Abstract

This chapter analyses the administrative challenges presented by different resource tax instruments. It concludes that all tax bases commonly used for resource taxation present significant administrative challenges. Progressive profit-based taxes1 can present greater challenges than others. Importantly, however, the capacity required to meet those challenges in a well-designed progressive profit-based resource tax regime can be quite limited, and is often exaggerated. Certainly the potential difficulties need not rule out adoption by a developing country with poor administrative capacity if, as is often the case, the country’s resource industry is concentrated in the hands of a relatively small number of large companies. In any case, the apparent simplicity of alternatives to such regimes is often, in practice, deceptive.

1 Introduction

This chapter analyses the administrative challenges presented by different resource tax instruments. It concludes that all tax bases commonly used for resource taxation present significant administrative challenges. Progressive profit-based taxes1 can present greater challenges than others. Importantly, however, the capacity required to meet those challenges in a well-designed progressive profit-based resource tax regime can be quite limited, and is often exaggerated. Certainly the potential difficulties need not rule out adoption by a developing country with poor administrative capacity if, as is often the case, the country’s resource industry is concentrated in the hands of a relatively small number of large companies. In any case, the apparent simplicity of alternatives to such regimes is often, in practice, deceptive.

The conclusion that administrative difficulty need not rule out a progressive profit-based resource tax regime is subject to two important provisos, namely that within such a regime, so far as is possible: policy is simplified and made workable, and administrative procedures and institutional capacity and governance strengthened.

In practice these provisos are often not met. This chapter does not discuss strengthening of administrative procedures and institutional capacity (which are discussed in Chapter 12 by Calder). But it discusses ways in which policy might be simplified to minimize administrative complexity. It briefly discusses practical and political obstacles. Finally it discusses the role of tax administrators in the formulation of resource tax policy.

2 Types of resource tax base and challenges they present

Resource tax policy means the design of the rules governing resource taxes. These rules may be found either in tax legislation or in licence agreements. There are two different types of tax rule: (1) those that determine who pays tax, on what (the tax base), and at what rate, and (2) those that set out the administrative procedures to be followed. The design of administrative procedures is itself a matter of choice and policy, but the term tax policy is more commonly used to describe the design of the tax base and rates, and it is in that sense that policy is discussed in this chapter.2

There are various types of resource tax base, and some present greater administrative challenges than others. To mention some of the most common:

  • Bonuses payable when exploration and production licence agreements are signed (or on some later event such as commercial discovery) are the simplest of all. They require a single payment on the happening of a clearly defined event, with no on-going administration. (Of course, awarding licences in a way that achieves the best possible negotiated terms and avoids the risks of collusion and corruption requires the design of sound administrative procedures, and raises many important and complex issues.3 These are not, however, generally thought of as a tax administration issues, and are not discussed in this chapter.)4 Bonuses, being paid up-front, are obviously not responsive to later unforeseen changes in profitability or prospects, so large bonuses may lead to re-negotiation of the resource tax regime, thus indirectly creating administrative complication later.

  • Specific (volume-based) taxes ($x per barrel or tonne, for instance) are the simplest on-going tax. This is not to say that they are without difficulty. Establishing the volume of production is essentially a physical process – installing, maintaining and testing meters to measure production quantities, analysing the quality of production, monitoring production flows to ensure there is no scope for illegal extraction or theft. These processes are sometimes described as physical audit. They are highly technical and also require complex equipment. Analysing production can be particularly difficult with mining extraction, where tax authorities typically face the challenge of having to determine the mineral content of large piles of rocks being exported for processing. This requires considerable expertise both in mineralogy and sampling techniques, as well as sensitive and expensive measuring equipment.

  • Ad valorem (value-based) taxes (y% of gross revenue, for example) are the next simplest tax. Value is volume times price, so the difficulties of establishing price are added to those of establishing volume. The huge volatility of natural resource prices increases the scope for error and manipulation. Reliance on realized sale prices presents major risks. The main problem is transfer pricing between connected parties. Connected party transactions are common in resource industries, which are often carried out by vertically integrated company groups engaged in downstream as well as upstream operations. Resource production is normally subject to a high tax regime, so the risk of these transactions being mis-priced in order to transfer profits to a lower tax regime is significant, and can arise with not just cross border but also domestic transactions. Establishing market values is often easier for natural resources than for other industries since prices of internationally traded physical commodities are generally quoted on international exchanges and by international pricing services such as Platt’s. (For other industries it is often necessary to value non-traded services or intellectual property). But prices may not be quoted for rarer minerals, and even for common ones pricing can still present difficulties because of variations in quality, or because there is no access to international markets (often the case for gas,5 and sometimes even for oil where pipeline capacity is limited) and a limited domestic market from which to establish comparable uncontrolled prices. Even where parties are not connected, there are risks of artificial and manipulative pricing, for example where overseas energy markets are subject to government regulation, or where the terms of contracts between unconnected buyers are affected by undisclosed separate contracts. Use of different pricing bases also presents problems.6 Use of financial instruments to hedge against (or speculate on) commodity or currency price movements can be a further complicating issue (and discussed further in Appendix I).

