It should be noted that most of the RRT at this stage “appears to be”, because there is no locked in worked example, just what may happen within broad guidelines. This column has been based on presentations that we have attended and articles read, we have not gone through the actual document but have registered to attend one of the briefings planned to be held in various Australian cities in May/June 2010 (http://www.futuretax.gov.au/pages/Consultation.aspx).

The basics of the RRT are that it is a super profits tax that appears to come in on a per Australian-based project basis (ie each Australian project has to be accounted for separately), and is a 40% royalty on “RRT profit”. “RRT profit” is EBIT (or earnings before interest and tax, so no financing/interest costs can be deducted), and corporate overhead costs and mineral rights or state royalty costs cannot be deducted either.

Before corporate costs is of course because they could increase, and State royalties are going to be reimbursed by each State at a later date, as in the Govt directs the States to return their royalties because the RRT is replacing them, but the State royalties are State money and the RRT is Govt money. So it appears to be up to each State when (and whether?) they return their State royalties back to a company.

It has been stated that it means the Govt hence takes a 40% risk too because the capex is depreciated beforehand as it is EBIT and not EBITDA. Comments along the lines that the Govt will return 40% of the capex on a project that fails are not correct.

As in BHPB spending say $1bn capex on Ravensthorpe and it failing, doesn’t mean that BHPB gets $400m back – no. It is a calculation on defined RRT profit, the 40% Govt risk appears to be the D & A (depreciation and amortisation deduction) - the Govt does not actually pay 40% of the capex. Apparently there may be some payment on projects that fail although it sounds like it’s one of those “read the fine print” as it seems that any payments that may be made are going to be according to a “reasonable basis”.

A return is allowed, as in the bond rate (~6% of RRT profit) is deducted before the 40% RRT calculation is made.

Then it seems, the company can pay the State royalty, deduct interest, and corporate costs and if there is any form of profit left, pay 30% in normal tax to the Govt too. As for exploration – well there does not appear to be any write off until the project becomes a mine because the calculation is on a per project basis.

It has been stated that it will mainly affect the majors, because they appear to be the only ones that will be able have a profit on which to pay the normal 30% tax after deducting the RRT, corporate costs, possible exploration costs, interest costs and State royalties.

It appears to also have the added advantage for the Govt of possibly eliminating most franking credits too as companies paying dividends out of the D & A / cashflow may not be paying enough tax to cover the franking.

From what we recall of the PNG super or additional profits tax when it came in, it was a tax that came in on NPAT after a company had made a 25% profit and was a “super profit tax”. In other words companies could achieve their project returns. A standard return for a project being 15% real or about 22% to get the money back.

The RRT in its current form infers that the majority of mining projects are likely to fail to achieve their required hurdle rate of return.

This RRT appears to have completely overlooked the risks associated with mining and processing an orebody. Aside from commodity volatility and expected costs, an orebody before it is mined is simply a geologists interpretation of a number of drillholes. When it is mined (especially underground) it often does not match the geologists interpretation. “Many geological models have been destroyed by miners mining them”. There is also ground control risk as in how competent the rock is and whether there is rock pressure, and if that is not enough, the ore then has to get through a plant and come out economically at the other end (eg Ravensthorpe).

At the recent RIU conference (10-12 May 2010), Lime Street Capital showed in a presentation why the there is little support outside of BHP and RIO for investing in resource stocks, namely the majority of SMSF individuals are frightened off by the risks associated with mining.

Some of the comments made in a lift at the Sydney Mining Club were “well it solves the skills shortage and hence reduces immigration, although there will have to be an influx of accountants to work it out”. And another that “it is clearly a win-win from the Govt’s viewpoint, if they can get it – fantastic (for them), but it will probably be modified and any modification can be blamed on the opposition for reducing workers’ potential benefits”, and finally “this is the kind of behaviour you expect from a third world country like the DRC, not Australia”.

Malcolm Turnbull replied to the RRT at the RIU conference, but it became awkward when the Chairman of the conference (who did an excellent job in keeping the whole thing on time over 3 days), grilled Malcolm in question time along the lines of what do the Liberals plan to do. While Malcolm commented that he was not the leader of the Liberal party, judging by the reply, it appeared that some form of additional tax may have been looked at.

The current resources boom is expected to run for at least 25 years (as per a presentation at the October 2009 China Mining Conference in Tianjin, China’s 15-year growth plan instigated in 2006 was still “on-track”, “Global Mining is China and was expected to remain so for at least the next 25 years.” China has stated on more than one occasion that it wants to have a minimum average growth rate of 8%pa, and will periodically try and rein it back if it overheats. To fuel that target China ideally wants to have a >50% interest in almost any orebody that has some grade and a life ideally >12 years, even if it is currently uneconomic, as sometime in the next 100 years or so it has to become viable.

A super profits tax seems to be inevitable, provided that it is a super profits tax, or in other words companies can make an adequate return that ensures that their projects are profitable, otherwise the commodity boom for Australia appears likely to mostly shudder to a halt as the majors divert their monies to projects in other parts of the world. Simply on a project return ranking basis. As for the juniors that mostly don’t have choice, it depends on what they can finance. The Australian RRT is actually worse than PNG’s APT – at least in PNG you are allowed to make an adequate profit before it kicks in.

It is a great pity that this “outburst” was made without consulting the mining industry. One of Australia’s greatest marketing comments that we/ERA were able to make (when trying to get investors to buy Australian stocks or invest in Australian projects), was “one of the main advantages Australia has in the world is that if the Govt changes so what, nothing happens, your investment in safe”. That is no longer the case, a change of Govt in Australia has affected investment with its proposed RRT.

It only takes a look at a comparison of the performance of Eldorado (who took over Sino Gold and has no mines in Australia, but is listed in Australia), with Newcrest and Avoca to see what impact the proposed RRT is having on investment in Australian exposed gold stocks as shown in Figure 1 (we compared gold stocks to avoid any commodity differences).

The proposed RRT has already reduced the value of most super funds, so if it is blocked or modified by the opposition there could actually be some rerating and improvement in super fund values.

Unfortunately for most Australian listed resource companies, what the RRT does mean is that the North American premium now has some justification, and a premium appears likely to be paid for having operations and projects that are not in Australia. The market accepts that royalties change, many mining companies also have additional land or holding royalties on their projects, however, the market hates uncertainty and what it does not accept is negatively moving the "tax goalposts”.

The tragedy is that the damage has been done. From this point on, even if RRT is blocked, the risk of its introduction will always be there, all that goodwill and marketing of Australia as a “completely safe” investment destination has “gone out of the window”. Pandora’s box has been opened and the genie has been let out, no rubbing of the box is ever going to get all of the genie back in again.

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is a Financial Services Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.

Figure 1. Chart Comparison of Newcrest, Avoca and Eldorado (Source : www.yahoo.com)