Download Annet Oguttu (Statement)

SUBMISSION BEFORE THE INDEPENDENT COMMISSION FOR THE REFORM
OF INTERNATIONAL CORPORATE TAXATION
Prof Annet Wanyana Oguttu
University of South Africa
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What are the specific challenges faced by your constituents regarding
domestic resource mobilization?
In order to build economic growth and fund government expenditure, many African
countries have relied on donor aid but this is not sufficient to achieve sustainable
development. Many traditional donors from Europe and the USA now have limited
budgets due to the recession caused by the 2008/2009 global financial. The volatility
associated with outside funding has prompted African leaders to realise that the
development of their economies has to depend primarily on domestic resource
mobilisation from the public and private sectors. The public sector does this through
taxation, non-tax and other forms of government revenues generation. DRM can
ensure a stable and predictable source of own revenue to facilitate long term fiscal
planning in that be resources are allocated to priority sectors rather than being
constrained donor conditions which often dictate the sectors to which their aid should
flow. DRM fosters government accountable to its taxpaying citizens than is the case
when it is heavily dependent on foreign aid reason as it would then pay attention to
the demands of taxpaying citizens.
In recent years, there has been increased growth of DRM many African countries. In
sub-Saharan Africa DRM is estimated to constitute about 70% of development
finance with the 30% deficit is usually filled by loans or Aid or other forms of public
finance. Nevertheless there are still enormous challenges facing DRM in SubSaharan Africa:
o The tax bases across much of Africa are very narrow and the tax burden falls
disproportionately on the small formal sector of the economy.
o Many African countries grant tax incentives to foreign investors in order to
encourage foreign investments, but tax incentives have been noted to distort
resource allocation leading to sub-optimal investment decisions which are
harmful to long term growth.
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o Many African tax statues have various tax exemptions which are costly in
terms of forgone revenue. The exemptions complicate tax systems and open
the door to political interference and corruption.
o The limited tax reporting, low levels of tax education among the population as
well as the general culture of non-tax compliance contribute to low DRM.
o The weak capacity and inadequate resourcing of most tax administrations as
well as the lack of political will to insulate tax administration from political
incursions, contributes to low DRM.
o Many
African
countries
levy
high
taxes.
This
coupled
with
the
incomprehensive and complex tax legislation is in some countries encourage
tax evasion and avoidance that undermine collection.
o Tax officials often have high discretionary power which leads to pervasive
corruption and the lack of transparency which inhibit citizens’ willingness to
comply with tax laws.
o Over and above the factors above, the main stumbling block to DRM in Africa
is capital flight. Global Financial Integrity notes that “Illicit financial flows are
by far the most damaging economic problem facing Africa” and it’s considered
the “most pernicious global development challenge of our time.”
There is no universally agreed definition of “illicit financial flows”. The term can refer
to the movement of money that is the product of illegal activities, such as tax
evasion, organized crimes, customs fraud, money laundering, terrorist financing, and
bribery. Some definitions also include flows from certain corporate tax avoiding
practices, such as base erosion and profit shifting, which are legal. Over the years,
there has been a tide of tax and illicit capital flight from African economies that is
estimated between $50billion and $80 billion per annum and in some cases revenue
lost exceeds the level of aid received by developing countries. Global Financial
Integrity notes that “these illicit outflows sapped 5.7 percent of GDP from SubSaharan Africa over the last decade, more than any other region in the developing
world. Perhaps most alarmingly, outflows from Sub-Saharan Africa were found to be
growing at an average inflation-adjusted rate of more than 20 percent per year,
underscoring the urgency with which policymakers should address illicit financial
flows”.
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What are the impacts of the current international corporate taxation
framework on your constituents' ability to mobilize tax revenue?
The current international corporate taxation framework has not have kept pace with
the changing business environment, which impacts negatively on the ability to
mobilize tax revenue in Africa. The international corporate taxation framework is still
grounded in an economic environment characterised by a lower degree of economic
integration across borders, rather than today’s environment of global taxpayers,
characterised by MNE companies that are increasing placing importance on
intellectual property as a value-driver and the development of information and
communication technologies. This has encouraged MNEs to get involved in
sophisticated tax planning schemes minimise their global tax exposure. They often
exploit the legal arbitrage opportunities and the boundaries of acceptable tax
planning by taking advantage of gaps in the interaction of different tax systems to
artificially reduce taxable income or shift profits to low-tax jurisdictions in which little
or no economic activity is performed. As businesses increasingly integrate across
borders, the tax rules often remain uncoordinated so businesses come up with
structures which are technically legal but they take advantage of asymmetries in
domestic and international tax rules. What is at stake is the corporate income tax.
