Taddese and Hanna
Taddese and Hanna
I. Introduction
Ethiopia has followed the classical approach to corporate taxation since 1978. Prior
to 1978, the Ethiopian income tax system exempted dividends from taxation and
limited itself to taxation of corporate profits. The 1978 income tax amendment (to
the then Income Tax Proclamation of 1961) introduced a number of mainly final
withholding taxes on what it called “miscellaneous income” and charged
dividends with 25% withholding tax over and above the then corporate tax rate of
50%.1Both the corporate and dividend taxes have since then come considerably
down after the liberalization of the Ethiopian economy in the 1990s (the current
corporate and dividend tax rates are 30% and 10% respectively). There have been
intermittent calls for elimination of dividend taxation (on familiar grounds of
economic double taxation), but the Ethiopian Government has so far resisted and
maintained the classical approach to corporate and dividend taxation.
The tax policy of Ethiopia towards dividends has been very clearly in favor of
levying taxes on dividends in addition to the tax due on corporate profits, but the
efforts shown by the Ethiopian tax administration to enforce the tax has been
unsatisfactory by its own admissions. The absence of detailed regulations
governing the area coupled with the lack of administrative attention to the
enforcement of dividend taxation have for a long time hampered the effective
collection of revenues from this source. By and large, the enforcement of dividend
taxation in Ethiopia was confined to the formal dividends declared by companies
in accordance with the Commercial Code of Ethiopia (1960). The association of
dividend taxation with formal dividends meant that only companies that formally
declared dividends were liable for withholding taxation on dividends. Companies
∗
LL.B (Addis Ababa University); LL.M (University of Michigan Law School, Ann Arbor); PhD
(University of Alabama Department of Interdisciplinary Studies, Tuscaloosa);
∗∗
LL.B (Addis Ababa University, School of Law)
1Dividends became one of the miscellaneous sources of income chargeable with final
withholding taxation along with royalties, income from technical services rendered outside
Ethiopia and income from games of chance; see A Proclamation to Amend the Income Tax,
1978, Proc. No. 155, Negarit Gazeta, Year 38, No. 3 (now repealed)
147
that found a way not to declare dividends and those that put off declaring
dividends were simply left untroubled by the Ethiopian tax administration.
After years of neglect and lackadaisical performance, dividend taxation came to the
attention of the public only after the tax authorities took some “controversial”
actions to enforce dividend taxation against the undistributed profits of companies.
Perhaps frustrated by the reluctance of private companies in particular to declare
and distribute dividends, the tax authorities literally sought to hold the bull by its
horns by issuing an administrative fiat that construed “undistributed profits” of
companies remaining after legal reserves as dividends.2 The companies
(particularly the private limited companies) that for a long time thought they were
safe as long as they did not declare dividends were outraged by the decisions of the
authorities. Many took their case to the public media, some argued vociferously in
the private business newspapers and some even threatened going to courts to
challenge the actions of the tax authorities.
2The Commercial Code of Ethiopia requires companies to put away legal reserves (about 5%
of their profits) until the legal reserve reaches one-fifth of the Company’s capital; see
Commercial Code of the Empire of Ethiopia, 1960, Proc. No. 166, Negarit Gazeta, Year 19, no. 3,
Article 454
148
II. Review of the Controversies
The question of when taxes on dividends should be withheld by companies has
divided opinions both within and outside the tax authorities. Owners of many
private companies have for a long time believed that they can keep the withholding
of dividend tax at bay by simply not distributing dividends among their
shareholders. It was asserted by those who support this line of argument that
companies were obligated to withhold dividend taxes only when the general
meeting of shareholders formally decided to distribute the net profits of companies
in accordance with the provisions of the Commercial Code.3 Many private
companies had, as a result, seldom bothered to take the formal decisions that
triggered the withholding of dividend taxation, thinking that they could hold off
withholding the tax by avoiding such formal company decisions for declaring
dividends or sharing profits among their members.
The situation on the ground began to change after some members of the tax
administration started arguing that formal declaration and distribution of
dividends by companies was not at all necessary for the enforcement of dividend
taxation against companies. This position of the tax authorities was crystallized in
Seferian Co.4case in which the ERCA argued successfully that formal declaration
and distribution of dividends was not a necessary condition for the enforcement of
dividend taxation against companies. The line of argument which came down to us
from Seferian Co. case holds that the tax authorities can enforce withholding
taxation against companies in the absence of formal decision making once certain
conditions are met: i) the company has put away some of the profits for the
reserves required by law; ii) the articles of association contain a provision or
provisions that impose upon companies the obligation to distribute the balance of
the profits as dividends among shareholders; iii) the company has not taken any
formal step to transfer the profits earned into the increase of its capital and thereby
increased the share of shareholders accordingly; and iv) the company is not
covered by law in Ethiopia that allows select companies to use their profits to
3 See Yohannes Woldegebriel, “Dividend Tax Notice Illegal”, Fortune, vol. 13, No. 664,
In Seferian Ethiopia PLC v. FIRA, the audits of the tax authorities led to the
discovery that Seferian Co. (an importer and distributor of vans and trucks) kept its
profits in its so-called “Retained Earnings Account” for the years 1991-1996 E.C
(1998-2003). The authorities found that Seferian failed to take formal steps either to
distribute these profits among its shareholders or use the earnings to increase its
capital. Federal Inland Revenue Authority (FIRA, the predecessor of ERCA),
argued that Seferian owed dividend taxes on its retained earnings even though its
general shareholders’ meeting never decided to declare these as dividends. The
Company not surprisingly objected, arguing that dividend taxes were not due until
the general meeting of shareholders decided to declare its profits as dividends.
The case went to the Tax Appeal Commission which agreed with the position of
the FIRA that dividend taxes were due on retained earnings even if no formal
decisions were taken by the general meetings of the members of Seferian Company.
The Commission found that Seferian Company did not formally transfer the
retained earnings to increase its capital in accordance with Articles 455 and 456 of
the Commercial Code. From this fact, the Tax Appeal Commission concluded that
Seferian was therefore holding the profits in trust for its shareholders. The
Commission ruled that Seferian owed a dividend tax on its retained earnings since
it failed to take formal steps to use these earnings to increase its capital. The
agreement of the Tax Appeal Commission with the position of the FIRA in Seferian
5 A Directive issued by ERCA relieves companies from withholding tax on dividends as long
as they have transferred their annual profits to their capital accounts; see ገቢዎችና ጉምሩክ
ባለስልጣን፤ የገቢ ግብር ነፃ መብቶች አፈጻጸም መመሪያ ቁ. 21/2001፤አዲስአበባ፤ያልታተመ፤አንቀፅ 8; this exemption is
not extended to companies involved in the following activities: hotels and restaurants other
than star-designated hotels; trading activities, such as wholesaling, retailing and importing;
maintenance services; passenger, freight transport services and car rental services; postal and
courier services; real estate; consultancy services; advertisement services; film and related
services; radio and television broadcasting services; cinema and theatre halls; customs transit
services; laundry services; travel agency, trade representatives, and lottery and related
services.
