Presentation to ETAWAThe Mining Tax: Insider’s Perspective

Julian Tapp – Director Strategy, Fortescue

1 July 2011

• Director Strategy• Mining Tax, Carbon Tax• Joint Ventures, Infrastructure Access, Third Party Matters• Economic matters – macro economics, iron ore demand/prices• Legal, Commercial, Regulatory

• Previously - Government Relations/Approvals/Special Projects• 2 State Agreements – Infrastructure and Mining• Approvals - State Agreement Acts, Mining Act, Environmental Protection

Act, Aboriginal Heritage Act, Native Title Act.• Access to Pilbara Railways (Part IIIA TPA)• Third party access arrangements – Economic Regulation Authority

Railways (Access) Act, Port Access Regime, 3rd Parties• Hunan Valin investment – getting FIRB approval

• Fortescue Metals Group Ltd (7 years)• From concept to ASX listed (top 20)• Iron Ore – Mining and Infrastructure company

• Previously• IFS, LSE, Murdoch University, Brunel University, Automotive Industry

Consultant, Ford, BP, BAeSystems, Venture Capital Consulting

Introduction – Julian Tapp

Here is the theory• Because non-renewable resources are finite there comes a time when that

limitation causes scarcity • Scarcity leads to rising prices (as prices rise to ration demand)• Entities with the right to exploit those increasingly scarce resources enjoy

rising prices and therefore profits due to no action of their own – “economic rent”

• The Australian community that owns the resources misses out as the benefits accrue to the companies that exploit them

• Profits taxes and royalty payments don’t adequately capture a fair share of this “economic rent” that accrues to the exploiter

• Introduce a new tax that captures a share of this economic rent• Give it a fancy name – Resource Super Profits Tax (“RSPT”)• Promote it as merely ensuring that the community gets its fair share

Tax the super profits made by mining (that they didn’t earn) and give it to the community – who could argue with that? Simple tax and a sensible reform!

Economic Rent Tax on Non-renewable Resources?

However the facts are different!• Rising prices associated with most minerals has nothing to do with their non-

renewable nature• The potential supply of iron ore from the Pilbara is almost limitless

• Easy to extract low cost hematite (Fe2O3) will last another 25 years• Energy intensive, heavily processed high costs magnetite (Fe3O4)

will last another 250+ years• So what is the real explanation?

• A rapid increase in demand driven by China• Strategic control over infrastructure – ports and railways• Massive time lags associated with any supply response – 5-7 years

• The resources are owned by the States – not the Commonwealth and not the Australian community – and paid for through royalty payments (not a tax!)

Federally based swipe for additional funds (from activities that happened to have become temporarily very profitable) to be extracted from an area properly the preserve of the States Horribly complicated!

Or a gross misrepresentation supporting bad policy?

• It was supposed to be a cashflow tax (similar to a Brown Tax):• Establish value of mined ore as close to production point as possible• Deduct allowable costs incurred to create that product

• Net margin created at the mine site• Government collects 40% of the net margin• In exchange government pays the royalty payments

• Future investment where qualifying treated as a cash outflow so effectively deducted as an allowable cost

• Where net margin negative – loss carried forward at LTBR (~ 6%)

• Past investment brought in as a loss allowance carried forward• Book value of assets as at 1 May 2010 inflated by LTBR

• RSPT payment allowed as a deduction against Corporate Income Tax (CIT)• $1 of extra margin – results in an additional 40c RSPT payment• The remaining 60c would then be income for CIT purposes

• If reduced to 28% then company left with 43.2c• Effective marginal rate is therefore 56.8%

RSPT – what it actually was

• RSPT = Resource Super Profits Tax; MRRT = Mineral Resource Rent Tax

• WACC = Weighted Average cost of Capital

• LTBR = Long Term Bond Rate

• CIT = Corporate Income Tax

• ‘Brown Tax’ – cashflow based tax in which the government pays x% of any cash outflows experienced by a company or project (including investments) in exchange for receiving back x% of the subsequent cash inflows.

In effect a pure ‘Brown Tax’ is simply the government becoming an x% partner in the company or project. It is theoretically non-distortive to investment because

– Investment analysis evaluated Net Present Value (NPV) of cashflows would show that the NPV of the project had decreased by x% as a result of an x% Brown Tax

– Note that any positive NPV remains positive

– Investment analysis evaluated by IRR% of investment will show an unaltered IRR% after the imposition of Brown Tax.

