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Part C: Fiscal Terms - 36. Fiscal Terms - 36.3 Taxes | 36.3(f). Deductions

Deductions are costs that may be deducted from gross revenues before corporate income tax is applied to the remaining revenues net of costs.

Which kinds of costs are deductible and which are not should generally be detailed in a law. For example, a government may want to consider specifying whether costs outside of a company’s normal business, such as community development spending, will be deductible. The law might also specify how rehabilitation costs will be treated, including whether contributions to rehabilitation funds will be deductible, whether actual rehabilitation costs will be deductible, and tax treatment of monies withdrawn from the fund for rehabilitation activities or unused monies returned from the fund to the company (for example, Kenya’s Income Tax Act addresses such issues). Countries can use legislative means to further the government interest in controlling company cost.

Generally, legislation and rules addressing deductions should include provisions for:

  • Determining the size of these deductions
  • Determining the timing of these deductions
  • Incentivizing desired behaviour by companies.

Concerning size, it is important that laws and regulations address the risk of companies inflating costs in the host country through related party transactions that reduce taxable income in the host country and shift income to a lower tax jurisdiction, thereby lowering overall tax liability. Costs may be inflated by overpaying for goods and services purchased from affiliates, which is addressed further under the section on transfer pricing in the Guiding Template.

Companies may also reduce taxable income via excessive interest payments. This may be done by borrowing at higher than market interest rates. This may also be done through “thin capitalization”, a practice whereby international investors fund projects with a small portion of equity and a large portion of loans from affiliated companies. By using more loans than equity, investors may reduce their taxable income by deducting the interest paid on these loans as costs.

Countries may address the issue of excessive interest payments by different means, including:

  • Limiting allowable debt to equity ratio for purposes of interest deductions. Rules may provide that interest payments on loans in excess of the allowable debt to equity ratio may not be deducted for tax purposes. It may be advisable to specify in law or regulations whether the debt-to-equity ratio restriction only applies to debt from related parties (if only applicable to related-party debt, the law may need to address the risk that debt is routed through an unrelated party; see the Ghana example below) and the definition of debt (for example, whether average debt over a period of time or debt at any given point in time and whether debt includes other debt instruments apart from loans).
  • Limiting deductible interest to some percentage of earnings before interest. For example, Action 4 of the OECD final Base Erosion and Profit Shifting (BEPS) report recommends that countries adopt the “earnings stripping rule” that restricts interest deductibility to between 10 percent and 30 percent of a company’s earnings (defined as EBITDA – earnings before interest, tax, depreciation and amortization).
  • Limiting use of excessive interest rates, by providing that rates may not exceed a certain percentage above a quoted benchmark rate, such as London Interbank Offered Rate (LIBOR). Use of interest rates above market rates for loans from affiliates may also be generally addressed under transfer pricing rules that require pricing for transactions between affiliates to be based on “arm’s length prices.”

Concerning timing, laws and regulations should address the rules for depreciation and loss carry forward.

Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Amortization is the equivalent for intangible assets. Depreciation/amortization rules determine what portion of the cost of the asset may be deducted as a cost in a given year and is meant to reflect the loss in value of the asset over its useful life. Accelerated depreciation/amortization allows investors to deduct a larger portion of the cost of the asset in earlier years, versus straight-line depreciation rules, which spread the cost of the asset evenly over the asset’s useful life. Accelerated depreciation reduces tax liability in earlier years, deferring tax payments to later years. This is generally preferred by investors as it allows them to retain more money in the present and, all other things being equal, that money in the present is more valuable than the same amount in the future due to its potential earning capacity (the concept of the time value of money).

Loss carry forward rules dictate whether or not unused losses from a previous year may be deducted from profits in later years to reduce taxable income. That is, a company making a loss of $10 million in year 1 and a profit of $5 million in year two, may deduct that loss in year 1 from the profit in year 2 such that net taxable income is - $5 million. In year three, it may then deduct the unused loss of $5 million in year 2 from the profit in year three and so on until the loss is fully recovered. The ability to carry losses forward again defers tax liability. Some countries allow indefinite loss carry forward; that is, losses may be carried forward for an unlimited number of years until fully recovered. Many countries limit loss carry forward to a certain number of years, usually 5-7 years.

Concerning incentivizing desired behaviour, governments may allow for accelerated depreciation for certain kinds of capital expenditures in order to incentivize companies to make such investments.