150
Co. case boosted the confidence of the tax authorities in their efforts to pursue other
companies that adopted approaches similar to Seferian in the belief that they could
hold off withholding taxation of dividends by placing their undistributed profits in
their retained earnings accounts.
Another high profile case that began the sea change in the taxation of dividends
was the case against Oil Libya (Ethiopia). The Tax Authorities initiated a case
against Oil Libya (Ethiopia) Ltd. after obtaining a leaked information that the
transfer of shares from its predecessor – Shell (Ethiopia) Ltd., to Oil Libya
(Ethiopia) Ltd. was grossly understated for the purpose (the tax authorities
suspected) of avoiding the capital gains tax due on the transfer of shares.6 In 2008,
Shell (Ethiopia) Ltd., which was operating in Ethiopia since the 1950s, decided to
leave the “downstream market” by transferring all of its operations in Ethiopia to
Oil Libya. Shell (Ethiopia) Ltd paid some amount in capital gains at the time of the
transfer but leaked information led to the investigation that the actual amount of
transfer was much higher than that publicly declared. After conducting its
investigation, the Tax Authority started proceedings for the payment of capital
gains taxes and dividend taxes upon undistributed profits against the transferee of
Shell Ethiopia Ltd – Oil Libya. The Tax Authority argued that Shell Ethiopia should
have paid dividend taxes on its accumulated earnings and Oil Libya owed the
obligation as it has acquired the interest of Shell Ethiopia Ltd. Oil Libya took its
case to the Review Committee but the Review Committee concurred with the Tax
Authority and ordered Oil Libya to pay both capital gains taxes and dividend taxes
as claimed by the Tax Authority. The dispute could not go beyond the Review
Committee as Oil Libya was allegedly unable to post the 50% payment condition
for appealing to the Tax Appeal Commission.
The Oil Libya case, as the Seferian Ethiopia Ltd. case before it, illustrates the
increasingly popular position within the tax authorities that dividend taxes should
be enforced against companies that keep retained earnings and refuse to convene
general meetings of shareholders to decide on the distribution of dividends among
shareholders or members. Buoyed by the successes in Seferian Co. and other cases,
6See Mahlet Mesfin, “Tax Authority Claims 210m Br. In Back Taxes from Libya Oil” (sic),
This action of the ERCA stirred a storm of controversy and consternation within
the business community. In a display of collective action, the representatives of the
business community, through the Addis Ababa and Ethiopian Chambers of
Commerce and Sectoral Association, demanded a forum with the heads of the
ERCA in a bid to persuade ERCA to rethink its position on taxation of dividends.8
In a meeting held on January 19, 2013, representatives of the business community
and concerned taxpayers were told in no uncertain terms about the firm position of
ERCA with regard to the collection of unpaid dividends over the last how-so-ever
many years.9 The only point upon which ERCA showed some softening of stance
was in the payment of interest and penalties, which the Authority agreed to
rescind, admitting that the Authority contributed to the general state of
7See Muluken Yewondwossen, “ERCA to Collect Tax Arrears from Undistributed Dividend,”
Capital, December 17, 2012,
(http://www.capitalethiopia.com/index.php?option=com_content&view=article&id=2166:er
ca-to-collect-tax-arrears-from-undistributed-dividend) last visited on February 10, 2014;
Mahlet Mesfin, “ERCA seeks Dividend Tax Whether Retaining Earnings or Not”, Fortune,
vol. 13, No. 659, December 16, 2012, (http://addisfortune.net/articles/erca-seeks-dividend-
tax-whether-retaining-earnings-or-not/) last visited on January 26, 2014
8 See “Tax Authorities to Explain Demand on Dividend Tax, in Retrospect”, Fortune, vol. 13,
In addition to the judicial support it received in the Seferian Co. case, ERCA sought
the opinion of the Ministry of Finance and Economic Development (MoFED) with a
view to strengthening its position on collection of dividend taxes on undistributed
profits. In this regard, the Authority received a massive boost from the MoFED
which penned a legal opinion that supported ERCA’s position. In a letter written to
ERCA, the Ministry opined that dividend tax was due on undistributed profits of
share and private limited companies even though the general meeting of
shareholders never met and decided to distribute dividends.10 In its operative
paragraphs, the MoFED’s Letter reads:
…
ምላሽየሚሻውዓቢይጉዳይበአክስዮንትርፍድርሻላይየሚከፈለውግብርትርፋባለአክስዮኖችዘንድእስከሚደር
ስሊጠበቅይገባልወይስአይገባም;የሚለውጥያቄነው፡፡ከዚህቀደምተመሳሳይየመከራከርያነጥብእየተነሳበአፈፃ
ፀምችግርሲያጋጥምበመቆየቱበሥራላይያለውየገቢግብርአዋጅበሚረቀቅበትወቅት (ገቢ) ለሚለው ቃል
የተሰጠው ትርጉም ሁሉን የሚያካትት እንዲሆን ተደርጎአል፡፡በዚህም መሰረት በአዋጁ አንቀጽ 2/10/
‹ለገቢ› በተሰጠው ትርጉም ለግብር ከፋይ በስሙ የተያዘለትን ጥቅም ሁሉ እንደሚጨምር ተደርጎአል፡፡
በንግድ ህጉ አንቀጽ 458(1) እንደተመለከተው የትርፍ ድርሻ የሚከፈለው በፀደቀው የሂሳብ ሚዛን
ውስጥ ከተገለፀው የተጣራ ትርፍ ላይ ነው፡፡በመሆኑም የተጣራው ትርፍ እንደታወቀ ባለአክስዮኖች
በማህበሩ መመስረቻ ደንብ በተመለከተው የአክስዮን ድልድል ልክ ከትርፉ የመካፈል መብት
ይኖራቸዋል፡፡በንግድህጉአንቀጽ 458(3) የትርፍ ደርሻ የሚከፈልበትን ቀንና ዓይነት የሚወስነው
በጠቅላላ ጉባዔው መሆኑ መመልከቱ ይታወቃል፡፡ይሁን እንጅ የጠቅላላ ጉባዔው የሚወስነው የትርፉ
ድርሻ የሚከፈልበትን ቀንና ዓይነት እንጂ የትርፉን ድርሻ አይደለም፡፡
…
…
የማህበሩ የተጣራ ትርፍ እንደታወቀ ባለአክስዮኖች በማህበሩ ውስጥ ባለቸው አክስዮን መጠን ከትርፉ
የመካፈል መብት ስለሚኖራቸው ማህበሩ ከዚህ ገቢ ላይ ግብሩን ቀንሶ ገቢማድረግ ይኖርበታል፡፡
…
ስለዚህ የአክስዮን ማህበራት እና ሃላፊነታቸው የተወሰነ የግልማህበራት ትርፉ ለአባላቱ መከፋፈሉን
ሳይጠብቁ ለባለአክሰዮኖች ተከፋይ ከሆነው የአክስዮን ድርሻ ላይ ተገቢውን ግብር ቀንሰው ለግብር
አስገቢው ባለስልጣን ገቢ ማድረግ እንዳለባቸው እንገልፃልን፡፡11
Development, Legal Opinion Letter Written to Ethiopian Revenues and Customs Authority,
27/11/2004 E.C., in Amharic, unpublished
11 Ibid
153
This, translated, reads:
… the issue that requires an answer is whether the imposition of the tax on
dividends should remain on hold until the dividends are distributed to
shareholders? Previously, this issue as a point of contention had created problems
in the enforcement of the [income] tax which is why an all-inclusive definition
was given to “income” during the drafting of the current income tax law (in
2002). Accordingly, the definition of “income” in Article 2(10) [of the Income
Tax Proclamation] was made to include benefit held in the name of the taxpayer.
