Australia's Future Tax System

Final Report: Detailed Analysis

Chapter C: Land and resources taxes

C1. Charging for non-renewable resources

C1–3 Replacing current arrangements with a resource rent tax

Recommendation 45:

The current resource charging arrangements imposed on non-renewable resources by the Australian and State governments should be replaced by a uniform resource rent tax imposed and administered by the Australian government that:

  1. is levied at a rate of 40 per cent, with that rate adjusted to offset any future change in the company income tax rate from 25 per cent, to achieve a combined statutory tax rate of 55 per cent;
  2. applies to non-renewable resource (oil, gas and minerals) projects, except for lower value minerals for which it can be expected to generate no net benefits. Excepted minerals could continue to be subject to existing arrangements if appropriate;
  3. measures rents as net income less an allowance for corporate capital, with the allowance rate set at the long-term Australian government bond rate;
  4. requires a rent calculation for projects;
  5. allows losses to be carried forward with interest or transferred to other commonly owned projects, with the tax value of residual losses refunded when a project is closed; and
  6. is allowed as a deductible expense in the calculation of income tax, with loss refunds treated as assessable income.

Recommendation 46:

The resource rent tax should not provide concessions to encourage exploration or production activity at a faster rate than the commercial rate or in particular geographical areas, and should not allow deductions above acquisition costs to stimulate investment.

Recommendation 47:

Existing projects should be transferred into the proposed system with an adjustment, as appropriate, to the starting base for the allowance for corporate capital. The Australian government should set out a time-frame to implement the resource rent tax and provide guidance at the time of announcement on how existing investments and investment in the interim will be treated under the resource rent tax.

Recommendation 48:

The Australian and State governments should negotiate an appropriate allocation of the revenues and risks from the resource rent tax.

Recommendation 49:

The Australian and State governments should consider using a cash bidding system to allocate exploration permits. For small exploration areas, where there are unlikely to be net benefits from a cash bidding system, a first-come first-served system could be used.

Recommendation 50:

The Australian and State governments should abolish fees and stamp duties on the transfer of interests in a resource project except those related to administrative costs.

A uniform resource rent-based tax

The current resource charging arrangements should be replaced with a uniform rent-based tax legislated for and administered by the Australian government (see Recommendation 45). This would enable the community to collect a greater and constant share of the return on its non-renewable resources. It would also promote an efficient level of output by reducing distortions to investment and production decisions as well as reducing sovereign risk over the long term.

In some areas of Australia, legal ownership of certain non-renewable resources rests with the land owner, and private rather than government royalties are charged. Where private royalties are paid to, for example, Indigenous communities, such royalties should continue unaffected. However, consideration would need to be given to how these private royalties and associated resources are dealt with under the resource rent tax.

The resource rent tax would likely involve greater variability in revenue collections than the current resource charging arrangements. This variability should for fiscal purposes be managed through a revenue stabilisation mechanism to smooth revenue over time. In periods of high profitability some of the returns should be set aside so that they can be drawn down during periods of lower profitability.

A cash bidding system should be used to allocate exploration permits, rather than using a work bidding program system or a first-come first-served system (see Recommendation 49). A cash bidding system would complement a rent-based tax by promoting the efficient allocation of exploration permits and collecting upfront any expected rent above the tax.

The cash bidding system would be operated by the relevant jurisdiction and be triggered when an application for an exploration permit is made. Exploration permits would, as now, be well defined and include environmental protection conditions, including clean-up and rehabilitation requirements.

Governments should not provide concessions to the rent-based tax in order to encourage exploration or production activity at a faster rate than the commercial rate or in specific geographical areas, and should not allow deductions above acquisition costs to stimulate investment (see Recommendation 46). Under a cash bidding system, businesses would pay less to purchase exploration permits for frontier areas where commercial discoveries are less likely and other businesses are less willing to explore.

For small exploration areas, where there are unlikely to be net benefits from cash bidding (due to poor prospects of significant competition), a first-come first-served system rather than the work program bidding system could be used to allocate exploration permits.

Setting the rate of the resource rent tax

The rate of the resource rent tax should be set to achieve an appropriate return for the community for the exploitation of its resources.

Taking into account the quality of Australia's natural resources and other location-specific rents, as well as the expected ongoing strength of Australia's terms of trade, the Review recommends that the resource rent tax be levied at rate of 40 per cent on rents from a resource project (see Recommendation 45a).

