Cancelling tax treaties: a lesson from the 1970s

Mike Lewis at ActionAid had a blog yesterday about the problem posed by Zambia’s tax treaty with Ireland, following up on ActionAid Zambia’s call for the treaty to be renegotiated. But how easy would that be?

One of the main points about the Ireland-Zambia treaty is that when it was negotiated 40 years ago, Ireland’s economic position, and its tax rates, were very different. For example, it hadn’t yet introduced its 12.5% tax rate as part of moves to attract mobile capital. As Mike points out, the problem now is not just that the treaty is extraordinarily lopsided in Ireland’s favour, but also that it doesn’t include the anti-treaty shopping clauses that can be introduced to prevent treaties with tax planning ‘conduit’ countries like Ireland and the Netherlands from being exploited. So it would be sensible for Zambia to renegotiate this treaty. The trouble is, that’s not always easy to do. After all, in this case, what would be in it for Ireland?

Tax Justice Network recently noted with satisfaction that both Mongolia and Argentina had cancelled a number of treaties. It’s interesting to look into these moves in a bit more detail. Argentina cancelled its treaties with Switzerland, Chile and Spain last year, but it’s clear that in the latter case what it really wanted was a renegotiation, because a new Argentina-Spain treaty has already been signed.

In Mongolia’s case, the focus seems to have been on treaties with tax planning conduit countries, and according to E&Y [pdf], cancellation was a last ditch option, after the Netherlands had “agreed to amend the dividend clause of its treaty from 0% to 5%, but have refused various other amendment requests.” Luxembourg had apparently “agreed to start negotiations” before Mongolia changed its tune. E&Y’s explanation of the rationale is very interesting, and taken with the above points suggests that anti-treaty shopping provisions were exactly what Mongolia was trying to get:

The MoF has been conducting research into Mongolia‟s double tax treaties, comparing Mongolia‟s treaties with the treaties of countries in a similar economic position to Mongolia (ie Philippines and Ghana) and undertaking some quantitative analysis of the estimated lost revenue from perceived treaty shopping. The conclusion reached from their analysis was that Mongolia’s double tax treaties are too generous towards taxpayers and result in significant tax revenue being lost.

Recalcitrance by wealthier countries who got a good deal in the original treaty is not a new problem. Around the time that the Zambia-Ireland treaty was being negotiated, a footnote to a rather old academic paper shows that one of its neighbours had other ideas:

based on conversations between the writer and the Assistant Secretary to the Kenya Treasury and the Financial Adviser to the Kenya Treasury on Mar. 26 and 27, 1973, it appears that Kenya recently cancelled all its tax agreements because it was recognised that the agreements were resulting in substantial losses of tax revenues and developed countries were found to be dragging their feet on negotiations for new double taxation agreements (or modifications of old double taxation agreements) while the old agreements continued in force.

This tactic has clearly worked for some countries. But it’s a dangerous game to play. At a meeting last week in central London, one participant cited a tax treaty negotiator saying that cancelling a tax treaty is “like declaring war”. Business representatives at that meeting emphasised that the main reason that they like to invest in countries with tax treaties is because of the ‘stability’ they create. The abrupt cancellation of a treaty rather sends the opposite message. Ernst & Young’s report on the Mongolian cancellation [pdf] says, menacingly, that the government,

does not discuss the implications to foreign direct investment and international reputational issues associated with unilateral cancellation of treaties, which is an important consequence of this move.

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5 thoughts on “Cancelling tax treaties: a lesson from the 1970s

  1. One of the things I’m curious about is that Chris Jordan said in a comment on my blog:

    “ActionAid colleagues in Zambia are lobbying the government hard to renegotiate, and we understand that there is some willingness on the part of the Irish to do the same.”

    This had left me with the impression that it was the Zambian policy-makers who were dragging their feet, rather than the Irish. However, on rereading it I see it’s a bit more ambiguous than that.

    Do you know what the Irish policy-making position is with regards to renegotiating the treaty?

  2. It seems to me that ActionAid / Chris Jordan take quite an absolutist position with regard to with-holding taxes. They seem to regard them as unambiguously a good thing. If they are not there then the (developing) country in question is in some way being exploited.

