International taxation controversy: the coming storm

McDermott Will & Emery logoAuthor:  Cym H. Lowell and William Zhang

There is a revolution underway in the world of international taxation.  The current essential treaty and substantive taxation rules were developed shortly after the end of World War I using England and India—denominated “imperial” and “colony” countries, respectively—as a model.  The purpose of these treaty and substantive rules was to repatriate income from the colony country to the imperial country to facilitate repayment of war debts.  As a result, the model treaties that formed the basis of the current Organisation for Economic Co-operation and Development (OECD) and United Nations models essentially allowed source countries to tax only a limited share of the overall (combined) income, and allocated the residual income to the “residence” country (England, or the imperial country).

The central flaw in this approach was the treatment of interim holding companies as “residence” countries.  The assumption was that all countries would ultimately adopt the same taxation regimes and rates.  Needless to say, this never happened.  A related flaw was the framework of the transfer pricing rules promulgated under the model treaties.  In this context, “transfer pricing” refers to the mechanisms for allocating income between affiliates located in different jurisdictions.  In order to allocate residual income to the residence country, the primary transfer pricing methods were so-called “one-sided” methods, which tested the source country entity.  A combined or “two-sided” approach (profit split) was typically the lowest priority method.

These two critical issues have undergirded multinational enterprise (MNE) global income tax planning for generations.  In mid-2013, the G-8 and G-20 countries expressed concern about the perception that MNEs do not pay their fair share of tax in their respective countries, and directed the OECD to study the matter.


On July 17, 2013, the OECD released its contemplated Base Erosion and Profit Shifting (BEPS) Action Plan.  The Action Plan identified 15 subjects to be addressed, which for present purposes can be categorized as follows (with parenthetical references to the Action number assigned by the OECD):

  1. Transfer Pricing Matters
    a.   Intangibles transfer (Action 8)
    b.   Risks and capital (Action 9)
    c.   Non-third-party arrangements (Action 10)
    With respect to this action item, the details suggest a need to “(ii) [c]larify application of transfer pricing methods, in particular profit splits, in the context of global value chains; and (iii) provide protection against common types of base eroding payments, such as management fees and head office expenses.” In other words, the OECD is concerned about the mechanics of base erosion.
    d.   Re-examination of documentation (Action 13)
  2. Treaty Matters
    a.   Treaty abuse—commissionaire-type arrangements (Action 6) 
    b.   Permanent establishment definition (Action 7)
    c.   More effective dispute resolution (Action 14)
    d.   Development of a multinational instrument to amend treaties (Action 15)
  3. Backstop Matters
    a.   Digital economy (Action 1)
    b.   Hybrid mismatch (Action 2)
    c.   Country foreign corporation rules (Action 3)
    d.   Interest and financial payment deductions (Action 4)
    e.   Substance for preferential regimes (Action 5)
  4. Information Exchange and Documentation
    a.   Disclosure of rulings on preferential regimes (Action 5)
    b.   Disclosure of aggressive tax planning arrangements (Action 12)
    c.   Collection and evaluation of data about BEPS (Action 11)

The critical issues for most MNEs are the transfer pricing and treaty-related matters (items 1 and 2 above).

Challenges of the BEPS Project

There are a variety of elements that all parties must consider in evaluating the BEPS Action Plan and the way forward.

Limits of OECD Authority

The OECD itself has no mandate to change the law, even with the broad public endorsement of the G-8 and G-20.  Accordingly, any actual change in treaty or transfer pricing policy will depend on take-up from interested sovereign states.  Therein lies the fundamental problem for an initiative such as this: it relies on domestic implementation on a country-by-country basis. 

Because there inevitably will be variation in how states adopt the OECD proposals, there will never be a perfectly coordinated, supra-national action on BEPS.  In practical terms, the process envisioned by the Action Plan will be a starting point to address perceived shortcomings of the current principles of international taxation.

The difficulties of sovereign country action is perhaps best illustrated by the United Kingdom’s newly introduced “patent box,” which from one perspective could be interpreted as a base-eroding tactic in favor of the UK fisc.  The OECD cannot force the United Kingdom to abandon the patent box regime, and, given the regime’s relatively recent appearance on the statute books, it seems highly unlikely that the United Kingdom would remove it voluntarily.  In addition, the regime almost certainly was enacted with due consideration of the OECD’s public and prominent work in the BEPS space, in which the United Kingdom is a leader.

On the other hand, there has been recent governmental cooperation across a broad spectrum of domestic systems and points-of-view in other areas of international tax compliance.  For example, there has been broad international cooperation with the U.S. initiative addressing investment income reporting, framed by the U.S. Foreign Account Tax Compliance Act. 

Prior OECD Initiatives

A related practical reality is that the BEPS Action Plan is not the first time that the OECD has undertaken broad-based efforts to address perceived tax base erosion matters.  In May 1996, OECD ministers called upon the OECD to “develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases . . . .”  The heads of state of the then-current G-7 countries endorsed this request, urging the OECD “to vigorously pursue its work in this field, aimed at establishing a multilateral approach under which countries would operate individually and collectively to limit the extent of these practices.”  While the project started off in a similar manner as the BEPS Action Plan, the net result after several years of what became the Harmful Tax Competition initiative was a broad-based expansion of information exchange agreements.  The takeaway for the BEPS process is that the study may or may not result in concrete proposals that would materially affect the effective tax rate (ETR) planning of many MNEs.

Posture of BRICS and Non-Member Source Countries

A third practical element relates to the posture of Brazil, Russia, India, China and South Africa (BRICS) and other non-OECD-Member countries.  The BRICS in particular have been outspoken critics of the OECD model treaty and its transfer pricing guidelines for many years.  Indeed, the BRICS even have suggested the possibility of developing their own model treaty.  The background of this situation is an interesting element of tax policy history, as noted above. 

For most MNEs, the most serious current international taxation issue is the difficulty of implementing global ETR plans in the BRICS and other source countries.  While the BRICS members of the G-8 and G-20 have endorsed the BEPS Action Plan process, it should be kept in mind that reaching high-level political agreement to a plan of action is a far cry from subscribing to, and implementing, the more granular proposals that may be forthcoming.

Nonetheless, the apparent trend of thinking in the BRICS and source countries seems to coincide with what can be anticipated from the BEPS Action Plan process.  The issues likely to be most important to the BRICS and other non-OECD-Member countries could be along the following lines:

  • Preference for two-sided (versus one-sided) transfer pricing testing to ensure that source country functional activities are appropriately taken into account in allocating residual income
  • Permanent establishment of limitations in the current model treaties
  • Expansion of the definition of “intangible” assets to include a broad range of local market synergies (so-called China premium)
  • Backstopping of transfer pricing and domestic tax enforcement, tax base protection requiring:
    • Exit taxes
    • General anti-avoidance principles
  • Extra-territorial reach (so-called Vodafone issue in India)

Several of the BRICS have suggested a potential need for a new “source” country model tax treaty, at least for purposes of framing discussion in future treaty deliberations.  The BEPS Action Plan clarifies that it is “not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income,” which means that MNEs should expect that the BRICS countries may continue to pursue their respective agendas outside the context of the OECD’s BEPS project.


The European Union has undertaken its own action plan to “strengthen the fight against tax fraud and tax evasion.”  If both the EU and OECD action plans continue, coordination will be necessary at some point.

Other OECD initiatives also are underway that could have an impact on any ultimate BEPS proposals.  For example, the intangibles project involves many elements of the transfer pricing portion of the BEPS Action Plan.  In addition, the first Action Plan item is the digital economy, which the OECD tried to address in its 2010 update of the model treaty, although that update probably created more issues than resolutions.


Another issue that must be considered in-depth as the process evolves is how transition from the status quo will be addressed with respect to any specific action ultimately undertaken by one or more countries.  Oddly enough, the Action Plan seems to discourage this reality, as it calls in several places for concerted and coordinated action.  The likelihood that some states will wish to move faster and more comprehensively than others is almost inevitable. 

Nonetheless, if there is material change in specific treaties or transfer pricing guidelines, there will be a grandfathering process of effective dates and other items, which will provide a transitional period to adapt the ETR planning of MNEs.


Notwithstanding these practical issues, the BEPS Action Plan reflects a process that has commenced with broad political support and which could lead to an update of the OECD model treaty and transfer pricing guidelines in due course.  At the same time, it may end up like the Harmful Tax Competition initiative, with nothing of materiality to MNEs.  If there is not an outcome that addresses the demands of the BRICS and source countries, there may well be an entirely different process to be undertaken.

Areas of Likely Concern for MNEs

As noted, the BEPS Action Plan can be broken down into four areas of focus.  We will use the same format to highlight the areas of likely concern.

  1. Transfer Pricing Matters
    a.   Intangibles transfer (Action 8)
    Basis of Concern: Continued expansion of “soft” intangibles concepts, reflecting posture of BRICS and source countries.  The revised draft intangibles guidelines further this area of concern.
    b.   Risks and capital (Action 9)                          
    Basis of Concern: It is likely that “risk-taker” concepts will be under attack, as opposed to functions having substantial people content. 
    c.   Non-third-party arrangements (Action 10)
    Basis of Concern: Continued focus on two-sided transfer pricing (profit splits) confirmation or elevated status.
  2. Treaty Matters
    a.   Treaty abuse—commissionaire-type arrangements (Action 6) 
    Basis of Concern: All “global principal”-type structures likely will receive greater scrutiny, perhaps to be tested as noted above.
    b.   More effective dispute resolution (Action 14)
    Basis of Concern: Could be trade-off for more assertive transfer pricing.
  3. Backstop Matters
    a.   Digital economy (Action 1)
    Basis of Concern: How will it be addressed from sourcing standpoint? 
    b.   Substance for preferential regimes (Action 5)
    Basis of Concern: What about regimes like the UK “patent box”?
  4. Information Exchange and Documentation                 
    a.   Country-by-country reporting of financial information to disclose combined financial information to all countries in a uniquely specified manner (Action 12)
    b.   Disclose aggressive tax planning arrangements (Action 12)
    Basis of Concern: Definition.

