By Jim Brumby, Director, Public Service and Performance, Governance Global Practice; and Michael Keen, Deputy Director of the IMF's Fiscal Affairs Department
Tax officials and experts grappled with the issue of tax treaties several weeks ago at the IMF-World Bank Annual Meetings. This arcane subject has now emerged as a new lightning rod in the debate on fairness in international taxation. As citizens demand that corporations pay their fair share of taxes and some governments struggle to raise enough revenues for basic services, tax treaties present difficult issues.
These treaties - there are now over 3,000 - are generally designed to avoid taxing the same profit twice by determining, for example, when and how a treaty country can or cannot tax foreign-owned companies. Developing countries have used them with the intention of boosting economic development. The evidence for that is weak, but certainly treaties can provide important benefits, such as exchange-of-information provisions and mechanisms for resolving disputes between taxpayers and tax administrations.
The problem is that tax treaties - and the international system of taxation more generally - are highly complex and have unleashed unforeseen forces. Multinational companies, with much at stake, can use treaties to route income through third countries to exploit favorable tax treaties. Tax authorities, particularly in developing countries, are finding it hard to counter such "treaty shopping."
What became clear at this discussion on October 9 - the latest in a series hosted jointly by the IMF and World Bank - was that certain aspects of tax treaties are particularly damaging to developing countries. Addressing those aspects will be key to shoring up domestic revenues in the developing world.
Here are three insights from the expert roster of panelists, including keynote speaker Stephen Shay, Senior Lecturer at Harvard Law School, and current treaty negotiators from the Ukraine, Colombia and the United States.
Tax treaties are like a bathtub; a single leaky one is a drain on a country's revenues
Professor Shay has gone to bat on both sides of the tax treaty divide. He has negotiated on behalf of the U.S. government, trying to prevent double taxation of U.S. companies' income and protecting the country's tax base, and he has helped private corporations navigate the world of tax treaties to minimize their tax payments.
He advised countries to be systematic about their approach to tax treaties. Developing economies should be skeptical as to whether benefits of a bilateral income tax treaty program outweigh costs, and any one treaty should be considered "a potential treaty with the world": if a country has 10 treaties, he said, investors will take advantage of the 'worst' one. That is, the treaty that allows for the most tax avoidance and establishes tax-treaty linkages to jurisdictions with very low or even zero corporate income tax rates. Such strategies help reduce effective corporate tax rates of multinational groups.
Countries can protect themselves from this behavior by thinking about whether a tax treaty makes economic sense and how it will fit within a government's overall tax and fiscal policy framework. As a best practice, they should develop their own model treaty before entering into negotiations, so they have a clear idea of what they will accept. Most importantly, key benefits of a treaty can be accomplished by relying on other instruments or using a "light treaty approach": signing agreements limited to (i) information exchange; (ii) a commitment to transfer pricing principles; and (iii) a mutual agreement procedure to resolve tax disputes.
Sometimes it's a country's finance ministry versus its diplomatic corps, not country versus multinationals
This insight falls into the category of "politics always matters, dummy," but was, nonetheless, somewhat surprising. A number of panelists, including Professor Shay, described the pressures treaty negotiators face from the diplomatic corps in their country. "No state department likes to see any treaty terminated," Shay said. One negotiator from Eastern Europe said her country has even set a target - 100 treaties - and it is hard to persuade leaders to look at the quality of what they're negotiating, not the number. This presupposes that treaties are an unfettered benefit to the countries agreeing to them - but often this is not the case.
Don't throw out the baby with the bathwater
One simple tool for keeping tax resources within a country's borders is "withholding" obligations. In a situation where a firm is operating in another country, that "host" country - say, for instance, the country with the customers, as opposed to the one with the headquarters - withholds a certain portion of income before it is transferred back to the "resident" headquarters country. Withholding instruments can generate revenue or be a simple safeguard against profit shifting.
But they may impose negative effects on the investment climate, as we learned from Natalia Aristizabal, who has negotiated treaties for Colombia. She described a situation in which a combination of the taxing rights Colombia and a high withholding tax in Peru leads to Colombian companies not being willing to provide services in Peru which otherwise would be profitable and promote trade and economic development.
What can be done?
We know that governments that raise less than 15 percent of their gross domestic product in tax revenues have trouble funding basic services; undue loss of tax income is a critical development problem. Professor Shay proposed three options for countries with damaging treaty regimes: (1) renegotiate those treaties; (2) terminate them in accordance with their terms; or (3) if constitutionally possible, and as a last resort, override offending provisions with domestic legislation. But however countries approach the reform of their treaties, he recommends that they start with the worst treaty first.
The good news is that the potential downside of treaties is now receiving much more attention. This month, countries have the option of signing an OECD-constructed, multilateral legal instrument designed to allow for the large-scale amendment of existing treaties. This is no simple matter, however, as each country will retain its own treaty priorities. The advice heard at the IMF-World Bank event will continue to apply. Stay tuned!