Fiscal Prices. Price determination for fiscal purposes can be complicated in the EI sectors. In all cases, the goal is to set or agree to a price which is as close as possible to that which would be realized in a genuine third party, arms-length market sale. This is important for several reasons:

a) to avoid fiscal revenue loss by under-pricing of the resource (see the section on Transfer Pricing, below);

b) to avoid government over-pricing of the resource to raise revenues; and

c) to help ensure the availability of foreign tax credits to investors (see the section on Foreign Tax Credits, below).

The goal is most easily accomplished in the case of oil where well-established international markets exist, and price quotes, together with price adjustments for crude oil quality and transport differentials are almost continuously available. The fiscalization point (at the point of export, ex-field, or at the wellhead) has to be agreed, but need not present particular difficulties as long as associated taxes or royalties are adjusted to reflect the choice made. Establishing fiscal prices for mining and natural gas is more problematic in the sense that their markets may be harder to identify or observe.

In the case of gas, competitive markets currently exists only the US and the UK; readily observable prices for fiscal purposes do not exist outside those markets and are often set on a project by project basis. Further, the marketing of natural gas and some minerals may be integrated all the way from the wellhead or mine-mouth through processing or smelting and transport all the way to final consumer, with different tax regimes applicable along the integrated chain. Setting the value of the resource along that chain will, as a result, have significant implications for total fiscal revenues and their sharing among fiscal jurisdictions. Good practice generally calls for netting the price paid by the final consumer back to the wellhead or mine-mouth in such a way that rents accrue at those resource extraction points.

Transfer Pricing. Transfer pricing refers to the pricing of sales to, or purchases from, parties affiliated with the EI sector investor. Transfer pricing applies not only to the sale of products and goods but also to the supply of services and the terms and pricing of loans or credit instruments such as pre-financing arrangements. Such pricing is considered abusive when, by under-pricing a sale or over-pricing a purchase results in shifting profits from a host state resource extraction jurisdiction to a lower tax jurisdiction outside the EI host state – with the result that the tax payments to the host state are reduced.^[32] 

Monitoring and policing inter-affiliate transactions can be an extremely difficult task.  Tax authorities are well-advised to set clear rules and procedures for tax treatment of inter-affiliate transactions. Abuses with respect to both sales and purchases (interest costs, or subcontractor goods and services) can be mitigated by:

• preparing tax returns, for the purpose of tax assessment, using either an advance pricing agreement for any inter-affiliate transactions, or agreed ex ante prices, or arm’s length market prices with benchmarking by reference to observable markets (as suggested in the preceding paragraph for pricing of sales);
• requiring investors to provide both advance notification each year and an annual projection of the value (in terms of price and quantities) of any planned inter-affiliate transactions and then, based on the information provided, setting a ceiling for such transactions beyond which they will not be eligible to be deducted for tax purposes; 
• requiring investors to identify all affiliated sales and justify their pricing; and
• referencing or incorporating into local legislation the OECD guidelines on transfer pricing.

It is not unknown for companies to attempt to reduce tax assessments by having highly leveraged capital investment programs with as much as 95 percent debt financing: a percentage that is considered much higher than prudent.^[33]  This can happen especially where a subsidiary company takes on excessive debt while the parent company maintains more prudent debt levels. In the case of interest costs, extra protection is often provided by not only benchmarking rates against observable market rates, but also by limiting the total debt allowed for purposes of tax calculations in the host state to a set debt-equity ratio ceiling (for example, a three to one ratio). 

Ring-Fencing. Ring-fencing is a cost recovery issue with important consequences for both the pace of exploration and development activities and the timing of government revenues. Ring-fencing limits cost recovery from the revenues of a particular producing petroleum or mining project to costs which are incurred in the same project or license area. This has two consequences. The first is positive; ring-fencing avoids the delays in government revenues which might otherwise result if investors were allowed to write-off new expenditures or investments made outside the producing area against producing area income. The second may be viewed as negative; ring-fencing does not permit the right to consolidate new costs with existing income for fiscal purposes, eliminating an incentive to spend on new exploration and development. Policy-makers face a trade-off between early revenue with deferred activity, and accelerated activity with delayed revenue. How the trade-off is resolved will depend on both country context and country priorities. 

Decommissioning Costs. Petroleum and mining investors are now almost universally required to ‘decommission’ the site of their operations once operations cease (decommissioning requires the investor to rehabilitate the site and restore or remove any causes of danger or injury to the environment). Since there is no income against which to recover the costs involved once operations cease, it is now common to allow or require investors to establish a decommissioning fund or mine reclamation fund in advance of termination of operations through payments based on estimates of decommissioning costs and made into an escrow account at an approved bank, and to allow those payments to be deducted for tax purposes.

