Problems with Calculating Royalties

Problems with CalculatingRoyalties

Michael Coyle *

Introduction 243Scope of paper 245

Recent Case Law-Lessons to be Learned 245

Other Issues 249Types of royalties 249Ranking of royalties 251Stage at which royalty is struck 251Control by the payee....................................................................... 252Protection of the payee 253Auditing and dispute resolution 254Content of the royalty deeds 255Taxation issues 256Netting back to the wellhead 257

Documentation 257Example A: definition of "net profits" 257Example B: definition of "realised value" 259Example C: net smelter returns 259

INTRODUCTION

This paper is intended to expand one area referred to in Howard PlayerBishop's paper entitled "Financial Non-Working Interests", which wasdelivered at AMPLA's 1990 Annual Conference. The area I have focusedon is the difficulty which all too often arises in the calculation of privateroyalties.

As was Howard's intention, this paper is practically rather thanacademically oriented. To that end I have included some royalty andcalculation clauses which I believe strike a fair balance between theinterests of the recipient of the royalty (the payee) and those of thegrantor of the royalty (the payer).

In the first part of this paper I have briefly examined some of theemerging case law involving disputes over the manner in which private(non-government) royalties should be calculated. The cases illustrate a

• Solicitor, Sydney.

243

244 AMPLA YEARBOOK 1993

number of points which should be borne in mind when documentingthe commercial bargain between a payer and payee. In the secondpart of the paper I have dealt with some of the basic issues whichshould be addressed in the preparation of a royalty agreement. 1 Inthe third part of the paper I have focused on those parts of royaltydocumentation which are at the heart of the commercial bargain and yetparadoxically are often given inadequate attention-being definitions ofkey terms and the provisions concerning the actual calculation of theroyalty.

Before examining the recent case law and the lessons which emergefrom those cases in relation to calculating royalties, below are somepreliminary observations arising from my experience with privateroyalties.

Despite the clear advantages of having a commercial bargain reflectedin a written document which accurately and comprehensively reflect theintentions of the parties, my experience and recent case law suggests thatin the case of royalty arrangements there is often unclear or inadequatedocumentation. This perhaps occurs because:

• If the royalty agreement is entered into at the exploratory stage theprospect of future profits may be considered very remote. (So whybother documenting something properly which is very unlikely tohappen?)

• Often the payee is impecunious at worst, or in an inferior bargainingposition at best. Accordingly, any documentation which is preparedis likely to be drawn in terms which favour the payer. Moreover,payees are usually reluctant to spend money on lawyers reviewingor preparing the royalty documentation.

• Whilst the payee may be looking for certainty the payer may not.(Perhaps the payer expects that if the venture proves to besuccessful the payee will be unable to afford to take the matter tocourt and challenge the payer's assessment of the royalty.)

• There is a general ignorance or perhaps arrogance throughout theresources industry that many terms used in the calculation ofroyalties (like "treatment charges", "delivery charges" and even"net smelter returns") are terms of art and require no definitionwhen, as the Tecbnomin case 2 so clearly established, such termsstill give rise to multiple interpretations.

The case law examined below reinforces the necessity of havingprivate royalty arrangements properly documented. A failure to do so isunlikely (ultimately) to be in the interests of either the payer or the payee.In most cases the matter will end up being disputed by the parties,wasting valuable management time, and, if litigated, costing both partiesfurther time and money.

1. Howard covered these issues very well in his paper. I have simply provided anotherview or elaborated on some of his points.

2. Technomin Australia NL v Southern Resources (unreported, WA Sup Ct, 13 November1989).

PROBLEMS WITH CALCULATING ROYALTIES

Scope ofpaper

245

For the most part I have dealt with royalties in respect of minerals.John Grace and Robert Laws will deal in more detail with petroleumroyalties.

RECENT CASE LAW-LESSONS TO BE LEARNED

As an American author put it, in relation to oil and gas leases in the UnitedStates:

"Too much care cannot be devoted to the preparation of a royaltyclause in an oil and gas lease. The prospective payment of royaltiesof great monetary value is involved, potentially at least, in thedrafting of every lease, and any slight error in content orter~inology is apt to prove exceedingly costly." 3

An elementary warning one would have thought.

However, if the royalty calculation clauses which have arisen forconsideration in the course of recent litigation in Australia are anythingto go by, it seems that practitioners and in-house counsel have been slowto heed this warning; or, perhaps more likely, have been unable toconvince their clients/employers that time spent on drafting acomprehensive royalty agreement is time well spent.

Take for example the clause which arose for consideration in theTecbnomin case,4 the facts of which are reasonably simple. In June1986 the defendants entered into an Agreement whereby they agreed todevelop certain ground in Western Australia, part of· which wasdescribed as the Blue Development Area, as a joint venture. The interestsof each of the defendants was expressed to be subject to the "3% netsmelter returns entitlement" of the plaintiff,5 Technomin Australia NL.

The expression "3% net smelter returns" was relevantly defined asfollows:

"3.1 The 3% NSR is the sum which is equal to (3% of) the Value (ashereinafter defined) of all minerals produced and ... sold from theBlue Development Area."

