Certainty in the tax treaty regime

Here’s the text and slides of a talk I gave yesterday at an event called Harnessing the Commonwealth Advantage in International Trade.

I want to talk today about issues related to tax treaties in developing countries, and their impact on tax certainty for multinational investors. To do this I think we have to consider two aspects of the tax treaty regime: the multilateral norm-setting processes at the OECD and United Nations, and the individual bilateral treaties negotiated by pairs of countries. The key point I want to make is that, at both these levels, the elaboration of a regime that constrains developing countries’ source taxation rights in ways that risk being seen as excessive is not sustainable in the long term.

Consider first the multilateral level. Last week I was reading a PWC document, ‘Navigating the Maze: Impact of BEPS and Other International Tax Risks on the Jersey Funds Industry [pdf].’ It notes that:

Countries are already diverging from suggested guidance from the OECD, which was meant to bring coherence and consistency.

This does not only apply to developing countries, but there is plenty of evidence to suggest that in emerging markets there is a growing dissatisfaction with the OECD approach, as illustrated by the ongoing row over the status of the UN tax committee, and India’s recent financial contribution to its trust fund, which until then had been empty for over a decade.

Here are two quotes that illustrate this sentiment further:

“For developing countries the balance between source and residence taxation [is] very crucial. International tax rules with its preferences for residence based taxation [are] not in interest of developing countries.”

Eric Mensah, Ghana Revenue Authority, 2017 [pdf]

“The global tax system is stacked in favour of paying taxes in the headquarters countries of transnational companies, rather than in the countries where raw materials are produced.”

Francophone LIC Finance Ministers Network, 2014 [pdf]

It seems that, to maintain the integrity of the international tax system as emerging market voices become stronger, countries that favour residence-based taxation will need to accept greater flexibility within the instruments agreed at multilateral level.

Turning to the bilateral treaties that developing countries have negotiated, here I want to introduce you to some research I conducted at the LSE, funded by an NGO called ActionAid. ActionAid used it to inform a campaign that has targeted individual governments and treaties, calling for renegotiations.

Slide2

I took 500 tax treaties concluded by developing countries and had a group of LLM students code them for the main clauses that could vary on a source-residence axis, using an International Bureau of Fiscal Documentation analysis. We can use that data to plot each treaty along a simple axis from 0 to 1, where 0 means an overwhelmingly residence-based treaty, and 1 a more source-based treaty. Remember that 1 here represents the presence of the most source-based clauses within existing treaties, and doesn’t take into account the concerns about inherent bias in the parameters for those treaties set by the OECD and UN models. In this first slide you can see that treaties among developing countries, in light blue, are becoming marginally more source-based over time, while treaties between developing countries and OECD members are becoming more residence-based.

Slide3

The next chart shows some of the underlying drivers of those trends. You can see that permanent establishment definitions are becoming more expansive, perhaps reflecting changes to the model treaties, while withholding tax rates are trending downwards. There are diverse trends in different clauses within areas such as capital gains tax and taxation of services.

I want to talk to you about a few examples.

Slide4

Here we see Vietnam’s treaties taken from the same dataset. Vietnam has actually expressed a comprehensive set of observations on the OECD model convention, broadly following the UN model. So here a zero on the vertical axis means the treaty contains none of those positions and instead follows the OECD model, while 1 means it includes all of Vietnam’s observations. You can see that in the 1990s Vietnam signed a number of more residence-based treaties that are completely the opposite of its stated negotiating position. And of course, these are with many of its biggest sources of investment.

More recently, Vietnam has come to regret those earlier treaties, and has chosen to interpret certain provisions on PE and technical services in the way it wished it had signed them, rather than the way it did. Businesses are very unhappy, and in the words of the Vietnam Business Forum, it has:

made the application of DTA[s] of foreign enterprises impossible, effectively it obliterate[s] the legitimate benefit of enterprises.

The residence-based treaties that Vietnam signed when it was inexperienced and urgently in need of investment are creating uncertainty, rather than the stability that investors are looking for.

Slide5

You might be aware that a few years ago Mongolia tried to renegotiate a few of its treaties, and when it was unsuccessful it terminated them. They’re the treaties with the Netherlands, Luxembourg, Kuwait and the UEA, marked in black on here. But if you look on the bottom left, you see a number of treaties with OECD countries, including the UK and Germany, that have even more limited source taxing rights. Indeed, according to an IMF technical assistance report from 2012 [pdf]:

The Mongolian authorities are currently considering cancelling all DTAs and start building up a new DTA network with countries based on trade volumes and reciprocity in economic relations.