The payment of the resource rent tax would be a deductible expense for income tax purposes (see Recommendation 45f). This would result in a combined statutory tax rate on rents (at the corporate level) of 55 per cent (including the tax on rents imposed by a 25 per cent company income tax rate, minus an income tax deduction for payment of the resource rent tax). This is slightly less than the combined statutory PRRT rate and current company income tax rate.

If a rent-based tax is levied at a rate of 100 per cent, it would be similar to the government outsourcing exploration and production to private firms — the government would effectively pay all the costs and, in return, receive all the receipts from a project. This would erode the return to resources because there would be no incentive for private firms to make decisions that maximise the return. Further, a very high tax rate would increase the incentive for private firms to minimise tax by understating revenue and overstating costs. It could also lead to viable projects not being undertaken if the amount subject to tax overstates the rent due to the design of the tax law.

The value of the rent from resource production may also include firm-specific rent that arises from production by a particularly efficient firm. This rent is the value that accrues to the private firm (in excess of its expenses) above the value that would have accrued to other firms if they had undertaken the project. A high tax rate may discourage firms with firm-specific rent from exploring and producing resources in Australia where access to capital is limited and may cause them to relocate to countries that undercharge for the exploitation of their resources.

Under a rent-based tax, private firms share their firm-specific rent with the government, and the government shares its resource rents as well as other location-specific rents with the firm. These are shared according to the tax rate. As such, firms decide where to locate by reference not only to the tax rate but also to the amount of resource rent and other factors such as location-specific rents that they gain from locating in a particular country. These other factors arise from existing infrastructure, political stability, policy stability and regulatory certainty. Such features make Australia an attractive place to locate (Fraser Institute 2008).

The nature of the resource rent tax

A rent-based tax with an allowance for corporate capital (ACC) is preferred to other forms of rent-based tax because revenue collections are likely to be more stable and there is likely to be less of a lag before the government receives a (net) payment of tax (see Recommendation 45c). Although the government should be indifferent as to whether it receives a payment soon or a payment later with interest, the delay could create a public perception that the resource sector is not paying an adequate charge for the use of non-renewable resources because projects could be generating significant operating profits but not yet paying tax.

Further, it is likely to be easier for the government to budget for its contribution to expenditure and to audit expense claims under an ACC rent tax because assets are depreciated over time, rather than being allowed as a deduction immediately (as would be the case under a Brown tax).

The ACC base would comprise the resource rent tax value of project assets and unutilised losses associated with a project. A worked example of an ACC calculation is provided in Annex C1 (see Table C1–5).

The treatment of project losses

The economic efficiency and design of the resource rent tax would be improved significantly if a full loss offset were allowed (see Recommendation 45e). Providing a full loss offset means that the government would share in the risks of a resource project in proportion to the resource rent tax rate. This is a marked change from the current royalty arrangements, where the government accepts none of the risk, and from the PRRT, where the government may not accept risk when a project fails.

A full loss offset would ensure a symmetric tax treatment of gains and losses, with the government contributing to costs at the same rate as it shares in receipts. Not providing a full loss offset would lead to the mismeasurement of rent and would discriminate against riskier projects. This would prevent otherwise commercially viable projects from being undertaken and lead to inefficiently low levels of exploration and production.

Not providing a full loss offset would also complicate the choice of the allowance rate, giving rise to distortions in business decision-making. The denial of a full loss offset in the PRRT regime has given rise to a number of concessions and further distortions in the exploitation of offshore petroleum.

A full loss offset can be achieved by allowing the transfer of losses to other commonly owned resource projects or by allowing losses to be carried forward (uplifted at the ACC rate) so that they can be utilised against future income. If losses cannot be utilised against future income in this way, the tax value of residual losses (the ACC base) would be refunded when a project is closed. The ability to transfer expenditure reduces the stress on the full loss offset.

The allowance rate

Under the proposed full loss offset arrangements, businesses should be confident that they would receive the full tax credit for expenses because the tax value of residual losses would be refunded when a project is closed.

