Taxing investments on a cash flow basis involves the investor paying tax at a specified rate on positive cash flow (revenue from the investments greater than associated capital and operating costs) and receiving payments at that same rate on negative cash flow (revenue less than associated costs). Traditional theoretical tax design that achieves these outcomes includes the exclusion of interest from the tax base, immediate expensing of all investment costs plus government-backed 'full loss offset' (absent other positive cash flow to absorb losses or sale of losses to others, immediate government cash rebates equal to tax losses times the tax rate).

A resource rent tax (RRT) is a variant of cash flow taxation that involves cash flow losses being carried forward with interest (the threshold or uplift rate) 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 (economic rent) and to have minimal effect on investment decisions - though the absence of government cash rebates means the investor faces the risk that the value of losses may never be recouped.

This note provides a potted history of the RRT in Australia through the eyes of the author who was involved in resource rent taxation at the:

• Industries Assistance Commission (now Productivity Commission) during Commission inquiries into the taxation of the petroleum and mining industries and into crude oil pricing; and

• Australian Treasury in the lead-up to the Australian Government's decision to apply an RRT to offshore ' greenfields' petroleum projects from 1 July 1984 - the Petroleum Resource rent Tax (PRRT) - and after the announcement in May 2010 by the Australian Government of its intension to broaden the scope of resource rent taxation in Australia.

EARLY THEORETICAL DISCUSSION

Garnaut and Clunies Ross (1975) proposed an RRT for large natural resource projects with the RRT threshold rate set around the concept of the "minimum expected (weighted average) rate of return" (pg 273) required by investors in the corresponding industry (possibly incorporating a series of progressive tax rates at higher threshold rates). In indicating that the RRT could be implemented in conjunction with an income tax system, Garnaut and Clunies Ross suggested that the RRT would be applied after income tax.

Swan (1976) viewed the Garnaut and Clunies Ross RRT as a version of a cash flow tax, or Brown tax - after Brown (1948) - incorporating the exclusion of interest, immediate expensing of expenditure and full loss offset in the form of immediate government cash rebates equal to any loss (negative cash flow) times the tax rate. This view sees the carrying forward of losses at a threshold rate as a practical surrogate for full loss offset. Swan noted how the Brown tax can impose a capital levy on existing assets if "the market value of existing assets is not permitted as a tax deduction at the time the tax is introduced" (pg 176).

Swan (1976) also shows (pg 176) that a Brown tax is equivalent to allowing economic depreciation, rather than immediate expensing, plus an annual deduction for implicit interest payments on the market value of the investment. The design "bites on pure profits and not on income" from investments (pg 175) and does not affect investors' discount rates. This is the same concept underpinning later literature that discusses what came known as the allowance of corporate capital (ACC) - literature including Boadway and Bruce (1984) who explain that depreciation need not be economic depreciation and can be chosen arbitrarily (pg 237). The Industries Assistance Commission (May, 1976) in its report dealing with the taxation and royalty treatment of Australia's petroleum and mining industries briefly raises (pg 23) the issue of an allowance for the opportunity cost of equity funds tied up in assets (resulting in criticism in public forum that such a shift to cash flow taxation would pose a threat to the corporate income tax base). The Commission, while noting the desirability of levying royalties more uniformly on a profits basis (pg 90), did not see as feasible the application of an RRT across the Australian petroleum and mining industries in part because of what the Commission saw as information demands involved in setting differential RRT parameters for different projects (pg 43).

FIRST PROPOSAL TO GOVERNMENT

When recommending the introduction of import parity pricing of crude oil in Australia the Industries Assistance Commission (September, 1976), noted that its recommendations would "significantly increase" the profits of local producers (pg 33). The Commission suggested that should the government decide to increase the community's share of profits from the industry an RRT - or "Petroleum Rent Royalty" (pg 62) - warrants serious consideration in order to "minimise discouragement of oil exploration and development and to reduce differences between States" (pg 33). The Commission suggested an RRT design which:

• applied to all oil and gas production before income tax (with RRT payments deductible for income tax purposes);

• applied on a company basis rather than a project basis shifting risk from the project to the company level;

• incorporated a single tax rate and single threshold rate; and

• replaced Australian government levies and royalties and allowed regional government royalties to be deductible for RRT purposes if agreement could not be reached for their replacement by the RRT.

Mayo (1979), in comparing a Brown tax and an RRT, puts a focus on the symmetrical effect that a Brown tax has in reducing the net present value (NPV) of a project at both the profitable and loss-making ends of the spread of possible project outcomes - in contrast with the inevitable distortions imposed by the asymmetrical effect of an RRT which taxes the profitable end without reducing NPV at the loss-making end. Mayo (1984) notes that with full loss offset operating (with either cash flow or income taxation) risk characteristics of individual investments are irrelevant to tax design. With full loss offset (either immediate or delayed) there is no risk of losing the value of excess deductions and, regardless of the project risk involved, with a rent tax "applied before income tax the appropriate threshold rate would correspond to, say, the going long term bond rate" (pg 44). Fane (1987) comes to the same conclusion with a rigorous proof. Mayo (1984) went on to conclude that under an RRT with consequent risk of losing deductions a loading on the RRT threshold rate above a risk-free rate might be viewed as "a method of offsetting, in a very rough way, the effect of skewed (NPV) probability distributions" arising from the RRT (pg 44).

