SUBMISSION BEFORE THE INDEPENDENT COMMISSION FOR THE REFORM OF INTERNATIONAL CORPORATE TAXATION

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SUBMISSION BEFORE THE INDEPENDENT COMMISSION FOR
THE REFORM OF INTERNATIONAL CORPORATE TAXATION

• Prof Annet W Oguttu
• University of
• South Africa

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WHAT ARE THE SPECIFIC CHALLENGES FACED BY
YOUR CONSTITUENTS REGARDING DOMESTIC RESOURCE
MOBILIZATION?

• Background
• Previous heavy reliance on donor aid in Africa
  for economic growth funding government
  expenditure
• Limited donor budgets due global financial crisis
  
• Realisation to move to DRM from public private
  sectors
• Public sector DRM - taxation, non-tax other
  government revenue generation
• Ensures stable predictable source of own
  revenue to facilitate long term fiscal planning
• Resources are allocated to priority sectors
  rather than donor constrained conditions
• Fosters government accountability
• Currently DRM in sub-Saharan Africa estimated to
  constitute 70 of development finance with 30
  filled by loans or Aid

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Challenges facing DRM in Sub-Saharan Africa

• Very narrow tax bases across Africa
• Tax burden falls disproportionately on small
  formal sector of the economy
• Many African countries grant tax incentives to
  foreign investors to encourage FDI
• Distortions to resource allocation sub-optimal
  investment decisions harmful to long term growth
  
• Many African tax statues have various tax
  exemptions
• Costly in terms of forgone revenue
• Exemptions complicate tax systems - open doors
  to political interference corruption
• Limited tax reporting
• low levels of tax education general culture of
  non-tax compliance - low DRM
• Weak administrative capacity inadequate
  resourcing of most tax administrations
• Lack of political will to insulate tax
  administration from political incursions - low
  DRM

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Challenges facing DRM in Sub-Saharan Africa cont.

• Many African countries levy high taxes
  incomprehensive complex tax legislation
• encourages tax evasion avoidance - undermines
  collection
• High discretionary powers of tax officials
• leads pervasive corruption lack of
  transparency inhibit citizens willingness to
  comply with tax laws
• Main stumbling block to DRM in Africa is capital
  flight
• Global Financial Integrity IFF the most damaging
  economic problem facing Africa
• No universally agreed definition of IFF
• money from illegal activities - tax evasion,
  organized crimes, customs fraud, money
  laundering, terrorist bribery
• Some definitions include corporate tax avoidance
  schemes - base erosion and profit shifting -
  legal
• Tax illicit capital flight from African
  between 50billion 80 billion per annum -
  revenue lost exceeds aid
• Outflows from Sub-Saharan Africa growing more
  than 20 per year

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WHAT ARE THE IMPACTS OF THE CURRENT
INTERNATIONAL CORPORATE TAXATION FRAMEWORK ON
YOUR CONSTITUENTS' ABILITY TO MOBILIZE TAX
REVENUE?

• Background
• International corporate taxation framework not
  kept pace with changing business environment -
  impacts negatively on DTM in Africa
• Old business models - lower degree of economic
  integration across borders
• Modern business models - Global taxpayers MNE
  value drivers - IP information communication
  technologies
• Result - encourages tax avoidance by MNE - to
  minimise global tax exposure
• Exploitation of legal arbitrage opportunities
  boundaries of acceptable tax planning
• Exploiting gaps in interaction of different tax
  systems - artificial reduction of taxable income
• Shifting profits to low-tax jurisdictions where
  little or no economic activity is performed
• Businesses integrate across borders - tax rules
  remain uncoordinated - technically legal
  structures devised to take advantage of
  asymmetries in domestic international tax rules
• What is at stake is the corporate income tax
  (CIT)
• CIT among OECD countries not high - average
  about 10 of total tax revenues
• CIT important source of revenue in Africa -
  average 29 - revenue from individuals
  consumption taxes limited
• African countries have more at stake in an
  effective international tax system - their
  development depends on it
• Response OECD 15 Point Action Plan - largely a
  developed country perspective

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Some International corporate taxation principles
that are ineffective in enabling DRM

• Challenges posed to the bases of taxing income
• OECD BEPS Project doesnt cover taxing rights
  between residence source countries
• This a fundamental BEPS issue - harmful tax
  competition race to the bottom
• An effective tax system requires the right basis
  for taxing income Two main bases
• Territorial (source) tax income derived from
  the territorial most developing countries -
  easier to administer
• Worldwide (residence) residents taxed on
  worldwide income most developed countries -
  administrative capacity to caste tax net
  worldwide
• Normally both bases applied in hybrid form - some
  countries lean towards territoriality, others
  towards worldwide
• Historically countries tax policies generally
  territorial but had international dimension
• Globalisation of trade shift to worldwide
  systems to preserve tax bases offshore
  investments
• To lessen global tax exposure, taxpayers employ
  global tax avoidance strategies
• Countries enact anti-avoidance legislation -
  taxpayers a step ahead - cycle
• Tax policy issue Should countries resources be
  used to tax worldwide prevent offshore tax
  avoidance or should resources be used to
  effectively tax domestic income encourage
  competiveness of domestic enterprises
• To remain competitive, reduce administrative
  costs, ensure simplicity - many developed
  countries (e.g Japan UK) have migrated to
  largely territorial systems
• 27 of 34 OECD countries employ some form of
  territoriality system - a pragmatic response to
  the practicalities in a world where competition
  is fast moving and truly global.
• African countries should place emphasis on
  strengthening source basis

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International corporate taxation principles that
are ineffective in enabling DRM cont.

• The Permanent Establishment (PE) concept -
  crucial element of DTAs article 5
• Fixed place of business through which
  enterprise's business is wholly or partly
  carried out
• Special rules for building constructions cites
• Deemed PE - dependent agents
• Exclusions preparatory auxiliary activities
• Basic nexus to determine if country can tax
  business profits of foreign enterprise
• Foreign enterprises should create significant
  substantial economic presence
• Article 7(1) - only profits attributable to PE
  taxed by source state
• Challenges of applying PE concept
• MNE can artificially fragment operations among
  multiple group entities to qualify for PE
  exclusions
• Manipulation of PE time limits
• Non-residents service activities
  consultants/engineers allege services of
  temporary nature
• Challenges posed by digital economy
• PE - physical presence as basis for taxation
• Modern business models - MNE can transact in a
  without creating a taxable presence
• Anonymous nature of e-commerce tax compliance
  challenges identification difficulties
  verification of taxable transactions
  establishing a link between taxpayers taxable
  transactions
• The PE issue concerning for developing countries
• Base erosion if foreign investors avoid PE status
• Yet its not in the interest of developed
  countries to expand PE concept

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International corporate taxation principles that
are ineffective in enabling DRM cont.

• The arms length Principe (ALP) - to prevent
  transfer mispricing
• When conditions between two associated
  enterprises in their commercial/financial
  relations differ from those between independent
  enterprises, any profits which would have
  accrued, but havent because of those conditions,
  may be included in the profits of the enterprises
  and taxed
• Entities in MNE treated separately
• Conceptual practical difficulties in applying
  ALP
• Requires matching comparable transactions between
  non-arms length entities arms length entities
• MNE transactions often not comparable to those
  between arms length parties
• MNE do not operate as if their subsidiaries were
  separate enterprises
• Requires taxpayers to comply with diverse
  documentation requirements
• Challenges of treating PEs as fictitious
  separate legal entities
• Difficulties of applying OECD Transfer Pricing
  methods
• Some African countries have transfer pricing
  legislation
• Applying OECD Transfer Pricing Guidelines
  challenging for African countries
• Difficult to find African comparables - few
  organised companies in any given sector no
  African databases
• European comparables used - these need to be
  adjusted to suit an emerging market business.
• Gathering taxpayer information - absence of
  documentation requirements inability to enforce
  existing ones
• Capacity in tax administrations to process data
  evaluate information - resource capacity
  technical expertise

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International corporate taxation principles that
are ineffective in enabling DRM cont.

• Thin capitalisation other schemes for claiming
  excessive interest deductions
• Thin capitalisation - tax avoidance scheme -
  companys equity capital small in comparison to
  its debt capital
• Debt interest is deductible
• Equity dividend distribution not deductible
• OECD recommends use of arms length principle
• If loan exceeds what would have been lent in
  arms length situation, lender is taken to have
  an interest in the profitability of the
  enterprise and the loan.
• Any interest rate in excess of arms length
  amount, is taken to have been designed to procure
  a share in the profits
• The challenges of applying the arms principle to
  transfer pricing also apply to thin
  capitalisation

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International corporate taxation principles that
are ineffective in enabling DRM cont.

