5 steps to better mining taxes

The last few years have brought an uptick in the number of mining investments that have been the subject of disputes between investors and governments. This trend is of considerable concern to the players in the sector across the globe.

Yet, there is a wealth of wisdom to be—pardon the pun—mined from the literature over the past few decades in an attempt to distill what the main risk factors are in agreements that govern investments in the sector, with specific focus on taxation regimes.

Number of Expropriatory Acts by Sector – three-year rolling averages

Source: Chris Hajzler (2010), “Expropriation of Foreign Direct Investments: Sectoral Patterns from 1993 to 2006,” University of Otago in MIGA,World Investment and Political Risk 2011

For the purpose of MIGA’s analysis that follows, we worked with a few assumptions/definitions:

• Players in this space represent a government, a community, and a mining company.
• The ultimate goal is a stable and credible tax regime that appropriately and fairly distributes mining profits among players.
• There are significant challenges given the long life-cycle of mining investments and volatile, inherently unpredictable returns. The players cannot control commodity prices or global trends like demand and supply.

Indeed, this is very complex, inter-temporal game with a high degree of uncertainty and changing payoffs.   Moreover, expectations are often extremely polarized. This statement from a 2007 World Bank study on mining royalties is telling: “In matters of mining taxation, governments rarely believe that companies pay too much tax; companies rarely believe that they pay too little tax; and citizens rarely believe that they actually see tangible benefits from the taxes that are paid.”

Given these barriers, we undertook some analysis to better understand potential red flags when it comes to mining tax regimes and—more specifically—to determine potential risk factors in mining tax regimes that can lead to disputes. These are the flags we found:

Red Flag #1 – A rapid increase in commodity prices. This is a principal factor in the initiation of renegotiations by governments aimed at achieving a new “fair share” equilibrium.  However, whether rapid increases result in successful fiscal renegotiations depends primarily on the strengths of
a country’s institutional framework and capacity, as well as its stage of economic development and legal system.  Caution is advised when deals are struck at the bottom of the commodity price cycle.

Red Flag #2 – Lack of Progressive Taxation. The general current consensus is that a mining tax regime should be progressive in order to be stable and credible. If the tax regime allows the government to capture an increased share of rents in the case of high windfall profits, it will be more resilient to changing circumstances. As argued by the IMF: “No regime is ideal for all, but for low-income countries, combining a modest ad valorem royalty, corporate income tax, and resource rent tax has considerable appeal. The first one ensures some revenue whenever production is positive, the second one ensures that the normal return to equity is taxed at the corporate level in the mining sector as in other sectors, and the last one exploits the distinct revenue potential of the mining sector.”

Red Flag #3 – Overly generous fiscal incentives. There tends to be an inverse relationship between generous fiscal incentives offered to investors and the stability of the fiscal regime. This is primarily because after investments are sunk (and become hard to remove without incurring large losses) the bargaining power switches to the government, which may then seek a renegotiation of terms, especially during commodity price booms. Therefore, tax holidays and other generous incentives usually are not needed, and may even have a deleterious effect in the long run.

Red Flag #4 – Lack of stability and credibility. In countries where the legal and sector regulatory frameworks are weak, bilaterally negotiated contracts fill the regulatory gaps. Such bespoke contracts tend to be very complex, which increases the scope for misinterpretation and the likelihood that they are subject to special negotiations. Governments are encouraged to move from bilaterally negotiated contractual arrangements towards a more generic mining tax code.

Red Flag #5 – Lack of transparency and accountability mechanisms. The IMF sums this issue up well: “Public knowledge and understanding of fiscal terms and amounts paid by mining companies reduce the risk of misplaced political pressures and build public support for, and hence credibility of, those terms. Expectations and requirements have risen considerably in recent years, especially in the extractive industries—notably with the Extractive Industries Transparency Initiative.”

It is important to emphasize that this list of red flags is not comprehensive, as there are many other factors in this mining game that can lead to disputes and renegotiations. For example, one important issue not addressed here is how revenues are distributed, and perceived to be distributed, among the company, national and sub-national governments, and any affected communities.

There are also concrete risk-mitigation tools, such as political risk insurance, that aim to reduce the risk profile of mining investments, increasing the probability of a better risk-weighted return for all players. MIGA not only provides such political risk insurance, but also works in collaboration with World Bank Group colleagues and investors to help structure transactions in ways that benefit all parties.

Last, I want to thank Aibek Ashirov, Senior Economist & Head of Division for the Monetary Operations Department at the National Bank of Kyrgyz Republic, for his invaluable contribution to this research during his work with MIGA this summer.

This post first appeared on the World Bank Blog

Author: Paul Barbour is a Senior Risk Management Officer in the Economics and Policy Group of MIGA, the political risk insurance arm of the World Bank Group.

Image: An aerial view shows pools of mineral-coloured water gathered on salt flats in holes dug by salt collectors on the Senegalese coastline near the border with Gambia June 12, 2006. REUTERS/Finbarr O’Reilly