1. Introduction and overview
- Michael Keen, and Victor Thuronyi
- Published Date:
- September 2016
Issues and context
The mismatch between where natural resources are found and where they, or their derivatives, are needed means that the business of finding, developing and selling them has for centuries been inherently international. The modern manifestation of this is the importance within the sector of large multinational enterprises – and their dominance where the state does not own all assets above the ground, as well as the resources below. Several state-owned enterprises have now themselves become important multinationals in the resource sector. Among resource-rich countries, for instance, multinationals account for the vast bulk of fiscal receipts from private business activity in the sector, especially in petroleum: in Ghana, Liberia, Peru and Trinidad and Tobago, they account for all such receipts (see Figure 1.1). In designing fiscal regimes for the extractive industries, international aspects – including the opportunities for tax planning by multinationals to avoid their liabilities – thus need to be center stage. This book aims to provide a comprehensive (and comprehensible) account of these sometimes difficult issues.
Figure 1.1Proportion of natural resource taxes paid by multinational enterprises
Notes: data from EITI; excludes payments made by state-owned companies
*: Only includes income taxes
The importance for resource-rich countries of managing these difficulties needs little emphasis. Receipts from the extractive sector are a – often – the major source of revenue in many countries (Figure 1.2), especially, though not only, in Africa and the Middle East (where state-owned enterprises have a central and even dominant role). The central task for policy makers is to design fiscal regimes for the extractive industries that raise sufficient revenue, provide adequate incentives to invest and are implementable at reasonable cost to both the government and taxpayers. These challenges receive considerable attention when resource prices and the potential revenue are high. But those are precisely the circumstances in which achieving these objectives is easiest. It is when resource prices seem set for a lengthy subdued spell, as at the time of writing, that the trade-offs can be most brutal, the resilience of regimes most tested, coherence in the design and implementation of taxation in the extractive industries most needed – and the importance of ensuring effective taxation of multinationals is most pronounced.
Figure 1.2Government receipts from natural resources, averages 2000–2013 (Selected countries, in percentage of total revenue excluding grants.)
The difficulty of taxing multinationals – not only or even especially in the extractives, has attracted considerable concern and attention in recent years. Discontent is apparent not only in public disquiet at the success of aggressive tax planning by many multinationals but also in the discourse and actions of many emerging and developing countries that have perceived themselves as being placed at a disadvantage by current arrangements. This discontent has been especially apparent in the extractive industries. Mongolia’s renunciation of its tax treaty with the Netherlands, for instance, was prompted by dissatisfaction at the consequent treatment of a large copper mining project;1 and one of the more controversial responses to the difficulties of transfer pricing – the ‘sixth method’ – is used specifically in relation to natural resources and other broadly homogeneous commodities for which some benchmark market price can be found. Substantial discontent is perhaps not surprising, as the basic structure of the current international framework was set out at the time of the League of Nations, when the extent of transactions within firms and importance of hard-to-value intangibles were much less and political power relations very different. It has led to an ambitious attempt to strengthen that system, in the G20-OECD project on base erosion and profit shifting (BEPS).2 While the implications remain to be seen (and are considered in various chapters of this book), it seems clear that while they may mitigate they will not eliminate many of the challenges that arise – including not least in the extractive industries. What is increasingly clear is that the revenue at stake is substantial and quite possibly greater (relative to GDP) in non-OECD economies: Crivelli, de Mooij and Keen (2016) put it, for them, at around 1 percent of GDP, which, given that tax revenues are commonly in the order of 15 percent of GDP in low-income countries, is a sizable amount. And there is increasing evidence too that the sums at issue can be especially large in the extractive sector.
Many of the international tax issues that arise in the extractive industries are, of course, far from unique to the sector. Profit shifting through intra-firm lending, for instance, is a generic difficulty with multinationals. But, as in other areas, common problems often loom especially large by virtue of the sheer scale of their operations and the unusually high nominal tax rates that are commonly applied, since these amplify the gains from shifting profits to lower tax jurisdictions. Moreover, the location of resource deposits often does not respect national boundaries or requires cross-border co-operation for development and export of products. These features present special cases of the wider international fiscal challenges.
This book does not address all aspects of international taxation but focuses on two sets of issues: those that have proved especially important, problematic and recurrent in the extractive industries and those that arise from specific aspects of the operations of extractive enterprises, such as those that arise from cross-border infrastructure or joint developments in disputed maritime zones.
