TAxATION AND INVESTMENT ISSuES IN MINING

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1 TAxATION AND INVESTMENT ISSuES IN MINING PAUL MITChELL Between 1 and 00 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.

2 Table 1. Top ten company decision criteria in mining investments 1 Geological potential for target mineral 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 Source: UN survey of companies quoted by Prof. James Otto, 00, unpublished. Notes: the survey included a total of 6 factors, not necessarily in the numerical order given. Bold: tax-dependent. Italics: tax-related. 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. 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

3 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., 005, 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 0-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 ). 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

4 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% Effective Tax Rate (%) Figure. Division of mine revenues 0 year typical medium sized copper mine Gross revenue: us$3.3 billion (50% Effective Tax Rate) loan costs % Bank Taxes and fees 17%* National Provincial local profits 17%* New exploration New mines Dividends Operating costs 44% Wages Consumables Spares Power Water Community * Note 50% division Capital costs 1% Contractors Suppliers Infrastructure Others 30

5 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 (005), Responsible Tax. Henderson Global Investors ltd., london, uk, 005. Humphreys, M., Sachs, J., and Stiglitz, J. (007), Escaping the Resource Curse. Columbia university press, Ny. ICMM, World bank and unctad (008), Resource Endowment Toolkit. The Challenge of Mineral Wealth. ICMM london, Otto, J. (005), 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. (006), Mining Royalties: A Study of Their Impact on Investors, Government, and Civil Society. World bank, Washington DC. 31