"Value" was in turn defined to allow for the following deductions:

"(i) Transportation costs on a elF basis from the Blue DevelopmentArea to the place where the minerals are smeltered;

(ii) penalties; and

(iii) treatment costs."

3. A W Walker, "Nature of Property Interests Created by an Oil and Gas Lease in Texas"(1932) 10 Texas Law Review 291.

4. The case was heard at first instance by Ipp J-see above, n 2.5. In the context of Ipp)'s judgment, Technomin was the plaintiff. Justice Ipp's judgment

was subsequently affirmed on appeal by the Full Court of the Supreme Court ofWestern Australia (unreported, 18 June 1990).


The expressions "transportation costs", "penalties" and "treatmentcosts" were not defined in the Agreement.

A dispute arose between Technomin and the defendants concerningthe meaning to be attributed to "treatment costs". Technomincontended that the phrase should be limited to the costs payable by thedefendants to the Perth Mint for refining the gold delivered to it. Thedefendants propounded a broader interpretation, contending that"treatment costs" meant either all costs associated with producing thegold from the time the mine was in production, being the costs of miningthe ore, milling, processing and refining it or alternatively all costsassociated with the production of the gold from the point the orecontaining the mineral was mined to the point of sale.

The consequences of the respective contentions of the parties werewell illustrated in the following example put to the court by Mr Anthony,a director of Technomin.

For the purposes of his example, Mr Anthony assumed a notionalannual ore production of 500,000 tonnes of ore, with 60,000 ounces ofgold recovered at an average price of $500 per ounce. On Technomin'sversion, Mr Anthony estimated that the "treatment costs" associatedwith such annual production would be in the order of $60,000. On thedefendants' version, milling costs would be of the order of $16.00 pertonne resulting in milling costs of S8 million in the example postulated.Mining costs would be of the order of $20.00 per tonne resulting inmining costs of $10 million. Thus, on the defendants' calculations, afurther $18 million would need to have been included in the calculationof "treatment costs", reducing Technomin's annual royalty payment by$540,000 (that is, 3 per cent of $18 million).

Perhaps the percentages illustrate the difference more graphically. Onthe plaintiff's version of treatment costs the deduction from the netsmelter return would be less than 0.5 per cent. On the defendants'version the deduction would be about 60 per cent.

In the result Ipp J favoured Technomin's interpretation. His Honourheld that the meaning of "treatment costs" could not be ascertained inisolation and had to be interpreted in the context of the Agreement asa whole and, in particular, with regard to the fact that it was an importantelement of the "net smelter return".

His Honour accepted extrinsic evidence of the meaning of "netsmelter return" in the mining industry and concluded that the expressiondoes have a commonly accepted meaning in the industry (but not inrespect of the considerably more narrow gold mining industry), namely:

"It is regarded as the price received by the producing mine for themineral less the smelting costs and associated costs such astransportation and penalties."

Ipp J concluded that because refining costs in the gold productionprocess are broadly equivalent to smelting costs incurred in theproduction of base metals, the parties, by using the expression "netsmelter return", intended that the costs up to the stage of refining wouldnot be part of the treatment costs.

PROBLEMS WITH CALCULATING ROYALTIES 247

His Honour also concluded that had the parties intended that all thecosts which the defendants argued should be taken into account as"treatment costs" the royalty would not have been termed a net smelterreturn royalty but a net profit interest royalty.

The case was an expensive lesson for the defendants on the desirabilityof precise definition in the creation of royalty reservations. It is no doubta common occurrence, particularly when no commercially exploitablediscoveries have been made on an exploration tenement, for royaltyinterests to be assigned or created with a minimum of documentation orprecision. It is, I suppose, understandable, although not condonable, thatin such circumstances executives of small companies do not perceive aneed to resort to lawyers. However I am sure that the defendants wouldagree that the result in the Technomin case demonstrates the hazards ofsuch approach.

There are of course other examples of inadequately drafted royaltyprovisions in the case law. Another obvious one is the letter agreementwhich caused so many problems for the parties involved in theAustralian Energy Ltd v Lennard Oil NL 6 litigation.

In that case a dispute arose between Australian Energy Ltd on the onehand, and Lennard Oil NL on the other, in regard to the following royaltyreservation:

"There is a 6 per cent overriding royalty interest in the Authority.Three per cent is held by International Oil Service, Cisco, Texas. Theremaining 3 per cent is to be retained by AEL which will convert toa 12.5% netprofit revenue interest after payout." (emphasis added).

