Improving the Income Taxation of the Resource Sector in Canada

Transcription

1 Improving the Income Taxation of the Resource Sector in Canada March 2003

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3 Table of Contents 1. Introduction and Summary The Income Taxation of the Resource Sector: Background... 7 A. Description of the Current Tax Structure... 7 B. Considerations Underlying the Current Tax Structure i. Resources as Key Economic Assets ii. Characteristics of Resource Exploration and Extraction iii. Competitiveness: The North American Context The Income Taxation of the Resource Sector: Issues and Analysis A. The Framework for Analysis B. Reviewing the Resource Allowance i. Distorting Effects ii. Complexity and Lack of Transparency iii. New Economic Realities The Income Taxation of the Resource Sector: An Improved Structure A. Description of the Proposal B. Analysis of the Proposal i. International Competitiveness of the Resource Sector ii. Resource Sector Firms iii. Provincial Corporate Income Tax Revenue iv. Federal Corporate Income Tax Revenue Conclusion

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5 Introduction and Summary 1. Introduction and Summary As part of the Five-Year Tax Reduction Plan set out in the October 2000 Economic Statement and Budget Update, the Government of Canada legislated a reduction in the general statutory rate of corporate income tax, from 28 to 21 per cent over five years. This reduction applies to the most highly taxed sectors, including services. It does not apply to manufacturing and processing (M&P) income, eligible for the 7-percentage-point M&P allowance, nor to income from the nonrenewable resource sector, which is subject to sector-specific income tax provisions. In the Economic Statement and Budget Update, the Government indicated its interest in consulting on options to extend the lower corporate income tax rate of 21 per cent to resource income, while at the same time improving the tax structure. As indicated in Budget 2003, the Government proposes to improve the taxation of resource income by phasing in over a period of five years: a reduction of the federal statutory corporate income tax rate on income earned from resource activities from 28 to 21 per cent, beginning with a 1-percentage-point reduction to 27 per cent in 2003, and declining to 21 per cent in 2007; a deduction for actual provincial and other Crown royalties and mining taxes paid and the elimination of the existing 25-per-cent resource allowance; and a new 10-per-cent tax credit for qualifying mineral exploration expenditures. Transitional arrangements are proposed, in particular relating to the income tax treatment of the Alberta Royalty Tax Credit. These proposed income tax changes will improve the international competitiveness of the Canadian resource sector, in particular relative to the United States. By establishing a common statutory rate of corporate income tax for all sectors and by treating costs more consistently, both across resource projects and between the resource sector and other sectors of the economy, they will promote the efficient development of Canada s natural resource base. The proposed new structure will be simpler, streamlining tax compliance and administration and sending clearer signals to investors. Budget 2003 also proposed to legislate the elimination of the federal capital tax over a period of five years. This will strengthen the Canadian tax advantage for investment, including investment in the capital-intensive resource sector. The changes proposed in this paper, together with the elimination of the capital tax over five years, will establish a strong competitive position for oil and gas and mining exploration and development in Canada. This will support investment, innovation, productivity, economic growth, and jobs for Canadians. 5

6 Improving the Income Taxation of the Resource Sector in Canada The Department will review the proposed changes to the income taxation of the resource sector with industry and provinces prior to the tabling of legislation. Comments from interested parties should be submitted to the Department on an expeditious basis. Section 2 of the paper describes the current resource tax structure in both a historical and international context. Section 3 identifies issues relating to the current tax structure. Section 4 outlines the new structure for the taxation of resource income. 6

7 Background 2. The Income Taxation of the Resource Sector: Background A. Description of the Current Tax Structure As with all income subject to federal income tax, the amount of tax levied on income from non-renewable resources is determined by two main factors: the income base upon which the tax is levied, and the rate at which it is applied. What Qualifies as Non Renewable Resource Income? For income tax purposes, income from non-renewable resource production includes income arising from extracting, concentrating, smelting and refining of minerals to the prime metal stage, and from the production and initial processing of natural gas and crude petroleum. Generally, income derived from transportation and marketing and from the further processing of natural gas is not regarded as resource revenue and not subject to provincial resource levies. Refining crude petroleum, processing foreign ores and fabricating metal are regarded as manufacturing and processing activities and are thus separately eligible for the 21-per-cent tax rate on manufacturing and processing income. The calculation of the taxable income base of a resource corporation for a year starts with gross revenues from the sale of goods and services in this case the extraction and processing of domestic minerals to the prime metal stage, and the production and initial processing of crude oil and natural gas. Expenses incurred to earn the income are deducted from these revenues, specifically: salaries and wages, purchases of supplies and services, depreciation of the cost of capital assets (as determined by income tax rules), and other expenses such as exploration and development costs and interest. Provincial and other Crown royalties are not deductible for federal income tax purposes. However, as described below, a resource allowance is deducted in lieu of these charges. The federal corporate income tax rate applied to this base amount is 28 per cent, provided that the base amount is subject to tax in a province or territory. The current corporate surtax, equivalent to 1.12 percentage points of tax, is added to the federal income tax rate to determine federal tax payable. This amount of tax may be reduced by federal tax credits (such as those that might be earned from eligible expenditures on research and development). In any particular year, losses or accrued credits from other years may be utilized within defined limits to reduce tax otherwise payable. 7

8 Improving the Income Taxation of the Resource Sector in Canada A number of existing provisions of the income tax system are specific to the resource sector only, while others, which may have broader application, have particular relevance to the resource sector. Eight such provisions are described in the inset on the next page. They may be categorized as follows: Four provisions those relating to Canadian exploration expenses, Canadian development expenses, Canadian oil and gas property expenses, and capital cost allowances determine the timing of the deduction of capital expenditures. A fifth provision, the resource allowance, is a deduction equivalent to 25 per cent of resource profits (before deductions of interest and exploration and development expenses). It is a proxy for royalties and mining taxes paid to provinces amounts not allowed to be deducted for income tax purposes since A sixth provision is the Atlantic investment tax credit which, while available to corporations across all sectors, is used predominantly by the resource sector as a significant investor in Atlantic Canada. A seventh provision allows corporations in the non-renewable resource sector that issue flow-through shares to renounce deductions in respect of exploration and development expenditures in favour of investors who may apply such deductions against their income for tax purposes. An eighth provision, the mineral exploration tax credit, is a temporary tax credit for grass roots exploration activity that enhances flow-through shares for individuals by providing a credit of 15 per cent against personal income tax otherwise payable. Both the federal and provincial governments collect corporate income taxes from the resource sector. Several resource producing provinces as well as the federal government also levy capital taxes. The federal capital tax is paid by all large corporations. It is currently levied at a rate of per cent of a corporation s taxable capital employed in Canada in excess of $10 million. The surtax paid by a corporation reduces the federal capital tax. Budget 2003 proposes to eliminate the federal capital tax over a period of five years starting January 1, The tax will be eliminated for medium-sized corporations in 2004, by raising the capital threshold for application of the tax from $10 million to $50 million. 8