Although corporate income tax among OECD countries is on average about 10% of
total tax revenues, in Africa the continental average is 29%. Since governments’
ability to raise revenue from individuals and consumption taxes is limited, corporate
income tax is an important source of revenue in Africa; which much more at stake in
an effective international tax system because their development depends on it. To
address the challenges of the international tax system, in 2013 the OECD came up
with a 15 Point Action Plan, which is largely a developed country perspective. From
the perspective of developing countries in Africa, some of the international corporate
taxation principles, which have become ineffective in enabling revenue mobilisation,
include the following:
2.1
Challenges posed to the bases of taxing income
The OECD has made it clear that it is beyond the scope of the BEPS project to try to
deal with fundamental issues, such as allocation of tax rights between residence and
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source countries, which divides predominantly capital-exporting and capital-importing
countries. However the issue relating to source and residence basis of taxation are
the fundamental issues that are behind BEPS that arises as a result of harmful tax
competition and the “race to the bottom”. For any country to have an effective tax
system it has to consider the right basis for taxing the income of its residents and the
non-residents trading within its borders. Indeed the two main bases for taxing income
that are applied internationally are the territorial (source) basis and the worldwide
(residence) basis of taxation. Under a pure worldwide or residence basis of taxation
residents are taxed on their worldwide income regardless of the source of the
income. A number of developed countries generally apply the residence basis of
taxation since they tend to have the administrative capacity to caste their tax nets
worldwide. Under a pure territorial or source basis of taxation, persons are taxed on
income that originates within the territorial or geographical confines of the country,
irrespective of the taxpayer’s home country. Most African countries predominately
apply the source basis of taxation because it is considered easier to administer.
Nowhere in the world are either of these bases applied with any degree of purity. In
many countries, both these bases are applied in a hybrid form; with some countries
leaning more towards the territorial system and others leaning more towards the
worldwide basis of taxation.
Historically most countries tax policies were generally territorial in nature in that they
were developed to deal mainly with domestic economic and social concerns.
Although the domestic tax systems of most counties also had an international
dimension, since they had to deal with the foreign source income of domestic
residents, the interaction of domestic tax systems was relatively minimal, since there
was limited mobility of capital. With the globalisation of trade and the removal of
barriers to the free movement of capital, many developed countries shifted towards
the worldwide system of taxation to ensure the preservation of their taxes base when
their residents invested offshore. Faced with high tax rates in their countries of
residence, taxpayers begun to increasingly employ global tax avoidance strategies to
maximise profits, lessen their global tax exposure. Taxpayers would ensure that
foreign assets and income are concealed and kept outside their domestic tax
jurisdiction. In response, countries started enacting various anti-avoidance legislation
(such as CFC legislation) to curtail these tax avoidance strategies but taxpayers are
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always a step ahead. This created a cycle of continuous complex amendments to
cover loopholes in the legislation so as to keep up with sophisticated tax planning.
Faced with these challenges many country’s tax legislators have had to grapple with
the tax policy issue as to whether the country’s resources and administrative
capacity should be used to cast the domestic tax net worldwide and to devise
measures to prevent residents’ from avoid tax on foreign investments; or whether the
country’s resources should be used to effectively tax income that is within their
borders and encourage the competiveness of domestic enterprises to invest
offshore. To remain competitive in a globalised world, reduce administrative costs
and to ensure the simplicity of their tax systems many developed countries (for
example Japan and the UK) have in the past decades been compelled to migrate to
largely territorial systems. Of the 34 OECD member countries, 27 employ some form
of territoriality system or are gradually gravitating to this system. Indeed, the
territorial taxation has been referred to as ‘a pragmatic response to the practicalities
in a world where competition is fast moving and truly global.’ It is therefore important
that African countries note the trend of developments internationally and place more
emphasis on strengthening their source basis of taxation rather than strengthening
the worldwide system.
2.2
The Permanent Establishment Concept
The permanent establishment concept (PE) is a crucial element of double tax
treaties. It is defined in article 5(1) of the OECD MTC a fixed place of business
through which the business of an enterprise is wholly or partly carried out. Article 5
also has a special meaning of PEs with respect to building and constructions cites. A
PE is also deemed to exist if a dependent agent habitually enters into contracts on
behalf of the enterprise in the other contracting state, and that bind the principal.
Excluded from the concept are preparatory and auxiliary activities under article 5(4).
The PE concept is the basic nexus/threshold rule for determining whether a country
has the right to tax the business profits of a non-resident taxpayer. It is designed to
limit source countries’ tax jurisdiction over foreign enterprises unless significant and
substantial economic bonds have been created with that State. Even then, in terms
of article 7(1), only profits attributable to the PE can be taxed by the source state.
