Nilesh Ashar, Tax Partner at KPMG Lower Gulf provides insight into the complex key current international tax issues that could impact Middle East based companies and government owned entities with international operations.
TAX DIRECTORS around the world are shouldering the impact of fundamental changes in attitudes and approaches to tax.
Whether it is corporate social responsibility, tax governance, enhanced transparency with tax authorities and investors, or society holding individuals and businesses accountable for paying a fair amount of tax, these issues are subject to increasingly heated debates.
The sentiment around the issues described above have resulted in a number of legislative changes and proposals both at an international level – the OECD BEPS action plan, automatic information sharing agreements between countries, increased focus on transfer pricing; to individual countries adopting unilateral measures – such as FATCA, GAAR, black list of countries etc.
Tax is no longer only another finance function, but has crept into the boardroom as a key agenda item, particularly around the tax strategy of the company and the tax governance framework within which a company operates.
Transparency and governance
Transparency of international groups’ tax affairs has increasingly been in the spotlight with the likes of Starbucks, Google and Amazon having their tax affairs heavily scrutinised and publicised in the media.
The forenamed groups have faced accusations of tax avoidance in the House of Commons Public Accounts Committee in the UK. Although the Chair of the Committee stated that the accusations are not of illegality but of immorality, this raises some interesting questions:
a) Do tax payers have a moral obligation to pay tax in jurisdictions where they have operations?
b) Or should stakeholders and board of directors expect their companies to structure and plan their tax affairs appropriately to minimise their tax bill (whilst remaining within the boundaries of the law of course!)?
One thing is for sure, there has been a global shift in attitude towards tax. It appears that the rest of the world has jumped on this band wagon with the Organisation for Economic Co-operation and Development (OECD) stating that the fairness and integrity of tax systems are undermined by companies who avoid taxation in their home countries by pushing activities abroad to low or no tax jurisdictions.
At the request of G20 Finance Ministers, in July 2013, the OECD launched an Action Plan on Base Erosion and Profit Sharing (BEPS). The BEPS report identified 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes. BEPS will undoubtedly dominate the minds of all involved in the tax world in the coming year as the OECD are scheduled to complete a number of their identified action points in 2014 and mid-2015.
Shift in attitude
There have been other developments internationally which further supports this shift in attitude towards tax transparency and governance. The UK and India have introduced General Anti Avoidance Rules (GAAR) to tackle tax avoidance. The rules, which apply to most taxes, are intended to tackle abusive tax arrangements where obtaining a tax advantage is the main purpose or one of the main purposes.
There is also more focus on internal tax systems and controls with company management expected to understand existing tax systems and controls and to regularly review them to ensure that they are adequate such that the company’s tax liability is calculated accurately. In the UK, Senior Accounting Officers are required to sign a certificate stating that this is the case. Penalties are levied for non-compliance.
Without a doubt, our Middle Eastern clients with an international presence will need to prepare themselves for the increased focus on tax transparency and governance.
Tax in the Boardroom
In recent years, tax has slowly crept up the agenda in Boardroom meetings. Companies are increasingly recognising the importance that tax plays in their multi-national businesses. With Tax attracting front page headlines, perhaps companies are recognising the consequences of not being on top of their tax affairs!
Either way, it is crucial that tax remains on the agenda at Board level. Boards and audit committees are increasingly discussing tax strategies, and requiring tax and finance functions to report on tax governance and risks impacting their business. For companies operating in the Middle East, in particular, this issue has been gaining importance in Board meetings.
Companies are also encouraged to adopt a more proactive approach to their tax affairs. On numerous occasions, we see companies carrying out transactions where tax is an after-thought. Had tax been on the agenda at the planning stage, the transaction would have been structured in a far more tax-efficient manner.
With this in mind, we spend time with some of our clients’ “deal teams”, educating them on key tax issues that arise on transactions. Our clients see great benefit in this as this allows for tax issues to be identified at an early stage and for appropriate advice and action to be taken, so that a tax “sign-off” is obtained before the deal reaches the Board / investment committee for approval.
It is imperative that company directors take a more proactive and hands-on approach to their companies’ tax affairs. A big part of this is ensuring that directors have a better understanding of taxation and how it fits into their businesses. This of course leads to greater tax governance and a lower tax risk profile for the company, while ensuring that decisions around tax are made taking into account reputational risks and not simply whether the company has complied with the tax laws in various jurisdictions.
Transfer Pricing (pricing for transactions between two related companies) is probably the most common tax issue for international groups with intra-group transactions, and which carries significant risk as a tax avoidance tool.
