Article by Ambassador Shirinish Manaklal Soni, South African Ambassador to Kazakhstan, Tajikistan, Kyrgyzstan, Turkmenistan"
Co-Authors: Ms. Assel Iliyassova, Tax Partner, GRATA International Law Firm
Ms. Luiza Dyussengaliyeva, Senior Lawyer, GRATA International Law Firm
The purpose of this publication is to provide practitioners working in the framework of the AIFC with an understanding of harmful tax competition measures. The discussions on establishing of the AIFC are currently in the conceptual phase. This article is published using “Astana International Financial Centre (AIFC) – The Practitioners Handbook on International Tax” documented by Ambassador SM Soni on 25th May 2016, “The constitutional law of the Republic of Kazakhstan on Astana International Financial Centre” and “Explanatory Note to the issue on the Strategy for the development of the Astana International Financial Centre”.
The Effects of Globalisation and Liberalization on Harmful Tax Practices
The past decades have seen a rapid spread of preferential tax regimes in high tax countries as well as in the tax havens themselves. Liberalisation and globalisation have led a number of governments to introduce special tax structures; today virtually every high tax country has adopted some type of preferential tax regime. Over recent years, the number of tax havens has more than doubled, while the value of investments into low tax jurisdictions has expanded exponentially.
Because these tax policies may result in the siphoning off of parts of countries’ tax bases, this proliferation of what are considered harmful preferential tax regimes and tax havens has become a growing concern for governments.
Globalisation is a major economic process that breaks down economic barriers between nations and leads enterprises to develop global strategies. It was the liberalisation of national economies that opened the way for globalisation, just as the emergence of new technologies made that globalisation happen.
The OECD provides a framework for identifying harmful regimes and suggests counter-measures for them. Accordingly, harmonising tax rates across countries or installing minimum tax levels is not the aim. Countries will remain free to decide their own tax rates, with checks and balances coming from competitive forces of the global marketplace. This will encourage countries to adopt “best practice” policies on taxation.
The OECD makes a distinction among three situations in which the tax levied on income from geographically mobile financial and other service activities in one country is lower than the tax that would be levied on the same income in another country:
1. the first country is a tax haven and, as such, generally imposes no or only nominal tax on that income;
2. the first country collects significant revenues from tax imposed on income at the individual or corporate level but its tax system has preferential features that allow the relevant income to be subject to low or no taxation; or
3. the first country collects significant revenues from tax imposed on income at the individual or corporate level, but the effective tax rate that is generally applicable at that level is lower than the tax rate levied in the other country.
Each of these situations may have undesirable effects when seen from the perspective of the other country. However, the report is careful not to suggest that there is some general minimum effective tax rate on income below which a country would be considered to be engaging in harmful tax practices.
Focus on Financial Services
The main focus of the OECD’s work is on financial and other service activities because these are the activities that are the most geographically mobile and therefore the most sensitive to tax differentials.
If combined with a situation in which the jurisdiction offers itself as a place where non-residents can escape tax in their country of residence, any of the above factors may be sufficient to identify a tax haven. The OECD’s concept of “tax haven” thus refers to tax jurisdictions that offer themselves as a place that non-residents can use to escape tax obligations in their countries of residence. A number of factors identify these jurisdictions, in particular the virtual absence of taxes (combined with minimum business presence requirements) and a lack of legislative and administrative transparency. Bank secrecy and other features that prevent effective exchange of information are also discernible. Using these definitions, a list of jurisdictions identified as tax havens has been published in order to help form the basis for unilateral or collective countermeasures.
The OECD’s Concept of “Harmful” Preferential Tax Regimes
Four key factors are used by the OECD to assist in identifying harmful preferential tax regimes:
1. the regime imposes a low or zero effective tax rate on the relevant income;
2. the regime is “ring-fenced”;
3. the operation of the regime is non-transparent; and
4. the jurisdiction operating the regime does not effectively exchange information with other countries.
A low or zero effective tax rate is the necessary starting point for an examination of a preferential tax regime.
The concept of “harmful” preferential tax regimes thus refers to low tax regimes—provided for either in the general tax legislation or as administrative measures—that are primarily tailored to tap into the tax bases of other countries. Characteristics of such regimes are their low effective taxes combined with “ring-fencing,” whereby they are partly or fully insulated from the domestic economy. Furthermore, there is often a lack of legislative and administrative transparency, as well as difficulties in accessing information. The potentially harmful regimes in the OECD area tend to target banking, financing, insurance, location of headquarters, and distribution and similar services, although of themselves these are legitimate commercial activities.
Recognising the positive aspects of the new global environment in which tax systems operate, member countries have concluded that they need to act collectively as well as individually to curb harmful tax competition and to counter the spread of harmful preferential tax regimes directed at financial and service activities. Since it is difficult for individual countries to combat effectively the spread of harmful preferential tax regimes, a co-ordinated approach and international co-operation are being intensified to avoid competitive bidding by countries for geographically mobile activities. Consequently, a strong case is made for reinforcing existing measures and for intensifying international cooperation when formulating a response to the problem of harmful tax practices.
