Do tax treaties override domestic law in Africa?

A tax treaty concluded between two contracting states generally overrides the domestic tax law of each one, insofar as domestic law is inconsistent with the provisions of the relevant tax treaty. Accordingly, taxpayers who are unfamiliar with the domestic tax laws of one or other of the contracting states often rely solely on the provisions of a particular tax treaty to determine the practical tax implications of that treaty.

In Africa, such an approach may be very risky and a number of multinational companies have been caught out in recent years.

In Tanzania, Ghana and Uganda, domestic tax legislation may override tax treaty provisions. The tax treaty itself would typically not provide any indication that domestic limitations exist. From a taxpayer's perspective, this state of affairs may have a significant impact on the amount of withholding tax and capital gains tax it is expected to pay.

UK HoldCo, a company incorporated and tax resident in the United Kingdom (UK), is listed on the London Stock Exchange; the majority of its shareholders being, for example, foreign pension funds or corporate investors. UK HoldCo has a wholly owned subsidiary in Ghana (Ghana OpCo), which is incorporated and tax resident in Ghana, and is not regarded as land rich. UK HoldCo wishes to dispose of its shares in Ghana OpCo to a third party, which transaction would give rise to a capital gain in its hands.

Diagram 1

Under Ghana's domestic tax law, the gain realised by UK HoldCo should be taxed in Ghana at the rate of 15%. The UK/Ghana tax treaty, however, assigns the taxing right for the gain to the UK (where relief from capital gains tax should be available under the Substantial Shareholding Exemption (SSE) rules). It is therefore reasonable for a taxpayer to assume that the UK/Ghana tax treaty would provide relief from the 15% capital gains tax imposed by Ghana's domestic tax law.

However, section 111(4) of Ghana's Internal Revenue Act, 2000 (Act 592), states:

(4) Where an international arrangement provides that income accruing in or derived from Ghana or some other amount is exempt from Ghanaian tax or is subject to a reduction in the rate of Ghanaian tax, the benefit of that exemption or reduction is not available to a person who, for the purposes of the arrangement, is a resident of the other contracting state where fifty per cent or more of the underlying ownership of that person is held by an individual or individuals who are not residents of that other contracting state for the purposes of the arrangement.

Section 166 of the same law defines "underlying ownership" in relation to an entity as "an interest held in or over the entity directly or indirectly through one or more interposed entities by an individual or by an entity not ultimately owned by individuals".

Under section 111(4): "where fifty percent or more of the underlying ownership of that person is held by an individual or individuals [our emphasis] who are not residents of that other contracting state [UK]", then the tax treaty relief should not apply. At first glance, this provision would not appear to apply to the facts at hand as the majority of shareholders of UK HoldCo are not individuals. However, the definition of underlying ownership suggests that the tax residency of non-individuals (for example, pension funds, corporate or sovereign funds) should also be considered, with the effect that tax treaty relief would be unavailable if more than 50% of the shareholders (whether individuals or not) of UK HoldCo are not tax resident in the UK.

The fact that UK HoldCo is a listed company, makes it very difficult to prove that more than 50% of its shareholders are UK tax resident, since shareholders of London listed companies constantly change, and some shares are held by nominee shareholders. Section 111(4) of the Ghana Internal Revenue Act has the consequence that it becomes very difficult for London listed companies to avail themselves of the benefits conferred by the UK/Ghana tax treaty.

To complicate matters, some interpret Ghana's domestic law to mean that when the underlying ownership of a particular company is investigated, indirect ownership should also be considered. Accordingly, if UK HoldCo was, for example, owned by a UK tax resident shareholder, whose shareholders are mainly foreign, the Ghana tax authority may still try to deny the benefits of the UK/Ghana tax treaty to UK HoldCo.

The wording of section 88(5) of the Income Tax Act, Cap 340 of the Laws of Uganda is almost identical to that of section 111(4) of the Ghana Inland Revenue Act. The definition of underlying ownership is also the same.

However, there appears to be differences in how the Ghanaian and Ugandan tax authorities apply the law. Whereas the Ghana tax authority may try to apply its section 111(4) to non-resident shareholders of listed companies, Uganda appears, in practice, to only consider the tax residency of the listed company (as opposed to that of its shareholders). The reason for this is that it may be impractical for the non-resident listed company to prove the tax residency of its shareholders, for the reasons explained earlier. The approach of the Uganda tax authority appears to be more practical; otherwise section 88(5) may have the unintended consequence of automatically negating tax treaty benefits for non-resident listed companies.

