UK: Operating in Emerging Markets - Tax Lessons for Success in Supergrowth Economies

Last Updated: 4 May 2010
Article by Deloitte Tax Group

Most Read Contributor in UK, August 2017

Fresh into partnership and with 12 years international tax experience under his belt, Tim Haden has clocked up a fair few air miles advising multinationals on operating in emerging markets. Michelle Hanrahan hears his lessons for success in supergrowth economies.

"An article about emerging markets tax wouldn't be complete without mention of BRICs or tigers," says Tim Haden, tax partner. "And surely we need to mention dragons at some stage?"

He's got a point. These well worn labels are a sure sign that we've all been talking about these economies for some time now – to the extent that the emerging have emerged and lessons have been learned. But what can the Tax function take from the experience so far?

"The first challenge," says Haden "is part and parcel of international business operations in emerging markets – they're commonly low margin operations with significant start up losses for which there is no immediate relief." Loss planning can be difficult when future income is uncertain and deferred tax assets are therefore difficult to justify. "The absence of tax grouping or consolidation in many Asian, African and South American countries just adds to the challenge."

When it comes to tax-sensitive funding for emerging market operations, Haden stresses the importance of foresight, and that consideration of the changing fortunes of the business is necessary in order to avoid problems in the future. For example, currency restrictions in many emerging markets push businesses towards equity loans but, says Haden "it's important that such loans can be treated as quasi-equity for UK tax purposes to prevent a tax charge on the deemed interest accrual.

It's also important to structure the term of the loan such that it can become interest-bearing once local taxable profit arises."

Transfer pricing can present other issues. "Sympathetic intra-group pricing is commonly offered as a leg up for emerging market operations but it can create problems," warns Haden. "Well intentioned pricing can mask poor performance. Central management can be blissfully unaware of problems unfolding at local level until things reach breaking point." Another common issue with favourable pricing is that without careful consideration, it can end up trapping profits in what may be a high tax jurisdiction when the business takes off. To prevent this, Haden advocates building pricing flexibility into plans. "Low pricing arrangements may be justified in the initial start up phase but you need to enter into the arrangements with a clear end date in mind. Pricing agreements should also anticipate and include provisions for changes to the pricing basis, for example, restricting royalty free periods."

Tax holidays can be helpful to companies aiming to get a foothold in new markets but in Haden's experience, the benefits often go unrealised. "It sounds obvious, but it's not really a tax holiday unless you're making a profit. In reality many businesses are still making losses long after the holiday period ends."

Compliance with holiday rules is key. "A tax holiday is not somewhere to kick back and relax, although a tax free status lulls many into a false sense of security," warns Haden. "As a result, the conditions of the holiday can be overlooked. I know of a five year Indian tax holiday where the need for a robust transfer pricing strategy was overlooked. When a review by the authorities later concluded that more income should have been recognised in India, the company had to pay the related tax – Indian tax holidays don't apply to income arising from transfer pricing adjustments."

Authorities will respond to holiday abuse and, warns Haden, "this can result in some pretty hefty tax bills for those caught out". He cites China as an example where the authorities are actively closing in on holiday abuse by undertaking post-holiday transfer pricing reviews to identify where transfer pricing policies have been used to accumulate profit to take advantage of a holiday, before flipping back when the holiday expires.

Tax Complexity

Haden is wary of the tendency for international organisations to apply established business models to their emerging market operations. "Business models which work in Western economies can fail to take into consideration the complex and shifting nature of emerging regimes, so it's important for Tax to be at the table when business operating models are being drawn up."

Local structuring decisions are particularly important in emerging markets with dual state and federal regimes. Haden cautions against being cajoled by local authorities into setting up multiple entities in different states. "You see this in China and India, where taxes are collected at regional or state level. But this can be costly in an environment with no tax consolidation where losses can get stranded." Surely this also throws up additional compliance requirements and raises the issue of pricing between entities? "Absolutely – these challenges should inform local structuring decisions. While there might be pressure to establish a number of local legal entities, a single company with branches in each state might be the way to go."

There are numerous taxes, many unfamiliar, which need to be considered from day one. These include indirect taxes, such as business taxes (China) and service taxes (India), which can add real cost to cross border flows and another layer of complexity to group transactions. According to Haden withholding taxes are generally more difficult to mitigate than in Western economies and the scope is often much wider. "You see this with India which levies withholding tax on the provision of many services including management services from overseas and Brazil where the UK is unlikely to negotiate a double tax treaty in the near term."

Then there are currency control regulations. Haden agrees that they seem to have a nasty habit of forcing tax outcomes and decisions. "Sometimes interest rates on loans, royalty rates and management charges are legally restricted and force companies away from arms length pricing."

