Taxation concerns for natural resourcesALTax
Companies may avoid tax by charging excessive financing costs. CIT is most likely to be at risk, because finance costs are generally deductible, whereas equity financing costs are not. Some countries may negotiate generous interest deduction rules as a deliberate tax incentive, but the following discussion assumes that their aim is to prevent excessive deductions.
Financing costs may be excessive in two ways:
– They may be excessive relative to the level of borrowing (for example, interest rates or guarantee or facilitation fees at higher than usual market rates); and/or
– The level of borrowing may be excessive, generally described as thin capitalization.
The industry’s unique features, such as the high risk of exploration operations, may justify special rules. There is a range of approaches to countering thin capitalization; some lend themselves to more effective and transparent administration than others. Some countries have little protection against excessive borrowing or interest rates other than general transfer pricing rules.
Others impose specific limits. For example, maximum debt to equity ratio disallowance of interest on borrowing that exceeds that ratio: There is considerable variation in such ratios, ranging from 1:1 to as much as 4:1. It is sometimes unclear whether the ratio represents a permitted level or simply a maximum level subject to further restrictions.
There is frequently no special debt to equity ratio for natural resource companies, and a generous ratio may apply even to an exploration company operating in a new region. Sometimes the rule applies only to borrowing from abroad and/or borrowing from associates. This may allow excessive borrowing by means of so-called back-to-back loans (loans from an associate routed through an independent bank) or parent company guarantees (explicit or implicit).
Where thin capitalization rules are inadequate, insult may be added to injury, because companies may borrow far more than they could if operating independently and then argue that the interest rate should be higher than usual to reflect the exceptional risk. An alternative approach would set the maximum rate at a specific percentage above a quoted benchmark rate.
Because natural resource prices are volatile, companies may hedge them. The results should in principle be unpredictable. Over the last decade, NR prices have on average increased substantially, and because NR producers hedge against price declines, in practice hedging is much more likely to have generated losses than gains. Taxation of hedging gains and losses varies from country to country.
Where countries recognize hedging gains and losses in taxing natural resource profits, the rules can be complex and open to avoidance. Some countries recognize them for the purpose of some taxes but not others. Some recognize them if the instrument is genuinely used for hedging purposes and not for speculation, although this distinction can be difficult to apply in practice.
Some recognize gains and losses on some types of hedging (for example, forward sales) but not others (for example, exchange-traded forward contracts). Often these different types of instruments are economically equivalent, and treating them differently may be inconsistent from a policy viewpoint and may create opportunities for artificial tax planning.
Concern is widespread that natural resource companies manipulate hedging instruments and the timing of transactions to generate predictable losses, perhaps because they are on non-arm’s-length terms, perhaps because they are matched by offsetting gains realized by tax haven based associates. There may be grounds for this concern, or it may simply reflect the fact that in recent years hedging losses have been more common than gains. But in case manipulation is possible, countries that recognize hedging gains and losses for tax purposes should have a general or specific anti avoidance provision to counter it.
Because forward contracts are a hedging mechanism, this approach implies that all forward sales should be valued on the basis of the market price at the date of delivery rather than the price in the forward contract. If a general valuation rule applies see the earlier discussion of transfer pricing it may provide for that; otherwise, forward contracts must be deemed non-arm’s-length transactions. It may, however, be difficult to do this when arm’s-length spot prices are difficult to establish, so exceptions may be necessary.
GENERAL CONDITIONS FOR TAX DEDUCTIBILITY OF COSTS
Countries need to have general conditions for deductibility of costs, but the interpretation of these rules is sometimes problematic. If countries merely attempt to list all categories of deductible and nondeductible cost individually, there will inevitably be costs that do not clearly fit into the listed categories, the tax treatment of which will be unclear.
Legislation should therefore allow costs to be deducted if they meet certain general conditions and are not specifically disallowed. Sometimes legislation applies the same general conditions as apply to business taxation generally, sometimes it applies general conditions specific to natural resources.
A common but potentially problematic approach is to limit costs to ordinary and necessary costs, or to costs wholly, exclusively, and necessarily incurred for business purposes. It could be argued that companies need not incur any particular cost for business purposes.
It would be unreasonable to disallow costs on that basis, and in practice most countries interpret the necessary test quite loosely, treating any normal cost for the purpose of earning income as necessary, as long as it is not specifically disallowed. In other countries the position is more ambiguous, and tax authorities reserve the right to use this test to challenge normal business costs on commercial grounds.
