Transfer pricing challenges for the extractive industry

Ali will be presenting today on transfer pricing issues at the IBFD Africa Tax Symposium on taxation of the extractive sector, being hosted in Arusha.

From a transfer pricing perspective, one of the issues faced by the extractive industry in Tanzania is the treatment of interest free loans. Although I am concentrating on the mining industry, the same also applies to the upstream oil and gas industry.

A bit of background might be useful to understand the issues. It is only once a final investment decision has been made that a mine will be constructed and thereafter production begins.To arrive at the final investment decision on whether to construct a mine, a lot of activities/work has already taken place.

This work is typically known as mineral exploration which is the process of seeking concentrated deposits of minerals for the purpose of extracting these minerals for economic benefit. Mineral exploration typically follows a sequence of 8 phases which are (i) locating potential deposits, (ii) obtaining an exploration licence, (iii) undertaking surface exploration, (iv) early stage exploration (rock and soil sampling, geophysical studies, etc),(v) core drilling (drilling a small diameter of rock to measure how much metal is in the rock), (vi) resource modelling (involving further drilling), (vii) feasibility studies and (viii) final investment decision.

The stages prior to the final investment decision require a lot of capital (especially the early stage exploration, core drilling and resource modelling stages). This financial capital is effectively sunk costs as it would only be recoverable if (i) the area has an adequate level of mineral deposits and more importantly (ii) being economically viable.

The exploration stage is usually conducted by junior mining companies (exploration companies in search of new deposits of minerals), who typically do not have their own mining operation and tend to rely on venture capital or stock markets to finance exploration operations. Once a viable mineral resource is found, these companies would either (i) partner or (ii) sell part of their interest to a larger mining company.

Junior mining companies would source funding in the international markets and usually advance these funds to their Tanzanian entity in the form of interest free loan. The funding is used to undertake mineral exploration work by the entity in the area that ii has an exploration licence. Since this is a transaction between related parties it is subject to transfer pricing with the issue being whether a loan advanced without interest is at arm’s length.

The consensus view held by the industry and tax practitioners is that in this particular scenario an interest free loan is at arm’s length.

This is on the basis that the substance of the loan meets all the criterias (known as “delineation” in transfer pricing) to be classified as share capital from a tax perspective (i.e.there is no security, repayment of the loan is only possible if a mine is constructed, the source of the funding itself is capital, etc).

However,at times the tax authority seems to have a different perspective and seeks to deem an interest expense so as to charge withholding tax on this deemed interest.

Aside from the question as to whether the deeming of interest can crystalise “payment” for withholding tax purposes, the more fundamental questioning of such deemed interest is from a transfer pricing perspective.

The purpose of transfer pricing is to ensure that transactions between related parties are conducted on the same terms as if that transaction was between third parties.

When one just considers that no financial institution would lend to these entities due to the risks involved in the early stages of exploration (i.e. there is no guarantee that the exploration will be successful) which significantly increases the risks of non repayments and there is no security or asset that these entities are able to provide to financial institutions to secure a loan, any funding can only be classified as equity in substance as a third party would not provide a loan. Junior mining companies are very high risk with some statistics indicating that only 1 in 5,000 exploration projects reach production stage.

Why invest, well the sector can nevertheless be an attractive proposition for investors whose investment capital is diversified by way of equity capital invested in multiple companies.

The funding raised at group level is by issuance of shares which itself is equity so the funding by group to the Tanzanian entity (even if in the form of an interest free loan) retains this characteristic from a transfer pricing perspective.

 As such the substance of funding arrangements at the exploration stage should be recognised - to do otherwise and deem withholding tax on interest in essence would simply eat into exploration capital (as there is no income to fund such interest) by deeming a withholding tax liability, money that would be better spent on exploration!

Ali Dawoodbhai is an Associate Director - Tax Services, PwC.