EI Sourcebook | 7.5 Fiscal Administration

7.5 Fiscal Administration

Fiscal Administration. Fiscal Administration^[43] involves assessing taxes, auditing tax returns, and collecting taxes. Careful identification of fiscal objectives and selection of fiscal instruments is of little use if fiscal authorities prove incapable of implementing the resulting regime.

Given the amounts of money at stake, getting fiscal administration ‘right’ in the EI sectors is critically important since a well-designed regime that is poorly implemented may fall far short of its tax raising potential.

Tax Policy and Administration. A number of the key fiscal objectives identified at the beginning of this chapter argue in favor of a progressive, profits-based tax regime. Critics have faulted these regimes on grounds of their perceived complexity and difficulty of administration. However, simpler systems with which the critics would replace them (such as royalty-based regimes) have drawbacks of their own in terms of efficiency or neutrality.

Box 7.3: Angola’s Fiscal Package for Petroleum.

Angola’s fiscal regime for petroleum has gone through a number of iterations since oil activity began. However, the package that has now emerged is generally regarded as representing good practice, and includes the following components:

Signature Bonus. Signature bonuses are included as bid items in competitive licensing rounds. Angola’s positive track record in honoring contracts and its oil prospectivity have resulted in significant bonuses in recent years.
Production Sharing. Investors are permitted allowable cost recovery of up to 50 percent to 65 percent of production. Remaining profit oil is split according to a scale which escalates from 20 percent to 85 percent in government’s favor as a function of the investor’s actual achieved profitability.
Corporate Income Tax. A 50 percent tax is levied on the investor’s profit oil share.
State Participation. Sonangol (Angola’s NRC) equity participation varies from 0 percent to 20 percent depending on the contract.

Under these terms, the state’s share in benefits is decidedly progressive, while still allowing the investor to share in the upside. The resulting range of government take is consistent with Angola’s prospectivity and take obtained in comparable states. Emphasis on profits-based taxation provides an incentive to extended, broad-based development. Application of the corporate tax allows investors to claim foreign tax credits. Sonangol’s equity participation has been kept at relatively modest levels. Angola’s decision to seek external audit support has provided protection of its interests in fiscal administration.

Two alternative approaches to resolving this dilemma can be considered. The first is to adjust tax policy to administrative capacity (for instance, adopt a second best tax policy in the interests of administrative ease). The second is to adopt a sophisticated, first best tax policy and tackle the administrative challenge head-on by committing to a long-term program of serious administrative capacity building, complemented by the immediate engagement of qualified consultant support.

Of course, an intermediate approach might be considered as well; one which opts for the simpler, but less efficient tax design as a starting position, while adding capacity and transitioning towards something more sophisticated. In assessing these trade-offs, it is worth bearing in mind that the ease of administration associated with simpler fiscal regimes may be, and often proves, deceptive. Their economic drawbacks can lead to pressures for renegotiation, legislative amendments and or special deals, which in the end will considerably complicate administration.^[44]

Finally, it should be recognized that administration of the more sophisticated EI sector tax regimes requires no more, or very little more, capacity than that required to administer any income tax. To reject these regimes because they are profits-based or income-based suggests there are much broader fiscal administration problems than those associated with the EI sectors alone.

States which lack the necessary capacity to administer a profits-based EI sector tax regime, and where it is not available domestically, can quickly put in place the capacity through the use of foreign experts who would not only undertake and lead specific assessment and field auditing tasks, but would also provide on-the-job training to build the capacity and experience needed for state-based staff to be able to take on those roles over time.

Routine Administrative Functions. Routine functions are about the mechanics of gathering tax: registering taxpayers, processing returns, issuing tax assessments, and collecting the tax. A number of considerations should make the job of routine administration easier in the EI sectors. The oil, gas, and mining companies participating in the EI sector tend to be relatively few in number, easy to find, and for the most part willing and able to carry out routine tax obligations. Adoption of self-assessment procedures should additionally facilitate routine administration by transferring many routine tasks to the taxpayers.

