Part EightResource Tax Accounting

Characteristics of natural resource exploitation – its impact on tax policy design

1. Potential for huge rents

2. Volatility of commodity prices – structural change surprises

3. Enclave status of mines

4. Potential for overinvestment into supporting infrastructure

5. ‘Politically motivated’ downstream beneficiation of minerals domestically extracted vs. creating functional markets

6. Ad hoc changes to fiscal regime if ‘windfall’ profits arise

7. Creating power base for elite, thereby encouraging corruption

8. What preventive measures exist in expectation of deposit depletion?

9. Lack of transparency & accountability regarding tax proceeds

10. Tendency to prescribe price controls for domestically produced mineral resources (ie, oil & gas)

11. Trend to introduce state enterprises vs. leaving it to the market

12. Environmental degradation:

These factors combined, can trigger the “Resource Curse”

Historic trends of resource taxation• Mining/oil sector dominates economy in many LDCs

• Resource sector dominated by transnational / foreign co’s

• For centuries royalties formed backbone of mineral taxation

• Since 1950s combination of fiscal instruments: – Royalties/production taxes (average rates of 2-5%) & ordinary profit taxes

– Since 2000 global convergence of CIT rates (average of 26.7%)

• Since 1970s increasing fiscal burden on mineral sector (oil & gas)

• More direct government involvement with rising shares in economic rents:– More sophisticated rent sharing measures: resource rent taxes, APT

– Production-sharing contracts

– Equity participation (= contract-stability enhancing outcome as automatically shares in windfall profits)

• Race to the bottom: aggressive tax incentives/tax holidays for mining to

attract FDI (many African states)

• Key policy question: Are tax incentives needed? – regional tax

coord.

Negotiating fiscal regime – fluctuating balance between governments & investors

INVESTORS ― prefer back-end loading of tax payments:

– Low burden fiscal measures to compensate for project & sovereign risk

– Recoup initial capital outlay on mining, oil & gas projects over shortest time possible

– Maximising long-run post-tax returns

– Fiscal stability provisions – no windfall profit taxes when commodity prices increase

– Preference for Rent Resource Tax or Brown Tax (negative tax or subsidy by governments)

GOVERNMENTS ― prefer front-end loading of tax payments: – Securing substantial share of

resource rent– Minimising tax-induced

inefficiencies– Receive fiscal revenues as

production commences– Integrating mining and oil &

gas tax issues into general tax codes

– Simplify tax administration & protect with anti-avoidance measures against transfer pricing practices

– Minimise information asymmetry as to projects’ profitability

Factors determining resource taxationThomas Baunsgaard – Primer on Mineral Taxation, IMF WP/01/139

Hard-rock mining:– Artisan mining, may escape standard tax regime: only attracting

licensing fees, royalties or surface fees– Small-scale mining– Large-scale projects may negotiate special tax allowance systems– Production-sharing agreements very rare

Oil:– Large oil/gas fields generate super rents, therefore royalties & other

fiscal charges are commonly much higher than in mining (between 12.5% and 20%)

– Size of oil field shows high correlation with profitability– Production-sharing contracts are common

Gas:– Not as profitable as oil – demand market must first be created

– Expensive pipeline infrastructure, cross-border problems, exceedingly expensive downstream liquification & transportation

– High political risks, individually negotiated with flexible fiscal regimes

Why does tax design of natural resource sector deviate from other economic activities?

• Separate fiscal system for resources sector due to resource rent potential (scarcity of resources, Hotelling rule,1931)

• Resource rents are surplus return over & above input costs (capital, labour, other production factors, opportunity costs of sunk capital)

• Pure rent represents financial surplus that could be taxed away without influencing econ. behavior or distorting resource allocation

• 2 risks are present in developing resource projects: – Commercial risk– Sovereign risk (constructive expropriation by regulation, taxation decisions)

• Govt’s can reduce both risks by adhering to macroecon. & fiscal stability, providing exploration data, delivering good physical infrastructure

• Practically, deposit-by-deposit approach difficult to achieve due to information asymmetry regarding deposits’ profit potential, informed by―– Differing grades– Geographic distance to market– Infrastructure availability– Cost of development– Sovereign risk

Types of resource taxes• No single best model of different tax combinations―

– Model incorporating self-adjusting tax increases in times of high commodity prices, will guarantee stability of fiscal contract & increase country’s LT-attraction for FDI

