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Tag: #TaxManagement

  • Tax Tips (18) – The Final Days of Tax Haven

    What would you do if every tax haven (e.g. BVI) company under your control is required by law to hire full-time qualified employees there and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in?

     

    Harmful tax practice
    BEPS Action in action

    In Tax Tips (13), the issue of tax residency of tax haven companies was discussed.  Smart corporates will be able to ensure that the tax residencies of their tax haven entities are properly managed and thus would not create tax exposures.  That does not necessarily mean that these companies can continue to book un-taxed profits with no substance. The BEPS machine is not stopping.

    Substance

    Last month, the OECD Inclusive Framework on BEPS: Action 5 issued a paper called “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”), which sets out the substance requirements for tax havens.  To the tax havens around the world, this Paper could be the last straw on the camel’s back (incidentally, tax havens such as the BVI, Cayman Islands etc are members of the Inclusive Framework).

    Background

    The OECD issued the report “Harmful Tax Competition: An Emerging Global Issue” in 1998 (“the 1998 Report”) setting out a framework for approaching the perceived problem that certain no or only nominal tax jurisdictions (i.e., tax havens) and harmful preferential tax regimes “affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems”.  The 1998 Report called this “harmful tax practices,” and built a framework to assess these practices.  The aim was to deliver a level playing field between jurisdictions in a context where taxpayers can easily relocate their mobile activities in response to tax considerations.

    The framework for assessing whether a jurisdiction is a tax haven is based on four criteria:

    (a) whether a jurisdiction imposes no or only nominal taxes;

    (b) lack of effective exchange of information;

    (c) lack of transparency and

    (d) the absence of a requirement that the activity be substantial.

    Notwithstanding, in 2001 the Forum on Harmful Tax Practice decided to only determine whether or not a jurisdiction was considered uncooperative on the basis of the first three criteria, and focused on making them cooperative and transparent.

    With the implementation of BEPS Action 5 and the peer review process to ensure tax breaks are only offered to substantive activities and only if they do not pose risks of harmful competition to others, the focus is now shifted to ensure that business activity does not simply relocate to tax haven in order to avoid the substance requirements.  Against this background, the Inclusive Framework has decided to apply the Substantial Activities Requirements for tax havens.

    The Scope of the Substantial Activities Requirements

    The types of activities that are within the scope of the Substantial Activities Requirements are geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and Non-IP activities which includes headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping and holding companies.

    What are the Substantial Activities Requirements

    Non-IP-Related

    For income from income not related to IP (“Non-IP Income), tax havens would be required to introduce laws to:

    (i) define the core income generating activities for each relevant business sector;

    (ii) ensure that the activities are undertaken by the entity (or are undertaken in the jurisdiction);

    (iii) require the entity to have an adequate number of full-time employees with necessary qualifications and incurring an adequate amount of operating expenditures to undertake such activities; and

    (iv) have a transparent mechanism to ensure compliance and provide an effective enforcement mechanism of the laws.

    IP-Related

    For income related to IP (“IP Income) derived from patents or similar assets, the core income generating activities would be the conducting of research and development activities with an adequate number of qualified full-time employees and adequate amount of operating expenditures.  A similar requirement would apply where an entity is exploiting marketing IP assets such as trademarks, where the core income generating activities are branding, marketing, and distribution.

    In other cases of IP Income, the entity would need to demonstrate that it is conducting strategic decision making, managing and bearing the principal risks relating to the development and subsequent exploitation of the IP asset, or carrying on the underlying trading activities through which the asset is exploited, with the adequate number of qualified full-time employees and an adequate amount of operating expenditures.  

    IP Income – Higher risk scenarios

    Higher risk scenarios would be cases that involve related parties outside of the tax haven where (i) the entity has acquired the IP asset from related parties or through the entity funding research and development activities which took place outside the tax haven; and (ii) the IP asset is licensed or sold to related parties, or the exploitation is conducted by related parties outside the tax haven (e.g. foreign related parties are paid to develop and sell a product in which the intangible asset is embedded).

