SUBMISSION BEFORE THE INDEPENDENT COMMISSION FOR

THE REFORM OF INTERNATIONAL CORPORATE

TAXATION

Prof Annet W OguttuUniversity ofSouth Africa

WHAT ARE THE SPECIFIC CHALLENGES FACED BY YOUR WHAT ARE THE SPECIFIC CHALLENGES FACED BY YOUR CONSTITUENTS REGARDING DOMESTIC RESOURCE CONSTITUENTS REGARDING DOMESTIC RESOURCE MOBILIZATION?MOBILIZATION? Background:

Previous heavy reliance on donor aid in Africa for economic growth & funding government expenditure

Limited donor budgets due global financial crisis

Realisation to move to DRM from public & private sectors Public sector DRM - taxation, non-tax & other government revenue generation

Ensures stable & predictable source of own revenue to facilitate long term fiscal planning Resources are allocated to priority sectors rather than donor constrained conditions Fosters government accountability

Currently DRM in sub-Saharan Africa estimated to constitute 70% of development finance with 30% filled by loans or Aid

Challenges facing DRM in Sub-Saharan AfricaChallenges facing DRM in Sub-Saharan Africa

Very narrow tax bases across Africa Tax burden falls disproportionately on small formal sector of the economy

Many African countries grant tax incentives to foreign investors to encourage FDI Distortions to resource allocation; sub-optimal investment decisions; harmful to long term growth

Many African tax statues have various tax exemptions Costly in terms of forgone revenue Exemptions complicate tax systems - open doors to political interference & corruption

Limited tax reporting low levels of tax education & general culture of non-tax compliance - low DRM

Weak administrative capacity & inadequate resourcing of most tax administrations Lack of political will to insulate tax administration from political incursions - low DRM

Challenges facing DRM in Sub-Saharan Challenges facing DRM in Sub-Saharan Africa cont.Africa cont.

Many African countries levy high taxes; incomprehensive & complex tax legislation encourages tax evasion & avoidance - undermines collection

High discretionary powers of tax officials leads pervasive corruption & lack of transparency; inhibit citizens’ willingness to comply with tax laws

Main stumbling block to DRM in Africa is capital flight Global Financial Integrity: IFF the most damaging economic problem facing Africa No universally agreed definition of IFF

money from illegal activities - tax evasion, organized crimes, customs fraud, money laundering, terrorist & bribery

Some definitions include corporate tax avoidance schemes - base erosion and profit shifting - legal

Tax & illicit capital flight from African: between $50billion & $80 billion per annum - revenue lost exceeds aid

Outflows from Sub-Saharan Africa growing – more than 20% per year

WHAT ARE THE IMPACTS OF THE CURRENT INTERNATIONAL WHAT ARE THE IMPACTS OF THE CURRENT INTERNATIONAL CORPORATE TAXATION FRAMEWORK ON YOUR CONSTITUENTS' CORPORATE TAXATION FRAMEWORK ON YOUR CONSTITUENTS' ABILITY TO MOBILIZE TAX REVENUE?ABILITY TO MOBILIZE TAX REVENUE?

Background International corporate taxation framework not kept pace with changing business environment -

impacts negatively on DTM in Africa Old business models - lower degree of economic integration across borders Modern business models - Global taxpayers; MNE value drivers - IP; information & communication

technologies

Result - encourages tax avoidance by MNE - to minimise global tax exposure Exploitation of legal arbitrage opportunities & boundaries of acceptable tax planning; Exploiting gaps in interaction of different tax systems - artificial reduction of taxable income Shifting profits to low-tax jurisdictions where little or no economic activity is performed Businesses integrate across borders - tax rules remain uncoordinated - technically legal structures devised to

take advantage of asymmetries in domestic & international tax rules

What is at stake is the corporate income tax (CIT) CIT among OECD countries not high - average about 10% of total tax revenues CIT important source of revenue in Africa - average 29% - revenue from individuals & consumption taxes limited African countries have more at stake in an effective international tax system - their development depends on it

Response: OECD 15 Point Action Plan - largely a developed country perspective

Some International corporate taxation principles that are Some International corporate taxation principles that are ineffective in enabling DRMineffective in enabling DRM Challenges posed to the bases of taxing income

