27 October 2017 by Tax and Exchange Control Alert - 27 October 2017

A win for the mining industry: The High Court’s recent decision regarding the calculation of a royalty

In the recently decided matter of United Manganese of Kalahari (Proprietary) Limited v Commissioner for the South African Revenue Service (74158/2016) [2017] ZAGPPHC 628 (3 October 2017), United Manganese of Kalahari (Proprietary) Limited (UMK) applied to the Gauteng Provincial Division, Pretoria (High Court) for declaratory relief in relation to the correct interpretation and application of s6(3)(b) of the Mineral and Petroleum Resources Royalty Act, No 28 of 2008 (Royalty Act). 

Facts

UMK conducts ‘mining operations’ as defined in s1 of the Mineral and Petroleum Resources Development Act, No 28 of 2002 (MPRDA). It is an ‘extractor’ of an ‘unrefined mineral resource’ (it mines unrefined manganese) and is liable for payment of a ‘royalty’ in terms of s3 the Royalty Act. 

The High Court explained that as part of the value chain, the manganese ore is loaded onto trucks or trains for delivery to UMK’s customers. UMK bears the obligation to incur all costs necessary to effect delivery of the manganese from the mine to its customers, if so required in terms of the relevant contract delivery terms. These costs include transport, insurance and handling (TIH) costs. In its royalty calculation for the 2010 and 2011 years of assessment, UMK calculated its gross sales by deducting the TIH expenditure from the amounts it received in respect of its transfer of manganese.

The South African Revenue Service (SARS) conducted an audit and after numerous correspondence between the parties, SARS issued a letter of audit findings in relation to UMK’s royalty payment for the 2010 and 2011 years of assessment. The letter of findings stated, among other things, that UMK incorrectly deducted transport and distribution costs from gross sales and in so doing it estimated these costs instead of using actual costs incurred. UMK maintained that it determined its gross sales in terms of s6(3)(b) of the Royalty Act with reference to expenditure actually incurred by it, and not based on any estimated figures as SARS alleged.

UMK launched an application to the High Court to seek declaratory relief to obtain certainty in relation to the correct interpretation of s6(3)(b) of the Royalty Act.

Legal framework

Section 2 of the Royalty Act imposes the obligation on a person to “pay a royalty for the benefit of the National Revenue Fund in respect of the transfer of a mineral resource extracted from within the Republic”.

Section 3(2) of the Royalty Act further provides for the manner in which the royalty is calculated. In terms of s3(2), the royalty “in respect of the transfer of an unrefined mineral resource is determined by multiplying the gross sales of the extractor in respect of that mineral resource during the year of assessment:

(a)  by the percentage determined in accordance with the formula in s4(2); or

(b)  by the percentage determined in accordance with the formula as the Minister may announce in the national annual budget contemplated in s27(1) of the Public Finance Management Act, 1999 (Act No 1 of 1999) with effect from a date mentioned in that announcement.” 

The formula presently applicable in s4(2) is as follows:

     0.5 + [earnings before interest and taxes/(gross sales in respect of unrefined mineral resources x 9)] x 100. 

In terms of s4(3)(b), the percentage determined in terms of the formula must not exceed 7%.

Section 6(2)(a) states that gross sales in respect of an unrefined mineral resource transferred - as mentioned in paragraph (a) of the definition of ‘transfer’ in s1, in the condition specified in Schedule 2 for that mineral resource - is the amount received or accrued during the year of assessment in respect of the transfer of that mineral resource.

Section 6(3)(b) states that for purposes of s6(2), gross sales are determined without regard to any expenditure incurred in respect of transport, insurance and handling of an unrefined mineral resource after that mineral resource was brought to the condition specified in Schedule 2 for that mineral resource or any expenditure incurred in respect of transport, insurance and handling to effect the disposal of that mineral resource.

Schedule 2 to the Royalty Act sets out the conditions that mineral resources, including manganese, must meet in order to constitute an “unrefined mineral resource”.

Judgment

UMK contended that it was entitled, in terms of s6(3)(b) of the Royalty Act, to calculate its gross sales by deducting the TIH expenditure, or any expenditure incurred by it in respect of TIH, after the manganese was brought to the condition specified in Schedule 2, or to effect the disposal of the manganese, from the amounts received by or accrued to it during the 2010 and 2011 years of assessment in respect of its transfer of manganese.

