Why taxing an indirect disposal is easier said than done

A transfer of ownership may give rise to a taxable capital gain if the price paid for a business asset is greater than the price at which the asset was bought. Companies can own assets directly or indirectly through other companies.
Many countries tax the capital gain realised by residents and non-residents on the sale of assets located within their borders. Many of them also subject the sale of shares in domestic companies to the same tax.

Avoiding tax
However, companies have been able to avoid this tax by setting up complex group structures in tax havens owning assets in other countries, for example Uganda. These companies could avoid paying Capital Gains Tax in Uganda by selling the offshore entities that owned assets located in Uganda, rather than selling the assets themselves. This is commonly referred to as an offshore indirect transfer.

In 2010, a Dutch subsidiary of the Indian multinational Bharti Airtel International BV purchased from Zain International BV, a Dutch company, the shares of Zain Africa BV (also a Dutch company) which owned Celtel Uganda Limited among other assets. This is an example of an offshore indirect transfer.

Concern
The taxation of offshore indirect transfers has emerged as a major concern for developing countries, given that non-taxation of these transfers usually results in massive revenue losses for the countries in which assets are located. To address this issue, the Organisation for Economic Development and Cooperation (OECD) proposed two methods of taxing gains on offshore indirect transfers namely: taxing the non-resident seller, or taxing a deemed direct sale by a resident entity.

Of the two options proposed, the OECD leaned heavily towards the option of taxing a deemed direct sale by a resident entity. This was mainly informed by the enforcement challenges associated with taxing a non-resident seller such as lack of information relating to the transaction that has occurred overseas and enforcing collection of the tax from the non-resident.

In July 2018, the Government of Uganda adopted the option of taxing a deemed direct sale by a resident entity where an offshore indirect disposal has occurred. In addition, a mechanism of determining the gain on an offshore indirect disposal was also put in place.

Where an indirect disposal by an offshore company of an interest in an asset held by a Ugandan company occurs, the Ugandan company is deemed to have disposed of all its assets and liabilities at market value immediately before the change. Any gain arising on the difference between the cost base of the assets and liabilities before the change and the market value of the assets and liabilities after the change in ownership is then taxed in Uganda. This does not apply to listed institutions and government institutions.

Whereas the above measure ensures that gains on indirect disposals of assets located in Uganda are taxed in Uganda, the measure has various implementation challenges.

Market value
The determination of market value is a highly subjective exercise. This is because there are various methods of determining market value and each method has its own set of assumptions. This means that two companies with exactly the same asset may arrive at different market values simply because of the valuation method used. This violates the principle of equity in taxation. In my view, market valuation should only be applied where information relating to the indirect transfer is not availed to the tax authority.

In addition, the new provision does not give guidance on what should be considered as the cost base of a company’s assets in an indirect disposal. Is it the cost base, the value of the asset in the company’s books, the value of the asset for tax purposes or the historical cost of the asset?

The OECD recommends that an apportionment rule should be adopted and applied so that the price paid for any shares is allocated among the assets held by the local entity.

Taxation of offshore indirect disposals may generate more tax revenues. However, government should ensure that clarity is provided regarding the practical application of the law. Lack of clarity creates uncertainty of the capital gains tax consequences and this may discourage investors from investing in Ugandan companies.

The writer is a senior tax consultant at KPMG. The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG.