The Panama papers and the OECD: re-reading Havens in a Storm

Last week I re-read Jason Sharman’s classic Havens in a Storm, described by Tax Analysts’ Martin Sullivan as “one of the best books out there for tax experts trying to make sense of big countries’ policies toward tax havens” (Sullivan’s review includes a length summary of the book). I was looking for a hook for this blog and, well, it was provided by Jürgen Mossack and Ramón Fonseca.

The OECD has published a curious Q&A on the Panama papers leak, according to which the problem is “Panama’s consistent failure to fully adhere to and comply with international standards”, which it contrasts with “almost all international financial centres including Bermuda, the Cayman Islands, Hong Kong, Jersey, Singapore, and Switzerland.” But the Panama papers story isn’t just about Panama, it’s about the other financial centres that were used by Mossack Fonseca (see the chart below), most of which are rated as “largely compliant” by the Global Forum, the OECD satellite body that peer reviews information exchange compliance.

panama

Arguably the OECD have a point: the Mossack papers show how the world was before the G20 got involved and these jurisdictions reformed, in which case there’s been a lot of unnecessary hot air on British TV news over the last few days. There is certainly some evidence on the ICIJ’s data page to support this view:

Mossack Fonseca’s clients have been rapidly deactivating companies since 2009, records show. The number of incorporations of offshore entities has been in decline for the past four years.

But the main groundswell of opinion, as anticipated by Rasmus Christensen (Fair Skat), is that it’s time to use some serious economic and (in the UK’s case) legal power to overturn haven secrecy. That’s Global Witness’s position. France has wasted no time in restoring Panama to its tax haven blacklist. According to Richard Brooks, with his typically powerful prose:

To tackle the cancer of corruption at the heart of the global financial system, tax havens need not just to reform but to end. Companies, trusts and other structures constituted in this shadow world must be refused access to the real one, so they can no longer steal money and wash it back in. No bank accounts, no property ownership, no access to legal systems.

Turn the clock to 1998…

Havens in a Storm gives us some important context about why we are where we are. The OECD’s Harmful Tax Competition project has come to be seen as the defining international political tax project of a generation of global tax actors – both OECD bureaucrats and governments – in the way that BEPS is for the current generation.  The initial 1998 report [pdf] is still a reference point, primarily for its classic definition of ‘tax haven’, and the list of ‘uncooperative tax havens’ published in 2000 has not ceased to be cited, even though the last jurisdictions were removed from it in a 2009 update.

The four characteristics of the OECD’s 1998 tax haven definition
1. No or only nominal taxes
2. Lack of effective exchange of information
3. Lack of transparency (i.e., bank secrecy)
4. No requirement that activities booked there for tax have economic substance

Yet the 1998 and 2000 reports are also anachronisms. They raised the spectre of sanctions against countries meeting the tax haven definition, but within a few years, the project had been dramatically scaled back and watered down. The initial threat of specific sanctions against jurisdictions that did not commit to comply by 31st July 2001 became a partnership approach accompanied by what Sullivan refers to as “a series of toothless pronouncements, a mixture of cheerleading and scorekeeping.” Furthermore, the OECD’s ambitious original aim of dealing with harmful competition for mobile capital was abandoned for a focus exclusively on the exchange of tax information on request.

According to Sharman, these failures came about because the OECD lost a battle of ideas and language, not an economic (or, for that matter, military) one. Central to this analysis is that “the technocratic identity of the OECD as an international organisation comprised of ‘apolitical’ experts” resulted in a battle waged in a rhetorical and normative space, rather than a political one dominated by the calculus of economic power. “The OECD made the struggle with tax havens a rhetorical contest, that is, one centred on the public use of language to achieve political ends.” The OECD is able to do this not because of the economic dominance of its members, but because of the secretariat’s use of “expert authority” to create influential regulative norms. The power of ‘blacklisting’ tax havens lies not in the economic might behind the implied threat of sanctions, but in the very act of labelling, with its reputational consequences (“the bark is the bite”).