As indicated in Article 458(1) of the Commercial Code [of Ethiopia), dividends
are to be paid only from the net profits as shown in the approved balance sheet [of
a company]. Once the net profits are ascertained, the shareholders shall have the
right to the distribution of dividends in accordance with the rules of Articles of
Association [of the company]. It is to be noted that Article 458(3) of the
Commercial Code authorizes the general assembly [of shareholders] to determine
the manner and time of payments of dividends to shareholders. The general
assembly, however, is authorized to determine only the manner and time of
payment of dividends, and not the amount of dividends to be paid.
… since the shareholders of a company have the right to the distribution of
dividends once the net profits of the company are known, the company has the
obligation to withhold the [dividend] tax from the [net] profits and transmit the
same to the [authority].
….
….
Thus, it is incumbent upon share companies and private limited companies to
withhold dividend taxes and transmit the proceeds to the tax authorities without
waiting for the actual distribution of dividends to the shareholders (author’s
translation).
The Letter from MoFED relieved ERCA from having to show any distributions to
shareholders and what is more from even waiting until companies take some
formal steps to declare and distribute dividends to shareholders. Relying on the
Amharic version of Article 34 of the Income Tax Proclamation,12 the Ministry
12 The Amharic version of Art. 34(1) reads: “የአክሲዮን ማኅበር ካከፋፈለው የአክሲዮን ድርሻ ወይም ኀላፊነቱ
የተወሰነ የግል ማኅበር ከሚያከፋፍለው ትርፍ ገቢ የሚያገኝ ማንኛውም ሰው ባገኘው ገቢ ላይ 10 ፐርሰንት (አሥርበመቶ)
ግብርይከፍላል፡፡” In specifying when taxation is due, this provision, roughly translated, states that
154
argued that dividend tax was due not only upon the actual distribution of profits,
but also on the net profits of the company remaining after reserves required by law
were deducted. Once the net profit is ascertained, MoFED concluded in its Letter
that shareholders will have a right to distribution of profits as per the terms of the
memorandum of association of the company. The Letter written by MoFED
relegated the mandate of the general meeting of shareholders to that of deciding
the dates and modes of payment (and not on whether dividends are to be paid or
not).
Both the actions of the ERCA and the Letter written by MoFED attracted a fair
amount of criticism and some support. Not surprisingly, the arguments of the
Authorities have not gone down well with members of the business community,
many of whom have continued to hold on to the view that no dividends are
payable to shareholders until the general assemblies of shareholders meet and
decide to distribute the net profits of a company. Some critics have contended that
the undistributed profits of companies are not even income within the meaning
given to “income” in the Income Tax Proclamation.13 According to these critics, the
circular issued by the ERCA is essentially the levying of a new tax on a previously
untaxed source, challenging the ERCA on whether it has the power to impose tax
as part of the executive branch of government.14 One critic described the
Authority’s move as “expecting an employee to pay income tax” on a salary an
employee has not yet received.15
profits ‘distributed’ in the case of share companies (SCs) and ‘to be distributed’ when it comes
to private limited companies (PLCs) attract dividend taxation. The Ministry argued that since
the amount of tax imposed is 10% for both types of companies (SCs and PLCs), the two
expressions are used interchangeably and that dividend taxation applies to both SCs and
PLCs on profits yet to be distributed. It cited Art. 6(h) of the Proclamation that talks about
taxable income under the Proclamation to buttress this position since it similarly applies the
term ‘to be distributed’ for share companies.
13 In this regard, see Zafu, cited above at note 3; see also Editorial, “New Dividend Tax
Interpretation Unlawful, Unfair”, Fortune, vol. 13, No. 665, January 27, 2013,
(http://addisfortune.net/columns/new-dividend-tax-interpretation-unlawful-unfair/) last
visited on January 26, 2014
14 YohannesWoldegebriel, “Limitless Power Corrupts, Fortune, vol. 13, No. 670, March 3, 2013,
155
Just as the MoFED relied on the Amharic version of the Income Tax Proclamation
to argue its positions, the critics claimed that the Income Tax Proclamation
presupposed distribution of dividends and a formal decision to that effect by the
company before dividend tax was due.16Some critics went beyond the substance of
the Letter issued by the MoFED and disputed whether the Ministry had the legal
authority to write legal opinions. One critic of the Letter argued that MoFED lacks
the legal mandate to give legal advice and opinion, and if ERCA needed some legal
opinion, it should have sought it from the Ministry of Justice (and not from the
Ministry of Finance and Economic Development).17 On the substance of the Letter,
this Critic wrote:
Most of the writings that came after the Government’s move to enforce dividend
tax on undistributed profits were critical of the moves, but the positions of the
Authorities drew at least one support from one writer who argued that the Circular
of the ERCA “simply enforces the collection of tax on an income already taxable by
16 Yohannes, cited above at note 14, Yohannes states “… the words “deriving” and
“withdrawal” [in Article 34 of the Proclamation] are conditions precedent for the Authority to
claim the dividend tax.”
17 Id.
18 YohannesWoldegebriel, “Dividend Tax Notice Illegal”, Fortune, vol. 13, No. 664, January 20,
The controversies surrounding the meaning and scope of dividend taxation became
even more confusing after the Government appeared (at least as the reports
appeared in the newspapers) to have changed its original position in subsequent
discussions with members of the business community. In one of these discussions,
the Minister of Finance and Economic Development, for example, was reported to
have said that dividend tax was due only after part of the net earnings of
companies are paid to shareholders –which, if true as reported, would reverse the
position of both the ERCA and the MoFED.20 Although this development may
solve some of the problems that recently arose in the implementation of dividend
taxation (at least to the satisfaction of those who thought dividend taxation was
due only after formal distribution by companies), it does not decisively quell the
concerns that ensued after ERCA’s expansive definition of dividends for purposes
of withholding taxation.21 The gaps in the law continue to be sources of uncertainty
in the area of dividend taxation.In the following sections, we will try to show that
the problems of dividend taxation in Ethiopia are far deeper than the controversies
about distribution of profits.
