The Fiscal Terms and Resource Revenue Collection

The Fiscal Terms and Resource Revenue Collection

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1- Why does extractive industry require a special taxation regime?

2- What is this special taxation system?

3- Why do we need progressive fiscal regime?

4- Why can we speak about a mirage regarding locally-held equity ?

5- Capital Gains Tax: What is challenging about it ?

6- Do low income countries need tax incentives to attract investment?

7- What is the importance of fiscal modeling for host countries?

8- What are the main challenges of fiscal regime design ?

Stylized Mining and Gas Project Timeline

Project Timeline

Revenue

Capital Costs

Operating Costs

Exploration Costs

Source: Revenue Watch Institute

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Stylized Oil Project Timeline


Oil depleted faster than minerals, payback period is shorter, opex over the life of the project lower -> more profitable than mining , generally speaking

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High Potential For Increase In “Rent ”


“RENT” or “SUPER/EXCESS

PROFIT”

Stylized Project Breakdown

Total Costs

Minimum Return

Rent

Why is Extractive Industry specific ?• Lengthy exploration period with no revenue

• High Capital expenditure making the capital captive and not transportable

• High probability of social and environmental damage

• Cyclical revenues because of volatile commodity market

• Minerals are finite and belong to the State or the land owner

• Long life of mine implies potential for regime changes and policy instability

•Tremendous potential for high “rent” (Financial returns above those a company requires to invest ). The rent increases with the quality of the mineral deposit

Extractive Industry: A Specific Sector With a Specific Tax Policy

Calls for a resource specific taxation• Special Tax Treatments to encourage exploration - always demanded and considered justified by companies

•Use of taxation incentives for investment in communities and protection of the environment

• Request for use of profit-based taxes by the investors

• Royalty: price of the right to use the land belonging to either the national state / local government or the landowners (US) + immediate revenues

•Need of a progressive fiscal regime that self-adjusts to circumstances and profitability to ensure stability of the system

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4- Why can we speak about a mirage regarding locally held equity ?




8- What are the main challenges of fiscal design ?

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Main Types of Tax Instruments

• On Dividends for foreign shareholders- common and encourage re-investment in the country

• Most states apply a standard national corporate rate in the range of 20% to 35% of profits

Withholding Tax on Dividends

Corporate Income Tax Investment

Credit/ Capital allowance

• A percentage of the capital expenditure that is tax deductible

Loss and Carry Forward

• An accounting technique that applies the current year's net operating losses to future years' profits in order to reduce tax liability

Royalty• Imposed on value of mineral sales (ad

valorem) or on production volume (unit based).

• The value can be defined in different maners (FOB, CIF, mine – gate, netback )

Depreciation and Amortization (D&A)

• Accounting mechanism to spread out the capital expenditure over many years-> tax deductible and investment incentive

1. The Rate: 5% royalty 30% income tax rate 10% equity share

2. The Base The number against which the rate is applied. Revenue-based? Production – Based? Profit - Based? Need of a clear definition : gross revenue? Net revenues? Profit

including depreciations? Before depreciation?

3. TimingFor developing countries funding growth and development, timing

matters.Timing also relates to the risk of different revenue streams.

Elements of Fiscal instruments

Room for manipulation

Room for political

economy

Importance of the Tax Base !

- Royalty Rate of 3% for Copper- Copper Sold at Export Point at $7500/Ton - Transport and Processing Costs of $500/Ton

Royalty per Ton under Net Back= rate * (gross – costs)= 3% * (7500 – 500)= 3% * 7000= $210

Royalty per Ton under Gross= rate * gross = 3% * 7500 = $225

How to manipulate the royalty base ?

Room for manipulati

on

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Complexity of the Definition of the Tax Base

Source: World Bank

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Complexity of the Definition of the Tax Base

Fiscal Instruments – A Common Example In Extractive Industries

Gross Revenue To Investor

Pre- Tax Profit (EBT)

After-Tax Profit

Inv.’sDividend

W/Htax

Government Revenue

Gross Revenue From Oil, Gas or Mining (P*Q)

RoyaltyProduction Cost – “OPEX”

Profit Tax

Govt. Equity

Reserves

[W/H = withholding]

Investor ReturnSource: Revenue Watch Institute

Includes financial cost and depreciations

Dividends

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Fiscal Regime in the Oil Sector is often Different from Mining

Mining mostly here

15PSCs have never taken off in the mining sector … why?

In PSC, contractor receives a share of the proceeds from Cost Recovery and Profit Split

In PSC, government receives a share of the proceeds from Profit Split and taxes paid by the contractor on its take

Profit Sharing – How Does It Work?

