A 'pure' cash flow tax on investments would see negative cash flow (revenue from investment less than the associated capital plus operating costs) either attract an immediate (or delayed) government cash rebate equal to the cash flow loss times the tax rate or able to be sold to others who have positive cash flow - that is, 'full loss offset' would apply. Symmetrically, tax would be paid on positive cash flow (revenue greater than associated costs).

A resource rent tax (RRT) is a variant of cash flow taxation that involves cash flow losses being carried forward with interest to be offset against future positive cash flow rather than attracting government cash rebates. Like cash flow taxation, an RRT seeks to tax above normal profits (from whatever source) and to have minimal effect on investment decisions - though the absence of government cash rebates means there is a risk of the value of losses never being recouped.

The Australian Government introduced an RRT to apply to offshore 'greenfields' petroleum projects from 1 July 1984 - the Petroleum Resource Rent Tax (PRRT). In May 2010, the Australian Government proposed the application of a tax, called the Resource Super profits Tax (RSPT), to all mining and petroleum operations in Australia (except those subject to the PRRT). By incorporating delayed full loss offset, the RSPT was financially equivalent to a cash flow tax. After a period of consultation, the Government proposed in July 2010 revised arrangements involving: an RRT to apply to the mining of iron ore and coal in Australia - the Minerals Resource Rent Tax (MRRT); and, extension of the PRRT to all Australian onshore and offshore oil and gas projects.

This paper looks at a number of common misconceptions concerning the design of an RRT.

1. An RRT is complex

2. Loss carry-forward with interest (threshold rate) is the basis of an RRT

3. Loss carry-forward with interest is only relevant to an RRT

4. Threshold rate for loss carry-forward should be based on characteristic level of risk in associated industry

5. The threshold (or uplift) rate defines what economic rent (or excess profits) an RRT taxes

6. The interrelationship between RRT (or cash flow taxes generally) and income taxation raises no special issues

7. Hedging should be excluded from an RRT

MISCONCEPTION 1: AN RRT IS COMPLEX

Some people, familiar with income tax laws, view resource rent taxes as unusual and complex. An RRT is, however, not complex at all. At its core it is a simple cash flow tax. Cash outflow on activities subject to an RRT is immediately deductible. Revenue from the activities is immediately assessable. Cash outflow might be for capital expenditure on assets (producing revenue streams beyond the year of expenditure) or for regular annual operating costs. Figure 1 illustrates early deductible capital expenditures (start and end of Year 1) on a project subject to an RRT and the later assessable net receipts (gross revenue less operating costs) flowing from those capital expenditures.

Income taxation requires a decision to be made over whether an item of expenditure either:

• creates or adds to an asset and, if so, how annual change in the asset's value over its life is to be treated for income tax purposes; or

• is entirely 'used up' in the current year and is therefore immediately deductible.

In contrast, an RRT involves no such complexities. Under an RRT: cash flow out, immediately deductible; cash flow in, immediately assessable. With an RRT therefore where capital expenditure in a year can be written off against positive RRT cash flow, the after-RRT outlay on capital expenditure is reduced by a proportion equal to the RRT tax rate. Similarly, positive annual net receipts (gross revenue less annual operating costs) flowing from a taxpayer's RRT assets are also reduced by a proportion equal to the RRT tax rate. Thus, in these circumstances, the after-tax outlay on capital expenditure in any year is reduced (through immediate write-off) by the same proportion (the tax rate) that ensuing annual net receipts are reduced by tax payments. In Figure 1, if the RRT tax rate were 50%, the capital expenditures in at start and end of Year 1 would be reduced by half by the RRT, as would the net receipts in Years 2, 3 and 4.

In such circumstances where all pre-tax cash flow is reduced in proportion to the RRT tax rate, pre-tax return of the project in Figure 1 would be the same post-RRT. To illustrate further, take a very simple example where $100 is invested at start Year 1 to get $106 at end Year 1. The pre-tax return of this investment is 6% pa. If, under an RRT with a 50% tax rate, the $100 outlay could be written off immediately against other RRT income, the post-RRT cash flow would become $50 at start Year 1 to get $53 at end Year 1 (with the $106 taxed at 50%). Post-RRT, the investment still has a 6% pa return. Thus, unlike the situation with income taxation, the investor's discount rate is unchanged by an RRT when negative cash flow can be immediately offset against other RRT income.

An RRT could be designed to apply to to all the cash flows of an investment project, including financing flows. Unchanged return given the same proportional reduction in pre-tax cash flow applies equivalently to liabilities as to assets. Design of RRT is, however, usually discussed in terms of exclusion of interest from the RRT tax base (contrasting income taxation which includes interest in its base). More specifically, cash flows associated with any borrowing (or capital raising generally) or lending are usually excluded from design of an RRT. Under this design, When analysing investments subject to an RRT it is cash flows associated with return on total investment that are involved, not those associated with returns on equity investment.

Viewed from this traditional RRT design, some may construe exclusion of interest from the RRT base as the underlying reason an RRT does not affect an investor's discount rate - with that unchanged discount rate, in turn, requiring capital expenditure to be immediately expensed for the achievement of investment neutrality. That explanation then nicely contrasts the parallel explanation with income taxation which says that because interest is included in the tax base, the investor's pre-tax discount rate is changed and with that change the treatment of capital expenditure required for neutrality changes from immediate write-off under the RRT to annual change in value of assets under income taxation.

Typically, an investment project involves a stream of capital expenditures (resulting in negative annual cash flow) in the early years followed by positive cash flows over ensuing years. Net present value, NPV, is the sum of all the positive and negative cash flows of a project brought together in dollars of the same point in time – say, the start of the investment project or the ‘present’. A specified interest, or 'discount', rate - say the ‘going’ interest rate available from financial markets - is used to bring all the flows to the ‘present’ so they can then be added together. An up-front capital outlay is already a 'present' valuation. The 'present value' of a cash flow one year out is obtained by dividing (or discounting) the cash flow by 1 plus the discount rate (1.06 if the discount rate was 6%). Viewed in reverse, investing the present value of that year-one cash flow in the financial market at the going interest rate would convert it into the actual cash flow one year out. The present value of a cash flow, say, four years beyond the start of the project is obtained by discounting the cash flow at the specified discount rate four times.

Say all cash flows of a project, discounted at a going 6% pa rate, added together to produce a NPV of zero (and therefore an internal rate of return equal to 6%). Risk considerations aside, the investor would be indifferent between investing in the project and, instead, putting the investment funds in the financial market. The project would be regarded as ‘marginal’ in terms of viability. A positive NPV would suggest the investment project is financially viable – and vice-versa for a negative NPV.

The net present value of a project before RRT, NPVb, when using any discount rate may be represented as:

NPVb = R - C                    (1)

C = sum of discounted capital expenditures in each year,

R = sum of discounted net receipts arising from the capital expenditures (gross revenue less operating costs) in each year.

In the circumstances described earlier where the after-RRT outlay on capital expenditure is reduced (through immediate write-off against RRT income) by the same proportion (the tax rate) that net receipts are reduced by tax payments, the net present value after RRT, NPVt, using unchanged pre-RRT discount rate becomes:

NPVt = (R - C) (1 - t)        (2)

t = RRT tax rate.

• Risk aside, a project marginal before RRT with zero NPV would still have a zero NPV after RRT. The ranking should be unaffected of projects above the margin before RRT with the RRT reducing net present values of potential projects by the same proportion (the tax rate). Moreover, a project's pre-RRT internal rate of return would be unchanged by the RRT. Thus, the project in Figure 1 subject to an RRT with a 50% tax rate (cutting all the cash flows in the figure in half assuming positive cash flows from other projects absorb the capital expenditure deductions) would have a post-RRT NPV of $94.5 - half its pre-RRT NPV. The post-RRT internal rate of return would be 44.2%, the same as the pre-RRT return.

• If an RRT reduced the NPV of all potential projects subject to the tax (and the NPV of all possible outcomes of each of those projects) in proportion to the RRT tax rate - and if rates of return are unaffected by the tax - investors should be taking much the same decisions after the RRT as before, both in terms of whether projects are viable or not and the ranking of viable projects.

In practice, sufficient positive cash flow from other RRT projects would not always be available against which to deduct immediately expenditures on a particular project - especially the early expenditures for proving and developing a stand-alone project. Where 'full loss offset' is assured through the provision (immediate or delayed) of government cash rebates for annual negative cash flow the tax design is no longer that of an RRT but of a pure cash flow tax (or Brown tax). Governments are not usually prepared to ensure full loss offset either through the provision of cash rebates (immediate or delayed) equal to annual negative cash flow times the tax rate or through allowing losses to be sold to others subject to the RRT (with government payments picking up any slack in the market for losses). The RSPT proposed by the Australian Government in May 2010, which included delayed full loss offset (incorporating loss carry-forward at the government bond rate), is an exception to this general rule.

When full loss offset is not assured by government, the carrying forward of RRT losses with interest year by year then becomes an important component of RRT design.

MISCONCEPTION 2: LOSS CARRY-FORWARD WITH INTEREST (THRESHOLD RATE) IS THE BASIS OF AN RRT

Capital expenditures (creating assets) within a project occur before the ensuing hoped for stream of positive net receipts, as illustrated in Figure 1. If no positive RRT cash flow from other projects is available against which to deduct these early capital expenditures, RRT losses (negative cash flows) will arise. RRT design has these losses carried forward with interest (at a specified RRT threshold rate) to be written off against later positive RRT cash flow.

The practical effect of this carry-forward at a threshold rate is that a project subject to the RRT will not pay tax until the project starts producing a return greater than the RRT threshold rate. This practical observation might be construed to conclude that the loss carry-forward with interest is the central design feature of an RRT. However, the main design features of a traditional RRT comprise:

• interest not included in the RRT base (cash flows associated with borrowing and lending excluded);

• investment receipts assessable;

• immediate deductibility of all investment costs (both capital and recurrent expenditure); and

• negative cash flow (RRT losses) carried forward with interest designed as a surrogate for 'full loss offset'.

Not surprisingly, governments do not readily provide such immediate or delayed cash rebates. The interest component on RRT losses carried forward at a threshold rate is designed to maintain the value of these deductions so that, when sufficient positive cash flow is available to the investor from activities subject to the RRT, the benefit in terms of tax savings obtained from these deductions is equivalent (in present value terms) to having full loss offset provisions. Absent government-assured full loss offset, however, the risk of not achieving the required tax savings varies greatly from project to project. At the extreme, a stand-alone project may producing no RRT receipts and attract no tax savings at all for up-front RRT losses being carried forward.

The substitution of loss carry forward at the threshold rate for the full loss offset ideal means that the neat NPV outcome of equation (2) only arises with a project in certain specific circumstances. Thus, a variety of RRT outcomes arise in the absence of full loss offset and the necessarily arbitrary specification of a single RRT threshold rate for loss carry-forward. To illustrate, in the circumstances where threshold rate equals discount rate for NPV determination:

• projects whose rate of return is less than the threshold rate pay no RRT but do not get fully recompensed for RRT losses ('unrecouped' losses remain at the end of the projects);

• projects whose rate of return equals the threshold rate have their compounded-forward losses just fully absorbed as the project shuts down (they pay no RRT so their NPV stays at zero and their rate of return is unchanged); and

• projects with negative up-front cash flow followed by positive cash flow whose rate of return exceeds the threshold rate have their compounded-forward losses written off in full during the life of the projects and have their net present values reduced in proportion to the tax rate (and their internal rates of return reduced towards the threshold rate).

MISCONCEPTION 3: LOSS CARRY-FORWARD WITH INTEREST IS ONLY RELEVANT TO AN RRT

If an RRT loss (negative cash flow) realised by a taxpayer's project in a year can be deducted, or offset, against RRT income (positive cash flow) from that taxpayer's other projects in the same year, the taxpayer achieves immediate RRT savings from the loss equal to the loss times the RRT tax rate - consistent with equation (2). The tax savings arise from the achievement of 'full loss offset' against other available RRT income. Such tax saving, however, is not confined to RRT schemes. It also occurs with income taxation. A taxpayer making a loss for income tax purposes (negative income for income tax purposes) on one activity in a particular year may have sufficient income in that same year from other activities against which to deduct the loss. Absent quarantining arrangements applying to the loss, the taxpayer achieves an immediate income tax saving from the loss equal to the loss times the taxpayer's income tax rate.

Annual RRT losses of a project arise when RRT income from the taxpayer's other projects is not available to absorb them. RRT arrangements that provide for the carrying forward of RRT losses with interest (at a specified threshold rate) are designed to provide RRT savings - made when the compounded losses are eventually written off against positive cash flow - that are the same in present value terms as the saving that would have been achieved from deduction of the loss when it originally arose. Such arrangements therefore maintain the integrity of equation (2) with its proportional reduction in pre-RRT net present values (at the RRT tax rate) forming the basis of the investment neutrality properties of an RRT. Thus, the carrying of RRT losses forward at a threshold rate is a practical surrogate for immeditae government cash rebates equal to RRT losses times the RRT tax rate, cash rebates which would achieve 'full loss offset' in all circumstances.

