Chapter

5. International tax and treaty strategy in resource–rich developing countries: Experience and approaches

Editor(s):
Michael Keen, and Victor Thuronyi
Published Date:
September 2016
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1 Introduction

Interest in international tax issues has seldom been greater than in the aftermath of the financial crisis that broke out in 2008. In addition to the high-profile cases of tax loss recorded in a number of countries a flurry of initiatives emerged from inter-governmental summits and international organizations. The phenomenon of base erosion and profit shifting (BEPS) and the possibility of initiatives to mitigate damaging effects were the subjects of a joint OECD and G20 project. The IMF (2014) published a major paper on spillovers in international taxation, showing that macroeconomic spillovers from weaknesses in the international tax architecture were significant – especially for developing countries.

The spillovers for countries exporting mining and petroleum commodities appear notably problematic, and developing countries with large extractive industry (EI) sectors have long faced challenges from the commercial organization of these sectors. First, the necessary involvement (in many countries) of multinational mining and energy companies as sources of capital, technology and managerial expertise brings with it the political problem of objection to extraction of host country resources by foreign companies. Second, these companies operate by definition in international capital markets, undertaking myriad cross-border transactions and selling products in international trade; they thus operate squarely within an international system for the taxation of corporate income. Third, fiscal regimes for extractive industries are often complex, involving a mix of contractual and legislated systems and fragmented administration as discussed by Calder (2014).

This chapter addresses issues for EI fiscal regimes from the international corporate tax framework and bilateral taxation treaties (BTTs). The structure and measurement of spillovers for resource-rich countries are discussed by Keen and Mullins in Chapter 2 of this book and in IMF (2014). The chapter outlines the key challenges that have arisen, drawing upon inter alia IMF advisory work with member countries. The principal focus is on corporate taxation, though the relevant transfer pricing issues affect other fiscal instruments too (see the chapters by Calder and also by Shay in this book). We illustrate the impact of these issues on potential extractive industry revenues for host countries. Finally, we ask if there are some defensive steps that host countries can take even if overall reform of the international architecture is delayed or fails to materialize.

2 The extent and nature of tax treaties

A number of countries with an important extractive sector already have a fairly extensive tax treaty network, but many do not.2 Resource-rich countries with an extensive treaty network may have negotiated their treaties on the view that treaties are important in attracting foreign investment, particularly in a sector in which long-term stability is important, and mindful of the important role that multinational companies play in this sector.3 However, if the question is examined more carefully, it becomes clear that treaties are not necessarily needed to accomplish the goals commonly attributed to treaties. Much of what treaties can accomplish can be done unilaterally, for example, defining permanent establishment in domestic law consistently with treaty models. The appropriate approach therefore is not for countries to rush headlong into signing treaties but rather to weigh the costs and benefits of alternative approaches and to develop a strategy that suits the needs of the country in question.

Tax treaties have proliferated as a part of the international corporate tax framework (Keen and Mullins, this volume). After steady growth in the 1970s and 1980s, the BTT network expanded significantly in the following two decades – partly as a result of the independence of states of the former USSR but also because many developing countries saw expansion of their treaty networks as positive encouragement for inflows of foreign investment. Treaties between OECD countries and non-members multiplied, but not as much as treaties among non–OECD members. Keen and Mullins (this volume) illustrate these points and also the rapid recent spread of more limited tax information exchange agreements (TIEAs).4

BTTs aim to avoid double taxation and counter tax evasion. The broad idea stems from the notion that taxing the same income twice in two jurisdictions is inefficient, though the point is not obvious if the sum of two impositions of tax is sometimes less than the amount of single taxation in one place. Similarly, treaties seek to establish the right of at least one treaty partner country to tax income from activities distributed across the two, and thus to prevent “double non-taxation”; treaties also aim to counter evasion of established taxing rights.

The key provisions follow these twin aims. BTTs clarify which party can tax which income and when a taxpayer can obtain a credit in one state for tax paid in the other. For payments from an entity in one state to a recipient in the other, BTTs set out the rights of the state that is the source of the payment to impose withholding tax on it and at what maximum rate. Typically, such payments subject to withholding tax cover dividends, interest, royalties on intellectual property and sometimes management fees or technical service payments. Treaties provide for information exchange between the tax authorities of the parties in certain circumstances. And treaties specifically provide a means for the settlement of tax disputes, both between the parties and with respect to a taxpayer resident in one state and the tax authority of the other. Dispute settlement would cover, for example, the resolution of a transfer pricing issue between related taxpayers.

The pattern of purely bilateral treaties seems inefficient and open to question. Despite the ostensibly bilateral approach, each treaty is in effect a treaty with the world – in the sense that country A, making a treaty with country B, establishes an implied relationship with all of country B’s other treaty partners, and vice versa. Taking only the 34 OECD countries, full coverage under bilateral treaties (every country has a direct treaty with everyone else) would require 561 separate treaties, and only 33 are needed for all to be indirectly linked – so the separate bilateral treaties probably mean multiple non-equivalent treaty channels.5 Within the BEPS project, international consideration of a possible multilateral treaty instrument was initiated and due for completion by the end of 2016.

Tax treaties pose important risks for host countries of extractive industries. This is especially true for those developing countries with less diversified economies, unlikely to be the source of investment in EI, of international corporate headquarters, or of technology and services for EI projects. The main areas of concern, discussed in what follows, include (i) base erosion from limitations on withholding taxes on payments to non-residents; (ii) “treaty shopping” – location for tax reasons of providers in source countries with advantageous treaty provisions with the host country; (iii) limitations on the ability of host countries to tax gains on transfers of interest, direct or indirect, in mineral rights; and (iv) exclusions of taxing powers, for example, through narrow definitions of real property or broad definitions of business profits.

