Natural resources and transfer pricingALTax
The valuation of natural resource sales and gross revenues for the purpose of ad valorem royalties and profit-based taxes such as corporate income tax (CIT), resource rent tax (RRT), and production sharing raises a number of linked administrative issues: The point at which sales of natural resources are to be evaluated for the purpose of those taxes; The pricing basis and method of valuation to be used; and
Transfer pricing rules for non-arm’s-length sales. The law should also stipulate how revenues indirectly related to natural resource sales are to be treated for the purpose of special natural resource taxes.
These could include, for example, exchange gains and losses on natural resource sale proceeds or gains and losses from hedging of natural resource sales (discussed in more detail later). The Point of Valuation Special natural resource taxes are usually intended only for upstream operations and not downstream for processing and distribution. This may be because downstream operations do not have the same capacity to generate rent (excess profits), which special natural resource taxes aim capture, or because unlike upstream operations processing often takes place abroad, perhaps encouraged by special taxes, thereby reducing rather than increasing tax collection.
If special taxes applied only to processing by companies in upstream operations, those companies might see this as inequitable and reorganize to avoid them (by setting up separate domestic processing subsidiaries and/or moving processing abroad). Governments in developing economies often see domestic processing of the nation’s natural resources as particularly desirable, because they consider it (sometimes with scant justify cation) an activity that adds more value than extraction and/or as a stimulus for industrial development. Instead of imposing special taxes, governments are likely to offer special tax incentives for domestic processing. The value of production must be set for the purpose of special natural resource taxes at the point it passes from upstream to downstream. If a company is engaged in both upstream and downstream activities, there is no actual sale at that point, which requires establishment of an internal transfer price. Similarly, in the case of profit-based taxes, costs should be limited to those for extraction and exclude those of downstream operations. If the value of sales or gross revenues subject to special taxes excludes value added by downstream operations, the cost of downstream operations should not offset those gross revenues. The exclusion of downstream costs is achieved by ring-fencing rules. Pricing Basis Different pricing bases may be used by the parties to a sale of natural resources.
The main ones are:
Free on board (FOB): Property and risk pass to the buyer at the point of loading and the buyer is liable for further transportation and insurance costs;
Cost, insurance, and freight (CIF):
Although property passes to the buyer, the seller remains liable for costs and risks until the cargo is unloaded;
Cost and freight (CF): Similar to CIF except that the seller is not liable for cargo insurance; and Delivery: Property and risk pass to the buyer on delivery at the destination point and the seller is liable for all costs to that point. The law must state the basis to be used for tax purposes. Usually, countries tax natural resource sales based on FOB prices. Sale prices on CIF or CF terms are higher than FOB prices and must be adjusted for tax to arrive at the FOB price, but the seller’s costs beyond the delivery point must be disallowed, or there would effectively be a double deduction (since the FOB price excludes the value added by those costs). If there is no other way, the FOB price can be established by netting back from the CIF or CF price the seller’s costs beyond the point of loading; if these costs are paid to an associate they must be at arm’s length prices. Standard international freight charges may be required for transportation by associated companies for example, from the London Tanker Brokers Panel, widely used in the extractive industry to fix shipping rates.
If valuation is based on a benchmark FOB price, it may have to be adjusted to reflect transportation cost differentials; if possible, standard international freight charges should be used. Transfer Pricing Profit shifting through transfer pricing presents a major risk in natural resource taxation. There is such risk in general business taxation, but high natural resource taxation rates can be a strong incentive for transfer pricing abuse.
But there is also exceptional opportunity. In developing economies like Albania, large-scale extraction operations are usually carried out mainly by foreign owned multinational companies; most natural resource production is exported; operations are financed with foreign capital; and the highest-value goods and services are imported. These multinational companies are often vertically integrated: their operations range from exploration through the sale of final products, which makes sales to downstream associates common.
Even without vertical integration, sales are often channeled through an associate for marketing purposes. Goods and services are commonly provided to locally based upstream companies by a central group management and services company. Associates may be based in tax havens, which maximized the potential tax savings from non-arm’s-length pricing. Transfer pricing risks apply to royalties based on sales value as well as to profit and rent taxes.
It is important to acknowledge, however, that the natural resource sector is composed of an array of firms with different compliance behavior, including many that are reputable, carry out group transactions on arm’s-length terms, and do not make use of tax havens. What is crucial is that tax administrations incorporate in their risk management models the assumption that the natural resource sector, in general, is more subject to transfer pricing risks than, for example, sectors that operate mainly in the domestic market at standard tax rates.
If a country taxes natural resource profits at a higher rate than other profits, transfer pricing abuse can occur not just in cross border transactions, but also in domestic transactions with a less highly taxed associate. This risk is aggravated if there are special tax incentives for some operations, such as favorable regimes to encourage development of local downstream infrastructure. International tax planning may seek to exploit these opportunities for example, by routing goods and services to upstream companies through lower-taxed domestic associates.
There can even be transfer pricing abuse within a single company, because, as discussed previously, it may be necessary to price transactions between the upstream and downstream operations of a single company when these are taxed differently. Some factors, however, make for lower natural resource transfer pricing risks compared with other industries. Extractive industries are physical operations. Outputs are standard commodities, not branded products, and can be physically weighed and measured. Variations in their type and quality can likewise be physically defined and measured.
Standard commercial measurements are used. The prices of the most common are quoted on international exchanges. These features increase price visibility. Although the value of a barrel of oil may be subject to dispute, it will usually be within a narrow range. Costs charged by associates may be more difficult to valuate, but they generally relate to physical goods and operations involving genuine technical know-how, and not to more nebulous intellectual property, such as brand values. And, at least in the case of petroleum, commercial structures may limit transfer pricing risks, as discussed in more detail later.
Some multinationals require their subsidiaries to price all transactions on arm’s-length terms, although others may not. There are often special transfer pricing rules for natural resource businesses, and the rules vary considerably from one country to another. In some countries they allow much more transparent and effective administration than others.