By CPA James Mugambi
Tax sparing is one of those rare fiscal concepts that links national development policy with international taxation. It emerged in the middle of the twentieth century, when newly independent economies were trying to attract investment through tax incentives, while developed countries were tightening their domestic rules for taxing foreign income. The issue was straightforward: when a developing country offered a tax holiday to encourage investment, the investor’s home country often reclaimed that benefit by taxing the same income. The tax sparing clause was created to prevent that outcome and preserve the intended incentive.
The Origins of Tax Sparing
Tax sparing arose from the limitations of the foreign tax credit system. Under normal double taxation rules, a resident taxpayer can deduct from their domestic tax liability the amount of income tax paid abroad. When no tax is paid, because the host country has granted an exemption, no credit is available. The investor, therefore, ends up paying tax at home, effectively cancelling the benefit of the host country’s incentive.
The tax sparing clause modifies this by allowing the home country to give a credit not only for taxes actually paid abroad, but also for those legally forgiven. The home country treats the investor as if the tax had been paid, thereby ensuring that the benefit of the host country’s incentive remains with the investor. It is a small technical adjustment with significant implications for capital flows and the design of tax treaties.
The idea first appeared publicly in 1953, when the British Royal Commission on the Taxation of Profits and Income examined how fiscal measures could support investment in the Commonwealth. The United Kingdom initially dismissed the proposal but later incorporated it into the 1961 tax treaty with Pakistan. The United Kingdom’s approach was quickly followed by West Germany, which included tax sparing in its treaty with India, and by Sweden in its agreement with Israel.
The United States took a different path. Influenced by the work of Stanley Surrey, then a leading voice in American tax policy, the U.S. Senate rejected the treaty with Pakistan because it contained a tax sparing clause. Surrey argued that granting credit for taxes not actually paid conflicted with the logic of the U.S. worldwide tax system and created opportunities for abuse. The United States has maintained this position ever since, excluding tax sparing provisions from all its treaties.
Institutional Perspectives
The Organisation for Economic Co-operation and Development (OECD) initially took a neutral stance. Its early model conventions noted that contracting states could adopt tax sparing clauses if they wished to maintain the effectiveness of developing countries’ incentives. Over time, however, the OECD’s position hardened. In its 1998 report, Tax Sparing: A Reconsideration, the organisation concluded that such provisions were largely ineffective and open to misuse.
The report cited several concerns. Some developing countries had deliberately inflated their statutory tax rates to increase the value of notional credits under tax sparing arrangements. In other instances, multinational companies had used intermediary jurisdictions to exploit treaty benefits through conduit structures. The administrative burden of verifying the amount of tax spared and ensuring it corresponded to legitimate incentives was also considerable. Moreover, many countries once regarded as developing had by then achieved greater fiscal and institutional capacity, weakening the original justification for special treatment.
Support and Criticism
Supporters of tax sparing view it as a necessary form of cooperation between developed and developing states. It ensures that investment incentives offered by capital-importing countries are not eroded by taxation in capital-exporting ones. In this way, tax sparing acknowledges the fiscal sovereignty of developing countries and supports their efforts to attract productive investment. It can also be interpreted as a form of indirect development assistance—an arrangement through which developed countries forgo some tax revenue to promote industrial growth abroad.
Critics, however, focus on the inconsistencies it introduces into the international tax system. Granting credit for taxes that were never paid allows income to escape taxation in both jurisdictions. It can distort investment decisions, encourage profit shifting, and undermine the integrity of the tax credit mechanism. Some analysts also question whether tax incentives themselves achieve their intended purpose, arguing that they often benefit projects that would have been undertaken anyway and contribute little to long-term development.
From a practitioner’s standpoint, tax sparing adds administrative complexity. Accountants and tax authorities must determine not only what income qualifies for relief but also what level of tax would have been due in the absence of the exemption. Documentation requirements can be onerous, especially when host-country legislation changes or when multiple incentive schemes overlap. For these reasons, several OECD members have progressively removed tax sparing clauses from their newer treaties.
Systems and Policy Context
The relevance of tax sparing depends on the home country’s method of taxing foreign income. Under a territorial system, only domestic income is taxed, and foreign income is generally exempt. Tax sparing is unnecessary in such cases because the host country’s incentive remains effective by default. Under a worldwide system, however, residents are taxed on their global income but receive a credit for taxes paid abroad. Without tax sparing, a host country’s incentive could be completely offset by the home country’s tax, making it meaningless to the investor.
This explains why tax sparing clauses appear mostly in treaties between developed and developing countries, particularly where the latter use fiscal incentives to attract capital. The United Kingdom, Japan, and the Netherlands have historically included such provisions in treaties with Commonwealth and developing partners, while the United States and Canada have avoided them entirely.
The Matching Credit Approach
A variation of the concept, known as the matching credit or crédito presumido, appeared later as an attempt to simplify administration. While tax sparing ties the credit to the specific relief granted by the host country, the matching credit sets a fixed rate of credit directly in the treaty. It applies regardless of whether the host country grants an exemption or what rate it imposes.
A useful illustration is the 1993 tax treaty between the Netherlands and Bangladesh. The treaty treated certain categories of income—such as dividends, interest, and royalties—as having borne a notional ten per cent tax, even if Bangladeshi law imposed a lower rate. This approach gave both investors and tax authorities predictability. Matching credits were often used for passive income streams, while traditional tax sparring was reserved for active business profits.
The distinction between the two approaches reflects a difference in emphasis. Tax sparing follows the host country’s policy decisions and varies with its incentive structure. Matching credit, by contrast, is defined within the treaty itself, giving the resident country more control over the fiscal cost of the arrangement. It preserves the developmental intention behind tax sparing while avoiding some of its unpredictability and potential for abuse.
Present Relevance
Although tax sparing has become less common, it remains a feature of many treaties involving developing countries. For them, it continues to represent a modest assertion of fiscal independence—the right to design tax policies that support national objectives without interference from foreign tax systems.
At the same time, the international tax landscape has undergone significant changes. The introduction of controlled foreign company rules, minimum tax regimes, and the OECD’s global anti-base erosion framework has reduced the opportunities for tax arbitrage. In this new context, the space for tax sparing has narrowed, yet its underlying principle remains instructive.
Although its use has declined, the concept endures in modern forms through targeted incentives, tax stability agreements, and negotiated provisions that aim to balance investment promotion with tax integrity. These arrangements carry forward the same objective that motivated tax sparing in the first place: to ensure that taxation supports rather than undermines development.
CPA Mugambi is a seasoned Finance, Administration, and Tax Professional He leads the Finance departments of two sister companies based in Nairobi, where he oversees financial strategy and operations. James holds a Master’s degree in Tax Administration and is a Certified Public Accountant. Beyond his corporate responsibilities, he dedicates time to maketax theory accessible and understandable to a wider audience.