In focusing on these issues, this book complements both Daniel, Keen and McPherson (2010), which focuses mainly on domestic aspects of fiscal regime design, and Calder (2014), which focuses on administrative issues. As there, the present book mainly takes the perspective of resource-producing emerging-market and developing countries. That is where the international tax challenges for the extractive sector arise in most pronounced form and, within the wider fiscal scheme of things, are most significant for both revenue and wider economic performance. Their significance in Africa, for instance, is highlighted and explored in Africa Progress Panel (2013). These are also the cases in which the IMF, through its technical assistance and other activities, tends to become most closely involved3 with many of the authors of this book playing leading roles. An appendix later in the chapter lists some of the international tax issues that are most frequently encountered in this advisory work and that guided the selection of topics for this book.
The book can be thought of as falling into four parts. The first sets the scene for the discussion of international tax issues in the extractive industries. The second part takes up generic issues in international taxation with an eye to the specifics of the application to the extractives, focusing on transfer pricing issues, tax treaty strategies and design and the taxation of capital gains associated with natural resources. Cross-border issues, including those related to international pipelines and joint development zones, are taken up in the third part of the book. The fourth part takes up some core policy issues: the interactions between components of fiscal regimes and inter-governmental tax competition and coordination in the extractive sector.
Setting the scene for the chapters that follow, Michael Keen and Peter Mullins provide in Chapter 2 an overview, with an eye to the extractive industries, of the current international tax framework, common tax planning devices and recent initiatives to address them. They also review the emerging evidence pointing to the considerable scale of profit shifting both in general and, perhaps especially, in the extractives and in non-OECD countries. This chapter also highlights three specific issues that later chapters examine in more depth: the difficulties of the arm’s length principle and transfer pricing, treaty abuse and the taxation of capital gains on asset transfers.
On the first of these issues, transfer pricing, Stephen Shay provides in Chapter 3 an overview of major rules that apply in the context of extractive industries in resource-rich developing countries. He considers a number of examples and discusses steps that developing countries can take to mitigate transfer pricing tax avoidance by multinationals. Jack Calder complements this analysis in Chapter 4 by focusing on complications added by ring-fencing, special methods for valuing extractive industry sales and special rules for costs. In addition, he considers a number of tax administration issues, particularly special bench-marking and ‘physical audit’ procedures.
Chapter 5 by Philip Daniel and Victor Thuronyi outlines the principal international tax and fiscal regime issues faced by developing countries engaged in natural resource extraction or exploration. The focus of the chapter rests on corporate tax issues for extractive industries. It considers the principal elements in tax treaty strategy that form an integral part of tax policy making. The chapter concludes with a brief discussion of defensive steps that developing countries can take unilaterally.
The role of tax treaties in the extractives sector is further taken up in Chapter 6 by Janine Juggins, who – writing from the investor’s point of view – provides an overview of the different types of taxes that arise over the life cycle of a mine, followed by a discussion of the relevance of tax treaties to investment financing decisions, the role that tax treaties play in relation to capital gains and in supplementing gaps in domestic tax law. Further to that, she considers the importance of tax treaties as a component of foreign investment tax policy development and choices.
In Chapter 7 Lee Burns, Honoré Le Leuch and Emil M. Sunley focus on the tax treatment of gains arising on a transfer of a mining or petroleum right under both domestic tax law and tax treaties – which has proved a controversial issue in many countries. They investigate the complexities concerning the characterization, valuation, timing and geographic sourcing of the gain both made directly by the holder of the right or indirectly by a person disposing of an interest in the entity holding the right.
Joseph C. Bell and Jasmina B. Chauvin in Chapter 8 set the scene for discussion of cross-border projects. They focus on potential arrangements for allocating the taxable income from a project crossing national boundaries among different national entities, using as an example a hypothetical mining project with the mine and infrastructure in two different countries.
In Chapter 9 Honoré Le Leuch focuses specifically on the key role of cross-border pipelines in the global oil and gas industry and their commercial structure and taxation. He highlights the striking differences and challenges between the two main categories of transnational pipelines and provides a brief review of the international law applicable to landlocked countries and transit countries. The chapter also highlights the special issues pertinent to the design of the tax regime applicable by each state to the segment of a transnational pipeline under its jurisdiction, as well as possible interactions between the regime and international taxation and double tax treaties.
