data/interim/cr-2011-138/document.md

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© **2009 International Monetary Fund** June 2011
IMF Country Report No. 11/138


**Iceland: Advancing Tax Reform and the Taxation of Natural Resources**

This paper was prepared based on the information available at the time it was completed on May
2011. The views expressed in this document are those of the staff team and do not necessarily reflect
the views of the government of Iceland or the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of
market-sensitive information.


Copies of this report are available to the public from


International Monetary Fund           - Publication Services

700 19th Street, N.W.           - Washington, D.C. 20431
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#### **International Monetary Fund** **Washington, D.C.**

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# _Advancing Tax Reform and the_ _Taxation of Natural Resources_

### **Philip Daniel, Ruud De Mooij, Thornton Matheson,** **and Geerten Michielse**

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### **FOR OFFICIAL USE ONLY**

## **INTERNATIONAL MONETARY FUND**

### Fiscal Affairs Department

## **ICELAND**

### **ADVANCING TAX REFORM AND THE TAXATION OF NATURAL RESOURCES**

#### **Philip Daniel, Ruud De Mooij, Thornton Matheson, and Geerten Michielse** **May 2011**



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The contents of this report constitute technical advice provided
by the staff of the International Monetary Fund (IMF) to the
authorities of Iceland (the "TA recipient") in response to their
request for technical assistance. This report (in whole or in part)
or summaries thereof may be disclosed by the IMF to IMF
Executive Directors and members of their staff, as well as to
other agencies or instrumentalities of the TA recipient, and upon
their request, to World Bank staff and other technical assistance
providers and donors with legitimate interest, unless the TA
recipient specifically objects to such disclosure (see Operational
Guidelines for the Dissemination of Technical Assistance
Information—
http://www.imf.org/external/np/pp/eng/2009/040609.pdf).
Disclosure of this report (in whole or in part) or summaries
thereof to parties outside the IMF other than agencies or
instrumentalities of the TA recipient, World Bank staff, other
technical assistance providers and donors with legitimate interest
shall require the explicit consent of the TA recipient and the
IMF’s Fiscal Affairs Department.

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**Contents** **Page**


Abbreviations and Acronyms ....................................................................................................5
Preface ........................................................................................................................................6
Executive Summary ...................................................................................................................7


I. Introduction ..........................................................................................................................10

A. Tax Reform, Revenue Developments, and Short- to Medium-Term Strategy .......10
B. Natural Resources and Energy Sectors in Iceland ..................................................12
C. Outline of Report .....................................................................................................15


II. Corporate Income Tax .........................................................................................................15

A. Capital Losses and Debt Forgiveness .....................................................................15
B. Interest Deductions ..................................................................................................16
C. Interest Payments to Non-Residents .......................................................................17
D. Intercompany Dividends .........................................................................................18
E. Investment Incentives ..............................................................................................19


III. Taxes on Labor Income .....................................................................................................20

A. Closely-Held Businesses .........................................................................................20
B. Personal Income Tax Rates .....................................................................................24
C. Social Security Contributions..................................................................................25
D. Pension Contributions .............................................................................................26


IV. Capital Income and Wealth Taxes .....................................................................................27


V. The Value-Added Tax and Excises on Alcohol, Tobacco, and Food .................................28

A. Value-Added Tax ....................................................................................................28
B. Excises on Tobacco, Alcohol, and Food .................................................................30


VI. Taxation for Municipalities: The Property Tax .................................................................31


VII. Taxation of the Financial Sector ......................................................................................33

A. Special Tax on Banks ..............................................................................................33
B. VAT on Fee-Based Services ...................................................................................36
C. Taxation of Derivatives ...........................................................................................37
D. Stamp Duty .............................................................................................................39


VIII. Environmental Taxation ..................................................................................................40

A. Electricity Tax .........................................................................................................40
B. Carbon Taxation ......................................................................................................42
C. Vehicle Taxes ..........................................................................................................44
D. Fuel Excises ............................................................................................................45
E. Waste Taxes.............................................................................................................46
F. Aviation Taxation ....................................................................................................47

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IX. Taxation of Natural Resources ..........................................................................................48

A. Issues and Challenges in Natural Resource Sectors ................................................48
B. Allocation of Rights to Hydro and Geothermal Resources .....................................48
C. Ownership and Competition in Power-Generating Industries ................................52
D. Commercial Terms for Electricity in Energy-Intensive Industries .........................55
E. Taxation and Resource Charges for Power-Generating Companies .......................57
F. Taxation of Energy-Intensive Industries .................................................................62
G. Taxation of Offshore Petroleum Resources ............................................................64

Tables
1. Electricity Production in a Selection of Countries, 2008 .....................................................13
2. Individual Taxpayers Receiving Wages and Dividend Payments
from Same Corporation (2009) ....................................................................................21
3. Distribution of Tax Under the Dual Income Tax .................................................................22
4. Definitions of Closely-held Companies ...............................................................................23
5. Revenue Impact of Proposed VAT Changes .......................................................................29
6. Bank Taxation in Selected EU Countries ............................................................................34
7. Average Tax on Electricity in a Selection of Countries in 2010 .........................................41

Figures
1. Electricity Use in Iceland by Sector .....................................................................................14
2. Resource Rent ......................................................................................................................58
3. Resource Rent with Extraction Levy ...................................................................................58
4. Resource Rent Taxation .......................................................................................................59
5. Pricing of Electricity by Capital Attribution and Division of Residual ...............................61

Boxes
1. Recent tax reform measures in Iceland ................................................................................11
2. Resource Rent Taxation Options .........................................................................................60

Appendixes
1. Summary of Recommendations ...........................................................................................67
2. Simulating Tax Regimes for Hydro and Geothermal Energy ..............................................72

References ................................................................................................................................77

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**Abbreviations and Acronyms**



ACC
ALG



ACC Allowance for corporate capital
ALG Association of Local Governments

ASAs Aviation service agreements
CHB Closely held business



ASAs Aviation service agreements
CHB Closely held business

CO2 Carbon dioxide
CPI Consumer price index
CIT Corporate Income Tax
EEA European Economic Area
EFTA European Free Trade Association
ETP Electricity transfer price
ETS Emissions Trading System
EU European Union
EU27 All 27 members of the European Union
EUR Euro (or when plural, euros)
FAD IMF’s Fiscal Affairs Department
FAT Financial Activities Tax
FMI Icelandic Financial Supervisory Authority
Group A Residential and agricultural properties
Group C Commercial properties
Gwh Gigawatt hour
HUF Hungarian forint
IRAP Italian regional production tax
ISK Icelandic króna (or when plural, Icelandic krónur)
LG Local government
MIW Minimum imputed wages
MW/Mwh Megawatt/Megawatt hour
OECD Organization for Economic Co-operation and Development
NOx Nitrogen Oxide
PIT Personal Income Tax
PPA Power purchase agreement
R&D Research and development
RSK Icelandic Revenue Authority
SO2 Sulphur Dioxide
SSC Social Security Contribution
TOP Take or pay
UJV Unincorporated joint venture
VAT Value added tax
VIT Variable income tax

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**PREFACE**


In response to a request from the Minister of Finance, Mr. Steingrimur Sigfússon, for a
further tax policy mission to advance the agenda set out in the previous FAD report, and also
to review environmental taxation and the taxation of natural resources, a mission from the
Fiscal Affairs Department (FAD) visited Reykjavik from March 21 to April 1, 2011. The
mission comprised Messrs. Philip Daniel (Head) and Ruud De Mooij,
Ms. Thornton Matheson (all FAD), and Mr. Geerten Michielse (External Expert).
Mr. Franek Rozwadowski (IMF Resident Representative) and Ms. Edda Rós Karlsdóttir
(IMF Resident Representative’s Office) participated in meetings and supported the work of
the mission. Ms. Oana Luca, Messrs. Alistair Watson and David Wentworth (all FAD)
contributed to the report from headquarters.

At the Ministry of Finance, the mission met with Mr. Sigfússon; Mr. Guðmundur Arnason,
Permanent Secretary; Mr. Indriði Thorlaksson, Tax Policy Advisor,
Mr. Huginn Thorsteinsson, Political Advisor; Ms. Marianna Jónasdóttir, Director-General,
Tax Department; Mr. Sigurður Guðmundsson, Deputy Director-General; and other staff of
the Tax Department. At the Prime Minister’s Office, the mission met with
Mr. Sigurður Snævarr, Economic Advisor to the Prime Minister, and Mr. Páll Thórhallsson,
Director-General. The mission also held discussions with staff of: the Ministry of Industry,
Energy and Tourism, and of the National Energy Authority; the Ministry of Environment;
Statistics Iceland; the Revenue Administration (RSK); and the Directorate of Tax
Investigations.

The mission met with representatives of: the Association of Local Governments; the
Icelandic Confederation of Labour (ASI); the Public Sector Union (BSRB) and the Teachers’
Association (KÍ); the Iceland Chamber of Commerce; the Confederation of Icelandic
Employers; the Icelandic Financial Services Association; the public accounting firms,
Deloitte, Ernst & Young, KPMG, and PwC; Landsvirkjun (the National Energy Company);
Reykjavik Energy (Orkuveita Reykjavikur, OR); Magma Energy Corporation and HS Orka;
the Association of Aluminum Smelting Companies, Samál, and Century Aluminum
Company.

The mission gained great benefit from discussions with members of two official committees:
Steering Committee for the Formulation of a Comprehensive Energy Policy for Iceland; and
the Committee appointed by the Prime Minister to address leasing arrangements for water
and geothermal utilization rights owned by the Icelandic government.

The mission thanks Ms. Marianna Jónasdóttir, Ms. Elin Gudjonsdóttir, and
Ms. Linda Gardarsdóttir for coordinating the work of the mission from the Ministry of
Finance, in close collaboration with Ms. Edda Rós Karlsdóttir of the IMF. The mission
acknowledges with gratitude the excellent cooperation and warm hospitality of the
authorities.

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**EXECUTIVE SUMMARY**

**Iceland’s government has made commendable progress in raising revenues to close its**
**fiscal gap.** In future, the emphasis should shift to the role of the tax system in promoting
efficiency and stimulating growth. The recommendations of this report, including those on
resource taxation, pursue these goals―always subject to the requirement for equity. This
report builds on earlier technical assistance, [1] and presents a menu of options aimed at
improving the efficiency of the tax system, and underpinning the authorities’ broader social
and economic objectives. The options include a particular focus on environmental tax
measures, and on allocation, pricing, and taxation of Iceland’s major hydropower and
geothermal resources.


**Reform of the current tax system**


**The priority given to fiscal consolidation since early 2009 has led to revenue increases**
**from all segments of the tax system.** It is now necessary to work more selectively, to
broaden tax bases where possible, and to aim at rationalizing anomalies in the tax
system―both legacy anomalies, and those that may have crept in during the response to the
2008 crisis.


**For example, the need to stimulate growth and investment suggests some rebalancing of**
**the tax effort.** The eventual relaxation of foreign exchange controls will make taxation of
mobile financial assets particularly difficult, and so further increases in tax on capital income
are not advisable. This report proposes that the net wealth tax, which is effectively a second
income tax on capital, be allowed to expire. To replace the revenues it provides, taxes should
be increased on the less mobile components of its base: real estate (the local property tax)
and high-income labor from a steepening of personal income tax (PIT) rates and the
reallocation of income from capital to labor in closely held businesses (CHBs).


**VAT reform would raise revenue without repressing growth.** Reform should reduce or
eliminate the gap between VAT rates, and remove non-standard exemptions, while lowering
the top rate. While much of the burden of a consumption tax falls on labor, a portion of it
also falls on wealth, making it a more efficient and equitable source of revenue than raising
labor taxes. Since the revenue cost of the lower rate of VAT greatly exceeds the benefit to
lower-income households of cheaper necessities, those households can be compensated for
higher prices with refundable tax credits while raising net revenue. Iceland’s main VAT rate,
which is the highest in the OECD, could also be reduced to soften the price impact of an
increased lower rate.


1 IMF FAD, _Iceland: Improving the Equity and Productivity of the Icelandic Tax System_, by Julio Escolano,
Thornton Matheson, Christopher Heady, and Geerten Michielse, June 2010.

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**Measures to secure the tax base for the corporate income tax (CIT) are proposed** . Most
of these are technical in nature, but could make a significant difference to revenue over time
while promoting efficiency in the system. These include: new rules on deductibility of
interest, and taxation of interest paid abroad; treatment of intercompany dividends should be
brought in line with standard European practice; temporary provisions introduced to enable
tax neutral debt forgiveness in Iceland need to be extended to situations of debt conversion
into equity. Above all, the report emphasizes the need to adopt financial accounting rules in
determining profit for tax purposes.


**Taxation of financial sector can be improved by a number of measures.** The bank tax
that was recently introduced should be maintained, but the rate and base should be modified
to take account of the risks of a financial institution. The VAT treatment of financial
institutions should be reformed, and a financial activity tax (FAT) introduced. The report
proposes revisions to the tax treatment of derivatives.

**There is ample room for further environmental tax reform measures.** In an attempt to
‘set prices right’, Iceland has recently started to introduce environmentally related taxes, such
as a carbon tax. From 2013, it will also participate in phase III of the EU Emissions Trading
Scheme (ETS), thus charging a price for CO2 emissions from its industries. There is scope to
extend the use of corrective taxes to achieve environmental objectives. Following the
experiences in Scandinavia, Iceland could consider new taxes on emissions from sulphur and
nitrogen oxide, as well as taxes on landfill and incineration of waste. The carbon tax—
introduced as a temporary tax—should be extended beyond 2012, its base should be
broadened and the rate increased. Excises on fuels, electricity, and flight departures primarily
serve fiscal objectives, but have positive side effects for the environment. The excise rates on
petrol and diesel are still low compared to other European countries, leaving scope for higher
rates. The electricity tax—also introduced as a temporary measure—should be extended and
increased to comply with EU minimum standards, at least for households.

**Taxation of natural resources**

**Iceland’s key challenge is to increase value retained from use of its hydro and**
**geothermal resources.** Iceland’s power was not priced on international markets, but by
negotiations. There was no market for the power unless an energy-intensive project was
constructed. That situation is changing, both with respect to pricing of electricity and in the
enterprises that may come to Iceland to use power. There is, however, a legacy of long-term
assurances properly given in the past that restrict what government can do today.
Developments call for an integrated reconsideration of several institutions, including
allocation of rights, market structure, ownership and taxation.

**The report proposes** : (1) a move in steps towards consolidation of publicly-owned resource
rights into a single entity; (2) preparation for resource allocations by auctions and by

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transparent comparison of proposals; (3) consolidation of resource assessments into packages
of resource leases that are offered for investment projects; (4) linkage of the duration of
leases to the flexibility of resource charges; (5) continuation of easily renewable long leases
where a progressive resource charge is applied; (6) setting the base extraction levy in relation
to anticipated environmental costs;(7) making additional extraction levy a bid variable at
auctions; (8) introduction of a resource charge geared to the achieved results of a project;
(9) permitting transferability of rights, to affiliates, upon sale or farm-in, and for third party
financing, subject to regulatory safeguards.


**Transparency of electricity prices and separation of accounts of entities in government-**
**owned power companies is vital in creating a level playing field between government**
**and privately owned power companies** . Resource taxation should complement by use of an
extraction levy on electricity sales, adjusting the levy in specific cases for the estimated
environmental costs; and adopting a resource tax for access to rights, either by means of a
cash flow tax surcharge scheme, or an allowance for corporate capital (ACC) scheme.


**Sudden measures to increase fiscal levies on energy-intensive industries should be**
**avoided** ; the way to extract rent for the nation is through competitive pricing of electricity.
Existing incentives legislation can expire as scheduled, without replacement, and investment
agreements can expire as agreed.


**The petroleum fiscal terms can be revised** to include an extraction levy at a modest flat
rate, normal CIT, and a simple special hydrocarbon tax. A different model for special
hydrocarbon tax is preferable (not geared to a profit ratio calculation), such as a cash flow
surcharge or an ACC scheme.


**The proposals in this report aim at efficiency and equity in the tax system, rather than**
**revenue growth alone** . Nevertheless, over the medium term, quantifiable measures could
add 1.6 percent of GDP to revenues compared with a baseline of the tax system in
early 2011.

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**I.  INTRODUCTION**


**A.  Tax Reform, Revenue Developments, and Short- to Medium-Term Strategy**


1. **Iceland made various amendments to the tax system to alleviate its budget**
**deficit** . The various measures will help raise the estimated revenue in 2011 by
approximately ISK 8 billion, and by 2 percent of GDP between 2009 and 2011. Some of the
measures were recommended in the 2010 FAD report. (See Box 1.)


2. **The government of Iceland’s decisive actions to cut its fiscal deficit will increase**
**primary revenues by 2 percent of GDP in 2011 compared with 2009.** This substantial
increase is particularly impressive in light of the economic downturn suffered in the wake of
Iceland’s financial crisis. The IMF estimates that primary expenditur **e** s have also been
reduced by about 5.1 percent of GDP over the same period.


3. **Looking ahead, the need to stimulate growth and investment suggests that**
**higher taxes on capital income are not advisable** . The prospective relaxation of foreign
exchange controls will make taxation of mobile financial assets particularly difficult. This
report therefore proposes that the net wealth tax, which is effectively a second income tax
on capital, be allowed to expire. To replace the 0.3 percent of GDP in revenues it provides,
taxes should be increased on the less mobile components of its base: real estate (the local
property tax) and high-income labor from a steepening of personal income tax rates and the
reallocation of income from capital to labor in closely held businesses (CHBs). Increasing
residential property taxes to the currently low maximum rate of 0.625 percent could alone
provide an extra 0.7 percent of GDP in revenues for local governments. Steepening the PIT
schedule as suggested in the 2010 report would yield an additional 0.25–0.4 percent of
GDP. Broadening the SSC base through a reallocation of income from labor to capital in
CHBs would allow for lower social security tax rates for all workers.


4. **A second means of raising income without repressing growth would be the**
**reduction or elimination of the gap between VAT rates, and removal of non-standard**
**exemptions, while lowering the top rate** . While much of the burden of a consumption tax
falls on labor, a portion of it also falls on expected wealth, making it a broader-based and
more efficient source of revenue than labor taxes. Since the revenue cost of the lower rate of
VAT greatly exceeds the benefit to lower-income households of cheaper necessities, those
households can be compensated for higher prices with refundable tax credits while raising
net revenue.

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**Box 1. Recent Tax Reform Measures in Iceland**


The _**PIT**_ was lowered by 1.2 percent in all brackets to allow for a local government rate increase from
13.12 percent (2010) to 14.41 percent (2011). The combined tax rate on personal income remained
approximately the same. By this measure, the Central Government shifted ISK 10.2 billion to the
local government. Income tax brackets were adjusted by 4.7 percent.


The _**capital income tax rate**_ was raised from 18 percent to 20 percent. The estimated revenue
amounts to ISK 1.1 billion in 2011 (0.07 percent of GDP).


The **CIT** rate was also raised from 18 percent to 20 percent. The estimated revenue amounts to
ISK 0.5 billion in 2011 (0.03 percent of GDP).


From 1 January 2011 the _**net wealth tax**_ rate was raised to 1.5 percent and the threshold was reduced
to ISK 75 million (for couples: ISK 100 million). The estimated revenue amounts to ISK 1.5 billion
in 2011 (0.09 percent of GDP).


Also from 1 January 2011 the _**inheritance tax**_ was raised from 5 percent to 10 percent. The tax free
limit was raised from ISK 1 million to ISK 1.5 million. The estimated revenue amounts to
ISK 1 billion in 2011 (0.06 percent of GDP).


