Chapter 6. Tax policy and incentives in Egypt

Domestic taxation

Table 6.1 reports the tax mix in Egypt in fiscal year 2016/17, including the recent introduction of VAT showing tax revenues in millions of Egyptian pounds and as a percentage of GDP. One notable feature is the relatively low contribution of personal income tax (PIT), due in part to the importance of the informal market and in part to narrow rules governing the taxation of investment returns at the individual level (as noted below).

The corporate tax-to-GDP ratio is not low by international comparison but has declined sharply from 6% over the past decade and may decline further over time, depending on the path of corporate tax policies, administration and governance going forward. The statutory corporate income tax (CIT) rate is moderate at 22.5%, the second lowest rate in the Mediterranean region after Lebanon (Figure 6.1).4 The CIT base is nevertheless at risk, depending on how broadly the FZ regime is applied (number and size of firms covered), how successful authorities are in protecting the CIT base from profit stripping, and other factors.

Table 6.2 provides a summary of corporate income tax provisions in Egypt. Ordinary business losses may be carried forward for up to five years for both listed and non-listed companies, with few exceptions.5

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Figure 6.1. The CIT rate in Egypt is in line with many other emerging economies

Source: Based on KPMG (2017), Tax Tools & Resources (database).

The tax depreciation system is attractive in its simplicity, based on four asset classes. Buildings and intangible assets are depreciated on a straight-line basis at 5% and 10%, respectively. Computer devices and information-technology assets are depreciated on a declining-balance basis at 50%. Other depreciable assets are depreciated at a 25% declining-balance rate.

Under the Investment Law No. 17 of 2017, businesses may claim an immediate 30% deduction on the machinery and equipment used in production (with 70% of investment costs depreciated according to the above-noted tax deprecation rules). Presumably, this acceleration of depreciation, through immediate expensing of 30% of capital costs, applies to the acquisition of both new and used capital goods. To improve efficiency, the expensing should be targeted at new (rather than pre-existing) capital.6 This could be accomplished using a ‘first-in-use’ rule that limits the expensing to new capital used in production.

Egypt is currently planning to implement e-invoicing. One provision that should be reviewed, to assess the implications for income tax revenues, is a general deduction for undocumented business expenses equal to 7% of documented general and administrative expenses (including wages). This provision, which applies to (closely-held) private corporations and unincorporated businesses, may have been understandable in years past, when provided to micro-businesses challenged by tasks of record-keeping. But given current low costs of keeping digital records on expenses (e.g., as required for VAT purposes), this provision appears to be dated and offering poorly targeted tax relief. At a minimum, it would seem appropriate to target the provision (if retained) to small firms that are below the VAT registration threshold.

The personal income tax exemption for dividends on shares in FZ companies is inefficient,7 providing investors with windfall gains on their returns, as opposed to lower costs of finance for FZ firms. Moreover, to the extent the PIT exemption lowers the rate of return shareholders expect on their investments in FZ companies, this relief tends to favour FZ companies relative to companies outside FZs. As noted earlier, the multiple forms of tax relief targeted at FZ companies may be limiting productivity growth and wages in the economy and should be scaled back.

General, special and additional incentives

Tax incentives are included in Income Tax Law No. 91 of 2005 and Investment Law No. 72 (INVL). Tax incentives under the INVL include general incentives, special incentives and additional incentives, and varied incentives across a number of categories of zones. Law No. 83/2002 on “Economic Zones of Special Nature Law”, amended by Law No. 27/2015, does not provide for corporate income tax incentives.

Tax incentives for investment in zones

There are multiple zone designations applied in Egypt, as described extensively in Chapter five. This chapter focuses on public and private FZs. Two other zones (not described in detail here) which were created by the new investment law (INVL) are investment and technological zones. Incentives offered for investment in these latter two zones are as follows.

• Incentives for investment zone projects: Projects located in investment zones, established by the prime minister, are eligible for general incentives, special incentives and additional incentives (as described above).18 Each investment zone is governed by a board of directors which approves projects, subject to the approval GAFI,19 and sets rules and requirements.

• Incentives for technological zone projects: Projects specialised in communications and information technology located in technological zones, established by the prime minister, are eligible for special incentives (as described above)20 and are exempt from customs duties on machinery and equipment.21 Each technological zone is governed by a board of directors, which approves investment projects, and sets rules and requirements.

The most extensive tax incentives are available to investment projects in FZs. A FZ established for a single large-scale project is designated as a private FZ. Other FZs are designated as public FZs. Private and public FZs (and their shareholders) enjoy the same tax incentives. Fees and taxes on domestic sales differ between the two. Certain business activities are denied registration in FZs:22 oil processing; natural gas processing, liquidation, transport; energy-intensive industries; fertiliser industries; iron/steel industries; liquor and alcohol industries; guns, ammunitions and explosive industries; and other industries of national security interest. The INVL and Executive Regulations do not set minimum export percentages for public FZ projects (the percentage of output that must be exported). Instead, the power to set requirements on export percentages is assigned to relevant ministers.23

Tax incentives provided to FZ companies are as follows:

• Exemption from corporate income tax on business profits (indefinite CIT holiday)24

• Exemption from personal income tax on dividends and gains on FZ company shares

• Exemption from customs duties and VAT on imports of goods and services25

• Zero-rating of VAT on purchases of domestic goods and services (with VAT charged on goods and services sold to the domestic market).26

The exemption from customs duties and VAT (third bullet) continues to apply for machinery and equipment (other than passenger cars) that “temporarily exit” FZs into the domestic market. The conditions (and presumably the maximum amount time for “temporary exit”) are established by the Council of Ministers. While providing these exemptions, the INVL imposes certain charges on imports, and charges akin to turnover taxes on domestic sales and exports of FZ products, as summarised in Table 6.3.

For storage projects,27 the 2% charge on imports matches the 2% customs duty provided by the INVL as a general incentive (noted above). For manufacturing and assembly projects, the charge (1 or 2%) on gross revenues on sales (export or domestic) is akin to a turnover tax. Presumably, the turnover taxes are applied given the exemption from CIT on profit. A well-known problem with a turnover tax is that, when used as a substitute for taxation of profit, the effective tax rate on profit increases inversely with the profit rate – less profitable firms bear a higher tax rate on their profit. Given the distortions to competition amongst firms that this creates, turnover taxes are typically targeted in other countries at small firms as a simplification measure, substituting for tax on profit and/or VAT. Turnover taxes are targeted to small firms by applying only to firms with turnover below a ‘small business’ threshold.

Concerns with customs duty exemptions and design of the ITA

The customs duty exemption for imported items brought into Egypt for temporary use should be circumscribed to a fixed list of products, and the term ‘temporary’ should be defined with objective criteria and prescribed in the associated Law.28 Presumably the exemption is provided to reduce the cost of business inputs, and therefore the list should be specified to exclude final consumption goods. To mitigate against tax avoidance, conditions should be specified in regulations that indicate when a duty exemption can be provided, and the considerations determining the maximum duration of ‘temporary.’

According to the authorities, the new Investment Law (art. 39) and its executive regulation regulate the movement of local and foreign goods, materials, parts, and raw materials between the Free Zone and the domestic market, as well as the allowed time periods. The technical committee recommendations of Free Zones (no. 2/206/2011) specifies three months with a possible renewal for another three months for local and foreign goods and materials.

The basic design of the investment tax allowance is also problematic for the following reasons:

• The ITA is based on the ‘investment cost of a project’ determined as the amount (value) of equity rights plus long-term liabilities of a company invested in fixed assets, intangible capital and working capital.29 By focusing on balance sheet amounts, rather than actual expenditures on physical capital assets, the base of the ITA could include amounts invested abroad (foreign assets generating income outside of Egypt), and tangible and/or intangible assets licensed to foreign companies. The base is too broad where the purpose is to incentivise investment in production in Egypt.

• The ‘one-time’ feature means that where the amount of capital injected into a company is increased following the commencement of activity, the additional investment is not included in the base of the ITA (an additional deduction is not available).

• The Article 12 restriction to curtail churning is limited to tangible assets.30 Given that the investment deduction can be claimed in respect of intangible (‘non-material’) assets, as indicated in the Executive Regulations, this means that the base of the ITA could include pre-existing intangible assets. MOF authorities explain that the reason for this is to avoid instances where investors are denied an ITA where ‘investment cost’ includes amounts paid for an existing trade name.

