Stepping up efforts to seal gaps and mismatches in tax rules

Change is inevitable, sometimes, uncomfortable. Globalisation and international trade has shaken the way business is done. Things are moving with such speed that it is sometimes hard to keep up. Kenya, most certainly, needs to get with the programme.

The country has been propped up as a strategic investment destination. It is certainly a business gateway into East and Central Africa. Understandably, there are several businesses operating in Kenya with transactions cutting across different jurisdictions, tax or otherwise. These transactions are governed through various legal agreements and contracts.

Such agreements and contracts sometimes include tax planning strategies aimed at “shifting” profits to otherwise perceived lower-tax jurisdictions. This “erodes” the “tax base” of the jurisdictions considered to have higher taxes. This phenomenon is referred to as Base Erosion and Profit Shifting (BEPS). These strategies are designed to “exploit gaps and mismatches in tax rules.” Every tax jurisdiction insists that profits should be taxed in the jurisdiction where the economic activities generating the profits are located. The mismatch therefore is economically a genuine concern.

This has led to an internationally co-ordinated approach by governments, and unilateral measures designed by individual countries, to tackle the concerns around BEPS, and the perceived tax avoidance techniques by high-profile multinationals.

The recommendations of the BEPS Project, led by the Organisation for Economic Co-operation and Development (OECD), are at the root of this co-ordination. The OECD’s Action Plan on BEPS was first published in July 2013 with a view of addressing the perceived tax gaps. The final report was published in October, 2015.

It may take some time for the impact of these recommendations to be fully applied in practice. However, the BEPS Project, and related developments, are constantly leading to the need for business to take action (in some cases, urgent action) to comply with new requirements on one hand, and to reconsider ways in which they do business in different countries, on the other.

It therefore begs the question, in a post-BEPS world, where the transfer pricing landscape has shifted to place greater emphasis on “economic substance,” does this mean that intercompany legal agreements have become irrelevant?

To answer this question, it is important to understand that a key aim of the BEPS Project was to counter arrangements where the “allocation of profits is not aligned with the economic activity that produced the profits.” How then does one defend such structures? The simple answer is, by defending substance.

One of the core principles for testing substance is that the actual conduct of related parties will either supplement, or potentially supersede, intercompany legal agreements for transfer pricing purposes. Consequently, any legal agreements should be based upon this “truer” or “more complete” picture. Intercompany legal agreements should accurately present the resultant transfer pricing obligations.

This is because in practice, legal agreements are still the starting point for any transfer pricing analysis. If a taxpayer argues that the substance differs from its intercompany legal agreements, they will be arguing against their own documented transfer pricing position.

Such arguments may lead to dire practical consequences. They may also complicate any resultant tax disputes. Alternatively, where no intercompany legal agreements exist, similar types of issues may arise, as there is no historical evidence of the planned arrangement between the parties.

Therefore, taken together, with the broader measures undertaken as part of the BEPS Project, the priority for taxpayers should be to review their tax and transfer pricing arrangements to ensure that policies are appropriately rewarding group entities and are being correctly implemented. It may also be prudent for taxpayers to review their intercompany legal agreements to ensure that they reflect the factual substance.

Alambo is a Tax & Regulatory Services Manager at KPMG Advisory Services Limited