Court of Justice of Mongolia Declares that SouthGobi Sands and Three of Its Former Employees are Guilty of Tax Evasion

SouthGobi Firmly Rejects and Will Appeal What It Considers To Be a Gross Miscarriage of Justice
HONG KONG, CHINA--(Marketwired - Feb. 1, 2015) - SouthGobi Resources Ltd. (TSX:SGQ)(HKSE:1878) ("SouthGobi" or the "Company") announced on January 7, 2015, that the Company had been informed that the re-investigation by the State Investigation Agency into alleged violations of Mongolian taxation law against three (3) former employees of SouthGobi Sands LLC ("SGS"), the Company's Mongolian subsidiary, and against SGS as "civil defendant" had been completed and that the case had been transferred back to the Second District Criminal Court of Justice for trial. Further detail in respect of the tax investigations can be found in section 6 "Regulatory issues and investigations" of the Company's Management Discussion and Analysis ("MD&A") for the three months ended September 30, 2014, which is available atwww.sedar.com.
The trial commenced on January 28, 2015. On January 30, 2015, the panel of appointed judges from the Second District Criminal Court of Justice found the three (3) former employees guilty of tax evasion and gave sentences ranging from 5 years and 6 months to 5 years and 10 months of imprisonment in the correctional facilities of strict regimen in Mongolia.
Although SGS was not a party to the criminal proceedings and was not allowed to call witnesses in its own defence, the Court declared it to be financially liable as a "civil defendant" for a penalty of MNT35.3 billion (approximately US$18.1 million). The Company is awaiting written reasons for the Court's judgment. The Company has been advised that the penalty would only be payable after a final appeal.
Notwithstanding the intention to file appeals by SGS and its three (3) former employees, the Company understands that under Mongolian law the former employees will not be granted bail after the Court's sentence and have been remanded into custody.
President and CEO Mr. Enkh-Amgalan Sengee said "We are extremely disappointed by the Court's decision. The conclusions reached by the experts as highlighted in their report presented to the Court are erroneous and there is a complete lack of evidence to support this harsh verdict. We fully support our former employees and will lodge an immediate appeal against the Court's decision".
BACKGROUND AND ANALYSIS
SGS and its former employees Messrs. Justin Kapla, Hilarion Cajucom Jr. and Cristobal David have been subject to various investigations with regards to allegations of breaching Mongolia's taxation laws for the past thirty months. Since October 2012, these persons have been prevented from leaving Mongolia under Mongolia's Law on the Legal Status of Foreign Citizens. The experts appointed by the relevant authorities in Mongolia have issued in total four reports (one report after each series of investigations). These reports have all been different and contradicted one another in terms of content and final sums of purported tax evasion. The conclusions contained in the experts' reports are neither supported by nor consistent with Mongolian tax law or international accounting standards utilized by reputable Mongolian and international firms. The Company believes that the inconsistencies are manifest when considering the systematic changes in the sums of alleged tax evasion from one report to another. For example, the total amount alleged in the latest report dated December 2014 is MNT35.3 billion, i.e.:
  • 85% lower compared to the amount alleged in the second experts' report dated December 2012 (MNT234 billion); and
  • 59% lower compared to the amount alleged in the third experts' report dated January 2014 (MNT84.9 billion).
These inconsistencies and errors in the experts' reports were recognized by the same panel of appointed judges from the Second District Criminal Court of Justice in August 2014, who at that time, viewed the Prosecutor's accusations as lacking evidence and ordered the case be returned for re-investigation. The fourth and latest experts' report resulting from this re-investigation was presented to the Court on January 28, 29 and 30, 2015. It appears that this report contains the same information and errors as the three previous reports although the amount of alleged tax evasion had been reduced. The Company believes that the latest report, like the previous reports, fails to provide any evidence supporting the case against SGS and its former employees.
The Company, including SGS, has prepared its financial statements in compliance with International Financial Reporting Standards ("IFRS"), and lodged all its tax returns as required under Mongolian tax law. For the period under investigation, i.e. between 2007 and 2011, the Company earned revenues of MNT456.8 billion (US$349.7 million) from coal sales and paid MNT103.1 billion (US$79.7 million) in taxes in Mongolia. The amounts of purported tax evasion, when added to the taxes already paid by SGS, would mean the Company's tax rate as a percentage of revenue (not profit) would be 74%, 41% and 30% respectively. This would be grossly above the amounts prescribed to be paid on taxable income under Mongolian law.
