Certainty in the tax treaty regime

Here’s the text and slides of a talk I gave yesterday at an event called Harnessing the Commonwealth Advantage in International Trade.

I want to talk today about issues related to tax treaties in developing countries, and their impact on tax certainty for multinational investors. To do this I think we have to consider two aspects of the tax treaty regime: the multilateral norm-setting processes at the OECD and United Nations, and the individual bilateral treaties negotiated by pairs of countries. The key point I want to make is that, at both these levels, the elaboration of a regime that constrains developing countries’ source taxation rights in ways that risk being seen as excessive is not sustainable in the long term.

Consider first the multilateral level. Last week I was reading a PWC document, ‘Navigating the Maze: Impact of BEPS and Other International Tax Risks on the Jersey Funds Industry [pdf].’ It notes that:

Countries are already diverging from suggested guidance from the OECD, which was meant to bring coherence and consistency.

This does not only apply to developing countries, but there is plenty of evidence to suggest that in emerging markets there is a growing dissatisfaction with the OECD approach, as illustrated by the ongoing row over the status of the UN tax committee, and India’s recent financial contribution to its trust fund, which until then had been empty for over a decade.

Here are two quotes that illustrate this sentiment further:

“For developing countries the balance between source and residence taxation [is] very crucial. International tax rules with its preferences for residence based taxation [are] not in interest of developing countries.”

Eric Mensah, Ghana Revenue Authority, 2017 [pdf]

“The global tax system is stacked in favour of paying taxes in the headquarters countries of transnational companies, rather than in the countries where raw materials are produced.”

Francophone LIC Finance Ministers Network, 2014 [pdf]

It seems that, to maintain the integrity of the international tax system as emerging market voices become stronger, countries that favour residence-based taxation will need to accept greater flexibility within the instruments agreed at multilateral level.

Turning to the bilateral treaties that developing countries have negotiated, here I want to introduce you to some research I conducted at the LSE, funded by an NGO called ActionAid. ActionAid used it to inform a campaign that has targeted individual governments and treaties, calling for renegotiations.

Slide2

I took 500 tax treaties concluded by developing countries and had a group of LLM students code them for the main clauses that could vary on a source-residence axis, using an International Bureau of Fiscal Documentation analysis. We can use that data to plot each treaty along a simple axis from 0 to 1, where 0 means an overwhelmingly residence-based treaty, and 1 a more source-based treaty. Remember that 1 here represents the presence of the most source-based clauses within existing treaties, and doesn’t take into account the concerns about inherent bias in the parameters for those treaties set by the OECD and UN models. In this first slide you can see that treaties among developing countries, in light blue, are becoming marginally more source-based over time, while treaties between developing countries and OECD members are becoming more residence-based.

Slide3

The next chart shows some of the underlying drivers of those trends. You can see that permanent establishment definitions are becoming more expansive, perhaps reflecting changes to the model treaties, while withholding tax rates are trending downwards. There are diverse trends in different clauses within areas such as capital gains tax and taxation of services.

I want to talk to you about a few examples.

Slide4

Here we see Vietnam’s treaties taken from the same dataset. Vietnam has actually expressed a comprehensive set of observations on the OECD model convention, broadly following the UN model. So here a zero on the vertical axis means the treaty contains none of those positions and instead follows the OECD model, while 1 means it includes all of Vietnam’s observations. You can see that in the 1990s Vietnam signed a number of more residence-based treaties that are completely the opposite of its stated negotiating position. And of course, these are with many of its biggest sources of investment.

More recently, Vietnam has come to regret those earlier treaties, and has chosen to interpret certain provisions on PE and technical services in the way it wished it had signed them, rather than the way it did. Businesses are very unhappy, and in the words of the Vietnam Business Forum, it has:

made the application of DTA[s] of foreign enterprises impossible, effectively it obliterate[s] the legitimate benefit of enterprises.

The residence-based treaties that Vietnam signed when it was inexperienced and urgently in need of investment are creating uncertainty, rather than the stability that investors are looking for.

Slide5

You might be aware that a few years ago Mongolia tried to renegotiate a few of its treaties, and when it was unsuccessful it terminated them. They’re the treaties with the Netherlands, Luxembourg, Kuwait and the UEA, marked in black on here. But if you look on the bottom left, you see a number of treaties with OECD countries, including the UK and Germany, that have even more limited source taxing rights. Indeed, according to an IMF technical assistance report from 2012 [pdf]:

The Mongolian authorities are currently considering cancelling all DTAs and start building up a new DTA network with countries based on trade volumes and reciprocity in economic relations.

I’m told the IMF talked them out of this, but it is worth knowing that they considered it.

Slide6

Here is Zambia, a Commonwealth example. You can see the same pattern. Its earlier treaties were very residence-based. I did some archival and interview work on those early treaties, and you can see that when they were first signed, Zambia had a hugely under-resourced civil service, with no experience of negotiation, and other countries took advantage of this. The most egregious example is its treaty with Ireland, which had zero withholding tax rates on all types of payment. That’s in contrast to the East African community countries, which had very strong negotiating red lines, and as a result either walked away, or obtained more source-based treaties that today appear quite generous, but have stood the test of time.

Slide7

This chart shows a few renegotiations that have taken place in response to government and civil society concerns. You can see that Zambia’s renegotiations have focused more on updating treaties and closing loopholes, not dramatically shifting the balance of taxing rights. In contrast, Pakistan and Rwanda have both negotiated big overhauls.

So in conclusion, as the politicisation of the international tax regime continues, especially in developing countries, I think we’re likely to see growing demands for a rebalancing between source and residence not just in the multilateral setting, but also in individual treaties. My advice to OECD governments, and businesses who engage with them, is that tax certainty in the future depends on an enlightened approach to the tax treaty regime that leaves more developing country taxing rights intact.

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British tax treaties with developing countries, 1970-1981

It’s been quiet on here because of a field trip in Thailand, Vietnam and Cambodia, of which more anon. In the meantime, I’ve been given the opportunity to present a paper based on a chapter of my thesis several times this autumn. It’s a historical study of the politics of Britain’s tax treaty negotiations. I presented it at the excellent African Tax Research Network conference earlier this month, where a few treaty negotiators told me it was interesting to see what goes (well, went) on behind the scenes on the other side. I’ll be giving it again at the Oxford University Centre for Business Taxation’s doctoral workshop, and as the papers there are posted online, I thought it might be time to post it here, too.

Here’s the abstract:

Why have developing countries concluded so many double taxation treaties with developed countries? Much existing research assumes that this diffusion results from the active pursuit of such treaties by developing countries, which have been willing to give up considerable taxing rights through them, in order to attract inward investment. This paper uses archival documents to examine treaty negotiations between the UK and developing countries during the 1970s. It finds that in many cases negotiations were in fact driven by the UK as a means of increasing the competitiveness of British firms in developing country markets. It also reveals a divide between the tax specialist community, for whom tax treaties were a project to export ‘acceptable fiscal standards’, and generalists in business and government, for whom they were a means of securing lower effective tax rates. When these two groups’ objectives came into conflict, it was generally the experts who determined the UK’s policy objectives.

Here’s a link to the PDF.

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.

Is it or isn’t it a spillover?

Last week’s Global Tax Policy Conference at Maastricht University on “international spillovers in taxation” has got me thinking. In particular, I was fascinated by Belema Obuoforibo’s presentation on the IBFD’s methodology for ‘spillover analyses’ (here is a link to an IBFD Powerpoint describing it). The term ‘spillover’ comes from the IMF, a term they use in economic analysis more generally to refer to “the impact of policy actions in one country on others” and around which the IMF framed a whole policy paper. Since its mention in the famous international organisations’ report to the G-20 [pdf], spillover analysis has become a common civil society demand, and the Netherlands and Ireland have gone on to commission them, with a focus on the interplay between their tax treaties with developing countries and certain provisions of their domestic tax law.

But a ‘spillover analysis’ is not the same as an ‘impact assessment’, and I think it’s important to understand the distinction.

The IMF’s recent paper on spillovers in international taxation distinguishes between ‘base’ spillovers, in which an action by one country affects another country without that country doing anything in response, and ‘strategic’ spillovers, in which the change creates an incentive for the second country to change its own policies – tax competition being the obvious example. All very interesting, but I sometimes find it tricky to see how the IMF’s definition applies to the specific areas discussed later on the same report.

One reason for this is that a ‘spillover’ effect from one country on another implies that the affected country is a passive victim. This is not the only way in which one country’s tax system might affect another’s. The decision by a developing country to sign a treaty, or to adopt an international norm, makes it an active participant, but that doesn’t diminish the impact on it of doing so.

A second issue is that ‘spillover analysis’ in practice has tended to focus on how one individual country’s tax system might be different to the norm. Following the Dutch spillover analysis, the government noted that Dutch treaties with developing countries were generally on the same terms as those countries had secured with comparable treaty partners. The IBFD’s methodology is based on how aspects of one country’s tax system compare with similar countries. So the growing practice of spillover analysis, it seems, considers impacts relative to the international average, not absolute impacts. It is a way of finding out if a country is worse or better than average, rather than seeking out all positive or negative impacts.

Let’s consider some examples from the area of tax treaties, to illustrate how these limitations play out in practice:

1. Is it a ‘spillover’ if the affected country actively opened itself up to the vulnerability?

Ireland didn’t used to be a tax haven. It used to be a ‘high tax’ jurisdiction like most OECD countries. Its transformation into a hub used for base erosion and profit shifting is relatively recent, and many of its tax treaties predate this. The changes to Ireland’s tax system transformed its tax treaty network into a major headache for countries such as Zambia, and it seems quite right to describe these effects as spillovers: treaty partners could not have anticipated them when agreeing terms in their tax treaties.

