Mining Tax and VAT Reform in Mongolia – Kerver
Purpose of Mining Tax
While compulsory payments such as “royalties” paid for the right to extract and sell mineral resources are often labelled a “tax”, from a design point of view, it is more useful to recognise their economic function rather than their legal form. A mining tax is simply the price charged by a country for the sale of mineral resources that belong to the country. The owner of the resource (Mongolia in this case) sells it to an intermediary (the mining company) that in turn sells it to customers who use the resource to make various types of metals or who use it in their business (for example, burning coal). In return for a payment, the country sells the resource to a mining company and, because the resource it is selling lies beneath the surface of the ground, also gives the mining company the right to extract the resource it is buying.
The mining tax that is in effect the selling price for minerals is quite different from the profits tax (the company income tax) that is imposed on all businesses. The ideal company income tax applies in a similar fashion to all companies so it does not distort economic behaviour by changing the after tax rate of return for some sectors compared to others. So long as all profits are taxed similarly, ordinary market forces will lead investors to decide which businesses should be supported and the economy will enjoy the most efficient allocation of foreign and domestic capital.
There is sometimes a confusion between the mining tax and the profits tax. Some observers argue that the separate mining tax and company income tax amounts to two taxes on this industry while all other industries are only subject to the company income tax on their profits. This view ignores the fact that the first “tax” is actually the price to acquire trading stock or inventory. Just as a flour mill buys wheat from a farmer, the mining company buys ore from the owner of that ore, the Mongolian state. The mining tax for a mining company is the cost of buying raw materials similar to the payment the mill makes to buy wheat. In both cases, these are simply the cost of acquiring stock needed by the business.
By coincidence, the owner of the raw material in the case of the mining company is the same entity that imposes the company income tax. So, the mining company pays its cost of raw materials and its income tax to the same person while the flour mill pays its cost of raw materials and its tax to different persons. If a comparison of the total tax burden on the mining industry and the tax burden on other industries considers both the cost of raw materials (the mining tax) and the company tax in the case of miners, it should add the cost of raw materials and company income tax together for all other industries to find a meaningful comparison.
Types of Mining Tax
Nations use three types of charges to sell natural resources: royalties based on quantity, royalties based on turnover (“ad valorem” taxes based on the value of sales or the market value of output), and “resource rent” tax that allows the government to share with the mining company the profits that exceed a normal rate of return for the mining company. Mongolia has experimented with a fourth type of tax it labelled a “windfall profits tax”. As is explained further below, this tax is a type of royalty.
Royalties based on quantity mined or sold (for example, a certain amount per tonne of ore mined and sold) is the least effective means of pricing the sale of the state’s resources as it does not allow the state to vary the price as market conditions change. Normally, sellers of inventory are able to adjust the price quickly as market conditions change. For example, if a farmer in Mongolia invested in seeds and fertilisers expecting a certain price (and thus a certain rate of return) on his wheat crop and the world price for wheat rose unexpectedly because of a drought in Australia, the US and Canada, the farmer would charge more for his wheat, in line with the change in world price. Similarly, if a mining company would determine its expected costs and selling price to ensure an appropriate rate of return on its investment and the price of ore rose higher than was projected, the person providing the mining company with its raw material (the state of Mongolia, in this case) should charge more for the raw material. This cannot be done if the price of the ore uses a royalty regime that calculates the cost by reference to the volume mined or sold rather than the increased market price of the mineral in the ground.
A further drawback to royalties based on volume is the distorting effect it has on mining behaviour. A price based on volume only cannot take account of the cost to the miner of extracting minerals out of the ground. The royalty is another cost of obtaining the minerals and from the miner’s perspective this must be added to the direct costs of extracting the ore for the miner to calculate its full cost. Over time, the cost of extraction will increase at most mine sites as the easy to access ore is removed and the mining company must go deeper to obtain more ore. In the market, ore in the ground that is more difficult to extract has a much lower value than ore that is easy to extract. If the price charged by the state for the ore in its ground cannot reflect this reduced value, the mine becomes unviable at some point. For example, the mining company might make its investment on the assumption that the cost of the ore is 100 per tonne and the cost of extraction for the first deposit is 200, with a total cost of 300. If the market value of ore is 400, the profit market justifies the investment and mining operation. However, as the easy to access ore is removed and the price of extracting the remaining ore rises, the mine will no longer be economically viable if the price of ore cannot drop to reflect the fact that difficult-to-mine ore is has a lower market value. If the price of extraction rises to 300 for deeper ore and the price remains 100 in royalties, the cost is 400 and there is no profit or a profit that is too low a rate of return for the capital invested. The mining company will stop mining and leave the remaining ore in the ground.