• The targeting of the 30% ITA for Sector B investments is imprecise. For example targeting to SMEs is imprecise as the term ‘SMEs’ is not defined (e.g., with reference to turnover or asset size). Similarly, there are no thresholds given that specify ‘projects depending on or producing new and renewable energy’. This lack of precision makes it unclear whether a project that uses a minimal amount of new or renewable energy (e.g., a single solar panel) qualifies.

• Determining how to treat firms that operate in targeted and non-targeted regions (and sectors) is difficult, requiring separate accounting of the base that is used to determine the incentive amount – which enables creative accounting by tax advisers.31 Tax incentives to stimulate economically depressed areas should be subject to proper cost-benefit analysis, given the poor track record worldwide of location-based targeting.

• Rather than listing qualifying sectors, consideration should be given to listing non-qualifying sectors – for example where national security concerns arise and foreign investment is less desirable. This would recognise the difficulty for policy makers to identify sectors where markets fail in allocating capital or where net benefits to society from investment are the greatest.

Concerning additional incentives, the scope of subsidies provided is uncertain. Neither the law (Article 13) nor the Executive Regulations specify the types of technical training that qualify, or the training institutions (including in-house) that qualify, or the fraction of expenses that are covered. Similarly, under Article 13, all or part of expenses incurred in providing utilities to an investment project are subsidised. This provision raises questions over the types of utility expenses that qualify (electricity, gas, water?) and the fraction of expenses that are covered. Decisions to be taken are based on decisions of the Council of Ministers and GAFI, presumably on a case-by-case basis.

The Executive Regulations that specify conditions for obtaining additional incentives also raise questions, requiring administrative discretion in deciding whether conditions are met in practice.32 The requirements and measures of technology transfer are not specified in the law or regulations. Similarly, requirements and measures of research findings used in production are not specified. Presumably, GAFI holds the power to determine how the conditions are to be interpreted on a case-by-case basis.

The imprecise nature of the targeting (scope) of these incentives and conditions on eligibility create uncertainty and require further guidance from authorities. In general, this approach is problematic as it involves significant discretion on the part of authorities in awarding subsidies. As observed elsewhere, administrative discretion should be kept to a minimum through greater guidance and specificity in the laws and regulations themselves (and not on their interpretation by officials) to avoid opportunities for corruption. Moreover, where rules are applied on a case-by-case basis in a non-uniform manner across taxpayers, unfair competition results. Uncertainty over eligibility, the cost of bribes, and scope for an uneven playing field all pose a deterrent to investors.

Investment zone and technological zone projects are eligible for general incentives, special incentives and additional incentives and the concerns identified above in relation to these (see sub-section 2) apply. In particular, the conditions for duty exemptions should be clarified in regulations (including lists of eligible products and conditions around temporary use). Also, the investment tax allowance should be based on expenditures on depreciable capital used in Egypt and targeting criteria should be clarified and sharpened to avoid efficiency losses and specified in regulations to reduce discretionary power in deciding how subsidies are allocated.

Efficiency concerns with corporate tax holidays for free zones

As highlighted in a recent report to the G20 by international organisations,34 profit-based tax incentives, such as corporate tax holidays, are generally less efficient than cost-based tax incentives, such as accelerated tax depreciation and investment tax allowances and tax credits. This observation, based on many years of disappointing experience with CIT holidays, is an important consideration for Egyptian authorities as they seek to revitalise their investment promotion strategy.

As noted in the previous section, the current tax system in Egypt provides two main corporate income tax incentives35 – a CIT holiday that exempts profit from corporate income tax, available to FZ companies, and an ITA that provides a deduction against the CIT base, available to non-FZ companies. The authorities are encouraged to reconsider the relative advantages of granting an ITA rather than CIT holiday to new investments.

