New UN extractives industry guidance note analyzes value chain for mining, oil and gas

by Robert Feinschreiber & Margaret Kent

The UN’s Committee of Experts on International Cooperation in Tax Matters on April 6 released a guidance note for developing countries on how to analyze transfer pricing issues associated with extractive industries.

The UN extractives industry guidance note is expected to be included in the UN’s forthcoming “Handbook on Selected Issues in the Taxation of the Extractive Industries for Developing Countries,” to be launched this October.

The note analyzes the major consecutive stages within the extractive industry, namely, the facets of the extractive industry value chain. In particular, the study examines mining and mineral extraction and the production of oil and natural gas.

This would be the fifth document published in the last 18 months authored by a transnational institution intent on bringing transfer pricing analytical techniques to the attention of resource-rich developing countries.

The guidance follows work prepared by the OECD and G20 for base erosion profit shifting (BEPS) plan Action 8-10, concerning commodity transactions, which adds paragraphs 2.16A-2.16E to Chapter II of the Transfer Pricing Guidelines; the Platform for Collaboration on Tax’s January 24, paper titled “Information Gaps on Prices of Minerals Sold in an Intermediate Form;” and a World Bank Group procedural guide for practitioners and tax administrations, also published in January, titled “Transfer Pricing in Mining with a Focus on Africa.”

Unfortunately, this new UN guidance, like the recent work the other transnational institutions, ignores a host of legal and economic developments, including the impact of bilateral investment treaties on the extractive locations.

What the UN extractives industry guidance note does

As a beginning point, the UN extractives industry guidance note examines seven transfer pricing extractive industry facets: the negotiation and bidding process; the exploration and appraisal process; the development process; the production and extraction stage, namely, processing, including refining and smelting; sales and marketing; and decommissioning activities.

The UN extractives industry guidance note specifies whether each facet applies to mining or to the oil and gas industry, and discusses the nature of the specific activity and specific applicable transfer pricing methods.

The UN note fails to reach the product-specific metallurgical analysis reflected in the World Bank Group study.

As to the negotiation and bidding process, the UN note focuses on the perils of obtaining products or information, such as data?, from a related party. Similarly, the study addresses the application of the benefits test in ascertaining advisory or management services. The UN’s approach looks to cost allocation as being applicable whether or not a party can obtain a profit percentage above the cost allocation.

As to the exploration and appraisal process, the UN study examines the measures the enterprise or the tax administration should take to determine the arm’s length amount for long-term related-party leased equipment. The study focuses on the possibility that the enterprise might be overstating rental rates to the affiliate in the developing country. In addition, the enterprise might be overstating intercompany exploration services.

As to the development process, the UN extractives industry guidance note examines the assignment of extractive rights to related companies. The note suggests that tax authorities compare the assignment of rights with the outright transfer of these rights.

As to the production and extraction stage, the UN note examines concession owner lease or sale transactions. The note examines sales-based allocation keys. The UN study addresses sales of unrefined minerals, analogous to the Platform on Collaborations on Tax information gaps on prices of minerals sold study.

As to processing, refining, and smelting, the UN extractives industry guidance note addresses the transfer pricing issues affecting contract processing tolling fees. The study examines how changes in conditions determine the market price. The UN note also examines the crediting process for recoverable metals, and looks to benchmarks in the oil industry.

As to sales and marketing, the UN extractives industry guidance note addresses marketing hubs and a sales percentage award to distributors of the goods. The study raises questions concerning hindsight pricing.

The UN note also looks to the role of spot sales to determine reference pricing. The note examines the entrepreneur’s scheme to artificially create an intermediary service provider to purchase the commodity below market price and then sell the product to independent parties at a profit.

As to decommissioning costs, the UN explains how the party providing the decommissioning service to a related party might overstate its decommissioning costs.

Mining and minerals extraction value chain

The UN study provides eight specific mining and minerals extraction examples:

In example 1, a mining company in a developing country ships the physical commodity to the third-party customer. However, through a reinvoicing structure, the mining company invoices an intermediary group distribution company in a low tax jurisdiction and then the third party customer. The UN note uses a flash title concept to reflect back to back sales. The profits of the intermediary group depend on the company’s substantial marketing and distribution functions

In example 2, a coal group in a developing country mines, produces, and distributes coal. The enterprise exports ninety percent of its coal for electricity generation. The coal company has a related-party marketing company that sources customers, undertakes contract negotiations with customers, delivers the coal, and exploits the coal market.

The marketing affiliate bears inventory, credit, price, foreign exchange, and delivery risks. The marketing company is a fully-fledged distributor, earning a 7 percent margin. Customers expect a coal company to blend different coal blends, manage caloric values and impurities, and provide prompt delivery to end customers, but this marketing company has no technical sales personnel. The marketing company has no staff familiar with environmental laws necessary for competitive purposes. The marketing company outsources these functions with a related party agent, paying this company a 3 percent commission.

The revenue authority finds that comparable entities earn a 2 to 4 percent commission, not a 7 percent commission.

In example 3, company A operates a uranium mine in a developing country and sells the mined uranium to a related Swiss marketing entity at an agreed per-kilogram price under a long-term contract. Then, external developments cause the uranium price to decrease by 30 percent. The tax authorities have to be careful in applying “a hindsight analysis,” the note states.

In example 4, company B obligates itself to buy 100 percent of the coal that company A produces, an “off-take” agreement. Company B has no inventory risk from these transactions. Company A is in a position to adjust its production based on market supply and demand conditions. The drafters suggest that the tax administration should consider whether company B has assumed these additional market risks.

In example 5, taxpayer T, located in a developing country having a low tax rate, buys and sells iron ore. The intermediate headquarters are in Europe; the direct parent company is a Middle East holding company. The tax administrations are unable to find comparable data. Their data reflects 0.5 mark-up on its buy-sell transactions. Other companies in the industry have margins of 10-15 percent. T has a 6-year tax holiday. Let’s see what happens to T when the tax holiday ends.

In example 6, a US holding company owns a parent/headquarter company located in a developing country and has two Africa-based mining and operations companies. The parent company has a loss, borrowing funds at LIBOR + 2.5 percent and lending no-interest amounts to its African subsidiaries. The drafters acknowledge the difficulty of obtaining data in this instance.

Example 7 involves a copper joint venture that enters into service agreements with its joint venture owners. Under the agreement, 5 percent of its revenues are paid as compensation for technical services, in proportion to the equity interests. The joint venture participants never provided substantiation for services they ostensibly performed. They were unable to claim the services deduction.

In example 8, a mining company acquired dump trucks to transport ore and applied accelerated depreciation to these trucks. Then, after claiming this depreciation, the mining company undertook a sale-leaseback for these trucks. The country’s tax law does not include depreciation recapture provisions, creating a distortion.

Oil and gas industry value chain

Example 1 involves a fuel company engaged in the blending and refining of crude oil. Country A imports this crude oil for its customers. Unrelated parties in countries D and E acquire the crude oil in the first instance via long-term contracts. Sourcing company C (located in a low tax jurisdiction) purchases the crude oil from countries D and E, and sells the crude oil to shipping company B, which in turn sells the crude oil to a fuel company.

The drafters are concerned that the fuel company might be shifting much of its profits to sourcing company C though mispricing, and suggest the controlled foreign corporation rules might be relevant to the pricing issues at hand.

In example 2, a company is  in the petroleum industry is in process of exploration, extraction, refining, transporting, and marketing of petroleum products. The oil is the raw material for many chemical products, including pharmaceuticals, solvents, fertilizers, pesticides, synthetic fragrances, and plastics.

The company’s upstream business focuses on exploration and expensive long-term projects involving partnership interests and that include governments. The company sets up a tax haven-based subsidiary with a heavy markup to undertake the exploration. Moving from upstream to downstream, the company uses a cost contribution arrangement, making use of allocation keys. The drafters suggest that relevant tax administrations examine the selection of allocation keys and debt-equity structures.

In example 3, drilling equipment is a volatile segment of the oil and gas industry. A company decided to lease drilling equipment from a related party in boom times, when drilling equipment was scarce, paying very high amounts for the equipment. Oil prices dropped significantly a few years later and drilling equipment became available at a lower cost. The duration of the equipment lease and its cost became the issue.

In example 4, an oil and gas enterprise has received a tax concession in one jurisdiction but not in another jurisdiction. The developing country, having the concession, disallows the oil and gas company’s interest costs. The other related company includes the full interest amount of the oil and gas enterprise in its tax base. Double taxation is the result.

The issue under review in example 5 is whether an exploration success fee is an amount determined as being at arm’s length. The fee at issue is “ring fenced,” applicable to one block at a time. Stranded costs apply to when the block is at a loss.

In example 6, an oil and gas company has a cost sharing agreement (CSA). The CSA involves the sharing of R&D development costs among participants on a “projected benefits” basis using proportionately allocated costs. The drafters suggest that tax administrations review the results to determine the possibility of cherry-picking among affiliates and the selection of allocation keys.

The issue in example 7 is whether a related services company should reflect services amounts at cost or with at a mark-up. The parties at issue had developed a cost-sharing agreement among the consortium. Countries in the consortium have different views toward having a mark-up, creating a disparity among members. The drafters address the ways members of the group might cope with the disparity among consortium members.

Example 8 illustrates how the treatment of guarantees and bonds can be problematical, and suggests that the tax administrations undertake extensive further analysis when a related party undertakes guarantees or bonds.

It might not be feasible for a party to obtain the guarantee or bond but for a related party relationship, causing comparability concerns, the note observes.

Robert Feinschreiber and Margaret Kent are international transfer pricing lawyers. See their website, Their clients include diversified multinational enterprises and governments.

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