9 Background Non-Renewable Resource Income Tax Provisions Canadian exploration expense (CEE) is deductible at a rate of 100 per cent. For the oil and gas sector, CEE includes certain intangible costs incurred to determine the existence, location, extent or quality of a crude oil or natural gas reservoir not previously known to exist. For the mining sector, CEE has a much broader definition and includes not only expenses incurred for the purposes of determining the existence, location, extent or quality of a mineral resource, but also pre-production development expenses costs incurred for the purpose of bringing a new mine into production in reasonable commercial quantities. Canadian development expense (CDE) is deductible at a rate of 30 per cent on a declining balance basis. For the oil and gas sector, CDE includes the costs of drilling, converting or completing a well, building a temporary access road or preparing a site to the extent such costs are not CEE. For the mining sector, CDE includes the cost of sinking or excavating a mine shaft, main haulage way or similar underground work designed for continuing use after the mine came into production. It also includes the cost of acquiring a mining property in Canada. Canadian oil and gas property expense is deductible at a rate of 10 per cent and includes the costs of acquiring an oil or gas well in Canada, an interest or right to explore, drill, or extract petroleum or natural gas, or a qualifying interest or right in oil or gas production. Capital cost allowance (CCA) is depreciation for income tax purposes for the cost of tangible capital. For resource extraction, heavy crude oil processing and natural gas processing plant assets, CCA is deductible at a rate of 25 per cent per year on a declining balance basis. An accelerated CCA deduction is available for new mines and mine expansion assets (including oil sands mines and in-situ projects). This deduction can be taken to the full extent of income from the new or expanded mine. Essentially, this provision results in no corporate income taxes being paid on the income from the mine until all capital expenses are recognized for tax purposes. The resource allowance is a 25-per-cent deduction against resource profits (before deductions of interest, and exploration and development expenses) that functions as a proxy for royalties and mining taxes paid to provinces, which are not deductible for income tax purposes. The purpose of this structure, as described in the 1975 budget, was to provide some form of deduction in recognition of provincial and other Crown resource levies, while offering an incentive for exploration and development in Canada. Certain types of activities have also been included in the definition of resource profits as a way of providing the lower manufacturing and processing (M&P) rate. For example, in vertically integrated mining operations and at natural gas processing facilities, it is often difficult to determine the value of the product at intermediate processing stages. Mining taxes and royalties are not generally payable on the added value from this processing. Providing a resource allowance of 25 per cent against a 28-per-cent tax rate effectively results in a tax rate of 21 per cent on such income. However, the resource allowance can provide a greater benefit than the rate reduction for M&P income because the latter only applies to income subject to tax after all deductions (including interest, and exploration and development expenses). The Atlantic investment tax credit promotes economic development in the Atlantic provinces and the Gaspé region. Eligible investments include qualifying buildings, machinery and equipment used or leased by the taxpayer. A business is allowed to deduct 10 per cent of eligible costs from its federal income tax liability. The incentive is available to all sectors, though firms engaged in resource activities such as mining and offshore oil and gas have been the largest recipients of this tax credit. Flow-through shares are a financing mechanism that assists a mining or oil and gas corporation to raise capital for exploration and development expenses. In addition to an equity interest in the issuing corporation, the flowthrough share transfers to the purchaser of the share the right to the income tax deductions associated with new expenditures on exploration and development by the corporation. Flow-through shares are particularly important as a financing mechanism for smaller oil and gas and mining corporations that are not currently in a taxable position and do not have easy access to alternative financing arrangements. The mineral exploration tax credit, a temporary measure introduced in the 2000 Economic Statement and Budget Update, is available at the rate of 15 per cent of qualifying expenditures to individual investors in respect of grass roots mining exploration expenses financed using flow-through shares. Grass roots exploration focuses on finding new resources, as opposed to delineating existing resources. Budget 2003 proposes to extend this credit from December 31, 2003, to December 31, It also proposes to extend the 12-month look-back rule for this credit, allowing qualifying exploration costs to be incurred until December 31,

10 Improving the Income Taxation of the Resource Sector in Canada Federal and Provincial Revenue From the Oil and Gas and Mining Sectors Federal, provincial and territorial governments each have policy responsibilities to help ensure the competitiveness of the Canadian fiscal regime that applies to the resource sector. Both levels of government collect income and capital taxes. The Crown owners of natural resources, generally the provinces, also collect royalties and mining taxes. Historically, provinces have captured the larger share of the revenues paid to governments. Royalties and Taxes Paid by the Oil & Gas Sector Royalties and Taxes Paid by the Mining Sector Total royalties and taxes = $5.9 billion Federal Income Tax 21% Federal Capital Taxes 2% Total royalties and taxes = $850 million Federal Income Tax 18% Federal Capital Taxes 6% Provincial Royalties 65% Provincial Income Tax 11% Provincial Capital Taxes 1% Provincial Mining Taxes and Royalties 51% Provincial Income Tax 11% Provincial Capital Taxes 14% Sources: Canada Customs and Revenue Agency data for 1997, with calculations done by the Department of Finance. B. Considerations Underlying the Current Tax Structure As in many resource producing jurisdictions, income earned in Canada from the extraction and initial processing of non-renewable resources has historically been subject to special tax treatment. The reasons underlying the special characteristics of resource income taxation may be grouped into three categories: the need to mobilize key economic assets; the characteristics of resource exploration and extraction; and international competitive pressures, particularly relevant for Canada in a North American context. i. Resources as Key Economic Assets The extraction of a non-renewable resource can produce substantial income and jobs in Canada. Since development of such resources can create significant economic and social benefits, there is a strong incentive for governments to design a sound economic and fiscal framework for the required large capital investments. In Canada, provinces have a very important role to play as owners of resources. Economic activity generated by resource industries has been important to Canada s emergence as an advanced economy. Resource activity is an important generator of investment, exports, and jobs for Canadians. In 2001, the resource sector accounted for almost 4 per cent of Canada s GDP, with over $64 billion in exports and more than 10

