TAxATION AND INVESTMENT ISSuES IN MINING

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TAxATION AND INVESTMENT ISSuES IN MINING
 TAxATION AND INVESTMENT ISSuES IN MINING
PAUL MITChELL
Between 1 and 200 over 100 hundred countries introduced new mining laws, most involving reforms to
their fiscal systems, including taxation. These reforms were motivated by a desire to encourage greater mining
investment and concerns about the public–private shares of mining revenues. It is clear that tax revenues derived
from mining activities represent an important public policy issue. This chapter outlines key policy issues as they
relate to the mining sector: the role of tax in companies’ investment decisions; the optimum level of tax and effective
tax administration; observations about a “good” taxation system; and conclusions about the role of tax regimes in
development generally.
The role of tax in investment decisions
Mining is a cyclical industry, and investment in exploration and
mine development follows these cycles. All regions of the world
are affected by this cyclicity, and, as mentioned in the previous
chapter, companies usually compare numerous development
options internationally, and screen these options to obtain
the best balance between risk and reward. The key factor
determining investment decisions is the geological potential
of a site, but it is strongly offset by fiscal and socio-political
considerations, with the former including tax rates and the latter
the stability of the tax system. Table 1 below details the most
important criteria which companies consider in making
investment decisions, and it can be seen that more than a
third relate to taxation.
Designing mining tax systems
The ultimate goal of any government's mining tax system is
to ensure the greatest possible benefit for the public while
simultaneously encouraging investment in the sector. Achieving
this requires realistic consideration and careful balancing of the
objectives of the two key players: companies and governments.
For companies, the overall level of tax, including royalties,
influences incentives to explore and develop. Higher taxation
levels are likely to reduce incentives to invest, and, in marginal
cases, even to keep some mines operating. The timing of tax
charges also influences investment patterns. Raising tax rates
will increase government receipts in the short term, but if
an increase is too high it will discourage exploration and
development, thus reducing the tax revenues generated
by the sector over the longer term.
Different types of taxes influence investment behaviour and
government administration. For instance, taxes based on units
of production irrespective of profitability may create economic
inefficiencies by discouraging the exploitation of lower grade
ore and shortening the life span of some mines. Conversely,
taxes on corporate profits (and to a lesser degree incomes) are
more efficient and recognise the inherent risks in mining
operations, particularly wide fluctuations in international
minerals prices and the difficulties of anticipating all geological,
technical, financial and political factors over a mine’s lifetime.
ADVANCING THE EITI IN THE MINING SECTOR 2
Table 1. Top ten company decision criteria in mining investments
1 Geological potential for target mineral
2 Profitability of potential operations
3 Security of tenure and permitting
4 Ability to repatriate profits
5 Consistency of minerals policies
6 Realistic foreign exchange controls
7 Stability of exploration terms and conditions
8 Ability to pre-determine environmental obligations
Ability to pre-determine tax liability
10 Stability of tax regime
Bold: tax-dependent. Italics: tax-related.
Source: UN survey of companies quoted by Prof. James Otto, 200, unpublished.
Notes: the survey included a total of 62 factors, not necessarily in the numerical order given.
Further, profits-based taxes tend to distribute these risks more
evenly between companies and the state. While perhaps
economically superior, the challenge with profit-based systems
is their greater complexity, which may be a genuine constraint
in developing countries with limited administrative capacity.
Also, more complex profit-based systems have greater potential
for corruption and tax fraud – key concerns in the EITI context.
When deciding whether or not to invest, companies consider
not only the expected rate of return (or profitability) but also the
associated risks of a new project. An important risk consideration
is the perceived stability of a tax regime over time. perceived
stability is also important for governments. This is because of
the risk–return trade-off: where companies perceive greater
risks, they and their financiers will demand a higher return,
thus lowering the returns available to the government when
determining the required profitability of a new project.
Therefore, tax systems play an important role for the government
in terms of influencing the relative attractiveness of a jurisdiction
for investors.
To summarise: a government's objective for the minerals
sector is to obtain an appropriate share of income and to foster
development, while companies want an adequate return on
investment. Thus, it is in the interests of both parties to facilitate
projects that are successful for their full potential life-spans.
key issues affecting taxation systems
A number of factors that are unique to the mining sector need
full consideration in the design of mining tax regimes. The
primary one is the characteristic minerals and financial cycle
that was discussed in Chapter 3. The cycle means that different
mines have differing capacities to pay taxes at various points, as
is explained below.
• Exploration: this is a substantial cost phase without any
income and is highly risky. Governments typically respond
by allowing losses to be carried forward and to be off-set
against profits in the production phase. This has the
secondary benefit of encouraging firms to continue beyond
exploration to development.
2 ADVANCING THE EITI IN THE MINING SECTOR
Mine development: this too is a high-cost phase requiring the
purchase of substantial capital inputs, most of which need
to be imported. Typical responses are to enable accelerated
recovery (depreciation) of capital costs once production
begins, and to have low import duties and value added
taxes (VATs).
