BASIC CONCEPTS OF ROYALTY, MINERAL RESERVATION, RING-FENCING

AND CASH FLOW SURCHARGE IN MINING

Since all mineral resources in public and private lands within the territory and exclusive
economic zone of the Philippines are owned by the State, there is a responsibility on its part to
promote their rational exploration, development, utilization and conservation taking into
consideration national growth vis-à-vis protection of the environment and the rights of the
communities.

In this regard, as owner of mineral resources, the state regulates and manages the
activities regarding the use of the said resources so much so that it issued the Mining Act of
1995 and the various rules, regulations and guidelines subsequent to it. Pursuant to Section 8
of Republic Act (R.A.) No. 7942, Department Administrative Order No. 2010-211 is
promulgated as the revised rules and regulations.

The mining Act further provides that a royalty must be paid “upon utilization of the
minerals” which shall be “agreed upon by the parties” i.e. mining companies and the ICC2 or
the small-scale miners in areas covered by the latter.3

I. Royalty

A royalty is defined as a payment to an owner for the use of property, especially patents,
copyrighted works, franchises or natural resources.4

Rationale5: There are at least 3 reasons for charging resources

1
Providing for a Consolidated Department of Environment and Natural Resources Administrative Order
for the Implementing Rules and Regulations of Republic Act No. 7942, Otherwise Known as the “Philippine
Mining Act of 1995”
2
Sec. 17, RA 7942
3
Sec. 19 (e), ibid.
4
Investopedia website (https://www.investopedia.com/terms/r/royalty.asp)
5
Kevin Guerin, Principles for Royalties on Non-Mineral Natural Resources in New Zealand, New
Zealand Treasury Policy Perspectives Paper 06/08 November 2006, pp. 6-8. Available at
http://www.treasury.govt.nz/publications/research-policy/ppp/2006/06-08/05.htm. Accessed, February 2, 2018.
 a. Funding / general revenue. This is directed to fund government activities which
may or may not be related to the resource use. The main objective is to raise revenue
in the least economically distorting manner, while taking equity issues into account
(examples include income tax or goods and services tax as applied to individuals or
businesses using a resource – such taxes typically do not vary depending on the
resource used and are not directly related to the level of resource use).
b. Cost recovery. This is to meet the administrative costs of planning, approving and
monitoring resource use. Failure to recover costs from users encourages over-use
and limits funding to support administration and enforcement.
c. Economic. This is aimed to capture a share of economic rent for owners of a
resource and address the interests of resource ‘owners’ and encouraging efficiency
in resource use.

Royalty’s rationale addresses the economic reason for it (e.g. mining royalty) can be a
way of collecting economic rent. Economic rent is the margin between the income realized by
an owner of a factor of production (such as land, minerals, or water), and the cost of
development, including financing costs and compensation for risk. Collecting economic rent is
one possible rationale for imposing royalties, either for equity (fair distribution of returns from
public resources) or efficiency reasons (achieving optimal resource allocation or avoiding
resource dissipation). In strict theoretical terms, collecting economic rent can be seen as the
sole justification for charging a royalty.

Specifically, a mining royalty is collected for the payment to the owner of the mineral
resource in return for the removal of the minerals from the land. Mining royalty is payment in
return for the permission that gives the mining company access to the minerals and gives the
company the right to develop the resource for its own benefit. Royalty is a payment for a
continued right to mine, with no actual or implied mineral ownership by the state.6

6
James Otto et. al, Mining Royalties: A Global Study of Their Impact on Investors, Government, and
Civil Society. World Bank, Washington, D.C., 2006, p. 41. (Available at,
http://siteresources.worldbank.org/INTOGMC/Resources/336099-
1156955107170/miningroyaltiespublication.pdf. Accessed, Feb. 2, 2018.)
 Sources.7
A mining royalty can be sourced depending on the basis of its imposition. It may be
Unit-based royalties (UBR), Value-based royalties (VBR), Profit-based royalties (PBR) or a
hybrid of the three.
a. UBR - is based on fee levied per unit volume or weight. It is more often applied to
minerals that are more or less homogeneous, such as industrial minerals.
a. VBR –is payable regardless of profitability. This is calculated as the product of a
royalty rate times the value of the mineral.
b. PBR- is based on the ability to pay i.e. some measure of profitability or adjusted
income.
c. Hybrid royalty – is a combination of the concept of profitability with value or unit
based royalties.

Rate and Base

1. UBR
a. Units of volume
b. Units of weight
c. Graduated fee per unit that increases with the number of units produced

2. VBR
a. Basis of mineral valuation
i. Gross sales price as billed (invoice value, billed value)
ii. Gross market value
1. Refiners certificate and a daily international reference price
quotation
2. Government official to determine product value
3. International market price to establish value of metal in ore
exiting the mine mouth
4. International market price to establish the value of the metal in
the product sold

7
Ibid., p 50-55
 5. International market price to establish the value of contained
metal that is recoverable
6. Government to publish the market price from time to time
7. Minister to determine the market value
8. Valuation expert to set the value (diamonds and gemstones)
iii. Net market value (adjusted for nonproduction costs such as
transportation, insurance, and handling)
iv. Net smelter return (adjusted for smelting and refining and related costs)
v. Best price available within an agreed-upon range (sets a floor)

b. Royalty rate
i. Fixed
ii. Varies according to the level of profit
iii. Graduated depending on level of cumulative annual production
iv. Graduated depending on level of cumulative annual sales.

3. PBR
a. Net value (market value less allowed capital and operating costs)
b. Net profit (realized sales value minus allowed capital and operating costs)
c. Net income (realized income less allowed capital and operating costs)

II. Mineral Reservation

Definition and Basis. Mineral Reservations are established by the President of the
Philippines. Sec. 5 of RA No. 7942 provides that when the national interest so requires, such
as when there is a need to preserve strategic raw materials for industries critical to national
development, or certain minerals for scientific, cultural or ecological value, the President may
establish mineral reservations upon the recommendation of the Director through the Secretary.
Mining operations in existing mineral reservations and such other reservations as may
thereafter be established, shall be undertaken by the Department or through a contractor. All
submerged lands within the contiguous zone and in the exclusive economic zone of the
Philippines are hereby declared to be mineral reservations. A ten per centum (10%) share of all
royalties and revenues to be derived by the government from the development and utilization
of the mineral resources within mineral reservations as provided under this Act shall accrue to
the MGB to be allotted for special projects and other administrative expenses related to the
exploration and development of other mineral reservations. The Mineral Reservations were
administered by the MGB. However, with the objective of making the mineral reservations
revenue-generating, its transfer to the PMDC8 seems to be the logical direction to take.9

III. RING-FENCING

What is ring fencing? Ring fencing refers to a situation in which each of the taxpayer’s
operations is treated independently, for tax purposes, from all of the taxpayer’s other
operations.10 The most common function of ring-fencing is to protect a firm from becoming
subject to liabilities and other risks associated with bankruptcy. Another function of ring-
fencing is to help ensure that a firm is able to operate on a standalone basis even if its affiliated
firms fail. Yet another function of ring-fencing is to protect a firm from being taken advantage
of by its affiliated firms essentially preserving the business and assets of the ring-fenced firm.
And still another function of ring-fencing is to limit a firm’s risky activities and investments.11

Rationale. In a regulatory context, the term can best be understood as legally

deconstructing a firm in order to more optimally reallocate and reduce risk. So utilized, ring
fencing can help to protect certain publicly beneficial activities performed by private-sector
firms, as well as to mitigate systemic risk and the too-big-to-fail problem inherent in large

8
Philippine Mining Development Corporation (PMDC) formerly the Natural Resources Mining
Development Corporation, was incorporated with the Securities and Exchange Commission on July 4, 2003,
pursuant to an authority contained in a Memorandum of the President of the Philippines dated April 9, 2003. The
PMDC is a wholly-owned and controlled government corporation. Being a government corporation, the PMDC
was attached to the Department of Environment and Natural Resources (DENR). Pursuant to
DENRAdministrativeOrderNo.2003-38 and by virtue of a Memorandum of Agreement between and among the
DENR, PMDC (then NRMDC) and NRDC, the PMDC was designated/appointed as the new implementing arm
of the DENR in undertaking the mining and mineral processing operations in the 8,100 hectare Diwalwal Mineral
Reservation located in the municipality of Monkayo, Compostela Valley Province. From DENR, the PMDC was
transferred to the Office of the President on July 18, 2007, through Executive Order No. 636 signed by President
Gloria Macapagal Arroyo. On December 27, 2007, the PMDC was transferred back to the DENR through
Executive Order No. 689 signed by President Arroyo. The transfer was made to closely monitor and oversee the
efficient and effective implementation of the country’s utilization and development of its mineral resources.
9
Philippine Mining Development Corporation, Mineral reservations. Available at
http://pmdc.com.ph/site/mineral-reservations/. Accessed, Feb. 2, 2018.
10
James Otto, Mineral Royalties, p. 134.
11
Steven L. Schwarcz, Ring-Fencing, Southern California Law Review, p. 73-74. Available at,
https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=5531&context=faculty_scholarship. Accessed,
February 2, 2018.
financial institutions. If not structured carefully, however, ring-fencing can inadvertently
undermine efficiency and externalize costs.12

Advantages and disadvantages. If the mining tax regime is more onerous than the
standard tax regime, the taxpayer will seek to have these project related activities treated as
down-stream activities outside the ring fence. If they are treated as a separate activity, the
taxpayer through abusive transfer pricing may shift profits to the lightly taxed downstream
activities. Ring-fencing rules matter for two main reasons:
- Absence of ring-fencing can seriously postpone government tax revenue because an
investor who undertakes a series of projects will be able to deduct exploration or
development expenditures from each new project against the income of projects that
are already generating taxable income.

- As a mining (or petroleum) area matures, absence of ring fencing may discriminate
against new investors who have no income against which to deduct exploration or
development expenditures.13

Countries adopting ring fencing.14Some of the countries adopting ring-fencing are

the following.
o Ghana
o Kazakhstan

12
Ibid, p. 69.
13
Emil M. Sunley and Thomas Baunsgaard, The Tax Treatment of the Mining Sector: An IMF
Perspective, World Bank, Washington D.C. Background paper prepared for the World Bank workshop on the
taxation of the mining sector, April 4-5, 2001 p. 5.
http://siteresources.worldbank.org/INTOGMC/Resources/sunley-baunsgaard.pdf. Accessed, February 2, 2018.

Another trend is a limitation with respect to the use of mining losses known as the “ring fencing rule”.
14

Ghana’s 2012 Budget Statement provides that losses incurred with respect to one mining site will no longer be
available for offset against profits generated from another contract area or site belonging to the same company in
determining income subject to corporate income tax. This limitation is known as “ring fencing”. The Ghana
government, in the 2012 Budget Statement, proposed an increase to the corporate income tax rate from 25% to
35% and an additional tax of 10% on mining companies. Ghana’s proposed tax increases are likely to take effect
during 2012. Similar to Ghana, Kazakhstan has a rule that provides that subsurface users operating under more
than one subsurface contract are required to maintain separate accounts and records for tax purposes with respect
to each contract or other activity. The subsurface contract miner is not permitted to offset costs of one mining
contract against income of another contract or activity. Since July 2010, Tanzania has a “ring fencing rule” in
that losses incurred in one mine cannot be used to offset profits of another mine, notwithstanding that both mines
are part of the same legal entity. (https://www.pwc.com/gx/en/energy-utilities-mining/publications/pdf/pwc-gx-
miining-taxes-and-royalties.pdf)
 o Tanzania

IV. Cash flow surcharge

Definition. Tax surcharge on cash flow is imposed by adjusting accounting profit by
adding back depreciation and interest, and deducting any capital expenditure in full, yielding
to a base of net cash flow.15

Basis. The tax base for the surcharge would be determined by adding back depreciation
and interest and other financing charges to regular taxable income before the loss carryover,
and deducting any capital expenditure and the regular CIT. This yields a tax base of net cash
flow in the year after the regular income tax but before any financing. 16

Purpose. Additional profit-based government share which serves as a minimum tax

after cost recovery.17

Rationale.

1. First, the contractor commences to pay the additional government share only
after the recovery period, which is a maximum of five years or at a date which the aggregate
of the net cash flows from mining operations is equal to the aggregate of pre-operating
expenses, whichever comes first. The recovery period, however, may be extended with
approval by the Secretary of DENR. Second, after the recovery period, the additional
government share is paid if the basic government share, which consists of all direct taxes,
royalties, fees, and related payments paid by the contractor, is less than 50 percent of the net
mining revenue, which is equal to gross output less deductible expenses.18

15
Fiscal Affairs Department, Fiscal Regimes for Extractive Industries: Design and Implementation,
International Monetary Fund, 2012. Available at https://www.imf.org/external/np/pp/eng/2012/081512.pdf.
Accessed, February 2, 2018, p. 20.
16
Emil M. Sunley et al., Philippines: Reform of the Fiscal Regimes for Mining and Petroleum,
International Monetary Fund, Fiscal Affairs Department, 2012. Available at,
https://www.imf.org/external/pubs/ft/scr/2012/cr12219.pdf. Accessed, February 2, 2018, p. 34
17
Ibid. p. 33
18
Ibid. p. 33
 Challenges.19
1. It offers investors that finance operations through debt the opportunity to in effect
recognize costs twice. Loan amortization is treated as a negative cash flow. This results, in
effect, in a double deduction, which will extend the recovery period. The double deduction
occurs because the recovery period lasts until the pre-operating expenses, financed by the loan,
are recovered (the first deduction), and loan amortization reduces net cash flow, as defined for
purposes of determining the recovery period (the second deduction). Loan amortization should
not be allowed as a deduction in determining net cash flow.
2. Many of the taxes, royalties, fees and other payments included in the basic share
are also operating expenses therefore recoverable costs. For example, royalties are treated as a
deductible expense in determining net mining income and it is also included in the basic
government share and therefore can reduce the additional government share that would
otherwise be due. Similarly, the withholding tax on interest is included in interest expense and
therefore deductible in determining net mining income and also included in the basic
government share.
3. Together with excises taxes it operates as a minimum tax that can impose very high
levels of taxation relative to profits on low profit investments while failing to capture for the
government a greater share of profits as profits rise due to an increase in the value of the state’s
natural mineral resources

19
Ibid. pp. 33-34.