One big theme from the interviews I conducted on my recent African trip is that tax officials in developing countries are really starting to raise concerns about some of their tax treaties. This is particularly true of treaties with the Netherlands, Mauritius and other countries that can leave them vulnerable to treaty shopping, although it doesn’t stop there.

Why are you thinking about this now? I asked. One finance ministry official told me that there had been three factors: first, seeing countries such as Mongolia and Argentina cancel some of their treaties; second, recent NGO reports that had focused on the abuse of tax treaties, in particular the ActionAid report on Zambia sugar; third, the growing body of practical experience inside the country’s revenue authority.

If developing countries are watching what each other does, as well as learning from their own experiences, that’s interesting for international relations. It means we can draw direct parallels with Bilateral Investment Treaties (BITs), where a similar process has been studied in a lot more depth. This first chart compares the growth in BITs and tax treaties (DTTs) over time.

Growth in Bilateral and Investment Treaties (BITs) and Tax Treaties (DTTs)Whereas the number of tax treaties is still on the upward slope of a comparatively gentle exponential rise, investment treaties went through an explosive period in the mid 1990s and early 2000s, before tailing off almost to zero. (By the way, bilateral investment treaties are usually signed by developing countries, since this is the situation where investors are most concerned about possible appropriation of their investments by governments. The chart below shows that the overall pattern for tax treaties is the same if you only consider treaties signed by developing countries)

The spread of tax treaties to developing countriesThe now-classic explanation for this pattern of “three waves of diffusion” of BITs is as follows [pdf]:

In the first period, BITs provided a solution to the time inconsistency problem facing host governments and foreign investors. In the second period, these treaties became the global standard governing foreign investment. As the density of BITs among peer countries increased, more countries signed them in order to gain legitimacy and acceptance without a full understanding of their costs and competencies. More recently, as the potential legal liabilities involved in BIT signing have become more broadly understood, the pattern of adoption has reverted to a more competitive and rational logic.

Lauge Poulsen and Emma Aisbett present some pretty convincing evidence that the tailing off of BIT signatures in that “third wave” came as countries started to see the consequences of their actions in the form of claims made by investors. Their study suggests that countries only really learned from their own experience, or to a lesser extent from that of other countries in their own region: their field of vision didn’t extend much further than this.

I think there are three relevant points for the comparison between tax treaties and investment treaties. First, there has been no significant tailing off in tax treaty signings yet, which is consistent with the fact that there has not been the same volume of high-stakes disputes resulting from tax treaties as there has been over investment treaties. The comparison seems to offer support for Poulsen and Aisbett’s argument.

Second, this might change. Like BITs, tax treaties result in occasional disputes over large amounts of capital gains tax, as I wrote about recently in Uganda’s case. But tax treaties also have an ongoing cash cost to a developing country government in lost withholding tax and corporation tax. This includes the amount that is sacrificed directly to businesses from the treaty partner, but it also includes additional amounts lost through treaty shopping and transfer pricing structures, such as those documented in the ActionAid report and last year’s report produced by SOMO on Dutch treaties.

The question is whether only high profile cases with large amounts at stake – in other words capital gains disputes and reports by NGOs – are enough to cause developing countries to review their approach to treaties, or whether decisions might also be made on the basis of that ongoing cash cost. In fact, I think most of the instances of treaty cancellations have been for the latter reason. Certainly that appears to have been the rationale behind Mongolia’s decision to cancel treaties with several European tax havens [link is in Mongolian], as well as Indonesia’s decision to cancel with Mauritius. Where there wasn’t a dramatic case to catch policymakers’ attention, what provoked countries to reconsider their tax treaties?

A third point for comparison is that there is actually a fundamental difference between investment treaties and tax treaties. The whole point of the former has become to give investors recourse to arbitration, the very thing that then caused developing countries to stop signing. In contrast, what generally leads to concerns about tax treaties is when they are abused in tax planning structures, something that can be prevented through a well-negotiated treaty. Tax treaty cancellations have generally come about when requests to renegotiate fail (the above Mongolian link says the Netherlands and Luxembourg cancellations happened because of lack of progress with renegotiations) or as tactics to bring the other side to the table (Argentina-Spain and Rwanda-Mauritius are both examples of treaties cancelled by a developing country and then subsequently renegotiated).

