Abstract
Islamic Republic of Iran: Selected Issues
International Taxation in Iran1
Iran needs to ready its tax system to deal with cross-border flows and safeguard against the potential erosion of its tax base.
Replacing open-ended tax incentives with accelerated depreciation allowances; introducing a thin capitalization and a ‘limitation-of-benefits’ provision in its tax treaties would help protect Iran’s tax base.
Defining income “derived from Iranian sources” and introducing a “permanent establishment” concept in the Direct Tax Act would strengthen Iran’s tax treaties.
Domestic withholding taxes on cross-border flows are low and could be raised and provision made for a withholding tax on service fee income.
A. Introduction
1. Cross-border economic activity, including flows of foreign direct investment, are expected to increase as Iran re-integrates into the global economy. It is therefore important for Iran to consider early how to best modernize its regime for international taxation and put in place provisions that can safeguard its domestic tax base against potential erosion. Such erosion could occur, for example, if business profits can escape Iran’s tax system by being redirected to low(er) tax jurisdictions via the use of inflated payments for services procured outside Iran, e.g. financial services and license activities. As set out in the 2016 Article IV Staff Report, Iran derives a little over one-third of its tax collections from corporate income taxes (CIT) and as such would benefit from rules that limit the potential for such base eroding payments. Its tax treaties should also include rules to avoid abusive international tax planning arrangements. Examining the issue of international taxation now is even more opportune because there is increased global focus on issues of cross-border tax base erosion and profit shifting under the G20/OECD BEPS project.
B. Maintaining the Integrity of the Tax System
Redesigning Investment Tax Incentives2
2. Tax incentives are favorable tax provisions granted to qualified investment projects or firms. They can take several forms, e.g., an exemption from tax for a certain duration (tax holidays), preferential tax rates by region, sectors or asset types, or targeted allowances (tax deductions or credits). Besides encouraging domestic investment, an important motivation for such tax incentives is to attract foreign direct investment (FDI.) It is important to monitor the number of firms that apply for tax incentives, the impact on revenues, and effectiveness in generating new investment to prevent abuse.
3. Iran, under the Iranian Direct Taxes Act (IDTA), has over time offered various tax incentives ranging from tax exemptions, tax holidays and reduced tax rates to attract investment (Box 1). It also offers enhanced incentives for activities in free trade zones, special economic zones, and less-developed areas. Many of these incentives work by enhancing the recipient firm’s profitability. These incentives have eroded Iran’s tax base. In 2015, the CIT-to-GDP ratio in Iran was 2.5 percent, two-thirds of the comparator economy average.3 As in many countries, investment would have been undertaken in any case and the type of incentives offered by Iran only work to enhance investor’s profits and so are redundant.
4. Iran could better attract investment by offering tax incentives linked to firms’ actual investment as opposed to its profits. Investment-linked incentives lower the marginal cost of new investments and allow a greater number of investment projects to become profitable at the margin, especially less profitable projects (Box 1). Examples of investment allowances that are linked to investment expenses include accelerated depreciation schemes and investment allowances. Iran could transition to a new scheme of investment-linked incentives for all future tax incentives, but existing investments that have already qualified for current tax incentives should be grandfathered
Preventing Base Erosion: Introducing Thin Capitalization Rules
5. Like most countries, the Iranian tax system allows for interest expenses to be deducted from taxable income. However, a common concern in an international setting is the risk of erosion of the tax base by multinational enterprises (MNEs) via excessive interest deductions. Such “base erosion” can be problematic for emerging economies which are typically more reliant on CIT. Iran derives just over a third of its total tax revenues from CIT.
In Iran, investment financed by debt is taxed more lightly than that financed by equity.4 This advantage is amplified for MNEs that have the ability to choose the location of their borrowing. This gives them scope to arrange financing so as to locate interest deductions where they will be most valuable. For example, financing can be structured so that interest income is received in a jurisdiction that either does not tax the interest income or applies a low tax rate to it. Failure to tackle excessive interest payments gives MNEs an advantage over domestic businesses.
7. Iran’s tax base as it opens to FDI. These rules can be designed in two ways: (1) determining a maximum amount of debt on which deductible interest payments are allowed; and (2) determining a maximum amount of interest that may be deducted, by reference to the ratio of interest expense to another variable (e.g., earnings before interest, tax, depreciation and amortization; EBITDA). The latter is increasingly popular5 and will be relevant for Iran because applying a uniform ratios or caps across diverse sectors and types of business could be problematic.
