Richard Karn: A Bridge Too Far. . .to the Left?
Source: Brian Sylvester and Karen Roche of The Gold Report (6/14/10)
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.
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 Liberal (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."
RK: 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?
RK: 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?
RK: 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?
RK: 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?
RK: 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?
RK: The ascendance of Australian mining over the last three decades is attributable to previous administrations, Labor and Liberal 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" fails 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, such as BHP Billiton Limited (NYSE:BHP; PKSHEETS:BHPLF) or Rio Tinto Ltd. (LSE:RIO; NYSE:RTP; AUS:RIO). For a second-tier company, such as Fortescue Metals Group Ltd. (ASX:FMG), 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.
Let me give you an example of this high cost of capital. Macarthur Coal Ltd. (TSX.V:MCC), a roughly A$3 billion company, recently negotiated a take-or-pay contract with Queensland Rail (QR Limited) for the construction of a new railway spur. The state-owned utility demanded a 15% rate of return to underwrite the project.
TGR: And if a company as big as Macarthur Coal pays 15% for its capital, small companies will pay considerably more.
RK: Some critics suggest that the academics, economic modelers and politicians behind the RSPT seem to believe the expertise to develop massive 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 last month when he wrote that Australia is "at risk of killing the goose that laid the golden egg" with the RSPT.
RK: 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.
RK: 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?
RK: 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?
RK: 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 U.S. 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?
RK: 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?
RK: 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 reach an agreement 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?
RK: 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, and 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: In your four months investigating precious and specialty metal projects in Australia, you've obviously been talking to people in the mining industry about the RSPT. What have they been saying?
RK: I'm happy to share some of their opinions, but bear in mind that, by comparison, you'd consider my comments pretty tame.
Crescent Gold Ltd. (TSX:CRA; ASX:CRE; FKFT:CRE5) CFO Mark Tory said that his company was in the middle of a marketing campaign in North America when Mr. Rudd announced the tax, "and it immediately put a hold on any investment money going into an Australian resource company, as well as prompting analysts to downgrade resource stocks on a cash-flow basis by up to 27%." He also said that companies such as Crescent, which have spent money over a number of years to bring development projects into production, "will not get the deductions of that expenditure under the announced resource tax regime and will pay tax on first-time profits at a higher rate." He called RSPT a myth, "as most resource companies' weighted average cost of capital is closer to 15% than the current level set by the government for when the tax kicks in at around 6%."
John Merity, managing director of Northwest Resources Ltd. (ASX: NWR) said, "the abrupt announcement of the tax, its inherently retrospective nature and the government's unwillingness to negotiate on anything other than peripheral aspects, put at risk future investment in the resources sector in Australia." He admitted that the exploration expenditure rebate "looks promising," but went on to say that if that rebate is "the carrot to win the support of juniors, the government has fundamentally misunderstood the exploration sector." As he put it, "You don't take the huge risks exploration companies do (less that 5% of exploration companies will ever build a mine) unless the equally huge rewards are there. A 'reasonable return' is not what exploration is about. If investors want a business with a reasonable return, they will invest in pizza shops."
Richard Wolanski, director of NiPlats Australia Ltd. (ASE:NIP) shares that view in terms of juniors because the RSTP compromises "the long-term ability to generate the capital investment or financing needed to develop mines," thus "reducing investment in juniors." He criticizes the RSTP as "an ill-conceived tax that has been proposed without consultations with the mining industry by a government whose ability to manage Australia's finances now has to be questioned. It contributes to sovereign risk in that it introduces uncertainty regarding what tax will eventually be levied." He further suggested that confidence in Australia as an investment destination "is now only likely to be restored by a change in government."
That day isn't far off, according to Nicholas Garling, managing director of Morning Star Gold NL. (ASX:MCO). He says that the Prime Minister "has signed his political death warrant. The tax is not only unfair and unpopular but completely unnecessary and, in all likelihood, unconstitutional. But it will all matter little. Rudd's Labor Party was teetering prior to this politically."
Ian Chalmers, managing director of Alkane Resources Ltd. (ASX:ALK) makes yet another point. Because the individual states own the minerals, he claims "it could be argued that the RSPT is an attempt by the federal government to wrest control, and hence revenues, from the states." He says that taxing state-owned property violates Section 114 of Australia's Constitution. Mr. Chalmers pulls no punches, describing RSTP as a "cynical political ploy to try and win over the great masses of voters in Sydney and Melbourne, who have always thought mining is a dirty industry that generates environmental messes and makes a few people very wealthy." He goes on to say the RSTP "is an attempt to take the heat off major policy failures, such as the (carbon) emissions trading scheme, the deadly home-insulation scandal, wasteful school building programs. . .People and the media in eastern states have been very slow to recognize that the Australian mining industry kept the country afloat for the last two years and insulated us from the worst of the global financial crisis."
Barry Dawes, managing director of Martin Place Securities, calls the RSPT a "poorly conceived. . .policy concocted by bureaucrats, academics and ex-union officials with but minimal external consultation or internal debate," really zeros in on the math. "This RSPT brings in a 40% tax at the operating surplus level offset only by a capital charge equal to the depreciated plant book value times the 10-year government bond rate and applies before interest, royalties and income tax. The tax reduces NPVs on new projects by 30% to 40%, reduces free cash flow for debt service, raises cutoff grades and reduces resources, and then reduces attractiveness to equity and debt providers." Importantly, he points out that "whilst the 'Crown' through the state governments is the ultimate owner of the mineralization, this mineralization only becomes a resource after substantial efforts by the tenement holder; so ownership is transferred to the tenement holder with compensation and profit sharing made through payment of a royalty. The broad public cannot expect more."
TGR: Any other peripheral issues you'd like to discuss?
RK: 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?
RK: My opinion 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?
RK: 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 these metals 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.
Richard Karn, as managing editor of The Emerging Trends Report has a broad, multi-disciplinary background and a working knowledge of precious and specialty metals, as well as considerable research, analytical and writing experience. The first nine Emerging Trends Reports, which pertained to coal, gold, nuclear energy, silver, the North American electrical grid, transportation fuels, recycling and specialty metals and natural gas were reevaluated and updated within the context of the global financial crisis and then published in the form of an e-book, Credit & Credibility. This spring, Richard—who divides his time between Alaska and Australia—embarked on a lengthy tour circumnavigating Australia by four-wheel drive to evaluate dozens of remote projects and recommend the stocks of companies that are well-positioned to supply burgeoning market demand for these critical metals. In addition to managing The Emerging Trends Report and conducting contract research for companies, Richard has written for publications ranging from Barron's, Kitco and Fullermoney to Financial Sense Online.
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1) Brian Sylvester and Karen Roche of The Gold Report conducted this interview. They personally and/or their families own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Morning Star Gold.
3) Richard Karn: I personally, my fund and/or my family own shares of the following companies mentioned in this interview: Alkane Resources Ltd., Northwest Resources Ltd. and Morning Star Gold NL.