TAX NEWS - JUNE 2010
Canada Tax: Oil isn't subsidized
New investments in oil and gas are already taxed more heavily than are other industries
One does not have to look far. On the chopping block at the G20 level are "fossil fuel subsidies," which are viewed as promoting excessive development of "old" energy sources. The tax-starved U.S. and EU are already on record as wanting to raise producer levies. Australia has announced new royalties on oil, gas and mining activities, creating an uproar, with promises by the industry to move investments elsewhere.
A leaked Finance Canada memo last week raises the possible curtailment of corporate tax write-offs for exploration, development and flow-through shares. Again, the subsidy issue is at the heart. In the new world of clean energy, tax subsidies for wind, solar and bio-diesel seem perfectly acceptable, no matter their size or effectiveness. Fossil fuels are another matter, even if more than 80% of energy comes from these sources.
But do tax subsidies actually exist for fossil fuels? The best way to answer this question is to look at how taxes affect the allocation of capital in a country. If some industry activities bear higher taxes on new investments than others, they won't be able to get as much financing from investors for capital projects. After all, investors can allocate their money anywhere around the world — what they care about is the after-tax return on their investments.
If a country decides to tax an industry more than others, they will shift capital away from that industry toward others industries and the rest of the world. If taxes are low — the "subsidy" — more capital will be invested in that industry. In this case, it might be justified to level out taxes so all industries bear a similar burden in order to make better economic use of scarce resources. This is a matter of neutrality and efficiency, not a matter of killing subsidies.
With fossil fuels, fiscal impacts include not only corporate taxes but also provincial resource royalties. While royalties are a payment for the right to exploit resources owned by governments, the appropriate royalty is a pure rent tax by which the payment is applied to returns in excess of the cost of exploration, development and extraction. This means resource royalties should not collect any tax on marginal investment projects that earn returns just sufficient to attract financing from investors. If royalties are collected on marginal projects, they will discourage oil and gas investments and reduce rents.
If "subsidies" are measured by the extent to which new investment in oil and gas is taxed less than other industries, it is clear that the no subsidy generally exists. Royalties act as an important deterrent to oil and gas investment, except in Newfoundland and Nova Scotia, which have highly distortive systems as a result of cost deductions that are carried forward at unbelievably high discount rates. This could be easily fixed by adopting a royalty similar to Alberta's flat-rate oil sands levy, with a full deduction of both successful and unsuccessful exploration costs, rather than generous discount rates for carrying costs forward.
In the case of conventional oil and gas, investments are highly discouraged since the royalties, applied to production revenues, weigh heavily on marginal projects. Alberta recently reduced royalties charged on conventional oil and gas because its 2009 changes went too far in discouraging investment.
In the case of Alberta oil sands, the net profit royalty does not nearly have the same impact on new investment. However, it does aggravate the corporate tax distortion and therefore results in oil sand investments being more heavily taxed than other industries.
So leaving aside Eastern offshore investments, where is the "subsidy"? New investments in oil and gas are more highly taxed than other industries, so therefore adjustments to taxation to eliminate "subsidies" are not appropriate.
The case for reducing exploration deductions for oil and gas investments under the corporate tax would also be unfair. Industries are able to claim a full deduction for research and development expenses since finding new ideas provides significant gains to the economy. Finding oil and gas deposits is equally important, having a large benefit to others once the resource pool is found. Moreover, the technology involved with shale gas, oil sands and offshore drilling is costly and novel, leading to significant gains in wealth to Canada.
Neutral treatment of R&D and exploration costs seems quite appropriate. Less of a case can be made to maintain flow-through shares. Studies have shown that incentives for equity financing have made it easier for bad players to enter the market, resulting in poor economic returns on projects.
Perhaps the real motive for greater corporate taxation of oil and gas is a revenue grab by the federal government, now that Alberta has reduced its royalty rates. The last thing Canada needs is a war among governments over the distribution of rents. Canadian unity is still bearing the scars of Trudeau's National Energy Program, which saw a major transfer of wealth from the West to Central and Eastern Canada.
The federal Conservative government is too smart to fall for this one. It has been proud of its Advantage Canada plan. As we climb out of this recession, it should keep to its drilling.