I was asked to present on this topic at Strathmore Tax Research Centre in Nairobi's inaugural conference

1. Double tax treaties: a poisoned
chalice for developing countries?
Strathmore Business School, Nairobi
11 September 2013
Martin Hearson
m.hearson@lse.ac.uk
martinhearson.wordpress.com

2. Outline
1. Core principles
2. Tax treaties
3. Transfer pricing

3. 1. Core principles

4. The international tax regime
"I would argue that the freedom of most countries to adopt
international tax rules is severely constrained, even before
entering into any tax treaties, by the need to adapt to
generally accepted principles of international taxation.”
- Reuven Avi-Yonah, International Tax as International Law,
2007
Many countries have had to alter their international tax laws
to make them conform.
- Mexico use of formulae
- South Korea definition of PE
- US & Germany thin cap rules
- Kenya – Unilever ruling on TP

5. The international tax regime
According to Avi-Yonah, the international tax regime is based on two
core principles:
- Single taxation
- Benefits
- active income mostly taxed @ source
- passive mostly @ residence
Further principles can be derived:
- Arm’s length transfer pricing
- Non-discrimination
- Jurisdiction to tax
- Credit/exemption
- Bilateral tax treaties based on models

6. What if those principles are not the
right ones for developing countries?
For example, why not start from inter-nation equity?
“With a highly unequal distribution of resource
endowments and per capita income among countries and
in the absence of an adequate method for dealing with
the problem, an appropriate pattern of tax-imposed
national gains and losses might be used to secure some
degree of adjustment.”
- Peggy & Richard Musgrave, 1972
How would this change international tax instruments?

7. 2. Tax treaties
• Why should developing countries sign tax
treaties (or not)?
• Why do developing countries sign tax treaties
(or not)?
• What are the policy implications?
Big health warning: almost everything written
on this is by academics in Europe and the US.
Few developing country perspectives.

8. Why do countries sign tax treaties? Kenya
Partner Year In force?
Zambia 1968 F
Denmark 1972 F
Norway 1972 F
Sweden 1973 F
United Kingdom 1973 F
Germany 1977 F
Italy 1979 NF
Canada 1983 F
India 1985 F
Italy (protocol) 1997 NF
Thailand 2006 NF
France 2007 F
Iran 2009 NF
South Africa 2010 NF
UAE 2011 NF
Mauritius 2012 NF

9. Main sources of FDI into Kenya
0
500
1,000
1,500
2,000
2,500
3,000
3,500
FDIstock,end2011,US$m
Treaty in force
No treaty in force

10. Why should developing countries sign
tax treaties (or not)?
Conventional perspective
• Purpose of treaty is primarily to alleviate double
taxation, also to aid cooperation on tax evasion
• Developing country gives up tax revenue, but is
compensated through greater inward investment
– Some argue the treaty causes reallocation of capital from
residence to source country
– Others describe it as a competition effect – treaty gives a
relative advantage over other source countries
• Hence developing countries seek tax treaties
• But: evidence for effect on investment is mixed,
because it’s hard to isolate the effects of individual tax
treaties

11. Why should developing countries sign
tax treaties (or not)?
Critical perspective
• Treaty is unnecessary to alleviate double taxation,
as residence states do so unilaterally
• Primarily a political settlement through which
taxing rights are transferred from source to
residence country
• A ‘badge of respectability’ to show that countries
are part of an international economic club
• No evidence that they increase overall levels of
investment in a country

12. Do tax treaties attract foreign direct
investment? Macroeconomic studies
“The effect of treaties on foreign direct investment” (Sauvant
& Sachs, 2009) compiles a series of studies on tax treaties.
None finds a positive association for low-income countries,
and for other countries the results are mixed.
• Barthel & Neumayer, 2009, do find a positive association,
but they look at bilateral effects, not the overall level of FDI
=> treaty shopping?
• Neumayer, 2007, asks how the number of treaties affects
overall levels of investment => no association.
So, current evidence suggests tax treaties affect the
structuring of investments, but not overall levels.

13. Do tax treaties attract foreign direct
investment? Investor surveys (1)
Reasons for investing in Kenya (%)
Market in Kenya and Neighbouring countries 36
Political Stability/Economic 18
Favourable Climate 7
Stable and growing economy 7
Bilateral trade agreements 6
cheap labour and cost of production 5
Resources and Raw material availability 4
Financial systems 3
Human resource availability 2
Existence of similar businesses 2
Liberalization of the economy 1
Absence of Maximum retail price 1
Kenya's popularity world wide 1
Entrepreneurial spirit in Kenya 1
Easy process of acquiring licenses 1
EPZ concessions 1
Strategic infrastructure e.g port 1
Beauty of the people 1
Main impediments to investment in Kenya
Political instability and its neighbours 27
Crime and Insecurity 19
corruption 9
Unreliable infrastructure 7
Delays in licenses & Work permits 6
Competition 5
Lack of clear policies and regulatory
impediments
5
Climate change 4
Lack of law enforcement/weak legal
infrastructure
4
Cost of financing 4
Exchange rate volatility/Currency risk 3
Economic growth 3
Lack of skilled labour/High cost of
production
3
Lack of proper knowledge of regional
blocks
2
Source: Kinuthia, 2010. Survey of 210 businesses in Kenya, 127 responses

14. Do tax treaties attract foreign direct
investment? Investor surveys (2)
• Tax is never a high priority in investor
motivation surveys in developing countries.
• Even where tax is a factor, treaties are
probably not the most important element.
• The following slides use the Fraser Institute’s
annual survey of 4100 mining companies, of
which 720 responded. Does the number of tax
treaties influence the taxation score?