  • Profit-based taxes add significant additional complications. Profits are essentially revenues less costs. Establishing revenues involves not only all the difficulties of valuing production but the difficulties of valuing other revenues that might be included, such as ancillary income, financial income, gains on disposal of licence interests, etc. It also involves all the difficulties of establishing costs. For example:

    • Applying different depreciation rates and categorizing costs for that purpose;

    • Applying “uplift”7 (where relevant) and categorizing costs for that purpose;

    • Accounting issues on timing of cost recognition, including the treatment of stocks, and of provisions and reserves (abandonment provisions are a particularly important feature of resource production accounting);

    • Allocation of cost, and ring-fencing8 issues – difficult generally, and particularly difficult where widely different tax rules and rates apply to linked operations such as oil and gas production;

    • Applying cost recovery limits;

    • Transfer pricing of costs;

    • Treatment of finance costs. This includes the problem of thin capitalization,9 and may be complicated by finance leasing,10 currency gains and losses, and use of financial instruments to hedge against interest and exchange rate movements on borrowings;11

    • Applying cost control rules and mechanisms;

    • Applying other specific limits on deductibility;

    • Links to other cost regulation (where tax deduction depends on adherence to non-tax regulations, e.g. on employment policy);

    • The treatment of cost offsets, e.g. compensation receipts, insurance recoveries;

    • The treatment of losses.

  • Rent capture mechanisms of various kinds (as reviewed in Land (2010) and, for minerals, Otto et al. (2006)) modify volume, value or profits-based taxes in ways intended to capture a larger share of rent.12 Sometimes the modification may simplify the underlying tax (for example, an excess profits tax could have simpler or more restrictive rules for finance costs than the normal profits tax)13 but more often the modification adds complexity, and may also magnify the difficulty of the underlying tax (for example, a profits-based rent capture mechanism increases sensitivity to misallocation of cost). Some rent capture mechanisms are less complex than others, but the least complex (for example, oil royalties with a rate that varies with water depth) may be the least effective at capturing rent. To meet their intended purpose some rent capture mechanisms, such as excess profits taxes or rate of return-based production sharing, ought to apply to cumulative results over the life of production, which adds slightly to their administrative complexity.

  • State commercial participation is not strictly a tax, but limits on government commercial risk may make it tax-like. It poses some administrative challenges similar to those of tax administration, for example the need for reliable and transparent accounting, as well as commercial and business challenges (though these will be reduced to the extent that the government merely acts as a sleeping partner). State commercial participation may involve service or “buy back” contracts with international oil companies (where the company has no equity interest but merely receives a fee). Oversight of such contracts presents some challenges similar to those faced in administering profits taxes (for example, monitoring and controlling costs).

It can be seen that the above types of resource tax form an ascending ladder of administrative complexity, with each new step adding a further level of complexity to the previous level, and with a particularly large increase at the step from value-based to profit-based taxes.14

Resource production companies are also subject to normal business taxes, such as VAT, import and export duties, income tax on non-production activities, and withholding taxes. These taxes normally apply in the same way as to other companies, so they do not normally raise policy or administrative issues peculiar to resource production. They are therefore not directly relevant to the subject of this chapter, but two points are worth mentioning:

  • Resource production companies typically become entitled to large VAT repayments (since almost all of their output is exported, and hence zero-rated), and these present particular administrative difficulties (discussed in Chapter 3 on resource tax administration);

  • Payments to service contractors are a particularly important feature of resource production, and withholding taxes on those payments present significant administrative problems in their own right, discussed at Appendix II.

3 Administrative difficulty not to rule out progressive profit-based regime

If administrative considerations are ignored, resource tax policy should be determined entirely by the government’s wider policy aims. The main objective will generally be to strike the best balance between, on the one hand, maximizing government revenue and, on the other, providing a competitive enough regime to encourage development of resources in accordance with overall economic and resource management policy. A further but possibly secondary objective may be to secure early and assured resource revenues, thus reducing government risk.

It is sometimes argued that these objectives are difficult to achieve with a tax regime based wholly or mainly on production taxes such as royalties. A low royalty rate encourages investment when prices are low, but gives the government a poor return when prices are high; a high rate gives the government a good return when prices are high, but discourages investment when prices are (or are expected to be) low. Similar arguments apply to very simple profits taxes. The desired objectives can generally best be fulfilled by a mainly profit-based tax regime incorporating an effective rent capture mechanism, with a limited role for royalties or cost recovery limits to reduce government risk and provide assurance of early revenues.

Apart from these theoretical arguments, practical international tax considerations may also point in the same direction. If international companies pay mainly production taxes, they are likely to be subject to profits taxes in their home country, since production taxes are not creditable. Taxing rights are thus in effect shared with the overseas country, reducing the tax the resource producing country can impose without creating disincentives. Profits taxes, on the other hand, can be designed to be creditable against home country tax under double tax provisions, giving the resource-producing country sole taxing rights. (Government share of profit oil may not itself be a creditable tax, so resource-producing countries normally impose income tax on the contractor’s share of production to ensure that taxing rights do not pass overseas).

But, as explained, profits taxes and sophisticated rent capture mechanisms present complex administrative problems. Their complexity and difficulty of calculation make them less transparent than other taxes and thus increase opportunities for corruption and bureaucratic rent-seeking. Administrative considerations must be taken into account in designing a tax regime. It is no use having a theoretically perfect regime that is in practice impossible to administer. On the other hand the administrative tail must not wag the policy dog. The aim is not to avoid administrative difficulty for its own sake, but only so far as that difficulty makes the government’s policy objectives impossible to meet in practice.

The argument that resource taxation should be based mainly on progressive profits taxes is not without controversy, and this chapter does not aim to take sides on the issue (discussed more fully in Boadway and Keen (2010) and Land (2010)). Instead it merely addresses the question: If a progressive profit-based resource tax regime (i.e. one based mainly on profits taxes and effective rent capture mechanisms) is considered to meet a government’s broad policy objectives more effectively than the alternatives, should the difficulty of administering such a regime nevertheless discourage governments with poor administrative capacity and governance from adopting it? And if so, what levels of capacity and governance are required before such a regime should be adopted?

