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Fiscal terms must be robust to changing circumstances and ensure that the country gets full value from its resources.
Resource projects are long term, involve large upfront capital expenditures, and are subject to significant uncertainties and risks – operational, economic, technological, geological, environmental, and political. Most notably the volatility of commodity prices means that revenue flows may vary widely. Changing circumstances, over the life-cycle of the project and as external factors change, mean that the balance of power between government and investors changes, and so too do domestic political pressures on government.
The investor will be locked in by large fixed costs once the investment is made and may want to compensate for the risk of future policy changes by offering less favorable terms as a condition for proceeding. On the government’s side contracts which produce results that later look unfair in high price or high margin environments, even when the risks and gains were allocated up front, may generate substantial political pressure for revision in spite of whatever contractual guarantees were initially made. Fiscal terms need to be designed to be robust to changing circumstance, particularly to large swings in commodity prices, to reduce the incentive for either side to demand a renegotiation that can disrupt production and increase costs for both. Fiscal terms need to be clearly understood by the government and the investors, and the rights of both need to be sufficiently clearly defined that the government can in fact realize the revenues due to it and the investor is reasonably protected against unilateral changes by future governments.
Well-designed fiscal regimes can provide the government with a revenue stream in all production periods but with an increased share of revenues as profitability increases. Fiscal terms need to contain mechanisms to provide some minimum revenue flow at low prices, as well as mechanisms to share in the profitability of the project. This suggests that they should contain both a royalty charge linked to production and a charge linked with profitability. The latter may be achieved through production sharing arrangements, the corporate or entity income tax (perhaps at a special resource sector rate3)1, possibly supplemented with additional taxes linked to particularly high returns. Enforceability and administration will be enhanced if these contingent elements are linked to variables that are observable and verifiable, such as world prices.
Structural stability can be increased by basing contracts on otherwise applicable laws. Uniform application across operations combined with transparency will also help ensure that operators know that treatment is non-discriminatory, and thus operators have less incentive to attempt obtaining special deals.
While tax and royalty payments can be made contingent on some variables it is impossible to foresee and contract upon all possible future circumstances. Payments contingent on achieved profitability can provide some protection, but contracts need to explicitly recognize that during their term adjustments may be necessary to account for unforeseen circumstances. However, such renegotiation should be infrequent and should be conducted within parameters that preserve to the extent possible the reasonable expectations of the parties including a fair rate of return for investors.
Uniform application across operations combined with transparency will also help ensure that operators know that treatment is non-discriminatory, and thus operators have less incentive to attempt obtaining special deals.
2Corporate income taxes in the host country may be creditable against taxes payable in the home country and any tax design should preserve that feature because it allows the host country to shift some revenues to itself from the home country without additional burden on the investor.
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