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However the application of the PE concept by developing countries as a means of
DRM faces major challenges today. Often MNEs, abuse the PE concept by artificially
fragmenting their operations among multiple group entities to qualify for the PE
exclusions for preparatory and ancillary activities. For instance, contractors and subcontractors often take advantage of the PE time limits by dividing contracts into
several artificial parts, each covering a period less than the prescribed time limit
which is attributed to different companies that are part of the same group thereby
avoiding PE status through such artificial arrangements. In the same vein, nonresidents engaged in service activities; such as consultants or engineering often
allege that their services are of a temporary nature.
The application of the PE concept also faces challenges as a result of developments
of the digital economy, since the concept is based on physical presence as the
primary basis for taxation. With modern business models MNE can be heavily
involved in the economic life of another country, by doing business with customers
located in that country via the internet, without creating a taxable presence under
existing tax treaty principles. The anonymous nature of e-commerce also brings new
challenges to tax compliance. E-commerce creates difficulties: in the identification
and location of taxpayers, the identification and verification of taxable transactions
and the ability to establish a link between taxpayers and their taxable transactions,
thus creating opportunities for tax avoidance.
The OECD Commentary on article 5 provides that a server, as distinct from a
website could constitute a PE where the equipment is fixed and the supplier has the
server at its own disposal. However servers are highly mobile and flexible in nature.
The location of a server can be easily moved (without affecting the underlying
transaction) between different countries. Servers can transfer their programs almost
instantaneously to a server in a different jurisdiction if necessary. It is not uncommon
for an enterprise can have more than one server and e-commerce suppliers can
utilise multiple servers in multiple jurisdictions which may result in multiple
jurisdictions claiming there is a PE in their jurisdiction. Thus, even though a server
could constitute a place of business of an enterprise, if it is not located in a place for
at least a year, it cannot be considered a PE. In addition, for a server to constitute a
place of business that qualifies as PE, it should be suitably equipped with on-site
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managerial and operational management and employees. A PE would also not be
created if the activities carried on via the server are restricted to preparatory or
auxiliary functions for example the delivery of goods to a warehouse used as part of
the digital trading model. The result of all the above is that the current PE rules
cannot ensure a fair allocation of taxing rights on business profits.
Indeed the PE issue as covered the OECD Action Plans 1 and 7 is perhaps one of
the most challenging action items that OECD policymakers face and perhaps one of
the most concerning in developing countries, whose source basis of taxation would
be eroded if foreign investors avoid PE status. Yet, it is not in the interest of
developed countries to allow the expansion of the PE concept to grant source states
a wider scope to tax profits of MNE digital businesses as this would reduce the
profits of those companies when taxed in their residence states. Any foreign tax
credits granted would only be to the maximum of foreign taxes paid. In view of the
strong presence of such digital companies in the highly developed OECD countries,
it may be very difficult to obtain international consensus which is required before
major amendments on PE could be made.
2.3
The arm’s length Principe
The arm’s length principle is applied internationally to prevent transfer mispricing,
when related entities manipulate the prices of transactions between each other so as
to reduce profits or increase profits artificially so as avoid taxes in a specific country.
The OECD recommends the use of the arm’s length principle to curb transfer pricing.
This principle requires that when conditions are made between two associated
enterprises in their commercial or financial relations which differ from those which
would have been made between independent enterprises, then any profits which
would have accrued to any of the enterprises, but have not accrued because of
those conditions, may be included in the profits of that enterprise and taxed
accordingly. When applying the arm’s length principle, each entity in the MNE is
treaty as a separate entity.
There are however serious conceptual and practical difficulties in applying the arm’s
length principle because it requires matching comparable transactions between non7
arm’s length entities and arm’s length entities whereas the transactions of
multinational enterprises are often not comparable to those of arm’s length parties.
Modern multinational enterprises do not normally operate as if their subsidiaries
were separate enterprises; they often operate as a single unified enterprise
managed from a central location that is responsible for the enterprise as a whole.
Multinational enterprises exist mainly because these interactions generate more
income than separate domestic firms interacting at arm’s length would generate.
Thus taxpayers and tax authorities are left to reconstruct, from largely dissimilar
transactions or entities, what parties at arm’s length would have done in similar
circumstances. This task requires taxpayers to comply with diverse documentation
requirements of their national tax authorities that are time-consuming and expensive.
These problems are compounded when taxpayers have to treat PEs as fictitious
separate legal entities. Most of these problems arise from the difficulties of applying
the methods set out in the OECD Transfer Pricing Guidelines to arrive at an arm’s
length price. The OECD has acknowledged the practical difficulties of applying the
transfer pricing rules.
