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Developing Countries and the Tax Treaties Myth

Posted on Jun. 21, 2021

In his new book, Imposing Standards: The North-South Dimension to Global Tax Politics, Martin Hearson examines a question tax and legal scholars have grappled with for decades: Why do lower-income countries tend to sign away their taxing rights in treaties with higher-income countries? Why do they repeatedly sign unbalanced treaties that leave them in a worse position than if they hadn’t signed in the first place? [Editor’s note: This article should have acknowledged Tsilly Dagan’s 2000 article “The Tax Treaties Myth.” It was not Tax Notes’ intention to use a similar headline without crediting Ms. Dagan or her article. Tax Notes apologizes for the oversight.]

It’s complicated. For years, the prevailing narrative has been that lower-income countries, eager for investment and development, entered treaties without proper knowledge or training. For lower-income countries — many former colonies finding their footing in the decades after independence — there have been capacity deficits and knowledge gaps that have at times felt insurmountable. Meanwhile, there’s been a strong political belief within some lower-income countries that tax treaties will attract investment and give their countries a veneer of respectability and prestige.

While those factors are real, Hearson, international tax program lead at the International Centre for Tax and Development, turns that narrative on its head and pushes some of the focus away from lower-income countries and onto their developed country partners. In his book, he takes a deep look at the role that developed countries — particularly the United Kingdom — have played in this imbalance and offers another, much less discussed narrative.

Hearson argues that tax treaties are often pursued by developed countries as a way to protect their own business interests and promote the tax standards they’ve developed among themselves for roughly a century. Lower-income countries eventually acquiesce, in some cases after years of negotiations or even flat-out repudiations, because they want to maintain good diplomatic relations. It’s a story that Hearson develops through detailed data analysis of over 2,000 treaties signed by lower-income countries and interviews over several years with nearly 100 tax treaty officials and private-sector officials spanning 30 countries. He also turns to the archives, including the U.K. National Archives, OECD and U.N. archives, and archives of U.S. diplomatic cables, all of which give Hearson a rich, historical foundation for his analysis.

Hearson says that two competing narratives — treaties as a vehicle for investment and treaties as a vehicle for standard setting — combined with capacity issues in lower-income countries have enabled higher-income countries to negotiate aggressive treaties. It’s a novel argument that raises questions about the way forward for lower-income countries.

Hearson makes three observations that could influence how these negotiations play out in the future. The first is that there’s little conclusive evidence that tax treaties attract new investors to lower-income countries — so that alone is not a sound justification for signing treaties. The second is that lower-income countries underestimate their power in these negotiations and often have much more leverage than they realize because their higher-income treaty partners are eager to make a deal. The third is that lower-income countries should carefully use the knowledge they gain through international capacity building to establish their own norms. But this, as will be discussed later, is easier said than done.

Imposing Standards arrives at a pivotal moment in international tax policymaking. To know where we are going, we must know where we have been. Yet what has been missing from international tax reform discourse is a serious, and robust, historical analysis. Hearson’s book shines a light on that historical narrative and illuminates some paths forward for lower-income countries trying to establish their own norms. There are questions that the book cannot answer because the story is still unfolding. But Hearson’s book could add fuel to those conversations. For example:

  • As lower-income countries develop more capacity, will they use that knowledge to create their own standards, or will global political pressures cause them to mostly align with current norms?

  • How can tax officials combat some of the political pressures that influence their home governments to approve unfavorable treaties with desired investment partners?

  • As lower-income countries close the knowledge gap, will they have enough leverage to substantially renegotiate old, unfavorable treaties?

How Did We Get Here?

Hearson challenges the assumption that tax treaties are important for everyone. For African countries in particular, they can be costly: The IMF estimates that every new treaty signed by an African country generates a 5 percent reduction in corporate tax revenues. On the other hand, treaties are a good deal for higher-income countries because they typically force the lower-income country to relieve double taxation, often at considerable cost. How did this dynamic start?

To answer this question, Hearson takes a short journey through the history of international tax policymaking, starting with the League of Nations and continuing through to the present day. It is a tale of first mover advantage. Western leaders created the League of Nations right after World War I to promote global peace and economic stability. Tax quickly became an agenda point when it was realized that tax disputes were threatening diplomatic cooperation. When the League disbanded right around World War II, it left behind two important tax treaty models colloquially known as the Mexico model and the London model.

The Mexico model aligned more strongly with the interests of developing countries and allocated greater taxing rights to source countries. The London model more closely followed the interests of developed countries and provided greater taxing rights to residence countries. The U.N. was supposed to continue the League’s work after World War II, but it never found the necessary momentum. Instead, the Organization for European Economic Cooperation, the predecessor to the OECD, started doing substantive tax policymaking on behalf of its member states, all wealthy industrialized countries. By the time the U.N. reengaged with tax work in the 1960s, the OECD had already crafted a model tax convention based on the League’s London model and had established several working parties. Meanwhile, the U.N., which was already behind, was tasked with addressing the tax needs of developing countries, many of whom were emerging from colonialism and did not have the same capacities as OECD members.

