A wide range of fiscal instruments exists and can be found in practice.  Some are common to all sectors in the economy, such as profits taxes, employment taxes, value added taxes (VAT), customs duties, and dividend withholding taxes. Others are specific to the EI sector itself, such as mining royalties and oil production sharing, bonuses, fiscal gearing mechanisms, cost recovery provisions, state participation, fiscal pricing, and fiscal packages. Fiscal instruments should be evaluated against fiscal objectives, taking into consideration differences among the EI sectors, specific state circumstances, and institutional capacity.

This section selectively reviews these instruments.  It also addresses incentives such as tax holidays and accelerated depreciation provisions. Immediately following this section is Section 7.3, which addresses a number of related special fiscal topics and provisions. While the instruments and provisions are discussed individually, it cannot be stressed too much that what ultimately matters in assessing the likely performance of any fiscal regime is the combination of all the instruments and provisions it contains (see Section 7.4 on Fiscal Packages).

Profits Taxes. Profits taxes, such as the corporate income tax, are appealing on neutrality grounds. A project which is profitable pre-tax will tend to be profitable post-tax, since as long as the rate applied is less than 100 percent, some profit is always left post-tax.^[12]  Profits taxes also contribute to international competitiveness, since the application of a general profits tax is, in critical investor home states such as like the United States (US) and the UK, a prerequisite to obtaining a foreign tax credit (for example,  a home country credit for taxes paid to the host country).

Profits taxes are sometimes faulted, however, for: deferring fiscal revenues to allow for investor cost recovery, for being less dependable than alternatives such as royalties, for increasing the volatility of government revenues (increasing government risk),^[13] and on account of perceived difficulties in their administration related to the need for careful audits of investor costs.

A particular form of profits tax is production sharing. This is very commonly applied to oil and gas operations in the developing world, although only very rarely to mining operations.^[14]  In their simplest form, these regimes are roughly equivalent to one based on a profits taxes, allowing the investor to recover costs through an allocation of ’cost oil,’ and sharing the remaining ‘profit oil.’ As a result of the similarity to profit taxes, production sharing regimes share the same pluses and minuses when measured against fiscal objectives.

Most states require payment of corporate profit taxes in addition to production sharing in order to allow investors to qualify for a foreign tax credit. The combination of the two regimes is illustrated schematically in Figure 7.4. This overlay of two fiscal regimes can create administrative difficulties, which are discussed below in Section 7.5.

Source:  IMF (2011). Production Sharing Agreements. Twenty-Fourth Meeting of the IMF Committee on Balance of Payments Statistics. Available at: http://www.imf.org/external/pubs/ft/bop/2011/11-17.pdf (last accessed 1 April 2012).

Royalties. Royalties have the advantage for a government in that they are relatively predictable and can help ensure that companies make some payments to government in times of low mineral prices and low revenues. The two main types of royalty are ad valorem royalties and unit of production (for example, per ton) royalties.^[15]  Royalties for most metal minerals are generally calculated on an ad valorem basis (that is, related to the price of the product) as a net smelter return royalty.  The net smelter return is based on the refined metal price less smelting and refining costs.  

Royalties for coal or bulk minerals, such as iron ore, are generally based on the mine head sales price. These are both relatively straight forward to calculate and vary with price. IMF estimates indicate that present practice is for ad valorem royalty rates to be generally in the range of three percent for metal minerals, and five to ten percent for diamonds.^[16]  Royalties may also be calculated as a fixed royalty per unit of production, which is simpler to asses.  

The biggest drawback of these two royalties is in their lack of sensitivity to profit, which makes them regressive rather than progressive, and distortionary rather than neutral. Where ad valorem or per unit royalties feature prominently in a fiscal regime, their insensitivity to profit may unduly limit the range of investment projects undertaken and or cause pre-mature abandonment of production as costs rise and margins fall.

The appeal of these royalties lies in the early dependable revenue they produce, and in their apparent simplicity of administration.^[17]  These pros and cons have resulted in fairly wide application of royalties in the EI sector, but at relatively modest levels. Their relative importance has been greater in the mining sector than the petroleum sector. Two states, Ghana and Armenia, use a sliding scale royalty which responds to profitability. Depending on how rates and triggers are set, these sliding scale tax instruments can be designed to have a progressive tax take.