Investment Tax Incentives in Iran
Tax incentives are defined in the IDTA and were recently amended in 2015. Prior to these amendments, fractions of taxable income were exempted. As of 2015, incentives operate through zero-rating taxable income.
For example, Article 132 sets out the incentives for producing and mining companies with exploitation licenses. For these enterprises, declared income will be subject to a zero rate for a period of 5 years after extractive activity begins. This period increases to 10 years if the activity occurs in less-developed regions. In addition, for producing or services-oriented enterprises, the period of exemption can also increase if they can raise their number of employees by at least 50 percent (from an initial labor force of 50). The period of reduced rates also increases by 2 (3) years) if the enterprise is located in special economic zones (special economic zones in less-developed areas).
Incentives are also subject to geographical restrictions. The zero-rate taxation does not apply to the income of producing and mining entities in a 120km radius of the center of Tehran province, 50km from the center of Isfahan province, and 30km from the administrative centers of provinces and cities with a population greater than 300,000.
Our figure compares the effective marginal tax rate (EMTR) facing an investment under a temporary 10-year tax holiday versus an accelerated system of capita allowances.1 By reducing the EMTR, the tax holiday makes a large profitable one-off investment very attractive at the start of the holiday. However, as it runs out, the investment becomes less attractive as tax rates increase and this deters additional investment. Over time, the effective tax rate quickly exceeds the rate firms would receive if that had benefited from accelerated depreciation. The latter is particularly beneficial when investments are less profitable and the statutory depreciation allowances provided exceeds the true rate of economic depreciation because firms can write-down investment costs more rapidly than the rate at which the asset depreciates.
Effective Marginal Tax Rates Under Alternative Tax Regimes
(Percent)
Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A004
Effective Marginal Tax Rates Under Alternative Tax Regimes
(Percent)
Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A004
Effective Marginal Tax Rates Under Alternative Tax Regimes
(Percent)
Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A004
Limitation of Treaty Benefits
8. In addition to base erosion, MNEs may use Double Taxation Treaty (DTT) networks of third countries to re-route income flows so as to reduce their worldwide tax burden (“treaty shopping”). Some countries have set themselves up as “conduits.” Such countries typically (1) negotiate DTTs with very low or no withholding taxes in the source country, (2) offer low or zero effective tax rates on specific activities in their domestic tax system, and (3) levy zero withholding taxes on outflows. Using legal persons as intermediaries in such countries allow MNEs to re-route their income to tax havens.
9. DTTs can contain specific provisions against treaty shopping: (1) a principal purpose test (PPT) or (2) a limitation of benefits (LoB) provision. Under a PPT rule, DTT benefits would be denied when it is reasonable to conclude that obtaining such benefits was one of the principal purposes of entering into an arrangement or transaction. LoBs, on the other hand, are provisions that provide a set of conditions to be met before a person can be considered as a ‘genuine’ resident in the other country and becomes eligible to the benefits of the tax treaty (Box 2). Iran’s new tax treaties should implement specific LoB provisions.
Eligible Persons Under a LoB Provisions
Typically, the following persons are considered genuine residents and eligible to treaty benefits:
➢ An individual;
➢ A person engaged in an active conduct of business in the State of residence;
➢ A company, the shares of which are traded in the State of residence on a substantial and regular basis on an officially recognized securities exchange or a company which is wholly owned, directly or indirectly, by another company that is resident of the State of residence and the shares of which are so traded;
➢ A not-for-profit organization that is generally exempt from income taxation in the State of residence, provided that more than half of the beneficiaries, members or participants, if any, in such organization are entitled to the benefits of the treaty; or
➢ A person that satisfies both of the following conditions:
More than 50 percent of the beneficial interest in such person or in a company, more than 50 percent of the number of shares of each class of the company’s shares, is owned directly or indirectly by persons entitled to the benefits of this treaty; and-
Not more than 50 percent of the gross income of such person is used, directly or indirectly, to meet liabilities (including liabilities for interest or royalties) to persons not entitled to the benefits of this treaty.
C. Domestic Legal Framework
10. The concepts of “residency” and “source” are the main pillars of international tax policy. They allocate taxable income between countries. In the IDTA, residency also determines the scope of the tax liability.
