how taxpayers are interpreting and
applying the law. However because rulings regimes are voluntary compliance initiatives,
they will apply to a smaller number of self-selected taxpayers.
27. While an effective co-operative compliance programme or targeted questionnaires
can provide a source of information on tax planning schemes, neither of these disclosure
initiatives target the same range of taxpayers or the advisers and other third parties
responsible for the design and implementation of such schemes. Although taxpayer surveys
and questionnaires can reach a wider group of taxpayers than a cooperative compliance
regime, they can only cover selected risks and the information obtained on those risks will
depend on the design of the questionnaire. The effectiveness of questionnaires will also
depend on the powers of the tax administration to require taxpayers to respond.
Mandatory disclosure provides specific information on the scheme, users and

suppliers
28. Many countries impose reporting obligations on their taxpayers in relation to
particular transactions or require taxpayers to specifically disclose the application of
the particular regime. These additional reporting obligations enable tax authorities to
improve audit efficiency through better data collection and analysis. However, in contrast
to mandatory disclosure regimes, additional reporting obligations do not focus on tax
avoidance and typically do not directly provide tax administrations with information on
tax planning techniques.
29. In the absence of a mandatory disclosure regime, tax authorities can not only find
it difficult to identify a scheme from available information but may also find that, by the
time the scheme has been identified, it is too late to prevent significant revenue loss. It can
also be difficult to identify all the users of a scheme, without using substantial additional
tax administration resource, so that quantifying the tax loss, or designing an effective
compliance strategy, can be challenging.
30. Because mandatory disclosure requires promoters and taxpayers to report specific
scheme information directly to the tax administration it is a more efficient and effective
method of obtaining comprehensive information on tax planning than relying on an
analysis or audit of tax return information. Mandatory disclosure also provides tax
administrations with information on the users of the scheme and those responsible for
promoting and implementing it. This use of client lists and scheme identification numbers
allows the tax administration to rapidly obtain an accurate picture of the extent of the tax
risk posed by a scheme and to easily identify when a taxpayer has used a scheme. Access
to client lists also opens up the possibility of using other tax compliance tools such as direct
communication with taxpayers.
Mandatory disclosure provides information early in the tax compliance process

31. One of the key objectives of a mandatory disclosure regime is to provide tax
administrations with early information on tax planning behaviour. Early warning
allows tax administrations to respond more quickly to tax policy and revenue risks
through operational, legislative or regulatory changes. Other disclosure initiatives do
not generally provide tax administrations with the same degree of advanced warning.
Ruling applications are perhaps the exception, in that taxpayers usually apply for a ruling
in anticipation of undertaking a transaction. Rulings regimes, however, are voluntary
disclosure initiatives used by a subsection of the taxpayer population and therefore do not
provide tax administrations with a comprehensive overview of taxpayer behaviour or a
reliable indicator of emerging tax policy and revenue risks.
Co-ordination with other disclosure and compliance tools

32. Both the decision as to whether to introduce a mandatory disclosure regime and
the structure and content of such a regime depend on a number of factors including an
assessment of the tax policy and revenue risks posed by tax planning within the jurisdiction
and the availability of other disclosure and compliance tools. In particular, the additional
intelligence on tax planning behaviour that a tax administration obtains under a mandatory
disclosure regime will depend on the breadth and effectiveness of other information
disclosure, such as co-operative compliance and rulings regimes, that collect substantially
the same information. Nevertheless the analysis in this chapter suggests that mandatory
disclosure provides tax administrations with a number of advantages over other forms of
disclosure initiative in that it requires both taxpayers and promoters to report information,
early in the tax compliance process, on tax planning schemes that raise particular tax
policy or revenue risks. Countries that have introduced mandatory disclosure rules indicate
that they both deter aggressive tax planning behaviour and improve the quality, timeliness
and efficiency in gathering information on tax planning schemes allowing for more
effective compliance, legislative and regulatory responses. This is supported by the data
set out in Table1.1.
33. While other disclosure and compliance initiatives can also produce similar outcomes
they do not fulfil exactly the same objectives because they: apply to a different and in some
cases a potentially smaller population of taxpayers, promoters, advisors and intermediaries;
do not target or provide the same level of information on avoidance or provide that
information later in the tax compliance process.
34. Just as disclosure initiatives such as rulings and cooperative compliance programmes
are not a good substitute for a mandatory disclosure regime, equally mandatory disclosure
cannot replace or remove the need for these other type of disclosure and compliance tools.
Mandatory disclosure can, however, reinforce other disclosure and tax compliance tools
such as co-operative compliance or voluntary disclosure in ensuring a more level playing
field as between large corporates and other taxpayers that do not have the same kind of
compliance relationship with the tax administration. In deciding whether to introduce a
mandatory disclosure regime or determining the kinds of arrangement targeted by the
regime a tax administration will need to take account of other information gathering tools
and its risk assessment processes so that they can be coordinated and harmonised as far
as possible. For example, if a jurisdiction already has specific reporting rules on certain
transactions it should consider whether to exclude these from the scope of any mandatory
disclosure regime.2 On the other hand a scheme that is required to be disclosed under a
mandatory disclosure regime should not be required to be disclosed a second time under
a voluntary disclosure requirement in order, for example, to benefit from a reduction in
taxpayer penalties.
35. There is also some inevitable (and desirable) overlap between the operation and
effects of mandatory disclosure and a General Anti-Avoidance Rule (GAAR). A GAAR
provides tax administrations with an ability to respond directly to instances of tax
avoidance that have been disclosed under a mandatory disclosure regime. Equally, from
a deterrence perspective, a taxpayer is less likely to enter into a tax planning scheme
knowing that the tax outcomes will need to be disclosed and may subsequently be
challenged by the tax administration. Mandatory disclosure and GAARs are therefore
mutually complementary from a compliance perspective. Equally, however, the purpose
of a mandatory disclosure regime is to provide the tax administration with information
on a wider range of tax policy and revenue risks other than those raised by transactions
that would be classified as avoidance under a GAAR. Accordingly the definition of a
reportable scheme for disclosure purposes will generally be broader than the definition
of tax avoidance schemes covered by a GAAR and should also cover transactions that are
perceived to be aggressive or high-risk from a tax planning perspective.
Effectiveness of mandatory disclosure3

36. Amongst the OECD and G20 countries, mandatory disclosure rules have been
introduced in the United States, Canada, South Africa, the United Kingdom, Portugal,
Ireland, Israel, and Korea.4 In 1984, the United States first introduced such rules, which
Yes
Yes
Can obtain information at

early stage
Mandatory
Deterrence on
consumption sidec
Deterrence on supply of
avoidance
Timing
Nature of reporting
requirement
Surveys
3. Effect
Mandatory
Generally part of return

filing process, so no early
detection
No
Yes
No
No
May not be targeted at

avoidance schemes or
only at specific schemes
2. What has to be reported
No
All taxpayers
Mandatory
Timing variable unlikely

to provide early detection
No
Yes
No
No
Particular areas of known

risk
No
Sub-set of taxpayers
Voluntary
Timing variable limited

early detection
No
Yes
No
No
Can apply to all tax

avoidance and to evasion
No
All taxpayers
Penalty reductions for

early disclosures
Voluntary

early stage
No
Yes
Yes
No
Tax planning or tax

avoidance undertaken
by taxpayers within the
programme
No
Sub-set of taxpayers
Co-operative
compliance programmes
Notes: a. Several countries expressed the opinion that their rulings regime did provide information on avoidance. This has not been tested but the comments made in the table
and in this chapter relate to how rulings regimes are generally applied in the countries involved in this work.

b. Information on the promoter is obtained except in the very limited circumstances in which only taxpayers report.

c. W hile the extent of any deterrent effect is difficult to measure, MDR may have a stronger deterrent effect than other regimes because it particularly targets aggressive
tax planning schemes and taxpayers can expect the disclosure to be scrutinised by tax authorities with a view to taking early action to address any tax policy or revenue
risks.
Voluntary

early stage
No
Yes
Yes,
specific transactions
No
Not primarily designed to

capture tax avoidancea
Certainty for taxpayer
Tax avoidance:
Areas of known risks, and
new or potentially abusive
transactions
Type of transactions
No
No
Promoters
Third parties
All taxpayers
Additional reporting
obligation
1. Who has reporting obligation under a regime
Rulings
Information on promoter Yesb
All taxpayers
Taxpayers
MDR
Table1.1. Comparison of Mandatory Disclosure Rules (MDR) with other regimes
were last revised significantly in 2004. Canada followed in 1989 with a Tax Shelter (TS)
regime for a specific tax planning arrangement involving gifting arrangements and
the acquisition of property. In addition, new mandatory Reporting of Tax Avoidance
Transactions (RTAT) legislation with much broader reporting requirements was enacted
in June 2013. South Africa introduced disclosure rules in 2003 and revised them in 2008.
The United Kingdom enacted disclosure rules in 2004 and revised them substantially in
2006. Further substantial amendments entered into force on 1January 2011. Portugal and
Ireland introduced their mandatory disclosure regime in 2008 and 2011 respectively and
since then Korea and Israel have also introduced mandatory disclosure rules. The design
(and consequently the effect) of these regimes varies from one country to the next. In
general, however, as noted above, the main objectives of mandatory disclosure rules can
be summarised as follows:
to obtain early information about tax avoidance schemes in order to inform risk
assessment;
to identify schemes, and the users and promoters of schemes in a timely manner;
to act as a deterrent, to reduce the promotion and use of avoidance schemes.
37. Not all of the countries with mandatory disclosure regimes have collected data on
the effectiveness of their regime in terms of these objectives. Much of the information in
this section focuses on data and statistics provided by the United Kingdom along with
some specific examples and data provided by other countries. However even though the
available data is not comprehensive or detailed, the feedback from those with disclosure
regimes provides a reasonably consistent picture that suggests that mandatory disclosure is
successful in meeting its objectives.
Obtaining early information

38. By providing tax administrations with an effective early warning system for
emerging tax policy and revenue risks, tax administrations have a wider range of options
for addressing these risks through compliance, legislative or regulatory responses.
39. The UK Disclosure of Tax Avoidance Schemes (DOTAS) has provided early
information about tax avoidance schemes, allowing the UK Government, where appropriate,
to introduce legislation closing them down before significant tax was lost. 925 of the
2366avoidance schemes disclosed up to 2013 have been closed by legislation (one legislative
change can close more than one scheme: over 200 stamp duty land tax schemes were closed
by just 3legislative changes). Schemes can also be shut down very quickly. For example, on
one occasion, a scheme was closed down within a week of the disclosure, protecting millions
in tax revenue.
40. The United Kingdoms experience has been that the early years following DOTAS
being introduced gave rise to an initial spike of action to close down loopholes by making
legislative change as more information became available about the schemes being promoted
in the market.5 This has tailed off since,for a number of reasons including:
the gradual narrowing of the scope for successful avoidance scheme design by
successive legislative change;
some of the larger and more expert advisory firms moving out of the avoidance
design market targeted by DOTAS;

other tools being added to the counter avoidance toolkit, such as targeted antiavoidance rules, GAAR, actions focused on promoters;
a downshift in the expertise of the type of firm promoting avoidance schemes
meaning that disclosed schemes can be challenged under existing law and do not
require a legislative response.
41. Examples of how mandatory disclosure has informed legislative change are also
available from other regimes. For instance a number of disclosures were received under the
Irish mandatory disclosure regime in relation to employee benefit trusts.6 A wide reaching
anti-avoidance provision was introduced in Irish Finance Act 2013 which counteracted
these schemes.
42. In South Africa any preference share that is redeemable within 10 years of issue
is listed as a reportable arrangement. These arrangements make up the majority of
transactions reported and the data collected has provided an insight into how preference
share funding is utilised. This understanding has informed the design of the new hybrid
equity tax rules that have been recently introduced.
Improved identification of schemes, users and promoters

43. The introduction of a mandatory disclosure regime should allow a tax administration
to reduce their reliance on audit and data analysis as a mechanism for detecting tax
avoidance.
44. The Aggressive Tax Planning (ATP) Directory is a secure database of tax planning
schemes maintained by certain OECD and G20 countries. The Directory is populated by
ATP schemes submitted by the countries that have access to it and it is used to identify
tax planning trends and formulate detection and response strategies. Of the more than 400
schemes posted on the Directory, two-thirds have been identified through data analysis
and audit. However the reliance on audit and data analysis would appear to be much lower
for countries that have introduced mandatory disclosure regimes. If the same analysis is
undertaken using a subset of four member countries with mandatory disclosure regimes,7
the number of contributed schemes that the tax administration has identified through
audit and data analysis falls to one-third with another one-third coming from mandatory
disclosure. This would indicate that countries with mandatory disclosure regimes place
significantly less reliance on audits and data analysis as a method of detecting tax planning
schemes.
45. Looking at specific countries, the information provided by the UK DOTAS regime
about the take up of a scheme has been useful in putting together an operational response.
Client lists have also enabled the deployment of UK tax administration resources to be
co-ordinated and planned more effectively because they identify the number of possible
cases at an early stage. Client lists have also provided an additional mechanism for
checking that schemes are disclosed by all users.
46. The UK tax administration has also used the opportunity created by early disclosure
to intervene with promoters. For example, in one case it was evident that a scheme did
not work and was based on an incorrect interpretation of the relevant tax law. As a result
of talking to the promoter and issuing a communication to warn potential users, the
promoter agreed not to market this scheme. This resulted in a more efficient use of resource
compared to waiting for the scheme to be widely sold and then challenging individual
returns.
47. Under the Canadian TS regime promoters are required to obtain an identification
number before selling a scheme and promoters must report all participants and amounts by
the end of February of the following year. This information enabled the Canada Revenue
Agency (CRA) to more quickly determine the extent of the problems raised by tax shelters
involving charitable donations. In addition, having the names of the participants up-front
made it much easier to conduct audits and meant that time was not spent on having to
identify participants. The CRA has now denied more than CAD5.9billion in donation
claims and reassessed over 182000 taxpayers who participated in these gifting tax shelters.
In addition the CRA has revoked the charitable status of 47 charitable organisations that
participated in these arrangements, and assessed third party penalties against promoters
etc. to the extent of CAD137million.
Deterrence
48. Taxpayers are likely to adopt a more cautious approach before entering into a tax
planning scheme if they know it has to be reported and that the tax authorities may take
a different position on the tax consequences of that scheme or arrangement. Because
mandatory disclosure regimes also require disclosure from third parties involved in the
design and marketing of a scheme it targets both the demand and the supply-side of the tax
avoidance market. Influencing the behaviour of promoters, advisers and intermediaries may
reduce the incidence of aggressive tax planning more quickly and in a more cost-effective
way than strategies that focus exclusively on the taxpayer. The fact that mandatory disclosure
provides an early warning system for tax administrations also alters the economics for
promoters as users may only have a limited opportunity to implement schemes before they
are closed down. While the extent of any deterrent effect is difficult to measure the data and
examples set out in Figures1.1 and 1.2 suggest that there is such an effect.
49. Under the UK DOTAS, 2366 avoidance schemes were disclosed up to 31March
2013. However, the number of schemes disclosed annually has reduced over the years and
most mainstream tax advisers have stopped promoting the marketed avoidance schemes
caught by the disclosure rules, which is now largely the province of a small minority of tax
advisory firms, generally referred to a boutique firms in the United Kingdom. DOTAS
is believed to be one, but not the only, factor in this change in behaviour.
50. There has been a general decrease in the number of schemes disclosed over the
years since DOTAS was introduced, which also implies the decrease in the number of
reportable schemes which have been used. When DOTAS was first introduced a significant
number of historic schemes were disclosed. As numbers have got much smaller in recent
years, further reductions are naturally less pronounced, which the UK tax administration
considers shows the market is shrinking, but they have put measures in place to check that
this is not down to non-compliance with DOTAS.
51. As the UK regime has matured and the number of reportable schemes has reduced,
the United Kingdom has looked to use the information provided by the regime to influence
behaviour in additional ways. For instance, the UK tax authority may use information on
disclosures and client lists to make early contact with promoters and potential users to
encourage them to change their view of a scheme. Under legislation introduced in 2014,
the United Kingdom may also require disputed tax in disclosed schemes to be paid before
the dispute is settled, thus ensuring that the Exchequer, not the taxpayer, holds the benefit
of the money during the dispute.
52. Similarly in the United States, the number of reports of all types of reportable
transactions including listed transactions and transactions of interest has reduced in the

years since those concepts were introduced in 2000 and 2006, respectively. These reductions
might be attributable to more than one cause, including trends in the overall economy. When
a transaction is listed, however, the notice that the transaction is likely to be disallowed, the
disclosure requirement, and imposition of penalties for failure to disclose generally create a
chilling effect, and it becomes less likely that taxpayers will enter into substantially similar
transactions. The same effect arose with the other reportable transaction categories when
they were first added (e.g.contractual protection, confidentiality, etc.).
53. In Canada, one of the most common and pervasive schemes used to abuse the tax
deductions and credits available for donations made to registered charities was gifting
arrangement tax shelters. These arrangements became common in the early 2000s and
reached their peak in 2006 with approximately 49000 participants in that year. The
sales and number of participants/investors for gifting tax shelters, for the period 2006-13
calendar years are illustrated in Figure1.1.
Figure1.1. Gifting tax shelters participants and donations (Canada, 2006-13)
USD 305
USD 320
USD 341
USD 112
2 518
2008
8 410
2007
9 022
2006
10 185
USD 347
USD 484
200
30 000
11 919
400
40 000
17 301
600
50 000
USD 926
1 000
48 096
USD millions
1 200
800
Donations/sales
60 000
33 114
1 400
USD 1 343
1 600
Investors
2009
2010
2011
2012
2013
20 000
10 000
0
Figure1.2. Annual disclosure by hallmark type (South Africa, 2009-14)

Listed category
Generic hallmarks
200
144
Number of disclosures
115
150
91
100
50
73
36
3
85
66
2009
2010
10
2011
4
2012
0
2013
2
2014
54. The South African reportable arrangements legislation came into force in 2005 and
new legislation took effect in 2008. The new legislation enhanced the scope of reportable
arrangements, in particular, the scope of the generic hallmarks. Under the South African
regime, 629arrangements have been reported since 2009. In the majority of cases the
disclosures have been made by several large companies. Whilst the data from South Africa
presents a more mixed picture in terms of the deterrent effects Figure1.2 indicates that the
majority of reports under the generic hallmarks were made during 2009 and the number
of arrangements disclosed annually under those hallmarks has reduced significantly. Since
this data was collected South Africa has extended the scope of its mandatory disclosure
regime with the addition of specific hallmarks targeting transactions that are of particular
concern to the South African tax administration.
55. This chapter has set out the basic objectives and design principles of a mandatory
disclosure regime, identifies the key features of mandatory disclosure which distinguish
it from other types of disclosure initiative and describes the effectiveness of mandatory
disclosure as a compliance tool based on data obtained from countries that have mandatory
disclosure regimes. However the actual impact of mandatory disclosure, from a tax
compliance perspective, will depend on the requirements imposed on taxpayers by the
regime and whether the regime adheres to the design principles set out in this chapter.
Notes
1.
The term Promoters, as used in this report, is applied broadly to capture both those who
promote a tax shelter or avoidance scheme in the traditional sense, and intermediaries (such as
material advisors) who facilitate the implementation of a reportable scheme. See further Study
into the Role of Tax Intermediaries (OECD, 2008).
2.
For example, the United States no longer includes transactions with a significant booktax difference in its mandatory disclosure regime after the issuance of a net income/loss
reconciliation schedule which provides the detailed information on transactions with significant
book-tax differences. See further paragraph128.
3.
This section was prepared on the basis of information on mandatory disclosure regimes provided
by countries (Canada, Ireland, South Africa, the United Kingdom and the United States).
4.
For relevant primary legislation in the US, see sections 6011, 6111, 6112, 6707, 6707A, 6662A,
and 6708 of the Internal Revenue Code, as well as the Treasury regulations issued thereunder.
In Canada, see sections 237.1, 237.3, 143.2 and 248 of the Income Tax Act and in South Africa,
see sections 80M to 80T of the Income Tax Act. In the UK, see Finance Act 2004, Part7(s.306
to s.319) and in Portugal, see Decree-Law No.29/2008 of 25February 2008. In Ireland, see
section149 of the Finance Act 2010.
5.
A link to the UK tax avoidance disclosure statistics is here: www.gov.uk/government/

uploads/system/uploads/attachment_data/file/379821/HMRC_-_Tax_avoidance_disclosure_
statistics_1_Aug_2004_to_30_Sept_2014.pdf (accessed on 16July 2015).
6.
Under the Irish regime, a transaction is disclosable if it enables a person to obtain a tax
advantage which is the main benefit of the transaction and it falls within one of four classes of a
specified description: (1)Confidentiality; (2)Premium fee; (3)Standardised documentation; or
(4)a class or classes of tax advantage (loss schemes, employment schemes, income into capital
schemes, income into gift schemes).
7.
Those four countries are Canada, Ireland, South Africa and the United Kingdom that have
mandatory disclosure regimes. The US statistics are removed from the analysis because the
United States only submits publicly available information to the ATP Directory.
Bibliography
OECD (2011), Tackling Aggressive Tax Planning through Improved Transparency and
Disclosure, OECD, Paris, www.oecd.org/ctp/exchange-of-tax-information/48322860.
pdf.
OECD (2008), Study into the Role of Tax Intermediaries, OECD Publishing, Paris, http://
dx.doi.org/10.1787/9789264041813-en.
2. Options for a model mandatory disclosure rule 31
Chapter2
Options for a model mandatory disclosure rule
32 2. Options for a model mandatory disclosure rule

56. In order to successfully obtain early information about tax planning schemes and the
users and promoters of those schemes, certain design features need to be considered when
constructing a mandatory disclosure regime. These include: who reports, what information
they report and when. Action12 recognises that the design of a mandatory disclosure
regime has to be flexible to the needs and risks in specific countries so this chapter sets out
options for a model mandatory disclosure regime. This should allow countries that wish to
introduce a mandatory disclosure regime to adopt a modular approach, which is dynamic
enough to allow tax administrators to adjust the regime to respond to new risks (or carveout obsolete risks), and to choose the options that best fit their requirements.
57. Existing mandatory disclosure regimes could be described as falling into two basic
categories:
The first approach, reflected in the approach adopted by the United States, is
a transaction-based approach. In general terms, this approach to mandatory
disclosure begins by identifying transactions that the tax administration considers
give rise to tax revenue or policy risks (a reportable scheme) and then requires
disclosure from taxpayers who derive a tax benefit from, and any person who
provides material assistance in relation to, that reportable scheme.
The second approach, reflected in the approach adopted by the United Kingdom
and Ireland, could be described as a promoter-based approach. In general terms,
this approach has a greater focus on the role played by promoters of tax planning
schemes but it does also consider what types of reportable scheme promoters and
taxpayers are required to disclose.
58. To the extent that there is any real difference between these approaches it is reflected
in the way in which each regime identifies schemes, taxpayers and promoters and the
nature of the disclosure obligations imposed upon them. For example, a promoter-based
approach places the primary disclosure obligation on the promoter, whereas a transactionbased approach may place identical disclosure obligations on both taxpayers and promoters.
There can also be a difference in the way in which each defines a reportable scheme. For
instance, a transaction-based approach will place more reliance on specific hallmarks;
while a promoter-based approach, which is more focused on the supply of tax planning
schemes, may rely more heavily on generic hallmarks and limit the disclosure to those
arrangements where tax is one of the main benefits of the scheme.1
59. Although the approaches may have slightly different starting points they cover
the same ground and have the same basic set of objectives, design features and effects.
Therefore the distinction between transaction and promoter-based approaches may not in
reality be that significant. In particular:
None of the existing mandatory disclosure regimes exhibit a purely transaction or
promoter-based approach. For example, as discussed below, whilst the United States
imposes the obligation to report on both promoters and taxpayers the mandatory
disclosure regime also utilises certain generic hallmarks to tackle promoter
behaviour.
Even when the approaches appear different in practice, they can end up in a similar
place. For example, as discussed below, when it comes to the question of who has
to report, the UK promoter-based regime achieves an outcome that is substantially
similar to the transaction-based approach by requiring additional disclosure from
the taxpayer in the form of scheme identification numbers.
60. Accordingly, while acknowledging the differences between mandatory disclosure

regimes, the design recommendations in this chapter are based on the core features
common to all these regimes.
Who has to report

Overview
61. Mandatory disclosure regimes need to identify the person who is obliged to disclose
under the regime. As highlighted above there are two different approaches based on
existing mandatory disclosure regimes: (1)to impose the primary obligation to disclose
on the promoter; or (2)to impose an obligation on both the promoter and the taxpayer.
The common feature is that both introduce some obligations on the promoter or material
advisor. This reflects the fact that the promoter who designs and sells a scheme inevitably
has more information on the scheme and how it works. Imposing an obligation on the
promoter also has the advantage of potentially influencing the behaviour of the promoter
and having an impact on the supply side of the avoidance market.
Options
62. There are therefore two options:
Box2.1. Options for who has to report

OptionA: Both the promoter and the taxpayer have the obligation to disclose separately
OptionB: Either the promoter or the taxpayer has the obligation to disclose
OptionA: Both the promoter and the taxpayer have the obligation to disclose
separately
63. The first option places the disclosure obligation on both the promoter and user.
Among countries that have mandatory disclosure rules, Canada and the United States
adopt this model. However, in Canada, with the proper election, the disclosure by one of
the parties can satisfy the obligation of each party whereas, in the United States, taxpayers
must provide information about specified transactions in their returns regardless of
whether the promoter has previously disclosed the transaction. Equally, in the United
States, the obligation of a promoter, who is a material advisor, to provide information about
reportable transactions will not be satisfied by a taxpayers disclosure of the same.
64. The Canadian regime imposes a disclosure obligation for each separate reportable
transaction of a tax avoidance scheme and imposes the obligation to disclose scheme
details equally on taxpayers who derive tax benefits from the transaction as well as
promoters and advisors who are entitled to certain fees in respect of the reportable
transaction. The filing of a full and accurate disclosure form by any one of the taxpayer,
promoter or advisor in respect of a reportable transaction, however, means that the other
persons will be treated as having met their separate disclosure obligations in respect of that
transaction. In addition, if the transaction is part of a series, the filing of an information
return by a person who reports each transaction in the series can be considered to satisfy
the obligation of each other person who must file for the series.

65. Under the US disclosure rules, each US taxpayer that has participated in a reportable
transaction is required to provide detailed information about the transaction and its
expected tax benefits on a separate disclosure statement attached to the taxpayers tax
return and filed concurrently with the Internal Revenue Service (IRS) Office of Tax Shelter
Analysis (OTSA).
OptionB: Either the promoter or the taxpayer has the obligation to disclose
66. Under this approach promoters have the primary obligation to disclose and if such
disclosure is made then users are not, as a general rule, required to provide details of
the scheme to the tax administration. In both the United Kingdom and South Africa, the
promoter must provide the participant or user with a scheme reference number to put on
their return and, in South Africa, the participants obligation to disclose only falls away
when the participant has obtained written confirmation that disclosure has been made by
a promoter or another participant.
67. A focus on the promoter as having the primary obligation to disclose may have the
advantage of efficiency and, particularly in the context of mass-marketed scheme, it is
likely to be the promoter who has a better understanding of the scheme and the tax benefit
arising under the scheme. Users are generally required to provide full details of the scheme,
however, in circumstances where there is no promoter of the scheme or where the promoter
does not disclose or is prevented from disclosing the scheme. The United Kingdom,
Portugal, Ireland and South Africa place the primary disclosure obligation on the user in
the following circumstances.
(i) Where the promoter is offshore

68. In theory, mandatory disclosure regimes apply equally to all promoters. However,
where a scheme involves a promoter based offshore, there are practical difficulties in
ensuring compliance so a scheme user is instead required to disclose the scheme details to
the tax authority.
(ii) Where there is no promoter

69. Where there is no person who is a promoter in relation to a scheme, it has to be
disclosed by the person using the scheme. This could arise, for example, where a scheme
is developed by a corporate in-house. It should be noted, however, that in such cases
disclosure only applies to schemes that have actually been implemented.
(iii) Where the promoter asserts legal professional privilege

70. While schemes promoted by legal professionals come within the scope of mandatory
disclosure rules, the existing legislation recognises that legal professional privilege, as
recognised under the UK and Irish law, may act to prevent the promoter from providing
the information required to make a full disclosure.2 In this circumstance, the obligation
to disclose falls on the scheme user. Alternatively, the client has the option of waiving
any right to legal privilege and, if that happens, the obligation to disclose remains with
the promoter. The legal professional asserting legal privilege must advise clients of
their obligation to disclose and must also advise the tax administration that the legal
professionals obligation to disclose has not been complied with because of the assertion of
legal professional privilege.
Further considerations
71. Under both options the promoter or advisor will need to be defined. Existing regimes
use differing definitions, although there is a degree of overlap, and these definitions are set out
in Box2.2 and summarised in AnnexE.
Box2.2. Draft definition of promoter or advisor in applicable legislation

A promoter is defined as a person, in the course of a relevant business, who is

responsible for the design, marketing, organisation or management of a scheme or who
makes a scheme available for implementation by another person.(UK and Irish legislation).
A material advisor is defined as any person who provides any material aid, assistance or
advice with respect to organising, managing, promoting, selling, implementing, insuring,
or carrying out any reportable transaction and who directly or indirectly derives gross
income in excess of the threshold amounts of USD50000 or 250000 (or 10000 or 25000)
depending on the type of taxpayer and type of reportable transaction. (US legislation).
An advisor means a person who provides any contractual protection in respect of a

transaction or series of transactions, or any assistance or advice with respect to creating,
developing, planning, organising or implementing the transaction or series, to another person.
A promoter means a person who (a)promotes or sells an arrangement that includes or
relates to a transaction or series of transactions; (b)makes a statement or representation that
a tax benefit could result from an arrangement in furtherance of the promoting or selling of
the arrangement, or (c)accepts consideration in respect of an arrangement in paragraph(a)
or (b). (Canadian legislation).
A promoter is defined as a person who is principally responsible for organising, designing,

selling, financing or managing the reportable arrangement. (South African legislation)
The common themes or principles within these separate definitions would appear to be as
follows:
-
The promoter is any person responsible for or involved in designing, marketing,

organising or managing the tax advantage element of any reportable scheme in the
course of providing services relating to taxation.
This definition can include any person who provides any material aid, assistance or
advice with respect to designing, marketing, organising or managing the tax aspects
of a transaction that causes the transaction to be a reportable transaction.
72. In addition as both options place an obligation on the promoter there will potentially
be a deterrent effect on the supply side of the avoidance market. The benefit of OptionA
is that it may have a stronger deterrent effect on both the supply (promoter) and demand
(user) side of avoidance schemes.
73. This approach also imposes a more extensive disclosure obligation on users compared
with OptionB and can trigger multiple disclosures of the same transaction. A dual
disclosure obligation reduces the risk of inadequate disclosure because, for example, a
taxpayers disclosure can be checked against the promoters disclosure to assess whether
the information provided is accurate and comprehensive.
74. However, the disadvantage of the first option is that it is likely to give rise to greater
costs as where a dual disclosure obligation is imposed, tax authorities may require the

taxpayer to file a separate form for each reportable transaction in which the taxpayer
participated. Consequently, this approach will increase the administrative and compliance
costs for the taxpayer, and potentially those of the tax administration. Whether these
increased costs merit the benefits of dual disclosure obligations must be considered in
deciding who has to report.
75. The option chosen is likely to have an impact on a countrys choices in respect of
other elements of a mandatory disclosure regime, for instance if there is a dual reporting
obligation which requires both taxpayers and promoters to disclose, there is no need for the
use of scheme reference numbers.
Recommendation
76. Countries adopting mandatory disclosure rules will need to decide whether or not
they introduce a dual reporting requirement that applies to the promoter and taxpayer
or whether they introduce a reporting obligation that falls primarily on the promoter.
However, where the primary reporting obligation falls on the promoter it is recommended
that the reporting obligation switches to the taxpayer where:
The promoter is offshore.
There is no promoter.
The promoter asserts legal professional privilege.
77. Countries are free to introduce their own definition of promoter or advisor but it
is recommended that any definition encompasses the principles set out in Box2.2. In
addition input from relevant domestic stakeholders will be important in order to establish
the appropriate promoter definition in a specific jurisdiction, for example to ensure that
those who have knowledge of the tax scheme are included but those who provide services
incidental to the scheme are not treated as a promoter where they did not have any
knowledge as regards the tax elements of the transaction or scheme.
What has to be reported

78. There are two key issues in respect of what has to be reported. The first issue
goes to the substance of a mandatory disclosure regime and focuses on what schemes
or arrangements a tax administration wants to know about. The second issue arises if a
transaction is reportable and is about the specific information to be disclosed (i.e.name,
taxpayer number, details of transaction, etc.). This section describes what types of schemes
and arrangements should be disclosed under the regime (i.e.the definition of what is
a reportable scheme). The second issue is discussed in more detail in the section on
procedural/tax administration matters.
Threshold requirement
79. Under existing mandatory disclosure regimes a transaction is reportable if it falls
within the descriptions or hallmarks set out in the regime. However, some regimes first
apply a threshold or pre-condition that a scheme must satisfy before it is assessed against
the hallmarks. Threshold tests may consider whether a transaction has the features of an
avoidance scheme or whether a main benefit of the scheme was obtaining a tax advantage.3
80. A number of countries such as the United Kingdom, Ireland and Canada impose a
threshold requirement or precondition for the application of the regime. A threshold can
be used to filter out irrelevant disclosures and may, subject to the concerns highlighted
in paragraph82 below, reduce some of the compliance and administration burden of the
regime by targeting only tax motivated transactions that are likely to pose the greatest tax
policy and revenue risks. There are different views on the merits of the single-step versus
the multi-step or threshold approach. Those who favour the former approach note that a
similar effect to the multi-step approach can be achieved under a single step approach
through using filters and narrower or more targeted hallmarks so that the two approaches
may not be inherently different.
81. One of the key challenges in applying a threshold condition is determining the
right threshold. The most common threshold requirement is a main benefit test. Under
such a threshold the arrangement must satisfy the condition that the tax advantage is, or
might be expected to be the main benefit or one of the main benefits of entering into the
arrangement. Such a test compares the value of the expected tax advantage with any other
benefits likely to be obtained from the transaction and has the advantage of requiring an
objective assessment of the tax benefits. A number of countries consider this to be effective
at filtering out all but the most relevant schemes.
82. However, the main benefit test sets a relatively high threshold for disclosure and
the experience of at least one country suggests that it can be used inappropriately as
a justification for not disclosing tax avoidance schemes that would be of interest to a
tax administration. Such a pre-condition may also make enforcement of the disclosure
obligations more complex and create uncertain outcomes for taxpayers.
Options
83. Based on the above analysis there appear to be two options:
Box2.3. Multi-step or single step approach to defining the scope of a disclosure
regime

OptionA: Countries adopt a single-step approach
OptionB: Countries adopt a multi-step or threshold approach
OptionA: Adopt a single-step approach

84. As highlighted above countries involved in this work had a range of views on the
inclusion of a threshold condition. One option therefore would be to exclude a threshold
condition entirely and simply recommend the adoption of a single-step approach. Among
countries having mandatory disclosure rules, the United States adopts a single-step
approach where the domestic tax benefit does not need to be identified as tax avoidance or
as the main benefit of the transaction.
85. There is a concern, however, that a single-step approach could generate a large
number of disclosures increasing the costs to both taxpayers and tax administrations and
also diluting the relevance of the information received. The amount of disclosures can
be controlled, however, by other means such as having narrower or more tightly defined
hallmarks and/or by filtering disclosures by reference to a monetary threshold. This

would appear to be the approach adopted in the United States as the number of disclosed
transactions is calibrated using specific hallmarks, i.e.listed transactions that are further
limited through the use of filters. For instance the US regime uses monetary filters in
respect of loss transactions and also includes a monetary filter in the definition of a
material advisor. There may therefore be little practical difference in the two approaches in
terms of the amount of disclosures received and the choice of approach may be influenced
by how well a threshold condition such as a main benefit test will be understood or applied
by taxpayers.
OptionB: Adopt a multi-step or threshold approach

86. The UK, Irish, Canadian, and Portuguese regimes adopt a multi-step approach and
require all schemes to meet a threshold condition as part of their mandatory disclosure
regime. The advantage of a multi-step approach is that it separately identifies the tax planning
element in each scheme by reference to a common standard and means that hallmarks can be
targeted at particular categories of transaction (such as leasing transactions) without the need
to separately identify and define any tax planning element. This flexibility is particularly
relevant in the context of generic hallmarks that do not necessarily identify a separate tax
motivated part. It was, however, recognised that a precondition that focuses on a tax benefit
may not work well in the context of international schemes so those countries who apply a
pre-condition may need to limit its application to domestic schemes and adopt a single-step
framework for the mandatory disclosure of international schemes. There is further discussion
of this in Chapter3. Concerns that the threshold condition may be used by taxpayers to justify
non-disclosure could be addressed by lowering the threshold for disclosure or exempting
certain hallmarks from the threshold requirement. This latter approach is one that has
been adopted in South Africa which excludes arrangements where the tax benefit is not the
main or one of the main benefits unless the arrangement is listed (i.e.equivalent to specific
hallmarks), in which case it is reportable, regardless of whether it satisfies the main benefit
test.
De-minimis filter
87. A de-minimis filter could be considered as an alternative to, or in addition to, a
broader threshold test and could operate to remove smaller transactions, below a certain
amount, from the disclosure requirements. It would therefore narrow the ambit of the
mandatory disclosure regime and reduce the risk of over-disclosure. It may also enhance
the usefulness of the information collected because the focus would be on more significant
transactions and excessive or defensive filings could be reduced. This could reduce the
costs and administrative burden for certain taxpayers and for the tax administration.
88. In addition a de-minimis filter could be applied to all transactions potentially
within scope or just to certain categories of transactions where there might otherwise
be large numbers of reportable transactions. Different threshold amounts could also be
applied to specific hallmarks to calibrate the disclosures in a particular area and some
countries already adopt this approach. For instance, in the US regime, reportable loss
transactions have their own dollar thresholds. The thresholds range from USD50000 to
USD10million, depending on the taxpayer and the type of loss transaction.
89. However, consideration would need to be given to what element a de-minimis
filter would apply to, that is, should it be applied to the amount of the tax advantage or
the value of the transaction? There could also be concerns that, if not carefully drafted,
the filter could be used to circumvent the disclosure obligation and may create additional
complexity in the application of the rules. Additionally including a de-minimis filter could
unhelpfully suggest that tax avoidance, in small amounts, is acceptable and there may in
fact be little or no correlation between the size of a transaction and its relative interest
to a tax administration. For instance a new or innovative transaction could be initially
tested on a small scale and if that transaction is not reported until it occurs on a wider
scale then a de-minimis limit will simply delay the time when a tax administration receives
information and can act against a scheme. Additionally the nature of the transaction may
remove any concerns that the transaction is low level or insignificant, this could be the case
if mandatory disclosure regimes picked up international transactions.
90. Based on the above analysis it was concluded that a de-minimis test would sit poorly
alongside any pre-condition based on a main benefit test as, in this situation, a regime is
already targeting transactions that were designed to generate a tax benefit so a further filter
is unnecessary. However a de-minimis filter could be easier to apply, and have a clearer
impact, where it is used in conjunction with a specific hallmark as is the case in the United
States. The level of any threshold would then be left to the discretion of individual tax
administrations and could help reduce the level of disclosures under a specific hallmark, if
these are expected to be numerous.
Hallmarks
91. Hallmarks act as tools to identify the features of schemes that tax administrations
are interested in. They are generally divided into two categories: generic and specific
hallmarks. Generic hallmarks target features that are common to promoted schemes, such
as the requirement for confidentiality or the payment of a premium fee. Generic hallmarks
can also be used to capture new and innovative tax planning arrangements that may be
easily replicated and sold to a variety of taxpayers. Specific hallmarks are used to target
known vulnerabilities in the tax system and techniques that are commonly used in tax
avoidance arrangements such as the use of losses.
Outline of generic hallmarks

92. Two typical generic hallmarks used for targeting promoted schemes are:
Confidentiality hallmarks where the promoter or adviser requires the client to
keep the scheme confidential.
Premium fee or contingent fee hallmarks where the amount the client pays
for the advice can be attributed to the value of the tax benefits obtained under the
scheme.
93. Other hallmarks which are less frequently used include contractual protection
where the parties agree an allocation of risk in respect of a failure of the tax consequences
of the scheme and standardised tax product intended to capture widely-marketed
schemes.
Confidentiality
94. A confidential scheme is one that is offered to the advisers clients under conditions
of confidentiality. The confidentiality obligation is owed by the client to the promoter
(not by the promoter to the client). The promoter might, for example, place a limitation

on the disclosure by the taxpayer of the tax treatment or tax structure. This limitation on
disclosure is to protect the value of the scheme designed by the promoter.
95. A confidentiality condition indicates that a promoter or a corporate wishes to keep
schemes or arrangements confidential either from other promoters or from the tax authorities.
This implies that the arrangements may be innovative or aggressive. A confidentiality
condition enables a promoter or a corporate to sell the same scheme to a number of different
taxpayers.
96. The use of a confidentiality clause in an agreement may mean that the hallmark is
met. However, even if certain promoters use such a clause or condition, tax authorities
might accept that the confidentiality hallmark was not met if the scheme is reasonably wellknown in the tax community. This is the United Kingdoms approach.
Premium or Contingent fee

97. The premium fee clause is also one of the most common generic hallmarks.
Versions of these hallmarks are found in the UK, US, Irish and Canadian regimes. It is
designed to capture those schemes that have been sold on the basis of the tax benefits that
accrue under them. The UK, Irish and Canadian regimes target both premium fees and
fees that are contingent on the tax benefits that arise under the scheme (i.e.contingent fees).
98. Under the UK rule, the hallmark referred to as premium fee tries to capture
arrangements from which a promoter could obtain an increased (premium) fee. A premium
fee is a fee that is to a significant extent attributable to the tax advantage, or to any extent
contingent upon obtaining that tax advantage. The idea of a premium fee is that there is an
amount payable that is attributable both to the value of the tax advice and the fact that it is
not available anywhere else. However if the consequences of the scheme are widely-known
and understood then the client would be unwilling to pay more than a normal fee for it.
99. While the fee hallmark in the US legislation is referred to as contractual protection
it is similar to the contingency fee hallmark in that it covers the situation where a taxpayer
or a related party has the right to a full or partial refund of fees if the intended tax
consequences are not obtained, and it applies if the fees are contingent on the taxpayers
receiving tax benefits from the scheme.
100. Some countries have suggested that, in certain circumstances a premium fee can
be replaced by an increased charge that is built into the transaction itself (rather than
a separate fee for legal or tax advice) and that this concept should be captured by the
definition of premium fee. However, other countries consider that the definition of a
premium fee should be broad enough to capture these types of charges while a few have
suggested that such a broad definition may raise compliance difficulties and that such
schemes may be better targeted with other types of hallmarks. Countries will wish to
consider these definitional and compliance issues when setting the definition of premium
fee.
Contractual protection
101. A contractual protection clause is used as a generic hallmark in Canada and Portugal.
In Canada, contractual protection means (1)any form of insurance (other than standard
professional liability insurance) or other protection such as an indemnity or compensation
that (i) protects against a failure of the transaction to result in any portion of the tax
benefit being sought from the transaction, or (ii)pays for or reimburses any expense, fee,
tax, interest, penalty or similar amount that may be incurred in the course of a dispute
in respect of a tax benefit arising from the transaction; and (2)any form of undertaking
provided by a promoter that provides assistance to the taxpayer in the course of a dispute
in respect of a tax benefit from the transaction.
102. In Portugal, there is one generic hallmark which is used in order to determine
whether any transaction falls within the mandatory disclosure rule. This hallmark captures
transactions with a clause waiving or limiting the liability of a promoter.
Standardised tax products

103. This hallmark is intended to capture what are often referred to as mass-marketed
schemes and is used as a generic hallmark in the UK and Irish regimes. A mass-marketed
scheme means an arrangement that is made available to more than one person and that
uses standardised documentation that is not tailored to any material extent to the clients
circumstances.
104. The fundamental characteristic of such schemes is their ease of replication. Schemes
with this replication characteristic have variously been described as shrink-wrapped or
plug and play schemes. Essentially, all the client purchases is a prepared tax product
that requires little, if any, modification to suit their circumstances. The adoption of the
scheme does not require the taxpayer to receive significant additional professional advice
or services.
105. Korea has a similar hallmark to the standardised tax product hallmark. The Korean
mandatory disclosure regime is targeted at standardised financial products which have
a tax benefit. A financial tax product is typically one that is mass-marketed and where a
number of participants enter into substantially the same contractual arrangements. Such
products are mainly tax driven and it is therefore highly unlikely that the financial product
would be sold without the tax benefit. The Korean mandatory disclosure regime therefore
requires financial institutions which have designed financial products containing tax
benefits such as exemption and a reduced rate of withholding tax to disclose the product to
the tax authorities before selling it to investors in the financial market.
Model generic hallmarks

106. Most countries agreed that a mandatory disclosure regime should include a
combination of generic and specific hallmarks and that a transaction should be reported if
it met just one hallmark. Boxes2.4 and 2.5 include some of the generic hallmarks included
in existing mandatory disclosure regimes and combine these into some common principles
that could be used to draft model generic hallmarks. Countries wishing to introduce
mandatory disclosure rules could use these as a base for their generic hallmarks but could
revise and adapt them to fit with a countrys domestic law.
107. It should be noted that most generic hallmarks (with the exception of the United
States) have been designed to operate subject to a threshold requirement that considers
whether the transaction has features of a tax avoidance scheme or whether a main benefit
of the scheme was obtaining a tax advantage. Therefore further consideration may need
to be given to whether such hallmarks would operate equally effectively where there was
no such threshold, or whether changes would need to be made to appropriately limit the
number of disclosures generated.4
Confidentiality
108. A confidentiality hallmark is used in four mandatory disclosure regimes (the United
Kingdom, the United States, Canada and Ireland) and given its potential to capture new and
innovative tax planning it seems to be a key hallmark. The United Kingdom, and Ireland
use a hypothetical version of this hallmark and this is discussed below.
Box2.4. Hallmarks for confidentiality

A confidential transaction is a transaction that is offered to a taxpayer under conditions

of confidentiality and the advisor is paid a minimum fee. The amount of the fee is
USD250000 if the taxpayer is a corporation and USD50000 for all other taxpayers. A
transaction is considered to be offered under conditions of confidentiality if the advisor
who is paid a minimum fee places a limitation on a taxpayers disclosure of the tax
treatment or tax structure of the transaction to any person and the limitation on disclosure
protects the confidentiality of the advisors tax strategies. The transaction is treated as
confidential even if the conditions of confidentiality are not legally binding on a taxpayer.
A claim that a transaction is proprietary or exclusive is not treated as a limitation on
disclosure if the advisor confirms to the taxpayer that there is no limitation on disclosure
of the tax treatment or tax structure of the transaction. (US legislation).
Confidential protection means anything that prohibits the disclosure, to any person,
of the details or structure of the transaction or series under which a tax benefit results.
(Canadian legislation).
Confidential arrangements are those where it might reasonably be expected that a

promoter would wish to keep the way in which any element of those arrangements secures,
or might secure, a tax advantage confidential from any other promoter or a tax authority.
Such arrangements will fall within the hallmark where a reason for keeping any element
of them confidential is to facilitate repeated or continued use of the same element, or
substantially the same element, in the future. (UK and Irish legislation).
The common themes or principles within these hallmarks would appear to be as follows:
-
The scheme or arrangement is offered to the taxpayer under conditions of confidentiality.
This places a limitation on the taxpayers disclosure of the tax treatment, the tax
structure of the transaction or on the resulting tax benefit.
This limitation protects the tax advisors strategies and may enable further use of the
same scheme or transaction.
Premium or contingency fee

109. Premium or contingency fee hallmarks are found in the UK, US, Irish and Canadian
regimes. Whilst a premium fee hallmark is slightly different to the contractual protection
hallmark used in Canada and Portugal there is some commonality as both are looking at
the expected outcomes from a transaction and whether or not these are achieved. It may not
therefore be necessary to include both premium fee and contractual protection hallmarks
in a mandatory disclosure regime. As noted above, a premium fee may not be a separate
charge but could be built into the cost of the transaction itself.
Box2.5. Hallmarks for contingency fee/premium fee

A transaction with a contingency fee hallmark (subject to certain exceptions), is a

transaction for which a taxpayer has the right to a full refund or partial refund of fees if
all or part of the intended tax consequences from the transaction are not sustained. It also
includes a transaction for which fees are contingent on the taxpayers realisation of tax
benefits from the transaction. (US legislation described as contractual protection)
A premium fee means a fee chargeable by virtue of any element of the arrangements from
which the tax advantage expected to be obtained arises; and which is (a)to a significant
extent attributable to that tax advantage, or (b)to any extent contingent upon the obtaining
of that tax advantage. (UK and Irish legislation)
A tax results oriented fee is a fee which an advisor or promoter is entitled to receive in
respect of an avoidance transaction and the fee is (a)based on the amount of the tax benefit
obtained from the transaction; (b)contingent upon the obtaining of a tax benefit from the
transaction; or (c)attributable to the number of taxpayers who participate in the transaction
or have been given access to advice by the advisor or promoter. (Canadian legislation)
The common principles within these hallmarks would appear to be:

-
The taxpayers fee for the scheme or transaction is directly based on, or linked to the
amount of, the tax benefit they expect to receive.
If the expected tax outcome is not achieved this may affect the amount of the fee that
the taxpayer pays.
Hypothetical application of generic hallmarks

110. Under the UK and Irish regimes, the confidentiality and premium fee hallmark targets
not only schemes that are sold to clients for a premium fee but also schemes that could be
sold by a promoter for a premium fee. The scope of the hallmark is extended in this way by
effectively posing a hypothetical question:
Might it reasonably be expected that any promoter of the arrangements would
wish the way in which any element of those arrangements gives rise to a tax
advantage to be kept confidential from any other promoter. (Confidentiality)
Might it reasonably be expected that a promoter would be able to obtain a
premium fee from a person experienced in receiving services of the type being
provided. (Premium fee)
111. In terms of applying hypothetical tests the confidentiality hallmark would be met
if a scheme was sufficiently new and innovative such that an adviser who designed the
scheme would have required the details of the scheme to remain confidential irrespective
of the existence of actual terms of confidentiality. The use of an explicit confidentiality
agreement may indicate that this test is met. However, even where there is a confidentiality
clause it may be clear from, for example articles in the tax press, textbooks or case law, that
the scheme is in fact well known in the tax community. In the United Kingdom the factors
that should be considered include:5
How new, innovative and aggressive the scheme is. Schemes known to the tax
administration are not caught by the confidentiality hallmark. The fact that a scheme

is known can be evidenced by, for example, technical guidance notes, case law, or
past correspondence with the tax administration.
Whether a promoter imposes an obligation upon potential clients, whether in writing
or verbally, to keep the details of the scheme confidential from third parties including
the tax administration.
Whether confidentiality agreements between a promoter and client allow the client
to disclose information to the tax administration without referral to the promoter.
The use of explicit warnings in marketing material or other communications to a
client to the effect that the scheme may have a limited shelf life because legislative
changes may close the scheme once it becomes known.
112. In terms of the hypothetical version of the premium fee test, it is important to look at
the value of the scheme from the clients perspective. Where a client regards the advice as
valuable and not generally available, then the client might be prepared to pay a premium
for it. It is not conclusive that the advisor does not charge a premium fee for the advice. By
contrast, if similar tax advice was available elsewhere it is assumed that the client would
be unwilling to pay more than a normal fee for it. Therefore, the question is whether it
might reasonably be expected that a promoter could charge a premium fee if he wished to
do so. At the same time, it is also necessary to consider whether a fee could be charged in
respect of any element of the tax arrangement such that it would to a significant extent be
attributable to, or contingent upon, the expected tax advantage. For instance in the United
Kingdom, a fee is not a premium fee solely on account of factors such as:6
The advisers location e.g.fees could be expected to be higher in say London.
The urgency of the advice a fee that is higher due to the adviser having to give the
advice urgently is not a premium fee for that reason alone.
The size of the transaction if a large amount is at stake on a deal, the tax adviser
may wish to increase his fee to reflect the greater level of exposure.
The skill or reputation of the adviser some advisers normally charge more for
advice than others to reflect the perceived higher quality of the advice they offer.
The scarcity of appropriately skilled staff some areas of tax advice are more
complex and fees may be higher to reflect this.
113. The use of hypothetical tests can broaden the scope of generic hallmarks and may
prevent circumvention of hallmarks drafted in a more objective way. Hypothetical tests
may also be useful in capturing tax planning schemes that are specifically designed for a
particular taxpayer and transaction (bespoke transactions).
114. On the other hand, the generic hallmarks used by the United States, Canada and
Portugal do not have hypothetical tests and therefore provide more certainty since the
disclosure requirement can be judged based on the existence of an actual confidentiality
or premium fee agreement. This objective enquiry into the actual arrangements between
adviser and client maybe an easier test for the taxpayer and promoter to apply than the
hypothetical question posed in the United Kingdom, and Ireland. It may also be easier
for a tax administration to apply an objective test rather than potentially spending time
evaluating whether or not transactions should or should not be disclosed.
Options
115. Whilst most countries involved in this work expressed a preference for objective
hallmarks several thought that there was a role for subjective tests to prevent circumvention
of the disclosure provisions. Both objective and subjective tests are therefore included as an
option. However, tax administrations will need to consider the workability of hypothetical
or subjective tests in the context of their own domestic tax system.
Box2.6. Options for designing generic hallmarks

OptionA: Adopt hypothetical/subjective hallmarks
OptionB: Adopt objective hallmarks
OptionA: adopt hypothetical/subjective hallmarks

116. Those countries who see benefits in a hypothetical test and think that the potential
uncertainty and any additional administrative burden are outweighed by better disclosure
may want to consider an approach similar to that adopted by the United Kingdom and
Ireland. Although consideration would need to be given to how such an approach would
operate in the context of their own domestic law and within their tax compliance framework.
OptionB: adopt objective hallmarks