These advantages notwithstanding, many developing states have faced enormous difficulties, traceable to the obstacles or challenges of the type listed in Box 6.4 above. The box makes it clear that building capacity is not simply a matter of skills but also very much about attention to procedures, infrastructure or resources, and institutional organization.

Steps required to simplify routine resource tax administration are immediately suggested by the obstacles themselves. While self-assessment ‒ backed up by strong penalties for non-compliance and by effective audit and enforcement (major challenges in and of themselves) ‒ may limit the risk of large direct losses attributable to weaknesses in routine administration matters. Poor routine administration and associated reporting will confuse economic and budgetary planning, undermine sector accountability and governance, and damage government’s reputation with investors.

Box 7.4: Routine Tax Administration: Challenges

Many developing countries have encountered enormous difficulties in routine EI sector tax administration, which are traceable to:

Number of Taxes. Too many different EI sector taxes with differing filing and payment rules, and poor procedures and forms.
Number of Agencies. Different agencies for different taxes.
Banking and Accounting. Different arrangements for different taxes.
Technology. Poor information technology (IT) and management information systems. No IT network connecting different agencies.
NRC. Limited or no control over NRC tax payments.
Accountability. No one person responsible for the whole job.

Non-Routine Functions. These functions have to do with ensuring that the tax is calculated correctly. The most important among them deal with resource valuation (prices and volumes), audit and appeals, and dispute resolution. They are demanding functions which require professional skill and judgment. In this case, very large amounts of money are at risk.

Resource Valuation. Valuation of petroleum or mineral resources need to be established for both profits taxes and royalties. The challenges of establishing prices for this purpose are discussed in the preceding section.. Physical or volume audits can be similarly complicated. Volume measurement can be highly technical, involving complex equipment.

Audit. Under any fiscal regime there is always scope for error, differences of opinion, or unacceptable manipulation. Where petroleum or mining are concerned, even marginal errors can involve very large sums of money; hence the importance of effective tax audits. The ideal starting point for effective audit is a clear well-designed tax, supported by clear instructions to both taxpayers and administrators alike in the form of a public, regularly updated taxpayers’ manual. Fiscal administration of the EI sector, like other sectors of the economy, is based on a self-assessment system whereby companies prepare and submit tax returns according to their understanding of tax rules. In a tax administration system that is based on self-assessment, field tax audits of EI sector enterprises, led by qualified and experienced staff, are essential to reduce the risk of substantial underestimation in tax assessments since companies will always interpret tax rules to their advantage unless audited.

Box 7.5: Fiscal Administration in the Minerals Sector

In addition to the general profits and dividend related taxes that are applicable to all sectors (which will collect a part of the economic rent associated with profitable projects and with periods of windfall profits due to commodity price booms), a well-designed minerals tax regime will be administered by the Taxation Authority which is also responsible for administering the general profits and dividend taxes regime and which will

be familiar with the operations and profitability of each large mining tax payer and large mining operation and will cross check the additional tax calculations and data for consistency with other tax submissions such as profits tax, dividend tax, VAT and customs declarations;
have financial models that provide tax projections for large operations and develop strong tax projection capabilities including obtaining financial projections from large tax payers;
Develop a high degree of collaboration and cooperation with the mining authority so that the technical competency is available to audit quantities and prices and ensure the correct tax treatment of sector specific amortization rules including for exploration expenditures;
develop strong tax audit capabilities, as well as adequate rules necessary to protect inter affiliate transactions being used to siphon off profits from the host country to another jurisdiction and thus reduce tax payments in the host country through improper transfer pricing (of products and services – both sales and purchases), thin capitalization, interest charges and management or marketing fees;
have access to strong legal capacity in the event of disputes or legal action over tax avoidance or tax evasion - this is essential in order to be able to effectively implement such procedures;
include fixed rate instruments to generate a minimum fairly stable flow of tax receipts providing that production and/or sales are taking place and that consist of
- a fixed charge per unit of production (or sales) royalty or
- a fixed ad valorem royalty (which is a fixed percentage of sales value); and
- in some countries the Unit or Ad Valorem royalty is collected by the Mining Ministry and used as a source of income for the mining authority.
include a suitable instrument (such as an additional profits tax, a cash flow tax or a sliding scale royalty) to capture in a progressive manner a share of the economic rent ('excess profit') over and above the risk adjusted rate of return required for investment approval;
avoid tax holidays that distort investment and production decisions and cause high grading before the tax holiday expires;
avoid tax free processing zones for mineral projects because mining and processing are capital intensive and provide very modest employment benefits; and
only consider import duty exemptions that do not risk a perverse effect of making duty free imports cheaper than domestic products which must pay domestic sales taxes; and
- might include possible incentives to reduce risk for the investor such as
- accelerated capital recovery tax provisions for large investments - but government must be fully cognizant that these will delay early tax payments;
- tax stabilization clauses – but these should be restricted to tax rates and should not stabilize loopholes or tax conditions that apply across the economy;
- double taxation agreements (DTA) treaties – but legislation should require that a parent company’ies management and staff be located in the DTA country to prevent ‘treaty shopping’ for tax avoidance purposes.