Clearly it is difficult to generalize. Where, at one extreme, a resource industry consists of a small number of major sophisticated investors producing minerals with high but volatile unit prices from a small number of hugely profitable projects, then the case for such a regime may be stronger, and the administrative challenges it presents less demanding – for taxpayers and governments – than where it consists of a large number of small unsophisticated businesses producing low value bulk commodities at steady prices from numerous small, low profit operations.

This is no doubt one of the reasons that mining tax regimes tend in practice to be more oriented than oil tax regimes towards production taxes:15 in some countries mineral production is carried out by a relatively large number of players, some of whose operations, particularly before the commodity boom, were not necessarily very profitable. But in other countries the mining industry is highly profitable and concentrated in a few hands, as the oil industry usually is. One of the main reasons for the greater production tax orientation in those countries may be simply that their tax regimes are older and came into existence when economic theories of tax design were less well developed.

This chapter is mainly focused on the situation where resource production is dominated by a small number of highly profitable companies. There is a strong case for arguing that if a progressive profit-based resource tax regime has significant policy advantages, then all such countries, no matter how poor their levels of capacity and governance, should be capable of developing the capacity needed to administer such a regime to the standard required to achieve those advantages. The standard required is not necessarily perfection. If the policy advantages are significant then an imperfectly administered progressive profit-based regime may meet the government’s objectives more effectively than a regime based mainly on simpler taxes, however well administered. In other words the policy benefits such a regime may outweigh the administrative benefits of the simpler alternatives. The question therefore is not whether a developing country can develop the capacity to administer a progressive profit-based regime perfectly, but whether it can develop the capacity to administer it effectively.

Say that the government of a developing country concludes that in most likely scenarios a progressive profit-based regime will, if administered to the standards prevalent in developed countries, result in significantly higher investment and a significantly higher tax take than a regime based mainly on production taxes. The argument that it should nevertheless adopt the latter kind of regime must rest on the proposition that the additional capacity required for effective administration of a progressive profit-based regime cannot be acquired at any cost, or at least not at a cost (including opportunity cost) significantly less than the likely benefit. Just how credible is that proposition, given the scale of resource tax revenues in most resource-rich countries, and the small number of companies whose tax has to be administered? Just how expensive can a good tax auditor be? Can the cost really be so significant relative to the tax involved? The capacity demands of a progressive profit-based resource tax regime can in fact be quite limited, and are often exaggerated.

But this argument does not just have to be settled on the basis of theory. The test case is Angola: a poor country, ravaged by years of civil war, generally perceived as having extremely poor capacity and governance, which nevertheless adopted what is regarded as one of the most progressive and sophisticated resource tax bases, rate of return-based production sharing. Angolan oil tax administration is far from perfect: it has many serious defects. It also has strengths, and continues to be strengthened, though it has a long way to go. The important point is that, taken in the round and despite all its serious administrative weaknesses, Angola’s progressive profit-based oil tax regime broadly achieves the intended policy objectives and is generally considered, by international standards, to be reasonably effective. If Angola can achieve this, can it really be beyond other countries?

A second leg to the argument that limited administrative capacity should not be a barrier to adoption of progressive profit-based taxes is that in practice the administrative simplicity of tax regimes based mainly on production taxes is often deceptive. Even their original design tends to be complicated by multiple royalty rates for different minerals and different project areas, often with complex, discretionary provisions built in to cope with adjustments to costs or prices. Then, despite these complications, such regimes are often destabilized by later resource price volatility, with new taxes being introduced, or bells and whistles added to existing taxes, to make them responsive to changing economic environments.16 These changes create an administratively complex patchwork of taxes, and may also offer opportunities for corruption since they are often based on administrative discretion or informal memoranda of understanding. They also increase perceived investor risk. So as well as being less fitted to meet government policy objectives in theory, this kind of regime may in practice be administratively more complex and less transparent than a progressive profits-based regime built on one or two complex but uniform, flexible and stable taxes.

Of course the fact that even countries with poor general administrative capacity should be capable of effective administration of a progressive profit-based tax resource tax regime is no guarantee that they will be. That depends on them taking the steps necessary to strengthen administrative procedures and institutional capacity. Often there is a lack of political will to do this. (But without this political will it is likely that any tax regime will be badly administered).

It also depends on them having a workable progressive profit-based resource tax regime. Often, administrative capacity is inadequate not so much because this kind of regime has been adopted as because it has been poorly designed.

4 Scope for simplification within progressive profits-based tax regime

Clearly if countries adopt a progressive profit-based regime, they should do as much as they reasonably can to simplify administration within that overall framework. It may be possible to do this in ways that carry no significant policy cost.

A Consolidate tax sub-regimes

One source of complexity in many countries is the existence of several different resource tax regimes. Often this is for the reasons discussed earlier, that simple tax regimes have been progressively complicated to make them more responsive to changes in the economic environment. Sometimes it reflects changes of tax policy and fashion. For example it is not uncommon to find a traditional tax and royalty regime applying to original resource concessions, and PSAs applying to later ones, with different negotiated fiscal parameters and production sharing rules in later PSAs from those in earlier ones. Bringing these different sub-regimes more closely into line would simplify administration.

B Use standardized contracts

If tax policy requires different licence areas to be taxed in different ways, the resulting complexity will be greatly reduced by the use of standardized contracts or concession regimes, with a limited number of variable parameters.

C Use familiar industry and accounting concepts

The use of familiar and internationally established industry concepts – for example in the categorization of tax deductible costs – will also simplify administration. Commercial accounting principles may not provide a sufficiently reliable measure of profit, but there are administrative advantages to using them as the starting point, with modifications only where required to provide greater clarity and uniformity or incorporate specific policy objectives.