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Effective Tax Rate (ETR)Definition: Total government taxes Cumulative Pre-tax profit

Comparing the fiscal regimes based on this ETR in a selection of countries that compete for mining investment (“peer countries”) helps assess the fairness FOR BOTH PARTIES of the fiscal regime

Internal Rate of Return (IRR)Definition : Makes the positive cash flows (project revenues) equal to negative cash flows (initial investments)

- Must be above the cost of capital

- The higher the better!

- Can be used to rank several prospective projects a firm is considering.

- Can be increased by leverage hence the interest of thin capitalization

Assess the profitability of the project

Assess what is called theGovernment Take in the project

Fiscal Regimes Are Assessed Against 2 Main Indicators Revealed by the Fiscal Model

USED BY THE

INDUSTRYUSED BY POLICY

MAKERS AND

ADVISERS

ETR=

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When commodity prices go up and/ or project costs go down, everybody benefits, but

the percentages may change.

Government Share (Gov Take)

Contractor ShareTotal Net Profit

$670 Million$330 Million$1 Billion

- 67%

$1.5 Billion

Government

Contractor

Low Oil Prices or High Cost

situation

High Oil Prices or Low Cost

situation

33%

67%

37%63%

$945 Million$555 Million

Source: Adapted from Daniel JohnstonWHY WOULD IT HAPPEN?

- 33%- 63%- 37%

The Need For a Progressive Fiscal Regime

From B. Land, Taxing the Minerals Industry in Turbulent Times, 2009 (citing PWC report, “Mine: As Good as it Gets?” 2008)

Prices, Internal Rate of Return, Rent..

HOW TO FIX THIS SITUATION ?

Easy First Step But Not Optimal : Progressive vs. Flat

Royalty RatesProgressive Royalty Rate

Price Rate Total Royalty Take

$100 7% $7

$200 8.5% $17

$300 9% $27

Flat Royalty Rate

Price Rate Total Royalty Take

$100 7% $7

$200 7% $14

$300 7% $21NOT TIED TO PROFITABILITY or ACCUMULATED PROFITS AND

CAN BE DETERRENT

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Reminder: Costs Go Down Naturally


“RENT”

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What Would Be Such a Progressive Tax?

Resource Rent Tax Rate

Project Internal Rate of Return

20%

50%

25% 45%

Gradual increase

Threshold

Resource Rent Tax: Highly tied to profitability and to accumulated cash flow

0%

If suddenly the net cash flow is negative again, the RRT stops kicking in

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Can the fiscal regime carry one more input tax and still remain viable for the investor?

Resource Rent

Tax

Income Tax

Royalty Tax

Withholding Tax

Timing of Different Fiscal Tools


Timing matters for developing countries

Optimal Progressive Taxation

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Qualities of a progressive fiscal regime?

• Captures the rent

• Does not distort investment decisions

• Self-adjusts to richness of the deposit, price, cost and risk = capable of accommodating wide ranges of profitability

• Avoids the need to change tax regime (fiscal reforms) according to market and geological conditions

BUT! Almost NO African countries have progressive taxation!

Less Optimal Progressive Taxation

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Other less progressive ainstruments

• Windfall profit tax (often price-based)

• Variable income tax

• Other sliding-scale instruments

Less progressive but maybe more adapted to the tax administration capacity

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Responsiveness of Proxies to Profitability

Source: IMF

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7 - What is the importance of fiscal modeling for host countries?


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Mirage Of Equity Participation

WHY CAN WE SPEAK ABOUT A MIRAGE?

EQUITY PARTICIPATION

FORMS

So-called “free” equity

Paid-up equity

Equity in exchange

for a non-cash

contribution

Paid-up equity

for local ownership

Carried interest

Tax swapped for equity

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The Mirage – WHY?

• Can be costly option. (ex: Nigeria)• Possibly, dividends never paid (widely experienced )• Possible conflict of interest ( government’s role as regulator vs equity shareholder. ) (ex: Mozambique)

• Economic: share in any upside of a project,

• Non-economic : nationalistic sentiment (DRC), transfer of technology and know-how (South Africa), direct control over project development (Guinea)

Motivation for state equity

Problems

• Economic impact of an equity share can in principle be replicated by tax instruments.

THE IRONY

The government is often better off by focusing on taxing and regulating a project rather than being directly involved as an equity participant.

