Double Taxation Agreements: How they Work
Category: Taxation
By: Faith Nzomo,
Introduction
According to the United Nations, Double Taxation Agreements (DTAs) are “bilateral agreements between two countries which allocate taxing rights over income between those two countries thereby preventing double taxation of income. The main objective of DTAs therefore, is to prevent and or eliminate avoidance and evasion of taxes on income and capital by both individuals and companies particularly, multinational enterprises. The negotiation process is on a “give” and “take” basis and involves one country giving up their taxing rights (or opting for reduced tax rates) while the other country takes up the foregone rights. Since DTAs offer reduced tax rates, they incentivise individuals and corporations operating in foreign jurisdictions to pay taxes.
Generally, DTAs combat double taxation thus reducing tax avoidance. They have however proven to provide additional benefits especially to developing countries (DCs). This is because removal of tax barriers creates favourable business environment, therefore increasing inflow of foreign investment. Multinational enterprises moving into these DCs brings with them foreign improved technologies and better expertise. This in return contributes to the overall improvement of production capacity – hence increased profitability and ultimately, increased tax revenue. Again, since more entities and individuals are now willing to pay taxes, tax administrations become more certain and can easily predict the amount of tax revenue expected. There is also increased consistency in terms of treatment of tax laws in the two jurisdictions involved. Overall, this fosters more cooperation amongst the two countries and thus leads to strengthening of international relations.
States seeking to enter into DTAs use two main models as a guide during negotiation. The first model is the United Nations Model Convention, and as the name suggests, was designed and developed by the UN. This model seeks to give the host country of investment (source country) more taxing rights than the residence country (resident country) of investor. Most source countries are the DCs; thus, the UN model convention seeks to protect them by allocating more taxing rights to them since they are believed to have low negotiating power. On the contrary, the second model, which was developed by the Organization for Economic Cooperation and Development (OECD), is skewed towards developed countries or in this case, the resident country. The model, popularly known as the OECD Model Convention, seeks to provide more taxing rights to resident country which in this case, are mostly developed countries and owners of capital. See Box 1 for further illustration.
Both the UN and OECD models contain articles which are designed to either encourage retention of source country’s taxing rights (UN model) or encourage retention of resident country’s taxing rights (OECD model). For instance, the time limit threshold placed for permanent establishment under article 5 on Permanent Establishment is six months in the UN model and twelve months in the OECD model. In the same paragraph, the UN model has expanded the definition of Permanent Establishment to cover assembly and supervisory activities, thereby increasing the tax base, while the OECD model has omitted these activities.
Kenyan Perspective
DTAs in Kenya are negotiated by the DTA negotiating committee, consisting of members from several institutions including, The National Treasury and Economic Planning, Kenya Revenue Authority (KRA), and Office of Attorney General (OAG). The UN and OECD models and a draft Kenyan model serve as starting point for the country to enter into DTA negotiations. Several rounds of negotiation take place depending on how agreeable the parties are regarding the applicable rates of taxes on income and capital. Under the laws of Kenya, DTA making process is governed by two laws, namely; the Statutory Instruments Act, 2013, and Treaty Making and Ratification Act, 2012. Failure to adhere to these laws leads to nullification of the Agreements reached. Upon conclusion of the negotiation process, the draft Agreement is signed by competent authorities from both parties and then subjected to the ratification process in both countries. In Kenya, the ratification process begins with the submission of the signed draft to the Cabinet for approval. Approval by cabinet paves way to gazettement of the Agreement by the Attorney General. The process then ends with the approval or rejection of the DTA by members of the National Assembly. The end of the ratification process, whatever the outcome, signifies the beginning of the Entry into force as per the “Entry into Force” Article of the DTA.
The Kenyan Government has not been left behind on matters of treaty-making. Data from The National Treasury[1] shows that the country has successfully enforced a total of fourteen DTAs, and is in the process of negotiating five additional ones. However, there is no publicly available information as to how well we are doing as a country on this matter. Some of the active DTAs that the country already has include: DTAs with The Governments of Canada, Zambia, France, Iran, South Africa and the United Kingdom. Most of these DTAs follow a mix of both the UN and the OECD models. It is worth noting that, despite the considerable efforts made, the country is yet to conclude a large number of DTAs. Most of these pending agreements have already undergone the internal processes and have been signed. But due to failure to follow the laid down rules and regulations, the DTAs have either been nullified or are being revised to take into account recommendations based on public participation processes. A good example is the nullification of the DTA between the Government of Kenya and the Government of Mauritius on account of failure to subject the Agreement to public participation as stipulated under Kenya’s Treaty Making and Ratification Act, 2012.