The upshot is that with tax treaties we may not see a wave of cancellations, or a slow-down in negotiations, but rather a wave of renegotiations, something that is already ticking along in the background.

Tax treaty renegotiationsNote on data: I compiled the numbers of tax treaties from the IBFD database. The numbers only include treaties that have been signed (including treaties that have been signed but not ratified, and excluding treaties initialled but not signed). They exclude treaties signed by jurisdictions that were not fiscally independent at the time (no treaties signed by colonies, except for British and Dutch overseas territories that set their own economic policy). Numbers of investment treaties were taken from UNCTAD, and compiled by Lauge Poulsen.

Link to Google spreadsheet

This is the second of three posts in which I’m reflecting on the recent report on BEPS and developing countries [pdf] during a short stay in Africa. Today, I’m looking at the digital economy. This visit to Africa has been the first time I’ve really grasped the scale of what mobile internet is doing to Africa. It’s huge. Half of all urban-dwelling Africans have smartphones, and mobile internet use is growing at twice the rate of the rest of the world. Nairobi, Kampala and Lusaka have all been festooned with adverts promising “world class internet”.

Buying a SIM card in Kampala, I commiserated with the vendor about the recent discontinuation of Skype on our outdated Windows Phone devices. Later, I debated the merits of Facebook and Whatsapp with the boy serving breakfast at my guest house. At a music festival I found the best implementation of a Twitter wall that I’ve seen.

Here in Lusaka, I had a long chat with the manager of a hostel about Zambians’ penchant for second hand Japanese cars, only to log on to the internet and find every website plastered with adverts for exactly that. And when you ask for directions, people just say “don’t you have Google maps?”

So I thought it quite odd that the BEPS and developing countries report – unlike the BEPS project itself – pretty much skips over the digital economy. McKinsey think that by 2025 the internet could be the same or even a bigger share of African GDP than it is in the UK – as much as ten percent. It’s precisely because Africa lags behind in everything from telephone lines to bank accounts to textbooks that this might happen: the internet, and particularly the internet on mobile devices, offers the chance to leapfrog that capital-hungry stage.

There are two sides to the digital challenge when it comes to taxation, as the BEPS digital economy report [pdf] outlines. The first is the challenges it creates for getting our current international tax rules to deliver the intended outcome, which is broadly that multinational companies pay tax on their profits where they generate them through a physical presence.

Leaving aside the stratospheric “double Irish” schemes and their like, the report discusses some nuts and bolts areas where companies have gone right to the edge of the definition of a taxable permanent establishment (PE), without crossing it. For example, OECD (but not UN) model treaties exempt a delivery unit from the definition of a PE, which is how Amazon avoided a tax liability in the UK despite its huge warehouses. Zambia is not well prepared for similar developments, as most of its treaties follow the OECD provision on this, not the UN one.

But it’s the second side of the issue that I think is big for Africa. This is the growing irrelevance of physical presence to modern business models. The OECD report talks about problems with ‘nexus': how digital companies can make a lot of money in a country over the internet without needing any physical presence at all. It moots the idea of supplementing the physically-rooted PE concept with a new concept of “significant digital presence”, levying a withholding tax on digital transactions, or even abandoning PE altogether,

It also talks about the value attached to data: how digital companies can generate significant value in a country from user data without any money changing hands. There’s no mention of the French Colin/Collin report [pdf], which I thought was fascinating on this. Digital companies like Facebook and, I guess, WordPress, have millions of users creating value (and hence, profits) for them for free, so how does that affect a tax system that tries to allocate taxing rights based on where a company’s value is created?

It’s not just the likely size of the digital economy in Africa that makes this an important issue for the future here. It’s also the fact that digital’s exponential growth here is happening precisely because there isn’t the infrastructure to support physical presence. People will be increasingly downloading textbooks instead of buying them, Whatsapping instead of telephoning, faxing or writing, and using Facebook instead of sending out mailshots, Digital will render irrelevant some of the growth of the physical, taxable economy that already exists in more developed regions. (The exception, of course, is the mobile phone companies…but that’s for another day).