117. If countries are less concerned about circumvention, and key design issues for their
tax administration are greater certainty and ease of operation, then objective hallmarks
may be more suitable.
Specific hallmarks
118. Generic hallmarks such as confidentiality and standardised tax products can target
schemes that promoters replicate and sell to more than one person. Therefore, they can
obtain information about formulaic and mass-marketed transactions in addition to those
that are new and innovative. On the other hand, specific hallmarks reflect the particular
or current concerns of tax authorities, and can therefore target areas of perceived high risk
such as the use of losses, leasing and income conversion schemes. Specific hallmarks can
also be a useful way of keeping a disclosure regime up to date. Some countries such as
South Africa have found that specific hallmarks can be more effective in collecting relevant
information than generic hallmarks. Reflecting that, different countries may benefit from
different combinations of hallmarks.
119. Under specific hallmarks, the disclosure obligation is triggered by describing certain
potentially aggressive or abusive transactions and including them as a hallmark. While
specific hallmarks are designed to target particular transactions, or particular elements
of a transaction, they should be drafted broadly and avoid providing too much in the
way of technical detail. Overly narrow or technical hallmarks can be given a restrictive
interpretation by taxpayers or may provide opportunities for taxpayers and promoters to
structure around their disclosure obligations. Given Action Item12s reference to a modular
design and the fact that risks will differ between countries then this is an area where
countries may need maximum flexibility to design their own specific hallmarks. Examples
of specific hallmarks used in existing regimes are set out below.
Loss schemes (the United States, the United Kingdom, Canada, Ireland, Portugal)
120. This hallmark is intended to capture various loss creation schemes. The schemes
vary considerably in detail but are normally designed so as to provide all or some of
the individual participants with losses that will be used to reduce their income tax or
capital gains tax liabilities or to generate a repayment. For example, the Canadian tax
shelter regime7 includes the acquisition of property or a gifting arrangement for which
representations are made that losses, deduction, or credits in the first four years would be
equal to or greater than the net cost of the property invested or acquired under the gifting
arrangement. Versions of specific hallmarks involving loss transactions are also found in
the United Kingdom, Ireland and the United States.
121. This type of hallmark could be coupled with a threshold applied to the amount of
the loss. For example, in the United States, a loss transaction is a transaction that results
in a taxpayer claiming a loss that equals or exceeds a threshold amount ranging from
USD50000 to 10million in any single taxable year depending on the type of taxpayer and
the transaction.
Leasing arrangements (the United Kingdom)

122. This hallmarks aims to capture tax advantages gained from leasing transactions.
The hallmark only applies if the arrangement includes a high value plant or machinery
lease. Arrangements to lease assets with an individual value of GBP10million or an
aggregate value of at least 25million are caught by this test. The hallmark only applies
where the lease term is longer than two years. Additionally any one of the three additional
conditions needs to be met: (1)the lease arrangement involves a party outside the charge to
corporation tax; (2)the lease arrangement removes the whole or the greater part of the risk
from the lessor; (3)the lease arrangement involves a finance leaseback.
Employment scheme (Ireland)

123. This specific hallmark targets employment schemes which may seek to use vehicles
such as employee benefit trusts or schemes that in some fashion seek to circumvent salary
sacrifice anti-avoidance provisions.
Converting income schemes (Ireland, Portugal)

124. This hallmark addresses schemes for converting income into capital or gifts in order
to avoid the higher rate of income tax and to have the gain taxed at a lower rate or relieved
or exempted from tax in the case of Ireland.
125. In Portugal, this hallmark covers insurance or financial transactions that may give
rise to a reclassification of the income or to a change in its recipients and in particular this
is aimed at finance leasing, transactions concerning hybrid instruments, derivatives or
contracts on financial instruments. There is some overlap with the UK hallmark (leasing
arrangements) in terms of involving finance leasing.
Schemes involving entities located in low-tax jurisdictions (Portugal)

126. This hallmark aims to capture schemes involving entities located in low-tax
jurisdictions. The term low-tax jurisdiction includes an entity located in a listed tax
haven, an entity located in a country where there is no corporate income tax or the tax paid
is less than 60% of the applicable standard corporate income tax or involves an entity that
benefits from a partial or total tax exemption.
Arrangements involving hybrid instruments (South Africa)

127. This hallmark covers any arrangements that would have qualified as a hybrid equity
instrument as defined in the relevant tax legislation. These are essentially transactions
involving redeemable preference shares and normal shares where the rights attaching to
such shares differ from the rights normally attached to ordinary shares. This hallmark also
targets any arrangements that would have qualified as a hybrid debt instrument as defined
in the relevant tax legislation, if the prescribed period in that section had been ten years.
This is essentially aimed at convertible loan/debenture arrangements (excluding listed debt
instruments).
Transactions with significant book-tax differences (the United States)

128. The United States previously included this transaction as a category of reportable
transactions. It covered transactions with a USD10million book-tax difference (i.e.a
difference between tax accounting and financial accounting). The IRS and Treasury
Department subsequently determined that including transactions with significant booktax differences as reportable transactions was not necessary after the issuance of the
ScheduleM-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of
$10 Million or More8 which provides the IRS with detailed information on transactions
with significant book-tax differences.
Listed transactions (the United States)

129. The United States requires any listed transaction to be disclosed in accordance with
its reportable transaction rules. A listed transaction is a transaction that is the same as or
substantially similar to one that the IRS has determined to be a tax avoidance transaction
and has been identified by IRS notice or other form of published guidance.
Transactions of interest (the United States)

130. The United States requires any transaction of interest (TOI) to be disclosed in
accordance with its reportable transaction rules. A TOI is a transaction that the IRS and
the Treasury Department believe is a transaction that has the potential for tax avoidance
or evasion, but for which they lack sufficient information to determine whether the
transaction should be identified specifically as a tax avoidance transaction.
Model hallmark for loss transaction

131. A common area of concern is losses; schemes involving losses vary considerably in
detail but are normally designed so that they generate trading losses for wealthy individuals
or corporates that can then be offset against their income tax (including capital gains tax)
liabilities. Given the variety of loss schemes, and the recognition that countries will need
maximum flexibility in drafting specific hallmarks, setting out common principles may be
less helpful in this context. However some principles, along with summaries of the existing
legislative provisions, are set out in Box2.7.
Box2.7. Hallmarks for loss transaction

A loss transaction is a transaction that results in taxpayer claiming a loss if the amount
of the loss exceeds a certain amount depending on the type of taxpayer. (US legislation)
A loss transaction is prescribed if (a)the promoter expects more than one individual to
implement the same, or substantially the same, transaction; and (b) the transaction is
such that it could be reasonably concluded that the main benefit of the transaction is the
provision of losses and that those individuals would be expected to use those losses to
reduce their income tax liability. (UK legislation this hallmark is intended to capture
loss schemes that are typically used by wealthy individuals)
A loss transaction is prescribed if one of the parties to the scheme is a company that has or
expects to have unrelieved losses at the end of an accounting period and it could be reasonably
concluded that (a)the main benefit of the scheme is that the company transfers those losses
to another party which would be expected to use them to reduce its corporation tax liability,
or (b)the company is able to accelerate the use of those losses to reduce its corporation tax
liability. (Irish legislation the hallmark is expanded to deal with company losses)
With the exception of the United States which focusses exclusively on the amount of the loss,
the common principles would appear to be that a person incurs or acquires a loss and that loss:
-
is transferred to another person to set off against other income and reduce their tax
liability;
is accelerated to reduce the current tax liability of a person;
is part of a promoted scheme or transaction, used by more than one person, to reduce
tax on their other income.
Recommendations on hallmarks
132. Generic hallmarks may increase the amount of reportable transactions, potentially
increasing costs for taxpayers but, as already mentioned, they are a useful tool for capturing
new and innovative transactions which specific hallmarks have difficulty in capturing. The
use of generic hallmarks such as premium fee, confidentiality and contractual protection
therefore appear to be key in enabling tax administrations to detect and react quickly to new
schemes. Requiring the reporting of these types of transactions may also have the effect of
reducing such transactions in the market.
133. Specific hallmarks or listed transactions allow tax administrations to target known
or common areas of risk. They also appear to provide flexibility in terms of enabling
a tax administration to strike a balance between costs and capacity issues for the tax
administration and the reporting burden on promoters or taxpayers. Some countries such as
South Africa have found that specific hallmarks can be more effective in collecting relevant
information than generic hallmarks. Reflecting that, different countries may benefit from
different combinations of hallmarks.
134. Specific hallmarks can also be a useful way of keeping a disclosure regime up to date
and for dealing with avoidance on non-mainstream taxes. As can be seen from the existing
specific hallmarks, whilst there is some level of overlap, such hallmarks generally reflect
the key risk areas in a given jurisdiction.
Recommendations
135. Where countries introduce a mandatory disclosure regime they have the option to
use a single-step approach or a multi-step/threshold approach. It is, however, recommended
that mandatory disclosure regimes include a mixture of generic and specific hallmarks.
Generic hallmarks should include a confidentiality and premium/contingent fee hallmark.
A country may also want to adopt additional generic hallmarks such as the one applying
to standardised tax products.
136. Countries can choose whether or not to adopt a hypothetical approach or adopt purely
factual objectives tests. Specific hallmarks should reflect the particular risks and issues in
individual countries. The design and selection of specific hallmarks should be left to each
country taking into account their own tax policy and enforcement priorities. Countries are
free to choose whether or not specific hallmarks are linked to a de-minimis amount to limit
the number of disclosures.
137. It is recommended that where a scheme or transaction triggers one hallmark that
should be sufficient to require disclosure.
When information is reported

138. There are significant differences as to when countries require disclosure of schemes.
Timing depends on the relevant trigger event and the time period for reporting allowed
under the regime. This time period can vary from within days, months, or longer.
139. If the main objectives of a disclosure regime are to provide early information on
avoidance schemes and their users and to deter the use of those schemes then the timeframe
within which a disclosure has to be made will be important in achieving these objectives
as the earlier the reporting, the more quickly a tax administration can act against a scheme.
This may enhance the deterrent effects by reducing the time available to take advantage of
any tax benefit, so altering the economics of the transaction.
140. There are several questions that need to be considered in setting the timeframe for
disclosure and the answers to these questions will impact on the timeliness of a disclosure
and may impact on the ability of a disclosure regime to meet some of its objectives. The
questions are:
At what point should the obligation to disclose start, or, to put it another way, what
event or action triggers the need to report?
How soon after that event should a disclosure be made?
Should there be different reporting timeframes for promoters and taxpayers?
Options for timing of promoter disclosure

Box2.8. Options for timing of promoter disclosure

OptionA: Timeframe linked to availability of a scheme
OptionB: Timeframe linked to implementation
Timeframe linked to availability of a scheme

141. The earliest event that can realistically trigger a disclosure requirement is the point
at which a promoter makes a scheme available to users. At this point the scheme will be
sufficiently well-developed to be marketable and all the necessary information on how the
scheme works must be available if it is being promoted and sold. Under the UK legislation
a scheme is regarded as made available for implementation at the point when all the
elements necessary for implementation of the scheme are in place and a communication is
made to a client suggesting that the client might consider entering into transactions forming
part of the scheme, it does not matter whether full details of the scheme are communicated
at that time. Further details on how this operates in the United Kingdom are included in
AnnexA.
142. The UK, Irish and Portuguese disclosure regimes all use this as the trigger event.
However, the timescale within which the disclosure must then be made differs between
the three countries. In the United Kingdom and Ireland a promoter must disclose a scheme
within five working days of making a scheme available for implementation by another
person. Therefore both the trigger event and the reporting period are designed to ensure a
quick disclosure which may well take place before the users have implemented the scheme.
This maximises a tax administrations ability to risk assess schemes early and if necessary
to take legislative action to close any loopholes before significant amounts of revenue can
be lost.
143. Whilst Portugal uses the same trigger event the timescale for reporting is slightly
longer as tax promoters who are involved in any tax planning must disclose within 20 days
following the end of the month in which the scheme was made available. Again this also
ensures a relatively quick disclosure but it is less likely that the tax administration is aware
of the scheme before it is implemented which could ultimately impact on the amount of
any revenue loss.
144. In the United States instead of linking the disclosure period directly to the point at
which the scheme is made available to users the disclosure requirement is triggered on
an advisor becoming a material advisor. A material advisor is defined as a person who
provides any material aid, assistance or advice with respect to organising, promoting,
or carrying out any reportable transaction and who directly or indirectly receives or is
expected to receive gross income in excess of the threshold amount of USD50000 or
250000 (lowered to USD10000 and 25000 for listed transactions) depending on the type
of taxpayer and the type of reportable transaction. A person becomes a material advisor
when all of the following events occur in no particular order: (1)the person provided
material aid, advice or assistance with respect to a reportable transaction; (2)the person
indirectly or directly derived fees in excess of the threshold; (3)the taxpayer entered into
the reportable transaction; and (4)in the case of a listed transaction or transaction of
interest the guidance is published identifying the transaction as such. Again there is a link
to the actions of the material advisor and reference to activities that either make a scheme
available or enable its implementation. However the timescale for reporting in the United
States is different in that a material advisor is required to file a disclosure statement with
the IRS OTSA by the last day of the month that follows the end of the calendar quarter in
which the advisor became a material advisor with respect to the reportable transaction.
This can introduce a longer timescale particularly when compared to that in the United
Kingdom and Ireland.
Timeframe linked to implementation

145. A disclosure regime could also link the reporting requirement to when a scheme has
been implemented by users. At this point it is more likely that there is a real tax loss but
there is also limited potential to influence the taxpayers behaviour which means that the
overall revenue loss could be greater.
146. Under the South African regime a reportable arrangement must be disclosed within
45 days after the date that any amount is first received by or accrued to a taxpayer or is paid
or actually incurred by a taxpayer in terms of that arrangement. The disclosure obligation
is therefore triggered where there is receipt or payment of money, for a transaction forming
part of a reportable arrangement; this effectively shows that the arrangement has been
implemented.
147. In Canada a reportable transaction must be disclosed by 30June of the calendar
year following that in which the transaction became a reportable transaction. A reportable
transaction is an avoidance transaction that meets at least two of the hallmarks in the
Canadian regime. The timeframe for reporting is therefore triggered by the transaction
becoming reportable. This would occur once it has been implemented. This trigger event
combined with a long reporting timescale means that information is received much later
than under the UK, Irish and Portuguese regimes. This will inevitably impact on a tax
administrations ability to react quickly, potentially leading to greater revenue loss and a
reduced deterrent effect.
Options for timing of taxpayer disclosure

148. As discussed in this chapter existing mandatory disclosure regimes either require
both the promoter and the taxpayer to disclose (the United States and Canada) or they put
the primary obligation on the promoter and only require the taxpayer to disclose where
there is no promoter or the promoter is unlikely to disclose, for instance, because the
promoter is offshore (the United Kingdom, Ireland, Portugal and South Africa).
149. Similar policy considerations would seem to apply to the timing of a disclosure by a
taxpayer as apply to the promoter, that is: the earlier the disclosure, the greater the ability
of a disclosure regime to meet its objectives. However this is especially true where there is
no promoter disclosure and only the taxpayer discloses.
150. In the United States the taxpayer reports their involvement in a reportable scheme as
part of the tax return process and with the IRS OTSA (which is where any material advisor
should also have sent its disclosure) the first time that the taxpayer reports the transaction
on their tax return. In the US experience, taxpayer reporting that is not tied to the time
a tax return is due is often inadvertently overlooked or missed.9 In Canada the reporting
requirement is the same for taxpayers and promoters. In both situations the requirement
to report effectively arises after a scheme has been implemented and the timescale for
reporting is such that there could be significant time lag between implementation and
subsequent disclosure.
151. The United Kingdom, Ireland, Portugal and South Africa only require the taxpayer
to disclose in relatively limited circumstances. But when the taxpayer is required to report
the scheme then, unlike the situation in the United States and Canada, that will be the only
disclosure made. The United Kingdom, Ireland and Portugal all modify both the trigger
event and the period within which a disclosure must be made in the case of a taxpayer
disclosure. For instance for in house schemes both the UK and Irish regimes require a
taxpayer to disclose within 30 days from the date of the first transaction entered into by

the user. So the reporting period is triggered by implementation and the taxpayer is given
slightly longer to report. Similar modifications apply in Portugal where users are required
to report a scheme before the end of the month following the month of implementation.
The definition of implementation needs to identify the point at which it is clear that
a transaction will proceed, this will provide certainty but also prevent taxpayers from
artificially delaying disclosure.
152. Where only the taxpayer/user reports then it seems sensible to link the reporting
requirement to implementation because it is difficult to identify another point or event
that provides an objective trigger for the reporting obligation. It would be possible to use
a more subjective trigger, such as the point at which the taxpayer decided to undertake
the transaction. This could lead to an earlier disclosure than a reporting period linked
to implementation but it would also provide less certainty for the taxpayer and may be
difficult to administer.
153. The South African regime applies the same timeframe for a taxpayer as promoter and
therefore a taxpayer must disclose a reportable arrangement within 45 days after an amount
has first been received by or accrued to a taxpayer or is first paid or actually incurred by
a taxpayer.
154. Whilst the timeframe for a taxpayer disclosure in the United Kingdom, Ireland and
Portugal is longer than that allowed for a promoter, it is still designed to generate an early
disclosure thus enabling the tax administration to react more quickly.
155. It could be argued that there is less need to have early disclosure if a government
is unable to react quickly to change their legislation and the administrative constraints
on each tax administration do need to be taken into account. However, whilst this is a
relevant consideration there are many ways in which governments and tax administrations
can influence taxpayer behaviour, they could for instance publish a view on a scheme
or transaction if they think it does not work. Additionally the bigger the gap between a
scheme being marketed and the eventual disclosure the more users there will be. The tax
administration will therefore need to challenge more cases, potentially tying up resources
and if the scheme is successful there will be a greater loss of tax revenues. Therefore the
countries involved in this work agreed that the timeframe for disclosure should be as
efficient as possible within the context of their domestic law.
Recommendations
156. It is recommended that where the promoter has the obligation to disclose then the
timeframe for disclosure should be linked to the availability of the scheme and that the
timescale for disclosure should aim to maximise the tax administrations ability to react
to the scheme quickly and to influence taxpayers behaviour. This would be achieved by
setting a short timescale for reporting once a scheme is available.
157. Where a taxpayer has to disclose it is recommended that the disclosure is triggered
by implementation rather than availability of a scheme. In addition if only the taxpayer
discloses (i.e.because there is no promoter or the promoter is offshore) the timescale for
reporting should be short to maximise the tax administrations ability to act against a
scheme quickly.
Other obligations to be placed on the promoters or users

Process of identifying scheme users
158. Identifying scheme users is an essential part of any mandatory disclosure regime
and existing regimes identify these in two ways: (1)through the use of scheme reference
numbers which enable them to identify which taxpayer has used a specific scheme; or,
(2)instead of (or in addition to) using an identifying number, they impose an obligation on
the promoter to provide a list of clients who have made use of a disclosed scheme.10
159. Where a scheme reference number is used, the process will generally need to cover
three steps:
The tax authority issues a scheme reference number to a promoter or the users (as
appropriate).
The promoter provides the scheme reference number to the users.
The users report the scheme reference numbers to the tax authority when the users
submit their tax returns.
These three steps are discussed in a little more detail below.
160. The reference number is issued by the tax authority at the time the scheme is
disclosed and is provided to the person who disclosed the scheme. Where the scheme
reference number is given to a promoter, he must then provide the reference number to a
scheme user within a given timeframe (the United Kingdom provides a 30-day deadline
and the United States gives 60 calendar days). Where the user is the person required to
disclose the scheme then the tax authority will allocate a scheme reference number directly
to the user.
161. The user must then include the scheme reference number on their tax return. For
instance in the United Kingdom, the number must be entered on the return that relates to
the year of assessment, tax year, accounting period or earnings period (as the case may be)
in which the user first enters into a transaction forming part of the scheme. The user must
continue to include the scheme reference number for every subsequent year or period until
the advantage ceases to apply.
162. The allocation of a scheme reference number does not indicate that a tax authority
accepts the efficacy of the disclosed scheme or the completeness of a disclosure. Both the
United States and United Kingdom are explicit in this regard. The US instructions make
it clear that receipt of a reportable transaction number does not indicate that the IRS has
reviewed, examined or approved the transaction. The UK guidance also states that the
allocation or notification of a scheme reference number does not indicate that the UK tax
administration accepts that the scheme achieves, or is capable of achieving, any purported
tax advantage. Nor does it indicate acceptance that the disclosure is complete.
Box2.9. Options for identifying scheme users

OptionA: Through scheme number and clients list
OptionB: Through clients list only
OptionA: Through scheme number and clients list

163. The United States, the United Kingdom and Canada use a scheme reference number
as a unique identifier for different schemes.11 Promoters or material advisors receive a
number for the disclosed scheme or transaction which they provide to taxpayers who have
implemented the scheme. Taxpayers must include the scheme number on their tax returns
on which the transaction is disclosed. In addition, the United Kingdom require promoters
to provide a quarterly report of clients to the tax authority and the US material advisor must
maintain a list of clients and furnish the list (together with all documents that are relevant
to determining the tax treatment of the transaction) to the IRS within 20 business days
after the date of a written request by the IRS.
164. Canada first introduced a TS regime in 1989 with a relatively narrow range of
reportable transactions. Under the TS regime, a promoter is required to obtain a tax shelter
identification number, provide the number to participants and provide the list of scheme
users. The identification number allows the tax authorities to track the arrangement and
taxpayers who participate in it. Canada has additionally introduced a new RTAT regime
that extends disclosure to avoidance schemes that were not caught under the TS regime.
However the scheme reference number only applies to tax shelters under the TS regime and
does not apply to reportable transactions under RTAT.
165. Using a combination of a scheme reference number and a client list can help a tax
authority to more easily identify the extent to which a scheme has been used and should
ensure that there is full disclosure. Scheme reference numbers may also enable a tax
authority to identify an individual taxpayers appetite for undertaking certain types of
transactions, as a tax administration can quickly and easily see what schemes the taxpayer
has been involved in. This can then inform the risk assessment process for that particular
taxpayer. However there may be higher up front resource and compliance costs from using
a scheme reference number.
OptionB: Through clients list only

166. Client lists can provide an alternative for user identification if countries do not use
a scheme reference number system. Under such a requirement a promoter is obliged to
provide the tax administration with a list of clients who have used a scheme. The time
limits for providing client lists vary. Under the old Irish regime the list must be provided
within 30-days of the promoter first becoming aware of any transaction forming part of
the reportable transaction having been implemented without assigning any unique scheme
number to the transaction. However Ireland introduced scheme reference numbers in 2014
and now has a similar system to the UK system.12 On the other hand the United Kingdom
requires the promoter to provide lists quarterly.13
167. A variation of this approach is to require the promoter to maintain lists identifying
each person to whom a promoter has provided a scheme reference number with the
promoter furnishing a list, upon request, to the tax authority. For example, the United
States requires clients list to be provided to the IRS within 20 business days after the date
of a written request by the IRS.
168. As mentioned above identification of users is an essential part of a mandatory
disclosure regime. It allows a tax administration to improve risk assessment and the
targeting of enquiries; it also enables them to better quantify the extent of any revenue loss.
All scheme details are filed per that scheme reference number, facilitating the easy retrieval
of the details at a later date if required. Where a user is required to disclose directly to the
tax administration, as is the case in the United States, then there is less of a need to include
a further requirement, such as a scheme reference number, to identify a user, but gathering
information from multiple sources (although it does use more resources) also allows for
double-checking and easier linking between the promoter and the participants in the
transaction. Requiring that the promoter provide a list may also identify other taxpayers
that participated in a scheme but did not disclose.
169. However where the primary disclosure obligation is placed on the promoter, other
mechanisms need to be introduced to ensure that users of the scheme can be identified.
Countries may need to undertake data analysis on the basis of tax returns in order to
identify scheme users if they do not have comprehensive information on the scheme users
through the operation of scheme number systems or client lists. In addition, in this second
situation, the fact that the user knows they will be identified either through a client list
or more directly, through entering a number on their tax return, may deter some from
undertaking a scheme in the first place. In conclusion, different considerations arise where
there is a dual-reporting requirement compared to those that arise where only the promoter
discloses. In this second situation there appears to be a much greater need for scheme
reference numbers and client lists.
170. Using a scheme reference number may initially increase both the resource costs for
the tax administration and the compliance costs for the promoter. However, once a process
has been set up it seems likely that the on-going costs would be low. Balanced against this
a tax administration not only obtains information on the users of a specific scheme it can
also build up a picture of the risk presented by individual taxpayers. The use of scheme
reference numbers may also improve administrative processes for instance, in South
Africa; a scheme reference number is issued as a control measure to indicate the date and
the sequence of the reporting. There may also be a greater deterrent effect if a taxpayer is
personally obliged to include a scheme reference number on their returns, obviously the
same deterrent effect arises if the taxpayer has an obligation to make a disclosure directly.
171. Client lists are generally received before a tax return so they provide information
about the uptake of avoidance schemes much earlier than scheme reference numbers alone.
This allows compliance plans to be put in place before tax returns are received, sometimes
a year in advance. It also enables a tax authority to carry out early interventions such as
contacting taxpayers who appear on the lists to advise them not to claim the effects of the
avoidance scheme on their returns. These benefits are likely to be more obvious if client
lists are automatically provided to the tax administration and the lists are provided sooner
rather than later. However not all countries domestic laws may enable automatic provision
so there needs to be some flexibility.
Recommendations
172. Where a country places the primary reporting obligation on the promoter it is
recommended that they introduce scheme reference numbers and require the preparation
of client lists in order to fully identify all users of a scheme and to enable risk assessment
of individual taxpayers. In this context it is recommended that, where domestic law allows,
client lists should automatically be provided to the tax administration.
173. Where a country introduces a dual-reporting obligation where both the promoter and
the taxpayer report then scheme reference numbers and clients lists may not be as essential

however they are likely to aid cross-checking and allow a tax administration to quantify
the risk and tax loss from specific schemes.
Consequences of compliance and non-compliance

Consequences of compliance
Legitimate expectation
174. Disclosure of a reportable transaction enables a tax authority to identify a transaction
of potential interest to them as well as the taxpayer seeking to obtain a tax benefit from that
transaction. Generally the fact that a transaction is reportable does not necessarily mean
that it involves tax avoidance. Equally disclosure does not imply any acceptance of the
validity, or tax treatment, of the transaction by the tax authority.
175. Several countries have expressed concern about legitimate expectations in the
context of a mandatory disclosure regime. That is, they are concerned that where an
obligation to disclose is introduced taxpayers may believe that any disclosure to the tax
authorities leads to an implicit agreement that the scheme is valid, if there is no response to
the contrary from the tax authority. If such a legitimate expectation were to arise it could
impact on a tax authoritys ability to subsequently act against a scheme and a requirement
to respond to all disclosures would effectively provide a clearance mechanism for such
transactions. This would be contrary to the existing practice of many countries who
explicitly exclude avoidance transactions from their clearance or rulings process.
176. To avoid legitimate expectations from arising it is important for tax authorities to be
clear that the disclosure of reportable transactions has nothing to do with the effectiveness
of the transactions nor is there any automatic link to obtaining a ruling on the validity of
the transaction or to the application of any anti-avoidance rules. Existing regimes already
do this with the United Kingdom, United States, Ireland and Canada making it clear that
the mere reporting of any scheme does not have any bearing on whether or not a tax benefit
is allowed. Similarly it is clear that the disclosure of a tax arrangement has no effect on the
tax position of any person who uses the tax arrangement.
177. The Portuguese regime operates within a civil law system but as with the regimes
in operation in the United Kingdom, the United States, Ireland and South Africa, the
disclosure of the scheme does not affect how it is treated and the lack of response from the
tax authority does not give rise to a legitimate expectation, on the part of the taxpayer, that
the scheme is valid or will be accepted.
178. It is therefore recommended that when introducing a mandatory disclosure regime
the legislation and guidance follows the approach adopted in existing regimes and makes it
clear that the disclosure of a transaction does not imply any acceptance of that transaction
or any acceptance of the purported tax benefit obtained by any person.
Issue of self-incrimination
179. The information that a taxpayer is required to provide under a mandatory disclosure
regime is generally no greater than the information that the tax administration could
require under an investigation or audit into a tax return. Potential tax avoidance and tax
planning transactions reported under existing mandatory disclosure regimes should not
therefore give rise to any greater concern over self-incrimination than would arise under
the exercise of other information collection powers. Furthermore the types of transactions
targeted for disclosure will not generally be the types of transactions that will give rise
to criminal liabilities. For countries that impose criminal liabilities on taxpayers for
undertaking certain tax avoidance transactions, it may be possible to simply exclude those
transactions from the scope of the disclosure regime without substantially curtailing the
scope of the regime. In addition there should not be an issue with self-incrimination where
a promoter is obliged to disclose instead of a taxpayer except in the circumstances where
the promoter could have criminal liability in relation to the promotion or facilitation of a
scheme. Further details on the compatibility between self-incrimination and mandatory
disclosure are included in AnnexB.
Consequences of non-compliance
180. Mandatory disclosure regimes will not be effective unless promoters and taxpayers
fully comply with the reporting requirement. Compliance with disclosure requirements
can be enhanced in several ways; first of all rules that are precisely articulated and clearly
understood will be easier to comply with; second mandatory disclosure regimes need to
include clear sanctions to encourage disclosure and to penalise those who do not fulfil
their obligations. The usual sanction for non-disclosure is the imposition of penalties but
the structure and amount of the penalty varies among countries depending on the type of
taxpayer (i.e.corporate or individual) and the type of transaction.
181. The question of whether penalties should be monetary, non-monetary or include
elements of both, and the amounts of any monetary penalties will generally be an issue for
each country to consider. However, the following discussion looks at the issues that will
need to be taken into account, based on the provisions in existing regimes.
Monetary penalties
182. Non-compliance with mandatory disclosure rules and therefore monetary penalties
could arise in a number of situations:
Monetary penalty for non-disclosure of a scheme this is the most common type
of penalty and will arise where the promoter or the taxpayer fail to disclose a
transaction or fail to report complete information.
Monetary penalty for failure to provide or maintain client lists a penalty may also
be imposed if the promoter is required to provide or maintain a client list and he
fails to comply with the obligation.
Monetary penalty for failure to provide a scheme reference number penalties may
arise if a promoter is required to provide a scheme reference number to all relevant
clients and fails to do so, or fails to do so within a specified time frame.
Monetary penalty for failure to report a scheme reference number a penalty may
also be applied to a taxpayer if he is required to report a scheme reference number
on his return but he fails to do so.
The structure of penalties for non-disclosure

183. In setting penalty levels jurisdictions may take into account factors such as whether
there is negligence or deliberate non-compliance or penalties may be linked to the level
of fees or tax benefit. However, the main aim in setting a limit and in fixing a penalty
structure is to increase the pressure to comply with the law. Penalties should be set at

a level that encourages compliance and maximises their deterrent value without being
overly burdensome or disproportionate. Consideration should be given to percentage based
penalties based upon transaction size or the extent of any tax savings.
(i) Daily penalties

184. Daily penalties put an emphasis on timely disclosure and are used in the United
Kingdom and Ireland. They may be effective in encouraging the promoter and taxpayer
to comply with the disclosure obligation as further daily penalties can be imposed if noncompliance continues. Under the UK regime, penalties consist of two types: an initial
penalty and a secondary penalty. The initial penalty is determined by a Tribunal and a
secondary daily penalty may be imposed by the UK tax administration. The initial penalty
may be calculated on the basis of a daily amount not exceeding GBP600 a day.14
185. If the Tribunal considers that the maximum daily penalty described above is likely
to be insufficient it may determine a higher penalty of up to GBP1million. The higher
penalty amount is determined having regard to the amount of fees received or likely to have
been received by the promoter, in the case of non-compliance by a promoter. In the case of
a failure to disclose by the taxpayer, the Tribunal will have regard to the amount of the tax
advantage gained or sought to be gained.
186. In addition, the UK tax administration may impose a secondary daily penalty, not
exceeding GBP600, for each day that the failure to disclose continues after an initial
penalty has been imposed. In such cases, the UK tax administration normally imposes a
secondary daily amount that is proportionate to the initial penalty. So the penalty structure
used in the United Kingdom and Ireland do also take account of the amount of tax benefit
or fees received.
187. However a different approach is taken if a user fails to report the use of a scheme
on a return. In this situation the penalties are GBP100 for the first failure, GBP500 for a
second failure and GBP1000 for any subsequent failures. Ireland has a similar penalties
regime to that of the United Kingdom although the monetary amounts differ.
188. Daily penalties can be also imposed on any promoter or advisor who fails to maintain
a client list and to make that available upon request. For instance under US tax law, any
material advisor who fails to maintain a list under the reportable transaction regime,
and who fails to provide the list to the IRS upon written request shall pay a penalty of
USD10000 per day for each day of failure after the 20th day.
(ii) Penalty proportionate to tax savings or promoters fee

189. The penalty structure used by the United Kingdom and Ireland can take into account
the amount of the tax benefit or the fees received. However the approach taken by the
United States and Canada makes this link more explicitly by directly basing the level
of penalties on the amount of the tax benefit achieved by the taxpayer or on the fees/
remuneration paid to the advisor or promoter.
190. In the United States, the penalty for a material advisor failing to disclose a reportable
transaction other than a listed transaction, or for filing false or incomplete information with
respect to such a transaction, is USD50000. The penalty imposed for listed transactions
is the greater of USD200000 or 50% (increased to 75% where such failure or false or
incomplete filing is intentional) of the gross income derived from providing aid, assistance,
or advice with respect to the listed transaction.
191. For a US taxpayer, the penalty for taxpayer non-disclosure is 75% of the decrease in
tax as a result of the transaction, subject to minimum and maximum penalties that range
from USD5000 to USD200000 depending on the type of taxpayer and type of reportable
transaction. These penalty amounts reflect changes made to the US penalty regime in 2010
to ensure that the penalty amount was proportionate to the misconduct being penalised.15
192. Under the Canadian penalty regime the penalty is proportionate to the amount of
fees. Each person required to file is liable to pay a penalty equal to the total of all fees
payable to the advisor or promoter. Each advisor or promoter is jointly and severally liable
with the taxpayer, which incentivises advisors and promoters to report or to encourage their
clients to report. However, advisors and promoters are liable only to the extent of fees that
they are entitled to receive. This penalty is not explicitly linked to the tax benefits received
by the user, however, it will implicitly reflect the benefits to the extent that the fees are
based on the tax benefit received.
193. In South Africa, a monthly penalty for non-disclosure of between ZAR50000 and
ZAR100000 (for up to 12 months) is imposed and the penalty is doubled if the amount
of the anticipated tax benefit exceeds ZAR5million and is tripled if the anticipated tax
benefit exceeds ZAR10million.
194. Penalties for failure to comply with a disclosure regime generally relate to the disclosure
itself not the tax consequences of the underlying scheme. Disclosure penalties therefore,
operate separately to, and are independent of, other penalty provisions in a countrys domestic
tax code and the disclosure of a scheme cannot cure a separate failure to comply with some
other aspect of a taxpayers obligations. Some examples, based on the provisions of the United
Kingdom and the United States are included in AnnexC.
Non-monetary penalties
195. Non-monetary penalties can also be applied. For instance, a failure to disclose
suspends the efficacy of the scheme and taxpayers can be denied any tax benefit arising
from the scheme in Canada. On the other hand, non-disclosure itself does not affect the
efficacy of a scheme in the United States, the United Kingdom, Portugal, Ireland and South
Africa.
196. In the United States, publicly traded companies that are required to file certain
reports with the Securities and Exchange Commission (SEC) are required to disclose
the requirement to pay the monetary penalty for failure to disclose certain reportable
transactions. In the United States, the failure to comply with the disclosure rules may
also impact on whether the taxpayer is able to mount an effective defence to any penalty
for a substantive tax understatement relating to the transaction (i.e.the non-disclosure
may impact on the analysis of whether the taxpayer acted with reasonable cause and
good faith in taking the tax-reporting position). Additionally in the United States, nondisclosure extends the statute of limitations (the time period the government has to dispute
a taxpayers claimed tax treatment) in respect of listed transactions.
Initiatives targeting promoters

197. Promoters have a greater knowledge of a schemes tax effects and are better placed to
know whether a scheme constitutes tax avoidance and to be aware of any risks inherent in
that scheme. For this reason tax compliance strategies, including mandatory disclosure rules,
are likely to be more effective if they focus on promoters, and improving tax compliance
via the supply side, rather than focusing exclusively on the end user, i.e.the taxpayer. This

dual approach is evident outside the context of mandatory disclosure regimes for instance
under the Mexican tax code a penalty is imposed on a tax advisor who provides an advisory
service to a taxpayer in order to reduce or omit some federal contribution. However this
penalty is not applicable if the tax advisor provides the taxpayer with a written opinion
saying that the tax authority may not agree with the position taken. This type of penalty
regime encourages the tax advisor to advise his clients of the risk of undertaking certain
transactions and may also, more generally, encourage a tax advisor to be more careful about
the advice he provides.
198. Other promoter initiatives may also be considered as part of, or in connection with a
mandatory disclosure regime. For instance the United Kingdom tackles the behaviour of
high-risk promoters in order to increase transparency and is introducing new rules. The
rules make a promoter who fails to comply with the disclosure regime vulnerable to further
action by the tax authority, including information powers and penalties, designed to improve
their behaviour. In its consultation document entitled Strengthening the Tax Avoidance
Disclosure Regimes published in July 2014,16 the UK tax administration suggests that
anyone working with a non-resident promoter (such as a business partner) should be required
to disclose reportable arrangements that are promoted by the offshore promoter to deter the
use of offshore promoters to circumvent the UK disclosure requirements.
Recommendations
199. It is recommended that countries are explicit in their domestic law about the consequences
of reporting a scheme or transaction under a disclosure regime, i.e.that this does not imply
acceptance of the scheme or its purported benefits.
200. In order to enforce compliance with mandatory disclosure rules, countries should
introduce financial penalties that apply if there is failure to comply with any of the obligations
introduced. Countries are free to introduce penalty provisions (including non-monetary
penalties) that are coherent with their general domestic law provisions.
Procedural/tax administration matters

Types of information to be reported
201. Once a transaction is reportable, the person who is obliged to disclose must provide
the tax authorities with particular information about how the transaction works and how the
expected tax benefit arises along with details of the promoter and scheme user. Commonly,
the information to be reported is the kind of information that a taxpayer would need to
comply with their tax obligations in any event and includes details of the transactions,
names and the tax reference number for the promoter and scheme users.
202. Promoters and, in certain circumstances, users need to provide sufficient information
to a tax authority to enable them to understand how a scheme operates and how the
expected tax advantage arises. A possible draft template setting out the type of information
required to be reported under existing mandatory disclosure regimes is set out below. This
is based on the forms used in the mandatory disclosure regimes of the United Kingdom,
the United States, Canada, Ireland and South Africa.17
Identification of promoters and scheme users

203. To identify the promoters and scheme users, details including the full name, address,
phone number and tax reference or identification number (if any) are required. In Canada
and South Africa there is a single form available for use by a scheme user and a promoter.
Other countries (the United Kingdom, the United States and Ireland) require the promoter
and taxpayer to use a separate form for disclosure.
Details of the provision that makes the scheme reportable

204. Promoters or scheme users are required to specify the provision, i.e.the hallmark(s),
under which the disclosure is being made. Where more than one hallmark applies, the
United States, Canada, Ireland and South Africa require them to specify all hallmarks
that apply to the reportable transaction. The United Kingdom, however, only requires a
promoter or scheme user to indicate the main hallmark that is applicable (this allows the
UK tax administration to monitor the effectiveness of the different hallmarks).
Description of the arrangements and the name by which they are known (if any)
205. Sufficient information must be provided to enable a tax authority to understand how
the expected tax advantage arises. The explanation should be clear and describe each step
involved. Common technical or legal terms and concepts need not be explained in depth
but the description of the reportable transaction/s must include the relevant facts, details of
the parties involved, full details of each element of the transaction and must explain how
the expected tax advantage arises.
Statutory provisions on which tax advantage is based.

206. There should be a full reference to the legislative and regulatory provisions relevant to
the tax treatment of the transactions. This information explains how the relevant provisions
are being applied and how they allow the taxpayer to obtain the desired tax treatment. In the
context of international tax schemes such information should include relevant provisions of
foreign law.
Description of tax benefit or advantage

207. The promoter and/or the taxpayer are required to describe the tax advantage generated
by the arrangements. In the United States, the taxpayer must check all the boxes that apply
to the tax benefits expected from the transaction. In other countries the taxpayer has to
describe the tax advantages.
List of clients (promoter only)

208. Certain mandatory disclosure regimes require promoters and tax advisors to provide
client lists at the time of disclosure or, in the case of the United States, promoters are
required to maintain a client list and provide it upon request.
Amount of expected tax benefit

209. Some countries (the United States, Canada and South Africa) require the actual or
expected amount of the tax benefit generated by the disclosed scheme to be reflected on the
disclosure form. For example, in the United States, each taxpayer and material advisor is
required to report a reportable transaction on a separate form. To be considered complete,
a taxpayer must report the amounts of the expected tax treatment and all the potential tax
benefits expected to result from the transaction. However, it may be difficult for a taxpayer
to accurately calculate the amount of a tax benefit and this is particularly likely where
the disclosure obligation arises before a scheme is implemented (i.e.when a scheme is
made available by a promoter) for this reason this information is described as optional in
Boxes2.10 and 2.11.
Box2.10. Draft disclosure form A (for scheme user)

Users details : name, address, phone number, tax reference number (if any)
Scheme details: describe each element in the transaction from which the intended tax
effect arises
Disclosure provision: specify relevant hallmark(s) under which the disclosure is being made
Statutory or regulatory provisions: describe the key provisions of law relevant to the
elements of the disclosed transaction from which the expected tax benefit arises
Amount of expected tax benefit (optional)
Details of all parties to the transaction: useful particularly where bespoke schemes are
being reported
Declaration: signature, date, name of signatory
Box2.11. Draft disclosure form B (for scheme promoter or advisor)

Promoter or advisors details : name, address, phone number, tax reference number (if any)
Scheme details: describe each element in the transaction from which the intended tax
effect arises
Disclosure provisions: specify relevant hallmark(s) under which the disclosure is being
made
Statutory or regulatory provisions: describe the key provisions of law relevant to the
elements of the disclosed transaction from which the expected tax benefit arises
List of clients: name of clients to whom the transaction was offered (where domestic law
allows)
Amount of expected tax benefit (optional)
Details of all parties to the transaction : useful particularly where bespoke schemes are
being reported
Declaration: signature, date, name of signatory
Powers to obtain additional information

210. Once an initial disclosure has been received a tax administration may need to follow
this up with a request for additional information, for instance to obtain further details
about a scheme and how it operates or to clarify information that is incomplete or unclear.
In addition information powers may also be necessary where no disclosure has actually
been made, to check that the taxpayer and promoter are complying with their disclosure
obligations.
211. Consideration will therefore need to be given to the extent to which new or additional
powers are necessary to enable a tax administration to:
enquire into the reasons why a scheme has not been disclosed by a promoter or a
user in circumstances where it believes a disclosure should have been made;
require an intermediary/introducer (a person who introduces clients to a promoter)
to identify the person who provided them with information relating to the scheme;18
call for more information where a disclosure is incomplete;
request further information, after an initial disclosure from the promoter or user of
a proposal or arrangement.
Use of the information collected

212. Once a mandatory disclosure regime is introduced there are several ways in which
tax authorities can use the information collected to change behaviour and to counteract tax
avoidance schemes. These include counteraction through legislative change; through risk
assessment and audit; and through communication strategies.
Legislative or regulatory change

213. The early detection of tax avoidance schemes enables tax authorities to make changes
to tax law more quickly. For example, in the United Kingdom, there have been numerous
changes in tax law, informed by disclosures, since DOTAS was introduced in 2004. This
has helped to close off billions in avoidance opportunities.
214. Quick legislative change is dependent on a countrys legislative system but also
requires a country to set up a process that analyses and risk assesses new schemes quickly.
Risk assessment
215. There is generally a dedicated team, within the tax administration, dealing with
disclosures. This team undertakes an initial review of the arrangement and plays a role
in determining whether further action should be taken in the form of legislative change,
audits, or more inquiries, etc. The specific internal procedure varies depending on the
administrative structure of countries.
216. In the United Kingdom, once a disclosure is received, a separate team assesses
the risk of the disclosed arrangement and co-ordinates responses from different policy
and operational areas. This includes devising and delivering the operational strategy
for handling enquiries into the respective avoidance scheme. In the United States, a
team called the Office of Tax Shelter Analysis (OTSA) is the focal point for tax shelter
compliance, responsible for monitoring all reportable transactions disclosed and for

identifying potential cases of non-compliance, and ensuring the appropriate dissemination
of tax shelter information within the tax administration.
Communication strategy
217. Tax authorities may issue publications to taxpayers as a way of providing an early
warning that they have detected an arrangement in the marketplace and are currently
considering its tax implications. In such publications tax authorities describe the arrangement
and their concerns with the arrangement so that taxpayers are aware of the risks in undertaking
the scheme. This mass media (one too many) approach can play an important role in
influencing taxpayers and promoters behaviour on tax compliance. For instance the United
Kingdom issues Spotlight which warns taxpayers about certain tax avoidance schemes.19
218. Canada has a product similar to the United Kingdom, which is called Tax Alert.20
The CRA occasionally issues Tax Alert on specific tax issues in order to help tax payers
understand the tax consequences they might face if they undertake a scheme or transaction.
These publications are a way of providing timely communication to taxpayers to keep them
informed and to potentially deter them from undertaking certain transactions.
219. In the United States, the IRS publicises its view of transactions that it has identified
as tax avoidance transactions by designating such transactions as listed transactions in
administrative notices or other public guidance.21 The IRS also identifies transactions that
it has determined may have the potential for tax avoidance by designating such transactions
as transactions of interest in administrative notices or other public guidance.22 These
public notices describe both the features of identified transactions and their intended tax
effects.
Recommendations
220. Tax administrations will need to set out the information that a promoter or taxpayer
is required to disclose. It is recommended that the information should include:
identification of promoters and scheme users;
details of the provisions that make the scheme reportable;
a description of the arrangements and the name by which they are known (if any);
details of the statutory provisions on which a tax advantage is based;
a description of the tax benefit or advantage;
a list of clients (promoter only) where domestic law allows;
the amount of expected tax benefit.
221. In addition any mandatory disclosure provisions will need to be supported by
information powers necessary to enable a tax administration to:
enquire into the reasons for a failure to disclose;
enquire into the identity of promoters and intermediaries;
request further follow up information in response to a disclosure.
222. In order to use the information from a mandatory disclosure regime effectively it is
recommended that tax administrations set up a small unit to risk assess the disclosures
received and to co-ordinate action within and across the taxing authorities.
Notes
1.
Hallmarks act as tools to identify the features of aggressive tax planning schemes and are
generally divided into two categories: generic and specific hallmarks. Further details are
included in section Hallmarks in this chapter.
2.
Except for those cases where litigation is in actual contemplation, legal privilege generally only
applies to confidential legal advice given to the client by the professional adviser and does not
extend to documentation prepared in the ordinary course of the transaction or to the identity of
the parties involved. The legal professional privilege is similar to the attorney-client privilege
recognised under US common law. US legislation also recognises a statutory protection for
communications between a taxpayer and a practitioner authorised to practice before the IRS,
but like the attorney privilege, this generally does not extend to the identity of the taxpayer.
See, e.g.United States v. BDO Seidman, 337 F.3d 802 (7thCir. 2003); Doe v. KPMG LLP, 325
F. Supp. 2d746 (N.D.Tex. 2004). Furthermore, the US statutory protection does not protect
communications regarding tax shelters.
3.
Thresholds test are used in a number of different legislative provisions and often refer to
de-minimis limits. However, in the context of existing mandatory disclosure regimes, the most
common threshold is a main benefit or main purpose test. Therefore when this report refers to
threshold tests this is the type of test that is being referred to.
4.
However, as mentioned earlier, the experience of some countries indicates that the introduction
of generic hallmarks reduces the prevalence of certain transactions so further thresholds may
not be necessary.
5.
See HMRC (2014), Disclosure of Tax Avoidance Schemes: Guidance, 14May 2014, p.40.
6.
See HMRC (2014), Disclosure of Tax Avoidance Schemes: Guidance, 14May 2014, p.46.
7.
Canada has two kinds of mandatory disclosure regimes: tax shelter (TS) regime, reporting of
tax avoidance transactions (RTAT). The TS regime which was introduced in 1989 is narrow in
scope as it includes only gifting arrangements and the acquisition of property. As such, while
it has been effective in providing timely information, many more tax avoidance arrangements
are not caught by the rule. The new mandatory disclosure regime, which was enacted in 2013,
is intended to disclose tax avoidance arrangements not caught under the tax shelter regime.
8.
For more details, see Notice 2006-6, 2006-5 I.R.B. 385: www.irs.gov/pub/irs-irbs/irb06-05.pdf
(accessed 17June 2015).
9.
It could also be the case that the taxpayer ultimately decides not to claim the aggressive or
abusive tax benefits on the return.
10.
Scheme reference numbers may have less importance where there is a dual reporting
requirement imposed on both the promoter and taxpayer such as in the United States. The fact
that both taxpayers and promoters/material advisors report in the United States may also reduce
the reliance on client lists. Scheme reference numbers and client lists would appear to be more
essential in the context of a regime that places the primary reporting obligation on the promoter
and only requires the user to report in limited circumstances. One additional benefit to dual
reporting is the ability to cross-check.
11.
Under the South African mandatory disclosure regime, a reference number is issued to
taxpayers, who must disclose that they entered into a reportable transaction and include the
reference number in their annual tax returns. However, the South African regime does not use
a client list.
12.
Any disclosable transaction which is commenced after 23October 2014 must be assigned
a unique transaction number by the Irish Revenue (Chapter3 of Part33 of the Taxes
Consolidation Act (as amended by Finance Act 2014)).