At first instance before McPherson J, third parties (but not thedefendant) being companies which had farmed into Lennard's interestargued that because the expressions "overriding royalty interest", "netprofit revenue interest" and "payout" were not defined, the agreementwas wholly or partly void for uncertainty. Somewhat surprisinglyMcPhersonJ rejected that argument, instead opting to "fill in the blanks"left by the parties by admitting extrinsic evidence of the usage of thoseterms in the petroleum exploration industry. Based on that extrinsicevidence his Honour made. the following declaration:

"1. Until payout [the defendant], to pay 3 per cent of the wellheadvalue of petroleum recovered by virtue of any lease granted orto be granted by virtue of the Petroleum Act 1923 ... ; and

2. after payout, to pay 12.5 per cent of the difference between:

(i) accumulated revenue from sales of petroleum, and

6. The case was heard at first instance by McPherson J (unreported, Qld Sup Ct, No 2948of 1984) and subsequently appealed to the Full Court of the Supreme Court ofQueensland ([1986] 2 Qd R 216). It was affirmed on appeal. The critical question in theappeal proceedings was whether the letter agreement in issue extended to a discoveryof oil or gas made in the area covered by a surrendered authority to prospect (ATP)after the date when that ATP would have expired in the normal course. As a matterof contract, it was found that, notwithstanding the change in the statutory titles, boththe overriding royalty and the net profit interest continued to be enforceable in respectof the land they originally affected.


(ii) accumulated costs including exploration expenses andnormal operating costs,

where:

(a) 'payout' means the time at which the total of accumulatedrevenue derived from sales of petroleum less normaloperating expenses is equal to the total accumulatedexploration expenses;

(b) 'wellhead value' means the sales value of petroleum lessnormal operating costs;

(c) 'normal operating costs' means operating costs ordinarilyincurred in the course of production of petroleum includingfuel-gathering costs, pipeline tariffs, trucking costs and othertransportation expenses, but not lifting expenses or incometax or exploration expenses;

(d) 'exploration expenses' includes costs incurred in exploringand prospecting for petroleum and outlays on plant andother items of capital equipment required to producepetroleum from a well;

(e) 'petroleum' means hydrocarbon in gaseous, liquid 'or solidstate, occurring naturally, ~nd whether or not in the form ofa mixture."

It has been pointed out in other reviews of this case and it is worthnoting again that it would be unwise to conclude from this case that theabove terms had been raised to the state of terms of "legal art", because:

• their meaning was arrived at by reference to expert evidence; and

• their meaning could be changed by different expert evidence. 7

Whilst his Honour's definitions are a useful starting point for draftersin this area, it should be stressed that that is exactly what they arestarting points (or guidelines).

With respect, his Honour's definitions are imprecise and in somerespects raise more questions than they answer. For example, insubsequent appeal proceedings Lennard Oil sought clarification of thefollowing issues in regard to his Honour's declaration:

(a) whether "accumulated revenue" should relate to income on a cashbasis as distinct from accruals;

(b) whether "accumulated costs" excluded indirect costs such asoverheads; and

(c) whether the definition of "exploration expenses" includedexpenditure from the whole exploration program or expenditurewell by well.

In the result, the court found it unnecessary to rule on these issues,preferring to leave them to be litigated separately if events made itnecessary.

7. J R Forbes, "AEL Appeal Dismissed, Interpretation Headaches Remain" (1986) 5AMPLA Bulletin 42.


At the risk of stating the obvious, the case is yet another illustrationthat it is very unwise for parties to a royalty agreement to rely on vaguetechnical expressions such as "net profit interest" and "net smelterreturns" without comprehensively defining those terms in the body ofthe agreement. It is clear, from the decisions discussed above, thatalthough the courts accept that expressions such as "net smelter returns"and "net profit interest" are technical terms within the resourcesindustry, it would be treading a dangerous path to rely solely on theimprecise definitions thus far assigned to those expressions by thecourts. It is axiomatic that if the losing parties in the cases discussedabove had their time over they would have taken more care to draftcomprehensive royalty provisions rather than placing themselves at themercy of the judicial system to flesh out their obligations in expensivelitigation.

Lawyers involved in the drafting of royalty agreements shouldapproach their task as if they were preparing a long-term sales contract.Aside from defining virtually everything which is capable of more thanone meaning those lawyers must think of every possible contingencywhich could arise during the life of the mine, which may extend for 30years or more.

A royalty agreement is in no way comparable to a joint ventureagreement and if the lawyers involved have forgotten something theusual legal comforts like good faith, fiduciary obligations and the oldpanacea-s 52 of the Trade Practices Act-will normally not apply.

I should add, however, that it is clear from the Lennard case that thecourts are generally prepared to bend over backwards to avoid declaringinadequately drafted royalty provisions void for uncertainty.8 HoweverI hope, after having read this paper, that none of you will ever be in theposition where you may need to rely on this point.

OTHER ISSUES

Types of royalties

Howard Player-Bishop set out in his paper the various types of royaltyand divided them into several categories.

For the purpose of this paper I have dealt in depth with only one ofthose categories (the others being uncommon in Australia and thereforelargely irrelevant), which comes under the general heading of "in cashroyalties". Under that heading the most commonly negotiated royaltiesare in respect of:

• gross revenue returns;

• net smelter returns; and

• net profits interests.

8. In this regard reference should also be made to Hammond v Vann Ltd [1972] 2 NSWLR16.


The other category of royalty which justifies brief considerationbecause it sometimes occurs in Australia is the "in kind royalty", wherethe payee receives a share of production of the mineral or petroleumwon from the payer's tenement, after the minerals or petroleum havebeen extracted from the ground.