A royalty based on the selling price of the mineral (an “ad valorem” royalty) similar to that used in Mongolia can better accommodate changes in the market value. Increases in market value will mean higher sales prices and a royalty that is a percentage of the sales price will rise as the market value of the ore rises. However, like a royalty system based on volume, this pricing system also fails to adjust to the different value of the mineral in the ground. That is, the price is based on the selling price while the value of the mineral being sold from a location beneath the soil is based on the difficulty encountered in extracting it and delivering it. A royalty calculated by reference to the selling price of a mineral will set the same rate for minerals close to the surface and easy to extract and those buried deeply in complex rock structures that are difficult to extract. It similarly imposes the same rate on minerals that are mined close to existing transportation infrastructure and those that require expensive new infrastructure to make delivery to customers possible. A royalty based on the selling price of the mineral will have an effect similar to that of a royalty based on volume and discourage miners from extracting all ore from a mine site where the cost of extraction plus the fixed royalty rise to a point that the required return cannot be realised.
A resource rent tax establishes the price for the sale of minerals using a system that takes account of the cost of extraction and the selling price. The tax starts with a benchmark of the mining company’s invested capital and calculates a risk-free rate of return that the mining company could have realised had it simply purchased government debt with the funds rather than establish a mine. A reasonable additional rate of return is added to this risk-free rate of return to reflect the additional return a company would expect and require if it invested in a mine rather than in passive government debt. The combined rate of return reflects the expected return for the use of the miner’s capital and the additional risk the miner takes by engaging in mining activities. This combined return is then treated as a threshold for measuring the value of the ore. Profits up to this point are attributable to the use of capital and assumption of risk, not the value of the ore that is extracted and sold. Profits in excess of this threshold are attributable to the ore. If resource rent tax is used to pay for the minerals, the government shares with the miner the excess profits attributable to the ore. The amount the government charges for ore is a percentage of these profits that exceed the threshold.
The resource rent tax provides an adjustable price for ore sold by the government depending entirely on the market price of the ore that is sold. Unlike a royalty based solely on the sales price, it also takes into account the value of the ore before it is mined. This can be calculated by comparing the profit above the normal threshold. To illustrate, consider a research rent tax that divided excess profits above the threshold so 40% of the excess profits go to the government and 60% to the miner. Assume the risk free rate of return is 10% and the additional amount recognised as an appropriate risk return for the industry is 6%. Profits in excess of 16% would be divided between the miner and the government with the government’s share being 40% of the excess profit.
Since the profit takes into account costs, the profits will reduce as the ore becomes more expensive to extract. If the profits drop, the government’s revenue from its portion of the profits reduce. This reflects correctly the fact that the difficult to extract ore has a lower sale value when it is in the ground than the ore that was easier to extract (leading to larger profits).
Mining tax theoreticians generally agree that a resource rent tax is the most efficient way to charge for minerals made available to mining companies. It is the only pricing system that will not distort miner’s behaviour in terms of how quickly a mine is developed and how completely the ore is exploited. However, where it has been implemented, the tax has initially generated substantial resistance by mining companies and it is a significant political challenge to overcome this resistance and adopt a resource rent tax. Also, the calculation of the tax is quite different from the calculation of royalties or income tax on profits and the transition to a new tax would pose a challenge to tax administrators. Finally, it should be noted that while a number of countries are considering adopting a resource rent tax, the number that have done so is small. There is much to be said for being a follower in adopting tax changes and learning from the experience of others rather than an initiator.
Mongolia’s brief experiment with its windfall profits tax is best explained as an attempt by a country to claw back some of the exceptional profits earned by a mining company when the original sale price for the ore in the ground based on royalties turned out to be very low relative to the high value of the ore once it is extracted, leaving the mining company with profits significantly higher than the risk-free rate of return plus a reasonable risk premium. The motivation was similar to that explaining a resource rent tax. The government wished to share in the profits attributable to the ore it was selling. However, the windfall profits tax operated as a form of royalty, not a profits tax. Despite the name of the tax, it was based on the difference between the sale price and a base price with no regard to cost or actual profit. The new surtax royalty that replaced the windfall profits tax applies to the full price at a lower rate but has a similar impact in the sense of being tied to the sale price, not the profits taking into account costs.
