BASE erosion is the latest buzzword in international taxation. The OECD having published a discussion paper in February,2013, the issue has got the attention it deserves. But, before we enter into a discussion of the OECD's work, it is first necessary to have an idea about the concept of tax base.

Every tax must have a base and a rate. In so far as income tax in concerned, the tax base of a country is generally defined as all income from whatever sources derived. Thus, section 5 of the Income tax Act prescribes that the total income of a resident is ‘income from whatever source derived' which is received or deemed to be received in India; which accrues or arises in India or which accrues or arises outside India. For a non-resident also, the base is income from whatever sources derived which is received or deemed to be received in India and which accrues or arises in India during the relevant income year. Thus the difference between a resident's tax base and that of a non-resident is that a non-resident's income, which accrues outside India, is not chargeable to tax in India. This therefore is broadly speaking the tax base of the country.

After this comes the act of limiting the tax base. When a basic exemption limit is prescribed, the tax base automatically shrinks. Similarly, when various exemptions or deductions are given, the tax base is reduced. There would be erosion of the tax base, whenever people, for whom they were not meant, take such deductions or exemptions. By putting interpretations different from the intention of the legislature, Courts and Tribunals can also destroy the tax base. Unless the legislators nullify such interpretations, the judicial acts indeed result in erosion of tax base. One example of such wrong perpetuation of a mistake, which has the effect of eroding the tax base, is the decision of the Supreme Court in the Chettiar case (2004-TII-01-SC-INTL). We had occasion to discuss this case in one of our earlier articles. ['May be taxed' or Pranab Babu ko gussa kyuon ata hai ]

Base erosion takes place when less than appropriate income is shown or when more than appropriate deduction is claimed. However, if the transaction is between residents, the second kind of erosion is not relevant because the expenditure is income of another resident, which then will be subject to taxation in India. Although even here there is a possibility of the income going out of the tax net, the problem gets further accentuated whenever the transaction involves a non-resident. This is because of the fact that apart from the statutory scheme of taxation, double tax avoidance treaties almost always govern the taxation of the non-residents. India has such tax treaties with a whopping 84 countries and jurisdictions and a combination of the treaties and the domestic law often leads to serious tax base erosion. In this context, it is important to keep in mind that under section 90, the provisions of the treaty or the domestic law whichever is more beneficial to the taxpayer has to be applied.

Most of the double tax avoidance treaties that are in place today, whether following the OECD model or even the UN model, follow the pattern or logic that evolved under the aegis of the League of Nations in 1920s in the aftermath of world War-I. Following the wartime restrictive practices of the national governments, it was necessary to put in place a mechanism to avoid double taxation. While this is a noble objective, the mechanism through which this was put in practice was the classification and assignment approach. Under this approach income is divided into various classes and the taxation right is assigned to one or the other of the Contracting State. Since the beginning, there has been a debate as to whether the country where the income is earned (source country) or the country whose residents invest abroad should get the primacy in taxing the income. The countries that were in the forefront of developing the model were the victors of the World War-I and most of the present developing countries including India were colonies and had hardly any say in the development of the model. In a seminal paper titled ‘Tax Base Erosion and Homeless Income,' Bret Wells and Cym Lowell of the University of Houston charts the history of the development of the model treaty and points out that the basic tax structure was premised on the belief that the colonial countries would be the source of capital and know how and the colonies were the passive suppler of low cost goods and services with very little value addition. The right to tax the residual income was with the home country and the source country was allowed to tax only the routine profits earned there and impose withholding taxes on certain types of payments like royalties and interest. The source country taxes could therefore be easily base eroded. The authors point out that despite various developments and the role reversal that is taking place, the basic structure of this division of revenue remains the same. The OECD Model, which developed subsequently, followed this basic structure. The UN model of 1980 basically followed the OECD model although source countries had a little more of the taxing rights.

In this structure, it is very easy to base erode the source country by charging royalties, interest, lease payments or payment for services which are not available for full taxation by the source country, the full right of taxation over these streams of income having been given to the residence countries.

The interesting aspect of this scheme of distribution of taxing rights is that it now creates opportunities for base erosion even in the residence countries. Source countries are not allowed to tax certain streams of income for the reason that the residence country would be in a better position to tax its residents on a worldwide basis. This might have worked well till a point in time. However, the mobility of capital has increased manifold. There has also been the proliferation of financial centres where companies can now be incorporated at will without being subject to comprehensive taxation. In other words, source is a fact while residence is a matter of choice for the mobile capital. The result is the creation of a significant stream of what has been described as ‘stateless income' or ‘homeless income'. These are income streams, which are not taxed anywhere resulting in what is known as double non-taxation as a result of the application of the extant DTAAs. It is only now with the economies of the western countries being in tatters, that the revenue authorities of capital exporting countries have woken up to the phenomenon. The result is the work of the OECD: ‘Addressing Base Erosion and Profit Shifting' (BEPS).

To give the devil its due, India has been in the forefront of the debate about source country taxing rights, championing the cause from the very beginning - whether in the expansion of the PE concept, taxation of royalties and fees for technical services or the like. In this context, it is interesting to recall that in the late nineties, an issue was flagged that it is possible to do extensive business in a country without any physical presence. The ‘fixed place of business', which is the cornerstone of the permanent establishment concept would be inapplicable in such cases. India appointed a high-powered committee to examine the taxation issues arising out of e-commerce. This committee, apart from having government representatives, also had Rashmin Sanghvi, Mukesh Butani, (then Partner of Arthur Andersen), Suman Ghose Hazra, of HCL Infosystems Ltd, and TV Mohandas Pai ( then with Infosys).

