Double tax agreements – enabling sleazy business in Africa

2021-05-28

Africa loses around $88.6 billion, equivalent to 3.7% of its gross domestic product, through illicit financial flows annually. This deprives governments of much-needed funds for development, undermines transparency and accountability, and erodes public trust in institutions.

There are two types of illicit financial flows – illegal capital and illicit capital. Illegal capital includes laundering of criminal proceeds, such as drug and human trafficking, and corruption in the form of bribing officials and stealing state assets. Illicit capital encompasses wide-ranging market and regulatory abuses, such as trade misinvoicing and tax abuse.

The latter forms the biggest source of illicit financial flows in Africa, with an estimated US$50 billion annually lost across the continent due to tax evasion and avoidance mainly by the private sector.

Tax avoidance is legal, while tax evasion is illegal and constitutes a criminal act. There’s a thin line and often blurry line between tax evasion and legal tax avoidance. One key feature of tax avoidance used by companies is the double taxation agreement (DTA).

Countries should review and renegotiate outdated and even current DTAs that no longer reflect the present economic conditions

Simply put, DTA is an agreement between two countries to ensure that income gained in one and received in the other is taxed only once. This seems fair and makes sense. For example, an international construction company operates in South Africa and has a subsidiary in Namibia. One way to prevent the company’s assets, products, or profits from being taxed in both jurisdictions is through a double taxation treaty between Namibia and South Africa.

Such agreements then prevent the same asset, income stream, or transaction from being taxed more than once. It also aims to prevent instances where two countries assume jurisdiction over the same asset, income, or transaction.

DTAs are effective in reducing or removing tax barriers and attracting foreign investments. According to the United Nations Model Taxation Convention, other benefits include ‘greater access to foreign technology and skills, flow-on benefits to the local economy from [foreign direct investments], increased certainty for taxpayers and tax administration and protection for investment abroad.’

However, and here is where the thin line blurs, DTAs have also been used by foreign and local companies to pay as little tax as possible or no tax at all. Assisted by accounting and advisory firms, multinationals shift their profits from high-tax to low-tax jurisdictions. While this may make sense for the bottom line, it is highly questionable and at odds with the intention of such agreements. A 2013 presentation by a major accounting and consulting firm demonstrated how companies are able to structure their investments through Mauritius to enjoy significant tax advantages.

Africa loses around $88.6 billion, equivalent to 3.7% of its gross domestic product, through illicit financial flows annually

This presentation also described the scenario of a foreign company investing in Mozambique. The company would be expected to pay a 20% withholding tax on its dividends and a 32% tax bill should it decide to sell its investments in the country.

However, if the company opened a holding company in Mauritius, the withholding tax would be around 8% and the tax on capital gains would be reduced to 0% due to the double taxation treaty between the two countries. It’s not hard to deduce which is more appealing to the holding company.

Increasingly, DTAs that are meant to reduce taxation burdens between two countries, are instead being misused as a key facilitator of illicit financial flows from Africa. This money that would have accrued to the public purse and used for financing public services such as education, healthcare, and social welfare, is simply not available.

To curb this problem, regular reviews and renegotiations of outdated and even current DTAs containing unfavourable tax provisions are likely to reduce revenue leakage. Several African countries are already doing this.

So too, improving transparency in the (re)negotiation of DTAs is essential in addressing the problems associated with them. This could take the form of public disclosure of information on the negotiation and renegotiation processes of DTAs. Governments could put in place policies guiding the negotiation and implementation of such agreements and open consultations beyond the countries’ revenue authorities and finance ministries to include tax and financial experts from the private sector, civil society, and academia.

The fact that African countries have started paying closer attention to their DTAs is encouraging

Meanwhile, the potential fallout from being placed on the blacklist or being sanctioned due to their weak monetary legislation is a compelling reason for low-tax jurisdictions or tax havens to take measures to deal with the challenge of tax avoidance through DTAs.  A key example of how to achieve this is the case of Mauritius.

In 2019, Mauritius’s government announced several measures aimed at preventing the island from being used as a tax avoidance hub. These were based on recommendations by the Organisation for Economic Co-operation and Development’s Forum on Harmful Tax Practices and the European Union Code of Conduct Group.

One recommendation, in particular, included amending the rules for determining tax residency for companies. Previously, a foreign company would be considered a tax resident if it set up its corporate offices in Mauritius while being managed and controlled outside the island. Under the new amendments to the Financial Services Act of 2007, this will no longer be the case. Any company centrally managed and controlled from outside the island won’t be considered a tax resident.

Under the new legislation, the Deemed Foreign Tax Credit regime which provided up to 80% reduction to foreign companies was abolished and the rate of tax for both domestic and foreign companies has been harmonised at 15%. Also, to be considered a tax-paying resident, the company’s core income-generating activities must be carried out in or from Mauritius.

These measures alone won’t eradicate tax avoidance by foreign companies. Some businesses would rather move to another tax haven jurisdiction than implement measures to curb tax avoidance.

However, the fact that African countries have started paying closer attention to their DTAs is encouraging. It’s a small but crucial step in curbing the exploitation of taxation agreements by major companies and in so doing curbing the sleaze of doing business.

Richard Chelin, Senior Researcher, ENACT Project

Photo © Tony Cenicola

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