"An entire country’s budget may have been written and sold to domestic constituencies on the basis of a fixed amount of revenue generated by the mining industry. Reduce that revenue significantly and fault lines beyond the mining industry start to appear."
Recently, a key theme of the mining industry has been the settlement of the conflicting interests of the host state and sponsor in the development and operation of mining projects. Clearly both parties are required for development to occur (the state-sponsored mining company option seemingly having fallen from grace). However, both parties have different priorities. The host state wants to optimise revenue from mining activity for the benefit of its constituent population. The sponsor, on the other hand, must ensure an adequate return to shareholders. Load the scales too heavily on either side and the net result is less than optimal mining activity. This conundrum has been thrown into stark relief by the end of the so-called super-cycle for commodity prices.
In an environment of steadily falling commodity prices, how is the host state to react? Maybe it is not too much of an issue when mining is just one industry in a fully industrialised economy. In the host state where mining is by far the largest domestic industry more significant issues have to be faced. An entire country’s budget may have been written and sold to domestic constituencies on the basis of a fixed amount of revenue generated by the mining industry. Reduce that revenue significantly and fault lines beyond the mining industry start to appear. Promises made in elections cannot be met and much-needed infrastructure cannot be developed – such that political considerations begin to come into play.
So how can these competing interests be balanced? A detailed World Bank survey of mining royalties in 2006 gave eight principal recommendations and best practices in connection with this question. The first of these was, “The overall tax system should be equitable to both the nation and the investor and should be globally competitive.” Also raised was the notion that, in the case of the host state, the fiscal system should weigh the consequences of immediate revenue against long-term development. Developing government abilities in connection with financial reporting and calculating taxes, etc, was also emphasised, on the basis that the host state would be better able to propose and administer a variety of different fiscal options. The importance of avoiding high royalty rates was similarly underscored. Excessive royalty rates are in many ways the ultimate own goal – reducing the size of the deposit footprint that can be developed profitably.
In 2009 the Extractive Industries Transparency Initiative (EITI) produced a paper on taxation and investment issues in mining. While accepting the absence of a “one size fits all” model, EITI surmised that there might be a “common objective of encouraging successful and sustainable projects that exploit resources fully while avoiding social costs”. Transparency and inclusiveness were also emphasised, as was the question of how mining-related revenue was actually being used in the host state. EITI speculated that the latter issue might ultimately become more challenging than the question of revenue division between host state and sponsor.
Zambia provides the most recent example of how this conflict has been played out of the last couple of years. The mining industry in Zambia employs around 90,000 people (and almost certainly more when indirect employment is taken into account); it contributes three-quarters of the country’s foreign exchange, and up to 30 per cent of government revenue. The hoopla began in October 2014, when the budget statement for 2015 – an election year – was delivered by the local finance minister. The statement announced an increase in mineral royalties from 6 per cent to 8 per cent in the case of underground mining. The statement also announced royalties of 20 per cent in the case of open-cast projects. In addition, it proposed a 30 per cent corporate income tax on income earned from tolling, as well as tax at a similar rate imposed on income earned from the processing of purchased ores, concentrates, etc.
In aggregate the new proposals were estimated to produce a 30–40 per cent increase in the amount of revenue generated for the state by the mining industry. The increase in the government’s cut from local projects was described as an attempt to achieve “a more equitable distribution of the mineral wealth between the government and the mining companies”. That may have been the stated aim, but the controversy soon began. Immediately commentators began speculating that the proposed increase would render world-class mines (such as those operated by First Quantum, Glencore, Barrick, Vedanta and others) cashflow-negative. This was quickly followed by the sponsors themselves stating that the proposals rendered many projects unviable, so that future expansion schemes would be put on hold and, in some cases, all operations suspended. The closure of just one of those mines (Lumwana) would have led to an estimated 12,000 job losses.
Things soon changed. Following the elections, and more emollient statements from sponsors, the government announced in April 2015 that the royalty rate for all mines would be set at 9 per cent. This marked a 50 per cent increase on the initial rate – which, while still significant, was nothing like as large as had previously been proposed for open-cast projects. The new tax regime was scheduled to come into effect on 1 July. However, in June the government rolled back the proposed changes even further, with royalties on open-cast and underground mines set at 9 per cent and 6 per cent respectively. It also announced other sponsor-friendly changes to the way income tax was calculated.
