Base Erosion and Profit Shifting (BEPS)

What Is Base Erosion and Profit Shifting?

Base erosion and profit shifting (BEPS) describes tax planning strategies used by multinational groups to exploit gaps and mismatches between national tax rules. The effect is that taxable profits are moved, on paper, away from the countries where the economic activity and value creation actually take place, and into jurisdictions where they are taxed lightly or not at all.

The term is most closely associated with the OECD/G20 BEPS Project, an international effort to update the rules for taxing cross-border business. That project produced a package of 15 actions, and its implementation is coordinated through the OECD/G20 Inclusive Framework on BEPS, which brings together a large number of countries and jurisdictions.

BEPS is generally about tax avoidance, meaning arrangements that may comply with the letter of the law while defeating its purpose. It is distinct from tax evasion, which is illegal concealment of income or assets. The line between the two matters a great deal for compliance teams.

Why BEPS Matters

For governments, BEPS reduces the tax base and shifts the burden toward taxpayers who cannot move profits. For businesses, it creates uncertainty and reputational exposure, and aggressive arrangements are increasingly challenged by tax authorities.

For financial institutions, BEPS is relevant even though banks are not usually the parties doing the planning:

• Structures look alike. The entities used in aggressive tax planning, such as intermediate holding companies, conduit entities and companies with little substance, can resemble the shell structures used in money laundering.
• Tax crimes are predicate offenses. FATF includes tax crimes in its list of designated categories of offenses for money laundering, so proceeds of tax evasion are criminal property.
• Transparency rules overlap. Disclosure and reporting regimes that grew out of the tax agenda, such as country-by-country reporting and automatic exchange of financial account information, increase the information available about corporate customers.

How BEPS Arrangements Work

Common techniques targeted by the BEPS actions include:

1. Transfer pricing manipulation. Prices for goods, services or intellectual property traded between related companies are set to move profit to a low-tax affiliate.
2. Hybrid mismatch arrangements. An instrument or entity is treated differently by two countries, producing a deduction in one with no matching taxable income in the other.
3. Excessive interest deductions. A group lends to its high-tax subsidiaries from a low-tax affiliate so that interest payments reduce the taxable base.
4. Treaty shopping. An intermediate entity is placed in a country only to access the benefits of its tax treaties.
5. Artificial avoidance of a taxable presence. Business is structured so that it does not create a permanent establishment where sales are actually made.
6. Locating intangible assets in low-tax jurisdictions. Valuable intellectual property is held by an entity with few staff, and royalties flow to it.

The International Response

The BEPS actions address these techniques through a mix of minimum standards, recommended approaches and best practice. Elements that are widely known include:

• Action 5 on harmful tax practices, including substance requirements for preferential regimes and exchange of tax rulings
• Action 6 on preventing treaty abuse
• Action 13 on transfer pricing documentation, including country-by-country reporting by large multinational groups
• Action 14 on making dispute resolution more effective
• Actions 8 to 10 on aligning transfer pricing outcomes with value creation
• Action 2 on neutralizing hybrid mismatches

Many treaty-related measures are implemented through the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, often called the MLI, which modifies existing bilateral tax treaties without renegotiating each one.

Later work addressed the tax challenges of the digitalized economy through a two-pillar approach. Pillar Two introduces a global minimum effective tax rate of 15% for large multinational groups.

In the European Union, BEPS measures were carried into law through instruments such as the Anti-Tax Avoidance Directive (Council Directive (EU) 2016/1164), the mandatory disclosure rules for cross-border arrangements in Council Directive (EU) 2018/822 (known as DAC6), and the Pillar Two Directive (Council Directive (EU) 2022/2523).

What Compliance Teams Should Watch For

BEPS planning is not in itself a reason for a suspicious activity report. Compliance teams are concerned with the point where structures stop being explainable and start suggesting concealment. Useful questions include:

• Does each entity in the ownership chain have a clear commercial purpose and real activity, or is it a conduit with no staff or premises?
• Are payments between related companies consistent with the services or assets they purport to pay for?
• Can the customer explain why profits, royalties or interest flow to a particular jurisdiction?
• Are beneficial owners transparent, or hidden behind nominees, trusts or bearer instruments?
• Is the customer subject to public scrutiny, disputes or investigations over tax matters?

Where structures are complex, firms should consider enhanced due diligence, including a full ownership map and an understanding of the source of funds moving through the accounts. Tax advice to the customer is outside the role of the compliance function, but understanding the customer's structure is not.

Related Terms

• Offshore Financial Center (OFC)
• Shell Company
• Passive NFE (Non-Financial Entity)
• UBO (Ultimate Beneficial Owner)
• VAT / TIN Validation
• EDD (Enhanced Due Diligence)