I imagine that the more radical ideas mooted in the OECD paper to deal with the challenges of nexus and data will face stiff opposition from certain countries that are big exporters of digital services. After all, this is not strictly speaking base erosion or profit shifting, because it’s about changing what the rules are intended to do, rather than making sure that they work.

Ordinarily, in this kind of situation I would suggest that developing countries band together to implement a home-grown, tailor-made solution to this problem, and add it to their domestic laws and the COMESA/EAC/SADC model treaties. But they are going to need help. The reason is that if companies are making money from their citizens without any physical presence, they don’t have any cash in the country to take the tax from. To collect tax revenue from digital companies, African governments will need the assistance of tax authorities in the home countries of those companies, which will in turn mean a treaty (either bilateral or multilateral) that supports this.

I’ve realised in my interviews here that developing countries are running just to keep up with the changes to model tax treaties. All their energy is taken up trying to understand, obtain and implement the newer treaty provisions, transfer pricing rules, and information exchange standards. What they aren’t doing so much is evaluating them. So I’d suggest that countries such as Zambia stop, take a breath, and think about what they are likely to want to tax in ten or twenty years’ time. Then they’ll be ready to throw themselves into building a future-proofed set of international tax rules that works for them.

Zain

Uganda is pursuing Zain for $85m capital gains tax on the indirect sale of its Ugandan subsidiary

I’m writing this post from under a mosquito net on a close Kampala evening. Since arriving on Wednesday I’ve had a whistlestop tour of the issues facing Uganda as it embarks on a review of its tax treaties. So far I’ve met with four tax inspectors, two finance ministry officials, four (count ‘em) tax advisers, one academic and three NGO people. I also spoke at an event to launch a a report on Uganda”s tax treaties written by Ugandan NGO SEATINI and ActionAid Uganda.

This post is about “indirect transfers” of assets, where a sale is structured to take place via offshore holding companies, thus escaping capital gains tax. It turns out there is an $85m tax dispute on this between Uganda and the mobile phone company Zain. This is just about the biggest issue in Ugandan tax right now: the tax inspectors are even tweeting about it.

“Indirect transfers” were highlighted in the recent (and generally solid, I thought) OECD report to the G-20 development working group [pdf].* It says:

Developing countries report that the profit made by the owner of an asset when selling it (for example, the sale of a mineral licence) is often not taxed in the country in which the asset is situated. Artificial structures are being used in some cases to make an ‘indirect transfer’; for example through the sale of the shares in the company that owns the asset rather than the sale of the asset itself.

Unfortunately, it is pretty lame on the solutions. As far as I can tell from the G-20 response [pdf], what is going to happen on it is this:

(deep breath…)

As part of its multi-year action plan, the G-20 development working group will consider calling on the OECD, in consultation with the IMF, to report on whether further analysis is needed.

(…and exhale)

I don’t hear the sound of tax positions unwinding.in response to that one.

To remind you, the big daddy of indirect transfer cases is the Vodafone-India dispute. In that case,  according to this handy summary:

In 2007, Vodafone’s Dutch subsidiary acquired the stock of a Cayman Islands company from a subsidiary of Hutchinson Telecommunications International Ltd. (the subsidiary was also located in the Cayman Islands). The purchase price was $11.1 billion. The Cayman company acquired by Vodafone owned an indirect interest in Hutchinson Essar Ltd. (an Indian company) through several tiers of Mauritius and Indian companies.

Like India, Uganda is trying to tax the sale of a mobile phone company when the transaction took place via offshore holding companies:

Zain International BV owned Zain Africa BV, which had equity in 26 companies all registered in the Netherlands, but effectively owning the telephone operator business in as many African countries. One of them, Celtel Uganda Holding BV, owned 99.99 per cent of the Kampala-registered Celtel Uganda Ltd. On March 30, 2010 Zain International BV sold its shares in Zain Africa BV to Bharti Airtel International BV. As all three companies are registered in the Netherlands, and as the transaction was a sale of shares rather than assets, the company said it did not attract capital gains tax.