Definitions

• The way that the so called “RSPT” was introduced was quite frankly shameful, demonstrating the following attributes:

• Bad Faith• The don’t worry phone calls

• Misinformation/misrepresentation• Ownership of resources• The amount of tax being paid• Modelling showed it would be more efficient• Industry had been consulted

• Disingenuity• Consultation process

• Strategic ineptness• Not separating principles from a swingeing tax increase

• Old style ‘class warfare’ tactics not modern consensus approach

RSPT – the Politics

• Fortescue’s Key concerns were:• The 40% marginal tax rate

• Results in combined marginal rate of 56.8% (28% CIT; 40% RSPT)

• The Uplift Rate• Should be WACC not LTBR

• Royalty cash rebate scheme• Subsidises/encourages unprofitable/strategic investment

• Absence of interest deductibility• Hurts leveraged finance• Puts government equity above debt

• Other• Taxation point• Netback pricing mechanism

• Panel lacked understanding about industry or finance

The Trip to Canberra

• RSPT was efficient because it was a Brown Tax• But ‘Government cash’ replaced by ‘IoU’

• IOU@LTBR (interest capitalised; date of re-payment uncertain)• Inefficiency = f (‘value of IoU’ < ‘face value’)

• Model showed RSPT was more efficient tax than royalties• Assume RSPT has no adverse effect (Brown Tax)• Then CGE model shows increase in output ~ 8%

• Perfect capital mobility; long run equilibrium• Leverage problems invisible; dynamic issues ignored

• Investment if risk adjusted return > cost of funds• If true there would be no ‘Super Profits’

• Resources were immobile and therefore couldn’t avoid tax• Ignores the fact that resources worthless without infrastructure

• Investment required to create infrastructure is mobile• RSPT would adversely affect infrastructure returns

• Existing businesses can’t escape; but• RSPT potentially drives new investment elsewhere

Economic theory issues

• Fortescue’s Key concerns were:

• The 40% marginal tax rate• Outside terms of reference and not negotiable

• The Uplift Rate• Outside terms of reference• Couldn’t see problem at first

• Understood ‘Factoring the IOU Argument’ Solution?

• Royalty cash rebate scheme• Appreciated insights – removed from proposed MRRT

• Absence of interest deductibility• Tax should be indifferent to financing method• Actually wanted to deter highly leveraged finance

• Other• Taxation point – At mine site• Netback – Market mechanism (regulated returns) ATO?

Outcome of Canberra Trip

?

?

• RSPT was selectively picked from the Henry tax review• But Henry’s view based on a theoretical view of finance that

was misplaced• Rudd relied on Swan• Swan relied on Henry and advisers• Ferguson left in the dark

• BHP, Rio and Xtrata furious about retrospectivity• Minerals Council of Australia (MCA) led the charge

• Smaller players more worried about deterrence to investment• Led by AMEC

• Mining Industry acted collectively• Also backed by CME and CCI• And a huge numbers of suppliers (even camping equipment!)

• Rudd attempted to solve the unfolding disaster• Divisive negotiating tactics – reached agreement with FMG• Deposed before deal confirmed by wider industry

RSPT – back to the Politics

• Gillard takes what Rudd had been negotiating with the big 3• Interests of cabal converted into a secret Heads of Agreement

• Conditions require a cessation of their hostilities• Announces that industry has agreed to MRRT

• Calls an election

• Key differences• In addition to not instead of royalties• Headline rate reduced to 30%, actually 22.5%

• marginal rate (CIT 29%, MRRT 22.5%) = 45%• Allows market value (incl. resources) depreciated over life of assets

• Huge benefit to existing companies with valued resources• No use to prospective companies with high development risk

• Uplift increased to LTBR + 7%• Above WACC for majors but below for juniors

• No help for leveraged finance; $50m threshold; only iron and coal

• Helps Majors• Massive capital shield depreciated over truncated asset lives• Increases barriers to entry consolidating existing oligopoly

The MRRT is born

• Continuing political dishonesty:• Gillard didn’t negotiate it, Rudd did but didn’t adopt because too biased to big 3• Suits big 3 but remains problematic for the rest of iron or industry

• Big balance sheets and existing businesses relatively unscathed• Speculative operations needing leveraged finance will face problems

• ‘Intended targets’ let off whilst juniors become collateral damage

• Effective marginal rate reduced to 22.5% - combined with CIT = marginal rate 45%• Highest marginal rate on mining elsewhere = ~40% USA• A 15% MRRT combined with 29% CIT would equal a combined rate of 40%

• Rate still too high - it should have been set at 15%

• Uplift rate LTBR +7% ~ 13% (nominal pre-tax)• TPI – WACC determination by ERA = 14.3% nominal pre-tax (2.6% inflation)

• Would have liked higher – but isn’t obviously wrong

• Threshold set at $50m, but phase in of MRRT between $50 and $100m• Administrative costs still imposed on those below $50m – two sets of accounts• Phase in makes marginal MRRT rate 45% ($50m-$100m) – 61% with CIT

• Big deterrence to mergers amongst juniors and takeovers

Assessment of MRRT

• Netback pricing calculation• Requires valuation of ore once mined but before processing

• Sale price at port, less: a) port services – includes port capacity (strategic asset)b) rail haulage – who appropriates innovation productivity gains?c) normal processing services - crushing & screening, washingd) Beneficiation or de-sanding – do these add value? e) blending services (at port or mine site) – does blending add value?

• Beneficiation/de-sanding and blending can convert waste into valuable ore• Value of ore prior to upgrading or blending can be zero

• What if sold as landed in China (“CFR”)?• Deduct shipping costs (at what rate?)

• What if production is from a multi-product mine• Vanadium (iron ore –worthless?); Manganese (iron sold for zero?)

• What about multi-product companies – including infrastructure services• Head office costs? Marketing fees? Unsuccessful exploration?

Assessment of MRRT – Complexity

• Short term - It probably won’t raise the expected income• Market value method depreciates over ‘life of mine assets’

• Proposal limits that to a maximum life of 25 years• No minimum limit

• There is a difference between ‘life of assets’ for tax purposes and the likely real life of those same assets

• Treasury modelling crudely assumes 25 year life• BHP/Rio probably working off something considerably

shorter ~ say 8-10 years• Difference increases annual tax shield by 2.5-3x• Government won’t find out until tax returns filed

• Long term – It won’t be there• 10 years from now when the tax shield is used up

• Iron ore no longer generating ‘super profits’• But the concessions it is supposed to fund will be

• Creates a structural deficit problem

Further thoughts

1. A bird that lays its eggs in the nests of birds of other species• MRRT results in government

taking preferential equity with no actual investment

2. Lacking in sense; foolish or crazy• Justifications based on theory

divorced from reality

3. To repeat over and over• Disinformation repeated

incessantly to drown out rational debate

MRRT - The “Cuckoo” Tax

• Politically mismanaged• ‘Us v them’ mentality blinded them to the flaws

• Consultation process was and remains nothing but an artifice• Terms of reference preclude all important issues

• The political and economic justifications were simply wrong• Resources owned by the States• Not a ‘Brown Tax’ – It won’t be more efficient – no new investment• In ground resource immobile but required capital very mobile

• The MRRT isn’t what it is claimed to be• It hasn’t simplified anything – increased complexity• Doesn’t target non-renewable resources – just iron and coal• Doesn’t deliver any efficiency improvements – royalties still there

• Will deter ‘leveraged finance’ style investment• Re-inforces oligipolistic control exerted through infrastructure• Cabal agreed – this is their silver lining

• This will be a highly unstable revenue stream• It shouldn’t be used to fund tax reforms

It is basically unfair

Summary - critique

MRRT: FAVOURS BIG 3

2013 2014 2015 2016 201730%

35%

40%

45%

50%

New Miner will pay higher effective rate of tax

All taxes and royalties (ie company tax, royalties and MRRT) as per Fact Sheet example`New Miner $1 billion book value depreciated over five years Mature Miner $3b market value starting base depreciated over 8 years

MRRT: FAVOURS BIG 3

Example mine used in Government’s Fact Sheet released 10 June 2011 but showing how book value starting base and market value starting base will operate

New Miner $1 billion book value depreciated over five years Mature Miner $3b market value starting base depreciated over 8 years

2013 2014 2015 2016 2017

(20m)

0m

20m

40m

60m

80m

100m

New Miner will pay far more MRRT than Mature Miner

New Miner

Mature Miner

• Political Avenues• No election – no leverage

• ALP – three monkeys approach• Greens – think MRRT set too low• Independents

• ‘Status quo’ versus ‘political integrity’• Amendments to address unfairness

• Legal Avenues• Is the MRRT Constitutional?

• Three groundss.51(ii) – no discrimination between Statess. 99 – no preference between Statess.114 – no taxing State’s property

• Modern interpretation of the meaning of ‘Discrimination’ offers potential

• Once the legislation finalised – watch this space !

Where to next?

?

• Was the RSPT part of a program of sensibly structured tax reform?– Would it have achieved the objective of giving a “fair” return to the Australian

community?– Was it the case that what was previously in place (State based royalties) was

squandering the opportunity to extract value from “Australia’s non-renewable resources”?

– Can a new mining tax be justified on the basis of the reduction in corporation tax and the increase in pension contributions that it will allow?

• Is it acceptable for a government to use taxpayer funds to “educate” the public about its proposed tax reforms?

– Is it misappropriation of public funds if the subsequent announcements are grossly misleading?

– What are the limits on government if it believes that its opponents (non-political) are misrepresenting the truth?

• What is the appropriate rate for government to pay industry if it is borrowing funds from them?

– Is it the rate at which government can borrow the funds from elsewhere? – Or is it the opportunity cost imposed on the company by requiring it to lend those

funds to the government?

Issues and/or questions

• Should tax reform be limited to prevent changes that adversely impact projects after the investment has been made?

– This is the retrospectivity argument effectively deployed by majors!– If not, what is the appropriate level of protection that should be afforded?

• Almost any tax change will producer winners and losers, with the losers protesting loudly.

– What consultation should be undertaken and with whom and should the terms of the consultation be restricted to certain issues?

– How should government weigh the losers’ ‘Armageddon’ complaints?– Is it appropriate to structure taxation around particular companies’ requirements?

• How important is tax neutrality when evaluating proposed taxes?– Should it be a primary consideration?– How does it rank compared to the objectives of revenue raising potential or

revenue stability or even equity?

• Did the RSPT/MRRT really pose a sovereign risk problem for Australia?– Exactly what was at risk if the RSPT had been implemented as proposed?– Was Garnaut correct when he asserted that because the RSPT would be

sensibly structured it would actually lower perceived sovereign risk?

Issues and/or questions (cont’d)

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