Developing a tax treaty strategy implies coming up with an overall plan, based on analysis of the current situation (including existing treaties) and policy aims. The strategy is intended primarily to guide future treaty negotiation. It is particularly important to have a strategy because the treaty area is unforgiving of mistakes. Even a provision found in only one treaty can have an important effect on future negotiations, because it can become a precedent that other negotiating partners will ask for. Moreover, depending on whether the treaty in question has effective anti–treaty-shopping provisions (limitation of benefits), a single treaty with favorable terms can in practice often be used by an investor that is not resident in the treaty partner using a conduit entity that is resident in the treaty partner. Another reason treaties are unforgiving is that, unlike domestic legislation, treaties tend to be difficult and slow to change. To change a treaty, the negotiating partner must agree, and often the partner does not feel a compelling reason to move quickly. While a country can always withdraw from a treaty, countries are reluctant to do so, and instances of this happening are relatively rare.6 So in the treaty area, changes usually come very slowly. An unfavorable treaty provision can therefore remain on the books (and cause trouble) for years.

Tax treaty policy is (or should be) a subset of tax policy in general. The importance of tax treaty policy compared with tax policy in general depends on the extent of the country’s treaty network and the importance of international issues for taxation. But tax policy (including tax treaty policy) also is part of economic policy for the extractive industry sector. The extent of the overlap between these policy areas in a particular country depends on the importance of the natural resource sector and the importance of multinational companies in this sector. In an extreme case in which the EI sector dominates the economy and only multinationals are involved in it, the overlap among tax policy, tax treaty policy and economic policy for natural resources is substantial, so that there are not many tax policy choices unrelated to treaties and the EI sector. This means of course in this case that treaties must be negotiated with the EI sector primarily in mind.

Many of the policy goals of treaties can be achieved by unilateral means.7 A unilateral approach might involve the following. First, a country can exercise restraint in taxing non-residents, generally doing so only to the extent that typical treaty provisions would allow. This is a flexible approach, because there is no hard-and-fast legal constraint. Thus, for example, withholding tax rates could be limited to rates that would typically be allowed by treaty and could avoid taxing items of income that could not be reached if a treaty were in effect (for example, a withholding tax imposed on “all services”, which treaties would not allow in the absence of a permanent establishment). A country could define a permanent establishment using text similar to the UN Model and could tax non-residents only in those situations where treaties would permit. In the transfer pricing area, a country could adopt rules that are consistent with the arm’s length principle. A unilateral approach could also involve providing stability to investors through practice or agreements.8 Finally, a country could assure the creditability9 of its corporate income tax through careful tax design. In any event, the importance of creditability has been diminished because most countries have now switched to an exemption regime.

The extent to which a country can rely on a unilateral approach depends on how many treaties a country already has. A number of countries with an important EI sector already have a substantial network of treaties. These will presumably continue to expand their treaty network, and can therefore take a unilateral approach only with respect to investors from countries that are not treaty partners. Countries with few or no treaties might consider a unilateral approach. For countries with a substantial number of treaties, gradual expansion, adding or renegotiating two or three treaties a year, may be realistic. A rapid expansion would be difficult or virtually impossible given the limited capacity of treaty negotiators as well as limited negotiating capacity on the part of potential treaty partners. This leaves room for a unilateral approach to some extent.

Stability agreements can be used regardless of overall treaty strategy. 10 They should be designed with care given the pitfalls involved. Stability agreements have a number of advantages. A stability agreement can be concluded more quickly than a treaty. It can cover more taxes than a treaty typically covers. It can cover entities that might reside in different countries. However, there are pitfalls in a complex stability agreement that freeze the entire tax system. It is advisable to draft a stability agreement by focusing it only on the key elements. One reason is the incredible complexity that can be involved in administering frozen law for what can be a long period of time depending on the terms of the agreement.

Preliminary analysis for developing a tax treaty strategy involves the following steps. Types of cross-border transactions that would be affected by treaties, the aggregate volume of which is likely to be significant, should be identified and their quantity estimated. The nature of inbound and outbound investment should be identified and research undertaken to identify whether there are currently any tax barriers to such investment. Similarly identified should be any international tax problems that resident individuals are facing. The operation of any existing treaties should be studied to determine what problems, if any, existing treaties are posing (which might signal the need for renegotiation as well as for negotiating new treaties differently so as to avoid these problems). One can identify some problems on the face of the treaty. Better yet is to quantify the extent of misuse of the treaty or undesired results that the treaty has led to. These should be prioritized for renegotiation. Treaty partners may be interested in renegotiation anyway to reflect the latest updates to the OECD/UN Models (or their own country-specific models).

Using these considerations, negotiating partners can be prioritized. Thus, for example, if existing or potential new investment is coming from a handful of countries, those countries might be at the top of the list, particularly if the existing treaty framework (or absence of treaties) is posing problems for such investment. The overall tax treaty strategy may end up not being driven by EI; this depends on the relative importance of EI in the economy.

Any well-thought-out tax treaty strategy would involve avoiding negotiations that are primarily politically motivated. Priority of potential treaty partners should be based on their importance for the tax system not on political convenience. A country should avoid negotiating a treaty with another country involving no important transactions for which a treaty would be significant.

Each treaty is a treaty with the world. One should generally avoid negotiating a treaty with any country that is a tax haven. This is because such a treaty will likely be used by investors for tax planning in a way that achieves little or no taxation for the investor. In such a situation, the investor will often be stripping profits out of the source jurisdiction into the tax haven. While transfer pricing and other auditing tools can in principle police these transactions, in practice these may not be effective. In short, entering into such a treaty tends to lead to tax administration difficulties down the road and provides an invitation to investors to structure transactions in such a way as to avoid paying significant corporate tax in the source country. Even some OECD countries have some of the features of tax havens, namely that foreign investors will use that country as a country of convenience to make investments into the source country structured to minimize or virtually eliminate corporate tax.

A treaty strategy can be organized around a treaty model. The main orientation of the model should be to protect the source country’s right to tax at source and to defend against base erosion of corporate tax. A model should avoid any excessively reduced withholding rates. In developing a model, both UN and OECD Models provide a starting point – the UN Model was specifically designed with the needs of developing countries in mind (UN, 2011).

Several provisions of tax treaties are of particular relevance to extractive industries.

We start with the set of rules that allows a country to defend against base erosion of the corporate tax. Such rules typically provide for taxation (usually through withholding) of payments made abroad, mitigating their use to siphon off profits. The key base erosion threat arises from payments of interest, royalties, technical services payments and management fees. Many older (or even recent) treaties either do not contain provisions on some of these (management and technical services) or provide for exemptions or low or zero rates.

