Policymakers should be careful what they wish for, says this Gold Mining analyst...
NOW IN THE MIDST of a boots-on-the-ground survey of Australian precious and specialty metal projects, The Emerging Trends Report's Managing Editor, Richard Karn took time between mine site visits to share his insights about the controversial Resource Super Profits Tax that's pending Down Under with The Gold Report...
The Gold Report: As an American involved with the Australian Gold Mining and minerals industry, can you give us an overview of the Rudd government's proposed Resource Super Profits Tax (RSPT)?
Richard Karn: Certainly, but from the outset keep two things in mind. First, the tax scheme is very complicated. Some details are murky and seem to conflict with others in a number of ways. Secondly, the mining industry itself has argued for streamlining the existing system, which entails companies paying as many as six or seven different state or territory royalties on the minerals they extract. Apparently, they were prepared to pay a higher tax for a simpler system. They did not, however, expect the tax reform the Labor government wants to implement, which the Conservative Party is now calling Prime Minister Kevin Rudd's "great big new tax".
TGR: Sounds like a case of "be careful what you wish for..."
Richard Karn: Exactly. In essence, the RSPT has been derived from aspects of the Henry Tax Review and, if passed, it will apply to all existing and future non-renewable resource projects beginning July 1, 2012.
TGR: Who is Henry?
Richard Karn: Treasury Secretary Dr. Ken Henry chaired the review panel formed when the Rudd government established Australia's Future Tax System Review in May of 2008 to examine Australia's tax and transfer system.
TGR: Without getting into every nut and bolt, what is the RSPT basically about?
Richard Karn: It has four basic tenets. First, profits derived from Australia's non-renewable resources in excess of the rate of return from the 10-year bond (currently 5.7%) will be taxed at 40%. Let me point out that this is in addition to the existing 30% corporate tax and royalty structures.
The tax will not be collected on individual mining projects until the project becomes profitable; in the event of a loss on the project, the federal government guarantees to credit mining companies for 40% of the extraction costs – but not until the government has determined that the expenditures could not be carried on to another project.
Current state and territory royalty arrangements would remain in place, which mining companies will be required to continue to pay, but the federal government will issue rebates of a corresponding amount to offset the royalties. When RSPT takes effect, the rebate probably would be sufficient to offset the royalty rate; but there's nothing to prevent states and territories from increasing their royalties in the future.
TGR: How would they use the tax revenues?
Richard Karn: The federal government expects to make about A$12 billion over the first four years after the tax is introduced and plans to direct the revenues toward several things. It intends to increase the compulsory superannuation (retirement program) contribution by working Australians from 9% to 12% over seven years, and to provide low-income workers with as much as A$500 a year to supplement their superannuation. The government also says it will reduce the corporate tax rate from 30% to 28% over two years, and create an A$700 million fund to boost resource-related infrastructure around the country in the first year.
TGR: Which issues are the most contentious?
Richard Karn: First, let me make a brief disclaimer. We are guests in Australia and have been treated very well by everyone we have come in contact with during the four months we've been investigating precious and specialty metal projects. Our approach is predicated on the notion that many of these companies have significant resources but are not well-enough capitalized to put together road shows to North America or Europe to bring their projects to the attention of investors there. We are, thus, in a position to help each other; and we don't want to jeopardize this relationship by being seen as outsiders editorializing on the Australian political system.
That being said, in addition to a couple peripheral matters, the three most contentious issues are 1) the 5.7% threshold at which the 40% RSPT is levied, 2) the retrogressive nature of the tax, and 3) the manner in which the administration is trying to force mining companies to make the government a 40% partner in resource projects.
TGR: Okay, would you address those issues one by one?
Richard Karn: The ascendance of Australian mining over the last three decades is attributable to previous administrations, Labor and Conservative alike, embracing policies that encouraged competition. Those policies fostered an environment in which mining companies could attract the capital investment needed to put remote, high-risk, very difficult projects into production. A significant portion of this capital originated overseas, and the investors put up only the capital for the chance of reaping large profits.
The RSPT would vault Australia from its current 38% cumulative tax rate to more than 55% and into the dubious position of having the second-highest mining taxes in the world behind Finland. According to Citigroup, Australia's tax rate would rank well ahead of the USA's 40%, Brazil's 38%, South Africa's 33%, Peru's 32%, China's 30%, Russia's 30%, Chile's 26% and Canada's 23%. All things being equal, capital tends to go where it is treated best, which makes it hard to imagine that the new tax regime would help raise domestic or foreign capital investment in Australian resource projects.