The emerging challenges
The process of negotiation, signing and implementation of DTAs is plagued with numerous challenges, some of which stem from the long processes involved, lack of administrative capacity and high costs involved.
(i). Treaty shopping
This is an attempt by a non-resident individual or entity accessing benefits of a DTA between two states without being a resident of either state. It can lead to reduction of benefits in the form of tax revenues meant to accrue to the member states involved.
(ii). Interpretation of DTAs
Improper interpretation of DTAs due to limited understanding or even exclusion of some articles can provide loopholes for Treaty abuse practices. DTAs are generally complex documents comprising different articles. Some of these articles are not straightforward and thus pose challenges to tax authorities and businesses as to how and when they are applicable. Exclusion of important articles has also proven to be detrimental to the successful implementation of DTAs. A good example is the exclusion of the article on Professional and Management fees in the Kenya-South Africa DTA. This led to the dispute between KRA and Mckinsey, a company incorporated in South Africa and operating as a branch in Kenya. The contention was as to whether professional fees should be taxed under “other income” or it was part of the business profit. The dispute was later resolved by the Tax Tribunal and it was ruled that, in the absence of this article, professional fees would fall under business profits. Finally, DTAs could contradict interpretation of domestic law, especially when the negotiating parties don’t do further research to understand the impact of such agreements on domestic law.
(iii). Lack of capacity
This is mainly witnessed in developing countries. Tax administration authorities in these countries lack capacity to, for example, assist in the collection of tax revenue and provision of tax information. This could easily result to tax avoidance contrary to the objectives of these agreements.
(iv). High costs involved
DTA negotiations are costly since the processes takes two or more rounds and involve travelling of parties involved hence needing a lot of time and resources which are not readily available. Sometimes internal processes such as recommendations from public participation or even external changes such as changes in international trade laws, would require reopening of already concluded DTAs leading to prologing time required to finalize DTAs and inflating overall costs of negotiation.
To address some of these challenges, the OECD, in 2013, in collaboration with G20 countries launched an inclusive Framework on Base Erosion and Profit Shifting (BEPS) Multilateral Instruments Action plan. The Action Plan, to which Kenya is a signatory, seeks to amend DTAs by providing solutions which are designed to close loopholes in tax treaties and enhancing transparency through exchange of information.
Conclusion
DTAs have the potential of providing countries, like Kenya, with alternative sources of revenue, especially if the agreements work the way they are supposed to. However, before entering into these agreements, the key DTAs issues that the country should be aware of include: the costs and time it takes to negotiate, the benefits to be reaped from these agreements and the potential challenges the negotiators are likely to face. It is evident that, the country is in dire need of alternative sources of revenue and therefore, successful negotiation and finalization of DTAs would represent a crucial stride towards achieving the national budget goals. Impediments to successful negotiation and implimentation of DTAs should therefore, be carefully analyzed and eliminated. At the same time, further analysis should be done to ascertain the actual monetary benefits that DTAs can bring to the country. Going forward, the Kenya Revenue Authority and The National Treasury should make information around DTA available to foster transparency and accountability
References
https://www.oecd.org/tax/beps/beps-actions/
Organization Economic Cooperation Development Model Tax Convention on Income and on Capital, 2017 Update. https://www.oecd.org/ctp/model-tax-convention-on-income-and-on-capital-full-version-9a5b369e-en.htm
United Nations Model Double Taxation Convention between Developed and Developing Countries, 2017 Update. https://www.un.org/esa/ffd/wp-content/uploads/2018/05/MDT_2017.pdf
[1] https://www.treasury.go.ke/agreements/
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Double Taxation Agreements: How they Work
| Post date: Wed, Mar 13, 2024 |
| Category: Taxation |
| By: Faith Nzomo, |
Introduction
According to the United Nations, Double Taxation Agreements (DTAs) are “bilateral agreements between two countries which allocate taxing rights over income between those two countries thereby preventing double taxation of income. The main objective of DTAs therefore, is to prevent and or eliminate avoidance and evasion of taxes on income and capital by both individuals and companies particularly, multinational enterprises. The negotiation process is on a “give” and “take” basis and involves one country giving up their taxing rights (or opting for reduced tax rates) while the other country takes up the foregone rights. Since DTAs offer reduced tax rates, they incentivise individuals and corporations operating in foreign jurisdictions to pay taxes.