This raises the wider issue of the relationship between taxation and industry regulation. Countries generally give the natural resource ministry (and sometimes the NRC) extensive powers to control costs. Typically, private natural resource companies must submit work plans and budgets for approval, but these can be withheld on various grounds.
Governments obviously have a legitimate interest in ensuring that companies commercial decisions are in line with national resource management policy. They also have an interest in company cost control, which some companies manage more efficiently than others.
In principle, therefore, government oversight and regulation are necessary to control costs (although in practice in some countries excessive, inefficient, rent-seeking government regulation is a main cause of high business costs). Such oversight and regulation generally take place in real time. Some countries are concerned that their natural resource fiscal regimes give companies an inadequate commercial incentive to control costs because, for example, where tax rates are higher than 50 percent, the government bears a higher share of the cost than the company.
In extreme cases countries may be concerned that the fiscal regime gives companies an incentive to incur unnecessary costs, where a dollar spent saves more than a dollar in tax. Few practical examples of such gold-plating incentives have been identified in practice, and obviously it is a serious weakness in legislation if they occur.
Tax authorities should not disallow costs as unnecessary unless the grounds on which such a disallowance may be made are clearly spelled out in legislation or official guidance. If not, the law will be fundamentally nontransparent; tax auditors will have to make judgments they are unlikely to be qualified to make; there will be scope for corruption; and investors will face uncertainty and risk, highly damaging to the investment climate.
RING FENCING OF COSTS
Countries commonly ring-fence natural resource production, so that only directly attributable costs are deductible. This is needed where natural resource production is subject to higher rates of CIT than other businesses, or to additional profit taxes.
Ring-fencing adds significant administrative complexity and risk, particularly when license areas or even individual projects are ring-fenced, as is true in many countries. The area or activities to be ring-fenced and the costs to be treated as falling inside or outside the ring-fence must be clearly defined. A basis then must be established for allocation of costs shared by separately ring-fenced areas.
– The costs to be shared may be incurred by the local company. The basis for allocation may not be straightforward, for example, if the company moves equipment between separately ring-fenced areas. A standard cost allocation rule may be necessary in such situations, such as time-apportionment of depreciation allowances, which will produce a reasonable result on average and be applied consistently.
Problems of cost allocation will be most common where ring-fencing applies to individual mines or oil fields within a license or contract area, because the same company will be involved in different projects. Where ring-fencing applies by reference to contract or license area, companies operating in different contract areas will need to allocate costs between them, but some countries require a separate company to be established for each contract area, which reduces the need to apply ring-fencing rules.
This approach may be less cumbersome from an administrative viewpoint but may be inefficient for investors. Where countries apply different profit tax regimes to different types of natural resources, profits must be calculated separately, raising similar but even more difficult cost allocation issues, particularly if the natural resources come from the same mine or oilfield, which calls for a standard cost allocation rule.
– Common costs may include service costs recharged by a foreign parent or management company to its operating subsidiary (for example, for management or technical services). Companies often adopt standard methods of apportioning such head office costs (for example, on the basis of share of production or allocation of capital). Countries either need their own specific rules, or a mechanism such as an advance pricing agreement for negotiating a consistent and reasonable allocation of such costs.
In that case, in addition to an agreed basis of allocation in principle, it may be necessary to reach agreement on the head office records that will be available as evidence of compliance.
It is common for governments to provide investment incentives, and for mining these too often take the form of tax holidays.
They are less common for petroleum. Tax holidays are widely regarded as a particularly poor form of investment incentive, and one that poses risks to the wider tax system. The objections to them are largely policy based, but they are likely to have major administrative disadvantages too.
They are often adopted as a supposedly simple form of tax incentive, with the result that the precise nature and boundaries of the tax holiday are poorly defined. It may be unclear whether the holiday is defined purely as a period of time or if production and grading levels are taken into account, and if so, the consequences if these differ significantly from original assumptions; and the treatment of depreciating assets at the end of the holiday may be uncertain. Such factors can give rise to uncertainty and technical disputes.
They also create significant opportunities for abuse through transfer pricing and other profit-shifting arrangements. The transition to regular taxation at the end of the tax holiday can be administratively complex, even if the rules are clear, particularly in the absence of adequate record-keeping requirements.