The Committee was of the view that applying the existing principles and rules to e-commerce did not ensure certainty of tax burden and maintenance of the equilibrium in sharing of tax revenues between countries of residence and source.

The Committee, therefore, was of the view that the concept of PE should be abandoned and a serious attempt should be made within OECD or the UN to find an alternative to the concept of PE. In this context, the committee endorsed the ‘base erosion' approach suggested by Professor Doernberg for an equitable tax sharing between residence and source countries which involved application of a low withholding tax on all tax deductible payments to the foreign enterprise.

In the context of the current work, it is also interesting to note that the OECD had also come up with a Technical Advisory Group (TAG report) on the issue, “Are the current treaty rules for taxing business profits appropriate for e-commerce?”

Having examined all the proposals including the one from India, the OECD ultimately concluded that the current rules were fine. At Para No 350 the Report concluded:

“As regards the various alternatives for fundamental changes that are discussed in section 4-B above, the TAG concluded that it would not be appropriate to embark on such changes at this time. Indeed, at this stage, e-commerce and other business models resulting from new communication technologies would not, by themselves, justify a dramatic departure from the current rules. Contrary to early predictions, there does not seem to be actual evidence that the communications efficiencies of the internet have caused any significant decrease to the tax revenues of capital importing countries.”

Therefore, it is paradoxical to note that the OECD is now openly admitting that there is a problem in the current consensus relating to international taxation. In this context, the following observation from the BEPS report are worth noting : “… the international common principles drawn from national experiences to share tax jurisdiction rules for international taxation and internationally agreed standards are still grounded in an economic environment characterized by a lower degree of economic integration across borders, rather than today's environment of global taxpayers, characterized by the increasing importance of intellectual property as a value-driver and by constant developments of information and communication technologies.”

And again, “This report also shows that current international tax standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of the digital economy. For example, today it is possible to be heavily involved in the economic life of another country e.g. by doing business with customers located in that country via the internet without having a taxable presence there or in another country that levies tax on profits. In an era where non-resident taxpayers can derive substantial profits from transacting with customers located in another country, questions are being raised on whether the current rules are fit for (the) purpose. Further, as businesses increasingly integrate across borders and tax rules often remain uncoordinated, there are a number of structures technically legal, which take advantage of asymmetries in domestic and international tax rules.”

This is precisely the point that India has been raising all along. In the application of the tax treaties also, Indian Revenue has been taking an expansive definition of PE. Whether OECD ultimately agrees to modify the PE concept or agrees to give more taxing rights to the source countries remains to be seen. However, it is heartening to note that the international community is at least taking note of the concerns raised by India and other developing countries.

It is well known that significant base erosion and profit shifting also takes place through transfer pricing resorted to by the MNEs. The current OECD TP guidelines have been found to be lacking in effectively dealing with the practice. The problem is acute in cases involving intangibles as also in cases of mergers and acquisitions and restructuring. In the absence of comparables, the one-sided transfer pricing adjustments do not effectively deal with the problem. Indian tax administration also has preference for two-sided methodologies (profit –split) although Tribunals here seem to be taking a different view. In this connection, it is interesting to note that the OECD report calls for a broader reflection on transfer pricing rules.

For the present, OECD has flagged the following pressure areas

•  International mismatches in entity and instrument characterization including, hybrid mismatch arrangements and arbitrage;

•  Application of treaty concepts to profits derived from the delivery of digital goods and services;

•  The tax treatment of related party debt-financing, captive insurance and other intra-group financial transactions;

•  Transfer pricing, in particular in relation to the shifting of risks and intangibles, the artificial splitting of ownership of assets between legal entities within a group, and transactions between such entities that would rarely take place between independents;

•  The effectiveness of anti-avoidance measures, in particular GAARs, CFC regimes, thin capitalization rules and rules to prevent tax treaty abuse;

•  The availability of harmful preferential regimes.

The OECD also openly recognises that the tax practices of some multinational companies have become more aggressive over time, raising serious compliance and fairness issues. Again Indian Revenue has not endeared itself to the international business by pointing out the compliance issues of the MNCs. However, the latest buzz created in the UK about the dismal tax payment record of Starbucks, Google and Amazon might have helped precipitate the issue.

However, whether OECD will recognise that the root cause of the homeless income and documented efforts at profit shifting are to a large measure due to the skewed distribution of taxing rights between the source countries and the residence countries remains to be seen. How the OECD fixes its transfer pricing guidelines, which are at times taken as gospel truth by some Tribunals here in India, also remains to be seen. As pointed out by Lee Shepherd [OECD tries to fix Income Shifting-TNI, February, 18,2013], the extant TP rules do not compel the multinationals to account for 100 percent of the profits or ensure that they are taxed somewhere.

Three working groups have been set up with the U.K chairing Transfer Pricing, Germany, the Base erosion and the USA and France jointly chairing the allocation of taxing rights. India is not a member of the OECD. However, it is reported to be supporting the initiative. How far India's voice will be heard is a matter of conjecture. What is surprising though is the time frame. OECD is supposed to come out with the detailed action plan in June 2013. One hopes that it does not end up with doing a patchwork.