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State Equity Problems Can be Exacerbated in the Presence of a SOE

Problems of NOC in general:

- Are assigned contradictory objectives:

- Providing employment (China, Russia)

- Providing fuel subsidies (Saudi Arabia, Venezuela)

- Providing infrastructure (Nigeria – Angola : pipelines)

- Foreign policy objectives (China)

- Answer government’s cash demand (Mexico)

- And…. Be the National Oil Company!

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Capital Gains Taxes and Indirect Transfer

There is no direct transfer or “assignment” of the rights in the project. A new agreement (e.g., mining license) is not signed.

There is a change in control (“indirect transfer”) , happening offshore of the company holding the right/ mining license

Change in control = sale of shares of either the company holding the license, or of one of the companies in the chain of ownership of that company (e.g., the holding company/ultimate parent company) (sales happening somewhere in the beneficial ownership)

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A Famous Case from Mozambique

Riversdale Mining Limited

Rio Tinto

Riversdale Energy

AUSTRALIA – STOCK EXCHANGE

MAURITIUS

Riversdale Mozambique Limitada

MOZAMBIQUE

Rights to the Coal project

Owns the companyBoughtOwns the right

On the grounds that Riversdale Ltd holds

underlying assets which are in the

country, GoM is claiming a CGT

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The Regulatory Solution to CGT

Indirect transfers should also be covered by CGT regs All license holders should disclose “beneficial ownership” Prior notice of such transactions + with all relevant documents

should be given to the Government Sometimes restriction of scope of application (% of mineral assets

ownership or % of shares transferred) Enforcement: tax withheld from the purchase price. “Lien” on the

concession agreement and/or other assets of the local company to cover defaulted tax obligations. Shares of the local company would be considered to be held in trust for the government.

Ability to tax depends on DTA – that might only authorize taxation on residents or taxation on direct transfer

Challenge: not easy to determine to what extent the value of the non-resident shares is reflected by an increase in value the host country’s assets when the non-residents owns several assets!

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Different Investment Incentives

Corporate income tax incentives

• Tax holidays or reduced tax rates• Tax credits• Investment allowances• Accelerated depreciation -> tax base – transfer tax burden but doesn’t

wave it

• Reinvestment or expansion allowances

Other tax incentives

• Exemption from or reduction of withholding taxes• Exemption from import tariffs• Exemption from export duties• Exemption from sales, wage income or property taxes• Reduction of social security contributions

Financial and regulatory incentives

• Subsidized financing• Grants or loan guarantees• Provision of infrastructure, training• Preferential access to government contracts• Protection from import competition• Subsidized delivery of goods and services• Derogation from regulatory rules and standards

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Text

• No companies had paid income tax until 2011 besides Anglogold Ashanti, 10 years after starting production

• Barrick Gold 97 million$ between

2004 and 2007 but 0 income tax

TANZANIA

• 1992 international copper prices 2280$/ton production 400 000 tons: In coffer: 200 m$

• 2004 copper price 2868$/ton production 400 000 tons: In coffer : 8m$

ZAMBIA

Text

Developmental Impact of Tax Incentives

Tax Incentives and Loopholes

Lack of ring-fencing

Thin capitalization

Transfer Pricing

In addition to progressive decrease in tax rates AND tax base

REVENUES COLLAPSED!

70’s-80’s

2000’s

Washington consensus

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Do Countries Need Tax Incentives to Attract Investment?

Mc Kinsey, 2009: “popular incentives, such as tax holidays (..) serve only to detract value from those investments that would likely be made in any case”

IMF, 2009 : “ tax incentives in sub-Saharan Africa are now used more widely than in the 80’s with more than two thirds of the countries in the region providing tax holidays to attract investment. Such incentives not only shrink the tax base but also complicate tax administration and are a major source of revenue loss and leakage from the tax economy

DOES THIS ISSUE ONLY AFFECT AFRICA?

IF no Ring Fencing, Government loses !

Project 1 Project 2

- Gross Revenue $750 - Gross Revenue $ 5000

- Total Costs $4000 - Total Costs $ 7000

- Net Revenues $3500 - Net Revenues - $ 2000

- Tax (@30%) $1050 - Tax (@ 30%) $ 0

Project 1+2 (NO Ring-fencing)– Gross Revenues: $12500

– Total Costs: $11000– Net Revenues: $1500– Tax (@ 30%) = $450

If the law is silent, you just don’t apply ring fencing of profits and losses!

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Transfer Pricing Practice and How To Limit It?

HOW TO FIX IT ?TRANSFER PRICING PRACTICE

• Definition: prices charged for cross-border transactions between related parties

• WHAT DO YOU NEED TO SUCCEED ( as a company) ?