I’m told the IMF talked them out of this, but it is worth knowing that they considered it.

Slide6

Here is Zambia, a Commonwealth example. You can see the same pattern. Its earlier treaties were very residence-based. I did some archival and interview work on those early treaties, and you can see that when they were first signed, Zambia had a hugely under-resourced civil service, with no experience of negotiation, and other countries took advantage of this. The most egregious example is its treaty with Ireland, which had zero withholding tax rates on all types of payment. That’s in contrast to the East African community countries, which had very strong negotiating red lines, and as a result either walked away, or obtained more source-based treaties that today appear quite generous, but have stood the test of time.

Slide7

This chart shows a few renegotiations that have taken place in response to government and civil society concerns. You can see that Zambia’s renegotiations have focused more on updating treaties and closing loopholes, not dramatically shifting the balance of taxing rights. In contrast, Pakistan and Rwanda have both negotiated big overhauls.

So in conclusion, as the politicisation of the international tax regime continues, especially in developing countries, I think we’re likely to see growing demands for a rebalancing between source and residence not just in the multilateral setting, but also in individual treaties. My advice to OECD governments, and businesses who engage with them, is that tax certainty in the future depends on an enlightened approach to the tax treaty regime that leaves more developing country taxing rights intact.

Revenue foregone through tax treaties in context

In the recent Tax Justice Network Africa report on tax treaties, I had a go at estimating some costs to governments, based on a back-of-the-envelope figure for cross-border dividend and interests payments.  This is similar to the methodology used by SOMO and the IMF. (It’s a bit rough and ready, because some of the return on FDI figures I used will include reinvested profits, not cross-border remittances, but I’ve seen some other more sophisticated working recently that produces roughly similar figures.)

What I didn’t realise when I wrote that report is that both Uganda and Zambia break out withholding tax revenue (which includes taxes on domestic as well as cross-border payments) in their budgets, so we can set these very rough estimates in context. I’ve been curious for a while to know the order of magnitude of the importance of tax treaties.

The upshot is that revenue foregone from the lower tax rates on qualifying dividends and interest in tax treaties (which is just one part of the revenue foregone through tax treaties) is about 15 percent of withholding tax revenue. As WHT revenue is about 40 percent of corporate tax revenue and five percent of total tax revenue, this means the revenue foregone is something like five percent of corporate tax revenue, and a little less than one percent of total tax revenue.  Here’s how I get there.

Estimating revenue foregone

Here’s the table from the TJN-A report. I take figures for the primary return on foreign direct investment and assume that investment from each country gets the same return. Then I apply the tax rate discount in the treaty to that those estimated flows. The revenue foregone using 2012 data is about US$17m in Uganda and US$42m in Zambia.

wht table

Uganda

Here’s the table from Uganda’s budget. The 2011/12 withholding tax (WHT) outturn works out at about US$130m using the exchange rate on 1st January 2012. The revenue foregone of US$17m is about 13 percent of total WHT revenue, or 0.7 percent of Uganda’s total tax revenue.

uganda

Zambia

For Zambia I only have the 2014 budget figures, which we can assume with inflation will be larger than those for 2012, the year for which the revenue foregone is estimated, and hence this will be an underestimate of the proportions. WHT foregone of US$42m is 15 percent of the total WHT revenue of US$280m, or 0.8 percent of total tax revenue (using the exchange rate on 1st January 2014).

zambia

Since these calculations don’t include the revenue foregone through reduced rates of other withholding taxes on portfolio dividends, royalties and technical service fees, never mind all the other ways in which tax treaties curb taxation of foreign investors, it seems reasonable to conclude that the total of all revenue foregone from Uganda and Zambia’s tax treaties is of the order of several percent of their total government revenue. There may be benefits to offset these costs, but the starting point for a cost/benefit analysis of tax treaties is certainly to estimate the costs!

Tax treaties in sub-Saharan Africa: a critical review

The report I authored for Tax Justice Network-Africa is now available. It’s based on field research done a year ago and has been a little while getting into print.

Here’s a link to read it online at academia.edu

Here’s a link to download the PDF

Tax treaties in sub-Saharan Africa report cover

And here’s the introduction:

There is growing attention on the question of tax treaties signed by developing countries. The costs of tax treaties to developing countries have been highlighted in recent years by NGOs such as ActionAid and SOMO. During 2014, an influential IMF paper warned that developing countries “would be well-advised to sign treaties only with considerable caution,” and the OECD, as part of its Base Erosion and Profit Shifting (BEPS) project, proposes to add text to the commentary of its model treaty to help countries decide “whether a treaty should be concluded with a State but also…whether a State should seek to modify or replace an existing treaty or even, as a last resort, terminate a treaty.”

Meanwhile, some developing countries seem recently to have become concerned by the negative impacts of some of their treaties. Rwanda and South Africa have successfully renegotiated their agreements with Mauritius. Argentina and Mongolia have cancelled or renegotiated several agreements. Responding to this pressure, two of the developed countries whose treaty networks have raised concerns, the Netherlands and Ireland, have begun a process of review.

To investigate this apparent shift in opinion among policymakers, and to see what lessons can be drawn by other developing countries, Tax Justice Network Africa commissioned this study of current policy towards tax treaties in Uganda and Zambia, two countries that appear to be questioning past decisions. Fieldwork, which consisted of interviews with government officials and private sector tax advisers, took place in Kampala and Lusaka in September 2014.

Uganda has announced a review of its policy towards tax treaties, while Zambia is renegotiating several of its treaties. The Ugandan review has several motivations, according to finance ministry officials. The lack of a politically enforced policy to underpin negotiations is one concern. “When I go to negotiate, all I have is my own judgement,” according to a negotiator. “We thought that cabinet should express itself.” Officials are also concerned about the taxation of technical services provided by professionals in the oil industry, and are asking questions about the relatively poor deal Uganda got in its as yet unratified agreement with China.

Zambia, it seems, is keen to update very old treaties that were negotiated on poor terms by over-zealous officials in the 1970s. But a recent treaty signed with China on poor terms has created a difficult precedent, dragging down the terms of its recent negotiation with the UK. Zambia is also encumbered with several colonial-era treaties that need urgent attention.

This report is divided into four following sections. Section 2 describes the historical development of sub-Saharan Africa’s tax treaty network, including some of the reasons given for its development. Uganda and Zambia are used as examples. Section 3 looks at some of the core vulnerabilities in the content of tax treaties signed by African countries, set in the context of weaknesses in their domestic laws. Section 4 provides a critical perspective on recent initiatives taken by individual countries, regional organisations and other international organisations.

Section 5 provides recommendations for African countries. In summary, they should:

  • Review all their existing tax treaties and domestic legislation, to identify areas where they are most vulnerable to revenue loss. This should include permanent establishment definitions, protection from treaty shopping, and withholding and capital gains taxes.
  • Formulate ambitious national models by applying a “best available” approach to existing models (EAC, COMESA, UN), current treaties, and domestic legislation, none of which are currently adequate.
  • Identify red lines for negotiations from within these models.
  • Based on investment and remittance data, request renegotiations of treaties that have the greatest actual (or potential in terms of capital gains) cost. These renegotiations should be conducted on the basis of an improved distribution of taxing rights, not a “balanced” negotiation.
  • Cancel these high-impact treaties if the red lines cannot be obtained.
  • Incorporate an assessment of tax foregone due to tax treaties into an annual breakdown of tax expenditures.
  • Ensure that all tax treaties are subject to parliamentary approval as part of the ratification process.
  • Ensure that future updates to provisions of the UN and OECD model treaties, or to their commentaries and reservations/observations, reflect the positions set out in their national models.
  • Strengthen the African model treaties (EAC, COMESA, SADC) so that they act as opposite poles to the OECD model, rather than compromises between the UN and OECD models.

The Mopani saga and Zambia’s windfall tax: an alternative reading

In 2010, Zambian NGOs obtained a leaked copy of an audit report conducted for the Zambia Revenue Authority into Mopani Copper Mine, a subsidiary of the Swiss behemoth Glencore. I was working at ActionAid at the time, where we took an active interest in the case. The particular allegation concerning systematic transfer pricing abuse contained in the report was consistent with the experience of many tax authorities, so much so that many Latin American countries have a specific transfer pricing rule to combat it. And with the Grant Thornton imprimatur, it seemed like the perfect story. The company denied it, but then of course they would.

A group of NGOs filed a complaint with Swiss National Contact Point for the OECD Guidelines for Multinational Enterprises (not to be confused with the OECD Transfer Pricing Guidelines), triggering an investigation, but with the parties disputing the facts, there was no concrete outcome. The European Investment Bank, which had lent money to Mopani, conducted an investigation, but so far the findings have not been published. The whole thing feels frustratingly inconclusive.

So while I was in Zambia recently I thought I would look into the story. I have pieced together the account below from interviews with current and former government officials, and with tax advisers from the private sector. It is no doubt only one interpretation of the facts, given to me by stakeholders with their own interests to defend. But it is certainly an interesting one.

