OECD Initiative on Harmful Tax Competition

In this article we will discuss about:- 1. Background of OECD Initiative 2. Historical Development of OECD Initiative 3. Comments.

Background of OECD Initiative:

Harmful competition arises due to mismatches in the existing tax systems of countries that can be exploited by taxpayers. Such economic behaviour may be considered as unacceptable tax avoidance by certain countries since they believe that it undermines the integrity and fairness of their tax systems. In December 1997, ECOFIN adopted a Code of Conduct for European Union Member States.

It required them to abolish existing practices that promoted harmful tax competition, and not to take new measures that may be harmful. In 1998, the OECD published its own report on harmful tax competition (“1998 Report”). This subsection provides a brief summary of the developments in the OECD initiative since 1998, and its status.

Historical Development of OECD Initiative:

(i) The 1998 Report:

The 1998 OECD Report dealt with tax practices among nations that compete for geographically mobile activities, such as financial and other services (e.g. centralised operations of multinational activities), including the provision of intangibles.

It did not apply to other types of tax competition such as:

(i) Competition to attract foreign direct investment for industrial or commercial activities, or

(ii) Competition to attract passive, portfolio investment.

The Report was approved by all the OECD Council members, other than Luxembourg and Switzerland. According to the Report, harmful tax competition affects the location of activities, and erodes the tax base of other countries. The recent trend towards globalisation had led to increased competition among businesses in the global marketplace.

As countries compete for related tax revenues through tax incentives in their own jurisdiction, they effectively divert real investment and “poach” at the tax base that “rightly” belongs to another nation.

The spill-over effect leads to unfair allocation of global tax revenues and interaction of tax systems that harm global capital flows. It also distorts trade and investment patterns and undermines the fairness, neutrality and the broad social acceptance of national tax systems

The Report recommended measures to “counter the distorting effects of harmful tax competition on financing decisions and the consequences for national tax bases”. It, however, concluded that the problem could only be resolved satisfactorily through a collective or multilateral approach by all countries. It identified three types of tax regimes that could divert investment, and tax revenues, to other countries.

They were:

1. Tax havens:

Tax havens impose no tax or nominal tax, and assist nonresidents to avoid the taxes in their home country. They attract investment or transactions that are purely tax- driven without economic substance. Many of them have a weak regulatory framework or business infrastructure. As they usually have few or no tax treaties, they impose serious limitations on effective exchange of tax information.

2. Preferential tax regimes:

These regimes are based in countries with high taxes that allow certain business activities to be subject to low or zero effective tax under special tax rules.

They include tax concessions, such as an artificial definition of the tax base, inadequate transfer pricing rules, tax exemption for foreign source income, negotiable tax rate or tax base, secrecy provisions, access to a wide treaty network, etc. Such regimes may also be isolated from the domestic economy (i.e. ring fenced), non-transparent or again lack effective exchange of tax information.

3. “Normal” tax regimes:

Countries that collect significant revenues at low tax rates and do not have special tax concessions to attract mobile financial activities from abroad. (This category was excluded from the study.)

The Report concentrated only on tax havens and preferential tax havens, and suggested several indicators of harmful tax competition. In particular:

4. Is the preferential tax regime the primary motivation for the location of an activity?

5. Is there a shift of a business activity from one country to a country providing the preferential tax regime without generating significant new activity?

6. Are the activities in the country commensurate with the amount of investment or income?

The OECD Report also made nineteen specific recommendations to curb harmful tax practices, as follows:

(a) Recommendations concerning domestic legislation and practices:

(1) Wider and more effective use of controlled foreign corporation or equivalent rules;

(2) The adoption of controlled foreign corporation rules over foreign investment funds that may escape anti-abuse provisions;

(3) The restriction over participation exemption and tax exemption of foreign source income on income from tax havens or listed harmful tax preferential tax regimes;

(4) More extensive exchange of information, as provided under Article 26 of the OECD MC, to counter harmful tax practices;

(5) The publication of advance tax rulings, where given, with the reasons for granting, denying or revoking such decisions;

(6) The adherence to the OECD 1995 transfer pricing guidelines; and

(7) The adequate access to banking information to tax authorities.

