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Tax Aspects of Domestic Resource Mobilisation

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Tax Aspects of Domestic Resource Mobilisation a Discussion of Enduring and Emerging Issues Taxation of Natural Resources UN Financing for Development Office & IFAD – PowerPoint PPT presentation

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Title: 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 27 12 315 5706
  • Fax 27 12 323 2917
  • Cell 082 461 5545
  •  
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