Determining a country’s treaty negotiation position could start by identifying what kinds of rules the country might want to include in its domestic law. Then existing treaties could be reviewed to determine whether the country’s existing treaties allow the desired rules and, if not, what steps to take. The exercise is not an easy one, because on the one hand one would want to include in treaties sufficiently broad provisions that allow the source country to tax all kinds of payments, but on the other hand an attempt by source country negotiators to stake out their taxing rights too broadly is likely to encounter resistance. Ideally, the source country will not ask for taxing rights that are broader than rights they intend to include under domestic law. But these cannot be delimited exactly, given that the country may change its rules for taxing base-eroding payments as problems arise and as tax planning techniques used by multinationals change.

In respect of interest and royalties, it may be relatively easy to negotiate treaties that are consistent with anti–base-erosion rules. Payments for items like management fees or technical services present more challenges. This is because traditionally tax treaties have allowed the source country to tax such payments only where the payee has a permanent establishment in the source country (on grounds of avoidance of double taxation), which will generally not be the case for base-erosion payments. Expansion of the source country’s taxing rights to these types of payments requires defining precisely what is meant by “management fee” or “technical service”, and this is not an easy task.11 A possible approach would be to use a broad definition but then to limit the situations in which the source country may tax to payments made (directly or indirectly) to related parties. Because base erosion typically involves siphoning off profits to a related company (often one residing in a tax haven), this approach meets the need of protecting against base erosion while not expanding taxation to payments for services more broadly. The difficulty of identifying a transaction that occurs between related parties rather than parties at arm’s length may work against this approach.

A treaty strategy should be designed bearing administrative capacity in mind. If the treaty network is to be expanded, a tax authority needs to make sure it has in place a unit that can administer the treaties well. This typically raises a need for training. Also needed are procedural rules12 for how to apply treaties and to make sure they are being applied properly. Greater consistency among the terms of a country’s different treaties will reduce the demands upon administrative capacity.

Treaties have an article concerning exchange of information. This might be helpful to obtain information needed in auditing multinationals in the EI sector if the tax authorities have difficulty obtaining information from the taxpayer directly or need a way to verify the information that the taxpayer provides. If the source country has a treaty with the residence country of an investor, then it can ask for information concerning the corporate group from the tax authorities of the investor’s residence country. An alternative, or supplement, to an exchange of information clause in a double tax treaty, would be to enter into the Convention on Mutual Administrative Assistance in Tax Matters.13 Many countries are party to this convention, and it would therefore provide a wider opportunity to obtain information needed.14

A treaty strategy should allow treaties to be coordinated with income tax reform. A number of countries with an incipient EI sector have been reviewing their domestic law and making sure that it reflects an appropriate policy. It would be appropriate to coordinate treaty policy with such a review. For example, where a country introduces tax by withholding on payments to nonresidents for technical services, with extractive industry services in mind, a treaty should clearly permit such taxation. Similarly, a treaty should not override any domestic provisions on taxation of gains from transfers of interest in mineral rights, direct or indirect.

Extractive industry investments involve long lead times and high sunk costs. In those circumstances, providers of loans or equity capital may view tax treaties between the host country and source countries as further assurance against the effects of unilateral changes of terms by the host – the time inconsistency problem. While important, this advantage of tax treaties should provide a rationale for allowing anti–base-eroding measures, relative to domestic legislation, to be included in these treaties.

In conclusion, any country with a significant extractive industry sector should develop a strategy for how it will use tax treaties as part of policy relating to that sector. Treaty strategy is needed by all countries but may be of particular salience for countries with extractive industries given the importance of multinational companies for that sector.

3 Base erosion: border withholding

Income tax legislation usually provides for withholding taxes (WHT) on payments to non-residents of dividends, interest, royalties and, less frequently, of management fees and technical service payments. The aim is to ensure that income with a domestic source, when remitted abroad, is subject to domestic tax. In most cases, though not for dividends, the payment from which tax is withheld is deductible for income tax purposes in the source country. The traditional target for dividend withholding taxes was portfolio investment, but where a direct investment originated from a country with a worldwide (residence) tax system the dividend tax would usually be creditable against home country obligations.

For developing countries, in particular, ease of assessment and collection of border withholding taxes can make them an important element in overall income tax. Withholding tax on interest remittances is a first line of defense against “earnings stripping” through use of excessive debt in the capital structure of a foreign-owned enterprise – especially where domestic thin capitalization rules are either inadequate or feebly enforced. Withholding taxes on payments for headquarters services (management fees and the like), technical or professional services or royalties for the use of intellectual property ensure collection of tax if these have a local source and also deter the removal of profits through inflation of these payments. Not all such payments are liable to withholding, notably when, for example, a service is performed overseas with no domestic presence and perhaps paid for by an overseas affiliate or parent of the domestic firm. Source rules on these matters are often complex, have evolved over time and yet frequently present difficulty in keeping up with developments in technology, intellectual property rights or commercial structures.

Treaties conventionally place limitations on withholding tax rates and may modify domestic source rules. For developing countries with extractive industries the potential tax base erosion is significant as illustrated by the IMF (2014). The argument for relief through treaties was originally that it would stimulate two-way flows of investment. In the case of EI, however, the argument seldom holds since the direction of investment is determined by the location of likely resources. Nevertheless, companies exploring for or developing natural resources will seek treaty relief on the grounds that it will reduce the cost of investment. This case is made most vigorously in respect of interest and technical services, where the practice of grossing up by banks or service providers is widespread.15 Thus countries sometimes use treaties with long-term effects to secure an individual EI investment.

Reduction or elimination of withholding potentially discriminates among sources of investment or services and encourages “treaty shopping”. Relief of withholding on payments to one foreign destination rather than another sets up an incentive to source from that destination, or to incorporate an affiliate in that destination through which capital or services are then channeled. From the host government viewpoint, this amounts to another means of unilaterally granting tax relief rather than being a tool for advancing international trade or capital flows. When the host country has a significant network of treaties (and sometimes even where the network is quite limited) companies will consider adjusting commercial arrangements to take advantage of them.