(b) Recommendations concerning tax treaties:

(8) More efficient use of the Exchange of Information Article under the tax treaties and the OECD Multilateral Convention for Mutual Assistance in Tax Matters by tax authorities;

(9) The reduction in the risk of unintended use of the treaty by third-country residents through better use of the existing treaty restrictions and the development of additional provisions to curb treaty shopping;

(10) Further amendments in the MC Commentary to remove any uncertainty or ambiguity regarding the compatibility of domestic anti-abuse provisions with tax treaties;

(11) The preparation of a list of specific exclusion provisions found in treaties to provide a reference point in treaty negotiations;

(12) The termination of existing tax treaties (and also avoid future treaties) with tax havens;

(13) The undertaking of co-ordinated enforcement programs among tax authorities, such as simultaneous examinations, specific exchange of information projects or joint training activities; and

(14) The mutual assistance of tax authorities in the recovery of cross-border tax claims.

(c) Recommendations for International co-operation:

(15) The adoption of the Guidelines prescribed in the Report by member countries for dealing with harmful preferential tax regimes, and the establishment of a Forum on Harmful Tax Practices to carry out the guidelines and other recommendations;

(16) The preparation of a list of tax havens;

(17) The review by countries that have links with tax havens as dependencies to ensure that they do not encourage harmful tax competition;

(18) The development and active promotion of principles of a good tax administration; and

(19) The involvement of non-OECD member countries to promote the recommendations in the Report.

Under Recommendation 15, the Forum on Harmful Tax Practices (“Forum”) set out six “Guidelines” for the OECD Member States, as follows:

(i) Member countries are to refrain from adopting new measures or extending the scope of or strengthening existing measures that constitute harmful tax practices, as defined in the report.

(ii) Member countries should review their existing measures for identifying harmful tax practices and report them (if any) to the Forum.

(iii) Member countries must remove those measures identified and listed as harmful tax practices by the Forum by mid-2003.

(iv) Member countries may request that measures of another member that are not listed be examined.

(v) Member countries should co-ordinate, through the Forum, their responses to harmful tax practices of non-members.

(vi) Member countries should use the Forum to encourage non-members to associate themselves with the guidelines.

These Guidelines were meant both to remove harmful tax practices among Member States and to co-ordinate their responses to the harmful practices of non-member countries. The Forum was concerned that taxpayers will be tempted to move to them once these practices were eliminated by Member States.

ii. Towards Global Tax Co-operation (2000-2003):

In June 2000, the OECD issued a progress report on its efforts to identify and eliminate harmful tax competition under the 1998 Report. This Report published two lists: a list of tax havens (Recommendation 16) and a list of potentially harmful measures of OECD Member States (Guideline 2). The primary focus of these Reports was on tax havens, and not on preferential tax regimes.

Preferential tax regimes: The OECD Forum identified and listed 47 potentially harmful practices within Member States, which were applicable to geographically mobile activities.

A regime was considered potentially harmful if it had the potential to constitute a harmful tax practice. The Forum also agreed to develop a set of “application notes” for Member States to identify harmful features, to determine whether they were actually harmful and to consider how such features could be remove.

The Guidelines required that the existing harmful preferential tax regimes in Member States were to be remove by April 2003, and the benefits to taxpayers under these regimes at 31 December 2000 must cease by the end of December 2005. Moreover, under a “standstill” provision the Member States must not adopt new measures or extend such harmful tax practices.

Tax havens:

The list of non-member tax havens was reduced to 35 from the original list of 47 countries. Besides the six countries, which were deemed not to be tax havens (Brunei, Costa Rica, Dubai, Jamaica, Macao and Tuvalu), they excluded the six countries that had made advance commitments to the principles of the 1998 Report (Bermuda, Cayman Islands, Cyprus, Malta, Mauritius and San Marino).

By April 2002, only seven jurisdictions remained on the list. Out of the offshore jurisdictions identified in the 2000 Report, 28 of them had agreed to phased commitments on transparency and effective exchange of information by 2006. Three countries were excluded as not harmful (Example: Barbados, Maldives and Tonga).

The 2000 Report also listed the proposed “defensive measures” for co-ordinated action to be applied to uncooperative tax havens. They included:

1. Disallow deductions, exemptions, credits or other allowances on transactions with unco­operative tax havens and on transactions that take advantage of their harmful tax practices.

2. Require comprehensive information reporting rules for transactions that involve uncooperative tax havens or take advantage of their harmful tax practices, and provide for substantial penalties for inaccurate reporting or non-reporting of those transactions.