13.
Note that legal privilege generally does not extend to client lists.
14.
Initial period begins with the first day following the end of the period in which the scheme
should have been disclosed and ends with the earlier of: the day on which the Tribunal
determines the penalty or the last day before the day on which the scheme is disclosed.
15.
The 2010 amendment to the penalty regime apply to penalties assessed after December 31,
2006. Prior to the amendment, a taxpayer that failed to disclose a listed transaction was subject
to a flat penalty of USD100000 in the case of an individual, or USD200000 in any other
case. A taxpayer that failed to disclose a reportable transaction that was not a listed transaction
was subject to a flat penalty of USD10000 in the case of an individual, or USD50000 in any
other case.
16.
https://www.gov.uk/government/consultations/strengthening-the-tax-avoidance-disclosureregimes (accessed 14June 2015).
17.
Links to disclosure forms available at:

UK: https://www.gov.uk/forms-to-disclose-tax-avoidance-schemes (accessed 17June 2015)
US: www.irs.gov/pub/irs-pdf/f8918.pdf, www.irs.gov/pub/irs-pdf/f8886.pdf (accessed
17June 2015)
Ireland: www.revenue.ie/en/practitioner/law/mandatory-disclosure.html (accessed
17June 2015)
South Africa: www.sars.gov.za/AllDocs/OpsDocs/SARSForms/RA01%20-%20
Reporting%20Reportable%20Arrangements%20-%20External%20Form.pdf
(accessed 17June 2015)
Canada: www.cra-arc.gc.ca/E/pbg/tf/rc312/rc312-13e.pdf, www.cra-arc.gc.ca/E/pbg/
tf/t5001/t5001-14e.pdf (accessed 17June 2015).
18.
The United Kingdom has such a provision which applies where they suspect a person of acting
as an introducer for a notifiable scheme that has not been disclosed.
19.
Spotlight, available at: https://www.gov.uk/government/publications/tax-avoidance-schemescurrently-in-the-spotlight (accessed 17June 2015).
20.
Tax Alert, available at: www.cra-arc.gc.ca/nwsrm/lrts/menu-eng.html (accessed 17June 2015).
21.
An up-to-date record of listed transactions is available at: www.irs.gov/Businesses/Corporations/

Listed-Transactions (accessed 17June 2015).
22.
Links to transactions of interest available at: www.irs.gov/Businesses/Corporations/Transactionsof-Interest---Not-LMSB-Tier-I-Issues (accessed 17June 2015).
Bibliography
HMRC (2014), Disclosure of Tax Avoidance Schemes: Guidance, 14May 2014
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/341960/
dotas-guidance.pdf (accessed 17June 2015).
Irish Revenue Commissioners (2011), Guidance Notes on Mandatory Disclosure Regime,
January 2015, www.revenue.ie/en/practitioner/law/notes-for-guidance/mandatorydisclosure/ (accessed 17June 2015).
3. International tax schemes 67
Chapter3
International tax schemes
68 3. International tax schemes

223. Part of the work required under Action12 is considering how to make mandatory
disclosure more effective in the international context. Action12 specifically calls for
recommendations on the mandatory disclosure of international tax schemes and the
exploration of a wide definition of tax benefit in order to capture them.
224. The work under Action12 is intended to give countries an additional tool for tackling
BEPS by providing tax administrations with real-time information on cross-border tax
planning. As noted in Chapter1, one of the key strengths of mandatory disclosure is its
ability to provide tax administrations with current, comprehensive and relevant information
on actual taxpayer behaviour. These benefits are particularly important in the context of
cross-border schemes where tax administrations could otherwise find it difficult to obtain
information on the facts of a scheme or a complete picture of its overall tax and economic
consequences. The challenge, however, is to develop disclosure requirements that are
appropriately targeted and that capture the key information tax administrations need in
order to make informed policy decisions, while avoiding over-disclosure or placing undue
compliance burdens on taxpayers.
225. This chapter identifies some of the key differences between domestic and international
schemes that make such schemes more difficult to tackle from a disclosure perspective. It
then sets out recommendations for elements that could be included in mandatory disclosure
regimes to make them more effective at targeting cross-border tax planning.
Application of existing disclosure rules

Defining a reportable scheme
226. There is nothing in principle that prevents current mandatory disclosure regimes
from applying to international schemes. Existing disclosure regimes require any scheme to
be disclosed if it meets any threshold requirement and the particular features of that scheme
fall within one of the hallmarks. The existing hallmarks used in mandatory disclosure
regimes do not generally discriminate between schemes that are wholly domestic and
those that have a cross-border component and some jurisdictions also have hallmarks
that specifically target cross-border schemes or may separately identify an international
transaction under their rules.
227. Several countries with mandatory disclosure regimes indicate, however, that, in
practice, they receive comparatively fewer disclosures of cross-border schemes. The
reason for this lower number of disclosures appears to be partly a consequence of the
way international schemes are structured and the approach taken by these regimes in
formulating the requirements for disclosure of a reportable scheme.
228. Cross-border schemes typically generate multiple tax benefits for different parties in
different jurisdictions and the domestic tax benefits that arise under a cross-border scheme
may seem unremarkable when viewed in isolation from the rest of the arrangement as a
whole. The ambiguous nature of the tax benefits that arise in respect of cross-border tax
planning means that disclosure regimes which focus exclusively on domestic tax outcomes
for domestic taxpayers, without understanding the global picture, may not capture many
types of cross-border tax planning.
229. As discussed in Chapter2, some disclosure regimes require reportable schemes to meet
a formal threshold condition for disclosure (such as the main benefit or tax avoidance test).
This threshold condition can be difficult to apply in the context of cross-border schemes that
trigger tax consequences in a number of different jurisdictions. Such schemes may not meet
the disclosure threshold if the taxpayer can demonstrate that the value of any domestic tax
benefits was incidental when viewed in light of the commercial and foreign tax benefits of the
transaction as a whole. In certain cases the foreign tax benefits of a cross-border scheme may
even be returned to the taxpayer in the reporting jurisdiction in the form of a lower cost of
capital or higher return. This has the effect of converting a tax benefit for a foreign counterparty
in the off-shore jurisdiction into a commercial benefit for the taxpayer in the reporting
jurisdiction, thereby further reducing the overall significance of the domestic tax benefits under
the transaction that nevertheless may pose a risk to the domestic tax administration.
230. Cross-border tax planning schemes are often incorporated into a broader commercial
transaction such as an acquisition, refinancing or restructuring. Such schemes tend to
be customised so that they are taxpayer and transaction specific and may not be widely
promoted in the same way as a domestically marketed scheme. It may therefore be difficult
to target these schemes with generic hallmarks that target promoted schemes, which can be
easily replicated and sold to a number of different taxpayers. Some countries target these
more specialised types of tax planning with the use of broader generic hallmarks, such as
the hypothetical premium fee test used in the United Kingdom and Ireland, which covers
arrangements where the tax planning is sufficiently innovative that a promoter would be
able to obtain a premium fee for it. These countries, however, typically limit the application
of those hallmarks with a threshold condition that restricts the application to schemes that
are designed with the main purpose of generating domestic tax benefits.
231. Specific hallmarks will generally be the most effective method of targeting crossborder tax schemes that raise tax policy or revenue risks in the reporting jurisdiction. Some
of the specific hallmarks presently used in mandatory disclosure regimes (e.g.leasing,
income conversion schemes) can apply equally in the domestic and cross-border context.
Furthermore countries such as the United States, South Africa and Portugal have also
developed specific hallmarks for targeting international transactions.
232. One of the challenges in the design of specific hallmarks is to formulate a definition
that is sufficiently broad to pick up a range of tax planning techniques and narrow
enough to avoid over-disclosure. One approach to dealing with this issue is to focus on
the kinds of BEPS outcomes that raise concerns from a tax policy perspective, rather than
the mechanisms that are used to achieve them. Identifying an international scheme by
reference to a specific outcome and the general technique used to achieve it is similar to the
US approach of extending the disclosure obligations to transactions that are substantially
similar to listed transactions (i.e.transactions that are expected to achieve the same or
similar consequences as a listed transaction and are based on the same or similar strategy).
Identifying who must report

233. A reporting jurisdiction should only require disclosure of an international scheme
where the scheme has a substantive connection with the reporting jurisdiction (i.e.the
scheme results in domestic tax consequences for a domestic taxpayer). A mandatory
disclosure regime should avoid imposing disclosure obligations on persons that are not
subject to tax in the reporting jurisdiction or on advisers or intermediaries that do not
provide any advice or assistance in respect of domestic taxpayers or transactions. This
means that a mandatory disclosure regime should only apply to domestic taxpayers and
their advisors and only in respect of schemes that have a material impact on domestic
tax outcomes in the reporting jurisdiction. Limiting disclosure in this way ensures that
reporting obligations are not imposed in circumstances where the tax authority would have
limited practical ability to enforce them.

234. Once the ability to require disclosure is established, further consideration needs to be
given to how a taxpayer in the reporting jurisdiction would comply with additional information
requirements for international tax schemes. Simply because an international scheme results
in domestic consequences for a taxpayer does not mean that the taxpayer will be aware of
the offshore elements of the scheme or be in a position to properly understand its effects. At
the same time, disclosure obligations should not be framed in such a way as to encourage a
taxpayer to deliberately ignore the offshore aspects of a scheme simply to avoid disclosure.
Describing what must be reported

235. Once a disclosure obligation has been triggered there remains the question of what
information needs to be disclosed. While taxpayers should only be required to disclose
information that is within their knowledge, possession or control, they can be expected to
request information on the operation and effect of an intra-group scheme from other group
members.
Recommendation on an alternative approach to the design of a disclosure regime for

international tax schemes
236. Based on the above discussion the following design elements are recommended in
order for a mandatory disclosure regime to better target cross-border tax planning:
the removal of the threshold condition for cross-border schemes;
the development of hallmarks that focus on BEPS related risks posed by crossborder schemes and that are wide enough to capture different and innovative tax
planning techniques (cross-border outcomes);
a broad definition of reportable scheme that would include any arrangement that
incorporates a material transaction with a domestic taxpayer and that gives rise to
a cross-border outcome.
avoid imposing undue burden on taxpayers or their advisers by requiring disclosure
only in circumstances where the domestic taxpayer or their advisor could
reasonably have been expected to be aware of the cross-border outcome under the
arrangement;
require the domestic taxpayer or their advisor to disclose to the tax administration
any material information on the scheme that is within their knowledge, possession
or control;
impose an obligation on a domestic taxpayer at the time they enter into a material
transaction with a group member to:
- make reasonable enquiries as to whether the arrangement that gave rise to
the transaction incorporates a cross-border outcome identified in a hallmark
developed under paragraph(b) above;
- notify the tax administration if:
- the group member does not provide relevant information on the arrangement;
- the information on the arrangement is inadequate or incomplete;
- there is an unreasonable delay in providing such information.
A more detailed explanation setting out the key elements of this approach is set out below.
No threshold requirement
237. The function of a threshold requirement is to filter out irrelevant disclosures and reduce
the compliance and administration burden by targeting only tax motivated transactions that
are likely to pose the greatest tax policy and revenue risks.
238. The hallmarks for international schemes (discussed below) would, however, target
only arrangements that produced cross-border outcomes, which were of particular concern
to a tax administration and would only require disclosure of those arrangements in
circumstances where they presented a material risk to the reporting jurisdiction from a tax
revenue perspective. Provided the new hallmarks give a precise description of the types of
tax outcomes that are of concern to the reporting jurisdictions tax administration and the
materiality thresholds are set at level that avoids over-disclosure, there should be no need
to apply a threshold requirement to filter-out irrelevant or non-material disclosures.
New hallmarks based on identification of cross-border tax outcomes

239. The most direct way of targeting cross-border schemes is for the tax administration
to develop hallmarks that focus on the kinds of base erosion and profit shifting techniques
that are known to give rise to tax policy or revenue concerns (cross-border outcomes).
Cross-border outcomes would include the types of structures identified in the BEPS Action
Plan (OECD, 2013) (for example, hybrid mismatch and treaty shopping arrangements) and
may include other cross-border tax outcomes that are known to pose material risks to the
tax base of a reporting jurisdiction. These could include, for example:
Arrangements that give rise to a conflict in ownership of an asset that results in
taxpayers in different jurisdictions claiming tax relief for depreciation or amortisation
in respect of the same asset or claiming relief from double taxation in respect of the
same item of income.
Deductible cross-border payments made to members of the same group that are not
resident for tax purposes in any jurisdiction or that are resident in a jurisdiction that
does not impose tax on income.
Transactions that give rise to a deduction or equivalent relief resulting from a
deemed or actual transfer of value for tax purposes, where that transaction is not
treated as giving rise to tax consequences in the jurisdiction of the counterparty.
Asset transfers where there is a material difference in the amount treated as payable
in consideration for the asset.
240. The hallmarks for international schemes must be both specific, in that they should
identify particular cross-border tax outcomes that raise concerns for the reporting
jurisdiction, and generic, in that they should be defined by reference to their overall tax
effects and be capable of capturing any arrangement designed to produce those effects
regardless of how the arrangement is actually structured. This combination of specific and
generic elements will allow tax administrations to target those international tax planning
arrangements that raise the most significant tax policy or revenue concerns while still
capturing novel or innovative schemes. In addition to setting out general descriptions of
cross-border outcomes, the tax administration should provide a specific list of tax regimes
and outcomes that are not required to be disclosed under the international hallmarks in
order to avoid disclosure of arrangements that are known to the tax administration and are
not thought to raise any particular tax policy issues.

241. As part of the work on monitoring the outputs from the BEPS project, countries may
consider whether additional hallmarks are required to ensure that the outputs of the BEPS
project are working as intended. This work could include development of model hallmarks,
in order to minimise the additional compliance costs that would otherwise flow from
different countries targeting the same cross-border scheme with overlapping disclosure
obligations, each with its own definition and scope.
Broad definition of arrangement that includes offshore tax outcomes

242. The definition of a reportable scheme in the international context should capture
any arrangement involving a domestic taxpayer if that arrangement includes a crossborder outcome. Domestic taxpayers should be under an obligation to disclose their
participation in that arrangement even if they are not a direct party to that cross-border
outcome. If disclosure was only required from taxpayers that were directly affected by
a cross-border outcome, then tax planners could simply use intermediaries and back-toback structures to avoid triggering domestic disclosure requirements. Equally, however, a
reporting jurisdiction should not require disclosure of cross-border arrangements that do
not raise any material tax revenue risks in that jurisdiction. Accordingly an arrangement
that gives rise to a specified cross-border outcome should only be reportable if it involves a
transaction or payment that has a material tax impact on the reporting jurisdiction.
Arrangement
243. The definition of arrangement should be sufficiently broad and robust to capture
any scheme, plan or understanding; all the steps and transactions that form part of that
arrangement and all the persons that are a party to, or affected by that arrangement.
For example, in the context of a group financing (or re-financing), the arrangement
would cover the initial transaction that introduced new capital into the group and all the
subsequent steps and intra-group transactions that explain how the capital was deployed:
including transactions taken in contemplation of, or as a consequence of, the financing
or refinancing. In the context of the acquisition of a new entity, the arrangement would
include not only the acquisition itself but also the financing of the acquisition and any
post-acquisition restructuring. Although the definition of arrangement should be broadly
construed, so as to pick up any arrangement incorporating a cross-border outcome that
gives rise to material tax consequences in the reporting jurisdiction, it is only those
transactions that explain the direct or indirect tax effects of the cross-border outcome in the
reporting jurisdiction that should be required to be disclosed (see below).
Arrangement includes a cross-border outcome

244. Any arrangement that incorporates a specified cross-border outcome will potentially
be subject to disclosure. A mandatory disclosure regime for international schemes should
not limit disclosure to those schemes where the cross-border outcome is the purpose or
one of the main purposes of the arrangement. It will be sufficient to bring an arrangement
within the purview of a mandatory disclosure rule if the effect of the arrangements is to
bring about a cross-border outcome, noting that the cross-border outcome itself will need
to be set forth with a high degree of specificity so that taxpayers can easily determine
whether a transaction is in scope.
Arrangement includes a transaction with a material tax impact

245. The requirement that the arrangement includes a transaction with a material tax
impact in the reporting jurisdiction ensures that international schemes are only reportable
in those jurisdictions where they actually have tax revenue impacts.
246. An arrangement will have a tax impact on a reporting jurisdiction if the arrangement
has the effect, or is likely to have the effect, of reducing the tax payable in that reporting
jurisdiction. The tax impact should be material. The materiality threshold should be a
monetary amount (to facilitate certainty) and set by reference to the economic and tax
consequences of the transaction entered into by the domestic taxpayer (or payments made
by or to that taxpayer). Materiality should be measured over the lifetime of the arrangement.
247. Measuring whether a transaction has a tax impact does not require a before-and-after
comparison of the tax consequences of the transaction that has been entered into, but rather
a direct analysis of the economic and tax impact of the transaction and any payments made
under it. Transactions or payments with a tax impact could, for example, include a payment
of interest to an offshore related party, a payment that is eligible for treaty relief or the
transfer of an income-earning asset to a non-resident. The definition of transaction should
also capture notional or deemed transactions that are recognised for tax purposes in the
counterparty jurisdiction even if such transactions are not treated as having any economic
or tax consequences in the reporting jurisdiction (such as a deemed transfer of goodwill).
Domestic taxpayer
248. A domestic taxpayer, in this context should include any person that is tax resident
in the reporting jurisdiction and any non-resident to the extent that person is subject to a
tax reporting obligation on income that has a source or nexus in the reporting jurisdiction.
Limitations on disclosure
249. In order to prevent mandatory disclosure imposing an undue burden on taxpayers,
disclosure in the reporting jurisdiction should only be required where the taxpayer
could reasonably have been expected to be aware of the cross-border outcome under the
arrangement.
250. A person can reasonably be expected to be aware of a cross-border outcome where
the person has sufficient information about the arrangement to understand its design and
to appreciate its tax effects. This will include any information obtained by a taxpayer
under the obligation to make reasonable enquiries (described below) but, in the context
of transactions with unrelated parties, the test should not be taken as requiring a person
to gather more information than it could have been expected to obtain in the course of
ordinary commercial due diligence on a transaction of that nature.
Enquiry and notification requirements

251. A taxpayer can only be expected to provide the tax administration with information
that is within that persons knowledge, possession or control. Information that is within
a persons control includes information held by agents and controlled entities. As is the
case for domestic schemes, mandatory disclosure should not require any person to provide
information that is subject to a non-disclosure or confidentiality obligation owed to a third
party.

252. Where a taxpayer enters into a transaction with a group member that has a material
tax impact, then that taxpayer can be expected, at the time that arrangement is entered into,
to make reasonable enquiries of those group members as to whether that transaction is part
of an arrangement that includes, or will include, a cross-border outcome. In certain cases
information about the scheme may be subject to confidentiality or other restrictions that
prevent it from being made available to the reporting taxpayer. In these cases, where group
members are unable or unwilling to provide this information within a reasonable period of
time then the taxpayer should notify the tax administration of the fact that:
It has entered into an intra-group transaction with a material tax impact.
After making reasonable enquiries, has been unable to obtain information on
whether the transaction is part of an arrangement that incorporates a cross-border
outcome.
The notification should include any relevant information the domestic taxpayer has on the
intra-group transaction and circumstances giving rise to the transaction. Tax administrations
would be able to use this information as the basis for an information request under their
existing exchange agreements with other jurisdictions (for example under a double tax treaty
which contains an information exchange provision; the multilateral convention on mutual
administrative assistance or a tax information exchange agreement).
Disclosure obligation on material adviser and/or taxpayer

253. As for domestic schemes, countries should choose whether the disclosure obligation
for international schemes should be imposed on either the taxpayer or the promoter or
both. When defining the disclosure obligations on the promoter, these should capture
any person who is a material advisor in relation to that taxpayer or an intermediary in
relation to any domestic transaction that forms part of that arrangement. As is the case for
domestic disclosure rules, it will be important, when defining the scope of an adviser or
intermediary, to ensure that the definition captures those who can reasonably be expected
to have knowledge of the tax consequences of the arrangement but excludes those advisers
or intermediaries who would either be unaware of the cross-border outcome or of the
domestic transactions that trigger the operation of the mandatory disclosure rules in the
reporting jurisdiction.
Information required
254. The information that should be required to be disclosed in respect of international
tax schemes will be similar to the information required for domestic schemes. Such
information should include information about the arrangement so far as it is relevant to the
tax impacts in the reporting jurisdiction and should include key provisions of foreign law
that are relevant to the cross-border outcome.
255. As part of the work on monitoring the outputs from the BEPS project, countries may
consider whether the information required for international schemes could be standardised,
in order to minimise the compliance costs that may arise from overlapping disclosure
obligations imposed by different jurisdictions in respect of the same scheme.
Example intra-group imported mismatch arrangement

256. The following example, which is adapted from the facts described in Example8.2 in
the Report on Neutralising the Effects of Hybrid Mismatch Arrangements (Hybrids Report,
OECD, 2015), illustrates how the recommendations on the disclosure of international tax
schemes might apply to an imported mismatch arrangement.
257. In this example ECo, a company that is tax resident in CountryE, is an operating
subsidiary of the ABCDE Group. ECo manufactures industrial equipment for sale to third
party customers. The transactions ECo has with other group members primarily involve
ECo making payments for intra-group services. The group structure is illustrated in
Figure3.1.
Figure3.1. Intra-group imported mismatch arrangement
A Co
Interest
B Co
C Co
Hybrid Financial
Instrument
D Co
Loan
E Co
Interest
258. ACo, a company that is tax resident in CountryA, is the parent of the group. ACo
owns all the shares in BCo, a holding company tax resident in CountryB. BCo owns all
the shares in both CCo and DCo which are tax resident in CountryC and D respectively.
ECo is a wholly-owned subsidiary of CCo.
259. BCo is responsible for managing the groups financing operations and regularly
borrows money from, and makes loans to, other group members. As part of these financing
operations BCo borrows money from ACo under a hybrid financial instrument. Because
payments of interest on the hybrid financing instrument are deductible by BCo but not
included in ordinary income under CountryA law, this is a deduction/no inclusion (D/NI
outcome). ECo is recapitalised by CCo with additional debt funding at, or around the
same time that BCo borrows money from ACo under the hybrid financial instrument.
260. CountryE has implemented the recommendations regarding the mandatory disclosure
of international tax schemes. A D/NI outcome under a hybrid financial instrument is one
of the cross-border outcomes that is required to be disclosed under CountryEs mandatory
disclosure regime. It is expected that ECo will also have introduced the recommendations
set out in the Hybrids Report (OECD, 2015) including those on imported mismatch
arrangements. The imported mismatch rule will neutralise the effect of any D/NI outcome
arising from a hybrid mismatch arrangement that is imported into CountryE through the

interest payments on the loan to CCo. However, as noted further below, CountryE may
have an interest in ensuring the imported mismatch rule is being applied correctly and in
monitoring the effectiveness of the hybrid mismatch rules in addressing the indirect risk
posed to CountryEs tax base by such arrangements.
Question
261. Is the financing arrangement entered into between ACo and BCo a reportable scheme
under CountryE law? What reporting obligations should be imposed on ECo given that it is
not a direct party to any hybrid mismatch arrangement?
Answer
262. If ECos interest payments under the intra-group loan are deductible under CountryE
law, and the amount of those deductions are material for tax purposes, then ECo will be
obliged to make reasonable enquiries as to the wider arrangement that gave rise to the
recapitalisation and whether those arrangements include a cross-border outcome. ECo will
be obliged to notify its own tax authority in accordance with the mandatory disclosure rules
of CountryE in the event the information provided by other group members in response to
any such request is inadequate, incomplete or unreasonably delayed.
263. The information provided by the group members on the wider arrangement and
cross-border outcome may trigger a disclosure obligation for ECo and any material advisor
if it transpires that the recapitalisation is part of the same arrangement that gave rise to the
hybrid mismatch.
Analysis
The D/NI outcome under the hybrid financial instrument is a cross-border
outcome
264. The D/NI outcome that arises under a hybrid financial instrument is identified as a
cross-border outcome under CountryEs mandatory disclosure regime. It is not necessary
for ECo to be a direct party to that D/NI outcome in order to trigger disclosure obligations
under CountryE law. In fact, in this case, if ECo had been a direct party to the hybrid
financial instrument, then the mismatch in tax outcomes would have been neutralised
under CountryEs hybrid mismatch rules and there would not have been any cross-border
outcome for ECo to report under the mandatory disclosure regime.
The cross-border outcome and the recapitalisation of ECo are likely to form part
of a wider arrangement
265. CCo provides additional debt funding to ECo at, or around the same time, that BCo
borrows money from ACo under the hybrid financial instrument. The facts of this example
do not provide sufficient information to determine whether the recapitalisation of ECo was
part of the same arrangement as the hybrid financial instrument, however, taking the broad
definition of arrangement and the fact that both transactions were financing transactions
which occurred within a similar time frame, it may be reasonable to infer, in the absence of
evidence to the contrary, that both transactions were, in fact, part of the same arrangement.
Recapitalisation of ECo triggers reasonable enquiry and notification requirements

266. In certain cases a group member such as ECo will not be aware of the existence of the
wider financing arrangement or that it includes a cross-border outcome. This is particularly
the case in the context of operational subsidiaries like ECo, where the transactions with other
group members primarily involve making (deductible) payments for intra-group services.
267. The mandatory disclosure rules in CountryE impose reasonable enquiry and notification
requirements on taxpayers that enter into transactions with group members where those
transactions have a material impact, or are likely to have a material impact on the tax
payable under CountryE law. Accordingly, if the recapitalisation transaction results in
material payments of deductible interest to a group member, then ECo will be under an
obligation to make reasonable enquiries as to whether the recapitalisation is part of an
arrangement that includes, or will include, a cross-border outcome. If the group members
are unable or unwilling to provide this information within a reasonable period of time,
then ECo will be required to notify the tax administration of its inability to obtain further
information about the arrangements that gave rise to the refinancing.
Enquiry and notification requirements not triggered if interest payment is subject

to full adjustment under imported mismatch rule
268. As discussed above, the hybrid mismatch rules include an imported mismatch rule
that is designed to protect the integrity of the hybrid mismatch rule by preventing taxpayers
from engineering an offshore hybrid mismatch (such as a D/NI outcome under a hybrid
financial instrument) and then importing its effect into the domestic jurisdiction through a
non-hybrid instrument such as an ordinary loan.
269. In this case the imported mismatch rule may operate to deny ECo a deduction for
the full amount of interest paid on the loan. If this is the case the interest payments made
to CCo will not have a material tax impact in CountryE and accordingly ECo will not
be under an obligation to make any further enquiries as to the arrangement that gave rise
to the loan or make any disclosure under the mandatory disclosure rules in CountryE.
As discussed in further detail in the Hybrids Report, there may be a number of reasons,
however, why the interest payment to CCo is not subject to full adjustment under the
imported mismatch rule. Such reasons include:
The hybrid financial instrument is entered into as part of a structured arrangement
involving a taxpayer in another jurisdiction and the mismatch in tax outcomes is
fully neutralised by the adjustment made under the imported mismatch rule in that
jurisdiction.
CountryC has also implemented the hybrid mismatch rules so that no imported
mismatch arises on the facts of this case.
The amount of the interest expense incurred by ECo under the loan is in excess of
the deduction under the hybrid financial instrument or the taxable payments made
by CCo to BCo.
270. In each of these cases, CountryE has an interest in ensuring the imported mismatch
rule is being applied correctly and in monitoring the effectiveness of these rules in addressing
the indirect risk posed to CountryEs tax base by such arrangements. Accordingly the
disclosure rule will continue to apply in circumstances where, after the operation of the
imported mismatch rule, the amount of deductible interest paid by ECo to CCo is in excess
of the materiality thresholds set by CountryE law.
Disclosure only required where ECo could reasonably be expected to be aware of

the arrangement and cross-border outcome
271. CountryEs mandatory disclosure regime will only apply where ECo could reasonably
have been expected to be aware of the cross-border outcome under the financing arrangement.
A person can reasonably be expected to be aware of an arrangement where the person has
sufficient information about the arrangement to understand its basic design and to appreciate
its overall tax effects. The information that triggers an obligation to disclose will include any
information obtained by ECo through the reasonable enquiries described above.
Disclosure obligation on material advisor and/or taxpayer

272. As for domestic tax schemes, disclosure will be required from ECos material advisors
and/or the taxpayer (ECo) in respect of the recapitalisation
Information required to be disclosed

273. ECo and its advisers should be required to disclose information about the arrangement
and the cross-border outcome (including key provisions of foreign law relevant to that
outcome) and the direct or indirect tax impact of the arrangement and cross-border outcome
on ECos tax position. In the context of an imported mismatch arrangement this will include
the calculation of any adjustment required under the imported mismatch rule.
274. In order to avoid unnecessary compliance costs, a taxpayer should not be required
to duplicate the disclosure of information that is already fully and fairly disclosed under
another domestic reporting obligation. For example, mandatory disclosure rules should
allow a taxpayer to incorporate, by reference, information on advanced pricing agreements
and other tax related rulings that has already been provided or made available to a country
under Action13.
275. In certain cases material information about the arrangement may be held offshore
and may be subject to confidentiality or other restrictions that prevent it from being made
available to the person required to make disclosure. In these cases the person making the
disclosure should certify to the tax administration, as part of the disclosure requirements,
that a request for such information has been made to the appropriate party.
Bibliography
OECD (2015), Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 2015
http://dx.doi.org/10.1787/9789264202719-en.
4. Information sharing 79
Chapter4
Information sharing
80 4. Information sharing
Developments in information exchange

276. The OECD has a long history of fostering greater tax co-operation and exchange
of information between tax administrations. A major breakthrough towards more tax
transparency was accomplished in 2009 with information exchange upon request becoming
the international standard. This was also the year when the restructured Global Forum
on Exchange of Information and Transparency for Tax Purposes started to monitor the
implementation of the standard through in-depth peer reviews. A further step change in
international tax transparency took place in 2014 with the approval of the Standard for
Automatic Exchange of Financial Information in Tax Matters (OECD, 2014).
277. The legal basis for information exchange will be provided by bilateral or multilateral
agreements between jurisdictions, which will generally be based on models such as
Article26 of the OECD Model Tax Convention on Income and on Capital (OECD Model
Tax Convention, OECD, 2010a) and the Agreement on the Exchange of Information on Tax
Matter (OECD, 2002). The Multilateral Convention on Mutual Administrative Assistance
in Tax Matters, Amended by the 2010 Protocol (Multilateral Convention, OECD, 2010b)
provides an independent basis for exchange of information. This Multilateral Convention
provides for all possible forms of administrative co-operation between States and contains
strict rules on confidentiality and proper use of the information. As of 1July 2015
87jurisdictions participate in the Multilateral Convention,1 including all G20 countries.
Transparency and information exchange under the Action Plan

278. The need for improved transparency and information exchange is recognised in the
Action Plan. Globalisation has resulted in a move away from country-specific operating
models towards global business models that involve integrated supply chains and the
centralisation of core functions at a regional or global level. Just as these models give rise to
BEPS risks they also make the job of a local tax administration harder. Countries recognise
that efforts to tax such businesses in the appropriate jurisdictions and on the correct amounts
of income and gains cannot succeed without international co-operation and collaboration.
279. A number of the transparency measures under the Action Plan include requirements
related to information exchange. The transparency framework developed by the Forum
on Harmful Tax Practices in the context of the work on Action5 requires the compulsory
spontaneous exchange of information in respect of rulings that could give rise to BEPS
concerns in the absence of such exchange. The framework sets out a two-step process;in
the first step some basic information on the ruling and to whom it relates would be
provided to another tax authority in accordance with the governing legal instrument; in
the second step the receiving tax authority could ask for further information if this was
foreseeably relevant to the tax affairs of their taxpayer.
280. The guidance on transfer pricing documentation issued under Action13 also requires
Multinational Enterprises (MNEs) to provide tax administrations with high-level global
information on their global business operations and transfer pricing policies. The guidance
sets out a three-tiered standardised approach to transfer pricing documentation. This
standard consists of (1)a master file containing standardised information relevant for all
MNE group members; (2)a local file referring specifically to material transactions of the
local taxpayer; and (3)a country-by-country report containing certain information relating
to the global allocation of the MNE groups income and taxes paid together with certain
indicators of the location of economic activity within the MNE group. Guidance on the
4. Information sharing 81
implementation of transfer pricing documentation and country-by-country reporting is

included in the consolidated report on Action 13 (OECD, 2015).
Expansion and reorganisation of the JITSIC Network under the FTA

281. Given the importance of improved transparency and international co-operation in
combatting BEPS, and building on the progress in the area of information exchange, the
Forum on Tax Administration (FTA) held the first meeting of the newly expanded Joint
International Tax Shelter Information and Collaboration Network (JITSIC Network) in
Paris on 4-5March 2015.
282. The JITSIC Network is an international platform open on a voluntary basis to tax
administrations and provides the opportunity to further enhance relationships to enable
bi-lateral and multi-lateral co-operation and collaboration, based on existing legal instruments.
Members of the JITSIC Network are actively encouraged to spontaneously exchange early
information on emerging tax risks that may be foreseeably relevant to network members. This
could include information obtained under a mandatory disclosure regime. Early exchange
of information is not only important in addressing the revenue risks raised by cross-border
aggressive tax planning but is also seen as a catalyst for closer and increased co-operation and
collaboration.
283. The JITSIC Network offers a number of advantages over the more traditional forms
of bilateral co-operation.
Active commitment to sharing information

284. Membership of the JITSIC Network entails an active commitment to increased
sharing of intelligence, the spontaneous exchange of foreseeably relevant information and
a focus on multi-lateral information exchanges. The JITSIC Network also provides an
opportunity for tax administrations to aggregate the experience, resources and expertise of
a number of different tax administrations to tackle issues of common concern.
Appointment of a SPOC
285. When a country joins the JITSIC Network it appoints a Single Point of Contact (SPOC)
as a primary point of contact for network activities. The SPOC will not necessarily participate
directly in any JITSIC projects but is the person appointed by the tax administration to
manage the tax administrations participation in the Network. Having a SPOC as the main
contact for JITSIC related projects facilitates interactions and the information exchange
process and means that there is at least one person in each tax administration with
responsibility for managing and monitoring the frequency and quality of that countrys
JITSIC interactions.
Establishment of best practices

286. The JITSIC Network provides an opportunity to test what types of information
exchange practices are most effective and to promote these as best practices. Best practices
can be used to enhance the quality of interactions under the Network and reduce the need
for tax administrations to negotiate a framework for engaging with other countries each
time they wish to collaborate on a project.
82 4. Information sharing
Secretariat support
287. The JITSIC Network is supported by the FTA Secretariat. The Secretariat does
not actively participate in network interactions. Its role is to monitor the frequency and
effectiveness of Network interactions and assist with information communication and
capture. Secretariat support for the network includes the maintenance of a secure website
and providing SPOCs with regular reports and updates on network activities. Sharing this
information on a common platform increases the potential for interactions and multilateral
collaboration and allows for information on best practices and emerging tax risks to be
captured and shared with all the network members.
Exchange of information on aggressive tax planning and other BEPS risks

288. The JITSIC Network provides both a reliable platform for exchanging information
obtained through the mandatory disclosure of international tax schemes and a forum for
deeper co-operation and collaboration between tax administrations in respect of emerging
issues that are identified as a consequence of such disclosure and exchange.
289. The JITSIC Network provides tax administrations with an efficient and reliable way
to obtain further information about offshore structures that a tax administration considers
may give rise to BEPS risks, such as those identified in Action2 (Hybrid Mismatch
Arrangements) and Action6 (Treaty Abuse). It also provides opportunities for countries to
collaborate with other JITSIC members to ensure that MNEs are taxed in the appropriate
jurisdictions and on the correct amounts of income and gains.
Note
1.
Jurisdictions Participating In The Convention On Mutual Administrative Assistance In Tax Matters:

www.oecd.org/ctp/exchange-of-tax-information/Status_of_convention.pdf.
Bibliography
Action 13 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project,
OECD (2014), Standard for Automatic Exchange of Financial Information in Tax Matters,
OECD Publishing, http://dx.doi.org/10.1787/9789264216525-en.
OECD (2010a), OECD Model Tax Convention on Income and on Capital, Condensed
version, OECD Publishing, http://dx.doi.org/10.1787/mtc_cond-2010-en.
OECD (2010b), The Multilateral Convention on Mutual Administrative Assistance
in Tax Matters, Amended by the 2010 Protocol, OECD Publishing, http://dx.doi.
org/10.1787/9789264115606-en.
OECD (2002), Agreement on the Exchange of Information on Tax Matters, www.oecd.org/
ctp/harmful/2082215.pdf.
AnnexA. Further discussion on availability in the United Kingdom 83
AnnexA
Further discussion on availability in the United Kingdom
For marketed schemes, disclosure under UK law is required when the promoter makes
a scheme available for implementation.
A scheme is to be regarded as being made available for implementation at the
point when all the elements necessary for implementation of the scheme are in place and
a communication is made to a client suggesting the client might consider entering into
transactions forming part of the scheme. It does not matter whether full details of the
scheme are communicated at that time.
A person makes a scheme available for implementation if and when:
the scheme is fully designed;
it is capable of implementation in practice;
a promoter communicates information about the scheme to potential clients
suggesting that they consider entering into transactions forming part of the scheme.
The design of a scheme will typically consist of a number of elements (e.g.a partnership,
a loan, partners contributions, the purchase of assets, etc.) structured to deliver the expected
tax advantage. The scheme will be capable of implementation in practice only when the
elements of the design have been put into place on the ground. So, for example, if the
design includes a loan, it will be capable of implementation only if and when an actual loan
provider is in place and funds made available.
Under the concept of availability a scheme can be regarded as being made available
for implementation when the promoter communicates what is essentially a fully designed
proposal to a client in sufficient detail that he could be expected to understand the expected
tax advantage and decide whether or not to enter the scheme.
The makes a scheme available for implementation test was intended to trigger
disclosure of a marketed scheme early in the marketing process. However, it became
apparent that some promoters were taking steps to delay having to make a disclosure
under the letter of the law in order to maximise potential avoidance opportunities before
the tax authority was able to react to any disclosure. In the United Kingdom, the UK tax
administration had examples of promoters taking steps to ensure that a disclosure was not
triggered until virtually the point where it was implemented. As a result the application of
the provision in practice was not consistent with the policy objective.
Consequently, the makes a firm approach/marketing contact test was introduced
in the United Kingdom in order to ensure that disclosure of a marketed scheme is triggered
as soon as a promoter takes steps to market the scheme to potential clients, as originally
intended. It is the time when the promoter first makes a marketing contact: this intends to
84 AnnexA. Further discussion on availability in the United Kingdom

ensure that disclosure of a marketed scheme is triggered as soon as a promoter takes steps
to market the scheme to potential clients. This test has to be considered before the makes
a scheme available for implementation test.
AnnexB. Compatibility between self-incrimination and mandatory disclosure 85
AnnexB
Compatibility between self-incrimination and mandatory disclosure
The information that a taxpayer is required to provide under a mandatory disclosure
regime is generally no greater than the information that the tax administration could
require under an investigation or audit into a tax return. Tax avoidance and tax planning
transactions reported under existing mandatory disclosure regimes should not therefore
give rise to any greater concern over self-incrimination than would arise under the exercise
of other information collection powers.
Object and scope

Furthermore for many countries the types of transactions targeted for disclosure
will not generally be the types of transactions that will give rise to criminal liabilities.
Mandatory disclosure regimes are intended to obtain early information about aggressive
(or potentially abusive) tax planning which often takes advantage of loopholes in the law
or uses legal provisions for purposes for which they were not intended. Compared to tax
avoidance, tax fraud (or tax evasion) has a different object and scope. Tax fraud involves
the direct violation of tax law and may feature the deliberate concealment of the true state
of a taxpayers affairs in order to reduce tax liability. The cases of illegal tax fraud vary
among countries but examples include false claims to exemption or deductions, unreported
income, organised failure to withhold taxes, etc. which may result in a criminal charge.
Criminal proceeding
It is also understood that the issue of self-incrimination may arise if tax authorities
require taxpayers to disclose some information about a potentially illegal scheme while
criminal proceedings are pending. In such circumstances, tax authorities may wish to
determine whether criminal proceedings have commenced or are under consideration at
the time information disclosure is required.
However under mandatory disclosure regimes reportable information can be required
to be disclosed prior to the actual implementation of a scheme. Such early reporting can be
considered to be a part of the ordinary information collection activity undertaken for tax
assessment purposes. To the extent that information is required merely for tax assessment
purposes, taxpayers may not be able to invoke the privilege against self-incrimination at
the time that disclosure of a tax avoidance scheme is required.
86 AnnexB. Compatibility between self-incrimination and mandatory disclosure
Disclosure obligations compatibility with the privilege against self-incrimination

Mandatory disclosure should not, in general, infringe upon the privilege against
self-incrimination. However, countries that impose criminal liabilities on taxpayers for
undertaking certain tax avoidance transactions may choose to simply exclude those
transactions from the scope of the disclosure regime without substantially curtailing the
scope of the regime. In addition there should not be an issue with self-incrimination where
a promoter is obliged to disclose instead of a taxpayer except in the circumstances where
the promoter could have criminal liability in relation to the promotion or facilitation of a
scheme.
In addition, if countries are concerned about the existence of some disclosable
transactions which explicitly lead to criminal charges in any particular cases, countries
can also specify that privilege against self-incrimination is a reasonable excuse for not
reporting a disclosable transaction. For instance countries may consider a taxpayer to have
a reasonable excuse for not disclosing a scheme where the scheme can be considered as a
tax fraud subject to criminal charges.
AnnexC. Interaction of penalty regimes and disclosure requirement 87
AnnexC
Interaction of penalty regimes and disclosure requirement
I. United Kingdom
Penalties which may be charged under the DOTAS regime are independent from
penalties which may be charged when taxpayers make a statement on their tax return which
leads to an understatement of tax.
Information about penalties for failing to comply with the DOTAS regime is published
on the UK tax administration website.1
If a scheme falls into one of the categories where the user is obliged to disclose it under
DOTAS rules, the user will be charged a penalty if they fail to disclose it without having
a reasonable excuse. That penalty is entirely independent of whether or not the scheme
works. Similarly, if the user of a DOTAS scheme fails to enter the Scheme Reference
Number on their tax return, they will incur a penalty regardless of whether or not the
scheme works.
Our Compliance Handbook contains information about penalties for inaccuracies,
including inaccuracies in returns.2
Inaccuracy penalties are payable where the persons behaviour is either careless or
deliberate and such penalties are based on the amount of tax understated, known as the
potential lost revenue. It does not automatically follow that a taxpayer will be charged a
penalty if they disclose that they have used an avoidance scheme which is subsequently
found not to work. This is because penalties are not generally appropriate if the inaccuracy
was made on the basis of a reasonably arguable view of the law that is not subsequently
upheld.3
However, if the taxpayer is unable to show that they took reasonable care to ensure
that a disclosed scheme was based on a reasonably arguable view of the law as applied to
the facts of their case they may be charged a penalty. But that penalty is not intrinsically
connected to the fact that they used a disclosed scheme. They would be in exactly the same
position had they used a scheme which was not reportable under DOTAS and they had
failed to exercise reasonable care.
A scheme may also cross the line into tax evasion if it requires a taxpayer to supply
false information. Again, the taxpayer may be charged a penalty or potentially subjected
to criminal action in that situation but that would be because they had taken fraudulent or
dishonest steps to evade tax, not because they had used a reportable scheme.
88 AnnexC. Interaction of penalty regimes and disclosure requirement
II. United States

IRC section6662 imposes a penalty on any underpayment, attributable to negligence
or disregard of rules or regulations, substantial understatement of income tax, valuation
misstatements relating to income tax, transactions lacking economic substance, and
undisclosed foreign financial asset understatements, which may include underpayments
attributable to tax shelters. For tax years ending after October 22, 2004, IRC section6662A
imposes an accuracy-related penalty on reportable transaction understatements. To be
subject to the section6662A penalty, the understatement must be attributable to a listed
transaction (which is one category of reportable transactions) or to any other reportable
transaction if a significant purpose of the other reportable transaction is the avoidance or
evasion of federal income tax. The penalties under sections 6662 and 6662A cannot both be
applied to the same portion of an underpayment (in other words, stacking of section6662
and 6662A penalties is not permitted).
The IRC section6662A penalty is 20% of the reportable transaction understatement
where the reportable transaction was properly disclosed and 30% of the reportable
transaction understatement where the transaction was not properly disclosed.
If taxpayers do not disclose a reportable transaction, they also can lose the ability to argue
that they had reasonable cause for their tax treatment of the transaction (which otherwise
would be one of their defences to having the penalty apply). The IRC section6662A penalty,
unlike the IRC section6662 penalty, may apply even if a taxpayer has a loss for the taxable
year, owes no tax, and has no underpayment.
The IRC section6662A penalty also provides special coordination rules with other
penalties that could arise from the reportable transaction. These rules generally result in
application of only one penalty for the inaccurate reporting of tax.
Separately from penalties on inaccurate returns, IRC section6707A imposes a penalty
on the taxpayer for failure to disclose a reportable transaction. This penalty is not in lieu of
any understatement or underpayment penalty.
Notes
1.
www.hmrc.gov.uk/aiu/dotas-guidance.pdf page 133 onwards (accessed 14June 2015).
2.
www.hmrc.gov.uk/manuals/chmanual/Index.htm (accessed 14June 2015).
3.
www.hmrc.gov.uk/manuals/chmanual/CH81130.htm (accessed 14June 2015).
AnnexD. Information power in the UK DOTAS regime 89
AnnexD
Information power in the UK DOTAS regime
A tax administration may require additional information powers in order to enforce
compliance with a mandatory disclosure regime.
Such additional information powers can allow tax authorities to:
enquire about the reasons why a scheme has not been disclosed;
require supplementary information or documents;
require an introducer to provide information leading to the promoter of a scheme;
request further information on an incomplete disclosure and the end user of an
arrangement.
In order to use many of the powers described above, the UK tax administration must
have reasonable grounds to suspect that a person has been non-compliant in relation to a
particular scheme.
I. Explaining why a scheme has not been disclosed

The UK tax administration can require a person, suspected of being a promoter or
introducer of a reportable scheme, to provide an explanation of why they think that a
scheme is not notifiable.
Introducers are included within this information gathering power because it is not
always obvious whether a person advertising a scheme to potential buyers is a promoter of
that scheme or merely an introducer.
If the person to whom the notice is issued is an introducer, their reply should be that
the scheme is not notifiable by them because they are not the promoter. The explanation
should provide sufficient detail of their role in relation to the scheme to enable the UK tax
administration to confirm that they are not a promoter. The explanation does not strictly
need to identify the promoter in order to satisfy the persons obligation. If details of the
promoter are not provided, then the UK tax administration have further powers to require
disclosure of the person who provided them with information on the scheme as mentioned
below.
If the person is a promoter of the scheme, they must, if required to do so, provide an
explanation of why they consider the scheme is not reportable by them. In doing so it is
insufficient for the reply to simply refer to the fact that a lawyer or other professional has
given an opinion to that effect. Instead the promoter must engage with all the relevant legal
tests.
90 AnnexD. Information power in the UK DOTAS regime

In particular, where the promoter maintains that the arrangements do not fall within
any of the existing hallmarks, the explanation must provide sufficient information for the
UK tax administration to verify whether this is the case.
The information required at this preliminary stage is that which is required to test
whether or not a scheme is reportable, not information that describes how the scheme works.
II. Requiring supplementary information or documents

The UK tax administration may require a person to provide specified information or
documents in support of their stated reasons as to why a scheme is not reportable.
III. Requiring an introducer to provide information leading to the promoter of a scheme

Where the UK tax administration suspect a person of acting as an introducer for a
notifiable scheme which has not been disclosed, it may require them to provide the name
and address of any person who has provided them with information about that scheme.
That person may be the promoter or another intermediary. This formal power will be used
only if the introducer is not willing to identify the promoter voluntarily.
IV. Further information on incomplete disclosures

If the UK tax administration believes that a promoter has not provided all the prescribed
information in relation to a disclosure, they may require the promoter to provide specified
information and/or related documents.
V. Further information on the end user of a proposal or arrangement

If the UK tax administration suspects that a client on a client list is not a user of the
proposal or arrangement but an intermediary, they can require the promoter to provide
further information. The promoter is only required to provide the information it has in its
possession at the time the written notice requiring the further information is received. The
required information is:
the name and address of any person on the client list who is likely to sell the
arrangements to another person or achieve a tax advantage by implementing the
arrangements;
the unique taxpayer reference of that person;
sufficient information to enable an officer of the UK tax administration to understand
the way in which that person is involved in the arrangements.
Promoter or User
Who
Discloses
A promoter is defined as
a person, in the course of
a relevant business, who is
responsible for the design,
marketing, organisation or
management of a scheme
or who makes a scheme
available for implementation
by another person.
User must disclose where

the scheme is devised
in-house, the promoter
is offshore or legal
professional privilege
applies.
Income Tax, Corporation

Tax, Capital Gains Tax,
National Insurance
Contributions, Stamp Duty
Land Tax, Inheritance Tax
(for Trust arrangements),
Annual Tax on Enveloped
Dwellings.
Scope
United Kingdom
In addition, taxpayer is
required to provide detailed
information about the
transaction and its expected
tax benefits on a separate
disclosure statement
attached to the taxpayers
tax return, and the first time
the transaction is disclosed
to OTSA.
A material advisor is
defined as any person
who provides any material
aid, assistance or advice
with respect to organising,
managing, promoting,
selling, implementing,
insuring, or carrying out any
reportable transaction and
who directly or indirectly
derives gross income
in excess of threshold
amounts of USD50000 or
USD250000 (or 10000 or
25000) depending on the
type of taxpayer and type of
reportable transaction.
Material advisor and

Taxpayer
Income tax (individual,

corporate), Estate and Gift
tax, other federal tax
United States
A promoter is defined to
include any person, who,
in the course of a relevant
business, is responsible
for the design, marketing,
organisation or management
of a scheme or who makes
a scheme available for
implementation by another
person.

in-house, the promoter is
located outside Ireland and
there is no promoter in the
State, or legal professional
privilege applies.
The general rule is that the

promoter must disclose the
scheme.
Promoter or User
Income Tax, Corporation

Tax, Capital Gains Tax,
Capital Acquisitions Tax,
Valued Added Tax (VAT),
the Universal Social Charge,
Stamp Duties and Excise
Duties (but not Customs
Duties)
Ireland
A promoter is involved
in designing, structuring,
or implementing any tax
planning scheme.

in-house or the promoter is
outside Portugal.
Promoter or User

corporate), VAT, immovable
property tax, immovable
property transfer tax, stamp
duties
Portugal
A promoter means a
person who (a)promotes
or sells an arrangement
that includes or relates to
a transaction or series of
transactions;(b)makes a
statement or representation
that a tax benefit could
result from an arrangement
in furtherance of the
promoting or selling of the
arrangement, or (c)accepts
consideration in respect
of an arrangement in
paragraph (a) or (b).
An advisor means a
person who provides any
contractual protection in
respect of a transaction or
series of transactions, or
any assistance or advice
with respect to creating,
developing, planning,
organising or implementing
the transaction or series, to
another person.
Promoter (Advisor) and

Taxpayera

corporate)
Canada
Comparison between different countries with mandatory disclosure rules
AnnexE
A promoter is defined as
a person who is principally
responsible for organising,
designing, selling, financing
or managing the reportable
arrangement.
The obligation to disclose

scheme details is imposed
on the promoter. If there
is no promoter then the
taxpayers must disclose the
information.
Promoter or User
Income tax, donations tax,

Capital Gains Tax, VAT
and any other tax under a
tax Act administered by the
Commissioner
South Africa
What is
Disclosed
There are separate

descriptions to capture
Stamp Duty Land Tax and
Inheritance Tax schemes.
Four specific hallmarks

to target known risks
e.g.losses, leasing,
employment income and
Annual tax on Enveloped
Dwellings.
i. confidentiality
ii. premium fee
iii. standardised tax
product;
Three Generic
hallmarks to capture
features indicative of
avoidance
Current Hallmarks
Arrangements falling within

certain descriptions
(known as Hallmarks) which
are expected to provide a
tax advantage as a main
benefit.
United Kingdom
A transaction of interest
is one that is the same
as or substantially similar
to a transaction the IRS
identified in published
guidance as a transaction
of interest. These are
transactions that the
IRS would like additional
information on in order to
determine whether it has a
tax avoidance purpose.
A listed transaction is
a transaction that is the
same or substantially
similar to one that the IRS
has determined to be a
tax avoidance transaction
and has been identified by
notice, regulation, or other
form of published guidance
as a listed transaction.
i. listed transactions
ii. confidential
transactions
iii. transactions with
contractual protection
iv. loss transactions
v. transactions of interest
A reportable transaction
is any transaction that falls
within one of the following
five categories:
United States
A specific class
or classes of tax
advantage to target
known risks e.g.losses,
employment schemes.
i. confidentiality
ii. premium fee
iii. standardised tax
product
Three Generic
hallmarks to capture
features indicative of
avoidance
Current specified
descriptions
Arrangements falling within

one of four classes of
specified descriptions
which are expected to
provide a tax advantage as
a main benefit.
Ireland
Disclosable arrangements
aim at obtaining a tax
advantage solely or as its
main purpose.
i. participant of an entity
subject to specially
favourable tax regime
or tax exempt
ii. financial transactions
giving rising to
reclassification of the
income e.g.leasing,
hybrid instruments
iii. The use of tax losses
Specific hallmarks
One Generic hallmark

Transaction with a clause
of waiving or limiting
liability of promoter
Arrangements falling under

this regime are involved
with :
Portugal
The scope of reportable

transaction has been
broadened. The TS regime
only includes gifting
arrangements and the
acquisition of property.
Under the Canadian Income

Tax Act, an avoidance
transaction is a transaction
that results in a tax
benefit and that cannot
reasonably be considered
to have been undertaken
or arranged primarily for
purposes other than to
obtain the tax benefit.
i. tax-results oriented fee

such as a contingency
fee,
ii. confidential clause,
iii. contractual protection
is an avoidance transaction
that bears at least two of the
following three hallmarks
Canada
Reportable
arrangements with
certain characteristics:
i. the calculation of any
interest, finance costs,
fees or other charges
are wholly or partially
dependent on the tax
benefits derived by the
arrangement;
i. an arrangement that
would have qualified
as a hybrid equity
instrument if the
prescribed period had
been ten years;
ii. an arrangement that
would have qualified
as a hybrid debt
instrument if the
prescribed period had
been ten years; or
iii. )any arrangement that
has been listed in a
public notice
Specifically defined
categories listed by the
Commissioner:
Reportable arrangements
are classified into
two groups namely
specifically defined and
listed categories and
transactions with certain
characteristics which are
expected to provide tax
benefits.
South Africa
92 AnnexE. Comparison between different countries with mandatory disclosure rules
What is
Disclosed
(continued)
United Kingdom
United States
Ireland
Portugal
Canada
ii. the transaction results
in round tripping of
funds, involving an
accommodating or
tax indifferent party
or contains elements
that have the effect of
offsetting/cancelling
each other or has
substantially similar
characteristics;
iii. the transaction gives
rise to an amount
that is:
a. a deduction for
income tax purposes
but not an expense
for purposes of
financial reporting
standards; or
b. revenue for
purposes of financial
reporting standards
but not gross income
for tax purposes.
iv. the transaction
does not result in a
reasonable expectation
of a pre-tax profit for
any participant;
v. the present value of
the tax benefit exceeds
the present value of the
pre-tax profit derived
by the participants
South Africa
Process
Disclosure
of Schemes
Details
on both taxpayers and
material advisors.
United States
Taxpayer must disclose

by attaching a statement
to the taxpayers
return and by filing the
disclosure with OTSA the
first time the taxpayer
discloses.
Material advisor is
required to file a material
advisor disclosure
statement with the IRS
Office of Tax Shelter
Analysis (OTSA) by the
last day of the month that
The UK tax administration
follows the end of the
issues a SRN to the
calendar quarter in which
Promoter;
the advisor became a
Promoter must pass
material advisor;
the SRN to clients who
Material advisor
implement the scheme;
will receive a 9 digit
Promoter provides
reportable transaction
quarterly report to the
number for the disclosed
UK tax administration
reportable transaction;
of clients who have
implemented the scheme. Material advisor must
provide the number to
Clients must report the
all taxpayers to whom
SRN on a return affected
they provide material aid,
by the use of the scheme.
assistance or advice;
Promoter discloses
scheme to the UK tax
administration, usually
within five days of
scheme being made
available to clients;
Users are not, as a

general rule, required
to provide details of the
scheme to the UK tax
administration.
Promoters: required to
disclose the scheme
Users: required to disclose

the scheme by reporting a
Scheme Reference Number
(SRN) on a return.
United Kingdom
Users are required to

report the scheme before
the end of the month
following the month of
implementation if the
disclosure obligation falls
on them. (noted above)
Promoter does not have

any obligation to provide
the tax authorities with
client lists who have
implemented the scheme.
Promoter discloses
scheme to the tax
authorities within 20days
following the end of
the month in which the
scheme was made
available to clients;
disclose the scheme.
Users: Users are not, as

a general rule, required
scheme to the Portuguese
tax authority. However,
they are required to report
the scheme if the scheme
is devised in-house or
the promoters are based
offshore.
Portugal
If the scheme is disclosable by a promoter, then

the promoter must give
that transaction number to
clients.
The Irish Revenue must

No unique identification
notify a unique transaction
number system operates.
number to the person who
disclosed the scheme.
Where the disclosure

obligation falls on the
user, the disclosure must
also be made within five
days from the date of the
first transaction entered
into by the user, which
forms part of the scheme.
Promoter discloses
a transaction within
five days of the point
at which a scheme is
fully designed and a
marketing contact is
made, or within five
days of making the
scheme available for
implementation by
another person.
disclose the scheme. (The
general rule is that the
promoter must disclose the
scheme.)

to provide details of
the scheme to the Irish
Revenue. However, they
may do under certain
circumstances where the
promoter does not (noted
above).
Ireland
Unlike the TS rules, there

is no unique identification
number issued for
schemes.
If more than one person

is required to file a form
in respect of a reportable
transaction, filing of full
and accurate disclosure
by one of the persons in
respect of the transaction
satisfies the obligation of
others.
must be disclosed by
30June of the following
calendar year in which
the transaction became a

scheme details of a
reportable transaction is
imposed on taxpayers,
advisors and promoters.
Canada
Taxpayers must disclose

that they entered into a
reportable transaction
and include the reportable
transaction tax reference
number in their annual tax
return.
SARS issues a reportable

arrangement reference
number.
The reportable
arrangement must be
disclosed within 45days
after an amount has
first been received by or
accrued to a tax payer
or is first paid or actually
incurred by a tax payer.
disclose the scheme.