D Reduce the number of taxes

Another source of complexity is the existence of numerous different resource taxes. To some extent this may be unavoidable. For example, a single tax combining a charge on profits with a royalty on production might not qualify for double tax relief against overseas profits taxes, so royalty has to be a separate tax. And production sharing might have to be combined with a separate income tax, again to ensure there is no overseas tax (as explained earlier).

But often there is a whole zoo of minor additional taxes, such as education tax, surface rental, tariffs, and so on, with little apparent policy justification: often a minor adjustment to the rates of the main resource taxes would generate as much revenue as all these minor taxes combined. Sometimes the intention is to hypothecate these taxes to a particular purpose. But it is questionable whether meeting, say, education expenditure from a possibly volatile tax has clear policy advantages over meeting it from a planned central budget. These minor taxes are often individually simple to administer, but their overall effect is to complicate the tax regime.

Regional taxes (for example, taxes charged by states operating within a federal structure) are often an issue, especially because of the highly uneven geographic distribution of resource production in many countries. Sharing of resource tax revenues with sub-national governments may be desirable on policy grounds, but it is administratively much simpler if this is done by distributing a centrally administered tax via the central budget, rather than allowing sub-national governments to administer their own separate taxes, and it can also be argued that this is preferable for policy reasons.17

E Coordinate rules for different taxes

Reducing the number of taxes, where possible, will simplify administration. Where it is not possible, the complexity resulting from having several resource taxes can be reduced by:

  • Using common building blocks in their design. For example, the measure of production for royalty purposes can be the same as its measure for income tax purposes. In a combined production sharing and income tax regime, the measure of profit oil and of income tax profit often differs (for example, interest may be allowed as a deduction in calculating income tax profit but not profit oil) but even if not identical, the measures should at least capable of straightforward reconciliation.18

  • Minimizing the number of government agencies responsible for them.

  • Coordinating their administrative rules. For example it may be possible to bring different taxes together in a single tax return so that they are subject to common filing rules. And if different taxes use common building blocks, common audit and disputes resolution procedures may be possible.

F Simplify particular provisions

In many countries particular provisions of resource tax legislation present more than their fair share of administrative difficulty, and there is often scope to reduce that difficulty by simplifying those provisions. The following are examples of approaches taken by some countries to simplifying the treatment of problematic issues:

  • Pricing of production on the basis of benchmark prices may be a cruder but simpler and more transparent method than pricing it on the basis of actual sales subject to transfer pricing rules.

  • Differences in the tax treatment of different cost categories (for example, different rates of depreciation or uplift on exploration, development and production costs) are a major source of complexity. Reducing these differences may result in a less sophisticated measure of profit, but may be simpler and more transparent.19 Allowing immediate write-off of costs more widely may reduce government cash flow, but this can possibly be compensated for by adjusting royalty rates or cost recovery limits.

  • Allowing interest deductions based on standard rules (for example limiting eligible debt to 50 per cent of development costs less production income, or applying earnings stripping limits) may be cruder than allowing interest based on individual assessments of what companies could borrow in the open market, but again may be simpler and more transparent.

  • Placing reasonable limits20 on deductible costs paid for goods and services from associated companies may be cruder than allowing full deduction but restricting costs to market value, but again may be simpler and more transparent.

  • The treatment of currency gains and losses is often seen as problematic. International accounting standards now provide generally consistent rules, but may not apply in a particular country, or may not form the basis for a particular tax. Where, as is often the case, resources and major contracts for costs are priced in US dollars, and companies prepare their accounts in dollars, the incidence of exchange differences in tax computations will generally be minimized if companies are also allowed to account in dollars for tax purposes.

  • Taxation of capital gains on disposal of licence interests can add numerous complications and uncertainties to resource taxation, but some approaches are simpler and more transparent than others.21

Some simplifying measures of the above kind involve departures from taxing companies on the basis of their actual profits. Foreign tax credit for resource taxes may require them to be based on profits, and there is a risk that any such departures will lead to loss of tax credit. It is difficult to be specific about this, because the law in the overseas country is often unclear on this issue (and the line taken by the overseas tax authority may differ from the one taken by the courts). But generally, if the departure from actual profits has a marginal overall effect, or is narrowly targeted on tax avoidance, or is mainly to clarify something that would otherwise be uncertain, there is a reasonable chance that the tax will remain creditable.

Simplifying measures of this kind undoubtedly introduce rough edges into the tax system, and quite apart from causing foreign tax credit problems these may make administration more, not less, difficult. For example:

  • Formulas to cap costs can become arbitrary and unrealistic, distorting decisions and generating avoidance and pressure for negotiated concessions. If deductible costs cease to bear any relation to real costs, foreign tax credit is also jeopardized.

  • Some countries allow uplift on certain categories of cost instead of allowing a deduction of finance costs. This can increase disputes about cost categorization, and the combination of uplift and high tax rates can reduce companies’ incentive to control costs, and even create “gold plating” incentives, where for each dollar spent a company saves more than a dollar in tax.22 Tax administrators must then try to identify and disallow unnecessary expenditure, which can involve complex and opaque negotiations. Non-recognition of finance costs may also jeopardize foreign tax credit.23

Striking the best balance between administrative simplicity and transparency on the one hand and optimal policy objectives on the other is not straightforward. Many developing countries have individual resource taxes that are admirably simple and straightforward from an administrative viewpoint, but have a resource tax regime that is too complex overall, because of the number of different taxes and the number of different sub-regimes applying to different licence areas. (But considering the extravagant complexity and obscurity of the tax regimes of some developed countries, there should certainly be no assumption that they are any better at striking the right balance).

