Withholding tax – often the single biggest cost of investing in Africa
One thing we know is that African tax authorities love withholding tax (“WHT”). In this article, we discuss how WHT comes about, why it can be particularly painful in Africa, and what you can consider to mitigate the tax consequences.
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. It is paid 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”.
When is WHT applied
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 including 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. It allocates taxing rights between countries. This prevents businesses residing in one country getting 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. The model DTA is produced by the Organisation for Economic Cooperation and Development (“The OECD”).
OECD approach to WHT
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 place of business (referred to as a permanent establishment) in the country where the services are being rendered. Also where the service fees are attributable to that permanent establishment. Even if such a permanent establishment exists, a WHT will not be imposed. 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.
WHT in Africa
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. Where 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. However the taxation authorities impose WHT anyway.
In these instances, the tax credit can be denied to the recipient in his home country. 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 with giving double tax credit for the tax imposed in contravention of the DTA. This relief summarily fell away.
The 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 worsen matters, many African countries 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. This is 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 significantly alter the economics of doing business in a particular country.
Investing in Africa
Under these circumstances, it should come as no surprise that investors are reluctant to put their resources into the African continent. As 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. This is simply shooting themselves in the foot.
The African withholding tax framework is extremely complex. Please contact us to discuss further or click here to arrange a call with one of our team.
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.