Tax Aspects of Domestic Resource Mobilisation

1
Tax Aspects of Domestic Resource Mobilisation a
Discussion of Enduring and Emerging
IssuesTaxation of Natural Resources

• UN Financing for Development Office IFAD
• Rome, 4-5 September 2007
• M Grote
• National Treasury, South Africa

2
Characteristics of natural resource exploitation
its impact on tax policy design

• 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
• Environmental degradation
• These factors combined, can trigger the
  Resource Curse

3
Historic trends of resource taxation

• Mining/oil sector dominates economy in many LDCs
• Resource sector dominated by transnational /
  foreign cos
• 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.

4
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

5
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

6
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

7
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 countrys
  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

8
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 cos
• 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)

9
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)

10
Resource rent taxes (RRT)

• Garnaut Clunies-Ross, 1975, 1983) designing
  neutral tax, affecting only economic rent
• R-factor (investment-payback ratio?ratio of
  investors 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)

11
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
• Hence, universally rejected by governments

12
Indirect charges royalties

• Royalties oldest form of mineral extraction
  taxation is it a tax???
• Imposed in 3 forms
• Value of mineral sales (ad valorem)
• Set charge per production volume ( unit or
  specific royalty)
• 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

13
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

14
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

15
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 mines 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

16
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

17
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

18
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 governments 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

19
Comparative efficiency impact of resource taxes
?Baunsgaard (2001), Daniel (1995) Garnaut and
Clunies-Ross (1983)
Neutrality Investor risk Investor risk Government/sovereign risk Government/sovereign risk Government/sovereign risk Implementation Implementation 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
20
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)

21
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 1001-(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 tax Profit-based royalty
65.7 35 40 12
34.9 29 0 8.25
29.1 25 0 5.5
22
Preservation of mineral wealth when mines are
depleted

• Hicksian concept of income to mineral
  extraction how much of countrys current
  mineral revenues can be consumed without LT
  impoverishment?
• Mineral wealth should be invested, thereby
  permanently increasing mineral states command
  over goods and services
• Investment in permanent resource rent fund,
  without depleting principal
• Income earned on Funds 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 states 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

23
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

24
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?

25
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

26
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

27
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)?

28
Thank you

• Contact Details
• Martin Grote
• National Treasury's Tax Specialist
• Republic of South Africa
• e-mail martin.grote_at_treasury.gov.za
• taxpolicy_at_mweb.co.za
• Tel [phone]
• Fax [phone]
• Cell 082 461 5545
•