TAX STABILIZATION AGREEMENTS AND COUNTRY RISK ASSESSMENT CONSIDERATIONS: THE PERUVIAN CASE

• Jurisdiction: Derecho Internacional

International Mining Law and Investment in Latin America and the Caribbean
(Apr 2005)
CHAPTER 6B
TAX STABILIZATION AGREEMENTS AND COUNTRY RISK ASSESSMENT CONSIDERATIONS: THE PERUVIAN CASE
Marcial Garcia Schreck ¹
Ernst & Young
Lima, Peru

Marcial A. Garc´cmb;ia is a tax partner with Ernst & Young in the Lima-Peru office. He practices in the tax advisory area, specializing in corporate taxation, international tax, petroleum, mineral and foreign investment taxation. He also is in charge of the transfer pricing practice of his office in Lima. In 2001 he finished a six month rotation in Washington DC, where he became acquainted with U.S. and OECD transfer pricing guidelines and other aspects of international taxation.

Mr. Garc´cmb;ia graduated from the University of Lima in 1993 and was admitted as a Lawyer early in 1994. After receiving a merit scholarship from the British Council, he completed with distinction his LLM studies in Natural Resources Law and Policy at the Centre for Petroleum and Mineral Law and Policy of the University of Dundee, Scotland in 1996. He also graduated with distinction in May of 2003 from Georgetown University Law Center where he was awarded an LLM in Taxation and the Cali Excellence for the Future Award for excellent achievement in the study of U.S. Income Tax.

He has been an adjunct tax professor at the University of Lima, served as a guest lecturer at numerous tax law seminars and written extensively on tax related topics.

Introduction

Several local and global surveys of mining company investment preferences clearly indicate that the stability of the fiscal regime is one of the most important factors leading to an investment in a particular country. ² Being able to predetermine the tax liability that a mineral project will bear is another key criteria taken into account in their decision-making process, as this is necessary to estimate the rate of return of the project if the mining company decides to go ahead with the investment. ³ However, as one would expect, all these factors depend not only on what is written in the various tax laws and regulations, but also on how they are interpreted and applied by the competent authorities. ⁴

It is for this reason that, since the 70's, more and more mining companies are demanding concrete guarantees before seriously considering investments in countries that do not offer clear and predictable rules over time. ⁵ It is within this context that tax stability agreements have emerged as instruments for attracting private investment. ⁶ Through this type of agreements, a country temporarily waives its sovereign power to levy new taxes on certain companies or projects, or to modify/eliminate taxes existing on the date of the agreement. As a tradeoff, that country receives the investments it needs to ensure its development.

This type of guarantees is even more necessary when an investment project is located in a country, like Peru, that is not precisely characterized for imposing stable tax rules to local and foreign companies. This problem was confirmed recently, when Economy and Finance Minister Pedro Pablo Kuczynski admitted that the government had promulgated more than 230 tax laws only over the last three years. ⁷ The attention drawn to Peru's intricate tax legislation has stirred those who believe that, in an increasingly global and competitive world, a country should tend to modernize and simplify, rather than to complicate, the tax system. The reason is that overregulation leads to more informality and tax evasion. ⁸ Moreover, -- as we shall see later - it generates uncertainty which discourages private investment. Unfortunately, everything makes us think that things will not change, at least in the short term.

There is always a reason, or said differently, an excuse to revise the tax legislation. Perhaps the most recent excuse was the need to substitute the fiscal revenues that would have been collected under the Additional Advance Income Tax, after this tax was declared unconstitutional; who knows what will happen tomorrow? ^{9 10} Instead of this tax, the government created a new one so-called Temporary Net Assets Tax through Law 28424 dated 21 December 2004. This new tax is similar to the former Extraordinary Net Assets Tax, which was revoked because businessmen complained that it discouraged investments. ¹¹ The fact is that, in Peru, anticipating a "heavy fiscal package" (package of fiscal measures involving a substantial increase in existing taxes) at the end of each year has become an unpleasant custom, as deeply entrenched as the bullfights. ¹²

The aforementioned problem, however, is not exclusive of Peru. Experience shows that this phenomenon has occurred, and still occurs, in many other countries, particularly in developing countries where political volatility and social demands have a direct repercussion on the stability of tax legislation.

