Chapter

12. Taxes, royalties and cross-border resource investments

Editor(s):
Michael Keen, and Victor Thuronyi
Published Date:
September 2016
Share
  • ShareShare
Show Summary Details

1 Introduction

Developing economies that are dependent on non-renewable resources face two major objectives: attracting capital for major projects and deriving revenue to fund public services. These objectives need not be antagonistic since resource producers know that the government, typically owner of the resource, is entitled to benefits from resource extraction similar to landowners when resources are owned privately.

The relationship between the government as owner of the resource and the private company that plays a role in the exploration, development and extraction of resources is little different than a principal–agent relationship. The principal, the government, seeks revenue and other economic benefits from large extractive projects. The agent, the private producer, is invited to participate in projects and obtain a sufficient rate of return on projects to cover investment costs and risks, competitive with returns elsewhere. A government seeking the most able producer would need to give up some of the rents accruing from the project.1 A stable regime reduces uncertainty not only for the private producer but also for a government reliant on volatile revenues.

Many resource-rich developing economies rely on foreign companies to provide the management, technology and capital needed for large extractive projects. Thus, many projects involve cross-border investments made by private producers, many of which are global companies operating at a large scale in countries.

This chapter is focused on company tax and resource royalty issues related to cross-border investments. The company income tax is a significant generator of revenues for developing economies not only in the resource sector but also in other sectors. The company income tax also serves as a backstop to the personal income tax in a country to ensure that income earned by owners left in the corporations is taxed. Other company taxes levied by developing countries that directly affect capital decisions include taxes on assets, financial transaction taxes and sales taxes on capital purchases, but the company income tax is the most significant and complex tax for analysis.2

Royalties are defined in this chapter as any type of payment made by private producers to governments for the use of resources.3 They are usually thought of as charges assessed on volume or value of production, although it is becoming more common for government to impose “profit-based royalties”, with project costs being deducted from revenues. These payments are intended to collect economic rents for governments from resource exploitation including levies related to “net profits”, production sharing (that is similar to a net profit approach), revenues or cash flows. The net profit-based royalties have some similarity to company income taxes, although important differences arise, especially with the treatment of interest and their application to a specific project (so-called ring-fencing).

The main purpose of this chapter is to provide a characterization of several cross-border fiscal issues that impact the incentive to invest and the resource revenues derived by governments. A definition of economic rent is first provided as well as a characterization of the decisions made by non-renewable resource producers taking into account both company taxes and royalties using a “time-to-build” model.4 A key point to emerge is that company income tax and royalty interact with each other such that even a well-designed rent-based royalty will be generally non-neutral when a company income tax is also imposed.

Section 3 then provides some cross-country comparisons of marginal effective and royalty tax rates (METRRs) for Australia, Brazil, Canada, Norway, United Kingdom and United States on oil exploration, development and extraction, which will be explained in more detail in what follows. Several cross-border issues are highlighted that impact taxes and royalties levied on resource investments. These relate to the use of tax structures such as transfer pricing and conduit financing that affect payment of tax in the host country. Cross-border financial structures also affect the discount rate for carrying forward unused deductions under rent-based royalties and a corporate tax.

The central conclusions from this analysis are that, generally, rent-based approaches to royalty design are appropriate so long as a creditable minimum revenue or output-based royalty is used to ensure governments obtain a certain level of revenues (see Chen and Mintz, 2012, for further details). A company income tax should follow the principle of neutrality with similar tax burdens on business activities with tax rates conditioned on international circumstances.

2 The meaning of economic rent

Economic rent arises from non-reproducible (or fixed) factors of production such as entrepreneurship, land and natural resources. It can also arise from the presence of natural or artificial barriers to entry that generate market power and special advantages that firms may possess (such as location, patents, etc.). More generally, rent is the surplus value of revenues net of all economic costs, including opportunity costs, which are subtracted from revenues arising from the sale of goods and services. Rent is thus measured as output multiplied by the difference between the price at which a resource can be sold and its unit cost of discovery, extraction and production, including a rate of return on capital that can be obtained by investing in projects with similar risk and scale.

In recent years, governments have resorted increasingly to rent-based systems by which costs are deductible in determining the royalty base rather than a conventional royalty based on a percentage of production revenues or a levy on output. A resource royalty based on “rents” is typically measured as revenue net of current and capital expenditures (an investment allowance is provided to carry forward unused deductions by a rate of interest to preserve the time value of money). In the non-renewable resource sector, the obvious example is the “cash flow tax”, which is a form of rent tax on ex post returns.5 Alternatively, the government will tax rents as return in excess of a minimum rate of return on capital (the R-base approach), which in principle is the same as the cash- flow approach on a present value basis, differing only in the timing of revenue streams (in the discussion that follows, the cash flow approach will be the main focus). Governments also use bonus bids for land tracts to raise revenue, which taxes rents on an ex ante basis.

Any tax or levy applied to pure economic rent will not distort the use of capital or other production factors. At the margin, firms employ capital, labour and other factors until the marginal return on the last unit employed is equal to its economic costs. In economic terms, rents are zero at the margin, negative if too much production takes place and positive if too little rent-earning production is undertaken by the producer. Hence, for marginal decisions – investment or otherwise – the rent earned is zero, as returns equal costs in using production factors. A pure rent-base tax will neither discourage nor encourage the investment or production decision since the levy is neutral in not affecting investment and technology decisions.

3 Impact of company taxes and royalty levies on incentive to invest

Taxes and resource royalties affect the decisions of resource firms with respect to their investments in exploration and development to develop reserves and extraction of output requiring capital and other inputs. Royalties and taxes of various types can distort firm decisions, thereby leading to suboptimal or inefficient production and fewer rents. Often much analysis is focused on the overall levy imposed on present value of investment without looking at distortionary effects. This section and theoretical appendix lay out a model to analyze the impact of company income taxes, capital taxes and sales taxes on capital purchases affecting the exploration, development and investment decisions of non-renewable resource companies. Before doing so, however, a heuristic explanation is provided of the “marginal effective tax and royalty rate” (METRR), which is the focus for our analysis on investment impacts.

3.1 Marginal effective tax and royalty rates

Conceptually, a business invests in capital until the rate of return on incremental dollars is equal to the cost of capital (at this point no further rents are earned). To measure the effect of taxes and royalties on investment decisions, the METRR is calculated as the amount of taxes and royalties paid as a percentage of the pre-tax-and-royalty net-of-risk return on capital that would be required to cover taxes, royalties and the financing of capital with debt and equity. Risk is incorporated in the analysis by measuring the certainty-equivalent rate of return on capital (this is the expected rate of return net-of-risk costs). To the extent that the tax or royalty system shares risks with the producers by allowing for the full refundability of losses, the government provides an implicit deduction for the cost of risk, thereby treating risk costs no different than costs like labour.6 I shall assume this is the case for the analysis for the theoretical model.