The cases are of course not identical. For one thing, Uganda is going after the firm that actually made the capital gain. But the Indian jurisprudence is being used in the Ugandan case.

Just last week, an appeal court ruled that the Uganda Revenue Authority does have the jurisdiction to assess and tax Zain on the gain. Zain will now argue that the transaction was exempt. One of its core arguments is sure to be the Netherlands-Uganda tax treaty.

In common with 86% [pdf] of tax treaties signed by developing countries since 1997, this treaty does not contain the UN model treaty provision that would have allowed Uganda to tax gains on the sale of shares in Ugandan companies made by Dutch residents. It may be that Celtel Uganda counts as a ‘property rich’ company because of all its infrastructure assets, in which case Uganda would have been able to fall back on the OECD and UN model provision permitting it to tax those…except (oops!) even that isn’t included in its treaty with the Netherlands. Yes, this treaty is worse for Uganda than the OECD model, never mind the UN.

So instead we come to Section 88(5) of Uganda’s Income Tax Act [pdf] . This is an anti-treaty shopping provision, which denies the benefits of the treaty to a company whose ‘underlying ownership’ is mostly in a third country:

Where an international agreement provides that income derived from sources in Uganda is exempt from Ugandan tax or is subject to a reduction in the rate of Ugandan tax, the benefit of that exemption or reduction is not available to any person who, for the purposes of the agreement, is a resident of the other contracting state where 50 percent or more of the underlying ownership of that person is held by an individual or individuals who are not
residents of that other Contracting State for the purposes of the agreement.

Sounds like Uganda has it in the bag, right? Unfortunately, this matter will turn on whether Uganda’s domestic law can override its treaty commitments. It is quite likely (certain, if you ask Zain’s tax adviser) that a court will decide it cannot. What everyone I have spoken with agrees on (apart, perhaps, from Zain’s tax adviser) is that it would be preferable to have some certainty about this unresolved question.

The URA has recently begun denying treaty benefits under section 88(5), and until now taxpayers have accepted its reasoning. But, speaking in genera terms at the SEATINI/ActionAid public meeting, a tax official said that the URA doesn’t know if its position will stand up to a court challenge. Tax advisers in the private sector say that, as well as the question of treaty override, the meaning of “underlying ownership” needs to be clarified. Because the Zain case has so far been fought on technicalities, “we were robbed of the opportunity to see how it [Section 88(5)] would work in practice,” one told me.

Perhaps the next stage of the Zain case will answer this question. If it does, it should give some welcome guidance to developing countries struggling with these indirect transfers. If they can’t use their domestic law to override their treaties, they will need to insert an anti-abuse clause into their treaties, strengthen their source taxing rights, or consider cancelling them.

This brings us back to BEPS, and the action on tackling treaty abuse. The OECD is proposing a limitation of benefits clause based on that used by the US, which is similar to that in Uganda’s domestic legislation, only a lot more detailed about who is ruled in and out. This would do the trick, but the challenge would be getting it into treaties that have been already signed.

To solve that, the OECD is pushing a multilateral convention to modify treaties all at once, built on a flexible level of commitment. It concedes [pdf] that the multilateral instrument “has not been identified as high priority by developing countries.” For it to work for them, I think it would need two things:

1. Genuine flexibility so that developing countries can opt into only the bits they want, such as the anti-abuse clause.

2. Willingness on the part of high-risk jurisdictions for treaty shopping (in Uganda’s case the Netherlands, Mauritius, and perhaps now the UK) to opt in to the anti-abuse clause as well.

For Uganda, it might not make sense to wait for this, since we are only talking about two or three treaties. It could ask its partners for a protocol containing a limitation of benefits clause right now. Or, of course, it protect itself and raise more revenue by strengthening all its treaties’ capital gains articles, as the UN model provides for in the first place.

*thanks to @psaintamans for the link!