11 Background $30 billion in capital expenditures. Upstream and primary resource businesses employ over 170,000 Canadians. The resource sector in general and the mining industry in particular are vital to rural and northern economies while the oil and gas industry long important in western provinces has also in recent years become a significant economic presence in Atlantic Canada. The potential for future resource development exists in virtually every region of the country. Moreover, many decades of robust resource activity have created a resource exploration and extraction industry with global reach. Canadian resource industries are large investors in innovative technology and major participants in the provision of exploration and extraction services internationally. ii. Characteristics of Resource Exploration and Extraction The second reason underlying the tax treatment of the resource sector is that governments in many jurisdictions have come to accept that there is a specific set of risks and benefits inherent in the business of resource extraction. The commercial risks include the uncertainty related to exploration, large capital requirements for development, and financial vulnerability due to price volatility and cyclicality. This tax treatment acknowledges that the resource sector is operating in a distinct business environment. The goal of exploration is to obtain new and valuable knowledge about the location of a previously unknown resource, the discovery and profitability of which is uncertain. Special tax treatment of exploration costs (e.g. 100-per-cent deductibility as Canadian exploration expense and various federal and provincial exploration tax credits) recognizes that exploration creates benefits for other businesses beyond the firm that incurred the original expenditure that is, exploration can generate positive externalities. In many ways, this is similar to research and development (R&D) costs that are incurred to gain knowledge about improved processes and products. R&D costs receive special tax treatment in many countries including Canada because of the fact that this investment can generate significant benefits beyond those captured by the firm performing the activity. iii. Competitiveness: The North American Context The third reason underlying the tax treatment of the resource sector is direct competition for mobile international investment dollars. Historically, international capital has been a critical factor underpinning the development of Canada s resource industry. This arises from a combination of factors: a resource base that is immobile; markets for commodities that are inherently global or continental; and capital requirements to leverage the potential of the resource that are large in relation to domestic savings. Competition for this capital including Canadian capital is increasingly intense. While this competition is now global, involving both developed and emerging economies, for Canada, the United States remains a benchmark of particular relevance. From the perspective of the potential investor, Canada and the U.S. share attributes that distinguish them from many other resource producing jurisdictions. Both countries offer modern infrastructure, skilled work forces and stable political environments elements not uniformly found in the emerging economies of Asia, Africa and South America. 11

12 Improving the Income Taxation of the Resource Sector in Canada Additionally, Canadian and U.S. markets, infrastructure and business ownership structures are deeply interrelated a fact of economic geography that naturally focuses attention on policies to maintain Canada s competitiveness with the U.S. A comparative look at how each country treats resource income for income tax purposes is thus instructive. While the U.S. tax system differs considerably from the Canadian system, it contains several special measures that are analogous to those in the Canadian system, and they have been implemented for generally similar reasons. One feature of the Canadian system which has no parallel in the U.S. system is the resource allowance as a proxy for nondeductible provincial and other Crown royalties and mining taxes. Canada U.S. Comparison of Federal Resource Taxation Provisions Canada U.S. Exploration expenses 100% 70% for integrated companies (remaining 30% deduction over 5 years) 100% for non-integrated companies Development expenses 30% declining balance Same as above Property expenses Depreciation Royalties and mining taxes 10% oil and gas; 30% mining 25% declining balance; 100% for oil sands and mining assets up to project income Provincial and other Crown royalties and mining taxes not deductible Based on expected life of the property Mining and oil and gas equipment can be written off over 7 years (approximates 30% declining balance rate) Deductible Resource allowance 25% of resource profits No equivalent Flow-through shares Financing incentive for exploration and certain development costs No equivalent Depletion Not available Available as a percentage of gross income from the property (even when capital is fully depreciated) Alternative minimum tax (AMT) None Some depreciation or depletion deductions may be taxed back at 20% under the AMT Capital taxes Federal capital tax levied at a rate of 0.225% of taxable capital employed in excess of $10 million (Budget 2003 proposes to legislate the elimination of this tax by 2008) No federal capital tax 12