Proposals on Harmful Tax Practices
The OECD offers proposals for the examination of issues of harmful tax competition to be explored, apart from the issue of geographically mobile financial and other service activities. It is proposed that, in the context of the Forum, member countries and interested non-member countries will continue to examine these issues with the aim of developing new recommendations.
1. Restriction of deductions for payments to tax haven entities
A number of countries have rules imposing restrictions on the deduction of payments made to tax haven countries or rules imposing a reversal of the onus of proof in case of such payments.
2. Imposition of withholding taxes on certain payments to residents of countries that engage in harmful tax competition
Many countries currently have legislation that imposes withholding taxes on various types of payments to non-residents but eliminates or substantially reduces the rate of withholding tax on payments made to residents of treaty countries.
It is considered that the imposition of withholding taxes at a substantial rate on certain payments to countries that engage in harmful tax competition, if associated with measures aimed at preventing the use of conduit arrangements, would act as a deterrent for countries to engage in harmful tax competition and for taxpayers to use entities located in those countries.
3. Residence rules
Revising the definition of corporate residence might be considered a possible measure to counteract the use of foreign corporations to avoid domestic tax. Accordingly, one option is to extend the domestic tax definitions of corporate residence so that a foreign corporation controlled by residents would be considered to be resident. Control for this purpose could be limited to the control of the affairs of a corporation as exercised by its board of directors or management. Alternatively, control could be determined by reference to the ownership of its shares. Several countries already treat corporations as residents if the corporation’s management and control are located in the country. However, this concept of control is easily manipulated by taxpayers, in contrast to the share ownership concept of control.
On the treaty side, the definition of “resident of a Contracting State” could be restricted to expressly exclude certain entities subject to no or little tax. One possibility is to narrow the scope of the definition of resident in the OECD Model Tax Convention to exclude other taxpayers who are liable to tax in a country but do not in fact pay tax on all of their income like ordinary residents. Moreover, a specific rule might be adopted to deny certain treaty benefits to corporations resident in countries that exempt foreign branch income. For example, the benefit of reduced withholding taxes might be denied to such a corporation with respect to amounts attributable to a foreign branch located in a tax haven. Furthermore, the definition of resident could be revised to exclude legal entities that take advantage of specified regimes that constitute harmful tax competition.
4. Application of transfer pricing rules and guidelines
The application of transfer pricing rules may constitute a useful counteracting measure to the situation in which significant income may be attributed to a foreign entity that performs few, if any, real activities. (Transfer pricing rules typically start from an analysis of the true functions performed by each part of a group of associated enterprises.) It is suggested that rules affecting a reversal of onus of proof in certain cases might help to address the specific circumstances of tax havens and regimes that constitute harmful tax practices.
5. Thin capitalisation
A large number of OECD countries apply general or specific legislative rules to address cases of base erosion that are attributable to the thin capitalisation of resident companies by non-residents. Such rules can act as a block against the tax-free repatriation of domestic profits to entities that may be located in tax havens or in countries that provide, directly or indirectly, favourable taxation of interest income from foreign subsidiaries. Some domestic rules, however, such as the setting of safe harbour debt/equity ratios, can, conversely, be used to facilitate harmful tax competition.
6. Financial innovation
Financial markets are constantly evolving, and innovative financial products are continually being created. Such instruments have the potential to be used to assist harmful tax competition, as well as being used for legitimate business purposes. For example, derivative products, in addition to hedging interest rate risk, can be used to create synthetic loans. Such “loans” give the taxpayer the same economic effect as if a loan had been made, but with the potential to avoid withholding tax and thin capitalisation rules. The Committee intends to keep monitoring this area to insure that financial innovation is not used to assist harmful tax competition.
Pending developments worldwide
• Stricter “all crimes” legislation
• Stricter money laundering provisions
• Removal of the time limit on prosecutions
• Police and criminal evidence law
• International co-operation
• Extra staffing of law enforcement services
• Fraud and financial investigation procedures
• Licensing and regulation of trust and company service providers
• Changes in companies regulation
• Changes in trust legislation
• Disclosure of beneficial ownership of corporations
• Toughening of audit and disclosure requirements
• Registration of foreign incorporated entities
• Business rescue measures
• Customer protection schemes
• Financial services ombudsman
• Insurance regulation
• Investment business regulation
• Possible new tax treaties and exchange of information agreements
• Restriction of deductions for payments to tax haven entities
• Imposition of withholding taxes on certain payments to residents of countries that engage in harmful tax competition
• Revision of residence rules
• Stricter application of transfer pricing rules and guidelines
• Tightening of thin capitalisation rules
• Attack on certain financial innovation
• New uses of non-tax measures to restrain harmful tax practices
1. “Astana International Financial Centre (AIFC) – The Practitioners Handbook on International Tax” documented by Ambassador SM Soni on 25th May 2016,
2. “The constitutional law of the Republic of Kazakhstan on Astana International Financial Centre”,
3. “Explanatory Note to the issue on the Strategy for the development of the Astana International Financial Centre”.
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