In the analysis that follows, I focus on METRRs to determine how the investment decision is affected by tax and royalty systems.7 As a simple illustration of the METRR, consider the following. If a business invests in capital at the margin that yields a pre-tax and royalty net-of- risk rate of return equal to 15% and, after taxes and royalties, a net-of-risk rate of return equal to 5%, then the METRR is 15% minus 5% divided by 15%, giving a result of 67%.8

The advantage of the marginal approach is that the variation in METRR across assets and industries provides a basis for analyzing capital distortions in fiscal systems. The higher the METRR, the lower will be investment since the tax adjusted cost of capital is higher, squeezing out marginal projects in an industry. Similarly, if one type of asset is favoured over others, companies will have an incentive to change the mix of assets including shifting expenditures from one stage of production to another, thereby impacting the technical choices made by firms in developing extractive projects. For example, fiscal systems typically provide incentives for exploration and development – it is not inconceivable that firms will push capital expenditure into the exploration or development phase that could have taken place post-production to reduce the present value of tax payments even though it adds cost to the project by investing too early.

With marginal analysis, there is no need to specify project revenues and costs since companies will invest in capital until the rate of return on capital is equal to the cost of capital (the weighted cost of debt and equity finance). This is in contrast to measuring the average tax rate which is equal to the present value of all levies paid divided by the present value of the project’s cash flow (or the annualized amount of tax paid divided by the average or internal rate of return on capital). To estimate the average tax rate, one needs information on the certainty-equivalent value of revenues and costs, which are specific to each project (the cash flows and payments to governments will therefore depend on how much rents are earned).

Some analysts prefer average tax rate and cash flow analysis since resource projects are lumpy. However, firms do have the ability to change the scale and size of projects to some extent. Further, despite the size of large resource projects, each firm can be a small part of the industry, resulting in output being determined at the point at which marginal revenue is equal to marginal cost of production. Much of this debate goes back to Alfred Marshall’s characterization of competitive markets in which the minimum efficient scale of a firm may still be relatively small compared to the market. Nonetheless, the average tax rate calculation to analyze a specific industry can be instructive for markets with one or two large projects.

Nonetheless, given the difficulty measuring rates of return or cash flows on a certainty-equivalent basis, theory would predict firms will invest if the rate of return on capital is at least as high as the marginal return. Since this enables the analyst to avoid measuring revenues and costs, the marginal analysis is also useful in this sense.

Studies9 that focus on average cash flows earned by the industry require a specification of revenues and costs that are best representative of the industry even though they widely vary by project. Average effective tax and royalty rates are calculated as a share of the internal rate of return earned on projects, which is typically above the cost of capital used for marginal analysis due to the existence of rents (recall at the margin, rents are zero). The average effective tax and royalty rate is therefore sensitive to the internal rate of return. For example, with a high internal rate of return, a fiscal regime with a high statutory rate and accelerated cost deductions and tax credits could have an average effective tax and royalty rate that would be greater than the case of a regime with low rates and broad bases. The amount of tax paid on rents is equal to the statutory tax multiplied by the difference between revenues and costs, thereby leading to a higher share of tax paid compared to a project that earns a return close to the marginal return, assuming costs are the same. On the other hand, with a low internal rate of return, the opposite would hold. Thus, in comparison with the marginal analysis (that focuses on low internal rates of return equal to the observed cost of capital earned at the margin), the average effective tax rate analysis could lead to a conclusion that a high-rate narrow-base regime provides less incentive for investment than a low–rate broad-base regime, assuming a high internal rate of return on a projects. This conclusion might be appropriate if projects are lumpy and large relative to markets. On the other hand, marginal analysis may provide a more suitable answer if capital can shift by downsizing one project in favour of another.

The METRR does not provide an estimate of the overall taxes and royalties governments collect since those amounts depend on both the marginal and infra-marginal returns (rents) earned on an investment. It is not unusual, for example, for the METRR to be negative even though the government could be collecting revenues. The implication is that any losses on the marginal investment are being used to offset levies on rents or carried forward to shelter income from royalties in the future. The METRR is a benchmark with which to determine the effects of taxes and royalties on investment decisions.

As mentioned, the model provided in the appendix accounts for the time taken to develop non-renewable resource projects before they are available for extraction. There are several stages of production: exploration and development phase to discover reserves and make them available for extraction and a subsequent production phase that leads to output sold to the market. With these two stages, the analysis is based on a flow of inputs to develop a reserve available for production of oil and gas – a “time-to-build” analysis.10 The following stage of production, extraction, depletes the discovered reserves until exhaustion.11

The METRR for resource companies is calculated for each type of asset expenditure: exploration, development, depreciable capital, land and inventories. The METRR on capital is equal to the annualized value of tax and royalty paid divided by the gross-of-tax-and royalty rate of return on capital. The analysis includes federal and provincial/state corporate income, capital and sales taxes, as well as provincial royalties. Various features of taxes are modelled including inventory valuation, capital cost allowances, statutory tax rates and the investment tax credit.

3.2 Comparative analysis

In this section, comparison of METRRs across different countries is provided based on three critical assumptions that shall be relaxed in what follows. First, transfer prices for outputs, inputs and financing costs are equal to market prices. Second, the cost of financing is based on the equity and debt financing costs from third parties (thereby abstracting from any multinational tax planning, which will be further discussed later). Third, losses are fully refundable (the discount rate used to carry forward any unused deductions is equal to the government bond rate since governments fully share risks).

METRRs are calculated for Australia, Brazil, Canada (five provinces), Norway, UK and U.S. (four states). The specific regimes are described in detail in Mintz and Chen (2012), which also provides detailed equations used for each jurisdiction. Here a brief review is provided of the various 2012 tax and royalty systems, with some further details provided in an appendix to this chapter.

  • Australia’s has effectively two levies, the corporate income tax and the Petroleum Resource Rent Tax (PRTT), as state royalties are credited against the federal rent tax. The corporate income tax is applied at a rate of 30% on profits with a deduction for depreciation, inventory, reclamation costs and the PRTT as well as expensing for exploration and development. The PRRT tax rate for offshore projects is 40%, under which exploration and rehabilitation expenditures are expensed and may be carried forward at an uplift rate of 15% points above the government long-term bond rate (LTBR). Other capital expenditure may be carried forward at a rate of 5% points above LTBR.

  • Brazil has both a company tax and resource royalties applied to oil production. The combined company tax is applied at a 34% rate on profits, with deductions provided for exploration (expensed) while development and capital is depreciated. Other costs including royalties are deductible from profits under the company tax. The revenue-based royalty is 10% on the value of products sold, net of any indirect taxes and transportation costs using common carriers. A 1% landowner fee, applicable to onshore activities only, shares the same base as royalties. Rental fees are based on the area of fields and location; the signature bonus is a lump-sum payment due upon signing the contract. A special participation (SP) fee is levied on substantial profits (net of all the other oil and gas levies) that surpass the threshold on a field-by-field basis, which threshold volume varies by location (onshore or offshore; the latter is further differentiated by water depth) and declines with the production years. The SP rate is progressive from 10% to 40%, depending on the aforementioned varying thresholds.