This type of royalty is not common and usually carries with it theproblem of marketing and selling the product-an obligation andresponsibility which most payees are reluctant to accept. That problemcould be avoided by simply appointing the payer as joint marketingagent, but because the end result of that process is virtually the sameas if the payee had an in cash royalty, the latter is the more favouredoption.

Dealing with the most common forms of in cash royalties:

(i) Gross revenue returns royalties: This is usually a percentage ofthe gross revenue derived by the payer from the sale of the product,without any deductions.

(ii) Net smelter returns royalty: This is perhaps the least wellunderstood type of royalty, with the result often being that it isdifficult to distinguish this type of royalty from a net profits royalty,when in fact the two are quite different.

Neil Cole acting as an expert witness in the Technomin casedescribed a net smelter return royalty as "the gross value ofrecovered metals less off-site treatment costs adjusted by bonusesfor penalties".

I suggest that this definition would not have wide acceptancewithin the industry because it is silent as to many other costs whichare normally deducted in arriving at a net smelter return royalty,such as some delivery charges, marketing expenses, insurances,other royalties (for example crown royalties) and taxes-all of whichare often taken into account in arriving at the final figure.

Another expert witness in the same case, Ike Shulman, stated thatthe net smelter return royalty was the relevant percentage of thesales price (of the product concerned) less transportation chargesfrom the mine to the smelter less treatment costs and penalties.

As indicated above it is interesting to note that, whilst most of theexperts in the Technomin case thought that a net smelter return hada commonly accepted meaning in the mining industry (but whichvaried from expert to expert), they agreed that this did not apply togold. However the general consensus was that all deductions shouldbe very carefully spelled out and defined.

(iii) Net profits royalty: The net profits royalty is generally apercentage of gross returns from the sale of product, usually less allcosts of production, handling, treatment and selling.

The essential difference between a net profits royalty and a netsmelter return royalty is really one of degree-in respect of thenumber and description of deductions in arriving at the respectivefinal figures.


Ranking of royalties

251

Clearly for the payee's purposes (with the converse applying to thepayer), the most attractive form of royalty would be a gross productionroyalty for the following reasons:

(i) the payee would receive the royalty as soon as the mine/well beganproducing-unlike the situation in respect of net profits royalties andto a lesser extent in respect of net smelter returns royalties where theapplication of the deductions might result in the payee waiting yearsafter production first commences before receiving any income; and

(ii) a gross production royalty by virtue of its simplicity is a relativelyeasy concept to document clearly-with the only difficulty beingreaching agreement on the actual percentage of gross returns (withtwo percentage points usually being the maximum agreed royalty).Consequently these documents are less likely to give rise todisputes than royalties calculated on a net basis-where lawyersand accountants can be more "creative", to the detriment of thepayee.

Generally speaking, the next most attractive form of royalty (from thepoint of view of the payee) is the net smelter returns royalty. Eventhough opinions differ throughout the mining industry as to whichparticular costs should be deducted, there is general agreement thatdeductions are fewer (resulting in a higher net figure) in the case of netsmelter royalties than in the case of net profits royalties.

Interestingly, there is often a lack of logic in negotiating royaltiesinasmuch as a great deal of time and effort is spent in arriving at thepercentage figure. Then having done so, the tendency is for the partiesto agree on whether that percentage will be on the net smelter returnsbasis or a net profits basis.

Of the three types of royalty (again from the payee's viewpoint), thenet profits royalty (unless there is an appropriate adjustment in thepercentage figure) is the least attractive of the three, because usually allproduction, treatment and selling costs are deducted in arriving at thefinal figure.

Stage at which royalty is struck

In a development where there is any possibility that special treatmentof the product could increase its value, it is obViously of vital importanceto the payee that the royalty is struck when the product reaches itsmaximum value (while still owned and controlled by the payer).

To illustrate the point-whilst there is no royalty payable in respect ofthe Cooljarloo Mineral Sands development in Western Australia (a jointventure development between the Kerr-McGee group and the Minprocgroup), this represents a good example of the "loss" which a payee couldsuffer if there was a mistiming as to when the royalty was actuallycalculated. The Cooljarloo project is in three distinct stages:


(i) the production of ilmenite (and other heavy minerals) in raw formby a process of "wet" mining-that is using a very large dredge inan artificial lake;

(ii) the treatment of that product in a dry processing plant to producesynthetic rutile (which is really just a refined form of ilmenite);and

(iii) further processing of that synthetic rutile to produce titaniumdioxide or pigment, which is a relatively high value product.

Clearly a royalty struck at the first stage in the process would producefar less in the hands of the payee than a royalty struck at the pigmentlevel (again unless the percentage figure was appropriately adjusted).

Control by tbe payee

This represents a very difficult area for negotiation by the payeeinasmuch as virtually all payers will actively resist any loss of control inrespect of a project which they own.

N.umerous issues arise under this heading, some of which are asfollows:

(i) The decision to commence mining operations and the extentand term of those mining operations should the decision bemade to proceed: This raises various questions: Should a payer beentitled to delay the commencement of development, havingprepared or arranged the preparation of a feasibility study whichrecommends that development be carried out? Should thatsame payer be entitled to delay development in particularcircumstances-for example where it is engaged in a sequentialdevelopment programme and simply chooses to develop anotherproject prior to the one in which the payee has a vestedinterest?