Both sides to the argument have cited the Commercial Code and the Income Tax
Proclamation in support of one or another meaning of dividends for purposes of
19 YitayalMekonnen, “Dividend Tax Uproar Unwarranted”, Fortune, vol. 13, No. 672, March
17, 2013 (http://addisfortune.net/columns/dividend-tax-uproar-unwarranted/) last visited
on January 26, 2014
20 Tamrat G. Giorgis, “Government Accepts: No Tax on Undistributed Dividends,” Fortune,
misunderstanding as other officials of the Ministry and ERCA have later downplayed the
importance of this statement. See ZafuEyesusworkZafu, “Undelivered Promises Erode
Governmental Credibility,” Fortune, vol. 14, No. 707, Nov 17, 2013
(http://addisfortune.net/columns/undelivered-promises-erode-governmental-credibility/)
last visited on January 26, 2014
157
dividend taxation. It is therefore in order to review what the Commercial Code and
the Income Tax Proclamation stipulate about the meaning and scope of dividends.
22 See Seferian Ethiopia PLC v. Federal Inland Revenue Authority (FIRA), cited above at note 4
23 Commercial Code of the Empire of Ethiopia, cited above at note 2, Art. 458(1)
24 Id, Art. 458(2)
158
of profits as shown in the approved balance sheet is the only legitimate source of
“dividends.”
Both sides to the debate over the meaning and scope of dividend taxation agree
that “profits” are a condition precedent to the enforcement of dividend taxation,
but disagree on when the profits become “ripe” as “dividends.” The Commercial
Code declares that shareholders become creditors of the Company “from the date
fixed for the payment.”25The Code appears to cede the power to declare dividends
to the organs of the companies that are authorized to declare dividends, but the tax
authorities, as we have seen, are not prepared to concede this power to the very
companies which are suspected of acting for the sole purpose of avoiding dividend
taxation.
The Commercial Code does not compel companies to distribute net profits among
shareholders. It states only that the balance of profits may, after transfer to legally
required reserves, be distributed in accordance with the articles of association.26
This implies that it is up to shareholders to specify in articles of association how net
profits are distributed amongst them. The only restriction the Code imposes, as
stated before, is that dividends may only be made out of net profits shown in the
approved balance sheet – an injunction obviously intended to protect the interest of
creditors and third parties in general.27
The Commercial Code also regulates many other forms of corporate distributions
without formally calling them “dividends.” One of these distributions is the
distribution of what the Code calls “residual surplus” upon dissolution of
companies.28In the event of dissolution of companies, the Code prescribes that all
creditors (secured and unsecured) must be paid before any distribution of the
proceeds is made to shareholders.29 Once all creditors are paid, the Code states that
the “residual surplus” may be distributed according to the share of shareholders.30
liability
28 Id, see Art. 501-504
29 Id, see Art. 501
30 Id, Art. 504(1); the Code states that fully paid up shares enjoy full distribution according to
the share while unpaid shares shall be deducted before any distribution is made to a
159
The Commercial Code does not say whether the distribution of “residual surplus”
to shareholders constitutes “dividends,” or “return of capital” or “capital gains.” In
practice, some within the tax authorities have used this provision and general
accounting rules to enforce the payment of dividends upon that part of the
distribution of “residual surplus” that exceeds the “return” of the shareholder’s
capital.31
Apart from distribution of profits and the “residual surplus” (upon dissolution of
companies), the Commercial Code regulates other forms of distributions. One of
these distributions is the redemption of shares by companies. In one form of
redemption, the Code authorizes companies to redeem their own shares by paying
out shareholders from the “net profits of the Company.”32 This form of redemption
presumably leads to the cessation of shareholding by the payee-shareholder, but
the Commercial Code does not state whether this distribution constitutes
“dividends,” “return of capital” or even “capital gains” to the shareholder. The
other form of the redemption of shares the Code regulates is the redemption of
shares by paying the par value of the shares. The Code states that such buyback of
shares can only be made from the profits or reserve funds of the company and may
not result in the reduction of the capital of the company.33
In another place, the Code regulates the remuneration of corporate directors from
the net profits and states that the share of directors from net profits is to be
calculated after the legally required deductions are made and onlywhere dividends
are distributed to shareholders.34The Code does not permit companies to pay out
“interim dividends” but it authorizes the payment of “interim interest” during the
formative period of company establishment.35 The Code prohibits directors from
drawing loans from companies in which they serve as directors (unless the
company involved is a bank)36 but does not prohibit shareholders (other than
directors) from obtaining loans from the companies in which they are shareholders.
shareholder; the Code also states that preferential shares enjoy preferential rights in the
distribution of surplus during liquidation; see Id, Art. 504(2)
31 Interviews with AtoYonasArgaw, ERCA, Tax Audit, April 27, 2012;AtoGirmaCherinet,
ERCA, Tax Audit, May 23, 2012; AtoTibebeMengistu, TibebeMengistu& Co, April 07, 2012
32 Commercial Code of Ethiopia, cited above at note 2, Art. 332 (1(b)
33 Id, Art. 337
34 Id, Art. 353
35 Id, Art. 457
36 Id, See Art. 357
160
The question is whether these kinds of dealings between companies and
shareholders have any tax consequence at all.
161
3. Double Taxation Treaties
Ethiopia has to date signed double taxation treaties (DTTs) with more than twenty
countries.37DTTs are seldom consulted as sources for the interpretation of rules in
the Ethiopian domestic tax legislation but can serve as useful templates for
understanding the meaning and scope of terms like dividends. DTTs contain
provisions on dividend taxation laying down a definition of the term that is more
detailed than that of the Income Tax Proclamation. Since the purpose of the treaties
is regulating taxation between states, their relevance to what “dividend” means
under the Ethiopian tax system is more apparent than other areas of law, such as
the Commercial Code, that are promulgated with a different purpose.
Unfortunately, the DTTs are seldom mentioned in Ethiopian tax practice.
A double taxation treaty between Ethiopia and Tunisia, under a provision on
“Dividends,”38 for example defines dividends as follows:
The term “dividends” as used in this Article means income from shares
or other rights, as well as income from other corporate rights
assimilated to income from shares or any other item which is deemed to
be a dividend or distribution of a company by the taxation of the
Contracting State of which the company making the distribution is a
resident but does not include debt claims, participating in profits not
assimilated to share.