• Production: minerals production is the longest and most
profitable phase in the cycle and is usually when payments
to the government begin to be generated. However,
minerals are sold into competitive markets and prices
fluctuate, meaning that governments often provide
flexibility, such as relief from export duties and VATs, or, in
more serious cases, relief from other more substantive taxes.
• Post-mining: after mining ceases and there is no income,
projects often incur significant rehabilitation costs and also
in some instances extended liabilities for site management.
The typical response is to provide tax deductibility to
encourage companies to set aside funds progressively
during the production phase. Some have suggested that tax
relief for such funds should not apply because rehabilitation
is a social responsibility.
Some mines are large in scale and have long life spans, and
these need specific consideration. Such large, long-life mines
may operate through many political regimes and economic
cycles, and can involve numerous laws. A common response in
these circumstances is to negotiate specific agreements which
provide some stability for key items like tax terms.
A further consideration is that minerals are a finite resource
and are subject to property rights laws – in most countries
minerals are owned by the state. To compensate for lost
property rights many nations impose royalties, or encourage
companies to invest in infrastructure and other public goods.
To accommodate variations in the value of different minerals
and in the scale of mining operations, tax systems often vary
royalties according to mine scale and commodity value.
Other factors require consideration. Companies can pay
taxes or reduce the tax payable by investing in additional
infrastructure and other public goods – how does a tax system
•
balance these trade-offs? Minerals must be processed after
extraction – how should a tax system encourage greater domestic
processing?
It is important to note the above distinctive features of the
mining industry and how they affect taxation. There is however
an opposite argument which says that tax systems should be
uniform across all industry sectors. uniformity encourages
economic efficiency where investment attractiveness is not
distorted by government incentives, reduces the potential for
harmful special-case lobbying by industry, and reduces
administrative complexity.
All these factors mean that designing good tax systems for the
minerals sector is challenging. In practice, perhaps the best
systems are those which are essentially uniform across all industry
sectors but which recognise some distinctive features of mining
and provide some flexibility, such as flexible profit-based
royalties. The designing of royalty regimes is not without its
challenges however. Systems based on economic theory often
incorporate technical considerations (e.g. geology) and
sophisticated calculations. In practice, some of the necessary
inputs for these models are hard to obtain. This difficulty often
leads governments to use royalties systems that are simpler to
administer, especially administrations that do not have the
technical capacity to manage the complex mechanisms required
for optimal royalties calculations.
Governments need to understand the effects of their tax
systems on investment and respond accordingly. Fortunately,
there is a ready measure that they can use, which is based on
relative exploration expenditure: all things being equal (including
tax), a country should attract exploration investment proportional
to its international geological attractiveness rating. If investment
is less, it implies other faults in the investment climate, such as
excessive tax. However, if investment is greater than geological
potential, investment conditions may be overly generous.
Evaluating a tax system
Given the sensitivity and importance of minerals taxation as a
public policy issue, it is essential that key stakeholders consider
it to be fair and reasonable. Inclusive procedures for objective
evaluation are needed. Here, the main questions are:
• Are payments to society adequate?
• Are investors receiving a fair return?
• Is the system competitive with those of other nations or
provinces?
It is essential to address two factors for any evaluations to be
legitimate. First, evaluations must incorporate all applicable
taxes and fees; one measure of this is the Effective Tax Rate or
ETR (Otto, J., 2005, unpublished) – the value of all payments to
governments divided by the value of gross or pre-tax profits.
The second factor is the need to understand as clearly as
possible the particular financial circumstances that apply in the
mining sector being evaluated, so that its capacity to pay is
realistically known. In theory this can be obtained by building
models of all (or typical) mines’ cash flows in the jurisdiction
concerned. In practice such an exercise may be impractical, as
such models must incorporate assumptions about prices, costs
and production volumes, etc., which will change over time.
Notwithstanding these challenges, for public policy to be
effective and credible, decision-makers must understand the
impacts of changing tax rates, adding or deleting a tax, offering
incentives, or any combination of these, before policy changes
are made.
It is instructive to note what has emerged as most common
international practice in regard to ETRs. Figure 1 below shows
comparative ETRs for a hypothetical copper mine, but uses
actual taxes applicable in major mining countries. It can be seen
that the majority of countries fall within the range of 40-50%
ETR. This implies that tax and company profit would be about
equal over the life of a mine. With an ETR of 50% and a typical
cost structure for a 20-year medium-sized copper mine, this
would imply 17% of gross revenues going to corporate profits
and the same figure going to taxes (see Figure 2).
An effective tax system
Given the diversity of operations in the mining sector, it is
impossible to define an ideal tax system for all jurisdictions.
There is, however, a common objective of encouraging
successful and sustainable projects that exploit resources fully
while avoiding social costs. In this context, four observations can
be made about a good tax system.