    An entity in a higher risk scenario could meet the substantial activities requirements by providing evidence that there was, and historically has been, a high degree of control over the development, exploitation, maintenance, enhancement and protection (the DEMPE functions) of the intangible asset, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities in the tax haven. This would need to be demonstrated by providing additional information including:

    • detailed business plans which demonstrate the commercial rationale for holding the IP assets in the jurisdiction;
    • employee information, including the level of experience, type of contracts, qualifications,
      and duration of employment; and
    • evidence that decision making is taking place within the jurisdiction, rather than
      periodic decisions of non-resident board members.

    Ensuring Compliance

    To ensure compliance, tax havens would need to:

    1. Set up a mechanism to collect various information from entities including details of the core income generating activities, the amount and type of gross income and expenses, the assets and premises held in the course of carrying out the business, and the number of full-time, qualified employees.
    2. Set up a sanction mechanism that is rigorous, effective and dissuasive to take action in the event an entity failed to meet the substantial activities requirements. Sanction mechanism could include striking an entity off the register. The tax havens would also need to continue enforcement efforts and remedy any shortcomings in the enforcement process.
    3. For any entities that do not comply with the substantial activities requirements, tax havens would be required to spontaneously exchange all relevant information with the jurisdictions of residence of the immediate parent, ultimate parent, and ultimate beneficial owner.

    The effectiveness of the information collection and exchange mechanism is to be reviewed in 2022.  

    What about Holding Companies?

    As discussed in Tax Tips (13), tax haven company is the ideal type of vehicle for investment holding, i.e. holding equity participations and earn only dividends and capital gains.  Such companies are recognised in BEPS Action 5 that they may not require much substance in order to exercise their main activity of holding and managing equity participations, and therefore is less of a concern from BEPS’ perspective.  The Substantial Activities Requirements on investment holding companies are that they respect all applicable corporate law filing requirements and have the substance necessary to engage in holding and managing equity participation (for example, by showing that they have both people and the premises necessary for these activities).   

    The Mauritius Example

    Mauritius imposes nominal tax on companies with Category 1 Global Business Licence (“Cat 1 GBL”, commonly used as holding companies with access to the Mauritius tax treaty network).  In the recent months, the Mauritius authorities issued new rules to bring about changes with effect from 1 January 2019. Under the new rules, Cat 1 GBL will be replaced by a new licence called Global Business Corporation (“GBC”) and the licensing conditions for GBC include, inter alia, carrying out of its core income generating activities at all times in, or from, Mauritius by:

    • Employing, either directly or indirectly, a reasonable number of suitably qualified persons to carry out the core activities; and
    • Having a minimum level of expenditure, which is proportionate to its level of activities.

    In addition, the regulations provided the indicative core income generating activities and the minimum annual expenditure and employees (direct or indirect).  For an investment holding GBC, the indicative minimum annual expenditure is USD12,000 and there is no minimum employee specified.

    The Mauritius rules could be an example of what is forthcoming in other tax havens.

    Tax Tips

    Subject to the actual regulations to be introduced by the tax havens, the requirement that the entities in tax havens should maintain “an adequate number of qualified full-time employees and adequate amount of operating expenditures” and the threat of information exchange is likely sufficient to kill most tax haven entities earning IP or Non-IP Income (except for investment holding companies).  Corporates that have not already restructured the activities to “normal tax jurisdictions” should speed up their review process and take action.

    As to investment holding, which probably is a major business activity of most tax havens, corporates should follow the development closely and react to that accordingly.  It is foreseeable that the OECD may accept more lenient substance requirements in order not to hurt the economies of the tax havens too significantly. The introduction of requirements on annual minimum expenditure even full-time employees will reduce the attractiveness of tax haven.  As these are real additional costs of setting up investment holding companies, corporates should consider consolidating the group holding structures to eliminate duplicated costs, if not pulling out completely. The days of letterbox and brass plate companies appear to be limited.

     

    Contact Us

     

    (This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 December 2018: https://manageyourtax.com/HKEJ-Forum-18)

    REF:

    The Paper: http://www.oecd.org/tax/beps/resumption-of-application-of-substantial-activities-factor.pdf

    Members of the Inclusive Framework on BEPS: http://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf   

    Mauritius Circular CL1-121018: https://www.fscmauritius.org/media/67458/cl-on-substance-gb.pdf

  • Tax Tips (10) – Are you sleeping well at night?

    Tax Tips (10) – Are you sleeping well at night?

