Fiscal policy for mining
TAXATION ODE
Fiscal policy for mining
Owing to specific features of mining, e.g. the risks associated and limited exploitation periods, special approaches to taxation in that sector are practiced throughout the world. Unfortunately, Ukraine’s taxation introduces certain elements that simply facilitate tax discrimination and provide for no compensations for the sake of renewal of mineral resources. That is why it is time to analyze the fiscal policy in mining in order to increase Ukraine’s competitiveness on the world market and attract foreign investment.
Fiscal policy is among the key tools for regulation of mining in the market economy. Application of different policies depends on economic and social priorities of a specific country and is far from being universal for all cases. Inflexible taxation can be extremely harmful in the changing modern business environment.
Ukraine’s implementation of economic experiment in the mining and metal sector is a good example of extraordinary measures that a country and government may take in case of negligence of those factors. The experiment shows close connections between political and economic aspects of regulation in mining. The success of this undertaking proves that no universal approach should be given to fiscal issues.
Analysis of internal and external development shows the bases for that policy. Considering the high commercial and social significance of mining for Ukraine’s economy, special mechanisms of state support should be established in that sector.
A while ago, the fiscal policy for mining was the same as for other industries. A straightforward solution was given to the issue of resource royalties; i.e. a mining tax was introduced to the taxes in force. At the same time, no specific incentives were given to mining.
So, in addition to regular taxation, the mining companies had to pay charges for geological prospecting and mining tax. Being introduced to provide revenues for governmental actions, these taxes obviously lowered the profitability in mining, iron & steel and non-ferrous metal industries. Introduction of land tax applicable to mining companies added some more problems.
At the same time, Ukraine made use of nothing similar to discount mechanisms (e.g. discount for depletion of deposits, etc.) that are practiced in market economies and facilitate development of the mining business. The only smart step was the application of reduced ratios for mining tax rates. On the other hand, the charge for geological prospecting was paid in full.
The new draft Tax Code of Ukraine provides for a uniform single tax instead of prospecting charge and mining tax. There is reasonable ground for that because the taxable base is the same in both cases. Unification of charges is a unique opportunity for better fiscal approaches.
Despite large overall mineral inventories, Ukraine’s mining has almost depleted the highest quality deposits; thus exploration is worsening.
Natural characteristics are the key basis for assessment of current and future competitiveness of particular deposits. Moreover, natural characteristics show the mining prospects and act as the source information for economic forecasting.
Over the past decade, overwhelmingly extensive mining of all mineral resources has led to extremely deep exploration in Ukraine, e.g. 350 meters in iron ore mining, 150 to 190 m in flux mining and 50 to 60 m in refractory mining. The world hardly knows any other mining business operating at similar depths. Accordingly, stripping ratios increased in Ukraine, other mining parameters deteriorated, while labor inputs and costs grew.
Technological qualities of mineral materials are the next most important factors for profitability. Permanent reduction in iron contents in ore has been a general trend for ore mining companies of Ukraine recently. Low quality of minerals and bad physical and chemical properties led to low iron and manganese contents in concentrate, together with high contents of silica. Diagram 1 shows that, in terms of Fe/Si02 ratio, Ukraine’s mining companies rank the worst in the world out of all producers of iron ore concentrate. Despite intensified competition in the last decade, quality of Ukrainian mined products has not improved.
Diagram 1. Rating of quality of iron ore concentrate
(Ukrainian mining companies compared to foreign businesses)
As a consequence, Ukraine-based mining companies show poor financial performance. During the past couple of years, accounts payable exceeded accounts receivable by some UAH 1.3 bln. Profit analysis reveals that the majority of Ukrainian mining companies operates ineffectively.
The market for iron ore is directly related to the quality of ore concentrate, agglomerated ore and pellets. Ukraine’s mining companies traditionally make sales in several regions, i.e. Central and Eastern Europe and Austria. So far, Ukraine is among the leading exporters of iron ore to those countries accounting for 48 to 55% of their total imports compared to Russia’s share of 20 to 22%. That market has a capacity for about 37.5 to 42.5 mln. tons.
In the second quarter of 1999 Ukraine’s mining industry started moving out of recession. This trend continued in 2000 owing to significant recovery of the market for iron ore products and greater exports of those commodities from Ukraine. However, in terms of strategic factors Ukraine is vulnerable as it benefits only from proximity to main clients and low cost of its iron ore that covers poor quality of mined products (contents of iron and silica). Owing to those factors, Ukraine-based mining companies are highly vulnerable to trade expansion of other countries, mostly their neighbors. This points out a high risk of gradual loss of traditional markets without the opportunity for diversification and compensation of costs.
There are two types of taxes, namely, those levied on production and on profit. Most frequently, the former ones are applied to mining companies, e.g. royalty as a ratio to revenue (cost of sales).
In mid-1990s, when the inflation was high and economy was in recession, Ukraine made a fresh decision, i.e. mining tax and prospecting charge were fixed as a single payment per unit of minerals mined. Therefore, it could be treated as an indirect type of production tax.
Production taxation provides for stable tax revenues at little administrative effort. However, this tax is levied regardless of whether an enterprise makes a profit or not, i.e. it is levied without proper economic justification. This can drive a mine or a quarry to early closure of business. Considering the cyclical nature of pricing, even a small production tax can result in a sharp drop of profitability at the times of downturn.
