6. Extractive investments and tax treaties: Issues for investors
- Michael Keen, and Victor Thuronyi
- Published Date:
- September 2016
It is difficult to know when significant history is being made. Our professional experience accumulates in layers, some of which do not make much sense without an appreciation of the context, some of which assume greater significance because of what immediately precedes or follows, and some that may not seem important at all until viewed with the benefit of hindsight. The international tax system comes under stress when there is a perception that it no longer delivers a fair result for developed and less developed countries alike, taking into account the evolution of business practices. At such times we may be at the cusp of a fundamental once-in-a-lifetime change, or we may be dealing with a natural yet transient response to a weak global economy in the aftermath of the global financial crisis of 2008 onward.
The current focus on the effectiveness of the international tax system assumes a zero-sum game in two senses. First, a redistribution of the cross-border corporate income tax cake – in which there is the potential for winning and losing countries. Second, under the assumption that the corporate tax burden is increased while the overall taxes raised remain constant, an initial redistribution of the direct tax burden from individuals to companies. It is an initial redistribution because ultimately all taxes paid by corporations will be borne by individuals whether in the form of an increased cost of goods or services, reduced investment income, or reduced employment opportunities. However, if instead the focus is on efficient and sustainable global economic growth, the cake is larger, and, all things being equal, everyone’s slice of cake is also correspondingly larger. This is as true for the extractives sector as it is for every other business sector. More than ever we need an international tax framework that will support efficient and sustainable global economic growth. Ultimately loss of productivity resulting from double taxation placing barriers in the path of sound investments hurts us all.
The OECD base erosion and profit shifting (BEPS) work aims to reform the international tax framework so that in simple terms tax is paid where value is created. Let’s put to one side for a moment the potential for increased double taxation that will undoubtedly arise from different country points of view on where value is created. The real legacy of BEPS could well rest in driving forward the continuing improvements in the tax governance and transparency of the world’s largest companies. A further significant achievement for many countries will be access to additional information that will help focus tax compliance efforts and make best use of scarce tax administration resources. The world faces enormous economic and social challenges from a growing population and greater pressure on all natural resources, whether extracted or grown. There are greater mismatches than in the past between where mineral resources are found and where they are consumed, with the scale of those basic physical mismatches compounded by differences in the stage of development and levels of institutional and human capacity among countries in the value chain. Given these mismatches, global economic growth is efficient where the mineral resources (wherever they are located) are delivered to the end consumer (wherever they are located) at the lowest all-in cost. This all-in cost includes the costs of exploration, development, financing,2 extraction, processing, manufacture, and distribution, including the correct pricing of externalities arising from these activities and including the taxes borne in the value chain from start to finish. In this analysis the taxes paid represent both a contribution to the current budget and also funding for capital investments to meet the development agenda of a particular country and therefore need to be sufficient to meet both. Mechanisms (whether through tax policy, alternative tax systems, or other approaches) that support sustainable consumption in a world where natural resources are under stress must also be part of this equation. Slow to acknowledge the benefits conferred upon us by the contributions of those who have gone before, so too perhaps we have taken for granted the significance of tax treaties in supporting efficient economic development. For investors, tax treaties are an essential part of the international tax framework supporting the foreign direct investments vital for global economic growth.
It is worth pausing to reflect on why tax treaties came about. Remarkably, the first draft of the OECD Model Tax Convention was 52 years old on 8 September 2015, but it built upon the older conventions drafted by the League of Nations.3 The objectives were to deal with the obstacle to the development of trade and investment posed by double taxation, to cut the length of time needed to negotiate a network of bilateral tax treaties, to achieve common definitions and principles where possible, to minimise distortions in trade, and also to provide the tools to tackle tax evasion. The system of bilateral tax treaties was implemented in the context of one country agreeing to cede taxing rights over income to another country in the furtherance of trade and investment between the two countries. One of the main reasons differences between tax treaties can arise is that certain bilateral trade and investment relationships are considered to be more important than others, and the existence of these differences may give rise to opportunities to optimise investment flows. Put simply the multinational investor has multilateral investment options as it is by definition established in more than one country, whereas tax treaties have their origin in a bilateral relationship, an important consideration for tax treaty policy.4 Since the first model tax convention was developed, technological advances have changed both the way in which most businesses are conducted and spawned entirely new forms of business, but the fundamental objectives of addressing double taxation and tax evasion remain just as valid today as they were 50 years ago. On the other hand tax avoidance, by which is meant the legal minimisation of taxes by using available tax laws and reliefs, was not one of the objectives. Although clearly since a tax treaty affords reliefs it becomes one of the tax planning tools available to reduce the overall tax burden on an investment, and therefore tax treaty policy should take this aspect into account.
Potential investors in the EI come in all shapes and sizes. They have differing business strategies, core competencies, risk appetites, and ability to bear risk but share a common goal of maximising the return on the capital they have placed at risk, taking into account the need for an extractive investment to be sustainable over the long term whilst complying with all environmental obligations.
When we think about what a tax treaty means for an investor in EI we have to think about the full spectrum of potential EI investors. These include:
The junior exploration company – which has the technical expertise and the appetite to risk equity capital on the more speculative exploration activity. These investments are highly risky and characterised by many failures and a few outstanding successes.
The large multinational – which draws on a strong balance sheet to provide equity and debt capital, technology and know-how, project management expertise, communities, environmental and remediation expertise, and is capable of developing and operating a natural resource for the benefit of many stakeholders.
The buyer of natural resources – who may be willing to provide equity or debt capital to finance the development of a natural resource in exchange for a right to acquire a share of production. This could include a state-owned company whose objective is to secure a supply of raw materials or a trader of minerals whose objective is to secure a position against which to execute or hedge other trading transactions.
The providers of project finance – generally a group of international financial institutions that may include supranational lenders like the IFC and EBRD.
The government – either acting directly or through a national champion, which participates through equity and debt funding, typically as a joint venture partner in a mining company.
The provider of specialist services or capital equipment – for example the sub-contractor or EPCM (engineering, procurement, and construction management) contractor, who may manage all or a significant part of the mine design and construction, sometimes on a fixed-price turnkey basis.
In order to place the relevance of tax treaties for the EI investor in context, we will first review the typical life cycle of an extractive investment. We will then move on to consider how that investment is financed, recognising that the financing requirements will change over the life cycle, and the underlying commercial reasons a change in capital structure or ownership may be required. The one thing that is certain about an extractive investment is its uncertainty. Having then understood the relevance of tax treaties to these investment decisions, we will review how tax treaties may also assist in practice where there may be gaps in domestic law. Finally, it will be time to step back and consider the role of tax treaties in overall tax policy for EI in the round.
2 The life cycle of an extractive investment
Figure 6.1 shows the typical life cycle of a mine. Each phase of the life cycle can last for many years, and once in operation there is the potential for mine life to be extended – or curtailed – through phased expansions, the implementation of new technologies, and significant and sustained changes in relative economic competitiveness. For example, the relative economic competitiveness of a mine can be affected by changes in the commodity price cycle, exchange rate shifts, and changes in restrictive practices, the regulatory environment, or the tax system.
