Profitable deal or losing trade? It all depends on excise taxes
All trading companies that deal with energy products—crude oil, renewable energy, and the like—will have tax liability associated with their trades. Sometimes it’s high and sometimes it’s low, but it’s always present. And when you don’t know which rules and rates are going to apply to a provisional trade, the consequences can be costly.
Unfortunately, energy trading companies often ignore indirect taxes when making trading decisions. What they fail to recognize is that the sheer complexity of energy taxation can mean they’ll have a significant impact on trading margins when there’s a failure to factor them in.
In energy trading, taxes are often considered a cost of doing business. However, the underlying assumption that taxes are the same regardless of the parameters of the trade couldn’t be more wrong. Tax is much more than a simple fixed cost.
Yes, the complexities are high. But once the appropriate tax implications are factored in at the outset, the opportunities for greater profit margins can increase exponentially.
Energy Trading Tax Complexities
Ensuring excise tax accuracy in energy trading is no easy task. When you’re buying in bulk and dealing with high volumes, all it takes is one incorrectly taxed or exempted transaction for major impacts from fees and penalties to follow. However, it's not just audit liabilities and back taxes that are at stake: Failing to consider tax implications in the early stages can quickly turn an otherwise advantageous exchange into an unprofitable trade.
Most individuals involved in the process are aware that each physical trade will involve taxation as product ownership changes, but they may not be attuned to just how wildly those taxes and fees can vary from trade to trade. For example, in a typical commodities trading scenario involving the purchase or sale of bulk refined fuel, state and federal excise taxes will come into play—as will inspection fees, environmental fees, handling fees, demurrage charges, lightering costs...and the list goes on. As these fees and duties are assessed, a host of variables will come into play: the origin and destination, whether the trade is occurring at or below the rack, licenses and exemptions, and many other factors that can change significantly from one trade to another.
It’s more than the average ETRM is capable of calculating.
The ETRM Conundrum
While Energy Trading and Risk Management (ETRM) solutions are reliable for handling everything from price management to logistics, there's one mission-critical element they’re not built to support when it comes to risk reporting:
When tax liabilities are visible up front during trade evaluation, it becomes much easier to determine the true asset value of a trade and its potential impact on margins. Unfortunately, few ETRM systems make all tax implications visible.
While many ETRM vendors offer simple tax table capabilities, this doesn’t allow them to reflect the true complexity of tax regulations. And without a system to proactively monitor indirect taxes, there’s simply no way for users to stay on top of regulatory changes. Excise tax rules and rates change constantly, and the lack of built-in rules or rates makes it nearly impossible to monitor and account for changes at the federal, state, and local levels.
Exemptions, Registrations, and Licenses
In the U.S., many above-the-rack fuel transactions are exempt as long as both parties have a Form 637 Registration. This is another example where the complexities of taxation in commodities trading really comes into play. Simply having a registration is not enough. Each license and registration must be consistently validated (often through the collection of highly specific documentation), monitored, and stored. With fuel excise taxes charged by the gallon, invalid exemptions based on poor license management have the potential to expose companies to increased tax costs and can even put a business at heightened risks for painful audits.
A Tale of Two Trades
Because taxation is frequently considered a cost of doing business in commodities trading, its impact on profitability is often overlooked. For example, consider the roles taxes and regulatory fees may play in an international crude oil trade:
At Company A, the chief risk officer (CRO) is weighing the opportunities of each investment against potential threats. He’s analyzing current investments against market forecasts and asking mission-critical questions such as:
- How soon will prices drop? What long-term predictions should be prepared for?
- Which investments are currently at heightened risk?
- Should we offset those potential risks with positions in other commodities?
- Is it time to sell future positions?
As crude oil is exchanged, he’s motivated by one overarching goal: to buy low and sell high. It’s his main concern and has been the primary objective in all assessments and advice on the physical exchange of crude oil. Taxation is secondary, factored in as an aggregated, fixed-rate expense.
Meanwhile, back in the finance department, the individuals responsible for tax determinations and reporting requirements are frantically working to keep up as the trade is finalized. The company’s ERP system has been handling sales and use tax for the trade, but its capabilities end there. It’s not designed to calculate excise taxes or determine other costs incurred during the physical trade. As a result, the tax team is using a custom-coded tax module to build out custom rules where it can, and tracking the rest in spreadsheets and manual uploads.
