When a business is considering a new jurisdiction, one of the first questions is whether a tax treaty (aka a Double Taxation Agreement or DTA), exists between the investor’s own jurisdiction and the other country. But what is a DTA and why is it important?
A DTA is a bilateral agreement between two counties, which seeks to facilitate trade by minimising double taxation where a resident of one country is doing business in the other. It does this by assigning taxation rights to one or the other country (or occasionally both, in which case the home country must give relief) delineated on a per revenue stream basis. So, for any given scenario there is a “home” country, i.e., where the person or company is tax resident, and a “source” country, i.e., where the disputed income arises, usually the other country, and the DTA goes through each possible source of income one by one and decides which country may tax it. DTAs all look largely the same as they are generally based on the OECD model tax treaty (or less commonly the UN model tax treaty), which is a kind of pro forma layout. This makes them easy to follow and apply.
DTAs are thus extremely important as they assist with eliminating double taxation and harmonising potential taxation conflicts between the two signatory countries. Therefore, they facilitate and foster trade between the two countries, and should make life a lot easier for companies resident in one jurisdiction who are earning taxable income from or doing business in the other.
Sounds great! But what happens when a DTA goes wrong or simply doesn’t work? What can go wrong, when, and what can the taxpayer do?
This article deals with three key situations where DTAs don’t work. Unfortunately, all are common with African countries.
Reduced withholding tax rates not being respected
One of the key benefits of DTAs is the reduction of withholding taxes (“WHT”) on flows between the countries. A WHT is levied on payments made between countries because the paying country wants to tax a portion of what is flowing from its country. Traditionally, WHT is only levied on so-called “passive” streams, i.e., flows from one country to another which don’t need the recipient to be present or active in the paying country to earn them. WHT thus generally applies on royalties, interest, and dividends. That’s fine, but many African countries follow an approach of slapping WHT on any payment that leaves the country, including in particular service fees, and often at very high rates.
Further, to add insult to injury, many African countries do not respect the DTAs in terms of reducing WHT rates, and in particular levy WHT on specific elements in direct contravention of their DTAs. Most DTAs provide that the source country does not have taxing rights (i.e., cannot levy WHT) on anything not specifically covered, i.e., generally on anything except dividends, interest, or royalties. The source country cannot levy WHT unless the other party has created a taxable presence or a permanent establishment (“PE”) in that country.
Despite that, many African countries still levy WHT on all service fees leaving the country. This creates difficulties in claiming foreign tax credits for the recipient as most countries, including South Africa, will not allow foreign tax credits for foreign tax levied illegally, i.e., in contravention of the applicable DTA.
We often say that WHT can be the single biggest cost of doing business in Africa, and that is particularly the case when a 20% WHT applies on services which are then also taxed in the home country but where double taxation relief cannot be claimed as the WHT was levied in contravention of the DTA. To make things worse, the service fee can also be disallowed as a tax deduction in the paying country which results in a triple whammy!
Domestic legislation curbing the DTA from applying at all
As if matters weren’t bad enough, certain African countries have a domestic “limitation of benefits” or LOB clause which they use to override the application of DTAs entered into.
For example, both Tanzania and Kenya have enacted provisions in their domestic tax laws that seek to deny treaty benefits to a resident of a country that has entered into a tax treaty with Kenya, unless one of two requirements are met:
- Either 50% or more of the underlying ownership of the Kenyan company must be held by an individual or individuals who are residents of that other country; or
- A resident of the other country must be a company that is listed on the stock exchange of that other country.
This LOB clause goes far beyond what is typically done by countries to avoid treaty shopping by taxpayers and will be particularly felt by group companies that make use of an intermediary holding company for their African subsidiaries.
It’s not yet clear whether the validity of the Kenyan LOB provision will withstand a legal challenge since its scope appears to go beyond the spirit that underpins the purpose of DTAs. Nevertheless, until such time as the legal position is tested by the courts, we would suggest that taxpayers tread carefully when relying on treaty benefits with Kenya.
The impact of the multi-lateral instrument on DTAs
Finally, many African countries have now implemented the snappily-named Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”). This is a Multilateral Convention (i.e., can be signed by many parties) to implement tax anti-avoidance measures in treaties in order to prevent base erosion and profit shifting, which is the product of OECD BEPS Project Action 15.
In theory, the MLI can be signed unilaterally by a country in order to, in one sweep, modify the application of all its DTAs, which is why there has been such a hasty take-up. However, there is no one composite MLI, rather each country takes its own unique position as to how the MLI will be implemented, in particular which DTAs are covered, which articles, and what the country’s specific position for each article will be. Given that a DTA is an agreement between two countries, this creates massive complexity in understanding how each party’s MLI position will apply and what happens if the two countries have differing views as to the application of the MLI for any particular article.
For a specific DTA to be amended by the MLI, both countries covered by the DTA must have signed the MLI, both countries must have chosen for the DTA in question to be covered by the MLI and must have chosen the same position on the MLI article in question. Where at least one party has made a reservation in respect of a certain MLI article or the parties did not choose to apply the same optional provision, that reservation or difference in optional provisions will block the modification of the DTA in question, but only in respect of the specific MLI article (that is, amendments driven by other MLI articles in respect of which both countries have the same stated position will still be affected).
In some ways, this is similar to throwing a pack of cards up in the air a la Alice as there are multiple permutations for the various DTAs in place. This is creating a very real challenge in the interpretation and application of DTAs in Africa.
In Africa therefore, applying DTAs can be like wading through quicksand. Think carefully before you rely on them, as some DTAs are not respected, or are subject to arbitrary in-country challenges, or must be re- interpretated through the lenses of differing MLI interpretations. Contact us for a life-line through the morass.
How can we help?
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.