Tax in Developing Countries: Increasing Resources for Development

Written evidence submitted by Revenue Watch Institute

Information about the respondent - Revenue Watch Institute

The Revenue Watch Institute is the only international non-profit policy institute and grant-making organization whose sole focus and expertise is the responsible management of oil, gas and mineral resources for the public good. This includes a strong focus on maximizing the ‘tax take’ in resource rich countries, and its sound investment in economic and social development. We work in resource rich countries in Africa, the Middle East, Eurasia, Latin America, South East Asia and the Pacific.

We also work at the international level on areas of relevant policy and regulation. We have played central roles in the establishment of the Natural Resources Charter, the Extractive Industries Transparency Initiative and the Publish What You Pay coalition. Revenue Watch has also been at the core in driving new country and project specific reporting rules for extractive companies in the US, UK, Hong Kong, and EU.

Executive summary including summary of recommendations

Oil, gas and mining very likely represent the single most significant untapped source for financing development in resource-rich low- and middle-income countries, especially in Africa. But while extraction and wealth generation from developing countries is accelerating, domestic revenue capture to date has generally been low and poorly used. This is a consequence of problems in both the resource rich countries themselves (of government capacity and independent oversight) and in weak international systems for regulation and transparency of the extractive and financial sectors. Non-renewable resources are, by definition, a one-time opportunity – when they are gone, they are gone. So focus and speed is of the essence for both domestic and international reform in three main areas:

A. Lifting the cloak of secrecy around the extractive sector and the global flows of revenues they generate

To do this, three principles must be integrated into all interventions and policies:

· Citizens have a right to expect to be unequivocally better off as a result of the exploitation of their resources. Principals that act to manage the resources on their behalf, such as governments or companies, must be accountable to these ‘citizen owners’ for the use of resources and where the benefits accrue.

· Such accountability requires transparency. Citizens therefore have a right to information sufficient to allow them to judge whether they are receiving a fair return for their resources and that the revenues generated are being well used.

· Such accountability and governance also requires symmetry between the capacity of the governments and companies, and between these principals and oversight bodies (parliaments, civil society and media). Development assistance must strengthen these symmetries. This typically requires investment in governments but also strong investment in the capacity of oversight actors at the sub-national, national and international levels.

Such principles will generate policy and funding implications, not just for ‘aid’ work by DFID, but also for trade, financial and corporate regulation by BIS and the Treasury, and the need for UK leadership in bodies that set standards like the EU, and the International Accounting Standards Board.

B. Prioritising development aid in resource rich countries, and improving revenue collection and use from the oil, gas and mining sectors.

· There is a clear need for higher DFID investment in strengthening revenue frameworks, collection and management related to the extractive sector and corporate taxes in resource rich countries.

· This should include the development of local ‘capacity to develop capacity’ on extractive resource management by investing in regional ‘hubs’ of training and expertise, reducing external dependency.

· To improve revenue collection, aid should support development at the following key stages of the extractives value chain:

Ø Strengthening cost-benefit analysis and other initial assessments to inform the decision to extract

Ø Establishing effective national fiscal and legislative frameworks

Ø Ensuring good terms in licenses and contracts and their transparency

Ø Fostering transparency and accountability to support revenue collection

Ø Improving revenue collection systems and capacity.

· To improve the use of the revenue base to improve service delivery and development outcomes, aid priorities in resource rich countries should include:

Ø Strengthening transparency and accountability for the use of extractive revenues

Ø Supporting increased diversification to reduce dependency

Ø Improving the reinvestment of revenues domestically to build the non‐resource economy

Ø Fostering the movement for budget transparency and accountability to citizens.