He talks of recent examples where exchange regulations have resulted in an unexpected withholding tax charge when it arguably should not have applied. "Some companies find themselves held to ransom. Sadly, when there's no time to argue, they are forced to swallow withholding taxes in order to get approval to make payments into another territory."

There is also a relative lack of sophistication and different approaches in emerging markets' tax regimes from those taken in the West. Haden's experience is that tax authorities dealing with foreign businesses often have limited experience in how new, often complex, rules are to be applied or an understanding of the intended 'mischief' which the law intends to remedy. He sees relationships with local tax authorities as key to resolving issues. "As with any new legislation, if any challenge is mounted by either the taxpayer or the tax authorities as to the intended purpose of legislation it can be difficult to predict what the court's interpretation will be and it may take years to reach a conclusion. Your local operator or joint venture partner can help you manage the relationship with local tax authorities. Their knowledge can be really valuable in helping you navigate local tax and commercial complexities."

Understandably, the aim of much new legislation being introduced in emerging markets is to safeguard their share of the overall group's tax liability. To illustrate, Haden points to the thin cap, transfer pricing rules and anti tax-haven legislation being introduced in China and India.

"The introduction of transfer pricing legislation in India has led to the tax authorities listing several court cases without first giving foreign businesses the opportunity to discuss their particular facts with them. There has also been inconsistency in approach between different regions."

Focus on Tax Revenues

"Groups shouldn't be surprised when emerging market authorities don't always seem bound by established international tax principles," says Haden. He points to the unusually wide reach of Indian taxation and a swathe of tax cases where India has sought to tax foreign companies on profits only loosely connected with the Indian market. "After all, those principles and the bodies that manage them stem from international agreements dominated by Western economies. And that, combined with the need to sustain growth, can result in very different approaches to challenging tax payers than they might be used to in Western markets."

Haden points to Permanent Establishment (PE) as an area to watch. "Several disputes are unfolding and companies are being stung with unexpected tax charges and fast changing local tax policies. As an example, China and India in particular are increasingly pursuing tax payments where secondees are not on local contracts. In these cases the authorities are arguing that the secondees are doing business for the parent, therefore creating a PE. This could lead to some of the home country profits being taxed in the emerging market territory." To overcome this, many groups are considering employing those who would have been secondees locally or are spending time clarifying where individuals are doing work for the local entity and where they are representing the parent.

Other areas to watch? "Non-resident capital gains tax – it may impact not only the ultimate exit strategy, but also group restructuring and perhaps cash repatriation if return of capital is a likely route." Many groups have tried to minimise the impact of non-resident capital gains tax by using treaty-protected overseas holding companies or SPVs. Haden cites the recent Vodafone case, in which the Indian authorities are challenging an SPV structure (claiming that the disposal of a nonresident SPV was, on the facts, effectively a disguised disposal of an Indian sub) as testimony to the stance some tax authorities are taking.

"India and China are both seeking to challenge the use of treaty-protected entities," says Haden. "Either through a radical change of law, as in India, or by challenging residency or motive where there is limited substance – many groups are reeling from the recent retrospective change introduced by China in this area and the volume of documentation now required by local Chinese tax authorities (all in Chinese) in respect of indirect transfers of Chinese subsidiaries, even where no Chinese tax may be due."

It would seem that it's essential to keep the investment strategy and structure under review and have an eye on the changes which could leave the business exposed. "Absolutely," says Haden," and groups should also be looking to give as much substance as possible to their holding companies and reviewing potential exit routes if disposals are envisaged." This might lead groups to channel investment via international hub territories (see box overleaf: 'Location, location, location) where substance is achievable – for example, via location of procurement operations.

Those falling foul of local tax rules in emerging markets may be in for a rough ride. Governing bodies can levy stringent penalties for perceived non-compliance. Yet bureaucracy and red tape, coupled with lack of resources and training at the local and regional levels, increases the risk of companies breaching the rules and of misunderstandings between authorities and taxpayers. Relationships with local tax authorities can be key and taxpayers must ensure they understand where the authorities are coming from.

What Next?

The picture you're left with is that managing the tax cost of operating in emerging markets isn't for the faint hearted. "True," says Haden, "it's easy for companies to make mistakes and there can be significant risks to both a company's return on investment and reputation when they do." But he's keen to point out that whilst there are many war stories for the intrepid business to ponder, there are also groups getting it right and making the most of the opportunities that these markets have to offer. "They're the ones which recognise the different approaches that prevail in emerging markets and the importance of getting good local advice. They ensure that tax effectiveness is embedded in future business performance and they're able to do that by getting involved in operational design early on, ensuring flexibility in arrangements and talking to the business about the future direction of these operations."

Emerging economies are set to be key drivers for future global GDP growth and Haden sees Tax is instrumental in ensuring that companies make the most of the opportunities they have to offer. Sounds as though it's going to keep him busy for some time to come. He grins and apologises – we're out of time. He's got a plane to catch.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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