Foreign investment in a capital market

Unity University, Addis Ababa Ethiopia

Group members
 Eman Mecha UU 71505/E
 Misganaw Asnake ye Hula UU 71455E
 Bezawit Tesfaye UU 71350E
 Dinku brhanu UU 71608E
 Selam Zeru UU 71473E
 Ferdos Jamal UU 71596E
 Abdurahman Mohammed UU63496E

Submitted To Teklu K

Date 11/06/2018

1
Contents
Introduction........................................................................................................................................................ 2

Basics of the Foreign Tax Credit........................................................................................................................... 3

Who is Eligible?..........................................................................................................................................................4

Be Careful with Overseas Fund Companies................................................................................................................4

The Bottom Line.........................................................................................................................................................5

How to Calculate and Pay Taxes on Foreign Investments.....................................................................................5

Have to Pay Foreign Taxes?................................................................................................................................. 5

Foreign Tax Credit............................................................................................................................................... 6

How do You Pay Foreign Taxes?.......................................................................................................................... 6

INVESTING IN ETHIOPIA...................................................................................................................................... 6

Investment incentives......................................................................................................................................... 7

Customs duty...................................................................................................................................................... 7

Income tax exemption Investors......................................................................................................................... 7

Export incentives................................................................................................................................................ 8

Tax holiday (exemption from income tax)........................................................................................................... 8

Deductible expenses........................................................................................................................................... 9

Transaction taxes................................................................................................................................................ 9

Conclusion........................................................................................................................................................ 10

References........................................................................................................................................................ 11

Appendix.......................................................................................................................................................... 12

2
Introduction
A foreign direct investment is an investment in the form of a controlling ownership in a
business in one country by an entity based in another country. It is thus distinguished from a
foreign portfolio investment by a notion of direct control. Foreign direct investment is
considered as an alternative source to fill the gap between savings and the required
investments in the developing countries.

For many of today’s investors, diversification goes beyond owning companies in a variety of
industries – it means adding securities from different parts of the globe, too. In fact, many
wealth management experts recommend diverting a third or more of one's stock allocation into
foreign enterprises to create a more efficient portfolio.

But if you’re not aware of the tax treatment of international securities, you’re not maximizing
your true earnings potential. When Americans buy stocks or bonds from a company based
overseas, any investment income (interest, dividends) and capital gains are subject to U.S.
income tax. The government of the firm’s home country may also take a slice.

If this double taxation sounds draconian, take heart. The U.S. tax code offers something called
the “foreign tax credit.” Fortunately, this allows you to use all – or at least some – of those
foreign taxes to offset your liability.

The paper types to address issues on the taxation on investment for capital market in Ethiopia
putting in appendix the investment types that are entitled for tax benefits, the paper covers the
taxes for transaction when investing in a business in the country.

3
Basics of the Foreign Tax Credit
Every country has its own tax laws, and they can vary dramatically from one government to the
next. Many countries have no capital gains tax at all or waive it for foreign investors. But plenty
do. Italy, for example, takes 20% of whatever proceeds a non-resident makes from selling his or
her stock. Spain withholds slightly more, 21%, of such gains. The tax treatment of dividend and
interest income runs the scale as well.

While it doesn’t hurt to research tax rates prior to making an investment – especially if you’re
buying individual stocks and bonds – the IRS offers a way to avoid double taxation anyway. For
any “qualified foreign taxes” that you’ve paid – and this includes taxes on income, dividends
and interest – you can claim either a tax credit or a deduction (if you itemize) on your tax
return.

In most cases, you’re better off choosing for the credit, which reduces your actual tax due. A
$200 credit, for example, translates into a $200 tax savings. A deduction, while simpler to
calculate, offers a reduced benefit. If you’re in the 25% tax bracket, a $200 deduction means
you’re only shaving $50 off your tax bill ($200 x 0.25).

The amount of foreign tax you can claim as a credit is based on how much you’d be taxed on
the same proceeds under U.S. tax law, multiplied by a percentage. To figure that out, you’ll
have to complete Form 1116 from the Internal Revenue Service.