Figure 6.1Typical life cycle of a mine
However, most potential investments do not proceed through the full cycle because of various commercial issues – the geology is not as prospective as thought, poor project economics due to changes in key assumptions, lack of political support, lack of access to sufficient capital, inadequate infrastructure, or environmental or local community concerns. Reflective of these risks and the fact that as capital is invested more information for decision making becomes available, an investor’s internal capital authorisation processes typically take the form of a series of stage gates. At each such stage gate, a decision can be made to continue, defer, or abort investment programmes, to make changes in scope, or to impose qualitative or quantitative investment hurdles. As the investments are made, the capital at risk becomes greater, since the money is largely spent up front but the payback and profits accrue only over many years into the future. In this most uncertain of investment environments it is not really surprising that EI investors seek to mitigate as many risks as possible.
Different taxes arise over the life cycle of a mine by virtue of the different activities taking place. The exploration phase may require only a small number of employees and fixed assets to support the exploration activities, and some of the exploration services may be sub-contracted. Once the mineral resource has been determined to be economically viable, which is generally only after an extended feasibility analysis, the decision may be taken to develop the mine. The development phase will typically require a much larger number of employees and sub-contractors and significant imports of materials and capital equipment. Some or all of the construction may be sub-contracted under an EPCM contract, and the EPCM contractor will in turn sub-contract elements of the construction and development work. When the mine comes into commercial production in the operating phase the numbers of employees will increase.
During the mine’s operating life there will be a certain level of sustaining capital expenditure required. One of the biggest differences between oil and mining is that in general the up-front capital expenditure for an oil project is much larger, but conversely the ongoing sustainable capital expenditure is much greater for a mine. There may also be additional near-mine exploration and development activity. The mine may be expanded in phases for which significant new capital investments are needed, for example moving from an open-pit mine to an underground mine, the investment in additional processing equipment or infrastructure to allow increases in production, a significant expansion of the mine’s footprint where new geological information is obtained or the economic environment or mining technologies change such that additional resources become capable of economic recovery. Therefore, although there is a mine plan and a projected outcome based on a mine model, this is based on a significant number of assumptions which may change over time. Although mineral price remains the key variable, all of these factors will influence the actual performance of the mine, the production volumes, and level of profits generated.
Once the mine is no longer economically viable, it enters the remediation and closure phase. This may require only a small number of employees and sub- contractors but may extend for many years after the mine has ceased to operate. Licence and surface fees may be payable during the exploration phase and throughout the lifecycle of the extractive investment. Employer taxes in respect of employees and the personal income taxes paid by employees will arise throughout the lifecycle but peak during the operating phase when the greatest number of employees will be needed.
Unless there is an agreement to exempt these in the period prior to commercial production, VAT and customs duties on imported equipment and materials will be greatest during the initial development phase and in the course of additional mine expansions when most capital expenditure is incurred. During the operating phase, assuming that the mine’s output is exported, under most VAT systems no VAT should be due, and therefore all VAT on purchases should be refunded. Where VAT is not refunded promptly it imposes a significant cash-flow disadvantage. Where no VAT refund is made at all this effectively becomes an additional capital investment to be financed (e.g., assuming a VAT rate of 15 percent, a project with capital purchases of $100m now costs $115m). Irrecoverable VAT is borne by the project and therefore impacts the project economics.
Throughout the lifecycle suppliers of goods and services to the project may be liable for profits-based taxes on the profits they make. This liability may be collected through the project withholding tax on the payments made to suppliers. In some cases the supplier may have negotiated that the project bears the cost of any withholding taxes (through a gross-up clause), and in this case the economic burden of the tax will fall back onto the project. This is a particularly relevant consideration where there is a large EPCM contract.
Profits-based taxes will arise in the operating phase, but only once the capital investments have been amortised in accordance with the applicable tax laws. As the capital investments are large this can mean that taxable profits are not realised for the first years of commercial production, and profits-based taxes will be low at first before increasing in later years. Where the extractive investment is significant for a country’s economy this can be a significant budgetary management issue. More immediately, however, this can be a significant expectation- management issue, since the distinction between gross revenues and net profits after taking into account all relevant deductions is not clear to many in less developed countries and indeed in many developed countries also. Occasionally profits based taxes may arise where residual stockpiles are processed, or where provisions that have previously received tax relief and are now no longer required are released to income (although the latter is rare, as in most cases a tax deduction is not allowed until the expense has actually been incurred). There may be the potential for refunds of profits-based taxes if the expenses of remediation are allowed to be carried back for relief against the profits of the prior operating periods.
Royalties can be production or profit based (with some wide variations in the scope and scale of deductible expenses) but in both cases will arise only when the mine is in the operating phase or in remediation where a residual stockpile is processed. As they are independent of profit, production-based royalties will generate a more steady stream of tax revenue and may therefore be an important base component for the country’s budget. Profit-based royalties that vary based on the commodity price or level of operating profits can be used to raise additional tax revenue during periods of high prices. However, this means that the project risk profile is changed for the investor – the upside is removed but the downside risk of low profits during periods of low prices remains – and this will be factored into the evaluation of the project economics and the cost of finance.
Withholding tax on interest is likely to be greatest during the first years of the operating phase and immediately after any further mine expansions, as it will take some time to generate the mine revenues to pay down debt finance.
As discussed later in the section dealing with financing, withholding taxes on dividends will generally be greatest once the mine has been operating for a number of years.
Capital gains (or losses) can arise at any stage in the life cycle where there is a disposal event, but would be most common in the exploration and development phases, when a junior company needs to bring in a more experienced partner with skills and capital, or in the operation phase where there is a need to source new capital from a joint venture partner to finance mine expansion. Occasionally an indirect disposal can arise because of mergers and acquisitions at the level of the parent company, or because the investment no longer meets the investment criteria of the provider of equity capital.
Taxes due during the life cycle of the mine may be reduced or more clearly specified by tax treaty provisions relating to:
Reduced rates of withholding taxes on cross-border payments of interest, dividends, royalties, service fees, technical fees, or management fees
Specified circumstances in which personal income tax liability will arise, for example, in the case of foreign or seconded employees or contractors
Circumstances in which corporate income tax liability will arise, for example in the case of non-resident providers of services and technology when those services take place in the country where the extractive investment is being made
The method by which business profits will be allocated to a tax presence created by a non-resident
The approach taken to the pricing of related-party transactions
The process for giving relief from foreign taxes
The process for resolving double taxation disputes
Circumstances in which capital gains derived from extractive investments or immoveable property, whether realised directly or indirectly by a non-resident, will be subject to tax by the country in which the extractive investment is located.5
3 Tax treaties and financing of investment
Extractive investments are capital intensive with significant initial investment required and the returns – which are inherently uncertain – only earned over a long period of time. Access to capital and its price will have a dramatic impact on whether a resource is economic to mine and therefore whether the investment proceeds at all. The cost of capital will also reflect the fact that interest expense on debt funding is generally tax deductible for corporate income taxes within certain defined parameters, whereas the cost of equity in the form of a dividend payment is not generally deductible for corporate income tax. To understand where tax treaties have a role to play in this process, we examine here how the capital structure for each phase of the investment life cycle will reflect its different financing profile and the requirements of the providers of capital.
