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The History of Mining Taxation Conflicts in Zambia

Introduction

The process of liquidation of Konkola Copper Mines (KCM) commenced by the government of Zambia in May 2019 is but an episode in the historical conflict over taxation between the Mining Companies and various governments of Zambia since independence in 1964. Will it ever be resolved. This article analysis the various stages and consequences of that conflict from the Chiluba Government of 1991 to the present Lungu government in 2019.

Zambia is one of Africa’s and probably the world at large with a lot of natural resources, the most prominent of which are minerals- Copper. However, with over a century of mining activities in the country, Zambia still lags in terms of revenue collection from a sector which is the country’s major economic resource. It has been argued that despite the various ways in which mineral extraction can benefit Zambia, by far the most important channel is from tax revenues. Given this argument, the principal objective of a mining policy therefore is to maximise government revenue from the mining sector over time.

 

The debate on how the mining sector should be taxed does not seem to yield a satisfactory and settled position year in year out. Different stakeholders have different ideas. Some of these ideas are informed ones while others are not. It is this vein that I would like to add my voice to.

 

To better comment on this hot issue, one needs to have some basic understanding of the different taxes that the mining companies are subject to and probably how the same are enforced. Among the several taxes that the mining companies are supposed to pay in Zambia, some of the few are Customs and Excise Duty, Value Added Tax (though refunded) and Income Tax. A combination of these and other taxes are what constitute a taxation regime for mining companies in Zambia. However, the most contentious of all is the Income Tax which poses a lot of challenges for the government to collect and for the mining companies to comply with. In order to calculate how much income tax a company should pay; the simple formula is to remove all the expenses from the gross sales. If anything remains, that’s the profit that the government is supposed to collect its 35 per cent from in form of income tax. Conversely, if nothing remains, then the company has made a loss and therefore nothing for the government to collect its tax from.

 

Now here is the difficulty…the income tax comes with a lot of adjustments that reduce its taxable income. In addition to the most obvious ones such as salaries, maintenance costs, electricity and other direct expenses, there are other costs which are difficulty to measure and therefore a challenge to the tax authorities to enforce comprehensively. Some of these are:

  1. Depreciation allowances

Depreciation allowance refers to the allowable period an asset is said to decrease in value (fair value depreciation). For example, in addition to regular cash costs, companies can count a proportion of their capital investment as “depreciation” costs each year. Since mines typically have to incur substantial capital costs before production commences, the particular percentage they are allowed to claim as depreciation each year can make a big difference to estimates of profit (and tax). In order to encourage mining investment, many countries allow mines to claim, “accelerated depreciation”. This term merely reflects a higher rate at which expenses can be depreciated. Increasing the depreciation rate has the effect of reducing profit and tax in the early years and increasing it later – so tax payment is postponed.

  1. Loss-carry forward provisions

If a company’s profit in a year is negative (i.e. it made a loss) in Zambia it is allowed to carry the loss forward to the following year and use it to reduce its taxable income and tax in that year. Tax only becomes payable once cumulative profits exceed cumulative losses. If losses are substantial, or if they accumulate over a number of years, the company may only start paying company tax several years after it starts earning profits.

  1. Ring-fencing

Ring-fencing is the separation of a company’s operations for the purposes of calculating taxes. Such a separation can be done in a variety of ways. One of them could be the geographical location of different operations or the types of operations, and so forth. Ring-fencing is used to limit the ability of companies using costs from one operation to offset taxable profits in another.

  1. Tax holidays

A tax holiday is a temporary reduction or even elimination of a tax. It can be applied on an individual company basis or across a whole industry. Tax holidays can be used to relieve cash flow problems a company may experience in the early years of the production cycle, in a similar manner to a loss carry-forward provision.

Problems Faced by Tax Administrators

There are several problems that our tax administrators face in enforcing the tax regimes but four of those problems are now highlighted:

Transfer pricing abuse

The global mining industry is dominated by multinational companies (companies with operations in more than one country). Such companies do not pay taxes on their global income, but on their operations in each tax jurisdiction. While companies are concerned about their operations , across  all regions, they have to calculate taxable income for their operations in each country in order to pay taxes to individual governments.