Opponents forced the OECD to abandon key planks of the project by turning its rhetorical weapons against it. First, they portrayed the idea of sanctions as a contravention of the principle of fiscal sovereignty, suggesting that by its implied advocacy of sanctions, the OECD secretariat was breaching norms of reasonable conduct. Second, they turned the term ‘harmful tax competition’ back on the OECD, forcing it to defend its pro-tax competition stance and eventually to replace the term with ‘harmful tax practices’. Third, they alleged hypocrisy among OECD countries, pointing to Luxembourg and Switzerland’s (and later Belgium and Austria’s) refusal to be bound by the project’s outcomes. In the world of rhetorical power, such ‘rhetorical entrapment’ is a powerful tool..

If the project had been primarily a manifestation of raw state power, these rhetorical skirmishes would have mattered little to the eventual outcome. Yet Sharman makes a powerful case that they were its main determinants. One important example is that he attributes the decisive intervention of the Bush administration not to its being ’captured’ by multinational businesses with material interests in the project being scaled back, but to the ideologically-driven machinations of lobbyists from the Center for Freedom and Prosperity.

So what does it mean that, in 2016, language continues to be the OECD’s main weapon? As its Q&A on the Panama papers makes clear:

As part of its ongoing fight against opacity in the financial sector, the OECD will continue monitoring Panama’s commitment to and application of international standards, and continue reporting to the international community on the issue.

On one hand, the OECD’s normative claims are more powerful because of its claim to be the custodian of ‘international standards’, a claim that probably has more weight as a result of the increasing involvement of some non-OECD countries in its various tax projects. On the other hand, the peer review approach seems to implicitly concede a conservative notion of procedural fairness (reasonable behaviour, again) towards secrecy jurisdictions.

And the allegations of hypocrisy among its members don’t help its authority: the US’ ambivalence [pdf] towards sharing tax information automatically on a reciprocal basis is the standout example; there is talk about the use of US states as tax havens by Mossack Fonseca; the list of non-compliant jurisdictions that marked the G20’s entry into tax information exchange in 2009 gave Hong Kong and Macao special treatment.   This is perhaps also one sense in which the UK’s actions towards its overseas territories could have some bearing on how Panama behaves.

…now turn the clock forward to 2013

To finish, the parallels between the Harmful Tax Competition project and the Base Erosion and Profit-Shifting (BEPS) project on multinational corporate taxation are worth pointing out. Consider: an initial ground-breaking report from the OECD secretariat that has become an intellectual reference point, a whittling away of that initial ambition in intergovernmental negotiations, and an inevitable feeling after the fact that the policy reforms agreed won’t quite fix the problem so eloquently framed by the OECD in the first place. It would be too soon, of course, to judge how successful BEPS has been in comparison to its predecessor.

But it’s more interesting, I think, to look at the rhetorical battle. In inventing a new term, ‘Base Erosion and Profit Shifting’, the OECD succeeded in owning the construction of the problem just as it did by defining ‘tax haven’. ‘BEPS’ refers simultaneously to a set of corporate practices that, because they are brought under this umbrella, are hard to define, but it also refers to the OECD’s own project to tackle them. In using the term, critics and supporters alike endorse the OECD’s intellectual leadership. The rapid and widespread adoption of the term illustrates that in 2013, just as in 1998, the OECD knew how to operate in a rhetorical battlefield.