3.1 Treaty shopping

Treaty shopping arises because the most favorable provision in any treaty may be available to the whole world. Keen and Mullins in this volume provide a diagram illustrating the phenomenon, also explained in IMF (2014). The residence country of an investor may, however, apply controlled foreign corporation (CFC) rules – meaning rules for taxing residents on their share of low-taxed foreign income derived by nonresident companies controlled by residents (Arnold, 1986; Vann, 1998). The host country for the activity – the source country – also has tools available to curtail treaty shopping and its effects.

A “limitation of benefits” (LOB) provision in a treaty between the host country and a third country would aim to address this. It would deny the benefits of such a treaty to an investor from elsewhere unless the beneficiary in the relevant third country undertakes some substantial activity. These LOB provisions were originally applied comprehensively only in the United States, but their use has spread. In Kenya, for example, the Income Tax Act now provides that a resident of a country with which Kenya has a tax treaty may not claim the benefits of the treaty when 50 percent or more of its underlying ownership is held by individuals not resident in that treaty partner state unless the resident of the partner state is listed on a stock exchange in the partner state.16 A “principal purpose test” offers a companion or alternative to a provision on LOB. Under this test, treaty benefits would be denied when it is reasonable to conclude that one of the principal purposes of an arrangement or transaction is to secure a benefit under a tax treaty – unless it is established that obtaining such benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the tax treaty. The OECD report on Action 6 under the BEPS Action Plan recommends the use of one or other of these measures, though not that both should be mandatory and offering the opinion that in some circumstance neither may be appropriate.17

3.2 An example of treaty-shopping opportunities in source countries: Namibia

Namibia had 11 ratified and effective double taxation agreements (DTAs) in 2011. Key terms of these DTAs are set out in Table 5.1.18 The limitations on withholding taxes on dividends, interest and royalties differ significantly from country to country. Withholding on technical service payments is mentioned in only three DTAs, and the limit is at a different rate in each case. The treatment of capital transactions in immovable property is broadly consistent, except in the case of France – where business assets are substantially exempted from tax on gains or transactions. Treatment of independent personal services (lawyers’ fees, etc.) is substantially similar but varies slightly.

Table 5.1Namibia: double taxation agreements and provisions
CountryDateDividendsInterestRoyaltiesTechnical services1/Capital gains, Immovable property
France1998151010Not mentionedTaxable, but exempt if part of business assets of a company
5 with minimum 10% holdingExempt if export credit, enterprise to enterprise services or bank loan.Independent personal services exempt2/
Germany199815Nil – taxable only in recipient state10Not mentionedTaxable4/
10 with minimum 10% holdingExcess over arm’s length terms taxable 3/Independent personal services exempt unless 183 days in country
India199810101010

Independent personal services exempt unless 183 days in country
Taxable
Mauritius199810105Not mentionedNot mentioned
5 with minimum 25% holdingNil if bank loanIndependent personal services exempt unless 183 days in country
Romania199815105Not mentioned Independent personal services exempt unless fixed base in countryTaxable
Russian Federation199810105Not mentionedNot mentioned
5 with minimum 25% holding and min. US$100,000 investmentIndependent personal services exempt unless 183 days or fixed base in country
South Africa1998151010Not mentionedTaxable
5 with minimum 25% holdingIndependent personal services exempt unless 183 days or fixed base in country
Sweden199815101515Taxable
5 if 10% minimum holdingNil if export credit or bank loan MFN terms for other OECD treaties5/5 for patents and certain other itemsIndependent personal services exempt unless 183 days or fixed base in country
United Kingdom196715205, or ½ prevailing rate if lessNot mentionedNot mentioned
5 if 50% minimum voting power Appears to exempt additional tax on branchesNil – copyrightsIndependent personal services exempt unless “fixed base” in country
Malaysia2004101055
5 with minimum 25% holdingIndependent personal services exempt unless 183 days or US$10,000/yearNot mentioned

"Technical services" usually means services of a technical, managerial or consulting nature.

"Independent personal services" usually means independent professional services of accountants, lawyers, physicians etc.

This arm’s length proviso applies in most of the treaties.

In most treaties, gains on transfers of shares in companies holding immovable property are also taxable.

Provision unique to the Swedish treaty; provides for equal treatment with better terms granted in any arrangement with an OECD country. All treaties have provision for avoidance of double taxation, usually by a mutual tax credit procedure.

Source: Texts of Double Taxation Agreements provided by Ministry of Finance of Namibia, November 2010.

"Technical services" usually means services of a technical, managerial or consulting nature.

"Independent personal services" usually means independent professional services of accountants, lawyers, physicians etc.

This arm’s length proviso applies in most of the treaties.

In most treaties, gains on transfers of shares in companies holding immovable property are also taxable.

Provision unique to the Swedish treaty; provides for equal treatment with better terms granted in any arrangement with an OECD country. All treaties have provision for avoidance of double taxation, usually by a mutual tax credit procedure.

Source: Texts of Double Taxation Agreements provided by Ministry of Finance of Namibia, November 2010.

In three cases (France, Sweden and Mauritius) interest paid to a non-resident on a bank loan is exempt from withholding tax. For France and Sweden, moreover, interest paid on export credit financing is also exempt,19 while for France interest on loans that finance “enterprise-to-enterprise services” is exempt. Interest paid by government entities or to government entities is also usually exempt. The exclusion of bank loans may make sense where a third-party lender is entitled to gross up interest charges for any tax withheld (as is commonly the case in international loan agreements) and the host country seeks to reduce the cost of third-party loans, though even when grossed up and fully borne by the borrower withholding at least secures some revenue for the government to offset the tax deduction for interest cost. The blanket provision, however, opens up the possibility of back-to-back transactions in which the ultimate origin of the loan is not a bank at all, but the loan is channeled through one. Namibia also had generous thin capitalization provisions on deduction of interest.

Limits on dividend taxation especially affect direct foreign investment. Most of the treaties have “substantial holdings provisions” under which withholding tax on dividends is reduced to 5 percent (compared with standard non-resident shareholder’s tax [NRST] of 10 percent); for some countries 10 percent applies, and the “substantial holdings” criterion varies among 10, 25 and 50 percent as a minimum. In some cases, this would mean not only that portfolio investors bear higher withholding tax but also that minority direct investors who do not cross the relevant threshold will incur a higher rate of NRST than their fellow shareholders in the same business.

