Chilean Mining at the Crossroads: The 3% Factor
Chile’s mining sector has long been one of the world’s most attractive, but it is currently embroiled in controversy. For 30 years, the country’s mining firms have enjoyed legal protection from any change in tax law. Now the country’s ruling coalition wants to introduce a 3% royalty on revenues of all privately owned mines. Mining executives warn that a change in the rules of the game could cast a dark cloud over their plans for further investment and expansion and have an impact on the country’s economic growth.
Chile is the world’s largest copper producer, and global copper prices are sky-high now, which augurs extremely well for profits. Having decided in favor of the royalty, the Chilean government is trying to find some common ground for agreeing with the mining companies. It hopes to avoid endangering Chile’s image as a stable country that is respectful of the law and open to foreign investment.
Ever since last year, legislators of the four center-left parties that comprise Chile’s governing coalition (the “Alliance of Parties for Democracy”) have been arguing that copper mining is a highly profitable business and should contribute more to Chile’s public sector, which still needs plenty of funding to improve public health, education, housing, and other neglected basic needs.
Public interest in this issue has been growing, along with public support for the legislative proposal. Meanwhile, the price of a pound of copper has risen to its highest level in eight years - currently about $1.38 on the London Metal Exchange. That means an increase of about 70% over the past 12 months, thanks to growing demand fueled by economic recovery in the United States; stability in Europe and Japan; and, above all, expanding demand from industry in China.
When the leaders of Chile’s governing coalition met in early March, they were thinking about all of those things. Deputies from the right-of-center opposition then presented their proposal for applying a royalty of 3% to all mining companies with annual sales equivalent to 60,000 or more tons of copper content. Proponents of the law made it clear that it treats the royalty not as a tax but as “compensation to the State for exploitation of nonrenewable resources.” According to Chile’s constitution, only the executive branch can introduce actual tax legislation.
It didn’t take long for copper producers to criticize the new proposal. The National Society of Mining (Sonami) and the Mining Council – the trade associations that bring together, respectively, domestic and foreign miners – warned that the senior managers of several companies were already evaluating the impact of a possible royalty, as well as the end of the traditional “invariable” approach to taxation.
Sonami criticized the local mining industry for postponing new projects worth between $5 billion and $6 billion until the discussions are completed. It has argued that today’s high price of copper allows small and midsize companies to reactivate many mining projects. Sonami estimates that, for each one-cent rise in the price of a pound of copper, the country takes in $100 million.
Foreign mining companies in Chile have expressed similar concerns. They see the royalty as a disincentive for further investment in the sector. Multinational mining companies have authorized about $20 billion worth of new projects that have yet to materialize. However, both sides in the dispute deny that mining companies intend to stop investing in Chile if the new royalty is applied. They simply argue that the royalty would affect their profitability.
A Highly-rated Sector
Several voices are calling for the debate to become less dramatic and more focused on factual analysis. Joseph Ramos, dean of the faculty of economics and administrative sciences at the University of Chile, notes that, when compared with every other mining country, Chile offers the world’s best geological conditions. Chile provides large-scale deposits of high quality, located near ports, and in regions without environmental obstacles. It also offers a trained workforce and political stability. “All of these factors make Chile especially attractive to foreign investors,” says Ramos.
The Fraser Institute, a prestigious Canadian think-tank, agrees with Ramos. In its most recent study of the mining sector, Fraser collected the views of senior executives at 159 mining companies who are responsible for investing a combined total of $624 million in exploration projects. Chile wound up being the most attractive country for investment, scoring 92 points out of a possible 100. The country was rated high both for its Mineral Potential (96) and for its Policy Potential (85). The latter rating measures the impact of government policies such as regulations and land-use policy when it comes to attracting investors.