Under the new Investment Law No. 72, the rate of ITA differs depending on targeting criteria including the location of investment – sector A (50%) and sector B (30%). As noted in the previous section, the ITA is a one-time deduction earned as a percentage of investment (equity plus long-term debt) in a project assessed at the start of production. While the more limited targeting of newly granted CIT holidays in the new Investment Law is a positive development,36 the continued reliance on this form of tax incentive is of concern given the relatively large scale of FZ companies, the corresponding amounts of profit that escape CIT and the profit-shifting possibilities that continue to exist.37

Key factors in a cost-benefit assessment of corporate tax incentives for investment include returns on estimated additional capital and employment, and the social opportunity cost of forgone CIT revenues that inevitably result when tax relief is provided to redundant investment – that is, investment that would have occurred without the tax incentive. The review draws on the G20 report on effective and efficient use of tax incentives. In anticipation of next steps of incentive reform, the review is intended to offer general guidance in identifying the types of data that would be needed, to factor into a formal cost/benefit assessment of past and current incentives in Egypt.38

Productivity concerns from direct and indirect tax relief to free zones

Direct tax relief (profit exemption) and indirect tax relief provided to FZ companies raise concerns about reduced productivity growth in the Egyptian economy. Productivity growth may be hindered where these tax reliefs encourage firms to supply the domestic market where they enjoy a competitive advantage, rather than export markets where greater efficiency of business operations may be required to be competitive and profitable. These mechanisms are at play in Egypt’s FZs, as described in chapter 5 and according to the IMF (2017) and Mori (2017).

FZ companies enjoy considerable indirect tax advantages, including indirect tax deferral. FZ companies are encouraged to purchase inputs from domestic suppliers producing outside of FZs (non-FZ companies). Such purchases (backward linkages) are intended to bring wider benefits to the Egyptian economy of the FZ system. As non-FZ companies must compete with foreign suppliers, sales by non-FZ companies to FZ companies are zero-rated for VAT purposes. With zero-rating of sales by domestic suppliers, FZ companies are not charged VAT on domestic purchases and domestic suppliers are provided with tax credits to offset VAT paid on their inputs. Thus, VAT is removed from the entire chain of production underlying domestic supplies to FZ firms. This treatment matches that of foreign supplies, which are zero-rated exports in the host (source) country and are exempt from Egyptian VAT when imported by FZ companies.39

A non-negligible portion of FZ output is supplied to the domestic market (see Chapter 5 for further evidence). When output is sold to domestic purchasers, VAT should apply in full, without input tax credits, and customs duties should be collected on the foreign content of products sold. As noted below, the practice of waiving duties and not collecting any VAT on supplies to FZs creates opportunities for tax evasion. However, even in instances where taxes due are collected on sales to the domestic market,40 the ability to defer payment of tax provides cash-flow advantages and a lower effective tax rate on business supplies to FZ firms (with tax payments measured on a present value basis). In addition, profits of FZ companies are exempt from corporate income tax, and dividends, capital gains and interest on investments in FZ companies are exempt from personal income tax. These tax policies tend to lower the cost to FZ companies of domestic sources of finance.41 FZ firms are also exempt from paying property taxes, as well as enjoying other cost advantages.

These indirect tax and direct tax reliefs provide FZ companies with a competitive advantage when supplying goods and services to the domestic market relative to non-FZ firms. Given this advantage, FZ companies may be oriented to domestic markets.42 Chapter 5 provides evidence that this is the case, as a sizeable fraction of output of FZ companies (particularly those in public FZs) is sold to the domestic market, rather than exported. If tax policy does indeed encourage FZ firms to supply the domestic market, then this outcome raises a concern to the extent that it lessens pressures for FZ firms to innovate and transition to productivity-enhancing business strategies generally required to compete successfully in export markets. Moreover, tax policies that place non-FZ companies at a competitive disadvantage, tending to limit their domestic sales, may seriously curb their ability to achieve economies of scale required in order to position themselves to compete successfully in export markets.

Tax revenue losses from tax avoidance and evasion possibilities

While normally VAT and customs duties should be levied when products are sold by FZ companies into the domestic market, opportunities may arise whereby these taxes can be avoided, as the Investment Law allows commodities to be brought into the domestic market in some cases on a temporary basis free of VAT and customs duties.43 Neither the Investment Law nor the Executive Regulations define ‘temporary’, implying an uncertain deferral advantage. Additionally, as some tax/customs officials may succumb to accepting returns to facilitate a side-stepping of the law/administrative practices, the unfortunate reality is that VAT and customs duties are illegally avoided in some cases. While this outcome can occur under any system, the possibilities of deferral and the creation of multiple border crossing and transit check-points under a zone system multiply these opportunities.

