Review of the wagering tax rate post 16 August 2012 [COMMERCIAL-IN-CONFIDENCE INFORMATION REDACTED]

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1 Review of the wagering tax rate post 16 August 2012 [COMMERCIAL-IN-CONFIDENCE INFORMATION REDACTED]

2 The Secretary Department of Treasury and Finance 1 Treasury Place Melbourne Victoria 3002 Australia Telephone: Facsimile: Authorised by the Victorian Government 1 Treasury Place, Melbourne, 3002 Copyright State of Victoria 2012 This report is copyright. No part may be reproduced by any process except in accordance with the provisions of the Copyright Act Published May 2012.

3 Contents 1. Key findings and recommendation Background Introduction Current financial arrangements between the Victorian Racing Industry and Tabcorp Licensing restructure and wagering and betting licence arrangements post 16 August Summary of old and new funding arrangements Approach to the review Examining the entirety of post-2012 arrangements Defining a no less favourable funding arrangement A central estimate with a lower bound alternative Recommending an appropriate tax rate Scope of this review Forecasting methodology Introduction General forecasting approach Pari-mutuel wagering revenue Sportsbet and Trackside revenue Total wagering licence revenue JV wagering profit: actual and counterfactual EGM player loss JV gaming profit: counterfactual Full set of assumptions Actual and no less favourable funding Central estimate comparison Lower bound comparison Submission from the Victorian Racing Industry VRI s comments on the review s terms of reference VRI s financial modelling VRI recommendations Appendix A: Terms of Reference i

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5 1. Key findings and recommendation On 16 August 2012 the new wagering and betting licence commences, and a new Joint Venture (JV) agreement between the licensee (Tabcorp) and the Victorian Racing Industry (VRI) will take effect. Under this new JV the arrangements for funding the VRI will change. The purpose of this review is to determine an appropriate pari-mutuel wagering tax rate to ensure that post-2012 funding arrangements are at least no less favourable to the VRI in comparison to the old JV and taxation arrangements. The review considers the entirety of post-2012 arrangements when considering an appropriate tax rate. These include: the decoupling of wagering and gaming licences, and the discontinuation of electronic gaming machine (EGM) profit sharing between the licensee and the VRI; the competitive allocation of the new wagering licence and the resulting characteristics of the new JV arrangements, including a doubling of the VRI s share of wagering profits; and the impact of the pari-mutuel wagering tax rate reduction applying from 2012 (to be passed on to the VRI via the Victorian Racing Industry Benefit, or VRIB). The Department of Treasury and Finance (DTF) considers this the most appropriate approach to fulfilling the terms of reference for the review and associated requirements under the Gambling Regulation Act DTF has forecast the stream of funding to the VRI under the new funding arrangements, and compared this to the estimated funding stream had the old licence, JV, and taxation arrangements remained in place. The details of this approach are described in Chapter 3. These estimates were based on forecasts (described in Chapter 4) of JV revenues and profits including (hypothetical) EGM profits had the old arrangements continued. Two funding scenarios were modelled: a central estimate and a more conservative lower bound. Table 1: Financial impact on the VRI under the new licence central estimate $ million Licence ( dollars) Loss of gaming machine profits (82) (1067) VRIB Doubling of JV Wagering Profit share Other tax / JV changes Total gain/loss under future system Source: Department of Treasury and Finance calculations Table 1 displays the estimated financial impact from the change in arrangements under the central estimate assumptions. It shows that the VRI will be significantly better off under post-2012 arrangements than it would have been under the old arrangements, with the relicensing process and tax cuts delivering an estimated $49 million in additional funding in the first licence year. 1

6 Over the lifetime of the licence the VRI is estimated to receive a windfall gain of around $700 million (in real terms), even after accounting for the loss of EGM profits. Under the central estimate a pari-mutuel tax rate of 15.0 per cent would ensure that post-2012 funding arrangements were at least no less favourable, leaving the VRI with approximately unchanged funding in and a net gain in subsequent licence years. However in recognition of the many factors that could change over the lifetime of the licence, and the direction to recommend a tax rate that ensures an at least no less favourable outcome, the review considers that the more conservative forecast scenario should be the basis for a recommendation about an appropriate tax rate. Under the lower bound scenario with relatively higher EGM profits and lower pari-mutuel wagering revenue growth a tax rate of 13.8 per cent would ensure that VRI funding was more favourable in every licence year than under the old arrangements. The VRI would still gain approximately $27m in and more than $180 million (in real terms) over the lifetime of the licence under this tax rate. VRI funding could be expected to grow by an average of 3.4 per cent per annum, compared to 2.7 per cent had the old arrangements continued. Even assuming implausibly low wagering growth extrapolating the rate of decline observed since 2010 over the entire licence the VRI will be better off under this tax rate in early licence years and approximately no worse off in later years from the change in funding arrangements. Recommendation A pari-mutuel wagering tax rate of 13.8 per cent would be appropriate to ensure that post-2012 arrangements are at least no less favourable to the VRI. The terms of reference make particular reference to the industry s loss of funding from EGMs under the new licensing structure. When the previous government legislated wagering tax reductions to apply from the commencement of the new licence, the terms of the new JV agreement were unknown. The currently legislated pari-mutuel tax rate was calculated on the basis of JV funding arrangements remaining otherwise unchanged; that is, the appropriate rate to ensure a no less favourable outcome was framed solely with regard to the industry s anticipated loss of EGM profits. Under the central estimate a pari-mutuel tax rate of 4.6 per cent would be sufficiently low to fully replace foregone gaming profits through the VRIB in every year of the licence. Under the lower bound scenario the rate would need to be reduced to 2.8 per cent in to fully replace lost JV gaming profits, and would need to decline to zero by even to partially offset forecast gaming profits in later licence years. 2