OECD BEPS Project: doesn’t cover taxing rights between residence & source countries This a fundamental BEPS issue - harmful tax competition & “race to the bottom”

An effective tax system requires the right basis for taxing income: Two main bases: Territorial (source) – tax income derived from the territorial – most developing countries - easier to administer Worldwide (residence) – residents taxed on worldwide income – most developed countries - administrative capacity to

caste tax net worldwide Normally both bases applied in hybrid form - some countries lean towards territoriality, others towards worldwide

Historically countries’ tax policies generally territorial but had international dimension Globalisation of trade – shift to worldwide systems to preserve tax bases – offshore investments To lessen global tax exposure, taxpayers employ global tax avoidance strategies Countries enact anti-avoidance legislation - taxpayers a step ahead - cycle

Tax policy issue: Should countries’ resources be used to tax worldwide & prevent offshore tax avoidance; or should resources be used to effectively tax domestic income & encourage competiveness of domestic enterprises To remain competitive, reduce administrative costs, ensure simplicity - many developed countries (e.g Japan & UK)

have migrated to largely territorial systems 27 of 34 OECD countries employ some form of territoriality system - ‘a pragmatic response to the practicalities in a

world where competition is fast moving and truly global.’ African countries should place emphasis on strengthening source basis

International corporate taxation principles that are ineffective International corporate taxation principles that are ineffective in enabling DRM cont.in enabling DRM cont.

The Permanent Establishment (PE) concept - crucial element of DTAs – article 5 Fixed place of business through which enterprise's’ business is wholly or partly carried out Special rules for building & constructions cites Deemed PE - dependent agents Exclusions: preparatory & auxiliary activities

Basic nexus to determine if country can tax business profits of foreign enterprise Foreign enterprises should create significant & substantial economic presence Article 7(1) - only profits attributable to PE taxed by source state

Challenges of applying PE concept MNE can artificially fragment operations among multiple group entities to qualify for PE exclusions Manipulation of PE time limits Non-residents service activities – consultants/engineers allege services of temporary nature Challenges posed by digital economy

PE - physical presence as basis for taxation Modern business models - MNE can transact in a without creating a taxable presence Anonymous nature of e-commerce: tax compliance challenges; identification difficulties; verification of taxable transactions;

establishing a link between taxpayers & taxable transactions

The PE issue concerning for developing countries Base erosion if foreign investors avoid PE status Yet its not in the interest of developed countries to expand PE concept

International corporate taxation principles that are International corporate taxation principles that are ineffective in enabling DRM cont.ineffective in enabling DRM cont. The arm’s length Principe (ALP) - to prevent transfer mispricing

When conditions between two associated enterprises in their commercial/financial relations differ from those between independent enterprises, any profits which would have accrued, but haven’t because of those conditions, may be included in the profits of the enterprises and taxed

Entities in MNE treated separately Conceptual & practical difficulties in applying ALP Requires matching comparable transactions between non-arm’s length entities & arm’s length entities MNE transactions often not comparable to those between arm’s length parties MNE do not operate as if their subsidiaries were separate enterprises Requires taxpayers to comply with diverse documentation requirements Challenges of treating PEs as fictitious separate legal entities Difficulties of applying OECD Transfer Pricing methods

Some African countries have transfer pricing legislation Applying OECD Transfer Pricing Guidelines challenging for African countries Difficult to find African comparables - few organised companies in any given sector; no African databases European comparables used - these need to be adjusted to suit an emerging market business. Gathering taxpayer information - absence of documentation requirements; inability to enforce existing ones Capacity in tax administrations to process data & evaluate information - resource capacity & technical expertise

International corporate taxation principles International corporate taxation principles that are ineffective in enabling DRM cont.that are ineffective in enabling DRM cont. Thin capitalisation & other schemes for claiming excessive interest

deductions Thin capitalisation - tax avoidance scheme - company’s equity capital

small in comparison to its debt capital Debt – interest is deductible Equity – dividend distribution not deductible

OECD recommends use of arm’s length principle If loan exceeds what would have been lent in arm’s length situation, lender is taken

to have an interest in the profitability of the enterprise and the loan. Any interest rate in excess of arm’s length amount, is taken to have been designed to

procure a share in the profits

The challenges of applying the arm’s principle to transfer pricing also apply to thin capitalisation