If the tax you paid to the foreign government is higher than your U.S. tax liability, then the
maximum foreign tax credit you can claim will be the U.S. tax due, which is the lesser amount. If
the tax you paid to the foreign government is lower than your tax liability in the U.S., you can
claim the entire amount as your foreign tax credit. Say you had $200 withheld by an outside
government, but are subject to $300 of tax at home. You can use that entire $200 as a credit to
trim your U.S. tax bill.
Example 1

Now imagine just the opposite. You paid $300 in foreign taxes but would only owe $200 to the
IRS for those same earnings. When your taxes abroad are higher, you can only claim the U.S. tax
amount as your credit. Here, that means $200. But you can carry the remaining $100 over one
year – if you completed Form 1116 and file an amended return – or forward up to 10 years.

Example 2

4
The whole process is quite a bit easier, however, if you paid $300 or less in creditable foreign
taxes ($600 if married and filing jointly). You can skip the Form 1116 and report the entire
amount paid as a credit on your Form 1040. In order to qualify for this de minimums
exemption, the foreign income earned on the taxes paid must be qualified passive income.

Who is Eligible?
Any investor who must pay taxes to a foreign government on investment income realized from
a foreign source may be eligible to recoup some or all of the tax paid via this credit. But he or
she must have paid foreign income taxes, excess profit taxes or other similar taxes. More
specifically, they include:

 Taxes that resemble U.S. income tax

 Any taxes that are paid by a domestic taxpayer as a substitute for income tax that would
ordinarily be required by a foreign country
 Foreign income tax that is measured in terms of production because of inability to
determine basis or income within the country
 Pension, unemployment or disability funds from a foreign country (some foreign social
security-type income is excluded)

Be Careful with Overseas Fund Companies

Given the difficulty of researching foreign securities and the desire for diversification, mutual
funds are a common way to gain exposure to global markets. But U.S. tax law treats American
investment firms that offer international funds much differently than funds based offshore. It’s
important to realize this distinction.

If a foreign-based mutual fund or partnership has at least one U.S. shareholder, it’s designated
as a Passive Foreign Investment Company, or PFIC. The classification includes foreign entities
that make at least 75% of their revenue from passive income or uses 50% or more of their
assets to produce passive income.

The tax laws involving PFICs are complex, even by IRS standards. But overall, such investments
are at a significant disadvantage to U.S.-based funds. For example, current distributions from a
PFIC are generally treated as ordinary income, which is taxed at a higher rate than long-term
capital gains. Of course, there’s a simple reason for this: to discourage Americans from parking
their money outside the country.

5
In a lot of cases, American investors, including those living abroad, are better off sticking with
investment firms based on U.S. soil.

The Bottom Line

For the most part, the foreign tax credit protects American investors from having to pay
investment-related taxes twice. Just watch out for foreign-based mutual fund companies, for
which the tax code can be much less forgiving. When in doubt about your situation, it’s a good
idea to consult a qualified tax expert who can guide you through the process.

How to Calculate and Pay Taxes on Foreign

Investments
Albert Einstein once said, "The hardest thing to understand in the world is the income tax."

The rapid growth of the international marketplace has created many opportunities for investors
in recent years. Unfortunately, it has also created a complicated and difficult to understand tax
situation. In addition to paying U.S. tax on all income earned from foreign sources, international
investors may also have to pay taxes to the foreign country in which their investment is located.

While this double-taxation can often be recouped via the Foreign Tax Credits, international
investors should still familiarize themselves with foreign tax rules and regulations. These
regulations differ from country to country, but we've provided some resources below to help
make the process much easier.

In this article, we will take a look at whether or not it's necessary to pay foreign taxes, eligibility
for tax credits, how to pay foreign taxes, and some other considerations for international
investors.

Have to Pay Foreign Taxes?

