Apples and oranges: the tax is a matter of ROCE
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The debate on the RSPT, to date, is not getting to the heart of the matter. For whatever reason, the wrong financial metrics are being used to assess whether “the 40% tax rate is too high” or “the 6% cut-in rate is too low”. The main distraction is the “effective tax rate” (ETR) figure that mining companies are using to argue against the tax. It is a mistake to compare effective tax rates directly between industries because it does not tell us exactly how profitable the industry is overall, but only what slice of those indeterminate profits are paid as tax. The argument has been made many times that the high risk of mining projects demands a high return — but again, repeatedly pointing to the ETR for projects only tells us the slice paid in tax, not the level of earnings the company can retain to distribute as dividends or invest in other projects. An alternative way to evaluate these questions is to look at profitability of mining projects as Return on Capital Employed (ROCE) — a percentage calculated by dividing the adjusted net profits before interest and tax by the value of the capital employed. A simple model can be built that does not require either a detailed knowledge of mining industry economics nor makes simplifying assumptions that can be challenged by either side of this debate. Put another way, ROCE cuts through the confusion and gets to the crux of the debate — whatever the average effective tax rate is within a sector, it is the average ROCE that shows whether or not super profits are being made. One factor that has been widely overlooked in the RSPT debate is that the RSPT deducted before interest and tax, is not actually accounted for as a tax, but as a dividend to the government. That means that when corporate tax is finally applied to earnings, the RSPT amount already paid is not taxed again. Moreover, as is widely known, the corporate tax rate is proposed to be reduced from the current 30 per cent to 28 per cent over two years. Finally, then, using the ROCE method of assessing the tax leads to the following question (perhaps the most important question in the debate): by how much would a company’s after-tax earnings decrease under the RSPT? That is, how much less is available to distribute as dividends or reinvest in the business? The calculation produces some surprising results as the table below shows.
It must be noted here that this example does not take account of a company’s gearing position. Miners typically fund their fixed capital costs with equity, and then fund working capital with debt. The more a company borrows, the less will be the amount of ROCE left to distribute to shareholders. This has been clearly shown in the case of Fortescue, which has seen its share price tumble since the RSPT announcement. On the other hand, the figures above do not take account of accelerated depreciation in mining assets when calculating the corporate tax bill — which, of course, reduces the amount of corporate tax paid. What the table does show is that the amount money to be distributed as dividends or reinvested, is nowhere near the 40% headline figure used to calculate the RSPT, and shows even more clearly how misleading the effective tax rate of 56.8% being promoted by the mining industry is. That figure is not wrong — but it gives a misleading impression of the true impact of the tax on the return investors make on their money. *Munif Mohammed is presently GM finance projects for a major retailer in Sydney, and has worked as a CFO and finance professional in government, financial services, IT, FMCG and retailing for 25 years. |
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15 Comments
Talking of an “effective tax rate” which includes both royalties/dividends (including the RSPT) and regular tax is wrong by definition, because if it were reduced to zero, it would mean that the mining industry was getting their inputs (the minerals) for free. No other industry gets to pay nothing for their raw materials. Royalties and the RSPT are fundamentally not “taxes”, they are input prices.
Correct me if I’m wrong, but does the above table not account for royalties? Difficult to include in a simple and clear way, I know, since it changes the ROCE itself, in a project-specific manner rather than how ROCE gets carved up. But surely it is an important element of the debate?
Could we assume that miners are currently earning at least a minimum 10% ROCE? And then based on the Henry Review’s remarks that royalty revenues are currently approximately $1 in $7 profit (sorry, I don’t remember exactly which measure of profit) royalties are therefore a minimum of $10 (1/7th of $70 after-tax profit in the 10% ROCE line)?
That would mean that in the top line “Investors share of ROCE under current tax regime” should be more like $63, and the “% change in investor’s share of ROCE” would be -4%.
With a ROCE of 30%, the % change becomes -27.6% …
It is good to see Munif Mohammed place these calculations on record; such factual analysis has been sorely missing in this debate so far. And these numbers are before the rebate of the royalties miners currently pay, thereby reducing the overall “tax” cost to them.
Re Jamesh: Even if the RSPT is to be viewed as the input price then a significant increase still changes the economics of mining projects and many will be no longer viable, thus reducing future employment.
Previously published analysis indicates that the break-even point, after allowing for return of royalties, etc, is actually reached at an ROCE of approximately 11%.
Very broadly speaking, this article’s conclusions understate the amount of ROCE available for shareholder returns or retention within the corporation at the lower end (6% return) by about 20%. It is thus apparent that the analysis is fatally flawed through not including industry figures for return of royalties.