Even though some African countries have transfer pricing legislation, many often do
not have formal transfer pricing guidelines and reference is had to the methods
stipulated in the OECD Transfer Pricing Guidelines to determine an arm’s length
price, even though African countries are not OECD member countries and are not
required to adhere to the OECD guidelines. The applicability of the OECD Transfer
Pricing Guidelines require that the prices charged by the related parties should be
comparable to those charged in market conditions, is however challenging for
African countries. It is difficult to find African comparable as there are very few
organised companies in any given sector and there are hardly any African
benchmarking databases. When assessing the arm’s length criteria of related party
transactions, African countries tend to accept European comparables, but most tax
authorities insist that these comparables need to be adjusted to make them
comparable to an emerging market business. Further problems exist in gathering
taxpayer information due to the absence of documentation requirements or the
inability to enforce existing requirements. Sometimes, Tax administrations lack the
capacity to process and evaluate such information, partly because of the lack of
technical expertise or because they do not have the necessary resources at their
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disposal to process the data. It is encouraging to note that the G20 has agreed to
undertake an initial exploration with the OECD and World Bank Group of ways to
support ongoing efforts to improve the availability of quality transfer pricing
comparability data for developing economies.
2.4 Thin capitalisation and similar schemes for claiming excessive interest
deductions
Thin capitalisation is a tax avoidance scheme employed to ensure a company’s
equity capital is small in comparison to its debt capital. There are essentially two
ways in which a company may be financed; debt (loan capital) or equity capital. The
tax treatment of a company and its financers differ fundamentally depending on
whether it is financed by loan or equity capital. If capital is loaned by a parent
company to its subsidiary in another jurisdiction, the subsidiary company will have to
pay interest to the parent company, which in most jurisdictions is regarded as an
expense incurred in earning profits, and is deductible by the payer of the interest in
computing its taxable income. If the parent company were to subscribe for shares to
its subsidiary in another jurisdiction, dividends would have to be distributed by the
subsidiary to the parent company. In most jurisdictions the dividends are not
deductible when calculating the subsidiary’s taxable income since dividends are
distributions of profits that have to be taxed. It is thus clear that financing a company
with debt, is more effective in reducing source country tax than it is with equity
financing. Thus multinational companies will often come up with thin-capitalisation
arrangements to ensure that their subsidiaries are financed with increased levels of
debt as compared to equity.
To prevent the ensuing tax avoidance, the OECD recommends that the “arm’s length
principle” which is applied to curb “transfer pricing”, should also be applied to curbing
thin capitalisation. Thus transfer pricing and thin capitalization, are dealt with as if
they are part and parcel of each other (although the schemes they entail are quite
different) and it is not often clear as to how the two regimes interact. In applying the
arm’s length principle to curb thin capitalisation, it has to be determined if the loan
exceeds what would have been lent in an arm’s length situation, if so, then the
lender must be taken to have an interest in the profitability of the enterprise and his
loan, so any interest rate that is in excess of the arm’s length amount, must be taken
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to have been designed to procure a share in the profits. The challenges of applying
the arm’s principle to transfer pricing as discussed above also apply to thin
capitalisation.
2.5
Beneficial ownership provision to curb treaty shopping
Taxpayers often get involved in “treaty shopping”; which is the use of double tax
treaties by the residents of a non-treaty country in order to obtain treaty benefits that
are not supposed to be available to them. This is mainly done by interposing a
“conduit company” in one of the contracting states so as to shift profits out of those
states. The OECD Model Convention recommends that treaty shopping may be
countered by jurisprudential rules that are part of the domestic law of the state
concerned. The OECD also suggests a range of specific provisions that countries
could opt to inserted in their tax treaties to curb treaty shopping. The main specific
treaty provision that is applied in the treaties that African countries have signed is the
“beneficial ownership” in articles 10, 11 and 12 of the OECD MTC. This provision
has the effect of denying treaty benefits to a conduit company, unless the beneficial
owner is a resident of one of the contracting states. However internationally there
has been lack of clarity on the meaning of the term “beneficial ownership”. In terms
of the OECD MTC, a nominee or agent who is a treaty country resident may not
claim benefits if the person who has all the economic interest in, and all the control
over, property is not also a resident. Furthermore, a conduit company cannot be
regarded as a beneficial owner if, through the formal owner, it has as a practical
matter, very narrow powers which render it in relation to the income concerned, a
mere fiduciary or administrator acting on account of the interested parties. The
OECD further clarifies that beneficial ownership has a treaty meaning independent of
domestic law and that it means “the right to use and enjoy” the amount
“unconstrained by a contractual or legal obligation to pass on the payment received
to another person.” However the effectiveness of the beneficial ownership provision
in curbing treaty shopping is now questionable in light of international cases such as
the Canadian cases of Velcro Canada Inc. v The Queen and Prevost Car Inc. v Her
Majesty the Queen. In the 2014 version of the OECD MTC the OECD acknowledged
the limits of using that concept as a tool to address various treaty-shopping
situations, noting that: “whilst the concept of “beneficial ownership” deals with some
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forms of tax avoidance (i.e. those involving the interposition of a recipient who is
obliged to pass on the dividend to someone else), it does not deal with other cases
of treaty shopping and must not, therefore, be considered as restricting in any way
the application of other approaches to addressing such cases.”