Bonuses. Bonuses are one-off payments which may be fixed, bid or negotiated, and are linked to particular events such as license award or signature, or to the attainment of a particular level of production. Signature bonuses, especially when competitively bid, can be sizeable, and as a result have attracted considerable attention in recent years.^[18]  Bonuses boost the government’s take in situations where there is a concern that other dimensions of the fiscal regime may ‘leave money on the table;’ that is, collect less than the investor is willing to pay. Bonuses are neutral in that, once paid, they have no effect on investment or production decisions going forward. They provide early revenue, and they are certainly easy to administer.

Reservations about signature bonuses relate primarily to issues of risk. Where there are concerns regarding a government’s commitment to honoring fiscal terms, investors will be very wary about paying out large sums of money up-front, and government’s full project cycle take may be reduced as a result. Most government continue to rely principally on other, contingent fiscal instruments; that is, instruments linked to actual project outcomes, while including up-front signature bonuses as a useful complement.

Cost Recovery. Cost recovery provisions are critical to assessing any fiscal regime, yet they are often notoriously under-rated in terms of the attention they are given by government in their fiscal design. Investors, however, are well aware of their importance. Cost recovery provisions include, inter alia, a definition of recoverable costs, depreciation rates, cost oil limits in the case of production sharing, capital allowances, so-called investment ‘uplifts,’ and limits on loss-carry-forwards. Their detailed specification will have an impact (either positive or negative) on almost every one of the fiscal objectives listed above in Section 7.1.

The definition of recoverable costs can singularly generate considerable debate. Issues arising include the recovery of: (1) overseas headquarters costs (usually limited as a percent of project costs); (2) interest costs (subject to limits on debt and equity ratios, and the application of market benchmarks); (3) costs related to purchases from affiliated parties (addressed by applying OECD rules on transfer pricing or requiring demonstration of third party pricing equivalence); and (4) costs incurred beyond the vicinity of the revenue generating project.^[19]  The definition of recoverable costs primarily affects the size of government revenues.

Provisions related to expensing, depreciation rates, and limits on cost recovery for production sharing purposes may have significant implications for the timing of those revenues. Tax depreciation provisions need careful consideration because of their implications for the time profile of tax payments. Due to ‘obsolescing bargain’^[20]  considerations, IRCs can be hesitant to make fixed mining investments which are large relative to the size of the host economy, especially in states which do not have a well-established track record for foreign investment.

Governments can use accelerated depreciation for tax purposes to allow accelerated capital recovery, which reduces financial risks for investors. However, in doing so, governments must fully appreciate that if profits increase sharply due to a mineral price boom, tax payments will not increase until such time as the permitted depreciation has been fully utilized.

Cost recovery provisions are particularly critical in the areas of environmental and social remediation, and in the restoration of petroleum and mining sites on closure.^[21]  A number of the cost recovery provisions featured in EI sector fiscal regimes are further discussed in the next section.

Progressive Tax Instruments.  In the mining sector, a number of different instruments have been used to collect what have come to be referred to as ‘windfall profits taxes’ or ‘additional taxation.’ One type of instrument is the so-called ‘resource rent’ (rate of return) tax,^[22]  which involve calculating the internal rate of return of a project (based using on discounting all revenues, capital expenditures and cash operating costs) and then raising the marginal tax rate during times when a pre-determined ‘hurdle’ rate of return has exceeded expenditures.

Another instrument is the variable income tax linked to profitability (which is used in South Africa, Botswana, Uganda, and Zambia). In Armenia, a royalty is applied where the royalty rate is determined by the ratio of profitability to sales.  However, these taxes are highly controversial and recent attempts to introduce a windfall profits tax in Mongolia and Zambia were withdrawn in the face of strong resistance from the mining industry.

Fiscal Gearing Mechanisms. Fiscal gearing mechanisms, which are widely applied in the petroleum sector and increasingly common in mining, usually come in the form of additions to, or adaptations of, other base-level fiscal instruments.  They may be expressed as: (1) additional profits or rent taxes (linked to absolute profit levels or profit indicators); (2) sliding scale production shares (escalating in government’s favor with production levels); (3) sliding scale royalties (escalating with price, sometimes with production, and often linked to location); or (4) special cost recovery provisions designed to shelter high cost operations against the higher taxes which they introduce.

