In Africa, the Big Five are the lion, leopard, rhinoceros, elephant and Cape buffalo. For investors in Africa, fast-paced and fundamental international tax changes, both in African countries and at the Organisation for Economic Co-operation and Development (OECD) and UN level, require careful assessment of the Big Five of tax structuring: capital gains tax, withholding tax, permanent establishment, corporate income tax, and investment protection planning through the use of bilateral investment treaties.
In practice, foreign investors will want to explore legal structures and set-ups that provide them with a favorable post-tax return on investment. Therefore, in addition to a favorable bilateral investment treaty network, potential holding jurisdictions should have an extensive double tax treaty network that could aid in the prevention of any unnecessary tax leakage. For investing into Africa, certain holding jurisdictions including Mauritius, the Netherlands, the UAE and the UK will continue to be favored by those foreign investors.
For such holding jurisdictions to be effective, in light of the OECD's new principal purpose test (PPT) rule and in order to successfully claim tax treaty benefits (if any), companies should avail themselves of adequate local substance (e.g. office space, qualified personnel, and key decision-making). In our view, this development is likely to encourage centralization of activities, people and functions in one place or a few places globally by international businesses, resulting in the formation of global or regional investment platforms. From an Africa inbound investment perspective, the four holding jurisdictions mentioned above are well equipped to do just that, even though the tax structuring of each individual investment should be carefully analyzed.
Characteristics of the Big Five
Compared to other regions, African countries generally have relatively high levels of domestic taxation, which can erode profitability.
Capital gains tax (CGT)
In most countries, CGT is levied on the capital gains (profits) realized on the sale of an asset that increased in value under certain circumstances, such as the shareholding in a local subsidiary. Tax treaties can allocate taxing rights to the investor country, as opposed to the source country.
Several African countries have issued legislation that allows for CGT in case of an indirect transfer of assets (such as indirect share transfers). These include Cameroon, Kenya, Mozambique, Tanzania and Uganda.
Withholding tax (WHT)
WHT can be levied on a wide array of payments, including dividends, interest and royalties. Some African countries also levy WHT on payments for services, such as management services. In Liberia, WHT is imposed on proceeds (as opposed to capital gains arising). In certain situations, tax treaties can reduce such WHT (e.g. to 0 or 5 percent) or eliminate it altogether.
Permanent establishment (PE)
Activities carried out by a business in another country resulting in revenue being generated or value created can be deemed taxable by local tax authorities. This concept, generally referred to as a PE (or a fixed establishment), may require the revenue-generating foreign company to formally register under some corporate identity, such as a branch, representative office or subsidiary.
Many tax treaties define permanent establishment. Generally speaking, tax treaties are based on either the OECD Model Tax Convention on Income and on Capital (OECD Model Tax Convention), or the United Nations Model Double Taxation Convention between Developed and Developing Countries (UN Model Tax Convention). In the OECD Model Tax Convention, essentially three types of PE can be construed:
- A fixed place of business PE
- A construction or project PE, which is a special subset of the fixed place of business permanent establishment, with different requirements such as a set period of a project's duration in-country
- An agency PE, through the actions of a dependent agent
The UN Model Tax Convention, which gives greater consideration to developing countries, adds what is known as a service PE, where merely the provision of services to customers in a source country (i.e. without any further tangible presence) can create a PE taxable therein. In addition to the definition of the PE concept itself, tax treaties provide guidance on the allocation of profits between the PE and the foreign company.
In addition to tax treaties, some African countries may have local guidance on what does and does not constitute a PE. For example, South Africa released a binding private ruling in May 2010, stating that the presence of a database replica and a web server will constitute a PE of a foreign company (which in some other countries has been subject to debates for years).
Corporate income tax (CIT)
Each African country will have its own CIT regime, the details of which require careful consideration prior to making an investment. Investors should pay attention among others to transfer pricing (TP) requirements and interest deductibility restrictions, such as thin capitalization rules. For example, Nigeria has very recently revised and strengthened its TP regulations.
Bilateral investment treaties (BITs)
Although the fifth category of the Big Five of tax structuring – BITs – is not a tax matter, it is nevertheless an extremely important consideration for international investors, as it can significantly reduce local country risk exposure. Historically, BITs are developed by capital-exporting countries to promote investment and protect their nationals' interests in capital-importing countries.
BITs impose a number of obligations for the host country with respect to the foreign investments. In broad terms, the nationalization or expropriation of investments is typically prohibited under the BITs, unless such measures are taken in the public interest and the host state pays prompt, adequate and effective compensation to the investor. Other obligations typically found in BITs require the host state to be fair and equitable in how they treat foreign investments, and to treat foreign investments at least as favorably as investments made by nationals of the host state.
BITs generally offer international arbitration as the means of resolving investor-state disputes. This provides the investor with the possibility of bringing a claim directly against the host state in a neutral forum, if the investor believes that the state has violated any of the substantive protections available under the BIT. In many instances, such disputes are brought under the auspices of the International Centre for Settlement of Investment Disputes (ICSID), although other options are sometimes available, including ad hoc arbitration under the UNCITRAL Arbitration Rules. The investor should seek advice on the relative merits of the potential avenues available before asserting a claim.
The right base camp
There are several factors to consider when setting up a base camp for (intermediate) holding and finance companies. The primary function is to position investors optimally regarding the Big Five of tax structuring, while securing legal rights with respect to the investments. We will focus on four jurisdictions currently popular among Africa-focused investors: Mauritius, the Netherlands, the UK and the UAE.
First of all, the right country provides tax benefits to foreign investors at the following levels:
- Reduced WHT and CGT protection at source country level (with the use of tax treaties)
- Efficient tax treatment at intermediate level (such as participation exemption for dividends and capital gains)
- Reduced or no WHT on repatriation of income by the intermediate holding to investors
- A BIT network for protection against nationalization/expatriation
Over the last years, this island in the Indian Ocean has become a gateway for the African mainland. This success is in large part due to a relatively large double tax treaty network, and 0 percent WHT on dividends, interest and royalties. The standard corporate income tax regime is also competitive.
In addition, Mauritius has many non-tax advantages, including its position as one of Africa's most interconnected countries and over 25 BITs with African countries that mitigate the risk of nationalization.
In late 2016, Mauritius joined the OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS) by adding a rider stipulating that it would review all its tax treaties to bring them up to G20 minimum standards by the end of 2018. Regardless, assuming investors can demonstrate adequate substance at the intermediate holding level, Mauritius is still a viable option in light of its extensive double tax treaty network.
The Dutch have always been known for their affection with international commerce and trade. At present, the Netherlands has one of the largest double tax treaty and BIT networks worldwide. Further, pursuant to the so-called participation exemptions, benefits derived from foreign participations (e.g. dividends and capital gains) are generally exempt from Dutch CIT.
At present, the Netherlands does not impose WHT on interest and royalties. On September 18, 2018, the Dutch government published tax proposals outlining the government’s intention to further enhance the investment climate for groups with operations in the Netherlands, by lowering the corporate tax rate to 22.25 percent in 2021 and abolishing the current dividend withholding tax (of 15 percent) by 2020. The government also seeks to introduce new measures, including a conditional WHT on royalties, interest, and dividends, and an increase in the substance requirements for Dutch holding/license/financing companies to stay aligned with the latest international (OECD/EU) tax developments.
Similar to the Netherlands, the UK has an extensive double tax treaty and BIT network, and levies no CGT on the sale by an investor of its interest in a UK company. It also provides a tax exemption on the sale by a UK holding company of its interest in (trading) subsidiaries. Further, no UK WHT is levied on outbound dividends. Apart from tax advantages, the UK historically has close ties with many countries on the African continent.
In light of the impending withdrawal of the UK from the EU, the UK may lower its CIT rate and provide additional incentives to keep and attract businesses. At the time of writing, the precise impact of Brexit is not yet clear.
Strategically situated between Europe, Asia and Africa, the UAE is actively promoting its African trade and investment links, and has been very successful in doing so. Further, the UAE does not levy CIT, CGT or WHT. Over the last decade, the UAE has been massively expanding its double tax treaty and BIT network, including with many African countries. In order to promote foreign investments, the UAE has set up numerous free-trade zones that are governed pursuant to a special framework of rules and regulations and generally provide additional tax concessions and customs duty benefits. These zones are extensively used by foreign investors and multinationals as regional hubs for their investments and operations in the Middle East, North Africa and Sub-Saharan Africa.
The UAE is favored among international companies and expats alike for its ease of doing business, well developed infrastructure and interconnectivity. In addition to its large harbors, the UAE provides one of the best "air lifts" in the world, where the local airlines (Emirates and Etihad) service almost every top destination on the African continent.
The matrix below provides an overview of the number of tax treaties and BITs concluded between the aforementioned countries and African countries.
* Entered into with African countries.
There has been growing concern in various African countries that multinationals have not been paying their fair share of source tax on the continent. As a result, many countries have been trying to strengthen their tax regimes, as well as enhance their domestic tax authorities.
In June 2018, the OECD and the African Tax Administration Forum (ATAF) signed a renewal of their Memorandum of Understanding (MoU) until June 2023, agreeing to continue to work together to further improve tax systems in Africa. The MoU sets their cooperation towards the achievement of the common objective of promoting fair and efficient tax systems and administrations in Africa. Simultaneously, the UN Committee of Experts on International Cooperation in Tax Matters is reviewing and updating the UN Model Tax Convention.
Effectively starting with the development by the OECD of its BEPS project in 2012, the international tax landscape has changed drastically in recent years. With its BEPS Action Plan published in 2015, the OECD aims to provide governments with clear international solutions for fighting corporate tax planning strategies that exploit gaps and loopholes of the current system to artificially shift profits to locations where they are subject to more favorable tax treatment.
The most recent instrument devised by the OECD to counter tax avoidance, including treaty shopping, is its Multilateral Instrument (MLI). The MLI came into force in July 2018, and provides unilaterally alters existing tax treaties by including, among others, the PPT test and a mutual agreement procedure (MAP) for countries that choose to apply the MLI for specific bilateral tax treaties concluded by them
The PPT rule denies double tax treaty benefits to a taxpayer where one of the principal purposes for entering into a transaction or arrangement was to obtain that benefit. For the rule to apply, the obtaining of a tax benefit need not be the sole or main or dominant purpose of the arrangement or transaction in question. As a result, centralization and the related concentration of actual substance, for example at the holding company level, will be instrumental for demonstrating commercial reasons and economic substance to counter another country's tax authorities' challenge under the PPT rule. Some examples of substance include having: a physical office, qualified personnel on the payroll (and on the board) for proper decision making, execution and registration of the transactions entered into by the company/group, and locally kept primary bank accounts and administration (bookkeeping).
The MAP provision will facilitate resolution of cases of double taxation as well as a proper and correct interpretation and application of the provisions of a bilateral double tax treaty by allowing taxpayers to approach the competent authorities of both states for that purpose.
Currently, the MLI has been signed by over 83 countries, covering more than 1,400 bilateral tax treaties.
UN Model Tax Convention
Tax treaties provide a balance of source country (i.e. host country) and residence country (i.e. investor country) taxation and are originally aimed to avoid double taxation. More recently, a secondary objective has been introduced: the avoidance of double non-taxation. As mentioned above, tax treaties are either based on the OECD Model Tax Convention or the UN Model Tax Convention. Both conventions come with their own set of rules and commentary and assistance to countries in negotiation processes.
There are numerous differences between the OECD Model Tax Convention and the UN Model Tax Convention. As the full name implies, the UN Model Tax Convention aims to promote greater inflows of foreign investment to developing countries. Generally speaking, the UN Model Tax Convention favors retention of greater so-called source country taxing rights. One of the significant features of the UN Model Tax Convention is a limited "force of attraction" rule, allowing the source country to tax certain profits not actually attributable under normal rules to the PE, but which relate to sales of similar goods or merchandise in the source country, as well as other business activities of the same or similar kind carried on by the enterprise in the source country.
Another significant difference between the OECD Model Tax Convention and the UN Model Tax Convention is that the latter does not contain maximum WHT rates whereas the former does (from 5 to 15 percent, depending on several conditions such as a specific minimum ownership in the paying company). As a result, tax treaties based on the UN Model Tax Convention generally have higher maximum rates than those based on the OECD Model Tax Convention.
Taking notice of the OECD's BEPS Action Plan, the United Nations Conference on Trade and Development (UNCTD) released an updated UN Model Tax Convention in May 2017 (the previous UN Model Tax Convention originated from 2011). The new UN Model Tax Convention adds a PPT as well as a limitation on benefits test (LOB) to counter double tax treaty shopping (both the PPT and LOB are also included in the OECD Model Tax Convention).
Through LOB rules, the UN Model Tax Convention seeks to target structures that are seen as typically resulting in the indirect granting of treaty benefits to persons that are not directly entitled to them. In other words, the LOB is a mechanism that addresses particular conduit arrangements.
In order to protect their tax base as efficiently as possible, it seems logical that most African countries prefer the UN Model Tax Convention over the OECD Model Tax Convention, although many of the treaties concluded with Mauritius, the UK, the Netherlands and the UAE still follow the OECD approach.
BIT renegotiations on the horizon
As is currently happening with tax treaties, there are talks in the international community about renegotiation of BITs in order to create more balance between the rights and duties of the host countries and the investors. For example, in May 2018, the Dutch Ministry of Foreign Affairs launched an internet consultation in relation to a new draft model BIT that may be the basis for the renegotiation of Dutch BITs. One of the most notable implications of this model is the introduction of substance requirements in order to benefit from BIT benefits (i.e. excluding "mailbox companies"). It can be expected that other EU Member States may follow and introduce similar criteria/restrictions. Where substance has become an increasingly important topic for tax over recent years, the same might be happening for BITs in the near future.