• Direct tax instruments / in personam taxes / net revenue:– Corporate income tax plus capital gains tax– Progressive profit taxes such as gold mining formula– Resource rent taxes– Brown tax, cash flow tax with government subsidy– Windfall profits tax, additional profit tax, super-profit tax, net profits royalties

• Indirect tax instruments / in rem:– Ad valorem, specific/production volume royalties– Import duties, export duties – VAT, sales tax– Property or capital taxes, stamp duties

• Non-tax instruments:– Competitive bonus bidding, auctions (e.g., hydrocarbons)– Surface or usage fees – Production sharing contracts– State equity participation

Corporate tax – mining (forestry, fishing)• Most jurisdictions apply standard corp. rate

• Higher CIT rates apply in oil & gas sector (bigger rents)

• Resource deposit specificity, may lead to individually negotiated corp. tax dispensation for large-scale projects

• Some jurisdictions exempt mineral extraction activities from withholding taxes due to higher tax burden on mining co’s

• Special capital allowances for capital intensive projects (100% expensing)

• Mining rehabilitation / decommissioning trust funds: deduction for contributions to fund & tax-free buildup of fund

• Transfer pricing incidence potentially high ― requires introduction of OECD-type anti-transfer pricing rules & ring-fencing provisions:

– TNCs dominate & with multi-jurisdictional operations

– Sale of minerals below market prices to affiliates in low-tax jurisdictions

– For example: diamonds notoriously difficult to value – see lessons from

Southern Africa on need for GDV

– Not all minerals are traded on metal exchanges (vertically integrated firms)

Progressive profit tax vs. excise-type windfall profit tax e.g., SA gold mining tax formula

• Introduction of progressivity into CIT: Governments automatically participate in greater share of economic rent as commodity prices rise

• Various methods:– Ad hoc graduated CIT rate linked to higher unit price of commodity or higher

production volume / sales turnover / profit-to-sales ratio– Stepped rate structure (not accurate proxy for varying RoR)– Monitoring of higher profit ratios administratively costly– Taxpayers have increased incentive to under-report income

• SA gold mining tax formula with built-in progressivity, linked to level of profitability of gold mine – marginal mine taxed at 0%:

• Only taxable income from 5% profit ratio upwards attracts tax• Formula:

y = a-(ab/x), where• ‘y’ = tax rate to be determined (sliding scale: higher profits at higher rates)• ‘a’ = marginal tax rate• ‘b’ = portion of tax-free revenue• ‘x’ = ratio of taxable mining income to total income (including non-mining

income)

Resource rent taxes (RRT)• Garnaut & Clunies-Ross, 1975, 1983) designing ‘neutral’

tax, affecting only economic rent:– R-factor (investment-payback ratio―ratio of investor’s cumulative

receipts over cumulative costs, incl. upfront investments)• Tax kicks in when R-factor greater than 1

• Some production-sharing contracts include this progressive feature with growing government share as investment-payback ratio grows

• Accumulated cash flows are not discounted

– Resource Rent Tax is cash flow tax linked to real rate of return• Applies after hurdle real RoR on investment has been achieved

• Hurdle real RoR equals supply price of investment/capital

• RoR is mark-up on rate of return of some other alternative safe investment

• Tax calculated by increasing annual cash flow (without deductions for interest cost & depreciation allowance) by hurdle RoR & continuously carry forward until it turns positive

• Few jurisdictions have imposed this regime due to back-loaded nature of tax payment (governments bear all the cash flow risk)

Brown tax, even more neutral

• Brown tax imposed at flat rate on annual net cash flow with immediate expensing of all capital expenditure– Negative net cash flow would not be carried forward at real rate of interest as

in RRT, BUT triggers govt. subsidy payment to investor

– Unrealistic, as developing countries don’t have cash flow

– Brown tax absolute neutral -- transfers all risks to governments

– Governments potentially face huge fiscal losses (negative tax)

– Will investors trust government in making good on its subsidy promise?

– It could trigger wasteful utilisation of capital by investor

• Hence, universally rejected by governments

Indirect charges: royalties

• Royalties oldest form of mineral extraction taxation – is it a tax???