The hypocrisy concern applies here too: for example, several OECD and EU members are in trouble for providing selective tax advantages to multinationals. It’s quite noticeable that, from the start, the OECD secretariat has tried to neutralise this problem by tackling it head on. For example, its tax chief, Pascal Saint-Amans, told the Financial Times in 2012:

The aggressive tax planning of the last 20 years was achieved with the complicity of governments themselves to cope with tax competition

An interesting research question is whether Sharman’s analysis of why the Harmful Tax Competition project struggled can still explain developments in its successor, the Global Forum, or indeed the outcomes of the BEPS project. Do OECD tax projects always stand and fall on the secretariat’s skill at owning the rhetorical space, or do we need to acknowledge governments’ material interests and incentives to fully explain outcomes? (In their commentary on the Panama papers, Len Seabrooke and Duncan Wigan, political scientists who believe in the causal role of ideas, seem to emphasise the latter, how “big, powerful states…themselves may benefit from sheltering other countries’ hot money.”) Answering that question might help us resolve a second, prescriptive one: can the problem of offshore tax avoidance and evasion ever be fully addressed on the technical, normative and rhetorical terrain occupied by the OECD, or does it require an institution with a more political modus operandi? This is certainly an interesting time to be studying the politics of international tax!

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The tax treaty arbitrators cometh

Next month sees the results of the OECD’s Base Erosion and Profit-Shifting project, as well as a discussion at the UN tax committee on alternative dispute resolution in tax treaties. India has apparently vetoed the inclusion of mandatory binding arbitration by default in the OECD model tax treaty, and it remains an optional provision within the UN model too. This post will show that arbitration provisions in treaties with developing countries are nonetheless on the march, and it will discuss some of the issues that this raises. It is taken from some comments I submitted alongside Todd Tucker on a draft paper for the UN committee’s discussion.

I’ve just returned from a field visit to, among other countries, Vietnam. With around 60 tax treaties in force, it’s been one of the most enthusiastic concluders of tax treaties over the last two and a half decades. It’s also quite clear that the General Department of Taxation regrets some of the things that the country gave away in its early negotiations. It is endeavouring to apply some provisions of these treaties in unconventional ways, and coming under pressure from foreign businesses who say that by doing so it is breaking with international norms. I sat in on a large meeting between the Vice Minister of Finance and Vietnam Business Forum (VBF) members, at which these concerns were raised. According to a typical statement from the VBF [pdf], Vietnam’s interpretations have “made the application of DTA[s] of foreign enterprises impossible, effectively it obliterate[s] the legitimate benefit of enterprises.”

As a consequence, Korean investors have recently begun to invoke the mutual agreement procedure (MAP) in the Korea-Vietnam tax treaty. Vietnam’s first ever MAP negotiation was taking place while I was there. MAPs, remember, do not require the two countries to reach an agreement, just to try their best. The resulting backlog of disputes among OECD countries is the reason why the OECD now seems to favour mandatory binding arbitration. Vietnam does not want to see mandatory binding arbitration clauses in its tax treaties, having already had its fingers burnt with investor-state arbitration. I am informed that such a clause was proposed by the US and rejected by Vietnam when the two countries negotiated their new tax treaty.

Vietnam said no, but others have not. One outcome of the Netherlands’ programme of renegotiations with developing countries, which is supposed to be about adding anti-abuse clauses, has been the insertion of binding arbitration clauses in several treaties with African countries. Here are all the arbitration clauses in African tax treaties to date (based on searching the IBFD tax treaties database for the term ‘arbitration’). They key column to look at is “how triggered”. Whereas the Canadian and Italian arbitration clauses require both countries’ consent before the case enters arbitration, all the others, following the OECD and UN model provisions, are binding on the developing country and can be triggered by either the other country or the taxpayer. The rest of the typology indicates that, as per usual, OECD-type provisions are more common than UN-type ones, even though the latter are supposed to be better for the developing country.

Arbitration clauses in African tax treaties

If we search for the term ‘arbitration’ in the IBFD tax treaties database, there are 219 results (caveat: not all of these references might be to ‘an arbitration clause’ as such, and some foreign-language treaties may have been missed). As the table below shows, arbitration clauses are of particular importance to jurisdictions whose treaty networks are used as part of tax planning strategies. By far the most arbitration clauses are in the treaty networks of the Netherlands and Switzerland, although the presence of Liechtenstein and Luxembourg in the top 10 list may also be indicative. At least two of the Swiss clauses, in its treaties with Peru and Argentina, are actually Most-Favoured Nation clauses triggered if the Latin American countries agree to binding arbitration with a third country. This suggests that, for Switzerland at least, arbitration clauses are important for its competitive position.

