Mine operators are facing increasing challenges to obtain financing in today’s economic environment. Traditional sources of financing, such as the debt and equity markets, are becoming scarcer and many mining companies, particularly junior mining companies, must now look to alternative sources of financing.
At the same time, investors and investment managers are considering ways to improve yields in a low-interest rate environment, and are seeking exposure to commodity markets without all of the risks of mine operations. As a result, non-conventional financing arrangements, such as streaming contracts, are becoming increasingly common.
Let us survey the key U.S. federal income tax implications of streaming contracts, some of the common variations, and related tax considerations for investors that may help determine the cost the mine operator will bear to obtain financing.
Although streaming contracts come in many varieties, in a traditional streaming contract, an investor will give a miner a cash payment upfront in exchange for the right to purchase some percentage of the mineral produced from the mine. Under the terms of the contract, the miner will agree to sell to the investor, say, 5% of mineral produced from the mine at the relevant spot price, and the amount payable pursuant to those deliveries are credited against the investor's prepayment. Once the cash deposit has been fully credited, the investor has the right to purchase 5% of all future production from the mine at a substantially reduced price (which merely compensates the mine operator for its operating costs).
These contracts may provide for minimum deliveries, and often allow the mine operator to source the mineral from other properties, or the open market, to satisfy its obligations. Furthermore, in the event that the mine does not produce sufficient mineral to fully utilize the prepayment, the remaining balance may or may not be refunded, depending upon the agreement.
In a traditional streaming contract, the mine operator is often willing to provide the investor with the potential upside in the property, should the mineral reserves turn out to be far greater than anticipated, in return for the much needed financing. There are many variations on the traditional streaming contract that allow for varying degrees of upside potential to the investor. In all variations, however, the contracts commonly take the form of a prepaid forward purchase agreement, whereby an investor makes an upfront cash payment and agrees to receive deliveries of the mineral (or the cash equivalent) over time.
Key tax concepts
There is no specific judicial or administrative guidance that addresses the U.S. federal income tax treatment of streaming contracts. However, for U.S. tax purposes, streaming contracts can generally be characterized as either open transactions (e.g., a prepaid forward contract) or production payments, which are treated as a loan for U.S. federal income tax purposes.
Prepaid forward contract
Even though prepaid forward contracts are, in substance, very similar to loans, the Internal Revenue Service (IRS) has not generally declared that such transactions should be recast as loans for U.S. federal income tax purposes under substance-over-form principles. Thus, it is generally presumed that the IRS would respect the form of the transaction as a prepaid forward purchase contract, and there would be no tax consequences to the investor until deliveries are made pursuant to the contract, however, as described in more detail below, the prepayment may be included in the income of the miner under section 451).
Contracts that qualify as a “production payment” are subject to a different tax treatment. A contract is a “production payment” in respect of a mineral property under section 636 if it calls for the right to a specified share of the mineral in place and the following conditions are met: Pursuant to the contract, there is a conveyance of an economic interest in mineral in place; the rights under the contract have an expected economic life (at the time of its creation) shorter than the economic life of one or more of the mineral properties burdened thereby; the right cannot be satisfied by sources other than the production of mineral from the burdened mineral property; the funds provided pursuant to the contract are not required to be used by the recipient to finance exploration or development of the mineral property.
If a conveyance satisfies the definition of a “production payment”, then the initial advance is treated as a loan to the miner, and payments made pursuant to the contract, whether in-kind or in cash, are treated as, in part, payments of principal and payments of interest (using the effective interest method).
While the traditional streaming contract does not typically satisfy the requirements to achieve tax treatment as a “production payment” (because, for example, it may convey a right that has an economic life that is not shorter than the mine’s economic life), it may be possible to structure a streaming contract to obtain production payment treatment for all or some of the payments. As discussed below, structuring the contract to provide one of these tax treatments may result in tax savings to the mine operator, the investor, or perhaps both in the right situation.
Miner’s tax consequences
From an income tax perspective, the miner’s key tax considerations are the treatment of the upfront payment (e.g., income recognition) and the ability to claim deductions for payments made pursuant to the contract.
In general, if the streaming contract is not characterized as a production payment, under most streaming contracts the receipt of the upfront deposit is likely to be treated as a prepayment on account of the sale of property. This is because the miner would often have dominion and control over the funds and will not generally be considered to have an absolute obligation to return the deposit.
Although the miner may be able to defer the recognition of this income until such time as the revenue is recognized for financial reporting purposes (i.e., usually when the product is delivered), the miner may, in some circumstances, be required to recognize such amounts in income at the end of the second taxable year following the year in which the amounts were received. This risk is particularly acute if the streaming contract provides that the miner can obtain the mineral from sources other than the burdened mineral property. By contrast, if the arrangement is structured as a production payment, the initial receipt of the proceeds is characterized as the receipt of proceeds from a loan and, as such, the proceeds are not taxable in the year of receipt, or in any future year.
