BEPS: Hypocrisy and tax protectionism in disguise?

KUDOS to Deputy Prime Minister Lawrence Wong for delivering an extensive and far-reaching Budget. It was not only deeply researched, well thought-out and targeted, but also far-sighted in kickstarting focus on areas that will be of keen importance in years to come. While most of the issues covered are easily digestible to the man on the street, the subject of BEPS is perhaps something that is less familiar to many.

What is BEPS?

The BEPS (Base Erosion and Profit Shifting) project was started in 2013 by the Organisation for Economic Co-operation and Development (OECD) and the G20 to combat increasingly aggressive tax planning by corporations that unfairly eroded tax revenue. This subsequently laid the foundations for 15 action plans, covering areas such as harmful tax practices, treaty abuse and disclosure of aggressive tax planning.

These were legitimate areas of concern that, if left unchecked, would lead to serious tax leakages that would have repercussions on the ability of governments to function effectively.

What are Pillars One and Two then? In 2020, BEPS further evolved and a blueprint report on the two pillars was born. At the risk of oversimplification, the report sought to rein in large multinational enterprises (MNEs) in the following areas:

• allocation of certain taxing rights to destination jurisdictions, where the MNEs’ customers are located (Pillar One); and
• introduction of a minimum corporate tax of 15 per cent (Pillar Two).

The issue of income source

To understand why the proposals do not sit well with a number of countries, one needs to revisit the basic principle of “source taxation”. At its simplest, the taxing right of business profits is traditionally attributed to the jurisdiction where the business activities are conducted. Take the example of a Singaporean supplier of exotic Indonesian teak furniture to customers in the United States.

Going by the century-old principle of source taxation, the source of business profits is where the key activities are performed – in the case above, Singapore. The Singaporean company is neither taxable in Indonesia (where the supplier is) nor in the US (where the customers are) as it does not have any presence in either of these countries.

This principle was reinforced in 2000 by the OECD when e-commerce was taking off and jurisdictions where the customers and the IT servers were located wanted to tax the profits. After a comprehensive review by the OECD, it was declared that the principle would remain unchanged: the MNE would not be taxable in jurisdictions where it did not have “people functions”.

At this point, one needs to remember that the developed world was the early mover in e-commerce, exporting its services to the rest of the world, and had the most to gain from the status quo.

The approach prior to Pillars One and Two

Aggressive tax planning is not new, pre-dating BEPS. Prior to BEPS, countries took the approach of disregarding profits in “paper companies” set up in jurisdictions where the firms had no actual commercial substance and attributing the profits to the jurisdiction that was controlling the paper company. This was in line with the source principle and no special changes to laws were needed to empower tax authorities to correct this injustice.

In the earlier example, had the Singaporean company been a paper firm operated by US employees, the US Internal Revenue Service would have flexed its muscles to bring the profits of the Singapore company to tax as if it were an American company.

Changes in the global landscape

Over the last three decades, MNEs began looking outwards to new markets, particularly in developing countries with lower costs and lower taxes, while the developed world experienced stagnating markets, higher costs and taxes.

Initial attempts by MNEs to reduce their tax burden via new companies in tax-friendly jurisdictions faced strong challenges in their home countries as these new entities were often disproportionately profitable, given that many of the commercial functions remained unmigrated.

However, as cost pressures mounted and with the rise of Asian MNEs, many of the traditional MNEs decided to bite the bullet and relocate in a bigger way, including moving the crucial headquarter functions. This posed a serious challenge to developed countries as it could result in an exodus of commercial activities.

Are Pillars One and Two the correct reactions?

I would argue that the reactions are politically motivated, academically flawed and hypocritical:

• Tax rates are lower in many developing countries as they do not bear burdens such as bloated welfare schemes or expensive military policies. This is hardly unfair tax competition considering that many countries even manage to run a fiscal surplus despite dishing out generous incentives. A top-up tax to “level the playing field” is laughable as it actually discriminates against tax efficiency. 
• The OECD already concluded in 2000 that destination-based taxation was incorrect if the MNEs did not have any activities in those countries. This U-turn to levy a top-up tax is conveniently happening at a time when the developed world is no longer the net exporter of e-commerce services.
• There is also the somewhat hypocritical statement that the 15 per cent base taxation would benefit developing countries as they would collect more tax revenue as a result. However, tax collections have already been on the uptrend in developing countries, many of which would gladly offer tax incentives instead to further stimulate their economy. The implementation of Pillar Two would actually cancel out the benefits of tax holidays, leading to a rethink of operations relocation by MNEs. So I fail to see how this benefits developing nations.

While Singapore was doing fine before the BEPS pillars came along, it really has no choice but to adopt Pillar Two as to not do so would provide a windfall to the opposite jurisdiction.

However, this does throw a spanner in the works for the Republic, which now has to work harder to attract new investments.

But, as DPM Wong pointed out, this is hardly Singapore’s first crisis and we will ride it out, and emerge triumphant eventually.

The writer is director of tax at PKF-CAP Tax Solutions