Tax levels and transparency. Governments should try to maximise
tax revenues over the longer term by encouraging investment in
their jurisdiction and a profitable and technologically advanced
industry. To do this they need to institute tax systems that are
neutral or progressive to motivate corporate innovation and
profit-seeking. Regressive taxes that take increasing shares of
profits and discourage investment should be avoided.
Given that any set of tax rates and the mix of taxes will be
based on assumptions about future prices and costs, and that
these will inevitably change over time, there should be a
preference for transparency. This can be implemented by
establishing multi-stakeholder bodies to conduct regular
reviews of key assumptions, so that any policy change is
predictable and decision-making is consensual.
Mix of taxes. previous discussion has shown that the mining
industry is often subject to many taxes, frequently levied by
different levels of government. This is counter to the objectives
of simplicity and uniformity in taxation systems to ease
administrative burdens and reduce the risks of corruption, poor
policy and fragmented public expenditure. Also, taxes should be
responsive to fluctuations in minerals prices. In combination
these factors suggest that preference should be given to
centralised direct taxes, based on profit or income, while
reliance on indirect taxes, such as units of production or
ADVANCING THE EITI IN THE MINING SECTOR 2
Figure 1. Model copper mine: comparative effective tax rates
Uzbekistan
Ivory Coast
Mongolia
Ghana
Guinea
Greenland
USA (Arizona)
Mexico
Poland
Tanzania
Peru
Indonesia
Kazakstan
Philippines
South Africa
Bolivia
Papua New Guinea
China
Argentina
Zimbabwe
Chile
Western Australia
Sweden
ideal range?
ETR = 40-50%
0
10
20
30
40
50
60
70
Effective Tax Rate (%)
Figure 2. Division of mine revenues
20 year typical medium sized copper mine
Gross revenue: uS$3.3 billion
(50% Effective Tax Rate)
loan costs 2%
Bank
profits 17%*
Operating costs 44%
New exploration
New mines
Dividends
Wages
Consumables
Spares
Power
Water
Community
Taxes and fees 17%*
National
Provincial
local
* Note 50% division
Capital costs 21%
Contractors
Suppliers
Infrastructure
Others
30 ADVANCING THE EITI IN THE MINING SECTOR
value-based taxes, should be minimised.
Uniformity across sectors. Many countries have special tax
systems for their mining industry, and, as stated previously, this
adds complexity, costs and risks. It is feasible and preferable for
mining companies to be subject to a country’s general tax
system, perhaps incorporating a few special allowances such as
a royalty. putting all tax-payers on an equal footing can provide
greater certainty, stability and efficiency, and increase incentives
for governments to improve tax administration and fiscal
policy-making more generally. For industry, one important
benefit is the reduction in pressures for coercive taxation once
capital investments have been made and thus become
immobile.
Distribution of tax revenues. The allocation of revenues between
different tiers of government is a long-standing and increasingly
important issue. Here, experience to date about development
impacts is inconclusive, implying that there is no clear-cut
finding for or against fiscal decentralisation. Nevertheless, it
seems sensible for companies to cultivate constructive relations
with all tiers of government, and to encourage collaboration
and capacity-building for all relevant parties in proportion to
their influence.
Conclusions
The taxing of mining activities is an important public policy
issue that raises questions of fairness about the exploitation of
nations’ natural capital. unfortunately, the sector is so diverse
that it is not possible to specify an optimum tax system that can
be used as a model, although certain universal characteristics of
good systems can be defined. Given that any system will be
based on a set of assumptions about the future that will change,
a fundamental principle is that there is a strong case for
transparency and inclusiveness. All stakeholders share a
common goal of seeking successful and sustainable projects
that foster development. In seeking to achieve this goal, it is
essential for all to realise that the tax system is only a part of the
challenge: as tax systems increasingly converge, the question of
whether mining tax revenues are being properly utilised will
become more important than the division of wealth between
companies and the state.
Paul Mitchell is Director of Mitchell McLennan Pty Ltd, a specialist
environment and planning consultancy in Australia and former
President of the International Council on Mining and Metals (ICMM)
and former Member of the EITI International Board.
References
Henderson Global Investors (2005), “Responsible Tax”. Henderson Global
Investors ltd., london, uk, 2005.
Humphreys, M., Sachs, J., and Stiglitz, J. (2007), Escaping the Resource
Curse. Columbia university press, Ny.
ICMM, World bank and uNCTAD (2008), “Resource Endowment Toolkit.
The Challenge of Mineral Wealth”. ICMM london, www.icmm.com.
Otto, J. (2005), “Mining Taxation”. unpublished presentation to World
bank seminar, Washington DC.
Otto, J., Andrews, C., Cawood, F., Doggett, M., Guj, p., Stermole, J., and
Tilton, J. (2006), “Mining Royalties: A Study of Their Impact on Investors,
Government, and Civil Society”. World bank, Washington DC.
ADVANCING THE EITI IN THE MINING SECTOR 31

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