59792 investment climate June 2010 IN PRACTICE Business TaxaTion no. 13 Using Taxation to Enable a Fair and Thriving Mining Industry Tax policy is an important tool for attracting investment and spurring Farid Tadros Kristina svensson growth in mining--a valuable industry. This note examines the implications of tax policy from the perspectives of both governments Farid Tadros (ftadros@ifc.org) advises client governments as and investors, analyzing royalties, windfall taxes, depreciation a member of IFC's Advisory allowances, loss carry-forward provisions, and tax administration. Services in the Middle East and North Africa. His work focuses on regulatory reforms for Tax policy plays a key role in making mining Prevents resources from being exploited business taxation and the mining financially attractive and economically feasible. But inefficiently. industry that reduce barriers to many governments view mining taxation primarily Does not allow substantial rents to accrue to compliance, investment, and as a way to maximize fiscal revenue, rather than recipients other than the state and investors. growth in developing countries. as an opportunity to shape the industry. Mining is capital intensive, has extremely high upfront costs Mining companies, on the other hand, tend Kristina Svensson and long lead times before profits are made, and to be large multinational corporations. They (ksvensson@worldbank.org) is sensitive to changes in global commodity prices. allocate capital in ways intended to maximize advises governments on mining These factors affect how investors view potential the value of their companies, which partly and sustainable development mineral investments and how governments try depends on the share of rents they can retain. to maximize fiscal revenues while maintaining These companies argue that the risky nature of as a member of the World Bank's attractive investment climates. mining should provide them with higher returns Oil, Gas, and Mining Policy than would be tolerated in other industries. In Division. She has managed particular, they argue that the high returns on projects aimed at improving Using tax policies to some projects are offset by the low returns on investment climates in Africa, foster mining investment others and by failed exploration ventures. Latin America, and the Deciding on policies for mining taxation requires Cash flow is a key concern for mining investors. Middle East. understanding the perspectives of the government Given mining's high upfront costs, the levels and This note and others in the as well as investors. A government must determine timing of tax payments directly affect a project's how to identify, maximize, and retain a fair share internal rate of return. Accordingly, depreciation IN PRACTICE series of notes of mineral rents. That involves designing--in rates and loss carry-forward provisions affect a on business taxation reform the face of significant uncertainty in the mining project's cash outflows and hence its economic were developed as part of a industry--a revenue-sharing system that: feasibility. Moreover, large international mining joint program between the U.K. companies can choose among potential projects Department for International Maximizes government revenue over time. in various countries. Development and the Investment Does not deter exploration and development activities that would otherwise be A tax regime should not distort mining investment, Climate Advisory Services of economically justified. production, or extraction. If the policy goal is to the World Bank Group. maximize short-term revenue, policymakers might Tax tools for mining be tempted to impose a high effective tax rate. But if the rate is too high, in the long run there Governments take a variety of approaches to collect will be fewer mines and fewer taxpayers because revenue from mining investments. Among the investors will not come, explore, and discover challenges are striking a fair balance between benefits new mines. Yet if the effective tax rate is too low, for governments and investors and ensuring that the government will forgo revenue (CMA Limited mining taxes are properly paid and credited. and Otto 2007b). Some governments choose to take an equity stake Good tax policy should strive to set the effective in the mining sector to help secure revenues during tax rate at T *, as defined in Figure 1. If the tax rate commodity boom markets, but this approach is too high, it could result in a lower net present carries risks (Box 1). value of government revenue because fewer mines are invested in due to marginal investments not Royalties being undertaken. Alternatively, if the tax rate is Royalties allow governments to capture tax revenue too low, more mining investment is made but the when mining profits are low or even nonexistent government's fiscal take is lower per mine. Perhaps (a common occurrence in the first few years of the most important aspect of fiscal policy is to production). A government might instinctively ensure it is clear, transparent, and predictable, impose high royalties to secure its fiscal take, but enabling investors to accurately assess investments doing so does not necessarily maximize revenue from and compare them with opportunities elsewhere. its geological endowment because it undermines project viability and deters investment. Because royalties are levied early in a project, before Figure 1: Setting an Optimal Effective Tax Rate a profit is made, their rate influences a project's net present value. Still, if royalties are too low and other instruments are not available to extract additional taxes, the government may not receive the optimal amount of revenue from projects. Net present value of government revenues Good practice is to define royalty rates in a country's mining law as nonnegotiable percentages of the basis used to value metallic and fuel minerals (Table 1). To ensure competitiveness, rates should be comparable to those in other mining countries. In a hypothetical gold mine model, raising the royalty rate from 0 to 5 percent lowers the investor's internal rate of return from 13.7 percent to 9.0 percent (CMA Limited and Otto 2007a). Windfall taxes Windfall taxes are designed to capture additional 0 T* 100 revenue during commodity price booms, but they do not always work the way they were intended. Tax rate (percent) This is one of the challenges facing mining and Source: Otto and others 2006. tax authorities when establishing reasonable tax policies for mining. When mineral prices are high High tax rates will not necessarily result in higher government revenues, because the and mining companies are making good profits, e ective tax rate a ects the attractiveness of the investment. governments are tempted to try to capture a larger share of those profits by raising taxes, imposing in PRaCTiCe BusINEss TAxATIoN 2 royalties, or both. This typically involves tying a Box 1: State Equity Participation in Mining windfall tax (either a profit tax or royalty) to the price of the commodity. Most governments do not take equity participation in mining. The risk of this approach is that capital and During commodity booms state equity participation is sometimes production costs often rise with the price of used to secure higher fiscal revenue. It can also be seen as a way the commodity, negating part or all of any windfall to enhance stability, promote technology transfers, and prevent for the investor. As the price of a commodity renegotiation of fiscal terms. The three main approaches to increases, the resulting growth of the industry government equity participation are paid (working) interest equity, often leads to rising equipment, engineering, logistics, and consulting costs. For instance, if a free interest equity, and, more rarely, carried interest equity. Recently, windfall tax is set using a threshold price for a equity in exchange for infrastructure or reduced tax liability has also commodity, in the medium to long term an become more common. investor would argue that the threshold price no longer represents a windfall because capital and But state equity participation carries risks. If a government takes production costs have increased. an equity stake and pays for it through a working interest, the Ideally, the threshold level for a windfall tax should opportunity costs can be substantial. State revenue invested in a reflect the increased value of the commodity as mine is diverted from other uses and put at risk. Not all mines well as the change in cost structure for the investor. are successful: some fail or do not generate sufficient profits to Rather than using the price of the commodity, a justify a distribution to shareholders. And if the equity is free or function of operating profit or net income provides a more accurate measure of windfall. But taking exchanged for infrastructure or reduced tax liability, transparency that approach requires significant capacity in the might be lacking--which can hurt the overall investment climate. tax administration. Botswana and Namibia, both considered success stories in terms of the role of government in mining, opted for private sector­led Accelerated depreciation allowances mining and focused the government's role in the sector on economic Depreciation is a noncash expense used to distribute the cost of capital assets over their management and regulation. Mining revenue helped finance public estimated useful lives. Rather than providing investment, supporting economic growth. Table 1: Government Mining Royalties in Various Countries Country Rate (percent) Basis Botswana 3­10 Ad valorem (net smelter return) Brazil 3 Gold: gross sales revenue Ghana 3­12 Ad valorem (sales revenue) Guyana 