As with cash flow taxation, neutrality properties of income taxation systems also derive from income taxation causing a proportional reduction in pre-income-tax net present values like that of equation (2) - with a different proportional effect depending on whether the income tax system is designed to tax nominal (where again the proportion is simply the investor's income tax rate) or real income. And, like an RRT, that proportional outcome requires the achievement of full loss offset when annual losses arise. But, unlike an RRT, the proportional outcome with income taxation depends crucially on there being a wedge between pre-and post-tax discount rates. Despite that (crucial) difference in relation to discount rates, from a theoretical perspective loss carry forward with interest is required with income taxation arrangements just as much as with RRT arrangements as a surrogate for government-backed full loss offset.

Why is loss carry forward with interest not usually part of income tax laws but is seen as a crucial part of RRT arrangements? There may be three main reasons for this.

1. Potential reductions in income tax revenue is one reason. In contests between investment neutrality and revenue, revenue is often the winner particularly when long-standing income taxation systems representing an important tax base are involved. Moreover, income tax losses - including capital losses - require particular attention from income taxation administrators to minimise scope for exploitation from taxpayers. Some income tax laws have, in fact, only relatively recently removed limits on the number of years that losses could be carried forward and allowed indefinite carry-forward of losses.

2. Perhaps more relevant is the observation that income taxation laws do not generally encompass all the other requirements of neutral income taxation beyond full loss offset - namely, not only the inclusion of annual net receipts but also annual change in value of assets and liabilities so that the income tax base reflects taxpayers' positive and negative (ie tax losses) economic income. A movement towards the general achievement of full loss offset with income taxation - something that sectors characterised by stand-alone investments, such as the infrastructure sector, often seek - might therefore be expected to first require the income tax base to be targeting economic income. In contrast, full loss offset aside, the traditional RRT base required to achieve investment neutrality - annual cash flow excluding flows relating to borrowing and lending - is readily able to be implemented in practice.

3. Income taxation necessarily applies across the board as its neutrality properties depend crucially, as already noted, on a wedge between pre- and post-tax discount rates, a wedge that is driven by the fact that economic income includes accrued gains and losses of investment assets and liabilities (and therefore the inclusion of interest in the income tax base). For that wedge to be reflected in investors' post-tax discount rates (what post-tax interest rate they can alternatively get from financial markets), income taxation must be applied to all activities of investors. Moreover, income taxation applying to all activities of each individual or incorporated taxpayer increases the likelihood that positive income from one activity will be available to absorb losses from another. In contrast, RRT arrangements are usually aimed at above normal profits of projects in particular sectors of an economy. These arrangements are suited to narrow sector- or project-specific application because pre-RRT discount rates are unchanged by cash flow taxation, the conceptual basis of an RRT. Moreover, with an RRT say 'ring-fencing' individual projects in a particular sector, there is no opportunity for RRT income from other projects to offset the RRT losses from any one project. RRT losses are then assured at least at the start of each individual project.

In sum, both income taxation and cash flow taxation require full loss offset to achieve investment neutrality. In contrast to income taxation in practice, however, RRT can be viewed as meeting the theoretical ideals of cash flow taxation sufficiently to justify loss carry forward with interest as a surrogate for full loss offset:

• in contrast to economy-wide income taxation arrangements providing a high proportion of a country's tax revenue, an RRT would typically be an additional revenue source targeting above-normal profits of specific types of operations in particular industry sectors;

• the typically limited reach of an RRT, particularly if implemented on a project-specific basis - with cash flows from each individual project 'ring-fenced' from those of other projects - rather than say on a company-wide basis, mean that RRT losses assume heightened importance with losses typically arising at the early stages of a project; and

• the traditional RRT base - annual cash flow excluding flows relating to borrowing and lending - is readily able to be implemented in practice. Unlike income tax arrangements where tax losses are usually very different from negative economic income (the income tax base required for investment neutrality), annual RRT losses are negative cash flows which match the requirements for investment neutrality with cash flow taxes.

MISCONCEPTION 4: THRESHOLD RATE FOR LOSS CARRY-FORWARD SHOULD BE BASED ON LEVEL OF RISK TYPICAL OF THE INDUSTRY INVOLVED

An RRT loss from a project arises in a year when RRT expenditure on the project exceeds the project's RRT revenue in that year resulting in negative cash flow. If the developers of the project had sufficient RRT income (positive cash flow) from other projects to fully absorb the project's loss in that same year, 'full loss offset' would be achieved in that year with associated reduced RRT payments. The RRT savings associated with an RRT loss from the project in a year is then equal to the loss times the RRT tax rate.

The carrying forward of RRT losses with interest at a specified threshold rate is designed as a surrogate for 'full loss offset' when other RRT income is not available to absorb losses. Loss carry-forward with interest maintains the value of the tax savings in present value terms when the compounded loss can eventually be written off against positive cash flow. Thus, so long as a project's annual losses are eventually written off in full, the identity in equation (2) is maintained with discounting at the RRT threshold rate. The investment neutrality properties of an RRT derive from equation (2).

In this role of preserving the value of RRT losses being carried forward, what should be the basis of setting the RRT threshold rate?

Risk-free threshold rate with no unrecouped RRT losses

Say entrepreneurs were sure they would always be able to write off projects' RRT losses against future positive cash flow (that is, there would be no 'unrecouped' losses). In that case, the RRT threshold rate would logically be set at a risk-free rate of interest, such as the long-term government bond rate. The entrepreneur is sure that reimbursement for a loss will occur so the entrepreneur only has to be compensated for the opportunity cost of waiting for that sure payment to be received. The relevant risk here is not the unique risk of a project itself - or some measure of the risk typical of projects in the industry subject to the RRT - but the risk that excess deductions being compounded forward would not be offset against later positive cash flow from the project (or from other projects).

In practice, however, unrecouped losses would be common when, for example, a project turns out to be unprofitable or large closing down costs arise at the end of a project. Thus, absent a market in RRT losses, governments would have to provide arrangements that might be called 'delayed full loss offset' to ensure no project faced unrecouped losses. Such arrangements would see compounded-forward RRT losses (including losses arising on the closing down of a project) that are not able to be written off against positive cash flow attract government cash rebates equal to the compounded loss times the RRT tax rate. Delayed full loss offset provisions generally-available for all RRT losses, however, might seem to be no more likely in practice than governments' stepping in to ensure full loss offset is achieved in any year an RRT loss is realised (the government paying a cash rebate equal to the loss times the RRT tax rate in that same year in the absence of the sale of the loss to others subject to the RRT). Nevertheless, targeted arrangements providing some delayed full loss offset might be expected in practice. The Australian PRRT, for example, allows for refunds of prior RRT payments (equal to expenditure times the RRT tax rate) for eligible closing down expenditure that cannot be immediately written off against RRT receipts. Moreover, in May 2010, the Australian Government proposed the broadening of resource rent taxation in Australia by the application of a tax, called the Resource Super profits Tax (RSPT), which did incorporate delayed full loss offset and was financially equivalent to a cash flow tax. After a period of consultation, however, the government announced in July 2010 a revised proposal to broaden resource rent taxation in Australia via traditional RRT-type arrangements.