  • Canada has federal and provincial corporate income taxes applied to oil as well as provincial royalties (the provinces are owners of resources in their own jurisdictions). The federal-provincial corporate income tax varies from 25% in Alberta to 29% in Newfoundland & Labrador. Under the corporate income tax, exploration, reclamation costs and provincial royalties are expensed, development expenditures written off at a 30% declining balance rate and depreciation of other assets written off at a 25% declining balance rate. Provincial royalties for conventional oil are assessed on revenues with rates varying by price and volume of each well. “Net profit” royalties apply to Alberta oil sands, British Columbia shale gas and Canada Atlantic offshore oil and gas projects. The Alberta royalty is fashioned after a cash-flow approach with a carry-forward of unused deductions at the LTBR. The royalty rates on payouts (net of recovered costs) are price sensitive, varying from a minimum of 25% to a maximum of 40%. A revenue-based minimum tax is also imposed on all provinces that are credited against the net profit royalty. The Atlantic offshore and BC shale gas royalties do not allow unsuccessful exploration costs to be deducted from the royalty base (unlike the corporate income tax).

  • Norway assesses two taxes on offshore oil production: the regular corporate income tax at a rate of 28% and a non-deductible supplementary tax at a 50% rate based on a cash-flow approach. The corporate income rate is 28%. Exploration costs are expensed. A cash refund is provided for tax losses resulting from exploration. Oil production facilities and pipelines may be depreciated within 6 years with a straight-line rate up to 16.66%. The cash- flow tax base is the corporate tax base grossed up by financing cost and net of an uplift factor (7.5% of the cost price of depreciable operating assets including development expenditures for the first 4 consecutive years) and unused uplift carried forward from previous years.

  • The United Kingdom offshore royalty for petroleum has many features similar to the Norwegian system. The 2012 UK corporate income tax rate is 28%, except a ring-fence corporation tax of 30% is applied to petroleum with allowances provided for exploration costs, development and depreciation costs. A supplementary tax (the “royalty” for purposes here) is 32% and non-deductible from the ring-fence company tax. Both the corporate income and supplementary taxes provide deductions for the following: (1) 100% of the cost of exploration, appraisal, development and installation of production, (2) a 100% first-year allowance for development expenditure is provided except for the costs of acquiring mineral assets, which attracts a 10% annual relief (some development expenditures may only be depreciated under the corporate income tax and (3) a 10% ring-fence expenditure supplement (uplift factor) for up to 6 years. Post-production capital is depreciated under the corporate income tax while expensed under the supplementary tax. Inventories are treated on a first-in-first-out basis for the corporate income tax.

  • The United States assesses both a corporate income tax at the federal and state levels as well as severance taxes (similar to revenue-based royalties) at the state level (except Pennsylvania, which has no severance tax). Oil and gas companies benefit from the reduced federal corporate income tax rate on resource profits (32.9% instead of 35%). Exploration and development are expensed or depleted after commencement of production as elected by the company. State corporate income tax rates vary – these taxes are deductible from the federal rate. Texas also levies a 1% franchise tax on margins (revenues net of cost of goods sold) in lieu of a corporate income tax. Severance tax rates are 5% of revenues in Arkansas and Colorado, with lower rates applying to first years of production. Texas imposes a royalty based on sales at a rate of 16.67 to 25% as well as a severance tax (the royalty is deductible from the severance tax).

The effects of these various regimes are shown in Table 12.1 for each type of capital and jurisdiction. Figure 12.1 provides both the aggregate METRR and decomposed rates when excluding certain levies.

  • The highest METRRs in Table 12.1 and Figure 12.1 tend to be those jurisdictions that apply revenue-based royalties: U.S. states, Alberta and Saskatchewan (for conventional oil) and Brazil. This is not surprising; revenue- based royalties provide no deduction for costs and therefore increase the cost of capital for all types of capital expenditures including exploration and development. On the other hand, rent-based royalties in the Alberta oil sands, Canadian Atlantic offshore, Australia and the UK tend to have much lower METRRs since costs are deductible from the revenue base.

  • The cases of Australia, Newfoundland & Labrador and Nova Scotia are particularly notable since exploration is provided a large incentive as shown by a negative METRR. In large part, this arises from an excessively high uplift factor for carrying forward unused exploration expenditure written against future payouts (a similar situation arises for Canadian Atlantic Offshore). The carry-forward rate is an issue that will be further discussed in what follows.

  • It is also worthwhile to note that Alberta oil sand royalty on its own imposes no tax at the margin.12 However, in the presence of the company income tax, an otherwise neutral royalty increases the METRR even though, in principle, a cash flow tax is a pure rent tax (unused deductions are carried forward at the government bond rate for oil sands investments, which is far less generous than in Australia or Canada Atlantic offshore). For example, in the case of royalty deductibility under the company tax, neutrality can be reestablished for the cash flow tax by making two corrections to the company tax (Mintz, 2010). First, annual capital cost allowances under the company income tax should be calculated on the cost basis of assets net of the value of the deduction provided under the royalty base. Second, an investment tax credit should be provided to offset the impact of a reduced value for the deduction of expenses from the rent-based royalty base. The investment tax credit rate should be equal to the royalty rate multiplied by the company income tax rate.

  • The rent base for assessing supplementary taxes on petroleum in the UK and Norway are not pure cash-flow taxes as in the case of Alberta oil sands. Norway limits carry-forwards for unused deductions to 4 years even though it does provide up-front refunds for unused exploration deductions. The UK does not provide expensing for inventories.

  • Other taxes on capital impact the incentive to invest in a jurisdiction. For example, the retail sales taxes in Saskatchewan, British Columbia and the U.S.13 increase the cost of capital in those jurisdictions since many capital goods are subject to tax.

  • Inflation also affects the cost of capital since depreciation and inventory cost deductions are based on the original cost of assets, which is offset by the deduction of nominal debt interest charges under the company tax. Brazil has a relatively high inflation rate compared to other jurisdictions.

Table 12.1METRRs by jurisdiction (in percent), 2012
ExplorationDevelopmentDepreciableInventoryAggregate
Canada
B.C.*28.532.529.523.230.2
Alberta:
Conventional48.451.821.923.240.3
Oil sands−2.95.633.333.127.7
Saskatchewan37.441.233.726.437.4
Newfoundland4.9−26.8−26.8NA−6.8
Nova Scotia−7.4−49.1−73.232.1−26.0
The U.S.
Arkansas24.026.635.226.328.8
Colorado28.631.033.325.231.0
Pennsylvania4.27.738.428.217.5
Texas31.733.832.123.232.5
Australia−132.213.229.438.3−19.6
Brazil48.349.774.145.657.7
Norway−3.314.964.183.028.5
The UK−4.0−0.84.170.84.6
Source: Mintz and Chen (2012)

Assumes that the retail sales tax in BC is reinstated and the Atlantic Investment Tax Credit for oil and gas activities is fully phased out as proposed in the 2012 Federal Budget in Canada.

Source: Mintz and Chen (2012)

Assumes that the retail sales tax in BC is reinstated and the Atlantic Investment Tax Credit for oil and gas activities is fully phased out as proposed in the 2012 Federal Budget in Canada.

Figure 12.1Decomposing the effective tax and royalty rate 2012

* Other taxes included sales taxes on capital purchases and asset-based taxes.

Several observations are made here with respect to these estimates.

This analysis provides a benchmark for examining the impact of multinational cross-border planning for company taxes and rent-based royalty systems, which is discussed in the next section.

