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OPIC officials and Congressional sources, my reading of the provisions of the bill indicate that they are less generous, when full consideration is given to evolving OPIC insurance and guarantee standards. Of course, I am taking into account compensation premiums to be paid by companies into the Deep Seabed Mining Fund. OPIC has asked Congress to cover 100 percent (rather than 90 percent) of loans from institutional sources against political risks of expropriation, war and currency inconvertability. This is a risk transfer device applicable to large, contingency situations covered by an insurance company that is provided for a premium. I understand this proposed change has already been reported out favorably by a House subcommittee. In addition, OPIC has a financing program of guarantees which apply only to loans, e.g., loans from insurance companies, pension funds and banks. The guarantee covers 100 percent of the institutional loans. It has been granted in the case of large land-based mining projects, e.g., $48 million for a project in Indonesia.
The types of uninsurable risks that must be faced by a potential investor in deep seabed mining would be far broader than conventional investment risks, especially if processing is accomplished in another country. The most disturbing of these risks is the establishment of an international authority by treaty that would, according to the terms of the treaty or by subsequent action by the authority, result in the exercise by the authority of the power to deny the profitability of a private operation, limit its duration, permissable level of production or its market access, or require the transfer of private technology without adequate compensation. You may recall the "serious points of substantive difficulty” that representatives of the United States Government stated that they have with the latest composite' text prepared by Chairman of the First Committee, Paul Engo. This is reported in the "'Delegation Report of the Sixth Session of the Third United Nations Conference on the Law of the Sea, May 23-July 15, 1977.” Since no a priori assurance can be given by the U.S. government to private companies or banks as to the content of a future international treaty that might be accepted or the power to be granted to a Seabed Authority, investors have to place a high probability on the prospect that many difficulties will remain unresolved or many more concessions will have to be made by U.S. negotiators if a treaty is finally to be agreed to. This means that seabed mining investments will only proceed if protection against potential losses due to unique political risks is assured before large financial commitments are made.
I know that you have received competent testimony from bankers and insurance executives on the proposed “compensation” provisions of this bill. But to assure myself that there is a genuine need for special incentives and protection for participating U.S. mining companies, I made a non-random sample of the views of international banker friends. My findings will not startle you. Without the provisions for adequate government insurance, no deep seabed mining project could be financed and stand on its own. It's impossible and even pointless to try to estimate interest rates in this case: no rates would be high enough because of the risks related to the uncertain provisions of a further international treaty or treaties, or the inforeseeable decisions of an international authority that operates on the basis of one-nation, one-vote. In theory, a major oil company could borrow the required money on the strength of its general balance sheet, but this would be a high risk decision that would be extremely difficult for the Board of Directors of a public corporation to make, particularly when alternative investment needs are taken into account.
The major oil companies, with a developing capability in deep seabed mining, face horrendous capital expenditure requirements in the energy field.
While oil companies historically had financed 85 percent of their capital spending programs with internally generated funds, leaving 15 percent to be financed by external capital markets, this situation has changed. By 1975 the industry was financing only about 67 percent of its capital needs internally. The percentage will probably decline further because of tax changes and other government-imposed restrictions on the ability of the oil industry to internally generate funds.
The tremendous concurrent demands for capital expenditures to meet energy demands—for conservation, conversion, production, etc.—will make the long-term debt market tight for firms with lower credit standings than oil companies and companies in energy-related fields, e.g., railroads to transport coal and utility companies. This category of firms that will have added problems in raising long-term, external capital includes mining corporations.
As I read the bill in detail in an attempt to estimate the many financial burdens placed on U.S. companies that would presumably be its beneficiaries, I am struck by their number and their open-ended nature. There are license and permit fees; costs to respond to departmental and public comments; costs of reacting to environmental impact studies and rules; costs of responding to antitrust reviews; minimum expenditures for exploration; added costs of using U.S. flag ships, processing on U.S. territory and possible sales to the U.S. of processed minerals (unless exempt by the Secretary), premium payments to a Deep Sea Mining Fund and contributions to a special fund to be used to make the U.S. contribution to an international regime that is established under a future international agreement. In a few cases there are guidelines, but in most cases there are no limits to the amounts that may be imposed upon the company. Has anyone made these estimates?
The total burden on a participating company will clearly have a significant, adverse impact on any Discounted Cash Flow (DCF) and profitability calculations, if they can reasonably be made, in view not only of these uncertainties, but also of possible interpretations of present U.S. Federal tax laws made by the IRS and of changes that may be made in these laws in the next few years.