7 2. Background 2.1 Introduction The Gambling Regulation Act 2003 was amended in 2009, creating a legislative obligation to review the new pari-mutuel tax rate applying from 16 August Section 4.6.3A of the Act specifies that: The Treasurer must cause a review to be made of the tax rate set out in section 4.6.3(1A) and must cause a copy of the report to be laid before each House of Parliament on or before 31 December The Department of Treasury and Finance (DTF) has been asked to conduct this review in accordance with the terms of reference at Appendix A. The key task is to: recommend an appropriate pari-mutuel tax rate to ensure that post-2012 arrangements are at least no less favourable to the Victorian Racing Industry, taking into account in particular the industry s loss of funding from electronic gaming machines through the current joint venture arrangement with Tabcorp Holdings Ltd. 2.2 Current financial arrangements between the Victorian Racing Industry and Tabcorp The current funding arrangements for the Victorian Racing Industry (VRI) 1 were established in In that year, the Victoria Government privatised the former TAB and granted a wagering licence and gaming licence to Tabcorp Holdings Limited (Tabcorp). Tabcorp was granted exclusive rights to conduct off-course wagering on all Victorian thoroughbred, harness and greyhound racing, and was the only retail operation authorised to provide on-course wagering. It was also granted one of two licences to operate electronic gaming machines in licensed hotels and clubs. The current licence expires at midnight on 15 August A Joint Venture (JV) Agreement was created to govern the relationship between the VRI and Tabcorp. Under this agreement Tabcorp and the VRI hold 75 per cent and 25 per cent shares in the JV respectively, entitling the VRI to a quarter of the profits from both gaming and wagering JV operations. Tabcorp and the VRI entered into two supporting agreements, the Product Supply Agreement and the Racing Program Agreement. These govern the fees paid to the VRI in exchange for various obligations around the provision of the agreed racing program, racing information, and marketing activities. 1 Comprising the controlling bodies for thoroughbred, harness, and greyhound racing. 3

8 In the VRI received around $330 million in revenue from the JV, comprising: a product fee of 18.8 per cent of pari-mutuel wagering revenue (totalisator turnover less dividends) plus 1 per cent of fixed-odds (racing) turnover, together amounting to $124 million; a marketing fee amounting to $4 million in ($2.5 million indexed from to growth in off-course wagering revenue); a program fee amounting to $83 million in ($50 million indexed from to growth in off-course wagering revenue); and, JV profits of $117 million, the majority ($87 million) from gaming operations and the remainder ($30 million) from wagering. This total was reduced by around $36 million, reflecting the VRI s liability under the existing JV arrangement to bear race fields fees paid by Tabcorp to inter-state and international jurisdictions for wagering on their product. More detailed information about the pre-2012 licensing and racing industry funding arrangements can be found within the 2006 Issues Papers on wagering licence arrangements and racing industry funding Licensing restructure and wagering and betting licence arrangements post 16 August 2012 In 2008 the Government announced that the post-2012 wagering and betting licence would be a single, exclusive pari-mutuel and fixed odds licence. A commitment was made that the VRI was to be funded from wagering operations, with post-2012 funding arrangements to be no less favourable to the racing industry than those applying in This commitment was reaffirmed by the current Victorian Government. A competitive bidding process was conducted to award the new licence. A key element of this process was the legislative requirement that applicants propose a JV arrangement that would be no less favourable to the VRI than existing arrangements. In July 2011 Tabcorp was announced as the successful bidder for the post-2012 wagering and betting licence. JV arrangements were ratified by Tabcorp and the VRI, and accepted by the Government in December Consistent with the decoupling of wagering and gaming, the VRI will no longer receive funding from electronic gaming machine operations under the new JV. A key feature of the new arrangements, however, is a doubling of the VRI share of JV wagering profits from 25 per cent to 50 per cent. The basis for JV fees paid to the VRI will also change, in recognition of the growth in fixed-odds betting and the option available to the licensee to operate a betting exchange. In particular: the product fee will be calculated as 15.0 per cent of net wagering revenue (the sum of pari-mutuel revenue, fixed-odds and simulated racing revenue plus betting exchange commissions); the program fee will be $72.6 million in (pro-rata) and , subject to indexation by net wagering revenue growth thereafter; and the marketing fee has been abolished. 2 Review of the Electronic Gaming Machine, Club Keno and Wagering Licences and Funding Arrangements for the Racing Industry Post-2012, Issues Paper, Gambling Licences Review, Office of Gaming and Racing, March

9 Finally, the burden of race fields fees on non-victorian product has been shifted in the VRI s favour: whereas previously the VRI effectively paid these fees (via a reduction in the product fee), the new agreement includes race fields fees as a JV expense, effectively shifting half the burden to Tabcorp. In addition to the no less favourable requirement applying to the competitive bidding process, the previous Government sought to provide further assurance of the equivalency of future support for Victorian racing by legislating wagering tax reductions to apply from the commencement of the new licence. These changes were legislated before the new JV terms and their impact on the VRI s funding stream were known. Specifically, the pre-gst tax on pari-mutuel wagering will fall from per cent to 7.6 per cent of pari-mutuel revenue upon commencement of the licence, while the fixed-odds betting tax will fall from per cent to 4.38 per cent. 3 Under the Wagering and Betting Licence Related Agreement, the full amount of the pari-mutuel tax reduction must be passed on to the VRI as a separate payment from the JV, referred to as the Victorian Racing Industry Benefit (VRIB). Because the Related Agreement allows for future changes in this rate to be incorporated into the VRIB by direction of the Minister for Gaming, the pari-mutuel tax rate is the policy instrument of interest for VRI funding; changes in the pari-mutuel rate (as a result of this review or otherwise) may be used to adjust VRI funding without impacting on the revenue of the licensee. A useful perspective from which to view the roles of the tax cut, licensing process, and JV negotiations is as determinants of the split of monopoly rents between the racing industry, the licensee, and the Victorian public via the state. By restricting retail wagering to a single licensee and placing requirements on that licensee to appropriately fund the activities it conducts wagering on, the state both ensures the viability of the racing industry and allows supernormal profits, or rents. The tax rates and the licence premium paid determine the share of monopoly rents captured by the public, and the JV fee and profit-sharing arrangements determine how the remainder is split between the licensee and the VRI. From this perspective, the pari-mutuel and fixed-odds tax cuts were not the only means by which the state ensured the racing industry s funding was maintained. By requiring licence applicants to submit bids with no less favourable arrangements, the state also set a benchmark for the support of the VRI required under the bidders proposed JV terms. 4 The VRI funding terms faced by bidders will have influenced the profitability of the exclusive retail licence and likely influenced the premiums they offered, representing an additional financial contribution by the state towards the VRI s post-2012 funding. 3 Simulated racing revenue will continue to be taxed at per cent. 4 Although it is noted here that the concept of arrangements in the test applied during the licensing process could potentially encompass a broader range of considerations than the funding parameters. The legislative requirement does not therefore make a review focussed on the narrower financial question redundant. 5