Tax revenues are also lost where FZ companies use their CIT holiday status to shelter profits of other companies from corporate tax. Because profits of FZ companies are exempt from tax, while profits of non-FZ companies are not, tax-planning opportunities are created to artificially shift taxable profit to FZ companies. One way is through commodity transactions between FZ companies and related non-FZ companies, with non-arm’s length pricing used to shift taxable profit. Taxing projects rather than entities through a modified form of group taxation can provide partial tax base protection, but such measures are limited in scope and reach. Financing arrangements (including back-to-back loans) and other arrangements may be used to shift otherwise taxable profit into a CIT-free enclave.

Proper management of tax holidays requires continuous monitoring of operational activities and financial arrangements of tax holiday firms, to verify compliance with qualifying conditions and to detect tax evasion. Where key conditions for tax holiday status are not observed, then it would be appropriate that actions be taken to withdraw tax relief that has been provided.

The treatment of transit goods, free of all taxes and charges, would be expected to encourage businesses to consider ways in which non-transit goods could be mischaracterised as transit goods. Given this, it would be prudent to ensure that goods passing through the country as transit goods be subject to inspection, while the Executive Regulations appear to allow for random verification. The Executive Regulations (Article 37, paragraph 3) state that “The Zone Management shall inspect the goods once they reach the Zone through random sample or detailed inspection.”

Given opportunities created for avoiding customs duty and VAT on goods brought into the country through FZs, and opportunities for avoiding VAT on zero-rated domestic supplies purchased by public and private FZ companies, it is prudent to monitor export percentages, as per the requirements defined in the Investment Law. Export share percentages should however be a temporary measure. Such requirement should be removed in cases where CIT holidays are phased-out and/or the gap in customs duty and VAT rates between the FZ and inland regime are reduced. The terms of the export share percentage should not raise potential risk of non-compliance with WTO rules, notably the Agreement on Subsidies and Countervailing Measures (ASCM).

Introducing and amending tax incentive legislation

Accountability of government over tax incentives is weakened by diffuse legislative powers, the involvement of multiple ministries and agencies in setting tax incentive policies, and broad discretion in interpreting tax incentive eligibility. Each of these contributes to the opaqueness of tax incentive policy and administration, which translates into reduced government accountability. A review of the new Investment Law finds a complex and non-transparent tax incentive policy decision-making structure, with diffuse responsibilities and powers amongst the Ministry of Finance, GAFI, and relevant ministers. The current patchwork complicates decision-making and creates a lack of accountability, which limits analysis, evaluation and fundamental reform. The Prime Ministerial Decree No.7/2020 identifies Zones A and B and provides for tax incentives specific to each zone. Zones A, which include South of Giza Governorate, Governorates affiliated to the Suez Canal Region (Suez - Ismailia - Port Said) and Border Provinces (Governorates of the Red Sea from the South of Safaga), are identified as priority development areas. Prime Ministerial Decree (6/2020) clarifies the conditions of project expansion benefitting from investment incentives.

While certain improvements have been made, including less pervasive use of corporate tax holidays, relief from income taxes, VAT and customs duties is still embedded outside of the main legislation.45 In particular, tax incentives are provided mainly in the new Investment Law or in the SEZ Law, and not in the Income Tax Law, VAT Law and Customs Law that the tax incentives provide relief from. This makes it difficult to determine the net implications of various provisions that together determine effective tax rates and the amount of tax due. This practice also clouds responsibility over tax policy.

To address this, legislation that authorises the provision of tax incentives should be embedded in main statutes that the tax incentives provide relief from (e.g., law providing an investment tax allowance should be contained in the Income Tax Law; law providing for a VAT exemption should be contained in the VAT Law). With this change, the recently enacted Investment Law would be amended, so that articles that currently provide for tax incentives are revised to reference new articles in the Income Tax Law, VAT Law and Customs Law. Similarly, regulations for tax incentives should be included in the regulations of the relevant tax legislation.

Furthermore, following best practice, the Minister of Finance should have sole authority to introduce, amend or withdraw tax incentive legislation, after approval of the Council of Ministers.46 This could be anchored in the Constitution or in public finance management legislation.47 Responsibility for deciding tax incentive policy and design should be centralised within the Ministry of Finance and the Egyptian Tax Authority, drawing on tax experts from multiple fields (e.g., economists, lawyers, accountants). The General Authority for Investment and Free Zones (GAFI), as well as other ministries should be involved in the design process.48 In deciding upon tax incentive design, a main objective should be to minimise the discretion of government officials in determining eligibility for tax relief (Box 6.2).

