Taxing the digital economy is (going to be) an African issue

This is the second of three posts in which I’m reflecting on the recent report on BEPS and developing countries [pdf] during a short stay in Africa. Today, I’m looking at the digital economy. This visit to Africa has been the first time I’ve really grasped the scale of what mobile internet is doing to Africa. It’s huge. Half of all urban-dwelling Africans have smartphones, and mobile internet use is growing at twice the rate of the rest of the world. Nairobi, Kampala and Lusaka have all been festooned with adverts promising “world class internet”.

Buying a SIM card in Kampala, I commiserated with the vendor about the recent discontinuation of Skype on our outdated Windows Phone devices. Later, I debated the merits of Facebook and Whatsapp with the boy serving breakfast at my guest house. At a music festival I found the best implementation of a Twitter wall that I’ve seen.

Here in Lusaka, I had a long chat with the manager of a hostel about Zambians’ penchant for second hand Japanese cars, only to log on to the internet and find every website plastered with adverts for exactly that. And when you ask for directions, people just say “don’t you have Google maps?”

So I thought it quite odd that the BEPS and developing countries report – unlike the BEPS project itself – pretty much skips over the digital economy. McKinsey think that by 2025 the internet could be the same or even a bigger share of African GDP than it is in the UK – as much as ten percent. It’s precisely because Africa lags behind in everything from telephone lines to bank accounts to textbooks that this might happen: the internet, and particularly the internet on mobile devices, offers the chance to leapfrog that capital-hungry stage.

There are two sides to the digital challenge when it comes to taxation, as the BEPS digital economy report [pdf] outlines. The first is the challenges it creates for getting our current international tax rules to deliver the intended outcome, which is broadly that multinational companies pay tax on their profits where they generate them through a physical presence.

Leaving aside the stratospheric “double Irish” schemes and their like, the report discusses some nuts and bolts areas where companies have gone right to the edge of the definition of a taxable permanent establishment (PE), without crossing it. For example, OECD (but not UN) model treaties exempt a delivery unit from the definition of a PE, which is how Amazon avoided a tax liability in the UK despite its huge warehouses. Zambia is not well prepared for similar developments, as most of its treaties follow the OECD provision on this, not the UN one.

But it’s the second side of the issue that I think is big for Africa. This is the growing irrelevance of physical presence to modern business models. The OECD report talks about problems with ‘nexus’: how digital companies can make a lot of money in a country over the internet without needing any physical presence at all. It moots the idea of supplementing the physically-rooted PE concept with a new concept of “significant digital presence”, levying a withholding tax on digital transactions, or even abandoning PE altogether,

It also talks about the value attached to data: how digital companies can generate significant value in a country from user data without any money changing hands. There’s no mention of the French Colin/Collin report [pdf], which I thought was fascinating on this. Digital companies like Facebook and, I guess, WordPress, have millions of users creating value (and hence, profits) for them for free, so how does that affect a tax system that tries to allocate taxing rights based on where a company’s value is created?

It’s not just the likely size of the digital economy in Africa that makes this an important issue for the future here. It’s also the fact that digital’s exponential growth here is happening precisely because there isn’t the infrastructure to support physical presence. People will be increasingly downloading textbooks instead of buying them, Whatsapping instead of telephoning, faxing or writing, and using Facebook instead of sending out mailshots, Digital will render irrelevant some of the growth of the physical, taxable economy that already exists in more developed regions. (The exception, of course, is the mobile phone companies…but that’s for another day).

I imagine that the more radical ideas mooted in the OECD paper to deal with the challenges of nexus and data will face stiff opposition from certain countries that are big exporters of digital services. After all, this is not strictly speaking base erosion or profit shifting, because it’s about changing what the rules are intended to do, rather than making sure that they work.

Ordinarily, in this kind of situation I would suggest that developing countries band together to implement a home-grown, tailor-made solution to this problem, and add it to their domestic laws and the COMESA/EAC/SADC model treaties. But they are going to need help. The reason is that if companies are making money from their citizens without any physical presence, they don’t have any cash in the country to take the tax from. To collect tax revenue from digital companies, African governments will need the assistance of tax authorities in the home countries of those companies, which will in turn mean a treaty (either bilateral or multilateral) that supports this.

I’ve realised in my interviews here that developing countries are running just to keep up with the changes to model tax treaties. All their energy is taken up trying to understand, obtain and implement the newer treaty provisions, transfer pricing rules, and information exchange standards. What they aren’t doing so much is evaluating them. So I’d suggest that countries such as Zambia stop, take a breath, and think about what they are likely to want to tax in ten or twenty years’ time. Then they’ll be ready to throw themselves into building a future-proofed set of international tax rules that works for them.

Thoughts on Deloitte and the China-Mauritius-Mozambique route

Sunday’s Observer carried a story, prompted by ActionAid, based on a presentation given by Deloitte to a group of Chinese investors. The presentation explained how to avoid withholding tax and capital gains tax in Mozambique by routing the investment through Mauritius. It’s great to see this kind of common or garden tax arbitrage highlighted and controversialised.

What caught my eye was Deloitte’s response. The company said:

It is wrong to describe applying double tax treaties, such as the treaty between Mauritius and Mozambique, as tax avoidance. Such treaties are freely negotiated between the Governments of the countries involved.

Double tax treaties exist to enable the countries concerned to strike a balance between the need to encourage investment, including cross-border investment, to raise tax revenue, and to work together with other countries who have the same legitimate concerns to raise revenue and promote business.

