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
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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 sector�led
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 3�10 Ad valorem (net smelter return)
Brazil 3 Gold: gross sales revenue
Ghana 3�12 Ad valorem (sales revenue)
Guyana 5 Gold: gross sales revenue
Mozambique 3�12 Ad valorem (sales revenue)
Namibia 5�10 Ad valorem (sales revenue)
Suriname 2 Gold: based on gross sales; Other: based on net sales
Tanzania 0�5 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.
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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.
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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,
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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.
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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
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competitive markets, growth, and
job creation. Funding is provided
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through the multidonor FIAS
platform.
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