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A new 5-percent mining royalty tax passed by the Mexican Congress in April is sending a chill through the country’s mining sector, especially in light of the recent pullback in precious metals prices.

Mexico, an important destination for mining and exploring for gold and silver, is one of the few mining jurisdictions left in the world that does not charge a royalty on mining production or profits. Instead, companies pay fees based on the number of hectares covered by mining concessions; they also pay 30-percent income tax. However, last year, Mexico’s newly elected president, Enrique Pena Nieto, and his Institutional Revolutionary Party, promised a number of proposed overhauls to Latin America’s second-largest economy; mining reform was among the changes.

The royalty scheme is also part of a larger effort for Mexico to “broaden its tax take,” which, according to Reuters, is the lowest in the 34-nation Organization for Economic Co-operation and Development. Its competitors — Peru, Brazil and Chile — have already implemented royalty regimes.

Under terms of the bill, which still has to be passed by the Mexican Senate, a percentage of miners’ pre-tax profits would be redistributed to the states and municipalities where they operate. The royalty is expected to raise between US$250 million and $500 million a year.

Mining companies push back

While the royalty is obviously good news for Mexico’s tax coffers, foreign mining companies are crying foul. It is estimated that 70 percent of mining companies operating in Mexico are Canadian, and most of those are at the costly exploration stage. Some are saying that the tax is unfair because they already pay a hidden “security tax” to guard against drug-related crime.

“The mining industry is under attack,” Keith Neumeyer, the CEO of Canadian silver miner First Majestic Silver (NYSE:AG,TSX:FR), told Reuters, noting that the company spends about 10 percent of its annual budget on security costs. “We have armed guards around all of our mines; 10 years ago we didn’t have any security. It’s just the cost of doing business in Mexico. We have no choice.” He said First Majestic has slashed its 2013 Mexico investment budget by more than 15 percent, to $160 million, citing falling metals prices, the new tax and the cost of guarding its assets and workforce, according to Reuters.

Another Canadian CEO, Bradford Cooke of Endeavour Silver (NYSE:ESK,TSX:EDR), predicts that foreign mining companies will cut their investments in Mexico in half due to the “double whammy” of the 5-percent royalty and the recent crash in gold and silver prices. In an interview with BNamericas, Cooke recommended that the Mexican government either allow for “deduction of capital investments” from the royalty or “deduction of the royalty from corporate income tax.” ”This would keep the door open for new capital investments into the mining sector in Mexico,” he stated.

Is 5-percent royalty a game changer?

While the royalty tax would probably not be a significant deterrent for large mining companies operating in Mexico such as Industrias Peñoles (OTC Pink:IPOAF), Grupo México (BMV:GMEXICOB) and Minera Frisco (OTC Pink:MSNFY), the tax could hurt smaller operators. Haywood Securities analyst Stefan Ioannou was quoted as saying that any figure higher than 4 percent ”may start to squeeze” companies with more marginal mines or projects.

“If you are a producer, if you have mines and mills already built, you are not going to stop because the government wants a bit more money,” Ioannou told BNamericas.

Constitutional challenge expected

At this point, questions are still being asked about whether changes could be made to the royalty tax, or even whether it will go through at all. Bruce Bragnagnolo, CEO of Vancouver-based precious metals miner Timmins Gold (TSX:TMM), said in a conference call earlier this month that opposition from major Mexican mining companies could mean amendments to the bill. ”I would guess there will be something of a pushback on royalties,” he said in the call, noting that a study is currently underway to determine how the royalty will affect Mexico’s competitiveness.

Even if the bill is passed into law, it may still be subject to legal challenges, although one expert believes it would be upheld.

“At that point the courts may determine the changes to the law [relating to the royalty] are unconstitutional,” Jorge Ruiz, partner at law firm Baker McKenzie, told BNamericas. He added, however, that while the royalty could be adjusted up or down, he has “no doubt” it will become law.

Investors with holdings in Mexico-focused companies should not be unduly alarmed by this latest example of “resource nationalism;” royalty payments are a cost of doing business for most mining companies. However, it is also apparent that implementation of the royalty will take away some competitive advantage from Mexico, which has up to now enjoyed a reputation as one of the lowest-cost mining jurisdictions in the world. As companies struggle to control costs in this new reality of falling metals prices, that is an advantage that the Mexican government should not squander unless it is demonstrated that the benefits of the tax — measured by higher tax revenues and community buy in — clearly outweigh its costs, which could add up to a flight of foreign investment from the mining sector to lower-cost jurisdictions.


Securities Disclosure: I, Andrew Topf, hold no direct investment interest in any company mentioned in this article.