Policymakers don't seem to appreciate that the A$202 billion mining industry – which contributed 18% of GDP and accounted for 42% of total exports last year – has itself been relying on a 17% annual growth rate in foreign direct investment to make its fabulous growth possible. Incidentally, that foreign direct investment amounted to A$92 billion in 2009.
Further, the notion that an extractive project earning profits in excess of 5.7% constitutes a "super profit" appears not to consider the fact that no company would take on the kind of risks these projects entail for that kind of pre-tax return. It would be significantly below the cost of capital needed to undertake the project.
The cost of capital today is roughly 8% for the majors, capital may run as much as 13% to 14%; but a greenfield development, which carries an even higher-risk premium, would pay more along the lines of 16% to 18% for capital. Combined with other aspects of the tax, this essentially would put many projects underwater from the get-go.
TGR: And if a major company as big as Macarthur Coal pays 15% for its capital, small companies will pay considerably more.
Richard Karn: Some critics suggest that the academics, economic modelers and politicians behind the RSPT seem to believe the expertise to develop massive Gold Mining and diversified projects, such as Olympic Dam, is widely available. They figure that if the BHP Billitons and Rio Tintos of the world won't develop Australia's vast but remote resource wealth, an army of Andrew Forrest-like entrepreneurs waiting in the wings will. And they apparently assume that banks will develop loan products at little more than the 10-year bond rate.
A number of commentators have pointed out that it's as if the Rudd government formulated the RSPT in a vacuum, seemingly unaware that the cost of capital is increasing at the same time its availability is decreasing – in itself a foreboding prospect. Because decisions about which projects to develop or fund are based on what promises the greatest after-tax returns, the RSPT significantly undermines the attractiveness of a whole range of projects.
As it stands, it appears that roughly A$275 billion worth of mining projects are on hold simply because long-term investment assumptions cannot presently be factored into their risk/reward models. Very few financings will get done until RSPT details are ironed out and the matter is resolved.
TGR: That's what Graham Frank at Ernst & Young meant when, last month, he wrote that Australia is "at risk of killing the goose that laid the golden egg" with the RSPT.
Richard Karn: Some claim the RSPT wants to cook the goose's ancestors, too.
TGR: Which brings up your second contentious point – that the tax is retrogressive.
Richard Karn: Yes. They claim the retrogressive aspect makes the tax both punitive and likely to discourage future investment in Australian resources. It introduces policy instability and ex post facto taxation to long-term investment decisions that were made under an entirely different set of sovereign-risk and tax assumptions. That amounts to reneging on an agreement.
The combination of this retrogressive aspect and mining companies having to take on the government as a partner leads some people to refer to the RSPT as a 'resource nationalization ploy.' The retrogressive tax sets a precedent that, in and of itself, will stifle foreign direct investment.
TGR: How so?
Richard Karn: It introduces the possibility that the risk-reward parameters can change materially during a project's lifetime at the apparent whim of whichever administration happens to be in power – potentially undermining a project's profitability and continued economic viability. As a result of all of this, at least one financial institution now ranks Australia on a par with Indonesia in terms of sovereign risk.
TGR: You've mentioned having the government as a partner in mining projects. Can you explain that for our readers?
Richard Karn: The idea of a resource rent tax was developed by American Economist Cary Brown in 1948 and stipulated the government would supply the cash for its share of a resource project – not, as is the case with the RSPT, to essentially require mining companies to lend the government its 40% share, which would be repaid to miners over time via tax concessions at the 10-year bond rate. The RSPT amounts to demanding that a mining company lend money to the government at a rate significantly below what a company pays to borrow capital itself.
Further, Larry Summers, President Obama's chief economic advisor, wrote a paper in the 1980s concluding the hurdle rate for assessing US firms' resource project viability far exceeded their cost of capital – in fact often requiring twice that much. Thus, this de facto loan to the government for its share of the project would constitute a material expense. The notion that the government will cover 40% of the losses incurred in a project with credits, rather than contributing development costs, is such a hollow promise that some financiers view it as an incentive to fail. They would attach zero value to it in their loan decisions, simply because it is unlikely any of the guarantee would find its way back to them.
TGR: What's the story with those credits?
Richard Karn: The government has guaranteed to credit mining companies if they have a loss on a project. But there's a catch. The credit – 40% of the firm's extraction costs paid over time at the 10-year bond rate – will not be paid until the government determines the expenditures could not be carried over to another project.
TGR: You mentioned a couple of peripheral issues, too. What are they?
Richard Karn: State and territory royalty programs now account for roughly $1 of every $9 of pre-tax mining profits, just as they have for about a decade. By and large, royalties are ad valorem – or levied on the value of the resource extracted, so the Dollar value has increased in lock-step with commodity prices.