The same could probably be said of the Mauritius-India treaty, which originally predates Mauritius’ generous offshore regime. But it couldn’t be said of Mauritius’ treaties with many African countries, which they signed up to at a time when the risk of treaty shopping through Mauritius would have been clear. This is not a ‘spillover’ of Mauritius’ tax system, because it was a conscious choice taken by the developing countries. But it would be a shame if any analysis of the impact of Mauritius’ treaty network didn’t consider these costs.

2. Is precedent in tax treaty negotiations a strategic spillover?

When Zambia signed a treaty with China containing much lower withholding rates than it had previously agreed to, it may not have anticipated the British reaction, which was to request a renegotiated treaty on similar terms. Zambia also wanted to renegotiate with the UK, mainly to seek improved powers for cooperation and information exchange with the British tax authorities. The implication of the Chinese treaty, however, was that the UK expected similar terms in return for Zambia’s demands, significantly lowering the Zambian tax take from British investors. It seems to me that this was a ‘spillover’ effect of China’s aggressive negotiating position…but I suspect it would be unlikely to be picked up in any ‘spillover analysis’.

3. Are most-favoured-nation effects spillovers?

In April 2003, Venezuela and Spain signed a treaty with a most favoured-nation (MFN) clause in its interest article, which would be triggered if either country subsequently signed a treaty with a lower maximum rate in the interest article. In May 2006, the bilateral MFN clause in its interest article was triggered through a kind of domino effect: Estonia and the Netherlands signed a treaty granting exclusive residence taxation rights over interest; this activated the MFN clause in the September 2003 Spain-Estonia treaty, which in turn activated the MFN clause in the Venezuela-Spain treaty. As a result, according to an article in Tax Notes International, “Venezuela’s treaty with Spain has undoubtedly become the most favorable tax treaty executed by Venezuela to date.”

This was a policy action by two countries that had ramifications for two other countries, but which they should have anticipated when they agreed to the clause. The inclusion of a symmetrical clause, which could be activated by Spain as well as Venezuela, may have been a negotiating error by the latter. But was the MFN activation a spillover?

4. Is it a spillover if a country is just an aggressive negotiator?

The countries that have tended to do spillover analysis so far are those facing accusations that they’re used for treaty shopping. And the main policy response, at least from the Netherlands, seems to have focused on adding anti-abuse provisions into its treaties. What if there is no treaty shopping, but instead just a set of treaties that take most of the taxing rights away from developing countries? As I noted in point 1, the developing countries actively signed up to these treaties at some point in their histories. The IMF spillover paper sounds a cautious note about tax treaties because of the fiscal costs to developing countries of limiting their source taxing rights, but it’s not clear (to me at least) how the plain vanilla impact of the source/residence split could meet the definition of a spillover.

5. Is it a spillover if it’s no different to the norm?

Consider many developed countries’ unwillingness to share the right to tax their shipping firms with the developing countries whose waters they use, and who are in some cases very keen to tax the profits from shipping. Developed countries have been relatively united on this, so even if we accepted that the case described in point 4 above was a ‘spillover’ effect, I think the implication of the IBFD’s methodology would be to find no negative spillover from the hardline stance taken by, say, the UK. But just because this ‘policy action’ is consistent with comparable treaties and with the model conventions, does that mean countries should not assess the impact on developing countries of the policy stance?

In conclusion, it seems to me there is a risk that the focus on the concept of ‘spillover effects’ might lead to an overly narrow analysis of the impacts of a jurisdiction’s tax policy actions on developing countries. Or, to put it another way, could the choice of terms used to discuss this issue have linguistic spillover effects?

Update: Joe Stead points out that I have slightly undersold the 2011 International Organisations’ report to the G-20:

Uganda’s tax treaties: a legal and historical analysis

It’s been a bit quiet on here recently, the result of a busy term at LSE. At least I am at not the only PhD-student-and-tax-blogger whose blog has been suffering from the demands of teaching and research!

This week I’ve been at the International Centre for Tax and Development Annual Meeting, a chance to compare notes with other people working on tax and development, as well as with tax officials from a range of African countries. It’s a great environment to present in, because there is feedback on both an academic level and also from the tax practitioners present.

Here’s the presentation I gave based on my field research in Uganda earlier this year. This is just a taster of what will hopefully result in a couple of full length papers in the new year.

[Link to presentation on Slideshare]

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.

Developing countries and the social nature of international tax

Over the weekend I was lucky enough to be able to attend the 16th annual Critical Tax Theory conference, held this year at the Hastings College of Law in San Francisco. It was a chance to get some really useful feedback from a group who are very focused on using empirical evidence to answer questions about tax policy and administration questions.

Here is my powerpoint. I’ll post something more substantive in the coming weeks to fill in the gaps.