Taxation of Natural Resources: Challenges and Strategies for Domestic Resource Mobilization

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 co’s • 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) • Govt’s 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 country’s 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 co’s • 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 investor’s 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 don’t 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 mine’s 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 government’s 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)

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:Combiningtax instruments, leads to high marginal tax rate as calculated per following formula (Higgins 1992, 59): marginal rate = 100[1-(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)

22. Preservation of mineral wealth when mines are depleted • Hicksian concept of ‘income to mineral extraction’: how much of country’s current mineral revenues can be consumed without LT impoverishment? • Mineral wealth should be invested, thereby permanently increasing mineral state’s command over goods and services • Investment in permanent resource rent fund, without depleting principal: • Income earned on Fund’s 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 state’s 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@treasury.gov.za taxpolicy@mweb.co.za Tel: +27 12 315 5706 Fax: +27 12 323 2917 Cell: 082 461 5545