Countries around the world often design their taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policies to become attractive targets for foreign investment. These policies can be anything from a system with special preferences for certain industries to a well-designed tax system based on principles of sound tax policy. Systems that are rife with special preferences and complexities can create distortions in local jurisdictions and across the global economy.
Last month, the Organisation for Economic Co-operation and Development (OECD) released its most recent update on the peer review of harmful tax practices around the world. This effort is undertaken by OECD’s Forum on Harmful Tax Practices (FHTP) under Action 5: “Harmful tax practices” as part of the broader Base Erosion and Profit Shifting (BEPS) project. The aim of the initiative is to improve transparency and to prevent low-tax jurisdictions from attracting geographically mobile income without corresponding economic activity. For example, a business could move its patents and the corresponding income to a low-tax jurisdiction while conducting its research and development activities in a high-tax jurisdiction.
The FHTP for the first time reviewed whether the 12 jurisdictions identified as no-or-only-nominal-tax jurisdictions meet an economic substance requirement. A jurisdiction is considered a no-or-only-nominal-tax jurisdiction if it does not impose a corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. or only a nominal corporate income tax to avoid the requirements. Jurisdictions that had already been reviewed were out of scope, unless they subsequently abolished their corporate income tax. The substance requirement aims to ensure that “mobile business income cannot be parked in a zero tax jurisdiction without the core business functions having been undertaken by the same business entity, or in the same location.”
The no-or-only-nominal-tax jurisdictions identified by the FHTP include Anguilla, the Bahamas, Bahrain, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey, Turks and Caicos Islands, and the United Arab Emirates. According to the report, 11 of these jurisdictions’ domestic legal frameworks now meet the economic substance requirement and are therefore considered “not harmful.” The United Arab Emirates is required to make a further legislative change in order to comply with the standard.
Including the most recent update, the FHTP has now reviewed (or is currently reviewing) a total of 287 preferential tax regimes around the world that grant special tax treatment to certain entities, activities, or structures. Of these 287 preferential tax regimes, four are currently considered “harmful,” seven are “potentially harmful but not actually harmful,” 109 are “not harmful,” 15 are in the process of being eliminated or amended, three are not operational, and 76 have been abolished. Thirty-five are currently under review, 35 are considered out of scope, and three relate to disadvantaged areas.
Examples of preferential tax regimes that have been reviewed by FHTP are intellectual property (IP) regimes (also referred to as patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. es). These regimes provide lower effective tax rates on income derived from IP assets. To prevent patent boxes from being used as a tool for profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. , countries have agreed on the so-called Modified Nexus Approach for IP Regimes, which limits the scope of qualifying IP assets and requires a link among R&D expenditures, IP assets, and IP income. As a result, countries have either abolished their patent boxes or implemented the Modified Nexus Approach.
Tax jurisdictions providing preferential tax regimes to attract mobile income without the underlying economic activity can constitute harmful tax competition. FHTP’s substance and transparency requirements are designed to limit such tax policy practices.
However, it is important to keep in mind that not all tax competition goes hand in hand with harmful tax practices. Tax competition based on sound economic principles, such as neutrality, simplicity, transparency, and stability, can improve a country’s tax code, fostering investment and economic growth.
Stay informed on the tax policies impacting you.
Subscribe to get insights from our trusted experts delivered straight to your inbox.Subscribe