Precept 4

Precept 4

Tax regimes and contractual terms should enable the government to realize the full value of its resources consistent with attracting necessary investment, and should be robust to changing circumstances.

Natural resource development may provide employment and other returns, but its principal benefit is the generation of government revenue to support development and the wellbeing of citizens. Realizing these revenues requires a well-designed fiscal system that takes into account the nature of extractive resources, the considerable uncertainties inherent in their exploitation, and the capacities of the government.

Important characteristics of the sector include:

  • The existence of substantial "rents," which are returns beyond those which would be required to recover costs and to give an investor the minimum rate of return required to invest
  • Exhaustibility of resource deposits
  • Asymmetry of information between the government and potential investors
  • High upfront costs and significant periods of exploitation, requiring a long-term investment in the presence of significant market, geological, and political uncertainties
  • Challenging accounting and audit environment for fiscal control (regardless of whether investors are private or state actors)

Against this background, governments should design fiscal systems that provide strong returns for their resources and a reasonable timeline for receipts, and take account of uncertainty and the trade-off of risk and reward—while at the same time attracting the necessary capital and investment for development of the resource when such development is warranted. In addition, countries must account for individual legal traditions and constitutional constraints that may dictate a particular pattern of ownership and taxation.

Consider function, not the form, of the tax regime

These imperatives suggest that the development of a good fiscal regime in developing countries should exhibit the following two basic components: a royalty or other production-based charge that provides a minimum flow of revenue to the state whenever production occurs; and a mechanism for capturing a share of profits and remaining rents.

While fiscal regimes may vary in terminology and legal form, most include these two elements. In "tax-and-royalty" systems used in both mining and petroleum, the investor makes a royalty payment to the government based on output and is subject to ordinary income taxation on its profits. Under "production-sharing" arrangements—principally used in petroleum but potentially applicable to mining—a portion of the output is reserved for the investor or contractor for recovery of its costs ("cost oil") and the remainder ("profit oil") is split between the investor and the government. Service contracts are a further alternative to tax-and-royalty and production-sharing systems. Here governments may grant exploitation rights to state-owned firms, which in turn may contract for services from third parties. Systems may also be mixed.

Despite the various contract forms and nomenclature, each of these structures may incorporate profit- and production-based elements, and each can be designed to achieve similar returns. The government’s task is to therefore ensure that the risks and timing of revenue receipts are shared between the state and investor(s) in a way that is consistent with the government’s development strategy and maximizes overall value to citizens.

Use a royalty system or equivalent

A royalty, or its production-sharing equivalent, assures the government of a revenue stream from the beginning of production, and also ensures that the country receives some minimum payment for the resource and to cover the social costs of extracting it. If a project cannot sustain a reasonable royalty to cover these costs, it is highly unlikely that the project is a good deal as the country would be giving up a non-renewable resource without any assurance of payment.

Royalties require accurate measurement of output, well-defined timing rules, and good measures of market value. Royalties that allow production cost deductions are profit taxes by another name. The measurement of market value is greatly facilitated by tying the royalty to some international and publicly quoted price when such prices are available, rather than more traditional computations which "net back" the value to the point of production.

Consider how to tax income and rent

Another kind of charge is a tax on income ("profits tax"). In a tax-and-royalty system this is typically the generally applicable corporate income tax—a tax on the return to equity. It is usually modified to take account of specific characteristics of the sector and to minimize abuse. Sometimes regimes use a higher tax rate in an effort to tax rents. If the government uses production-sharing arrangements, the government can achieve the same result as a tax-and-royalty system by choosing a particular share of "profit oil" or "profit gas" and a recovery rate of costs ("cost oil" or "cost gas") that would provide an equivalent government take.

The profits tax provides for significant risk-sharing between the government and the investor, with the government having the opportunity to share in the upside of a highly profitable investment while the investor has some downside protection from losses or low returns.

Unlike a royalty, a profits tax or its equivalent does require the measurement of costs. The costs as disclosed by companies are frequently susceptible to manipulation because they can be incurred in transactions for goods and services acquired from related parties. Moreover, the form of financing affects the returns to the government, with excessive debt capitalization leading to the loss of revenues. Thus, in the absence of careful auditing and controls and well-written statutes or regulations, there is considerably less certainty that a government will actually collect what is due under a profits tax. In addition, the large upfront investments characteristic of the extractive industries, when combined with the expensing or accelerated depreciation of investment, will produce large deductions against taxable income which, when carried forward, can significantly delay the receipt of income taxes.

Profits may include a significant amount of rent in a high-value project. The government may consider a supplemental rent tax, or a tax surcharge on cash flow, that transfers a higher share of profits to the government than the ordinary income tax when profit rates are high. The government can design a production-sharing system to provide the same result by increasing the government’s share of profit oil based on some measure of the project’s overall profitability.