4 Multinational cross-border fiscal issues

Governments, as owners of the resource, want to ensure that they derive a reasonable and fair amount of revenue from extractive industry projects. Multinational companies have a fiduciary duty to their shareholders to reduce tax and royalty payments by adopting various tax planning techniques that are in accordance with the law. Such tax planning can result in the shifting of profits from high- to low-tax jurisdictions including tax havens, leading to a loss of revenues paid to government. Given a recent focus on aggressive tax avoidance, multinationals face the need to balance the benefits of tax minimization with reputation effects arising from little or no payment of taxes and royalties in a country.14

As mentioned, the specific tax planning issues addressed here are with respect to transfer pricing, financing structures and discount rates for carrying forward unused deductions. Each of these issues would impact the analysis provided in the previous section.

4.1 Transfer pricing

The analysis assumes that taxes and royalties are based on market-determined prices for outputs and inputs. However, in many situations, multinationals operating in a developing country are selling their products to related parties abroad. Under the OECD transfer pricing guidelines (OECD 2010), transfer prices for transactions between related parties should follow the arm’s length standard. If comparable uncontrolled prices are observed between unrelated parties (after adjustments such as transportation costs, quality and volumes), the arm’s length standard could be implemented by the use of market prices. Such is the case of many extractive industry products, as observed by Bernard and Weiner (1990) in the case of U.S. petroleum.

Nonetheless, transfer-pricing issues still abound in the extractive industry since the point of production is often distant from the market where traded prices are observed. This requires a determination of the output and input prices on an arm’s length basis between related parties with regard to distribution of products, overhead costs, intangibles, intellectual property and risks. As for the determination of transfer prices for intangibles, intellectual property and risks, a country would likely follow international practices for determining fees, royalties and financing costs between related prices. These practices are little different than for other industries and therefore shall not be discussed in this section.

Both the revenue-based and rent-based royalties as well as the corporate income tax require a determination of the “net-selling price” of sales of extracted products at the wellhead. Given that the observed prices are away from the point of extraction, the net-selling price received by the producer is assessed as the market price net of transport and other distribution costs (such as gas compression equipment). This issue is therefore similar to a transfer-pricing problem when measuring profitability for distribution companies (selling price less a margin for distribution costs). The net selling price should reflect comparable distribution cost margins. The allowance could be based on actual costs, which could result in low or negligible revenues during downturns, or a presumptive margin could be provided instead as a portion of the gross selling prices. If the company can incur costs lower than the presumptive margin through efficiencies in distribution, the company will have an incentive to keep costs low.

Another issue particularly with the rent-based royalty and corporate income tax that allows costs to be deductible is the treatment of overhead costs such as general administrative and financing costs that are not easily observable to be attributed to a specific extractive project. These overhead costs of multinationals are difficult for a developing country to measure or audit. Therefore, as seen in Australia, Canada and the UK, rent-based royalties, a presumptive allowance, is often provided for overhead costs (either as a share of revenues or uplift factor for costs).

Assuming that allowances approximate accurately net-selling prices and overhead costs attributed to an extractive industry project, then the METRR calculations are appropriate.

As a further point, net-profit royalty systems typically include ring-fencing whereby revenues and costs are measured with respect to a specific project rather than taxing all the projects held by a company together (under the company income tax, all sources of income and costs incurred by projects in a jurisdiction are combined to assess the income base). While costs can be attributed to the specific project, overheads (general and administrative expenses) become that much more significant to measure when joint factors of production are involved in the company’s operations. If transfer prices for overhead costs are understated for profits or rents in the host country, both company tax and rent- based royalty revenue will be understated.

4.2 Tax-efficient financing structures

Even if transfer prices reflect arm’s length pricing, it is not difficult for multinationals to shift profits by structuring financing in favourable terms. The use of offshore entities holding assets in low-tax jurisdictions provide financial opportunities to reduce taxes on income and capital gains earned in a host country. Two particular structures are discussed here: direct financing and indirect financing following Mintz and Weichenrieder (2010) and Chen and Mintz (2008).

Direct financing structures involve financial transactions between a parent and an affiliate to reduce taxes paid in a high-tax-rate jurisdiction resulting in higher taxes paid in a low-tax-rate jurisdiction. Assume the multinational is taxed on its parent profits at the rate u and abroad at the rate u0 on affiliate profits. Also, assume that dividends and capital gains on equity income earned by the parent on its equity investment in the affiliate are tax exempt and inter-affiliate interests are fully taxed. Let N0 be the equity transfer from the shareholder to parent and N0 is the equity transfer from parent to the subsidiary. B is debt borrowed by the parent from third parties, X0 is the inter-affiliate loan from the parent to subsidiary and B0 is debt borrowed by the subsidiary. For simplicity, assume interest rates are the same across the two countries (so that exchange rates are constant over time). No withholding taxes are imposed on interest or dividends by the capital-importing country.

To understand the incentive effects of company taxes on financing, the marginal decision to finance one incremental unit of capital in the host country by an affiliate is considered, restricted to three methods by which a multinational parent funds capital investments by an affiliate in the host country:

  • (i) The parent borrows (B) in the home country, transfers equity (N0) to the affiliate and the subsidiary remits dividends or the parent repurchases shares to earn capital gains in the foreign affiliate.

  • (ii) The parent borrows in the home country (B) and transfers funds via internal financing (X0) to the affiliate in the host country. Interest at the rate i on the internal debt is remitted back to the parent.

  • (iii) The affiliate borrows funds from third parties (including offshore institutions) and invests the funds in the host country. The after-tax income covers the interest cost of borrowed money from third parties, leaving no excess marginal income to be paid to the parent.

If the parent borrows, the cost of borrowing is i(1 − u). The funds are transferred as equity, N0, to the affiliate who invests the funds in the resource-producing jurisdiction. The marginal after-tax income generated by investment in the host country is Y(1 − u0), and dividend and capital gain income earned by the parent on its investment in the affiliate is exempt from the parent’s country tax. The simple cost of capital for the investment when the parent provides debt financing is:

Instead, suppose the affiliate borrows funds from the parent instead of receiving a transfer of equity. The cost of debt finance for the parent is i(1 − u) that is reinvested as an internal loan, F, to the affiliate, whereby the parent receives net interest income equal to i(1 − u). Given that the home country fully taxes interest received from abroad, after-tax income earned on internal debt fully offsets the parent’s cost of debt finance (therefore a wash). The affiliate is able to deduct interest expense, implying the cost of debt financing is i(1 − u0) with the project generating marginal after-tax income of Y(1 − u0). The cost of capital for internal loan financing is therefore equal to:

The third case is for the affiliate to borrow from third parties and deduct interest costs at i(1 − u0) to generate marginal income Y(1 − u0). This is identical to the case of internal loan financing so the cost of capital remains the same as equation (2).

It can be easily shown that the affiliate should borrow B0 from the market or the parent if the company tax rate in the home country is less than that of the affiliate (u < u0). If the host country has the higher tax rate, profits will be maximized by the affiliate borrowing from the market or the parent since the tax saving is equal to iu0 in the host country (any equity income transferred to the parent is exempt from tax by the home country).

However, the result is different if the parent borrows money and injects equity into the affiliate. The interest deduction is taken in the parent’s country tax rate with a tax savings at iu at a lower tax saving. In particular, the cost of finance for home country borrowing is higher at i(1 − u) than for host country borrowing at i(1 − u0).