Residency
11. The residency rule for individuals is unclear. The IDTA describes which persons are residents abroad and provides an exception based on (1) having an occupation in Iran, (2) living in Iran for more than 6 consecutive months in a year, or (3) staying abroad for mission, medical treatment etc. This definition relies on physical presence. Other countries also apply criteria, e.g., a permanent home or place where direct family members live, where bank accounts or investments are held, etc.
12. Residency for legal persons/entities is linked to registration under the Iranian Commercial Code, but this could be supplemented by other criteria. Iran would benefit from the possibility to deem legal persons resident based on the “place of effective management.” Factual circumstances, such as the location of annual shareholders’ meetings; where records are kept, or day-to-day management is exercised, or board members reside; can be used to determine this.
13. Iran should move from a citizen- to residence-based tax system. The scope of tax liability in Iran depends on whether the person is Iranian or foreign. Iranian persons resident in Iran are subject to tax on worldwide income, but all other persons are subject to tax on income derived in Iran. Iran could broaden the tax base to foreign nationals resident in Iran and subject them to same tax treatment as Iranian residents.
Income Derived in Iran (“Source”)
14. The law does not include a clear definition of what income is considered “derived in Iran.” For example, employment income is derived in Iran when the employment contract is concluded with an Iranian employer, rather than on whether the employment is in Iran. This establishes a legal linkage, rather than an economic linkage to its territory. Likewise, profit derived in Iran is defined by whether the business is registered in Iran. Typically, countries use a threshold for business activities before they start taxing profits as derived in their country. This threshold is set exclusively by qualitative criteria cumulating in a definition of “permanent establishment” (PE).
15. Clear source rules would strengthen the legal framework for international cooperation and should be in-line with the following principles:
Simple to administer by taxpayers and tax administrators;
Based on a substantial economic linkage between the income and the geographical area;
The source country should not object to the rule if it were applied in the residence country (between-country neutrality);
Introducing a specific source rule suggests the intention by the source country to tax income from that source, otherwise international loopholes are created;
The definition of the source of income cannot be manipulated by the taxpayer. It can only be defined by the lawmakers.
Permanent Establishment
16. Non-Iranian persons (individuals and legal entities) conducting business activities in Iran are required to register under the Commercial Code. Under the IDTA, these businesses become liable to tax after registration. The law does not contain any threshold for imposing tax on businesses in Iran. This creates an incentive for businesses not to register. Most countries include the recognized international concept of “permanent establishment” (PE) in domestic legislation. This enables the tax administration to enforce tax collection, in the absence of formal registration, if there is sufficient evidence of business activity.
17. The domestic PE concept is usually transplanted into domestic legislation from double tax treaties (DTTs) to avoid differences. A PE definition is provided in the model conventions published by the OECD (OECD, 2014) and the UN (UN, 2011). The latter definition is broader, as it captures a services-PE. Creating a threshold for taxing business service activities in this way provides an alternative to a withholding tax (WHT) on services. A services-PE subjects the service provider’s net income to income tax by filing tax returns in Iran, whereas a WHT on services subjects the gross payment to tax if purchased by a business.
Taxing Cross-Border Payments
18. The IDTA provides for withholding tax on cross-border payments.6 Dividends and most interest paid abroad is exempt in Iran. Cross-border royalty payments and service fees are subject to very low effective tax rates. By applying the (CIT) rate of 25 percent on a reduced tax base (10–40 percent of total annual receipts), these taxes effectively mimic WHT of 2.5–7.5 percent (Box 3). Normally, WHTs are applied to interest and dividend income and expense payments that are prone to abuse (i.e., earnings stripping).
19. The effective WHT rates range from 0 (dividends) to 7.5 percent (certain service payments) and are low compared to the statutory CIT rate and WHT rates in other countries (Table 1). These rates are possibly too low to deter base erosion using interest payments, royalties, or service fees. Given the 25 percent CIT rate in Iran, the typical WHT rate of 5 percent effectively allows for 80 percent of these payments to be deducted from the tax base. Raising the WHT rate to 15 percent would reduce this deduction to 40 percent.