The _**social security contribution**_ (SSC) had already been raised twice since 2008 and there were no
changes in 2011. The rate remained at 8.65 percent.


Apart from the raise in the top rate from 24.5 percent to 25.5 percent on 1 January 2010, no revenueyielding measures have been taken in the _**value-added tax**_ .


In January 2011 the _**excise tax**_ rates on alcohol were raised by 4 percent, on liquors by 1 percent, and
on tobacco by 7 percent. In addition the excises in duty free stores were raised from 0 to 10 percent of
the ad valorem excise duty on alcohol and from 0 to 40 percent of the ad valorem excise duty on
tobacco. The estimated revenue in 2011 amounts to ISK 0.5 billion (0.03 percent of GDP). The excise
on motor vehicles and the half-yearly fee on motor vehicles were reformed in 2010 and became
effective in 2011. The estimated additional revenue in 2011 amounts to ISK 0.2 billion (0.01 percent
of GDP).


The _**excise taxes**_ on petrol and diesel oil have been raised repeatedly since December 2008. The
excise tax was increased by 4 percent, considered as an inflation adjustment but providing a revenue
increase since inflation is now lower than projected.


The _**carbon tax**_ which was introduced in January 2010 and calculated as 50 percent of the ETS price
in each category, was raised to 75 percent in 2011. The estimated revenue in 2011 amounts to
ISK 1 billion (0.06 percent of GDP).


From 1 January 2011 a _**bank tax**_ has been introduced on the liabilities of banks and other financial
institutions. The tax rate is 0.041 percent, which will result in estimated revenue in 2011 of
ISK 1 billion (0.06 percent of GDP).

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5. **Concomitantly, Iceland’s various excise taxes on food and non-alcoholic**
**beverages could be eliminated in order to mitigate the effect of the higher VAT rate** .
Iceland’s main VAT rate, which is the highest in the OECD, could also be reduced to soften
the price impact of an increased lower rate. Increasing the lower VAT rate to 14 percent,
taxing non-standard exempt items at that rate, cutting the top VAT rate to 25 percent, and
compensating bottom-quartile households for higher food, energy, and transportation prices
would yield approximately 0.5 percent of GDP.


**B.  Natural Resources and Energy Sectors in Iceland**


6. **Iceland hosts important natural resources: hydroelectric power, geothermal**
**energy, possible offshore petroleum resources, and fisheries** . This report deals with the
energy resources, but not with fisheries.


**Hydropower and geothermal energy**


7. **Iceland is well-endowed with water course resources.** The island’s topography and
heavy rainfall provide extensive resources for hydro electricity generation. The least-cost
sites have already been developed, and there are legitimate environmental (and tourism)
concerns about further development in some areas. Nevertheless, a substantial pipeline of
possible projects remains available to power company investors. In principle, hydropower
resources are not exhaustible; they can, however, deteriorate over the long term as a result of
climate change or poor water management.


8. **Geothermal resources have been developed more recently** . Geothermal energy is
associated with the seismic and volcanic activity due to Iceland’s location on the midAtlantic ridge, at the junction of tectonic plates. The resulting superheated water generates
electrical energy, in plants with lower capital costs than for hydropower, but higher operating
costs. Total costs, including return to capital, are similar per megawatt hour (mwh) for both
hydro and geothermal, although they will vary with location. The geothermal resource is not
exhaustible in the sense conventional for petroleum and mineral resources, but the resource
can be depleted by over-exploitation leading to cooling; the resource will regenerate, but only
over long periods of time. Seismic or volcanic events can make geothermal resources
vulnerable to sudden change. Iceland’s households also make direct use of geothermal hot
water.


**Electricity in Iceland**

9. **Iceland is a power-intensive economy** (Table 1). According to the International
Energy Agency (IEA), production was almost 50 mwh per capita in 2008, six times the
OECD average. Production was also higher than in other power-intensive economies, such as
Scandinavia, Canada, and Switzerland. Electricity in Iceland is generated solely by

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hydropower (73 percent) and geothermal energy (27 percent). [2] Only Norway also generates
its power from renewable sources (hydropower), while other countries rely more on nuclear
energy or power from fossil fuels.


**Table 1. Electricity Production in a Selection of Countries, 2008**


Production Percentage
Mwh/capita Hydro/geothermal Wind Nuclear Thermal
Iceland 49.7 100

Denmark 6.5 19 81
Finland 16.4 22 30 47
Norway 24.9 98 2
Sweden 14.8 49 2 37 12
Canada 17.1 60 15 25
Switzerland 8.2 51 45 4


Source: IEA (2010).


10. **Being geographically isolated, specific demand creates supply in the Icelandic**
**power market** . On the supply side, a small number of companies produce the power. The
biggest is Landsvirkjun, a state-owned company that generates 96 percent of all hydropower
in Iceland and which has an overall electricity market share of 72 percent. Reykjavik Energy,
jointly owned by municipalities and the state, generates geothermal power and heat and has a
market share of 16 percent. It supplies electricity to one of the aluminum smelters as well as
the retail market. The third company is HS Orka with a market share of 8 percent. It was
recently taken over by Magma Energy, Sweden. The sole transmission operator in Iceland is
Landsnet. Six firms operate in the distribution of electricity. Since 2008, Iceland has
complied with the EU Directive 2003/54/EC regarding the internal market for electricity. [3]


11. **On the demand side, three large aluminum smelters consume approximately**
**three quarters of the power in Iceland** (Figure 1). Recently, a number of other powerintensive industries have started to settle in Iceland, such as silicon-refining firms and data
centers. Domestic households consume only 6 percent of electricity produced in Iceland. The
markets for small consumers and energy-intensive industries are segmented and
characterized by very different circumstances.


2 Note that for geothermal energy, electricity accounts for only 39 percent of the total energy production:
another 45 percent of energy (hot water) is used directly for space heating and the remaining 16 percent for
other purposes (swimming pools, agriculture, and snow melting).


3 This directive requires the separation of generation and distribution activity, and aims to create a competitive
spot market for electricity in EU countries. The mission received representations that the smallness and special
nature of the market in Iceland made it unsuited to application of this directive.

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**Figure 1. Electricity Use in Iceland by Sector**



![](assets/figures/cr-2011-138-fig-p0017-001.png)





Source: Statistics Iceland.


12. **On the retail market, a handful of companies owned by municipalities supply**
**power to domestic small-scale users** . Free choice for consumers and low switching costs
have caused convergence of retail prices, reflecting the marginal production costs of the
marginal producer that just breaks even. The other producers will then enjoy a surplus, a rent.


13. **Power supplied to smelters is usually specific for that purpose―the supplier and**
**demander are bound to deal with each other** . The specificity of the contract enables
parties to bargain over the rent generated by the agreement, including the resource rent. The
bargaining strength of the smelter depends on its options to secure power and produce
elsewhere in the world; that of the electricity company on its options to sell power to other
firms. In the past, firms have concluded long-term contracts (up to 40 years) that included a
link to the aluminum price. Some power companies used a cost-plus method to determine the
price. The agreed prices turned out to be competitive internationally, probably leaving a
substantial share of the rents with the buyers of the power. Electricity supplied to other
power-intensive industries is also agreed in contracts, but of shorter duration and with
different prices.


**Petroleum resources**


14. **Petroleum is not yet produced in Iceland, but potential exists in deep waters to**
**the north of the country** . The prospective area of Iceland’s continental shelf is known as
Dreki, adjacent to the Jan Mayen ridge―a submerged micro-continent, geologically similar
to neighboring hydrocarbon basins in Greenland and Norway exclusive economic zones.
Located in water depths of 1,500 to 2,000 meters, and believed to lie at least 2,000 meters
below the sea floor, these prospects are difficult and expensive to explore. Only large
discoveries are likely to merit development, with current technology.

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15. **Iceland held a first, unsuccessful licensing round in 2009. This followed adoption**
**of petroleum legislation, including an act on the taxation of hydrocarbon extraction.**
Companies apparently found the proposed fiscal terms (including a royalty rising steeply
with the rate of production) unattractive in this challenging technical environment. The
government is currently revising these terms, with the aim of holding a second licensing
round later in 2011.


**C.  Outline of Report**


16. **This report takes forward the analysis of FAD’s 2010 tax policy report, and adds**
**review of environmental taxation and the taxation of natural resource exploitation**
**activities.** The proposals aim at efficiency and equity in the tax system, rather than revenue
growth alone **.** Nevertheless, over the medium term, quantifiable measures could add
1.6 percent of GDP to revenues compared with a baseline of the tax system in early 2011
(Appendix 1). Analysis and proposals from the FAD 2010 report are repeated only when
essential for the argument. This report covers: corporate income tax (chapter II); personal
income tax and social security (chapter III); capital income and wealth taxation (chapter IV);
value added tax and excises (chapter V); allocation of tax revenues to municipalities (chapter
VI); taxation of the financial sector (chapter VII); environmental taxation (chapter VIII); and
the taxation of natural resources (chapter IX). Appendices contain a summary of
recommendations, and model simulations of fiscal regimes for hydropower and geothermal
energy projects.


**II.  CORPORATE INCOME TAX**


**A.  Capital Losses and Debt Forgiveness**


17. **Currently capital losses are only recognized upon realization** . When recognized,
they are treated as ordinary losses and can be offset against other income categories,
including income arising from debt forgiveness. Capital losses on the sales of shares,
however, can only be offset against capital gains on shares in the current tax period. The
Income Tax Act does not allow for mark-to-market valuation of current assets. Many
companies suffered significant capital losses during the crisis on their holdings of equity and
other financial assets, so that they need to restructure their debt. The debt restructuring takes
the form of debt write-offs, conversion into equity, or amendment of the terms of loan
agreements.


18. **In 2010 a temporary provision was introduced in the Income Tax Act which**
**provides for a tax deferral of taxable income from debt write-offs** . Debt write-offs in
excess of operational losses can be carried forward until 2014. Any remainder of debt writeoffs at the end of 2014 that is in excess of ISK 500 million is taxed in equal parts from 2015
through 2019. This relief is conditional upon the business having used all its depreciation

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opportunities. Taxpayers are prohibited from distributing profit and engaging in business
reorganizations. Debts between related parties are excluded from this relief.


**Issues**


19. **Financial accounting rules typically recognize capital gains and losses on current**
**assets when they accrue** —e.g., by using a mark-to-market valuation or other fair value
methods. The idea is that those assets can be easily made liquid. By applying this valuation
rule, in combination with the tax treatment of capital losses as ordinary income, debt
restructuring becomes neutral for tax purposes. Creditors will forgive debt only if the debtor
cannot fulfill its liability because of accumulated losses. In that case, the debtor would
recognize forgiveness of debt as taxable income, but would be able to absorb it with the
accumulated tax losses. Any part of the forgiven debt in excess of losses would be taxable
income.


20. **The temporary rule introduced provides for relief of legacy cases**, in which losses
were incurred in the past that may not have resulted in tax losses eligible to offset the income
from debt forgiveness. However, this rule excludes debt restructuring in the form of
conversion into equity and changes in the term of the loan agreement. In cases of debt
conversion into equity, the difference between the nominal value of the debt and the fair
market value of the shares received is typically considered a capital gain, and subject to tax.
As in the case of debt forgiveness, the incurred losses that caused the debt restructuring may
not have resulted in tax losses eligible to offset the taxable capital gain. Thus, the temporary
rule should have been extended to situations in which debt is converted into equity. The
changes made in the term of the loan agreement typically do not give rise to a taxable event.
The temporary rule therefore correctly excludes this form of debt restructuring.


**Recommendations**


- For companies, income tax assessment should follow the valuation provisions used in
the financial accounting rules.


- The temporary provision regarding relief for debt forgiveness should be extended to
cases in which debt restructuring has taken the form of conversion of debt into equity.


**B.  Interest Deductions**


21. **Corporate acquisitions of Icelandic businesses by non-resident investors are**
**typically debt financed** . Thus the target company—as much as possible—finances its own
acquisition. As a consequence, Iceland is confronted with corporate tax base erosion.

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17


**Issues**


22. **The debt is contracted either from a third party bank or through a special**
**finance vehicle set up by the investor in a low tax jurisdiction** . The investor requires—as
its new shareholder—the target company to distribute its retained earnings. These dividend
receipts are used by the investor company to pay off the principal debt amount. If the
retained earnings are insufficient, the target company is required to enter into a loan
agreement itself to enable transfer of sufficient funds to its new parent company. The final
result is that the full financial costs of the acquisition become a burden for the target
company and erode its tax base.


**Recommendation**


- Limit debt-financed acquisitions by non-residents by disallowing deductibility of
interest paid to creditor’s resident in low tax jurisdictions, and by introduction of a
thin capitalization rule (as discussed in the previous FAD report).


**C.  Interest Payments to Non-Residents**


23. **The tax incidence of Iceland’s withholding tax on interest payments often lies**
**with the debtor** (because of contractual stipulations) and results in higher costs on
borrowings from abroad.


**Issues**


24. **Currently Iceland levies a 20 percent withholding tax on interest payments to**
**safeguard its corporate tax base** . If interest is paid to resident creditors the withholding tax
is either credited against the income tax liability (corporations) or the capital income tax
liability (individuals). If the creditor is a resident of a treaty country, the withholding tax is
typically reduced to zero or a tax credit is provided in the country of residence. [4] If the
creditor is a resident of a non-treaty country, the withholding tax is a final tax.


25. **In practice, the incidence of the withholding tax on interest payments to non-**
**resident creditors often lies with the Icelandic debtor** (often because of contractual
stipulations). Although it is common international practice that reduced treaty rates can be
applied if the creditor provides a certificate of residence, creditors do not seem to have any
incentive to provide such certificates. Nevertheless, it is recommended that a moderate
withholding tax on interest (perhaps at 10 percent) remains to protect the corporate tax base.


4 Currently Iceland has concluded double tax treaties with 36 countries, out of which 20 do not allow the
country of source any withholding tax on interest. In most other cases a limited withholding tax of 10 percent is
allowed.

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**Recommendation**


- The 20 percent withholding tax on gross interest payments to corporate creditors and
non-resident creditors should be reduced to 10 percent.


**D.  Intercompany Dividends**


26. **The threshold of 10 percent shareholding for relief from double taxation hinders**
**investments** . On the other hand, financial and other expenses incurred by the Icelandic
parent company, related to foreign participation shares, might further erode the domestic tax
base.


**Issues**


27. **The introduction of a threshold of 10 percent of the shareholding was aimed at**
**distinguishing between portfolio and strategic business investments, so that only the**
**latter would enjoy relief from double taxation** . An alternative requirement—in the form of
a minimum acquisition price—was suggested in the 2010 FAD report. The alternative would
ease the 10 percent restriction, though this report favors its elimination.


28. **A full exemption of dividends received by an Icelandic parent company raises**
**the issue of where to allocate the expenses related to the investment** . In the Bosal case [5]
the European Court of Justice decided that a Member State should—in compliance with the
freedom of establishment—allow equal tax treatment regarding expenses made in relation to
its investments in other companies irrespective of whether they are domestic or foreign. The
Parent/Subsidiary-Directive [6] allows Member States to limit the exemption of dividends
received to 95 percent. The—mostly financial—expenses related to the investment can be
offset against the remaining taxable dividends.


**Recommendations**


- Consider abolishing the threshold of 10 percent shareholding and apply an exemption
for all dividends received by Icelandic corporations.


- The dividend exemption should be limited to 95 percent of the amount received to
allow for a small taxable portion to offset participation-related expenses.


5 Decision of the European Court of Justice in Case C-168/01 of 18 September 2003 ( _Bosal_ ).


6 Council Directive of 23 July 1990 on the Common System of Taxation Applicable in the Case of Parent
Companies and Subsidiaries of Different Member States (90/435/EC).

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**E.  Investment Incentives**


29. **General investment incentives—that include some modest tax reductions—**
**replaced the case-by-case special agreements from 2008 onwards for new projects** .
Furthermore, a tax credit has been introduced to stimulate research and development
activities and stimulate the competitiveness of innovation businesses.


**Issues**


30. **The general investment incentives apply to companies in all sectors (except the**
**financial sector) planning to invest in a new project with a minimum turnover of**
**ISK 300 million (approx. US$2.6 million) and creating at least 20 jobs** . The incentives
can be obtained for investment in an area that covers almost the entire geographical area of
Iceland, including areas close to Reykjavik. The tax incentives provide: (1) for a maximum
corporate tax rate that is set at the rate applicable at the moment the agreement is concluded;
(2) pro-rated depreciation in the first year in which the assets are placed into service; (3) full
amortization of business assets; [7] (4) exemption from certain fees—industrial, market, and
electrical safety charges; (5) 30 percent reduction of the property tax; (6) 20 percent
reduction of the social security charge; and (7) an exemption for custom and excise duties on
certain capital goods. These incentives are provided for a period of 10 years, or a maximum
of 13 years after the investment agreement has been signed. The accumulated tax incentives
cannot exceed 15 percent of the initial investment cost. [8] In addition to this regional aid
scheme, some additional general incentives are applicable in the form of direct cash grants. [9]
The incentives are granted in accordance with an agreement made between the investor and
the Ministry of Industry. [10]


31. **The incentives are not well targeted to attract major investment projects that**
**would not take place otherwise and that play a key role in the growth prospects of the**
**Icelandic economy** . In principle, if incentives are to be available, they should be
incorporated in the main tax legislation. This law expires at the end of 2013 and the
government should allow it to lapse. [11]


32. **Since 2010 an income tax credit of 20 percent has been available for research**
**and development costs** . The credit applies to R&D expenses of at least ISK 1 million

7 The normal depreciation rules allow an amortization of 90 percent of the acquisition or production cost.


8 For medium-sized enterprises the ceiling is increased to 25 percent and for small enterprises a ceiling of
35 percent applies.


9 For training costs, small- and medium-sized enterprises, R&D projects, and environmental-related projects.


10 The Ministry of Industry is advised by a committee of three members, one nominated by the Ministry of
Finance.


11 The treatment of major energy-intensive investments is discussed in Chapter IX.

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(approx. US$8,700) annually and that are approved by Rannís—Icelandic Centre for
Research, a state agency under the Ministry of Education, Science and Culture. The annual
cost ceiling for the credit is ISK 100 million (approx. US$870,000), or ISK 150 million
(approx. US$1.3 million) in case the R&D services are purchased. If the tax credit exceeds
the income tax liability, the unused part is refundable in cash.


**Recommendations**


- Allow the general investment incentive package to lapse upon expiry.


- Keep the R & D credit under review, to monitor its effectiveness.


**III.  TAXES ON LABOR INCOME**


**A.  Closely-Held Businesses**


33. **The most salient policy issue for Iceland’s dual income tax is misallocation of**
**labor and capital income within closely-held businesses** . Because capital income is taxed
at a lower rate than labor income under the dual income tax and is also not subject to social
security charges, there is a strong incentive for private businesses to maximize their
allocations to capital. Table 2 shows the distribution of wages and dividends for employees
that receive both forms of income from the same corporation. As can be seen, many highincome employees receive dividends greatly in excess of their wage income.


34. **Iceland’s dual income tax system traditionally allocated income to labor based**
**on a non-indexed minimum imputed wage, which was widely recognized as too low.** In
2010, an allocation rule was introduced for closely held corporations requiring them to split
distributions in excess of 20 percent of net capital 50/50 between labor and capital
(the “20/50” rule). This arbitrary rule distorts the relative taxation of different business
forms. It is unclear what distinction is used to separate closely-held businesses from widelyheld businesses.