5 Resource tax and resource management

Links between resource taxation and resource management add considerably to administrative complexity. By resource management is meant the management and control of resource operations. All countries regulate resource operations to some degree. They designate licence areas, negotiate and issue licence agreements, agree and monitor work programs, impose health and safety rules, set out obligations to protect the environment, for example, by removing oil installations at the end of production, and so on. This regulation is normally the responsibility of a sector ministry, but in PSA regimes it is usually shared with the national resource company (NRC).

In most developed countries, there is little connection between resource management and resource tax administration, but in developing countries there is often a close connection. This is clearest in PSA regimes, where companies must have their budgets and costs approved by the NRC or sector ministry on a day-to-day basis. Approval might be withheld for a range of operational reasons, for example, technical objections, commercial objections, environmental objections, employment policy objections, objections about lack of local content and so on. Whatever the reason, costs not approved are non-recoverable for the purpose of calculating profit oil. Often this means they are not deductible for the purpose of income tax on the contractor’s share of profit oil either. Operational requirements are also more likely to be built into developing countries’ traditional tax and royalty regimes. For example, costs may not be deductible if they are not in accordance with employment laws, insurance requirements, environmental regulations and so on. More generally, tax legislation may require costs to be “necessarily” incurred.

A simplified way of describing this difference of approach is to say that in some countries the job of the tax authorities is to tax the production or profits companies actually achieve, while in others the job is to tax the production or profits they ought to achieve. A major factor behind the second approach is a concern that resource production companies, left to themselves, cannot be relied upon to control costs. This concern may be justified if the tax regime contains inadequate cost containment incentives or even “gold plating” incentives.

What is certain is that building resource management objectives into resource tax legislation makes tax administration much more complex and demanding. It is hard enough to find people able to interpret tax laws and audit tax returns effectively, let alone able to tell oil companies how to run an oilfield. Tax administration can be made simpler and more transparent if tax design contains adequate cost containment incentives, and fiscal and resource management regulatory functions are then kept separate.

6 Practical obstacles to policy simplification

The foregoing discussion of tax policy and administration may seem somewhat academic, given that resource rich countries already have resource tax regimes in place. (Indeed countries often have resource tax regimes in place before resources are even discovered). These tax regimes may be sub-optimal, but in practice may be difficult to modify even to eliminate major policy flaws, let alone to simplify administration. Re-negotiation of contracts or introduction of new tax legislation may face practical or political obstacles. Any change of tax base creates losers, who will object to the change. The existing tax regime may be frozen by stabilization clauses (the pros and cons of such arrangements are discussed in Daniel and Sunley (2010)). Even where the granting of new concessions creates an opportunity to change the rules, the advantages to be gained from doing so may be outweighed by the disadvantages of creating yet another distinct sub-regime.

What this means is that there are often severe practical limits on the scope for amending tax policy to simplify tax administration. As is so often the case, the best way to reach the desired destination is “don’t start from here,” but starting from anywhere else is impossible. That said, new tax resource tax regimes do come into existence, and existing ones are often not quite as stable in reality as they are in theory. And even within an existing regime companies may be willing to accept changes that make the law clearer, simpler and more uniform, if introduced with proper warning and consultation. Companies, after all, have an interest in stabilization of tax, but they have no interest in the stability of unpredictable and inconsistent tax administration. Some of the simplifications suggested earlier relate to the administrative framework rather than to tax policy. Even these may require extensive changes to legislation and licence agreements, which countries may be reluctant to contemplate, but in general changes to the administrative framework are less sensitive than changes to the tax base, and less likely to be challenged under stabilization clauses, particularly where they benefit companies as well as the government.

So opportunities to re-design tax so as to improve administrative simplicity and transparency may arise, and should be taken. An important part of any tax administration reform programme should be a detailed review of resource tax legislation to identify sources of avoidable administrative difficulty.

7 Policy role of tax administrators

There are clear arguments against combining the tax policy and administrative functions. Tax administrators are not best qualified to develop resource tax policy so as to reflect the government’s overall economic and resource management policies. They may also face a conflict of interest, and, whether for honourable or self-interested motives, give excessive weight to administrative considerations in formulating policy. Combining policy and administration may also increase the risk of inappropriate political interference in administration.

Tax administrators should, however, be involved in the process of tax design, particularly on its practical aspects. They are best placed to advise on the practical implications of new tax policy, and to identify areas where existing policy is failing to achieve its desired objectives, perhaps because of loopholes or uncertainties in the law. Many issues that countries identify as causing problems for tax administration essentially result from such policy failings. Often there is scope to resolve them by administrative means, but sometimes what is needed is a change in the law. But where administrative departments have no effective tax policy advisory function these detailed issues are not brought to the attention of ministers. There may be a presumption (on the part of ministers and companies as well the administration itself) that stabilization clauses rule out changes in the law anyway. But where the tax base is being eroded by the exploitation of loopholes or ambiguities in the law, governments must be ready to change the law, whatever stabilization clauses may be in place (a risk that companies should be aware of). So tax authorities should be encouraged and given the resources to carry out a limited policy advisory function.

Long range revenue forecasting and scenario building are essential to policy formulation, and tools such as economic models may be developed for this purpose. This is primarily a matter for tax policy makers rather than tax administrators. But again it is appropriate for tax administrators to play some part in this, since their work provides information helpful for forecasting, and they also need to understand and be able to account for any major discrepancies between forecast and actual revenues.