The government may supplement any of these systems with certain discrete payments. For instance, in a competitive license allocation process an up-front bonus payment may be the bid element, while all other fiscal terms are kept fixed.

Avoid tax incentives and simplify tax regimes

Investors often request that governments with potential or newly discovered resources provide special incentives in the form of tax holidays, accelerated recovery of capital expenses, or reduced royalty or profit rates. A government should resist offering such incentives. If a project cannot bear the royalty or a normal tax on equity investment, the investment is unlikely to be a good deal for the country. Changing circumstances—higher commodities prices or new technology, for example—frequently result in projects that were once deemed uneconomical becoming feasible without the benefit of government subsidies. Not all resources have to be developed at any given time, and some resources may never warrant development.

Provided that the basic elements are in place—a royalty, a profits tax, and some sort of rent tax—the government can benefit from simplifying or eliminating many of the other charges that are sometimes imposed. Value-added tax (VAT) should work as intended, as a tax on the domestic consumption of a good, not as a tax on investment. As such extractive companies should not pay VAT on the product that they export. In addition, duties on imports should not be at a level that deters investment. Fiscal systems that rely too heavily on such charges, or on other fixed fees and charges on inputs, can be unwieldy and have unanticipated negative outcomes that outweigh the tempting promise of up-front revenues. Government authorities must also pay attention to international tax systems in order to prevent non-resident corporations from evading taxes on revenue attributable to resource development. Governments should have reasonable and preferably uniform rates of withholding on payments such as dividends, interest, service fees, and royalties to non-residents. In the absence of robust mechanisms for collecting income taxes from foreign entities, withholding taxes is often the surest way of securing extractive profits in a host country. Tax treaties may limit withholding and other taxation of non-residents, and governments need to carefully review existing treaties and avoid or tailor such obligations in proposed treaties.

An important emerging issue of political and economic significance is the taxation of capital gains attributable to the sale of rights to the host country’s resources. Reaching those gains—particularly where a transfer of rights is achieved through transactions at the level of a foreign holding company—requires careful tax legislation and reporting requirements, and consideration of how the payments that create those gains are later treated for tax purposes.

Avoid using state equity to increase government returns

See Precept 6 on national resource companies.

The fiscal regime already provides the government with a return on its resources, but governments frequently seek to take further equity interest in a project which can, depending on its form, increase the fiscal burden on the state as equity investor. The government may consider state equity participation for other purposes, however: as a second-best means of rent capture (especially where informational asymmetries are severe, or monitoring capacity constrained); as a means to invest state assets (although this may conflict with an objective of economic diversification); as a way of potentially influencing corporate decision-making (although regulation may be more appropriate); or as a means to transfer knowledge of business practices.

Establish transparency, stability, and robustness

See Precept 1 on legal frameworks, and Precept 2 on transparency.

Transparent and uniform rules reassure investors, reduce opportunities for corruption, and may reduce the demand by individual investors for special treatment. Uniformity also facilitates administration. Uniformity does not mean that new projects must be subject to the same rules or contractual provisions as existing projects, or that governments should forgo the flexibility to change tax rates, even for older projects. Countries often change corporate and personal income tax rates. Auctions can also capture for governments part of the differences in expected value among deposits. Uniformity should extend to the taxation of nationally owned resource companies: they should face the same tax terms as private companies.

Investors may seek contractual assurances regarding stability. Many countries do not provide contractual assurances, but if the government does consider them, it should limit provisions so that the state remains free to regulate other areas of concern such as labor, health and safety, environment, security, and human rights. Furthermore, the government should avoid an asymmetric situation in which, on the one hand, the company can subsequently seek concessions through threat of closure, but on the other hand, the government does not have the opportunity to realize a greater share of the benefits if the project becomes highly profitable.

Ensure competent tax administration and implement tax avoidance rules

See Precept 3 on contract negotiation and allocation.

All governments face tax administration challenges. Some of these challenges are the result of poorly designed systems that may not provide the tax agency with adequate authority to contest or prevent abusive tax-avoidance practices. Implementing tax rules to address common causes of tax avoidance can help. Such rules might provide for ring-fencing and limitations on the deductibility of certain related-party payments—for example, management fees, excessive interest charges or hedging losses. But the problem is in part organizational, and in part relates to general capacity constraints. Contract negotiation processes that result in bespoke fiscal arrangements may place added burdens on administrators as well as negotiators. The following can all help tax authorities: integrated information and filing systems; centralization of collection functions for royalties, other taxes, and revenues from production shares; a requirement for companies to pay into a single, transparent, central account; integration of physical monitoring with revenue collection; and elimination of "in-kind" payments. Governments can import foreign expertise to address some of the common capacity gaps while domestic capacity is built—for example, by contracting with international financial accounting entities to assure compliance and full collections.

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