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The Fiscal Terms and Resource Revenue Collection

The Fiscal Terms and Resource Revenue Collection. 1- Why does extractive industry require a special taxation regime? 2- What is this special taxation system? 3- Why do we need progressive fiscal regime? 4- Why can we speak about a mirage regarding locally-held equity ?

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The Fiscal Terms and Resource Revenue Collection

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  1. The Fiscal Terms and Resource Revenue Collection

  2. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally-held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  3. Stylized Mining and Gas Project Timeline Revenue Capital Costs Operating Costs Exploration Costs Project Timeline  Source: Revenue Watch Institute

  4. Stylized Oil Project Timeline Source: Revenue Watch Institute Oil depleted faster than minerals, payback period is shorter, opex over the life of the project lower -> more profitable than mining , generally speaking

  5. High Potential For Increase In “Rent” “RENT” or “SUPER/EXCESS PROFIT” Source: Revenue Watch Institute

  6. Extractive Industry: A Specific Sector With a Specific Tax Policy Calls for a resource specific taxation Why isExtractive Industry specific ? • Lengthyexploration period with no revenue • • High Capital expenditure making the capital captive and not transportable • • High probability of social and environmental damage • Cyclical revenues because of volatile commodity market • Minerals are finite and belong to the State or the land owner • Long life of mine implies potential for regime changes and policy instability • Tremendous potential for high “rent” (Financial returns above those a company requires to invest ). The rent increases with the quality of the mineral deposit • Special Tax Treatments to encourage exploration - always demanded and considered justified by companies • Use of taxation incentives for investment in communities and protection of the environment • Request for use of profit-based taxes by the investors • Royalty: price of the right to use the land belonging to either the national state / local government or the landowners (US) + immediate revenues • Need of a progressive fiscal regime that self-adjusts to circumstances and profitability to ensure stability of the system

  7. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal design ?

  8. Main Types of Tax Instruments • Royalty • Imposed on value of mineral sales (ad valorem) or on production volume (unit based). • The value can be defined in different maners (FOB, CIF, mine – gate, netback ) • Most states apply a standard national corporate rate in the range of 20% to 35% of profits • Corporate Income Tax • Investment Credit/ Capital allowance • A percentage of the capital expenditure that is tax deductible • An accounting technique that applies the current year's net operating losses to future years' profits in order to reduce tax liability • Loss and Carry Forward • Depreciation and Amortization (D&A) • Accounting mechanism to spread out the capital expenditure over many years-> tax deductible and investment incentive • Withholding Tax on Dividends • On Dividends for foreign shareholders- common and encourage re-investment in the country

  9. Elements of Fiscal instruments • The Rate: • 5% royalty • 30% income tax rate • 10% equity share • The Base • The number against which the rate is applied. • Revenue-based? Production – Based? Profit - Based? • Need of a clear definition : gross revenue? Net revenues? Profit including depreciations? Before depreciation? • Timing • For developing countries funding growth and development, timing matters. • Timing also relates to the risk of different revenue streams. Room for manipulation Room for political economy

  10. Importance of the Tax Base! How to manipulate the royalty base? - Royalty Rate of 3% for Copper - Copper Sold at Export Point at $7500/Ton - Transport and Processing Costs of $500/Ton Royalty per Ton under Net Back = rate * (gross – costs) = 3% * (7500 – 500) = 3% * 7000 = $210 Royalty per Ton under Gross = rate * gross = 3% * 7500 = $225 Room for manipulation

  11. Complexity of the Definition of the Tax Base Source: World Bank

  12. Complexity of the Definition of the Tax Base

  13. Fiscal Instruments – A Common Example In Extractive Industries Gross Revenue From Oil, Gas or Mining (P*Q) Gross Revenue To Investor Royalty Production Cost – “OPEX” Pre- Tax Profit (EBT) After-TaxProfit Profit Tax Includes financial cost and depreciations Dividends Reserves W/H tax Inv.’s Dividend Govt. Equity [W/H = withholding] Investor Return Government Revenue Source: Revenue Watch Institute

  14. Fiscal Regime in the Oil Sector is often Different from Mining Mining mostly here

  15. Profit Sharing – How Does It Work ? In PSC, contractor receives a share of the proceeds from Cost Recovery and Profit Split In PSC, government receives a share of the proceeds from Profit Split and taxes paid by the contractor on its take PSCs have never taken off in the mining sector … why?

