Improving Natural Resource Taxation in Developing Countries

This blog entry and the referenced paper address issues faced by tax authorities in resource-rich countries, described in detail in NRGI’s Preventing Tax Base Erosion in Africa: A Regional Study of Transfer Pricing Challenges in the Mining Sector.

Policy-makers in developing countries, when choosing a mix of fiscal instruments to govern a mining or oil-and-gas development, often face a dilemma. It’s a tug-of-war between tradition, as represented by a preference for royalties that are based on the gross value of extracted product, and economic theory, represented by the use of taxes based on the extracting company’s net income, like corporate income taxes and resource rent taxes.

In the last 60 years, the balance has shifted away from royalties toward the use of levies based on net income: although producing countries typically use both royalties and income-taxes, income-based taxes have gained over the decades in relative importance.

Greater reliance on income-based levies, at least in theory, mitigates the investing company’s business risks, thereby enhancing the pool of capital available for natural resource development. But the move toward income-based levies also has brought serious, and intractable, administrative difficulties, since the measurement of a taxpayer’s net income is far more difficult and prone to taxpayer avoidance than measurement of the fair market value of extracted product. In addition, political hostility toward corporate income taxation has led to tolerance for significant tax avoidance using techniques of “base erosion and profit shifting.”

I recently wrote a working paper released by the International Centre for Tax and Development titled “Improving the Performance of Natural Resource Taxation in Developing Countries,” reflecting on this dilemma and suggesting practical solutions for developing countries.

The paper begins by demonstrating that the greater vulnerability of income-based measures to taxpayer avoidance reflects a basic arithmetical difference between royalties and income-based taxes. Companies pay royalties based on the gross value of product extracted from a mineral property, whereas they pay income taxes based on their net margin, which typically is much smaller than their gross revenues. Therefore, if an extractive company succeeds in understating the fair market value of its extracted product by even a small percentage, the government’s revenue losses under a royalty might be negligible, whereas the government’s revenue losses under an income-based tax are likely to be much more serious. Also, tax-paying companies’ overstatements of deductible expenses, including intragroup technical and management fees, and interest paid on loans from related parties, will not affect the government’s take under a gross-income based royalty, but can severely reduce revenues under income-based taxes.

In the paper I argue that, generally, governments of developing countries have not yet developed effective means of enforcing fair market valuations of extracted product, or of the amounts of properly deductible related-party expenses. I suggest two kinds of policy responses to this challenge:

• Governments should consider administrative innovations, generally in the area of transfer pricing rules, by which developing-country governments might improve their enforcement abilities under income-based taxes. These innovations are based in part on the model of “administrative pricing” or “norm pricing” that Norway has pioneered in the administration of its North Sea oilfields. The paper urges that these kinds of innovations be pursued energetically by resource-producing countries.
• Governments should avoid moving fiscal instruments toward reliance on income-based levies, as the loss of revenues from noncompliance appears more serious than any incremental benefit of income-based taxes in terms of greater economic efficiency. This is especially the case where royalties are “progressive,” the rates of which vary positively with market prices.

Michael C. Durst is a long-time U.S. tax practitioner, an author of articles on international taxation and developing countries, a former government official and law professor, and a senior fellow at the International Centre for Tax and Development.