Fiscal scope of natural resourcesALTax
There are often special rules for natural resource capital expenditure. Tax depreciation rules are sometimes based on elaborate classification of assets, but this may be difficult to apply to natural resource operations, opening the door to technical disputes.
New asset classifications specific to natural resource operations may be introduced, but these too may be complex, requiring extensive detailed guidance, and still leaving room for technical disputes.
Such complexity may be unnecessary and is best avoided. Governments often allow accelerated depreciation of natural resource capital expenditure as a tax incentive for investment (combined with counterbalancing ad valorem royalties or cost recovery limits to ensure that some tax is payable from start of production). This permits simpler depreciation rules than if depreciation aims to reflect the varying lives of different capital assets. It may also minimize noncompliance because it reduces the tax benefits of misclassifying capital expenditure as operating expenditure. Even if depreciation is not accelerated, there are advantages to keeping classifications simple and the number small.
For petroleum, expenditure can be classified into broad categories of exploration, development, and production. Production expenditure can be treated as operating expenditure and immediately expensed. Development expenditure can be treated as capital expenditure, and all such expenditure subjected to a common depreciation rule, possibly with limited and clearly defined exceptions.
Accounting standards allow different accounting treatment for exploration expenditure. Exploration is often counted as capital expenditure under general taxation principles, but in practice governments may offer special tax incentives for exploration for example, immediate write-off or exemption from normal ring-fence restrictions. These three broad categories are usually defined in legislation, but are well understood in the industry, and their use can simplify administration considerably.
A further common source of dispute is the treatment of indirect or intangible costs, such as intangible drilling costs. It generally simplifies administration if the law presumes that expenditure capitalized under standard accounting principles must also be capitalized for tax purposes.
Similar classifications may be useful for mining, but the rules may have to be more complex. For petroleum, drilling and installation of machinery generally happen mainly at distinct exploration and development stages.
There are similar distinct stages in mining, but ongoing production operations often require upgrading of very expensive heavy machinery, which is normally regarded as a capital expenditure even though not incurred as part of mine development. Again, it may help to rely mainly on classification of expenditure as capital or operating expenditures under generally accepted accounting principles.
Companies usually present their results favorably in their commercial accounts, which gives them an incentive to capitalize expenditure rather than write it off.
(Mining) The tax treatment of stripping costs (removal of overburden and waste materials to obtain access to ore) can be problematic. For accounting purposes, stripping costs incurred before production begins are generally capitalized, but until recently there was a wide variety of accounting treatments for stripping costs after production begins.
Accounting principles generally require depreciation of assets over the period in which they produce economic benefits. Depreciation could therefore be based on economic factors such as mineral depletion rate (described as the unit of production method), mine life, or the useful life of the asset. In some countries depreciation of assets for tax purposes follows accounting principles, or concepts such as useful life, mine life, or mineral depletion rate may be explicitly built into tax depreciation rules.
As a result, tax auditors must judge the amount of natural resources still in the ground and how long it will take to extract. Even experts may be unable to judge such matters with precision. Such rules will require tax authorities to develop specialized technological expertise, and even then, there will still be room for tax planning and dispute. Estimates of depletion rates or mine life, furthermore, change from year to year, complicating calculations and prolonging the scope for dispute.
Administration is much simpler if depreciation follows simple rules (for example, straight line depreciation of capital expenditure over x years or the shorter of x years and the number of years the license has left to run). The rules about the start of depreciation allowances (and any time apportionment within a year) should also be clear to prevent manipulation of timing of deductions.
Investment allowances (sometimes called uplift) and credit for capital expenditure are common in natural resource taxation, but like other artificial tax costs, present an opportunity for artificial tax planning and abuse, particularly where rates are high, and misclassification of expenditure is likely.
Basic computational rules for such allowances for example, the interaction with depreciation rules are sometimes unclear and open to dispute. The risks need to be understood and managed. Accelerated depreciation may be simpler to administer than investment allowances or credits.
Profits must be set aside for back-loaded costs of mine and well closures and environmental restoration. It is generally the responsibility of the natural resource ministry to negotiate abandonment and decommissioning plans and their funding.
Many countries require natural resource companies to place funds in an escrow account to meet this expenditure. Sometimes general tax rules disallow deduction of reserves and provisions, or leave their treatment unclear, but this is generally considered inappropriate for natural resource abandonment costs because it is in the government’s interest that companies provide for such costs, and profits during the abandonment years may not cover them.
From a tax administration viewpoint, the most straightforward approach is generally to link the deductibility of reserves to the abandonment plan agreed by the company with the natural resource ministry.
SOCIAL INFRASTRUCTURE COSTS
The law on deductibility of social infrastructure costs often needs clarification. Capital expenditure necessary for mining operations such as expenditure on transport infrastructure may be clearly deductible, but the position may be less clear for expenditure on schools, hospitals, and other facilities not directly used in mining operations. This may reflect unclear policy.
For example, the government may require natural resource companies to meet such costs under the terms of negotiated agreements, but regular CIT deduction rules may not cater clearly to their deduction. Reputable natural resource companies, recognizing the need for popular support, may voluntarily incur social infrastructure costs not specifically required by agreements.