Generally, DTAs combat double taxation thus reducing tax avoidance. They have however proven to provide additional benefits especially to developing countries (DCs). This is because removal of tax barriers creates favourable business environment, therefore increasing inflow of foreign investment. Multinational enterprises moving into these DCs brings with them foreign improved technologies and better expertise. This in return contributes to the overall improvement of production capacity – hence increased profitability and ultimately, increased tax revenue. Again, since more entities and individuals are now willing to pay taxes, tax administrations become more certain and can easily predict the amount of tax revenue expected. There is also increased consistency in terms of treatment of tax laws in the two jurisdictions involved. Overall, this fosters more cooperation amongst the two countries and thus leads to strengthening of international relations.
States seeking to enter into DTAs use two main models as a guide during negotiation. The first model is the United Nations Model Convention, and as the name suggests, was designed and developed by the UN. This model seeks to give the host country of investment (source country) more taxing rights than the residence country (resident country) of investor. Most source countries are the DCs; thus, the UN model convention seeks to protect them by allocating more taxing rights to them since they are believed to have low negotiating power. On the contrary, the second model, which was developed by the Organization for Economic Cooperation and Development (OECD), is skewed towards developed countries or in this case, the resident country. The model, popularly known as the OECD Model Convention, seeks to provide more taxing rights to resident country which in this case, are mostly developed countries and owners of capital. See Box 1 for further illustration.
Both the UN and OECD models contain articles which are designed to either encourage retention of source country’s taxing rights (UN model) or encourage retention of resident country’s taxing rights (OECD model). For instance, the time limit threshold placed for permanent establishment under article 5 on Permanent Establishment is six months in the UN model and twelve months in the OECD model. In the same paragraph, the UN model has expanded the definition of Permanent Establishment to cover assembly and supervisory activities, thereby increasing the tax base, while the OECD model has omitted these activities.
Kenyan Perspective
DTAs in Kenya are negotiated by the DTA negotiating committee, consisting of members from several institutions including, The National Treasury and Economic Planning, Kenya Revenue Authority (KRA), and Office of Attorney General (OAG). The UN and OECD models and a draft Kenyan model serve as starting point for the country to enter into DTA negotiations. Several rounds of negotiation take place depending on how agreeable the parties are regarding the applicable rates of taxes on income and capital. Under the laws of Kenya, DTA making process is governed by two laws, namely; the Statutory Instruments Act, 2013, and Treaty Making and Ratification Act, 2012. Failure to adhere to these laws leads to nullification of the Agreements reached. Upon conclusion of the negotiation process, the draft Agreement is signed by competent authorities from both parties and then subjected to the ratification process in both countries. In Kenya, the ratification process begins with the submission of the signed draft to the Cabinet for approval. Approval by cabinet paves way to gazettement of the Agreement by the Attorney General. The process then ends with the approval or rejection of the DTA by members of the National Assembly. The end of the ratification process, whatever the outcome, signifies the beginning of the Entry into force as per the “Entry into Force” Article of the DTA.
The Kenyan Government has not been left behind on matters of treaty-making. Data from The National Treasury[1] shows that the country has successfully enforced a total of fourteen DTAs, and is in the process of negotiating five additional ones. However, there is no publicly available information as to how well we are doing as a country on this matter. Some of the active DTAs that the country already has include: DTAs with The Governments of Canada, Zambia, France, Iran, South Africa and the United Kingdom. Most of these DTAs follow a mix of both the UN and the OECD models. It is worth noting that, despite the considerable efforts made, the country is yet to conclude a large number of DTAs. Most of these pending agreements have already undergone the internal processes and have been signed. But due to failure to follow the laid down rules and regulations, the DTAs have either been nullified or are being revised to take into account recommendations based on public participation processes. A good example is the nullification of the DTA between the Government of Kenya and the Government of Mauritius on account of failure to subject the Agreement to public participation as stipulated under Kenya’s Treaty Making and Ratification Act, 2012.
The emerging challenges
The process of negotiation, signing and implementation of DTAs is plagued with numerous challenges, some of which stem from the long processes involved, lack of administrative capacity and high costs involved.
