Where does mining stop and manufacturing commence? A critical analysis of section 15A of the Income Tax Act

2 1 Background

One of the main questions that needed to be addressed by the courts in CSARS v Foskor,7 was whether the taxpayer was involved in a “process of mining” or in a “process of manufacturing”. The distinction between the mining and manufacturing processes was therefore important, but not easy. It is a common practice to mine more than one mineral at a time as minerals are not contained in neat pockets in the earth that allows the miner to mine only the specific mineral that it wants. A company involved in the platinum industry will, for example, not only mine platinum, but as part of the mining process, palladium, gold, rhodium, osmium, rhenium, iridium and ruthenium may also be extracted from the soil. In all instances, the liberated mineral will be in a very different form from that which it had when it was still in the ore-bearing rock and the processes involved in an attempt to isolate the existing mineral into its purest form can very easily be incorrectly viewed as a process of manufacturing. The nature and complexity of these processes make the distinction between mining and manufacturing problematic. In addition to this, the mining and manufacturing processes are often part of one continuous process.

“Mining operations” and “mining” are defined in section 1 of the ITA. The term “process of manufacture” however, is not defined in the ITA. The following paragraphs aim to provide a general background on the difference between the processes.

2 2 Process (Course) of Mining

Mining and mining operations are defined in section 1 of the ITA as “... every method or process by which any mineral is won from the soil or from any substance or constituent thereof” (own emphasis).8

An excellent formulation of the essence of the process of mining is contained in ITC 1455.9 In that case, the court described the process of mining in the following way:

... it is tempting to compare appellant’s operation to the production of gold bullion in a gold mine. The gold ore exists in discreet particles in the rock. The mined rock is crushed and the gold is leached out. The gold ore is then heated and bullion is poured. In ordinary parlance the latter operation will not be referred to as the manufacturing of gold but to the mining of gold.

In the abovementioned example, the gold already existed in the earth, and was merely isolated from the earth, which is considered a mining process.

2 3 Process (Course) of Manufacture

“Process of manufacture” or “manufacturing” is not defined in the ITA. Guidance in the courts regarding what a process of manufacturing would constitute was found in the decided case of SIR v Safranmark (Pty) Ltd:10

Process of manufacture is an action or series of actions directed to the production of an object or thing which is different from the materials or components which went into its making [which] appears to have been gradually accepted. The emphasis has been laid on the difference between the original material and the finished product (own emphasis).

Based on this description of what manufacturing would entail, there is a process (action or series of actions) where the original material used in the process differs from the finished product. The moment this can be verified as true, we are dealing with a manufacturing process and section 15A will no longer be applicable.

For example, in a case where gold particles are mined from the earth, the extraction of the particles from the earth itself does not constitute the creation of a new subject matter - the item originally won in the process was gold, and remained gold as it was only isolated from the earth. Generally speaking, section 15A will be applicable to the classification of the gold in this stage of the process. The moment, however, the extracted gold is processed further to manufacture gold earrings, the earrings (finished product) are substantially different from the original gold extracted from the earth. A process of manufacturing has occurred, the section 15A definition is no longer applicable and one must revert to the section 1 definition and application in terms of section 22 provided in the ITA.

2 4 Domestic Precedent on the Differentiation Between Mining and Manufacturing

The case of ITC 1455 has been referred to in numerous cases where the distinction between mining and manufacturing had to be made, for example in CSARS v Foskor11 as well as in Richards Bay Iron &

Titanium.12 It is therefore considered to be of valuable guidance with reference to establish the point where the mining process ends and the manufacturing process commences. In ITC 1455, the main business objective of the company was the manufacture of steel and vanadium products. The appellant was conducting opencast mining for magnetite ore. The magnetite ore was mined at site B. It was also crushed, washed, screened and stockpiled at site B. The magnetite ore was processed at plant A to produce liquid pig iron and vanadium-bearing slag. The appellant admitted to conducting both a manufacturing and a mining enterprise. The Court was therefore required to decide where the mining operations ended and where the manufacturing process commenced. The appellant argued that its mining operations ended at site B. In terms of the ordinary meaning of “mining operations”, the Court was therefore satisfied that the operations of the appellant ended at site B.

2 5 Summary on the Distinction Between Mining and Manufacturing

Whether a mineral forms part of a mining process or part of a manufacturing process will depend on commodity being extracted and the level of purity and refinement. Based on local precedent, the following factors may have an impact on where the mining process ends and where the manufacturing process commences:

(a) whether any part of the taxpayer's process is a distinct and separate operation;13

(b) whether the entire process is carried on by the same taxpayer;14

(c) whether the end product of the process occurs naturally in the earth or whether it exists in another form;15 and

(d) whether the end product is a result of an industrial process.16

The mining process can therefore end either when the mineral is available or accessible to be removed from the earth or when the mineral is in metal or its purest form. A number of factors exist that will influence the cut-off point between mining and manufacturing. Each case, however, will have to be determined on its facts and the type of mineral being mined. Mining operations cover more processes than the mere excavation of the ore from the earth. It includes the procedures necessary to recover or liberate the mineral. Any procedures that are performed after the mineral has been won or that is embarked on for the better utilisation of the mineral would not qualify as a mining process, but may qualify as a process of manufacture.

3 1 Background

Prior to the introduction of section 15A into the ITA, if a subject matter met the definition of trading stock as per section 1 of the ITA, the subject matter was considered trading stock and was accounted for income tax purposes in terms of section 22 of the ITA. In cases where the expenditure incurred on the subject matter did not meet the general definition of trading stock, the deduction was allowed as a section 11(a) 17 deduction, and no additional adjustments as prescribed in section 22 of the ITA will be required at the end of the tax year or in the subsequent year of assessment.

Before the introduction of section 15A, the definition of trading stock provided in section 1 of the ITA was applicable to all industries, including taxpayers conducting mining operations. In the latter definition, “trading stock” includes -

(a) anything -

(i) produced, manufactured, constructed, assembled, purchased or in any other manner acquired by a taxpayer for the purposes of manufacture, sale or exchange by him or on his behalf, or

(ii) the proceeds from the disposal of which forms or will form part of his gross income, otherwise than in terms of paragraph (j) or (m) of the definition of ‘gross income’, or a recovery or recoupment contemplated in section 8(4) which is included in gross income in terms of paragraph (n) of that definition; or

(b) any consumable stores and spare parts acquired by him to be used or consumed in the course of his trade, but does not include a foreign currency option contract and a forward exchange contract as defined in section 24I(1)18

This definition of trading stock contains subparagraphs (a) and (b), with paragraph (a) in turn containing subparagraphs (i) and (ii), effectively resulting in a generally accepted and established three-part division of the definition.19 This definition (with the exclusion of part three that was not included for purposes of this article) is analysed below.

3 2 Part 1 of the Section 1 Definition of Trading Stock

The first part of the definition of trading stock, as mentioned above, provides for trading stock to be:

... anything produced, manufactured, constructed, assembled, purchased or in any other manner acquired by a taxpayer for the purposes of manufacture, sale or exchange by him or on his behalf.20

The phrase “or in any other manner acquired”, read with the aforementioned extensive list of verbs, interpreted on a grammatical basis, creates a very wide ambit of the method of acquisition of the subject matter if such subject matter is tested against the definition of trading stock. The legislator therefore clearly provided for a wide range of methods of acquisitions of the subject matter.

3 3 Part 2 of the Section 1 Definition of Trading Stock

The second part of the definition of trading stock states that:

... the proceeds from the disposal of which forms or will form part of his gross income, otherwise than in terms of paragraph (j) or (m) of the definition of ‘gross income’, or a recovery or recoupment contemplated in section 8(4) which is included in gross income in terms of paragraph (n) of that definition.22

Except for the exclusions specifically provided for in this part of the definition, the second part read with the “or” of the first part of the definition, provides for a situation where the first part of the definition is not met, the item will still be considered trading stock on the premise that the subject matter is sold and the income derived from the sales transaction is included in the taxpayer’s gross income. CIR v Richards Bay Iron and Titanium23 confirmed that the second part of the definition only has the objective requirement that the proceeds from the sale of the subject matter must be included in gross income,24 for the subject matter to meet the requirement of the second part of the definition of trading stock.

Part two of the definition therefore postulates an objective question that is not dependent on the intention or the possibility to sell the subject matter in future. The only relevant factor for consideration as per this part of the definition is whether the subject matter has been disposed of or not. Once the item is disposed of, the only additional requirement is that the subject matter sold must be revenue in nature (a requirement for the inclusion as per the definition of gross income per section 1 of the ITA). Should the subject matter constitute an asset of a capital nature, the proceeds will not constitute gross income and will thus fall outside the ambit of the second part of the definition.

If the subject matter acquired by the taxpayer meets the definition of trading stock as per section 1 of the ITA, the subsequent treatment of the asset for taxation purposes is in terms of section 22 of the ITA, which is discussed below.

3 4 The Valuation of Trading Stock

The general framework of the ITA, within which the sections of the ITA (including section 2225 function were described by the courts in CSARS v Foskor:26

... the South African system of taxation of income entails determining what the taxpayer’s gross income was, subtracting from it any income which is exempt from tax, subtracting from the resultant income any deductions allowed by the Act, and thereby arriving at the taxable income. It is on the latter income that tax is levied27 (own emphasis).

The general effect on the deduction of expense where trading stock is acquired by the taxpayer and the consequent inclusion of the amount received as a result of the selling of this trading stock or the effect where trading stock acquired during the year was still unsold on year end are described in CSARS v Foskor:28

... where a taxpayer is carrying on a trade, any expenditure incurred by him in the acquisition of trading stock is deductible in terms of section 11(a) of the Act because it is expenditure incurred in the production of income and it is not of a capital nature. Income generated by the sale of such stock is of course part of the trader’s gross income. Where in his first year of trading a trader has bought, and thereafter sold, all the stock which he acquired during that year, no problem arises. There will be a perfect correlation between the trading income earned and the expenditure incurred in that particular year in purchasing and selling the stocks sold, and the difference between the two sums will give a true picture of the result of the year’s trading. There will be no stock on hand at the close of the year of which account need be taken (own emphasis).29

Section 22 of the ITA therefore provides for the situation where trading stock has been acquired during the year of assessment, and a deduction has been allowed in terms of section 11(a) of the ITA, but where the trading stock was unsold at year end. Section 22 creates provisions for the inclusion of this closing stock at year end effectively in order only to allow the original deduction permitted in terms of section 11(a) to the extent that the stock has actually been sold and accounted for as part of gross income in the year of assessment. Section 22 of the ITA therefore provides for the treatment where expenses are incurred and allows as a deduction in the current year of assessment but the gross income due to a selling transaction is only received and accounted for in gross income in subsequent years, or where stock in trade is used as a manipulation to artificially increase the deduction of an expense incurred just before year end.

Subsequently, government found it necessary to introduce a new definition to be applied in respect of trading stock derived from mining operations. The introduction of section 15A in the ITA resulted from the difficulties experienced with the classification of stockpiles held by the taxpayer in CSARS v Foskor.30

4 1 The Background and Facts of CSARS v Foskor

The dispute arose as a result of the inclusion of an amount of R203 million in Foskor’s taxable income in respect of the year of assessment ended 30 June 1999. The Commissioner contended that the amount represented trading stock (closing stock) in terms of section 22 read with section 1 of the ITA. The matter was heard by the Tax Court in ITC 1836,33 which found in favour of the taxpayer (therefore the R203 million was found not to be included in the gross income of Foskor). The matter was taken on appeal by the Commissioner to the Supreme Court of Appeal (SCA) in CSARS v Foskor.34

A brief background of the facts of the case is that Foskor acquired the rights to mine base minerals, including phosphates, belonging to the State, during 1952. In 1963, Phalaborwa Mining Company (PMC) obtained the right to mine copper and other base minerals, except phosphorous minerals, over the same areas on which Foskor held its rights. Since the copper and the phosphates were located in the same portion of earth, Foskor and PMC entered into an agreement. In terms of this agreement, PMC extracted the ore from the earth and Foskor bore a portion of the mining costs incurred. The phosphate-bearing rock was allocated and dumped by PMC for Foskor to recover the phosphates. The extensive procedures applied by Foskor resulted in the liberation of the mineral, apatite, from the ore. The Court a quo described the process as follows:

The phosphate-bearing ore is loaded and hauled to a primary crusher and then conveyed to secondary and tertiary crushers for crushing. The crushed material is then conveyed to Rod and Ball Mills for milling to liberate the minerals from the rock;