List of countries by number of tax treaties with some kind of arbitration clause

Here are a few issues that are presented by the spread of arbitration provisions that are binding on developing countries:

  1. There is barely any MAP experience in many developing countries. Interviews with revenue authority staff across numerous developing countries indicate that, outside perhaps the BRICS, many countries have yet to enter into a single MAP. Vietnam is a typical example. So the case for arbitration based on the huge backlog in OECD and G-20 countries is simply not there in many other countries, and may never be. Furthermore, that developing countries do not have the same experience of MAP negotiations as developed countries is a further reason why they should wait before agreeing to mandatory binding arbitration. If arbitration is designed primarily to increase pressure for a resolution in MAP, then the pressure on a developing country to capitulate at this stage will surely be increased by its inexperience in arbitration as well as MAP.
  2. The current UN model provision does not provide for the possibility of optional arbitration. If arbitration helps solves a structural problem in tax treaties, it is good for developing countries to consider it. But one way for them to take it slow is to sign up for clauses that create the option of arbitration without forcing them into it, such as those in the Italian and Canadian treaties with African countries. With such a provision, developing countries could build up some experience before deciding whether mandatory and binding arbitration is right for them. Unfortunately, this is not the current path taken by the UN committee, and so there’s little chance of developing countries obtaining it in negotiations.
  3. Arbitration enhances the negative impact of negotiation oversights. We know that, as in the case of Vietnam’s early treaties, the present impact was often not anticipated at the time the agreements were signed. While this situation has improved in some developing countries, in others, treaties are still being concluded now without adequate awareness among all parties of how they will bind future governments. There are various reasons for this, including: lack of technical expertise at the time of negotiation; politically driven negotiations in which the content of these treaties is barely considered; changing tax systems and economic conditions, especially the growth of e-commerce and services; new tax planning mechanisms; the relative autonomy of a small set of negotiators; weak or non-existent parliamentary ratification processes. Binding arbitration will further enhance this ‘golden straightjacket’ impact of tax treaties, reducing room to manoeuvre in cases where latter day tax treaties frustrate present day policy goals. This would especially be the case if a multilateral instrument were used retrospectively to add arbitration provisions to existing tax treaties.

A final thought. There are lots of reasons why eliminating all forms of double taxation faced by cross-border investors is a sensible thing to try to do. It is what tax treaties are supposed to be for. But sometimes governments, especially in developing countries, might deliberately choose to prioritise the maximisation of their tax base even when that leads to some double taxation. This is, arguably, what China, India and Brazil have done by adopting their own approaches to transfer pricing. Perhaps it is good if tax treaties leave sufficient space for this, so long as countries take seriously the repercussions of making use of that space.

Policy drift in international tax

The more I think about it, the more I like the idea of policy drift as a way to explain what might at times seem like perverse outcomes in the international tax system. This post is an attempt to road test this idea.

Policy drift seems to originate with this 2004 article by Jacob Hacker [pdf], which was then magnified by the seminal book he co-authored, Winner Take All Politics. It starts from two powerful insights. First: it is much easier for interest groups to defend the status quo than it is for them to change it. Second: if a policy does not adapt in response to changes in the economic or social world, then its effects may change. Combined, these insights show the effects of a policy may change over time because it is too difficult to make the changes needed to adapt it to changing circumstances.

Hacker discusses how economic and social changes in the US from the 1970s onwards, such as the decline in privately provided healthcare, exposed people to new risks. Efforts to adapt government social policies, which had originally been designed to protect people from such risks, were defeated in the political process, so that they no longer achieved the outcomes for which they had been created. As Hacker puts it, “formal policies have been relatively stable but outcomes have not.”

Policy drift is said to happen when it is hard to make formal and informal changes to a policy. There are two other concepts in the same literature that are worth considering. Where it is hard to make formal changes to a policy, but easy to ‘convert’ it by reinterpreting it, there can be an internal adaptation of a policy. Where it is easier to make formal changes but harder to convert existing policies, the outcome may be ‘layering’, in which a new policy is implemented on top of an existing one.

Let’s consider three taxation examples.

Property taxation

It’s 1991, and the UK government introduces a new tax to fund local council services. It is based on house prices, valuing every property in the country and putting it within eight price bands. 24 years later, all properties are still placed in a band based on an estimate of what their value would have been in 1991. There are many arguments for and against this approach, but you can make the case that it achieved a form of horizontal and vertical equity when it was introduced, especially compare with what it replaced.

But over those 24 years, the value of properties has not changed equally in different areas. People living in London, for example, where prices have risen much faster than the UK average, do very well out of a system that is based on what their property was worth in 1991. Successive governments have recognised this, but feared the electoral consequences of a reform that would increase the council tax charges of a large number of people.

It seems that an internal conversion – revaluation of properties – is a harder thing to achieve than a formal layering – the introduction of a new tax on the most valuable properties, which was proposed by some parties at the election just gone. Absent both, the policy has drifted, from a broadly progressive tax on property towards one that is flat at the higher levels.

Tax treaties

It’s 1970, and the government of a recently independent developing country wants to attract foreign investors, who will bring with them much needed capital and technical expertise. It offers them generous tax incentives, but it finds that these incentives are frustrated by the foreign tax credit system of the investors’ home country: the investor pays less tax in the developing country, but this just means they pay more tax in their home country instead. So the two countries conclude a tax treaty. The treaty requires the developed country to grant ‘matching credits’ so that firms can keep the benefits of any tax incentives, but in return the developing country must lower its withholding tax rates on dividends remitted by investors from the treaty partner. These lower rates transfer the burden of double taxation relief away from the developed country, which would otherwise have paid for it through its foreign tax credit, onto the developing country. Maybe that was a fair deal, maybe it wasn’t.

Now it’s 2014, and most developed countries have moved from a foreign tax credit system to a dividend exemption. The tax sparing credits are no longer necessary, because the developed country doesn’t tax its outward investors’ foreign profits. Meanwhile the lower dividend withholding tax rates no longer shift the burden of double tax relief from the devloped to the developing country, since the developed country has foregone the revenue either way. So now the agreement serves a very different function: it makes it cheaper for the investor to repatriate profits from the developing country, an effect that is paid for by the developing country. It distorts the market for inward investment by treating investors from this one country differently, and it might have become a conduit through which investors from third countries divert their investments to obtain the more generous treaty.

Maybe these present day effects are good for the developing country, or maybe they aren’t. But the policy has drifted, because the treaty certainly has very different effects from those intended when it was signed; furthemore, the original bargain between the two countries is no longer relevant, and the distribution of the costs and benefits between the two partners may have changed dramatically. There could perhaps be an internal conversion, by chosing to interpet the treaty in certain ways, but this would be difficult; formal change is tricky too, because it requires cancellation or renegotiation of the treaty, which might scare investors, and because if one country loses out from the shift in costs and benefits, the other country generally has no incentive to renegotiate!

International tax rules

For much of the 20th century, government representatives and technical experts sat in rooms developing the component parts of the international tax system. Let’s simplify and say that the purpose of this exercise was to reach a situation in which multinational companies’ tax bases were distributed among the countries in which they operated according to the contribution their operations in each country made to their overall profits. The deal was reached at a time when, broadly speaking, you needed a physical presence in a country to do that. (The arguments made for a withholding tax on management fees in the 1970s tended to be about preventing tax avoidance, not fair distribution of taxing rights). So the concepts and tools developed in the past all require some kind of physical presence.