A key weakness in many states is that tax administrations do not undertake field tax audits, and even if they do, are at a great disadvantage given that EI sector tax returns are generally very large and complicated relative to most other tax returns in developing states. Thus, obtaining the services of qualified and experienced tax auditors, experienced in undertaking tax audits of EI sector companies is essential; this is not only important for undertaking audits, but also for ensuring that all the necessary accounting rules and audit procedures are in place. Establishing the accounting rules in advance is essential to have a benchmark to audit against.

In addition, the auditing task can be made much more manageable if tax administration staff becomes familiar with the enterprises they are auditing, and also obtain annual projections from each enterprise on a quarter-by-quarter basis of expected tax assessments. The tax authority staff and auditors then have an initial reference point when examining the actual assessments. EI sector projects involves a variety of activities such as exploration work, development work, co-production of different products, decommissioning, reclamation, and restoration which are not found in other businesses and for which the accounting treatment may have significant implications for tax assessments.

The procedures for selection of exchange rates will also need very careful attention. The tax authority will be well-served to agree a detailed accounting treatment for these various activities. Ideally, the tax administration staff ‒ together with the EI sector ministry staff ‒ should have computerized, financial models of each of the operations and enterprises, preferably using inputs received from or agreed with the companies.

In the petroleum industry, tax audit are assisted by the common practice of investor joint ventures whose rules provide not only for detailed (and increasingly standard) accounting for costs, but also for partner audits of the joint venture operator.

The mining industry to date has not been characterized by either joint ventures or standardized accounting procedures, which makes tax audit more difficult. Different states take different approaches on audit coverage; some opt for full investor coverage with comprehensive field audits, and others adopt a varied approach that combines risk-assessed field audits of selected companies with desk audits of others. For large EI sector companies, annual audits are usually desirable given the significant amounts of tax at risk. Due to the large amounts of tax involved, an effective tax audit usually repays the cost of the audit many times over in terms of agreed adjustments to payments. Both interest and penalties on any tax increase resulting from the audit should be charged. Some of the specific features of the mining sector are identified in Box 7.5 above.

Dispute Resolution and Appeals. Resolving tax disputes by formal litigation can be extremely expensive and slow. The preferable route is to settle differences by mutual agreement during the audit. If disputes remain unresolved, investors must have some formal right of appeal to tax courts or tribunals; but in this case, credibility and a reputation for non-discriminatory handling of appeals is of fundamental importance. The tax authority should also have readily accessible expert legal capacity (either on its staff or as outside counsel) so that disputes can be taken with confidence to the tax court, in the event that it is necessary to do so.^[45]

Institutional Structures. In most sectors of the economy, tax administration is the responsibility of the national or in some cases (such as Canada and Argentina), the provincial tax authority. For petroleum, however, tax administration may be assigned to the EI sector ministry, or more commonly, shared with the tax authority and or the finance ministry. A typical division of responsibilities would assign taxes to the ministry of finance, and royalties to the EI sector ministry or the NRC. The rationale advanced for this division is that physical measurement requires special technical expertise, which is available only in the EI sector ministry. The same reasoning has made the EI sector ministry, or more often the NRC, responsible for fiscal calculations under production sharing (for instance, in making cost recovery and profit oil sharing calculations).

