The Proposed S.A. 8% Royalty Regime on Diamonds will Impact Marketing Policies and is likely to lead to Renewed Friction between De Beers and Government
April 03, 03The South African government doesn’t like De Beers. No other conclusion can be drawn from the provision in the draft “Money Bill” in which the diamond mines are singled out to pay 8% royalties, as compared to 3% for gold and silver, 1%-3% on oil and gas, 2% for copper, iron and zinc, etc. But the diamond industry at large should realize that the contemplated tax changes may well impact the marketing policies of De Beers – and not for the better. Our expectations are that, in reality, De Beers may well end up paying a royalty that is much more than 8% of the value of the production. In order for the government to collect the tax, it first has to establish the fair market value of the thousands of categories which make up the De Beers S. African diamond production. According to the proposed legislation, the basis for its royalty payment must “at least be equal to the actual gross sales price” of the diamonds. Can be higher; not lower. Says the government: “the proposed law provides for upward value adjustments to address deliberate under-valuations or avoidance issues. The government has a right to increase the value above the gross sales price, if that price does not fully reflect the arm’s length value of the mineral resource transferred.” It almost sounds as if one should get ready for seeing who will be able to collect the most above the gross sales price….
The word “deliberate” scares me, as even the most honorable members of the diamond fraternity, with the best of intentions, will differ in their valuations on rough diamonds. There are no absolute market prices. If a DTC sight box is traded in the market at a 10%-15% premium, as many boxes were a few weeks ago, could that be interpreted as showing that the De Beers’ sales price is below fair market value? Then there remains the perennial argument about “spot market” and “fair market” value – bearing in mind that sometimes certain categories of diamonds may have to be kept in stock for quite a while before they can be sold. In the past, all the heated arguments around the valuations by the Government Diamond Valuator had, at the end of the day, hardly any financial impact on De Beers. The company’s taxes were based on its financial results, on its profits, and not on the value of the production. [The theoretical 15% export tax has never been charged or paid.] If the so-called “Money Bill” passes, the consequences for De Beers may not only be of a monetary nature (and money is just money), but it may also put the producer and its government again on a conflict and friction course. That’s something nobody needs.
Let’s look at (1) the principles involved, and (2) the impact on the bottom line. In terms of principle, the money bill proposes that certain royalties be paid by holders of mineral rights for the extraction and transfer of South African mineral resources. The idea is that the nation is entitled to a consideration for the extraction of its non-renewable mineral resources. That concept is universally accepted. In Canada, royalty payments are based on the taxable income of the mine. In Botswana and Namibia 10% royalties also apply on gross revenue (on value), but the high level of mutual trust between the producer and government (in Botswana higher than in Namibia) ensured that the royalty has never become a point of friction. Actually, the overall tax burden in Namibia is exceedingly high. But the principle that the country has the right to get a return on its mineral resources is not being challenged.
How does an ad valorem royalty affect the bottom line? Strictly speaking, the royalty is a new tax -an addition to present taxation. Actually, there is an equivalent tax in place that can be compared to royalty, which is called a “mining lease consideration”. This refers to a 3%-5% (sliding scale) payment based on taxable income, not on the value of the product. If one increases corporate deductible expenses, the payment goes down. [In practice, the mining lease consideration is only applied on the Finsch, Namaqualand and the Oaks mines. It is calculated on a percentage that is set differently for each mine and is tied to the respective profit to revenue ratio.]
Executives at De Beers anticipate that the “mining lease consideration” will be discontinued after an ad valorem royalty regime is introduced, so it is relevant to reduce these payments from the potential royalty payable, if one wants to get a proper appreciation of the effect of the proposed royalty regime on De Beers earnings. As the privately-owned De Beers doesn’t provide as much financial information as in its former “public life”, it is easier, for this purpose, to deduce the information from the financial figures available for 1999 and 1998. In 1999, for example, in South Africa the profits in the diamond account totaled $149 million; the pre-tax profits (including investment income, interest, etc.) totaled $325 million. The mining lease payment came to $14.8 million, which is the equivalent of 9.9% on diamond profits and 4.5% on total pre-tax profits. In that year, De Beers South African diamond sales were $834 million, thus the mining lease payment equaled 1.8% of gross turnover. If the new royalty regime would have been in effect in 1999, the royalty payment would have totaled $66.7 million. More than quadruple the amount (4.5 times more). But that’s only part of the story: who knows whether the GDV would have accepted the $834 million sales figure! [All rand figures converted at end of year exchange rates.]
If we make a similar calculation for 1998, we see that the mining lease payment was merely $7.8 million, the diamond account profits were $149 million, and pre-tax profits $325.3 million. The mining lease payment was thus the equivalent of 5.2% on diamond profits; 2.4% on all profits. On turnover of $680 million, it represented merely 1.1%. If the 8% royalty would have been in place, the payment would have been at least $54.4 million, instead of $7.8 million!
The question which should be of concern to the entire diamond industry is how the new 8% royalty regime in South Africa will impact the behavior of De Beers. Let’s look at the figures first. In 2002, Tacy Ltd.’s independent research put the value of the De Beers South African diamond production at $720.2 million. We expect it to grow to $783.5 million in 2003. If the royalty regime would have been in effect, this means basically new tax charges of $57.6 million and $62.7 million respectively. Even if we assume that the mining lease charge will be discontinued, the extra burden may well be the equivalent of between one-third and half of the diamond account profits! Though the royalty is a deductible expense for tax purposes (which somewhat lowers the effective rate), we are worried that it will force De Beers to rethink many policies or practices.
In all fairness, the ad valorem basis of royalty (i.e. royalty based on gross sales value) is not unusual. The South African government says this “is consistent with international best practice”. No argument about that. The government frankly admits that when royalty is based on profits, this invites tax evasion (or rather avoidance) by “artificially inflating costs, thereby reducing royalty collection to marginal levels.” [Thank you – this is really a statement underscoring the profound trust and confidence of government vis-?-vis its mining companies.] The diamond trade and industry should be concerned with the royalty’s impact on Supplier of Choice. That marketing system is premised on allowing customers sufficient margins to expand downstream advertising, to develop marketing policies aimed at increasing the rate of growth of demand. De Beers will not be trying to squeeze the last dollar out of its clients – otherwise it could not be “the Supplier of Choice.” Will premiums on the boxes effectively push the royalty burden of De Beers above 8%? In the (not yet published) new Diamond Bill, the Government Diamond Valuator will be responsible to the Ministry of Finance. Will that Ministry use the GDV function to exact royalties on values that exceed the export price set by De Beers itself?
The issue is not only affecting De Beers of course. There are also small alluvial diggers in South Africa of which the government says they “can extract and sell diamonds at great profit without government detection.” Instead of improving monitoring of alluvial diggings, the government proposes that the purchasers of the diamonds – the traders – will be required to collect and pay the royalty on behalf of any diamond digger out of the diamond sales proceeds. Hallelujah! The diamond traders will now act as government diamond royalty collectors? If there is one way that will drive the alluvial diggings totally into the parallel market, it is that provision in the Money Bill. Let’s hope that common sense will prevail. It is the tone of the entire presentation that should worry the industry most. The government’s underlying assumptions are that a profit related royalty would lead to cooking of the books, while diggers shouldn’t be trusted with responsibility to pay their own taxes at any rate. Not a promising atmosphere.