The intent of fiscal gearing mechanisms is to ensure progressivity of the fiscal regime, especially in the light of the dramatic increases in petroleum and minerals prices seen in recent years.^[23]  Since they focus on acquiring a share of perceived excess profits, their impact on incentives is intended to be neutral. Whether or not progressivity and or neutrality are achieved depends on the detailed specification of these mechanisms. Each tries to link additional payments or fiscal exposure to underlying profitability, but very often the proxy for profitability (which triggers the additional payment) is faulty or incomplete, and the intended objective is not achieved.

For example, production is an incomplete measure of profitability because it ignores the influence of prices and costs. Price is an incomplete measure of profitability because it ignores production and cost; and both indicators ignore the influence of time on profitability. Location at best may be very crude indicator of cost and so profitability, but it is more likely to be very inaccurate, and furthermore, misses out on the influence of price and production (see Table 7.1 below).

Source: McPherson, C. (2009). Fiscal and Financial Policies for Extractive Industries in Turbulent Times, Resource Curse to Development Conference, September 8-11, Oslo, Norway. Available at: http://www.cmi.no/file/?853 (last accessed 1 April 2012).

The most accurate fiscal gearing mechanisms are those which are based on actually achieved investor profitability rather than some proxy for profitability. The fact that they are based on actual profitability (rather than anticipated or guessed-at profitability) is an additional plus, which can act to significantly reduce tensions during negotiations over what profitability might turn out to be. This particular class of fiscal gearing mechanisms, which depends on accurate measurement of income, is typically faulted on the grounds of perceived administrative complexity.

Source:  McPherson, C. (2010). State Participation in the Natural Resource Sectors: Evolution, Issues and Outlook. In: Daniel, P., Keen, M., and McPherson, C. (eds.). The Taxation of Petroleum and Minerals: Principles, Problems, and Practice. London: Routledge, p. 271.

State Participation. State Participation in oil, gas or mining projects may be motivated by non-fiscal objectives, as reported in Chapter 6, but, as typically structured, it has a fiscal motivation or tax dimension as well. The motivation is participation in profits, especially in their upside potential. The tax dimension depends on how participation is specified. Several forms of state participation can be found in the EI sectors: full equity participation, carried interest participation, free equity participation, and production sharing. These are described in Box 7.1, below.

With the exception of free equity participation and production sharing, these forms of participation, full equity participation included, add little to government revenues relative to application of an efficient tax regime, although they may add considerably to risk. See Figure 7.5 and the discussion of NRCs in Chapter 6.

Capital Gains Taxes. License or concession interests often change hands; they are often sold from one investor to another. This can serve a very useful function. For example, small companies with an appetite for risk may take on projects with little appeal to major investors. In the event of success, these small companies (called ‘independents’ in the petroleum industry and ‘juniors’ in the mining industry) will look for their reward through transfers or sales of their interest to ‘majors’ with the financial and technical muscle to exploit the discovery.

A large part of the premium, or capital gains, that independents or juniors achieve on such sales (which may be substantial) is rent; yet depending on the legislation and regulations in place, the sale may be structured in such a way as to escape taxation altogether. Arguably, it should be structured this way so that exploration risk is encouraged, and the EI sector explorer who made the discovery should be allowed to recoup a full reward. That said, the premiums observed in the last few years have considerably exceeded expectations as a result of dramatically increased prices for oil and minerals, and have understandably encouraged re-examination of their fiscal treatment.^[24]   Best practice in the design and enforcement of capital gains taxation of resource-related transactions is still evolving. Options under discussion, and existing in practice, are shown in Box 7.2 below.

