Tanzania in International Tax Law: Intercompany lending and anti-tax avoidance

As at 13 May this year, the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ("the MLI”) issued by the Organisation for Economic Co-operation and Development (OECD) covers 94 jurisdictions, including neighbouring Kenya. Notably, Tanzania is not yet a signatory to the MLI. 
The MLI allows countries to implement some OECD BEPS Action Plans into existing double taxation agreements (“DTAs”) to counter tax avoidance strategies used by multinational companies (“MNCs”) to minimize their tax burden and erode tax revenues by strategically transferring profits.
Nevertheless, there is still concern on tax base erosion in capital-importing developing countries, one of which is Tanzania.
    It is in this context that intercompany lending transactions that may be perceived to allow MNCs to engage in “aggressive tax planning” and transfer pricing schemes are coming under increasing scrutiny from tax authorities around the world.
For MNCs, intercompany loans offer the possibility to capitalise and financially leverage their Tanzania resident subsidiaries owing to the high cost of borrowing externally. Yet, cross-border intercompany lending could lead to tax base erosion of the subsidiaries.
    At the international level, the OECD on 11 February this year published its final paper on transfer pricing aspects of financial transactions focusing on BEPS Action Plan 4 (Limiting base erosion involving interest deductions and other financial payments) and Actions 8-10 (Aligning Transfer Pricing Outcomes with Value Creation).
Implementation of these BEPS Action Plans requires countries to comply with OECD-administered transfer pricing standards or enact legislation; however, they do not bind non-member countries like Tanzania.
In the EAC, the EAC Treaty allows free movement of capital to spur cross-border trade and financing. Pursuant to this Treaty, Tanzania entered into the EAC Double Taxation Agreement containing the arm’s length principle enshrined in the OECD and UN Model Tax Conventions as well as the ATAF (African Tax Administration Forum) Model Tax Agreement.
The arm’s length principle requires that transfer prices including interest rates for intercompany loans charged between related parties should be charged at market rates like those charged between independent parties. As we shall see below, Tanzania endorsed the use of this principle in its tax law.
Although international and EAC discussions on the most suitable rules are far from over, intercompany and cross-border lending transactions remain below the “radar screen” of the Tanzania Revenue Authority (TRA) and the Bank of Tanzania (BoT).
In terms of the Foreign Exchange Circular No.6000/DEM/EX.REG/58 dated 24 September 1998 (“the BoT FX Circular”), all foreign loans must be registered with the BoT and a debt registration number (DRN) obtained. In the absence of a DRN, it is not possible to remit the money back to the foreign lender. Foreign lending operations in favour of non-residents are also subject to restrictions.
Compliance with the BoT FX Circular is mandatory and infringement attracts penal sanctions in line with the Foreign Exchange Act, 1992, as amended from time to time.
Moreover, Tanzania has transfer pricing provisions based on the arm’s length principle to arrangements between associated parties under section 33(1) of the Income Tax Act, 2004 (“the ITA-2004”) and in accordance with the OECD standards. Failure to comply with this principle may trigger adjustments by the Commissioner General of the TRA to reflect an arm’s length result by, inter alia, “[re-characterising] the source and type of any income, loss, amount or payment” (section 33(2)(a)).
The penalty for non-compliance with the arms’ length principle (upon a TRA audit) is 100 percent of a transfer pricing adjustment, not the resultant tax. Penalties for failing to provide transfer pricing documentation for intercompany loans and other intragroup activities is 3,500 currency points (currently, Sh52.5 million or circa US$22,690).
With respect to deductibility of interest, by virtue of section 12(2) of the ITA-2004, as amended by the Finance Act, 2012, controlled-resident entities in which 25 percent or more of the entity’s underlying ownership is held by non-resident persons or associates of such entity or persons may generally deduct interest expenses incurred under a debt obligation not exceeding the sum of interest equivalent to debt-to-equity ratio of 7 to 3.
This tax bias in favour of debt financing instead of equity financing (dividend payments on shares are not deductible for tax purposes) has created a strong inclination toward debt financing by MNCs to reduce taxable incomes of borrowing Tanzanian subsidiaries.
Perhaps, is it time to remove this economic distortion by either reducing the tax deductibility of interest or introducing a deduction for the normal return on equity? Both of these approaches have limitations, I must concede, as they still leave room for tax avoidance.
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Paul Kibuuka ([email protected]), a tax and corporate lawyer and tax policy analyst, is the CEO of Isidora & Company and the Executive Director of the Taxation and Development Research Bureau.