By Poupak Bahamin, partner, Heenan Blaikie, LLP

Over the past twenty years, and prior to the recent market meltdown, the mining industry has witnessed spectacular growth caused mainly by an unprecedented demand for metals coupled with increasing commodity prices. Under these circumstances, mining companies have generally flourished and reported large profits.

Poupak Bahamin

Poupak Bahamin, Partner,
Heenan Blaikie, LLP

Countries with mining resources have also benefited from this remarkable growth; for example, gold mine production in Ghana increased 700% over the last two decades. To attract foreign investment, developing countries had previously established significant incentives to explore and exploit their natural resources such as tax exemptions, low royalty rates and agreements for long-term concessions. More recently, faced with the rapid expansion of mining investment and the high profits generated by mining companies, several countries have reached out for a bigger share of the profits and perhaps a stronger control over their mineral reserves.

From a country’s perspective, such initiatives are beneficial and are directed at correcting irregularities, flaws or unbalances in their existing legal, fiscal or contractual regimes. Investors, however, do not share this point of view and perceive these measures as concerns that adversely affect their investment or production decisions from an economic perspective. Yet, the ultimate objective of mineral rich countries is, or should be, to adopt an optimal tax regime to foster serious investment enabling them to share the wealth of their natural resources, while remaining attractive to foreign investment. This is particularly true in times of economic crisis when private investment is rare and countries must provide employment and generate tax revenues.

Governments have undertaken a series of initiatives to increase the benefits from their natural resources including i) increasing taxes, royalties and introducing windfall taxes (Papua New Guinea, Mongolia), ii) reviewing existing mining contracts (DRC, Tanzania, Guinea); iii) changing their legal and economic mining regimes (Zambia, Ecuador), and ultimately iv) expropriation and nationalisation of deposits, both in the mining and oil sectors (Ecuador, Bolivia).

This article analyses the first two of the above methods which have more of an immediate impact on the distribution of revenues generated by the mining industry. It also includes an analysis of several jurisdictions which recently introduced measures with the objective of increasing the government’s take from mining projects.

Increased Royalties and Taxation (Windfall Taxes)
Taxation in the mining sector is a means to ensure that countries receive a share of the revenues generated by the exploration and exploitation of their resources. It therefore comes as no surprise that a country’s desire to increase its share of mining revenues translates into a review of mining taxation regimes or the introduction of new taxes.

Several countries, and especially several African countries, have claimed that their mining taxation reform is warranted by the fact that in the 1990s, international institutions and donors encouraged them to shift their regimes toward lower taxation, in order to attract investment and to revitalise their mining sectors. While this led them to establish ‘competitive’ tax regimes, these regimes have also left the countries with an unfairly low participation in the profits generated by the exploitation of their mineral resources. Such discrepancies became more apparent when the boom in metal price occurred and several African countries felt mounting public pressure from their population which, ‘too aware of the good times benefiting the global mining industry, saw little spending on their basic development needs.’

Taxation of the mining sector includes a variety of taxes at the federal, provincial and local levels such as income tax, import and export taxes, tax on fuels and royalties. Royalty tax is a common and relatively easy to administer form of imposition. From the government’s perspective, its popularity lays, in part, on the fact that it is often based on value of production or value of sales rather than profits. Therefore, it is not affected by an increase in exploration and exploitation costs. Furthermore, when based on sales price, the royalty will generally follow commodity prices and allow the host country to capture higher revenues at times of economic growth.

In addition to the widespread means of taxation, some resource (oil/minerals) countries have introduced windfall taxes. This new form of taxation aims at securing, for the government, a percentage of the commodity sales prices, over an established threshold. From the government’s perspective, this form of taxation seems harmless as it is only triggered when commodity prices soar over a certain level and only applies to the excess portion of sales price. In fact, the windfall tax is often adopted following popular views that excessive soaring prices of commodities should be taxed for the benefit of the country. Although this may be true on the short-term, countries that impose windfall taxes generally experience the negative consequences in their total tax take. Recent history and the case studies below show the lack of success of the windfall taxes, at least in the mining sector.

This may be explained, at least in part, by the fact that the mineral industry is a cyclical industry with long low commodity prices and narrow higher commodity price peaks. Whenever commodity prices decline, high royalties may have a dramatic effect on the overall economics of most mines and result in them becoming unprofitable. In addition, royalties impact different types of deposits differently. Very few producing mines are of sufficient tonnage and grade to be economic throughout the whole commodity cycle. Therefore, other than that high grade large tonnage mines, mining projects need the extra revenues generated during price peaks and depriving them of such excess revenues through increased royalties and/or windfall taxes will actually reduce their chances of survival through the lower parts of the cycle. This was particularly true during the last commodity cycle, when overall mining and extraction costs accelerated much faster than commodity prices and as a result, increased royalty rates and windfall taxes had the effect of rendering all but high grade large tonnage projects uneconomical.

Papua New Guinea – In Papua New Guinea (PNG), a large increase in royalty was partly responsible for the country’s decline in levels of exploration and development. Between 1996 and 2000, the government raised the royalty rate from 1.25% to 2%. In addition, a 4% mining levy was introduced in July 1999 to capture the windfall gain of the mining industry from the introduction of the VAT. This increase of 6% had a negative effect and seriously undermined the mineral investment climate in PNG. These changes were imposed on top of a corporate income tax, a dividend withholding tax, an additional profits tax and significant restrictions on deductions for off-site exploration expenditures. In addition, the state reserved the right to assume up to a 30% equity share in all projects at the time a mining lease was issued, at a price based on the project’s exploration costs, rather than its full market value.

By 2000, the country had lost its competitive edge and struggled to create a climate attractive to new investors. The mining sector accounted for a timid 17.1% of the gross domestic product (GDP) as opposed to 30% in 1994. This decline reached its peak in 2002 when only 15.5% of the Country’s GDP came from the mining sector. As a result of the general depression in the mineral sector during that time and its own decline, PNG re-examined its fiscal regime between 2000 and 2002. In 2003, the government reduced the corporate income tax to 30% and the dividend withholding tax to 10%. The royalty rate was based on ad valorem and fixed at 2% of net smelter returns. As a result of these measures, the mining sector expanded its activities and the whole country benefited from the revenues with a contribution of 21% of the GDP in 2004 and up to 49.7% in 200510 from the mining sector.

Mongolia – In 1997, a set of flexible mineral laws was introduced in Mongolia and contributed to its mineral industry prosperity. By 2005, the mineral sector was a significant contributor to the country’s GDP (18%).11

In May 2006, the government shifted its mining policy and imposed a 68% windfall tax on the commodity prices exceeding the threshold prices of US$500 per ounce for gold and US$2,600 per tonne for copper concentrate.12 In addition to this windfall tax, new legislative amendments empowered the government to acquire a substantial equity in the exploitation of all ‘mineral deposits of strategic importance’ and required that at least 10% of the equity be listed on the Mongolian stock exchange.13

Before the windfall tax came into effect, gold producers in Mongolia extracted 24.1 tonnes of gold a year. In 2006 and 2007, gold production decreased to 22.5 tonnes and 17.4 tonnes a year respectively.14 By implementing such laws, the government sought to augment its share of profits. Yet, the windfall profit tax significantly reduces the country’s investment competitiveness.15 In fact, it has been said that the removal of these laws that are burdensome would allow the mining sector to maximise its contribution to the growth of the Country’s GDP over the longer term.16

Zambia – In April 2008, the Zambian government announced it would undertake a legislative reform of its mining sector.17 This was done as a response to a growing public and civil society outcry over the low level of revenues generated by the country despite its then newly revitalised mining industry, which had been earning record prices for copper between 2004 and 2008. It is noteworthy that initially, the government intended to carry out a review of existing mining contracts; however, for a number of political reasons, a path of legislative reform was selected.18

The legislative reform proposed inter alia an increase of the corporate tax from 25% to 30% and a windfall tax of 25% when copper prices increased between US$2 and US$3 per pound.19 Moreover, Zambia introduced a 15% variable profit tax (on income above 8% of sales) and raised mineral royalties to 3% from 0.6% and corporate tax to 30% from 25%.20

The impact of these new taxes which coincided with the dramatic collapse of commodity prices in the fall of 2008 led to the closure of many mines and a fall in government revenues and ultimately led to the government announcing that Zambia’s parliament would abolish the controversial 25% windfall tax.21

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Mining taxation is a complex and multi-faceted subject and it may prove difficult to assess the impact of one form of taxation without taking into account the overall total tax take of a particular country in comparison to other countries. While it is every country’s inherent right to change its fiscal regime, countries would be wise to introduce increases to taxation or new taxes in harmony with their existing applicable taxes and in a manner which maintains their competitive investment climate. The overall effect of taxation is one of the major factors mineral exploration and mineral development companies look at when deciding their investment strategy.

Finally, recent history has shown that taxation targeting exclusively high commodity prices (such as windfall taxes) is unsuccessful and ultimately detrimental to the host country. This lack of success may be partly related to the cyclical nature of the mineral industry and the need for mineral companies to fully benefit from high commodity prices during price peaks. Nevertheless, and citing the PNG and Mongolia examples, one may wonder whether the results would have been the same had these countries introduced only one taxation measure (ex: the windfall tax) rather than multi-faceted reform which, globally, had the effect of discouraging existing and new investors. One may also wonder whether the windfall taxes would have had better success if it was a common measure adopted by many mining countries. However, introduced in conjunction with other restrictive measures and on an isolated basis, windfall mining taxes have, so far, met no success in increasing a government’s overall tax take from its mineral industry.

Review of Contracts
The process of reviewing mining contracts is not common, but may be adopted when countries wish to increase their revenue stream or their control over their mining sector, without reforming their entire mining regime.

The review process involves revisiting and re-opening contracts signed between mining companies and host countries. In justifying this process, countries argue that contracts were signed at times of war when the countries had a weak negotiating position or with authorities that had no legitimacy and/or through individuals with little to no mineral industry expertise. In other cases, countries will simply contend lack of transparency in the negotiations leading to the granting of mining concessions.