In the mid 2000s, as copper prices rose dramatically, the lack of tax revenue from copper mines started to become an issue in Zambia. So in 2008, the government decided to break the fiscal stability clauses in its agreements with mining companies, and enact new taxes.

Historical Copper Prices - Copper Price History Chart

There were two: the windfall tax was based on the value of copper extracted, and the variable profits tax was levied when profitability exceeded a certain amount. There’s an excellent paper by David Manley [pdf], who was in the Zambian finance ministry at the time, explaining all of this. The idea, so I was told, was to begin with a moderate tax on sales, and meanwhile to build capacity in the Zambia Revenue Authority to administer a variable profits tax.

Officials were frustrated, however, that the original proposal to levy the withholding tax at between five and 15 percent (depending on the price of the copper sold) was rejected by politicians, who instead set it at between 25 and 75 percent. This was politically unsustainable in a country where the mining industry is willing and able to lay off hundreds or thousands of unskilled workers in a standoff with the government, as it is doing now in a dispute over VAT refunds, and (so I was told by one researcher) powerful enough to manipulate the exchange rate.

“At the time the mines were in the development stage, and it would have killed them to tax on sales,” a former official told me. According to a tax adviser, “It was pushing the mines into a loss.” Manley is more understated:

The mining companies were upset by the unilateral revocation of the Development Agreements and some refused to pay the new taxes. The announcement was followed shortly after by the onset of the global financial crisis. Copper prices fell sharply and marginal mines started laying off workers.

In 2009, the government backed down, and the windfall tax was repealed. It is here that the Mopani audit comes into play. The ZRA, with support from Norwegian technical assistants, began to conduct (or rather commission) audits of all the mining companies. The purpose was to start enforcing the variable profits tax with a clear idea of the mines’ cost bases. This targeted approach would work well with limited tax authority capacity and only a few very large mines. As the Mopani audit report makes clear, the company wasn’t very cooperative with the audit. Here I paraphrase what a former official told me:

“It was a tactic.” It’s what you do in an audit if they are not supplying the information. There was a lot of missing information and so the report was written with the intention of giving it to the company and saying ‘either you provide the information, or we will tax you on this basis.’ So of course you take an aggressive position in the audit report to create an incentive for them to supply the information. Then it was leaked and it all exploded internationally. Over time, some information came and we settled with them. Of course it was lower than the amount in the audit.

According to this official’s version of events, the audit tells a tale of a company doing its best to frustrate a tax authority by obfuscating, but for that same reason it can’t be read as a final word on Mopani’s tax affairs.

As for taxing mining profits, it now seems that Zambia’s new government has given up on this altogether, opting instead for a much higher royalty rate – effectively a return to the windfall tax. The industry is unhappy. Worse still, “as audit firms we’ve been rendered useless,” a tax adviser said to me.

But one way to interpret this in the light of the Mopani audit is that, if firms make it difficult for developing countries to administer taxes on their net income, they risk being taxed on gross instead. Zambia has, after all, already raised withholding taxes on management and consultancy fees to 20 percent.

 

Time we scrutinised China’s tax treaty practice, too

Democracy in action: David Gauke at Monday's delegated legislation committee session

Democracy in action: David Gauke at Monday’s delegated legislation committee session

On Monday the UK parliament took a total of 17 minutes to scrutinise new tax treaties with Zambia, Iceland, Germany, Japan and Belgium. I’ve complained before about how paltry these debates tend to be, and was all set for another blog along those lines. There was, indeed, much to grumble about. No questions from the opposition about the UK’s renegotiated treaty with Zambia at all, a week after the IMF warned that developing countries should exercise “considerable caution” when entering into tax treaties.

Instead, Labour’s Shabana Mahmood asked how the UK’s treaty making priorities were set, and why there is no treaty with Brazil. The response from the Minister David Gauke was considerably less informative than what I’m sure Mahmood could have found out by asking, say, her colleague Stephen Timms, Gauke’s predecessor.

But something interesting did come up when Gauke was introducing the Zambia treaty. He noted that the withholding tax rates have been reduced in line with Zambia’s treaty with China. And indeed they have. It seems to be China, often regarded as the champion of source state taxation at the UN tax committee, which is responsible for the lower withholding tax rates. I’m going to explain here why I think both the UK and China have questions to answer about these treaties.

The UK-Zambia renegotiation: a missed opportunity

The UK-Zambia renegotiation looks like a ‘balanced package’, meaning that Zambia will have gained and lost in roughly equal measure. Looking at the treaty, I don’t think it can be seen as a win for Zambia.