WordPress can’t make its mind up if this is my 100th or my 101st post. No matter, I thought I’d mark the milestone by telling you all about who you are. So here are some of the key stats for this blog. Page views by country:

Page views by country

Page views by country

Top 5 posts by total views (or “maybe I could have stopped writing a while ago”):

  1. UN transfer pricing manual: what Brazil, India and China do differently (June 2013)
  2. The United Nations Practical Manual on Transfer Pricing: a bluffer’s guide (June 2013)
  3. What will BEPS mean for developing countries? (February 2013)
  4. ABF’s misleading statements (February 2013)
  5. Why the US and Argentina have no Tax Information Exchange Agreement (September 2013)

Words people search for to get here:

Wordle of search terms

Wordle of search terms

A few typical search terms that brought people here:

  • how taxation can help improve growth
  • base erosion and profit shifting wiki
  • do tax treaties increase gdp
  • “name-and shame campaigns”
  • tax havens for venezuelans
  • difference between un and oecd transfer pricing
  • double taxation treaties benefits to developing countries
  • what do professional advisers say on starbucks tax avoidance?
  • ngo tax studies vodafone
  • base erosion profit shifting what do you think?
  • what have uk uncut achieved?

And some less typical:

  • parental products manufacturers in india “leave a reply”
  • “margaret hodge” “politicised”
  • starbucks tax jokes
  • sol picciotto wikipedia
  • starbucks and (tax or taxes or zerga or zergak or падатак or падаткаў or данък or данъци or impost or impostos or porez or porezi)
  • how much are you taxed when you resign from public service in south africa
  • anything new in taxes

Who gets the most traffic from this blog?

  1. un.org (by a long way)
  2. actionaid.org.uk
  3. bensaunderscta.wordpress.com
  4. oecd.org
  5. guardian.co.uk
  6. ft.com
  7. imf.org
  8. green-tax.co.uk
  9. papers.ssrn.com
  10. twitter.com
  11. sbs.ox.ac.uk
  12. taxjustice.net
  13. ictd.ac
  14. lse.ac.uk
  15. storify.com
Democracy in action: David Gauke at Monday's delegated legislation committee session

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

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

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

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

The UK-Zambia renegotiation: a missed opportunity

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

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

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

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

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

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

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

China is driving the falling withholding tax rates

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

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

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

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

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

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

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

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

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

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

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

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

I’m at Allison Christians’ brilliant Tax Justice and Human Rights Symposium. Yesterday I began my presentation, as I usually do, by discussing the link between tax treaties and foreign direct investment (FDI). I wrote about this a while ago, but since then I’ve found some more research on the topic. It’s not as simple as saying tax treaties do, or don’t, attract investment. And here’s why.

The story so far

Until 2009, the considered view was that there’s no strong evidence that treaties affect investment, at least not into developing countries. The state of the art was collected in a book edited by Carl Sauvant and Lisa Sachs. Not one of those studies found a positive effect of tax treaties on investment into lower income countries, while they found a mix of positive and negative effects for investment into developed and wealthier developing countries.

There are some intuitive arguments for why the results might be different for developing countries. Tax competition is likely to be less significant in lower income countries, where getting the basics in place (rule of law, transport infrastructure, etc.) is much more important for investors. And large investors can often negotiate bespoke tax incentives that are at least as generous as a tax treaty would have been.

I’m going to give a quick summary of the newer papers. They all use larger or more detailed datasets than in the past to study how a tax treaty between a pair of countries in their sample affects bilateral FDI flows between those countries. I will explain at the end why I think this is the wrong way to ask the question.

New papers using aggregate investment data

Fabian Barthel, Matthias Busse and Eric Neumayer, in 2009 [pdf]  found a solid, positive effect of tax treaties on FDI stocks in developing countries, in the region of 30 percent. The main innovation of that paper was to use a more comprehensive set of bilateral FDI data purchased from UNCTAD, and it did seem to make a difference.

Using similar data but a range of different techniques, Arjan Lejour in a recent paper finds that a tax treaty increases FDI stocks between the signatories by 21 percent. He also finds that treaty shopping exists, but doesn’t attempt to quantify how much it contributes to the increase in FDI stocks.

New papers using firm-level microdata

The other papers all use more detailed microdata on the level of individual firms. These data have a couple of strengths. First, they allow us to rule out treaty shopping. Aggregate FDI data generally captures the first link in the ownership chain, as demonstrated by the prominence of tax havens as sources or destinations of investment, when in fact they’re mere conduits. But the microdata tell us the home country of the investor and the final destination country of the investment.

