RSPT – A Fair Valuation Based on True Value of New and Existing Mines

by zebra on 12 June 2010 · 13 comments

Following on from the interest generated by his last post, Mule Stable regular Zebra (James Glover) returns to the subject of the Resources Super Profits Tax in another guest post.

In a previous post I explained how the formula for the RSPT (Resource Super Profits Tax) was derived by considering the Government to be a 40% silent investor in any mining project. I showed that the correct deduction from the return on investments is indeed GBR (Government Bond Rate), as proposed, not a higher rate that includes a “price of risk”. One important thing I missed in this analysis, however, was whether the investment amount (I) was the correct basis for valuing the Government’s new 40% “investment”. I aim to show that the correct variable should actually be the Market Value of Assets (MVA) and as such the appropriate deduction from profits is several times (maybe as much as 4 times) higher for established mines.In the example given based on the mining industry “price to earnings ratio” of 14 the RSPT would only be 9% of earnings. I should emphasise this is not about having separate formulas for new and existing mines but correctly taking into account the fair, market based, price the Govt should pay for it’s 40% share of the earnings.

For new mines MVA = I (where all “=” signs should be taken to mean “approximately equal” to head off the pedants) so the proposed tax is correct in this case.

The Government says that in return for this tax take they are taking downside risk as well as upside benefit. One of the criticisms of the RSPT is that the Government is effectively nationalising 40% of ongoing mines and the GBR deduction is irrelevant as there is no serious downside risk. In the framework I propose the Government is not currently proposing to pay a fair price for this “nationalisation”. If the fair price of the Government’s stake is taken into account then the tax from existing mines is considerably lower than proposed. It may be as low as 9% of earnings. This does not require a backdown by either the miners or the Government, although the Government’s tax take might be less than forecast

If the Government is going to nationalise 40% of a mine – at a fair price – then it needs to effectively pay 40% of the Market Value of Assets (or MVA) for the mine. For new mines the Investment = Equity + Debt is pretty much set at this value. The Government RSPT tax is then:

Tax = 40% x (Earnings – GBR x MVA)

The first term is the Government’s 40% share of the earnings (here taken as Earnings before Tax). The second term is the deduction for the interest that recognizes that the funding of the Government’s share is undertaken by the mine at the Government Bond Rate or GBR. There is no good reason for the Government to pay less than the market value of this asset or MVA. For a new mine just starting up MVA = I, the investment amount, so

Tax = 40% x (Earnings – GBR x I)

If ROI = Return on Investment = Earnings/I then we can write this as:

Tax = 40% x (ROI – GBR) x I

which is the proposed RSPT formula.
For an ongoing mining operation with established operations and contracts, the market value will exceed the book value several times over. I am going to take the very simple assumption that MVA = Price ie the market value of the assets is the market value of the equity. This ignores leverage and is probably too simplistic. Price is based on share price and the number of outstanding shares. In terms of PE-ratio (the ratio of Price to Earnings as determined by the share price) we can write

Tax = 40% x Earnings x (1 – GBR x PE-ratio)

Compared to the original formula the deduction is  40% x GBR x PE-ratio x Earnings. Alternatively we can write this as 40% x GBR x I x MBR where MBR is the Market to Book ratio = MVA/I. So the original Govt funding deduction is just multiplied by MBR. The current formula assumes implicitly that MBR = 1. For existing businesses eg. banks MVA/BVA can be as high as 4 (which is BHPs current value). This gives a very simple deduction in terms of % of earnings, rather than Investment/I, of 40% x GBR x PE-ratio. Note that this is really the same formula for new and existing mines; it just makes proper allowance for the true value of established mines.

So what is the fair deduction for existing mines? It obviously varies with share price and hence market conditions. For mines which are privately held we need a proxy based on publicly traded stocks. The PE-ratio for traded mining stocks is currently about 14. So now, using GBR=5.5%, the  fair deduction for the Govt’s nationalised share for existing mines is not 5.5% (as many erroneously claim) or 22% (allowing for a 25% ROI) but 31%! Note this deduction is off the 40% so the total RSPT tax on earnings would be 9%.

So under a scheme based on a fair deduction for existing mining assets the tax should be:

RSPT = 40% x  Earnings x (1 – 5.5% x 14) = 9% x Earnings.

After 30% company tax this represent a total tax of 38%. Even if we don’t know what the PE-ratio would be for mines which aren’t publicly traded we can use an industry based proxy for the mines whose stocks are publicly traded. Currently this is in the range 13-14. If I was the miners I’d be pretty happy with that. Maybe they should have taken a closer look at the RSPT before opposing it. All the miners have to do is get the Govt to accept it should pay a fair value for its stake and the framework I propose makes that transparent.

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{ 11 comments… read them below or add one }

1 Scarlet_Pimpernel June 16, 2010 at 7:36 pm

Closing Oz Down

This is not the first time a totalitarian oriented government has closed down a nation. Great Nations like Russia, China, Argentina, Chile, The Democratic Republic of Congo, and many others have been literally shut down. As is Venezuela now, by their maniacal President Chavez.

Judging by the needless chaos already generated in the exploration and mining industries, many Australian families now face a bitter winter instead of a season full of hope.

And it is pitiful to see Queensland Treasurer and others advocating that “….there is room to move”.

Either we have a totalitarian government or we are free – there is no half way measure.

It was Ludwig Von Mises’ writing in 1944, the closing paragraph in his short masterpiece titled “Bureaucracy” who wrote:

“The champions of socialism call themselves progressives, but they recommend a system which is characterized by rigid observance of routine and by a resistance to every kind of improvement. They call themselves liberals, but they are intent upon abolishing liberty.
They call themselves democrats, but they yearn for dictatorship. They call themselves revolutionaries, but they want to make the government omnipotent. They promise the blessings of the Garden of Eden, but they plan to transform the world into a gigantic post office. Every man but a subordinate clerk in a bureau. What an alluring utopia! What a noble cause to fight!

“Against all this frenzy of agitation there is but one weapon available: reason. Just common sense is needed to prevent man from falling prey to illusory fantasies and empty catchwords.”

Ludwig Von Mises (1944)

Closing down Australia is a serious business and should be resisted by every able Australian.

2 Marco aka Cracticus June 16, 2010 at 8:40 pm

Jimbo,

I guess a fair solution to this problem could come from a compromise, where the Government gives something in exchange of something:

(1) The government forgets the whole bloody RSPT. This would be good, because it would avoid Australia becoming a communist nation…

(2) The miners accept an increase in the royalties they pay. This should be acceptable to them, as Mr. Palmer himself had agreed that miners could share a bit of their profits.

(3) No reduction on the company income tax (from 30% to 28%).

As I posted at the Stable, even the Lord Himself seems to be against this tax:

‘Touchdown Jesus’ statue in Ohio destroyed by lightning http://www.usatoday.com/news/nation/2010-06-15-touchdown-jesus-fire_N.htm

And everybody’s happy! How about that? ;-)

3 zebra June 17, 2010 at 10:53 am

Marco. If only it were that easy. Remember the raison detre of the RSPT is to fund a much needed increase in superannuation benefits to fill a gap that Australia (and all western nations) face over the next 20-30 years with aging populations. I think the Rudd govt is brave for even attempting to solve it. Most nations seem to just hope it sorts itself out somehow and ignore it. The looming pension crisis is really a gigantic pyramid scheme. So any alternative to the RSPT needs to provide an alternative solution to this problem. As to the rather silly reduction in company tax that was meant to get the non-mining businesses on side. It seems to have had little or no effect in that direction.

As far as an adjustment to the existing royalties scheme with an allowance for profitability that would presumably include a % of earnings. That would be the RSPT by another name would it not?