Limits on withholding on technical service fees are selective and inconsistent. This type of withholding taxation on payments to nonresidents, whether final or creditable against tax by assessment, can be especially important in a country with developing mining and petroleum industries, such as Namibia (Table 5.2).

Table 5.2Southern Africa: withholding tax on payments for services to subcontractors
CountryResident ContractorNon-resident Contractor
Withholding Tax Rate in percent
Angola1/5.255.25
Botswana3.003.00
Lesotho2/10.0010.00
Malawi3/4.0015.00
Mauritius4/3.003.00
Swaziland15.00
Tanzania15.00
Zambia15.00
Zimbabwe10.00
Unweighted average5.0511.13
Source: Deloitte, Guide to Key Fiscal information, Southern Africa: 2010–2011

Construction services attract a 3.5 percent withholding tax.

Management charges: for non-residents it is a final withholding tax unless a return is filed.

Contractors and sub-contractors in the construction industry.

Contractors in the construction industry attract 0.75 percent.

Source: Deloitte, Guide to Key Fiscal information, Southern Africa: 2010–2011

Construction services attract a 3.5 percent withholding tax.

Management charges: for non-residents it is a final withholding tax unless a return is filed.

Contractors and sub-contractors in the construction industry.

Contractors in the construction industry attract 0.75 percent.

Although in most treaties there is no limitation, in one case, Malaysia, the limit is set at 5 percent – quite likely below a reasonable level for such taxation if it were to be introduced.

The treaties imply discrimination among sources of capital imports, know-how and technical skills. There was no strong reason for this deviation from capital-import neutrality. The DTAs provide extensive opportunities for tax planning by foreign investors in Namibia. For example, investors concerned to minimize tax on dividends (and with no other considerations) could channel investment through subsidiaries in France or Sweden.20 The same locations would work for the origin of loan capital flows. On the other hand, companies licensing technology, know-how or patents, could channel license payments through Mauritius, Romania, Russia, Malaysia or Sweden. Using a subsidiary in France would minimize possible capital gains tax liabilities. Technical services would be best supplied from Malaysia or India. In summary, the optimal combination might be: capital from France, services and know-how from Malaysia. These possibilities, of course, assume that treaties between these potential conduit countries and the ultimate country of residence of the investor do not stand in the way. Beyond tax planning, however, these options have little logic.

3.3 An example of border withholding and treaties: Kenya

Kenya levies final withholding taxes on payments to non-residents to ensure that tax is paid on Kenyan source income. Standard and treaty rates are shown in Table 5.3.

Table 5.3Withholding rates and the capital gains article in double taxation agreements with Kenya
CountryYear SignedDividends (In percent)Interest (In percent)Royalties (In percent)Management/Professional FeesCapital Gains, Immoveable Property
Treaties in Force
Canada198310151515Taxable including gains on shares2/
Denmark197310152020Taxable, but not gains on shares
Germany198010151515Taxable including gains on shares
India198910152017.5Taxable including gains on shares
Norway197210152020Taxable, but not gains on shares
Sweden197310152020Taxable, but not gains on shares
United Kingdom197610151512.5Taxable, but not gains on shares
Zambia196410152020Taxable, but not gains on shares
Memorandum items
EAC5/20105101015
Resident withholding rates101053 (5)2/
Nonresident rates10153/2020
Petroleum companiesPayable from government profit oil12.54/

5.6251/

For petroleum service subcontracts, By application of 37.5 percent tax rate (nonresident companies operating through a permanent establishment) to an assumed 15 percent profit margin on the service component of fees to petroleum service subcontractors.

5 percent when below KES 24,000 per month.

Bank interest – 25 percent appears to apply to “bearer instruments”.

For deductible management and professional fees paid outside Kenya.

As currently provided in ITA 3rd Schedule.

Source: Treaty documents and IBFD, situation in 2014

For petroleum service subcontracts, By application of 37.5 percent tax rate (nonresident companies operating through a permanent establishment) to an assumed 15 percent profit margin on the service component of fees to petroleum service subcontractors.

5 percent when below KES 24,000 per month.

Bank interest – 25 percent appears to apply to “bearer instruments”.

For deductible management and professional fees paid outside Kenya.

As currently provided in ITA 3rd Schedule.

Source: Treaty documents and IBFD, situation in 2014

Dividend withholding tax rates are usefully standardized at 10 percent. With the branch profits tax rate set at 37.5 percent and the standard corporate rate at 30 percent, then the rate of income tax on remitted profits is effectively the same (within half a percentage point) whatever the country of origin of the investment or the legal form of operations in Kenya. Dividend withholding tax, however, does not bear currently upon petroleum companies – for them, any withholding on dividends remitted is met from the government’s share of profit oil.

Withholding on interest should reduce the incentive for excessive debt finance. Nevertheless, withholding on interest paid to non-residents may result in higher interest rates being charged on the debt. The reason for this is that (1) many countries have eliminated withholding on interest paid to nonresidents in an effort to attract savings from abroad and (2) suppliers of savings, often in a tax haven or low-tax jurisdiction, set their lending rates taking into account any taxes that are going to be withheld and paid to the source country. Kenya’s interest withholding rate is consistent across sectors at 15 percent for interest paid to nonresidents.

Withholding on management and professional fees covers technical service fees except in the case of petroleum. In DTAs “technical fees” are usually defined more broadly to include technical services, managerial services and consultancy services.21 In Kenya these are taxed at varying rates according to treaty, except in the case of petroleum, where concessional rates apply both to the main category (12.5 percent) and a special category defined in the 9th Schedule of payments to petroleum service subcontractors (effectively 5.625 percent). These arrangements for petroleum conformed to relatively common practice in the international petroleum industry, but there was a case for reconsidering them and not extending this treatment to other sectors such as mining in order to maintain the integrity of taxation by assessment and provide an incentive to incorporate (or at least register) in Kenya. Subcontractors with permanent establishments should be taxed by assessment not withholding. Where the payment is made offshore for a service performed outside Kenya it should not be deductible for Kenyan tax purposes by the payor.