Second, microdata allow the studies to draw a distinction between effects on FDI at the ‘extensive’ and ‘intensive’ margins. Essentially this means the difference between an effect that encourages new companies to invest in a market for the first time (extensive), and an effect that encourages existing investors to put more resources into a market (intensive).

There are four papers. The first, in 2009, was by Ronald B Davies, Pehr-Johan Norbäck and Ayça Tekin-Koru, using data on Swedish firms’ investments abroad. Then in 2011, Peter Egger and Valeria Merlo did the same with German microdata. In a very recent paper, Bruce A. Blonigen, Lindsay Oldenski and Nicholas Sly made use of similar data from the United States. Julia Braun and Daniel Fuentes have also looked at Austrian companies, although they didn’t have access to the same level of detail.

This spread of home countries is important, because it helps to eliminate some of the natural biases in the data, although I think some still remain. To my mind, only the Swedish paper gives us a convincing answer for developing countries: the US only has one treaty with sub Saharan Africa; Austria didn’t sign many treaties with lower income countries; the German FDI data only covers 51 host countries, with a bias towards larger economies and not a single African country.

All these studies agree that tax treaties have effects at the extensive margin, although the effect is not huge. For Swedish firms, a tax treaty increases the likelihood of establishing an affiliate in a country by a small but statistically significant amount – from 0.6% to 0.7%. The German study concurs (its figures vary depending on the variables used). It also includes the effect of the corporation tax rate, and finds this to be much more important. As for the Austrian data, there is more likely to be Austrian investment in a country if there is a tax treaty.

The evidence is less clear at the intensive margin. The German and Swedish studies don’t find a significant effect, while for Austria a treaty does seem to mean a larger number of Austrian-owned FDI projects. This is where the US study comes in. Its main insight is that treaties might affect different sectors differently. It finds that a tax treaty increases both the number of new entrants into a market (the extensive margin) and the volume of sales by a given affiliate (the intensive margin), but only for some firms.

The authors suggest that the attraction to multinationals of a tax treaty is the Mutual Agreement Procedure (MAP), through which countries can settle disputes about who gets to tax them in certain circumstances. Without a treaty, in the event of a dispute the company will most likely be taxed by both countries, because they have no mechanism to resolve it.

They employ a clever test. Internal trade within some firms is dominated by ‘homogenous’ goods for which a price can easily be found, and so (they argue) determining the transfer price will be a relatively uncontroversial affair. The MAP is unlikely to be invoked, and a treaty is not so important. In contrast, firms trading in ’differentiated’ products are more likely to want a treaty to be in place, because pricing these goods is a more subjective business.

This chart illustrates this finding. Three years after a tax treaty with the US comes into force (t0), there’s a big increase in the share of activity in the treaty partner by US companies dealing in differentiated goods, compared to those dealing in homogenous goods.

Relative Foreign Affiliate Activities across Treaty Status and Time

Source: Blonigen et al 2014

Why I’m not yet convinced

I said I’d add my own thoughts on this data. Well, to begin with, there’s still the old ‘endogeneity’ question. Do treaties lead, or follow, surges in investment? Studies tend to deal with this by lagging the data by a certain number of years (they ask how much investment there was in, say, year t+1 when a treaty was signed in year t – Lejour’s paper uses time lags as long as six years). From my own research, I know that treaties are often intimately linked with particular large investments: a company planning a big investment will lobby for a treaty. Firm-level microdata should be particularly sensitive to this kind of process. But if the investment decision-making and the treaty lobbying are happening simultaneously, it’s impossible to use the chronological sequencing to untangle whether the treaty influenced the firm’s decision, or whether the firm had already made up its mind to invest.

But the more important point is this: what’s the policy-relevant question? Based on these papers I feel comfortable saying that tax treaties do influence bilateral investment flows. A treaty between A and B is likely to increase investment from A into B. But B doesn’t want more investment from A particularly, it just wants more investment. My own research leads me to believe that tax treaties are often instruments to make firms from A more competitive in B relative to firms from C, D or E. If that is the case, B needs to be sure that any new investment stimulated by a treaty doesn’t simply come because firms from A are outcompeting those from C, D and E; investment from A should be additional to, rather than at the expense of, investment from those other countries.