**Issues**

35. **The dual income tax system requires a special rule for allocating income from**
**closely-held companies whose owners contribute both capital and labor** . In Iceland, this
is done by stipulating that owner-employees attribute to themselves an “arm’s length wage.”
Minimum imputed wages (MIW) for owner-employees in different sectors and sizes of
companies are published each year by the Finance Ministry. Since 2007 the minimum
imputed wages have not been changed or indexed to inflation, except that for tax year 2010
an additional high-wage category was introduced for members of the bank resolution
committees.

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**Table 2. Individual Taxpayers Receiving Wages and Dividend Payments from Same**

**Corporation (2009)**



**Per capita**

**dividends**
**(ISK mns.)**



**Number of**
**Employees** **Total Wages**



**Per capita**

**dividends**



**Dividend**

**share**
**(Percent)**



**Total**
**Dividends**



**Per**
**capita**
**wages**



**Wage**
**share**
**(Percent)**



0 – 1 1,106 4,340,860,144 533,006,890 3,924,828 481,923 89.1 10.9
1 – 2 657 2,794,500,562 1,073,143,448 4,253,426 1,633,399 72.3 27.7
2 – 3 423 1,773,066,655 1,101,554,284 4,191,647 2,604,147 61.7 38.3
3 – 4 245 1,130,199,401 874,939,998 4,613,059 3,571,184 56.4 43.6
4 – 5 243 1,084,762,409 1,152,617,328 4,464,043 4,743,281 48.5 51.5
5 – 6 130 556,519,164 732,734,149 4,280,917 5,636,417 43.2 56.8
6 – 7 107 549,381,797 706,781,091 5,134,409 6,605,431 43.7 56.3
7 – 8 126 838,949,269 953,347,683 6,658,328 7,566,251 46.8 53.2
8 – 9 71 299,110,422 617,045,455 4,212,823 8,690,781 32.6 67.4
9 – 10 96 480,051,688 943,481,409 5,000,538 9,827,931 33.7 66.3
10 – 20 345 2,007,665,425 4,661,740,520 5,819,320 13,512,291 30.1 69.9
20 – 30 107 557,510,307 2,512,545,009 5,210,377 23,481,729 18.2 81.8
30 – 40 51 267,998,048 1,699,855,220 5,254,864 33,330,495 13.6 86.4
40 – 50 14 79,740,647 585,566,356 5,695,761 41,826,168 12.0 88.0
50 – 60 30 162,502,063 1,583,660,415 5,416,735 52,788,681 9.3 90.7
60 – 70 10 54,630,794 620,860,449 5,463,079 62,086,045 8.1 91.9
70 – 80 5 24,240,184 356,139,854 4,848,037 71,227,971 6.4 93.6
80 – 90 7 29,655,516 589,444,445 4,236,502 84,206,349 4.8 95.2
90 – 100 7 36,445,438 661,824,188 5,206,491 94,546,313 5.2 94.8
 - 100 18 97,532,001 3,589,994,035 5,418,445 199,444,113 2.6 97.4


**Total** **3,798** **17,165,321,934** **25,550,282,226**


Source: Icelandic Revenue Directorate.


36. **The minimum imputed wage applies to sole proprietorships, partnerships, and**
**closely-held businesses.** In all three types of business, principals must allocate to themselves
the appropriate minimum wage, upon which they pay PIT and the 8.65 percent social security
charge (SSC). In sole proprietorships, the remainder of earnings is taxed under the
progressive PIT schedule, but is not subject to the SSC. The profit of partnerships after the
MIW deduction is taxed at the special partnership rate of 36 percent (= 0.20 + (1-0.20)*0.20).
For closely held corporations, the 20/50 rule applies according to which, after deduction of
(minimum) wages, 20 percent of net capital may be paid out as capital income; further
distributions are allocated 50/50 between labor and capital. It is not clear from existing law
and regulation whether the SSC is levied on the labor share of this allocation, though the IRD
does not include this labor share in the SSC base. A comparison of total tax burden between
the various legal forms of businesses is provided in Table 3.

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**Table 3. Distribution of Tax Under the Dual Income Tax**


**Sole Proprietor** **Partnership** **Closely-held Business**


**Total Income (in ISK)**




- Employment Income (MIW)
10,000,000
30,000,000



(MIW) 10,000,000 (MIW) 10,000,000
(50/50-allocation) 14,400,000




- Capital Income 30,000,000 (20 percent capital) [1] 1,200,000

(50/50-allocation)14,400,000
**Taxation (in ISK)**
Income Tax 17,390,667 3,527,667 10,181,907
Partnership Tax (36 percent) 10,800,000
Corporate Income Tax (20 percent) 6,000,000
Capital Income Tax (20 percent) 3,120,000
Social Security Contribution
(8,65 percent) [12] 865,000 865,000 865,000

**Deductible Cost (20/50 rule)** -2,880,000
Total Burden 18,255,667 15,192,667 17,286,907



(50/50-allocation)14,400,000
**Taxation (in ISK)**
Income Tax 17,390,667 3,527,667 10,181,907
Partnership Tax (36 percent) 10,800,000
Corporate Income Tax (20 percent) 6,000,000
Capital Income Tax (20 percent) 3,120,000
Social Security Contribution
(8,65 percent) [12] 865,000 865,000 865,000



Source: IMF staff calculations; and Iceland Finance Ministry.


1/ The closely-held business in this example has ISK 6 million capital (approx. US$52,000).


37. **Under current rules, partnerships receive the most favorable tax treatment,**
**followed by corporations and then sole proprietorships** (Table 3). Prior to the introduction
of the 20/50 law, corporations were most tax-favored, since they offered the option of
retained earnings on which the capital income tax could be deferred, but the introduction of
the splitting rule produced a wave of conversions from corporations to partnerships. Ideally,
the allocation of capital and labor income should be the same for sole proprietorships,
partnerships and private corporations, so that the form of business does not depend on tax
considerations. At least, however, the method should be unified for partnerships and
corporations, since sole proprietorships have the option of adopting one of these forms if they
have significant capital assets.


38. **The allocation of income in private businesses should be done in as objective a**
**manner as possible** . Because the returns to labor of the self-employed are highly variable
according to skill and effort, and because for some types of labor there is no corresponding
arms-length wage, the most objective manner of allocating income is on the basis of capital.
Icelandic authorities confirm that even small private businesses in Iceland would have little
difficulty measuring their capital assets. The 20/50 method was adopted as a compromise
between the MIW and a capital-based allocation method because the latter was opposed by
private businesses with labor-intensive firms.


12 Social Security Contribution (and mandatory pension premium) is due on the minimum imputed wages.

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39. **In addition to being more accurate, a capital-based allocation method would be**
**more equitable to salaried employees, who must pay higher SSC contributions due to**
**the lower SSC base of the self-employed** . However, if Iceland retains its MIW-based
allocation method, it should at least reset minimum wages to more reasonable levels based on
a comprehensive study of private businesses, measuring their labor income by a capital-based
allocation method. The MIW should then be indexed each year according to the Icelandic
wage index. To keep abreast of technological changes affecting labor productivity, the MIW
should be reviewed every several years. If the 20/50 splitting rule is also retained, the law
should be made clear on whether the 50 percent allocation to labor is subject to the
8.65 percent social security charge.


40. **Currently Icelandic tax law does not have a clear definition of closely-held**
**businesses other than any business in which employees control the company** . The result
is that even widely-held companies in which shareholders are acting as employees may also
be included in the 20/50 rule. Other Nordic countries having a dual income tax system are
dealing with the same issue. Other countries have decided to define substantial shareholders
of companies to establish tax neutrality with respect to various legal forms available for
doing business. [13] In general, closely held firms are those in which a small group of
shareholders control the operating and managerial policies of the firm. Table 4 provides an
overview of definitions:

|Col1|Table 4. Definitions of Closely-held Companies|
|---|---|
|**Country**|**Definition**|
|<br>Norway|<br>More than 2/3 is owned by shareholders who are active in the daily operation of the<br>business; a shareholder is deemed to be ‘active’ if (s)he is working > 300 hours/annum<br>in the business.|
|Finland|All companies that are not registered on the stock exchange.|
|Sweden|Companies where more than 50 percent of the ownership/voting rights is concentrated<br>upon less than five owners.|
|Denmark|No definition found.|
|Germany|A shareholder is deemed to have a substantial interest if (s)he owns at least 1 percent of<br>the shares (directly or indirectly) for the last five years.|
|Netherlands|A shareholder (with or without associated persons) is deemed to be a dominant<br>shareholder for tax purposes if (s)he owns at least 5 percent of the shares of a (closely-<br>held) company.<br>|



13 Thus the rules with respect to the taxation of substantial shareholdings in Germany and the Netherlands
mirror the tax position of a sole proprietorship.

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**Recommendations**


- Capital income allocation rules should be the same for partnerships and closely-held
corporations.


- Income should be allocated between labor and capital within closely held businesses
according to the net or gross assets method.


   - However, if the minimum wage system and/or the 20/50 split is retained,
minimum wages should be reset using a comprehensive study that employs
the gross or net assets method to measure labor income, and the minimum
wage should be annually indexed.


- The government should clarify whether SSC charges apply to the 50 percent labor
allocation.


- A definition of closely-held business should be included in the income tax act, based
upon the number of active shareholders and their joint shareholding.


**B.  Personal Income Tax Rates**


41. **Most of the progressivity of the Icelandic system derives from its high basic**
**allowance, which provides for a smoothly increasing average tax rate over most of the**
**wage spectrum.** The 2010 FAD report pointed out that, compared to other Nordic countries,
Iceland’s personal income tax (PIT) has a relatively high basic allowance (28 percent of the
average wage), a high initial tax rate (37.31 percent), and a low top marginal rate
(46.21 percent). However, the marginal tax rate schedule faced by low-income Icelanders is
far from smooth: Workers in the lowest quintile who increase their earnings face a “tax cliff”
of almost 40 percentage points in their tax rate, which creates a disincentive to participate in
the formal labor force. Informality is generally not considered a serious problem in Iceland,
and labor force participation rates are very high at 81 percent. Nonetheless, both government
and union officials expressed concern about the PIT structure creating a “poverty trap” for
lower-income workers in Iceland.


**Issues**


42. **It is important not to exacerbate the existing PIT “cliff” for low-income workers** .
The initial 37.31 percent bracket is very narrow, containing only about 14,500 taxpayers
in 2011; expansion of the basic credit, under some proposals, would cut this number by more
than half. Combined with the mortgage and child tax credits, this would effectively raise the
initial marginal PIT rate to 40.21 percent. The 2010 FAD report, by contrast, stated that in
order to reduce the low-income tax cliff, the Icelandic government should refrain from
further increases in the basic PIT allowance and allow it to erode with inflation; it also
proposed that the initial tax rate should be lowered over the medium term, once budgetary

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pressures subside. Alternatively, the government could currently reduce both the initial tax
rate and the basic tax credit in a revenue-neutral manner.


43. **The two PIT surcharges introduced in 2010 do not provide for much**
**progressivity at the higher end of the wage distribution.** The first 2.9 percent surcharge
applies to most taxpayers with positive tax liabilities, while the second surcharge applied to
taxpayers in the top decile of the income distribution is fairly modest in size at 6 percent. The
top marginal PIT rate in Iceland is low relative to that of other Nordic countries, which have
an average top marginal rate of 52 percent (OECD, 2010). However, compulsory non-tax
payments in Iceland are higher than elsewhere in the region: Icelandic workers are required
to pay at least 12 percent of their income before tax into private pension funds, while
elsewhere in the region a larger share of pensions are funded through explicit taxes on labor
income. This has the effect of making Iceland’s labor income taxes appear relatively low.
Moreover, the withdrawal of mortgage interest and child tax credits often raises the marginal
PIT rate on above-average wages above 50 percent.


44. **Nonetheless, the 2010 FAD report saw some room for increased marginal tax**
**rates on higher-income earners.** It recommended that the two surcharges be replaced either
with a single 10 percent surcharge levied on incomes above ISK 4.5 million (approximately
the average private-sector wage in 2010), or two 5 percent surcharges levied at ISK 3 million
and ISK 6 million. Both of these measures would increase both revenue and progressivity,
with the 10 percent surcharge being somewhat more progressive and the dual 5 percent
surcharges raising somewhat more revenue (0.4 percent vs. 0.25 percent of GDP).


**Recommendations**

- Do not increase the basic tax credit for the PIT. Consider lowering both the tax credit
and the initial PIT rate in a revenue-neutral manner.


- Eliminate the first 2.9 percent surcharge and replace the second 6 percent surcharge
with a single 10 percent surcharge levied on above-average incomes.


**C.  Social Security Contributions**


45. **In 2009 and 2010, social security contributions (SSC) levied on labor income**
**were increased from 5.34 percent to 8.65 percent in order to pay for an expected rise in**
**unemployment** . The actual rise in unemployment, which peaked at 9.3 percent in early 2010
but has since fallen more than 2 points, was less than anticipated. The authorities are,
therefore, contemplating a reduction in the social security contribution rate to 6.8 percent.


**Issues**

46. **The 2010 FAD report recommended reducing social security taxes as labor**
**market conditions improved to lower wage costs and stimulate employment** . The

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prospective reduction in SSCs is thus a positive development. Broadening the SSC tax base
by reallocating capital income to labor within closely held businesses would likely permit a
further reduction in SSC charges. Alternatively, the SSC base per worker could be capped at
a certain level for both salaried and self-employed workers, to the extent that the
corresponding benefits do not increase with salary level.


**Recommendations**

- Reduce the rate of social security contributions as much as possible, given expected
unemployment and any increase in the SSC base.


- Consider capping the base of the SSC at a certain level of earnings for both salaried
and self-employed workers.


**D.  Pension Contributions**


47. **There is currently no absolute cap on how much Icelanders may contribute to**
**tax-exempt pension plans** . During the boom years prior to the crisis, high-income
individuals thus made very large contributions to tax-exempt plans, thereby reducing the
capital income tax base. Although high contribution levels are less likely under current
economic conditions, Iceland may wish to consider imposing either a limit on tax deductions
for voluntary pension contributions in excess of a certain amount, or a surtax on benefit
withdrawals above a certain level.


**Issues**

48. **Countries often limit the absolute amount that may be allocated to tax-preferred**
**investment vehicles, such as pension funds, in order to protect their capital income tax**
**base while still providing a tax incentive for adequate pension savings** . Iceland restricts
employee contributions to “second pillar” mandatory pension savings to 4 percent of salary,
and while the minimum employer contribution to these funds is 8 percent, it may be higher
according to contract. Contributions to “third pillar” voluntary plans are limited to 4 percent
of salary for employees and 2 percent for employers. Iceland also places certain restrictions
on savings vehicles to qualify as pension plans—e.g., pension savings cannot be withdrawn
until the age of 60 and must pay out over a period of at least seven years.


49. **Although some countries allow unlimited tax-deductible contributions and**
**retirement withdrawals from pension funds, many OECD countries impose an absolute**
**limit on contributions, withdrawals, or both** . Annual contribution limits are often agedependent, with higher contributions allowed by individuals approaching retirement age.
Some countries, such as Spain, allow unused contribution amounts to be carried forward for a
limited number of years. Benefit limits are generally set as a maximum amount that may be
withdrawn at regular income tax rates, which amount may vary according to whether it is

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taken as a lump sum or annuity. Alternatively, the replacement rate of annual salary may be
capped, as for defined benefit plans in the Netherlands and Canada. Withdrawals in excess of
the benefit limit are often subject to a penalty rate of taxation, as in Britain, Australia, and
Ireland.


**Recommendation**

- Consider placing an absolute cap on annual or lifetime tax deductions for voluntary
pension contributions.


**IV.  CAPITAL INCOME AND WEALTH TAXES**


50. **Since 2008, taxes on capital and wealth have increased sharply in Iceland** . The
capital income tax rate was doubled in three steps from 10 percent to 20 percent. A broad net
wealth tax covering financial assets, business assets and real estate was introduced in 2010 at
a 1.25 percent rate; the rate was increased to 1.5 percent in 2011, and the threshold was
lowered from ISK 90 million to ISK 75 million (US$625,000) for single persons and from
ISK 120 million to ISK 100 million (US$833,000) for couples. Projected revenues from the
net wealth tax are approximately 0.3 percent of GDP per year.


**Issues**

51. **As Iceland reintegrates with the international economy, heavy taxation of capital**
**income will likely become more difficult and deleterious to growth** . At the onset of the
financial crisis, Iceland’s tax rates on corporate and capital income—15 percent and
10 percent, respectively—were quite low by international standards, allowing them to be
raised sharply without undue disruption even in the midst of a severe economic downturn.
The imposition of foreign exchange controls that resulted from the crisis moreover trapped
both domestic and foreign capital within Iceland, greatly reducing the mobility of the capital
tax base. As these controls are relaxed in the coming years, however, this base—in particular,
wealth held in the form of cash and liquid financial securities—is likely to become much
more sensitive to the tax burden.


52. **As noted in the 2010 report, the layering of Iceland’s net wealth tax on top of the**
**capital income tax can result in very high marginal rates on capital income, particularly**
**in the presence of inflation** . For an investor earning a 7.5 percent real return on assets, the
1.5 percent net wealth tax effectively doubles the 20 percent capital income tax to 40 percent;
in the presence of 3 percent inflation, however, the tax on the real return rises to 67 percent.
It is unlikely that investors would be willing to pay such high rates if they have other
alternatives. In particular, wealthy Icelandic taxpayers are likely to leverage their assets to
avoid the net wealth tax or, if the assets are liquid, move them offshore.

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28


53. **It is therefore recommended that, as Iceland liberates its foreign exchange**
**controls, the government allows the net wealth tax to expire.** This policy is preferable to a
reduction in the rate of the capital income tax for two reasons: First, since it is levied on
gross income, the capital income tax does not create an incentive to increase financial
leverage in the same manner as the net wealth tax. Second, unlike the capital income tax, the
net wealth tax requires valuation of private companies and other illiquid assets, which can be
difficult. If a taxpayer’s assets do not generate current income, then the net wealth tax can
also pose illiquidity problems, although high-net-worth taxpayers likely have sufficient liquid
assets to pay the tax.


54. **To replace the 0.3 percent of GDP that the tax generates in revenues, the less**
**mobile components of the wealth tax base can be taxed more heavily** . Specifically, taxes
should be increased on real property (discussed in Chapter VI) and the labor income of
closely-held businesses (Chapter III). These bases should be both progressive and much less
elastic with respect to tax rates than the liquid financial assets also included in the net wealth
tax base, so the substitute taxes should be less distortive.


**Recommendation**

- Allow the net wealth tax to expire, and replace the revenues with a combination of
higher property taxes and a broader and more progressive personal income tax.


**V.  THE VALUE-ADDED TAX AND EXCISES ON ALCOHOL,** **TOBACCO, AND FOOD**


**A.  Value-Added Tax**


55. **Iceland levies a dual-rate VAT whose main rate of 25.5 percent is the highest in**
**the OECD.** The lower rate of 7 percent applies to food and non-alcoholic beverages, heating
energy, hotels and restaurants, and printed materials, music, and radio licenses. Exemptions
not included in the EU VAT directive include sporting events, public transportation, travel
agencies, burials, and authors and composers’ income.


**Issues**

56. **As discussed in the 2010 report, dual rate VAT systems introduce economic**
**distortions, complicate administration, and lose revenue.** The justification for having a
lower VAT rate on necessities is usually to support the purchasing power of the poor, who
are likely to spend a larger portion of their income on food, etc. However, analysis of
Icelandic household expenditures indicated that the difference between the share of
expenditures on food and other necessities varies little by income quartile. The majority of
the benefits of the lower VAT rate thus accrue to non-poor households. The report, therefore,
recommended that the lower rate of VAT be eliminated or at least raised to 14 percent, while
compensating low-income households for the price increase through direct transfers.

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Concomitantly, the report recommended eliminating non-standard exemptions, such as
passenger transport, and using some of the revenue to subsidize public transport.


57. **Government and private sector officials all recognize the inefficiency and**
**distortions created by the dual VAT rate, but cite the political sensitivity of increasing**
**the lower rate.** In addition to the effect on lower-income households’ purchasing power, any
increase in the consumer price index resulting from an increase in VAT rates translates is
added to the principal balance on indexed loans, thereby increasing Iceland’s already heavy
private debt burden.


58. **This report, therefore, recommends that the government approach a single-rate**
**VAT in two steps:** First, it should increase the lower rate back to 14 percent and tax nonstandard exempt items (public transport, sports and cultural events, and travel agents) at that
rate. At the same time, the top rate on the VAT should be lowered from 25.5 percent to
25 percent, and bottom-quartile households could be compensated for higher food, heating,
and transport costs. The net impact of these measures would be a revenue increase of
0.5 percent of GDP and a 1.3 percent increase in the price level (Table 5). Second, it could
move to a unified single VAT rate on all items of approximately 20 percent on a revenue
neutral basis. The cost to compensate bottom-quartile households for this step would be an
additional 0.1 percent of GDP, and the lower unified rate would reduce the price level by
approximately 2.6 percent. [14]


**Table 5. Revenue Impact of Proposed VAT Changes**



VAT Policy Option Revenue/GDP



Price
Level
Change



Phase I
Increase lower rate to 14% 0.6% 1.4%
Increase exempt items to 14% 0.1% 0.3%
Lower top rate to 25% -0.1% -0.4%
Compensate LIHs -0.1%      Total Effect 0.5% 1.3%
Phase II
Increase lower rate to 20% 0.7% 1.5%
Lower top rate to 20% -0.6% -4.1%
Compensate LIHs -0.1%      Total effect 0.0% -2.6%


Source: Statistics Iceland data and IMF staff calculations.

14 These values may differ from subsequent official estimates. They are probably conservative insofar as they
are based on Iceland’s survey of household expenditures, which does not capture all domestic
consumption―for example, local government and tourism sectors are not covered.

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59. **There are at least two possible means of administering VAT rebates: Lower-**
**income households could apply for a VAT rebate, or the government could offer an**
**additional refundable tax credit through the income tax.** Granting a VAT rebate to
unregistered VAT payers would likely run afoul of the EU VAT directive. Reimbursement in
the form of an income tax credit would in any event be a simpler way to offer a means-tested
credit, since the income tax administration already tracks household income and assets. If
desired, the government could also soften the impact of a VAT-induced price increase on
debt levels through a temporarily higher mortgage interest or debt principal allowance.


**Recommendations**


_**Short term**_


- Increase the lower rate of the VAT to 14 percent and tax non-standard exemptions at
the lower rate.


- Lower the main rate of the VAT to 25 percent.


- Compensate lower-income households for higher costs of necessities through
refundable income tax credits.


_**Medium term**_


- Tax all items at a unified rate of approximately 20 percent.


**B.  Excises on Tobacco, Alcohol, and Food**


60. **Excises on alcohol and tobacco in Iceland are high by European standards and**
**similar to those in the Scandinavian countries.** Since 2008, alcohol excise rates have risen
by between 44 and 48 percent and the excise on cigarettes by 52 percent. Despite a rise in the
CPI of 30 percent, this implies quite a sharp increase in real terms. Iceland also charges
excise rates on a large number of food products. Excises are either ad-valorem or specific and
then measured by ISK per kilogram or per liter. The list of products to which these rates
apply originates from 1987. A number of products are related to the sugar content, but not all
and not in a consistent way. In 2010, rates have been doubled compared to the original act.


**Issue**

61. **Excise rates seem generally appropriate, except for food excises.** The excise rates
on ‘sin’ products are a matter of national preferences, trading off health arguments,
externalities, distortions, and the risks of tax evasion. The rationale for the long list of excises
on food products is not clear though. It seems that products containing sugar appear
frequently on the list, but not in a consistent manner. For instance, mineral water contains no
sugar but is charged an excise of ISK 16 per liter; the highest rate of ISK 160 per kilo is

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charged on dried fruit for making broth; cane sugar is charged only ISK 60 per kilo. The
absence of a clear rationale for these taxes puts doubt on their justification. This is all the
more so since food falls under the reduced VAT rate. Hence, there is a situation in which
food products are on the one hand tax-favored through a reduced VAT rate and, on the other
hand, tax penalized by a list of specific excises on food products. The obvious reform would
be to eliminate both the reduced VAT rate on food products and all food excises. This would
improve transparency and simplicity and eliminate distortions in consumption choices.


**Recommendation**

- Eliminate the excises on food products as part of a broader reform of the VAT.


**VI.  TAXATION FOR MUNICIPALITIES:** **THE PROPERTY TAX**


62. **The property tax is an attractive option for small open economies due to the**
**immobility of the base (which also recommends it an ideal local government tax).** Base
inelasticity makes it less distortive than most other taxes and thus less likely to deter growth.
Property taxes are also usually progressive, since higher-income individuals tend to own
more property. For these reasons, this report recommends substituting higher property
taxation for the net wealth tax. Because, as is typical, the property tax is levied by local
governments (LGs) in Iceland, increasing its productivity will require reassessing the overall
division of revenues between central and local governments.


**Issues**

63. **Property taxes in Iceland are imposed by LGs, subject to central government**
**rate caps of 0.625 percent on residential and agricultural properties (“Group A”) and**
**1.65 percent on commercial properties** **[15]** **(“Group C”).** As noted in the 2010 report,
Iceland’s property tax revenue, at 1.8 percent of GDP, is high relative to that of other Nordic
countries, but lower than that of some other OECD countries including the United States,
Britain, and Canada. The 0.625 percent cap on residential properties is low and should be
raised to at least 1 percent. [16]


64. **Most LGs currently raise the maximum or close to the maximum revenue**
**permitted from commercial properties, but some raise substantially less than the**
**maximum from residential properties.** Association of Local Governments (ALG) data


15 Government-owned properties are subject to a flat 1.32 percent tax rate.


16 Given that property taxes are highly visible, and Icelandic authorities report that LGs face political pressure to
keep rates as low as possible, it is indeed questionable whether a rate cap on residential property is needed.

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show that 97 percent of potential Group C revenue is currently collected. The picture is much
different for Group A properties, however, where only 44 percent of potential revenue is
collected, even given the lower cap on Group A tax rates. Exploitation of the Group A
property tax varies considerably by region: Whereas many rural jurisdictions impose rates at
or close to the maximum, most jurisdictions in the Reykjavik area tend have substantially
lower rates. ALG statistics show that increasing local property taxes to the current maximum
rate of 0.625 percent would generate close to 0.7 percent of GDP in revenues, much of it in
the Reykjavik area. Raising local residential property taxes to a minimum of 0.5 percent
would raise about 4.5 percent of GDP.


65. **As noted in the 2010 report, it is politically difficult to increase tax rates on high-**
**value urban housing that, unlike commercial property, may generate no income with**
**which to pay the tax.** The current high levels of housing debt also create resistance to higher
property taxes in the near term. The 2010 report presented the option of deferring a portion of
the property tax until the property is sold, although this would generate little near-term
revenue. Another way to increase the productivity of the property tax would be for the central
government to set minimum as well as a maximum property tax rates.


66. **Increasing the productivity of the property tax would necessitate a renegotiation**
**of the division of revenues between central and local governments.** Currently, PIT
revenue constitutes more than three quarters of LG tax revenue, which in turn accounts for
just under three quarters of their total income (12.6 percent of GDP). Property tax revenue
accounts for an additional 20 percent of LG tax revenue. Transfers from the central
government account for another 10 percent of total LG income. LGs have also requested
shares of CIT, capital income tax, and some excise tax revenues from the central
government.


67. **An appropriate division of revenues and expenditures between levels of**
**government depends on the roles and capacities of each level.** To the extent that local
governments supply a federally mandated set of benefits, it is reasonable for them to require
central government revenue transfers. Localities with a smaller tax base may require a higher
share of central transfers, if required to provide a standard package of benefits. To the extent
that LGs provide a locally chosen set of services, however, they should be required to raise
local revenues for such projects. LG accountability to their local constituents also requires
that they raise their own revenue at the margin. It is reasonable for the central government to
require a minimum level of local tax effort (e.g., a minimum property tax rate) as a
counterpart to receiving federal transfers. As recommended in IMF (2010), increased tax

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effort should also be required for LGs that have run up significant budget deficits as a result
of discretionary spending. [17]


68. **In dividing the proceeds of different revenue sources, the volatility of revenues**
**with respect to borrowing capabilities and expenditure needs should be taken into**
**account.** If LGs have steady or countercyclical spending requirements and restricted access
to capital markets, their revenue sources should not be volatile over the economic cycle.
Since 1998, CIT and capital income have been particularly volatile, with coefficients of
variation of at least 50 percent. PIT, VAT, and excise revenue have been far less so, with
coefficients of 16–18 percent. The most stable yielding tax has been the property tax, with a
coefficient of only 10 percent, recommending it as a good source of stable income for LGs.


**Recommendations**

- Increase the cap on “Group A” property tax rates to at least 1 percent.


- Consider setting minimum rates of property tax for local governments.


**VII.  TAXATION OF THE FINANCIAL SECTOR**


**A.  Special Tax on Banks**


69. **Iceland recently introduced a special tax of 0.041 percent on total liabilities of**
**banks and other financial institutions that operate on a special license from the**
**Icelandic Financial Supervisory Authority (FME).** Branches of foreign banks or financial
institutions that accept deposits in Iceland are also subject to this tax. Institutions that are
established under a special law and are fully owned by public bodies, or institutions that have
officially filed for bankruptcy are excluded. The estimated revenue amounts to ISK 1 billion
(0.06 percent of GDP) in 2011 and flows directly into the state budget. In the long term the
revenue will be used to establish a special contingency fund that will serve as a guarantee
against future financial crises. This bank tax is subject to review after the first year.


**Issues**


70. **Iceland has followed many other countries in establishing a bank tax to cover the**
**net fiscal cost of direct public support to financial institutions and help reduce excessive**
**risk-taking** (Table 6). The institutions that are subject to the bank tax could be narrowly
(banks only) or broadly (all financial institutions) defined. As the narrow application would


17 International Monetary Fund, “Strengthening the Local Government Fiscal Framework,” IMF Fiscal Affairs
Department Technical Assistance Report, Washington, DC, December 2010.

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**Table 6. Bank Taxation in Selected EU Countries**
























|Col1|Base|Rate|Revenue|
|---|---|---|---|
|**Austria**|Non-consolidated balance total,<br>excluded paid-up capital, insured<br>deposits and certain debts to banks, if<br>necessary to comply with liquidity<br>requirements, and increased by<br>financial derivatives in portfolio|< EUR 1 billion: 0%<br>EUR 1 billion – EUR 20 billion: 0.055%<br>> EUR 20 billion: 0.085%<br>+ <br>0.015% on amount of all financial<br>derivatives|General Budget|
|**Belgium**|Insured deposits|0.15% of the deposit base|Deposit Guarantee<br>Fund|
|**Cyprus**|Liabilities, excluding equity and<br>insured deposits|0.05% of the liabilities as defined in the<br>base at the end of the year|Resolution Fund|
|**Denmark**|Insured deposits and securities|Ex post, if needed, with a maximum of<br>0.2% of the insured deposits and securities|Deposit Guarantee<br>Fund|
|**France**|Risk-based average assets|0.25% of capital requirements (based on<br>risk-based average assets)|General Budget|
|**Germany**|Liabilities, excluding equity and<br>insured deposits, increased by the<br>nominal value of derivatives|_Progressive rate for liabilities_: <br>< EUR 10 billion: 0.02%;<br>EUR 10 billion – EUR 100 billion: 0.03%;<br>> EUR 100 billion: 0.04%.<br>_Fixed rate for derivatives:_ 0.00015%<br>_Maximum_ _rate_: 15% of the annual profit of<br>financial institution (after tax)|Resolution Fund|
|**Hungary**|Liabilities, excluding loans between<br>financial institutions|< HUF 50 billion: 0.15%<br>> HUF 50 billion: 0.5%|General Budget|
|**Portugal**|Liabilities, excluding tier 1 and tier 2<br>capital and insured deposits; and<br>notional value of off-balance<br>derivatives|Progressive rate:<br>0.01% - 0.05% on liabilities<br>0.0001% - 0.0002% on off-balance<br>derivatives (thresholds are set in<br>regulations)|General Budget|
|**Sweden**|Liability, excluding share capital,<br>bonds treated as equity, internal debt<br>transactions between entities of the<br>group paying the bank tax, and debt<br>securities issued within the framework<br>of a guarantee program|2010-2011: 0.018%<br>> 2011: 0.036%|Resolution Fund|
|**United**<br>**Kingdom**|Liabilities, excluding tier 1 capital,<br>insured deposits, and liabilities against<br>policyholders; and<br>Assets that are included in the liquidity<br>buffer according to the Financial<br>Services Authority|2011: 0.04%<br>> 2011: 0.07%<br> <br>Reduced rate for capital financing with<br>long term (remaining term > 1 year):<br>0.02%, after 2011 increased to 0.035%|General Budget|



Source: Dutch Ministry of Finance.


single out specific institutions, and create incentives for systemic risks to migrate, a broad
application, with appropriate allowances for riskiness in the base and rate, would address
these concerns and better cover institutions that could become systemic in the future. In
addition, it would recognize that all institutions benefit from the public good of enhanced
financial stability provided by the resolution scheme. It would also help create a broad
constituency to provide some level of accountability that any funds raised are used efficiently
and remain available for financial sector support. Finally, singling out a narrow group of

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institutions to pay the levy could worsen moral hazard by suggesting that they are less likely
to fail than those outside the scheme. These considerations suggest that the bank tax should
be imposed on all financial institutions.


71. **In deciding which components of the balance sheet to include in the tax base, two**
**issues arise** : (1) whether the base should be represented by assets or liabilities; and
(2) whether it should be broad or narrow (include off-balance sheet items or not). A broad
base on the liability side of the balance sheet may be preferable, as it allows a lower rate for
any given amount of revenue, and so limits the risk of unintended distortion. It would also
acknowledge that the cost of resolution arises from the need to support liabilities. However, it
would be important to exclude equity (so as not to discourage capital accumulation). In
principle, other liabilities could also be excluded to reflect their risk-characteristics or to
avoid double taxation, such as subordinated debt, government guaranteed debt and intragroup debt transactions (an approach taken by Sweden). The levy could be applied only to
select liabilities (such as wholesale funding, short-term debt or foreign funding) with the
explicit objective of discouraging such activities. However, the narrower the base concept,
the higher the risks of arbitrage, evasion, and unintended effects. To avoid double imposition,
insured liabilities could be excluded or, better, a (nonrefundable) credit given for payment of
premiums in respect of insured liabilities. Off-balance sheet items could be included to the
extent that they represent a significant source of systemic risk.


72. **The setting of the rate could draw on experiences of past crises and their fiscal**
**costs, and should take into account the risk profile of the financial system (including its**
**structure and regulatory framework).** Empirical analysis [18] suggests that, given present
institutional structures in major G-20 countries, (implicit) government support provides “too
big to fail financial institutions” with a funding benefit between 10 and 50 basis points, with
an average of about 20 basis points. The rate for non-systemic and less risky financial
institutions could be substantially lower, implying a lower overall rate. As risks vary over the
cycle, the rate would have to be adjusted so as to help make the financial system less procyclical.


**Recommendations**


- Maintain the bank tax introduced in January 2011.


- Modify the balance sheet base on the liabilities side, excluding equity capital, by
allowing for a credit for payments in respect of insured liabilities.


- Consider including off-balance sheet derivatives in the tax base.


18 See: Rime (2005), Soussa (2000), Baker and McArthur (2009), and Haldane (2009).

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- Consider, over the medium term, adjusting the rate to address institutions’ specific
risks and their contribution to systemic risk.


**B.  VAT on Fee-Based Services**


73. **All financial services are tax exempt under the current Icelandic VAT,**
**irrespective whether they are fee-based transactions or margin-based transactions** . By
regulation, some transactions—executed by providers of those exempt services—that are in
competition with others, are subject to VAT by reverse charge. [19]


**Issues**


74. **The rationale for the exemption of financial services under the standard invoice-**
**credit form of VAT is the practical difficulty of taxing them fully under such a system** . [20]
For financial services provided on a fee-paying basis, VAT can be charged in the usual way.
The difficulty arises for services charged for in the margin on intermediation services
(‘margin-based transactions’). The allocation of the margin relative to some benchmark
‘pure’ interest rate is complex, and results in high administrative and compliance costs. A
common response has been to exempt such services (meaning that no tax is chargeable on
sales, but associated input tax is not recovered).


75. **Exemption of margin-based transactions means that business use of financial**
**services tends to be overtaxed** . The prices charged by financial institutions will likely
reflect the unrecovered VAT charged on their inputs, so that business users will pay more
than they would have in the absence of the VAT. The distortion of production decisions by
exemption is felt, for example, through the tax incentive for financial institutions to selfsupply services rather than purchase externally (and so incur unrecovered VAT), in too little
use of domestic financial services by business users, and a tendency to purchase financial
services abroad (since services provided to a non-resident are commonly in effect zerorated). For final consumers, on the other hand, exemption likely means under-taxation, since
the price they pay does not reflect tax on the full value added by financial service providers,
but only their use of taxable inputs.


19 For instance, construction, maintenance and repairs of business assets, laundry, printing, or canteen
exploration, cleaning activities above a certain threshold, certain skilled service activities, and security services.


20 While the extent of exemptions of financial services is largest in the EU countries, more recently-introduced
VATs have brought more financial services, especially fee-based services and insurance, into the VAT net.
New Zealand and South Africa have gone very far along this road.

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76. **Several countries have sought to correct for this by imposing on the sector some**
**form of sector-specific addition-based tax** . [21] A ‘Financial Activities Tax’ (FAT), levied on
the sum of profits and remuneration of financial institutions (including insurance companies),
could raise significant revenue and be designed to serve as an alternative tax on value added,
and so would partially offset the risk of the financial sector becoming unduly large because
of its favorable treatment under existing VATs. [22] Taxing value-added in the financial sector
directly would mitigate this. To avoid worsening distortions, the tax rate would need to be
below current standard VAT rates. The size of financial sector value-added in Iceland
suggests that even a relatively low-rate FAT could raise significant revenue in a fair and
reasonably efficient way: for instance, a 5 percent FAT (with all salaries included in the
base), might raise about 0.33 percent of GDP. [23]


**Recommendation**


- Consider abolishing the reverse charge on self-supply by financial institutions and
introduce a tax on the profits and remuneration of financial institutions (FAT).


**C.  Taxation of Derivatives**


77. **Currently derivatives are taxed as interest payments and subject to 20 percent**
**withholding tax** . Derivatives are financial instruments whose value depends on other, more
basic, underlying variables. Such variables can be the price of another financial instrument
(the underlying asset), interest rates, volatilities, or indices. The taxation of derivatives
typically depends on three criteria: (1) the characterization of income; (2) the determination
of income—timing of taxable event; and (3) the withholding tax implications. As Iceland
does not treat capital gains differently from ordinary income—except regarding capital losses
on shares—the first criterion is less relevant.


21 Israel applies an addition basis tax to financial institutions, the base being taxable income for company
income tax purposes plus wages paid and the rate the same as the standard VAT rate. In Italy, the regional tax
on productive activities (IRAP), introduced in 1998 to replace several existing taxes, is similar to an addition
basis VAT, and applies to both financial and non-financial businesses. France and Denmark both levy a
compensatory tax on the financial sector to broadly offset the under-taxation implied by exemption. In France,
the _tax sur les salaries_ applies to all employers subject to VAT on less than 90 percent of their total turnover. In
Denmark, as in France, the payroll tax applies to various sectors which are largely exempt from VAT.


22 Relative, that is, to a situation in which the VAT applied uniformly to financial services and all other goods
and services.


23 The potential tax base in Iceland could amount to 6.5 percent of GDP [i.e., Gross operating surplus and mixed
income in the financial intermediation sector (3.2 percent of GDP) -/- Gross fixed capital formation in the
financial intermediation sector (0.9 percent of GDP) + Labor costs in the financial intermediation sector
(4.2 percent of GDP)].

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**Issues**


78. **Because the rules for taxation of business enterprises are normally based on**
**financial accounting rules, definition of taxable income in most European countries**
**follows these rules** . These rules tend to be more flexible than accounting rules set forth in
the tax laws themselves and provide a sound basis for dealing with new financial instruments
so that no significant threat to erosion of the tax base arises from use of such instruments.
Countries which (1) do not have reduced rates (or exemption) for capital gains, (2) base their
corporate income tax on the financial accounting rules, and (3) have kept their corporate
income tax rules simple, therefore, may not need extensive special rules for derivatives in
their domestic legislation.


79. **Legal form makes a difference in the area of withholding** . Under each country’s
domestic law, as limited by tax treaties, withholding applies only to specified types of
payments. Iceland imposes withholding tax on dividends, interest, and royalties, but not on
capital gains and other contractual payments. Because taxpayers can use derivatives to
manipulate the legal form of payments, the integrity of withholding taxes is likely to come
under pressure. In the case of certain derivatives, tax policy concerns militate against the
imposition of a withholding tax, because the payments may not be closely correlated with the
income actually earned. This is particularly the case for swap payments. There is a risk,
therefore, that if a gross basis tax is imposed at source, taxpayers simply will not enter into
the type of transaction subject to withholding, because the withholding would be out of
proportion to the amount of income involved. Such a policy may therefore deny to domestic
companies the risk-shifting benefits that new financial instruments can provide.


80. **Tax treaties place significant constraints on countries’ freedom of action in**
**imposing a withholding tax on derivatives** . Tax treaties following the OECD Model
classify income from derivatives as business income, capital gain, or ‘other income’. [24] Under
any of these characterizations, the income would generally be taxable only in the residence
country―although some tax treaties may not follow the OECD Model as far as the ‘other
income’ article is concerned. Therefore other income is taxable in the source state without
limitation. In such cases, it becomes important whether the income is characterized as
business income or as other income. Presumably, where a derivative is issued by a financial
institution in the ordinary course of its business, the income should be regarded as business
income.


24 This conclusion holds, for example, even in the case of an interest rate swap. Although the payments under
the swap agreement are determined with reference to an amount of interest payable by each of the parties to the
swap, the swap payments themselves are not interest. They are not payments for the use of money, there being
no loan between the parties to the swap.

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81. **An interest element can be embedded in a swap because of deferred timing, even**
**where the swap as a whole is not just a disguised loan** . The calculation of the implicit
interest element in swap agreements is relatively complex, but this complexity should be
manageable, given that the parties to swap agreements are financially sophisticated and able
to make the requisite calculations. Moreover, most swap agreements are not likely to involve
an implicit interest element. Taxing the interest element of derivatives may be particularly
important where a country’s policy is generally to impose a withholding tax on all payments
for capital invested in the country.


82. **Although the vast majority of countries generally do not impose withholding on**
**derivatives (absent those payments characterized as implicit interest), Iceland imposes a**
**withholding tax more generally on derivatives** . This may be motivated by a concern that
derivatives could be used to erode the domestic tax base in the absence of a withholding tax.
In particular, it risks cutting off the benefits of these transactions for its residents, because the
withholding tax may make the transactions unviable. However, taxpayers may be able to
avoid the withholding tax by structuring the transaction through a taxpayer resident in a
treaty country with a treaty that precludes the tax. The result will be that the withholding tax
will in effect preclude domestic taxpayers from entering into derivative agreements with
taxpayers resident in non-treaty partners, in particular with tax havens.


**Recommendations**


- Consider withdrawing the 20 percent withholding tax on derivatives, except for the
implicit interest element in swap agreements or other derivatives.


**D.  Stamp Duty**


83. **The 2010 FAD report recommended the abolition of stamp duties, which applied**
**to a broad range of financial contracts including share trading (50 basis points) and**
**loan contracts (50–150 basis points).** The government is currently eliminating stamp duties,
and replacing them with “registration taxes” on real estate and on insurance premiums and
contracts. The overall change is designed to be revenue-neutral and comply with EU
financial directives.


**Issues**

84. **Although taxes on real estate transactions are less harmful than taxes on**
**securities transactions due to their less mobile base, they can still inhibit an efficient**
**allocation of real property.** An excessive levy on real estate transactions may do so and any
levy should not exceed 1 percent. The revenue could be made up through higher property
taxes, which do not discourage transactions.

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**Recommendation**

- Restrict any tax on real estate transactions to at most 1 percent.


**VIII.  ENVIRONMENTAL TAXATION**


85. **Iceland does not share the Scandinavian tradition of extensively using**
**environmental taxes to internalize externalities, although recent reforms mark a**
**change.** During the late 1990s, Iceland started to introduce economic instruments for
environmental policy, such as municipal waste fees, recycling fees and taxes on hazardous
waste (batteries, chemicals, residuals from oil). Yet, contrary to the Nordic countries—where
environmental taxes form a substantial share of total tax revenue, up to almost 6 percent of
GDP in Denmark in 2008—Iceland raises relatively little revenue from environmentally
related taxes (less than 2 percent of GDP in 2008). [25] Indeed, such taxes have been especially
low in the area of transportation and energy. [26] In 2010, however, Iceland introduced a
number of new environmental taxes. Moreover, it reformed existing taxes to better reflect
environmental externalities. There are options for further ‘greening’ of the tax system, with
some of these taxes having mainly a fiscal motivation and others primarily a regulatory
purpose.


**A.  Electricity Tax**


86. **On January 1, 2010, Iceland introduced its energy tax, a levy on electricity and**
**hot water.** The rate on electricity is ISK 0.12 per kwh (approximately US$1 per mwh) and is
levied on both households and industry (except for very small firms). The rate for hot water
from geothermal sources is 2 percent of the retail price. In 2010, the taxes raised respectively
ISK 1.8 billion and ISK 0.2 billion, adding up to 0.13 percent of GDP. The energy tax is
temporary and will expire at the end of 2012. An agreement with the power-intensive
industry—more generally dealing with the pre-payment of tax—stresses this temporary
nature of the tax and refers to Iceland’s participation in phase III of the European emissions
trading scheme (ETS). That will open a new era for the power-intensive industry, which
requires reconsideration of its taxation.


25 European Commission (2010).


26 See e.g., H. Lindhjem, J. Magne Skjelvik, A. Eriksson, T. Fitch and L. Pade Hansen, 2009, The Use of
Economic Instruments in Nordic Environmental Policy 2006–2009, Nordic Council of Ministers, Copenhagen.

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**Issues**

87. **Iceland’s tax rate on electricity is low compared to other European countries.**
Table 7 shows the average tax on industry and households in a selection of European
countries in 2010, based on data from the International Energy Agency. The average rate for
industry runs from US$0.7 per mwh in the U.K. to US$13 per mwh in Norway. [ 27] For
households, it lies between US$9 per mwh in the U.K. and US$191 per mwh in Denmark
(including VAT). EU Council Directive 2003/96/EC also sets minimum excise rates on
electricity in EU Member States. For industries, the minimum is set at EUR 0.5 per mwh; for
households it is EUR 1 per mwh. For energy-intensive industries, however, the Directive
allows for measures to alleviate the tax burden or for refunds.


88. **While environmental concerns are usually a key motivation for taxes on**
**electricity, the case is less clear-cut in Iceland** . For instance, if the carbon content from
fossil fuels used in the generation of electricity is underpriced, a tax on electricity enables
governments to indirectly internalize such externalities and encourage energy-saving
behavior. Moreover, there may be other externalities from electricity generation, e.g., due to
other emissions and waste or because of under-pricing of risks associated with generating the
power. In Iceland, however, environmental rationales are less clear-cut than elsewhere. For
instance, the generation of hydropower causes no CO2 emissions; and geothermal energy
comes along with some emissions of carbon, hydrogen sulfide, and methane, but the amounts
are considerably lower than for traditional power generation from fossil fuels. In geothermal
power, there is also a risk that suppliers overexploit the resource, thus undervaluing the
benefits for future generations. These concerns may justify some tax on electricity in Iceland,
also beyond 2012.


**Table 7. Average Tax on Electricity in a Selection of Countries in 2010**


Industry (US$/mwh) Households (US$/mwh)


Norway 13.0 48.5
Finland 3.3 4.,9
Sweden 0.7 76.6
Switzerland 4.0 16.1
Denmark 9.8 191.3
France 11.4 39.5
UK 3.9 9.2
Netherlands 17.5 40.5


Source: International Energy Agency (2010).


27 These averages may hide exemptions or much lower rates charged to energy-intensive industries.

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89. **Fiscal concerns can justify the tax on electricity.** This is especially so as long as the
tax is easy to collect and comes along with low cost of compliance and administration. The
electricity tax also aligns Iceland’s policy with that in other European countries and makes it
compliant with the EU requirements regarding the minimum excise. In Iceland, aluminum
smelters consume 80 percent of the electricity and thus bear the brunt of the current energy
tax. In the short run, this is efficient since these firms have engaged in large fixed
investments that are sunk. Thus, imposing the tax skims off profits, without causing
immediate relocation. In the long run, however, higher taxation of these power-intensive
industries runs the risk of undermining government credibility, thus hampering future
investment in Iceland. We discuss the taxation of the power-intensive industry in more detail
in chapter IX.


**Recommendations**


- Maintain the energy tax beyond 2012 and consider a small increase for households
and other small consumers.


- Consider the future electricity tax for power-intensive industries in the broader
context of the taxation regime for these firms.


**B.  Carbon Taxation**


90. **In January 2010, Iceland introduced a carbon tax.** Since 2011, the rates are set so
as to reflect a carbon price equivalent to 75 percent of the current price in the EU ETS
scheme (equal to €14 per ton of CO2). It comes down to a tax rate per liter of fuel of ISK 3.8
for petrol, ISK 4.35 for diesel/gas, ISK 5.35 for unrefined oil and ISK 4.1 for jet fuel. The
carbon tax has been introduced as a temporary measure and expires at the end of 2012. The
revenue of the carbon tax in 2011 is predicted at ISK 3.7 billion, or 0.25 percent of GDP.


**Issues**

91. **Pricing carbon is an appropriate step for Iceland.** First, a carbon tax is an
important instrument to achieve reductions in greenhouse gas emissions in an efficient
manner. The appropriate rate of tax would equal the social cost of carbon. Estimates on this
differ widely, but recent consensus tends towards a price of approximately US$21 per ton of
CO2, close to the ETS price of €14. [28] Second, a carbon tax raises public revenue, a welcome
by-product of the policy. It is, therefore, recommended to maintain the carbon tax, also
beyond 2012.


28 Interagency Working Group on social cost of carbon, 2010.

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92. **A substantial share of carbon emissions in Iceland is still exempt from the**
**carbon tax.** For instance, the tax on jet fuel only applies to domestic flights and exempts
international flights on the basis of international agreements (see below). Likewise, the tax
on unrefined oil is levied on domestic vessels (including the fishery fleet), but does not extent
to the international maritime transport sector. Also industries that emit substantial amounts of
carbon, such as the cement and aluminum sectors, are currently not charged for their
emissions. Such exemptions cause distortions, as emissions are not reduced where abatement
is cheapest.


93. **Aviation will be subject to carbon pricing in the EU ETS from 2012.** The number
of permits will be capped at the average level of emissions between 2004 and 2006. In the
first year of the scheme, 10 percent of the allowances will be auctioned and the remaining
90 percent will be allocated for free according to historical emissions. At the margin, airline
companies will face an incentive to reduce emissions, though, as do other emitters. With the
inclusion in the ETS, there is little Iceland can do to further price CO2 emissions of the
aviation sector.


94. **Other industries—including the marine transport sector and the aluminum**
**industry—will be subject to phase III of the EU ETS (as of 2013)** . In phase III, the
European Commission aims at a 60 percent auctioning of emission rights. However, it has
identified 164 sectors that are deemed exposed to a significant risk of carbon leakage. These
sectors will receive relatively more free allowances, thus reducing the risk of relocation. This
will leave a substantial share of the scarcity rents with these industries, rather than with the
government. There is little Iceland can do, however, to change this. At the margin, however,
the industries will face an incentive to reduce their emissions. The cement industry in Iceland
is likely not be covered by the EU ETS due to its small size. To charge a proper price of
carbon, extending the carbon tax to this sector should be considered.


95. **Iceland can raise the carbon tax to fully reflect the ETS price.** Such an extension
would require a 25 percent increase in the tax in 2012, and then at least maintaining it in real
terms thereafter. It would most likely raise another ISK 1 billion, equivalent to 0.07 percent
of GDP. The rate should gradually rise in the future, preferably at the same rate as the social
cost of carbon (generally estimated at 2 to 3 percent per year in real terms). The carbon tax
should not be directly linked to the EU ETS price. Indeed, one of the major disadvantages of
an ETS scheme is the large volatility in the price. It would serve Iceland better if the carbon
tax would keep up with the trend development in the ETS price over a longer period of time
if that would follow the trend increase in the social cost of carbon.


96. **While industries in Iceland will soon face a higher cost of carbon under the EU**
**ETS, they are not charged on other emissions from fossil fuels, such as nitrogen oxides**
**(NOx) and sulfur dioxide (SO2).** These compounds―generated by fuels used in the fishing
fleet and the production of aluminum―are important for their role as contributors to acid wet
and dry precipitation. Emissions are regulated under the Gothenburg protocol, which

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prescribes emission reduction obligations by participating countries, although Iceland has not
ratified this part of the protocol. Charging an appropriate price for emissions, as for instance
done by Norway and Sweden, will help internalize externalities in an efficient way.


**Recommendations**

- Maintain the carbon tax beyond 2012 and extend it to sectors not covered by the EU
ETS, such as the cement sector.


- Increase the carbon tax rate to the price of carbon in the EU ETS.


- Consider introducing taxes on NOx and SO2.


**C.  Vehicle Taxes**


97. **Iceland has two vehicle taxes: a bi-annual road tax on passenger cars and an**
**excise duty on motor vehicle purchases.** Both taxes have been substantially reformed
in 2011. Being previously based on the weight or engine size of vehicles, they are now based
on the carbon emissions they cause. For each car, carbon emissions are registered in grams
per kilometer driven for combined average use of city and road driving. The government uses
this as the base for differentiating taxes.


98. **The bi-annual road tax is ISK 5,000 if emissions of a car are lower than**
**121 grams of carbon per kilometer, and ISK 120 for each gram exceeding that.** Vehicles
for which there is no information on emissions are taxed on the basis of weight. The
maximum tax for heavy vehicles is ISK 73,800 per semester. In 2011, the projected revenue
of this tax is ISK 7 billion, or 0.45 percent of GDP.


99. **The ad valorem excise duty on motor vehicles is divided in 10 categories, based**
**on emissions.** The excise is zero for the lowest category (less than 80 grams) and goes up
with steps of 5 or 10 percent to 65 percent for cars emitting more than 250 grams per
kilometer. There are a large number of exceptions to this rule, however. For instance, there is
separate list with lower rates for vehicles used by taxi firms and car rentals; several vehicles
other than ordinary passenger cars are exempt or face a fixed low rate of 13 percent; and
vehicles primarily using methane receive a credit of ISK 1,250,000. In 2011 and 2012, there
is also a transitional regime in which the most polluting cars face somewhat lower rates than
what they will ultimately be in 2013. Revenue from the vehicle excise in 2011 is projected at
ISK 1.9 billion, equal to 0.13 percent of GDP.


**Issues**

100. **Taxing vehicles based on their carbon emissions is a good step and consistent**
**with trends elsewhere in the EU.** The European Commission aims to reduce the average
emissions of new cars in 2012 to 120 grams of CO2 per kilometer, a reduction of 25 percent

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compared to 2006. Differentiating excises and road fees according to CO2 emissions will
help achieving this.


101. **Special rates and exemptions undermine the effectiveness of vehicle taxes in**
**reducing emissions from vehicles.** When viewed from the perspective of an efficient
environmental policy, there is little reason for a more favorable treatment of taxis and rental
cars, especially since these cars might be used more rather than less intensively than an
average passenger car and thus involve more carbon emissions. A special treatment of
vehicles other than passenger cars (busses, rally cars, snow mobiles, tractors) may be
justified, however, since they probably feature a very different average use compared to
passenger cars. Exemption seems overly generous though, as these vehicles cause emissions
too. Thus, exemptions create distortions in the achievement of a given reduction in
emissions. The use of vehicle taxes as instruments of environmental policy can thus be
improved further by reconsidering exemptions and the low rates for commercial use of cars.


**Recommendations**

- Bring taxis and rental cars under the regime for excise duties as other passenger cars.


- Introduce an excise on vehicles that are currently exempt from the vehicle excise
duty.


**D.  Fuel Excises**


102. **Excise rates on petrol and diesel have increased in Iceland.** Since 2008, the sum of
the earmarked excise (which feeds the Road Authority’s funds) and general excise has risen
for petrol and diesel by, respectively, 48 and 34 percent in nominal terms. In real terms, the
increase was much more modest as the CPI increased during that period by approximately
30 percent. In addition to higher excise rates, the government introduced carbon taxes that
also bear on petrol and diesel. In 2011, the total excise on petrol is ISK 62.41 per liter and on
diesel ISK 54.88 per liter. Together, the excises raise ISK 19.5 billion, equal to 1.2 percent of
GDP.


**Issues**

103. **Despite recent increases, fuel excises in Iceland remain relatively low compared**
**to other Nordic countries.** Although these excises have an impact on environmental
externalities too, they have traditionally functioned as fiscal instruments. For instance, the
retail price of a liter of petrol in Iceland, in February 2011, was €1.39, compared to €1.54 in
Sweden, €1.60 in Finland, €1.66 in Denmark and €1.8 in Norway. As Iceland does not have
to fear cross-border fuelling, there is scope further to increase the excise rates. The
motivation for this is mainly a fiscal one, driven by the revenue needs of government. If
circumstances permit, an increase in the rate on petrol in the coming years by, say ISK 20 per

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liter in real terms, would bring the retail price in Iceland close to that currently in Sweden,
Belgium, Ireland, Italy, Portugal, and the U.K., and still quite a bit lower than in Germany,
Greece, France, the Netherlands, and the other Scandinavian countries. If the same increase
were imposed on diesel, revenue would increase by some 0.4 percent of GDP in 2013.


**Recommendation**

- Increase the excise rates on petrol and diesel by ISK 20 in real terms if circumstances
permit.


**E.  Waste Taxes**


104. **Iceland levies a number of waste fees, but no taxes landfill or incineration.**
Iceland has adopted hazardous waste fees on several products and recycling fees that finance
the cost of collection, transport, and recovery or disposal of waste. It has, however, not
imposed taxes on waste put in landfill or emissions from waste incineration. Landfill is much
more common in Iceland than incineration, with the latter comprising less than 10 percent of
total waste treatment.


**Issues**

105. **Taxes on landfill and incineration can help internalize externalities from waste,**
**but the size of the external cost in the case of Iceland is unknown.** The rationale for a
corrective tax on landfill occurs if its market price in the form of land use—under the
environmental rules and regulations set by the government—is lower than the social cost of
such waste treatment. External costs may take different forms, such as methane emissions
that contribute to the greenhouse effect or unpriced risk of leaching accidents and pollution
of water systems. Also incineration may cause externalities due to emissions of metals, dust,
dioxins and nitrogen, and sulphur dioxides. These externalities have motivated the Nordic
countries to set a price on their environmental cost. It aims to stimulate recycling and reduce
the amount of waste generated. Most countries differentiate the rates for landfill and
incineration to reflect the differences in social costs, usually in favor of incineration. Pricing
the external cost of landfill and incineration would increase the price of waste treatment,
which will ultimately bear on consumers. It will provide incentives for recycling and
prevention and could thus form an efficient part of waste management in Iceland.


**Recommendation**

- Consider the introduction of corrective taxes on landfill and incineration, following
the systems in the Nordic countries.

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**F.  Aviation Taxation**


106. **Keflavik airport levies a number of fees and new taxes are proposed.** There are
landing, parking, and security fees for domestic and international landings. In addition, an
airport tax of ISK 382 is levied on departures, feeding expenditures for security, and
research. There is also a charge of ISK 598 to cover the cost of maintaining other airports as
international reserve airports. The government has just launched a proposal for new departure
tax, which is related to the distance of travel. The tax lies between ISK 65 for flights less than
500 kilometer to ISK 390 for flights of more than 4000 kilometer. The new tax should
finance investments in popular tourist attractions, together with a new tax on hotel
accommodations. The expected revenue of the departure tax is ISK 195 million.


**Issues**

107. **Aviation contributes significantly to global warming.** Apart from emissions of
carbon, flying comes along with emissions of nitric oxide, nitrogen oxide, and sulphur
oxides. The most direct way to internalize the externalities going beyond CO2 emissions, is to
impose an additional tax on fuels. Yet, taxing aviation fuel is considerably constrained by
international agreements, such as those governed by the International Civil Aviation
Organization. In Europe, moreover, special rules and bilateral Aviation Service Agreements
(ASAs) constrain the use of such taxes. Restrictions apply to many countries, including
Iceland.


108. **Aviation services are also under taxed compared to other goods and services,**
**which offers a rationale for other forms of taxation.** In particular, no VAT is charged on
international flights. This leads to distortions in consumption patterns. To reduce the under
taxation and indirectly internalize environmental externalities, countries have introduced
departure taxes on tickets. For instance, the U.K. introduced during the 1990s an air
passenger duty with four rates, depending on the destination and class. In 2011, Germany
introduced an ecological departure tax of a similar kind, with four different distance
categories. These taxes may help internalize the externalities from aviation, albeit in an
indirect manner (e.g., freight flights are not taxed and the link with emissions is rather
indirect). The Icelandic proposal for a passenger tax falls in the same category as the ones in
the U.K. and Germany. The proposal has, however, not been accepted by parliament.


**Recommendation**

- Introduce the proposed ecological passenger tax, differentiated by distance travelled.

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**IX.  TAXATION OF NATURAL RESOURCES**


**A.  Issues and Challenges in Natural Resource Sectors**


109. **Iceland’s key challenge is to increase value retained from use of its hydro and**
**geothermal resources, under historical circumstances of bilateral monopoly, and of**
**possible petroleum discoveries** . Iceland’s power was not priced on international markets,
but by negotiations in which there would be no market for the power unless an energyintensive project was constructed. That situation is changing, both with respect to pricing of
electricity and in the enterprises that may come to Iceland to use power. There is, however, a
legacy of long-term assurances properly given in the past that restrict what government can
do today. Developments call for a reconsideration of several institutions, including
allocation, market structure, ownership, and taxation.


**B.  Allocation of Rights to Hydro and Geothermal Resources**


110. **The present allocation of hydro and geothermal resources is confusing and**
**chaotic** . The government is working on reform of the system. In Iceland, by contrast with
many other countries, title to subsoil or hydropower resources belongs to the owner of the
land surface. Until 1998, there was no separate regulation or licensing of resource rights by
the state, beyond planning, environmental, and other regulation applying generally. The state
itself owns substantial amounts of land, and thus rights to resources, through various types of
tenure, including that of municipalities. Public enterprises such as Landsvirkjun also own
land where resources are located. By a law of 2008, the state, municipalities and public
enterprises are prohibited from transferring ownership of rights to private entities. [29] Thus in
many cases negotiation of rights to resources has taken place with the central government or
municipalities as owners. Access to resource rights has thus grown under a “first-come-firstserved” system, with sometimes multi-tiered transactions with landowners, municipalities,
public enterprises, or the central government. This system has made it difficult to treat the
resources as belonging to the people of Iceland as a whole, or to allocate them in the most
efficient way, or to charge appropriately for their use.


111. **Survey or utilization of resources now requires a license from the Minister for**
**Industry, Energy, and Tourism** . Legislation of 1998 introduced a licensing system, now
administered on behalf of the government as a whole by the Prime Minister’s office. [30] This
legislation recognizes continuing private ownership, but limits the use a private owner may
make of resources for economic purposes. A license applicant must negotiate separately with


29 Act amending various acts of law relating to natural resources and energy, adopted May 29, 2008.


30 Act on the survey and utilization of ground resources, 1998, no. 57 of June 10, amended in 2006 by Act No. 5
effective February 18.

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a landowner (including the state) on compensation for the use of resources. The original
legislation specified neither the duration of any license, nor any charge or fee for the grant of
the license―amendments of 2008 (see below) set a limit of 65 years. This framework, in
effect, adds a procedure of discretionary allocation to the “first-come-first-served” and
market mechanism previously prevailing. Using the reports of two recent committees, the
government has the allocation of these rights under review. [31]


**Issues**


112. **The principal issues concerning resource rights are: ownership, allocation**
**procedures, duration, fees and charges, and transferability** . These issues need to be
considered as interlinked. Despite the introduction of licensing, ownership of rights remains
an issue distorting competition because of the extent of ownership rights remaining with
public enterprises and municipalities. Allocation procedures need revision either to
accommodate auctions where feasible, and in any case to open access to rights in a
transparent and fair way to competent energy companies. The duration of licenses needs to
take account of measures to secure their economic worth for the state, balanced by the need
to attract investment (and especially third party finance) in energy intensive industries. The
fees and charges must observe the same considerations. Transferability terms need to balance
the objective of controlling and regulating resource use, with that of ensuring the resources
are used by those who can do so most efficiently, and of providing adequate security for
financing facilities.


_**Ownership**_


113. **Resource ownership rights held in the public sector are not transferable into**
**private ownership** . Despite the requirement for further licensing of the right to exploit
natural resources, the continued ownership of rights by different public sector institutions
(including power companies) creates the impression that the rules of allocation will be biased
against future private investors. A two-stage solution to this has already been canvassed
within government. Step (1) requires each public sector entity to transfer ownership of such
rights to a specially-incorporated subsidiary, so that they are transparently held and (in the
case of enterprises) separable from the balance sheets of the parent company. Step (2)


31
(1) Steering Committee for the Formulation of a Comprehensive Energy Policy For Iceland (Icelandic:
“Orkustefnunefnd”); Rreport (January 2011): Energy Policy for Iceland—Draft for discussion (Icelandic:
“Orkustefna fyrir Ísland—drög til umsóknar”). (2) Committee appointed by the Prime Minister to address
leasing arrangements for water and geothermal utilization rights owned by the Icelandic government (Icelandic:
Nefnd forsætisráðherra sem skipuð var samkvæmt III. Bráðbirgðaákvæði laga nr. 58/2008); report
(March 2010): Leasing Arrangements for Water and Geothermal Utilization Rights Owned by the Icelandic
Government (Icelandic: “Fyrirkomulag varðandi leigu á vatns- og jarðhitaréttindum í eigu íslenska ríkisins”).

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requires consolidation of these holdings into a single “resource management fund”, so that
resource ownership is no longer an issue when rights of use are allocated. [32]


_**Allocation of rights**_

114. **Both efficiency and transparency are currently damaged by the absence of clear**
**procedures for allocation of rights, including procedures for auctions** . The committee
mandated by the parliament in 2008 (see note 33) was to “address methods of choosing
between those who express an interest in utilizing the resources.” This committee favors the
use of auctions, but its report recognizes that genuine competitive bidding may not always be
feasible. It favors a two-stage auction process involving, first, prequalification and, second,
the bidding itself. The committee suggests the bid variable could be a bonus (one-time fee)
but with the possibility of converting this into an annuity payment over the life of the lease.
The auction method and the minimum number of bidders will also be important. Auctions, in
any case, cannot substitute fully for assessment of the technical and environmental qualities
of project proposals.


115. **A framework for allocation without auctions is also needed** . Auctions and other
means of allocation can co-exist, with auctions feasible in some circumstances but not others.
In either case, the government could move away from “first-come-first-served’ by
consolidating its own resource assessments into “packages” of geothermal or hydro resource
rights that are offered for investment during a selected time period. Where there are no
auctions, proposals could be assessed on technical, environmental, and other grounds, under
published criteria and possibly with numerical weightings. Selection by the government
could be complemented by an independent advisory committee, perhaps supported by
contracted international expertise.


_**Duration**_


116. **Duration of resources leases is linked to the structure of tax and resource**
**charges** . The amendments of 2008 set a limit of 65 years on the period of time for which
public entities could grant rights of use to resources they own. Debate in Iceland has centered
on pressures to shorten such leases, to preserve flexibility to adapt terms and conditions to
changing circumstances. In view of the commitments for long periods of time made in the
past, on fiscal and commercial terms that, in retrospect, may seem too generous to investors,
these pressures are understandable. The significance of lease duration, however, depends on
the adaptability (and progressivity) of fiscal and other terms built into lease conditions. If the
lease contains nothing but a small flat charge, with the leaseholder then obliged to pay CIT


32 This consolidation may require balance sheet adjustments in public enterprises such as Landsvirkjun, since
the removal of the notional value of these property rights could affect the extent of their apparent solvency. It
should be stressed that this is not an issue of the real solvency of such enterprises.

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on business profits, a very long lease may well turn out to be inequitable. If, as this report
proposes, there is a resource charge geared to project results, the lease duration becomes less
important.


117. **Capacity to grant long leases (or simple renewals) may be important to the**
**commercial viability of major power projects** . Where the power project depends for a
market on a major energy-intensive user, such as an aluminum smelter, the ability to offer
power for long periods of time consistent with amortization of the consumer’s investment
will be important. The more flexibility is built into the method of charging for the resource,
the less will be the need for short lease periods or major reviews of terms on grounds of
“change of circumstances”.


_**Fees and charges**_

118. **Charges facing an investor have four elements: payment to the landowner; the**
**extraction levy; a variable resource charge; and income tax** . In the case of state-owned
resources it is feasible to roll the first two items into one, thus simplifying the structure. The
committee proposed that the base level of a fixed extraction levy should be the estimated
environmental cost of resource utilization: this is a sound approach, on the understanding that
there should be some consistency across projects, and thus there will be an arbitrary element
in individual cases. Additional extraction levy (perhaps annuitized) will be a bid variable
where auctions take place. Payments to private landowners have reached 1.4 percent of
project investment cost; these are significant amounts, but mitigated where deductible as a
cost against CIT and a variable levy.


119. **A variable resource charge will better extract resource rent over time, and allay**
**fears about the length of leases** . This report addresses the possible form of a variable
resource charge in Section IX.E, below. Normal CIT should be payable, with no application
of special incentive packages.


_**Transferability of rights**_


120. **Transferability of rights of use (not ownership) can be consistent with strong**
**public regulation** . The 2008 amendments exhibit government and public concerns about the
transfer of resource ownership to private parties. The recent committee report does not
address transferability, but the mission understood the committee intended rights of use (as
distinct from ownership) to be transferable. Transferability is important to ensure efficiency
of use, and also to reduce the cost of financing by providing adequate security to lenders. The
public interest requires that conditions of transferability meet these purposes, while
protecting the state’s right to determine resource use.


121. **Rights of use can be transferable subject to regulatory approval in three**
**circumstances.** (1) Where there is corporate reorganization, a transfer to an affiliate should
be straightforward. (2) Where there is a sale, or a farm-in/farm-out, of a project using

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existing rights, the necessary transfer of rights should be permissible subject to regulatory
approval “not to be unreasonably withheld.” As usually interpreted, this would give the state
the right to vet the transferee for technical and commercial integrity. (3) Where there is third
party financing, borrowers should be able to offer security to lenders such that, in the event
of default, lenders can step in for a period sufficient to organize the restoration of cash flow
at the project, sufficient to resume debt service. This is short of an unconditional mortgage,
but likely to be sufficient for genuine financing needs.


**Recommendations**


- Move in steps towards consolidation of publicly-owned resource rights into a single
entity.


- Prepare for resource allocations by auctions and by transparent comparison of
proposals; consolidate resource assessments into packages of resource leases that are
offered for investment projects.


- Link the duration of leases to the flexibility of resource charges; continue to grant
easily renewable long leases where a progressive resource charge is applied.


- Set the base extraction levy in relation to anticipated environmental costs; make
additional extraction levy a bid variable at auctions.


- Introduce a resource charge geared to the achieved results of a project.


- Permit transferability of rights of use, to affiliates, upon sale or farm-in, and for third
party financing, subject to regulatory safeguards.


**C.  Ownership and Competition in Power-Generating Industries**


122. **The Icelandic electricity market complies with EU Directive 2003/54/EC**
**regarding competition.** The Electricity Act of 2003 prescribes the unbundling of vertically
integrated power companies into electricity generation, transmission, distribution, and
supply. The markets for power generation and supply are competitive. Transmission and
distribution are subject to concession arrangements and specific regulation by the National
Energy Authority. A power company can be a generator, distributor, and supplier, but
accounting separation is required between concession and competitive activities.


123. **The retail market seems to function properly.** The Icelandic power market can be
divided into two segments: the retail market for small consumers, and the wholesale market
for power-intensive industries. In the retail market, individuals, businesses, and public
organizations are free to choose their electricity supplier. Suppliers sell electricity to the end
consumer, either through their own generation or by purchasing electricity from generators or
the distributor holding the concession for a respective area. As a result of competition,

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consumer prices have converged in Iceland. The consumer price is low compared to what is
common in Europe due to the low cost of production and the low tax on electricity.


124. **The wholesale market is subject to international competition for investment.**
Power-intensive industries directly receive electricity from power generating companies.
Bilateral contracts determine the conditions and price. Wholesale prices are the result of a
bargaining process between the generator and the user. The bargaining position of the user is
stronger if he has several locations to choose from, both within Iceland and elsewhere in the
world. The bargaining position of the power generator is stronger if he has several clients to
choose from. Hence, while Icelandic power cannot be exported directly, it is exported
indirectly via the power embodied in products that are traded in world markets, such as
aluminum. The electricity market is thus exposed to international competition and forces of
demand and supply on the international markets determine the electricity price.


125. **While the power market in Iceland will be isolated in the coming years, long-**
**term developments may take a different course.** In the longer term, the electricity market
in Iceland may evolve along two lines: a ‘Cable Scenario’, where Iceland will be connected
to mainland Europe and be part of a much bigger market; or an ‘Isolated Market Scenario’, in
which there is no Cable and Icelandic electricity remains an issues of domestic supply and
demand. These scenarios are fundamentally different. In the ‘Cable scenario’, Icelandic
power companies would be able to sell at much higher prices and be very lucrative, despite
some transmission losses. For instance, in 2009, the average price of power supplied to
industrial users in the EU27 was close to €90 per mwh. In Iceland, the average electricity
price for power-intensive industry was around €35. Today’s electricity price at Nord Pool,
the Scandinavian spot market, is around €64 per mwh. In a cable scenario, the rent generated
by power companies could thus significantly increase.


**Issues**

126. **The market environment is changing, which calls for a reconsideration of**
**ownership structures and competitive conditions.** Iceland has ample opportunities for
expansion of power supply to energy-intensive industries and its portfolio of industries is
expanding as new users find their way to Iceland. Power supply is currently dominated by a
few government-owned players. Ensuring production efficiency and proper incentives
requires more transparency in the market and the creation of a level playing field.


_**Transparency**_

127. **Lack of transparency reduces efficiency and hampers competition.** The nontransparency of electricity contracts—described as ‘half confidential” since prices are known
to consultants and anyone with inside information—does not serve the public interest and
hinders competition and market development. Landsvirkjun has, this year, taken an important
step by publishing average prices. An enterprise contract disclosure law is before parliament,

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but it is only forward looking. Transparency will improve market efficiency in future. Peer
pressure and voluntary agreement may help reveal price information on existing contracts.
Another concern is that Landsvirkjun owns 13 power stations and 2 geothermal fields, but its
annual reports only show the consolidated financial accounts. Insight into the performance of
individual projects—perhaps by designing a holding structure with subsidiaries—would
reveal the relevant information to the state as the sole shareholder, both about the market
conditions in the power sector and about the performance of the company.


_**Ownership**_

128. **Two of the three major power companies in Iceland are publicly owned** .
Landsvirkjun is state-owned, Reykjavik Energy is owned by municipalities, and HS Orka is
privately owned. Together 92 percent of power generation is in government hands.
Government owned enterprises typically have lowering borrowing costs, and soft-budget
constraints. They also own a portfolio of hydropower and geothermal resources. If, for these
reasons, competition between government and private enterprises is not on level terms, stateowned companies can exhibit excess investment and inefficiency, insufficient private
investment will be forthcoming, and potential fiscal costs arise. Landsvirkjun and Reykjavik
Energy are heavily indebted, which implies contingent state liability under sovereign
guarantees (for which the companies do pay a fee, but it is difficult to tell if that fee has been
appropriately priced).


129. **A level playing field for competition between state-owned and private companies**
**is in the public interest** . The benefits would be more efficient investment, and probably
lower fiscal cost. The level playing field requires: the same regulations for all producers;
clear separation of natural resource ownership from the right to their use; maintenance of
equivalent tax treatment; and steps to eliminate taxpayer support for the state-owned
enterprises, whether by direct subsidy or differential borrowing costs.


130. **Ownership matters also for the interaction of dividend and tax policies.** To the
extent that a government-owned company generates rents from hydro and geothermal energy,
it can pay the government through either tax payments or dividends payments. The
appropriate mix is a matter of corporate governance. The state can reduce the free cash flow
available to management by imposing taxes that directly skim off the rents. Thus, in a
scenario where power companies remain predominantly public, taxes remain important. A
concern may be the conflicting interest between the state and local governments, as is the
case with Reykjavik Energy. Rent taxes on locally owned companies may then require
compensation from the state to municipalities.


**Recommendations**


- Improve transparency of electricity prices and use separating accounts of entities in
government-owned power companies.

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- Create a level playing field between government and privately owned power
companies.


**D.  Commercial Terms for Electricity in Energy-Intensive Industries**


131. **Long-term commitments are critical for both users and suppliers.** Apart from
price, power contracts specify the duration and sometimes risk sharing agreements, e.g., by
indexing the power price to the price of aluminum. Negotiations on these terms of agreement
essentially involve a bargaining over the rent that is generated by the specific investment of
the power generator and the user. This rent includes the quasi-rent associated with specific
investments by the two parties. As the hold-up problem looms large in such circumstances of
specific investment (i.e., investment is held up due to fear of expropriation of the (quasi-)
rent by the other party), long-term contracts form an important commitment and enable the
investment to take place. The ex-ante bargaining power then determines the terms of the
contract. The stronger is the bargaining position of the power generator, the bigger is the
share of profit that it obtains.


132. **The terms of historical contracts leave a large share of the rent with the users of**
**power.** In Iceland, the first contracts with large aluminum smelters date back from the 1960s
and 1970s. The investments of both the power company and the aluminum smelter were
highly specific and parties were bound to one another: the aluminum smelter could not obtain
the required electricity from any other supplier in Iceland, while the power company could
not sell the large amount of power to any other user. The parties, therefore, committed to
long-term agreements of 40 years. They included some risk sharing, whereby the price of
electricity was linked to the world-market price of aluminum. As the bargaining position of
the user was relatively strong in light of its outside options, the terms of the contracts were
relatively favorable for the smelters.


133. **Recent developments tend to improve the position of power companies, leaving**
**them a larger share of the rent.** Since recently, historical contracts have been expiring or
the terms of contracts have been renegotiated in light of plant expansions. In these new
agreements, the bargaining positions seem to have shifted towards the power generating
companies, leaving them with a larger share of the rent. Indeed, recent contracts tend to be of
shorter duration, do not always involve risk sharing with the users and feature higher prices.
In its latest annual report, Landsvirkjun shows that the average price charged to the
aluminum smelters (including transmission) in 2010 was US$25.7 per mwh. This price and
the relative stability of the Icelandic contracts make the country a competitive location for
smelters, despite that wages and tight environmental regulations create higher costs than in,
for instance, China or the Middle East.


134. **The bargaining position of the power companies has also strengthened because**
**of the interest of other industries, such as ferro-metal or data centers.** Contracts with
these sectors are generally of shorter duration and feature higher prices. Newly concluded

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contracts, also with the aluminum smelters, therefore, contain better terms for the powergenerating companies. This is important for the future of Iceland, as the country has abundant
new sources of energy, especially in the geothermal area. Indeed, the marginal production
cost of new sites is generally in the order of US$30 per mwh, compared to a threefold in
mainland Europe. [33] To the extent that the price of carbon will increase in the future in light of
tighter policies regarding CO2 emissions, the competitive position of Iceland will improve
further as its power is virtually free from CO2.


135. **The smelting industry is not uniform** . Some are tolling smelters, not taking title to
aluminum (century), while the other major smelters have their own sources of alumina. The
key elements of the production process are: electricity, alumina, and carbon anodes. Two
tons of alumina are required for each one ton of aluminum. Alumina makes up 12–14 percent
of the price of one ton of aluminum. A smelter retains some 75 percent of price of a ton of
aluminum, and about 45 percent of the cost in aluminum smelters is electricity. Pricing,
taxing, and contractual arrangements for this chain of energy using activities are this critical
both for investors and government.


**Issues**

136. **The electricity price link to the aluminum price causes Iceland to lose out when**
**international energy prices rise faster than aluminum prices** . Iceland’s major power
generator, Landsvirkjun, assumed more and more of aluminum price risk over the period
1969 to 2006, with increased sales to smelters, and is only now beginning to adjust its
portfolio. A greater diversity of projects and pricing schemes in the national portfolio is an
important aim.


137. **Electricity prices that are too low would be state aid to energy users under**
**EFTA and EU rules** . The EFTA surveillance authority has so far concluded there is no state
aid—costs are recovered and reasonable return earned. This, however, says nothing about
transfer of rents to energy users.


138. **There is public concern about the length of electricity pricing contracts** (Power
Purchase Agreements—PPA). Despite this, some long-term contracts have been frequently
renegotiated—notably Alcan/Alusuisse, now owned by Rio Tinto. Renegotiations have
occurred in changing circumstances or at expansion by smelters. The Take or Pay (TOP)
guarantee of purchase by smelters has been vital to justify, and support finance for, building
the generating capacity.


33 The most cost-effective projects in Iceland that reap the largest rents have already been undertaken, reflecting
decreasing returns to scale in power generation.

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57


139. **In light of these developments, it is timely to design a special tax regime for**
**power generating companies.** Power-generating companies are expected to capture a
growing share of the resource rent.


**Recommendation**

- Introduce a regime for resource taxation as soon as possible.


**E.  Taxation and Resource Charges for Power-Generating Companies**


140. **At present, no significant prescribed levies exist to charge for access to hydro**
**and geothermal resource rights** . The Act of 1998 refers only to “payment of a license fee to
meet the cost of the preparation and issue of the license.” The Minister for Industry may
negotiate remuneration with license holders for resources on land owned by the state, but any
payment is subject to the rules of the Act on Public Lands. The committee mandated by
parliament has raised the possibility of resource rent tax or charge, levied over the life of a
hydro power or geothermal lease. This would introduce to Iceland the type of charge
commonly used for exhaustible resource elsewhere in the world, and a variant on the
resource rent tax for hydropower in use in Norway.


**Issues**


_**Taxing resource rent in stand-alone power projects**_

141. **Charging for hydropower and geothermal resources involves defining resource**
**rent, and finding a suitable levy to tax it** . This is intrinsically the same as the problem of
taxing other natural resources, except that exhaustibility of the resource is arguably not as
important. Figure 2 illustrates resource rent. With a fixed price of output (in this case,
electricity), P1, the chart shows projects in ascending order of costs per unit, including a
minimum required return to capital. All but Project F are viable, and all that are viable except
Project E (which is marginal) generate rent―in the sense of surplus over all necessary costs
of production.


142.   A **simple extraction levy taxes some rent, but adds to costs** . Figure 3 shows that
the flat rate (turnover levy) royalty charge only accidentally taxes the rent in one case: with
more profitable projects it taxes insufficiently, while it reduces the feasible range of projects
by making Project E now uneconomic. This levy is, of course, warranted where the
opportunity cost of exploiting the resource is positive, or where there are significant
environmental costs. In these cases, the state will not seek to promote projects that cannot
pay, from gross revenues, the cost to society of the development.

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P1



![](assets/figures/cr-2011-138-fig-p0061-001.png)





58


**Figure 2.** **Resource Rent**



|Rent<br>F<br>E<br>D<br>Project C<br>Project B<br>Project A|Col2|
|---|---|
|||


Cumulative Production



Prod1



**Figure 3. Resource Rent with Extraction Levy**


P1
P2



|Extraction Levy<br>Rent<br>F<br>E<br>D<br>Project C<br>Project B<br>Project A|Col2|
|---|---|
|||


Cumulative Production





Prod2



143. **By contrast, a well-designed resource rent tax targets the rent in each case more**
**precisely** . Levied on net cash flow, or adjusted profit, above certain thresholds a rent tax
should adjust to the realized profitability of individual projects. It does not require a
prediction of the future course of prices, but it does require that the price of electricity be
transparent and measurable. Using the same framework, Figure 4 illustrates resource rent
taxation. Project E is now viable again, so that the tax does not disturb the pre-tax economic
feasibility of projects, while capturing more of the overall rent than an extraction levy.

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**Figure 4. Resource Rent Taxation**



P1







|Rent tax Rent tax Rent Tax<br>Rent tax<br>Rent<br>F<br>E<br>D<br>Project C<br>Project B<br>Project A|Col2|
|---|---|
|||


Cumulative Production



Prod1



144. **From a range options, two forms of rent tax appear most suited for use in**
**Iceland.** Box 2 describes the principal forms of resource rent tax proposed or in use around
the world. The “Brown Tax” or R-based cash flow tax is neutral but requires government to
meet its share of negative cash flows as well as tax the positive ones. The resource rent tax
proposed by the committee approaches neutrality if failed exploration (research or survey) is
refunded, but the immediate deduction of capital, coupled with annual uplift of unrecovered
accumulated negative cash flows, will cause long deferral of potential revenues. The variable
income tax (similar to that now proposed for offshore petroleum) is too likely to tax elements
of profit that are not rent, and is in any case unsuited to industries where wide price
fluctuations are not expected. This leaves: (1) the simple cash flow surcharge in the corporate
income tax; or (2) the surcharge calculated on the CIT base, with an allowance for corporate
capital (ACC) replacing interest deductions and providing for a return on equity.


145. **Modeling results suggest a balanced overall package** . The appendix shows
modeling results for a hydropower and a geothermal energy project under alternative
resource tax schemes. The schemes illustrated are: the resource rent tax (RRT), the tax
surcharge on cash flow (termed a cash flow tax), and the ACC sheme adapted from the
Norwegian rent tax on hydropower. In the simulations, a package combining a 5 percent
extraction levy and an 18 percent cash flow surcharge produces acceptable results.
Alternatively, a tax surcharge of 27 percent with a 5 percent allowance for corporate capital
(ACC) for the undepreciated asset value—along the lines of the Norwegian tax on the
hydropower sector—yields an acceptable balance between upfront revenue, progressivity,
and minimal investment distortion.

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**Box 2. Resource Rent Taxation Options**


_**Brown Tax or R-based cash flow tax**_ . This is a pure rent tax in which the state acts as a passive investor, meeting its share
of all net negative cash flows by direct cash payment at the same percentage as the tax rate, and taxing all net positive cash
flows at the same rate. The tax only narrows the distribution of possible outcomes, but does not change the mean expected
return―any tax paid is thus a tax on rent. Accounting and tax depreciation do not feature: all capital is immediately
expensed, so that calculations are on cash flows.


_**Resource rent tax (Garnaut/Clunies Ross model).**_ This replicates many features of the brown tax, but instead of direct cash
payments by the state, the investor receives an annual uplift on accumulated losses until these are recovered. The uplift rate
should be set at the minimum required rate of return for the investor. To the extent that losses can be offset against profits
elsewhere, the tax comes closer to neutrality and, in principle, the uplift factor should come closer to a risk-free interest rate.
Again, the calculations use cash flows, not book or tax depreciation.


_**Variable income tax (VIT)**_ . This scheme uses the CIT base, but varies the rate of tax according to the ratio of profits to
gross revenues. The VIT is proposed for use with offshore petroleum in the second licensing round. It developed first in the
gold mining industry of South Africa, where the effective tax rate may be lower or higher than the standard CIT base. The
VIT is relatively simple but introduces distortions, particularly when a period of high accounting profit occurs early in the
life of a project causing tax to rise well before the required return has been earned, or rent generated.


_**Tax surcharge on cash flow**_ . A simple adjustment to the tax base of accounting profit by adding back depreciation and
interest, and deducting any capital expenditure in full, yields a base of net cash flow in the year. This, too, could form the
base for a surcharge. Instead of permitting an annual uplift for losses carried forward, the rate could be set sufficiently low
to imply such compensation, or a simple uplift (investment allowance) could be added to capital costs at the start. This
surcharge is used in the U.K. sector of the North Sea as a CIT surcharge on petroleum projects (rate from 2011/2012 is 32
percent, in addition to normal CIT).


_**Allowance for Corporate Capital (ACC) surcharge scheme**_ . Instead of converting the tax base to cash flow, the ACC
permits an annual uplift on the balance of undepreciated capital assets on the books. Actual interest paid is not deductible.
The ACC, therefore, creates neutrality between debt and equity financing, and should make the investor indifferent as to the
rate of tax depreciation (since faster depreciation diminishes the money amount of ACC deductible). The Norwegian
hydropower rent tax uses this scheme, with a rate of 30 percent added to the CIT rate of 28 percent.


_**Taxation of integrated projects**_


146. **Iceland at present has no integrated power and smelting projects, but these**
**could arise in future** . If they do, and resource rent charges have been introduced, there are
two options for applying these to cases where the project is integrated from generation of
power through to production of aluminum. One is to levy the resource charge on the whole
integrated enterprise, at a rate designed to approximate the charge on rent in a stand-alone
generating project. The other is to create notional separation of the accounts of the power
segment and the smelting segment, attributing as the electricity transfer price a combination
operating costs plus capital recovery with a reasonable return in each segment. A formula can
then attribute any difference between the resulting prices to each segment. In Figure 5, the
assumption is of an equal division of the “residual price”.

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**Figure 5. Pricing of Electricity by Capital Attribution and Division of Residual**


_**Application to existing projects**_

147. **Application of rent tax to existing projects would not affect electricity prices**
**under long-term contracts** . There would thus be no implications under the stability
provisions of investment agreements for smelters. The extraction levy would clearly affect
the economics of existing power companies, and might need to be phased in over time. The
resource rent taxes proposed would have very little effect, except to the extent that they
inhibit retention of rent as profit to pay down debt. If this occurs, then for the state-owned
enterprises the government has the option of dedicating the tax receipts initially to
restructuring the debt position of these enterprises.


148. **Application of the tax again requires segregation of the accounts of generation**
**for sale to power-intensive users** . The aim is not to impose the rent tax on all existing
operations of large companies such as Landsvirkjun; conversely, capital for other activities
should not enter into the deductions for major hydro and geothermal projects.


149. **Opening negative balances for existing projects should use written down asset**
**values** . Where historical accounts do not permit calculating of project life-cycle positions,
the written-down value of assets for tax purposes should be the starting balance, possibly
with a predetermined one-time uplift to act as a proxy for returns to capital that would have
been available under one of the schemes in the past. Operating losses carried forward should,
in principle, be deductible.

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**Recommendations**


- Adopt an extraction levy of on electricity sales; adjust the levy in specific cases for
the estimated environmental costs.


- Adopt a resource tax for access to rights, either by means of a cash flow tax surcharge
scheme, or an ACC scheme.


- If the cash flow surcharge is adopted, consider adding a one-time uplift for capital
investment.


- For integrated projects, review the feasibility of overall rent taxation, or of a capital
attribution and residual pricing mechanism to establish the transfer price of
electricity.


- For existing projects, use written down asset values for tax purposes, possibly with a
one-time uplift, to establish the starting tax base.


**F.  Taxation of Energy-Intensive Industries**


150. **The motivation for promoting energy-intensive industries has changed since the**
**sector first developed** . Originally, the Icelandic authorities aimed to attract foreign
investment to increase the size of the economy and improve infrastructure, even if only a
modest numbers of jobs created were as a result. More recently, and especially since the
crisis of 2008, these large industries have been subject to greater scrutiny of the observable
benefits they bring to the Icelandic economy: especially in public revenue, stimulation of
local supplies and services, and transfer of skills to the Icelandic workforce and
entrepreneurs.


151. **Existing energy-intensive industries are protected by investment agreements**
**with tax stability provisions** . The initial agreements for Alusuisse, Alcoa, (for aluminum
smelting) Union Carbide (for ferro-silicon processing) and others all differed case-by-case.
At least one of the older agreements (Alusuisse—agreement now defunct) provided for
payment by the smelter company of a “consolidated tax” set in dollar amounts per ton of
aluminum produced instead of corporate income tax, together with a positive list of minor
taxes. The present owners of this smelter (Rio Tinto) decided to move away from these
earlier arrangements to the new scheme described next. Some of the earlier agreements took
account of a more highly-tax environment than now prevails, so that the value of the stability
assurance diminished over time.


152. **Special limitations apply in the 2003 agreement for the largest smelter** . The
agreement for Alcoa limits the rate of income tax to 18 percent, allows full depreciation of
assets (no 90 percent restriction), and limits tax on dividends paid to a 25 percent shareholder
to 5 percent. It also explicitly preserves the rules on deductibility of interest available at the

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time of the agreement. These provisions prevail for the “initial term” of 20 years. Alcoa (as
in other cases) may make a one-time election to move from the special provisions to the
general tax law.


153. **Government moved in 2008 to standardize the incentive package to all**
**industries** . The new package was drawn up under EU/EEA rules, and limited the amount of
“state aid” to a large enterprise to a present value of benefits (including tax foregone) of
15 percent of the initial investment cost. [34] Some incentives are generally available; others are
limited to areas covered in the regional aid map (currently most of Iceland outside
Reykjavik). An agreement is still made when an incentive is granted: one of the most
important incentives is the assurance that the applicable tax rate will not rise above that
prevailing at the time of the agreement; this cannot be quantified in advance. Other
incentives include discounts on property tax and social security contributions. This law
expires on December 31, 2012, but agreements made under it will be valid for 13 years from
signature.


154. **Power companies have taken advantage of expansion plans at smelters to**
**renegotiate PPAs** . Fiscal stability provisions do not guarantee stable operating costs.
Conditions may arise (as happened with Rio Tinto) when it is in the mutual interest of
government and companies to move beyond an original special agreement on fiscal terms.


**Issues**


155. **Energy-intensive companies appear to contribute relatively little to public**
**revenue** . [35] Manufacturing as a whole contributed 6.6 percent of CIT receipts in 2009 (and
similar proportions in previous years); the energy-intensive companies fall within that group.
The exemptions and privileges under the investment agreements do restrict the national
contribution that these projects make―begging the question of whether these projects would
have gone ahead without such incentives. It seems likely that the availability of cheap and
reliable electricity, in a stable environment that is part of the EEA, had more to do with the
investment decisions than fiscal incentives.


156. **The way to extract rent for the nation is through competitive pricing of**
**electricity** . Electricity prices in recent PPAs have increased, and high aluminum prices
currently allow power companies to participate in increased revenues where aluminumrelated pricing of power prevails. Development of the electricity market, with new pricing


34 Act on incentives for initial investments in Iceland.


35 Although the mission received no official figures, the Association of Aluminum Smelters has indicated that
the sector paid ISK 4.2 billion in taxes in 2010 (0.26 percent of GDP)—it is not clear whether this figure is the
sum of all taxes, including SSC.

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schemes, together with appropriate charges for resources, offers a quicker and more reliable
route to enhanced public revenues than undertaking revision of tax terms for smelters.


157. **Stability and credibility of the tax regime for large-users is important to**
**continued investment and third-party financing** . Whether this is best promoted by formal
agreements with assurances of fiscal stability may be an issue. For the present, it would be
preferable to permit the current incentives legislation to expire at the end of 2013, while (in
accordance with law) preserving agreements made under it and under prior terms. Where
there is occasion by mutual agreement, and in the mutual interest, for government to
encourage companies to move on to general tax terms (particularly in terms of allowable
deductions, if not of tax rates), those opportunities should be taken. Meanwhile, government
should set out long term plans for stable and credible arrangements for resource taxation,
electricity pricing, and overall taxation of business.


**Recommendations**


- Avoid sudden measures to increase fiscal levies on energy-intensive industries; focus
instead on securing fair market value for electricity sales.


- Allow existing incentives legislation to expire as scheduled, without replacement, and
allow investment agreements to expire as agreed.


- Consider elimination of tax stability assurances for new projects in future, or at least
limiting them to rates of specific taxes rather than to deductions and tax calculations
in general.


**G.  Taxation of Offshore Petroleum Resources**


158. **The fiscal terms of 2008 contained a high progressive extraction levy** . This levy
applied to gross revenues at a rate determined by multiplying the excess production over
10 million barrels by 0.5. [36] The terms also included a hydrocarbon tax, applicable when
profits reached 20 percent of operating income, and replacing the extraction levy at that
point. The tax base restricted interest deductions to 5 percent of liabilities, and excluded
deduction of rental payments exceeding normal depreciation and interest for the assets
concerned. The tax rate was to be the profit ratio (as a percentage) minus 10 percentage
points, multiplied by 0.55. Normal CIT was also payable.


36 Act No. 170/2008 on the taxation of hydrocarbon extraction. This, if 50 million barrels were produced in a
year, the levy rate would be (50 – 10) = 40 * 0.5 = 20, applied as a 20 percent levy on total revenues (unless the
first 10 million barrels are excluded—the translation is ambiguous.)

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159. **Proposed new fiscal terms for a second licensing round eliminate the progressive**
**extraction levy.** Instead a flat levy (royalty) of 6 percent is proposed. Once again, in addition
to normal CIT there will be a special hydrocarbon tax. This again takes the profit to revenue
ration, expressed as a percentage, and then multiplies by 0.45 to find the tax rate.


**Issues**


160. **The terms of the 2008 legislation clearly required revision.** The mission was
advised that, in formulating new terms, the authorities took account of comparators in
Norway, Faeroe Islands (Denmark), and Greenland. The new regime is intended to be more
generous to investors than Norway’s, and to remain approximately competitive with those
offered in Faeroes and Greenland. The comparisons have been done using a time path of
revenues on a simulated field.


161. **This procedure reasonably compares overall government take, but is less helpful**
**in assessing the effect on investors’ perceptions of risk.** For example, Iceland’s new terms
will contain a 6 percent extraction levy, whereas Norway’s contain no such levy. Norway’s
terms are not ring-fenced, and unrecouped losses are refunded. The ring-fencing provisions
in Iceland appear to be limited to deduction of failed exploration, and there is no provision
for refund of losses. Norway may, therefore, take more from a successful project, but its
favorable treatment of losses reduces investor risk compared with the terms in Iceland.


162. **In Iceland’s circumstances a 6 percent royalty is probably appropriate, as is a**
**different scheme from that in Norway.** Although Faeroes has only 2 percent royalty, and
Greenland none, any discovery in Icelandic waters that is commercial is likely to be
sufficiently attractive to meet a 6 percent royalty, especially if other taxes remain
significantly below those of other producers in the region. Iceland can expect only a limited
number of discoveries on present knowledge, so ring-fencing project-by-project is
appropriate. The government is not in a position to take exploration and project risk by
offering refunds of the tax value of losses.


163. **The special hydrocarbon tax scheme could be reconsidered.** The mission was
advised that the authorities have no interest in a rate of return scheme. Other simpler
alternatives exist to the proposed hydrocarbon tax design, which run less risk of taxing
returns that are normal profits (not rents) than the scheme currently proposed. These include
the cash flow surcharge (used in the U.K. sector of the North Sea at a 32 percent rate), and
the ACC scheme for a surcharge on CIT. Both these options have been discussed above.


164. **In the first licensing round, the authorities required single companies (not**
**unincorporated joint ventures―UJV) to hold licenses** . Although this is not required under
the petroleum law (which provides for joint ventures) the mission was advised that the
revenue authority (RSK) had insisted upon the condition for fear of tax avoidance. This
position misconceives the role of UJVs in the petroleum industry, where the practice is
standard. From government’s point of view, UJVs have great advantages in containing costs

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and preventing tax avoidance. They introduce adverse interests to the venture, where the nonoperator parties have a strong interest in seeing that the operator contains costs. Furthermore,
each party to the UJV (and thus the license) has a strong interest in seeing that the others
comply with the law.


**Recommendations**


- Revise the petroleum fiscal terms to include an extraction levy at a modest flat rate,
normal CIT, and a simple special hydrocarbon tax.


- Consider a different model for special hydrocarbon tax (not geared to a profit ratio
calculation), such as a cash flow surcharge or an ACC scheme.


- Permit unincorporated joint ventures to apply for and hold petroleum licenses.

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**Appendix I. Summary of Recommendations**
**M = Medium Term; S = Short Term (within 1 year); I = Immediate**






















|Time Frame|Recommendation|Revenue|
|---|---|---|
|**Corporate income tax**|**Corporate income tax**||
|M|For companies, income tax assessment should follow the valuation<br>provisions used in the financial accounting rules.||
|S|The temporary provision regarding relief for debt forgiveness<br>should be extended to cases in which debt restructuring has taken<br>the form of conversion of debt into equity.|–|
|I|Limit debt-financed acquisitions by non-residents by disallowing<br>deductibility of interest paid to creditors resident in low tax<br>jurisdictions, and by introduction of a thin capitalization rule (as<br>discussed in the previous FAD report).|+|
|I|The 20 percent withholding tax on gross interest payments to<br>corporate creditors and non-resident creditors should be reduced to<br>10 percent.|–|
|S|Consider abolishing the threshold of 10 percent shareholding and<br>apply an exemption for all dividends received by Icelandic<br>corporations.|–|
|S|The dividend exemption should be limited to 95 percent of the<br>amount received to allow for a small taxable portion to offset<br>participation-related expenses.|–|
|M|Allow the general investment incentive package to lapse upon<br>expiry.|+|
|M|Keep the R & D credit under review, to monitor its effectiveness.||
|**Taxes on labor income**|**Taxes on labor income**||
|S|Capital income allocation rules should be the same for<br>partnerships and closely-held corporations.||
|S|Income should be allocated between labor and capital within<br>closely held businesses according to the net or gross assets<br>method.|+|
|M|However, if the minimum wage system and/or the 20/50 split is<br>retained, minimum wages should be reset using a comprehensive<br>study that employs the gross or net assets method to measure labor<br>income, and the minimum wage should be annually indexed.||

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|Time Frame|Recommendation|Revenue|
|---|---|---|
|S|The government should clarify whether SSC charges apply to the<br>50 percent labor allocation.|+|
|S|A definition of closely-held business should be included in the<br>income tax act, based upon the number of active shareholders and<br>their joint shareholding.||
|S|Do not increase the basic tax credit for the PIT. Consider lowering<br>both the tax credit and the initial PIT rate in a revenue-neutral<br>manner.|+|
|S|Eliminate the first 2.9 percent surcharge and replace the second<br>6 percent surcharge with a single 10 percent surcharge levied on<br>above-average incomes.|0.25<br>percent|
|M|Reduce the rate of social security contributions as much as<br>possible, given expected unemployment and any increase in the<br>SSC base.|–|
|M|Consider capping the base of the SSC at a certain level of earnings<br>for both salaried and self-employed workers.|–|
|M|Consider placing an absolute cap on annual or lifetime tax<br>deductions for voluntary pension contributions.|+|
|**Capital income and wealth taxation**|**Capital income and wealth taxation**||
|M|Allow the net wealth tax to expire, and replace the revenues with a<br>combination of higher property taxes and a broader and more<br>progressive personal income tax.|-0.30<br>percent|
|**Value-added tax (VAT) and excises**|**Value-added tax (VAT) and excises**||
||**_Short term_**||
|S|Increase the lower rate of the VAT to 14 percent and tax non-<br>standard exemptions at the lower rate.|0.70<br>percent|
|S|Lower the main rate of the VAT to 25 percent.|-0.10<br>percent|
|S|Compensate lower-income households for higher costs of<br>necessities through refundable income tax credits.|-0.10<br>percent|
||**_Medium term_**||
|M|Tax all items at a unified rate of 20 percent.|0|

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|Time Frame|Recommendation|Revenue|
|---|---|---|
|S|Eliminate the excises on food products as part of a broader reform<br>of the VAT.||
|**Allocation of tax revenues to municipalities**|**Allocation of tax revenues to municipalities**||
|S|Increase the cap on “Group A” property tax rates to at least<br>1 percent.|+|
|S|Consider setting minimum rates of property tax for local<br>governments.|+|
|**Taxation of the financial sector**|**Taxation of the financial sector**||
|M|Maintain the bank tax introduced in January 2011.||
|S|Modify the balance sheet base on the liabilities side, excluding<br>equity capital, by allowing for a credit for payments in respect of<br>insured liabilities.|–|
|M|Consider including off-balance sheet derivatives in the tax base.||
|M|Consider, over the medium term, adjusting the rate to address<br>institutions’ specific risks and their contribution to systemic risk.||
|M|Consider abolishing the reverse charge on self-supply by financial<br>institutions and introduce a tax on the profits and remunerations of<br>financial institutions.|+|
|S|Consider abolishing the 20 percent withholding tax on derivatives,<br>except for the implicit interest element in swap agreements or<br>other derivatives.|–|
|S|Restrict any tax on real estate transactions to at most 1percent|–|
|**Environmental taxation**|**Environmental taxation**||
|M|Maintain the energy tax beyond 2012 and consider a small<br>increase for households and other small consumers.|0.05/-<br>0.10<br>percent|
|M|Consider the future electricity tax for power-intensive industries in<br>the broader context of the taxation regime for these firms.||
|M|Maintain the carbon tax beyond 2012 and extend it to sectors not<br>be covered by the EU ETS, such as the cement sector.|0.25<br>percent|

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|Time Frame|Recommendation|Revenue|
|---|---|---|
|S|Increase the carbon tax rate to the price of carbon in the EU ETS.|0.06<br>percent|
|M|Consider introducing taxes on NOx and SO2.||
|S|Bring taxis and rental cars under the regime for excise duties as<br>other passenger cars.|+|
|S|Introduce an excise on vehicles that are currently exempt from the<br>vehicle excise duty.|+|
|S|Increase the excise rates on petrol and diesel by ISK 20 in real<br>terms if circumstances permit.|0.4<br>percent|
|M|Consider the introduction of corrective taxes on landfill and<br>incineration, following the systems in the Nordic countries.|+|
|S|Introduce the proposed ecological passenger tax, differentiated by<br>distance travelled.|+|
|**Taxation of natural resources**|**Taxation of natural resources**||
|S|Move in steps towards consolidation of publicly-owned resource<br>rights into a single entity.||
|S|Prepare for resource allocations by auctions and by transparent<br>comparison of proposals; consolidate resource assessments into<br>packages of resource leases that are offered for investment<br>projects.||
|M|Link the duration of leases to the flexibility of resource charges;<br>continue to grant easily renewable long leases where a progressive<br>resource charge is applied.||
|S|Set the base extraction levy in relation to anticipated<br>environmental costs; make additional extraction levy a bid<br>variable at auctions.||
|S|Introduce a resource charge geared to the achieved results of a<br>project.||
|M|Permit transferability of rights, to affiliates, upon sale or farm-in,<br>and for third party financing, subject to regulatory safeguards.||
|M|Improve transparency of electricity prices and use separating<br>accounts of entities in government-owned power companies.||

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|Time Frame|Recommendation|Revenue|
|---|---|---|
|M|Create a level playing field between government and privately<br>owned power companies.||
|S|Introduce a regime for resource taxation as soon as possible.||
|S|Adopt an extraction levy of approximately 2.5 percent of<br>electricity sales; adjust this in specific cases for the estimated<br>environmental costs.|+|
|S|Adopt a resource tax for access to rights, either by means of a cash<br>flow tax surcharge scheme, or an ACC scheme.|+|
|S|If the cash flow surcharge is adopted, consider adding a one-time<br>uplift for capital investment||
|M|For integrated projects, review the feasibility of overall rent<br>taxation, or of a capital attribution and residual pricing mechanism<br>to establish the transfer price of electricity.||
|S|For existing projects, use written down asset values for tax<br>purposes, possibly with a one-time uplift, to establish the starting<br>tax base.||
|M|Avoid sudden measures to increase fiscal levies on energy-<br>intensive industries; focus instead on securing fair market value<br>for electricity sales.||
|M|Allow existing incentives legislation to expire as scheduled,<br>without replacement, and allow investment agreements to expire<br>as agreed.||
|M|Consider elimination of tax stability assurances for new projects in<br>future, or at least limiting them to rates of specific taxes rather<br>than to deductions and tax calculations in general.||
|S|Revise the petroleum fiscal terms to include an extraction levy at a<br>modest flat rate, normal CIT, and a simple special hydrocarbon<br>tax.||
|S|Consider a different model for special hydrocarbon tax (not geared<br>to a profit ratio calculation), such as a cash flow surcharge or an<br>ACC scheme.||
|S|Permit unincorporated joint ventures to apply for and hold<br>petroleum licenses.||

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**Appendix 2 . Simulating Tax Regimes for Hydro and Geothermal Energy**


**The generation of hydroelectric power and geothermal energy can yield economic**
**surplus over and above the value of the production factors used.** With several power
projects featuring different costs of production, and a single market price at which the power
is sold, there will be a marginal project that just breaks even. All other projects featuring
lower unit production costs will generate economic rent. In principle, one can calculate the
total rent from power generation using information about the cost structure of the average
power plant and the appropriate price at which power is sold in the market.


**Determining the rent from hydro and geothermal is difficult, as power prices in Iceland**
**differ greatly, and so do cost structures.** Choosing the output price would be obvious if
there were a spot market for electricity sales, as is the case in the Nord Pool market in
Scandinavia. Iceland has no such pool or price. Cost structures also differ significantly across
projects, with the least-cost options already developed.


**Studies for Canada and Switzerland have tried to calculate the rent from hydropower,**
**with very diverse outcomes.** Gillen and Wen (2000) compute the rent for an Ontario hydro
plant. They take the price of electricity from recent export contracts―at that time US$41.06
per mwh; the average cost comes from the annual accounts of a hydropower company,
estimated at US$7.18 per mwh (including the cost of capital). The rent per mwh is thus
calculated at US$33.88, about 80 percent of sales revenue. An earlier study for Canada by
Bernard, and others (1982), however, estimated the rent at a much lower US$9.68 per
mwh―there were much larger unit production costs (using alternative technologies). Here
the rent is only about 20 percent of the revenue. Banfi, and others (2005) estimate the rent in
the Swiss hydropower sector by taking the average price and average cost of a large number
of plants. They distinguish between run-of-river plants and storage plants. Storage plants can
easily produce electricity during more lucrative peak periods. The average price for the runof-river plants is, therefore lower (€36.40 per mwh) than for storage plants
(€62.40 per mwh). The unit cost for the two types of plants is, respectively, €26.50 and
€39.00 per mwh. Here rent per mwh is €10.70 and €22.80 per mwh respectively―between
one-third and one-half of the unit costs.


**These calculations suffer from several other limitations.** Determining the appropriate
price and unit cost is far from trivial and difficult. A comprehensive analysis should include
the value of hydropower sites in alternative use, and positive or negative externalities from
developing a hydro project. Nevertheless, it seems evident that significant rent is generated
from the exploitation of hydropower.


**Countries adopt a variety of taxes to skim off the rents from hydropower.** Switzerland,
Canada, and France levy water charges as a fixed amount per mwh of electricity produced.
Rates run up to more than €9 per mwh in France. Norway introduced a hydro rent tax in
1997―additional to the regular CIT. Its base is total sales minus operating costs,

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depreciation (1.5 percent for installations and 2.5 percent for equipment) and an uplift of
5 percent of the undepreciated asset value in the tax accounts. This base reflects the rent, as
the full cost of capital (depreciation and finance) is deductible. The rate of tax is 30 percent.


**We simulate two projects that broadly reflect Icelandic data for a hydro project and a**
**geothermal project.** Data come from annual reports of Landsvirkjun and Reykjavik Energy.
The hydroproject involves relatively high investment costs, but has lower operating costs; the
geothermal project involves lower investment upfront, but has a shorter lifespan and higher
operating cost. (Table 8.) Both projects turn out to be profitable at a 5 percent discount rate.
The pre-tax internal rate of return of both projects―the discount rate at which the project
would just break even―is 10 ¾ percent.


**Table 8. Assumptions about Two Simulated Power Projects**



**Geothermal project**


100 mw



Capacity



**Hydropower project**


100 mw



Production per year 825 gwh 825 gwh



Capital expenditure US$153 million
(Yr 1, 50; Yr 2, 50; Yr 3, 50)



US$120 million
(Yr 1, 50; Yr 2, 50; Yr 10, 10; Yr



20, 10)
Operating cost US$10 per mwh US$15 per mwh


Sale price US$30 per mwh US$30 per mwh


Project life 55 years 35 years


Assumed discount rate 5 percent 5 percent


Internal rate of return 10¾ percent 10¾ percent


**For both projects, we simulate the implications of five alternative tax regimes.** The
regimes all contain the conventional corporate income tax (CIT) of 20 percent. In addition,
we consider the following additional taxes.


- A royalty (or water fee) of 10 percent of sales (approximately US$3 per mwh).


- A Resource Rent Tax (RRT) of 38 percent. The CIT is deductible for the RTT. The
RTT is levied as soon as the net present value of net cash-flows, evaluated at a
5 percent discount rate, becomes positive.

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- A Cash-Flow Tax (CFT) of 21 percent. The CIT is not deductible for the CFT, nor is
the CFT deductible for the CIT. The loss-carry forward period in the CIT applies also
to the CFT.


- A combination of a royalty of 5 percent and a RRT of 18 percent.


- A Norwegian Resource Rent Tax (NRRT) of 27 percent, applied to the CIT base
without a deduction for interest, but instead a 5 percent uplift for the undepreciated
value of capital.


**The five tax regimes yield the same amount of public revenue under the hydroproject,**
**but the timing of revenue is very different.** Figures 6 and 7 show this for the hydro and
geothermal project, respectively. The dashed area in both figures shows the net cash flow.
All projects quickly yield revenue from the 20 percent CIT rate. The royalty yields the
highest revenue in the early years, not increasing in later years. The RRT only starts to raise
revenue after 16 years when it has obtained a return of 5 percent. Beyond this year, however,
revenue is considerably higher than of any other tax. The cash-flow tax and the Norwegian
RRT take intermediate positions. The CFT starts to raise revenue after 10 years when the
loss-offset period expires. The NRRT raises revenue earlier and increases gradually in time
as the capital stock depreciates. A combination of a royalty and RRT lies between: yielding
some revenue upfront (from the royalty) and a larger amount in later years (from the RRT).


**Figure 6. Hydroproject Pre-tax Cash Flows and Government Revenue Profile**



![](assets/figures/cr-2011-138-fig-p0077-001.png)

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**Figure 7. Geothermal Project Pre-Tax Cash Flows and Government Revenue under**

**Five Tax Regimes ($mm real 2011 terms)**



![](assets/figures/cr-2011-138-fig-p0078-001.png)









**The royalty distorts investment decisions most and the resource rent taxes distort them**
**least.** This is reflected in the marginal effective tax rates (METRs), which measure the tax
burden on the project if it just breaks even (Table 9).


**Table 9. METRs under Five Regimes for Hydro- and Geothermal Projects**


Hydro project Geothermal project


CIT + Royalty 24.0 27.6


CIT + RTT 21.0 24


CIT + CFT 22.2 25.2


CIT + Royalty + RTT 22.7 25.7


CIT + NRRT 22.0 25.7


**The royalty is the least progressive and the resource rent tax the most progressive.**
Figures 8 and 9 show this by relating the government revenue generated to the profitability of
the projects (measured by IRR and varied by assuming a gradually higher sales price of
electricity (from left to right)). Both figures show that the royalty rises in profitability, but
only mildly (it would be flat if the water charge were levied as a fixed fee per mwh, as is

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done in Canada, France, and Switzerland). The RRT is the steepest as it charges the highest
rate on the rent once it materializes. The other taxes lie between.


**Figure 8. Geothermal Project Tax Progressivity (Correlation of Government Revenue**

**and Profitability (Measured by IRR))**



![](assets/figures/cr-2011-138-fig-p0079-001.png)





**Figure 9. Hydro Project Tax Progressivity (Correlation of Government Revenue and**

**Profitability (Measured by IRR))**



![](assets/figures/cr-2011-138-fig-p0079-002.png)

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