Domestic Taxes on Cross-Border Payments
| The following payments made to foreign persons are subject to tax in Iran | |||||
|---|---|---|---|---|---|
| Reduced Tax Base (In Percent of Gross Receipts) | Effective WHT Rate (In Percent) | ||||
| Dividends | − | 0 | |||
| Interest (intra-group) | 20 | 5 | |||
| Royalty: | |||||
| • | Design of buildings (surveying, drawing, supervising, and technical calculations) | 20 | 5 | ||
| • | Licensing and other rights | ||||
| • | Manufacturing and mineral extraction | 20 | 5 | ||
| • | Government contracts | 20 | 5 | ||
| • | Other | 30 | 7.5 | ||
| • | Cinematographic contracts | 20 | 5 | ||
| Services: | |||||
| • | Contract-based activities and technical services | ||||
| Construction (incl. infrastructure) | 20 | 5 | |||
| • | Exploration, development, and upstream | 15 | 3.75 | ||
| activities hydrocarbon | |||||
| • | Supply and equipment inclusive price | 10 | 2.5 | ||
| • | Transportation | ||||
| • | International rail and road | 20 | 5 | ||
| • | Domestic rail, road, water, and air | 18 | 4.5 | ||
| • | Education, training, and technical assistance | 15 | 3.75 | ||
| • | Exploiting investments on economic activities | 20 | 5 | ||
| • | Medical services | 30 | 7.5 | ||
| • | Other services | 30 | 7.5 | ||
| The following payments made to foreign persons are subject to tax in Iran | |||||
|---|---|---|---|---|---|
| Reduced Tax Base (In Percent of Gross Receipts) | Effective WHT Rate (In Percent) | ||||
| Dividends | − | 0 | |||
| Interest (intra-group) | 20 | 5 | |||
| Royalty: | |||||
| • | Design of buildings (surveying, drawing, supervising, and technical calculations) | 20 | 5 | ||
| • | Licensing and other rights | ||||
| • | Manufacturing and mineral extraction | 20 | 5 | ||
| • | Government contracts | 20 | 5 | ||
| • | Other | 30 | 7.5 | ||
| • | Cinematographic contracts | 20 | 5 | ||
| Services: | |||||
| • | Contract-based activities and technical services | ||||
| Construction (incl. infrastructure) | 20 | 5 | |||
| • | Exploration, development, and upstream | 15 | 3.75 | ||
| activities hydrocarbon | |||||
| • | Supply and equipment inclusive price | 10 | 2.5 | ||
| • | Transportation | ||||
| • | International rail and road | 20 | 5 | ||
| • | Domestic rail, road, water, and air | 18 | 4.5 | ||
| • | Education, training, and technical assistance | 15 | 3.75 | ||
| • | Exploiting investments on economic activities | 20 | 5 | ||
| • | Medical services | 30 | 7.5 | ||
| • | Other services | 30 | 7.5 | ||
Corporate Income Tax and Withholding Tax Rates for Selected Economies
The first percentage refers to recipients that are legal persons, whereas the second percentage refers to individuals;
Turkey applies a number of different WHT rates for various types of interest depending on the status of the lender and/or the denomination of the loan.
Corporate Income Tax and Withholding Tax Rates for Selected Economies
| Country | CIT Rate | WHT Rates | |||
|---|---|---|---|---|---|
| Dividends | Interest | Royalty | |||
| Investment | Participation | ||||
| Columbia | 25 | 0 | 0 | 33 | 33 |
| Egypt | 22.5 | 10 | 5 | 20 | 20 |
| Philippines1/ | 30 | 30/25 | 15 | 20/25 | 30/25 |
| Poland | 19 | 19 | 0 | 20 | 20 |
| South Africa | 28 | 15 | 15 | 15 | 15 |
| Thailand | 20 | 10 | 10 | 15 | 15 |
| Turkey | 20 | 15 | 15 | 0-182/ | 20 |
The first percentage refers to recipients that are legal persons, whereas the second percentage refers to individuals;
Turkey applies a number of different WHT rates for various types of interest depending on the status of the lender and/or the denomination of the loan.
Corporate Income Tax and Withholding Tax Rates for Selected Economies
| Country | CIT Rate | WHT Rates | |||
|---|---|---|---|---|---|
| Dividends | Interest | Royalty | |||
| Investment | Participation | ||||
| Columbia | 25 | 0 | 0 | 33 | 33 |
| Egypt | 22.5 | 10 | 5 | 20 | 20 |
| Philippines1/ | 30 | 30/25 | 15 | 20/25 | 30/25 |
| Poland | 19 | 19 | 0 | 20 | 20 |
| South Africa | 28 | 15 | 15 | 15 | 15 |
| Thailand | 20 | 10 | 10 | 15 | 15 |
| Turkey | 20 | 15 | 15 | 0-182/ | 20 |
The first percentage refers to recipients that are legal persons, whereas the second percentage refers to individuals;
Turkey applies a number of different WHT rates for various types of interest depending on the status of the lender and/or the denomination of the loan.