13 Issues and Analysis 3. The Income Taxation of the Resource Sector: Issues and Analysis A. The Framework for Analysis The resource sector tax regime can generate greater investment and jobs for Canadians if it achieves three main goals: to be internationally competitive, particularly in a North American context; to be transparent for firms and investors; and to promote the efficient allocation of investment both within the resource sector and between sectors of the Canadian economy. It is important to recognize that it is the combination of both the statutory rate of tax and the tax structure that determines tax payable and that will affect the conditions for investment and the allocation of resources in the economy. The two factors are inextricably linked and must be treated together in seeking improvements to the tax system. In the Five-Year Tax Reduction Plan, the Government legislated a reduction in the general rate of corporate income tax with a view to enhancing the competitiveness of sectors, such as services, that were subject to a statutory tax rate of 28 per cent while not benefiting from other provisions in the tax system available to other sectors. The five-year plan did not reduce the statutory rate of corporate tax applying to manufacturing and processing (M&P) income because the M&P allowance of 7 percentage points already reduced the rate of tax applying to this sector to 21 per cent. Similarly, it did not reduce the statutory rate of corporate tax for the resource sector because of the sector-specific tax provisions, described in Section 2, that delineate the tax base and that correspondingly reduce the effective rate of tax paid by resource sector firms. In a global economy with intense competition for mobile capital, a tax system with a lower rate of tax, applying uniformly across all sectors, with a simpler and more efficient tax structure, would be more effective than one with a higher rate of tax applying on a less efficient tax base. The statutory corporate income tax rate is important because it is often the first piece of information viewed by prospective investors. A uniform, low statutory rate would send a positive, transparent signal to investors in Canada and internationally about Canada s relative competitiveness. In addition, a single rate would reduce compliance costs for taxpayers and the tax administration. Finally, the application of the same rate of tax to all medium and large business corporations would eliminate arbitrage opportunities between such firms based on tax rate differentials. 13

14 Improving the Income Taxation of the Resource Sector in Canada In regard to the tax structure, the Department s review with the industry focused on assessing whether special tax provisions operated as originally intended, both from a domestic perspective and from the perspective of competing for capital in a North American context. Provisions such as Canadian exploration expense, Canadian development expense, Canadian oil and gas property expense, and capital cost allowance, which determine the timing of deductions for capital costs, recognize risks inherent to the large investments required for resource exploration and extraction and play an important role in ensuring a competitive business environment. These provisions are also generally consistent with provisions applying in other jurisdictions, in particular the U.S. The Atlantic investment tax credit is a targeted tax credit that supports resource development and other investment in Atlantic Canada. Flow-through shares are also a targeted vehicle to support junior exploration firms that could otherwise not utilize as effectively the provisions of the tax structure available to firms in a taxable position. The temporary mineral exploration tax credit has further facilitated access to capital by these mining firms in a period of downturn for the industry. In the context of this review, the aspect of the existing tax structure that raised the most difficult issues was the resource allowance. B. Reviewing the Resource Allowance The review of the resource allowance highlighted a number of distinct problems. In particular, the resource allowance: distorts investment decisions and is arbitrary in its impact on individual resource projects and firms; introduces complexity in the tax system, thus adding to the cost of compliance and administration; and operates in economic conditions that have changed significantly from those that gave rise to it, thus leaving its original policy rationale much less relevant. 14

15 Issues and Analysis The Resource Allowance The resource allowance was introduced in 1976 primarily to protect the federal income tax base from the effects of what were then rapidly increasing provincial royalties and mining taxes. Provincial and other Crown royalties and mining taxes had been deductible in calculating taxable income for federal income tax purposes. The resource allowance was introduced to put a ceiling on deductions in respect of provincial and other Crown royalties and mining taxes. The resource allowance, calculated as 25 per cent of resource profits (see below), functions as a proxy for actual royalties and mining taxes paid to provinces. At the same time, the resource allowance was designed to encourage investment in exploration and development. The incentive effect of the resource allowance arises because exploration and development expenses (as well as interest expense) are deducted from income subject to tax after computing the resource allowance, thus giving rise to deductions at a rate of 28 per cent. By contrast, operating expenses are deducted before the resource allowance calculation at an effective rate of 21 per cent. Federal Income Tax Revenue from Resource Activities less Operating Expenses (not including Crown royalties and mining taxes) less Capital Cost Allowance equals Resource Profits less Resource Allowance less Canadian Exploration Expense (100%) less Canadian Development Expense (30%) less Canadian Oil and Gas Property Expense (10%) less Interest Expense (100%) equals Taxable Income X 28% Resource Allowance Calculation (in lieu of royalty deductibility) Resource Profits X Resource Allowance Rate of 25% equals Resource Allowance 15

