The recent publication of the Draft Taxations Laws Amendment Bill, 2013 ("the TLAB") would have raised more than a few eyebrows insofar as the proposed amendments to the Mineral and Petroleum Resources Royalty Act 28 of 2008 ("the Royalty Act") is concerned. It is clear from the media release that accompanied the publication of the TLAB, that the proposed amendments are specifically aimed at increasing the mineral royalty contributions made by coal mining companies to the National Revenue Fund.
Due to "some companies incorrectly interpreting the legislation or the legislation not being sufficiently clear", National Treasury is proposing amendments to the Second Schedule of the Royalty Act (i.e. the schedule for unrefined minerals – of which coal is one), as well as section 6A of the Royalty Act, which deals with the application of the Second Schedule.
To appreciate the impact of the proposed amendments, it is necessary to understand the current methodology applied in determining the mineral royalty payable in respect of coal.
Section 2 of the Royalty Act states that a mineral royalty is to be levied "in respect of the transfer of a mineral resource extracted from within the Republic". The mineral royalty amount is determined by multiplying the gross sales (as defined in the Royalty Act) of the extractor for that year of assessment ("the tax base"), with a percentage ("the royalty rate") as determined in terms of section 5 of the Royalty Act. The royalty rate is, however, also determined with reference to the gross sales of the extractor for that specific year of assessment. Needless to say, any impact on the gross sales of the extractor will have a substantial influence on the mineral royalty that is to be paid, as this will have an effect on the tax base, as well as the royalty rate to be used.
The gross sales amount for unrefined mineral resources is determined in terms of section 6(2) of the Royalty Act. In this regard, the Royalty Act determines that where a mineral resource is transferred "in the condition specified" in the Second Schedule thereof, the gross sales amount will be the "total amount received or accrued during the year of assessment in respect of the transfer of that mineral resource". Where the mineral resource is transferred in a condition other than the condition specified in the Second Schedule, the gross sales amount will be "the amount that would have been received or accrued during the year of assessment... had that mineral resource been transferred in the condition specified in Schedule 2 for that mineral resource in terms of a transaction entered into at arm's length". The "condition specified" for coal, in terms of the Second Schedule, is currently set at a minimum calorific value ("CV") of 19MJ/kg (referring to the energy potential per kg of coal).
When reading section 6 of the Royalty Act in isolation, mineral royalties will be payable when an extractor transfers coal at a CV of 19MJ/kg or higher. Commencing at a minimum CV of 19MJ/kg, there would thus be an unlimited range within which coal can be transferred. Where coal is transferred above the minimum condition specified, the extractor should determine the gross sales, at an arm's length price, that it would have or did receive for the coal at that higher CV.
The above interpretation of section 6 of the Royalty Act, however, completely ignores the provisions of section 6A thereof, which specifically deals with the application of the Second Schedule. In this regard section 6A(1) provides that:
"If any unrefined mineral resource –
a Is transferred below the minimum condition specified in Schedule 2 for that mineral resource, the mineral resource must be treated as having been brought to the minimum condition specified for that mineral resource; or
b Is transferred at a condition beyond the minimum condition specified in Schedule 2 for that mineral resource, the mineral resource must be treated as having been transferred at the higher of the minimum condition specified for that mineral resource or the condition in which that mineral resource was extracted."
Section 6A of the Royalty Act thus specifically provides for the situation where an unrefined mineral resource (i.e. coal) is transferred in a condition other than the minimum condition specified in the Second Schedule. Where an extractor transfers coal below the minimum CV of 19MJ/kg, that extractor, for purposes of determining its mineral royalty liability, will be deemed to have transferred the coal at the minimum CV of 19MJ/kg and as such, will be deemed to have received consideration equal to an arm's length price for the coal at a CV of 19MJ/kg, irrespective of the actual consideration received.
Similarly, where an extractor transfers coal at a CV over and above the minimum condition specified, that extractor will be deemed to have transferred the coal at the higher of the minimum condition specified or the condition in which the coal was extracted. Section 6A(1)(b) of the Royalty Act effectively ensures that an extractor only pays a mineral royalty on the coal that it extracts and does not get "punished" for beneficiating its coal (being the process of increasing the CV by removing impurities). Should the coal be extracted below the minimum CV of 19MJ/kg, but beneficiated to a CV higher than 19MJ/kg, the gross sales will be determined as if the coal was transferred at a CV of 19MJ/kg. In the event that coal is extracted at a CV higher than the minimum condition specified and transferred immediately thereafter or beneficiated and then transferred, the gross sales amount will be determined as if the coal was transferred at the point of extraction. This means that the extractor's gross sales will be determined on a deemed consideration amount i.e. an arm's length price for coal with a CV value as at extraction, but before beneficiation.
The above interpretation appears to be in line with the statement made by National Treasury in the Draft Explanatory Memorandum to the Royalty Act, wherein it stated that:
"The purpose of these alternative deviations is two-fold. Firstly, the Schedule 1 and 2 conditions are intended to act as minimum bases. This minimum base ensures that extractors do not structure their affairs so as to undermine the royalty (i.e. by adding little or no value to the mineral from its mine mouth condition so as to artificially reduce the gross sales value below general industry practices).
Secondly, it also prevents the royalty from acting as a hidden penalty for beneficiating mineral resources. The Schedule 1 and 2 conditions effectively acts as maximum bases upon which the royalty can be applied (so that additional addition by way of further beneficiation does not increase the gross sales base for the royalty)."
