Double tax treaties: a poisoned chalice for developing countries?

Strathmore Business School, Nairobi

11 September 2013

Martin Hearson

m.hearson@lse.ac.uk martinhearson.wordpress.com

Outline

1. Core principles

2. Tax treaties

3. Transfer pricing

1. Core principles

The international tax regime

"I would argue that the freedom of most countries to adopt international tax rules is severely constrained, even before entering into any tax treaties, by the need to adapt to generally accepted principles of international taxation.” - Reuven Avi-Yonah, International Tax as International Law,

2007

Many countries have had to alter their international tax laws to make them conform. - Mexico use of formulae - South Korea definition of PE - US & Germany thin cap rules - Kenya – Unilever ruling on TP

The international tax regime

According to Avi-Yonah, the international tax regime is based on two core principles: - Single taxation - Benefits

- active income mostly taxed @ source - passive mostly @ residence

Further principles can be derived: - Arm’s length transfer pricing - Non-discrimination - Jurisdiction to tax - Credit/exemption - Bilateral tax treaties based on models

What if those principles are not the right ones for developing countries?

For example, why not start from inter-nation equity? “With a highly unequal distribution of resource endowments and per capita income among countries and in the absence of an adequate method for dealing with the problem, an appropriate pattern of tax-imposed national gains and losses might be used to secure some degree of adjustment.” - Peggy & Richard Musgrave, 1972

How would this change international tax instruments?

2. Tax treaties

• Why should developing countries sign tax treaties (or not)?

• Why do developing countries sign tax treaties (or not)?

• What are the policy implications?

Big health warning: almost everything written on this is by academics in Europe and the US. Few developing country perspectives.

Why do countries sign tax treaties? Kenya

Partner Year In force? Zambia 1968 F Denmark 1972 F Norway 1972 F Sweden 1973 F United Kingdom 1973 F Germany 1977 F Italy 1979 NF Canada 1983 F India 1985 F Italy (protocol) 1997 NF Thailand 2006 NF France 2007 F Iran 2009 NF South Africa 2010 NF UAE 2011 NF Mauritius 2012 NF

Main sources of FDI into Kenya

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1,500

2,000

2,500

3,000

3,500

FDI s

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Treaty in force No treaty in force

Why should developing countries sign tax treaties (or not)?

Conventional perspective • Purpose of treaty is primarily to alleviate double

taxation, also to aid cooperation on tax evasion • Developing country gives up tax revenue, but is

compensated through greater inward investment – Some argue the treaty causes reallocation of capital from

residence to source country – Others describe it as a competition effect – treaty gives a

relative advantage over other source countries

• Hence developing countries seek tax treaties • But: evidence for effect on investment is mixed,

because it’s hard to isolate the effects of individual tax treaties

Why should developing countries sign tax treaties (or not)? Critical perspective

• Treaty is unnecessary to alleviate double taxation, as residence states do so unilaterally

• Primarily a political settlement through which taxing rights are transferred from source to residence country

• A ‘badge of respectability’ to show that countries are part of an international economic club

• No evidence that they increase overall levels of investment in a country

Do tax treaties attract foreign direct investment? Macroeconomic studies

“The effect of treaties on foreign direct investment” (Sauvant & Sachs, 2009) compiles a series of studies on tax treaties. None finds a positive association for low-income countries, and for other countries the results are mixed. • Barthel & Neumayer, 2009, do find a positive association,

but they look at bilateral effects, not the overall level of FDI => treaty shopping?

• Neumayer, 2007, asks how the number of treaties affects overall levels of investment => no association.

So, current evidence suggests tax treaties affect the structuring of investments, but not overall levels.

Do tax treaties attract foreign direct investment? Investor surveys (1)

Reasons for investing in Kenya (%)

Market in Kenya and Neighbouring countries 36 Political Stability/Economic 18

Favourable Climate 7 Stable and growing economy 7 Bilateral trade agreements 6

cheap labour and cost of production 5 Resources and Raw material availability 4

Financial systems 3 Human resource availability 2

Existence of similar businesses 2 Liberalization of the economy 1 Absence of Maximum retail price 1

Kenya's popularity world wide 1 Entrepreneurial spirit in Kenya 1

Easy process of acquiring licenses 1 EPZ concessions 1

Strategic infrastructure e.g port 1 Beauty of the people 1

Main impediments to investment in Kenya

Political instability and its neighbours 27 Crime and Insecurity 19

corruption 9 Unreliable infrastructure 7 Delays in licenses & Work permits 6

Competition 5 Lack of clear policies and regulatory impediments

5

Climate change 4 Lack of law enforcement/weak legal infrastructure

4

Cost of financing 4 Exchange rate volatility/Currency risk 3

Economic growth 3 Lack of skilled labour/High cost of production

3

Lack of proper knowledge of regional blocks

2

Source: Kinuthia, 2010. Survey of 210 businesses in Kenya, 127 responses

Do tax treaties attract foreign direct investment? Investor surveys (2)

• Tax is never a high priority in investor motivation surveys in developing countries.

• Even where tax is a factor, treaties are probably not the most important element.

• The following slides use the Fraser Institute’s annual survey of 4100 mining companies, of which 720 responded. Does the number of tax treaties influence the taxation score?

Do tax treaties attract foreign direct investment? Investor surveys (2)

Source SS df MS Number of obs = 44 F( 7, 36) = 2.08 Model 1132.40654 7 161.772363 Prob > F = 0.0707 Residual 2794.54418 36 77.6262272 R-squared = 0.2884 Adj R-squared = 0.1500 Total 3926.95072 43 91.3244353 Root MSE = 8.8106 MINING Coef. Std. Err. t P>t [95% Conf. Interval] PAYMENTS -.012905 .0361544 -0.36 0.723 -.0862294 .0604194 TIME -.005671 .0038068 -1.49 0.145 -.0133916 .0020496 PTAX .2447436 .1649603 1.48 0.147 -.0898113 .5792986 LTAX .213348 .167875 1.27 0.212 -.1271182 .5538143 OTAX -.0667492 .0383009 -1.74 0.090 -.1444272 .0109287 TREATIES -.1142176 .0575385 -1.99 0.055 -.2309111 .0024758 GDPPERCAPITA .0007269 .0003476 2.09 0.044 .000022 .0014318 _cons 41.22174 5.785293 7.13 0.000 29.48862 52.95486

Do tax treaties attract foreign direct investment? Investor surveys (2)

35

40

45

50

55

Ave

rage in

vest

men

t sco

re

0 20 40 60 80 100Number of treaties

95% CI Fitted values

More treaties = less investment friendly! But it’s not very significant

Treaties and tax revenues

“The practical effect of the present network of double taxation agreements between developed and developing countries is to shift substantial amounts of income tax revenues to which developing countries have a strong legitimate and equitable claim from their treasuries to those of developed countries. Concomitantly. these double taxation agreements result in a very considerable and unnecessary loss of badly needed foreign exchange reserves for developing countries. In other words, the present system of tax agreements creates the anomaly of aid in reverse— from poor to rich countries.” - Charles Irish, 1974

Some potential drawbacks of tax treaties

• Withholding tax rates and PE thresholds • Capital gains tax • Taxation of services: some countries (eg Ghana) insist on

this • New OECD Article 7 • Anti-treaty shopping/LOB

– Unless deliberate. Baistrocchi 2008: “The developing countries allow treaty shopping to encourage capital and technology inflows.”

• Mutual Agreement Procedure: each case is a mini-negotiation

• New compulsory arbitration provision: mismatch of legal resources

• Locked in to OECD transfer pricing guidelines

Tax treaties concluded by sub-Saharan countries (excluding South Africa)

Countries that have concluded five or more tax treaties with sub Saharan countries

Policy diffusion as a framework of analysis

• Defined as when policy in one country influences that in another

• Four diffusion mechanisms: – Competition – Learning – Emulation – Coercion

• Emphasis now is on explaining heterogeneity: – National-level scope conditions – Regional variation – Non-linear patterns of diffusion

Using policy diffusion to explain why countries sign tax treaties

• Neumayer & Barthel (2012) find a role for competition in driving tax treaty diffusion.

• The more closely countries compete with each for FDI, the more likely they are to copy each other in signing tax treaties.

• But, a key assumption in their paper is that a treaty signing event corresponds to a policy decision by a developing country. This may not be valid if: – Country is in reactive mode

– Country is proactive, but treaty partner says ‘no’ or ‘wait’

Questions that are rarely asked

• How are tax treaties understood by policymakers in developing countries?

• What motivates their tax treaty policymaking? –Almost certainly depends on the treaty partner –Do outcomes correspond to a clearly defined policy?

• Which stakeholders are involved in the decision? –Officials/ministers? Tax or investment promotion? –Role of business? –Outside organisations e.g. OECD, IMF?

• What is the role of the treaty partner (instigator/reactor?) and what are their preferences?

Some comments from developing country treaty negotiators

“Normally we negotiate when we receive requests, and have always responded positively. It’s always a request from the other party.” “I know that there’s a position that these treaties affect FDI, but I think it’s not right…. We’re more or less on the waiting position. Companies come to resource rich countries regardless, but a bit later you cannot avoid it, you must have a treaty” as businesses expand. “We have a new minister. He’s had several complaints from investors saying [a country] next door has a better investment climate, because it has tax treaties.” “We have been working on a policy. When you negotiate you give up your tax base and you want something in return, but we aren’t getting anything back [in investment].” “I’ve heard this argument that treaties do not bring investment. But you must understand that we are afraid of losing investment. We are a poor country and we’re at the bottom of the pile.”

