Stricter Rules Eliminating Transfer-Pricing Schemes

Transfer-pricing schemes, under which Russian coal firms dodge taxes by selling output below market price to offshore resellers, are slowly disappearing because of state pressure and tighter corporate governance.

"It's a bit of a surprise that the government allowed it to continue for so long," said a Moscow-based fund manager who holds both steam and coking coal companies in his portfolio.

The change could mean good news for investors in the sector, as increased transparency attracts more money to Russian coal shares.

Coal sales practices have come under greater scrutiny since Prime Minister Vladimir Putin's public rebuke of Mechel in a separate pricing dispute in July 2008. The New York-listed coking coal miner's shares quickly plunged by more than a third.

The Audit Chamber then opened a separate probe into transfer pricing, reporting last July that 80 percent of the country's 100 million metric tons of annual export sales were made via transfer pricing schemes, analysts from UralSib bank wrote.

Since then, miners have curbed practices such as large-scale exports to offshore tax havens.

Kemerovo regional governor Aman Tuleyev said last month that most producers had also moved their trading operations back to Siberia's Kuznetsk Basin, or Kuzbass, giving local authorities greater control over their activities.

"The first step towards solving this problem has already been taken — 80 percent of the trading houses have moved from Moscow to the Kuzbass, and the coal companies should be praised for this," Tuleyev said.

He said transfer pricing cost his region about 1.7 billion rubles ($57.3 million) in lost tax revenues annually.

Legislators are now discussing tax changes that will allow the government to clamp down on transfer pricing, a spokeswoman for the Duma said, while market forces also play a role: Coal barons are cleaning up balance sheets to attract prospective investors to planned share sales.

Transfer pricing became commonplace among natural resources firms in the 1990s, when they took advantage of the gap between domestic and international prices to sell output to offshore trading houses at a steep discount to global prices.

Transfer pricing rules in place since 1999 say tax authorities can impose additional taxes if a local transaction price differs from the market price by more than 20 percent.

Artificially low Russian prices allowed the practice to continue in the coal sector through trading companies based in countries such as Cyprus and Switzerland. As a result, domestic miners often posted losses or small gains, while the offshore traders recorded hefty profits thanks to lower tax rates abroad.

Cyprus continues to receive an outsize quantity of Russian coal trade, though deals to the offshore haven declined to 4 million metric tons in 2009 from 17 million metric tons in 2008, coal information agency Rosinformugol said.

Most Russian coal majors, including Mechel and leading thermal coal producer SUEK, are affiliated to Switzerland-based traders. Kuzbassrazrezugol, Russia's No. 2 steam coal player, sells through an Austrian partner, KRUtrade.

Denis Nushtayev, an analyst with Metropol, said KRUtrade appears to be making purchases close to market prices after years of buying at a steep discount.

In the first nine months of 2009, the average dollar price at which Kuzbassrazrezugol sold its coal from Baltic Sea ports declined by 9 percent, compared with an industry average of 54 percent, Metropol said in a report dated Nov. 25.

"This is a clear indication that transfer pricing between KRUtrade and Kuzbassrazrezugol was at least partially eliminated," the bank's analysts wrote.

In an interview last month, Kuzbassrazrezugol director Vasily Yakutov said: "We do not engage in any transfer pricing. We sell coal for the full price."

Shares in Kuzbassrazrezugol have risen more than 60 percent on the RTS exchange since it issued nine-month results in November, as investors welcomed surging profits. The wider market has risen less than 3 percent in the same period.

Analysts say investors favor miners with transparent balance sheets, as they present fewer risks. Initiating coverage of Kuzbass Fuel Company, UBS praised the company's relatively high transparency, with "no transfer pricing risks."

Demands for greater transparency could also prompt SUEK to change its reporting practices should it proceed with plans for an initial public offering later this year.

"They issue separate results for the three mines that make up SUEK Krasnoyarsk, and do not consolidate those results into one clear statement," the fund manager said. "There are too many questions right now and they need to clean that up."

The company has yet to release any financial data for 2009 on its web site. A company spokesman said in an e-mailed statement that SUEK does not use any transfer-pricing schemes.