So actually we want a more blunt study: the effect of signing a new treaty on aggregate flows of investment into a country. The only study to date to have examined this is by Eric Neumayer back in 2006. He found that treaties had no effect. So if we combine this with the studies discussed above, the evidence seems to support the idea that tax treaties change the composition of home countries investing in a country, but not the overall volume of investment. If that’s right, then the answer to the policy-relevant research question is no, treaties don’t attract investment.


 

NB: It’s worth adding in an additional outcome from the Swedish study. Davies and Norbäck didn’t find any effect of tax treaties on the size of investments (intensive margin) but they did find that a tax treaty caused firms to export less back to their parent companies, and to import more inputs from their parent companies; these effects were stronger for affiliates that didn’t trade with the parent company as their main purpose. They interpret this change as profit shifting, which they argue is because the affiliate incurs a higher effective tax rate once the host country is able to gain information through the tax treaty. I find that interpretation hard to stomach: if firms are taxed more with a treaty in place, the whole argument for treaties would seem to have been turned on its head. It’s a puzzling finding.

In January, the UN tax committee sent out a call for submissions [pdf] to the update of its transfer pricing manual. The subgroup working on this update will be drafting additional chapters on intra-group services, management fees and intangibles, all topics that greatly interest developing countries and civil society organisations grouped around initiatives such as the BEPS monitoring group.

So who made submissions to the UN consultation? Four private sector organisations, two academics, the World Bank and the Chinese government. Not a single NGO. Meanwhile, considerable effort has been expended by civil society groups in drafting submissions to and reports about the OECD’s BEPS process, lamenting how issues of concern to developing countries are likely to be left by the wayside.

I think this is a pretty strange prioritisation. Why focus all your energies on a process that you suspect is not going to deliver results for developing countries, and ignore entirely a process with a specific mandate to do so? I debated this a bit on twitter earlier this week with, among others Alex Cobham of the Centre for Global Development, who told me he considered it “self-evident that BEPS is relevant to developing countries’ tax base in a way that UN Transfer Pricing Manual may not be.” (We were also discussing automatic information exchange, which I’ve discussed before).

I don’t agree with Alex on the detail. But let’s consider this from first principles. How do (or should) NGOs prioritise their campaigning resources? I suppose the equation is something like:

Importance = 1. Magnitude of potential impact x 2. Likelihood of success + 3. Effect on long term balance of power

In the short-to-medium term it’s important to take into account both the size of what is at stake and the capacity of civil society groups to influence it. But there’s a long term dynamic too that means it may be strategic (unstrategic) to work on something that is unlikely (likely) to succeed in itself but will contribute towards (undermine) a long term strategy.

When I ask them, NGO folks often suggest that they don’t want to prioritise the UN because it scores low on all three counts. That is:

  1. It’s just a talking shop, without the same influence as the OECD
  2. In any event, the UN’s track record shows that the OECD countries have got all the decisions sewn up
  3. And in the long term the UN would be too unwieldy and bureaucratic a forum to be a viable home for international tax politics

I’m going to try to explain why I think this calculation is wrong.

1. It’s just a talking shop, without the same influence as the OECD

Both the OECD and the UN are soft law bodies when it comes to tax treaties and transfer pricing. They set standards in the form of model treaties and guidelines, but these have no binding effect on countries unless they choose to use them in treaty negotiations and in their domestic transfer pricing rules. This applies to the outcomes of OECD deliberations just as much to those of the UN. (Nothwithstanding the OECD’s proposal for a mutlilateral convention to implement the treaty aspects of BEPS, which will presumably be offered as a fait accompli to developing countries, including negative as well as positive aspects for them).

To influence the distribution of the international tax base, then, you need to influence bilateral treaty negotiations and national lawmaking. When it comes to treaty negotiations, at the level of standard-setting you can do two things: influence the developed country position (the OECD model) and influence the developing country position (the UN and regional models). The former will be harder, but will it have a bigger potential impact than the latter?