Due to the scale of transactions that companies carry out in order to operate in global markets, and with various countries looking at making their tax systems attractive for foreign investment, transfer pricing has become one of the most significant and challenging tax issues facing multinationals and tax authorities.
Many tax authorities across the globe have identified a gap in tax revenue resulting from transfer pricing in relation to cross border transactions. In particular, related companies entering into cross-border trade, artificially distorting the price at which the trade is recorded, to minimise the overall tax bill.
This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes. Tax authorities have publicly stated that this is an area of focus in order to increase tax revenue. This is not a surprise. It is estimated that 60 to 70 per cent of international trade happens within multinationals, that is, across national boundaries but within the same corporate group.
The amount of tax revenue that governments lose as a result of incorrect transfer pricing is difficult to accurately quantify but it has been estimated to be up to several hundreds of billion dollars annually!
Getting the price right
Transfer pricing brings with it many challenges. Firstly, getting the price right. This is not always straight forward, as for certain non-standard transactions; there are not comparatives in the market to bench mark what an “arm’s length” price would be (that is, that which would be charged between two unconnected parties). Methodology has been developed to carry out this benchmarking but this will never be an exact science and there will always be a level of subjectivity.
The second challenge is documentation. In nearly all tax jurisdictions, it is a requirement to have documentation to evidence that the transfer pricing is arm’s length. This is an area where we see our clients requiring the most assistance. With tax authorities increasingly opening transfer pricing enquiries, developing and documenting robust group transfer pricing policies is key to withstand the challenge from the tax authorities.
Given that companies operating in the UAE pay no corporate income tax, it is no surprise that we are seeing tax authorities enquire into transfer pricing in relation to transactions which UAE based companies enter into with related companies that are tax resident in countries with a higher corporate income tax rate.
Groups with a presence in the Middle East will always be targeted by foreign tax authorities due to the risk of excessive profits being allegedly shifted to the Middle East through mispricing.
Even companies with regional presence in the middle east need to consider the impact of transfer pricing, as many middle east countries have basic transfer pricing provisions in their domestic legislations and rely on OECD approaches to transfer pricing methodologies and documentation.
We are seeing a number of UAE and Middle East based businesses actively carrying out transfer pricing studies and getting their transfer pricing documentation in place, in order to prepare for enquiries.
Should SWFs care?
Global investments have picked up dramatically recently and who is better to lead this trend than Sovereign Wealth Funds (SWFs), the investing arm of the governments. SWFs are increasingly investing across geographies and asset classes, and are seen as a significant source of capital.
SWFs generally (and SWFs in the Middle East in particular) enjoy special tax exemptions in their home countries, but if the gains are being taxed in foreign countries with no corresponding tax credits available in home countries, returns can get eroded in comparison to other investment companies / private equity funds.
Sovereign immunity is essentially an international judicial doctrine under which one country is immune from suit in another country. This concept has extended to include the exemption of taxation on foreign governments on their non-commercial activities. These exemptions range from exempting certain type of incomes (capital gains, dividends etc) to granting exemption from certain taxes (federal taxes, direct taxes etc).
Spotlight on US and UK
In the US, for example, Sovereign Immunity provisions exempt qualifying income such as current income, and capital gains from investments in US stocks, bonds, securities and financial instruments from federal taxation.
In the UK, all income and gains that are derived from direct beneficial ownership by the head of the state or the government of a non-UK sovereign state are generally exempt from direct taxes under sovereign immunity rules. Even as corporate taxes are steadily reducing globally, withholding taxes and taxes on operations and gains can vary between 5% -35% and with no formal mechanism of obtaining tax credit for these foreign taxes, incentives such as sovereign immunity are a welcome relief.
This being said, not all countries recognise sovereign immunity, and those that do, have specific criteria that needs to be met and maintained in order to be considered as sovereign immune from tax in another country. These criteria range from full immunity from direct taxes for trading and investment income, excluding income from commercial activities or commercially controlled entities, to denying sovereign immunity to SWFs owned directly by the foreign government.
Domestic tax rules
Therefore, it is imperative that SWFs consider the specific domestic tax rules to evaluate whether their income from investments or activities in the relevant country will be eligible to sovereign immunity.