Investors looking for exposure to foreign markets have three basic options: Mutual Funds,
Exchange-Traded Funds (ETFs) and Direct Investment. While U.S. mutual funds and ETFs may
hold foreign stocks, they typically pay the foreign taxes on the investors' behalf. However, these
funds may allocate foreign taxes to shareholders, providing a tax benefit.

Direct investment in foreign stocks and American Depository Receipts (ADRs) can prove
somewhat more complicated. ADRs are generally traded the same as domestic investments,
but some countries will withhold taxes on dividend payments. Meanwhile, direct investments
on foreign exchanges may involve foreign income taxes on both dividend payments and capital
gains.

6
Investors are encouraged to consult a professional investment or tax advisor to ensure they are
properly reporting and paying taxes on their foreign holdings.

Foreign Tax Credit

The U.S. Internal Revenue Service offers a foreign tax credit or deduction to eligible investors
who realize income from foreign sources. While all foreign investment income must be
reported on Form 1040 in U.S. dollars, investors may file Form 1116 to receive the credit or
deduction. Investors who paid less than $300 in creditable foreign taxes can usually deduct the
taxes paid on Line 51 of Form 1040.

According to the IRS, the following basic criteria must be met in order to be eligible:

 The tax must be imposed on you.

 You must have paid or accrued the tax.
 The tax must be the legal and actual foreign tax liability.
 The tax must be an income tax (or a tax in lieu of it).

How do You Pay Foreign Taxes?

Investment income generated in foreign countries is taxed at various rates, depending on the
laws and regulations in each country.

Fortunately, many countries have treaties with the United States making it easier to avoid
double-taxation. In the case of dividends, these taxes are often withheld automatically,
but capital gains taxes may also apply.

Capital gains tax rates and rules vary significantly by country, so investors are advised to consult
a professional investment or tax advisor.

INVESTING IN ETHIOPIA
Historical Background

In the Pre 1974, Emperor Haile Selasie period, a liberal policy was followed to encourage the
establishment of private industries and import substitution strategy was promoted. The liberal policies
were able to attract few investments though the amount is not significant. (Melese and Waldkirch
2011).

In post 1991 Ethiopian Peoples’ Revolutionary Democratic Front (EPRDF) has governed Ethiopia ever
since. EPRDF replaced the command system to free market system and undertaken many
macroeconomic reforms. The government implemented a series of reform measures like deregulation,

7
privatization, liberalization of foreign exchange market, elimination of export tax except for coffee,
lowering of maximum import duties from 230% to 60% and Provision of adequate incentives in order to
increase private sector participation in the economy which is believed to have an important role in the
development process of the national economy. (Astatike and Assefa 2006).

Investment incentives
The current Investment Proclamation offers various incentives to investors with projects in the
preferential investment sectors and/or areas as follows:

Customs duty
The Council of Ministers Regulations No.270/2012 specifies the areas eligible for investment
incentives.

 The Government of Ethiopia grants customs duty exemption provided for investors
engaged in eligible new enterprises or expansion projects, such as manufacturing,
agriculture, agro-industries and other sectors.
 100 per cent exemption from the payment of customs duties and other taxes levied on
imports is granted to all capital goods, such as plant, machinery and equipment and
construction materials.
 Spare parts worth up to 15 per cent of the total value of imported investment capital
goods, provided that the goods are also exempt from the payment of customs duties.
 An investor granted with a customs duty exemption will be allowed to import capital
goods duty free indefinitely if his investment is in manufacturing and agriculture, and
for five years if his investment is in other eligible areas.
 An investor entitled to a duty-free privilege that buys capital goods or construction
materials from local manufacturing industries will be refunded the customs duty paid
for raw materials or components used as inputs for the production of such goods.
 Investment capital goods imported without the payment of custom duties and other
taxes levied on imports may be transferred to another investor enjoying similar
privileges.
 Any investors who export or supplies to an exporter as a production or service input, at least
60% of his product or service shall be entitled to income tax exemption for 2 years in addition
to the exemption period provided.
 Duty paid at the port of entry or locally, on raw materials used in the production of
commodities is refunded, 100%, upon exportation of the commodity processed.