Inevitable unrecouped losses affect investment decisions

Similarly, looking across each possible pre- and post-RRT NPV outcome of a particular project, with discounting at a risk-free interest rate (as if each outcome was certain to be achieved) and with the RRT threshold rate set equal to that risk-free interest rate:

• each pre-RRT NPV that is negative (discounted capital expenditures greater than discounted net receipts) is unchanged by the RRT (no RRT paid and no recompense for RRT losses);

• a zero NPV is unchanged by the RRT (no RRT paid and losses compounded forward are just absorbed fully in final year of the project); and

• each pre-RRT NPV that is positive (discounted net receipts greater than discounted capital expenditures and no unrecouped losses) is reduced by the RRT in proportion to the RRT tax rate - consistent with equation (2).

Load the risk-free threshold rate to offset effect of unrecouped losses

The post-RRT asymmetry imposed on both the pre-RRT internal rate of return and NPV probability distributions skews these distributions negatively, reducing expected internal rate of return and NPV. The somewhat predictable nature of these effects under an RRT might suggest that RRT parameters could be adjusted to minimise the effect of an RRT on investment decision-making. Starting from the benchmark of a risk-free RRT threshold rate when there is no risk of unrecouped losses, the threshold rate might be increased above the risk-free rate (perhaps accompanied by a reduced RRT tax rate) in a rough attempt at minimising the distortive effect imposed by the possibility of unrecouped losses. Increasing the threshold rate would:

• increase the number of a project's possible outcomes that would pay no RRT (those with returns less than the new higher threshold in Figure 2); and

• increase the post-RRT return or NPV of outcomes with either internal rates of return greater than the new higher threshold (Figure 2) or with net present values that were positive when the threshold rate equalled the risk-free discount rate.

Increasing the RRT threshold rate above a risk-free rate, perhaps in conjunction with a somewhat reduced RRT tax rate, might therefore be viewed as a rough offset to the asymmetrical effects illustrated in Figures 2 and 3 caused by the carrying forward of RRT losses with interest as a substitute for (immediate or delayed) full loss offset provisions. The further the RRT design increases the possibility of full loss offset - for example, company-based rather than project-based or losses arising from closing down expenditure attracting cash rebates - the lower such a loading of the RRT threshold rate would be above a risk-free rate.

Regardless of the use of loadings above a risk-free rate, however, distortions associated with the asymmetric effect of the RRT on a project's spread of possible outcomes will inevitably remain. A loading does not directly compensate outcomes where unrecouped RRT losses arise. Moreover, a generally-applicable loading is not sensitive to the risk of unrecouped losses faced by particular projects. A project may, for example, have a wide spread of possible outcomes but have little or no prospect of losing available RRT deductions - in which case, no loading is justified. Against such considerations, an alternative strategy is to design the RRT to maximise the possibility of full loss offset and leave the threshold rate at a risk-free level - a level at which income taxpayers would, no doubt, be more than pleased to accept on their losses being carried forward, despite the risk that compounded-forward income tax losses could ultimately be lost completely.

Additive or multiplicative loadings on risk-free threshold rate

The form of the loading of the threshold rate above a risk-free rate could be either additive or multiplicative. The above rationale for a loading does not preclude a multiplicative loading. Against the above analysis, the loading would be designed to offset the effects of the skewing of the range of possible project outcomes by unrecouped losses.

• It would not be a reflection of the unique risk of a project or of the risk characteristics typical of projects in an industry subject to an RRT.

• And it would not be, say, an additive loading on a risk-free interest rate to reflect the risk premium of a project's (non-diversifiable) market risk in a capital asset pricing (CAPM) framework.

The two forms of loading result in very different threshold rates with changes in long-term bond rates. With the Australian PRRT, the loading is additive: initially set in 1984 at 15 percentage points above the long-term government bond rate, when the bond rate was about 14 to 15 per cent. In 1984, a multiplicative loading providing an equivalent percentage threshold rate would have been 2 times long-term bond rate. In early 2010, however, with the long term bond rate at about 5%, the 15% additive formula provides a threshold rate of 20% whereas a 2-times multiplicative rate would provide a threshold of 10%.

MISCONCEPTION 5: THE THRESHOLD (OR UPLIFT) RATE DEFINES WHAT ECONOMIC RENT (OR EXCESS PROFITS) AN RRT TAXES

An RRT may be applied on a project basis where costs associated with a defined project can only be offset against revenue from that same project. In these circumstances, up-front exploration and development expenditures create losses because of the inevitable delay in foreshadowed future revenue. These losses are carried forward at the threshold (or uplift) rate. Thus, the project does not start paying RRT until a return is achieved on those early costs equal to the uplift rate. Not surprisingly, therefore, people conclude that the uplift rate is a key design parameter required to determine the level of profit above which an RRT 'kicks in'. This conclusion, however, ignores the characteristics of cash flow taxation that underpin the neutrality properties of an RRT. A pure cash flow tax (or Brown tax) has no uplift rate at all as losses attract immediate cash rebates. And yet inherent in the design of a Brown tax is the taxing of above normal returns from whatever source (generally termed 'economic rent').

Brown tax

To illustrate the economic rent taxing characteristic of a Brown tax, take an investor with a 15% risk-weighted discount rate (that is, someone requiring a 15% pa return from the expected cash flows of a proposed mining investment). Say, in the event, that investor does actually earn 15% pa before tax from the highly stylised mining investment in Table 3 ('Pre-tax cash flow' column) - with that return to $1000m of development expenditure at the start of Year 1 (Year 0) coming from delayed net receipts (revenue less operating costs) in Years 3, 4 and 5. With the mining project subject to a 40% Brown tax, that investor looking back at the past stream of government cash rebates in Year 0 and tax payments in Years 3, 4 and 5 ('Brown tax rebates/tax' column) finds that he has paid no tax in discounted terms. Tax payments associated with the investment (in its later years) when discounted at the investor's 15% discount rate just balance the up-front $400m cash rebate to provide a zero NPV. But had the investment earned more than 15% - earning economic rent from the investor's point of view - the investor would then see the government taking out more than it put in. If, instead of 15%, the investor uses a 6% discount rate, the investor would view the project’s tax payments as exceeding the early cash rebate by $137m in discounted terms. The economic rent above the investor’s 6% required return would be seen by the investor as being subject to tax. Economic rent is in the eye of the investor and the inherent design of the Brown tax allows that personal view of economic rent to play out.