Planning for the investment ownership structure will usually be undertaken right at the start of the exploration activity. In some countries it may not be possible for the legal entity holding the exploration licence to transfer the right to convert an exploration licence into a permit or agreement to mine to another legal entity; therefore ideally the optimal investment structure will be decided up front. In addition there is often such a long lead time between an exploration prospect and a decision to mine that the risk of law changes means that it is prudent to work through this at the start including consideration of the possibility of tax relief for any exploration expenditures. Initial decisions also have the potential to create complications later on where there is a change in ownership, and the new investor may have different requirements if it is tax resident in a different country to the original investor and therefore subject to another country’s international tax regime. It may be preferable for the investor to have separate legal entities within a country to hold different exploration licences (rather than holding them in a single legal entity) to provide flexibility for different decisions in the future as to whether to proceed to development, sell, establish a joint venture, or relinquish the various interests.
The choice of parent entity for the exploration company in the host country will take into account the tax treaty provisions governing equity investments, in particular those for dividend withholding tax and capital gains. The investor will assess the comparative advantages of the different tax treaties in force with the host country. For a multinational company that has subsidiaries in many different countries the benefits available under a particular tax treaty will depend on whether there is business substance in the relevant treaty partner country. Tax treaties may also contain additional requirements that have the effect of limiting access to the tax treaty only to those who have a real business connection to the country of the tax treaty investor. The choice will also be significantly influenced by the international tax provisions of the country in which the ultimate holding company is tax resident. Finally consideration will also be given to the existence of a bilateral investment treaty network, which may provide some protection in the extreme and unlikely event that the investment is nationalised or expropriated. All of these factors will be taken into account in coming to a decision on the investment ownership structure. As an example, if the investor is tax resident in a country that does not tax dividend income from an active business investment in another country (various forms of territorial tax systems may have reliefs of this kind), any reduction in dividend withholding taxes through a tax treaty delivers an immediate benefit to the investor. Similarly, a beneficial capital gains tax article in a tax treaty may benefit the investor who does not hold its investment in the mine through to depletion. If a country has decided to offer these reliefs in its tax treaties in order to attract foreign investment, it seems unreasonable to criticise a foreign investor for responding. This does highlight though the importance of a thorough understanding of the role played by tax treaties for a country’s overall tax and investment policy.
The exploration phase is likely to be funded by equity since, in most cases, the project will not earn any income to allow it to service debt. Equity funding is also more practical because, more often than not, the project does not proceed and therefore the investments made are unlikely to be recovered in full. Similarly, additional funding required during the remediation phase will most likely be made by the shareholders in the form of equity because the investment will no longer produce income at this point.
When the project moves into the development phase there is likely to be a combination of equity and debt finance. At this point the decision to develop a mine has been made – so the project is proceeding on the assumption that cash will be generated in excess of the capital invested. It is therefore appropriate not to over-capitalise the investment and move towards the capital structure that is best suited for the investment in the longer term. During development any debt finance is most likely to be from a related group company initially because at this stage the project will not have any income of its own to service third-party debt funding. The tax treaty withholding tax provisions that apply to related party interest will be most relevant at this point, and these may distinguish between interest on debt from the parent and that from a related party and also distinguish between types of debt that are subject to reduced withholding taxes on interest. The group company debt finance may be refinanced (repaid and replaced) in full or in part with third-party finance once the mine begins commercial production.
Additional finance may also be provided in the form of an earn-in6 arrangement during the exploration or development phases or to fund expansions during the operating phase. Under an earn-in arrangement the investor may earn a specified equity stake in the project through funding future investments up to an agreed amount. This type of arrangement is not a disposal; rather it is an expansion of or addition to the existing pool of capital.7 It has the same economic effect as, and indeed may sometimes take the form of, a new issue of share capital the proceeds of which are spent by the company on acquiring or constructing new assets. A new issue of share capital would not usually be treated as a taxable disposal event. Tax treaty provisions that deal with capital gains, interest, and dividends may help provide certainty over the tax treatment of the earn-in structure for a non-resident investor.
A further alternative is for finance to be provided by an EI investor who does not wish to be a full-risk equity investor but who wishes to secure a share of the mine’s future production. This could be structured as a loan at commercial interest secured against future production, the purchase of an entitlement to a fixed percentage of future production at a fixed price, or the purchase of an entitlement to a fixed volume of minerals at a price that is indexed to an independent reference price. There are of course many variants on these themes that may be constructed to meet the respective commercial, accounting, and tax requirements of the contracting parties. Tax treaty provisions that deal with capital gains and finance income may help provide certainty over the tax treatment of the arrangement for a non-resident investor.
During commercial production the mine may be refinanced to fund further expansions or to accommodate changes in the joint venture parties. Again the tax treaty provisions relating to withholding tax on interest and dividends and the treatment of capital gains will likely be most relevant for such refinancing during the operating phase.
Any tax treaty benefits that an investor expects to realise will be reflected in the post-tax project cash flows that are used for analysis in support of the investment decision. Therefore, if the tax treaty benefits did not exist, the investor would use different figures in their analysis, and their investment decision may be different. In respect of equity capital, tax treaties may provide for a reduced rate of withholding tax on dividends compared with the usual domestic rate, and this tax treaty rate may vary depending on the percentage shareholding. For debt capital, tax treaties may provide for a reduced rate of withholding tax on interest compared with the usual domestic rate, and the rate may differ depending on whether the lender is a group company, a financial institution, or a government institution.
However, typically, providers of finance (and services) push back the risk of withholding taxes to the project through tax gross-up clauses. Particularly in the area of debt finance, international market practice is that lenders expect to receive their interest without any deduction on account of withholding tax or other costs, as they determine the price of the finance they offer on a cost-of-funds-plus basis.8 Therefore in addition to a tax gross up by the borrower for withholding taxes there may be a tax indemnity. Typically, the change of tax law risk is also for the account of the borrower. Since the lender has required the price of the debt finance to be increased, the cost of any additional payment in the form of a gross-up is generally treated as an additional payment of interest by the borrower and is therefore a potential deduction for corporate income tax purposes. Therefore, to the extent that tax treaty relief is unavailable, or does not completely eliminate the withholding tax, increased costs imposed on lenders will ultimately be borne by the project. This will reduce the project returns flowing back to the investor. It will also reduce the corporate income taxes paid by the project where the additional cost of the finance is deductible for corporate income tax purposes.
This issue is explicitly recognised in the approach taken for funding provided through the IFC, which is specifically exempt from interest withholding taxes.9 Some EI investments are significant in terms of a country’s GDP and financial institutions associated with the World Bank Group may participate in the financing of such projects. The interest paid on such funding will generally be exempt from withholding taxes regardless of the tax treaty position and regardless of the country’s domestic rules.