10 2.4 Summary of old and new funding arrangements The funding arrangements under the old and new JV Agreements are shown in Table 2 below. Table 2: Current and future financial arrangements between Tabcorp and the VRI Joint Venture (JV) profit share Product fees Program fee Marketing fee Race fields Asset charge revenue Tax rates (excluding GST) Victorian Racing Industry Benefit (VRIB) Minimum performance obligation Pre 16 August 2012 Post 16 August per cent Tabcorp 25 per cent VRI Includes share of gaming revenue Pari-mutuel 18.8 per cent of pari-mutuel revenue on thoroughbred, harness and greyhound racing. Fixed odds (racing) 1.0 per cent of turnover. Fixed odds (sports) nil Trackside nil $50 million in , subject to indexation at off-course wagering revenue growth $2.5 million in , subject to indexation at off-course wagering revenue growth Race field fees on interstate product and international product effectively borne by VRI, not the JV. The JV pays Tabcorp a cash amount equal to depreciation and financing costs of capex XXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXX. Pari-mutuel per cent of revenue Fixed odds per cent of revenue Simulated racing per cent of revenue None. None. 50 per cent Tabcorp 50 per cent VRI Gaming revenue no longer part of JV Product fee of 15.0 per cent of net wagering revenue (pari-mutuel, all fixed-odds and simulated racing revenue plus betting exchange commissions). $72.6 million in (pro rata) and in , thereafter subject to indexation at net wagering revenue growth. Abolished. JV will bear race field fees on non-victorian product. Asset charge rate has been lifted XXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXX. Pari-mutuel 7.6 per cent of revenue Fixed odds 4.38 per cent of revenue Simulated racing per cent of revenue VRI to receive per cent of pari-mutuel revenue on thoroughbred, harness and greyhound racing, which is to be paid by the JV (subject to change if the pari-mutuel tax rate changes). Minimum aggregate amount to be received by the VRI, with Tabcorp to pay any shortfall: $ million in (total under both old and new JV) $ million in $ million in The minimum aggregate amounts are subject to certain exceptions. Source: Tabcorp media release 19 July 2011; correspondence with VRI. 6

11 3. Approach to the review 3.1 Examining the entirety of post-2012 arrangements The policy of successive Victorian governments has been to ensure that the gambling industry provides financial support to Victoria s racing industry. In the changes that will be made post-2012 this support will be restructured to realign funding for the racing industry with the gambling products that rely on the performance of the industry. The terms of reference for this review direct DTF to: recommend an appropriate pari-mutuel tax rate to ensure that post-2012 arrangements are at least no less favourable to the Victorian Racing Industry, taking into account in particular the industry s loss of funding from electronic gaming machines through the current Joint Venture arrangement with Tabcorp Holdings Ltd. These terms of reference were first agreed in 2009, and revised in 2012 without substantively altering this objective. The Gambling Regulation Act 2003 provides that the report of the review must be tabled in Parliament by 31 December. It provides no other direction or definition to the review, and draws no link with other processes involved in the awarding or conduct of the wagering licence. The terms of reference note, as context, that tax reductions legislated in 2009 were intended to replace the revenue which the racing industry currently gets from EGMs. While this was evidently the driver of prospective tax changes, it is not the specified purpose of this review. The terms of reference refer to post-2012 arrangements and the industry s loss of EGM funding as separate concepts. DTF has been guided by the most literal objective of the review, to recommend an appropriate pari-mutuel tax rate to ensure that post-2012 arrangements are no less favourable to the Victorian Racing Industry, and has considered the entirety of post-2012 JV arrangements in undertaking the review. The pari-mutuel wagering tax reduction passed on through the VRIB, and the exclusion of gaming operations from the new JV, are important changes but not the only changes to these arrangements. Recommendations regarding an appropriate tax rate are based on an understanding of how the full suite of changes in the JV funding formula impact upon VRI funding in and throughout the term of the licence. The review is, however, asked to take particular account of the industry s loss of funding from EGMs. Accordingly the quantitative analysis in the review also provides a direct comparison of the VRIB and foregone EGM profits, and the appropriate tax rate to equate the two Views of the Victorian Racing Industry The VRI proposes the review should have focussed solely on whether the legislated pari-mutuel tax cut adequately compensates it for the loss of EGM profits following the separation of wagering and gaming licences. It considers that a broad no-less-favourable test is not relevant to the review, given processes undertaken as part of awarding the new licence. 7

12 An appropriate tax rate, from the VRI s perspective, should not be based on ensuring a no-less-favourable outcome considering all aspects of JV funding to the VRI. Rather the tax rate should be reduced to the level which equates the support delivered through the VRIB to the EGM profits no longer received under the new licence structure. As outlined above, DTF has been guided by the most literal purpose of the review, and considers this the most appropriate response to the terms of reference and legislative requirements. It has been as transparent as possible in presenting that analysis, for the information and discussion of the Government, Parliament and stakeholders. The views of the VRI have been included in Chapter Defining a no less favourable funding arrangement The approach adopted for calculating a no less favourable funding stream is to extrapolate the current funding arrangements throughout the life of the new licence. DTF agrees with the VRI s view, as expressed in the report prepared by Ernst & Young in 2008, that the interpretation of no less favourable should proceed on the assumption that the key features of the current JV funding arrangement are extrapolated to and beyond. The counterfactual scenario used to benchmark a no less favourable funding stream assumes that: (a) fee calculations and the burden of inter-state and international race fields fees remain as before, (b) the VRI s wagering profit share remains at 25 per cent, (c) the Tatts-Tabcorp gaming duopoly continues and the VRI s gaming profit share remains at 25 per cent, and (d) wagering and gaming tax rates remain at their pre-16 August levels. 3.3 A central estimate with a lower bound alternative The central estimate described in section 4 below represents the most likely scenario, in DTF s view, for the growth of the relevant revenues and profits. In accordance with point 7 of the terms of reference, this scenario adjusts gaming profits to account for an end-of-licence effect, in the face of evidence outlined further below that suggests the VRI has benefited from windfall gaming profits since However it is recognised that there is much uncertainty about the outlook for pari-mutuel wagering, fixed-odds betting, and the near-term macroeconomic environment in general. Basing a tax recommendation on this best-guess scenario risks leaving the industry in a less favourable funding position if downside risks to pari-mutuel revenue materialise. Accordingly a more conservative lower bound scenario has also been modelled, in which the structural decline in pari-mutuel revenue observed since 2010 is assumed to continue throughout the first two licence years. The strong gaming profits observed since could represent either a sustainable profit level or an end-of-licence spike. However, this is uncertain. Accordingly, the lower bound estimate also discounts the possibility that the recent trend in gaming profits represents an end-of-licence effect. This increases the forecast level of VRI funding under the old arrangements, lifting the no less favourable bar. 8