Notes to table:

1. Immediate expensing of all costs and immediate cash rebates for tax losses, so that negative cash flow is reduced by 40% rebate and positive cash flow is reduced by 40% tax.
2. Pre-tax cash flow less (negative) Brown tax rebates and (positive) tax payments.
3. Cash rebate equal to 40% of $1000 capital expenditure.
4. 60% of pre-tax NPV - ie pre-tax NPV reduced by the 40% Brown tax rate as shown in equation (2).
5. With all positive and negative cash flow reduced by the 40% tax rate, the internal rate of return is the same after tax as before.

If 6% were a risk-free interest rate, the cash flows in Table 3 and the associated NPV with discounting at 6%, could be one possible outcome of a proposed investment. In terms of Figure 3, this possible outcome with a positive pre-tax NPV would fall to the right of the y-axis (which cuts the x-axis at zero NPV), with the NPV reduced by 40% after the Brown tax to $205.6m. An outcome where the $1000m up-front capital expenditures were totally unsuccessful, the pre-tax NPV would be well to the left of the y-axis - but again would be cut by 40% after the government cash rebate under the Brown tax. The Brown tax acts even-handedly on both ends of the project's risk spectrum.

The rent-taxing and associated neutrality properties of a Brown tax remain at the heart of an RRT. In moving from a Brown tax with full loss offset to an RRT, losses are carried forward at an uplift rate with the attendant risk that insufficient RRT revenue will mean the value of the losses will never be recouped. Nevertheless, the irrelevance of the RRT uplift rate to define what is economic rent remains. Under an RRT, the uplift rate is designed to maintain the value of the losses carried forward in order to achieve an outcome equivalent to full loss offset when the losses are deducted against future revenue. The uplift rate is not designed to define economic rent or excess profits. Thus, if government undertakes to provide cash rebates for losses compounded forward so that there is no risk that the value of these losses will be lost, the uplift rate need just reflect a risk-free rate (say the government bond rate) to maintain the value of the losses. Such design could be described as a Brown tax with delayed full loss offset. Uplift at the government bond rate maintains the value of losses over time (until they are either absorbed by positive cash flow or attract government cash rebates). The uplift rate has nothing to do with determining when the tax 'kicks in' and nothing to do with the cost of funds to the investor.

Brown tax with delayed full loss offset

Taxes financially equivalent to a Brown tax

RRT

• recognition that there is no government guarantee covering the value of the losses being compounded forward and there is therefore a risk that the value of some losses will be lost entirely - a risk that is higher with a project-based RRT relative to a company-based RRT (where RRT profits from some of a taxpayer's projects may absorb RRT losses from others); or

• an attempt at offsetting the effects of the asymmetry imposed on the spread of possible project outcomes by the RRT which taxes upside outcomes without providing cash rebates for downside outcomes (illustrated in Figures 2 and 3). In a weighted-average sense, the lowering of expected returns or net present values by the asymmetric impact of the RRT may be reversed by the loading on the uplift rate.

• Carrying forward RRT losses with uplift cannot stop those losses being lost completely if there is insufficient RRT profit to absorb them - regardless of the level of uplift. The net outlay with $1000m of unsuccessful mining expenditure is still $1000m. There are no government cash rebates to reduce the $1000m outlaid. In Figure 3, the associated negative pre-tax NPV stays on the 'a-b' schedule after tax and is not reduced (as it would be under a Brown tax) to lie on the dashed schedule.

• Increasing the uplift rate just pushes out the point at which the tax starts to bite on the profit-making end of possible project outcomes (Figure 2). Moreover, higher uplift rates provide the incentive for distortive practices, such as, delaying production in order to increase the value of losses being carried forward.

Once full loss offset is dropped, along with its neutrality benefits, there are no neat second-best solutions.

Nevertheless, if an RRT with a 15% uplift rate applied to the cash flows of the project in the above tables, zero RRT would be paid, consistent with the outcome under a Brown tax for the investor with a 15% risk-weighted discount rate (Table 3). The project has a pre-tax return of 15% and the $1000m loss from the up-front capital expenditure, when compounded forward at 15% pa under the RRT, just absorbs the last dollar of net receipts of the project in the last year of the project. This is shown in Table 7.

Notes to table:

1. Immediate expensing of all costs and tax losses (negative cash flow) compounded forward at 15% (lost completely if insufficient revenue available).
2. Prior year negative amount uplifted by 15% plus this year's amount in 'Base before loss uplift' (or pre-tax cash flow).
3. 40% times any positive tax base after loss uplift.
4. Pre-tax cash flow less tax payments.

With discounting at the investor's assumed 15% discount rate, the project has a zero NPV before and after the RRT. The investor using a 15% risk-weighted discount rate perceives zero tax payable in discounted terms under the Brown tax (Table 3) and literally zero tax payable under the RRT (Table 7). This outcome might be interpreted to mean that the RRT uplift rate, necessarily higher than a risk-free rate, represents an arbitrary guess at a measure of economic rent for all investors and all projects subject to the RRT. That interpretation, however, leads to the incorrect conclusion that a risk-free uplift rate used with a cash flow tax incorporating delayed full loss offset (Tables 4, 5 and 6) is also a measure of when the tax 'kicks in'. This important interpretive issue aside, a fixed RRT uplift rate can only be appropriate for specific investors and particular projects.

• Were our investor using say a 6% discount rate rather than 15%, for example, the investor would view very differently the outcomes of a Brown tax and RRT applying to the above project. Under the Brown tax (Figure 3) the investor would observe $137m (in present value terms) of tax being paid on what the investor perceives as above normal profits and, consequently, pre-tax NPV would be reduced by 40%. In contrast, under the RRT despite the investor's perceiving economic rent in the project the investor would pay no tax and the project's pre-tax NPV of $342.6m would remain unaffected by the tax (Figure 7).

• As already noted, were the $1000m up-front expenditures unsuccessful, the NPV under the 40% RRT would be minus $1000m, very different from the minus $600m under a 40% Brown tax.

Moreover, with some mining projects, after successful exploration expenditure, there may be little or no risk that losses associated with subsequent development and operating expenditures would be lost completely - despite the project exhibiting a wide spread of different possible outcomes. In these circumstances, an uplift rate in line with a risk-free rate would provide the desired equivalence to full loss offset. An uplift rate set at some average measure of investors' risk-weighted discount rates would raise the prospect of perverse investment and production decisions.

Conclusion

In circumstances where government does not wish to provide cash rebates for losses under cash flow taxation, a practical conclusion to the above discussion is to design an RRT which approaches a Brown tax as much as practicable. Such design might include the following features:

• company-based RRT (where RRT profits from a taxpayer's RRT projects may absorb RRT losses from other projects of the taxpayer) to minimise the taxpayers' risk of losing RRT losses completely;

• RRT losses able to be sold to other taxpayers with current RRT profits to further reduce the risk of losing the value of those losses;

• possible refunds of prior RRT payments for losses arising from specified closing down expenditures (as applies with Australia's PRRT); and

• uplift rate set at a risk-free rate like a suitable government bond rate.