• The creation of an affiliate entity

• To whom you sell exports at below market price (=‘transfer price’)

• To whom you charge imports/ leasing at above market price (=‘transfer price’)

• From whom you borrow at above market interest rates to highly leverage projects

• Regulatory Solution!

Law/ Contract: 1) require arms-length basis

transactions between related parties

( article 9 of UN and OECD Models for DTA)

Difficulty : for some specialized goods and services , difficult to determine what exactly is a fair market price.• Requires closer monitoring• More reporting• Requests for comparable

transactions• Cooperation with tax

authorities of home countries

2) impose a cap on theallowable debt-leverage of a project

$10 bn/ year left Africa between 2002 and 2006 as a result of transfer pricing

DISHONNEST BUT LEGAL

!!

THIN CAPITALIZATION

Transfer Pricing (2)

Example:

Parent(UK)

Sub1(British V.I.)

Sub2(Angola)

Sub3(UK)

Purchase of Inputs: $100 Sale of Minerals: $120

Fair Market Value: $50 Fair Market Value: $150

Taxable Profit: $20

Taxable Profit (fair market value): $100


Transfer Pricing Practice – Example

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The UN Model Tax Convention Article 9(1)

“Where:(a) an enterprise of a Contracting State participates directlyor indirectly in the management, control or capital of an enterpriseof the other Contracting State, or(b) the same persons participate directly or indirectly in themanagement, control or capital of an enterprise of a ContractingState and an enterprise of the other Contracting State,and in either case conditions are made or imposed betweenthe two enterprises in their commercial or fi nancial relationswhich diff er from those which would be made between independententerprises, then any profi ts which would, but for those conditions, have accrued to one of the enterprises, but, by reason of these conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

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A concrete exampleAssume a corporation P (parent) manufactures automobile seats inCountry A, sells the finished seats to its subsidiary S in Country Bwhich then sells those finished seats in Country B to unrelated parties(say, the public at large). In such a case S’s taxable profits are determinedby the sale price of the seats to the unrelated parties minusthe price at which the seats were obtained from its parent corporation(cost of goods sold in the accounts of S, in this case the transfer price)and its expenses other than the cost of goods sold.

If Country A where the seats are manufactured has a tax rate muchlower than the tax rate in Country B where the seats are sold to thepublic at large, i.e. to unrelated parties, then perhaps corporation Pwould have an incentive to book as much profi t as possible in CountryA and to this end show a very high sales value (or transfer price) ofthe seats to its subsidiary S in Country B. If the tax rate was higherin Country A than in Country B then the corporation would have anincentive to show a very low sale value (or transfer price) of the seats toits subsidiary S in Country B and concentrate almost the entire profitin the hands of Country B. Source: UN Manual

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Applying the Arm’s Length principle (ALP) in practice

• Several acceptable transfer pricing methods exist, providing a conceptual framework for the determination of the arm’s length price.

• All these transfer pricing methods rely directly or indirectly on the comparable profit, price or margin information of similar transactions.

• 5 major transfer pricing methods: Comparable Uncontrolled Price Resale Price Method Cost Plus Profit Comparison Method Profit Split

• Advance Pricing Agreement (APAs): pricing methodologies agreed in advance in relation to certain types of transactions, often called the “covered transactions”. Provide greater certainty for the taxpayer on the taxation of certain cross-border transactions and are considered by the taxpayers as the safest way to avoid double taxation

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Applying ALP is COMPLEX

Fight against Thin Capitalization: International Practice

US: 1.5:1 debt-to-asset ratio

Australia: 3:1 debt-to-asset ratio

Canada: 2:1 debt-to-asset ratio

Chile: 3:1 debt-to-asset ratio

Liberia: interest + 50% taxable income before interest (or as negotiated)

Peru: 3:1 debt-to-asset ratio

Saudi Arabia: lower of actual interest or interest + 50% taxable income before interest Sierra Leone: 3:1 debt-to-paid up share capital

South Africa: 3:1 debt-to-asset ratio

Tanzania: lower of actual interest or 70% of taxable income before interest

Zambia: 3:1 debt-to-asset ratio

Malawi: 4:1 debt-to-asset ratio

Mongolia 3:1 debt-to-asset ratio (only applies to related-party debt)

No Thin Capitalization Rule in

Brazil - China - India - Indonesia - Papua New Guinea – many African countries!