Income tax exemption Investors

8
Engaged in manufacturing and agroprocessing, the production of agricultural products, the
generation, transmission and supply of electrical energy, and information and communication
technology development will be entitled to income tax exemption .

Foreign investors who establish a new enterprise in selected areas of Ethiopia (such as
Gambella; Benishangul-Gumuz; Afar, Somali, Guji and Borena Zones in Oromia and other
regions) will be entitled to an income tax deduction of 30 per cent for three consecutive years
after the expiry of the income tax exemption period.

An investor who expands or upgrades his existing enterprise and increases in volume by at least
50 per cent is entitled to income tax exemption.

Investors that export at least 60 per cent of products or services, or supply the same to an
exporter as production of service input, will be exempt from income tax for an additional two
years.

Export incentives
The fiscal incentives given to all exporters are the following: o

 With the exception of a few products (e.g. semiprocessed hides and skins-150 per cent),
no export tax is levied on export products of Ethiopia. o
 Duty drawback scheme: this scheme offers investors an exemption from the payment of
customs duties and other taxes levied on imported and locally purchased raw materials
used in the production of export goods.
 Bonded factory and manufacturing warehouse schemes: producers not eligible for
voucher schemes but having been licensed for bonded factory and manufacturing
warehouse schemes are entitled to operate such factories or warehouses to import raw
materials duty free.
 Exporters are allowed to retain and deposit in a bank account up to 20 per cent of their
foreign exchange earnings for future use in the operation of their enterprises, and no
export price control is imposed by the National Bank of Ethiopia.

Tax holiday (exemption from income tax)

Any investors who invest to establish a new enterprise in manufacturing, agro-processing, production of
agricultural products and information and communication technology development are entitled to
income tax exemptions. Any income tax derived from approved new investment shall be exempted for
periods of 1 to 8 years, depending upon the priority area of investment activities and the geographical
location of the investment. Conditions for income tax exemption eligibility are:

 If at least 50% of its production is to be exported; Profit Tax Exemption Years is 5 Years, if the
Investment is made in relatively under-developed regions, the exemption period is 6 years.

9
   If at least 75% of its production will be an input for the production of export items; Profit Tax
Exemption Years is 5 Years, if the Investment is made in relatively under-developed regions, the
exemption period is 6 years. 
 If the project is evaluated under a special circumstance by the BOI; Profit Tax Exemption Years is
no longer than 7 Profit Tax Exemption Years. If the Investment is made in relatively
underdeveloped regions the exemption is No longer than 8 years. However, the granting of
income tax exemption for a period longer than 7 years requires the decision of the Council of
Ministers.
  If less than 50% of the production is to be exported; Profit Tax Exemption Years is 2 Years, if
the Investment is made in relatively under-developed regions the exemption shall be 3 years. 
 If the production is for the local market; Profit Tax Exemption Years is 2 Years, if the Investment
is made in relatively under-developed regions it will be 3 years.

In addition investors that establish new enterprise in the regions of Gambella, Benshangul, Afar,
Somali, Guji and Borena and South Omo Zone are entitled to an income tax deduction of 30% for
three consecutive years after the expiry of income tax exemption. For expansion or upgrading of
enterprises that increases the existing production by 25% in value and 50% of the production is to
be exported; the Profit Tax Exemption granted is 2 years.

Notwithstanding the information given above, directives issued by the Board may prohibit
exemption from income tax with respect to an investor who supplies his products only to the
domestic market. Moreover, an investor who exports hides and skins after processing up to crust
level is not entitled for income tax holiday. The period of exemption of profit tax begins from the
date of commencement of production or provision of services, as the case may be.

Deductible expenses
In the determination of business income subject to tax in Ethiopia, deductions will be allowed
for expenses incurred for the purpose of earning, securing, and maintaining that business,
provided that the expenses can be proven by the taxpayer and subject to the limitations
specified by the Income Tax Proclamation No. 286/2002.