An ACC is required to compensate investors for the deferral of the tax credit, which is akin to a loan from investors to the government. The appropriate rate should compensate for the market interest that the government would have to pay for its borrowings, rather than being related to the riskiness of the project. Therefore, where a full loss offset is provided, the ACC rate should be set to the long-term Australian government bond rate (see Recommendation 45c). If a full loss offset is not provided but losses can be transferred, the ACC rate should be set to the average corporate bond rate.

Interaction with company income tax

Resource firms should continue to be subject to income tax on their exploration and production business so that the normal return on investment is taxed in the same way as for other businesses. Otherwise, equity investments in marginal resource projects, which do not generate economic rent, would not pay tax on their normal return.

As well as taxing the normal return on an investment, the company income tax applies to economic rent. To ensure that the combined statutory tax rate on rent is kept at a reasonable level in spite of any mismeasurement of rent, the payment of the resource rent tax should be allowed as a deductible expense in the calculation of income tax. Consistent with this, any refund for losses under the tax should be treated as assessable income in the calculation of income tax (see Recommendation 45f).

To keep the combined statutory tax rate on resource rents collected at the corporate level steady over time at 55 per cent, the resource tax rate should be adjusted to offset any changes in the company income tax rate (see Recommendation 45a). For example, if the company income tax rate is reduced there should be an increase in the resource rent tax rate to ensure that the combined statutory tax rate on resource rent is unchanged.7 This would remove a constraint on setting the company income tax rate. The resource rent tax rate would be determined by the formula:

 

tr =
0.55 − tc
1 − tc

 

where tr represents the resource rent tax rate and tc represents the company income tax rate.

Even with this adjustment, resource companies would still benefit from any future reductions in the company income tax rate as they would be subject to a lower tax rate on the normal return to all their operations and on the economic rent earned in their non-mining operations. Only in relation to rent from a non-renewable resource project would a company not benefit from reductions in the company income tax rate.

Changes to the company income tax base can also lower the community's return from a non-renewable resource. The total tax on resource rent (including company income tax) would fall if items could be deducted for income tax purposes at a value higher than their acquisition costs (such as through an investment allowance). In such cases, it would not be practicable to adjust the resource rent tax rate or base to offset for the concession in the income tax system. If the resource rent tax uses elements of the company income tax rules, any provision that allows an item to be deducted at a value above its acquisition cost should be inoperative in calculating the resource rent tax. This would insulate the resource rent tax from concessions introduced into the company income tax system.

Projects would be taxed separately

The resource rent tax should be calculated for project interests, rather than for each company (see Recommendation 45d). This would disaggregate the company's operations so that rents accruing to other operations would not be subject to the tax. For example, a vertically integrated petroleum company with extraction and refinery businesses would be subject to the tax only on its extraction business.

Setting the taxing point at the project level would also identify the State where the resource is being exploited. This would enable the revenue from the resource rent tax to be allocated on a State-by-State basis, if this is considered appropriate (see below).

In principle, the taxing point should be a sale of resources as close to the well head or mine gate as possible to ensure that only rents from resource extraction are subject to the resource rent tax. Liability would be calculated by reference to the taxable profit of the project (receipts from the sale of the resource minus allowable deductions). Where the resource is sold at the point at which it is produced, the receipts would be the amounts actually received. Where it is not sold at that point, the market value of the resource at that point would need to be attributed, as is the case under the existing ad valorem royalties.

The need to attribute a transfer price can arise if a vertically integrated company both extracts the resource and refines it or subjects it to some further manufacturing process. The bauxite to alumina to aluminium and natural gas to liquid natural gas industries are examples of vertical integration. For integrated companies, transfer pricing requirements would necessarily involve greater compliance costs.

The need to attribute a value may also arise, for example, if the resources were sold 'free on board', with the producer incurring the costs of transporting the resource to port as well as loading costs. The amounts received for the resource would be calculated as actual receipts minus the free on board costs. A number of existing State royalty regimes have similar rules.

There would also be pressure on the resource rent tax from companies engaging in transfer pricing, with both associates and others, to reduce the amount of rent subject to tax. Given the high combined statutory tax rate on resource rents relative to other income tax rates applying domestically, domestic as well as international transfer pricing would be an issue. The existing PRRT legislation includes non-arm's-length integrity rules that deal with attempts to reduce the amount of receipts or inflate the amount of deductible expenditure, with the Commissioner of Taxation able to substitute arm's-length amounts. Similar rules would be required for the resource rent tax.

