Worldwide: Tax Challenges In Emerging Markets

Last Updated: April 17 2013
Article by Jenny E. Doak

Introduction

As multinational businesses increase their activity in rapidly-expanding economies, many local tax authorities have responded with an urgent effort to recoup tax on the increased profits being generated in their jurisdiction. Such efforts have, in the past, led to sudden and significant changes to local tax policies, often to the surprise and detriment of international businesses used to more developed tax regimes. This underlying tension has been brought to the forefront in a number of recent high-profile disputes between major multinationals and tax authorities in Africa and the BRIC jurisdictions and has, in places, prompted concerns that the commercial rationale for investing and transacting in certain emerging economies is being undermined.

This article seeks to highlight some common tax challenges facing multinationals doing business in emerging markets, and to suggest ways in which such challenges might be managed, mitigated and addressed.

Another, more draconian, way in which the tax authorities could collect tax from entities with no presence in a jurisdiction is to seize their assets in that jurisdiction if the tax is not paid.

The Challenges

Businesses transacting in foreign jurisdictions will want to assess, with reasonable certainty, the tax costs of entering into a transaction, the tax treatment of the cashflows over the life of the transaction, and tax on exiting the transaction. Unanticipated tax charges at any of these stages could have a significant impact on the profitability of the transaction (and, in extreme cases, whether the transaction is economically viable). Even if businesses are ultimately successful in defending challenges by tax authorities, the prospect of facing lengthy negotiations or litigation with tax authorities will be unattractive for businesses who will want to focus on their commercial activities.

The ways in which tax authorities have sought to impose taxes on foreign businesses are wide ranging. Examples include the following:

  • Extra-Territorial Tax: Taxing Indirect Transfers

    This was the theme of the high profile battle between Vodafone and the Indian tax authorities relating to the acquisition of Hutchison Essar in 2007. In broad terms, the parties to the sale were non-Indian and the transaction involved the acquisition of control of a non- Indian target company. However, the Indian tax authorities sought to impose a tax on the transfer because the value of the target company was derived substantially from Indian assets. The Indian tax authorities tried to assess Vodafone, the purchaser, for the tax (effectively by reference to the capital gain of the seller), by arguing that Vodafone should have withheld tax from the purchase price and accounted for that tax to the Indian authorities on the acquisition. In essence, the Indian tax authorities had sought to "pierce the corporate veil" and treat the transaction as a sale of the underlying Indian assets. Although Vodafone ultimately succeeded in defending their position in the Indian Supreme Court, the Indian tax authorities continued to pursue the claim by threatening to introduce retrospective legislation which would effectively override the Supreme Court decision (the position remains unresolved as at the date of this article).

    Imposing tax on "indirect transfers" of assets is not unique to India, and jurisdictions may seek to impose such tax through explicit legislation (as China has done and, more recently, Mozambique has sought to do) or through applying a "substance over form" approach.
  • Extra-Territorial Tax: Broad Concept of "Permanent Establishment"

    The concept of a "permanent establishment" is often important in determining whether a jurisdiction has taxing rights over an entity (both in domestic legislation and in a double tax treaty context). The term usually encompasses both (i) a fixed place of business in a jurisdiction and (ii) a person acting on behalf of a business in that jurisdiction (regardless of whether that person has a fixed place of business). Tax authorities in emerging markets have been known to construe "permanent establishment" broadly, assessing businesses to tax in unexpected circumstances. For example, concerns could arise as to whether any of the following could be treated as a taxable permanent establishment: a construction project or installation in progress; the presence of secondees, sales agents, engineers or contractors in a jurisdiction; or the transportation of oil and gas through a pipeline which passes through a jurisdiction.
  • Collecting Tax: Withholding Taxes

    Tax authorities are likely to have practical issues in terms of collecting taxes from entities with little presence in their jurisdiction. This issue is often dealt with through collecting the tax by way of imposing withholding taxes on payments made by residents of that jurisdiction to non-residents. Of course, although this is technically a tax liability on the payee's profits, the parties may agree to shift that risk contractually by including a "gross up" provision in the contract, meaning that the resident payer bears that cost.

Given the uncertainties involved in how transactions will be taxed in emerging markets, it is important to identify tax risks at the earliest possible stage in a transaction.

