Getting acquainted with the new tax law

Wollela Abehodie Yesegat (PhD) is an assistant professor at the Addis Ababa University who lectures taxation to graduate students at the Faculty of Business and Economics. In addition to the academic career, Wollela is involved in various research activities. Based on the Ethiopian taxation system and short-term consultancy services she provided on the subject, Wollela joined the International Finance Corporation (IFC), which serves as a financial arm of the World Bank. She took part and led a project dubbed tax simplification project that was initiated by both the Ethiopian Revenues and Customs Authority (ERCA) and the Ministry of Finance and Economic Cooperation(MoFEC) supported by IFC.  This project was responsible to bring to light the newly-drafted tax reform which has been tabled for the council of ministers recently. The amendment quickly grabbed attention since it was forthcoming for nearly fifteen years. Wollela argues that beyond the mild reduction in the employment tax category, there are considerable changes that the amended tax law will introduce to the taxation system. She argues that an internationally acceptable tax regime has to become a functioning system in the country as well as comply with the existing Ethiopian status quo. Birhanu Fikade of The Reporter sat down with Wollela at her office located in the College of Business and Economics, Eshetu Cholle Building and grasped what the new tax system has brought to the fore. Excerpts:


The Reporter: Can you give us the background for the recent tax reform?


Wollela Behode Sigat (PhD): First I like to give you the background for the reform program which was initiated nearly two years ago by MoFEC and ERCA. What they did was to review the issues in relation to the income tax regime and identified the problems. Then they drafted a tax law which they insisted has to be compliant with the international standards. For that reason, MoFEC requested IFC to support the process and the IFC extended both financial and technical facilities. As part of that support facility, an international consultant was hired to advise on all the existing tax laws and come up with a new draft law. However, tax brackets and thresholds were left out of the scope; while the consultant was allowed to judge and review other components and existing provisions. The consultant was sought to provide review and report on it; and it did that. The review report has been disseminated to various stakeholders like the IFC, IMF, ERCA and MoFEC and has been further enriched. Based on the review report, a draft law was proposed.  By the way, IFC has supported studies of tax compliance cost burden in Ethiopia and tax payers’ perception towards ERCA. Therefore, the outcomes of these studies have helped the consultant to incorporate a number of issues as an input to the new draft. There were also other studies like dispute resolution mechanisms which were conducted by the support of IFC. In terms of addressing the tax issues, the majority of the tax payers agree that the country has no effective dispute resolution mechanism. Hence, prior to the introduction of the new draft law, studies were conducted to serve as an input. The draft was also circulated among various local institutions and with the likes of IMF and the World Bank. These tasks took close to two years. Once the draft was in place and before it was implemented, it was important for the government to seriously look into it. But, it was also important that it was not shoved in a shelf for another 15 years.


What are the rationales behind the new income tax amendment which took nearly fifteen years to happen?


There are quite lot of rationales to reform the existing tax law. One of the reasons which I feel necessitated the tax reform, particularly the income tax legislation, was the fact that it has been in place for nearly fifteen years without any change. It was enacted back in 2002. Nobody went back to look at it to check whether it remained effective to achieve its policy objectives or not. Hence, this outdated income tax legislation should be renewed and it needed to keep up in pace with the changing environment in Ethiopia and the globe. Things are changing dramatically and the business environment is getting more dynamic. New ideas come to the business platform. Inflation causes problems to the bracket rates and different thresholds in the income tax legislation. Inflation for long had eroded those brackets and thresholds since 2002. As a result, taxpayers were forced to bear unnecessary tax burdens. Therefore, addressing that is very important. You can’t leave thing unchanged for long in tax systems. You have to revisit what is there to make it up-to-date. This is one explanation in my view. The other is problems in the tax system itself. We often hear taxpayers complaining about the tax administration and some aspects of the tax system. For instance, a tax payer has to pay 50 percent of the disputed amount in advance to file an objection to the appeal commission. That amount adds late payment penalties and interest rates. If you add up all of that, the amount you are required to pay just to appeal will accumulate to hundred times the original tax. In addition to that, interpretational variances between taxpayers and tax administrators have remained a challenging issue. Even among tax administrators, the interpretation varies from one individual to the other regarding same tax matters. From the side of the taxpayer, it is quite a burden. These are problems that taxpayers were facing for years. The coming of foreign capital to Ethiopia is also another challenge that requires attention and proper amendment. The tax system has to be ready to deal with the complex nature of multinational businesses that are pouring into the country. The tax administration in this case needs to be prepared to deal with such an environment. Currently, we have three income tax laws. The ordinary income tax legislation, mining operations’ income tax proclamation and the petroleum operations income tax legislation. These different laws in some situations might have contradictory provisions. It’s important to bring them together because they all talk about income tax and contradictions had to be addressed in any form. While bringing different laws into one legal document, we shouldn’t forget the importance of the special nature of the extractive sector. Hence, the tax regime you design for that sector has to reflect the nature of mining and petroleum operations.


When you say there are contradictory laws, can you mention in what ways they are contradictory?