Obviously, the contrary holds if u > u0. If the home country tax rate were higher than that of the host country, the parent would borrow funds and transfer equity to the affiliate. Income earned in the host country is taxed at the rate u0, while an interest deduction taken in the home country saves taxes at the rate u. Overall, the cost of capital is lower in equation (1) than in equation (2) due to tax arbitrage by borrowing in a country with a high corporate income tax rate to earn income taxed at a lower rate.

If inflation rates differ across jurisdictions, the location of debt finance will be affected. If the host country has a higher inflation rate (π0) than the home country (π), its currency would be expected to depreciate in accordance with purchasing power parity. As a result, the nominal interest rate in the host country would be higher than the interest rate in the home country: i0 > i. With an expected depreciation of the host country exchange rate, a capital loss is accrued to the lender and capital gain to the borrowing parent for its investment in the host country equal to the difference between the host and home country inflation rates: – π + π0. In this case, countries with weak currencies have a lower cost of debt finance given the deductibility of nominal interest from the corporate tax. Overall, the cost of debt finance in the home country is only lower in the host country if i(1 − u) < i0(1 − u0) − π + π0.

So what happens to the METRR? If the cost of finance in the host country (taking into account corporate tax deductibility and exchange rate depreciation) is less than the home country (i0(1 − u0) − π0 + π < i(1 − u)), then the analysis provided is unaffected. However, if the cost of finance in the home country is less than in the host country, i(1 − u) < i0(1 − u0) − π0 + π), the parent will borrow in the home country to finance investments in the host country. The cost of finance in equation (3) becomes15

The impact of 3’ is to lower the METRR in a host country when a parent has the incentive to borrow funds in their jurisdiction to fund investments.16 Thus, if the capital export country has a higher corporate income tax rate than that prevailing in the host country, the METRR will be lower to the extent that debt is borrowed in the home country (each case of cross-border investments by country would need to be evaluated separately17).

Multinational companies also use tax indirect financing structures with one or multiple conduits to reduce the cost of finance. The key is that a break occurs between the inclusion and deduction of income, thereby enabling multiple deductions for financing costs (see Mintz, 2004; Mintz and Weichenrieder, 2010 for detailed analysis). A simple case is an intermediate operating in a tax haven by which the intermediate pays no tax on its income, no withholding taxes are imposed on cross-border flows of interest or dividends and the home country does not treat such income as subject to home country tax.18

The effect of these conduit structures is to enable double- (or multiple-) dip deductions for financing costs. A conduit is an intermediate placed between the parent and affiliate operating in separate, low-tax jurisdictions. A parent borrows in the home country and deducts interest expense to reduce home country tax. Transferring equity to the conduit, the conduit lends the funds to an affiliate in another jurisdiction – the loan interest is deductible in the host country. The conduit pays little or no tax on income received from the affiliate, while the interest is a deductible charge against the affiliate’s company income, with little or no withholding tax pay on the interest paid to the conduit. The conduit in turn pays tax-exempt income to the parent (typically dividends), with little or no withholding tax deducted by the conduit jurisdiction. Overall, the multinational is able to achieve two interest deductions for a single investment placed in the host country where the affiliate operates.

Tax havens such as those in the Caribbean Islands have often been used to effect double-dip financing deductions. So have special entities in developed countries such as Belgium, Luxembourg and the Netherlands been used to achieve similar tax benefits under indirect financing structures. With U.S. check-the-box rules,19 hybrid or reverse hybrid (tower) structures have been used to achieve double-dip interest deductions without routing funds through a third country. For example, this has been widely used for cross-border investment flows between Canada and the United States: an intermediate is established that is recognized as a corporation by the Canadian government and a partner by the U.S. government.

Under indirect financing involving one conduit and a double-dip interest deduction, the cost of finance is the following:

With x being the withholding tax imposed by the host country on the loan to the affiliate or the tax rate imposed by the home country on income received by the conduit entity from next-tier affiliates.

The effect of both direct and indirect financing on the METRR is illustrated in Table 3.2 for a Canadian parent. The domestic investment case is for company financing capital with 40% debt. The base case is a Canadian parent that borrows 40% of domestic financing at home and 25% in the host country (the lower effective tax rates reflect a higher overall debt–asset ratio of 55%). The third column reports the effective tax rates assuming that 5 percentage points of debt is shifted to the jurisdiction with the lowest cost of financing due to lower corporate tax rate and weak currencies (maintaining a 55% overall debt to asset ratio). The final case is for conduit financing with double-dip interest deductions.

Obviously, indirect financing through conduits enables companies to reduce the METRR the most compared to the direct financing structure, although not that severely in the case of Brazil (with a relatively high withholding tax rate on interest) and Texas, where the royalty and severance tax are assessed on revenues only.

Table 12.2.METRRs by jurisdiction for a canadian parent 2012
Domestic
InvestmentBase CaseDebt ShiftingConduit financing
Australia−19.6−35.4−39.8−46.6
Brazil57.750.146.946.0
Norway28.524.323.317.2
The UK4.63.21.3–2.1
The U.S. – Texas32.531.430.027.7

4.3 Discount rates

Discount rates play a critical role in determining royalties assessed on rent or “net profits”. In the case of the cash flow approach, the discount rate is used to carry forward unused deductions, which is particularly important at the beginning of projects when exploration and development expenditures are incurred before the realization of income. With the R-base royalty, the return on investments reflecting the opportunity cost of investing in other similar activities is exempt (this exempt return is the “normal” rate of return with rents being the excess amount).

Some jurisdictions, such as Australia and Nova Scotia, have permitted quite high discount rates, which are expressed as the government bond rate plus a factor to incorporate risk (such as 15 points in the case of exploration costs in Australia). Others have measured the exempt rate of return as the current long-term bond rate as in the case of Alberta oil sand investments.

Many analysts20 would argue that the riskless (government) bond rate is an appropriate proxy for the multinational’s discount rate since the government already implicitly deducts the cost of risk through loss offsetting provisions under the net profit royalty (see, for example, Australia, 2010). However, risk sharing by governments is often not perfect – the government through refunds may not share losses at time of bankruptcy and losses at the end of the project in the case of ring-fencing. Moreover, unlike rent-based royalties that typically allow companies to carry forward losses, company income tax losses are carried forward to limited periods at no rate of interest. Nonetheless, including risk in the discount rate as measured for stockowners in stock markets is not appropriate since governments share a significant share of losses under rent-based royalty systems.

If the discount rate used to carry forward losses is incorrect, it will affect the cost of capital as specified in measuring the METRR. For example, if the discount rate is too low relative to the firm’s financing costs, the METRR will be higher. If the allowable discount rate is too high relative, the METRR will be lower.21

In principle, the use of the long-term government bond rate, as suggested by the Mirrlees Review, is not correct for multinational discount rates to determine carry-forward of losses. Not only do governments not fully share risks with the private sector, such discount rates ignore tax effects, which vary for risk-free equity and debt costs of finance. Once accounting for international tax planning, the multinational’s nominal cost of finance could well be above or below the government bond rate (the nominal cost being in equations 3, 3’ and 3” except for the inflation rate being added back).