In many African countries curbing treaty shopping has not received much attention.
In tax treaty negotiations many African countries do not fully taken into account the
ways tax treaties could allow certain jurisdictions to act as conduits for tax avoidance
even though African tax officials often deal with multinational companies involved in
treaty shopping. Often these schemes make use of companies registered in
Mauritius under Global Business Licenses 1, that are subject to nil or minimum
active business as well as companies based in Netherlands, Luxemburg and
Switzerland which are used as conduits for disposing of assets in offshore
jurisdictions so as to avoid tax. It is important that African countries begin to
strengthen the way they negotiate double tax treaties, doing more research into the
potential treaty partner beforehand and bringing more diverse expertise into the
negotiating team.
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In light of these concerns, provide the five most important and specific
recommendations for reform of the international corporate tax system
rules and institutional framework
The OECD notes that its BEPS project marks a “turning point in the history of
international co-operation on taxation”. The OECD BEPS Action Plan does not
address the fundamental reforms in international tax system or deal with a reexamination of the basic principles of the international tax system. An opportunity for
an overall of the international tax system appears to have been evaded. The OECD
has generally adopted to do a patch work of tax avoidance legislation to make it
more effective in modern business models. It has chosen to generally strengthen
existing anti-avoidance provisions, for example the CFC rules, limiting deductions of
interest deductions; and yet taxpayers have manipulated this very anti-avoidance
provisions to a point of being ineffective, there is no reason to expect that
strengthening the rules further will prevent BEPS. It should also be noted that on a
political front some OECD countries are reluctant to address international tax issues
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head on. They may not wish to strengthen these laws so that they maintain a
competitive advantage and protect their national interests. Experience from the 1998
OECD Report on Harmful tax competition shows that rich countries find it easier to
pressure smaller tax havens jurisdictions to close tax loopholes but are do not easily
accept limits placed on them to prevent harmful tax practices that attract investments
in their jurisdictions. Although the OECD BEPS Action Plan articulates the need for
reform noting that “new international standards must be designed to ensure the
coherence of corporate income taxation at the international level” and that
“fundamental changes are need to effectively prevent double non-taxation”; there
has not been any globally serious solution seeking process to address fundamental
issues. The matter is of concern to developing countries, that have for long been
calling for international corporate tax reform. Although the OECD BEPS Action Plan
may have been well-intentioned, it was not drawn up jointly with developing countries
so it does not address their immediate BEPS concerns. Some of the Action Plans
(such as those relating to CFC legislation, hybrid mismatch arrangements, transfer
pricing of intangibles, the tax challenges of the digital economy), will most likely
benefit developing countries in the long term, as and when their economies and
administrative capacities advance. From an African perspective, the BEPS project
does not explore certain practical measures (as discussed below), which may be
more suitable for developing countries in addressing BEPS. Now this does not mean
that that developing countries in Africa should be passive to OECD BEPS Action
Plan, on the contrary, they should use the current international political will to
address BEPS to get together in platforms such as the UN and ATAF to develop
policies that will ensure that their national tax systems address the BEPS concerns
that are relevant them. Some of the recommendations for the reform of international
corporate tax system that are not covered in the OECD BEPS report but are
important in preventing BEPS from the perspective of developing countries include
the following.
3.1
Strengthen source basis of taxation through enhancing withholding
taxes
One of the practical ways that developing countries can use to enhance their source
bases of taxation that is not addressed in the OECD Action Plan is through levying of
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withholding taxes. To defend their right to tax income at source and to reduce the tax
losses through tax avoidance schemes, many developing countries impose
withholding taxes on interest, dividends and royalties paid to non-residents. The
withholding tax mechanism helps alleviate the difficulties these countries face in
collecting tax from non-residents’ transaction in their territories. The withholding tax
is collected by appointing a resident as the non-resident’s agent and imposing an
obligation on the resident agent to withhold a certain percentage of tax from
payments made to the non-resident. If the resident agent does not comply with this
duty or if he/she withholds an incorrect amount of tax, personal liability can be
imposed on the resident agent.
