Tax Treaties: Boost or Bane for Development?

IMF Blog, November 16, 2016

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Tax treaties number "over 3,000" and are generally designed to avoid taxing the same profit twice by determining when and how a treaty country can or cannot tax foreign-owned companies.
Developing countries have used treaties with the intention of boosting economic development; the evidence for that is weak.
Treaties can provide important benefits, such as exchange-of-information provisions and mechanisms for resolving disputes between taxpayers and tax administrations.
The international system of taxation is highly complex; multinational companies can exploit treaties to route income through third countries and engage in “treaty shopping,” which is difficult for tax authorities—particularly in developing countries—to counter.

Tax treaties as systemic revenue drains
- A single disadvantageous treaty can act as a drain on a country’s revenues; Professor Stephen Shay described treaties as like a bathtub where one leaky treaty is a drain.
- Countries with multiple treaties are exposed to the "worst" treaty: if a country has "10 treaties," investors will take advantage of the treaty that allows the most tax avoidance and links to jurisdictions with very low or zero corporate income tax rates.
- Such strategies reduce effective corporate tax rates of multinational groups.

Domestic politics and treaty strategy
- Treaty negotiation pressures often come from a country’s diplomatic corps rather than its finance ministry.
- One negotiator reported a domestic target of "100 treaties," illustrating a political focus on treaty counts rather than treaty quality.
- This political dynamic can make it hard to persuade leaders to prioritize fiscal protection and the economic sense of individual treaties.

Withholding taxes and trade-offs
- Withholding obligations can help keep tax resources within a country’s borders by requiring the host country to withhold a portion of income before transfer to the resident headquarters.
- Withholding instruments can generate revenue and act as safeguards against profit shifting.
- Withholding may have negative effects on investment and trade: an example from Colombia shows that the combination of Colombian taxing rights and a high withholding tax in Peru can deter Colombian firms from providing profitable services in Peru, reducing trade and economic development.

Best-practice preparatory steps for treaty negotiation
- Be systematic about treaty approach and skeptical about whether the benefits outweigh costs for a bilateral income tax treaty program.
- Consider any one treaty as “a potential treaty with the world.”
- Develop a domestic model treaty before entering negotiations so the government has a clear idea of acceptable terms.
- Use other instruments or a “light treaty approach” focused on: (i) information exchange; (ii) a commitment to transfer pricing principles; and (iii) a mutual agreement procedure to resolve tax disputes.

Options for addressing damaging treaty regimes (as proposed by Professor Shay)
- (1) Renegotiate those treaties.
- (2) Terminate them in accordance with their terms.
- (3) If constitutionally possible, and as a last resort, override offending provisions with domestic legislation.
- Recommendation: start with the worst treaty first.

Multilateral developments
- Countries have the option of signing a OECD-constructed, multilateral legal instrument designed to allow for the large-scale amendment of existing treaties; each country will retain its own treaty priorities, making implementation complex.

Governments that raise less than "15 percent" of their gross domestic product in tax revenues have trouble funding basic services; undue loss of tax income is a critical development problem.
Addressing treaty-related revenue loss will be key to shoring up domestic revenues in the developing world.

Source: IMF blog post “Tax Treaties: Boost or Bane for Development?” by Jim Brumby and Michael Keen, November 16, 2016.