    Tax Management

    Rest assured, this article is not about tips on sleeping well…it is about something that could keep the CFO awake at night: is your company’s tax affairs being well-managed?  The problem with poor tax management is that you often realise it too late. It happens because the company has not been targeted by the tax office, management does not realise the danger ahead and does not want to dig up issues, and the Board of Directors has no idea about tax management.

    What leads to this hazardous situation? The common reasons include: people in the past took bad tax advice, did not implement structure and arrangement properly, no documentation exists to support the story, no one was aware of tax law changes so that tax returns were filed incorrectly etc. All these could lead to under accrual of tax liabilities and, more painfully, the heavy interest and penalties. Even worse is reputational damage, as tax offices around the world like the “name and shame” game.

    When you search on the Internet on “tax management”, what you often find are topics that are either basic focusing on tax compliance or about technology which is somewhat disconnected with the real situation in Asia. For example, collecting tax data would be relatively important in countries like the United States, where companies pay State Income Taxes, Sales Tax and various fees at different rates in different States. Country-by-Country Reporting is another area where technology can help, except that companies could run into difficulties when different accounting systems are used in the organisation.

    More and more people talk about “tax strategy” these days, especially when governments, such as the UK, requested large organisations to publish their tax strategies or face a penalty. In practice, tax strategy is really just the organisation’s risk appetite on tax matters. If management of an organisation realises tax is a risk that needs to be managed, the organisation will then need to actively manage its tax affairs. The key is “HOW”.

    This article discusses what is tax management, how to manage tax and who should be the tax manager, based on my own experience.

    What is tax management

    Tax management is to protect the company’s balance sheet and ensure that there are no surprises.

    How to manage tax

    There are five building blocks to successful tax management:

    1. Tax returns are filed correctly and on time
    2. Identify the right tax advisors
    3. Tax implications of new transactions are analysed
    4. Tax matters are discussed regularly with C-suites and internal functions
    5. No harmful documentations exist

    Sounds simple but it is almost an art, and certainly requires experience, deep thoughts and good communications, in making sure that these simple matters are executed right. For the ease of discussion, we call the person responsible the tax manager (who can be the finance manager or a dedicated tax manager).

    Filing tax returns correctly and on time

    There are three things the tax manager needs to do.

    First: Assign Responsibilities. Responsibilities for preparation and review of different kinds of tax filings shall be assigned. Hong Kong would be simple but when we are talking about other jurisdictions, the number of tax returns and documentations required would be of multiple folds. In some jurisdictions such as Indonesia, just for payment to overseas vendors, one would need to collect the applicable Tax Resident Certificates of the vendors, calculate and withhold the correct amount of tax, arrange the necessary treaty benefit claim forms (the infamous DGT-1 Form). Staying with Indonesia, certain payments to local vendors are subject to tax withholding, and on top of that, there is VAT…we have not even touched on the corporate income tax filing and transfer pricing documentation.

    Second: Staff Training. It is worth spending some training costs and time to ensure the staff responsible understand the importance of their job and where to find help. The staff need to be updated on tax law changes, tax audit trend, and maybe the outcome of recent tax cases by attending tax seminars. The tax manager himself has to be trained as well, on the latest tax rules in jurisdictions covered and keep himself up to date with tax development on a macro level.

    Third: Process Design. The tax manager needs to design and put in place a seamless process such that all the different elements of every tax filing: preparation of tax return, data collection, documentation of tax position taken, review, submission, payment and keeping files would work like clockwork.

    It is not necessary for the tax manager to review the actual tax returns, especially those related to jurisdictions outside of the home base) because he does not have the local tax knowledge or even the language skills. If the tax manager is responsible for signing-off the tax returns, it may cause a moral hazard, as the local team may take their job less seriously. The tax manager will also need to decide, by working with the local team, the involvement of external tax advisors in the process. Typically, they create most value in terms of tax training and perhaps review or even prepare the more important tax returns.

    Would technology help? From experience, full automation in tax return preparation is almost not possible except for VAT, when the local rules require that the company’s invoicing system is linked to the tax office’s system. For the other tax returns, there is often a high degree of judgement involved on what is taxable/non-taxable and deductible/non-deductible, and thus the establishment of a real-time dashboard on tax reporting status should not be on top of the priority list of a tax manager. The key to managing tax risk is to do the above three things right, and the tax manager monitors the situation from time to time. Once the basic compliance mechanism is in place, the tax manager may investigate investing in automatic VAT reconciliation.

