International tax planning by multinationals: Simulating a tax-minimising intercompany response to the OECD's recommendation on BEPS Action 4

In October 2015, the OECD/G20 presented their final report on the Base Erosion and Profit Shifting (BEPS) Project. This article presents a unique analysis of the OECD/G20’s recommendation on Action 4 by utilising tax optimisation modelling to simulate and examine a hypothetical multinational enterprise’s (MNE’s) behavioural response to this recommendation. The literature to date has primarily focused on the “debt bias”, which arises from the distortion in the tax treatment between debt and equity financing. The BEPS Project is no exception, despite acknowledging that the “mobility and fungibility of money makes it possible for multinational groups to achieve favourable tax results”, the focus has remained on the debt bias. Prior work by the author introduced a broader conception of funding biases; specifically, the tax‑induced cross‑border “funding bias”. The funding bias includes intercompany licensing and leasing activities in addition to debt and equity financing. These four forms of fungible intercompany financing are built into the tax optimisation model developed by this article. This model presents a unique contribution to the literature by simulating complex cross‑border intercompany tax planning strategies. This facilitates a formal analysis of one of the most significant challenges presented by the mobility and fungibility of capital, namely, anticipating how an MNE structures its internal affairs in a tax‑minimising manner given the current tax regime — and designing improvements to tax laws accordingly. The model developed by this article shows that the OECD’s fixed ratio rule is more effective than the current regime of thin capitalisation rules at protecting the tax revenue base from the most tax‑aggressive MNEs. However, the model also indicates that it is ultimately more effective to equalise the tax treatment among otherwise fungible intercompany funding activities. This outcome is consistent with the principle of tax neutrality, which suggests that, ceteris paribus, all like income should be treated alike for tax purposes. This shows that rules eliminating the “underlying disease” (the tax incentive for thin capitalisation) are more effective at targeting BEPS than rules which mitigate the “symptom” (such as thin capitalisation rules or the OECD’s fixed ratio rule).