MNE involved in cross-border investments, find withholding taxes as a major loss of
revenue since the tax is a flat rate on gross income. However when countries enter
into double tax treaties, source country withholding taxes, can be reduced. In treaty
negotiations, developed countries argue against levying withholding taxes in that the
gross tax often wipes out the entire profit creating adverse consequences for the
import of capital and technology. In an endeavour to preserve their countries tax
base, developing countries often find that withholding-tax rates are one of the key
areas on which they must fight when negotiating double taxation agreements. They
often come under considerable pressure from developed nations to reduce
withholding taxes rates to zero or near zero or to give up their right to tax these
payments and yet these developing countries contribute to the earning of this
income.
3.2
Positions on attribution of Profits to PEs: Denial of notional internal
payments
Article 7(1) of the OECD and the UN MT provide that “The profits of an enterprise of
a contracting state shall be taxable only in that state unless the enterprise carries on
business in the other contracting state through a permanent establishment situated
therein. And it is only the profits attributable to that permanent establishment that
may be taxed in that state.
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Article 7(2) of the OECD MTC (inserted in the 2010 version) sets out the OECD
authorised approach for attributing profits to PEs. However this approach differs from
the UN Model Convention and the 2008 version of the OECD MTC (upon which
many treaties are still based). In terms of the UN MTC and also the 2008 version of
the OECD MTC, a “single entity” approach is used to attribute profits to a PE such
that only the actual income and expenses of the PE are allocated. However the
OECD MTC tries to recognise the economic differences between permanent
establishments and subsidiaries by adopting the “functionally separate entity”
approach whereby in attributing profits to a PE, its internal dealings are recognised
by pricing them on an arm’s length basis, without regard to the actual profits of the
enterprise of which the PE is a part. This implies that non-actual management
expenses, notional interest and royalties from head office may be charged on the
PE.
Many countries argued that this approach may result into exploitation since it allows
deductions for notional internal payments that exceed expenses actually incurred by
the taxpayer and have not adopted the new Article 7 as it is presumed that it would
have serious detrimental tax revenue consequences particularly through allowing
financial services businesses deductions for notional payments on internal loans and
derivatives involving PEs. Developing countries are very concerned about the
treatment of deductions and many are very sceptical about adopting the OECD’s
authorised approach. They are especially sceptical about multinational companies
that often try to avoid taxes levied on the PE by claiming deductions of various forms
of fees charged to the headquarter office on the PE. The disallowance of head office
expenses should be maintained in order to preserve source countries’ tax bases.
3.3 A practical way to deal with transfer pricing: Unitary taxation and
formulary appointments
The OECD BEPS Action Plan rejects a radical switch to a formulary apportionment
system in resolving transfer pricing problems. Rather, it advocates building on the
existing separate entity approach in terms of the arm’s length principle. Various
commentators have suggested that instead of applying the OECD separate entity
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approach “unitary taxation” which treats related parties as part of a single enterprise
should be considered by the OECD as a long term solution to transfer pricing.
Unitary taxation would entail the use of a “formulary apportionment” approach to
ensure that the tax liabilities of a multinational enterprise are based on its global
income, and the share that is taxed by the each country depends on the fraction of
the enterprise’s economic activity that occurs in a particular country. It is argued that
this approach addresses the economic reality of multinational companies which are
becoming more highly integrated with each other’s operations located in different
regions. This makes it difficult to apply the arm’s length principle and to find
comparable transactions with unrelated parties. Formulary apportionment accepts
the reality of firm integration and tries to come up with a workable solution that
matches each jurisdiction with tax revenues related to the economic activity that
takes place within the jurisdiction. Developing a fixed formula for profits attribution
provides a reasonable, administrable, and conceptually satisfying compromise that
suits the nature of the global economy. By contrast, the arm’s length principle
artificially attempts to draw lines between aspects of an enterprise where no lines
exist in reality.
The most common objection to formulary apportionment is that it requires countries
to agree on a fixed formula which would be impossible as arbitrary predetermined
formulas that could make it difficult to apply, depending on the particular
circumstances of each multinational enterprise. It is also argued that the method
relies heavily on access to foreign-based information. The amount of profits
attributed to each member may also differ from the income shown on its books of
account, even though they may be kept in good faith. In addition, it is argued that
formulas based on factors such as sales and wages do not provide a fair allocation
of tax revenues and are open to manipulation. With respect to intangibles, it may be
difficult to use formulary apportionment to determine the geographical location of
income produced by intangible assets, thus making it difficult to determine which
jurisdiction has the right to tax.
Despite these disadvantages, it is still argued that the formulary apportionment offers
a means of overcoming the challenges of applying of the arm’s length principle.