16 Improving the Income Taxation of the Resource Sector in Canada i. Distorting Effects The economic distortions caused by the resource allowance arise from the fact that the allowance can provide tax deductions in excess of actual royalties and mining taxes incurred either in a particular year or over the life of a project. Alternatively, if provincial and other Crown royalties or mining taxes paid exceed the resource allowance deduction, the amount of the resource allowance does not accurately reflect these costs. The incentives or disincentives to invest that result are essentially arbitrary and therefore distort economic signals. For example, the resource allowance may result in a bias against investment in the more valuable resources those more likely to yield higher royalty returns to their owners. In the aggregate, actual provincial and other Crown royalties paid in the oil and gas sector have historically matched the total resource allowance fairly closely, although there are some substantial discrepancies at the firm or project level that are not observable in this aggregate data. For the past decade the mining sector, in aggregate, has deducted resource allowance significantly greater than the actual provincial and other Crown royalties and mining taxes paid. Overall, a provision originally established to put a ceiling on the deduction of provincial and other Crown royalties and mining taxes today represents a net benefit for the resource sector. Comparison of Provincial and Other Crown Royalties and Mining Taxes and Resource Allowance $ millions 12,000 Oil and Gas Sector Royalties Resource Allowance 10,000 8,000 6,000 4,000 2, $ millions 1,200 Mining Sector Royalties and Mining Taxes Resource Allowance 1, Sources: Natural Resources Canada, Canada Customs and Revenue Agency, Statistics Canada, ARC Financial Corporation and Department of Finance Canada. 16

17 Issues and Analysis ii. Complexity and Lack of Transparency The resource allowance creates an arbitrary dividing line between expenses that are taken into account before the allowance is calculated and those that apply only after that calculation. As a result, the detailed application of the calculation gives rise to ongoing disputes between taxpayers and the Canada Customs and Revenue Agency, thereby raising the costs of compliance and administration. Canada is the only country that provides this type of allowance instead of a deduction for actual royalty and mining tax payments. This makes the Canadian tax system less transparent to investors. iii. New Economic Realities Several factors have combined over the last several years to substantially change the economic environment in Canada from that in which the resource allowance was implemented. Unlike the regulated oil price environment of the 1970s and early 1980s, Canada s oil and gas markets are now deregulated, and prices fluctuate with international crude oil and gas prices. The competition for exploration and development capital is far more robust and internationalized than in previous decades. With respect to mining, there has been a marked decline over the past decade in many metal prices, with new entrants into the raw minerals markets putting considerable pressure on producers to be productive and efficient, and host jurisdictions to levy royalties and mining taxes at competitive rates. Provinces have correspondingly been adjusting royalties and mining taxes over time to bring them more into line with the value of the resource. 17

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19 An Improved Structure 4. The Income Taxation of the Resource Sector: An Improved Structure The new policy framework for income taxation in the resource sector set out in this paper reflects the Government s ongoing commitment to an efficient and competitive corporate income tax system. The measures that make up this framework will: enhance the competitiveness of the resource industry; simplify the taxation of resource income, streamline compliance and administration, and send clearer signals to investors; and improve the efficiency of the tax system by treating costs in a more consistent manner both within the resource sector and between sectors of the Canadian economy. Taken together, these measures will build upon a Canadian tax advantage for investment in a sector where international competitiveness especially with respect to the U.S. is a significant factor. A. Description of the Proposal The new structure for federal income taxation of resource income consists of the following elements, which will be phased in over a period of five years: a reduction of the federal statutory corporate income tax rate on income earned from resource activities from 28 to 21 per cent, beginning with a 1-percentage-point reduction on January 1, 2003; a deduction for income tax purposes of actual provincial and other Crown royalties and mining taxes paid, and the elimination of the existing 25-per-cent resource allowance; and a new tax credit at a rate of 10 per cent for corporations incurring qualifying mineral exploration expenditures. No changes will be made to the existing income tax provisions relating to: Canadian exploration expenses; Canadian development expenses; Canadian oil and gas property expenses; capital cost allowance, including the accelerated capital cost allowance provisions for new or expanded mines, oil sands mines and in-situ projects; the Atlantic investment tax credit; and flow-through shares. 19

