The Conference Board on Potash Royalties
A week ago, the Government of Saskatchewan released the Conference Board of Canadaâ€™s report on the possible Potash Corporation of Saskatchewan (PCS) takeover. It provides 77 pages of useful information, but is disappointingly thin on policy recommendations.
The Conference Board downplays concerns about BHP leaving Canpotex after acquiring PCS. It argues that, with or without Canpotex, profit maximization would motivate BHP to adhere to â€œmarket disciplineâ€ about potash supply and pricing.
Basically, it assumes that BHP would run the mines in the same way as PCS. (I do not often agree with Roger Phillips, but he wrote a rather good op-ed questioning this assumption.)
If so, the main consequence of a takeover is that BHP could write off the costs of developing its Jansen Lake mine against profits from existing PCS mines. The Conference Board estimates that this writeoff would reduce Saskatchewanâ€™s potash royalties, which mostly consist of a profit tax, by $2 billion over the coming decade. (If BHP built Jansen without acquiring other mines, it would have to wait years longer to start writing off the capital costs against future profits from Jansen.)
Furthermore, BHP could deduct the costs of financing the takeover from profits for corporate tax purposes. The Conference Board notes that â€œthis revenue loss depends on a myriad of factorsâ€ and makes no attempt to estimate it.
Nevertheless, the Conference Board sees BHPâ€™s bid as relatively benign, especially compared to the alternative possibility of a Sinochem takeover. Representing Chinese consumer interests, Sinochem might be more willing to undermine profits by supplying additional potash. That approach would more sharply reduce Saskatchewan royalties.
The Conference Board concludes that, rather than trying to obstruct BHPâ€™s bid, the provincial government should focus on royalties. But it emphasizes the â€œpolicy riskâ€ of royalty changes: â€œa punitive regime in one area may tarnish the provinceâ€™s overall reputation in capital markets . . . It is already seen as a high tax jurisdiction in potash.â€
The Conference Board does not deny that Saskatchewan could realistically collect higher royalties from potash. It simply claims that businesspeople would dislike higher royalties.
Despite this deference to perceived business perceptions, the Conference Board puts forward a good suggestion: â€œmaking the impact of capital expenditures on potash royalties project-specific, rather than company-specific.â€
In collecting resource rent, there is a case for allowing producers to first deduct capital costs. This approach failed in Albertaâ€™s tar sands because companies could always write off some new development against profits from existing operations to avoid ever paying royalties. But for potash, it is pretty easy to distinguish one mine from another.
There is no reason to allow companies to write off capital spending at one mine against profits from another mine. Making writeoffs project-specific would prevent BHP from counting Jansen development against existing PCS mines. But this reform would make sense even without a takeover.
However, allocation between mines is not the only problem with these writeoffs. The depreciation rate is a whopping 120%. As Reuters notes, â€œFor every dollar a miner spends on expansion, it collects C$1.20 in credits against the production [profit] tax.â€ Depreciation in excess of 100% seems difficult to justify.
Not only is capital investment deducted from profits, but profits from potash production above the 2001-2002 average are not even counted for the profit tax. For new entrants, which had no production in 2001 or 2002, annual production above 1,000,000 tons of K2O (less than one-tenth of Saskatchewanâ€™s peak output) is exempt from the profit tax.
The Conference Board muses, â€œAnother option would be to revisit this policy framework to make it more sensitive to production rather than prices. But such steps may involve serious policy risks.â€
As far as I can tell, making royalties â€œmore sensitive to productionâ€ is code for ending the royalty holiday on increased production. Since potash companies get to write off new investments, they could indeed make do without a royalty holiday on the production flowing from those investments.
To the extent that writeoffs and holidays are maintained, they argue for a higher royalty rate on profits in excess of those amounts. The profit tax currently tops out at 35%, which might almost be reasonable if that rate applied to all profits. But if it only applies to the economic rent remaining after capital costs are deducted, then a higher rate is warranted.
Whatever the cost of increased production, todayâ€™s potash prices clearly create windfall profits on 2001-2002 production levels. As long as the profit tax only applies up to this threshold, the rateÂ should beÂ much higher.
Like the Conference Board, both of Saskatchewanâ€™s main political parties seem reluctant to talk about reversing any of the incredibly generous writeoffs and holidays given to potash companies in 2003 and 2005. But even if those unnecessary incentives were continued, there are other viable means to collect higher royalties.