13 3.4 Recommending an appropriate tax rate The current government has committed to delivering a no less favourable outcome for the VRI over the full term of new wagering licence, not just the first 12 months. This commitment, as well as the direction to ensure that recommended funding arrangements are at least no less favourable (emphasis added), suggests a generally conservative choice of tax recommendation, erring on the side of increased VRI funding over that which would have been derived had the old arrangements continued. Accordingly, the final tax recommendation has been based on the lower bound funding scenario, considered to be the most conservative (yet still plausible) funding forecast possible. As shown in section 5.2, the recommended rate is sufficiently low to ensure the VRI receives higher funding in every year of the licence than would have been received under the old tax and JV arrangements (with the JV minimum performance obligation providing a significant boost in funding in the early licence years). Section 5.2 also shows that even in the extremely unlikely event that the recent pari-mutuel wagering downturn were to persist throughout the entire licence term, the VRI would be approximately no worse off under the recommended tax rate than they would have been under the old arrangements. 3.5 Scope of this review There are a number of broader issues that are not considered as part of this review. Issues that are treated as out of scope are: analysis of the distribution of funding to the three racing codes individually. For the purposes of this report funding is considered to be provided to the VRI as a whole; analysis of aspects of no less favourable other than the funding stream, such as VRI decision-making and control rights within the JV; direct support to the VRI from the Victorian Government (e.g. through the Victorian Racing Industry Fund); VRI revenues other than from the JV, such as race fields fees received from inter-state operators; the prospective value of a betting exchange to the licensee; and qualitative risks such as the prospect of legislation affecting the ability of the Victorian Commission for Gambling and Liquor Regulation (VCGLR) to enforce retail exclusivity. 9

14 4. Forecasting methodology 4.1 Introduction As is clear from section 2.4, the estimation of actual and counterfactual VRI funding streams requires forecasts of: the (hypothetical) JV gaming profits that would have been realised had the pre-2012 licensing and taxation arrangements continued; JV wagering profits, under both pre-2012 and post-2012 tax and JV arrangements; pari-mutuel wagering revenue since this is a component of JV profit, a determinant of VRI fees, and the determinant of the VRIB; revenue from fixed-odds sports (including racing) betting, referred to as Sportsbet since this is both a component of JV profit and a determinant of VRI fees; and revenue from simulated racing, or Trackside as both a component of JV profit and a determinant of VRI fees. The construction of forecasts for these variables is described here. Section 4.2 outlines the data sources and the general approach to forecasting the revenue lines, section 4.3 presents the central estimate and lower bound pari-mutuel revenue forecasts, and section 4.4 describes the Sportsbet and Trackside forecasting methodology. Sections 4.5 and 4.6 summarise the wagering licence figures and explain how JV wagering profits are forecast. Sections 4.7 outlines DTF s electronic gaming machine (EGM) player loss forecasting model, and section 4.8 discusses the gaming profit forecasts including the end-of-licence adjustment used in the central estimate scenario. Section 4.9 summarises the full set of forecasting assumptions. To ensure the methodology and forecasts used in the review were robust, a draft version of this report was submitted to an external consultant for peer review. The consultant concluded the methodology was sound and defensible. 4.2 General forecasting approach In line with DTF s standard gambling tax forecasting methods, licensee revenue (or player loss) the amounts staked less payouts to players is modelled as a proportion of household consumption. This approach allows the separate influences on gambling expenditure of trends in underlying product demand and general consumption expenditure to be distinguished, allowing the impacts of (for instance) strong economic growth in the mid-2000s and recent softness to be stripped from the forecasts. DTF s household final consumption expenditure (or HFCE) forecasts are as per the Budget forecasts out to the year. For the remaining licence years to , HFCE is assumed to continue to grow at the long-run trend rate of 5.2 per cent per annum. Forecasts are on a quarterly basis this allows the September and December 2011 actual figures to be incorporated into the financial year forecast. Data on Tabcorp s revenue from pari-mutuel wagering, fixed-odds betting ( Sportsbet ), simulated racing ( Trackside ), and EGMs were sourced from tax collection data held by the VCGLR. The VRI provided data on fees and JV wagering and gaming profits received over the to period. 10