Ramos says that the tax rate that mining companies pay in Chile “is among the lowest in any mining country.” That leads him to this logic: “If the country is more attractive, there’s no need to give any tax incentives to make it [more] competitive.” It’s not like Argentina, which “no one thinks of as a mining nation. In that country, it’s natural that taxes have to be set at a low level for at least five to ten years, in order to attract investors. But the history of mining in Chile goes back 150 years. It’s one of the country’s most famous activities, ranking even above salmon and wine production. So there’s no need to give any incentives.”
Ernesto Rencoret, a professor of tax management at the Adolfo Ibáñez University, takes a different approach. Mining companies, like others, have built their business around knowledge of existing law, says Rencoret, and the smallest possible imposition of taxes can have an impact. “Is it bad to organize your business in such a way that you have to pay the lowest possible tax? Is it bad to avoid taxes (not evade them, which is a crime), through legal methods that take account of the legal framework?”
Rencoret argues that what we are talking about is the legitimacy of tax avoidance, and he says there are many reasons to take that position. Those reasons range from simply viewing taxes as a mere demand for one’s private property; to the fact that taxes can be seen as a legitimate institution that has become illegitimate as a result of the government’s financial mismanagement. “In my view, the latter reason is valid if you add another factor – the contributions to economic development that come from those who avoid taxes, and [consequently] contribute to growth by adding jobs and investments.” That is the case in private-sector mining, Rencoret asserts. “Clearly, more growth leads to greater collection of taxes.”
For economist Ricardo French-Davis, a consultant at the Economic Commission for Latin America and the Caribbean (ECLAC), this sort of contribution is not enough. French-Davis calls the parliamentary proposal “very moderate,” and adds that “it merely attempts to correct a shortcoming of Chilean regulations by introducing a charge for the extraction of a nonrenewable mineral. That’s the way most mining countries do things, especially Australia, Canada and the United States, which apply much higher taxes.”
According to French-Davis, royalties imposed on mining by various jurisdictions in Canada and Australia vary between 2% and 5%. Adding a moral factor to the discussion, French-Davis asks, “The multinational mining companies are paying these duties in the countries they come from. Why can’t they do that in Chile?”
French-Davis argues that Chile is receiving compensation for only a part of production of the state-owned firm Codelco, which sends all of its profits to the national treasury because of its status. According to his calculations, a possible royalty of 3% would generate an additional $100 million to $150 million for Chile’s national treasury each year.
Sonami’s estimates suggest that Chile’s privately owned mines contributed $7.4 billion to the country’s GDP between 1990 and 2001, when the multiplier effect on the rest of the economy is included. Between 1990 and 2002, they paid out a total of $2.577 dollars in taxes and duties.
Stopping new investments and expansion?
Just because other countries impose a duty on mining royalties doesn’t automatically make that a good idea, Rencoret asserts. “The economic analysis has to be more precise than the simple argument that we should do what others are doing. Moreover, there is already a special tribute on the mining sector in Chile; that’s the mining patent.”
Juan Luis Ossa, a professor of mining law at the Catholic University of Chile, argues that it’s irrelevant that some developed – as well as some developing – nations impose royalties on mining. “Mining is not an important activity in Cuba, Ecuador or El Salvador, to cite some other cases. On the contrary, it is relevant that Chile, Peru and Mexico – countries that have a great mining tradition and high level of mining development – do not impose this charge. For example, Argentina provides an optional royalty for each province with a maximum rate of 3%. However, Argentina guarantees the stability of the normal tax regime for up to 30 years. Bolivia has various ad valorem royalties, but the royalty amount is credited to income taxes, so mining companies only pay if the royalty winds up being higher. Peru does not apply royalties, and offers stabilization contracts on a tax valuation that is slightly higher, for up to 15 years. Like Chile, it doesn’t impose royalties. Stabilization agreements are for a period of 10 to 20 years, on a case by case basis, but with a much higher income tax rate (42%).”