15. Do tax treaties attract foreign direct
investment? Investor surveys (2)
Source SS df MS Number of obs = 44
F( 7, 36) = 2.08
Model 1132.40654 7 161.772363 Prob > F = 0.0707
Residual 2794.54418 36 77.6262272 R-squared = 0.2884
Adj R-squared = 0.1500
Total 3926.95072 43 91.3244353 Root MSE = 8.8106
MINING Coef. Std. Err. t P>t [95% Conf. Interval]
PAYMENTS -.012905 .0361544 -0.36 0.723 -.0862294 .0604194
TIME -.005671 .0038068 -1.49 0.145 -.0133916 .0020496
PTAX .2447436 .1649603 1.48 0.147 -.0898113 .5792986
LTAX .213348 .167875 1.27 0.212 -.1271182 .5538143
OTAX -.0667492 .0383009 -1.74 0.090 -.1444272 .0109287
TREATIES -.1142176 .0575385 -1.99 0.055 -.2309111 .0024758
GDPPERCAPITA .0007269 .0003476 2.09 0.044 .000022 .0014318
_cons 41.22174 5.785293 7.13 0.000 29.48862 52.95486

16. Do tax treaties attract foreign direct
investment? Investor surveys (2)3540455055
0 20 40 60 80 100
Number of treaties
95% CI Fitted values
More treaties = less investment
friendly! But it’s not very
significant

17. Treaties and tax revenues
“The practical effect of the present network of double
taxation agreements between developed and developing
countries is to shift substantial amounts of income tax
revenues to which developing countries have a strong
legitimate and equitable claim from their treasuries to
those of developed countries. Concomitantly. these
double taxation agreements result in a very considerable
and unnecessary loss of badly needed foreign exchange
reserves for developing countries. In other words, the
present system of tax agreements creates the anomaly of
aid in reverse— from poor to rich countries.”
- Charles Irish, 1974

18. Some potential drawbacks of tax treaties
• Withholding tax rates and PE thresholds
• Capital gains tax
• Taxation of services: some countries (eg Ghana) insist on
this
• New OECD Article 7
• Anti-treaty shopping/LOB
– Unless deliberate. Baistrocchi 2008: “The developing countries
allow treaty shopping to encourage capital and technology
inflows.”
• Mutual Agreement Procedure: each case is a mini-
negotiation
• New compulsory arbitration provision: mismatch of legal
resources
• Locked in to OECD transfer pricing guidelines

19. Tax treaties concluded by sub-Saharan
countries (excluding South Africa)

20. Countries that have concluded five or more tax
treaties with sub Saharan countries

21. Policy diffusion as a framework of analysis
• Defined as when policy in one country influences that
in another
• Four diffusion mechanisms:
– Competition
– Learning
– Emulation
– Coercion
• Emphasis now is on explaining heterogeneity:
– National-level scope conditions
– Regional variation
– Non-linear patterns of diffusion

22. Using policy diffusion to explain why
countries sign tax treaties
• Neumayer & Barthel (2012) find a role for competition
in driving tax treaty diffusion.
• The more closely countries compete with each for FDI,
the more likely they are to copy each other in signing
tax treaties.
• But, a key assumption in their paper is that a treaty
signing event corresponds to a policy decision by a
developing country. This may not be valid if:
– Country is in reactive mode
– Country is proactive, but treaty partner says ‘no’ or ‘wait’

23. Questions that are rarely asked
• How are tax treaties understood by policymakers in
developing countries?
• What motivates their tax treaty policymaking?
–Almost certainly depends on the treaty partner
–Do outcomes correspond to a clearly defined policy?
• Which stakeholders are involved in the decision?
–Officials/ministers? Tax or investment promotion?
–Role of business?
–Outside organisations e.g. OECD, IMF?
• What is the role of the treaty partner
(instigator/reactor?) and what are their preferences?

24. Some comments from developing
country treaty negotiators
“Normally we negotiate when we receive requests, and have always
responded positively. It’s always a request from the other party.”
“I know that there’s a position that these treaties affect FDI, but I think
it’s not right…. We’re more or less on the waiting position. Companies
come to resource rich countries regardless, but a bit later you cannot
avoid it, you must have a treaty” as businesses expand.
“We have a new minister. He’s had several complaints from investors
saying [a country] next door has a better investment climate, because
it has tax treaties.”
“We have been working on a policy. When you negotiate you give up
your tax base and you want something in return, but we aren’t getting
anything back [in investment].”
“I’ve heard this argument that treaties do not bring investment. But
you must understand that we are afraid of losing investment. We are a
poor country and we’re at the bottom of the pile.”