As I mentioned in my post a couple of weeks ago, a recent IBFD study shows that, where the model treaties diverge, the OECD model seems to be used more often than the UN model, which seems like a logical outcome of differentials in negotiating strength. So before even looking at how the model treaties might be changed, the best outcome for developing countries is surely to increase the prevalence of UN model provisions in negotiated treaties. In any event, the UN model is by no means ignored. Some of its most distinctive provisions, such as the services permanent establishment and source state taxation of royalties, have been adopted quite widely..

Turning to transfer pricing, you might remember that the first edition of the transfer pricing manual created some waves. This was mainly because of its inclusion of a annex on the ‘country practices’ of China, Brazil, India and South Africa, which emphasised their points of dissatisfaction with the OECD’s predominant transfer pricing guidelines. It is perhaps too early to see how influential the UN manual will be.

Accept for a moment the view, propounded by NGOs and sketched out in Chapter 10 of the UN manual, that OECD transfer pricing rules deprive developing countries of tax revenue because of enforcement troubles and an inherent bias towards countries that can capture the intangibles and high-value services. In that case an official document written by government officials discussing these issues and articulating alternatives is clearly very useful. Some people have suggested to me that the authors of Chapter 10 might be using it mainly as a tool to influence the OECD, but on the other hand there’s definite interest in its content from developing countries. South Africa indicates in its contribution that it is considering some aspects of the Indian and Chinese approaches.

2. In any event, the UN’s track record shows that the OECD countries have got all the decisions sewn up

I realised last October that although OECD members are in a minority on the UN committee, once you include the G20 members who are full partners in the BEPS process, the figure rises to 16 out of 25. And many of the individuals in key positions on the UN committee are the same people who represent their countries in the relevant OECD committees. So it would appear that for the UN to articulate any kind of alternative to the OECD, some of these people would need to set aside narrow national interest. Cynics feel that this is unlikely.

And yet the UN is doing alright. In the face of stiff opposition from a number of developed countries and the private sector, it’s ploughing ahead with a new article in its model treaty giving source countries the right to tax technical service fees. Developing countries often want such an article included when they negotiate, and they’re more likely to get it if it’s in the UN model.

I noted above that the UN’s transfer pricing manual is quite critical of the OECD approach, if only in its annex. Early plans for the manual proper had included greater divergence from the OECD approach, including discussion of fixed margins and formulary apportionment. During the drafting process these points were largely eliminated or relegated to the aforementioned annex.

If NGOs feel let down by what they see as the timidity of the UN committee, they might do well to study how their own (lack of) engagement in processes like this contributes to the outcomes in which they express disappointment. Having sat in on several sessions of the committee, I’m in no doubt that when matters like this come up for debate they stand or fall on the strength of feeling among the committee’s members, who in turn listen to the views of lobby groups. Business groups certainly think so, as evidenced by their submissions to the transfer pricing manual consultation.

If UN committee members were being lobbied at committee meetings, held to account in their home countries, and barraged with written submissions, all on the basis of a coordinated and specific agenda such as NGOs have developed for BEPS, the outcomes really would be different. That more confident exploration of unorthodox approaches proposed for the UN transfer pricing manual, for example, might well have made it into the final draft.

3. And in the long term the UN would be too unwieldy and bureaucratic a forum to be a viable home for international tax politics

I have less to say about this, because my experience of the UN is limited to the tax committee we have today. Most international relations theories accord power to international organisations in their own right, not just the sum of their members. An organisation’s power might come from its technical dominance, by exerting social pressure as monitoring reports from the OECD and IMF do, and through agenda setting, which is also a power that NGOs have. How much attention NGOs show towards an international organisation most certainly affects that organisation’s capacity to set the agenda, and its authority to speak about developing country issues.

It’s only one part of a bigger picture, of course, but nonetheless, development NGOs’ propensity to engage in media battles with Pascal Saint-Amans, and to attend OECD meetings in force, even if making critical comments, reinforces the idea that the OECD is where the action is for developing countries too. Of course the OECD can make technical reforms that help developing countries, but, since international tax is also about political settlements, I think it’s a strategic error to focus the overwhelming share of NGOs’ resources there at the expense of the UN.