Hearson argues this history is important because the OECD’s head start cemented residence taxation as the international default and gave the OECD an international policymaking advantage that’s been difficult to surmount. It’s a common argument, but Hearson goes one step further and essentially casts the entire international tax policymaking system as a legacy of the OECD. He argues that even the U.N. model tax convention is in some ways a legacy of the OECD because the U.N. treaty references the OECD’s convention, although it has been independently adapted over the years. Beyond that, he notes that, at the time he wrote his book, some of the U.N. tax committee’s transfer pricing subgroup members previously held OECD posts.

Hearson calls this the OECD-U.N. complex. What does this mean? It means that when lower-income countries emerged on the international tax scene, they walked into a system that fundamentally was not created for them and seemingly lacked space to be shaped by them. Hearson argues that spaces designed for lower-income countries do not fully promote their interests as source countries. For example, regional treaties created by organizations like the Common Market of Eastern and Southern Africa and the Association of Southeast Asian Nations do not deviate strongly from the OECD model. International tax capacity building, while helpful, reinforces current standards because it is largely driven by the OECD-U.N. complex, he writes.

At this point, readers might think about campaigns to house tax policymaking within an intergovernmental U.N. tax body instead of the OECD. Hearson doesn’t get into that argument, but he seems to suggest that the issues lower-income countries face are not entirely about the specific forum, but rather larger global power dynamics. He cites archives of old U.N. Fiscal Commission meetings demonstrating that source versus residence policy fights were happening then, too, and were largely dominated by larger residence countries. This raises questions about the structure of international tax policymaking — are large, global bodies the best forums for lower-income countries to debate international tax policy? Hearson doesn’t explicitly raise this question in the book, but it’s worth thinking about.

The Tax Treaties Myth

There’s a belief among some policymakers in lower-income countries that tax treaties increase investment. It tends to proliferate among policymakers who are not tax specialists, but Hearson says this is a myth that evaporates with increased expertise. Across his interviews, he found that members of the international tax community on both the developed/developing country sides believe tax treaties are best for reducing prices for investors after they choose to invest, not for inducing them to invest in the first place.

The treaty-investment connection is not a simple area to study; Hearson points out that economic evidence is all over the place in this area and that studies find both positive and negative associations between tax treaties and investment in lower-income countries. Beyond that, it’s hard to make a distinction between new investment that is specifically generated from a treaty and investment that was diverted from elsewhere to take advantage of a particular treaty based on available data.

While it’s too soon to definitively say whether tax treaties attract investment, Hearson says that “in all probability, any effect of a tax treaty on investment depends on the characteristics of the two signatories’ tax systems, on the presence or absence of specific clauses, on whether the treaty contains effective protection against treaty shopping, and on the treaties concluded by a country’s competitors.”

“The research question lower-income countries need answered, then, is not ‘Do tax treaties attract investment?’ but ‘In what circumstances might a tax treaty attract investment, and on what terms?’” he wrote.

What Is Happening in Negotiations?

What Hearson does find is that when lower-income countries need investment, they tend to sign away their taxing rights. His review of lower-income countries found that they tend to have fewer source taxing rights in treaty relationships in which they receive more foreign direct investment.

Interestingly, he also found that lower-income countries are able to obtain greater taxing rights as they gain more experience with treaties; but those gains mostly occur in treaties with other non-OECD countries, not in treaties with OECD countries in which increased source taxing rights are more important. Meanwhile, in treaties between two non-OECD members, source taxation clauses from the U.N. model treaty appear more frequently. Hearson’s analysis found that there’s a “widening gap” in how lower-income countries negotiate with each other versus how they negotiate with OECD member states and that this gap has been widening over the past 15 years.

But Hearson is clear that these dynamics are not caused by a lack of talent. Rather, they are caused by structural power imbalances that tip the scales in favor of higher-income countries.

“It is not hard to find intelligent, astute, and well-informed negotiators from lower-income countries, whose meticulousness and tenacity are acknowledged by their opposite numbers. What is at issue here is the structural constraints in which they operate: a relative lack of experience and training combined with bureaucratic and political pressures that reduce their room to maneuver.”

Fitting In vs. Belonging

The pressures Hearson describes are not just technical and political. They are also social. No one wants to be the social outcast, and that is especially true in international tax.