8 Conclusion

Weaknesses in administrative capacity should not prevent countries from adopting what they see as the best resource tax policy framework. But within such a framework they need to design policy so as to make administration simple and transparent as possible. There may be practical and political obstacles to achieving this, particularly where a resource tax regime is already established, but political will, constructive dialogue with companies, and development within tax administration of a strong tax policy advisory function may allow some of these difficulties to be overcome.

Appendix I Taxation of hedging instruments

Many resource tax administrations report particular difficulty with the tax treatment of hedging instruments. (These instruments can of course also be used for speculation).

Companies can hedge receivables or payables. Examples of the latter include hedging against interest or exchange rate movements on borrowings. Insurance contracts can also be considered as a type of hedging. For simplicity, however, this appendix focuses on hedging against commodity or currency price movements relating to resource revenues. There are many types of hedging instrument, but in general they are based either on a forward contract (which obliges both parties to deal at a future date at a set price) or an option (which gives one party the right to deal with the other at a future date at a set price). Instruments of the latter type raise more complex accounting issues. Again for simplicity, this note considers the issues by reference to the former type of instrument.

International companies often carry out hedging operations through their head office management company, since it has a complete picture of group companies’ overall net exposure to risks, and can hedge them more efficiently. But sometimes local companies may be allowed to hedge their own risks, perhaps because it is considered more tax efficient.

The basic problem often faced by tax administrators is a lack of clear policy on these instruments. Tax law often contains no specific provisions about them, and their treatment under general tax provisions may be unclear. Sometimes this uncertainty just relates to timing of recognition of gains and losses. International accounting standards have in recent years developed more consistent treatment of these instruments, but that is of little help if the tax concerned is not based on commercial accounting principles, or if international standards do not apply in the country concerned. Sometimes there is a more fundamental uncertainty as to whether tax law provides for gains and losses on these instruments to be recognized at all. The lack of a clear policy direction makes it difficult for administrators to decide how to attempt to resolve these uncertainties.

Even where a particular treatment can reasonably be inferred from general tax provisions, tax authorities are often uneasy about whether it is appropriate or consistent with policy intentions. In some cases this unease may reflect the fact that different taxes appear to treat hedging in different ways. For example, it may be clear that hedging transactions cannot be recognized for the purposes of royalties or production sharing, but that they can be recognized for the purposes of company profits tax. Of course, different taxes do not have to be consistent, but the absence of any clear policy reason for the inconsistency inevitably raises doubts about whether it is intended. Another possible inconsistency is between the treatment of a forward sale (where a company sells nickel in June, say, for delivery at the end of December) and of a spot sale hedged by a separate forward contract (where, say, a company sells nickel on the spot market in December, which it had hedged by a separate forward contract with a third party in June). These two transactions may be economically equivalent, but in some countries tax law may apply to them differently. Again this inconsistency may raise doubts about the underlying policy intention. There may also be concerns that companies can somehow exploit such inconsistencies to avoid tax. Indeed tax authorities may be generally uneasy about the tax avoidance potential of these instruments, and this may be amplified by their lack of knowledge or understanding of them.

To the extent that this is a policy issue, it strictly falls outside the scope of this chapter. But it is the sort of technical policy issue with which tax administrators have to grapple and on which they are commonly expected to advise. The appropriate advice may, however, depend on a number of factors.

One factor that may influence thinking is a perception that resource companies can consistently “beat the market” when using hedging instruments. If they can, the government might fear that they can use their forecasting skills to avoid tax. For example if a company “knew” that oil prices would rise more than the market expected, it could generate a loss by hedging in (high tax) country A against the price going down, but generate a corresponding profit by betting in (foreign tax haven) country B that the price would go up. It would seem quite unlikely that resource companies can consistently beat the market in this way, but some government officials and ministers may think otherwise.

A more important issue is whether the treatment of these instruments is consistent with the broad underlying policy objectives of the country’s resource tax regime. Broadly the policy options for these instruments are:

  • 1 Recognize all gains and losses for tax purposes;

  • 2 Disregard all gains and losses;

  • 3 Tax gains but disallow losses;

  • 4 Recognize some gains and losses, but not others.

In most developed countries the broad aim of company tax policy is to tax companies on the commercial profits they actually make (so long as derived entirely on an arm’s length basis) and not on the basis of some artificial construct created by tax law. The emergence of more consistent accounting standards has reinforced this trend. Option 1 is consistent with that policy, since hedging transactions form part of a company’s profit. But even in those countries there are often major exceptions to following commercial accounting principles for tax, and these often become a focus of tax planning and avoidance. Because of concerns about use of financial instruments for tax planning, countries adopting option 1 generally buttress it with some sort of anti-avoidance provision. Companies would probably prefer option 1 (assuming that the option of allowing losses and not taxing gains is unavailable!).

With natural resources, however, governments tend, particularly in the developing world, to see production companies primarily as instruments in the execution of the national resource exploitation policy, and resource tax as the price they pay for the privilege of being selected as such an instrument. Taxing them on their actual profits might be seen as a good idea if it promotes the government’s resource management policy, but is not a tax policy objective in itself; and in practice, in various ways, tax is charged without regard to actual profits. (For example, royalties and cost recovery limits produce tax irrespective of profits, ring-fencing rules exclude costs not related to resource production, and a whole range of other costs are disregarded as not in line with resource management objectives). Governments with this sort of outlook are unlikely to be persuaded that the fact that hedging transactions form part of companies’ actual profits is in itself a good reason to recognize them for tax purposes. And they may have positive reasons for not recognizing them. The fact that their tax regimes depart so far from commercial profit criteria may be seen as increasing the risk of such instruments being used for tax avoidance and arbitrage. Governments may be uncertain how far such fears are justified, but may be unwilling to take the risk. They may have little confidence in any anti-avoidance restriction or their capacity to enforce it.