C. Leading the reform of regulatory and other international mechanisms to improve revenue collection and reduce capital flight

The UK is positioned powerfully to lead global reform by:

· Demonstrating clear and public UK leadership in the development of mandatory reporting standards for companies that are country and project specific, starting with extractive activities. Grabbing the current 6 month window of opportunity at the EU to ensure that new proposed reporting rules are fit for purpose and the highly active corporate lobby does not roll back transparency

· Pressing for development of an International Financial Reporting Standard on country by country reporting

· Expanding transparency requirements for multilateral investments and export promotion, in the UK and through the G20, relating to the publication of:

Ø extractive contracts

Ø payments and other key financial information

Ø the beneficial owners of all corporate actors.

Outline of the problems faced

Strong domestic resource mobilization and use is the only path to genuine sustainable development and an end to aid dependency. Oil, gas and mining very likely represent the single most significant untapped source for financing development in resource-rich low- and middle-income countries, especially in Africa. In 2008, aid flows to sub-Saharan Africa reached $36 billion per year. Natural resource rents, by contrast, stood at $240 billion. But in the more than 50 countries that are classified as ‘resource-rich’ by the IMF, there are still in excess of 1.5 billion people living in poverty on less than $2 a day.

The history of this paradox shows developing countries receiving a low share of the wealth generated by extraction [1] , benefits concentrated in the hands of the elite few, with the resulting poverty and inequality fuelling instability and conflict in which millions have died, often funded at least in part by natural resource wealth [2] . But this outcome is not inevitable. Countries like Botswana and Chile have shown that extractive resources can be used to fund development. The potential is huge. Focus on this vital area and understanding of the need for systemic changes is growing. But non-renewable resources are, by definition, a one-time opportunity – when they are gone, they are gone. So speed is of the essence to increase support to developing countries and reform extractive and financial corporate regulation.

The problems preventing strong resource use for development arise from three main areas and the UK is positioned powerfully to act in all of them:

A. At the root, there has been a cloak of secrecy around the extractive sector and the global flows of revenues they generate.

Loose use of terms such as ‘commercial confidentiality’ and ‘national interest’ have been used to keep crucial information and decision making away from citizens, making accountability impossible, even though the country’s population are the legal owners of the resources.

For example, the Revenue Watch Index (2010) showed that only five of the 41 countries surveyed fully disclosed their extractive contracts, a form of transparency essential to ensuring oversight of the deals done and collection of revenues owed [3] . But the rationales for such secrecy norms do not hold up to scrutiny. A study by Columbia School of Law showed that the so-called confidentiality clause in most extractive contracts actually allows public disclosure if both parties agree, that there is very little content that is actually commercially sensitive in most contracts which can be readily removed for general contracts disclosure, and that many contracts are actually available for sale within the industry. [4] . Contracts disclosure, publication of revenue flows, disclosure by public officials of assets and conflicts of interests, use of tax havens – these are all areas where radical new norms and systems of transparency are needed.

Then to translate transparency into accountability, development aid needs to invest as heavily in the capacity of oversight actors as in governments if they are to have the skills and resources to hold governments, extractive companies and banks to account.

B. In resource rich countries, there has been inadequate capacity to manage extractives well

Extractives are a very complex and volatile sector. Developing country governments often have limited capacity to engage with and oversee the multi-nationals that bring huge capital, experience and expertise. They need help to establish good fiscal frameworks, negotiate good deals, track and collect revenues owed, prevent corruption, minimize tax evasion and capital flight, and invest the resources in effective development. Improvements that Revenue Watch recommended in Guinea’s mining fiscal code are expected to bring over US$3 billion per year into Guinea’s treasury from iron ore mines, beginning in 2017. Suggested changes in Ghana’s Petroleum Revenue Management Bill should make available an additional $240 million to $440 million per year for investment in agriculture, rural development, forestry management and other key development areas. Such policy improvements clearly have huge potential, but only if they are backed by effective implementation. This is a technical challenge, but also a political one, and domestic oversight actors need adequate capacity to build political will and accountability.

