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ICTD Annual Lecture: The Missing Principle of Resource Tax Design

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Keynote lecture by Alexandra Readhead, International Taxation and Extractive Industries Consultant, at the 7th annual ICTD meeting in Kigali on February 7th 2019.

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ICTD Annual Lecture: The Missing Principle of Resource Tax Design

  1. 1. The Missing Principle of Resource Tax Design Alexandra Readhead ICTD Seventh Annual Meeting Rwanda, February 7, 2019
  2. 2. • Income from natural resource endowments is substantial for many economies, frequently accounting for more than half of government revenue (IMF, 2011) • Mining is the dominant earner of export revenues in many developing countries (ICMM, 2014) • Corporate tax avoidance is a risk for mining revenue collection (IMF, 2017) Assumptions
  3. 3. Many papers identifying channels and estimating magnitudes: • Cross-border transactions (IMF, 2017; UN 2018) • Profit shifting in the oil and gas sector (Leoprick & Beer, 2015) • Common pathways to revenue loss (Hubert, 2017) • Transfer pricing (Guj, 2017; Durst, 2016; Readhead, 2017) • Country-specific e.g. Malawi – Paladin mine (Action Aid, 2015) How big a risk?
  4. 4. Risks to revenues framework Taxrates Tax breaks • Tax incentives • Tax holidays Treaty shopping • Withholding taxes • Capital gains tax Taxbase Under-reported project revenues • Production volumes • Sale price Over-reported project costs • Ineligible costs • Misallocated costs • Inflated goods and services • Debt financing How big a risk? Source: Hubert (2017)
  5. 5. • Excessive interest deductions, approx. $380 mn - Chevron v. Australian Tax Office • Profit shifting via marketing commission, approx. $245 mn - BHP vs. Australian Tax Office • Re-structuring to avoid capital gains tax, approx. $404 mn - Heritage Oil v. Uganda Revenue Authority • Alleged under-pricing of mineral sales, approx. $1.8bn - Cameco vs. Canadian Revenue Authority Real world cases
  6. 6. Tax avoidance is a widely acknowledged problem. But it is not a core principle of resource tax design. The missing principle
  7. 7. Frameworks for resource tax design Garnaut and Clunies-Ross Daniel Baunsgaard Daniel et al. 1983 1995 2001 2010 o Neutrality o Stability o Investor risk o Maximum-rate test o Adaptability o Government-risk o Delay o Imposition o Administration + Tax credit eligibility + Fiscal loss + Revenue raising potential - Imposition and administration + Interaction between criteria Same criteria
  8. 8. • Neutrality: the tax system does not, of itself, divert investment, or alter the order of projects. ▹Not an appropriate yardstick for royalties (Conrad, 1990) • Stability: likelihood that fiscal terms remain unaltered during the life of the project (investor risk) (Garnaut, Baunsgaard) ▹Prioritise high correlation between the tax burden and RoR. ▹Link between progressive taxes and instability? (Conrad, 1990) What do selected principles mean?
  9. 9. • Timing: avoiding undue delay of receipts. ▹“…probably the least important” objective (Garnaut, 1983) ▹LDCs strongly prefer revenue upfront (Baunsgaard, 2001) • Revenue raising potential: capacity to tax as much of the rents as is compatible with the desired level of investment. ▹Government will want to maximise revenue (Garnaut, 1983) ▹Not a principle of optimal tax design (Mirlees, 2015) What do selected principles mean?
  10. 10. • Administration: the cost and difficulty of enforcing a tax. ▹“…less vital except in special circumstances” however “generally problem are superable” (Garnaut, 1983) ▹Secondary to broad economic objectives (Calder, 2014) ▹Tax avoidance is a potential consequence of complex taxes. (Baunsgaard, 2001) What do selected principles mean?
  11. 11. 1. Fiscal Analysis of Resource Industries (FARI) modelling tool: “…the model assumes full efficiency of revenue collection, no international tax planning” *Starting to be used for tax administration. Not just academic – real world impact
  12. 12. 0 5 10 15 20 1980 1985 1990 1995 2000 2005 2010 2015 2017 2. No. of countries that apply a resource rent tax* Source: Land (2010) and author. *Those listed on the chart are developing countries according to UN classification. Ghana Tanzania Madagascar Namibia Zimbabwe Angola Solomon Islands Timor-Leste Malawi Liberia Sierra Leone Commodity super- cycle starts Not just academic – real world impact
  13. 13. Despite the potential downsides – “If a tax office [is not capable of imposing income tax on resource businesses consistently and effectively] then a move to resource rent taxation could represent a significant additional administrative burden and create considerable additional risks of tax leakage.” (Land, 2010) Not just academic – real world impact
  14. 14. Tax avoidance is a widely acknowledged problem. But it is not a core principle of resource tax design. Is there a good reason why? The missing principle
  15. 15. • Captured by the other principles? • Ease of administration? Fiscal loss? • Related but not exhaustive; different indicators and responses. • Times have changed • Intra-group commodity trade has grown from 41-62% since 1990 (UNCTAD) • LDCs’ losses from BEPS exceed $200 billion annually (IMF, 2015) • A secondary objective • Tax avoidance (like administration) is only relevant if there is investment • Logic in reverse: investment is only relevant if taxes are collected. Possible reasons