International corporate taxation principles International corporate taxation principles that are ineffective in enabling DRM cont.that are ineffective in enabling DRM cont. Beneficial ownership provision to curb treaty shopping

Treaty shopping - use of DTAs by residents of non-treaty country to obtain treaty benefits not supposed to be available to them

Normally done by interposing a conduit company in one of the contracting states OECD counteracting measures:

Use of domestic law provisions Specific treaty provisions

Beneficial ownership - used in most African treaties - art 10, 11 & 12 OECD MTC Denies treaty benefits unless beneficial owner is resident of one of the contracting states However internationally - lack of clarity on meaning of “beneficial ownership” Challenges posed by international case developments - Velcro Canada ; Prevost Car 2014 OECD MTC - OECD acknowledged limits of beneficial ownership - it doesn’t deal with other cases of

treaty shopping - should not restrict application of other approaches BEPS Action Plan 6: Use of LOB clause; Principle purpose test; preamble of treaties – not intended for non-

taxation

In many African countries curbing treaty shopping has not received much attention Tax treaty negotiations do not fully take treaty shopping into account Yet African tax officials often deal with multinational companies involved in treaty shopping –often via Mauritius

Netherlands, Luxemburg & Switzerland

IN LIGHT OF THESE CONCERNS, PROVIDE THE IN LIGHT OF THESE CONCERNS, PROVIDE THE FIVEFIVE MOST MOST IMPORTANT SPECIFIC RECOMMENDATIONS FOR REFORM OF THE IMPORTANT SPECIFIC RECOMMENDATIONS FOR REFORM OF THE INTERNATIONAL CORPORATE TAX SYSTEM RULES AND INTERNATIONAL CORPORATE TAX SYSTEM RULES AND INSTITUTIONAL FRAMEWORKINSTITUTIONAL FRAMEWORK

Background OECD - BEPS project “marks a turning point in the history of international co-operation

on taxation” But: fundamental international tax reform not dealt with Basic principles of international tax system not re-examined Focus - strengthen tax avoidance legislation to be effective for modern business models To remain competitive some OECD countries reluctant to strengthen these laws No clear global solutions to address fundamental issues

Developing countries have for long called for international corporate tax reform BEPS Agenda not drawn up with developing countries - does not address their immediate

concerns Most Actions to benefit developing countries in the long term – with economic & capacity

advancement BEPS project doesn’t explore certain practical measures more suitable for developing countries

Specific Recommendations for Reform of the International Specific Recommendations for Reform of the International Corporate Tax System Rules and Institutional Framework Corporate Tax System Rules and Institutional Framework cont.cont.

Strengthen source taxation by enhancing withholding taxes (WHT) Practical way to enhance source taxation - not addressed in OECD Action Plan Many developing countries impose WHT on interest, dividends & royalties paid to non-

residents Alleviates difficulties in collecting tax from non-residents

Resident appointed as non-resident’s agent – obliged to withhold % of tax from payments to non-resident

Failure to comply - personal liability imposed on resident agent

MNEs find WHT a major loss of revenue - flat rate on gross income DTAs can reduce WHT Treaty negotiations:

Developed countries - gross tax wipes out profits – impacts on importation of capital & technology

Developing countries have to fight for WHT in DTA negotiations Pressure to reduce WHT rates to zero/near zero or to give up their right to tax these payments Developing countries also contribute to the earning of this income – WHT should be used to

strengthened source taxation

Specific Recommendations for Reform of the International Specific Recommendations for Reform of the International Corporate Tax System Rules and Institutional Framework Corporate Tax System Rules and Institutional Framework cont.cont. Positions on attribution of Profits to PEs: Denial of notional internal payments

 Art 7(1) OECD MTC Foreign enterprise only taxable in source state if PE created Only profits attributable to PE may be taxed

Art 7(2) - OECD authorised approach for attributing profits to PEs Functionally separate entity - internal dealings of PE recognised without regard to the actual profits of the

enterprise of which the PE is a part Allows deductions for notional internal payments that exceed expenses actually incurred

Non-actual management expenses, notional interest & royalties from head office may be charged on the PE Notional payments for financial services on internal loans & derivatives involving PEs