SARS, on the other hand, contended that UMK may only deduct those costs that were included in UMK’s prices to its customers, in calculating gross sales as contemplated in s6(3)(b). Stated differently, if UMK’s gross revenue is simply a function of the market price applying from time to time and not a function of the costs incurred in delivering the manganese to its customers, such costs cannot be deducted from gross sales as contemplated in s6(3)(b). 

SARS opposed the relief sought by UMK on a number of different grounds. Firstly, SARS argued that the High Court lacked jurisdiction to hear the matter. The matter ought to properly have been brought in the Tax Court after SARS had had an opportunity to render a decision in respect of the assessments at issue. The High Court rejected SARS’s argument and referred to tax cases where it had been decided that a Superior Court has jurisdiction to hear and determine tax cases turning on a question of law. As the issue before the High Court did not involve a question of fact, but simply one of law, the Commissioner for SARS and the Tax Court were not the only competent authorities to decide the issue.

Secondly, SARS argued that UMK failed to exhaust its internal remedies provided for in the Tax Administration Act, No 28 of 2011 (TAA). The High Court held that it has the power to decide tax matters where the relief sought is for declaratory orders involving questions of law only or is interlocutory in nature, without first exhausting the remedies provided for in the TAA.

Thirdly, SARS contended that the granting of declaratory relief is discretionary and the court ought not to exercise its discretion to grant such relief in the circumstances of the case. However, the High Court took the view that it should exercise its judicial discretion in favour of the adjudication of the relief sought as there are no judicial pronouncements on the interpretation and application of the Royalty Act.

Finally, regarding the merits of the case, SARS argued that the language of s6(3)(b) of the Royalty Act is clear and unambiguous and that the interpretation contended for by UMK ought not to be adopted by the High Court.

On the question of the interpretation of s6(3)(b), the High Court said that the section must be interpreted in accordance with the established principles of interpretation. The words used in s6(3)(b) were clear and unambiguous and made it plain that, in calculating the royalty payable, the legislature intended to exclude TIH “expenditure incurred” post the condition specified in Schedule 2 and TIH “expenditure incurred” to effect the disposal of the mineral resource. That is, whether or not the extractor, being UMK in this case, “actually received” or is “entitled to” recover the TIH costs from its customer. 

Section 6(3)(b) can only be understood to provide for the exclusion of all expenditure relating to TIH costs incurred by the seller of an unrefined mineral resource and the provision is not limited to amounts received by or accrued to a seller in the recovery of distribution costs. It contains no provision in terms of which UMK (an extractor) would have to show that expenditure incurred in respect of TIH or expenditure incurred in respect of TIH to effect the disposal of the mineral resource occurred in circumstances where such expenditure was taken into account in determining UMK’s gross price.

The High Court noted that the legislature deleted the words “any amount received or accrued for the TIH of an unrefined mineral post the condition specified” in Schedule 2 and the words “any amount received or accrued” to effect the disposal of that mineral resource, when s6(3)(b) was amended. These words were substituted with the words “any expenditure incurred” in respect of the TIH of an unrefined mineral resource and “any expenditure incurred” in respect of transport, insurance and handling to effect the disposal of that mineral resource. According to the High Court, this indicated that the legislature intended to exclude TIH expenditure incurred after the condition specified in Schedule 2 and TIH expenditure incurred to effect the disposal of the mineral resource, whether or not the extractor “actually received” or is “entitled to” recover the TIH costs from its customer. In other words, whether or not the TIH expenditure was included by the extractor in the calculation of its sales price(s).

The court ordered that UMK is entitled to calculate its gross sales by deducting any expenditure incurred in respect of transport, insurance and handling of the manganese after the manganese had been brought to the condition specified in Schedule 2 of the Royalty Act and any expenditure incurred in respect of transport, insurance and handling to effect the disposal of the manganese. It held that such expenditure could be deducted irrespective of whether any such expenditure was specifically and/or consciously considered in the determination of UMK’s gross sales and irrespective of whether such transport, insurance and handling costs were of a capital nature.

Comments

Interestingly, prior to the decision in this matter, SARS issued a draft binding general ruling on 10 March 2017, which suggested that “all expenditure in respect of transport, insurance and handling incurred after the mineral resource is brought to the condition specified in Schedule 1 or 2 must not be taken into consideration when calculating gross sales and EBIT”. It remains to be seen whether s6(3)(b) will be amended in order to state that a deduction of TIH is not allowed, as SARS argued in this matter.

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