scheme to SARS. However
they are required to include
the reportable transaction
tax reference number in
their annual tax returns.

on the promoter and the
participants.
South Africa
Process
(continued)
United Kingdom
Clients must include the
transaction number on
their returns.
Ireland
For in house schemes,

disclosure must be made
within 30days from date
of the first transaction
entered into by the user.
The client list must be

provided within a 30day
limit of the promoter
first becoming aware of
any transaction forming
part of the reportable
transaction having been
implemented.
A promoter is obliged
to provide the Irish
Revenue with a list of
all the taxpayers to
Material advisor must also
whom the scheme has
maintain a list identifying
been made available
each person with respect
for implementation.
to whom the advisor
However, Finance Act
acted as a material
2011 modified the original
advisor; and
provisions by removing
the disclosure obligation
The list must be furnished
on promoters where they
to the IRS within 20
are satisfied that the
business days after the
client did not undertake
date of a written request
the transaction at the
by the IRS.
time in question. If at a
later time the transaction
is undertaken, then the
client details must be
disclosed in the normal
way.
Taxpayer must include

the reportable transaction
number(s) in the
disclosure statement if
there is a material advisor
and the material advisor
received the number(s);
United States
Portugal
Canada
South Africa
[penalty regime]
[penalty regime]
The penalty for failure

by a material advisor to
make the required list
available to the IRS within
20 business days after
the date of the written
request of the IRS is
USD10000 for each
day of the failure after
the expiration of the 20th
business day, unless
such failure was due to
reasonable cause.
[penalty regime]
Failure to disclose doesnt

affect the efficacy of
scheme.
Portugal
Initial penalty for non Penalties for nondisclosures of up to

disclosure range
EUR500 per day is
from EUR5000 to
imposed during an initial
EUR100000 for
promoter and from
period and followed
EUR500 to EUR80000
by daily penalties of
EUR500.
for user.
The failure by a promoter
to provide a client list
attracts an initial penalty
of up to EUR4000
followed by daily penalties
of EUR100, if the failure
continues after the
initial penalty has been
imposed.

scheme.
Ireland

scheme.
United States
Material advisor: The

penalty for failure by
a material advisor to
disclose a reportable
Penalties if a user fails
transaction other than a
to report the use of a
listed transaction, or for
scheme on a return are
filing false or incomplete
GBP100 for first failure,
information with respect
GBP500 for second
to such transaction, is
failure; GBP1000 for
USD50000.
subsequent failures (apply
to each scheme to which The penalty imposed on
the failure relates).
a material advisor for
failure to disclose listed
Penalty for failure to
transactions is the greater
provide a client list of up
of USD200000 or 50%
to GBP5000 per client
(increased to 75% in case
omitted.
of an intentional failure
or false or incomplete
filing) of the gross income
derived from providing
aid, assistance, or advice
with respect to the listed
transaction.
Penalties for nondisclosure are up to

GBP1million
[penalty regime]
Enforcement Failure to disclose doesnt

scheme.
United Kingdom
Extension of normal
reassessment period
to no earlier than three
years from date the form
is filed.
Each promoter or advisor

is jointly and severally
liable with the taxpayer
liable only for the amount
of fees that the promoter
or advisor is entitled to
receive.
Each person required

to file is liable to pay a
penalty equal to the total
of all tax-result oriented
fees and contractual
protection fees to which
promoters/advisors are
entitled in respect of a
[penalty regime]
Any tax benefit from a

reportable transaction is
disallowed until properly
disclosed (and applicable
penalties paid), without
having to establish that the
scheme is abusive.
Canada
A monthly penalty
for non-disclosure of
ZAR50000 in the
case of a participant
and ZAR100000 in
the case of a promoter
(up to 12months) is
imposed and the penalty
is doubled if the amount
of anticipated tax benefit
exceeds ZAR5million
and tripled if the
anticipated tax benefit
exceeds ZAR10million.
[penalty regime]
Failure to disclose does

not affect the efficacy of
scheme.
South Africa
Taxpayer: The penalty

for failure by a taxpayer
to disclose a reportable
transaction is 75% of
the decrease in tax as a
result of the transaction,
subject to minimum and
maximum penalties that
range from USD5000 to
USD200000 depending
on the type of taxpayer
and type of reportable
transaction.
United States
Ireland
Portugal
Canada
Note: a. The obligation to disclose has been enhanced: under the tax shelter rules, only promoters are required to report the tax shelter to the CRA.
Enforcement
(continued)
United Kingdom
South Africa

AND DEVELOPMENT

(23 2015 37 1 P) ISBN 978-92-64-24137-4 2015

Contents
Introduction
Chapter 1. Overview of mandatory disclosure
Chapter 2. Options for a model mandatory disclosure rule
Chapter 3. International tax schemes
Chapter 4. Information sharing
Annex A. Further discussion on availability in the United Kingdom
Annex B. Compatibility between self-incrimination and mandatory disclosure
Annex C. Interaction of penalty regimes and disclosure requirements
Annex D. Information powers in the UK DOTAS regime
Annex E. Comparison between different countries with mandatory disclosure rules

isbn 978-92-64-24137-4
23 2015 37 1 P
9HSTCQE*cebdhe+

Project
Transfer Pricing
Documentation and
Country-by-Country
Reporting
Transfer Pricing
Documentation
and CountrybyCountry
Reporting, Action 13
2015 Final Report

OECD (2015), Transfer Pricing Documentation and Country-by-Country Reporting, Action 13 - 2015 Final
http://dx.doi.org/10.1787/9789264241480-en
ISBN 978-92-64-24146-6 (print)

ISBN 978-92-64-24148-0 (PDF)

OECD 2015
Foreword 3
Foreword
TRANSFER PRICING DOCUMENTATION AND COUNTRY-BY-COUNTRY REPORTING OECD 2015
4 Foreword
TABLE OF CONTENTS 5
Table of contents

Executive summary 9
ChapterV of the Transfer Pricing Guidelines on Documentation11
A. Introduction 11
B. Objectives of transfer pricing documentation requirements 12
C. A three-tiered approach to transfer pricing documentation 14
D. Compliance issues 16
E. Implementation 20
AnnexI to ChapterV. Transfer pricing documentation Master file 25
AnnexII to ChapterV. Transfer pricing documentation Local file 27
AnnexIII to ChapterV. Transfer pricing documentation Country-by-Country Report 29
A. Model template for the Country-by-Country Report 29
B. Template for the Country-by-Country Report General instructions31
C. Template for the Country-by-Country Report Specific instructions 33
AnnexIV to ChapterV. Country-by-Country Reporting Implementation Package 37
Introduction 37
Model legislation related to Country-by-Country Reporting 39
Multilateral Competent Authority Agreement on the Exchange of Country-by-Country Reports 45
Competent Authority Agreement on the Exchange of Country-by-Country Reports on the basis of
aDouble Tax Convention (DTC CAA) 59
Competent Authority Agreement on the Exchange of Country-by-Country Reports on the basis of
a Tax Information Exchange Agreement (TIEA CAA) 65
Bibliography 70

APA
Advance pricing agreement
BEPS
CAA
Competent authority agreement
CbC
Country-by-Country
DTC
Double tax convention
FTE
Full-time equivalent
G20
Group of twenty
MAP
MCAA
Multilateral competent authority agreement
MNE
OECD
PE
R&D
SME
Small and medium-sized enterprise
TIEA
Tax information exchange agreement
XML
Extensible markup language
Executive summary 9
Executive summary
This report contains revised standards for transfer pricing documentation and a
template for Country-by-Country Reporting of income, taxes paid and certain measures of
economic activity.
Action13 of the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan,
OECD, 2013) requires the development of rules regarding transfer pricing documentation
to enhance transparency for tax administration, taking into consideration the compliance
costs for business. The rules to be developed will include a requirement that MNEs provide
all relevant governments with needed information on their global allocation of the income,
economic activity and taxes paid among countries according to a common template.
In response to this requirement, a three-tiered standardised approach to transfer pricing
documentation has been developed.
First, the guidance on transfer pricing documentation requires multinational enterprises
(MNEs) to provide tax administrations with high-level information regarding their global
business operations and transfer pricing policies in a master file that is to be available to
all relevant tax administrations.
Second, it requires that detailed transactional transfer pricing documentation be
provided in a local file specific to each country, identifying material related party
transactions, the amounts involved in those transactions, and the companys analysis of the
transfer pricing determinations they have made with regard to those transactions.
Third, large MNEs are required to file a Country-by-Country Report that will provide
annually and for each tax jurisdiction in which they do business the amount of revenue,
profit before income tax and income tax paid and accrued. It also requires MNEs to
report their number of employees, stated capital, retained earnings and tangible assets in
each tax jurisdiction. Finally, it requires MNEs to identify each entity within the group
doing business in a particular tax jurisdiction and to provide an indication of the business
activities each entity engages in.
Taken together, these three documents (master file, local file and Country-by-Country
Report) will require taxpayers to articulate consistent transfer pricing positions and will
provide tax administrations with useful information to assess transfer pricing risks, make
determinations about where audit resources can most effectively be deployed, and, in the
event audits are called for, provide information to commence and target audit enquiries.
This information should make it easier for tax administrations to identify whether
companies have engaged in transfer pricing and other practices that have the effect of
artificially shifting substantial amounts of income into tax-advantaged environments. The
countries participating in the BEPS project agree that these new reporting provisions, and
the transparency they will encourage, will contribute to the objective of understanding,
controlling, and tackling BEPS behaviours.
The specific content of the various documents reflects an effort to balance tax administration
information needs, concerns about inappropriate use of the information, and the compliance
costs and burdens imposed on business. Some countries would strike that balance in a different
way by requiring reporting in the Country-by-Country Report of additional transactional data
(beyond that available in the master file and local file for transactions of entities operating in
their jurisdictions) regarding related party interest payments, royalty payments and especially
related party service fees. Countries expressing this view are primarily those from emerging
markets (Argentina, Brazil, Peoples Republic of China, Colombia, India, Mexico, South Africa,
and Turkey) who state they need such information to perform risk assessment and who find it
challenging to obtain information on the global operations of an MNE group headquartered
elsewhere. Other countries expressed support for the way in which the balance has been struck
in this document. Taking all these views into account, it is mandated that countries participating
in the BEPS project will carefully review the implementation of these new standards and will
reassess no later than the end of 2020 whether modifications to the content of these reports
should be made to require reporting of additional or different data.
Consistent and effective implementation of the transfer pricing documentation
standards and in particular of the Country-by-Country Report is essential. Therefore,
countries participating in the OECD/G20 BEPS Project agreed on the core elements of the
implementation of transfer pricing documentation and Country-by-Country Reporting. This
agreement calls for the master file and the local file to be delivered by MNEs directly to
local tax administrations. Country-by-Country Reports should be filed in the jurisdiction
of tax residence of the ultimate parent entity and shared between jurisdictions through
automatic exchange of information, pursuant to government-to-government mechanisms
such as the multilateral Convention on Mutual Administrative Assistance in Tax Matters,
bilateral tax treaties or tax information exchange agreements (TIEAs). In limited
circumstances, secondary mechanisms, including local filing can be used as a backup.
These new Country-by-Country Reporting requirements are to be implemented for
fiscal years beginning on or after 1 January 2016 and apply, subject to the 2020 review, to
MNEs with annual consolidated group revenue equal to or exceeding EUR750million. It
is acknowledged that some jurisdictions may need time to follow their particular domestic
legislative process in order to make necessary adjustments to the law.
In order to facilitate the implementation of the new reporting standards, an implementation
package has been developed consisting of model legislation which could be used by countries
to require MNE groups to file the Country-by-Country Report and competent authority
agreements that are to be used to facilitate implementation of the exchange of those reports
among tax administrations. As a next step, it is intended that an XML Schema and a related
User Guide will be developed with a view to accommodating the electronic exchange of
Country-by-Country Reports.
It is recognised that the need for more effective dispute resolution may increase as a
result of the enhanced risk assessment capability following the adoption and implementation
of a Country-by-Country Reporting requirement. This need has been addressed when
designing government-to-government mechanisms to be used to facilitate the automatic
exchange of Country-by-Country Reports.
Jurisdictions endeavour to introduce, as necessary, domestic legislation in a timely manner.
They are also encouraged to expand the coverage of their international agreements for exchange
of information. Mechanisms will be developed to monitor jurisdictions compliance with their
commitments and to monitor the effectiveness of the filing and dissemination mechanisms. The
outcomes of this monitoring will be taken into consideration in the 2020 review.
ChapterV of the Transfer Pricing Guidelines on Documentation 11
ChapterV of the Transfer Pricing Guidelines on Documentation

The text of ChapterV of the Transfer Pricing Guidelines is deleted in its entirety and
replaced with the following language and annexes.
A. Introduction
1. This chapter provides guidance for tax administrations to take into account in
developing rules and/or procedures on documentation to be obtained from taxpayers in
connection with a transfer pricing enquiry or risk assessment. It also provides guidance to
assist taxpayers in identifying documentation that would be most helpful in showing that
their transactions satisfy the arms length principle and hence in resolving transfer pricing
issues and facilitating tax examinations.
2. When ChapterV of these Guidelines was adopted in 1995, tax administrations
and taxpayers had less experience in creating and using transfer pricing documentation.
The previous language in ChapterV of the Guidelines put an emphasis on the need for
reasonableness in the documentation process from the perspective of both taxpayers and
tax administrations, as well as on the desire for a greater level of cooperation between
tax administrations and taxpayers in addressing documentation issues in order to avoid
excessive documentation compliance burdens while at the same time providing for
adequate information to apply the arms length principle reliably. The previous language
of ChapterV did not provide for a list of documents to be included in a transfer pricing
documentation package nor did it provide clear guidance with respect to the link between
the process for documenting transfer pricing, the administration of penalties and the burden
of proof.
3. Since then, many countries have adopted transfer pricing documentation rules
and the proliferation of these requirements, combined with a dramatic increase in the
volume and complexity of international intra-group trade and the heightened scrutiny
of transfer pricing issues by tax administrations, has resulted in a significant increase in
compliance costs for taxpayers. Nevertheless tax administrations often find transfer pricing
documentation to be less than fully informative and not adequate for their tax enforcement
and risk assessment needs.
4. The following discussion identifies three objectives of transfer pricing documentation
rules. The discussion also provides guidance for the development of such rules so that
transfer pricing compliance is more straightforward and more consistent among countries,
while at the same time providing tax administrations with more focused and useful
information for transfer pricing risk assessments and audits. An important overarching
consideration in developing such rules is to balance the usefulness of the data to tax
administrations for transfer pricing risk assessment and other purposes with any increased
compliance burdens placed on taxpayers. In this respect it is noted that clear and widely
12 ChapterV of the Transfer Pricing Guidelines on Documentation

adopted documentation rules can reduce compliance costs which could otherwise arise in
a transfer pricing dispute.
B. Objectives of transfer pricing documentation requirements

5.
Three objectives of transfer pricing documentation are:

1. to ensure that taxpayers give appropriate consideration to transfer pricing
requirements in establishing prices and other conditions for transactions between
associated enterprises and in reporting the income derived from such transactions
in their tax returns;
2. to provide tax administrations with the information necessary to conduct an
informed transfer pricing risk assessment; and
3. to provide tax administrations with useful information to employ in conducting
an appropriately thorough audit of the transfer pricing practices of entities subject
to tax in their jurisdiction, although it may be necessary to supplement the
documentation with additional information as the audit progresses.
6. Each of these objectives should be considered in designing appropriate domestic

transfer pricing documentation requirements. It is important that taxpayers be required to
carefully evaluate, at or before the time of filing a tax return, their own compliance with
the applicable transfer pricing rules. It is also important that tax administrations be able to
access the information they need to conduct a transfer pricing risk assessment to make an
informed decision about whether to perform an audit. In addition, it is important that tax
administrations be able to access or demand, on a timely basis, all additional information
necessary to conduct a comprehensive audit once the decision to conduct such an audit is
made.
B.1. Taxpayers assessment of its compliance with the arms length principle
7. By requiring taxpayers to articulate convincing, consistent and cogent transfer
pricing positions, transfer pricing documentation can help to ensure that a culture of
compliance is created. Well-prepared documentation will give tax administrations some
assurance that the taxpayer has analysed the positions it reports on tax returns, has
considered the available comparable data, and has reached consistent transfer pricing
positions. Moreover, contemporaneous documentation requirements will help to ensure the
integrity of the taxpayers positions and restrain taxpayers from developing justifications
for their positions after the fact.
8. This compliance objective may be supported in two important ways. First, tax
administrations can require that transfer pricing documentation requirements be satisfied
on a contemporaneous basis. This would mean that the documentation would be prepared
at the time of the transaction, or in any event, no later than the time of completing and
filing the tax return for the fiscal year in which the transaction takes place. The second
way to encourage compliance is to establish transfer pricing penalty regimes in a manner
intended to reward timely and accurate preparation of transfer pricing documentation
and to create incentives for timely, careful consideration of the taxpayers transfer pricing
positions. Filing requirements and penalty provisions related to documentation are
discussed in greater detail in SectionD, below.
9. While ideally taxpayers will use transfer pricing documentation as an opportunity

to articulate a well thought-out basis for their transfer pricing policies, thereby meeting
an important objective of such requirements, issues such as costs, time constraints, and
competing demands for the attention of relevant personnel can sometimes undermine these
objectives. It is therefore important for countries to keep documentation requirements
reasonable and focused on material transactions in order to ensure mindful attention to the
most important matters.
B.2. Transfer pricing risk assessment

10. Effective risk identification and assessment constitute an essential early stage in
the process of selecting appropriate cases for transfer pricing audits or enquiries and in
focusing such audits on the most important issues. Because tax administrations operate
with limited resources, it is important for them to accurately evaluate, at the very outset
of a possible audit, whether a taxpayers transfer pricing arrangements warrant in-depth
review and a commitment of significant tax enforcement resources. Particularly with
regard to transfer pricing issues (which generally are complex and fact-intensive), effective
risk assessment becomes an essential prerequisite for a focused and resource-efficient
audit. The OECD Handbook on Transfer Pricing Risk Assessment is a useful tool to
consider in conducting such risk assessments.
11. Proper assessment of transfer pricing risk by the tax administration requires access
to sufficient, relevant and reliable information at an early stage. While there are many
sources of relevant information, transfer pricing documentation is one critical source of
such information.
12. There is a variety of tools and sources of information used for identifying and
evaluating transfer pricing risks of taxpayers and transactions, including transfer pricing
forms (to be filed with the annual tax return), transfer pricing mandatory questionnaires
focusing on particular areas of risk, general transfer pricing documentation requirements
identifying the supporting evidence necessary to demonstrate the taxpayers compliance
with the arms length principle, and cooperative discussions between tax administrations
and taxpayers. Each of the tools and sources of information appears to respond to the same
fundamental observation: there is a need for the tax administration to have ready access to
relevant information at an early stage to enable an accurate and informed transfer pricing
risk assessment. Assuring that a high quality transfer pricing risk assessment can be carried
out efficiently and with the right kinds of reliable information should be one important
consideration in designing transfer pricing documentation rules.
B.3. Transfer pricing audit

13. A third objective for transfer pricing documentation is to provide tax administrations
with useful information to employ in conducting a thorough transfer pricing audit. Transfer
pricing audit cases tend to be fact-intensive. They often involve difficult evaluations
of the comparability of several transactions and markets. They can require detailed
consideration of financial, factual and other industry information. The availability of
adequate information from a variety of sources during the audit is critical to facilitating
a tax administrations orderly examination of the taxpayers controlled transactions with
associated enterprises and enforcement of the applicable transfer pricing rules.
14. In situations where a proper transfer pricing risk assessment suggests that a thorough
transfer pricing audit is warranted with regard to one or more issues, it is clearly the case

that the tax administration must have the ability to obtain, within a reasonable period,
all of the relevant documents and information in the taxpayers possession. This includes
information regarding the taxpayers operations and functions, relevant information
on the operations, functions and financial results of associated enterprises with which
the taxpayer has entered into controlled transactions, information regarding potential
comparables, including internal comparables, and documents regarding the operations
and financial results of potentially comparable uncontrolled transactions and unrelated
parties. To the extent such information is included in the transfer pricing documentation,
special information and document production procedures can potentially be avoided.
It must be recognised, however, that it would be unduly burdensome and inefficient
for transfer pricing documentation to attempt to anticipate all of the information that
might possibly be required for a full audit. Accordingly, situations will inevitably arise
when tax administrations wish to obtain information not included in the documentation
package. Thus, a tax administrations access to information should not be limited to, or
by, the documentation package relied on in a transfer pricing risk assessment. Where a
jurisdiction requires particular information to be kept for transfer pricing audit purposes,
such requirements should balance the tax administrations need for information and the
compliance burdens on taxpayers.
15. It may often be the case that the documents and other information required for a
transfer pricing audit will be in the possession of members of the MNE group other than
the local affiliate under examination. Often the necessary documents will be located
outside the country whose tax administration is conducting the audit. It is therefore
important that the tax administration is able to obtain directly or through information
sharing, such as exchange of information mechanisms, information that extends beyond
the countrys borders.
C. A three-tiered approach to transfer pricing documentation

16. In order to achieve the objectives described in SectionB, countries should adopt a
standardised approach to transfer pricing documentation. This section describes a threetiered structure consisting of (i)a master file containing standardised information relevant
for all MNE group members; (ii)a local file referring specifically to material transactions
of the local taxpayer; and (iii)a Country-by-Country Report containing certain information
relating to the global allocation of the MNEs income and taxes paid together with certain
indicators of the location of economic activity within the MNE group.
17. This approach to transfer pricing documentation will provide tax administrations
with relevant and reliable information to perform an efficient and robust transfer pricing
risk assessment analysis. It will also provide a platform on which the information necessary
for an audit can be developed and provide taxpayers with a means and an incentive to
meaningfully consider and describe their compliance with the arms length principle in
material transactions.
C.1. Master file

18. The master file should provide an overview of the MNE group business, including
the nature of its global business operations, its overall transfer pricing policies, and its
global allocation of income and economic activity in order to assist tax administrations
in evaluating the presence of significant transfer pricing risk. In general, the master file
is intended to provide a high-level overview in order to place the MNE groups transfer
pricing practices in their global economic, legal, financial and tax context. It is not intended
to require exhaustive listings of minutiae (e.g.a listing of every patent owned by members
of the MNE group) as this would be both unnecessarily burdensome and inconsistent with
the objectives of the master file. In producing the master file, including lists of important
agreements, intangibles and transactions, taxpayers should use prudent business judgment
in determining the appropriate level of detail for the information supplied, keeping in
mind the objective of the master file to provide tax administrations a high-level overview
of the MNEs global operations and policies. When the requirements of the master file
can be fully satisfied by specific cross-references to other existing documents, such crossreferences, together with copies of the relevant documents, should be deemed to satisfy the
relevant requirement. For purposes of producing the master file, information is considered
important if its omission would affect the reliability of the transfer pricing outcomes.
19. The information required in the master file provides a blueprint of the MNE group
and contains relevant information that can be grouped in five categories: a) the MNE
groups organisational structure; b) a description of the MNEs business or businesses; c)
the MNEs intangibles; d) the MNEs intercompany financial activities; and (e) the MNEs
financial and tax positions.
20. Taxpayers should present the information in the master file for the MNE as a whole.
However, organisation of the information presented by line of business is permitted where
well justified by the facts, e.g.where the structure of the MNE group is such that some
significant business lines operate largely independently or are recently acquired. Where
line of business presentation is used, care should be taken to assure that centralised group
functions and transactions between business lines are properly described in the master file.
Even where line of business presentation is selected, the entire master file consisting of all
business lines should be available to each country in order to assure that an appropriate
overview of the MNE groups global business is provided.
21. AnnexI to ChapterV of these Guidelines sets out the information to be included in
the master file.
C.2. Local file

22. In contrast to the master file, which provides a high-level overview as described
in paragraph18, the local file provides more detailed information relating to specific
intercompany transactions. The information required in the local file supplements the
master file and helps to meet the objective of assuring that the taxpayer has complied with
the arms length principle in its material transfer pricing positions affecting a specific
jurisdiction. The local file focuses on information relevant to the transfer pricing analysis
related to transactions taking place between a local country affiliate and associated
enterprises in different countries and which are material in the context of the local
countrys tax system. Such information would include relevant financial information
regarding those specific transactions, a comparability analysis, and the selection and
application of the most appropriate transfer pricing method. Where a requirement of the
local file can be fully satisfied by a specific cross-reference to information contained in the
master file, such a cross-reference should suffice.
23. AnnexII to ChapterV of these Guidelines sets out the items of information to be
included in the local file.
C.3. Country-by-Country Report

24. The Country-by-Country Report requires aggregate tax jurisdiction-wide information
relating to the global allocation of the income, the taxes paid, and certain indicators of the
location of economic activity among tax jurisdictions in which the MNE group operates.
The report also requires a listing of all the Constituent Entities for which financial
information is reported, including the tax jurisdiction of incorporation, where different
from the tax jurisdiction of residence, as well as the nature of the main business activities
carried out by that Constituent Entity.
25. The Country-by-Country Report will be helpful for high-level transfer pricing risk
assessment purposes. It may also be used by tax administrations in evaluating other BEPS
related risks and where appropriate for economic and statistical analysis. However, the
information in the Country-by-Country Report should not be used as a substitute for a
detailed transfer pricing analysis of individual transactions and prices based on a full
functional analysis and a full comparability analysis. The information in the Country-byCountry Report on its own does not constitute conclusive evidence that transfer prices
are or are not appropriate. It should not be used by tax administrations to propose transfer
pricing adjustments based on a global formulary apportionment of income.
26. AnnexIII to ChapterV of these Guidelines contains a model template for the
Country-by-Country Report together with its accompanying instructions.
D. Compliance issues
D.1. Contemporaneous documentation
27. Each taxpayer should endeavour to determine transfer prices for tax purposes in
accordance with the arms length principle, based upon information reasonably available
at the time of the transaction. Thus, a taxpayer ordinarily should give consideration to
whether its transfer pricing is appropriate for tax purposes before the pricing is established
and should confirm the arms length nature of its financial results at the time of filing its
tax return.
28. Taxpayers should not be expected to incur disproportionately high costs and burdens
in producing documentation. Therefore, tax administrations should balance requests for
documentation against the expected cost and administrative burden to the taxpayer of
creating it. Where a taxpayer reasonably demonstrates, having regard to the principles
of these Guidelines, that either no comparable data exists or that the cost of locating the
comparable data would be disproportionately high relative to the amounts at issue, the
taxpayer should not be required to incur costs in searching for such data.
D.2. Time frame

29. Practices regarding the timing of the preparation of the documentation differ among
countries. Some countries require information to be finalised by the time the tax return is
filed. Others require documentation to be in place by the time the audit commences. There
is also a variety in practice regarding the amount of time given to taxpayers to respond to
specific tax administration requests for documentation and other audit related information
requests. These differences in the time requirements for providing information can add to
taxpayers difficulties in setting priorities and in providing the right information to the tax
administrations at the right time.
30. The best practice is to require that the local file be finalised no later than the due
date for the filing of the tax return for the fiscal year in question. The master file should
be reviewed and, if necessary, updated by the tax return due date for the ultimate parent of
the MNE group. In countries pursuing policies of auditing transactions as they occur under
co-operative compliance programmes, it may be necessary for certain information to be
provided in advance of the filing of the tax return.
31. With regard to the Country-by-Country Report, it is recognised that in some instances
final statutory financial statements and other financial information that may be relevant
for the country-by-country data described in AnnexIII may not be finalised until after
the due date for tax returns in some countries for a given fiscal year. Under the given
circumstances, the date for completion of the Country-by-Country Report described in
AnnexIII to ChapterV of these Guidelines may be extended to one year following the last
day of the fiscal year of the ultimate parent of the MNE group.
D.3. Materiality
32. Not all transactions that occur between associated enterprises are sufficiently
material to require full documentation in the local file. Tax administrations have an interest
in seeing the most important information while at the same time they also have an interest
in seeing that MNEs are not so overwhelmed with compliance demands that they fail to
consider and document the most important items. Thus, individual country transfer pricing
documentation requirements based on AnnexII to ChapterV of these Guidelines should
include specific materiality thresholds that take into account the size and the nature of
the local economy, the importance of the MNE group in that economy, and the size and
nature of local operating entities, in addition to the overall size and nature of the MNE
group. Measures of materiality may be considered in relative terms (e.g.transactions not
exceeding a percentage of revenue or a percentage of cost measure) or in absolute amount
terms (e.g.transactions not exceeding a certain fixed amount). Individual countries should
establish their own materiality standards for local file purposes, based on local conditions.
The materiality standards should be objective standards that are commonly understood and
accepted in commercial practice. See paragraph18 for the materiality standards applicable
in completing the master file.
33. A number of countries have introduced in their transfer pricing documentation
rules simplification measures which exempt small and medium-sized enterprises (SMEs)
from transfer pricing documentation requirements or limit the information required to
be provided by such enterprises. In order not to impose on taxpayers costs and burdens
disproportionate to the circumstances, it is recommended to not require SMEs to produce
the amount of documentation that might be expected from larger enterprises. However,
SMEs should be obliged to provide information and documents about their material crossborder transactions upon a specific request of the tax administration in the course of a tax
examination or for transfer pricing risk assessment purposes.
34. For purposes of AnnexIII to ChapterV of these Guidelines, the Country-by-Country
Report should include all tax jurisdictions in which the MNE group has an entity resident
for tax purposes, regardless of the size of business operations in that tax jurisdiction.
D.4. Retention of documents

35. Taxpayers should not be obliged to retain documents beyond a reasonable period
consistent with the requirements of domestic law at either the parent company or local
entity level. However, at times materials and information required in the documentation
package (master file, local file and Country-by-Country Report) may be relevant to a
transfer pricing enquiry for a subsequent year that is not time barred, for example where
taxpayers voluntarily keep such records in relation to long-term contracts, or to determine
whether comparability standards relating to the application of a transfer pricing method in
that subsequent year are satisfied. Tax administrations should bear in mind the difficulties
in locating documents for prior years and should restrict such requests to instances where
they have good reason in connection with the transaction under examination for reviewing
the documents in question.
36. Because the tax administrations ultimate interest would be satisfied if the necessary
documents were submitted in a timely manner when requested by the tax administration
in the course of an examination, the way that documentation is stored whether
in paper, electronic form, or in any other system should be at the discretion of the
taxpayer provided that relevant information can promptly be made available to the tax
administration in the form specified by the local country rules and practices.
D.5. Frequency of documentation updates

37. It is recommended that transfer pricing documentation be periodically reviewed
in order to determine whether functional and economic analyses are still accurate and
relevant and to confirm the validity of the applied transfer pricing methodology. In general,
the master file, the local file and the Country-by-Country Report should be reviewed and
updated annually. It is recognised, however, that in many situations business descriptions,
functional analyses, and descriptions of comparables may not change significantly from
year to year.
38. In order to simplify compliance burdens on taxpayers, tax administrations may
determine, as long as the operating conditions remain unchanged, that the searches in
databases for comparables supporting part of the local file be updated every three years
rather than annually. Financial data for the comparables should nonetheless be updated
every year in order to apply the arms length principle reliably.
D.6. Language
39. The necessity of providing documentation in local language may constitute a
complicating factor with respect to transfer pricing compliance to the extent that substantial
time and cost may be involved in translating documents. The language in which transfer
pricing documentation should be submitted should be established under local laws.
Countries are encouraged to permit filing of transfer pricing documentation in commonly
used languages where it will not compromise the usefulness of the documents. Where
tax administrations believe that translation of documents is necessary, they should make
specific requests for translation and provide sufficient time to make such translation as
comfortable a burden as possible.
D.7. Penalties
40. Many countries have adopted documentation-related penalties to ensure efficient
operation of transfer pricing documentation requirements. They are designed to make
non-compliance more costly than compliance. Penalty regimes are governed by the laws of
each individual country. Country practices with regard to transfer pricing documentationrelated penalties vary widely. The existence of different local country penalty regimes may
influence the quality of taxpayers compliance so that taxpayers could be driven to favour
one country over another in their compliance practices.
41. Documentation-related penalties imposed for failure to comply with transfer pricing
documentation requirements or failure to timely submit required information are usually
civil (or administrative) monetary penalties. These documentation-related penalties are
based on a fixed amount that may be assessed for each document missing or for each
fiscal year under review, or calculated as a percentage of the related tax understatement
ultimately determined, a percentage of the related adjustment to the income, or as a
percentage of the amount of the cross-border transactions not documented.
42. Care should be taken not to impose a documentation-related penalty on a taxpayer for
failing to submit data to which the MNE group did not have access. However, a decision
not to impose documentation-related penalties does not mean that adjustments cannot
be made to income where prices are not consistent with the arms length principle. The
fact that positions are fully documented does not necessarily mean that the taxpayers
positions are correct. Moreover, an assertion by a local entity that other group members are
responsible for transfer pricing compliance is not a sufficient reason for that entity to fail
to provide required documentation, nor should such an assertion prevent the imposition of
documentation-related penalties for failure to comply with documentation rules where the
necessary information is not forthcoming.
43. Another way for countries to encourage taxpayers to fulfil transfer pricing
documentation requirements is by designing compliance incentives such as penalty
protection or a shift in the burden of proof. Where the documentation meets the
requirements and is timely submitted, the taxpayer could be exempted from tax penalties
or subject to a lower penalty rate if a transfer pricing adjustment is made and sustained,
notwithstanding the provision of documentation. In some jurisdictions where the taxpayer
bears the burden of proof regarding transfer pricing matters, a shift of the burden of proof
to the tax administrations side where adequate documentation is provided on a timely
basis offers another measure that could be used to create an incentive for transfer pricing
documentation compliance.
D.8. Confidentiality
44. Tax administrations should take all reasonable steps to ensure that there is no public
disclosure of confidential information (trade secrets, scientific secrets, etc.) and other
commercially sensitive information contained in the documentation package (master
file, local file and Country-by-Country Report). Tax administrations should also assure
taxpayers that the information presented in transfer pricing documentation will remain
confidential. In cases where disclosure is required in public court proceedings or judicial
decisions, every effort should be made to ensure that confidentiality is maintained and that
information is disclosed only to the extent needed.
45. The OECD Guide (2012) Keeping It Safe on the protection of confidentiality of
information exchanged for tax purposes provides guidance on the rules and practices that

must be in place to ensure the confidentiality of tax information exchanged under exchange
of information instruments.
D.9. Other issues

46. The requirement to use the most reliable information will usually, but not always,
require the use of local comparables over the use of regional comparables where such
local comparables are reasonably available. The use of regional comparables in transfer
pricing documentation prepared for countries in the same geographic region in situations
where appropriate local comparables are available will not, in some cases, comport with
the obligation to rely on the most reliable information. While the simplification benefits
of limiting the number of comparable searches a company is required to undertake are
obvious, and materiality and compliance costs are relevant factors to consider, a desire for
simplifying compliance processes should not go so far as to undermine compliance with
the requirement to use the most reliable available information. See paragraphs1.57-1.58 on
market differences and multi-country analyses for further detail of when local comparables
are to be preferred.
47. It is not recommended, particularly at the stage of transfer pricing risk assessment, to
require that the transfer pricing documentation should be certified by an outside auditor or
other third party. Similarly, mandatory use of consulting firms to prepare transfer pricing
documentation is not recommended.
E. Implementation
48. It is essential that the guidance in this chapter, and in particular the Countryby-Country Report, be implemented effectively and consistently. Therefore, countries
participating in the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project have
developed the following guidance on implementation of transfer pricing documentation
and Country-by-Country Reporting.
E.1. Master file and Local file

49. It is recommended that the master file and local file elements of the transfer
pricing documentation standard be implemented through local country legislation or
administrative procedures and that the master file and local file be filed directly with the
tax administrations in each relevant jurisdiction as required by those administrations.
Countries participating in the OECD/G20 BEPS Project agree that with regard to the local
file and the master file confidentiality and consistent use of the standards contained in
AnnexI and AnnexII of ChapterV of these Guidelines should be taken into account when
introducing these elements in local country legislation or administrative procedures.
E.2. Country-by-Country Report

E.2.1. Timing: When should the Country-by-Country Reporting requirement start?
50. It is recommended that the first Country-by-Country Reports be required to be filed
for MNE fiscal years beginning on or after 1 January 2016. However, it is acknowledged
that some jurisdictions may need time to follow their particular domestic legislative
process in order to make necessary adjustments to the law. In order to assist countries in
preparing timely legislation, model legislation requiring ultimate parent entities of MNE
groups to file the Country-by-Country Report in their jurisdiction of residence has been
developed (see AnnexIV to ChapterV of these Guidelines). Jurisdictions will be able
to adapt this model legislation to their own legal systems. Given the recommendation in
paragraph31 that MNEs be allowed one year from the close of the fiscal year to which
the Country-by-Country Report relates to prepare and file the Country-by-Country
Report, this recommendation means that the first Country-by-Country Reports would
be filed by 31 December 2017. For MNEs with a fiscal year ending on a date other than
31 December, the first Country-by-Country Reports would be required to be filed later
in 2018, twelve months after the close of the relevant MNE fiscal year, and would report
on the MNE groups first fiscal year beginning after 1 January 2016. It follows from this
recommendation that the countries participating in the OECD/G20 BEPS Project agree that
they will not require filing of a Country-by-Country Report based on the new template for
MNE fiscal years beginning prior to 1 January 2016. The MNE fiscal year relates to the
consolidated reporting period for financial statement purposes and not to taxable years or
to the financial reporting periods of individual subsidiaries.
E.2.2. Which MNE groups should be required to file the Country-by-Country

Report?
51. It is recommended that all MNE groups be required to file the Country-by-Country
Report each year except as follows.
52. There would be an exemption from the general filing requirement for MNE groups
with annual consolidated group revenue in the immediately preceding fiscal year of less
than EUR750million or a near equivalent amount in domestic currency as of January
2015. Thus, for example, if an MNE that keeps its financial accounts on a calendar year
basis has EUR625million in consolidated group revenue for its 2015 calendar year, it
would not be required to file the Country-by-Country Report in any country with respect
to its fiscal year ending 31 December 2016.
53. It is believed that the exemption described in paragraph52, which provides a
threshold of EUR750million, will exclude approximately 85 to 90 percent of MNE groups
from the requirement to file the Country-by-Country Report, but that the Country-byCountry Report will nevertheless be filed by MNE groups controlling approximately 90
percent of corporate revenues. The prescribed exemption threshold therefore represents an
appropriate balancing of reporting burden and benefit to tax administrations.
54. It is the intention of the countries participating in the OECD/G20 BEPS Project
to reconsider the appropriateness of the applicable revenue threshold described in the
preceding paragraph in connection with their 2020 review of implementation of the new
standard, including whether additional or different data should be reported.
55. It is considered that no exemptions from filing the Country-by-Country Report
should be adopted apart from the exemptions outlined in this section. In particular, no
special industry exemptions should be provided, no general exemption for investment funds
should be provided, and no exemption for non-corporate entities or non-public corporate
entities should be provided. Notwithstanding this conclusion, countries participating in the
OECD/G20 BEPS Project agree that MNE groups with income derived from international
transportation or transportation in inland waterways that is covered by treaty provisions
that are specific to such income and under which the taxing rights on such income are
allocated exclusively to one jurisdiction, should include the information required by the
country-by-country template with respect to such income only against the name of the
jurisdiction to which the relevant treaty provisions allocate these taxing rights.
E.2.3. Necessary conditions underpinning the obtaining and the use of the
Country-by-Country Report
56. Countries participating in the OECD/G20 BEPS Project agree to the following
conditions underpinning the obtaining and the use of the Country-by-Country Report.
Confidentiality
57. Jurisdictions should have in place and enforce legal protections of the confidentiality
of the reported information. Such protections would preserve the confidentiality of
the Country-by-Country Report to an extent at least equivalent to the protections that
would apply if such information were delivered to the country under the provisions of
the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, a Tax
Information Exchange Agreement (TIEA) or a tax treaty that meets the internationally
agreed standard of information upon request as reviewed by the Global Forum on
Transparency and Exchange of Information for Tax Purposes. Such protections include
limitation of the use of information, rules on the persons to whom the information may be
disclosed, ordre public, etc.
Consistency
58. Jurisdictions should use their best efforts to adopt a legal requirement that MNE
groups ultimate parent entities resident in their jurisdiction prepare and file the Countryby-Country Report, unless exempted as set out in paragraph52. Jurisdictions should utilise
the standard template contained in AnnexIII of ChapterV of these Guidelines. Stated
otherwise, under this condition no jurisdiction will require that the Country-by-Country
Report contain either additional information not contained in AnnexIII, nor will it fail to
require reporting of information included in AnnexIII.
Appropriate Use
59. Jurisdictions should use appropriately the information in the Country-by-Country
Report template in accordance with paragraph25. In particular, jurisdictions will commit
to use the Country-by-Country Report for assessing high-level transfer pricing risk.
Jurisdictions may also use the Country-by-Country Report for assessing other BEPSrelated risks. Jurisdictions should not propose adjustments to the income of any taxpayer on
the basis of an income allocation formula based on the data from the Country-by-Country
Report. They will further commit that if such adjustments based on Country-by-Country
Report data are made by the local tax administration of the jurisdiction, the jurisdictions
competent authority will promptly concede the adjustment in any relevant competent
authority proceeding. This does not imply, however, that jurisdictions would be prevented
from using the Country-by-Country Report data as a basis for making further enquiries
into the MNEs transfer pricing arrangements or into other tax matters in the course of a
tax audit.1
E.2.4. The framework for government-to-government mechanisms to exchange

Country-by-Country Reports and implementation package
E.2.4.1. Framework
60. Jurisdictions should require in a timely manner Country-by-Country Reporting
from ultimate parent entities of MNE groups resident in their country and referred to in
SectionE.2.2 and exchange this information on an automatic basis with the jurisdictions
in which the MNE group operates and which fulfil the conditions listed in SectionE.2.3.
In case a jurisdiction fails to provide information to a jurisdiction fulfilling the conditions
listed in SectionE.2.3, because (a)it has not required Country-by-Country Reporting from
the ultimate parent entity of such MNE groups, (b)no competent authority agreement
has been agreed in a timely manner under the current international agreements of the
jurisdiction for the exchange of the Country-by-Country Reports or (c)it has been
established that there is a failure to exchange the information in practice with a jurisdiction
after agreeing with that jurisdiction to do so, a secondary mechanism would be accepted
as appropriate, through local filing or through filing of the Country-by-Country Reports
by a designated member of the MNE group acting in place of the ultimate parent entity and
automatic exchange of these reports by its country of tax residence.
E.2.4.2. Implementation Package

61. Countries participating in the OECD/G20 BEPS Project have therefore developed an
implementation package for government-to-government exchange of Country-by-Country
Reports contained in AnnexIV to ChapterV of these Guidelines.
More specifically:
Model legislation requiring the ultimate parent entity of an MNE group to file the
Country-by-Country Report in its jurisdiction of residence has been developed.
Jurisdictions will be able to adapt this model legislation to their own legal systems,
where changes to current legislation are required. Key elements of secondary
mechanisms have also been developed.
Implementing arrangements for the automatic exchange of the Country-by-Country
Reports under international agreements have been developed, incorporating the
conditions set out in SectionE.2.3. Such implementing arrangements include
competent authority agreements (CAAs) based on existing international
agreements (the Multilateral Convention on Mutual Administrative Assistance in
Tax Matters, bilateral tax treaties and TIEAs) and inspired by the existing models
developed by the OECD working with G20 countries for the automatic exchange of
financial account information.
62. Participating jurisdictions endeavour to introduce as necessary domestic legislation
in a timely manner. They are also encouraged to expand the coverage of their international
agreements for exchange of information. The implementation of the package will be
monitored on an ongoing basis. The outcomes of this monitoring will be taken into
consideration in the 2020 review.
Note
1.
Access to a mutual agreement procedure (MAP) will be available when the government-togovernment exchange of the Country-by-Country Reports is based on bilateral treaties. In
cases where the international agreements on which the government-to-government exchanges
of the Country-by-Country Reports are based do not contain provisions providing access to
MAP, countries commit to introducing in the competent authority agreement to be developed
a mechanism for competent authority procedures to discuss with the aim of resolving cases of
undesirable economic outcomes, including if such cases arise for individual businesses.
AnnexI to ChapterV. Transfer pricing documentation Master file 25
AnnexI to ChapterV
Transfer pricing documentation Master file
The following information should be included in the master file:
Organisational structure
Chart illustrating the MNEs legal and ownership structure and geographical
location of operating entities.
Description of MNEs business(es)

General written description of the MNEs business including:
- Important drivers of business profit;
- A description of the supply chain for the groups five largest products and/
or service offerings by turnover plus any other products and/or services
amounting to more than 5 percent of group turnover. The required description
could take the form of a chart or a diagram;
- A list and brief description of important service arrangements between
members of the MNE group, other than research and development (R&D)
services, including a description of the capabilities of the principal locations
providing important services and transfer pricing policies for allocating
services costs and determining prices to be paid for intra-group services;
- A description of the main geographic markets for the groups products and
services that are referred to in the second bullet point above;
- A brief written functional analysis describing the principal contributions
to value creation by individual entities within the group, i.e.key functions
performed, important risks assumed, and important assets used;
- A description of important business restructuring transactions, acquisitions and
divestitures occurring during the fiscal year.
MNEs intangibles (as defined in ChapterVI of these Guidelines)

A general description of the MNEs overall strategy for the development,
ownership and exploitation of intangibles, including location of principal R&D
facilities and location of R&D management.
26 AnnexI to ChapterV. Transfer pricing documentation Master file
A list of intangibles or groups of intangibles of the MNE group that are important
for transfer pricing purposes and which entities legally own them.
A list of important agreements among identified associated enterprises related to
intangibles, including cost contribution arrangements, principal research service
agreements and licence agreements.
A general description of the groups transfer pricing policies related to R&D and
intangibles.
A general description of any important transfers of interests in intangibles among
associated enterprises during the fiscal year concerned, including the entities,
countries, and compensation involved.
MNEs intercompany financial activities

A general description of how the group is financed, including important financing
arrangements with unrelated lenders.
The identification of any members of the MNE group that provide a central
financing function for the group, including the country under whose laws the entity
is organised and the place of effective management of such entities.
A general description of the MNEs general transfer pricing policies related to
financing arrangements between associated enterprises.
MNEs financial and tax positions

The MNEs annual consolidated financial statement for the fiscal year concerned
if otherwise prepared for financial reporting, regulatory, internal management, tax
or other purposes.
A list and brief description of the MNE groups existing unilateral advance pricing
agreements (APAs) and other tax rulings relating to the allocation of income among
countries.
AnnexII to ChapterV. Transfer pricing documentation Local file 27
AnnexII to ChapterV
Transfer pricing documentation Local file
The following information should be included in the local file:
Local entity
A description of the management structure of the local entity, a local organisation
chart, and a description of the individuals to whom local management reports and
the country(ies) in which such individuals maintain their principal offices.
A detailed description of the business and business strategy pursued by the local
entity including an indication whether the local entity has been involved in or
affected by business restructurings or intangibles transfers in the present or
immediately past year and an explanation of those aspects of such transactions
affecting the local entity.
Key competitors.
Controlled transactions
For each material category of controlled transactions in which the entity is involved,
provide the following information:
A description of the material controlled transactions (e.g.procurement of
manufacturing services, purchase of goods, provision of services, loans, financial
and performance guarantees, licences of intangibles, etc.) and the context in which
such transactions take place.
The amount of intra-group payments and receipts for each category of controlled
transactions involving the local entity (i.e.payments and receipts for products,
services, royalties, interest, etc.) broken down by tax jurisdiction of the foreign
payor or recipient.
An identification of associated enterprises involved in each category of controlled
transactions, and the relationship amongst them.
Copies of all material intercompany agreements concluded by the local entity.
A detailed comparability and functional analysis of the taxpayer and relevant
associated enterprises with respect to each documented category of controlled
transactions, including any changes compared to prior years.1
An indication of the most appropriate transfer pricing method with regard to the
category of transaction and the reasons for selecting that method.
28 AnnexII to ChapterV. Transfer pricing documentation Local file
An indication of which associated enterprise is selected as the tested party, if

applicable, and an explanation of the reasons for this selection.
A summary of the important assumptions made in applying the transfer pricing
methodology.
If relevant, an explanation of the reasons for performing a multi-year analysis.
A list and description of selected comparable uncontrolled transactions (internal or
external), if any, and information on relevant financial indicators for independent
enterprises relied on in the transfer pricing analysis, including a description of the
comparable search methodology and the source of such information.
A description of any comparability adjustments performed, and an indication
of whether adjustments have been made to the results of the tested party, the
comparable uncontrolled transactions, or both.
A description of the reasons for concluding that relevant transactions were priced
on an arms length basis based on the application of the selected transfer pricing
method.
A summary of financial information used in applying the transfer pricing methodology.
A copy of existing unilateral and bilateral/multilateral APAs and other tax rulings
to which the local tax jurisdiction is not a party and which are related to controlled
transactions described above.
Financial information
Annual local entity financial accounts for the fiscal year concerned. If audited
statements exist they should be supplied and if not, existing unaudited statements
should be supplied.
Information and allocation schedules showing how the financial data used in
applying the transfer pricing method may be tied to the annual financial statements.
Summary schedules of relevant financial data for comparables used in the analysis
and the sources from which that data was obtained.
Note
1.
To the extent this functional analysis duplicates information in the master file, a crossreference to the master file is sufficient.
Tax Jurisdiction
Unrelated Party
Related Party
Revenues
Total
Profit (Loss)
before
IncomeTax
Income Tax
Paid (on Cash
Basis)
Income Tax
Accrued
Current Year
Name of the MNE group:

Fiscal year concerned:
Currency used:
Stated Capital
Accumulated
Earnings
Table1. Overview of allocation of income, taxes and business activities by tax jurisdiction
A. Model template for the Country-by-Country Report
Transfer pricing documentation Country-by-Country Report
AnnexIII to ChapterV
Number of
Employees
Tangible Assets other

than Cash and Cash
Equivalents
3.
2.
1.
3.
2.
1.
Tax Jurisdiction
of Organisation or
Incorporation if Different
from Tax Jurisdiction of
Residence
Administrative, Management
or Support Services
Sales, Marketing or
Distribution
Manufacturing or Production
Purchasing or Procurement
Holding or Managing
Intellectual Property
Other1
Dormant
Holding Shares or Other

Equity instruments
Regulated Financial
Services
Please include any further brief information or explanation you consider necessary or that would facilitate the understanding of the compulsory information provided in the Country-by-Country Report.