Needless to say that news regarding the review of mining contracts is not welcome within the mining industry. For their part, companies will submit that they have embarked on their mining project in good faith and have developed a business model based on the terms of a valid and binding agreement. In fact, under international law, countries wishing to modify contracts cannot act unilaterally and can be limited by a complex set of rules.22 The credibility and impartiality of the review process will be questioned because of a lack of uniformity in the negotiations and the requirements imposed on the concerned companies. Indeed, the discretionary power granted to the reviewing authority can discredit the whole process in the eyes of investors.23

The most notable and comprehensive example of a revisitation process has recently occurred in the Democratic Republic of Congo (DRC) where, by ministerial decree,24 the minister of mines announced on April 20, 2007, the creation of a ministerial commission charged with the ‘revisitation’ of mining contracts (Commission ministérielle chargée de la revisitation de contrats miniers).25 In the DRC, the process was among others justified as an opportunity to evaluate the status of the contracts under review and assess the level of execution and observance, by the mining companies, of their obligations under their respective agreement.

The scope of the review was limited to 63 mining contracts signed between mining companies and the DRC’s state owned mining entities.26 Almost a year and a half after launching the review process, in December 2008, the minister of mines of the DRC published its report on the renegotiation of mining contracts, setting out that a total of 63 contracts were reviewed of which 40 were to be renegotiated and 23 cancelled.

At the time of drafting this article, most companies concerned had announced having reached a deal with the government regarding the renegotiation of their mining contracts. A few are still under discussion.

The review process still being ongoing, it is perhaps too early to assess its concrete impact on the country’s economy, although one can already detect opposing views on the subject. Indeed, some investors and the mining industry have adopted the view that the revisitation process may have prevented investors from pouring in much needed additional money in the country’s economy. The exact financial impact of this assertion remains difficult to assess, as the revisitation unfortunately coincided with the world’s global financial crisis which severely affected the mining sector.

DRC officials, on the other hand, point to the new revenues generated for the country through the process, including US$31 9,783 ,040 in cash bonuses (pas-deporte) which mining companies have voluntarily agreed to pay, and US$5,206,000 identified as outstanding superficiary rights, and for which guarantees of payment have been obtained.27 To that, one needs to add extra revenues to be generated as a result of new or higher royalties payable to the DRC state owned mining entities as well as more dividends to result from higher equity participation; the exact financial impact of these measures can only be assessed when production begins.

Following the DRC example, the Tanzanian government appointed a committee to review all mining contracts in November 2007. The committee was expected to complete its work and report to the government in 2008, but Tanzania is still undergoing the review to propose reforms that would bring in more revenues from the mining sector while still providing incentives for private sector involvement. At the time of drafting this article, a local newspaper reported that reforms to the mining legislation were expected in an amended mining act to be presented to parliament.28 It is said that a 5% royalty tax will be enacted in Tanzania.

At the end of 2008, Guinea announced it would review its mining contracts and halt gold exploitation until further notice.29

Conclusion
Recent history has shown that mining industry projects can be highly volatile, as they follow the rise and fall of mineral commodity prices which, in turn, follow the growth of the global economy and specific developmental needs. Mining reforms, including taxation review, are common in the industry and will continue as countries endeavour to improve and modernise their mining taxation regimes. Mining contracts review commissions are less frequent but may be warranted when there are genuine issues with the circumstances under which contracts were negotiated.

There is an inherent risk in undertaking any measure, be it mining reform or a contract review, when it is only warranted by raising commodity markets. Indeed, those measures will have no positive impact in times of market meltdowns. But because of the climate of uncertainty they create at the time of their introduction, they may in fact prevent the countries from benefiting from substantial revenues through new investment while commodity markets are flourishing. They may also prevent the mining companies from the full benefit of price peaks which is needed for the companies’ survival during difficult times.

The Fraser Institute rightfully points out that ‘in today’s globally competitive economy where mining companies may be examining properties located on different continents, a region policy climate has taken on increased importance in attracting and winning investments’.30 When comparing possible places to invest, mining companies will examine the overall investment climate but will also pay attention to specific criteria. Initiatives that are perceived as threats to profitability may push an investor into another country’s mine.

One can therefore conclude that initiatives such as increased taxation, mining reforms and mining contract reviews will have higher rates of success when undertaken independently from market conditions and for reasons that are genuine and that aim at correcting irregularities and flaws on a long term basis. In addition, those countries which embark on this path should not lose sight of those factors that will contribute to making their jurisdiction an investor friendly destination. More specifically, we refer to the certainty concerning the administration, interpretation and enforcement of existing laws and regulations, policies, regulatory duplication and inconsistencies, taxation regimes, infrastructure, socioeconomic agreements, political stability and security. On the other hand, mining companies should also act responsibly and make every effort to ensure that the stability and transparency is maintained on a long term basis. In establishing an investor friendly climate and stability for essential fiscal conditions, countries and companies should collaborate towards a win-win structure that is beneficial to all parties involved and that will maintain the mining projects’ financial viability while allowing the country’s economic and social development.