• Imposed in 3 forms:

1. Value of mineral sales (ad valorem)

2. Set charge per production volume (= unit or specific royalty)

3. Profit-based or net smelter royalty

– Favoured by governments due to front-end loading of tax payments

– Is a consideration for right to extract (similar to capital and labour input costs)

– Analogous to lease payment: if lessee is operating unprofitably, lessor will not

rent-out property for free

– High rate royalties deter investments as it increases economic cut-off grade

– Will make development of marginal deposit unprofitable

– In case of oil/gas production royalties can be imposed on net of cost basis to

accommodate for production & transportation cost

– Admin capacity must exist to monitor closely production volumes

Ad valorem royalty vs. profit royalty

• “By far the predominant form of mineral taxation is the ad valorem

royalty which simply takes a percentage share of the gross value of

output from specified mining project” – Head & Krever (eds.): Taxation towards 2000 – Australian Tax Research

Foundation, p. 210

• Ad valorem royalty is determined by applying royalty rate on gross sales

value of minerals

• Royalty does not accommodate:– Differences in production costs of minerals – Differences in profit ratios from sale of minerals

• Profit-based royalty focuses on after-cost profits from sale of minerals

• Profit-based royalty base is narrower― hence, much higher rate structure

(e.g., Canada, at 18% to 21%)

• Royalty payments in terms of ITA principles deductible expense

• Ad valorem & specific royalties create least uncertainty for governments

Advantages / disadvantages of ad valorem royalty

ADVANTAGES:• Companies cannot artificially inflate costs• Less collection risk for Government• Royalty adjusts automatically for commodity price & profit fluctuations• Non-negotiable aspects of royalty has fiscally stabilising impact:

– Communities benefit of increased public resources as mining commences

– Over long run should maximise investor certainty• Narrow compliance gap as administration is straight forward & predictable• However, fair market value must be ascertainable

DISADVANTAGES:

• Base of royalty is broad ― high rates may unduly erode investor profits

• Encourages mining of high-grade ores (“picking-the-eye”)

• Need command & control measures against ‘high-grading’

• Regulatory capacity to enforce mining of deposit to "average grade of ore"

• Complex calculations in case of composite minerals in concentrate/sulphides rock

Advantages & disadvantages of profit royalty

ADVANTAGES:

• Profit royalty has minimal adverse impact on private investment behaviour:

– Government & investors are both proportionately at risk

• It focuses on mine’s ability to pay

– But it is a factor payment not a tax!

• Royalty calculation does not require segregation based on mineral type,

grade, or level of processing

• One rate could be applied to all mineral categories

DISADVANTAGES:

• Profit royalties may easily be subject to aggressive tax accounting

• Comprehensive anti-avoidance measures needed (as in ITA)

• High collection risk for government because royalties vary with profits

Non-tax fees ― not creditable ito DTAs front-end loading favouring government as resource owner

• Fixed fees, prospecting/mining surface rental fees:– Administrative charges unrelated to profits but a function of size of area under

license (more regulatory measure to make unaffordable the sterilisation of mineral deposits as anti-competition strategy by firms)

• Competitive bonus bidding (petroleum sector) / discovery or production bonuses:

– In competitive bidding market for oil/gas leases, government could get up-front

appropriate share of economic rent

– If too few players bid, high risk of collusion with low rent capture for govt.

– Front-end loading may discourage marginal resource development

– Needs little admin effort

– In cases of uncertain geological potential & high sovereign risk, investors are

loath to commit significant funds & bidding amounts may generally be too low

– Could destabilise project over long run, as initial low bids for potentially rich

resource may trigger re-negotiations of fiscal terms

Production sharing contracts (PSC) – oil & gas• Ownership of hydrocarbon resource remains with government

throughout exploitation period– Operator company is contracted to develop resource

• As consideration, co can retain share of production• Three generic types of production sharing:

– Concession agreement

– Production sharing contract

– Risk service contract (contractor receives flat fee for services)

• PSCs developed in Indonesia in 1960s, but now quite common in oil-producing countries (tax creditable if very similar to CIT):– LT arrangement between host govt., whereby investor takes on pre-production

risk & recovers cost and profit share out of production

– Profit oil is derived from gross production minus allowable production costs

– Profit oil shared in pre-determined ratio between govt. & investor

– PSCs can be graduated with rising shares to govt. as production volume, crude price or returns increase

– Allowable production cost that can be claimed per acct. period can be capped & carried forward (period or unlimited) = equivalent to royalty