It is worth noting that in most instances, the price used by extractors to determine their gross sales for mineral royalty purposes, is the price at which it sells its coal to Eskom or an adjusted amount derived from the Eskom price.
The proposed amendments to the Royalty Act could, however, result in a substantial increase in a coal extractor's mineral royalty liability, where that extractor beneficiates its coal. The TLAB proposes amending the Second Schedule so as to no longer provide for a minimum condition in which coal is to be transferred, but instead creates a CV range of 19MJ/kg to 27MJ/kg within which coal is to be transferred. It furthermore proposes that section 6A be amended by the insertion of section 6A(1A), which is to read as follows:
"If any unrefined mineral resource with a range is transferred –
- at a condition below the minimum of the range of conditions specified in Schedule 2 for the mineral resource, the mineral resource must be treated as having been brought to the minimum of the range of conditions specified for that mineral resource;
- at or within the range of conditions specified in Schedule 2, the mineral resource must be treated as having been transferred at that condition; or
- at a condition above the maximum range of conditions specified in Schedule 2, the mineral resource must be treated as having been transferred at the higher of the maximum of the range of conditions specified for that mineral resource or the condition in which that mineral resource was extracted."
Accordingly, to the extent that coal is transferred below the minimum of the range of conditions specified (i.e. below a CV of 19MJ/kg), the determination of an extractor's gross sales remains unchanged, as the mineral royalty will continue to be determined on a deemed arm's length price, as if the coal was transferred at the minimum of the range. Where coal is extracted within the specified range and transferred at that extraction CV, the extractor's gross sales will be determined on the actual consideration received for the coal at that extraction CV.
However, as mentioned above, the proposed amendments could result in an increase in an extractor's gross sales where it beneficiates its coal. This is because the implementation of a CV range and the insertion of section 6A(1A) in the Royalty Act will result in the extractor's gross sales no longer being determined at a deemed arm's length price, but at the actual consideration it received for the transfer of its beneficiated coal.
While an extractor's gross sales would previously have been determined at a deemed arm's length price for coal transferred at the minimum condition specified, where it extracted coal below the minimum condition of 19MJ/kg and beneficiated it to a condition above the minimum condition, its gross sales will now be determined on the actual consideration received for the coal transferred at that beneficiated CV.
Similarly, where the coal is extracted within the specified range (i.e. above a CV of 19MJ/kg) and then beneficiated, the gross sales will no longer be determined on a deemed arm's length price for that coal at the extraction CV, but on the actual consideration received for the beneficiated coal.
According to statistics released by Eskom (http://www.eskom.co.za/c/article/200/coal-power/), South Africa produces an average of 224 million tonnes of coal a year, of which approximately 25% is exported. Of the 75% that is sold locally, it is estimated that 53% is used for electricity generation by Eskom. As the majority of local coal sales consist of sales to Eskom, which purchases coal within a relatively low CV range of 19MJ/kg – 21 MJ/kg, the effect of the proposed amendments should have a limited impact on extractors operating in the local market, as this coal requires very little or no beneficiation. The extractors to be hit hardest by these amendments, will be those operating in the export market, where the coal quality ranges between 24MJ/kg – 27MJ/kg and the sales price is considerably higher than the price paid by Eskom.
Although extractors should now be able to deduct the additional costs associated with beneficiating coal upon determining their Earnings before Interest and Tax ("EBIT"), when calculating the royalty percentage with which the tax base is to be multiplied, the additional deductions will not absorb the increase in gross sales created by the proposed amendments. Inevitably the royalty percentage will increase, which in turn will be multiplied with the higher tax base which will result in a greater mineral royalty liability for the extractor.
The proposed amendments will essentially not only levy a mineral royalty on the value of the coal extracted, but also on the value added to the coal through beneficiation and by doing so, "penalise" the extractor for beneficiating its coal.
The above was brought to the attention of both National Treasury and SARS during the first round of comments on the TLAB. Amongst other things, it was noted that one of the key principles agreed upon by National Treasury and the Mining Industry, prior to the enactment of the Royalty Act, was that the mineral royalty should be calculated at the mineral's first saleable point, as close to the mouth of the mine as possible. This would ensure that the State was properly compensated for the minerals that were being extracted and that the extractor was not taxed on the beneficiation of the mineral.
It was furthermore stated that "The proposed amendments create a disincentive for extractors to beneficiate their minerals further than the minimum specified condition and incur a higher royalty charge".
National Treasury and SARS' view on the above is, however, that the reference to "first saleable point" necessarily implies that some degree of beneficiation is required and that the extractor is sufficiently compensated through a reduced royalty rate. Although there is no doubt that some form or crushing and/or screening (coal beneficiation methods) is required to get coal to its first saleable point, the proposed amendments, especially section 6A(1A), would ultimately result in the mineral royalty being charged at the final saleable point when the maximum amount of value has been added and the selling price is at its highest.
Since coal has clearly been identified by National Treasury as an underutilised revenue source, it is perhaps time for a complete and thorough overhaul of the manner in which mineral royalties for coal are determined. In this regard, a distinction could be made between the different types of coal (such as thermal coal, coking coal and anthracite), as well as the different markets in which the coal is traded (which is determined by the different uses of the coal). Alternatively, it may be sensible for National Treasury to consider classifying coal beneficiated above a certain quality, as a Schedule One mineral resource, on which the effective royalty rate is lower than that of a Schedule Two mineral resource.
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.