Tax Justice and Global Inequality

Practical Solutions to Protect Developing Country Revenues

Krishen Mehta, Esther Shubert, Erika Dayle Siu, Krishen Mehta, Esther Shubert, Erika Dayle Siu

• Publisher: Zed Books
• Year: 2020
• ISBN:
  9781786998118
• Edition: 1
• Topic: Social Sciences
• Subtopic: Global Development Studies
• Index: Social Sciences

In the wake of the Panama Papers scandal and similar leaks, tax havens are now firmly in the spotlight. Today, roughly half of all global trade still passes through tax haven jurisdictions, costing millions in lost revenue to countries around the world. Such practices affect all of us, but are most keenly felt by poorer people in developing countries, where unfair tax practices have become a major obstacle to development, and which have allowed multinational corporations to continue to exploit developing economies. This collection argues that, for developing countries to achieve social justice and lasting prosperity, they must take control of their own tax destinies, and that this will also be crucial to achieving the Sustainable Development Goals. Covering such topics as natural resource management, representation in global tax institutions and effective strategies for building and protecting tax bases, the collection brings together expertise from a variety of countries and disciplines. It explores the options available to developing countries, and provides a basis for concerted action by tax authorities, policy makers, academics and civil society experts to design tax systems that can sustain a just society.

1 | SECURING MINING, OIL, AND GAS REVENUES: LESSONS FROM SEVEN RESOURCE-RICH COUNTRIES

Alexandra Readhead¹

Executive Summary

For many resource-rich developing countries, mineral resources present an unparalleled economic opportunity to increase government revenue through effective taxation of mining companies. Multinational tax avoidance, particularly transfer pricing manipulation, threatens this prospect. However, the conventional legal response – the arm’s length principle – is difficult for developing country tax authorities to implement. They lack appropriate regulations, data on comparable independent transactions, the necessary administrative structures, and access to tax information from other jurisdictions.

One way to potentially overcome the difficulties of the arm’s length principle, is to identify areas of transfer pricing risk along the extractive industry value chain, and develop context-relevant legal and institutional responses at the country level. This chapter will describe the alternative legal and institutional mechanisms that Zambia, Angola, South Africa, Indonesia, Guinea, and Sierra Leone have put in place to control the price of related-party sales, operational and capital expenditures, and the cost of intra-company debt, as well as to improve inter-agency coordination and institutional oversight in extractive industries. These rules may not perfectly adhere to global standards, but the trade-off from their application can be justified by the challenges developing countries experience implementing the arm’s length principle, and the urgency of capturing revenues from non-renewable resources.

Introduction

For many developing countries, natural resources present a significant economic opportunity to increase government revenue through effective taxation of mining, oil, and gas companies. The substantial funding needs of developing countries to provide basic public services make this critically important.² However, the challenge of ensuring that natural resource wealth contributes to government revenues – and prosperity and economic development moreover – is formidable.

A critical area of reform is to counter aggressive tax avoidance in the extractive industries. Tax avoidance is the use of legal methods to minimize the amount of income tax owed.³ One of the principal instruments of tax avoidance is transfer pricing. The transfer price is the price of a transaction between two entities that are part of the same multinational corporation, and ‘transfer pricing’ is the process of setting it. The risk is that companies will manipulate the transfer price to make higher profits in lower-taxed jurisdictions and lower profits in higher-taxed ones, as a means of reducing their overall tax bill.

To address the risk of transfer pricing manipulation, many countries have put in place legal rules that require taxpayers to price transactions between related parties as if they were taking place between unrelated parties.⁴ This ‘arm’s length principle’ is at the core of most global standards on controlling transfer pricing, led by the Organization for Economic Cooperation and Development (OECD). If a related-party transaction does not conform to the arm’s length principle, transfer pricing rules give governments the legal right to adjust the price in the reported profits of the company.⁵ However, enforcement of the letter and the spirit of these rules depends on the administrative capacity of countries, and the political will of governments to actively enforce legislation and accurately set the adjusted price.

The difficulty of applying the arm’s length principle for both developed and developing countries has led many stakeholders to consider the alternatives. Most recently, the OECD has proposed a ‘new taxing right’ that would not require a physical presence and would allocate profits by means of a formula.⁶ Other proposals to overhaul the international tax system have included global formulary apportionment, which allocates a multinational corporation’s total worldwide profit (or loss) across the jurisdictions in which it operates,⁷ and a destination-based cash flow tax, which levies corporate income tax based on where goods end up (destination), rather than where they were produced. But, as this chapter will illustrate, none of these proposals are particularly suited to the extractive industries in developing countries.