At a mining conference held in Lusaka in June 2015, The Wall Street Journal quoted the Zambian mining minister, Christopher Yaluma: “We listen very, very well to the mining industry.” He added that negotiations with the mining industry over the proposed increases had involved “some not very, very lovely notes” from sponsors. A ministerial statement to Parliament on mining taxation, issued around the same time, said: “The government is committed to ensuring that the tax system is not burdensome but conducive to tax compliance and beneficial to the country.”
A host state may attempt to extract further value from a project through means other than enhancing revenue returns by increasing royalty and tax rates. For example, governments in many emerging markets (particularly Africa) are entitled to free carried interests in projects – commonly around 10 per cent – with the ability to increase the same by acquiring further ownership interests at market prices. In March 2015 the Minister of Mines submitted a draft of a new mining code to Parliament in the Democratic Republic of the Congo. The draft is awaiting approval, but contemplates an increase in the state’s free carried ownership interest in mining projects from 5 per cent to 10 per cent.
Kenya has also made various efforts to increase the host state’s benefit from local projects. The difference here is that, unlike such jurisdictions as Zambia and the DRC, a mature mining industry has yet to develop; there are relatively few mining projects of any size, and the sector has historically produced less than 1 per cent of the country’s GDP. This may be why several government initiatives have foundered. The latest such attempt is incorporated in the new Mining Bill, which is expected to pass into law. This involved three key changes. First, the state was entitled to a 10 per cent free carried interest in new projects, while mining companies would be obliged to float 20 per cent of their shares on the Nairobi Stock Exchange. Second, certain non-material changes were made to the income tax regime. Third (and of greater concern to the mining fraternity), royalty rates were increased: for example, they rose from 3 per cent to 10 per cent for titanium ores, and to 12 per cent for diamonds. Mines processing minerals locally are entitled to a lower royalty rate.
In the early years of the 21st century Mexico attracted a significant amount of investment in the mining industry. By 2013, it placed fifth in Behre Dolbear’s ranking of attractive destinations for foreign investment in mining. That same year, the Mexican government proposed new tax rules, applicable to the mining industry and due to take effect on 1 January 2014. These rules involved four significant changes: an increase in the corporate income tax rate to 30 per cent; a 10 per cent withholding tax on dividends payable to offshore shareholders; a 7.5 per cent mining royalty on adjusted earnings; and a 0.5 per cent environmental erosion fee, based again on adjusted earnings (this fee applied only to precious metal operations). These changes were estimated to raise the marginal tax rate for mining companies from 30 per cent to approximately 41 per cent.
At the time, commentators suggested that the increases would lead to decreases in investment; “dramatically” so, in the view of one Canadian commentator (the Canadians are among the most active foreign investors in Mexico’s mining industry). However, the introduction of a royalty could hardly be seen as out of kilter with other emerging markets (although the actual rate is comparatively high). It is unclear whether this warning has proved accurate or not. The royalty has, however, inevitably had an adverse impact on those who were in the middle of developing projects when it was implemented. For example, Pan American, which was developing a project at the time, estimated that the royalty had an adverse effect on its IRR to the tune of 5 per cent. Other companies seemed more dismissive of the royalty’s impact upon them, deeming it the cost of doing business in an otherwise attractive jurisdiction. Investment has been affected though: in 2012, spending on exploration activity in Mexico was approximately $1.165 billion. The estimated figure for 2015 is $673 million. Much of this decrease, however, might well be accounted for by the general decrease in activity as a result of falling commodity prices.
The rapid rise in commodity prices in the earlier part of this century led many host states to believe that they were benefiting insufficiently from the boom. Somewhat rapaciously in the view of some, certain governments moved to correct the perceived injustice. This was possibly easier to understand in the good times; in the not-so-good times that have followed, the situation has become more complex. Declining revenues from the mining industry have left some host states – or rather, some host governments – unable to deliver on political promises. Of more significant consequence, absolute revenue levels have declined; as a result, it may not be possible to meet local government budgets. The knee-jerk reaction – an attempt to extract another pound of flesh from an already-overstretched industry – needs to be avoided. Governments must be able to think in the long term. They must also recognise that stability is key to investment decisions. So both host states and sponsors need to continue walking the line. Those that can do so during this stage of the commodities cycle will surely reap rewards.