How Tax Treaties Prevent Tax Leakage in Cross-Border Projects

What Is The Purpose Of Tax Treaties?

Although what tax treaties do — which is to allocate taxing rights between two jurisdictions — might sound mundane, their potential for positive effect on cross-border transactions should not be underestimated.

When structuring a power, energy or infrastructure project, tax is rarely a driver, but the transaction parties will want to ensure that tax leakage is kept to an absolute minimum.  Unanticipated tax charges on cash flows between the parties can make the difference between an economically attractive project, and one which is unviable.   

One of the key purposes of tax treaties is to limit the circumstances in which countries can impose tax on cross-border cash flows. Their other major function is to eliminate double taxation — where a taxpayer would be subject to tax, on the same income or gain, in more than one jurisdiction.

For example, take a company headquartered in Jurisdiction A, which starts operating in Jurisdiction B as part of a development project there. The profits of that operation might be subject to tax both in Jurisdiction A and  in Jurisdiction B. They would be taxable in the former because Jurisdiction A imposes tax on a company’s worldwide profits and in the latter because they are profits of a business being carried on there. Tax treaties prevent such double taxation and, in the process, facilitate cross-border transactions. 

How Tax Treaties Work — The Main Provisions

Tax treaties are typically based on a standard form — most commonly, the Model Tax Convention produced by the OECD. The following is a summary of the provisions most commonly encountered and relied upon in the context of cross-border transactions.

Residence

In order to benefit from the provisions of a tax treaty, a taxpayer must be treated as tax resident by one of the two jurisdictions which are party to the treaty. However, the residence article of a treaty also addresses the important question: what if both jurisdictions regard the taxpayer as tax resident there? 

For example, in the case of a US-incorporated company with senior management personnel located in a country in Africa, both the US and the relevant African jurisdiction could regard the company as tax resident.

This is where the residence article steps in.  It prevents the company from being subjected to tax in both jurisdictions by setting out the criteria for determining in which of the two relevant jurisdictions the company is to be treated as tax resident.

Typically the treaty provides that the question is determined either:

• according to where the company has its “place of effective management” — broadly, the place where the decisions determining the strategy of the company are taken; or
• by means of the two relevant tax authorities agreeing between themselves where the company should be treated as tax resident.

In reality this should be an issue only in relatively rare cases — normally there will not be much debate as to where a company is tax resident. But it does mean that where a tax treaty exists between two jurisdictions, a company will not be subject to tax in both of those jurisdictions on the basis of being tax resident in each.

Permanent establishment

One of the key points to bear in mind in the context of cross-border investment transactions is: in what circumstances can a company resident in one jurisdiction become liable to tax in another? For example, at what point may a project undertaken in a country in Africa by a company which is tax resident in, say, the US, give rise to a local tax charge in the country in which the project is located? 

Generally, countries do not impose taxation on a foreign company carrying out operations in their territory unless that foreign company has a certain level of presence there. However, precisely what level of local presence is required to create a tax liability will vary from jurisdiction to jurisdiction. Some jurisdictions may require more of a presence than others before they start to impose a tax charge on the foreign company.

What this article of the treaty does is to define — and therefore limit — the circumstances in which a jurisdiction is entitled to impose such a tax charge. It does this by specifying the nature of local presence that will create a “permanent establishment” (i.e. taxable presence).

The first category of permanent establishment is the physical presence. Thus a branch, office, mine, or quarry are specified among others. Certain types of physical presence will be taxable only in certain circumstances – for example, a construction or installation project is treated as a permanent establishment only where it lasts for over 12 months. And certain types of presence are specifically treated as not constituting a permanent establishment, such as where an enterprise uses facilities merely for storing goods.

There is also a completely difference category of permanent establishment — requiring no physical presence on the part of the foreign company – known as the “dependent agent” permanent establishment. This exists where the foreign company has an agent in the local jurisdiction invested with authority to enter into contracts on behalf of the foreign company.

