In almost every joint venture or other property acquisition agreement wheremoney is spent on exploration, development or other mining work, the operator is allowed to charge an allowance for overhead and administration over and above reimbursement of direct expenditure. Unfortunately, within the mining industry this allowance is often referred to as a management fee. It is not and never will be a management fee! A management fee is a fee charged by a party for providing its expertise to, and management of, a project and represents a profit or potential profit to the operator, on the same basis as a cost-plus contract with any contractor.
The overhead and administration allowance is intended to reimburse the operator for general business costs that are not (and usually cannot be in practice) specifically charged to the venture. It is not intended to give the operator a profit. The allowance is really an acknowledgement that the operator has the requisite organization in place to carry on an active mining business on various fronts. This organization will be one of the major factors in appointing a party as operator, but to maintain such an organization costs money. With such an organization, the operator will have certain “fixed costs” for such things as offices, general staff and services that are shared by all of its undertakings. These are also necessary in order to carry on any individual project properly. The end result is that these general facilities are made available to and used to carry out a project for a “fee,” or allowance, that is intended to reimburse the operator such that it will not suffer a financial detriment (and the other venturers a financial advantage) by acting as operator. The other venturers do, however, receive the advantage of the use of the operator’s established organization without the costs of setting it up, so it is logical for them to pay for part of its upkeep.
There are numerous methods of calculating an allowance. Each corporation that habitually acts as a joint-venture operator usually has its “pet” method.
Some of the numerous methods of calculating an allowance, and some comments thereon, are as follows:
*permitting a percentage of the amounts expended by the joint venture under the management of the operator, usually with different rates for direct expenditures and those expended under contracts. Rates of up to 20% on direct expenditures and up to 10% on those made under contracts are common. This is the most common method used, with 15% and 5% being reasonably average percentages.
*A variation of the first method is to permit the higher percentage to be charged for expenditures of up to a specified amount (usually in the order of $100,000, depending on the size of programs being anticipated) which are incurred under a third party agreement. This acknowledges that sometimes start-up under an 0506,0000 agreement or the administration of small contracts will be more burdensome for the operator — a fair concept.
*to permit the operator a reasonable allowance up to a maximum percentage of expenditures. This is a method to be avoided. It can easily result in disputes and the operator must be able to show what items have been included in its calculation of the allowance and that it has acted reasonably in including them.
*to provide for an initial allowance for the first year or so and then provide that it may be renegotiated at the instance of the operator or any participant in the joint venture. This sounds fine and may well work so long as the parties are friendly and prepared to act reasonably. Remember, however, that it is one thing to renegotiate and quite another to agree on a solution. Settling the matter by arbitration can be provided for, but it may prove expensive and time-consuming if the parties are inclined constantly to want new rates.
*to provide for a specified percentage rate for types of expenditures, such as one rate for seconded hourly paid personnel, another for salaried personnel occasionally involved in the project, another for the contracting of services, another for the procurement of assets, and so on. This obviously has the potential of being an accountant’s delight and an operator’s nightmare — and what happens to an expenditure that does not fall into a defined category?
*to acknowledge that rates will change at some specified point (or points) of time, but make sure these points are clearly set forth in the agreement and readily identifiable in the field. Times commonly used are the delivery or approval by the management committee of a feasibility study and/or the commencement of commercial production — but make sure the agreement is clear on what constitutes a feasibility study and when commercial production will be achieved. (With regard to the latter, be careful of the traditional definition of commercial production requiring “X” consecutive days of production at a minimum of “Y%” capacity — consecutive means what it says and one bad day can break the string. Average production rates should be used.)
Few, if any, agreements differentiate among the exploration, development and operating stages of a project when specifying the method of calculating an allowance. (Even though most operators will readily admit that there are different considerations at each stage.) The prevailing philosophy seems to be that, since so few joint ventures reach the development or operations stage, defining each stage to provide for different allowances is an “unnecessary bother.” On the other hand, every so often there is a successful joint venture.
Where an allowance is based on a percentage of amounts expended in doing work, the participants should establish, before agreeing to the quantum of the percentage, the manner in which the operator will charge out its costs and what types of charges will not be charged against the project directly. It upsets a participant to have agreed to, say, a 15% rate only to find out that the operator has a very sophisticated docketing and accounting system and charges out secretarial and bookkeeping time on an hourly basis and that even local telephone calls are docketed and charged out — just as a lawyer does. In such circumstances, the operator may be making a profit from the allowance.
If the allowance rates are to change during the course of the joint venture, obviously the agreement is going to have to provide for various rates or, alternatively, provide for a method of determining the rates at the appropriate time or times. It will not be practical to provide specific percentage rates unless the participants have a good idea of the nature and extent of future operations, which is highly unlikely. If only one or two rate changes are contemplated, arbitration may be a satisfactory method of resolving a failure by the participants to agree on a rate, although the arbitrators should be given some restraints and/or guidelines to use when deciding on a rate. If they are not included, the arbitrators can do as they wish. If several rate changes are contemplated, it may be that arbitration will prove to be too cumbersome, time-consuming and expensive as a settling device.
A fairly recent innovation for determining a rate for the operations stage is to make it a percentage of operating profits. This method purports to offer the operator an incentive to be efficient and reduce costs to increase operating profit and at the same time automatically allows for size and type of operation. It is potentially very advantageous (or very disastrous) for the operator and does not really allow for different types of operations. For example, a small, highly profitable gold operation may yield much greater benefit to an operator than a large, complex marginally profitable operation, many of which will not produce an operating profit until well after commercial production rates have been achieved. This type of allowance is more akin to a management fee and should not be considered as a substitute for an allowance. It is also to be suspected that, while an operator may well be able to satisfy Rev
enue Canada that an allowance of one of the other types referred to above represents a reimbursement and is therefore not a taxable receipt, one would suspect that the task would be very much harder with a payment based on operating profit.
In short, the nature and extent of an allowance and the reason for its insertion in the agreement, as understood by the parties to that agreement, should be addressed during the negotiation and drafting of an agreement. Its inclusion should be equitable to all the parties, but as with many things, it can backfire and not fulfill the intended purposes. In which event it may form the basis for yet another of the increasing number of mining matters before the courts.
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