4 Marco aka Cracticus June 17, 2010 at 2:05 pm

Hey, Jimbo!

“Remember the raison detre of the RSPT is to fund a much needed increase in superannuation benefits”

Yes. At least, that’s the rhetoric. The reality is that funds generated by the RSPT will be mostly re-distributed among business: from the company tax income reduction to the infrastructure promised to the miners in the vain attempt to convince them.

“Remember the raison detre of the RSPT is to fund a much needed increase in superannuation benefits to fill a gap that Australia (and all western nations) face over the next 20-30 years with aging populations.”

As a chartalist, maybe the Mule would have his own ideas about this.

“I think the Rudd govt is brave for even attempting to solve it. ”

Here we agree, to some degree, although, to be frank, I am no Rudd fan. Mind you, between Rudd and the plutocrats, there is no question for me: Rudd wins.

“As far as an adjustment to the existing royalties scheme with an allowance for profitability that would presumably include a % of earnings. That would be the RSPT by another name would it not?”

Questions are there, friend and companion, that ought not be inquired. ;-)

5 Marco aka Cracticus June 17, 2010 at 4:18 pm

Jimbo,

As a follow up to our conversation:

Michael Pascoe has published an article (with numerical examples) explaining his understanding (and apparently PriceWaterhouseCoopers’) of the mechanics of the RSPT.

He says that the RSPT does not contemplate “depreciation of tenement cost and the interest expense” in the determination of profits, which to me sounds extremely odd. But then again, he’s Michael Pascoe and I’m only the Magpie (bitter old fart and local eccentric, to be charitable).

According to Pascoe, this exclusion of costs inflates the profits to be taxed under current corporate income tax. But, on top, the RSPT rate is applied BEFORE taxes. So, I would say (if am not mistaken) according to Pascoe, some of this “profit” is taxed twice!

Maybe you should have a look at what Pascoe says:

“Mining Kev’s 77% effective tax rate”
http://www.smh.com.au/business/mining-kevs-77-effective-tax-rate-20100617-yhw2.html

6 Marco aka Cracticus June 17, 2010 at 4:55 pm

Jimbo,

Disregard the second paragraph. Michael Pascoe first finds the RSPT (without previous corporate income taxes) and then, after deducting the RSPT, he finds the corporate income taxes.

This way, his profits (although still questionable, as they do not include “depreciation of tenement cost and the interest expense”) are not necessarily taxed twice

7 JamesGlover June 17, 2010 at 4:55 pm

Marco – I read the article. Unfortunately his example is wrong. He makes a very common error (as does PWC who he gets his numbers from) that the GBR deduction is times earnings. It is in fact times the Investment amount which will be several times higher (1/ROI higher so if ROI = 25% then it is off GBR x 4x earnings). In his example the deduction would be $25 not $8.
This mistake has got so out of hand that someone writing in the Business Spectator has suggested that the way forward for the Govt is to multiply the GBR times Capital Expenditure rather than Earnings (this article has been reprinted in that venerable old financial rag Crikey). This is the Govt’s ACTUAL PROPOSAL. If I had any hair left I’d pull it out.

I am at least comforted by the fact the a widely reported Morgan Stanley analyst report today said the Govt should use the Market Value of Assets rather than Book Value of Assets (my terminology) for the deduction. There’s another factor of 4! At this rate by the end of next week the Govt will be paying money to the miners. Hooray!

8 JamesGlover June 17, 2010 at 5:06 pm

Marco – regarding the point about interest. The RSPT is effectively a cost for having access to the minerals (hence the term “resources rent tax”). It is paid and then deducted like any other expense. Then, inter alia, interest is deducted and the corporate tax rate applied to the final result. There is no double taxation, the RSPT is deducted as an expense.

Interest is determined by your capital structure. The cost of renting minerals shouldn’t depend on how you choose to balance equity and debt, anymore than wages.