MISCONCEPTION 6: THE INTERRELATIONSHIP BETWEEN RRT (OR CASH FLOW TAXES GENERALLY) AND INCOME TAXATION RAISES NO SPECIAL ISSUES

A pure cash flow tax, or Brown tax, will exhibit its investment neutrality properties regardless of the cash flows to which it is applied. Thus, if applied to post-income tax flows, post-income tax internal rates of return (IRRs) will be maintained after the Brown tax and post-income tax net present values (NPVs) will be reduced in proportion to the Brown tax rate, regardless of the (post-income tax) discount rate used.

A practical difficulty associated with applying a Brown tax to say the mining industry after income tax is the requirement to attribute the right amount of a taxpayer’s overall income tax liability to the taxpayer’s mining operations to get a true measure of post-income tax flows of the mining operations.

With a Brown tax applied before income tax, an interesting question is whether the neutrality properties of cash flow taxation are maintained after the application of income taxation. Typically, cash rebates and/or tax payments from cash flow taxation are assigned simple income tax treatment incorporating:

1. cash rebates for negative pre-tax cash flow included in assessable income; and

2. tax payments on positive pre-tax cash flow allowed as an income tax deduction.

This issue is assessed here using a stylised mining project over 5 years with typical delay between up-front capital investment and realisation of revenue from product sales. Three different cases are analysed, each with a different income tax treatment:

1. 5-year straight line write-off of capital expenditure with cash rebates for negative pre-tax cash flow assessable and Brown tax payments deductible;

2. economic depreciation – annual change in pre-tax value of the project (increases, as well as decreases) – included in the income tax base, again with cash rebates for negative pre-tax cash flow assessable and Brown tax payments deductible; and

3. economic depreciation applying but this time with the annual change in value of the project that is included in the income tax base determined from cash flows of the project after the application of the Brown tax (rather than the project’s pre-tax cash flows).

The project

The highly stylised mining project under study has the following pre-tax cash flows:

• $1000m of capital expenditure at start Year 1 (Year 0);

• 3-year delay before net receipts (revenue less operating costs) are realised from the sale of product in Years 3, 4 and 5; and

• the mine's assets are scrapped for no value at the end of the project's life, resulting in a 10% pa return over the 5-year life of the project.

The project before any taxation is shown in Table 8 and illustrated in Figure 4.

Notes to table:

1. Future cash flow discounted at 10%.

FIGURE 4: Project value before taxes

Before all taxes, the project has an IRR of 10% and, with discounting at 10%, a NPV of zero. For the purposes of this stylised project, the investor could alternatively earn 10% by investing in the financial market. Thus, the project would be marginal for an investor using a pre-tax 10% discount rate to assess project viability. Project value increases in Years 1 and 2 as the project becomes closer to yielding tangible net receipts and then declines as the mineral resource is used up with no value remaining at end Year 5.

Analysis

Case 1. Table 9 has a 40% Brown tax applying to the project's cash flows (revenue from the sale of product less capital and operating costs). Thus, negative cash flow attracts a cash rebate equal to the loss times 40% and positive cash flow attracts tax at 40%. The tax outcomes for the project under the Brown tax with full loss offset achieved via cash rebates would be the same as those under an RRT where annual losses (incorporating immediate write-off of capital expenditure) could be offset against RRT profits from the taxpayer's other projects. Table 9 shows in column (c) that the IRR of the project post-Brown tax stays at the pre-tax 10% and its NPV (with the discount rate unchanged at the 10% pre-tax rate) stays at zero. These outcomes result from all the project’s pre-tax cash flows (negative as well as positive) being reduced by the 40% tax rate. The project remains marginal after the Brown tax.

Notes to table:

1. From table 8.
2. Pre-tax cash flow (column (a)) times 40% tax rate. Negative number represents a cash rebate and positive numbers tax payments
3. Column (a) less column (b).
4. 5-year straight line depreciation of capital expenditure for income tax purposes.
5. Net receipts (Table 8) less depreciation allowances (column (d)).
6. Column (e) less Brown tax rebates/payments (Column (b)) making the rebates assessable and Brown tax payments deductible.
7. Column (f) times 30% income tax rate. Income tax losses are able to be written off immediately against the taxpayer's other income.
8. Column (a) less column (b) less column (g).

In fact, the investor sees that he has paid no Brown tax in discounted terms. The Brown tax payments made in Years 3 to 5 (column (b) in Table 9), when discounted at 10%, match the $400m up-front amount in Year 0 ($400m government cash rebate under the Brown tax or, under an RRT, the effect of offsetting the write-off of the $1000 capital outlay in Year 0 against positive RRT cash flow of other projects).

Table 9 also shows outcomes after the Brown tax and after income tax applied at 30% with 5-year straight line write-off allowed - column (e) includes net receipts less depreciation and column (f) includes Brown tax rebates and payments. The project’s IRR falls to 6.7% after Brown and income taxes (column (h)). Its NPV is -$7.1, this time with discounting at 7% – that is, 10x(1-0.3)% to take into account the wedge imposed by income taxation between pre- and post-tax discount rates. Before income tax the investor compares project returns with the 10% available from the financial market. After income tax at the investor's 30% income tax rate, the investor compares project returns with the post-tax 7% financial market return.

On the basis of these static figures, the project has moved from being marginal before tax and after Brown tax to being slightly below the margin after both Brown and income taxes (that is, a return of 6.7% instead of 7% and a NPV of -7.1m rather than zero). Either the 5-year straight line depreciation (illustrated in Figure 5) or the treatment of the Brown tax for income tax purposes, or both, might be causing this.

FIGURE 5: Project value and tax value with 5-year straight line depreciation

Case 2 changes the income tax depreciation arrangements and Case 3 the Brown tax treatment for income tax purposes.

Case 2. Table 10 has economic depreciation replacing 5-year straight line income tax depreciation - in the ‘Income tax depreciation' column (d). This means annual change in value of the project shown in the last column of Table 8 and illustrated in Figure 4 (or project cash flow discounted at 10% to end of year less cash flow discounted to start of year) is included in the income tax base. Thus, accrued capital gains of $100m and $110m are included for Years 1 and 2, respectively, with accrued capital losses allowed in ensuing years as the mineral resource is used up. To that are added annual net receipts (from Table 8) to compute column (e) and then Brown tax cash rebates – or the effect of negative cash flow being applied against other positive cash flow with an RRT – less Brown or RRT tax payments to compute column (f).