5 Gold: gross sales revenue Mozambique 3­12 Ad valorem (sales revenue) Namibia 5­10 Ad valorem (sales revenue) Suriname 2 Gold: based on gross sales; Other: based on net sales Tanzania 0­5 Ad valorem (net smelter return) Zambia 2 Ad valorem (net smelter return) Source: Otto and others 2006; PriceWaterhouseCoopers data. Note: Ad valorem is a tax, duty, or fee that varies based on the value of the products, services, or property on which it is levied. in PRaCTiCe BusINEss TAxATIoN 3 extended tax holidays or exemptions, good practice costs required to set up a mine before it begins paying has been to grant generous or accelerated income tax. This approach protects the mine's early depreciation allowances to mining companies. income so that it can be used to reduce debt and to Accelerated depreciation recognizes the high minimize financial vulnerability during downturns capital investment requirements and long lead in commodity prices--an important benefit because times before mines begin generating sufficient mines are usually cash-strapped in their early years profits to repay their initial investments, and so (Figure 2). Good practice is to grant allows larger deductions in the early years of an generous or accelerated asset's life. Loss carry-forward provisions Loss carry-forward provisions allow mines that depreciation allowances With accelerated depreciation, the mine plant and incur operational losses to use those losses to reduce to mining companies. related exploration and feasibility activities are their taxable income in future years. Such provisions typically capitalized (made into assets on the are typically used to allow mines to recover losses balance sheet) and depreciated (expensed on the caused by commodity price downturns or by initial income statement). Table 2 compares depreciation losses from setting up (Box 2). There is a close rates in various countries and the bases on which relationship between depreciation and loss carry- they are calculated. The higher the depreciation forward provisions. For instance, if fiscal policy rate, the quicker the asset can be expensed-- provides accelerated depreciation allowances but reducing taxable income. only allows for a mine to carry forward the loss for a limited number of years, the investor will Allowing an investor to depreciate assets over a likely be unable to take full advantage of the shorter period allows it to recover the high investment depreciation incentive. Table 2: Depreciation Rates for Mining Investments in Various Countries Country Depreciation rate (percent) Basis Argentina 60 Initially 60 percent, then 20 percent straight line Botswana 100 Initially 100 percent Brazil 20 Straight line Chile 33 Straight line Ghana 75 Initially 75 percent, then 50 percent declining balance Indonesia 10 Straight line Lesotho 20 Declining balance Mexico 10 Straight line Namibia 33 Depreciated over three years Peru 20 Straight line Rwanda 50 Initially 50 percent, then 25 percent South Africa 100 Initially 100 percent Suriname 25 Straight line Tanzania 100 Initially 100 percent Zimbabwe 100 Initially 100 percent Source: FIAS 2007. Note: "Straight line" is defined as spreading the cost of an asset over several years--for example, 25 percent a year over four years. in PRaCTiCe BusINEss TAxATIoN 4 Figure 2: Effect of Accelerated Depreciation on Tax Payments over the Life of a Hypothetical Mine 150 Deferred income tax payment 100 Millions of U.S. dollars 50 Royalty payment 0 ­2 ­1 0 1 2 3 4 5 6 7 8 9 10 Year Mine is depreciated ­50 Capital costs Operating expenses Tax Mine development period Net income ­100 Source: Authors' example, drawing on Bergevin 2008. Income tax payments can be deferred in the early years of a mine with an accelerated depreciation allowance. Rather than spreading depreciation evenly over the life of the asset, the bulk of the allowance is weighted to the mine's early years of operation. Tax administration and auditing Box 2: Why Should Governments Provide Many countries face large gaps between mining Incentives for Mining? taxes--which should be paid based on effective tax rates--and the amounts actually received. Accelerated depreciation allowances and loss carry-forward provisions This disparity can be significant: in 2005 it was $500 million in the Democratic Republic of Congo. for mining may cause government officials to wonder why they should The reasons are largely tied to tax administration, provide such incentives. Both are widely accepted ways of attracting including limited capacity to enforce contracts, lack investment and create fewer distortions than tax holidays. Such of coordination between ministries of mining and incentives can also result in marginal investments being undertaken and finance, nontransparent contracts, and rent seeking. maximize the level of resources being exploited in a country. Without