Many goods and services are traded between different operating units within multinational organisations in the course of their operations. To calculate the financial position of each operating unit, a company must assign prices to the traded goods and services. This is problematic for tax purposes because prices are usually determined by markets. However, by definition, there are few markets for the goods traded within the same company. For instance, suppose that the UK head office sends a team of technical experts to undertake some work in a Zambian subsidiary. What price should be assigned to this service? There will be no market value for the specific expertise or the specific assignment. How companies deal with this issue is called transfer pricing. This poses problems for tax administration because there is an incentive for firms to deliberately price their inter-company transactions in such a way as to reduce their overall tax payments.

Thus companies can reduce their overall tax payments by selling goods and services from an operating unit in a low tax jurisdiction to one in a higher tax jurisdiction at a relatively high transfer price. Income is transferred away from the high tax jurisdiction, where both taxable profits and tax payments fall. Correspondingly, taxable income increases in the low tax jurisdiction. Because the tax rate is lower there, the company’s overall tax bill is reduced.

Under-reporting of production values

Under reporting of production values refers to a situation where mines report to the tax authority that the value of their production is less than is its actual market value. This can be done in a number of ways: mines may under-report the volume of production or the grade of the mineral, or they may fail to report by-products contained in the ore. Often multiple minerals are found within the same ore body. For example, minerals such as gold and silver are sometimes found within copper ore.

Checking the quality and content of all production – not just in mines, but also in smelters and refineries – poses significant problems for governments. They need to have an understanding both of the geology of the area being mined and of the processing technology for extracting the various mineral types from the ore. This requires close cooperation between the mines ministry and the tax authority. Without proper processes in place and competent staff to operate them, under-reporting of production costs government considerable tax revenue.

Debt payments abuse

Interest payments on debt are almost always allowed to be deducted from profits when determining taxable income. This can create an incentive for a multinational company to lend funds to a subsidiary at a high rate of interest in order to reduce the subsidiary’s taxable profits. This is a different form of transfer pricing.

Hedging manipulation

Mining companies face more volatile prices for their products than firms in most other industries. To reduce the impact on their profits, mines can enter into derivative contracts (like futures and options) that guarantee a specific price for their output in the future. For instance, a firm may enter in to a futures contract that stipulates that it must sell a tone of copper at a price of $7,000 in three months’ time. The firm no longer has to worry that the copper price will fall; the futures contract acts as insurance against a fall in the copper price. This is called hedging. It is a legitimate and useful business activity.

However, hedging can also be used to shift income out of high tax jurisdictions in the same manner as transfer pricing described above. Instead of using derivatives to protect themselves against falls in mineral prices, firms can deliberately trade in order to lose money in a subsidiary facing a high tax rate and to gain in another subsidiary facing a lower tax rate. In effect, firms can transfer income from one subsidiary to another by trading derivatives.

The common adjustments to the tax base and the challenges faced by the tax administrators have cumulatively created discontent among the various stakeholders as regards the contribution the mining industry is making to Zambia’s treasury in form of taxes. Following this discontent, the Zambian government has reacted by changing the tax laws relating to mining taxation more than seven times since privatisations as follows:

 

1) The Development Agreements (DAs) negotiated with individual mines at privatisation.

2) The “2008 Regime” (the tax regime used between April 2008 and March 2009).

3) The “2009 Regime” (the tax regime used between April 2009 to March 2012)

4) The “2012 Regime” (the tax regime that has been in effect up to April 2012).

5) The 2015 Mineral Royalty Regime.

6) The 2016 Regime (the regime that is in currently in effect)

7) The 2019 Sales Tax Regime

Development Agreements

After privatisation in 1997, agreements were made between the Zambian government and each company that bought the assets of Zambia Consolidated Copper Mine (ZCCM). These agreements, however, have never been made publicly available by the Zambian government though it is believed, through some leaked documents accessed on Mine Watch Blog, that tax rates and other details for each company differed to some extent. Those agreements signed in 1997 had higher tax rates than those signed in 2000. However, in 2003 it was agreed between the Zambian Government and the new mine owners that all mining companies operating former ZCCM assets would pay the same rates for Company Income Tax and Mineral Royalty. Other details such as the length of fiscal stability clauses and the allowed period of loss carry forward stated in each agreement are believed to have remained the same.

