Mining Taxation

1. Mining Taxation Professor James Otto Director of Graduate Studies Environmental and Natural Resources Law Program University of Denver College of Law

2. Division of Mine Revenues20 Year Typical Medium Sized Copper MineGross revenues - 3.3 billion USD(50% Effective Tax Rate) Wages Consumables Spares Power Water Community? Banks New exploration New mines Dividends National? Provincial? Local? Contractors Suppliers Infrastructure Others Note: 50% division

3. Structure of Talk • Taxation and investment • Principal issues affecting modern taxation design • Principal taxation methods & incentives • Analyzing a mining tax system • Recommendations

4. Part 1. Role of Tax in Investment Decisions Since 1985 over 100 countries have introduced new mining law Most nations have reformed or are now reforming their mining sector fiscal system Most developing and transition nations reformed so as to attract investors Has there been a race to the bottom? Are taxes too low? Too high?

5. Exploration Investment is Cyclical SE Asia / Pacific Rest of World Latin America Africa USA Canada Australia

6. Investment Cycle Affects All Regions 1997 – $5 billion 2002 – $1.7 billion 2005 - $5.1 billion Source: MEG, WMC, ABM

7. ExplorationDownturn & Upturn • Global exploration expenditure: • 1997: US$5.2 billion • 1998: US$3.7 billion • 1999: US$2.8 billion • 2000: US$2.6 billion • 2001: US$2.2 billion • 2002: US$1.9 billion • 2003: US$2.4 billion • 2004: US$3.8 billion • 2005: US$5.1 billion Temptation to lower taxes Temptation to raise taxes MEG 2006/7 – Top of the cycle? Is now a good time to raise taxes?

8. Role of Tax in Investment Decisions • Companies have many options, but only limited budgets • Key factors need to be met to attract investment • Companies will screen investment opportunities applying criteria balancing risk and reward How does taxation fit in?

9. Investor Perception Geology – the most important criteria Fraser Institute Poll 2005/2006

10. Percent of Surveyed Mining Companies That Consider Jurisdiction’s Mining Taxation Regime a Strong Deterrent Russia, New Zealand, Sweden PNG, Indonesia, Mongolia (before reform) Chile, Congo, Peru Ghana, Alaska, Mexico, Brazil Fraser Institute Survey 2005/2006

11. Fraser Institute Poll 2005/2006 Investor Perception Tax is part of policy Higher risk Lower Risk Geology must be balanced against government policies

12. Balancing Geology and Policies in Investment Decisions Companies balance different factors, like tax, when balancing geological potential and risk Fraser Institute Poll 2005/2006

13. Role of Tax in Investment Decisions Top 10 ranked Company Decision Criteria for exploration (out of 62 factors) • Geological potential for target mineral • Profitability of potential operations • Security of tenure & permitting • Ability to repatriate profits • Consistency of mineral policies • Realistic foreign exchange controls • Stability of exploration terms/conditions • Ability to predetermine environmental obligations • Ability to predetermine tax liability • Stability of fiscal regime • United Nations Survey of • 45 companies Tax related

14. Part 2. Principal Issues To Consider in Mining Taxation Policy J. Otto

15. Principal Issues Affecting Taxation Systems- Primary Goal of mining taxation policy - • to achieve a win-win situation for society & companies • society’s objectives: achieve development and obtain income at an acceptable social cost • company’s objective: achieve adequate return on investment It is in the interest of both parties to obtain successful projects J. Otto

16. Principal Issues Affecting Taxation SystemsThe Government’s taxation dilemma: fiscal diversity or uniformity? • same tax treatment for all sectors? (fishing, light industry, mining) • each sector can claim some uniqueness • special treatment can cause distortions between sectors • Since each sector is unique, shouldn’t each sector be taxed in a manner that takes that uniqueness into account? Government dilemma: uniform tax system applicable to all sectors or system that accounts for uniqueness in each sector

17. Principal Issues Affecting Taxation Systems - Unique nature of mining: tax policy response - Trend is to harmonize fiscal systems across economic sectors, but most nations still provide some special treatment to the mining sector

18. Principal Issues Affecting Taxation Systems- Fiscal diversity or uniformity within the mining sector? - • Mineral type? • (sand, dimension stone, coal, base metals, gold, diamonds) • Scale? • (panners, small scale, large scale) • Nationality? • (discrimination, tax treaties, foreign investment act)