The government is encouraged to provide the Ministry of Finance with the necessary resources to finance the hiring of highly-qualified staff to undertake economic analysis of current tax policies and possible reforms.49 Staff need to be trained in modern public finance theory, frameworks and toolkits to assess tax proposals submitted to government for consideration, and to propose and analyse reform agendas.

Analysis of tax policy, including the costing of tax incentives, is data intensive. Given this, and the importance of the Ministry of Finance being equipped to provide high-quality, independent policy analysis, it is imperative that tax authorities regularly collect taxpayer-level data (gathered from tax returns) to feed into revenue estimation (microsimulation) models. Comprehensive taxpayer data collection requires that all businesses, including FZ companies, complete and file tax returns. These changes will involve institutional arrangements that may require legislative action. The ETA is currently undertaking a wide-ranging business process reengineering project, whereby all tax administration processes will be automated. This provides a timely opportunity to address key governance issues.

Monitoring tax incentives

As a check on the operation and outcomes of any tax incentive regime, careful monitoring is essential. As reviewed earlier, the tax incentive regime has many concessions intended to limit unintended distortions. Examples include the duty exemptions provided to domestic firms supplying zone companies, the temporary exit of goods to the domestic market and the allowance of transit commodities without VAT and duties that would otherwise apply. Given these concessions, data collection and monitoring are needed as a check on the integrity of the system and to make adjustments to policies and practices where fraud is detected. It is not clear from a review of the investment promotion legislation and regulations which government body is responsible for monitoring tax incentives, including data collection on take-up, the measurement of forgone tax revenues, and the determinations of whether investors (FZ companies) are complying with commitments in relation to export percentages and employment of local workers. It is also not clear which entities are tasked with determining corrective interventions when tax incentive design is found to be problematic.

Legislation authorising tax incentives should specify which government agency has responsibility for monitoring compliance and enforcing penalties in cases of non-compliance. In practice, experience shows that electronic tracking is required of transactions in goods and services (quantities and values) – including the tracking of commodity codes and values for commodities receiving duty waiver, duty drawback, transit goods, exported goods, goods sold to domestic market, and goods temporarily brought into the domestic market.

Strict and proportionate penalties are required as a deterrent to fraud, including a claw-back of tax relief in cases of non-compliance (e.g., export requirements as percentage of production, local hiring commitments). Where FZ companies are permitted to continue (under grandfathering rules) to benefit from FZ incentives provided to them, these firms should be held to account for the commitments made to the government in benefiting the host country (e.g., in terms of local hires, and exports).

Reporting of tax incentives

Annual tax expenditure reporting to parliament of revenues forgone by tax incentives (part of tax expenditure reporting), as part of the annual budget and budget documentation cycle, is recognised as a cornerstone of good practice in providing tax incentives. Tax expenditure reporting is required to ensure transparency and oversight, in the same way that tabling direct expenditure programmes is of central interest to parliament.

In its pursuit of best practice, the government is encouraged to introduce legislation requiring tax expenditure reports to be included with budget documents (annually or bi-annually). The reporting of tax incentives should identify the policy purpose (as specified when introduced or amended) and the estimated amount of forgone tax revenue. Consistent with this, legislation should be introduced that requires the ETA each year to provide the Ministry of Finance with anonymised micro-level data (e.g., gathered from tax returns) to enable robust estimates of forgone tax revenues. Furthermore, given the extensive tax incentives provided to FZ companies, reports should be prepared (annually or bi-annually) giving aggregate data by sector, on total production, inventories (storage), export and domestic sales, customs duty waivers and customs duty drawbacks (for FZ companies and separately for domestic suppliers).

Lastly, it is recommended that the government instruct the MOF to undertake cost-benefit analysis of FZ incentives and other major tax incentives (identified by a ranking of tax revenue forgone estimates). While resource demanding, it is important given the scarcity of public funds that societal benefits and costs be compared, and corrective action taken when necessary. Of major fiscal policy concern are instances of incentives having limited impact in boosting investment expenditure, and yet involving significant forgone revenue, due to tax relief provided to redundant investment, and limited success in countering tax avoidance and evasion by MNEs, facilitated by tax incentives (most notably CIT holidays).