Beneficial Ownership and Networks of Incorporation

4. Significance of beneficial ownership in extractives

Corruption and Tax Planning

In the context of natural resource governance, beneficial ownership addresses two issues.

The first is the question of illegal access to resources. This has been the focus of civil society campaigners over the last few years, considering the various scandals that have emerged in the industries.

Because hidden ownership relates to illegal activity, the resulting financial flows can be classified as illicit. Reliable figures are hard to come by but various estimates have put such illicit financial flows from developing countries at $1 trillion annually, though it should be added that caution should be exercised since the flows are outside the normal ability to track financial activity.

In these cases, knowledge of the real ownership and control of these companies would reveal who was reaping the benefit of these illegal activities.

The second major set of issues relates to activities which could be legal, but which could result in much lower revenues flowing to government from natural resource exploitation than had otherwise been anticipated. Here it is the interaction of all the moving parts of a complex web of incorporations, across many different countries, which could be the determining factor.

This application of beneficial ownership has received less attention than the first. The emerging EITI initiative on beneficial ownership, for example, is structured around introducing new reporting procedures at the country level which would require the upstream operating entities to declare their ultimate beneficial owners, but not the intervening stages. This would clearly fit the first application of beneficial ownership in the extractives context, but not the second. 

Transfer Pricing: arm’s length and related party transactions

Transfer pricing takes place when commercial transactions occur between two related parties. Beneficial ownership is also key in finding a way in to determine if transfer pricing, or to be more precise abusive transfer pricing, has been happening in a way designed to reduce the profits reported in an operating country, and therefore erode the profit base.

A brief explanation follows: Oil, gas and mining operations need to buy in goods and services for the purposes of production. If they buy these goods and services at high prices from affiliated companies and then, once they have produced their commodities, sell them on low, to other affiliated companies, any tax stream will be squeezed because the base from which it is calculated has just been eroded.

These are the issues which lay behind the stories about Starbucks and Google not having paid any profit taxes in the United Kingdom because they haven’t earned any profits there, despite operating sizeable businesses for over a decade. In these cases, it appears profits shifted to Ireland, which has a relatively low 12% corporate tax rate, because the UK operations were paying extensively for intellectual property provided by Starbucks and Google affiliates in Ireland. 

The nature of goods and services being swapped between oil and mining companies might be very different. It could be hiring in oil rigs, or selling iron ore at a million dollars a day. But the principle is the same. Make as little profit as possible in high tax jurisdictions and as much as possible in low tax jurisdictions. In this sense, the idea that we live in a global free market is a myth. According to the best estimates more than half of the goods and services that pass across international borders every day are between affiliated companies – who may or may not be swapping those goods at market prices.

As it is such a major feature of world trade, transfer pricing is supposed to be regulated and there are complex agreements and pre-agreements and systems in place around the world, sometimes down to the level of individual enterprises reaching a specific understanding with a tax authority on how it will report its own transfer pricing. These are called Advanced Pricing Agreements.

This question of companies shifting profits out of one country into another with lower taxation has become a major topic among the industrialised countries. The OECD was tasked by the leaders of the G7 group of industrialised nations to provide recommendations on how to overhaul this aspect of the international tax system in a project known as “Base Erosion and Profit Shifting”, or BEPS. They issued various recommendations on how to tighten up surveillance of intra-group business transactions.

The problem with implementing those recommendations is, with regard to extractive industries, especially in the global South, that it relies on being able to compile bases of comparison for all the prices paid out for supplies, and the prices received in for sale of raw commodities. And while there are commercial databases which provide such comparisons by industry sector, many of the supplies and services are so specific that easily comparable transactions do not exist, or at least cannot be accessed. This makes the task of identifying abusive transfer pricing harder.

It also makes it more challenging to establish beneficial ownership networks, and to understand the parties in a company’s supply chain which are related, which is essential for a government with limited oversight capacity to be able to concentrate its efforts on investigating where it really has reason to suppose there might be abuses.

One key area of transfer pricing is project finance. Often the largest input needed for a scaled extractives project which is being supplied by another part of a large business empire is the money itself. As we have seen, multinationals often operate a “group treasury” function from a tax haven, an affiliate which might have only a handful of direct employees, but whose job is to channel sometimes billions of dollars in project finance through to affiliates registered in, and operating in, the upstream.

The entity in the operating country, say in Africa, then has to pay back the loan to the lending entity, say in a tax haven in the Caribbean. which can sharply reduce the amount of profits the upstream entity in Africa is registering. This might be compounded by interest rates which are higher than might be expected, and which are tax deductible for the borrowing entity based in Africa.

While global interest rates have been low since the financial crash of 2008, with LIBOR, the reference rate used between banks, at less than one percent for most of this period, intra-group loans in the extractive industries have been registered at 10%, 12% or even 15%. These high interest rates can be explained in part, but not in whole by higher risk in operations.

Governments can protect against the use of project financing for transfer pricing in its fiscal regime, by specifying debt to equity ratios for investments and by specifying a range of interest rates which are allowable for tax deductions. But many countries have not done so systematically, and even if regulations exist there is a wide, legitimate scope for differences between one loan and another in the same country, making the job of interpreting the reasonableness, or the “arm’s length” nature of the transaction, requiring complex interpretation.

Jurisdiction shopping: interaction with Bilateral tax treaties

The incorporation networks used by businesses are often around “tax shopping” – allocating different functions such as operations, or management, or finance, to entities incorporated around the world because the jurisdiction of interest, the Netherlands say, or the Cayman Islands, has a more favourable tax treatment of that activity than elsewhere, and then combining them all in a network which achieves maximum tax advantage for the company by working a synergy across all of them.

But such a strategy also relies on tax treaties between different countries.

There are more than 3,000 bilateral tax treaties (BTT) in the world, many of them introduced in the past two decades as free market economics became a global orthodoxy. What they do is to ensure reciprocity between country A and country B in a range of tax matters. For example, if the Acacia Group uses a group treasury affiliate in Barbados to lend capital to its operating affiliates in Africa, underpinning the business logic of those transactions is the fact that Barbados and the United Kingdom, the headquarters of the company, have a BTT. It is this which allows the increased profits in Barbados to flow back to the holding company in the UK, for distribution to shareholders as dividends, without being retaxed in the UK.

One notable case in recent years of the effect of BTTs on tax receipts, and their connection to BO networks, was when in 2011 Mongolia cancelled its treaty with the Netherlands. The two countries had signed the treaty in 2004 but the Mongolian government believed that the treaty stripped a significant part of profits from the Oyu Tolgoi gold and copper mine run by Turquoise Hill, an affiliate of Rio Tinto. The particular Dutch entity which was in the Oyu Tolgoi transaction, Turquoise Hill Netherlands, had only three employees, and no office at all, yet was channelling billions of dollars of revenues out of Mongolia.

It is thus the interaction between incorporation networks and their beneficial ownership structures with the range of tax jurisdictions around the world which must be looked at in the round.