Developing countries are faced with several dilemmas when it comes to development, growth, and poverty reduction. To achieve their development, growth, and poverty reduction targets, a certain level of investment is needed.
The dilemma governments in developing countries, especially in Africa, face is how to raise revenue from domestic sources and through the international investment agreements they enter. Unfavourable double tax agreements particularly those signed with tax havens, not only limit taxing rights but they also open up the country to treaty abuse by unscrupulous investors who use the treaty provisions to aggressively shift their profits to avoid taxation. Forgone revenue as a result of harmful tax incentives and unfavourable double tax, trade and investment agreements have impeded state ability to deliver services.
The potential tax revenue loss for African countries is compounded by the base erosion and profit shifting (BEPS) situation that African countries find themselves in through giving up some of their taxing rights in domestic policy instruments such as double tax agreements (DTAs) and tax incentives. Sub-Saharan African countries have signed over 300 bilateral tax treaties since independence . The benefits of these treaties are yet to be proven. DTAs bind African countries into constraints on their taxing rights, and are often exploited in tax planning structures. A new IMF report concludes that “considerable caution is needed in entering into any Bilateral Tax Treaties” . A number of African countries have been offering tax incentives to multinational companies which operate in African countries in the name of attracting Foreign Direct Investment (FDI).
Tax Justice Network-Africa (TJN-A) through its study on tax competition in East Africa in 2012 highlighted that ‘Increased competition over FDI and growing pressure to provide tax holidays and other investment incentives to attract investors could result in a “race-to-the-bottom” that would eventually hurt all EAC members.’ According to the 2016 TJN-A/ ActionAid report on tax incentives Kenya, Uganda, Tanzania and Rwanda are, cumulatively, losing up to US$ 2.8 Billion annually as a result of unnecessary tax incentives. This represents in average 3.9% of the region’s GDP. It is quite clear from the above statistics that one of the urgent areas of intervention in terms of expanding and protecting African countries’ tax base is pushing for national measures that ensure domestic tax systems and policies are able to prevent engagement in these harmful treaties and tax incentives.
Key terms to know:
Domestic Resource Mobilisation-Commonly referred to as DRM, this refers to the process through which a state is able to internally raise the necessary capital, either in cash or other forms, to finance its own development agenda. This can be through taxes, bonds and levies. Increasing domestic resources to finance policies, offers governments the advantage of ownership and coherence with domestic needs.
Double taxation-Where a company or individual incurs a tax liability in more than one country, the two countries’ claims on the taxing rights can overlap, resulting in double taxation of the same declared income. Some tax avoidance strategies exploit international tax instruments in ways that were not intended, for example by ensuring that the right to tax a transaction is allocated to a country that levies no or low taxation on it.
Double tax avoidance agreement (DTA- A)/Double taxation treaty (DTT)- Agreements between states (usually in the form of bilateral treaties) that are designed to prevent an individual from being taxed on the same income (or other forms of wealth, e. g., an estate or a gift) by two different countries. This is aimed at minimising incidences of double taxation. The OECD suggests that countries often suffer from “double non-taxation” as a result of abuse of these treaties.
False invoicing- Also referred to as trade misinvoicing, this is the practice declaring incorrect value of goods imported or exported to evade customs duties and taxes, circumvent quotas or launder money. The value of goods exported is often understated or the value of goods imported is often overstated, and the proceeds are shifted illicitly overseas. Most estimates of trade-based illicit financial flows focus on this mechanism.
Tax avoidance-The legal practice adopted by taxpayers to minimize a tax bill by taking advantage of loopholes or exceptions that exist in tax regulations or adopting an unintended interpretation of the tax code. Such practices can be prevented through statutory anti-avoidance rules; where such rules do not exist are not effective, tax avoidance can be a major component of IFFs.
Tax evasion- Illegal actions by a taxpayers to minimize tax liability, this is done mostly by concealing from the revenue authority the income on which the tax liability has arisen. Tax evasion can be a major component of IFFs and entails criminal or civil penalties.
Harmful tax practices-Charging the same rates for particular types of taxes or offering reduced taxes in order to out-compete other countries especially in attracting investments. This also includes lack of effective exchange of tax information and transparency amongst countries concerned.
Thin Capitalisation- Form of indirect tax which is calculated as a percentage of the value or price of a commodity. These taxes adjust automatically to inflation. It is also referred to as ad valorem tax. A company thinly capitalised when it is financed by a higher proportions of debt than the available equity. The proportions of debt to equity that can be tolerated depends on the existing legislation which varies from one country to the other. Thin capitalisation restrict the tax benefit that can be enjoyed on interest that is charged on the said debt. Where there are no thin capitalisation rules, most companies take advantage and enjoy the tax benefit on the interest that is charged on the huge debt held in their books.
Round tripping- This is a form of barter trade which involves a company trading out unused asset to another company, while at the same time agreeing to trade them in at about the same price or posingas a foreign investor and bringing in the asset back into the country while receiving tax incentives that attract foreign direct investents. This kind of arrangement is commonly used for tax evasion and money laundering.
Double Irish Agreement/ Irish Sandwich- This is an arrangement used by multinationals in lowering their corporate tax liability by moving income from a higher-tax country to a lower or no tax jurisdiction. This arrangement was applied mostly in Ireland since its tax law lacked transfer pricing rules and no taxes were charged on income reported in subsidiaries of Irish companies that are outside Ireland.
Money Laundering- This is the process of concealing the origins of illegally obtained money by transferring the money into foreign banks and investing the same in legitimate businesses. Literally money laundering refers to a process of cleaning illegally acquired money through legitimate investments.
Treaty shopping-This process where multinational corporations structure their business with a view of taking advantage of jurisdictions with favourable double taxation treaties or with laws in place protecting financial secrecy, low taxes advanced through tax treaties available in a given jurisdiction. This practice is harmful to a number of states because they lose their right to tax certain incomes.
Domestic Resource Mobilisation- Commonly referred to as DRM, this refers to the process through which a state is able to internally raise the necessary capital, either in cash or other forms, to finance its own development agenda. This can be through taxes, bonds and levies. Increasing domestic resources to finance policies, offers governments the advantage of ownership and coherence with domestic needs.