Royalty-dee, royalty-dum: how governments take their cut

“Royalty” is a term which defines its own origin and meaning. Sometime way back when, in the dim and hoary past, kings and queens must have managed to con (and/or intimidate) their subjects into believing it was they, not the citizenry, who retained title to everything (and everyone) under their domain, and were thereby entitled to benefit from any of the wealth generated from everything and everyone under their domain (as distinguished from, and in addition to, taxation!). And verily, the royalty was born.

“Long live the royalty!” It has to this very day.

Of course, the French put an end to such pilfering in their inimitable way (however temporarily), and the Americans shortly thereafter in a less dramatic but more permanent fashion. Few monarchs remain today. The state has replaced them in most cases; however, most have kept the royalty in place in at least some circumstances, and none has even bothered to change its name, regardless of how avowedly republican the state may claim to be. One could say that, in most cases today, the name itself if the only thing ‘royal’ about royalties. Various governments claim it, ostensibly on behalf of their electorate. Where the money goes is another question, but I’m sure at least a few dozen social programs or a few dozen whales (or something of similar value) have been saved, to be sure.

Although royalties have been removed in most areas of commerce in most countries, there’s just something about minerals, especially the shiny, expensive kind, which captures the imagination of revenue departments. (I’ve never heard of a royalty on gravel, for example, despite the fact that gravel pits generate more per capita profit than most other mining operations.)

There’s also the notion that, somehow, what lies inert in the ground belongs to the state — a national treasure, if you will, regardless of the fact that it isn’t worth a dime until somebody invests a huge amount of his own money, time, energy and intelligence in finding it, digging it out of the ground, processing it, and finally selling it.

However, I digress. Fact is, many countries around the world, Canada included, deem mineral resources to be a national asset of determinate value owned by the state, and have decreed that anyone extracting them for commercial purposes must pay a levy upon doing so, in addition to the usual income tax annually payable on profits. It’s as if the state holds the minerals in inventory, and the wholesale price is the royalty; income tax is what is paid from profits on retail sales (a simple but succinct analogy). The difference in Canada is that, with the exception of the territories, mining law is administered provincially, and whereas federal mining regulations provide for royalties, most provinces do not. However, now that the prospect of commercial diamond production is becoming an increasing possibility in at least two provinces, there is every likelihood we’ll see an exception to this general rule. Diamonds are too shiny.

Agree or disagree, the principle of a royalty is fairly straightforward; its implementation, however, is not. The methods currently employed to collect royalties from diamond mining can be categorized into five basic groups, from countries like Russia, at one end of the spectrum, where diamond mining operations are state-owned so that there is no royalty to collect, to South Africa, at the other end, where mining properties are considered private property and only income taxes are collected. Halfway in between is the system that is based on mandated 50-50 joint ventures between the state and the private sector, such as is found in Botswana and Namibia (though the case could perhaps be made that the royalty rate in these countries is effectively 50%).

The system in Africa’s remaining diamond-producing countries — namely Congo, Tanzania, Central African Republic, and, during the brief interludes when total anarchy does not prevail, Angola and Sierra Leone — is an ad valorem royalty. In order for the exporter to get approval to export a parcel of rough diamonds, he must go into a room with the appropriate government official, where the value of the package of diamonds is assessed. The exporter then pays the prescribed fee and the official seals the package and provides the approval stamp and accompanying papers. The typical royalty rate is 5%.

‘Confidential’

The valuation of the diamonds, and whatever other matters may be agreed upon while such valuation and permitting are taking place, remains, ahem, strictly confidential!

In the case of large-scale diamond mining operations, chances are that the process is undertaken properly, but in the case of smaller-scale operations or of individuals purchasing diamonds from artisanal miners (of which there are thousands across Africa), it’s anybody’s guess. Of course, some folks dispense with the process entirely and simply distribute the diamonds in various hiding places within and without their person, and make a quiet departure. Soon, this practice may become less profitable, thanks to increasing concern about the origin of diamonds: specifically, that they are not “conflict diamonds” (more about which in the next article in this series).

The one system remaining is that which was first implemented in Australia, and more recently in Canada. It does not demand state participation; it is transparent; it is impartial; and, it is not easy to corrupt. It is roughly similar to a net profits royalty of the type commonly found in agreements between mining companies and claim owners in the metals sector. It is based on the value of the diamonds recovered, minus direct capital development and operating costs (all of which are defined). On an annual basis, it is calculated as the revenue from sales, plus inventory (unsold diamonds at year’s end) minus the opening inventory (unsold diamonds at the beginning of the year).

Variation

The percentage charged — in other words, the amount of the royalty — varies according to net profits in a graduated system, not unlike that in use for the calculation of income taxes. It starts at 0% for the first $10,000, then goes to 5%, where it stays until $5 million in profits have been generated. Then, it increases by 1% for every additional $5 million in profits, up to a maximum of 14%. In Australia, the rates are somewhat higher, but inventories are not included.

All monies collected go to the federal government. In the Northwest Territories, aboriginal groups that have reached a land claims settlement with the government (of which there are currently two, with more anticipated in the future) are each entitled to receive 7.5% of the first $2 million in royalties collected, plus an additional 1.5% of any additional royalty revenues, on an annual basis. In Nunavut, the Inuit are entitled to half of the first $2 million of royalty revenues, and 5% of all revenues collected thereafter, again, on an annual basis.

Historically, royalties have been based on profits from sales plus the value of inventory based on the London Metal Exchange price for the commodity in question at Dec. 31 of that year. However, in the case of diamonds it is much more difficult to verify the actual price in any given sale, and even more difficult to place a value on diamonds in year-end inventory based only on their total weight in carats. Therefore, Canada has instituted a system wherein a third party has been contracted to value rough diamonds recovered from mining, prior to their export from the jurisdiction within which they have been mined (that is, the Northwest Territories). This provides the government with an audit tool for use when reviewing the profit statements of diamond mining companies, as well as when the value of year-end inventory must be assessed.

5-week cycle

The valuators are professional gemologists with training and experience in assessing the value of rough diamonds, who have been approved by the government and the mining companies. Working on a 5-week cycle, and based on the statistical parameters of diamonds recovered on a deposit-specific basis, diamonds are select
ed for valuation.

Each and every diamond over a certain size is assessed. In the case of Ekati, it is in the 4-carat range; on sizes below, and depending on the size category, anywhere between 5% and 25% of the cycle’s production will be assessed, based on a sample retrieved from a random split of the total. Valuators observe the actual splitting process from time to time, and maintain statistics on all valuations conducted in order to be on guard for unusual changes. Considering that the fortunes of both the mining companies and the federal government ride on their valuations and that De Beers has a rough grading system with more than 15,000 categories, the job of the valuators is not an easy one. At the giant Argyle mine, in Australia, average diamond values are much lower, so valuations are not carried out for auditing purposes, except for the prized and valuable fancy pink diamonds for which Argyle is renowned.

The next, and final article of this series will deal with the marketing, sales, and purchase of rough diamonds around the world, and with the issue of conflict diamonds.

— The author is a Toronto-based geologist and gemologist, and vice-president of a Canadian junior mining company. He wishes to thank Robert Lauer, chief of financial analysis and royalty administration for mineral resources, Indian and Northern Affairs Canada. He is a friendly and knowledgeable source of information, and living proof that at least some of those royalty funds have been well spent.