20 January 2013

Ethiopia: Dividend Tax Notice Illegal

The Ethiopian Revenue & Customs Authority (ERCA) recently launched an unprecedented and unwarranted campaign of issuing a new circular to collect 10pc dividend tax on retained earnings from all businesses limited by shares that have reported profits and paid profit tax but failed to distribute dividends or withdraw profits.

Accordingly, several companies have received dividend tax assessment notifications to settle the dividend tax along with interest and penalty payments since 2004, on their retained earnings, "in accordance with the income tax proclamation of 2002."

The circular issued and the actions taken by the Authority on dividend tax seemed to have been prompted by the alleged huge "unpaid dividend tax arrears".In addition to the suspicion that companies liable for dividend tax are engaged in tax avoidance.

Tax avoidance on dividend tax has been one of the major difficulties facing nations, including theUnited States, to issue new laws aimed at encouraging the distribution of dividend tax and discouraging accumulated earnings by imposing a 15pc tax. The enforcement of the accumulated earnings tax by the Internal Revenue Service (IRS) of theUnited Statesis however, said to be very difficult. This is caused by the inability to determine "the amount accumulated beyond reasonable needs of the business and the subjective test of whether a corporation had a purpose to avoid tax."

Retained earnings of companies are not basically aimed at avoiding tax. Companies often need to retain a reasonable amount of their earnings in order to cover, and salvage their losses from certain needs, such as, working capital, business expansion, asset purchases, and for ongoing or anticipated litigations.

A few weeks ago, the ERCA started the implementation of its new and sweeping measure on companies on 'unpaid dividend tax'. This was subsequent to a "legal opinion" tendered from the Ministry of Finance & Economic Development's (MoFED) Chief Legal Advisor that had been accepted as guaranteeing the infallibility of the ERCA's understanding and interpretation of the income tax proclamation, in respect of the assessment and collection of dividend tax.

In ERCA's circular, issued by the Deputy Director General for Change & Modernisation, to all branch offices regarding the "assessment and collection of dividend tax arrears from companies," dated October 08, 2012, the Authority complained that, while payment of dividend tax has been provided by law since 1978, "when we see enforcement of the provisions of the proclamation, collection of such tax has been made from organisations that have distributed dividend and no assessment and collection was made on those that did not notify and distributed dividend."

"The tax payers" the circular noted, "have been scheduling for various financial years this income by recording in their account under the heading of retained earnings. It has been confirmed that some of them were using the untaxed income to offset their losses."

Then comes the following, the grand statement of the circular that raised so much havoc among the business community and the attention of this writer; "a concept paper was submitted and discussions held at various levels of the Authority whereby understanding was reached that there should be collection of tax regardless of distribution of dividend even though the matter was referred to the MoFED to solicit opinion to verify if legal gaps might exist."

The ERCA has already convinced itself and maintained a firm position that dividend tax must be collected regardless of its distribution to beneficiaries and before it sought the advice MoFED on a fait accompli case. In fact, judging from the action plan attached with the circular, even the opinion of MoFED was forecasted to be an affirmation of the ERCA's position as evidenced by the detailed implementation plan for the assessment and collection of the dividend tax.

Predictably, in its legal opinion, explanation and interpretation of the income tax proclamation, pertaining to the payment of dividend tax, MoFED's legal department observed that "as indicated in the letter, (referred to it from the ERCA) dividend tax is collected from every person deriving income from dividends or withdrawals of profits." It cannot be concluded that the law maker sought to achieve any objective by differentiating the phrase, "deriving income from dividends or withdrawals profits from these two types of companies."

According to article 458(1) of the commercial code, dividends may only be paid from net profit shown in the approved balance sheet. However, while the general meeting can decide on the date and methods of the payment of dividend, it cannot decide on the amount of the dividend to be paid. Therefore, as soon as net profit is shown, shareholders shall have the right to distribute the dividend and the company should withhold and pay the dividend tax. Accordingly, share companies and private limited companies should withhold dividend tax from dividends payable, from each shareholder, and pay the tax authority, regardless of the distribution of dividends to shareholders.