Need to clearly

include shareholders’

loans in the definition of

“debt” or “interest”

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As a Starting Point : Fallacy of Discussing Individual Fiscal Tools in

Isolation

FISCAL MODELING TO KNOW THE OVERALL FISCAL BALANCE! AND UNDER DIFFERENT SCENARIOS!

Knowing that a royalty is 4%, 5% or 10% will not give you a sense of whether the country is getting a good deal unless you also know how much the country earns from other fiscal tools (profit taxes, bonuses etc )!

Fiscal modeling will tell you that Different Combinations of Fiscal Tools Can Yield the

Same Outcome for the Government

Example 1Corporate Income Tax as

primary tool to extract revenue

Royalty = $10 million Profit tax = $40 million Total revenue= $50million

Example 2Royalty as primary tool to

extract revenue

Royalty = $45 million Profit tax = $5 million Total revenue = $50 million

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Financial Modeling: A Tool For Fiscal And Public Investment Policy

WHY Forecasting the revenue flows to the government under different scenarios ?

What long term public investment policy can be funded and planned?

What is the fairness of the current and potential deals?

What is the equitability of the fiscal regime for investors and government?

What is the trade-off between “quick money” through signature bonuses and a higher share of profits ?

What is the efficiency of tax incentives?

If we change the tax regime, what is the impact for the parties?

How does this fiscal regime compare with others?

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Effective Tax Rate (ETR)Definition: Total government taxes Cumulative Pre-tax profit

Comparing the fiscal regimes based on this ETR in a selection of countries that compete for mining investment (“peer countries”) helps assess the fairness FOR BOTH PARTIES of the fiscal regime

Internal Rate of Return (IRR)Definition : Makes the positive cash flows (project revenues) equal to negative cash flows (initial investments)

- Must be above the cost of capital

- The higher the better!

- Can be used to rank several prospective projects a firm is considering.

- Can be increased by leverage hence the interest of thin capitalization

Assess the profitability of the project

Assess what is called theGovernment Take in the project

Fiscal Regimes Are Assessed Against 2 Main Indicators Tested By The Model

USED BY THE

INDUSTRYUSED BY POLICY

MAKERS AND

ADVISERS

ETR=

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Govt Take= Effective tax rate (ETR)*Percentage

IRR Percentage

846362

5854

5050494846454543434240403737

Burkina FasoUzbekistan Ivory Coast

Papua New Guinea Ghana

Greenland Mexico

Indonesia Tanzania

Kazakhstan Philippines

South Africa Bolivia

Peru China

Argentina Zimbabwe

Poland Chile

Average

3.39.38.910.811.91311.312.212.412.913.513.511.412.312.713.913.512.215

49.2

Copper Mines

Source: J. Otto et al, Global Mining Taxation Comparative Study, Colorado School of Mines

International Benchmarking Comparing Government Take AND Profitability Is Needed To Assess The Fairness Of a Deal

Take a standardized mine model

and apply all applicable taxes for each

country in that one model and

compare the outcomes

Examples of Copper Mines:

Average ETR: 49.2%

for IRRs that are

all below 15%

Important Note On Government Take : Mining Is Not Oil !

Government Take Oil: 60-80%

Government Take Mining: 25-60%

WHY? In mining, a lot more fiscal incentives, no cartel like OPEC to keep prices up, no progressive fiscal regime, less rent to make

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7 - What is the importance of fiscal modeling for host countries?


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What Are the Common Goals to Take Into Account in a Fiscal Regime

Design?

Government Take/Overall fiscal balance adapted to level of attractiveness of the mineral/ hydrocarbon deposits

Government Take/Overall fiscal balance competitive with the peer group countries

Government Take not collapsing over time Government Take/Overall fiscal balance adapted to

capacity of the tax administration

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Source: IMF

What Are the More Country-Specific Objectives?

Tax Administration Capacity and Policy Design

Possible trade-off between progressivity and ease of administration

The simplest fiscal tools to administer (bonuses and royalties) are also the least progressive …whereas the most complicated (resource rent taxes) are the most progressive.

“Most complicated” means high risk of leakages in low capacity governments

Possible trade-off between efficiency/credibility and ease of administration

Ex: price-based taxes may eventually become untenable and require adjustment if costs rise disproportionately and thus decrease profit margins

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Policy response?

-> MINIMIZE TRANSFER PRICING-> STANDARDIZE CONTRACTS-> FOCUS ON THE MAIN REVENUE STREAMS -> ELIMINATE MINOR TAXES

DON’T GIVE UP ON PROGRESSIVE TAX REGIMES BUT INVEST IN CAPACITY BUILDING !!

Documents

The Fiscal Terms and Resource Revenue Collection