19. Principal Issues Affecting Taxation Systems - Unique nature of mining: tax policy response - • Exploration will precede startup of mining-- exploration expenses will occur before taxable income is available. • Response: special provision for how pre-production / pre-income exploration expenses are handled for future income tax purposes • Mine development is capital intensive. • Response: accelerate recovery of capital costs once production commences

20. Principal Issues Affecting Taxation Systems- Unique nature of mining: tax policy response - • Mine will initially import equipment from specialized suppliers. • Response: low or no import duty and VAT relief • Mineral product must compete for share of global market. • Response: relief from VAT and export duties

21. Principal Issues Affecting Taxation Systems- Unique nature of mining: tax policy response - • In most nations minerals are the property of the state or the public. • Response: assess a royalty (a public to private ownership tax) • The scale of operation may be small or large. • Response: exempt small scale miners from royalty • Response: vary royalty by scale of production • Different minerals have very different labor, cost, price, value-added, environmental and social attributes. • Response: vary royalty rate for different groups of minerals

22. Principal Issues Affecting Taxation Systems- Unique nature of mining: tax policy response - • After mining ceases and there is no income, a mine incurs significant costs related to closure and reclamation. • Response: require a tax deductible set-aside of funds early-on • Mining project may have a long life span & will live through many political regimes and national economic ups and downs. • Response: stabilize some taxes • Scale of investment may be huge and many laws may be involved. • Response: negotiated agreement, including special tax terms, supplanting general laws • Response: ring fence

23. Principal Issues Affecting Taxation SystemsRevenue raising objective:maximize immediate or long-term revenue? • Cash cow? • Short term maximization - government seeks to maximize fiscal revenues from every mine • Grow the size of the herd? • Long-term maximization - seek increased levels of investment with attractive, moderate taxes thus creating more tax-paying mines over the long-run

24. 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 1900 1910 1920 1930 1940 1950 1960 2000 1890 1880 1990 1870 1970 1980 Year Real Copper Price: 1870 – 2001 (US Prices, $2001/1b) Tax system needs to recognize cycles Tilton 2006

25. Principal Issues Affecting Taxation SystemsShould the tax system adjust for price cycles? • When prices are high: • Surpluses are available to be taxed • Special taxes: additional profit tax, graduated royalty • Experience: almost all nations have eliminated these • When prices are low: • Without relief from non-profit based taxes, mines may close • This can result in both short and long term fiscal reductions • Approaches: loss carry forward, allow good year surpluses to offset poor years, discretionary relief from royalty Most mineral fiscal system today partially self-adjust because they are based mainly on profitability (income tax, withholding tax on remittances)

26. Principal Issues Affecting Taxation System- Tax Stabilization - • Government perspective: • Administrative challenge: different mines will have different tax systems • Don’t bind the hands of future lawmakers • Should a risk-premium be paid? (Peru, PNG, Chile) • How long? Which mines (all, or only large mines)? • Which taxes? • Company perspective: • Need to provide assurance to lenders that cash-flow will be sufficient to meet repayment • Reduces risk that a mine may be subject to changed rules once the capital is captive J. Otto

27. Principal Issues Affecting Taxation SystemsCommunity Related Costs • Policy Debate : • Should a mine be allowed a tax deduction or credit for investment in communities and public infrastructure? • This will increase local benefits, but decrease treasury revenues available to benefit other communities • What types of investment qualify: hard infrastructure, recurring costs for teachers, non-essential school uniforms? • Company perspective: • Such costs are an important part of doing business today and should be recognized for tax purposes

28. Community related costs – deductible/credits? clinic / school / water supply / housing / nutrition

29. Sustainable development programs – deductible? improve or introduce new skills and capacities that will outlive the mine

30. Principal Issues Affecting Taxation Systems- Fiscal decentralization & distribution (money is power!) - • Should central government levy and collect all taxes? • disburse revenues through the budgeting process • a statutory percentage of some tax types automatically will be remitted by central government to lower levels of government • Should different levels of government levy and collect taxes? Challenges: accountability, capacity, corruption, political will