Analysts agree that mining in Chile enjoys several advantages, most of all geological conditions that are “extremely attractive.” However, Ossa says that factor is not enough in itself. Many other countries are also attractive, and they are competing with Chile to attract mining investment. “The royalty would affect the discount rate for projects in Chile, compared with projects in other countries,” predicts Ossa. “Some projects [in Chile] would wind not being developed. Some mining projects in other countries that have been unable to get started until now would wind up starting production. Many investors would abandon our country.”
One indication of the risks facing mining firms came when Canada’s Placer Dome – the world’s largest gold producer – announced recently that it is paying careful attention to a possible Chilean royalty. If a royalty is imposed, it could have an impact on the company’s plans to proceed with Cerro Casale. That project would cost $1.4 billion, and deliver almost one million ounces of gold and 130,000 tons of copper each year for 18 years.
Ramos doesn’t discount the possibility the royalty will have such an impact. He recognizes that, for example, if the overall tax rate were raised to between 20% and 25%, “some projects would disappear without doubt. But if the only thing that happens is, one percent of the projects don’t materialize, then it’s worth specifying that, because we could compensate by collecting more taxes.”
High Prices, Low Taxes?
The government has reacted cautiously to the moves by legislators. But it’s clear that they are convinced there is room for private-sector companies to make a greater contribution to the economic development of the country. Clearly, public opinion cannot understand why, in these days when copper prices are so high, tax collections in this sector are so low.
Finance Minister Nicolás Eyzaguirre has made it clear that his government may launch its own proposal. Meanwhile, the government has taken the intermediate step of assuring business groups that a mining royalty is not currently on its agenda. In so doing, the government hopes that the companies themselves will renounce in good faith the “invariable taxation” established 30 years ago by Legal Decree 600. The goal would be to provide an incentive for foreign investors by introducing changes in the way of thinking and raising payments on mining patents. If that happens, a royalty would not be necessary.
When foreign investors sign Decree 600 with the government of Chile, it exempts projects worth more than $5 million from any changes in tax regulations that might take place within 20 years of their arrival in the country. Investors who opt for this benefit have just one opportunity to renounce it and enter the normal system of tax collections.
In Chile, corporate taxes are called First Category taxes, and they rise as high as 15% of a company’s profits. An additional tax of 35% is imposed on any withdrawal, distribution, or remittance of profits made by a company. The public rejects this regulation because it allows large mining companies to take their profits out of the country without paying taxes through use of the mechanism of accelerated depreciation.
More enthusiasm has been stirred up by the notion of negating the impact of Decree 600 than by all the talk of establishing a royalty. That’s because the ultimate responsibility lies in the wording of the law, not with the companies. “It is scandalous that [Chile] has legally authorized companies to pay an ‘invariable’ rate, and that it has been upheld until now,” says Ramos. “Copper prices are at about $1.38 and profits are going to be enormous this year. Yet only a small part of that will be taxable, and the overall increase in [national] tax collections won’t amount to much. Of course this is something that should change. Perhaps, ten years ago it was justifiable; then, there wasn’t much investment. Now, private firms represent almost 60% of all mining production.”
Meanwhile, Rencoret believes that Decree 600 is gradually losing its importance. “Perhaps if the rules of the tax game were changed right now, [Decree 600] would be as important as it once was.”
Nevertheless, Ramos warns that all initiatives currently on the table must avoid taking on a retroactive character. Moreover, they must tax current investors only in a way that makes sense, Ramos argues. “Personally, I believe that Chile has an enormous asset: It is not a ‘banana republic.’ There is a danger that, even if the royalty is not viewed as a tax and its ‘invariable’ character is maintained, companies would be forced to make back payments on their taxes. That would be wrong, and the country’s reputation would pay a high price as a result.”
At the moment, the royalty proposal is undergoing a process that will determine if it is approved by the parliament or declared unacceptable. Although its backers say the law won’t be retroactive, the Chilean government could face an uphill battle in that regard, now that all the parties in the ruling coalition have lined up to create a mining royalty.