VOLATILE COMMODITY PRICES: HOW KAZAKHSTAN MANAGES RISK
During the global economic slowdown, commodity prices have both soared and plummeted. As gold’s value recently reached all-time highs, journalists discussed gold-bar-dispensing ATM’s in Abu Dhabi, and investment experts proffered dire warnings of a crash. Industrial commodities, in contrast, suffered deep contractions in demand. Just as individual investors faced increased risk, the government of Kazakhstan saw its tax revenue stream swing with the vicissitudes of the world’s commodity markets. To enhance stability in the private and public sectors, new transfer pricing regulations were introduced in July. The goals were to increase transparency, smooth out price fluctuations, and conform to accepted international standards.
BACKGROUND: Kazakhstan has struggled to enact equitable tax regulations for multinational firms carrying out business within its borders. When a company exports a partially produced product from its Kazakh division to another subsidiary, that economic activity is taxed based on a set of rules known as transfer pricing. Ideally, the transfer price will be an “arm’s length transaction”, or the price as if the divisions had been independent and unrelated. Various methods for transfer price calculation exist, but Kazakhstan has faltered in creating a transparent methodology. A fair and correct transfer price implies that tax liabilities are accurately assessed.
In its first attempt at transfer price legislation, Kazakhstan fundamentally misapplied rules in direct opposition to OECD standards and recommendations. In its initial 2001 law, tax authorities were allowed to set prices between any two parties, even in some exclusively domestic transactions between unrelated firms, if there was a substantial (over 10 percent) differential between the contract and published market price. This policy was murky because prices were published only after the contract was signed. Thus, firms were unable to guarantee an arm’s length transaction. An amended 2009 law still did not address these issues and in some cases led to double taxation on foreign-owned companies.
Notwithstanding this regulatory framework, the geography of the region plays a role. Kazakhstan is the ninth largest country in the world; transportation is time consuming and expensive. The lag between production and delivery can be upwards of a month, barring backlogs in the rail transport network. Under the amended 2009 rules, a transfer price was set on the date of dispatch, but significant price fluctuations occurred during transit. For periods of rising prices, firms benefited from date-of-dispatch rules, but the government under-collected tax revenue. As commodities weakened, companies were taxed on much higher prices than they realized at final delivery. In theory, firms could have applied for tax relief, but the administrative mechanisms to do so were insufficient in most cases. This brought about widespread frustration with the system.
Because of Kazakhstan’s numerous cross border projects, the entire region has been affected by its transfer pricing rules. Whether it is joint uranium production with Russian firms, gold and copper exploration ventures in Kyrgyzstan, or Chinese investments in rare metals, Kazakh laws have influenced competitiveness. Unclear regulations have increased uncertainty, but access to strategic resources remains enticing.
IMPLICATIONS: Kazakhstan’s economy is closely tied to commodity production and its subsequent taxation. Although gold has experienced dramatic price increases, it only plays a minor role in the national economy. Industrial metals – zinc, chrome, copper, iron, uranium – along with energy reserves of coal, gas and oil constitute the lion’s share of exports. In concert with the global slowdown, tax receipts fell 13 percent from July 2008 to 2009 only to rebound by 16 percent in 2010.
The markets for Kazakhstan’s rare earth and industrial metals are fairly illiquid, making price spikes and plunges likely. Market prices move instantaneously, but the actual sale and transfer of the bulky and heavy underlying products is measured in weeks. To address this issue, the government instituted changes in its price calculation methodology in July. Specifically, firms can now use an arithmetic average of published prices over a circumscribed time period to calculate transfer prices. For oil, the quotation period is five days before and after transfer of ownership; for all other commodities, thirty days. In other words, the new regulations use a form of dollar cost averaging, the same strategy used by long term stock and mutual fund investors to limit risk in volatile markets. The new law was made retroactive to January 2009 so that existing producers could apply for tax relief. During periods of rising prices, the government will be able to increase its revenue through the average price formula. Smoothing out the price changes will bring stability to the economic sector as a whole, and these improvements have been well received in the business and investment communities.
The new average price formula more accurately reflects the country’s published tax schedule. The government’s old policy of under-collecting revenues and rebating taxes amounted to stealth subsidies. The net result reduced effective tax rates and created favorable terms of trade for key industries. Since Kazakhstan’s neighbors produce similar raw materials, domestic production could flourish at the expense of foreign suppliers. The motivation for giving up this advantage is driven by the desire to ascend to the World Trade Organization. Kazakhstan is close to completing the WTO’s membership process and is currently in the fifth year of bilateral negotiations with major trade partners. One of the few remaining points of contention is with the European Union Trade Commission’s demand for transparent and equitable taxes and duties on commodities. Kazakhstan’s Minister of Economic Development and Trade met with the EU Trade Commission in mid-July. Although the recently adopted price regulations should address many of the EU’s concerns, Kazakhstan’s recent reintroduction of export duties and tariffs remains at issue. Nevertheless, Kazakh negotiators expect to conclude bilateral negotiations in September or October and seek final approval by the WTO General Council by the end of the year.
The July 2010 law has increased the transparency of tax policies in a number of other ways. Transfer pricing rules are now limited to the sale of goods and services directly interconnected to an international transaction. By better defining how to create an arm’s length transaction, the regulations eliminate double taxation and create a “safe harbor” for liability protection. A clear method for calculating tax liabilities reduces corruption and capricious assessments. Overall, the improved regulations reduce systemic financial and fiscal stress and create a more level playing field for the region.
CONCLUSIONS: The new transfer pricing rules develop a stronger regulatory framework for international investments and transactions. Uncertainty is endemic to the global commodity markets, and the new regulations create a more stable pricing regime for the government and private sector. By using a range of prices over an appropriate period of time, a familiar dollar cost averaging approach reduces extremes of price variation. The improved methodological changes account for the transit time of commodities across an expansive landlocked country and provide augmented legal protection to multinational firms.
The motivation for transfer pricing reform has a broader context than revenue and economic stability, however. Transparency is one of the five guiding principles on the path to WTO ascension, and the new legislation brings Kazakhstan closer to its goal of full membership by the end of the year. However, these regulatory changes must be followed up with fair enforcement and reasonable administrative policies. Should Kazakhstan’s bid to join the WTO prove successful, then it would join Kyrgyzstan as the only other member from post-Soviet Central Asia.
AUTHOR’S BIO: Tony Pizur is an independent researcher based in New York. He has a Master’s Degree from Brown University and a PhD from the International University of Kyrgyzstan in economics.