Commentators have pointed out that introducing the formulary apportionment
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approach would not be a far-fetched idea. Article 7(4) of the 2008 version of the
OECD MTC permitted countries that customarily used various apportionment
formulae to continue doing so. This version of the article is still in existence in many
treaties worldwide. Some transfer pricing methods recommended by the OECD,
such as the profit split methods, entail apportionment of profits and seem closer to
formulary apportionment than to the arm’s length method. Advance pricing
agreements that many countries have entered into in order to resolve transfer pricing
disputes often use the formulary apportionment approach. It is, for instance,
suggested that not all nations have to agree on a formula for this approach to work.
As with the procedure of APAs which is usually bilateral, only the jurisdictions
significantly involved with the particular enterprise can agree on a certain formula
while continuing to rely on transactional arm’s length transfer pricing with others.
For developing countries that have challenges in applying the transfer pricing
methods due to the lack of data bases for comparables adopting unitary taxation with
a formulary appointment would be clearer and easier to administer as it would entail
assigning to each country an estimated market return on tax deductible expenses
incurred by the multinational group in that country. The concerns about this approach
being heavily reliant on access to foreign-based information are now being
addressed internationally. For instance, developing countries can follow the UN
Transfer Pricing Manual which recommends that in a transfer pricing audit, tax
authorities should (among other documents) request for “Group global consolidated
basis profit, loss statement and the ratio of taxpayer’s sales towards group global
sales for five years”. If implemented, this provides a good basis for the application of
unitary taxation. The OECD BEPS Action plan on transfer pricing documentation in
Action 13, which requires country-by-country reporting, will also facilitate the
application of unitary taxation.
Formulary appointment in some form or another is now being adopted by many
countries. For example, apportionment formulas are commonly used in American
Federal States. Brazil uses a radical approach in its transfer pricing system, which
uses standardised margins and fixed margins rather than relying on comparable
transactions and asserts. The varying approaches in the use of formulas are of
course not good for international trade. The OECD says it does not support a “radical
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switch to formulary appointment”, this implies that that a gradual approach can be
entertained. To ensure sustained international tax reform, effort should put on
developing guidance on formulary appointments, to be introduced gradually. This is
in line with the OECD’s BEPS Action Plan which calls for congruence between value
drivers and the location of value adding activities. A number of commentators hold
the view that there has to be some degree of convergence between the arm’s length
methods and the formulary approach. The two should not be seen as polar
extremes; rather, as part of a continuum of methods ranging from CUP to
predetermined formulas. Given the potential strength of formulary apportionment, its
use in some transfer pricing methods, its varied use among developing countries and
the well-documented problems with the arm’s length standard, the formulary
apportionment method is likely to continue to be an important part of the international
tax scene.
3.4 Practical way to deal with excessive deductions of fees: A provision on
taxation of Income from technical services in tax treaties
A major BEPS concern among many developing countries in which multinational
enterprises operate is that such companies keep claiming deductions for various
management, technical and service fees, and yet they pay little or no taxes in those
countries alleging that they make losses year after year, yet they keep investing in
those apparently unprofitable operations. Often there is no justification for such fees
other than tax avoidance. One possible explanation for the alleged losses is that
profits are shifted to low tax jurisdiction while taxes are minimized in the source
state.
Concerns about excessive deductions of management fees are the reasons why
some developing countries have signed treaties with articles on services,
management and technical fees that deviate from the OECD and the UN MTC.
Broadly these articles define services, management and technical fees is a similar
manner as being “payments of any kind to any person, other than an employee of
the person making the payments, in consideration for any services of a managerial,
technical or consultancy nature, rendered in a contracting state”. In terms of these
articles, the relevant fees may be taxed in the resident state. However these fees
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may also be taxed in the source state if the beneficial owner thereof is a resident of
the other contracting state. In that case, the charge for the fee shall not exceed a
certain percentage of the gross amount as agreed upon. For example, Ghana has
signed treaties with Germany and Netherlands with combine “royalties and service
fees. Uganda has signed with South Africa, Mauritius and the United Kingdom which
contain an article on “technical fees”.
Ghana has signed treaties with Italy and
Belgium that cover “management fees”.
