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Part C: Fiscal Terms - 36. Fiscal Terms | 36.2 Royalties

Royalties refer to payments made by mining license holders to the government for the privilege of extracting minerals from the area defined under the mining license. Sometimes royalties are referred to as “mineral tax”, “extraction tax” or “export tax”. However, they are not a tax in the strict sense of the term; their purpose is to compensate the owner of the mineral resource for the loss of a non-renewable asset regardless of the profitability of the project. Therefore it is critical to price royalties at the right level.

There are three main types of royalties:

  • Fixed-rate (ad-valorem) royalties charge a fixed percentage of the value of extracted resource, or the value less some allowable costs.
  • Variable-rate (ad-valorem) royalties charge a rate that varies according to some defined factor, usually the market price of the commodity. This rate is applied to the value of extracted resource, or the value less some allowable costs.
  • Per-unit royalties charge a fixed fee for each unit of production (for instance, five dollars per ton). This type of royalty is less common than ad-valorem royalties, except for low value commodities, such as gravel.

Beyond setting the royalty rate, defining the base (how the value of the extracted resource is calculated) rigorously is critical for mining legislation. In some countries the sales price is used, however, the sales price may not always reflect the market value of the minerals. A mining company may sell its minerals to an affiliated company (generally, another company that is part of the same group of companies as the license holder) at an artificially low sales price in order to reduce its declared revenues and thus the size of its royalty or income tax obligations. Governments may get around this by specifying in law that the value of minerals will be calculated using international index prices. The law should then further specify that minerals sold to an affiliated company for which there is no international reference price will be on the basis of the “arm’s length principle”, that is, the price at which the transaction would take place if the buying and selling entities were not related. The OECD Transfer Pricing Guidelines propose five major transfer pricing methods to apply the arm’s length principle and are regarded as the international authority on common practices and methods in the area of transfer pricing with more than 100 countries referring to these guidelines in their domestic legislation. In 2013 the United Nations released its own transfer pricing manual that attempts to adapt transfer pricing guidance to the circumstances, priorities, and administrative capacity of non-OECD countries. Another practical option for valuation of minerals where an international reference price does not exist is a provision in law requiring independent third-party valuation at the company’s expense. This issue of abusive transfer pricing (buying or selling from related parties at an artificially high or low price to shift taxable income out of the country where mining is taking place) is discussed further in the transfer pricing section in this Guiding Template.

It should be noted that law or regulations should also spell out further details on the implementation of the royalty provisions, such as point of valuation (e.g. whether at the mouth of the mine or at the point of sale) and any allowable deductions or “netbacks” for costs incurred between the point of extraction and the point of sale (such as transportation costs or processing costs). Disallowing any netbacks is the simplest administratively but may result in royalties imposed on a higher value than what the license holder actually received for the minerals, even in an arm’s length transaction, and may make the overall fiscal regime less attractive for investors. Note that deductions for costs may also be susceptible to transfer pricing abuses. See section on transfer pricing in the Guiding Template. The law or regulations should also specify which entity is responsible for collection of royalties.

Thorough financial modelling and market and legal analysis, along with industry consultations, will be necessary to find the right level of royalty obligation, in order to provide a stable revenue stream for both the state and the investor and compensate the state for the costs of extraction in a manner that takes into consideration the cyclical fluctuations in commodity prices.

Specific royalty rates are sometimes provided in contracts or in regulations with the law broadly providing that mining companies will be required to pay royalties. Another option is to set the required range within which royalties must fall in law, for example, 3-5% for a particular metal. Providing a band sets a floor and a ceiling, but still allows for some flexibility for variation based on the nature of the market and the project. As stated before, setting as much of the fiscal regime in law or regulation as possible facilitates a transparent and predictable regime that is easier to administer and monitor and provides potential investors with clarity.

36.2. Example 1:

Article [_]

(1) A holder of a mining licence shall pay a mineral royalty at the rate of nine percent for open cast mining operations and six percent for underground mining operations of—

(a) the norm value of the base metals or precious metals produced or recoverable under the licence; and

(b) the gross value of the gemstones or energy minerals produced or recoverable under the licence.

(2) The mineral royalty payable on industrial minerals shall be at six percent of the gross value of the minerals produced or recoverable under the licence.

(3) A person who is not a holder of a mining licence and who is in possession of minerals extracted in [Country] for which mineral royalty has not been paid is liable to pay mineral royalty at the rate of —

(a) nine percent of the norm value for base metals or precious metals;

(b) nine percent of the gross value for gemstones or energy minerals; and

(c) six percent of the gross value for industrial minerals.

(4) Where the [Tax Regulating Authority] determines that the realised price does not correspond to the price that would have been paid for the minerals if they had been sold on similar terms in a transaction at arm’s length, between a willing seller and a willing buyer, the [Tax Regulating Authority] may give a notice to that effect to the licensee and the amount of the gross value shall be determined in accordance with the mechanism contained in sections [_] of the [Income Tax Code].

(5) In this section—

“ gross value ” means the realised price for a sale free on board at the point of export from [Country] or point of delivery within [Country];

“ norm value ” means—

(a) the monthly average London Metal Exchange cash price per tonne multiplied by the quantity of the metal or recoverable metal sold;

(b) the monthly average Metal Bulletin cash price per tonne multiplied by the quantity of metal sold or recoverable metal sold to the extent that the metal price is not quoted on the London Metal Exchange; or

(c) the monthly average cash price per tonne, at any other exchange market approved by the [Commissioner-General], multiplied by the quantity of the metal or recoverable metal sold to the extent that the metal price is not quoted on the London Metal Exchange or Metal Bulletin; and

“Open cast mining operations” includes winnings from tailing dumps or similar dumps and leaching.