This and similar provisions under other double taxation treaties provide a
definition of what dividend means by outlining what is considered a ‘dividend’ for
the purposes of taxation and which distributions are excluded.39 Though not a
comprehensive treatment of the area, such provisions are indicative of how
March 2013
38 Agreement between the FDRE and the Republic of Tunisia for the Avoidance of Double
taxation with Respect to Taxes on Income (2003), Article 10 (3); this definition is typical of
such definitions in almost all the DTTs Ethiopia has so far signed.
39 See also Convention between The FDRE and the Czech Republic for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (2007);
Agreement Between the Government of the FDRE and the Government of the Republic of
India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect
to Taxes on Income (2011); Convention Between the Government of the Federal Democratic
Republic of Ethiopia and the Government of the UK of Great Britain and Northern Ireland for
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income and on Capital Gains (2011)
162
detailed a definition of “dividends” should be – something the Income Tax
Proclamation neglected.
In this section we will look at the experience of some countries of the developed
world as well as developing (African) countries with a view to understanding how
income tax systems in other parts of the world have confronted the problem of
corporate distributions for income tax purposes. In reviewing how other countries
have approached the problem of corporate distributions for income tax purpose,
we hope to draw a few lessons for future tax reforms in Ethiopia.
A. The Relationship between Corporate Law and Tax Law in Defining the Scope
of Dividend Taxation
Comparative literatures on the topic of corporate and dividend taxation show that
most developed income tax systems rely in one way or another on their commercial
or corporate laws to define and interpret the scope of dividend taxation. The extent
to which these countries depend on commercial or corporate law for defining
“dividend” for tax purposes greatly varies from country to country. Nonetheless, it
is easy to see how much income tax systems seek to regulate the taxation of
dividends through detailed provisions of the income tax laws themselves rather
40For the treatment of corporate distributions in general, see Hugh J. Ault and Brian J.
Arnold, Comparative Income Taxation (3rd ed., 2010), pp 352-375
163
than relying on the second-guesses of general provisions of commercial or
corporate law. Some income tax systems have provided for virtual sui generis rules
in their income tax laws.
In the US, the notion of “dividends” is tied to the concept of ‘earnings and profits,’
which are understood in the context of corporate law. But the US tax code makes
several modifications to the definitions found in corporate law. For example, the
characterization of a distribution as formal dividend or otherwise by the corporate
law is irrelevant for tax purposes.41 Thus unreasonable compensation made to a
shareholder may be considered as a “constructive dividend”– the name given to
various shareholder benefits flowing from a corporation, and disallowed as a
deduction even when such payment is not formally characterized as a dividend.42
The US tax law also disregards the corporate law aspects of a change in the
capitalization of a corporation as well as the effects of the capitalization of earnings
that usually accompany stock dividend.43Thus the US attaches dividend taxation to
a corporate distribution subsequent to a reduction of capital as long as the
corporation has earnings even though the reduction of capital constitutes a return
of capital under corporate laws.44
The Canadian system relies upon corporate law to determine what is considered
the paid-up capital of the company (with certain adjustments under the income tax
law). When distributions of the paid-up capital are made, the Canadian income tax
laws regard as dividends only the excess over the paid-up capital.45 When a
shareholder receives amounts from a reduction in the paid-in capital of the
corporation, the amount that exceeds the portion of stated capital allocated to
shares is taxed as a dividend.46
41 Id,p. 352
42 David J. Shakow, The Taxation of Corporations and Their Shareholders, (1991), p. 99
43 Ault and Arnold, cited above at note 40, p. 365
44 Ibid
45 Id, p. 355
46 Id, p. 365
47 Ibid
164
while any distribution in excess of the “return of capital” may entail dividend
taxation. The UK system does not, however, depend entirely upon the scope of
“distribution” under corporate law to characterize it as a dividend. Corporate
distributions for tax purposes may include items other those recognized as
“dividends” under UK corporate laws. For UK tax purposes, whether or not the
corporation has profits is irrelevant.48
The Swedish income tax system uses corporate law to delimit the scope of dividend
taxation in some respects. For example, it relies upon corporate law for
characterizing certain loans extended to shareholders as “constructive
dividends.”Swedish income tax law stipulates that all types of corporate loans
made to shareholders that are improper under company law are taxed in full as
dividend distributions even if the loans are made at arm’s length.49An interesting
aspect of the Swedish income tax system is that the Swedish income tax laws make
no connection between the earnings or income of the corporation and the taxation
of the corporate distribution.50 The tax laws state that a payment made to
shareholders which reduces either the equity or reserves without reducing the
number of shares is treated as a dividend.51
In the Netherlands, the tax laws in general regulate “income from shares” which is
defined broadly to include any distribution by a company other than a repayment
of the fiscal paid-up capital.52 The tax law definition of the fiscal paid-up capital is
different from that provided in company law and is important in categorizing a
dividend. Dividend treatment attaches even where payments are made in violation
of company law.53In the Netherlands, dividend tax is withheld by the company
when the dividends are put at the disposal of the shareholder.54
48 Id, p. 353
49 Id, p. 358
50 Id, p. 353
51 IBFD, Sweden- Shareholders and Directors of Resident Companies, Section 6.1.1., updated
up to 2012
52 IBFD, Netherlands- Country Analyses, Section 6.1.1., updated up to 2012; hence “any
economic benefit received by the shareholder as such is taxable without regard to the
financial results on the corporation.” – Ault and Arnold, cited above at note 40, p. 353
53 Ibid
54 IBFD, Netherlands- Country Analyses, Section 1.11.9.1., 1, updated up to 2012
165
Australian income tax laws stipulate that dividends must be made ‘out of profits’55
and distributions which are in the nature of repayments of share capital in
accordance with company law are generally tax free. These distributions normally
have the consequence of merely reducing the cost basis of the share. Where the
distributions are in excess of the share capital, however, Australian income tax laws
impose taxes upon the excess as capital gains.56
The degree of influence corporate law has on tax law differs in the different
jurisdictions discussed above. The relationship between their respective corporate
and tax laws varies as some use the corporate law notion of ‘profits’ as a reference
for characterizing distributions as dividends while others disregard this and
instead provide for a separate basis in their tax laws.