Even if not used for tax avoidance, a more basic objection these governments might have is that tax recognition of hedging transactions would fundamentally weaken their control over resource management policy. In effect resource revenues would come to be determined not by actual prices in world markets, but by company decisions on hedging those prices. The extent of hedging would, moreover, be arbitrary as far as the government was concerned, since it would depend on the extent to which particular companies chose to hedge, and, in the case of international companies, the extent to which they did so through the local company. Governments might feel that, rather than subject themselves to such vagaries, they should adopt option 2 and then decide for themselves whether and how far to hedge their exposure to oil and currency prices, in the light of their own economic plans and risk management priorities.

Option 3 – tax gains but disallow losses – obviously gives governments the best of both worlds. Companies would object to it on basic grounds of unfairness, and on that basis it might seem that no government would adopt it. In some countries, however, it may be the reality, if their profits taxes apply to companies’ gross revenues, broadly defined, but give deductions for specifically defined costs, which do not include hedging losses (perhaps for the simple reason that no-one gave any thought to such things at the time when the law was framed). For practical purposes option 3 would soon morph into option 2, at least for international companies, since they would ensure that any hedging operations were carried out elsewhere (perhaps after having their fingers burnt in the meantime).

Option 4 – recognize some hedging transactions but not others – may currently prevail de facto in some countries, without any deliberate policy choice on the matter, simply because, as explained above, tax law recognizes them for the purpose of some taxes and not others. Alternatively, countries could actively choose this option because they wanted to distinguish transactions on some other basis – for example, to recognize genuine hedging transactions for the purpose of resource taxes, but not speculative transactions; or to recognize commodity price hedging but not currency hedging; or to recognize hedging transactions within defined limits but not beyond. Any such option is likely to be much more complex than the other options.

If hedging transactions cause tax administrations problems, it may be that what is needed is for them to identify examples and use them to initiate a policy discussion with ministers and companies, to establish clearly which of these options will be adopted as the way forward.

Appendix II Payments to subcontractors

A large part of the value of production is paid to service contractors. Understandably governments want to tax this activity (though it might conflict with their desire to build up their own service industries).

Service contractors should be taxed on their actual profits, but ensuring that they pay local business profits taxes can be administratively difficult, because they are often in the country temporarily and may have no permanent office. So governments often apply a simple but crude withholding tax (WHT) to the companies that pay service contractors.

Ideally contractors should be able to offset any WHT deducted from their receipts against their liability to local business profits tax. For contractors compliant with local business tax obligations, the WHT essentially becomes a payment on account of that tax. It is a final tax only for contractors not complying with local business tax obligations. An essential element of this arrangement is that where the WHT deducted exceeds the final business tax liability, the excess should be repaid. (In practice tax repayment procedures in developing countries are often very poor.)

In order to tax service contractors, it may be necessary to legislate to extend the normal geographic range of business taxes to include offshore areas.

The definition of the scope of the services to which WHT applies can raise a number of technical issues (for example, distinguishing service payments from lease rentals, agency fees, etc) to be considered in the course of tax audit. (WHT may, however, apply to lease rentals, etc, as well).

Service companies often demand payment on net of tax terms. Resource production companies then gross up the payment. The result is that the WHT becomes an additional company cost deducted in calculating their resource tax. With a 10 per cent WHT rate, a net payment of $90 is grossed up to $100. With a 60 per cent resource tax rate, the net cost of the $10 WHT to the resource company is $4, and $6 is in effect recouped from the government. But if service companies obtain tax credit for WHT suffered, resource companies may be able to resist net of tax arrangements or alternatively negotiate lower prices.

Taxation of service contractors raises various international tax issues. The normal rule in double taxation agreements (DTAs) is that a country can tax business activities of foreign taxpayers only if carried on through a permanent establishment. In some DTAs this requirement is disapplied to resource industry services. Clearly it is best for resource-producing countries if their DTAs are of this kind. In some cases this might require re-negotiation of DTAs. Many developing countries do not have a wide range of DTAs. Where DTAs do not exist companies may well be able to obtain double tax relief in their home jurisdiction in practice, and if the home country insists on their having a permanent establishment in the developing country to obtain double tax relief, setting up such a permanent establishment may be relatively straightforward.

It can be difficult in practice to establish where services are performed, and this too may require careful audit. Services may be performed partly in the country and partly abroad. If WHT is not to be easily avoided it will have to apply to such cases. How business profits taxes apply to such cases will depend on the precise wording of the legislation. Companies may split contracts to provide separate payment for services performed abroad and services performed locally, and the tax authorities will have to determine whether these are genuinely separate services, and if so, whether the allocation of price between them is reasonable.

Some developing countries have attempted to extend the scope of their taxes on services to include services performed wholly overseas – for example the overseas construction of a rig sold to an oil production company, or administrative and technical services provided by head office management companies. This is contrary to all the normal principles of international taxation. The overseas country in which the services are performed will reasonably regard those principles as giving it primary taxing rights over them, and will therefore not allow double tax relief for taxes charged elsewhere. The service company will therefore suffer double taxation, and may well recoup the additional cost from the production company.

In some cases it may be doubtful whether the country’s legislation allows the scope of the WHT to be extended in this way. But withholding taxes are not normally covered by PSA arbitration procedures, and companies may have no confidence in their ability to obtain a fair ruling under tax appeals procedures. In other cases it may be clear that the legislation does indeed provide for taxation of services performed wholly overseas.

