1. Extractive Industries Taxation Master Class WorkshopBy
Ruth Wachira

2. Risks from Taxation Point of View
Transfer Pricing Sales Related Risks
Transfer Pricing Cost Related Risks

3. Why is Transfer Pricing so key in the Sector?
Most of the services and inputs for operations are imported since they are highly specialized. Hence the transfer pricing cost risks.
Most of the products extracted are exported mostly in raw form. Hence the transfer pricing sales risks.

4. Transfer Pricing Sales Risk
Easy to mitigate with the right tools;
Verify Quantity after extraction
Quality-verify using lab testing and other internationally recognized methods of testing.
Quoted Values-There are internationally recognized commodity exchanges available on subscription

5. Transfer Pricing Cost Risks
Knowledge gaps on the industry by Tax Authorities
Highly specialized commodities
Most operators and contractors tend to have some relationship
Need to be aware of intra-company transactions and the resultant Transfer Pricing Issues, especially for services and financing
High Barriers to entry
Could lead to profit manipulation through Hedging
Foreign Currency Denominated Transactions
Lenders are worry to lend to risky entities. This leads to intra-company financing and the interest rates may not pass arms length test.
High Risk Industries

6. Cost Related Tax Risks in the Extractive Industries
Transfer Pricing
Most of the players in the industry are Multinationals.
Thus, TP issues are many due to the related party transactions.
Common issues:-
Intra-group services
Intra-group financing
Transfer of interests amongst related parties

7. Transfer Pricing Cost Risks: Intra-group Services
Two tiered approach i.e.
Evidence for provision of services.
Determination of the arms’ length price of the services.
Often, this analysis takes time due to the level of evidence required as well as the complexity and technical nature of the transactions involved.
Benchmarking studies have to be conducted to determine the arms’ length price of the tested transactions. Commercial databases are used and sometime Internal Comparables.

8. Transfer Pricing Cost Risks: Intra-group Financing
Objective: Ensure that the related party loans are priced at arms’ length.
Documentation about the borrowing and the general terms and conditions of the transactions is key for Transfer Pricing analysis.
Overcharged interest is normally adjusted to reflect the arms’ length rate.
What about interest free loans? Deeming provisions apply.
WHT is charged at the prescribed rates
Deemed interest expenses is not allowable.

9. Why is Intra-group Financing Important?
Debt Shifting to high tax jurisdictions and hence more interest deductions compared to the rest of the group.
Lower Taxes paid by the resident Company.
The above requires that contractors distribute the interest expense reasonably within the group to avoid punitive adjustments. Evidence shows that the effect on group profitability may not be significantly affected but tax is.

10. Effect of Intra-Group Financing: Illustration
Country A
Low Tax Jurisdiction-15% tax Rate
Does not tax dividends
Country B
Developing Country, rely on CIT-37.5% tax rate. Has DTA with Country A
Scenerio A
Company X in Country A borrows 3% and on lends to Company Y in country 10%
Win-Win Scenerio
Company X in Country A borrows USD 3% and on lends to Company Y in country 5%
Scenerio B
Company X in Country A borrows USD 3% and on lends to Company Y in country 10% X Y
Group 15 30 7 -
(10) 22 5 27
(3.3)
(1.875)
(5.175)
18.7
3.125
21.825 X Y
Group 15 30 2 -
(5) 17 10 27
(2.55)
(3.75)
(6.3)
14.45
6.25
20.7 X Y
Group 15 30 -
(3)
(10) 12 27
(1.8)
(5.625)
(7.425)
10.2
9.375
19.575
Gross Revenues
Interest Income
Interest Expense
Profit before Tax
Tax
Net Profit

11. Taxation of Dilutions

12. Dilutions Transfer of Interest (Farm out/Farm in) Two Types:
Direct-mainly within the country and is easy to detect
Indirect-Outside the country and more difficult to detect
Characteristics
1. Difficult to value since interest transferred is not always proportional to consideration
2. These form part of the capital expenditure that is recoverable in five years. This is a timing expense to the companies. It also acts as a deterrent for those who would want to hold the license for speculation.

13. Transfer of Interest to Related Party
Transfer of interest in a person
The net gain on disposal of interest in a person if the interest derives 20% or more of its value from immovable property in Kenya.
For the purpose of this law “immovable property” means – mining right, an interest in a petroleum agreement, mining information or petroleum information.
The applicable rate of tax is as per the Ninth Schedule to the Income Tax Act – 30% for residents and 37.5% for non residents with permanent establishments
The valuation of the interest transferred would be exposed to transfer pricing risk where such transaction take place between related parties.

14. Other Tax Risks in Extractive Industries

15. Other Cost Tax Risks in the Extractive Industries
Allowable expenses
Generally, allowable expenses are those incurred wholly and exclusively for production of income.
Auditors are required to verify the expenses incurred including the capitalized costs with a view to ensuring that the same are allowable under ITA.
Production and valuation of commodities
At production stage, KRA will be keen on ascertaining the level of production.
Valuation will be audited to ensure it is in line with the Law especially where the sales are made to related parties.

16. Other Tax Risks in the Extractive Industries
Employment benefits
Total gains or profit from employment or services rendered must be in line with the law.
The risk relates to failure to include non-cash benefits i.e.
Housing benefit/ Accommodation of employees at the sites?
Other non-cash benefits“..value of benefit, advantage or facility of whatsoever nature the aggregate value whereof is not less than KES 36,000..” e.g. staff meals.
The above items should be charged PAYE at the appropriate rates as provided by the current law.
Any industry challenges, should be addressed through the on-going Income Tax Act overhaul.

17. Distribution of Gross Revenue
1. Total Government Share
Government Share
Taxes Paid on behalf of the contractor
2. Total Contractor Share
Cost Recovery
Contractor Share of Profits

18. Basis of Cost Recovery Anchored in the Agreement
PSCs allow recovery of 60% of operating costs from the gross revenues. If the costs exceed 60%, recovery is carried forward until such a time full recovery is made.
Other costs recovered –Exploration Costs
Capital Expenses-at a rate of 20% per year for five years
Financing Expenses

19. How can Government Share Be Assured?
Increase in Profitability-this is however not inelastic so it may not be the best option.
Reduction of Costs-More realistic intervention and hence need for proper audits
Ring Fencing of expenses to a license area to avoid double recovery of costs

20. Subcontractor Issues

21. Subcontractor Tax Issues
Mainly affected by two taxes;
Withholding Tax-this could lead to double taxation if the country of resident for the company does not allow tax credits from the full taxes recovered in the source country.
Supply of locally sourced or imported goods that are exempt and hence inputs are not recoverable since they supply exempt persons.

22. Incentives
The applicable incentives are in built within the Production Sharing Agreements and includes stabilization clauses