The opinion of the MoFED, thus disparages any legal significance of the phrases under 'article 34 'of the Income Tax Proclamation, which act as a precedent to the payment of dividend tax. It advices the ERCA to ignore whether a shareholder has derived income from dividends or withdrawn profit, and proceed with the assessment and collection once the company's balance sheets have shown a net profit.

Basically, article 34 is drafted so clearly it does not call for any explanation or interpretation by executives or even judicial authorities. Unpaid dividends are often placed in company accounts, under the 'retained earnings' heading. Based on the general meeting decision, net profits of companies may be distributed as dividends among members, where appropriate, or it may be decided that the money is placed as retained earnings for future eventualities.

Contrary to the opinion given by the MoFED, the general meeting of a company, in accordance with article 419 - sub-article one of the Commercial Code, "shall approve or reject the accounts for the past financial year... decide, where necessary, on the allocation and distribution of profits and on all question arising out of the accounts for the past financial year." Therefore, the power of the general meetings of each company is not limited merely to the time and method of payment of dividends, as asserted by the MoFED's opinion.

Therefore, the circular for the payment of dividend tax on retained earnings, which directs the assessment and collection, regardless of the distribution of dividends, is not only based on the incorrect understanding of the relevant and applicable legal and accounting principles, but also on the incorrect premise; that the opinions, explanation and interpretation of executive bodies can be used for the assessment and collection of unpaid taxes, in order to meet planned revenue collection.

Executive bodies can apply laws to assess and collect taxes. What the ERCA and the MoFED have done, under the new circular, is issue a new executive law and interpretation that has, essentially, not only amended the meaning of the existing law, but even issued a new law, in order to levy a tax. This transgresses the power reserved to law makers. Both the MoFED's legal opinion and the ERCA's circular have increased the rate of corporate tax by 10pc on the existing 30pc; and from now on, companies should concurrently declare and pay tax from their gross and net profits, whether such profits are distributed to shareholders or not. This is with the exception of companies exempted by law from such tax when directing the net profit towards expansion works.

The executive declarations also stripped away the power of courts to interpret tax laws. The ERCA felt that the law on dividend tax prevented it from fully assessing and collecting dividend tax. It attributed the wordings of the law as stumbling blocks that hindered the process.

Thus, the ERCA would have to cross the barriers imposed by the law, by introducing its own understanding and interpretation, in such a way as to enable it to get the 10pc dividend tax before distribution of dividend, or withdrawals of profits to shareholders. This dramatic twist in the application of the law was endorsed by the MoFED.

Accordingly, with a single circular, the ERCA assumed legislative and judicial power, by imposing a new dividend tax law and giving its own interpretation for its enforcement. This is despite their duty to simply administer the law, by assessing and collecting the dividend as authorised in the tax proclamation, issued by the law maker.

Whether by design or default, the acts of the MoFED and the ERCA shock the very founding principles of taxation. The circular, on the assessment and collection of dividend tax arrears, has brought uncertainty and unpredictability to tax administration.

Judging by the positions maintained by these two executive bodies, it is justifiable to speculate that the exemption of tax may suddenly be revoked and citizens may be required to pay, simply through the introduction of a new interpretation.

Nay, the MoFED is legally empowered to "initiate fiscal policies that particularly serve as a basis for taxes and duties and follow up the implementation of the same." On the other hand, the ERCA is mandated to asses and collect taxes in accordance with tax laws.

Consequently, the legal opinion tendered by the MoFED and the new circular, issued by the ERCA, trespass the legal mandate provided to both organs. It may be asked why the Authority resorted to such drastic measures, which intrude on the power reserved to the legislative and judicial bodies.

The Authority has already planned to collect hundreds of billions of Birr for the current fiscal year and this difficult task can be partly achieved by focusing on the huge unpaid dividend tax that it has targeted, through any means available. Yet, these measures are unconstitutional and unwarranted and will only fuel the latent discontent of a business community ready to explode, with no monetary or political gain.

Yohannes Woldegebriel, a lawyer who has served as public prosecutor in four different institutions

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