20. The multiple and differentiated WHT rates creates an administrative burden for both taxpayers and tax administrators, and causes arbitrage between the various payments. In addition, the unconditional exemption for cross-border dividends makes Iran vulnerable to international tax planning where Iranian residents transfer their wealth, and subsequently their investment income, into low tax jurisdictions. A unified WHT rate of 15 percent for all kind of cross-border payments, including dividends would help minimize this risk.
D. Tax Treaty Network
21. DTTs eliminate double taxation to protect against tax avoidance. Double taxation arises if both the residence and source country claim tax rights over the same income. DTTs allocate income between the contracting countries, whereby the source country typically gives up (part of) its taxing rights to attract FDI. Iran is the source country with most of its treaty partners and should weigh the cost of lower WHT rates on income generated in Iran against the benefits it receives in return.
Existing Network
22. Iran has negotiated over 60 DTTs in the last two decades and has DTTs with its main trading partners, including the four main countries where its FDI investors reside.78 It has a special unit within the tax authority dealing with DTT negotiation that has gained extensive experience. Most DTTs follow the OECD Model Convention. Iran has not yet entered into Tax Information Exchange Agreements (TIEAs) that could provide a good alternative to concluding full DTTs with potential partner countries, because TIEAs allow exchange of tax information without forgoing any revenue.
Allowable WHT Rates
23. Iran has reserved its right to levy WHTs on cross-border payments in most of its DTTs, except for cross-border service payments. The allowable WHT rates under DTTs are generally higher than the domestic WHT rates. Most DTTs allow WHT rates on dividends, interest, and royalties up to 10 or 15 percent. Both treaty partners have explicitly agreed that the source country is allowed to levy these WHTs and the resident country commits to credit these taxes against their own taxes.
24. Iran can better exploit the full potential of its DTTs by raising its domestic WHT rates to the allowable rates in its DTTs. This would not deter FDI or raise financing costs because the higher WHT rates would be fully absorbed by the treaty partner who provides a tax credit for taxes paid in Iran by its resident investor. The total tax cost of the cross-border investment does not increase, but tax revenue would be re-allocated between the treaty countries. Box 4 provides an example.
Re-Allocation of Tax Cost
A foreign investor invests 1,000,000 units in Iran, financed by a loan of 600,000 units taken up in the country of residence. The interest rate is 12 percent. Taxable interest income is 72,000 units. The CIT rate in the residence country is 25 percent. The DTT allows a maximum WHT rate of 10 percent.
| Iranian WHT rate on interest payments | 3 percent | 10 percent |
|---|---|---|
| Iranian WHT | 2,160 | 7,200 |
| Foreign CIT | 18,000 | 18,000 |
| Foreign tax credit | 2,160 | 7,200 |
| Foreign tax payable | 15,840 | 10,800 |
| Total Tax Cost | 18,000 | 18,000 |
| Iranian WHT rate on interest payments | 3 percent | 10 percent |
|---|---|---|
| Iranian WHT | 2,160 | 7,200 |
| Foreign CIT | 18,000 | 18,000 |
| Foreign tax credit | 2,160 | 7,200 |
| Foreign tax payable | 15,840 | 10,800 |
| Total Tax Cost | 18,000 | 18,000 |
References
Organisation of Economic Co-operation and Development, 2014, “Model Convention with Respect to Taxes on Income and Capital.”, (Paris: OECD.)
United Nations, 2011, “Model Double Taxation Convention between Developed and Developing Countries (Update).” United Nations Department of Economic & Social Affairs; (New York: United Nations.)
Prepared by Aqib Aslam, Geerten Michielse, and Christopher J. Heady.
This paper does not cover taxation of oil investments.
Comparator economies—based on nominal GDP, population, nominal GDP per capita, GDP at purchasing power parity, and GDP at market prices—are Colombia, Egypt, Philippines, Poland, South Africa, Thailand, and Turkey.
A highly-leveraged company—one with a high debt-to-equity ratio—is “thinly capitalized.”
Recommended by the OECD in BEPS Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.
Article 107 and the IDTA By-Law.
China, South Africa, France, and Turkey. Iran is currently negotiating a DTT with the Netherlands.
Currently Iran has 43 DTTs in force, 9 DTTs are concluded but not yet in force, and 8 DTTs are under negotiation. Some DTTs were negotiated but did ultimately not result in the conclusion of a DTT.