• Beneficial ownership provision to curb treaty
  shopping
• Treaty shopping - use of DTAs by residents of
  non-treaty country to obtain treaty benefits not
  supposed to be available to them
• Normally done by interposing a conduit company in
  one of the contracting states
• OECD counteracting measures
• Use of domestic law provisions
• Specific treaty provisions
• Beneficial ownership - used in most African
  treaties - art 10, 11 12 OECD MTC
• Denies treaty benefits unless beneficial owner is
  resident of one of the contracting states
• However internationally - lack of clarity on
  meaning of beneficial ownership
• Challenges posed by international case
  developments - Velcro Canada Prevost Car
• 2014 OECD MTC - OECD acknowledged limits of
  beneficial ownership - it doesnt deal with
  other cases of treaty shopping - should not
  restrict application of other approaches
• BEPS Action Plan 6 Use of LOB clause Principle
  purpose test preamble of treaties not intended
  for non-taxation
• In many African countries curbing treaty shopping
  has not received much attention
• Tax treaty negotiations do not fully take treaty
  shopping into account
• Yet African tax officials often deal with
  multinational companies involved in treaty
  shopping often via Mauritius Netherlands,
  Luxemburg Switzerland

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IN LIGHT OF THESE CONCERNS, PROVIDE THE FIVE
MOST IMPORTANT SPECIFIC RECOMMENDATIONS FOR
REFORM OF THE INTERNATIONAL CORPORATE TAX SYSTEM
RULES AND INSTITUTIONAL FRAMEWORK

• Background
• OECD - BEPS project marks a turning point in the
  history of international co-operation on
  taxation
• But fundamental international tax reform not
  dealt with
• Basic principles of international tax system not
  re-examined
• Focus - strengthen tax avoidance legislation to
  be effective for modern business models
• To remain competitive some OECD countries
  reluctant to strengthen these laws
• No clear global solutions to address fundamental
  issues
• Developing countries have for long called for
  international corporate tax reform
• BEPS Agenda not drawn up with developing
  countries - does not address their immediate
  concerns
• Most Actions to benefit developing countries in
  the long term with economic capacity
  advancement
• BEPS project doesnt explore certain practical
  measures more suitable for developing countries

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Specific Recommendations for Reform of the
International Corporate Tax System Rules and
Institutional Framework cont.

• Strengthen source taxation by enhancing
  withholding taxes (WHT)
• Practical way to enhance source taxation - not
  addressed in OECD Action Plan
• Many developing countries impose WHT on interest,
  dividends royalties paid to non-residents
• Alleviates difficulties in collecting tax from
  non-residents
• Resident appointed as non-residents agent
  obliged to withhold of tax from payments to
  non-resident
• Failure to comply - personal liability imposed on
  resident agent
• MNEs find WHT a major loss of revenue - flat rate
  on gross income
• DTAs can reduce WHT
• Treaty negotiations
• Developed countries - gross tax wipes out profits
  impacts on importation of capital technology
• Developing countries have to fight for WHT in DTA
  negotiations
• Pressure to reduce WHT rates to zero/near zero or
  to give up their right to tax these payments
• Developing countries also contribute to the
  earning of this income WHT should be used to
  strengthened source taxation

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Specific Recommendations for Reform of the
International Corporate Tax System Rules and
Institutional Framework cont.

• Positions on attribution of Profits to PEs
  Denial of notional internal payments
•  Art 7(1) OECD MTC
• Foreign enterprise only taxable in source state
  if PE created
• Only profits attributable to PE may be taxed
• Art 7(2) - OECD authorised approach for
  attributing profits to PEs
• Functionally separate entity - internal dealings
  of PE recognised without regard to the actual
  profits of the enterprise of which the PE is a
  part
• Allows deductions for notional internal payments
  that exceed expenses actually incurred
• Non-actual management expenses, notional interest
  royalties from head office may be charged on
  the PE
• Notional payments for financial services on
  internal loans derivatives involving PEs
• Differs from approach in UN MTC 2008 version of
  OECD MTC
• Single entity approach - only actual income
  expenses of PE allocated
• Developing countries very sceptical about
  adopting OECD approach
• MNEs often avoid PE taxes - claiming deductions
  of fees charged to headquarter office
• Disallowance of notional head office expenses
  should be maintained to preserve source tax bases

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Specific Recommendations for Reform of the
International Corporate Tax System Rules and
Institutional Framework cont.