Withholding Taxes. Given the typical financing requirements of petroleum and mining projects, and their requirements for special expertise and services not customarily available in the host state, dividend and interest payments and subcontractor payments to non-residents are common, and usually significant. Withholding taxes on these payments allow host states to effectively tax this income as there is no practical way to force non-residents to file returns and account for their incomes. Beyond revenue generation, withholding taxes have the additional advantage of discouraging excessive payments to non-residents as a means of shifting profits to lower tax jurisdictions (see Section 7.3 below). Withholding tax rates are relatively low reflecting the fact that they are levied on gross income.^[25]

Import and Export Duties. Since there is rarely domestic production of the equipment imported for petroleum or mining operations, the main purpose of import duties in the EI sectors is revenue raising, rather than revenue protection. This may be appealing in that it produces early revenues (even before project start-up), but it also raises costs in the EI sectors, and reduces ultimate tax revenues from EI sector production. Recognizing this, most states exempt imports used in oil field or mine development from duties, either on a specific list or blanket basis, as an incentive to investors. However, inputs at the production stage may or may not be duty exempt.

Export duties, while virtually non-existent in the petroleum sector, have been applied in mining states. This practice in the past has been driven as much by industrial policy, as by any of the fiscal objectives listed above, although revenue generation has played a role as well. In many states, governments introduced export duties with the intention of encouraging investment in domestic processing and smelting capacity. In most cases, the duty was probably unnecessary.^[26]  The high cost of transporting raw minerals usually provided adequate incentive to domestic processing. Where duties did have the effect of forcing domestic processing, they were distortionary; and rather than adding value, they may (on a net basis) have subtracted from it. This occurred by diverting mining output from more efficient foreign processing centers to less efficient domestic processing. With that said, almost all states have discontinued mining export duties.

VATs.  Value-added taxes (VATs) are levied as a percentage of the value of goods and services, with VAT paid on inputs credited against VAT paid on domestic outputs. Since the EI sectors are largely export-oriented, they have no domestic output VAT against which they can credit their VAT payments on inputs. Relief for EI sector products when exported must come instead from refunds paid by domestic tax authorities. Given the heavy upfront costs and long lead times characteristic of the EI sectors (including the delays experienced in obtaining refunds), this can pose a serious problem.^[27] 

Many states have resolved this problem expediently by simply zero-rating (as is the practice for export sectors) the VAT from domestic purchases destined for EI projects.^[28]  However, in considering VAT (and also customs duties), care should be taken to avoid creating a perverse incentive whereby imports are duty free and local inputs are taxed to the detriment of local producers. Since the overall economic development aim is to see EI sector development stimulating other parts of the local economy (including the provision of local goods and services where feasible and where this is economic), it is important that these types of perverse incentives are avoided.

Discounted Sales Prices. In the past, some governments in petroleum producing states (such as Nigeria and Indonesia) have required sale of at least part of crude oil production to domestic market refiners at discounted, below-market prices. This is essentially equivalent to a royalty, and suffers from the same drawbacks as royalties, but without the same benefits. The benefits of discounted sales prices flow directly to the domestic refiner, not the government, and represent an opportunity cost loss to the budget. Further, the discounts can be expected to distort domestic investment and consumption decisions with resulting economic losses. The practice of discounted sales at the level of upstream production is now very rare.^[29]

Tax Holidays. As their name suggests, tax holidays provide the investor with an exemption from taxes and duties for a period of years, possibly as long as five to 10 years. Once a common feature in mining sector fiscal regimes, tax holidays, like export duties, are increasingly rare. Given mining’s long exploration and development periods, high costs, low margins, and long pay-back periods, tax holidays were originally promoted and introduced as essential incentives to investment. However, their use in practice has exposed serious investment and operating distortions. These relate to the practice of ‘high-grading.’^[30]  Investors were found to be unduly accelerating mine production, focusing only on high margin ores, in an effort to extract as much value as possible before the tax holiday ended. Tax holidays considerably reduced total tax revenues, and in the very worst case, may have resulted in no taxes being paid at all (even though production was highly profitable). Tax holidays have been largely discontinued in favor of less distorting incentives such as rapid depreciation rates.^[31]

Renegotiating and Updating Tax Regimes.  While mature states may be able to have stable tax regimes, some states experience difficulty with this. States with new EI sector industries, states privatizing loss-making companies, or states recovering from civil war, may make certain tax concessions or provide certain tax incentives in order to attract early investors. If this is the case, then there is a risk that a successor government will demand a renegotiation of the fiscal package if the state’s track record in the EI sector becomes more established or stable. In the latter event, good practice for the government may be to review its tax regime on a regular basis and increase its tax rates so that its tax take moves closer to states with similar prospectivity.

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