company accounts or financial statements. Court rulings however suggest that anything not
debited to share capital qualifies as such; See Ault and Arnold, cited above at note 40, p. 354
56 Ault and Arnold, cited above at note 40, p. 356
57 Shakow, cited above at note 42, p. 26
58 Ault and Arnold, cited above at note 40, p. 352
59 Id, p. 356
166
shareholders.60 The reduction in capital and subsequent distribution to
shareholders attracts tax consequences so long as the corporation has earnings for
tax purposes. If a corporation distributes shares (stocks) pro rata, known as stock
dividends, the distribution of stocks is in principle not taxable unless the
shareholder has the right to choose between a cash dividend and a stock
dividend.61The distribution is however taxable if the distribution is not pro rata
and results in an increase in the proportionate interest of the receiving
shareholder.62
The Canadian system is slightly different from that of the U.S. in that it imposes tax
on distributions by corporations regardless of the existence of profits at the
corporate level except when such distributions are made subsequent to a
liquidation of a corporation or reduction of capital (in which case the portions
forming the return of capital are tax free).66Distributions following reduction of
capital are taxable as dividends only if the distributions are in excess of the paid-up
capital.67 Somewhat similar to the US system, Canada treats distribution of
appreciated or depreciated property to shareholders as a disposal of the property
(the value of which is considered to be at its fair market value)– the corporation
distributing property is subject to capital gains taxation. In addition, the
shareholder to whom the distribution of property is made is considered tohave
60 Id, p. 365
61 Id, p. 366; Shakow, cited above at note 42, p. 207
62 Ault and Arnold, cited above at note 40, p. 367
63 Id, p. 369
64 Under US law, distribution of dividends to corporate shareholders is generally exempted
from dividend taxation to prevent the cascading effects of dividend taxation upon
distributions to corporate shareholders.
65 Ault and Arnold, cited above at note 40, p. 370
66 Id, p. 353
67 Id, p. 355
167
acquired the property at a cost to its fair market value and should include the fair
market value as a dividend.68
A shareholder who receives amounts following the reduction in the paid-in capital
of the corporation should include the amount that exceeds the portion of stated
capital allocated to shares as a dividend.69 Canada treats stock dividends as taxable
dividends to the extent that their payment increases the stated capital of the
corporation.70 As regards redemptions, the amount received on the redemption is
taxed as a dividend only when the amount exceeds the paid-up capital of the
shares redeemed;71 similar rules apply on distributions following liquidation. 72
As in the other income tax systems of the developed world, the UK regards
“distribution” as central to determining the application of dividend taxation.
Special income tax rules help to broaden the concept of “distribution” to include
benefits-in-kind conferred on shareholders by closely held corporations73A
“distribution” is deemed to be made where value passes from the corporation to
the shareholder in a transfer of assets or liabilities to shareholders not in exchange
for equal value.74Except in some conditions under whichredemption of shares may
receive capital gains treatment,75a redemption that results in distribution of the
excess ofthe amount paid up on the shares is treated as a distributionand subject to
dividend taxation.76As in many other tax systems such distributions made to a
corporate shareholder are, however,exempt from taxation as inter-corporate
dividend distributions.77
Sweden has special rules governing constructive dividends according to which all
types of corporate loans made to shareholders that are improper under company
law (even when made at arm’s length) are taxed in full as dividend
68 Id, p. 363
69 Id, p. 365
70 Id, p. 367
71 Id, p. 370
72 Id, p. 373
73 Id, p. 357
74 Ibid
75 Capital gains treatment applies only if the company can establish a business purpose for the
168
distributions78Where profit distributions are made without approval by the general
shareholders’ meeting, a hidden profit distribution may be detected and treated as
constructive dividend. 79 Any distribution in connection with redemption of shares
is also treated as a distribution of dividends.80
Australian tax law requires a dividend to be made “out of profits” which is defined
as anything not debited to share capital.84 In addressing constructive dividends, the
law treats certain benefits provided to shareholders in closely held companies –
such as interest-free loans and excessive compensation to shareholders who are
employees –as non-deductible dividends.85Redemption is treated as a dividend
unless the redemption amount is debited to share capital account and is less than or
equal to the amount subscribed as share capital for the shares.86Where redemptions
are not made in the ordinary course of trading on the stock exchange, the purchase
price that is in excess of the amount charged to share capital in the exchange is
78 Id, p. 358
79 IBFD, Sweden- Country Analyses, Section 6.1. 5, up dated up to 2012
80 IBFD, Sweden- Country Analyses, Section 6.1. 7, updated up to 2012
81 Ault and Arnold, cited above at note 40, p. 353
82 Id, p. 357
83 Id, p. 375
84 Id, p. 354; The determination of what is ‘out of profits’ was traditionally made by reference
to company accounts or financial statements. Court rulings however suggest that anything
not debited to share capital qualifies as such; See Ault and Arnold, cited above at note 40, p.
354
A distribution out of share capital is deemed to be an unfranked distribution. Hence, even if a
capital distribution is deemed an assessable dividend, it is not able to be paid as a franked
dividend. Graeme S. Cooper, Richard E. Krever, Richard J. Vann, Cameron Rider, Income
Taxation: Commentary and Materials, (5th Ed., 2005), p. 701
85 Ault and Arnold, cited above at note 40, p. 357
86 Cooper, Krever, Vann, Rider, cited above at note 84, p. 696
169
treated as a dividend.87Although a liquidation distribution does not normally
attract dividend taxation, Australia treats liquidating distributions as dividends to
the extent the distributions “represent income derived by the company” and
“income” is given a special extended meaning to include statutory income and
gross assessable capital gains, as well as ordinary income.88
The US tax system does not attach dividend taxation to stock dividendsas long as
they are proportionately distributed and the stocks distributed belong to the same
class as the stock on which the distribution is being made.89 If the distribution of
170
stock dividends is, however, “substantially disproportionate,” the distribution of
stock dividends might be taxable as dividend. The other form of corporate
distribution that is not characterized as a dividend is payment to shareholders in
redemption of shares as long as the distribution is not in excess of the capital
contributed. This is the case even when redemption terminates a shareholder’s
interest in the company.90 A liquidating distribution is treated entirely as an
exchange transaction, and no attempt is made to tax the undistributed corporate
profits as a dividend,91i.e. corporations recognize gain or loss when they are
liquidated and the distribution of assets on liquidation is considered as an
exchange/sale and no dividend taxation attaches.92
The Canadian system, in dealing with constructive dividends, holds that the
various shareholder benefits must be included in the shareholder’s income but are
not treated as dividends.93This is significant because while a shareholder is taxable
on benefits flowing from the corporation for having received income, she is not
entitled to some of the special privileges available to dividends, such as imputation
credit (for corporate tax paid by the corporation) and inter-corporate dividend
exemptions (for dividends paid to corporate shareholders).94A shareholder
receiving redemptions is considered to receive the paid up capital of the redeemed
shares first on a tax-free basis.95Similarly, distributions to shareholders upon
liquidation of companies are treated as tax free first as long as they constitute
redemptions of the share capital contributed by shareholders.96
The UK income tax rules have expressly excluded a return of capital from the
definition of distribution and the application of dividend tax.97The UK does not
impose tax on the distribution of stock dividends98and attaches capital gains
consequences to certain distributions. Capital gains, rather than dividend taxation,
attach in cases of redemption if the redeeming corporation is engaged in a trade
90 Id, p. 369
91 Id, p. 372
92 Shakor, cited above at note 42, p. 221
93 These benefits include discount purchases, rent-free use of property and reimbursements of
personal expenses; see Ault and Arnold, cited above at note 40, p. 357
94 Auld and Arnold, cited above at note 40, p. 357
95 Id, p. 370
96 Id, p. 373
97 Id, p. 353
98 Id, p. 368
171
and its shares are not quoted on an exchange.99 Similarly, the UK attaches capital
gains taxes to distribution of assets as well as liquidating payments.100
99 Id, p. 372
100 Id, p. 375
101 Id, p. 367
102IBFD, Sweden - County Analyses, Section 7.3.4.1., updated up to 2012; Exemption does not
apply to shares held as inventory, see IBFD, Sweden - Country Analyses, Section 6.1.3.,
updated up to 2012
103Ault and Arnold, cited above at note 40, p. 375
104 Id, p. 362
105 Id, p. 367
106IBFD, Netherlands - Country Analyses, Section 1.10.3.1, updated up to 2012
107 Ault and Arnold, cited above at note 40, p. 372
108 Id, p. 375
172
generally tax-free.109 Bonus shares are also exempt from dividend taxation where
they are issued for no consideration with shareholders having no choice in the
receipt and where no amount is transferred from a profit and loss account to share
capital account.110 The distribution of appreciated or depreciated property is
subject to capital gains tax at the corporate level.111 In relation to redemptions,
buybacks involving traded stock are treated as capital gains transactions provided
the transaction occurs in the ordinary course of trading on the stock exchange.112
In addition to providing a detailed definition of what is considered a dividend, the
tax systems discussed here contain rules excluding certain distributions from such
definition. In most of these jurisdictions a return of capital or distribution of stock
dividends is free from tax if it meets the prescribed conditions. They also
conditionally exclude redemption of shares and distributions following liquidation
from application of dividend taxation. With a view to avoiding cascading taxation,
most of these systems also provide for inter-corporate dividend exemption.