C. At the international level, systems of transparency and regulation of both extractive multinationals and the financial sector have been wholly inadequate, allowing tax avoidance and evasion on a huge scale by both multinationals and individuals

According to Global Financial Integrity (GFI), approximately $1.26 trillion left developing countries in 2008, with average illicit outflows averaging $725 billion to $810 billion annually over the 2000 to 2008 time period measured. During this period GFI estimates that Africa experienced the largest real growth of illicit flight of any region, at 21.9% [5] .

For the period from 2007 through 2010, the IMF found that $32 billion were missing from government funds in Angola alone, equivalent to a quarter of its annual GDP. Despite its huge oil wealth, Angola ranks 148th on the Human Development Index [6] .

Studies suggest that there is a link between extractive activities and high levels of illicit financial flows [7] . Of the three recognized streams of proceed for illicit financial flows - (i) corruption by government officials, (ii) criminal activities (i.e. drug trading, oil bunkering, etc.), and (iii) commercial transactions (e.g. corporate tax evasion and commercial money laundering) - within developing countries, GFI estimated that losses stemming from commercial transactions represents the lion's share, at 60-65% of the total.

Oil, gas and mining companies are some of the most powerful and profitable in the world. They are using sophisticated accounting practices to reduce the payment of taxes in the countries where the extraction of resources actually takes place, the countries where the majority of their profits are actually generated [8] .

Developing countries cannot solve such problems alone. They need leaders in the regulation of the financial sector, and countries that are home to many of the world’s extractive companies-or that regulate the exchanges on which their stock is traded-to take action to improve transparency and reduce illicit flows. The UK is powerfully positioned on both fronts.

Recommendations for action

A. Lifting the cloak of secrecy around the extractive sector and the global flows of revenues they generate by integrating three principles into all interventions and policies:

Strengthening governance is as vital to improving revenue collection and use for the public interest as strengthening technical skills of mining and oil ministries. In almost all countries, sub-soil resources are owned by the population. This generates three principles which should inform all interventions:

· Citizens have a right to expect to be unequivocally better off as a result of the decision to exploit their resources. Principals that act to manage the resources on their behalf, such as governments or companies, must be accountable to these ‘citizen owners’ for the use of resources and where the benefits accrue.

· Such accountability requires transparency. Citizens therefore have a right to information sufficient to allow them to judge whether they are receiving a fair return for their resources and that the revenues generated are being well used.

· Such accountability and governance also requires symmetry between the capacity of the governments and companies, and between these principals and oversight bodies (parliaments, civil society, media). This means that development assistance should strengthen these symmetries – this typically requires investment in governments but also strong investment in the capacity of oversight actors. This must be considered when looking at support at the sub-national, national and international levels.

These apparently obvious standards, if implemented, would actually generate important and fundamental changes in some of the established norms surrounding resources management.

Then in terms of specific areas for UK action, these are as follows:

B. Prioritising development aid in resource rich countries, and improving revenue collection and use from the oil, gas and mining sectors.

Increasing DFID investment in strengthening revenue frameworks, collection and management related to extractives and corporate taxes in resource rich countries

There is scope for much more concerted investments in this priority area that should yield strong returns in these high value sectors [9] . A rapid analysis of investment to date and possibilities for joined up and concerted action would be a good start. This might include existing priorities (for example in Africa) but also include new opportunities (for example in Libya and the Middle East in the wake of the Arab Spring. Investment should then follow rapidly to minimize waste, developing both oversight and government capacity and systems.

Developing capacity strengthening approaches that are themselves sustainable

There has been much flying in of international experts to developing countries. There will always remain niche areas where this is needed. But there is a huge and pressing need for developing countries and regions to ‘develop the capacity to develop their own capacity’.

Revenue Watch has been focusing on this for the past six years through the creation of a series of regionally based capacity building institutions, or ‘Extractive Knowledge Hubs’. Each is based in an existing academic or training institution, independent, locally staffed, and focused on meeting the local needs of actors in the region. Hubs have been created in Africa, Eurasia and Latin America, with plans for South East Asia and the Middle East, but all need additional support. We offer this model to encourage thinking about capacity building approaches that are long-term, locally owned but internationally supported in their early years.

Using development aid to better support developing countries to improve revenue collection

Ø Importance of looking at the entire ‘value chain’ in a country to maximize revenue collection

There are many stages between identifying the potential of resources in the ground and collecting maximum revenues from those areas. Each requires careful structuring and management. The following headings go through key stages of the value chain, showing where development aid can improve ultimate revenue collection:

Ø Strong cost-benefit analysis and other initial assessments to inform the decision to extract

Extractive resources are location specific, but they are not the only possible use of most land or sea areas, and they typically generate adverse costs. Support for effective analysis of actual costs of extraction, opportunity costs from the loss of other more sustainable uses, and likely returns are necessary to decide whether or not to extract, and if so, how to best to structure deals with companies.

Ø Establishing effective national fiscal and legislative frameworks

Multinational companies often have much greater financial and legal capacities than governments, and can currently make use of international financial structures to minimize their apparent profits and therefore payments. Countries need advice on: structuring their fiscal frameworks to maximize their chances of collecting what is owed; dealing with the high volatility of the extractives sector; judging where to set tax rates; establishing transparency and oversight systems within the legal system.

Ø Ensuring good terms in licenses and contracts and their transparency

Many extractive deals are currently negotiated in secret. Where they do come to light, they often show poor terms for the country, even when the laws are strong. Aid can support the establishment of strong systems for licensing and contracting. This includes encouraging the establishment of open bidding processes whenever there is sufficient data on the resource (and investment in data generation where there is not), and establishing legal requirements for disclosure of the genuine ‘beneficial’ owners of companies that are bidding, to prevent shell companies distorting the process. Government negotiators are often ‘out-gunned’ by companies. Aid can help support government negotiators access independent expert advice. It can support publication of contracts on national databases that ease access and analysis.

Ø Improving revenue collection – fostering transparency and accountability

For decades, many developing countries have received very low returns for the resources extracted and/or the general population has seen very little benefit – but actual data to prove this in relation to particular deals, or to systematically hold governments and companies to account, has been extremely difficult to access, especially for citizens in the affected countries.

To hold governments to account for the revenues received, and therefore how they use them, initiatives like the Extractives Industry Transparency Initiative (EITI) are crucial. (For more on the EITI, see below).

However, in terms of holding companies to account for paying revenues owed, and governments to account for collecting them, the EITI is more problematic at present. The minimum standard only requires the publication of payments data itself. This can be very useful where there are extreme cases e.g. where a report shows that companies are paying no corporate taxes at all (e.g. Tanzania EITI report 2011). This might assist with helping revenue authorities with limited resources prioritize their audits. But payments data alone does not allow comparison with the value of the resources extracted or the costs incurred in order to determine what should be paid.

A stronger approach would be to support the development of standard broader transparency that led to the publication of production, costs, sales and profits as well as revenues paid for each project by each company. This would allow real understanding of the wealth generated and of the effective tax rates. It would also act as a deterrent to reduce the extremes of tax evasion and avoidance. This could be done within the national EITI mechanism, or published by the government alone. For genuine accountability, this should be linked to disclosure of contracts, to determine whether companies are meeting the terms of those agreements. This broader remit of the EITI is under discussion in the EITI’s strategy discussions (see below).

Ø Improving revenue collection - systems and capacity to increase revenue capture

Countries face huge problems in collecting the revenues they are owed. Some lack basic systems for physically monitoring and valuing production and exports, often relying on the companies to tell them what has been produced and what it is worth. This is a clear area for investment and support. They often also lack the electronic systems to map the concessions and track payments against what is owed. Here, it may be useful to look at the new system being piloted in Sierra Leone especially since the government has chosen to share the information publicly on an interactive website [10] . Government audit departments are typically under-staffed and resourced. Investments in government capacity must be supported by that for civil society, media and parliament so that they can play an effective watchdog role.

But even countries with relatively good capacity and systems face problems in dealing with trade and transfer mispricing that cannot be dealt with at the level of individual countries. This could be assisted by the creation of central databases on pricing information to assist revenue departments reduce tax evasion, especially in the overpricing of intangibles. But the most effective solutions lie in the creation of international systems of transparency (country by country reporting, automatic exchange of information, international disclosure of beneficial ownership) to give countries the systematic information they need.

Using aid to support developing countries to use the revenue base to improve service delivery and development outcomes

There are a range of interventions needed to support better use of the revenue base. Priorities include:

Ø Strengthening transparency and accountability to improve the use of revenues collected

The Extractive Industries Transparency Initiative (EITI) represents a good starting point in generating public data about what revenues have actually been collected, a crucial first step to track their use [11] . Priorities for aid should include: supporting civil society involvement since they are usually the least well-resourced of the three official multi-stakeholder participants required; making reporting regular, reliable and fit for purpose; supporting dissemination and use of the data, such as through the use of electronic platforms that aid comparative analysis [12] ; and tracking payments into the budget and onto spending.

The EITI is currently reviewing how to make the initiative more effective and impactful, primarily from making EITI reports more reliable and far-reaching. There is resistance to these improvements from some companies and governments, even though several independent evaluations of the initiative find it must do more in order to actually improve natural resource governance. Given their founding and continued investment in EITI, the support of the UK - given its investment in EITI - would help significantly.

Ø Support for increased diversification to reduce dependency

Volatility in commodity prices underscores the need for long‐term economic diversification in low‐income resource‐dependent countries. Support for the development of prudent fiscal policies driven by medium and long‐term expenditure frameworks-and not by revenue availability-are critical to mitigate vulnerability to erratic prices. This is essential to avoid boom‐bust cycles, sustain economic growth, and reduce dependency on non-sustainable resource revenues

Ø Support the reinvestment of revenues domestically to build the non‐resource economy

Support is needed to facilitate the use of natural resource revenues for domestic investment in physical, social and human assets, not for consumption or current spending. Governments from low‐income countries need to prioritize the adequate provisioning of key public goods and social protections for the most vulnerable sectors of society. Parliamentarians, civil society and the media need support to assess the policy options and trade‐offs necessary to foster sustainable economic growth and human development [13] .

Ø Support the movement for budget transparency and accountability to citizens

Citizens should be able to see clearly how their budgets are allocated, be involved in this decision making and be supported to monitor implementation and effectiveness of spending. The International Budget Partnership has pioneered work in this area, with DFID’s support and this should remain a priority [14] .

C. Use of regulatory and other international mechanisms to improve revenue collection and reduce capital flight

There are some essential mechanisms to generate open and comparable information and provide a disincentive to illicit flows that can only be generated by regulators that hold the keys to international corporate and financial regulation.

Ø Express clear UK leadership in the development of mandatory reporting standards for companies that are country and project specific, starting with extractive activities. Grab the 6 month window of opportunity at the EU to ensure that new proposed reporting rules are fit for purpose and the corporate lobby does not roll back transparency.

To determine real profits made in relation to real jurisdictions and therefore taxes owed, companies must disclose their financial transactions (production, costs, revenues and payments to government) broken down so that it is possible to see this on a country and project-specific basis. To be genuinely useful in identifying illicit flows, this information would need to be reliable, comparable and therefore standardized between companies and jurisdictions. Such reporting would make a pivotal difference in identifying tax evasion and avoidance and incentivizing its reduction globally, and make a huge contribution to resource mobilization in resource rich developing countries. There are two mechanisms by which this would be achieved, both of which involved setting mandatory financial reporting rules for companies with extractive activities: listing rules and accounting standards.

