Unprecedented: Kenya-Mauritius tax treaty ratification struck down in court

Back in 2014 I was in touch with Nairobi-based Tax Justice Network Africa, as they prepared to take the Kenyan government to court over its tax treaty with Mauritius, signed in 2012. The treaty seemed a pretty poor deal for Kenya, lacking adequate anti-abuse protection, preventing Kenya from imposing withholding tax on technical fees, and restricting its ability to impose capital gains tax, which it was in the process of introducing. It has taken more than four years, but on Friday the High Court ruled, and it has declared the ratification of the treaty in Kenya to be invalid.

This is a landmark case, because tax treaties are usually technical instruments that undergo only cursory parliamentary scrutiny, if any at all. For a civil society organisation to challenge one in court, let alone win, is quite astonishing. Kenyans I know were excited by the possibilities of the country’s new constitution, and this shows their optimism was not misplaced!

TJN-A argued that the treaty was unconstitutional for two reasons: in content terms, the treaty would lead to an unacceptable loss of revenue; in process terms, it should have been subject to public consultation and approval by parliament. The court actually sided against TJN-A on both counts, stating among other things that it should have provided figures for the revenue lost (which should make it untenable for governments to refuse to do the same) and that consultation with Kenya Revenue Authority constituted adequate public participation. The ruling is that the statutory instrument giving effect to the treaty should have been laid before parliament, and was not. I disagree with a lot if what is in this judgement, but its political impact is nonetheless huge and welcome, as this message from TJN-A’s Alvin Mosioma illustrates:

Here are a few documents for reference:

TJN-A’s press release summarising their argument

My expert opinion submitted to the court by TJN-A (pdf)

The court ruling (pdf)

TJN-A’s press release on the judgement

Learning from past mistakes in tax and investment treaties

One big theme from the interviews I conducted on my recent African trip is that tax officials in developing countries are really starting to raise concerns about some of their tax treaties. This is particularly true of treaties with the Netherlands, Mauritius and other countries that can leave them vulnerable to treaty shopping, although it doesn’t stop there.

Why are you thinking about this now? I asked. One finance ministry official told me that there had been three factors: first, seeing countries such as Mongolia and Argentina cancel some of their treaties; second, recent NGO reports that had focused on the abuse of tax treaties, in particular the ActionAid report on Zambia sugar; third, the growing body of practical experience inside the country’s revenue authority.

If developing countries are watching what each other does, as well as learning from their own experiences, that’s interesting for international relations. It means we can draw direct parallels with Bilateral Investment Treaties (BITs), where a similar process has been studied in a lot more depth. This first chart compares the growth in BITs and tax treaties (DTTs) over time.

Growth in Bilateral and Investment Treaties (BITs) and Tax Treaties (DTTs)Whereas the number of tax treaties is still on the upward slope of a comparatively gentle exponential rise, investment treaties went through an explosive period in the mid 1990s and early 2000s, before tailing off almost to zero. (By the way, bilateral investment treaties are usually signed by developing countries, since this is the situation where investors are most concerned about possible appropriation of their investments by governments. The chart below shows that the overall pattern for tax treaties is the same if you only consider treaties signed by developing countries)

The spread of tax treaties to developing countriesThe now-classic explanation for this pattern of “three waves of diffusion” of BITs is as follows [pdf]:

In the first period, BITs provided a solution to the time inconsistency problem facing host governments and foreign investors. In the second period, these treaties became the global standard governing foreign investment. As the density of BITs among peer countries increased, more countries signed them in order to gain legitimacy and acceptance without a full understanding of their costs and competencies. More recently, as the potential legal liabilities involved in BIT signing have become more broadly understood, the pattern of adoption has reverted to a more competitive and rational logic.

Lauge Poulsen and Emma Aisbett present some pretty convincing evidence that the tailing off of BIT signatures in that “third wave” came as countries started to see the consequences of their actions in the form of claims made by investors. Their study suggests that countries only really learned from their own experience, or to a lesser extent from that of other countries in their own region: their field of vision didn’t extend much further than this.

I think there are three relevant points for the comparison between tax treaties and investment treaties. First, there has been no significant tailing off in tax treaty signings yet, which is consistent with the fact that there has not been the same volume of high-stakes disputes resulting from tax treaties as there has been over investment treaties. The comparison seems to offer support for Poulsen and Aisbett’s argument.

Second, this might change. Like BITs, tax treaties result in occasional disputes over large amounts of capital gains tax, as I wrote about recently in Uganda’s case. But tax treaties also have an ongoing cash cost to a developing country government in lost withholding tax and corporation tax. This includes the amount that is sacrificed directly to businesses from the treaty partner, but it also includes additional amounts lost through treaty shopping and transfer pricing structures, such as those documented in the ActionAid report and last year’s report produced by SOMO on Dutch treaties.

The question is whether only high profile cases with large amounts at stake – in other words capital gains disputes and reports by NGOs – are enough to cause developing countries to review their approach to treaties, or whether decisions might also be made on the basis of that ongoing cash cost. In fact, I think most of the instances of treaty cancellations have been for the latter reason. Certainly that appears to have been the rationale behind Mongolia’s decision to cancel treaties with several European tax havens [link is in Mongolian], as well as Indonesia’s decision to cancel with Mauritius. Where there wasn’t a dramatic case to catch policymakers’ attention, what provoked countries to reconsider their tax treaties?

A third point for comparison is that there is actually a fundamental difference between investment treaties and tax treaties. The whole point of the former has become to give investors recourse to arbitration, the very thing that then caused developing countries to stop signing. In contrast, what generally leads to concerns about tax treaties is when they are abused in tax planning structures, something that can be prevented through a well-negotiated treaty. Tax treaty cancellations have generally come about when requests to renegotiate fail (the above Mongolian link says the Netherlands and Luxembourg cancellations happened because of lack of progress with renegotiations) or as tactics to bring the other side to the table (Argentina-Spain and Rwanda-Mauritius are both examples of treaties cancelled by a developing country and then subsequently renegotiated).

The upshot is that with tax treaties we may not see a wave of cancellations, or a slow-down in negotiations, but rather a wave of renegotiations, something that is already ticking along in the background.

Tax treaty renegotiationsNote on data: I compiled the numbers of tax treaties from the IBFD database. The numbers only include treaties that have been signed (including treaties that have been signed but not ratified, and excluding treaties initialled but not signed). They exclude treaties signed by jurisdictions that were not fiscally independent at the time (no treaties signed by colonies, except for British and Dutch overseas territories that set their own economic policy). Numbers of investment treaties were taken from UNCTAD, and compiled by Lauge Poulsen.

Link to Google spreadsheet

Cancelling tax treaties: a lesson from the 1970s

Mike Lewis at ActionAid had a blog yesterday about the problem posed by Zambia’s tax treaty with Ireland, following up on ActionAid Zambia’s call for the treaty to be renegotiated. But how easy would that be?

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