Let’s turn to psychology for a moment and the concepts of fitting in and belonging. They are not the same. Fitting in is inauthentic; it’s about hiding or disregarding your true self in order to gain acceptance. Belonging is about standing firm in your identity and navigating the world based on your unique characteristics. There are parallels here in the international tax context. Source countries are mostly trying to fit in; they’re adopting norms that were developed for residence countries instead of operating on their own standards.

But belonging is hard, and there’s no easy answer to how lower-income countries can do it. Hearson finds that civil servants from lower-income countries often adopt the taxation principles promoted by higher-income countries because it’s the only way they can fit into the club.

“If they want to be part of this expert community, there is little room for those from lower-income countries to challenge such a long-standing consensus, even where it exhibits a strong bias against them,” Hearson writes.

This is compounded by the fact that tax treaty specialists seem to derive their sense of community from belonging to a small transnational expert community trained on standards developed and refined by experts from OECD countries. When lower-income countries push back against these standards, they are pushing back against a strong identity that is difficult to crack because it is framed around technical expertise and economic efficiency.

“A powerful logic of appropriateness pervades this community,” Hearson writes. “The OECD’s model tax treaty is the acceptable way to tax multinational companies. . . . Its bias against lower-income countries was never agreed to by those countries at a political level; instead, it is justified in technical terms as more economically efficient.”

Flipping the Narrative

Hearson’s most attention-grabbing finding is that higher-income countries actively sought treaties with lower-income countries, not the other way around. This is because tax treaties mostly confer benefits on multinationals based in the higher-income country, and when competitors learn about their disadvantage, they ask their home countries to enter tax treaties so they can have comparable benefits, according to the book.

Hearson illustrates this through the United Kingdom, which has the largest treaty network in the world. It took this approach primarily so that its companies would not be disadvantaged compared with competitors. But Hearson also argues that U.K. firms sought this first mover advantage so they could ensure that lower-income countries were following the OECD’s standards. These advantages were important enough that the United Kingdom often spent years courting reluctant lower-income countries to strike a deal.

Hearson’s analysis shines when it comes to his field interviews with former treaty officials, especially in several case studies analyzing treaty outcomes in Zambia, Vietnam, Cambodia, Nigeria, and Brazil. These countries have had vastly different treaty negotiation experiences, which Hearson presents as potential lessons for the future. For example, Zambia’s desire for international prestige combined with treaty inexperience and a large amount of mining revenue depressed its need for tax revenue and led the country to sign a number of treaties that gave away most of its taxing rights. Cambodia waited until 2016 to sign treaties and did so only after its officials amassed years of tax education and training. As a result, its tax treaties are strong agreements that retain many of the country’s taxing rights.

Implications for the Future

Now that lower-income countries are becoming more fluent in the language of international tax and are building their capacities, will they promote their own interests more forcefully? This is one of the most interesting and open-ended questions from Hearson’s book.

Some of this is already happening. He points out that a number of countries, including Indonesia, Senegal, South Africa, Rwanda, Argentina, and Mongolia, have canceled or renegotiated tax treaties in different ways. Kenya, Uganda, and Nigeria forced treaty renegotiations by completely canceling some of their old treaties.

But Hearson also showcases some of the legal and political difficulties in doing this. Zambia is a case study. Zambia took a lighter-handed approach and sought to renegotiate its old treaties one by one. It didn’t entirely work because its old colonial-era treaties with France and Switzerland still stand. France and French businesses threatened Zambia with litigation. For all the work Zambia poured into renegotiations, the country only managed to expand its taxing rights incrementally. Relatedly, African countries have scored the largest changes on renegotiation with their fellow African countries. Hearson cites the Rwanda-Mauritius negotiation as an example.

Hearson seems to hint strongly that regional associations or groupings could help lower-income countries on the international stage. But there, too, they are vulnerable to power imbalances. He presents the example of the Community of Andean Nations, a group of five Latin American countries that signed their own multilateral treaty — Decision 40 — in 1971. That treaty gave source countries exclusive taxing rights over most income, and no OECD countries would engage with the group.

It is impossible to read Hearson’s book and not draw parallels to the state of international tax policymaking. But the book leaves the reader with many questions. For countries that are considering new tax treaties, the warning is clear: Proceed carefully. For countries thinking about renegotiating bad treaties, their options seem less promising especially since existing tax treaties set the stage for renegotiations and for new treaties with third countries. That said, in recent years, some higher-income countries like Ireland and the Netherlands have decided to reevaluate their tax treaty policies with lower-income countries. After reading Hearson’s book, one must question the motives. Are these reevaluations occurring because of altruism? Or are these residence countries trying to maintain their first mover advantage?

What Hearson does make amply clear is that if the tensions between higher-income and lower-income countries are not emphasized in international tax policymaking, lower-income countries will continue to lose out.

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