  16. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  17. Fiscal Regimes Are Assessed Against 2 Main Indicators Revealed by the Fiscal Model Effective Tax Rate (ETR) Internal Rate of Return (IRR) • Definition: Makes the positive cash flows (project revenues) equal to negative cash flows (initial investments) • Must be above the cost of capital • The higher the better! • Can be used to rank several prospective projects a firm is considering. • Can be increased by leverage hence the interest of thin capitalization • Definition: • Total government taxes • Cumulative Pre-tax profit • Comparing the fiscal regimes based on this ETR in a selection of countries that compete for mining investment (“peer countries”) helps assess the fairness FOR BOTH PARTIES of the fiscal regime ETR= USED BY POLICY MAKERS AND ADVISERS USED BY THE INDUSTRY Assessthe profitability of the project Assesswhatiscalled the GovernmentTakein the project

  18. When commodity prices go up and/ or project costs go down,everybody benefits, but the percentages may change. 37% 33% 63% 67% High Oil Prices or Low Cost situation Low Oil Prices or High Cost situation Contractor Government Total Net Profit $1 Billion $1.5 Billion Contractor Share - 37% - 33% $330 Million $555 Million - 63% Government Share (Gov Take) - 67% $945 Million $670 Million Source: Adapted from Daniel Johnston WHY WOULD IT HAPPEN?

  19. The Need For a Progressive Fiscal Regime Prices, Internal Rate of Return, Rent.. From B. Land, Taxing the Minerals Industry in Turbulent Times, 2009 (citing PWC report, “Mine: As Good as it Gets?” 2008) How to fix this situation ?

  20. Easy First Step But Not Optimal : Progressive vs. Flat Royalty Rates Progressive Royalty Rate Price Rate Total Royalty Take $100 7% $7 $200 8.5% $17 $300 9% $27 Flat Royalty Rate Price Rate Total Royalty Take $100 7% $7 $200 7% $14 $300 7% $21 NOT TIED TO PROFITABILITY or ACCUMULATED PROFITS AND CAN BE DETERRENT

  21. Reminder: Costs Go Down Naturally “RENT” Source: Revenue Watch Institute

  22. WhatWould Be Such a Progressive Tax? Resource Rent Tax Rate 50% Gradual increase If suddenly the net cash flow is negative again, the RRT stops kicking in 20% 0% 25% 45% Project Internal Rate of Return Threshold Resource Rent Tax: Highly tied to profitability and to accumulated cash flow

  23. Can the fiscal regime carry one more input tax and still remain viable for the investor? Royalty Tax Withholding Tax Income Tax Resource Rent Tax

  24. Timing of Different Fiscal Tools Source: Revenue Watch Institute Timing matters for developing countries

  25. Optimal Progressive Taxation Qualities of a progressive fiscal regime? • Captures the rent • Does not distort investment decisions • Self-adjusts to richness of the deposit, price, cost and risk = capable of accommodating wide ranges of profitability • Avoids the need to change tax regime (fiscal reforms) according to market and geological conditions BUT! Almost NO African countries have progressive taxation!

  26. Less Optimal Progressive Taxation Other less progressive ainstruments • Windfall profit tax (often price-based) • Variable income tax • Other sliding-scale instruments Less progressive but maybe more adapted to the tax administration capacity

  27. Responsiveness of Proxies to Profitability Source: IMF

  28. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7 - What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  29. Mirage Of Equity Participation Paid-up equity Carried interest So-called “free” equity EQUITY PARTICIPATION FORMS Tax swapped for equity Paid-up equity for local ownership Equity in exchange for a non-cash contribution WHY CAN WE SPEAK ABOUT A MIRAGE?

  30. The Mirage – WHY? • Economic: share in any upside of a project, • Non-economic : nationalistic sentiment (DRC), transfer of technology and know-how (South Africa), direct control over project development (Guinea) Motivation for state equity • Can be costly option. (ex: Nigeria) • Possibly, dividends never paid (widely experienced ) • Possible conflict of interest ( government’s role as regulator vs equity shareholder. ) (ex: Mozambique) Problems THE IRONY • Economic impact of an equity share can in principle be replicated by tax instruments. The government is often better off by focusing on taxing and regulating a project rather than being directly involved as an equity participant.

  31. State Equity Problems Can be Exacerbated in the Presence of a SOE • Problems of NOC in general: • Are assigned contradictory objectives: • Providing employment (China, Russia) • Providing fuel subsidies (Saudi Arabia, Venezuela) • Providing infrastructure (Nigeria – Angola : pipelines) • Foreign policy objectives (China) • Answer government’s cash demand (Mexico) • And…. Be the National Oil Company!