(ii) Exploration expenditure: Should the payee be entitled to dictatethe exploration programme to any extent, such as methods ofexploration, places in which exploration should be concentrated,minimum periods during which exploration should be conductedand/or extent of that exploration (or more particularly the amountof money to be incurred on exploration over the agreed period)?

(iii) Stockpiling: Should the payer be entitled to stockpile the productand not treat it for extended periods; and if so what compensationshould be payable to the payee? Should there be an imputed valueplaced on the stockpiled product (based on the known grades andpercentages) so that the royalty is payable notwithstanding that thepayer is not treating or selling the product?

(iv) Sweetheart deals: Care should be taken to ensure that if there isany transfer pricing which could have an effect on the calculation ofthe royalty then all such transfers must be at arm's length. Noartificial transactions should be entered into to reduce the return tothe payee.


Protection of the payee

253

Howard Player-Bishop dealt with this issue very well in his paper.However for the sake of completeness and to bring a few of the relevantissues up to date-in summary the protection/security which should besought to protect the payee would be one or more of the following:

(a) Caveats: These should be lodged wherever possible to put onnotice any prospective assignee of the payer's interest-that theroyalty is payable to the payee. The difficulty with this however isthat in Western Australia the Department of Minerals and Energy willreject a caveat unless the applicant can establish that the royaltyagreement constitutes an interest in the relevant tenement-whichnormally it does not, being a contractual right only. I have no doubtthat where a royalty agreement provides (as most of them do) thatthe payee will be entitled to an amount of money calculated byreference to a quantity of product from the mine or well only, acontractual right is created-that is, a payee would have noproprietary interest in the product on which the royalty was based,nor in the underlying tenement. 9

Quite apart from that issue often the caveat will be of limitedprotection because in other States the relevant legislation allows itonly a short life-usually three months, for example New SouthWales: see s 124(2) of the Mining Act 1992.

Gerald Ryan in his paper on petroleum royalties given at the 1985Conference expressed the view that a royalty right, if properlystructured, could constitute a rent charge and therefore create aninterest in land through the production lease.

If a rent charge is to be created a number of factors must besatisfied:

(i) the respective tenement must create an interest in land, whichclearly a mining lease or production lease will do-butpreliminary exploration tenements will not;

(ii) the seemingly archaic words to reserve the royalty rights as arent charge when the lease is transferred from the payee to thepayer must be used;

(iii) the royalty calculation cannot be left "open-ended". A fixedminimum payment of some nominal amount per year must bestipulated. There would be a formula included to cater for thebalance of the royalty.

Having said all that I am not as confident as Gerald Ryanapparently was that this would achieve the desired objective.

However if it did there would be clear advantages for the payeethe royalty would run with the land and the need for deeds ofcovenant and deeds of assumption in the event that the payer

9. Although there is a Canadian case which would indicate to the contrary: SaskatchewanMinerals v Keys (1972) 23 DLR (3rd) 573.


assigned all or part of its interest in the tenement would disappear.Also that interest could be readily secured.

(b) Registration: The royalty deed (again if the respective Departmentwill accept it) should be approved and registered with the respectiveMines Department (or Departments in the case of explorationprogrammes extending over two or more States) again to protect bynotice the rights of the payee.

(c) Mortgages/Charges: Clearly this would be the most effective formof security and should in all cases be sought. It will doubtless beactively resisted by the payer, with the argument being that it willinterfere with the payer's chances of raising project finance. Thatargument can be defeated however by ranking the charge in favourof the payee after any cross-charge and any project lender's securityand/or placing a limit or cap on the amount covered by the chargein favour of the payee.

Auditing and dispute resolution

Care should be taken in negotiating and drafting substantial auditingrights to keep the payer "honest".

This should be combined with detailed reporting, monitoring andinspection rights so that the payee is at all times kept fully informed. Thiscould even extend to giving the payee rights to attend operating ormanagement committee meetings-perhaps even including some sort ofvoting entitlement. This (like all other" control" issues referred to in thispaper) would however carry with it the risk of partnership-both atgeneral law and for tax purposes.

The other vitally significant area is provision for dispute resolution.Whilst I am not a strong supporter of the concept of resolution by a thirdparty (that is other than a court), I believe that there is a useful role tobe played by independent experts in resolving disputes arising underroyalty provisions. Consideration might also be given to using anarbitrator. The principal advantage of this mechanism is that anarbitrator/expert with a good working knowledge of the industry can beappointed to determine the dispute. The other advantage generallyreferred to is that arbitration or expert determination is preferable tolitigation because it can be quicker and cheaper. There are howevermany who disagree with this argument because they have experiencedprotracted and expensive arbitrations.

Similarly, the theory that arbitration results in a compromise that theparties can live with can be rejected. As I stated at the 1980 AMPLAConference,lo no arbitrator or expert, however skilful or objective heor she might be, can always reconcile the disparate and subjectiveinterests and priorities of the parties. Furthermore, the parties can neverbe sure that the factors which the arbitrator or expert will take intoaccount are material or relevant.

10. [1980] AMPLA Yearbook 336.


