Free Carry Interest and Production Share - overseas double tax risk

Oil refinery machine

The contribution of the extractive sector in Tanzania has been somewhat better understood in more recent years, particularly during the COVID-19 crisis when it was the mining sector that ensured resilience of the economy not least in terms of its role in generating foreign exchange.

In addition, cleaner energy initiatives have generated significant interest in not just gold, but also “green minerals” (including graphite, rare earths and nickel) with a number or agreements signed in respect of new projects.

Similarly, the oil and gas sector has also seen progress with the Government’s efforts in expediting the liquified natural gas (“LNG”) project, with the announcement on 19 May that agreement has been reached the main elements of a host government agreement to provide a regulatory framework and a production sharing agreement, and is subject to legal reviews and quality assurance before an expected signing in the coming weeks.

For these projects to move ahead timely, consideration should be made to the tax and policy matters.

 It is therefore timely that this week in Arusha the International Bureau of Fiscal Documentation (IBFD) Africa Tax Symposium will discuss taxation of the extractive sector including a particular focus on the host country (Tanzania).

In Tanzania, on top of the normal tax obligations (such as corporate income tax) Government also receives sector specific contributions in the form of royalties (based on the value of resources extracted) as well as “production share” and potentially “additional profits tax” in the oil and gas sector and “free carried interest” (“FCI”) in the mining sector.

The (petroleum) production share is a contractual commitment under production sharing arrangements (entered with the National Oil Company - Tanzania Petroleum Development Company (TPDC)) and is effectively a share of profits (but with a formula for cost relief that normally results in earlier returns to Government than under corporate income tax) for the oil and gas sector. The (mining) FCI is effectively a share of post-tax profits.

Where the extractive company has a significant shareholding by an overseas shareholder (e.g. a UK holding company with a subsidiary in Tanzania in which it has at least 10% voting power), then frequently the overseas jurisdiction will tax dividends received from the subsidiary by looking at the underlying income of the subsidiary (i.e. its profit before tax) and apply the local income tax rate (i.e. the rate applicable in the UK, in this case) to this amount, with a credit allowed for underlying income tax paid in the overseas jurisdiction (Tanzania in this case).

In practice, the term “income tax” normally refers to a tax on income (based on profits rather than any other base like say turnover) under prevailing income tax legislation.

So, whilst credit can normally be claimed by the overseas holding company for Tanzanian income tax (the underlying corporate income tax and dividend withholding tax), there will be no credit for any other imposts like royalty, which is turnover based, or other charges which are not levied under the income tax legislation.

 It is worth noting that Tanzania's controlled foreign company rules (provided under the Income Tax Act, 2004) in effect arrive at a similar result as the above in the context of a Tanzania holding company with overseas subsidiaries.

So then a challenge for the extractive sector arises because production share and FCI - much as they do have a relation with profit, they do not constitute taxes on income per se, and they are not products of the income tax legislation.

As such there is a risk of double taxation if the overseas jurisdiction does not give credit for these contributions (production share, FCI) and if at the same time other creditable taxes on income (such as corporate tax, dividend withholding tax) do not fully cover the income tax charged in the other jurisdiction.

The mechanism that some other countries use to deal with this is to have a tax treaty in place with relevant jurisdictions that are the ultimate source of the investment capital, and for the treaties to expressly recognise production share and FCI as creditable as in effect a tax on income.

The impact in this case is not to diminish the Government’s take in Tanzania, but rather to ensure that additional tax is not levied overseas if not economically justified.

Given the significant interest in the extractive sector, there would seem to be significant merit in ensuring double tax treaties are in place with likely source countries of extractive sector capital and that such treaties include appropriate tax credit mechanisms thereby ensuring we remain competitive and attract more investment.