We have now reviewed some of the financing considerations that apply at different stages of an extractive investment’s life cycle. However, there are a number of other practical factors that an investor will bear in mind when considering the right capital structure for an extractive investment. Some of these are tax related, but many are commercial.
i Extractive investments differ from some other investments, as they will ultimately be worth nothing once fully depleted. Therefore there will be a requirement at some point in the future to extract any residual cash from the company.
ii In some countries it can be very difficult to redeem or reduce share capital. Where there is a high level of political risk, an investor would most likely wish to maintain a higher proportion of the financing in the form of debt so that it can be repatriated quickly if needed.
iii Trapped cash can arise where cash accumulates in excess of accounting profits, and there may be a company law requirement for distributable reserves in order to declare a dividend. This is a common problem for capital-intensive investments, as depreciation deductions will depress accounting profits in the earlier years of operation. Trapped cash may also arise where there are restrictions on foreign exchange. Where interest is tax deductible (and subject to any thin capitalisation limits) it generally makes sense to push borrowings taken out to finance extractive investments down to the project itself. This is because under a territorial tax system the parent company will most likely not be allowed to take an interest deduction for borrowings incurred to make equity investments, and in any case the debt has been economically incurred to finance the project and for no other reason.
iv Debt can be pushed down to the project through group company loans or by the project borrowing directly from a third party. However, as a practical matter third-party debt financing may not be available until the point of commercial production. In general any short-term construction finance raised by the project would need some form of credit support from the extractive investor.
v Non-recourse third-party finance may be attractive to reduce project risk for the equity investor, but the cost of the third-party finance will reflect the risk profile of the investment. The third-party finance may also contain restrictions on the use of project cash flows until such time as the third- party finance has been repaid.
vi Domestic law or tax treaties may have different rates of withholding tax that apply to dividends, related party interest, and interest paid to third parties. Taking into account the commercial factors, the net post-tax cost of all of these cash flows would be analysed to determine the most efficient capital structure from a tax perspective.
vii A bilateral investment treaty will generally provide additional certainty to an EI investor in the form of greater legal protections and guarantees than those that may be available under domestic law. It could be considered as a kind of insurance policy for the EI investor, since invoking a bilateral investment treaty would come only after all other avenues for dispute resolution had been exhausted. In the case of a very risky investment, a structure that permits access to a bilateral investment treaty may be a key factor.
How does one weigh up the relative importance of tax treaty benefits to the investment decision compared with the other considerations that are taken into account?
Typically an extractive investment would be evaluated using discounted cash flows and supplemented by other investment appraisal analysis such as the time taken to pay back the initial capital. This requires a project cash flow model to be constructed and the project cash flows discounted back at the chosen discount rate to give a project value in today’s terms (this is the net present value). All cash flows that arise in moving the funds from the investment to the hands of the ultimate investor will be modelled, and these will include dividend withholding taxes. The chosen discount rate will be based upon the investor’s risk adjusted cost of capital, which, if it assumes a tax deduction for debt, will be applied to cash flows expressed in real terms, based on 100 percent equity finance.
The relative attractiveness of the project can be compared with other projects in the portfolio in terms of the ratio of net present value generated per dollar of capital invested. Where relevant, the overall impact of the investment on the value of the investment portfolio in aggregate can be compared by valuing the portfolio on a “with new investment” and “without new investment basis”. For example, a material increase in production of a certain commodity may have a significant impact on the global balance of supply and demand, including causing some higher-cost mines to become uneconomic as a result.
Thinking then in terms of discounted cash flows and the typical life cycle of an extractive investment, it follows that costs that arise earlier in the life of the project are more damaging to the investment economics than costs that arise later in the life of the project. It is the very reason tax exemptions during construction (such as VAT and customs duties on capital equipment and materials) are often critical to supporting the development of a mine. It is also the reason changing the profile of tax payments so that they arise more evenly over the life of the mine – perhaps to address the fiscal needs of the country or province where the investment is being made – can be very expensive for the project economics relative to alternative investments in the portfolio.
Since withholding taxes generally only arise on actual payment of the dividend or interest, in the context of discounted cash flow evaluation, their relative importance for an extractive investment depends upon when they are likely to be paid. Figure 6.2 shows a typical cash waterfall that illustrates the priority use of project cash flows and therefore the impact this has on timing.
Figure 6.2Typical cash waterfall
Cash generated by the project will first be used to pay operating expenses, to make capital investments that are needed to keep the mine in operation (sustaining capital), and to pay tax liabilities. The third-party financing arrangements may impose a restriction on the payment of related-party operating expenses if the cash flow generated by the project does not meet certain financial criteria.
Next the cash will generally be used to pay some third-party finance in priority to related-party debt and further capital investments (e.g. project expansion). The remaining cash is available for distribution to equity holders subject to any foreign exchange, corporate law, or accounting restrictions. The depreciation of the up-front capital investments can result in limited accounting reserves available for distribution, even where there is cash on the balance sheet. In practice this lack of distributable reserves, together with the higher-priority claims of debt providers, may mean that dividends will not be paid for many years.
Due to the protections required by third-party lenders, third-party finance will almost always need to be repaid in priority to related-party debt. In turn, generally related-party debt will be repaid in priority to equity. The pricing of the debt in each case will reflect this priority ranking. The principal exception to this usual order is where initial related-party construction finance is repaid in conjunction with a third-party project finance raising as part of a project refinancing.
Therefore tax treaty considerations will certainly be taken into account in determining the optimal capital structure for the investment and to optimise the project economics, but depending on the particular circumstances they may not be the most important factors. In the case of a particularly risky investment it may be the case that access to bilateral investment treaty protection provisions (which may mean forgoing access to the best tax treaty) or the ability to extract cash quickly will be more important considerations.
4 Tax treaties and capital gains
Under their domestic law some countries choose to tax direct and indirect transfers of shares in companies that derive most of their value from immoveable property. Other countries choose only to tax such gains when made by their own tax residents or may choose not to tax certain gains at all. For example, long-term capital gains may enjoy a preferential tax treatment compared with short-term capital gains to encourage investment and to discourage speculation. The Australian TARP (taxable Australian real property) rules, the Canadian TCP (taxable Canadian property) rules and the U.S. FIRPTA (foreign investment in real property tax act) rules are examples of some domestic-law approaches to taxing real property capital gains realised by non-residents.
The reason for the wide variance in domestic-law approaches in different countries reflects the fact that these choices are essentially driven by tax policy decisions. The at times competing requirements to attract foreign direct investment and to maintain a cohesive and sustainable tax base will be important considerations.
There is a broad range of extractive investments to consider. Where the extractive investment is more intangible than tangible or where it is only a part of what is being disposed of, valuation issues can become quite tricky – for example, the sale of the rights to the proceeds from or the sale of the actual production of an operating mine’s mineral by-product10for a fixed period of time. The extractive sector is also very cyclical and it is not unusual to see sudden changes in forward prices that have a dramatic impact on the fair value of an extractive investment (upwards or downwards) within a relatively short time period. Recent accounting impairments11 of acquisitions made by a number of large mining companies are practical evidence of these dramatic swings.
The disposal of extractive investments can also be made in different forms. All of the following could be ways in which an interest in an extractive investment is disposed of directly by the holder or indirectly through a disposal higher up the ownership chain:
The disposal of an existing retained royalty or the granting of a newly carved out royalty;12
The disposal of a percentage of shares in a company that holds an extractive investment – where the extractive investment could range from a mining exploration licence to a fully fledged operating mine;
The disposal of an unincorporated joint venture or partnership interest in an extractive investment;
The disposal of a share of or the rights to a percentage of a mine’s existing or future production;
The disposal of capacity or access rights in mining-related infrastructure, for example roads, rail, ports;
The disposal of an interest in mining technology.