Joint development zones are discussed in Chapter 10 by Peter Cameron and Chapter 11 by Philip Daniel, Chandara Veung and Alistair Watson. Chapter 10 discusses design of joint development zones (JDZs) treaties and international unitization agreements. This outlines the conceptual framework for both arrangements and the differences between them, focusing largely on legal aspects and international obligations. It compares JDZ and unitization structures, providing examples of actual operations and challenges therein. Chapter 11 then examines the fiscal structure of JDZs and sets out examples from around the world, drawing lessons for the future use of this important institutional structure.
Interactions between different tax regimes and instruments are the topic of Chapter 12, by Jack M. Mintz. He shows how to assess the impact of oil tax and royalty regimes on investment decisions by calculating an effective tax and royalty rate for marginal projects. The analysis highlights several cross-border fiscal issues that affect the incentive to invest and the resource revenues derived by governments. This chapter also looks at the impact of various financial strategies of multinational companies when investing abroad such as transfer pricing, conduit financing and the discount rate for carrying forward unused deductions under rent-based royalties.
The book concludes with an analysis by Mario Mansour and Artur Świstak of the issues of tax competition and coordination in the extractive industries. In Chapter 13 they attempt to answer the key questions of whether tax competition is a reality in relation to the extractives and if so, why (which is far less obvious than it may seem), which taxes it affects – and, critically, to what extent and in what ways governments should consider coordinating their tax treatment of the extractive industries.
International tax issues in some IMF FAD advisory work on resource-rich countries
This appendix draws upon advisory work between 2010 and 2014 in about 20 countries and upon regional workshops. Advice or analysis specific to individual countries remains confidential.
The international or BEPS issues arising included: source and residence taxation, double tax treaties (including border withholding taxes), transfer pricing, thin capitalization limitations, taxation of gains on transfers of interest in immoveable property and mineral rights and the treatment of financial instruments. Recent activity reflected an upsurge of interest from the authorities in the content and desirability of double taxation treaties and in the taxation of gains on transfers of interest.
Source and residence taxation
A few countries inherited territorial systems at independence that had already been substantially amended in the jurisdictions formerly governing. In some cases, technical assistance (TA) recommended an explicit switch to worldwide taxation of resident individuals and corporations. In other cases, recommendations to widen the definition of permanent establishment (especially for provision of services) and to strengthen or clarify definitions of domestic source income were made.
Double tax treaties
TA consistently recommended that governments refrain from concluding new tax treaties, at least until a uniform and consistent national policy on treaties has been formulated. The policy should ensure full taxing rights with respect to extractive industries, border withholding on dividend, interest and royalty payments abroad and also payments for services. Where the existing treaty network was limited, the recommendation sometimes included maintenance of full legislated rates of border withholding.
As an alternative to treaties, TA sometimes recommended tax information exchange agreements (TIEAs) or joining the Convention on Mutual Administrative Assistance in Tax Matters. Full integration of treaty policy with domestic tax policy was advised, making the point that many things done in treaties could be done in domestic law in a non-discriminatory way. One example concerns introduction of a rule that a cost is not deductible unless the counterpart receipt is also taxable and perhaps taxable at some minimum rate.
Some of the TA reports gave a detailed analysis of existing treaties and the treaty-shopping opportunities the treaty network might present. More recent TA has recommended introduction of a provision in domestic legislation that would protect against treaty-shopping practices. The same suggestion (together with a possible ‘principal purpose’ rule) came from the BEPS reports: should a multilateral treaty instrument eventually become effective, the appropriate national action might, of course, change.
TA has not called for repudiation of ratified treaties, but recommendations were made to clarify the validity or operation of very old treaties. In some cases, treaties that were signed but not ratified had serious inadequacies, and the authorities were advised to review them before ratification. In one case (Mongolia) the authorities independently decided to seek treaty renegotiations.
The detail of treatment of transfer pricing policy issues deepened in more recent advice. The standard position has called for adherence to the arm’s length principle and implementation, by various means, of the OECD guidelines on transfer pricing. In many cases, the introduction of advance pricing arrangements (APAs) was proposed. In more recent cases, TA suggested stronger powers for the authorities to make regulations on transfer pricing. Some TA called for consistent transfer pricing rules for transactions among residents as well as with non-residents.
Some TA (especially where oil and gas is involved) has suggested use for tax purposes of transfer pricing rules devised for transactions among private parties (such as the ‘transfer at cost’ rules among affiliates for services under joint operating agreements) or devised for production-sharing contracts.