All project expenditures incurred up to the point where the resource is sold or its value is taxed should be deductible for resource rent tax purposes, including exploration and closing down expenditure. Because the tax value of residual losses would be refunded, a PRRT-style carry-back rule would be unnecessary.

Under the resource rent tax, certain types of expenditure would not be deductible. While requiring further consideration, these would likely include:

  • payments of interest and borrowing costs;
  • payments of dividends and the cost of issuing shares;
  • repayment of equity;
  • payments to acquire an interest in an existing exploration permit, retention lease, production licence, pipeline licence or access authority;
  • payments to acquire interests in projects subject to the resource rent tax;
  • payments of income tax or GST;
  • payments of administrative or accounting costs incurred indirectly with the carrying on of the project; and
  • payments in respect of land and building not adjacent to the project for use in connection with administrative and accounting activities.

The PRRT has similar exclusions.

What resources would be subject to the resource rent tax?

The resource rent tax should be applied to non-renewable resources other than those expected to generate low rent where the administration and compliance costs are likely to outweigh any gains from a rent-based tax (see Recommendation 45b).

The resources that can be expected to generate net benefits to the community from being subject to the resource rent tax are:

  • petroleum (including crude oil, condensate and natural gas, including coal seam gas);
  • uranium;
  • bulk commodities (black coal and iron ore);
  • base metals (gold, silver, copper, lead, nickel, tin, zinc, bauxite);
  • diamonds and other precious stones; and
  • mineral sands.

Whether brown coal should be subject to the resource rent tax merits further consideration.

The State royalty systems provide a useful guide to identifying other resources that may not merit inclusion, by reference to those mineral resources currently subject to specific (volume-based) royalties.8 Table C1–1 lists these minerals, for which the resource rent tax may not be suitable. These resources if excluded could continue to be subject to royalties or other arrangements if appropriate.

Table C1–1: Resources that may merit exemption from the resource rent tax

Barite

Borates

Calcite

Chert

Chlorite

Clays
(bentonite, kaolin, structural
and cement clay/shale clay)

Dimension stone
(granite, marble, sandstone, slate)

Diatomite

Dolomite

Feldspar

Fluorite

Gypsum Halite

Lime

Limestone

Magnesite

Magnesium salts

Marble

Mica

Olivine

Peat

Perlite

Phosphates

Potassium minerals and sands

Pyrophyllite

Quartzite Salt

Sand, gravel and rock

Serpentine

Silica

Sillimanate group metals

Talc

Vermiculite

Wollastonite

Zeolites

The transition to the resource rent tax

Existing resource projects should be subject to the new resource rent tax (see Recommendation 47).

Leaving existing projects outside of the new regime would increase administration costs by requiring multiple schemes operating in parallel. Bringing existing projects into the regime would ensure that the future expansion of existing projects would be treated in the same way as the development of new projects. This is important as a significant part of the expected growth in mining industry output is likely to come from the expansion of existing mines.

The resource rent tax would also apply to projects currently subject to negotiated special royalty arrangements, including those in place for iron ore mines, the Argyle diamond mine in Western Australia and Olympic Dam in South Australia.

Transferring existing projects into the resource rent tax system

A move to a rent-based tax would lower the perception of sovereign risk in the long term as the rent-based tax would be more stable than current resource charging arrangements. However, depending on the transitional arrangements, the transfer of existing projects into the new system may increase perceived sovereign risk in the short to medium term.

Other than to address sovereign risk concerns, the case for providing transitional assistance is far from clear. Legally, non-renewable resources remain the property of the Crown until they are exploited. As a consequence, governments have not in the past compensated resource firms for changes to resource charges. Further, investors can be expected to have taken into account potential changes to resource charges when they made investment decisions.

Governments should also not compensate investors for the change in the value of projects or companies associated with resource rights or expected benefits from future expenditure and investment. To the extent the Australian government decides transitional assistance is warranted, assistance should be directed to recognising previous expenditure and investment.

Any transitional assistance should be delivered by providing a starting ACC base, as deemed appropriate, to recognise investment made at the project level. The starting ACC base would effectively operate as a lump-sum transfer to existing projects and consequently would not distort subsequent production decisions (see Recommendation 47). For example, the starting ACC base for PRRT projects could be set equal to the value of carried-forward expenditure.

