Tax Aspects of Domestic Resource Mobilisation
– a Discussion of Enduring and Emerging Issues
Taxation of Natural Resources
UN Financing for Development Office & IFAD
Rome, 4-5 September 2007
M Grote
National Treasury, South Africa
Characteristics of natural resource exploitation –
its impact on tax policy design
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Potential for huge rents
Volatility of commodity prices – structural change surprises
Enclave status of mines
Potential for overinvestment into supporting infrastructure
‘Politically motivated’ downstream beneficiation of minerals domestically
extracted vs. creating functional markets
Ad hoc changes to fiscal regime if ‘windfall’ profits arise
Creating power base for elite, thereby encouraging corruption
What preventive measures exist in expectation of deposit depletion?
Lack of transparency & accountability regarding tax proceeds
Tendency to prescribe price controls for domestically produced mineral
resources (ie, oil & gas)
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 backend 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 taxation
Thomas 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―
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–
–
–
–
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 LTattraction 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:
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–
–
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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
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Is a consideration for right to extract (similar to capital and labour input costs)
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Analogous to lease payment: if lessee is operating unprofitably, lessor will not
rent-out property for free
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High rate royalties deter investments as it increases economic cut-off grade
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Will make development of marginal deposit unprofitable
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In case of oil/gas production royalties can be imposed on net of cost basis to
accommodate for production & transportation cost
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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 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
State equity in resource projects
• Some governments hold equity in resource projects (see
diamond industry in Namibia, Botswana)
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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:
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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
Efficiency Stability Project
risk
Loss
Flexibili- Delay
ty
Implementation
Design
Adminis Tax
-tration 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:
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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)
Marginal rate
Corporate
income tax
Additional / super Profit-based
profit tax
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 taxation
R 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)?
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