The requirements partly depend on whether the income is from intellectual property (IP).
By LEON HARRISApproximately 170,000 Americans live in Israel. In total, more than one million U.S. citizens and green card holders – who both live overseas and own more than 10% of a foreign corporation – faced the prospect of paying the tax.(photo credit: REUTERS)
How do you know whether an offshore location is okay for tax purposes? The term “offshore” is a misnomer of course, as some are inland and have no coast. And many “onshore” countries have favorable tax regimes – such as Israel, the US and the UK.The OECD has issued guidance on this issue that aims to sort out the tax wood from the trees (“Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions”). This aim to expand Action 5 of the 2015 OECD campaign against BEPS – base erosion and profit shifting.Action 5 of BEPS deals with harmful tax practices. It recommends that countries only grant tax breaks if the taxpayer entity itself conducted the core income-generating activities concerned, for example, R&D without outsourcing. This is called the nexus approach.The latest guidance addresses no-or-nominal tax jurisdictions that don’t need to offer tax breaks. The OECD recommends that core income-generating activities (CIGA) in no-or-nominal tax jurisdictions meet certain “substantial activities” requirements.The requirements partly depend on whether the income is from intellectual property (IP).ScopeThe OECD says the substantial activities requirements should apply to a jurisdiction which applies no corporate income tax or a nominal rate to avoid the requirements. That should rule out countries like Ireland and Cyprus, which apply a 12.5% rate. The requirements apply to “geographically mobile” activities: headquarters, distribution centers, service centers, financing, leasing, fund management, banking, insurance, shipping, holding companies and the provision of “intangibles” (presumably digital products).IP and non-IP incomeThe OECD says the low-tax jurisdiction should have laws to: 1) define core income generating activities; 2) ensure they are undertaken by the entity or in the jurisdiction; 3) require the entity to have an adequate number of full time employees with necessary qualifications and incur adequate expenditures to undertake such activities; 4) have a transparent compliance enforcement mechanism – for example, financial services regulation or incorporation framework.AdvertisementIP income – patents and similar assetsThe OECD says the entity should conduct R&D, as the core income-generating activity with an adequate number of full-time employees and adequate operating expenditures – the nexus approach.IP income – marketing intangibles such as trademarksThe OECD says the entity should conduct substantial activities such as branding, marketing and distribution.IP income exceptionIn the case of IP income, the substantial activities requirement will never be met if:• The entity only passively holds IP assets which were created and exploited on the basis of decisions made and activities performed outside the jurisdiction concerned, or if• The only activities contributing to the income were periodic decisions in the jurisdiction of non-resident board members (Guidance Paragraph 29).This rule is clearly aimed at well-known US multinationals.High-risk inter-company scenariosThe OECD recommends a rebuttable assumption that the above substantial activities test may not be met in high risk scenarios where IP is acquired from related parties and licensed or sold or exploited via related parties. The low-tax entity can rebut this by providing evidence that there has always been a high degree of control over the development, exploitation, maintenance, protection and enhancement (“DEMPE”) of the IP. (This rules out most lawyers and accountants in offshore trust companies).Ensuring complianceThe OECD says that low-tax jurisdictions should institute a mechanism requiring entities to report whether core income generating activities are carried out. If the substantial activities test is not met, the entity should be sanctioned, e.g., struck off the relevant register. Also, there should be spontaneous exchange of information with the jurisdictions of the immediate parent, the ultimate parent and the ultimate beneficial owner – but only of high-risk scenarios if the low-tax jurisdiction has a fully equipped monitoring process.CommentsThe OECD does not spell out what happens if an offshore entity lacks sufficient substantial activities. Presumably most onshore jurisdictions will impose their tax on the profits of the offshore entity. The risk for multinational groups is multiple taxation in each of the onshore countries they have commercial links to. This necessitates new tax planning and reorganization.As always, consult experienced tax advisers in each country at an early stage in specific cases.leon@hcat.co.The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