Mining differs from oil and gas in that decommissioning takes place in phases during mine operations, and not only after the mine is closed. Decommissioning costs incurred in advance of closure are allowed as deductible expenses.

Infrastructure Obligations. Investors may sometimes be obligated to provide the host state with social or physical infrastructure as part of their contractual undertakings (see Chapter 9). This is tantamount to earmarking government revenues. The motivations behind the requirement may have to do with lack of government capacity, or with political expediency. Whatever the motivations are, except where the expenditure is allowed as a full credit or offset against the investor’s tax obligation, the requirement is analogous to an explicit tax on the investor, the scale of which depends on whether or not the infrastructure expenditure is deductible.

Fiscal Stabilization.  A major concern of investors, noted elsewhere in the Source Book, is the perceived lack of credibility on behalf of the host state to refrain from introducing adverse terms ‒ especially, but not exclusively, fiscal terms ‒ once risks have been borne and major expenditures sunk. These concerns have been at least partially addressed by introducing stability clauses in legislation or, more commonly, in licenses or contracts.

In practice, two formulations of contractual fiscal stability clause can be found: the frozen law formulation, and the economic equilibrium formulation. Under the frozen law formulation, the laws in force when the agreement was signed are frozen for the life of the contract, or for a period of years.^[34] Under the second approach (now more common), the parties to the contract agree to negotiate in good faith to maintain the original economic equilibrium of the contract by introducing compensating changes to any adverse revisions to applicable laws or to the contract itself.^[35]

A growing reluctance to accept stability clauses is emerging on the part of governments.^[36] However, absent a track record of broad-based improvements in governance, it seems likely that these provisions will remain. At the same time, it is increasingly recognized that good fiscal design (by providing for automatic responsiveness of terms to changed circumstances) can reduce pressures to renegotiate or revise agreements, making it less likely that stability clauses will be invoked.   

Foreign Tax Credits. Whether or not a credit is available in an investor’s home state for taxes paid to the host state is an important consideration for investors whose home states apply a system of worldwide taxation (for example, states that tax foreign source income in the home state).^[37] Most host states are aware of this issue and adjust their resource tax regimes to ensure the availability of foreign tax credits. This can be done without prejudice to host state tax revenues and has the benefit of encouraging inward international investment.  Criteria for foreign tax creditability include:

1. a host state tax based on net income (ideally closely resembling the income tax applied in the investor’s home state);
2. use of actual third party market prices or equivalent benchmarks in the calculation of host state taxable income; and
3. allowable deduction of all significant costs attributable to the taxed operation.

Some specialized resource taxes such as rent taxes, additional profits taxes, or payments under production sharing arrangements may be considered to differ in nature from a standard corporate tax and face difficulties in qualifying for a credit. The treatment of these taxes can be clarified in a double tax treaty (see the section on Tax Treaties below). Home states may limit the total credit available to what would have been paid in the home state absent a credit. Host states will want to package their EI sector taxes to maximize the home state credit available to investors and thus avoid any leakage of potential tax revenue to the home state.  

Tax Treaties. Tax treaties prevent double taxation of the same income or profits by two different governments. For example, tax treaties between home and host states often reduce withholding tax rates on dividend remittances by the subsidiary located in the host state to their home state parents. This is acceptable in cases where the parent company has its head offices (and head office staff) domiciled in the tax treaty state. In situations where tax treaties do not exist to prevent double taxation, some parent companies may be tempted to set up an intermediary ‘paper’ company in a tax haven as the owner of the subsidiary company in order to gain those tax benefits. Governments can prevent this by including provisions in their tax laws which deem such practice as tax avoidance, subject to substantial penalties.^[38]

Confidentiality. While all EI states have a fiscal regime embedded in the law, some state have also negotiated and signed separate, generally confidential, EI sector agreements that contain ‘special deal’ fiscal regimes that are unknown except to the investor, the tax authority, and a very small number of officials who have access to the agreement. During the commodity boom of 2007 and 2008, a number of these agreements in the mining sector came to light when governments found that tax payments did not increase commensurate with profitability because of fiscal concessions made in the contracts.^[39] By keeping the mining fiscal regime in the law and refraining from modifying it in separate confidential agreements, governments and the state at large will have full knowledge and transparency regarding the tax regime; and the risk of corrupt practices, poorly informed decisions, and mismatched negotiating capabilities can be avoided.

Additional Reading: