What are best practices for fiscal terms?
Since each country is characterized by variations in economic priorities, administrative capacities, mineral/petroleum endowments, and levels of political risk, it is impossible to identify one type or mix of fiscal instrument as best for all countries across the board. But there are certain considerations that governments should include in the design of fiscal regimes:
Since each country is characterized by variations in economic priorities, administrative capacities, mineral/petroleum endowments, and levels of political risk, it is impossible to identify one type or mix of fiscal instrument as best for all countries across the board. But there are certain considerations that governments should include in the design of fiscal regimes:
- The fiscal regime for mining or petroleum should be clearly established by laws and regulations that should be readily accessible to the public. Minimizing parties' discretion to alter fiscal terms in individual contracts facilitates contract enforcement and the application of a coherent sector-wide fiscal strategy, and reduces the risk of corruption in negotiations.
- Fiscal regimes are most stable when they contain progressive elements that give the government an increasing share of revenues as profitability increases. This can be achieved using a variety of instruments, including progressive income taxes, windfall profits taxes, and variable-rate royalties.
- When developing a fiscal regime, it is important to consider not only the total value over the life of a project, but also the timing of the expected revenue flows. Some fiscal instruments – bonuses and royalties, for example – generate revenues to the state at an earlier stage than instruments such as profits-based taxes. Governments should develop their fiscal regimes so as to generate revenues on a timeframe that corresponds with national development plans.
- Transfer Pricing. An integrated international company may use sales among various subsidiaries as a means to reduce its fiscal obligations within a particular country. A sale of mineral or petroleum output from one subsidiary to another at a price under the fair market value may serve to reduce the revenue the company reports to the government and thus limit the royalty or tax payments it owes. Similarly, by purchasing a good or service from a related company at an inflated price, a company can raise its reported costs, thereby increasing deductions and decreasing income tax liabilities. In order to limit transfer pricing abuse, a government should put in place a firm policy for the valuation of transactions between related parties, linking the prices utilized for revenue-collection assessments to objective market values wherever possible.
- Debt-to-Equity Ratios. Interest payments on loans are often deductible for income-tax purposes. Integrated international companies sometimes finance subsidiaries in extractive-rich countries with extremely high levels of debt in the form of related-party loans, which means that interest payments made from the subsidiary to its parent company are deducted, limiting the subsidiary’s tax liability. Governments can combat this problem by capping the level of debt that an extractive subsidiary can take on in relation to its total capitalization, or by mandating that interest payments made on debt exceeding a certain debt-to-equity ratio will not be deductible for tax purposes.
- Ring-Fencing. Companies that have multiple activities within one country sometimes use losses incurred in one project (say, exploration expenses from a new mine that has not yet begun production) to offset profits earned in another project, thereby reducing overall tax payments. Governments can overcome this situation through ring-fencing, the separate taxation of activities on a project-by-project basis, which facilitates the government collecting tax revenue on a project each year that it earns a profit.
- Loss Carry-forwards. Many tax systems allow a taxpayer to deduct losses generated in one year from income earned in a subsequent year. Such a system takes into account the heavy up-front costs necessary to get a project off the ground. But in an effort to prevent unfettered carry-forwards from overwhelmingly reducing long-term revenue generation, some governments have placed limits on them, restricting either the period of time that a loss can be kept on the books or the amount of income in any given year that can be offset by past losses.
- Stabilization Clauses. Petroleum and mineral contracts often have clauses that establish that the law that exists on the day that the contract is signed will govern the agreement, and that subsequent legal changes will not have any effect on the contract. These clauses offer investors some assurance that they will not be subjected by legislative action to a drastically different fiscal regime than the one on which they based their decision to invest. But in order to protect the interests of citizens, preserve state sovereignty, and remain flexible to changing economic and political circumstances, stabilization clauses should be narrowly drafted and limited to major revenue streams such as royalties, taxes, duties, and major fees. Stabilization clauses should not freeze environmental, labor or other similar rules....