On the other hand, if the payment is deductible in Kenya it should not matter whether the service is performed in Kenya or abroad. In general, when a good is manufactured abroad or a service is performed abroad, the income earned is considered foreign source income and should not be taxable in Kenya. Some countries (for example, Chile and Uruguay) impose their withholding tax on technical fees whether the service was performed locally or from abroad, because payments of technical fees, particularly management fees, to related parties are often used by companies to shift income abroad, and the tax authority has difficulty making transfer price adjustments.

3.4 Taxation of transfers of interest

One topic relevant to treaties that has assumed importance in the past several years is the taxation of gains resulting from the indirect transfer of a mineral interest.22 This kind of gain can be particularly challenging from a technical point of view because gains can be realized far outside the jurisdiction. A strategic decision should be made to either pursue taxation of gains seriously or to drop it. If a country determines to tax gains and also plans to have in place a network of treaties, those treaties must be designed so as to allow the taxation that is planned under domestic law. Why tax capital gains in the first place? Profit tax may not capture economic income in practice. One option would be to tax gain but allow a basis step-up. A threshold question is defining what kind of property it is intended to subject to a capital gains regime (real property, any interest in a mining concession?). If capital gains are to be taxed, it is necessary to define indirect interests subject to tax and to specify procedural rules, including withholding requirements. In this respect, it is critical to make sure that procedural mechanisms are in place to secure payment.

A country wishing to tax gains on the transfers of mineral interests first of all needs to examine the domestic law framework and work out appropriate rules. A second step (which might in practice be done in parallel with the first) is to examine the entire network of the country’s tax treaties to see what constraints they impose. The exercise needs to be undertaken, as there are several interacting provisions involved, and the language used in specific treaties may differ from the OECD or UN Model, thus requiring an individualized assessment of the effect of each treaty. As a result of such a review, existing treaties may need to be renegotiated and new ones negotiated with particular attention to this issue. This is a fairly technical area, and even a small difference in wording of a treaty might defeat an attempt to impose a tax in the domestic law. Some of the issues involved are as follows:23

  • Whether article 13 of treaties covers all gains from the disposition of property, including mineral rights.

  • Do treaties exclude taxation of overriding royalties? This use of “royalties” refers to continuing payments made to the seller of an interest in a mineral right as part consideration for the sale, usually in the form of a percentage of gross revenues generated.24

  • Are all interests in mining rights defined as immovable property in domestic law, so that this definition carries over to treaties? Does the definition of immovable property in article 13 incorporate the definition in article 6?

  • Does the treaty specify what indirect dispositions of immovable property may be taxed by the source country in a manner that is sufficiently broad to prevent taxpayers from structuring transactions in ways that avoid taxation?

The taxation of direct or indirect transfers of interest in mineral rights (and in other grants of public rights) became a major issue after a number of high-profile cases. The issue is reviewed from an international tax perspective by Keen and Mullins (this volume) and in full detail by Burns, Le Leuch and Sunley (this volume). In this chapter, we set out the key challenges faced by developing countries bearing upon the content of treaties. The most prominent issue arises from trading, directly or indirectly, in exploration rights when there are significant discoveries or the possibility of making discoveries. In countries with diverse portfolios of resource projects and strong systems of rent taxation (take, for example, Norway, the UK, Canadian provinces or Australia) the issue is usually not major, but in low-income countries with few projects it attracts strong public and political attention. At its core is the suspicion that if large gains can be made on transfers, rents were not properly anticipated when the original fiscal regimes were put in place, so that the host country is in a sense “cheated” of the expected value of its resource.

3.4.1 Direct transfers of interest

“Direct transfers” refer to transactions in mineral rights not mediated through a legal entity holding these rights (in the sense also explained in Burns, Le Leuch and Sunley, Chapter 7 of this volume). Transfers within the continental shelf regime for petroleum rights are understood to be exempt from tax in Norway, subject to conditions – but they became a big issue in developing countries during the commodity boom. Uganda, Ghana, Mozambique – and telecoms in India – all provided important examples.

Taxation of such gains through the corporate tax system requires inclusion of EI rights and information in domestic law as a category of property, or indeed as “immovable property”, making gains taxable under CIT for companies. The domestic provision then needs not to be overridden by treaties. The amount included in the income of a transferor should be the consideration received, reduced by the undeducted cost of the transferred right. The transferee will be entitled somehow to deduct the consideration paid for the right (there is a step up in cost), but rules differ on treatment of deduction: some jurisdictions permit deduction against the proceeds of future capital transactions of a similar nature, while others permit amortization of these costs in the same way as the initial acquisition costs of a mineral or petroleum right. Some countries retain non-final withholding on the total transaction value as a prepayment of the tax payable on the gain.

A “farm-out” occurs when the holder of a mineral right transfers an interest in that right (either immediately or upon some defined event) to another company that undertakes to fulfill some or all of the initial holder’s obligations to explore or develop. Farm-outs create significant complication for the taxation of transfers but form a significant part of commercial and financing operations for EI exploration, so that the provisions must accommodate these in a way that does not obstruct commercially warranted transactions. Income tax law can provide that any initial amount paid under a deferred interest farm-out is income when the amount is received. If the right is transferred, only the additional consideration, if any, is included in income at the time of the transfer. The rules on farm-outs can apply to both mining and petroleum operations.

3.4.2 Indirect transfers of interest

The income tax provisions will deal separately with direct transfers of interest in the manner just outlined. Similarly, the income tax legislation requires specific reference to indirect transfers of interest in mining and petroleum rights and information, so that these EI rights and information are included in the definition of immovable property for ITA purposes. Again, treaty provisions may obstruct taxing rights if the treaties have not been negotiated to protect domestic taxing rights. For a diagrammatic representation of the indirect transfer process, see IMF (2014) and Keen and Mullins in this book.

The most important matter is to set rules for what constitutes an indirect transfer, or a whole or partial change of control, for the purpose of taxing gains on transfers. One possibility is to link the sector (mining or petroleum) legislation to the tax legislation and require notification by the license holder as a condition of rights, then include a reporting mechanism under which the relevant ministry informs the revenue authority of any substantial change in ownership of contractors or rights holders.

Enforcement of payment requires a specific mechanism if the liability effectively lies with a non-resident. Some countries deem the local entity to be the agent of the non-resident for payment of tax due in respect of an indirect transfer of interest. Others operate a scheme in which a transaction in the domestic mineral right is deemed to have occurred and the local entity is liable.

4 Other risk areas

Transfer pricing risks in EI sectors are important but not necessarily greater than in other major sectors. Calder and Shay in this book deals in detail with the risks to taxation of EI, and the principal issues are addressed in Keen and Mullins (this volume). Both special incentives and special opportunities for transfer mis-pricing exist in EI. The special incentive consists mainly in the special tax regimes (usually with higher taxes) in the upstream segment of natural resource extraction: evidently, the risk here arises both in cross-border and in domestic transactions. The special opportunity arises principally from the commercial character of EI investments: investors are international, and their multinational enterprises are often vertically integrated (combining extraction of raw materials, transportation and processing activities).25 The international character of transactions means low-tax jurisdictions are easily and commonly used as conduits for sales, for purchases of inputs and services and for financing transactions. Other factors, however, reduce transfer pricing risks to the tax base by comparison with other sectors: the physical and measurable character of operations; the availability of standard physical outputs, measures and reference prices; the use of unincorporated joint venture structures (especially in petroleum) that set private parties up with adverse interests from which governments benefit in determining transfer prices.

Other risks are the subject of extensive treatment in the BEPS project (see Keen and Mullins, 2016, in this book). These include: intra-company debt shifting; thin capitalization (excess ratio of debt) usually with debt provided by affiliated parties; “inversions” or removal of headquarters and nominal sources of sales to tax-efficient locations – combining, often, with issues in the location of intangible assets and thus the payments accruing to ownership of them; finally, narrow definitions of source of income, or of business profits, thus eroding the domestic tax base.

Excessive deduction of interest charges, especially those paid to affiliates, poses a threat of “earnings stripping” in extractive industries as in other sectors. “Thin capitalization” refers to a capital structure for a company or project that contains less equity (and thus more debt) than would be commercially warranted in order to maximize deductible interest for tax purposes. It is, in effect, a special case of abusive transfer pricing. The solution probably lies in strengthening overall limitations on the deductibility of interest rather than in proposing something specific for extractive industries. The issue extends beyond corporate taxation when, for example, provisions in production sharing contracts permit recovery of interest as a cost. Traditionally, restrictions on the tax effects of thin capitalization took the form either of a debt–equity ratio test or a test of the ratio of interest expense to income in different circumstances.26 In a few cases, both have been used in combination. A debt–equity test was until recently more usual, with the recommended ratio tightening from 3:1 or 4:1 to 2:1 or 1.5:1, but BEPS recommendations (report on Action 4) and recent initiatives in some OECD countries (Germany, for example) have restored the potential importance of the income test. Rules usually allow the carry-forward of all or part of disallowed interest for deduction, within annual permitted limits, in future years.

The BEPS recommendations address three main issues concerning debt and debt interest: (i) corporate groups placing higher levels of third-party debt in high-tax countries; (ii) groups using intragroup loans to generate interest deductions in excess of the group’s actual third-party interest expense; and (iii) groups using third-party or intragroup financing to fund the generation of tax-exempt income. Not all of these become an issue for tax treaties, but it will be important in treaty strategy to ensure that treaty provisions do not override protective measures on these established in domestic law.

Leasing transactions offer another channel for maximizing deductions in respect of debt. An operating lease leaves legal and economic ownership of the asset in the hands of the lessor, making the payment by the lessee analogous to a payment of rent – and thus clearly an operating expense. Under a finance lease, by contrast, the lessor effectively transfers the benefits and risks of ownership to the lessee while retaining legal title to the asset – at least until all payments are complete. The finance lease thus, in substance, resembles a debt transaction, with interest and principal amounts included in the lease payment. Tax rules, however, sometimes permit the whole payment to be deducted as an operating expense, as for an operating lease. One solution is reclassification of finance leases as loans, accompanied by use of rules analogous to those for thin capitalization for other types of base-eroding payments.

5 What can be done?

International initiatives to relieve these problems have recently centered on the OECD BEPS project. The project had by 2016 produced a significant quantity of reports and proposals. The participating countries have sought reform, in part, through a new multilateral instrument (due for completion at the end of 2016), though implementation (at the time of writing) remains a long-term prospect. Many governments have taken unilateral actions to reduce the extent of base erosion and profit shifting: the UK, for example, introduced in 2015 what is called a “diverted profits tax” – effectively a minimum tax on profits of foreign enterprises operating in the UK.

In the case of low- and lower-middle-income countries with significant extractive industries or exploration activity, a number of useful principles can apply. These are reflected in recommendations of recent IMF advisory work in many relevant member countries (see Appendix to the Introduction for this volume).

Treaty making needs to be integrated with tax policy making. It is preferable to avoid negotiating a treaty simply because another country asks to do so and integrate treaty making with tax policy making. A national strategy will limit new treaties with potential intermediary countries or countries with special holding company regimes. Domestic law could, in addition, provide stronger powers for tax authorities to review and adjust prices used in transactions between the host country and known low-tax jurisdictions.

At the same time, review of unfavorable treaties, especially where created by inheritance from very old treaties, has become a serious option which a number of OECD countries have become willing to entertain. The Netherlands, for example, made a specific offer to review and renegotiate for a selection of its treaty partners among developing countries.

Within reviewed or new treaties, governments can ensure that the treaties enshrine the broad right to levy withholding tax on payments to non-residents and, where relevant, ensure that these are creditable in the partner country. The same applies to permitting consistency with domestic legislation on a broad definition of real property, to include mineral and petroleum rights, and the right to tax gains on transactions in companies that directly or indirectly hold real property in the host country. Certain categories of payments such as royalties on intellectual property, management fees or technical service payments should be open to taxation by withholding and not necessarily be subsumed under “business profits”. A sufficiently wide definition of business income will include both gains from continuing commercial activities and gains from disposal of assets (Burns and Krever, 1998).

Domestic law can include a “limitation of benefits” provision in domestic tax law preventing “treaty shopping” or the alternative of a “principal purpose test” for access to treaty benefits. The LOB provision would usually require a business seeking to take advantage of a treaty with the host country to demonstrate a substantial presence in the treaty partner country. The problem of treaty shopping will, in any case, be much reduced if the host government can ensure consistency in the withholding tax provisions of treaties. Where this has proved impossible, alternatives exist in the possibility of taxing underlying profits at higher rates (a practice common for EI in any case) or by imposing some form of minimum taxation.