15 Revenue and profit forecasts are prepared on the basis of extrapolating historical trends. As mentioned in section 3.5, the prospect of major structural changes to industry funding is considered out of the scope of the review. Similarly, the gaming profit forecasts also ignore the risk of major gaming machine regulation (e.g. the introduction of mandatory pre-commitment technology) that would impact on licensee revenue. This could result in the counterfactual (the VRI s forecasting funding stream had the old arrangements continued) appearing more attractive than in reality, thereby biasing the comparisons against the new funding arrangements. As also indicated above, future commissions from a betting exchange are not explicitly forecast; in the absence of information about the timing and operation of this product any other approach would be arbitrary. 4.3 Pari-mutuel wagering revenue Pari-mutuel wagering can be separated into three categories. These are (with JV revenue in parentheses) 5 : off-course racing ($538 million); on-course racing ($71 million); and pari-mutuel sports betting, or Footybet ($2 million). For forecasting purposes pari-mutuel revenue has been aggregated, instead of preparing forecasts for each component separately. While there was significant growth in on-course wagering over the four year period to (approximately 25 per cent per annum), growth before this period and in generally tracked alongside or below off-course revenue growth. Given the small proportion of pari-mutuel revenue sourced on-course, little accuracy is likely to be lost by aggregating these categories. 6 While nominal pari-mutuel revenue has grown steadily since , revenue as a share of consumption has declined over that period, exhibiting a clear structural break from 2010 onwards. As shown in Figure 1 below, the trend decline in the ratio of revenue (seasonally-adjusted) to HFCE was around 2 per cent per annum to the December 2009 quarter, but the two years since have seen this ratio fall sharply at a rate of around 10 per cent per annum. 7 Although this decline coincides with a period of increased household saving and changes in consumption patterns, trends in wagering (such as the expansion of internet betting and increased promotion of fixed-odds products) are likely also responsible. The recent decline may thus be a level shift rather than a cyclical fluctuation. 5 VCGLR data excludes from these categories the licensee s revenue from fractions (revenue derived from rounding dividends down to the nearest 5 cents; $27 million in ) and the expense of under-pars (amounts paid to round up dividends paid to the minimum dividend; $2 million in ). 6 The small (and diminishing) importance of Footybet, and the clear relationship between fractions, under-pars, and total pari-mutuel revenue further support this assumption. Note however that since under the old JV arrangements the Program and Marketing fees were indexed in accordance with off-course pari-mutuel revenue growth, the fee calculations in section 5 below must use the forecasts of total pari-mutuel growth instead. 7 These figures refer to the rate of decline of the ratio, not to the percentage point decline. 11

16 DTF considers a generally conservative approach to forecasting to be appropriate in light of the terms of reference and Government commitments regarding VRI funding. Accordingly and despite the timing of the recent decline coinciding with a significant macroeconomic slowdown the approach adopted here treats the post-2010 decline as a structural shift, not a cyclical downturn. It is assumed the pari-mutuel share of consumption will not recover to the pre-2010 level. In the central estimate, although the recent decline is not reversed, the trend rate of growth of the ratio of revenue to HFCE up to December 2009 (negative 2 per cent per annum) is assumed to resume immediately. In the more-conservative lower bound scenario, the current rate of decline is assumed to continue throughout the first two licence years before the pre-2010 trend decline resumes from In the midst of a level shift which has not yet begun to level off, the choice of a further two year decline for the lower bound scenario inevitably involves a degree of subjective judgement. However this judgement has been guided by several considerations. First, this choice implies a severe reduction in the consumption share of a well-established product a 40 per cent reduction in only four years, compared to a 15 per cent reduction in the preceding eight. It is unclear to DTF that developments in the wagering market since 2010 have been so qualitatively different to the trends apparent before that as to justify such pessimism. Second, the pari-mutuel forecast has been considered in the light of overall wagering revenue, particularly given that at least some of the recent decline can be attributed to migration towards fixed-odds betting. Thus the pari-mutuel forecast has been chosen in conjunction with the fixed-odds forecast so that future projections of total wagering activity are consistent with historical trend. An even more pessimistic pari-mutuel forecast would imply a decline in overall gambling on racing that (in DTF s understanding) is unsupported by any evidence. DTF considers the lower bound scenario to be the most conservative plausible forecast. However, in light of the VRI s view about the pessimistic outlook for pari-mutuel wagering, section 5 explores the implications of an indefinite continuation of the post-2010 decline for the favourability of VRI funding (vis-à-vis current arrangements), under the recommended tax rate in the lower bound scenario. This provides a further form of sensitivity analysis. The central estimate and lower bound forecasts are shown in Figure 1 below. The annual pari-mutuel revenue forecasts are shown in Figure 2 that follows. Weak revenue in the September and December 2011 quarters and continued macroeconomic sluggishness result in the to forecasts being below the figure, even in the central estimate scenario. 12

17 Figure 1: Actual, trend, and forecast pari-mutuel revenue/hfce (quarterly s.a.) Source: VCGLR data; Department of Treasury and Finance calculations Figure 2: Pari-mutuel wagering revenue: actual and forecast ($m per annum) Source: VCGLR data; Department of Treasury and Finance calculations 13

18 4.4 Sportsbet and Trackside revenue Unlike pari-mutuel wagering, fixed-odds betting and simulated racing have both experienced exponential growth over the period from (albeit off low bases). On average to Sportsbet and Trackside revenue grew at 32 per cent and 15 per cent per annum respectively. These relatively new products are evidently in the growth phase of their product life-cycles, and DTF has attempted to account for this in the forecasts by imposing rough assumptions about the likely decline in revenue growth over the licence. For both products, the trend growth rate of revenue/hfce up to the December 2011 quarter (a 25 per cent rate of growth in this ratio per annum for Sportsbet; 9 per cent for Trackside) is assumed to decline on a straight-line basis over the first three years of the new licence. Growth in the ratio of revenue to HFCE from onwards is assumed to be zero (although general growth in consumption means nominal revenue continues to rise). Figures 3 and 4 display the actual, trend, and forecast evolution of (seasonally-adjusted) revenue as a share of HFCE for these two products, incorporating the growth curve assumptions described above. 8 Although the Sportsbet growth profile appears optimistic, it is consistent with recent trends and is the corollary of the decline in pari-mutuel revenue driven by migration of demand to fixed-odds betting. The choice of a 3-year deceleration before the consumption share plateaus results in overall wagering growth remaining consistent with historical trend, as shown in the next section. 8 Note that to avoid the projections being overly influenced by the Dec-11 quarter figure (the final actual data point); the first forecast figure (Mar-12) is calculated as an average of the Mar-11 to Dec-11 quarterly figures compounded at the historical trend quarterly growth rate. This is partly also to compensate for the inability of the estimated seasonal adjustment factors to pick up the recent change in seasonality, which was likely driven by winter sports in the past but appears dominated now by the seasonality of fixed-odds racing products. 14

19 Figure 3: Actual, trend, and forecast Sportsbet revenue/hfce (quarterly s.a.) Source: VCGLR data; Department of Treasury and Finance calculations Figure 4: Actual, trend, and forecast Trackside revenue/hfce (quarterly s.a.) Source: VCGLR data; Department of Treasury and Finance calculations 15