36.3(f). Example 1:

Article [_] Capital allowances

(1) Any licence holder eligible under the provisions of this Part of this [Code][Act][Law] shall be entitled, in determining its total profits, to deduct from its assessable profits a capital allowance of ninety-five percent of qualifying capital expenditure incurred in the year in which the investment is incurred-

(a) all certified exploration, development and processing expenditure, including feasibility study and sample assaying costs; and

(b) all infrastructure costs incurred regardless of ownership and replacement.

(2) The amount of any loss incurred by any person eligible under the provisions of this Part of this [Code][Act][Law] shall be deducted as far as it is possible from the assessable profits of the first year of assessment after that in which the loss was incurred and in so far as it cannot be so made, then from such amounts of such assessable profits of the next year of assessment, and so on up to a limit of four years after which period any unrelieved loss shall lapse.

Annotation

Drawn from Nigeria’s mining code (2007), this provision seeks to incentivize diligent exploration and development, including development of infrastructure, by allowing immediate deduction of the cost of exploration, development or infrastructure in the year in which the cost was incurred. The sooner a company moves from exploration to development and production, the sooner revenues may be generated from the sale of the minerals and the sooner revenues will begin to flow to the government.

Further, the provision allows for losses to be carried forward for up to four years.

36.3(f). Example 2:

Article [_]: Thin Capitalisation

(1) Where an exempt-controlled resident entity which is not a financial institution has an exempt debt-to-exempt equity ratio in excess of 2 to 1 at any time during a basis period, a deduction is disallowed for any interest paid or foreign currency exchange loss incurred by that entity during that period on that part of the debt which exceeds the 2 to 1 being a portion of the interest or loss otherwise deductible but for this subsection.

(2) In this section “exempt-controlled resident entity” means a resident entity in which fifty per cent or more of the underlying ownership or control of the entity is held by an exempt person, in this section referred to as the "exempt controller", either alone or together with an associate or associates; "exempt debt", in relation to an exempt-controlled resident entity, means the greatest amount, at any time during a basis period, of the sum of :

(a) the balance outstanding at that time on any debt obligation owed by the exempt controlled resident entity to an exempt controller or an exempt person who is an associate of the exempt controller with respect to which i. interest is paid which is, or ii. in the case of a debt obligation denominated in foreign currency, any foreign currency exchange loss incurred is, or if incurred would be, deductible to the exempt-controlled resident entity and the interest or foreign currency exchange gain is not or would not be included in ascertaining assessable income of the exempt controller or associate; and

(b) the balance outstanding at that time on a debt obligation owed by the exempt controlled resident entity to a person other than the exempt controller or an associate of the exempt controller where that person has a balance outstanding of a similar amount on a debt obligation owed by that person to the exempt controller or an exempt person who is an associate of the exempt controller; “exempt equity”, in relation to an exempt-controlled resident entity and for a basis period, means the sum of the following amounts:

(i) so much of any amount standing to the credit of the capital accounts of the entity at the beginning of the period as the exempt controller or an exempt person who is an associate of the exempt controller is entitled to or would be entitled to if the entity were wound up at that time;

(ii) so much of the accumulated profits and asset revaluation reserves of the entity at the beginning of the basis period as the exempt controller or an exempt person who is an associate of the exempt controller is entitled to or would be entitled to if the entity were wound up at that time; reduced by the sum of the balance outstanding at the beginning of the period on a debt obligation owed to the entity by the exempt controller or an exempt person who is an associate of the exempt controller; and

(iii) where the entity has accumulated losses at the beginning of the period, the amount by which the return of capital to the exempt controller or an exempt person who is an associate of the exempt controller would be reduced by virtue of the losses if the entity were wound up at that time; “exempt person” means a non-resident person; and a resident person for whom interest paid to that exempt person by the exempt-controlled resident entity or for whom any foreign currency exchange gain realized with respect to a debt claim against the exempt controlled- resident entity i. constitutes exempt income; or ii. is not included in ascertaining the exempt person's assessable income; iii. “Resident entity” means a resident partnership, resident company, resident body of persons, or a permanent establishment of a non-resident person in [Country].

Annotation

Taken from Ghana’s Internal Revenue Act (2000), this provision is meant to address thin capitalization by placing a cap of 2:1 on the ratio of debt to equity with respect to financing of the mining company by a related party. Interest payments with respect to related party debt in excess of the ratio may not be deducted for tax purposes.

The provision goes on to define related party debt and equity (“exempt debt” and “exempt equity”).

Note that the related party debt also covers debt owed to unrelated parties who have made a loan of a similar amount to a related party of the mining company. This provision allows the law to capture related party debt that is passed through an unrelated party before being issued to the mining company.