The main danger is that in "resolving" the conflict, the resultproduced is often one which one or both parties to the impasse wouldnever have agreed to, had they been left to their own devices.

Another dispute resolution mechanism which is worth considering inthis context is the concept of the "swing-man".

This type of provision is really a refinement of resolution by a thirdparty. It provides for a third party (the "swing-man") to listen to thearguments of both parties and then to make a determination. The swingman's determination can however only be in accordance with theproposal made by one of the parties (that is, he or she cannot choose athird, "compromise" position).

This concept/mechanism avoids the major risk of other forms of thirdparty determination-that the third party (be that an independent expertor arbitrator) will "go off on a frolic of his own" and arrive at adetermination which neither party is happy with and which neitherwould have arrived at had the parties been left to their own devices.

This concept forces the parties to take a position which is logical andreasonable, because they would not wish to risk the swing-man sidingwith the other party. If both parties are being logical and reasonable,their positions should in fact not be too far apart.

Content of royalty deeds

Aside from reflecting all the points made earlier and reflecting theprovisions contained in the various attachments to this paper, particularattention should be paid to the following:

(i) The actual area of land which is subject to the royaltyprovision: In this regard care should be taken to ensure that theroyalty obligation runs with the original land referred to in theroyalty deed so that if there is an assignment, joint venture or otherform of disposition of any part of the original land, the obligation topay the royalty runs with the land which is disposed of. This raisesthe whole question of controlling of assignments and in particularwhether a payee should be given any sort of pre-emptive right orright of first refusal in the event of a proposed assignment. I can seeno good reason as to why these rights could not be negotiated.

(ii) The term during which the royalty is payable: This is reallyrelated to paragraph (i) above inasmuch as an agreement shouldprovide that if the payer surrenders the land which is subject to theroyalty deed and then within a stipulated period (say five years)obtains tenements or an interest in tenements over all or part of thatsame land, then the royalty provisions should be revivified. This isparticularly appropriate in areas of large-scale mineral or petroleumexploration where companies will drop tenements and relinquish allinterests in respect of a particular area and then some time later comeback into that same area when a new chief geologist is appointed, orgeological fashions change-reawakening interest in an otherwiseforgotten area.

256

Taxation Issues

AMPLA YEARBOOK 1993

No paper on the calculation of royalties would be complete withouta reference to the so-called leading case of Cliffs International Inc vFederal Commissioner of Taxation 11 which dealt with the deductibilityof deferred payments, being part of the consideration for the purchaseof shares in a single purpose company which owned iron ore reserves.

Howard Player-Bishop wrote: 12

"The High Court, in a split decision, determined that the deferredpayments constituted revenue expenditures as opposed to formingpart of the purchase price of the asset, and were deductible.However there is some doubt as to whether the decision would beupheld by the High Court today."

Doubtless these comments sprang from the fact that Barwick andMurphy comprised two of the majority of three, coupled with Barwick'sperceived loathing of the taxation authorities and the difficulty Murphyhad of being taken seriously.

However, Hill J last year expressed the view that the Cliffs case is anexample of the trend towards analysing the deductibility of amountsunder s 51(1) from a "practical and business point of view, rather thanto give too great a weight to matters of form". 13

Although the subject of the Cliffs acquisition was shares, the purposein acquiring those shares was to give the purchaser access to thecompany's underlying reserves for the purposes of a joint venture whichin turn paid royalties to the taxpayer.

In the words of one commentator-the shares would ultimately"metamorphose" into trading stock. 14 The court chose to look throughthe shares, which would normally be a capital asset, to the underlyingiron ore reserves. The finding could well have been different if the sharesrepresented a discrete mine rather than just reserves.

The lesson to take from this is that the Cliffs case probably has arelatively narrow application. When tax planning in relation to royaltycalculations, the lawyers for both payers and payees should not place toomuch relevance on that case unless they can establish that the royalty isin respect of trading stock rather than a capital asset.

In any event lawyers for payers should provide for the possibility thatthe Cliffs decision will one day be reversed or be held to be inapplicable.To this end a clause should be inserted in all agreements where theamount of the royalty has been based on it being deductible in the handsof the payer, so that if the deduction is denied the payer is restored tothe same position it was in prior to such denial.

Given that it could be several years after payment of the royalty beforethe actual denial becomes effective, provisions should also be included

11. (1979) 142 CLR 140.12. [1990] AMPLA Yearbook 429.13. Extracted from a paper entitled "The Courts, What Direction are They Heading?", WA

State Convention 1992.14. Allan Blaikie.


for recovery (by the payer) of overpayments, interest and any penaltiesfrom future royalty payments.

Netting back to tbe wellbead

Both John Grace and Robert Laws will deal with this issue in detail.However, because the choice of this subject stems from an AMPLAdirectors' meeting where the concept of "netting back to the wellhead"gave rise to some confusion I felt that I should at least touch on the issue.

The value of oil and gas for the purpose of calculating royalties is oftenthe "value" on the wellhead or the value of the product when it comesfrom the ground. The difficulty in Australia (and in other oil producingcountries) is that the product is not usually sold at the wellhead, but isoften shipped great distances, processed and then sold to specialisedcustomers before an objective value is established. 15

In simple terms "netting back" or "working back" to the wellhead isthe process of deducting from the price established by the final arm'slength sale the costs accruing between the well and that arm's length sale.