20 Improving the Income Taxation of the Resource Sector in Canada The transition path for the phase-in of various elements of the proposal is as follows: Proposed Transition Path for the Taxation of Resource Income (%) Corporate income tax rate Deductible percentage of existing 25% resource allowance Deductible percentage of royalties and mining taxes New tax credit for mineral exploration The federal corporate income tax rate reductions will be effective on January 1 of each year and will be pro-rated for corporations with taxation years that include days in more than one calendar year. The resource allowance, calculated as 25 per cent of resource profits, will be phased out such that a declining portion of the allowance will be deductible in determining income subject to tax. Correspondingly, the deduction for provincial and other Crown royalties and mining taxes that are paid or payable will be phased in by allowing an increasing percentage of these amounts to be deducted in determining income subject to tax. These percentage amounts will be effective as of January 1 of each year and will be pro-rated for corporations with taxation years that include days in more than one calendar year. The existing tax structure requires the inclusion in income, or disallows the deduction from income, of royalties or mining taxes which are receivable by the Crown or payable to the Crown, as the case may be, under an obligation imposed by statute. Depending on the specific royalty or mining tax, resource producers are subject to one of these two measures. The proposal will have the effect of removing this inclusion in income, or prohibition on deduction (whichever is applicable) of Crown royalties and mining taxes over a five-year transitional period in the percentages set out in the above chart. This measure, and the corresponding reduction in the deductible percentage of the resource allowance, will be pro-rated for fiscal periods which do not match the calendar year. During the transitional period, a person receiving government assistance in respect of a royalty or mining tax will be required to include in income for tax purposes only the percentage of the assistance that equals the percentage for deductibility of the royalty or mining tax for that year. Where such assistance is netted against the royalty or mining tax prior to determining the deductible amount, no income inclusion will apply. Fully implemented, the proposal will result in a tax structure that imposes the same corporate tax rate on resource income as on other corporate income and that also allows deductions for actual costs instead of an arbitrary allowance. 20

21 An Improved Structure The Government proposes to introduce a 10-per-cent tax credit for qualifying mineral exploration expenses. The new credit will apply to both grass roots exploration for, and pre-production development expenditures for, base metals, precious metals and diamonds in Canada. The new tax credit will be available only to corporations, and will not be refundable nor transferable under a flow-through share agreement. The new corporate mineral tax credit will apply in respect of eligible expenditures made on or after January 1, 2003, at a rate of 5 per cent. The rate will rise to 7 per cent on January 1, 2004, and will be fully phased in at a 10-per-cent rate on January 1, A special transitional measure is proposed in respect of the income tax treatment of the Alberta Royalty Tax Credit (ARTC), which will reduce the amount of government assistance otherwise includable in income for tax purposes. Under the ARTC program, the Province of Alberta refunds a minimum of 25 per cent of the first $2 million in Crown royalties paid by each corporation or group of related corporations. The $2-million cap is designed to target the benefits to smaller producers. The special transitional measure will be available to any recipient of the ARTC, other than a large corporation, as determined for income tax purposes, so as to focus the benefits of this measure on smaller corporations. Specifically, only half of the otherwise includable amount of the ARTC will be added to income for tax purposes for calendar years 2003 through For years 2008 through 2012, the effective inclusion rate will increase by 10 percentage points per year: that is, the amount included will be 60 per cent in 2008, 70 per cent in 2009, 80 per cent in 2010 and 90 per cent in 2011, with full inclusion reached in In Budget 2003 the Government indicated its commitment to legislate the phase-out of the federal capital tax over five years. Similarly, the proposed changes to the taxation of resource income, including the general 5-year transition and 10-year ARTC transition, will be legislated, thus providing investors with the certainty needed to factor the changes into their investment decisions. B. Analysis of the Proposal i. International Competitiveness of the Resource Sector The improved international competitiveness of the Canadian resource sector that would result from implementation of the proposal may be shown from two perspectives. First, there would be a marked improvement in the Canadian competitive position as measured by a comparison of statutory rates of corporate income tax. Indeed, in some circumstances, there would be a marked competitive advantage for Canada, as shown in the following graphs. 21

