Why Windfall tax is the Solution by N'gandu Magande (Former Finance Minister)

Windfall Tax

Recently we wrote an article explaining why we thought Windfall tax is not the solution in taxing the mines. We have had the great pleasure of receiving some feedback from the Former Finance Minister Ngandu Magande who is a proponent of windfall tax.

Filled with valuable insight, below is his line of argument which we have deemed as a very much worthy a counter balance to our approach. The choice now lies in the public not to take sides but pick information from both sides to make a better tax framework.

Windfall Tax by N'gandu Magande

2008 Budget Speech Introducing the New Mining Tax Regime

1.            Mr. Speaker, I beg to move that the House do now resolve into Committee of Supply on the Estimates of Revenue and Expenditure for the year 1^st January 2008 to 31^st December 2008, presented to the National Assembly in January 2008.

2.            Sir, I am the bearer of a message from His Excellency the President recommending favourable consideration of the motion I now lay on the Table.

3.            Mr. Speaker, over the past five years, the nation has achieved macroeconomic stability characterised by growth in the real Gross Domestic Product (GDP) in excess of 5 percent per annum, the reduction of inflation to single digit, a stable exchange rate, declining interest rates, a stable financial system, the removal of the external debt burden, and a substantial build-up in foreign exchange reserves. These achievements have resulted in notable successes in the creation of jobs and wealth, and the reduction in poverty levels.

4.            Sir, our cherished and chosen vision is to be a prosperous middle income country by 2030. This will be achieved by creating a nation of dynamic, self confident and vibrant entrepreneurs. Our foremost challenge, this year and in the medium-term, is to create the fiscal space that will allow us to marshal both human and financial resources. This will enable us to accelerate the implementation of the Fifth National Development Plan.

5.            Mr. Speaker, to realise this vision, the theme of this year’s budget is “Unlocking Resources for Economic Empowerment and Wealth Creation.”

6.            Mr. Speaker, the preparation of this Budget has benefited from broad-based consultations with various stakeholders. This is in line with this Government’s policy of openness and transparency. I, therefore, wish to express my utmost gratitude for the valuable contributions made by various organisations and individuals.

Changes to the Mining Fiscal and Regulatory Regime

144.Mr. Speaker, in my 2007 Budget Address to this august House, I proposed new tax measures for the mining sector. I also informed the nation that the Government would engage mining companies, with whom we had signed Development Agreements, as part of the process of introducing the new tax regime for the mining sector.

145.Sir, given the complexity of the mining sector, a team of experts was appointed to study this matter in great detail. The findings of the study show that:

(a)           the Development Agreements in their current form are lopsided; and

(b)          even if mining companies were to move to the 2007 tax regime, the country would still not get a fair share from its mineral resources.

146.Sir, the Government has, therefore, decided to introduce a new fiscal and regulatory regime in order to bring about an equitable distribution of the mineral wealth between the Government and the mining companies.

147.Mr. Speaker, effective 1st April 2008, the new fiscal regime for the mining sector will include the following:

(a)           The corporate tax rate will be 30 percent;

(b)          Mineral royalty rate on base metals will be 3 percent of gross value;

(c)           Withholding tax on interest, royalties, management fees and payments to affiliates or subcontractors in the mining sector will be at the rate of 15 percent;

(d)          Withholding tax on dividend will be at zero percent;

(e)           A variable profit tax of up to 15 percent on taxable income, which is above 8 percent of the gross income, will be introduced;

(f)           A windfall tax will be introduced to be triggered at different price levels for different base metals. For copper, the windfall tax shall be 25 percent at the copper price of US $2.50 per pound but below US $3.00 per pound, 50 percent at price for the next 50 cents increase in price and 75 percent for price above US $3.50 per pound;

(g)          Hedging as a risk management mechanism shall be treated as a separate activity from mining;  

(h)          Capital allowance, that is a depreciation of capital equipment, shall be reduced from 100 percent to 25 percent per year;

(i)            A reference price, which shall be the deemed arms length price, shall be introduced for the purposes of assessing mineral royalties and any transaction for the sale of base metals, gemstones or precious metals between related or associated parties. The reference price shall be the price tenable at the London Metal Exchange, metal Bulletin or any other commodity exchange market recognised by the Commissioner General; and

(j)            Capital expenditures on new projects shall be ring fenced and only become deductible when the projects start production. 

148.Mr. Speaker, the new mining regulatory framework will be provided for in the Mines and Minerals Act. The framework will also have a modern licensing system based on transparent procedures.

149.Sir, these measures are competitive, reasonable and balanced. The expected additional revenues, in 2008, as a result of these new measures are estimated at US $415 million.