• A practical way to deal with transfer pricing
  Unitary taxation (UT) with formulary appointment
  (FA)
• OECD BEPS rejects radical switch to FA- advocates
  ALP approach
• Commentators suggest unitary taxation - treats
  related parties as part of a single enterprise
• FA MNE taxed on global income - each countrys
  tax depends on fraction of economic activity
  therein
• Addresses economic reality of MNEs - highly
  integrated with operations in different regions
• Fixed formula for profit attribution -
  administrable
• Objections to FA
• Requires countries to agree on a fixed formula
• Relies heavily on access to foreign-based
  information
• Profits attributed to each member may differ from
  income in its books of account
• Difficult to apply with respect to intangibles 
• The case for FA overcomes the challenges of ALP
  
• Art 7(4) 2008 version OECD MTC permitted
  customarily use of apportionment formulae
• Some OECD TP methods (profit splits) entail
  apportionment of profits
• APAs often use FA 
• Developing countries lack data bases for
  comparables FA - clearer easier to administer
  
• Access to foreign-based information addressed
  in UN Transfer Pricing Manual BEPS Action plan
  13
• Varied use of FA American Federal States
  Brazil - varying approaches not good for
  international trade
• OECD should developing guidance on FA -
  Convergence between ALP FA needed

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Specific Recommendations for Reform of the
International Corporate Tax System Rules and
Institutional Framework cont.

• Practical way to deal with excessive deductions
  of fees An article on income from technical
  services in tax treaties
• MNE keep claiming deductions for various
  management, technical service fees
• Little or no tax paid in source countries
  allegations of making losses year after year
• Profits shifted to low tax jurisdiction while
  taxes are minimized in source state
• Response treaties with articles on services,
  management technical fees - deviating from
  OECD UN MTC
• Services, management technical fees generally
  defined as payments of any kind to any person,
  other than an employee of the person making the
  payments, in consideration for any services of a
  managerial, technical or consultancy nature,
  rendered in a contracting state
• Fees may be taxed in resident state but also in
  source if beneficial owner is a resident of
  other state - fee not to exceed a certain
  percentage
• Examples Royalty service fees - Ghanas
  treaties with Germany Netherlands Technical
  fees Ugandas treaties with South Africa,
  Mauritius UK Management fees Ghanas
  treaties with Italy Belgium US-India treaty
• No standard way of drafting these articles -
  creates uncertainties
• OECD countries oppose such article prefer PE
  taxation under art 5 and 7 or fixed base UN
  MTC
• 2012 UN proposed new article on technical
  services - allows country to tax service
  provider even if no physical presence is created

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Specific Recommendations for Reform of the
International Corporate Tax System Rules and
Institutional Framework cont.

• Develop Guidelines on granting tax incentives
  (TI)
• TIs considered a tool for encouraging FDI
  However
• TI distort resource allocation, lead to
  sub-optimal investment decisions harmful to long
  term growth
• TI not primary determinant of investment
  decisions
• Internationally not much guidance on granting TI
• Treaty context some guidance on tax sparing
  provisions between developing developed
  countries
• To prevent elimination or reduction of TI
  offered to foreign investor by his residence
  country credit method
• Developed countries allow residents to retain TI
  tax is spared
• However tax sparing can lead to tax abuse (e.g.
  transfer pricing, round tripping and treaty
  shopping)
• Inevitably results in the direct loss of revenue
  for the foregone tax
• Developing countries have to make concessions to
  obtain tax sparing
• 1998 OECD Report on Tax Sparing -
  recommendations on tax sparing
• Tax incentive should be defined precisely - no
  open-ended tax sparing
• Set maximum tax rate for the tax sparing credit
• Inclusion of anti-abuse clauses
• Time limitations or sunset clauses
• Restrictions to business income not passive
  income

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