Insofar as source-based taxation is likely to remain a major part of the resource tax landscape, the purpose of this chapter is to consider a targeted, incremental approach to tackling transfer pricing risks in the extractive sector in developing countries. The approach involves (1) identifying transfer pricing risks along the value chain, and (2) developing corresponding context-relevant legal and institutional responses at the country level. The appropriate legal solutions may not always perfectly adhere to global standards, but the trade-off can be justified by the challenges developing countries experience in implementing the arm’s length principle, and the urgency of capturing revenues from non-renewable resources.

The chapter is divided into four sections:

First, the chapter provides a brief overview of the challenges to implementing transfer pricing rules in the mining sector specifically. These are broadly the same in oil and gas, although for oil-producing countries that use contractual systems the main challenge will be verifying cost claims, which have the potential to significantly erode government’s share of production.

Second, the chapter highlights the transfer pricing risks along the extractive industry value chain.

Third, the chapter discusses global formulary apportionment and a destination-based cash flow tax, and why they may not be appropriate solutions to corporate tax avoidance in the extractive industries.

Fourth, the chapter presents examples of alternative legal and institutional mechanisms that Zambia, Angola, South Africa, Indonesia, Guinea, Tanzania, and Sierra Leone have put in place to control the price of related-party sales, operational and capital expenditures, and the cost of intercompany debt, as well as to improve inter-agency coordination, and institutional oversight in extractive industries. These examples represent innovative ways for resource-rich developing countries to reduce reliance on the arm’s length principle, limit the opportunities for multinational extractive companies to avoid taxes, and increase government revenue collection from finite resource endowments.

1. Challenges to Implementing Transfer Pricing Rules in the Extractive Industries

The limitations of the arm’s length principle have been discussed in detail.⁸ These arguments will not be rehashed here. However, this section provides a brief overview of key challenges to implementing transfer pricing rules in the mining sector, which are drawn from this author’s research in Guinea, Ghana, Sierra Leone, Tanzania, and Zambia.⁹

Box 1.1 Challenges to implementing transfer pricing rules in the mining sector in Africa

1 Introducing the concept of the arm’s length principle into a country’s income tax law is only a first step. Few countries have followed up with the regulations, or administrative guidance to clarify documentation requirements and methods for determining an acceptable transfer price based on the arm’s length principle.

2 Laws or contracts that impose taxes on the mining sector do not always refer to generally applicable transfer pricing rules, leaving an ambiguity that could be exploited by, or lead to disputes with mining companies.

3 Assessing transfer pricing in a way that is consistent with the arm’s length principle requires data on comparable independent transactions. Data specific to Africa’s mining sector is extremely limited. Consequently, authorities have had to adjust comparable data for other regions, which may be expensive, complex, and yield unsatisfying results. For some transactions, for example, loans, and intellectual property, a market price may not exist.

4 The administrative structures of revenue authorities are rarely adapted to the efficient implementation of transfer pricing rules. A dedicated transfer pricing unit, the common approach recommended by international organizations, may not be appropriate in developing countries with limited resources and a small number of multinational corporations.

5 Information and expertise exist in silos, preventing revenue authorities and the agencies responsible for mining sector regulation from developing a comprehensive picture of transfer pricing risks created by the mining industry and deciding which risks warrant an audit.

6 Revenue authorities have difficulty accessing taxpayer information from other jurisdictions. Consequently, they are unable to develop a full picture of a company’s global operations for the purpose of investigating transfer pricing risks. At times, they are also lax at enforcing domestic reporting obligations leaving them ill-equipped to review complex transactions.

7 The political economy of many resource-rich countries undermines the implementation of transfer pricing rules. The privileged relationship between the mining industry and the political leadership can prevent the systematic implementation of transfer pricing rule...

Table of contents

• Cover
• Series Page
• About the Editors
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of Figures, Tables, and Boxes
• Acknowledgements
• Practical Solutions to Protect Developing Country Tax Revenues
• 1. Securing Mining, Oil, and Gas Revenues: Lessons from Seven Resource-Rich Countries
• 2. Transfer Pricing Rules and Alternative Paths for the Tax Administrations of Developing Countries
• 3. International Tax Competition, Harmful Tax Practices and the ‘Race to the Bottom’: A Special Focus on Unstrategic Tax Incentives in Africa
• 4. Taxing Digitalized Companies: Options for African Countries
• 5. Tax Aspects of Bilateral Investment Treaties and Free Trade Agreements
• 6. Multinational Entity Finance Schemes: Formulary Apportionment as the Way Forward
• 7. Joint Tax Audits between Developed and Developing Countries
• 8. Tax Avoidance in Development Finance: The Case of a Finnfund Investment
• 9. Raising Revenue and Improving Health through Targeted Fiscal Policies
• 10. Taxing Carbon: Time for a Multilateral Approach
• 11. Taxing for Justice: Fiscal Policy, Inequality, and Human Rights
• 12. Towards a Just International Tax Order: Giving Content to Article 28 of the Universal Declaration of Human Rights through the Global Tax System
• Index