While these divisions appear logical, spreading fiscal administration among several agencies has disadvantages that including: increased complexity, duplication of effort, and reduced accountability. Where differing institutional comparative advantage is perceived to outweigh the disadvantages of dispersal of administrative responsibilities, and responsibilities are divided, clear definition of roles and responsibilities, regular communication, and effective coordination among the agencies involved become vitally important.^[46]

Inter-Agency Coordination. The tax authority and the EI sector ministry also need to coordinate closely in terms of production and or sales data on which royalties and income taxes are assessed. The EI sector ministry should also work closely with the tax authority so that the tax authority has good comprehension of the production and explorations process, and is able to make an informed judgment as to the eligibility of different charges and expenditures for tax purposes.

Even when good accounting rules have been established, expert judgment may be needed to determine whether rules are being applied correctly; for example, whether or not exploration charges are being correctly assigned as development or green field exploration charges in situations where the two have different tax expense or depreciation rules. It will likely take the expertise of the EI sector ministry or the geological survey to determine if exploration activities have been correctly categorized in the tax return. Technical expertise may also be needed in cases where EI sector companies claim tax deductions for intellectual property.

The central bank should not play any direct role in fiscal administration, but it is one of the key agencies that must be kept in the loop of communication and coordination. Ideally, all resource payments made to the government should go into a single unified treasury account held within the central bank. The fiscal authority should be responsible for preparing comprehensive accounts of payments assessed, collected, and paid into the treasury account; and these accounts should be capable of being reconciled with central bank accounts.

In practice, the spreading of administration functions has meant that there is no single fiscal authority responsible for producing these accounts. Wherever EI sector taxation functions are found within government agencies, it is generally considered good practice to concentrate them within a specialized office, either stand-alone or as a subdivision of another office (such as the main tax authority office). Finally, the importance of giving these offices the skills and resources they require cannot be overstated. Where requisite domestic skills are not immediately available, good practice would recommend engagement of qualified international audit, legal, or commercial consultants; and twinning their support with the development of local capacity.

Box 7.6: The Energy Charter Model Agreements for Cross-Border Pipelines

The Energy Charter Secretariat has prepared a set of Model Agreements for Cross-Border Pipelines which address many of the issues discussed in this section. Although the Model Agreements were designed with respect to cross-border oil and gas pipeline projects in particular, many of the solutions proposed with respect to tax (and other) issues are equally relevant to EI projects in general. The text of the Model Agreements (consisting of a model Intergovernmental Agreement or IGA and a model Host Government Agreement or HGA) may be obtained online.

The purpose of the preparation of the Model Agreements was to provide a neutral starting point for negotiation of cross-border pipeline project documentation (i.e. unduly favourable neither to project investors nor to host governments). The Energy Charter Model Agreements have been used as a basis for negotiation of several projects both within and outside the Energy Charter’s (essentially Eurasian) geographical constituency.

The purpose of the preparation of the Model Agreements was to provide a neutral starting point for negotiation of cross-border pipeline project documentation (i.e. unduly favourable neither to project investors nor to host governments). The Energy Charter Model Agreements have been used as a basis for negotiation of several projects both within and outside the Energy Charter’s (essentially Eurasian) geographical constituency.

With respect to tax, the Model Agreements (IGA Article 13 and HGA Articles 26 and 27) deal with several issues. These include:

Definition of the tax base (negative aspects). The position taken in the Model Agreements is that the relevant project should not be taxed except as specifically authorized by the project documentation. In particular, taxes should not be imposed on investor equity capital, project construction activities, land rights, project assets, input or output of materials, payments with respect to the project, transfers of project interests to other investors, or salaries and other amounts paid to project employees or contractors. In addition, no import or export duties should be levied with respect to imports or exports related to the project.
Definition of the tax base (positive aspects). The Model Agreements allow the imposition of a tax on profits, calculated in accordance with internationally accepted accounting principles. In addition, in order to ensure an early flow of revenue to the host government, the Model Agreements allow the imposition of an “advanced profit tax” calculated as, in effect, a tax on throughput. This is specifically stated to be an advance payment on account of profit tax and must be credited against profit tax ultimately due or, if not fully offset by such profit tax, refunded by the host government.
VAT (substantive and timing aspects). Consistently with para. [241] above, the Model Agreements take the view that, on the assumption that all project outputs are destined for export, the project should effectively be zero-rated for VAT purposes. Accordingly, in order to mitigate or eliminate the cash-flow burden to the project which could be caused by delays in issuing VAT refunds, the Model Agreements offer three alternative solutions. The first solution is a simple obligation for the host government to issue VAT refunds promptly, accompanied by a right for project investors to offset such refunds against other tax liabilities. The second is more radical: the project investors are entitled to sell VAT claims to other VAT payers in the host state, who can then offset these against their own tax liabilities. The third is the most radical of all: the host government agrees to provide the project investors with a certificate exempting them from paying VAT on project-related purchases within the host state in the first place.
International issues. Where a project involves more than one state (as is frequently the case with pipeline projects, less frequently with other EI projects), no state may tax more than its pro rata share, calculated in accordance with agreed allocation keys, of the total taxable profit. The normal methods of allocating profit for international pipeline projects are (i) in proportion to distance, or (ii) in proportion to construction cost. This provision is necessary, for the bankability of projects involving more than one state, so that the project investors are not taxed more than once on the same profits. Moreover, where a double tax treaty applies between the host country and the home country of a project investor, the host government should allow an exemption or credit in accordance with the relevant treaty with respect to any tax paid.

In addition to tax, the Model Agreements deal with many other issues which are relevant to EI projects. These include standards for employment, for technical safety and security, and for environmental and social impact; land rights; cooperation; technology transfer; training of local personnel; access to resources and facilities; host government and project investor liabilities; force majeure; changes of law; and dispute resolution.

Box 7.7: Summary and Recommendations

The effectiveness of an EI sector fiscal regime depends on the objectives established for that regime, on the fiscal instruments selected to achieve those objectives, and on the quality of fiscal administration.
Both the design and implementation of EI sector fiscal regimes are complex, requiring appropriate expertise.

The mineral-specific fiscal regime is generally contained in legislation and consists of taxes and fees that apply to all sectors (such as profits taxes, employment taxes, and import duties), plus mineral sector taxes (which generally consist of additional taxes and royalties that apply only to minerals).
The mineral-specific fiscal regime is generally administered by the taxation authority and supported by the ministry of mines.

The petroleum fiscal regime contained in legislation is often supplemented by fiscal or other terms specified in petroleum agreements or contracts and includes not only taxes and fees but also production sharing arrangements involving cost oil, profit oil, and royalties. The petroleum fiscal regime is generally administered by the taxation authority in close collaboration with the NRC and the EI sector ministry.

The key principle underlying an efficient and effective fiscal regime is to strike the right balance between the risks and rewards for the investor ‒ who requires a satisfactory risk-adjusted rate of return to justify a new investment, and the government which requires adequate compensation for the use of a resource and a fair share of the economic rent associated with the extraction of a non-renewable resource.

A well-designed fiscal regime will:

provide an investment environment that is fair, stable, and predictable with a tax take that responds fairly and robustly to changes in both prices and costs;
be transparent (not hidden, but confidential agreements) and applicable to all new investors (a regime may change over time as a state establishes a positive track record with investors);
have fiscal instruments that are efficient and progressive and that provide an dependable minimum flow of tax receipts to the government each year, starting early in the project life;
ensure that the design and complexity of the fiscal instruments are commensurate with the administrative capacity of the government entities administering the tax regime;
have clearly elaborated dispute resolution procedures; and
protect against tax avoidance and tax evasion which can significantly reduce actual tax payments in relation to expected collections by:requiring the use of internationally recognized accounting rules and standards (including foreign exchange rules) for preparing income statements for tax submissions; and providing rules in the law and any related agreements for special issues such as: the use of inter-affiliate transactions (including transfer pricing, loans and management fees), ring fencing, thin capitalization, interest rate caps for borrowing, capital gains on the transfer or sale of exploration or mining rights, stabilization agreements, and the domicile of parent companies for DTTs.

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