A. Kenya
Kenya operates a classical taxation system whereby the company is treated
separately from its shareholders. Dividends paid to resident individuals are subject
to withholding tax at 5% on the gross amount while the rate is set at 10% for
dividends paid to a non-resident company.113 This is a final tax that is imposed at a
rate significantly lower than the corporate tax rate.114 There is no provision
regulating the taxation of foreign dividends.115
and is treated as a dividend to the extent to which the company does not debit the buy-back
price to a share capital account” Cooper, Krever, Vann, Rider, cited above at note 84, p. 696
113 Fredrick Omondi, Kenya- Corporate Taxation, IBFD, Section 6.3.1., last updated on April
29, 2013
114 Fredrick Omondi, Kenya- Income Tax, IBFD, Section 1.5., last updated March, 2012
115Omondi, cited above at note 107, Section 6.1.1.
173
The Income Tax Act of Kenya requires all resident companies to maintain a
memorandum of account called a “dividend tax account.”116 If the net balance on
this account is a debit, the company is required to bring the balance to zero by
making a payment of compensating tax. The purpose of compensating tax is taxing
distributions of dividend out of exempt or untaxed income.117 The Act addresses
the issue of possible tax avoidance through non-distribution of profits by
empowering the Commissioner to treat profits not distributed ‘within a reasonable
period’ as dividends ‘which could be so distributed without prejudice to the
requirements of the company’s business’.118
B. Ghana
The Ghanian system also treats companies and their shareholders as separate
entities for tax purposes. According to the Internal Revenues Act of Ghana, a
dividend is defined as to include:
(a) a capitalization of profits, whether by way of a bonus share issue or
increase in the amount paid-up on shares, or otherwise involving a credit
of profits to the share capital or share premium account; or
(b) an amount derived by a shareholder from a company
i) in the course of liquidation or reconstruction, or
174
ii)with respect to a reduction of share capital or share buyback, but only to
the extent that the amount is not debited to the company's share capital or
share premium account;122
As can be clearly seen from the definition of ‘dividends’ as quoted above, the
notion of dividends is defined broadly to include “capitalization of profits” and
amounts derived by shareholders in the course of liquidation or reconstruction as
well as amounts distributed after a reduction of a share capital or redemption of
shares.125
In order to control tax avoidance, the Internal Revenue Act of 2000 empowers the
Commissioner General to take a number of actions. The Commissioner General has
the power to re-characterize or disregard any arrangement that is entered into or
carried out as part of a tax avoidance scheme which is fictitious or does not have a
substantial economic effect or whose form does not reflect its substance. For a
company that is controlled by not more than five persons and their associates, the
Commissioner, upon consideration of some factors, can treat a part of the
company’s income as having been distributed as dividends to the shareholders
where the company fails to distribute a reasonable part of its income within a
reasonable time.126 In addition to these general measures, the Act also contains
specific measures that address ‘profit and dividend-stripping arrangement.’127
175
dividends controls, directly or indirectly, 25% or more of the voting power in the
former.128 This does not apply if a dividend is paid to a company by virtue of its
ownership of redeemable shares in the company paying the dividend, or if after
acquiring the interest in a target, the target makes a dividend distribution to the
acquirer which represents profit.129
C. South Africa
The South African tax system is a global income tax system that is imposed on an
annual basis with no separate individual or corporate income tax. Dividends
received by or accrued to any person from South African resident companies are
generally exempt from income tax.130 On the other hand, foreign dividends
received by or accrued to residents are generally subject to income tax.131
All dividends, including foreign dividends, form part of the gross income of an
individual on which income tax is imposed. A number of extensive exemptions will
exclude a dividend or a foreign dividend from the recipient’s taxable income.132 In
general, nearly all dividends declared by a resident company are treated as tax-
exempt income for the recipient. This exemption applies only for income tax
purposes whereas the dividend tax, as a separate tax regime, may nonetheless
apply.133 Dividend tax is a tax imposed at shareholder level by way of withholding
at source. Domestic dividends are subject to a withholding tax at 15%, unless the
recipient is a South African resident company.134
2013, § 1.10.3.2.
131 Id, Section 1.2.3.11.
132Id, Section 1.5.1
133 Ibid
134 Ibid
176
profits are used as references for characterizing distributions as dividends. Other
countries, such as the UK and Sweden, on the other hand, disregard the notion of
corporate profits in general and provide a different basis for the taxation of
dividends.
As regards the scope of dividend taxation, the systems go beyond the formal labels
attached by the corporations and provide for detailed rules on what is considered a
dividend. By including direct as well as indirect benefits to shareholders within the
definition of dividends, such rules help close down the gaps thatare left
unregulated by corporate or commercial laws.In this regard, constructive
dividends – cash benefits (in the form of loans or excessive compensation), in-kind
benefits (property distributions) are characterized as dividends regardless of what
corporate or commercial laws might say about these distributions. Property
distributions constitute disposals of property by the corporation and may lead to
capital gains taxation even though the distributions are made to shareholders. Since
the distributions are in principle suspect, the countries have developed arm’s
length rules for revaluating the transactions. Where it meets certain conditions, a
reduction of capital of a company is also considered as a dividend in some of the
systems. Redemption of shares and liquidation distributions are similarly subject to
dividend taxation when such transactions meet a set of criteria.
