Energy and Resources M&A Transaction Guide – Bridging the price expectation gap with effective royalty arrangements
ABOUT THE GUIDE
- This is the second of McCullough Robertson’s six part Energy and Resources M&A Transaction Guide developed for the resources sector.
ABOUT THIS ARTICLE
- Private contractual mining royalties have proven to be popular in resources transactions as a means of partially replacing traditional all cash consideration. Here, we discuss the key commercial, legal and taxation factors to consider when utilising a private contractual royalty as purchase price consideration.
- We’ll wrap up the series with a Masterclass where you can ask our expert panel any questions related to undertaking a transaction.
Private contractual mining royalties have proven to be a crowd pleaser in resources M&A transactions in recent times as a means of partially replacing traditional all cash consideration. While this has been driven in part by the difficulties the industry has experienced in securing conventional debt and equity funding, it is also due to the unique characteristics of private contractual royalties, which make them attractive to sellers and buyers alike.
The following is a discussion of the key commercial, legal and taxation factors to consider when utilising a private contractual royalty as purchase price consideration from the perspectives of both the seller and the buyer.
A private contractual mining royalty is at its essence a future income stream, which is agreed to be paid by the developer or owner of a mining project by reference to the success of the project. Beyond that general description, there are no set guidelines or attributes required to be negotiated or included in any agreed royalty terms. This flexibility is an attractive proposition for both sellers and buyers as it allows them to agree to arrangements that might satisfy a broad range of commercial needs.
The introduction of a royalty from a buyer’s perspective is a very favourable outcome commercially in that it allows them to de-risk their investment. For the most part, a buyer may not agree to pay anything to a seller until a project is successful. While on its face, the deferred timing of royalty payments to a seller may appear detrimental, it is in many ways a form of ‘at risk’ vendor finance. A seller might not receive any proceeds from the sale of its mining operations until a later date, however, it is still attractive to the extent it may allow the seller to secure higher ultimate sale proceeds than might otherwise have been available. It may even be that given the limited funding options available in the current market, a royalty arrangement could be the component of the transaction structure that clinches the deal.
Commonly, the amount of the royalty payable is calculated by reference to the commodity price paid by the end consumers or alternatively, the mine’s production volume. It might be payable over the life of the mine, only on commodity prices above an agreed floor price or be capped in value, length of time or by production volume. There are also varying levels of operational involvement that a seller might want to retain following the sale, from having no involvement in respect of the decision making and development of the project, to having approval rights over development decisions and in some extreme circumstances having the ability to buy-back their assets for nominal consideration when development has not progressed. A seller will be seeking as uncapped or unrestricted royalty as possible with tight operational levers whereas a buyer will want to include some restrictions on entitlement to provide certainty for their financial model. As can be seen, a broad range of royalty terms are available and a landing will really depend on the specific negotiating positions of the seller and buyer.
Drafting considerations and risk management issues
Given the long-term nature of a royalty, a seller, when negotiating the terms of a royalty, needs to consider various potential scenarios which may occur during the life of the arrangement. For example, a seller should consider the possibility that the buyer might seek to on-sell the project at some time in the future. In those circumstances, it is imperative that a seller secures a contractual obligation from the buyer that on any subsequent sale the buyer will be required to procure a covenant from the incoming owner to abide by the terms of the royalty in favour of the seller. Ideally, the seller would also seek the ability to consent to any assignment, however, a buyer will resist this on the basis that it will restrict the buyer’s ability to deal with the project. Similarly, in circumstances where the buyer might be in default of the terms of the royalty, the seller must ensure they have sufficient contractual levers to either enforce their royalty rights in dealing with the underlying project and/or have those rights preserved should a liquidator or other administrator step in. Again, the buyer will seek to water down any obligations in that regard and, although likely to have no issue procuring covenants from any subsequent owners, will resist agreeing to take any further steps beyond this.
In order to secure performance by the buyer of its obligations under the royalty arrangement, any well advised seller will secure its contractual rights by registering security over the relevant tenement (e.g. mining lease). Issues can arise though in relation to the priority of security interests granted by the buyer, including security held by joint venture partners and project financiers. If possible, a seller will seek to maintain a first ranking security in support of its royalty, however, the buyer will want to agree priorities for project finance, including priority for any project finance which may be required at some time in the future.
Practical issues to be managed
Once a royalty agreement is in place, the mechanics of its operation should be, and is normally, easy to manage. Common features of a royalty agreement include rights to access information and audit and review processes all of which are designed to ensure compliance by the payer with its obligations under the agreement.
GST is, however, an unresolved issue as it is likely there are no supplies made in exchange for the royalty payments and therefore GST ought not be payable. If that is the case then perhaps more concerning is that the buyer (as the payer of the royalty) will not be entitled to input tax credits for that additional GST component of a royalty payment.
Unfortunately, a royalty may not always work in circumstances where, for example, it is proposed as consideration for the purchase of an interest in a mining operation that is subject to an existing pre-emptive arrangement. Please see our comments from the first masterclass article of our Energy & Resources M&A Transaction Guide Pre-emptive pitfalls released 13 July 2016 for further details on this topic. Traditionally those processes require a cash only purchase price consideration to trigger the pre-emptive process. There is an argument that a royalty is not cash but rather is a contractual right and therefore may not satisfy this ‘cash only’ requirement.
One area not frequently commented on but necessary to watch when negotiating royalties for M&A transactions are the taxation consequences. On the whole, the acceptance of a royalty by a seller as purchase price consideration is not dissimilar to accepting cash consideration from a taxation perspective. Practically, the seller is able to treat the royalty as if it were a cash equivalent and return as income from the sale of a depreciating asset. Conversely, the buyer is also able to record the royalty as part of the cost of buying the mining tenements and depreciate its value again as if it were a cash equivalent. There is a technical issue for the buyer in that the grant of the royalty might be the grant of a right to income from mining operations and, if so, its value taxable to the purchaser in the year of its grant. On balance though, the better view is that royalties are not rights to income from mining operations.
Two revenue considerations for the seller of a project who receives royalty rights as consideration for that sale are that:
- if the seller ever sells the royalty rights, its taxable capital gain might be on the gross sale proceeds (ignoring the cost of acquiring those rights), and
- somewhat unfairly, in the case of an on-sale by the buyer (i.e. the payer of the royalty) the assumption of the obligation to pay the royalty by the new owner and a corresponding release of the original buyer of those obligations might trigger a tax liability for the seller (i.e. payee of the royalty) on the basis that the seller’s contractual rights with the original buyer end at that time.
Stamp duty on grants and assignments of rights to royalties is normally manageable to a nominal amount although issues have arisen from time to time where the royalty rights have a monetary cap.
The rise and rise of royalties
While there are certainly some traps to watch out for when offering or accepting a royalty, they are on the whole advantageous to both buyer and seller and we expect their use to increase particularly while funding for resource industry investments remains tight.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.