Table3. Additional Information
1. Please specify the nature of the activity of the Constituent Entity in the Additional Information section.
Tax Jurisdiction
Constituent Entities
Resident in the Tax
Jurisdiction
Provision of Services to
Unrelated Parties
Main Business Activity(ies)
Internal Group Finance

Insurance
Table2. List of all the Constituent Entities of the MNE group included in each aggregation per tax jurisdiction
30 AnnexIII to ChapterV. Transfer pricing documentation Country-by-Country Report
B. Template for the Country-by-Country Report General instructions

Purpose
This AnnexIII to ChapterV of these Guidelines contains a template for reporting a
multinational enterprises (MNE) group allocation of income, taxes and business activities
on a tax jurisdiction-by-tax jurisdiction basis. These instructions form an integral part of
the model template for the Country-by-Country Report.
Definitions
Reporting MNE
A Reporting MNE is the ultimate parent entity of an MNE group.
Constituent Entity
For purposes of completing AnnexIII, a Constituent Entity of the MNE group is (i)any
separate business unit of an MNE group that is included in the Consolidated Financial
Statements of the MNE group for financial reporting purposes, or would be so included if
equity interests in such business unit of the MNE group were traded on a public securities
exchange; (ii)any such business unit that is excluded from the MNE groups Consolidated
Financial Statements solely on size or materiality grounds; and (iii)any permanent
establishment of any separate business unit of the MNE group included in (i) or (ii) above
provided the business unit prepares a separate financial statement for such permanent
establishment for financial reporting, regulatory, tax reporting, or internal management
control purposes.
Treatment of Branches and Permanent Establishments

The permanent establishment data should be reported by reference to the tax
jurisdiction in which it is situated and not by reference to the tax jurisdiction of residence of
the business unit of which the permanent establishment is a part. Residence tax jurisdiction
reporting for the business unit of which the permanent establishment is a part should
exclude financial data related to the permanent establishment.
Consolidated Financial Statements

The Consolidated Financial Statements are the financial statements of an MNE group
in which the assets, liabilities, income, expenses and cash flows of the ultimate parent
entity and the Constituent Entities are presented as those of a single economic entity.
Period covered by the annual template

The template should cover the fiscal year of the Reporting MNE. For Constituent
Entities, at the discretion of the Reporting MNE, the template should reflect on a consistent
basis either (i)information for the fiscal year of the relevant Constituent Entities ending
on the same date as the fiscal year of the Reporting MNE, or ending within the 12 month
period preceding such date, or (ii)information for all the relevant Constituent Entities
reported for the fiscal year of the Reporting MNE.
Source of data
The Reporting MNE should consistently use the same sources of data from year to
year in completing the template. The Reporting MNE may choose to use data from its
consolidation reporting packages, from separate entity statutory financial statements,
regulatory financial statements, or internal management accounts. It is not necessary to
reconcile the revenue, profit and tax reporting in the template to the consolidated financial
statements. If statutory financial statements are used as the basis for reporting, all amounts
should be translated to the stated functional currency of the Reporting MNE at the average
exchange rate for the year stated in the Additional Information section of the template.
Adjustments need not be made, however, for differences in accounting principles applied
from tax jurisdiction to tax jurisdiction.
The Reporting MNE should provide a brief description of the sources of data used in
preparing the template in the Additional Information section of the template. If a change
is made in the source of data used from year to year, the Reporting MNE should explain
the reasons for the change and its consequences in the Additional Information section of
the template.
C. Template for the Country-by-Country Report Specific instructions

Overview of allocation of income, taxes and business activities by tax jurisdiction
(Table1)
Tax Jurisdiction
In the first column of the template, the Reporting MNE should list all of the tax
jurisdictions in which Constituent Entities of the MNE group are resident for tax purposes.
A tax jurisdiction is defined as a State as well as a non-State jurisdiction which has fiscal
autonomy. A separate line should be included for all Constituent Entities in the MNE group
deemed by the Reporting MNE not to be resident in any tax jurisdiction for tax purposes.
Where a Constituent Entity is resident in more than one tax jurisdiction, the applicable
tax treaty tie breaker should be applied to determine the tax jurisdiction of residence.
Where no applicable tax treaty exists, the Constituent Entity should be reported in the
tax jurisdiction of the Constituent Entitys place of effective management. The place of
effective management should be determined in accordance with the provisions of Article4
of the OECD Model Tax Convention and its accompanying Commentary.
Revenues
In the three columns of the template under the heading Revenues, the Reporting MNE
should report the following information: (i)the sum of revenues of all the Constituent
Entities of the MNE group in the relevant tax jurisdiction generated from transactions
with associated enterprises; (ii)the sum of revenues of all the Constituent Entities of the
MNE group in the relevant tax jurisdiction generated from transactions with independent
parties; and (iii)the total of (i) and (ii). Revenues should include revenues from sales of
inventory and properties, services, royalties, interest, premiums and any other amounts.
Revenues should exclude payments received from other Constituent Entities that are treated
as dividends in the payors tax jurisdiction.
Profit (Loss) before Income Tax

In the fifth column of the template, the Reporting MNE should report the sum of the
profit (loss) before income tax for all the Constituent Entities resident for tax purposes
in the relevant tax jurisdiction. The profit (loss) before income tax should include all
extraordinary income and expense items.
Income Tax Paid (on Cash Basis)

In the sixth column of the template, the Reporting MNE should report the total amount
of income tax actually paid during the relevant fiscal year by all the Constituent Entities
resident for tax purposes in the relevant tax jurisdiction. Taxes paid should include cash
taxes paid by the Constituent Entity to the residence tax jurisdiction and to all other tax
jurisdictions. Taxes paid should include withholding taxes paid by other entities (associated

enterprises and independent enterprises) with respect to payments to the Constituent Entity.
Thus, if company A resident in tax jurisdiction A earns interest in tax jurisdiction B, the
tax withheld in tax jurisdiction B should be reported by company A.
Income Tax Accrued (Current Year)

In the seventh column of the template, the Reporting MNE should report the sum of the
accrued current tax expense recorded on taxable profits or losses of the year of reporting
of all the Constituent Entities resident for tax purposes in the relevant tax jurisdiction.
The current tax expense should reflect only operations in the current year and should not
include deferred taxes or provisions for uncertain tax liabilities.
Stated Capital
In the eighth column of the template, the Reporting MNE should report the sum of the
stated capital of all the Constituent Entities resident for tax purposes in the relevant tax
jurisdiction. With regard to permanent establishments, the stated capital should be reported
by the legal entity of which it is a permanent establishment unless there is a defined capital
requirement in the permanent establishment tax jurisdiction for regulatory purposes.
Accumulated Earnings
In the ninth column of the template, the Reporting MNE should report the sum of the
total accumulated earnings of all the Constituent Entities resident for tax purposes in the
relevant tax jurisdiction as of the end of the year. With regard to permanent establishments,
accumulated earnings should be reported by the legal entity of which it is a permanent
establishment.
Number of Employees
In the tenth column of the template, the Reporting MNE should report the total number
of employees on a full-time equivalent (FTE) basis of all the Constituent Entities resident
for tax purposes in the relevant tax jurisdiction. The number of employees may be reported
as of the year-end, on the basis of average employment levels for the year, or on any other
basis consistently applied across tax jurisdictions and from year to year. For this purpose,
independent contractors participating in the ordinary operating activities of the Constituent
Entity may be reported as employees. Reasonable rounding or approximation of the number
of employees is permissible, providing that such rounding or approximation does not
materially distort the relative distribution of employees across the various tax jurisdictions.
Consistent approaches should be applied from year to year and across entities.
Tangible Assets other than Cash and Cash Equivalents

In the eleventh column of the template, the Reporting MNE should report the sum
of the net book values of tangible assets of all the Constituent Entities resident for tax
purposes in the relevant tax jurisdiction. With regard to permanent establishments,
assets should be reported by reference to the tax jurisdiction in which the permanent
establishment is situated. Tangible assets for this purpose do not include cash or cash
equivalents, intangibles, or financial assets.
List of all the Constituent Entities of the MNE group included in each aggregation
per tax jurisdiction (Table2)
Constituent Entities Resident in the Tax Jurisdiction
The Reporting MNE should list, on a tax jurisdiction-by-tax jurisdiction basis and by
legal entity name, all the Constituent Entities of the MNE group which are resident for
tax purposes in the relevant tax jurisdiction. As stated above with regard to permanent
establishments, however, the permanent establishment should be listed by reference to
the tax jurisdiction in which it is situated. The legal entity of which it is a permanent
establishment should be noted (e.g.XYZ Corp Tax Jurisdiction A PE).
Tax Jurisdiction of Organisation or Incorporation if Different from Tax

Jurisdiction of Residence
The Reporting MNE should report the name of the tax jurisdiction under whose laws
the Constituent Entity of the MNE is organised or incorporated if it is different from the
tax jurisdiction of residence.
Main Business Activity(ies)

The Reporting MNE should determine the nature of the main business activity(ies)
carried out by the Constituent Entity in the relevant tax jurisdiction, by ticking one or more
of the appropriate boxes.
Business Activities
Holding or Managing Intellectual Property
Purchasing or Procurement
Manufacturing or Production
Sales, Marketing or Distribution
Administrative, Management or Support Services
Provision of Services to Unrelated Parties
Internal Group Finance
Regulated Financial Services
Insurance
Holding Shares or Other Equity Instruments
Dormant
Other1
1. Please specify the nature of the activity of the Constituent Entity in the Additional
Information section.
AnnexIV to ChapterV
Country-by-Country Reporting Implementation Package
Introduction
In order to facilitate a consistent and swift implementation of the Country-by-Country
Reporting developed under Action13 of the Base Erosion and Profit Shifting Action Plan
(BEPS Action Plan, OECD, 2013), a Country-by-Country Reporting Implementation
Package has been agreed by countries participating in the OECD/G20 BEPS Project. This
implementation package consists of (i)model legislation which could be used by countries
to require the ultimate parent entity of an MNE group to file the Country-by-Country
Report in its jurisdiction of residence including backup filing requirements and (ii)three
model Competent Authority Agreements that are to be used to facilitate implementation
of the exchange of Country-by-Country Reports, respectively based on the 1) Convention
on Mutual Administrative Assistance in Tax Matters, 2) bilateral tax conventions and 3)
Tax Information Exchange Agreements (TIEAs). It is recognised that developing countries
may require support for the effective implementation of Country-by-Country Reporting.
Model legislation
The model legislation contained in the Country-by-Country Reporting Implementation
Package takes into account neither the constitutional law and legal system, nor the
structure and wording of the tax legislation of any particular jurisdiction. Jurisdictions will
be able to adapt this model legislation to their own legal systems, where changes to current
legislation are required.
Competent Authority Agreements

The Convention on Mutual Administrative Assistance in Tax Matters (the
Convention), by virtue of its Article6, requires the Competent Authorities of the Parties
to the Convention to mutually agree on the scope of the automatic exchange of information
and the procedure to be complied with. In the context of the Common Reporting Standard,
this requirement has been translated into a Multilateral Competent Authority Agreement,
which defines the scope, timing, procedures and safeguards according to which the
automatic exchange should take place.
As the implementation of the automatic exchange of information by means of a
Multilateral Competent Authority Agreement in the context of the Common Reporting
Standard has proven both time- and resource-efficient, the same approach could be used
for the purpose of putting the automatic exchange of information in relation to Countryby-Country Reports in place. Therefore, the Multilateral Competent Authority Agreement
38 AnnexIV to ChapterV. Country-by-Country Reporting Implementation Package

on the Exchange of Country-by-Country Reports (the CbC MCAA) has been developed,
based on the Convention and inspired by the Multilateral Competent Authority Agreement
concluded in the context of the implementation of the Common Reporting Standard.
In addition, two further model competent authority agreements have been developed
for exchanges of Country-by-Country Reports, one for exchanges under Double Tax
Conventions and one for exchanges under Tax Information Exchange Agreements.
In line with paragraph5 of ChapterV of these Guidelines, one of the three objectives
of transfer pricing documentation is to provide tax administrations with the information
necessary to conduct an informed transfer pricing risk assessment, while paragraph10
of ChapterV of these Guidelines states that effective risk identification and assessment
constitute an essential early stage in the process of selecting appropriate cases for
transfer pricing audit. The Country-by-Country Reports exchanged on the basis of the
model competent authority agreements contained in the present Country-by-Country
Reporting Implementation Package, represent one of the three tiers of the transfer pricing
documentation and will, in accordance with paragraphs16, 17 and 25 of ChapterV of
these Guidelines, provide tax administrations with relevant and reliable information to
perform an efficient and robust transfer pricing risk assessment analysis. Against that
background, the model competent authority agreements aim to provide the framework to
make the information contained in the Country-by-Country Report available to concerned
tax authorities, such information being foreseeably relevant for the administration and
enforcement of their tax laws through the automatic exchange of information.
The purpose of the CbC MCAA is to set forth rules and procedures as may be
necessary for Competent Authorities of jurisdictions implementing BEPS Action13 to
automatically exchange Country-by-Country Reports prepared by the Reporting Entity of
an MNE Group and filed on an annual basis with the tax authorities of the jurisdiction of
tax residence of that entity with the tax authorities of all jurisdictions in which the MNE
Group operates.
For most provisions, the wording is substantially the same as the text of the Multilateral
Competent Authority Agreement for the purpose of exchanges under the Common
Reporting Standard. Where appropriate, the wording has been complemented or amended
to reflect the Guidance on Country-by-Country Reporting set out in ChapterV of these
Guidelines.
As a next step, it is intended that an XML Schema and a related User Guide will be
developed with a view to accommodating the electronic exchange of Country-by-Country
Reports.
Model legislation related to Country-by-Country Reporting

Article1
Definitions
For purposes of this [title of the law] the following terms have the following meanings:
1. The term Group means a collection of enterprises related through ownership
or control such that it is either required to prepare Consolidated Financial Statements
for financial reporting purposes under applicable accounting principles or would be so
required if equity interests in any of the enterprises were traded on a public securities
exchange.
2. The term MNE Group means any Group that (i)includes two or more enterprises
the tax residence for which is in different jurisdictions, or includes an enterprise that
is resident for tax purposes in one jurisdiction and is subject to tax with respect to the
business carried out through a permanent establishment in another jurisdiction, and (ii)is
not an Excluded MNE Group.
3. The term Excluded MNE Group means, with respect to any Fiscal Year of the
Group, a Group having total consolidated group revenue of less than [750million Euro]/
[insert an amount in local currency approximately equivalent to 750million Euro as of
January 2015] during the Fiscal Year immediately preceding the Reporting Fiscal Year as
reflected in its Consolidated Financial Statements for such preceding Fiscal Year.
4. The term Constituent Entity means (i)any separate business unit of an MNE
Group that is included in the Consolidated Financial Statements of the MNE Group for
financial reporting purposes, or would be so included if equity interests in such business
unit of an MNE Group were traded on a public securities exchange; (ii)any such business
unit that is excluded from the MNE Groups Consolidated Financial Statements solely on
size or materiality grounds; and (iii)any permanent establishment of any separate business
unit of the MNE Group included in (i) or (ii) above provided the business unit prepares
a separate financial statement for such permanent establishment for financial reporting,
regulatory, tax reporting, or internal management control purposes.
5. The term Reporting Entity means the Constituent Entity that is required to file
a country-by-report conforming to the requirements in Article4 in its jurisdiction of tax
residence on behalf of the MNE Group. The Reporting Entity may be the Ultimate Parent
Entity, the Surrogate Parent Entity, or any entity described in paragraph2 of Article2.
6. The term Ultimate Parent Entity means a Constituent Entity of an MNE Group that
meets the following criteria:
(i) it owns directly or indirectly a sufficient interest in one or more other Constituent
Entities of such MNE Group such that it is required to prepare Consolidated
Financial Statements under accounting principles generally applied in its jurisdiction
of tax residence, or would be so required if its equity interests were traded on a
public securities exchange in its jurisdiction of tax residence; and

(ii) there is no other Constituent Entity of such MNE Group that owns directly or
indirectly an interest described in subsection(i) above in the first mentioned
Constituent Entity.
7. The term Surrogate Parent Entity means one Constituent Entity of the MNE Group
that has been appointed by such MNE Group, as a sole substitute for the Ultimate Parent
Entity, to file the Country-by-Country Report in that Constituent Entitys jurisdiction of
tax residence, on behalf of such MNE Group, when one or more of the conditions set out
in subsection(ii) of paragraph2 of Article2 applies.
8. The term Fiscal Year means an annual accounting period with respect to which the
Ultimate Parent Entity of the MNE Group prepares its financial statements.
9. The term Reporting Fiscal Year means that Fiscal Year the financial and
operational results of which are reflected in the Country-by-Country Report defined in
Article4.
10. The term Qualifying Competent Authority Agreement means an agreement
(i)that is between authorised representatives of those jurisdictions that are parties to an
International Agreement and (ii)that requires the automatic exchange of Country-byCountry Reports between the party jurisdictions.
11. The term International Agreement shall mean the Multilateral Convention for
Mutual Administrative Assistance in Tax Matters, any bilateral or multilateral Tax
Convention, or any Tax Information Exchange Agreement to which [Country] is a party,
and that by its terms provides legal authority for the exchange of tax information between
jurisdictions, including automatic exchange of such information.
12. The term Consolidated Financial Statements means the financial statements of
an MNE Group in which the assets, liabilities, income, expenses and cash flows of the
Ultimate Parent Entity and the Constituent Entities are presented as those of a single
economic entity.
13. The term Systemic Failure with respect to a jurisdiction means that a jurisdiction
has a Qualifying Competent Authority Agreement in effect with [Country], but has
suspended automatic exchange (for reasons other than those that are in accordance with
the terms of that Agreement) or otherwise persistently failed to automatically provide
to [Country] Country-by-Country Reports in its possession of MNE Groups that have
Constituent Entities in [Country].
Article2
Filing Obligation
1. Each Ultimate Parent Entity of an MNE Group that is resident for tax purposes
in [Country] shall file a Country-by-Country Report conforming to the requirements of
Article4 with the [Country Tax Administration] with respect to its Reporting Fiscal Year
on or before the date specified in Article5.
2. A Constituent Entity which is not the Ultimate Parent Entity of an MNE Group
shall file a Country-by-Country Report conforming to the requirements of Article4 with
the [Country Tax Administration] with respect to the Reporting Fiscal Year of an MNE
Group of which it is a Constituent Entity, on or before the date specified in Article5, if the
following criteria are satisfied:
(i) the entity is resident for tax purposes in [Country]; and
(ii) one of the following conditions applies:

a) the Ultimate Parent Entity of the MNE Group is not obligated to file a
Country-by-Country Report in its jurisdiction of tax residence; or,
b) the jurisdiction in which the Ultimate Parent Entity is resident for tax
purposes has a current International Agreement to which [Country] is a
party but does not have a Qualifying Competent Authority Agreement in
effect to which [Country] is a party by the time specified in Article5 for
filing the Country-by-Country Report for the Reporting Fiscal Year; or,
c) there has been a Systemic Failure of the jurisdiction of tax residence of
the Ultimate Parent Entity that has been notified by the [Country Tax
Administration] to the Constituent Entity resident for tax purposes in
[Country].
Where there are more than one Constituent Entities of the same MNE Group that
are resident for tax purposes in [Country] and one or more of the conditions set out in
subsection(ii) above apply, the MNE Group may designate one of such Constituent Entities
to file the Country-by-Country Report conforming to the requirements of Article4 with
[Country Tax Administration] with respect to any Reporting Fiscal Year on or before the
date specified in Article5 and to notify the [Country Tax Administration] that the filing
is intended to satisfy the filing requirement of all the Constituent Entities of such MNE
Group that are resident for tax purposes in [Country].
3. Notwithstanding the provisions of paragraph2 of this Article2, when one or more
of the conditions set out in subsection(ii) of paragraph2 of Article2 apply, an entity
described in paragraph2 of this Article2 shall not be required to file a Country-byCountry Report with [Country Tax Administration] with respect to any Reporting Fiscal
Year if the MNE Group of which it is a Constituent Entity has made available a Countryby-Country Report conforming to the requirements of Article4 with respect to such Fiscal
Year through a Surrogate Parent Entity that files that Country-by-Country Report with the
tax authority of its jurisdiction of tax residence on or before the date specified in Article5
and that satisfies the following conditions:
a) the jurisdiction of tax residence of the Surrogate Parent Entity requires filing of
Country-by-Country Reports conforming to the requirements of Article4;
b) the jurisdiction of tax residence of the Surrogate Parent Entity has a Qualifying
Competent Authority Agreement in effect to which [Country] is a party by the time
specified in Article5 for filing the Country-by-Country Report for the Reporting
Fiscal Year;
c) the jurisdiction of tax residence of the Surrogate Parent Entity has not notified the
[Country Tax Administration] of a Systemic Failure;
d) the jurisdiction of tax residence of the Surrogate Parent Entity has been notified in
accordance with paragraph1 of Article3 by the Constituent Entity resident for tax
purposes in its jurisdiction that it is the Surrogate Parent Entity; and
e) a notification has been provided to [Country Tax Administration] in accordance
with paragraph2 of Article3.
Article3
Notification
1. Any Constituent Entity of an MNE Group that is resident for tax purposes in
[Country] shall notify the [Country Tax Administration] whether it is the Ultimate Parent
Entity or the Surrogate Parent Entity, no later than [the last day of the Reporting Fiscal Year
of such MNE Group].
2. Where a Constituent Entity of an MNE Group that is resident for tax purposes in
[Country] is not the Ultimate Parent Entity nor the Surrogate Parent Entity, it shall notify
the [Country Tax Administration] of the identity and tax residence of the Reporting Entity,
no later than [the last day of the Reporting Fiscal Year of such MNE Group].
Article4
Country-by-Country Report
1. For purposes of this [title of the law], a Country-by-Country Report with respect to
an MNE Group is a report containing:
(i) Aggregate information relating to the amount of revenue, profit (loss) before income
tax, income tax paid, income tax accrued, stated capital, accumulated earnings,
number of employees, and tangible assets other than cash or cash equivalents with
regard to each jurisdiction in which the MNE Group operates;
(ii) An identification of each Constituent Entity of the MNE Group setting out the
jurisdiction of tax residence of such Constituent Entity, and where different from
such jurisdiction of tax residence, the jurisdiction under the laws of which such
Constituent Entity is organised, and the nature of the main business activity or
activities of such Constituent Entity.
2. The Country-by-Country Report shall be filed in a form identical to and applying
the definitions and instructions contained in the standard template set out at [AnnexIII of
ChapterV of the OECD Transfer Pricing Guidelines as the same may be modified from
time to time] / [AnnexIII of the Report Transfer Pricing Documentation and Country-byCountry Reporting on Action13 of the OECD/G20 Action Plan on Base Erosion and Profit
Shifting] / [the Appendix to this law].
Article5
Time for filing
The Country-by-Country Report required by this [title of the law] shall be filed no later
than 12 months after the last day of the Reporting Fiscal Year of the MNE Group.
Article6
Use and Confidentiality of Country-by-Country Report Information
1. The [Country Tax Administration] shall use the Country-by-Country Report for
purposes of assessing high-level transfer pricing risks and other base erosion and profit
shifting related risks in [Country], including assessing the risk of non-compliance by
members of the MNE Group with applicable transfer pricing rules, and where appropriate
for economic and statistical analysis. Transfer pricing adjustments by the [Country Tax
Administration] will not be based on the CbC Report.
2. The [Country Tax Administration] shall preserve the confidentiality of the

information contained in the Country-by-Country Report at least to the same extent that
would apply if such information were provided to it under the provisions of the Multilateral
Convention on Mutual Administrative Assistance in Tax Matters.
Article7
Penalties
This model legislation does not include provisions regarding penalties to be imposed
in the event a Reporting Entity fails to comply with the reporting requirements for the
Country-by-Country Report. It is assumed that jurisdictions would wish to extend their
existing transfer pricing documentation penalty regime to the requirements to file the
Country-by-Country Report.
Article8
Effective Date
This [title of the law] is effective for Reporting Fiscal Years of MNE Groups beginning
on or after [1 January 2016].
Multilateral Competent Authority Agreement

on the Exchange of Country-by-Country Reports
Whereas, the jurisdictions of the signatories to the Multilateral Competent Authority
Agreement on the Exchange of Country-by-Country Reports (the Agreement) are
Parties of, or territories covered by, the Convention on Mutual Administrative Assistance
in Tax Matters or the Convention on Mutual Administrative Assistance in Tax Matters as
amended by the Protocol (the Convention) or have signed or expressed their intention to
sign the Convention and acknowledge that the Convention must be in force and in effect in
relation to them before the automatic exchange of country-by-country (CbC) reports takes
place;
Whereas, a country that has signed or expressed its intention to sign the Convention
will only become a Jurisdiction as defined in Section1 of this Agreement once it has
become a Party to the Convention;
Whereas, the jurisdictions desire to increase international tax transparency and
improve access of their respective tax authorities to information regarding the global
allocation of the income, the taxes paid, and certain indicators of the location of economic
activity among tax jurisdictions in which Multinational Enterprise (MNE) Groups operate
through the automatic exchange of annual CbC Reports, with a view to assessing high-level
transfer pricing risks and other base erosion and profit shifting related risks, as well as for
economic and statistical analysis, where appropriate;
Whereas, the laws of the respective Jurisdictions require or are expected to require the
Reporting Entity of an MNE Group to annually file a CbC Report;
Whereas, the CbC Report is intended to be part of a three-tiered structure, along with
a global master file and a local file, which together represent a standardised approach to
transfer pricing documentation which will provide tax administrations with relevant and
reliable information to perform an efficient and robust transfer pricing risk assessment
analysis;
Whereas, ChapterIII of the Convention authorises the exchange of information for
tax purposes, including the exchange of information on an automatic basis, and allows
the competent authorities of the Jurisdictions to agree on the scope and modalities of such
automatic exchanges;
Whereas, Article6 of the Convention provides that two or more Parties can mutually
agree to exchange information automatically, albeit that the actual exchange of the
information will take place on a bilateral basis between the Competent Authorities;
Whereas, the Jurisdictions will have, or are expected to have, in place by the time the
first exchange of CbC Reports takes place, (i)appropriate safeguards to ensure that the
information received pursuant to this Agreement remains confidential and is used for the
purposes of assessing high-level transfer pricing risks and other base erosion and profit
shifting related risks, as well as for economic and statistical analysis, where appropriate,
in accordance with Section5 of this Agreement, (ii)the infrastructure for an effective
exchange relationship (including established processes for ensuring timely, accurate, and

confidential information exchanges, effective and reliable communications, and capabilities
to promptly resolve questions and concerns about exchanges or requests for exchanges
and to administer the provisions of Section4 of this Agreement) and (iii)the necessary
legislation to require Reporting Entities to file the CbC Report;
Whereas, the Jurisdictions are committed to discuss with the aim of resolving cases of
undesirable economic outcomes, including for individual businesses, in accordance with
paragraph2 of Article24 of the Convention, as well as paragraph1 of Section6 of this
Agreement;
Whereas, mutual agreement procedures, for instance on the basis of a double tax
convention concluded between the jurisdictions of the Competent Authorities, remain
applicable in cases where the CbC Report has been exchanged on the basis of this
Agreement;
Whereas, the Competent Authorities of the jurisdictions intend to conclude this
Agreement, without prejudice to national legislative procedures (if any), and subject to
the confidentiality and other protections provided for in the Convention, including the
provisions limiting the use of the information exchanged thereunder;
Now, therefore, the Competent Authorities have agreed as follows:
SECTION 1
Definitions
1. For the purposes of this Agreement, the following terms have the following
meanings:
a) the term Jurisdiction means a country or a territory in respect of which the
Convention is in force and is in effect, either through ratification, acceptance
or approval in accordance with Article28, or through territorial extension in
accordance with Article29, and which is a signatory to this Agreement;
b) the term Competent Authority means, for each respective Jurisdiction, the
persons and authorities listed in AnnexB of the Convention;
c) The term Group means a collection of enterprises related through ownership or
control such that it is either required to prepare consolidated financial statements
for financial reporting purposes under applicable accounting principles or would
be so required if equity interests in any of the enterprises were traded on a public
securities exchange;
d) the term Multinational Enterprise (MNE) Group means any Group that
(i)includes two or more enterprises the tax residence for which is in different
jurisdictions, or includes an enterprise that is resident for tax purposes in one
jurisdiction and is subject to tax with respect to the business carried out through a
permanent establishment in another jurisdiction, and (ii)is not an Excluded MNE
Group;
e) the term Excluded MNE Group means a Group that is not required to file a
CbC Report on the basis that the annual consolidated group revenue of the Group
during the fiscal year immediately preceding the reporting fiscal year, as reflected
in its consolidated financial statements for such preceding fiscal year, is below the
threshold defined in domestic law by the Jurisdiction and being consistent with the
2015 Report, as may be amended following the 2020 review contemplated therein;
f) the term Constituent Entity means (i)any separate business unit of an MNE
Group that is included in the consolidated financial statements for financial
reporting purposes, or would be so included if equity interests in such business
unit of an MNE Group were traded on a public securities exchange, (ii)any
separate business unit that is excluded from the MNE Groups consolidated
financial statements solely on size or materiality grounds and (iii)any permanent
establishment of any separate business unit of the MNE Group included in (i) or
(ii) above provided the business unit prepares a separate financial statement for
such permanent establishment for financial reporting, regulatory, tax reporting or
internal management control purposes;
g) the term Reporting Entity means the Constituent Entity that, by virtue of
domestic law in its jurisdiction of tax residence, files the CbC Report in its capacity
to do so on behalf of the MNE Group;
h) the term CbC Report means the Country-by-Country Report to be filed
annually by the Reporting Entity in accordance with the laws of its jurisdiction
of tax residence and with the information required to be reported under such laws
covering the items and reflecting the format set out in the 2015 Report, as may be
amended following the 2020 review contemplated therein;
i) the term 2015 Report means the consolidated report, entitled Transfer Pricing
Documentation and Country-by-Country Reporting, on Action13 of the OECD/
G20 Action Plan on Base Erosion and Profit Shifting;
j) the term Co-ordinating Body means the co-ordinating body of the Convention
that, pursuant to paragraph3 of Article24 of the Convention, is composed of
representatives of the competent authorities of the Parties to the Convention;
k) the term Co-ordinating Body Secretariat means the OECD Secretariat that,
pursuant to paragraph3 of Article24 of the Convention, provides support to the
Co-ordinating Body;
l) the term Agreement in effect means, in respect of any two Competent
Authorities, that both Competent Authorities have indicated their intention to
automatically exchange information with each other and have satisfied the other
conditions set out in paragraph2 of Section8. A list of Competent Authorities
between which this Agreement is in effect is to be published on the OECD website.
2. As regards the application of this Agreement at any time by a Competent Authority
of a Jurisdiction, any term not otherwise defined in this Agreement will, unless the context
otherwise requires or the Competent Authorities agree to a common meaning (as permitted
by domestic law), have the meaning that it has at that time under the law of the Jurisdiction
applying this Agreement, any meaning under the applicable tax laws of that Jurisdiction
prevailing over a meaning given to the term under other laws of that Jurisdiction.
SECTION 2
Exchange of Information with Respect to MNE Groups
1. Pursuant to the provisions of Articles6, 21 and 22 of the Convention, each
Competent Authority will annually exchange on an automatic basis the CbC Report
received from each Reporting Entity that is resident for tax purposes in its jurisdiction
with all such other Competent Authorities of Jurisdictions with respect to which it has this
Agreement in effect, and in which, on the basis of the information in the CbC Report, one

or more Constituent Entities of the MNE Group of the Reporting Entity are either resident
for tax purposes, or are subject to tax with respect to the business carried out through a
2. Notwithstanding the previous paragraph, the Competent Authorities of the
Jurisdictions that have indicated that they are to be listed as non-reciprocal jurisdictions
on the basis of their notification pursuant to paragraph1 b) of Section8 will send CbC
Reports pursuant to paragraph1, but will not receive CbC Reports under this Agreement.
Competent Authorities of Jurisdictions that are not listed as non-reciprocal Jurisdictions
will both send and receive the information specified in paragraph1. Competent Authorities
will, however, not send such information to Competent Authorities of the Jurisdictions
included in the aforementioned list of non-reciprocal Jurisdictions.
SECTION 3
Time and Manner of Exchange of Information
1. For the purposes of the exchange of information in Section2, the currency of the
amounts contained in the CbC Report will be specified.
2. With respect to paragraph1 of Section2, a CbC Report is first to be exchanged, with
respect to the fiscal year of the MNE Group commencing on or after the date indicated
by the Competent Authority in the notification pursuant to paragraph1a) of Section8,
as soon as possible and no later than 18 months after the last day of that fiscal year.
Notwithstanding the foregoing, a CbC Report is only required to be exchanged, if both
Competent Authorities have this Agreement in effect and their respective Jurisdictions have
in effect legislation that requires the filing of CbC Reports with respect to the fiscal year
to which the CbC Report relates and that is consistent with the scope of exchange provided
for in Section2.
3. Subject to paragraph2, the CbC Report is to be exchanged as soon as possible and
no later than 15 months after the last day of the fiscal year of the MNE Group to which the
CbC Report relates.
4. The Competent Authorities will automatically exchange the CbC Reports through a
common schema in Extensible Markup Language.
5. The Competent Authorities will work towards and agree on one or more methods for
electronic data transmission, including encryption standards, with a view to maximising
standardisation and minimising complexities and costs and will notify the Co-ordinating
Body Secretariat of such standardised transmission and encryption methods.
SECTION 4
Collaboration on Compliance and Enforcement
A Competent Authority will notify the other Competent Authority when the firstmentioned Competent Authority has reason to believe, with respect to a Reporting Entity
that is resident for tax purposes in the jurisdiction of the other Competent Authority, that
an error may have led to incorrect or incomplete information reporting or that there is noncompliance of a Reporting Entity with respect to its obligation to file a CbC Report. The
notified Competent Authority will take appropriate measures available under its domestic
law to address the errors or non-compliance described in the notice.
SECTION 5
Confidentiality, Data Safeguards and Appropriate Use
1. All information exchanged is subject to the confidentiality rules and other safeguards
provided for in the Convention, including the provisions limiting the use of the information
exchanged.
2. In addition to the restrictions in paragraph1, the use of the information will
be further limited to the permissible uses described in this paragraph. In particular,
information received by means of the CbC Report will be used for assessing high-level
transfer pricing, base erosion and profit shifting related risks, and, where appropriate,
for economic and statistical analysis. The information will not be used as a substitute for
a detailed transfer pricing analysis of individual transactions and prices based on a full
functional analysis and a full comparability analysis. It is acknowledged that information
in the CbC Report on its own does not constitute conclusive evidence that transfer prices
are or are not appropriate and, consequently, transfer pricing adjustments will not be based
on the CbC Report. Inappropriate adjustments in contravention of this paragraph made
by local tax administrations will be conceded in any competent authority proceedings.
Notwithstanding the above, there is no prohibition on using the CbC Report data as a basis
for making further enquiries into the MNE Groups transfer pricing arrangements or into
other tax matters in the course of a tax audit and, as a result, appropriate adjustments to the
taxable income of a Constituent Entity may be made.
3. To the extent permitted under applicable law, a Competent Authority will notify
the Co-ordinating Body Secretariat immediately of any cases of non-compliance with
paragraphs1 and 2 of this Section, including any remedial actions, as well as any
measures taken in respect of non-compliance with the above-mentioned paragraphs. The
Co-ordinating Body Secretariat will notify all Competent Authorities with respect to which
this is an Agreement in effect with the first-mentioned Competent Authority.
SECTION 6
Consultations
1. In case an adjustment of the taxable income of a Constituent Entity, as a result of
further enquiries based on the data in the CbC Report, leads to undesirable economic
outcomes, including if such cases arise for a specific business, the Competent Authorities
of the Jurisdictions in which the affected Constituent Entities are resident shall consult each
other and discuss with the aim of resolving the case.
2. If any difficulties in the implementation or interpretation of this Agreement arise,
a Competent Authority may request consultations with one or more of the Competent
Authorities to develop appropriate measures to ensure that this Agreement is fulfilled.
In particular, a Competent Authority shall consult with the other Competent Authority,
before the first-mentioned Competent Authority determines that there is a systemic failure
to exchange CbC Reports with the other Competent Authority. Where the first mentioned
Competent Authority makes such a determination it shall notify the Co-ordinating Body
Secretariat which, after having informed the other Competent Authority concerned,
will notify all Competent Authorities. To the extent permitted by applicable law, either
Competent Authority may, and if it so wishes through the Co-ordinating Body Secretariat,
involve other Competent Authorities that have this Agreement in effect with a view to
finding an acceptable resolution to the issue.

3. The Competent Authority that requested the consultations pursuant to paragraph2
shall ensure, as appropriate, that the Co-ordinating Body Secretariat is notified of any
conclusions that were reached and measures that were developed, including the absence
of such conclusions or measures, and the Co-ordinating Body Secretariat will notify all
Competent Authorities, even those that did not participate in the consultations, of any such
conclusions or measures. Taxpayer-specific information, including information that would
reveal the identity of the taxpayer involved, is not to be furnished.
SECTION 7
Amendments
This Agreement may be amended by consensus by written agreement of all of the
Competent Authorities that have the Agreement in effect. Unless otherwise agreed upon,
such an amendment is effective on the first day of the month following the expiration of a
period of one month after the date of the last signature of such written agreement.
SECTION 8
Term of Agreement
1. A Competent Authority must provide, at the time of signature of this Agreement or as
soon as possible thereafter, a notification to the Co-ordinating Body Secretariat:
a) that its Jurisdiction has the necessary laws in place to require Reporting Entities to
file a CbC Report and that its Jurisdiction will require the filing of CbC Reports
with respect to fiscal years of Reporting Entities commencing on or after the date
set out in the notification;
b) specifying whether the Jurisdiction is to be included in the list of non-reciprocal
Jurisdictions;
c) specifying one or more methods for electronic data transmission including
encryption;
d) that it has in place the necessary legal framework and infrastructure to ensure
the required confidentiality and data safeguards standards in accordance with
Article22 of the Convention and paragraph1 and Section5 of this Agreement,
as well as the appropriate use of the information in the CbC Reports as described
in paragraph2 of Section5 of this Agreement, and attaching the completed
confidentiality and data safeguard questionnaire attached as Annex to this
Agreement; and
e) that includes (i)a list of the Jurisdictions of the Competent Authorities with respect
to which it intends to have this Agreement in effect, following national legislative
procedures for entry into force (if any) or (ii)a declaration by the Competent
Authority that it intends to have this Agreement in effect with all other Competent
Authorities that provide a notification under paragraph1e) of Section8.
Competent Authorities must notify the Co-ordinating Body Secretariat, promptly,
of any subsequent change to be made to any of the above-mentioned content of the
notification.
2. This Agreement will come into effect between two Competent Authorities on
the later of the following dates: (i)the date on which the second of the two Competent
Authorities has provided notification to the Co-ordinating Body Secretariat under
paragraph1 that includes the other Competent Authoritys Jurisdiction pursuant to

subparagraph1e) and (ii)the date on which the Convention has entered into force and is in
effect for both Jurisdictions.
3. The Co-ordinating Body Secretariat will maintain a list that will be published on the
OECD website of the Competent Authorities that have signed the Agreement and between
which Competent Authorities this is an Agreement in effect. In addition, the Co-ordinating
Body Secretariat will publish the information provided by Competent Authorities pursuant
to subparagraphs1a) and b) on the OECD website.
4. The information provided pursuant to subparagraphs1c) through e) will be made
available to other signatories upon request in writing to the Co-ordinating Body Secretariat.
5. A Competent Authority may temporarily suspend the exchange of information under
this Agreement by giving notice in writing to another Competent Authority that it has
determined that there is or has been significant non-compliance by the second-mentioned
Competent Authority with this Agreement. Before making such a determination, the
first-mentioned Competent Authority shall consult with the other Competent Authority.
For the purposes of this paragraph, significant non-compliance means non-compliance
with paragraphs1 and 2 of Section5 and paragraph1 of Section6 of this Agreement and/
or the corresponding provisions of the Convention, as well as a failure by the Competent
Authority to provide timely or adequate information as required under this Agreement. A
suspension will have immediate effect and will last until the second-mentioned Competent
Authority establishes in a manner acceptable to both Competent Authorities that there has
been no significant non-compliance or that the second-mentioned Competent Authority
has adopted relevant measures that address the significant non-compliance. To the extent
permitted by applicable law, either Competent Authority may, and if it so wishes through
the Co-ordinating Body Secretariat, involve other Competent Authorities that have this
Agreement in effect with a view to finding an acceptable resolution to the issue.
6. A Competent Authority may terminate its participation in this Agreement, or with
respect to a particular Competent Authority, by giving notice of termination in writing to
the Co-ordinating Body Secretariat. Such termination will become effective on the first
day of the month following the expiration of a period of 12 months after the date of the
notice of termination. In the event of termination, all information previously received under
this Agreement will remain confidential and subject to the terms of the Convention.
SECTION 9
Co-ordinating Body Secretariat
Unless otherwise provided for in the Agreement, the Co-ordinating Body Secretariat
will notify all Competent Authorities of any notifications that it has received under this
Agreement and will provide a notice to all signatories of the Agreement when a new
Competent Authority signs the Agreement.
Done in English and French, both texts being equally authentic.
Annex to the Agreement

Confidentiality and Data Safeguards Questionnaire
1. Legal Framework
A legal framework must ensure the confidentiality of exchanged tax information and
limit its use to appropriate purposes. The two basic components of such a framework
are the terms of the applicable treaty, Tax Information Exchange Agreement (TIEA) or
other bilateral agreement for the exchange of information, and a jurisdictions domestic
legislation.
1.1 Tax Conventions, TIEAs & Other Exchange Agreements
Primary Check-list Areas
Provisions in tax treaties, TIEAs and international agreements requiring confidentiality of

exchanged information and restricting use to intended purposes
How do the exchange of information provisions in your Tax Conventions, TIEAs, or other exchange agreements
ensure confidentiality and restrict the use of both outgoing information to other Contracting States and incoming
information received in response to a request?
1.2 Domestic Legislation
Domestic law must apply safeguards to taxpayer information exchanged pursuant to

a treaty, TIEA or other international agreement, and treat those information exchange
agreements as binding, restrict data access and use and impose penalties for violations.
How do your domestic laws and regulations safeguard and restrict the use of information exchanged for tax
purposes under Tax Conventions, TIEAs, or other exchange instruments? How does the tax administration prevent
the misuse of confidential data and prohibit the transfer of tax information from the tax administrative body to
non-tax government bodies?
2. Information Security Management

The information security management systems used by each jurisdictions tax
administration must adhere to standards that ensure the protection of confidential
taxpayer data. For example, there must be a screening process for employees handling
the information, limits on who can access the information, and systems to detect and
trace unauthorized disclosures. The internationally accepted standards for information
security are known as the ISO/IEC 27000-series. As described more fully below, a
tax administration should be able to document that it is compliant with the ISO/IEC
27000-series standards or that it has an equivalent information security framework and
that taxpayer information obtained under an exchange agreement is protected under that
framework.

2.1.1 Background Checks and Contracts
Screenings and background investigations for employees and contractors

Hiring process and contracts
Responsible Points of Contact
What procedures govern your tax administrations background investigations for employees and contractors
who may have access to, use, or are responsible for protecting data received through exchange of information?
Is this information publicly available? If so, please provide the reference. If not, please provide a summary of the
procedures.
2.1.2 Training and Awareness
Initial training and periodic security awareness training based on roles, security risks, and
applicable laws
What training does your tax administration provide to employees and contractors regarding confidential
information including data received from partners through the Exchange of Information? Does your tax
administration maintain a public version of the requirements? If so, please provide the reference. If not, please
provide a summary of the requirement. [/End
2.1.3 Departure Policies
Departure policies to terminate access to confidential information
What procedures does your tax administration maintain for terminating access to confidential information for
departing employees and consultants? Are the procedures publicly available? If so, please provide the reference.
If not, please provide a summary of the procedures.
2.2.1 Physical Security: Access to Premises
Security measures to restrict entry to premises: security guards, policies, entry access
procedures
What procedures does your tax administration maintain to grant employees, consultants, and visitors access to
premises where confidential information, paper or electronic, is stored? Are the procedures publicly available? If
so, please provide the reference. If not, please provide a summary of the procedures.
2.2.2 Physical Security: Physical Document Storage
Secure physical storage for confidential documents: policies and procedures
What procedures does your tax administration maintain for receiving, processing, archiving, retrieving and
disposing of hard copies of confidential data received from taxpayers or exchange of information partners? Does
your tax administration maintain procedures employees must follow when leaving their workspace at the end of
the day? Are these procedures publicly available? If yes, please provide the reference. If not, please provide a
summary.
Does your tax administration have a data classification policy? If so, please describe how your document storage
procedures differ for data at all classification levels. Are these procedures publicly available? If yes, please
provide the reference. If not, please provide a summary. [/End
2.3 Planning
Planning documentation to develop, update, and implement security information systems
What procedures does your tax administration maintain to develop, document, update, and implement security
for information systems used to receive, process, archive and retrieve confidential information? Are these
procedures publicly available? If yes, please provide the reference. If not, please provide a summary.
What procedures does your tax administration maintain regarding periodic Information Security Plan updates to
address changes to the information systems environment, and how are problems and risks identified during the
implementation of Information Security Plans resolved? Are these procedures publicly available? If yes, please
provide the reference. If not, please provide a summary.
2.4 Configuration Management

Configuration management and security controls
What policies does your tax administration maintain to regulate system configuration and updates? Are the
policies publicly available? If yes, please provide the reference. If not, please provide a summary. [/End question]
2.5 Access Control
Access Control Policies and procedures: authorized personnel and international exchange
of information
What policies does your tax administration maintain to limit system access to authorized users and safeguard
data during transmission when received and stored? Please describe how your tax administrations access
authorization and data transmission policies extend to data received from an exchange of information partner
under a treaty or TIEA or other exchange agreement. Are the policies publicly available? If yes, please provide the
reference. If not, please provide a summary.
2.6 Identification and Authentication
Authenticating the identifying users and devices that require access to information systems
What policies and procedures does your tax administration maintain for each information system connected to
confidential data? Are the policies and procedures publicly available? If so, please provide a reference. If not,
please provide a summary.
What policies and procedures govern the authentication of authorized tax administration users by systems
connected to confidential data? Are the policies and procedures publicly available? If so, please provide a
2.7 Audit and Accountability
Traceable electronic actions within systems

System audit procedures: monitoring, analyzing, investigating, and reporting of unlawful/
unauthorized use
What policies and procedures does your tax administration maintain to ensure system audits take place that will
detect unauthorized access? Are the policies publicly available? If so, please provide a reference. If not, please
provide a summary.
2.8 Maintenance
Periodic and timely maintenance of systems

Controls over: tools, procedures, and mechanisms for system maintenance and personnel
use
What policies govern effective periodic system maintenance by your tax administration? Are these policies
publicly available? If so, please provide a reference. If not, please provide a summary.
What procedures govern the resolution of system flaws identified by your tax administration? Are these
procedures publicly available? If so, please provide a reference. If not, please provide a summary.
2.9 System and Communications Protection
Procedures to monitor, control, and protect communications to and from information

systems
What policies and procedures does your tax administration maintain for the electronic transmission and receipt
of confidential data. Please describe the security and encryption requirements addressed in these policies. Are
these policies publicly available? If so, please provide a reference. If not, please provide a summary.

2.10 System and Information Integrity
Procedures to identify, report, and correct information system flaws in a timely manner
Protection against malicious code and monitoring system security alerts
What procedures does your tax administration maintain to identify, report, and correct information system
flaws in a timely manner? Please describe how these procedures provide for the protection of systems against
malicious codes causing harm to data integrity. Are these procedures publicly available? If so, please provide a
2.11 Security Assessments
Processes used to test, validate, and authorize the security controls for protecting data,
correcting deficiencies, and reducing vulnerabilities
What policies does your tax administration maintain and regularly update for reviewing the processes used
to test, validate, and authorize a security control plan? Is the policy publicly available? If so, please provide a
2.12 Contingency Planning
Plans for emergency response, backup operations, and post-disaster recovery of

information systems
What contingency plans and procedures does your tax administration maintain to reduce the impact of improper
data disclosure or unrecoverable loss of data? Are the plans and procedures publicly available? If so, please
provide a reference. If not, please provide a summary.
2.13 Risk Assessment
Potential risk of unauthorized access to taxpayer information

Risk and magnitude of harm from unauthorized use, disclosure, or disruption of the
taxpayer information systems
Procedures to update risk assessment methodologies
Does your tax administration conduct risk assessments to identify risks and the potential impact of unauthorized
access, use, and disclosure of information, or destruction of information systems? What procedures does your
tax administration maintain to update risk assessment methodologies? Are these risk assessments and policies
2.14 Systems and Services Acquisition
Methods and processes to ensure third-party providers of information systems process,

store, and transmit confidential information in accordance with computer security
requirements
What process does your tax administration maintain to ensure third-party providers are applying appropriate
security controls that are consistent with computer security requirements for confidential information? Are the
processes publicly available? If so, please provide a reference. If not, please provide a summary.
2.15 Media Protection
Processes to protect information in printed or digital form

Security measures used to limit media information access to authorized users only
Methods for sanitizing or destroying digital media prior to disposal or reuse
What processes does your tax administration maintain to securely store and limit access to confidential
information in printed or digital form upon receipt from any source? How does your tax administration securely
destroy confidential media information prior to its disposal? Are the processes available publicly? If so, please
provide a reference. If not, please provide a summary.
2.16 Protection of Treaty-Exchanged data (formerly Prevention of Data Commingling)

Procedures to ensure treaty-exchanged files are safeguarded and clearly labeled

Classification methods of treaty-exchanged files
What policies and processes does your tax administration maintain to store confidential information and clearly
label it as treaty-exchanged after receipt from foreign Competent Authorities? Are these policies and processes
2.17 Information Disposal Policies
Procedures for properly disposing paper and electronic files
What procedures does your tax administration maintain for the disposal of confidential information? Do these
procedures extend to exchanged information from foreign Competent Authorities? Are the procedures publicly
available? If so, please provide a reference. If not, please provide a summary.
3. Monitoring and Enforcement

In addition to keeping treaty-exchanged information confidential, tax administrations
must be able to ensure that its use will be limited to the purposes defined by the applicable
information exchange agreement. Thus, compliance with an acceptable information
security framework alone is not sufficient to protect treaty-exchanged tax data. In addition,
domestic law must impose penalties or sanctions for improper disclosure or use of taxpayer
information. To ensure implementation, such laws must be reinforced by adequate
administrative resources and procedures.
3.1 Penalties and Sanctions
Penalties imposed for unauthorized disclosures

Risk mitigation practices
Does your tax administration have the ability to impose penalties for unauthorized disclosures of confidential
information? Do the penalties extend to unauthorized disclosure of confidential information exchanged with a
treaty or TIEA partner? Are the penalties publicly available? If so, please provide a reference. If not, please provide
a summary.
3.2.1 Policing Unauthorized Access and Disclosure
Monitoring to detect breaches

Reporting of breaches
What procedures does your tax administration have to monitor confidentiality breaches? What policies and
procedures does your tax administration have that require employees and contractors to report actual or potential
breaches of confidentiality? What reports does your tax administration prepare when a breach of confidentiality
occurs? Are these policies and procedures publicly available? If so, please provide a reference. If not, please
provide a summary.
3.2.2 Sanctions and Prior Experience
Prior unauthorized disclosures

Policy/process modifications to prevent future breaches
Have there been any cases in your jurisdiction where confidential information has been improperly disclosed?
Have there been any cases in your jurisdiction where confidential information received by the Competent
Authority from an exchange of information partner has been disclosed other than in accordance with the terms of
the instrument under which it was provided? Does your tax administration or Inspector General make available to
the public descriptions of any breaches, any penalties/sanctions imposed, and changes put in place to mitigate
risk and prevent future breaches? If so, please provide a reference. If not, please provide a summary.
Competent Authority Agreement

on the basis of aDouble Tax Convention (DTC CAA)
Whereas, the Government of [Jurisdiction A] and the Government of [Jurisdiction B]
desire to increase international tax transparency and improve access of their respective tax
authorities to information regarding the global allocation of the income, the taxes paid, and
certain indicators of the location of economic activity among tax jurisdictions in which
Multinational Enterprise (MNE) Groups operate through the automatic exchange of annual
CbC Reports, with a view to assessing high-level transfer pricing risks and other base
erosion and profit shifting related risks, as well as for economic and statistical analysis,
where appropriate;
Whereas, the laws of their respective Jurisdictions require or are expected to require
the Reporting Entity of an MNE Group to annually file a CbC Report;
analysis;
Whereas, Article [] of the Income Tax Convention between [Jurisdiction A] and
[Jurisdiction B] (the Convention), authorises the exchange of information for tax
purposes, including the automatic exchange of information, and allows the competent
authorities of [Jurisdiction A] and [Jurisdiction B] (the Competent Authorities) to agree
the scope and modalities of such automatic exchanges;
Whereas, [Jurisdiction A] and [Jurisdiction B] [have/are expected to have/have,
or are expected to have,] in place by the time the first exchange of CbC Reports takes
place (i)appropriate safeguards to ensure that the information received pursuant to this
Agreement remains confidential and is used for the purposes of assessing high-level
transfer pricing risks and other base erosion and profit shifting related risks, as well as
for economic and statistical analysis, where appropriate, in accordance with Section5 of
this Agreement, (ii)the infrastructure for an effective exchange relationship (including
established processes for ensuring timely, accurate, and confidential information
exchanges, effective and reliable communications, and capabilities to promptly resolve
questions and concerns about exchanges or requests for exchanges and to administer the
provisions of Section4 of this Agreement), and (iii)the necessary legislation to require
Reporting Entities to file the CbC Report;
Whereas, [Jurisdiction A] and [Jurisdiction B] are committed to endeavour to mutually
agree on resolving cases of double taxation in accordance with Article [25] of the
Convention, as well as paragraph1 of Section6 of this Agreement;
Whereas, the Competent Authorities intend to conclude this Agreement on reciprocal
automatic exchange pursuant to the Convention and subject to the confidentiality and other

protections provided for in the Convention, including the provisions limiting the use of the
information exchanged thereunder;
SECTION 1
Definitions
1.
For the purposes of this Agreement, the following terms have the following meanings:
a) the term [Jurisdiction A] means [];
b) the term [Jurisdiction B] means [];
c) the term Competent Authority means in case of [Jurisdiction A], [] and in
case of [Jurisdiction B], [];
d) The term Group means a collection of enterprises related through ownership or
e) the term Multinational Enterprise (MNE) Group means any Group that
Group;
f) the term Excluded MNE Group means a Group that is not required to file a
CbC Report on the basis that the consolidated group revenue of the Group during
the fiscal year immediately preceding the reporting fiscal year, as reflected in
its consolidated financial statements for such preceding fiscal year, is below the
g) the term Constituent Entity means (i)any separate business unit of an MNE
unit of an MNE Group were traded on a public securities exchange (ii)any
establishment of any separate business unit of the MNE Group included in (i) or
(ii) above provided the business unit prepares a separate financial statement for
h) the term Reporting Entity means the Constituent Entity that, by virtue of
i) the term CbC Report means the Country-by-Country Report to be filed annually
by the Reporting Entity in accordance with the laws of its jurisdiction of tax
residence and with the information required to be reported under such laws covering
the items and reflecting the format set out in the 2015 Report, as may be amended
following the 2020 review contemplated therein; and
j) the term 2015 Report means the consolidated report, entitled Transfer Pricing
G20 Action Plan on Base Erosion and Profit Shifting.
2. As regards to the application of this Agreement at any time by a Competent Authority
SECTION 2
Pursuant to the provisions of Article [] of the Convention, each Competent
Authority will annually exchange on an automatic basis the CbC Report received from
each Reporting Entity that is resident for tax purposes in its Jurisdiction with the other
Competent Authority, provided that, on the basis of the information provided in the CbC
Report, one or more Constituent Entities of the MNE Group of the Reporting Entity are
resident for tax purposes in the Jurisdiction of the other Competent Authority or, are
subject to tax with respect to the business carried out through a permanent establishment
situated in the Jurisdiction of the other Competent Authority.
SECTION 3
2. With respect to Section2, a CbC Report is first to be exchanged with respect to fiscal
years of MNE Groups commencing on or after []. Such CbC Report is to be exchanged
as soon as possible and no later than 18 months after the last day of the fiscal year of the
MNE Group to which the CbC Report relates. CbC Reports with respect to subsequent
fiscal years are to be exchanged as soon as possible and no later than 15 months after the
last day of the fiscal year of the MNE Group to which the CbC Report relates.
electronic data transmission including encryption standards.
SECTION 4
that is resident for tax purposes in the Jurisdiction of the other Competent Authority, that
an error may have led to incorrect or incomplete information reporting or that there is noncompliance of a Reporting Entity with the respect to its obligation to file a CbC Report.