So is considering sovereign immunity worth the effort? Sovereign Immunity may not be a concern for some countries, as double tax treaties (DTT) may act as an alternative in mitigating taxes in the investee jurisdictions, however sovereign immunity should not be taken lightly especially by the Middle Eastern SWFs, who are making significant investments in the key investment markets such as the US and UK but do not necessarily have access to tax treaties or the tax treaty provisions are not applicable due to the tax exempt status of the SWF in the home country.
In summary, sovereign immunity from tax does make a difference as they can grant relief from taxes where double tax treaties cannot. It may even allow SWFs to bid for assets with more attractive pricing, given the comparative benefit of more attractive post tax returns, as compared to a private equity or non-sovereign investor. But in order take benefit, SWF’s must be diligent in complying with the requirements of investee jurisdictions for meeting the sovereign immunity criteria.
The Foreign Account Tax Compliance Act or FATCA is the brain child of the US Government who is using FATCA as one of the tools in its battle against tax non- compliance and tax abuses by US persons. Under US tax law, US taxpayers are subject to tax on their worldwide income, and if everyone were reporting their foreign income and offshore accounts diligently, then there would be no need for FATCA. But the US government has seen the reality and FATCA is their response.
Enacted into law in 2010, FATCA targets non-compliance by US taxpayers using foreign accounts, by requiring financial institutions worldwide to inform the Internal Revenue Service (IRS, the US tax collection and enforcement agency) about accounts held by US tax payers or foreign entities in which US taxpayers hold substantial ownership. In other words, FATCA shifts the onus of tax reporting and compliance onto any company holding or trading U.S assets on behalf of others.
The ground is slowly shrinking for tax evaders, as FATCA regulations require foreign financial institutions (FFIs) such as banks, mutual funds, etc to register themselves with the IRS and disclose information about their US accounts, including accounts of certain foreign entities with substantial US owners. The FFIs may also be required to withhold 30% on payments to those who refuse to declare their obligations to pay US tax.
To “motivate” compliance with FATCA, the US is levying heavy penalties by requiring withholding agents (any individual or entity that has control, receipt, custody, disposal or makes payment of any witholdable payment) to withhold 30% withholding on all US source income flowing to the FFIs and their customers, and a 30% withholding tax on the gross proceeds of the sale of US securities by the FFIs and their customers.
Even the withholding agents are not spared as failure to comply would result in them being liable for 100% of the amount not withheld as well as related interest and penalties.
But are local laws preventing you from complying with FATCA? The US has thought of that as well by entering into intergovernmental agreements (IGA’s) with the governments, through which the FFI’s would report the information to their governments who will then share the information with the IRS under the IGA.
The US is already in talks with more than 80 countries, UAE being one of them. The Central Bank of the UAE has recently issued a Notice, confirming their intention of signing the FATCA IGA Model 1 Agreement with the US Government, and has directed all banks and other financial institutions to begin implementations. The Central Bank has contracted with a legal firm, to provide legal support and conduct workshops designed to assist with the meeting the FATCA compliance requirements. FATCA readiness surveys will be conducted.
Rules and regulations
A quick reading of the FATCA rules would indicate that they are directed at financial institutions which are defined broadly, however upon closer look, one would realise that FATCA has widespread implications and is very much applicable to non-foreign financial entities (NFFEs) as well. Such entities should be diligent about the type of income they are receiving as it may be subject may be subject to 30% FATCA withholding if they fail to timely and properly identify themselves to their withholding agents.
The FATCA regulations are not entirely cold-hearted and allow for certain exceptions and exemptions, but the fact of the matter is that they have caused a severe dilemma for everyone. On one hand, complying with FATCA, may prevent reputational risk and severe penalties, but on the other hand will result in burdensome and costly implementation, and may also conflict with the local laws.
The FATCA regulations were set to come into effect on January 1, 2014, however an additional 6-month reprieve has been provided for many of the provisions including the start of FATCA withholding, account documentation, and due diligence requirements. The regulations are now expected to be enforced on July 1, 2014, and FFIs, withholding agents and NFFEs should use this time to assess the implication FATCA may have on their operations and implement a strategy that will address them.
* Nilesh Ashar is Tax Partner with KPMG Lower Gulf, and his role involves leading the Firm’s international and Mergers & Acquisitions tax advisory services. He is a member of the Institute of Chartered Accountants in India and was previously working as a Director for another ‘Big 4’ firm in the UK. Nilesh has over 17 years of experience working in tax and has led several tax structuring assignments for private equity and sovereign wealth fund clients on their acquisitions in the UK and Europe. He has a degree in Chartered Accountancy from the Institute of Chartered Accountants of India and also a Bachelor of Commerce from Mumbai University.