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Three ways lower-income countries can use new UN guidelines on the taxation of aid

Written by Iain Steel

Hero image description: UN flags, Geneva Image credit:Romina Santos Image license:CC BY-NC-ND 2.0

The United Nations has just released new guidelines on the tax treatment of government-to-government aid projects. These guidelines could address some of the issues in the system of tax exemptions for development assistance. But they are also likely to be controversial for many donors that have longstanding policies of not paying taxes in the countries they support. Here I look at what the guidelines say and suggest three ways that lower-income countries can use them.

Should aid projects pay taxes?

The practice of granting tax exemptions for aid projects is widespread among lower-income countries. Our survey with the Africa Tax Administration Forum in 20 countries found that 95% provide tax exemptions for VAT, 85% for customs duties, and 60% for corporate taxes. Supporters of the system argue that it ensures more finance flows to the projects that donors intend to support. It is also said to help secure political buy-in for aid, especially in countries where donors do not want to directly contribute to government budgets. But for lower-income countries, these exemptions increase administrative costs in revenue authorities, distort markets in favour of tax-exempt foreign suppliers over domestic companies, and reduce tax revenues available to fund public services. They can also be exploited by private contractors to avoid paying income tax.

What the guidelines do (and what they don’t do)

The guidelines start from the basic principle that donors should refrain from requiring tax exemptions for aid projects unless the recipient country’s tax rules are inconsistent with internationally agreed tax principles, or if there are concerns over governance. To reduce situations where specific exemptions are requested, recipients should ensure that the tax treatment of aid projects is consistent with internationally agreed tax principles. When exemptions are requested, negotiations should involve tax authorities in the recipient country. And when exemptions are agreed, they should be limited in scope to donors and their aid agencies, and not be extended to private sector contractors. This is key to ending tax avoidance on private profits.

The guidelines also address issues with transparency, accountability and implementation. These include developing public policies on the taxation of aid projects, making the text of any exemptions granted in treaties and other agreements publicly available, and ensuring exemptions are compliant with the law in recipient countries. Unlike the basic principle that donors should refrain from requiring tax exemptions, the guidelines on transparency, accountability and implementation ought to be relatively uncontroversial for donors. Indeed, these are exactly the sorts of governance reforms that donors routinely support in lower-income countries.

However, it’s important to note that the guidelines are non-binding on donors and recipients. Both are free to decide how best to tax aid projects. Lower-income countries will therefore need to act to take full advantage of the guidelines. Here are three things recipients of aid can do.

How lower-income countries can take advantage of the guidelines

1. Review current practices to ensure they are consistent with the guidelines and with the law itself

Sometimes, tax exemptions for aid projects are granted even though they are not permitted by law or included in a treaty. Where this is the case, recipient governments have a choice to make. They can either continue the practice of granting exemptions and provide for them in law, or they can approach the donor to renegotiate the practice to one that is compliant with the law. Hopefully, donors would be receptive to a renegotiation that is based on the premise of ensuring they are treated consistent with the law.

2. Develop and publish their policy on the tax treatment of aid projects

This could address a number of issues, such as which parts of government are responsible for policy and negotiations, what the overall policy is, and what exemptions can be granted. Crucially, they can also state which taxes cannot be exempted and which taxpayers cannot benefit. This can help anchor expectations with donor countries, strengthen recipient governments in negotiations, and ensure citizens can hold the government to account. The last part will require complementary policies to facilitate greater transparency, for example ensuring that all tax exemptions are publicly disclosed.

3. Build the evidence base and help make the case for reform

There remains a dearth of information on the administrative costs and revenue foregone from tax exemptions for aid projects. The estimates that do exist suggest costs are high. For example, one study proposes that exemptions for project aid could represent as much as 3% of Gross Domestic Product (GDP) in countries where tax revenues barely surpass 15% of GDP. While some donors have already committed not to seek exemptions for aid, including the Netherlands, Norway, and the International Development Association, others are likely to require more evidence on the harm caused before committing to reform. To build the evidence base, recipient governments can produce and publish estimates of both administrative costs and revenue foregone.

A clear path forward

The guidelines were finalised by a subcommittee of the UN Committee of Experts on International Cooperation in Tax Matters, building on earlier efforts to agree guidelines dating back to 2007. The fact that it has taken over 13 years to finalise them shows how controversial the taxation of development assistance is.

In the last few years, donors have increased support for domestic resource mobilisation. The inconsistency between supporting governments to collect more tax revenues on the one hand, while refusing to pay any taxes on the other, has become more apparent. I was privileged to serve on the subcommittee that drafted the guidelines in the final few months of the process. I saw how hard members worked, and how effectively they navigated a particularly contentious issue with donors and recipients. The challenge of reforming the system remains, but the guidelines show a clear path forward.