 

  1. Income Tax was levied at a rate of 25 per cent on gross profits less deductions. The three principle deductions were mineral royalty payments, any price participation payments, capital expenditure incurred during the year (100 per cent depreciation rate), and accumulated losses from previous years (loss carry forward). The period for which losses could be carried forward varied between companies, but usually was between 10 and 20 years. Losses from hedging could be counted alongside normal operating costs when calculating gross taxable profits.
  2. Mineral royalty was levied at a rate of 0.6 per cent on the gross value of sales, less the cost of transporting, insuring and processing/refining the mineral products. This meant that the true tax burden was less than if the base was purely gross sales value. The value of sales was calculated using the realised prices submitted by the companies, rather than a standard defined price such as the LME price.

iii.         Price participation agreements. Some mining companies also faced price participation agreements. These essentially acted like a variable-rate royalty. They were levied on the gross value of production less transport and other costs and the rate varied according to the prevailing LME price. This was not officially a tax, but rather a charge that was paid to ZCCM Investment Holdings PLC (the holding company for the government’s remaining mining assets). However, since mining companies still had to pay, it contributed to their fiscal burden and that is the reason it is considered alongside other payments to government.

  1. Fiscal stability clause. Each Development Agreement contained a clause that stated that the Zambian government would not adversely alter the tax regime for a given period of time. This period differed between agreements and ranged from 15 to 20 years.

 

The 2008 Regime

In 2008 the Zambian government breached the fiscal stability clauses contained in the Development Agreements and imposed a new tax regime with a higher tax burden by enactment of the Amendment Act No.7 of 2008 which increased the company income tax rate from 25 per cent to 30 per cent. Deductions also changed as follows:

  1. Depreciation allowance was cut from 100 per cent to 25 per cent. This meant that only a quarter of the value of a company’s capital expenditure (investment) could be charged to depreciation each year, instead of the full amount. In other words, tax payments would be brought forward and it would take longer for companies to recoup investment expenditure.
  2. Losses could be carried forward for a maximum of 10 years, instead of 10 to 20 years. Again, this would have the effect of bringing forward income tax payments.

iii.         Hedging operations were to be taxed separately from mining operations. Losses from hedging could no longer be used to reduce taxable profits from operations. This was intended to prevent companies from adopting hedging strategies deliberately designed to reduce taxable profits in Zambia.

  1. The Mineral Royalty rate for copper and cobalt was increased from 0.6 per cent to 3 per cent. In addition, henceforth it was to be based solely on gross sales value using the LME price instead of the price claimed by the mining companies. This ensured that mines could not avoid taxes by understating the realised sales price, or over-stating the costs of transport, etc. As before, royalty payments could be deducted from taxable income for the purposes of calculating income tax.
  2. A Windfall tax was introduced and operated like a variable rate royalty. It was calculated each month from the gross sales revenue of the taxpayer (in the same manner as the Mineral Royalty), using a tax rate that increased with the average LME cash price (for copper) or the Metal Bulletin price (for cobalt). It should be noted that the rate was cumulative. For example, if the price is $3.25 per lb. then the first $2.50 per lb. is taxed at 0 per cent, the next $0.50 at 25 per cent and the last $0.25 at 50 per cent [1].

 

  1. A Variable Profits Tax (VPT) was also introduced at the same time. It was intended to make the tax regime more progressive by collecting a higher proportion of revenue when profits were high than when profits were low. VPT allowed mining companies to earn profits equivalent to 8 per cent of their gross sales revenue before the tax kicked in.

The 2009 and 2012 Regimes

The 2008 regime only lasted a year. The mining companies were upset by the unilateral revocation of the Development Agreements and some refused to pay the new taxes. The announcement was followed shortly after by the onset of the global financial crisis. Copper prices fell sharply and marginal mines started laying off workers. The Government responded by reversing some of the 2008 tax measures in the 2009 Budget:

  • Windfall tax was abolished.
  • Tax depreciation reverted to 100 per cent.
  • Mines were again allowed to combine hedging and operating income for income tax purposes.

