Thursday, October 18, 2007

Recent changes in taxing business profits

Last week, the parliament tackled a number of proposed tax law changes including a provision related to Armenian firms incorporated in tax havens. The proposed amendments are briefly "described" in the parliament briefing on October 1, but the text is not very helpful. I was not able to locate any of the specific details on the various proposals presented and discussed at the parliament, which eventually adopted the proposed changes on October 11. In addition, I could not find anything on the ministry of finance and tax services websites. Also, the information reported in the press is very confusing and provides little meaningful information, which, unless I read incorrectly, suggest that the profit of Armenian firms incorporated offshore will be taxed at 10 percent as of July 2008; the general profit tax rate is 20 percent.

Governments levy taxes to fund their expenditures. In general, their goal is to ensure that taxpayers comply with the tax laws of the land and pay their assessed tax liabilities. At times, they extend preferential treatment to particular groups or specific industries to encourage an expansion in economic activities. Taxpayers, of course, are not passive economic agents. Putting aside tax cheats, they are able and willing to legally exploit tax provisions to minimize their tax bills. While each tax law provision may have a specific predictable consequence, when combined they may have unintended consequences that may work to the advantage of taxpayers.

Consider the case of foreign businesses investing in Armenia. They are accorded tax holidays whereby firms investing a minimum of 500 million Drams (1 USD=333 Drams) benefit from 100 percent forgiveness from the profit tax in 2008 and 2009; 2007 is the last year when new investments qualify for tax holidays in Armenia. The benefit of the tax holiday is not available to domestic firms. But this does not mean that a local firm cannot avail itself to this benefit. A start up firm may incorporate itself in a tax haven country where no or very low taxes prevail, and taxpayers' privacy is respected, and invest in Armenia as a foreign entity. With some planning, an existing firm may reincorporate itself as well. I believe, there are no tax consequences to this reincorporation (zero capital gains taxes). Once incorporated offshore, and in addition to the tax holiday on investments in Armenia, the parent company may be able to exploit other provisions in the tax laws. An example is the case of interest allocations whereby the local firm is able to claim interest expenses on loans from the parent company (not sure what type if any earnings stripping rules apply); before incorporating, such deductions may not exist as there would be one local company (inter-company loans).

Such tax motivated incorporations and inversions have been around for some time. Again, and as eluded to above, in an inversion, a firm reincorporates itself outside its home country, typically in a country with low or no taxes. The reincorporation, notwithstanding its tax implications, has little effect on how the firm is operated. (see here for a description and tax implications of inversions).

I continue to be amazed at the swiftness with which proposed changes to tax laws get adopted. Little information about the revenue effect and the distributional implications of the changes or on the number of affected taxpayers are provided. Also, there is a general lack of public discussions which may help flush out problems in the proposed legislation.

Anyway, returning to the inversion issue, taxing capital in a global setting is very difficult, and requires considerable expertise and careful design. From the little I have read, it is not clear how the inversion problem will be solved. And, perhaps more importantly, the adopted changes may have the reverse effect in that they may encourage inversions where the profits of firms incorporated offshore will be subject to a tax rate of 10 rather than 20 percent.

Again, it is not clear what if any effect the proposed changes will have. But I really wish for the process to be slowed down a bit and modified so as to allow for greater discussion and feedback from the public. I am confident that every foreign firm operating in Armenia with shares traded on a stock exchange in the west carries a warning on its financial reports related to taxation contingencies. HSBC bank, for instance, reports in its 2006 financial statement (arm p. 40, eng p.34) that "The taxation system in the Republic of Armenia is relatively immature and is characterised by numerous taxes and frequently changing legislation which is often unclear, contradictory, and subject to interpretation. Often, differing interpretations exist among numerous taxation authorities. ..."

I am not sure if anyone is writing on this subject, and so your comments and corrections are welcome.

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