References

    ArnoldB.J. (1986) The Taxation of Controlled Foreign Corporations: An International Comparison (Toronto: Canadian Tax Foundation).

    BurnsLee and RickKrever. (1998) International Aspects of Income Tax” in VictorThuronyi (ed.) Tax Law Design and Drafting Vol. II (Washington, DC: International Monetary Fund) pp. 587681.

    CalderJack. (2014) Administering Fiscal Regimes for Extractive Industries: A Handbook (Washington, DC: IMF).

    DrevetSebastien and VictorThuronyi. (2009) “The Tax Treaty Network of the U.N. Member States54Tax Notes International 783(June).

    IMF. (2014) Spillovers in International Corporate TaxationIMF Policy Paper [online] Available at https://www.imf.org/external/np/pp/eng/2014/050914.pdf.

    LangMichael PasqualePistoneJosefSchuchClausStaringer and AlfredStorck eds (2010) Tax Treaties: Building Bridges Between Law and Economics. International Bureau of Fiscal Documentation (IBFD)Amsterdam. Available at: http://www.ibfd.org/IBFD-Products/Tax-Treaties-Building-Bridges-between-Law-and-Economics-Contributors

    OECD. (19882010) Convention on Mutual Administrative Assistance in Tax Matters.

    OECD. (2014) OECD Model Tax Convention on Income and on Capital 2014 and previous versions. Available at http://www.oecd.org/ctp/treaties/oecd-model-tax-convention-available-products.htm.

    OECD. (2015) BEPS 2015 Final Reports. Available at http://www.oecd.org/ctp/beps-2015-final-reports.htm.

    ThuronyiVictor. (1998) Tax Law Design and Drafting (Volumes 1 and 2) (Washington, DC: IMF).

    ThuronyiVictor. (2010) “Tax Treaties and Developing Countries” in Lang et al. (eds).

    UN. (2011) Model Double Taxation Convention between Developed and Developing Countries Available at http://www.un.org/esa/ffd/documents/UN_Model_2011_Update.pdf

    VannRichard. (1998) “International Aspects of Income Tax” in VictorThuronyi (ed.) Tax Law Design and Drafting Vol. II (Washington, DC: International Monetary Fund) pp. 718810.

Notes

The authors acknowledge helpful comments on earlier drafts from Michael Keen.

See Drevet and Thuronyi (2009). Among countries with a fairly extensive network are Kazakhstan, Indonesia, Mongolia, Turkmenistan, Vietnam and Zambia. A number of resource-rich developing countries lack an extensive network, including Angola, Cameroon, Chad, Democratic Republic of Congo, Republic of Congo, Equatorial Guinea, Iraq, Laos, Liberia, Niger, Timor-Leste and Papua New Guinea (as of 2009 each of these countries had 8 or fewer treaties, some of them no treaties; as of early 2016, this remained the case, counting income tax treaties in force, except for Laos with 9 treaties and Papua New Guinea with 10).

For a general discussion of advantages and disadvantages of tax treaties, see Lang et al. (2010).

For further discussion of these data and of the impact of treaties, see IMF (2014).

Observation from a presentation made originally by Michael Keen.

A recent example of a resource-rich country doing so is Mongolia, which recently terminated four tax treaties (with Kuwait, the United Arab Emirates, Luxembourg and the Netherlands). See the website of the General Department of Taxation, Mongolia.

This is explored in greater depth in Thuronyi (1998, 2010).

For example, through a stability clause in a production sharing agreement.

The United States is now one of the few major economies that provides a foreign tax credit for income tax paid abroad on business income. In order to qualify for the foreign tax credit, the foreign tax must be considered an “income tax”, and there are various technical rules attached to this requirement. Most other major capital-exporting countries have switched to an exemption system. Under an exemption system, the nature of the tax imposed in the foreign country is not relevant.

See generally Daniel and Sunley (2010) and Mansour and Nakhle (2015).

In defining “interest” a country can rely on its domestic law so that if a payment is not interest under domestic law (i.e., it is a dividend) it will not be deductible and hence not pose a base erosion problem. “Management fee” or “technical service” payments, by contrast, rely upon more slippery concepts and the payments form deductible costs.

For example, rules concerning the procedure for benefitting from the treaty in case of various payments. Some countries require advance permission from the tax authorities based on a certificate of residence in the treaty partner, while other countries extend relief more automatically.

The convention can be found at www.oecd.org. It commenced in 1988 and was amended by a protocol of 2010. At end-November 2015 more than 92 countries had signed it, and 78 competent authorities from those countries had signed agreements under Article 6 providing for automatic exchange of information (OECD, 2014).

Country-by-country reporting should also assist, especially under guidelines now part of the BEPS Action Plan reports.

“Grossing up” describes, for example, the practice of lenders in requiring borrowers to remit to the lender interest and fees at full face value net of any withholding taxes or charges levied in the borrower’s home jurisdiction (the source country); for technical services the service fee might similarly be “grossed up” to relieve the provider of the effect of any withholding tax.

Republic of Kenya, Income Tax Act (as amended 2013) section 41, subsections (5) and (6).

The text of the treaty with Portugal was not available at the time of review.

Strictly, in the French case, the terms cover the sale on credit of any industrial, commercial or scientific equipment or any merchandise.

Subject of course to the tax treatment of the flows in those countries and beyond.

Services are of a technical nature when special skills or knowledge related to a technical field are required for the provision of such services. Services of a managerial nature are services rendered in performing the functions of management. Consultancy services refer to services such as the provision of advice by experts or professionals who have special skills and qualifications allowing them to offer such services.

This issue is dealt with in Chapter 7 by Burns, Le Leuch and Sunley (this volume) and also highlighted in Chapter 2 by Keen and Mullins (this volume) and therefore is only briefly discussed here.

See Chapter 7 by Burns, Le Leuch and Sunley (this volume) for further details.

For avoidance of confusion, recent amendments to the Income Tax Act in Kenya refer to these as “natural resource payments” rather than “royalties”.

Or upstream, midstream and downstream in industry parlance.

Income defined, for example, as earnings before interest, taxation depreciation and amortization (EBITDA).

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