Section 128 of the Tanzanian Income Tax Act, 2004 makes it clear that a tax treaty overrides domestic law, except in the case where the tax treaty provides for an exemption or reduction in tax due to the United Republic of Tanzania. In particular, subsection 5 says that, "the exemption or reduction shall not be available to any entity that meets the following conditions:

a) The entity is, for the purposes of the agreement, a resident of the other contracting state; and

b) 50 percent or more of the underlying ownership of the entity is held by persons, being individuals or entities in which no individual holds part of the underlying ownership, that are not, for the purposes of the agreement, residents of the other contracting state or the United Republic."

For the purposes of section 128, underlying ownership in relation to an entity means membership interests owned in the entity, directly or indirectly through one or more interposed entities, by individuals or by entities in which no person has a membership interest ...".

It is clear that the indirect ownership of a non-resident entity in a contracting state, would also be considered. The position can be illustrated by an example (see Diagram 2).

Diagram 2

For the purposes of this example, it is assumed that the shareholders of UK Company and Mauritius HoldCo are all resident in the UK and Mauritius respectively.

Tanzania OpCo pays royalties to SA HoldCo 2 for the use of certain intellectual property. The Tanzanian withholding tax is 15%, while the SA/Tanzania tax treaty rate is 10%.

If we take into account the indirect shareholding of SA HoldCo 2, more than 50% of its underlying ownership is held by entities not tax resident in South Africa. Accordingly on a strict interpretation of section 128(5), SA HoldCo 2 should not be able to benefit from the reduced royalty withholding tax rate of 10%. Reverting to a rate of 15%, may have significant cost implications for the taxpayer.

Ghana, Tanzania and Uganda are good examples of African jurisdictions where domestic law provisions can override tax treaties

Though the wording of the above Ghanaian, Ugandan and Tanzanian legislative tax provisions provide little indication as to their purpose, it can safely be assumed that it is primarily to limit instances of treaty shopping and tax treaty abuse. This creates uncertainty. For example, if the majority of the indirect shareholders of a company claiming treaty benefits are not resident in the contracting state, but it is clear from other evidence that there has not been any attempts at treaty shopping (for example, the company is listed), would treaty benefits be denied?

On the basis of past experience of working with the tax authorities in Ghana, Uganda and Tanzania, it is likely that the relevant tax authority would follow a strict interpretation of the law, regardless of whether there has been actual treaty shopping or not. However, the possibility always remains that a practical approach can be agreed with the relevant tax authority. This becomes particularly relevant in the case of listed companies, considering that their shareholders may be constantly changing, and an intended abuse of the tax treaty system by a listed entity is unlikely. As mentioned above, the Ugandan tax authority already appears to take a practical approach in this regard, relaxing the application of the relevant tax provisions to listed companies.

From the taxpayer's perspective, the question is whether a strict or more practical approach should be taken concerning the application of the limitation of benefit provisions. When deciding on whether the relevant provisions would apply to a particular situation, the taxpayer may think it reasonable to take the main purpose of the legislation, that is, to prevent treaty shopping, into account. If that is done, it may be the taxpayer's view that a listed company should not be denied tax treaty relief. The same argument may be applied to companies with real operations in the contracting state (as opposed to holding companies), as it is unlikely that the reason for establishing an operating company would have been to obtain a tax treaty benefit.

A more practical, and arguably more reasonable, application of the limitation of benefit provisions, may be challenged by a strict interpretation by the relevant tax authority. In that case, if negotiation does not work, the solution may be to refer the dispute to competent authority in the contracting state in which the taxpayer is resident, as per the Mutual Agreement Procedure outlined in tax treaties. To what extent this is a workable solution, remains debatable.

Investors in Africa clearly need to be aware that all may not be what it seems insofar as tax treaties in certain African jurisdictions are concerned. The fact that domestic law may sometimes override tax treaty provisions should be on the radar screen of investors which indirectly acquire interests in Ghana, Uganda and Tanzania in particular. For example, if an investor (not tax resident in either contracting state) acquires, from a Dutch tax resident seller, a wholly owned Dutch tax resident holding company (with a Ugandan subsidiary), that investor should be aware that the Dutch holding company is unlikely to be entitled to the benefits of the Netherlands/Ugandan tax treaty after the acquisition, such as a reduction in withholding taxes. This may have serious implications for the acquisition price payable or for the forecasting models that influence the acquisition decision.

Africa is increasingly viewed as an attractive investment destination. However, some of the tax challenges faced by investors in Africa, such as the domestic limitation of benefit provisions, may have serious implications if not properly understood and considered when investing in certain African countries.

Leon Steenkamp (lsteenkamp@uk.ey.com) is based in Ernst & Young's transaction tax group in London and is the Africa Tax Desk for the Europe, Middle East, India and Africa (EMEIA) and Stephen Hales (shales1@uk.ey.com) is a partner in Ernst & Young's transaction tax group in London