Transaction taxes
Value-added tax VAT is charged, under the Value-Added Tax Proclamation on the supply of
goods and services by registered persons, and on import of goods and services into Ethiopia, in
addition to services performed by a nonresident (not registered for VAT in Ethiopia) who
performs services for a resident in Ethiopia. The rate of VAT is 15 per cent.

Turnover tax Turnover tax is charged under the Turnover Tax Proclamation and at a rate of 2
per cent on the supply of goods and services relating to contractors, grain mills, tractors and
combine harvesters, and at a rate of 10 per cent on other services. Turnover tax is payable on
goods and services supplied by persons who are not registered for VAT.

10
Excise tax Excise tax is payable on certain goods specified under the Schedule to the Excise Tax
Proclamation, when imported and when produced locally. The excise tax rate varies from 10 to
100 per cent of the cost of production, or CIF (“cost-insurance-freight”) as the case may be.

Conclusion
Important Tips to Remember About Foreign Tax

 Mutual funds and ETFs may provide investors with a tax benefit, but they rarely require
investors to directly pay any foreign taxes.
 ADRs and direct investments in foreign markets may be subject to both dividend
withholdings and capital gains taxes, which vary country to country.
 Qualified U.S. citizens and aliens may be eligible for a foreign tax credit to avoid double
taxation, while those reporting less than $300 in foreign taxes can usually automatically
take a deduction.

All investors are advised to consult a professional investment or tax advisor to ensure they are
properly reporting and paying any foreign taxes.

Ethiopia has concluded bilateral investment treaties (BITs) and Double Taxation Treaties (DTTs)
with a number of countries.

BIT: Algeria, Austria, Belgium, Luxembourg, China, Denmark, Egypt, Equatorial Guinea, Finland,
France, Germany, India, Iran, Israel, Italy, Kuwait, Libya, Malaysia, Netherlands, Nigeria, Russian
Federation, South Africa, Spain, Sudan, Sweden, Switzerland, Tunisia, Turkey, United Kingdom,
and Yemen.

DTT: China, Czech Republic, Iran, Israel, South Africa, Tunisia, Turkey, and United Kingdom. o
Everything but Arms Agreement (EBA) with the European Union.

Offering tax incentives to attract FDI may lead to a significant revenue decline in Ethiopia.
Among different tax revenue types, the corporate income tax revenue has been highly affected
may be due to tax holiday provision. However, there is a tendency for firms to avoid the local
taxation using transfer pricing and tax base erosion methods.

In contrast to FDI increasing domestic indirect tax revenue, the opposite is found to be true in
Ethiopia which requires further investigation. Moreover, despite the increase in number of
employment opportunities through FDI, its impact on the personal income tax revenue has
been found to be negative. This is in contrast what has been normally expected. The provisions
of tax incentives need to be carefully assessed and monitored. The costs and benefits related to
incentives have to be taken in to consideration. Monitoring and evaluation system should be
developed and implemented properly so as to reduce negative impacts. The provision of tax
holiday should be reduced or replaced by reduced tax rate. Tax incentives should be provided

11
based on critically studied approach; a casual provision of such incentive can affect the country
tax revenue.

References
 IRS Publication 514.
 Understanding taxation of foreign investments | Investopedia
https://www.investopedia.com/articles/personal-finance/012214/understanding-
taxation-foreign-investments.asp#ixzz5GuL5xFoV
 GUIDE TO DOING BUSINESS AND INVESTING IN ETHIOPIA,
 The Relationship between FDI flows and Tax Revenues in Ethiopia: an Evidence based on ARDL
Model with a Structural Break, by Million Timer Jeza, Dept. of Public Financial Management,
ECSU, Addis Ababa Azime A. Hassen, Dept. of Public Financial Management, ECSU, Addis Ababa
Gollagari Ramakrishna, School of Graduate Studies, ECSU, Addis Ababa


12
Appendix

13