East Africa: New Rules Will Ensure Profits Are Tied to Economic Activities

What is the whole point of the 15 actions in the Base Erosion and Profit Shifting (BEPS) code? How will they curb tax dodging and make taxation of multinationals more transparent?

Historically, the interaction of different tax policies lead to instances where taxes paid are not commensurate to economic value created has led to instances such as no tax being paid or double deductions for the same expense in multiple tax jurisdictions. In essence, the BEPS measures ensure that there is a clear alignment between profits and economic activities and that profits are not divorced from economic activities.

The BEPS actions focus on substance, coherence and transparency. The substance measures ensure that economic value will be taxed where it is created. Actions such as reduction in scope of activities that do not create a permanent establishment and measures such as revised guidance on intangibles will reduce tax avoidance through transfer pricing.

The BEPS coherence actions aim at removing gaps created by interaction of different tax systems such as hybrid mismatches and excessive interest deductions.

Finally, the transparency actions propose disclosure by MNCs of economic activities and taxes paid in each jurisdiction. These actions will persuade MNCs to align their tax outcomes with value creation as tax agencies will now have adequate information to identify any misalignment.

Have you come across particular disputes with the tax agencies in East Africa that would have been quicker to resolve were the new rules in place?

We have come across instances where application of the BEPS measures would have given the revenue agencies greater standing in law to make transfer pricing and tax assessments.

Implementation of the BEPS actions does not necessarily mean that disputes will become easier to resolve. It will however be easier for disputes to be resolved in favour of the tax agencies.

It is expected that there will be increased tax disputes between taxpayers and revenue agencies arising from implementation of the BEPS actions. It is on this basis that one of the BEPS action items (action 14) focuses on measures to make dispute resolution mechanisms more effective.

Multinationals have expressed concern that the actions will lead to higher compliance costs and disclosure of proprietary information to third parties without any undertakings on confidentiality. What are your views on this; is there a middle way?

There is no doubt that the BEPS measures will lead to increased costs of compliance for taxpayers, what with their requiring services of specialised tax professionals both as external advisers and consultants to advise them on their tax policies and ensure that these are BEPS compliant.

Measures such as country- by-country reporting also require full disclosure to the revenue agencies of an MNC’s economic activity in each jurisdiction that it operates in on parameters such as number of staff, type of assets, profits and taxes paid. Depending on the exact industry of the taxpayer, such disclosures may include proprietary information that could harm the taxpayer’s business when disclosed to the general public. It will be up to the revenue agencies to uphold the confidentiality of information that they receive.

However, do note that there are revenue thresholds for which MNCs would be required to implement country by country reporting and only the very large MNCs will be over this threshold. Such MNCs are accustomed to increasing compliance requirements and often have capacity to deal with such requirements.

Specific to East Africa, how acute is transfer pricing as a tax dodging tactic? The actions talk of making it more “at arm’s-length.” How can this be achieved?

Where the transfer pricing is not on an arm’s length basis and is not reflective of the way in which transactions would have been priced between unrelated parties, then transfer pricing can be seen as eroding the tax base.

There are instances where transfer pricing is used as a tax avoidance tool. However, the vast majority of transfer pricing disputes in the region are in relation to what percentage of profits should be taxed in country vis-a-vis offshore. There the issue is more of profit allocation and less of tax avoidance.

The BEPS transfer pricing actions are principally concerned with ensuring that transfer pricing outcomes are in line with value — creation commonly referred to as economic substance. These actions, for example contain measures such as ensuring that parties that earn returns from intangible property are both the legal and economic owners of the intangible property.

While the arm’s-length principle remains, these measures provide enhanced guidance as to what constitutes arm’s length practices and what does not.

The actions also seek to require country-by-country reporting, for multinationals (most of them do it by region currently). How will this help curb tax avoidance ? How different would it be if taxes were assigned by sales as fronted by some multinationals?

Country-by-country reporting will curb tax avoidance through the disclosure requirements. As earlier mentioned, MNCs will be required to disclose information to tax agencies on income and taxes paid as well as other measures of economic activity such as personnel and assets in every jurisdiction they operate in.