MNE Planning Considerations

These trends related to BEPS and BRICS suggest that epochal change in treaty and transfer pricing policies may be on the horizon.  If there is enough political will to push through even some of the changes envisaged by the BEPS Action Plan, then, in view of the rather short proposed timeframe, MNEs should engage proactively with the principles and policies underlying the Action Plan’s stated aims.  MNEs also should be vigilant in keeping fully abreast of developments in this sphere and in considering potential implications of the evolving process on their global value supply chains, particularly their global ETR planning.  An important element on the global tax agenda of all MNEs should be consideration of how ETR planning will be affected by any or all of the evolutions noted above.  In this respect, all MNEs engaged in cross-border business should address at least two questions as the BEPS Action Plan process evolves:

  • What does the project mean to my company?  The likely outcomes of the BEPS process are as noted.  These elements should be reviewed in terms of their importance to a specific MNE and its ETR plan.
  • What should we be doing as the BEPS process evolves, recognizing that it is a political process that ultimately reflects competing governmental interests?  The answer should include the following elements: 
    • Establish a simplified spreadsheet version of the ETR plan.
    • Evaluate the likely impact of each of the elements noted above.
    • Identify which elements are material to the ETR plan and which are not.
    • For those that are material, evaluate steps that could be taken, consistent with overall business plans, to mitigate adverse consequences of such elements if they should become reality.  In essence, create contingency plans.
    • Such plans then can be taken into account as business decisions are made over time.
    • Consider transitionary issues.
    • Determine home country tax authority coordination, as needed.

In practice, modeling such matters is a relatively straightforward process.  For example, it is a process that is regularly undertaken with respect to resolution of substantive tax or transfer pricing disputes, either administratively or in Competent Authority, Advance Pricing Agreement or litigation contexts.  In all of these contexts, likely outcomes are evaluated to develop contingency plans or business plan adaptations.

As is true in any type of material evolution, legacy structures may need to be revisited, especially where anticipated tax benefits accrue annually and the existing planning will be affected by that evolution.

A specific approach could be along the following lines.  In evaluating a potential transaction, the in-house tax audit manager would prepare mock Information Document Requests (IDRs) from the relevant tax authorities.  An external accounting or law firm could respond to these mock IDRs, perhaps in such a manner as to ensure attorney-client privilege.  From these responses, a risk matrix can be prepared, which should list the various outcomes, quantify them using tax software and compute a risk weighted value for the respective outcomes.  Once that risk matrix is evaluated, the transaction could be revised to mitigate the risk, be scrapped or tabled, or proceed.

There are a number of ways to arrive at the risk quantifications.  One is the “Las Vegas bookie” approach.  External advisors, not involved in the transaction, would be provided with the pertinent data and asked to place a wager, which will establish a betting line.  If the final betting line is 3 to 2, meaning that one would need to wager $3 to win $2, it would translate into a 60 percent chance of prevailing on the tax position. 

Another approach is “role playing,” in which an external tax expert would be asked whether he or she wants to represent the taxpayer or the Internal Revenue Service (IRS) on the case, with the winner receiving a $1 million fee.  This may determine the level of opinion that could be issued.  Depending on this result, the process could continue with a change in the stakes—e.g., if the external adviser represented the taxpayer and would receive $1 million for a win, a fee appropriate for an IRS victory could be determined.  Presumably it would be much higher.

Not surprisingly, the risk established by these two approaches can be materially different from the posture of the external advisor’s opinion.

It is appropriate that privilege issues be addressed in such a process.


We are entering an exciting and challenging time for MNEs.  The G-8, G-20 and OECD have made it clear that they seek a fundamental rewrite of the international taxation principles laid down almost a century ago. 

The ultimate value of the BEPS Action Plan will be determined by its implementation.  Given that the current opportunities for international tax planning and BEPS are largely a consequence of the rules on international tax enacted by states (rather than anything MNEs have created on their accord), it is possible that little may come of the Action Pan if those states ultimately determine to protect their own interests, as occurred with the Harmful Tax Competition process.

That said, it seems possible that BEPS has gained sufficient political momentum for some form of change to occur in due course, which would justify the internal evaluation process noted above.

In any event, the likelihood of an ever-escalating international tax controversy docket for all MNEs is high, for a variety of reasons:

  • The list of countries focusing on transfer pricing and other perceived means of base erosion has grown (encouraged by international finance and related organizations, with more than 70 countries requiring transfer pricing documentation).
  • The volume of transfer pricing controversies and mutual agree procedure (MAP) cases is growing steadily in all countries.
  • In many countries, the treaty dispute resolution process (so-called MAP cases under the pertinent articles of treaties) is slow, inefficient or non-existent.
  • BEPS Action Item 4 is dispute resolution, but this item is vague and probably the least likely element to result in serious improvement of the unfortunate situation that exists in many countries.
  • MNEs will be well advised to undertake the self-examination process noted above and to press their home country tax authorities to focus on dispute resolution (double or multiple taxation avoidance) as a critical element of their own tax base defense.