This is sometimes described as a difficult issue, but there is no difficulty in judging the rights and wrongs of it. The developing country may resent so much of its resource revenues being used to pay for services performed overseas, but that provides no justification for taxing those services. If the shoe were on the other foot, and an overseas country decided to tax companies’ resource production activities in the developing country because it resented the high cost of those resources, there would be howls of outrage. The situation is no different.

It may be difficult in practice for companies to do anything about this. In some cases they may resort to avoidance – for example, buying equipment through an intermediary rather than direct from a construction company – but in other cases that may not be possible. They are unlikely to be able to persuade their home government to take retaliatory action against the developing country. (In some ways the developing country’s action presents the same problems as asymmetric guerrilla warfare.) Service companies will insist on net of tax arrangements or higher prices, so that most of the additional tax cost is effectively recouped from the government, but that may take time, and some of the additional cost will stick with resource production companies. In the longer term they will need to take account of this issue in negotiating licence agreements, and either obtain assurances of adherence to accepted principles of international taxation, or factor the additional tax cost into their bids.

Acknowledgements

I am grateful to David Kloeden, Michael Keen, Charles McPherson and other participants at an IMF seminar in July 2008 for helpful comments and suggestions.

1

By a “progressive profit-based tax” is here meant a profit tax levied at a rate that increases with the level of profit or profitability.

2

The choice between a traditional tax/royalty regime and a Production Sharing Agreement (PSA) regime is not a matter of tax policy in that sense, because, as has often been pointed out, similar tax bases can be designed under either regime. At the risk of oversimplification, the choice between these types of regime is essentially a choice between different administrative frameworks.

3

See for instance Chapter 10 by Cramton.

4

Tax administration requirements should be a factor taken into account in evaluating licence bids. It should be important, for example, that bidders have strong internal anti-corruption policies; are subject to anti-corruption laws in their home state; have strong administrative systems and controls; use international accounting standards; and require group companies to trade with each other on arm’s length terms. Awarding licences to a single company rather than a consortium may seem an administrative simplification but the lack of oversight by commercial partners may actually increase administrative risk.

5

See Kellas (2010) for a detailed discussion of gas pricing.

6

Ring-fenced resource taxes are generally intended to tax resource production at its value at a specified delivery point (for example a tanker inlet) less costs limited to those required to get it to that point. If, as is sometimes the case, a pricing basis other than FOB (free on board) is used – for example CIF (Cost Insurance Freight) – this effectively brings non-ring-fenced costs into account, and an adjustment (up or down depending on the exact nature of the pricing basis used) may be required.

7

Uplift means increase of actual costs by a fixed percentage for tax deduction purposes.

8

Ring-fencing may apply to resource production generally (that is, with revenues and/or costs arising from a company’s non-production activities excluded in calculating its resource tax liability) or to particular areas (where resource taxes for each area must be calculated separately). Complications are increased where these different kinds of ring-fencing apply to different taxes within a regime.

9

Thin capitalization is the excessive financing of business by debt rather than equity so as to exploit tax deductibility of interest.

10

A finance lease is an instrument that in substance is a loan financed asset purchase, but in legal form is an asset rental. International accounting standards recognize the substance and treat part of the lease rental as interest. If this is not followed for tax, finance leases can be used to circumvent tax restrictions on interest deductibility. (And if it is not followed for the purpose of PSA rules they can be used to avoid ownership of production assets passing to the state).

11

Appendix I contains a detailed discussion of the taxation of hedging instruments.

12

The term rent is used in this chapter to mean excess profits.

13

Interest deductibility is generally a requirement for income tax to be creditable against foreign tax. So long as income tax credit eliminates liability to foreign tax, there is no need for other taxes to be designed so as to be creditable.

14

Various hybrid taxes blur the distinction between value and profits-based tax. For example royalty may be calculated on production less certain defined costs – not enough to make it a true profits tax, but enough to ensure that it is not simply related to production value either.

15

Otto et al. (2006) provide an excellent and comprehensive summary of mining royalty regimes.

16

Most oil-producing countries have found it necessary to modify their tax regimes in recent years so as to capture more of the rent generated by high oil prices (Angola and Norway being two of the rare exceptions).

17

Sub-national taxes are less common for oil than other minerals. They are an important feature of some industrialized countries (e.g. Canada and Australia) and some Asian countries (e.g. Malaysia and Indonesia) but are not so common in sub-Saharan Africa.

18

PSA cost recovery limits are a major source of discrepancy between profit oil and income tax. Unusually, Indonesia decided to allow 100 per cent cost recovery to eliminate this discrepancy.

19

In the UK, for example, all oil company costs are now immediately written off. This is a departure from the accountancy principle of matching costs with revenues, but is a major simplification.

20

For example PSAs usually impose narrow limits on the goods and services that can be provided by associates and the charges that can be made for them.

21

The simplest and fairest way to incorporate licence disposals into profits taxes is to give symmetrical treatment to buyer and seller, but this produces little if any additional tax. An alternative simple approach, also producing no tax, is simply to disregard proceeds and costs of licence disposals for tax purposes. Some regimes provide for asymmetrical treatment (where the seller is taxed on the proceeds but the buyer’s ability to deduct the cost is limited). This may produce additional overnment revenues, but results in profits being taxed on an unrealistic basis, distorting investment decisions and encouraging complex tax planning and avoidance.

22

Cases where a dollar spent saves a large part of a dollar in tax are common, but cases where it actually saves more than a dollar are very rare (taxation of Nigerian natural gas providing one example).

23

It is understood, however, that the UK’s Petroleum Revenue Tax is accepted as creditable in the US on the grounds that uplift is a proxy for interest.

References

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Principles, Problems and Practice