By Daniel Mulé and Eneya Maseko
In a move that will hopefully reduce corporate tax evasion in Zambia’s mining sector, multinational companies must now document all their “related party transactions” to show they aren’t using them to reduce their tax bill.
Traffic lights and speed limits set rules for driving on the road. But traffic cameras and police radar guns can also serve as effective additional enforcement and even deterrents as drivers know they can be caught and punished if they don’t comply with the rules.
Is there a parallel lesson to be learned in combating corporate tax avoidance?
This month, Zambia’s Ministry of Finance adopted new regulations that give the government one more tool to reduce the chance that mining companies are dodging taxes. Zambia is now hoping better informed tax auditing will deter corporations from manipulating the prices at which they sell goods and services to related companies, including parent companies, subsidiaries, and others within the same corporate structure. And if not, Zambia’s tax auditors will have the information needed to more effectively audit and make tax adjustments.
What is transfer pricing and why is it relevant?
Imagine that it costs (fictional) Nsima Mining $5 to mine a kilogram of a certain mineral that it sells to its parent company, Nsima Global, which markets the minerals at a cost of $1, before reselling it for $10. The group of Nsima companies has $10 in income, $6 in costs, and a total profit of $4. But what price did Nsima Global pay Nsima Mining for the minerals?
Defining this “transfer price” – the price of the first sale between the companies – matters if Nsima Mining and Nsima Global are in two different countries, where the profit can be taxed by two different governments. If the rates at which the profits are taxed in the two countries are different, companies may be able to increase after-tax profit by shifting their profits to the lower tax jurisdiction.
In the example above, surely Nsima Mining does not accept less than $5/kg, to cover costs, and surely Nsima Global does not pay more than $9/kg if it intends to resell the minerals at a price of $10/kg and had $1/kg of marketing costs. Between $5 and $9, the Nsima group has some control over setting the price, but it would be artificial for the group to assign a price at either extreme, and would raise eyebrows for tax authorities looking to address tax avoidance. For instance, with a transfer price of $5/kg, Nsima Mining reaps zero profit, meaning that the country where the minerals are being mined receives no profit tax.
The Mbeki Panel on Illicit Financial Flows has suggested that corporate tax avoidance may be costing Africa some $50 billion annually, and manipulation of transfer pricing is a key form of tax avoidance. In Zambia, particular concerns over potential transfer mispricing have been raised in the mining sector, which dominates the Zambian economy. Some of the largest mining companies, like Glencore’s Mopani Copper Mines, have been featured in the headlines over payments to related parties that may have significantly diminished their taxes paid. Some reports suggests that transfer pricing and other forms of corporate tax avoidance could be costing Zambia hundreds of millions of tax dollars annually. While it’s difficult to reliably quantify the scale of the problem, additional safeguards can be put in place to reduce the risk of transfer mispricing.
Combatting transfer pricing in Zambia
One common way in which governments often protect against profits being artificially located elsewhere is by requiring that the related companies use the “arm’s length price” – that is, the price they would get if the transaction took place between two unrelated parties. If the transfer price is equivalent to the arm’s length price, the transaction may be considered valid. In 2008, Zambia enacted incorporated an arm’s length pricing requirement (Income Tax Act Art. 97A). However, determining what the arm’s length price is can be a challenge without sufficient evidence.
Fortunately, there is a growing body of guidance on how to address transfer pricing, including specific guidance to Africaand the mining sector. In addition the African Tax Administration Forum (ATAF) has provided technical support to Zambia on transfer pricing. In line with this guidance, the Natural Resource Governance Institute (NRGI) and Oxfam have specifically encouraged Zambia to require transfer pricing documentation to allow tax authorities to verify compliance.
With its new transfer pricing regulations, Zambia takes an important step, joining a growing number of countries around the world in using documentation requirements to protect against erosion of the tax base and artificially shifting the profit. The regulations require companies to document transactions between related parties and to demonstrate that the transfer is at an arm’s length price. Multinational corporations must also maintain detailed information about the structure of the group of companies and their intra-group relationships. The documentation must be ready annually by the tax filing deadline, and must be shared with the Zambia Revenue Authority (ZRA) within 30 days upon request.
A key challenge going forward will be to ensure that the ZRA has the human resources and technical capacity to review the documentation generated by the new requirements. The ZRA must be well equipped both to assess transfer mispricing risks, so that it can request the most useful information, and to perform audits on the basis of such information. If the ZRA is empowered and sufficiently resourced, the documentation requirement can have impact: reducing transfer mispricing, both via tax adjustments and as a deterrent.
By reining in transfer pricing risks, Zambia can limit profit shifting by multinational companies, ensuring that more tax revenues are generated. If well managed, in part through stronger public finance management laws and efficient resource allocation and oversight, such revenues can provide Zambia the means to prioritize spending to address poverty as well as different forms of inequality, including gender and income inequality, as both Zambian civil society and the World Bank have recommended.
Daniel Mulé is a senior policy advisor for tax and extractive industries and Eneya Maseko, Extractive Industries Program Coordinator for Oxfam in Zambia.