6. Pros and Cons of Taxes and Other Fiscal Instruments
Advantages and disadvantages of corporate income tax
The principal advantage from corporate income tax (CIT) stems from the large scale revenues which can be collected as a result of the potential for high profits from extractive industry projects. Because profits are not directly touched by royalties, the use of CIT can often be the largest revenue stream. Therefore, CIT scores well in terms of progressivity. In terms of neutrality, CIT is also effective since it will not affect whether or not a project is profitable, but merely how much an investor receives from the project.
However, timeliness is not a strength of CIT as it only becomes payable once a project becomes profitable and losses have been carried forward. Its dependability as a revenue stream is also limited since CIT sensitivity to profit levels makes it highly volatile and difficult to predict. Finally, CIT requires significant auditing of costs to Government, making the administrative ease of CIT low.
Additional measures to capture revenue
The potential for exceptionally high profits from extractive industry investments means that corporate income tax rates (typically 20-35%) are sometimes considered insufficient for capturing a 'fair share' of revenues for the governments, especially when prices are high. To address such circumstances, governments have devised additional fiscal instruments. One option is ‘variable income tax’ whereby corporate income tax rates vary according to levels of specified criteria (such as profitability or resource prices).
Another is resource rent tax (RRT) whereby a special tax kicks in once a project has achieved a pre-determined rate of return, as in Australia’s mining resource rent tax. Design is important for example, whether the base of a RRT considers depreciation/finance.
These instruments have similar characteristics to CIT, but score even better in terms of progressivity and neutrality. However, they will generally are worse in terms of timeliness and dependability, as they only take effect in hard-to-predict circumstances.
Withholding tax, reduces avoidance
Withholding taxes require payers of income (e.g. extractives companies) to deduct or ‘withhold’ a certain percentage of the payment to the individual (e.g. employees) and instead pay it directly to the government. The purpose is to capture some revenue in advance and avoid taxpayers facing a large tax bill that they may not be able to pay. Withholding taxes can also protect against tax avoidance by non-residents. Extractives companies often pay significant dividends and interests to non-residents. They also make substantial payments to subcontractors. Withholding tax is thus a powerful tool for ensuring government secures some revenue from payments to non-residents. It also increases the cost of paying non-residents thus reducing incentives to shift profits to avoid taxes.
Often levels of withholding tax are determined in double tax treaties between the host country and the country where the extractives investor is registered, overriding any rates set in legislation.
This is a tax on profits (revenue minus costs) of any operation. It is not a tax specific to extractives as it would normally apply to all companies operating in a jurisdiction. However, there are often differences between the corporate income tax regime for extractive industries and other sectors.
The key decisions for policy makers concern the basis and rate of tax. The tax basis is the key driver of revenue collection as it determines what the tax rate is applied to, whilst the rate itself typically is fixed between 20-35%. In the case of corporate income tax for extractives, the basis is the difference between project revenues and project costs. Whilst theoretically simple, many rules determine what is included, particularly the definition and treatment of costs.
Capital allowances can reduce government revenue
- One very important factor relates to capital allowances which enable companies to record depreciation of capital inputs such as mining equipment as a cost, thereby reducing their taxable profits. Behind this is another key distinction-- between capital and operating expenditures. The latter refers to ongoing expenses such as staff salaries which are recorded as costs on an annual basis whilst capital expenditures relate to future benefits e.g. purchase of machinery for which depreciation over time needs to be reported as a cost.
- Capital allowances are a mechanism to do this by recording as an annual cost a set percentage of the remaining value of an asset against taxable income. ‘Accelerated depreciation’ is often used as an incentive to investors with up to 100% of the value of capital items allowed as deprecation in the first year. This enhances reported costs in the capital intensive early years of projects, thus leading to reduced profits (or larger recorded losses). That reduces investors’ tax obligations, but also generates less revenue for the government.
Losses carried forward
- Substantial early losses due to significant upfront capital investments needed in the sector mean that rules around ‘losses carried forward’ are very important. These rules relate to the extent to which losses can be used to reduce future profits. When ‘losses carried forward’ are unlimited, investors benefit, but governments often restrict such losses to minimise the extent to which profitable companies can avoid paying corporate income tax. The extent to which losses from one project can be offset against profits made on another project depends on ring-fencing rules. Such rules typically aim to prevent taxable profits from one extractives project being reduced by losses from the operator’s other activities or by exceptionally high interest payments.
- Another rule relates to the extent to which interest can be deducted from reported profits. The substantial upfront financing requirements behind extractive industry projects mean that projects are often funded through heavy use of debt (instead of or in addition to equity). Repaying interest on the debt could be a substantial cost to the project, which companies might use to reduce taxable profits. Governments often put rules in place that restrict interest deductibility, called ‘thin capitalisation’ rules which apply to projects that are heavily reliant on debt or ‘thinly capitalised’.
Double Tax Treaties: Safeguarding source-country rights
These treaties set out the taxing rights between two states for different types of income, especially for cases when an individual/business is resident of one country but earning income in the other. The purpose is to prevent ‘double taxation’, i.e. paying tax the same income twice. Such treaties are a major reassurance to investors, but they have to be written carefully to avoid excessively reducing the taxing rights of the extractives ‘source’ state. Dividends remitted by companies to shareholders in their home state are often liable for lower withholding taxes.
Negotiating such treaties usually takes many years, but there are templates upon which negotiations can be based. The best known is the OECD Model Double Tax Treaty. However, there is a rival UN Model, designed specifically for developing countries, which allows greater taxing rights for ‘source’ countries. For countries with large extractive industries, this is relevant as they want to maximise taxing rights over income earned by non-resident individuals/companies in their jurisdictions.
Capital Gains Tax: Captures increased value
This tax captures the benefits of an increase in the value of an asset over time. It is particularly relevant for extractive industries as concessions and licenses often change ownership, with a common situation being a small company (juniors/independents in mining/petroleum) selling their interest to ‘majors’ after exploration has suggested very promising resource deposits which are best extracted by a larger company.
Other Fiscal Instruments
Some fiscal instruments are not specific to extractive industries but still affect their operations. For states that have a value added tax, exports would normally be zero-rated allowing producers to claim refunds on all tax paid on their inputs. Additionally, income tax can be a source of revenues although many expatriate workers will be taxed in their home countries.
Extractives projects often require substantial imports during early stages, making import duties a significant factor. Timeliness is an advantage of import duties, as they are generally largest in the development and early production stages. However, since duties add significantly to investors’ costs of business before revenues begin flowing in, they violate the neutrality principle by potentially deterring investors from going ahead with a project.