  • Collecting Tax: Secondary Liabilities

    Another solution for tax authorities wanting to collect taxes from non-resident entities is through so-called "secondary liability" provisions. These are provisions which allow tax authorities to collect tax from a party where the person on whom a "primary" tax liability is assessed has failed to pay that tax. The provisions usually work by imposing a "secondary" tax liability on persons with some connection with the defaulting tax payer, although this connection might be as little as having acquired assets from the defaulting taxpayer.
  • Collecting Tax: Risk of Forfeiture

    Another, more draconian, way in which the tax authorities could collect tax from entities with no presence in a jurisdiction is to seize their assets in that jurisdiction if the tax is not paid.
  • Tax Incentives: Withdrawal or Loss

    Governments and municipalities frequently offer tax reliefs and exemptions to incentivize investment in particular activities, sectors or regions, often including infrastructure and energy projects which typically have high upfront costs. Such incentives can be an important feature in attracting foreign investment. However, whereas emerging markets were at one time focussed on attracting foreign investment, the position is shifting so that many jurisdictions are now reducing incentives and, in certain cases, withdrawing incentives after the start of a project. Businesses should also be conscious that, where a tax holiday applies, continuing care needs to be taken to ensure compliance with the (often strict) conditions attaching to that regime.
  • High or Arbitrary Penalties and Interest

    Some countries seek to impose hefty interest and penalties (which in some cases are more than the tax payable), as well as penalties which appear to be arbitrary or unfair (for example, for paying the right amount of tax too early or for filling in the wrong box in a tax return).
  • Lack of Certainty

    As noted above, in some cases the main objection of businesses is not that they are subjected to unreasonably high tax rates in emerging markets, but rather to the risks created by the unpredictability of the tax regime in the particular jurisdiction. Some of these issues are highlighted above, but frequent changes to the tax code, the introduction of retrospective legislation, anti-avoidance measures being imposed with no warning, inconsistent practices by tax authorities and lengthy court procedures to defend claims by tax authorities, all of which contribute to uncertainty.

Addressing the Risks

Given the uncertainties involved in how transactions will be taxed in emerging markets, it is important to identify tax risks at the earliest possible stage in a transaction. As well as speaking to tax advisers about the current position in the relevant jurisdiction, it is a good idea to consider developments in other jurisdictions as, once one tax authority imposes a measure, other governments may well follow suit (an example is the taxation of "indirect transfers" cited above).

Once risks have been identified, it may be possible to mitigate them through structuring. For example, withholding taxes may be reduced by making payments to an entity which has the benefit of a double tax treaty with the country imposing the withholding tax. On this point, it is becoming increasingly important to be able to demonstrate real commercial substance in such entities to withstand challenges from tax authorities that the entity is a mere conduit that should not be able to access tax treaty benefits. Tax treaty structuring is often considered alongside investment treaty planning (i.e., which jurisdictions have treaties to protect investors from certain legislative, regulatory and judicial actions of the state).

Another way to address identified risks upfront is through obtaining rulings from the relevant tax authorities. In some cases it may not be possible to obtain rulings, but a discussion with the tax authorities may nonetheless be a good opportunity to explain the commercial rationale behind a transaction, establish a good relationship with the tax authorities (which can be very important) and gauge their attitude towards the project.

Of course, it is usually not possible to address all possible current and future tax risks and, therefore, parties to a transaction will often want to include provisions to address risks in their contracts. Provisions might include: warranty and indemnity protection for primary and secondary tax liability exposures (including that there are no circumstances under which assets may be seized); "gross up" clauses for withholding taxes; provisions allocating value added taxes, customs and excise duties and stamp taxes between the parties; termination rights where a party suffers an unexpected tax treatment; and provisions regulating the conduct between parties in the event of a dispute with a tax authority.

Conclusion

Tax risks are, of course, not the only challenges facing businesses in high growth jurisdictions, but tax should not be overlooked at the initial stages of a project. Addressing likely tax issues early in the life of a project provides the best chance of being able to mitigate them in the manner described above and minimise the prospect of a future battle with the tax authorities. It is also important to ensure that contracts between the parties include appropriate provisions allocating tax risk, so the parties are clear about who is liable if the tax treatment is not as expected under current law or as a result of a change in law.

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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