22 Improving the Income Taxation of the Resource Sector in Canada Canada U.S. Comparison of Statutory Corporate Income Tax Rates on Resource Income Oil and Gas Sector Mining Sector % 50 Current (2002) Proposed (2007) % 50 Current (2002) Proposed (2007) U.S. (Alaska) U.S. (Texas) Canada (Alberta) U.S. (Nevada) Canada (Ontario) Note: A provincial corporate income tax rate of 8 per cent for the year 2007 is assumed as per the announced policy intentions of the provinces of Alberta and Ontario. The rates for Canada include federal surtax. The federal U.S. tax rate is 35 per cent. Texas and Nevada do not levy corporate income taxes. Alaska levies a corporate income tax at a rate of 9.4 per cent that is deductible at the federal level, resulting in a total rate of corporate income tax of 41.1 per cent. These charts do not include any capital taxes. The changes will result not only in more competitive tax rates but also in a more competitive overall tax structure. This is often represented by the marginal effective tax rate (METR), which measures tax in proportion to pre-tax profit over the life cycle of a marginal investment (an investment just sufficient to pay for the financial cost of capital, and taxes). METRs incorporate all elements of the income and capital tax structure federal, state and provincial or territorial and therefore provide an important indicator of the competitiveness of the tax system. Canada U.S. METR comparisons are provided below for representative oil and gas and mining investments, under both the current structure and the structure proposed in this paper, including the proposed new corporate mineral tax credit, fully implemented. The comparisons also take into account the complete elimination of the federal capital tax by For both industries, the METR is reduced significantly by For oil and gas, this reverses a current disadvantage relative to the U.S. For mining, it builds on an existing advantage. In both cases, the changes place the Canadian resource sector in a markedly improved position to attract capital for exploration and development, notably relative to the U.S. 22

23 An Improved Structure Canada U.S. (Federal and Provincial/State) Marginal Effective Tax Rates Oil and Gas % Current (2002) Proposed, including elimination of capital tax (2008) Mining % Current (2002) Proposed, including elimination of capital tax (2008) U.S. (Texas) Canada 0 U.S. (Nevada) Canada Note: Current (Canada) includes all announced changes to provincial tax rates. Calculations have been done by the Department of Finance. Additional information is available on request. ii. Resource Sector Firms Under the current tax system, the resource allowance can either exceed or be less than nondeductible royalties and mining taxes for a specific project either over the full life cycle of a project or during its different phases. By providing a deduction for the actual amounts of provincial and other Crown royalties and mining taxes paid, the proposal will result in projects being treated in a more comparable fashion. Investment decisions will therefore be based more consistently on the underlying economics of the project. Regardless of how a firm s tax base is affected by the removal of the resource allowance and deductibility of Crown royalties, all resource firms will benefit from a lower rate of corporate income tax. The actual net impact of the proposal on a particular firm will depend on the mix of projects undertaken by each firm, the financing structure of the firm and the size of accumulated tax pools carried forward from previous years. Also, in the case of mining firms, it will depend on their exploration expenditures and therefore the extent to which they avail themselves of the new corporate mineral tax credit. The oil and gas sector will pay less federal corporate income tax as a whole as a result of this proposal. Similarly, it is anticipated that the proposed new taxation regime for mining, which includes a new corporate mineral tax credit, will result in a lower tax burden for the mining sector. A key initiative in Budget 2003 is the elimination of the federal capital tax by Both the oil and gas and mining sectors will benefit significantly from this measure, further enhancing the competitive position of the Canadian industry. 23

24 Improving the Income Taxation of the Resource Sector in Canada iii. Provincial Corporate Income Tax Revenue Most provinces rely on the federal resource allowance in the calculation of their provincial corporate income tax. Some provinces provide the equivalent of royalty deductibility. Others provide the greater of royalties or the resource allowance. To the extent that provinces rely on the federal tax base, absent any offsetting adjustment, provincial income tax revenue from the resource sector may increase as a result of the new federal tax structure. However, it may be expected that provincial governments would take action, where necessary, to appropriately adjust their corporate income tax regimes in order to offset any such effect. The federal government will be attentive to any situation where provincial income tax rates on resource income were reduced below the level of tax applied to other sectors in the provincial economy if undertaken as part of a strategy to replace non-deductible taxes on resource income with deductible resource-based charges. iv. Federal Corporate Income Tax Revenue Budget 2003 estimated the projected impact of the resource tax proposal on federal income tax revenues over the current and next two fiscal years to be $10 million ( ), $55 million ( ) and $100 million ( ). Over the longer term, the impact of the proposal will depend on a number of factors, including commodity prices. When fully phased in, it is estimated that the annual revenue cost to the federal government will be about $260 million ( ). 24

25 Conclusion 5. Conclusion Establishing a common statutory rate of corporate income tax for all sectors and treating costs more consistently, both across resource projects and between the resource sector and other sectors of the economy, will promote the efficient development of Canada s resource base. The proposed new tax structure will be simpler, streamlining tax compliance and administration and sending clearer signals to investors. It will improve the international competitiveness of the Canadian resource sector, in particular relative to the United States. This will support investment, innovation, productivity, economic growth, and jobs for Canadians. 25