Mining Agreements and Royalties by runout


									Delivering Smarter Solutions                                                                                     ISSUE NO. 63 — February 2005

                                                               Mining Agreements and Royalties

  OSM PROPOSED NEW RULES FOR                    The mining industry is once again riding           mineral-rich countries, mineral
                                                high due to an across the board increase           agreements can be divided into two main
  PHILIPPINE COURTS ALLOW                       in metal prices. Landowners (individuals or        groups: exploration agreements and
                                                companies) and mining companies are                production agreements.
                                                heavily involved in deal making to develop
                                                their mineral properties. After all, the goal      Exploration Agreements
  MINING INDUSTRY ZERO                          of successfully negotiating a mining
  TOLERANCE ON BRIBERY                          agreement is to provide maximum benefit            The structure of the exploration
                                                to all parties.                                    agreement depends on each party’s
 C A L E N D A R                                                                                   degree of sophistication, knowledge of
                                                The intent of this paper is to describe the        the mineral property and tax regimes
 SME Annual Meeting and                         various mining royalty agreements and the          under which the negotiations are taking
  Exhibit                                       economic implications with respect to              place. Generally the landowner (lessor)
  February 28–March 2, 2005
                                                project development. Royalty arrangements          requires some form of upfront payment
  Salt Palace Convention Center
  Salt Lake City, Utah
                                                represent an operating cost and can                from the mining company (lessee), which
  email:                         substantially influence project economics.         allows the interested corporation to
  Visit us at Booth 1002                                                                           explore the property for a certain period
                                                Mineral exploration is a high-risk activity        of time. Depending on the
 PDAC 2005 International
  Convention                                    and the cost can be substantial. While             aforementioned items, mining
  March 6–9, 2005                               there is never an assurance that a                 agreements can vary widely at this stage.
  Metro Toronto Convention Centre
                                                commercially exploitable deposit will
  Toronto, Ontario, Canada
                                                result, projects usually require long lead         In negotiating exploration agreements the
  Visit us at Booth 312                         times where returns may not be realized            lessor wishes to maintain as much control
                                                for years. This is why small companies or          and ownership as possible, minimize
 Asia Mining Congress 2005
                                                individuals turn to larger, more integrated        expenditures and limit risk exposure. The
  March 21–24, 2005
  The Oriental Hotel
                                                firms to develop their property. Likewise,         lessor generally requires the mining
  Singapore, Singapore                          larger firms, even with significant financial      company to meet certain commitments or
  email:                 resources, turn to smaller companies or            milestones to insure the property is
                                                individuals who may control a property             explored and evaluated in a timely
 Mining World Russia 2005
  April 5–8, 2005                               with significant mineral potential, to avoid       manner.
  World Trade Center                            the long lead times in mineral exploration.
  Moscow, Russia                                                                                   The mining company is interested in
  email: oleg.netchaev@miningworld-
                                                Whether negotiations occur between                 putting money in the property’s
                                                individual landowners or governments of            exploration effort rather than making the

Copyright 2005 by Pincock, Allen and Holt, a division of Hart Crowser, Inc. All Rights Reserved.
Pincock Perspectives