The notified Competent Authority will take all appropriate measures available under its
domestic law to address the errors or non-compliance described in the notice.
SECTION 5
provided for in the Convention, including the provisions limiting the use of the information
exchanged.
for making further enquiries into the MNE Groups transfer pricing arrangements or into
other tax matters in the course of a tax audit and, as a result, appropriate adjustments to the
taxable income of a Constituent Entity may be made.
3. To the extent permitted under applicable law, each Competent Authority will notify
the other Competent Authority immediately regarding of any cases of non-compliance
with the rules set out in paragraphs1 and 2 of this Section, including any remedial actions,
as well as any measures taken in respect of non-compliance with the above-mentioned
paragraphs.
SECTION 6
Consultations
1. In cases foreseen by Article [25] of the Convention, the Competent Authorities of
both Jurisdictions shall consult each other and endeavour to resolve the situation by mutual
agreement.
either Competent Authority may request consultations with the other Competent Authority
to develop appropriate measures to ensure that this Agreement is fulfilled. In particular,
a Competent Authority shall consult with the other Competent Authority before the firstmentioned Competent Authority determines that there is a systemic failure to exchange
CbC Reports with the other Competent Authority.
SECTION 7
Amendments
This Agreement may be amended by consensus by written agreement of the Competent
Authorities. Unless otherwise agreed upon, such an amendment is effective on the first day
of the month following the expiration of a period of one month after the date of the last
signature of such written agreement.
SECTION 8
Term of Agreement
1. This Agreement will come into effect on [/the date of the later of the notifications
provided by each Competent Authority that its Jurisdiction either has the necessary laws in
place to require Reporting Entities to file a CbC Report].
this Agreement by giving notice in writing to the other Competent Authority that it has
determined that there is or has been significant non-compliance by the other Competent
Authority with this Agreement. Before making such a determination, the first-mentioned
Competent Authority shall consult with the other Competent Authority. For the purposes of
this paragraph, significant non-compliance means non-compliance with paragraphs1 and 2
of Section5 and paragraph1 of Section6 of this Agreement, including the provisions of the
Convention referred to therein, as well as a failure by the Competent Authority to provide
timely or adequate information as required under this Agreement. A suspension will have
immediate effect and will last until the second-mentioned Competent Authority establishes
in a manner acceptable to both Competent Authorities that there has been no significant
non-compliance or that the second-mentioned Competent Authority has adopted relevant
measures that address the significant non-compliance.
3. Either Competent Authority may terminate this Agreement by giving notice of
termination in writing to the other Competent Authority. Such termination will become
effective on the first day of the month following the expiration of a period of 12 months
after the date of the notice of termination. In the event of termination, all information
previously received under this Agreement will remain confidential and subject to the terms
of the Convention.
Signed in duplicate in [] on [].
Competent Authority for
[Jurisdiction A]

[Jurisdiction B]
Competent Authority Agreement

on the basis of a Tax Information Exchange Agreement (TIEA CAA)
Whereas, the Government of [Jurisdiction A] and the Government of [Jurisdiction B]
intend to increase international tax transparency and improve access of their respective
tax authorities to information regarding the global allocation of the income, the taxes paid,
and certain indicators of the location of economic activity among tax jurisdictions in which
Multinational Enterprise (MNE) Groups operate through the automatic exchange of annual
CbC Reports, with a view to assessing high-level transfer pricing risks and other base
erosion and profit shifting related risks, as well as for economic and statistical analysis,
where appropriate;
Whereas, the laws of their respective Jurisdictions require or are expected to require
the Reporting Entity of an MNE Group to annually file a CbC Report;
analysis;
Whereas, Article [5A] of the Tax Information Exchange Agreement between
[Jurisdiction A] and [Jurisdiction B] (the TIEA), authorises the exchange of information
for tax purposes, including the automatic exchange of information, and allows the
competent authorities of [Jurisdiction A] and [Jurisdiction B] (the Competent Authorities)
to agree the scope and modalities of such automatic exchanges;
Whereas, [Jurisdiction A] and [Jurisdiction B] [have/are expected to have/have,
or are expected to have,] in place by the time the first exchange of CbC Reports takes
place (i)appropriate safeguards to ensure that the information received pursuant to this
Agreement remains confidential and is used for the purposes of assessing high-level
transfer pricing risks and other base erosion and profit shifting related risks, as well as
for economic and statistical analysis, where appropriate, in accordance with Section5 of
this Agreement, (ii)the infrastructure for an effective exchange relationship (including
established processes for ensuring timely, accurate, and confidential information
exchanges, effective and reliable communications, and capabilities to promptly resolve
questions and concerns about exchanges or requests for exchanges and to administer the
provisions of Section4 of this Agreement) and (iii)the necessary legislation to require
Reporting MNEs to file the CbC Report;
Whereas, the Competent Authorities intend to conclude this Agreement on reciprocal
automatic exchange pursuant to the TIEA and subject to the confidentiality and other
protections provided for in the TIEA, including the provisions limiting the use of the
information exchanged thereunder;

SECTION 1
Definitions
1. For the purposes of this Agreement, the following terms have the following
meanings:
a) the term [Jurisdiction A] means [];
b) the term [Jurisdiction B] means [];
c) the term Competent Authority means in case of [Jurisdiction A], [] and in
case of [Jurisdiction B], [];
d) The term Group means a collection of enterprises related through ownership or
e) the term Multinational Enterprise (MNE) Group means any Group that
Group;
f) the term Excluded MNE Group means a Group that is not required to file a
CbC Report on the basis that the consolidated group revenue of the Group during
the fiscal year immediately preceding the reporting fiscal year, as reflected in
its consolidated financial statements for such preceding fiscal year, is below the
g) the term Constituent Entity means (i)any separate business unit of an MNE
unit of an MNE Group were traded on a public securities exchange (ii)any
establishments of any separate business unit of the MNE Group included in (i) or
(ii) above provided such business unit prepares a separate financial statement for
h) the term Reporting Entity means the Constituent Entity that, by virtue of
i) the term CbC Report means the Country-by-Country Report to be filed
annually by the Reporting Entity in accordance with the laws of its jurisdiction
of tax residence and with the information required to be reported under such laws
covering the items and reflecting the format set out in the 2015 Report, as may be
amended following the 2020 review contemplated therein; and
j) the term 2015 Report means the consolidated report, entitled Transfer Pricing
G20 Action Plan on Base Erosion and Profit Shifting.
2. As regards to the application of this Agreement at any time by a Competent Authority
SECTION 2
Pursuant to the provisions of Article [5A] of the TIEA, each Competent Authority will
annually exchange on an automatic basis the CbC Report received from each Reporting
Entity that is resident for tax purposes in its Jurisdiction with the other Competent
Authority, provided that, on the basis of the information provided in the CbC Report, one
or more Constituent Entities of the MNE Group of the Reporting Entity are resident for
tax purposes in the Jurisdiction of the other Competent Authority or, are subject to tax
with respect to the business carried out through a permanent establishment situated in the
Jurisdiction of the other Competent Authority.
SECTION 3
2. With respect to Section2, a CbC Report is first to be exchanged with respect to fiscal
years of MNE Groups commencing on or after []. Such CbC Report is to be exchanged
as soon as possible and no later than 18 months after the last day of the fiscal year of the
Reporting Entity of the MNE Group to which the CbC Report relates. CbC Reports with
respect to subsequent fiscal years are to be exchanged as soon as possible and no later than
15 months after the last day of the fiscal year of the MNE Group to which the CbC Report
relates.
electronic data transmission including encryption standards.
SECTION 4
that is resident for tax purposes in the Jurisdiction of the other Competent Authority, that
an error may have led to incorrect or incomplete information reporting or that there is noncompliance of a Reporting Entity with the respect to its obligation to file a CbC Report.

The notified Competent Authority will take all appropriate measures available under its
domestic law to address the errors or non-compliance described in the notice.
SECTION 5
provided for in the TIEA, including the provisions limiting the use of the information
exchanged.
for making further enquiries into the MNEs transfer pricing arrangements or into other tax
matters in the course of a tax audit and, as a result, appropriate adjustments to the taxable
income of a Constituent Entity may be made.
3. To the extent permitted under applicable law, each Competent Authority will notify
the other Competent Authority immediately regarding of any cases of non-compliance
with the paragraphs1 and 2 of this Section, including any remedial actions, as well as any
measures taken in respect of non-compliance with the above-mentioned paragraphs.
SECTION 6
Consultations
1. In case an adjustment of the taxable income of a Constituent Entity, as a result of
further enquiries based on the data in the CbC Report, leads to undesirable economic
outcomes, including if such cases arise for a specific business, both Competent Authorities
shall consult each other and discuss with the aim of resolving the case.
either Competent Authority may request consultations with of the other Competent
Authority to develop appropriate measures to ensure that this Agreement is fulfilled. In
particular, a Competent Authority shall consult with the other Competent Authority before
the first-mentioned Competent Authority determines that there is a systemic failure to
exchange CbC Reports with the other Competent Authority.
SECTION 7
Amendments
This Agreement may be amended by consensus by written agreement of the Competent
Authorities. Unless otherwise agreed upon, such an amendment is effective on the first day
of the month following the expiration of a period of one month after the date of the last
signature of such written agreement.
SECTION 8
Term of Agreement
1. This Agreement will come into effect on [/the date of the later of the notifications
provided by each Competent Authority that its Jurisdiction either has the necessary laws in
place to require Reporting Entities to file a CbC Report].
this Agreement by giving notice in writing to the other Competent Authority that it has
determined that there is or has been significant non-compliance by the other Competent
Authority with this Agreement. Before making such a determination, the first-mentioned
Competent Authority shall consult with the other Competent Authority. For the purposes
of this paragraph, significant non-compliance means non-compliance with paragraphs1
and 2 of Section5 and paragraph1 of Section6 of this Agreement and the provisions of
the TIEA referred to therein, as well as a failure by the Competent Authority to provide
timely or adequate information as required under this Agreement. A suspension will have
immediate effect and will last until the second-mentioned Competent Authority establishes
in a manner acceptable to both Competent Authorities that there has been no significant
non-compliance or that the second-mentioned Competent Authority has adopted relevant
measures that address the significant non-compliance.
3. Either Competent Authority may terminate this Agreement by giving notice of
termination in writing to the other Competent Authority. Such termination will become
effective on the first day of the month following the expiration of a period of 12 months
after the date of the notice of termination. In the event of termination, all information
previously received under this Agreement will remain confidential and subject to the terms
of the TIEA.
Signed in duplicate in [] on [].
[Jurisdiction A]

[Jurisdiction B]
70 BIBLIOGRAPHY
Bibliography
OECD (2014), Standard for Automatic Exchange of Financial Account Information in Tax
Matters, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264216525-en.
http://dx.doi.org/10.1787/9789264202719-en.
OECD (2012), Keeping it Safe: The OECD Guide on the protection of confidentiality of
information exchanged for tax purposes, OECD Publishing, Paris, www.oecd.org/ctp/
exchange-of-tax-information/keeping-it-safe-report.pdf.
OECD (2010), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations 2010, OECD Publishing, Paris, http://dx.doi.org/10.1787/tpg-2010-en.

AND DEVELOPMENT

(23 2015 38 1 P) ISBN 978-92-64-24146-6 2015
Transfer Pricing Documentation

and Country-by-Country Reporting
Contents
Chapter V of the Transfer Pricing Guidelines on Documentation
Annex I to Chapter V. Transfer pricing documentation Master file
Annex II to Chapter V. Transfer pricing documentation Local file
Annex III to Chapter V. Transfer pricing documentation Country-by-Country Report
Annex IV to Chapter V. Country-by-Country Reporting Implementation Package

isbn 978-92-64-24146-6
23 2015 38 1 P
9HSTCQE*cebegg+

Project
Making Dispute Resolution Mechanisms

More Effective
Making Dispute
Resolution Mechanisms
More Effective, Action 14
2015 Final Report

OECD (2015), Making Dispute Resolution Mechanisms More Effective, Action 14 - 2015 Final Report,
http://dx.doi.org/10.1787/9789264241633-en
ISBN 978-92-64-24158-9 (print)

ISBN 978-92-64-24163-3 (PDF)

OECD 2015
FOREwORD 3
Foreword
MAKING DISPUTE RESOLUTION MECHANISMS MORE EFFECTIVE OECD 2015
4 FOREwORD
TABLE OF CONTENTS 5
Table of contents
Abbreviations and acronyms ................................................................................................................ 7
Executive summary................................................................................................................................ 9
Introduction.......................................................................................................................................... 11
I.
Minimum standard, best practices and monitoring process..................................................... 13

A.
B.
C.
II.
Elements of a minimum standard to ensure the timely, effective and efficient

resolution of treaty-related disputes ........................................................................................ 13
Best practices ........................................................................................................................... 28
A framework for a monitoring mechanism ............................................................................. 37
Commitment to mandatory binding MAP arbitration .......................................................... 41
Annex A. Mandate for the development of the terms of reference and the assessment
methodology .......................................................................................................................................... 43
Bibliography ......................................................................................................................................... 45

APA
Advance pricing arrangement
BEPS
FTA
MAP
OECD
EXECUTIVE SUMMARY 9
Executive summary
Eliminating opportunities for cross-border tax avoidance and evasion and the
effective and efficient prevention of double taxation are critical to building an
international tax system that supports economic growth and a resilient global economy.
Countries agree that the introduction of the measures developed to address base erosion
and profit shifting pursuant to the Action Plan on Base Erosion and Profit Shifting (BEPS
Action Plan, OECD, 2013) should not lead to unnecessary uncertainty for compliant
taxpayers and to unintended double taxation. Improving dispute resolution mechanisms is
therefore an integral component of the work on BEPS issues.
Article 25 of the OECD Model Tax Convention (OECD, 2014) provides a
mechanism, independent from the ordinary legal remedies available under domestic law,
through which the competent authorities of the Contracting States may resolve
differences or difficulties regarding the interpretation or application of the Convention on
a mutually-agreed basis. This mechanism the mutual agreement procedure (MAP) is
of fundamental importance to the proper application and interpretation of tax treaties,
notably to ensure that taxpayers entitled to the benefits of the treaty are not subject to
taxation by either of the Contracting States which is not in accordance with the terms of
the treaty.
The measures developed under Action 14 of the BEPS Action Plan aim to strengthen
the effectiveness and efficiency of the MAP process. They aim to minimise the risks of
uncertainty and unintended double taxation by ensuring the consistent and proper
implementation of tax treaties, including the effective and timely resolution of disputes
regarding their interpretation or application through the mutual agreement procedure.
These measures are underpinned by a strong political commitment to the effective and
timely resolution of disputes through the mutual agreement procedure and to further
progress to rapidly resolve disputes.
Through the adoption of this Report, countries have agreed to important changes in
their approach to dispute resolution, in particular by having developed a minimum
standard with respect to the resolution of treaty-related disputes, committed to its rapid
implementation and agreed to ensure its effective implementation through the
establishment of a robust peer-based monitoring mechanism that will report regularly
through the Committee on Fiscal Affairs to the G20. The minimum standard will:
Ensure that treaty obligations related to the mutual agreement procedure are fully
implemented in good faith and that MAP cases are resolved in a timely manner;
Ensure the implementation of administrative processes that promote the prevention
and timely resolution of treaty-related disputes; and
Ensure that taxpayers can access the MAP when eligible.
The minimum standard is complemented by a set of best practices. The monitoring
of the implementation of the minimum standard will be carried out pursuant to detailed
terms of reference and an assessment methodology to be developed in the context of the
OECD/G20 BEPS Project in 2016.
In addition to the commitment to implement the minimum standard by all countries
adhering to the outcomes of the BEPS Project, the following countries have declared their
commitment to provide for mandatory binding MAP arbitration in their bilateral tax
treaties as a mechanism to guarantee that treaty-related disputes will be resolved within a
specified timeframe: Australia, Austria, Belgium, Canada, France, Germany, Ireland,
Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Poland, Slovenia,
Spain, Sweden, Switzerland, the United Kingdom and the United States.1 This represents
a major step forward as together these countries were involved in more than 90 percent of
outstanding MAP cases at the end of 2013, as reported to the OECD.2
Notes
1.
The Leaders Declaration issued following the 7-8 June 2015 G7 Summit (available at
www.g7germany.de/Content/DE/_Anlagen/G8_G20/2015-06-08-g7-abschlusseng.pdf?__blob=publicationFile) contained the following statement regarding MAP
arbitration:
Moreover, we will strive to improve existing international information networks
and cross-border cooperation on tax matters, including through a commitment to
establish binding mandatory arbitration in order to ensure that the risk of double
taxation does not act as a barrier to cross-border trade and investment. We support
work done on binding arbitration as part of the BEPS project and we encourage
others to join us in this important endeavour.
2.
See www.oecd.org/ctp/dispute/map-statistics-2013.htm.
INTRODUCTION 11
Introduction
1.
At the request of the G20, the OECD published its Action Plan on Base Erosion
and Profit Shifting (BEPS Action Plan, OECD, 2013) in July 2013. The BEPS Action
Plan includes 15 actions to address BEPS in a comprehensive manner and sets deadlines
to implement these actions.
2.
The BEPS Action Plan recognises that the actions to counter BEPS must be
complemented with actions that ensure certainty and predictability for business. The work
on Action 14, which seeks to improve the effectiveness of the mutual agreement
procedure (MAP) in resolving treaty-related disputes, is thus an integral component of the
work on BEPS issues and reflects the comprehensive and holistic approach of the BEPS
Action Plan. The relevant part of the Action Plan reads as follows:
The actions to counter BEPS must be complemented with actions that
ensure certainty and predictability for business. Work to improve the
effectiveness of the mutual agreement procedure (MAP) will be an important
complement to the work on BEPS issues. The interpretation and application of
novel rules resulting from the work described above could introduce elements
of uncertainty that should be minimised as much as possible. Work will
therefore be undertaken in order to examine and address obstacles that prevent
countries from [re]solving treaty-related disputes under the MAP.
Consideration will also be given to supplementing the existing MAP
provisions in tax treaties with a mandatory and binding arbitration provision.
ACTION 14
Make dispute resolution mechanisms more effective
Develop solutions to address obstacles that prevent countries from [re]solving
treaty-related disputes under MAP, including the absence of arbitration
provisions in most treaties and the fact that access to MAP and arbitration
may be denied in certain cases.
3.
This Report is the result of the work carried out on Action 14. The Report reflects
a commitment by countries to implement a minimum standard on dispute resolution,
consisting of specific measures to remove obstacles to an effective and efficient mutual
agreement procedure. The Report also reflects agreement by countries to establish a
monitoring mechanism to ensure that the commitments contained in the minimum
standard are effectively satisfied. The minimum standard, complementary best practices
and resulting changes to the OECD Model Tax Convention (OECD, 2014) are set out in
detail in Sections I.A and I.B of this Report. The framework for a peer-based monitoring
mechanism is set out in Section I.C of this Report.
4.
The minimum standard is constituted by specific measures that countries will take
to ensure that they resolve treaty-related disputes in a timely, effective and efficient
12 INTRODUCTION
manner. The elements of the minimum standard are set out below in relation to the
following three general objectives:
Countries should ensure that treaty obligations related to the mutual agreement
procedure are fully implemented in good faith and that MAP cases are resolved in
a timely manner;
Countries should ensure that administrative processes promote the prevention and
timely resolution of treaty-related disputes; and
Countries should ensure that taxpayers that meet the requirements of paragraph 1
of Article 25 can access the mutual agreement procedure.
5.
The specific measures that are part of the minimum standard are accompanied by
explanations and, in some cases, changes to the OECD Model Tax Convention (changes
to the existing text of the OECD Model Tax Convention appear in bold italics for
additions and strikethrough for deletions). Other changes to the Commentary of the
OECD Model Tax Convention (hereafter the Commentary) will be drafted as part of
the next update to the OECD Model Tax Convention in order to reflect the conclusions of
this Report.
6.
The elements of the minimum standard (which are included in boxes in this
Report) have been formulated to reflect clear, objective criteria that will be susceptible to
assessment and review in the monitoring process. As indicated in Section I.C, future work
to develop the monitoring mechanism will include elaboration of (i) the Terms of
Reference that will be used by peers to evaluate implementation of the minimum standard
and (ii) the Assessment Methodology that will be used for the purposes of such
monitoring.
7.
The conclusions of the work on Action 14 also reflect the agreement that certain
responses to the obstacles that prevent the resolution of treaty-related disputes through the
mutual agreement procedure are more appropriately presented as best practices, in
general because, unlike the elements of the minimum standard, these best practices have a
subjective or qualitative character that could not readily be monitored or evaluated or
because not all OECD and G20 countries are willing to commit to them at this stage.
These best practices are therefore not part of the minimum standard. The best practices
are accompanied by explanations and, in some cases, changes to the OECD Model Tax
Convention.
8.
Finally, the agreement to a minimum standard that will make tax treaty dispute
resolution mechanisms more effective is complemented by the commitment, by a number
of countries, to adopt mandatory binding arbitration. Whilst there is currently no
consensus among all OECD and G20 countries on the adoption of mandatory binding
arbitration as a mechanism to ensure the timely resolution of MAP cases, a significant
group of countries has committed to adopt and implement mandatory binding arbitration.
This commitment to MAP arbitration is set out in Section II of this Report.
I. MINIMUM STANDARD, BEST PRACTICES AND MONITORING PROCESS 13
I.
Minimum standard, best practices and monitoring process
A. Elements of a minimum standard to ensure the timely, effective and efficient

resolution of treaty-related disputes
1.
procedure are fully implemented in good faith and that MAP cases are resolved
in a timely manner
9.
The dispute resolution mechanism provided by Article 25 (Mutual Agreement
Procedure) of the OECD Model Tax Convention (OECD, 2014) forms an integral and
essential part of the obligations assumed by a Contracting State in entering in to a tax
treaty; the provisions of Article 25 must be fully implemented in good faith, in
accordance with their terms and in the light of the object and purpose of tax treaties. The
elements of the minimum standard set out in Section I.A.1 are intended to ensure the full
implementation of treaty obligations related to the mutual agreement procedure and the
timely resolution of MAP cases.
1.1
Countries should include paragraphs 1 through 3 of Article 25 in their tax

treaties, as interpreted in the Commentary and subject to the variations in these
paragraphs provided for under elements 3.1 and 3.3 of the minimum standard;
they should provide access to MAP in transfer pricing cases and should
implement the resulting mutual agreements (e.g. by making appropriate
adjustments to the tax assessed).
10.
Paragraphs 1 through 3 of Article 25 provide a mechanism, independent from the
ordinary legal remedies available under domestic law, through which the competent
authorities of the Contracting States may resolve differences or difficulties regarding the
interpretation or application of the Convention on a mutually-agreed basis. This
mechanism the mutual agreement procedure is of fundamental importance to the
proper application and interpretation of the Convention, notably to ensure that taxpayers
entitled to the benefits of the Convention are not subject to taxation by either of the
Contracting States which is not in accordance with the terms of the Convention.
Countries should accordingly include in all of their tax treaties paragraphs 1 through 3 of
Article 25, as interpreted in the Commentary (in particular paragraph 55 of the
Commentary on Article 25, which refers to the situation of States whose domestic law
prevent the Convention from being complemented on points which are not explicitly or at
least implicitly dealt with in the Convention) and subject to the variations in these
paragraphs provided for under elements 3.1 and 3.3 of the minimum standard.
11.
In general, the economic double taxation that may result from the inclusion of
profits of associated enterprises under paragraph 1 of Article 9 (Associated Enterprises) is
not in accordance with the object and purpose of the Convention to eliminate double
14 I. MINIMUM STANDARD, BEST PRACTICES AND MONITORING PROCESS

taxation. In particular, the failure to grant MAP access with respect to a treaty partners
transfer pricing adjustments, with a view to eliminating the economic double taxation that
may follow from such an adjustment, will likely frustrate a primary objective of tax
treaties. Countries should thus provide access to MAP in transfer pricing cases. Where, in
particular, treaty provisions such as paragraph 2 of Article 9 or, in the absence of
paragraph 2 of Article 9, provisions of domestic law enable Contracting States to provide
for a corresponding adjustment and it is necessary for the competent authorities of the
Contracting States to consult to determine the appropriate amount of that corresponding
adjustment with the aim of avoiding double taxation, countries should provide access to
MAP. Countries should also implement any mutual agreement resulting from these and
other MAP cases.
12.
It is intended to make amendments to the Commentary on Article 25 of the
OECD Model Tax Convention as part of the next update of the OECD Model Tax
Convention in order to clarify the treaty obligation to undertake to resolve by mutual
agreement cases of taxation not in accordance with the Convention.
1.2
Countries should provide MAP access in cases in which there is a

disagreement between the taxpayer and the tax authorities making the
adjustment as to whether the conditions for the application of a treaty antiabuse provision have been met or as to whether the application of a domestic
law anti-abuse provision is in conflict with the provisions of a treaty.
13.
As provided in paragraph 26 of the Commentary on Article 25, in the absence of a
special provision, there is no general rule denying MAP access in cases of perceived
abuse. Paragraphs 9.1 to 9.5 of the Commentary on Article 1 are also relevant to the
question of whether there is an obligation to provide MAP access in cases of abuse;
paragraph 9.5 provides in particular that treaty benefits may be denied through the
application of an anti-abuse provision where obtaining a more favourable treatment based
on the applicable treaty would be contrary to the object and purpose of the relevant treaty
provisions. The guiding principle in paragraph 9.5 will be incorporated into tax treaties
through the general anti-abuse rule based on the principal purposes of transactions or
arrangements (the principal purposes test or PPT rule) developed in the work on Action
6 of the BEPS Action Plan, according to which the benefits of a tax treaty should not be
available where one of the principal purposes of arrangements or transactions is to secure
a benefit under a tax treaty and obtaining that benefit in these circumstances would be
contrary to the object and purpose of the relevant provisions of the tax treaty. The
interpretation and/or application of that rule would clearly fall within the scope of the
MAP.
14.
In this regard, it should be emphasised that the obligation to provide access to the
mutual agreement procedure pursuant to paragraph 1 of Article 25 is distinct from the
obligation to endeavour to resolve the case pursuant to paragraph 2 of Article 25 and from
any obligation to submit an issue to arbitration that may arise under treaties that contain
an arbitration provision. The provisions of paragraph 1 give the taxpayer concerned the
right to present a case to the competent authority where the taxpayer considers that there
is or will be taxation not in accordance with the provisions of the Convention. To be
admissible, a case presented under paragraph 1 must be presented within three years from
the first notification of the action which gives rise to taxation not in accordance with the
Convention. Once a case that meets the requirements of paragraph 1 has been accepted,
the competent authority to which the case was presented must determine whether the
taxpayers objection appears to be justified. If that is the case, that competent authority
may be able to resolve the case unilaterally, e.g. where the taxation contrary to the
provisions of the Convention is due in whole or in part to a measure taken in the State to
which the taxpayer has presented its MAP case. A MAP case that has been accepted will
only move to the second, bilateral stage of the mutual agreement procedure where it
meets the two requirements provided by paragraph 2 of Article 25: (i) the taxpayers
objection appears to be justified to the competent authority to which it has been presented
and (ii) that competent authority is not itself able to arrive at a satisfactory unilateral
solution. Finally, arbitration will only be available if the relevant treaty allows arbitration
of the issue that the two competent authorities are subsequently unable to resolve under
the bilateral stage of the procedure paragraph 2 of Article 25.
15.
With regard to the threshold issue of the acceptance of a MAP case for
consideration (i.e. MAP access), where there is a disagreement between the taxpayer and
the competent authority to which its MAP case is presented as to whether the conditions
for the application of a treaty anti-abuse rule (e.g. a treaty-based rule such as the PPT
rule) have been met or whether the application of a domestic anti-abuse rule conflicts
with the provisions of a treaty, taxpayers should be provided access to the mutual
agreement procedure where they meet the requirements of paragraph 1 of Article 25. If a
country would seek to limit or deny MAP access in all or certain of these cases, it should
specifically and expressly agree on such limitations with its treaty partners, which should
include a requirement to notify treaty partner competent authorities about such cases and
the facts and circumstances involved.
16.
The commitment under 1.2 of the minimum standard deals only with access to
MAP, which, as explained in paragraph 14, is distinct from any obligation to endeavour
to resolve the case pursuant to paragraph 2 of Article 25 and from any obligation to
submit an issue to arbitration that may arise under treaties that contain an arbitration
provision, whether mandatory or not. That commitment should therefore not be
interpreted as including any implicit commitment with respect to these other obligations.
Also, States whose practices may not currently conform to that element of the minimum
standard agree to make that commitment with respect to new MAP requests.
17.
It is intended to make amendments to the Commentary on Article 25 as part of the
next update of the OECD Model Tax Convention in order to clarify the circumstances in
which a Contracting State may deny access to the mutual agreement procedure.
1.3
Countries should commit to a timely resolution of MAP cases: Countries commit

to seek to resolve MAP cases within an average timeframe of 24 months.
Countries progress toward meeting that target will be periodically reviewed on
the basis of the statistics prepared in accordance with the agreed reporting
framework referred to in element 1.5.
18.
Whilst the time taken to resolve a MAP case may vary according to its
complexity, most competent authorities endeavour to reach bilateral agreement for the
resolution of a MAP case within 24 months. Countries should thus commit to seek to
resolve MAP cases within an average timeframe of 24 months. Countries progress
toward meeting that target will be periodically reviewed on the basis of the statistics
prepared in accordance with the agreed reporting framework referred to below in element
1.5. This reporting framework will include agreed milestones for the initiation and

conclusion/closing of a MAP case, as well as for other relevant stages of the MAP
process. It is also contemplated that the work to develop the reporting framework will
seek to establish agreed target timeframes for these different stages of the MAP process.
1.4
Countries should enhance their competent authority relationships and work

collectively to improve the effectiveness of the MAP by becoming members of
the Forum on Tax Administration MAP Forum (FTA MAP Forum).
19.
The Forum on Tax Administration (FTA) is a subsidiary body of the OECD
Committee on Fiscal Affairs and brings together Commissioners from 46 countries1 to
develop on an equal footing a global response to tax administration issues in a
collaborative fashion. The Forum on Tax Administration MAP Forum (FTA MAP
Forum) is a forum of FTA participant country competent authorities created to deliberate
on general matters affecting all participants MAP programmes that has developed a
multilateral strategic plan2 to collectively improve the effectiveness of the mutual
agreement procedure in order to meet the needs of both governments and taxpayers and
so assure the critical role of the MAP in the global tax environment. In light of the
objectives of the FTA MAP Forum and, in particular, in view of the role of the FTA
MAP Forum in monitoring the implementation of the minimum standard set out in this
Report (see element 1.6 below) countries should become members of the FTA MAP
Forum and participate fully in its work.
1.5
Countries should provide timely and complete reporting of MAP statistics,

pursuant to an agreed reporting framework to be developed in co-ordination
with the FTA MAP Forum.
20.
Since 2006, the OECD has collected and published MAP statistics from OECD
member countries and from non-OECD economies that agree to provide these statistics.
These statistics provide transparency with respect to each reporting economies MAP
programme as well as a comprehensive picture of the overall state of the MAP in all of
the economies reporting statistics. In the context of the work on Action 14, MAP statistics
should be expected to provide a tangible measure to evaluate the effects of the
implementation of the minimum standard set out in this Report and will be an important
component of the monitoring mechanism described in Section I.C of this Report.
Countries should accordingly provide a timely and complete reporting of MAP statistics,
pursuant to an agreed reporting framework that will be developed in co-ordination with
the FTA MAP Forum. As noted above, this reporting framework will include agreed
milestones for the initiation and conclusion/closing of a MAP case, as well as for other
relevant stages of the MAP process.
1.6
Countries should commit to have their compliance with the minimum standard
reviewed by their peers in the context of the FTA MAP Forum.
21.
As provided above in element 1.4 of the minimum standard, countries should
become members of the FTA MAP Forum and participate fully in its work. Countries
should further commit to have their compliance with the minimum standard reviewed by
their peers (i.e. the other members of the FTA MAP Forum) through an agreed
monitoring mechanism that will be developed in co-ordination with the FTA MAP
Forum. A framework describing the general features of the monitoring mechanism is

provided in Section I.C of this Report. Such monitoring is essential to ensure the
meaningful implementation of the minimum standard provided in Section I.A of this
Report.
1.7
Countries should provide transparency with respect to their positions on MAP

arbitration.
22.
Mandatory binding MAP arbitration has been included in a number of bilateral
treaties following its introduction in paragraph 5 of Article 25 of the OECD Model Tax
Convention in 2008. A footnote to paragraph 5 notes that national law, policy or
administrative considerations may not allow or justify this type of dispute resolution and
that States should only include the provision in the Convention where they conclude that
it would be appropriate to do so, based on the factors described in paragraph 65 of the
Commentary on Article 25. Based on the footnote and paragraph 65 of the Commentary
on Article 25, it is unnecessary for countries to enter reservations (in the case of OECD
member countries3) or positions (in the case of non-OECD economies4) on the provision.
As a consequence, however, there is a lack of transparency as to countries positions with
respect to MAP arbitration.
23.
In order to provide transparency with respect to country positions on MAP
arbitration, the footnote to paragraph 5 of Article 25 will be deleted and paragraph 65 of
the Commentary on Article 25 will be appropriately amended when the OECD Model
Tax Convention is next updated. Consequential changes to the Commentary on Article 25
would also be made at the same time as these amendments. These changes to the
Commentary on Article 25 will include in particular suitable alternative provisions for
those countries that prefer to limit the scope of MAP arbitration to an appropriately
defined subset of MAP cases.
2.
Countries should ensure that administrative processes promote the prevention

and timely resolution of treaty-related disputes
24.
Appropriate administrative processes and practices are important to ensure an
environment in which competent authorities are able to fully and effectively carry out
their mandate to take an objective view of treaty provisions and apply them in a fair and
consistent manner to the facts and circumstances of each taxpayers specific case. The
elements of the minimum standard set out in Section I.A.2 are intended to address a
number of different obstacles to the prevention and timely resolution of disputes through
the mutual agreement procedure that are related to the internal operations of a tax
administration and the competent authority function, as well as to the transparency of
procedures to use the MAP and to the approaches used by competent authorities to
address proactively potential disputes.
2.1
Countries should publish rules, guidelines and procedures to access and use
the MAP and take appropriate measures to make such information available to
taxpayers. Countries should ensure that their MAP guidance is clear and
easily accessible to the public.
25.
Countries should develop and publish rules, guidelines and procedures for their
MAP programmes, which should include guidance on how taxpayers may make requests
for competent authority assistance. Such guidance should be drafted in clear and plain
language and should be readily accessible to the public (e.g. made available on the
websites of the tax administration and/or ministry of finance). Since such information
may be of particular relevance where an adjustment may potentially involve issues within
the scope of a tax treaty (e.g. where a transfer pricing adjustment is made with respect to
a controlled transaction with an associated enterprise in a treaty jurisdiction), countries
should take appropriate measures to ensure that their MAP programme published
guidance is available to taxpayers in such cases.
2.2
Countries should publish their country MAP profiles on a shared public

platform (pursuant to an agreed template to be developed in co-ordination with
the FTA MAP Forum).
26.
In order to promote the transparency and dissemination of MAP programme
published guidance, countries should publish their country MAP profiles on a shared
public platform (e.g. dedicated website). For these purposes, a country MAP profile
should be understood as a document providing competent authority contact details, links
to domestic MAP guidelines and other useful country-specific information regarding the
MAP process. A template for the content of the country MAP profiles will be developed
in co-ordination with the FTA MAP Forum. The development of this template will take
into account the need for transparency with respect to country positions in relation to the
best practices contained in this Report.
2.3
Countries should ensure that the staff in charge of MAP processes have the
authority to resolve MAP cases in accordance with the terms of the applicable
tax treaty, in particular without being dependent on the approval or the
direction of the tax administration personnel who made the adjustments at
issue or being influenced by considerations of the policy that the country
would like to see reflected in future amendments to the treaty.
27.
Countries internal guidance and procedures for the operation of their MAP
programmes should clearly establish that their staff in charge of MAP processes have the
authority to resolve MAP cases in accordance with the terms of the applicable tax treaty,
based on the objective and consistent application of treaty provisions to the specific facts
and circumstances of a taxpayers case, with a view to eliminating taxation not in
accordance with the treaty. Such internal guidance and procedures should, in particular,
provide that the competent authority does not require the approval or direction of the tax
administration personnel who made the adjustments at issue to resolve a MAP case and
that, in resolving a MAP case, the competent authority should not be influenced by
considerations of the policy that the country would like to see adopted and reflected in
future amendments to the treaty (or, more broadly, to the countrys preferred negotiating
position with respect to all of its future treaties). The commitment to ensure that the staff
in charge of MAP cases have the authority to resolve MAP cases pursuant to element 2.3
of the minimum standard must be understood to include a commitment to ensure the
timely implementation of the agreements that are reached by competent authorities
through the MAP process.
2.4
Countries should not use performance indicators for their competent authority
functions and staff in charge of MAP processes based on the amount of
sustained audit adjustments or maintaining tax revenue.
28.
Countries internal procedures for the operation of their MAP programmes should
clearly establish that the performance of their competent authority functions and staff in
charge of MAP processes shall not be evaluated based on criteria such as the amount of
sustained audit adjustments or the maintenance of tax revenue. These internal procedures
should instead provide that competent authority functions and staff in charge of MAP
processes will be evaluated based on appropriate performance indicators, which could
include
number of MAP cases resolved;
consistency (i.e. a treaty should be applied in a principled and consistent manner to
MAP cases involving the same facts and similarly-situated taxpayers); and
time taken to resolve a MAP case (recognising that the time taken to resolve a
MAP case may vary according to its complexity and that matters not under the
control of a competent authority may have a significant impact on the time needed
to resolve a case).
2.5
Countries should ensure that adequate resources are provided to the MAP
function.
29.
Countries should ensure that adequate resources including personnel, funding,
training and other programme needs are provided to the MAP function, in order to
enable competent authorities to carry out their mandate to resolve cases of taxation not in
accordance with the provisions of the Convention in a timely and effective manner.
2.6
Countries should clarify in their MAP guidance that audit settlements between tax
authorities and taxpayers do not preclude access to MAP. If countries have an
administrative or statutory dispute settlement/resolution process independent from the
audit and examination functions and that can only be accessed through a request by
the taxpayer, countries may limit access to the MAP with respect to the matters
resolved through that process. Countries should notify their treaty partners of such
administrative or statutory processes and should expressly address the effects of those
processes with respect to the MAP in their public guidance on such processes and in
their public MAP programme guidance.

30.
Countries MAP programme guidance should make clear that audit settlements
between the tax authorities and taxpayers do not preclude access to the mutual agreement
procedure.5 In such cases, after the mutual agreement procedure has been initiated, the
competent authority should independently consider whether the audit settlement would
result for the taxpayer in taxation not in accordance with the provisions of the
Convention, recognising the fundamental role of the competent authority in ensuring the
proper application and interpretation of a countrys tax treaties. Even where the
competent authority would not consider the taxpayers objection to be justified, it should
provide appropriate notification of the case to the competent authority of its treaty
partner. It must be understood that the question of providing access to MAP in a case in
which a taxpayer has reached an audit settlement with the tax authorities is distinct from
the question of whether MAP arbitration is available (where the relevant treaty contains
an arbitration provision); MAP arbitration will only be available with respect to a case
that has been provided access to the mutual agreement procedure where the case satisfies
the requirements of paragraph 2 of Article 25 (i.e. the competent authority to which the
case is presented considers the taxpayers objection to be justified), as well as those of the
applicable arbitration provision.
31.
Where, however, a country has in place an administrative or statutory dispute
settlement or resolution process independent from the audit and examination functions
and that can only be accessed through a request by the taxpayer, that country may limit
access to the mutual agreement procedure with respect to the matters resolved through
that administrative or statutory process. This would include, for example, a settlement
process that clearly provides for a voluntary request by the taxpayer for a final audit
settlement and clearly ensures that this request is made to and decided upon by a body
consisting of persons that have neither directly nor indirectly been involved in the audit
itself and that have the authority to independently decide on the settlement in a way that
ensures that the settlement is in line with the applicable legislation, including any
applicable treaty. Countries should in all cases notify their treaty partners of such
processes. Countries should in addition expressly address the effects of such processes
with respect to the MAP in their public guidance on these processes and in their public
MAP programme guidance, in order to ensure that taxpayers who choose to make use of
these processes are fully informed of the consequences as far as their access to the MAP
is concerned.
32.
It is expected that the issue of MAP access for cases in which there has been an
audit settlement will be addressed in amendments to the Commentary on Article 25 when
the OECD Model Tax Convention is next updated. These amendments would address in
particular the policy considerations that support the provision of MAP access in such
cases, notably the double taxation that may result where a taxpayer is required to give up
the right to have questions related to the interpretation and application of a treaty resolved
bilaterally through the mutual agreement procedure.
2.7
Countries with bilateral advance pricing arrangement (APA) programmes

should provide for the roll-back of APAs in appropriate cases, subject to the
applicable time limits (such as statutes of limitation for assessment) where the
relevant facts and circumstances in the earlier tax years are the same and
subject to the verification of these facts and circumstances on audit.
33.
Where a country has implemented a bilateral advance pricing arrangement (APA)
programme (see best practice 4 below), situations may arise in which the issues resolved
through an APA are relevant with respect to previous filed tax years not included within
the original scope of the APA. The roll-back of the APA to these previous years may be
helpful to prevent or resolve potential transfer pricing disputes. Countries with bilateral
APA programmes should accordingly provide for the roll-back of APAs in appropriate
cases where the relevant facts and circumstances in the earlier tax years are the same and
subject to the verification of these facts and circumstances on audit. The roll-back of an
APA will remain subject to the applicable time limits: those provided by Article 25 where
a MAP request has been or will be made with respect to the earlier tax years; or those
provided by the relevant domestic law (such as statutes of limitation for assessment)
where no MAP request has been or will be made with respect to the earlier tax years.
Downward adjustments should only be made after notification to or consultation with the
other competent authority, in order to prevent an outcome that leads to non-taxation of all
or part of the adjusted profits.
3.
Countries should ensure that taxpayers that meet the requirements of

paragraph 1 of Article 25 can access the mutual agreement procedure
34.
Certain of the main obstacles to the resolution of treaty-related disputes through
the mutual agreement procedure are issues regarding the extent of the treaty obligation to
provide MAP access. Such issues are likely to become more significant as a result of the
work on BEPS, as more stringent rules are implemented and tax administrations are
required to develop both practical experience and common interpretations in relation to
new tax treaty and transfer pricing rules. The elements of the minimum standard set out in
Section I.A.3 are intended to ensure that taxpayers that meet the requirements of
paragraph 1 of Article 25 have access to the mutual agreement procedure.
3.1
Both competent authorities should be made aware of MAP requests being

submitted and should be able to give their views on whether the request is
accepted or rejected. In order to achieve this, countries should either:
amend paragraph 1 of Article 25 to permit a request for MAP
assistance to be made to the competent authority of either Contracting
State, or
where a treaty does not permit a MAP request to be made to either
Contracting State, implement a bilateral notification or consultation
process for cases in which the competent authority to which the MAP
case was presented does not consider the taxpayers objection to be
justified (such consultation shall not be interpreted as consultation as
to how to resolve the case).
35.
The competent authorities of both Contracting States should be made aware of the
MAP requests that are submitted pursuant to paragraph 1 of Article 25 and have the
opportunity to provide their views on whether the MAP request should be accepted or
rejected and on whether the taxpayers objection is considered to be justified. To achieve
this objective, countries should take one of two alternative approaches: (i) amend
paragraph 1 of Article 25 to permit a request for MAP assistance to be made to the
competent authority of either Contracting State; or (ii) implement a bilateral notification
or consultation process for cases with respect to which the competent authority to which
the case is presented does not consider the taxpayers objection to be justified (making
clear that such notification or consultation should not be interpreted as consultation as to
how to resolve the case).
36.
The following changes will be made to paragraph 1 of Article 25 and the
Commentary thereon to reflect these conclusions:
Replace paragraph 1 of Article 25 by the following:
1. Where a person considers that the actions of one or both of the Contracting
States result or will result for him in taxation not in accordance with the provisions of
this Convention, he may, irrespective of the remedies provided by the domestic law of
those States, present his case to the competent authority of eitherthe Contracting State
of which he is a resident or, if his case comes under paragraph 1 of Article 24, to that
of the Contracting State of which he is a national. The case must be presented within
three years from the first notification of the action resulting in taxation not in
accordance with the provisions of the Convention.
Replace paragraph 7 of the Commentary on Article 25 by the following:
7. The rules laid down in paragraphs 1 and 2 provide for the elimination in a
particular case of taxation which does not accord with the Convention. As is known,
in such cases it is normally open to taxpayers to litigate in the tax court, either
immediately or upon the dismissal of their objections by the taxation authorities.
When taxation not in accordance with the Convention arises from an incorrect
application of the Convention in both States, taxpayers are then obliged to litigate in
each State, with all the disadvantages and uncertainties that such a situation entails. So
paragraph 1 makes available to taxpayers affected, without depriving them of the
ordinary legal remedies available, a procedure which is called the mutual agreement
procedure because it is aimed, in its second stage, at resolving the dispute on an

agreed basis, i.e. by agreement between competent authorities, the first stage being
conducted exclusively in one of the Contracting Statesthe State of residence (except
where the procedure for the application of paragraph 1 of Article 24 is set in motion
by the taxpayer in the State of which he is a national) from the presentation of the
objection up to the decision taken regarding it by the competent authority on the
matter.
Replace paragraphs 16 to 19 of the Commentary on Article 25 by the following:
16. To be admissible objections presented under paragraph 1 must first meet a
twofold requirement expressly formulated in that paragraph: in principle, they must be
presented to the competent authority of either Contracting Statethe taxpayers State
of residence (except where the procedure for the application of paragraph 1 of Article
24 is set in motion by the taxpayer in the State of which he is a national), and they
must be so presented within three years of the first notification of the action which
gives rise to taxation which is not in accordance with the Convention. The Convention
does not lay down any special rule as to the form of the objections. The competent
authorities may prescribe special procedures which they feel to be appropriate. If no
special procedure has been specified, the objections may be presented in the same way
as objections regarding taxes are presented to the tax authorities of the State
concerned.
17. The requirement laid onoption provided to the taxpayer to present his case to the
competent authority of either Contractingthe State is intended to reinforce the general
principle that access to the mutual agreement procedure should be as widely available
as possible and to provide flexibility. This option is also intended to ensure that the
decision as to whether a case should proceed to the second stage of the mutual
agreement procedure (i.e. be discussed by the competent authorities of both
Contracting States) is open to consideration by both competent authorities. Paragraph
1 permits a person to present his case to the competent authority of either Contracting
State; it does not preclude a person from presenting his case to the competent
authorities of both Contracting States at the same time (see paragraph 75 below).
Where a person presents his case to the competent authorities of both Contracting
States, he should appropriately inform both competent authorities, in order to facilitate
a co-ordinated approach to the case.of which he is a resident (except where the
procedure for the application of paragraph 1 of Article 24 is set in motion by the
taxpayer in the State of which he is a national) is of general application, regardless of
whether the taxation objected to has been charged in that the other State and regardless
of whether it has given rise to double taxation or not. If the taxpayer should have
transferred his residence to the other Contracting State subsequently to the measure or
taxation objected to, he must nevertheless still present his objection to the competent
authority of the State in which he was a resident during the year in respect of which
such taxation has been or is going to be charged.
18. However, in the case already alluded to where a person who is a national of one
State but a resident of the other complains of having been subjected in that other State
to an action or taxation which is discriminatory under paragraph 1 of Article 24, it
appears more appropriate for obvious reasons to allow him, by way of exception to
the general rule set forth above, to present his objection to the competent authority of
the Contracting State of which he is a national. Finally, it is to the same competent
authority that an objection has to be presented by a person who, while not being a

resident of a Contracting State, is a national of a Contracting State, and whose case
comes under paragraph 1 of Article 24.
19. On the other hand, Contracting States may, if they consider it preferable,
givethat taxpayers should not have the option of presenting their cases to the
competent authority of either State, but should, in the first instance, be required to
present their cases to the competent authority of the State of which they are
resident. However, where a person who is a national of one State but a resident of
the other complains of having been subjected in that other State to taxation (or any
requirement connected therewith) which is discriminatory under paragraph 1 of
Article 24, it appears more appropriate for obvious reasons to allow him, by way of
exception to the alternative rule which obliges the taxpayer to present his case to the
competent authority of his State of residence, to present his objection to the
competent authority of the Contracting State of which he is a national. Similarly, it
appears more appropriate thatFinally, it iswould be to the same competent authority
that an objection has toshould be presented by a person who, while not being a
resident of a Contracting State, is a national of a Contracting State, and whose case
comes under paragraph 1 of Article 24. To accommodate the alternative rule and the
exception for cases coming under paragraph 1 of Article 24, paragraph 1 would have
to be modified as follows:
1. Where a person considers that the actions of one or both of the Contracting
States result or will result for him in taxation not in accordance with the provisions
of this Convention, he may, irrespective of the remedies provided by the domestic
law of those States, present his case to the competent authority of eitherthe
Contracting State of which he is a resident or, if his case comes under paragraph 1
of Article 24, to that of the Contracting State of which he is a national. The case
must be presented within three years from the first notification of the action resulting
in taxation not in accordance with the provisions of the Convention.
Contracting States that prefer this alternative rule should take appropriate
measures to ensure broad access to the mutual agreement procedure and that the
decision as to whether a case should proceed to the second stage of the mutual
agreement procedure is appropriately considered by both competent authorities.
19. It may be noted that if the taxpayer becomes a resident of the other
Contracting State subsequently to the taxation he considers not in accordance with
the Convention, he must, under the alternative rule in paragraph 18 above,
nevertheless still present his objection to the competent authority of the State of
which he was a resident during the period in respect of which such taxation has
been or will be charged.
Replace paragraphs 31 to 35 of the Commentary on Article 25 by the following:
31. In the first stage, which opens with the presentation of the taxpayers objections,
the procedure takes place exclusively at the level of dealings between him and the
competent authorities of his the State to which the case was presented of residence
(except where the procedure for the application of paragraph 1 of Article 24 is set in
motion by the taxpayer in the State of which he is a national). The provisions of
paragraph 1 give the taxpayer concerned the right to apply to the competent authority
of theeither State of which he is a resident, whether or not he has exhausted all the
remedies available to him under the domestic law of each of the two States. On the
other hand, the competent authority is under an obligation to consider whether the
objection is justified and, if it appears to be justified, take action on it in one of the

two forms provided for in paragraph 2.
31.1 The determination whether the objection appears to be justified requires
the competent authority to which the case was presented to make a preliminary
assessment of the taxpayers objection in order to determine whether the taxation in
both Contracting States is consistent with the terms of the Convention. It is
appropriate to consider that the objection is justified where there is, or it is
reasonable to believe that there will be, in either of the Contracting States, taxation
not in accordance with the Convention.
32. If the competent authority duly approached recognises that the complaint is
justified and considers that the taxation complained of is due wholly or in part to a
measure taken in that the taxpayersState of residence, it must give the complainant
satisfaction as speedily as possible by making such adjustments or allowing such
reliefs as appear to be justified. In this situation, the issue can be resolved without
moving beyond the first (unilateral) stage ofresort to the mutual agreement
procedure. On the other hand, it may be found useful to exchange views and
information with the competent authority of the other Contracting State, in order, for
example, to confirm a given interpretation of the Convention.
33. If, however, it appears to that competent authority that the taxation complained
of is due wholly or in part to a measure taken in the other State, it will be incumbent
on it, indeed, it will be its duty as clearly appears by the terms of paragraph 2 to
set in motion the second (bilateral) stage of the mutual agreement procedure proper.
It is important that the competent authority in question carry out this duty as quickly
as possible, especially in cases where the profits of associated enterprises have been
adjusted as a result of transfer pricing adjustments.
34. A taxpayer is entitled to present his case under paragraph 1 to the competent
authority of eitherthe State of which he is a resident whether or not he may also have
made a claim or commenced litigation under the domestic law of one (or both) of
thethat States. If litigation is pending in the State to which the claim is presented, the
competent authority of that the State of residence should not wait for the final
adjudication, but should say whether it considers the case to be eligible for the mutual
agreement procedure. If it so decides, it has to determine whether it is itself able to
arrive at a satisfactory solution or whether the case has to be submitted to the
competent authority of the other Contracting State. An application by a taxpayer to set
the mutual agreement procedure in motion should not be rejected without good
reason.
35. If a claim has been finally adjudicated by a court in eitherthe State of residence,
a taxpayer may wish even so to present or pursue a claim under the mutual agreement
procedure. In some States, the competent authority may be able to arrive at a
satisfactory solution which departs from the court decision. In other States, the
competent authority is bound by the court decision. It may nevertheless present the
case to the competent authority of the other Contracting State and ask the latter to take
measures for avoiding double taxation.
3.2
Countries published MAP guidance should identify the specific information

and documentation that a taxpayer is required to submit with a request for
MAP assistance. Countries should not limit access to MAP based on the
argument that insufficient information was provided if the taxpayer has
provided the required information.
37.
Element 2.1 of the minimum standard provides that countries should develop and
publish rules, guidelines and procedures for their MAP programmes, which should
include guidance on how taxpayers may make requests for competent authority
assistance. This published MAP guidance should in particular identify the specific
information and documentation that a taxpayer is required to submit with a request for
MAP assistance. Where a taxpayer has provided the required information and
documentation consistent with such guidance, a competent authority should not deny the
taxpayer MAP access based on the argument that the taxpayer has provided insufficient
information. The FTA MAP Forum will develop guidance on the specific information and
documentation required to be submitted with a request for MAP assistance.
3.3
Countries should include in their tax treaties the second sentence of paragraph
2 of Article 25 (Any agreement reached shall be implemented notwithstanding
any time limits in the domestic law of the Contracting States). Countries that
cannot include the second sentence of paragraph 2 of Article 25 in their tax
treaties should be willing to accept alternative treaty provisions that limit the
time during which a Contracting State may make an adjustment pursuant to
Article 9(1) or Article 7(2), in order to avoid late adjustments with respect to
which MAP relief will not be available.
38.
The second sentence of paragraph 2 of Article 25 provides that any mutual
agreement reached by the competent authorities pursuant to that paragraph shall be
implemented notwithstanding the time limits in the domestic law of the Contracting
States. Paragraph 29 of the Commentary on Article 25 recognises that this sentence
unequivocally states the obligation to implement such agreements and notes that
impediments to implementation that exist at the time a tax treaty is entered into should
generally be built into the terms of the agreement itself. Countries should accordingly
include the second sentence of paragraph 2 of Article 25 in their tax treaties to ensure that
domestic law time limits do not prevent the implementation of competent authority
mutual agreements and thereby frustrate the objective of resolving cases of taxation not in
accordance with the Convention.
39.
Where a country cannot include the second sentence of paragraph 2 of Article 25
in its tax treaties (i.e. where a country has a reservation or position with respect to the
second sentence of paragraph 2 of Article 25), it should be willing to accept the following
alternative treaty provisions that limit the time during which a Contracting State may
make an adjustment pursuant to Article 9(1) or Article 7(2), in order to avoid late
adjustments with respect to which MAP relief will not be available. It is understood that
such a country would satisfy this element of the minimum standard where these
alternative treaty provisions are drafted to reflect the time limits for adjustments provided
for in that countrys domestic law; it is also understood that a country that prefers to
include the second sentence of paragraph 2 of Article 25 would not be obliged to accept
such alternative provisions.
[In Article 7]:
A Contracting State shall make no adjustment to the profits that are attributable to
a permanent establishment of an enterprise of one of the Contracting States after
[bilaterally agreed period] from the end of the taxable year in which the profits
would have been attributable to the permanent establishment. The provisions of this
paragraph shall not apply in the case of fraud, gross negligence or wilful default.
[In Article 9]:
3. A Contracting State shall not include in the profits of an enterprise, and tax
accordingly, profits that would have accrued to the enterprise but by reason of the
conditions referred to in paragraph 1 have not so accrued, after [bilaterally agreed
period] from the end of the taxable year in which the profits would have accrued to
the enterprise. The provisions of this paragraph shall not apply in the case of fraud,
gross negligence or wilful default.
40.
The following changes to the Commentaries on Article 7 and Article 9 will
provide the possibility of using such alternative provisions:
62. Like paragraph 2 of Article 9, paragraph 3 leaves open the question whether
there should be a period of time after the expiration of which a State would not be
obliged to make an appropriate adjustment to the profits attributable to a permanent
establishment following an upward revision of these profits in the other State. Some
States consider that the commitment should be open-ended in other words, that
however many years the State making the initial adjustment has gone back, the
enterprise should in equity be assured of an appropriate adjustment in the other State.
Other States consider that an open-ended commitment of this sort is unreasonable as a
matter of practical administration. This problem has not been dealt with in the text of
either paragraph 2 of Article 9 or paragraph 3 but Contracting States are left free in
bilateral conventions to include, if they wish, provisions dealing with the length of
time during which a State should be obliged to make an appropriate adjustment (see
on this point paragraphs 39, 40 and 41 of the Commentary on Article 25). Contracting
States may also wish to address this issue through a provision limiting the length of
time during which an adjustment may be made pursuant to paragraph 2 of Article
7; such a solution avoids the double taxation that may otherwise result where there
is no adjustment in the other State pursuant to paragraph 3 of Article 7 following
the first States adjustment pursuant to paragraph 2 of Article 7. Contracting States
that wish to achieve that result may agree bilaterally to add the following paragraph
after paragraph 4:
5. A Contracting State shall make no adjustment to the profits that are
attributable to a permanent establishment of an enterprise of one of the
Contracting States after [bilaterally agreed period] from the end of the taxable
year in which the profits would have been attributable to the permanent
establishment. The provisions of this paragraph shall not apply in the case of
fraud, gross negligence or wilful default.