    Surely the situation is rather more nuanced than that? Take dividends and interest, clearly countries differ in their preferences. For example, the UK does not impose withholding taxes on dividends. The US does. The US / UK tax treaty partly reduces these withholding taxes on US dividends – but does not entirely eliminate them.

    Now let’s look at interest. Schwarz on Tax Treaties says: “The UK negotiating position is to seek to eliminate source country taxing rights entirely.” It goes on “As a result 24 treaties provide that interest arising in one contracting state may only be taxed in the country of residence of a beneficial ownership resident in the other state.”

    Clearly the position of the countries will differ some will tend to benefit more from source country taxation and others more from residence country taxation. When treaties are (re)negotiated countries will often have a differing outcomes in mind when they start the process. What comes out will be a compromise – although as with all negotiations the party with the stronger hand and the one who plays their hand more skilfully will tend to get more of what they want. But to expect that one country can just impose its own terms unilaterally is not very realistic.

    A further questions is: are withholding taxes is a good idea? I guess there are two factors that a country needs to consider. The first is raising tax revenue, the second is encouraging investment. All other things being equal having higher withholding taxes will tend to reduce the (after tax) profitability of any given investment and so tend to reduce the level of investment. Countries will make different choices.

    I am not trying to argue that Zambia should not attempt to renegotiate its treaty with Ireland (maybe it should), rather that I think the situation is somewhat more complicated than ActionAid would like us to believe.

  3. Hi Tim,

    I absolutely agree that the debate over withholding taxes is a big one, and I hope we haven’t given the wrong impression in it. To be clear: we’re *not* saying in absolutist terms that countries should always impose withholding taxes, or necessarily seek to privilege source taxing rights. As you say, that’s a sovereign decision about protecting tax base, attracting foreign investment, and many other considerations. Countries will make different choices, and they will obviously carry different costs and benefits for different pairs of countries.

    As you say, for example, the UK’s default DTC negotiating position is to largely eliminate source country taxing rights. (I’ve discussed this with HMRC officials, and it’s clear that this position is based on a clear policy decision that revenue can be foregone for the perceived benefit of UK businesses operating overseas. Although as public finances get squeezed, and the UK becomes more of a capital-importing country, it will be interesting to see if the calculus changes and revenue concerns become more dominant?)

    But that debate, I think, is an entirely separate one from the one we’re having in relation to the Zambia-Ireland DTC. What we’re taking issue with here is that this specific DTC provides an open door for *treaty-shopping* – in other words, for treaty abuse. That’s got little to do with the ordinary division of taxing rights between treaty partners. In the case of the specific transactions we highlight in our Zambia report, for instance, there’s no investment actually coming from Ireland, and no services being provided *from* Ireland. Ireland’s getting very little tax revenue from these transactions either. It’s just being used as a conduit to get round the treaty terms of the Zambia-UK treaty and the Zambia-South Africa treaty: the specific effect of a treaty that combines a low-tax treaty partner, cancelling all source taxing rights, and the absence of up-to-date anti-abuse provisions.

    It’s for this reason that we think Ireland should offer to renegotiate with its development partner, Zambia. Within such a renegotiation there would also, of course, be debate 1 – should Ireland accord Zambia greater taxing rights on income from *genuine* Ireland-to-Zambia investment or *genuine* Ireland-to-Zambia services? But that’s a separate debate.

    There’s also, of course, debate 3: would it be a useful protective measure for countries to deny treaty benefits, impose higher withholding taxes, or restrict deductibility of cross-border payments into jurisdictions they regard as having positively harmful tax regimes – comparable to Brazilian or Argentinian practice?

    I think the international tax discussion would benefit from clarity (including from us!) about these three debates: the appropriate division of taxing rights between particular countries; stopping opportunities for treaty abuse; and protective measures against particular jurisdictions. There’s nothing inherently contradictory, I think, about believing that in some cases a developing country could benefit from having 0% WHT in a range of well-negotiated DTCs with economically-comparable treaty partners (debate 1), while imposing heavy WHT on a tax haven (debate 3).

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