OSM PROPOSED NEW RULES FOR                      lessor wealthy. The mining company       subject to different tax rules and
                                                wants to spend the least amount of       rates. Analyzing these projects on an
The mining industry is one step closer to
ending a fifteen year-old battle between        money possible to evaluate the           after tax rate-of-return basis avoids
the Office of Surface Mining (OSM) and          property’s mineral potential, knowing    ambiguity by comparing projects on
the National Mining Association (NMA)           that the chances against developing      an equal basis.
over ownership and management issues.
                                                a mineral property are quite large;
OSM Reclamation and Enforcement has
proposed new rules designed to ensure           estimates indicate that about 1 in       Tax treatment of royalty (leasing)
that the agency will not have actual            1,000 exploration deposits lead to a     expenditures vary from country to
approval of major acquisitions and              viable operation.                        country. For properties in the United
management changes by coal companies.
The new rules clarifies that the Surface                                                 States, payments made during the
Mining Control and Reclamation Act              During negotiations of exploration       exploration stage must be recovered
requirement which states that OSM sign          agreements, mining companies need        by depletion deductions over the life
off on any transfers or sales of coal mine
                                                to know what economic limits the         of the project. The only option for
permits does not apply to such business
transactions. In 2001 the NMA filed a           project holds in order to gauge the      the lessor is to treat the royalty
lawsuit over OSM’s interpretations of who       negotiation. The negotiator needs to     payment as ordinary income and pay
is liable for a specific violation. OSM         know what level of royalty expenses      taxes according to their appropriate
wanted to include individuals who had no
                                                the project can withstand before it      tax bracket.
direct control over a mine that was in
violation while the NMA wanted those            becomes marginal or uneconomic.
directly responsible for management of a                                                 Although this paper discusses the
mine to be liable. OSM will accept public       If the lessor is too demanding at this   after tax implications of royalty
comment on the proposal of these new
rules through March 27.                         stage of the negotiation, the mining     agreements, it is done primarily with
                                                company may decide it is not worth       regard to corporations. Individual tax
PHILIPPINE COURTS ALLOW                         the effort to continue discussions.      scenarios vary so much that it would
                                                The lessor’s payment requirements or     be beyond the scope of this paper to
A recent court decision in the Philippines is
hoping to start a rebirth of exploration and    exploration commitments may be so        address all those cases. Individual
mine development in that country. The           onerous as to condemn the                landowners would need to seek the
court decision now allows for unrestricted      property’s economics before the          advice of qualified attorneys and
foreign ownership of mines. As a result of
this decision the Mines and Geoscience
                                                mining company has a chance to           accountants specializing in mineral
Bureau in the Philippines is estimating         start exploration. On the other hand,    agreements in order to determine
US$6 billion in mining investment by            a property owner who is aware of         their specific tax situation.
2010. Approximately 23 mining projects
                                                and accepts the technical
are planned, including the Rapu gold
project of Australian junior Lafayette
                                                uncertainties associated with project    In regard to exploration agreements,
Mining.                                         development will probably take less      there are no terms that have
                                                upfront money in order to share in       particularly favorable tax advantages
                                                the profits from future production.      for either party. For companies,
The new version of the JORC Code was
released in December 2004. Changes                                                       royalty payments are no more than
include:                                        It is common to include the effects of   out-of-pocket expenses, which
• The recognition of overseas professional      taxes in project evaluations. This       require recapture from future
  organizations (ROPO) to satisfy
                                                allows one to rank projects in terms     allowances. The lessor receives
  Competent Person requirements
  (previously the Competent Person had to       of their net after-tax return on         royalty income with no particular tax
  be a member of AusIMM or AIG).                investment. While there are several      advantages, treating the income as
• The requirement for a Competent Person        reasons to include the effects of        ordinary income.
  to be responsible for reporting
  Exploration Results.                          taxes in project evaluations, the most
• Revised coal reporting, including             important is to ensure comparability     When negotiating mining agreements,
  reference to a supplemental coal              between projects. As more                consider that exploration royalties are
  reporting document
                                                companies perform exploration in         generally offset against production
• Revised diamond reporting.
• Guideline on level of study expected for      various parts of the world, the mix of   royalties should the project go into
  Ore Reserves                                  foreign and domestic projects will be    production. Depending on the

                                                                                  Delivering Smarter Solutions

                                                                                         MINING INDUSTRY ZERO
landowner’s risk tolerance and tenor       requiring litigation to be resolved. Net
                                                                                         TOLERANCE ON BRIBERY
of the deposit, both the mining            profits interest royalties are not            Several mining companies are lending
company and the landowner may be           considered in this paper.                     their support for a zero-tolerance policy
financially better off by constructing                                                   towards bribery and the development of
                                                                                         a practical and effective implementation
their agreement around production          NSR royalty is based on the gross
                                                                                         program. Sixty-two companies have
royalties and minimizing the               revenue received by the mine less             signed the Partnership Against
exploration royalties.                     costs incurred subsequent to                  Corruption Principles, which are derived
                                           concentrating, which includes                 from Transparency International’s
                                                                                         Business Principles for Countering Bribery
While exploration agreements are           smelting, refining, marketing,
                                                                                         and in partnership with the Basel Institute
generally not going to be structured       transportation, and insurance. Usually        on Governance. The companies have
for the sole purpose of minimizing         no provision is made for deducting            pledged either to implement anti-bribery
                                                                                         and anti-corruption practices based on
taxes, agreements should be                direct mine operating costs. The NSR
                                                                                         the Partnership Against Corruption
negotiated to maximize information         royalty is simple and straight forward        Principles or will use them to improve
gathering on behalf of the project.        to administer.                                their own existing programs. The
Should the project move on to the                                                        principals address political contributions,
                                                                                         charitable contributions and
next stage of development, both            Landowners generally prefer the NSR
                                                                                         sponsorships, and gifts, hospitalities and
parties will reap the benefits. It is at   royalty to avoid the detail and               expenses. It also calls for the elimination
this stage where the more                  negotiations associated with net              of facilitation payments or small
                                           proceeds or net profits royalties. While      payments made to expedite the
complicated and financially rewarding
                                                                                         performance of routine action to which
mining agreements occur.                   the NSR is easy for mining companies
                                                                                         the business is entitled. The principals
                                           to administer, NSR royalties are paid to      were announced at the World Economic
Production Agreements                      the landowner whether or not the              Forum in Davos, Switzerland in January.
                                           project makes a profit.
Production agreements can take the
form of a sale, lease or joint venture     Net proceeds is a more general term
arrangement. The sale of the property      that has no established accounting            Minerals Corner —
does not include royalties because the     definition, allowing significant
mining company is purchasing the           flexibility when negotiating                  Kaemmererite
mineral interest from the other party.     agreements. In general, net proceeds          (Fe, Mg)3Fe3AlSi3O 10(OH)8 , Iron
The joint venture arrangement takes        refers to the net amount from revenue         Magnesium Aluminum Silicate
on an entirely different type of           received by the mine less direct
mineral interest. Usually the joint        operating costs, which includes               Kaemmererite, also spelled
venture partner is required to spend a     mining, milling, ongoing reclamation,         kammererite, is the chromium rich
                                           general and administrative costs.             variety of clinochlore. Clinochlore is a
certain level of funds in order to earn
                                                                                         part of a large group of minerals called
an interest, or share, in the project.     Additional charges, such as offsite
                                                                                         chlorites. While most chlorites have a
This discussion only considers the         overhead fees, taxes, in-house cost of        green color as a result of iron and
various lease agreements.                  equity financing and replacement              magnesium ions, kaemmererite has
                                           capital, will require negotiation.            only small amounts of chromium in its
                                                                                         structure. Crimson red is the most
Lease agreements consist of net                                                          common color of kaemmererite but it
smelter return (NSR), net proceeds         Net proceeds royalty agreements are           can also be found in lavender.
and net profits interest royalties.        usually structured such that the              Kaemmererite’s crystals are similar to
                                                                                         erythrite, which are usually thin platy
Royalty payments based on net profits      operator will be able to recoup capital
                                                                                         crystal aggregates. But erythrite’s
interest deduct mine operating costs       expenditures prior to royalty payments        crystals are more pointed and have
and are generally avoided because of       being made. Capital costs typically           acute angles, which are lacking on
differences in accounting, particularly    include mine development, mine/mill           kaemmererite’s crystals. This mineral is
                                                                                         found in Lancaster, County,
for non-cash charges and taxes.            plant and equipment, working capital,
                                                                                         Pennsylvania and California, USA; and
Inclusion of these items adds to the       and replacement capital. This allows          Guleman, Turkey. Kaemmererite’s only
complexity of the agreement, often         the mine to gain a healthier cash flow        use is as a mineral specimen.

Pincock Perspectives                                                                                        Delivering Smarter Solutions

position and pay royalties when                         Based on previous work conducted                        cutoff grade, which in turn reduces
profits are actually being recognized.                  by the author, one can equate the                       the project’s mineral reserve. Royalties
In addition, a provision can be made                    economic tradeoffs between NSR                          that are too high can make the project
to carry forward a net operating loss                   royalties and net proceeds royalties.                   uneconomic, forcing the company not
to offset net proceeds payments in                      The results of this work indicate that,                 to develop the property.
future years. This provision reduces                    based on after-tax net present value
the total net proceeds royalty that the                 analysis, one percentage point of NSR                   Although most countries have enacted
lessor would otherwise have received.                   is equivalent to 3.5 percentage points                  legislation governing their mining
                                                        of net proceeds royalty. Results                        sector, most companies negotiate
Although the net proceeds royalty                       further indicate that the equivalency                   some form of mineral agreement with
agreement is very flexible and can be                   is consistent regardless of size or type                that government prior to conducting
tailored to fit any project, they are                   of mine. If the landowner desires to                    exploration or developing mineral
extremely complicated to negotiate.                     indulge in the higher-risk potential of                 properties, particularly in regard to
Many areas of dispute may arise, and                    the project yet maintain the simplicity                 taxes and royalties. However,
the administrative burden, renego-                      of the NSR royalty, one could do so                     governments have been securing a
tiation or legal expenses may offset                    by applying the equivalency                             larger portion of project revenues by
the benefits. However, depending on                     guideline.                                              applying additional taxes and royalties
the sophistication of the landowner                                                                             on mineral projects within their
and the degree of risk tolerance, this                  Although, the net proceeds royalty is                   borders. As the country’s mineral
type of royalty agreement might be to                   more advantageous to the mining                         wealth becomes established, these
both party’s advantage. Should the                      company because profitability is                        countries are in a strong position to
risks tend to the upside, each group’s                  taken into account, most companies                      change tax laws or royalties as they
wealth may significantly improve.                       prefer the NSR royalty because it is                    wish. While it is their sovereign right to
                                                        far less of an administrative burden,                   make changes benefiting their country,
NSR royalties can vary from a low of                    even though royalties are paid                          doing so may jeopardize their
one percent to a high of 15 percent                     regardless of profit.                                   reputation and force investors to
(if multiple property owners are                                                                                explore for and develop mineral
involved) and typically range from two                  One cannot discuss royalties without                    properties elsewhere.
to six percent. Net proceeds royalties                  noting the impact royalties have on
vary from 10 to 35 percent,                             project economics and mineral
depending on the agreement terms                        reserves. Royalties, no matter what
and number of landowners involved,                      type, represent a direct operating                      This month’s article was provided by
and typically range from 15 to 30                       cost to the project. Thus, royalties                    Don Tschabrun, Principal Mining
percent.                                                have the direct impact of raising the                   Engineer

Pincock, Allen & Holt is a consulting and engineering firm serving the international mineral resource industry. Your comments and suggestions are always
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sources; references available upon request.

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