The pulp containing the materials is then pumped to a flotation plant where the minerals of economic importance are separated by means of three metallurgical separation processes, which is a froth flotation process, a magnetic concentration step and a gravity separation process. During the froth flotation process certain ingredients (reagents) are added to the froth. During this process the minerals that have been released stick to the bubbles. At the end of the process the reagents are removed. The final product from these separation steps are concentrates consisting of phosphates which are then dried, stockpiled and sold to worldwide customers, which use the minerals mainly for the manufacture of fertilisers.35

The Commissioner and Foskor agreed to the facts of the case. Despite this agreement, however, there was a discrepancy between the Tax Court in ITC 1836 and the SCA with regard to the nature of Foskor’s activities, as discussed below.

4 2 Nature of Foskor’s Activities: Mining or Manufacturing?

Both the Tax Court and the SCA had to determine whether Foskor’s activities constituted mining or manufacturing. Since the term “process of manufacture” is not defined, the Tax Court had to look at legal precedents on the matter.

The Tax Court referred to ITC 1455, which gives some direction as to the distinction between mining and manufacturing. It was held by the Tax Court:

... the essence of the aforementioned processes is the extraction or winning of the phosphates, without a different finished product emerging. What is sold to customers is the phosphates originally found in the phosphate-bearing ore, and that no different substance with different qualities has been produced. All that occurs is a process which liberates the mineral particles from the ore and which separates the mineral particles.36

The Tax Court concluded:

In the result it must be held that the phosphates sold by the appellant occur naturally in the earth and the phosphates is not, and cannot be manufactured, just as gold or diamonds cannot be manufactured, but can only be mined.37

Once the mineral is extracted, the mining operation ends. Any subsequent process is an industrial process and will have to satisfy the requirements of a process of manufacture as laid down in SIR v Safranmark.38 The Tax Court described the processes by Foskor as:

... the extraction or winning of the phosphates, without a different finished product emerging. What is sold to customers is the phosphates originally found in the phosphate-bearing ore. All that occurs is a process which liberates the mineral particles from the ore and which separates the mineral.39

The mineral was not extracted until Foskor submitted the ore to the extensive processes of crushing, milling, flotation and separation. Once the concentrate had been formed, the mineral was extracted. Furthermore, the chemical composition of the phosphates did not change as a result of the processes applied to liberate the mineral. The phosphates had the same chemical composition as when it was excavated from the earth. If the chemical composition had changed, this could have been an indication of an industrial or manufacturing process as the item that was produced was not something that can be found in the earth’s crust.

In ITC 1836, the Tax Court concluded that the taxpayer (Foskor) was carrying on a process of mining and viewed all the processes in dispute as part of the process of extracting the mineral from the earth to render it in its purest form. This decision of the Tax Court was appealed to the SCA.

The SCA disagreed with the conclusion reached by the Tax Court with regard to when the mining process ends and the manufacturing process starts, as was illustrated by the following statement:

In my view, that the submission the phosphate minerals that occur naturally in the earth are contained in what is sold to fertilizer producers worldwide and that the end product was therefore not manufactured, is too simplistic. It ignores not only the complexity of the processes to which the ore was subjected but the fact that in the result several minerals are separated and sold independently. It also ignores the fact that before the process referred to the ore is not saleable but that what is produced thereafter has a worldwide market. Put simply, the end products that emerge after the processes referred to above are significantly different from the raw ore40 (own emphasis).

The SCA found that the taxpayer was carrying on a process of manufacturing. It was of the view that mining operations end when the ore is extracted from the soil. Any processing beyond the extraction of the ore would not form part of the mining process but would constitute mining.

The only legal question that the SCA had to answer was whether or not the phosphate-bearing ore stockpiles were part of a process of manufacture and therefore included in trading stock. In arriving at its conclusion, the Court should have considered the mining tax principles to distinguish the mining and manufacturing processes. The SCA found the foskorite to be part of a process of manufacture. If this approach is to be followed, mining operations will only extend to the excavation process and will end once the rock is severed from the earth. This is a very narrow approach to what would constitute mining operations. Very few minerals are taken from the soil and require no additional procedures to liberate the mineral from the soil and to separate it from other minerals that occur naturally with the particular mineral being mined.