  16. 16. • Not a principle of optimal tax theory • Resources require different treatment… • big money in absolute and relative terms • finite, non-renewable • …as do developing countries • Tax avoidance relative to GDP is greater in non-OECD countries (Crivelli, 2016) • Measurement difficulties • E.g., modelling relationship between rates and admin costs (Heady, 1993) Possible reasons
  17. 17. Tax avoidance is a widely acknowledged problem. But it is not a core principle of resource tax design. Is there a good reason why? Not really. So what should we do about it? The missing principle
  18. 18. Minimising the risk of tax avoidance • Tax avoidance: vulnerability to tax planning. • Legal (rather than illegal) methods to pay less tax; • Includes international and domestic tax planning.
  19. 19. Neutrality Investor risk Government risk Implementation Efficiency Stability Project risk Loss Flexibility Delay Tax abuse Design Administ ration Tax credit Fixed fee -3 -3 -2 +3 -2 +3 +3 -2 +2 -3 Royalties -3 -1 -1 +2 -1 +3 +2 to -1 -1 +1 -3 CIT -1 +1 0 0 +1 +2 -1 +1 -1 +3 Progressive profits tax +1 +3 +1 0 +2 +1 -2 +2 -2 0 Resource rent tax +2 +3 +2 -2 +3 -1 -3 +3 -3 -2 Production sharing -1 +1 0 0 +2 +2 0 to -1 +2 -2 -3 Paid equity +3 -1 +3 -3 +3 -2 +2 +3 +3 0 Carried interest +2 +3 0 +3 +3 -3 +1 +3 +1 +1 Ranking taxes on risk of avoidance Source: adapted from Baunsgaard, 2001. +3 indicates the best performance and -3 the worst performance
  20. 20. Main issue: turnover vs. net income Tax on turnover Tax on net income Fair market value of ore 100 100 Annual operating expenses - 80 Royalty (10 percent gross) 10 - Taxable profit - 20 CIT (50 percent) - 10 Below-market value of ore 92 92 Royalty (10 percent) 9.2 - Taxable profit - 12 CIT (50 percent) - 6 Revenue loss 0.8 4 Source: Durst 2016
  21. 21. More specifically Type Possibilities for avoidance Rank Volume • under-reporting of production • may miss valuable by-products +2 Value • value may be understated • complex quality adjustments • cost inflation +1 Price • same as value-based risks • if using an aggregate structure there may be an added incentive to under-report 0 Profit/ income • cost inflation • “net profit” is ellusive (Harries, 1996) -1 • Royalties (+2 to -1) Source: Otto (2006) and author’s assessment.
  22. 22. 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 0 250 500 750 1,000 1,250 1,500 1,750 2,000 Effectiveroyaltyrate Gold price, $/oz Incremental Aggregate More specifically • Price-based royalties – aggregate versus incremental
  23. 23. • Production sharing (0 to -1) • If there is a joint venture, internal checks may limit the risk of shared costs being inflated (Calder, 2017) but partner-level costs remain a risk (Readhead, 2017). • If no JV the risk of avoidance is similar to CIT. • Carried equity (+1) • There is an incentive to shift profits via inflated related party costs to compensate for carrying the state’s share. More specifically
  24. 24. • For example, the IGF tax incentives financial model • Introducing potential behavioural responses Modelling for tax avoidance 1. Model the direct cost of a tax incentive 2. Plus any additional revenue loss associated with the investor’s behavioural response
  25. 25. • Optimism bias means that people underestimate the costs, and risks of planned actions, and overestimate the benefits of those same actions (Kahneman, Tversky, 1979) • Reference class forecasting is a method that predicts the future, through looking at past situations and their outcomes. • Widely used in other areas, such as cost overruns in megaprojects by Bent Flyvberg. Reference class forecasting
  26. 26. How RCF might work for extractives RCF Steps Example for extractives 1. Identify a reference class of past, similar projects. Corporate income tax (CIT) as applied to mining projects in developing countries. 2. Establish a probability distribution for the selected reference class for the parameter that is being forecast. Model CIT for as many fiscal regimes as possible (checking estimates against actuals, reconciling for differences). Measure the extent to which previous estimates turned out differently; establish the probability distribution. 3. Compare the specific project with the reference class distribution, in order to establish the most likely outcome for the specific project. Adjust the CIT parameter down by X% on the basis that this is a peer regime (project) allowing comparison.
  27. 27. • RCF uses a purely empirical approach – inductive reasoning; • Difficult to conclusively pinpoint the reasons, or allocate weightings between different reasons for the tax gap; • Adding any sort of tax gap analysis is an improvement on current modelling practice. Some limitations of RCF
  28. 28. 1. Minimising tax avoidance is elevated from a secondary concern to an explicit aim of resource tax design, and technical assistance; 2. The trade-off between production efficiency and revenue collection is more stark in the choice of tax instruments; 3. Alternative tax policy proposals may be given more weight • Sixth method / norm pricing (Durst, 2016; Readhead, 2017) • Unitary taxation (Picciotto et al., 2015) • Price-based royalty vs. resource rent tax (Durst et al., 2015; Manley 2017) Would my proposal change anything?
  29. 29. “In the near future the need to shift to fossil-free energy will increase the demand for minerals and metals considerably.” (World Bank 2017). It’s not over yet for resource tax design
  30. 30. Tax avoidance is a widely acknowledged problem. But it is not a core principle of resource tax design. Is there a good reason why? Not really. Let’s introduce and apply it! Conclusion
  31. 31. Thank You! Want more info on the IGF-OECD project on BEPS issues in mining? Go to: https://bit.ly/2Tz4iiB