The international experience shows that production tax is applicable when enterprises or projects feature high rates of return. In case of unstable finance and economy, like in Ukraine, even moderate extra taxes may result in significant financial problems for enterprises.
Most economies practice a complex system of income taxation with respect to mining, and levy production tax (levied on the basis of mining activity) as royalty. Overall, this corresponds to Ukraine’s practices.
Income tax rates fluctuate from 15 to 45% around the world, with 30-35% being the most common.
Production tax (similar to royalty) has the rates of 0 to 5%, with 2-3% being the most widespread. Fiscal policy is considered to have a heavy impact on business if production tax rate exceeds 2%. Royalty rate of 5% is indicative of a risky fiscal policy.
Here are some comparatives of Ukraine’s fiscal policy for mining vs. global approaches. Using information of the Canadian Department of Natural Resource, we have selected a sample of mining projects implemented around the world in the past 5 years. Each project is sorted by effective tax rates applicable to that project. Additionally, all projects are sorted by internal rates of return into two groups, namely around 10% and around 25%. The geographical analysis of this information is set out in diagram 2 (a and b) showing the most common tax rates applicable to specific projects.
Diagram 2. Tax rates applicable to mining projects implemented throughout the past 5 years
а) Internal rate of return at around 10%
Ukraine’s Zaporozhye Iron Ore Works has the most similar tax rates to unfavorable project of Brazil. Even with tax incentives introduced in the mining and metal sector of Ukraine, this enterprise is subject to one of the highest tax rates.
The highly profitable mining projects around the world are subject to tax rates between 26 and 44%, which is lower than those for low profitability projects.
Based on financial data for the year ended December 31, 1999, Yuzhny Ore Mining & Concentrating Works was the closest to highly profitable performance in Ukraine’s mining. However, that company is subject to the topmost tax rates even in the condition of the economic experiment that provides for income tax rate of 15%.
Summing up, one can state that the global fiscal policy for mining features the most likely income tax rate of 30% (less likely rate of 35%) and mining tax rate of 2%.
Overall tax rates ranging between 30 and 35% (depending on profitability of an enterprise/project) mean that an undertaking is competitive.
One should keep in mind the general trend towards lower share of royalty (mining tax) in the fiscal system. Certain countries give temporary or partial exemption from this tax in case of deteriorated mining conditions, during payback period, etc. Many countries have no such tax at all.
The global experience also shows that fiscal systems are becoming more flexible. In response to lower profitability of mining companies, governments (above all, in Canada) rapidly lower effective tax rates.
We have not reviewed a number of other taxes levied on cost of sales, e.g. road construction charges, land tax, mandatory insurance, contributions to innovation funds, etc. Such taxes may also have a significant impact on enterprise economy and impede investment. Therefore, application of these taxes should be reasonable, especially as regards the mining business. Introduction of land tax incentives is the soundest approach.
Diagram 2. Tax rates applicable to mining projects implemented throughout the past 5 years
b) Internal rate of return at around 25%
The generally accepted international standards define mining tax as a rent or royalty payable to the owner of resources (usually, the State). Therefore, it has a nature of a single tax levied for a specific purpose.
The proposal to merge the effective mining taxes into a single tax (as provided for in the draft Tax Code of Ukraine) rests on those reasons. There is no other alternative to this approach both within the framework of the tax reform in Ukraine and in harmonization with European and international standards.
Mining tax accounts for 1 to 10% of mining costs of Ukrainian companies, with 2.5 to 4.5% being the most common share. In 1997 through 1999 the share of mining tax in cost of iron ore mining lowered from 4-6% down to 2.5-4.5%. The share in manganese ore mining enterprises was below 2% due to high mining costs (four to fivefold of those in iron ore mining).
Mining tax has a similar, though a little lower, share of the cost of sales in mining companies. For instance, mining tax accounts for 1.5 to 2.5% of the cost of sales of iron ore concentrate and 1 to 1.7% of the cost of sales of manganese ore. Flux-mining enterprises have a higher share of 2 to 5%.
Introduction of a single mining tax without application reduced rates would lead to an increase in that payment by 1.81 times in iron ore mining, 2.05 times in manganese ore mining, 2.05 times in flux mining, 2.46 in dolomite mining and so on. Average weighted payments of mining tax would rise 1.92 times. At the same time, the share of mining tax in the cost of sales of iron ore would increase to 3.5 to 4%.
Analysis of investment projects and assessment of mineral inventories and their quality in Ukraine prove it rational to reduce the mining tax rate down to 2%. The rate above that level would affect financial & economic performance and competitiveness, while in the times of crisis it would even facilitate the adverse processes.
Introduction of a single tax calculated on the basis of effective and reduced rates generally meets these conditions. Fiscal policy and mining taxation should be balanced to reflect the permanent deterioration of mining conditions and qualities.
Fiscal burden as a whole and mining tax should be lowered considering the critical performance of Ukraine’s mining companies, poor quality of Ukrainian ore products compared to major competitors (predominantly, Russia), downswing in competitiveness due to a mark up in energy prices (notably, in the second half of 2000) and crisis expectations caused by cyclical behavior of prices for mined products.