Provisions on services, managements and technical fees do not only appear in
treaties signed by small countries such as Ghana and Uganda; there is also one in,
for example, the US-India tax treaty and there are over 100 treaties now which
include an article on such fees. However there is no standard way of drafting these
articles which makes treaty negotiations very difficult and creates uncertainties for
tax payers who have to check the provisions of each treaty to be sure they’ve got it
right. Since the articles on these types of fees deviate from what is in MTCs, the
provisions adopted tend to be less well thought-out than those arising from debate
and negotiation and adopted under the OECD or the UN MTCs. Despite the wide
spread use of these articles, many OECD countries oppose the idea of having an
article on these fees in the MTC. They would rather that the international tax system
work as it is, giving the residence countries of the MNE that specialise in high value
services, a bigger share of the right to tax those profits. Under article 5 of the OECD
MTC, a source country may only tax a foreign service provider (such as construction
companies or management consultants) if it has a PE in the country for more than
six month in a one year period, or under the UN MTC, the consultant must have a
“fixed base” that they use regularly. However as explained above, MNE often come
up with artificial schemes to avoid PE status. Secondly since only profits attributable
to PE are taxed in the source state, where services are offered between the PE and
its office, the arm’s length principle has to be applied to prevent transfer pricing.
Enforcing the arm’s length principle with respect to service fees is cumbersome for
source countries because it is difficult to verify whether the service fee payments are
appropriate. In 2012, the UN started work on a proposal for a new article on income
from technical services that would allow developing countries to levy a tax on
payments made to overseas providers of ‘technical services’. The UN Committee’s
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proposal allows a country to tax the income of a service provider even if it has no
physical presence in their country. This UN proposal should be supported.
3.5
Develop Guidelines on granting tax incentives
One of the main causes of for BEPS in African countries is tax incentives offered to
foreign investors. Tax incentives entail “any tax provision granted to a qualified
investment project that represents a favourable deviation from the provisions
applicable to investment projects in general.” The economic theory is that tax
incentives act as a tool for encouraging foreign investments. However, it has been
observed that tax incentives distort resource allocation leading to some sub-optimal
investment decisions and are therefore harmful to long term growth. It is also argued
that tax incentives are not the primary determinants of the decision to invest. Most
investors base their investment decisions not only on economic and commercial
factors but also on institutional and regulatory factors. Despite these concerns,
internationally not given much attention has been given to developing guidelines on
tax incentives.
In the context of tax treaties, tax incentives are normally protected through tax
sparing provisions which developing countries often insist on in their tax treaties with
developed countries. It is argued that when countries sign a double tax treaty, and
an investor from a developed country is offered a tax incentive by a developing
nation, the tax incentive may be eliminated or reduced by the tax regime of the
investor’s residence country through corresponding tax increases which ends up
benefiting the developed country. This particularly occurs where the investor’s
residence country applies the credit method to prevent the double taxation of
income. In reaction to this possibility, some double tax treaties preserve the benefit
of source country tax incentives through “tax sparing” that is granted to foreign
investors whereby the developed countries amend their taxation of foreign source
income to allow their residents who invest in developing countries to retain the
advantages of tax incentives provided by those countries.
As is the case with tax incentives in general, many developing countries contend that
tax sparing encourages foreign direct investment and contributes to economic
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growth in those countries. However, tax sparing can provide significant scope for tax
abuse (e.g. transfer pricing, round tripping and treaty shopping) both in the country of
the investor and in the country of the investment. The 1998 OECD Report on tax
sparing points out that tax incentives are not that effective in promoting foreign
investment. Tax sparing inevitably results in the direct loss of revenue for the
foregone tax by developing county. In treaty negotiations often developing countries
have to make concessions to obtain tax sparing. They are for instance, forced to
grant developed countries favourable withholding taxes and higher thresholds for
taxing permanent establishments in the source country. Despite the above concerns,
and the fact that the OECD and the UN MTCs do not contain tax sparing provisions,
many tax treaties between developed and developing countries have “tax sparing”
provisions. To prevent the tax abuse the OECD Report on Tax Sparing, sets out
several recommendations that have been included in the Commentary on tax
sparing in the OECD MTC. These include the following:
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The relevant tax incentive should be defined precisely so as to prevent openended tax sparing. The provision should for instance refer to the specific
legislative incentives for which the tax will be spared in order to prevent
abuse.
-
Restricting the tax sparing credit for local as opposed to export activities.
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Setting a maximum tax rate for the tax sparing credit. This would prevent the
artificial increase of the rate of the underlying tax incentive.
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Inclusion of an anti-abuse clause, which would prevent foreign investors from
using the tax sparing provision for abusive purposes.
-
Inclusion of time limitations or sunset clauses, so that the provision is not
indefinitely used to abuse the countries’ tax bases.
-
Tax sparing provisions should be restricted to business income and in general
it should not be extended to passive income.
It is important that these guidelines on tax sparing, are built on in order to develop
guidelines on granting tax incentives so as to prevent base erosion in developing
countries. It is encouraging to note that the G20 has called upon the IMF, OECD, UN
and World Bank Group to work jointly to present a report in 2015 on options for low
income countries on the efficient and effective use of tax incentives for investment.
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