With royalty review given the go-ahead for late 2016 by the Alberta provincial government, the question now remains what the Royalty Review Panel’s final recommendation will look like. A report released today by the C.D. Howe Institute offers a starting point for the discussion on what changes, if any, should be introduced to Alberta’s resource tax system.
With $75 billion in oil & gas tax revenues collected between 2009 and 2013, and said revenues accounting for a whopping 21.8 percent of government revenues for Alberta, it is difficult to overstate the gravity of this issue.
Put simply, the report suggests a structural overhaul of the tax resource system, moving it away from a gross revenue royalty system to a cash flow tax system, similar to the regime employed in other petroleum producing jurisdictions, such as Norway and Australia.
The report suggests a broad outline for reform and advocates adoption of the best practices used in other countries and other resource extraction industries. It leaves the question of specific tax rates for future decision-makers.
The Idea of Cash Flow Taxes
The central tenet of the report’s recommendation is that a cash flow tax better reflects the cumulative costs of resource extraction than a gross revenue royalty. The thrust of the report’s argument is that the tax system as it is dissuades investment in risky exploration and development activities, and thus limits growth while failing to maximize government revenue.
This underlying efficiency rationale for a switch to cash flow based resource taxation is predicated on the concept of economic rents. This posits a theoretical, above-normal return that amounts to such a rent. Using the report’s example as an illustration, if the cost of capital is 5 percent, an above normal – or excess – rate of return could perhaps be 15 percent. Whatever this excess return – the rent – is also the tax base.
For clarification, a normal rate of return is that theoretical rate of return where the difference between total revenue and total cost is zero. Under this theory, total cost includes the aforementioned cost of capital, which would include an appropriate risk premium to compensate owners for undertaking the risks inherent in the business.
While rents are not easily observable, the report argues that cash flows – which equals revenue less costs and where the present value of cash flows also equal the present value of rents – serve as a relatively quantifiable proxy for rents.
The report further argues that this cash flow based approach is conducive to correctly pricing risk. This includes factoring in the cost of exploration, both successful and unsuccessful. The report places special emphasis on the latter, since even unsuccessful exploration can advance other firms’ delineation efforts.
Indeed, one of the primary concerns with the current system is that it disproportionately burdens relatively unprofitable projects. Under a cash flow approach, unprofitable or low profit ventures would be spared much of the tax burden, while more profitable ventures would be on the line for a heavier tax burden. The implication is that this would tend to provide greater incentive to undertake the risk needed to explore and develop new oil & gas projects, presumably because many projects are relatively unprofitable in their early life.
The basic mechanic is that of risk allocation. Under a gross revenue royalty system, the government takes its cut regardless of a company’s ability to pay. This could endanger less established projects. Under a cash flow tax system, the government takes on the risk that it may forego revenue should a young project fail to return a profit. The government hopes that its restraint will lead to greater revenues down the road, either because it provides sufficient breathing room for an infant project to reach profitability, or because it encourages a project that – but for the cash flow tax treatment – would not have been undertaken at all. Put succinctly, the government foregoes some present revenues for the chance of greater future revenues.
Theory has been applied to practice in Alberta, as the province is no stranger to cash flow taxation. For example, a form of cash flow tax currently applies to oil sands projects. But since the report studies tax practices employed world-wide, it stresses that the adoption of cash flow taxation alone is not enough. Wherever such a system is the rule, it should be married to loss offsetting, which in turn should be relatively generous as to deductible expenses and to the interest rate applied to carry forward amounts.
Norway’s system provides an example. The country collects a hefty 51 percent cash flow tax plus a general corporate income tax. Company expenses are deductible in full even on wind up and said expenses can be carried forward indefinitely to offset future tax liabilities. However, the offset is carried forward only at the relatively low risk-free rate set by the government.
In contrast, the Australian system has a generous carry forward discount rate for exploration expenses, but is otherwise quite restrictive on the scope of deductible expenses more generally. It is also less generous with the carry forward discount rate as far as these latter expenses are concerned.
For clarification, the rate applied to the carry forward amount reflects a concern to preserve the time value of money for the producer’s tax assets.
Of course, the report acknowledges the challenges that would accompany a shift to a cash flow based taxation system.Simply put, the report’s study of cash flow taxes in practice worldwide allows policymakers to identify the choices available to them and learn from others’ mistakes.
One problem is that tax authorities are better at observing production than they are at observing costs, which militates in favour of production-linked gross revenue royalty systems. A related problem is that cash flow taxes may be avoidable through profit shifting via transfer pricing and intra-firm transactions.
Another significant problem is that tax authorities may have difficulty in determining the interest rates that reflect the “normal” rate of return. Without objective and neutral criteria to determine this, the above-normal rate of return may vary and with it the tax burden.
Regardless, at the very least the report does put forward a balanced reasoning behind its proposal.
Implication for Royalty Review
It remains unclear at what level of specificity Premier Notley’s government has contemplated changes to the royalty system. Publicly, the provincial government’s proposed changes seem largely focused on rate adjustment, rather than structural overhaul. The ongoing political debate on royalty review seems to echo this focus.
Some of Alberta Energy Minister McCuaig-Boyd’s past statements appear to confirm this view.
“Our commitment to not change rates until the end of next year should serve as a clear signal that our government… wants to be a reliable partner,” said Minister McCuaig-Boyd.
Similarly, the 2007 panel report dealt with the issue of royalty review primarily in terms of rate adjustments. In regards to non-oil sands development, it touched on the concept of economic rents, but not in the context of a cash flow based taxation system. Indeed, its treatment of economic rents is inconsistent with some key assumptions of today’s report.
Specifically, the panel concerned itself with raising the royalty burden on high production wells while easing the burden on relatively mature, low production wells. The C.D. Howe report’s aim is to ease the burden on less profitable projects. Since many wells see a high initial production rate followed quickly by substantial declines, and since many of these projects require substantial upfront costs, it stands to reason that the period of initially high production often coincides with either no or little profitability. If a taxation system is to be designed to mitigate the risks inherent in the early life of a project – to give it breathing room – it cannot contemplate the 2007 panel’s focus on production as the key determinant of tax levels.
The bottom line is if the current provincial government and the current panel’s expectations of royalty review is at least partly anchored by the recommendations of the prior panel, then the C.D. Howe report’s suggestion would be fairly novel.
Either way, the specifics of royalty review have been delegated to the current panel. The broad wording of the Royalty Review Panel’s mandate does not imply an intent to keep its inquiry limited to mere rate adjustments, so there is no reason to believe that the recent report’s recommendations will find no currency.
Indeed, panel chair Dave Mowat independently echoed the C.D. Howe Institute report’s recommendation to look at taxation regimes in other jurisdictions.
As stated earlier, the C.D. Howe Institute report does not provide a set percentage amount where resource taxes are “just right.” What it does do is provide a case for a structural overhaul of the existing system while also giving the review panel a conceptual apparatus to tackle the challenges before it. After all, a panel armed with the best information is preferable to a panel swinging in the dark.
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