Commentary: Stream financing in uncertain times

Now that mining has once again become one of the hottest sectors of the Canadian stock market, mining companies are reassessing opportunities to expand. Yet there remains some unpredictability surrounding access to conventional debt and equity financing on acceptable terms to fund such expansion.

Mining companies of all sizes are looking beyond traditional sources to fund their exploration and development projects, acquisitions, day-to-day operations and managing debt loads.

Metal streaming is one alternative form of financing that mining companies are considering. Metal streaming transactions came onto the Canadian scene in 2004 and have gained traction among juniors and many major mining companies.

Metal stream transactions are contractual financing obligations entered into between a mining company and an investor for the purchase and sale of a metal that is to be produced and delivered in the future.

At the time of entering into the contract, the mining company promises to sell to the investor a portion of a mine’s produced metal for: an upfront deposit for metal to be delivered in the future; and an amount for each ounce of metal to be delivered in the future.

The mining company has no obligation to pay “interest” or any other amount in respect of the deposit.

The upfront payment from the purchaser provides the mining company with cash which will allow the company to achieve its immediate objectives, whether they are to fund exploration or mine construction. From the company’s perspective, it is giving up potential future value for an instant cash injection on more acceptable terms than it could obtain from traditional debt or equity financing. From the purchaser’s perspective, it is deploying capital now with the hope that it will be able to buy metal in the future at a cost that is significantly less than the then-current spot price for the particular commodity.

Metal stream contracts generally contain long-term obligations entitling a purchaser to metal streams lasting several decades. In the first generation of streaming transactions, it was the by-product of the primary metal that the mining company produced that was the subject matter of the contract. For example, a gold mining company might enter into a stream agreement for its by-product silver production.

The decision to sell only a future stream of a by-product metal related to how mining companies were typically given little value in the market for their by-product output. However, if a mining company could monetize the value of the future production of a by-product, investors would be willing to give the mining company some credit for the cash obtained, thereby increasing the mining company’s share price.

More recently, some mining companies have been entering into streaming contracts for shorter periods of time with optional buy-backs of the stream and capping the total amount of the commodity to be sold. Some mining companies have also entered into contracts for the sale of the future stream of their primary metal production.

Another more recent phenomenon of these metal stream agreements is that purchasers such as private equity firms, tax-exempts and other players have entered the metal streaming space, sometimes as a syndicated group in the hopes of chasing larger acquisitions.

Form of agreement

A precious metals purchase agreement (PMPA) is a long-term purchase and sale agreement that provides for the purchase of an amount of metal equal to a percentage or all of one or more metals produced from a specific mine.

The PNPA’s term typically ranges from 25 to 50 years although the PMPA usually provides for one or more extensions at the option of the purchaser.

The obligation of the mining company selling the metal is to deliver either concentrate or refined metal to the purchaser.

Where the PMPA provides for the sale of concentrate, the sale takes place immediately before delivery to an offtaker. The purchaser as principal sells the concentrate to the offtaker who buys it as principal.

Where the PMPA provides for the sale of refined metal by the mining company, the mining company has an obligation to deliver the refined metal to a metals account of the purchaser. The PMPA does not require the selling mining company to deliver metal from the mine that is the subject of the PMPA and may actually prohibit the mining company from doing so. The PMPA also requires the mining company not to deliver any metal purchased on a commodities or commodities futures exchange. The reason for this restriction is set out under the discussion on income tax issues.

The PMPA provides for the payment of a deposit by the purchaser to the selling mining company. The mining company is not obligated to segregate the deposit from its other funds and can use the deposit for whatever activities it chooses. Where the mining company enters into the PMPA to fund the development of the mine, the PMPA will often provide for the payment of the deposit in stages so that the selling mining company is only entitled to draw-down from the deposit once the mine has reached a certain stage of development. Such an arrangement limits the risk of the owner of the mine not bringing the mine into production.

The purchase price under the PMPA consists of two distinct elements: the fixed price and the spot price.

The fixed price reflects the estimated current costs of carrying out mining operations at the mine once the infrastructure has been built. The spot price is the day-to-day trading price of the metal on a specific metal exchange.