Notes to table:

1. From table 8.
2. Pre-tax cash flow (column (a)) times 40% tax rate. Negative number represents a cash rebate and positive numbers tax payments.
3. Column (a) less column (b).
4. Economic depreciation (annual change in value) of project from Table 8 included for income tax purposes. Negative values represent assessable accrued capital gains, positive values deductible accrued capital losses.
5. Net receipts (Table 8 or Years 3 to 5 in column (a)) less economic depreciation (column (d)).
6. Column (e) less Brown tax rebates/payments (Column (b)) making the rebates assessable and Brown tax payments deductible.
7. Column (f) times 30% income tax rate. Income tax losses are able to be written off immediately against the taxpayer's other income.
8. Column (a) less column (b) less column (g).

In the absence of Brown taxation, income tax applying to net receipts plus economic depreciation would see the project’s IRR coming in at 7% – corresponding to the project’s 10% pre-tax return reduced by the 30% income tax rate. With discounting at 7%, the project’s NPV would be zero. The project, marginal before tax, would remain marginal after income tax.

However, with Brown tax cash rebates and payments being assessable and deductible, respectively, Table 11 shows the project has an IRR of 5.8% and an NPV of -$31.4m after Brown tax and income tax. On these numbers, the treatment in the table of Brown taxation for income tax purposes has a somewhat adverse effect on the project’s viability. Against that, substituting economic depreciation (and its taxation of the project's early accrued capital gains) with relatively generous 5-year straight line depreciation - the tax treatment in Table 9 - pushes the project's after-all taxes outcome closer to that of a marginal investment.

In sum, relative to a neutral post-tax outcome, the generosity of 5-year write-off compared to economic depreciation for this project is offset by the treatment of Brown taxation for income tax purposes - resulting in the 'slightly below the margin' outcome of Table 9.

Case 3 keeps economic depreciation for income tax purposes and changes the income tax treatment of the Brown tax.

Case 3. Table 11 has economic depreciation again applying but this time annual change in project value is not determined from pre-tax cash flow. It is determined from pre-tax cash flows after the impact on those flows of the Brown tax (Figure 6). The effect of the Brown tax is to reduce all pre-tax flows (capital expenditures, net receipts and any residual value of the project) by the 40% Brown tax rate.

Notes to table:

1. From Table 8.
2. Pre-tax cash flow (column (a)) times 40% tax rate. Negative number represents a cash rebate and positive numbers tax payments
3. Column (a) less column (b).
4. Economic depreciation (annual change in value) of post-Brown tax cash flow (column (c) cash flow discounted at 10% to end of year less cash flow discounted to start of year) included for income tax purposes. Negative values in column (d) represent assessable accrued capital gains, positive values deductible accrued capital losses.
5. Post-Brown tax net receipts (Years 3, 4 and 5 of column (c)) less economic depreciation post-Brown tax cash flow (column (d)).
6. Column (e) times 30% income tax rate.
7. Column (a) less column (b) less column (f).

FIGURE 6: Project value pre-tax and post-Brown tax

The resulting annual change in value of the post-Brown tax project flows (again in the ‘Income tax depreciation’ column) in each year in Table 11 is 40% less than the corresponding change in value in Table 10.

The income tax base in each year (the ‘Income tax base post-Brown tax’ column) in Table 11 then comprises the post-Brown tax net receipts (in Years 3, 4 and 5 of column (c)) less economic depreciation based on post-Brown tax cash flows (column (d)). Brown tax payments and cash rebates are not separately included as they have already been excluded from the pre-tax project flows.

The outcome of this treatment is a post-tax project IRR of 7% and an NPV of zero with discounting at the income tax-affected 7% discount rate. The project, marginal before tax, is again marginal after Brown tax (or RRT with full loss offset) and income tax.

Conclusion

From a theoretical perspective, the interaction of a Brown tax applied to mining projects before income tax and income taxation is a relevant issue in relation to neutrality of investment decisions. Change in project value – a key component of a neutral income tax base – needs to be determined on the basis of the project’s post-Brown tax cash flows, not its pre-tax cash flows, to meet the neutral ideal.

Nevertheless, there is probably no point contemplating such treatment in practice unless:

• income tax arrangements make a reasonable attempt at estimating annual change in value of mining projects; and

• either a ‘pure’ cash flow tax (Brown tax) is operative (providing immediate expensing and immediate cash rebates for losses) or a cash flow tax with delayed full loss offset that is financially equivalent to a Brown tax.

Income arrangements often do not closely track annual change in value of mining projects. Some mining expenditures might be capitalised and written off over the life of the mine. Much expenditure, however, is often written-off on a straight line or reducing balance basis when installed ready for use (reflecting the situation depicted in Figure 5) – not requiring, for example, production to have commenced before write-off commences. And successful exploration expenditure, despite feeding into increased project value, invariably attracts immediate write-off.

Moreover, as with other deferred-cashflow projects, like forestry, horticulture, real estate developments and infrastructure projects, annual capital gains accruing as mining projects approach production are not included in assessable income.

Thus, the ideal income tax treatment of cash flow taxes applied before income tax on mining projects, and the ideal income tax treatment itself, are relegated to the realm of theoretical interest only.

In practice, having RRT payments deductible for income tax purposes is a simple, practical approach to take with less than perfect rent tax and income tax arrangements. The effect of commonly more generous write-off of capital expenditure relative to economic depreciation, on the one hand, may in fact offset to varying degrees the effect of simply including cash flow tax payments in the income tax base, on the other - as observed in the stylised mining project analysed here.

MISCONCEPTION 7: HEDGING SHOULD BE EXCLUDED FROM AN RRT

The correct treatment of hedging under an RRT is most clearly appreciated through use of a hypothetical project subject to an RRT.

Figure 7 is a cash flow diagram of a stylised crude oil project. Following success in early exploration drilling, the following certainty-equivalent cash flows (flows that would be accepted with certainty against more beneficial but risky outcomes) are used to assess the project's viability. Those developing the project want to include in this assessment hedging arrangements to 'lock-in' a forecast price of $80/bbl for crude oil (the current spot and futures price of crude oil). The cash flows therefore include brokerage costs associated with selling (going short) sufficient crude oil futures contracts at $80/bbl to cover the forecast 95m barrels of crude oil production in Years 2 to 4 (if only the risk of reductions in crude oil prices were to be hedged, options or options over futures contracts could be used instead of futures contracts). The brokerage costs for the futures contracts are put at $120m in Years 1 and 2, $70m in Year 3 and $25m in Year 4 covering a fixed price per contract when contracts are rolled over ever month (there are speculators on the other side of the contracts hoping the price of crude oil futures increases). Thus, the project's cash flows are:

• $200m expenditure at the start of Year 1 on further drilling to confirm size and potential flows of the oil field;
• $1000m expenditure at end Year 1 on developing the field for production plus $120m brokerage for hedging;
• $2080m net receipts at end Year 2 (40m barrels of oil at $80/bbl less $1000m operating costs and $120m brokerage for hedging), with all that year's crude oil sold and associated futures contracts closed out at year end;
• $1730m net receipts at end Year 3 (35m barrels of oil at $80/bbl less $1000m operating costs and $70m brokerage for hedging); and
• $575m net receipts at end Year 4 (20m barrels of oil at $80/bbl less $1000m operating costs less $25m brokerage for hedging) less $500m closing down expenses.

FIGURE 7: Cash flows of crude oil project

Before RRT

Before RRT, the project's NPV is $2107 with discounting at 6% pa. This is confirmed in Table 12 (printout from the MyProject package).

If a price for crude oil lower than $80/bbl were fed into the cash flow analysis, the same year-by-year cash flows as in Figure 7 and Table 12 would result (with the lower spot price and futures price spiking lower each time crude oil is sold at the end of Years 2, 3 and 4 for simplification purposes). That is because for every $1 lost on the actual sale of crude because price is lower than $80/bbl, the project developers would gain $1 on their futures contracts. Similarly, for prices above $80/bbl the cash flows would remain unchanged - though in that case the project developers would get more from the sale of crude but lose the same amount on their futures contracts.

After RRT

After the imposition on crude oil projects of an RRT with a threshold carry-forward rate for losses of 6% pa and a 40% RRT tax rate, the NPV of the project with the pre-RRT cash flows in Figures 7 and Table 12 is $1264 with discounting at 6% pa. That post-RRT result - reflecting a crude oil price of $80/bbl - is shown in Table 13. With threshold rate equal to discount rate, the post-RRT NPV is equal to the $2107 pre-RRT NPV reduced by the 40% tax rate percentage, or $2107x(1-0.4) - as expected from equation (2). $989m of RRT is paid.

As before the RRT, if a price for crude oil lower or higher than $80/bbl were fed into the post-RRT cash flow analysis, the year-by-year post-RRT cash flows would be identical to those in Table 13 so long as:

• the amount received from the sale of crude oil for RRT purposes is net of hedging gains or losses associated with that crude oil; or

• hedging losses and hedging gains associated with the sale of crude oil subject to RRT are included in the RRT base as deductible costs and assessable receipts, respectively.

If, however, hedging gains and losses were excluded from the RRT base, the pre-RRT NPV of the project would be reduced by less than the tax rate proportion by the RRT if crude oil prices were less than $80/bbl - because lower receipts from crude oil sales would be included in RRT assessment but the associated hedging gains would not be (though exclusion of brokerage costs would dampen this effect somewhat). Even though the developers had effectively locked in a fixed price for their crude they would be taxed under the RRT on less than this. Table 14 shows the project's post-RRT cash flow analysis assuming crude prices spike down to $60/bbl at sale time and excluding associated hedging gains as well as brokerage costs. The post-RRT NPV of actual cash flow (not cash flow for RRT purposes) is $1696m - shown in column (g) - compared to the post-RRT NPV of $1264m in Table 13. Rather than a neutral 40% reduction in pre-RRT NPV ($2107m from Table 12), the reduction is now only 19.5%. Moreover, instead of $989m of RRT being paid (Table 13), column (c) in the table shows only $486m is paid.

Notes to table:

1. Crude oil production of 40m bbl, 35m bbl and 20m bbl from 2012 to 2014 at $60/bbl (effects of hedging excluded).
2. As in Table 13.
3. RRT payments based on cash flows in columns (a) and (b).
4. Column (a) less columns (b) and (c).
5. Hedging brokerage costs excluded from RRT base.
6. Hedging gains excluded from RRT base (crude oil production in year times $20/bbl) arising from futures contracts sold at a price of $80/bbl with prices falling to $60/bbl.
7. Column (a) plus column (f) less columns (b), (c) and (e).
8. Unrecouped RRT losses.

For prices higher than $80/bbl, the reverse of Table 14 would happen. The developers would be taxed on sales of crude for more than $80/bbl without being allowed deductions for associated hedging losses on the short futures contracts. The pre-RRT NPV of the project would be reduced by more than the tax rate proportion. Table 15 shows that the project's $2107m pre-RRT NPV would be reduced by 76.4% to $497m and $1886m of RRT (compared to the neutral $989m) would be paid.

Notes to table:

1. Losses (crude oil production in year times $20/bbl) arising from futures contracts sold at a price of $80/bbl with prices rising to $100/bbl.
2. Net receipts less capital expenditure less RRT payments less excluded brokerage costs less excluded hedging losses.

The developers would see adverse effects from the RRT in their cash flow analyses at prices greater than $80/bbl and incentive effects from the RRT in their cash flow analyses at prices less than $80/bbl - a strange situation, distorting investment and operational decisions simply because RRT would be applied on the basis of a price for product that the producers of that product did not actually receive.

It would generally be expected that standard income tax arrangements would apply income tax to the income that the taxpayer actually received - in the case of our hypothetical project, on income from the sale of crude oil net of associated hedging gains or losses. RRT arrangements should be no different. Cash flows relating to borrowing/lending and capital raising aside, the recurrent net receipt flows underpinning the parameter R in equation (2) for activities subject to the RRT would generally have a direct parallel with income taxation provisions (though RRT would be expected to be on a cash, not an accrual, basis). As with income taxation, those subject to RRT should not be subject to tax on fictitious recurrent flows that are not what they actually receive or pay (while recognising the likely narrow basis of an RRT, possibly restricted to specified activities within ring-fenced projects). It is necessarily the C parameter in equation (2) where income tax write-off of capital expenditures often differs from the immediate expensing of an RRT.

Conclusions

The following conclusions can be drawn from the above analysis of hedging and RRT regimes.

• As with any tax, no RRT should be imposed on fictitious cash flow that the taxpayer did not actually receive or pay out.

• In order to maintain the investment neutrality properties of RRT regimes, hedging gains and losses associated with the sale of product subject to the RRT (as well as associated brokerage costs, options premiums, etc) should be included in the RRT base.

• Hedging would however be excluded from an RRT where that hedging related to cash flows outside the RRT base. Thus,
  • gains or losses from hedging say for borrowing costs would not be included in the RRT base; and

  • gains or losses from speculative activity that may use the same instruments used to hedge (such as futures or options) would not be included in the RRT base. Thus, buying (rather than selling) futures contracts over product subject to an RRT would therefore be excluded (such contracts would not hedge against price movements but would exacerbate gains from rising prices and losses from falling prices).

© Copyright Wayne Mayo, May 2012