3. Each key factor is briefly described below.
The regime imposes no or low effective tax rates on income from geographically mobile financial and other service activities.
A low or zero effective tax rate on the relevant income is a necessary starting point for an examination of whether a preferential tax regime is harmful. When a preferential regime benefits income from geographically mobile activities and meets this factor, it is in scope for the FHTP. However, the tax rate factor alone does not imply that a preferential regime is harmful; rather it is a gateway criterion that if met means that the FHTP will continue the review process to determine if one or more of the other key factors are implicated.
The regime is ring-fenced from the domestic economy.
Some preferential tax regimes are partly or fully insulated from the domestic economy of the jurisdiction providing the regime. The fact that a jurisdiction has designed the regime in a way that protects its own economy from the regime by ring-fencing provides a strong indication that a regime has the potential to create harmful spill-over effects. Ring-fencing focusses on the legal or administrative barriers to participation in the domestic economy, rather than the case where only a small number of domestic taxpayers take advantage of the regime.1 Ring-fencing may take a number of forms, including:
A regime may explicitly or implicitly exclude resident taxpayers from taking advantage of its benefits.
Enterprises which benefit from the regime may be explicitly or implicitly prohibited from operating in the domestic market.
The regime lacks transparency.
A lack of transparency may arise from the way in which a regime is designed and administered. For example, where the details of the regime or its application are not apparent, or there is inadequate regulatory supervision or financial disclosure.
There is no effective exchange of information with respect to the regime.
When the jurisdiction lacks an effective exchange of information with respect to the regime, this can inhibit the ability of other tax authorities to enforce effectively its rules.
The regime encourages operations or arrangements that are purely tax-driven and involve no substantial activities.
This factor has been elaborated in the work of the 2015 BEPS Action 5 Report (OECD, 2015), requiring that in order to benefit from a preferential regime, the taxpayer must have engaged in the activities giving rise to the income.
In the case of regimes that give benefits to income from intellectual property (“IP”), this requirement means being compliant with the “nexus approach” as detailed in the 2015 BEPS Action 5 Report (OECD, 2015[2]). The nexus approach requires a link between the income benefiting from the IP regime and the extent to which the taxpayer has undertaken the underlying research and development that generated the intellectual property. The FHTP uses a substantive approach, reviewing IP regimes that are targeted at IP income (such as patent boxes) as well as regimes that provide for benefits to a wider range of geographically mobile activities but include income from IP (such as certain free zones or international business companies).
The 2015 BEPS Action 5 Report (OECD, 2015[2]) also contains more general guidance for the application of the substantial activities criterion to non-IP regimes, and further detail on the FHTP’s approach is set out in Annex D of the 2017 Progress Report (OECD, 2017[3]). This ensures that the core income generating activities are undertaken, including with an adequate number of full-time, qualified employees and an adequate amount of operating expenditure, supported by a transparent mechanism to ensure compliance.
4. In many cases, jurisdictions make government commitments to amend or abolish their regimes within a certain time, on the basis of concerns expressed by the FHTP that there are potentially harmful features, and such regimes are found to be “in the process of being amended or eliminated.” If the FHTP concludes that a regime meets the no or low effective tax rate factor, and one or more of the other factors applies, it would be found to be potentially harmful, whether in the absence of such a commitment or where such commitment to amend or abolish the regime was not met by the agreed time.
5. When the FHTP concludes that a regime is potentially harmful, the next step is to assess whether the regime has harmful economic effects. For this assessment, economic data is used (such as number of taxpayers and amount of income benefiting from the regime). When the economic effects shows that the regime is not harmful in practice, the regime is found be potentially harmful but not actually harmful. This means that the jurisdiction does not have to take steps to amend the regime, but the regime is subject to a yearly monitoring process by the FHTP and where changes in economic effects are identified, the conclusion can be revisited. Where a regime is found to be actually harmful, the jurisdiction is expected to amend or abolish the regime in accordance with the FHTP timelines. This includes ensuring that such regimes are quickly closed-off to new applicants and new expansions of business activities, and that any grandfathering is provided for a limited transition period only. These timelines are as follows:
