Africa: There is a better way to avoid tax evasion
Tax simplification would level the playing field between tax authorities and multinationals based on easily verifiable standards.
With one of the highest poverty rates in the world, Sierra Leone might wish to magically acquire a source of wealth to ease its struggles. Yet it already has one: it is one of the world’s largest producers of diamonds and other minerals.
The problem is that a large part of the profits end up in tax havens. For example, leaked documents revealed that one of the country’s largest diamond mines was undervaluing sales to its subsidiaries in tax havens by up to 35%, illegally reducing revenue that Sierra Leone could have used to schools, hospitals and roads. In total, the estimated amount of revenue that Sierra Leone loses to tax abuse is nearly 1.5 times its entire health budget.
Many African countries are in a similar position: resource-rich and cash-poor. The conventional wisdom is that they should fight corporate tax avoidance by mimicking the tax systems of northern countries as best they can. But this fight is taking place on a deeply unequal playing field. On the one hand, there are usually national tax authorities that lack resources and training. On the other, there are multinational corporations employing teams of top lawyers and accountants. Moreover, rich countries also suffer significant losses due to corporate tax evasion.
Fortunately, there is a better alternative: tax simplification. As I argue in a recent article in the Yale Journal of International Law, African governments can fight tax evasion and level the playing field between their tax authorities and multinational corporations by adopting rules that reduce administrative burdens and are based on easily verifiable standards.
Taxation ripe for exploitation
The international corporate tax system is based on a fiction. It assumes that trade takes place between companies, but most global trade takes place between subsidiaries of the same multinational. This poses a problem for taxation. If a Guinean company sells minerals to a separate Swiss company for $100,000, the tax implications are clear. But if the minerals circulate between the Guinean and Swiss subsidiaries of the same company, how does the tax authorities determine which profits are taxable in Guinea and which are taxable in Switzerland?
The unsatisfactory answer of the international corporate tax system is the “arm’s length principle”. Under this rule, the transfer price – that is, the price of the transaction between affiliates of the same company – is deemed to be the price that would have been used in a normal market transaction.
The problem is that it is up to the multinationals to determine this figure, which leaves them the possibility of manipulating the system to reduce their tax bill. A company transferring assets from its Guinean subsidiaries to Swiss subsidiaries, for example, can easily enter a transfer price of $75,000 even though the normal market price would have been $100,000. With the stroke of a pen, $25,000 of profits appear in Switzerland at a low tax rate and are no longer taxable in Guinea.
In theory, the tax authorities could challenge this transfer price. But in reality, overwhelmed officials sorting through thousands of corporate transactions are unlikely to notice the understated transfer price. And, even if it did, the company could cite several reasons to justify the price it set. The market transaction never took place – the minerals were just moved between different parts of the same company – so it is extremely difficult to disprove the advertised transfer price. Anecdotal evidence confirms that huge amounts of transfer pricing go undetected. For example, in a 2013 survey, three-quarters of African tax authorities indicated that they had not carried out any transfer pricing audits in the previous year.
Officials are also struggling to counter other ways companies shift profits to tax havens. For example, subsidiaries in tax havens offer loans to African-based subsidiaries at artificially high interest rates. This leads to the accumulation of profits declared in the tax haven and losses declared in the country from which the resources originate. Similarly, corporations may claim intellectual property as owned by a subsidiary in a tax haven and then charge other subsidiaries high royalties for its use, further distributing the multinational corporation’s taxable profits to low-tax jurisdictions or zero tax.
How to fight tax evasion
In response to massive corporate tax avoidance in Africa, international tax experts often call for two proposed solutions. First, they refer to the recent global corporate tax reforms led by the OECD. These policies are marginal progress, but they favor rich countries and are too limited to tackle most tax avoidance in the natural resource sector in Africa. Second, they call for capacity building of African tax authorities.
Tax simplification offers a better alternative. Unlike the long, costly and arduous process of capacity building, African governments can quickly implement legal reforms that reduce the need for administrative capacity.
For example, Zambia has adopted what is called “the sixth method”. Rather than allowing companies to report transfer prices based on a counterfactual transaction, this approach simply requires them to use the price of minerals quoted on international commodity markets.
African governments can also increase their use of mining royalties. Unlike profit-based corporate income tax, which encourages companies to claim artificial losses to reduce their tax bill, royalties are royalties based solely on production and revenue. Another option is to set strict limits on interest deductions. For example, South Africa does not allow companies to deduct interest payments to foreign-based companies exceeding 40% of turnover from taxable profits. This reform prevents companies from issuing excessive loans between subsidiaries in a simple way that does not require the tax authorities to compare each loan to a hypothetical market transaction.
By simplifying tax administration, these reforms leave far less room for armies of accountants and lawyers working for multinational corporations to manipulate complexity to their advantage. These reforms can reduce flexibility and nuance and, in some cases, they could moderately discourage investment. But compared to a status quo where foreign investment often yields little benefit for people in African countries, these trade-offs are worth it.
Ensuring that people benefit from their resource wealth was a fundamental requirement of post-colonial African leaders, but even today many of the benefits of the continent’s natural resources are found in the Global North. As the pandemic puts governments under fiscal pressure and commodity prices rise rapidly, now is the time to crack down on corporate tax avoidance. Although reforms may take place in legal codes and bureaucratic procedures, the effects will be felt by the citizens of African countries who have for too long been deprived of the prosperity they deserve.
Tim Hirschel-Burns is a student at Yale Law School and co-founder of Law Students for Climate Accountability. It focuses on policies impacting global poverty and inequality, human rights and climate change.