Extracting the profits of extraction: withholding taxes on oil, gas or mining extraction funds

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The rules can sometimes seem like a minefield. We explore the regulations and offer guidance on how natural resources companies can minimise the effect of withholding taxes on their extraction funds. 

Many businesses in the natural resources sector with assets held overseas are structured with an ultimate UK parent company.  When the overseas operations reach the point of income (and profit) generation, their focus often turns to repatriation of those funds for a number of potential reasons: 

  1. The need to apply transfer pricing principles to services provided intra-group (often, services from the parent company to the subsidiary) that may have been charged, or accrued earlier, and remain relevant now the subsidiary is income generating.
  2. The need to move funds upstream, to fund corporate-level costs of the group (such as costs of maintaining a listing), to make dividend payments to shareholders, or to fund new investments by the parent.
  3. The desire to reduce the level of cash holding in the subsidiary undertakings, perhaps because of the economic risks (for example, the operations may be in a jurisdiction that’s at greater risk of fraud activity or political instability). 

    How such fund movements are made may give rise to tax issues (and opportunities) in both the parent and subsidiary jurisdiction. 

    Repayment of investments

    In many jurisdictions, this is only likely to be a viable option where the investments initially made in the subsidiary were advanced by way of loan, rather than subscription of share capital. Not only is the repayment of equity capital legally more complex in many jurisdictions, but capital control and investment incentives may make such a route impossible or at least a bad idea. 

    Where loans have been made to the subsidiary, their repayment (if possible) would not typically incur tax. But where interest has been charged on the loan, any local withholding taxes on the interest are likely to crystallise in the subsidiary company on payment, where that interest is deemed settled by the payment. 

    Payment of dividends 

    Firstly, check whether the subsidiary can pay dividends. In many jurisdictions, they can only be paid from retained profits. So this may not be appropriate for an early stage extractor that has free cash but has not yet recouped its initial development spend. Again, capital controls may in any case prevent such fund flows. 

    Many jurisdictions continue to charge withholding taxes (WHT) on dividend payments. From a UK perspective this is often overlooked as the requirement was scrapped for UK companies in 1998. If these taxes are charged on dividends paid to the UK, they are a sunk cost. This is because the general exemption applying to dividend income removes dividends received (and associated WHT) from the charge to (and credit against) UK Corporation Tax. 

    Provision of services

    Often a parent undertaking (or other service entity) within the group will provide a function to the operating subsidiary which, under transfer pricing principles, should be charged for as a service provision at an arms-length rate. In a listed environment, as the parent undertaking often doesn’t trade externally, without charging for services provided to the group, it will likely accrue operating losses which may not have an outlet for relief.   

    So, in many cases, the imposition of charges will be a win:win group-wide. The subsidiary will obtain relief for the services charged, but the parent provider won’t recognise the same level of taxable profit due to the offset of costs. What’s more, by providing genuine services to subsidiary entities, and being correctly remunerated for them, the parent (if established in the UK) may be able to register for VAT in the UK. This allows recovery of UK VAT incurred on expenditure.   

    There may also be future services, such as the sales function for extracted assets into the market, which need not be performed in either the parent or subsidiary jurisdiction, but may form part of the operating structure in the future. These could provide tax advantages or make it easier to indirectly repatriate ‘cash’ by ensuring that it doesn’t transfer into the overseas subsidiary to start with. 

    That said, there will often be situations where WHT applies on the provision of services and local VAT may also potentially be charged in the overseas jurisdiction. The scope of such charges is often not as clear as knowing whether interest or dividends are subject to WHT, so it may be wise to seek local advice, as to whether a specific service provided falls within the scope of WHT. 

    The role of tax treaties

    WHT exposures are determined by the tax jurisdiction of the overseas subsidiary and are likely to be greater in less developed economies. But where transactions are between two jurisdictions that share a tax treaty, this may operate to: 

    • set a lower potential rate of WHT for transactions in scope (a treaty can only ever reduce the rate from the domestic basic provision); or 
    • set tighter parameters for the transactions to which the WHT applies (again, it can only reduce the potential exposure). 

    So where a company operates in multiple jurisdictions, it may be possible to ensure that certain services or transactions are entered into between ‘tax treaty friendly’ countries to reduce the potential burden. But beware. Increasingly, substance (“Boots on the Ground”) is required in a participating jurisdiction to benefit from a relevant tax treaty. Interposing a shell company with no real presence in a country into the transaction chain to benefit from treaties is unlikely to work. In fact, it could even worsen the position if it adds new levels of withholding into the chain. 

    Start at the beginning

    While profit extraction from overseas subsidiaries may be a long way off at the time of initial evaluation, it’s still of course the ultimate goal of any natural resources business. So it’s important to take time at the outset to identify the likely flows of funds, services and functions (all supported by transfer pricing analysis). This will enable new exploration and/or extraction companies to take appropriate tax advice early on And that in turn should help them to implement their initial plans (initial funding, parent company VAT structure, service and function flows) in a way that prevents future WHT leakage – or at least anticipates it.  

    If you would like further guidance on these complex issues, please contact Chris Riley.