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The authorities want to bring more transactions within their tax net |
Like most emerging markets, Africa presents a significant opportunity for investors but with that opportunity comes a challenge for tax directors: how to support and enable the overall business strategy while at the same time managing a complex and uncertain tax environment with all its associated risks. Moreover, the complexity and uncertainty of many African tax regimes are increasing, as governments try to balance an open-for-business approach to foreign investment with ensuring that they secure what they feel to be the right levels of tax revenue from capital flows and transactions.
Inheriting pre-transaction tax liabilities
Pre-transaction liabilities are commonly acquired by foreign investors in instances where:
The general lack of information and record-keeping by the target entity means that a due diligence exercise is not sufficient to highlight the key tax risk areas; and
The target company's tax affairs have not historically been managed properly such that a due diligence exercise highlights recurring anomalies in the tax function.
Some African jurisdictions see specific industries as the principal sources of tax revenue – for example, oil in Nigeria or mining in the DRC – and concentrate tax administration effort on those sectors. The result is often a lower level of tax compliance by businesses that operate outside these industries. Investors looking at these non-core industries should, therefore, proceed with particular caution.
In other instances, a target business may have kept two sets of accounts – one that it discloses for tax purposes and one that reflects the true economic position of the business. An investor may nevertheless decide to proceed with an acquisition, but only after the seller has made full disclosure of this dual accounting. This is likely to be the case where, despite the anomaly, there is an underlying profitable business and where the buyer is willing to accept the risk associated with correcting the historical position and settling the associated taxes. However, such tax settlements not only come with their own particular challenges: they can also increase the level of tax authority scrutiny for the future.
Uncertainty in tax practice and the application of tax law to a transaction
Uncertainty over the tax treatment may increase the perception of risk and discourage long-term, capital-intensive investments that governments are typically eager to attract. Such uncertainty generally tends to be higher in jurisdictions where tax legislation is either less sophisticated or in need of an update. Derivative trading contracts in the banking sector is a prime example of an area where most African countries would struggle to apply their existing tax legislation.
Even more sophisticated tax administrations struggle with certain areas of tax like the application of the arm's-length principle to some connected party transactions. We have seen a number of examples in Africa where non-OECD member countries make reference to the OECD transfer pricing guidelines when debating the arm's-length nature of certain cross border transactions, often with the view to a resolve that is in favour of the tax authority.
Also, the development of the local authorities' tax practice over time may often result in situations where ground rules no longer reflect the original underlying legal basis resulting in uncertainty of how a given transaction would be taxed.
Risk of local tax authorities looking through the structure of a transaction to bring it within their tax net
The tax to GDP ratio in Africa is relatively low compared to that of Europe. Amongst other indicators, this may suggest that sufficient tax revenue is not being raised from the economic activities occurring within the region. Other schools of thought argue that official GDP calculations for specific African countries are skewed by the impact of international donor funding such that tax to GDP ratio does not present a true indicator of how efficient those countries are in raising tax revenues from local economic activity. Both arguments carry merit.
In our experience, the approach adopted by tax authorities to ensure that local economic activities are taxed fairly has been two-fold within the context of M&A in Africa.
The first approach, and the more common one, is an emphasis on revenue collected from tax audits and policy measures to increase the tax base. This emphasis may result in tax administrators viewing tax audits and complex transactions as a potential mechanism for raising further taxes.
Under the second approach, it could be perceived that some countries raise extra revenue by taking a position on certain transactions that may have little or no basis in existing tax legislation. Some African countries are seeking to tax indirect transfers of companies. For example, the government of Uganda imposed a capital gains tax liability on a company following the sale of its Ugandan oil interests to an acquirer. The company challenged the Ugandan tax assessments on the basis that the sale was undertaken in an offshore jurisdiction. Despite the fact that Uganda had no provision in its tax legislation for the taxation of non-residents on capital gains, the Ugandan government took the view that the transaction was taxable in Uganda because the underlying asset sold was situated in Uganda and government consent had to be sought prior to undertaking the transaction.
A similar story recently occurred in Mozambique. A potential sale of an AIM listed company operating in Mozambique had been preceded by discussions with government officials aimed at understanding how the Mozambique authorities expected to tax the transaction. The company received written clarification that any capital gain arising on the indirect transfer of Mozambique assets would be taxed at an effective rate of 12.8%. This does not seem to have any basis in existing legislation but it may set a precedent for future transactions linked to Mozambique assets.
The positions adopted by the governments of Uganda and Mozambique could be the result of several factors. One explanation may be a previous failure by the Mozambique government to assess taxes when the disposal of a controlling stake in a company, which owned mining assets in Mozambique, resulted in pressure from civil society groups in Mozambique. Whatever the reason, such positions present a huge challenge for companies that are left with a question mark on how a future exit from their investment would be taxed.
Changes to tax law and their impact on projected tax costs
Globalisation has had a dramatic effect on business models. The growing disclosure and transparency requirements being driven by some jurisdictions, in particular the US and the European Union, and expansion into emerging markets has led many African tax administrations to become more focused.
Rapid capital inflows have had a major impact on tax policy in emerging markets. A similar trend is spreading across Africa.
African tax administrations are rapidly increasing their focus on those issues that reflect the globalisation of business. Top of their lists, in our experience, are transfer pricing, transactions involving tax haven countries, and the indirect transfers of assets.
In a bid to preserve and increase tax revenues, there is a growing trend of African countries more closely scrutinising transactions between connected parties. Most revenue authorities now realise the significant potential for revenue leakage through pricing of transactions between resident and non-resident related parties. Although the arm's-length principle in connected party transactions features in most tax legislations, until recently there has not been specific and clear guidance on its application. Considerable effort has gone into setting up structures like the regional economic communities in Africa to facilitate trade. Making such structures work is where the real challenge lies. Multilateral tax treaties have been on the agenda for most of the regional economic communities for the last few years but progress has been very slow.
Foreign exchange controls and income repatriation
Although a number of African countries have liberalised their exchange control regulations, foreign investors into Africa are likely to encounter exchange control restrictions intended to regulate the import and export of capital by resident and non-residents.
Some violations of exchange control constitute a criminal offence with associated penalties and it is generally a difficult process to seek retrospective approval under an exchange control regime. A rare example of government using exchange control as a corrective administrative measure to enforce compliance was the temporary period when Zimbabwe's central bank recently ordered local banks to cease processing cross-border payments by a local subsidiary company, accusing the subsidiary of failing to comply with an order to transfer funds from its offshore account into Zimbabwean banks.
Exchange control can have a fundamental impact on contracts and transactions involving cross-border payments. It is, therefore, vital that foreign investors have an appreciation of the regulatory environment and what impact it could have on both inward and outward remittances.
Transparency, collaboration and accountability
While recognising the investment opportunities in Africa, investors should be aware of the importance of practical tax advice in an M&A context. The challenge for a tax director is to distinguish between those inevitable uncertainties which can be addressed through negotiations with a seller and those which present a genuine threat to the success of a transaction.
Interaction with the tax authorities is an essential part of conducting business in Africa; and demonstrating transparency, collaboration and accountability can help to build constructive relationships with tax authorities.
The uncertainties inherent in many African tax regimes can be mitigated by:
Striking a balance between uncertainty, limited case law and the unpredictability and duration of litigation on the one hand and maximising the tax effectiveness on the investment in the other;
Ensuring that an investment makes commercial sense prior to assessing the benefits of tax losses or other tax incentives which may be built into the valuation models;
Spending time on the ground to understand the local tax environment – not just the local tax law, practice and procedure but also the reasoning behind it; and
Consulting a range of local advisers and understanding their respective strengths and limitations.
Francisco Almada (falmada@uk.ey.com and Ekow Eghan (eeghan@uk.ey.com)