  32. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  33. Capital Gains Taxes and Indirect Transfer • There is no direct transfer or “assignment” of the rights in the project. A new agreement (e.g., mining license) is not signed. • There is a change in control (“indirect transfer”) , happening offshore of the company holding the right/ mining license • Change in control = sale of shares of either the company holding the license, or of one of the companies in the chain of ownership of that company (e.g., the holding company/ultimate parent company) (sales happening somewhere in the beneficial ownership)

  34. A Famous Case from Mozambique • On the grounds that Riversdale Ltd holds underlying assets which are in the country, GoM is claiming a CGT AUSTRALIA – STOCK EXCHANGE Rio Tinto MAURITIUS Riversdale Mining Limited Riversdale Energy Owns the company Bought MOZAMBIQUE Owns the right Riversdale Mozambique Limitada Rights to the Coal project

  35. The Regulatory Solution to CGT • Indirect transfers should also be covered by CGT regs • All license holders should disclose “beneficial ownership” • Prior notice of such transactions + with all relevant documents should be given to the Government • Sometimes restriction of scope of application (% of mineral assets ownership or % of shares transferred) • Enforcement: tax withheld from the purchase price. “Lien” on the concession agreement and/or other assets of the local company to cover defaulted tax obligations. Shares of the local company would be considered to be held in trust for the government. • Ability to tax depends on DTA – that might only authorize taxation on residents or taxation on direct transfer • Challenge: not easy to determine to what extent the value of the non-resident shares is reflected by an increase in value the host country’s assets when the non-residents owns several assets!

  36. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  37. Different Investment Incentives Corporate income tax incentives • Tax holidays or reduced tax rates • Tax credits • Investment allowances • Accelerated depreciation -> tax base– transfer tax burden but doesn’t wave it • Reinvestment or expansion allowances Other tax incentives • Exemption from or reduction of withholding taxes • Exemption from import tariffs • Exemption from export duties • Exemption from sales, wage income or property taxes • Reduction of social security contributions Financial and regulatory incentives • Subsidized financing • Grants or loan guarantees • Provision of infrastructure, training • Preferential access to government contracts • Protection from import competition • Subsidized delivery of goods and services • Derogation from regulatory rules and standards

  38. Developmental Impact of Tax Incentives TANZANIA • No companies had paid • income tax until 2011 • besides AnglogoldAshanti, 10 • years after starting production • BarrickGold 97 million$ between • 2004 and 2007 but 0 income tax ZAMBIA • 1992 international • copper prices 2280$/ton • production 400 000 tons: • In coffer: 200 m$ • 2004 copper price • 2868$/ton production • 400 000 tons: • In coffer : 8m$ Text Text

  39. Tax Incentives and Loopholes In addition to progressive decrease in tax rates AND tax base • Lack of ring-fencing • Thin capitalization • Transfer Pricing 70’s-80’s REVENUES COLLAPSED! Washington consensus 2000’s

  40. Do Countries Need Tax Incentives to Attract Investment? Mc Kinsey, 2009: “popular incentives, such as tax holidays (..) serve only to detract value from those investments that would likely be made in any case” IMF, 2009 : “ tax incentives in sub-Saharan Africa are now used more widely than in the 80’s with more than two thirds of the countries in the region providing tax holidays to attract investment. Such incentives not only shrink the tax base but also complicate tax administration and are a major source of revenue loss and leakage from the tax economy DOES THIS ISSUE ONLY AFFECT AFRICA?

  41. IF noRing Fencing, Government loses! Project 1Project 2 - Gross Revenue $750 - Gross Revenue $ 5000 - Total Costs $4000 - Total Costs $ 7000 - Net Revenues $3500 - Net Revenues -$ 2000 - Tax (@30%) $1050 - Tax (@ 30%) $ 0 Project 1+2 (NO Ring-fencing) • Gross Revenues: $12500 • Total Costs: $11000 • Net Revenues: $1500 • Tax (@ 30%) = $450 • If the law is silent, you just don’t apply ring fencing of profits and losses!

