UN Financing for Development Office & IFAD Rome, 4-5 September 2007
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.
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)
Govts 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
Non-tax instruments:
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 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 dont 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
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 (e.g., Canada, at 18% to 21%) hence, much higher rate structure
Royalty payments in terms of ITA principles deductible expense Ad valorem & specific royalties create least uncertainty for governments
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
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
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 oilproducing 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
Neutrality
Investor risk
Efficiency Stability Project risk Fixed fee Royalties CIT Prog. Profit tax RRT PSCs Paid equity Carried interest -3 -3 -1 +1 +2 -1 +3 +2 -3 -1 +1 +3 +3 +1 -1 +3 -2 -1 0 +1 +2 0 +3 0
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)], where R = royalty rate P = add profit tax rate C = 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)
Additional / super Profit-based profit tax royalty 40% 0 0 12% 8.25% 5.5%
PUBLISH WHAT YOU PAY globally binding & condition for ODA?
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
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
Thank you
Contact Details:
Martin Grote National Treasury's Tax Specialist Republic of South Africa
e-mail: martin.grote@treasury.gov.za taxpolicy@mweb.co.za Tel: +27 12 315 5706 Fax: +27 12 323 2917 Cell: 082 461 5545