For the pricing of extractive industry outputs, reference prices (sometimes with adjustments) have been put forward where these are available.
Thin capitalization limitations
The recommendation has usually been to strengthen overall limitations on the deductibility of interest rather than to propose something specific for extractive industries. In some cases, however, it was necessary to recommend removal of provisions in production sharing contracts that permitted recovery of interest as a cost. TA has offered both a debt-equity ratio test and a test of the ratio of interest expense to income in different circumstances. In a few cases, both were suggested in combination.
In one case legal advice called for reclassification of finance leases as loans and also for use of rules analogous to those for thin capitalization for other types of base-eroding payments.
TA usually advised against using a distinction between interest payments nominally between third parties and those between affiliates.
Taxation of gains on transfers of interest in immoveable property and mineral rights
Recent TA has recommended that such gains be taxed as income within the corporate tax system rather than through a separate capital gains tax or segregated stream of capital transactions within the corporate income tax. The recommendation to tax follows political preference rather than a specific economic analysis or consideration of alternatives. In earlier TA, the point was made that (as, for example, in Norway) transactions within the petroleum tax ring-fence could be considered post-tax – in the sense that no tax would be due on any gain and no deduction available for any outlay – provided that the overall taxation of resource rents was appropriate.
Recommendations have differed on whether to follow the course of segregating capital transactions (the U.S. model) so that payment of premiums for acquisition can only be offset against future capital transactions of a similar nature or to follow the more widespread treatment of the cost of acquisition of mineral rights under which the cost is amortized (usually over the life of the right). Both courses have justification, and the choice between has depended on local circumstances.
In either case, a frequent issue has been whether to define mineral rights as immovable property (or to make transactions in them taxable in their own right as assets) and then to ensure that both domestic law and treaties permit the taxation of transactions in such property by non-residents.
TA has adopted more than one approach to the problem of taxing indirect transfers of interest through disposal of shares in companies holding mineral rights or non-resident companies holding such companies. Recommendations were usually made to tighten rules on ‘change of control’. Obligatory notification of transfers and change of control can be required in sector legislation or in tax law or both, with stiff penalties for failure to notify (financial or forfeiture of the license). There are differences among legal advisers on the merits (and treaty implications) of using a ‘deemed disposal’ mechanism to tax the local entity, obliging a local entity to withhold tax due from a non-resident or attempting directly to tax the transaction by the non-resident as domestic source income. Withholding pending final assessment is in any case an option.
In some cases, TA has dealt with farm-in/out, with work obligations as consideration, as the method of transfer of interest and also with the creation of an over-riding royalty.
For extractive industries the issue is usually the use of instruments for hedging, not only of commodity prices but also foreign exchange and the cost of debt. The common approach has been to attempt to exclude transactions in financial instruments (or forward sales) from the regime of resource taxation (royalty, rent taxes or production sharing) and thus to get as close as possible, for calculating the tax base, to the intrinsic costs and proceeds of resource production. For income tax purposes, the recent recommendation for extractive industries is to quarantine losses on financial instruments so that they can only be set against losses on financial instruments. More work on the taxation of hedging is warranted.
Africa Progress Panel. (2013) Equity in Extractives: Stewarding Africa’s Natural Resources for All. Available at http://app-cdn.acwupload.co.uk/wp-content/uploads/2013/08/2013_APR_Equity_in_Extractives_25062013_ENG_HR.pdf
CalderJack. (2014) Administering Fiscal Regimes for Extractive Industries: A Handbook (Washington: International Monetary Fund).
CrivelliErnestoRuuddeMooij and MichaelKeen. (2016) “Base Erosion Profit Shifting and Developing Countries” forthcoming in Finanzarchive.
DanielPhilpMichaelKeen and CharlesMcPherson eds. (2010) The Taxation of Petroleum and Minerals: Principles Practices and Problems (London and New York: Routledge).
International Monetary Fund (IMF). (2012a) Fiscal Regimes for the Extractive Industries: Design and Implementation. Available at https://www.imf.org/external/np/pp/eng/2012/081512.pdf
International Monetary Fund (IMF). (2012b) Mongolia: Technical Assistance Report - Safeguarding Domestic Revenue - A Mongolian DTA ModelIMF Country Report No. 12/306. Available at https://www.imf.org/external/pubs/ft/scr/2012/cr12306.pdf