One of the big questions in the mining world of late has been: How will the new tax reform legislation affect our operations? I thought I would use this column to give my take on what we might expect to see in the coming years as the issues are sorted out.
As you might recall, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) on Dec. 22 last year after the House and Senate came to a compromise agreement. The final bill has, as usual, different rules for individuals versus corporations. Since most of the larger operations are corporate ventures (C-corps), I will focus on those issues, with a few sidebars regarding taxation of individuals including Partnerships, LLCs and S-corps.
The most important change for corporations is the decrease of the maximum tax rate from 35 percent to 21 percent, effective for tax years beginning after Dec. 31, 2017. All else being equal, this should reduce overall expenses for mining operations and increase free cash flow. Running this change through a few models that I have developed for clients over the years, I found that for short- to medium-term projects (5-10 years) the Discounted Cash Flow Rate of Return (DCF-ROR) impact of the tax rate cut was between 3 to 7 percentage points, which I found to be equivalent to about a 5 percent to 9 percent increase in gross revenue. Given a current gold price of about $1,300 per ounce, the effect would be the same as an increase of from $65 to $120 per ounce.
Probably the second-most impactful provision on cash flow is the full expensing of capital expenditures also called 100 percent bonus depreciation. Normally, big ticket items (think haul trucks and loaders) must be deducted for tax purposes over the life of the equipment through a depreciation deduction. The impact of that is to cause companies to pay higher taxes in the early years when the capital cost is incurred. Moving the deductible expenditures into the year the cost is made means the payback of the costs through decreased taxes occurs earlier, and thereby the DCF-ROR improves along with the free cash flow in the earlier years. Depending on the relative size of the capital costs to the total operational cash flow, the impact of this change on DCF-ROR in my models was about the same as the impact of the reduction in the tax rate, mostly due to the fact that mining operations are very capital intensive.
Interestingly, when the two changes are combined (tax rate change and 100 percent bonus depreciation) the effects are not completely additive. In one model, the rate change generated an increase in return of 3.8 percentage points, and the depreciation change showed at 4.1 point increase under the old (35 percent) rate. However, when the two were combined, the joint impact was only a 6.1 point advantage. The lower tax rate decreases the impact of the early write-off.
The third change that ties this together for mining operations is the removal of the Alternative Minimum Tax (AMT) for corporations. AMT is a provision in the tax code that limits the deductibility of certain “tax preference items,” such as percentage depletion and accelerated depreciation (both of which are of major importance to mining operations. The TCJA repeals the AMT for corporations, although it still applies to individual taxpayers. Without that repeal, the positive effects of the 100 percent bonus depreciation would have been diminished. Also notice that the percentage depletion allowance remains unchanged for both corporations and individuals.
All in all, the TCJA appears to have a lot of goodies for mining companies. The question is: What will be the day-to-day impact? What will the companies do with their newfound cash flows? I offer the following observations:
- The most likely place that the new cash flow will be utilized is in expansion projects. Decreased tax costs are equivalent to increased metal prices. That means that cut-off grades will go down, and resource tons can be moved into the reserve category. I look for an increase in drilling programs and expansion of existing operations to exploit newly created reserves. Note that because the 100 percent bonus depreciation phases out starting in 2023, there will be some urgency to get the capital expenses in quickly. Therefore because of this time limit, I expect more in the way of ramp-up expansion rather than entirely new operations with long lead times.
We probably will not see wage increases. Mining jobs are already at the top of the pay scale in the U.S. (and abroad). On the other hand, the expansion projects mentioned above will need staffing, so I do look forward to increased employment, which will increase demand for skilled workers and could have a positive impact on wages as the industry is already facing labor shortages.
- There are also some negative provisions in TCJA that will affect our industry. On the negative side, there is a cap on how much interest can be deducted (30 percent of net earnings) and a limit on operating loss carry forward (80 percent of taxable income). And there is one provision I am still researching: The law eliminates the deductibility of “transportation or commuting expenses of employees.” This could have an impact on “taking the bus to work.” We’ll have to see how this pans out.
Meanwhile, “Keep on Muckin’.”