Double tax warning for South African companies

A new proposed solution from the United Nations (UN) to tackle base erosion and profit shifting from multinational corporates will increase the risk of double taxation on these companies. 

This is particularly problematic for African countries, which have limited and outdated double taxation agreements. This is likely to impact South African companies, which have extensive operations on the continent. 

Thus, the solution proposed may end up harming the countries it seeks to protect by limiting the international expansion of multinational companies and economic growth. 

Financial services firm PwC explained why the UN’s proposed solution may create more harm than good in its most recent Synopsis. 

Multinational companies now generate a substantial portion of their revenue outside of their home countries through cross-border services delivered remotely. 

PwC explained that these challenges to traditional international tax frameworks are based on the principle of physical presence, resulting in base erosion and profit shifting. 

This results in inadequate tax being collected on the provision of services in various countries, particularly developing nations that have little bargaining power. 

The UN has proposed a new Framework Convention on International Tax Cooperation to create a broad-based approach to the rules of international taxation. 

PwC said the UN has the right intentions and such an intervention is arguably necessary in a modern economy, with digital services requiring a new form of tax framework. 

However, one of the main instruments in the framework is a withholding tax on services, which PwC warned could be damaging if levied incorrectly. 

“Policymakers, especially in capacity‑constrained administrations, may view gross‑basis tax instruments as attractive due to their simplicity, enforceability, and immediate revenue collection,” it said. 

However, this is likely to result in punitive tax burdens and increase the risk of double taxation, ultimately imposing costs on the businesses it intends to help. 

As a result, it is likely to impede long-term economic growth and investment by creating an increasingly onerous tax burden on multinational companies. 

UN tax proposals under fire

PwC said that despite its administrative simplicity, applying a withholding tax to the gross value of a service payment is a blunt instrument that may create economic distortions and risks. 

In particular, a gross-basis tax is levied on total revenue without taking into account the costs incurred to generate that revenue. This ignores the fundamental business reality of profitability. 

The true measure of a tax burden is its effective tax rate, which is typically calculated as the percentage of pre-tax profit actually paid in tax. 

A withholding rate of 15%, a common rate in many tax treasuries, can have a detrimental impact on effective tax rates of service providers with different business models. 

PwC’s analysis shows that for a high-margin business, a withholding tax of 15% results in an effective tax rate of 21.4%. 

On the other end of the spectrum, a low-margin business will suffer from an effective tax rate of 300% under the same withholding tax of 15%. 

“As this illustrates, the effective tax rate for a low-margin support service provider becomes confiscatory, with a tax liability three times the actual profit earned,” PwC said. 

“Such punitive effective tax rates make it commercially unviable to provide these services, discouraging foreign investment and reducing the availability of essential business inputs that local economies need to thrive.” 

A major risk for companies operating in Africa is the increased likelihood of double taxation under the new framework. 

PwC explained that the primary mechanism for preventing double taxation is a double tax agreement (DTA), which obligates an investor’s resident country to provide relief for taxes paid in another country where revenue is generated. 

The firm said many African countries have limited and outdated DTA networks, often reflecting a legacy of unequal negotiating power. 

When a country unilaterally imposes a withholding tax on services in the absence of a DTA, there is no legal mechanism to compel the company’s resident country to grant a foreign tax credit for the tax paid in the source country. 

The result is unrelieved double taxation, with a multinational company paying the withholding tax in the source country and then being taxed again on the same profit in its residence country. 

This creates a prohibitive barrier to cross-border trade and investment, undermining the very development goals that increased tax revenues are meant to fund. 

This push for unilateral measures, without a concurrent plan to modernise and expand treaty networks, threatens to unwind decades of progress in facilitating global commerce.