Following general elections in September 2011 and the resulting change of government, further reforms were made to the mining tax regime in the 2012 Budget. The two main changes for the mining industry tax regime were as follows:

  • The mineral royalty rate for copper and cobalt was doubled from 3 per cent to 6 per cent.
  • Hedging and operating income were again to be treated separately for income tax purposes.

The 2015 and 2016 Regimes.

In the 2015 Budget, the Zambian government revised its tax regime structure by replacing the 2012 regime that combined mineral royalty tax (at 6 per cent) and corporate tax (at 35 per cent) with a single system of the mineral royalty tax at 20 per cent as the final tax. Though the mining companies did briefly comply with this particular regime under protest, it sparked a lot of controversy with some mining companies threatening mass retrenchments and halting expansion projects. The mining companies argued that the tax regime was too harsh to the industry as it hinged on the cost of production without regards to the profitability of the entity or mine grade. The falling copper prices on the London Metal Exchange Market also contributed to the debate that the 20 per cent mineral royalty regime was unsustainable for the mining industry. The combination of these reasons are said to have put the mining industry in Zambia on the verge of collapsing. The government responded to this criticism by suspending the operation of the 2015 regime and replacing it with the 2016 regime which is currently in operation. Its structure is similar to the 2012 regime but the difference is that it responds to low market prices. However, on 1st July 2019, the government seeks to implement a new Sales Tax Regime which will replace the regime briefly discussed above.

Analysis of Zambia’s Mining Tax Regimes since Privatisation

The general terms of sale in the Development Agreements embodied highly generous tax and other concessions. Several issues stand out: there was no VAT charge for mine products; capital expenditure had a deductible allowance of 100 percent; and stability periods” of 15 to 20 years during which no changes could be made to the agreements. Mining companies have been enjoying excise duty rebates on electricity supplied by the state utility firm. A major concern was the low average rate of mineral royalty, which in most cases was set at 0.6 percent and thus way outside the global average range of 2 percent to 6 percent and below the IMF’s own estimates of between 5 percent and 10 percent for developing countries.

It is worth noting that the first batch of privatized companies paid royalty rate of between 2 percent to 3 percent. But this rate was revised downwards following negotiation of a highly generous 0.6 percent by Anglo America Corporation, which was subsequently applied uniformly across all mining firms. This reflects the dangers to governments of negotiating discretionary tax regimes applicable to individual companies, a tendency prevalent in countries emerging from crisis situations and eager to attract foreign direct investment by offering overly generous terms and conditions.

The Foreign Investment Advisory Service of the World Bank argued that, due to the incentives granted to the mining sector, the marginal effective tax rate was in the neighbourhood of zero percent. The subsidy granted to the purchase of mining machinery, at 18.3 percent, represented the largest in any sector for any asset. It was  estimated that the positive shock from price increases generated a permanent income stream in excess of 5 percent of pre-boom GDP, translating into a potential saving of US$1.4 billion (39 percent of 2002 GDP) in net present-value terms. However, the private mining companies, through profit repatriation, appropriated the bulk of this windfall and made dividend pay-outs to foreign shareholders which in turn deprived the government of the much needed revenue.

Five main factors explain the generous incentives provided to the private operators of the mines. First, the mining infrastructure and ZCCM’s assets were by and large dilapidated. Attracting viable investors would have been difficult without favourable concessions. Second, low copper prices weakened the bargaining power of the government. Third, ZCCM was incurring debt equivalent to US$1 million per day. Fourth, given the geological features, copper mines in Zambia have higher cost structures, which can add to investor caution. The 2008 figures show that the unit production cost in Africa was US$160.6 cents/lb., compared to US$96.5 cents in Latin America and US$138.2 cents in Asia. Finally, as part of its aid conditionality, the IMF pressed for transfer of ownership of ZCCM with concluded sale marked for March 1999. The government also yielded to the IMF’s conditions by committing to refrain from granting fiscal incentives, except provision of specific tax concessions to buyers of ZCCM.