During the investigative period, the Company requested that one of the largest and most reputable international auditing firms conduct an independent assessment of the allegations raised through the investigations. The auditing firm concluded that the experts' reports had no basis and were the result of incomplete reviews and erroneous interpretation of a mining company's financial statements prepared in accordance with Mongolian accounting and reporting standards and Mongolian tax laws. The auditing firm also concluded the experts had failed to consider all relevant information and documents provided by the Company during the investigations. To illustrate the confusion and lack of support for the experts' conclusions presented by the Prosecutor to the Court in the hearings of January 28, 29 and 30, 2015, the Company notes, by way of example:
  1. The experts' report alleges that SGS falsely increased its accounts payable balance in order to reduce its taxable income. This claim amounts to 70% of the overall tax evasion penalty recommended by the experts (MNT 24.3 billion out of MNT35.3 billion). This increase in the payable balance relates almost exclusively to unrealized foreign exchange losses which arose on MNT968.9 billion (US$693.9 million) in investments made into SGS by its parent company, SouthGobi Resources Limited, in US Dollar and translated into MNT. The loss itself resulted from the depreciation of the MNT against the US Dollar over the period being investigated. This significant investment made by the Company was for the development of the mining resource in the South Gobi region, directly for the benefit of the Mongolian economy. The Company notes that this investment is precisely the type of investment that Mongolia is currently trying to attract from overseas investors.
Under Mongolian tax law, unrealized foreign exchange losses cannot be used to reduce taxable income. SGS has precisely followed this regulation as shown in its tax statements that are available to the public and never deducted the foreign exchange losses from its taxable income in its tax filings. SGS is also required to file separately statutory financial statements with the Ministry of Finance of Mongolia. These statutory financial statements need to be done, by law in Mongolia, in accordance with IFRS. Under IFRS, unlike under Mongolian tax law, SGS is required to reduce its income by unrealized foreign exchange losses. The experts have therefore confused tax accounting rules with IFRS accounting rules that are used for statutory financial statements.
In order to assist the experts in understanding the difference between IFRS and tax accounting rules in Mongolia for the calculation of taxable income, SGS prepared and provided reconciliation statements to various experts and authorities throughout the investigation. The Company believes that the experts have failed to properly evaluate and assess the validity of the reconciliation statements.
  1. As another example, the experts' report claimed that the Company should have paid value added tax ("VAT") on goods allegedly "transferred to other parties free of charge". These goods described in the experts' report are (i) mobile equipment owned by SGS and destroyed by an accidental fire at the mine site; (ii) fixed assets that are fully depreciated and still held at the mine site; (iii) equipment relating to expired exploitation requirements and still held at the mine site; and (iv) cash donations paid by SGS to local communities, including donations that contributed to the construction of a kindergarten. Paying VAT on these items, including donations, is strictly prohibited under the law on VAT in Mongolia.
The General Tax Law of Mongolia outlines precisely the process and which authorities should be responsible for the resolution of tax disputes. The Company has enquired and not received any explanation as to why this case is being treated as a criminal case as opposed to a civil case. Consequently, the Company disputes both the process as well as the conclusions of the investigations that led to the accusations and verdict against SGS and its three (3) former employees. No new evidence was presented during the latest Court hearing and the Company firmly considers these allegations were not proven.
In addition, the Company notes that the Prosecutor's recommended sentence on January 29, 2015 against the three (3) former employees excluded imprisonment. On January 30, 2015, the Prosecutor amended the recommended sentence to then include imprisonment. The Company is currently seeking legal advice and clarification on this matter.
The Company has not committed tax evasion and will absolutely appeal the Court's verdict. It will continue to vigorously defend itself and support its three (3) former employees in the appeal process.
POTENTIAL IMPACT ON THE COMPANY
The Company has cash of US$3.3 million at January 30, 2015 which excludes restricted cash of US$1.2 million held in Mongolia. The consequences for the Company from the verdict relating to the tax investigations are uncertain. If the verdict is not reversed on appeal, the Company is likely to be unable to meet its obligations, which could result in voluntary or involuntary insolvency proceedings involving the Company as discussed under the heading "Risk Factors" in the MD&A issued on November 10, 2014 and available on SEDAR atwww.sedar.com.
About SouthGobi
SouthGobi is listed on the Toronto and Hong Kong stock exchanges, in which Turquoise Hill Resources Ltd. ("Turquoise Hill"), also publicly listed in Toronto and New York, has a 47.9% shareholding. Turquoise Hill took management control of SouthGobi in September 2012 and made changes to the board and senior management. Rio Tinto has a majority shareholding in Turquoise Hill.
SouthGobi is focused on exploration and development of its metallurgical and thermal coal deposits in Mongolia's South Gobi Region. It has a 100% shareholding in SouthGobi Sands LLC, Mongolian registered company that holds the mining and exploration licences in Mongolia and operates the flagship Ovoot Tolgoi coalmine. Ovoot Tolgoi produces and sells coal to customers in China.

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