While it is generally desirable to provide a full loss offset, it may not be appropriate for losses to be refunded or transferred where they are associated with past expenditure recognised in the starting ACC base. This is because fully refunding losses on past expenditure may create an incentive for firms to report expenditure incurred for projects that have already failed. As such, losses arising from past expenditure should be quarantined from other losses and would not be refundable.

Transitional relief should not be provided through adjustments to the tax rate or other design features, or, in general, by providing a period of grace for existing projects. Such approaches would distort investment and production decisions or compromise the long-run improvement in the community's return from non-renewable resources.

The Australian government should set out a time-frame to implement the resource rent tax and provide guidance at the time of announcement on how existing investments and investment in the interim will be treated.

The resource rent tax and the States

Where State royalties are replaced by the resource rent tax, the Review recommends that the allocation of the revenues and risks from the tax be negotiated between the Australian government and the States (see Recommendation 48).

State royalty collections were $4,756 million in 2007–08. Western Australia (52 per cent), Queensland (29 per cent) and NSW (12 per cent) raise most of the States' royalty revenue. The other States contributed only 7 per cent to the aggregate. The States' apparent reliance on mining royalties also varies, with Western Australia the most reliant (22 per cent of total State revenue), followed by the Northern Territory and Queensland (both 9 per cent). However, the horizontal fiscal equalisation process takes into account the differences in revenue-raising capacities between the States in the distribution of GST revenue (see Section G2 State tax reform). As such, all States effectively share, over time, in total resource royalties.

Options for dealing with existing State royalties on resources that would be subject to the resource rent tax include replacing State royalties or applying State royalties in parallel, with royalties credited against the resource rent tax.

Option 1: Replace State royalties and assign resource rent tax revenues to the States

Revenues could be allocated in proportion to each State's share of gross resource rent tax receipts calculated before the transfer of losses from non-tax-paying projects. This would ensure that a State's share of net revenues is not diminished because of loss-making projects in another State. Transitional arrangements could be considered to help the States manage the impact on their revenue flows of moving away from royalties.

The horizontal fiscal equalisation process would, as now, eventually achieve a more equal distribution of these resource revenues between the States.

The resource rent tax would promote efficient production and would not impose additional compliance and administration costs associated with running two systems in parallel. Each State would continue to receive a share of the revenue that reflects activity in its jurisdiction, though that revenue could be more variable and less certain than now.

Option 2: Apply State royalties in parallel, with royalties credited against the resource rent tax

If the States place a premium on certainty as to their future revenues, their existing royalty regimes could be kept in place. A firm subject to both the resource rent tax and a State royalty would be entitled to a credit for the royalty against the total liability for the tax. If in a period the credit exceeded the resource rent tax liability, the excess would be refunded.

Under this option, the States would continue to receive the revenue stream from their royalty arrangements and could be expected to benefit from increased production due to the efficiency gains from the resource rent tax. The Australian government would take on revenue risks, but benefit from the expected long-term net revenue gain. Because the State royalty payments would be creditable — and, where required, refundable — State royalties would not bias investment decisions. For example, decisions to keep a marginal mine open would have no regard to the cost of the State royalty payment.

The State royalty regimes would need to be fixed at a particular point in time to ensure that the Australian government does not automatically fund future increases in royalties.

While this arrangement would realise the efficiency gains of the resource rent tax, the net gains would be tempered by the compliance and administration costs of running dual regimes. A variant to address this downside would be to remove the need for firms to pay royalties. Instead the Australian government would make regular payments to the States based on notional royalties applied to State-based production data. This option would then be akin to Option 1, but with a different allocation of revenues and risks between levels of government.

Under this option, existing Australian government tax regimes would be replaced.

Abolish inefficient stamp duties and fees

The Australian government and the States should abolish fees and stamp duties on the transfer of interests in a resource project except those related to administrative costs (see Recommendation 50). These stamp duties and fees erode the value of resource rent available for the community because they inhibit the transfer of interests to the most efficient firm.


7 Flexibility could be required as the company income tax rate transitions from 30 per cent to 25 per cent (see Recommendation 27, Section B1 Company and other investment taxes).

8 Although bauxite is subject to a specific royalty in Queensland ($1.50-$2.00 per tonne), it is subject to an ad valorem royalty in Western Australia (7.5 per cent), and the value of resource rents can fluctuate as it is a globally traded commodity.