9 Marco aka Cracticus June 17, 2010 at 6:21 pm

Jimbo,

It makes sense that the GBR must be times earnings, as we are considering this as a virtual partnership miner-Govt, and the GBR would be the Govt’s financial cost. I also noticed he never mentioned Investment in his example.

The point about “depreciation of tenement cost and the interest expense” is that, from Gross Total Earnings of $100, following Pascoe’s example, miners currently are entitled to deduct 4 items:

(1) Royalties ($5)
(2) Depreciation of plant and equipment ($25)
(3) Depreciation of tenement ($20)
(4) Interest on borrowed money ($15)

So, following Pascoe, currently net profits before tax are 100-5-25-20-15 = $35.

Under the RSPT, and always according to Pascoe (1) disappears, (3) and (4) are not allowed to be considered towards the determination of net profits before tax (although they still apply). This way, the previous deduction list becomes one item only:

(2) Depreciation of plant and equipment ($25)

And Pascoe’s net profits before tax are: 100-25 = $75. It is on this definition of net profits before tax ($75) that Pascoe first applies the RSPT (deducting $8 for “Govt sanctioned profitability of the project”) and then applies the 40% RSPT rate: ($75-$8)*40% = $26.80.

As I had understood, the net profit calculation before tax was:
100-25-20-15 = $40. On this, one would temporarily deduct $8 and apply the 40% RSPT: ($40-$8)*40% = $12.80.

He makes a big deal out of this, and maybe he should, but my question is: is this really a part of the RSPT? In other words: are miners not entitled to deduct depreciation of tenement ($20) and interest on borrowed money ($15), at least for their part in the virtual investment? This is what appears very odd to me.

If you think about it, your own example mentions Earnings (which I assume are net of all costs, or equivalent to what Pascoe calls net profit before tax, plus royalties: $40).

What I referred with the double taxation remark, however, is an altogether separate matter: in his calculation, it matters which tax you apply first. If you apply first the RSPT, and then the corporate income tax, you get a result. If first you apply the corporate income tax, and then the RSPT, you get a different result.

For some reason, I got confused and thought this difference meant a double taxation. Clearly not so, because first RSPT is deducted and the result (obviously, net of RSPT) is what pays corporate income tax.

10 zebra June 18, 2010 at 8:45 am

Marco – this really relates to my previous post but think of it this way. If you wanted to invest in $100 worth of shares that paid a dividend of $20 per year but didn’t want to outlay any cash up front you could “borrow” the shares and pay the interest on borrowing. In other words a margin loan. If your cost of borrowing were, say, GBR=6%, then you would receive the $20 dividend less interest of $6=GBR x $100, not $1.20=GBR x $20. This is essentially what is going on with the RSPT. The fact that it has been widely misreported by the miners, (some) financial journalists and consultants just supports my personal and professional view of the financial commentariat.

It would be interesting if you went back through the analysis with the correct deduction. But I leave that to you!

11 Marco aka Cracticus June 21, 2010 at 8:59 pm

Aw mah gawd!

Rudd’s May Revolution is succeeding! Any day now we’ll see a hammer-and-sickle red flag flying on top of Parliament House.

Mining tax fails to spook Chinese investors. June 21, 2010. SMH
“Australia and China have inked commercial deals worth more than $10 billion, largely in mining, in another sign that a new Australian mining tax has failed to dampen inward Chinese investment.”
http://www.smh.com.au/business/world-business/mining-tax-fails-to-spook-chinese-investors-20100621-yqdb.html

And, on top, Twiggy “Fortescue” Forrest is involved in a project.

Another project involves ANU and… brace yourselves, people… the Party School of the Central Committee of the Communist Party of China.

I guess Twiggy may yet seek political asylum… in Beijing. And, with any luck, he’ll take Wilson Tuckey with him.

Run for the hills, folks: the end of times is upon us.

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