Given the high capital mobility and sharp competition for investments in the global market, countries have continued to employ varying strategies to attract investments and drive economic growth into their respective jurisdictions. For example, some countries offer tax incentives to investors to engender foreign investment and stimulate economic growth. Such incentives include tax exemptions, tax incentives for exports, reduced tax rates for corporations, or creation of tax-free zones, amongst other measures.
The consequence of the above approach is that a competitive tax regime is created among countries that strive to offer the lowest and the most attractive tax incentives.
According to some studies, tax incentives could be very costly for a number of countries despite the positive role they could play in attracting investments or shaping a country's economy.1 A 2016 World Bank survey revealed that Nigeria conceded $2.9 billion in tax incentives, which was twice the budgeted amount for education, in the year. Kenya also lost about $1.1billion to tax exemptions and incentives in the same year, which was almost two times the government's health budget. 2
Notwithstanding, governments across the world continue to engage in the race to the bottom largely because of the perceived fear that investors could move their investments to other low-tax jurisdictions in the absence of tax incentives.
In a bid to create a level playing field for countries all around the world, international organizations such as the Organization for Economic Co-operation and Development (OECD) and the European Union (EU) did not only label certain tax practices as harmful (including the grant of certain tax incentives) but also blacklisted countries engaged in such tax practices. Nonetheless, some experts have argued that the intervention of the OECD and EU encroaches on the fiscal sovereignty of states given that the principle of "fiscal sovereignty" allows every country to determine its tax policies and its suitable tax rates, independently. Furthermore, given that the OECD's harmful tax practice reports also cover jurisdictions that are not a part of the OECD, some of its policy decisions may not favour every jurisdiction alike because of the varying economic needs of each country.
This Newsletter seeks to discuss tax incentives in the light of harmful tax competition between jurisdictions and the fight to eradicate the harmful tax practices by the OECD.
Tax Incentives as Harmful Tax Practices
Since the mid-90s, the OECD and the EU have produced several criteria and standards to identify and neutralize harmful tax regimes/practices. According to the OECD, a tax incentive may be considered harmful if it allows companies that do not have any substantial presence or real economic activity enjoy the benefits of no or low effective tax rates. The OECD also considers the transparency of a tax regime and if such regime aligns with international transfer pricing rules.3
However, some experts have argued that many countries adopt tax incentives to drive certain sectors of their economy. For example, Nigeria grants the Pioneer Status Incentive (PSI), which grants tax exemptions to companies that operate in specified sectors for their first 3 – 5 years of operations to encourage investments in those sectors. The PSI framework along with some other incentives are targeted at boosting trade and investments in budding sectors of the Economy. For example, with the privatisation of the Nigerian Telecommunications sector in the early 2000s, various incentives including the PSI were put in place to attract investors. As at 2018, the Nigerian telecommunications sector had attracted investments worth up to $70 billion dollars.4 On a similar note, the United States offers tax credits to companies that make qualified research expenditures to develop new or improved products, manufacturing processes, including software development in the United States to encourage research and development.
Based on the foregoing, it would appear that tax incentives are determined by the economic needs of a particular jurisdiction. Therefore, labelling such tax incentives as harmful may be disadvantageous to countries that do not have other adequate infrastructure to attract foreign investments.
We have analysed some tax regimes which the OECD and EU have labelled as "harmful tax" regimes and the responses of some jurisdictions to the recommendations of the OECD and the EU.
Analyses of Harmful Tax Incentives across Various Jurisdictions
As a small island with no natural resources, Mauritius has created a competitive edge for itself through tax incentives over the years. Mauritius has become a top choice Holding Company (HoldCo) jurisdiction for investors because of its numerous tax treaty networks and incentives. This has thrust Mauritius into the spotlight in the global crackdown of harmful tax practices.
As at 2017, the OECD and the EU identified a number of Mauritian tax practices as harmful. These practices included the Mauritian Global Business Licence (GBL) 1 & 2 Regime which allowed for an 80% tax credit on foreign income of a Mauritian company and also exempted other categories of companies from Mauritian taxes. One of the issues identified by the OECD and the EU was that the economic substance requirements for a company to enjoy the tax benefits of the regime were insufficient.5
In response, Mauritius abolished the GBL 1 & 2 Regime and introduced a single GBL Partial Exemption Regime in 2018. The Partial Exemption regime exempts 80% of foreign sourced passive income and profits from a permanent establishment from tax. The Regime also introduced additional economic substance requirements for companies seeking to enjoy the tax benefits of this regime.
However, the EU Code of Conduct Group (EU COCG or the Group), in a letter to the Mauritian government dated 1 February 2019, stated that the Partial Exemption regime has a similar harmful effect as the abolished GBL 1 & 2 Regime. Although the EU COCG acknowledged that the new regime has requirements for companies to have real economic activities in Mauritius, the Group highlighted that the Partial Exemption regime is not generally in line with international best practice, as it does not have appropriate anti-abuse measures to tackle tax-planning opportunities.6
Thus, the OECD has requested that the regime be abolished by 31 December 2019 without any grandfathering mechanism. Mauritius has, however, committed to effect changes to its Partial Exemption regime to address the identified deficiencies with the partial exemption regime by the stated date.7
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4. OECD BEPS Action 5 2015 - Final Report Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance
5. Mauritius Selected Issues; IMF Country Report No. 17/363; November 6, 2017 https://data.consilium.europa.eu/doc/document/ST-5443-2019-DCL-1/en/pdf
6. Letters seeking commitment on the replacement by some jurisdictions of harmful preferential tax regimes with measures of similar effect- Mauritius https://data.consilium.europa.eu/doc/document/ST-5981-2019-INIT/en/pdf
7. Commitment letters by some jurisdictions regarding the replacement of harmful preferential tax regimes with measures of similar effect- Mauritius https://data.consilium.europa.eu/doc/document/ST-6097-2019-ADD-1/en/pdf
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