CHAPTER 12 INTERNATIONAL TAXATION FOR THE MINERAL PRACTITIONER

• Jurisdiction: United States

International Resources Law: A Blueprint for Mineral Development
(Feb 1991)
CHAPTER 12
INTERNATIONAL TAXATION FOR THE MINERAL PRACTITIONER
Dennis J. McCarthy ¹
Coopers & Lybrand
New York, New York

I. Introduction

This paper represents an attempt to bring together in the framework of a general discussion the wide range of international tax issues which face U.S. multinationals engaged in the mining industry. The intent is to present these numerous and often complex issues in a logical fashion, demonstrate their inter-relationships and highlight their relevance to the mining industry. In addition, where appropriate, an effort is made to outline some specific ideas as well as general approaches which may be employed in the important exercise of planning transactions and structuring operations in a way which minimizes the worldwide tax on earnings.

This paper seeks to address tax issues from the perspective of an integrated mining/processing/selling operation. The ultimate parent corporation is presumed to be incorporated and headquartered in the United States, to be engaged in mining and processing operations outside the United States, and to have customers in markets around the world. The author has sought to anticipate the varied circumstances under which different taxpayers operate and to present tax principles in a manner which makes the implications to different types of operations evident.

The paper is organized so that the taxation of the earnings associated with each of three types of activities — mining, processing and selling — is discussed separately in Sections II, III and IV, respectively. In all three cases, the manner in which foreign tax normally applies and the associated issues which merit consideration are reviewed first. Following that, the incidence of U.S. taxation on the same earnings is reviewed, with particular attention being given to the mechanism in U.S. tax law — namely, the foreign tax credit — which is intended to serve to effectively "undo" the double-taxation of the foreign earnings of U.S. taxpayers. This mechanism is discussed most fully in the context of the U.S. taxation of mining earnings (under II.B.), which affords the first occasion to address the subject in detail. Throughout all three sections, however, attention is paid to tax planning to optimize the utilization of foreign tax credits, given the constraints imposed by U.S. tax law.

Finally, in Section V, the tax issues associated with selected matters relating to debt and equity in establishing foreign

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operations are addressed. In particular, considerations to be taken into account in structuring external debt financings and intercompany transfers of funds are highlighted, as are the special tax issues associated with equity participation by outside parties through joint ventures and the use of debt-for-equity swaps as sources of local currency for investments in certain countries.

II. Taxation of Earnings from Mining Activities

A. Basic Issues in Host Country Taxation

The first incidence of taxation on mining operations is that which occurs in the country where the mine is located. The major part of the tax burden usually is in the form of an income tax; however, a number of other taxes can be significant, including taxes on net worth and customs duties on imports. In addition, in many countries, a "royalty" is charged by the national or local (i.e., state or province) government on the extraction of minerals.

Among the major considerations relating to local income taxes are the following:

1. In the computation of taxable income:

(i) Is there any allowance for recovery of the cost of acquiring mineral rights?

Different possibilities include the immediate write-off of this cost (unlikely, and only beneficial if the resulting loss can be carried forward), amortization (generally over the expected life of the mine), or the denial of any corresponding tax deduction. For example, in Australia, no deduction is permitted, whereas, in Peru, the cost of acquiring a concession can be amortized over the projected life of the mineral reserves. In some countries, such as Jamaica, this is a matter for negotiation with the government when the mining concession is obtained.

(ii) What allowance is available for costs incurred for exploration and development?

Some sort of deduction is generally available for expenditures on exploration and development (meaning the sinking of shafts, tunnelling, constructing buildings and acquiring plant and equipment), although the rapidity with which the deduction can be claimed varies. For example, in Australia, exploration expenditures can generally be deducted in the year incurred, subject to a deferral if insufficient income is generated to absorb the deduction; development and associated expenditures are normally deducted on a straight-line basis over

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the lesser of 10 years or the mine's projected life. In South Africa, most exploration and development expenditures are deductible fully in the year incurred or in the first year the mine is in operation, whichever is later.

(iii) What are the local "transfer pricing" rules and how aggressive are the tax authorities in enforcing them?

"Transfer pricing" involves transactions between related parties. It is of particular significance when the parties are resident in separate countries for tax purposes, since the prices at which the transactions are effected determine the income subject to tax in each country. The tax authorities in most countries are empowered to examine transfer pricing issues. While the legislation is often vague, an "arm's length" standard is normally applied. Under such a standard, transactions between related parties should take place as if they had been negotiated at arm's length (i.e., between unrelated parties).

Transfer pricing issues can arise at several points in the mining process, including:

— The price at which capital equipment is transferred to the operation. ²

— The price at which units of the mined product (or refined product if refining takes place locally) are sold to a related party after extraction. ³

— The amount of royalties which are charged by the parent corporation in consideration for the use of technology and other intangibles.

— The fees charged by the parent for management and other services.

— The rate of interest charged on intercompany loans.

Should the host country tax authorities take the position that a local entity has engaged in transactions with a related party which were not priced at arm's length, the authorities will normally seek to adjust the income of the entity to

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what it would be under the arm's length principle. There may also be a constructive dividend, however, in which case withholding tax could be imposed.⁴ Conflicts with tax authorities resulting in adverse rulings are best avoided through development of a well-documented, consistently applied approach to establishing intercompany prices.⁵ It should be kept kept in mind, however, that, within reasonable bounds, transfer pricing can serve as a planning tool to reduce taxation. In particular, repatriation of local earnings through interest, royalties and fees is often preferable to repatriation in the form of dividends since the three former are often deductible locally and may not be subject to withholding tax, while dividends almost always are not deductible and are usually subject to withholding tax.

(iv) Are there restrictions on the deductibility of interest paid to related parties?

So-called "thin capitalization" rules operate on the concept that debt owed to a related party may, in substance, constitute equity. The presumption is that, because interest is deductible while dividends are not, there is an incentive for local operations to be capitalized with debt.⁶ Accordingly, in instances where these rules apply, interest is re-characterized as a dividend for tax purposes, the result being that the interest deduction is denied and withholding tax is determined at the rate applicable to dividends rather than interest (the former rate often being the higher).

The tax systems of many advanced countries and those of most less-developed countries do not contain thin capitalization rules. There is, however, a growing sensitivity to this issue, and legislation is expected in the future in countries including the United Kingdom and Germany (and possibly the

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European Community as a whole). Examples of countries which have legislation in place are Australia and Canada.⁷

(v) For operations conducted in branch form, what allowance is provided for deducting management and other costs incurred by the "home office" outside the country where the mine is located but which relate to the mining operation?

Most countries permit the deduction of such costs to the extent they relate to the host country operation. A central issue for the taxpayer is how specific that relationship must be: Must it be clear and direct, or is there scope for the allocation of expenses which cannot be identified as specifically relating to an activity in a specific location?⁸ Countries differ somewhat in the extent to which expenses must be specifically identified. A thorough approach to identifying home office expenses associated with the appropriate branch operations is advisable given the possible reduction in the foreign tax burden which results.

(vi) Can losses be carried back or forward to offset taxable income in other years?

Most countries permit some sort of carry forward for a specified number of years; fewer countries also permit a carry back. In some countries, the carry forward period is permanent; however, certain limitations may apply. For example, the carryover of a loss created by expenditures attributable to a given mine might be restricted such that it can only be used to offset income generated by the same mine.

2. Is withholding...