Whether these are deductible may be even less clear. The rules may be inconsistent for CIT and other taxes such as production sharing. This could of course reflect a different policy intention for each tax, but more likely just shows that policy has not been clearly thought through. Where the law is unclear, the tax authority should establish the government’s policy intention and seek to apply the law in a manner consistent with it. Where, however, it is clear that the law does not allow these costs, the tax authority of course cannot allow them. In that case, it may be appropriate to recommend amendment of legislation if it is inconsistent with the government’s underlying intention.
Transfers of natural resource license interests are common, and there is considerable variation in how they are taxed.
Taxation of business transfers is not unique to natural resources, but the amounts involved can be exceptionally large, even billions of dollars, and there are often special natural resource provisions.
Some countries do not impose tax. Some charge CIT (or capital gains tax) on the transferor’s gain, but allow the transferee to depreciate the cost (a license is a wasting asset).
This treatment is broadly symmetrical but the government gains from timing of cash flow. Others charge CIT on the gain, but disallow or restrict the transferee’s costs. Some countries disallow particular costs of acquisition, such as signature bonuses or apply other taxes, such as value-added tax (VAT) or stamp duty to sale proceeds.
In some countries the rules, and the interaction with depreciation rules, are complex. Diff rent tax rates may apply to different kinds of assets included in a sale, which may give rise to valuation disputes and artificial tax planning.
Transfer pricing may further complicate the picture. The treatment of unrelieved losses incurred by the seller can also be complex because rules may be needed to prevent loss-buying: the purchasing of a loss-making business so that its losses can be counted against the profits of a different business (ring-fencing rules may be enough to prevent this).
Companies may seek to avoid tax on license transfers. The incentive is strongest where gains taxed are artificial (because they ignore acquisition costs) or the treatment of seller and buyer is asymmetrical.
One way to avoid tax on license transfers is through indirect transfer (that is, transfer of shares in the company holding the license.) This may be difficult for tax authorities to detect; general legislation on taxation of gains may not apply to gains on sales of shares held abroad. If it does, treaty restrictions may make it impossible to enforce payment even if tax is due.
Some countries are very concerned about indirect transfers and have developed legislation intended to tax them more effectively. One approach (adopted by the United Kingdom) makes nonresidents liable for tax on a gain on sales of shares whose value derives wholly or mainly from natural resource rights or assets, with a right to recover unpaid tax from the license holder.
Another approach is to deem that a license holder has made a disposal or partial disposal if there is a significant change in the ownership, direct or indirect, of its shares. Companies should self-assess such gains, subject to penalties for failure to do so. Such rules may, however, present major technical challenges.
Transfers of licenses for noncash consideration, such as swaps and farm-outs, may offer other avoidance opportunities.
These deals can be complex. A farm-out may, for example, require the farmer-in to pay a higher share of costs than the ownership share it is acquiring or to pay the farmer-out future overriding royalties contingent on results. The issue then is not just how to treat the payments for tax purposes when they are made, but how to tax the value of the right to receive them when the interest is transferred.
Capital gains legislation may not apply adequately to that value or tax auditors may not recognize that it represents a gain or may simply find it too difficult in practice to apply the law. If transfers for cash consideration are taxed, but not transfers for noncash consideration, companies will obviously structure transfers to avoid tax. Legislative change and/or training may be needed to ensure that valuable noncash consideration is taxed.
There may of course be genuine commercial reasons for structuring disposals in these ways, but where tax avoidance is the motive, the loss of tax may be significant.
WITHHOLDING TAXES AND DOUBLE TAX AGREEMENTS
WHT and double taxation agreements can play an important part in natural resource taxation, and there is a wide variety of approaches with different administrative implications. Some countries have very complex WHT regimes under domestic law and/or as a result of varied rates negotiated in double taxation agreements leading to administrative complexity and scope for tax planning. Treaty shopping may be a risk (for WHT on interest and dividends as well as on service payments), but this depends on the extent and nature of the country’s double taxation agreements. Limiting variations in WHT rates and widely defining the payments to which they apply simplified administration.
The application of WHT rules to service payments often depends on whether they are deemed domestic or foreign-sourced income. Disputes can arise over the source.
A clear definition of what constitutes a permanent establishment and of what should be regarded as domestic source income is required, but sometimes lacking. For natural resource producing countries, it is advantageous if legislation and double taxation agreements expand the permanent establishment definition to include natural resource exploration and exploitation installations generally, so that there can be no doubt that the host country has full taxation rights over all natural resource operations in the country.
VAT AND CUSTOMS IMPORT EXEMPTIONS
Countries often exempt imports for natural resource operations from VAT and customs duties. One of the main reasons for VAT exemption of imports may be to avoid the administrative problems of handling extremely large VAT repayment claims arising from zero-rating of natural resource exports.
Distinctions between exempt and nonexempt imports are sometimes difficult to apply and open to abuse. Both to prevent abuse and limit their economic impact, such exemptions should be clearly defined and limited to capital goods specific to the sector that are not available in, or resellable in, the domestic market.
This needs clear legislation and rules, often contained in a mining list prepared jointly by customs and the natural resource department, and sufficient expertise to verify that imports meet the exemption conditions. This is likely to require cooperation between customs and the natural resource department. Assessment of the value of the exempt imports is good practice, both to measure the amount of the tax expenditure and to enable subsequent assessment if goods are not put to the approved use.
If natural resource companies do have output VAT (for example, sales in the domestic market), another option is the use of deferred payment plans. In this case, the payment of VAT on imported goods is deferred until the taxpayer files the next VAT return, with the input tax credit effectively removing the need for actual payment.