3. Adopt CFC or equivalent rules if they do not have them and to apply them, if they have them, to curb harmful tax practices.

4. Deny any exceptions that may otherwise apply to the application of regular penalties in the case of transactions that either involves entities organised in uncooperative tax havens or take advantage of their harmful tax practices.

5. Deny the availability of the foreign tax credit or the participation exemption on distributions that are sourced from uncooperative tax havens and to transactions that take advantage of their harmful tax practices.

6. Impose withholding taxes on certain payments to residents of uncooperative tax havens.

7. Enhance audit and enforcement activities with respect to uncooperative tax havens and on transactions that take advantage of their harmful tax practices.

8. Ensure that any existing and new domestic defensive measures against harmful tax practices are also applicable to transactions with uncooperative tax havens, and to transactions that take advantage of their harmful tax practices.

9. Not to enter into any comprehensive income tax conventions with uncooperative tax havens, and to consider terminating any existing conventions, unless certain conditions are met.

10. Deny deductions and cost recovery, to the extent otherwise allowable, for fees and expenses incurred in establishing or acquiring entities incorporated in uncooperative tax havens.

11. Impose “transactional” charges or levies on transactions involving uncooperative tax havens.

During this period, the OECD modified its approach and timetable for tax havens. In the 2001 Progress Report, the “absence of a requirement for substantial activity” was deleted. For a tax haven to exist, besides nil or nominal tax, the only requirements were fiscal transparency and exchange of information.

The OECD also maintained that tax competition was not harmful but that there were harmful tax practices that could be used to compete in a globally harmful way. From then onwards the OECD renamed the project as “Harmful Tax Practices”.

In April 2002, the OECD published a “model exchange of tax information agreement” to provide further guidance to tax havens. However, the required level was left to the OECD Member States and their needs, based on either bilateral or multilateral agreements to be entered by them.

Moreover, whereas the OECD initiative was confined to mobile financial activities, these agreements required effective exchange by tax havens for all tax matters. The concept of transparency, which was closely linked with the exchange of information, was also prescribed with certain deadlines that must be met. These requirements did not apply to OECD Member States with preferential tax regimes.

The deadlines and requirements under the OECD commitments for tax havens were, as follows:

(a) December 31, 2002:

Know the beneficial owner and ensure that proper financial accounts (audited or filed) under generally accepted accounting standards were kept. The information must be accessible by the regulatory body or tax authorities in the country for them to exchange the information, if required.

(b) December 31, 2003:

Provide for exchange of information, including access to bank information, on criminal tax matters. The term was widely defined to include any matters involving tax frauds.

(c) December 31, 2005:

Provide for exchange of information on civil tax matters. The term included any issues affecting the determination, assessment, collection or enforcement of taxes.

These commitments were subsequently made conditional on:

(i) All OECD member countries accepting the same rules and the same timetable, and

(ii) The same defensive measures were to be applied to them in case of non-compliance.

There was only one standard and it applied irrespective of whether the country was within or outside of the OECD area. The OECD established a Global Forum to monitor including members from “tax haven” countries, to monitor the compliance with the commitments and ensure a “level playing field”.

(iii) 2004 Progress Report Onwards:

The 2004 Progress Report mentions that its initiative on harmful tax practices was virtually complete. Nearly all the potentially harmful tax regimes among its Member States, as listed in its 2000 Report, had been abolished, were in process of being abolished, amended or found not to be harmful.

There were only two regimes that required further investigation: the Luxembourg 1929 Company and the 50/50 practice or Administrative Company regime in Switzerland.

Most OECD States met the exchange of information standards, as only four OECD countries (Austria, Belgium, Luxembourg and Switzerland) did not exchange bank information in civil tax matters. Moreover, Switzerland had agreed to effective exchange of information in bilateral treaties.

According to the Report, the future OECD work on preferential tax regimes will focus on monitoring remaining regimes and any new potentially harmful regimes identified.

The emphasis for them was on lack of information exchange and lack of transparency, besides ring fencing. Although low tax was not a relevant criterion by itself any more, the other factors could make a regime potentially harmful. The Report also concluded that the OECD efforts on tax havens had made good progress with the diluted requirements.

The commitments for tax havens were now confined to:

(i) Knowledge of beneficial ownership,

(ii) Exchange of tax information, and

(iii) Keeping of reliable financial accounts that could be accessed by the authorities.