Recognising that there may be practical or policy reasons to limit taxing rights in certain situations calls for some sensible exemptions. For example, in the case of a publicly traded mining company with investments in a number of countries it would be impractical to subject each and every trade of shares on the stock exchange (or, by extension, any over-the-counter derivative trade referenced to the actual share) to a special country-specific extractive investment capital gains tax regime. A further example may be where as part of a group reorganisation there is a transfer of the underlying extractive investment within the group. Stepping back and looking at the position as a whole, the ultimate parent has not changed, and no disposal proceeds have been received into the group. Imposing a tax in this situation would effectively place a barrier in the way of tidying up the group corporate structure13 or a group’s ability to react to regulatory or market changes. Further exemptions may apply in the case of a public bid or where no cash changes hands as in a share-for-share transaction, a demerger or an earn-in arrangement. As discussed earlier, an earn-in arrangement is where a party agrees to fund a certain amount of future expenditure in exchange for a percentage interest and is economically equivalent to (and indeed may be in the form of) a subscription for new shares.
The price paid for an extractive investment will generally be based on the value today of the future post-tax cash flows that the buyer expects to receive in the future. These are project cash flows that will be subject to tax in the country as they are earned. Therefore the taxation of the capital gain in the country where the extractive investment is located may result in the country collecting tax twice on the same income, once on the capital gain and again in the future as the profits are realised and taxed.
To better illustrate this point, consider Investor A which acquires an exploration licence for $10m, invests a further $500m on mine exploration, development, and sustaining capital, and operates a mine for the whole of its life cycle through to remediation and closure. As the mine is a depleting asset, it is worth nothing once it has come to the end of its economic life. The tax contribution made by Investor A consists of all the taxes paid by the mine on its profits, royalties, fees, and any withholding taxes on payments made to non-resident providers of services and debt and equity capital. Now let’s assume that the facts remain exactly the same but instead Investor B purchased the exploration licence from Investor A for $100m and Investor B went on to invest the further $500m in the mine and to operate it through to remediation and closure. If the $90m gain made by Investor A on the sale of the exploration licence to Investor B is taxed in the country where the mine is located without any corresponding increase in the tax basis of the mining assets being given to Investor B, the total tax contribution made by the mine is higher but only because it happened to change ownership during its life cycle. Levying a tax in these circumstances is therefore a deterrent to transfers of ownership that may be essential to ensure the most efficient development of a mining asset.
For completeness, since the capital gain is based on future projections, there can be scenarios in which this is not the case, such as a capital gain on an exploration project that never proceeds to production, an operating project where the future profits generated are either less or more than expected, or because a reduced amount of tax is paid due to tax incentives granted to a subsequent mine operator or changes in the tax law are made.
If the seller’s country of tax residence also taxes the capital gain, it may be possible to obtain a tax credit for the capital gains tax paid in the investment country, although this will not generally be the case under a territorial tax system with a participation exemption regime.
To address the issue of potential double taxation, some countries have symmetrical tax rules so that if the seller pays tax on the sale, the buyer benefits by being able to uplift the tax-depreciable basis of the assets to reflect the price paid to the seller. There is still some disadvantage for the investor and a corresponding advantage to the country due to the timing of the tax payment (see the earlier discussion about discounted cash flow investment appraisal), but this at least reduces the disincentive to transfers of ownership that are helpful for the efficient development of mineral assets. Where a capital gains tax will apply and where it is feasible in terms of title transfer and other regulatory constraints, it may make sense to structure the transaction as a domestic sale of assets in country in order to achieve a more symmetrical tax outcome. The purchase price of the assets should provide a higher depreciable tax base for the purchaser. Otherwise for a purchaser based in a country with a territorial tax system and participation exemption regime there may be little benefit from obtaining a high tax basis in the shares for capital gains tax purposes if the purchaser intends to hold what is after all a depleting asset.
A potential buyer of an investment that will be subject to capital gains tax should reflect the potential for a future tax liability on disposal in the price they are willing to pay for the investment and the impact of this on the relative attractiveness of the investment compared with other investment options. Clearly a buyer will not always have a predefined view on how long they will hold the investment, as an extractive investment can be held until it is fully depleted. However, a prudent investor needs to factor this into the asset’s valuation, as the future is inherently uncertain, and they may be required to reorganise or divest unexpectedly.
Some business models also deliberately anticipate a disposal at some point in the future. For example, it is relatively common for junior exploration companies to transfer or sell interests in an extractive project to a larger company with greater technical capability to bring the project into production or to gain access to financing. Significant capital gains taxes may deter this beneficial activity and slow down the development of projects.
Most would acknowledge that the prices at which some extractive investments have changed hands in the past decade can appear large particularly when compared to the budget for public services of a lower-income resource-rich country. As the benefits of the natural resources14 can only be obtained once by the country of extraction, such high prices may result in political pressure to have a greater share of the rent allocated to the country. There is nothing wrong in principle with such a decision, but as with all good legislation it needs to be properly designed and administered. As stated earlier many countries such as Australia, Canada, and the United States tax real-property capital gains realised by non-residents in certain circumstances. However, such legislation needs to be prospective in its application, as retrospective taxation changes are inequitable when applied to investments already made and which cannot be withdrawn or when assessed on those who have not actually realised the gains, as in the case of a purchaser retrospectively assessed for the capital gains of the seller. Retrospective legislation also creates an unstable investment environment that may put off future potential investors. In the context of discounted cash flow evaluation, retrospective tax changes increase the rates of return required to make future investments economic in comparison with alternative investment opportunities (given the higher risk involved and its reflection in the discount rate).
Therefore there is a policy choice to be made, a need to balance the relative importance of attracting foreign investment and the timing and incidence of tax revenues. Key policy decisions include whether to differentiate between short-term and long-term capital gains and whether to differentiate between direct disposals in country and indirect disposals outside of the country. This will impact the overall attractiveness of the investment environment.
Readers who are paying attention will notice that I have not yet mentioned tax treaties in connection with capital gains. This is deliberate. A country must first decide what its capital gains tax policy is with respect to foreign investment in the extractive sector before it can consider how the tax treaty provisions relating to capital gains should operate in support of that policy.
How important are the capital gains provisions of a tax treaty to an extractive investor? For a depleting asset, in practice the capital gains tax provisions are most likely to be relevant in the peaks and troughs of the commodity cycle. The peak may encourage the sale of assets before the commodity cycle turns, especially for those investors whose strategy is based on an exit well before the end of a mine’s life. The trough may force sales of assets to repay debts or to reshape the investment portfolio. It may seem counter-intuitive, but even sales of assets at the trough can generate capital gains depending on when the original investments were made and in what currency the capital gains are calculated.
For an investor from a country with a territorial tax system and a participation exemption regime any capital gains tax paid will be an additional cost. An extractive investor in this position should therefore have factored the benefit of any capital gains tax treaty provision into their original investment decision and will also factor it into their disposal analysis. Since the disposal effectively accelerates and crystallises all of the future value of the investment (as the disposal value should be equivalent to the discounted sum of its future post-tax cash flows) it is likely to be a significant figure, and therefore the value of any beneficial tax treaty provisions to this type of extractive investor is likely to be correspondingly significant.
Clearly in the situation in which a resource-rich country decides to change its tax policy on capital gains on extractive investments, there will be a period of time over which tax treaties will need to be renegotiated (or in extreme cases terminated) in order to bring the domestic and the international tax policies into alignment.