Table 12.3Financing cost by type of investors, 2012
10-year govt bond rate10-year corporate bond rateBase caseDebt shiftingConduit financing
Australia3.46.95.75.55.3
Brazilna8.97.46.96.8
Norway2.15.94.84.84.4
UK1.96.75.55.45.1
Texas1.86.25.04.94.6
Note: The 10-year corporate bond rate is estimated by taking U.S. corporate bond rates, adjusting for differences in inflation rates across countries (purchasing power parity). Long-term government bond rates are taken from the OECD (http://stats.oecd.org/index.aspx?querytype=view&queryname=86) and thus not strictly comparable.
Note: The 10-year corporate bond rate is estimated by taking U.S. corporate bond rates, adjusting for differences in inflation rates across countries (purchasing power parity). Long-term government bond rates are taken from the OECD (http://stats.oecd.org/index.aspx?querytype=view&queryname=86) and thus not strictly comparable.

Table 12.3 illustrates the nominal cost of finance (including equity) for different jurisdictions compared to the corporate bond rate taken as a surrogate for non-refundable bankruptcy risk. If the 10-year government bond rate is used to proxy the discount rate, it will be too low when governments do not fully share risks such as in the case of corporate bankruptcy. It will be too high if tax planning reduces the financing cost, once accounting for the tax savings from interest deductibility.

Overall, government bond rates, which have been abnormally low since 2008, could underestimate the appropriate discount rate. On the other hand, the use of a corporate bond rate may be too high since tax-planning effects reduce corporate bond financing costs.

5 Conclusions

This chapter focuses on the company tax and resource royalty issues related to cross-border investments. The company income tax is a significant generator of revenues for governments not only in the resource sector but also in other sectors. Royalties are aimed at deriving economic rents from resource exploitation including levies related to “rents” including “net profits”, production sharing (that is similar to a net profit approach), revenues or cash flows. The company tax and rent-based royalties interact with each other in important ways, resulting in a cash-flow tax, for example, not being neutral in the presence of a company tax.

This analysis characterizes several cross-border fiscal issues that impact the incentive to invest and the resource revenues derived by governments. Cross-country comparisons of marginal effective tax and royalty rates (METRRs) for Australia, Brazil, Canada, Norway, United Kingdom and United States on oil exploration, development and extraction are contrasted, demonstrating the revenue-based royalty systems such as those used in the United States and Brazil, tend to result in relative high taxes on marginal investments that are expected to earn little rent. This is further complicated by several general cross-border issues such as transfer pricing, conduit financing and the discount rate for carrying forward unused deductions under rent-based royalties.

References

    Australia. (2010) Australia’s Future Tax System Review (Chaired by Dr. Ken Henry) (Australia: Canberra).

    BernardJean-Thomas and RobertWeiner. (1990) “Multinational Corporations, Transfer Prices and Taxes: Evidence from the U.S. Petroleum Industry” in AssafRazin and JoelSlemrod (eds) Taxation in the Global Economy (Chicago: University of Chicago Press) pp. 123160.

    BoadwayRobinNeilBruceKennethMcKenzie and JackMintz. (1987) “Marginal Effective Tax Rates for Capital in the Canadian Mining IndustryCanadian Journal of Economics30 (1) 116.

    BoadwayRobinNeilBruce and JackMintz. (1984) “Taxation, Inflation and the Effective Marginal Tax Rate on Capital in CanadaCanadian Journal of Economics17 (1) 6279.

    ChenDuanjie and JackMintz. (2008) “Taxation of Canadian Inbound and Outbound InvestmentsAdvisory Panel on Canada’s System of International Taxation Finance Canada Ottawa Canada. Available at http://publications.gc.ca/collections/collection_2010/fin/F34–3-13–2009-eng.pdf.

    DanielPhillipMichaelKeen and CharlesMcPherson. (2010) “Evaluating Fiscal Regimes for Resource Projects: An Example from Oil Development” in PhilipDanielMichaeklKeen and CharlesMcpherson (eds) The Taxation of Petroleum and Minerals: Principles Problems and Practice (Routledge Explorations in Environmental Economics) (New York: Routledge and Washington: International Monetary Fund) pp. 187240.

    DevereuxMichaelP. and RachaelGriffith. (2003) “Evaluating Tax Policy for Location DecisionsInternational Tax and Public Finance10107126.

    GordonRoger and JohnD. Wilson. (1989) “Measuring the Efficiency Cost of Taxing Risky Capital IncomeAmerican Economic Review79 (3) 427439.

    LaffontJean-Jacques and DavidMartimort. (2002) The Theory of Incentives: The Principal- Agent Model (Princeton: NJ: Princeton University Press).

    MacKie-MasonJeffreyK. and JackMintz. (1991) “Taxation and Uncertainty When Capital Takes Time to Build” DraftUniversity of TorontoDecember1991.

    McKenzieKennethJ.MarioMansour and ArianeBrûlé. (1998) “The Calculation of Marginal Effective Tax RatesWorking Paper 1997–15 (Ottawa: Department of Finance).

    MintzJ. (1990) “Corporate Tax Holidays and InvestmentWorld Bank Economic Review4 (2) 81102.

    MintzJack. (1995) “The Corporate Income Tax: A SurveyFiscal Studies16 (4) 2368.

    MintzJack. (2004) “Conduit Entities: The Implications of Indirect Tax Efficient Financing Structures for Real InvestmentInternational Tax and Public Finance11 (4) 419434.

    MintzJack. (2010) “Evaluation of the Business Tax Recommendations of the Henry Review and the Australian Government Response” in ChrisEvansRichardKrever and PeterMellor (eds) Australia’s Future Tax System: The Prospects after Henry : Essays in Honour of John W Freebairn (Pyrmont, NSW: Thomson Reuters) pp. 161182.

    MintzJack and DuanjieChen. (2012) “Capturing Economic Rents from Resources Through Royalties and Taxes,” SPP Research PapersSPP Research Papers 12–30 (Calgary: The School of Public Policy, University of Calgary).

    MintzJack and Thomas A.Tsiopoulos. (1994) “The Effectiveness of Corporate Tax Incentives for Foreign Direct Investment in the Presence of Tax CreditingJournal of Public Economics55 (2) 233255.

    MintzJack and AlfonsWeichenrieder. (2010) The Indirect Side of Direct Investment (Cambridge MA: MIT Press).

    MullisK. (2011) “Check-the-Box and Hybrids: A Second Look at Elective U.S. Tax Classification for Foreign EntitiesTax Notes InternationalNovember42011.

    Organization of Economic Cooperation and Development. (2010) OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010 (Paris: OECD).

    Organization of Economic Cooperation and Development. (2013) Action Plan on Base Erosion and Profit Shifting (Paris: OECD).

    SmithJames. (2012) “Issues in Extractive Resource Taxation: A Review of Research Methods and ModelsIMF Working Paper WP/12/287 (Washington: International Monetary Fund).