A representative of the Treasury Department in testimony at Senate Hearings on ocean mining attempted to summarize briefly how present tax laws would theoretically operate with respect to ocean mining. This testimony may have left the incorrect impression that in practical economic terms the tax treatment for ocean mining would be significantly different than for domestic mining if S. 2053 were enacted. The tax picture for ocean mining is largely the same as for domestic mining when the economic realities of ocean mining, and the effect of enactment of S. 2053 are taken into account. Further, any possible tax discrimination against ocean mining would readily be remedied by the inclusion in S. 2053 of a provision such as section 107 of H.R. 3350 which assures domestic tax treatment of ocean mining. A comparable provision is found in Sec. 10, S. 2085.
On the one hand the Administration interprets U.S. tax law to mean that a U.S. individual or corporation engaged in deep seabed mining is subjected to U.S. taxes but on the other hand is denied a number of benefits enjoyed by a mining activity on U.S. territory. To restate a few of the points made in this testimony: according to present U.S. tax laws exploration expenses are not to be deducted but must be capitalized and recovered through depletion, accelerated depreciation would be limited, investment tax credit would not be available, percentage depletion "if available at all” would be at a lower rate than for domestic deposits. The Administration offers policy remedies in principle, which are really unnecessary. But even if they are granted after a laborious process involving additional Congressional Committees, they would still fall far short of non-discrimination.
INVESTMENT TAX CREDITS AND ASSET DEPRECIATION RANGE ALLOWANCES According to the Treasury Department, assets used in ocean mining would be "used predominantly outside of the United States," and would therefore not qualify for investment tax credits and certain depreciation deductions. As a practical matter, ocean mining would be eligible for these tax benefits. I understand that provisions in the current tax laws would qualify the assets of presently contemplated ocean mining ventures for investment tax credits and the asset depreciation range (ADR) system. In essence, these provisions would provide for domestic tax treatment of ocean mining vessels documented in the United States, and for domestic tax treatment of any asset (other than a vessel or aircraft) used in international waters located in the northern portion of the Western Hemisphere. All presently contemplated commercial recovery operations which would be eligible for a permit issued pursuant to S. 2053, if enacted, would fall within the ambit of these provisions and would receive domestic tax treatment.
The Internal Revenue Code confers eligibility for investment tax credits and ADR on "any vessel documented under the laws of the United States which is operated in the foreign or domestic commerce of the United States All ocean mining vessels operating under the authority of a permit issued pursuant to section 102(cX2) of S. 2053 must, by the terms of the restrictions on a permit imposed by that section, fall with the vessel provision quoted above. Because vessels will account for one-third of project capital costs, their eligibility for investment credits and ADR has substantial tax consequences.
The Internal Revenue Code also provides for the investment tax credit and ADR eligibility of:
Any property (other than a vessel or an aircraft) of a United States person which is used in international or territorial waters within the northern portion of the Western Hemisphere for the purpose of exploring for, developing, removing, or transporting resources from ocean waters or deposits under such waters.
The term “northern portion of the Western Hemisphere” as used above means:
* Testimony of Helen B. Junz, Deputy Assistant Secretary of the Treasury before the Senate Committeee on Commerce, Science, and Transportation; and the Senate Committee on Energy and Natural Resources, Subcommittee on Public Lands and National Resources, September 19, 1977 (hereafter “Treasury Department Statement”).
The area lying west of the 30th meridian west of Greenwich, east of the international dateline, and north of the Equator, but not including any foreign country which is a country of South America.
Since only United States citizens are eligible for S. 2053 permits and presently contemplated mine sites are within the northern portion of the Western Hemisphere, the entire water-borne portion of an ocean mining investment would receive a full investment tax credit and ADR allowance. The balance of the capital investment would be for assets physically located in the United States; without question such assets would receive domestic tax treatment.
DEPLETION ALLOWANCE ELIGIBILITY The Treasury Department testimony states: “Because there are no clear ownership rights to deposits in the deep seabed, it is not likely that under present laws deep seabed mining would have the requisite economic interest to qualify for depletion allowances."
Treasury's opinion relates only to present law and does not take into account the impact of S. 2053, if passed. Treasury's testimony might be misunderstood to mean that ocean miners will not qualify for depletion allowances or that only the owner of minerals in place qualifies for depletion deductions. Ownership of a deposit in place is not a prerequisite to eligibility for a depletion allowance. Only an economic interest in the deposit is required.
Ocean miners operating under permits issued pursuant to S. 2053 would possess the legally secured right to mine and remove manganese nodules and to reduce them to possession and ownership. This legal right to mine the deep sea coupled with an investment of $500-700 million in a mine site and associated sea and land based assets creates a real economic interest in the nodule deposits covered by a permit. Such an economic interest would qualify ocean miners for depletion allowances.