10. The paragraph also leaves open the question whether there should be a period of
time after the expiration of which State B would not be obliged to make an
appropriate adjustment to the profits of enterprise Y following an upward revision of
the profits of enterprise X in State A. Some States consider that State Bs commitment
should be open-ended in other words, that however many years State A goes back
to revise assessments, enterprise Y should in equity be assured of an appropriate
adjustment in State B. Other States consider that an open-ended commitment of this
sort is unreasonable as a matter of practical administration. In the circumstances,
therefore, this problem has not been dealt with in the text of the Article; but
Contracting States are left free in bilateral conventions to include, if they wish,
provisions dealing with the length of time during which State B is to be under
obligation to make an appropriate adjustment (see on this point paragraphs 39, 40
and 41 of the Commentary on Article 25). Contracting States may also wish to
address this issue through a provision limiting the length of time during which a
primary adjustment may be made pursuant to paragraph 1 of Article 9; such a
solution avoids the economic double taxation that may otherwise result where there
is no corresponding adjustment following the primary adjustment. Contracting
States that wish to achieve that result may agree bilaterally to add the following
paragraph after paragraph 2:
3. A Contracting State shall not include in the profits of an enterprise, and tax
accordingly, profits that would have accrued to the enterprise but by reason of the
conditions referred to in paragraph 1 have not so accrued, after [bilaterally agreed
period] from the end of the taxable year in which the profits would have accrued
to the enterprise. The provisions of this paragraph shall not apply in the case of
fraud, gross negligence or wilful default.
41.
Some countries may be willing to include the second sentence of paragraph 2 of
Article 25 in their tax treaties subject to agreement to limit the time during which a
Contracting State may make an adjustment pursuant to Article 9(1) or Article 7(2). This
reflects the view of some countries that an open-ended commitment to make a
corresponding adjustment is unreasonable as a matter of practical administration, but
certainty that double taxation will be relieved is appropriate if an adjustment pursuant to
Article 9(1) or Article 7(2) is made within a reasonable period. It is understood that a
country would meet the minimum standard where the second sentence of paragraph 2 of
Article 25 is included in its tax treaties in addition to the alternative provisions to Article
7 and Article 9 set out in paragraph 39 of this Report.
B. Best practices
42.
As noted above, the work mandated by Action 14 also identified a number of best
practices related to the three general objectives of the minimum standard. These best
practices, which are not part of the minimum standard, are set out below.
1.
procedure are fully implemented in good faith and that MAP cases are resolved
in a timely manner
Best practice 1: Countries should include paragraph 2 of Article 9 in their tax
treaties.
43.
Most countries consider that the economic double taxation resulting from the
inclusion of profits of associated enterprises under paragraph 1 of Article 9 is not in
accordance with the object and purpose of tax treaties and falls within the scope of the
mutual agreement procedure under Article 25. See generally paragraphs 10 to 12 of the
Commentary on Article 25. Some countries, however, take the position that, in the
absence of a treaty provision based on paragraph 2 of Article 9, they are not obliged to
make corresponding adjustments or to grant access to the MAP with respect to the
economic double taxation that may otherwise result from a primary transfer pricing
adjustment. Such a position frustrates a primary objective of tax treaties the elimination
of double taxation and prevents bilateral consultation to determine appropriate transfer
pricing adjustments. Element 1.1 of the minimum standard will ensure that access to
MAP is provided for such transfer pricing cases. However, it would be more efficient if
countries would also have the possibility to provide for corresponding adjustments
unilaterally in cases in which they find the objection of the taxpayer to be justified.
Countries should accordingly include paragraph 2 of Article 9 in their tax treaties, with
the understanding that such a change is not intended to create any negative inference with
respect to treaties that do not currently contain a provision based on paragraph 2 of
Article 9.
2.
Countries should ensure that administrative processes promote the prevention

and timely resolution of treaty-related disputes
Best practice 2: Countries should have appropriate procedures in place to publish
agreements reached pursuant to the authority provided by the first sentence of
paragraph 3 of Article 25 to resolve by mutual agreement any difficulties or
doubts arising as to the interpretation or application of the Convention that
affect the application of a treaty to all taxpayers or to a category of taxpayers
(rather than to a specific taxpayers MAP case) where such agreements provide
guidance that would be useful to prevent future disputes and where the competent
authorities agree that such publication is consistent with principles of sound tax
administration.
44.
The authority provided by the first sentence of paragraph 3 of Article 25 to
resolve by mutual agreement any difficulties or doubts arising as to the interpretation or
application of the Convention may be an effective tool to reinforce the consistent
bilateral application of tax treaties. Competent authorities should accordingly be
encouraged to make active use of that authority. Moreover, countries should have
appropriate procedures in place to publish Article 25(3) mutual agreements which relate
to general matters that affect the application of a treaty to all taxpayers or to a category of
taxpayers (rather than to a specific taxpayers MAP case), where these agreements
provide guidance that would be useful to prevent future disputes and where the competent
authorities agree that such publication is consistent with principles of sound tax
administration. It should be understood that procedures for the publication of Article

25(3) mutual agreements must include appropriate provisions to protect the
confidentiality of taxpayer information.
45.
It is intended to make amendments to the Commentary on Articles 3 and 25 of
the OECD Model Tax Convention as part of the next update of the OECD Model Tax
Convention in order to clarify the legal status of a mutual agreement entered into under
Article 25(3).
Best practice 3: Countries should develop the global awareness of the

audit/examination functions involved in international matters through the delivery
of the Forum on Tax Administrations Global Awareness Training Module to
appropriate personnel.
46.
The FTA MAP Forums Strategic Plan6 identifies a number of specific initiatives
to address particular challenges faced by competent authorities with respect to resources,
empowerment, relationships and posture, process improvements, relationship with the
audit function, and responsibility and accountability. A countrys participation in the FTA
MAP Forum reflects a commitment by participating competent authorities to advance
through these initiatives the goals reflected in the Strategic Plan and to be accountable for
these efforts to their FTA MAP Forum colleagues.
47.
The Strategic Plan notes that increasing the global awareness of the audit and
examination functions involved in international matters is of central importance in
preventing dysfunctional tax administration behaviours (e.g. unprincipled adjustments to
non-resident companies) and avoiding the disputes that these behaviours can create. In
this regard, the Strategic Plan provides: All audit functions involved in adjusting
taxpayer positions on international matters must be aware of (1) the potential for creating
double taxation, (2) the impact of proposed adjustments on the tax base of one or more
other jurisdictions, and (3) the processes and principles by which competing jurisdictional
claims are reconciled by competent authorities. One of the several initiatives pursued by
the FTA MAP Forum is thus to encourage the delivery of training on these matters, and
the FTA has prepared and approved a Global Awareness Training Module that may be
used for that purpose. Countries should seek to develop the global awareness of the audit
and examination functions of their tax administrations, making appropriate use of the
FTAs Global Awareness Training Module.
Best practice 4: Countries should implement bilateral APA programmes.

48.
An advance pricing arrangement (APA) is an arrangement that determines, in
advance of controlled transactions, an appropriate set of criteria (e.g. method,
comparables and appropriate adjustments thereto, critical assumptions as to future events)
for the determination of the transfer pricing for those transactions over a fixed period of
time. See paragraph 4.123 of the OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations. APAs concluded bilaterally between treaty partner
competent authorities provide an increased level of certainty in both jurisdictions, lessen
the likelihood of double taxation and may proactively prevent transfer pricing disputes.
Countries should accordingly seek to implement bilateral APA programmes as soon as
they have the capacity to do so.
Best practice 5: Countries should implement appropriate procedures to permit, in

certain cases and after an initial tax assessment, taxpayer requests for the multiyear resolution through the MAP of recurring issues with respect to filed tax
years, where the relevant facts and circumstances are the same and subject to the
verification of such facts and circumstances on audit. Such procedures would
remain subject to the requirements of paragraph 1 of Article 25: a request to
resolve an issue with respect to a particular taxable year would only be allowed
where the case has been presented within three years of the first notification of the
action resulting in taxation not in accordance with the Convention with respect to
that taxable year.
49.
In certain cases, a request for competent authority assistance in respect of a
specific adjustment to income may present recurring issues which will also be relevant in
previous or subsequent filed tax years. MAP procedures that allow a taxpayer also to
request MAP assistance with respect to such recurring issues for these other filed tax
years generally subject to the requirement that the relevant facts and circumstances are
the same and subject to the verification of such facts and circumstances may help to
avoid duplicative MAP requests and permit a more efficient use of competent authority
resources. Countries should accordingly seek to implement appropriate procedures to
permit, in certain cases and after an initial tax assessment, taxpayer requests for the multiyear resolution through the MAP of recurring issues with respect to filed tax years, where
the relevant facts and circumstances are the same and subject to the verification of such
facts and circumstances on audit. Such procedures would remain subject to the
requirements of paragraph 1 of Article 25: a MAP request to resolve an issue with respect
to a particular taxable year would only be allowed where the case has been presented
within three years of the first notification of the action resulting in taxation not in
accordance with the Convention with respect to that taxable year (i.e. such procedures
would not allow MAP requests that would be time-barred under paragraph 1 of
Article 25).
3.
Countries should ensure that taxpayers that meet the requirements of

paragraph 1 of Article 25 can access the mutual agreement procedure
Best practice 6: Countries should take appropriate measures to provide for a
suspension of collections procedures during the period a MAP case is pending.
Such a suspension of collections should be available, at a minimum, under the
same conditions as apply to a person pursuing a domestic administrative or
judicial remedy.
50.
Where the payment of tax is a requirement for MAP access, the taxpayer
concerned may face significant financial difficulties: if both Contracting States collect the
disputed taxes, double taxation will in fact occur and the resulting cash flow problems
may have a substantial impact on a taxpayers business, at least for as long as it takes to
resolve the MAP case. A competent authority may also find it more difficult to enter into
good faith MAP discussions when it considers that it may likely have to refund taxes
already collected. Countries should accordingly take appropriate measures to provide for
a suspension of collections procedures during the period a MAP case is pending. Such a
suspension of collections should be available, at a minimum, under the same conditions
as apply to a person pursuing a domestic administrative or judicial remedy. When the
OECD Model Tax Convention is next updated, it is expected that amendments related to
this best practice will be made to the Commentary on Article 25, in particular to expand
on existing Commentary describing the policy considerations that support a suspension of
collection procedures during the period a MAP case is pending.
Best practice 7: Countries should implement appropriate administrative measures

to facilitate recourse to the MAP to resolve treaty-related disputes, recognising
the general principle that the choice of remedies should remain with the taxpayer.
51.
The mutual agreement procedure provided for by Article 25 is available to
taxpayers irrespective of the judicial and administrative remedies provided by the
domestic law of the Contracting States. Because the constitutions and/or domestic law of
many countries provide that no person can be deprived of the judicial remedies available
under domestic law, a taxpayers choice of recourse is generally only constrained by
applicable time limits (such as those provided by a domestic law statute of limitation or
by paragraph 1 of Article 25) and by the circumstance that most tax administrations will
not deal with a taxpayers case through both the MAP and a domestic court or
administrative proceeding at the same time (i.e. one process will typically take
precedence over the other). Recognising, however, that an agreement reached through the
MAP will typically provide a comprehensive bilateral resolution of a case and thereby
ensure relief from double taxation countries should implement appropriate
administrative measures to facilitate recourse to the MAP to resolve treaty-related
disputes whilst observing the general principle that the choice of remedies should remain
with the taxpayer.
Best practice 8: Countries should include in their published MAP guidance an

explanation of the relationship between the MAP and domestic law administrative
and judicial remedies. Such public guidance should address, in particular,
whether the competent authority considers itself to be legally bound to follow a
domestic court decision in the MAP or whether the competent authority will not
deviate from a domestic court decision as a matter of administrative policy or
practice.
52.
The complex interaction between domestic law remedies and the MAP is
generally governed by a Contracting States domestic law and/or administrative
procedures (i.e. a tax treaty will generally not itself contain any provisions on this point)
and may thus give rise to uncertainty, particularly in light of the different approaches
adopted in different jurisdictions. Such uncertainty may concern, for example, the
continued availability of other remedies where a taxpayer has chosen first to pursue the
MAP and the extent to which a competent authority may depart from a decision by a
domestic court. Countries should thus include in their published MAP guidance (see
element 2.1 above) an explanation of the relationship between the MAP and domestic law
administrative and judicial remedies, including guidance on the processes involved and
the conditions, rules and deadlines associated with these processes. This public guidance
should specifically address whether the competent authority considers itself to be legally
bound to follow a domestic court decision in the MAP or whether the competent authority
will not deviate from a domestic court decision as a matter of administrative policy or
practice.
53.
The following changes will be made to the Commentary on Article 25 in order to
clarify the issue:
35. If a claim has been finally adjudicated by a court in the State of residence, a
taxpayer may wish even so to present or pursue a claim under the mutual agreement
procedure. In some States, the competent authority may be able to arrive at a

satisfactory solution which departs from the court decision. In other States, the
competent authority is bound by the court decision (i.e. it is obliged, as a matter of
law, to follow the court decision) or will not depart from the court decision as a
matter of administrative policy or practice. It may nevertheless present the case to the
competent authority of the other Contracting State and ask the latter to take measures
for avoiding double taxation.
42. The case may arise where a mutual agreement is concluded in relation to a
taxpayer who has brought a suit for the same purpose in the competent court of either
Contracting State and such suit is still pending. In such a case, there would be no
grounds for rejecting a request by a taxpayer that he be allowed to defer acceptance of
the solution agreed upon as a result of the mutual agreement procedure until the court
had delivered its judgment in that suit. Also, a view that competent authorities might
reasonably take is that where the taxpayers suit is ongoing as to the particular issue
upon which mutual agreement is sought by that same taxpayer, discussions of any
depth at the competent authority level should await a court decision. If the taxpayers
request for a mutual agreement procedure applied to different tax years than the court
action, but to essentially the same factual and legal issues, so that the court outcome
would in practice be expected to affect the treatment of the taxpayer in years not
specifically the subject of litigation, the position might be the same, in practice, as for
the cases just mentioned. In either case, awaiting a court decision or otherwise holding
a mutual agreement procedure in abeyance whilst formalised domestic recourse
proceedings are underway will not infringe upon, or cause time to expire from, the
two year period referred to in paragraph 5 of the Article. Of course, if competent
authorities consider, in either case, that the matter might be resolved notwithstanding
the domestic law proceedings (because, for example, the competent authority where
the court action is taken will not be legally bound or constrained by the court
decision) then the mutual agreement procedure may proceed as normal. A competent
authority may be precluded as a matter of law from maintaining taxation where a
court has decided that such taxation is not in accordance with the provisions of a
tax treaty. In contrast, in some countries a competent authority would not be legally
precluded from granting relief from taxation notwithstanding a court decision that
such taxation was in accordance with the provisions of a tax treaty. In such a case,
nothing (e.g. administrative policy or practice) should prevent the competent
authorities from reaching a mutual agreement pursuant to which a Contracting
State will relieve taxation considered by the competent authorities as not in
accordance with the provisions of the tax treaty, and thus depart from a decision
rendered by a court of that State.
Best practice 9: Countries published MAP guidance should provide that

taxpayers will be allowed access to the MAP so that the competent authorities
may resolve through consultation the double taxation that can arise in the case of
bona fide taxpayer-initiated foreign adjustments i.e. taxpayer-initiated
adjustments permitted under the domestic laws of a treaty partner which allow a
taxpayer under appropriate circumstances to amend a previously-filed tax return
to adjust (i) the price for a transaction between associated enterprises or (ii) the
profits attributable to a permanent establishment, with a view to reporting a result
that is, in the view of the taxpayer, in accordance with the arms length principle.
For such purposes, a taxpayer-initiated foreign adjustment should be considered
bona fide where it reflects the good faith effort of the taxpayer to report correctly
the taxable income from a controlled transaction or the profits attributable to a
permanent establishment and where the taxpayer has otherwise timely and
properly fulfilled all of its obligations related to such taxable income or profits
under the tax laws of the two Contracting States.
54.
Under the laws of some States, a taxpayer may be permitted under appropriate
circumstances to amend a previously filed tax return to adjust the price for a controlled
transaction between associated enterprises, or to adjust the profits attributable to a
permanent establishment, in order to reflect a result in accordance (in the view of the
taxpayer) with the arms length principle. Such a taxpayer-initiated adjustment may
include, for example, the filing of an amended tax return to reflect an arms length price
of a controlled transaction or other taxpayer action to adjust the previously-reported
attribution of profits to a permanent establishment to conform such attribution to the
separate entity and arms length principles on which Article 7 is based. In order to ensure
that competent authorities may resolve through consultation the double taxation that can
arise in the case of a bona fide taxpayer-initiated foreign adjustment i.e. any action
permitted under the domestic laws of a treaty partner and undertaken at the initiative of
the taxpayer to adjust the previously reported results of controlled transactions, or the
attribution of profits to a permanent establishment, in order to reflect an arms length
result countries MAP guidance should provide that taxpayers will be allowed access to
the MAP with respect to such adjustments. For such purposes, a taxpayer-initiated foreign
adjustment should be considered bona fide where it reflects the good faith effort of the
taxpayer to report correctly the taxable income from a controlled transaction or the profits
attributable to a permanent establishment and where the taxpayer has otherwise timely
and properly fulfilled all of its obligations related to such taxable income or profits under
the tax laws of the two Contracting States.
55.
The following changes will be made to the Commentaries on Articles 7, 9 and 25
in order to reflect this best practice:
Add the following paragraph 59.1 to the Commentary on Article 7:
59.1 Under the domestic laws of some countries, a taxpayer may be permitted under
appropriate circumstances to amend a previously-filed tax return to adjust the
profits attributable to a permanent establishment in order to reflect an attribution of
profits that is, in the taxpayers opinion, in accordance with the separate entity and
arms length principles underlying Article 7. Where they are made in good faith,
such adjustments may facilitate the proper attribution of profits to a permanent
establishment in conformity with paragraph 2 of Article 7. However, double
taxation may occur, for example, if such a taxpayer-initiated adjustment increases
the profits attributed to a permanent establishment located in one Contracting State
but there is no appropriate corresponding adjustment in the other Contracting
State. The elimination of such double taxation is within the scope of paragraph 3.
Indeed, to the extent that taxes have been levied on the increased profits in the firstmentioned State, that State may be considered to have adjusted the profits
attributable to the permanent establishment, and to have taxed, profits that have
been charged to tax in the other State. In these circumstances, Article 25 enables
the competent authorities of the Contracting States to consult together to eliminate
the double taxation; the competent authorities may accordingly, if necessary, use
the mutual agreement to determine whether the initial adjustment met the
conditions of paragraph 2 and, if that is the case, to determine the amount of the
appropriate adjustment to the amount of the tax charged on the profits attributable
to the permanent establishment so as to relieve the double taxation.
Add the following paragraph 6.1 to the Commentary on Article 9:
6.1 Under the domestic laws of some countries, a taxpayer may be permitted under
appropriate circumstances to amend a previously-filed tax return to adjust the price
for a transaction between associated enterprises in order to report a price that is, in
the taxpayers opinion, an arms length price. Where they are made in good faith,
such adjustments may facilitate the reporting of taxable income by taxpayers in
accordance with the arms length principle. However, economic double taxation
may occur, for example, if such a taxpayer-initiated adjustment increases the profits
of an enterprise of one Contracting State but there is no appropriate corresponding
adjustment to the profits of the associated enterprise in the other Contracting State.
The elimination of such double taxation is within the scope of paragraph 2. Indeed,
to the extent that taxes have been levied on the increased profits in the firstmentioned State, that State may be considered to have included in the profits of an
enterprise of that State, and to have taxed, profits on which an enterprise of the
other State has been charged to tax. In these circumstances, Article 25 enables the
competent authorities of the Contracting States to consult together to eliminate the
double taxation; the competent authorities may accordingly, if necessary, use the
mutual agreement procedure to determine whether the initial adjustment met the
conditions of paragraph 1 and, if that is the case, to determine the amount of the
appropriate adjustment to the amount of the tax charged in the other State on those
profits so as to relieve the double taxation.
23. In self assessment cases, there will usually be some notification effecting that
assessment (such as a notice of a liability or of denial or adjustment of a claim for
refund), and generally the time of notification, rather than the time when the taxpayer
lodges the self-assessed return, would be a starting point for the three year period to
run. Where a taxpayer pays additional tax in connection with the filing of an
amended return reflecting a bona fide taxpayer-initiated adjustment (as described
in paragraph 14 above), the starting point of the three year time limit would
generally be the notice of assessment or liability resulting from the amended return,
rather than the time when the additional tax was paid. There may, however, be cases
where there is no notice of a liability or the like. In such cases, the relevant time of
notification would be the time when the taxpayer would, in the normal course of
events, be regarded as having been made aware of the taxation that is in fact not in
accordance with the Convention. This could, for example, be when information
recording the transfer of funds is first made available to a taxpayer, such as in a bank
balance or statement. The time begins to run whether or not the taxpayer actually
regards the taxation, at that stage, as contrary to the Convention, provided that a
reasonably prudent person in the taxpayers position would have been able to
conclude at that stage that the taxation was not in accordance with the Convention. In
such cases, notification of the fact of taxation to the taxpayer is enough. Where,
however, it is only the combination of the self assessment with some other
circumstance that would cause a reasonably prudent person in the taxpayers position
to conclude that the taxation was contrary to the Convention (such as a judicial

decision determining the imposition of tax in a case similar to the taxpayers to be
contrary to the provisions of the Convention), the time begins to run only when the
latter circumstance materialises.
14. It should be noted that the mutual agreement procedure, unlike the disputed
claims procedure under domestic law, can be set in motion by a taxpayer without
waiting until the taxation considered by him to be not in accordance with the
Convention has been charged against or notified to him. To be able to set the
procedure in motion, he must, and it is sufficient if he does, establish that the actions
of one or both of the Contracting States will result in such taxation, and that this
taxation appears as a risk which is not merely possible but probable. Such actions
mean all acts or decisions, whether of a legislative or a regulatory nature, and whether
of general or individual application, having as their direct and necessary consequence
the charging of tax against the complainant contrary to the provisions of the
Convention. Thus, for example, if a change to a Contracting States tax law would
result in a person deriving a particular type of income being subjected to taxation not
in accordance with the Convention, that person could set the mutual agreement
procedure in motion as soon as the law has been amended and that person has derived
the relevant income or it becomes probable that the person will derive that income.
Other examples include filing a return in a self assessment system or the active
examination of a specific taxpayer reporting position in the course of an audit, to the
extent that either event creates the probability of taxation not in accordance with the
Convention (e.g. where the self assessment reporting position the taxpayer is required
to take under a Contracting States domestic law would, if proposed by that State as
an assessment in a non-self assessment regime, give rise to the probability of taxation
not in accordance with the Convention, or where circumstances such as a Contracting
States published positions or its audit practice create a significant likelihood that the
active examination of a specific reporting position such as the taxpayers will lead to
proposed assessments that would give rise to the probability of taxation not in
accordance with the Convention). Another example might be a case where a
Contracting States transfer pricing law requires a taxpayer to report taxable income in
an amount greater than would result from the actual prices used by the taxpayer in its
transactions with a related party, in order to comply with the arms length principle,
and where there is substantial doubt whether the taxpayers related party will be able
to obtain a corresponding adjustment in the other Contracting State in the absence of a
mutual agreement procedure. Such actions may also be understood to include the
bona fide taxpayer-initiated adjustments which are authorised under the domestic
laws of some countries and which permit a taxpayer, under appropriate
circumstances, to amend a previously-filed tax return in order to report a price in a
controlled transaction, or an attribution of profits to a permanent establishment,
that is, in the taxpayers opinion, in accordance with the arms length principle (see
paragraph 6.1 of the Commentary on Article 9 and paragraph 59.1 of the
Commentary on Article 7). As indicated by the opening words of paragraph 1,
whether or not the actions of one or both of the Contracting States will result in
taxation not in accordance with the Convention must be determined from the
perspective of the taxpayer. Whilst the taxpayers belief that there will be such
taxation must be reasonable and must be based on facts that can be established, the tax
authorities should not refuse to consider a request under paragraph 1 merely because
they consider that it has not been proven (for example to domestic law standards of
proof on the balance of probabilities) that such taxation will occur.
Best practice 10: Countries published MAP guidance should provide guidance
on the consideration of interest and penalties in the mutual agreement procedure.
56.
Issues related to competent authority consideration of interest and penalties in the
context of a MAP cases are of significant importance, particularly in light of the potential
for the work on BEPS to increase pressure on the mutual agreement procedure.
Countries published MAP guidance should accordingly provide guidance on the
consideration of interest and penalties in the mutual agreement procedure.
57.
It is intended to make amendments to the Commentary on Article 25 of the
OECD Model Tax Convention as part of the next update of the OECD Model Tax
Convention in order to address issues related to the consideration of interest and penalties
in the mutual agreement procedure.
Best practice 11: Countries published MAP guidance should provide guidance
on multilateral MAPs and advance pricing arrangements (APAs).
58.
In recent years, the substantial increase in the pace of globalisation has created
unique challenges for existing tax treaty dispute resolution mechanisms. Whilst the
mutual agreement procedure provided for in Article 25 of the OECD Model Tax
Convention has traditionally focused on the resolution of bilateral disputes, phenomena
such as the adoption of regional and global business models and the accelerated
integration of national economies and markets have emphasised the need for effective
mechanisms to resolve multi-jurisdictional tax disputes. Countries should accordingly
develop and include in their published MAP and advance pricing arrangement
programme guidance appropriate guidance on multilateral MAPs and APAs.
59.
It is intended to make amendments to the Commentary on Article 25 as part of
the next update of the OECD Model Tax Convention in order to address the issue of
multilateral MAPs and APAs.
C. A framework for a monitoring mechanism

60.
As already noted, the conclusions of the work carried out on Action 14 of the
BEPS Action Plan reflect the agreement that the implementation of the minimum
standard should be evaluated through a peer monitoring mechanism in order to ensure
that the commitments embodied in the minimum standard are effectively satisfied. The
monitoring mechanism will have the following general features:
1. All OECD and G20 countries, as well as jurisdictions that commit to the
minimum standard set out in Section I.A of this Report, will undergo reviews of
their implementation of the minimum standard. The reviews will evaluate the
legal framework provided by a jurisdictions tax treaties and domestic law and
regulations, the jurisdictions MAP programme guidance and the implementation
of the minimum standard in practice.
2. The core output of the peer monitoring process will come in the form of a report.
The report will identify and describe the strengths and any shortcomings that exist
and provide recommendations as to how the shortcomings might be addressed by
the reviewed jurisdiction.

3. The core documents for the peer monitoring process will be the Terms of
Reference and the Assessment Methodology. The Terms of Reference will be
based on the elements of the minimum standard set out in Section I.A of this
Report and will break down these elements into specific aspects against which
jurisdictions legal frameworks, MAP programme guidance and actual
implementation of the minimum standard are assessed. The Terms of Reference
will provide a clear roadmap for the monitoring process and will thereby ensure
that the assessment of all jurisdictions is consistent and complete. The Assessment
Methodology will establish detailed procedures and guidelines for peer
monitoring of OECD and G20 countries and other committed jurisdictions by the
FTA MAP Forum (see element 1.6 of the minimum standard) and will include a
system for assessing the implementation of the minimum standard.
4. Both the Terms of Reference and the Assessment Methodology will be developed
jointly by Working Party No. 1 and the FTA MAP Forum by the end of the first
quarter of 2016.
5. The peer monitoring process conducted by the FTA MAP Forum, reporting to the
G20 through the OECD Committee on Fiscal Affairs, will begin in 2016, with the
objective of publishing the first reports by the end of 2017.
61.
A mandate for the development of the Terms of Reference and the Assessment
Methodology is contained in the Annex to this Report.
Notes
1.
In addition to all OECD and G20 countries, FTA participating countries/jurisdictions

include Colombia, Hong Kong China, Malaysia and Singapore.
2.
See www.oecd.org/site/ctpfta/map-strategic-plan.pdf.
3.
See paragraph 31 of the Introduction to the OECD Model Tax Convention.
4.
See paragraph 5 of the Introduction to the Non-OECD Economies Positions on the

OECD Model Tax Convention.
5.
Element 2.6 of the minimum standard does not address transfer pricing safe harbours
provided under a countrys domestic law and no inference should accordingly be
drawn with respect to such safe harbours.
6.
Available at www.oecd.org/site/ctpfta/map-strategic-plan.pdf.
II. COMMITMENT TO MANDATORY BINDING MAP ARBITRATION 41
II.
Commitment to mandatory binding MAP arbitration
62.
The business community and a number of countries consider that mandatory
binding arbitration is the best way of ensuring that tax treaty disputes are effectively
resolved through MAP. Whilst there is no consensus among all OECD and G20 countries
on the adoption of arbitration as a mechanism to ensure the resolution of MAP cases, a
group of countries has committed to adopt and implement mandatory binding arbitration
as a way to resolve disputes that otherwise prevent the resolution of cases through the
mutual agreement procedure. The countries that have expressed interest in doing so
include Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, Japan,
Luxembourg, the Netherlands, New Zealand, Norway, Poland, Slovenia, Spain, Sweden,
Switzerland, the United Kingdom and the United States; this represents a major step
forward as together these countries are involved in more than 90 percent of outstanding
MAP cases at the end of 2013, as reported to the OECD.1
63.
A mandatory binding MAP arbitration provision will be developed as part of the
negotiation of the multilateral instrument envisaged by Action 15 the BEPS Action Plan.
The countries in this group will, in particular, be required to consider how to reconcile
their different views on the scope of the MAP arbitration provision. Whilst a number of
the countries included in this group would prefer to have no limitations on the cases
eligible for MAP arbitration, other countries would prefer that arbitration should be
limited to an appropriately defined subset of MAP cases. The work of the group of
committed countries on the arbitration provision will be informed by the previous work of
the Focus Group on Dispute Resolution concerning issues that have prevented the
adoption of MAP arbitration and options to address them.
Note
1.
See www.oecd.org/ctp/dispute/map-statistics-2013.htm.
ANNEX A. MANDATE FOR THE DEVELOPMENT OF THE TERMS OF REFERENCE AND THE ASSESSMENT METHODOLOGY 43
Annex A
Mandate for the development of the
terms of reference and the assessment methodology
Pursuant to element 1.6 of the Action 14 minimum standard, countries commit to have
their compliance with the minimum standard reviewed by their peers i.e. the other
members of the FTA MAP Forum (as provided in element 1.4 of the minimum standard,
countries should become members of the FTA MAP Forum and participate fully in its
work). This review will take place through a monitoring mechanism, the framework for
which is described in Section I.C of this Report. Such monitoring is essential to ensure
the meaningful implementation of the minimum standard and will be conducted pursuant
to Terms of Reference and an Assessment Methodology to be developed by the OECD
Committee on Fiscal Affairs through its Working Party No. 1 on Tax Conventions and
Related Questions (Working Party 1) and the Forum on Tax Administration MAP Forum
(the FTA MAP Forum). The mandate for the development of the Terms of Reference and
the Assessment Methodology is set out below:
Preamble
Recognising that the conclusions of the work on Action 14 of the BEPS Action Plan
reflect the agreement that countries should commit to a minimum standard comprising a
number of specific elements that are intended to ensure that treaty-related disputes are
resolved in a timely, effective and efficient manner;
Noting that the conclusions of the work on Action 14 also include agreement that the
implementation of the minimum standard should be evaluated through a peer monitoring
mechanism in order to ensure that the commitments embodied in the minimum standard
are effectively satisfied, and that all OECD and G20 countries, as well as jurisdictions
that commit to the minimum standard, will undergo reviews pursuant to that monitoring
mechanism;
Considering that the peer monitoring process will require the development of Terms of
Reference that will be used to assess the implementation of the Action 14 minimum
standard and of an Assessment Methodology that will establish procedures and guidelines
for the peer monitoring process;
The countries participating in the OECD-G20 BEPS Project have agreed that Terms of
Reference and an Assessment Methodology will be developed by the OECD Committee
on Fiscal Affairs, through its Working Party No. 1 on Tax Conventions and Related
Questions and the Forum on Tax Administration MAP Forum (the FTA MAP Forum)
pursuant to the following mandate.
44 ANNEX A. MANDATE FOR THE DEVELOPMENT OF THE TERMS OF REFERENCE AND THE ASSESSMENT METHODOLOGY
A. Objective
The OECD Committee on Fiscal Affairs through its Working Party No. 1 on Tax
Conventions and Related Questions and the Forum on Tax Administration MAP Forum
(the FTA MAP Forum) shall develop the core documents for the monitoring of the
implementation of the Action 14 minimum standard: the Terms of Reference and the
Assessment Methodology. The Terms of Reference will be based on the elements of the
minimum standard and will break down these elements into specific aspects against
which jurisdictions legal frameworks, MAP programme guidance and actual
implementation of the minimum standard are assessed; they will provide a clear roadmap
for the monitoring process and thereby ensure that the assessment of all jurisdictions is
consistent and complete. The Assessment Methodology will establish detailed procedures
and guidelines for the peer monitoring of OECD and G20 countries and other committed
jurisdictions by the FTA MAP Forum, which will be open to all such countries
participating on an equal footing and will include a system for assessing the
implementation of the minimum standard.
B. Participation
The Terms of Reference and the Assessment Methodology shall be developed jointly by
the OECD Committee on Fiscal Affairs, through its Working Party 1 on Tax Conventions
and Related Questions, and the FTA MAP Forum, with all countries participating on an
equal footing.
C. Duration and Term

The development of the Terms of Reference and the Assessment Methodology shall start
no later than November 2015. Working Party 1 and the FTA MAP Forum shall aim to
conclude their work on the Terms of Reference and the Assessment Methodology by the
end of the first quarter of 2016.
ANNEX A. MANDATE FOR THE DEVELOPMENT OF THE TERMS OF REFERENCE AND THE ASSESSMENT METHODOLOGY 45
Bibliography
http://dx.doi.org/10.1787/9789264202719-en.

AND DEVELOPMENT

(23 2015 39 1 P) ISBN 978-92-64-24158-9 2015
Making Dispute Resolution Mechanisms More Effective

BEPS Project aims to create a single set of consensus-based international tax rules to address BEPS, and hence
to protect tax bases while offering increased certainty and predictability to taxpayers. A key focus of this work
is to eliminate double non-taxation. However in doing so, new rules should not result in double taxation, unwarranted compliance burdens or restrictions to legitimate cross-border activity.
Contents
I. Minimum standard, best practices and monitoring process
II. Commitment to mandatory binding MAP arbitration
Annex A. Mandate for the development of the terms of reference and the assessment methodology
Consult this publication on line at http://dx.doi.org/10.1787/ 9789264241633-en.

isbn 978-92-64-24158-9
23 2015 39 1 P

Project
Developing a Multilateral
Instrument to Modify Bilateral
Tax Treaties
Developing a Multilateral
Instrument to Modify
Bilateral Tax Treaties,
Action 15 2015 Final
Report

OECD (2015), Developing a Multilateral Instrument to Modify Bilateral Tax Treaties, Action 15 -2015 Final
http://dx.doi.org/10.1787/9789264241688-en
ISBN 978-92-64-24167-1 (print)

ISBN 978-92-64-24168-8 (PDF)

OECD 2015
Foreword 3
Foreword
DEVELOPING A MULTILATERAL INSTRUMENT TO MODIFY BILATERAL TAX TREATIES OECD 2015
4 Foreword
TABLE OF CONTENTS 5
Table of contents

Executive summary 9
A mandate for the development of a multilateral instrument on taxtreaty measures to tackle
BEPS 11
2014 Report Developing a Multilateral Instrument to Modify Bilateral Tax Treaties 13
Introduction 15
1. A multilateral instrument is desirable and feasible 18
A. D
eveloping a multilateral instrument is desirable: The benefits are numerous, while burdens
can be addressed or avoided 18
B. D
eveloping a multilateral instrument is feasible: Legal mechanisms are available to achieve a
balanced instrument that addresses the technical and political challenges 20
2. The nature of the treaty-related BEPS measures will facilitate the conclusion of a targeted
multilateral instrument, which could be further expanded at a later date 24
3. Next steps: Scoping the International Conference 27
AnnexA. A toolbox for a multilateral instrument for the swift implementation of BEPS measures 29
Introduction 30
A.1. A multilateral instrument can modify the network of bilateral tax treaties 31
A.2. A multilateral instrument can provide flexibility in the level of commitment 41
A.3. A multilateral instrument can ensure transparency and clarity of commitments 49
Conclusion 53
Bibliography 54

APA
Advance pricing agreement
BEPS
CFA
EU
European Union
ICAO
International Civil Aviation Organisation
ILO
International Labour Organisation
MAC
Convention on Mutual Administrative Assistance in Tax Matters
MAP
OECD
PE
SAARC
South Asian Association for Regional Cooperation
UN
United Nations
VCLT
Vienna Convention on the Law of Treaties
Executive summary 9
Executive summary
The endorsement of the Action Plan on Base Erosion and Profit Shifting (BEPS
Action Plan, OECD, 2013) by the Leaders of the G20 in Saint-Petersburg in September
2013 shows unprecedented political support to adapt the current international tax system
to the challenges of globalisation. Tax treaties are based on a set of common principles
designed to eliminate double taxation that may occur in the case of cross-border trade
and investments. The current network of bilateral tax treaties dates back to the 1920s
and the first soft law Model Tax Convention developed by the League of Nations. The
Organisation for Economic Co-operation and Development (OECD) and the United Nations
(UN) have subsequently updated model tax conventions based on that work. The contents
of those model tax conventions are reflected in thousands of bilateral agreements among
jurisdictions.
Globalisation has exacerbated the impact of gaps and frictions among different
countries tax systems. As a result, some features of the current bilateral tax treaty system
facilitate base erosion and profit shifting (BEPS) and need to be addressed. Beyond the
challenges faced by the current tax treaty system on substance, the sheer number of
bilateral treaties makes updating the current tax treaty network highly burdensome. Even
where a change to the OECD Model Tax Convention is consensual, it takes a substantial
amount of time and resources to introduce it into most bilateral tax treaties. As a result, the
current network is not well-synchronised with the model tax conventions, and issues that
arise over time cannot be addressed swiftly. Without a mechanism to swiftly implement
them, changes to models only make the gap between the content of the models and the
content of actual tax treaties wider. This clearly contradicts the political objective to
strengthen the current system by putting an end to BEPS, in part by modifying the bilateral
treaty network. Doing so is necessary not only to tackle BEPS, but also to ensure the
sustainability of the consensual framework to eliminate double taxation. For this reason,
governments have agreed to explore the feasibility of a multilateral instrument that would
have the same effects as a simultaneous renegotiation of thousands of bilateral tax treaties.
Action15 of the BEPS Action Plan provides for an analysis of the tax and public
international law issues related to the development of a multilateral instrument to enable
countries that wish to do so to implement measures developed in the course of the work on
BEPS and amend bilateral tax treaties. On the basis of this analysis, interested countries
will develop a multilateral instrument designed to provide an innovative approach to
international tax matters, reflecting the rapidly evolving nature of the global economy
and the need to adapt quickly to this evolution. The goal of Action15 is to streamline the
implementation of the tax treaty-related BEPS measures. This is an innovative approach
with no exact precedent in the tax world, but precedents for modifying bilateral treaties
with a multilateral instrument exist in various other areas of public international law.
Drawing on the expertise of public international law and tax experts, the 2014 Report,
which is reproduced hereafter, explored the technical feasibility of a multilateral hard
law approach and its consequences on the current tax treaty system. It identified the
issues arising from the development of such an instrument and provided an analysis of
the international tax, public international law, and political issues that arise from such an
approach.
The 2014 Report also concluded that a multilateral instrument is desirable and feasible,
and that negotiations for such an instrument should be convened quickly. Based on this
analysis, a mandate for the formation of an ad hoc Group (the Group) to develop a
multilateral instrument on tax treaty measures to tackle BEPS, which is reproduced
hereafter, was approved by the OECD Committee on Fiscal Affairs and endorsed by the
G20 Finance Ministers and Central Bank Governors in February 2015. The Group is open
to participation from all interested countries on an equal footing and is served by the
OECD Secretariat. The Group begun its work in May 2015 with the aim to conclude its
work and open the multilateral instrument for signature by 31 December 2016. Participation
in the development of the multilateral instrument is voluntary and does not entail any
commitments to sign such instrument once it has been finalised.
A MANDATE FOR THE DEVELOPMENT OF A MULTILATERAL INSTRUMENT ON TAX TREATY MEASURES TO TACKLE BEPS 11
A mandate for the development of a multilateral instrument on

taxtreaty measures to tackle BEPS
Preamble
Recognising that Action 15 of the Action Plan on Base Erosion and Profit Shifting
(BEPS Action Plan, OECD, 2013) called for the development of a multilateral instrument
to implement measures developed in the course of the work on BEPS and modify bilateral
tax treaties;
Considering that the report Developing a Multilateral Instrument to Modify Bilateral
Tax Treaties (OECD, 2014), which was approved by the Committee on Fiscal Affairs
(CFA) and endorsed by the Leaders of the G20, concluded that a multilateral instrument
is desirable and feasible, and that negotiations for such an instrument should be convened
quickly;
Noting that the G20 Leaders Communiqu adopted in Brisbane on 16November 2014
welcomes the significant progress of the BEPS Action Plan to modernise international
tax rules;
The countries participating in the OECD-G20 BEPS Project have agreed to establish
an ad hoc Group (hereinafter the Group) with the mandate set out below. They recognise
that the Group is not a formal or informal OECD body and therefore participation of
non-OECD members in the Group does not create, and cannot be interpreted to create,
a precedent in the context of OECD procedures for the participation of non-members in
OECD activities.
A. Objective
1. The Group shall develop a multilateral instrument to modify existing bilateral tax
treaties solely in order to swiftly implement the tax treaty measures developed in
the course of the OECD-G20 BEPS Project.
B. Participation
1. Membership of the Group is open to all interested States.
2. All members of the Group participate on an equal footing.
3. Non-State Jurisdictions can participate in the Group as Observers upon a specific
invitation by the Group.
4. Relevant international and regional intergovernmental organisations can be invited
by the Group to participate as Observers.
12 A MANDATE FOR THE DEVELOPMENT OF A MULTILATERAL INSTRUMENT ON TAX TREATY MEASURES TO TACKLE BEPS
C. Duration
1. The Group will start its work no later than July 2015.
2. The Group will aim to conclude its work and open the multilateral instrument for
signature by 31December 2016.
3. The term of the mandate for the Group will end upon the opening of the
multilateral instrument for signature.
D. Governance
1. The Plenary of the Group is the decision-making body of the Group.
2. The Plenary is assisted by:
a. A Bureau appointed by the Plenary of the Group, which will prepare and guide
the work of the Group; and
b. Sub-groups or existing OECD bodies, as deemed appropriate by the Plenary.
3. The Plenary of the Group shall appoint a Chair and two Vice-Chairs at its first
meeting, who are also Chair and Vice Chairs of the Bureau.
4. The Group is convened under the aegis of the OECD and G20 and is served by the
OECD Secretariat.
5. The functioning of the Group and its sub-groups will be governed by the
OECD Rules of Procedure and the provisions of international law related to the
development and conclusion of treaties.
6. The Group will provide periodic updates to the CFA regarding progress made
and will consult with the Committee and its subsidiary bodies as necessary and
appropriate.
E. Funding
1. The functioning of the Group will be funded by its members.
2. Members and Observers in the Group will be responsible for covering the costs of
their participation in the work of the Group.
2014 Report Developing a

Multilateral Instrument to
Modify Bilateral Tax Treaties
Introduction
1. There is strong political support to eliminate BEPS. In an environment of
severe fiscal consolidation and social hardship, BEPS has become a high priority for
governments. BEPS relates chiefly to instances where the interaction of different tax rules
leads to double non-taxation or less than single taxation. It also relates to arrangements
that achieve no or low taxation by shifting profits away from the jurisdictions where those
profits are generated. The OECD/G20 BEPS Project aims to address BEPS concerns in a
comprehensive manner.
2. The current system of bilateral tax treaties focuses on the elimination of double
taxation. The interaction of domestic tax systems can lead to overlaps in the exercise of
taxing rights that can result in double taxation. For example, if an item of income is earned
in one jurisdiction (the source jurisdiction) by a resident of another jurisdiction (the
residence jurisdiction), both jurisdictions may tax that income under their domestic laws.
International treaties to address double taxation, many of which originated with principles
developed by the League of Nations in the 1920s, aim to address these overlaps so as to
minimise trade distortions and impediments to sustainable economic growth. The resulting
network of more than 3000 bilateral tax treaties, based on model tax conventions, is very
valuable. It ensures that there is broad consistency in the tax rules applicable to crossborder trade and investment. Countries around the world agree on the need to eliminate
double taxation and to do so on the basis of agreed international rules that are clear and
predictable, giving certainty to both businesses and governments.
3. However, some features of the current tax treaty system facilitate BEPS. The
interrelationship between domestic tax laws and the international tax framework is a
key pillar in supporting the growth of the global economy. However, as globalisation has
changed the way business is done, the gaps and frictions that were always present in the
existing bilateral tax treaties have grown more important. Existing tax treaty provisions
are sometimes exploited, in some cases in conjunction with domestic law rules, so that
large amounts of income are not subject to tax in any jurisdiction. Moreover, the existing
bilateral tax treaties vary widely in their details, including when the differences are not
necessary to reflect specificities in the economic relations between the two contracting
states. Rather, certain differences in detail appear to be due to the fact that treaties have
been negotiated over a long period of time, and in some circumstances these differences
create opportunities for BEPS, which are then exploited by taxpayers.
4. Change is needed to eliminate the opportunities the current tax treaty system
creates for double non-taxation. The BEPS Action Plan identifies treaty abuse as one
of the most important sources of BEPS concerns. OECD and non-OECD government tax
treaty experts agree that changes to the model tax conventions, as well as the bilateral tax
treaties based on those model conventions, are required to stop or significantly reduce
these abuses. A wide range of specific issues addressed in current model tax conventions,
including changes to the definition of permanent establishment (PE), and improvements to
dispute resolution procedures are being considered by leading tax treaty negotiators from
16 2014 Report Developing a Multilateral Instrument to Modify Bilateral Tax Treaties

OECD and G20 governments. These tax treaty experts have also identified the need for
new model treaty provisions targeted at specific issues that generally were not addressed in
bilateral tax treaties, including the introduction of an anti-treaty abuse provision in relation
to hybrid mismatch arrangements, and the compatibility with tax treaties of certain antiBEPS measures. The work is expected to be finalised in 2015.
5. The sheer number of bilateral treaties makes updates to the treaty network
burdensome and time-consuming, limiting the efficiency of multilateral efforts. After
any change to the model tax conventions is agreed multilaterally, it takes a substantial
amount of time and resources to introduce that change into most bilateral tax treaties.
Indeed, renegotiating a countrys treaty network takes decades. As a result, the current
network is not well-synchronised with the model tax conventions. Since the actual treaties
are many years behind the models on which they are based, any multilaterally-agreed
changes to the models take a generation to implement.
6. In contrast the need for change is urgent, and this is both a challenge and a
unique opportunity. The BEPS Action Plan was developed quickly because of political
imperatives to address BEPS, and the expectation is that agreement on how to solve the
problem will be implemented quickly as well. However, multilaterally-agreed changes to
the model tax conventions to tackle BEPS only make the gap between the content of the
model tax conventions and the content of actual tax treaties wider. To address BEPS in a
reasonable timeframe, a mechanism to facilitate swifter implementation is hence required.
This is challenging but at the same time creates a unique opportunity to modernise the
architecture of the international tax treaty network.
7. A multilateral instrument can address treaty-based BEPS issues while
respecting sovereign autonomy in tax matters. The concept of sovereign autonomy
is a basic principle underpinning the international order and providing the foundation
for the negotiation of international treaties. In tax matters, the concept of sovereignty
underpins the stable tax framework within which governments have been able to facilitate
arrangements that allowed for the benefits of globalisation to flow to all market economies.
Governments have historically used domestic legislation and bilateral treaties to reach
the appropriate balance between national sovereignty and international co-operation in
this area. As BEPS results from the interactions of multiple countries laws and treaties,
governments need to collaborate more intensively through a hard law multilateral
instrument both to prevent the tax treaty network from facilitating BEPS and to protect
their tax sovereignty. Recognising the tax sovereignty concern, the report focuses on
implementing treaty measures, even though a multilateral instrument could in principle
also be used to express commitments to implement certain domestic law measures.
8. A multilateral instrument facilitates speedy action and innovation. A multilateral
instrument will implement agreed treaty measures over a reasonably short period and at the
same time it would preserve the bilateral nature of tax treaties. This innovative approach
has at least three important advantages. First, it would help ensure that the multilateral
instrument is highly targeted. Second, it would allow all existing bilateral tax treaties
to be modified in a synchronised way with respect to BEPS issues, without a need to
individually address each treaty within the 3000+ treaty network. Third, it responds to the
political imperatives driving the BEPS Project: it allows BEPS abuses to be curtailed and
governments to swiftly achieve their international tax policy goals without creating the
risk of violating existing bilateral treaties that would derive from the use of unilateral and
uncoordinated measures.
9. Overcoming traditional obstacles to swiftly implement agreed tax treaty measures

requires political willingness to act. The efficiency and innovation represented by a
targeted multilateral instrument does come with certain challenges. First, bilateral treaties are
highly varied in their details, and there are limited precedents for modifying bilateral treaties
with a multilateral instrument. Technical challenges therefore must be given careful attention.
Second, even when solutions to the technical issues are available, the trade-offs in terms of
respecting sovereign rights, providing consistency, and achieving political acceptance from
a critical mass of jurisdictions requires strong impetus at the highest political level. Meeting
these challenges is necessary not only to tackle BEPS, but also to strengthen and ensure
the future sustainability of the existing consensual framework to eliminate double taxation.
With political will, however, even difficult treaty-based challenges can be met successfully
and swiftly. The recent work on the Convention on Mutual Administrative Assistance in Tax
Matters (hereafter MAC), which was undertaken at the direction of the G20 in connection
with Leaders desire to address offshore tax evasion, provides one example of the impact G20
leadership can have in the international tax area.
10. This report concludes that a multilateral instrument is desirable and feasible,
and that negotiations should be convened quickly. The present report explores the
questions raised by the use of a targeted multilateral instrument to modify tax treaties,
and provides a high-level analysis of both the technical (public international law and
international tax law) and political issues that arise. It highlights the feasibility of a
multilateral approach as the way to streamline the implementation of the BEPS Action Plan
with a view to responding to the current state of urgency, and also to improve efficiency. It
concludes that a multilateral instrument is desirable and feasible and it should be negotiated
through an International Conference open to G20countries, OECD members and other
interested countries and convened under the aegis of the OECD and the G20. The mandate
of the Conference should be limited in scope (implementing the BEPS Action Plan) and in
time (no more than 2years). The Conference could also be invited to reflect on possible
further steps to continue to streamline the implementation of agreed changes to the existing
model tax conventions and could make recommendations in that respect.
A recent success story: the Convention on Mutual Administrative Assistance in