While the deposit is in existence, the purchase price of the metal is the spot price. Where the spot price exceeds the fixed price, the purchaser pays the fixed price portion of the purchase price in cash and the balance of the purchase price by the application of a portion of the deposit.

Once the deposit has been eroded, the purchase price is the lesser of the fixed price and the spot price.

If the deposit has not been fully applied by the end of the term, the selling mining company has an obligation to refund the balance of the Deposit.

Advantages and disadvantages

A major advantage of stream financing from the perspective of the mining company is that the contractual terms are, to varying degrees, friendlier than say a debt financing.

A conventional loan usually requires the borrower to make fixed payments on fixed dates. A rigid loan repayment schedule presents challenges for mining companies given commodity cycles and production challenges. A loan default is more likely if commodity prices unexpectedly drop or production encounters unexpected shortfalls or delays. The problem is even more acute in the case of a mining company that is still in the development stage and does not yet have a solid grasp of production schedule and timing.

In contrast, under a PMPA, there is no obligation to pay any amount to the purchaser. The principal obligation of the seller is to deliver all or a portion of a commodity when produced.  The PMPA provides that the deposit is applied against the purchase price until the deposit is exhausted. If amounts still remain on deposit at the end of the term, the seller is obligated to return such amounts. For these reasons, streaming transactions offer substantial flexibility.

Streaming transactions also differ from traditional equity financings because they are non-dilutive to the mining company’s existing shareholders. Moreover, compared to prospectus offerings which are highly regulated, streaming transactions can often be completed faster and with fewer transaction costs.

Of course, there is a cost to streaming agreements from the mining company’s perspective and its shareholders. If production goes well and commodity prices are high, the amount received by the mining company for the metal subject to the agreement may be substantially less than the spot price at the time of delivery. This may result in the potential increase in the metal price accruing to the benefit of the purchaser of the stream instead of the mining company’s shareholders.

However, some mining companies are recognizing the need to preserve some of the future upside in the value of the commodity being sold. Accordingly, some recent streaming contracts contain terms which require the purchaser to pay a higher sales price in the future if the price of the particular commodity being sold increases.

Purchaser’s upside

In exchange for offering more economically friendly financing terms to the mining company, the purchaser receives greater upside participation in the economic returns from the mining operations. This may include full or partial participation in the commodity price of the mineral being purchased pursuant to the PMPA, the possible production increases that exceed estimates at the initial time that the stream was entered into (not only due to successful mining but also possibly from additional successful exploration on the related property), and higher ore grades realized over what was originally projected at the time the stream was entered into.

Streaming transactions increase the alignment of interests between the mining company selling the metal and the purchaser(s). Specifically, each party is rewarded by increased successful mining operations and each will experience greater returns as a mine becomes successful and the amount of ore being mined increases. Moreover, the flexible nature of the contracts allows the purchaser and the mining company to tailor the terms of the contract to the specific situation of the mine. This can be more difficult to do in the context of an equity investment.

Traditional financial institutions normally require borrowers to meet certain constraints and be willing to accept various restrictive terms. During uncertain economic times like today, mining companies may not be able to commit or may not desire to make a commitment to such restrictive terms. Therefore, an increasing number of mining companies are receptive to the more flexible terms and to entering into agreements with traditional investors and non-traditional investors who are starting to enter the stream purchasing marketplace.

For example, Canadian pension funds and private equity funds appear to be increasingly interested in entering into PMPAs. The long term nature of a streaming agreement aligns with the long term obligations of pension plans. Other non-traditional, conservative investors such as life insurance companies could possibly be attracted to streaming transactions because their investment philosophy should be similar to that of pension plans.

In addition, private equity funds have started to combine PMPAs together with more conventional debt and equity investments with a view towards enhancing their overall returns. For example, Orion Mine Finance and Resource Capital Funds recently financed Lydian International’s Amulsar gold project in Armenia with a combination of equity, a term loan, and a gold and silver stream.

Income tax considerations

If the mine is located outside Canada, it is necessary to take into account the various laws of the jurisdiction in which the mine is located. The PMPA needs to be drafted so as to minimize any adverse tax consequences to the vendor and purchaser  under the laws of that jurisdiction.