In some provisions for instance, I think in the case of mining, the reporting time is 90 days. But, when you look at the regular income tax legislation, the reporting time becomes four months. This seems minor but in order to create certainty, it’s essential to clarify discrepancy. There may be other issues similar to this one. There are others like, let say in the existing system, both the substantive provisions and the administrative related provisions are contained in one income tax proclamation. If you look at the income tax proclamation, it provides the substantive aspects of the tax i.e. the rates, the base and the likes. In addition to that, it provides the administration procedures which are mostly common with the administration procedures of other types of taxes. The administration procedures we use for the income tax is very similar to VAT, excise tax and turnover tax. Hence, as far administrative procedures are concerned, each tax law repeats the same provision over and over again.  Generally, in my view, these are some of the reasons that warrantied the reform program.


In your view, does the new tax reform address the disproportionate tax burden on the employees?


Before answering that we should note that it is essential to see the income tax reform in Ethiopia as a package; it is not just about the rates. When we see the benefits, I would say it has lots of advantages both for taxpayers and the government. When I say taxpayers, I am referring to all categories of taxpayers that include employment, businesses, property owners (those paying rental income tax) and what have you. In addition to revising the tax brackets and thresholds, the reform has brought lots of changes to the entire tax system which I will mention specifically later on. The reform has clarified many ambiguous areas. It tries to address many concerns that taxpayers were facing. Clarifying different provisions and directly addressing problems, dealing with issues of lack of consistency in the administration process are some of the aspects the reform has looked at. Some of the measures taken I think will help reducing the burden of taxpayers. The tax burden is just one aspect and the compliance burden and the cost is another. The burden and the cost of compliance deters taxpayers not to fulfill their tax obligations. Apart from reducing the burden, it is also necessary to work on reducing the burden of tax compliance costs. From the government side, I would say there are a number of benefits. The reform attempts to broaden the tax base. Some of the income which were not treated as income in the existing proclamation have now been included as incomes categories subjected to taxation. But as far as costs of living are concerned, freeing up some income would help the consumer but as you might know the amount is not that big to impact lives on a larger scale. I can’t say there won’t be any benefits. There are benefits in it though it’s very tiny. But, we need to see the reform in its holistic form and the corresponding positive outcomes. We need to bear in mind that the government is sacrificing certain level of revenue.


The tax savings under the amended tax schedule were expected to be beneficiary to employees.  Do you think the actual gains are at the level that was expected?


You are right and what matters is the expectation we have. But, as I said before, it’s important to see the reform in its entirety, as it is a package deal. The reform in my view has brought lots of benefits to the taxpayers.


Is it possible to judge who is most likely to benefit out of the new reform? Is it employees or businesses or other groups who would benefit most out of the reform?


At this stage, I think it is very difficult to come to that kind of conclusion. You need to carefully look at the overall benefit coming to employees and the overall benefits coming to business operators. Hence, at this stage, it will be very difficult to compare and contrast the benefits across segments of taxpayers. 


Consumers are subjected to payroll tax, whose maximum bound goes as high 35 percent, and a consumption tax in the form of Value Added Tax (VAT). The cumulative effect of the two tax types brings the employees to the top of the tax burdened taxpayers categories in Ethiopia. How can we say employees have benefited especially compared to businesses from the newly amended tax proclamation?


In my view, employment income tax should not be compared with income earned by businesses. If you take businesses, the tax is imposed on the taxable portion of income which is profit. But, to earn that taxable income, the business has to incur various costs which are taken as deductible items. Hence, if you want to compare the business operators with the employees, you need to take the employment income and the business net income (profit) which is earned by the business owner. But, VAT applies to both the employees and businesspersons. When you come to the rates as you mentioned, employees pay a maximum of 35 percent income tax and business income tax is limited at 30 percent. But, the latter is levied on the company, not on the individual business owners. But, if you bring on board individual shareholders, the tax rate goes up to 40 percent, the sum of 30 percent and 10 percent of dividend tax makes it to be more than the contributions of employment income tax.


There is an emerging public outcry against the new reform. Could you mention additional benefits from the reform that can substantiate the outcry?


I have reflected on most of the things. The reform tries to free up some incomes but as I said it is not that much. The most important issue to consider is that it has brought clarity and certainty to the tax system. Whenever an investor looks for investment locations one of the considerations is the tax administration and the legal framework. They require some level of certainty and consistency in the system. The draft tax law attempts to be fair. You know the fringe benefits in the new provisions are expected to be taxed because it has clearly provided a way to tax the income category. The existing regulations dictate that fringe benefits are taxable but silent on the mechanisms. I hope this time the government will further work on developing mechanisms of taxing fringe benefits and other income categories. Doing so, in some way helps to bring fairness in the tax system. Some benefits include special scheme for category B business taxpayers where it reduces the tax compliance burden.


What were the considerations when producing the matrices of the new income tax proclamation?


I was not part of the entire tax reform program. I came across the income tax amendment when I was assigned as coordinator of the tax simplification project at the IFC. My part was to help on all issues, excluding tax rates and thresholds.  Hence, I don’t think I am in a position to answer this question.


It is feared that expectation in connection to the new tax amendment would instigate an inflation pressure. It that a concern for you?  