In the 21st century, it’s become apparent that a physical presence is no longer a prerequisite for significant value-added in a country. So the system does not achieve this original purpose. Instead, it gives an advantage to those countries that are home to the physical establishments of businesses that generate a lot of value in other countries without one. Arguably, the source/residence balance has shifted in favour of residence countries. Certainly, the policy has drifted.

The OECD’s desire not to open up the source/residence discussion during its BEPS process illustrates the difficulty in achieving any formal change in these existing policies. That China and India have been attempting to re-interpret the core concepts that they’ve already signed up to, including through changes in the commentary to the UN model treaty, suggests that there may be some internal conversion afoot.

In any event, I think these concepts of drift, conversion and layering – and especially drift – are quite helpful in understanding the path-dependent development of national and international tax systems. There are, of course, proposals to rebuild both from the ground up. But such proposals need to take into account the political constraints and the economic and social developments that have moulded the status quo.

Taxing the digital economy is (going to be) an African issue

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.

Capital gains tax avoidance: can Uganda succeed where India didn’t?

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!

BEPS Part 2: international politics and developing countries

sluto | beps

This graffiti is definitely about Base Erosion and Profit Shifting (Photo credit: feck_aRt_post)

I wrote earlier this week with some questions about UK tax policy and the OECD’s Action Plan on Base Erosion and Profit Shifting. A lot of the areas that it’s looking at are probably not going to affect smaller developing countries very much, but there are a few things worth highlighting. I also recommend Chris Lenon’s comments on the action plan, to which I’ll refer below.

Beyond the arm’s length principle

I thought it very interesting that the action plan concedes that some of the current problem with tax planning derives from the transfer pricing rules themselves:

multinationals have been able to use and/or misapply those rules to separate income from the economic activities that produce that income and to shift it into low-tax environments.

But the more significant rhetorical shift from the OECD is that it now appears to believe that solutions within the arm’s length principle (ALP) may not be enough. The ALP’s self-sufficiency has seemed to me to be an article of faith for the OECD secretariat every since I began working on tax. The action plan says:

special measures, either within or beyond the arm’s length principle, may be required with respect to intangible assets, risk and over-capitalisation to address these flaws.

Some academics are fond of arguing that the OECD abandoned the ALP in all bit name some time ago. So I wonder whether this is really a substantive change or just a rhetorical shift designed to underline that BEPS is a ‘radical rethink’.

Chris thinks that “[t]his is a clear indication that apportionment may be considered as the way to deal with high value intangibles.” It does seem to imply that the OECD may come more into line with the Chinese approach.

Tax reporting

Noting that “timely, comprehensive and relevant information on tax planning strategies is often unavailable to tax administrations”, the action plan proposes to:

Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE’s provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

Chris thinks that this is “very significant”, and that “business needs to develop a strategic response to the issue of transparency”. I think that it is worth considering in the context of the report to the OECD task force on tax and development last year [pdf], which outlined the information challenges faced by developing country tax authorities. The main value of a global report as proposed would be to give tax authority in country A some readily available information on a multinational’s operations in country B, if neither country is the head office. At the moment this is difficult to obtain, because the subsidiary in country A can’t be required to provide information on a sister company in country B, despite them being under common control. Tackling this problem through global documentation seems sensible.

A multilateral treaty and mandatory arbitration

I said when the original BEPS report came out that a multilateral treaty designed to update current treaties in one fell swoop has potential dangers for developing countries. They’re mostly excluded form the BEPS process, but a multilateral treaty could gain such momentum that it becomes obligatory for them to sign up, despite the difference of interests acknowledged by the existence of separate UN and OECD model bilateral treaties. The new UN tax committee‘s response to any multilateral treaty will surely be very significant.

As an example, the Action Plan implies that one area for change is in the area of mutual agreement procedures (MAPs) and arbitration:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

Alison Christians has written about her concerns about this in the past. Experience with investment treaties shows that developing countries should be wary of mandatory arbitration, yet they may find themselves with little choice if this makes it into a multilateral treaty.