Line of Reasoning

In the 2008 Budget Speech I delivered under which the windfall tax was introduced in the Zambian tax regime. I and officials took time to discuss with individual mining companies on these proposals between February and May 2008. They agreed to the tax with observations that it will take away some of their income.

The price of copper then had risen from US $2,000 in 2002 to US $7,500 in 2007 per tonne, ie less than US $1 per pound to US $3.4 per pound. Somewhere in 2008, the price rocketed to just below US $10,000 per tonne or US $4.2 per pound. Most of the mining houses had invested in the early 2000's on the basis of a projected best price of US $2.5/lb and a breakeven price of less than US$2.00/lb. These statistics were presented by both parties and discussed in our meetings in 2008. Just enquire with Chibuluma Mines whether they had a meeting with me and officials at 0930 on 6th March and at 1100 hours on 18th March 2008. The government team and mining company officials agreed that prices of over US $3/lb were a windfall to be shared by the owner/introducer of the new technology and the owner/guardian of the historical God-given copper deposits. we all realized that many mines would recover their CAPEX and other initial costs in a short time than had been projected at the beginning of the century.

Our meetings with the individual mining companies in 2007 and 2008, opened by inviting them to present their investment plans which contained estimated costs of production and anticipated income. From these numbers, both sides were aware of the break-even numbers. Each mining company had its unique set of figures. All of them were above the 18 % margin, which is the world average rate for mining operations

Variable tax was on taxable income below $2.5 per pound (lb). The windfall tax was for any additional taxable income above this threshold. They were and could not be applied on the same income. All this was explained to the companies on individual basis. On 30th June 2008, the Deputy Commissioner General of ZRA had a meeting in Chingola with Finance Directors of all mining companies. he explained the new tax and a new variation to collecting the windfall tax. They all agreed that they understood the procedure, which was given later in writing. The following is the text:

"The Commissioner General of ZRA to collect the windfall tax as a provisional tax at the lowest rate of 25 percent only, so that the mining companies are not adversely affected during the year. The full effective tax rate will be calculated at the end of the operating year and the windfall tax will then be adjusted accordingly to a maximum of 47 percent. We project that in spite of these adjustments in the collection of the windfall tax, we will still achieve a collection of around US $400 million by the end of the year."

Example Calculation of Windfall Tax

TAXES FOR A MINE PRODUCING 50,000 TONNES OF COPPER IN ZAMBIA

PARAMETERS

1. TOTAL PRODUCTION:                                                50,000 TONNES
2. PRICE PER TONNE:                                         US $7,000 LME
3. GROSS INCOME:                                            US $350,000,000
4. COST OF PRODUCTION (30 %);                     US $105,000,000
5. TAXABLE INCOME:                                         US $245,000,000
6. CORPORATE TAX (30 %);                                                                   US $73,500,000
7. MINERAL TAX (6% OF GROSS VALUE):                                             US   $21,000,000
8. WINDFALL TAX:          25% between US $2.5 but below 3.00/lb (6,000 to 7,000)

25% x 50,000 x 7,000 =           US $87,500,000

50% for every 50 cents increase above 3.00 (7,000 to 8,000)

            50% x 100,000 x (7,000 minus 7,000) = US $0

75% for every 50 cents increase above 3.5 (above 8,000)

75% x 100,000 x (7,000 minus 7,000) = US$0

I.        TOTAL TAXES:   F + G  +  H + I =   73.5 + 21 + 87.5   = US $182,000,000 =52% of Gross Income

N.B: Variable tax was on taxable income below $2.5 per pound (lb). The windfall tax was for any additional taxable income above this threshold. They were and could not be applied on the same income

The formula is mathematical and the numbers could  be changed, but the rationale of sharing the WINDFALL INCOME should be maintained. The farmer must enjoy the golden eggs while looking after the Goose as it is getting old and will soon die!

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Why Wind Fall Tax is not the Solution: The Golden Goose Example By Kampamba Shula

Windfall tax
First off before we delve into this subject we must define what Windfall tax actually is.
Windfall tax is a tax levied by governments against certain industries when economic conditions allow those industries to experience above-average profits. Windfall taxes are primarily levied on the companies in the targeted industry that have benefited the most from the economic windfall, most often commodity-based businesses (Collins, 2013).

The Problem
A combination of an excessively investor-friendly copper-mining tax regime, persistent and even tolerated tax  evasion among very high income earners, a low corporate tax take generally, and the  suspected purposeful neglect of taxing the gemstone sector have diminished state tax-revenue mobilization.
Firstly, Zambia does not benefit extensively from mining operations the way it should. All countries that depend on natural resources face the shared challenge of taxation: determining tax levels and administering tax revenues in an effective manner that balances the needs of Government and investors. Mining depletes a valuable natural asset and taxing the mining companies is a way of generating savings that can be redeployed to increase the productive capacity of the rest of the economy, and thereby help sustain the country over the long-term. Despite the revival of the industry post-privatization, the mining industry’s contribution to government revenues in Zambia has remained low.
Earlier this year Finance Minister Alexander Chikwanda signaled that Government was considering introducing new "tax measures" in mining to boost revenues:
"We will introduce measures and relook at the tax system in the mining sector. Our mining sector has not contributed much compared to the rest of the region. So we want to engage local experts and ensure we have the statistics on mineral production and exports, and then we will find modalities to effect new tax measures to increase revenue collection..." (Times of Zambia, 2013)
Windfall Tax
A windfall tax will be introduced to be triggered at different price levels for different base metals. For copper, the windfall tax shall be 25 percent at the copper price of US $2.50 per pound but below US $3.00 per pound, 50 percent at price for the next 50 cents increase in price and 75 percent for price above US $3.50 per pound;
Back in 2009 when the Windfall tax was still applicable the Government removed the upper 2 bands before it eventually scrapped windfall tax altogether.
Windfall is effectively a “revenue-based tax”, meaning that it is applied on the basis of gross revenue, without taking account of costs.
In addition, the windfall tax and the variable profits tax appear to duplicate each other – both being aimed at capturing that part of gross profits which is attributable to price windfalls.  From an economic viewpoint, the variable profits tax is preferable, because it takes account of costs and more closely approximates value-added.  However, there are concerns about the mining companies’ cost data, due to possible transfer pricing.  In addition, the mines apparently reported costs for tax purposes prior to 2008 that are lower than those they claim to be incurring now.  While this may well be true, it gives rise to a need to verify cost information.
Solution
ZRA’s capacity to review and verify cost information is in the process of being built up.  While this is being done, there is a case for a windfall tax based on revenues.  In addition, there is a strong case for independent verification of mining company cost information, and for open public scrutiny.
In 2008 the Economics association of Zambia suggested that “Government should seek to replace it as soon as possible by either the variable profits tax which would consider the cost structures of companies or structure the revenue based tax regime in such a way that the windfall tax will only apply from a price level which takes into consideration the cost structures of companies. The windfall tax should also be a flat rate. Thus the government should in the meantime re-examine the issues of tax deductibility, as well as the price thresholds and tax bands in the current legislation.”
I personally support the intentions of the  general public but windfall tax as it was initially introduced in 2008 does not yet provide the stability and predictability needed to sustain investment in the mining sector.
Much of the difficulty and, indeed, suspicion surrounding mining company representations reflects concerns that they are exaggerating their costs and thereby reducing the potential tax take if taxes are based largely on profits. We know that ZRA is in the process of building up its capacity to review mining company tax returns critically, and would strongly encourage that this continue and be accelerated.
The EITI, as an internationally supported mechanism, appears to have started to help such countries as Nigeria address issues of transfer pricing in their extractive industries.  The initiative is at an early stage in Zambia, and should be pursued with vigor.
The Example
A Farmer has some golden geese which lay golden eggs on his farm, he also has other geese which lay normal eggs. He keeps all the geese in the barnyard with other geese. The golden geese are very stubborn and require sensitive treatment and care; otherwise they refuse to lay as many eggs.
The farmer runs into some debt and needs to borrow money to keep his farm running. An animal care doctor comes to his aid and gives him a loan on condition that he treats the golden geese with even more care and preferential treatment than the other geese. He treats the golden geese well but to his dismay the geese (which are very smart) lays their eggs in cracks in the barnyard in which the farmer cannot reach. The geese then communicate to other geese that take those hidden eggs and go trade them for other assorted items to the Birds.
When the farmer occasionally does get some eggs, the farmer can’t price these eggs any way he would like but sells them at the market price for every ounce of gold eggs he brings. The farmer begins to get frustrated that he is not benefiting and has two options. Firstly he considers whipping and strangling the golden geese to force them to lay more eggs for him and secondly he considers covering the cracks in the barnyard to prevent the geese from sneaking out golden eggs.
He attempts to whip and strangle one of the golden geese and it dies, it lays two eggs then dies.
He tries the second option and he closes the entire cracks in the barnyard such that the geese are forced to lay the eggs out in the open where the farmer can easily pick them up and go sell them. The geese lay the Eggs and the farmer lives happily ever after.
In this story the farmer is the Zambian government, the golden goose are the mining companies. The animal care doctor is the IMF and World Bank who had the Zambian government sign very investor friendly concession in exchange for debt cancellation.
The first option of strangling the golden goose is Windfall tax.
The second option is covering tax loopholes that exist in Zambia’s current Tax laws and empowering ZRA with greater capacity to audit and tax mines properly.
It’s not rocket science to see which one is the better option.

Kampamba Shula | Economist

Economeka Capital

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