Where capital gains are taxed, investors want to have clarity over the process so that they properly understand their liabilities and responsibilities. This includes for example what the withholding and reporting requirements are, whether there are any exemptions, and how they apply in practice. Where there is tax treaty protection an investor would prefer a treaty clearance up front rather than having to pay the tax and make a tax treaty refund claim. A common issue that arises is when the seller is responsible for withholding capital gains tax from the purchase price but the amount of tax to be withheld is greater than the likely tax liability. In some countries it can be difficult to obtain a refund of overpaid tax, and this may become a contentious issue as between seller and purchaser. Some form of tax clearance mechanism would assist in this case. Another common issue is that of purchase price allocation and valuation disputes when the asset subject to the capital gains tax is just one part of a bundle of assets that is being sold. Disputes may also arise over the tax basis of the asset subject to the capital gains tax, particularly if there have been group reorganisations or other changes to the capital structure since the original acquisition.
For these and similar reasons both sellers and buyers have to deal with the risk of a capital gains tax liability in the legal agreement covering the sale, including the application of any relevant tax treaty provisions.
5 Domestic tax law and tax treaties
Investments in the extractive sector have certain characteristics that need to be considered in the context of a country’s tax policy and legislation. These issues will assume more importance the larger the share of the economy that is represented by the extractive sector. This is because a large extractives sector relative to the economy as a whole will create more volatility in terms of changes in the fiscal revenues from year to year as the commodity cycle fluctuates. It may also have an impact on the local exchange rate and inflation and therefore indirectly impact the tax base represented by other sectors of the economy as well as impacting the price of basic essentials consumed by the local population.
This can make forecasting tax revenues and budgeting for public expenditure very challenging even for the most sophisticated of countries. But for lower-income resource-rich countries this can seem insurmountable where there is a reduced buffer (such as flexible access to sovereign debt markets or accumulated state reserves) upon which to draw. Such scenarios may create an expectation management issue between the government and the EI sector at a minimum and, at the extreme, foster a sense of mistrust. Paradoxically, extractive companies face a similar dilemma in terms of ensuring that their own capital structure is sufficient to meet future capital expenditure commitments in the face of volatile income streams and in managing the expectations of their various stakeholders.
It is against this background that gaps in the domestic tax law and regulations of resource-rich countries can assume greater significance. The domestic tax law may be unclear or simply not contemplate the particular issue under review, for example how to obtain tax relief for the large remediation and closure costs that are incurred at the end of the lifecycle. Obtaining this further certainty is one of the reasons large extractive investments may benefit from a negotiated fiscal regime, along with any tax concessions needed to make the investment economic. However, where there is weak capacity in the host country tax administration dealing with the combined effects of uncertainty in the domestic law, the impact of a negotiated fiscal regime, and the relevant tax treaty provisions is challenging. So what are the areas in which a tax treaty may help plug these gaps?
At its simplest a tax treaty can help to clarify what host country income earned by the non-resident EI is to be subject to tax in the host country and how the amount of income is to be calculated. A permanent establishment is not always well defined in domestic law, or the domestic law may have been drafted at a time when the type of business conducted or the way in which the business was conducted was very different. Similarly, a country that has not had many foreign citizens working in its country may not have well-defined laws that set out when the foreign citizen becomes subject to domestic taxation, how the taxable income should be determined, and the interaction with another country’s tax system.
In practice for large extractive investments withholding taxes are often the earliest matter for potential discussion and dispute with the host country tax authority. This is due to the fact that payments to foreign suppliers and contractors for goods, services, and interest arise much earlier in the life cycle of an extractive investment than do profits taxes. Large extractive investments (relative to the size of the country’s economy as a whole) may be expected to generate large withholding tax receipts. A failure to appreciate where these forecasted withholding tax receipts will be impacted by a tax treaty that has lower withholding tax rates than those that apply domestically will cause problems for the budget.
Practical problems can also arise where the impact of tax treaty provisions are not well understood. For example, a tax authority may see a tax treaty withholding tax rate that is higher than the actual domestic withholding tax rate simply as an opportunity to levy the higher tax treaty rate. This results from a lack of understanding of the main purposes of a tax treaty, which are to protect the taxpayer from double taxation (and thereby promote cross-border trade) and to combat tax evasion. Another practical example is when there is insufficient clarity in domestic law over when and how the domestic withholding tax will be applied – perhaps there is no clear concept of source. This can give rise to confusion as to when the withholding tax will be applied to payments made to non-residents, with the default position often being that the withholding tax is applied to all payments whether in respect of host-country source income or not and without any distinction being drawn between payments for services and cost reimbursements.
To the extent that host-country transfer pricing legislation has gaps, the tax treaty provisions that deal with related party transactions can be helpful.
Similarly, in the case when the host country tax legislation is unclear a capital gains tax provision in a tax treaty can clarify if and how a capital gain that derives from an extractive investment is to be taxed.
Clearly, in situations where there are both gaps in the host-country tax law and tax authority capacity is weak, and the extractive investment is significant for the country, it is easy to see that the potential for disputes and misunderstandings may be large. This may be further compounded by other practical considerations. For example, much of the documentation may be in a foreign language and currency or exist in an unfamiliar format, such as purchase orders against a large umbrella contract rather than separate invoices for each item or fixed assets accounted for piecemeal as assets under construction.
Where there is a dispute about a tax issue, a common problem is the lack of a clear process to try and resolve the dispute without by default proceeding to litigation. This is by no means an issue unique to lower-income resource-rich countries. Many countries have struggled to put in place an effective disputes resolution process that provides a fair balance between the rights of the taxpayer to pay only the tax that is due and the goal of the tax authority to collect the right amount of tax and to do so in a way that is transparent as well as being efficient. The governance around this process is critical and can be hard to achieve in a country where the tax authority has weak capacity or there are concerns about minimising the opportunities for corruption. This can lead to a reluctance to delegate or to take decisions, resulting in more tax matters proceeding to court. Tax authority performance management also plays an important supporting role here. Tax authorities that set revenue collection or tax assessment goals for their tax auditors without taking into account the likelihood that the tax demanded will actually be sustained will place increased pressure on the tax courts.
However, where the tax matter under review is a tax treaty issue, the tax treaty can help by providing for a resolution process when one may not exist under domestic law, other than by litigation. Providing that the competent authority of the tax treaty partner is willing to provide support, the mutual agreement procedure (MAP)15 can be invoked. Unfortunately, most tax treaties require only that the competent authorities use best endeavours to reach agreement unless the tax treaty contains a binding arbitration clause. In countries where there are limited alternative dispute resolution options, it is generally advisable for the affected company to begin the MAP process as soon as a tax adjustment appears probable. This is because in such circumstances the next step may well be tax assessments and commencement of the formal domestic litigation procedures, which may require the payment of the tax in dispute. However, engagement in the MAP process may not be sufficient to prevent the tax in dispute having to be paid into tax court, which will increase the burden on the taxpayer whilst the dispute is resolved, and the tax paid may in practice be difficult to recover should the issue be resolved in the taxpayer’s favour. It would be desirable for domestic law or the treaty to provide that any domestic tax litigation should be held in abeyance pending the conclusion of the MAP discussions, because the two processes should not be operating simultaneously.
Clearly tax treaties can play an important role in making up for deficiencies or gaps in the host country legislation, but the practical impact will depend in large part on the host-country tax authority having sufficient capacity and resources to administer the tax treaties.
6 Role of tax treaties in overall tax policy for EI
Tax treaties are sometimes adopted as a badge of statehood, but like any contractual agreement, tax treaties impose responsibilities as well as confer benefits. Whilst tax treaties can be amended by mutually agreed protocols, these take time to negotiate and occur infrequently. As such, a tax treaty is an agreement that is expected at the outset to have a long life, and therefore the provisions of the tax treaty should be ones that each country is willing to live with over the long term. Given this it is clear that governments need access to expert advice so that no party is placed at an undue disadvantage at the negotiating table. This applies both to tax treaty negotiation and to foreign investment tax policy more broadly.
However, when faced with changed circumstances agreements that are negotiated by others can become problematic for their successors. This is particularly so where the issues at stake are significant for the country as a whole and thus assume greater political and economic importance. So a tax treaty negotiated in an earlier time may in an altered environment no longer appear to be a reasonable and equitable agreement.
Ironically there are parallels here with the negotiated investment agreements that may be put in place to support a significant extractive investment. Such a negotiated investment agreement may contain fiscal stability provisions amongst other things and may draw from or cross-refer to the existing tax treaty network. A common criticism is that such agreements are too inflexible and should provide formal opportunities for amendment. But in the context of EI investments, both the tax treaty and the fiscal stability provisions of an investment agreement are serving a critical function, which is to provide greater certainty to investors when significant money needs to be invested up front for a return that will be realised over a long period of time. The major differences are in scope and in the degree of the incentive to respect the agreement. The tax certainty in an investment agreement is tailored to the specific requirements of extractive investment, whereas the tax treaty provisions apply uniformly across all business sectors. There will be sovereign state-level pressure to respect a tax treaty, whereas in practice the pressure to respect an investment agreement will depend upon its relative importance to the overall economy and a country’s desire to attract future foreign investments.
Many tax treaties were negotiated a long time ago when the business landscape was different. Without a doubt, business has become more global and interconnected as improvements in logistics and communications have made it easier to take advantage of relative differences in climate, access to natural resources and labour, and to supply more diverse markets. Providing that externalities are correctly priced and responsibly managed, this should benefit everyone through increases in productivity. In the context of a multinational group, taking advantage of these efficiencies through activities such as centralised procurement, centralised marketing, and contracting out of non-core services have led to increased cross-border transactions between related parties.
These same improvements in logistics and communications mean that some businesses are more mobile, giving rise to issues of harmful tax competition. Clearly, an extractive investment is not mobile per se, although given that investment capital is finite extractive investors do need to choose between alternative investment options. However, other parts of the extractive supply chain may be best undertaken in a country other than the country of production. As discussed in the introduction, efficient global growth occurs where the mineral resources (wherever they are located) are delivered to the end consumer (wherever they are located) at the lowest all-in cost. This all-in cost includes the costs of financing, extraction, processing, manufacture, and distribution, including the correct pricing of externalities arising from these activities and including the taxes borne in the value chain from start to finish.
At the same time, with the notable exception of the United States, there has been a shift towards territorial taxation systems. This means that under their domestic law many developed-country treaty partners are giving up some (but not all) taxing rights over income earned offshore by their tax-resident companies. This does not so far seem to have been accompanied by a corresponding return to source country withholding taxes to the extent that may have been expected.
From the perspective of a developing-country tax treaty party, one way of looking at this is that the value of the tax treaty concession given to such a developed country is now worth less than at the time the tax treaty was negotiated. Perhaps – but given the expected longevity of the tax treaty – it is worth reflecting on what future changes may take place that would challenge that view. For example, given concerns around base erosion and profit shifting it is not inconceivable that the next phase of the move to territorial taxation is accompanied by an increase in withholding taxes to protect the source country’s tax base. Why would this matter to a lower-income resource-rich country that expects mainly foreign investment inflows? This potentially matters a great deal in a number of areas. For a lower-income resource-rich country, one of the significant challenges is managing the impacts of the so-called resources curse. The creation of a fund that makes foreign investments can be a common part of an overall strategy to manage the resource curse as well as to manage the resource wealth for the benefit of future generations, and tax treaties can support this outbound foreign investment. Transformative economic development can flow from successful extractive investments and investments in related infrastructure. It may not be so many years before the relative balance of investments flows into and out of a lower-income resource-rich country becomes more nuanced. Furthermore, large mineral-producing countries are rarely also large mineral-consuming countries; in terms of realising taxable income they are therefore dependent on being able to export their production to a consuming country. Analysis of base erosion and profit shifting and the UN work on transfer pricing are also questioning the appropriate way in which to view the taxation rights that should accrue to a country by virtue of its large markets and large consumer populations. Viewed through this lens the bargain may start to look different again.
If tax treaties are not respected or are applied incorrectly in practice by the tax administration, this will contribute to the cost of doing business. The renegotiation or termination of tax treaties will increase the perception of country risk and will increase the cost of finance. Therefore any change in tax treaty policy needs to be carefully evaluated for (i) the impact it has on future investment and (ii) the impact on existing investment (which may in any event be stabilised by an investment agreement). From the extractive investor’s perspective, the certainty and stability benefits provided by tax treaties are very valuable and have a direct impact on project funding costs. However, the tax result delivered by tax treaty benefits is just one factor in the post-tax project investment analysis. If there were no tax treaty, the higher – or the risk of a higher – tax burden would be taken into account in the project economics and will impact the investment decision, as well as the relative competitiveness of the investment opportunity versus a competing alternative. Therefore in the case of foreign investment tax policy the agreement of a tax treaty is as much a part of the policy framework as the domestic tax legislation.
Since tax treaties apply to investments in all business sectors, it makes sense to review the particular fiscal considerations of the extractives sector and to determine what aspects of these need to be addressed in the context of (i) foreign investment through a tax treaty and (ii) foreign investment not through a tax treaty, for example relying simply on domestic law or targeted investment incentives where the situation merits. So making clear policy choices rather than arriving haphazardly at an unexpected outcome with the potential for unintended political consequences is surely the preferred course of action.
Through consideration of the extractive investment life cycle, the factors impacting access to investment capital, and the competing interests of various stakeholders, we can see that a successful extractive investment requires the alignment of a great many variables. Indeed given the enormous obstacles to be overcome it almost seems surprising that any manage to make it to fruition at all. Many readers will recognise how difficult it is to deliver infrastructure investment within a single developed-country context, and arguably an extractive investment is even more difficult to realise with the added complexities of the one-time nature of the resource benefit (often an emotive issue) and a revenue stream that is determined by reference to a global price.
There is competition for extractive investment capital in two senses. First, there are more potential projects available in the world than the funds to finance them. Second, for a limited number of the more attractive “tier-one” projects it is also true that there may be more potential providers of investment capital than needed. However, in both cases the degree of competition is not static but responds to changes in the extractive investment cycle, which ebbs and flows as supply and demand for minerals changes. This cycle is accentuated due to the lagging effect of the long lead time for a new mine to come into production. This is further compounded by the fact that it is harder to access capital to pursue a counter-cyclical investment strategy. The simple reason for this is that the future is inherently hard to forecast, and more weight is always given therefore to the near term.