This article is important because it draws the line between the situation where a foreign company has a taxable presence in the overseas jurisdiction, and where it does not. Only where a foreign company has a permanent establishment in a jurisdiction will a typical tax treaty permit that jurisdiction to impose tax on the foreign company’s profits, and then only to the extent that those profits arise from the company’s operations carried on there.

Withholding Tax: Dividends, Interest and Royalties

It is common for countries to impose withholding taxes on payments of dividends, interest and royalties when these payments are made to an overseas recipient. 

For example, a jurisdiction may impose a 20% withholding tax on dividends paid overseas. So where a dividend of $100 is declared by a company to its overseas shareholder, the shareholder will receive a net payment of only $80. And this form of tax, deducted at source by the payer, is one of the most significant tax considerations in cross-border transaction structuring.

At best it is a cash flow issue for the recipient: the recipient receives a reduced dividend, as in the example above, but is then able to set the tax suffered off against taxation that its home jurisdiction would otherwise have imposed. However, it is not always feasible for the recipient to obtain a credit for tax deducted at source in this way. For example, the recipient may be a tax-exempt investor, such that it has no home tax liability capable of being reduced. 

Or a recipient may not be tax-exempt, but for other reasons may have no tax liability against which to set the withholding tax that has been deducted: perhaps because its home jurisdiction does not impose a tax charge on the receipt of dividends, or because it has not made taxable profits in the period of account concerned. In these cases, tax withheld at source represents a permanent cost, not merely a cash flow issue.  All in all, the imposition of such withholding taxes can have a significant negative impact on cash flows. 

What the dividend, interest and royalties articles do is to reduce — or wholly eliminate — the imposition of such withholding taxes. Often a treaty will provide two reduced rates, with the lower rate of tax applying where the shareholder holds more than a specified percentage of the share capital.

For example, the US-Tunisia treaty provides for a rate of withholding tax on dividends of 20%, but this is reduced to 14% where the recipient holds at least a 25% stake in the dividend payer. The rate of withholding tax on payments of interest will often be similarly limited.  Thus the US-Morocco treaty limits the withholding tax rate on interest paid by a company resident in Morocco to one resident in the US (and vice versa) to 15%. However the US – South Africa treaty goes further, preventing the imposition of any withholding tax at all on payments of interest flowing between companies resident in the two jurisdictions. 

Where an investor is considering the structure of its investment or project, the imposition of withholding taxes on profit extraction and on inter-company cashflows, and the potential assistance of tax treaties, can be a significant consideration.

The “Other Income” Article

This “sweep up” article can be of crucial importance in a cross-border context, effectively providing that all other types of cross-border cashflow not dealt with by the foregoing provisions of the treaty cannot be subject to tax in the jurisdiction where they arise, but rather only in the hands of the overseas recipient.

So, for example, if a US-based company provides services to a company based in a country in Africa, and the African jurisdiction concerned would normally impose a local withholding tax on the payment of fees for those services, the tax treaty prevents this – consequently keeping the US recipient whole.  

Elimination of Double Taxation 

This is another key provision of the tax treaty.   It ensures that tax suffered by a party overseas must be taken into account by the party’s home jurisdiction when determining its home tax liability.

So, for example, if a US company has received a dividend from a subsidiary on which local withholding tax has been imposed, this Article requires the IRS to reduce the US taxpayer’s US tax liability accordingly (to the extent that the taxpayer would otherwise have had such a liability). 

This provision thus plays a key role in preventing potential double taxation. 

In Conclusion 

Tax treaties encourage cross-border investment by reducing the tax barriers that would otherwise apply; and this is the case in a projects context as much as in any other. 

The combined effect of the tax treaty provisions summarized above is that, where a tax treaty is in place between two jurisdictions, then companies resident there and which are entering into cross-border transactions are able to do so in a manner which is less likely to be adversely impacted by tax, than if a tax treaty did not apply.

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