27 January 2013

Ethiopia: New Dividend Tax Interpretation Unlawful, Unfair


Whatever power relates to money, Melaku Fenta, director of the Ethiopian Revenues & Customs Authority (ERCA), has it. A law, established in the very institution that he oversees, provides it with the utmost of disposable powers, including owning a prison.

As long as Melaku sits at the helm of such a powerful organisation, he too, indirectly, holds a significant amount of power.

His reign at the ERCA has indeed been revolutionary, in many aspects, for major reforms in the national tax system have been made during his tenure. The growth rate in tax revenue has also been impressive, slowly getting closer to the sub-Saharan standard of 18pc, as a ratio of gross domestic product (GDP).

Melaku is even more ambitious than his contemporaries within the EPRDF. He sets unique annual revenue targets for the Authority he leads; a bit exaggerated in comparison to the official targets of the government, and too, he organises task forces along the in-house targets. This year's target, for example, is to go a little beyond the 100 billion Br mark and, if achieved, this would be a milestone, not only for the ERCA but for the whole nation.

Yet, the ERCA, under Melaku, has also become belligerent and uncaring. It has introduced many regulatory surprises that a stable market might not have wished to see.

As much as it has grown ambitious, it too has become draining. Its relationship with taxpayers may have improved, but it has equivalently evolved to become a popular forest of corruption and extensive rent-seeking.

As if to extend its belligerence to one more frontier, the Authority has recently introduced a new legal interpretation on dividend tax. It has sent a notice to private limited companies (PLCs) to pay tax on dividends retrospectively, despite the fact that they did not distribute dividends to shareholders. The legal interpretation, which has benefited from a legal reflection by the Ministry of Finance & Economic Development (MoFED), forces companies to pay dividend tax on dividends that were redirected towards any sort of capital, not to mention retained earnings.

Indeed, the notice has sent shockwaves through the spines of struggling PLCs in Ethiopia. It has put the survival of many of them in danger.

At the base of the notice, and the subsequent uproar of businesses, lays a commercial code article that exposes dividends to taxation when earned. For Melaku et al, earning includes both the possibility of paying out the dividend and, alternatively, redirecting it into other streams. However, traditional business practice considers dividends to be earned only once they have been distributed to shareholders.

With the history of taxpaying in the country full of both anecdotal and numerical evidence of tax avoidance, Melaku, and his comrades at the ERCA, seem to take redirection of dividends as an attempt at tax avoidance. And they, thus, seem in favour of capping the gap with regulatory measures.

However, this would be a dismissal of reality. In a capital constrained economy, such as Ethiopia, businesses have little financial leverage. They live each day by striking a good financial balance out of their expenditures and revenues. Worsening their struggle further, is the severe shortage of credit in the market.

In their effort to strike a balance, they have put in place tailored corporate strategies. One such popular strategy has been redirecting dividends to retained earnings and underpinning the balance sheet with additional liquidity. Certainly, this strategy has been the lifeline of many small and medium sized businesses.

Considering this strategy as an attempt to avoid tax would be a gross misjudgement. It also discourages strategic thinking, an element in short supply in the local business environment. Intentionally or unintentionally, however, that is what the recent surprise, by Melaku et al, has resulted in.

Even by the strict workings of a government, the introduction of the new legal interpretation, which, by extension, brings a new tax law, stands beyond the reaches of the ERCA, which is an executive unit. Legislation on tax is the duty of the House of People's Representatives (HPR). Thus, what Melaku et al seem to have forgotten, or overlooked, is the fact that their power is limited to executing whatever tax law the HPR approves, and in a way that aligns with the original intent.

Even then, the new interpretation of the Commercial Code seems to involve some inherent flaws.

On the one hand, it confuses dividends with retained earnings. Any revenue redirected to a new stream within the balance sheet cannot have the identity of the first stream, for such a practice would be double accounting. Hence, it is unjustified to impose dividend tax on a different stream of income, dubbed 'retained earnings'. No accounting principle could consider the two as similar and treat them accordingly.

On the other hand, the interpretation seems to confuse individuals, as owners of companies, and companies, as the same, when in fact they are different legal entities. Dividends are, after all, earned by individuals and it is thus the individuals who have the responsibility of paying taxes on them. It is, by no means, justified to impose the responsibility of paying dividend taxes on companies, for they are not one and the same with their owners.

Of course, as the ERCA rightly perceives, companies redirect dividends to other streams, rather than distributing it. And, eventually, retained earnings have been the streams that host the redirected dividends, in many companies. Yet, it is clear that dividends are not earned when redirected.

Above all, however, by introducing the new interpretation, the ERCA has overlooked the basic principles of tax. Universal principles of taxation dictate that taxes should not threaten the survival of tax payers. They also have to be fair in their treatment of the taxpayers.

Retrospective application of dividend tax on unearned dividends contradicts these basic principles. It endangers the survival of taxpaying businesses and deprives the nation of sustainable revenue.

Little is expected from Melaku, as he has made it clear that the application of the new interpretation will go forward. Businesses, he reflected in a recent meeting with businesspeople, have only one option and that is abiding by the interpretation.

However, there is one course of action that businesses might test, in this term, and it is the legal recourse. After all, the duty of interpreting the law resides in the hands of the judiciary. So much as the business community believes in its argument, testing the waters of the judicial system may be the most appropriate action.

It would all be very different if Melaku and his comrades would care about the very goose that lays their golden eggs, rather than wishing to have all the eggs at once, whilst simultaneously killing the goose.

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