One of the chief advantages of structuring an arrangement as a production payment, where possible, is that it can help to mitigate the significant upfront tax cost to the miner under a streaming contract. However, even where a streaming contract is not a production payment, mine operators may be able to elect to deduct up to 70% of their exploration and costs in the year incurred, rather than capitalize such costs and recover them when the mine enters into operation. Thus, the miner may have sufficient net operating losses (NOL) in the year the payment is received (or NOL carryovers) to fully absorb the upfront income inclusion without a significant cash tax cost or adverse financial statement impact.
Treatment of contract payments
For payments made pursuant to the contract, in the case of a streaming transaction that is not a “production payment”, the miner would generally claim a deduction for cost of goods sold at the time the inventory is sold under their method of accounting. In the case of a production payment, these payments would be a combination of principal and interest, and therefore only a portion of the payment made to the investor would be deductible as interest expense in the year of payment, as computed using the principles of the constant yield method under section 1272. There is generally no hard and fast rule to determine whether any one treatment may give a better tax result (e.g., the net present value of accelerated deductions). In the case of the junior mining company with significant net operating losses, the timing of the deduction associated with payments is generally not a significant concern. Those companies who are profitable may want to consider a detailed modeling of the consequences over the life of the contract to see if there is any advantage to structuring into production payment treatment.
Tax implications to the investor
Unlike other non-operating interests, such as royalty interests, streaming contracts do not often constitute an economic interest in the underlying mineral property for the purposes of the depletion rules in section 611 of the Code. As a result, an investor generally will not be able to claim a depletion deduction under section 612 or 613 for its investment in the streaming contract.
With that said, if the contract is not treated as a “production payment”, a portion of the upfront payment, to the extent it is used to acquire the mineral from the miner, would be expected to be reflected in the basis of the property received by the investor pursuant to the contract. This payment would be amortized over some period that reflects the terms of the arrangement (e.g., generally over the period that the mineral is mined and delivered to the investor).
In the case of a production payment, the investor would not receive any deductions over the term of the contract, however a portion of the payments received would be received tax-free as a repayment of principal (as noted above).
Unless the contract is structured as a production payment, the receipt of minerals pursuant to a streaming contract generally should not result in immediate income recognition. By contrast, a streaming contract structured as a production payment may result in income recognition to the extent that the payment is characterized as interest.
An investor in a streaming contract would not typically hold the mineral for any significant period of time. Thus, the characterization of the contract as a production payment or a prepaid forward contract may have little consequence for a domestic corporate investor. With that said, certain non-corporate U.S. investors may have a preference as to the characterization of the proceeds received (e.g., as interest, which it can receive tax-free, rather than some form of trading income upon which it may be subject to U.S. tax). In the international context, whether the income received pursuant to the contract is passive or active may also be relevant in determining whether or not the foreign corporation’s U.S. shareholders are subject to the punitive anti-deferral rules under the Passive Foreign Investment Company (PFIC) regime (for a detailed discussion of the PFIC regime and its application to the mining industry, see Carr & Calverley: Canadian Resource Taxation (Carswell) Chapter 19A).
While the domestic tax consequences of streaming contracts are relatively well defined, these contracts have very complex tax considerations in a cross-border context. Although, generally, some form of physical presence and activity in the U.S. is a precondition for any gain from the sale of personal property to be “effectively connected income” (ECI) and subject to U.S. taxation, in a streaming contract, non-U.S. investors may never set foot on U.S. soil. Furthermore, the sale of severed minerals acquired pursuant to a streaming contract is not considered to be a disposition of interests in real property under U.S. tax law. Notwithstanding these arguments, there is a significant risk that the IRS may subject income derived by an investor from streaming contracts to tax either as ECI or as interest subject to withholding tax. For example, certain special sourcing rules for natural resources a portion of the gain realized by the investors from the sale offshore of minerals extracted from a U.S. mine should be treated as U.S. source income even if title transfers outside of the U.S. Furthermore treaty protection arguably may not be available as income from real property may, under many U.S. treaties, be taxed in the source state whether or not the taxpayer does not have a “permanent establishment” in that state. Although taking the position that the income realized pursuant to these contracts is not ECI may carry significant risks, it may also be possible in some cases to structure streaming arrangements to reduce the tax burden of the investor, helping the miner to obtain financing at a lower cost than would otherwise be the case.
As mine operators and investors have continued to devise innovative strategies to meet their respective business and investment goals, tax law in this area has not been able to keep pace. Understanding the associated risks and opportunities is essential to the successful negotiation of financing arrangements using streaming contracts. Mining companies, and especially junior mining companies shouldn’t ignore the unique opportunities that streaming contracts may present.
— Ronald C. Maiorano, CPA, is a partner at accounting firm KPMG, and has 29 years of cross-border taxation, transaction, accounting and advisory experience with KPMG. Based in Toronto, he currently serves as the lead partner of the U.S. Corporate Tax Practice in the greater Toronto area.
Frank Simone, CPA, is a manager/senior manager of U.S. Corporate and International Corporate Tax Services at KPMG’s Toronto office.
See www.kpmg.com for more information.
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