- Tax avoidance is a major risk for developing countries collecting revenue from natural resource extraction, but it is not currently considered a core principle of resource tax design. - There are some potential reasons why tax avoidance has not been elevated as a principle, such as that it relates to tax administration, but times have changed with increased commodity trading and developing country losses from tax avoidance. - Elevating tax avoidance as an explicit aim and applying tools like reference class forecasting to model behavioral responses could help address this missing principle in resource tax system design.

1. The Missing Principle of
Resource Tax Design
Alexandra Readhead
ICTD Seventh Annual Meeting
Rwanda, February 7, 2019

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. 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. 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. • 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. Tax avoidance is a widely acknowledged problem.
But it is not a core principle of resource tax design.
The missing principle

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. • 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. • 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. • 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. 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. 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. 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. 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. • 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. • 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. 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. 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. 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. 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. 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. 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. • 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. • 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. • 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. 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. • 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. 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. “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. 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. Thank You!
Want more info on the IGF-OECD project on BEPS issues in mining?
Go to: https://bit.ly/2Tz4iiB