Rethinking royalties: New taxes on mining stir debate

Mexico is the world’s largest producer of silver and a top-10 producer of a number of minerals including copper, lead and zinc. Gold, which comprises about one-quarter of Mexican mining production, is the industry’s most important segment. The industry produced about $23bn in 2013 and attracts a significant amount of investment, about 70% of it from abroad. In 2011, total investment was $5.6bn, and in 2012 the figure climbed to more than $7.5bn.

Then & Now

The industry has been booming since 1990, when mining was opened to foreign investment. For most of the almost 25 years since, Mexico has had one of the world’s most competitive fiscal regimes for mining: companies were only required to pay corporate income tax and implement profit-sharing with workers. There were no mining royalties. This has changed. Beginning in the first quarter of 2013, Congress discussed plans for adding a royalty to mining earnings or revenue. The initial proposal was a 5% levy on earnings. Later in the year, however, this plan was rolled into a more wide-ranging fiscal reform. As part of that package, the proposed royalties took the form of a 7.5% tax on mining earnings before interest, taxes, depreciation and amortisation (EBITDA) and a 0.5% tax on revenue from operations in precious metals.

The reform also introduced a tax that serves as a sanction for any concession that goes unexplored or undeveloped for two years. The new royalties are higher than those in many countries in the region.

Market Reaction

These taxes raised more than a few eyebrows in the industry and even produced some belligerent talk of closing operations in Mexico. As the fiscal reform was being debated in 2013, several of the biggest mining companies operating in Mexico, including Grupo México and Goldcorp, threatened to divert planned investments to other countries should the new taxes be introduced. For the most part, that kind of talk was to be expected and was considered straightforward and legitimate lobbying against the planned new tax. Grupo Mé xico said it would be “obliged to redirect” $5.4bn of planned investment in infrastructure to countries with “stable tax regimes that stimulate the mining industry”. Goldcorp, too, said it might divert billions of dollars of investment. Yet the fiscal reform passed, with the new mining taxes included.

The markets, predictably, reacted by pulling back. Shares in North American mining companies fell. Some companies, such as Argonaut Gold, saw a double-digit drop in their stock prices, although it should be pointed out that falling commodities prices were also partly responsible for the decline.

In November 2013, Rosalind Wilson, head of the Canadian Chamber of Commerce’s mining task force in Mexico, told than half of the money Mexico raised on the Toronto Stock Exchange was marked for mining in Latin America. In the first eight months of 2013, however, as companies anticipated the new taxes, the figure dropped to 18%. “Mexico is completely pricing itself out of the market,” she said.

Moving Up A Tier

With its complete lack of royalties, Mexico had been one of the most competitive options for mining investment. The new taxes of up to 8%, however, have moved Mexico to the upper tiers of fiscal expense. According to José Martínez Gómez, president of the Association of Mining Engineers, Metallurgists and Geologists of Mexico, the country was one of the most competitive locations for mining in the Americas. Before the new taxes it was less expensive than Canada, Peru and Chile – all competitors for foreign investment dollars. After the reform, Mexico leapfrogged all of these countries in terms of fiscal expense. “The total tax burden puts Mexico on par with jurisdictions such as Peru from a tax perspective,” Christos Doulis, analyst at Stonecap Securities, wrote in a note to clients reported by Canada’s we classify such jurisdictions as high tax regimes.”

Palm Readings

Even within Mexico, some have raised doubts whether the new mining taxes will increase revenue in the long run. The new royalties, which were implemented on January 1, 2014, came at a time of falling prices for gold and other commodities. Falling revenues would depress the share for the government anyway, even before the new tax was introduced, because the corporate income tax would be less. One fear expressed by some analysts was that the new taxes could prompt some mines to close until commodities prices rebound.

If investment is, in fact, diverted away from Mexico as some operators have threatened, the country could lose out on growth in mining from which it would otherwise have benefitted. The government could hence wind up with a bigger piece of a smaller pie. “In Mexico, we are killing the goose that lays the golden egg,” Manuel Molano, an economist at the Instituto Mexicano de la Competitividad, told OBG. “By taxing the productive sectors, such as the new royalties on mining activity, the government will keep existing miners paying taxes, but it is hard to see any new capital flowing into that activity.”

The Flip Side

Yet the assessment is far from one sided and not all have predicted a significant downturn. Trevor Turnbull, director of gold and precious metals at Scotiabank, told BNA mericas, a Latin America business news outlet, that the new taxes would not be a significant deterrent to investment. Miners still consider Mexico a good place to work, he said, with favourable regulations and an experienced workforce. He estimated that the net effect of the new taxes on operators’ cash flow (after taxes) will be around 4-5% – not enough to prompt big projects to change horses mid-stream. “If there is a drop in investment,” he said, “it is going to be metal-price-related rather than royalty-related.”

It is also hard to say to what extent the threats of companies such as Grupo México and Goldcorp are real. Did their statements before the bill’s passage represent true contingency plans? Or were they merely gamesmanship, designed to influence the legislation that might hurt margins but not deter operations, while fiscal reforms were being debated? Either theory seems plausible.

In the end, the reform’s consequences for investment will have to be evaluated throughout 2014 and 2015. There could be an uptick in production as companies divert resources away from exploration and towards extracting from existing mines, Martínez told OBG. He says the government has held up robust production as evidence that the new taxes are not hurting the industry, but that this may not be a correct interpretation of the facts. “The government can keep saying that there hasn’t been an impact and, indeed, production has increased,” Martínez said. “But it may be a case of operators thinking, ‘I’ll produce faster, recover my investment, then leave.’”

The government naturally sees the situation in an entirely different light. The royalty tax is based on successful models in Canada, Peru, Chile and Australia where royalties are directed to communities, an operation seen as essential to avoiding conflict. At the same time, Mexico is obviously keen to promote its advantages over other mining locations.

An article published by ProMéxico in February 2014 quoted Karina Rodríguez Matus, a partner at mining legal specialists PS&RM Abogados, as saying, “Generally speaking, the current mining law stimulates the development of the mining industry, since it only regulates the essential aspects of mining concessions and grants significant freedom to stakeholders, within the framework of a regulatory state.”

This freedom is also reflected in the fact that private corporations can be funded, the article continues, with up to 100% foreign investment and that overseas entities can hold 100% of the concession rights on a given piece of land. “Acquiring a mining concession is straightforward, with concessions granted on a first come, first served basis (there is no bidding process). Mining concessions, which are issued for 50 years, can be sold and transferred freely but they can also be returned to the government before that period is over without incurring any penalty,” the article says.

Challenge

Not all views concur and, indeed, a legal challenge may yet be made. In the same month that Rodríguez Matus was talking the industry up, for example, a memo by Santamarina y Steta, a Mexican law firm, suggested several arguments that could be used to challenge the taxes on constitutional grounds. Several mining companies were said to have prepared to file an official challenge to the taxes. The legal argument against them hinges on the fact that the taxes are levied on EBITDA, not earnings before interest and taxes, thus severely curtailing the extent to which mining investments may be used as deductions against the royalty.

In addition, the sanction for leaving concessions in disuse, thinks Santamarina y Steta, may also be unconstitutional. The debate is clearly far from over.