Theoretical appendix

The theoretical model follows that found in Boadway, Bruce and Mintz (1984), Boadway et al. (1987) and McKenzie, Mansour and Brûlé (1998), with an adjustment to recognize that it takes time to build up reserves with exploration and development before extraction takes place. It is a time-to-build model in the sense capital (reserves) must be created first before being depleted by the firm by extracting the resource to be sold to the market (MacKie-Mason and Mintz, 1991; Mintz and Chen, 2012). The “time-to-build” analysis results in a higher cost of capital for a company since income is earned after spending on exploration and development has taken place with a financing cost. Tax payments are affected since tax deductions for exploration and development expenditures are often expensed prior to income being earned (unless governments restrict deductions to be taken when income is earned, which we have accounted for when relevant). This leads to a mismatching of income and costs for tax purposes. The delay in creating income raises the cost of capital but the deductions taken earlier than when income is earned reduced tax payments and the cost of capital as shown in what follows.

A resource firm maximizes the present value of cash flows from its project subject to the constraint that the extracted resources is equal to the amounts discovered over time. We abstract from uncertainty since its incorporation with full loss offsetting under the tax system would not affect the measure of the marginal effective tax and royalty rates. Let T be the period in which reserves are discovered and prepared for extraction that begins at that time.

V is the present value of the firm’s nominal cash flows CF, discounted by the nominal financing rate R over the lifetime of the firm’s project. The nominal cost of finance is the weighted average of debt and equity finance (R = Bi (1 − u) + (1 − B)ρ) used by the firm for all of its projects, adjusted for the deductibility of interest expense (B is the portion of assets financed by debt, i is the nominal cost of debt and ρ is nominal cost of equity, net of risk with all values expressed in certainty-equivalent terms1). These costs are determined by international markets and can depend on tax planning opportunities.

Note that Pt = nominal price of output normalized to one and rises at the same inflation rate as other prices (Pt = P(1 + π)t) and wtLt are current costs (which we will later denote as C and wt = w(1 + π)t). We note that these costs are equivalent to market prices, abstracting from any transfer pricing issues that is discussed in the text). The marginal productivity of outputs declines with the use of factors of production. Current costs, Ct[Qt,kt], QK and QL, can therefore be treated as a strictly joint convex in output Q (denoted as CQ > 0 and CQQ > 0) and capital that reduces costs (denoted as CK > 0 and CKK > 0) with Kt = depreciable capital stock, kt = new investment = Kt + 1 − Kt and δ = economic depreciation. (Note that CQ = w/QL with profit maximization). Capital is treated as the numeraire with a real price equal to one.

Note that f[et] are reserves found through spending on exploration in period t with the function being strictly concave in expenditure on exploration and development (f’ > 0 and f” < 0).

  • TAXc[t] = company tax payments (paid in each period and can be negative) and

  • TAXR[t] = royalty payments in each period t (only paid after extraction begins).

The company tax is imposed on the revenues earned from the sale of resources net of the costs of production, which include current extraction costs, capital cost allowances and exploration and development costs (exploration is expensed, but development is capitalized and written off at the declining balance rate σ). This implies the following:

Manipulating the terms associated with capital cost allowances and investment, (δKt + kt)(1 + π)t, in equation (A.1) with the insertion of terms in (A.3), (A.4) and (A.5), one can show that the investment costs are reduced by the present value of capital allowances which is denoted as adjusted cash flow CFt:

Next, a typical royalty based on the value of production is analyzed. This is followed by a rent-based royalty following the cash flow approach. Note that “payments” in the exploration and development phase are “negative” if such costs are deductible from the rent base, which will be the case for the rent-based royalty.

Revenue-based royalty

Revenue-based royalties are a percentage of the value of extracted output, and the corporate income tax system allows companies to deduct exploration and development expenses against other income earned. Let τ be the ad valorem payment on sales, PQ, so that TR = τPQ (suppressing time scripts here on in unless needed). Maximizing equation (A.1), subject to (A.2) and (A.2’), choosing L, K, k and E, with appropriate substitutions, yield the following:

Output decision

The choice of Q yields the following result (λ is the Lagrange multiplier for the constraint in (A.2)):

The implied Hotelling Rule by using two first-order conditions is the following:

{(pt + 1 –pt)(1 − τ) – (CQ,t + 1CQ,t)} / {pt(1 − τ) – CQ,t}. = r. The firm extracts output until the net of royalty gain from holding a unit of reserve is equal to financing costs that could be saved by selling one more unit of output.

The shadow price of extracted output λ is equal to marginal value of extracting a marginal unit of output. The royalty rate on ad valorem sales generally reduces quasi-rents and the incentive to extract since the royalty reduces revenues relative to costs of extraction. On the other hand, the deductibility of interest expense from taxable income lowers the cost of finance, r, and increases the present value of the marginal quasi-rent, P(1 − τ) – CQ)). The lower interest rate means that firms need a lower gain in quasi-rents and therefore causes extraction to take place in earlier.

Depreciable capital

The choice of capital stock and new investment, post-exploration and development yields the following cost of capital for depreciable capital:

This is the familiar cost of capital expression, noting that R is the weighted average of the cost of debt and equity finance and Z is the present value of depreciation.

Exploration and development

The choice of exploration and development, e, yields the following costs:

The quasi-rent earned by investing in exploration (PTCT’)ft’ is equal to the interest-adjusted cost of exploration (the price of exploration and development is set equal to unity) divided by the one minus the royalty imposed on the cost of capital. The term in the denominator τP/(PC’) is the ad valorem tax paid as a share of the quasi-rents on incremental sales (this is expected to be less than one so long as the ad valorem tax rate is less than the margin (P – C’)/P). The cost of exploration is reduced by interest deductions taken early at time t relative to the earning of income at time T. Given the deductibility of interest expense from income, the effect of corporate taxation is to reduce the real cost of finance (r) and the discount factor (1 + r)(T – t) resulting in a lower cost of capital (and lower effective tax rate on capital).

Rent-based royalty

The rent-based royalty is assumed to be a rate applied to revenues or payouts net of operating costs after the full recovery of exploration and development costs. This cash flow approach requires both current and capital costs to be expensed. Interest expense is not deductible, but unused deductions, fully written off in later years, are carried forward at the riskless bond rate (the uplift factor).

The royalty payment after payout is the following: TR = τ[PtQtC(Qt,Kt) (1 + π)tKt + kt)(1 + π)tet(1 + π)t], which is substituted into equation (A.3).

Choice of output

The determination of output, Q, accords with the following Euler equation:

implying that only interest deductibility of debt financing costs under the corporate income tax (incorporated in r) affects the extraction decision: {(pt + 1 – pt) – (CQ,t + 1CQ,t)} / {ptCQ,t}. = r.

Depreciable capital

The user cost for depreciable capital is similar to equation (A.9), but royalties directly affect the cost of capital because current costs are deductible from the royalty base. That is, changes in the stock of capital reduce current costs, which are netted from royalty payments.

Exploration and development

The user cost for exploration and development for the cash flow tax is the following:

If the company tax terms are zero (u = 0 and Z = 1), the royalty terms appearing in equations (A.12) to (A.14) disappear. Otherwise, the rent-based royalty is not neutral, as it increases the company tax burden on capital. Government might fully share returns, risk and the cost of investment but not the company tax on marginal investments.