G20 versus OECD

The new model of G20-OECD cooperation is intriguing. The Action Plan explains it as follows:

interested G20 countries that are not members of the OECD will be invited to be part of the project as Associates, i.e. on an equal footing with OECD members (including at the level of the subsidiary bodies involved in the work on BEPS), and will be expected to associate themselves with the outcome of the BEPS Project.

The equal footing part is new and unusual, but that last clause means that countries who have got used to stating their difference of opinion with the OECD will presumably want to think carefully. I will be very interested to see which of the non-OECD G20 members take up this invitation.

BEPS part 1: three places where the Action Plan seems to contradict UK policy

I’ve finally got around to pronouncing on the OECD’s action plan on base erosion and profit-shifting. Surely the only response at this stage is that the jury is out. BEPS is an ordering principle for a quite disparate programme of work, and so it’s hard to reach an overarching verdict.

Later this week I’ll write about developing countries. In this post I want to highlight three things that I read in the action plan published a couple of weeks ago that at first sight seem to contradict what we know about UK tax policy – all areas that have been discussed on this blog before. This is to pose questions, not reach conclusions. It will be interesting to see how the UK position develops in these areas, as I think they might be useful yardsticks to measure how radical the OECD members really want this work to be.

1. CFC rules

The report says:

While CFC rules in principle lead to inclusions in the residence country of the ultimate parent, they also have positive spillover effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low-tax jurisdiction.

This was precisely the argument that we made at ActionAid when the UK relaxed some of its CFC rules, which are designed to prevent the artificial diversion of profits into tax havens. Here is the government’s response in 2011, given by Treasury minister David Gauke:

Our corporate tax system is not the best way to help those [developing] countries; it is designed to protect the UK’s taxing rights, not those of other countries. Rather, it is for the countries themselves to have effective systems that build and protect their own tax base, and to ensure that they can access and act upon tax information…Such an assessment [of the impact of changes on developing countries] would not be relevant to the task of creating the most competitive corporate tax system in the G20 and encouraging more businesses to be based in the United Kingdom.

The Treasury rejected outright the position that is now stated in the BEPS Action Plan, when it came from an NGO and a parliamentary committee. Maybe this is a non-consensual area among the OECD members, because all that is promised is to “develop recommendations regarding the design of controlled foreign company rules.”

2. Patent box

The Action Plan says that:

the “race to the bottom” nowadays often takes less the form of traditional ringfencing and more the form of across the board corporate tax rate reductions on particular types of income (such as income from financial activities or from the provision of intangibles).

Yet the UK’s introduction of a ‘patent box’ that gives a lower corporate tax rate on income from exploiting patents is precisely this kind of measure. Having said that, the actions in this section – unlike the discussion – seem to shy away from anything that might counteract competitive measures per se, unless they are used for abusive structures:

Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime. It will take a holistic approach to evaluate preferential tax regimes in the BEPS context. It will engage with non-OECD members on the basis of the existing framework and consider revisions or additions to the existing framework.

3. e-Commerce

Addressing “the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules” is one of the most intriguing parts of the BEPS agenda.

Many of the high profile cases such as Google and Amazon relate precisely to this point. As the action plan describes it:

In many countries, the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor.

My question here is, does the UK really want this change? A shift towards greater source taxation, which is what this would entail, would cost some countries more than they would gain. The UK’s track record, for example the way in which it disregards the OECD consensus by refusing to treat an internet server as a taxable entity, suggest that it favours a more residence-based system, not a more source-based system.

According to this McKinsey survey, the UK is a world leader in the share of eCommerce in its GDP, but it also has an internet trade deficit. This is because Britons do more internet shopping than most other countries. This suggests that the UK would stand to benefit from the change implied by the BEPS action plan, but also to lose from its current policy position. I wonder what is going on?