Some large extractive investments have associated infrastructure requirements in the form of roads, rail, air, and port facilities that can underpin an entire region’s or a country’s economic development. The scale of extractive investments like these can also have the side effect of accelerating improvements in local country institutional capacity. For example, the capital and raw material import requirements of a project may be so large that it represents a high percentage of a country’s total imports. Practically speaking the extractive investor has a self-interest in ensuring that the country has the systems, the controls, and the administrative capability to properly deal with this volume of imports on a timely basis whilst incorporating appropriate safeguards against corruption. The same observation can be made with respect to the supply of contracted services and the administration of any VAT and withholding taxes, including the processing of refunds. These kinds of legacies will benefit all sectors of the country’s economy.
As explained in the section dealing with the extractive investment life cycle, fiscal revenues from the extractive investment will be subject to considerable fluctuation, and this volatility presents challenges for governments in terms of planning and budgeting. There will also be considerable challenges for some tax authorities in terms of the capacity to administer large extractive taxpayers.
Therefore understanding the total economic impacts flowing from a large extractive investment is fundamental to developing the appropriate tax policy framework. This includes the broader benefits described earlier as well as the impact on other sectors of the economy. It includes an appreciation of the full spectrum of extractive investors and the way in which investment decisions are made and financed. A government must decide how much foreign extractive investment it wishes to attract as a proportion of the overall economy and on what terms, for example as an exporter or perhaps as a catalyst for regional economic development. Understanding the economy, the major financing, trade, and investment flows is key to understanding where support is needed and where tax policy decisions – including tax treaty policy decisions – could hinder or promote economic growth.
Tax treaties are simply one tool that can be used as part of the overall foreign investment framework (inbound and outbound). Tax treaties generally apply to all business sectors, and therefore the provisions of most relevance to the extractive sector will need to be considered in that context. Of course the reverse is also true, so that amending or terminating a tax treaty solely because of its impact on the extractive sector will also impact other business sectors.
The policy objective that is furthered by entering into a tax treaty and the related trade-offs need to be clearly understood. For example, imposing with-holding tax on interest paid to a foreign lender will protect against tax base erosion, but as explained in the section dealing with financing, since lenders invariably require a tax gross-up, it also effectively makes the cost of borrowing higher. Where this gross-up is tax deductible, the additional cost will be partly financed by reduced corporate income taxes.
At its simplest, a tax treaty can help eliminate or minimise double taxation for an extractive investor. This in turn improves the project’s post-tax returns to the investor and may improve the relative competitiveness of the project versus another competing investment. A tax treaty can also support a stable investment environment, as the tax treaty position should take precedence over future changes in domestic tax law and therefore effectively provide a known ceiling against future change of tax law risks. Through competent authority and mutual agreement procedures, a tax treaty can also provide a potential means to resolve tax disputes.
In conclusion, if the goal is to optimise the mineral production required to support global economic growth, there is a clear role for tax treaties to play as part of the overall tax policy framework for foreign investment. Since most major mineral producers are not also major mineral consumers, there is a collective interest in supporting a multilateral international tax framework – including tax treaties – that provides clear guidelines, supports efficient investment, and delivers benefits to all stakeholders.
The author of this chapter is the former global head of tax at Rio Tinto, and whilst the views expressed are strictly those of the author, the perspective and experience drawn upon are those of an international mining company investor.
Financing costs comprise the price for the provision of debt and equity capital, including any related financing and professional fees. It is the all-in cost of funding the investment expenditures and is incurred in addition to the expenses that the capital raised is spent on.
To learn more, visit http://www.taxtreatieshistory.org/, a not-for-profit joint project of the OECD, Institute for Austrian and International Tax Law Vienna (WU), IBFD, Università Cattolica del Sacro Cuore, IFA Canadian Branch, and the Canadian Tax Foundation, on the history of tax treaties and their provisions.
For more discussion on capital import neutrality, please refer to Chapter 5 in this book (Daniel and Thuronyi, 2016).
For a more detailed discussion on taxation of capital gains, please refer to Chapter 7 in this book (Burns, Le Leuch and Sunley, 2016).
Farm-in is the acquisition of a license for a consideration which, usually, is satisfied by an obligation to bear future costs connected with the license, although the consideration can take many forms, including cash. Earn-in is similar to a farm-in, but the license is not acquired until the consideration has been settled, usually by undertaking works in the license area.
Assume Investor A has a mining project that is worth $100m. The project needs an additional $100m of investment in order to begin production, when it will be worth $200m. Investor A enters into an earn-in agreement with another unconnected person – Investor B. Under this earn-in agreement Investor B will earn a 50 percent share of the mining project provided that Investor B invests the $100m capital needed to bring the mine into production. Investor A currently owns 100 percent of a mining project that is worth $100m. Once the earn-in is completed Investor A will own 50 percent of a mining project worth $200m, or $100m. In other words, the value of what Investor A expects to have before and after the earn-in agreement is the same, and in that sense there is no disposal to tax. It is economically equivalent to and often takes the form of the mining company issuing new shares and using the capital proceeds to develop the mine. Shareholders who do not participate in such an equity raising see their interests in the company diluted but have not made a disposal.
For a good description of the purpose of tax gross-up clauses in lending documentation, see The ACT Borrower’s Guide to LMA loan documentation for Investment Grade Borrowers, produced by Slaughter & May February 2010.
See this explanation on the IFC website: http://www1.ifc.org/wps/wcm/connect/Topics_Ext_Content/IFC_External_Corporate_Site/IFC + Syndications/Overview_Benefits_Structure/Syndications/B + Loan + Structure + And + Benefits/
For example, a copper mine may produce significant by-products such as gold, silver, molybdenum, and others.
International Accounting Standard 36 Impairment of Assets seeks to ensure that an entity’s assets are not carried in the financial statements at more than their recoverable amount (i.e., the higher of fair value less costs of disposal and value in use). With the exception of goodwill and certain intangible assets for which an annual impairment test is required, entities are required to conduct impairment tests where there is an indication of impairment of an asset, and the test may be conducted for a “cash-generating unit” where an asset does not generate cash inflows that are largely independent of those from other assets. For examples in the mining sector, see the BHP Billiton financial statements for the year ended 30 June 2012, Rio Tinto financial statements for the years ended 31 December 2011 and 2012, and Anglo American financial statements for the year ended 31 December 2012.
A retained or overriding royalty can be used in the situation in which a seller and buyer may not agree on the value of a mineral asset. The seller may retain a royalty that pays in certain price scenarios as a practical way of bridging that valuation gap. The seller can then dispose of the retained royalty at a later time if it wishes. Another common scenario is when the seller wishes to insure against seller’s remorse by using a royalty to preserve some upside interest.
Many large multinationals engage in periodic reviews of their corporate structure to eliminate companies that are inactive or superfluous to requirements, as these are costly to administer in terms of compliance and audit responsibilities.
I have deliberately not described these as non-renewable natural resources because many metals can be and are in fact recycled. However, from the perspective of the country where the minerals are extracted they may be a non-renewable source of income.
See the OECD Manual on Effective Mutual Agreement Procedure for a detailed description of best practice in this area – http://www.oecd.org/ctp/dispute/manualoneffectivemutualagreementprocedures-index.htm.