How do Mining Taxes Affect the Level of Mining Investment?
A most important debate in Mongolia and in all jurisdictions with mining operations is the question whether higher mining taxes will discourage investment in mineral resources and cause mining companies to invest in other jurisdictions. Opponents of taxation use “cherry picking” comparisons to show that selective other countries have lower taxes on mining while supporters of higher levels of taxation argue these comparisons fail to take into account other factors that affect investment decisions. The empirical evidence shows conclusively that it is impossible to consider the effect of taxes in isolation as they are only one factor that affects the cost base of an investor and thus the expected rate of return from a project. It is also very difficult to isolate the effect of taxation from other factors.
For example, the adoption of higher royalty rates and the windfall profits tax was followed by a decline in investment and production in Mongolia and this could have been interpreted as a cause and effect. However, the changes coincided with a worldwide financial crisis and economic downturn and this rather than the tax changes could have been the true cause of the decline. The evidence suggests this is the more likely explanation since investment did not decline to the lower levels before any of the tax changes. Also, levels of investment and production did not decline as much as they did in some countries that had no tax changes. Equally significantly, when the world economy recovered, interest in new mining projects returned to previous levels even though the royalty surcharge was in effect and had not been in place before the tax changes. Experience of other countries has been similar. Australia, for example, has experienced a surge of actual and announced investments after it announced it would apply a national resource rent tax on top of the minerals royalties imposed by the state governments. The increased interest after the announcement of the new tax indicates that these projects are still capable of generating substantial returns with a higher tax cost.
It cannot be doubted that royalties or other mining taxes are a factor considered by mining companies when deciding which projects merit investment. They are, however, only one element of cost and will, accordingly, be considered in the mix of all other costs including labour, infrastructure needs (particularly transport of the ore for delivery) and the cost of extraction based on the nature of the actual mine. A more important consideration in many cases is the value of the risk premium needed to compensate for political risks of investment in a jurisdiction that might be mineral rich but lack political stability or corrupt-free government structures.
VAT and Mining Tax
As explained in a separate paper on VAT, the value added tax is designed to be a non-distorting tax on final consumption taking place within the country.
The “non-distorting” feature means the tax should have no impact on businesses so it does not cause businesses to organise themselves in particular ways that might be less efficient than the structure they would use if there were no tax. It also means that the tax will not influence which parts of the economy investors place their capital.
The imposition of the VAT on consumption within the country only is designed to ensure that there will be no tax imposed on any exports. This is important to prevent double taxation because the purchaser of items exported from Mongolia will pay VAT on importation into its country. It is important that there not be double taxation on these products that are exported because other countries ensure exports from their countries do not face any VAT in the exporting country and products form a country that fails to remove all VAT from exports will be less competitive on the international market.
The model VAT relieves business from any tax burden by providing businesses with a credit for all VAT paid on imports or acquisitions (the input tax). This credit can be deducted from the VAT paid by the customers of the business and if the input tax on purchases exceeds the output tax on sales, in the model VAT the excess is refunded promptly to the company.
It can be seen that a model VAT which applies to domestic consumption only will raise almost no revenue from the mining industry. Almost all of the outputs of the mining industry are exported and this means that all VAT should be removed from mining outputs. The Mongolian government encourages some processing of ores prior to export and where this happens there may be another transaction inserted between the miner and the exporter. This will not affect VAT collection, however, as the VAT is designed to accommodate business-to-business sales and remove all VAT from exports regardless of how many intermediary transactions there may be. So long as the product is finally exported, all VAT will be removed. The only VAT that will be collected is on mining output that is processed in the country and used to manufacture products that are purchased by local consumers.
A model VAT cannot, therefore, be used as a mechanism for taxing the mining industry. The entire design of the VAT aims to remove all tax from businesses such as the mining industry and ensure tax is only paid by final consumers.