The US has already passed a listing law requiring country and project specific reporting of payments for all extractive companies reporting to the Securities Exchange Commission – Dodd Frank Section 1504. Since so many international extractive companies are listed on the major stock exchanges (including those from China, Brazil, Canada, US and Europe) this will have global impact. Similar rules have also already been adopted by the Hong Kong stock exchange in China. Europe lags behind. The importance of the UK as a key financial market makes leadership vital.

Similar legislative proposals were tabled by the European commission in October 2011 and are currently under consideration. Decision making may be complete by June 2012. There is an urgent need for the UK to express stronger leadership in taking these forward. There have been general public statements of support by the Prime Minister and the Chancellor, but DFID is not seen to be promoting the issue despite the clear development advantages.

For the reporting rules to be fit for purpose, key elements will need to be promoted but it is extremely concerning that the UK has so far failed to express support for key elements. These include avoidance of exemptions for opaque regimes that do not wish to have data made transparent, definitions of projects that are meaningful for locally affected communities, and reporting thresholds that are relevant to local governments, not giant multinational companies.

Extractive multinationals are fighting hard to roll back the progress on transparency. They have mounted an aggressive attack in the US, threatening regulators with legal action, and have come together to hire professional lobbyists to target the EU and its member states. Politically, there is need for a strong message that opacity and financial manipulation by corporates in the wake of the financial crisis will no longer be tolerated, for the benefit of developed and developing countries alike.

Ø Actively promote movement to a global reporting country by country standard by pressing for development of an International Financial Reporting Standard on country specific reporting

International Financial Reporting Standards (IFRSs) are set by the International Accounting Standards Board, registered in Delaware but headquartered in London. The key advantage of IFRSs relates to their broad geographical coverage. More than 110 countries already require or allow the use of IFRSs. All the EU members, South Africa, and Australia currently require companies to use the IFRSs. Other countries are on paths of ‘convergence’. China is already "substantially converged". Other countries already require IFRS use or will do soon - Brazil (December 2010); Canada (January 2011); India and Korea later in 2011; Mexico and Argentina in 2012. Other countries are on paths to convergence but the timeframe is not yet clear – these include the US, Japan, Indonesia and Russia [15] .

Despite six years of constructive engagement by civil society to generate a new standard on country by country reporting, and many false starts, (including development of a Development Draft,) the IASB has failed to even put the generation of a new extractives or country-specific reporting standard on its formal agenda. It has remained extremely resistant to non-corporate inputs. Despite its mandate is to work in the public interest, its apparent failure to set standards that would have prevented or mitigated the effects of the financial crisis, and its aim to be the sole global setter of accounting standards and therefore corporate financial reporting, it has repeatedly stated that its sole concern is generating buy-sell data for investors and it need neither address the needs of other users of financial information such as tax authorities or citizens affected by corporate behavior, nor generate reporting requirements that will curtail illicit flows.

The IASB needs to hear a clear message that standard setters tasked with acting in the public interest must respond to the needs of the public and establish a new progressive standard for country by country reporting of key financial data.

Ø Expand transparency requirements for multilateral investments and UK export promotion

Investments and development projects offer an opportunity for the UK to promote greater transparency in raw materials governance through the addition of transparency requirements to lending and export credit provisions, such as those made through the UK’s export credit agency. The UK is also well positioned to promote such requirements amongst multilateral bodies supported by the UK (such as the European Investment Bank and Bretton Woods actors) and to lead an OECD and G20 effort to have export credit agencies adopt common high transparency requirements.

Revenue Watch recommends that improved transparency requirements include disclosure of:

- extractive contracts (following the precedent set by the IMF in its Guide to Resource Revenue Management in 2005.)

- payments to governments by companies, and of receipts by governments (in line with the EITI and IMF Guide).

- other key information – reserves, production, costs, revenues (in line with reporting requirements sought above through listing and accounting requirements).

- the beneficial owners of all corporate actors.

February 2012