The absence of such treaties could result in a reduction of investment, and less profit subject to normal business taxes in the countries concerned.

Any discussion of tax treaties by tax professionals would typically be around the technical and administrative aspects of the treaties and not an expression of favour of any particular country at the expense of any other country.

Leaving aside the questionable empirical basis of the tax treaties-investment link, what interests me is the way the statement completely glosses over the difference between “applying double tax treaties”, and treaty shopping, i.e. structuring investments through an intermediate jurisdiction like Mauritius in order to obtain more preferential treaty benefits. It raises a couple of questions for me.

First, is that obfuscation just a good PR strategy, or is it the case that tax advisers don’t see this distinction as valid? Is advice on tax treaties always aimed at getting the best treaty rates available, with no conceptual (or ethical) difference between a direct investment and one via a tax treaty conduit?

Second, how can we say whether this is tax avoidance or not? At first sight, I’d argue that the intention of the Mozambique-Mauritius treaty is to provide benefits to Mauritian investors in Mozambique, and vice versa, while the absence of a Mozambique-China treaty reflects those governments’ intention that a Chinese firm investing in Mozambique should incur taxes at the non-treaty rates. In that interpretation, tax treaty shopping contravenes the intention of the treaties and is tax avoidance.

But it’s more tricky than that. It’s technically fairly easy to include an anti-abuse clause in a treaty, to spell out this intention. If there isn’t one, it might be because of poor negotiation by Mozambique, or Mauritian unwillingness to renegotiate, but it might also be that Mozambique intends investors from other jurisdictions to use Mauritius as a route to invest, since this reduces the perceived need to negotiate treaties with every potential source of investment. After all, Mozambique only has a handful of treaties, and its Mauritius treaty was signed just after Mauritius adopted the offshore regime that creates the problem. Meanwhile, China is a pretty aggressive negotiator, and those African countries that have signed treaties with China seem to have ended up with less taxing rights than Mozambique has from its treaty with Mauritius. So Mozambique may actually be better off letting Chinese investors exploit its treaty with Mauritius, rather than negotiating a treaty with China. Though it would be better off still in terms of taxing rights if it had neither!

And what about China? It only has a few treaties with African countries, but it does have a treaty with Mauritius. China has foreign tax credits, so the less its multinationals pay abroad, the more revenue it gains (of course a lot of its overseas investment is by state-owned enterprises, and there again, tax savings abroad go straight into government coffers). So maybe China doesn’t see any urgent need to change the status quo. That said, at least half of the African countries with which it has signed tax treaties also have treaties with Mauritius, which suggests a preference for its multinationals investing directly.

One of the main issues in all this is that we don’t know what developing countries intend when they negotiate treaties. To make matters worse, in many developing countries, including (I think) Mozambique, the executive has historically had the power to ratify treaties. So there’s no ‘will of parliament’ to look for, and no public record of any debate among decision-makers. Mozambique’s treaty was signed almost 20 years ago. If my experience talking to officials in other countries is anything to go by, it will be hard to find anyone who can remember how and why this treaty came about. The tax landscape has changed in the meantime, as has the economy, not least with the growth of cross-border services. This would be a good time for Mozambique to review its treaty network.

Unitary taxation, Barclays and Africa

I just read the Tax Justice Network briefing which is explained in Richard Murphy’s blog title “Barclays and HSBC make the case for unitary tax in the UK – because we’d have collected £2.6 billion more in 4 years.” Now I haven’t checked out the UK figures at all, but the inclusion of Barclays piqued my interest, because by some measures it has a bigger operation in Africa than it does in the UK.

Unitary taxation makes me nervous, because while the idea is to draw the tax base away from tax havens and towards economic substance, I worry that under most formulae – certainly those acceptable to the G20 – it may also suck the tax base away from developing countries.

The segmental analysis in Barclay’s accounts means that it’s possible to conduct a hypothetical case study to help answer this: would Africa be better or worse off under a simple unitary tax formula as compared to the current system?

I’ve quickly cobbled together a spreadsheet to do that for the last three years. I reproduced the TJN figures to make sure it’s comparable. I couldn’t find a tax figure for Africa, but that’s fine, the best comparison is anyway the tax base, that is, the pre-tax profits. So I applied the same two-factor formula as the TJN report proposes, which divides up the group profits on the basis of staff numbers and turnover. TJN wanted to use fixed assets as a third factor well, but couldn’t find any data. I’ve had a go at it, by using the number of distribution points (branches and sales centres), although this doesn’t change the overall distribution very much.

The result is interesting. When the group as a whole is profitable, Africa does better from this simple unitary approach than it does from the status quo. But because the African operations are not subject to the same shocks as other parts of the business have been, in 2012 Africa is much more profitable than the group overall, and so it does a lot worse under the unitary approach that takes the overall group profits as its starting point. The net effect of the unitary approach over three years is still positive, though: the African tax base is £2.9bn-£3.3bn as compared to £2.0bn under the status quo.

Link to Google spreadsheet

There are of course caveats. The staffing and profit figures I used are for the Africa segment, which doesn’t quite include all the African operations (though the turnover figure does). According to the ActionAid tax haven tracker, Barclays has six subsidiaries in the tax haven of Mauritius, which might distort the Africa figures.

Most importantly, though, Barclays is a big service provider in Africa. It has a lot of sales, a lot of staff, and a lot of branches in Africa. So it’s not a typical case study. I don’t think Africa would do so well out of unitary taxation of a company that was primarily extracting minerals or growing agricultural commodities for export.