(i). Treaty shopping
This is an attempt by a non-resident individual or entity accessing benefits of a DTA between two states without being a resident of either state. It can lead to reduction of benefits in the form of tax revenues meant to accrue to the member states involved.
(ii). Interpretation of DTAs
Improper interpretation of DTAs due to limited understanding or even exclusion of some articles can provide loopholes for Treaty abuse practices. DTAs are generally complex documents comprising different articles. Some of these articles are not straightforward and thus pose challenges to tax authorities and businesses as to how and when they are applicable. Exclusion of important articles has also proven to be detrimental to the successful implementation of DTAs. A good example is the exclusion of the article on Professional and Management fees in the Kenya-South Africa DTA. This led to the dispute between KRA and Mckinsey, a company incorporated in South Africa and operating as a branch in Kenya. The contention was as to whether professional fees should be taxed under “other income” or it was part of the business profit. The dispute was later resolved by the Tax Tribunal and it was ruled that, in the absence of this article, professional fees would fall under business profits. Finally, DTAs could contradict interpretation of domestic law, especially when the negotiating parties don’t do further research to understand the impact of such agreements on domestic law.
(iii). Lack of capacity
This is mainly witnessed in developing countries. Tax administration authorities in these countries lack capacity to, for example, assist in the collection of tax revenue and provision of tax information. This could easily result to tax avoidance contrary to the objectives of these agreements.
(iv). High costs involved
DTA negotiations are costly since the processes takes two or more rounds and involve travelling of parties involved hence needing a lot of time and resources which are not readily available. Sometimes internal processes such as recommendations from public participation or even external changes such as changes in international trade laws, would require reopening of already concluded DTAs leading to prologing time required to finalize DTAs and inflating overall costs of negotiation.
To address some of these challenges, the OECD, in 2013, in collaboration with G20 countries launched an inclusive Framework on Base Erosion and Profit Shifting (BEPS) Multilateral Instruments Action plan. The Action Plan, to which Kenya is a signatory, seeks to amend DTAs by providing solutions which are designed to close loopholes in tax treaties and enhancing transparency through exchange of information.
Conclusion
DTAs have the potential of providing countries, like Kenya, with alternative sources of revenue, especially if the agreements work the way they are supposed to. However, before entering into these agreements, the key DTAs issues that the country should be aware of include: the costs and time it takes to negotiate, the benefits to be reaped from these agreements and the potential challenges the negotiators are likely to face. It is evident that, the country is in dire need of alternative sources of revenue and therefore, successful negotiation and finalization of DTAs would represent a crucial stride towards achieving the national budget goals. Impediments to successful negotiation and implimentation of DTAs should therefore, be carefully analyzed and eliminated. At the same time, further analysis should be done to ascertain the actual monetary benefits that DTAs can bring to the country. Going forward, the Kenya Revenue Authority and The National Treasury should make information around DTA available to foster transparency and accountability
References
https://www.oecd.org/tax/beps/beps-actions/
Organization Economic Cooperation Development Model Tax Convention on Income and on Capital, 2017 Update. https://www.oecd.org/ctp/model-tax-convention-on-income-and-on-capital-full-version-9a5b369e-en.htm
United Nations Model Double Taxation Convention between Developed and Developing Countries, 2017 Update. https://www.un.org/esa/ffd/wp-content/uploads/2018/05/MDT_2017.pdf
[1] https://www.treasury.go.ke/agreements/
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The Price Control Act of 2011, with its imposition of price ceilings on essential goods, represents a significant intervention in the natural forces of supply and demand that govern a free market. The Act empowers the Minister to control the prices of essential goods, preventing them from becoming unaffordable. The Act outlines a specific mechanism […]
Why is Kenya’s Fiscal Consolidation Agenda Facing Failure?
The earliest proposition of fiscal consolidation can be traced back to the Keynesian theory which argues that fiscal austerity measures reduce growth and increases unemployment through aggregate demand effects. According to this theory, government undertaking contractionary fiscal policies of either reducing government spending or increasing tax rates, will eventually suffer a reduction in aggregate demand […]
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We recommended (“And then, Floods”) that the Central Bank of Kenya policy rate should be lowered by 300 basis points, from 13 to 10 percent, from August 6. Instead, a reduction of just 25 basis points, from 13 to 12¾, was made on that date. Someone is wrong. Who? In explaining the 25bp decision, it […]
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