Canada: Will Fiscal Uncertainty Undermine Investment And Stifle Wealth Creation?

After the Forum on Mining Royalties organized by the Quebec government and held in Montréal on March 15, 2013, apprehension remains the order of the day. At least, that seems to be the prevailing sentiment of industry players.

The Facts

Quebec's mining duties regime was overhauled following the 2010-2011 Budget (for more information, see our Blakes Bulletin: Quebec Mining Duties Regime – Substantial Changes Proposed) resulting in mining royalties, or more accurately the mining tax, being henceforth determined on a mine-by-mine basis, so that a company's loss in operating one mine cannot be used to reduce the annual profit of another mine.

For each profitable mine (i.e., one which generates an annual profit as determined under the Mining Tax Act) located in Quebec, a company must currently pay the Quebec government (the State) a royalty equal to 16% of its profits. The implementation of a mine-by-mine approach and certain other measures, along with an increase in metal prices, have allowed the government to more than triple the royalties it has collected, which were C$365-million for fiscal year 2011-2012. Net royalties paid to the State were thus 4.7% of the extracted value of the minerals, more than seven times the average percentage for the period from 1995 to 2009.

The Government's Perspective

Despite these facts, the government states that the current regime does not give the State its "fair share" of mining operations in Quebec, as only half of operational mining companies in the province paid royalties despite the fact that high prices were reached for certain metals.

The government's stated objective is to collect more royalties from all 22 operating mining companies, whether or not they are profitable.

In its consultation document tabled on March 7, 2013, the government recommends setting up an ad valorem royalty. Set, for example, at 5% of the gross value of a mining company's annual production, this royalty would be combined with a second, profit-based royalty which could be up to 30% when a company has profits considered "exceptional" by the State. The threshold over and above which profits would be considered "exceptional" would be determined based on the expected return on the investment.

The Industry's Position

For the industry, such a regime would be the death knell for Quebec's minerals resources sector. Industry players are speaking with one voice in the hope of convincing the government of the soundness of their concerns, enjoining it to consider several points in making decisions, such as the following:

  • Half of all mining companies which did not pay royalties in 2011 are either unprofitable or in their first few years of operation (i.e., junior companies) and can reduce their tax base through accelerated depreciation, the effect of which is in all cases temporary. These mines represent less than 20% of gross annual production.
  • A mining company's contribution to the economy is not only limited to the royalties the State collects from it. The following should also be taken into account: the paying jobs that are created, the income tax the company pays, the taxes collected by municipalities, the contracts given to local suppliers, and the local and aboriginal communities that benefit from investments in infrastructure.
  • For a mining company to remain competitive, its tax burden in terms of net cash flow (i.e., before tax and financing charges) cannot exceed a certain level.
  • A mining project with an internal rate of return (IRR, determined after income tax and mining duties) of less than 15% will generally not be implemented.
  • A royalties regime should never be imported from another country, as the government is preparing to do with the Australian regime, without making significant changes to take into account any structural constraints relating to geography (distance from lead markets), terrain (accessibility), climate (harsh winters), mineral characteristics (low content) and types of mines (open pit mines vs. underground mines). Due to these unique aspects, gold and iron ore mines in Quebec are generally in the third and fourth quartiles (Q3 and Q4) in terms of production costs.
  • The fact that metal prices are increasing does not necessarily mean that mining companies' profits are keeping step with them. A price increase will put pressure on supply by turning likely projects into actual projects, thus increasing the number of economically minable deposits. The increase in metal prices explains the 20% average annual increase in the value of mineral production in Quebec between 2003 and 2011.
  • Continued fiscal uncertainty and the spectre of a regressive royalties regime – a tax is considered "regressive" when it is calculated using a uniform rate, thus representing a proportionately greater burden for a taxpayer showing a loss or marginal profit – are affecting the quality of Quebec's business environment (stability and predictability of the political, legal and fiscal context) with the following consequences, to name only two:
    • the decline in Quebec's competitive advantage from both the investor's point of view and that of the mining company, which can always explore and start mining projects elsewhere around the world;
    • the calling into question of the conclusions of past feasibility studies, on which the decision to pursue mining projects was made.
  • A mining company's costs are much higher than many would think. The overused notion of "production cost" should be replaced by "total cost".
  • Investors expect mining companies to be able to recover the cost of a mining project (during the pre-production phase, investments often exceed C$1-billion) plus a return over the first five to seven years of production, hence the importance of allowing the accelerated depreciation of a company's assets.
  • Although mining investments increased by 21.4% on average between 2003 and 2012, they will drop by 12.9% in 2013. The reasons for an investor choosing Quebec, including the clarity and stability of the Mining Act and the royalties regime, are now disappearing.
  • The mining industry invests heavily in sustainable development.
  • A royalty regime with an ad valorem component should be avoided for the following reasons:
    • it leads to distorted investment decisions;
    • it does not take into account a taxpayer's ability to pay;
    • it ignores any increase in the cost base, including inflation;
    • it has a very significant negative impact on Q3 and Q4 mines, particularly in a context of declining metal prices;
    • it ignores the cyclical nature of mineral markets;
    • it reduces the mine life.
  • The current royalty regime (exclusively based on profits) should be maintained since such a regime:
    • takes a company's ability to pay into account;
    • has little impact on investment decisions;
    • provides a greater share of the extracted wealth when profits are high (top of a mining cycle);
    • is better adapted to Q3 and Q4 mines, particularly at the bottom of a cycle.

In view of studies dealing with different royalty regimes and their impacts on both the decision to choose one jurisdiction over another and that made by investors, the following assertion can reasonably be made: fiscal uncertainty and/or excessive taxation could lead to a decline in mining investment and shorten the life of the mining phase due to the negative impact these factors have on the net present value (NPV) of mining projects. Under such conditions, the mining industry might not be able to create the wealth so coveted by the State and Quebec society as a whole.

At a time when employment forecasts in Quebec are being revised downward, it will be interesting to see whether the government will take to heart the recommendations mining industry players and experts made at the recent Forum on Mining Royalties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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