It is establishing what those costs are or should be which gives rise toa great many problems-which John Grace and Robert Laws will dealwith in detail.

DOCUMENTATION

In this section I have suggested some royalty provIsions which aredesigned to be acceptable to all parties to a royalty deed and thereforeshould be taken with an appropriate grain of salt. In the examples whichI have used, terms which begin with a capital letter would be definedelsewhere in the document (if not so defined in the example itself).

Example A (below) is a definition of "net profits" which has been usedby one of Australia's major mining companies for some time-usually aspartof a joint venture agreement. This would represent the generous endof the spectrum from the payer's viewpoint. Depending on thenegotiating skills of the respective parties and the ruthlessness of theprospective payer the other end of the spectrum can be very tough onpayees-with some mining companies being known to have includedrecovery of the exploration and development costs incurred in theproject, before a "profit" is arrived at and the royalty payable.

Example A: Definition of ~~netprofits"

"For the purposes of paragraph [ ]* * 'Net Profits' shall mean thatamount which is calculated in each year ending [ ], by

15. From an article entitled "Determining Wellhead Value For Tax Purposes" byR G Crawford & G C Cornia published by Matthew Bender & Co Inc, (Vol 4),No 2-12/92 Pub 520.

• • Usually in respect of a royalty of 2.5 per cent or thereabouts.


deducting from the total sales revenue derived by the Payer from thesale of the Payer's Product all operating and administrative costsrelated thereto, interest and other charges in respect of debtrepayment, depreciation, amortisation of exploration anddevelopment expenditures, treatment charges (if applicable), sellingcosts, bad debts written off, taxes, duties and like charges imposedon production, transport, export, distribution, stockpiling or sale ofthe Payer's Product, royalties and rentals and other like paymentsassociated with the Tenement and such Product (excluding incometax payments) PROVIDED THAT:(a) all the said deductions shall be arrived at on an arm's length basis

or, if the Payer makes charges against the revenue from MiningOperations, such charges shall for the purposes of this paragraphnot exceed those that would be made on an arm's length basis;

(b) whilst the Payer shall have the discretion as to whether any itemof plant or equipment shall be depreciated or amortised, onceany such item is depreciated or amortised (as the case may be)that Payer shall not be entitled to depreciate any item which wasformerly amortised and vice versa;

(c) where the Payer elects to depreciate an item of plant orequipment the rate of depreciation at any particular time shall bethat specified in its tax return for the respective period;

(d) if in any year ending [ ] there is an excess of chargeableexpenditure in terms of this paragraph over income from the saleof the Payer's Product, such excess shall be carried over to thefollowing year ending [ ] and shall be deducted fromincome from the sales of the Payer's Product in that year; and

(e) if the Payer finances Mining Operations from general corporateborrowings and/or share issues and/ot its existing financialresources, then for the purpose of this paragraph the debt/equityratio of the finance provided by the Payer in terms hereof shallbe deemed to be in the proportion of 1: 1 and interest shall becalculated on fifty percent (50%) of the capital expenditure ofthe Mining Operations financed by that Payer (to the date ofcalculation) at the bill rate being the rate (expressed as apercentage per annum) which is the average of the bid ratesshown at approximately 11.00 am on page "BBSW" on theReuters Screen on the date of calculation for Bills indorsed by anAustralian trading bank having a tenor of 90 days PROVIDEDTHAT if the Payer is unable to make a determination of suchaverage or, in the opinion of the Payer such rate becomesinappropriate, unfair or incapable of application, the Bill Rateshall mean the rate reasonably determined by the Payer to be theappropriate equivalent rate having regard to prevailing marketconditions. "

Example B provides some idea of the types and range of net profitsroyalty provisions which are negotiated. This represents a limitation ofthe net profits concept-with the royalty being struck on "realisedvalue" and consequently carrying with it a reduction in the overallpercentage from the usual 2.5 per cent to 1.5 per cent.


Example B: Definition of ~~realised value"

259

"The Purchaser shall as part of the consideration for the purchase ofthe Tenements pay to the Vendor a Royalty on the following termsand conditions:

(a) the Royalty shall only be paid if and when Mining Operations arecommenced on any part of the Tenements by the Purchaser;

(b) the amount of the Royalty shall be 1.5 % of the realised value ofall Minerals obtained by the Purchaser from the Tenements andsold to any other person;

(c) for the purposes of paragraph (b) of this clause "realised value"shall in relation to Minerals mean the proceeds of sale of theMinerals after deducting costs and expenses incurred by thePurchaser in selling the Minerals, which costs shall include butnot be limited to:

(i) road, sea and rail transportation costs;

(ii) handling costs including assaying, sampling, weighing,loading, unloading, stockpiling and storage;

(iii) shipping agency fees;

(iv) bank charges on sales receipts and payments;

(v) government charges on banking transactions;

(vi) any royalty paid to the Department pursuant to the [Mining Act; and

(vii) all other outlays which are a direct incident of the marketingand sale of the Minerals."