25. My model to explain tax treaty events
• What triggers a treaty event?
– Change of investment policy in developing country
– Personal project of an ambassador, minister or civil servant
– Request from treaty partner
– Change of position by treaty partner
– Project to strengthen political and/or economic relations with
treaty partner
• What determines developing countries’ attitude towards a
potential treaty?
– How much the treaty partner pushes for it
– Generalised desire to appear open to investment/fear of losing
investment (tax competition)
– Political relationship with potential partner
– Economic relationship with potential partner

26. What determines US policy in
response to treaty requests?
Cables reveal one thing in particular…
• Taiwan, 2006: “there are real and immediate benefits that
would accrue to U.S. firms once a tax agreement is
implemented. One firm told us that it believes a tax
agreement would generate a 10% saving in its cost structure.”
• Macedonia, 2007: “We have advised the MFA that action on
[tax] agreements would require strong lobbying from US
companies doing business in Macedonia, which has not yet
been the case.”
• Qatar, 2008: “Post is unaware of any specific U.S. business
concerns on double taxation or other tax issues…will consult
with local U.S. business contacts”
Source: Wikileaks database of leaked US embassy cables

27. Argentina
• March 2007: requests a TIEA with the US
• US response is to say no, we will only sign a full tax
treaty with you
• November 2007, head of Argentinian tax authority
complains to US ambassador that this condition is
inconsistent, because “the U.S. in 2007 signed a TIEA
with Argentina's Mercosur partner Brazil based only on
the promise of future tax treaty negotiations.”
• 2013: the stalemate has not been resolved
Source: Wikileaks database of leaked US embassy cables

28. Bulgaria
• 2005: requests a tax treaty with the US as part of
a shopping list “to show Bulgarian voters that
participation in the [Iraq war] Coalition has
brought concrete benefits”
• The government is said to be “eager to publicly
announce this ahead of the June general
elections. They have pushed this as a major
deliverable in return for GOB support in Iraq and
Afghanistan.”
Source: Wikileaks database of leaked US embassy
cables

29. Tax treaty cancellations
• Kenya, 1973: cancelled all its colonial era treaties
“because it was recognised that the agreements
were resulting in substantial losses of tax
revenues and developed countries were found to
be dragging their feet on negotiation” (Irish,
1974)
• Mongolia, 2011-12: sought to renegotiate
treaties with Netherlands and Luxembourg,
revoked them when dissatisfied with response.
• Argentina, 2012: after an inquiry into tax treaties,
cancelled those with Spain, Uruguay and Chile.
New treaty signed with Spain immediately.

30. Tax treaty conclusions & policy implications
• Tax treaties have (tax) costs and (tax/non-tax) benefits.
• The evidence suggests that increased FDI is not a major
benefit - more likely that treaties are a consequence of
inward investment, through lobbying by investors.
• Most developing countries’ existing treaty networks do not
reflect a deliberate strategy.
• Countries should formulate a policy, based on cost-benefit
analysis: how much are they willing to give up, and for
what?
• Then revisit their treaty networks. Revoke/renegotiate, and
pursue new treaties if necessary.
• It’s not just about OECD v UN model: think outside the box
and then try to change the models (eg service fees).
• In doing so, the single tax and benefits principles may not
be the most important.

31. 3. A brief comment on transfer pricing
The arm’s length principle divides up the tax base of a
multinational according to the terms of trade in a free market.
Why should it?
- Dependency theorists argue that the terms of trade are
stacked against developing countries.
- Tax system could take account of externalised costs in
developing countries, like environmental damage,
exploitation of low-skilled labour.
The main argument made in favour of the current system is
inertia.

32. Heterodox transfer pricing methods
Methods that are designed to be simpler to enforce
without changing the division of taxing rights:
- Brazil: fixed margins
- Argentina et al: sixth method
Methods that are designed to change the division
of taxing rights:
- India and China: location specific advantages

33. Transfer pricing politics:
current state of play
• G77 have repeatedly tried and failed to strengthen the
position of the UN committee.
• Brazil, India & China using UN to articulate an
alternative position re transfer pricing:
– Chapter 10 of the UN transfer pricing manual is an
extended critique of OECD and description of how they
differ from it
– Reservations to reference to the OECD guidelines in the
UN model treaty
• The OECD is trying to reach out to developing
countries. BRICS are all associates in the BEPS project
and “will be expected to associate themselves with the
outcome

34. Transfer pricing politics:
current state of play
China: “The UN Transfer Pricing Manual must address
these common issues [with the OECD guidelines] for it to
be useful to developing countries.”
India: “[The OECD] guidelines on transfer pricing only
reflect the agreements amongst Government of those
countries that are members of OECD (developed
countries) and accordingly tend to take care of interest of
only developed countries. The guidelines do not give
right of taxation to source countries accordingly eroding
taxing rights of developing countries.”

35. Location savings
Link to presentation on Chinese system

36. Double tax treaties: a poisoned
chalice for developing countries?
Strathmore Business School, Nairobi
11 September 2013
Martin Hearson
m.hearson@lse.ac.uk
martinhearson.wordpress.com