Transfer Pricing Risk and the Extractive Industries: A Case Of Uganda

There has recently been significant debate about Uganda’s double taxation treaties with countries like Mauritius and the Netherlands and the amount of revenue lost through these agreements. Much as this is an issue, there is an even deeper underlying problem.

Countries around the world and especially resource rich African countries are grappling with the ever increasing threat of multi-national company transactions. Over 60% of international transactions are between companies within the same group structure, which exposes the countries of operation to the risk of transfer mispricing.

In simple terms, the price at which one company sells to another company within the same group structure is the “transfer price”. This price can be abused through “transfer mispricing”. The “arms-length principle” however requires companies to transact as though they were non-related (Independent).

The extractive industries comprise majorly mining and oil and gas from which many African countries derive their revenue. As a result, the issue of transfer mispricing should be of major concern to these states otherwise they will not realize the full potential revenues associated with the sector.

It is important to understand the extractive industries value chain for both mining and petroleum and assess the risk across this chain based on the functions performed at each stage.  According to the Natural Resource Governance Institute (NRGI), the value chain consists of the Acquisition and exploration phase, Development and production, Transportation, Refining and finally trading, marketing and sales of petroleum or minerals.  There are however different variants of the value chain introducing aspects of the legal framework, contract award, licensing and revenue allocation and management.

Depending on what stage of the value chain a country is, the risk of transfer mispricing may vary. A lot of focus is normally centred at the end of the value chain where revenue begins to flow to the country and thus the cost aspects that determine the resultant revenue are often ignored.

To put this into perspective, there have been numerous discussions around the value of the Extractive Industries Transparency Initiative (EITI) to a country like Uganda. However, despite the various facets of the EITI guidelines, more emphasis is placed on transparency of the revenues earned from payments made by the oil companies. This ignores the cost element that could be inflated by practices like transfer mispricing resulting in further erosion of revenues. This affirms the significance of cost recovery audits under a production sharing regime in the petroleum industry.

In the exploration and development phase of the oil and gas industry where Uganda lies, different transfer pricing risks may arise. This is more of an expenditure phase and thus more emphasis is placed on cost management. As earlier mentioned, it is the efficient monitoring and management of these costs that will provide us with an adequate share of revenue at the end of the value chain.

Locally registered oil companies (subsidiaries) receive various forms of support from their headquarters (parent company) during this phase. This phase involves numerous technical and research oriented studies normally performed at a technical hub at the headquarters or another low tax jurisdiction. The studies are usually undertaken using a time-rate system whose rates are subject to debate. These are considered high value adding services. It is still important to ensure that these rates are at arms-length and that these studies and research are of benefit to the subsidiary incurring the cost.

Further, parent companies may offer loans to their subsidiaries to aid in cost intensive exploration and development work programs. There is always a risk that these rates are above average market rates or international comparable interest rates on loans to similar projects in similar jurisdictions.  Other low value adding support services such as legal services, audit and accounting need adequate attention to establish the value added to the subsidiary and the cost and markups charged.

At the end of the value chain, the risks tend towards the pricing mechanisms and the marketing costs for the oil or minerals. The parent company could set up a marketing hub at the headquarters or a low tax jurisdiction to market and sell the products on behalf of the subsidiary. It is important to understand the functions of these hubs, the risks they incur and their ability to provide this service. It is also vital to ensure that the marketing cost charged is comparable to what an independent party would pay for the same service.

Pricing becomes more complicated especially with related party transactions. The parent company or marketing hub could offer lower prices for the products sighting quality reasons. The government should hence have the capacity to determine the quality of its products. Further, the subsidiaries could enter into long term hedging contracts with the parent or marketing hub to buy the products at lower prices than the prevailing market rate. All these measures erode the revenue due to the country, if not checked.

Legislation plays an important role in addressing these issues. Uganda has transfer pricing regulations enshrined within the Income Tax Law. Many other countries however lack sufficient legislation. The OECD (Organization for Economic Co-operation and Development) through the BEPS (Base Erosion and Profit Shifting) project has made significant steps in designing guidelines on tackling transfer pricing issues across the globe. Many countries have adopted these guidelines (Uganda inclusive) and if implemented, should reduce the loss of revenue through transfer mispricing.

It is important for this legislation to be consistently applied in both mining and petroleum agreements. Uganda’s petroleum sharing agreements consistently refer to the arms-length principle between related party transactions, which gives the country a buffer against the risks involved. Further, regulation 73 of the Petroleum Exploration Development and Production regulations 2016 clearly defines the mechanism of pricing crude oil clearly making reference to the arms-length principle and a “norm price” mechanism that provides a buffer against transfer mispricing risk.

Transfer pricing audits normally fall within the mandate of the revenue authority. Within the East African region, both Tanzania and Kenya have recognized the risk and conducted separate transfer pricing audits across various sectors. The Tanzania Revenue Authority in particular has performed audits in both the mining and petroleum sectors. These audits require efficient co-ordination of government agencies such as the Ministry of Energy, Sector regulators, the Office of the Auditor General and the Revenue Authority.

The International Monetary Fund (IMF) estimates that over USD 50 Billion annually is lost from Africa through Illicit Financial flows especially by aggressive transfer mispricing arrangements. Resource dependent African countries thus need to enhance their capacity in the audit and review of transfer pricing issues in the extractive industries to reduce these outflows.

By Godwin Matte – SAI Uganda

Comments are closed.