31. Principal Issues Affecting Taxation Systems- Influencing taxpayer behavior: examples - • Encourage value added processing: • High royalties on ore, lower royalties on concentrates & metal • “free trade zones” & “special industrial zones” that provide reduced tax regime (beware – transfer pricing problems) • Encourage exploration: • Double deduction for exploration costs (Argentina, PNG) • Encourage R & D: • Tax credit for approved research to improve mineral processing

32. Principal Issues Affecting Taxation SystemsCharacteristics of a good mineral tax system: Investor’s view • Tax system should: • maximize the net present value of the company’s revenue • be based on realized profitability • permit early pay-back of capital • recognize the volatility of markets • be stable and predictable • transparent • avoid tax types that distort extraction profiles • avoid tax types that do not reward increased efficiency • encourage investment in exploration • encourage investment in marginal mines

33. Principal Issues Affecting Taxation SystemsCharacteristics of a good mineral tax system: Government’s view • Tax system should: • maximize the net present value of tax revenue • support macroeconomic stability by providing predictable and stable tax revenues • capture more revenues during periods of high profits • capture more revenue rent from extraordinarily low cost, high grade mines • be effective with low-cost administration • not be vulnerable to tax avoidance • encourage exploration and expansion of the tax base

34. Part 3.Taxes & Incentives What types of taxes are assessed? What rates are imposed? What incentives are available? J. Otto

35. Principal Tax Types & Rates • Usually applied: • income tax ( 25 to 35% ) • withholding tax on dividends, loan interest and services ( 10 to 20% ) • royalty ( 2-4% ) • land use fees (per square unit area, low) • administrative fees and transaction charges ( low ) • Rarely applied: • excess profits taxes ( very rare ) • import and export duties ( zero rated or exempt ) • VAT ( refunded, offset, exempted ) • free equity dividends ( indirect taxation ) J. Otto

36. Principal Tax Incentives • Common Incentives • accelerated depreciation • loss carry forward • no ring fencing rules • carry forward of exploration, feasibility, development • deductible environmental and closure costs • deductible community and public infrastructure costs • Less common incentives • tax stabilization • tax holiday or initially reduced rates • depletion • loss carry back J. Otto

37. Typical 2006 Mining Tax System • Income tax 30% • Dividend withholding tax 15% • Royalties (sales value based) 2-4% • Import duty on equipment none • Export duty on minerals none • VAT negated • Depreciation accelerated (5 yr) • Depletion none • Ring fencing none • Exploration amortized (5 yr) • Environmental costs expensed • Tax holidays none • Loss carry forward 5 year limit

38. Part 4. Analyzing a Mining Tax System J. Otto

39. Analyzing a Tax System • In analyzing mining taxes tax, it is essential to look at the complete system of all taxes and fees • The overall tax impact on a mine can be measured: • Is there an adequate return to the investor? • Is there an adequate payment to society? • Is the tax system competitive with that in other nations? J. Otto

40. Analyzing a Tax SystemModel Mine Cashflow Diagram Models can be created for representative mines

41. Analyzing a Tax System- Model Mine Cashflow Diagram -

42. Analyzing a Tax System ETR: A Measure of All Taxes Collected -What is the impact of all taxes combined? value of all amounts paid to government Effective Tax Rate = -------------------------------------------------- value of profits before taxes are paid Internal Rate of Return (a measure of profitability)

43. Ideal range ? ETR = 40 to 50%

44. Analyzing a Tax System • Using mine models, it is possible to analyze the impact of: • changing any existing tax rate • adding a new tax • deleting a tax • offering tax incentives • any combination of tax reform Mine model analysis: can be applied to an individual mine or to a sector-wide analysis

45. Part 5. Recommendations

46. Mining Tax Policy “Don’t kill geese that lay golden eggs - – leave enough eggs to grow the flock” It is in the interest of both parties to obtain successful projects

47. Conclusion • Countries compete for investment • Investment will flow to where geology is attractive, regulatory systems are workable, and taxation is reasonable • Tax systems are converging, need to be competitive • Tax systems should accommodate low and high prices • Well designed tax systems can provide a fair contribution to the treasury • ARE YOU COMPETITIVE? • ARE YOU TOO GENEROUS?

48. Don’t expect mines to carry too heavy a burden - every one wants a bigger piece of the pie - Can it carry one more stakeholder and still remain viable?