FIRST GOVERNMENT ACTION

A new (Hawke) Australian Government came to power in March 1983 with an RRT for taxing Australia's natural resources on the agenda. In December 1983 the government released a discussion paper on the application of an RRT to all petroleum mining onshore and offshore in Australia to replace existing excises and royalties - in the hope that the RRT would serve as a model for replacing existing taxes in other parts of the mining sector. After subsequent consultation and release of a paper on the effects of an RRT with full loss offset, the government announced in April 1984 that the scope of the RRT would be narrowed to new offshore petroleum projects - thus, excluding onshore projects (subject to regional government royalties) and existing offshore projects, including the Bass Strait and fledgling North West Shelf fields. The government specified its preferred design of the RRT for further consultation, and sought responses on the merits of two design alternatives: one with a single threshold rate and tax rate and no cash rebates for exploration expenditure; the other with multiple and progressive threshold/tax rates and cash rebates for eligible exploration expenditure (representing partial loss offset).

The government announced in June 1984 a project-based, pre-income tax RRT to apply to new offshore petroleum projects from 1 July 1984 - the Petroleum Resource Rent Tax (PRRT) - with a 40% tax rate and single, general threshold rate of 15 percentage points above the long term government bond rate (LTBR), though with early project expenditures attracting a threshold rate of LTPR plus the GDP deflator. In May 1985, the government announced that a project's RRT losses created by eligible closing down expenses would attract a refund of the project's prior RRT payments equal to 40% of the losses - thus, reducing the risk of losing available deductions (without any changes then to other RRT parameters). From July 1990, the Bass Strait project came within the PRRT regime and the 15 percentage points threshold rate loading above the LTBR was reduced to 5 percentage points for general project expenditure.

LATEST GOVERNMENT PROPOSALS

The Henry Report (2009) recognises that, with immediate or delayed full loss offset applying, the riskiness of projects is irrelevant to the design of cash flow taxes. Thus, in recommending (pg 231) broadening the scope of the Australian government's resource rent taxation using cash flow tax arrangements incorporating delayed full loss offset (in the form of the ACC design), the report recommended an uplift rate set at the LTBR. Under the cash flow equivalent ACC design, the uplift rate applies to both the depreciated value of capital expenditure (written off over time rather than immediately as under a Brown tax) and to losses carried forward. With government guaranteeing to provide cash rebates for unutilised losses carried forward at the LTBR (achieving delayed full loss offset), the ACC design is financially equivalent to a Brown tax. The report saw the advantages of the ACC design over a Brown tax in terms of stability of revenue collection and less lags associated with net tax revenue collection (pg 233).

Consistent with the Henry Report (2009), the Australian (Rudd) Government in May 2010 proposed a cash flow equivalent tax of ACC design incorporating delayed government-guaranteed cash rebates for unutilised expenditure, called the Resource Super profits Tax (RSPT). The proposal was for the RSPT to apply to all existing and new Australian mining and petroleum operations (except those subject to the PRRT which would be able to elect into the RSPT), to be company-based and to apply before income tax (with RSPT payments deductible and RSPT cash rebates assessable). Capital expenditure was to be written off over a number of years (subject to consultation), with uplift applying to depreciated value, consistent with ACC design. Existing royalties paid to regional governments (as well as scheduled increases) were to be credited against RSPT payments with excess royalties over RSPT payments immediately refunded. For existing projects, the accounting book value of existing assets was to form the starting base and be written off over a number of years, again with uplift applying to depreciated value. By incorporating delayed full loss offset with an ACC uplift rate equal to the LTBR, the RSPT was financially equivalent to a cash flow tax but many erroneously viewed the LTBR as a measure of when the tax 'kicked in'.

After a period of consultation, the Australian (Gillard) Government proposed in July 2010 revised arrangements involving:

• a company-based RRT (that is, tax design with immediate expensing and no cash rebates for unrecouped losses) to apply to the mining of iron ore and coal in Australia - the Minerals Resource Rent Tax (MRRT) - with an uplift, or threshold, rate equal to the LTBR plus 7 percentage points and a net 22 1/2% tax rate; and

• extension of the PRRT to all Australian onshore and offshore oil and gas projects.

REFERENCES

Boadway, R and Bruce, N. (1984), 'A general proposition on the design of a neutral business tax', Journal of Public Economics, 24(2), pp231-239.

Brown, E. C. (1948), 'Business-Income Taxation and Investment Incentives', in Income, Employment and Public Policy, Essays in Honor of Alvin H. Hansen, Norton, New York, pp300-316.

Fane, G. (1987), 'Neutral taxation under uncertainty', Journal of Public Economics, 33(1), pp95-105.

Garnaut, R. and Clunies Ross, A. (1975), 'Uncertainty, Risk Aversion and the Taxing of Natural Resources Projects', Economic Journal, 85, June, 272-87.

Industries Assistance Commission (1976), Petroleum and Mining Industries Report, Australian Government Publishing Service, Canberra, May.

Industries Assistance Commission (1976), Crude Oil Pricing Report, Australian Government Publishing Service, Canberra, September.

Henry Report (2009), Australia's future tax system, Report to the Treasurer, 'Part Two: Detailed analysis', (K. R. Henry, Chairman), CanPrint Communications, Canberra.

Mayo, W. (1979), 'Rent Royalties', The Economic Record, 55, September, pp202-213.

Mayo, W. (1984), '(Tax) Depreciation and Inflation: Some Practical Observations', Economic Papers, 3(4), December, pp30-47, 1984.

Swan, P. L. (1976), 'Income, Taxes, Profit Taxes and Neutrality of Optimizing Decisions', Economic Record, 52, June, 166-81.

© Copyright Wayne Mayo, May 2012