20 Note that the forecast of fixed-odds revenue (Sportsbet) is based on historical trends, and does not factor in any potential revenue growth generated by an improved competitive position of the licensee as a result of the reduction in the fixed-odds tax rate from per cent to 4.38 per cent on 16 August This means the forecast may be used for estimating VRI funding under both the new and old funding and taxation arrangements. However by ignoring the potential expansion in fixed-odds betting resulting from the tax cut, VRI funding under the new arrangements is likely underestimated, biasing the comparisons in favour of the old arrangements (the counterfactual). 4.5 Total wagering licence revenue The forecasts described above are summarised in Table 3 below, which shows the estimated JV revenue from each of the wagering licence products to as well as the total (referred to as net wagering revenue'). 9 Any effect on the licensee s competitiveness from the prospective shift to a turnover-based race fields fees model is also not incorporated into the forecasts. 16

21 Table 3: Wagering licence revenue forecasts ($ million) Central estimate Pari-mutuel Sportsbet Trackside Net wagering revenue (total) Growth (%) Lower bound Growth (%) Growth (%) Growth (%) Central estimate (actual) (forecast) Licence average Source: VCGLR data; Department of Treasury and Finance calculations Note: figures are a combination of actual data (to the December quarter of 2011) and forecasts. Growth (%) Lower bound Growth (%) 17

22 Figure 5 below shows the forecast evolution of total wagering licence revenue as a share of household consumption in the two forecast scenarios. In the central estimate, the growth in fixed-odds betting (and to a lesser extent simulated racing) is sufficient to enable a small recovery in the consumption share of net wagering revenue, somewhat offsetting the recent decline. In the lower bound scenario this growth can only slow the rate of decline, given the assumed fall in pari-mutuel revenue. Figure 5: Actual and forecast net wagering revenue (licensee revenue)/hfce (quarterly s.a.) Source: VCGLR data; Department of Treasury and Finance calculations 4.6 JV wagering profit: actual and counterfactual Because the three wagering licence products have different growth profiles and tax rates, and because JV parameters and tax rates differ under the new arrangements, future JV wagering profits cannot be forecast simply by extrapolating the historical trend. Separate profit forecasts for the actual future (under the new arrangements) and the counterfactual future (under the old arrangements) must instead be constructed from forecasts of the various components revenues, taxes, fees, and costs. 18

23 Tax and fee calculations follow straightforwardly from the revenue projections described above, according to the JV funding arrangements summarised in section ,11 Data on Joint Venture costs encompassing all expenses bar taxes and fees paid to the VRI has been inferred from historical revenue and profit data. From to costs ranged between 28.4 and 31.8 per cent of net wagering revenue, averaging 30.2 per cent and displaying no obvious trend. On that basis, future costs have been assumed equal to 30.0 per cent of net wagering revenue (the figure). 12 The old-arrangement and new-arrangement wagering JV profit forecasts are simply calculated as the residual of net wagering revenue less state taxes, GST, fees to the VRI, costs, and (under the new arrangements only) the VRIB, race fields fees on non-victorian product, and the additional depreciation charge. 4.7 EGM player loss Estimates of JV gaming profit under the counterfactual scenario (had the current duopoly licensing arrangements continued) are based on forecasts of EGM player loss (amounts staked less amounts won) from EGMs operated by Tabcorp. DTF routinely forecasts EGM player loss for tax revenue purposes using an explanatory model which is adopted here. The model forecasts quarterly rates of growth of player loss/hfce for both gaming licensees combined, which have been applied to the December 2011 Tabcorp-only (seasonally-adjusted) figure to forecast player loss out to In this model, player loss/hfce is explained primarily as a function of EGM density the number of EGMs per capita with dummy variables capturing the influence of the ban on smoking in venues from September 2002, and of the introduction of banknote acceptors to the previously-coin-based EGM stock. 13 The forecasts hold the state wide number of EGMs at 26,393 (the December 2011 figure) over the forecast period, while population growth is assumed to continue at the trend growth rate of 1.6 per cent per annum. Over the licence period the share of household consumption accounted for by Tabcorp EGM player loss is projected to decline from around 0.7 per cent to 0.6 per cent, while in absolute terms player loss (i.e. Tabcorp s revenue) continues to grow steadily in nominal terms by an average of 3.4 per cent per annum. 10 The estimation of the fixed-odds-turnover component of the Product Fee under the old arrangements (the counterfactual) assumes racing comprises 50 per cent of total fixed-odds (Sportsbet) revenue, and that revenue is 11.8 per cent of turnover (as in ). 11 Note that since February 2011 a concessional rate of tax has applied to pari-mutuel revenue from premium customers. Since this concession expires on 16 August, it is assumed there is no effect of the concession on post-2012 revenue and profit. 12 Race fields fees on non-victorian product are not included in these cost figures, since they were borne by the VRI (not the JV) under the old arrangements. Profit calculations under the new arrangements include these fees as a separate expense in addition to operational costs. This expense is assumed to be $36.3 million in and , $38.0 million in and growing at the rate of growth of pari-mutuel plus fixed-odds revenue thereafter. The new-arrangement profit calculation also includes the additional expense of a XXXXXXXXXXXXX XXXX increase in Tabcorp s asset depreciation charge, on an assumed base of XXXXXXXXXXX in (growing at net wagering revenue growth thereafter). 13 It is noted that a general product life-cycle model performs equally as well as the EGM density model in explaining player loss, indicating there is not necessarily a strong causal link between EGM density and expenditure. 19