12A.1 Data Appendix: non-tax parameters by country, 2012
CANADA:B.C.,AlbertaSaskatchewanNfld.,N.S.,
Fed-prov company tax rate25%25%27%29%31%
Rent-based royalty: τVarying*Varying**NoneVarying2-tier
* For shale oil only. ** Long-term government bond rate.
U.S.:ArkansasColoradoPennsylvaniaTexas
Company tax rates36.3%35.0%38.6%32.5%
Combined fed-state: Uc = Uf (1 - Us) + Us with Uf = 31.85%
State CIT rate6.5%4.63%9.9%1.0%
Revenue-based royalty: g*17%21%None24%
* This is the combined rate for both severance tax and royalty taking into account deductibility.
Other CountriesAustraliaBrazilNorwayUK
Combined tax and royalty rates30%34%78%62%
Company tax rates30%34%28%30%
Revenue-based royalty: gNone11%NoneNone
Rent-based royalty rate:40%Varying50%32%
AustraliaBrazilCanadaNorwayUKU.S.
Inflation rate: π*3.3%5.1%2%2.1%2.9%2.4%
Commonly shared non-tax parameters
Real cost of debt finance**3.8%
Debt–asset ratio40.0%
Nominal cost of equity finance5.3%
Nominal cost of finance4.9%
Net of tax real return3.4%
Time to build:
Exploration5-year
Development1-year
Time from making investment to payout:
Exploration10-year
Development6-year
Capital weights**
Depreciable assets33.3%
Inventory2.4%
Exploration26.7%
Development37.6%
Aggregate-including E&D100%
* Our estimate based on CPI for 2005–11, published by the World Bank up to 2010 and The Economist for 2011.** Adopted from our Canadian model and applied across-borders.*** It is the sum of the country-specific inflation rate and the cross-border real interest rate.
* Our estimate based on CPI for 2005–11, published by the World Bank up to 2010 and The Economist for 2011.** Adopted from our Canadian model and applied across-borders.*** It is the sum of the country-specific inflation rate and the cross-border real interest rate.
Notes

I wish to thank Duanjie Chen, who assisted with the empirical analysis in this chapter, and participants at the International Monetary Fund conference on “Resources without Borders”, May 2013. I am very grateful for the astute comments provided by Michael Keen and Artur Świstak.

See Laffont and Martimort (2002). As the authors demonstrate, the principal, knowing the most cost-efficient producers, designs a contract to attract the best agent to produce the resource. This requires the government to share some of the rents with the agent.

Some of the analysis in this chapter follows Mintz and Chen (2012).

In this chapter, I shall use the term “royalty” to apply to any type of levy, including profit- or rent-based ones. The alternative approach is to define royalties specifically as a percentage of revenues or a levy on output from the sale of extracted product and resource taxation to refer to both regular taxes and rent-based or profit- based payments to governments for extraction. (See Daniel, Keen and McPherson (2010.)

The Henry report (Australia, 2010) recommended a mining tax on rents based on the cash flow approach. Companies expense costs are deducted from revenues, and any unused deductions are carried forward at the government bond rate. The Henry report recommended that any unused deductions left at the end of the project would be refunded at the cash flow royalty rate to ensure that the government fully shares risks (this is equivalent to giving a full deduction for the cost of risk). See further discussion in Mintz (2010).

This proposition is well known in the literature, which implies that the risk premium from capital asset pricing models is reduced by the factor one minus the tax rate (see Gordon and Wilson, 1989, and Mintz, 1995).

An alternative approach is to model an expected average tax rate based on the assumption that investments are indivisible (such as large-scale projects or ownership of intellectual property). Companies can therefore earn a rate of return on capital that is more than the cost of capital (“economic rent”). Taxing rents across jurisdictions could also impact the decision to invest in large-scale investments (Devereux and Griffith, 2003). To calculate the average tax rate, it requires knowing the pre-tax rate of return on capital net of risk. Empirically, this is virtually unknown, but we do know that firms, even with fixed costs, will intensively invest in assets at the margin when the risk-adjusted rate of return on capital is equal to the cost of capital. Thus, the METRR captures the minimum rate of return or hurdle rate needed by investors to compensate for the cost of capital and taxes.

The 5% rate of return is the after-tax required return for the project to attract financing from shareholders. To be clear, the empirical analysis that follows does not assume that 5% is the after-tax rate of return for a project. Instead, the after-tax required rate of return is based on a modelling of capital market equilibrium for observable interest rates.

Smith (2012) provides a detailed survey on various models used to analyze fiscal impact on investments in extractive industries.

The “time-to-build” analysis results in a higher cost of capital for a company since its income is only earned at a later time. Tax payments are affected since tax deductions for exploration and development spending are taken prior to income being earned when the resource is exploited. The delay in creating income raises the cost of capital, but the mismatch of income and expenses under the tax system provides a tax benefit that reduces the cost of capital.

In this time-to-build model, it is assumed for simplicity that the debt to asset ratio is fixed over time. A more complex treatment of financing is discussed in Mackie-Mason and Mintz (1991).

In these calculations for Alberta oil sands, it is assumed that the price of oil is fixed over time rather than varying. While this simplifies the analysis, varying royalty rates impose greater tax cost on companies since the government-expected revenues increase progressively with profits. On the other hand, companies can take advantage of tax planning opportunities such as investing when royalty rates are high to maximize the value of deductions and holding back investment when royalty rates are low.

Due to lack of data, our analysis does not include unfunded VAT on capital purchases in Brazil, which could have a significant impact on the cost of capital and overall METRRs.

It is an issue that is currently being studied by the G20, with analysis provided by the OECD base erosion study (OECD 2013).

See also Mintz and Tsiopoulos (1994) for a detailed discussion of the cost of finance in the presence of inflation and corporate taxation in the presence of exemption and tax crediting.

Note that this analysis is further complicated with respect to foreign investments under-taken by U.S. companies given that the U.S. is the only major capital-exporting country to tax foreign-source dividends received by U.S. parents. See Chen and Mintz (2009) for further details.

Given the complexity of evaluating different cases, the reader is referred to Chen and Mintz (2009) to see the impact for non-resource companies.

Multiple examples exist. Taking one example, a Canadian parent invests equity in a Barbados international business company that pays tax at a rate varying from 0.25 to 2.5% (the schedule is actually regressive, with high rates associated with lower income). In turn, the Barbados entity loans the funds to a foreign affiliate, where the investment takes place (such as Germany). The Barbados entity receives interest, deductible from German tax, with little Barbados tax paid. Under the Canada-Barbados treaty, dividends are paid to the Canadian company exempt from withholding tax and Canadian tax. If the Canadian parent also borrows to fund the equity transfer to the Barbados affiliate, two interest deductions are possible for one investment in Germany. Many countries, including the United States, which taxes foreign remitted income (with a tax credit for foreign taxes), provide similar opportunities for multiple interest deductions. These tax-efficient structures are limited by thin-capitalization or earnings-stripping rules imposed by capital-importing countries, foreign income taxation by the capital exporter and denial of treaty benefits, resulting in high withholding tax rates.

K. Mullis (2011) provides some description of hybrids and check-the-box rules.

See for example Institute of Fiscal Studies (the Mirrlees Review), Tax by Design, Oxford University Press, United Kingdom, 2011.

In Mintz and Chen (2012), the high discount rates afforded to investments in Australia, Newfoundland & Labrador and Nova Scotia lowered the METRR.

Note that it is assumed that full refundability of losses is provided in this model.

2

For an explicit derivation, see J. Mintz (1990).

    Other Resources Citing This Publication