Example C contains the critical definitions in a net smelter returnsroyalty deed in respect of a gold, copper and silver deposit. At first glancethese look impressive but from the payee's viewpoint they are less thansatisfactory. Paragraphs (a) and (c) of the definition of "gross revenue"beg the question-what if the refined copper/silver do not meet thespecifications?

Also in respect of paragraph (d)-what if a mixture of metals includingunrefined copper and precious metals are produced?

In short this is an example of the sort of provision in a royaltyagreement which should be painstakingly analysed by the lawyers for thepayee.

Example C: net smelter returns

" 'Net Smelter Returns' means Gross Revenue minus Deductions;

'Deductions'means:

(a) all smelting and refining costs, penalties and all umpire charges,whether made by the Payer, the purchaser of the Product, or anyother third party;


(b) all road, sea and rail transportation and insurance costs incurredin connection with the transportation of concentrates (when theProduct is in that form) from the concentrator to the buyer and,in the case of Product other than concentrates, from the outerboundary of the Tenements to the buyer;

(c) all handling costs including assaying, sampling, weighing,loading, unloading, stockpiling and storage;

(d) all taxes (excluding taxes based on income) which the Payer maybe required to pay;

(e) actual sales, marketing and brokerage costs in respect of theProduct on which the Royalty is based;

(f) shipping agency fees and demurrage;

(g) bank charges on sales receipts and payments;

(h) government charges on banking transactions;

(i) any royalties paid pursuant to any agreement concerning theProperty or the Tenements (other than the Royalty); and

(j) any royalty payable to the Department pursuant to the Act;

'Gross Revenue' shall have the following meanings for thefollowing categories of Product produced and sold by the Payer:

(a) if the Payer causes refined copper (meeting the specifications forrefined copper subject to the High Grade First Position CopperPrice published by COMEX) to be produced from ore minedfrom the Tenements, for the purposes of this Deed the refinedcopper shall be deemed to have been sold at the MonthlyAverage Copper Price for the month in which it is produced, andthe Gross Revenue shall be determined by multiplying CopperProduction during the calendar month by the Monthly AverageCopper Price. "Copper Production" shall mean the quantity ofrefined copper outturned to the Payer's pool account by anindependent third-party refinery for copper produced from theTenements during the calendar month on either a provisional orfinal settlement basis. "Monthly Average Copper Price" shallmean the average High Grade First Position Copper Price aspublished daily by COMEX, calculated by dividing the sum of allsuch prices reported for the calendar month by the number ofdays for which such prices were reported;

(b) if the Payer causes gold to be sold in the Product, for thepurposes of this Deed the said gold shall be deemed to havebeen sold at the Monthly Average Gold Price for the month inwhich it was produced, and the Gross Revenue shall bedetermined by multiplying Gold Production during the calendarmonth by the Monthly Average Gold Price. "Gold Production"shall mean the quantity of gold contained in the Product duringthe respective calendar month. "Monthly Average Gold Price",shall mean the average daily London Bullion Brokers second(PM) gold fixing, as published in Metals Week, calculated bydividing the sum of all such prices reported for the calendar


month by the number of days for which such prices werereported;

(c) if the Payer causes refined silver (meeting the specifications forrefined silver subject to the New York Silver Price published byHandy & Harman) to be produced from ore mined from theTenements, for the purposes of this Deed the refined silver shallbe deemed to have been sold at the Monthly Average Silver Pricefor the month in which it was produced, and the Gross Revenueshall be determined by multiplying Silver Production during thecalendar month by the Monthly Average Silver Price. "SilverProduction" shall mean the quantity of refined silver outturnedto the Payer's pool account by an independent third-partyrefinery for silver produced from the Tenements during thecalendar month on either a provisional or final settlement basis."Monthly Average Silver Price" shall mean the average NewYork Silver Price as published daily by Handy & Harman,calculated by dividing the sum of all such prices reported for thecalendar month by the number of days for which such priceswere reported;

(d) if the Payer causes metals other than refined copper, gold orsilver to be produced from ores mined from the Tenements, theGross Revenue shall be equal to the amount of the proceedsactually received by the Payer during the calendar month fromthe sale of such refined or processed metals; and

(e) in the event that the Payer sells raw ores, or concentratesproduced from ores mined from the Tenements, then the GrossRevenue shall be equal to the amount of the proceeds actuallyreceived by the Payer during the calendar month from the saleof such raw ore or concentrates,

PROVIDED THAT where outturn of refined metals is made by anindependent third party refinery on a provisional basis, the GrossRevenue shall be based upon the amount of such provisionalsettlement, but shall be adjusted in subsequent statements toaccount for the amount of refined metal established by finalsettlement by such refinery;'Sale' or 'sold' in respect of Product means, upon the passing oftitle from the Payer in conjunction with the physical delivery ofProduct to a buyer, or upon the outturn of refined metals by therefiner to the Payer's pool account."

Finally-my gratitude to a couple of Simons who work with me:Simon Truskett and Simon Brady who helped me in the preparation ofthis paper.

Problems with Calculating Royalties

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