Since the vendor is selling a refined product, it will be carrying on an active business which is not an investment business. Provided that the income is earned in a country with which Canada has a tax treaty or a tax information exchange agreement (TIEA), any income that it realizes will be exempt income for Canadian tax purposes.

Since the purchaser’s activity consists of purchasing a specific number of ounces of metal, it is carrying on an active business. Because the purchaser is not purchasing the metal on a commodities exchange, it is not carrying on an investment business. Therefore, provided that the purchaser earns the income in a country with which Canada has a tax treaty or TIEA, any income derived from the purchase and sale of the metal will be exempt income for Canadian tax purposes.

Where the contract is for the purchase and sale of metal from a mine located in Canada and the vendor and purchaser are corporations resident in Canada, both the vendor and the purchaser will be subject to the tax treatment that applies to the purchase of a commodity.

The metal will constitute inventory to the purchaser, the cost of which will be the amount specified in the PMPA. Until the deposit has been applied against the purchase price, the purchase price will be the spot price of the metal at the time of purchase as specified in the PMPA.

The vendor will be required to include in income the full amount of the deposit.  However, the vendor will be entitled to claim a deduction in the year in which the deposit is received and in every subsequent year with respect to that portion of the deposit that has not been applied against the purchase price. As a result, the vendor will not be required to recognize income until such time as it delivers metal under the PMPA.

The provision of the relevant mining tax legislation will also be relevant to the manner in which the transaction is structured.  Where the vendor is itself the owner of the mine, the issue arises as to whether the vendor is subject to tax on the proceeds received in the year received. Most of the mining statutes impose a tax on the amount of the product produced by the mine. Therefore, the vendor would not be subject to tax on the deposit until the vendor receives proceeds for the metal.

However, each relevant mining tax act should be reviewed to ensure that the PMPA does not produce unanticipated or unintended consequences.

U.S. income taxes

Even though streaming contracts can be, in substance, similar to loans, the U.S. 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 purchaser until deliveries are made pursuant to the PMPA, however, as described in more detail below, the prepayment may be included in the income of the vendor.

The vendor’s key income tax considerations are the treatment of the upfront payment (e.g., income recognition) and the ability to claim deductions for deliveries of metal  made pursuant to the PMPA.

Under most streaming agreements, the receipt of the deposit is likely to be treated as a prepayment on account of the sale of property. The vendor 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). However, the vendor 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, particularly acute if the streaming contract provides that the vendor can obtain the mineral from sources other than the burdened mineral property. For deliveries made by the vendor pursuant to the streaming agreement, the vendor would generally claim a deduction for cost of goods sold at the time the inventory is sold under their method of accounting.

The requirement to include the prepayment in income can increase the cost of this form of financing to the vendor relative to more traditional forms of financing. However, if mining companies may have sufficient net operating losses (NOL) in the year the payment is received (or NOL carryovers), they may be able to fully absorb the upfront income inclusion without a significant cash tax cost or adverse financial statement impact.

The receipt of minerals pursuant to a PMPA generally should not result in immediate income recognition. Rather, income is recognized by the purchaser at the time the mineral is sold. 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 Internal Revenue Code of 1986.

However, a portion of the upfront payment by the purchaser to the vendor, to the extent it is used to acquire the mineral from the vendor, would be expected to be reflected in the basis of the property received by the purchaser pursuant to the PMPA. This payment would be amortized over some period that reflects the terms of the agreement (e.g., generally over the period that the mineral is mined and delivered to the purchaser).

It may be possible to structure certain streaming agreements as contracts that are governed by section 636 of the Code. Such arrangements are generally treated as loans for U.S. tax purposes, with payments made by the mining company pursuant to the contract treated as a repayment of principal and interest. Such arrangements may be advantageous in circumstances where, for example, the mining company wishes to avoid income recognition on receipt of the upfront payment, or the purchaser is not a U.S. person and wishes to avoid net basis taxation on a stream entered into with respect to a U.S. mineral property.

— The authors — Ronald C. Maiorano, Zahra Nurmohamed, Frank Simone, Brian R. Carr (retired partner) and Karl P. Dennis — are partners at the Toronto and Vancouver offices of accounting firm KPMG. Visit www.kpmg.ca for more information.