How withholding taxes, particularly on service fees, can be the biggest single cost to doing business in Africa.
Ask any businessperson what the worst part about investing in Africa is and, more likely than not, one of the things they will cite will be withholding taxes (“WHT”).
What is a WHT? Well, it is a tax on an income stream which the payer (i.e. not the person earning the income) is obliged to collect and pay over to the revenue authorities of a country on behalf of the recipient from which the tax is due. The payer effectively withholds the tax from the payment it owes to the recipient hence the name “withholding tax”.
WHT is generally applied by tax authorities in situations where the recipient has few ties to the country in which the income was earned, generally where the recipient is a non-resident. In such a case it is simply easier to make the resident payer responsible for the non-resident’s fiscal obligations.
Historically, WHTs have been imposed on passive income streams such as dividends, royalties and interest paid by residents to non-residents. More recently however and especially in African countries, it has become common to also levy WHT on payments for services rendered by non-residents to residents. In the investment context, non-resident companies that provide management and technical services to their African subsidiaries face WHT when they attempt to recover the costs of making these services available to the group entities, which they are generally obliged to do from a transfer pricing perspective.
It is fair to say that these WHTs on service fees are anathema to international investors. What makes them worse than most other taxes is that they are imposed on the gross amount of an income stream as opposed to the net. In other words, expenses the investor incurs in generating the income stream from services it renders in the foreign country do not reduce the WHT imposed thereon. So while a 20% tax on net income might be bearable, a 20% tax on gross turnover can have a huge impact, particularly where margins are low, as they typically are on services.
In theory, relief from WHT on service fees is usually available under the terms of a Double Tax Agreement. A Double Tax Agreement or “DTA” is an international treaty that allocates taxing rights between countries so that businesses residing in one country do not get taxed again on the same income that was generated in another country. Most DTA’s that are concluded worldwide follow, more or less, the wording in a model or pro forma tax treaty produced by the Organisation for Economic Cooperation and Development (“The OECD”).
The OECD Model DTA generally prevents a non-resident from being taxed on service fees that non-residents earn unless the non-resident has a fixed placed of business (referred to as a permanent establishment) in the country where the services are being rendered and where the service fees are attributable to that permanent establishment. Even if such a permanent establishment exists, a WHT will not be imposed but instead, the permanent establishment will be taxed on the services fees earned by the non-resident as if it were a resident of the country. This is not as bad as a WHT because it means only the net amount of income earned by the non-resident from its services will be hit.
However, many African countries either ignore this provision and levy WHT on services regardless typically at high rates, or (less commonly but at least legitimately) apply the so-called UN Article 12A treatment, which is a principle from the UN Model tax convention that generally allows the country in which the payer is resident to impose WHT on service fees irrespective of whether a permanent establishment has been established.
In terms of relief for this foreign tax suffered on service fees earned, the recipients can generally claim double tax relief in their home country. However, countries often do not grant double tax relief where the WHT has been illegally imposed, i.e. where WHT has been applied in contravention of the DTA. This happens very often in Africa, i.e. the relevant DTA follows the OECD Model and the payer’s country had no taxing rights over the service fees paid to the non-resident but the taxation authorities impose WHT anyway. In these instances, the tax credit can be denied to the recipient in his home country and double tax is thus suffered. South Africa, for example, used to permit a limited tax credit where WHT was illegally levied but from 2016 onwards, it got fed up for giving double tax credit for the tax imposed in contravention of the DTA and this relief summarily fell away.
The current likely culprits of African countries that apply WHT on services in contravention of their DTAs include Botswana, Lesotho Mozambique, Rwanda, Swaziland, Tanzania, Uganda, Zambia and Zimbabwe, although practice changes regularly.
To make matters worse, many African countries then seek to disallow service fee payments to connected persons for corporate tax deduction purposes. A growing number of African countries have blanket disallowances for connected person payments in a blatant abuse of transfer pricing provisions. This can lead to a trifecta of tough tax impacts where WHT is levied on a payment that the payee is not permitted to deduct, but where the recipient must pay corporate tax on the income in its home country, AND is unable to claim double taxation relief if the WHT was levied in contravention of the applicable DTA.
The impact of such effective triple taxation can have significantly alter the economics of doing business in a particular country.
Under these circumstances, it should come as no surprise that investors are reluctant to put their resources into the African continent when they may have such punitive impacts. African Governments that apply WHT in contravention of their DTAs while also being overly aggressive in disallowing payments to a connected person may simply be shooting themselves in the foot.
For advice about this, withholding taxes and other pitfalls of investing in Africa, you are welcome to contact us.
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How you structure your business is a critical question as you expand globally. The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.
Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.