Conclusion
The chief blame for the controversies surrounding taxation of dividends must be
laid on the door of Ethiopian income tax laws. The Income Tax Proclamation
177
dashes off the taxation of dividends as if everyone were in agreement about the
meaning and scope of dividends for purposes of taxation. Neither the Proclamation
nor the subsidiary pieces of legislation have ever provided a definition for
dividends capable of encompassing the distributions that are treated elsewhere as
dividends and closing down the loopholes that have exposed the Ethiopian tax
system to tax avoidance schemes.
The absence of definitions for dividends in the Income Tax Proclamation and other
tax laws has so far forced both the tax authorities and the taxpayers involved to fall
back upon the meaning of “dividends” under the Commercial Code of Ethiopia.
Each side swears by their own version of the Commercial Code, often those
provisions that support one side of the argument over the other. The question that
neither side has been willing to consider is whether the Commercial Code
provisions in respect of dividends are controlling on the question of dividend
taxation under the Income Tax Laws of Ethiopia.
It was known for a long time that this narrow rendition of “dividends” opened the
Ethiopian dividend taxation regime to massive tax avoidance schemes particularly
by the closely held private limited companies, which are virtual one-man
companies in many cases or closely held by members of a single family. The
companies that found it hard to escape the withholding taxation on dividends were
those widely held public share companies whose diffused relationship with
shareholders imposed an obligation upon them to distribute dividends from time
to time. It is an open secret that the privately held companies that were in existence
for a long time never declared dividends and never saw any reason to withhold the
dividend taxation. It is naïve to assume that these companies never really
distributed benefits to their shareholders. It is simply that these companies could
178
easily find back alleys through which economic benefits flowed to their members
or shareholders. The companies knew full well that the rules on withholding
taxation on dividends could be avoided very easily by circumventing the formal
company decision making processes that stamped the name “dividends” upon
company distributions.
The tax authorities never really enforced the withholding taxation on dividends
against companies except when the companies themselves gave them the excuse by
making the formal decisions which stamped the name of “dividends” on company
distributions. It is only after the tax authorities found themselves under pressure to
meet some revenue targets particularly after the promulgation of the GTP and
started looking for additional sources of revenues that authorities ratcheted up
their enforcement muscle against sources of revenue which were neglected under
previous tax administrations.
One of these targets was the enforcement of dividend taxation against companies
which found it convenient to place their profits in the retained earnings accounts
(permanently and indefinitely it seemed). The tax authorities knew that private
limited companies and some share companies never withheld any taxes from
dividends.
Buoyed by some successes in the courts, the tax authorities adopted a strategy that
sought to enforce dividend taxation against companies regardless of whether the
formal shareholder meetings were convened and decided to distribute dividends
among shareholders. The companies which for long time believed that formal
shareholder meetings were required to declare and distribute dividends were
unnerved by the change of tactics and reacted angrily against the tax notices which
not only asked them to pay dividend taxes on undistributed profits but also
required them to account for tax arrears going back at least five preceding tax
years.
This action of the tax authorities enraged the business community. Some prominent
members expressed their outrage publicly; some even deemed it illegal and
unconstitutional. Now that the dust has somehow settled over the taxation of
dividends, one must note in retrospect that both parties overplayed their cards in
the course of the dispute. The expression of outrage by members of the business
community simply turned a blind eye to the fact that many companies were able to
avoid paying dividend taxation by holding off the formal requirements for
179
declaring dividends – that is calling for the meeting of shareholders and deciding
to declare and distribute dividends. The tax authorities took a rather drastic action
of extending the meaning of dividends to undistributed profits after tolerating
company inactions over the distributions of dividends for a very long time. The tax
authorities also tried to save face in the face of stiff opposition by sticking to their
expanded rendition of dividends although many of them understood at least
privately that there were serious legal loopholes that allowed the distributions by
companies to go untaxed for a long time. Both sides to the argument are a little
insincere about their positions. It is now time to admit that the tax regime on
dividends was susceptible to massive tax avoidance schemes by companies
(particularly private limited companies) and the government did not close down
the loopholes that allowed these schemes for a long time.
Recommendations
In view of the problems explored fully in this article, we make the following
alternative recommendations:
1. The relationship between the Commercial Code and the tax laws must be
clearly delineated. Both sides have invoked the provisions of the commercial code
in support of their respective positions. Both sides have expressed outrage over the
violation of some basic principles outlined in the Commercial Code without really
asking themselves whether the Commercial Code should serve as a source of
authority over the meaning and scope of dividends for tax purposes. The
Commercial Code may be the basis of authority for identifying the types of entities
that are subject to withholding dividend taxation, but to rely upon the formal labels
of the Commercial Code for purposes of defining the scope of dividends is an
invitation for massive tax avoidance, as witnessed in the past. The experience of
other countries shows that the solution to the effective taxation of dividends rests
on the detailed regulation of dividend taxation in the income tax laws themselves
and not in the commercial or corporate laws.
The Commercial Code of Ethiopia is good enough within the bounds of its
jurisdiction; that is, defining and regulating commercial matters. The Commercial
Code of Ethiopia mentions many of the corporate distributions that have been
adjudged as having some tax consequences in the rest of the world. The Code, for
example, regulates redemption of shares by companies (Article 332); dividend
180
shares (Article 337); fictitious dividends (Article 458); distribution upon liquidation
(Article 504). But the Code is not judgmental in tax terms; it does not adjudge these
distributions to be dividends or not dividends. In none of its provisions does the
Commercial Code suggest anything of relevance to withholding taxation on
dividends. The aim of the Commercial Code in regulating the various types of
corporate distributions is one of protecting the rights and interests of shareholders
and creditors. It is, therefore, irrational to refer to the Commercial Code to support
one or another meaning of dividends for tax purposes particularly in view of the
fact that Commercial Code of Ethiopia was enacted long before dividend taxation
was even contemplated in Ethiopia.
Instead of relying upon the supposed meaning and scope of dividends under the
Commercial Code, the Income Tax Laws of Ethiopia should come with detailed
regulations regarding the tax consequences of all forms of corporate distributions,
including:
• Constructive dividends – e.g., loans to shareholders;
• Distributions of property (appreciated or depreciated property);
135We do not anticipate significant fall in revenues as a result of the elimination of dividend
taxation if the current corporate tax is effectively enforced and some loopholes in the existing
tax system are closed. In that case, raising the corporate tax rate may not even be necessary.
182