The OECD has changed its approach from fighting tax competition to combating tax evasion by its residents using tax havens. It now maintains that tax harmonisation with the same level and structure of tax is (and was) not its objective. In its view, transparency and exchange of information were adequate to ensure more tax competition with greater compliance and less tax evasion and to safeguard their own tax base.

Guidance (Application Note) Report:

As part of the 1998 Report, the OECD had adopted certain Guidelines for dealing with harmful tax competition in Member States for geographically mobile (primarily financial) activities. These Guidelines defined what it termed as “harmful tax competition” and also laid down the criteria for defining both tax havens and preferential tax regimes.

The rules applied for classification of such regimes and tax havens were as follows:

(a) The four main criteria for harmful preferential tax regimes were:

(i) Nil or low effective tax rate on the relevant income.

(ii) Ring-fenced tax regime for tax concessions to nonresidents.

(iii) Lack of transparency with inadequate regulatory supervision and financial disclosure.

(iv) No effective measures for exchange of tax information.

(b) The four key factors for identifying tax havens were:

(i) Nil or nominal taxes.

(ii) Lack of effective exchange of information.

(iii) Lack of transparency.

(iv) Absence of a requirement that the activity be substantial.

The Guidance (Application Note) Report issued in March 2004 by the Forum further explained the criteria for harmful preferential tax regimes.

Some of its significant comments are summarised below:

Nil or low effective tax rate:

a. The presence of a low or zero effective tax rates alone, due to either low tax rate or low tax base or both, did not make a preferential regime harmful. However, it was necessary (“gateway criterion”) to determine whether the other criteria made such regimes harmful.

b. Every jurisdiction had the right to determine whether to impose direct taxes and, if so, to determine the appropriate tax rate for a particular activity. They were essentially political decisions for national governments.

Ring fencing:

a. The Report did not prevent a country from providing a preferential regime to encourage an activity in a particular sector of its economy, even if the preference involved geographically mobile activities (i.e. a lower rate for some particular activity).

b. A preferential regime was ring-fenced only in situations when it either explicitly or implicitly excluded resident taxpayers from the tax benefits of the regime, or when the enterprise qualifying for the regime did not have unrestricted access to the domestic market.

c. Ring-fenced enterprises may be restricted from operating in the domestic market either explicitly or implicitly. The latter example would include requirements to do business only in foreign currencies. This condition did not apply if the ring fencing of the domestic market was done for non-tax reasons.

d. Ring fencing applied only to regimes that deviated from the general structure of the tax system in the country. However, different taxation for significantly different domestic and foreign markets would not constitute ring fencing. It was also unaffected by measures applied to avoid or relieve double taxation.

e. Worldwide or territorial tax systems, as well as differing source-based taxes on residents and nonresidents under the general tax system, did not constitute ring fencing. It was also possible to have separate preferential regimes for residents and nonresidents for non-tax reasons.

f. The term “ring fencing” was not applicable to preferential regimes, which permitted qualifying enterprises to operate in the domestic market or allowed residents to benefit from them, but in practice, did not do so. There must be a deliberate legal restriction or other similar restriction on access to the domestic market.

Lack of Transparency:

a. Lack of tax transparency allowed taxpayers in the same or similar circumstances to be treated differently.

Lack of transparency can arise either due to:

(i) The way the tax regime was designed or administered, or

(ii) The existence of provisions to prevent effective exchange of information.

For example, if taxpayers could negotiate their tax rates or tax bases they were unlikely to be transparent.

b. Effective exchange of information required both the existence of relevant and reliable information and the ability to access such information when needed. A country lacked transparency if it did not maintain, or could not obtain information on legal and beneficial ownership, or could not provide reliable and up-to-date books and records of the entity for a reasonable time-period.

c. To be effective, there must be legal access to the information. The access should include information on both criminal and civil tax matters, on request, but may exclude mere “fishing expeditions”. It should be available to the tax authorities of the requesting state in criminal tax cases on request even if it is not legally a crime in the requested country, or needed for its own tax purposes.

Others:

a. The Report also provided comments on harmful tax practices involving transfer pricing, tax rulings, holding companies and shipping, along with its recommendations. It mentioned that preferential tax regimes could serve legitimate commercial and policy objectives. For example, holding companies were acceptable as they allowed repatriation of profits without multiple layers of tax and were not generally harmful.

b. It is not the preferential nature of the regimes that is of concern. It is only the characteristics of ring fencing, lack of transparency or lack of information exchange that create potential harm.

The OECD definition of “harmful tax practices” affecting mobile financial services has changed since the 1998 Report. Although “ring fencing” is retained as a criterion for preferential tax regimes, the equivalent “non-substantial activities” for tax havens has been dropped. A general low or nil tax-rate for all activities is not deemed as harmful.

Special tax regimes are permitted for certain activities, e.g. shipping. Holding companies are allowed, even though they have certain unacceptable features (e.g. treaty shopping). Advanced tax rulings on transfer pricing and general tax compliance issues are not harmful. Participation exemption for foreign dividends and capital gains are acceptable.

Comments on OECD Initiative:

The primary purpose of the OECD initiative on harmful tax practices appears to be to remove preferential tax regimes within its Member States. However, as any attempt to do so would have simply shifted the activities to similar regimes in non-member countries, the OECD expanded the scope of its project to certain countries that it defined as “tax havens”.

According to the 2004 Progress Report, it had substantially achieved its objectives within its Member States. The progress with tax havens was still ongoing.

From now on, the timetable for the commitment and the defensive measures on tax havens is dependent on the “level playing field” doctrine. They have to be applied simultaneously to all tax havens, as well as to both OECD and non-OECD countries with harmful preferential tax regimes. So far, four OECD countries have declined to exchange bank information upon request on civil tax matters.

The EU Savings Directive provides for transitional provisions for certain Member States, and exempts them from information exchange obligations until, at least, 2010. Concerns have been expressed that the OECD initiative may not comply with the norms under the World Trade Organisation.

There is also concern about certain non-OECD countries, which have escaped the OECD list, creating a further lack of a level playing field.

Harmful tax practices in offshore transactions are not confined to tax havens. They are as prevalent through preferential tax regimes in developed countries. It is estimated that around 80% of the world’s offshore financial services industry is located in OECD Member States and over 10% in other non-OECD countries.

Less than 10% of these activities are based in the traditional tax havens. It is difficult to foresee how and when the requirement of “level playing field” where the same norms apply simultaneously to all international financial centres, both offshore and onshore, will be met.

Preferential tax regimes appear to be a greater cause of tax base erosion for OECD Member States than tax havens. For example, a recent US study showed that more than half of the growth in profits of US foreign controlled corporations during 1998-2000 was in countries with low effective taxes.

Eleven such countries accounted for 47% of the total pre-tax profits of US subsidiaries abroad in 2001 with just 9% of their employees. Besides the traditional tax havens like Bermuda and Cayman Islands, they comprised preferential tax regimes in OECD Member States, such as the Netherlands, Ireland, Luxembourg, Switzerland, Belgium and Denmark.

Non-OECD members included Hong Kong and Singapore. Preferential tax regimes are widely used by multinational enterprises to provide geographically mobile intra-group services including conduit or holding company base for overseas investments.

The distinction between traditional offshore centres and non-traditional onshore centres is becoming increasingly blurred. Under the OECD criteria in the 1998 Report, both preferential tax regimes and tax havens (as defined) levied low or nil taxation, lacked transparency and did not permit effective exchange of information.

The only difference was the absence of substantial activity in tax havens, which did not differ much from “ring fencing” requirement for preferential tax regimes. Therefore, in substance there were few differences in the two categories, as defined in the Report.

Preferential tax regime could be considered as the description given to the regime of an OECD Member State that provided tax privileges for geographically mobile services. A non-member regime that did the same thing was called a tax haven.

The OECD initiative has had a significant impact on international financial centres classified by it as tax havens. Most of them have restructured themselves to meet the OECD demands. There is a general acceptance of the need for greater transparency and cross-border exchange of tax information.

Moreover, as a result of this project (and efforts under the various international anti-money laundering and terrorist financing initiatives), the regulatory framework of several financial centres has significantly improved. Many of them have better financial and legal regulations today than some of the developed countries.

The Harmful Tax Practices initiative on tax havens has slowed down and its future implementation and timing now seem uncertain. The concerted effort behind the OECD harmful tax initiative appears to have been driven more by the concern of its Member States to protect their own direct tax base from erosion through tax competition within the OECD itself, than a dislike of the tax practices in tax havens.

Although the future progress of this OECD project on tax havens may be in doubt, it seems to have made progress towards meeting this objective.