Many people consider this to be an RSPT in itself, and it's understandable that states and the Northern Territory are loath to relinquish control of such substantial sums of money. In fact, they may have a Constitutional defense for not relinquishing that control. The RSPT also wants to broaden the scope of what is taxed to include both the resource extracted and the value added in logistics, processing and smelting; but it is difficult to conceive under what circumstances 'the people' Mr. Rudd constantly purports to defend would have a right to a share of such capital investments in a capitalist system.
Further, because they could not agree with the states and Northern Territory on the issue, the Rudd administration proposes to levy the new tax on top of the state royalties, and then to give mining companies a rebate for state royalties. Ironically, this would further complicate the system rather than streamline it; it would create a whole new layer of bureaucracy to deal with compliance issues.
More than one pundit has quipped that soon mining companies will employ more accountants and lawyers to deal with compliance issues than miners to extract resources.
TGR: What else do you find troubling about the RSPT?
Richard Karn: Admittedly, I'm a bit cynical these days; but the RSPT being announced during the height of the European sovereign debt crisis I find highly suspect, because history has borne out FDR's comment: "In politics, nothing happens by accident. If it happens, you can bet it was planned that way."
It turns out the Rudd administration had the Henry Tax Review in its possession since December 2009, which moved to circumvent its own campaign promises regarding the use of public money for political advertising purposes by arranging for a A$38 million television campaign in support of the RSPT well in advance of the announcement. They also chose the very time that markets everywhere were under significant pressure from the sovereign-debt crisis to announce what many suggest are the most sweeping changes in Australian economic history. Clearly the administration knew the RSPT was going to adversely affect the Australian Dollar, stock market, foreign capital investment and superannuation accounts, because they made a frantic attempt, initially, to attribute the effects of the RSPT announcement to the sovereign-debt crisis – this despite the Australian Dollar and stock market falling far more dramatically than any other developed country, including both its resource-producing peer Canada and the European markets at the epicenter of the crisis.
TGR: Any other peripheral issues you'd like to discuss?
Richard Karn: Only that the RSPT seems apt to have unintended consequences.
Mining projects are not light switches that can be thrown on and off; sometimes billions of Dollars are spent just to get a project ready to go into production. Right now, the majority of project funding has been frozen until some kind of decision is reached. Because the RSPT will not be debated until after the Federal election, slated for September or October, it is creating a gap in the continuity of Australian projects coming onstream to meet global mineral demand. And when a decision is eventually reached regarding changes to the tax regime, all of the projects currently in limbo will have to go back to square one and restart feasibility studies and the like based on the new parameters.
This means the RSPT has effectively slammed the door not behind companies operating today, but in the face of companies trying to go into production tomorrow. It can be argued that the uncertainty surrounding the RSPT has, itself, raised significant barriers to entry for both exploration and upcoming development projects, because funding will not be forthcoming in the current environment. Companies that are cashed up, free of debt and in production now may, in fact, be provided with competitive advantage in that they have to opportunity to act while others do not. The longer the issue remains unresolved, the weaker the companies in the latter group will become – rendering them increasingly vulnerable to acquisition at a discount.
TGR: Is your hunch that RSPT will be the law of the land soon?
Richard Karn: My opinion, which $5 will buy you a cup of coffee, is that the RSPT will not stand in its current form. I think either a significant compromise will be reached, or the RSPT will be voted down in the Senate. But until the issue is resolved, we think the best way to proceed is to tighten our screening criteria further; it is clear that we cannot recommend precious and specialty metal companies whose projects are unfunded or underfunded at present, regardless of their potential.
TGR: So you have no plans to cancel your circumnavigation of Australia?
Richard Karn: No. The damage to Australia's reputation, currency and stock markets by the less-than-optimal way in which the RSPT was framed and introduced – the impact of which we believe was compounded by its poor timing – will be only a temporary affliction. Barring an outright global economic collapse, demand for base metals, and gold, will not abate significantly. Most are price-inelastic and have no substitutes in a range of primary applications. If anything, the RSPT will contribute to a shortage of these metals and correspondingly higher prices by slowing the development of Australian projects.
Eventually, though, the market will recognize that precious and specialty metal companies that are in production today – and have the cash flow to expand production tomorrow – should command a premium. The pullback that has been exacerbated by the introduction of the RSPT affords long-term investors the opportunity to pick up a number of excellent companies at a significant discount.
TGR: This has been really informative, Richard. Thank you so much for your time and insight.
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