Whether an interest is depletable depends more on investment economics than on legal technicalities. Mineral lessees are entitled to depletion allowances when they possessed the right to extract and to market minerals, though they did not own the minerals in place.
A depletable interest must meet the following requirements: (1) The taxpayer acquires an “interest” in the deposit by "investment"; (2) he secures the right to income from the deposit by legal relationship; and (3) he looks solely to the income from extraction for a return on his investment.
As noted above, the type of “interest” to be acquired by investment is economic in nature and not legal in nature. Ocean miners, who will bear the complete capital costs of a mine site, make the kind of investment that is essential to all mining. The full capital investment required for mining consistently has been held to confer an economic interest in the deposit in place. Also joint venturers who share develop ment investment both may claim depletion deductions, though neither own the minerals in place.
Permits issued under S. 2053, if enacted, would confer the right to engage in commercial recovery. These permits would constitute the relationship by which income from a mine site would be secured. The fact that permits rather than leases are involved is of no importance. The allowance for depletion is not made dependent upon the particular legal form of the taxpayers interest in the property to be depleted. Permits which carry the right to exploit natural resources many times have been held sufficient to secure depletion allowances.
Adequate protection of an income interest must allow a miner sufficient opportunity to remove a substantial amount of the mineral deposit to which he looks for a return on his investment. Ocean mining permits which are exclusive against all U.S. citizens would allow substantial mining, and thus adequately secure the right to mine manganese nodules.
The I.R.S. appears to take the position that an investment in the legal right to mine is required before a depletable interest is created.
The requirement of an investment in a legal right to mine rather than in an economic interest in the minerals in place has already been expressely rejected by the Supreme Court. The tax court has twice refused to predicate depletion allowances on an investment in a legal interest and has instead relied on the fact that an investment created an economic interest in minerals in place. A depletable interest has been found solely because the use of land for operations relating to river dredging (an investment of land) created an economic interest in the dredging. It has been held that the investment created an interest in the minerals in place without relying on an investment in a legal instrument.
Even if an investment in a legal instrument is necessary, an ocean miner makes an investment when he provides legal consideration for a permit; i.e. complying with the terms and conditions of the permit, paying a fee for the permit, or by relying on the permit. In permit cases, legal consideration given in exchange for the permit has been held to create a depletable interest.
Ocean miners provide a classic example of taxpayers who must look to income from the extraction of minerals for a return on their investment. This requirement, primarily, is designed to foreclose the depletion deduction claims of contract miners, who are more like employees than true investors, because they are paid fixed amounts for their work. Ocean miners will look solely to their mining enterprise to earn an income secured by a U.S. permit which will provide a return on their investment. They will have an economic interest, a depletable interest in manganese nodule deposits.
EXPLORATION EXPENSES Treasury's testimony states that the expenses of "exploration” for mineral deposits located outside the United States are non-deductible. Although Treasury's testimony is literally correct, it should not be misconstrued to mean that tax deductions will be denied for the expenses of all activities authorized by a license for "exploration" issued under S. 2053 (if enacted). The definition of exploration in the tax code is markedly different than the definition of "exploration” in S. 2053. In fact, the expense of most operations conducted by an ocean miner under the authority of a license will be deductible as development expenses.
The expense of exploration for mineral deposits located outside of U.S. territorial waters must be capitalized and can not be deducted once a $400,000 cumulative limit has been exceeded. However, all domestic exploration expenses are deductible. Exploration expenses, foreign or domestic, are defined as expenditures "for ascertaining the existence, location, extent or quality of an ore deposit.” In ocean mining parlance this would be the prospecting stage. The expense of activities conducted immediately after prospecting/exploration is fully deductible as a “development” expense, whether foreign or domestic mining is involved. After a mine becomes commercially productive it enters the “producing stage,” in tax terminology. S. 2053 defines only two stages of mining activity. Commercial recovery (as defined in S. 2053) is roughly equal to a producing mine in tax terms. Activity prior to commercial recovery in the terminology of S. 2053 is "exploration.” Thus the exploration stage of S. 2053 includes the development stage" for tax purposes. For example, expenses of the detailed mapping of a mine site are deductible as development expenses if the mapping takes place after the commercial, viability of the mine had been determined. For example, the cost of core drilling designed to "delineate the extent and location of the commercially marketable ore reserves in order to facilitate development of the ore" is deductible. The expense of most activities conducted under a license would be deductible as development expenses.