Annotation

Drawn from the Zambia’s mining code (2015), this is a good example of a fixed-rate ad-valorem royalty provision.

The code uses both sale value of minerals and international index prices for valuation of the minerals (note that international index prices for gemstones and energy minerals like uranium may not always be available, whereas index prices are available for most base and precious metals). But where the sale value is used to calculate royalties, the code also provides for a mechanism of correction if the tax regulating entity determines that minerals were sold for less than market (“arm’s length”) prices, which may indicate abusive transfer pricing (see discussion on transfer pricing above and in the section of the Guiding Template on transfer pricing). Such a provision can be quite robust, if a country has the means to assess whether companies are engaged in unfair pricing of their commodity exports.

If international index prices are used, valuation should be based on the actual mineral content. If not, then a lower rate of royalty can compensate for a cruder measure of the base, as has been used for bauxite in Guinea. However, this is not necessarily considered best practice.

In addition, article 138 of the Zambian mining code leaves the actual implementation of the royalty provisions to be specified in the Income Tax Act. This leaves the finance and tax regulating entities authority with more authority to administer the royalty in the most efficient way possible.

36.2. Example 2:

Article [_] Royalty payable for minerals

(1) Definitions

In this part, average market price, for a prescribed mineral, means the average for a return period of the following price, converted to [Australian dollars] at the hedge settlement rate for each day of the return period—

(a) for cobalt, copper, lead, nickel or zinc—the spot price quoted on the London Metal Exchange;

(b) for gold—the p.m. fix price quoted on the London Bullion Market;

(c) for silver—the fix price quoted on the London Bullion Market.

reference price 1, for a prescribed mineral, means—

(a) for cobalt—$55,115 for each tonne; or

(b) for copper—$3600 for each tonne; or

(c) for gold—$600 for each troy ounce; or

(d) for lead—$1100 for each tonne; or

(e) for nickel—$12,500 for each tonne; or

(f) for silver—$9 for each troy ounce; or

(g) for zinc—$1900 for each tonne.

reference price 2, for a prescribed mineral, means—

(a) for cobalt—$83,775 for each tonne; or

(b) for copper—$9200 for each tonne; or

(c) for gold—$890 for each troy ounce; or

(d) for lead—$2500 for each tonne; or

(e) for nickel—$38,100 for each tonne; or

(f) for silver—$16.50 for each troy ounce; or

(g) for zinc—$4400 for each tonne.

Article [_] Royalty rate for prescribed mineral

(1) The royalty rate for a prescribed mineral is—

(a) if the average market price for the mineral is equal to or lower than reference price 1 for the mineral—2.5% of the value of the prescribed mineral; or

(b) if the average market price for the mineral is higher than reference price 1 for the mineral but lower than reference price 2 for the mineral—the prescribed percentage of the value of the prescribed mineral; or

(c) if the average market price for the mineral is equal to or higher than reference price 2 for the mineral—5% of the value of the prescribed mineral.

(2) In this section—

prescribed percentage means the amount, expressed as a percentage, rounded down to the nearest increment of 0.02%, worked out by using the following formula—

PP = 2.5 + (PD/RFD*2.5)

where—

PP is the prescribed percentage.

PD is the difference between the average market price and reference price 1 for the prescribed mineral.

RFD is the difference between reference price 2 and reference price 1 for the prescribed mineral.

Example— If, for a return period, the average market price for copper is $8300 for each tonne of copper, the royalty rate for copper for the return period must be worked out under subsection (1)(b), given the average market price is higher than reference price 1 for copper ($3600) but lower than reference price 2 for copper ($9200). The royalty rate would be 4.58%, being the amount (4.598214%) worked out by using the formula in subsection (2), definition prescribed percentage, rounded down to the nearest increment=t of 0.02%.

Annotation

Drawn from Queensland Australia’s Mineral Resources Regulation (2013), this provision offers an example of a variable rate ad-valorem royalty. The rate varies between 2.5% and 5% of the value of the ore, depending on market prices. Having variable rates can make royalties more palatable to investors, as they are more progressive than fixed rate royalties: that is, in theory they require the mining company to pay more when their capacity to pay increases with the price of commodities and less when prices are low (though an increase in prices alone may not reflect increased profits for companies). However, it requires additional efforts from the regulating entity to monitor and publish Quarterly and annual metal prices and variable rates, so that companies know what they have to pay. This approach may not be practical for countries that have limited administrative capacity.

The reference prices (here in Australian dollars) are used as a thresholds to determine whether the average market prices are “high” or low”. The reference prices a country uses could be based on moving historical averages. In this case, the establishment of these reference prices in regulation allows for them to be adjusted by the regulating ministry more regularly than legislation to reflect changes in market price trends over time and inflation or changes in exchange rate.

Queensland’s regulations allow for deductions of some expenses from gross revenues for calculation of royalties, including late dispatch costs (for coal only), ocean freight and insurance costs, loss of metal content in processing (for certain minerals) and other approved deductions. As noted, it is administratively simplest to disallow any deductions as their allowance creates the potential for companies to inflate these costs and thereby reduce their royalty obligations (see section in the Guiding Template on transfer pricing). If deductions are allowed to better reflect the actual price received by license holders for sale of the minerals, a government should consider including reference prices for such costs, where available. Guinea’s 2011 mining code, as amended, provides such an example: an international index for transportation costs is included.