To illustrate this, an MNC that discloses little economic activity in a country but comparatively larger profits in the same country is likely to come under the scrutiny of tax agencies as economic activities should not be divorced from profits.

The information to be disclosed under country-by-country reporting is generally not available to tax authorities and with the new, additional information, tax authorities will have access to the length and breadth of the operations of MNCs.

We are not aware of the preference by MNCs for taxes to be assigned on sales. Assignment of taxes on sales would not necessarily solve the current problems as there can be multiple sales of the same product within one MNC.

Secondly, taxation at sales level would no longer be tax on income but more akin to transaction taxes such as VAT and excise, which already exist. Further, where sales are taxed rather than profits, there is a likelihood of significantly increasing the effective tax rate of corporates, a move that many free markets would reject.

How do you see these measures affecting related party transactions like purchases, management contracts, shared infrastructure and shareholder loans?

As the East African economy is principally a source economy, the BEPS measures will put transactions such as management contracts, shared infrastructure and shareholder loans in sharp focus.

The BEPS transfer pricing actions contain comprehensive guidance on what constitutes a value adding management service and what does not, including guidance on what the arm’s-length charge for management services should be. Where management charges do not meet these criteria, these are likely to be disregarded by tax authorities.

The BEPS actions also contain guidance regarding what level of interest should be earned by a non-resident lender that provides interest with the general underlying theme being that interest earned should be closely aligned with the risks that the loan provider is managing.

Where a non-resident does not perform functions to mitigate the risks of the resident (to whom the loan has been advanced), it should earn no more than a risk-free interest.

There recently has been an uproar about companies with the bulk of their operations in Kenya/East Africa registering in Mauritius, where low taxes and double taxation treaties minimise exposure to revenue authorities. Is this likely to change with the actions in place and why?

First, it is important to note that the Kenya-Mauritius Double Tax Treaty is not yet in force. Second, there are non-tax issues as to why companies register their African holding companies in Mauritius. It is important to further note that it is not the operating companies that are registered in Mauritius but the holding companies.

However, it is recognised that low-tax jurisdictions may have provided favourable tax outcomes where transactions are routed through such countries and or tax treaty locations for no other purpose than to take advantage of the preferential tax regime in these jurisdictions, despite no significant economic activity taking place in these jurisdictions.

The BEPS measures recognise abuse of tax heavens and double tax treaties. Infact, BEPS action 6 contains detailed guidance on curbing abuse of treaties. BEPS action 6 has introduced recommendations such as the “limitation of benefit test” and the “principal purpose test” to act as safeguards against structuring fictitious transactions that have no economic purpose other than reduction of taxes paid.

The East African economies will be keen to implement the proposed BEPS measures either through revisions in their double tax treaties or changes in the local legislation. The Finance Act 2014 saw Kenya introduce a limitation of benefit clause in its local legislation.

The above measures mean that there are now higher thresholds created for access to double tax treaties and requirement for economic substance even in low-tax jurisdictions.

When, in your view, are these measures likely to come into force and what prior actions are necessary?

It is difficult to give a precise date for commencement but it is expected that over the next couple of years, BEPS measures will come through to developing countries either through changes in domestic legislation and double tax treaties that developing countries have signed and will sign in the future.

Representatives from the Kenya Revenue Authority have attended various meetings with the OECD as representatives of developing countries with the aim of contributing to the BEPS agenda.

How does this affect your work as an accountant/auditor and that of regulators (Treasury) and collectors (revenue agencies)?

More and more taxpayers now recognise a tax adviser as a key influencer of a company’s business strategy, which means more businesses will now require the services of a tax specialist. On the other hand, the BEPS measures mean there is a higher bar required of the work of a tax specialist to make sure that all advice given is robust and in line with BEPS measures.

Treasury and revenue agencies need to work hand in hand to ensure that measures to pass BEPS proposals are legislated. In particular, the revenue agencies need to ensure their staff have skills to apply the BEPS proposals in their audit methodologies.