The Organization for Economic Co-operation and Development (OECD) introduced an initiative during 2019 to address the tax challenges relating to the digital economy. The initiative is divided into two pillars, with Pillar One relating to the new nexus and profit allocation rules, and Pillar Two relating to a minimum tax regime (referred to as “Pillar One” and “Pillar Two” in this chapter). These global tax measures potentially could create serious constraints on mining economics. To mitigate any unexpected tax obligations, mining companies should be aware of these changes and understand how they could impact their tax affairs.
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The mining industry breathed a sigh of relief when the OECD Secretariat Proposal document released in October 2019 (“OECD Secretariat Proposal”) assumed that extractive industries and commodities would not be subject to the new tax approach being proposed under Pillar One.1
As eluded to, Pillar One seeks to reset the nexus rules that have been the basis of the international tax system for decades. Under the nexus rules, a company can be taxed only in countries where it has a “nexus”—which has typically been defined as a physical presence. In today’s digital economy, however, the OECD Secretariat Proposal argues that companies should pay taxes where the consumer of the product resides. For mining companies this would have meant that the country purchasing minerals or metals could establish the right to tax the profits, even if the mining company concerned is not physically located there.
The extractive sector’s assumed exemption from this, however, doesn’t mean it will not be subject to new international tax rules. Pillar Two may subject mining companies to minimum tax in instances where little to no tax is paid in the mining jurisdiction in which such companies operate. “Although the sector may be exempted from the proposed new nexus rules, the BEPS 2.0 deliberations have spurred tax authorities and nongovernmental organizations (NGOs) alike to revisit some of the tax rules that apply to resource companies,” explains James Ferguson, Global Mining & Metals Tax Leader, Deloitte UK. “As a result, mining companies may once again find themselves being challenged by the ever-evolving rulebook for tax in the host countries and the international chain back to their investors.”
Transfer mispricing disputes seem to be increasing with a number of commodity-related transfer pricing cases subject to litigation in recent years. According to the International Trade Center, transfer pricing litigation has risen notably in commodity-exporting countries, such as Australia, Canada, and Russia.2
Three practices, in particular, are coming under greater scrutiny:
What is the actual “price” of a commodity? Although the question seems simple, the answer can be complex. Mining companies typically use commercial sales contracts in mineral and metal transactions, which usually contain complex pricing clauses to formulate the price at which they sell the commodities, taking into account further processing, transportation, etc.
These transactions generally take a range of considerations into account when setting commodity transfer prices—including the activities performed with respect to the marketing/trading activities (e.g., managing logistics, selling and marketing, transport and handling) and the risks assumed (e.g., product quality, liquidity, volume differences). While the industry fully understands that mineral contracts adjust the “reference” price of minerals and metals based on the terms and conditions of the agreement, the current focus by the OECD and NGOs would suggest that the commercial complexities of these agreements are not always considered by governments and tax authorities.
The OECD intends to issue guidance that addresses the reference price at which commodity transactions take place. The mining industry faces the possibility that tax authorities may use the guidance to standardize the mineral reference prices mining companies use by aligning them to prices that are more readily available to the authorities, such as prices quoted on an international or domestic commodity exchange market, or from recognized statistical agencies, independent brokers, or governmental price-setting agencies. Such an approach is unlikely to represent the full commercial aspects and could inevitably lead to further transfer pricing disputes.
Given the fact that mining companies often operate in developing markets with many risks associated with mine development, the capital costs of building a new mine are significant. So significant, in fact, that companies typically need to rely not only on internal funds and equity but also external loans and debt to fund their development costs.
The OECD and NGOs have shifted the focus onto what they perceive as excessive interest deductions claimed by mining companies. This focus is ongoing, and mining companies are set to face yet another type of tax dispute with their host nations.
The correct approach to tax relief on interest expense has been an issue that countries have been grappling with for many years, such as using thin capitalization rules that limit the level of debt relative to equity in local entities, to interest withholding taxes, and to revised transfer pricing rules. This problem now is part of the OECD recommendations in BEPS Action 4, which is designed to help host countries ensure that a company’s net interest expense deductions are directly linked to the taxable income it generates from its economic activities.
While the dust has yet to settle on these proposals, it is clear that mining companies may soon need to reconsider how they fund their mine development activities. The industry is confronted by the fact that the OECD is aiming its policy initiatives on the instruments that facilitate mine development. Financing for the mining sector is at record lows, and the competition for capital in this sector is fierce. Investors seek legitimate returns, yet the OECD’s policy initiatives do not necessarily fully consider the complexity of mining finance projects and the economic realities of investment returns. Governments receive compensation or returns for the exploitation of resources through the tax systems they deploy. The returns to the government via the tax system and the returns to the investors that risk capital should balance. This balancing act should be assessed on a continuous basis in order for an imbalance to not result in negative consequences for investment into various sectors, including the mining sector.
Mining companies invest in assets all over the world. Although many of these ownership structures are set up as direct investments, indirect investments are equally common. There are countless reasons why a company might hold an indirect interest in a foreign entity—from complying with local foreign ownership rules to building strong local networks of expertise, etc.
But what are the consequences where a mining company that is considered a tax resident of one country decides to sell its indirect foreign interest to an offshore buyer? At first glance, this may not seem like a significant issue, but such “offshore indirect transfers” raise serious questions about which tax authorities have the right to tax these transactions.
From a strictly commercial perspective, a company could argue that a transaction that takes place outside the borders of a host country should not attract tax from the host country; it is, in essence, an extraterritorial event that should not trigger domestic taxes.
Many host countries, however, do not agree. In their view, the country where the asset is located should be entitled to tax any gain made on these indirect transfers because the host country is at least partly responsible for helping to enhance the value of the asset.
Despite the existence of tax treaties, offshore indirect transfers by host countries are now more often than not subject to tax in the host country, which results in economic double taxation of transactions. Mining companies increasingly need to rely on “negotiated” outcomes to avoid double taxation, especially where the host country is not party to transactions occurring between shareholders. Tax authorities are sometimes taking this even further, seeking to tax simple business restructurings where there is no change of economic ownership at all.
“There’s a groundswell right now on additional tax measures that may be imposed on global extractive industries,” says Ben-Schoeman Geldenhuys, Mining & Metals Tax Leader, Deloitte Canada. “If these mechanisms are deployed unchecked, they could create serious constraints on mining economics, which currently face a number of commercial challenges.”
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