Copper price increases from 2003 onwards represented a huge resource windfall for the new private owners. For instance, in the case of the First Quantum’s Kansanshi Copper Project, the annual average operating cost for the initial five years was estimated at US$11.26 per ton of copper. Then the forecast was that the cost would fall to US$10.30 per ton over the next five years, but then increase to US$11.23 per ton during the last five years of the 16-year mine life. Under the Development Agreement, the average annual price for the project was set as at end-December 2002 level, which was US$0.72 per pound. However, the actual realized price was US$2.6 per pound over the same period. With such cost-price configuration, the boom allowed most mining firms to recoup their investment much faster than scheduled. At 25 percent corporate tax rate, Kansanshi was expected to pay US$161.2 million in taxes after recovery of capital costs and US$14.2 million in royalties over the project life but these figures were based on the conservative cost-price estimates without recognizing the possibility of a significant turnaround in international copper prices. Thus, given the surge in prices, it was likely that the payback period may have come even earlier, bringing the company into profitability much quicker.

Recent estimates indicate that Zambia lost US$17.3 billion (in real 2010 prices) in illicit capital flight in the period between 1970 and 2010. This was driven by unaccounted-for balance of payment movements as well as transfer mispricing, mainly through manipulation of prices in trade between multinational companies in different tax jurisdictions.

According to KPMG, “There are no detailed rules on transfer pricing in Zambia.” This is precisely what some companies have exploited. For instance, companies registered in Switzerland have copper producing subsidiaries in Zambia. One such Zambian based subsidiary reportedly sold copper to its Swiss-based counterpart at below-market price. Then, the Swiss-based company sold the copper at world prices as if it originated from Switzerland (netting the price difference as profit whilst consistently reporting losses in Zambia). Switzerland has in effect become a “major copper exporter”.

The share of Zambian exports to Switzerland in total exports increased from one percent in 1995–1998 to more than fifty percent in 2008. According to Cobham, “The use of Switzerland for transit in commodities in this way was well known, but remains highly opaque. What is absolutely clear is that declared Zambian copper exports, on which the country depended economically, effectively disappeared once they left the country.”

The Mopani Copper Mines (MCM) Plc, which is the second largest mining company and acquired by Glencore in 2000, was implicated in the transfer-pricing plot. In 2009, the Zambian Revenue Authority contracted the Norwegian tax auditors Grant Thornton and Econ Poyri to investigate tax avoidance and tax evasion related to the operations of the MCM. Secondary sources indicate that the auditors found serious malpractices, which were in breach of the OECD guidelines. It was found that the company:

  1. overestimated operating costs, compared to other firms in the industry;
  2. underestimated production volumes; and

iii.         manipulated its financial statements, particularly the selling price of copper. The company was selling copper to its parent company Glencore at a quarter of the official price quoted at the London Metal Exchange. At the same time, it was reporting losses in its operations in Zambia.

Conclusion

From the trend above, it is clear that we are still far from discovering a lasting solution to the problem regarding mining taxation. We are more or less on a trial and error 55 years after independence. Even the newly introduced Sales Tax has already been received with mixed feelings especially from the mining companies operating in Zambia. Should we continue negotiating? Should we legislate? Should we liquidate? I strongly believe the solution lies in negotiation, the adherence to the rule of law governing the contracts we have signed and lasting informed legislation in the interests of Zambia that take into account the economic interests of the investor. We must send the best lawyers, economists and accountants who understand the various terminologies that are alien to our ears and the government must be prevented from bowing down to the melodies of the these conglomerates. If we legislate and let the law stand, it will be up to the investor to come forward or not.  However, we should be careful when we legislate so that we do not suffocate the industry to death.

 

Dr. Munyonzwe Hamalengwa teaches law in Zambia and has written a book on the centrality of the Copper Mines in the economy of Zambia as well as the role of the unions in the struggle for democracy from colonial times to the end of the one party state dictatorship (See Dr. Munyonzwe Hamalengwa, “Class Struggles in Zambia, 1889-1989 and the Fall of Kenneth Kaunda, 1989-1991, Latham: University Press of America, 1992).

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