Tax Matters
The Convention on Mutual Administrative Assistance in Tax Matters (Convention) was
opened for signature by the member states of the Council of Europe and the OECD in
1988, entered into force in 1995, and had only 14 signatories as of 2009. At its April 2009
London Summit the G20 Leaders called on the OECD to modernise this instrument to align
it to contemporary international standards on exchange of information, and to open it to all
countries, by stating in the G20 Declaration on Strengthening the Financial System that
they were committed to developing proposals, by end 2009, to make it easier for developing
countries to secure the benefits of a new cooperative tax environment (G20, 2009). A Protocol
to the Convention was negotiated in 2009 and the amended Convention was presented at the
annual OECD Ministerial meeting in May 2010, and the amended Convention and Protocol
were opened for signature by a wide range of countries on 1st June 2011. As of 3July
2014, 66 countries, including all G20countries, had signed the amended Convention, and
14jurisdictions were covered by territorial extension. The Convention a single multilateral
legal instrument performs functions that would have otherwise required negotiating over
1800 new bilateral agreements. By means of the Convention, the G20 swiftly and successfully
initiated a step change in transparency in cross-border tax matters globally.
1. A multilateral instrument is desirable and feasible
A. Developing a multilateral instrument is desirable: The benefits are numerous,

while burdens can be addressed or avoided
11. Changes to the OECD Model Tax Convention are intended to ultimately produce
changes to the network of bilateral tax treaties that form a key component of the
broader international tax architecture. G20 Leaders endorsed the BEPS Action Plan,
and committed to take the necessary individual and collective actions in order to tackle
BEPS. The 15 BEPS Action Plan deliverables span three different areas: recommendations
for domestic law taking the form of best practices and model domestic rules, other reports,
as well as changes to the OECD Model Tax Convention and internationally agreed
guidance on implementation. Tax treaty-related issues are agreed to be a key focus of BEPS
concerns. The development of a multilateral instrument to tackle these treaty-based BEPS
issues first of all requires agreement on the substance of the tax treaty measures required to
respond to BEPS. Working groups are making steady and important progress towards this
goal. Indeed, the first outputs are being made public at the same time as this report, while
other outputs are expected by 2015.
12. A multilateral negotiation can overcome the hurdle of cumbersome bilateral
negotiations and produce important efficiency gains. Given the decades-long process for
bilateral treaty negotiations, a multilateral instrument represents the only way to address
treaty-based BEPS concerns in a swift and co-ordinated manner. The current network of
bilateral treaties involves substantial complexity because each treaty is a legally distinct
instrument, and its relationship to other bilateral treaties is undefined. As a result, lawyers,
tax administrators, and courts spend a lot of energy interpreting each individual treaty,
especially when treaties differ in small ways. This problem would become more severe
if varied anti-BEPS measures were included in thousands of new bilateral protocols to
existing treaties. The multilateral instrument will instead produce synchronised results
that would save resources and improve the clarity of BEPS-related international tax treaty
rules. These benefits are in addition to the simple reality that only a multilateral instrument
can overcome the practical difficulties associated with trying to rapidly modify the 3000+
bilateral treaty network.
13. The multilateral instrument can provide developing countries with the
opportunity to fully benefit from the BEPS Project. For developing countries, the practical
problems that are encountered in trying to address BEPS from within the bilateral tax treaty
system alone are even more relevant than for developed countries. Developing countries find
it more difficult than other countries both to conclude double tax treaties, and to interest
other countries in tax treaty (re)negotiation, and their tax treaty negotiation expertise is often
more limited than in the governments of developed economies. A multilateral instrument
therefore offers the best opportunity to ensure that developing countries reap the benefits of
multilateral efforts to tackle BEPS. In a multilateral negotiation, similarly-minded developing
governments may co-operate, pooling their expertise to be efficacious in the negotiating

process.
14. Some issues are much easier to address multilaterally than in bilateral instruments.
The bilateral treaty architecture was not originally designed to address high levels of factor
mobility and global value chains. For example, globalisation substantially increases the
need to resolve multi-country tax disputes. Although competent authorities within tax
administrations have expressed interest in the possibility of developing a multilateral mutual
agreement procedure (MAP) to resolve such multi-country disputes, some countries foresee
legal constraints in the absence of a hard law instrument authorising multilateral MAP.
Other countries do not believe they can use MAP to resolve cases that touch on issues not
explicitly addressed in their existing bilateral tax treaties in the absence of an international
law instrument that provides that authority. These and other legal obstacles that arise in
implementing multilateral MAP can easily be addressed in the context of the multilateral
instrument.
15. A multilateral instrument can increase the consistency and help ensure the
continued reliability of the international tax treaty network, providing additional
certainty for business. In contrast to amendments to thousands of bilateral tax treaties, a
targeted multilateral instrument to address BEPS would be much more likely to produce
consistent results. The multilateral nature of the instrument would focus the attention
of a large number of highly qualified treaty negotiators on a single document that could
incorporate the language deemed most appropriate by all concerned countries. In addition,
having a single text, instead of thousands of similar but slightly varying texts, would be
more likely to produce consistent interpretation across jurisdictional boundaries. As a
result, a common international understanding would develop about the meaning of the
text of the provisions of the multilateral instrument. By addressing a number of contested
questions surrounding international tax rules in a definitive way, a multilateral instrument
can restore clarity and ensure future certainty for the status of a variety of important rules
that business relies upon to be able to invest with confidence cross-border.
16. Flexibility, respect for bilateral relations, and a targeted scope are key to
success. The benefits of swift implementation, improved consistency, certainty, and
efficiency, can only be achieved if bilateral specificities and tax sovereignty are fully
respected, so that the process does not bog down or involve too few countries. Allowing
countries to tailor their commitment under the instrument in pre-defined cases can help
address these concerns. On the other hand, in order to feel comfortable moving ahead
in tackling BEPS, countries will want assurance that other countries are tackling BEPS
simultaneously. Parties could therefore commit to a core set of provisions as part of a
multilateral instrument, but then have the possibility to opt-out, opt-in or choose between
alternative and clearly delineated provisions with respect to other issues covered by
the instrument. Negotiations would thereby accommodate bilateral specificities, reinforce
governmental policy goals, and reassert tax sovereignty in the face of globalisation.
17. At the same time, a level playing field will require broad participation. Some
provisions of the treaty-based portion of the BEPS Project require broad participation in
order to successfully address BEPS concerns. Thus, to ensure a level playing field and
fairly shared tax burdens, flexibility and respect for bilateral relations will need to be
balanced against core commitments that reflect new international standards that countries
are urged to meet and for which the multilateral instrument is a facilitative tool.
B. Developing a multilateral instrument is feasible: Legal mechanisms are available

to achieve a balanced instrument that addresses the technical and political challenges
18. The technical legal challenges that arise in modifying the international tax treaty
architecture by means of a multilateral instrument will require careful attention.
Nevertheless, an analysis of precedents in other areas of international law and the specifics
of various proposed changes to the model tax conventions illustrate that developing a
multilateral instrument to rapidly implement agreed changes is completely feasible from a
legal point of view.
19. The multilateral instrument would coexist with the existing bilateral tax treaty
network. The most promising approach for pursuing the goal of a multilateral instrument to
consistently modify the existing, varied, 3000+ tax treaty architecture involves developing
a multilateral instrument that would co-exist with bilateral tax treaties. Like existing tax
treaties, this instrument would be governed by international law and would be legally
binding on the parties. A multilateral instrument will modify a limited number of provisions
common to most existing bilateral treaties, and would, for those treaties that do not already
have such provisions, add new provisions specifically designed to counter BEPS. It could
also clarify the compatibility with tax treaties of other anti-BEPS measures developed in
the course of the BEPS Project. The multilateral instrument could be accompanied by an
explanatory report to facilitate the implementation of the provisions contained therein.
20. This approach will ensure that the multilateral instrument is highly targeted
and efficient. A multilateral instrument that coexists with bilateral tax treaties was
identified to be more appropriate than other approaches because it is more efficient and
more targeted. Other options that were evaluated included (1) the use of a self-standing
instrument that would wholly supersede bilateral tax treaties, governing the relationship
between all the parties, whether or not they have concluded bilateral tax treaties amongst
themselves and (2) an instrument whose sole purpose would be to operate like a bundle of
amending protocols, precisely amending the varying language of each of the 3000+ tax
treaties. A self-standing instrument that would wholly supersede bilateral tax treaties
was viewed to be overbroad given the importance of bilateral relations in international
tax affairs and the importance of preserving tax sovereignty. A bundle of amending
protocols was viewed as less appealing than a coexisting multilateral instrument because
it would be both more technically complex and less efficient. As a result, this approach was
viewed as being too cumbersome and time consuming to satisfy the central purpose of the
multilateral instrument, which is to implement treaty-related responses to BEPS quickly.
21. A multilateral instrument would follow established negotiating processes, and
ratification would require conventional domestic procedures, pursuant to national
laws. The intent of this multilateral instrument would be to ensure the effective and efficient
implementation of the outputs of the BEPS Project that bear a relationship to the operation of
tax treaties. Once the implications of this innovative solution have been fully considered and
addressed, an International Conference would negotiate the content and actual text of the
multilateral instrument, which would then be subject to the regular ratification procedures
by each party. Therefore, this multilateral instrument would follow traditional negotiating
processes, and ratification would take place according to national laws.
22. The relationship between parties to a multilateral instrument that are not
parties to a bilateral tax treaty between themselves generally would not be affected. In
some instances, parties to a multilateral instrument will not yet have concluded a bilateral
tax treaty between themselves. In general, a multilateral instrument would only govern the
relationship between parties that have concluded bilateral tax treaties amongst themselves.
One exception to this general rule could be a multilateral dispute resolution mechanism
which operates among all parties to the multilateral instrument, including in cases where
certain parties to the instrument lack bilateral treaty relationships with one another.1 A
separate question to be examined by the treaty negotiators at the International Conference
is whether this multilateral instrument would impose any obligation on the parties to the
instrument with respect to a situation in which two States conclude a bilateral tax treaty
covering the same issue for the first time at a date after they each become parties to the
instrument. From a legal point of view the relevant provisions could be crafted to apply in
such a case, and therefore a decision will have to be taken at the political level.
23. Technical challenges arising from the interaction between a multilateral instrument
and bilateral tax treaties can be addressed.
Variations in scope between similar provisions of existing bilateral treaties
can be successfully resolved. The prospective treaty outputs of the BEPS Project
will take into account current best practices in tax treaty negotiation and therefore
the provisions of a multilateral instrument could, to a certain extent, overlap with
certain provisions found in some bilateral tax treaties. Potential conflicts may arise
from the interaction between new multilaterally agreed provisions and similar
provisions included in some existing bilateral treaties that fully or partly cover the
same subject matter. Such cases raise questions as to whether existing bilateral
provisions incorporated in existing tax treaties should remain fully or partially
applicable alongside a multilaterally-agreed provision designed to address the same
basic questions, and if so under what circumstances and to what extent. From a legal
standpoint, the interaction between multilaterally agreed provisions and similar
provisions of existing bilateral treaties could be resolved through the inclusion of
specific compatibility clauses (or primacy clauses) in the multilateral instrument.
Variations in the wording of similar provisions of existing bilateral treaties
can be addressed through superseding language in a multilateral instrument.
Introducing multilaterally agreed changes through a multilateral instrument may
raise technical challenges due to variations in the wording of existing bilateral
tax treaties. Whether this is a real issue will depend largely on the extent to which
each treaty-based output of the BEPS Project is a stand-alone measure which easily
complements existing treaties, or relies heavily on existing concepts that are already
defined in model tax conventions. If a given output of the BEPS Project relies
on an existing concept, and those concepts do not appear, or have an alternative
meaning, in some bilateral treaties, a multilateral instrument will be unable to
assume uniform usage of the Model Tax Convention concept. However, negotiators
of a multilateral instrument can address this issue by ensuring that the instrument
defines its own terms when necessary, and does so in a way that is compatible with
the range of existing bilateral treaties. Similarly, specifying the provision of existing
bilateral treaties that is being addressed in a multilateral instrument through general
description rather than specific textual cross-references can ensure that minor
differences in the wording of existing tax treaty provisions do not pose an obstacle
for uniform effect and implementation of an agreed provision in a multilateral
instrument. The explanatory report to this multilateral instrument can give examples
and further ensure consistency of understanding regarding the interaction of a
multilateral instrument and existing bilateral tax treaties.

Addressing variations in the numbering of provisions simply requires careful
drafting. Multilaterally agreed measures being developed in the course of the
BEPS Project will likely use numerical cross-references to existing provisions
of the model conventions as a shorthand to give technical precision to the treatybased proposals to address BEPS. However, the numerical cross-references in
most treaties do not align precisely with the numbering of the model conventions.
As a result, model bilateral treaty provision cross-references cannot be transposed
directly into a multilateral instrument. In principle, this potential issue can be
addressed by a multilateral instrument that avoids explicit numerical crossreferences to articles of the model tax conventions or specific articles of existing
bilateral treaties, and instead clearly cross-references the relevant subject matter of
bilateral treaties with appropriate language. Practical issues associated with this
approach are likely to be identified and resolved in the context of negotiation of the
multilateral instrument.
The timelines for signature and entry into force can be calibrated for flexibility.
In particular, it would be possible to set up different dates for the entry into force
of the instrument for the parties depending on the provisions of the instrument
(e.g.some provisions could enter into force at the start of a new tax year while other
could enter into force at the date of ratification). In addition, express mechanisms
and procedures could be incorporated into a multilateral instrument to ensure
expeditious amendment procedures in the future. These mechanisms would be
consistent with traditional negotiating processes, and ratification would require
conventional domestic procedures.
Solutions for other technical issues, such as questions of language and
translation, are readily available. Language issues may arise with respect to
the modification of bilateral tax treaties authenticated in languages different
from the authenticated language(s) of the multilateral instrument. Drafting a
multilateral instrument in a number of languages would increase its cost, the risk
of conflict between versions in different languages and practical challenges in its
administration. This question has arisen in other areas of international law, and
precedents support various potential solutions.
24. In general, a flexible approach will be paramount for the multilateral instrument.
As is reflected in the existing network of bilateral tax treaties, parties to a multilateral
instrument may have tax policies that differ from one another and could not be harmonised
amongst all the parties to the instrument. They may not be ready to accept the same precise
commitments vis--vis all other parties.One of the main challenges for negotiators of a
multilateral instrument will therefore be to ensure flexibility regarding the extent of the
rights and obligations established by the treaty vis--vis all the other parties, as well as
the level of commitments towards certain parties, while at the same time maintaining
consistency, in order to create a level playing field, and transparency, in order to provide
certainty.
25. There are ample legal means for providing flexibility to modulate, within agreed
boundaries, parties commitments. It is possible for a multilateral instrument to allow
for the tailoring of the level of certain commitments towards all the other parties and/or
depending on the partner country.There are a number of tools to ensure flexibility and a
number of relevant precedents in this regard. It should be recognised that some provisions
may require consistent adoption among the parties to a multilateral instrument for reasons
of technical administrability.
26. The relationship with other multilateral instruments should be closely examined.
Once the work on the actual measures is completed, the relationship of a multilateral
instrument with European Union (EU) law and other relevant multilateral agreements,
e.g.regional tax treaties such as the Nordic tax treaty, will also need to be addressed.
27. Negotiation of the multilateral instrument must be speedy to avoid uncertainty.
It is quite important for measures countering BEPS to be agreed and put in place quickly,
so that business may adjust to the new reality and continue to support growth, create jobs,
and foster innovation. At the same time, it is worth underlining that putting some issues
within a multilateral instrument could in principle slow the ability to address BEPS, by
extending the timetable for responding to other parts of the BEPS agenda. In this context,
a targeted multilateral instrument with a well-defined scope and a precise timetable for
negotiation is key.
28. The BEPS Project is intended to result in shared principles to shore up the clarity
and predictability of the tax treatment of cross-border activities. Once bilateral tax
treaties are modified through a multilateral instrument, it will be important to ensure
clarity so that the interaction between the multilateral instrument and bilateral tax
treaties is clearly outlined. One of the challenges related to the development of a flexible
multilateral instrument involves ensuring that mechanisms and procedures are developed
and put in place to achieve full transparency. From a legal standpoint, a number of
mechanisms are available, such as the publication of versions of bilateral tax treaties that
also include the relevant provisions of the multilateral instrument, a system of notifications
deposited by pairs of parties for permitted opt-outs or opt-ins, etc.
29. Mechanisms to resolve the technical challenges that might arise from the use
of a multilateral instrument, and relevant precedents in other areas of international
law, are described in more detail in the annex to this report. An informal group of
eminent experts in tax and public international law was gathered in September 2013 to
work with the OECD Secretariat on an analysis of the issues arising from the development
of a multilateral instrument. The Secretariat developed the technical annex to this report A
toolbox for a multilateral instrument for the swift implementation of BEPS measures based
on input received from these experts. It provides illustrative solutions to potential issues
lying at the interstices of international tax law and public international law and how they
could be successfully addressed by a multilateral instrument.
Note
1.
In the absence of bilateral treaty relationships between all of the parties, a number of governments
are of the view that a multilateral MAP or advance pricing agreement (APA) would only be
possible where the multilateral instrument itself contains a specific multilateral MAP provision
as well as an exchange of information provision that would permit taxpayer information to
be exchanged between all the parties (assuming there is not some other basis for exchange of
information between the parties, such as the MAC or a bilateral Tax Information Exchange
Agreement).
2. The nature of the treaty-related BEPS measures will facilitate

the conclusion of a targeted multilateral instrument,
which could be further expanded at a later date
30. The multilateral instrument provides an innovative approach to address the
rapidly evolving nature of the global economy and the need to adapt international
rules quickly. Changes to the OECD Model Tax Convention are intended to produce
changes to the network of bilateral tax treaties that forms a key component of the broader
international tax architecture. This is, for example, the case for the introduction of an antitreaty abuse provision, changes to the definition of PE, improvements to dispute resolution
procedures, and the introduction of treaty provisions in relation to hybrid mismatch
arrangements. It may also include provisions that clarify the relationship with double
tax treaties of special measures that aim to counter abuses. As outlined above, the main
objective of a multilateral instrument would be to modify existing bilateral tax treaties,
in a synchronised and efficient manner, to implement treaty measures developed in the
course of the BEPS Project, without a need to individually renegotiate each treaty within
the 3000+ treaty network.
31. Some of the measures developed in the BEPS Project are multilateral in nature.
A number of treaty-based outputs of the BEPS Project can be drafted as stand-alone
measures that complement and co-exist with bilateral tax treaties. These provisions can be
directly implemented without the need to take bilateral specificities into account. Indeed,
some provisions would be much more effective if implemented through a multilateral
instrument. The paragraphs below note a few potential provisions that are multilateral in
nature and which could be introduced by a multilateral instrument.
Multilateral MAP: as highlighted above in section1 of this report, there is merit
in developing a truly multilateral MAP if the goal is to resolve multi-country
disputes. Such a provision would enable MAP consultation with the competent
authority of all parties to a multilateral instrument that are concerned with a
case involving a taxpayer active in many jurisdictions. To provide certainty and
resolution of disputes in the post-BEPS environment, such a provision would
further provide for arbitration where the competent authorities are unable to resolve
the case by mutual agreement.
Addressing dual-residence structures: although dual-residence for business
entities is relatively rare, an increasing number of BEPS strategies involve dualresident companies. Given the risk of abuse arising from the use of these structures,
countries may conclude that it is better to address dual-residence situations on a
case-by-case basis in order to deter aggressive tax planning that facilitates BEPS.
However, this simple anti-abuse measure would be most effective if adopted
consistently across the existing bilateral tax treaty network.
Addressing transparent entities in the context of hybrid mismatch arrangements:
hybrid mismatch arrangements often lead to double non-taxation that may not be
intended by either country, or to unintended long-term tax deferral. It is difficult

to determine unequivocally which individual country has lost tax revenue under
such arrangements, but they often impact negatively on tax revenues, and also
undermine transparency and fairness. Addressing hybrid mismatch arrangements
comprehensively requires changes to domestic law. Nevertheless, a coherent
policy response that also avoids double taxation would be facilitated both at the
domestic level and at the multilateral level by consistently modifying existing tax
treaties so that the eligibility for tax treaty benefits of payments made to entities in
another jurisdiction is determined based on whether the payment is considered to
be income of a resident for purposes of the tax law of the jurisdiction of residence
of the payee.
Addressing triangular cases involving PEs in third states: so-called triangular
cases can arise where income of a tax treaty resident is attributed by the country of
residence to a PE in a third State and exempt from tax in the residence State, often
together with low taxation in the State of the PE. Bilateral treaties can provide rules
that partially address such cases, but comprehensively addressing the problem requires
incorporating a solution into all of a countrys tax treaties. Thus, a multilateral
instrument represents the most efficient mechanism for action.
Addressing treaty abuse: there are a number of arrangements through which a
person who is not a resident of a treaty country may inappropriately obtain the tax
benefits that a bilateral tax treaty is intended to provide on a reciprocal basis to
appropriate claimants. A multilateral instrument could incorporate approaches to
prevent the granting of treaty benefits in inappropriate circumstances.
32. Some tax treaty provisions that may implicate BEPS concerns are bilateral in
nature, and for these provisions flexibility can be provided within certain boundaries.
Some treaty outputs of the BEPS Project may need to reflect specificities in the economic
relations and/or in existing bilateral tax treaties between pairs of parties. For instance,
a multilaterally agreed provision which introduces changes to the definition of PE may
need to provide for some flexibility to tailor the level of commitment towards all the other
parties and/or depending on the partner country. At the same time, flexibility has to be
within certain boundaries to ensure consistency and administrative feasibility. Generally, it
will be important to determine a set of core provisions to which all parties to a multilateral
instrument will have to adhere to ensure a consistent and internally coherent approach to
addressing treaty-related BEPS issues.
33. The precise content of a multilateral instrument is yet to be defined but the
sense of direction is clear. OECD and G20 governments are vigorously working towards
agreement on substantive treaty-based measures to counter BEPS. Although the final outputs
in all areas are not expected until 2015, discussions indicate the need for substantial changes
to model treaties and a corollary desire to speedily implement those changes into bilateral
tax treaties. Indeed, other reports made available to the G20 at the same time as this report
already provide substantive recommendations for change in a number of treaty-based areas.
A multilateral instrument might also facilitate coordination across a wider range of BEPSrelated issues. For example, the implementation of work on country-by-country reporting
may be facilitated by the use of a multilateral instrument which also includes rules regarding
the confidentiality of the information obtained by tax administrations. Similarly, problems
of both double taxation and double-non-taxation associated with expense allocation are
particularly noteworthy in the context of interest expense. A multilateral interest expense
allocation agreement could be implemented through the multilateral instrument. It also may

be possible to develop new dispute resolution mechanisms that could further ensure that
double taxation does not result from unilateral and uncoordinated responses to BEPS.
34. A multilateral instrument to implement BEPS outputs is an effective and innovative
solution. This feasibility study concludes that despite potential challenges, a multilateral
instrument is a promising way to quickly implement treaty-related BEPS measures. The
G20 asked for this feasibility study to be prepared in parallel to the development of the
actual measures to counter BEPS-related issues so as to most efficiently lay the groundwork
for implementation. Continuing that process would require convening an International
Conference to implement treaty-related BEPS measures. The mandate of the Conference
should be limited in time and in scope (implementing the BEPS Action Plan).
35. A multilateral instrument should be conceived in a dynamic way. Many countries
recognise the need to update their international tax rules to reflect changed circumstances
of international business, and tax treaties are an important part of that process. Recognising
that the initial work is focused on BEPS-related treaty measures, it is sensible to also
reflect on possible further steps to continue to streamline the implementation of changes to
the international tax treaty architecture using the same mechanism. For example, further
updates to the model tax conventions might be implemented multilaterally. On the other
hand, any decision to address a broader range of international tax issues multilaterally
would represent a more significant step towards multilateralism in tax matters than the
current work to use a multilateral instrument to address BEPS-related tax treaty issues. For
the moment, it is important to keep the multilateral instrument narrowly targeted, and at
the same time start a reflection on what further incremental opportunities may be available.
3. Next steps: Scoping the International Conference

36. The treaty-based BEPS actions must be completed before the substantive
components of the multilateral instrument can be finalised. The development of
a multilateral instrument requires framework provisions related to its entry into force,
language, etc. and more importantly agreement on the substance of the tax treaty measures
required to respond to BEPS. The OECD/G20 BEPS Project is making steady progress
towards the development of those measures. Some of the treaty-based BEPS outputs will be
delivered by September 2014, while a number of others will be delivered in 2015. Plans for
an International Conference to negotiate a multilateral instrument that implements agreed
treaty-based measures to tackle BEPS must take this timetable into account.
37. This report recommends convening an International Conference to develop the
multilateral instrument in 2015. In accordance with standard treaty-making practice, an
International Conference should be convened to develop the multilateral instrument. The
International Conference should be open to all interested countries, under the aegis of the
OECD and the G20. To maintain momentum, the work on the framework provisions of
the multilateral instrument should begin in 2015. Once the recommendations for BEPSrelated treaty measures are finalised in the context of the BEPS Project, they can then be
considered by the International Conference and included in the multilateral instrument. In
addition to incorporating the BEPS-related treaty measures, the International Conference
should reflect on whether further protocols or similar multilateral instruments could be
used in the future to foster a more effective international tax environment.
38. On that basis it is recommended that, if the present proposal is endorsed, a
mandate be quickly developed so that the International Conference be gathered in
early 2015 to start its work.
AnnexA
A toolbox for a multilateral instrument
for the swift implementation of BEPS measures
Executive summary
1. This annex offers a toolbox of theoretical options which could be used, as appropriate,
in the development of a multilateral instrument for the swift implementation of base erosion
and profit shifting (BEPS) measures. The options presented are based on an analysis of
doctrine and precedents in public international law. It draws on the work of the informal
group of experts on the multilateral instrument, a group comprised of both experts in
public international law and experts in international taxation set up by the Committee on
Fiscal Affairs (CFA) to advise on the feasibility of a multilateral instrument. The annex is
structured around the three key conclusions: a multilateral instrument can (1)implement
BEPS measures and modify the existing network of bilateral tax treaties; (2)provide
appropriate flexibility in their level of commitment; and (3)ensure transparency and clarity
for all stakeholders.
2. (1) The objective of the multilateral instrument would be the implementation of measures
to address BEPS and its consequence would be the modification of certain provisions of the
existing network of bilateral tax treaties. The bilateral tax treaties would remain in force for
all non-BEPS related issues. It would be preferable, for reasons of efficiency and transparency,
to define this relationship through the inclusion of compatibility clauses in the multilateral
instrument. There are several options in order to ensure consistency in the interpretation and
implementation of the multilateral instrument. Solutions also exist with regard to the dates
of entry into force of different provisions and logistical issues including differences in the
authentic languages of the multilateral instrument and bilateral tax treaties.
3. (2) As appropriate, the multilateral instrument can offer parties flexibility in their
level of commitment within certain defined boundaries in order to move towards a level
playing field. Defined flexibility as to the level of commitment of the parties vis--vis all or
certain parties can be achieved through the use of opt-out mechanisms allowing parties to
exclude or modify the legal effects of certain provisions; a choice between alternative and
clearly delineated provisions; and opt-in mechanisms offering parties the possibility to
take on additional commitments. The level of commitment of parties can also be modulated
through the language used in the multilateral instrument (strong or soft wording) and types
of obligations (of results and/or means).
4. (3) Considering the complexity of the network of bilateral tax treaties and the number
of interested stakeholders (tax administrations, tax payers, third parties), it is vital that
the multilateral instrument ensures the transparency and clarity of the commitments
undertaken by the parties. Mechanisms are available to ensure clear and publicly accessible

information as regards, on the one hand, the interaction between the multilateral instrument
and bilateral tax treaties and, on the other hand, the use of the mechanisms for flexibility
set up by the multilateral instrument.
5. The annex concludes that a multilateral instrument to implement the measures developed
in the course of the work on BEPS is feasible and would be the most efficient way to modify
the existing network of bilateral tax treaties. A multilateral instrument offers an expansive
and adaptable toolkit: once the substantive measures have been agreed, all the necessary
mechanisms exist to reflect them as multilateral undertakings. As with the development of any
new instrument, there are technical issues but they can be solved through well-tested solutions
drawing on treaty law and practice. International tax experts and public international law
experts will need to continue working hand in hand as this project moves forward.
Introduction
6. Action15 of the BEPS Action Plan mandates the analysis of tax and public
international law issues related to the development of a multilateral instrument to enable
interested parties to implement measures developed in the course of the work on BEPS
and amend bilateral tax treaties. Action15 refers to a multilateral instrument i.e.a treaty
concluded between more than two parties. According to the Vienna Convention on the Law
of Treaties (VCLT), a treaty can be defined as:
an international agreement concluded between States in written form and
governed by international law, whether embodied in a single instrument or in two
or more related instruments and whatever its particular designation.1
7. The annex to the report on Action15 draws on the work of the informal group of
experts on the multilateral instrument2 set up by the CFA to advise on the feasibility of a
multilateral instrument to implement BEPS measures. The group was comprised of thirteen
experts in public international law or international taxation from both civil and common
law countries.
8. It is important to underline that the annex has been prepared in parallel to the
discussions on the substance of the possible BEPS measures and that the experts have not
participated in those intergovernmental discussions.
9. Accordingly, this annex offers a toolbox of theoretical options which could be used,
as appropriate, in the development of a multilateral instrument. The options presented are
based solely on an analysis of doctrine and precedents in public international law and should
not be seen in any way as concrete proposals for the future multilateral instrument on BEPS.
10. The examples set out in the annex deliberately offer a vast array of options so that
the drafters of a future multilateral instrument can pick and choose the solutions which
are most appropriate for their purposes. As with any toolbox, it is not possible to use all of
the tools at the same time. Moreover, the examples necessarily come from a wide range of
subject areas and may have to be adapted to the specificities of the area of taxation.
11. The present annex is structured around three key issues that work on the multilateral
instrument will need to address: (1)how to modify the network of bilateral tax treaties;
(2)possibilities for providing the appropriate flexibility in States level of commitment in
order to enable effective coordination to tackle BEPS while preserving State sovereignty in tax
matters; and (3)how to ensure transparency and clarity for all stakeholders. As set out below,
there are various options for the multilateral instrument to fulfil each of these objectives, based
on the law of treaties as well as existing precedents in various fields of international law.
A.1. A multilateral instrument can modify the network of bilateral tax treaties3
12. The primary objective of the multilateral instrument would be to implement the
measures agreed in order to address BEPS, thereby modifying the existing network of
bilateral tax treaties. At the outset, it is important to note that public international law allows
various options for the modification of treaties as long as the principle of sovereignty and
State consent is respected. Accordingly, if the parties agree, a treaty can be modified in
a number of different ways, including through the adoption of a subsequent multilateral
agreement, as envisaged here.
A.1.1. Terminology: Modification is more appropriate than amendment

13. The underlying goal of the BEPS Project is to develop and implement new common
rules to tackle BEPS among all interested parties. The multilateral instrument need not and
would not terminate the pre-existing network of bilateral treaties in order to achieve this goal.
Instead it would aim to achieve a concurrent and integrated application of the provisions of
the multilateral instrument and the bilateral treaties as they relate to BEPS. The bilateral
treaties will not only remain in force but they will continue to play a major role in defining
the specific relations of each pair of parties with regard to co-operation in tax matters.
14. Under international law, the basic principle is that a subsequent treaty prevails over
a previously concluded treaty on the same subject matter. Accordingly, without formally
amending each and every bilateral treaty, a new multilateral instrument would operate
to modify the overlapping provisions in all bilateral treaties. Indeed, there have been a
number of situations in which States have adopted multilateral conventions in order to
introduce common international rules and standards and thereby harmonise a network of
bilateral treaties, for example, in the area of extradition.
15. Accordingly, the term modification is better adapted to this project than the term
amendment. There is no need for a formal amendment of each one of the existing bilateral
tax treaties. Rather, these treaties will be modified automatically by the multilateral instrument.
A.1.2 Relationship between the multilateral instrument and bilateral tax

treaties
16. In the present case, it is foreseen that only certain provisions of the bilateral tax
treaties will be modified and superseded by the multilateral instrument. Therefore the
substantive rules contained in the bilateral tax treaties will remain in force in areas not
covered by the multilateral instrument.
A.1.2.1 Bilateral tax treaties concluded prior to the entry into force of the
multilateral instrument
17. There are two ways to address the question of the relationship between a multilateral
instrument and the bilateral treaties modified by it: (1) to explicitly define this relationship
in the multilateral instrument or (2) to let this relationship be defined by the general rules
of international law.
18. In the silence of the multilateral treaty, the applicable customary rule, codified in
Article30(3) of the VCLT,4 is that when two rules apply to the same matter, the later
in time prevails (lex posterior derogat legi priori). Accordingly, earlier (i.e.previously
concluded) bilateral treaties would continue to apply only to the extent that their provisions
are compatible with those of the later multilateral treaty.

19. However, in order to preserve clarity and transparency, it would be important to
explicitly define the relationship between the multilateral instrument and the existing
network of bilateral treaties. This can be done through the inclusion of compatibility
clauses in the multilateral instrument.
i. The rationale for compatibility clauses

20. When treaties are negotiated in areas where other treaties already exist, it is common
practice to include a compatibility clause (or conflict clause) to explicitly address the
relationship between the treaties. This has been done in several other cases in which the
provisions of a multilateral instrument have superseded the provisions of an existing
network of bilateral treaties, particularly when the subject matter is complex (see below).
21. In the present case, given the number of bilateral treaties concerned and the
technical nature of their content, it would be preferable to have an express provision
in the multilateral instrument to define its relationship with existing bilateral treaties.
If the parties agree, a mechanism could also be set up to resolve issues related to the
implementation of the compatibility clause.
22. This would ensure clarity and transparency for all stakeholders (national administrations,
tax services, domestic judges, taxpayers, civil society, etc.) on the fact that, in principle, the
provisions of the multilateral instrument are to be applied in case of conflict with pre-existing
rules of the bilateral treaties.
ii. Types of compatibility clause

23. The practice is diverse and there is no standard compatibility clause. In the precedents
described below, multilateral instruments have abrogated, replaced, superseded and/
or modified the provisions of pre-existing bilateral treaties. In one example, the provisions
of the multilateral instrument have been included in the bilateral treaties. The level of
precision and the extent of changes made to the bilateral treaties vary.
24. In the following examples, it is important to note that the bilateral treaty survives,
either in areas not addressed by the provisions of the multilateral instrument or as between
a party to the multilateral instrument and a third party both of whom are parties to a
previously concluded treaty (see section A.1.3 below).
The multilateral instrument supersedes the provisions of bilateral treaties which cover
the same specific subject matter as the multilateral instrument.
European Convention on Extradition (1957)
Article28(1) Relations between this Convention and bilateral Agreements: This Convention
shall, in respect of those countries to which it applies, supersede the provisions of any bilateral
treaties, conventions or agreements governing extradition between any two Contracting Parties.
European Convention on the Repatriation of Minors (1970)
Article27(1): Subject to the provisions of paragraphs3 and 4 of this article, this Convention
shall, in respect of the territories to which it applies, supersede the provisions of any treaties,
conventions or bilateral agreements between Contracting States governing the repatriation of
minors for the reasons specified in Article2, to the extent that the Contracting States may always
avail themselves of the facilities for repatriation provided for in this Convention.
The multilateral instrument modifies the provisions of pre-existing (bilateral or other)

treaties only in so far as they differ from or are incompatible with the provisions of
the multilateral instrument. There are various thresholds for the invocation of these
compatibility clauses: in some cases, any difference will suffice (at variance), while
others require inconsistency or incompatibility between the provisions.
European Convention on the Suppression of Terrorism (1977)
Article8(3): The provisions of all treaties and arrangements concerning mutual assistance in
criminal matters applicable between Contracting States, including the European Convention
on Mutual Assistance in Criminal Matters, are modified as between Contracting States to the
extent that they are incompatible with this Convention.
North American Free Trade Agreement (1994)
Article103 Relation to Other Agreements: 1.The Parties affirm their existing rights and
obligations with respect to each other under the General Agreement on Tariffs and Trade and
other agreements to which such Parties are party. 2.In the event of any inconsistency between
this Agreement and such other agreements, this Agreement shall prevail to the extent of the
inconsistency, except as otherwise provided in this Agreement.
International Convention for the Suppression of the Financing of Terrorism (1999)
Article11(5): The provisions of all extradition treaties and arrangements between States
Parties with regard to offences set forth in article2 shall be deemed to be modified as between
States Parties to the extent that they are incompatible with this Convention.
There are also cases in which the compatibility clause, while providing for the primacy
of the multilateral instrument over pre-existing (bilateral or other) treaties, explains
that the rights and obligations arising from these other treaties are not affected by the
multilateral instrument to the extent that they are compatible with the multilateral
instrument. The first example is noteworthy: the multilateral instrument stipulates
that its provisions supersede those of pre-existing treaties but explicitly provides
that obligations in pre-existing treaties on issues not addressed by the multilateral
instrument continue to apply.
European Convention on Mutual Assistance in

Criminal Matters (1959)
Article26: 1.Subject to the provisions of Article15, paragraph7, and Article16, paragraph3,
this Convention shall, in respect of those countries to which it applies, supersede the provisions of
any treaties, conventions or bilateral agreements governing mutual assistance in criminal matters
between any two Contracting Parties. 2.This Convention shall not affect obligations incurred
under the terms of any other bilateral or multilateral international convention which contains or
may contain clauses governing specific aspects of mutual assistance in a given field.
United Nations Convention on the Law of the Sea (1982)
Article311(2) Relation to other conventions and international agreements: This Convention shall
not alter the rights and obligations of States Parties which arise from other agreements compatible
with this Convention and which do not affect the enjoyment by other States Parties of their rights
or the performance of their obligations under this Convention []

A variant is the case when the multilateral instrument creates an exception to a
general principle that the provisions of the multilateral instrument supersede those
of prior agreements, by providing that more favourable provisions of a bilateral
or multilateral treaty existing at the time of the conclusion of the multilateral
instrument shall not be affected.
Convention for the Elimination of All Forms of Discrimination Against Women

(1979)
Article23: Nothing in the present Convention shall affect any provisions that are more
conducive to the achievement of equality between men and women which may be contained:
[] (b)In any other international convention, treaty or agreement in force for that State.
International Convention on the Protection of the Rights of All Migrant Workers and
Members of their Families (1990)
Article81(1): Nothing in the present Convention shall affect more favourable rights or
freedoms granted to migrant workers and members of their families by virtue of: [] (b)Any
bilateral or multilateral treaty in force for the State Party concerned.
Finally, in some cases, the multilateral treaty goes further and clearly indicates
which of its provisions are added to the bilateral instruments or which provisions
of the bilateral treaties are modified and how. The following example concerns
the addition by a multilateral treaty to a list of offences defined as extraditable in
bilateral treaties.
Convention for the Suppression of Unlawful Acts against

the Safety of Maritime Navigation (1988)
Article11(1): [t]he offences set forth in article3 shall be deemed to be included as extraditable
offences in any extradition treaty existing between any of the States Parties.
iii. Compatibility clauses can address complex situations

25. A compatibility clause can take into account variations of scope, wording and
paragraph numbering between bilateral treaties modified by the multilateral instrument.
Careful drafting of the clause can circumvent the potential issues that could arise from
those variations.
26. There are useful precedents in which the compatibility clause in the multilateral
instrument describes:
The provisions to be modified by using a precise description which removes the
necessity to refer to a specific provision or paragraph number in the bilateral treaties.
The exact effect of its provisions on those of bilateral treaties, through the inclusion
of connecting terms such as in place of, in addition to, in the absence of.
Agreement on extradition between the European Union and the United States of
America (2003)5
Article3(1) Scope of application of this Agreement in relation to bilateral extradition treaties
with Member States: The European Union, pursuant to the Treaty on European Union, and
the United States of America shall ensure that the provisions of this Agreement are applied
in relation to bilateral extradition treaties between the Member States and the United States
of America, in force at the time of the entry into force of this Agreement, under the following
terms:
(a)Article4 shall be applied in place of bilateral treaty provisions that authorise extradition
exclusively with respect to a list of specified criminal offences;
(b)Article5 shall be applied in place of bilateral treaty provisions governing transmission,
certification, authentication or legalisation of an extradition request and supporting
documents transmitted by the requesting State;
(c)Article6 shall be applied in the absence of bilateral treaty provisions authorising direct
transmission of provisional arrest requests between the United States Department of Justice
and the Ministry of Justice of the Member State concerned;
(d)Article7 shall be applied in addition to bilateral treaty provisions governing transmission
of extradition requests;
(e)Article8 shall be applied in the absence of bilateral treaty provisions governing the
submission of supplementary information; where bilateral treaty provisions do not specify the
channel to be used, paragraph2 of that Article shall also be applied;
(f)Article9 shall be applied in the absence of bilateral treaty provisions authorising
temporary surrender of persons being proceeded against or serving a sentence in the
requested State;
(g)Article10 shall be applied, except as otherwise specified therein, in place of, or in the
absence of, bilateral treaty provisions pertaining to decision on several requests for extradition
of the same person;
(h)Article11 shall be applied in the absence of bilateral treaty provisions authorising waiver
of extradition or simplified extradition procedures;
(i)Article12 shall be applied in the absence of bilateral treaty provisions governing transit;
where bilateral treaty provisions do not specify the procedure governing unscheduled landing
of aircraft, paragraph3 of that Article shall also be applied;
(j)Article13 may be applied by the requested State in place of, or in the absence of, bilateral
treaty provisions governing capital punishment;
(k)Article14 shall be applied in the absence of bilateral treaty provisions governing treatment
of sensitive information in a request.
A.1.2.2. Bilateral tax treaties concluded after the entry into force of the
27. In order to ensure consistency with the legal regime established by the multilateral
instrument, the parties might deem it necessary to define certain parameters for their future
treaty-making activities through a forward looking compatibility or obedience clause.

28. Compatibility or obedience clauses, which are included in a number of existing
multilateral treaties, stipulate that parties shall not conclude subsequent agreements which
are in contradiction with the treaty.
29. In some cases, the objective of subsequent agreements by two or more parties to a
multilateral instrument may be to go further than the content of the main agreement by
establishing a special regime between themselves. This is the scenario addressed and
codified by article41 of the VCLT.6 According to this article, subsequent agreements must
not be prohibited by the main agreement and must not affect the rights and obligations of
other parties to the treaty.
Multilateral instruments may include clauses which allow parties to take on more
far reaching commitments with other parties on the condition that the subsequent
agreements can only confirm, supplement, extend or amplify the provisions of the main
multilateral treaty.
European Convention on Extradition (1957)
Article28(2) Relations between this Convention and bilateral Agreements: The Contracting
Parties may conclude between themselves bilateral or multilateral agreements only in order
to supplement the provisions of this Convention or to facilitate the application of the principles
contained therein.
Vienna Convention on Consular Relations (1963)
Article73(2) Relationship between the present Convention and other international agreements:
Nothing in the present Convention shall preclude States from concluding international agreements
confirming or supplementing or extending or amplifying the provisions thereof .
Multilateral instruments can also take the opposite approach providing that any
subsequent agreements must not run contrary to the object and purpose of the main
treaty or be inconsistent with its provisions.
Chicago Convention on International Civil Aviation (1944)

Article83 Registration of new arrangements: Subject to the provisions of the preceding
Article, any contracting State may make arrangements not inconsistent with the provisions of
this Convention. Any such arrangement shall be forthwith registered with the Council, which
shall make it public as soon as possible.
United Nations Convention on the Law of the Sea (1982)
Article311(3) Relation to other conventions and international agreements: Two or more States
Parties may conclude agreements modifying or suspending the operation of provisions of this
Convention, applicable solely to the relations between them, provided that such agreements do
not relate to a provision derogation from which is incompatible with the effective execution of
the object and purpose of this Convention, and provided further that such agreements shall not
affect the application of the basic principles embodied herein, and that the provisions of such
agreements do not affect the enjoyment by other States Parties of their rights or the performance
of their obligations under this Convention.
Council of Europe Convention on the Prevention of Terrorism (2005)

Article26(2) Effects of the Convention: [] However, where Parties establish their relations in
respect of the matters dealt with in the present Convention other than as regulated therein, they
shall do so in a manner that is not inconsistent with the Conventions objectives and principles.
Finally, in some cases the multilateral treaty may even invite parties to adopt
subsequent agreements in order to go further than the main treaty or facilitate its
effective application.
United Nations Convention Against Transnational Organized Crime and the

Protocols Thereto (2000)
Article19 Joint investigations: State Parties shall consider concluding bilateral or
multilateral agreements or arrangements whereby, in relation to matters that are the subject
of investigations, prosecutions or judicial proceedings in one or more States, the competent
authorities concerned may establish joint investigative bodies. []
A.1.3 Relationship between parties to the multilateral instrument and third parties
30. A corollary of the principle of State sovereignty is that treaties are only binding on
the parties.7
A treaty does not create either obligations or rights for a third State without its
consent8 and [a]n obligation arises for a third State from a provision of a treaty if the
parties to the treaty intend the provision to be the means of establishing the obligation
and the third State expressly accepts that obligation in writing. 9 (emphasis added)
31. Accordingly, in the present case, the content of the multilateral instrument would not
be binding on third parties (i.e.States which are not parties to the instrument). A party to
the multilateral instrument and a third party would continue to be bound by the provisions
of any bilateral tax treaty concluded between themselves without the modifications set
out in the multilateral instrument. It would however be possible to include a variant of the
compatibility clause which would request the parties to take into account as far as possible
the provisions of the multilateral instrument when negotiating bilateral tax treaties with
third parties. The multilateral instrument could also create the possibility for the parties to
confer regarding any issues that may be raised by third parties over time.
A.1.4 Timeline for entry into force of the multilateral instrument

A.1.4.1 Entry into force of the instrument and its provisions
i. The date of the entry into force of the instrument
32. The negotiating States can decide at what date and under which conditions the
instrument would enter into force, for example, after a certain number of ratifications. The
instrument would then be in effect but would only bind those States which have already
ratified by that date. Naturally the modalities for the implementation of the multilateral
instrument in each State would depend on its constitutional system.
Convention on Mutual Administrative Assistance in

Tax Matters (1988)
Article28(2) Signature and entry into force of the Convention: This Convention shall enter
into force on the first day of the month following the expiration of a period of three months
after the date on which five States have expressed their consent to be bound by the Convention
in accordance with the provisions of paragraph1.
ii. The start date of the different measures provided for in the instrument
33. Clauses in the multilateral instrument can specify a start date for the various measures
foreseen. It is possible to specify different dates for different provisions of the treaty to take
effect (e.g.a fixed period after the entry into force of the treaty for withholding taxes and
the start of the tax year in each country for other taxes).
34. The fact that the start of a tax year may be different in each State is not an obstacle.
For example, certain measures could take effect at the start of the next tax year in each
country following the entry into force of the treaty for that country (or provide for other
practical and flexible solutions).

Tax Matters (1988)
Article28(6) Signature and entry into force of the Convention: The provisions of this
Convention, as amended by the 2010 Protocol, shall have effect for administrative assistance
related to taxable periods beginning on or after 1January of the year following the one in
which the Convention, as amended by the 2010 Protocol, entered into force in respect of a
Party, or where there is no taxable period, for administrative assistance related to charges
to tax arising on or after 1January of the year following the one in which the Convention,
as amended by the 2010 Protocol, entered into force in respect of a Party. Any two or more
Parties may mutually agree that the Convention, as amended by the 2010 Protocol, shall have
effect for administrative assistance related to earlier taxable periods or charges to tax.
Agreement among the Governments of the Member States of the Caribbean Community
for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect
to Taxes on Income, Profits, or Gains and Capital Gains and for the Encouragement of
Regional Trade and Investment (1994)
Article28 Entry Into Force: 1.This Agreement shall enter into force on the deposit of the
second instrument of ratification in accordance with Article27 and shall there upon take effect
(a)in respect of taxes withheld at the source, on amounts paid or credited to a person, on the
first day of the calendar month next following the month of deposit of the second instrument
of ratification;
(b)in respect of other taxes, for taxable years beginning on or after the first day of January
next following the deposit of the second instrument of ratification.

Tax Matters (1988) (continued)
2.Where a State ratifies this Agreement after it was entered into force, the Agreement shall
take effect in relation to that State
(a)in respect of the taxes mentioned in paragraph1(a), on the first day of the calendar month
next following the deposit of its instrument of ratification;
(b)in respect of other taxes, for the taxable years beginning on or after the first day of January
next following the deposit of its instrument of ratification.
A.1.4.2 Entry into force for a party joining subsequently

35. The instrument can specify modalities for its entry into force for jurisdictions that
become parties after the entry into force of the instrument itself. The default position would
be entry into force upon deposit of instrument of ratification/accession but there can be a
time lapse, if necessary, in order to deal with potential technical difficulties.

Tax Matters (1988)
Article28(5) Signature and entry into force of the Convention: [] In respect of any State
ratifying the Convention as amended by the 2010 Protocol in accordance with this paragraph, this
Convention shall enter into force on the first day of the month following the expiration of a period of
three months after the date of deposit of the instrument of ratification with one of the Depositaries.
36. The provisions on the start date for certain provisions, for example those which
would take effect at the start of the next tax year, could also apply to jurisdictions which
become parties to the multilateral instrument after its entry into force.
A.1.5 Ensuring consistency in the interpretation and implementation of the

A.1.5.1. The instrument could be accompanied by interpretative guidance
37. Many treaties are accompanied by commentaries, agreed by all parties, providing
background information and guidance as to the meaning of provisions and modalities of
implementation (e.g.the Explanatory Report to the Convention on Mutual Administrative
Assistance in Tax Matters,10 hereafter MAC). The relationship between the treaty and its
commentaries could be defined in the provisions of the treaty itself.
A.1.5.2 Discussions between the parties on implementation

38. If agreed by the parties, a Conference of Parties or a Co-ordinating Body could be
given responsibility for discussing questions related to the instrument, or for monitoring
its implementation.
Convention on International Trade in Endangered Species of WildFauna and

Flora (1973)
Article11 Conference of the Parties: 1.The Secretariat shall call a meeting of the
Conference of the Parties not later than two years after the entry into force of the present
Convention. 2.Thereafter the Secretariat shall convene regular meetings at least once every
two years, unless the Conference decides otherwise, and extraordinary meetings at any time
on the written request of at least one-third of the Parties. 3.At meetings, whether regular or
extraordinary, the Parties shall review the implementation of the present Convention and
may:(a)make such provision as may be necessary to enable the Secretariat to carry out its
duties, and adopt financial provisions;(b)consider and adopt amendments to Appendices I
and II in accordance with Article XV;(c)review the progress made towards the restoration
and conservation of the species included in Appendices I, II and III;(d)receive and consider
any reports presented by the Secretariat or by any Party; and (e)where appropriate, make
recommendations for improving the effectiveness of the present Convention.
Convention on Mutual Administrative Assistance in Tax Matters (1988)
Article24(3) Implementation of the Convention: A co-ordinating body composed of
representatives of the competent authorities of the Parties shall monitor the implementation
and development of this Convention, under the aegis of the OECD. To that end, the
co-ordinating body shall recommend any action likely to further the

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OECD/G20 Base Erosion and Profit Shifting Project

OECD/G20 Base Erosion and Profit

2015 Final Reports

OECD/G20 Base Erosion and Profit Shifting Project

Please cite this publication as:

Photo credits: Cover ninog / Fotolia.com

Address the Tax Challenges of the Digital Economy ..................... 13

EXPLANATORY STATEMENT OECD 2015

EXPLANATORY STATEMENT OECD 2015

organisations such as the African Tax Administration Forum (ATAF), Centre de

Achievements of the BEPS Project

EXPLANATORY STATEMENT OECD 2015

EXPLANATORY STATEMENT OECD 2015

A. Implementation starts now

EXPLANATORY STATEMENT OECD 2015

B. Monitoring implementation and impact

C. Designing an inclusive framework

EXPLANATORY STATEMENT OECD 2015

ANNEX A. OVERVIEW OF THE BEPS PACKAGE 13

Action 1 Address the Tax Challenges of the Digital Economy

Action 2 Neutralise the Effects of Hybrid Mismatch Arrangements

Action 3 Strengthen CFC Rules

Action 5 Counter Harmful Tax Practices More Effectively, Taking into

Action 6 Prevent Treaty Abuse

ANNEX A. OVERVIEW OF THE BEPS PACKAGE 15

Action 7 Prevent the Artificial Avoidance of PE Status

Action 11 Measuring and Monitoring BEPS

Action 12 Require Taxpayers to Disclose their Aggressive Tax Planning

EXPLANATORY STATEMENT OECD 2015

ANNEX A. OVERVIEW OF THE BEPS PACKAGE 17

Action 13 Re-examine Transfer Pricing Documentation

Action 14 Make Dispute Resolution Mechanisms More Effective

EXPLANATORY STATEMENT OECD 2015

Action 15 Develop a Multilateral Instrument

EXPLANATORY STATEMENT OECD 2015

Albania, Argentina, Australia, Austria, Azerbaijan, Bangladesh, Belgium, Brazil,

EXPLANATORY STATEMENT OECD 2015

OECD/G20 Base Erosion and Profit Shifting Project

OECD/G20 Base Erosion and Profit

OECD/G20 Base Erosion and Profit Shifting

Addressing the Tax

OECD/G20 Base Erosion and Profit Shifting Project

Addressing the Tax

Please cite this publication as:

ISBN 978-92-64-24102-2 (print)

Series: OECD/G20 Base Erosion and Profit Shifting Project

Photo credits: Cover ninog Fotolia.com

Corrigenda to OECD publications may be found on line at: www.oecd.org/about/publishing/corrigenda.htm.

ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY OECD 2015

Abbreviations and acronyms 9

B.3. Cloud computing 175

Percentage of fibre connections in total fixed broadband subscriptions, June 2014 37

ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY OECD 2015

Ottawa Taxation Framework Conditions Principles17

ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY OECD 2015

A bbreviations and acronyms 9

Abbreviations and acronyms

Association des Bureaux pour la Protection de la Proprit Industrielle

Application programming interface

Application service provider

Base erosion and profit shifting

Business and Industry Advisory Committee to the OECD

Committee on Fiscal Affairs

Abbreviations and acronyms 9

B.3. Cloud computing 175

Percentage of fibre connections in total fixed broadband subscriptions, June 2014 37

Ottawa Taxation Framework Conditions Principles17