Under current law some expenses, e.g. basically early prospecting costs, might not be deductible. Additionally, foreign as opposed to higher domestic percentage depletion rates could be applied to ocean mining. The Treasury Department believes that as "a matter of tax policy any investment by a United States resident should be treated as 'domestic' so long as it is not located within the taxing jurisdiction of a foreign government." To effectuate this policy with respect to "exploration" ex. penses in the tax sense) and depletion percentages, a paragraph such as section 107 of H.R. 3350 should be added to S. 2053.
ESCROW FUND According to the Treasury, payments to an escrow fund under an international seabed authority are to be treated as a "royalty.” But such payments actually bear little resemblance to a royalty which under domestic mining laws are payable to the government of a national state and usually are only a small percentage of the value of the product mined. Payments to an international authority could represent a very large percentage of the value of the assets: the determination of the percentage or amount would be beyond the control of the U.S. Government or any other single government (whether or not the U.S. views the international authority as having sovereign taxing powers). The unique nature of a corporate payment to an international escrow account, a burden no purely-domestic mining company bears, justifies its being deductible from taxes otherwise owed, a tax credit, and not merely deductible from taxable income.
On balance, ocean mining will receive tax treatment in large measure comparable to the tax treatment of domestic mining. Ocean mining will qualify for depletion allowances, investment tax credits, and full asset depreciation range allowances. The expense of most activities authorized by a license for "exploration” will be
deductible. Possible tax problems, with respect to the deductibility of prospecting expenses and the applicable rates for percentage depletion, can be solved in the manner used in H.R. 3350. No change in current tax law is required.
If the special tax burdens that the Treasury would impose by its interpretation of law are accepted, the only recourse is for a U.S. company to go abroad or, writing off its losses, to redirect its investment into activities that are not treated so unfairly by Treasury. Neither course serves the national interest if the administration is sincere when, as its representative has stated, the wealth of resources at the bottom of the sea must not be left to be idle.
Economists in the Treasury Department should also look more carefully at the state of the outlook for the international mining industry, including prospective market prices of minerals, DCF requirements of an investing company and bank loan criteria and practices.
Deputy Assistant Secretary Helen Junz provided a somewhat arguable statement about corporate guarantees in trying to make the point that the investment guarantees proposed in the bill are unnecessary. She stated "(Banks) require that specific investments be fully backed by the corporations undertaking them • • • banks will not fund projects without corporate guarantees." This is not exactly the case in the international mining industry. Say Ŭ.S. company "X" enters a joint venture with a Philippine company in a minerals project in the Philippines with 30 percent of the equity. In such investments a U.S. company usually tries to put up a minimum amount of its capital and to leverage as much as possible. The U.S. company probably would not guarantee bank loans to the joint venture even up to 30 percent on the basis of its total balance sheet. It is impractical for corporations to fully guarantee all these losses of parent and subsidiaries. Options are available. More likely the banks would only require long-term sales contracts for the output for the project that would cover interest and repayment of principal over the scheduled amortization period of the loan. Alternatively, funds or guarantees could be pro vided by a development bank of the Government of the Philippines. All such options are not available to a deep seabed mining company. Since the mining is in international waters there is no governmental development bank to support loans or to put up capital. Also, long-term sales contracts for the output would be difficult to negotiate since the technology is new, innovative and untried on a commercial scale. Unanticipated technological difficulties may arise in scaling up for commercial production which would raise questions about delivery date or quality of product. Unfortunately, the Treasury Department's representative misinterprets the bills' provisions concerning political risk insurance: they are designed to provide equity and non-discriminatory treatment, not preference.
As regards future changes in the tax laws, no one can predict with confidence but speculative discussion has included doing away with capital gains, elimination of DISC, reduction or elimination of depletion allowances for hardrock minerals, eliminating foreign tax deferrals or credits, etc.
These considerations raise the question: Even with a measure of assured governmental political risk insurance at what point will the bill fail to accomplish the objective of facilitating the commercial exploitation of deep seabed nodules by U.S. companies?
The requirement for special incentives to attract capital for mining of deep seabed nodules is strengthened by the magnitude of capital investment that will have to be made in minerals projects if there is not to be a shortfall in future supply. In projecting costs, account must be taken of inflationary impacts. Increasing capital needs for energy projects will make borrowing even more difficult.
In a recent internal report to the President of the World Bank, the Bank staff estimated that gross investment required in the mineral sector between 1976 and 1980 would have to be $72-$97 billion (1975 dollars) for the world, with $38.5 billion to be made in the Developing countries, and $106 billion for the world between 1981-85, with $57 billion in Developing Countries. The figures included in these totals for the minerals found in deep seabed nodules which are located under the land area of nation states are as follows. (No estimate was made for cobalt.)