How might the Malawi government fail to secure a fair share of natural resource wealth?
‘Is the deal a good deal?’ is a question often asked about the agreement signed between Paladin and the government for Kayelekera uranium mine. Reductions in royalty rates and other tax incentives have come under public scrutiny, while the company and government argue that these were necessary for the project to go ahead.
In Malawi, negotiating tax terms has been the norm to date for mining and petroleum contracts. The amendments to the Taxation Act passed last year address this for solid minerals by fixing tax rates. This was done in an effort to protect future potential revenues from the sector. However, reduced tax rates are not the only way a government can lose revenue. Revenue can be lost through erosion of the tax base against which tax rates are applied.
A framework to assess all kinds of risks to government revenue is set out in a new study by Resource for Development, published by Publish What You Pay Canada. It looks at both the loss of revenue due to the tax rates for a particular project and the loss of revenue due to the tax base against which revenue is assessed. It argues that there are clear patterns in how companies try to reduce their payments to government.
The main pathways through which government lose revenues from the extractive sector are described briefly below.
Tax rates and reductions in revenue
- Tax breaks: To promote investment, governments often award tax breaks, such as allowing accelerated depreciation or tax exemptions, and these can be in place for the lifespan of the project due to stabilisation clauses added into agreements.
- Treaty shopping: Companies may also be able to reduce tax payments through making use of double taxation agreements (an act sometimes referred to as ‘treaty shopping’). ActionAid released ‘An Extractive Affair’ in 2015 on how Paladin purportedly used a tax treaty between Malawi and the Netherlands to route ‘its loan from Malawi to Australia via the Netherlands’ and ‘lowered its withholding taxes in Malawi by more than US$27.5 million over six years’.
Tax base erosion and reductions in revenue
Eroding the tax base is done in mainly two ways – through under-reporting project revenues and inflating costs.
- Under-reporting project revenues: To minimise the tax burden, companies often will shift profits between higher tax jurisdictions to lower ones through a large network of subsidiaries. This can be done through under-reporting production or not reporting by-products or reducing the sales price through intra-firm sales agreements, excessive marketing fees, and forward sales.
- Over-reporting project costs: In the same way, companies may try to inflate costs or to shift costs into the highly taxed producing countries to reduce the tax base and therefore taxes owed to government. This can be done in a number of ways including through claiming ineligible costs. A private Chilean iodine, potassium and lithium company, Sociedad Quimica y Minera de Chile, a few years ago encouraged companies to submit invoices even for services not provided and the money from the paid invoices was mostly transferred to politicians. In 2015, the company submitted amendments to its tax returns for a 5-year period and paid taxes and interest totalling approximately USD 7m. Companies can also inflate the prices of procured goods and services to increase costs. The Indonesian government has abandoned cost recovery in its production sharing contracts, even though it pioneered the production sharing fiscal regime in the 1960s, as it was unable to curb inflating cost recovery claims. Intra-firm financing for capital investments also poses a risk to government revenues where interest rates may not be ‘based on arm’s length ‘market’ prices but are rather designed to inflate costs that are deductible against taxable income’. Australia’s tax office recently won a case in which two Chevron subsidiaries used abusive debt financing and as a result, Chevron owed AUD 322 million in back taxes and penalties.
To address these challenges, the report makes a number of recommendations. First, the government should limit stabilisation and carefully analyse double taxation treaties. In order to protect the tax base, monitoring of the quantity and quality of commodity produced is essential. Establishing a reference price based on international benchmarks, where these exist, for the calculation of government revenues is also a useful tool. To control project costs claimed by a company, risk-based audits and anti-avoidance measures at the national level are important, such as setting caps on certain types of expenditures.
It also goes without saying that strengthening tax administration is vital, but an imbalance in expertise between companies and government ‘will remain, for the foreseeable future, between the lawyers and accountants’. And it may be wiser to change the balance between profit-based and production-based taxes to the latter, which have fewer associated revenue risks. Finally, project-level revenue analysis, using public disclosures, is the most effective way to understand payment to government through ‘taking into account project production and project costs, the sale value of the commodity and the applicable fiscal terms’.
The report is a reminder for the government to look beyond revisions to tax rates to ways to address the erosion of the tax base because ‘tax rates are meaningless in the absence of the tax base against which they are assessed. Put simply, whether the corporate income tax is 25 or 35 percent is irrelevant if companies report no taxable income’.
Take a look at ‘Many ways to lose a billion: How government fail to secure a fair share of natural resource wealth’: http://www.res4dev.com/many-ways-to-lose-a-billion/
This piece was initially published in Malawi’s Mining & Trade Review Issue Number 52 (August 2017).