Certainly, I am far from convinced that, across the board, the return to investors is reduced throughout the band +6% ROCE upwards.
Further, from Crikey earlier this week we discovered that larger mining corporations have been able to pull astonishing rates of return (profits before tax, to the common person) from their mining operations - 30% is not even attractive to the biggest players, who operate closer to 60% on average.
Re John Bennetts: Those high rates of return apply only when there is a boom and ignore loss-making projects. Averaging out the periods of low prices and the losses, the long run return on mining investment is more like 10%.
@PHILLIPW:
“Even if the RSPT is to be viewed as the input price then a significant increase still changes the economics of mining projects and many will be no longer viable, thus reducing future employment.”
The RSPT package will have a NEGATIVE to ZERO effect on taxation for projects with a rate of return below 11%. Thus, only those projects with a rate of return above 11% will be worse off. An 11% rate of return, which represents a profit of about 3 or 4 times the annual rate of inflation and twice that which is available from a bank on deposits, must be deemed to be viable, although perhaps not as attractive as an investment returning 60% (see my last comment above).
All projects returning less than 11% will be better off. These figures are not plucked out of my rectum - they were published by Crikey during this ongoing debate after being calculated by those with more knowledge and skill than I.
Thus, every single project which would be viable pre-RSTP will be viable after the RSTP.
Also, every marginal project pre-RSPT will be less marginal post-RSPT.
PhillipW is thus clearly, absolutely and totally incorrect, having based his argument entirely on an incorrect assumption.
Re PHILLIPW’s second go:
The long term returns on mining were discussed in Crikey this week and are well above 10%.
If this were not so, there would be no purpose in an RSPT as currently formulated at all. There would be no return to the Government.
Please do read your Crikey more closely and try to keep up with the debate.
Sorry to come back so soon, but I stuffed up.
Possum, in today’s Crikey, states 47% for long term returns by the large miners, not 60%. I stand slightly corrected. 10% it certainly ain’t.
But Possum is only referring to the profitability for one year, 2008-09. This is not representative of the long run returns in mining.
Careful John. You can’t compare Profit margins to Rate of Returns. They are measuring two different things. Profit ratios are about company performance. Rate of returns are about investor performance. Not the same thing.
i.e For example, Lets say a project is started and produces EBITDA = 1000 and Revenue = 2000. I can earn a high EBITDA profit ratio of 50%. This says the company is doing well as its costs are only 50% of its revenue. But if the amount of capital I employ to do so is high (say $10,000 worth of equity of debt is issued to create that EBITDA of $1000) , then the Rate of Return is less (EBITDA/Capital) = 10% . This is a simplified example of course. As mining requires a lot of infrastructure, the capital employed is usually large which means it requires high profit ratios to be attractive to investors. That is the one element that Possum missed in his analysis this week.
So happy we have a dude with finance experience in retail, financial services, government and fast moving consumer goods to help us figure out and understand how the tax would apply to a mining project.
@Scott:
Thanks for the clarifier. Profit margin I did not intend to say.
Having checked, I notice that I didn’t use the term profit margin anyway, so what’s the point?
I did use the term profit, which is another thing.
The head article still misses the bull’s-eye by the proverbial country mile. NB “Country Mile” is an undefined term, however its meaning should be clear to most of us.
Possum cites a survey of the top 40 mining companies in the world and quotes a profit margin of around 30% for 2009 but the the table he gets this from also shows that the return on capital employed was only 9%. This latter figure is the one relevant to the calculation of the RSPT.
OK, now I see where the profit MARGIN came from.
Possum isn’t using the usual definition of profit margin, which is the defined in various ways at various times, but could be thought of as (sales revenue) / (cost of sales). This is very different from Poss’s definition, and that of the table from which he was quoting.
Poss’s version is much more relevant to the RSP tax, because it is calculated as (Operating Profit Before Tax) / (Sales and Service Revenue). This is a measure of the operating profitability of the venture, after interest and depreciation.
The capital employed (PhillipW above) is not as relevant as might be thought at first, because the cost of borrowed money has already been deducted as an operating cost. This leaves, broadly speaking, a profit which is available for distribution or retention as equity and for paying corporate expenses including a fat cat CEO and his mates in an ivory tower somewhere. Notionally Dubai? Bermuda?
My understanding is that the proposed RSP tax will be calculated along the lines of Possum’s definition of profit percentage, not in relation to the return on capital employed.
There we differ, at least until the draft bill is published or the Government clarifies its intentions by releasing a briefing paper. I certainly will not rely on the MSM, except perhaps Ross Gittins.