What it lost was withholding tax rates. Zambian tax on dividends to British portfolio investors will be reduced under the new treaty from 15% to 5%, and tax on royalty payments for the use of British intellectual property will drop from 10% to 5%. This matches what’s in the 2010 Zambia-China treaty [pdf], so it looks like Britain was keen to keep its investors competitive relative to their Chinese competitors.

By way of context, Zambia’s non-treaty rates are much higher, 15% and 20% respectively. We can argue about the economic case for this level of withholding tax, but treaties are not just about rates, they’re about the right to raise rates. It will be five years before Zambia can re-examine these low withholding rates in its treaty with the UK.

What Zambia got in return for the reduced withholding tax rates was the UN concept of services permanent establishment, which will allow it to tax services provided within Zambia by British businesses or individuals. To do so, Zambia won’t need them to have a physical fixed base in Zambia, as it would have done before, but it will need them to be physically in Zambia, furnishing services, for at least 183 days in a given year.

(There are also some modernising changes, which may in practice benefit Zambia more than the UK. This includes simple anti-abuse wording such as the “beneficial owner” clause in the withholding tax articles and a “property rich companies” clause into the capital gains article. It also includes information exchange and assistance in recovery articles. These should be good for Zambia, if it takes advantage of them. The information exchange clause could, for example, allow Zambia to get hold of country-by-country reporting on British companies if that proposal is implemented by the OECD.)

But the overall picture, taking into account the lower withholding taxes, is of a treaty that is still much more disadvantageous to Zambia than one based on the UN model would have been. I’m not even sure it’s a better position than the OECD model. Since Zambia was not nearly as aggressive at negotiating after independence as, say, Kenya, it started this renegotiation from a lower base: already low withholding taxes, no taxing rights over British airlines, limited capital gains tax rights, and no right to tax management fees, to name a few examples.

In a context in which some countries are re-examining their tax treaties with developing countries, and organisations such as the IMF are calling into question the benefit of tax treaties on current terms, there would have been a strong case for the UK to seek not a balanced negotiation, but a reapportionment of taxing rights towards Zambia, in line with the UN model. It’s a real shame that the treaty slipped through parliament on Monday without anyone at least asking about this.

China is driving the falling withholding tax rates

This argument for a more pro-source taxation treaty between the UK and Zambia would be easier to make if the 2010 China-Zambia treaty had been more generous. But in fact the terms of the two treaties are near identical. On the face of it, it seems quite likely that Zambia has been bounced into this renegotiation to help keep British mining, agriculture and manufacturing companies more competitive in the face of competition from China. These companies will benefit from the lower withholding tax rates but are unlikely to be affected by the services permanent establishment quid pro quo.

The IMF report talked about “strategic spillovers” from tax policy, in which one country’s policy pushes other countries towards a response. I’m now starting to wonder if China’s negotiating stance might be having just such a strategic spillover, contributing to the decline in withholding tax rates in treaties also picked up by the IMF. Below you’ll see that China’s treaties with sub-Saharan countries have the lowest withholding taxes in a sample of countries investing into Africa.

Withholding taxes in treaties with sub-Saharan countries, 1973-2012

Withholding taxes in treaties with sub-Saharan countries, 1973-2012

China’s treaties are newer than other countries’, so what if this trend is just an artefact of the general decline? Not so if we look at just the last 20 years, where the story is much the same, with only Mauritius (which has several zero withholding tax treaties) having a more advantageous treaty network.

Withholding taxes in treaties with sub-Saharan countries, 1993-2012

Withholding taxes in treaties with sub-Saharan countries, 1993-2012

Let’s now test whether those three Chinese treaties in Africa are typical of China’s treaties more generally. This time we’re looking at all low-income countries. Not only is China the largest signatory of treaties with this group among my sample, it also emerges as one of the most demanding negotiators.

Withholding tax rates in treaties with low-income countries, 1993-2012

Withholding tax rates in treaties with low-income countries, 1993-2012

Withholding taxes are of course only one part of the source-residence balance in a tax treaty. I took a quick look at the China-Africa treaties, and – aside from the services permanent establishment.- there is no sign that they include pro-source provisions such as withholding taxes on management fees, or a “limited force of attraction”. It’s been well-documented that China favours expansive source taxation in its treaties with outward investors, while denying them to capital-importing developing countries.

The UK-Zambia treaty seems to be an example of a strategic interaction between two countries, one (the UK) with a longstanding investment base in Zambia, and the other (China) posing a threat to that investment. It’s all very well to criticise countries like the UK for not being more generous in negotiations with developing countries, but in doing so, critics should be careful not turn a blind eye to countries outside the OECD, who may even be the ones leading the race to the bottom.

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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