Although some commentators are reluctant to acknowledge this, private investment generally brings along a number of benefits that sooner or later translate into more fiscal revenues and employment opportunities. This in turn contributes significantly to alleviate poverty. This effect is certainly felt more intensely in the mining sector, whereas mining activities are often carried out in remote places where the presence of the State is nil or unperceivable. This situation forces mining companies to assume the role of the State, building schools, medical dispensaries, roads, and other public infrastructure in benefit of the neediest.

Reducing the risk of legislative changes that adversely affect business profits helps to create a favorable environment for private investment. In this task, as we shall see, tax stability agreements play a fundamental role.

The main objective of this paper is to determine whether the tax stabilization agreements signed under Peruvian mining legislation are serving their purpose. To begin with we will address this question by explaining the main characteristics of this type of agreements and the role they play. We will also examine their impact on country risk assessment by investors. Then we will review in some detail the so-called Contracts on Guarantees and Measures for Promoting Mining Investments, and analyze the main changes undergone in recent years by the rules governing those contracts. Finally, we will evaluate the extent to which the mining companies that have signed those agreements rely on them.

Tax Stabilization Agreements

Broadly speaking, the main purpose of tax stabilization agreements is to promote private investment by offering investors and their companies the guarantee that the tax regime effective on the date in which the agreement is signed will not be modified for a certain period of time. What these instruments definitely do is extend the effectiveness of the tax regime existing on the date of the agreement for as long as the agreement remains in effect. Therefore, the same rules will continue to apply to a party covered by said contractual guarantee, who will not be affected by subsequent tax changes, according to the terms and conditions provided in the agreement, even if the new provisions are more or less favorable than the foregoing.

For mining companies, being able to know, evaluate, and somehow anticipate the legal and regulatory tax framework that will apply to a new investment project is critical for evaluating its economic viability, since this factor has a direct impact on the expected rate of return. Naturally, before risking capital, investors prepare an economic-financial feasibility study on the proposed project. Based on this study, they estimate - among other things - the rate of return they expect to obtain if they decide to develop the project. Only if the result of this profitability analysis is positive will they go ahead with the investment. The profitability of a project is often measured through a global cost-benefit analysis made to obtain indicators such as the Net Present Value, cost-benefit ratio, and internal rate of return (IRR). ¹³ In case of a new project where background information is not available, the analysis is based on the estimated value of various factors, including taxes. ¹⁴ The more accurate those estimates are, the better and more reliable the results will be.

Given the nature of mining activities, it is impossible -- or at least very difficult -- to predict and quantify many of those factors with absolute certainty at the time of embarking on a new project. The size of the mineral deposit, volume of reserves, ore grade, revenues (which depend on the cyclic fluctuations of mineral prices), production costs, salaries, cost of capital, taxes, and other variables, are only some of them. ¹⁵

Because of this uncertainty, the rate of return expected by mining companies is generally higher than in other lower-risk industries. Reportedly, most mining companies would hesitate to invest in a new project unless they believe that it will yield an internal rate of return (IRR) of at least 12% on discounted future cash flows. ¹⁶ This profitability level is required because they consider that the reward must be directly proportional to the risk in every investment project. This means that, in general, the higher the risk and uncertainty are, the higher will be the reward that is expected, and, consequently, it will be more difficult that the investment is made if the necessary conditions are not met. In this sense, the only strong reason they have for deciding to invest in a high-risk activity such as mining is the expectation of higher profits.

Tax stability agreements can influence the risk/reward balance to a certain extent, since these agreements reduce the risk of unexpected changes in the tax legislation that can adversely affect the viability and profitability of an investment project. This guarantee is specially important in the mining business, where duration and risk...