The change is not that big and I think the problem might not be that serious. If you look at the theory, you might say that this will lead to inflation. But to me, the tax saving or the income left out of taxable portion is not that significant. However, it’s very hard to validate the assertion that it will not cause certain increases in prices of goods and services. Since the income tax saving is not that significant the impact it cause on inflation is likely to be less. But in any case, there were similar experiences in the past where the government might address if there happens to be an inflationary phenomenon. To me, this fear would be validated if the income saving from the new tax reform was very high on basis that it might create excessive demand.


Can you consider the reform as a real change to the existing tax system of Ethiopia?


Yes, to me it is a real change. There are lots of changes introduced which I have explained. But further, we can say that the reform recognizes the international financial reporting standards as the main guiding principles for the overall tax accounting with some exceptions. The new law will address one of the major issues of the tax base in the existing tax legislation.  As you might know, tax officers can reject the financial statements of taxpayers at their own discretion. If they are not satisfied with whatever report is presented to them, they can subjectively judge and reject reports instantly. In the new law this is not going to be the case. Unless they have valid and justified reasons not to accept the financial report, they can’t reject as in the past. The compliance cost burdens of category “B” businesses in the proposed law is greatly reduced. Category B taxpayers are those who have annual gross income ranging from 500,000 up to one million birr. For these category businesses, the compliance requirement has been made less than the larger businesses. Larger businesses, in this case category “A” businesses with gross income of over a million birr, will bear greater compliance cost than B category. In the new system, category B businesses are required to have a cash basis accounting. Whereas category “A” businesses are required to have an accrual basis of accounting.  The new law requires category B businesses to maintain book of accounts for two years as opposed to the five years in the existing law. In addition to that, they are required to produce financial statements. For category “C” businesses, the proposed legislation provides the scheme to tax this income category objectively. I hope a much simplified taxation system will be designed for this category. By the way, the categorization has its own purpose. It’s to determine the compliance requirements to serve the sizes of businesses.  The proposed law helps to strengthen the international tax regime. Many foreign companies are coming. But, the existing tax regime seems focused on domestic business operators. The other issue relates to strengthening the definition of permanent establishments. This helps to close up the opportunities of transfer mispricing, a practice where related companies try to shift profits from one jurisdiction to the other. Hence, the new low tries to tighten mechanisms to reduce mispricing.


Mispricing or in general form, illicit financial outflow in particular is the central issue in Africa and beyond. Finding ways to fight multinationals which easily shift funds with shadow banking practices is causing countries like Ethiopia lose billions of dollars. Are you saying that the new law tries to address this challenge?


Yes, if you look at the existing tax proclamation, as far as mispricing is concerned, it has one provision saying transactions between related parties need to be priced at the arm’s length principle. It further provides the manner of determining the arm’s length pricing and correct transaction prices and other aspects of price transfer issues will be determined according to the directive issued by MoFEC.  When the existing law was enacted in 2002, however, the directive was not in place. The directive was issued on October last year. But, in addition to the directive, the new law has made maximum possible efforts to provide the legal framework for the tax administration to address the transfer mispricing issue. In my view, there is the framework. What remains is the capacity to administer. 


How is the 50 percent advance payment requirement, in case of dispute, treated in the draft tax law?


The dispute resolution system has long been the major concern for taxpayers. Now, we have a number of changes. The dispute resolution has steps to settle issues. There is an internal committee within ERCA. If the dispute remains unsettled at this stage, the taxpayer will go to the tax appeal commission, then to the courts until it resolves the matter in the existing system. In the committee system, people from various departments of ERCA form an ad hoc committee and look at cases presented to them. They do that on top of their regular duties. As a result, they may not decide on cases on time. Decisions made are often contentious and end up unaccepted by taxpayers. Now, unsatisfied tax payers will proceed to the next level which requires them to pay 50 percent in advance. To address that problem, the proposed law came up with an idea to set up a department within ERCA fully dedicated to that activity. There will be administrative review department which will be responsible to review cases. This is one considerable change. Unlike the existing tax system, the new system requires ERCA to assign capable and experienced members to the administrative review committee. The existing law gives ten days to establish cases and file cases to the review committee. Now, that has been increased to 21 days. Additional ten more days could be added to help unforeseen situations to the taxpayer. The new law requires decisions to be made by the review committee in 180 days. If the review committee or department fails to decide in 180 days, the taxpayer is welcome to proceed to the appeal commission. Now, to file an objection to the appeal commission, the required advancement has been sliced into 25 percent as opposed to the 50 percent in the existing law.  Late payment of interest and penalties has now been nullified. If interest is payable, that shouldn’t exceed the tax amount. The appeal commission is to be accountable to the Prime Minister and the composition of members is provided in the law excluding ERCA staff as opposed to the existing law.  Advance ruling has become a component in the new law. MoFEC is responsible to interpret certain provisions upon the requests of taxpayers and they are considered binding for ERCA to comply. This is one basic outcome which has never been the case in the past. The new law regulates tax advisory agents to be licensed. No one is allowed to involve and represent taxpayers unless recognized legally. In general, I would say the new law in so many ways has bought light to the taxation system of the country.