And then, perhaps a month later at tax filing, they discover the real tax costs of doing business:
As the oil made its way from ship to harbor to physical trader, a long list of secondary costs added up:
- Inspection fees
- Container fees
- Quality testing and certification fees
- Demurrage fees
- Detention and per diem fees
- Environmental fees
- Regulatory fees
- VAT tax
- Federal excise tax
- Sales and use tax
- Federal oil spill liability tax
- State oil transfer fee
These duties, fees, and tax liabilities had been combined and estimated at one fixed rate. In fact, they deviated significantly from what was anticipated on the trading floor—and eroded profits in a big way.
At Company B, the CRO is doing her assessments and so is the tax team. As crude oil is exchanged, a secondary set of critical questions is being asked, such as:
- What regulatory risks will the physical trade be exposed to?
- Where is the counterparty coming from, and how will that location impact tax rules and rates?
- Where and how will the title transfer take place, and what fees will be incurred as a result?
- Will there be an excise or sales and use tax exemption?
- What paperwork is needed to validate and secure the exemption?
They know that the constantly-changing nature of regulatory tax can greatly impact the profit margin of a commodities trade, and use a tax engine that’s regularly updated with the latest tax rates, rules, and requirements and made visible to the entire team. Licenses have been filed and excise tax exemption documentation has been validated and stored. So when the CRO is giving her forecasts, all costs are accounted for. On the trading floor, even during lightning-fast negotiations, it’s relatively easy to quickly determine when it may be time to pass on an opportunity or seek out ways to offset anticipated costs.
Bottom line: Company A treated sales and use tax, excise tax, regulatory fees, and duty fees as the cost of doing business—and paid a steep price. Company B integrated those costs directly into its trading and accounting processes and went into the trade fully prepared and ready to maximize margins. Later, when the two companies come under audit, Company B will have detailed records and documentation on accurate tax payments and exemptions. Company A, meanwhile, may be looking at $3 million in penalties and interest.
For a trading company to truly maximize profits, the company must be equipped to consider the trading impact and book value of both taxes and non-tax fees, as well as the implications of alternate options using provisional trades. It's only with visibility to these costs that traders can truly minimize the risk of reduced margins.
Trading companies often consider indirect taxation a problem for the back-office and tax department, but big problems can occur if indirect taxes aren’t considered as part of trade evaluation. Customers become unhappy, profits are eroded, and audit risks increase. The situation becomes even more precarious when there’s no process in place to handle complex tax rules or monitor for changes in tax codes.
To see how these problems have played out in actual trading scenarios, download the ETRM white paper: ETRM Systems & Taxation: Why You Need Independent Tax Determination.
Maximizing Profits with AvaTax Excise
When it comes to physical trades, there is one tax solution that can make a big impact on profit margins.
Avalara’s AvaTax Excise is the industry’s only commercial commodity trading tax engine capable of making every last rate, rule, regulation, requirement, and fee visible to everyone who touches a trade—be it on the trading floor or elsewhere. By inserting taxes into the pricing processes of your ETRM system, indirect taxes can be determined quickly and instantly calculated on any energy transaction. Each time the ETRM system prices a trading position, applicable indirect taxes will be included. And because excise tax experts are continually monitoring changes, there’s never a need to research the accuracy of tax rules and rates.
In addition, AvaTax Excise:
- Tracks counterparty licenses and exemptions, further ensuring tax accuracy
- Makes it possible to conduct “what-if” analyses of provisional trades to evaluate potential risks
- Provides proven support for complex trading scenarios
- Handles complex tax rules as well as custom fees specific to energy trades
As tax implications are easily factored into each trade evaluation, tax teams spend less time scrubbing data and cleaning up tax calculation. Traders, meanwhile, benefit from better forecasts—with absolutely no need to learn a new process or train on new software. They simply begin entry on a preliminary trade and look at profit and loss forecasts. Rather than discovering after a deal is done that P&L was much lower than anticipated, they’ll have the opportunity to proactively manage license liabilities and tax implications with the potential to add up to millions.
Yes, commercial commodity trading is risky business. But once your ETRM is integrated with a tax engine that maintains updated rules and rates, managing profit margins becomes a much more predictable process. Avalara’s AvaTax Excise makes it easier for everyone—from the trading floor to the tax team—to account for every last cost.
The Team Behind This White Paper
Avalara helps businesses of all sizes achieve compliance with sales tax, VAT, excise tax, and other transactional tax requirements with a range of solutions that are fast, accurate, and easy to use. Avalara’s suite of automated, cloud-based excise tax tools is constantly updated to provide built-in support for federal, state, and local jurisdictions as rates and regulations evolve.