Minerals, oil, and gas in South Africa

5. Mining has historically been the mainstay of the South African economy. Mineral exports remain the principal contributor to foreign exchange earnings from merchandise exports (30.4 percent in 2013, Figure A1¹). Mining enterprises remain significant employers at 6 percent of wage employment—though numbers are much reduced from the past. The sector’s contribution to government revenue, however, is down from a peak of nearly 29 percent in 1981—of which nearly 93 percent came from gold—to just 2.5 percent in 2013/14 with a negligible contribution from gold.² Large-scale mining began in South Africa in the nineteenth century: the sector is thus mature and some minerals, particularly gold, are substantially depleted given current techniques, costs, and prices. The country still has enormous resources, however, and products such as coal and iron ore have assumed great importance.

6. South Africa is not yet a significant producer of crude oil or natural gas. During the apartheid era South African state-sponsored firms developed technology for producing synthetic fuels and petrochemical inputs from coal. One natural gas project at Mossel Bay was developed for gas-to-liquids conversion. These activities were developed in response to international sanctions that limited oil and petroleum product imports and production continues today. In 2004 the former state company, SASOL, commenced imports of natural gas from Mozambique for distribution and for petrochemical inputs.

7. Oil and gas exploration nevertheless shows promise. In the past 10-15 years almost all potential offshore acreage has been licensed, with participants including most of the major international oil companies (IOCs).³ Strong interest also exists in shale gas potential in the Karoo Basin, with five blocks likely to be licensed for exploration in the near future. Offshore conditions for exploration and development are extremely challenging: in addition to water depth, deep sea currents and surface weather conditions add to the cost and risk of operations. Although offshore exploration targets are large oil fields (in the region of one billion barrels of recoverable reserves), associated gas is a strong possibility. Both shale gas and offshore associated gas would be sold in the domestic market, making both pricing and competition in potential supply critical matters.

Considerations influencing fiscal regimes

8. Taxation is far from top of the list in current challenges facing the development of EI in South Africa. The “fiscal regime” broadly defined in the language of this report (see Box 1) has, however, become much more important with recent proposals for amendment of the MPRDA that include possible extensions of concessional participation by the state in petroleum activities, or by enterprises representing HDSA. Other challenges have dominated debate in recent times.

9. Returns to mining activities in South Africa appear to have declined. While a decline is not universal, data from pwc, a professional services firm, suggest reductions in returns to capital employed in the mining industry over a number of years.⁴ According to data from Statistics SA (Figure A4) returns to capital employed in the mining industry fell to 3.6 percent in 2013 from nearly 21 percent in 2008. Most of the causes are not fiscal. The recent sharp falls in commodity export prices on world markets have played a part, but the sector did not prosper as expected during periods of high prices. The mining sector is substantially reliant on reinvestment decisions by South African domiciled companies. New foreign investment in the mining sector has remained significant in Rand terms (Table A6). Large mining houses such as Anglo-American and BHP Billiton that were previously listed on the Johannesburg Stock Exchange (JSE) have delisted and moved domicile, mainly to London.

10. Depletion of known reserves has become severe in long-established sections of the mining industry. Depletion particularly affects the traditional gold mining sector. Gold mining now largely consists of deep underground operations, where even marginal ores have limited availability. New techniques (and higher prices) would be required to make it possible to go even deeper, where additional resources are already known to exist. Depletion also affects the diamond and platinum sectors with respect to known reserves. Substantial new discoveries of kimberlite pipes bearing diamonds appear to be unlikely. For platinum, however, significant new reserves may be available in the known reef systems, possibly leading to new mine developments as well as extensions of existing ones.

11. Coal has become the leading mine product by value with iron ore possibly the most profitable. South Africa is a large consumer of coal for power generation, while exporting coal of higher quality after further screening and washing. Coal exports were 29 percent of total production by volume in 2012 but a higher proportion by value. The privately-owned Richards Bay coal terminal is an efficient export facility and is expandable. Production of iron ore is centered on four large mines—iron ore is one sector where foreign direct investment is important with Anglo-American and Glencore strongly represented.

12. Labor costs in mining have risen sharply and major strikes have recently occurred. In the face of significant secular falls in productivity in gold mining resulting, in part, from depletion and limited new investment in mechanization, workers across the industry have still secured rates of wage increase. Unit labor costs in mining outpaced those of other sectors since 2000 (Figure A5) though reduced productivity as ore grades fell, and capital investment did not compensate, mattered as much as wage rises. A large-scale strike in 2014 at platinum mines in and around Rustenburg was settled only after five months. In 2012 tragic deaths occurred during workers’ protests at Marikana, into which inquiries continue. Living conditions at mine townships, in addition to wage levels, appear to have contributed to the intensity of industrial action and protests. Debate continues about the appropriate extent of responsibility of mining companies for direct provision of housing and amenities compared with the alternative of paying “living-out” allowances to workers.

13. The national goal of economic and social transformation in favor of HDSA has major impact on the mining sector. Under the Mining Charter and the relevant Codes of Good Practice for Broad-Based Black Economic Empowerment (B-BBEE) mining companies were to have transferred 26 percent of equity ownership in their operations to HDSA companies (a process more commonly known as Black Economic Empowerment, BEE) by November 2014, with a report on compliance due to be published in 2015. In most cases, BEE is financed by the transferring company with repayment out of subsequent dividends: where an enterprise fails no recourse is available. Thus the process has an unavoidable effect on anticipated returns to domestic private investment. BEE requirements also apply to new foreign investors. BEE also affects the commercial structure of the industry, since BEE interests have usually been transferred into companies distinct from the original company structure.⁵ Uncertainty also remains over the issue of “once empowered, always empowered”: in other words, if a BEE company is sold or sells its interest in a mine, other than to another BEE entity, does the original investor have a further obligation to create a new 26 percent BEE interest?

14. The government gives high priority to industrial development using mining as a base. Thus policy is directed towards promoting “linkages”⁶ and, in particular, “beneficiation” of minerals. “Beneficiation” in South African usage means transformation of mineral commodities beyond the stage of the first saleable product, using domestic investment and labor, to produce a higher quality mineral product or fabricated product of which the mineral commodity is the core material. Linkages and beneficiation are promoted by policy encouragement, regulation, and in some cases fiscal incentives. In public discourse, beneficiation appears to secure greater attention than the imperative of generating fiscal revenues. Debate continues over the use of export taxes to promote beneficiation: the one prominent example so far is the diamond levy on exports, designed (so far without great success) to promote a domestic cutting and polishing industry.

15. Infrastructure constraints have become acute, bearing heavily on the mining industry. Power generation and distribution remains the responsibility of ESKOM, the state-owned electricity utility, which has for some time been unable to maintain consistent supply to industrial and residential consumers. Frequent load-shedding has caused supply interruptions which, in turn, have forced some enterprises to invest in their own power infrastructure. In order to provide for better supply, ESKOM’s regulated tariffs have been raised substantially, but remain at higher levels for residential consumers than for industrial users (Figure A6). Many mining and beneficiation processes rely on intensive water use for cooling, separation, or washing of product before sale. Water supply is also reputedly now constrained, according to the mission’s discussions with the private sector. Finally, transportation infrastructure at railways and ports is overloaded, notably the two main rail connections to ports that transport bulk materials such as iron ore and coal.

16. New proposals for state participation in upstream petroleum ventures follow long debate about state involvement in mining. The 2014 Amendment Bill for the MPRDA of 2002 introduced the possibility of a “free carried interest” of 20 percent in petroleum ventures, with an option for additional paid equity interests. The upstream petroleum exploration companies made strong representations about these provisions; the President referred the Bill back to Parliament in January for other reasons but the petroleum provisions also came under renewed scrutiny.⁷ The ANC’s report on State Intervention in the Mineral Sector (SIMS) of 2012 considered the possibility of new state equity participation in the mining sector but came down in favor of additional taxation, and regulation to encourage linkages and beneficiation. Two state-owned mining enterprises operate but as commercial enterprises in their own right. The fiscal implications of state participation in mining or petroleum have not been set out; the motivation for these interventions appears to be non-fiscal, in search of “control”, or technology and skills development benefits.

17. Additional actual or proposed indirect levies, some as environmental charges, bear upon the mining sector. Discussed in detail in Chapter III, some of these function as taxes on inputs or otherwise raise costs of production.

18. Thus the operation of the current fiscal regime, or of new proposals, is circumscribed by multiple other considerations. South Africa’s current fiscal position is challenging⁸ and hence the requirement for the DTC to examine the revenue potential of the mining sector, taking account of wider considerations for transformation and the generation of employment. The task is to examine the fiscal regime with a view to generating a sustainable revenue contribution from mining and petroleum in future—which requires both an attractive climate for new investment to develop the tax base and a fiscal system that secures a reasonable contribution to state revenues from production and a higher share from especially profitable operations.

Scope of the EI Fiscal Regime

Interface between Special EI Rules and General ITA Rules

41. Once the scope of an EI fiscal regime has been set, there is an issue as to the location of the special rules that make up that regime. There is also an issue as to how those special rules interact with the general rules of the tax law in question. As to location, the SA approach to special rules for mining in the ITA is in stark contrast to the special rules for petroleum. The “mining regime” is scattered throughout the ITA. There is an attempt to isolate the special rules for petroleum in the Tenth Schedule of the ITA. The latter approach seems more instructive and can assist in retaining the structure of the general rules (part of the problem with navigating the ITA is that general rules are constantly mixed with special rules). The collecting of special rules can (but need not) be in a separate schedule, they can be placed in a dedicated division of the relevant tax law. Some countries have also considered placing the special rules for the EI in a special tax law. No matter which form is adopted, the issue of interface between the general rules and special rules remains the same.

42. There is some uncertainty as to the interface of the special mining rules and other ITA rules of a more general nature. In some cases the disapplication of a general rule for mining operations is express in that rule—the deduction under s. 12C, s. 12E and s. 13, and see s. 11D regarding research and development expenditure and oil and gas or mineral exploration or prospecting. In other cases it is not so clear: s. 12I and proposed s. 12L, particularly if the benefit of a provision is granted as a matter of discretion. Some of the special mining rules such as s. 15(1)(a) specifically disapply other provisions. Again, this fragmentation could be addressed by bringing together all of the special rules that apply to mining.

43. It seems that because “mining” under the ITA can include petroleum extraction, the exclusion of mining from the operation of specific provisions of the ITA will also exclude petroleum operations. This is despite the prescription in s. 26B that the income of an oil and gas company is determined under the general rules of the ITA but subject to the provisions of the Tenth Schedule. What is less clear is whether any of the specific provisions for mining operations apply to oil and gas companies. This might be an issue where the ring fence for a particular expense is broader or narrower under the mining provision than under a Tenth Schedule provision. For example, s. 15, s. 15A, s. 36, s. 37 and s. 37A make no reference to “natural oil” or “oil and gas”. It seems likely that at least s. 15A on trading stock would also apply to oil and gas companies.

44. There might also be reconciliation issues between general provisions of the ITA and the provisions of the Tenth Schedule. One example is the question of whether the general deduction rule in s. 11 can apply to amounts that otherwise fall to be deducted under paragraph 5 of the Tenth Schedule. Again, this might be important because as a general rule amounts deductible under s. 11 are not subject to a ring-fence. Indeed, s. 26B presumes that “taxable income of any oil and gas company” is “defined” in the Tenth Schedule, but that seems an inaccurate statement as there is no such definition in the Tenth Schedule. Outside of s. 26B, there are no express rules that reconcile the provisions of the Tenth Schedule with the remainder of the ITA.

45. There is again a major contrast between mining and petroleum under the ITA when it comes to the location of tax rates. As a general rule, mining is subject to standard income tax rates. A special rate formula applies “in respect of the taxable income derived by any company from mining for gold [and certain by-product minerals] on any gold mine”. This gold mining formula raises a number of issues, some of which are discussed below in Chapter III. For present purposes, it is enough to note that the formula requires the segregation of “taxable income from mining for gold” from the remainder of a company’s taxable income. There are few legislative rules for performing this apportionment, although given the long term standing of this formula an acceptable practice has built up with some administrative discretion. These rates of tax for mining are located in the annual rates law. The rates for the current year are located in paragraph 3 of Appendix I of the Rates and Monetary Amounts and Amendment of Revenue Laws Bill, which is currently before Parliament.

46. By contrast, the rates for petroleum are set out in paragraph 2 of the Tenth Schedule of the ITA, not in the annual rates law. One critical consequence of this is that a fiscal stability agreement in terms of paragraph 8 of the Tenth Schedule can apply to the rate of tax “on taxable income derived from oil or gas income”. Leaving aside the disparate location of these rates, an important point is that except in the case of taxable income from mining for gold and taxable income from oil or gas (terms which themselves are not precisely defined), there is no legislative framework for distinctly identifying taxable income from mining. This impacts on the manner in which (the fragmented) ring-fencing operates. It is also something that would have to be addressed if a special rate of tax were to apply to mining income or, depending on its nature, some form of additional tax were to apply to mining (such as a resource rent tax).

Reconnaissance

47. Expenditure incurred in reconnaissance and exploration is another area where there is no coordination between the MPRDA and the ITA. The MPRDA regulates reconnaissance permits (s. 13 to s. 15 for mining and s. 74 to s. 75 for petroleum), prospecting rights (s. 16 to s. 19 for mining), technical co-operation permits (s. 76 to s. 78 for petroleum) and exploration rights (s. 79 to s. 82 for petroleum). There is a suite of definitions that detail the scope of what is covered under each of these rights.

48. It is largely impossible to relate this regulatory environment to rules in the ITA. The body of the ITA seems to make no reference to reconnaissance, as such. The renewal of a reconnaissance permit does not trigger capital gains taxation (para. 67C of the Eighth Schedule). Further, a gain on the disposal of a petroleum reconnaissance permit is oil and gas income for the purposes of the Tenth Schedule (para. 1, definition of “oil and gas right”). It seems that this means that “reconnaissance operations” (as defined in the MPRDA) are subject to general income tax rules.

49. In particular, expenditure incurred in reconnaissance may be deductible under s. 11 of the ITA. However, there seem to be two risks here. One is that the expenditure is incurred pre-trading (not in the “production of income”), although s. 11A permits a deduction for pre-trading expenses. Depending on the facts, the reconnaissance expenditure might also be seen to be part of an existing mining business. In the context of petroleum reconnaissance, under paragraph 6 of the Tenth Schedule a person holding a petroleum right (including a reconnaissance permit) is deemed to be carrying on a trade and expenditure is deemed to be incurred in the production of income. While not express, this would seem to disapply s. 11A. The second risk is that such expenditure might be considered to be “of a capital nature”. This seems unsatisfactory and the treatment of expenditure incurred under a reconnaissance permit should be clarified, at least for mining.

Exploration

50. By comparison, the ITA does have some special rules for “prospecting” and “exploration”. “Prospecting” is not defined (although s. 15(b) includes “surveys, boreholes, trenches, pits and other prospecting work preliminary to the establishment of a mine”) and so it is not clear whether the definition in the MPRDA is relevant or whether, for example, “prospecting” in the ITA may be interpreted sufficiently broadly to cover activities falling within the definition of “reconnaissance operations” as defined in the MPRDA (which specifically excludes “prospecting”). The body of the ITA does not have a definition of “exploration”, although uses that term in a number of contexts with the term “prospecting”.

51. “Exploration” is defined in the Tenth Schedule of the ITA, but there are substantial differences between this definition and the definition of “exploration operation” in the MPRDA. In particular, it seems possible that the definition in the Tenth Schedule might include at least some activities that fall within the definition of “reconnaissance operations” in the MPRDA.

52. S. 15(b) of the ITA particularly allows a deduction for expenditure incurred in “prospecting operations”. However, as the deduction is only from income derived from mining operations, if the person incurring the expenditure has not yet proceeded to conducting mining operations there can be no deduction under s. 15(b). It seems that any mining operations would be sufficient to secure the deduction, even if the prospecting is not related to them. The tax administration has some discretion over the timing and allocation of the deduction. If the person incurring the expenditure conducts no mining operations, it seems that the person would have to look to other rules (e.g., s. 11) if seeking a deduction. It seems that the 150 percent deduction for research and development expenditure under s. 11D is available for “research and development carried on to develop technology used for” mineral or oil and gas exploration or prospecting. It is presumed (though not clear) that s. 15(b) and s. 11D are mutually exclusive.

53. By contrast, it is clear that all expenditure on exploration is deductible in calculating taxable income from oil and gas for purposes of the Tenth Schedule of the ITA (para. 5(1)). Further, the 100Main percent uplift in paragraph 5(2)(a) is available for all exploration expenditure, but only if it is of a capital nature. What is and what is not “of a capital nature” is not defined in the ITA and depends on a complex body of case law. In addition, only 50 percent uplift is available for “post-exploration” expenditure of a capital nature. As “exploration” and “post-exploration” are not defined by reference to whether an activity is conducted under an exploration or production right, there is likely to be difficulty in determining whether particular expenditure qualifies for 100 percent or 50 percent uplift.

54. Indeed, the difference in tax treatment between “exploration” and “post-exploration” expenditure may have distorting effects. It may be desirable from a tax perspective to hold an exploration right for as long as possible to support an argument that capital expenditure must be exploration expenditure. Placing such an important tax difference (between 100 percent, 50 percent or no uplift) on two particularly difficult distinctions (capital/revenue and exploration/post exploration) seems mistaken. In addition, the interface between these rules and the 150 percent deduction for research and development expenditure in s. 11D is not express.

Development and Production

55. As noted above, the general ITA rules apply in calculating income from mining, but this is subject to some important exceptions. Typically, operating expenditure is deductible under the general deduction rule in s. 11. The rule for trading stock in s. 22 is adapted for purposes of application to “mining operations” (s. 15A), which as noted above is presumed to include petroleum operations.

56. The most important special rule for mining operations is the deduction in s. 15(a) of the ITA for “capital expenditure” defined in terms of s. 36. As discussed above with respect to s. 15(b) (exploration), the deduction is only available against “income derived by the taxpayer from mining operations” and so expenditure incurred prior to commencement of those operations is not covered by s. 15. S. 36(11) contains a highly customized definition of “capital expenditure” which covers expenditure on many development and production activities. However, there is no direct relationship between expenditure on activities covered by this definition and activities regulated under the MPRDA, e.g., with respect to a mining or production right. A reconciliation rule ensures that any prospecting expenditure deducted under s. 15(b) is not “capital expenditure” for the purposes of s. 36 (s. 15(b)(iii)).

57. The primary category of capital expenditure is that on shaft sinking and mine equipment and as a rule interest, finance charges and management fees are excluded. However, capital expenditure does include “expenditure on development, general administration and management … prior to the commencement of production or during any period of non-production” and here even interest on loans may be included. There is little in the way of definitions to assist with interpretation of this addition (e.g., does “production” relate to anything under the MPRDA?) and it seems that at least some of these expenses may be deductible under the general provision of s. 11 of the ITA.

58. Not all capital expenditure incurred in mining operations is covered by s. 36(11). Particular issues arise with respect to the cost of intangibles (including the mining right, options and goodwill) and the cost of land and surface rights. Certain capital expenditure for employees is covered by the deduction (such as with respect to housing, hospitals, schooling, motor vehicles and recreation facilities) but spread out over ten years. However, similar capital expenditure for the community in which mining operations are conducted is not covered (so called discretionary or informal expenditure not covered by the social and labor plan). While an obvious deduction for accounting purposes, it is not clear how in this case an EI operator would get direct tax relief for this business expense. A deduction may be available if the community registers a public benefit organization under s. 30 and the operator makes a “donation” of “cash or property” (s. 18A). It is not clear that this would cover all benefits and services provided to local communities.

59. As a whole, the capital expenditure regime for mineral operations is little more than a disarmingly confusing and fragmented depreciation regime. The deductible amount under s. 15(a) of the ITA is reduced by amounts received from disposals of assets whose cost has in whole or in part been previously deducted (“capital expenditure incurred”, defined in ITA s. 36(11)). Any excess amount received is included in income (para (j) of the definition of ‘gross income’ in ITA s. 1). This is effectively a balancing charge. For amounts that are incurred in activities regulated by a mining right and that do not fall within that regime, one is again left searching for the relevant tax treatment in the general rules of the ITA.

60. In addition to the deduction for capital expenditure, certain gold mines are entitled to an uplift of what is effectively the unredeemed amount of qualifying capital expenditure (para. (c) of the definition of “capital expenditure” in ITA s. 36(11)). The uplift rate is 10 percent for post-1973 mines and 12 percent for post-1990 mines applied on a compound basis. The overall effect of this is of a style similar to an ACC, but of a peculiar nature where only certain expenses are counted (e.g., generally not operating expenses) and there is the potential to deduct and include for uplift at least some interest expense (see above). The effect of the uplift is to put pressure on identifying certain types of expenditure from certain types of activities.

61. Similar pressure occurs in the context of petroleum development and production due to the distinction between “exploration” and “post-exploration” in the Tenth Schedule of the ITA (noted above). The increases of 100 percent and 50 percent in capital expenditure on exploration and post-exploration activities (respectively) are not compounded in the way that the additional allowance for gold mining companies is.

62. This mechanism of using 100 percent and 50 percent increases in the Tenth Schedule of the ITA is particularly distorting. The increases are once and for all and are not apparently subject to recoupment if capital expenditure is redeemed. In particular, proceeds on disposal of an asset that qualified for the deduction is not increased by a similar percentage. There could be an incentive to sell an asset into a petroleum company and buy it back shortly after for a very significant tax advantage (subject to the general anti-abuse rule).

Decommissioning and Rehabilitation Expenditure

63. The nature of extraction in the EI and particularly mining requires large expenditure on decommissioning and rehabilitation. As a consequence, EI right holders are required to secure environmental authorizations for purposes of conducting mining operations in terms of s. 24 of the National Environmental Management Act, 1998. EI right holders are required to provide “financial or other security to cover the risks to the State and the environment of non-compliance with conditions attached to environmental authorizations”. The method of providing the security is laid out in the Mineral and Petroleum Resources Development Regulations (Reg. 53) and are primarily by way of contribution to a trust fund meeting the requirements of the ITA (s. 37A) or by provision of a financial guarantee approved by the DMR.

64. S. 37A of the ITA provides an EI operator with a deduction for “cash paid” to a trust or company meeting the requirements of the section. The operator must hold a “a permit or right in respect of prospecting, exploration, mining or production” or, so it seems, not the holder of the permit or right but, according to the terms of that permit or right, engaged in prospecting, exploration, mining or production. While these activities are not defined, it seems logical to interpret them in the context of the MPRDA. A company or trust that meets the requirements of s. 37A is exempt from tax (s. 10(1)(cP)). There are several restrictions on investments that such a trust or company may make and penalties for transfers from the trust or company before DMR provides a closure notice.

65. The requirement of a cash payment into the trust or company has made the form of financial provision contemplated by s. 37A of the ITA unpopular. Many EI operators prefer to provide various forms of financial guarantees. This route does not lead to a deduction and no provisioning is permitted. It appears that some EI operators may have tried to replace their rehabilitation trusts with a DMR approved guarantee and exposed themselves to double taxation of the full value of the trust fund when it was transferred out of the fund. This is under the penalty provisions which would tax the trust fund at the trust rate (40 percent) and also include the value in the income of the EI operator. The DMR also has particular difficulties with old-style EI rights, which do not have as part of their terms a legal requirement to establish a trust fund.

66. Presuming that actual expenditure by an EI operator on rehabilitation is not covered by reimbursement from a trust fund, an issue is the ITA treatment of such expenditure. It seems that the deduction for capital expenditure under s. 15(a) cannot apply because expenditure “in respect of infrastructure or environmental rehabilitation” is excluded from the definition of “capital expenditure” in s. 36(11) (para. (e) of the definition). The general deduction rule in s. 11 might apply, but there must be some risk that some types of rehabilitation expenditure might be “capital in nature”. There must also be a risk that some types of rehabilitation expenditure might be incurred after an EI trade has ceased.

67. A difficult question is the extent to which s. 37A of the ITA applies to petroleum operations. The terms of s. 37A are broad enough to apply to petroleum operations but s. 28B effectively gives priority to the Tenth Schedule. Rehabilitation could not be “exploration” for the purposes of the Tenth Schedule but one questions whether it could be “post-exploration” as defined in paragraph 1. Literally, it seems that rehabilitation is an “activity carried out after the completion of the appraisal phase”, but one also questions whether a contribution to a rehabilitation fund could be. If that is possible, then a deduction would be available under paragraph 5(1) of the Tenth Schedule. An additional question would then be whether rehabilitation expenditure or a contribution to a rehabilitation fund could be “of a capital nature”. At issue is whether such payments might qualify for the 50 percent uplift. This area seems in need of clarification.

Losses and Ring-fencing

68. Most income tax laws provide (at least in some circumstances) for a loss of a taxpayer incurred on one activity to be set against income the taxpayer derives from another activity (sideways relief). This is particularly so under the basic global approach adopted in the ITA. This can be distortive when taxpayers competing in the same industry are compared. One taxpayer may incur the full impact of losses whereas another may get relief for those losses by setting them against taxable income from another activity. Absent a system under which government provides cash payments for losses (government shares the full extent of downside as well as upside of activities) these distortions are present in all income tax laws that permit sideways relief.

69. While distortions arising from losses are inherent in most income tax laws, this can be particularly problematic in industries like the EI. This is because the EI involve large upfront expenses and long lead times before income is derived. If one EI operator has income against which these large front loaded costs can be set, they are at a substantial competitive advantage to a new entrant in the industry that does not have access to that relief. In other words, sideways relief provides an advantage to large well established operators compared to new entrants. This can be particularly acute where, as in the SA EI tax regime, large amounts of capital expenditure are immediately deductible. The balancing factor is that allowing this relief subsidizes and so encourages investment in these large scale projects.

70. Sideways relief can also be problematic in the opposite direction, where losses from other activities may be set against income from EI. This is the case where, as in many countries, the EI regime imposes a higher tax on income from EI than that imposed on other industries. At the moment, limitations on sideways relief under the ITA seem to be largely one way in character; they limit the use of deductions under the EI regime from being used against other income but have no apparent limitation on losses from other trade activities being set against income from EI (ITA s. 20). One exception is that foreign trade losses cannot be set against SA source income. In the future, should SA wish to tax EI at a higher rate than other industries, EI income will need to be protected from this form of set-off.

71. Further issues arise if different tax rates are applied to different activities or an attempt is made to limit the use of losses from one activity against the income from another activity. In this case, rules are required for allocating income and expenses between activities -this is referred to as ring-fencing. Here there is no global calculation of income, but rather the calculation of income becomes “scheduler”. While the SA income tax has scheduler features, its rules for allocating income and deductions between different activities are particularly confused and uncoordinated, at least in legislative form. The fragmented nature of the ITA rules applicable to the EI that were discussed above is reflected in the ring-fencing rules that apply to income from EI.

Acquisition and Disposal of EI Rights

Royalties

102. The scope of the MPRRA was discussed above. That discussion considered in particular the interface of the MPRRA with the MPRDA and complications arising because the imposition of royalties is triggered by a “transfer” of minerals. It was also pointed out that there are some mining right holders (such as aggregate extractors) that are subject to royalties but not entitled to the benefits of the mining rules in the ITA.

103. Other problems seem to be caused by the valuation of minerals under the MPRRA and its interface with the rate formula. The rate formula in s. 4 differentiates between “refined” and “unrefined” mineral resources, with a higher rate generally applying to unrefined resources. This differentiation was intended to reduce the potential that royalties would be imposed on value added to extracted minerals through processing (beneficiation). The identification of refined and unrefined resources in the First and Second Schedules seems a blunt instrument for excluding value added through beneficiation. Some resources are provided a specific concentrated value in these Schedules and others are provided a range. This then requires separate valuation rules depending on whether the concentration is specific or a range (s. 6 and s.7).

104. One problem with the valuation rules in the MPRRA is that the transaction price on transfer must be adjusted if the transfer is at a grade not mentioned in the Schedules. This raises questions as to whether or not determining the royalty at the point of “transfer” is critical (as opposed to export or extraction).

105. A second problem occurs as a result of 2013 amendments and is where the Second Schedule of the MPRRA (unrefined resources) contains a range. If the resources are transferred at a condition within that range, effectively the transaction price is used (s. 6A(1A)(b)). This means that because resources with a higher grade sell at a higher price, such resources also attract a higher royalty. As the higher grade may have been secured through processing, the result may tax beneficiation in a manner that is inconsistent with the original approach in the MPRRA. In particular, as discussed in Chapter III, this has caused an increase in the calculation of royalties payable by the coal industry.

106. Other issues arise from the complexity of the royalty formula in s. 4 of the MPRRA. This formula adjusts the royalty, within maximum and minimum rates, according to a person’s “earnings before interest and taxes”. This concept is largely derived from concepts used in the ITA, but it seems many details are not specified. Without drilling into the details of these concepts, the basic premise of the income adjustment may be questioned, at least when balanced against the simplicity of a flat rate royalty system. The MPRRA includes adjustments in relation to income while, as discussed above, the EI fiscal regime in the ITA includes some features consistent with a resource rent tax. These qualifications are to the confusion and complexity of both systems. Perhaps there would be greater policy clarity through a simple royalty, standard income tax and possible additional RRT with clear legal separation.

Recommendations

• Clarify MPRDA regulation of processing, leasing of rights and sub-contracting

• Amend the ITA to identify EI activities and EI rights by following MPRDA classifications and to follow MPRDA regulation generally

• Move the special rules that deal with particular features of mining to a new Part or Schedule in the ITA (or any rewritten version)

• Petroleum should be treated in a consistent manner, but in a separate Part or Schedule from mining

• Incorporate comprehensive reconciliation rules identifying which general rules of the ITA continue to apply to EI activities and which are overridden by the special rules in the new Parts

• Calculate income from EI activities on a right by right basis (activities with respect to each right deemed to be a separate trade)

• Apply transfer pricing rules in dealings between each EI trade conducted by an EI operator and an EI trade and non-EI trades conducted by the operator

• Ring-fencing should be on a right by right basis and in both directions (no loss from one right’s activities against any other income and no loss from other activities against income from right’s activities)

• Ensure that breaches of ring-fencing are based on clear policy objectives

• Define the particular breaches for reconnaissance expenses and exploration expenses

• Clarify and make explicit the treatment of reconnaissance, exploring, development and production and rehabilitation costs

• Revenue and capital amounts that go to make up EI income should be treated in a consistent fashion

• Deductions for capital expenditure (to the extent permitted) should contribute to carried forward losses from each EI ring-fence and not be carried forward separately

• The cost of EI rights, whether for an initial holder or a transferred holding, should be depreciated over the life of the right

• Amounts received on disposal of an EI right should be included directly in income

Recommendation

• Carry out a review of the scope, approach and framework for providing assurance of fiscal stability to EI rights holders.

Impact of recent regulatory changes on the fiscal regime

117. Public policies for extractive industries management should include a stable and predictable tax system plus transparent governance of collected revenues. The South African National Treasury and SARS have generally achieved these goals. New policies for addressing discriminatory practices of the past have unavoidably complicated the fiscal framework. Proposals for B-BBEE equity shares, free carried interest in oil and gas ventures, the diamond export duty and various expenditure requirements under the social and labor plan (SLP) were not coordinated with fiscal requirements. These factors combined, have cut across the intended gatekeeper role of the Minister of Finance through the instrument of money bills.¹⁰

Accelerated capital allowance

119. Income from mining means income directly derived from the winning of minerals from the soil and mining for gold includes the extraction of uranium. In addition to the normal CIT provisions, the following deductions may be made from mining income (s. 15, 36 and 11(a)): (1) certain prospecting expenditures, including surveys, boreholes, trenches, and pits preliminary to the establishment of a mine. In the case of other mining expenditures (not of a capital nature) if mining income is insufficient to absorb the deduction, the excess is available for deduction against other income. In the absence of mining income, prospecting expenditure is only deductible if it can be claimed as an expenditure actually incurred in the production of income (s. 11(a)) and is not of a capital nature. This will be the case if the company incurs prospecting expenditure as part of exploration operations to discover mineral deposits to sell at a profit.¹¹

120. South Africa’s CIT regime is attractive because of the 100 percent expensing rule for capital expenditure. This is granted in lieu of other capital allowances. Immediate expensing eases the problem of distinguishing between capital and revenue expenditure, but is not consistent with the function of CIT as a tax on returns to equity—the capital allowance should approximate the depreciation of the economic value of the asset to its owners. When income is generated so that the 100 percent deduction is used it offers the normal return to capital (though clearly not during periods prior to generation of income), deductibility of interest on debt thus provides an element of double deduction, as does any additional allowance for gold mining capital expenditure.

Table 1.

South Africa: Direct Tax Charges on Mining under the ITA

Table 1.

South Africa: Direct Tax Charges on Mining under the ITA

Fiscal Provisions for Mining of Minerals
No.	Direct Taxes	Rate	Description
1	Corporate Income Tax for non-gold mines	28%	Applies to mines, oil and gas extraction
	Gold Formula Capital Allowance Uplift factor	y = 34-(170/x) 10% for post-1973 mines and 12% for post-1990 mines
	Tax Depreciation: Investment Allowance/Accelerated Depreciation	100% immediate expensing
	Loss Carry Forward Ring-fencing	Unlimited at least two	Tax benefit reduced by the imposition of a ring-fence between mining and non-mining income and a ring-fence per mining license
	Thin Capitalization (Debt:Equity Limit)	The safe harbor rule of 3 : 1 debt to equity has been removed in the latest tax law amendments	Recently, a discretionary limitation on interest deductibility, capped at 40% of EBITDA has been announced but not yet promulgated
2	Capital Gains Tax	28% with a capital gains inclusion rate of 66.7%	Applied on the transfer of mineral rights
	Mine Rehabilitation	0% or tax exemption of investment income	Contribution to approved rehabilitation trust fund are fully deductible
3	Withholding Tax on Interest	15%	Can be reduced by tax treaty
4	Withholding Tax on Dividends	15%	Can be reduced by tax treaty
5	Witholding Tax on Royalties	15%	Can be reduced by tax treaty
6	Witholding Tax on Technical Services	15%	A final tax with effect 1 Jan 2016 on management and technical services

View Table

Table 1.

South Africa: Direct Tax Charges on Mining under the ITA

Fiscal Provisions for Mining of Minerals
No.	Direct Taxes	Rate	Description
1	Corporate Income Tax for non-gold mines	28%	Applies to mines, oil and gas extraction
	Gold Formula Capital Allowance Uplift factor	y = 34-(170/x) 10% for post-1973 mines and 12% for post-1990 mines
	Tax Depreciation: Investment Allowance/Accelerated Depreciation	100% immediate expensing
	Loss Carry Forward Ring-fencing	Unlimited at least two	Tax benefit reduced by the imposition of a ring-fence between mining and non-mining income and a ring-fence per mining license
	Thin Capitalization (Debt:Equity Limit)	The safe harbor rule of 3 : 1 debt to equity has been removed in the latest tax law amendments	Recently, a discretionary limitation on interest deductibility, capped at 40% of EBITDA has been announced but not yet promulgated
2	Capital Gains Tax	28% with a capital gains inclusion rate of 66.7%	Applied on the transfer of mineral rights
	Mine Rehabilitation	0% or tax exemption of investment income	Contribution to approved rehabilitation trust fund are fully deductible
3	Withholding Tax on Interest	15%	Can be reduced by tax treaty
4	Withholding Tax on Dividends	15%	Can be reduced by tax treaty
5	Witholding Tax on Royalties	15%	Can be reduced by tax treaty
6	Witholding Tax on Technical Services	15%	A final tax with effect 1 Jan 2016 on management and technical services

121. If a mine derives both mining and non-mining income, the excess of mining expenditure over mining income that results in a mining loss can be offset against non-mining income. (Curiously, this concession excludes capital expenditure but includes continuing general prospecting expenditure.) No portion of capital expenditure is allowable until the mine has reached production stage. Certain expenditures on assets such as residential housing for employees, furnishings and infrastructure, hospitals, schools, shops, recreation buildings and facilities, certain railway lines may be deducted over 10 years or shorter if the mine’s life is less than 10 years—motor vehicles are expensed over 5 years.

Unintended consequences of ring-fences

122. The benefit of the capital allowance regime is restricted through 3 ring-fences: (1) A ring-fence is imposed confining deduction of mining capital expenditure to mining income (since 1983); (2) A mine-by-mine ring-fence applies but 25 percent of excess capital allowances may be deducted against the taxpayer’s other taxable income from mining (by discretion); and (3) Prospecting, capital, and revenue expenditures are segregated and bear different treatment.

123. Ring-fencing exists for purposes of protecting the revenue base. In 1988-90, however, the Marais Technical Mining Tax Committee (Marais report) discussed the distorting impact of ring-fences on capital allocation in the mining industry (capital deepening per mine even though the project becomes more marginal because of ore grade depletion). The impact of accelerated capital allowances both during the prospecting and development phases is different for gold mines and other mines. Granting the 100 percent expensing rule was usually justified by the high costs of deep level mining, long lead times impacting on payback periods, the volatility of gold price, and the difficulty of distinguishing between capital and current expenditure. The tax deferral benefit was, however, curtailed in that losses created by expensing could not be offset against the profits of another operating mine.

124. Prospecting capital expenditure with an unsuccessful outcome cannot be deducted if there is no earned mining income. This undermines future delineation of exploitable ore bodies. In contrast, research and development (R&D) expenditures (prospecting is not dissimilar) qualify for a full deduction of capital and current expenditure incurred directly and solely on R&D undertaken in SA. Companies can deduct an additional 50 percent of the R&D expenditure.

125. Some manufacturing sectors enjoy beneficial capital allowances, affecting capital allocation in SA. This distortion calls for a system where tax depreciation of capital assets should be more closely aligned with economic depreciation as manufacturing firms do not face ring-fencing restrictions. Companies qualifying for tax incentives under the s.12I (ITA) in respect of an industrial policy project get a 35 percent or 75 percent additional investment allowance depending on whether they have a preferred industrial status or operate in an industrial development zone respectively. Platinum mines with smelters or refining capacity can possibly access this tax preference, but that is not certain. A beneficiation activity within a vertically integrated mining operation benefits from immediate expensing. By contrast, a standalone beneficiation activity would only qualify for the accelerated straight-line 4-year write-off period (40:20:20:20). This complicates the “mining” from “beneficiation” distinction.¹²

126. Costs for physical infrastructure developed by mines in terms of the Social and Labor Plan (SLP), under the Mining Charter, appear deductible only under certain conditions. The SLP requires expenditure on various infrastructure spending programs (roads, schools, clinics). If these structures were to be used by mine employees they would be deductible but if used by the community their tax deductibility is disallowed by SARS unless a Public Benefit Organization (PBO) is set up.

127. An additional capital allowance of 10 and 12 percent annually is allowed for unredeemed capital expenditure by post 1973 and post 1990 gold mines respectively. The allowance ceases when the relevant capital expenditure has been redeemed. The uplift compensates the mine for the loss position until redemption (time value of money). Since interest on borrowings remains deductible this allowance creates a double deduction where capital expenditure is financed by interest bearing loans.

Mine rehabilitation

128. South Africa’s long-established practice of tax deductible contributions to mine rehabilitation trust funds appears no longer to be working. The tax-free build-up of investment income and the withdrawals for mine decommissioning are now undermined by alternative schemes of insurance and bank guarantees (s. 10(1)(cP)). These recent pre-funding models may not sufficiently cover the clean-up costs. The mission was informed that the DMR has little choice but to withhold mine closure certificates, which free the company from further obligations. Many of the 1,700 mines, because of their age, have not built up resources in a mine rehabilitation trust fund. The DMR seeks to mitigate the financial risk to government from costly mine decommissioning and environmental clean-ups. The MPRDA stipulates that finances for mine rehabilitation can be provided through three methods: (1) the traditional mine rehabilitation trust fund or company; (2) the provision of a bank guarantee; and (3) an insurer provided financial guarantee or insurance policy. Lately, companies have disbanded the trust funding model and increasingly are pursuing the issuance of a bank guarantee or insurance instrument. Uncertainty exists as to whether remaining trust funds after completion could be accessed and transferred to a similar fund. Also, there are delays in getting timely disbursements from the trust fund for concurrent mine rehabilitation. Taxation is not the deterrent since regulatory concerns influence the pace of disbursements.

Acquisition of mineral and surface rights

129. Currently, no deductions from income are available for the acquisition of mineral/surface rights but the costs are included in the base cost of capital assets which attracts CGT on realization. Many other countries permit amortization of acquisition costs of mineral rights (see Chapter II).

The gold formula

130. The ITA provides differentiated tax treatment for gold, natural oil and gas extraction and other mining. Income tax is calculated separately for each mine. Uranium mining attracts gold mining tax treatment, as in South Africa uranium is won as a byproduct of gold mining. All mines, with the exception of gold, are taxed on their mining income at the standard company rate of 28 percent. In contrast, income derived from the mining of gold by companies is calculated according to a rate determined by formula.

131. The abolition of the STC and introduction of a 15 percent dividend WHT resulted in the adoption of the new 2013 single gold formula: y = 34-170/x.¹³ The formula has the economic effect that if a gold mine which makes a profit but has an X-factor of 5 per cent or less, it pays no tax. This situation is described as “a mine operating within the tax tunnel”. The revised formula establishes a maximum marginal rate of 34 percent but which, as a result of the 5 percent tax tunnel, theoretically only reaches an effective average rate of 32.3 percent (0.95 x 34). The current gold formula compared to the 28 percent CIT rate provides average effective rates (beyond the tunnel) ranging from greater than 5 percent to 32.3 percent. It is similar to the flat CIT rate of 28 percent if the profit to revenue (P/R) ratio exceeds 25 percent—rarely achieved; if the P/R ratio is between 5 and 20 percent the resulting average CIT rate ranges from >5 percent to 25 percent. Where one taxpayer operates more than one mine, the formula must be applied separately for each mine. Historically, the reason for the introduction of the gold-mining formula was to assist marginal mines and to encourage the extraction of low-grade ore. At a high gold price, mines tend to concentrate on mining low grade areas to remain within the tax tunnel. This system extends the life of South African gold mines as marginal operations are subsidized through the automatic granting of a lower tax rate.

132. Previous assessments have recommended abolition of this gold formula. The Marais report recommended that non-gold mining companies should be taxed under the standard CIT regime and the gold formula should be removed. Also, the SIMS report argues for a standardization of the CIT regime for mines with the separate adoption of a progressive resource rent tax.

133. Retention of the special gold formula dispensation can no longer be justified. Many deposits are essentially uneconomic, too deep for economic exploitation, and the rising cost structure due to regulatory measures, power shortages and rising labor costs has put most of the mines into a permanent loss position (or they continue to operate within the 0-5 percent tax tunnel). Only four gold mines retain the additional capital redemption allowance, which is in any case a double deduction when interest is already deductible. Moreover, the argument that the formula encourages mining of marginal ore at depths beyond 4,000 meters has fallen away since there are binding technological constraints on mining at those depths. The ACC system suggested below would provide a fair replacement for the formula, and would apply across the mining sector.

Additional Taxation of Mineral Rent and the Royalty System

135. The inclusion of a flexible and progressive rent taxation mechanism should be considered over the medium term. The SIMS report argues for the adoption of a resource rent tax (RRT) so that the state as custodian of the nation’s mineral resources ensures that the people of South Africa are getting a larger share of the resource rents from their minerals. The report suggests that the nation’s mineral assets have the potential for exceptional profits which should be shared between the people and the mining companies.

136. In 2008, South Africa introduced a variable royalty system as a proxy for taxation of mineral rent. The system imposes a royalty on gross value but varies the rate according to an annual calculation of earnings before interest and tax (EBIT), interpreted also to include immediate expensing of capital.

137. Global practices in respect of resource rent taxes vary but in essence there are three options (Box 2): (1) The ‘Brown Tax,’ or ‘R-based cash flow tax,’ has as its base all current receipts less all current expenses (both non-financial), with immediate refund (or carry forward at interest) when this is negative; this is sometimes expressed as a tax surcharge on cash flow where accounting profit is adjusted by adding back depreciation and interest, and deducting any capital expenditure in full, then yields a base of net cash flow, forming the base for a surcharge (2) Resource rent tax. This replicates many features of the Brown Tax, with the investor receiving an annual uplift on accumulated losses until these are recovered.

138. The tax surcharge on cash flow could be one of the options for South Africa over the medium term. It has the advantage of simplicity. The calculation takes gross revenues minus total cash expenditures, including capital expenditure, without deducting depreciation or interest. When the result is positive, tax is charged at a specific rate. Uplift on pre-production capital expenditure could also apply to allow the investor some compensation for the time value of money before the surcharge is triggered. If taxable income for the purposes of the surcharge is negative in a given year, the loss is carried forward to subsequent years, so the surcharge would not be triggered until the project has a positive cash flow. If a cash flow surcharge tax is introduced, it could be applied only to projects which commence after its introduction unless otherwise agreed by the parties. The rate and parameters should be specified in the law, and not be subject to negotiation or bidding. It would also be possible to impose this charge as a second tier of corporate income tax if the ACC is introduced, but again only for projects commence after introduction of the additional tier.

Mineral and Petroleum Resource Royalties

139. The royalty legislation came into effect on 1 March 2010, raising modest revenues with iron ore and gold contributing the most. In 2013/14 iron ore contributed more than half of all royalty collections of R6.4 billion (Table 2). The average effective rate for iron ore is 4 percent whereas for the rest of the minerals it ranges between 1 and 1.5 percent with coal being at the bottom on 0.3 percent. South Africa’s mineral royalty design is complicated by differentiating between refined and unrefined minerals in the profit-based formula:

• Variable Royalty on Refined Minerals—0.5 percent + [earnings before interest and taxes / (gross sales of refined mineral resources x 12.5) x 100], rate capped at 5 percent.

• Variable Royalty on Unrefined Minerals—0.5 percent + [earnings before interest and taxes / (gross sales of unrefined mineral resources x 9) x 100], rate capped at 7 percent.

Table 2.

South Africa: Royalty Collections since 2011/12

Source: South African Revenue Service.

^1/Industrial minerals are geological materials which are mined for their commercial value, which are not mineral fuels and are not sources of metallic minerals. They are used in their natural state or after beneficiation either as raw materials or as additives in a wide range of applications (i.e. industrial minerals are all those minerals other than gold, PGMs, coal, iron ore, chrome, manganese, diamonds, etc.).

^2/The commodities grouped under Other are: Chrome, Fluorspar, Nickel, Oil and Gas, Phosphates, Vanadium and Unspecified.

Table 2.

South Africa: Royalty Collections since 2011/12

Collections in R million	2011/12	% of total	2012/13	% of total	2013/14	% of total	Year-on-year growth
Coal	297,22	5,3%	435,66	8,7%	390,08	6,1%	−10,5%
Copper	79,31	1,4%	48,19	1,0%	36,55	0,6%	−24,2%
Diamonds	289,86	5,2%	174,78	3,5%	107,17	1,7%	−38,7%
Gold and / or uranium	817,06	14,6%	1.128,73	22,5%	837,53	13,0%	−25,8%
Industrial minerals /1	299,39	5,3%	185,58	3,7%	278,45	4,3%	50,0%
Iron ore	2.503,42	44,6%	1.920,54	38,3%	3.333,49	51,9%	73,6%
Manganese	149,32	2,7%	198,93	4,0%	235,28	3,7%	18,3%
Platinum	852,54	15,2%	460,65	9,2%	567,24	8,8%	23,1%
Zinc	142,68	2,5%	101,47	2,0%	47,85	0,7%	−52,8%
Other/2	180,75	3,2%	360,50	7,2%	586,28	9,1%	62,6%
Total	5.611,54	100,0%	5.015,04	100,0%	6.419,92	100,0%	28,0%

Source: South African Revenue Service.

^1/Industrial minerals are geological materials which are mined for their commercial value, which are not mineral fuels and are not sources of metallic minerals. They are used in their natural state or after beneficiation either as raw materials or as additives in a wide range of applications (i.e. industrial minerals are all those minerals other than gold, PGMs, coal, iron ore, chrome, manganese, diamonds, etc.).

^2/The commodities grouped under Other are: Chrome, Fluorspar, Nickel, Oil and Gas, Phosphates, Vanadium and Unspecified.

View Table

Table 2.

South Africa: Royalty Collections since 2011/12

Collections in R million	2011/12	% of total	2012/13	% of total	2013/14	% of total	Year-on-year growth
Coal	297,22	5,3%	435,66	8,7%	390,08	6,1%	−10,5%
Copper	79,31	1,4%	48,19	1,0%	36,55	0,6%	−24,2%
Diamonds	289,86	5,2%	174,78	3,5%	107,17	1,7%	−38,7%
Gold and / or uranium	817,06	14,6%	1.128,73	22,5%	837,53	13,0%	−25,8%
Industrial minerals /1	299,39	5,3%	185,58	3,7%	278,45	4,3%	50,0%
Iron ore	2.503,42	44,6%	1.920,54	38,3%	3.333,49	51,9%	73,6%
Manganese	149,32	2,7%	198,93	4,0%	235,28	3,7%	18,3%
Platinum	852,54	15,2%	460,65	9,2%	567,24	8,8%	23,1%
Zinc	142,68	2,5%	101,47	2,0%	47,85	0,7%	−52,8%
Other/2	180,75	3,2%	360,50	7,2%	586,28	9,1%	62,6%
Total	5.611,54	100,0%	5.015,04	100,0%	6.419,92	100,0%	28,0%

Source: South African Revenue Service.

^1/Industrial minerals are geological materials which are mined for their commercial value, which are not mineral fuels and are not sources of metallic minerals. They are used in their natural state or after beneficiation either as raw materials or as additives in a wide range of applications (i.e. industrial minerals are all those minerals other than gold, PGMs, coal, iron ore, chrome, manganese, diamonds, etc.).

^2/The commodities grouped under Other are: Chrome, Fluorspar, Nickel, Oil and Gas, Phosphates, Vanadium and Unspecified.

Simplification proposals

140. The administration of the royalty is complex. The royalty design was amended in 2014 to clarify rules associated with coal containing a range of grades. If the sale or disposal occurs at an average grade below the specified range, the value will be determined at the bottom point specified for the range. If the transfer occurs at a grade above the specified range, the value will be determined at the highest point specified for the range. If the transfer occurs between the bottom and top points, the average grade upon transfer will apply.

141. Under the revised rules, the range for coal will be from 19.0 MJ/kg to 27.0 MJ/kg. The weighted average calorific value of ‘low’ and ‘very low’ quality coal required by Eskom’s power stations is 19.0 MJ/kg. New power plants require coal with calorific values of between 22 MJ/kg and 24 MJ/kg. Coal that is exported is typically at 23 MJ/kg and above. The lower contribution by the coal sector to mineral royalties, compared to its share of total mineral sales and the very low estimated effective royalty rate for the coal sector suggested that the point reference of 19.0 MJ/kg was not appropriate. The new minimum reference price is now 23 MJ/kg and above.

142. The use of a net smelter return (NSR) valuation system is a possible improvement. “Net smelter return” is defined as the net revenue that the owner of a mining property receives from the sale of the mine’s metal/non metal products less transportation, processing and refining costs. It is the valuation of the metal contained in bulk sale of ores, concentrates or mattes. The valuation thus automatically adjusts with the stage of beneficiation, reducing the need to distinguish refined from unrefined products. Integrated gold and platinum production, with refining, would continue to be valued as at present.

143. Initially, the extraction of aggregate, building sand and construction material was exempt from the royalty regime. Later amendments included this category and subjected it to the unrefined mineral royalty formula with its inherent challenges of verifying volume and fair market value. Given that it is a high volume but low value commodity with many quality variations consideration should be given to impose a specific charge (R/ton of material removed)—which indeed is internationally the practice for these commodities. Using specific royalties on low value products (aggregates) would obviate the need for complex local transfer pricing rules that seek to establish an arm’s length price.

144. Royalties on gross revenues provide early revenues for government when commercial production commences. But, since they add to cost, they can make the extraction of some resource deposits unaviable. Where royalties form a major part of the overall fiscal regime, they tend to become more complex because refinements are needed to make them responsive to profitability (using proxies like price, location, or production level). Royalty rates that vary with price have easy appeal but, do not vary with costs and so will not be appropriate across the marginal cost curve of possible mines. Moreover, any rate scale geared to prices requires frequent adjustment when forecasts are wrong.

145. The use of gross royalties protects revenue against overstatement of cost, but too little knowledge of costs can weaken the government’s position. Companies can reduce profit-related taxes by increasing deductible costs, and gross royalties can be used to guard against this. But if royalties yield significant revenue and prices fall, companies will argue for reduced rates and governments will have no sound basis to challenge their case if they have not been closely monitoring costs. Reviewing the short royalty collection history in South Africa, the adoption of a single flat royalty of 1.5 percent on gross revenue would have raised (over the four-year period the variable royalty regime has been in effect) a total royalty stream of R21.3 billion versus the actual collected total of R20.6 billion. This method would have implied a small rise for some mines in the lowest applicable rate of royalty (0.5 percent).

146. SARS lacks the necessary skills in-house for verification of quantities of minerals extracted and contained metals in concentrate. These are core competencies in mine inspectorates or specialist service providers that monitor these aspects of mineral exports. Presently, negotiations by the DMR with the South African Bureau of Standards are well-advanced aiming to make this Bureau responsible for verification of volumes of minerals and assaying their respective values of contained metal for royalty administration purposes.

Evaluation of Results

148. The current regime and proposed alternatives were evaluated against the key fiscal objectives of revenue-raising capacity, neutrality and progressivity, and placed in international context of other mineral-producing countries. Figure 2 provides a summary of the key trends which emerge from the analysis of the regimes when applied to a stylized platinum project, described in Figure 1. Analysis of the stylized coal and iron ore projects display similar trends.

149. The current fiscal terms and reform scenarios were evaluated for revenue generating capacity using, firstly, the Average Effective Tax Rate (AETR) or “government take”. Figure 2 shows that for this platinum project the current regime generates an undiscounted AETR of 37 percent. The complete reform scenarios (scenarios 1(a) and 1(b)) improve the take of the regime through the introduction of the cash flow surcharge to 43 and 46 percent respectively, while maintaining the post-tax investor return on total funds at approximately 15 percent. The concessional financing of the BEE entity is assumed not to form part of the direct government take, and the rate of return is considered for the investor as a whole. However, the local ownership requirement has an impact on the non-BEE investor’s cashflow and return across all scenarios.

Platinum Project Economics

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Platinum Project Economics

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Platinum Project Economics

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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150. The revenue pattern over the cycle of the project under each scenario mainly reflects the production profile. The cash flow surcharge has the effect of generating significant additional revenue once the project is generating sufficient positive cash flow, the effect of which is slightly reduced when the royalty is creditable against the surcharge. The 5 year depreciation profile has the effect of altering the timing of corporate tax payments in the early years of production. The marginal reform scenario has little impact on government revenue, with the ACC providing some additional relief to the investor in the initial years of production when capital depreciation deductions are made in determining the corporate income tax payable. Disallowing interest deductions under this scenario has the effect of slightly increasing the overall AETR.

151. A key indicator of the effect on a marginal project is the “breakeven price” or the minimum primary mineral price required by the investor to meet its hurdle rate. The price is expressed in constant values and the hurdle rate is assumed in the analysis at 12.5 percent in post-tax real terms. An alternative indicator to measure the burden on a marginal investment is the Marginal Effective Tax Rate (METR). The METR illustrates the relative fiscal wedge taken from the project by the fiscal regime at the margin of project viability. The reform scenarios score well for investment incentive when placed in international perspective. Under the current regime the METR is slightly lower than under the reform scenarios; however, given the similarity in break-even platinum prices (Figure 2), the difference in the METR among these regimes is not significant.

152. The progressivity of the fiscal regimes was evaluated by estimating the government share of total benefits¹⁶ over a range of project results. “Progressivity” here means the capacity of the fiscal regime to ensure that government receives a rising share of project cash flows as the intrinsic profitability of the project increases (up to a realistic maximum share) while bearing part of the downside when projects are less profitable. It shows how the government can approach higher taxation of realized rents, even if taxing all of them is not possible. Variation in project net present value (reflecting project profitability) was generated by adjusting the platinum price in constant real terms. At low profitability levels, all the scenarios place a lower burden on projects with lower pre-tax profitability. With the additional progressive fiscal elements, the recommended scenarios yield a higher share of total benefits for the government as the profitability of the project increases (Figure 2).

153. The revenue benefit from the full reform program (Option 1) is likely to be greater than simulated here. The modeling assumes an accurate interpretation of the current regime, and full collection under it. In view of the complexities and distortions that prevail, full collection under a cleaned-up legal framework should already be greater. The combination of reform and a simplified legal framework has a high chance of bringing revenue increases in the medium term.

Simulation Results – Current Regime and Reform Scenarios

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Simulation Results – Current Regime and Reform Scenarios

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Simulation Results – Current Regime and Reform Scenarios

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Recommendations

VAT and diesel refund

155. Given the high export share of mining and the zero-rating of exports, mining and quarrying is in a net credit position for VAT—only 0.6 percent of VAT vendors are in the mining and quarrying sector. VAT is an issue, however, for diamond beneficiation as importers of rough diamonds experience debilitating cash flow consequences, waiting for VAT refunds. Relocation to the assigned Industrial Development Zone near the OR Tambo International Airport could resolve this matter.

Diesel rebates and contract mining

156. New forms of mining through sub-contracting have created problems for accessing the diesel refund or rebates. The diesel refund policy was introduced on 4 July 2001 and is governed by the Customs and Excise Act No. 91 of 1964 (Customs Act), and provides special dispensation to specific industries with regard to off-road diesel used in performing primary activities associated with certain industries. The industries that are listed as beneficiaries of the diesel refund are: mining, farming, forestry, commercial fishing, coastal shipping, rail and freight haulage and harbor services, and electricity generating plants. Mining license holders—not contractors—get a rebate for the General Fuel Levy (201.5c/l of petrol and 197.5c/l of diesel) and the RAF charging element. The rationale behind the introduction of the diesel refund policy was to assist these industries in reducing their input costs on the basis that the above industries seldom make use of the infrastructure for which these levies were intended. The levy itself exists partly for environmental reasons. However, contractors cannot access these benefits as they are not the mining right holder. A solution requires either the extension of the privilege to contractors or a mandate that the mining right holder must be the purchaser.

Table 4.

South Africa: Indirect Tax and Other Charges on Mining

Table 4.

South Africa: Indirect Tax and Other Charges on Mining

Indirect Taxes and Charges that Increase Mining Costs and as a Consequence the Cutoff Grade of a Mineral Deposit
1	Variable Royalty on Refined Minerals	0.5 + [earnings before interest and taxes / (gross sales in respect of refined mineral resources x 12.5) x 100	The royalty rate is capped at a maximum rate of 5%
	Variable Royalty on Unrefined minerals	0.5 + [earnings before interest and taxes / (gross sales in respect of unrefined mineral resources x 9) x 100	The royalty rate is capped at a maximum rate of 7%
2	Transfer Duty on Mineral Rights Transactions	8% ad valorem on the consideration for the property transfer	This applies to transactions where VAT is not imposed
3	Securities Transfer Tax	0.25% on the transfer of a security	Transfer of shares in a company or a right to receive any distribution from a company
4	Skills Development Levy	1% of payroll	Funds are utilized for sector-specific training of employees
5	Unemployment Insurance Fund Contribution & Occupational Injuries and Diseases Levy	1% on remuneration of employee payable by employer
6	Customs Duty	Duty rates in South Africa vary from 0% to 45%, with an average duty rate of 18.74%
7	SACU Excise Tax on Fuel	4c/liter of liquid fuel
8	General Fuel Levy	201.5c/liter for petrol; 197.5 c/liter for diesel
9	Electricity Generation Levy	3.5 c/kWh	This applies to all power generated from non-renewable sources
10	Carbon Dioxide Vehicle Emission Levy	R90 per g/km for passenger transport vehicles, R125 per g/km for goods transport vehicles	Levy is payable on new vehicles and is based on CO2 emissions
11	Proposed Carbon Tax	R120/ton CO2	With tax-free emission threshold of 60%
12	Acid Mine Drainage	water levy on mines	Proposed flat water use levy for all mines undermining polluter pays principle
13	Diamond Export Duty for Unpolished Diamonds	5% ad valorem of value of uncut diamond	Numerous exemptions exists that erode the effectiveness of the impost
14	Non-deductibility of some Infrastructure Development Costs iro Social Labor Plan		Costs cannot in all instances be recovered for contributions to local infrastructure, roads, schools and housing
15	Debt-financed 26 percent HDSA Ownership Transfer		Company incurs financing costs to finance for HDSAs the acquistion of co-stock

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Table 4.

South Africa: Indirect Tax and Other Charges on Mining

Indirect Taxes and Charges that Increase Mining Costs and as a Consequence the Cutoff Grade of a Mineral Deposit
1	Variable Royalty on Refined Minerals	0.5 + [earnings before interest and taxes / (gross sales in respect of refined mineral resources x 12.5) x 100	The royalty rate is capped at a maximum rate of 5%
	Variable Royalty on Unrefined minerals	0.5 + [earnings before interest and taxes / (gross sales in respect of unrefined mineral resources x 9) x 100	The royalty rate is capped at a maximum rate of 7%
2	Transfer Duty on Mineral Rights Transactions	8% ad valorem on the consideration for the property transfer	This applies to transactions where VAT is not imposed
3	Securities Transfer Tax	0.25% on the transfer of a security	Transfer of shares in a company or a right to receive any distribution from a company
4	Skills Development Levy	1% of payroll	Funds are utilized for sector-specific training of employees
5	Unemployment Insurance Fund Contribution & Occupational Injuries and Diseases Levy	1% on remuneration of employee payable by employer
6	Customs Duty	Duty rates in South Africa vary from 0% to 45%, with an average duty rate of 18.74%
7	SACU Excise Tax on Fuel	4c/liter of liquid fuel
8	General Fuel Levy	201.5c/liter for petrol; 197.5 c/liter for diesel
9	Electricity Generation Levy	3.5 c/kWh	This applies to all power generated from non-renewable sources
10	Carbon Dioxide Vehicle Emission Levy	R90 per g/km for passenger transport vehicles, R125 per g/km for goods transport vehicles	Levy is payable on new vehicles and is based on CO2 emissions
11	Proposed Carbon Tax	R120/ton CO2	With tax-free emission threshold of 60%
12	Acid Mine Drainage	water levy on mines	Proposed flat water use levy for all mines undermining polluter pays principle
13	Diamond Export Duty for Unpolished Diamonds	5% ad valorem of value of uncut diamond	Numerous exemptions exists that erode the effectiveness of the impost
14	Non-deductibility of some Infrastructure Development Costs iro Social Labor Plan		Costs cannot in all instances be recovered for contributions to local infrastructure, roads, schools and housing
15	Debt-financed 26 percent HDSA Ownership Transfer		Company incurs financing costs to finance for HDSAs the acquistion of co-stock

Environmental Charges

Carbon tax

157. According to the National Development Plan, South African mining’s¹⁷ Scope 1 and Scope 2 GHG emissions¹⁸ constitute 15 percent of total SA’s national carbon emissions. The Department of Environmental Affairs indicates that mining in SA is only responsible for 13.5 percent of the country’s total carbon emissions. Currently, the following energy taxes are imposed in South Africa and impact on the cost structure of the mining industry: the General Fuel Levy; the Electricity Generation Levy on non-renewable energy sources. These levies enhance the recent steep electricity tariff increases (Figure 2). Carbon levies include the Carbon Dioxide Vehicle Emission Levy, the proposed but not yet implemented Carbon Tax. If competing mining jurisdictions do not face these tax costs—which are otherwise laudable imposts internalizing the social costs of environmental degradation—the mining industry will face the prospect of more mine closures as commodity prices come under pressure. However, it is evident that individuals and agriculture have to absorb much higher electricity tariffs than mining and the industrial sectors—Figure 3, highlights the magnitude of this cross-subsidization.

Average Electricity Prices in c/kWh by Sector

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

Note: * Average prices from Jan 2004 to March 2005

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Average Electricity Prices in c/kWh by Sector

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

Note: * Average prices from Jan 2004 to March 2005

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Average Electricity Prices in c/kWh by Sector

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

Note: * Average prices from Jan 2004 to March 2005

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Table 5.

Countries with Carbon Taxes and their Respective Levels in US$/ton CO2e

Source: World Bank Group, 2014, State and Trends of Carbon Pricing, Washington, DC.

Table 5.

Countries with Carbon Taxes and their Respective Levels in US$/ton CO2e

No.	Country	US$/t of CO2e
1	Australia	21.54
2	British Columbia	28.00
3	Denmark	31.00
4	Finland,	48.00
5	France	20.00
6	Iceland	10.00
7	Ireland	28.00
8	Japan	2.00
9	Mexico, depending on fuel from US$1-4	2.50
10	Norway, depending on fuel from US$4-69	36.50
11	Sweden	168.00
12	Switzerland	68.00
13	United Kingdom	15.75
	Unweighted average, SA excluded	36.87
14	South Africa, US$12/ton of CO2e, with basic tax-free threshold of 60% of all stationary direct GHG emissions	4.80

Source: World Bank Group, 2014, State and Trends of Carbon Pricing, Washington, DC.

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Table 5.

Countries with Carbon Taxes and their Respective Levels in US$/ton CO2e

No.	Country	US$/t of CO2e
1	Australia	21.54
2	British Columbia	28.00
3	Denmark	31.00
4	Finland,	48.00
5	France	20.00
6	Iceland	10.00
7	Ireland	28.00
8	Japan	2.00
9	Mexico, depending on fuel from US$1-4	2.50
10	Norway, depending on fuel from US$4-69	36.50
11	Sweden	168.00
12	Switzerland	68.00
13	United Kingdom	15.75
	Unweighted average, SA excluded	36.87
14	South Africa, US$12/ton of CO2e, with basic tax-free threshold of 60% of all stationary direct GHG emissions	4.80

Source: World Bank Group, 2014, State and Trends of Carbon Pricing, Washington, DC.

158. The current carbon tax proposal of R120/ton of CO₂ equivalent—only effective above an initially 60 percent tax free emission threshold—would add to mines’ input costs. The mission was advised that the carbon tax could increase the cost of a kWh of electricity by approximately 5c in the first year with resulting knock-on effects in the economy, eroding further the dented competitiveness of the mining sector. For 2013, pwc estimates that for 13 of the biggest mining companies mining a broad range of minerals, the Carbon Tax liability above the tax-free threshold of 60 percent would raise R2,5 billion for Scope 1 and 2 emissions, being equal to 0.64 percent of total mineral sales of R384 billion.¹⁹ Both the NDP and the SIMS report assert that the currently proposed carbon tax would be damaging to the economy and suggest a delay in implementation. In particular, it may be necessary to exclude from the carbon tax Scope 2 emissions originating in the power generation sector.²⁰ Globally, there are currently 14 jurisdictions that have or are at the point of implementing a carbon tax (Table 5). In 2014, the unweighted average carbon tax charge is US$36.87/ton CO² equivalent—South Africa’s initial carbon tax of US$4.8 is modest. Australia as a direct mining competitor has recently put the introduction of the carbon tax on hold and the comparison indicates that major mining jurisdictions hold back on this tax despite its merits on environmental grounds. The solution will be to consider mitigating measures rather than withdraw implementation of the tax.

Beneficiation and Export Duty

160. Government policy actively pursues beneficiation of minerals. S. 26 of the MPRDA, and the proposed MPRDA amendments, give effect to the policy. The Minister of DMR can delay the exportation of minerals if they are exported for beneficiation purposes. The proposed amendments increase these Ministerial powers further so that local minerals could be designated for local beneficiation. Under the amendments, producers of such designated minerals, before exporting the production, would have to offer a certain percentage of that production locally. The quantities, qualities and timeliness of this offer would be prescribed and the mine gate price or an agreed price would be used.

161. The resulting regulatory uncertainty may have adverse effects on the international competitiveness of the South African minerals industry. It would probably increase borrowing costs for mining projects because of the financial risk that minerals could not be freely sold. This deteriorating risk profile could adversely impact on the credit rating of listed mining companies.

Diamond export duty

162. The Diamond Export Levy Act, 2007 imposes a 5 percent diamond export levy on the value of a diamond whenever a person exports a rough or unpolished diamond—which has not been offered on a local diamond exchange for purposes of selling it to a domestic beneficiator. For the period 2009/10 to 2013/14, the diamond export duty’s average annual collection was R63.8 million—increasing from R35.8 million in 2009/10 (the year of implementation) to R93.4 million in 2013/14. A person is entitled to receive a credit for imported rough diamonds that are offered to local polishers and cutters. Temporary exports of diamonds for purposes of getting an expert opinion on the value of the diamond or for exhibition purposes are also permitted. Numerous producer export duty relief measures exist: (1) Large producers are exempt from the export duty on their annual production if gross sales exceed R3 billion and if 40 percent of their production has been offered for sale to local beneficiators; (2) Medium producers with sales not exceeding R3 billion must provide at least 15 percent of their production to domestic cutters and polishers. All unsold unpolished diamonds are then exempt from export duty; and (3) In the case of small miners gross sales not exceeding R20 million are duty exempt on all of their unsold diamonds when they ultimately export them.

163. The diamond export duty offers built-in relief measures that erode collections and offer no price discount vis-à-vis foreign competitors. Evidence presented suggests that the volume of locally cut and polished diamonds has declined from 600,000 carats in 2013 to 200,000 carats in 2014 and over the years the number of cutters and polishers has shrunk from approximately 3,000 to about 800. This decline of the downstream diamond industry is not mirrored in Botswana and Namibia where it is expanding.

164. Review of global experiences suggests that only countries with market power can impose export taxes with some marginal benefit. (See, for example, World Bank (1996).²¹ In contrast, export taxes’ effectiveness is not guaranteed where the country is a small supplier (no market or pricing power—currently the case in South Africa as to mining of diamonds). In such instance, taxing exports to make a domestically produced commodity available to local beneficiators diminishes exports and foreign exchange earnings. The revenue effect of the diamond levy so far appears to be negligible. The export tax was not intended as a revenue instrument but as beneficiation stimulus measure.

Recommendations

• Introduce a scheme permitting contract mining to benefit from diesel levy rebates.

• Assess the potential impact of the proposed carbon tax on the costs of mining and consider mitigating measures where needed.

• Reconsider the structure and imposition of the diamond export levy.

Sector legislation: the MPRDA

165. Prior to the MPRDA of 2002 rights were granted under the “old order” mining legislation. Licenses to prospect or produce under pre-2002 legislation were granted with conditions attached, sometime including fiscal terms. The only discoveries of note were those leading to production of gas at Mossel Bay by the predecessors of PetroSA, the state-owned company that now holds these rights. The gas continues in production for feed to a gas-to-liquids plant supplying the local market. The 2002 Act required the gradual conversion of “old order” rights (sometimes called “OP 26” leases) to exploration rights under the new legislation. The income tax provisions made for the Mossel Bay projects were essentially inherited, but simplified, and substantially incorporated in Schedule 10 of the Income Tax Act dealing with petroleum income.

166. The MPRDA of 2002 continued a “first-in-first-assessed” (FIFA) system for allocation of exploration rights. This variation of the familiar “first-come-first-served” system for prospecting rights over minerals means that companies may apply as and when they wish, and the first applicant for a block will be assessed according to the criteria of the act and regulations but has no automatic right to grant of a license. The regulatory authority, currently the Petroleum Agency of South Africa (PASA),²² has promoted South Africa to petroleum companies but not through formal licensing rounds, nor has it restricted access to particular blocks or areas. As a result, rising interest over the past decade led to allocation of virtually all prospective areas under exploration licenses.

167. Proposed Amendments to MPRDA would alter the allocation to a system of “invitation”. The regulatory agency would change from PASA back to the Department of Mineral Resources (DMR). These amendments, although passed by Parliament, were referred back to Parliament by the President at the end of January 2015 for reconsideration, so the framework currently remains as under the MPRDA of 2002. The proposed system of “invitation” could be read as simple discretionary allocation. The DMR, however, advised the mission that a more likely framework (incorporated in as yet unpublished draft regulations) would open selected blocks for proposals for a defined time period. Selection criteria, both petroleum-related and for issues such as BEE and SLP, would be gazetted in advance. Proposals would be evaluated against these criteria and the results published.

168. With substantially all offshore acreage licensed new licenses depend on relinquishment by holders of existing rights. The exploration right falls into three periods in the common international pattern of 3, 2 and 2 years, with partial relinquishment obligations at each transition between periods. There will eventually be significant acreage available, but promotion of groups of blocks for bidding is not likely to be feasible in the near term.

169. With no new discoveries as yet the scope for bonus bidding is limited. Despite strong interest in apparently large potential offshore prospects the past licensing practice means little opportunity for competitive bidding over prospects that might bring immediate revenue in the form of bonuses. An exception would occur if a prospect is relinquished after significant exploratory work—though such rights are more likely to be sold if DMR permits the transfer of interest. The existing licensing practice, however, has clearly brought in significant IOC interest and has probably greatly improved the knowledge base on potential petroleum resources. The challenge for the government is to obtain the best value from that in the event of a commercial discovery.

Shale Gas

190. Shale gas exploration blocks have not yet been awarded. Five blocks in the Karoo Basin have been sought by three consortia of companies. The potential economics of shale gas in South Africa are discussed in the Analysis Supplement. While the present petroleum fiscal regime for the deep offshore may not be relevant to onshore shale gas, there is an opportunity to encompass terms for shale gas in any reformed fiscal regime for petroleum—rather than introduce a distinct fiscal regime for shale gas. This report takes that approach.

191. The domestic price for shale gas will be a more important determinant of project feasibility than the fiscal regime. The principal use is likely, initially, to be for power generation and the price in that use will probably be regulated. Opportunities will exist for additional sales of gas for industrial use at commercially negotiated prices.

Petroleum: Three options

192. Option One: Delete the state participation provisions altogether in revision of the MPRDA Amendment Bill. The state, through a commercially-constituted corporation would still be free to negotiate participation as a commercial transaction, but as a matter distinct from legislated fiscal terms. Additional tax could be introduced in Schedule 10 but applicable only to those without stability agreements (or newcomers), unless by mutual agreement.

193. Option Two: Comprehensive shift to a production sharing contract (PSC) system. Many precedents exist in nearby countries including; the rate of return sharing system for offshore petroleum that has allowed many new fields to be discovered and developed in Angola; or the R-Factor (payback ratio) system that has underpinned successful exploration and now progress towards offshore gas development for LNG in Mozambique.

194. Option Three: Define the state participation option precisely and publish a model participation agreement that companies with exploration rights could sign. The definition would apply to the terms of the maximum 20 percent carried participation. It could include the participation terms common elsewhere—a carry for the state participant through exploration with a paid interest at the development stage, albeit one which the private parties could finance, and be rewarded with a commercial interest rate plus a premium. A non-reimbursable carried interest through exploration is already a very substantial concession to the state, especially where (as in deep water) the exploration costs are likely to be high.

195. Each of these cases could be made equivalent in their effect on fiscal take. Nevertheless, the legal frameworks would differ. The MPRDA Amendment Bill proposes the right of the state to appoint two representatives to the operating committee of such ventures. There is no need for a state participating interest in the venture to achieve this objective; it could simply be a condition of the production license.

196. All three options merit serious consideration. The mission favors option one, or option one in combination with option three if non-fiscal considerations favor state participation. Option two, production sharing, however, will make it easier to offer comprehensive fiscal stability in the contract, and higher state shares might be the reward for that.

197. If properly structured, the fiscal effect of one of these options should not deter exploration and subsequent development. In fact, the opposite may be true if a revised scheme provides greater certainty to investors, combined with greater assurance to South Africa of significant participation in strong revenues from a profitable discovery. International oil companies are familiar with terms that take higher shares for the state than the present South African regime, provided that they are offered stability, control (in consultation) of operations, and the chances of both rapid payback and rising returns in profitable cases.

198. Additional fiscal devices should be so structured that they minimize risk of loss of investment when production starts. This requires recognition of any delay in achieving returns by some sort of uplift (or interest on a carry) that is received before significant additional sharing with the state takes place. With that in place, by way of example, a cash flow tax at 30 percent, or equivalent participation or production share on incremental cash flows produces a top marginal rate of 52.5 percent on an additional dollar of revenue (still low by regional standards and Australia has 58 percent).

199. In all cases, the royalty and CIT regime for petroleum needs revision. Much of the revision consists of simplification. It also consists of removing elements of discrimination against exploration expenditure. The incentives currently provided, principally as uplift and capital allowances, require modification while other allowances are introduced.

Deepwater Offshore Oil

200. Economic modeling was undertaken on stylized deepwater offshore oil fields of 500 million and 1000 million barrels (MMBbl).²⁴ Since SA waters are a ‘frontier’ area in deepwater oil exploration, it is difficult to predict accurately the cost structures and project economics that are likely to materialize as exploration progresses. Many variables would be subject to change, and the analysis considers a number of possible variations in price and cost which would alter the ultimate project economics.

201. A key variable underpinning the project economics is the oil price. As a base case assumption, the analysis assumes the oil price projections of the IMF World Economic Outlook (WEO) until 2020 beyond which the price projection is kept constant in real terms and inflated at a rate of 2 percent per annum. Under this price assumption, the 500MMBbl field yields a pre-tax IRR of 26 percent in real terms, while the 1000MMBbl field has a pre-tax IRR of 34 percent.

202. The current fiscal terms were evaluated for revenue generating capacity using the AETR or “government take”. The current regime generates an AETR of between 20 and 30 percent, which is very low by international standards. Simulations previously undertaken by FAD suggest that in the petroleum sector governments retain government shares of between 65 and 85 percent. Figure 4 illustrates the profile of government revenues relative to pre-tax project cash flows over the life of the 500MMBbl project. The analysis also suggests that the variable rate royalty is largely ineffective, with the royalty rate even in marginal scenarios quickly reaching the highest rate.

Government Revenue Profile – Current Regime (500MMBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Government Revenue Profile – Current Regime (500MMBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Government Revenue Profile – Current Regime (500MMBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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203. Examples of each of the proposed reform alternatives to the current SA regime are evaluated. Table 6 presents the key terms of each of the scenarios. All the scenarios include modifications to the CIT calculation involving 5 year depreciation using the straight line method along with a 10 percent ACC (disallowing deductibility of interest). Scenarios 1 and 3 also introduce a 5 percent flat rate royalty, reflecting the necessary reforms outlined in Section E. Scenario 1 (a) and (b) add an additional cash flow surcharge at 20 and 30 percent respectively, with ten percent uplift on capital expenditure in the year that it is incurred. Scenario 3 reflects a possible reform envisaged under the MPRDA Bill, introducing a 20 percent state participation, carried from development and repaid with interest. Under Scenario 2, a simple illustrative R-Factor based production sharing scenario is introduced. The current regime and proposed alternatives are evaluated against the key fiscal objectives of revenue-raising capacity, neutrality and progressivity, and placed in international context of other petroleum-producing countries.

Table 6.

Reform Scenarios

Table 6.

Reform Scenarios

Fiscal provision	Current Regime	Scenario 1 (a)	Scenario 1 (b)	Scenario 2		Scenario 3
Royalty	0.5 + [earnings before interest and taxes/(gross sales in respect of refined mineral resources x 12.5)] x 100. Max 5%	5% Flat Rate	5% Flat Rate			5% Flat Rate
Income tax	28%	28%	28%	28%		28%
Depreciation	Immediate Expensing of all Capital Expenditure	Straight Line Depreciation over 5 years from Production Year 1	Straight Line Depreciation over 5 years from Production Year 1	Straight Line Depreciation over 5 years from Production Year 1		Straight Line Depreciation over 5 years from Production Year 1
Uplift/Allowance for Corporate Capital	100% uplift on exploration expenditure; 50% uplift on development expenditure	10% uplift on balance of unredeemed capital	10% uplift on balance of unredeemed capital	10% uplift on balance of unredeemed capital		10% uplift on balance of unredeemed capital
Loss carry-forward	Unlimited	Unlimited	Unlimited	Unlimited		Unlimited
Additional Tax		Cash flow Surcharge at 20% with uplift on capital expenditure at 10%	Cash flow Surcharge at 30% with uplift on capital expenditure at 10%
Production Sharing				70% Cost Recovery Limit
				0<R<1	15%
				1<R<2	20%
				2<R	25%
State Participation						20% State Participation. Carry through to production with repayment of development costs from participation cashflows at interest rate of 7%
HDSA Requirements	10% Local Ownership	10% Local Ownership	10% Local Ownership	10% Local Ownership		10% Local Ownership

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Table 6.

Reform Scenarios

Fiscal provision	Current Regime	Scenario 1 (a)	Scenario 1 (b)	Scenario 2		Scenario 3
Royalty	0.5 + [earnings before interest and taxes/(gross sales in respect of refined mineral resources x 12.5)] x 100. Max 5%	5% Flat Rate	5% Flat Rate			5% Flat Rate
Income tax	28%	28%	28%	28%		28%
Depreciation	Immediate Expensing of all Capital Expenditure	Straight Line Depreciation over 5 years from Production Year 1	Straight Line Depreciation over 5 years from Production Year 1	Straight Line Depreciation over 5 years from Production Year 1		Straight Line Depreciation over 5 years from Production Year 1
Uplift/Allowance for Corporate Capital	100% uplift on exploration expenditure; 50% uplift on development expenditure	10% uplift on balance of unredeemed capital	10% uplift on balance of unredeemed capital	10% uplift on balance of unredeemed capital		10% uplift on balance of unredeemed capital
Loss carry-forward	Unlimited	Unlimited	Unlimited	Unlimited		Unlimited
Additional Tax		Cash flow Surcharge at 20% with uplift on capital expenditure at 10%	Cash flow Surcharge at 30% with uplift on capital expenditure at 10%
Production Sharing				70% Cost Recovery Limit
				0<R<1	15%
				1<R<2	20%
				2<R	25%
State Participation						20% State Participation. Carry through to production with repayment of development costs from participation cashflows at interest rate of 7%
HDSA Requirements	10% Local Ownership	10% Local Ownership	10% Local Ownership	10% Local Ownership		10% Local Ownership

204. Evaluating first the revenue raising potential, results illustrate that the range of reform scenarios allow for an AETR as high as 50 percent in both field scenarios. Figures 5 and 6 illustrate the profile and composition of government revenues under each reform scenario. The revenue pattern over the cycle of the projects mainly reflects the production profile of the project. The effect of the 5 year depreciation and allowance for corporate capital is to alter the timing of corporate tax payments in the initial years of production. The cash flow surcharge and state participation have the effect of generating significant additional revenue when the project is generating sufficient positive cash flow.

Total Government Revenue under Current and Reform Scenarios (WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Total Government Revenue under Current and Reform Scenarios (WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Total Government Revenue under Current and Reform Scenarios (WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Profile of Government Revenues – Reform Scenarios (500 MMBbl field, WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Profile of Government Revenues – Reform Scenarios (500 MMBbl field, WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Profile of Government Revenues – Reform Scenarios (500 MMBbl field, WEO Prices)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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205. The AETR, METR and breakeven prices for the current South African regime are low by international standards. The existing fiscal arrangements in South Africa and the alternative proposed reform scenarios were compared with fiscal regimes applicable in other petroleum producing countries from the region and elsewhere (Figure 7 and 8).²⁵ Some of the comparators included in the sample are regimes for other “frontier areas” (such as the Ghanaian regime before the 2008 Jubilee discovery); some are terms of established producers (Angola, Ghana post-Jubilee); and some have significant petroleum discoveries (Mozambique, Tanzania). The reform scenarios proposed place South Africa better in line with the sample of comparators. Under the field scenarios assumed, the Angolan, Brazilian and Tanzanian regimes generate marginal or unviable outcomes, placing high burdens on a marginal project relative to the rest of the comparators. For these regimes, breakeven prices are significantly higher than the WEO forecast, suggesting that more favorable project economics have facilitated viable projects in these areas. While these comparators are included for contextual purposes, the more appropriate comparators for South Africa would be those yielding average effective tax rates in the range of 60 to 80 percent.

Average Effective Tax Rate (500 MmBbl, WEO price forecast)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Average Effective Tax Rate (500 MmBbl, WEO price forecast)

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Average Effective Tax Rate (500 MmBbl, WEO price forecast)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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METR and Breakeven Price (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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METR and Breakeven Price (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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METR and Breakeven Price (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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206. The impact of oil price uncertainty on project outcomes was evaluated using stochastic price analysis. Monte Carlo simulations were used to account for price uncertainty, by assuming that oil prices follow a stochastic stationary first-order autoregressive AR(1) process. The results were then used to measure the dispersion of possible outcomes, and to infer the implied risk to the investor and the government under the current regime and reform scenarios.²⁶

207. Investor perception of risk is evaluated by analyzing the mean expected post-tax IRR to the investor and the coefficient of variation (CV) of investor returns. Figure 9 shows the mean expected post-tax IRR and the CV of post-tax IRR for each regime tested. These results further demonstrate the generosity of the South African regime when compared internationally. Relative to the sample, the current and proposed regimes generate the highest mean post-tax IRRs, and do not appear to significantly increase the risk to the investor.

208. The progressivity of the current and proposed fiscal regimes was evaluated by estimating the government share of total benefits over a range of project results. “Progressivity” here means the capacity of the fiscal regime to ensure that government receives a rising share of project cash flows as the intrinsic profitability of the project increases (up to a realistic maximum share). The variation in project NPV (reflecting project profitability) was generated by adjusting oil prices in constant real terms. At low profitability levels, all the scenarios place a lower burden on projects with lower pre-tax profitability. Figure 8 shows that with the additional progressive fiscal elements, Scenarios 2 to 4 clearly yield a higher share of total benefits for the government as the profitability of the project increases.

Measures of Investor Risk (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Measures of Investor Risk (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Measures of Investor Risk (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Government Share of Total Benefits (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Government Share of Total Benefits (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Government Share of Total Benefits (500MmBbl)

Citation: IMF Staff Country Reports 2015, 244; 10.5089/9781513514802.002.A001

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Recommendations

• Set the royalty at a flat rate on gross proceeds at delivery point determined in field development plan – probably at 5 percent.

• Maintain a ring-fence for CIT around oil and gas activities; limit deduction of 10 percent of assessed losses against non-oil and gas income to actual expenditures not including uplift.

• Unify treatment of exploration and development capital expenditure with write-off over five or six years, commencing in the year of commencement of commercial production.

• Review the treatment of unsuccessful exploration expenditure.

• Introduce amortization of the cost of acquisition of petroleum rights (over the same period or life of asset).

• Replace current uplifts on exploration and development expenditure with allowance for corporate capital (ACC) on unredeemed capital expenditure balances at annual rate.

• Eliminate deduction of interest – ACC stands in lieu.

• Consider use of US Dollar as functional currency for upstream petroleum activities.

• Define any state participation precisely, if included in the regime, and limit carried participation to a maximum of 20 percent.

• Use, in preference, the cash flow surcharge scheme at a 20 percent rate.

Recommendations

• Continue to monitor international developments and methods of addressing tax avoidance, particularly through South Africa’s observer status at the OECD and membership of the G-20

• Proceed with broadening of withholding taxes on base eroding payments and consider further broadening the withholding tax on royalties and service fees, and the possibility of a withholding tax on rent from tangible assets used in SA.

• Consider requiring non-residents to prove entitlement to exemption or reduction of withholding taxes under treaty (with a clearance and certificate approach for future payments to entities that have proved entitlement).

• Evaluate whether it is possible (constitutionally) to introduce a limitation of benefits provision for treaties into domestic law and monitor developments at the OECD in this regard.

• Consider whether the 80 percent test of value in the shares attributable to SA immovable property is too high, in the context of offshore indirect disposals of SA EI rights.

• Consider, as a possible alternative to taxing offshore disposals, a proportionate deemed disposal of an EI right held by a local entity where that entity suffers a direct or indirect change of ownership of 20 percent or more (mark-to-market approach).