State equity in resource projects

• Some governments hold equity in resource projects (see diamond industry in Namibia, Botswana)– Securing higher % of economic rent during commodity booms– Stability-enhancing & prevent renegotiation of fiscal terms (windfalls)– Non-economic reasons: increase govt. ownership, tech-transfer– More direct control in lieu of proper regulations?– But: Equity can be costly for paid-up equity or cash-calls– But: Conflict of interest as regulator (environmental, labour laws)– Investors prefer government’s role as regulator & tax collector

• Equity participation in many forms:– Commercially transacted paid-up equity– Paid-up equity on concessionary terms– Carried interest ― govt. pays for it out of converted production shares– Tax exchanged for equity (reduced tax liability)– Equity in exchange for provided infrastructure– Free equity, less transparent as taxes may be offset

Comparative efficiency impact of resource taxes ―

Baunsgaard (2001), Daniel (1995) & Garnaut and Clunies-Ross (1983)

Neutrality Investor risk Government/sovereign risk Implementation

Efficiency Stability Project risk

Loss Flexibili-ty

Delay Design Adminis-tration

Tax credit

Fixed fee -3 -3 -2 +3 -2 +3 -2 +2 -3

Royalties -3 -1 -1 +2 -1 +3 -1 +1 -3

CIT -1 +1 0 0 +1 +2 +1 -1 +3

Prog. Profit tax

+1 +3 +1 0 +2 +1 +2 -2 0

RRT +2 +3 +2 -2 +3 -1 +3 -3 -2

PSCs -1 +1 0 0 +2 +2 +2 -2 -3

Paid equity

+3 -1 +3 -3 +3 -2 +3 +3 0

Carried interest

+2 +3 0 +3 +3 -3 +3 +1 -1

Fiscal stability / equilibrium clauses

• Risks affect both investor & government

• Investors are risk adverse BUT so are LDCs-governments

• If taxes are deferred continuously, pressures for renegotiation grow

• Hence, investors seek fiscal stability clauses

• Perception of fiscal stability enhanced, if tax measures are introduced that correlate tax take closely with RoR:– Hence, progressive profit taxes– RRT in theory & to lesser extent CIT or PSCs

• Fiscal preservation clauses initially attractive, but over LT expensive as it limits govt. ability to change fiscal terms in times of ‘super profits’

• Different forms of stability clauses:– Freezing rates & tax base definition – Administrative complex if per project– Guaranteeing investor share of economic rent

– 1997: wide-spread fiscal preservation in petroleum sector (out of 109 agreements, 63% provided fiscal stabilisation for all taxes, 14% partial stab., 23% had none)

Risk of high marginal tax rate if combination of taxes or royalties at relatively high rates is imposed:Combining tax instruments, leads to high marginal tax rate as calculated per

following formula (Higgins 1992, 59):

marginal rate = 100[1-(1-R)(1-P)(1-C)], whereR = royalty rateP = add profit tax rateC = corporate rate

Formula can only apply if all 3 taxes are applied to uniform tax base (ad valorem royalty must be expressed as profit-based consideration)

Marginal rate Corporate income tax

Additional / super profit tax

Profit-based royalty

65.7% 35% 40% 12%

34.9% 29% 0 8.25%

29.1% 25% 0 5.5%

Preservation of mineral wealth when mines are depleted

• Hicksian concept of ‘income to mineral extraction’: how much of country’s current mineral revenues can be consumed without LT impoverishment?

• Mineral wealth should be invested, thereby permanently increasing mineral state’s command over goods and services

• Investment in permanent resource rent fund, without depleting principal: – Income earned on Fund’s assets could substitute tax payments from finite

resource sector when deposits become depleted

• International experience - Mineral Rent Investment Funds:

– Alaska Permanent Fund – constitutionally enshrined, dividend to all, highly successful,

keep management out of hands of spendthrift politicians, preserve state’s mineral wealth

for indefinite future, returns distributed among entire Alaskian population

– Alberta Heritage Fund – managed by politicians as budget balancing tool, low return

investment decision, cross subsidisation of poorer provinces, no dividend program

– Norwegian Petroleum Fund – managed in European parliamentary tradition,

independent board of investment managers, Central Bank-managed, annual deposits &

withdrawals at discretion of Parliamentary majority, investment portfolio spreads risk

Fiscal decentralisation & tribal / community royalties

• Fiscal devolution principles: unequal distribution of mineral deposits should transfer taxing & royalty sharing rights to the Centre

• Hence, State could insist on right to collect royalty:

– In case where tribal communities impose traditionally royalties on resource

extraction, central government may deny rebate to miner, thus, compelling

communities & mining co to mutually re-negotiate lower royalty rate regime in

case additional State royalty would make operation uneconomic?