My model to explain tax treaty events

• What triggers a treaty event? – Change of investment policy in developing country – Personal project of an ambassador, minister or civil servant – Request from treaty partner – Change of position by treaty partner – Project to strengthen political and/or economic relations with

treaty partner

• What determines developing countries’ attitude towards a potential treaty? – How much the treaty partner pushes for it – Generalised desire to appear open to investment/fear of losing

investment (tax competition) – Political relationship with potential partner – Economic relationship with potential partner

What determines US policy in response to treaty requests?

Cables reveal one thing in particular… • Taiwan, 2006: “there are real and immediate benefits that

would accrue to U.S. firms once a tax agreement is implemented. One firm told us that it believes a tax agreement would generate a 10% saving in its cost structure.”

• Macedonia, 2007: “We have advised the MFA that action on [tax] agreements would require strong lobbying from US companies doing business in Macedonia, which has not yet been the case.”

• Qatar, 2008: “Post is unaware of any specific U.S. business concerns on double taxation or other tax issues…will consult with local U.S. business contacts”

Source: Wikileaks database of leaked US embassy cables

Argentina

• March 2007: requests a TIEA with the US

• US response is to say no, we will only sign a full tax treaty with you

• November 2007, head of Argentinian tax authority complains to US ambassador that this condition is inconsistent, because “the U.S. in 2007 signed a TIEA with Argentina's Mercosur partner Brazil based only on the promise of future tax treaty negotiations.”

• 2013: the stalemate has not been resolved

Source: Wikileaks database of leaked US embassy cables

Bulgaria

• 2005: requests a tax treaty with the US as part of a shopping list “to show Bulgarian voters that participation in the [Iraq war] Coalition has brought concrete benefits”

• The government is said to be “eager to publicly announce this ahead of the June general elections. They have pushed this as a major deliverable in return for GOB support in Iraq and Afghanistan.”

Source: Wikileaks database of leaked US embassy cables

Tax treaty cancellations

• Kenya, 1973: cancelled all its colonial era treaties “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 negotiation” (Irish, 1974)

• Mongolia, 2011-12: sought to renegotiate treaties with Netherlands and Luxembourg, revoked them when dissatisfied with response.

• Argentina, 2012: after an inquiry into tax treaties, cancelled those with Spain, Uruguay and Chile. New treaty signed with Spain immediately.

Tax treaty conclusions & policy implications

• Tax treaties have (tax) costs and (tax/non-tax) benefits. • The evidence suggests that increased FDI is not a major

benefit - more likely that treaties are a consequence of inward investment, through lobbying by investors.

• Most developing countries’ existing treaty networks do not reflect a deliberate strategy.

• Countries should formulate a policy, based on cost-benefit analysis: how much are they willing to give up, and for what?

• Then revisit their treaty networks. Revoke/renegotiate, and pursue new treaties if necessary.

• It’s not just about OECD v UN model: think outside the box and then try to change the models (eg service fees).

• In doing so, the single tax and benefits principles may not be the most important.

3. A brief comment on transfer pricing

The arm’s length principle divides up the tax base of a multinational according to the terms of trade in a free market. Why should it? - Dependency theorists argue that the terms of trade are

stacked against developing countries. - Tax system could take account of externalised costs in

developing countries, like environmental damage, exploitation of low-skilled labour.

The main argument made in favour of the current system is inertia.

Heterodox transfer pricing methods

Methods that are designed to be simpler to enforce without changing the division of taxing rights:

- Brazil: fixed margins

- Argentina et al: sixth method

Methods that are designed to change the division of taxing rights:

- India and China: location specific advantages

Transfer pricing politics: current state of play

• G77 have repeatedly tried and failed to strengthen the position of the UN committee.

• Brazil, India & China using UN to articulate an alternative position re transfer pricing: – Chapter 10 of the UN transfer pricing manual is an

extended critique of OECD and description of how they differ from it

– Reservations to reference to the OECD guidelines in the UN model treaty

• The OECD is trying to reach out to developing countries. BRICS are all associates in the BEPS project and “will be expected to associate themselves with the outcome

Transfer pricing politics: current state of play

China: “The UN Transfer Pricing Manual must address these common issues [with the OECD guidelines] for it to be useful to developing countries.”

India: “[The OECD] guidelines on transfer pricing only reflect the agreements amongst Government of those countries that are members of OECD (developed countries) and accordingly tend to take care of interest of only developed countries. The guidelines do not give right of taxation to source countries accordingly eroding taxing rights of developing countries.”

Location savings

Link to presentation on Chinese system

Double tax treaties: a poisoned chalice for developing countries?

Strathmore Business School, Nairobi

11 September 2013

Martin Hearson

m.hearson@lse.ac.uk martinhearson.wordpress.com