24 4.8 JV gaming profit: counterfactual Gaming profit forecasts are constructed in a similar manner to the wagering profit forecasts described above, as EGM player loss less taxes, venue payments, and JV costs. Under the gaming operator model the licensees, Tabcorp and Tattersalls, each receive a net one-third of the EGM player loss in their venues after venue payments, GST, and state taxes. 14 They also pay a per-egm Health Benefit Levy (HBL). Although the HBL will be abolished and tax rates will change from 16 August, the appropriate counterfactual for the gaming profit forecasts is where these tax arrangements remain in place; hence the JV s projected gaming revenue (net) is one-third of player loss, less HBL (which is assumed to remain at its level). Note also that Tabcorp s Keno operations have been ignored in the profit forecasts. Keno forms a tiny portion (0.2 per cent) of overall gaming player loss, and revenue in nominal terms has been flat for a decade. Consistent with constructing the counterfactual on a no change basis, this trend should be assumed to continue despite the new single-keno-licensee model likely to generate growth in player loss. The review terms of reference direct DTF to consider whether the VRI was the beneficiary of windfall end-of-licence gaming profits and, if so, to discount this benefit in the forecasting methodology. There is some evidence of this occurring: over the four years to profit grew by an average 1.6 per cent per annum, while over the three subsequent years profit grew at 5.6 per cent per annum (inferred costs grew by an average of 6 per cent per annum in the first period but fell 10 per cent per annum in the second). Over both periods there was steady growth in player loss and a steady decline in the number of Tabcorp EGMs in operation. The profit forecast in the central estimate treats this pattern as an end-of-licence effect, likely resulting from the licensee running down gaming assets in anticipation of the venue operator model. Profit forecasts in the central estimate are based on the assumption that the cost share of player loss, 7.2 per cent, persists to and throughout the entire term of the licence to Under this assumption the VRI is estimated to have gained an end-of-licence windfall worth circa $8 million in , or one-quarter of the difference between the actual JV profit of $346 million and a hypothetical lower figure of $315 million which is intended to represent a sustainable profit level. The lower bound estimate of gaming profits excludes this adjustment, assuming instead that costs for and beyond remain at their level of 5.0 per cent (and effectively treating the decline in the cost share of player loss since as unrelated to the end of the gaming operator model). 14 Player loss in both hotels and clubs is subject to the per cent Hospitals and Charities Fund tax, and to GST (one-eleventh of player loss), summing to one-third of player loss. Prescribed venue payments to hotels and clubs are 25 per cent and one-third of player loss respectively. Hotel player loss is subject to the 8.33 per cent Community Support Fund tax and clubs submit Community Benefit Statements to the same proportionate value. 20

25 4.9 Full set of assumptions Table 4: Forecasting assumptions and construction of alternative comparisons Pari-mutuel: Revenue / HFCE growth Pari-mutuel: Revenue growth Sportsbet: Revenue / HFCE growth Sportsbet: Revenue growth Trackside: Revenue/HFCE growth Trackside: Revenue growth Net wagering revenue (NWR) Net wagering revenue (NWR): growth Wagering licence costs Central estimate Lower bound Wagering licence (old and new arrangements) -1.9 per cent per cent to per cent from per cent (licence average) 1.3 per cent (licence average) Straight-line decline in rate of growth of ratio from 25.4 per cent per annum in March quarter 2012 to 0 per cent per annum by per cent (licence average) Straight-line decline in rate of growth of ratio from 9.2 per cent per annum in March quarter 2012 to 0 per cent per annum by per cent (licence average) Sum of pari-mutuel, fixed-odds betting (Sportsbet) and simulated racing (Trackside) revenue. 4.4 per cent (licence average) 3.3 per cent (licence average) 30.0 per cent of NWR Fees, VRIB, and taxes As in Table 2. Race fields fees expense $36.3 million in and , $38.0 million in , growing at pari-mutuel plus fixed-odds revenue growth rate thereafter. Additional depreciation charge JV wagering profit EGMs: Player Loss / HFCE EGMs: Player Loss growth Gaming licence costs JV gaming profit Ad-valorem state taxes plus venue payments HBL XXXXXXXXXX on a base of XXXXX in , growth at NWR thereafter. NWR less state taxes, GST, fees to VRI, costs, and (under new arrangements only) VRIB, race fields fees, and additional depreciation charge. Gaming licence (old arrangements only) Determined by EGMs-per-capita model of player loss, holding EGM numbers constant with 1.6 per cent population growth. 7.2 per cent of Player Loss from per cent (licence average) 5.0 per cent of Player Loss from Player Loss less ad-valorem state taxes, venue payments, GST, Health Benefit Levy (HBL) and costs. Two-thirds of EGM Player Loss. $58 million (the figure), based on Tabcorp EGMs at $ per EGM. Notes: All percentage growth rates are per annum. Growth in ratios of revenue to HFCE are expressed as per cent rates of change in the ratio, not percentage point changes. 21

26 5. Actual and no less favourable funding 5.1 Central estimate comparison Table 5 below displays the full projection of the VRI funding stream under the new and old funding arrangements, plus relevant summary statistics. A comparison of the value of the legislated pari-mutuel tax cut (the VRIB) with foregone gaming profits clearly shows the tax cut will be insufficient, by itself, to replace the lost gaming profit stream. However the other changes in tax and JV arrangements more than compensate for this, leaving the VRI in a far superior position over the course of the licence than they would have been had the old arrangements continued. The final column shows that in every year of the licence the VRI is expected to gain additional funding from the change in arrangements. This gain amounts to $49 million in the financial year (incorporating funding under both old and new JVs). In real terms (adjusting for inflation) the VRI gains a total of $708 million over the lifetime of the licence. Table 6 decomposes this gain into the contributions of the various changes in taxation and JV funding arrangements, for the first licence year of and as a sum over the lifetime of the licence. The comparison of the VRIB and JV gaming profits in the and years is also shown for reference, although these years are not strictly relevant to the no less favourable question. 15 Figure 6 shows the same decomposition graphically, year-by-year to Note the JV gaming profit figures for and in the old arrangements column of Table 5 and in Table 6 are hypotheticals, incorporating an end-of-licence profit adjustment as described in section 4.8 (the actual gaming profit received by the VRI was $87 million). The figures in the lower bound results tables below exclude this end-of-licence adjustment. 22

27 Table 5: Central estimate comparison VRI funding under new and old arrangements ($ million) New arrangements (actual funding) Old arrangements (counterfactual funding) VRI gain Year Fees Race fields VRIB Gaming profit Wagering profit TOTAL Growth (%) Fees Race fields Gaming profit Wagering profit TOTAL Growth (%) fees share share fees share share (actual) 211 (36) (36) (a) (forecast) 202 (36) (36) (a) (b) (38) (40) (43) (44) (46) (48) (50) (51) (53) (55) (57) (60) Licence average growth Licence total (nominal) Licence total in dollars (2.5% inflation rate) Source: Department of Treasury and Finance calculations Notes: (a) The $8 million gain in and represents the estimated windfall gaming profit gain to the VRI resulting from the end-of-licence profit effect. (b) Includes approximately $4m top-up funding from Tabcorp under the JV minimum performance obligation (total funding excluding MPO top-up is $333 million). The minimum of $ million is for the entire financial year (under both old and new JVs). Note the and minimum amounts of $342 million and $ million are less than projected funding and hence do not affect the total. 23