The Court failed to decide the case on the core matter, namely where the mining process ends and where the manufacturing process commences. The legislator tried to prevent similar problems presenting themselves in future, and introduced section 15A as part of the ITA. It can therefore be said that the problems experienced by the Commissioner in the case of CSARS v Foskor41 served as the catalyst for the introduction of section 15A into the ITA. Section 15A is analysed in the following section of the article.

5 1 ‘‘[a]mounts to be taken into account in respect of trading stock derived from mining operations”44

This introductory provision of section 15A implies that, where the subject matter is acquired by any means other than “in the course of mining”, the definition of section 15A will not be applicable to the subject matter. This phrase therefore limits the entire section to taxpayers conducting mining operations only.

As was illustrated in the difficulties experienced in CSARS v Foskor45 as well as the discrepancies between the views held by the court a quo and the SCA, it was clear that in CSARS v Foskor46 the court did not address the problem to distinguish between a “mining” and a “manufacturing” process. The distinction between these two processes is considered crucial in order to provide a clear and definite “point of access” to the provisions of the newly inserted section 15A. It is submitted that without a clear differentiation as to when mining ends and when manufacturing starts, the objective of the legislator with the introduction of section 15A, being to provide clarity in guidance for taxpayers in the mining industry, cannot be considered achieved since this crucial element that needed clarification was not addressed.

This section therefore provides guidance and clarity on the classification and treatment of trading stock in the mining industry, provided that it is in the “course of mining”, in other words, the taxpayer must conduct mining operations in order for section 15A to be applicable.

5 1 “won or in any other manner acquired”47

Section 15A(a)(i) provides for the methods of acquisition for purposes of the section to be “won or in any other way acquired”. The Collins Concise Dictionary defines “win” as “to extract (ore, coal, etc.) from a mine or (metal or other minerals) from ore”.

The phrase “in other manner acquired” read together with the word “won” concerning the methods of acquisition for purposes of this definition expresses the notion of “all-inclusiveness” by the legislator, not excluding anything as a result of “method of acquisition”; therefore, acquisition of the subject matter by any possible method would be accepted for the purpose of defining the subject matter for this part of the definition. The term “won” is however not defined for purposes of the ITA. As mentioned earlier in the article, this may prove to be problematic, due to the relative complex nature of the processes involved in the process of mining that can be easily confused with a process of manufacturing.

5 3 “taken into account as inventory in terms of South African Generally Accepted Accounting Practice”48

This provision relates to the consideration of the general accepted accounting treatment of the subject matter to be considered once it is established that section 15A does in fact apply. It is important, to note the conjunction “and”, which implies that the first part of the definition (section 15A(a)(i)) needs to be read with section 15A(a)(ii)).

The second part of the definition as per section 15A of the ITA provides for the accounting treatment as prescribed by the General Accepted Accounting practice (GAAP) of the subject matter to drive and determine the classification and treatment for taxation purposes. It is beyond the scope of this article to analyse the detailed provisions for accounting purposes, but the following comments will provide a broad overview of the understanding of the significance of this second part of the section 15a definition.

Section 15A prescribes that the accounting treatment of the subject matter provides the guidance for the classification and treatment for taxation purposes. Therefore, based on the assumption that these stockpiles do in fact meet the criteria of the first part of the definition, the second part then provides for whatever the treatment and classification for accounting purposes are and will be followed for purposes of the tax treatment.

Section 15A(a)(ii) therefore creates a simple and uncomplicated measure to determine the classification for this trading stock, by providing for a similar treatment as has been utilised for accounting. Effectively, this results in a situation where the guidelines and measures that were already available and developed for the classification and measurement of assets for accounting purposes, became applicable and relevant for taxation purposes as well, creating an interdisciplinary (accounting as well as taxation) means for the classification of the subject matter. The formulation of section 15A(a)(ii) provides for valuable guidance on the classification of what would constitute trading stock for the mining industry. The reference to the accounting treatment widens the application of the specific section without creating difficulty where the tax treatment of assets differs from the accounting treatment. The formulation of section 15A(a)(ii) therefore effectively opens this door from a taxation point of view, to access all the established guidelines already existing from an accounting point of view.