  42. Transfer Pricing Practice and How To Limit It? DISHONNEST BUT LEGAL !! TRANSFER PRICING PRACTICE HOW TO FIX IT ? • Definition: prices charged for cross-border transactions between related parties • WHAT DO YOU NEED TO SUCCEED ( as a company) ? • The creation of an affiliate entity • To whom you sell exports at below market price (=‘transfer price’) • To whom you charge imports/ leasing at above market price (=‘transfer price’) • From whom you borrow at above market interest rates to highly leverage projects • Regulatory Solution! • Law/ Contract: • require arms-length basistransactions between related parties • ( article 9 of UN and OECD Models for DTA) • Difficulty : for some specialized goods and services , difficult to determine what exactly is a fair market price. • Requires closer monitoring • More reporting • Requests for comparable transactions • Cooperation with tax authorities of home countries • 2) impose a cap on the • allowable debt-leverage of a project THIN CAPITALIZATION $10 bn/ year left Africa between 2002 and 2006 as a result of transfer pricing

  43. Transfer Pricing (2) Transfer Pricing Practice – Example Parent (UK) • Example: Sub1 (British V.I.) Sub2 (Angola) Sub3 (UK) Purchase of Inputs: $100 Sale of Minerals: $120 Fair Market Value: $50 Fair Market Value: $150 Taxable Profit: $20 Taxable Profit (fair market value): $100 Source: Revenue Watch Institute

  44. The UN Model Tax Convention Article 9(1) “Where: (a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or (b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which diff er from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of these conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

  45. A concrete example Assume a corporation P (parent) manufactures automobile seats in Country A, sells the finished seats to its subsidiary S in Country B which then sells those finished seats in Country B to unrelated parties (say, the public at large). In such a case S’s taxable profits are determined by the sale price of the seats to the unrelated parties minus the price at which the seats were obtained from its parent corporation (cost of goods sold in the accounts of S, in this case the transfer price) and its expenses other than the cost of goods sold. If Country A where the seats are manufactured has a tax rate much lower than the tax rate in Country B where the seats are sold to the public at large, i.e. to unrelated parties, then perhaps corporation P would have an incentive to book as much profi t as possible in Country A and to this end show a very high sales value (or transfer price) of the seats to its subsidiary S in Country B. If the tax rate was higher in Country A than in Country B then the corporation would have an incentive to show a very low sale value (or transfer price) of the seats to its subsidiary S in Country B and concentrate almost the entire profit in the hands of Country B. Source: UN Manual

  46. Applying the Arm’s Length principle (ALP) in practice • Several acceptable transfer pricing methods exist, providing a conceptual framework for the determination of the arm’s length price. • All these transfer pricing methods rely directly or indirectly on the comparable profit, price or margin information of similar transactions. • 5 major transfer pricing methods: • Comparable Uncontrolled Price • Resale Price Method • Cost Plus • Profit Comparison Method • Profit Split • Advance Pricing Agreement (APAs): pricing methodologies agreed in advance in relation to certain types of transactions, often called the “covered transactions”. Provide greater certainty for the taxpayer on the taxation of certain cross-border transactions and are considered by the taxpayers as the safest way to avoid double taxation

  47. Applying ALP is COMPLEX

  48. Fight against Thin Capitalization: International Practice • Need to clearly include shareholders’ loans in the definition of “debt” or “interest” • US: 1.5:1 debt-to-asset ratio • Australia: 3:1 debt-to-asset ratio • Canada: 2:1 debt-to-asset ratio • Chile: 3:1 debt-to-asset ratio • Liberia: interest + 50% taxable income before interest (or as negotiated) • Peru: 3:1 debt-to-asset ratio • Saudi Arabia: lower of actual interest or interest + 50% taxable income before interest • Sierra Leone: 3:1 debt-to-paid up share capital • South Africa: 3:1 debt-to-asset ratio • Tanzania: lower of actual interest or 70% of taxable income before interest • Zambia: 3:1 debt-to-asset ratio • Malawi: 4:1 debt-to-asset ratio • Mongolia 3:1 debt-to-asset ratio (only applies to related-party debt) • No Thin Capitalization Rule in Brazil - China - India - Indonesia - Papua New Guinea – many African countries!

  49. 1- Why does extractive industry require a special taxation regime? • 2- What is this special taxation system? • 3- Why do we need progressive fiscal regime? • 4- Why can we speak about a mirage regarding locally held equity ? • 5- Capital Gains Tax: What is challenging about it ? • 6- Do low income countries need tax incentives to attract investment? • 7- What is the importance of fiscal modeling for host countries? • 8- What are the main challenges of fiscal regime design ?

  50. As a Starting Point : Fallacy of Discussing Individual Fiscal Tools in Isolation Knowing that a royalty is 4%, 5% or 10% will not give you a sense of whether the country is getting a good deal unless you also know how much the country earns from other fiscal tools (profit taxes, bonuses etc )! • FISCAL MODELING TO KNOW THE OVERALL FISCAL BALANCE! AND UNDER DIFFERENT SCENARIOS!

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