28 Table 6: Central estimate comparison composition of change in VRI funding ($ million) Licence total (nominal) Licence total ( $) Loss of JV Gaming Profit (79) (80) (82) (1 232) (1 067) VRIB Doubling of VRI wagering profit share Other JV and tax changes (total) Change in fees Fixed-odds tax cut profit effect 16 Change in race fields fees burden Higher depreciation rate Minimum performance obligation 22 (5) 5 19 (1) (3) (19) 4 Total VRI gain Source: Department of Treasury and Finance calculations Notes: Figures may not add exactly due to rounding. Licence totals in dollars are calculated using a 2.5 per cent inflation rate. The contribution of the increased profit share is calculated on the basis of the old fee, tax, and race fields fee arrangements. The net contributions of other tax and JV changes taking into account off-setting changes in JV profit disbursements are calculated assuming a 50 per cent wagering profit share (i.e. the multiplicative contribution of an extra 25 per cent profit with an amended fee basis is here ascribed to the change in fees figures). 322 (5) (17) 4 Figure 6: Central estimate comparison composition of change in VRI funding Source: Department of Treasury and Finance calculations 16 The fixed-odds tax cut profit effect represents the increase in VRI funding due to the JV facing a lower tax rate, and hence realising higher profits (assuming no change in volume as a direct result of the cut). The migration of business from the higher-taxed pari-mutuel to the lower-taxed fixed-odds product results in this gain to the VRI growing throughout the licence. 24

29 Finally, Table 7 below shows the change in the pari-mutuel tax rate, and the estimated break-even rate, that would leave the VRI no better or worse off in each year under the new taxation and funding arrangements as under the old arrangements. Note the break-even rate has been calculated ignoring the $4 million funding top-up from the minimum performance obligation (MPO) in the JV agreement. 17 The table shows the impact of introducing the break-even rate (15.0 per cent) in place of the 7.6 per cent rate currently legislated. The fifth and sixth columns respectively show the additional tax revenue to the state in each year, and the remaining gain to the VRI from the shift to new arrangements, if this rate were left in place throughout the lifetime of the licence. The final two columns show the tax cuts (and new tax rates) required to meet the alternative goal of ensuring that the VRIB by itself, without regard to the other changes in JV arrangements fully offsets the gaming profits that would have been received by the VRI under the old arrangements. Table 7: Implied pari-mutuel tax rates and gain to VRI throughout licence central estimate ($ million) VRI gain Break-even implied tax rate Change Rate (%) (%) Additional tax revenue (15.0%) VRI net gain (15.0%) Implied tax rate to fully replace gaming profits Change Rate (%) (%) (a) 15.0 (a) Licence total (nominal) Licence total in dollars (2.5% inflation rate) Source: Department of Treasury and Finance calculations Note: (a) Calculated based on projected funding excluding the approximately $4m top-up under the MPO. 17 DTF understands the minimum payments will be adjusted in line with any changes in the VRIB. Ignoring the MPO in calculating the break-even tax rate means that under this rate there is a margin of error of approximately $4 million between the adjusted minimum amount that the VRI will receive and the counterfactual (old arrangement) funding. This ensures an at least no-less-favourable funding outcome. 25

30 The analysis in Table 7 shows that a pari-mutuel tax rate of 15.0 per cent would ensure that the post-2012 funding arrangements were at least no less favourable to the VRI. Under this rate the VRI would benefit from funding arrangements that are increasingly favourable (compared with pre-2012 arrangements) as the licence term progresses. Table 7 also indicates a rate of around 4.6 per cent would be sufficiently low for the VRIB to fully replace foregone gaming profits throughout the entire licence term. The following section presents the same statistics for the lower bound estimates of VRI funding. 26

31 5.2 Lower bound comparison Table 8: Lower bound comparison VRI funding under new and old arrangements ($ million) New arrangements (actual funding) Old arrangements (counterfactual funding) VRI gain Year Fees Race fields VRIB Gaming profit Wagering profit TOTAL Growth (%) Fees Race fields Gaming profit Wagering profit TOTAL Growth (%) fees share share fees share share (actual) 211 (36) (36) (forecast) 199 (36) (36) (a) (38) (a) (38) (a) (39) (41) (42) (44) (46) (47) (49) (51) (53) (55) Licence average growth Licence total (nominal) Licence total in dollars (2.5% inflation rate) Source: Department of Treasury and Finance calculations Notes: (a) Includes top-up funding from Tabcorp under the JV minimum performance obligation of approximately $27 million, $31 million, and $0.6 million in , , and respectively (projected funding in these years excluding top-ups is $310 million, $311 million, and $320.6 million respectively). The minimum of $ million is for the entire financial year (under both old and new JVs). 27

32 Table 9: Lower bound comparison composition of change in VRI funding ($ million) Licence total (nominal) Licence total ( $) Loss of JV Gaming Profit (87) (88) (90) (1 349) (1 169) VRIB Doubling of VRI wagering profit share Other JV and tax changes (total) Change in fees Fixed-odds tax cut profit effect Change in race fields fees burden Higher depreciation rate Minimum performance obligation (1) (18) 59 Total VRI gain Source: Department of Treasury and Finance calculations Notes: Figures may not add exactly due to rounding. Licence totals in dollars are calculated using a 2.5 per cent inflation rate. The contribution of the increased profit share is calculated on the basis of the old fee, tax, and race fields fee arrangements. The net contributions of other tax and JV changes taking into account off-setting changes in JV profit disbursements are calculated assuming a 50 per cent wagering profit share (i.e. the multiplicative contribution of an extra 25 per cent profit with an amended fee basis is here ascribed to the change in fees figures) (16) 58 Figure 7: Lower bound comparison composition of change in VRI funding Source: Department of Treasury and Finance calculations 28

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