While the ideal VAT cannot be used as a tax on the mining industry, it is possible to modify the tax so it is borne by the industry to some extent. There are two ways this can be done. Countries that have tried these methods have been strongly criticised by international organisations and it has been argued that the methods cause economic damage by reducing competitiveness. However, the design of the VAT in Europe imposes some tax on intermediary businesses and there are design features of the consumption tax used in the United States that also cause it to impose tax on businesses. In both cases the theoreticians argue the taxes should be fixed to avoid this result but it does seem that a very strong economy with high levels of productivity can withstand some consumption taxation imposed on intermediary businesses and remain competitive. The experience of China, where the VAT (on goods) and Business Tax (on services) also imposes a tax burden on businesses, shows that very low labor costs can offset some of the tax burden and distortions of a consumption tax falling on business, at least for manufactured. It would be far more difficult to offset the burden of a consumption tax on business in the case of the mining industry where the cost of labor is not significant to the value of the mined commodity.
The first method of using the VAT to tax domestic mining companies is to remove the mechanism that allows companies to remove all tax on exports. The mechanism is a “zero rate” of tax imposed on exports. Under the normal VAT, exports are taxable but the rate is zero so no tax is imposed on sales that are exported. At the same time, because the exports are taxable sales (admittedly with a zero rate), the sellers are entitled to refunds of all the tax on their acquisitions. The result is removal of all tax on exports. This can be reversed simply by replacing the zero rate on exports with the standard rate.
Removing the zero rate on exports would appear to be a simple way of collecting VAT from the mining industry. While it appears the tax is borne by the foreign purchaser of ore, in reality the entire tax will be borne by the domestic miner. This is because the world price of every type of ore is based on its value with no VAT imposed. Since VAT on mining exports is normally not subject to tax, the world price will not include any VAT element. If VAT is imposed on ore exports from Mongolia, the miners would have to lower their selling price so the selling price plus the VAT equalled the world price for the commodities.
In effect, a VAT on exports would have to be treated as an additional cost of the mining company that could not be passed on to the buyer. The effect of a VAT on exports would be identical to raising the royalty by the amount of the VAT. This will reduce the profit of the mining company by the amount of the higher royalty including VAT. So long as the world price is much higher than the cost of the ore and the cost of extraction and delivery, the miner will be able to bear the reduced profit. The royalty augmented by the VAT will exacerbate the problem of miners being unable to fully exploit all the minerals. At some point the cost of extraction added to the higher royalty reaches a point where the profit margin becomes too small and the miner has no option but to stop mining expensive-to-extract minerals.
The second method of using the VAT to tax domestic mining companies is to deny input tax credits on acquisitions or to delay refunds of input tax credits where the company exports output and has input credits greater than its tax liability on sales. A delay in refunds is the economic equivalent of partial denial of input tax credits. Past studies of the VAT in Mongolia have been very critical of the delays in processing refunds and the ad hoc system of exemptions for imports of some types of equipment as a partial solution to the delay in refunds. The studies have suggested the issue is primarily a conceptual problem with a view in the government that refunds of input VAT to businesses is a type of spending program that can be reduced when the government needs more funds rather than recognition that it should be an inherent feature of the VAT to ensure the tax falls on final consumption rather than business. However, if the government wished to explicitly use the VAT as a means of taxing mining companies, denial of input tax refunds or deliberate delays in refunds would have the effect of leaving these companies with a VAT burden.
As with an extension of the VAT to exports, denial of input tax credits or delays in refunding input tax borne by exporters is equivalent to increasing the royalty rate.
It would greatly complicate the operation of the VAT system if it were modified to have special rules for the mining industry. Among other things, it could impose a very onerous burden on the GDNT. It would be particularly difficult if the VAT were imposed on mining companies by denying relief for input tax. Mining companies may also have ancillary operations and it would be necessary to determine whether each input was attributable to “mining” or a related activity or apportion the input if it were related to both.
Conclusion: The Mongolian government is looking at three different issues – reform of the VAT, replacement of the VAT with another indirect tax, and reform of the mining tax. These are distinct questions and should be addressed separately. It would be possible to modify the VAT or a replacement indirect tax to target the mining industry differently from all other types of businesses. However, this would be inefficient in many respects. First, it would not be an effective way of taxing mining. Second, it would weaken the indirect tax system if different rules were used for different industries. Third, it would place tremendous burden on the GDNT if a single law were applied differently to different companies or parts of companies. It is suggested that the question of reform of the VAT law or replacement of the VAT with another type of indirect tax be considered separately from the question of reform of mining taxation. The key questions concerning mining taxation are:
- whether there is satisfaction with the base currently used for calculating royalties and the rate of royalties; and
- whether the Mongolian government wishes the price of the ore it provides to mining companies to include a portion of additional profits where the miner is able to sell the ore at prices sufficient to generate abnormal profits.