remedial actions, these gaps will worsen as mining expands and investment increases. More important, accelerated depreciation allowances and loss carry- To ensure that revenues are collected, the tax forward provisions help ensure the financial stability and sustainability administration should audit selected mining of mines by postponing their tax payments from early to later companies to: years. After all, the financial health of mines is of mutual interest to Check payments of surface rents and royalties. governments and investors. Perform physical controls (generally the responsibility of the ministry of mining), including control of physical output, in PRaCTiCe BusINEss TAxATIoN 5 imported or re-exported production assets, and loss carry-forward provisions, are key to the and inventories. industry's success. Provide for better traceability and matching of amounts assessed with Still, there are no prescribed practices that amounts collected, in some cases by governments should follow. Country variations will creating a specialized unit in the ministry depend on the maturity of their mining industries, of finance to track mining taxes. each country's short- and long-term goals, and the Having a large state of global commodity markets. geological endowment In addition, the government, investors, and civil society need to continue implementing the Investors weigh risks and rewards when making does not guarantee a Extractive Industries Transparency Initiative, investments. Perhaps more important than tax rates healthy mining industry. which publicly discloses payments from mining and allowances is for investors to have clarity, companies to governments and government transparency, and predictability. That way they can receipts of those revenues. effectively assess mining opportunities and generate the confidence needed to commit to investments. Conclusion The recent financial crisis has left governments with plummeting revenues and rising debts. The mining industry can have a significant Although crises present opportunities to revisit development impact--creating jobs, generating fiscal policies and regulations, policy should not revenue, developing domestic expertise, stimulating be developed in isolation or on impulse. Simply downstream and upstream investment, and supplying raising taxes or reducing allowances may not local industry with needed materials. have the intended effect of reducing a revenue shortfall. When revisiting fiscal policy for But having a large geological endowment is mining, all stakeholders--including investors-- insufficient for ensuring a healthy mining industry. should be involved so that they can understand Countries compete for investment and expertise to the varying perspectives, goals, and challenges extract resources in a socially and environmentally and achieve optimal outcomes. Governments responsible way. Government tax policies, through also need to ensure that they have the capacity royalties, windfall taxes, depreciation allowances, to collect what is due. in PRaCTiCe BusINEss TAxATIoN 6 References IN PRACTICE Bergevin, Gilles. 2008. "Canada's Mining Taxation FIAS (Foreign Investment Advisory Service). 2007. The Investment Climate IN Regime." Presentation produced for Government "Sector Study of the Effective Tax Burden: Lesotho." PRACTICE note series is published of Canada, Tax and Exploration Division, Natural Report prepared for the Lesotho Ministry of Finance Resources Canada, Ottawa. and Development Planning. World Bank Group, by the Investment Climate Washington D.C. Advisory Services of the World CMA Limited, and James Otto. 2007a. "Mining Bank Group. It discusses practical Fiscal Systems Framework Analysis: Egypt." Study Otto, James, and others. 2006. Mining Royalties: considerations and approaches conducted for the International Finance Corporation, A Global Study of Their Impact on Investors, for implementing reforms that Washington, D.C. Government, and Civil Society. Washington, D.C.: aim to improve the business World Bank. ------. 2007b. "Mining Fiscal Systems Framework environment. The findings, Analysis: Yemen." Study conducted for the Inter- interpretations, and conclusions national Finance Corporation, Washington, D.C. in this note are those of the authors and do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. about the Investment Climate Advisory Services The Investment Climate Advisory Services of the World Bank Group helps governments implement reforms to improve their business environments and encourage and retain investment, thus fostering competitive markets, growth, and job creation. Funding is provided by the World Bank Group (IFC, MIGA, and the World Bank) and over 15 donor partners working through the multidonor FIAS platform. in PRaCTiCe BusINEss TAxATIoN 7 International Finance Corporation World Bank Group WWW.WBGINVESTMENTCLIMATE.ORG