– Rebate could be allowed with State imposing withholding tax regime on royalty

income received by communities, if funds are not appropriated for social

expenditure benefiting communities?

– Central government earmarks budget allocations away from communities as a quid pro quo for the right of such communities to receive royalties

– Most advisable: Revenue-sharing of royalty income to communities - Government substitutes tribal royalty with equivalent transfer payment from national revenue fund, since mining activities impose heavy social, infrastructure& environmental burden on lower levels of government

– See revenue-sharing options in PNG, Indonesia

‘Resource Curse’ – adopt EITI

• Resource-based economic & political developments in jurisdiction do not depend on level of resource endowment but―– Sound macro-economic & fiscal policies, good resource management– Disciplined re-investment of resource-based wealth/tax resources

• Globally, create binding rules-based & transparent arrangement for―

– Fiscal arrangement for state resource enterprises

– Oversight & reporting of Auditor-General to Parliament

– Protection from political interference

– Insulation/independence of monetary institutions

– Effectiveness of stabilisation funds

– Political rules of democracy that punish leaders abusing resource endowment

– Active participation by NGO sector (Global Witness and Conflict Diamonds)

– Multilateral Organisations insisting on adherence to Extractive Industries

Transparency Initiative: best practices on reporting & sound fiscal

policies

• “PUBLISH WHAT YOU PAY” – globally binding & condition for ODA?

Renewable resource taxationR Boadway & F Flatters, 1993. The Taxation of Natural Resources, World Bank WPS

• Key characteristics of renewable resources:– Renewables generate continuous output / revenue stream if

expeditiously managed– They include:

• Fisheries• Natural forests as opposed to plantations• Hydro-electricity• Water supplies• Clean air• Agricultural land

– As certain share of resource is exploited, it can replenish itself naturally or artificially through add. conservation measures

– Rate of replenishment depends on stock of resource, natural renewal rate, conservation & husbandry practices adopted by exploiters, ie:

• Replanting of forests• Regulating size of fish caught• Fertilisation practices• Use of water reservoir

Specifically targeted tax measures for renewables

• Adopted tax measures should not incentivise overexploitation• Tax treatment must consider dynamics of resource renewal process:

– Some resources (hydroelectricity, fisheries) – if managed carefully – represent

continuous flow of output (normal profit tax rules & combinations with royalties,

severance tax, stumpage fee)

– Forestry: there may be cycles of extraction / replenishment which will

necessitate income tax averaging rules to ameliorate high marginal rates

• High stumpage fees may lead to environmental degradation

– Fishing: who collects royalties from ocean fishing beyond 200 miles zone?

– Taxes of standard tax system apply to this sector:

• Corporate tax & capital gains tax, based on residence basis & creditable ito DTAs

• VAT, general sales tax

– Special production-based fees, taxes based on source principle:

• Stumpage fees (specific or ad valorem), not creditable taxes ito DTAs

• Special investment incentives for longer loss carry forwards, probably ring-fenced

Policy challenges for the future …

• Is the world moving towards LT “super commodity cycle”?

• Is balance of power shifting towards resource-rich countries?

• Will short-term policy objectives – ie, tax revenues – lead to renegotiation of fiscal contracts: windfall profit taxes?

• Will existing BITs deem this as constructive expropriation?

• Will this impact adversely on FDI into developing countries?

• Will windfall profit tax advance as 3rd element of resource taxation?

• Resource race: extraction offshore beyond 200 nautical mile commercial zone (oil resources in Artic & Ant-artic sea beds)

• “Planting flags on bottom of Artic Sea” OR enhanced Role of the UN:

UN Law of the Sea Treaty – – Revenue source for UN as world governing body vs. extension of national

commercial boundaries?

– Obtain revenues from the “commons” (= offshore minerals, ocean fishing) & share with land-locked, poor countries (UN will thereby lessen dependency on ODA commitments)?