Differs from approach in UN MTC & 2008 version of OECD MTC Single entity approach - only actual income & expenses of PE allocated

Developing countries very sceptical about adopting OECD approach MNEs often avoid PE taxes - claiming deductions of fees charged to headquarter office Disallowance of notional head office expenses should be maintained to preserve source tax bases

Specific Recommendations for Reform of the International Corporate Specific Recommendations for Reform of the International Corporate Tax System Rules and Institutional Framework cont.Tax System Rules and Institutional Framework cont. A practical way to deal with transfer pricing: Unitary taxation (UT) with

formulary appointment (FA) OECD BEPS rejects radical switch to FA- advocates ALP approach Commentators suggest unitary taxation - treats related parties as part of a single enterprise

FA: MNE taxed on global income - each country’s tax depends on fraction of economic activity therein Addresses economic reality of MNEs - highly integrated with operations in different regions Fixed formula for profit attribution - administrable

Objections to FA Requires countries to agree on a fixed formula Relies heavily on access to foreign-based information Profits attributed to each member may differ from income in its books of account Difficult to apply with respect to intangibles 

The case for FA: overcomes the challenges of ALP Art 7(4) 2008 version OECD MTC permitted customarily use of apportionment formulae Some OECD TP methods (profit splits) entail apportionment of profits APAs often use FA  Developing countries lack data bases for comparables: FA - clearer & easier to administer Access to foreign-based information – addressed in UN Transfer Pricing Manual & BEPS Action plan 13 Varied use of FA: American Federal States; Brazil - varying approaches not good for international trade OECD should developing guidance on FA - Convergence between ALP & FA needed With potential strength of FA, its varied use, ALP problems - FA important in international tax

Specific Recommendations for Reform of the International Corporate Specific Recommendations for Reform of the International Corporate Tax System Rules and Institutional Framework cont.Tax System Rules and Institutional Framework cont. Practical way to deal with excessive deductions of fees: An article on income

from technical services in tax treaties MNE keep claiming deductions for various management, technical & service fees

Little or no tax paid in source countries – allegations of making losses year after year Profits shifted to low tax jurisdiction while taxes are minimized in source state

Response – treaties with articles on services, management & technical fees - deviating from OECD & UN MTC

Services, management & technical fees generally defined as 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

Fees may be taxed in resident state but also in source if beneficial owner is a resident of other state - fee not to exceed a certain percentage

Examples: Royalty & service fees - Ghana’s treaties with Germany & Netherlands; Technical fees – Uganda’s treaties with South Africa, Mauritius & UK; Management fees – Ghana’s treaties with Italy & Belgium; US-India treaty

No standard way of drafting these articles - creates uncertainties

OECD countries oppose such article – prefer PE taxation under art 5 and 7 or “fixed base” – UN MTC

2012: UN proposed new article on technical services - allows country to tax service provider even if no physical presence is created

Specific Recommendations for Reform of the International Corporate Specific Recommendations for Reform of the International Corporate Tax System Rules and Institutional Framework cont.Tax System Rules and Institutional Framework cont. Develop Guidelines on granting tax incentives (TI)

TIs considered a tool for encouraging FDI – However: TI distort resource allocation, lead to sub-optimal investment decisions; harmful to long term growth TI not primary determinant of investment decisions

Internationally not much guidance on granting TI Treaty context – some guidance on tax sparing provisions between developing & developed countries

To prevent elimination or reduction of TI offered to foreign investor by his residence country – credit method Developed countries allow residents to retain TI – tax is spared However: tax sparing can lead to tax abuse (e.g. transfer pricing, round tripping and treaty shopping)

Inevitably results in the direct loss of revenue for the foregone tax Developing countries have to make concessions to obtain tax sparing

1998 OECD Report on Tax Sparing - recommendations on tax sparing Tax incentive should be defined precisely - no open-ended tax sparing Set maximum tax rate for the tax sparing credit Inclusion of anti-abuse clauses Time limitations or sunset clauses Restrictions to business income not passive income

Guidelines on TI should be developed – building on the above on tax sparing 2015: G20, IMF, OECD, UN & World Bank to work jointly on options for efficient & effective use of TI for investment