OECD issues Aggressive Tax Planning based on After-Tax Hedging report (Earnst & Young View)

Earnst & Young writes: On 13 March 2013, the OECD issued the report Aggressive Tax Planning based on After-Tax Hedging, describing the features of aggressive tax planning (ATP) schemes based on after-tax hedging, as well as the strategies used to detect and respond to those schemes. This report follows the 2011 OECD report Corporate Loss Utilisation through Aggressive Tax Planning, which advises countries to analyze the policy and compliance implications of after-tax hedges in order to evaluate the appropriate options available to address them.

Risk management and hedging are key issues in corporate management. In certain cases, taxpayers may see an opportunity or a need to factor taxation into their hedging transactions to be fully hedged on an after-tax basis. However, after-tax hedging, while not in itself aggressive, may be used as a feature of schemes which are designed to allow taxpayers to achieve higher returns, without actually bearing the associated risk that is, in effect, passed on to the government through the tax charge.

In general terms, after-tax hedging consists of taking opposite positions for an amount which takes into account the tax treatment of the results from those positions (gains or losses) so that, on an after-tax basis, the risk associated with one position is neutralized by the results from the opposite position. ATP schemes based on after-tax hedging pose a threat to countries’ revenue base: empirical evidence suggests that hundreds of millions of US dollars are at stake, with a number of multibillion US dollar transactions identified by certain countries.

ATP schemes based on after-tax hedging exploit the disparate tax treatment between the results (gain or loss) from the hedged transaction or risk on the one hand, and the results (gain or loss) from the hedging instrument on the other. In some of these schemes, the tax treatment of gains and losses arising from each transaction is symmetrical, while in others the tax treatment is asymmetrical.

Other schemes rely on similar building blocks and are often structured around asymmetric swaps or other derivatives. ATP schemes based on after-tax hedging can exploit differences in tax treatment within one tax system and are, in that sense, mostly a domestic law issue.

Any country that taxes the results of a hedging instrument differently from the results of the hedged transaction or risk is potentially exposed. The issue of after-tax hedging also arises in a cross-border context with groups of companies operating across different tax systems, which gives rise to additional challenges for tax administrations.

The report describes the following main challenges raised by after-tax hedging from a compliance and policy perspective, and takes the following positions:

• The difficulty in drawing a line between acceptable and non-acceptable after-tax hedging. The report concludes that, in practice, the decision on where to draw the line will depend on a number of elements, including the facts and circumstances of each case, the commercial reasons underlying the transactions, and the intent of the applicable domestic law.
• The difficulties in detecting ATP schemes based on after-tax hedging, especially cross-border schemes. These difficulties arise because often there is no explicit link between the hedged item and the hedging instrument or because there is no trace of them in the taxpayers’ financial statements. Here, the report underlines that, in order for tax administrations to be able to face the above challenges, it is important for them to ensure they have sufficient resources and expertise to understand schemes of this nature, which are often very complex. A fair and transparent dialogue with the taxpayer, as part of discussions which take place under cooperative compliance programs, has also proven to help tax administrations gain a better understanding.
• Deciding how to respond to ATP schemes based on after-tax hedging. The report shows that different response strategies have been used, including strategies seeking to deter taxpayers from entering into such schemes and promoters or advisors from promoting the use of such schemes.

Finally, the report recommends countries concerned with ATP schemes based on after-tax hedging to:

• Focus on detecting these schemes and ensure that their tax administrations have access to sufficient resources (in particular, expertise in financial instruments and hedge accounting) to detect and examine after-tax hedging schemes in detail
• Introduce rules to avoid or mitigate the disparate tax treatment of hedged items and hedging instruments
• Verify whether their existing general or specific anti-avoidance rules are suitable to counter ATP schemes based on after-tax hedging and, if not, to consider amending those rules or introducing new rules
• Adopt a balanced approach in their response to after-tax hedging, recognizing that not all arrangements are aggressive, that hedging in and of itself is not an issue and that ATP schemes based on after-tax hedging may necessitate a combination of response strategies
• Continue to exchange information spontaneously and share relevant intelligence on ATP schemes based on after-tax hedging, including deterrence, detection and response strategies used, and monitor their effectiveness