    Identify the right tax advisors

    This can actually be the hardest part of the job. There are many tax advisors in the big and small firms, as well as sole-proprietor type consultants. How to identify the right ones to advise the company can be a challenge.

    One needs to cast a net to catch the big fish. The tax manager should network with different advisors by attending tax seminars and social events held by the firms and professional organisations such as the local accounting or taxation institute, and make use of the Q&A sessions to ask questions to test their response and reaction. To be able to do that, however, the tax manager has to be reasonably experienced and possess good technical skills.

    In some developing countries, the quality of tax advisors can be appalling. To properly manage the tax issues, the level of experience and technical skills required on the tax manager would actually be higher, so that the tax manager can lead the advisor into providing the advice needed.

    For companies that operate in Mainland China, they need to be aware of the State Administration of Taxation’s Public Notice on the Supervisory Rules on Tax-Related Professional Services (Public Notice 2017 No.13, “PN13”). Under PN13, which became effective on 1 September 2017, only professional service firms with the Mainland-recognised qualifications are allowed to provide professional tax advisory and planning services, and they shall inform the tax authorities on “the relevant information”. Tax advice, memos or reports issued may need to be submitted to the tax authorities.

    Tax implications of new transactions are analysed

    “New transactions” can be any transaction with related or unrelated parties involving new jurisdictions, new business, service, intellectual properties or even M&A transaction.

    To properly manage the tax implications, the first thing to do is to understand the business objective and rationale, timing, preliminary information on contract terms, cash flow, accounting implications, capital and financing structure and degree of confidentiality. With the information, the tax manager can consult external tax advisors for tax implications and possible tax planning ideas. The process could last from weeks to months before the tax advice is finalised, thus having a good idea on timing and deadline is crucial. The tax manager must keep close contact with the functional teams (finance/legal/IT/Business Development/Company Secretarial etc) involved to learn the latest on the transaction and respond accordingly to ensure the tax advice is correct and relevant.

    It is very important for the tax manager to possess the business acumen and project management skills to really manage the process, which includes:

    • Narrow down the options to arrive at an executable transaction structure that supports the business objective
    • The advice has to be technically strong
    • Understand the tax advice and work with other functional teams to ascertain feasibility and timing of execution
    • Ensure the documentation are properly worded, executed (including the location of execution) and maintained
    • If new companies are to be set up, ample time should be allowed and proper board meetings should be held; in some countries, investments in certain industries require government pre-approval (e.g. the Foreign Investment Review Board in Australia)
    • Know where to, and where not to, take short-cuts
    • Keep senior management informed on progress and hurdles, if any, and seek direction where appropriate

    Tax matters are discussed regularly with C-suites and internal functions

    Tax expense is often one of the largest expenditure after salaries/wages and rent. However, as the amount is so-called “below the line” (i.e. below EBIT, which is the common performance measurement metric), and it is considered a somewhat less-controllable expense, management tends to pay less attention to it. With the rapidly changing tax rules and the tax offices’ increasingly hostile attitude towards taxpayers, it is important for the tax manager to bring tax matters to the attention of the C-suites and internal functions, which indeed is part of the expectation management: ensure that there are no surprises.

    Such discussions should include uploads and downloads: the tax manager provides the appropriate tax update on issues, disputes, law changes, project status etc to the management (upload), and obtain information from the team about new business direction and projects (download) so that the manager can raise the tax concerns on-the-spot, where applicable, to the management, which is often the most valuable part of the job. Direct participation in such meetings would help raise awareness of tax, making the tax manager part of the team, which will be beneficial in carrying out future tax projects.

    No harmful documentations exist

    What is meant by “harmful” documentation?

    Anyone who has been involved in tax planning would likely have come across discussions on “how much is the tax saving?”, which, to many, is the most exciting part of the project. People involved, including the external tax advisors, easily get carried away and start to communicate in writing (typically by email, and sometimes by instant messaging nowadays) about the tax saving, which would then be spread across the organisation, and sometimes across countries, at the speed of light. They forgot that tax offices would love to see these as evidence of tax-avoidance and they indeed have the power to ask for all emails or even confiscate the computers of taxpayers in dawn raids. Email has become an important evidence for taxpayers to prove their intention. For example, under the Administrative Measures for General Anti-avoidance Rules issued by the State Administration of Taxation in Mainland China (Order No.32) in 2014, Article 11 stated that in an investigation related to General Anti-avoidance, the taxpayers who wish to defend themselves shall provide correspondences related to internal decision and management such as board minutes, memorandums and emails to the tax office. If taxpayers cannot provide such documents or the correspondences contain harmful wordings, the best thing that the taxpayer could hope for is a reasonable settlement with the tax office.

    Governments are also trying to hold external tax advisors responsible for providing aggressive tax advice. Under Article 14 and 15 of the Order No.32, for example, the Mainland tax office could issue information demand notices to parties involved in tax planning, which include the external tax advisors, and the tax office is empowered to reach out to overseas tax jurisdictions for help to collect the relevant information if the evidence is located offshore. Order No.32 and PN13 mentioned earlier would give the Mainland tax office all the powers to obtain documentations in investigation tax avoidance.

    Who should be the tax manager?

    Most people would answer: “it depends on the size and complexity of the organisation…for smaller organisations, the CFO or finance manager can take up such a role…for larger organisations, a full-time tax manager may be needed”.

    The answer is correct subject to two caveats: (1) the scale of operations of the “smaller organisation” would likely be organisations that have simple business and perhaps operate in not more than three jurisdictions; (2) the person taking up the tax manager role has the time, and the ability, to do all the things discussed above in order to properly manage the tax for the organisation, large or small.

    For the “smaller organisations” that are growing to become medium-sized and are beginning to realise the value of professional tax management, they should start considering hiring a full-time tax manager. As this is going to be a new headcount, the company may find budget constraints thus it may be harder to hire experienced tax managers. If the company hires someone directly from the accounting firms, that person needs to be properly trained, and be guided continuously, in order to perform the role of tax management. Who in the organisation is qualified, and has the time, to be the trainer-supervisor?

    These medium-sized organisations should instead consider hiring experienced tax professionals who have years of experience in commercial organisations on a part-time basis. There are multiple benefits of hiring experienced part-time tax managers: (1) they know how to manage your tax; (2) no training and supervision are needed – they hit-the-ground-running; (3) they know how to work with other functions within the organisation; (4) they know the tax advisors and can identify the right ones for different countries or projects.  Our company, Manage Your Tax Company Limited, provides such part-time tax management services in Hong Kong.  The services are provided under a service contract so that the client would not need to be bothered with issues and costs associated with hiring employees, and can dedicate more time to developing the business. If the organisation’s tax workload does not justify hiring a full-time tax manager, then employing a part-time tax manager would be a win-win for everyone.

    What about tax planning?

    The days that external tax advisors selling tax planning packages out of thin-air have long gone. That doesn’t mean that tax planning is dead. Nowadays, tax planning has to be driven from within the organisation, by the tax manager, and there are two situations where tax savings can be created.

    One is when tax implications of new transactions are analysed, as discussed above. Two is based on the tax manager’s sharp eyes and his/her thorough understanding of the organisational structure, business model and transaction flows, tax planning opportunities could be spotted. The key to successful tax planning is that there has to be a business driven transaction behind it. Experienced tax managers should know that well.

    Conclusion

    Tax management (or tax risk management) is not about talking fancy words such as “strategy”, “technology”, “vision”, “KPI for tax function”, “tax data” etc. What companies need are experienced tax professionals who understand business, can implement processes, technically strong, constantly looking for value-creation, know where are the risks area and deal with them, able to spot opportunities, and can make practical decisions. Knowing that tax is under good management, the CFO can sleep well every night.

    (This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 May 2018: https://manageyourtax.com/HKEJ Forum 10)

    Ref:

    Order No.32: http://hd.chinatax.gov.cn/guoshui/action/GetArticleView1.do?id=483630&flag=1

    PN13:

    http://hd.chinatax.gov.cn/guoshui/action/GetArticleView1.do?id=5745825&flag=1

    http://www.chinatax.gov.cn/n810341/n810755/c2608065/content.html