As early as the 1920’s, the League of Nations recognized the potential adverse consequences of disparate domestic tax structures on global growth and prosperity, the most significant of which is double taxation. The dizzying pace of globalization has forced the Organization for Economic Cooperation and Development (OECD) to finally come to grips with this issue.
Unrestrained transfers of capital, shifts in production from high-cost to low-cost labor markets, reductions in trade barriers, technological advancements, increased emphasis on risk management, and the escalating need to develop, protect and exploit intellectual property also exert pressures on cross-border economic activity.
A Question of Sustainability
The benefits of globalization are indisputable. Globalization has dramatically increased trade and foreign investment which, in turn, fosters growth, creates employment opportunities and lifts millions from the depths of poverty.
For these benefits to continue, the OECD has adopted the position that international tax rules must be based on a doctrine that comprehends the ever-increasing global nature of economic development. To that end, the OECD launched an ambitious 15-point action plan to fight Base Erosion and Profit Shifting (BEPS) which will rewrite international tax policy.
While on its face, the plan’s targets are multinational enterprises; its potential reach may wash over hedge funds, both on and off-shore.
Defining Taxable Events
The current tax policy for most countries focuses on whether or not an enterprise has a physical presence. Although such a presence may include an office or resident agent, many countries exclude these as taxable events. This means that in many instances, the presence of a warehouse, a server or a major customer base is often ignored as a taxable event by many countries.
However, many of the proposals emanating from the BEPS project are redefining the concept of what constitutes a taxable event to cover a broader range of scenarios, including virtual establishments, such as a server, or contracts digitally executed with agents physically in a given country. There is also a proposal that would create a taxable event based solely on an enterprise having a significant digital presence in the country.
Impact on Hedge Funds
It isn’t difficult to read the tea leaves. Hedge funds will need to have a thorough understanding of these proposals and adjust their digital infrastructure accordingly. For example, a fund using high frequency trading, especially co-location, could be defined as taxable by the country in which its server is domiciled.
Profit allocation is undoubtedly the most arduous task BEPS faces and this is potentially the greatest source of friction between sovereign nations. As a result, this segment will take the longest to put into action.
While this project is far from concluded, hedge funds would be well-served by closely following the direction these proposals take and preparing for the tax consequences they may engender. Clearly, the OECD’s BEPS proposals do not have the force of law but, they will shape the direction of international and domestic tax legislation. Hedge fund firms prepared for these possible future scenarios will enjoy a competitive advantage.